3. Investment Planning. 4. Derivatives, Insurance Securities, and Other Investments

Question 1

Module Introduction

There are people who go to flea markets and antique stores looking for rare bargains. What are they in search of? These treasure hunters are seeking items that have values far exceeding the price that the vendor is charging. Antiques and rare collectibles can sometimes yield as much profit as a stock. Most investors limit their portfolio to stocks, bonds, and mutual funds. However, there are others who invest elsewhere for profits. Some people turn to investments that are derived from the securities markets, while others invest in real estate or collectibles. Some of these investments can be used for aggressive speculation, for hedging other investments or for further diversification. If you can afford to invest beyond stocks, bonds, and mutual funds, it is important to understand the risks versus rewards associated with the other investments.

Answer 1

The Derivatives, Insurance Securities, and Other Investments module, which should take approximately three and a half hours to complete, will introduce investment vehicles beyond stocks, bonds, and pooled investments.

Upon completion of this module you should be able to:
* Explain derivates,
* Discuss insurance-based investments, and
* List other types of investments.

Question 2

Module Overview

This module introduces you to investments vehicles beyond stocks, bonds and pooled investments. Stocks, bonds and mutual funds are some of the more important investment vehicles for your investment strategy. Knowing where to invest your money and what affects its return is an important step in planning for the future. This module focuses on three additional types of investments. The first lesson deals with derivatives, such as options and futures. The second lesson discusses insurance-based products such as guaranteed insurance contracts, and annuities. Finally, other investment options such as promissory notes, ADRs and tangible assets will be presented.

Answer 2

To ensure that you have an understanding of derivatives, insurance securities and other investments, the following lessons will be covered in this module:
* Derivatives
* Futures
* Other Investments

Question 3

Section 1 – Derivatives

A derivative security is so named because its value is derived from the value of another asset, referred to as the underlying asset. As that asset’s value changes, so does the value of the derivative. There is a speculative lure to investors because of their potential for large gains in short periods of time. However, most portfolio managers use derivatives as way to hedge their positions and add income to the portfolio.

A big appeal with derivatives is that the change in their value is usually far greater, percentage-wise, than the value change in their underlying assets. In this sense, they are said to have built-in leverage. For example, the price movement in AAPL stock could be 3% on a given day while the price movement on a call option contract on AAPL stock could be 12% on the same day. There are various types of derivatives, but you are most likely to encounter option contracts and futures contracts.

Answer 3

To ensure that you have an understanding of derivatives, the following topics will be covered in this lesson:
* Options
* Futures

Upon completion of this lesson, you should be able to:
* Define options,
* List the types of options,
* Discuss options trading,
* Discuss roles of the exchange (OCC),
* Define options quotes,
* Explain options margin, and
* Explain futures.

Question 4

Match the descriptions with the corresponding option contract element.
Writer
Buyer
Premium
Underlying Asset
* The person purchasing the contract
* The price of the contract
* The contract derives its value from this
* The person selling the contract

Answer 4

• Writer - The person selling the contract
• Buyer - The person selling the contract
• Premium - The price of the contract
• Underlying Asset - The contract derives its value from this

Question 5

Call Option: Example

The Widget Corporation’s stock is currently trading at $45 per share. Ben believes that the price of the stock will rise substantially over the next six months and wants to buy a call option. Wilma believes that the stock price will not rise above $50 over this time period. Wilma writes a 6-month naked call option for 100 shares of Widget stock with an exercise (strike) price of $50 per share. Ben buys the option for a premium of $3 per share, or $300 for the contract.

If the stock price rose to $60/share and Ben exercises the call option, then Wilma will need to purchase the stock in the market for $6,000 and sell them to Ben for $5,000. Netting the premium, Wilma will have a loss of $700. If Ben sells the shares for $6,000, then his total gain will be the same as Wilma’s loss, $700. Alternately, Ben can sell the option to someone else for $700 and thus pass the right to buy at $50 to the buyer.

Ben (Buyer) Wilma (Writer)
Premium ($300) Premium $300
Exercise option at strike price ($5,000) Buy stock at market price ($6,000)
Sells shares at market price $6,000 Payment for shares $5,000
Net Gain: $700 Net Loss: ($700)

Based on the facts presented on this page, assume that Widget Corporation’s stock is currently trading at $45 per share. What would happen if the stock price remained below $50?
* Ben would exercise the option.
* Ben would not exercise the option.

