Series 7

General Securities Registered Representative

Learning Guide / Workbook

v26
 Series 7 Top Off On-Demand Learning Guide

How to Use This Learning Guide

As the instructor presents the material through the On-Demand lecture, use this Learning Guide to take notes, answer
questions, and complete activities. Once the On-Demand program is complete, this Learning Guide can be used as an
ongoing resource.

About the Series 7 Exam

1 2 3 4 5
125 Multiple- 3 Hours and 45 10 Additional Minimum Required 30-, 30-, 180-Day
Choice Questions Minutes Allotted Questions are Passing Score Waiting Period
to Complete Exam Included as is 72% For Failures
Experimental
(don’t count for or
against the score)

Function Chapters # of Questions

1. Seeks Business for the Broker-Dealer from Customers and Potential 9

3 and 13
Customers (7% of exam)
2. Opens Accounts After Obtaining and Evaluating Customers’ 11
1 and 2
Financial Profile and Investment Objectives (9% of exam)
3. Provides Customers with Information About Investments, Makes 4, 5, 6, 7, 8,
91
Suitable Recommendations, Transfers Assets and Maintains 9, 10, 11, 12 ,
(73% of exam)
Appropriate Records 14, 15, 16 and 20
4. Obtains and Verifies Customers’ Purchases and Sales Instructions 17, 18, 14
and Agreements; Processes, Completes and Confirms Transactions 19 and 20 (11% of exam)

© Copyright 2024. All Rights Reserved. v26

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Chapter 1 – Building an Investor Profile

Key Topics

1 2 3 4
FINANCIAL FACTORS PERSONAL FINANCIAL KNOW YOUR
CHARACTERISTICS OBJECTIVES AND CUSTOMER
Learn about the
GOALS
financial concerns Learn about how an Learn about
when developing a investor’s age, risk Learn about what importance of
client’s investment tolerance, and types of investments suitability and
profile. experience are used may be used to FINRA’s rules for an
to develop the achieve various RR’s obligations.
investment profile. investment goals.

Know Your Customer

Since every customer is unique, it’s imperative to gather the necessary information and develop a complete profile of
the customer in order to recommend a suitable portfolio.

Financial Objectives
Financial Factors Personal Characteristics
and Investment Goals

Income  Age  Cash reserve

 Earned  Time horizon  Preservation of capital
 Investment  Investment experience  Liquidity
 Retirement  Risk tolerance  Current income
Tax Considerations  Social Values  Growth
 Marginal tax bracket  College funding
 Capital gains and losses  Retirement funding
 Estate and Gift taxes  Speculation
 Tax relief
Financial Situation
 Balance sheet and
Income statement
 Liquid net worth

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Financial Factors AN INVESTOR’S PERSONAL INCOME STATEMENT

MONTHLY INCOME
Salary $8,000
Create a personal income statement for the client: Investment Income 500
 Identify all sources and amounts of income Other Income 1,000
 Document all expenditures TOTAL MONTHLY INCOME $9,500
 Determine the amount of discretionary
MONTHLY EXPENDITURES
income available for investments
Taxes $3,100
Mortgage Payments 2,000
Loan Payments 1,000
Living Expenses 2,000
Insurance Premiums 200
Entertainment and Travel 400
Other Expenses 300
TOTAL MONTHLY EXPENDITURES $9,000
DISCRETIONARY OR NET INCOME $500

Tax Considerations
An investor’s tax situation is important when addressing investment objectives

MARGINAL TAX  At what rate is the individual taxed? Will the alternative minimum tax (AMT)
BRACKET apply?
INVESTMENT  Is the individual receiving dividends and interest from existing investments? For
INCOME dividends, are they qualifying dividends? For interest, is if from taxable bonds?
 Gifts up to $18,000 can be transferred to any number of individuals without tax
ESTATE AND
implication to the donor.
GIFT TAXES
 Gift amount doubles to $36,000 for married couples.
 Short-term gains are taxed at ordinary income rates, while long-term gains are
CAPITAL GAINS AND taxed at a maximum rate of 20%.
CAPITAL LOSSES  Capital losses are first used to offset capital gains; a maximum of $3,000 of
remaining losses must be used against ordinary income.

Non-Financial Concerns
There are personal characteristics that help define the client’s profile.
 Age
• Younger individuals can generally accept more risk as they have longer to earn and build capital
• Individuals who are nearing retirement usually need to be more conservative with their investments
 Time Horizon
• 100 – Age = Equity
− A formula often used to determine the percent of the portfolio that should be devoted to equities.
• The younger the investor, the greater the percentage in equities
• The older the investor, the greater the percentage in more conservative investments
(e.g., debt)

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Additional Personal Concerns

 Investment Experience
• A history of investing tends to lead to a better understanding of the different products and the
reason behind certain recommendations
 Social Values
• Certain companies’ policies and practices on social issues are contrary to an individual’s beliefs
• Investors may want to avoid including securities of these companies in their portfolio

Risk Factors
Risk tolerance for individuals is not based solely on their financial situation; it is also based on their values and
attitudes on investing. An RR needs to carefully develop a complete investor profile. Below are a few examples:

YOUNG MARRIED OLDER COUPLE

YOUNG SINGLE PROFESSIONAL
COUPLE PLANNING WITH SUFFICIENT
LIKES SPECULATION
FOR CHILD’S EDUCATION RETIREMENT SAVINGS
 Can likely be more aggressive  Will be investing for the long-  More concerned with income
with investments, but should term growth potential or and capital appreciation to
be aware of potential risks college savings plans offset inflation

Financial Objectives and Goals

Some of the common objectives and corresponding goals are listed below:

Safety Short-Term, Capital Preservation

Low credit risk Safety of principal

Income Growth and Income

Reliable stream of cash Less volatility; reduced earnings

Long-Term Growth Aggressive Growth

Longer time horizon; greater volatility High risk, high reward

Speculation Reduce/Defer Taxes

Active, short-term speculation Tax advantaged investments

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Activity
Which statements are TRUE regarding an investor’s profile and the investment objective?
Circle all that apply in your workbook.
I. A 40-year-old investor should consider her portfolio to consist of approximately 50-60% equity.
II. An older couple with sufficient retirement income will likely be aggressive in their investment strategy.
III. An individual who is concerned with labor policies in foreign countries may avoid investments in emerging markets.
IV. A couple saving for a child’s college education will tend to be very conservative and safe with the investments.

Suitability
The Basics of Suitability Institutional Suitability
Suitability is based on the client’s profile when an Institutional suitability – The extent of the obligations
account is opened is based on:
 Applies to recommended transactions and  Those servicing the account having a
investment strategy reasonable belief that the client is capable of
 Suitability is not determined by gains and evaluating investment risks
losses  The institutional client affirmatively stating that
 RRs may not place their own interests ahead it is exercising independent judgement
of the client’s, such as:
• Recommending one product over another
to generate a larger commission

FINRA’s Suitability Rules

Under FINRA’s three main suitability obligations, a member firm and its registered representatives must have a
reasonable basis to believe that:

The Reasonable Basis Obligation The Customer-Specific Obligation The Quantitative Obligation

A recommendation is suitable for a A series of recommended

A recommendation particular customer based on the transactions, even if suitable for a
is suitable for at least customer’s investment profile customer, are not excessive when
some investors (this provision does not apply to the customer’s investment profile is
institutional customers) taken into consideration

Verifying Net Worth and Sophistication

Certain investments may require individuals to satisfy net worth, earnings, or sophistication standards before investing.
The SEC has suggested these methods to verify a customer’s standing:
 Review previously filed IRS tax forms
 Review bank and brokerage account statements
 Obtain written verification as to the customer’s accredited status from broker-dealers, investment advisers, etc.
The SEC does not require that any of the methods be used, but requires a reasonable attempt should be made to
determine whether the investor’s status has been verified before recommending any similar investments.

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Using an Investment Analysis Tool

 An Investment Analysis Tool is a technological tool that provides simulations
THE TOOL and statistical analyses of the likelihood of different investment outcomes
when specific investments are made or strategies are implemented

 In order to provide such a tool to investors, the firm must:

• Describe the criteria, methodology, and the tool’s limitations
• Explain that results may vary over time and from use to use
• Describe the universe of investments the tool considers and:
‒ How investments are selected
FIRM REQUIREMENTS ‒ Whether certain investments are favored over others
‒ That other investments may provide similar or superior results
‒ Display a disclosure that the projections are provided by the
firm’s investment analysis tool
‒ Provide FINRA with access to the tool unless its solely used by
institutional investors

Activity
Read each statement and determine whether it is TRUE or FALSE.

AN INVESTMENT ANALYSIS TOOL USED ONLY BY INSTITUTIONAL

CLIENTS IS NOT REQUIRED TO BE PROVIDED TO FINRA

THE SEC REQUIRES A CLIENT’S NET WORTH TO BE VERIFIED

BEFORE RECOMMENDING CERTAIN INVESTMENTS

SUITABILITY IS NOT BASED ON GAINS AND LOSSES

SUITABLE RECOMMENDATIONS MAY BE CONSIDERED EXCESSIVE

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Chapter 2 – Customer Accounts

Key Topics

1 2 3 4 5
CUSTOMER ACCOUNT TYPES RETIREMENT ACCOUNT ACCOUNT
ACCOUNT AND ACCOUNTS CHANGES AND APPROVAL AND
He
REGISTRATIONS CHARACTERISTICS
Learn about ERISA
REQUIRED
DOCUMENTS
RESTRICTIONS
Learn about required Learn about day rules, different Learn about a
information and trading, prime qualified and non- Learn about how to principal’s
different types brokerage, qualified plans, and make changes to responsibilities and
of account DVP/RVP, and fee- basic educational an account and account
registrations. based accounts. savings plans. some of the restrictions.
required
documentation.

FINRA Rules for Customer Account Information

Required Information:
 Name of customer
• Numbered or coded account is acceptable
 Address
• Cannot open with P.O. box only (military P.O. box is acceptable) Customers are NOT required to
 Whether of legal age sign their new account forms
 Registered representative(s) of record
 Signature of supervising principal
Copy of the above information must be provided to clients at least every 36 months

Additional Information
Prior to settlement of the initial transaction, a reasonable effort must be made to obtain the following customer
information (this does not apply to institutional accounts):
Occupation, as well
Tax I.D./ Whether associated with
as name and address
Social Security number another member firm
of employer
If a client refuses to provide any requested information, the RR should document the refusal

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Customer Account Registrations

SOLE PROPRIETORSHIPS PARTNERSHIPS

JOINT ACCOUNTS UNICORPORATED ASSOCIATIONS

Joint Accounts
 New account information is obtained for each owner
 Any owner may initiate activity
 When signatures are required, all owners must sign
 Checks are made payable to all parties

COMMUNITY PROPERTY ACCOUNT JOINT TENANCY IN COMMON (JTIC)

 Can only be used by legally married couples  Common for business partners
 Must also complete Community Property  Each tenant owns a specified amount
Document  If one owner dies, decedent’s portion is
 Essentially the same as JTWROS transferred to her estate
 Based on laws of the state in which the
couple resides
 Each owns half of the account

Other Forms of Registration

 A sole proprietorship is a business operated under the name of an individual
owner
SOLE
 All investments in the account are titled in the owner’s name even if the
PROPRIETORSHIP
business is not in the business owner’s name
 The account is vulnerable to the owner’s personal creditors
 Similar to sole proprietorships and partnerships
UNICORPORATED
 Account is opened in the name of the owner(s)
ASSOCIATIONS
 The individual’s ownership in the account are subject to a creditor’s claims
 Partnership agreement specifies persons authorized to execute trades
PARTNERSHIP
 Information must be collected on each managing partner

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Discretionary Accounts
If a client authorizes another person to make investment decisions in her account or deposit and/or withdraw funds, the
following forms/steps are required:
 An authorization form signed by the client and the designated person (Power of Attorney)
• Principal must approve the account in writing prior to its opening
• Each order must be reviewed and approved promptly by a
principal (not in advance) Power of Attorney
Grants a person other than the
• Activity must be monitored for potential churning account owner with the authority to
(if the authorized person is an RR)
act on the owner’s behalf without
Limited Trading Authorization the owner’s prior knowledge.
 Allows for execution of trades
Full Trading Authorization
 Allows for execution of trades, withdrawal of cash and
securities, check writing privileges

Trust Accounts
Trust – a legal arrangement in which an individual (creator) gives fiduciary control of property to a person or institution
(trustee) for the benefit of beneficiaries

Revocable – also referred to as living or inter vivos trusts

 A person has the ability to revoke or change any terms in the trust
 Does not reduce estate taxes, but avoids probate if funded prior to donor’s death

Irrevocable
 Cannot be changed after being signed
 Will reduce estate taxes and avoid probate

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Pattern Day Trading

 Day Trading
• The purchase and sale (or short sale and purchase) of the same security, on
Definitions the same day, in a margin account
 Pattern Day Trader
• A client who executes four or more day trades within a five-day period

 Prior to opening a day trading account for a non-institutional customer, a firm must
provide a Risk Disclosure Statement which indicates:
• Day trading can be extremely risky
• Be wary of claims of large profits from day trading
Risk Disclosure
• Day trading requires knowledge of the securities markets and the firm’s
Statement
operations
• Day trading will generate substantial commissions
• Day trading on margin or short selling may result in losses beyond your
initial investments

 Firm must have reasonable grounds to believe that day trading is appropriate for
the customer
Approval
 If the customer has provided written notice that the account will not be used for day
Procedures
trading, but the firm has evidence of the occurrence of day trading, the account
must be approved for day trading within 10 days

Prime Brokerage Accounts

Prime Brokerage
 When a primary B/D provides a large client (e.g., hedge fund) with the ability to clear all trades through a
centralized firm with executions occurring with multiple B/Ds
• Prevents a single firm from determining the client’s strategy
 The prime broker offers specialized services such as custody, securities lending, margin financing, clearing
processing, operational support, research and customized reporting

Prime Brokerage
P.B.
The client, prime broker, and all executing brokers will
communicate regarding trades placed, settled, etc.

Equity Trades All trades settle and clear

through the prime broker

Bond Trades

Derivative Trades

Institutional
Customer

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COD/DVP/RVP
These acronyms are used to describe situations in which a client (usually an institution) uses a bank to settle trades
with one or more B/Ds

Delivery Versus Payment (DVP) or Collect On Delivery (COD)

DVP or COD  Client is buying securities
 B/D delivers securities to client’s bank and is paid by bank

Receipt Versus Payment (RVP)

RVP  Client is selling securities
 Client’s bank delivers securities to B/D; B/D makes payment to bank

 Before accepting a DVP/RVP account, the B/D must obtain the customer’s account number and the name of its
agent bank (i.e., an institutional identifier)
 Since DVP/RVP trades are settled with the customer’s agent, account statements from B/Ds generally do not
reflect any cash balance or security position at the quarter’s end

Fee-Based Accounts
Advisory and custodial fees, along with transaction costs, are wrapped into one comprehensive annual fee

 Fee-based accounts roll all of the costs for services into one fee
• Wrap accounts are a type of fee-based account

Suitability considerations:
 Are the services appropriate given client’s needs?
 Are the fees reasonable given the client’s trading history?
• Unsuitable for clients who trade infrequently (Buy and Hold)
• Designed primarily for active traders

 Traditional accounts charge on a per transaction basis assessing a commission on each trade

Activity
Match each description to the appropriate term.

COMMUNITY PROPERTY B/D delivers securities to a client’s bank and

ACCOUNT is paid by the bank
FULL TRADING Executes four or more day trades in a five-day
AUTHORIZATION period
A person can make changes to the trust at
REVOCABLE
any time

PATTERN DAY TRADER A joint account between a married couple

Allows another person to execute trades and

DELIVERY VS. PAYMENT
withdraw cash and securities from an account

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ERISA
Employee Retirement Income Security Act (ERISA) of 1974 was created to prevent misuse and mismanagement of
pension plan funds
 Rules apply to private sector defined benefit and defined contribution plans
 Determines qualified status
• Employer and employee contributions are tax-deductible
• Earnings are typically tax-deferred
 Plans must not be discriminatory and offered to all employees who:
• Are age 21 or older
• Have at least one year of full-time service (1,000 hours)
 An approved vesting schedule must be followed
• Specifies the percentage of the employer’s contributions to which the employee is entitled when
withdrawing from the plan
• Employees are 100% vested in their own contributions

Taxation of Retirement Plans

Tax status of contributions:
 Pre-tax contributions have a zero cost basis (taxable at withdrawal)
 After-tax contributions are part of cost basis (tax-free at withdrawal)
Earnings typically grow tax-deferred
Tax status of distributions: Retirement plans never generate
capital gains or losses
 Any portion representing pre-tax contributions is taxable as
ordinary income
 Any portion representing after-tax contributions is a return of capital and not taxed
• Earnings are typically taxed as ordinary income
 Subject to required minimum distributions (RMD)

Non-Retirement Distributions
Early withdrawal penalty:
 Before age 59 ½ and 10% of taxable amount
Exemptions from the penalty and taxation:

Rollover: Trustee-to-Trustee Transfer:

• Owner receives proceeds • Owner does not have access to the
• Once per year (rolling 12 months) funds
• Must be completed within 60 days • May be more than one per year

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457 and Profit-Sharing Plans

457 PLANS PROFIT-SHARING PLANS
 Employees may elect to contribute (generally  Contributions are discretionary and decided
pre-tax) by the board of directors
• 457 plans generally have a zero cost  Contributions are subject to maximum annual
basis since they are funded with pre-tax amounts
contributions, with earnings that grow  Allocation of contributions to employees is
tax-deferred based on a predetermined formula
• Contributions are subject to a maximum
annual amount
 Employers may match contributions, but are not
required to do so

ESOPs and Deferred Compensation Plans

Employee Stock Ownership Plans (ESOPs)
 Company contributes its stock or money to purchase its stock
 Stock not held directly while employed, but distributed when no longer employed

Non-Qualified Deferred Compensation Plans (NQDC)

 An agreement between an employer and an employee to pay the employee compensation in the future
 Generally unfunded; represent a “promise to pay” at retirement
 Not subject to ERISA requirements and exempt from IRS approval requirements

Education Savings Plans

Coverdell Education Savings Account (CESA) 529 Plan

 A trust or custodial account that’s created for the  A plan that is generally operated by a state and
purpose of paying the qualified education designed to meet the costs of both college and
expenses of a designated beneficiary K-12 education
• Maximum contribution: $2,000 annually per  Allows for much larger contributions than what
child up to age 18 CESAs allow
• Contribution is non-deductible, but earnings  Covered in greater detail in a later chapter
are tax-free if used for qualified education
expenses (contribution eligibility is subject to
income limits)
• CESAs may be used to pay for private
education on any level (i.e., kindergarten
through college)
• Funds must be used by the child’s 30th
birthday or transferred to a relative’s CESA

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Registration Changes and Internal Transfers

Account Registration Changes:

• For persons married or divorced:

− Requires marriage certificate, divorce decree, or court document
• To add a person to or remove a person from an account
− Birth date, Social Security number, and contact information for the person being added are required
− Typically both parties must sign and submit forms
• A registered principal must approve the change
− Change must be documented and approved before transactions are executed in the account
Internal Transfers:

• All parties on the account must provide approval of the transfer

• If transferring stock to another person, a stock transfer form must be completed
• This process is different than transfers of accounts between brokerage firms

Customer Identification Program

 Name
 Legal address (residence or business)
Required Identifying
 Date of birth
Information
 Identification number (which may be different for U.S. persons compared to non-
U.S. persons)
Identification Number  Taxpayer ID or
for U.S. Persons  Social Security number
 One or more of the following:
− Taxpayer ID
Identification Number
− Passport number
for Non-U.S. Persons
− Alien ID Card number
− Any other government-issued document establishing residence and identity
 An OFAC list is maintained to identify the names of terrorists and/or criminals
Office of Foreign Assets
 If a client’s name appears on the OFAC List, transactions are blocked and law
Control (OFAC)
enforcement is notified

Protecting Client Information

Privacy

Firms may not disclose client information unless: Regulation SP

 Ordered by a court or government entity or  Created rules for protecting the privacy of
 Client provides written permission clients’ confidential information
• A person does not have the right to  Clients provided with “privacy notice” at the
know the content of his spouse’s opening of account and annually thereafter
account  Requires disclosure of information that’s
shared and with whom it’s shared
 Requires a reasonable “opt out” provision

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Corporate Insiders
The SEC defines an insider as any officer or director of the issuer, or greater than 10% owner

 File Form 3 with the SEC within 10 days

Insiders Must:  File Form 4 to report purchases and sales within two business days; however,
there is no required filing for certain transactions within a 401(k) plan

Insiders are  Engaging in short sales of their company’s shares

Prohibited from:  Retaining short swing profits (stock held less than six months)

Outside Brokerage Accounts

Before a member firm employee can open an account with another firm, the
employee must:
Employee  Obtain employer’s prior written consent
Requirements  Provide written notification of his association to the executing firm
 Satisfy the previous two provisions within 30 days of employment if opened
prior to employment
 The executing firm must send duplicate confirmations and statements if
Executing Broker-Dealer requested by the employing firm.
Requirements  This applies to accounts for the employee’s spouse, dependent children, or an
account in which the person controls or has a beneficial interest.
 Requirements of this rule do not apply to transactions involving mutual funds,
Exemptions
variable contracts, unit investment trusts, or 529 plans.

Firm Supervision: Principals

Principals are persons who are engaged in management of a member firm and are responsible for account approval
and maintenance
 Includes officers, directors, and partners of the firm
 All RRs must be assigned to a principal

Activity Required Registration or Title

Supervise option activities Registered Options Principal
Supervise municipal securities activities Municipal Securities Principal
Supervise general securities activities and written
General Securities Principal
supervisory procedures (WSP)

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Restricting Activity in an Account

According to the FRB, the
Regulation T payment
If no payment is made and
must be obtained for Payment extension The result of non-payment
no extension is granted,
purchases that are made may be granted is that the account is
the position is closed out
in either cash or margin by the firm’s SRO frozen for 90 days
(securities sold) on the
accounts within two (all payments must
third business day
business days of be made in advance)
following settlement
settlement
(S + 2 or T + 3)

An investor who buys a stock and subsequently sells it, but fails
to meet the Regulation T requirement, is guilty of freeriding.

Activity
Read each statement and fill in the blanks.
1. ______ determines eligibility and vesting schedules for qualified retirement plans.
2. A privacy notice must be provided to client when ______ and ________.
3. Unfunded retirement plans that generally promise to pay are considered _______.
4. In order to change an account registration after marriage or divorce requires a ______
or a ________.
5. An individual holding more than a 10% voting interest in a corporate is defined as an ______.
6. The ______ is maintained to identify the names of terrorists and/or criminals.
7. An employee of a B/D opening an account at another B/D must ________ and provide __________.

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Chapter 3 – Customer Communications

Key Topics

1 2 3 4
COMMUNICATION TYPES OF PRODUCT SPECIFIC RESEARCH REPORTS
STANDARDS COMMUNICATION ADVERTISING
He Learn about the
rules on the
Learn about the Learn about the Learn about the
general standards that different types of disclosures required on distribution of research
apply to customer communications, mutual funds, variable reports and preparation
communications. approvals, and filing products, options, and by third parties.
requirements. other securities ads.

Communication Standards
All communications are subject to regulatory standards which include:
 Providing a basis for evaluating investments, being fair and balanced, and being based on fair dealing and good
faith
 Not containing false, exaggerated, or misleading claims
 Being clear and balanced as to the risks and potential benefits
 Being considerate of the audience to which the communication is directed
 Not predicting or projecting performance, or implying that past performance will be repeated

Definitions of Communications
Correspondence Retail Communication Institutional Communication

 Written or electronic  Written or electronic  Written or electronic

communication that a member firm communication that a communication that a member
distributes or makes available to member firm distributes or firm distributes or makes
25 or fewer retail investors makes available to more than available only to institutional
(prospective or existing) within any 25 retail investors within any investors (NOT to any retail
30-calendar-day period 30-calendar-day period investors)
• Subject to review and • Often subject to • Subject to review and
supervision preapproval and filing supervision

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Filing Requirements
The following retail communications must be filed with FINRA

At least 10 business days prior to first use Within 10 business days of first use

Communications regarding: Communications regarding:

 Investment companies that contain self-created  Investment companies that contain no self-
rankings created rankings
 Security futures  Direct participation programs (DPPs)
 Bond mutual funds that incorporate volatility  Collateralized mortgage obligations (CMOs)
ratings  Securities derived from another security or index
Any template for written reports that are produced by
investment analysis tools
Broker-prepared, widely disseminated free writing
prospectuses (FWPs)

Additional Communication Information

For the following communications, no principal approval is required

1. Retail communications
− Material that makes NO financial or investment recommendation and
does NOT promote a product or service of the member firm
− Market letters that make NO financial or investment recommendation
2. Correspondence
3. Institutional communications

Retail communications and correspondence

must disclose the name of the broker-dealer.

Public Appearances
When engaged in an unscripted seminar, public forum, radio or other public appearance, associated persons are
required to adhere to the following standards:

Written procedures
If making a recommendation, Any scripts, slides,
must be established
any conflict of interest handouts, etc. are
to supervise the
must be disclosed considered communications
public appearances

Unscripted public appearances are NOT considered

retail communications, institutional communications, or correspondence.

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Social Media
Interactive Content Supervision of Interactive Content

 Refers to content which is posted or  A principal must approve any social media site an
disseminated for direct, real-time interaction (e.g., RR intends to use for business communications
chatting or messaging) (not sites for strictly personal use)
 Any posting or dissemination of content to an  Social media cannot be used if it automatically
interactive social networking site, which may be deletes and erases content
defined as advertising, is supervised in a manner  Records must be maintained for any business
that’s similar to correspondence (i.e., it must be communication, including those made through
reviewed and supervised, but not preapproved) personal devices
 Static content posted for an extended period is  Suitability rules apply to recommendations made
not interactive, is considered retail through social media, and recommendations
communication, and may be subject to pre- made by a RR must be pre-approved
approval

Social Media and Third-Party Posts

Third-party posts to a broker-dealer’s social media
 Generally not considered a retail communication, but subject to recordkeeping rules
 Will be considered a retail communication if the broker-dealer:
Is involved in the preparation of the content (entanglement)
Has explicitly or implicitly endorsed or approved the content (adoption)

Links to third-party websites

 Broker-dealers are prohibited from linking to third-party sites that contains false or misleading content
 In a personal communication, an RR can link or share content from the broker-dealer that doesn’t relate to
the firm’s products or services
Not considered retail communication
For example, sharing a link to a charity event being sponsored by the firm

Testimonial concerns
 Unsolicited third-party opinions to a site that are used by an RR for business are not considered testimonials
 If the RR shares or likes the comments, they’re subject to FINRA’s rules and may be considered
testimonials
 The use of testimonials is prohibited by firms that are registered as investment advisers

Activity
Which statements are TRUE regarding requirements for customer communications?
Circle all that apply in your workbook.
I. An electronic communication to 35 retail investors within a 30-calendar-day period is a retail communication.
II. An advertisement regarding investment companies sent to 15 retail investors must be filed within 10 business days
of use.
III. Scripts used during a public appearance are considered retail communications.
IV. An electronic communication sent to 40 institutional investors need not be filed with FINRA.

