Chapter 7 - Suitability and Investment Risks

Question 1

An institutional account may be able to qualify for an exemption from
A) The quantitative aspect of the suitability rule
B) The customer-specific aspect of the suitability rule
C) The reasonable basis aspect of the suitability rule
D) All components of the securities industry suitability rule

Answer 1

Answer Explanation
An institutional account may qualify for an exemption from the customer-specific aspect of the suitability rule. The broker must believe the client is able to assess risks independently, and the client must confirm it is exercising independent judgement in evaluating the recommendation.

Textbook Reference
Please see textbook section 7.1.2.1

Question 2

A customer with an income objective believes that interest rates are likely to fall over the next 10 years. Of the following, which two are most suitable for this customer?

I. TANS
II. A 10-year non-callable bond
III. Floating rate notes
IV. A long term bond with a put feature after 5 years
A) I and III
B) I and IV
C) II and III
D) II and IV

Answer 2

Correct Answer:
D) II and IV

Answer Explanation
This customer is concerned with locking in the highest possible interest payments for the next 10 years. The noncallable bond will lock in current returns and will not be called away before maturity. The long-term puttable bond will also lock in the current interest rate, but give the investor the option of redemption at par if rates have increased in 5 years. A TAN is a short-term security and a floating rate note’s interest rate adjusts periodically with current interest rates, so neither will lock in the current rate.

Textbook Reference
Please see textbook section 7.2.1

Question 3

An airline is involved in a scandal of covering up defects that caused its planes to crash. As a result, the stock price plummets. This is an example of
A) systematic risk.
B) business risk.
C) outlier risk.
D) political risk.

Answer 3

Correct Answer:
B) business risk

Answer Explanation
Non-systematic risk or business risk is the risk inherent in individual stocks or companies. Changes in corporate management or product recalls, which could impact a single stock, are examples.

Textbook Reference
Please see textbook section 7.2.12

Question 4

If an investor wants to build a portfolio that will carry minimal capital risk, they should avoid
A) stock index funds
B) corporate bonds
C) call options
D) blue chip stocks

Answer 4

Correct Answer:
C) call options

Answer Explanation
An investor who purchases a call option is at risk of losing the entire premium paid for the option, and thus should be avoided in a portfolio that seeks to minimize capital risk.

Textbook Reference
Please see textbook section 7.2.3

Question 5

In mortgage-backed securities, prepayment risk accelerates when
A) housing prices rise.
B) housing prices fall.
C) homeowners pay off their mortgages on schedule.
D) homeowners refinance their mortgages.

Answer 5

Correct Answer:
D) homeowners refinance their mortgages

Answer Explanation
When homeowners refinance their mortgages, mortgage principal is repaid to mortgage-backed securities (MBS) pools faster than anticipated. This tends to happen when interest rates are falling.

Textbook Reference
Please see textbook section 7.2.7

Question 6

Call risk is the biggest threat to an investor when interest rates are
A) falling
B) volatile
C) rising
D) stable

Answer 6

Correct Answer:
A) falling

Answer Explanation
Call risk is the risk that an investment, typically a bond, may be called by an issuer when interest rates decline.

Textbook Reference
Please see textbook section 7.2.1

Question 7

Individuals who cite current income as their investment objective are most likely
A) Recent college graduates
B) Approaching retirement
C) Young professionals in the workforce
D) Middle aged investors with diversified stock portfolios

Answer 7

Correct Answer:
B) Approaching retirement

Answer Explanation
Individuals approaching, or in retirement would likely identify current income as one of their investment objectives. This is probably not an objective of a younger person who is starting out in their career.

Textbook Reference
Please see textbook section 7.3.2

Question 8

With regard to evaluating quantitative suitability, which of the following statements is TRUE?
A) MSRB rules include specific guidelines for determining when turnover rates, transaction costs and other trading techniques are inappropriate for a customer’s account
B) A transaction should not be considered suitable unless a large concentration of the security is appropriate for the account
C) Recommendations must be evaluated individually and should not be viewed in conjunction with other portfolio activity.
D) A recommendation is unsuitable if the customer does not have the financial ability to support it

Answer 8

Correct Answer:
D) A recommendation is unsuitable if the customer does not have the financial ability to support it

Answer Explanation
The customer’s financial ability to pay for a transaction is a key quantitative suitability factor. The MSRB does not have specific guidelines to test for quantitative suitability. Individual transactions should be evaluated in terms of their size and impact on the total portfolio in determining suitability.

Textbook Reference
Please see textbook section 7.1.3

Question 9

A broker must have a reasonable basis to make a recommendation, meaning the recommendation must be suitable
A) For some investors
B) For most investors
C) For reasonable investors
D) For at least a few investors

Answer 9

Correct Answer:
A) For some investors

Answer Explanation
Initially it seems that some answer choices are the same. However, in the case of this question one is more correct than the other. In fact, this question is testing the exact wording that FINRA uses in reference to reasonable basis suitability.