Answer 5

Ben would not exercise the option.
* If the price remained below $50, then Ben would not exercise the option. Wilma would make $300, the premium for the contract while Ben would lose $300 plus transaction costs.

Question 6

Put Option: Example

Andrew expects the price of Acme Construction Co.’s stock to decrease over the next few months. However, Maria believes that the stock price will remain steady and may even increase. Maria decides to write a put contract that will allow the buyer to sell 100 shares of Acme Construction to her for $30 per share at any time during the next six months. Currently Acme Construction Co. is trading at $35 per share on an organized exchange. Andrew paid $6 per share as premium for the put contract.

If the price of the stock decreases to $20/share, then Andrew could buy 100 shares for $2,000, then exercise the option and sell the shares to Maria for $3,000. In this case, Andrew would make $3,000 - $2,000 - $600 = $400. Maria would pay $3,000 for 100 shares that she can sell for $2,000. Netting the premium of $600, Maria’s loss would be $400. Andrew can choose to sell the contract for $400 instead.

Andrew (Buyer) Maria (Writer)
Premium ($600) Premium $600
Buy stock at market price ($2,000) Payment for shares at strike price ($3,000)
Sells shares at strike price $3,000 Sells shares at market price $2,000
Net Gain: $400 Net Loss: ($400)
Question
Based on the facts presented on this page, assume that Acme Construction Co.’s stock is currently trading at $35 per share. What would happen if the stock price goes to $40?
* Andrew will exercise the option.
* Andrew will not exercise the option.

Answer 6

Andrew will not exercise the option.
* If the price of the stock goes to $40/share, then Andrew would not exercise the option. If the price remained in the $40s, then the option will expire. Maria would make $600 for the premium while Andrew would lose $600 plus transaction costs.

Question 7

ACTIVITY

The Options Clearing Corporation (OCC) was founded in 1973 and is the largest clearing organization in the world for financial derivatives instruments. Go to their website optionsclearing.com and explore the “What is OCC?” section to learn more about its origin and purpose.
After reviewing the above link, you should be able to answer the following questions:
* What is the purpose of the OCC?
* What publications are available from the OCC?

Question 8

The difference between option contracts and futures contracts is that a futures contract gives the right to exercise the contract, but an option contract is an obligation to deliver.
* False
* True

Answer 8

False

Question 9

What does the futures market clearing house use to ensure it always has a sufficient security deposit to protect it from losses due to individual investors actions? Click all that apply.
* Daily marking-to-market procedure
* Reverse trades
* Margin requirements
* Breaking transaction

Answer 9

Daily marking-to-market procedure
Margin requirements
* A futures contract is replaced every day by adjusting the equity in the investor’s account and drawing up a new contract that has a purchase price equal to the current settlement price. The daily marking-to-market procedure, coupled with margin requirements, results in the clearinghouse’s always having a security deposit of sufficient size to protect it from losses owing to the actions of the individual investors.

Question 10

Example (Foreign Currency Exchange Rates)

You bought a contract where you agreed to exchange at a rate of US $1 to 100 yen, and the exchange rate changed so that on the delivery date it takes US $1.50 to purchase 100 yen, you would gain from the stronger yen and weaker dollar.

Answer 10

Foreign Currency Futures
* Have you ever traveled and had to exchange your native currency for a foreign currency? The value of your domestic currency versus that of a foreign country’s will change from day to day. There is an active spot market for foreign currency, and the rate at which one currency can be exchanged for another varies over time. Currency futures contracts involve a buyer and a seller who agree to exchange a specific amount of one currency for a specific amount of another currency at some future date.
* Markets for foreign currency futures attract both hedgers and speculators. Hedgers wish to reduce or possibly eliminate the risk associated with planned future transfers of funds from one country to another. Speculators use exchange futures to make bets based on the direction they believe exchange rates are heading.

Question 11

Section 1 - Derivatives Summary

In the world of investments, derivatives are securities whose value will change with an underlying asset. They can be used for speculative reasons or to hedge investment decisions. An option is a contract between two people for purchase and sale of a specific amount of a security by a certain date at a specific price. Futures, short for futures contracts, are based on the future delivery of commodities or financial instruments for a specific price.

