Congratulations — if you’ve reached this point, you’ve completed the practice exam in Chapter 17. (If you haven’t, flip back and take the test. You don’t want to spoil all the surprises, do you?) You can either stop here and review your answers, or, if you’re really, really brave, you can go to the second practice exam in Chapter 19. If you’re going to the second exam, take a 30- to 60-minute break before proceeding.

Review, review, review. And if I haven’t mentioned this yet, reviewing is definitely a good idea. Look at the questions you had problems with, retake all the questions you got wrong, and make sure you get them right the second (or third) time around. If you’re short on time but just can’t wait to see how you fared, you can check out the abbreviated answer key (without the explanations) at the end of this chapter. I explain how the Series 7 is scored in the section “Making the Grade,” just before the answer key. But I strongly suggest you come back later and — you guessed it — review.

Wait at least a week or two before taking the same test again. Retaking the test won’t help your cause if you’re just memorizing the answers.

1. D. (Chapter 7) You have to remember to look at this question from a corporation’s point of view. As a practical matter, the issuer will most likely refund the issue that will cost it the most money over the life of the issue. The first thing that an issuer would look at is the coupon rate (highest coupon first), next would be the call premium (lowest call premium first), after that, the call date (earliest call date first), and last, the maturity (longest maturity first). Following this formula leads you to Choice (D).
2. A. (Chapter 6) Common stockholders have equity (ownership) positions, as do preferred stockholders. However, bondholders are creditors, not owners.
3. C. (Chapter 6) Common stockholders of PXPX Corporation — or, for that matter, any publicly traded corporation — have a residual claim to the assets of the corporation at dissolution. PXPX Corp. common stockholders are entitled to receive a report containing audited financial statements on a yearly, not weekly, basis. Finally, PXPX Corp. stockholders never get to vote on dividends to be paid (whether stock or cash); dividends are decided by the board of directors.
4. C. (Chapter 13) Preferred stockholders and bondholders are subject to inflation risk. Inflation risk is the risk that the fixed interest or dividend payments will become worth less over time in terms of purchasing power. By purchasing convertible preferred stock, investors may convert their preferred stock into common stock of the same corporation at any time. Common stock has a greater chance of keeping pace with inflation, which reduces the inflation risk.
5. B. (Chapter 13) The quarterly dividend is $0.30, which makes the annual dividend $1.20 ($0.30 × 4 quarters).
   
6. A. (Chapter 7) Treasury bills, or T-bills, are short-term U.S. government debt securities that are issued at a discount and mature at par value. Since T-bills don't make interest payments, they are issued at a discount yield basis instead of a percentage of the dollar price.
7. A. (Chapter 7) You have to remember that accrued interest on U.S. government bonds is calculated in actual days instead of 30-day months like corporate and municipal bonds. U.S. government bonds settle in one business day from the trade date, so the settlement date is March 17 (3/17). Next, you need to subtract the previous coupon date, which is January 1 (1/1), from the settlement date.

   3/17	January +1
   1/1	February –2
   2 months 16 days	–1
   × 30
   60 + 16 = 76 – 1 = 75 days

   Next, multiply the 2 months by 30 days to get a total of 60 days. Then add the 16 days you get after subtracting 1 day from 17 days and you have a total of 76 days (60 + 16). Because U.S. government bonds are calculated in actual days, you need to add an extra day for January (31 days in January) and subtract 2 days for February (28 days in February). After subtracting the 1 from 76, you get an answer of 75 days. Note: Don’t add or subtract days for the settlement month (in this case March) because you didn’t go through the end of the month.

