Series 65 wk 4 Flashcards
(188 cards)
1
Q
What is economics?
A
The study of shortages: supply vs. demand
2
Q
What does a country’s gross domestic product (GDP) measure? What things does GDP include (4)?
A
The overall health of a nation’s economy.
Defined as the value of all goods and services produced in a country including consumption, investments, government spending and exports minus imports during a given year.
3
Q
What are the 4 stages of the business cycle?
A
- Expansion
- Peak
- Contraction
- Trough
4
Q
What is expansion?
A
During an expansionary phase, an economy will see an increase in overall business activity and output.
Corporate sales, manufacturing output, wages, and savings will all increase while the economy is expanding or growing.
5
Q
What is an economic expansion characterized by (5)?
A
- Increasing GDP
- Rising consumer demand
- Rising stock market
- Rising production
- Rising real estate prices
6
Q
What is the peak of the business cycle?
A
As the economy tops out, the GDP reaches its maximum output for this cycle as wages, manufacturing and savings all peak.
7
Q
What is contraction?
A
GDP falls, along with productivity, wages, and savings. Unemployment begins to rise, the stock market begins to fall, and corporate profits decline as inventories rise.
8
Q
What is a trough?
A
The economy bottoms out in the trough as GDP hits its lowest level for the cycle. As GDP bottoms out, unemployment reaches its highest level, wages bottom out, and savings bottom out.
The economy is now poised to enter a new expansionary phase and start the cycle all over again.
9
Q
How is a recession defined?
A
Defined as a period of declining GDP, which last at least six months or two quarters.
Recessions may vary in degree of severity and in duration.
Extended recessions may last up to 18 months and may be accompanied by steep downturns in economic output.
10
Q
In the most severe recessions, what do falling prices erode? (3)
A
Businesses’ pricing power, margins and profits erode as deflation takes hold.
11
Q
What are recessions generally triggered by?
A
An overall decrease in spending by businesses and consumers. If this happens, demand falls.
Businesses and consumers will often reduce spending as a cautionary measure in response to an economic event or shock, such as a financial crisis or a busting of a bubble in an inflated asset class.
12
Q
What is a depression?
A
Characterized by a decline in GDP, which lasts at least 18 months or 6 consecutive quarters. GDP often falls 10% or more during a depression.
A depression is the most severe type of recession and is accompanied by extremely high levels of unemployment and frozen credit markets.
Steep fall in demand is more likely to lead to deflation during a depression.
13
Q
What are the economic indicators to determine where we are in business cycle?
A
- Leading indicators
- Coincident indicators
- Lagging indicators
14
Q
What are leading indicators? What do they include (9)?
A
Business conditions that change prior to a change in the overall economy (can be used as gauge for the future direction of the economy).
Leading indicators include:
1. Building permits
2. Stock market prices
3. Money supply (M2)
4. New orders for consumer goods
5. Average weekly initial claims in unemployment
6. Changes in raw material prices
7. Changes in consumer or business borrowing
8. Average work week for manufacturing
9. Changes in inventories of durable goods
15
Q
What are coincident indicators? What do they include (7)?
A
Coincident indicators are changes in the economy that cause an immediate change in the activity level of coincident indicators. As the business cycle changes, the level of activity in coincident indicators can confirm where the economy is. Coincident indicators include: 1. GDP 2. Industrial production 3. Personal income 4. Employment 5. Average number of house worked 6. Manufacturing and trade sales 7. Nonagricultural employment
16
Q
What are lagging indicators? What do these include (6)?
A
Lagging indicators will only change after the state of the economy has changed direction (can be used to confirm new direction of economy). Lagging indicators include: 1. Average duration of unemployment 2. Corporate profits 3. Labor costs 4. Consumer debt levels 5. Commercial and industrial loans 6. Business loans
17
Q
What are the schools of economic thought (3)?
A
- Classical economics
- Keynesian economics
- The monetarists
18
Q
What is classical economics? What is it also known as?
A
Also called supply side economics
Classical economic theory believes that lower taxes, and less government regulation will stimulate growth and increase demand through higher employment. Less regulation of business creates lower barriers to entry for employers and allows employers to produce goods at lower prices and to create more jobs.
As a result of the lower prices, lower taxes, and higher employment, aggregate demand in the economy will increase, positively impacting the nation’s GDP
19
Q
What is Keynesian economics?
A
The Keynesian economic model believes that a mixed economy based on private and public sector efforts will produce desired economic conditions.
Keynesians believe that the decisions made in the private sector can lead to supply and demand imbalances and that an active policy response from the public sector in the form of government spending (fiscal policy) and adjustments to the money supply (monetary policy) is required.
20
Q
What is monetary economics?
A
Believe that the supply of money in the economy can influence the direction of the economy and prices as a whole.
During times of low demand and high unemployment the economy can be stimulated by increasing the money supply. As more money enters the system interest rates fall increasing demand. As more money enters the system the value of the currency tends to decline and during times of expansionary monetary policy inflation may increase.
21
Q
What two tools does the government have that it can use to try to influence the direction of the economy?
A
Monetary policy - controlled by Federal Reserve Board - determines the nation’s money supply
Fiscal Policy - controlled by the president and Congress - determines government spending and taxation.
22
Q
How does the Federal Reserve Board try to steer the economy? What actions can it take (6)?