In this lesson, we have covered the following:
* A derivative’s value is “derived” from the value of another asset, which is referred to as the underlying asset. As the underlying asset’s value changes, so does the value of the derivative with the further advantage that the derivative has built-in leverage..

Answer 11

• Options: There are two types of options: calls and puts. Calls give buyers the right to purchase stocks from the writer at a set price. Puts give buyers the right to sell shares of a stock to the writer at a set price. The Options Clearing Corporation facilitates trading in call and put options. They set margin requirements for buyers and writers in order to have some assurance of the delivery of securities.
• Futures are traded on various organized exchanges. Each futures exchange has an associated clearinghouse. Investors must open a futures account with an initial margin at a brokerage firm. Each day the account is adjusted to reflect the change in settlement price in a process called marking the market. There are futures for assets like agricultural goods, foreign currencies, fixed income securities, and market indices

Question 12

If you expect the price to increase, list 3 things to do.

Answer 12

1. Write a put
2. Buy a call
3. Buy a future

Question 13

If you expect the price to decrease, list 3 things to do.

Answer 13

1. Write a call
2. Buy a put
3. Sell a future

Question 14

An option is a contract between two people wherein one person grants the other person the right to buy a specific asset at a specific price within a specific time period.
* False
* True

Answer 14

True
* An option is a contract between two people where one person grants the other person the right to buy a specific asset at a specific price within a specific time period. There are two parties to the contract, the seller, who agrees to sell an asset to another, the buyer, at an agreed price before the expiration of a certain date.

Question 15

If you were expecting the price of a stock to increase because you think it will beat the market’s estimate of the company’s earnings, which of the following would you do? (Select all that apply)
* Write a call option on the stock
* Buy a call option on the stock
* Write a put option on the stock
* Buy a put option on the stock

Answer 15

Buy a call option on the stock
Write a put option on the stock
* If the price of a stock is expected to rise, then you would want to buy a call or write (sell) a put option. Buying a call option would give you the option to buy the stock at a set price. If the price of the stock increases, you will be able to buy it at a cheaper price.
* Put options allow the writer to sell you shares at a set price. If the price of the shares increases, the buyer would not exercise the contract because he or she can sell the shares at a higher price in the market.
* Writers of calls and buyers of puts expect the price to fall.

Question 16

A July wheat futures contract sells 5,000 bushels at $4 per bushel. Which of the options would be the deposit if the initial margin were 5%?
* $1,000
* $2,000
* $3,000
* $4,000

Answer 16

$1,000
* A July wheat futures contract for 5,000 bushels at $4 per bushel would have a total purchase price of $20,000. If the initial margin requirement is 5%, buyer and seller would each have to make a deposit of $1,000 (0.05 X $20,000).

Question 17

The initial margin for a July wheat futures contract for 10,000 bushels at $4 per bushel is $2,000, what is the maintenance margin if it were 65% of the initial margin?
* $1,800
* $1,700
* $1,600
* $1,300

Answer 17

$1,300
* If the maintenance margin is roughly 65% of initial margin, then the investor must have equity equal to or greater than 65% of the initial margin, or $2,000(0.65) = $1,300.

Question 18

What generally are the prevailing characteristics of options trading? (Select all that apply)
* Exchanges begin trading a new set of options on a given stock every three months.
* Newly created options have roughly nine months before they expire.
* Exchanges may decide to introduce long-term options or LEAPS.
* Exchanges may decide to allow customized options or FLEX options for flexible exchange options.
* The positions are marked to market daily.

Answer 18

Exchanges begin trading a new set of options on a given stock every three months.
Newly created options have roughly nine months before they expire.
Exchanges may decide to introduce long-term options or LEAPS.
Exchanges may decide to allow customized options or FLEX options for flexible exchange options.
* In options trading, exchanges begin trading a new set of options on a given stock every three months. The newly created options have roughly nine months before they expire, and options might be introduced in January, April, July, and October, with expiration dates in, respectively, September, December, March, and June.
* The exchange might decide to introduce long-term options also called LEAPS by the exchanges for long-term equity anticipation securities that expire as far into the future as two years.
* The exchange might also decide to allow the creation of customized options called FLEX options for flexible exchange options, that have exercise prices and expiration dates of the investor’s choosing.
* Daily marking to market is a practice used for futures contracts.