In this instance, you will have to memorize the use of the word ‘some’ in relation to when a broker must have a reasonable basis to make a recommendation.

Key takeaway: The standard of reasonable basis suitability states that a recommended security or strategy should be suitable for at least ‘some’ investors.

Textbook Reference
Please see textbook section 7.1.1

Question 10

In fixed income investing, the most reliable strategy for reducing or eliminating call risk is to
A) avoid naked short calls.
B) buy bonds with long maturities.
C) buy non-callable securities.
D) buy short puts.

Answer 10

Correct Answer:
C) buy non-callable securities

Answer Explanation
The investments with the greatest call risk vulnerability are callable bonds and callable preferred stock. The best strategy for mitigating this risk is to purchase non-callable securities.

Textbook Reference
Please see textbook section 7.2.1

Question 11

On a day when the Dow Jones Industrial Average loses 3%, market analysts expect most individual US stocks to lose value because of
A) political risk.
B) systematic risk.
C) business risk.
D) interest rate risk.

Answer 11

Correct Answer:
B) systematic risk

Answer Explanation
Systematic risk reflects that the performance of an individual security will be impacted by the performance of the stock market as a whole.

Textbook Reference
Please see textbook section 7.2.11

Question 12

Which of the following securities is the most liquid?
A) Highly-rated municipal bond
B) Alternative investments traded OTC
C) Limited partnerships
D) Treasury bill

Answer 12

Correct Answer:
D) Treasury bill

Answer Explanation
Next to cash, a Treasury security is the most highly liquid security.

Textbook Reference
Please see textbook section 7.3.5

Question 13

Which of the following factors would be least relevant in determining the suitability of a customer?
A) The client’s liquidity needs
B) The client’s educational background
C) The client’s investment experience
D) The client’s tax status

Answer 13

Correct Answer:
B) The client’s educational background

Answer Explanation
A client’s tax status, investment experience, liquidity needs, time horizon, and objectives are all relevant factors in determining the suitability. The customer’s educational background would not be relevant.

Textbook Reference
Please see textbook section 7.1.5

Question 14

An investor in a high tax bracket is seeking a tax advantaged investment to deliver additional monthly income. Which of the following choices is most appropriate for this investor?
A) A balanced fund
B) A high yield bond fund
C) A real estate fund
D) A municipal bond fund

Answer 14

Correct Answer:
D) A municipal bond fund

Answer Explanation
Municipal bond funds pay federally tax-exempt dividends to shareholders. If the shareholder lives in the state of issue of the investments in the portfolio, income may be exempt from state taxes as well

Textbook Reference
Please see textbook section 7.3.3

Question 15

Of the following, which investment choice is most appropriate for a high net worth investor with a primary objective of long-term safety of principal?
A) A non-investment grade corporate bond
B) A C rated general obligation bond
C) A highly rated tax anticipation note
D) An investment grade revenue bond

Answer 15

Correct Answer:
D) An investment grade revenue bond

Answer Explanation
An investor that wants safety of principal wants to preserve the investment over its life. The higher the rating, the greater the likelihood the investor will achieve safety of principal. Investment-grade municipal revenue bonds will offer safety of principal and tax-exempt income. A highly rated note has a much shorter time horizon.

Textbook Reference
Please see textbook section 7.3.3

Question 16

The files of a customer who received a recommendation to purchase an interest in a public oil and gas program must include
A) A signed attestation that the customer has reviewed the risks of the partnership with a purchaser representative
B) The documents collected to support the determination of suitability of recommended partnership interest
C) A signed statement that the customer does not hold the general partner responsible for potential financial loss related to the partnership business
D) Written approval from the principal approving the recommendation before it was delivered to the customer

Answer 16

Correct Answer:
B) The documents collected to support the determination of suitability of recommended partnership interest

Answer Explanation
FINRA rules require that representatives maintain in the files of the customer the documents that support the determination of suitability of the partnership interest for the customer.

Textbook Reference
Please see textbook section 7.1.2

Question 17

In financial markets, the risk created by volatility in stock prices, bond prices, currency rates, interest rates and dividends are most often hedged with transactions in
A) foreign currency
B) interbank securities
C) fungible assets
D) derivatives

Answer 17

Correct Answer:
D) derivatives

Answer Explanation
The derivatives market has grown into a marketplace for tools that are used to hedge or reduce the risk of many other investments. The countercyclical nature of certain derivative instruments and their highly leveraged status has made them suitable for this purpose.

Textbook Reference
Please see textbook section 7.2.11

Question 18

A municipal bond would be inappropriate for
A) A 25 year -old investment banking intern earning $50,000.
B) A physician at a medical clinic whose total compensation package exceeds $400,000
C) A 35 year- old college professor with a salary of $150,000, plus a bonus and benefits package
D) The CEO of a local power company, earning a mid- six-figure salary

Answer 18

Correct Answer:
A) A 25 year-old investment banking intern earning $50,000

Answer Explanation
In general, the lower an investor’s tax bracket, the less suitable municipal bonds are. Such an investor would benefit more from a higher yielding corporate bond.

