Unit 2 - Investment Vehicle Characteristics Flashcards Preview

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Flashcards in Unit 2 - Investment Vehicle Characteristics Deck (50):

According to federal law, an insurance company under the provisions of the Investment Company Act of 1940 must allow a variable life policyholder the option to convert the policy into a whole life contract for a period of:

Although state law may allow for periods longer than 24 months, federal law requires a two-year conversion privilege.


Maturities of:
- Money Market (many issued at a discount)
- Treasury Notes
- Treasury Bills
- Jumbo CDs
- Commercial Paper

Money market securities have a maximum maturity of 1 year. (market for buying and selling short-term loanable funds in the form of securities and loans)
Treasury notes are issued with maturities of 2 to 10 years.
Treasury bills are money market instruments with maturities of 52 weeks or less.
Jumbo CDs are issued by banks and have maturities of 1 year or less.
Commercial paper (issued by corporations) is unsecured short-term debt with maturities of 270 days or less.


Which of the following statements regarding the properties of duration is NOT true?
A) Duration measures a bond's price volatility by weighting the length of time it takes for a bond to pay for itself.
B) Duration measures the effect of an interest rate change on the price of a bond or bond portfolio.
C) Duration measures the holding period return on a bond.
D) Duration is a weighted-average term-to-maturity of a bond's cash flows.


Duration does not measure the holding period return on a bond, it measures the effect of an interest rate change on the price of a bond or bond portfolio. Duration measures a bond's price volatility by weighting the length of time it takes for a bond to pay for itself. Duration is also a weighted-average term-to-maturity of a bond's cash flows.


Universal variable life policies

Universal variable life policies are insurance company products that should be purchased primarily for the insurance features they offer rather than as an investment. Because they have a separate account, the investor assumes the investment risk. Unlike scheduled premium variable life, flexible premium (universal) variable life does not guarantee a minimum death benefit equal to the face amount of the policy.


Jumbo certificates of deposit

A) they are usually issued in denominations of $100,000 to $1 million.
B) they usually have maturities of 1 year or less.
C) they are readily marketable.

Negotiable CDs are general obligations of the issuing bank; they are not secured by any specific asset. They do qualify for FDIC insurance (up to $250,000), but that is not the same as stating that the bank has pledged specific assets as collateral for the loan.


The variable life exchange provision

allows a policyholder to convert the variable policy into a permanent form of life insurance policy within the first 24 months of variable policy ownership. The insurance company must use the initial contract date and can not require proof of insurability.


A new convertible bond has a provision that it cannot be called for five years after the issue date. This call protection is most valuable to a recent purchaser of the bond if:
A) interest rates are stable.
B) interest rates are rising.
C) interest rates are falling.
D) the market price of the underlying common stock is increasing.


Convertible bonds are more sensitive to the price of the underlying common stock than they are to interest rates. Call protection would enable this investor to hold onto the bond while the stock rises in value rather than having the bond called away.


leveraged exchange-traded fund (ETF)

- The leveraged ETF may be purchased on margin.
- Securities within the leveraged fund portfolio may be purchased on margin.

Because an exchange-traded fund is purchased and sold on an exchange, the rules generally applying to all exchange products, such as purchasing them on margin, would apply. Leveraged funds can use a number of different securities types including derivative products, and trading techniques such as trading on margin as a means of attaining the leveraged returns they promise.


Which of the following statements regarding a mutual fund that offers class A, B, and C shares are TRUE?
- Class A shares have a front end sales charge and a low 12b-1 fee.
- Class B shares have a declining contingent deferred sales charge and a high 12b-1 fee.
- Class C shares have a high 12b-1 fee and a level contingent deferred sales charge.
- Class B and C shares allow investors to put the shares back to the fund for their original purchase price for up to 1 year after purchase.

Which share class is least expensive

I, II and III.

There is no put provision that guarantees the return of an investor's purchase price associated with mutual fund shares.

Class C shares may be less expensive than Class A or B shares for investors with a short time horizon. The front-end load on Class A shares and the back-end load on Class B shares makes them unattractive for short-term investors. A shares do not convert to B shares it goes the other way.


