Series 7 sample questions with answers

• A. A guaranteed quarterly dividend
• B. Repayment of par value before bondholders in liquidation
• C. The right to vote on the election of the board of directors (right answer)
• D. A fixed maturity date when the company buys back the shares

Common shareholders elect the board and vote on major corporate matters such as mergers. Dividends are paid only if the board declares them, so they are never guaranteed. In liquidation, common stock has the last claim, behind creditors, bondholders and preferred stock, and common shares have no maturity date.

Outline point 2.1.1

• A. $6
• B. $12
• C. $18 (right answer)
• D. $24

Cumulative preferred carries forward missed dividends. Each year's dividend is 6% of $100, or $6. Two missed years ($12 in arrears) plus the current year ($6) gives $18 per share before common stockholders can receive anything. The $12 trap forgets the current year's dividend.

Outline point 2.1.1

• A. Settlement risk, because ADRs settle in the foreign market
• B. Currency risk, because the value of the underlying foreign shares depends on exchange rates (right answer)
• C. No additional risk, because the depositary bank guarantees the share price
• D. Interest rate risk only, because ADRs pay fixed coupons

An ADR is a receipt for foreign shares held by a U.S. depositary bank. The dollar price follows the foreign share price converted at the exchange rate, so currency moves affect the investor's value and dividends. Trading in dollars is the trap: it changes the quote currency, not the underlying currency exposure.

Outline point 2.1.1

• A. cast 200 votes for each director only
• B. cast 200 votes in total, split among the three seats
• C. cast only one vote per director
• D. cast 600 votes in any combination, including all 600 for one candidate (right answer)

Cumulative voting multiplies shares by the number of seats (200 x 3 = 600 votes) and lets the holder concentrate them, which helps minority holders elect a director. Casting 200 votes per seat with no concentration is statutory voting, the tempting confusion.

Outline point 2.1.1

• A. 4.00%
• B. 5.00%
• C. 6.25% (right answer)
• D. 8.00%

Current yield is annual interest divided by current market price. The coupon pays 5% of $1,000, or $50 a year; $50 divided by $800 is 6.25%. The 5.00% trap is the nominal (coupon) yield, which is based on par and does not change with price.

Outline point 2.1.2

• A. Yield to maturity, current yield, nominal yield
• B. Nominal yield, current yield, yield to maturity (right answer)
• C. Current yield, nominal yield, yield to maturity
• D. They are all equal

At a discount, the fixed coupon divided by a lower price makes current yield higher than nominal yield, and yield to maturity is higher still because it also counts the gain from the discount price up to par at maturity. At a premium the order reverses, which is what the first choice describes.

Outline point 2.1.2

• A. They pay interest every six months
• B. They are issued with maturities of 2 to 10 years
• C. They are backed only by the revenue of a federal agency
• D. They are sold at a discount and pay face value at maturity, with terms of one year or less (right answer)

T-bills are short-term Treasury obligations with terms from a few weeks up to 52 weeks. They pay no coupon; the investor buys below face value and receives face value at maturity. Semiannual interest and 2 to 10 year terms describe Treasury notes, the most common confusion.

Outline point 2.1.2

• A. zero-coupon securities created from the separate interest and principal payments of Treasury notes and bonds (right answer)
• B. Treasury bonds whose principal adjusts for inflation
• C. floating-rate notes reset weekly
• D. savings bonds sold only to individuals

STRIPS separate each coupon and the principal of a Treasury note or bond into individual zero-coupon securities, each bought at a discount and paying face value at one date. They have no reinvestment risk but are very sensitive to interest rates. Inflation-adjusted principal describes TIPS.

Outline point 2.1.2

• A. The coupon rate is reset monthly to the inflation rate
• B. The principal value is adjusted for changes in the Consumer Price Index, and the fixed coupon rate is applied to the adjusted principal (right answer)
• C. The Treasury pays a bonus at maturity if inflation exceeded the coupon
• D. TIPS are exempt from all federal taxes

With TIPS, the principal is indexed to the CPI; the coupon rate stays fixed but is paid on the adjusted principal, so interest payments rise with inflation. The coupon rate itself does not reset, which is the trap in the first choice. Interest and inflation adjustments are subject to federal income tax.

Outline point 2.1.2

• A. Fannie Mae securities
• B. Freddie Mac securities
• C. Ginnie Mae securities (right answer)
• D. Private-label CMOs

Ginnie Mae is a government corporation within the Department of Housing and Urban Development, and its guarantee is backed by the full faith and credit of the United States. Fannie Mae and Freddie Mac are government-sponsored enterprises: their securities carry their own guarantee, not an explicit U.S. government guarantee.

Outline point 2.1.2

• A. Extension risk
• B. Prepayment risk (right answer)
• C. Currency risk
• D. Political risk

Falling rates lead homeowners to refinance, so principal comes back early and must be reinvested at the new lower rates; this is prepayment risk. Extension risk is the opposite case: when rates rise, prepayments slow and the security's expected life lengthens.

Outline point 2.1.2

• A. the full faith, credit and taxing power of the issuing government (right answer)
• B. revenue from a specific facility such as a toll road
• C. the U.S. Treasury
• D. a letter of credit from a commercial bank

GO bonds are secured by the issuer's general taxing power (for example property taxes for local governments) and often need voter approval. A specific facility's user fees back a revenue bond, which is the main confusion. Bank letters of credit are a credit enhancement some issues add, not the basic security of a GO bond.

Outline point 2.1.2

• A. general obligation bonds
• B. special assessment bonds
• C. moral obligation bonds
• D. revenue bonds (right answer)

Revenue bonds are repaid from the income of the financed project, here landing fees and rents, rather than taxes. A special assessment bond is repaid from a levy on the specific properties that benefit from an improvement, such as sidewalks, which is the closest distractor.

Outline point 2.1.2

• A. Exempt from federal income tax and from State A income tax
• B. Exempt from federal income tax but possibly taxable by State A (right answer)
• C. Taxable at the federal level but exempt in State A
• D. Taxable at both levels

Interest on most municipal bonds is excluded from federal gross income. States, however, usually exempt only interest on their own bonds, so a resident of State A buying State B bonds generally owes State A tax on the interest. Assuming double exemption for an out-of-state bond is the trap.

Outline point 2.1.2 · Internal Revenue Code Section 103

• A. Interest rates have risen since the bonds were issued
• B. Interest rates have fallen, so it can refinance at a lower cost (right answer)
• C. The bonds are trading at a deep discount
• D. Its credit rating has been downgraded

Issuers call bonds when rates drop, replacing expensive debt with cheaper debt. For the investor this creates call risk and reinvestment risk, since the money comes back when rates are low. When rates rise and bonds trade at a discount, an issuer would rather buy them back cheaply in the market than pay the call price.

Outline point 2.1.2

• A. a higher coupon, because conversion is a risk to the investor
• B. the same coupon and a higher credit rating
• C. a lower coupon, because the conversion feature has value to the investor (right answer)
• D. no coupon at all

Investors accept a lower interest rate in exchange for the right to convert into common stock and share in its upside. The conversion feature costs the issuer less in interest, not more, so the higher-coupon choice reverses the trade-off. Conversion does not change the credit rating.

Outline point 2.1.2

• A. Both prices fall by the same amount
• B. The 3-year bond falls more
• C. Neither price changes until maturity
• D. The 25-year bond falls more (right answer)

Longer-maturity bonds are more sensitive to interest rate changes because the below-market coupon is locked in for more years, so the price must drop further to compensate. Short-term bonds return principal sooner, limiting price changes. This is why long bonds carry more interest rate risk.

Outline point 2.1.2

• A. XYZ 50 call
• B. XYZ 45 put
• C. XYZ 50 put (right answer)
• D. XYZ 47.50 call

A put is in the money when the stock price is below the strike; with XYZ at $47, the 50 put has $3 of intrinsic value. A call is in the money only when the stock is above the strike, so the 50 and 47.50 calls are out of the money, and the 45 put is out of the money because the stock is above $45.

Outline point 2.1.3

• A. $2
• B. $5
• C. $1
• D. $3 (right answer)

Intrinsic value of a call is the stock price minus the strike when positive: $62 minus $60 equals $2. Time value is the rest of the premium: $5 minus $2 equals $3. The $2 trap is the intrinsic value, not the time value.