Textbook Reference
Please see textbook section 7.3.3

Question 19

A new 60-year-old customer is concerned with capital preservation and is uncomfortable with taking on substantial investment risk. As a result, you would be most likely to recommend which of the following investments for this customer’s investment portfolio?
A) Exchange traded note (ETN)
B) Stock index Fund
C) Money market Fund
D) Exchange traded fund (ETF)

Answer 19

Correct Answer:
C) Money market Fund

Answer Explanation
An investor who is not comfortable taking significant risk should avoid investments that may jeopardize his capital. This investor will want to focus on safe, conservative products like a money market fund. An exchange-traded note, which is an unsecured debt instrument of an issuer, may expose the investor to a greater degree of risk than he is comfortable taking. Likewise, the stock index fund and ETF are both risk assets that could lose capital and have signfiicant risk.

Textbook Reference
See textbook section 7.3.1

Question 20

An investment is most likely to have currency risk if it is
A) subject to changes in international politics.
B) denominated in US dollars.
C) located in a foreign country.
D) denominated in a foreign currency.

Answer 20

Correct Answer:
D) denominated in a foreign currency

Answer Explanation
When US investors buy investments denominated in foreign currencies, they incur currency risk. Some investments located in foreign countries may be denominated in dollars – thus, would have little or no currency risk.

Textbook Reference
Please see textbook section 7.2.10

Question 21

When must a broker-dealer ensure that a recommended security is suitable for its customer?
A) At the point of sale and for one year following the sale
B) At the point of sale
C) As long as the customer stays with the firm
D) For the life of the investment

Answer 21

Correct Answer:
B) At the point of sale

Answer Explanation
Broker-dealers must apply suitability and fair-dealing standards and rules at the point of sale. The sale can be a recommendation to purchase, hold or sell a security. However, broker-dealers and their representatives usually do not have responsibilities to monitor customers’ investments beyond the point of sale.

Textbook Reference
Please see textbook section 7.1

Question 22

Investors who diversify their portfolios with companies in different industries are typically able to avoid
A) market risk
B) systemic risk
C) non-systemic risk
D) marketability risk

Answer 22

Correct Answer:
C) non-systemic risk

Answer Explanation
Non-systemic risk is company or industry specific risk that is inherent in each investment. No systemic risk can be reduced through appropriate diversification.

Textbook Reference
Please see textbook section 7.2.12

Question 23

An investor in a high tax bracket is interested in achieving the highest level of income from a mutual fund investment. Of these choices, which may be appropriate?
A) High yield municipal bond fund
B) An aggressive growth value fund
C) An international index fund
D) A commodity fund

Answer 23

Correct Answer:
A) High yield municipal bond fund

Answer Explanation
Municipal bond funds provide income that is exempt from taxation at the federal level and possibly the state level. These funds may be appropriate for meeting the income objectives of high income investors. High yield municipal bond funds offer greater income potential and higher risk because they primarily invest assets in municipal securities that are either not rated or that have been given a non-investment grade rating by a major agency.

Textbook Reference
Please see textbook section 7.3.3

Question 24

An investor with the goal of income preservation would be most likely to purchase
A) 1,000 shares of common stock
B) Exchange traded funds
C) Commercial paper and T Bills
D) Direct participation programs

Answer 24

Correct Answer:
C) Commercial paper and T Bills

Answer Explanation
An individual with a goal of income preservation would be most likely to purchase a money market security, such as commercial paper or Treasury paper.

Textbook Reference
Please see textbook section 7.3.1

Question 25

The downside of increased prepayment risk in mortgage-backed securities (MBS) is that
A) MBS investors must reinvest principal in a lower interest rate environment.
B) MBS investors lose liquidity.
C) MBS investors lose principal.
D) MBS securities have their credit ratings downgraded.

Answer 25

Correct Answer:
A) MBS investors must reinvest principal in a lower interest rate environment

Answer Explanation
Homeowners tend to refinance (pay down) their mortgages in falling rate environments. This increases prepayment risk as principal is returned to MBS investors faster than expected. This principal must be reinvested in a lower-rate environment.

Textbook Reference
Please see textbook section 7.2.7

Question 26

According to industry rules, which of the following evidence supports the suitability of an investment recommendation?
A) The firm has evidence indicating that customers are satisfied with the investment.
B) The recommendation was based on an evaluation of the latest research reports.
C) The investment product has a history of long-term gain.
D) The recommendation was based on facts disclosed by the customer.

Answer 26

Correct Answer:
D) The recommendation was based on facts disclosed by the customer

Answer Explanation
The recommendations of a registered representative must be suitable for each particular client; suitability is determined based on facts disclosed by the customer.

