NASAA Series 65 — All Questions

Which feature distinguishes preferred stock from common stock?

• a.Common stock has a stated par-based dividend that must be paid
• b.Preferred dividends fluctuate with company profits
• c.Preferred stock typically pays a fixed dividend and has priority over common in liquidation✓
• d.Preferred stockholders always have voting rights on corporate matters and are entitled to elect the entire board of directors each year

Preferred stock generally pays a fixed dividend and ranks ahead of common stock for dividends and in liquidation, though it usually lacks voting rights. Common stockholders normally vote but receive dividends only after preferred holders. Preferred dividends do not vary with profits like common dividends can.

A bond is trading at a premium to par. Which relationship is true?

• a.The current yield and yield to maturity are lower than the coupon rate✓
• b.The coupon rate equals the yield to maturity and both are identical to the bond's current yield at a premium
• c.The bond must be in default and its issuer must have already stopped making scheduled coupon payments
• d.The yield to maturity is higher than the coupon rate which would also push the current yield above the stated coupon rate

When a bond trades above par (at a premium), its yield to maturity is below its coupon rate, and current yield falls between the two. Bonds trade at a premium when market rates fall below the coupon. A discount bond, by contrast, has a yield to maturity above the coupon.

Duration is best described as a measure of which of the following?

• a.The bond's credit rating quality as assigned by the major rating agencies to reflect the issuer's default risk
• b.A bond's price sensitivity to changes in interest rates✓
• c.The number of years until a bond matures, exactly regardless of the size or timing of the coupon payments received
• d.The total coupon income a bond will pay over its entire life until the final stated maturity date arrives

Duration measures how sensitive a bond's price is to interest rate changes; a longer duration means greater price movement for a given rate change. It is expressed in years but is not simply the maturity. Credit quality and total coupon income are separate concepts.

If interest rates rise, what generally happens to the price of an outstanding fixed-rate bond?

• a.The bond automatically converts to a floating rate
• b.The price falls✓
• c.The price is unaffected because the coupon is fixed
• d.The price rises proportionally with rates

Bond prices move inversely to interest rates, so when rates rise, existing fixed-rate bond prices fall. This inverse relationship is a core principle of fixed income. Longer-duration bonds fall more sharply than shorter-duration bonds for the same rate increase.

A bond with a 5% coupon and $1,000 par is purchased for $800. What is its current yield?

• a.4.00%
• b.8.00%
• c.6.25%✓
• d.5.00%

Current yield equals annual coupon income divided by market price, or $50 divided by $800, which equals 6.25%. Because the bond trades at a discount, the current yield exceeds the 5% coupon rate. Current yield ignores any gain realized at maturity.

An open-end investment company (mutual fund) sells and redeems its shares at which price?

• a.A price negotiated between buyer and seller on an exchange during a continuous intraday auction held throughout the trading session
• b.The previous day's closing market price
• c.The net asset value per share, calculated at the next computed valuation✓
• d.A fixed price set at the fund's inception

Open-end mutual fund shares are bought and redeemed based on net asset value (NAV) computed at the next valuation point, a practice known as forward pricing. They are not traded between investors on an exchange. Closed-end funds, by contrast, trade at market prices that may differ from NAV.

Which statement about exchange-traded funds (ETFs) is accurate?

• a.ETFs are redeemed only once per day at net asset value at a price always exactly equal to its net asset value
• b.ETFs trade throughout the day on an exchange at market prices✓
• c.ETFs are prohibited from tracking an index and may not be structured to follow any published market benchmark
• d.ETFs cannot be bought on margin or sold short and may only be traded a single time each day after the market closes

ETFs trade intraday on exchanges at market-determined prices, unlike open-end mutual funds that transact at end-of-day NAV. Many ETFs are designed to track an index. Because they trade like stocks, ETFs can generally be bought on margin and sold short.

A U.S. Treasury bond differs from a corporate bond in which key respect?

• a.Treasury interest is exempt from all federal, state, and local taxes, leaving the interest completely free of income tax for every holder
• b.Treasury bonds pay no interest
• c.Treasury interest is exempt from state and local income tax but subject to federal tax✓
• d.Treasury bonds carry higher default risk

Interest on U.S. Treasury securities is subject to federal income tax but exempt from state and local income taxes. Treasuries are backed by the full faith and credit of the U.S. government and carry minimal default risk. Corporate bond interest is generally taxable at all levels.

Interest paid on most general obligation municipal bonds is generally treated how for federal tax purposes?

• a.Subject to a mandatory 20% federal withholding
• b.Exempt from federal income tax✓
• c.Taxed at the long-term capital gains rate
• d.Fully taxable as ordinary income at the federal level

Interest on most municipal bonds is exempt from federal income tax, which makes them attractive to investors in higher tax brackets. This tax advantage means municipal yields are often compared on a taxable-equivalent basis. Capital gains on munis, however, can still be taxable.

A call option gives the holder which right?

• a.The right to buy the underlying asset at the strike price✓
• b.The right to sell the underlying asset at the strike price
• c.The obligation to buy the underlying asset at the market price
• d.The obligation to sell the underlying asset at the strike price

A call option grants its holder the right, not the obligation, to buy the underlying asset at a fixed strike price before expiration. A put option, by contrast, grants the right to sell. The option writer, not the holder, takes on an obligation.

An investor who buys a put option is generally expressing which market view?

• a.Bearish on the underlying asset✓
• b.Expecting no change in volatility
• c.Bullish on the underlying asset
• d.Neutral, seeking only income

Buying a put gives the right to sell at the strike price, which becomes valuable if the underlying asset's price falls, reflecting a bearish outlook. Puts can also hedge a long position. A call buyer, by contrast, is typically bullish.

A fixed annuity differs from a variable annuity primarily because a fixed annuity:

• a.Places investment risk on the contract owner rather than placing that investment risk on the issuing insurer
• b.Provides returns tied to separate account subaccounts whose value fluctuates daily with the performance of the securities markets
• c.Guarantees a stated rate of return with the insurer bearing investment risk✓
• d.Is regulated as a security requiring a prospectus that must be delivered to every purchaser before the sale is completed

A fixed annuity guarantees a set rate of return, and the insurance company bears the investment risk. A variable annuity's value fluctuates with separate account subaccounts, placing investment risk on the owner and requiring securities registration and a prospectus. That risk shift is the central distinction.

Which of the following best describes a zero-coupon bond?

• a.It pays interest monthly rather than semiannually
• b.It cannot be issued by the U.S. Treasury
• c.It is issued at a discount and pays no periodic interest, maturing at par✓
• d.It pays a higher coupon than comparable bonds and distributes that higher interest to holders every single month

A zero-coupon bond is sold at a deep discount and makes no periodic interest payments, returning full par value at maturity. The investor's return is the difference between the purchase price and par. Treasury STRIPS are a common example of zero-coupon instruments.

A hedge fund is typically offered to which type of investor and under what structure?