A
Tries to adjust the level of money supply and interest rates.
The Fed may:
1. Change the reserve requirement for member banks
2. Change the discount rate charged to member banks
3. Set target rates for federal fund loans
4. Buy and sell US government securities through open-market operations
5. Change the amount of money in circulation
6. Use moral suasion
23
Q
What are interest rates? What are the 4 types?
A
“the cost of money”; Overall interest rates are determined by the supply and demand for money, along with any price movement in the cost of goods and services, known as inflation.
The key interest rates which all other rates depend:
1. Discount rate
2. Federal funds rate
3. Broker call loan rate
4. Prime rate
24
Q
What is the discount rate? What is bank free to do?
A
The interest rate that the Federal Reserve Bank charges on loans to member banks. A bank may borrow money directly from the Federal Reserve by going to the discount window, and the bank will be charged the discount rate.
Bank is free to lend out this money at a higher rate and earn a profit, or it may use these funds to meet a reserve requirement shortfall. Although a bank may borrow money directly from the Federal Reserve, this is discouraged, and the discount rate has become largely symbolic.
25
What is the federal funds rate? What is this an indicator of?
Rate that member banks charge each other for overnight loans. The federal funds rate is widely watched as an indicator for the direction of short-term interest rates?
26
What is the broker call loan rate?
The broker call loan rate is the interest rate that banks charge on loans to broker dealers to finance their customers' margin purchases.
Many broker dealers will extend credit to their customers to purchase securities on margin.
The broker dealers will obtain the money to lend to their customers from the bank, and the loan is callable or payable on demand by the broker dealer.
27
What is prime rate?
The rate that banks charge their largest and most credit-worthy corporate customers on loans.
Prime rate has lost a lot of its significance in recent years because mortgage lenders are now basing their rates on other rates, such as 10-year Treasury note. The prime rate is, however, very important for consumer spending, because most credit card interest rates are based on prime plus a margin.
28
What is Reserve requirement? How does increasing or decreasing the reserve requirement affect the economy?
The reserve requirement is a percentage that the member banks must keep of their depositors' assets in an account with the Federal Reserve. (intended to ensure that all banks maintain a certain level of liquidity)
If Fed wanted to stimulate economy, it might reduce the reserve requirement for the banks which would allow the banks to lend more (by making more money available to borrowers, interest rates will fall and demand will increase)
If Fed wanted to slow down the economy, it might increase the reserve requirement (make less money available to borrowers, interest rates would rise as a result and the demand for goods and services would slow down.)
29
Why would the Federal Reserve Board change the discount rate?
In an effort to guide the economy.
Discount rate is the rate that the Fed charges member banks on loans.
If Fed wants to stimulate the economy, it would reduce the discount rate (as discount rate falls, all other interest rates fall with it, making cost of money lower).
If Fed wanted to slow the economy down, it would increase the discount rate. As the discount rate increases, all other rates go up with it, raising the cost of borrowing.
30
What is the Federal Open Market Committee (FOMC)?
The Fed's most flexible tool.
The FOMC through open-market operations will buy and sell US government securities in the secondary market in order to control the money supply.
If Fed wants to stimulate the economy and reduce rates, it will buy government securities, which sends money into the banking system now available to lend. This will reduce interest rates and borrowing demand should increase to stimulate the economy.
If Fed wants to slow down the economy, it will sell US government securities, which causes money to flow from the banks into the Fed thus reducing money supply. Less money available to be loaned out will increase interest rates and slow down borrowing and demand.
31
Economists gauge the money supply using 3 measures, what are they?
M1, M2, M3
32
What does M1 include (2)?
M1 is the largest and most liquid measure of the nation's money supply, it includes:
1. Cash
2. Demand deposits (Checking accounts)
33
What is M2? What does it include (4)?
Includes all measure in M1 plus:
1. Money market instruments
2. Time deposits of less than $100K
3. Negotiable CDs exceeding $100K
4. Overnight repurchase agreements
34
What is M3? What does it include (2)?
Includes all measures in M1 and M2 plus:
1. Time deposits greater than $100K
2. Repurchase agreements with maturities greater than 1 day
35
What is disintermediation?
Disintermediation occurs when people take their money out of low yielding accounts offered by financial intermediaries or banks and invest money in higher yielding investments
36
What is moral suasion?
The Federal Reserve Board often will use moral suasion as a way to influence the economy. By simply implying or expressing their views on the economy, they can slightly influence the economy.
37
What is fiscal policy? Who is it controlled by? What can fiscal policy change the levels of (3)?
Fiscal policy is controlled by the president and Congress. Fiscal policy determines how they manage the budget and government expenditures to help steer the economy through the business cycle.
Fiscal policy may change the levels of:
1. Federal spending
2. Federal taxation
3. Creation or use of federal budget deficits or surpluses
38
What can the government influence through fiscal policy (2)?
Spending and taxation
As the government spends more, it will increase aggregate demand and therefore productivity. Also can stimulate economy by reducing taxation. This leaves a larger portion of earnings for the consumers and businesses to spend.
If the government wants to slow down the economy, it may reduce spending to lower the level of aggregate demand or raise taxes to reduce demand by taking money out of the hands of the consumers.
39
What are 3 indicators for the health of the US economy that the Federal Reserve Board and the government monitor?