Textbook Reference
Please see textbook section 7.1.5

Question 27

All of the following statements about call risk are true except
A) the risk is greatest when interest rates are rising.
B) bond buyers, not bond issuers, are vulnerable to call risk.
C) call risk jeopardizes the investor’s ability to realize the stated bond yield to maturity.
D) the risk is greatest in callable bonds and callable preferred stocks.

Answer 27

Correct Answer:
A) the risk is greatest when interest rates are rising

Question 28

An investor that is subject to high federal and state income taxes would benefit most from purchasing which of the following?
A) Treasury STRIPs
B) State issued GO bonds
C) Treasury bonds
D) Private activity bonds

Answer 28

Correct Answer:
B) State issued GO bonds

Answer Explanation
Bonds issued by the U.S. Treasury and Treasury STRIPS are subject to federal income taxes. Interest on private activity bonds may be subject to alternative minimum taxes, so the general obligation bond is most beneficial. A GO bond is exempt from taxation at the federal level and possibly at the state level as well (if the purchaser is a resident of the state of issue).

Textbook Reference
Please see textbook section 7.3.3

Question 29

A proven strategy for mitigating the non-systematic risk in a portfolio is to
A) purchase only blue-chip stocks.
B) diversify broadly among many individual stocks.
C) focus on dividend-paying stocks.
D) buy put options on a leading stock market index.

Answer 29

Correct Answer:
B) diversify broadly among many individual stocks

Answer Explanation
Non-systematic or business risk is the risk inherent in individual stocks or companies. It can be greatly reduced by diversifying broadly among many individual stocks or buying diversified equity mutual funds and exchange-traded funds.

Textbook Reference
Please see textbook section 7.2.12

Question 30

A portfolio manager of a mutual fund anticipates a short-term drop in the market. It might be expected that the manager would
A) sell the assets in the fund and use the proceeds to buy call options.
B) retain any excess cash or cash equivalents and then make trades once the anticipated drop occurs.
C) refrain from any portfolio trading until after the anticipated drop occurs.
D) use all available cash in the fund to buy Treasury securities.

Answer 30

Correct Answer:
B) retain any excess cash or cash equivalents and then purchase securities once the drop occurs.

Answer Explanation
In this scenario, the portfolio manager would keep excess cash in cash and cash equivalents and then purchase securities once the drop occurs.

Textbook Reference
Please see textbook section 7.5.1

Question 31

Investors who indicate they are seeking current income from an investment would be mostly likely to consider which of the following products?
A) Exchange traded notes
B) Non-dividend paying preferred stock
C) Limited partnerships
D) Real estate investment trusts

Answer 31

Correct Answer:
D) Real estate investment trusts

Answer Explanation
If the investment objective is current income, a real estate investment trust may be a suitable product, as these investments will pay dividends in many instances.

Textbook Reference
Please see textbook section 7.3.2

Question 32

Which of the following instructions is NOT a recommendation that is addressed by Regulation Best Interest (BI)?
A) Don’t liquidate an existing stock position
B) Open a 529 plan rather than an UTMA
C) Consolidate two former workplace retirement plans into one IRA
D) Use PDQ Commercial Bank for wiring trade payments

Answer 32

Correct Answer:
D) Use PDQ Commercial Bank for wiring trade payments

Answer Explanation
Giving administrative instructions regarding trade payment procedures is NOT a call to action that would influence a client’s investment behavior. The other three instructions meet Reg BI’s definition of a recommendation to a retail customer.

Textbook Reference
Please see textbook section 7.1.4

Question 33

A registered representative sends 10 clients a letter recommending that they sell shares of ABC Pharmaceuticals before the company declares bankruptcy. This is based on the rep’s own opinion and research, and the firm has not investigated the potential for bankruptcy. Is this a compliance problem?
A) Yes, because it violates suitability requirements
B) Yes, because it is based on speculation, in the eyes of regulators
C) No, because the rep is exercising free speech
D) No, because the rep has research to support the recommendation

Answer 33

Correct Answer:
A) Yes, because it violates suitability requirements

Answer Explanation
This is a suitability violation. Specifically, it violates the requirement that the firm perform reasonable basis suitability before any recommendation is made. The client to whom communication containing a recommendation is sent has a right to request information supporting the recommendation. This will be the information uncovered in the firm’s reasonable basis suitability investigation. It must reflect views of the firm, not a specific rep.

Textbook Reference
Please see textbook section 7.1

Question 34

The goal of portfolio rebalancing is to ensure that
A) All investment categories are equally weighted.
B) The registered representative handling the portfolio always has an opportunity to make changes in the investor’s portfolio.
C) The allocation of stocks, bonds, and cash is reviewed at least once each year to ensure that the best performing assets over the past year are given additional weighting in the portfolio.
D) No asset class becomes over-weighted in a portfolio

Answer 34

Correct Answer:
D) No asset class becomes over-weighted in a portfolio

Answer Explanation
The goal of portfolio rebalancing is to ensure that the portfolio is returned to its original proportionate investment mix. This may involve selling an asset that has become over-weighted due to recent strength in that sector.

