Series 7 Qualification Exam: General Securities Representative Study Manual - 42nd Edition

Series 7
Qualification Exam
General Securities Representative
Study Manual – 42nd Edition
The Final Exams are a critical part of your training.

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TABLE OF CONTENTS
INTRODUCTION
CHAPTER 1 Building An Investor Profile

Developing a Customer Profile ....................................................................1-1
Financial Considerations .............................................................................1-2
Occupation .............................................................................................1-2
Income ...................................................................................................1-2
Taxation .................................................................................................1-5
Capital Gains and Capital Losses ..........................................................1-6
Filing Tax Returns ..................................................................................1-7
Taxation—Series 7 Application ..............................................................1-7
Personal Balance Sheet.........................................................................1-7
Non-Financial Considerations ......................................................................1-10
Financial Goals and Investment Objectives .................................................1-12
Regulation of Customer Interactions............................................................1-14
Know Your Customer and Suitability ......................................................1-14
Conclusion .............................................................................................1-16
CHAPTER 2 Customer Accounts

New Account Documentation ......................................................................2-1
New Account Form.................................................................................2-2
Required and Requested Information.....................................................2-3
Account Registration—Forms of Account Ownership .............................2-4
Client Authorizations Permitting Third Parties to Trade ...............................2-7
Trading Authorizations ...........................................................................2-7
Discretionary Accounts ..........................................................................2-9
Special Client Arrangements .......................................................................2-9
Pattern Day Trading Account .................................................................2-9
The Employee Retirement Income Security Act (ERISA).............................2-11
Employer-Sponsored Retirement Plans—Qualified Plans ...........................2-13
Taxation of Retirement Plans .................................................................2-14
Copyright © Securities Training Corporation. All Rights Reserved. S7 - 1

TABLE OF CONTENTS
Chapter 2 (Cont.)
Employer-Sponsored Retirement Plans—Non-Qualified Plans ....................2-15

Types of Non-Qualified Plans.................................................................2-15
Account Registration Changes and Internal Transfers.................................2-17
Customer Screening ....................................................................................2-17
Verification of Client Information ..................................................................2-19
Account Information ...............................................................................2-19
SEC Regulation SP ................................................................................2-19
Reporting Requirement and Limitations on Insiders ...............................2-21
Accounts at Other Broker-Dealers and Financial Institutions .................2-21
Approving Customer Accounts ...............................................................2-22
Account Restrictions ..............................................................................2-22
CHAPTER 3 Customer Communications

Communication Standards ..........................................................................3-1
FINRA’s Communication Rules ...................................................................3-1
Communications—Internal Review Procedures ...........................................3-3
FINRA Filing and Review Requirements......................................................3-3
Exclusions from the Filing Requirements ...............................................3-5
Communications Regarding Investment Companies ...................................3-5
SEC Rule 156—Investment Company Sales Literature .........................3-7
Use of Investment Companies’ Rankings
in Retail Communications ....................................................................3-9
Bond Mutual Fund Volatility Ratings ......................................................3-10
Communication Regarding Variable Products .............................................3-11
Options Communications.............................................................................3-12
Options Disclosure Document ................................................................3-12
Regulation of Communications ..............................................................3-12
MSRB Rules—Communications ..................................................................3-13
Advertising .............................................................................................3-13

TABLE OF CONTENTS
Chapter 3 (Cont.)
SEC Rule 15c2-12: Municipal Securities Disclosure ..............................3-13

Advertisements for Municipal Fund Securities........................................3-14
Performance Indicators ..........................................................................3-14
Communication Regarding Collateralized Mortgage Obligations .................3-15
Disclosure Standards and Required Education Materials.......................3-15
Research Analysts and Research Reports ..................................................3-16
Investment Banking and Research
Department Controls Issues .................................................................3-16
Research Reports and Public Appearances Disclosures .......................3-17
New issues—Limitations on Research ...................................................3-18
CHAPTER 4 Equities
The Corporation...........................................................................................4-1
Corporate Organization ..........................................................................4-1
Raising Capital—Financing the Corporation ..........................................4-1
Common Stock ......................................................................................4-2
Shareholder Rights ................................................................................4-3
Corporate Actions ..................................................................................4-4
Preferred Stock............................................................................................4-5
Cumulative Preferred Stock ...................................................................4-6
Non-Cumulative Preferred Stock............................................................4-6
Participating Preferred Stock..................................................................4-7
Callable Preferred Stock ........................................................................4-7
Convertible Preferred Stock ...................................................................4-7
Variable/Adjustable Rate Preferred Stock ..............................................4-8
K Shares Preferred Stock ......................................................................4-8
Common versus Preferred Stock ...........................................................4-8
Penny Stock Regulations.............................................................................4-8
Definition of Penny Stock .......................................................................4-8