1. Consumer price index
2. Inflation/deflation
3. Real GDP
40
What is consumer price index (CPI)? What does a rising or falling CPI indicate?
The consumer price index is made up of a basket of goods and services that consumers most often use in their daily lives.
The consumer price index is used to measure the rate of change in overall prices.
A CPI that is rising would indicate that prices are going up and that inflation is present; A falling CPI would indicate that prices are falling and deflation is present.
41
What is inflation/deflation?
Inflation is the persistent increase in prices, while deflation is the persistent decrease in prices.
42
What is Real GDP?
Real GDP is adjusted for the effects of inflation or deflation over time.
GDP is measured in constant dollars so that the gain or loss of the dollar's purchasing power will not show as a change in the overall productivity of the economy.
43
What are 4 things that are bullish for the stock market?
1. Falling interest rates
2. Increasing money supply
3. Increase in government spending
4. Falling taxes
44
What are 4 things that are bearish for the stock market?
1. Increasing taxes
2. Increasing interest rates
3. Falling government spending
4. Falling money supply
45
What does currency value relative to other currencies impact?
Impacts a country's international trade and the balance of payments.
46
What is exchange rate?
The amount of another country's currency that may be received for a country's domestic currency
47
What does a weak/strong currency benefit?
Weak currency benefits exporters, while a strong currency benefits importers.
48
What is London interbank offered rate (LIBOR)?
LIBOR is the most widely used measure of short-term interest rates around the world. The LIBOR rate is the market-driven interest rate charged by and between financial institutions, similar to the fed funds rate in the US.
49
What is the range of LIBOR loans? How is the rate calculated?
1 day to 1 year
| Rate is calculated by British Banker's Association
50
What can be analyzed by the shape of the yield curve (2)?
Cost of borrowed funds given various maturities and the general health of the economy
51
What does a normal, ascending, positive or upward sloping yield curve mean?
The level of interest rates increases ads the term of the maturity increases. Simply put, lenders are going to demand higher interest rates on longer-term loans. The longer the lenders need to wait to be repaid (and money is at risk), the higher the level of compensation (interest) required to make the loan. Higher interest rates also compensate the lenders for the time value of money.
This curve is present during times of economic prosperity and depicts the expectation of increased interest rates in the future.
52
What does an inverted, negative, or downward slope yield curve mean?
Happens when demand for short-term funds are running much higher than the demand for longer-term loans or in times where the Federal Reserve Board has increased short-term rates to combat an economy that is growing too quickly and threatening long-term price stability.
With an inverted yield curve, interest rates on short term loans far exceed the interest rates on longer-term loans.
These tend to normalize quickly and is often a precursor to a recession.
53
What is the investment adviser required to do for a client (2)?
1. Develop a client profile when opening the client's account and must update it regularly as the client's needs change
2. Have fiduciary duty to provide only suitable advice to clients.
54
What is the Uniform Prudent Investors Act of 1994 (UPIA)?
This sets the basic standards by which all investment professionals acting in a fiduciary capacity must abide.
55
How does the UPIA update?
Updates the requirements and definitions of prudent standards in light of the application of of modern portfolio theory and the advancement in the understanding of the behavior of capital markets
56
What are the 5 fundamental changes in the approach to prudent investing for investment professionals acting in a fiduciary capacity?
1. The main consideration of a fiduciary is the management and trade off between risk and reward.
2. The standard of prudence for each investment will be viewed in relationship to the overall portfolio rather than as a stand alone investment
3. The rules regarding diversification have become part of the definition of prudent investing.
4. The restrictions from investing in various types of investments have been removed and the trustee may invest in anything that is appropriate in light of the objectives of the trust and in line with other requirements of prudent investing.
5. The rules against delegating the duties of the trustee have been removed and the trustee may now delegate investment functions subject to safeguards.
57
What can't an investment adviser employ or engage in (13)?
1. Churning
2. Manipulative and deceptive practices
3. Unauthorized trading
4. Fraudulent acts
5. Blanket recommendations
6. Misrepresentations
7. Omitting material facts
8. Making guarantees
9. Selling dividends
10. Recommending speculative securities without knowing the customer can afford the risk.
11. Short-term trading in mutual funds
12. Switching fund families
13. Charging fees in excess of fees disclosed in the advisory contract
58
What is churning?
Many advisers are compensated when the customer makes a transaction based on their recommendation.
Churning is the practice of making transactions are are excessive in size or frequency with the intention to generate higher commissions for the adviser.
59
What will regulators look for when determining if an account has been churned (3)? What is not an issue when determining if an account has been churned?
1. Frequency of transactions
2. Size of the transactions
3. Amount of commission earned by the representative
Customer profitability is not an issue
60
What is reverse churning?
Practice of placing inactive accounts or accounts that do not trade frequently into fee-based programs that charge an annual fee based on the assets in the account.
61
What are examples of manipulative and deceptive devises (5)?
1. Capping
2. Pegging
3. Front running
4. Trading ahead
5. Painting the tape/matched purchases/matches sales
62
What is capping?
A manipulative act designed to keep a stock price from rising or to keep the price down.
63
What is pegging?
A manipulative act designed to keep a stock price up or to keep the price from falling
64
What is front running?
The entering of an order for the account of an agent or firm, prior to the entering or a large customer’s order. The firm or agent is using the customer’s order to profit on the order they entered for their own account.