Question 19

Margin is a system that provides protection to the OCC to cover the writer’s inability to bear the net cost.
* False
* True

Answer 19

True
* The OCC has to see that the writer is able to fulfill the terms of the contract. The exchanges where the options are traded have set margin requirements, to relieve the OCC of this concern.
* In the case of a call, shares are to be delivered by the writer in return for the exercise price.
* In the case of a put, cash is to be delivered in return for shares.
* In either case the net cost to the option writer will be the absolute difference between the exercise price and the stock’s market value at the time of exercise.
* The OCC is at risk if the writer is unable to bear this cost. It has a system known as “margin” to protect itself from the actions of the writers.

Question 20

Section 2 – Insurance-Based Investments

Insurance companies provide investment products to help investors meet their insurance or retirement planning needs. To ensure that you have a solid understanding of insurance-based investments, the following topics will be covered in this lesson:
* Guaranteed Investment Contracts
* Annuities

Answer 20

After completing this lesson, you will be able to:
* Discuss guaranteed investment contracts,
* Explain annuities,
* Explain accumulation period,
* Distinguish between fixed and variable annuities, and
* Explain liquidation period.

Question 21

If annuity payments continue beyond the life expectancy noted on IRS Table V, all income generated from the annuity is considered __ ____??____ __.

Answer 21

There are two basic types of annuities:
* Fixed
* Variable

Exam Tip: If annuity payments continue beyond the life expectancy noted on IRS Table V, all income generated from the annuity is considered taxable income.

Question 22

Section 2 – Insurance-Based Investments Summary

Besides investing directly in stocks, bonds, mutual funds or derivatives, insurance companies offer a few retirement savings options as well. When considering insurance products as part of investment planning, it is appropriate to weigh the benefits of deferring taxes versus long-term capital gains. In this lesson, we have covered the following:
* Guaranteed Investment Contracts are large denomination debt instruments with guaranteed fixed rates and maturities. Investors will typically come across them as stable funds of an employer sponsored retirement plan. They are conservative, low yield options for shorter-term objectives.

Answer 22

• Annuities are sold by life insurance companies as a convenient means of saving for retirement and providing security in retirement. The principal builds through investments and returns on investments during the accumulation period. Owners receive the accumulated cash value in the liquidation period. Fixed annuities provide guaranteed interest rate for a short period of time while the value of variable annuities will increase or decrease with the value of the underlying securities.

Question 23

Match the description to the correct term.
Liquidation period
Fixed annuity
Accumulation Period
Variable annuity
* A mutual fund with an insurance wrapper
* Principal builds through investments and returns on investments reinvested
* When benefit is distributed through lump sum or annuity
* Principal is always guaranteed while interest rate is guaranteed for a brief period, then becomes changeable

Answer 23

• Liquidation period. When benefit is distributed through lump sum or annuity
• Fixed annuity. Principal is always guaranteed while interest rate is guaranteed for a brief period, then becomes changeable
• Accumulation Period. Principal builds through investments and returns on investments reinvested
• Variable annuity. A mutual fund with an insurance wrapper

Question 24

Which of the following are characteristics of variable annuities? (Select all that apply)
* Not dependent on market performance of a specified investment fund.
* Principal invested in a portfolio of securities.
* Value remains static irrespective of the changing value of the underlying securities.
* Future worth depends on the portfolio’s financial performance.

Answer 24

Principal invested in a portfolio of securities.
Future worth depends on the portfolio’s financial performance.
* The value of a variable annuity is dependent on market performance of a specified investment fund.
* The principal is invested in a portfolio of securities.
* The value of a variable annuity increases or decreases with the changing value of the underlying securities.
* The future worth of the annuity will depend on the portfolio’s financial performance. If it does poorly, you could lose some or the entire principal.