8. B. (Chapter 8) In order to determine the best investment for Jake, you must do a tax-equivalent yield (TEY) calculation. To accomplish this, you need to know Jake’s tax bracket. Remember, the interest received from municipal bond investments is tax-free, and investors in higher tax brackets save more money by investing in municipal bonds when compared to other investments. The Series 7 examiners are testing you to make sure you know that the other items listed here are not relevant to the question.
9. C. (Chapter 12) For an investor to profit when holding a long call, the investor has to exercise the option when the market price is above the strike (exercise) price plus the premium paid.
10. D. (Chapter 7) Collateralized debt obligations (CDOs) are asset-backed securities backed by a pool of bonds, loans, or other debt instruments. CDOs are broken down into tranches (slices) of differing amounts of risks and/or maturities. Because of the complexity of these investments, they’re not suitable for new or smaller investors; they’re more suitable for institutional or sophisticated investors.
11. D. (Chapter 5) When a company decides to go public, it must file a registration statement with the SEC. The registration statement must include
    • The issuer’s name and a description of its business
    • The names and addresses of all the issuer’s control persons (in other words, officers, directors, and investors owning 10 percent or more of the issuer’s securities)
    • What the money raised will be used for
    • The capitalization of the issuer
    • Complete financial statements
    • Whether there are any legal proceedings against the issuer
12. D. (Chapter 5) The securities listed in this question are all nonexempt, meaning that they all have to register with the SEC. The Securities Act of 1933 requires all new nonexempt issues of securities sold to the public to be registered. In general, exempt issues include municipal securities, U.S. government securities, bank issues, private placements, intrastate offerings, and securities issued by nonprofit organizations.
13. B. (Chapter 5) Remember, there's a difference between exempt securities and exempt transactions. Exempt transactions include intrastate offerings, Regulation D offerings, and Regulation A offerings. There are other securities that are exempt from registration based on who's issuing the securities. Exempt securities include: U.S. government securities, municipal bonds, securities issued by banks, public utility stocks or bonds, and so on.
14. D. (Chapter 16) I hope you found this question to be fairly easy. Confirmations must include pretty much all the information regarding the trade, including all the choices listed.
15. D. (Chapter 10) Mutual (open-end) and closed-end funds are considered management companies because they have actively managed portfolios and are defined as such according to the Investment Company Act of 1940. Because unit trusts do not have actively managed portfolios, they’re not considered management companies and have their own classification.
16. A. (Chapter 15) Qualified plans under IRS laws allow investors to invest money for retirement with pre-tax dollars (you can write qualified plan contributions off on your taxes). In addition, earnings accumulate on a tax-deferred basis (the investor isn’t taxed until withdrawal). However, distributions (tax-deferred earnings and contributions) for which the participant receives a tax deduction are 100 percent taxable.
17. D. (Chapter 10) Tricky, tricky. The Series 7 examiners want to make sure you know that a variable annuity is derived from two separate products: an insurance contract and securities held in a separate account. Consequently, a variable annuity must be registered with the State Insurance Commission (for the insurance contract) and the Securities and Exchange Commission (for the securities held in the separate account).
18. B. (Chapter 16) The customer’s signature is not required on a trade confirmation. However, the customer’s account number, the registered rep’s ID number, the trade date, whether the customer bought or sold, the number of shares or par value of bonds, the yield (if bonds), the CUSIP number, the price of the security, the total amount paid, the commission (if on an agency basis), and the net amount are all required on the confirmation.
19. D. (Chapter 16) Brokerage firms, investment companies, investment advisers, and so on, must have and adopt written policies for protecting customer's records and account information, which is covered under Regulation S-P.
20. B. (Chapter 16) Recommendations made to a customer must fit that customer’s objectives and risk tolerance. A review by a principal is necessary if the recommendations result in a trade. For the Series 7 exam purposes, individual recommendations are governed by FINRA, not the FRB (Federal Reserve Board).
21. A. (Chapter 16) If a registered representative believes that a customer is making an unsuitable trade, the representative may enter the order but must mark the order ticket “unsolicited.” In this question, the client is making a trade that you believe is unsuitable for her, but you can still execute the trade as long as you mark the order ticket as “unsolicited,” which will protect you and make your client happy.
22. B. (Chapter 15) I recommend that you set up the equation as if you’re dealing with one bond and then multiply the answer by 10 at the end. Mr. Jefferson purchased the bonds at $1,050 (105 percent of 1,000 par) and the bonds are maturing at $1,000 par. So as far as the IRS is concerned, Mr. Jefferson is losing $5 per year ($50 loss divided by 10 years) on the value of a bond. Because he sold the bonds in three years, the total amount of amortization per bond would be $15. After subtracting the $15 from the $1,050 purchase price, you see that the new cost basis is $1,035. After three years, Mr. Jefferson should sell the bonds for $1,035 each to break even. Because the bonds were sold for $1,020 (102 percent of 1,000 par), he had a loss of $15 per bond. Because Mr. Jefferson had 10 bonds, he had a capital loss of $150.
    
    
    
    
    
23. B. (Chapter 15) Qualified cash dividends received from stocks are taxed at a maximum rate of 0 percent, 15 percent, or 20 percent depending on the investor’s adjusted gross income (AGI). Non-qualified dividends are taxed at the investor's tax bracket.
24. D. (Chapter 16) The Bank Secrecy Act establishes the U.S. Treasury Department as the regulator of anti-money-laundering programs. As such, all broker-dealers are required to have programs set up to help detect the possibility of money laundering. Broker-dealers must also review the OFAC’s (Office of Foreign Asset Control’s) SDN (Specially Designated Nationals) list to determine that they’re not doing business with organizations or individuals that are on the list.
25. A. (Chapter 10) Life-cycle funds are actually funds of funds, which are based on an investor’s age. Investors buy a life-cycle fund designed for people their age. Life-cycle funds adjust their holdings every so often so that investors are taking less risk as they get older. Because younger investors can afford to take more risk, a larger percentage of their portfolio is in equities and less is in fixed-income securities. As investors get older, they should have an increasing number of fixed-income securities and less equity securities. Life-cycle funds automatically take care of that for investors.
26. C. (Chapter 16) Mutual fund account statements must be sent out at least semiannually (once every 6 months). However, if there was any trading done in the account, a statement must be sent out that month.
27. D. (Chapter 13) Systematic risk is also known as market risk. Systematic risk is the risk that securities could decline due to negative market conditions. All securities are subject to systematic risk.
28. B. (Chapter 7) Secured bonds are ones secured with collateral. Secured bonds include mortgage bonds, equipment trusts, collateral trusts, and guaranteed bonds.
29. C. (Chapter 8) Municipal fund securities include ABLE accounts, LGIPs (local government investment pools), and Section 529 plans. 529 plans are also known as qualified tuition plans because they allow money to be put aside by investors for qualified expenses for education.
30. A. (Chapter 12) The easiest way for you to see what’s going on is to set up an options chart. This investor wrote (sold) the XYZ put for a premium of 2.75, so you have to put $275 (2.75 × 100 shares per option) in the “Money In” side of the chart because the investor received the money for selling the option. Next, the option was exercised, so you have to put $3,000 (the 30 strike price × 100 shares per option) in the “Money Out” side of the chart because “puts switch,” meaning that the exercised option has to go on the opposite side of the chart from the premium. After that, the investor sold the 100 shares of stock in the market for $27.50 per share for a total of $2,750, which goes in the “Money In” side of the chart because the investor received money for selling the stock. Total up the two sides and you see that the investor received $3,025 and spent $3,000 for a whopping profit of $25.