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Investment Company Communications

Omitting Summary Prospectus (allowed under SEC Rule 482)
 Filed with the SEC and contains the highlights
 Client may make a purchase based on the contents of this document, but must be told a complete version is
available
 A complete prospectus must be sent by settlement (along with a confirmation)

Required Disclosures
 Before investing, an investor must carefully consider the investment objectives, risks, charges, and expenses
(which are included in the prospectus)
 The prospectus should be read carefully before investing
 The source from which an investor may obtain a prospectus

Additional Rule 482 Information

In an Omitting Prospectus:
Performance information and fee disclosure must be prominently displayed in a font size
that’s at least as large as that which is used for non-standardized performance information

If a 482 advertisement includes performance information, it must disclose:

 That the data being quoted represents past performance and that past performance does not guarantee future
results
 That an investment’s return and principal value will fluctuate; therefore, when shares are redeemed, they may be
worth more or less than their original cost
 Performance data does not reflect the deduction of the sales load or fee, but does reflect ongoing fees (expense
ratio)

Generic Fund Advertising

Although generic advertising cannot refer to a specific fund by name, it may include:
 How the fund operates and the services that it offers
 A basic description of the generic types of funds
 An invitation to inquire for additional information

Regulation of Investment Company Advertising/Sales Literature

Preceded/Accompanied May Performance
When it May Be Used?
by a Prospectus? Information be Included?
Waiting period and/or
Tombstone Ad No No
post-effective period
Waiting period and/or
Omitting Prospectus No Yes
post-effective period
Supplemental Sales
Yes Yes Post-effective period only
Literature

Generic Advertising No No At any time

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Use of Ranking Entities

An organization, independent from the investment company, that has been hired to
Ranking Entity provide a ranking symbol to the fund
 Nationally recognized ranking entities include Morningstar and Lipper
SEC Required  For money-market funds: 7-day yield
Standardized Yields  For other funds: 30-day yield
 The objective of the fund
 Name of the ranking entity
Disclosures  Criteria used for ranking
 That past performance is not a guarantee of future results
 An explanation of the symbols used in the ranking

Bond Fund Volatility Rating

Independent third party’s measurement of how sensitive a bond fund’s NAV is to changes in economic and market
conditions
 Ratings based on:
• Credit quality of fund’s portfolio
• Market volatility of the portfolio
• Fund performance
• Interest rate risk, prepayment risk, currency risk, etc.
 Can only be used in supplemental sales literature if a statutory prospectus is provided to the customer
 Disclosures:
• Name of the rating entity
• Most current rating and the date of the rating
• Explanation of the symbols used in the ranking

Variable Product Communications

Special guidelines have been established related to the sale of variable life insurance and variable annuities

Describing them as
Both must be identified Hypothetical illustrations
short-term, liquid Guarantees
as insurance products of rates of return
investments is prohibited

 Never state or imply  Must disclose that  Features are  A gross rate of 12% is
that they are mutual loans and guaranteed by permitted as long as a
funds withdrawals will insurance company, 0% is also provided
 Must disclose all impact both cash not by the selling B/D  Rates must be
charges and value and death or RR consistent with current
expenses associated benefit market conditions
with variable  Must reflect the
annuities maximum expenses
 Disclose the potential and sales charges
penalties and tax  Statement must be
implications of made that the rate is
liquidating a variable hypothetical and not a
annuity prematurely prediction of return

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Options Communications
The current options disclosure document (Characteristics and Risks of Standardized Options) must be delivered to
each customer either prior to or at the time the account is opened.
Additional rules for options communications include:
 A warning that options are not suitable for all investors
 Must be clear and balanced as to the risks and potential benefits of investing in options
 Projected annualized rates of return are permitted, but cannot be based on less than a 60-day experience
 Historical performance must cover no less than the most recent 12-month period and must include all
relevant costs

CMO Communications
Collateralized mortgage obligations (CMOs) are multi-class debt instruments backed by a pool of mortgage-related
securities. Due to their nature, they are subject to specific disclosures:

General Standards Educational Material Suitability

 Must include within the The following must be offered prior  They provide investors with
name “Collateralized to the sale to non-institutional the ability to choose the yield,
Mortgage Obligation” customers: maturity schedule, and risk
 Cannot compare to any  A description of the risks and exposure to meet their needs
other investment vehicle characteristics of CMOs  They allow investors to
 Disclose that yield and  The structure and types of customize prepayment risk
average life will fluctuate tranches  They may expose investors to
 Radio and TV ads must  Questions that should be extension risk
suggest contacting an RR asked  Retail investors should review
before investing  A glossary of terms carefully before investing

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Municipal Communications
 Ads include published or used in electronic or social media any promotional material
made available to the public
 Does not apply to preliminary official statements or official statements, but does apply
General
to abstracts of such
Provisions
 Form letter is any written letter or e-mail distributed to 25 or more persons within a 90
consecutive day period
 Ads cannot be false or misleading
 The syndicate may show the initial reoffering price or yield even if price, yield to
maturity or maturity have changed as long as date of sale by the issuer is contained.
New Issue  Date of sale for competitive is dates bids were submitted to issuer
Advertisements  Date of sale for negotiated is date the contract to purchase securities is executed
 Statement must be made that new issues may no longer be available at time of
advertisement
 In addition to basic disclosures, MFS requires:
• If investing outside of one’s state of residence, home state tax benefits should
be considered
Municipal Fund • If past performance is presented that it does not guarantee future performance
Securities • Maximum sales loads are included in performance
• Print or electronic advertisements must be presented in font sizes and styles
that provide information in a balanced manner
• Average annual yields must be presented for 1, 5 or 10 years
 Each advertisement must be approved in writing prior to first use by a general
Approval by
securities principal or municipal securities principal
Principal
 Copies of advertisements must be maintained for four years from each (last) use

Research Reports and Quiet Periods

Type of Offering Role of Firm Length of Quiet Period

IPO Manager/Co-Manager 10 calendar days

IPO Other distribution participant 10 calendar days

Follow-on offering Manager/Co-Manager Three calendar days

Follow-on offering Other distribution participant No restrictions

IPO or Follow On Non- Distribution Participant No Restrictions

Distribution participants may not initiate coverage (but may continue coverage) prior to the effective date

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Research Reports and Disclosures

Reports must be written in a plain English format and must disclose:
 Name and certifications of the analyst who prepared the report
 Plain meanings of the ratings used
 Any material conflicts of interest
 Whether the firm:
• Owns 1% or more of the stock
• Is a market maker for the stock
• Has received investment banking compensation in the past 12 months or expects to receive such
compensation in the next three months
 Whether the analyst (or any member of the analyst’s household):
• Has a financial interest in the company (owns shares, warrants, or options of the company)
• Is an officer, director, or subject company advisory board member

Third Party Research

Third-Party Research Independent Third-Party Research

 Defined as material prepared by either an Defined as material prepared by a person or firm that is
affiliate of a broker-dealer or at the request of a unaffiliated with the distributing broker-dealer
broker-dealer that maintains editorial influence  The distributing broker-dealer has no editorial
over the content of the report control and is not required to approve the report
 Disclosure rules apply to:
Disclosure rules apply to:
 The firm that created the report and
 The firm that creates the report, but NOT a firm
 Any firm that distributes the report
that distributes the report

Activity
Match the communication with its correct description.

Omitting Prospectus Investment cannot be compared to other investments

Ranking Entity May include hypothetical illustrations of rates of return

Bond Fund A document that can include mutual fund performance
Volatility Rating information; sent to a client before making a purchase
Variable Product An independent third party’s measurement of the NAV’s
Communication sensitivity to changes in economic and market conditions
Research reports may not be distributed by underwriting
CMO Advertising
participants
Quiet Period An organization hired to compare different mutual funds

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Chapter 4 – Equity Securities

Key Topics

1 2 3 4 5
COMMON STOCK PREFERRED RIGHTS, AUCTION EQUITY
STOCK WARRANTS, AND MARKETS TRANSACTION
He
Learn about the
characteristics of Learn about the
ADRs
Learn about the
TAX TREATMENT
common stock and characteristics of the Learn about the different types of Learn about
other means of different types of differences of rights electronic how different
acquiring stock. preferred stock. and warrants, and exchanges and equity transactions
investing outside auction markets. are taxed.
the U.S. with
ADRs.

Issued and Repurchased Shares

Corporate Charter determines Any outstanding shares
the number of shares that are repurchased by the issuer
authorized and can be issued become Treasury stock
Initial Public Offering After Share Repurchase

Authorized 1,000,000,000 1,000,000,000

Issued 10,000,000 10,000,000

Treasury

Outstanding

Treasury stock does not receive dividends and has no voting rights.

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Common Stock Ownership Rights

Participation in
Inspection of Corporate Earnings
Books – Entitled to dividends if
declared (not
guaranteed)

Evidence of
Ownership 
Voting power, including:
– Election of board members
Transfer of – Authorization of additional
Ownership shares and stock splits
(but NOT dividends)

Voting Methods
Statutory Cumulative
 Beneficial for large shareholders  Beneficial for small shareholders
 One vote, per share, per issue  Allows shareholders to multiply the number of
shares owned by the number of voting issues

If there are four candidates running for three seats on a corporation’s board of directors,
let’s consider how statutory or cumulative voting works for an investor who owns 300 shares:

Statutory Voting Cumulative Voting

Candidate A Candidate A
Candidate B Candidate B
Candidate C Candidate C
Candidate D Candidate D
Total Votes Total Votes

M&A and Spinoffs

Mergers and Acquisitions (M&A)
 Merger – the combination of two companies
• Results in the distribution of new shares
 Acquisition – one company purchasing and assuming control of another
• Acquiring company’s shares continuing to trade, while the acquired company’s shares cease to trade
Spinoffs
 A company may choose to spinoff a specific business unit to existing shareholders
• Shareholders receive new shares of the business unit

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Penny Stocks
Defined as over-the-counter (OTC) stocks that have a bid price below $5 per share
 Clients must be approved for penny stock trading and receive risk disclosure document
 Required disclosures for solicited sales include:
• Current quote of penny stock
• Compensation received by B/D and RR
• Does not apply to unsolicited transactions
 Special suitability rules apply for new clients, but not established clients
 Established clients are those who have:
• Been clients of the firm for more than one year, or
• Made three separate purchase of three different penny stocks on three different days

Preferred Stock
 Designed to provide returns that are comparable to bonds
 Pays a stated dividend
• Stated as a percentage of par
― Par value is typically $100
 Dividends are paid to preferred shareholders before common shareholders
 Senior to common stock in the event of corporate bankruptcy
 There are multiple types of preferred stock

Types of Preferred Stock

1. Non-Cumulative 5. Participating
 Investor is only entitled to the current dividend,  Investor may receive additional dividends based
NOT any unpaid dividend (dividend in arrears) on the company’s profits

2. Cumulative 6. Adjustable / Variable Rate

 Investor is entitled to unpaid dividends (those in  Dividends vary based on a benchmark
arrears) before common stock dividends are paid  The benchmark is typically T-bills

3. Callable 7. Series K Shares

 Issuer can repurchase its stock; typically  Begins with a fixed rate and later changes to a
repurchased at a premium over par value floating rate
 Depository shares with each share representing a
4. Convertible number of preferred shares

 Investor may convert the preferred stock into a

predetermined number of common shares

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Example of Cumulative Preferred Stock

ABC Corp. intends to pay a dividend to its common stockholders in Year 3

Dividend paid to Year 1 Year 2 Year 3

8% Preferred $0 $2

6% Cumulative Pfd. $0 $2

Common

Convertible Preferred Stock

An investor bought 4%, $100 par convertible preferred stock at $110.
The stock is convertible at $10 and the common stock’s price has risen $12.

 What is the conversion ratio?

Par $100
= =
Conversion Price $10

 Based on the increased price of the common stock, at what price should the preferred stock be trading?
Market value of common x Conversion ratio = Price of Preferred

Since the price of the common stock has risen to $12,

the convertible preferred stock should be trading at $120.

Preemptive Rights
 Provide shareholders with the ability to maintain
percentage ownership; no dilution Preemptive rights are given to existing stockholders
• Distributed through a rights offering when the issuer distributes additional shares
• One right for each share owned
 Discounted
• Shareholders exercise rights at a price that’s below the current market value prior to a public offering
• Immediate intrinsic value
 Short-term
• Typically must be exercised within four to six weeks
 Tradable

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Warrants
Attached to bonds or stock; act as “sweeteners”
Allow holders to purchase a specific number of the company’s common shares
 Exercise price is above the current market value (premium)
 Long-term
• May be exercised years after the original issuance
May be “detached” and traded separately

Rights Issued to shareholders Short-term Immediate Discount

Warrants Attached to a new issue Long-term Initial Premium

American Depositary Receipts (ADRs)

Characteristics:
 Facilitates trading of foreign equities in U.S. markets
 Priced in U.S. dollars
 Pay dividends in U.S. dollars
 Sponsored or Unsponsored

Sponsored Unsponsored
Issued in cooperation with the Issued without involvement of
foreign company the foreign company
May trade on U.S. exchanges Generally trade in OTC market
(Nasdaq or NYSE) (Pink Market)

Activity
Read each statement and determine what it describes.

STOCK REPURCHASED BY A CORPORATION

TYPE OF VOTING THAT

BENEFITS SMALL SHAREHOLDERS
UNLISTED STOCK WITH A
BID PRICE BELOW $5 PER SHARE
DIVIDENDS CAN EXCEED
THE STATED AMOUNT
STOCK CAN BE PURCHASED FROM THE
ISSUER AT LESS THAN MARKET PRICE

REPRESENTS FOREIGN EQUITY

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Secondary Markets
Trading markets that facilitate the exchange of existing financial instruments among investors
NYSE and other traditional centralized exchanges:
 Provide a specific location for trade execution
 Trading is normally monitored by a specialist or designated market maker (DMM)
 Exchanges include:
• NYSE
• Nasdaq
• Regionals

Taxation of Dividends for Corporations

 Dividends – Qualified vs. Non-Qualified
• Qualified cash dividends are taxed at a maximum of 20% after satisfying a holding period of more than 60
days for common stock and 90 days for preferred stock
• Non-qualified cash dividends are taxed at ordinary income rates
 Taxes paid on foreign investment income (ADRs) may be used as a tax credit or tax deduction
 Corporate Dividend Exclusion:
• Based on its ownership percentage, a corporation Ownership Percentage excluded
may exclude from taxes a portion of the dividends Percentage: from taxes:
that it receives from another corporation’s common or
Less than 20%
preferred stock
20% or greater
Dividends from REITs are not considered qualified and
they do not benefit from the corporate dividend exclusion.

Cost Basis and Capital Events

Cost Basis
 Represents the total amount paid to acquire a security
 Typically includes commissions and other fees paid
 The result of the sale or redemption of an asset if the proceeds exceed the
basis (Holding period is measured from trade date to trade date)
• Short-term: Assets that are held for one year or less
Capital Gains
− Taxed at: ____
• Long-term: Assets that are held for greater than one year
− Taxed at: _____
 The result of the sale of an asset if the proceeds are less than the basis
 As it relates to holding period, short-term and long-term losses are defined the
Capital Losses
same as capital gains
 If losses exceed gains up to $3,000 can be used to offset ordinary income

A return of capital is when the investor receives some of the original investment back.

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Offsetting Capital Gains and Losses

Capital Losses Capital Gains Ordinary Income
$40,000
$25,000 $110,000

$25,000 of the capital $0 $107,000

losses are used against
the capital gains

$15,000

$3,000 of the remaining

losses are used against
the ordinary income
$12,000 How much could the investor realize in capital gains
Carried forward in the following year without being subject to tax? ______

Basis – Special Cases

Securities Converted to Stock Inherited Securities Gifted Securities
 Stock takes the basis of the  Beneficiary’s basis is the  Recipient’s basis is the lower of
converted security market value at the time of donor’s cost or market value
• Cost of convertible death
÷ conversion ratio  Estate taxes are paid based on
= basis per share that market value
 Holding period is always long-
 No taxable event until stock is sold
term

Basis – Stock Split and Dividends

 Additional shares are generally not taxed when received
 Investor’s total basis is unchanged, but basis per share is adjusted

Example: Investor owns 100 shares of XYZ at $180 per share. XYZ Company executes a 3:2 split.

• Shares = 100 shares Investor’s total position:

Before the split:
• Basis per share = $180 $18,000

• Shares = 150 Investor’s total position:

After the split:
• Basis per share = $120 $18,000

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Identifying Securities Sold

An investor made the following purchases of the XYZ common stock:

Year Shares Price

FIFO; creates a
2013 1,000 $5 $15,000 capital gain

2014 2,000 $10

2015 2,000 $8
Specific ID; creates a
2016 1,000 $22 $2,000 capital loss

In the current year, the investor redeems 1,000 shares at $20 per share.

Taxpayer may use specific identification

 Must be identified at time of transaction
 If not identified, IRS assumes FIFO (first in-first out)

Tax Swaps and Wash Sale Rule

Assets may be sold to generate losses in order to offset taxable gains
However, the IRS will disallow the capital loss if, within 30 days of the sale, the investor purchases substantially the same
security (or covers a short position and shorts substantially the same security)
 Disallowed loss is added to the basis of the newly purchased security
 What is substantially the same?
• For stock – the stock itself, bonds and preferred stock that are convertible into the stock, as well as rights,
warrants and call options that are exercisable into the stock
• For bonds – bonds of the same issuer, coupon, and maturity

61-Day Wash Sale Period

Day 1 Day 30 Sale on Day 90 Day 120

Day 60

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Sale and Repurchase of Stock

An investor owns 1,000 shares of ABC with a basis of $43 per share. The current market value is $22, but it’s
expected to rise in the near future.
In order to offset significant capital gains, she sells the stock on December 3 at $22, recording a $21,000 loss. Fearing
an imminent rise in the stock’s value, she repurchases 1,000 shares of ABC at $24 on December 20.
 Consequences?

 What if she bought ABC Jan 25 Calls or ABC convertible bonds on December 20?

Activity
Read each statement and determine whether it’s TRUE or FALSE.

A CORPORATION CAN DEDUCT UP TO 65% OF

THE DIVIDENDS IT RECEIVES FROM STOCK
IF IT OWNS MORE THAN 20% OF THE ISSUER
AN UNLIMITED AMOUNT OF ORDINARY INCOME
CAN BE OFFSET WITH CAPITAL LOSSES
THE GAIN OR LOSS ON THE SALE OF INHERITED
SECURITIES IS BASED ON THE MARKET VALUE AT
THE TIME OF INHERITANCE
IF STOCK IS REPURCHASED WITHIN 30 DAYS OF A
SALE FOR A LOSS, THE LOSS WILL BE DISALLOWED

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Chapter 5 – Fundamentals of Debt

Key Topics

1 2 3 4
BASIC STRUCTURE BOND YIELDS RETIRING DEBT TAX IMPLICATIONS

He
Learn about the basic
characteristics, how
Learn about the
relationship between
Learn about call and
put provisions, as well
Learn about the
tax implications
bonds are quoted, nominal yield, current as methods used to when investing in
and risks influencing yield, yield-to-maturity, refinance debt. taxable debt.
their value. and yield-to-call.

Terminology
10% − The maturity or due date of the bond
− The date on which principal is returned
General Training and the last interest payment is made

− Interest rate, coupon rate, nominal yield 10% Debenture

− A fixed percentage of par; set at issuance Due 1/15/20XX
− Stated annually, but paid semi-annually

− Par value (face value or principal of the bond) $1,000 Par

− This is the amount that the issuer agrees to pay its
investors when the bond matures

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Quoting Bonds
Bond prices and interest rates are generally quoted as a percentage of par ($1,000):
 A bond priced at 100 is selling at 100% of its par value, or $1,000
Bonds may be quoted in terms of points or dollars
 Each point is equal to 1% of the bond’s par value, or $10.
 Corporate and municipal bonds trade in increments of 1/8 of a point, or $1.25.
Bonds may also be quoted in yield or basis terms
 Yield generally determines the bond’s value.
 Allows comparison of bonds with different characteristics.

Accrued Interest
Interest originally begins to accrue on the dated date and then every coupon date thereafter
 Buyer pays the seller the bond’s market price plus the accrued interest
• Start counting at: last coupon date
• And count up to: but not including, the settlement date
 Corporate, municipal and U.S. government agency bonds calculate accrued interest on a 30/360-day basis
 Treasury bonds and notes calculate accrued interest on an actual calendar/365-day basis
 The following formula is used to calculate the amount of accrued interest that’s added to the purchase price:

# of accrued days
Calculation: Annual Interest $ X
360 or 365-day year

Term and Serial Maturities

 Two of the ways that an issuer may structure its loan repayment or maturity are term and serial.
• Term maturity: the entire bond offering matures on the same date
− Generally quoted on a dollar basis
• Serial maturity: the bond offering matures over several years (i.e., has a series of maturity dates)
− Generally quoted on a yield basis
 For both types, bonds are issued on the same date and interest is paid each year
 Level debt service: Some serial maturities are structured so that principal and interest payments represent
approximately equal annual payments over the life of the offering.

Why Bond Prices Fluctuate from Par

 The par value of a bond can differ greatly from the price that investors pay to purchase the bond.
 Although most bonds are initially sold at par value, as time goes by, these same bonds will trade in the market at
prices that are less than or more than par.
 A bond that’s sold for less than its par value is selling at a discount. A bond’s par value can
differ greatly from the price
 A bond that’s sold for more than its par value is selling at a premium.
that investors pay

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Interest-Rate Risk
Bond trades $ % MARKET
BOND
at a discount PRICES
INTEREST 5%
RATES

INVERSE RELATIONSHIP
Interest-rate risk means that as market interest rates change, a bond’s price will
change in the opposite direction. They have an inverse relationship.

Credit Risk
Credit risk is a recognition that an issuer may default and be unable to meet its obligations to pay interest and principal
to its bondholders.
 Issuers that are considered high credit risks must pay a higher rate of interest in order to induce investors to
purchase their bonds.
 Securities issued by the U.S. government have the lowest possible credit risk.
 Credit risk is more difficult to evaluate when the bonds are issued by a corporation or a municipality.

If a bond has a high rating, it will have a lower yield and higher price.

Credit Ratings
S&P/Fitch Moody’s
AAA Aaa
AA Aa
Investment Grade
A A
BBB Baa
BB Ba
Speculative Grade
B (etc.) B (etc.)
+ or - 1, 2, 3

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Activity
Read each statement and determine what it describes.

PERCENTAGE OF PAR, STATED ANNUALLY,

PAID SEMI-ANNUALLY

INTEREST ACCRUES ON A 30/360 DAY BASIS

COMBINED INTEREST AND PRINCIPAL

PAYMENTS ARE THE SAME EACH YEAR
ISSUED AT THE SAME TIME,
MATURE AT THE SAME TIME
RELATIONSHIP BETWEEN BOND PRICES
AND INTEREST RATES
CONCERN THAT BOND ISSUER
MAY DEFAULT ON PAYMENTS

Bond Yields
Yield is the return an investor gets on a bond

NY CY YTM YTC
Nominal Yield (NY) Current Yield Yield-to-maturity Yield-to-call
 Same as coupon  Same as basis and yield  Includes the reinvestment
 Fixed percentage Annual Interest  Includes the reinvestment of interest and the gain or
of par of annual interest and the loss if the bond is called
Current Market Price
gain or loss over the life  Measured to the bond’s
of the bond call date(s)
 Measured to the bond’s  Disclosed if lower than
maturity YTM

1.00% = 100 basis points .01% = 1 basis point

Example: ABC Company

YTC
YTM
CY
Market Market
Prices PAR NY CY YTM YTC Rates

Market Market
Prices CY Rates
YTM
YTC

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Retiring Debt Prior to Maturity

When a bond reaches its maturity date, the bondholder will redeem it to the issuer and receive the bond’s par value
plus the last interest payment.
The issuer’s obligation to the bondholder has ended and the debt is considered retired.
Some bonds are redeemed before they mature.

What is it?
 Allows the issuer to redeem bonds prior to maturity – either in-whole or partial (lottery call)
 If called, the investor receives the full return of principal plus any accrued interest
When is it used?
Call Provision  When interest rates are falling
Why purchase?
 Higher yield
 Call protection
 Call premium

What is it?
 Gives the bondholder the right to redeem (or put back) the bond on a date prior to
maturity (opposite of a call provision)
When is it redeemed?
Put Provision
 When interest rates are rising
Why purchase?
 Allows bondholders to redeem their bonds at values greater than market value as
interest rates rise

Refunding
7% 10%
General Training General Training
7% Debenture 10% Debenture
Due 1/15/20XX Due 1/15/20XX
$1,000 Par Callable now at 102 $1,000 Par

Issued Now Buy Back

$
An issuer refinances an existing bond to take advantage of lower interest rates
 New bond is issued to raise capital in order to call the outstanding bond
• Existing bonds retired within 90 days of refunding issue
 Issuer benefits from lower interest rate
 Existing bondholders must reinvest at lower rate

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Advance Refunding (Pre-Refunding)

7% 10%
General Training General Training
7% Debenture 10% Debenture
Due 1/15/20XX Due 1/15/20XX
$1,000 Par Callable in 2 yrs. at 102 $1,000 Par

Issued Now $ Buy Back

in 2 years
ESCROW

 New bond issued; proceeds deposited into escrow account and invested in U.S. government securities;
managed by trustee
 Amount deposited is sufficient to pay debt service
• If paid off at call date: Pre-refunded to the call
• If paid off at maturity: Escrowed-to-maturity (ETM)
 Pre-refunded bonds are no longer the issuer’s liability (AAA rated)
 Defeasance – elimination of restrictive covenants

Tax Implications for Taxable Bonds

Interest Zero-Coupon Premium Bonds

 Treated as ordinary income;  Issued at a discount, but matures  Cost basis is amortized down
subject to federal, state, and at par value to par
local taxation  Difference between purchase price  Amortized amount reduces
 Accrued Interest: and par is considered interest taxable interest
• Seller reports the income
amount of interest  Cost basis is accreted each year
received from buyer up to par
• Buyer reports interest  Accreted amount is considered
payment minus the taxable income
amount paid to seller • IRS requires the constant
yield or constant interest
method of accretion
 Trades flat (without accrued
interest); has no reinvestment risk

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Discount Bond Taxation

Bond Sold Prior to Maturity
 Capital gain or loss determined by difference between the bond’s cost basis and the sales proceeds
 Zero-coupon bonds:
• If an investor purchased a 10-year zero-coupon bond three years ago for $500 and sold it today for $500,
she realizes a: ______

Accreted basis Accreted Basis

is $650

Year

Premium Bond Taxation

Premium bonds:
 Capital gain or loss is determined by the difference in amortized cost basis and sales proceeds
 An investor purchased a 5% bond with 10 years to maturity for $1,100. If it’s sold after three years for $1,050,
the result is a: ________
Amortized Basis

Amortized basis
is $1,070

Year

Activity
Match each description to the appropriate term.