Textbook Reference
Please see textbook section 7.5.1

Question 35

A US investor buys shares in a Canadian company that trade in Toronto and are denominated in Canadian dollars. The currency risk of this position can rise if
A) the US dollar strengthens against the Canadian dollar.
B) the Canadian dollar strengthens against the US dollar.
C) the Canadian dollar does not change in value against the US dollar.
D) the US dollar weakens against the Canadian dollar.

Answer 35

Correct Answer:
A) the US dollar strengthens against the Canadian dollar

Answer Explanation
When making investments denominated in a foreign currency, currency risk increases with the US dollar’s strength or the foreign currency’s weakness.

Textbook Reference
Please see textbook section 7.2.10

Question 36

A customer in a high tax bracket would like to establish a well diversified, tax advantaged portfolio with a $25,000 investment. The investor also wishes to protect the investment from principal risk. Which of the following is most appropriate?
A) A municipal bond laddering strategy that is protected from risk with the purchase of portfolio insurance
B) An investment in a U.S. government money market fund
C) An investment in a municipal bond fund
D) The purchase of several municipal bonds of different issuers, geographic locations and maturities

Answer 36

Correct Answer:
C) An investment in a municipal bond fund

Answer Explanation
Of the choices provided, the municipal bond fund is likely to provide the best diversification for an investment of this size. The large pools of these funds offer more issuers, credit qualities, maturities, and other individual characteristics, than can be obtained with investments in individual bonds.

Textbook Reference
Please see textbook section 7.3.3

Question 37

A proven strategy for mitigating the systematic risk in a portfolio of US stocks is to
A) emphasize dividend-paying stocks.
B) buy put options on a broad-based stock market index.
C) diversify among many different stock issues.
D) reduce stock holdings gradually during market downturns.

Answer 37

Correct Answer:
B) buy put options on a broad-based stock market index

Answer Explanation
Buying put options on a broad-based index can generate profits when all stocks are falling, that helps to mitigate market risk.

Textbook Reference
Please see textbook section 7.2.11

Question 38

An individual investor at a broker-dealer has assets over $50 million. Under FINRA rules, this individual is considered a(n)
A) established customer.
B) accredited investor.
C) institutional account.
D) qualified institutional buyer.

Answer 38

Correct Answer:
C) institutional account

Answer Explanation
Under FINRA rules, any party (retail or institutional) with at least $50 million in assets is defined as an institutional account.

Textbook Reference
Please see textbook section 7.1.2.1

Question 39

Falling interest rates can create additional risk for holders of mortgage-backed securities (MBS) because homeowners can refinance into lower-rate mortgages. This risk is called
A) mortgage acceleration risk.
B) credit risk.
C) capital risk.
D) prepayment risk.

Answer 39

Answer Explanation
Prepayment risk is associated with mortgage-backed securities (MBS). When interest rates are falling, homeowners refinance or prepay their mortgages, which causes principal to be repaid faster to MBS investors. Because mortgages are typically refinanced in falling-interest-rate environments, the MBS holder is left to reinvest the capital in the lower-interest-rate environment.

Textbook Reference
Please see textbook section 7.2.7

Question 40

Which of the following is not a component of the MSRB Suitability Rule?
A) Issuer-specific suitability
B) Quantitative suitability
C) Customer-specific suitability
D) Reasonable-basis suitability

Answer 40

Answer Explanation
The MSRB suitability rule does not include a provision for issuer related suitability.

Textbook Reference
Please see textbook section 7.1`

Question 41

Which of the following bonds is most vulnerable to interest rate risk?
A) Zero-coupon bond with 25 years to maturity
B) Corporate bond with 20 years to maturity and a 6.5% coupon
C) Municipal bond with 8 years to maturity and a 3.5% coupon
D) US Treasury with 8 years to maturity and a 5% coupon

Answer 41

Correct Answer:
A) Zero-coupon bond with 25 years to maturity

Answer Explanation
Interest rate risk is increased by long maturities and low coupons. Long-term zero-coupon bonds are the most vulnerable to interest rate risk.

Textbook Reference
Please see textbook section 7.2.6

Question 42

Collecting information to assess a client’s investment profile is paramount to being able to provide appropriate advice and recommendations. Knowledge of which of the following items is least important towards achieving this goal?
A) age of primary residence
B) life insurance policies
C) security holdings
D) credit worthiness

Answer 42

Correct Answer:
A) age of primary residence

Answer Explanation
The age of a client’s home is not a significant factor when gathering information about a client’s investment profile.