    

    
31. D. (Chapter 12) The easiest way for you to see what’s going on is to set up an options chart. Mrs. Smith purchased 100 shares of ABC at 35, so you have to put $3,500 (35 × 100 shares) in the “Money Out” side of the chart. Next, Mrs. Smith wrote (sold) an ABC call for 5.50, so you have to put $550 (5.50 × 100 shares per option) in the “Money In” side of the chart. After the stock increased, the call was exercised, so you have to put the exercised strike price of $4,000 (40 strike price × 100 shares per option) under its premium of $550 because “calls same,” meaning that for call options, the premium and the exercised strike price go on the same side of the chart. Total up the two sides and you see that Mrs. Smith had a gain of $1,050.

    

    
32. D. (Chapter 8) Factors that affect the marketability (how easy it is to buy and sell) of municipal GO (general obligation) bonds are the quality, maturity date, call features, coupon rate, block size, dollar price, issuer’s name, sinking fund, and credit enhancements (in other words, insurance).
33. B. (Chapter 16) You will find that this is not an unusual situation. When you’re opening an account for a new customer, the customer may not feel comfortable sharing all her financial information with you. However, you can still do trading in the account and make recommendations if you can determine financial information from other sources, such as D&B cards. Say, for example, that the D&B card says that the customer is the CEO of a corporation that made $5 billion last year. You can assume the customer has a lot of money. The recommendations you make to a customer should be suitable to her investment objectives and financial situation. If you can’t determine the information from other sources, you can still make trades and recommendations that would be suitable for all investors, such as mutual funds or U.S. government securities.
34. D. (Chapter 9) Because this margin account has a debit balance, it’s a long account; short accounts have a credit balance. The easiest way to deal with margin questions of this type is to set up a long margin account formula:
    

    Because the LMV equals $20,250 and the DR equals $3,000, the EQ has to be $17,250. From there, you have to compare what the investor should have in equity to be at 50 percent (Regulation T) of the LMV with what is actually in equity. With Regulation T at 50 percent, which is standard, the investor should have $10,125 in EQ to be at 50 percent. However, the investor actually has $7,125 more than that, so that is the investor’s excess equity.

35. B. (Chapter 5) A preliminary prospectus includes the purpose for the funds and financial statements. Because a preliminary prospectus (red herring) is printed before the final price is established, it may include a projected price range that is subject to change.
36. C. (Chapter 5) Certain purchases, such as a Regulation D private placement, may require investors to be accredited (although they have a 35 unaccredited investor exclusion). Accredited investors are ones with a net worth of at least $1 million excluding any equity they may have in their primary residence, or ones with an annual income of at least $200,000 (or $300,000 for joint accounts) for the last two (not three) years that’s expected to stay at least the same for the current year.
37. A. (Chapter 14) DMMs (Designated Market Makers) create a trading platform for particular securities on an exchange. DMMs not only trade out of their own inventory as dealers but also execute trades for others as a broker.
38. D. (Chapter 12) A long combination is when an investor purchases and calls a purchase a put on the same security but with different strike prices and/or expiration months. So when an investor purchases a straddle, the maximum potential gain is unlimited on the call side.
39. B. (Chapter 16) The SEC and FINRA require member firms to send customer account statements at least quarterly (once every 3 months) for inactive accounts. To help you remember how often account statements should be sent out, think “AIM”:

    A = Active account (monthly)

    I = Inactive account (quarterly)

    M = Mutual fund (semiannually)