Outline point 2.1.3

• A. a covered call, which earns premium income but caps the upside (right answer)
• B. an uncovered call with unlimited risk
• C. a protective put
• D. a long straddle

Writing a call against stock already owned is covered: if assigned, the investor delivers the shares held, so there is no unlimited risk. The trade-off is that gains above the strike are given up in exchange for the premium. An uncovered call is written without owning the stock and does carry unlimited risk.

Outline point 2.1.3

• A. Selling an uncovered put
• B. Buying a call
• C. Buying a put on the stock (right answer)
• D. Selling the stock short against the box

A protective put gives the right to sell at the strike, so it sets a floor on the position's value for the cost of the premium while keeping the upside. Selling a put adds downside exposure instead of hedging it, and buying a call adds bullish exposure. Shorting against the box is a different technique with its own tax rules.

Outline point 2.1.3

• A. Open-end shares trade on exchanges at market prices
• B. Closed-end funds continuously issue and redeem shares at NAV
• C. Open-end funds issue a fixed number of shares in a single IPO
• D. Open-end funds continuously issue new shares and redeem them at NAV (right answer)

Open-end (mutual) funds sell new shares and redeem shares on demand at net asset value, so the share count changes daily. Closed-end funds issue a fixed number of shares in an offering, after which shares trade on an exchange at prices that may be above or below NAV. The other choices swap the two structures.

Outline point 2.1.4 · Investment Company Act of 1940, Section 5

• A. $12.00
• B. $12.50 (right answer)
• C. $13.00
• D. $13.50

Net asset value equals total assets minus liabilities, divided by shares outstanding: ($52 million minus $2 million) divided by 4 million equals $12.50. The $13.00 trap divides total assets by the share count without subtracting liabilities.

Outline point 2.1.4

• A. 6.0% (right answer)
• B. 6.4%
• C. 5.6%
• D. 4.0%

Sales charge percentage is computed on the offering price: ($10.00 minus $9.40) divided by $10.00 equals 6.0%. The 6.4% trap divides the $0.60 load by the NAV instead of the POP, which is not how mutual fund sales charges are expressed.

Outline point 2.1.4 · FINRA Rule 2341

• A. Class C shares, because they have no front-end load
• B. Class B shares, because the deferred charge eventually disappears
• C. Class A shares, because breakpoints reduce the front-end load and ongoing 12b-1 fees are lower (right answer)
• D. Any class, because total costs are identical

Class A shares charge a front-end load that falls at breakpoints for larger purchases and usually carry lower ongoing 12b-1 fees, so they often cost least for large, long-term investors. Class C shares avoid the upfront load but charge higher annual fees every year, which add up over a long holding period.

Outline point 2.1.4

• A. Letter of intent
• B. Rights of accumulation (right answer)
• C. Exchange privilege
• D. Conversion privilege

Rights of accumulation let the value of existing holdings (here $40,000) count toward the breakpoint for a new purchase, so the $15,000 purchase brings her to $55,000 and qualifies for the lower charge. A letter of intent is a commitment about future purchases over a set period, typically 13 months, not credit for shares already held.

Outline point 2.1.4 · FINRA Rule 2341

• A. may still be described as no-load
• B. must be called a closed-end fund
• C. may not be described as no-load (right answer)
• D. is prohibited from charging the fee

A fund may be called no-load only if it has no front-end or deferred sales charge and its asset-based sales and service charges do not exceed 0.25% of average net assets per year. At 0.50%, the fund fails the test. The fee itself is allowed; it just limits how the fund can be marketed.

Outline point 2.1.4 · FINRA Rule 2341(d)

• A. Tax free, because premiums were paid with after-tax money
• B. As return of premium first, with no tax until all premiums are recovered
• C. As long-term capital gain
• D. Earnings come out first as ordinary income, plus a 10% additional tax because the owner is under 59½ (right answer)

Partial withdrawals from a nonqualified annuity are treated as coming from earnings first, taxed as ordinary income, and before age 59½ an additional 10% tax generally applies to the taxable part. Only after earnings are exhausted does the after-tax cost basis come out tax free. Annuity gains are never capital gains.

Outline point 2.1.4 · Internal Revenue Code Section 72

• A. The beneficiary, once the beneficiary turns 18
• B. The account owner (right answer)
• C. The state treasurer
• D. The college the beneficiary attends

The account owner, often a parent or grandparent, keeps control of a 529 account: choosing investments, timing withdrawals and naming or changing the beneficiary. Unlike an UTMA custodial account, the assets do not pass to the beneficiary at the age of majority, which is the trap in the first choice.

Outline point 2.1.5

• A. The earnings portion is taxable income and generally subject to a 10% additional tax (right answer)
• B. The entire withdrawal, including contributions, is taxed and penalized
• C. The withdrawal is tax free because contributions were after tax
• D. Only a state penalty applies

In a nonqualified 529 withdrawal, contributions come back tax free because they were made with after-tax money, but the earnings portion is included in income and generally hit with a 10% additional tax. Taxing the whole amount is the trap: contributions are never taxed a second time.

Outline point 2.1.5 · Internal Revenue Code Section 529

• A. The program pays corporate income tax and then distributes dividends
• B. Taxes are paid by the general partner only
• C. Income, gains, losses and deductions flow directly to the partners, who report them on their own returns (right answer)
• D. Distributions are always tax free

A limited partnership is not taxed at the entity level; each partner reports a share of the income, losses and deductions, avoiding double taxation. Paying corporate tax and then distributing dividends describes a C corporation, the opposite structure. Distributions can be taxable depending on the partner's basis.

Outline point 2.1.6

• A. The general partner has limited liability and no management role
• B. The general partner manages the business and has unlimited liability for its debts (right answer)
• C. The general partner may never invest in the partnership
• D. The general partner's role is to provide capital only

The general partner runs the partnership and carries unlimited liability. Limited partners provide capital, have liability limited to their investment, and lose that protection if they take part in management. The first and last choices describe the limited partner's position, which is the usual mix-up.

Outline point 2.1.6

• A. passes its losses through to shareholders
• B. pays corporate tax on all income before distributions
• C. avoids corporate-level tax on the income it distributes (right answer)
• D. must invest only in mortgages

A qualifying REIT deducts the dividends it pays, so income distributed to shareholders is not taxed at the corporate level; shareholders pay tax on the dividends. A REIT is not a partnership, so losses do not pass through to investors, which is the trap in the first choice.

Outline point 2.1.7 · Internal Revenue Code Section 857

• A. mortgage REIT (right answer)
• B. equity REIT
• C. hybrid REIT
• D. real estate limited partnership

Mortgage REITs hold real estate debt and earn interest, so they are sensitive to interest rates and credit. Equity REITs own properties and earn rents, and hybrid REITs combine both. A limited partnership is a different structure with pass-through of losses.

Outline point 2.1.7

• A. They are registered investment companies sold to any retail investor
• B. They must keep their portfolios fully liquid
• C. They are prohibited from using leverage or short selling
• D. They are usually limited to accredited or other qualified investors and often impose lock-up periods (right answer)

Private hedge funds are usually offered through private placements to accredited or other qualified investors, often set high minimum investments, are commonly organized as limited partnerships, and may lock up capital. They frequently use leverage, short selling and derivatives, so the prohibition in the third choice is wrong.

Outline point 2.1.8

• A. Both are priced once a day at NAV
• B. ETF shares trade continuously at market prices, while mutual fund orders are filled at the next computed NAV (right answer)
• C. ETFs are priced weekly
• D. Mutual funds trade at market prices that may differ from NAV

ETFs trade on exchanges throughout the day like stocks, at market prices that are usually close to but may differ from NAV. Open-end mutual fund orders receive forward pricing at the next NAV calculated, typically after the close. The last choice confuses mutual funds with closed-end funds or ETFs.

Outline point 2.1.9 · SEC Rule 22c-1

• A. Market risk
• B. Liquidity risk
• C. Credit risk of the issuing institution (right answer)
• D. Inflation risk

An ETN is an unsecured debt obligation of its issuer, usually a bank, promising a return linked to an index; if the issuer defaults, holders may lose money even if the index rises. An ETF owns the underlying securities, so it does not carry that issuer credit exposure. Market risk applies to both.

Outline point 2.1.9

• A. Systematic (market) risk
• B. Interest rate risk
• C. Purchasing power risk
• D. Non-systematic (company-specific) risk (right answer)

Non-systematic risk comes from events specific to one company or industry, such as a failed product, and diversification spreads it away. Systematic risk affects the whole market, so holding more stocks does not remove it; it is managed with hedging or asset allocation instead.