Question 25

Which of the following is NOT a reason to invest in a GIC fund in 401(k)plans?
* Temporary holding place
* Safe haven from extreme market conditions
* Long-term growth
* Soon to begin withdrawals

Answer 25

Long-term growth
* Guaranteed Investment Contracts (GICs) are conservative by nature. Funds made up of GICs are sometimes called stable funds. They are ideal for very conservative objectives such as a temporary holding place, safe haven, or nearing distributions.
* They are not suitable for long-term growth because they do not provide sufficient yield to outpace inflation in the long-run.

Question 26

Section 3 – Other Investments

It’s true that some people pay more attention to their classic sports cars than they do their investment portfolios. And why not, after all, a classic Corvette could be the most valuable part of the person’s total portfolio. There are still a variety of investments left that can become part of an investor’s total portfolio of assets. They range from investments in financial securities to tangible assets such as collectibles.

To ensure that you have an understanding of other investments, the following topics will be covered in this lesson:
* Promissory Notes
* Index securities
* American Deposit Receipts (ADR)
* Private Placement and Venture Capital
* Real Estate (investor managed)
* Tangible Assets
* Natural Resources.

Answer 26

Upon completion of this lesson, you should be able to:
* Define promissory notes,
* Explain index securities,
* Explain ADRs,
* Define private placement and venture capital,
* Explain real estate (investor managed),
* Define tangible assets, and
* Explain natural resources

Answer 27

Gold mania swept the world throughout the late 1970s and early 1980s and then again in the financial crisis of 2008. Almost overnight, every shopping center had a gold store where you could sell coins, jewelry, and anything else that had a trace of gold or silver. Gold can be an extremely risky investment, and this must be understood and appreciated before you invest. It also carries storage cost with no incoming cash flow.

Gold can also be invested in through the use of specialty mutual and exchange traded funds.

You can invest in gold in a number of ways. You can own gold indirectly by buying the common stock of companies that mine gold. Changes in the market prices of the stocks of these companies are closely correlated to changes in the price of gold. Buying gold indirectly by investing in such companies is called a play on gold. It has an advantage over owning gold directly in that many of these stocks pay annual dividends, thereby providing a current return.

Gold Bullion comes in various sizes from bars weighing one ounce up to ingots weighing 400 ounces. If the price of gold is say, $1,500 an ounce, each ingot would be worth $600,000. This puts it out of reach for most investors. Concerns include storing it and having it certified if you sell it.
Gold Coins: Popular gold coins include the one-ounce United States Double Eagle, the one-ounce South African Kruggerand and one-ounce Canadian Maple Leaf. Their weight and purity are standardized, making them easily transferable. Gold coins have two big disadvantages. They provide no current income and they sell at a premium over their intrinsic gold value.
Gold Certificates: Buying gold certificates may be the way to own gold if you don’t want current income and don’t care to handle or look at the metal itself. Many commercial banks sell gold certificates. The certificate is your ownership claim. The actual gold is owned or controlled by the selling institution. There are storage costs. Commissions or markups are lower with certificates than with bullion or coins, particularly on large orders.

Practitioner Advice: Mutual funds invested in gold and gold mining companies are often used by investors who are hedging against inflation and in times of international crisis.

Question 28

What would cause a collectible such as a Star Wars figure to increase in price?
* Oversupply - there are more in production than demanded
* Revival - nostalgic trend led to a resurgence of interest in collecting beanie babies
* Limited edition - limited number were produces
* Retired - production ceased for the particular version

Answer 28

Revival - nostalgic trend led to a resurgence of interest in collecting beanie babies
Limited edition - limited number were produces
Retired - production ceased for the particular version
* The change in price of a collectible is driven by basic micro-economic factors. Price will increase due to scarcity caused by limited editions, discontinued versions, and increase in demand while quantity supplied remained the same. The premise of an Internet auction such as eBay runs on the basis of price movements caused by supply and demand.

Question 29

Section 3 – Other Investments Summary

For those interested, there are many other types of investments available. Some may be attractive because they are a labor of love such as real estate or collectibles. Others may require more knowledge and/or risk. In this lesson, we have covered the following:
* Promissory Notes are issued by companies to finance business operations. They are debt instruments that provide fixed incomes. Caution should be used when investing in these instruments.
* American Deposit Receipts (ADR) are financial assets issued by U.S. banks. They represent indirect ownership of a certain number of shares of a specific foreign firm that are held on deposit in a bank in the firm’s home country.