You have a client who originally invested $25,000 into the ABC Growth Fund. Over the past 5 years, there have been no distributions and the value of the shares is now $35,000. If the client should ask about exchanging the entire holding for shares of the ABC Income Fund, you would explain

there is a long-term capital gain of $10,000

The exchange privilege permits shares of one fund in the family (The ABC Fund group) to be exchanged for shares of another at net asset value, not public offering price. However, for tax purposes, it is considered a sale and a purchase so there would be a capital gain realized on any difference between the cost basis and the proceeds. In this case, the new shares would have a new cost basis of $35,000.


Formula to determine NAV

assets minus liabilities divided by shares outstanding.

The sale of securities from the portfolio will replace the asset (securities) with an equal value of the asset (cash) and will have no effect on the NAV.

The reinvestment of dividends will also not affect the NAV, because the shares going out are offset equally by the cash coming in.

Market appreciation or decline will, however, affect the NAV because asset value will either increase or decrease, but liabilities and shares outstanding will remain unchanged.


The death benefit of a variable life policy must be calculated at least:
A) weekly.
B) monthly.
C) semiannually.
D) annually.

The death benefit must be calculated annually and the cash value monthly.



debt obligation of the corporation backed only by its word and general creditworthiness. Not secured by any pledge of property.

are general obligations of the issuing company. They are actually backed by the assets of the company. Prior claims to those specific assets by secured debt issues take precedence over the debentures.


The current yield of a 6% bond offered at 95 is:
A) the nominal yield.
B) 6%.
C) the yield to maturity.
D) 6.3%.

The current yield of 6.3% is computed by dividing the annual interest payment ($60) by the current market price ($950).


Net asset value per share for a mutual fund can be expected to decrease if the:
A) securities in the portfolio have appreciated in value.
B) fund has experienced net redemptions of shares.
C) fund has made dividend distributions to shareholders.
D) issuers of securities in the portfolio have made dividend distributions.

If dividends are distributed to shareholders, the fund's assets will decrease and value per share will fall accordingly. Appreciation of the portfolio and dividends paid to the portfolio will increase the value. If issuers have made distributions to the portfolio, the net asset value will increase. Net redemptions have no effect on the net asset value, as the money paid out is offset by a reduced number of shares outstanding.


A customer purchased new issue bonds at par two years ago. Since then, the CPI has declined by almost half and the current yield on his bonds has also declined. Which of the following best describes the value of the bonds he purchased?
A) They have increased in value.
B) This cannot be determined from the information presented.
C) They have declined in value.
D) There has been no change.

Because inflation is down and bond yields have declined, the bonds are selling for a premium due to an increase in value.


An employee is offered a non-qualified stock option with an exercise price of $20 per share. If the option is exercised when the current market value of the stock is $30, the employee:
A) is taxed on $30 per share as if it were salary.
B) is taxed on $10 per share as if it were salary.
C) is taxed on $20 per share as if it were salary.
D) has a capital gain of $10 per share.

In the case of NSOs, the difference between the exercise (or strike) price and the current market value is considered salary to the employee.


Preferred Stock

The rate of return on a preferred stock is fixed rather than subject to variation as with common stock. As a result, its price tends to fluctuate with changes in interest rate rather than with the issuing company's business prospects unless of course dramatic changes occur in the company's ability to pay dividends



Unlike a right a warrant is usually a long-term instrument that gives the investor the option of buying shares at a later date at the exercise price



Preemptive rights entitle existing common stockholders to maintain their proportionate ownership shares in a company by buying newly issued shares before the company offer them to the general public


Nonqualified Stock Options

Treated as a form of compensation.

When NSOs are exercised the difference between the current market price at the time of exercise and the strike price is reported as wages on the tax returns of the employer and the employee



the terms of the loan are expressed in a document known as the bond's indenture.

also referred to as the deed of trust, states the issuer's obligation to pay back a specific amount of money on a specific date


U.S. Treasury Bills

Short-term debt obligations of the U.S. government. Longest 52 weeks.