Outline point 2.2

• A. Credit risk
• B. Inflation risk
• C. Reinvestment risk (right answer)
• D. Liquidity risk

A zero-coupon bond pays no periodic interest, so there are no coupons to reinvest at uncertain future rates; the return is locked in if held to maturity. Credit and liquidity risk remain, and a fixed nominal payment far in the future is fully exposed to inflation risk.

Outline point 2.2

• A. 10%
• B. 15% (right answer)
• C. 5%
• D. 20%

Total return includes both income and price change: ($44 minus $40 plus $2) divided by $40 equals $6 divided by $40, or 15%. The 10% trap counts only the price gain and ignores the dividend income, and 5% counts only the dividend yield.

Outline point 3.1.2

• A. 150 shares with a cost basis of $40 per share (right answer)
• B. 150 shares with a cost basis of $60 per share
• C. 100 shares with a cost basis of $40 per share
• D. 66 shares with a cost basis of $90 per share

A 3-for-2 split gives 3 shares for every 2 held: 100 x 3/2 = 150 shares. Total cost basis stays at $6,000, so the per-share basis becomes $6,000 / 150 = $40. A split is not a taxable event; it changes the number of shares and the per-share basis but not the total.

Outline point 3.1.4

• A. Three years, the first year easily accessible
• B. Four years
• C. Six years, the first two years in an easily accessible place (right answer)
• D. Permanently

Rule 17a-4 requires blotters, ledgers and certain other core records to be preserved for at least six years, the first two in an easily accessible place. Many other records, such as order tickets and communications, must be kept for at least three years. Four years applies to FINRA's written complaint records.

Outline point 3.2.4 · SEC Rule 17a-4

• A. At or before the completion of the transaction (right answer)
• B. Within 30 days of the trade
• C. Only at the end of the quarter, on the account statement
• D. Only if the customer requests it

FINRA Rule 2232 and SEC Rule 10b-10 require a written confirmation at or before completion of the transaction, which in practice means no later than settlement. Account statements are separate and are sent at least quarterly under Rule 2231.

Outline point 3.2.4 · FINRA Rule 2232; SEC Rule 10b-10

• A. Monthly
• B. Annually
• C. Only when there is trading activity
• D. At least once each calendar quarter (right answer)

FINRA Rule 2231 requires account statements at least once every calendar quarter showing positions, money balances and account activity. Many firms send monthly statements when there is activity, but the rule's minimum is quarterly, so monthly is a firm practice, not the requirement.

Outline point 3.2.4 · FINRA Rule 2231

• A. Any customer with a trusted contact person
• B. Any customer aged 60 or older
• C. Any customer with a margin account
• D. A customer aged 65 or older, or aged 18 or older whom the firm reasonably believes has an impairment preventing self-protection (right answer)

Rule 2165 defines a specified adult as a natural person 65 or older, or 18 or older with a mental or physical impairment that makes the person unable to protect his or her own interests. It lets firms place temporary holds on disbursements when financial exploitation is reasonably suspected.

Outline point 3.3.3 · FINRA Rule 2165

• A. 3.00 to 1
• B. 1.25 to 1
• C. 1.75 to 1 (right answer)
• D. 2.00 to 1

The quick ratio removes inventory, the least liquid current asset: ($6 million minus $2.5 million) divided by $2 million equals 1.75 to 1. The 3.00 to 1 trap is the current ratio, which divides all current assets by current liabilities.

Outline point 3.1

• A. Issuing long-term bonds and keeping the cash (right answer)
• B. Paying off accounts payable with cash
• C. Buying inventory on short-term credit
• D. Declaring a cash dividend payable next month

Working capital is current assets minus current liabilities. Issuing long-term debt adds cash (a current asset) while the new liability is long term, so working capital rises. Paying payables or buying inventory on credit changes both sides equally, and declaring a dividend creates a current liability, reducing working capital.

Outline point 3.1

• A. $2.40
• B. $2.80
• C. $1.60
• D. $2.00 (right answer)

EPS measures earnings available to common stockholders: (net income minus preferred dividends) divided by common shares outstanding = ($12 million minus $2 million) / 5 million = $2.00. The $2.40 trap forgets to subtract the preferred dividends, which must be paid before common shareholders have any claim.

Outline point 3.1

• A. P/E of 15 and dividend payout ratio of 40% (right answer)
• B. P/E of 37.5 and payout ratio of 2.7%
• C. P/E of 15 and payout ratio of 2.7%
• D. P/E of 6.7 and payout ratio of 40%

P/E equals price divided by EPS: $30 / $2.00 = 15. The payout ratio equals dividends per share divided by EPS: $0.80 / $2.00 = 40%. The 2.7% figure is the current yield ($0.80 / $30), a different measure that is easy to confuse with the payout ratio.

Outline point 3.1

• A. $8.00
• B. $5.00 (right answer)
• C. $6.00
• D. $7.00

Net tangible book value per share subtracts intangibles, liabilities and the preferred par from total assets: ($100 minus $5 minus $60 minus $10) million = $25 million, divided by 5 million shares = $5.00. The $6.00 trap keeps the goodwill, and $8.00 ignores both goodwill and the preferred claim.

Outline point 3.1

• A. higher cost of goods sold and lower reported earnings (right answer)
• B. lower cost of goods sold and higher reported earnings
• C. the same earnings, since the method does not matter
• D. higher ending inventory on the balance sheet

Under LIFO, the most recent and more expensive units are treated as sold first, so cost of goods sold is higher, reported profit and taxes are lower, and the older cheaper units remain in inventory. FIFO produces the opposite results when prices rise, which is the trap in the second choice.

Outline point 3.1

• A. $9 million
• B. $10 million
• C. $12 million (right answer)
• D. $20 million

EBIT equals revenue minus cost of goods sold, operating expenses and depreciation: $50 minus $30 minus $8 minus $2 = $10 million. EBITDA adds back depreciation: $10 + $2 = $12 million. The $9 million figure is EBT (after interest), and $10 million is EBIT.

Outline point 3.1

• A. 0.25 times; greater safety
• B. 4 times; greater safety of interest payments (right answer)
• C. 4 times; greater default risk
• D. 18 times; greater default risk

Interest coverage equals earnings available to pay interest (EBIT) divided by annual interest: $24 million / $6 million = 4 times. The more times earnings cover interest, the safer the bond's interest payments. Reading a high coverage ratio as more risk reverses its meaning.

Outline point 3.1

• A. rise about 10%
• B. rise about 4%
• C. fall about 14%
• D. rise about 14% (right answer)

Beta measures sensitivity to market moves: a beta of 1.4 implies the stock tends to move 1.4 times the market, so about 14% in a 10% market rise, and it would be expected to fall more than the market in a decline. Beta measures systematic risk only.

Outline point 3.1

• A. 9.0% (right answer)
• B. 9.6%
• C. 6.0%
• D. 11.0%

CAPM: expected return = risk-free rate + beta x (market return minus risk-free rate) = 3% + 1.2 x (8% minus 3%) = 3% + 6% = 9.0%. The 9.6% trap multiplies the full 8% market return by beta, forgetting that beta applies only to the market risk premium.

Outline point 3.1

• A. beta
• B. standard deviation
• C. alpha (right answer)
• D. Sharpe ratio

Alpha is the return above or below what the portfolio's risk (beta) would predict; positive alpha suggests the manager added value. Beta is the measure of market sensitivity used to compute the expected return in the first place, which is why it is the tempting confusion.

Outline point 3.1

• A. Outstanding shares are 10 million, all with voting rights
• B. Outstanding shares are 9 million; treasury shares have no vote and receive no dividends (right answer)
• C. Outstanding shares are 11 million
• D. Treasury shares receive dividends but cannot vote

Outstanding shares equal issued shares minus treasury shares: 10 million minus 1 million = 9 million. Treasury stock was issued and then reacquired by the company; while held, it carries no voting rights and receives no dividends. The company may later reissue or retire it.

Outline point 3.2

• A. Cumulative
• B. Callable
• C. Adjustable rate
• D. Participating (right answer)

Participating preferred can share in additional dividends beyond its stated rate, alongside common stockholders, when earnings permit. Cumulative preferred only protects missed dividends, adjustable-rate preferred resets the rate to a benchmark, and callable preferred gives the issuer the right to redeem.

