Question 1
A broker-dealer offers customers participation in a hedge fund structured as a limited partnership that employs a 130/30 long-short equity strategy. Which of the following best describes the core mechanics of a 130/30 strategy?
- A. The fund invests 130% of its net assets in fixed income securities and uses 30% leverage to purchase equity derivatives
- B. The fund takes long positions equal to 130% of net assets, funded in part by short positions equal to 30% of net assets, resulting in net market exposure of 100% ✓ Answer
- C. The fund allocates 130% of its capital to domestic equities and 30% to international equities for a total gross exposure of 160%
- D. The fund holds 130 long positions and 30 short positions simultaneously, regardless of the dollar amounts involved
Explanation: A 130/30 long-short equity strategy takes long positions equal to 130% of net assets and short positions equal to 30% of net assets. The short-sale proceeds help finance the additional long exposure, producing gross exposure of 160% and net long market exposure of 100%. It is not market-neutral; it remains fully net long while allowing the manager to express negative views through short positions.
Question 2
An investor holds a bond with a 6% coupon that was originally issued at par. The bond is now trading in the secondary market at 115. Which of the following correctly describes the relationship between the bond's coupon rate, current yield, and yield to maturity (YTM)?
- A. Coupon rate > current yield > YTM ✓ Answer
- B. Coupon rate < current yield < YTM
- C. Current yield > coupon rate > YTM
- D. YTM > coupon rate > current yield
Explanation: When a bond trades at a premium (above par), all three yields are ordered from highest to lowest as: coupon rate > current yield > YTM. The coupon rate is fixed at 6%. Current yield equals the annual coupon divided by the market price, which is less than 6% because the denominator (market price) exceeds par. YTM is lower still because it accounts for the capital loss the investor will realize at maturity when the bond is redeemed at par (100), below the purchase price of 115.
Question 3
Which of the following most accurately describes the role of the Federal Open Market Committee (FOMC) and its primary policy tool for influencing short-term interest rates?
- A. The FOMC sets the prime rate directly by issuing binding directives to commercial banks, which are required to lend to their most creditworthy customers at that mandated rate.
- B. The FOMC establishes the discount rate charged to broker-dealers for overnight borrowing in the federal funds market, bypassing the banking system entirely.
- C. The FOMC sets a target range for the federal funds rate—the rate at which depository institutions lend reserve balances to each other overnight—and uses open market operations to keep the rate within that range. ✓ Answer
- D. The FOMC controls the 10-year Treasury yield by purchasing or selling corporate bonds in the open market, thereby establishing a benchmark for all long-term borrowing costs.
Explanation: The Federal Open Market Committee (FOMC) is the monetary policy-making body of the Federal Reserve System. Its primary tool is setting a target range for the federal funds rate, which is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to each other on an overnight basis. The Fed then uses open market operations—buying or selling U.S. Treasury securities—to add or drain reserves and keep the actual federal funds rate within the target range. The FOMC does not set the prime rate directly (banks set it based on the fed funds rate) and does not purchase corporate bonds as a standard policy tool.
Question 4
A corporation issues a bond with a face value of $1,000 that pays no periodic interest but is issued at a deep discount and matures at par. An investor purchases this bond for $600. Which of the following tax treatments applies to this bond under U.S. federal tax rules for a taxable investor?
- A. The investor recognizes no taxable income until the bond matures, at which point the entire $400 gain is taxed as a long-term capital gain.
- B. The investor must annually recognize a portion of the $400 discount as ordinary interest income even though no cash interest is received, a concept known as accreted interest or phantom income. ✓ Answer
- C. The $400 discount is treated as a tax-exempt return of capital and is never subject to federal income tax.
- D. The investor may elect to defer all income recognition until the bond is sold or matures, at which point it is taxed entirely as a short-term capital gain.
Explanation: Under IRS rules governing original issue discount (OID), the difference between a bond's purchase price and its par value is treated as OID interest income. For taxable zero-coupon bonds, the investor must accrete a portion of this discount into ordinary income each year using the constant-yield method, even though no cash coupon is received. This is commonly called 'phantom income.' The gain is not treated as a capital gain; it is ordinary interest income accreted annually over the life of the bond.
Question 5
Which of the following correctly describes the primary distinction between a negotiated underwriting and a competitive bid underwriting in the municipal bond market?
- A. In a negotiated underwriting, the issuer selects the underwriter through a formal bidding process, while in a competitive bid underwriting, the issuer negotiates terms directly with a chosen underwriter.
- B. In a negotiated underwriting, the issuer works directly with a chosen underwriter to determine offering terms, while in a competitive bid underwriting, multiple underwriting syndicates submit sealed bids and the issuer awards the deal to the lowest-cost bidder. ✓ Answer
- C. Negotiated underwritings are used exclusively for general obligation bonds, while competitive bid underwritings are required for all revenue bond offerings.
- D. Competitive bid underwritings always result in higher underwriting spreads than negotiated underwritings because multiple syndicates must be compensated.
Explanation: In a negotiated underwriting, the issuer selects an underwriter in advance and collaborates with it to set the price, coupon, and terms before the offering. In a competitive bid underwriting, multiple syndicates independently submit bids specifying the interest rate and price they will pay; the issuer awards the bonds to the syndicate offering the lowest net interest cost. Many states actually require competitive bidding for general obligation municipal bonds to promote transparency and lower borrowing costs.
Question 6
An investment adviser that manages several large accounts tells the syndicate desk of a FINRA member firm that it will substantially increase the agency commission business it directs to the firm if it receives a larger allocation of an oversubscribed new issue that the firm is underwriting. The syndicate manager agrees and increases the adviser's allocation accordingly. Under FINRA rules, this arrangement is:
- A. Permitted, because an investment adviser is not a restricted person under FINRA Rule 5130
- B. Prohibited under FINRA Rule 5131 as a quid pro quo allocation, since new issue shares are being used as consideration for excessive compensation for other services ✓ Answer
- C. Permitted, provided the commission arrangement is disclosed in the final prospectus
- D. Prohibited under the spinning provision of FINRA Rule 5131, because the adviser is an existing investment banking client of the firm
Explanation: FINRA Rule 5131(a) (Quid Pro Quo Allocations) prohibits a member or associated person from offering or threatening to withhold shares of a new issue as consideration or inducement for the receipt of compensation that is excessive in relation to the services provided. Trading allocations of a hot IPO for a promise of increased commission business is the classic quid pro quo violation. Option A is wrong because Rule 5130 (restricted persons) is a separate rule; the adviser's non-restricted status does not cure the improper inducement. Option C is wrong because prospectus disclosure does not make a quid pro quo allocation permissible. Option D describes 'spinning' under Rule 5131(b), which involves allocating new issues to executive officers or directors of a company in exchange for investment banking business, which is not the fact pattern here.