CALL PROVISION Also referred to as a bond’s basis

PREMIUM BOND Not subject to reinvestment risk
PRE-REFUNDING Issuing new debt to retire debt at some point in the future
ZERO-COUPON BOND Issuer’s ability to retire debt prior to maturity
YIELD-TO-MATURITY Basis is amortized to determine gain or loss on sale

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Chapter 6 – Corporate Debt

Key Topics

1 2 3
TYPES OF CORPORATE CONVERTIBLE BONDS EQUITY-LINKED
BONDS SECURITIES
He
Learn about the different
Learn about the
characteristics of Learn about exchanged-
types of corporate bonds convertible debt and the traded notes and
and the quality of secured ability to obtain an equity reverse convertibles.
vs. unsecured debt. position in the issuer.

Corporate Bonds
Corporations that issue bonds use the proceeds from the offering for many purposes – from building facilities and
purchasing equipment to expanding their businesses.
 The advantage is that the corporation does not give up any control or portion of its profits.
 The disadvantage is that the corporation is required to repay the money that was borrowed plus interest.
 Although buying corporate bonds puts an investor’s capital at less risk than purchasing stock of the same
company, bonds typically don’t offer the same potential for capital appreciation as common stocks.

Types of Corporate Bonds

Corporate bonds are divided into two major categories – secured and unsecured.
Although all debt that’s issued by a corporation is backed by the issuer’s full faith and credit, secured bonds are
additionally backed by specific corporate assets.

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Secured Bonds
 Mortgage bonds are secured by a first or second mortgage on real property
Mortgage Bonds  Bondholders are given a lien on the property as additional security for the loan
Collateral: real estate (land, buildings)
 Secured by a specific piece of equipment that’s owned by the company and
used in its business
Equipment Trust  Trustee holds legal title to the equipment until the bonds are paid off
Certificates  Usually issued by transportation companies and backed by the company’s
rolling stock
Collateral: planes, trains, trucks
 Secured by third-party securities that are owned by the issuer
 Securities (stocks and/or bonds of other issuers) are placed in escrow as
Collateral Trust Bonds collateral for the bonds
Collateral: securities (stocks, bonds) of other companies

Unsecured Bonds
When corporate bonds are backed by only the corporation’s full faith and credit, they’re referred to as debentures.
If the issuer defaults, the owners of these bonds have the same claim on the company’s assets as any other
general creditor.
Occasionally, companies issue unsecured bonds that have a junior claim on their assets compared to its other
outstanding unsecured bonds. These bonds are referred to as subordinated debentures.
 In case of default, the owner’s claims are subordinate to those of the other bondholders. Therefore, the owners
of subordinated debentures will be paid after all of the other bondholders, but still before the stockholders.

Liquidation Proceedings
Administrative
Secured expense
creditors, claims (taxes,
General Subordinated Preferred Common
including current wages,
creditors creditors stockholders stockholders
secured lawyer and
bonds accountant
fees)

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Other Types of Corporate Bonds

Income Bonds High-Yield Bonds Stepped Coupon Bonds
 Normally issued by companies  Bonds with a low rating that  Issued with low coupon rates
in reorganization must offer a higher yield due to that increase at regular
 Issuer promises to repay the the greater risk of default intervals
principal amount at maturity,  Bonds rated lower than  Issuers generally have the
but NOT interest unless it has Moody’s Baa3 or S&P and right to call the bond on the
sufficient earnings Fitch’s BBB are considered dates the coupon will be
high-yield adjusted
 Also referred to as low-grade  Also referred to as dual
or junk bonds coupon or step-up coupons

Zero-Coupon Bond
Issued Issued at deep discount

Maturity Matures at face value (par)

Interest Considered the difference between the purchase price and par value

Carrying Value The investor’s carrying value (cost basis) must be accreted yearly

How it Trades Trades flat (without accrued interest)

Reinvestment Risk Not subject to reinvestment risk

Suitability Suitable for an investor who is planning for a specific futures investment goal

Debt with Foreign Characteristics

Sovereign Debt Eurodollar Bonds Yankee Bonds Eurobonds

 Debt issued by a  Principal and interest  Allow foreign entities  Sold in one country,
foreign national are paid in USD, but to borrow money in but denominated in
government are issued outside of the U.S. marketplace the currency of
 Credit rating is based the U.S. (primarily in  Registered with the another
on the issuing Europe) SEC and sold  Issuer, currency, and
government  Issuers include primarily in the U.S. primary market may
 The country’s foreign corporations, all be different
repayment ability is foreign governments,
reflected in the debt’s and international
yield agencies (e.g., the
World Bank)

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Brokered CDs and Commercial Paper

 Brokered CDs – generally offered by broker-dealers and have different characteristics than typical bank
offered CDs
• If not a bank product, FDIC insurance will not apply
• Fees and/or commissions may apply
• Maturities are generally longer than one year
• Call features may apply
• A limited secondary market will influence liquidity
 Corporate commercial paper – unsecured debt that’s typically used for satisfying short-term liabilities
• Maturities are typically 270 days or less

Activity
Read each statement and fill in the blanks.
1. Bonds backed by investments of other issuers are referred to as ________.
2. A _______ is another name for an unsecured bond.
3. Bonds issued with low coupons that increase over time are referred to as ________.
4. High-yield bonds are a type of ______.
5. _________ is a type of bond that is issued by foreign government.
6. Bonds issued outside of the U.S. which pay their debt service in U.S. dollars are referred to as _______.
7. Unsecured corporate debt typically used to pay short-term liabilities is known as ______.

Convertible Debenture
 A convertible bond gives an investor the ability to convert the par value of his bond into a predetermined number
of shares of the company’s common stock.
 Convertible bonds provide investors with safety of principal and potential stock growth.
 They allow the issuer to pay a lower coupon rate.
 The conversion price is set at a premium at issuance and the bond’s price is influenced by the underlying stock’s
price.

The number of shares

the investor will receive Par Value of Bond
Conversion Ratio =
at conversion Conversion Price
The price at which the
bond can be converted

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Conversion Parity
XYZ Corporation
6% Debenture
Market Price $1,100 and Convertible at $20

Par Value of Bond $1,000

Conversion Ratio = = = 50 shares
Conversion Price $20

Conversion parity means equivalent market values

Price of Convertible Bond = Aggregate Market Value of the Common Stock
If XYZ’s common stock was currently trading at $25, the bond’s parity price would be $1,250 (50 shares x $25)

Exchange-Traded Notes (ETNs)

ETNs are structured products and are issued as unsecured debt. They trade on exchanges, have low fees, and
provide access to challenging areas of the market.

Performance of a market
ETN Linked to
index or other benchmark

ETN Details:
 Backed by only the full faith and credit of the issuer (credit risk)
 Not principal protected, but return is linked to performance of an asset
 May be purchased on margin, sold short, and traded on exchange
 Issuer obligated to deliver performance at maturity

Reverse Convertible
A structured product that’s issued as a short-term, high yield note
Often linked to a single underlying stock (reference security) of another issuer

Fundamental A high yield (coupon)

Characteristic  Typically much higher than other fixed income securities with similar maturities
This a level that’s normally 70 to 80% of the initial value of the reference security
Knock-In Level  If the reference security never falls below the knock-in level, the investor
continues to receive interest and the principal at maturity
If the reference security falls below the knock-in level and, at maturity, closes below
Value of Reference the initial value, the issuing broker-dealer will deliver the reference security at the
Security Falls depreciated value
 At this point, the investor no longer receives the principal at maturity

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Performance of Reverse Convertibles

60 Scenario #1:
• Principal value: $1,000
55 • Maturity: 1 year
• Annual coupon: 12%
50 • Initial value of XYZ: $50
• Knock-in level: $40
45 • Convertible into 20 shares of XYZ

40 Results:
• XYZ never falls below knock-in level
35 Maturity • At maturity, XYZ closes at $53
• Customer receives $1,000 of principal and
30 $120 of interest
Initial Value Knock-In Level XYZ Value

Since XYZ never fell below knock-in level, the principal

amount is paid regardless of where XYZ closes at maturity.

Performance of Reverse Convertibles

55 Scenario #2:
• Principal value: $1,000
• Maturity: 1 year
50
• Annual coupon: 12%
• Initial value of XYZ: $50
45 • Knock-in level: $40
• Convertible into 20 shares of XYZ
40
Results:
• XYZ falls below knock-in level
35 • At maturity, XYZ closes at $43
• Customer receives 20 shares of XYZ
30 (MV = $860) and may receive $120 of interest

Initial Value Knock-In Level XYZ Value

Since XYZ fell below knock-in level and ended below initial value,
the issuer delivers 20 shares of XYZ and $120 of interest at maturity.

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Activity
Read each statement and determine whether it’s TRUE or FALSE.

A CONVERTIBLE BOND IS AT PARITY WHEN

ITS MARKET VALUE IS EQUAL TO THE VALUE OF THE
SECURITY INTO WHICH IT’S CONVERTIBLE
AN EXCHANGE-TRADED NOTE IS SECURED
BY THE SECURITIES TO WHICH IT’S LINKED

AN INVESTOR DECIDES WHETHER TO

EXERCISE A REVERSE CONVERTIBLE
WHEN STOCK FALLS BELOW THE KNOCK-IN LEVEL,
THE REVERSE CONVERTIBLE MAY BE EXERCISED

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Chapter 7 – Municipal Debt

Key Topics

1 2 3
TYPES OF MUNICIPAL NOTES AND TAX
MUNICIPAL DEBT MUNICIPAL FUND CONSIDERATIONS
He
Learn about different
SECURITIES
Learn about the tax
types of municipal debt Learn about how benefits of investing in
and how they would municipal notes are used municipal securities
be evaluated. and the benefits of and the special rules
municipal fund securities. that apply.

Municipal Bonds and Their Issuers

States and Political Public Agencies
Territories
Subdivisions and Authorities

 Transit Systems
 Cities  Puerto Rico
 Housing Authorities
 Counties  Guam
 Water, Sewer, and Electric
 School Districts  U.S. Virgin Islands
Systems

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Types of Municipal Bonds

Purpose:
 Issued for general purposes to meet any need of the issuer
Sources for payment of debt service:
 Taxes and the Issuer’s full faith and credit
General Obligation State level:
(GO) Bonds  Sales taxes, income taxes
Local level:
 Ad Valorem (property taxes)
• Assessed value x millage rate = tax bill (1 mill = .001)
 Parking/licensing fees

Purpose:
 Issued to fund a specific project
Sources for payment of debt service:
 Revenue (user fees) from a specific project
Revenue Bonds
Typical Projects:
 Toll roads, bridges, stadiums, airports
Considered:
 Self-supporting debt

Analyzing General Obligation Debt

There are four fundamental factors in determining the ability of the issuer to generate sufficient taxes to pay debt service

Demographics Evaluate the tax base, geographic location, businesses and property values

Nature of the Consider the debt trend, past and present attitude toward debt, and the schedule of
Issuer’s Debt debt repayment
Aspects Affecting the Existing unfunded pension liabilities, tax limitations, tax rates and collections, current
Issuer’s Ability to Pay financial condition, and outstanding litigation
Issuer’s net overall debt (direct and overlapping), debt-to-assessed valuation, and per
Municipal Debt Ratios
capita net debt

Sample Property Tax Bill

TOWN OF HARWICH, MA – PROPERTY TAX BILL
Fair Market Values (FMV):
Land $120,000
Structure $300,000
Total FMV $420,000

Total Assessed Value: $336,000 80% of FMV

Tax Rate: .007 Based on $7.00 per $1,000 of Assessed Value

Property Taxes: $2,352 $336,000 x .007

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Types of Revenue Bonds

Type Source for Paying Debt Service
TRANSPORTATION
Use tolls and user fees
REVENUE

SPECIAL TAX Excise taxes on purchases, such as gasoline, tobacco, and liquor

SPECIAL ASSESSMENT Assessments on the benefitting properties; used for sidewalks, sewers, etc.

DOUBLE BARRELED Two sources – project revenue and tax dollars (from GO bonds)
If project revenue is insufficient, the state legislature is morally (but not legally)
MORAL OBLIGATION
obligated for the shortfall
A bond in which more than 10% of the proceeds will benefit a private entity
PRIVATE ACTIVITY
(e.g., a sports team)
INDUSTRIAL DEVELOPMENT Issued by a municipality and secured by a lease agreement with a corporate user
BOND (IDB) of the facility

Analyzing Revenue Bonds

 A detailed report focusing on the economic viability and the need for the program
or service
 Factors evaluated include:
Feasibility Study
• The anticipated demand for the program
• Revenues and costs for similar programs
• Engineering aspects of the proposed project
 Credit of an entity other than the issuer provides security of the debt financing
 Examples include:
Credit Enhancements • Bond insurance
• Letters of credit
• State or other government guarantees

Legal Opinion
 Prepared by bond counsel for the issuer and provides opinions on:
• Issuer’s legal, valid, and enforceable obligation
• Tax exempt status of the issue
 Qualified versus Unqualified legal opinion
• A qualified legal opinion is conditional and subject to qualifications
• An unqualified legal opinion is rendered if there is nothing to adversely affect the issue

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Covenants
Pledge to maintain the user fees at a level sufficient to meet debt service and other
RATE
obligations
MAINTENANCE AND Pledge to maintain the project in good working order and to contribute to a fund for
OPERATION that purpose
INSURANCE Pledge to carry insurance on the property

Provides the issuer with the ability to retire a bond due to destruction of the revenue
CATASTROPHE CALL
source backing the bond

ADDITIONAL BONDS Pledge not to issue more debt unless certain tests are met

NON-DISCRIMINATION Pledge to not grant special rates to any one person or group
Establishes the priority for payment of debt service
FLOW OF FUNDS  Net vs. Gross

Net vs. Gross Revenue Pledge

Net Revenue Pledge Bond
Start: Gross Revenue
Deduct: Maintenance and Operation Debt Service Coverage Ratio
is calculated by taking
Leaving: Net Revenue
the amount
From which is paid: Debt Service available for debt service
and dividing by the amount
Gross Revenue Pledge Bond needed for debt service.
Start: Gross Revenue
Deduct: Debt Service
From what’s left is paid: Maintenance and Operation

Activity
Read each statement and determine what it describes.
THE RATE CHARGED TO
GENERATE PROPERTY TAXES
BOND SUPPORTED FROM
BOTH TAXES AND REVENUES
DOCUMENT THAT PROVIDES INSIGHT INTO
THE TAX-EXEMPT STATUS OF THE ISSUER
THE COVENANTS STATING THAT THE FEES CHARGED
WILL BE SUFFICIENT TO COVER EXPENSES
A CALL THAT MAY BE USED TO RETIRE DEBT
DUE TO THE DESTRUCTION OF A FACILITY
THE PRIORITY USED FOR
THE PAYMENT OF DEBT SERVICE

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Municipal Notes
Municipal notes, or Tax-Free Anticipation Notes, are short-term issues that are normally issued to assist in financing a
project or getting it started, or to assist a municipality in managing its cash flow
Types include:
 Tax Anticipation Notes (TANs)
 Revenue Anticipation Notes (RANs)
 Bond Anticipation Notes (BANs)
 Grant Anticipation Notes (GANs)

Ratings for Municipal Notes

S&P Moody’s
SP 1+ MIG 1
Investment Grade SP 1 MIG 2
SP 2 MIG 3

Speculative Grade SP 3 SG

Variable Rate Municipal Securities

 Long-term securities marketed as short-term investments
 Debt securities that offer a variable rate of interest adjusted at specified intervals
Variable Rate Demand (e.g., daily, weekly, or monthly)
Obligations (VRDO)
 Holders can redeem for par plus accrued interest at any time that rates are reset
 Includes a Put provision

 Long-term investments with a variable interest rate that is reset at periodic

intervals through a “Dutch Auction”
Auction Rate  Auction sets the lowest interest rate at which all the securities being offered for
Securities (ARS) sale will clear the market (“net clearing rate”)
 Interest rate reset periods range from 7, 28, or 35 days
 Does NOT include a Put provision

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Municipal Fund Securities

Local Government
Prepaid Tuition Plans 529 Plans
Investment Pools (LGIPs)
 Created by state and local  A type of college savings plan  Primarily a type of college
governments to provide  Purchaser buys college tuition savings plan
municipal entities a place to credits  Account owner chooses a
invest funds • Locks in tuition costs at plan, but may alter the
 Government entities purchase current levels investment direction
interest in the trust (LGIP) • Protects against future  More detail on next slide
 Provides safety and cost increases
diversification  Not self-directed
 Not open to the public

529 Plans
 Funded with after-tax dollars; investment grows tax-deferred
 Money invested in one state’s plan may be used in another state
 To avoid gift tax, the maximum contribution is $18,000 per person, per year
(doubled for married couples)
• The plan allows for front-loading five years of contributions
($90,000 per person or $180,000 for married couples)
 A federal tax exemption is provided to the beneficiary for qualified withdrawals:
• College tuition, books and supplies, room and board, a maximum withdrawal of $10,000 for tuition and
books for grades K-12 per year, and up to $10,000 (lifetime limit) to repay a qualified student loan or
expenses related to certain apprenticeship programs

529 Plans and 529 ABLE Plans

529 plans may be direct-sold or adviser-sold

DIRECT-SOLD ADVISER-SOLD
 Involves no salespersons; instead,  The plan is sold through a broker-
the plan is sold directly through the dealer that has entered into a selling
529 savings plan’s website or agreement with the primary
through the mail distributor of the 529 plan

529 ABLE (529A) Plans (Achieving a Better Life Experience)

 Available to individuals who are disabled and are receiving Social Security disability, Medicaid, or private
insurance payments
• Maximum contribution is $18,000 per year (no front-loading)
• Disability payments continue if account value does not exceed $100,000
• Distributions are tax-free if used to pay qualified expenses

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Tax Considerations
Municipal bond interest:
 Interest received is exempt from federal tax; however, it may be subject to state and local tax if purchased from
a state that’s not the bondholder’s resident state
 Interest paid on bonds issued by U.S. territories and possessions is triple tax exempt
 Bank-Qualified (BQ) bonds are issued by “qualified small issuers” that issue no more than $10 million per year.
BQ bonds allow banks to deduct 80% of the interest cost paid to the depositors on the funds that are used to
purchase these bonds.

Investors in higher tax brackets benefit more from the tax-exempt nature of
municipal debt; however, municipals are generally unsuitable for investors
who are in lower tax brackets or as an investment in retirement accounts.

Additional Tax Considerations

Capital Appreciation Bonds
Zero-Coupon Municipals Private Activity Bonds
(CABs)

 Annual accreted amounts are  Issued at deep discount  Typically taxable for investors
considered tax-free interest  Investment return on initial who are subject to alternative
 Accretes to par value at value is reinvested at a minimum tax (AMT)
maturity compounded rate  Yields are higher than non-
 At maturity, investors receive a AMT bonds
single payment representing
initial amount and investment
return (discount is not
accreted)

Yield Calculations
An investor is earning 4.55% on a tax-free municipal and is in the 35% tax bracket. What must a taxable bond yield to
be equivalent?

Taxable Equivalent Tax-Free Yield

Yield Formula: (100% – Tax Bracket %)

An investor purchased a 7.0% corporate bond and is in the 35% tax bracket. What tax exempt yield would be required
to equal the taxable yield?

Net Yield Formula: Taxable Yield x (100% – Tax Bracket %)

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Considering the State Tax

An Ohio resident purchases a State of Ohio G.O. bond yielding 4.25%. He is subject to a 30% federal tax and a 3%
state tax. What must a taxable bond yield to be equivalent?

Taxable Equivalent Tax-Free Yield

Yield Formula: Neither federal nor state
(100% – Federal + State Tax %)
tax apply since he is an
Ohio resident

An Iowa resident purchases the same State of Ohio G.O. bond and is also subject to a 30% federal tax. What is the
taxable equivalent yield?

Taxable Equivalent Tax-Free Yield Since she is not an

Yield Formula: (100% – Federal Tax %) Ohio resident, she
is only exempt from
federal tax

OID Bond Taxation

 Original Issue Discount (OID) Bond
• Basis must be accreted at a rate that will bring basis to par at maturity
• If sold prior to maturity, capital gain or loss determined by difference between the bond’s cost basis and
the sales proceeds
• If held to maturity, accreted adjustment is considered tax exempt interest, which results in no taxable gain

The following examples for OID and Premium bond taxation use the straight line method
to adjust the cost basis, which is what’s used for any exam questions. However, the
actual method is referred to as the constant yield or constant interest method.

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OID Sold Prior to Maturity

An OID is purchased at $700 with 10 years to maturity. Five years later, the bond is sold for $880. What is the result
for tax purposes?

$1,000 par
$300 discount
- $700 cost = $30 is accreted each year, but not taxable
10 years
$300 discount

$1,200

After five years, the basis is $1,000

Basis
$850 ($30 x five years = $150). $800
The $150 is treated as tax
Basis
$600
exempt interest income. Accreted
$400
Accreated
If sold at $880, the $30
difference ($880 – $850) is $200

treated as a capital gain. $0

0 1 2 3 4 5 6 7 8 9 10
Year
Year

Premium Bond Taxation

 Premium Bond:
• Basis must be amortized at a rate that will bring basis to par at maturity
• If sold prior to maturity, capital gain or loss determined by difference between the bond’s adjusted cost
basis and the sales proceeds
• If held to maturity, amortized adjustment is not deductible, which results in no taxable loss

Premium Bond Sold Prior to Maturity

A bond is purchased for $1,050 with 10 years left to maturity. Five years later, the bond is sold at $1,030. What is the
result for tax purposes?
$1,050 cost
$50 premium
-$1,000 par = $5 is amortized each year
10 years
$50 premium

$1,200

$1,000
BasisBasis

After five years, the basis is

$800
$1,025 ($5 x five years = $25).
The $25 is an adjustment to the $600
Accreted

cost basis, but is not deductible.

$400
Accreated

When sold at $1,030, the $5 $200

difference ($1,030 – $1,025) is
$0
treated as a capital gain. 0 1 2 3 4 5 6 7 8 9 10
Year
Year

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Secondary Market Discount Bond Taxation

 Secondary Market Discount Bond
• Bond that was issued at par, but is later purchased at a discount in the secondary market
• The basis is not adjusted
• When the bond is sold or matures, the accreted market discount is taxed as ordinary income

Market Discount Sold Prior to Maturity

A bond was issued at par, later purchased for $900 with 10 years left to maturity. Five years later, the bond is sold at
$980. What is the result for tax purposes?

$1,000 par
$100 discount
- $900 cost = $10 is accrued each year
10 years
$100 discount

$1,200

After five years, the difference $1,000

BasisBasis

between the cost ($900) and $800

the proceeds ($980) is $80
$600
• $50 of the difference is
Accreted

treated as ordinary income $400

Accreated

($10 x five years) $200

• $30 is treated as a capital $0
gain 0 1 2 3 4 5 6 7 8 9 10
Year
Year

Activity
Read each statement and determine whether it is TRUE or FALSE.

A VRDO CONTAINS A PUT PROVISION

TAX-FREE DISTRIBUTIONS CAN BE TAKEN

FROM A 529 PLAN FOR PRE-COLLEGE EXPENSES

EXEMPTION FROM A STATE TAX NEED NOT BE

CONSIDERED WHEN EVALUATING EQUIVALENT YIELDS

THE DISCOUNT ON AN OID IS CONSIDERED ORDINARY INCOME

A CAPITAL LOSS CAN BE THE RESULT

OF SELLING A PREMIUM BOND PRIOR TO MATURITY

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Chapter 8 – U.S. Treasury and Government

Agency Debt
Key Topics

1 2 3 4
U.S. TREASURY ISSUING TREASURY U.S. GOVERNMENT CMOs AND CDOs
SECURITIES SECURITIES AGENCY DEBT
Learn about the
Learn about the Learn about how a Learn about the structure of
types of Treasury Treasury auction is different types of collateralized
securities and how conducted. agency debt and mortgage and
they are priced. their use. collateralized debt
obligations.

U.S. Treasury Debt Overview

Characteristics Taxation of Interest

 Issued directly by the U.S.  Interest taxable at federal level

Government  Interest exempt at state and local
 Highly liquid; no credit risk levels

T-Bills, T-Notes, and T-Bonds

Treasury securities are considered marketable securities since they are traded in the secondary market after issuance.
The three most prevalent types of these marketable issues are:
 T-Bills
 T-Notes
 T-Bonds
T-Bonds and T-Notes are interest-bearing securities that have all of the attributes of traditional fixed-income
investments.
Each pays a fixed rate of interest semi-annually and the investors receive the face value at maturity.

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Comparing T-Bills, T-Notes, and T-Bonds

T-BILLS T-NOTES T-BONDS
MATURITIES Up to 1 year 2 – 10 years Greater than 10 years
DENOMINATIONS All in $100 multiples
FORMS OF ISSUANCE Book Entry

INTEREST Discount securities

• Stated annually, paid semi-annually
• Accrued Interest: Actual/365
HOW THEY’RE
Weekly auction Periodic auction
INITIALLY SOLD

Pricing of Government Securities

Government bonds such as T-Notes, T-Bonds and Agency Securities trade in increments of 1/32 of a point

However, T-bills are quoted on a discount yield basis, not dollar

 In a T-bill dealer’s quotation, the bid’s higher yield represents a lower price, while the ask’s lower
yield is a higher price.