Outline point 3.2

• A. Adjustable-rate preferred (right answer)
• B. Straight noncumulative preferred
• C. Convertible preferred
• D. Callable fixed-rate preferred

Adjustable-rate preferred resets its dividend periodically to a benchmark rate, so its yield keeps up with the market and the price stays near par. Fixed-rate preferred behaves like a long-term bond and falls when rates rise. Convertible preferred tracks the common stock, which adds volatility.

Outline point 3.2

• A. $40.00
• B. $36.36
• C. $44.00 (right answer)
• D. $27.50

Conversion ratio = $1,000 / $40 = 25 shares. The bond's market price is 110% of par, or $1,100. Parity stock price = $1,100 / 25 = $44.00: at $44, converting gives the same value as holding the bond. The $40.00 trap is the conversion price, which is fixed by the indenture.

Outline point 3.2

• A. $1.00 (right answer)
• B. $1.20
• C. $6.00
• D. $0.83

Cum rights, the theoretical value is (market price minus subscription price) / (number of rights per share + 1) = ($50 minus $44) / (5 + 1) = $1.00. The $1.20 trap uses the ex-rights formula, which divides by the number of rights (5) without adding 1.

Outline point 3.2

• A. $5
• B. $10
• C. $35
• D. $15 (right answer)

When the value at the date of the gift is at least the donor's basis, the recipient takes the donor's adjusted basis ($20), a carryover basis. His gain is $35 minus $20 = $15 per share, and his holding period includes hers. Using the $30 value at the gift date, the $5 trap, is the rule for inherited property, not gifts.

Outline point 3.2 · Internal Revenue Code Section 1015

• A. $35 short-term gain
• B. $5 long-term gain (right answer)
• C. $5 short-term gain
• D. $35 long-term gain

Inherited property generally receives a basis equal to fair market value at the date of death ($40), so the gain is $45 minus $40 = $5. Gains on inherited property are treated as long-term regardless of how long the heir held it. Using the decedent's $10 cost is the rule for gifts, not inheritances.

Outline point 3.2 · Internal Revenue Code Section 1014

• A. A $1,000 deductible loss now; new basis $28
• B. No deductible loss now; new basis $28
• C. No deductible loss now; the $1,000 loss is added to the new shares, for a basis of $38 per share (right answer)
• D. A $1,000 loss, deductible only against dividends

Buying substantially identical stock within 30 days before or after a loss sale is a wash sale: the loss is disallowed now and added to the basis of the replacement shares, so the basis becomes $28 + $10 = $38 per share. The loss is deferred, not lost, which is the trap in the second choice.

Outline point 3.2 · Internal Revenue Code Section 1091

• A. $7,000 deducted, nothing carried forward
• B. $3,000 deducted, $6,000 carried forward
• C. $2,000 deducted, $5,000 carried forward
• D. $3,000 deducted, $4,000 carried forward (right answer)

Netting gives a $7,000 net capital loss ($9,000 minus $2,000). Up to $3,000 of net capital loss can offset ordinary income each year ($1,500 if married filing separately), and the remaining $4,000 carries forward to future years. The $6,000 trap ignores the netting against the long-term gain.

Outline point 3.2 · Internal Revenue Code Section 1211

• A. 110 shares with a basis of $50 per share; no tax due now (right answer)
• B. 110 shares with a basis of $55 per share; tax due on the 10 new shares
• C. 100 shares with a basis of $50 per share
• D. 110 shares; the 10 new shares have a basis of zero and the rest $55

A regular stock dividend is generally not taxable when received; the total basis of $5,500 is spread over 110 shares, so each share's basis becomes $50. Taxing the new shares or giving them a zero basis are the usual mistakes.

Outline point 3.2 · Internal Revenue Code Section 305

• A. LIFO
• B. First-in, first-out (FIFO) (right answer)
• C. Highest cost
• D. Average cost

For stock, if the investor does not adequately identify the specific shares sold, the IRS treats the earliest acquired shares as sold first (FIFO). Specific identification of high-cost lots could reduce the tax. Average cost is an option available for mutual fund shares and certain other holdings, not the default for individual stocks.

Outline point 3.2 · Treasury Regulation 1.1012-1

• A. An exchange that displays all orders publicly
• B. A market for municipal bonds only
• C. An alternative trading system that matches orders without publicly displaying quotes before the trade (right answer)
• D. An unregistered market for penny stocks

Dark pools are alternative trading systems that let institutions trade large blocks without showing their orders before execution, reducing market impact. They operate under Regulation ATS and executed trades are still reported. ECNs, by contrast, generally display their orders.

Outline point 3.2 · Regulation ATS

• A. Nothing beyond a normal confirmation
• B. Only verbal disclosure of the commission
• C. Approval by FINRA
• D. Delivery of a risk disclosure document, along with other required disclosures such as quotes and compensation (right answer)

SEC penny stock rules require broker-dealers to give customers a standardized risk disclosure document before a first penny stock trade, and to disclose current quotations and broker and salesperson compensation, with monthly statements; non-exempt customers also need a suitability statement and written agreement before the first trade.

Outline point 3.2 · SEC Rules 15g-2 through 15g-9

• A. Both at ordinary income rates
• B. Qualified dividends at the lower long-term capital gains rates; bond interest at ordinary income rates (right answer)
• C. Qualified dividends are tax exempt
• D. Bond interest at capital gains rates; dividends at ordinary rates

Qualified dividends, which require meeting a holding period, are taxed at the preferential long-term capital gains rates, while corporate bond interest is ordinary income. Non-qualified dividends, such as most REIT dividends, are also taxed as ordinary income. Neither is tax exempt.

Outline point 3.2 · Internal Revenue Code Section 1(h)(11)

• A. spinoff (right answer)
• B. tender offer
• C. reverse split
• D. rights offering

In a spinoff, the parent distributes shares of a subsidiary to its own shareholders, creating a separate public company; the parent's cost basis is then allocated between the two holdings. A tender offer is a purchase offer, and a rights offering lets holders buy new shares.

Outline point 3.2

• A. $19.93
• B. $20.00 (right answer)
• C. $19.98
• D. $20.80

Because the sales charge is a percentage of the offering price, POP = NAV / (1 minus sales charge) = $18.80 / 0.94 = $20.00. The $19.93 trap adds 6% to the NAV ($18.80 x 1.06), which understates the price because the load is not calculated on NAV.

Outline point 3.2 · FINRA Rule 2341

• A. The NAV calculated at the previous day's close
• B. The NAV at the moment the order was placed
• C. The next day's NAV
• D. The offering price based on the NAV calculated at that day's 4 p.m. close (right answer)

Rule 22c-1 requires forward pricing: orders are filled at the price based on the next NAV computed after the order is received, here that day's close. Using the prior day's NAV is the old backward-pricing practice that forward pricing was designed to eliminate.

Outline point 3.2 · SEC Rule 22c-1

• A. late trading, which is illegal (right answer)
• B. acceptable forward pricing
• C. market timing, which is always illegal
• D. a breakpoint sale

Orders received after the pricing time must get the next day's NAV. Giving them the same day's price is late trading, which violates Rule 22c-1 and lets the investor profit from news released after the close. Market timing, frequent in-and-out trading, is not illegal in itself but may violate fund policies.

Outline point 3.2 · SEC Rule 22c-1

• A. None, because no sales charge was paid
• B. The exchange is treated as a sale, so any gain or loss on the stock fund shares is taxable (right answer)
• C. Tax is deferred until the bond fund is sold
• D. Only state tax applies

Exchanges within a fund family usually avoid a new sales charge, but for tax purposes the investor sold one fund and bought another, so gain or loss is recognized in the year of the exchange in a taxable account. The absence of a sales charge has nothing to do with the tax result.

Outline point 3.2

• A. As short-term gain because the investor held the fund for four months
• B. As ordinary dividend income
• C. As long-term capital gain, regardless of how long the investor has held the fund (right answer)
• D. It is tax exempt

Capital gain distributions are taxed as long-term capital gains based on the fund's holding period of the securities, not the shareholder's holding period in the fund. The investor's own holding period matters only when the investor later sells the fund shares.

Outline point 3.2 · Internal Revenue Code Section 852(b)(3)

• A. 50%
• B. 75%
• C. 100%
• D. 90% (right answer)

Subchapter M of the Internal Revenue Code lets a fund that qualifies as a regulated investment company and distributes at least 90% of its net investment income avoid tax on what it distributes; shareholders pay the tax instead. This prevents double taxation of fund income.