40. C. (Chapter 10) Hybrid REITs (Real Estate Investment Trusts) trade on an exchange, provide mortgage loans to developers, and hold a portfolio of securities. Hybrid REITs are a combination of equity (ownership) and mortgage REITs.
41. D. (Chapter 9) When a corporation opens a margin account, the corporation has to provide a corporate charter, which needs to say that the corporation can buy securities on margin, and a corporate resolution, which says who has the trading authority for the account. A new account form is always needed for any type of account. The corporation also needs a hypothecation agreement, which allows the broker-dealer to hold the securities in street name so that they can be used as collateral for a loan. In addition, the corporation needs a credit agreement, which sets the terms for the loan.
42. C. (Chapter 8) The Municipal Bond Index is the average dollar price of 40 highly traded GO and revenue bonds with an average maturity of 20 years and a rating of “A” or better.
43. A. (Chapter 11) Exploratory or wildcatting programs have the highest capital appreciation potential because the drilling takes place in unproven areas. If the partnership finds oil, it paid relatively little for the land as compared to drilling in proven areas, so the capital appreciation potential is high.
44. A. (Chapter 13) Certainly, any information you can get about your client will help you set up a portfolio that fits the client’s needs. However, because Martina’s primary investment objective is making sure that she’s prepared for retirement, you need to begin by looking at her age. Someone who is younger can take more risk than someone who is older.
45. D. (Chapter 16) Pursuant to Conduct Rules (not the SEC), registered representatives may never guarantee a customer against losses; therefore, this action is never permitted. If the investor wanted to sell the shares, he would have to sell them at the bid price of $12.40, not $15.
46. D. (Chapter 7) The expression “quality over quantity” applies here. Rating services are concerned with quality, defined as the issuer’s (or guarantor’s) default risk or ability to pay interest and principal on time. The two biggest rating services are Moody’s and Standard & Poor’s. The highest ratings for these rating services are Aaa and AAA, respectively.
47. A. (Chapter 9) Remember, you can’t tender stock that is borrowed, and stock in a short account is borrowed stock.
48. D. (Chapter 16) All order tickets need to include the items listed in the question plus the customer’s account number; the number of shares or bonds being purchased or sold; whether the customer is buying, selling, or selling short; whether the customer is covered or uncovered (option orders); whether it’s a market order, good-till-canceled, and so on.
49. D. (Chapter 8) All the choices listed are important factors that can be used in determining the amount of commission, markup, or markdown charged on the purchase or sale of municipal securities.
50. C. (Chapter 6) Cumulative voting allows shareholders to aggregate (combine) their votes and vote for whomever they please. For argument’s sake, if an investor owned 1,000 common shares and there were four members of the board of directors open for vote, the investor could use all 4,000 votes (1,000 shares × 4 members) for a single candidate, if desired. Cumulative voting can be used to make it easier for smaller shareholders to gain representation on the board of directors.
51. D. (Chapter 6) The purpose of ADRs (American Depositary Receipts) is to facilitate the trading of foreign securities in U.S. markets. ADRs carry currency risk because distributions on ADRs must be converted from foreign currency to U.S. dollars on the date of distribution. The trading price of the ADR is actually quite affected by currency fluctuation, which can devalue any dividends and/or the value of the stock.
52. A. (Chapter 7) CMOs are backed by home mortgages, which are considered to be very safe (although not as safe as in previous years), and therefore are generally rated AAA.
53. D. (Chapter 5) Unless exempt, securities must be registered on the state level as well as with the SEC. State registration types are notification, coordination, and qualification.
54. D. (Chapter 16) After receiving Keith’s written complaint, the municipal securities broker-dealer must accept the complaint and write down any action taken to resolve the complaint. All broker-dealers should keep a complaint file for each customer and keep accurate records of any communications or actions taken regarding a complaint.
55. C. (Chapter 8) EMMA (Electronic Municipal Market Access) is a centralized online site that nonprofessional, retail investors can use to locate key information about municipal securities. Available on this site are official statements for most new municipal bond offerings and up-to-the-minute access to prices for outstanding municipal bonds.
56. C. (Chapter 12) You have to remember that sellers (shorters or writers) of options always face more risk than buyers; the buyer’s risk is limited to the amount invested. However, sellers of put options do not face a maximum loss potential that’s unlimited because put options go in-the-money when the price of the stock goes down below the strike price, and it can only go down to 0. Sellers of uncovered calls face a maximum loss potential that is unlimited because call options go in-the-money when the price of the stock goes above the strike price, and the seller has to purchase the stock at a price that could go higher and higher. Additionally, investors who short stock as in Statement II face a maximum loss potential that’s unlimited because the investors have taken a bearish position and lose money when the price of the security increases, and there’s nothing stopping the stock from increasing in value. Investors who have sold covered calls don’t face an unlimited maximum loss potential because they have the stock to deliver if exercised.
57. D. (Chapter 12) These trades aren’t suitable for any investor because it’s impossible for the investor to make a profit. I’ve set up an options chart to demonstrate to you how this is so. First, put the premiums for the options in the chart. Because the investor bought the May 30 call option at 8, you have to put $800 (8 premium × 100 shares per option) in the “Money Out” side of the chart. Next, put $300 (3 premium × 100 shares per option) in the “Money In” side of the chart because the investor sold that option. Because the investor has $800 out and $300 in, you know that the investor’s maximum loss potential is $500 ($800 – $300). To get the maximum gain, you have to exercise both options. Because “calls same,” you have to put the exercised strike prices below their respective premiums in the chart. Place $3,000 (30 strike price × 100 shares per option) under its premium of $800 and place $3,500 (35 strike price × 100 shares per option) under its premium of $300. After that, you have to total the sides to see that because the “Money In” side and the “Money Out” side of the chart each equal $3,800, there’s no way the investor can make a profit.

    

58. C. (Chapter 15) Remember that short-term gains or losses are ones that take place in one year or less. The fact that Fred purchased a call option does not affect his holding period on the stock that he purchased. Because Fred has held the stock for 19 months (1 year and 7 months), the sale of the stock would be treated as a long-term capital gain or long-term capital loss.
59. D. (Chapter 16) No rules prohibit opening an account registered as joint tenants with rights of survivorship (JTWROS) for two unmarried persons. The registered representative should, however, take all steps to be sure that the unmarried individuals understand the resulting consequences should one party to the account die. For example, in an account registered JTWROS, if one of the engaged parties to the account (for example, John Dow) dies, the deceased party’s ownership interest in the account passes to the surviving tenant (Jane Dough) rather than to the deceased party’s (John Dow’s) estate.
60. D. (Chapter 16) Advertisements that include recommendations of the firm do not need to include whether a firm acted as a selling group since selling group members have no financial risk.
61. B. (Chapter 9) Because this margin account has a debit balance, it’s a long account; short accounts have a credit balance. The easiest way to deal with margin questions of this type is to set up a long margin account formula:
    

    Because the LMV equals $18,000 and the DR equals $7,000, the EQ has to be $11,000. From there, you have to compare what the investor should have in equity to be at 50 percent (Regulation T) of the LMV with what is actually in equity. With Regulation T at 50 percent, which is standard, the investor should have $9,000 in EQ to be at 50 percent. However, because the investor has $11,000 in equity, the excess equity is $2,000.

    Because the account has excess equity (SMA), it has buying power. Remember, it is SMA/RT to use your buying power, which tells you that you need to divide the SMA by Regulation T to determine the buying power:

    SMA/RT = SMA / Regulation T = $2,000 / 50% = $4,000

    Long accounts like this one generate excess equity by the securities held in the account increasing in value.

    If the investor withdraws the excess equity, she’s essentially borrowing more money from the account and the debit balance increases, not decreases.