BID ASK

2.94% 2.90%

TIPS
How can Treasury investors protect themselves from inflation?
Acquire protection by investing in Treasury Inflation-Protected Securities (TIPS)

Offer a stated coupon with interest Principal adjusted for inflation and
paid semi-annually deflation, based on CPI

TIPS Example
PRINCIPAL COUPON RATE ANNUAL PAYMENT
$1,000 4% $40.00

CPI increases by 1% (inflation)

$1,010 4% $40.40

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T-STRIPS
Issued at a discount and mature at Forms of zero-coupon debt created
Issued with a variety of maturities
face value from T-Notes and T-Bonds

T-STRIPS are non-interest bearing

Bidding at the Auction

WHAT ARE AUCTIONS?
 The government sells Treasuries through auctions conducted by the U.S. Treasury.

COMPETITIVE BIDS
 Placed by large financial institutions
 Indicate both quantity and price

NON-COMPETITIVE BIDS
 Placed by the public
 Indicate quantity only
 Are filled first
 Bidder agrees to pay the lowest price (highest yield) of the accepted competitive bids

T-BILLS
 Settle on the Thursday following the auction.

EXAMPLE: $100,000,000 bond offering at 4.5% coupon

Bids across all bidders:

 $20 million (non-competitive)
 $40 million at 4.90%
 $40 million at 5.00%
 $30 million at 5.1%

THE RESULT?
The highest bid is 5%; therefore, all bidders get a 5% yield at the auction clears at 5%.

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Activity
Read each characteristic and then circle which types (or types) of Treasury debt to which it applies.

MORE THAN 10-YEAR MATURITY T-Bills, T-Notes, T-Bonds

INTEREST IS FEDERALLY TAXABLE T-Bills, T-Notes, T-Bonds

SOLD AT WEEKLY AUCTION T-Bills, T-Notes, T-Bonds

DISCOUNTED SECURITY T-Bills, T-Notes, T-Bonds

2 – 10 YEAR MATURITY T-Bills, T-Notes, T-Bonds

BOOK-ENTRY ISSUANCE T-Bills, T-Notes, T-Bonds

INTEREST PAID SEMI-ANNUALLY T-Bills, T-Notes, T-Bonds

Agency Securities
 Debt instruments issued and/or guaranteed by federal agencies and GSEs
 Exempt from state and federal registration
 Quoted in 32nds
 Accrued interest based on 30 days in the month
 Issued in book-entry form

Federal Farm Credit Bank (FFCB)

Farming Loans  Provides agricultural loans to farmers
 Subject to federal tax, but exempt from state and local taxes

Mortgage-backed securities represent an interest in a mortgage pool.

 Monthly payments consist of interest and principal
 Interest portion is fully taxable
 Subject to prepayment risk
Agencies that issue mortgage-backed securities include:
Mortgage-Backed  GNMA or Ginnie Mae
Securities  FNMA or Fannie Mae
 FHLMC or Freddie Mac
NOTE: The most common security issued by government agencies is a mortgage-
backed pass-through certificate. Pass-throughs provide excellent credit quality and a
slightly higher yield than Treasuries; they’re often used to supplement retirement
income.

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Collateralized Mortgage Obligations (CMOs)

Mortgage-backed bonds created by dividing mortgage pools (GNMA, FNMA, and FHLMC) into various bond
classes (tranches)
 Distribute the impact of prepayment risk to different tranches
 Interest is generally paid monthly (fully taxable), with principal paid sequentially
 Issued in $1,000 denominations
 Subject to Act of 1933 registration and the Trust Indenture Act of 1939
Private Label CMOs
 Pools include non-U.S. agency mortgage securities
 Subject to the credit risk of the issuer

CMOs – Sequential Pay/Plain Vanilla

P I P I P I

PERIOD
ONE
Tranche A Tranche B Tranche C

P I P I

PERIOD
P - principal TWO
Tranche B Tranche C
I - interest

P I

PERIOD
THREE
Tranche C

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Types of CMOS
Planned Amortization Class
 Provides the most predictable cash flow and maturity
Planned Amortization and  Designed for more risk-averse investors
Target Amortization Class Target Amortization Class
 Provides protection from prepayment risk
 Subject to extension risk

 Provides the least predictable cash flow and maturity

Companion Tranche
 Reflects excess or shortfalls in payments to PACs and TACs
 Last tranche to receive payments
Z-Tranche
 Similar in structure to a zero-coupon bond

Collateralized Debt Obligations (CDOs)

CDOs repackage individual fixed-income assets into a product that can be separated into tranches and then sold in the
secondary market.
Referred to as CDOs since the assets being packaged (e.g., mortgages, corporate debt, auto loans, or credit card
debt) serve as collateral for investors.
 Each of the tranches have different maturities and interest payments
CDO investors own a right to
 Similar to CMOs, but do not limit investments to mortgages
receive a portion of the pool’s
 Primary purpose of CDO is to distribute risk interest income and principal
 The quality of the underlying debt determines the risk of the CDO

Activity
Read each statement and fill in the blanks.
1. Although agency securities are not direct obligations of the U.S. government, their credit risk is still considered
___________.
2. Agency securities are _______________ from state and federal registration.
3. Ginnie Mae, Fannie Mae, and Freddie Mac offer ______________________________ securities.
4. Mortgage-backed securities represent an interest in a _____________ of mortgages.
5. __________________________________ is unique to mortgage-backed securities.
6. CMOs distribute payments through various ______________________.
7. _____________ are types of securities backed by various types of debt that attempt to distribute risk.

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Chapter 9 – Investment Companies

Key Topics

1 2 3 4 5
TYPES OF THE CATEGORIES OF BUYING AND OTHER TYPES OF
INVESTMENT ORGANIZATION OF MUTUAL FUNDS SELLING MUTUAL INVESTMENT
He
COMPANIES A MUTUAL FUND
Learn about the
FUND SHARES COMPANIES
Learn about the Learn about the different types of Learn about the Learn about unit
different types of responsibilities of funds and the costs associated investment trusts,
investment the different service contents of their with purchases and exchange-traded
companies, with a organizations portfolios. sales of mutual funds, and closed-
focus on mutual connected to fund shares. end funds.
funds. mutual funds.

Types of Investment Companies

Investment
Companies

Face Amount Management Unit Investment

Certificate Companies Trusts (UITs)

Closed End Open End

(Publicly Traded Funds) (Mutual Funds)

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Investment Companies
A corporation (sometimes a trust) that invests the pooled funds of investors; typically into a diversified portfolio of
securities
 Allows investors to acquire an interest in a large number of securities
 Mutual fund benefits include:
• Professional management • Convenience and cost
• Diversification • Exchanges at net asset value (NAV)
• Liquidity

Stocks Bonds

Investors
$ Investment $ Portfolio
Company

Money Market
The fund distributes common stock representing Instruments
an interest in the specific portfolio

Mutual Fund Structure

Fund Company Transfer Agent
Board

‒ Issues, redeems and

‒ Majority of board must be XYZ cancels fund shares;
independent Fund distributes dividends
‒ Deals with policy and
‒ Receives a fee
administrative matters

Underwriter /
Distributor / Custodian Bank
Sponsor

‒ Manages portfolio and Dealer ‒ Holds fund’s cash and

receives a management fee securities, but does NOT
which is based on assets manage
under management ‒ Receives a fee

Investors

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Mutual Fund Complex

ABC
ABC International ABC
Growth Fund U.S. Govt.
Fund Securities
Fund

ABC ABC Fund ABC

S&P 500 Complex Municipal
Index Fund (Family) Bond Fund

ABC
Income ABC
Fund ABC ABC Asset
Global Money- Allocation
Fund Market Fund
Fund

Net Asset Value

Accounting value of a fund’s positions; marked-to-the-market at closing prices as of 4:00 p.m. ET
 NAV is synonymous with the bid price or redemption (liquidation) price for mutual fund shares
• Investors who redeem their shares receive the next computed NAV (forward pricing)
 Public Offering Price (POP) is the NAV plus any applicable sales charges
• Investors who purchase fund shares pay the next computed POP

(Total Assets – Total Liabilities)

Calculating NAV per share: Number of Shares Outstanding

Calculating the Sales Charge

Difference between the NAV and POP is the sales charge

NAV (Bid) POP (Ask)

9.20 10.00

Sales charge is expressed as a percentage of the POP

Calculating (POP – NAV) (10.00 – 9.20) .80

= = = = 8%
Sales Charge % POP 10.00 10.00

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Calculating Public Offering Price

When given the NAV and sales charge percentage, use the following procedure to calculate the offering price:

NAV
Sales Charge NAV Simplify Resulting POP
(100 – Sales Charge %)

5% $69.80

8.5% $45.95

Sales Charges
Amount deducted from an investor’s purchase
 Benefits the selling brokers
 Used to cover the costs of promotion and sales literature
• Industry rules prohibit assessing charges in excess of _____% of the POP

 Assessed at the time an investor purchases shares

Front-End Loads  Total investment, less the sales charge, is directed to the portfolio
 Typically associated with Class A shares

Holding Period CDSC

1 year 5%
 Assessed at the time an
investor redeems 2 years 4%
Back-End Loads  Percentage decreases as the 3 years 3%
holding period lengthens
 Typically associated with 4 years 2%
Class B shares 5 years 1%
6 years + 0%

 Established under Section 12b-1 of the Investment Company Act of 1940

 Annual fee levied against the fund’s assets
• Allows distribution costs to be borne by the fund, rather than from
front-end charges
12b-1 Fees  Used to finance promotion, advertising, and commissions
• Includes continuing commissions or “trailers”
• If a written contract exists, it may be paid to RRs who are still
employed with a firm or to retiring RRs based on existing assets
 Typically higher for Class C shares

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No-Load Funds
For a fund to be described as a no-load, it must have:

1 2 3

No front-end No deferred sales charge No 12b-1 fee that exceeds

sales charge (load) (back-end load) .25% of the fund’s
average net assets per year

A no-load fund may have a redemption fee (since it’s not considered a sales charge)
 Rather than benefitting selling brokers, the fee represents what remains behind in the fund benefitting the
remaining owners

Mutual Fund Expense Ratio

Defined as the percentage of a fund’s assets paid for operating expenses and management fees, including 12b-1 and
administrative fees, and all other asset-based costs incurred by the fund
 Calculated by dividing a fund’s expenses by its average net assets (sales charges are not expenses)
 Will decline if:
• Assets under management increase
• Any fee or expense is reduced

The largest expense for a fund is typically the management fee.

Methods to Decrease Sales Charge

Breakpoints – dollar levels at which sales
Invested Amount Sales Charge
charge is reduced
 When investing an amount at or above
Less than $50,000 5.75%
the breakpoint, the investor qualifies for
the lower sales charge on the entire $50,000, but less than $100,000 4.50%
purchase
 Purchases of multiple funds within the $100,000, but less than $250,000 3.50%
same family or complex of funds are
consolidated to determine the sales $250,000, but less than $500,000 2.50%
charge
 Only available for purchases of Class A $500,000, but less than $1 million 2.00%
shares
$1 million or more None

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Breakpoints – Example
A customer invests $60,000 in a mutual fund. The Fund’s next calculated NAV is $19.61 and the maximum offering
price is $20.80. The fund charges a 1% redemption fee. Using the previous breakpoint schedule, how many shares is
the investor able to purchase?

Sales NAV
NAV Simplify Resulting POP
Charge (100 – Sales Charge %)

Mutual funds allow the purchase of fractional shares

Letter of Intent
Optional provision that allows investors to qualify for a breakpoint without initially depositing the entire amount required
 ______-month time period
 May be back dated ______ days
• If backdated, the fund will re-compute the sales charges on previous purchases
 Non-binding on customer; a portion of shares held in escrow in case of non-performance

A letter of intent is offered as an incentive for investors

to contribute as much as possible in the fund.

Rights of Accumulation (ROA)

Right to add up all of the purchases made from same family of funds
 When a breakpoint is crossed, current and future purchases will have a lower sales charge
Rights of accumulation may be made available to any of the following:

Purchaser’s Immediate Family Members

Individual Purchasers
(spouse, dependent children)

Fiduciary for a Single Fiduciary Account Trustee for a Single Trust Account

Pension and Profit-Sharing Plans Other Groups (Investment Clubs) formed for
(that meet IRC guidelines) reasons other than paying reduced sales charges

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Dollar Cost Averaging (DCA)

A method of investing which involves making the same periodic investment regardless of share price over a fixed period
 Results in average cost per share being less than the average price per share
 Does not guarantee attainment of any specific investment goals
 Necessary disclosures:
• No assurance of long-term growth
• Prices are subject to change
• Contributions must continue even when prices decline, otherwise losses could occur

Activity
Read each statement and determine what it describes.

DETERMINES WHICH INVESTMENTS

ARE PLACED IN THE FUND’S PORTFOLIO

DEDUCTED FROM THE POP AND

EXPRESSED AS A PERCENTAGE OF POP

AMOUNT THAT DECREASES

THE LONGER SHARES ARE HELD

RETROACTIVE REDUCTION
IN SALES CHARGE

SALES CHARGE IS REDUCED

WHEN A BREAKPOINT IS REACHED

RESULTS IN COST PER SHARE

BEING LESS THAN PRICE PER SHARE

Redeeming Mutual Fund Shares

 A mutual fund investor may redeem (sell) shares and receive the share’s next
calculated net asset value (minus any applicable contingent deferred sales
The Redemption charges or redemption fees)
Process
 Funds are required to send investors the payment for their shares within seven
calendar days of receiving the redemption notice

 Assessed against investors who redeem their shares after holding them for a
Redemption Fees short period (often one year or less)
 NOT a sales charge; it is returned to the fund’s portfolio

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Withdrawal Plans
Allows investors to receive regular, periodic payments from their accounts
 A minimum account value is required
 A variety of withdrawal methods are available, such as:
• Fixed dollar amount Clients should not be advised to
• Fixed percentage engage in a systematic purchase
• Fixed time and withdrawal plan simultaneously
• Fixed number of shares
 Payments are not guaranteed for the life of the investor

Sales Practice Violations

Breakpoint sales
 Soliciting sales of shares at amounts just below a breakpoint

Recommending purchases from different fund families due to the potential for higher sales charges

Switching between different fund families due to the impact of new sales charges or holding periods
 For switch recommendations, RRs may be responsible for justification of:
• Tax ramifications (both exchanges and switches are taxable)
• Potential sales charges on new purchases

Excessive purchases of Class B shares

 Salespersons should not recommend purchasing large quantities of B shares (since they don’t
qualify for breakpoints)

Mutual Fund Distributions

Earnings from a fund are distributed to shareholders and are reported on IRS Form 1099-DIV

1 2

Investment Income Capital Gains

 Cash dividends and interest from the  Generated by the sales of securities in
securities in the portfolio the portfolio where the proceeds exceed
 Short-term capital gains are distributed as the original cost (basis)
income  Distributed once per year
 May be distributed more frequently than  Always considered long-term capital gain
once per year

Both distributions are taxed in the year received

whether they’re taken or reinvested

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Subchapter M
Relieves a fund’s burden of paying taxes on income as the distributions pass through to the mutual fund shareholders
(conduit or pipeline theory)
 To qualify as a Regulated Investment Company, a fund must distribute at least ______% of net investment
income to its investors

Net
Investment = (Dividends + Interest) – (Expenses and Mgmt. Fees)
Income

 If it qualifies, the fund is only taxed on the undistributed portion

 Burden for paying taxes ultimately falls on shareholders

Investor’s Cost Basis

A person’s cost basis equals the invested amount plus any reinvested distributions

For example: Jun. 2015: A person invests $10,000 in the XYZ Growth Fund
Dec. 2015: Income of $600 is reported on Form 1099
Dec. 2016: Income of $700 is reported on Form 1099
Feb. 2017: The person redeems her shares for $14,500

What is the taxable gain? Proceeds:

– Basis:
Taxable Amount:

Other Types of Investment Companies

Face Amount Certificate Company (FAC)
 Issues debt certificates
 Issuer promises face value at maturity or surrender value if presented prior to maturity
Unit Investment Trust Company
 Supervised, not managed (no management fee)
 Portfolio generally remains fixed for the life of the trust
 Ownership usually referred to as shares of beneficial interest (SBI)

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Closed-End Compared to Open-End

Closed-End (Publicly Traded) Open-End (Mutual Fund)
Continually issue new shares
Typically a one-time issuance of common shares
 Common shares
 Could issue preferred stock or bonds
 Sold by prospectus

Shares may trade at a discount or premium to NAV with

Shares are sold at the NAV + sales charge (if any)
commission or mark-up added (supply and demand)

Sponsor stands ready to redeem shares at the next

Sponsor does not stand ready to redeem shares
calculated NAV (forward pricing)

Shares trade in the secondary market Shares remain in the primary market

Shares may be sold short Shares cannot be sold short

ETFs Compared to Index Funds

Exchange-Traded Fund (ETF) Index Fund

Portfolio consists of a basket of securities which mirror an Portfolio consists of a basket of securities which mirror an
index (Low expenses) index (Low expenses)

Shares trade in the secondary market; may be sold short Shares are redeemed by the fund; cannot be sold short

Commission is paid on trade Usually have no sales load

Intra-day pricing Forward pricing; once daily

Leveraged and inverse ETFs exist Do not allow leverage

Inverse and Leveraged ETFs

Inverse ETF Leveraged ETF
 Designed to perform in a manner that’s  Constructed to deliver 2x or 3x the index it is
inverse to the index it is tracking tracking
• If the index falls by 2% on the day, the • May be leveraged inverse ETF
ETF should rise by approximately 2% • If the index rises by 1.5%, a 2x long
• Similar to short selling without ETF should rise by approximately 3%
unlimited risk

The portfolios reset daily and, as a result, are designed for

short-term trading; they take advantage of intraday swings in the index

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Activity
Read each statement and fill in the blanks.
1. An investor who cashes out mutual fund shares too early may be subject to a ____________________________.
2. A ___________________________ is the result of selling mutual fund shares just below the amount that qualifies
for reduced sales charges.
3. Moving assets from one fund family to another family is referred to as ____________________ and is a
________________ event.
4. Mutual funds make _____________________________ distributions only once per year.
5. A ______________________________________________ serves as a pipeline for income distributions to be
taxed to the shareholder.
6. An investment company that can issue preferred stock and bonds is considered a
__________________________________.
7. _____________________________________________ can be inverse and leveraged.

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Chapter 10 – Variable Products

Key Topics

1 2 3 4
INSURANCE VERSUS VARIABLE SUITABILITY VARIABLE LIFE
ANNUITIES ANNUITIES INSURANCE
Learn how to identify
Learn about the Learn about what individuals who may Learn about the
difference between happens during the benefit from variable basic characteristics
pure insurance accumulation phase products. of variable life
products and annuities and the annuity insurance policies.
and the role of the phase.
separate account.

Types of Annuities
Annuities are products that are sponsored by insurance companies in which investment income grows tax-deferred;
they may be fixed or variable

Fixed Variable

Investment risk:

Is it a security?

Investment Account:

Portfolio:

Inflation hedge:

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What is an Annuity?
An annuity is a hybrid insurance/investment vehicle which allows for the tax-deferred growth of the contributions
 A person invests funds on either a lump-sum or periodic basis and can be either immediate or deferred

Purchased in one lump-sum with the payout generally

Immediate Annuities
starting immediately

Purchased with period payments and payout typically

Deferred Annuities
starts after retirement

 The contract has a death benefit if the owner dies during the contribution period
 Many contracts guarantee that the owner will not run out of money in retirement even if the funds are exhausted

The Separate Account

 An investment company product
• Regulated under the Investment Company Act of 1940
• Registered with the SEC
 Must be sold by prospectus
 Investments may be changed during the accumulation phase

The Separate Account and its Subaccounts

S&P 500 Index International High-Yield
Subaccount Subaccount Corporate Bond Subaccount

Value Biotech GNMA

Subaccount Subaccount Subaccount

Aggressive Global Special Situations

Growth Subaccount Subaccount Subaccount

The Accumulation Phase – Phase 1

Also referred to as the Pay-In Period or Deposit Phase
 During this phase, account is valued in terms of “accumulation units”
• Units are purchased after-tax, no deduction
• Investment income is tax-deferred until withdrawn
 The purchase price is referred to as the accumulation unit value (AUV); similar to a mutual fund’s NAV
• Unit value is calculated at the end of the business day (using forward pricing that’s similar to mutual funds)
 Accumulation units are invested in separate accounts

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Annuity Charges and Expenses

Like mutual funds, annuities have charges and expenses that are not invested in the separate account, including:
 Sales charges – there is no maximum; they must be fair and reasonable
 Expenses – insurance companies deduct various expenses from the investment income, such as:
• Management fee – adviser’s fee for making investment decisions in the separate account
• Expense risk charges – charged if expenses are greater than estimated
• Administrative expenses – cost of issuing and servicing contracts
• Mortality risk charges – a guarantee that annuitants will be paid for life even if they live beyond life
expectancies

Receiving Benefits – Withdrawals

While still in the accumulation phase …

 Annuitants may choose to take withdrawals from their annuity

• Annuitants control the timing and amount of their withdrawals
• Earnings are withdrawn first and taxable
 Premature withdrawals
• Withdrawals of earnings prior to age 59 ½ are subject to a 10% penalty
• The gross amount is also added to taxable income

Death During Accumulation Phase

If the annuitant dies during the accumulation phase, the payout to the beneficiary will represent:
 The greater of:
• The total contributions made or
• The current value of the contract
 Amount above cost basis could be taxable as income to beneficiary

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The Annuity Phase – Phase 2

Also referred to as the Pay-out, Withdrawal, or Annuitization Phase
 When receiving benefits at annuitization, accumulation units are converted into a fixed number of annuity units
 Unit value is based on:
• Age and gender of the contract holder
• Life expectancy
• Payout option selected
• Value of the separate account
 Payout is established by multiplying the fixed number of annuity units by the fluctuating value

Payout Options
Straight Life Annuitant receives payments for life
Annuity • Highest possible payout with highest risk

Life Annuity with Payments are made to annuitant for life or to beneficiary (in the case of annuitant’s death)
Period Certain for specified minimum number of years.

Joint and Last Payments are made for life so long as one annuitant is living
Survivor Annuity
Unit Refund Annuitant receives an amount at least equal to his original investment
Life Annuity • At death, any remaining amount is paid to a beneficiary

Assumed Interest Rate

AIR is:
 A hypothetical return on investment
 A fixed percentage
 Not a guaranteed or minimum rate

Cause: Effect:
If account performance is: Annuity payment will:

Higher than AIR

Lower than AIR

Equal to AIR

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Equity-Indexed Annuities (EIA)

Like a fixed annuity, an EIA offers a guaranteed minimum return that protects against loss of principal; but like a
variable annuity, its return varies (based on index performance)
Investor’s return is determined by a participation rate and cap rate:
Participation Rate:
 Sets the percentage of the index gain that’s credited to the annuity
 Example: If the index increases by 10% and the participation rate is 80% of the index, then 8% is
credited to the annuity
Cap Rate:
 Sets the maximum rate of interest that the annuity will earn
 For above example: If the contract has a 7% cap rate, then 7%, and not 8%, would be credited

Annuity Suitability Issues

 Generally for investors within the age range of 30 to 55
Target Market  Persons seeking tax-deferred growth or to offset inflation
 Persons who have maximized qualified plan contributions

 Senior citizens or persons who are seeking immediate tax benefits

Unsuitable for:
 Investors with short investment time horizons

 Customer must benefit from the new annuity

Concerns with  Any benefits potentially lost in the exchange
1035 Exchanges:  Whether the RR recommending the exchange has signed off and
the application was approved by principal

Activity
Match each description to the appropriate term.

The portfolio into which an investor directs some or

DEFERRED ANNUITY
all of their money in a variable annuity
The settlement option that offers the greatest
SUBACCOUNT PRODUCT
potential payout
An annuity purchased with periodic payments and
ACCUMULATION PHASE
distributions made at some point in the future
The period during which money is deposited and
STRAIGHT LIFE ANNUITY
growth is tax-deferred
The hypothetical return used to determine whether
ASSUMED INTEREST RATE
payouts are increasing or decreasing

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Life Insurance Terminology

Beneficiary – The person Insured – The person on
who receives the money whose life the policy is
Insured
from the policy written
/Beneficiary

Riders The Life Premium

Insurance
Policy

Additional benefits that can

be added to a policy (e.g., The amount of money
accidental death benefit, the policyholder must pay
disability income, etc.) the insurance company
to keep the policy in force
Death Cash
The amount of money Benefit Value
the beneficiary receives The policyholder’s equity
when the insured dies in a life insurance contract

Characteristics of Variable Life Insurance

Death Benefits Must provide a preset fixed minimum benefit, which may grow based on performance

Cash Value No guarantee of cash value

Loans Allows a loan against a percentage of the cash value

Premium Payments Premiums are generally paid in fixed amounts at fixed intervals

Investment Account Policyholders choose from various subaccounts of the separate account

Risk Policyholder assumes risk that investment returns will be lower than anticipated

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Tax Treatment of Variable Life

FIFO is the system used. Premiums paid (already taxed) are returned first,
Policy Surrender
while the excess is taxable as income.
Loans Loans against a policy’s cash value are tax-free

Death Benefit Tax-free to beneficiary

Estate Taxation Death benefit is included in the deceased’s estate

Activity
Read each statement and determine whether it’s TRUE or FALSE.

AN INSURANCE PREMIUM IS REDUCED IF A POLICY’S

CASH VALUE IS GREATER THAN ITS DEATH BENEFIT

DEATH BENEFITS IN A VARIABLE POLICY

MAY EXCEED ITS STATED AMOUNT

CASH VALUES ARE GUARANTEED IN VARIABLE LIFE POLICIES

IF A VARIABLE LIFE POLICY IS SURRENDERED,

THE PREMIUM PAYMENTS ARE RETURNED TAX-FREE,
FOLLOWED BY THE TAXABLE CASH VALUE

THE DEATH BENEFIT OF A VARIABLE LIFE POLICY

IS TAX-FREE TO THE BENEFICIARY

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Chapter 11 – Alternative Products

Key Topics

1 2 3
REAL ESTATE LIMITED HEDGE FUNDS
INVESTMENT TRUSTS PARTNERSHIPS
Learn about hedge funds
He
Learn about various types Learn about the and the suitability
of REITs and examine tax characteristics and concerns regarding these
and suitability issues. different types of limited aggressive investments.
partnerships.