- Pay no interest (have no stated interest rate)
- Issued at a discount from their par value (only treasury security issued at discount)
- Highly liquid
- 90 day or 13-week Treasury bills are used as "risk-free" investment


U.S. Treasury Notes

direct debt obligations of the U.S. Treasury:
- pay semiannual interest as % of the stated par value
- they have immediate maturities (2,3,5,7 and 10 years)
- they mature at par


U.S. Treasury Bonds

- pay semiannual interest as % of the stated par value
- they have long-term maturities, generally 10-30 years
- Older 30-year bonds are usually callable at par beginning 25 years after issue
- they mature at par



Protect investors against purchasing power risk
- issued with a fixed interest rate but the principal amount is adjusted semiannually by an amount equal to the change in the CPI


U.S. Federal Agency Securities

issued by U.S. government agencies that have been authorized by Congress to issue debt securities to help meet their financial needs

- Although the securities do not have direct Treasury backing, they are considered moral obligations of the U.S. government

Fannie Mae


Equipment Trust Certificate

A debt instrument that allows a company to take possession of an asset and pay for it over time. The debt issue is secured by the equipment or physical assets, as the title for the equipment is held in trust for the holders of the issue. When the debt is paid off, the equipment becomes the property of the issuer, as the title is transferred to the company


Collateral Trust Bonds

Doesn't have real estate or equipment. Instead deposits securities it owns into a trust to serve as collateral


General Obligation Bonds

backed by a pledge of the issuer full faith and credit for prompt payment of principal and interest
- ledge of unlimited ad valorem (property) taxes


Revenue Bond

bonds payable from the earnings of a revenue-producing enterprise such as water, sewer, electric or gas system


Investment-Grade Debt

bonds rated in the top four categories (BBB or Baa and higher) are referred to as investment grade


High Yield Bonds

junk bonds BB or Ba or lower


Eurobonds and Eurodollar Bonds

eurobond is any long-term debt instrument issued and sold outside the country of the currency in which it is demoninated

eurodollar bond is a bond issued and sold outside the US but for which the principal and interest are stated and paid in U.S. dollars
- bear no currency risk
- rated by us rating agencies

- not registered with the SEC
- have political and country risk
- less liquidity than domestic issues


Nominal Yield

the interest stated on the face of the bond
- sometimes referred to as the coupon rate


Interest Rate
"bond pays interest at a rate of 6% semiannually"

the interest rate is always stated on an annual basis ($60 per year), and it is paid twice per year


Current Yield

return / investment

Return = annual interest in dollars
Investment = current market price

also called current return or nominal yield


Bond at Premium

bond is selling at a price above par (or face), it is selling at a premium

an investor buying a bond at a premium will always receive a rate of return less than the coupon (or nominal) yield stated on the face of the bond

If bond had a 5% coupon, but the current return is 4% the bond is selling at a premium

Lowest: YTC - YTM - CY - Nominal :Highest

Bonds selling at a premium have higher coupons than those selling at par. Therefore, the current yield on those bonds is higher than the ones at par, even though they would have the same yield to maturity.


A CMO makes a combination principal and interest payment to an investor. This payment will be:
A) taxed as ordinary income.
B) taxed as a capital gain if underlying mortgage is prepaid.
C) partly taxed as ordinary income and partly a tax-free return of principal.
D) tax free.


All interest payments made by CMOs are taxed as ordinary income. CMOs may make principal and interest payments to investors, which would be partly taxed as ordinary income and partly a tax-free return of principal.


A customer purchased a 5% U.S. government bond yielding 6%. A year before the bond matures, new U.S. government bonds are being issued at 4%, and the customer sells the 5% bond. The customer probably did which of the following?
I - Bought it at a discount.
II - Bought it at a premium.
III - Sold it at a discount.
IV - Sold it at a premium.

I and IV

The customer purchased the 5% bond when it was yielding 6% (at a discount). The customer sold the bond when other bonds of like kind, quality, and maturity were yielding 4%. The bond is now at a premium. Therefore, the customer realized a capital gain.



consist of interest rate and maturity date
- the lower the coupon rate, the longer a bond's duration, the higher the coupon rate, the shorter the duration
- the longer a bond's maturity, the longer the bonds duration
- for coupon bonds, duration is always less than the bond's maturity
- duration for a zero-coupon bond is always equal to its maturity
- the longer a bond duration, the more its value will change for a 1% change in interest rates; the shorter the duration, the less it will change


All of the following debt instruments pay interest semiannually EXCEPT:
A) Ginnie Mae pass-through certificates.
B) industrial development bonds.
C) municipal General Obligation bonds.
D) municipal revenue bonds.


Ginnie Maes pay interest on a monthly basis, not semiannually.