62. C. (Chapter 9) A day-trading account requires an initial margin of $25,000, and the investor must keep $25,000 minimum equity in the account to keep trading. A portfolio margin account is relatively new and looks at the risk of the portfolio as a whole to determine the margin requirement. Only certain investors are able to take advantage of portfolio margin because it requires a certain degree of sophistication and a minimum equity of around $150,000.
63. A. (Chapter 12) Because of the additional risk involved when investing in options, such as the ability to lose all money invested or facing unlimited maximum loss, all investors must receive an ODD (Options risk Disclosure Document) prior to the first transaction. The ODD is not an advertisement; it contains the pitfalls of investing in options. After the customer receives the ODD, the ROP (Registered Options Principal) has to approve the account. Next, you can do the trade, and after that, the customer has to sign and return an OAA (Options Account Agreement).
64. C. (Chapter 14) When several bids or offers are made at the same price at a given time on the NYSE floor, the auction rules of priority (highest bid and lowest ask first), precedence (if orders are at the same price, the one that came in first is executed first), and parity (if all else is equal, the larger order is done first) allow for the efficient execution of orders.
65. C. (Chapter 14) The Designated Market Maker (DMM or Specialist) is responsible for maintaining a fair and orderly market on the NYSE floor.
66. D. (Chapter 12) Prior to a customer opening an options account and to begin trading options, he or she must receive an ODD (Options Disclosure Document or Options Risk Disclosure Document). This document explains the characteristics and risks involved in trading options.
67. B. (Chapter 16) The settlement date for stocks, corporate bonds, and municipal bonds is T+2 (2 business days after the trade date). The settlement date is the day that the issuer updates its records and certificates are delivered to the purchaser's brokerage firm.
68. B. (Chapter 14) Regulation SHO covers the rules for short sales. Under SHO rules, all order tickets must be marked as short sale as compared to long sale, which is when an investor is selling securities that are owned. In addition, all brokerage firms must establish rules to locate, borrow, and deliver securities that are to be sold short. All brokerage firms must make sure that the security can be located and delivered by the delivery date prior to executing a short sale.
69. B. (Chapter 10) As with most other investment company products, REITs have a professionally managed portfolio. Many investors use REITs as a potential hedge against a downturn in the market because often there is an inverse relationship between the real estate market and stock prices. In addition, REITs typically have a high degree of liquidity. However, there is no preferential dividend treatment for REITs.
70. A. (Chapter 8) The official statement for a municipal bond issue is similar to a prospectus for a corporate issue. The items that you find on an official statement include the offering terms, the underwriting spread, a description of the bonds, a description of the issuer, the offering price, the coupon rate, the feasibility statement, and the legal opinion.
71. B. (Chapter 10) When an investor of a variable annuity starts withdrawing money from the annuity, the accumulation units are converted into a fixed number of annuity units. However, the value of the annuity units varies based on the performance of the securities held in the separate account.
72. C. (Chapter 11) Because direct participation programs (limited partnerships) may require limited partners to come up with additional cash beyond their initial investment, investors must provide a written verification of net worth. After the general partner signs the subscription agreement, the investor is accepted as a limited partner.
73. C. (Chapter 13) Beta is a measure of how volatile a stock is as compared to the market. A stock with a beta of 1 would be equally volatile as the market, meaning that if the market increased 5 percent over a given period of time, you would expect the price of your stock to increase 5 percent. If the market declines by 5 percent, you would expect the price of your stock to decline by 5 percent. If you are purchasing a stock with a beta greater than 1, it is more volatile than the market. In this case, you are dealing with a stock with a beta of 1.6, meaning that if the market increased or decreased by 10 percent over a given period of time, you would expect the price of your stock to increase 16 percent or decrease 16 percent. A stock with a beta less than 1 would be less volatile than the market.
74. B. (Chapter 13) A head and shoulders bottom formation (inverted head and shoulders formation) is a bullish sign because it means that the stock hit a bottom and is starting to reverse. In other words, a head and shoulders bottom formation is a bullish sign because it’s the reversal of a bearish trend.
75. C. (Chapter 12) Because Michael owns 1,000 shares of WOW stock and wants to generate additional income, he could sell covered calls against the WOW that he owns. Additionally, by placing a sell-stop order for WOW slightly below the market price, Michael is protected against a major loss if WOW drops significantly.
76. B. (Chapter 12) The easiest way for you to see what’s going on is to set up an options chart. Your customer purchased 100 shares of ARGH at 44.10, so you have to put $4,410 (44.10 × 100 shares) in the “Money Out” side of the chart. Next, your customer purchased an OEX put for 4.50, so you have to put $450 (4.50 × 100 shares per option) in the “Money Out” side of the chart. If your customer closes the stock position (to close means to do the opposite … if he originally bought, to close, he has to sell) for 42.55, you have to put $4,255 (42.55 stock price × 100 shares) in the “Money In” side of the chart. Then, because you’re dealing with an option that settles in cash instead of delivery of the underlying security, you need to put the profit of $1,100 in the “Money In” side of the chart. To get the $1,100, you have to remember that put options go in-the-money when the price of the stock goes below the strike price, which it is by 11 (360 – 349), and options are for 100 shares. Total up the two sides, and you see that your customer has a profit of $495.

    

    
77. B. (Chapter 14) Unlike fill-or-kill (FOK) orders and immediate-or-cancel (IOC) orders, all-or-none (AON) orders do not have to be executed immediately. However, like FOK orders, they must be filled entirely or the order is cancelled. AON orders remain active until they are executed or cancelled.
78. B. (Chapter 16) To process an ACAT (Automated Customer Account Transfer), a brokerage firm must be a member of the NSCC (National Securities Clearing Corporation). When a brokerage firm is a clearing firm, the firm is assuming financial responsibility if a customer does not pay for a trade or does not deliver certificates that are sold.

79. B. (Chapter 9) This question is a tough one because of the way that it’s worded. I suggest that you write “increases SMA,” “decreases SMA,” or “doesn’t change SMA” next to each possible answer before answering the question.

    I. Selling securities in a margin account increases the SMA by half the amount of the sale and decreases the debit balance by half the amount of the sale (increases SMA).