65
What is trading ahead?
The entering of an order for a security, based on the prior knowledge of a soon-to-be-released research report
66
What is painting the tape?
A manipulative act by two or more parties designed to create false activity in the security without any beneficial change in ownership. The increased activity is used to attract new buyers.
67
What is unauthorized trading?
An unauthorized transaction is one that is made for the benefit of a customer account at a time when the customer has no knowledge of the trade and the adviser does not have discretionary power over the account.
68
How is “fraud” defined?
Fraud is defined as any act that is employed to obtain an unfair advantage over another party
69
What 7 things are included as fraudulent acts?
1. False statements
2. Deliberate omissions of material facts
3. Concealment of material facts
4. Manipulative and deceptive practices
5. Forgery
6. Material omission
7. Lying
70
What are blanket recommendations?
It is inappropriate for an adviser to make blanket recommendations in any security, especially low-priced speculative securities.
No matter what type of investment is involved, a blanket recommendation to a large group of people will always be wrong for some investors. (Sometimes this action could also be deemed to be market manipulation)
71
When is selling dividends a violation?
Selling dividends is a violation that occurs when an adviser use a pending dividend payment as the sole basis of their recommendation to purchase the stock or mutual fund. (Creating urgency on the part of the investor to purchase stock is prime example of this type of violation)
72
What can an adviser not knowingly make a misrepresentation regarding (5)?
1. Client’s account status
2. Representative
3. Firm
4. Investment
5. Fees to be charged
73
What are the rules with omitting material facts?
A representative may not omit any material fact either good or bad when recommending a security. A material fact is one that an investor would need to know in order to make a well-informed investment decision. The adviser may however omit an immaterial fact.
74
What are the rules with making guarantees?
No representative, broker dealer or investment adviser may make any guarantees of any kind. A profit may not be guaranteed and a promise of no loss may not be made.
75
What should an adviser recommending a mutual fund do?
Ensure that the mutual fund’s investment objective meets the customer’s investment objective.
76
If mutual fund company or broker dealer distributes advertising or sales literature regarding the mutual fund, what 6 things should be disclosed?
1. Highest sales charge charged by the fund
2. Fund’s current yield based on dividends only
3. Graph performance of the fund vs. a broad based index
4. Performance of the fund for 10 years or the life of the fund (whichever is less)
5. Not imply that a mutual fund is safer than other investments
6. Source of graphs and charts
77
When recommending or advertising a periodic payment plan, what 3 things must be disclosed?
1. A statement that a profit is not guaranteed
2. A statement that investors are not protected from a loss
3. A statement that the plan involves continuous investments, regardless of market conditions
78
What are the rules about disclosure of client information?
Investment advisers may not disclose any information regarding clients to a third party, without the client’s expressed consent or without a court order.
79
What are the factors used to create a client profile (8)?
1. Investment objectives
2. Financial status
3. Income
4. Investment holdings
5. Retirement needs
6. College and other major expenses
7. Tax bracket
8. Attitude toward investing
80
When developing the client’s profile, what 4 things should be calculated of the client:
1. Assets
2. Liabilities
3. Net worth
4. Monthly discretionary cash flow or income
81
What is a fiduciary account? What is needed for the authority to transact business for the account (what is this known as?)
One that is managed by a third party for the benefit of the account holder. The party managing the account has responsibility making all the investment decisions. This person needs to act as a prudent person would and may not speculate (known as prudent man rule)
82
What is full discretion? What is limited discretion?
Fiduciary may purchase and sell securities as well as withdraw cash and securities from the account.
Under limited power of attorney (or limited discretion), fiduciary may only buy and sell securities and may not withdraw assets.
83
Who are examples of fiduciaries (8)?
1. Administrators
2. Custodians
3. Receivers
4. Trustees
5. Conservators
6. Executors
7. Guardians
8. Sheriffs/marshals
84
What is required of the registered representative when opening a third party or fiduciary account?
Required to obtain documentation of the individual’s appointment and authority to act on behalf of the account holder.
85
What is required of the registered representative when opening a trust account? What are the restrictions?
Trust accounts require representative to obtain a copy of the trust agreement which states who has been appointed as the trustee and any limitations on the trust’s operation. Most trusts may only open cash accounts and may not purchase securities on margin
86
What is required of the registered representative when opening an account for a guardian?
Representative must obtain a copy of the court order appointing the guardian. The court order must be dated within 60 days of opening the account. Guardians are usually appointed in cases of mentally incompetent adults and orphaned children.
87
What is the uniform gifts to minors act (UGMA)?
Minors are not allowed to own securities in their own name because they are not of age to enter into legally binding contracts. This act regulates how accounts are operated for the benefit of minors.
88
What 4 things must all UGMA accounts have?
1. One custodian
2. One minor
3. UGMA and the state in the account title
4. Assets registered to the child’s name after he or she reaches the age of majority
89
What are the responsibilities of the custodian in UGMA and guidelines (10)?
Custodian has a fiduciary duty to manage the account prudently for the benefit of the minor child within certain guidelines:
1. No margin accounts
2. No high-risk securities, such as penny stocks
3. Custodian may not borrow from the account
4. No commodities
5. No speculative option strategies
6. Custodian my not give discretion to a third party
7. All distributions must be reinvested within a reasonable time
8. Custodian may not let rights or warrants expire; they must be exercised or sold
9. Custodian must provide support for all withdrawals from the account
10. Withdrawals may only be made to reimburse the custodian for expenses incurred in connection with the operation of the account or for the benefit of the minor.