• a.Any investor, with daily liquidity and low minimums with full daily liquidity and no restrictions on who may invest
• b.Accredited or qualified investors through a private, less-regulated structure✓
• c.Retail investors through a publicly registered continuous offering that is available at very low minimums to any interested retail buyer
• d.Only government pension plans by statute may invest, and only after a mandatory regulatory approval process

Hedge funds are generally sold through private placements to accredited or qualified investors and are subject to lighter regulation than registered funds. They often use leverage, derivatives, and limited liquidity with lock-up periods. High minimum investments are common, restricting broad retail access.

A real estate investment trust (REIT) must generally distribute what portion of its taxable income to shareholders to maintain favorable tax treatment?

• a.At least 90%✓
• b.Exactly 100% in all cases
• c.No more than 25%
• d.At least 50%

To qualify for pass-through tax treatment, a REIT must distribute at least 90% of its taxable income to shareholders as dividends. This high payout is why REITs are valued for income. REITs let investors gain real estate exposure without directly owning property.

Which bond carries the greatest interest rate risk, all else equal?

• a.A 5-year bond with a high coupon
• b.A 2-year bond with a high coupon
• c.A 30-year zero-coupon bond✓
• d.A 5-year zero-coupon bond

Interest rate risk increases with longer maturity and lower coupons, both of which lengthen duration. A 30-year zero-coupon bond has the longest duration and thus the greatest price sensitivity to rate changes. Shorter maturities and higher coupons reduce that sensitivity.

A convertible bond gives the holder the right to:

• a.Demand early repayment of principal at any time simply by notifying the issuer at any time before maturity
• b.Receive a floating interest rate tied to inflation that resets periodically in line with the consumer price index
• c.Vote on corporate board elections while holding the bond casting one vote for every underlying common share the bond represents
• d.Exchange the bond for a set number of the issuer's common shares✓

A convertible bond can be exchanged for a predetermined number of the issuer's common shares, letting holders participate in stock appreciation. This conversion feature usually allows the issuer to offer a lower coupon. Bondholders do not vote unless and until they convert to stock.

Commercial paper is best described as which of the following?

• a.Short-term, unsecured corporate debt used for near-term financing✓
• b.A perpetual security with no maturity date that continues paying interest to holders indefinitely
• c.A government-guaranteed savings instrument whose principal is fully insured by the government against any default
• d.A long-term corporate bond secured by real estate and secured by a first-mortgage lien on the issuing company's real property

Commercial paper is short-term unsecured corporate debt, typically maturing in 270 days or less, used to fund short-term needs like payroll and inventory. It is a money-market instrument issued at a discount. It is not government guaranteed and carries the issuer's credit risk.

An American Depositary Receipt (ADR) allows a U.S. investor to do which of the following?

• a.Buy U.S. Treasury securities at a discount directly from the Treasury through the depositary receipt facility
• b.Avoid all currency risk on foreign holdings by converting every foreign dividend at a single fixed exchange rate
• c.Hold shares of a foreign company that trade in U.S. markets and dollars✓
• d.Purchase municipal bonds tax-free issued by state and local governments across the country

An ADR is a negotiable certificate representing shares of a foreign company, allowing U.S. investors to trade in dollars on domestic markets. Despite dollar-denominated trading, ADRs still carry currency risk from the underlying foreign shares. They do not involve Treasuries or municipal bonds.

Yield to maturity (YTM) of a bond takes into account which of the following that current yield ignores?

• a.The gain or loss realized as the bond price moves toward par at maturity✓
• b.Only the annual coupon payment stated as a percentage of the bond's current market trading price
• c.Only the bond's face value
• d.The issuer's dividend policy

Yield to maturity reflects the total return if a bond is held to maturity, including coupon income plus any capital gain or loss as the price converges to par. Current yield considers only the coupon relative to price. YTM therefore gives a more complete measure of a bond's return.

A unit investment trust (UIT) differs from a mutual fund primarily because a UIT:

• a.Actively trades its holdings to beat the market through a portfolio manager who selects and trades securities daily
• b.Holds a fixed, unmanaged portfolio with a set termination date✓
• c.Has no defined maturity or termination and continues operating in perpetuity with no set end date
• d.Issues shares that trade only on an exchange at a premium throughout the trading day just like shares of a closed-end fund

A UIT holds a fixed portfolio of securities that is not actively managed and has a predetermined termination date. This contrasts with a mutual fund's actively or passively managed, ongoing portfolio. UIT units are redeemable rather than exchange-traded like closed-end funds.

Which risk is most directly associated with owning a callable bond?

• a.Reinvestment risk is eliminated because the bond can never be called away from the holder before its stated maturity
• b.The bond can never be redeemed early by the issuer under any market or interest-rate conditions
• c.The coupon automatically increases when the bond is called to compensate the holder for having the bond redeemed early by the issuer
• d.The issuer may redeem it early when rates fall, forcing reinvestment at lower yields✓

A callable bond lets the issuer redeem it before maturity, and issuers tend to call bonds when interest rates fall so they can refinance at lower cost. This exposes the investor to reinvestment risk, having to reinvest proceeds at lower prevailing yields. Call features therefore favor the issuer.

A money market fund seeks to maintain which of the following characteristics?

• a.Maximum long-term capital appreciation achieved by investing heavily in growth-oriented equity securities
• b.Exposure to volatile equity securities whose market prices may swing sharply from one day to the next
• c.A stable net asset value, typically $1.00 per share, with high liquidity✓
• d.A guaranteed return insured by the federal government covering both the principal and all accrued interest in full

Money market funds invest in short-term, high-quality instruments and aim to preserve a stable NAV, commonly $1.00 per share, while providing liquidity and modest income. They are not designed for capital appreciation. Although low risk, they are not federally insured like bank deposits.

A futures contract obligates the parties to do which of the following?

• a.Only the buyer is obligated to perform
• b.Only the seller is obligated to perform
• c.Both parties to buy or sell the underlying at a set price on a future date✓
• d.Nothing; it is an option that may be abandoned that either party may simply walk away from at the expiration date

A futures contract is a binding agreement in which both the buyer and seller are obligated to transact the underlying asset at an agreed price on a specified future date. Unlike an option, it cannot simply be abandoned without offsetting the position. Futures are standardized and traded on exchanges.

A high-yield (junk) bond is best characterized by which of the following?

• a.A tax-exempt status for all investors that shelters the bond's interest income from all federal income tax
• b.A guarantee by the U.S. Treasury covering full repayment of principal and interest
• c.A rating of AAA and minimal default risk as assigned by the major credit rating agencies to top-tier issuers
• d.A below-investment-grade credit rating and higher default risk✓

High-yield or junk bonds carry below-investment-grade ratings (below BBB- or Baa3) and compensate investors for greater default risk with higher yields. They are more sensitive to the issuer's financial health and economic conditions. They are neither government guaranteed nor uniformly tax-exempt.

A Guaranteed Investment Contract (GIC) issued by an insurer is most similar in risk profile to which of the following?

• a.A speculative growth stock
• b.A tax-free municipal bond whose interest is fully exempt from both federal and state income tax
• c.A leveraged commodity future
• d.A fixed-income instrument dependent on the insurer's creditworthiness✓

A GIC promises a fixed return over a set period and behaves like a fixed-income instrument, with its safety tied to the issuing insurer's financial strength. It carries credit risk of the insurer rather than market volatility of equities. It is neither speculative nor tax-exempt like a municipal bond.