Textbook Reference
Please see textbook section 7.1.5

Question 43

Regulation Best interest (BI) addresses recommendations made about all the following except:
A) Rollovers or transfers
B) Specific securities
C) Banking Services
D) Specific account types

Answer 43

Correct Answer:
C) Banking Services

Answer Explanation
Discussing banking services generally falls outside the bounds of recommendations as defined by Reg BI. The other three choices are categories that are cited in the regulation.

Textbook Reference
Please see textbook section 7.1.4

Question 44

An investor is concerned about credit risk. A suitable investment vehicle for this person would be
A) A Treasury bond fund
B) Preferred stock of an emerging growth company
C) A bond of a low rated corporation
D) A municipal bond of a financially unstable town

Answer 44

Correct Answer:
A) Treasury Bond Fund

Answer Explanation
Credit risk is the risk that an issuer will default on its debt payments.

Textbook Reference
Please see textbook section 7.2.4

Question 45

The fixed rate of return offered by preferred stock or bonds is a primary factor when considering
A) Inflation risk
B) Interest rate risk
C) Credit risk
D) Reinvestment rate risk

Answer 45

Correct Answer:
A) Inflation risk

Answer Explanation
Fixed income securities carry inflation, or purchasing power risk. When inflation occurs, the value of the returns generated by a fixed income product will be diminished.

Textbook Reference
Please see textbook section 7.2.5

Question 46

In which type of economic environment are bond investors most vulnerable to interest rate risk?
A) Rising interest rates
B) Recessions
C) Falling interest rates
D) Declining inflation

Answer 46

Correct Answer:
A) Rising interest rates

Answer Explanation
Bond prices move opposite interest rates. Therefore, interest rate risk is the risk that bond prices will fall during times when interest rates are rising.

Textbook Reference
Please see textbook section 7.2.6

Question 47

Zach, a member of your sales team, suggested that his client Monica purchase the Apple County GO bonds, maturing 20XX, first call date 20XX. CUSIP HMK202024. This recommendation resulted from a careful review of Monica’s investment profile. In carrying out his due diligence, Zach likely paid the least amount of attention to Monica’s
A) prior residential history
B) need for current liquidity
C) date of birth
D) prior investment experience

Answer 47

Correct Answer:
A) Prior residential history

Answer Explanation
MSRB rules require that a municipal securities dealer have a reasonable basis to believe that a recommended transaction in a municipal security is suitable for the customer, based upon information obtained through the reasonable diligence of the firm to learn of the customer’s investment profile. A customer’s investment profile takes many variables into account. Key among these are the client’s age, overall financial situation, tax status, investment objectives, investment experience, and risk tolerance. Of lesser significance in this analysis would be the client’s prior residential history.

Textbook Reference
Please see textbook section 7.1.5

Question 48

Liquidity risk may be avoided if an investor takes a position in
A) Penny stocks
B) Exchange traded funds
C) Limited partnerships
D) Municipal bonds

Answer 48

Correct Answer:
B) Exchange traded funds

Answer Explanation
Investments that should be made in the interest of avoiding liquidity risk include exchange listed stocks, treasuries, and exchange traded funds (ETFs).

Textbook Reference
Please see textbook section 7.2.8

Question 49

Investors whose bonds have been called as interest rates have fallen are now facing
A) reinvestment rate risk
B) inflation risk
C) capital risk
D) credit risk

Answer 49

Correct Answer:
A) Reinvestment rate risk

Answer Explanation
Investors would now be facing reinvestment rate risk, as bonds have been called and it will be difficult to find another investment offering the same return that was available prior to the bond being called.

Textbook Reference
Please see textbook section 7.2.2

Question 50

An investor concerned about interest rate risk might be advised to
A) Sell covered call options
B) Purchase common stock
C) Purchase preferred stock
D) Purchase high grade corporate bonds

Answer 50

Correct Answer:
B) Purchase common stock

Answer Explanation
An investor concerned about interest rate risk should purchase common stock or convertible bonds.

Textbook Reference
Please see textbook section 7.2.6

Question 51

An investor in a high tax bracket is seeking an investment opportunity that will generate income, but with as much protection from taxation as possible. Which of the following choices may be appropriate?
A) Municipal Zero coupon
B) GNMA pass-through certificates
C) Treasury notes
D) Puerto Rico bonds

Answer 51

Correct Answer:
D) Puerto Rico bonds

Answer Explanation
Bonds issued by the Commonwealth of Puerto Rico are referred to as triple-tax-exempt since they are exempt from federal, state, and local taxes. Municipal zero coupon bonds do not generate income, as they are purchased at a discount and mature to their face value. Treasury notes are subject to federal tax and exempt from state and/or local taxes. GNMA securities are subject to federal, state, and local tax.

Textbook Reference
Please see textbook section 7.3.3

Question 52

A recommendation to a married couple with three young children to purchase units of a direct participation program
A) Must be approved by a principal
B) May be made by a registered representative only after the rep determines that the couple understands the risks of the investment
C) Must meet appropriate suitability standards
D) Must first be approved by FINRA

Answer 52

Correct Answer:
C) Must meet appropriate suitability standards

Answer Explanation
All recommendations to customers must be suitable for that customer. Recommendations do not need to be approved by FINRA or a principal.