90
What can serve as contributions to an UGMA account? What is the limit?
Gifts of cash and securities or other property may be given to the minor. There is no dollar limit as to the size of the gift that may be given. The limit on size of tax-free gift is $14K/year
91
What are the rules for once a gift has been given to a UGMA account?
It is irrevocable, gifts to a UGMA account carry an indefeasible title and can’t be taken back for any reason. The custodian may, however, use the assets for the minor’s welfare and educational needs.
92
Who is responsible for taxes on UGMA account?
Minor is responsible, however any unearned income that exceeds $1500 per year will be taxed at the parents’ marginal tax rate if the child is younger than 14 years old.
For gifts that exceed $14K/year, the tax liability is on the donor of the gift, not the minor.
93
What happens to the UGMA account if the minor dies?
It goes to minor’s estate, does not automatically go to the parents. If the custodian dies, a court or the donor may appoint a new custodian.
94
What are additional types of advisory clients for a UGMA account? (8)
1. A sole proprietorship
2. A C corporation
3. An S corporation
4. A partnership
5. A limited partnership
6. A family limited partnership
7. A Limited Liability Company LLC
8. A trust
95
What is a sole proprietorship?
Easily established to allow a person to conduct business under a trade name. For all intents and purposes, the sole proprietorship is an extension of the proprietor. All taxes are reported on the individual’s return and there is no asset protection.
96
What is a corporation? What are the two types?
Corporations are their own legal entities with perpetual life independent from their owners. How the corporation is taxed depends upon how the corporation is organized.
A C corporation is taxed at the corporate rate independent from the owners’ tax rates
An S corporation allows the income to flow through to the owners and to be taxed as ordinary income. No more than 100 people can own an S corporation and the S corporation must be organized as a domestic corporation.
97
What is a partnership?
Partnerships are an association of 2 or more people who are either in business together or who hold assets in a partnership. The partnership agreement will detail each partner’s ownership interest and authority to act on behalf of the partnership
98
What is a limited partnership?
Consists of at least one general partner and one or more limited partners. It is the duty of the general partner to manage the partnership in accordance with the partnership’s objectives. The limited partners put up the investment capital required but may not exercise management or control over the partnership.
99
What is a family limited partnership?
Often used for estate planning. Parents may place significant assets into a family limited partnership as a way to transfer their ownership. Usually, the parents will act as the general partners and will transfer limited partnership interests to their children. As the interests are transferred to the children, the parents may become subject to gift taxes. However, gift taxes will be lower than without the partnership
100
What is a limited liability company?
Combines the limited liability of a C corporation with the benefit of the tax advantages of a partnership. The LLC will pass through income without being taxed at the LLC level just like a partnership.
The owners of the LLC are classified as members of the LLC not as shareholders and are not personally liable for the debts of the LLC.
101
What 3 structures provide asset protection and avoid double taxation by distributing income and losses to the owners or members?
Limited partnerships, LLCs, and S corporations
102
What are the different types of investment objectives (6)?
1. Income
2. Growth
3. Preservation of capital
4. Tax benefits
5. Liquidity
6. Speculation
103
What is income? What are the types of investments that can generate additional income? (6)
Investors are looking to have their investments general additional income to help meet their monthly expenses. Some of these are:
1. Corporate bonds
2. Municipal bonds
3. Government bonds
4. Preferred stocks
5. Money market funds
6. Bond funds
104
What is growth? What are the investments that will achieve this goal (2)?
Investors who are seeking capital appreciation over time want their money to grow in value and are not seeking any current income. Investments that will achieve this:
1. Common stock
2. Common stock fund
105
What is preservation of capital? What are 4 appropriate recommendations for investors who want this?
People who have preservation of capital as an investment objective are very conservative investors and are more concerned with keeping the money they have saved.
For these investors, high quality debt will be an appropriate recommendation, some choices are:
1. Money market funds
2. Government bonds
3. Municipal bonds
4. High grade corporate bonds
106
What are the appropriate recommendations for investors who are seeking tax benefits (2)?
1. Municipal bonds
| 2. Municipal bond funds
107
Investors that need liquidity and investments that will not fluctuate wildly in value should invest in (from most liquid to least liquid) (6):
1. Money market fund
2. Stocks/bonds/mutual funds
3. Annuities
4. CMOs
5. Direct participation programs
6. Real estate
108
What is speculation? What are speculative investments (4)?
A customer investing in a speculative manner is willing to take a high degree of risk in order to earn a high rate of return. Speculative investments:
1. Penny stocks
2. Small cap stocks
3. Some growth stocks
4. Junk bonds
109
What is the capital asset pricing model (CAPM)?
Operates under the assumption that investors are risk averse. Investors who take on high amount or risk need to be compensated through a higher expected rate of return known as risk premium. A security’s risk is measured by its beta. Therefore securities with high betas must offer investors a higher expected return.
110
What is Capital market line? What is Security market line?
Proponents of CAPM have developed capital market line (CML) to evaluate and measure the expected returns of a diversified portfolio relative to expected returns and expected risk-free return. This also measures standard deviation of the portfolio relative to the standard deviation of the market.