    II. The purchase of additional securities in a long margin account has no effect on the SMA unless using the buying power, which you can’t assume (doesn’t change SMA).

    III. Money being deposited into the margin account by way of cash dividend or cash payment increases the SMA by the amount of the deposit (increases SMA).

    IV. A decrease in the market value of the securities doesn’t change the SMA. Remember, you don’t lose SMA until you use it (doesn’t change SMA).

    Now that you have this part down, look at the question again to see what it’s asking. Because this is an EXCEPT question, you’re looking for the statements that do not increase the SMA, which are Statements II and IV.

80. B. (Chapter 5) The spread is the sum of the manager’s fee ($0.15) and the takedown ($0.50): $0.15 + $0.50 = $0.65. The selling concession is paid out of the takedown and is not added to the spread equation.
81. D. (Chapter 14) All the Roman numeral choices listed would be considered discretionary order and would require a written Power of Attorney signed by the customer in order to be accepted. To not need a Power of Attorney, the customer must provide or agree to the number of shares (or bonds), whether to buy or sell, and the specific security. Discretionary orders do not require a customer’s verbal approval to be executed.
82. C. (Chapter 14) If dark pools of liquidity execute trades, the trades are reported as over-the-counter (OTC) transactions, not exchange transactions. Dark pools of liquidity represent pools of institutions, large retail clients, and firms trading for their own inventory. Since the clients and sizes of accounts remain anonymous, dark pools reduce transparency of the markets.
83. D. (Chapter 16) Under the Investment Company Act of 1940, mutual funds must provide semiannual reports to shareholders. To help you remember how often account statements should be sent out, think “AIM”:

    A = Active account (monthly)

    I = Inactive account (quarterly)

    M = Mutual fund (semiannually)

84. D. (Chapter 16) Actually all the information listed needs to be on the new account form. In addition, you also need the Social Security number (or tax ID if a business), the occupation and type of business, bank references, net worth, annual income, if the customer is an insider of a company, and the signature of the registered rep and a principal.
85. B. (Chapter 16) Your client must have at least $500,000 in assets available for investments to establish a prime brokerage account. Although if the account is established through an investment adviser, the minimum requirement is only $100,000. Prime brokerage firms consolidate information from all brokerage accounts the client has to provide one statement for the customer.
86. C. (Chapter 11) Real estate DPPs (direct participation programs — limited partnerships) provide advantages for investors such as depreciation deductions, appreciation potential, and cash flow, but not depletion. Depletion only applies to partnerships that deal in natural resources that can be depleted (used up), such as oil or gas.
87. B. (Chapter 13) All long-term bonds have inflationary (purchasing power) risk. Inflationary risk is the risk that the return on the investment does not keep pace with inflation. To limit inflationary risk, investors should purchase stocks. Over the long haul, stocks have more than kept pace with inflation.
88. C. (Chapter 13) To determine a stock's earnings per share (EPS), you can divide the stock's price by the PE (price earnings) ratio.
    
89. A. (Chapter 13) The PE ratio is a tool that can be used by technical analysts to help determine whether a stock is overpriced or underpriced. Typically they will compare the PE ratios of several different companies within the same industry to see if there may be a good investment opportunity. Actually, the lower the PE, the better. A company with a low PE ratio means that the earnings per share (EPS) are high as compared to its price. The equation for PE ratio is
    
90. D. (Chapter 8) Because the investor bought 50 of each bond, they were all rated AA, and they mature around the same time, you can rule out maturity, quality, and quantity as your answers. The investor’s funds are an example of geographic diversification because the bonds are from a variety of issuers around the United States.
91. A. (Chapter 12) Although you may not need an options chart to figure out the answer to this one, creating a chart is good practice, and I think it lessens your chances of making mistakes. First, because the customer purchased the option for 4.50, you need to place $450 (4.50 × 100 shares per option) in the “Money Out” portion of the chart. Next, you have to close the option for 4.55 because you buy at the ask price and sell at the bid price. To close the option, the customer has to do the opposite of what he did originally; if he originally bought the option, as he did here, to close, he has to sell. So you need to put $455 in the “Money In” side of the chart. Now you can see that the customer had a $5 gain because he received $455 for selling the option and paid $450 for buying the option.

    

92. A. (Chapter 12) To hedge means to protect. If the investor would like to hedge his position, he should buy a call on XYZ. Remember that the investor is short the stock and must buy XYZ back at some point to close his short position. Buying an XYZ call gives the investor the right to buy back XYZ at a fixed price, which would allow the investor to protect the position and not face an unlimited maximum loss potential.
93. A. (Chapter 12) The easiest way for you to see what’s going on is to set up an options chart. Because Grant bought the put for 350 (3.50 × 100 shares per option) and the stock for 6,200 (62 × 100 shares), you need to put “350” and “6,200” in the “Money Out” side of the chart. Next, Grant sold the stock for $6,400 (64 × 100 shares) and closed (do the opposite — if originally you bought, to close you have to sell) the option for $75 (0.75 × 100 shares per option). So you have to put “$6,400” and “$75” in the “Money In” side of the chart. Total up the two sides and you see that he had a $75 loss.