Outline point 3.2 · Internal Revenue Code Section 852

• A. It offers to repurchase a set percentage of its shares from holders at NAV at scheduled intervals, rather than daily (right answer)
• B. It trades continuously on an exchange
• C. It redeems shares daily like a mutual fund
• D. It invests only in money market instruments

Interval funds are closed-end funds that make periodic repurchase offers, for example quarterly, for a stated portion of their shares at NAV. Shares usually are not listed, so liquidity is limited to those windows. Daily redemption describes an open-end mutual fund.

Outline point 3.2 · SEC Rule 23c-3

• A. The fund must redeem shares at $15.00 on request
• B. The fund trades at a 10% discount to NAV, and a buyer pays the $13.50 market price plus commission (right answer)
• C. The fund trades at a premium
• D. The sales charge is $1.50

Closed-end fund shares trade at prices set by supply and demand, which can be above or below NAV. Here ($15.00 minus $13.50) / $15.00 = 10% discount. The fund does not redeem shares on demand, which is the trap in the first choice, and buyers pay commissions rather than a sales charge.

Outline point 3.2

• A. The dollar amount of each payment is fixed; the number of annuity units varies
• B. Both the payment amount and the number of units are fixed
• C. The number of annuity units is fixed; the value of each unit, and so each payment, varies with separate account performance (right answer)
• D. Both vary every month by law

At annuitization, the accumulation units are converted to a fixed number of annuity units. Each payment equals that fixed number times the current annuity unit value, which changes with subaccount performance relative to the assumed interest rate. A fixed dollar payment describes a fixed annuity.

Outline point 3.2

• A. decrease
• B. stay the same
• C. fall to the minimum guarantee
• D. increase (right answer)

When actual separate account returns exceed the AIR, annuity unit values rise and payments increase; when returns fall below the AIR, payments decrease. A common trap is to think payments fall whenever returns are lower than in an earlier period: what matters is the comparison with the AIR, not with the prior month.

Outline point 3.2

• A. Life only (straight life) (right answer)
• B. Life with 10-year period certain
• C. Joint and last survivor
• D. Unit refund

Straight life pays only as long as the annuitant lives, with nothing to heirs, so the insurer can pay the most each month. Adding guarantees, such as a period certain, a refund or a second life, lowers each payment because the insurer may have to pay longer or pay a beneficiary.

Outline point 3.2

• A. The gain in the old contract is taxed in the year of the exchange
• B. The exchange is not taxable, but a new surrender period and loss of benefits may make it unsuitable (right answer)
• C. Section 1035 applies only to exchanges into mutual funds
• D. No suitability review is required for exchanges

A Section 1035 exchange of annuity contracts defers tax on the gain. FINRA Rule 2330 still requires a careful review because the new contract may restart surrender charges, raise fees or give up living or death benefits, and the firm must consider whether the customer had another exchange recently.

Outline point 3.2 · Internal Revenue Code Section 1035; FINRA Rule 2330

• A. As qualified dividends at capital gains rates
• B. As tax-exempt income
• C. Mostly as ordinary income, because REIT dividends generally do not qualify for the lower qualified dividend rates (right answer)
• D. As return of capital in every case

Because REITs avoid corporate tax on distributed income, their ordinary dividends generally do not count as qualified dividends and are taxed at ordinary income rates. Portions may be designated as capital gain distributions or return of capital, but treating all REIT dividends as qualified is the common mistake.

Outline point 3.2 · Internal Revenue Code Section 857(c)

• A. The tax benefits offered
• B. The general partner's commission
• C. The number of limited partners
• D. The economic soundness of the program (right answer)

A DPP should make economic sense on its own; tax benefits can disappear and do not rescue a program that loses money. Investors and representatives should look first at the program's economic viability, then at the general partner's expertise and track record and the program's objectives, with taxes as a secondary consideration.

Outline point 3.2 · FINRA Rule 2310

• A. Deduction of intangible drilling costs, generally in the early years (right answer)
• B. Tax-exempt income
• C. Depreciation of land
• D. Exemption from passive activity rules for all investors

Intangible drilling costs, such as labor and drilling services, can generally be deducted early, and producing programs may also take a depletion allowance. Land is not depreciable. Limited partners generally face passive activity limits, so the last choice overstates the benefits.

Outline point 3.2

• A. wages and salary
• B. passive income, such as income from other passive investments (right answer)
• C. portfolio income such as dividends and interest
• D. any type of income without limit

Losses from passive activities, including most limited partnership interests, can generally offset only passive income; unused losses carry forward until there is passive income or the investment is disposed of. Using them against wages or portfolio income was curtailed by the Tax Reform Act of 1986.

Outline point 3.2 · Internal Revenue Code Section 469

• A. A government agency that lends to small businesses
• B. A type of 529 plan
• C. A closed-end investment company that invests in and often provides managerial help to small and developing companies (right answer)
• D. An exchange for start-up stocks

BDCs are closed-end funds that elect special treatment under the Investment Company Act to invest in small and midsize private or thinly traded companies, often providing managerial assistance. They may be listed or non-listed and typically distribute most income to qualify for pass-through tax treatment.

Outline point 3.2 · Investment Company Act of 1940, Section 2(a)(48)

• A. lower total fees
• B. two layers of fees, one charged by the fund of funds and one by the underlying funds (right answer)
• C. guaranteed daily liquidity
• D. no minimum investment

A fund of funds diversifies across managers but adds its own management and sometimes performance fees on top of those charged by the underlying hedge funds. Liquidity is usually limited by lock-ups and redemption notice periods, and minimums still apply.

Outline point 3.2

• A. Breakeven $47; maximum loss $300
• B. Breakeven $53; maximum loss unlimited
• C. Breakeven $53; maximum loss $300 (right answer)
• D. Breakeven $50; maximum loss $5,000

For a long call, breakeven = strike + premium = $50 + $3 = $53, and the most the buyer can lose is the premium paid: $3 x 100 = $300. Unlimited loss belongs to the writer of an uncovered call, not the buyer. $47 would be the breakeven of a long 50 put at 3.

Outline point 3.2

• A. Gain $200; loss unlimited; breakeven $62 (right answer)
• B. Gain unlimited; loss $200; breakeven $62
• C. Gain $200; loss $5,800; breakeven $58
• D. Gain $6,200; loss $200; breakeven $60

The call writer keeps the $200 premium at most, if the call expires worthless. Above the strike the loss grows without limit as the stock rises. Breakeven = strike + premium = $62. The $58 breakeven and capped loss describe a short put, a common confusion.

Outline point 3.2

• A. $400
• B. Unlimited
• C. $4,000
• D. $3,600 (right answer)

A long put gains most if the stock falls to zero: (strike minus premium) x 100 = ($40 minus $4) x 100 = $3,600. Breakeven is $36. Gains are not unlimited because a stock cannot fall below zero; unlimited gain is a feature of long calls.

Outline point 3.2

• A. $300
• B. $4,200 (right answer)
• C. $4,500
• D. Unlimited

The put writer must buy the stock at $45 if assigned; the worst case is a stock price of zero, giving a loss of (strike minus premium) x 100 = ($45 minus $3) x 100 = $4,200. Breakeven is $42. The loss is large but limited, unlike an uncovered call.

Outline point 3.2

• A. Breakeven $46; maximum gain $400 (right answer)
• B. Breakeven $50; maximum gain $200
• C. Breakeven $46; maximum gain unlimited
• D. Breakeven $52; maximum gain $400

For a covered call, breakeven = stock cost minus premium = $48 minus $2 = $46. Maximum gain occurs if the stock is called away at $50: ($50 minus $48 + $2) x 100 = $400. Writing the call caps the upside, so the gain is not unlimited; that is the trade-off for the premium income.

Outline point 3.2

• A. Maximum loss $300; breakeven $57
• B. Maximum loss $500; breakeven $63
• C. Maximum loss $800; breakeven $63 (right answer)
• D. Maximum loss $5,800; breakeven $58

With a protective put, the stock can be sold at $55, so the maximum loss is (cost minus strike + premium) x 100 = ($60 minus $55 + $3) x 100 = $800. Breakeven = stock cost + premium = $63. The $500 trap forgets that the premium paid for the put is also lost.

Outline point 3.2

• A. Maximum gain $300; breakeven $45
• B. Maximum gain $500; breakeven $43
• C. Maximum gain unlimited; breakeven $43
• D. Maximum gain $200; breakeven $43 (right answer)

This bull call spread costs a net debit of $3 ($5 minus $2). Maximum gain = difference between strikes minus the debit = ($45 minus $40 minus $3) x 100 = $200. Breakeven = lower strike + net debit = $43. The short 45 call caps the upside, so gain is not unlimited; maximum loss is the $300 debit.