Answer 29

• Private Placement and Venture Capital are funds given to start-up companies in hopes that their business plans will be successful.
• Real Estate (Investor Managed) appeals to people who like to be active in managing their investments.
• Tangible Assets: Many people prefer investing in tangible assets like precious metals and gems, hobbies and collectibles as an alternative.
• Natural Resources: There are limited partnership programs available for people interested in investing in operations that explore, develop or manufacture natural resources.
• Previous unit: Natural Resources

Question 30

Owners of an income-producing property enjoy tax savings.
* A. True
* B. False

Answer 30

True
* The IRS allows owners of income-producing property certain deductions, which result in tax savings.

Question 31

Which of the following are advantages of holding gold company stocks, gold coins, bullion and certificates? (Select all that apply)
* A. Gold companies stock provides a current return in the form of annual dividends.
* B. Gold coins can be stored in bank safe deposit boxes.
* C. Commissions on gold certificates are higher than bullion or coins.
* D. Gold coins are standardized in weight and purity and can be purchased anywhere.

Answer 31

Correct Answer: A., B. and D.
* Explanation: There are certain advantages of holding gold coins, bullion and certificates.
* Gold companies stock provides a current return in the form of annual dividends.
* Gold coins can be stored in bank safe deposit boxes. They are standardized in weight and purity and can be purchased anywhere.
* Commissions on gold certificates are lower than bullion or coins.

Question 32

Which of the following are drawbacks associated with investing in real estate?
* A. Majority of money for the investment has to come from the investor
* B. Not a very liquid asset
* C. Not well suited for novice investors
* D. Many tax advantages are associated with it

Answer 32

Correct Answer: B. and C.
* Explanation: A major draw for investing in real estate is the income the property can generate coupled with the opportunity for capital gains. The tax advantages that were available in the past are largely gone or are on the way out. Investment in real estate is illiquid. If you sell your property holdings, it may take months to find a buyer, and there’s no guarantee that you’ll actually get what you feel is a fair price. In addition, overbuilding in some areas has actually resulted in a decline of property prices. The bottom line is that real estate investment is not well suited to the novice investor.

Question 33

Which of the following statements are true about ADRs vs. direct investment in foreign stocks?
* A. ADRs are certificates issued by U.S. banks that represent ownership in shares of foreign company stocks.
* B. ADRs are not reliable because foreign countries are not stringent with their financial statements.
* C. ADRs can increase the risk of a stock portfolio because they are highly correlated to U.S. stock market
* D. ADRs provide a means for domestic investors to access foreign stocks that they otherwise may not have been able to.

Answer 33

Correct Answer: A. and D.
* Explanation: ADRs are certificates issued by U.S. banks that represent ownership in shares of foreign company stocks. They provide investors access into foreign companies that they otherwise may not be able to.
* Regulation requires companies to follow Generally Accepted Accounting Principles to report financial information in order to qualify as ADRs.
* They lower the overall risk of a portfolio because their low correlation to the movement of U.S. markets.

Question 34

Module Summary

This module introduced other investment vehicles apart from stocks, bonds and pooled investments. In financial planning, a number of these investments may appear in client portfolios. It is important to understand the types of risk associated with each investment and how they work.

The key concepts to remember are:
* A Derivatives value is “derived” from the value of an underlying asset. As the underlying asset’s value changes, so does the value of the derivative.
* Option contracts are used as a way to speculate or a way to hedge. Portfolio managers often use options to hedge their investment decisions. When used improperly, they can increase the risk of an overall portfolio.
* Futures contracts are based on the future delivery of commodities or financial instruments. Futures for commodities have taken a back seat in popularity to futures for financial instruments. Futures for financial instruments have become a good indication of the direction of the value of underlying asset. For example, prior to the opening of the U.S. stock markets, analysts will watch the performance of index futures overseas to predict how the market will open.