    

    
94. C. (Chapter 15) Options are always taxed as capital gains or capital losses. This investor purchased an option that expired worthless, and, therefore, he lost money. Because the investor held the LEAP for over one year, it’s taxed as a long-term capital loss.
95. C. (Chapter 16) Without having discretionary authority, registered representatives may not decide on whether to buy or sell, the security to purchase or sell, or the amount of shares or dollar amount to purchase for the customer. Registered representatives may, however, without written power of attorney, choose the price or timing of an order.
96. D. (Chapter 5) You must distinguish a nonexempt security from an exempt security. A nonexempt security is one that is not exempt from SEC registration; in other words, it must be registered with the SEC. Variable annuities, which carry investment risk, are nonexempt securities under the Securities Act of 1933 and must be registered before public sale. Similarly, unit trusts and mutual funds are nonexempt even though the underlying securities may be exempt, such as municipals and U.S. government securities. However, a fixed annuity is an insurance product exempt from registration with the SEC. It’s not considered a security because of the guaranteed payout.
97. B. (Chapter 10) A specialized or sector fund invests a minimum of 25 percent of its assets in a particular region or industry and would be the most suitable for Buddy.
98. D. (Chapter 11) Intangible drilling costs (IDCs), the costs involved in actually getting to the oil, provide a tax benefit to investors of an oil and gas exploratory (wildcatting) program. IDCs are items such as labor and surveys. IDCs are deductible expenses in the year in which they occur.
99. B. (Chapter 13) As investors age, they should start shifting more of their investments from stocks into bonds and cash equivalents such as money-market instruments. The thought is that older investors cannot afford to take as much risk. The standard asset allocation model suggests that you take 100 and subtract the person's age to determine the percentage that he should have invested in stocks. In this case, the investor is 60, so he should have 40% (100–60) invested in stocks and the balance in bonds and cash equivalents.
100. C. (Chapter 12) The easiest way for you to see what’s going on is to set up an options chart. Ginny purchased 2 calls and 2 puts, so the first thing you should do is put the multiplier of “× 2” on the outside of the chart; this way, it’s as if you’re dealing with single options. Because she bought the calls for 300 each (3 × 100 shares per option) and the puts for 200 each (2 × 100 shares per option), you need to put “300” and “200” in the “Money Out” side of the chart. Next, Ginny closed her options for their intrinsic value (the in-the-money amount). Because put options go in-the-money when the price of the stock goes below the strike price, just the put option is in-the-money, not the call option. With the strike price at $44.50 and the strike price at 50, the put is 5.50 in-the-money ($50.00 – $44.50). So you need to put $550 in the “Money In” side of the chart because Ginny closed the option (to close means to do the opposite — if you originally bought, you have to sell to close). Total up the two sides and you see that Ginny had a profit of $50 per option. Because Ginny bought 2 options, she had a profit of $100.

     

     
101. B. (Chapter 13) CMOs (collateralized mortgage obligations) offer no tax advantages to buyers. However, the interest received on municipal bonds is federally tax-free and sometimes state-tax-free. In addition, retirement plans allow investors to deposit money tax-free (in most cases) and the money grows on a tax-deferred basis. DPPs (direct participation programs) allow for additional write-offs, such as depreciation and depletion, which provide for a cash flow that’s greater than the net income.
102. B. (Chapter 12) She is trying to generate income, so she has to sell something. The only answer that has her selling something is Choice (B). Writing (selling) a straddle would allow her to generate income on a stock that’s remaining stable, because she would receive the premiums for selling the straddle and be able to profit if neither the call option nor the put option that are part of the straddle go too much in-the-money.
103. A. (Chapter 6) Adjustable (floating rate) preferred stock receives a dividend that adjusts according to prevailing interest rates.
104. B. (Chapter 14) Regulation SHO covers the short sale of securities. According to Regulation SHO, all order tickets must be marked as short sale (as compared to long sale). In addition, brokerage firms must establish rules to locate, borrow, and deliver securities that are to be sold short.
105. D. (Chapter 7) The bond indenture (deed of trust) is the legal agreement between the issuer and investors. The bond indenture includes the maturity date, the par value, the coupon rate, any collateral securing the bond, any callable or convertible features, and the name of the trustee.
106. A. (Chapter 16) Under the USA Patriot Act, all financial institutions must maintain Customer Identification Programs (CIPs). It is up to the financial institution to verify the identity of any new customers, maintain records of how they verified the identity, and determine whether the new customer appears on any suspected terrorist list or terrorist organization. As part of the identification program, they must obtain the customer’s name, date of birth, address (no P.O. boxes) and Social Security number.
107. D. (Chapter 11) All the choices listed are important to evaluate for investors of direct participation programs.
108. C. (Chapter 15) Withdrawals must begin by April 1 of the year after the investor turns age 70½. At that point, the investor has to take a required minimum distribution (RMD), which can be determined by looking at the IRS’s required minimum distribution worksheet.
109. D. (Chapter 7) Treasury Inflation Protected Securities (TIPS) are U.S. government bonds that pay interest payments once every 6 months. The interest payments adjust according to prevailing interest rates which means that the bond price remains more stable. TIPS have initial maturities of 5, 10, and 30 years.
110. D. (Chapter 11) An oil and gas wildcatting (exploratory) program would best suit your client’s needs. Oil and gas wildcatting programs drill in unproven areas and create quite a lot of write-offs in the early years. However, if oil is hit, a wildcatting program will bring in a lot of money.
111. B. (Chapter 8) Remember that state governments do not collect ad-valorem (property) taxes. Ad-valorem taxes are assessed by local governments (for example, towns and counties). Generally, state governments receive the most income from income taxes and sales taxes.
112. D. (Chapter 16) The Series 7 examiners may try to trip you up by throwing in an irrelevant answer choice (like the date of maturity) to find out whether you know your MSRB (municipal securities rulemaking board) rules. MSRB rules require that confirmations include whether the trade was executed on a principal (dealer) or agency basis. The amount of the dealer’s markup or markdown on a principal trade does not have to be disclosed, but the commission on an agency trade does need to be disclosed.
113. A. (Chapter 10) If John wants to profit from a possible decline in the market, he has to employ bearish strategies. Inverse ETFs (exchange-traded funds) are funds that trade on an exchange and use derivative products, such as options, to attempt to profit from a decline in the underlying securities, such as the S&P 500. Selling SPX (S&P 500) calls is a bearish strategy in which the seller profits if the underlying securities stay the same or decline in value. High-yielding bond funds (junk bond funds) are more likely to be damaged if the market declines in value, and selling OEX (S&P 100) puts is a bullish, not bearish, strategy.
114. B. (Chapter 13) When you’re determining the dividend payout ratio, you have to remember that the formula is as follows:
     

     Because this question gives you the quarterly dividend, you need to multiply by 4 to get the annual dividend of $1.00 ($0.25 × 4).