Outline point 3.2

• A. A bear put spread with a maximum gain of $200
• B. A bull put (credit) spread with a maximum gain of $300, maximum loss of $200 and breakeven of $47 (right answer)
• C. A long straddle
• D. A debit spread with a breakeven of $53

Selling the higher-priced put creates a net credit of $3, which is the maximum gain if both puts expire worthless; the investor is bullish. Maximum loss = strike difference minus credit = ($5 minus $3) x 100 = $200. Breakeven = higher strike minus credit = $47. It is not a debit spread because more premium was received than paid.

Outline point 3.2

• A. $45 and $55 (right answer)
• B. $47 and $52
• C. $48 and $53
• D. $50 only

A long straddle costs the combined premiums, $3 + $2 = $5. It breaks even if the stock moves $5 either way from the strike: $50 + $5 = $55 and $50 minus $5 = $45. Maximum loss is $500 if the stock is exactly $50 at expiration. Using each premium separately gives the wrong pairs.

Outline point 3.2

• A. Expecting a large move in either direction
• B. Strongly bullish
• C. Strongly bearish
• D. Expecting the stock price to stay near the strike, with low volatility (right answer)

The short straddle writer collects two premiums and profits most if the stock finishes at the strike, so it is a bet on stability. The position faces unlimited risk on the upside and large risk on the downside if the stock moves sharply. Expecting a big move is the outlook of a long straddle buyer.

Outline point 3.2

• A. 2 ABC 30 calls, each for 200 shares
• B. 2 ABC 60 calls, each for 200 shares
• C. 4 ABC 30 calls, each for 100 shares (right answer)
• D. 4 ABC 60 calls, each for 50 shares

For an even split such as 2-for-1, the number of contracts is multiplied by 2 and the strike divided by 2: 2 contracts become 4, and the $60 strike becomes $30, each still covering 100 shares. Total exercise value stays the same: 2 x 100 x $60 = 4 x 100 x $30 = $12,000.

Outline point 3.2 · Cboe Rule 4.6

• A. The strike price is reduced by the dividend
• B. No adjustment is made for ordinary cash dividends (right answer)
• C. The number of shares per contract increases
• D. The options are cancelled

Listed options are generally not adjusted for ordinary cash dividends, so call holders who want the dividend must exercise before the ex-date. Adjustments are made for stock splits, stock dividends and certain special distributions. Reducing the strike is the common wrong assumption.

Outline point 3.2 · Cboe Rule 4.6

• A. Sale price of $48 per share, for a $8 gain per share (right answer)
• B. A $5 gain on the stock and a separate $3 gain on the option taxed as ordinary income
• C. A $3 gain only
• D. No gain until the premium expires

When a written call is assigned, the premium is added to the strike to find the sale proceeds: $45 + $3 = $48. The gain is $48 minus $40 = $8 per share, and its holding period depends on how long the stock was held. Treating the premium as separate ordinary income is the trap.

Outline point 3.2

• A. No deduction, because the option was never exercised
• B. A $400 ordinary loss deductible against wages without limit
• C. A $400 capital loss, recognized on the expiration date (right answer)
• D. The $400 is added to the basis of the stock

A purchased option that expires is treated as sold for zero on the expiration date, producing a capital loss equal to the premium; it is short- or long-term depending on how long the option was held. Adding the premium to stock basis happens only if the call is exercised.

Outline point 3.2

• A. an opening purchase
• B. an opening sale
• C. a closing sale
• D. a closing purchase (right answer)

Writing the put was an opening sale. Buying back the same series ends the position, so it is a closing purchase. The order ticket must state whether a trade opens or closes a position because it affects open interest and position records.

Outline point 3.2

• A. Long calls and long puts
• B. Long calls and short puts (right answer)
• C. Short calls and short puts
• D. Long calls and short calls

Position limits aggregate positions with the same market view. Long calls and short puts are both bullish, so they are combined; long puts and short calls are both bearish and combined separately. Long calls and long puts are on opposite sides, which is the trap.

Outline point 3.2 · FINRA Rule 2360(b)(3)

• A. Long-term listed options with expirations longer than standard options, often more than a year (right answer)
• B. Options on Treasury bills
• C. Options that can be exercised only once a year
• D. Short-term weekly options

Long-term Equity AnticiPation Securities are listed options with expirations that extend well beyond the usual cycle, commonly up to about three years. Their long life means a larger time value in the premium. They can be American style like other equity options.

Outline point 3.2 · Cboe Rule 4.5

• A. The exercising holder chooses which writer to assign
• B. The exchange assigns the writer with the largest position
• C. The OCC assigns the notice randomly to a clearing member account, and the firm allocates it to a customer by a fair method such as random selection or first-in, first-out (right answer)
• D. The writer who sold most recently is always assigned

Exercise goes to the OCC, which assigns it randomly among clearing members with short positions in that series. Each firm then allocates the assignment to a customer using a fair method disclosed to customers, typically random or FIFO. Holders never pick their counterparty.

Outline point 3.2 · Cboe Rule 6.21

• A. $30 per share
• B. $200,000
• C. $203,000
• D. $3,000 in cash (right answer)

Index options are cash settled: the writer pays the in-the-money amount times the multiplier, (2,030 minus 2,000) x $100 = $3,000. No securities change hands, so amounts based on the full strike value are wrong.

Outline point 3.2

• A. Buy euro calls (right answer)
• B. Buy euro puts
• C. Write euro calls
• D. Write euro puts

The importer is hurt if the euro rises, so it buys calls on the euro, which gain value as the euro strengthens and cap its dollar cost. Buying puts would protect someone who will receive euros, such as a U.S. exporter, which is the mirror-image trap.

Outline point 3.2

• A. Maximum gain $400; breakeven $54
• B. Maximum gain $100; breakeven $46 (right answer)
• C. Maximum gain $500; breakeven $46
• D. Maximum gain $100; breakeven $44

This bear put spread costs a net debit of $4 ($6 minus $2). Maximum gain = strike difference minus debit = ($5 minus $4) x 100 = $100. Breakeven for a put debit spread = higher strike minus debit = $50 minus $4 = $46. Maximum loss is the $400 debit.

Outline point 3.2

• A. The nominal yield
• B. The current yield
• C. The yield to maturity
• D. The yield to call, because it is lower than the yield to maturity for a premium bond (right answer)

For a bond bought at a premium, an early call means the premium is lost sooner, so yield to call is lower than yield to maturity. Quoting the lowest yield (yield to worst) avoids overstating the return. For a discount bond, yield to maturity would be the lower, more conservative figure.

Outline point 3.2 · MSRB Rule G-15

• A. $12.50 (right answer)
• B. $12.67
• C. $15.00
• D. $7.50

Interest accrues from the last coupon date up to, but not including, settlement: January (30 days) + February (30) + March 1 to 15 (15) = 75 days. Annual interest is $60, so $60 x 75 / 360 = $12.50, paid by the buyer to the seller. Counting the settlement day itself gives 76 days and $12.67, the trap.

Outline point 3.2 · FINRA Rule 11620

• A. 30/360
• B. Actual/360
• C. Actual/actual (right answer)
• D. No accrued interest is charged on Treasuries

Treasury notes and bonds accrue interest on an actual days elapsed over actual days in the coupon period basis. Corporate and municipal bonds generally use 30/360. Actual/360 is typical of some money market instruments. Treasuries do carry accrued interest between coupon dates.

Outline point 3.2

• A. As a capital gain at maturity
• B. It is accreted over the life of the bond as tax-exempt interest, increasing the investor's basis (right answer)
• C. As ordinary income at maturity
• D. As taxable interest each year

Original issue discount on a municipal bond is treated as tax-exempt interest earned over the bond's life; accretion raises the investor's cost basis toward par, so no gain is reported at maturity. A discount bought in the secondary market (market discount) is treated differently and can create taxable income.

Outline point 3.2 · Internal Revenue Code Section 1288

• A. A $40 capital loss at maturity per bond
• B. A $40 ordinary loss
• C. The premium is deducted all at once in the first year
• D. The premium must be amortized, reducing basis to par by maturity, so there is no gain or deductible loss (right answer)

Premiums on municipal bonds must be amortized over the remaining life, which lowers the basis each year; the amortization is not deductible because the interest is tax exempt. At maturity the basis equals par, so there is no capital loss. Claiming a $40 loss is the classic trap.