An investor buys a Treasury bill. How does a T-bill generate its return?

• a.Through semiannual coupon payments credited to the holder every six months until maturity
• b.Through a floating rate reset monthly that adjusts each month with prevailing short-term market interest rates
• c.By paying dividends tied to Treasury earnings that are distributed to all bill holders each calendar quarter
• d.By being purchased at a discount and maturing at face value✓

Treasury bills are short-term securities sold at a discount to face value and pay no periodic interest; the return is the difference between the discounted purchase price and the par value received at maturity. They mature in one year or less. This discount structure distinguishes them from coupon-bearing Treasury notes and bonds.

A closed-end fund is trading at a price below its net asset value. This is described as the fund trading at:

• a.Par value
• b.A premium
• c.Its redemption value
• d.A discount✓

Closed-end fund shares trade on an exchange at a market price that can differ from net asset value; a price below NAV is a discount, and a price above NAV is a premium. Open-end (mutual) fund shares always transact at NAV, so the trap is assuming a fund must trade at NAV.

Class A mutual fund shares are typically characterized by which of the following?

• a.A front-end sales load paid at purchase, often reduced by breakpoints✓
• b.A level load with high ongoing 12b-1 fees and no breakpoints
• c.A back-end contingent deferred sales charge that declines over time
• d.No sales charge ever and the lowest possible 12b-1 fee

Class A shares charge a front-end sales load at purchase but offer breakpoint discounts for larger investments and typically carry lower ongoing 12b-1 fees. Class B shares have a back-end contingent deferred sales charge that declines over time, and Class C shares are level-load with higher 12b-1 fees; those descriptions are the traps.

A mutual fund has $500 million in net assets and annual operating expenses of $6 million. Its expense ratio is closest to:

• a.1.2%✓
• b.2.4%
• c.0.6%
• d.8.3%

The expense ratio equals annual operating expenses divided by net assets: $6 million divided by $500 million equals 0.012, or 1.2%. It represents the yearly cost of owning the fund as a percentage of assets. Reversing the fraction produces the 8.3% trap.

A mutual fund breakpoint provides which benefit to an investor?

• a.A guaranteed minimum return over the holding period paid to the investor no matter how the fund actually performs later
• b.A reduced front-end sales charge for investing a larger dollar amount✓
• c.The elimination of all management fees
• d.Immediate conversion of Class B shares to Class A carried out automatically at no cost to the shareholder

A breakpoint is a discount on the front-end sales charge granted at higher investment levels; a Letter of Intent lets an investor qualify by pledging to reach the amount within 13 months. Failing to alert a client who is near a breakpoint (a 'breakpoint sale') is a prohibited practice. Breakpoints do not touch management fees or guarantee returns.

A warrant differs from a preemptive right primarily because a warrant:

• a.Is issued only by the U.S. Treasury
• b.Obligates, rather than entitles, the holder to buy the shares
• c.Must be exercised within roughly 30 to 45 days of issuance and is distributed to a corporation's existing shareholders at a subscription price set below the current market price
• d.Is a long-term instrument, often attached as a sweetener, allowing purchase of stock at a set price for years✓

A warrant is a long-term right, often lasting years, to buy stock at a fixed price, frequently attached to bonds or preferred stock as a sweetener, with a strike usually above the market price at issuance. A preemptive right is short-term (weeks) and issued to existing shareholders below market, which is the trap in the first option. Warrants entitle but never obligate the holder.

A municipal revenue bond differs from a general obligation (GO) bond because a revenue bond is:

• a.Always exempt from federal and state tax for every investor
• b.Backed by income generated from a specific project or facility rather than by general taxes✓
• c.Guaranteed by the U.S. Treasury
• d.Backed by the full faith, credit, and taxing power of the issuer

A revenue bond is repaid from the revenues of a specific project such as tolls, utilities, or an airport, and is not backed by the issuer's taxing power. A general obligation bond is backed by the issuer's full faith, credit, and taxing power (the trap in the second option) and often requires voter approval. Municipal interest is generally federally tax-exempt but not Treasury-guaranteed.

A Government National Mortgage Association (GNMA / Ginnie Mae) pass-through security is best described as:

• a.A tax-free municipal bond issued by a local housing authority whose interest is exempt from federal income tax and whose principal is separately guaranteed by the U.S. Treasury against any default
• b.A common stock issued by a housing company
• c.A zero-coupon Treasury bond
• d.A security representing an interest in a pool of mortgages that passes through principal and interest, backed by the full faith and credit of the U.S. government✓

A Ginnie Mae pass-through gives investors an interest in a pool of federally insured mortgages, passing through monthly principal and interest, and is backed by the full faith and credit of the U.S. government. Its interest is fully taxable at all levels, and it carries prepayment risk. It is neither a stock nor a tax-free municipal bond.

Treasury Inflation-Protected Securities (TIPS) protect investors against inflation by:

• a.Paying a fixed coupon that automatically rises each year
• b.Guaranteeing investors a fixed 10% real return
• c.Being fully exempt from federal income tax
• d.Adjusting the principal value up or down with changes in the Consumer Price Index✓

TIPS protect against inflation by adjusting their principal with the CPI; the coupon rate is fixed but is applied to the adjusted principal, so the dollar interest paid rises with inflation. The annual increase in principal is taxable even though not received in cash, known as phantom income. TIPS are not tax-exempt and carry no guaranteed 10% return.

A negotiable (jumbo) certificate of deposit differs from an ordinary bank CD because it:

• a.Can only be redeemed at the issuing bank
• b.Has a large face value, often $100,000 or more, and can be traded in the secondary market before maturity✓
• c.Is always fully insured by the FDIC for its entire face value no matter how large, so the holder bears no credit risk from the issuing bank whatsoever
• d.Pays no interest until maturity and cannot be sold

A negotiable (jumbo) CD carries a large denomination, typically $100,000 or more, and unlike an ordinary bank CD it can be sold in the secondary market before maturity. FDIC insurance applies only up to the standard limit, so amounts above that depend on the issuing bank's credit, which is the trap in the second option.

A key characteristic of a direct participation program (DPP), such as a limited partnership, is that it:

• a.Passes income, gains, losses, and deductions through directly to the investors✓
• b.Guarantees investors a fixed annual dividend
• c.Is a highly liquid, exchange-traded security
• d.Is taxed as a separate corporation before making distributions

A direct participation program such as a limited partnership is a flow-through entity: there is no tax at the entity level, and income, gains, losses, and deductions pass directly to the limited partners. DPPs offer limited liquidity and limited liability but no guaranteed return. Corporate-level taxation, the trap in the second option, is exactly what a DPP avoids.

An index mutual fund is designed primarily to:

• a.Outperform its benchmark through active security selection
• b.Replicate the performance of a specified market index at low cost✓
• c.Guarantee a positive return each year
• d.Invest only in tax-free municipal bonds

An index fund passively tracks a benchmark, aiming to match rather than beat it, with low turnover and low expenses. Active management, the trap in the first option, tries to outperform through security selection and typically costs more. No fund can guarantee a positive yearly return.