Real Estate Investment Trust (REIT)

A company that manages a portfolio of real estate investments in order to earn profits for its shareholders

Types of REITs Tax Benefit Characteristics

1. Mortgage/Debt: invests in No taxation on income if  Subject to registration

mortgages and mortgage- ______% of it is distributed requirements of the
backed securities (MBS);  Doesn’t pass through losses Securities Act of 1933
also originates mortgages (unlike limited partnerships)  Shares trade in the
2. Equity: owns and operates  20% of distributed income is secondary market and are
income-producing real tax-deductible marginable
estate  Distributions don’t qualify for
3. Hybrid: combination of the dividend exclusion rule
mortgage and equity REITs
 Attractive for investors
seeking current income

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Methods of Offering REITs

Registered, exchange-listed, and publicly traded
1.  Liquid, but may trade at a discount or premium to the portfolio’s NAV

Registered, but not exchange-listed (non-traded)

2.  Often have a lack of liquidity

Unregistered; offered through a private placement

3.  Illiquid

Direct Participation Programs (DPPs)

A DPP is a business venture that’s designed to
pass through both income and losses to investors

Examples of direct participation programs include:

 Subchapter S Corporations
 Joint Ventures
 General Partnerships
 Limited Partnerships
• An LP is formed by filing a Certificate of Limited Partnership with the state
− Owned by general and limited partners
− Limited Partnership Agreement defines the relationship between the partners

Advantages of Limited Partnerships

Flow-through of income  Income flows through as passive income
(no double taxation)
 A portion is taxed as ordinary income (20% is deductible)
and expenses

 Limited partners are only liable for the amount invested and any
Limited Liability loans assumed (i.e., the amount they have at risk)

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Disadvantages of Limited Partnerships

− Typically not publicly traded
Illiquidity − General partner’s approval may Increased Tax Complexity
be required to sell

− Limited partners have limited

Calls to Contribute
Lack of Control voting power and no managerial
Additional Funds
authority

Effects of
Tax Law Changes

General and Limited Partners

General Partner Limited Partner

 Day-to-day manager with unlimited  Passive investor with limited liability

personal liability  Contributor of capital
 Must have at least a 1% interest General creditor
 Have certain rights:
 Fiduciary toward limited partner • Lend money to the partnership,
 Last at liquidation: inspect books, and compete
• Secured Lender  Ways to endanger “limited” status:
• General Creditor • Negotiate contracts, hire/fire
• Limited employees, or lend name
• General
To assist in
raising capital

Offering Practices
Public Offering Private Placement

If a sponsor (GP) conducts a public offering of If a sponsor (GP) conducts a private placement
securities: of securities:
 Registration is required under the  Securities qualify for an exemption from
Securities Act of 1933 registration through Reg. D
 An underwriter is used to facilitate the
offering
 A prospectus is used as the disclosure
document

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Real Estate Programs

Category Details

Raw Land Speculation on land appreciation; no positive cash flow or depreciation

New Construction Risks of overbuilding, cost overruns, long duration, etc.

Existing cash flow, but potential problematic tenant issues

Existing
(e.g., long-term leases)

Low Income Beneficial potential tax credits; little chance of appreciation; high
(Government Assisted) maintenance costs

Oil and Gas Programs

Category Details Risk

Exploratory High risk with high potential reward

Developmental Drilling near an existing field

Balanced Combination of exploratory and developmental

Income Purchase of existing wells; creates immediate cash flow

Equipment Leasing Programs

Used to lease equipment, such as:
 Computers
 Transportation Equipment (Airplanes and railroads)
 Construction Machinery

Equipment is purchased from manufacturers and then leased to end users

Advantages: Disadvantage:
Investors receive consistent income as
No appreciation of underlying assets
well as depreciation tax benefits

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Public Equity and Debt Programs

DPPs may invest in the public equity of debt of existing issuers

Small Capitalization Debt Small Capitalization Equity

 Many of these bonds are illiquid  Publicly traded, but may be illiquid
 Many issuers are unrated  These programs are often
 Above average yields concentrated in a specific industry
in which the GP has expertise

Business Development Companies (BDCs)

Most BDCs are formed as registered investment companies (closed-end) and they invest in both the equity and debt of
typically non-public companies, including:
 Small and developing companies
 Financially troubled companies
 Private companies
Income and net worth requirements are avoided since BDCs are public offerings
Most trade on exchanges providing liquidity

PRIVATE
INVESTORS COMPANIES

DPPs – Risk Summary

Investors should be aware of the following risks of DPP investments:
 Management has extreme control
 Illiquid nature and potential loss of capital
 Unpredictable income
Successfully investing
 Potential future mandatory assessments is about managing risk,
 Rising operating costs not avoiding it.
 Changes in tax laws and government regulations
 Economic and environmental occurrences

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DPPs – Evaluation
Investors and RRs should use the following factors when evaluating the potential and merits of a given program:
 Managerial track record
 Start-up costs
 Time to crossover DPPs are complicated
 Use of leverage products. The focus
 Competitive landscape should be on finding the
 GP exit strategies (i.e., ultimate asset sale) best fit for the client.
 Economic soundness of the program

Investor Considerations
Investor Certification

• Registered representatives are required to certify they have informed their customers of all relevant facts and
lack of marketability
• Investors must have sufficient net worth and income to absorb a loss of the entire investment

Discretionary Accounts

• Registered representatives are not permitted to exercise discretion involving client investments in DPPs

DPP Suitability Issues

Those considering DPPs as a potential investment should:
 Have liquidity in other investments
• There may be an extended time required to reach the crossover point
(i.e., the beginning of positive cash flow)
 Have a need for both present and future tax benefits
 Be aware of the risks involved
 Be able to tie up funds for a long period of time

These products are often only suitable for sophisticated investors

who are seeking performance that’s not correlated to the stock market.

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Alternative Packaged Products

Hedge Fund Fund of Hedge Funds Interval Funds

 Investment fund generally for  Fund which allocates money  A type of closed-end fund
wealthy investors to hedge fund managers  Unlike most closed-end funds,
 Offered under Reg. D  Generally suitable for their shares are continuously
exemption to accredited wealthy investors offered, but don’t trade in the
investors  May place restrictions on secondary market at prices
 Not considered a registered withdrawing money that are above or below their
investment company under the current NAV
Act of ‘40  Instead, investors are able to sell
 Uses exotic strategies involving a portion of their shares back to
derivatives, leverage, and the fund at preset intervals
selling short  Their fees and expenses tend to
 Investors are seeking over- be higher than other closed-end
sized performance that’s often funds and mutual funds
uncorrelated to stock market  Offer limited liquidity and are
most suitable for long-term
investors

Hedge Funds – Risk Summary

Investors should be aware of the following risks of hedge funds:
 Illiquidity
 Gating policies
Hedge Funds are one of the
 Concentration of portfolio
most aggressive investment
 Use of leverage/derivatives choices and are only
 Lack of control over management appropriate for very
 High initial and ongoing costs sophisticated investors.
 Unregulated nature means far less regulatory disclosure

Activity
Match each description to the appropriate term.

HYBRID REIT Responsible for decisions in a limited partnership

GENERAL PARTNER Invests in mortgages and properties

RAW LAND Invests in developing and financially troubled companies

INCOME PROGRAM Riskiest real estate program

HEDGE FUND Oil and gas program that generates immediate cash flow

BUSINESS
Uses exotic investment strategies
DEVELOPMENT COMPANY

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Chapter 12 – Options

Key Topics

1 2 3 4 5
BUYERS VERSUS LIFE OF AN OPTION BASIC STRATEGY ADVANCED NON-EQUITY
SELLERS STRATEGY OPTIONS AND
Learn about the life Learn about the
He
Learn about the role of an option and basic strategies Learn about
TAXATION
of options buyers how the contract behind options and straddles, spreads, Learn about non-
and the sellers and may be adjusted how to calculate and combining equity options and
the standard while it is open. breakeven. stock and option how different
components of positions. positions are taxed.
option contracts.

Options Overview
An option is a contract between two parties

BUYER SELLER
 Long the option  Short the option
 Pays the premium (DEBIT)  Receives the premium (CREDIT)
 Acquires a right/control  Assumes an obligation

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Types of Contracts
If an option is exercised…

BUYER’S RIGHT SELLER’S OBLIGATION

CALL

PUT

Standardized Components
An equity option is a contract to buy or sell a specific number of shares of a particular stock at a fixed price over a
certain period and is described by:
 The name of the underlying security
 The expiration month of the contract
 The exercise (or strike) price
 The type of option
Strike price
100 shares $50/share Option to buy
Aggregate contract
price is $5,000
Buy 1 ABC June 50 Call at 5 Premium $5/share
Aggregate premium is
$500 ABC stock Expiration is the third
Friday in June

In-the-Money Versus Out-of-the-Money

CALLS: PUTS:
In-the-Money Out-of-the-Money

$70 $70
Market Price

Calls and Puts are

$60 STRIKE PRICE $60 At-the-Money if the option’s
strike price is equal to the
stock’s market price.
Market Price

$50 $50

CALLS: PUTS:
Out-of-the-Money In-the-Money

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An Option’s Premium
PREMIUM = Intrinsic Value + Time Value

The amount by which an The portion of an option’s premium

option is in-the-money that exceeds its intrinsic value

A contract has intrinsic value if it is in-the-money.

 Its intrinsic value equals its in-the-money amount.
The concept of INtrinsic value is tied
 It has zero intrinsic value if it is out-of-the-money or at-the-money.
to options that are IN-the-money.
Time value is based on:
 Time left until expiration
 Market volatility

Adjustment of Terms
Start: 1 ABC Feb 60 Call Aggregate Contract Value: $6,000
Number Shares
Adjust for: Strike Price Aggregate Value
of Contracts per Contract

Even Splits Increase Unchanged Decrease Aggregate

2-for-1

Odd Splits /
Unchanged Increase Decrease Aggregate
Stock Dividends
3-for-2

Adjustment of Terms
Start: 1 BBA Mar 5.00 Call Aggregate Contract Value: $500
Number Shares
Adjust for: Strike Price Aggregate Value
of Contracts per Contract

Reverse Split Unchanged Decrease Increase Aggregate

1-for-10

Strike price is not adjusted for a cash dividend on ex-dividend date.

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The Life of an Option

1. Expire Worthless 2. Exercised 3. Liquidated

If an option is at- or out-of-the- The investor who is long an option Liquidating (closing out) an option
money on the expiration date, the has the exclusive right to exercise position is essentially an alternative
holder of the contract has no the option at his own discretion. to exercising the option. The
incentive to exercise the contract. investor executes an opposite
The two styles of exercise are:
The contract expires worthless. transaction on the same series of
 American Style – options may
option.
The expiration triggers: be exercised at any time up
 The maximum profit for a until expiration In other words, what was bought is
seller of a call or put  European Style – options may sold or what was sold is bought.
 The maximum loss for the only be exercised on the day
buyer of a call or put of expiration

Example: Exercise Versus Close-out

When ABC’s current Later, near expiration, ABC’s market value
market value is 64, an 1 ABC May 65 Call at 3 has risen to 72 and the ABC May 65 Calls
investor buys: are trading at a premium of _____.

Scenario #1: Exercised, stock sold Scenario #2: Closed out at new premium
DEBIT CREDIT DEBIT CREDIT
(CASH OUT) (CASH IN) (CASH OUT) (CASH IN)

The OCC and Options Trading

The Options Clearing Corporation:
 Issues and guarantees listed option contracts
 Eliminates counterparty risk by acting as the third party in all option transactions
• Acts as the buyer for all sellers and the seller for all buyers
 Deals directly with broker-dealers, not customers
 Creates and requires the distribution of the Options Disclosure Document (Characteristics and Risks of
Standardized Options)
 Regulates exchange-traded options

Trade settlement between broker-dealers and

the OCC is next business day (i.e., T + 1).

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Four Key Concepts for Basic Options

Strategy: Breakeven:
For option BUYERS, remember the phrase To find the stock price (value) at which an investor will
“CALL UP and PUT DOWN” breakeven, remember the phrase “CALL UP and PUT
 Buyers of Calls are BULLISH (want stock to rise) DOWN”
 Buyers of Puts are BEARISH (want stock to fall)  For Calls, strike price + premium (CALL UP)
Sellers are the opposite (Sellers of Calls are BEARISH  For Puts, strike price – premium (PUT DOWN)
and Sellers of Puts are BULLISH)

Maximum Gain: Maximum Loss:

For SELLERS of options, the PREMIUM received For BUYERs of options, the PREMIUM paid represents
represents the MAXIMUM GAIN the MAXIMUM LOSS
For BUYERS of Calls, the maximum gain is UNLIMITED For SELLERS of Calls, the maximum loss is UNLIMITED
(since a stock’s rise is unlimited) (since a stock’s rise is unlimited)
For BUYERS of Puts, the maximum gain is realized if For SELLERS of Puts, the maximum loss is realized if
the stock falls to zero the stock falls to zero
(i.e., strike price – premium x 100 shares) (i.e., strike price – premium x 100 shares)

Long Call – Analysis

When the current market value of XYZ stock is at: Strategy:

45 Maximum Gain:

Maximum Loss:

Buy 1 XYZ Feb 45 Call at 3 Later, with XYZ at $58, the investor exercises
the option and immediately sells the stock.
Result?

Breakeven: Debit Credit

(Cash Out) (Cash In)

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Short Call – Analysis

When the current market value of XYZ stock is at: Strategy:

45 Maximum Gain:

Maximum Loss:

Sell 1 XYZ Feb 45 Call at 2.50 Later, with XYZ at $52.50, the investor is
exercised against. Result?

Debit Credit
Breakeven: (Cash Out) (Cash In)

Long Put – Analysis

When the current market value of ABC stock is at: Strategy:

94 Maximum Gain:

Maximum Loss:

Buy 1 ABC Apr. 95 Put at 3.50 Later, with ABC at $80, the investor exercises
the option. Result?

Debit Credit
Breakeven: (Cash Out) (Cash In)

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Short Put – Analysis

When the current market value of DEF stock is at: Strategy:

36 Maximum Gain:

Maximum Loss:

Sell 1 DEF Nov. 35 Put at 4 Later, with DEF at $25, the investor is exercised
against and the stock is immediately sold.
Result?
Breakeven: Debit Credit
(Cash Out) (Cash In)

Activity
Read each statement and determine what it describes.

MARKET PRICE ABOVE STRIKE PRICE

PREMIUM – INTRINSIC VALUE

INCREASE IN THE NUMBER OF CONTRACTS, BUT

THE SHARES IN THE CONTRACT STAY THE SAME

REQUIRED DOCUMENT WHEN

OPENING AN OPTIONS ACCOUNT

STRIKE PRICE + PREMIUM

STRIKE PRICE – PREMIUM

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Straddles and Combinations

Created by either:
 Buying both a call and a put on the same underlying security OR
 Selling both a call and a put on the same underlying security
Strategy
 Long straddle or combination:
 Short straddle or combination:

STRADDLE: COMBINATION:
 Same expiration months and strike prices  Different expiration months and/or strike prices

If an investor has one option component and adds another to create a

multiple option position, he is considered to have legged into the position.

Long Straddle – Analysis

Uncertain of the exact direction in which
ABC stock is going to move, an investor:

Buys 1 ABC Jun 40 Call at 3

Buys 1 ABC Jun 40 Put at 2
The total combined premium is ____

Breakeven Points: 40

Strategy:
Maximum Gain:
Maximum Loss:

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Short Straddle – Analysis

Believing that ABC’s stock price
will remain flat, an investor:

Sells 1 ABC Jun 40 Call at 3

Sells 1 ABC Jun 40 Put at 2
The total combined premium is ____

Breakeven Points: 40

Strategy:
Maximum Gain:
Maximum Loss:

Spreads
Positions which allow an investor to limit losses in exchange for limiting gains
 Created with the sale and purchase of two options of the same class, but different series
• Class: options of the same type on the same underlying security
• Series: options of the same class, same expiration, and same strike prices
 Spreads may be either bullish or bearish and either debit or credit

Price/Dollar/Vertical Time/Calendar/Horizontal Diagonal

Buy 1 ABC Jun 40 Call Buy 1 XYZ Dec 40 Call Buy 1 DEF Sep 40 Put
Sell 1 ABC Jun 50 Call Sell 1 XYZ Sep 40 Call Sell 1 DEF Mar 30 Put

Call Spread – Analysis

An investor who is moderately bullish on Net Premium:
XYZ stock, but wants to minimize the cost
Buyer or Seller:
of establishing the position, does the following:
Debit or Credit:
Buys 1 XYZ Feb 80 Call at 3 Widen or Narrow:
Sells 1 XYZ Feb 90 Call at 1 Breakeven:
Bull or Bear:
Maximum Gain:
Spread Rules:
Maximum Loss:
 The breakeven must be between the strikes.
 The max gain PLUS the max loss will equal
90
the difference in the strike prices.

80

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Put Spread – Analysis

An investor who is moderately bullish on Net Premium:
ELG stock, but wants to minimize the
Buyer or Seller:
risk of a short position, does the following:
Debit or Credit:
Sells 1 ELG Nov 95 Put at 8 Widen or Narrow:
Buys 1 ELG Nov 80 Put at 1 Breakeven:
Bull or Bear:
Maximum Gain:
Spread Rules:
Maximum Loss:
 The breakeven must be between the strikes.
 The max gain PLUS the max loss will equal
the difference in the strike prices. 95

88

80

Spreads – Bull/Bear, Debit/Credit,

Widen/Narrow?
Buy an XYZ Nov 90 Call
Sell an XYZ Nov 80 Call

For CALL spreads, the dominant leg

is always determined by the LOWER strike

Write an ABC Mar 35 Put

Buy an ABC Mar 40 Put

For PUT spreads, the dominant leg

is always determined by the HIGHER strike

Short a JMK Oct 75 Call

Long a JMK Dec 75 Call

For HORIZONTAL spreads, the dominant leg

is always determined by the LONGER expiration

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Butterfly Spread
A combination of two spreads – one is a debit and one is a credit
What insect has a short body,
 Can be created with either calls or puts
but two long wings?

Long 1 ABC May 60 Call (out-of-the-money)

Short 2 ABC May 50 Calls (at-the-money)

Long 1 ABC May 40 Call (in-the-money)

A neutral strategy (recognize the 1-2-1 strategy:

 Maximum gain is at the middle strike price ($50)
 Maximum loss is below the lower strike price ($40) and above the higher strike price ($60)

Hedging, Speculation, and Income Generation

Options may be created for different purposes:

Speculation Hedging Generate Income

 Options can be purchased or  To hedge (protect) an existing  To generate income on an

sold to generate a profit stock position, an investor existing stock position, an
 In this case, the investor has could BUY an option investor could SELL an option
no existing position in the • Long Puts may be used • Short Calls may
underlying security to protect the downside generate income on long
• Long Calls and risk of a long stock stock positions
Short Puts are bullish position • Short Puts may
• Long Puts and • Long Calls may be used generate income on
Short Calls are bearish to protect the upside risk short stock positions
of a short stock position

Covered and Uncovered Positions

Covered Call: Uncovered Call:
 A call is written against stock that’s already owned  A call is written against stock that’s not owned
 The sale of the call generates income, thereby  Considered the most speculative option position
increasing the yield on the underlying security with unlimited potential risk
 Considered a conservative option strategy which
may be executed in either a cash or margin
account
Covered Put: Uncovered Put:
 A put is written when the investor has a sufficient  A put is written without having sufficient cash to
amount of cash to satisfy the obligation of being meet the obligation of being exercised against on
exercised against on the put the put
 There is significant risk if the underlying security
falls

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Stock and Option Positions

Options may be purchased to hedge either long or short stock positions.
Options may be sold to generate income.

To protect (or hedge) stock in a volatile market:

 Long Stock + Long Put
• If the stock decreases, the value gained on the put can offset the loss on the stock
 Short Stock + Long Call
• If the stock increases, the value gained on the call can offset the loss on the stock

To generate income in a stable market:

 Long Stock + Short Call (Covered Call) OR
 Short Stock + Short Put (Covered Put)
• For both positions, if the stock remains stable, the options will expire and the premiums will be retained
• However, for the Covered Put, the upside risk is unlimited

Long Hedge or Protective Put

An investor who is bullish on ABC stock, but fears At what price must ABC be trading for the
the stock’s downside risk, does the following: investor to breakeven?
Debit Credit
Buys 100 shares of ABC at 96 and (Cash Out) (Cash In)
Buys 1 ABC Jun 90 Put at 3

Strategy:

Maximum Gain: Later, ABC falls to $80 and the investor

exercises the put. What’s the result?
Breakeven:
Debit Credit
(Cash Out) (Cash In)

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Covered Call Writing

An investor owns DEF stock, but believes it will At what price can DEF be trading for the
trade flat for the next short period. To generate investor to breakeven?
income, she could create the following position:
Debit Credit
(Cash Out) (Cash In)
Long 100 shares of DEF at 42 and
Sells 1 DEF Jun 45 Call at 2

What’s sacrificed?
Later, DEF rises to $67 and the investor is
exercised against. What’s the result?
Loss is realized if DEF stock:
Debit Credit
Breakeven: (Cash Out) (Cash In)

Ratio Call Writing

A position that consists of a long stock position, but more calls written than the number of shares owned

Buy 100 shares of XYZ at 50

Write 2 XYZ Jun 50 Calls Since ratio writing includes
an uncovered call, the
potential risk is unlimited.
A neutral strategy:
 In the above example, the maximum gain is realized at $50
 One call is covered by the 100-share position, but the second call is uncovered

Index Options
Provide the opportunity to speculate on, or hedge against, the movement of the market, rather than the movement of a
specific stock
Broad-based Index: reflects performance of Narrow-based Index: reflects performance of
the entire market a particular sector
 SPX – S&P 500  Biotechnology
 OEX – S&P 100  Computer Technology
 VIX – Volatility Index  Oil
 DJX – Dow Jones Industrial
 RUT – Russell 2000
 WLX – Wilshire 5000 (broadest)

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Index Option Specifications

Equity Index

Underlying Interest Stock Value or average of an index

Multiplier 100 shares $100

Exercise Receive or deliver stock Receive or deliver cash

Settlement on Exercise One business days One business day

Exercise Style American European

Volatility Index (VIX) Options

The VIX is a barometer of investor sentiment and expected market volatility based on the premiums for S&P 500 Index
options over the next 30 days
 VIX options are cash settled, with each point equal to $100
(value of 11.27 x $100 = $1,127)
 Use European style exercise

When does volatility tend to increase?

If an investor believes the S&P 500 Index will fall in value, an

investor may:

World Currency Options

Provide the opportunity to speculate on, or hedge against, the movement of exchange rates on foreign currencies
compared to the U.S. dollar
 Currency spot prices are established in the Interbank Market which:
• Has unlimited trading hours (spot trades)
• Is unregulated and decentralized
 Currency options trade on NASDAQ PHLX and currencies are selected by the exchange

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World Currency Option Specifications

Expiration: The third Friday of the expiration month

Exercise: U.S. dollar-settled, European style exercise

Contract Size: 10,000 units, except Yen which is 1 million

Most are quoted in cents per unit ($.01)

Quoted:
 Yen quoted in units of 1/100th of one U.S. cent per unit ($.0001)

Multiplier: $100 (e.g., 2.25 x $100 = $225)

There are no options on the U.S. dollar issued on U.S. exchanges.

Currency Option Strategy

A speculator believes the U.S. dollar will weaken, Strategy:
resulting in a British Pound rally. The speculator
decides to:
Maximum Gain:
Buy 1 Euro Jun 160 Call at 3.35 Maximum Loss:

If the Euro increases to 166 and the option is

closed out at its in-the-money amount, the
Breakeven:
result is:
Debit Credit
(Cash Out) (Cash In)

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Yield-Based Option Strategies

Preferred stock and bond prices and yields are inversely related:
 When anticipating a fall in bond prices, an investor expects a rise in bond yields
 When anticipating a rise in bond prices, an investor expects a fall in bond yields

If Investors Believe: They Should:

 Buy yield-based puts or

Yields will decrease
 Sell yield-based calls

 Buy yield-based calls or

Yields will increase
 Sell yield-based puts

Option Taxation
Tax result is determined by the method of option disposal

1. Expire Worthless 2. Liquidated, Offset, Closed-out 3. Exercised

 Short-term capital gain or loss  Short-term capital gain or loss  The option premium will not
if option purchased with if option was held for one year generate a gain or loss
maturities of one year or less or less  To calculate the cost basis or
 Long-term if a LEAPS® is  Long-term if a LEAPS® is sales proceeds:
purchased and held for more purchased and held for more  Of an exercised call, the
than one year than one year premium is added to the strike
 Short-term if option position is  Short-term if option position is price (i.e., CALL UP)
established with a sale (short) established with a sale (short)  Of an exercised put, the
premium is subtracted from the
strike price (i.e., PUT DOWN)

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Taxation of Exercised Call Options

Debit Credit
An investor is long one ABC Jun 90 Call at 4. If the option is (Cash Out) (Cash In)
later exercised, the investor will have:
1. A basis of $9,200 3. A basis of $8,600
2. A basis of $8,800 4. A basis of $9,400

The cost of the stock has NO impact on sales proceeds

Debit Credit
An investor owns 100 shares of XYZ at $42 per share and (Cash Out) (Cash In)
sells an XYZ Dec 40 Call for 3. If the call is exercised, what
are the investor’s sales proceeds for tax purposes?
1. $3,700 3. $4,300
2. $3,900 4. $4,500

Taxation of Exercised Put Options

Debit Credit
An investor is long a DEF Feb 45 Put at 3. If the option is (Cash Out) (Cash In)
later exercised when DEF is at 40, the investor will have:
1. Proceeds of $200 3. Proceeds of $4,500
2. Proceeds of $4,200 4. Proceeds of $4,800

The stock’s value has NO impact on cost basis

Debit Credit
An investor sells one GHI Aug 60 Put for 4. If GHI falls to 50 (Cash Out) (Cash In)
and the put is exercised, what’s the investor’s cost basis?
1. $4,600 3. $5,600
2. $5,400 4. $6,000

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Puts and Holding Period

 If a stock’s long-term holding period is not yet established:
• The purchase of a put terminates the holding period for the stock
Stock Holding Periods • The holding period begins anew only after the put expires or is closed out
 If a stock’s long-term holding period is already established, a put purchase
doesn’t change it (it remains long-term)

 A put purchased on the same day that stock is purchased

Married Put • The holding period for the stock starts on the purchase date
• The premium paid becomes part of the stock’s basis, even after expiration

Activity
Read each statement and fill in the blanks.

