1. Which of the following best describes a callable bond?
- A. A bond that can be redeemed by the issuer before maturity at a specified price ✓
- B. A bond that allows the holder to convert it into common stock at a set ratio
- C. A bond whose coupon rate adjusts periodically based on a benchmark interest rate
- D. A bond secured by specific collateral pledged by the issuer
A callable bond gives the issuer the right to redeem (call) the bond before its stated maturity date, typically at a premium above par. This feature benefits the issuer when interest rates decline, allowing refinancing at lower rates. Convertibility describes a convertible bond; adjustable coupons describe a floating-rate note; collateral backing describes a secured bond.
2. An investor buys a Treasury Inflation-Protected Security (TIPS). Which of the following correctly describes how TIPS work?
- A. The coupon rate increases with inflation while the principal remains fixed at par
- B. Both the principal and coupon payments adjust upward with inflation and downward with deflation ✓
- C. The principal adjusts with inflation, but coupon payments remain fixed in dollar amount
- D. TIPS pay no periodic interest; instead, all return is realized at maturity as a lump sum
With TIPS, the principal value is adjusted based on changes in the Consumer Price Index (CPI). Because the coupon rate is fixed as a percentage of the adjusted principal, the actual dollar coupon payments rise with inflation and fall with deflation, as does the principal. At maturity, investors receive the greater of the adjusted principal or the original par value.
3. Which of the following is a characteristic of common stock that distinguishes it from preferred stock?
- A. Common stockholders receive dividends before preferred stockholders
- B. Common stockholders have voting rights, while preferred stockholders typically do not ✓
- C. Common stock carries a fixed dividend obligation
- D. Common stockholders have priority over preferred stockholders in a liquidation
Common stockholders generally have voting rights on corporate matters such as electing the board of directors. Preferred stockholders typically lack voting rights. Preferred stock, not common stock, carries a fixed (or stated) dividend and has priority over common stock in both dividends and liquidation proceeds.
4. A mutual fund that continuously issues and redeems shares at net asset value (NAV) is best classified as a:
- A. Closed-end fund
- B. Exchange-traded fund
- C. Open-end fund ✓
- D. Unit investment trust
Open-end funds (mutual funds) continuously issue new shares and redeem existing shares directly with the fund at the end-of-day NAV. Closed-end funds issue a fixed number of shares that trade on exchanges at market prices. ETFs trade intraday on exchanges. Unit investment trusts hold a fixed portfolio and do not continuously issue shares.
5. Which of the following best describes the primary difference between an exchange-traded fund (ETF) and a traditional open-end mutual fund?
- A. ETFs are actively managed, while open-end mutual funds are always passively managed.
- B. ETFs trade on an exchange throughout the day at market prices, while open-end mutual fund shares are priced once daily at NAV. ✓
- C. Open-end mutual funds can be sold short, while ETFs cannot.
- D. ETFs are only available to institutional investors, while open-end mutual funds are available to retail investors.
ETFs trade on a stock exchange intraday at market-determined prices, just like common stock. Open-end mutual fund shares are bought and redeemed directly with the fund at the NAV calculated at the close of each business day. Both can be actively or passively managed, and both are generally available to retail investors.
6. An investor purchases a zero-coupon bond. Which of the following statements is most accurate regarding this investment?
- A. The investor receives semi-annual interest payments that are exempt from federal tax.
- B. The investor receives no periodic interest payments but must recognize imputed interest income annually for tax purposes. ✓
- C. The investor receives the bond's par value plus accrued interest at maturity.
- D. The investor's principal is adjusted for inflation each year until maturity.
Zero-coupon bonds are issued at a deep discount and pay no periodic (coupon) interest. However, the IRS requires holders to recognize 'phantom' or imputed interest (also called original issue discount, OID) as taxable income each year, even though no cash is received until maturity. This is a key tax consideration distinguishing zero-coupon bonds from standard coupon bonds.
7. A customer is considering investing in a limited partnership (LP). Which of the following is a key characteristic of a limited partner's liability?
- A. A limited partner is personally liable for all debts and obligations of the partnership.
- B. A limited partner's liability is limited to the amount invested plus any additional capital calls agreed upon. ✓
- C. A limited partner has unlimited liability but is protected by SIPC insurance.
- D. A limited partner bears no risk of loss because the general partner absorbs all losses.
A defining feature of a limited partnership is that limited partners' financial exposure is capped at their capital contribution plus any agreed-upon additional capital calls. They do not bear personal liability for partnership debts beyond that amount. The general partner, by contrast, retains unlimited liability for the partnership's obligations.
8. Which of the following correctly describes a 'closed-end fund'?
- A. It continuously issues new shares and redeems them at NAV on demand.
- B. It issues a fixed number of shares through an IPO, which then trade on a secondary market at prices that may differ from NAV. ✓
- C. It is only available for purchase directly from the fund company and cannot be sold to other investors.
- D. It automatically liquidates and returns capital to investors after a fixed period of ten years.
A closed-end fund raises a fixed amount of capital in an IPO and then lists those shares on an exchange. After the IPO, shares trade between investors on the secondary market, and the price is determined by supply and demand — meaning shares can trade at a premium or discount to NAV. Unlike open-end funds, the fund does not continuously issue or redeem shares.
9. Which of the following is a primary risk associated with mortgage-backed securities (MBS)?
- A. Currency risk, because the underlying mortgages are denominated in foreign currencies.
- B. Prepayment risk, because homeowners may refinance or pay off mortgages early when interest rates fall. ✓
- C. Legislative risk, because Congress can change the par value of MBS at any time.
- D. Liquidity risk, because MBS cannot be sold on any secondary market.
Prepayment risk is the primary unique risk of MBS. When interest rates decline, homeowners tend to refinance their mortgages, returning principal to MBS investors sooner than expected. This forces investors to reinvest that returned principal at the new, lower interest rates — a phenomenon known as reinvestment risk. MBS are generally dollar-denominated and trade in active secondary markets.
10. An options contract that grants the holder the right to SELL 100 shares of stock at a specified price before expiration is called a:
- A. Call option
- B. Put option ✓
- C. Covered option
- D. Futures contract
A put option gives its holder the right, but not the obligation, to sell the underlying security at the strike price on or before the expiration date. A call option grants the right to buy. A futures contract is an obligation — not merely a right — to buy or sell. 'Covered' describes a strategy, not a type of option.