A preemptive right granted to existing common shareholders allows them to:

• a.Receive a guaranteed dividend ahead of preferred holders each quarter, a payment the company is legally obligated to make before it may fund operations or repay any lender
• b.Buy the company's bonds at par before maturity
• c.Purchase newly issued shares to maintain proportional ownership, usually at a subscription price below the current market price✓
• d.Force the company to redeem their shares at book value

A preemptive (subscription) right lets existing holders buy new shares, typically below market, for a short period, preserving their percentage ownership and protecting against dilution. It applies to stock, not bonds, and creates no dividend priority.

A cumulative preferred stock differs from straight (noncumulative) preferred because cumulative preferred:

• a.Accrues any skipped dividends, which must be paid in full before common dividends resume✓
• b.Always carries full voting rights on corporate matters
• c.Pays a dividend that rises automatically with company profits and falls automatically when profits decline, adjusting every quarter
• d.Can be converted into bonds at the holder's option

Cumulative preferred accumulates unpaid dividends in arrears; all arrears must be paid before common shareholders receive anything. Straight preferred does not accumulate missed dividends. Rising-with-profits describes participating preferred, a separate feature.

The distinguishing feature of participating preferred stock is that holders may:

• a.Demand repayment of par value at any time
• b.Convert their shares automatically into debentures each year on a fixed schedule set by the issuer at the time of original issue
• c.Vote for twice as many directors as common holders
• d.Receive extra dividends beyond the stated rate when the company has strong earnings✓

Participating preferred can share in additional dividends above its fixed rate when profits are high, on top of its stated preference. Most preferred is nonparticipating. It does not carry enhanced voting or automatic conversion rights.

A callable preferred stock exposes the investor primarily to the risk that:

• a.The issuer will never be able to redeem the shares, leaving the holder locked into the position until the corporation is eventually dissolved and its assets are liquidated
• b.Dividends will automatically increase over time
• c.The issuer will redeem the shares, often when rates fall, forcing reinvestment at lower yields✓
• d.The shares must be converted into common stock

A call feature lets the issuer redeem preferred, typically after rates decline, creating reinvestment risk for the holder, the same reason issuers call bonds. The call favors the issuer, not the investor, and does not raise dividends.

A convertible bond has a par of $1,000 and is convertible into common stock at $50 per share. If the common stock trades at $60, the conversion (parity) value of the bond is:

• a.$833
• b.$1,000
• c.$1,200✓
• d.$600

The conversion ratio equals par divided by the conversion price: $1,000 divided by $50 equals 20 shares. Parity value equals 20 shares times the $60 stock price, or $1,200. Because parity exceeds par, the conversion feature is in the money.

A bond's yield increases from 4.00% to 4.50%. This is a change of:

• a.0.05 basis points
• b.5 basis points
• c.500 basis points
• d.50 basis points✓

One basis point equals 0.01%, or one one-hundredth of one percent. A move of 0.50% therefore equals 50 basis points. Confusing tenths or whole percents produces the trap answers.

For a bond trading at a discount to par, which ordering of yields is correct?

• a.Coupon rate is greater than current yield, which is greater than yield to maturity
• b.Yield to maturity is greater than current yield, which is greater than the coupon rate✓
• c.Current yield is greater than yield to maturity, which is greater than the coupon rate
• d.All three yields are equal

At a discount, yield to maturity is highest because the investor also gains as the price rises toward par; current yield falls between the coupon and the YTM. The reverse ordering, with the coupon highest, applies to a premium bond.

The nominal yield of a bond refers to:

• a.The fixed coupon (interest) rate stated on the bond as a percentage of par✓
• b.The total return earned if the bond is held to maturity, combining coupon income with any gain or loss realized at final redemption
• c.The annual interest divided by the current market price
• d.The bond's yield after adjusting for inflation

Nominal yield is the stated coupon rate on par value. Annual interest divided by market price is the current yield, and total return to maturity is the yield to maturity; those are the traps. Nominal yield does not adjust for inflation.

A banker's acceptance is best described as a money-market instrument that:

• a.Pays a variable dividend tied to bank profits
• b.Represents an ownership interest in a pool of residential mortgages and passes through monthly principal and interest to its certificate holders
• c.Is a short-term time draft used to finance international trade, guaranteed by a bank✓
• d.Is a long-term unsecured corporate bond

A banker's acceptance is a short-term, bank-guaranteed time draft that facilitates import and export trade, trading at a discount in the money market. It is not a mortgage security, a long-term bond, or an equity instrument.

In a repurchase agreement (repo), a dealer:

• a.Sells securities and agrees to buy them back later at a slightly higher price, effectively a short-term collateralized loan✓
• b.Permanently sells securities with no obligation to repurchase them, transferring full title to the buyer so the dealer keeps no further claim of any kind once the initial sale settles
• c.Lends stock to a short seller for an indefinite term
• d.Issues new equity shares to the public

A repo is a short-term financing tool: the dealer sells securities and repurchases them shortly after at a higher price, and the difference is the implied interest. It is a common, collateralized money-market transaction, not a permanent sale.

Eurodollars are best defined as:

• a.Shares of European companies traded on U.S. exchanges in the form of dollar-denominated depositary receipts held in trust
• b.U.S. dollar-denominated deposits held in banks outside the United States✓
• c.U.S. Treasury bonds that may be sold only in Europe
• d.The common currency used across the European Union

Eurodollars are U.S.-dollar deposits held at banks outside the United States; a Eurodollar bond is a dollar bond sold outside the U.S. The euro prefix denotes location, not the euro currency, which is the trap.

A U.S. Treasury note is a government security that:

• a.Has an original maturity longer than 30 years
• b.Has an original maturity of more than 1 year up to 10 years and pays semiannual interest✓
• c.Matures in one year or less and is sold only at a discount, never carrying a stated coupon rate of any kind
• d.Pays no interest and is fully exempt from federal tax

Treasury notes mature in more than one year up to ten years and pay semiannual coupons. T-bills mature in one year or less at a discount, and T-bonds run beyond ten years; those are the traps. Treasury interest is federally taxable.

Treasury STRIPS are best described as:

• a.Floating-rate notes whose coupon resets with the CPI
• b.Municipal bonds that have lost their tax exemption
• c.Short-term discount instruments maturing in about 90 days that the Treasury auctions weekly and rolls over automatically at each maturity date
• d.Zero-coupon securities created by separating a Treasury bond's interest and principal payments✓

STRIPS separate a Treasury's coupon and principal into individually tradable zero-coupon pieces sold at a discount and maturing at face value. They generate taxable phantom income annually even though no cash interest is received.

Which statement about federal agency securities is accurate?