1. A straddle involves _____________________________________________________________________

_____________________________________________________________________________________.
2. The breakeven on a straddle is found by __________________________________________ and
_____________________________________________ from the strike price.
3. Vertical spreads have ______________________________, but ______________________________.
4. For vertical spreads, the difference in the strike prices equals the
______________________________________________.
5. A debit put spread is ________________ and the investor wants the spread to ________________.
6. Long calls are used to hedge ___________________________ and short calls generate income on
________________________________.
7. A VIX call will likely become valuable after the market ____________________.
8. In an investor believes bond prices may be falling, she may want to purchase _________________________.
9. The holding period on stock and a put on the stock will run concurrently if the two are ___________________.

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Chapter 13 - Offerings

Key Topics

1 2 3 4
PRIMARY MARKET THE SECURITIES EXEMPT MUNICIPAL
AND UNDERWRITING ACT OF 1933 SECURITIES AND OFFERINGS
COMMITMENTS TRANSACTIONS
Learn about the Learn about the
Learn about the process of registration Learn about how to process of
primary market and and various be exempt from underwriting
issues regarding disclosure registration and other municipal securities
underwritings. documents. related rules. and available
information sources.

The Primary Market

• Needs capital
Issuer
• Hires underwriter

• Facilitates distribution
Underwriting Manager
• Assumes liability that varies with offering type
(Investment banker)
• Signs Underwriting Agreement with issuer

• B/Ds assisting in selling and sharing

Syndicate Members • Signs Syndicate Agreement with manager

• B/Ds accepting no liability, assist in sales only

Selling Group • Signs Selling Agreement with manager

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Underwriting Commitments
Unsold shares
Type of Underwriting Comments Principal/Agent
are directed to:
Syndicate “takes down” the entire
Firm Commitment
offering

Best Efforts Syndicate sells what it can

Offering is cancelled if all shares

Best Efforts All-or-None
are not sold
Offering is cancelled if a set
Best Efforts Mini-Maxi
minimum is not sold
Syndicate agrees to buy any
Stand-by shares that are bought through a
rights offering

The Underwriting Spread

Manager’s Fee Member’s/
$0.15 Underwriter’s
Fee $0.25

Public Offering Price Concession

$14 $0.60

$13 to Issuer

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Distribution of the Spread

Underwriter purchases from issuer at $13 and sells at the POP of $14

Manager’s Fee Member’s U/W Fee Concession

$.15 $.25 $.60

Example: 1,000 shares are sold to a customer at $14 per share

Manager sells Member sells

Selling Group sells
from its allocation from its allocation

Customer pays:

Issuer receives:

Manager:

Member:

Selling group:

Securities Act of 1933

Scope of the law
• To provide for “full and fair disclosure”
• Prospectus must precede or accompany any solicitation of a new issue (no marking or highlighting)
• SEC “no approval clause”

Requires SEC registration of new issues

• Registration exemptions are provided to issuers of certain securities and specific types of transactions

Liability
• Unconditional for issuers regarding information to investors
• Conditional for the underwriters that are required to perform:
− Reasonable investigation
− “Due diligence”

The Registration Process

1. Pre-Registration Period 2. Cooling-Off Period 3. Post Registration Period
 Document preparation and  File the registration statement  Effective date
due diligence begins with the SEC  Sales confirmed and Final
 Registration statement is  Issuer distributes preliminary Prospectus delivered
completed prospectus (Red Herring)  Must contain the SEC no-
 B/Ds and RRs may have no  “Blue Sky” the issue approval clause
communication with the public  Final due diligence meeting held

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Additional Underwriting Issues

 Gives certain issuers the flexibility of selling new issues on a delayed or
continuous basis
SHELF REGISTRATION  May be permitted for up to three years
 Issuer and underwriter can adjust the terms of the offering to reflect the market
conditions at the time of the sale

 Provides the underwriter with the ability to cancel the agreement

MARKET-OUT CLAUSE  Based on events that make marketing the issue difficult or impossible
• Reasons are limited and disclosed in the clause

Crowdfunding
The Jumpstart Our Business Startups (JOBS) Act established crowdfunding procedures
 Allows small businesses to raise capital using the internet
 Capital can only be raised through an online platform of a broker-dealer or an approved funding portal
 Amount that a person may invest is limited based on her income and/or net worth

Types of Prospectuses
A prospectus is any communication, written or broadcast, that offers a security for sale

Statutory Condensed form of the registration statement that provides detailed information on the
Prospectus offering

Also referred to as a Red Herring; used during the cooling off period
Preliminary  Omits the offering price, underwriting and dealer discounts, and proceeds to the
Prospectus issuer
 Once final offering price is set, a final statutory prospectus is filed

Summary Short-form prospectus typically used for mutual fund offerings

Prospectus  Investor must be informed of statutory prospectus

Any communication that does not meet the standards of a statutory prospectus
Free Writing
 Includes a legend recommending that investors read the statutory prospectus
Prospectus
(e.g., offering term sheets, e-mails, press releases, and marketing materials)

Direct Participation
Program Disclosure Similar to a statutory prospectus; used for unregistered real estate programs
Document

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After-Market Prospectus Requirements

Distribution participants that sell securities in the after-market must provide purchasers with a copy of the prospectus
for a specific period from the effective date

For a non-listed IPO 90 Days

For a non-listed, follow-on offering 40 Days

For an IPO of a security to be exchange-listed (NYSE or Nasdaq) 25 Days

For an exchange-listed, follow-on offering No Requirement

The more public information available about the company, the shorter the period.

The New Issue Rule

FINRA prohibits member firms from selling equity IPOs to accounts in which restricted persons have beneficial
interest

 Member firms and any member firm employees

 Immediate family members of member firm employees if:
• There is material support (25% of the person’s income), or
Restricted Persons • Sharing of a household, or
• The purchase is made through the family member’s firm
 Finders and fiduciaries
 Portfolio managers purchasing for their own account

 Verification that the account is eligible to purchase the IPO

Preconditions • May be a written statement or electronic communication
for Sale • May not be an oral statement
 Re-verification of eligibility every 12 months

 An account that includes restricted persons, provided their combined ownership does
not exceed 10% (de minimis)
 Issuer-directed sales that allow restricted persons to purchase if the associated
General Exemptions person or associated person’s immediate family is an employee or director of the
issuer
 Portfolio managers purchasing for the mutual fund
 A broker-dealer purchasing for its own account after making a bona fide public offering

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Activity
Read each statement and determine what it describes.

UNDERWRITING COMMITMENT THAT REQUIRES

THE ENTIRE OFFERING TO BE SOLD OR
RETURNED TO THE ISSUER
THE AMOUNT OF THE UNDERWRITING SPREAD
THAT’S USED TO COMPENSATE THE SELLING GROUP
AN OFFERING THAT CAN BE SOLD ON
A DELAYED OR CONTINUOUS BASIS
CAPITAL ONLY PERMITTED
THROUGH ONLINE OFFERING

OFFERING TERM SHEET IS AN EXAMPLE

PROSPECTUS FOR AN IPO TO BE LISTED

ON NASDAQ MUST BE DELIVERED
FOR NO LESS THAN ____________

Accredited Investors and QIBs

The following terms are used for certain investors; however, they are based on regulatory definitions
Accredited
 Accredited investors are institutional investors as well as individuals who have met a financial test:
• Net Worth of: $1,000,000 excluding their primary residence
OR
• Annual Income of: $200,000 in each of the last two years ($300,000 for married couples)

QIBs
 Qualified Institutional Buyers (QIBs)
• Buyer must own and invest a minimum of $100 million of securities
• Cannot be a natural person (human)

Registration Exemptions
Regulation A+ Tier 1 Regulation A+ Tier 2
Maximum offering size $20 Million $75 Million

Time period 12 Months 12 Months

Maximum amount that may be

$6 Million $22.5 Million
sold by existing shareholders

These are public offerings of securities and Offering Circulars must be provided.

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Exempt Transactions
Regulation D – Private Placement
 A sale of securities directly to “accredited” investors (and/or to a limited number of non-accredited investors)
 Unlimited number of accredited investors
• Officers/directors of the issuer
• Institutions
• Individuals who have met a financial test:
– Net Worth of: _____________________________________
OR
– Annual Income of: __________________________________
________________________________________________
 No more than ______ non-accredited investors

Regulation D – Private Placement

Purchaser Representative (no specific qualifications)
 Appointed by a non-accredited investor to evaluate the risks and merits of an offering
 May not be an officer, director, or greater than a 10% owner of issuer, unless related to the investor
Private placement (offering) memorandum (disclosure document)
 Not required if all investors are accredited
 Required for all investors if any non-accredited investors are included
 Includes the use of proceeds, suitability standards, and financials

Rule 144
Permits the sale of restricted and control stock

Unregistered stock that’s acquired through a private placement or as compensation

Restricted Stock
for senior executives of an issuer

Registered stock that’s part of an issuer’s public float and purchased in the open
Control (Affiliated) Stock
market by officers, directors, or greater than 10% shareholders of the issuer

When intending to sell, the SEC must be notified

 Form 144 filed at the time the sell order is placed
 Securities may be sold over ____________ through unsolicited broker’s trades or to dealers acting as principal
 To sell any shares remaining unsold from this filing, an investor must file an updated Form 144
Maximum sale allowed for control persons is the greater of:
 ______ of the outstanding shares or the average weekly trading volume over the ________________________

Filing Form 144 is NOT required if selling no more than 5,000 shares and $50,000 of securities.

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Rule 144 – Maximum Sale

For example: ABC Corporation has 5,700,000 shares outstanding with recent trading volume
as indicated below:

Week Ended Volume Traded

2/28 62,000 Multiple Choices:
2/21 60,000 1. 57,000

2/14 56,000 2. 58,000

2/7 58,000 3. 58,800

1/31 58,000 4. 59,000

Rule 144A
Provides an exemption for restricted securities that are sold to Qualified Institutional Buyers (QIBs)
 QIB is defined as an institution that has at least $100 million under management
 144A securities may be equity or debt securities which are offered by domestic or foreign issuers
 However, if securities of the same class are listed on an exchange, they are ineligible for 144A exemption
 Typically used for corporate debt offerings

Remember, QIBs are institutions, NOT individuals

(i.e., a wealthy individual is not a QIB).

Rule 147 and 147A

Rule 147 (Intrastate Offering) – Provides an exemption for the sale of securities to residents of one state if:
 The corporation has its principal place of business in the state and meets any one of the following four
requirements:
1. 80% of the assets located
2. 80% of the revenues generated
3. 80% of the proceeds used, or
4. A majority of issuer’s employees are based in the state
 Resales to non-residents are prohibited for six months from the end of the distribution

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Rule 145
This rule regulates the reclassification of one security into a new security
Reclassifications are generally considered sales and subject to registration and prospectus requirements
 Substitutions of one security for another
SUBJECT  Securities that are a result of a merger/acquisition
TO RULE 145
 Securities issued after a transfer of assets from one corporation to another
 Stock splits
NOT SUBJECT  Reverse stock splits
TO RULE 145
 Changes in par value

Regulation S
Provides an exemption from registration to U.S. and foreign issuers that offer securities outside of the U.S. if the offer
or sale is an offshore transaction
 No offer may be directed to a U.S. person and the transaction must be effected through an overseas securities
market
• U.S. person is any natural person who is a U.S. resident
Regulation S securities may be resold:
 Immediately through a designated offshore securities market, or
 In the U.S.:
• After 40 days if they are non-convertible debt
• After one year if they are equities of non-reporting issuers / six months if they are equities of reporting
issuers

Issuing G.O. and Revenue Bonds

Municipal debt issues are exempt from the registration and prospectus requirements

Issuing General Obligation (GO) Bonds Issuing Revenue Bonds

 Usually requires voter approval  Don’t required voter approval since they’re
 Subject to debt limitations placed on the backed by fees that are paid for use of the
municipality which limits its ability to add system or services
debt above its debt ceiling  A consultant is hired to produce a
feasibility study

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Selecting an Underwriter
There are two different methods that a municipality may use when selecting its underwriter

Competitive Sale Negotiated Sale

 Notice of Sale advertises the offering to  Issuer appoints its managing underwriter
underwriters  Both issuer and underwriter “negotiate” terms
• The Notice is prepared by the issuer of the deal
• Contains relevant details about the issue
 Issuer is inviting underwriters to submit sealed
bids
• Underwriting generally awarded to
lowest bid

Municipal Advisor – typically employed by a municipality to assist in selecting an underwriter

Syndicate Practice
Formation of a Syndicate
 Manager invites other B/Ds to participate and share in liability by sending Syndicate Letter (Agreement Among
Underwriters)
 Syndicate Letter addresses the following:

Size and type of offering (most offerings are firm Percentage required to participate
commitments) (manager usually assumes the greatest
responsibility)

Syndicate
Letter
Type of Syndicate Priority of orders
 Undivided (Eastern) – each member  The manner in which credit for
is responsible for a specific orders are allocated among
percentage of the unsold bonds members of the distribution group
 Divided (Western) – members are not responsible
for bonds that are left unsold by other members

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Syndicate Liability for Unsold Bonds

Member
Manager A 30% A three-member syndicate is involved in a firm commitment
50% underwriting of a $100 million bond offering
Member
B 20%

Reallocation of:

Member Sales Divided Acct. Undivided Acct.

Manager $50 million

Member A $30 million

Member B $5 million

Priority of Orders
The hierarchy by which underwriters allocate orders among the distribution group

1) Pre-Sale In a competitive underwriting, orders received before bonds are awarded and priced

2) Group Net Benefits all syndicate members according to their percentage interest

3) Designated Buyer determines which member or members will receive credit for the sale

4) Member Syndicate member placing the order is the only member to receive credit for the sale

Municipal Documents / Information

Official Statement Used by municipal issuers as a disclosure document

Prepared by Bond Counsel which renders its opinions as to:

Legal Opinion − Issuer’s legal, valid, and enforceable obligation
− Tax exempt status of the issue
New Issue Provided to purchasers, along with a copy of the official statement, by no later than
Confirmation settlement date
Committee on Uniform
Underwriters are expected to apply for CUSIP numbers that are used to identify unique
Securities Identification
securities (e.g., by maturity)
Procedures (CUSIP)

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Electronic Municipal Market Access (EMMA)

MSRB website used by issuers and underwriters to submit documents

 Provides electronic public access to information about the municipal market, including:
Electronic Access
• Trade activity and market statistics

 Various documents:
Documents
• Pre-sale documents, official statements, and continuing disclosures

Plan Info  Includes 529 plan information

Activity
Read each statement and fill in the blanks.
1. A ______________________________________ invests a minimum of ____________________ in securities.
2. Reg A+ Tier 1 allows a maximum offering size of _______________________.
3. The disclosure document used for a private placement is referred to as an _______________________________.
4. __________________applies to the sale of restricted and control stock.
5. Intrastate public offerings of securities are exempted under ________________________.
6. A U.S. issuer conducting a public offering outside the U.S. to non-residents is exempted under
___________________________.
7. A ____________________________________ uses a bidding process to choose an underwriter.
8. Unsold portions of an underwriting are reallocated in an ____________________________________.
9. A municipal bonds tax-exempt status is evidenced through the _____________________________.

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Chapter 14 – Account Disclosures,

Risks, and Returns

Key Topics

1 2 3 4
ACCOUNT ACCOUNT SYSTEMATIC VS. INVESTMENT
DISCLOSURES TRANSFERS UNSYSTEMATIC RETURNS
RISKS
Learn about the Learn about the Learn about the
disclosures that are process of Learn about the different investment
required on transferring an different risks that returns and the tax
transactions and account from one can influence an results of receiving
different accounts. B/D to another. investor’s decisions. gifts of securities.

Disclosures
Disclosures Made Prior to Execution Disclosure of Costs and Fees
 Risks associated with specific investments, Those assessed on different transactions
including:  Mutual funds
• Speculative nature of options • Different share classes (A, B, C, etc.)
• Limited marketability of penny stocks • Redemption fees
• Default risk of high-yield bonds  Annuities
 Potential conflicts of interest • Surrender charges
• Investment positions held by the firm • Mortality and expense charges
• Control relationships with issuers  Non-discretionary, fee-based accounts
 Investment limitations of the firm, including • Fee assessed based on AUM
whether: • Unsuitable for buy-and-hold investors
• Certain securities are unavailable
 Soft-dollar arrangements
• The B/D is limited in transactions

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Executing an Equity Trade

Capacity Form of Compensation and Disclosure

Agent  Commission is disclosed on the confirmation

 Markups on NMS securities are disclosed on client purchases

Principal  Markdowns on NMS securities are disclosed on client sales
 Compensation calculation is based on NBBO

 Internal trades that are executed between the bid and offer
Dual Agency Cross  Commission charged to both the buyer and seller
 Commissions must be disclosed on the confirmation

Executing an Equity Trade

Capacity Form of Compensation and Disclosure
 Firm’s purchase and resale to its client is reported as one trade
Riskless Principal
 Markup must be disclosed on confirmation
 Firm’s purchase and resale to its client is reported as two trades
 Markup is NOT disclosed
Net Basis  Retail client must provide prior written consent
 Institutional clients may provide both oral and written consent or use
a negative consent letter

Soft-Dollar Arrangement
This practice involves an investment adviser (IA) receiving research or other services from a B/D in exchange for order flow
 The services received from the B/D must benefit its clients.

Acceptable Unacceptable

 Research reports (in-house and third-party)  Office space

 Access to analysts  Accounting fees
 Portfolio analysis software  Advertising/marketing expenses
 Subscription to industry trade publications  Travel reimbursement
 Attendance cost for a securities conference or  Professional licensing fees
seminar  Subscription to mass-marketed publications
 IA Software (e.g., WSJ)
 Bloomberg hardware

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Trade Confirmations
Confirmations are sent on, or before,
settlement and include the following:
 Execution details:
• Name of customer
• Buy/sell
• Price and quantity
 Trade and settlement dates
 Firm capacity (agent or principal)
 For bonds, dollar price and yield
information
 Name of contra party or a statement of
the availability of the information upon
written request

Customer Account Statements

Broker-dealers must send customer statements at least quarterly
 For active accounts, they are sent monthly

Information includes:
 Summary of the total value of investments and cash
• Unrealized and realized gains and/or losses
 Detailed information on the specific investments in the portfolio
 Income generated from investment for the statement period and year-to-date
 Daily activity for the statement period
 Required disclosures

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Updating Client Information

Failure to update client information on a timely basis may result in the execution of unsuitable transactions or
regulatory issues
 If a client moves to a new state, both the firm and the RR must be registered in that state in order to continue
conducting business with the client
 Changes in the financial background of a client (for better or worse) must
be documented SEC requires the updating
of customer information
• A different pattern of transactions may indicate a change at least every three years.
 Objectives are typically adjusted as customers age

FINRA rules require firms to send a copy of updated changes to a

customer within 30 days or at the time the next statement is mailed.

Financial Exploitation Rules

DEFINITION PROCEDURE
If signs of diminished capacity or dementia are
Financial exploitation rules apply to specified identified, the firm should place a temporary hold
adults who are most likely to be exploited, on the disbursement of funds, execution of
including: securities transactions, and transfer of securities.
 Persons age 65 or older  The customer’s designated trusted contact
 Any persons age 18 or older who are person should be notified
believed to have a mental or physical • Information regarding the trusted
impairment that jeopardizes their ability to contact person should be obtained
protect their own interests when an account is opened (although
not required, a reasonable effort
should be made)

Account Transfer Process

Customer initiates
transfer by completing Receiving B/D inputs
Carrying B/D has
and delivering ACAT Form and a After validation, transfer
one business day
Automated Customer Transfer Initiation Form is completed within
to validate or
Account Transfer (TIF) is sent to the three business days
protest the transfer
Service (ACATS) Form carrying B/D
to receiving B/D

Once validated:
 Account is frozen
 Open orders cancelled
 No new orders accepted

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Account Transfer
Reasons to protest transfer request:
 Additional documentation is required (e.g., death certificate)
 Account is flat; reflects no assets
 Invalid account number
 Social Security number or account title does not match
 Existing court order or tax liens
 Written instructions to rescind the transfer are received from the client
But NOT due a dispute over securities positions or money balances

If discrepancy claim occurs after transfer, carrying B/D

must resolve it within five business days

Systematic Risks
Systematic risks are those that affect the value of all securities and cannot be avoided through diversification, including:

Market Risk Risk inherent in all securities due to market fluctuation

Risk that the value of a fixed income investment (bond) will decline due to a rise in
Interest-Rate Risk
interest rates
Risk that an asset or the purchasing power of income may decline over time, due to the
shrinking value of the country’s currency
Inflation Risk
 To find a bond’s real interest rate, the formula is:
Nominal Yield – Inflation Rate

Event Risk Risk that a significant event will cause a substantial decline in the market

Unsystematic Risks
These risks are unique to a specific security and can managed through diversification

BUSINESS RISK  Risk that a company may perform poorly causing a decline in the value of the stock

REGULATORY RISK  Risk that new regulations may have a negative impact on an investment’s value

 Risk that political event outside of the U.S. could adversely affect the domestic
POLITICAL RISK markets

 Due to a lack of marketability, this is risk that an investment cannot be bought or sold
LIQUIDITY RISK quickly enough to prevent or minimize a loss

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Additional Risks
CAPTIAL RISK CREDIT RISK CURRENCY RISK LEGISLATIVE RISK

 Risk of investors  Risk that a bond  Risk of loss when  Risk that new laws may
losing their invested may not repay its converting an have a negative impact
capital (lower for obligation investment that’s made on an investment’s
bonds) in a foreign currency value (e.g., tax code
into U.S. dollars changes)

Additional Risks
OPPORTUNITY RISK REINVESTMENT RISK PREPAYMENT RISK

 Risk of passing on the  Risk that interest rates will  Risk that mortgages will be
opportunity of making a fall and semiannual coupons paid off early due to lower
higher return on another will be reinvested at a lower interest rates, resulting in
investment rate reinvestment in lower
yielding investments

Investment Returns
The following return measures are based on the different types of investments

Annual Dividend
EQUITY  Current Yield
Current Market Price

 Nominal Yield
 Current Yield (based on annual interest)
DEBT
 Yield-to-Maturity
 Yield-to-Call

Tax-Free Yield
MUNICIPAL BONDS  Tax-Equivalent Yield
(100% - Tax Bracket %)

 Gain – realized when sales proceeds exceed cost basis

CAPITAL GAINS AND  Loss – realized when sales proceeds are below cost basis
CAPITAL LOSSES
 Return of Capital – return of investor’s original investment

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Tax Considerations
When giving or receiving securities the tax implications must be taken into account

Unified Gift and Estate Taxes Securities Received as a Gift Inherited Securities
 The amount of assets that can  If fair market value (FMV)  Cost basis is the value at time
be left in an estate without exceeds donor’s (original) of death
incurring estate taxes cost basis • Stepped up if
• Use original basis (OB) deceased’s cost basis
Annual Gift Limit • Use donor’s holding is lower
period • Stepped down if
 $18,000 can be gifted each
year to as many as desired  FMV less than donor’s cost deceased’s cost basis
without tax to the donor basis and sold for: is higher
• More than OB, use OB
 Amounts in excess reduce the
lifetime exclusion • Less than OB, use FMV
 Unlimited amounts can be
gifted between spouse

Activity
Match each portfolio to the appropriate term.

Paying for office space and professional

MARKUP/MARKDOWN
licensing fees
UNACCEPTABLE USE
Used in account transfers
OF SOFT DOLLARS
DESIGNATED TRUSTED
Charged on principal transactions
CONTACT

ACATS AND TIF Business, political, and prepayment risk

UNSYSTEMATIC RISK Required under Financial Exploitation Rules

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Chapter 15 – Portfolio and Market Analysis

Key Topics

1 2 3
INVESTMENT ASSET ALLOCATION TECHNICAL ANALYSIS
SELECTION
He Learn about how different Learn about the different
Learn about the factors asset classes can be tools that can be used to
which influence the used to construct an indicate the direction of
selection of investments optimal portfolio. prices and the market.
for a customer.

Clients’ Financial Objectives

OBJECTIVES
Preservation of Growth/Capital Tax
Current Income Speculation
Capital/Income Appreciation Relief

Time Horizon Short to Medium Medium Long Long Varies

Sector Funds, 1) Tax-Exempt:

Aggressive Municipal Bonds,
Bonds, Income Growth Funds, Municipal Money-
Money Market
Funds, Annuities, Common Stocks, Emerging Market Funds
Securities Funds and
Preferred Stocks, Growth Funds Markets Funds,
T-Bills 2) Tax-Deferred:
Utility Stocks Overseas/
Country Funds, Annuities and
Hedge Funds Retirement Plans

Risk Low Medium High Higher Varies

Steady, reliable
Phrases
Parking funds, stream of income, Speculation, able
associated Capital High tax bracket,
safety, liquidity, in retirement and to withstand
with the appreciation professional role
and income in need of fixed potential losses
objective
income

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Asset Allocation
Asset allocation focuses on a portfolio constructed of various
asset classes
An optimal portfolio (one producing the greatest return for a
given amount of risk) is based on a client’s goals, expected
return, and risk tolerance

Constructing Optimal Portfolios

Using the basics of Modern Portfolio Theory, investors can describe the relationship between expected risk and
expected return for a portfolio

Expected
Higher return
return than C; same risk
12%
Efficient
11% Same B Frontier
return as C;
10% less risk

9%
A
8% C Not optimal
• Same return as A, but more risk
7%
• Same risk as B, but lower return

7% 10% 13% 16% 19%

Risk (volatility of returns) (Standard Deviation)

Averages and Indexes

Investment returns are often compared against a benchmark of a group of securities
Narrow-based indexes focus on market segments, while broad-based indexes attempt to include the entire market,
such as:
 Standard & Poor’s 500 Index – comprised mostly of NYSE stocks
• 400 industrial
• 20 transportation
• 40 utility
• 40 financial
 Dow Jones Composite – broken down into three averages:
• Dow Jones Industrial – 30 stocks (most widely quoted)
• Dow Jones Transportation – 20 stocks
• Dow Jones Utility – 15 stocks

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Other Averages and Indexes

Equity Indexes:
 Wilshire Associates Equity Index – Largest index; 5,000 stocks The largest index is the Wilshire
 Russell 2000 – Focuses on small capitalized stocks Associates Equity Index,
 Nasdaq Composite Index – Based on all Nasdaq listed securities while one of the smallest is the
 Nasdaq 100 – The 100 largest companies listed on Nasdaq Dow Jones Industrial Average
Bond Indexes
 Barclay’s Capital and other B/Ds have created indexes based on existing bonds in the market
Tracking Performance:
 An investor must track how his investments are performing relative to a benchmark or index
(e.g., if his investment is up 5%, but the S&P 500 is up 10%)

Measuring Systematic Risk

Beta measures the volatility of an asset (typically an equity) relative to the entire market
 A stock’s beta is compared to the beta of the S&P 500, which is fixed at 1.00
 If a stock’s beta is more than 1, it’s expected to outperform when the market is up and underperform when the
market is down
 If a stock’s beta is less than 1, it’s expected to underperform when the market is up and outperform when the
market is down

Stock A Year 2
(Beta 1.5)
Stock B
(Beta .5)

S&P 500
S&P 500 Stock B Down 10%
Up 10% (Beta .5)
Stock A
Year 1 (Beta 1.5)

Alpha measures an investment’s risk-adjusted performance against a benchmark index.