Outline point 3.2 · Internal Revenue Code Section 171

• A. The annual accretion of the discount is taxable each year even though no cash is received (right answer)
• B. No tax is owed until the bond matures
• C. The bond's income is tax exempt
• D. Only a capital gain is taxed at maturity

Original issue discount on taxable bonds must be included in income as it accrues, so the holder pays tax yearly on phantom income. That is why taxable zeros are often held in tax-deferred accounts such as IRAs. Deferring tax to maturity is the trap.

Outline point 3.2 · Internal Revenue Code Section 1272

• A. 2.94%
• B. 5.46%
• C. 6.00% (right answer)
• D. 5.60%

Taxable equivalent yield = tax-free yield / (1 minus tax rate) = 4.2% / 0.70 = 6.00%. A taxable bond would need to yield 6% to leave this investor with the same after-tax income. The 5.46% trap multiplies by 1.30 instead of dividing by 0.70.

Outline point 3.2

• A. 4.55% (right answer)
• B. 10.77%
• C. 4.90%
• D. 2.45%

After-tax yield on the corporate bond = 7.0% x (1 minus 0.35) = 4.55%. A municipal bond yielding 4.55% gives the same after-tax income. 10.77% is the result of dividing by 0.65, which converts in the wrong direction, and 2.45% is the tax paid.

Outline point 3.2

• A. PAC tranches absorb most prepayment variability
• B. PAC tranches have more predictable cash flows, because companion tranches absorb faster or slower prepayments (right answer)
• C. Companion tranches have the lowest yields
• D. Both have identical prepayment risk

PAC tranches follow a principal schedule protected within a range of prepayment speeds; companion tranches take the excess or shortfall of principal, so they carry more prepayment and extension risk and offer higher yields in compensation. Reversing these roles is the main trap.

Outline point 3.2

• A. PAC tranche
• B. Planned interest-only tranche
• C. Floating-rate tranche
• D. Z-tranche (accrual tranche) (right answer)

A Z-tranche accrues interest that is added to its principal balance while earlier tranches are paid; it then receives principal and interest. It behaves like a zero-coupon bond during the accrual period and is among the most volatile tranches. Interest-only strips are a different structure.

Outline point 3.2

• A. The bid yield is higher than the ask yield, because a higher discount means a lower price (right answer)
• B. The ask yield must always be higher
• C. Prices are quoted in 32nds of a point
• D. The quote shows the coupon rate

For instruments quoted by yield, a higher yield means a lower price. Dealers bid a lower price (higher discount yield) and offer at a higher price (lower yield), so the bid figure is larger than the ask. Quotes in 32nds apply to Treasury notes and bonds, and T-bills have no coupon.

Outline point 3.2

• A. regardless of the issuer's earnings
• B. only if the issuer's earnings are sufficient, as stated in the indenture (right answer)
• C. only at maturity
• D. in shares of common stock

Income bonds are typically issued in reorganizations; the issuer must repay principal at maturity, but interest is paid only if earnings permit. This makes them speculative and they usually trade at a discount. Paying interest regardless of earnings describes ordinary bonds.

Outline point 3.2

• A. state governments
• B. the U.S. Treasury
• C. transportation companies such as airlines and railroads, secured by the equipment (right answer)
• D. banks to finance mortgages

Equipment trust certificates finance rolling stock, aircraft and similar movable equipment; title is held by a trustee until the certificates are paid, which secures the debt. Mortgage bonds are secured by real property, and debentures are unsecured.

Outline point 3.2

• A. before secured bondholders
• B. before general creditors and senior debenture holders
• C. after preferred stockholders
• D. after secured creditors and senior unsecured creditors, but before preferred and common stockholders (right answer)

Subordinated debentures are unsecured debt ranking behind senior debt but still ahead of all equity, including preferred stock. The higher risk usually means a higher coupon than senior debt of the same issuer. Placing them behind preferred stock is the trap.

Outline point 3.2

• A. issued and payable in euros
• B. denominated in U.S. dollars but issued and traded outside the United States (right answer)
• C. issued by the European Central Bank
• D. denominated in dollars and registered with the SEC

Eurodollar bonds are U.S. dollar denominated bonds issued outside the U.S., often by foreign or multinational issuers, and generally not registered with the SEC. The euro prefix refers to the offshore market, not the euro currency, which is the trap in the first choice.

Outline point 3.2

• A. She can always redeem at par with the issuing bank
• B. The FDIC covers any loss in market value
• C. She may have to sell at a loss in the secondary market, because brokered CD prices fall when rates rise (right answer)
• D. Brokered CDs cannot be sold before maturity under any circumstances

Brokered CDs are traded through the broker's secondary market, and their prices move inversely to rates, so selling early can mean a loss of principal. FDIC insurance covers the bank's failure within its limits, not market losses. Early redemption at par is usually available only in limited cases such as the holder's death.

Outline point 3.2

• A. Serial (right answer)
• B. Term
• C. Balloon only
• D. Perpetual

Serial bonds mature in installments over several years, which suits GO issuers whose tax revenue arrives steadily; serial maturities are usually quoted on a yield basis. A term issue has all bonds maturing on one date, often with a sinking fund, and term bonds are often quoted in dollar prices.

Outline point 3.2

• A. To rate the issuer's credit quality
• B. To guarantee timely payment
• C. To recommend the bonds to investors
• D. To confirm that the bonds are a valid and binding obligation and to address the tax-exempt status of the interest (right answer)

Bond counsel's legal opinion states that the issue is legally valid and binding and addresses the tax treatment of interest. An unqualified opinion is issued without reservations. Ratings come from rating agencies and guarantees from insurers or banks, not from the legal opinion.

Outline point 3.2

• A. tax anticipation notes
• B. bond anticipation notes (right answer)
• C. revenue anticipation notes
• D. grant anticipation notes

Bond anticipation notes provide interim financing that will be repaid from the proceeds of a future long-term bond sale. Tax anticipation notes are repaid from expected tax collections, revenue anticipation notes from other expected revenues, and grant anticipation notes from expected government grants.

Outline point 3.2

• A. A legal requirement that the state pay any shortfall
• B. A guarantee from the U.S. Treasury
• C. A nonbinding commitment that the state legislature may appropriate funds to cover a shortfall in the issuer's revenues (right answer)
• D. Insurance from a bond insurer

A moral obligation bond is typically a revenue bond backed by the state's pledge to consider appropriating money to fill a reserve deficiency. The legislature is not legally bound to appropriate, which is the trap in the first choice. A double-barreled bond, by contrast, carries a legally binding taxing pledge as backup.

Outline point 3.2

• A. revenue from a specific facility and also the full faith and credit (taxing power) of a government (right answer)
• B. two different bond insurers
• C. two separate states
• D. federal and state grants

A double-barreled bond is primarily paid from revenue of a facility but is also backed by the issuer's general taxing power, so it is often analyzed as a GO bond. A moral obligation bond has only a nonbinding legislative pledge as backup.

Outline point 3.2

• A. The issuer's tax base has grown
• B. They are insured by the FDIC
• C. They become general obligations of the federal government
• D. They are backed by an escrow of U.S. Treasury securities set aside to pay them (right answer)

In an advance refunding, the proceeds of a new issue are invested in Treasuries held in escrow to pay principal and interest on the old bonds to their call or maturity date. The escrow, not the original pledge, now secures them. They do not become federal obligations; the escrow just holds government securities.

Outline point 3.2

• A. legal opinion
• B. feasibility study (right answer)
• C. notice of sale
• D. official statement

A feasibility study, prepared by engineers and consultants, analyzes whether the project can generate enough revenue to cover operating costs and debt service. It is a key part of revenue bond analysis. The official statement may include it, but the study itself is the feasibility analysis.

Outline point 3.2

• A. 2.5 times
• B. 1.0 times
• C. 1.5 times (right answer)
• D. 0.6 times

Under a net revenue pledge, operating and maintenance costs are paid first. Net revenue = $10 million minus $4 million = $6 million, and coverage = $6 million / $4 million debt service = 1.5 times. The 2.5 times trap uses gross revenue, which describes a gross revenue pledge.

Outline point 3.2

• A. It shows the bond's call schedule
• B. It measures the city's sales tax rate
• C. It measures water system revenue
• D. It shows debt of other issuers, such as school or county districts, that the same taxpayers must also support (right answer)

Overlapping debt is the share of debt issued by other governments covering the same property, such as school districts or counties. Because the same taxpayers support all of it, analysts add it to the city's direct debt when measuring the burden per capita or relative to property values.