Security market line (SML) is used to measure the expected return of a single security based on its beta relative to the expectations of the market and risk-free rate of return.
111
Is CML or SML based on alpha or beta?
CML is not based on alpha or beta, while SML is partially computed based on the beta of the single security in question.
112
What are the types of risk associated with investing money (9)?
1. Capital risk
2. Market risk
3. Nonsystematic risk
4. Legislative risk
5. Timing risk
6. Credit risk
7. Reinvestment risk
8. Call risk
9. Liquidity risk
113
What is capital risk?
Risk that an investor may lose all or part of the capital they have invested.
114
What is market risk? What is it also known as?
Also known as systematic risk; risk that is inherent in any investment in the markets
115
What is nonsystematic risk?
Risk that pertains to one company or industry.
116
What is legislative risk?
Risk that the government will do something that adversely affects your investment.
117
What is timing risk?
The risk that an investor will buy and sell at the wrong time and will lose money as a result.
118
What is credit risk?
Risk of default inherent in debt securities. An investor may lose all or part of their money because the issuer has defaulted and cannot pay the interest or principal payments owed to the investor.
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What is reinvestment risk?
When interest rates decline and higher yielding bonds have been called or have matured, investors will not be able to receive the same return given the same amount of risk. This is reinvestment risk and the investor is forced to either accept the lower rate or must take more risk to obtain the same rate.
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What is interest rate risk?
Interest rate risk is the risk that the price of bonds will fall as interest rates increase. As interest rates rise, the value of existing bonds fall and may subject the bondholder to a loss if they need to sell the bond.
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What is call risk? What securities does this risk apply to (2)?
The risk that as interest rates decline, higher yielding bonds and preferred stocks will be called and investors will be forced to reinvest the proceeds at a lower rate of return or at a higher rate of risk to achieve the same return. Call risk only applies to preferred stocks and bonds with a call feature.
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What is opportunity risk?
Investors who hold long-term bonds until maturity must forgo the opportunities to invest that money in other potentially higher yielding investments.
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What is liquidity risk?
Liquidity risk is the risk that an investor will not be able to liquidate their investment when they need to or that they will not be able to liquidate without adversely affecting the price.
124
What is a stock or portfolio’s “alpha”?
It is its projected independent rate of return or the difference between an investment’s expected (benchmark) return and its actual return.
Portfolio managers whose portfolios have positive alphas are adding value through their asset selection. The outperformance as measured by alpha indicates the portfolio manager is adding additional return for each unit of risk taken on in the portfolio.
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What is a stock’s “beta”?
A stock’s projected rate of a change relative to the market as a whole. (Ex: If market was up 10% for the year, a stock with beta of 1.5 could reasonable be expected to be up 15%)
A security’s beta measures its nondiversifiable or systematic risk.
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How does value of “beta” reflect risk?
A stock with beta > 1 has a higher level of volatility and considered to be more risky than overall market
A stock with beta < 1 is less volatile and less risky than overall market
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If portfolio’s actual returns exceeds that of its expected return, the portfolio has generated _______?
Excess returns
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What is the Sharpe Ratio? What is formula?
Sharpe ratio can measure a portfolio’s risk adjusted return. It tells investor how well they are being compensated for the investment risk they are assuming.
The Sharpe ratio takes the portfolio’s return and subtracts the risk-free return offered on short-term Treasury bills (usually 90 days) to determine the level of return that the investor earned over the risk-free return. Risk premium is then divided by portfolio’s standard deviation.
Sharpe Ratio = (R-RFR)/SD
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What does modern portfolio theory state?
That the expected rate of return for an investment is the sum of its weighted returns. An investment’s weighted return is its possible return multiplied by the likelihood of that return being realized.
Weighted return includes (outperform, market perform and underperform cases to calculated weighted return)
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When calculating expected return, what does a higher standard deviation in the equation mean?
These investments are riskier than lower standard deviations
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What factors can be used to determine the future value of a sum invested (3)?
1. The interest rate
2. Time horizon
3. Compounding schedule
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What is the future value equation?
FV = PV(1+R)^t where R = Interest rate and t = number of compounding periods for which the money will be invested
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What is the present value equation?
PV = FV/(1+R)^t where R = Interest rate and t = number of compounding periods for which the money will be invested
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What is IRR? When evaluating investment in debt security what is IRR equal to?
Internal rate of return – annualized effective compound rate of return (takes into consideration the time value of money and all of the future cash flows generated by an investment)
Investment in debt security IRR is equal to bond’s yield to maturity
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What is the dollar-weighted return method?
Used to determine the IRR of the portfolio taking into consideration the cash flows in and out of the account (if investor is contributing and making withdrawals).
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What is time-weighted return?
If investor will not be making additional contributions or withdrawals to account, investor can use this method to determine IRR of the portfolio.
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In addition to weighted returns, what other 3 factors can you look at that provides additional and comparable return data?
1. Total return
2. Holding period return
3. Annualized return
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What is total return?
To determine total return of an investment, all dividend or interest cash flow must be taken into consideration.
If investment has increased in value, the sum of the cash flow is added to any capital appreciation. The addition of the cash flow will cause the total return to be higher.
If security has fallen in value, the total of the cash flow may partially or totally offset the loss of value of the security in question
Ex: SIA common stock appreciated 8% over 18-month period and paid a 2% cash dividend over the 18 months; Total return = 10% (8% +2%)
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What is holding period return?
investors hold securities for years while others may only hold securities for a few days or less.