Textbook Reference
Please see textbook section 7.1.2

Question 53

Which of the following items about a customer is least important pursuant to the Know-you-customer rule?
A) Net worth
B) Employment status
C) Investment knowledge
D) Risk tolerance

Answer 53

Correct Answer:
C) Investment Knowledge

Answer Explanation
A client’s investment knowledge would be the least important item among these choices when considering the Know-your-customer rule.

Textbook Reference
Please see textbook section 7.1.5

Question 54

An investor buys call options that expire worthless, out-of-the-money. This is an example of
A) systematic risk.
B) volatility risk.
C) non-systematic risk.
D) capital risk.

Answer 54

Correct Answer:
D) Capital Risk

Answer Explanation
Capital risk is the risk that an investor could lose an entire investment. This is most common in speculative investments such as options, penny stocks and direct participation programs.

Textbook Reference
Please see textbook section 7.2.3

Question 55

An individual indicates that his investment objective is growth. This individual is most likely in what age category?
A) 50 - 64
B) 65 +
C) 18 - 34
D) 35 - 49

Answer 55

Correct Answer:
C) 18-34

Answer Explanation
Growth may be a common investment objective for a younger individual, who will be better positioned to withstand occasional volatility in the securities markets.

Textbook Reference
Please see textbook section 7.3.4

Question 56

An investor who wishes to avoid reinvestment risk would be unlikely to purchase a
A) 60-day commercial paper
B) 7 -year Treasury Strip
C) 20-year zero coupon bond
D) 15-year AAA debenture

Answer 56

Correct Answer:
D) 15-year AAA debenture

Answer Explanation
Note that this question is asking for which purchase is UNLIKELY. Reinvestment risk can be avoided through the ownership of a zero-coupon bond. A debenture will make regular interest payments to the investor, which will then need to be reinvested at current interest rates. A coupon paying bond would not be appropriate for an investor who wants to avoid reinvestment risk.

Textbook Reference
Please see textbook section 7.2.5

Question 57

An investor would like to achieve monthly income from a mutual fund investment that has the highest level of principal protection available. A suitable recommendation is a
A) Balanced fund
B) High yield bond fund
C) Money market fund
D) U.S. Government Bond fund

Answer 57

Correct Answer:
D) U.S. Government Bond fund
Answer Explanation
Bond funds are used to meet income objectives. U.S. government bond funds offer the lowest level of credit risk so meet the objectives of this investor.

Textbook Reference
Please see textbook section 7.4

Question 58

An investor plans to purchase a home in the next 6 – 12 months and would like to invest funds for a down payment in a mutual fund. Which of the following choices is most suitable?
A) A U.S. government bond fund
B) A real estate fund
C) A money market fund
D) A balanced fund

Answer 58

Correct Answer:
C) A money market fund

Answer Explanation
Money market funds are appropriate for investments that need to be liquidated for their full value in a short time frame. Although not guaranteed, the value of each share has been held constant at $1, so investors in money market funds do not lose principal and can liquidate their shares for their full value plus interest that was earned.

Textbook Reference
Please see textbook section 7.4

Question 59

An investor seeking to avoid call risk due to falling interest rates should purchase
A) a callable bond
B) An interest rate sensitive security
C) A bond without a call feature
D) a call option

Answer 59

Correct Answer:
C) A bond without a call feature

Answer Explanation
For investors trying to avoid having a bond called due to falling interest rates, a bond, or preferred stock that does not carry a call feature would be an appropriate choice.

Textbook Reference
Please see textbook section 7.2.1

Question 60

Which of the following best suits an investor seeking interest income and growth potential?
A) Investment grade bond fund
B) Asset allocation fund
C) Balanced fund
D) Small cap fund

Answer 60

Correct Answer:
C) Balanced fund

Answer Explanation
A balance fund is the best choice because it invests in stocks, which provide growth potential, and bonds, which generate interest income. A bond fund generates income but has limited growth potential. A small cap fund has growth potential, but little current income. An asset allocation fund is best for an investor seeking an appropriate mix of all asset classes.

Textbook Reference
Please see textbook section 7.3

Question 61

An investor would like to invest a lump sum inheritance she received for a three month period and will use the funds for a down payment on a home purchase at that time. All of the following may be appropriate EXCEPT
A) A bond anticipation note
B) A tax anticipation note
C) An auction rate security
D) A variable rate demand obligation

Answer 61

Correct Answer:
C) An auction rate security

Answer Explanation
Tax anticipation notes and bond anticipation notes are short-term securities which meet this investor’s objective. VRDOs are issued as long term securities but are puttable for their par value at interest reset dates, which provides short-term liquidity. Auction rate securities are long-term and do not include a put feature, so they do not meet this investor’s objectives.