• a.Government-sponsored agencies are prohibited from issuing mortgage-backed securities, so all mortgage pools in the market are instead assembled and sold directly by the U.S. Treasury
• b.Securities of GSEs such as Fannie Mae and Freddie Mac are not directly backed by the full faith and credit of the Treasury, unlike GNMA✓
• c.Agency securities are always exempt from federal income tax
• d.All agency securities carry the full faith and credit of the U.S. government

GNMA (Ginnie Mae) carries the full faith and credit of the U.S. government, but government-sponsored enterprises like Fannie Mae and Freddie Mac carry only implied backing, so they yield slightly more for the added credit risk. Agency interest is generally taxable.

A debenture is a corporate bond that is:

• a.Secured by a specific parcel of real estate
• b.Backed only by the general credit and good faith of the issuer, with no specific collateral✓
• c.Guaranteed by the U.S. government
• d.Secured by equipment such as railcars or aircraft, giving holders a direct lien on that rolling stock ahead of every other creditor of the company

A debenture is unsecured debt backed solely by the issuer's creditworthiness. Mortgage bonds pledge real property and equipment trust certificates pledge equipment; those secured options are the traps. Debentures are not government guaranteed.

A collateralized mortgage obligation (CMO) is best described as a security that:

• a.Is a tax-free municipal housing bond
• b.Represents common stock in a homebuilding company whose share price rises and falls with the pace of new residential construction nationwide each quarter
• c.Is a single mortgage on one commercial property
• d.Divides the cash flows from a pool of mortgages into tranches with different maturities and risk profiles✓

A CMO repackages the cash flows from a pool of mortgages into tranches that receive principal in sequence, distributing prepayment and interest-rate risk differently across tranches. It is neither a single mortgage nor an equity or municipal security.

Under the Investment Company Act of 1940, the three classifications of investment companies are:

• a.Hedge funds, private equity funds, and REITs
• b.Open-end funds, closed-end funds, and ETFs only, the only three structures the Investment Company Act of 1940 recognizes by name
• c.Broker-dealers, banks, and insurance companies
• d.Face-amount certificate companies, unit investment trusts, and management companies✓

The Act defines three types: face-amount certificate companies, unit investment trusts, and management companies, the last of which includes open- and closed-end funds. Hedge funds and REITs are not classifications under the 1940 Act.

For a management company to call itself diversified under the Investment Company Act of 1940 (the 75-5-10 test), with respect to 75% of its assets it must ensure that:

• a.No more than 5% is in any one issuer and it owns no more than 10% of any issuer's voting securities✓
• b.It may place all assets into a single issuer
• c.It invests only in U.S. Treasury securities
• d.It holds at least 75 different bonds at all times drawn from at least ten separate industry sectors, with none exceeding a single year to maturity

The 75-5-10 rule requires that, for 75% of assets, no more than 5% be invested in any single issuer and no more than 10% of any one issuer's voting shares be held. The remaining 25% of assets is unrestricted.

A mutual fund has total assets of $100 million, total liabilities of $2 million, and 4.9 million shares outstanding. Its net asset value (NAV) per share is:

• a.$20.41
• b.$0.49
• c.$20.00✓
• d.$2.04

NAV per share equals net assets divided by shares outstanding: ($100 million minus $2 million) divided by 4.9 million equals $98 million divided by 4.9 million, or $20.00. Liabilities must be subtracted before dividing.

Under FINRA rules, the maximum sales charge on the purchase of an open-end mutual fund is:

• a.8.5% of the public offering price✓
• b.5% of net asset value
• c.There is no maximum
• d.12% of total fund assets

FINRA caps mutual fund sales charges at 8.5% of the public offering price, and the full 8.5% is allowed only if the fund offers breakpoints, rights of accumulation, and reinvestment of distributions at NAV. The charge is figured on the POP.

An open-end fund has a net asset value of $9.20 per share and a maximum sales charge of 8%. Its public offering price (POP) is:

• a.$8.46
• b.$10.00✓
• c.$9.94
• d.$9.20

POP equals NAV divided by (1 minus the sales charge percentage): $9.20 divided by 0.92 equals $10.00. The sales charge is figured on the POP, not the NAV, so simply adding 8% of NAV to reach $9.94 is the trap.

A 12b-1 fee charged by a mutual fund is:

• a.A charge assessed only when shares are redeemed
• b.A one-time front-end sales load paid at purchase
• c.An annual fee deducted from fund assets to cover distribution and marketing costs✓
• d.A performance bonus paid directly to the portfolio manager out of the fund's assets whenever the fund outperforms its benchmark index that year

A 12b-1 fee is an ongoing annual charge against fund assets for distribution, marketing, and sometimes shareholder servicing. A fund charging more than 0.25% generally may not call itself no-load. It is not a front-end or back-end sales charge.

Class B mutual fund shares are typically characterized by:

• a.No fees or charges of any kind
• b.A contingent deferred sales charge that declines the longer the shares are held, often converting to Class A over time✓
• c.A front-end sales load paid at the time of purchase, assessed as a fixed percentage of the amount invested and never reduced by breakpoints or rights of accumulation
• d.A mandatory performance fee each year

Class B shares carry a back-end contingent deferred sales charge that decreases over the holding period and usually convert to lower-cost Class A shares after several years. A front-end load describes Class A shares, which is the trap.

During the pay-in (accumulation) phase of a variable annuity, an investor's contributions purchase:

• a.Accumulation units, whose number varies as contributions are made while their value fluctuates with the separate account✓
• b.Shares of a fixed, guaranteed interest account only
• c.Whole life insurance cash value
• d.Annuity units that fix the size of the monthly payout for the remainder of the contract, a number established the day the first premium is paid and never revised thereafter

Contributions buy accumulation units during the pay-in phase; at annuitization these convert to a fixed number of annuity units whose value then varies with separate-account performance to determine each payment. The two unit types serve different phases.

In a variable annuity, if the separate account's actual return exceeds the assumed interest rate (AIR), the next monthly annuity payment will:

• a.Increase relative to the prior payment✓
• b.Decrease relative to the prior payment
• c.Remain fixed for the life of the contract
• d.Fall to zero

Payments rise when actual performance exceeds the AIR, stay level when it equals the AIR, and fall when it lags the AIR. The AIR is a benchmark used to set payments, not a guaranteed return.

An equity-indexed annuity (EIA) credits interest based on:

• a.A guaranteed flat 10% annual return
• b.The prime rate set by commercial banks
• c.The performance of a stock index, subject to features such as a participation rate and a cap, with a guaranteed minimum✓
• d.The daily net asset value of an underlying mutual fund, so the annuity's credited interest changes continuously throughout each trading session just as a mutual fund's price does

An EIA is a fixed annuity that links credited interest to an index such as the S&P 500 but limits gains through participation rates and caps, while guaranteeing a minimum return. It is generally not registered as a security.

Compared with term life insurance, whole life insurance:

• a.Fluctuates in value with a separate investment account chosen by the policyholder
• b.Is always cheaper for the same death benefit
• c.Provides coverage only for a set number of years with no savings element
• d.Builds cash value and provides lifelong coverage as long as premiums are paid✓

Whole life offers permanent coverage plus a cash-value component at higher premiums than term. Term provides pure death-benefit protection for a stated period with no cash value, which is the trap. Variable life ties value to a separate account.

