CHAPTER 14 - MAKING RECOMMENDATIONS Flashcards
(30 cards)
xSystematic Risk
Risk that is associated with the overall economy that can have negative effects on a company regardless of strength
Cannot diversify systematic risk
Types of Systematic Risk
Market Risk
Interest Rate Risk
Inflation Risk
Market Risk
Overall market declines, even if you have a diversified portfolio
Interest Rate Risk
Increase in interest rates will decrease value of bonds
Decrease in interest rates will increase value of bonds
Inflation Risk
AKA purchasing power risk
For anything with fixed payment
Inflation eats away at what you can buy
Nonsystematic Risk
Risk that can be diversified away that is unique to certain business or industry or investment type
Types of Nonsystematic Risk
Credit Risk - Risk that and issuer defaults on debt payments (aka default risk)
Capital Risk - Investor cannot get their original investment back (high in option and low in treasuries)
Business Risk - Risk of poor management decisions that can ruin a business
Liquidity Risk - Risk that investor might not be able to sell an investment quickly at a fair price (aka marketability risk (real estate, are, and LPs and illiquid)
Regulatory Risk - Risk that new regulation hurts a business
Legislative Risk - Risk that change in law hurts a business
Political Risk - Mostly in emerging economies, risk that political instability hurts a business
Sovereign Risk - Risk that a country defaulting on its debt will impact overall economy
Call Risk
Risk that when interest rates drop your bond could get called
Also reinvestment rate risk - If bond gets called you will reinvest it at a lower rate
Applies to callable preferred stock
Reinvestment Risk
When interest rates go down the proceeds you are receiving from bonds will be reinvested at those lower rates
May need to take more risk to get higher rates
Prepayment Risk
Risk that a borrower pays their principal quicker before maturity
GNMAs are subject to this because mortgages can be refinanced when interest rates drop - now that debt is refinanced you will reinvest at a possibly lower rate
Currency Risk
Investment in foreign currency could decline if the value declines against the US dollar
If currency investment is made in drops against drops, value of interest payment will drop as well
Risk Mitigation Against Systematic Risk
Hedging - Long puts on an index
Rebalancing - Asset allocation, this produces steadier returns with less volatility by keeping the ratio even to not take too much risk on
Diversification DOES NOT reduce systematic risk
Risk Mitigation Against nonsystematic risk
Hedging - Long puts on a security (harder will lots of securities)
Diversification - many difference securities to reduce impact of one or two losing value (BEST)
Recommendation
Suggesting course of action on a security, class of investment, or investment strategy
What is the knowledge level of the person?
Would a reasonable person view that as a recommendation?
What are recommendations?
Buy or sell
Hold
Employ strategy
Open account
Know Your Customer Rule
FINRA and other SROs require you to know customer
This means the BD should:
- Understand customers financial status
- Understand customer financial and non-financial circumstances
- Understand customers investment objectives
- Know facts essential to make suitable recommendations
RRs responsibility to determine customer info and need a reasonable basis
Customer does not include potential investors (not your client at the time)
Tolerance for Risk and Investment Goals
Risks they can afford to take
How liquid
Tax considerations
Long or short term
Investment experience?
Currently held?
Time frame?
Investor Goals
Most important is that any recommendation aligns with the customer investment objectives
Regulation Best Interest BI
Became effective on June 30, 2020
Rules around conduct of BDs and associated persons of BDs
Obligation created by BI
Any member or associated person making a recommendation must exercise reasonable care, skill, and prudence in making recommendation
- Acknowledge potential risk and rewards
- Act in their best interest
- Believe that series of recommendations is not excessive and unsuitable for the customer
- Identify conflicts of interest like sales contests and disclose and mitigate or eliminate
Summarized: Disclosure, Care, Conflict of Interest, and Compliance
Disclosure Obligation
Prior to recommendations should the customer:
- All material facts with scope and terms of relationship
- Material fees and costs
- Type and scope of services and limitations
- Material facts around conflicts of interest
Care Obligation
When making a recommendation
- Understand potential risks and rewards and have basis to believe its in the best interest
- Have reasonable basis to believe this is the best interest of a particular customer based on profile and risk and do not place BD interest ahead of customer
- Reasonable basis to believe recommended transactions are not excessive and in the best interest
Conflict of Interest Obligation
Applies to BD - BD must establish and maintain written policies to address conflicts of interest
Compliance Obligation
BDs must comply with all laws and regulations