     
115. A. (Chapter 15) Municipal original issue discount bonds must be accreted; the discount is treated as part of the investor’s tax-free interest. Because these municipal discount bonds must be accreted, the cost basis is equal to the par value, and, as a tax consequence, Gerry will have no losses or gains if he holds the bond to maturity.
116. B. (Chapter 16) The Trust Indenture Act of 1939 regulates all corporate bond issues exceeding $5 million. Treasury bonds and municipal bonds, such as general obligation bonds and revenue bonds, are exempt.
117. C. (Chapter 16) As you can see, the one common denominator is that all the answer choices have the word “FINRA” in them, which tells you that being a FINRA member must be pretty important. The Code of Arbitration is mandatory in member-against-member disputes including a member firm and one of its registered reps. However, FINRA has no jurisdiction over banks or over disputes between nonmembers such as customers or issuers; in cases such as these, the nonmember decides whether to use arbitration or a Code of Procedure hearing to settle a dispute.
118. D. (Chapter 15) There are no tax consequences to Duke for converting a bond into shares of common stock. In order for Duke to have a taxable gain or loss, the shares Duke received as a result of his conversion to common stock must be sold.
119. B. (Chapter 14) A designated market maker cannot compete with public orders, so Choices (A) and (C) are no good. The responsibility of a designated market maker is to keep trading as active as possible by narrowing the spread if necessary. Therefore, the only answer that works is Choice (B) because that answer is in-between the bid and ask prices.
120. D. (Chapter 8) Municipal short-term notes such as RANs (revenue anticipation notes), BANs (bond anticipation notes), TANs (tax anticipation notes), and CLNs (construction loan notes) are used to provide short-term (interim) financing until a permanent, long-term bond issue is floated, until tax receipts increase, or until revenue flows in.
121. A. (Chapter 7) You can assume that bonds normally make interest payments semiannually (once every 6 months). However, because the first payment for this bond doesn’t take place until 7 months after the dated date, the first payment is a long coupon. After the first payment, all additional coupon payments will be made every 6 months.
122. C. (Chapter 8) You need to be careful in this case because the Series 7 examiners are asking you for a false statement. The maturity of revenue bonds may be 25 to 30 years, but the facility being built by the income received from the revenue bond issue is usually expected to last a lifetime. Revenue bonds may be issued by interstate authorities, such as tolls, and the debt service (interest and principal) on the bonds is paid from revenue received from the facility backing the bonds. In addition, revenue bonds are not subject to a debt ceiling; general obligation bonds are.
123. B. (Chapter 16) All written complaints must be handled by a principal of the firm. All written complaints must be kept on file with the firm as well as a description of how the complaints were handled.
124. A. (Chapter 8) The Series 7 examiners want to make sure you can distinguish funds raised for municipal revenue bonds from those raised for general obligation bonds. Tolls, fees, airports, power plants, water, wastewater, and so forth may all be fund generators that subsidize revenue bonds. Property taxes (ad-valorem taxes) support general obligation bonds.
125. B. (Chapter 8) Ways to diversify in municipal bonds are geographically (buying bonds from different areas of the country), type of bonds (revenue, general obligation, notes, and so on), and ratings (AAA, AA, A, B, and so on). Buying bonds with different par values does not diversify a portfolio.

Making the Grade

Here’s how the Series 7 exam is scored:

• You get one point for each correct answer.
• You get zero points for each incorrect answer.

A passing score is 72 percent. To calculate your grade for this exam, multiply the number of correct answers by 0.8 or divide it by 125. Whatever grade you get, make sure you round down, not up. For example, a grade of 69.6 is a 69 percent, not a 70. If you got 90 or more questions right, you’re getting a passing score.

The actual test contains ten additional experimental questions that don’t count toward your actual score. You can’t tell these questions apart from the questions that do count, so you may have to answer a few more questions right to get your 72 percent. Don’t sweat it. Simply come prepared, stay focused, and do your best.

Answer Key for Practice Exam 1

1. D
2. A
3. C
4. C
5. B
6. A
7. A
8. B
9. C
10. D
11. D
12. D
13. B
14. D
15. D
16. A
17. D
18. B
19. D
20. B
21. A
22. B
23. B
24. D
25. A
26. C
27. D
28. B
29. C
30. A
31. D
32. D
33. B
34. D
35. B
36. C
37. A
38. D
39. B
40. C
41. D
42. C
43. A
44. A
45. D
46. D
47. A
48. D
49. D
50. C
51. D
52. A
53. D
54. D
55. C
56. C
57. D
58. C
59. D
60. D
61. B
62. C
63. A
64. C
65. C
66. D
67. B
68. B
69. B
70. A
71. B
72. C
73. C
74. B
75. C
76. B
77. B
78. B
79. B
80. B
81. D
82. C
83. D
84. D
85. B
86. C
87. B
88. C
89. A
90. D
91. A
92. A
93. A
94. C
95. C
96. D
97. B
98. D
99. B
100. C
101. B
102. B
103. A
104. B
105. D
106. A
107. D
108. C
109. D
110. D
111. B
112. D
113. A
114. B
115. A
116. B
117. C
118. D
119. B
120. D
121. A
122. C
123. B
124. A
125. B