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Understanding Products and Their Risks

Investors can choose from a wide menu of securities, each with its own claim on a company or borrower and its own reward-and-risk profile. This chapter surveys equity, debt, packaged products, and options, then classifies the main risks every investor faces.

Equity Securities

Equity represents ownership in a corporation. Common stock carries voting rights and unlimited upside, while preferred stock trades that flexibility for a fixed dividend and a higher claim if the company is liquidated.

Common stock
Ownership shares that usually carry voting rights and may pay variable dividends, with the lowest priority claim in bankruptcy.
Preferred stock
Pays a fixed dividend and ranks ahead of common in liquidation, but typically lacks voting rights and limited price appreciation.
Rights and warrants
Rights let existing shareholders buy new shares at a discount for a short window; warrants are longer-term certificates to buy stock at a set price.
ADRs
American Depositary Receipts let U.S. investors hold foreign company shares that trade in dollars, carrying currency risk.

Debt Securities

A bond is a loan from the investor to a corporation or government that promises interest and repayment of principal at maturity. Issuers range from companies to the U.S. Treasury, federal agencies, and state and local governments.

Bond basics
The issuer pays periodic interest (the coupon) and returns the face value at maturity; bondholders are creditors, not owners.
Government and agency debt
U.S. Treasury securities are backed by the full faith and credit of the government; agency securities carry slightly higher yield and risk.
Municipal bonds
Issued by states and localities, their interest is often exempt from federal income tax, making them attractive to higher-bracket investors.
Ratings
Rating agencies grade credit quality from investment grade down to speculative (high-yield or junk); lower ratings demand higher yields.

Yield and Price Relationship

A bond's price and its yield move in opposite directions, a core idea tested throughout the exam. When market interest rates rise, existing bonds with lower coupons become less attractive and their prices fall.

Inverse relationship
As interest rates rise, bond prices fall; as rates fall, bond prices rise.
Premium and discount
A bond priced above face value trades at a premium; below face value it trades at a discount.
Yield to maturity
The total return an investor earns holding a bond to maturity, factoring in coupon, price paid, and time remaining.

Packaged Products

Packaged products pool investors' money to provide instant diversification and professional management. They vary in how they trade, how they charge fees, and whether the portfolio is actively managed or fixed.

Mutual funds and share classes
Open-end funds price once daily at net asset value; share classes (A, B, C) differ mainly in how and when sales charges are paid.
Investment Company Act of 1940
ETFs
Exchange-traded funds hold a basket of securities but trade throughout the day like a stock, usually with low expenses.
UITs
Unit investment trusts hold a fixed portfolio for a set term and do not actively trade their holdings.
Annuities and REITs
Annuities are insurance contracts that can provide lifetime income, while REITs pool capital to invest in income-producing real estate.

Options Basics

An option is a contract giving its holder the right, but not the obligation, to buy or sell a security at a fixed price before expiration. Options let investors hedge existing positions or speculate with limited upfront cost.

Calls and puts
A call gives the right to buy at the strike price; a put gives the right to sell at the strike price.
Buyer vs. writer
The buyer pays a premium for the right, while the writer (seller) receives the premium and takes on the obligation if exercised.
Hedging vs. speculation
Options can protect a portfolio against adverse moves or magnify gains and losses through leverage.

Types of Investment Risk

Every investment carries risk, and the exam expects candidates to name and distinguish the main categories. A key distinction is whether a risk affects the whole market or only a single holding.

Market and interest-rate risk
Market risk is the chance that prices fall broadly; interest-rate risk is the danger that rising rates lower the value of existing bonds.
Credit and liquidity risk
Credit risk is that an issuer defaults; liquidity risk is being unable to sell an asset quickly without a steep price cut.
Inflation risk
Also called purchasing-power risk, it is the danger that rising prices erode the real value of fixed returns.
Systematic vs. unsystematic
Systematic risk affects the entire market and cannot be diversified away; unsystematic risk is specific to one company or sector and can be reduced by diversifying.
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Last updated: July 2026

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