Holding period return = Total return from any cash flow +/- any capital appreciation/depreciation realized during the time the investment was held
Ex: SIA common stock appreciated 8% over 18-month period and paid a 2% cash dividend over the 18 months; Holding period return = 10%
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What is annualized return?
Once holding period return has been calculated, it can then be used to determine the annualized rate of return
Investment annualized rate of return will allow investors to compare investment’s return against the performance of relevant benchmarks
If security was held for less than 1 year and its results would have to be multiplied to determine an annualized rate of return; if more than 1 year, results need to be divided to determine annualized rate of return
Ex: SIA common stock appreciated 8% over 18-month period and paid a 2% cash dividend over the 18 months; Annualized return would be 6.66%, dividing 10%/1.5 (18 months = 1.5 years)
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What is the goal of modern portfolio theory? What is optimal performance called?
To construct portfolios based on various allocations over the 3 main asset classes whose return will be the greatest given each unit of risk. Optimal performance is known as the efficient frontier
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What is a strategic asset allocation?
Allocating a client’s assets over various asset classes to achieve a given investment objective
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What are the two categories of asset rebalancing?
1. Systematic rebalancing
| 2. Active rebalancing
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What is systematic rebalancing?
Designed to keep the original asset allocation model in place. This can be done at regular intervals such as quarterly or whenever the asset allocation shifts by a certain percentage (such as 5% or more)
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What is active rebalancing?
Assumes that a portfolio manager can effectively shift the asset allocation to take advantage of shifts in the performance of the various asset classes. Rebalances based on redistributing to asset classes that they feel will outperform.
146
How do you predict portfolio income for retirement?
Need to estimate the amount of time to exhaust principal given a certain interest rate and a fixed withdrawal.
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What is a perpetual income account? How do you calculate this?
Has objective of providing income forever
Lump sum needed to deposit = Annual income benefit/Annual interest rate
Example: If investor wanted to generate a monthly income of $2K in perpetuity the annual income benefit would be $24K. If investor was placing money in account with a fixed rate of 6%, investor would need to invest $400K in account (Ex: $24K/0.06 = $400K)
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What is the rule of 72?
This will tell an investor how many years it will take for the principal of an account to double in value. (assumes compounding interest) 72/Interest rate = Time (years) it takes money to double
Ex: Investor who has $10K invested at an annual rate of 8%, will take 9 years to double (72/8% = 9 years)
Can also find return rate: Ex: $10K placed into an account that grew to $40K in 12 years (account doubled 2x therefore doubled 1x in 6 years so equation is 72/6 = 12%)
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What are the two types of taxes?
1. Progressive
| 2. Regressive
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What are progressive taxes? What are 2 examples?
Progressive tax levies a larger tax on higher income earners. Example include:
1. Income taxes
2. Estate taxes
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What are repressive taxes? What are 4 examples?
Regressive taxes level the same tax rate on everyone, regardless of income. As a result, a larger portion of the lower income earner’s earnings will go toward the tax. Examples include:
1. Sales taxes
2. Property taxes
3. Gasoline taxes
4. Excise taxes
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When does a taxable event occur (3) for investments?
Investors must be aware of the impact that federal and state taxes will have on their investment results. A taxable event will occur in most cases when an investor:
1. Sells a security at a profit
2. Sells a security at a loss
3. Receives interest or dividend income
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How do you calculate gains and losses for investment?
A capital gain is realized when the investor sells the shares at a price that is greater than their cost base. An investor who purchased stock at $10/share 3 years ago and receives $14/share and bought 1000 shares will have a $4K capital gain. ($14-$10 = $4x1000 = $4000)
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How are capital gains and losses further classified? What does this mean?
Further classified as short-term or long-term capital gains or losses.
Any gain or loss on an investment held for less than one year is classified as a short-term gain and is taxed as ordinary income
Long term capital gains on assets held for more than one year will be taxed at a maximum rate of 15% (this rule is subject to change)
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What are the 3 methods that an investor can determine their cost base at the time of sale for those that have been accumulating shares through multiple purchases?
1. First in, first out (FIFO)
2. Share identification
3. Average cost
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What is first in, first out (FIFO)?
If the investor does not identify which shares are being sold at the time of sale, the IRS will assume the first shares that were purchased are the first shares that are sold under the FIFO method. In many cases, this will result in the largest capital gain and as a result, the investor will have the largest tax liability.
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What is share identification?
At the time of sale, an investor may specify which shares are being sold.
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What is average cost?
An investor may decide to sell shares based on their average cost.
Average cost = total dollars invested/total shares purchased
Once an investor has elected to use the average cost method to calculate gains and losses, they may not change the method without IRS approval.
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How can an investor use capital losses to offset capital gains dollar for dollar in the year in which they are realized?
A net capital loss may be used to reduce the investor’s taxable ordinary income by up to $3000 in the year in which it is realized. Any net capital losses that exceed $3000 may be carried forward into future years and may be deducted at a rate of $3000 from ordinary income every year until the loss is used up.
If the investor has a capital gain in subsequent years, the investor may use the entire amount of the net capital loss remaining to offset the gain up to the amount of the gain.
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What is a wash sale?