Answer 34

• Insurance-based investments include Guaranteed Investment Contracts and annuities. Guaranteed Investment Contracts are debt instruments that are typically bought by employer sponsored retirement plans as assets for their stable funds. Annuities can be fixed or variable. They are used to help supplement retirement income.
• Other Investments option include ADRs, which represent indirect ownership of a certain number of shares of a specific foreign firm. Real estate appeals to people who like to be active in managing their investments. Income-producing property provides periodic rentals, but return on investment of land is modest. The risks associated with land depend directly on the kind of land you buy. Many people prefer investing in tangible assets as an alternative. Precious metals like gold and silver and gems like diamonds have appealed to people throughout the ages.

Question 35

Exam 4. Derivatives, Insurance Securities, and Other Investments

Exam 4. Derivatives, Insurance Securities, and Other Investments

Question 36

John is considering adding to his coin and stamp collection. Which of the following is true?
* This is an efficient market.
* John would not be subject to the same elements of risk attributable to the stock market.
* Stamps and coins have a small bid-ask margin.
* Stamps and coins are more marketable than art and antiques.
* The return on physical assets is normally negatively correlated with returns on financial assets.

Answer 36

The return on physical assets is normally negatively correlated with returns on financial assets.
* Inflation, while bearish to stocks and bonds, may be beneficial for collectibles. That John would not be subject to the same elements of risk attributable to the stock market is a good answer, but the correct answer is better.

Question 37

A private placement can be purchased by which of the following?
I. An unlimited number of non-accredited investors
II. A limited number of non-accredited investors
III. 35 accredited investors
IV. An unlimited number of accredited investors
* II, IV
* II, III
* I, III
* I, IV

Answer 37

II, IV

Question 38

The client feels the stock he owns is going to take a dive. He already has a substantial gain. Other than selling the stock, he wants to preserve his gain should the stock go down. Which of the following techniques should he use?
I. Sell a covered call
II. Buy a put
III. Use a stop-limit order
IV. Use a stop order
* I
* I, III, IV
* II, III, IV
* II

Answer 38

II
* If the client sells a call, he will receive premium income, but the stock may be called away. A stop-limit order is a specialized order in which a limit order and a stop order are combined. A stop-limit order to sell must have a stop-limit price below the security’s market price.
* Example: “Sell 100 GM 70 stop-limit.” Once the stock sells at or below $70, the order becomes a limit order to sell 100 shares at $70.
* Limit orders can also be placed on the buy side. The put protects the downside risk.

Question 39

An ADR is which of the following?
* An instrument used to affect payment in import-export transactions.
* A corporation organized under the laws of a foreign country.
* A receipt for shares of a foreign-based corporation.
* An instrument that contracts in the futures market for a foreign currency.

Answer 39

A receipt for shares of a foreign-based corporation.

Question 40

Because collectibles are generally neither liquid nor do they produce any income, why would a person purchase a collectible?
* For low acquisition cost and commissions.
* For enjoyment.
* For predictable price changes.
* For low capital gains rates when sold for a gain.

Answer 40

For enjoyment.
* With the exception of dealers, an investor who invests in collectibles realizes a gain subject to long-term capital gains rates of 28% upon sale (if held long-term). Acquisition and commissions are relatively high compared to alternative investments. Prices change frequently and unpredictably due to their markets.

Question 41

Do ADRs satisfy the definition of “qualified foreign corporations” to get the 15% qualified dividend rate?
* Yes
* Generally
* No

Answer 41

Generally
* Most (but not all) ADRs satisfy the IRS definition of a “qualified foreign corporation”. Most ADRs fit the Internal Revenue Code, but some ADRs do not meet the definition.

Question 42

If a portfolio manager of a S&P 500 fund is expecting to receive $10,000,000 in 90 days and is of the opinion that prices of large-cap stocks are about to increase, he could take advantage of the change by doing which of the following?
* Buying S&P 500 Index calls
* Buying additional S&P 500 Index stocks when the funds are received
* Writing S&P 500 Index covered calls
* Buying S&P 500 Index puts

Answer 42

Buying S&P 500 Index calls
* If the large-cap market were to rise, the manager could profit from increased prices by buying calls.

Question 43

Which of the following is the riskiest option position?
* Selling a naked call.
* Buying in the money call.
* Buying an out of the money call.
* Selling a covered call.

Answer 43

Selling a naked call.
* If the price of the stock rises, the seller of the naked call is forced to buy the stock at the higher market price in order to supply it to the option buyer. This is the riskiest option because the stock may rise without limit.