A call option with a strike price of $50 is held while the underlying stock trades at $55. The option's intrinsic value is:

• a.$55
• b.$0
• c.$50
• d.$5✓

A call's intrinsic value equals the stock price minus the strike when positive: $55 minus $50 equals $5, so the call is in the money. Any premium above $5 represents time value, not intrinsic value.

An investor buys a call with a $50 strike for a premium of $3. The breakeven price of the underlying at expiration is:

• a.$50
• b.$53✓
• c.$3
• d.$47

Breakeven for a long call equals the strike price plus the premium paid: $50 plus $3 equals $53. The stock must rise above breakeven for the buyer to profit, and the maximum loss is the $3 premium.

Rights of accumulation in a mutual fund allow an investor to:

• a.Count the current value of existing holdings toward reaching a breakpoint on new purchases✓
• b.Cast extra votes at the fund's annual meeting
• c.Convert the open-end fund into an exchange-traded fund at no cost, allowing the shares to trade intraday on a national exchange going forward
• d.Receive a guaranteed dividend each quarter

Rights of accumulation let an investor qualify for a reduced sales charge by adding the value of prior holdings to new investments to reach a breakpoint. Unlike a Letter of Intent, they need not be pledged in advance.

Which characteristic applies to a U.S. Treasury bill?

• a.Its interest is subject to state and local income tax but fully exempt from federal income tax in the hands of every holder
• b.It has an original maturity of 10 to 30 years
• c.It is issued at a discount, matures in one year or less, and pays no periodic interest✓
• d.It pays a fixed semiannual coupon to holders

T-bills mature in one year or less and are sold at a discount, returning par at maturity with no coupons. Like all Treasuries, their interest is federally taxable but exempt from state and local tax, so the state-tax option is the trap.

An equipment trust certificate is a debt security that is:

• a.Guaranteed by the FDIC
• b.Secured by specific physical equipment such as aircraft or railcars owned by the issuer✓
• c.A form of common equity ownership
• d.Backed only by the issuer's general credit with no collateral, ranking equally with the company's ordinary unsecured debentures in a liquidation

An equipment trust certificate is secured by title to specific equipment and is commonly issued by transportation companies, making it a secured bond. A debenture, backed only by general credit, is the unsecured trap.

In a corporate liquidation, a subordinated debenture is paid:

• a.After other general creditors and senior debt, but before preferred and common stockholders✓
• b.Before secured bondholders
• c.At the same time as common stockholders
• d.Before all other creditors of the company, ahead of even secured bondholders and general creditors, because subordinated status grants a first-priority claim

Subordinated debt ranks below senior debt and general creditors but still ahead of equity holders. The liquidation priority runs secured creditors, then senior debt, then general creditors, then subordinated debt, then preferred, then common stock.

A closed-end fund whose shares trade at a market price above net asset value is said to trade at:

• a.A discount
• b.Its redemption value
• c.A premium✓
• d.Par value

Closed-end fund shares trade on an exchange at supply-and-demand prices that can exceed NAV (a premium) or fall below it (a discount). Only open-end fund shares always transact at NAV, so the redemption-value option is the trap.

For a callable bond trading at a premium, the yield figure that assumes the bond is redeemed at the first call date is the:

• a.Current yield
• b.Nominal yield
• c.Tax-equivalent yield
• d.Yield to call✓

Yield to call computes the return if the bond is redeemed at the call date and call price. For a premium callable bond, the yield to call is typically lower than the yield to maturity, and the more conservative of the two is quoted as the yield to worst.

A Series I savings bond issued by the U.S. Treasury earns a return based on:

• a.A single fixed rate locked for 30 years that the Treasury guarantees will always exceed the prevailing rate of inflation
• b.The performance of the S&P 500 index
• c.A combination of a fixed rate and an inflation rate that adjusts with the CPI✓
• d.The prime rate set by commercial banks

Series I savings bonds pay a composite rate combining a fixed rate, constant for the life of the bond, and a semiannually adjusted inflation rate tied to the CPI, protecting purchasing power. Interest is state-tax exempt and federally deferrable until redemption.

A key difference between an exchange-traded fund (ETF) and a traditional open-end mutual fund is that an ETF:

• a.Trades intraday on an exchange at market-determined prices and can be sold short or bought on margin✓
• b.Guarantees that its price equals net asset value at all times, eliminating any possibility of trading at a premium or discount to the underlying holdings
• c.Is prohibited from tracking a market index
• d.Can only be redeemed once per day at net asset value

ETFs trade throughout the day at market prices and, like stocks, can be margined or sold short, whereas open-end mutual fund shares transact only at end-of-day NAV. Many ETFs are designed specifically to track an index.

Unlike a fixed annuity, a variable annuity is:

• a.Backed by the full faith and credit of the U.S. government for both principal and any credited interest, making it entirely free of investment and credit risk
• b.Exempt from securities registration requirements
• c.Regulated as a security requiring a prospectus, because the owner bears the investment risk of the separate account✓
• d.Guaranteed a fixed rate of return by the insurer

A variable annuity's value fluctuates with separate-account subaccounts, placing investment risk on the owner, so it is a security requiring registration and prospectus delivery, and selling it requires securities registration. A fixed annuity shifts risk to the insurer and is not a security.

Four bonds mature in ten years and carry identical credit quality. Which one has the longest duration?

• a.The 8% coupon bond, because its large coupons are reinvested each period
• b.The zero-coupon bond, because the holder receives no cash until maturity✓
• c.The floating-rate note, because its coupon resets with short-term rates
• d.The 5% coupon bond callable in two years at a premium above par value

Duration is the weighted average time until a bond's cash flows are received. A zero-coupon bond has only one cash flow, at maturity, so its duration equals its maturity of ten years, the maximum available in this group. Coupon bonds return cash sooner, which pulls duration below maturity, and the higher the coupon the shorter the duration. A floating-rate note reprices at each reset, so its interest-rate duration is very short.

A bond portfolio has a modified duration of 7. If market yields rise by one percentage point, the portfolio's value is expected to:

• a.Decline by approximately 7%✓
• b.Decline by approximately 0.7%
• c.Increase by approximately 7%
• d.Increase by approximately 1%

The duration approximation is: percentage price change is roughly the negative of modified duration multiplied by the change in yield. Here that is -7 x 1.00% = -7%. On a $1,000,000 portfolio the estimated loss is about $70,000. Prices and yields move inversely, so a rate increase must produce a price decline, and duration tells you how large it should be.

Convexity in a bond portfolio describes the fact that:

• a.The price-yield relationship is curved rather than a straight line✓
• b.Credit spreads always widen when the general level of rates rises
• c.Coupon income is reinvested at a constantly increasing interest rate
• d.Duration and maturity are identical for every fixed-coupon security

Duration is a straight-line estimate, but the actual price-yield curve bends. With positive convexity, a bond gains more when yields fall than it loses when yields rise by the same amount, so duration alone understates gains and overstates losses. That curvature matters most for large rate moves and for long-duration bonds.