Outline point 3.2

• A. Their interest is taxable at the federal level (right answer)
• B. Their interest is exempt from all taxes
• C. They are issued by the U.S. Treasury
• D. They are equity securities

Build America Bonds were taxable municipal bonds issued in 2009 and 2010 under the American Recovery and Reinvestment Act, with a federal subsidy to issuers or a tax credit to holders. They are municipal securities, but their interest is federally taxable, which made them attractive to investors who do not benefit from tax exemption.

Outline point 3.2

• A. subject to Social Security tax
• B. a preference item for the individual alternative minimum tax (right answer)
• C. taxed as a capital gain
• D. non-taxable under the AMT in all cases

Interest on many private activity bonds, such as those financing facilities used by private businesses, is a tax preference item for the alternative minimum tax. Investors subject to AMT may owe tax on it, so these bonds often yield slightly more than comparable non-AMT municipals.

Outline point 3.2 · Internal Revenue Code Section 57(a)(5)

• A. an optional call
• B. a sinking fund call
• C. an extraordinary (catastrophe) call (right answer)
• D. a make-whole call

An extraordinary call is triggered by a specific event outside the normal call schedule, such as destruction of the facility or loss of the revenue source. Optional calls are at the issuer's choice on set dates, sinking fund calls retire bonds on a schedule, and make-whole calls pay a price based on remaining cash flows.

Outline point 3.2

• A. an index of 20 corporate bonds
• B. the average price of 20 Treasury bonds
• C. an index of 20 municipal revenue bonds
• D. an index of yields on a group of general obligation municipal bonds maturing in about 20 years (right answer)

The Bond Buyer 20-Bond GO Index tracks average yields on 20 general obligation municipal bonds with roughly 20-year maturities; the 11-Bond Index uses a higher-rated subset. Revenue bonds are tracked by a separate revenue bond index. These indexes help investors follow the municipal market's yield level.

Outline point 3.3

• A. Monthly payments that include both interest and principal (right answer)
• B. Semiannual interest only
• C. A single payment at maturity
• D. Quarterly dividends

Mortgage pass-throughs pass monthly mortgage payments from homeowners to investors, so each monthly check includes interest and some return of principal, including prepayments. Because principal returns over time, part of each payment is not income. Semiannual interest is typical of Treasury notes and most corporate bonds.

Outline point 3.2

• A. a bullish continuation signal
• B. a sign of consolidation with no direction
• C. a bearish reversal signal (right answer)
• D. a buy signal for long-term investors

A head-and-shoulders top, three peaks with the middle highest, followed by a break below the neckline, typically signals that an uptrend is reversing downward. An inverted head-and-shoulders (at a market bottom) is the bullish reversal pattern, which is the mirror-image trap.

Outline point 3.3

• A. resistance level
• B. support level (right answer)
• C. moving average
• D. breakout point

Support is a price level where buying demand has repeatedly stopped declines. Resistance is the opposite, a level where selling has repeatedly stopped advances. A fall below support is a bearish breakout that technicians watch closely.

Outline point 3.3

• A. Short sellers must eventually buy the shares back to close their positions, creating future demand (right answer)
• B. Short sellers are usually wrong by law
• C. Short interest reduces the number of shares outstanding
• D. The company must buy back the shares

Every short position must eventually be covered by a purchase, so heavy short interest represents built-in future buying that can push prices up, especially in a short squeeze. Short sales do not change shares outstanding, and the issuer has no duty to buy back shorted shares.

Outline point 3.3

• A. a bearish sign, since many investors expect declines
• B. irrelevant to market analysis
• C. a sign that options volume will fall
• D. a bullish sign, since widespread pessimism may mean selling is near its end (right answer)

The put/call ratio compares put volume with call volume. Contrarians treat extreme readings as signals of crowd sentiment that is about to reverse: heavy put buying shows widespread pessimism, which they read as bullish. A non-contrarian reading would treat it as bearish, which is the trap.

Outline point 3.3

• A. the commissions are the lowest available
• B. the adviser determines in good faith that the commissions are reasonable relative to the value of the brokerage and research services received (right answer)
• C. the research is used only for personal accounts
• D. the arrangement is kept confidential from clients

Section 28(e) provides a safe harbor so an adviser does not breach its duty merely by paying more than the lowest commission, if it determines in good faith that the commission is reasonable for the brokerage and research provided. Soft dollar arrangements must be disclosed to clients, not hidden.

Outline point 3.3 · Securities Exchange Act of 1934, Section 28(e)

• A. It is taxed as ordinary income
• B. It is taxed as a long-term capital gain
• C. It is generally not taxed when received but reduces the investor's cost basis (right answer)
• D. It increases the investor's cost basis

A return of capital gives back part of the investor's own money, so it is generally not taxable when received; instead it lowers cost basis, which increases the gain (or reduces the loss) when the shares are sold. Once basis reaches zero, further return of capital is taxed as capital gain.

Outline point 3.3 · Internal Revenue Code Section 301(c)

• A. a document available on request that provides more detail than the prospectus, such as the fund's history and policies (right answer)
• B. the same as the summary prospectus
• C. delivered automatically with every confirmation
• D. a sales brochure

The SAI is part of the registration statement and supplements the prospectus with details such as fund history, officers and directors, and certain policies and financial statements. It must be provided on request, free of charge, but is not required to be delivered with the prospectus.

Outline point 3.3 · Investment Company Act of 1940

• A. Firm A, the delivering firm
• B. The customer's state regulator
• C. FINRA
• D. Firm B, the receiving firm, after the customer signs a transfer instruction (right answer)

Under FINRA Rule 11870, the customer gives a signed transfer instruction to the receiving firm, which submits it through ACATS; the delivering firm must then validate and complete the transfer promptly. The delivering firm cannot hold the account hostage over unrelated disputes.

Outline point 3.4 · FINRA Rule 11870

• A. prevent the analysts from publishing anything
• B. make public disclosure of the same information promptly (right answer)
• C. wait until the quarterly report is filed
• D. notify FINRA only

Regulation FD prohibits selective disclosure of material nonpublic information to market professionals or investors likely to trade on it. If an unintentional selective disclosure occurs, the issuer must promptly make the information public, for example through a press release or Form 8-K. Intentional selective disclosures require simultaneous public disclosure.

Outline point 3.4 · Regulation FD

• A. $1,015.00 (right answer)
• B. $1,011.60
• C. $1,016.00
• D. $1,001.60

Treasury notes and bonds are quoted in points and 32nds of a point, where one point is 1% of face value ($10 per $1,000). 101.16 means 101 and 16/32, or 101.5% of par, which is $1,015.00. Reading the quote as a decimal (101.16% = $1,011.60) is the trap.

Outline point 3.2

• A. $10,000
• B. $9,000
• C. $9,600 (right answer)
• D. $9,400

A CDSC is deducted at redemption: $10,000 x 4% = $400, leaving $9,600. The charge typically declines each year and eventually disappears; many funds apply it to the lesser of the original cost or current value, so the prospectus controls. Class B shares often convert to Class A shares after a set period.

Outline point 3.2

• A. Seven days (right answer)
• B. Three business days
• C. 30 days
• D. One business day

Section 22(e) prohibits a registered fund from postponing payment on redemption for more than seven days after tender, except in limited circumstances such as when the NYSE is closed or the SEC permits suspension. Many funds pay faster, but seven days is the legal outer limit.

Outline point 3.2 · Investment Company Act of 1940, Section 22(e)

• A. managing the subaccounts' investments
• B. the 12b-1 marketing plan
• C. guarantees such as lifetime annuity payments and the death benefit, and the risk that expenses exceed what is charged (right answer)
• D. the investor's state premium tax only

The M&E charge pays the insurer for its insurance guarantees, such as lifetime payout rates regardless of how long the annuitant lives, the death benefit, and the promise that administrative charges will not increase beyond stated limits. Investment management fees are charged separately by the subaccounts.

Outline point 3.3

• A. None, because a sibling is a member of the beneficiary's family (right answer)
• B. The earnings become taxable immediately
• C. A 10% additional tax applies
• D. The account must be closed and reopened

Changing the designated beneficiary to a member of the current beneficiary's family, which includes siblings, is not treated as a distribution, so there is no tax or additional tax. Changing to someone outside the family could be a taxable non-qualified distribution.

Outline point 3.2 · Internal Revenue Code Section 529(c)(3)