If an investor sells a security at a loss and shortly after repurchases the security to reestablish the position, they cannot claim the loss for tax purposes or deduct the loss form their ordinary income.
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What must an investor do to prevent a wash sale?
Investor needs to have held security for 30 days and must wait at least 30 days before repurchasing the same securities or securities that are substantially the same.
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What is the total number of days in a wash sale, how is it broken down?
61
Holding period: 30 days
Sale date: 1 day
Waiting period: 30 days
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What are securities that are substantially the same (4)?
Call options, rights, warrants, and convertibles
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What are the tax consequences of interest payments for a NJ resident of:
1. Corporate bond
2. CMO
3. GNMA
4. T-bond
5. New York muni bond
6. NJ muni bond
7. Puerto Rico/Guam muni
Corporate bond, CMO, GNMA - All taxes
T-bond – Federal taxes only
NY muni bond – NJ taxes only
NJ muni bond and Puerto rico/Guam muni – No taxes
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What happens if an investor dies and leaves securities to another person?
The person’s cost base for those securities is the fair market value of the securities on the day the decedent died (cost base of original investor does not transfer to the person who inherited the securities)
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What happens if an investor donates securities to a charity?
They will receive a tax deduction equal to the value of the securities; if the investor has an unrealized gain and has held the securities for more than 12 months, the investor will not owe any taxes on the appreciation; if held less than 12 months, investor will be responsible for taxes on appreciation
Recipient’s cost base will be equal to the value of the securities on the day they received the gift
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What are the 2 types of trusts?
1. Revocable
| 2. Irrevocable
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What is a grantor or settlor?
The individual who established the trust and contributes assets to the trust
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What is a revocable trust?
When the grantor or settlor can revoke the trust and take the assets back. The income generated is generally taxed as income to the grantor.
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What is an irrevocable trust?
Grantor may not revoke the trust and take the assets back. The trust usually pays the taxes as its own entity or the beneficiaries of the trust are taxed on the income they receive.
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What is the difference of a simple vs. a complex trust?
Simple trust – all income generated by the trust must be distributed to the beneficiaries in the year the income is earned.
Complex trust – trust may retain some or all of the income earned and the trust will pay taxes on the income that is not distributed to the beneficiaries
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What is an inter vivos trust? What is a testamentary trust?
Inter vivos -trust established during a person’s lifetime
| Testamentary trusts – Trusts that are established under the terms of a will
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What are all assets placed into a testamentary trust subject to (2)?
Estate taxes and probate
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What is a bypass trust? What does this allow?
One that is established to reduce the tax liability of an estate left to beneficiaries other than a spouse, such as to children.
Allows the grantor to take advantage of the lifetime estate tax exclusion and allows individuals with significant wealth to reduce the tax burden to their heirs
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What is a generational skipping trust? What is it subject to?
A type of bypass trust that is established for benefit of relatives more distant than one generation from the grantor such as grand children or great grand children. This type of bypass trust will allow assets to be passed on to grandchildren without first being passed to their parents and without potentially being taxed again upon their parents death.
Assets left to grandchildren or unrelated persons more than 37.5 years younger than the grantor may be subject to a generation skipping transfer tax (GSTT)
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What happens if the assets in a trust appreciate over time past the estate tax exclusion limit after the grantor’s death?
The assets will not be subject to estate taxes
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What is a grantor retained annuity trust (GRAT)?
A way a trust can be established and used for estate planning. With this trust the grantor places assets into the trust with the intention of drawing an income from the trust as an annuity payment for a set number of years
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Where must income be reported from Trust and estates that retain net income?
Form 1041
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What is not considered part of net income to the trust?
Capital gains on assets that are sold and reinvested as principal in the trust are not taxable to the trust and not considered part of net income to the trust
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Does the donor receive tax deduction when making gifts to family members or other individuals?
No
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What 3 gifts are made tax free?
Gifts to charity, paying for someone’s educational expenses or medical expenses
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How can an individual leave an estate without subjecting beneficiaries to estate taxes?
If estate is below $5M
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What does an individual’s gross estate include?
All of the assets they owned at the time of death, including assets placed in any revocable trusts (irrevocable trust assets are excluded from individual’s estate)
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What items will be added to the individual’s gross estate (3), what will be deducted (3)?
Included:
1. Assets transferred within 3 years of death
2. Annuity payouts payable to the estate or heirs
3. Life insurance
Excluded/Deducted:
1. Debts owed by the individual or estate
2. Funeral expenses
3. Charitable gifts made after death
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If an investor has not provided a social security number or a tax identification number, what % of sales proceeds and mutual fund distributions will be withheld by broker dealer?
31%
186
How much will corporations that invest in shares of other corporations pay taxes on dividends?
Only pay taxes on 30% of dividends it receives from those investments, 70% of the dividends are tax free to the corporation
187
What is the alternative minimum tax (AMT)? What items are included (5)?
Certain items that receive beneficial tax treatment must be added back into the taxable income for some high-income earners. These items include:
1. Interest on some industrial revenue bonds
2. Some stock options
3. Accelerated depreciation
4. Personal property tax on investments that do not generate income
5. Certain tax deductions passed through DPPs
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How much do foreign governments withhold taxes for investors that buy foreign stock?
Most foreign governments withhold 15%.
| US investors who own securities issued in a foreign country will owe US taxes on any gains or income realized