Under widely used rating scales, the lowest rating that is still considered investment grade is:

• a.BB+ from Standard & Poor's, or Ba1 from Moody's
• b.A- from Standard & Poor's, or A3 from Moody's
• c.B from Standard & Poor's, or B2 from Moody's
• d.BBB- from Standard & Poor's, or Baa3 from Moody's✓

Investment grade runs from AAA/Aaa down through BBB-/Baa3. The first rung below that line, BB+/Ba1, begins the speculative or high-yield tier. The distinction is not cosmetic: many fiduciary and institutional mandates prohibit holding below-investment-grade paper, so a downgrade across the line can force selling.

A sinking fund provision in a bond indenture requires the issuer to:

• a.Repurchase its own common shares whenever the bonds trade below par
• b.Set aside money each year to retire portions of the issue before maturity✓
• c.Pledge specific plant and equipment as collateral for the outstanding debt
• d.Increase the stated coupon rate whenever its credit rating is downgraded

A sinking fund forces the issuer to accumulate cash and redeem a portion of the bonds on a schedule. That reduces default risk near maturity, which is why sinking fund bonds usually yield slightly less than comparable bonds without one. The trade-off for the investor is that a specific bond may be called away early through the sinking fund draw.

A put feature attached to a corporate bond benefits the investor most when:

• a.Interest rates fall, because the issuer must then increase the stated coupon
• b.Inflation declines, because the principal amount is adjusted upward yearly
• c.Interest rates rise, because the bond can be sold back to the issuer at par✓
• d.The issuer's rating improves, because the bond will be called at a premium

A put bond lets the holder force redemption at par on set dates. When rates rise, an ordinary bond falls in price, but the put holder can hand the bond back at par and reinvest at the new higher rates, so the put limits the downside. A call feature is the mirror image and benefits the issuer when rates fall.

A Treasury note is quoted at 99-16. For a bond with $1,000 par value, the dollar price is:

• a.$991.60
• b.$1,001.60
• c.$995.00✓
• d.$999.16

Government notes and bonds are quoted in points and 32nds of a point. The '16' means 16/32, which is 0.50 of a point, so the quote is 99.50% of par: 0.9950 x $1,000 = $995.00. Reading the digits after the hyphen as cents or as hundredths is the classic trap in this question type.

A long-term U.S. Treasury bond held to maturity by an investor is generally:

• a.Free of purchasing power risk but exposed to reinvestment risk
• b.Free of both default risk and interest rate risk at all maturities
• c.Free of interest rate risk but fully exposed to default risk
• d.Free of default risk but fully exposed to interest rate risk✓

Treasuries carry the full faith and credit of the U.S. government, so credit or default risk is treated as negligible. They are not risk-free in a broader sense: a long-maturity Treasury has substantial duration, so its market price falls when yields rise, and its fixed coupons lose real value if inflation accelerates. Treasury interest is taxable federally but exempt from state and local income tax.

Which date determines the shareholders who are entitled to receive a declared cash dividend?

• a.The settlement date of the investor's most recent purchase
• b.The payable date, on which the distribution is actually made
• c.The declaration date, on which the board announces the dividend
• d.The record date, on which the issuer identifies its shareholders✓

The board declares a dividend on the declaration date, fixes a record date, and pays on the payable date. Only holders on the issuer's books as of the record date receive the payment. The ex-dividend date is the market convention that identifies when a buyer no longer purchases the right to that dividend, and the stock's price typically adjusts downward by roughly the dividend amount on that day.

Cumulative voting for directors differs from statutory voting because cumulative voting allows a shareholder to:

• a.Cast one vote per share for every candidate standing for election that year
• b.Carry unused votes forward and apply them at the next annual meeting
• c.Vote a number of shares greater than the number actually owned by them
• d.Concentrate all available votes on one or a few candidates for the board✓

Under statutory voting a holder may cast up to one vote per share for each open seat, and votes cannot be shifted between candidates. Cumulative voting pools the same total votes and lets the holder pile them on a single nominee. That is why cumulative voting is described as favoring minority shareholders, who can occasionally elect one director.

An exchange-traded note differs from an exchange-traded fund principally because the note:

• a.Must distribute at least 90% of its net investment income every calendar year
• b.Holds a portfolio of the underlying securities in a segregated custody account
• c.May be redeemed each day at net asset value directly with the sponsoring fund
• d.Is an unsecured debt obligation that exposes the holder to issuer credit risk✓

An ETN is a senior unsecured note that promises the return of an index; it owns no basket of securities. If the issuing bank fails, the investor is a general creditor, so tracking is precise but credit risk is real. An ETF holds actual portfolio assets at a custodian, which is the structural protection an ETN lacks.

A daily leveraged or inverse ETF is generally unsuitable as a long-term holding because:

• a.It resets exposure daily, so compounding causes results to diverge over time✓
• b.It charges no management fee, so the sponsor may terminate it without notice
• c.It pays no dividends, so the entire return is taxed at ordinary income rates
• d.It may be sold only to accredited investors who satisfy net worth standards

These funds are engineered to deliver a multiple of an index's return for ONE day. Because the leverage is rebalanced daily, the path of returns matters: in a volatile but flat market, a 2x fund can lose money even though the index ends where it started. Over months, results can differ sharply from twice the index's cumulative move, which is why they function as short-term trading tools.

A closed-end investment company differs structurally from an open-end fund because a closed-end fund:

• a.Issues a fixed number of shares that afterward trade between investors✓
• b.May not use leverage or issue any senior securities under any condition
• c.Issues new shares continuously and redeems them at net asset value
• d.Must invest at least 75% of its assets in U.S. government securities

A closed-end fund raises capital once in a public offering, after which the share count is essentially fixed and shares change hands on an exchange at whatever price supply and demand set, often a discount or premium to net asset value. An open-end fund continuously issues and redeems at net asset value. Closed-end funds may also use leverage, which open-end funds are largely restricted from doing.

Class C mutual fund shares are generally characterized by:

• a.A deferred load declining over six years and later conversion to Class A
• b.No front-end load, a higher ongoing 12b-1 fee, and a short contingent charge✓
• c.A front-end sales load, lower annual expenses, and breakpoint discounts
• d.No sales charge of any kind, with all fund costs paid by the sponsor

Class C is the level-load share: the investor pays nothing up front, a contingent deferred sales charge usually applies only for about the first year, and the annual 12b-1 fee is comparatively high. That makes Class C relatively cheap for a short holding period and expensive for a long one. Class A charges the front-end load with breakpoints, and Class B is the long-declining deferred load that converts to Class A.

Under the forward pricing rule, an order to purchase open-end mutual fund shares received at 2:00 p.m. is executed at:

• a.The net asset value that is next computed after the order is received✓
• b.The average net asset value over the five preceding business days
• c.The market price at which the fund's shares last changed hands
• d.The net asset value computed at the close of the prior business day

Open-end funds do not trade intraday. Rule 22c-1 under the Investment Company Act of 1940 requires that purchase and redemption orders be priced at the next net asset value calculated, normally at the close of that trading day. Forward pricing exists to stop investors from buying at a stale price they already know is favorable.