Outperforming the benchmark results in a positive alpha; underperforming results in a negative alpha.

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Capital Asset Pricing Model (CAPM)

Used to determine if the return on an investment equals the risk premium in excess of the risk-free rate of return.

Return %

Risk premium is the market return

in excess of risk-free rate

Market return
Risk-free rate is the
rate on long-term
Treasury bonds
Risk-free rate

Market Beta = 1 Risk (market)

Market Analysis Factors

MARKET SENTIMENT PUT/CALL RATIO
 Overall attitude of investors as it relates to  Gauges investors’ sentiment in the market.
the market or specific security.  A rising ratio indicates a bearish mood.

MARKET MOMENTUM INDEX FUTURES

 The trading volume that sustains an  Reflects investors’ attitude towards the
increase or decrease in prices. High direction the underlying market may be
volume increases momentum. headed

TRADING VOLUME SHORT INTEREST

 The number of shares that have been sold
 An indicator of the support behind a move short, but not yet covered.
in the direction of stock prices.  The ratio or days to cover is used to
determine the bearish or bullish sentiment.

OPTIONS VOLATILTY
 Used to evaluate a stock’s volatility in the
future.

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Municipal Market Analysis

Bond Buyer Indexes
20 G.O. bonds with 20-year maturities
20 Bond
 Average rating of AA or Aa2
11 of the above 20
11 Bond
 Average rating of AA+ or Aa1
25 Revenue 25 revenue bonds with 30-year maturities
(or Revdex)  Average rating of A+ or A1
40 recently issued and actively traded bonds
40 Bond
 Based on average prices as quoted by brokers’ brokers
Used as a benchmark
Treasury Bond
 Highest yield since interest is taxable

These indexes show the average yields and are compiled on a weekly basis.

Technical Analysis
These are basic chart patterns and terms used to indicate the direction of prices

TREND LINES  Straight lines that show direction and speed of price movements

 Chart formations showing that an upward trend has come to an end

SAUCER/INVERTED SAUCER
(inverse saucer), or a downward trend has come to an end (saucer)
 Provide a current direction of prices, removing random price fluctuations
MOVING AVERAGES
(e.g., 50-day, 200-day, etc.)
 Overbought – buying has pushed the price to high and a pullback is
expected
OVERBOUGHT/OVERSOLD
 Oversold – selling has pushed the price to low and a bounce is
expected

Resistance / Support Levels

Breakout
 In order to profit on a breakout, one could:
• Enter sell stop orders below a support level (or buy puts), or
• Enter buy stop orders above a resistance level (or buy calls)

 Buy 81.53 stop GTC

81.50 Resistance

79.70 Support
 Sell 79.66 stop GTC

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Head and Shoulder Patterns

Head and Shoulders Top Head
 Reversal of an _____________________ trend (Top)
 Bearish indicator Right
Left Shoulder
Shoulder

Head and Shoulders Bottom

 Reversal of a ______________________ trend
 Bullish indicator

Activity
Read each statement and determine whether it’s TRUE or FALSE.

ASSET ALLOCATION MODELS ARE

USED TO CREATE OPTIMAL PORTFOLIOS

THE RUSSELL 2000 IS THE LARGEST INDEX

A STOCK WITH A BETA OF 1.25 WILL OUTPERFORM IN A RISING

MARKET AND UNDERPERFORM IN A FALLING MARKET

CAPM STATES THAT THE RETURN ON AN INVESTMENT SHOULD

EQUAL A RISK-FREE RATE OF RETURN PLUS A RISK PREMIUM

A RISING PUT/CALL RATIO INDICATES A BULLISH SENTIMENT

A BUY STOP ORDER MAY BE USED TO TAKE

ADVANTAGE OF A BREAK IN THE SUPPORT LEVEL

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Chapter 16 – Fundamental Analysis

Key Topics

1 2 3 4
BALANCE SHEET FUNDAMENTAL INCOME EARNINGS PER
TOOLS STATEMENT SHARE
Learn about the
contents of a Learn about Learn about the Learn how to
balance sheet. measuring financial contents of a profit calculate EPS and
stability and what and loss statement. other investment
influences the returns.
balance sheet.

Balance Sheet
CURRENT ASSETS CURRENT LIABILITIES
Cash $500,000 Accounts Payable $500,000
Marketable Securities 80,000 Accrued Expenses 400,000
Accounts Receivable 90,000 Income Tax Payable 100,000
Inventories 800,000 Short-Term Debt 50,000
Other Current Assets 150,000
Total Current Assets $1,620,000 Total Current Liabilities $1,050,000

FIXED ASSETS LONG-TERM LIABILITIES

Property, plant and equipment (PPE) 2,000,000 Long-Term Debt (Notes and Bonds) 480,000
Other Long-Term Liabilities 20,000
Total Liabilities $1,550,000

INTANGIBLES STOCKHOLDERS’ EQUITY

Goodwill 400,000 Common Stock 10,000
Other intangibles 15,000 Additional Paid-in Capital 400,000
Retained Earnings 2,500,000
Treasury Stock at Cost (425,000)
Total Shareholders’ Equity $2,485,000
Total Assets $4,035,000 Total Liab. And Sh. Equity $4,035,000

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Inventory Valuation
 Oldest costs are matched with first units sold
First-In, First-Out (FIFO)  Inventories reflect the cost of the latest purchases
 If used during inflationary times, it results in greater profits

 Most recent costs are matched with first units sold

Last-In, First-Out (LIFO)  Inventories reflect the cost of the earliest purchases
 If used during inflationary times, it results in lower profits

Fundamental Tools
Measuring Financial Stability

1. Liquidity 2. Capitalization Ratios:

Working Capital: Bond Ratio:

Current Assets – Current Liabilities Total Debt
Total Capitalization
Current Ratio:
Debt-to-Equity:
Current Assets
Current Liabilities Total Debt
Total Shareholders’ Equity
Quick Asset Ratio:
(Acid Test)
Current Assets – Inventory
Current Liabilities

Adjustments to Balance Sheet

Transaction Effect on Working Capital C.A. C.L.

1. Issue Stock

2. Issue Bonds
F.A. L.T.L.
3. Buy Equipment for Cash

4. Declare Cash Dividend

INTANG. SH. EQ.
5. Pay Cash Dividend

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Income Statement
REVENUE (SALES)
– Cost of Goods Sold
Gross Profit
– Operating Expenses (SG&A, D&A)
Operating Income
± Other Income or Expenses
EBIT
– Interest
Taxable Income
– Taxes
Net Income
– Preferred Stock Dividends
Earnings Available to Common Stockholders

– Common Stock Dividends

Changes to Retained Earnings

EPS, Current Yield, and Dividend Payout Ratio

Earnings Available to Common Shareholders
Basic EPS =
Average Number of Shares of Common Stock Outstanding

Annual Dividend
Current Yield =
Current Market Price

Annual Dividend
Dividend Payout Ratio =
EPS

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Calculating EPS
A company has the following:  EBIT = $250 million
 21% tax rate
 80 million outstanding shares
 $600 million of 5% debentures
 $100 million of 6% preferred stock

Basic EPS Using P/E Ratio

EBIT $250MM Price-to-EPS 20:1

Less: Interest $30MM ($60MM x 5%) Market Value of Stock $42
Taxable Income $220MM Basic EPS is MV/PE = $42 / 20 = $2.10
Less: Taxes $46.22MM ($220MM x 21%)
Net Income $173.8MM ($220 – $46.2) If debt and/or preferred stock is convertible,
fully diluted EPS is recalculated after
Less: Preferred Dividends $6MM ($100MM x 6%)
converting to common stock.
Basic EPS is $167.8/80MM shares outstanding = $2.10

Activity
Read each statement and fill in the blanks.
1. During periods of inflation, profits will be greater if inventory is valued using ______________ and lower using
_______________.
2. The quick asset ratio removes _______________________ from current assets.
3. The percentage of total capitalization represented by debt is found in the ________________________.
4. Working capital will ____________________________________ when a cash dividend is paid.
5. To determine net income, taxes are deducted __________________ bond interest.
6. In order to find the current yield of stock, the ________________________________ is divided by the
_______________________________________.
7. Calculating EPS after accounting for convertible securities results in ________________________________.

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Chapter 17 – Orders and Trade Execution

Key Topics

1 2 3 4 5
OVERVIEW TRADE CAPACITY MARKET MAKING ORDER ENTRY REGULATION

He
Learn about the life
cycle of a trade and
Learn about the
difference between
Learn about the
process of market
Learn about the
different types of
Learn about the
various SEC and
obtain an overview a firm acting as a making and rules orders and the FINRA rules and
of trading markets. broker or a dealer concerning the required regulations which
on a transaction. various types of information on an govern trading
quote in different order ticket. markets.
venues.

Processing a Trade
1. 2. 3. 4. 5.

Order Entry Execution Clearing Settlement Custody

1. Order entry – Order ticket details regarding how a trade is to be executed

2. Execution – Occurrence of a trade in a market center
3. Clearing – Executing firms agree to the details of a trade; any unrecognized trades may result in a DK
(Don’t Know) notice
4. Settlement – The day on which the customer’s name is placed on or taken off the issuer’s books
5. Custody – Safeguarding of client and firm assets

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Secondary Markets
Trading markets that facilitate the exchange of existing financial instruments among investors
NYSE and other traditional centralized exchanges:
 Provide a specific location for trade execution
 Trading is normally monitored by a specialist or designated market maker (DMM)
 The DMM:
• Creates a fair and orderly market
• Keeps “the book” for a given security

How Broker-Dealers Function

B  Firm acts as a conduit or agent by finding another party willing
to take the other side of the trade A
R
O  Sells to a bid or buys from an offer B
K
E  Collects commission for the service
C
R  No risk to the firm

How Broker-Dealers Function

D  Firm acts as a principal P
E
A  Firm takes the other side of the trade
D
L  Entitled to markup/markdown (discussed shortly)
E M
R  Inventory/risk

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Dealer-to-Dealer Markets
 Non-physical; phone and computer network
 Negotiated market
Nasdaq
 Unlimited number of “market makers”
 Classified as a securities exchange

 Often low priced and thinly traded

 Two systems which offer real-time quotations:
Non-Exchange Issues • OTCQX – Issuers must be reporting companies
(OTC) • OTC Pink Market – Issuers are not required to be reporting companies
 During normal business hours, priced quotes are firm for a size that varies
inversely with the security’s price

 Stand ready to buy or sell at least 100 shares at their quoted prices
(quotes are firm)

Bid Ask
22.90 23.05
Market Makers
 The MM’s bid price is the price at which it will buy
 The MM’s ask price is the price at which it will sell
 The difference between the bid and ask is the spread
 Quotes are subject to SRO rules

 Execute trades for their firm or their firms’ clients

Traders
 Do not maintain an inventory

Other Secondary Market Terms

 Listed securities traded OTC
Third Market  Trades included in NYSE volume totals
 Transactions between institutions
Fourth Market  Most true fourth market trades are internal crosses set up by money managers
 Provides liquidity for large institutional investors and high-frequency traders
Dark Pools  Quotes are not disseminated to the public
 Limits impact on the market

Quotes
The Inside Market represents:
 The highest bid and lowest offer of all market makers for a given stock
Bid Ask
MM 1 10.00 10.10 The client sells to the high bid
MM 2 9.98 10.08 and buys from the low offer
MM 3 9.95 10.05

If an MM fails to honor its quote, it is considered a backing away violation.

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Types of Quotes
Quote is guaranteed for the size indicated.
 Typically priced in $.01 increments
Firm  Quote size is expressed in round lots
 For example, 16.50 – 16.57, 20 x 30 represents 2,000 shares bid and 3,000
shares offered)

Subject Quote is tentative and subject to reconfirmation

Bid Wanted A seller indicates the desire for a bid

Offer Wanted A buyer indicated the desire for an offer

Calculating Markups and Markdowns

Market maker quotes are inter-dealer, but are adjusted when trading with retail customers
 Allows dealers to profit on trades with customers
 Price adjustments are built into the trade, but are generally disclosed on the confirmation
 Mark-up/Mark-down is always calculated based on the inside market

Bid Ask
This quote shows the inside market:
22.95 23.00

Price for Price for

Factoring in a $.05 markdown or markup, Selling Client Buying Client
the prices to retail clients will be as follows:
22.90 23.05

The Nasdaq Stock Market

ABCO Bid Ask Size
22.95 23.00 10 x 30
MM 1 22.90 23.05 50 x 50
MM 2 22.95 23.15 10 x 40
MM 3 22.85 23.00 20 x 30

Level 1:
 Inside market only (highest bid and lowest asked/ offer) without identifying any market makers
Level II:
 Quotes of all market makers that deal in the security
 TotalView provides additional depth and aggregate size at the five best price levels
Level III: (same information as Level II)
 Allows market makers to enter or change their quotes

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Alternative Trading System (ATS)

Defined as an SEC-approved electronic trading system that’s designed to match the buy and sell orders of its
subscribers
 Under Regulation ATS, systems are required to register as either an exchange or broker-dealer
Examples include:
 Electronic Communication Networks (ECNs)
The importance of an ATS is that it provides
 Firm internal execution systems an alternative means to access liquidity.
 Trade Crossing Networks

Activity
Read each statement and determine what it describes.

A COMMISSION IS CHARGED
ON THE TRANSACTION

TRANSACTIONS DIRECTLY
BETWEEN INSTITUTIONS

HIGH BID AND LOW OFFER

QUOTE IS GUARANTEED FOR

A SPECIFIC PRICE AND SIZE
COST OF EXECUTING
A PRINCIPAL TRANSACTION

ECNs AND TRADE CROSSING NETWORKS

Components of an Order Ticket

Created at the time an order is received and includes:
 Branch identifier
 RR responsible for account and person accepting the order
 Whether a purchase or sale
 Sales must be marked long or short (covered shortly)
 Symbol or description of security and quantity
 Account number/name and type (e.g., cash or margin)
 Time stamps - time of entry and execution (if filled)
 Whether discretionary, solicited, or unsolicited (covered shortly)
Orders must be approved by a principal on the day of entry
Missing Information: firm capacity, accrued interest, compensation, and CUSIP number are items found on a
confirmation

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Types of Transactions
When an order is placed, it must be identified as either a:

Purchase Trade may be paid in full or purchased on margin

Long Sale Sale of securities that are owned by the customer

Sale of securities that are not owned by the customer

 Customer borrows securities from the B/D and sells them with the agreement to
Short Position
repurchase and deliver on a future date
Created By:
 The appropriate amount of margin must be deposited to borrow securities
 Risk is on the upside and unlimited

Regulation SHO
Regulates the practice of selling short

1. Marking Requirement 2. Locate Requirement

Sell order tickets must be marked long or short Applies if sell order ticket is marked short
 Tickets may be marked long if:  B/Ds must use an Easy-to-Borrow list that
• Client or client’s agent has title (e.g., is less than 24-hours old
DTCC or prime broker)  Difficult to borrow stocks may need to be
• Customer has unconditional contract, manually located prior to short sale
but the trade has not yet settled
• Convertibles have been tendered
• Options, warrants, or rights have
been exercised
And the B/D believes the security will be
delivered promptly

Types of Orders
• Customer wants to buy or sell
Market Order • Customer specifies the security and size of the order only
• Order is immediately executed at the best price available

• Customer wants to buy or sell at a set price or better

• Customer specifies the security, size, and price
Limit Order • Order is only executed if the limit price is able to be met
− Buy limit: at pre-set price or lower
− Sell limit: at pre-set price or higher

• Customer wants to protect an existing position.

• Customer specifies the security, size, and price
Stop Order • Order is only executed if trading occurs at or through the stop price
− Sell Stop: Exit long position if price hits stop price or lower
− Buy Stop: Exit short position if price hits stop price or higher

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Order Duration – Qualifiers

Different qualifiers can be used to influence when (and if) an order is executed
Two of the more popular are:
1. Day Order – unless otherwise indicated, all orders are day orders and are cancelled at day’s end if not executed
2. Good-’Til-Cancelled (GTC) or Open Order – stays on the book until it expires, is executed, or is cancelled by the
investor
• May be placed for one week, one month, or other specified period
• May be adjusted for distributions on the security or partial execution

Orders may specify exposure to only normal trading session

(9:30 AM to 4:00 PM) or request pre-market and/or post-market as well.

Additional Order Qualifiers

The following qualifiers may be added to an order:

All-or-None (AON) Fill the entire order by end of day or cancel (no partial fills)

Immediate-or-Cancel (IOC) Fill as much of the order as possible immediately and then cancel the remainder

Fill-or-Kill (FOK) Execute the entire order immediately or cancel

Market-on-Open (MOO)
Buy or sell as close to the market open or market close
Market-on-Close (MOC)

Discretionary Orders
For Discretionary Accounts:

When discretion is granted to an RR, each use must be documented

 If the trading decision was made by the RR without the client’s consent to the specific trade, the order ticket
must state that it was discretionary
 If the trade was executed with the client’s consent, the order ticket will indicate discretion not exercised

For Non-Discretionary Accounts:

Any order ticket must indicate solicited or unsolicited

 If a trade was recommended by the RR and accepted by the customer, the order ticket is marked solicited
 If a trade is placed by a customer without the RR’s recommendation, the order ticket is marked unsolicited

If a customer specifies the action (buy or sell), amount, and asset, but allows her RR
to determine time and/or price of execution, it’s a Not Held order (only good for that day).

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Regulation NMS (National Market System)

Quote Increment Limit Order Display Rule Limit Order Protection Rule

Minimum Price / Sub-Penny Rule Customer limit orders are subject to The Manning Rule
 Prohibits market participants display, allowing customer orders to  Firms may not trade ahead of
from accepting or displaying compete with market makers (MMs) customer limit orders
orders in pricing increments  If a customer’s limit price • While holding a customer
of less than one penny improves the MM’s quote, it limit (or market) order, if
 Exception: If stock is valued must immediately (within 30 the MM trades for its own
at less than $1.00, it may be seconds) display the order account at the same or
quoted in increments of no  If a customer’s limit price better price, it must
less than one hundredth of a matches the MM’s quote that’s immediately (within 60
cent ($0.0001) currently the inside market: seconds) fill the
• Customer’s size is added customer’s order at the
to the MM’s display same price or better

Prohibited Trading Practices

Quoting a Security
Interpositioning Trading Ahead of Research
in Multiple Mediums

Refers to the insertion of a third If a firm has knowledge of Refers to displaying quotes on the
party between a customer and the material, non-public information same security in multiple markets
best market. regarding the contents of a  Permitted if quotes are at the
 Prohibited if detrimental to research report, it may NOT same price
customer establish, increase, decrease, or
 Acceptable if advantageous liquidate an inventory position in a
to customer security or its derivative.
 Information barriers must
exist between trading and
research departments

Prohibited Trading Practices

Marking-the- Anti-Intimidation/
Market Rumors Front-Running
Close/Opening Coordination Interpretation

 Spreading false or  RRs executing trades  Effecting trades near Prohibited Actions:
misleading for proprietary the opening or close  MMs coordinating price
information to accounts (or those for of trading in an quotes, transactions, or
influence the price of which they have attempt to influence a trade reports
stocks and/or bonds discretion) ahead of a stock’s closing price  Threatening, harassing, or
customer’s block up or down intimidating other MMs
order (a market
 Retaliating against or
moving order)
discouraging the
competitive activities of
another MM

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Fair Prices and Commissions

 This is FINRA’s policy; it’s NOT a rule
 Instead, it’s a guideline for commissions, markups, and markdowns
The 5% Policy
• Certain transactions may justify a higher markup/markdown
• Other transactions may justify a lower markup/markdown

 Influential Factors
• Type of security involved (equity or debt)
• Availability of the security
The Factors That
• Price
Influence the Charge
• Amount of money involved
• Pattern of markups
• However, the type of client or whether the firm will profit is NOT relevant

Application
 The policy also applies to proceeds transactions
• Involves a client directing a B/D to liquidate securities and use the proceeds
to buy other securities
Application and
Exclusions • Markup is calculated based on one trade (as if done for cash)
Exclusions
 Trades involving securities sold by prospectus or offering circular (e.g., new
issues, mutual funds, variable annuities)
 Exempt securities (e.g., U.S. government and municipal securities)

Trading Halts
The SEC may issue a halt or trading suspension:
 For any individual security – for up to 10 business days
 On any exchange – for up to 90 days
During a halt, member firms are prohibited from all quoting and trading, even in foreign markets or internal crossing
systems
Trading halts may be imposed due to declines in the S&P 500 (percentage triggers are reset each day)

7% decline 13% decline 20% decline

Halt for 15 minutes Halt for 15 minutes Halt for remainder of day

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Activity
Read each statement and fill in the blanks.
1. If executed, order tickets must be __________________________ and approved
__________________________________.
2. In order to execute a short sale an ________________________________ must checked by the broker-dealer.
3. An order that may be activated but not executed is referred to as a _________________________________.
4. __________________________________ order must be completely executed immediately cancelled.
5. When a trading decision was made by an RR without the client’s consent the order ticket is marked
_______________________________.
6. If a customer’s limit order improves the market maker’s quote it must be displayed within
_______________________________.
7. Placing a third party between a customer and the best market is referred to as _________________________.
8. The __________________________ is a FINRA guideline that dictates fair prices.
9. A __________________________ in the S&P 500 from the previous day’s close results in a market halt for the
remainder of the day.

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Chapter 18 – Margin

Key Topics

1 2 3
OPENING MARGIN MARGIN ACCOUNT OTHER MARGIN ISSUES
ACCOUNTS VALUATION
He
Learn about what is Learn about how changes
Learn about some unique
margin considerations.
needed when opening in market value influence a
margin accounts and customer’s equity.
margin terminology.

Opening a Margin Account

 Use of margin increases customer purchasing power
 However, potential losses are also increased due to adverse market
changes
Margin Basics  Subject to the FRB’s Regulation T 50% deposit requirement, which can be
met by depositing:
• Cash equaling 100% of Reg T call
• Fully-paid marginable securities equaling 2 x the Reg T call
 This document discloses the terms of the loan
Credit Agreement
• Interest amount, how computed, and when charged
 Customer hypothecates securities to B/D as collateral
 B/D borrows money from a bank to replace the loan that was made to the
customer
Hypothecation • What amount of cash can the B/D borrow from a bank?
(Pledge) Agreement
• What amount of the customer’s securities can be rehypothecated to
the bank as collateral?