Question 44

Bob owns a variable annuity. The accrued gain for the year is 16% or $16,000. Is the gain tax-deferred?
* The gain for the year is ordinary income.
* The annuity is tax-deferred.
* Variable annuities pay capital gains tax.

Answer 44

The annuity is tax-deferred.
* This contract is owned by a natural person (Bob). Taxation is deferred.

Question 45

Trudy, a 40-year old single executive, has about 75% of her net worth in U.S. common stock securities. She owns a downtown condo overlooking the scenic riverfront. She is not planning to get married and likes her style of living. She is well paid and receives a large bonus at year end. The potential for large stock market drops like those in 2002 and 2008 concern her. Which of the following investments would you suggest?
I. 2-year S&P 500 call index options
II. A large position in 9 month put options
III. A quality collectible
IV. A natural resource fund
V. A global fund
* I, IV
* II, V
* III, IV
* I, V
* III, V

Answer 45

III, IV
* Collectibles and natural resource funds are negatively correlated with the market.
* The collectible may be perfect with her style of living.
* The index option is correlated.
* The puts may expire.
* The global fund includes US stocks.

Question 46

Which of the following statements is true about ADRs?
* ADRs facilitate trading of domestic securities in foreign countries.
* ADR holders receive foreign tax credits for income tax paid to a foreign country.
* ADR dividends are declared in U.S. dollars.
* ADR holders can vote for the Board of Directors.

Answer 46

ADR holders receive foreign tax credits for income tax paid to a foreign country.
* ADR holders cannot vote for the Board of Directors. Dividends are declared in local currencies but are paid in U.S. dollars.

Question 47

Futures: Maintenance Margin (Example)

Reconsider investors B and S, who had, respectively, bought and sold a July wheat futures contract at $4 per bushel. Each investor had made a deposit of $1,000 in order to meet the initial margin requirement. The next day the price of the wheat futures contract rose to $4.10 per bushel, or $20,500. Thus the equity of B increased to $1,500 while the equity of S decreased to $500. If the maintenance margin requirement is 65% of the initial margin, both B and S are required to have equity of at least $650 (0.65 X $1,000) in their accounts every day. Because the actual level of equity for B clearly exceeds that amount, B does not need to do anything. Indeed, B may withdraw an amount of cash equal to the amount by which the equity exceeds the initial margin. In this example, B can withdraw cash of $500.

However, S is under margined and will be asked to make a cash deposit of at least $500, because this will increase the equity from $500 to $1,000, the level of the initial margin. In the event that S refuses to make this deposit, the broker will enter a reversing trade for S by purchasing a July wheat futures contract. The result is that S will simply receive an amount of money approximately equal to the account’s equity, $500, and the account will be closed. Because S initially deposited $1,000, S will have sustained a loss of $500.

On the third day the price of the July wheat futures contract is assumed to settle at $3.95 per bushel, representing a $750 loss for B and a $750 gain for S. As a consequence, B is now under margined and will be asked to deposit $750 so that the equity in B’s account will be $1,000. (This example assumes that B had withdrawn the $500 in excess margin that had accumulated from the previous day’s price change.) Conversely, S can withdraw $750, because the equity in S’s account is over the $1,000 initial margin requirement by that amount. (Remember that S had added $500 to bring the account’s equity up to $1,000 at the end of the previous day.)

Question 48

Roles of Exchange (OCC): Activity

The Options Clearing Corporation (OCC) was founded in 1973 and is the largest clearing organization in the world for financial derivatives instruments. Go to their website optionsclearing.com and explore the About OCC section to learn more about its origin and purpose.

After reviewing the above link, you should be able to answer the following questions:
* What is the purpose of the OCC?
* What publications are available from the OCC?

Question 49

American Deposit Receipts (ADR): Activity

There are an abundance of foreign companies that offer ADRs. Some household names include Nokia, Sony and Shell. Go to adr.com and look up a few foreign companies to see if they have ADRs in an American stock exchange. You can also explore ADRs by region, country and sector.

After reviewing the above link, you should be able to answer the following questions:
* What type of data is provided for an individual ADR?
* What are the most active ADRs from the Nikkei? How about Hong Kong?