Which of the following is true of a zero-coupon bond?
I The rate of return is locked in.
2 There is no reinvestment risk.
3The imputed interest is taxed as ordinary income on an annual basis.
4 A check for the interest is paid at maturity.

I, II and III

Zero-coupon bonds pay no periodic interest and are always issued at a discount from par. The appreciation of the zero from its discounted purchase price to its face value is thought of as interest to the bondholder, but this annual "phantom income", so named because you don't receive it, is taxed as ordinary income on an annual basis. When the bond is purchased, the investor locks in that yield and, with nothing to reinvest, there is no reinvestment risk.


Limited Partners

Limited partners are passive investors in a partnership whose liability is limited to the amount of funds they have invested. They do not manage the funds in the partnership; the general partner has that responsibility. Owners, called members, are not personally liable for the debts that arise under an LLC. The LLC is a separate legal entity from its owners. A sole proprietorship account is the business account of an individual business owner and is handled in much the same way as an individual account. An S corporation is taxed as a partnership, although it operates like a regular corporation.


A client has purchased a nonqualified variable annuity from a commercial insurance company. Before the contract is annuitized, your client, currently age 60, withdraws some funds for personal purposes. What is the taxable consequence of this withdrawal to your client?

Ordinary income taxation on the earnings withdrawn until reaching the owner's cost basis.

Contributions to a nonqualified annuity are made with the owner's after-tax dollars. Distributions from such an annuity are computed on a LIFO basis with the income taxed first. Once the cost basis is reached, any further withdrawals are a nontaxable return of principal. Since the client is older than 59-½ at the time of distribution, the additional 10% penalty tax is not incurred.


Which of the following actions should be taken by an agent when a client decides to open an options account?

It is imperative that suitability and risk be addressed with the client before allowing option trading to take place. The ODD must be delivered no later than with account opening, and the options agreement must be returned no later than 15 days after the account opening. An options account must be approved by a designated supervisor prior to any trading takes place in the account.


exchange-traded notes (ETNs)

The only accurate statement is the one expressing that ETNs are issued by financial institutions and, therefore, the credit worthiness of the issuer should be a concerning factor. ETNs are debt instruments, not equity instruments. ETNs have a final payment at maturity based on the return of a single stock, a basket of stocks, or an equity index.


the SEC has placed what restrictions upon money market mutual funds

A) Investments are limited to eligible securities determined to have minimal risk.

B) Investments are limited to securities with remaining maturities of 397 days or less, with the average portfolio maturity not to exceed 90 days.

C) The prospectus must prominently indicate that the U.S. government does not guarantee the fund and that there is no guarantee that the NAV will be maintained.

The SEC requires that money market mutual funds' investments be limited to securities that are rated in the top-2 ratings categories by the nationally recognized rating services (e.g., Moody's, Standard & Poor's). Investment in below-investment grade securities is not allowed.


option exercise – American and European.

American style can be operationally exercised any day that the market is open before the expiration date. With European style, the only time you can operationally exercise your contract is the last trading day before expiration. Remember, even though there is only one day in which you can exercise your contract, you can always close out your option position in the secondary market any day prior to expiration.


One of your clients just inherited some money and wishes to invest $250,000 into the GEMCO International Equity Fund. The client is attracted to the Class B shares because there is no upfront sales charge on them while the Class A shares have a 3% front-end load. The appropriate response would be that
A) as long as the client will hold the Class B shares no longer than 4 years, the higher 12b-1 fees will be much less than the load paid on the Class A shares
B) you feel so strongly that the Class A shares represent a more attractive solution for the client that you will rebate your share of the commissions
C) the client is doing the smart thing by avoiding the sales charge, even though you will be losing out on the opportunity to earn a nice commission
D) because of the higher 12b-1 charges levied against the Class B shares as well as the CDSC, Class A shares are recommended for a purchase of this size

because of the higher 12b-1 charges levied against the Class B shares as well as the CDSC, Class A shares are recommended for a purchase of this size

In the real world, there is probably no fund group that would accept a $250,000 order for Class B shares; more than likely, no fund group would even accept one above $100,000. That is because at that level, the reduced front-end load available on the Class A shares due to reaching a breakpoint, combined with the lower (or lack of) 12b-1 charge and no redemption charge (CDSC), makes them a better deal than the Class B shares. Rebating of commissions is not permitted and, even at the 4-year holding period, there still is a CDSC.