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Additional Margin Documents

Loan Consent Agreement (generally used for short sales)
 Not mandatory for opening account
 If signed, B/D is able to lend the customer’s securities to others
Margin Disclosure Document – must be provided to all customers opening a margin account and indicates:
 A customer can lose more money than deposited
 The firm can force the sale of securities or assets in the account
 The firm can sell securities from the account without notifying the customer
 The customer has no control over which assets are sold to meet a margin call
 The in-house maintenance requirement can be changed without prior written notification to the client
 The client is not entitled to an extension for a maintenance call

Margin Terminology
Marginable Securities Non-Marginable Securities
• Determined by the FRB; includes all listed securities • OTC equities, standard options, and new issues
Long Market Value (LMV) Credit Balance
• The amount of money generated by the initial short
• The current value in the long margin account
sale plus the Reg. T deposit
Debit Balance Short Market Value
• The amount of money borrowed from the firm to
• The current value in the short margin account
create a long position
Equity Equity
• An investor’s ownership interest in an account • An investor’s ownership interest in an account
- For long account: LMV – Debit = Equity - For short account: Credit – SMV = Equity
Special Memorandum Account Restricted Account
• A line of credit that’s created when equity exceeds
• Occurs when equity is less than 50% of market value,
50% of market value. Not reduced due to market
but is not required to be remedied.
declines.
Maintenance Call
• Required deposit if equity falls below 25% of LMV in a long account, or below 30% of SMV in a short account

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LMV Increases
An investor purchases $100,000 LMV increases by
of securities in a margin account $10,000 to $110,000

Initial Purchase After Increase SMA = $5,000

Long Market Value $100,000 Long Market Value $110,000

– Debit Balance – $50,000 – Debit Balance – $50,000
Equity $50,000 Equity $60,000

 Equity must be LMV x Reg. T  Equity must be LMV x Reg. T

$110,000 x 50% = $55,000
$100,000 x 50% = $50,000
 Any equity above 50% = SMA
$60,000 – $55,000 = $5,000
 Buying Power = $10,000 (SMA x 2)

LMV Decreases
Later, the LMV decreases Later, the LMV decreased by
by $20,000 to fall to $90,000 another $30,000 to fall to $60,000

After Decrease SMA = $5,000 After Another Decrease SMA = $5,000

Long Market Value $90,000 Long Market Value $60,000
– Debit Balance – $50,000 – Debit Balance – $50,000
Equity $40,000 Equity $10,000

 Equity should be LMV x Reg. T  Equity must be LMV x Minimum Maintenance (25%)
$90,000 x 50% = $45,000 $60,000 x 25% = $15,000
 Since equity is below 50%, the account  Since equity is below 25% = Maintenance Call
is restricted; however, it’s not required  The $5,000 call must be fixed promptly or
to be fixed securities sold out

Remember, SMA is not reduced by market declines (you only lose it if you use it)

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SMV Decreases
An investor executes a $100,000 The SMV decreases by
short sale in a margin account $10,000 to fall to $90,000

Initial Short Sale After Decrease SMA = $15,000

Credit Balance $150,000 Credit Balance $150,000
– Short Market Value – $100,000 – Short Market Value – $90,000
Equity $50,000 Equity $60,000

 Equity should be SMV x Reg. T

 Equity must be SMV x Reg. T
$90,000 x 50% = $45,000
$100,000 x 50% = $50,000
 Any equity above 50% is SMA
 CB = Initial short sale + Reg. T deposit
$60,000 – $45,000 = $15,000
$100,000 + $50,000 = $150,000
 Shorting Power = $30,000 (SMA x 2)

SMV Increases
Later, the SMV increases by Later, the SMV increased by another
$20,000 to rise to $110,000 $10,000 to rise to $120,000

After Increase SMA = $15,000 After Another Increase SMA = $15,000

Credit Balance $150,000 Credit Balance $150,000
– Short Market Value – $110,000 – Short Market Value – $120,000
Equity $40,000 Equity $30,000

 Equity must be SMV x Minimum

 Equity should be SMV x Reg. T Maintenance (30%)
$110,000 x 50% = $55,000 $120,000 x 30% = $36,000
 Since equity is below 50%, the account  Since equity is below 30% = Maintenance Call
is restricted; however, it’s not required to
be fixed  The $6,000 call must be fixed promptly by
purchasing securities

Remember, SMA is not reduced by market increases (you only lose it if you use it)

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Initial Margin Requirement

For Long Positions: For Short Positions:
The lesser of $2,000 or 100% of the market value $2,000
Purchase: Deposit: Short Sale: Deposit:
Below $2,000 100% of purchase Below $4,000 $2,000
Between $2,000 and $4,000 $2,000 Above $4,000 50% (Reg. T)
Above $4,000 50% (Reg. T)

Buy $1,500 of ABC Short $1,500 of XYZ

Buy $3,000 of ABC Short $3,000 of XYZ

Buy $5,000 of ABC Short $5,000 of XYZ

Additional Margin Considerations

Also referred to as risk-based margin
 Margin requirement is based on net risk in the portfolio
Portfolio Margin • E.g., risk of a long stock position being offset by a put on that stock
 Eligibility limited to customers approved for uncovered options writing and
certain firms
Minimum maintenance for these products equals the leverage factor times 25% (long)
Leveraged ETFs
or 30% (short)

Defined as executing four or more day trades over a five-day period

Pattern Day Trading
 Minimum equity requirement of $25,000

Activity
Read each statement and fill in the blanks.
1. The document that allows a broker-dealer to lend a customer’s securities to another customer, but is not
mandatory when opening a margin account, is the _______________________________________________.
2. The ______________________________________________ determines the list of marginable securities.
3. In order to determine the equity in a long margin account, the ____________________________ is subtracted
from the ______________________________________.
4. A margin account is restricted when equity is ______________________________ of the market value.
5. When equity is greater than 50% of market value, ____________________________________ is created.
6. Excess equity is created in a short margin account when the ________________________________ declines.
7. If the first transaction in an investor’s margin account is a purchase of $1,800 worth of stock, the investor must
deposit _________________.
8. A 3x Long ETF requires minimum maintenance of ______________________________________________.

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Chapter 19 – Settlement and

Regulatory Reporting

Key Topics

1 2 3 4
OVERVIEW REPORTING CLEARING TRADES SETTLING TRADES
REQUIREMENTS
Review the Learn about the Learn about the
components of the life Learn about the process of agreeing process of moving
cycle of a trade. different trade to the terms of funds and securities
reporting systems a trade. and the role of the
used in the industry. DTCC.

The Life of a Trade

1. 2. 3. 4. 5.

Order Entry Execution Clearing Settlement Custody

1. Order entry – Order ticket details regarding how a trade is to be executed

2. Execution – Occurrence of a trade in a market center
3. Clearing – Executing firms agree to the details of a trade
4. Settlement – The process of the buyer and seller transferring money and securities
5. Custody – Safeguarding of client and firm assets

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Trade Reporting Overview

The following systems are used to report trade executions:

Trade Reporting Facility (TRF) For Nasdaq and third-market securities

OTC Reporting Facility (ORF) For OTC equities (Pink Market)

Facilitates mandatory reporting for secondary market transactions in eligible

Trade Reporting and
fixed-income securities (not corporate money market, foreign government or
Compliance Engine (TRACE)
municipal securities)

Real-Time Transaction
For trades in municipal securities (not municipal fund securities)
Reporting System (RTRS)

Electronic Municipal Market Access System

(EMMA)
EMMA is the official source for municipal securities data and
documents, including:
 Documents from issuers and underwriters related to the
primary market (e.g., official statements)
 Continuing disclosure information
 Daily statistics on trading activity
 Investor education materials
• Note: EMMA is NOT a trade reporting system;
it’s an information portal

Clearing a Trade
Don’t Know (DK)
 Terms of the trade don’t match
 Wrong security? Price? Quantity? CUSIP?
 Contra-broker has 20 minutes to DK or Affirm

Affirmation
 Buyer and seller agree to the terms
 The trade is “locked in” and DTCC is notified
 The trade is now ready to settle

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Physical or Electronic Ownership

The following are different methods that a client may hold a bond position:

In certificate form, with no owner name noted on the physical security

Bearer
(interest coupons physically attached)

Registered to In certificate form, with name of owner evidenced

Principal Only (interest coupons physically attached)

In certificate form, with name of owner evidenced

Fully Registered
(interest payments automatically mailed or paid electronically)

Book Entry Position is held electronically at a depositary

Other Methods of Holding Securities

Some clients choose to hold positions away from their broker-dealers

DVP/COD/RVP Direct Registration System (DRS)

Client uses a bank to consolidate multiple The Direct Registration System (DRS) enables
brokerage accounts. investors to hold their assets in book entry form
 Delivery versus Payment (DVP) or directly with the issuer or its transfer agent.
Collect on Delivery (COD)
• Client is buying securities
• Broker-dealer delivers securities to
client’s bank and is paid by the bank
 Receipt versus Payment (RVP)
• Client is selling securities
• Client’s bank delivers securities to
broker-dealer and B/D makes
payment to the bank

Depository Trust & Clearing Corporation

The DTCC provides clearing, settlement, and information services for depository-eligible securities through its
subsidiaries, including:
 National Securities Clearing Corporation (NSCC) – central counterparty for clearing, settling and guaranteeing
U.S. equity trades
 Depository Trust Company (DTC) – provides custody and safekeeping services for securities
Transactions among members are completed through computerized bookkeeping entries
 Referred to as book-entry settlement with no physical delivery of securities
 Client positions are held in “street name” (in the name of their broker dealer)

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Settlement Dates
Unless a specific exception is made, settlement (completion of the
transaction between the firms involved) will occur as follows:

Corporate and Municipal Securities

• One business day after the trade date (T + 1)

U.S. Government Securities and Option Trades

• One business day after the trade date (T + 1)

Cash Settlement for any security

• Same day as the trade date (both sides must agree)

Seller’s Option
• Negotiated settlement; not earlier than two business days after the trade

When Issued
• As determined by the National Uniform Practice Committee

Settlement versus Customer Payment

Payment date is set by the FRB under the provisions of Regulation T
 Reg. T applies to transactions involving corporate securities

Transaction Settlement Payment Date

Corporate securities in either a Three business days
One business day (T + 1)
cash or margin account (T + 3 or S + 2)

Exempt from Reg. T

Municipal securities One business day (T + 1)
(generally settlement)

Exempt from Reg. T

U.S. Government securities One business day (T + 1)
(generally settlement)

Three business days

Option Trades One business day (T + 1)
(T + 3)

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Settlement for Equity Option Exercise

OCTOBER
SUN MON TUES WED THURS FRI SAT

1 2 3 4 5
Options expire at
Trading ceases 11:59 pm ET
6 7 8 9 at 4:0010
pm ET 11 12
17
13 14 15 16 18 19
Buyer must submit
20 21 22 23
exercise notice 24
to her 25 26
broker by no later
27 28 29 30 5:30 pm ET
than 31

Exercising an Equity Option

Uses Random Selection to assign the
exercise notice to a B/D that has
clients short the ABC Feb 60 call

B/D A B/D B B/D C

Settles in one business day B/D issues the exercise notice to a

Customer’s
Broker/Dealer client using:
1. Random, or
2. FIFO, or
3. A fair and equitable method

LONG ABC FEB 60 CALL SHORT ABC FEB

SHORT ABC FEB 60 CALLS

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Good Delivery
A member firm’s transfer agent makes the final determination as to whether a security
is in good deliverable form and may be transferred to the new owner

Good Delivery Requirements Units of Delivery

• Properly registered • Stock transactions must be

• Properly endorsed certificate delivered in multiples of 100
• Signed stock power if the stock shares
certificate is sent unsigned • Bond transactions must be in
• CUSIP numbers may be used $1,000 units or multiples
to identify and clear thereof
− 100 units adding to
$1,000 are permissible

Delivery Issues with Physical Securities

 Stock is restricted (bears a legend)
 Security is not endorsed
 Endorsement does not match registration (if a joint account, both must sign)
 Security is mutilated/illegible
 Bond is missing coupons
 Missing documentation due to death of owner
 Stock has been reported lost, missing, or stolen

Other Settlement Concerns

The following are potential factors that could affect settlement:

Buyers must have a settled their trades on or before record date to be entitled to a
Ex-Dividend
cash or stock dividend (record and ex-date are the same day)

Buyers must have a settled their trades on or before record date to be entitled to a
Ex-Rights
participate in a rights offering

If a security is sold before it trades “ex-dividend” (or “ex-rights”) and is delivered

too late to be transferred on or before the record date, it will be accompanied by
Due Bill
a due-bill. The due bill is evidence of a seller’s obligation to deliver the dividend
(or right) to the buyer.

A due bill in the form of a check payable on the date of payment of a cash dividend,
Due Bill Check
interest on registered bonds, or interest on unit investment trust securities.

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Activity
Read each statement and determine what it describes.

TRACKS THE LIFE OF A NASDAQ

TRANSACTION FROM BEGINNING TO END

A SOURCE FOR MUNICIPAL DISCLOSURES

REPORT OF A TRADE THAT’S NOT

AGREED UPON BY BOTH PARTIES

ELECTRONIC OWNERSHIP OF
SECURITIES AT A DEPOSITORY

EXERCISE NOTICE FOR AN OPTION MUST BE

REPORTED BY NO LATER THAN THIS TIME

THE DATE ON WHICH A STOCK BEGINS

TO TRADE WITHOUT ITS DIVIDEND

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Chapter 20 – Resolving Disputes and Suitability

Key Topics

1 2 3 4
ERRONEOUS CUSTOMER DISPUTE REQUIRED
TRADES COMPLAINTS RESOLUTION DISCLOSURES
Learn about trade Learn about the SRO Learn about the Learn about the
errors and the process requirements for various procedures various disclosures
of trade corrections. handling customer used to resolve required of
complaints. complaints. associated persons.

Handling Errors
Error Account Failing to Follow Instructions Client Errors

 Maintained by all B/Ds; used if  Clients may refuse trades if  B/Ds are not responsible for
the firm or an RR executes a their instructions were not errors that are caused by the
trade in error followed (e.g., failing to client (e.g., client placed order
(wrong security/quantity or execute at the client’s limit for wrong stock or failed to
wrong side of market) price or better; buying more cancel an order)
 To place trades in the account, shares than ordered)
principal authorization is • To correct the error, a
required principal must be
 If execution was for the wrong consulted
customer, the cancel and rebill
process must go through error
account

Note: If client receives an erroneous

trade report, the actual price is binding.

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Clearly Erroneous Trades

 Trades done at prices not related to the current market value
 Erroneous transactions due to system malfunctions
Clearly Erroneous Trades may
 News events, trading halts, stock splits and reorganizations are be declared null and void and
all factors in making the determination cancelled by a regulator
 The process is designed to ensure fair and orderly markets
 FINRA decisions are appealable by affected parties

Customer Complaint
Defined as a grievance that’s delivered in any written form, including letters, e-mails, IMs, or text messages
 Complaints must be forwarded to a supervisor for review/investigation
 Complaint files, including copies, are maintained in an OSJ along with a report to indicate the action taken to
resolve the complaint
 Records are retained for four years
 Quarterly reports are sent to FINRA (not the SEC) to provide statistical and summary complaint information

Code of Procedure
Process used to discipline members who violate FINRA rules

Complaint Filed Forwarded to Department of Enforcement

Copy of complaint and Letter of Respondent is given opportunity to respond

Acceptance, Waiver, and Consent  First: 25 days  Second: 14 days
(AWC) is sent • If rejected (not signed), a hearing is held

Potential results: fine, suspend / revoke registration, bar from

Hearing Panel
association

First to National Adjudicatory Council, then to the SEC, and

Appeal Decision
finally to Federal Court

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Code of Arbitration
Participants Arbitration Panel Simplified Arbitration Statute of Limitations

Members and/or Typically three persons. If For disputes not exceeding There is a six-year statute
customers, provided a public customer is $50,000, one arbitrator, of limitations
customer has signed pre- involved, a majority of the generally no hearing held,
dispute clause of new panel must be and document submission
account form independent (not only
associated with the
securities industry)

Arbitration Disclosures
Before arbitration begins, firms are required to make the following disclosures to clients:
 The right to sue or to a jury trial is waived with arbitration
 Certain claims are not required to be arbitrated, including those related to:
• Discrimination or sexual harassment
• Disputes arising under a whistleblower statute
 Arbitration awards are generally final and binding
 The ability to obtain documents may be more limited
 Decisions made by arbitrators don’t require explanation
 Arbitration panels may consist of either industry or public arbitrators

Mediation
Viewed as an alternative to arbitration
 Neutral facilitator assists parties with a disagreement to reach a mutually acceptable resolution
 If a dispute is eligible for arbitration, mediation may be used instead
 If mediation is not successful, the parties proceed to arbitration
 If a settlement is reached, the decision is private and confidential

Mediation is generally a short-term, structured,

task-oriented, and "hands-on" process.

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Reporting Requirements
FINRA requires firms to file information relating to certain customer complaints and other incidents involving RRs by no
later than within 30 days of discovery. These events include:

 Being subject to a customer complaint involving  Having been indicted or convicted of, or pleaded
allegations of theft, misappropriation of funds or guilty or no contest to, any felony or misdemeanor
securities, or forgery involving securities violations

 Violating securities laws or regulations of the  Being the subject of a suspension, termination,
government, SRO, financial business or withholding of commissions, or fines in excess of
professional organization $2,500

 Having been named as a defendant by a regulator  Being a defendant or respondent in an award or

alleging violation of any securities, insurance, or settlement of more than $15,000
commodities regulation

Disclosures/Updates on Forms U5 and Form U6

If registration is terminated, Form U5 must be filed within 30 days
 Copy provided to the RR
 Changes to Form U5 must be made within 30 days
FORM U5  FINRA must be notified of written complaints that are received after the
representative leaves the firm
 Re-qualification is required if registration is terminated for more than two years
(FINRA maintains jurisdiction for those two years)

Form U6 is used to report:

FORM U6  Disciplinary actions against representatives and firms, and
 Final arbitration awards against representatives and firms

Reporting on BrokerCheck
This system allows investors to check the background and disciplinary history of their existing or prospective firm or
RR, including:
 The RR’s current employing firm, the last 10 years of employment history,
and all approved registrations
 Any felonies, certain misdemeanors and civil proceedings, and
investment-related violations
 Pending customer-initiated arbitrations and civil proceedings involving
investment-related activities
 Written customer complaints filed within the last 24 months alleging sales practice violations of $5,000 or more
 Terminations of employment after allegations involving violations of rules, fraud, theft, or failure to supervise

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Activity
Read each statement and fill in the blanks.
1. __________________________________ is used if an execution was for the incorrect customer.
2. In order for a trade to be placed in an error account, ______________________________________ is required.
3. A trade resulting from a system malfunction that can be voided by a regulator is referred to as a
________________________________________________.
4. FINRA receives _______________________ complaint reports from broker-dealers and the broker-dealers must
maintain records of complaints for __________________________.
5. The ________________________________ is the first to review and determine what if any action will be taken
regarding a violation of industry rules.
6. Monetary disputes between member firms and customers are settled through the __________________________.
7. A fine in excess of $2,500 that’s assessed to an RR must be reported within ______________________________.

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Suitability Review

The Basics of Suitability

Suitability is based on a client’s profile at the time that a transaction or investment strategy is recommended
 Suitability is not determined by gains and losses
 A client’s profile will change due to various life events
(e.g., marriage, children, job changes, college, retirement, etc.)
 Know your customer
• Objectives and goals
• Time horizon/age
• Risk tolerance
• Tax bracket
 Know your products

Steps to Determine Suitable Investments

There are basic factors to consider when evaluating a customer’s portfolio

Investment Objective  What does the customer want to accomplish with the investments?

 Is the customer seeking a short-term, intermediate-term, or long-term

Time Frame
investment goal?
 How much risk is the customer willing to assume?
 Risk is influenced by time frame:
Risk Tolerance
• Investors with long-term goals can typically assume more risk
• Investors with short-term goals will typically assume less risk
 Younger investors typically take long-term approaches
Age  Older investors generally have shorter time horizons and seek more stable
(Impacted by time frame investments
and risk tolerance) • 100% - Age = % of equity often used for asset allocation questions
• Tax implications for retirement plan distributions

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Suitability Question 1
A customer is in his late 20s, has an above-average income, has his own home and other valuable assets, and has
little debt other than his mortgage. He tells his RR that his goal is to retire before age 55. He indicates that the stock
market makes him nervous and he’s never been comfortable putting his money in anything but money-market funds.
Which of the following is TRUE regarding this situation?
I. The investor’s low risk tolerance is unsuitable for a person in his situation and the RR should ignore it.
II. Since the investor is capable of assuming risk, the RR cannot recommend conservative strategies.
III. Regardless of whether the investor can assume some risk, the RR must take his low risk tolerance into account
when making recommendations.
IV. Once the investor reveals his low risk tolerance, the RR cannot attempt to convince him that assuming a moderate
level of risk may be suitable.

Clients’ Financial Objectives

OBJECTIVES
Preservation of Growth/Capital Tax
Current Income Speculation Speculation
Capital/Income Appreciation Relief
Time
Short to Medium Medium Long Long Short Varies
Horizon
 Micro-Cap
 Bonds
Stocks
 Bond Funds
 Sector Funds  Tax-Exempt
 Income  Option
 Common  Aggressive Muni Bonds
Funds Strategies
Stock Growth and Funds
 Money  Preferred  Leveraged
 Growth Funds  Annuities,
Market Stock ETFs
Stock  High-Yield IRA and
Securities Funds  Utility Stock  Short
 ADRs Bonds Retirement
 T-Bills  Investment Positions
 Stock Funds  BDCs Plans
 CDs Grade Bonds  Margin
 Index Funds  Hedge  DPPs
 T-Bonds and Trading
 Stock ETFs Funds  CESA and
Notes  Day Trading
 Drilling and 529 Plans
 U.S. Agency
Raw Land
Debt
Partnerships

Risk Low Medium High Higher Highest Varies

Steady, reliable
Phrases
Parking funds, stream of income, Speculation, able
associated Capital Aggressive, short- High tax bracket,
safety, liquidity, in retirement and to withstand
with the and income in need of fixed
appreciation
potential losses
term speculation professional role
objective income

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Suitability/Risk Spectrum
Moderately Moderately Aggressive/
Conservative Moderate
Conservative Aggressive Speculation

Little Risk / Low Risk / Some Risk / High Risk / Extremely Risky /
Capital Preservation Low Return Higher Return Even Higher Return Highest Return

 Cash  Investment-  Blue Chips and  Growth Stocks  High-Yield Bonds

 Money Market Grade Corporate Utility Stocks  Growth Mutual  Precious Metals
Instruments Bonds  Growth and Funds  Hedge Funds
 Money Market  Income Mutual Income  Sector Funds  Oil and Gas
Mutual Funds Funds (Balanced)  Small/Micro-Cap Limited
 Preferred Stocks Mutual Funds Stocks Partnerships
 Fixed Annuities  Index Mutual  Certain Option
 U.S. Government Funds Positions
and Municipal  ETFs  Leveraged ETFs
Bonds  Variable  Short Stock
Annuities Positions
 Convertible
Bonds
 REITs

Suitability Question 2
A 32-year-old customer wants capital appreciation and is willing to accept a moderate level of risk. The customer is
concerned about the impact of inflationary risk on his portfolio. Which of the following investments is the MOST
suitable?
I. Equities
II. Treasury bond
III. High-yield corporate bond
IV. Variable annuity

Suitability Question 3
An investor who just turned 35-years-old wants capital appreciation and tax-deferred growth. She’s willing to accept a
moderate level of risk in her initial investment; however, she’s concerned about the impact of inflationary risk on her
portfolio. Which of the following investments is the MOST appropriate?
I. Equities
II. Treasury bond
III. High-yield corporate bond
IV. Variable annuity

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Suitability Question 4
An investor has been heavily invested in gold. Now that he’s retired, he wants to diversify and move some of his
investments into assets that will help to pay his expenses. Which of the following investments/strategies should an RR
recommend to the investor?
I. Buy a CMO Z-tranche
II. Sell equity options
III. Buy preferred stock
IV. Buy common stock

Age Considerations
 Younger individuals generally can accept more risk since they have longer to earn and build capital
 Individuals nearing retirement typically need to be more conservative with their investments

Time Horizon
 100 – Age = Equity
• A formula often used to determine the percentage of the portfolio that should be devoted to equities
‒ The younger the investor, the greater the percentage in growth investments (e.g., equity)
‒ The older the investor, the greater the percentage in more conservative investments (e.g., debt)

Asset Allocation
Asset allocation focuses on a portfolio constructed of various
asset classes
An optimal portfolio (one producing the greatest return for a
given amount of risk) is based on a client’s goals, expected
return, and risk tolerance

Suitability Question 5
A couple are both in their late 40s and are seeking to grow their investment portfolio. Which of the following portfolio
recommendations would be the LEAST suitable?
I. 10% Money Market, 70% Municipal Bond Fund, 20% Convertible Bond
II. 5% Cash, 40% S&P Index ETF, 10% Foreign Stock Mutual Fund, 45% Corporate Bond Fund
III. 20% Money Market Mutual Fund, 20% Growth Fund, 20% High Yield Bond, 40% in a Balanced Fund
IV. 10% Cash, 30% GNMAs, 20% Foreign Bond Fund, 10% in each of four different Blue Chip stocks

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Suitability Question 6
A 42-year-old New Jersey resident recently inherited $750,000. She’s married, has two children (ages 15 and 11), and
is a partner in a dental practice. She earns $325,000 with benefits, while her husband is a radiologist and earns
$175,000. They can comfortably handle their mortgage, car payments, two annual vacations, and life insurance
premiums. When re-assessing their portfolio, given their windfall, what should an RR recommend?
I. 45% Money-Market Funds, 35% State of New Jersey Bond Fund, 20% Index Fund
II. 65% Options, 20% REITs, 15% CMO tranche
III. 40% AA-Rated Corporate Bonds, 40% New Jersey Turnpike Bonds, 20% Sector Fund
IV. 40% Zero-Coupon Bonds, 55% Large-Cap Equity Fund, 5% Options

Suitability Question 7
A 56-year-old single mother has one child who started college two years ago. After receiving several unusually large
bonuses, she’s interested in finding the best investment strategy for maximizing tax-free income. Which of the
following represents the BEST allocation for the funds?
I. Contribute the maximum annual amount to a 529 plan
II. 50% ETF, 20% Treasury Inflation-Protected Securities (TIPS), 15% Dormitory Bonds, and 15% GO Bonds
III. 20% High-Yield Corporate Bonds, 20% Utility Revenue Bonds, 20% General Obligation Bonds, 20% Treasury
Bonds, and 20% Grant Anticipation Notes
IV. 40% General Obligation Bonds, 20% High-Yield Municipal Bonds, 20% Airport Revenue Bonds, 10% Special Tax
Bonds, and 10% Housing Revenue Bonds

Suitability Question 8
An individual is a fairly aggressive investor and is willing to take significant risk in his portfolio. He has made an
investment in a very volatile stock and is seeking a recommendation of how to best protect that position. Which of the
following recommendations is the MOST suitable?
I. Sell call options against the stock
II. Enter a sell stop order on the stock
III. Buy puts on the stock
IV. Sell put options against the stock position

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Suitability Question 9
A customer is in her late 40s and is currently in the 15% tax bracket. She recently inherited $6,000,000 and informs
you that she considers herself a somewhat conservative investor and wants your advice concerning investing the
inheritance. Which of the following choices is the BEST method of investing the funds?
I. 20% in equities, 30% in Treasury bonds, and 50% in tax anticipation notes
II. 40% in equities, a 30% mixture of in-state and out-of-state municipal bonds, 15% in Treasury bonds, 15% in
revenue anticipation notes
III. 30% in-state municipal bonds, 30% in out-of-state municipal bonds, 30% in Treasury bonds, 10% in revenue
anticipation notes
IV. 25% in-state municipal bonds, 25% in out-of-state municipal bonds, 25% in corporate bonds, and 25% in Treasury
bonds

Suitability Question 10
A couple, both in their late 50s, have a portfolio that’s structured to offset inflation and build value to prepare for
retirement. The portfolio consists of 60% growth fund, 10% international stock fund, 10% money market fund, and 20%
investment grade bond fund. The husband has lost his job and wants to adjust their portfolio. What’s the best
recommendation?
I. Sell the growth and international stock funds, invest some in an index fund, increase the investment in both the
money market fund and the investment grade bond fund.
II. Sell the investment grade bond fund and increase the investment in the growth fund.
III. Sell the international stock fund and invest the money in a high-yield bond fund.
IV. Sell the growth and international stock funds, invest the proceeds in a high-yield bond fund and retain the amount
in the money market and investment grade bond fund.

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