Compared with a listed equity REIT, a non-traded REIT typically exposes an investor to:

• a.Lower total fees, because no selling compensation is ever paid to brokers
• b.Less credit risk, because federal deposit insurance covers the shareholders
• c.Greater liquidity risk, because the shares are not listed on an exchange✓
• d.Greater interest rate risk, because it may hold only variable-rate debt

A non-traded REIT has no secondary market, so an investor generally must wait for a limited share repurchase program or a liquidity event that may be years away. Front-end selling and organizational costs are typically higher, not lower, and no federal insurance applies. Liquidity and valuation opacity are the central suitability concerns an adviser must address.

A mortgage REIT generates most of its income from:

• a.Management fees charged to outside investors in its affiliated funds
• b.Capital gains realized on the sale of commercial buildings it develops
• c.Rental payments collected from the tenants of properties that it owns
• d.The spread between interest earned on mortgage assets and its borrowing cost✓

An equity REIT owns buildings and collects rent. A mortgage REIT owns mortgage loans and mortgage-backed securities, borrows short, lends long, and earns the net interest spread. That leaves it far more sensitive to changes in interest rates and to prepayment behavior than a typical equity REIT.

Universal life insurance differs from traditional whole life insurance primarily because universal life:

• a.Provides pure protection for a stated term with no cash value component
• b.Invests all cash value in separate account subaccounts chosen by the owner
• c.Allows the owner to vary premium payments and to adjust the death benefit✓
• d.Requires a level premium for life and guarantees a fixed cash value schedule

Universal life unbundles the policy: within limits the owner may pay more, pay less, or skip a premium, and may raise or lower the death benefit subject to underwriting. Whole life uses a fixed level premium and guaranteed cash values. Investing the cash value in separate account subaccounts describes variable life, and term insurance builds no cash value at all.

For a given annuitant and account value, which annuity settlement option produces the largest monthly payment?

• a.Life only, because payments cease at the annuitant's death✓
• b.Installment refund, because any unused principal is repaid
• c.Life with 20-year period certain, because payments are guaranteed
• d.Joint and last survivor, because payments cover two lives

The insurer sizes each payment against how long it expects to pay. Life only (straight life) carries no guarantee to anyone after the annuitant dies, so the expected payout period is shortest and each check is largest. Every added guarantee, whether a second life or a certain period, lengthens the expected obligation and lowers the payment. Life only also carries the greatest risk of forfeiture for the annuitant's heirs.

An investor age 50 takes a partial withdrawal from a nonqualified deferred annuity that has grown above its cost basis. The withdrawal is generally:

• a.Taxed as ordinary income on the earnings first, plus a 10% penalty✓
• b.Treated entirely as a tax-free return of the owner's after-tax basis
• c.Excluded from gross income because annuity contracts are tax-exempt
• d.Taxed as a long-term capital gain on the full amount withdrawn

Nonqualified annuity withdrawals follow last-in, first-out ordering: earnings are deemed distributed before the after-tax principal. Those earnings are ordinary income, never capital gain, and because the owner is under age 59 1/2 an additional 10% penalty applies to the taxable portion. Basis comes out tax-free only after the earnings have been exhausted.

The exclusion ratio applied to payments from an annuitized nonqualified annuity determines:

• a.The share of the separate account invested in fixed-income subaccounts
• b.The maximum commission an agent may receive on the initial purchase
• c.The portion of each payment treated as a tax-free return of cost basis✓
• d.The percentage of the contract that may be surrendered without a charge

When a nonqualified annuity is annuitized, each payment is part return of the owner's after-tax investment and part taxable earnings. The exclusion ratio is the investment in the contract divided by the expected total return, and it fixes the tax-free fraction of every payment. Once total basis has been recovered, later payments become fully taxable as ordinary income.

Section 1035 of the Internal Revenue Code permits a contract owner to:

• a.Exchange one annuity contract for another without current tax on the gain✓
• b.Convert a nonqualified annuity into a Roth IRA entirely free of income tax
• c.Withdraw annuity earnings before age 59 1/2 without any penalty tax at all
• d.Deduct nonqualified annuity premiums from current-year gross income

A 1035 exchange lets an owner move from one life insurance or annuity contract to another of a permitted type without triggering tax on accumulated gain; the old basis carries over. It does not create a deduction, waive the early distribution penalty, or turn nonqualified money into Roth money. Advisers must still weigh new surrender charges and a fresh surrender period before recommending an exchange.

An investor who writes a call option without owning the underlying stock faces:

• a.No meaningful market risk, because the premium is collected up front
• b.An unlimited maximum loss, because the stock price has no upper bound✓
• c.A maximum loss equal to the strike price multiplied by 100 shares
• d.A maximum loss limited to the premium received when the option was sold

The uncovered (naked) call writer must deliver stock at the strike price no matter how high the market goes, and there is no theoretical ceiling on a share price, so the loss is theoretically unlimited. Writing a call against shares already owned (a covered call) caps the risk, because the shares are available for delivery. The premium received is the writer's maximum gain, not a limit on the loss.

An investor buys a put with a $40 strike price for a $2 premium. The breakeven price of the underlying at expiration is:

• a.$36
• b.$40
• c.$38✓
• d.$42

For a long put, breakeven equals strike minus premium: $40 - $2 = $38. At $38 the put's intrinsic value of $2 exactly offsets the $2 paid, so the position nets zero. Below $38 the buyer profits; above $40 the put expires worthless and the $2 premium is the maximum loss. Strike plus premium ($42) is the breakeven for a long CALL, which is the intended trap.

A forward contract differs from an exchange-traded futures contract because a forward is:

• a.Standardized in size and guaranteed by a central clearing organization
• b.Listed on an organized exchange and marked to market on a daily basis
• c.Privately negotiated and carries the credit risk of the counterparty✓
• d.Required to be settled in cash rather than by physical delivery of goods

Forwards are customized private agreements between two parties, so the terms fit the users but each side depends on the other's ability to perform. Futures are standardized in size, quality, and delivery date, trade on an exchange, and are novated to a clearinghouse that guarantees performance and requires daily mark-to-market variation margin. That counterparty guarantee is the defining difference.

An investor holding a corporate zero-coupon bond in a taxable account must:

• a.Report no income until the bond is sold or reaches its stated maturity
• b.Pay tax only on the coupon payments actually received during the year
• c.Treat the entire gain received at maturity as a long-term capital gain
• d.Report the annual accretion of the discount as taxable interest income✓

A corporate zero pays no cash, but the Internal Revenue Code requires the holder to accrete the original issue discount and report it as interest income each year. Because tax is owed on income never received, this is called phantom income, and it is the reason corporate zeros are often recommended for tax-deferred accounts. Accretion on a municipal zero is generally tax-exempt, following the character of the underlying interest.

A $1,000 par convertible debenture has a conversion price of $40. Its conversion ratio is:

• a.25 shares✓
• b.2.5 shares
• c.4 shares
• d.40 shares

Conversion ratio = par value / conversion price = $1,000 / $40 = 25 shares per bond. Parity (conversion value) is then 25 shares multiplied by the market price of the stock, so at a $44 share price the bond's parity value is $1,100. Conversion is attractive only when parity exceeds the bond's market price.