Textbook Reference
Please see textbook section 7.3.5

Question 62

A RR opens an account for a client. The RR should ask about the client’s

I. tax status
II. investment objectives
III. net worth
IV. education
A) I, II and III only
B) I and II only
C) II and III only
D) I, II, III and IV

Answer 62

Correct Answer:
A) I, II and III only

Answer Explanation
A Registered Rep does not need to ascertain the client’s level of education to open an account. Tax status, investment objectives and net worth are necessary information for making suitable recommendations.

Textbook Reference
Please see textbook section 7.1.5

Question 63

Which of the following statements regarding Regulation Best Interest (BI) is false?
A) A recommendation complies with Reg BI if it meets the retail client’s objectives
B) Client interests must be placed ahead of firm and registered representative interests
C) Broker-dealers and their registered representatives must make disclosures about their relationship with the retail client
D) Reg BI applies to all retail client recommendations

Answer 63

A)

Answer Explanation
A recommendation that simply meets the client’s objectives does not satisfy the higher standard of Reg BI. Each recommendation must be in the client’s best interest.

Textbook Reference
Please see textbook section 7.1.4

Question 64

In an effort to combat inflation risk, which of the following investment vehicles should be avoided?
A) Common stock
B) Top rated corporate bond
C) Real Estate Investment Trusts (REITs)
D) Treasury Inflation Protected Securities (TIPS)

Answer 64

B) Top rated corporate bond

Answer Explanation
Investors concerned about inflation risk should focus on products that will offer a hedge against rising prices. One product that would not be helpful in this regard is a bond. The coupon payments on the bond will not change, even though goods and services have become more expensive.

Textbook Reference
Please see textbook section 7.2.5

Question 65

The goal of portfolio rebalancing is to ensure that
A) The registered representative handling the portfolio always has an opportunity to make changes in the investor’s portfolio.
B) All investment categories are equally weighted.
C) The allocation of stocks, bonds, and cash is reviewed at least once each year to ensure that the best performing assets over the past year are given additional weighting in the portfolio.
D) No asset class becomes over-weighted in a portfolio

Answer 65

D)

Answer Explanation
The goal of portfolio rebalancing is to ensure that the portfolio is returned to its original proportionate investment mix. This may involve selling an asset that has become over-weighted due to recent strength in that sector.

Textbook Reference
Please see textbook section 7.5.1

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Question 66

A customer believes that a municipal securities representative has effected transactions that are excessive in size or frequency in her discretionary account. This prohibited practice violates rules of
A) Quantitative pricing
B) Matched purchasing
C) Fair and reasonable pricing
D) Quantitative suitability

Answer 66

D) Quantitative suitability

Answer Explanation
Excessive trades and activity that are inappropriate for customers are violations of quantitative suitability requirements. This practice was formerly known as churning.

Textbook Reference
Please see textbook section 7.1.3

Question 67

The best way to mitigate prepayment risk is to
A) reduce exposure to mortgage-backed securities (MBS).
B) reinvest prepayment as soon as they are received.
C) invest in mortgage-backed securities (MBS) that cannot be prepaid.
D) buy prepayment insurance.

Answer 67

A)

Answer Explanation
Prepayment risk is associated with mortgage-backed securities (MBS). When interest rates are falling, homeowners refinance or prepay their mortgages, which causes principal to be repaid faster to MBS investors. Because mortgages are typically refinanced in falling-interest-rate environments, the MBS holder is left to reinvest the capital in the lower-interest-rate environment.

Textbook Reference
Please see textbook section 7.2.7

Question 68

Which of the following statements are true about the par value of a bond?
I. It is also called the face value of the bond
II. It fluctuates based on market interest rates
III. Bonds with a lower par generally pay a higher coupon
IV. It is the amount of principal the investor will receive at maturity of the bond
A) I and IV
B) I and III
C) II and III
D) II and IV

Answer 68

A) I and IV

Answer Explanation
The par value of a bond is a fixed amount that is also known as its face or principal value. It is the amount of money that an investor will receive at maturity. Par value does not fluctuate based as interest rates change.

Textbook Reference
Please see textbook section 2.1.2

Question 69

An investor is concerned that he may receive his payment of invested principal at a time when interest rates are low. Which of the following is LEAST suitable for the investor?
A) A variable rate demand note
B) A municipal bond with a call feature
C) A municipal bond with a put feature
D) A Treasury bond

Answer 69

B) a municipal bond with a call feature

Answer Explanation
This investor is concerned with reinvestment risk, a risk associated with callable bonds. Issuers call bonds when interest rates have fallen. This allows them to pay principal to bondholders prior to the original maturity date, and refinance their debt at lower rates. While advantageous to issuers, this practice subjects bond holders to payout of principal when the options for reinvestment may not pay attractive rates.

Textbook Reference
Please see textbook section 7.2.2