TABLE OF CONTENTS
Chapter 4 (Cont.)
Penny Stock Disclosure Rules ...............................................................4-9

Sales Practice Requirements for Penny Stocks .....................................4-10
Derivative Securities ....................................................................................4-10
Preemptive Rights ..................................................................................4-10
Warrants ................................................................................................4-11
American Depositary Receipts (ADRs) ........................................................4-12
NYSE and Nasdaq-Listed Securities ...........................................................4-12
OTC Equities —Non-Exchange Securities...................................................4-13
Electronic Communications Networks (ECNs) .......................................4-13
Dark Pools .............................................................................................4-13
Tax Issues Associated with Equity Securities ..............................................4-13
Dividends—Cash Dividends ........................................................................4-13
Stock Splits ............................................................................................4-14
Rights Offerings .....................................................................................4-15
Cost Basis of Securities .........................................................................4-15
Capital Gains and Losses ............................................................................4-16
Recognition of Gains and Losses...........................................................4-16
Conclusion .............................................................................................4-18
CHAPTER 5 Fundamentals of Debt

Fixed-Income Securities ..............................................................................5-1
Basic Characteristics of Bonds...............................................................5-1
Why Bond Prices Fluctuate from Par? .........................................................5-4
Discounts and Premiums .......................................................................5-5
Bond Pricing ...............................................................................................5-6
Prices and Yields: An Inverse Relationship ................................................5-7
Calculating Bond Yields .........................................................................5-8
Redeeming Bonds .......................................................................................5-11
Call Provisions .......................................................................................5-11

TABLE OF CONTENTS
Chapter 5 (Cont.)
Put Provisions ........................................................................................5-13

Tax Issues Associated with Debt Securities ................................................5-13
Taxation of Interest ................................................................................5-14
Conclusion .............................................................................................5-14
CHAPTER 6 Corporate Debt

Types of Corporate Bonds ...........................................................................6-1
Secured Bonds ......................................................................................6-1
Unsecured Bonds ..................................................................................6-2
Non-U.S. Market Debt .................................................................................6-4
Eurodollar Bonds ...................................................................................6-4
Yankee Bond .........................................................................................6-4
Eurobond ...............................................................................................6-4
Sovereign Bond .....................................................................................6-4
Money-Market Securities .............................................................................6-5
Investor Profile .......................................................................................6-5
Types of Money-Market Securities .........................................................6-5
Convertible Bonds .......................................................................................6-8
Structured Products .....................................................................................6-13
Exchange-Traded Notes (ETNs) ............................................................6-13
Reverse Convertible Securities ..............................................................6-14
Conclusion .............................................................................................6-14
CHAPTER 7 Municipal Debt

Types of Municipal Bonds............................................................................7-1
General Obligation (GO) Bonds .............................................................7-1
Analyzing General Obligation Bonds ......................................................7-2
Revenue Bonds ...........................................................................................7-5

TABLE OF CONTENTS
Chapter 7 (Cont.)
Types of Revenue Bonds .......................................................................7-5

Legal Opinion .........................................................................................7-9
Analyzing Revenue Bonds .....................................................................7-9
Municipal Notes .....................................................................................7-13
Ratings for Municipal Notes ...................................................................7-13
Other Municipal Securities ...........................................................................7-14
Auction Rate Securities ..........................................................................7-14
Variable Rate Demand Obligations (VRDOs) .........................................7-15
Municipal Fund Securities............................................................................7-16
Section 529 College Savings Plans .......................................................7-16
529 ABLE Plans .....................................................................................7-17
Local Government Investment Pools (LGIPs) ........................................7-17
Tax Considerations ......................................................................................7-17
Preference for Local Issues ...................................................................7-18
Bond Taxation ........................................................................................7-18
Municipal Bonds—The Target Market ....................................................7-19
Capital Gains and Losses on Municipal Issues ......................................7-22
Tax Swaps .............................................................................................7-25
Conclusion .............................................................................................7-26
CHAPTER 8 U.S. Treasury and Government Agency Debt

Types of Treasury Securities .......................................................................8-1
Interest-Bearing Securities ..........................................................................8-1
Treasury Notes (T-Notes) and Treasury Bonds (T-Bonds) .....................8-1
Treasury Inflation-Protected Securities ..................................................8-3
Non-Interest-Bearing Securities ...................................................................8-3
Treasury Bills (T-Bills) ............................................................................8-4
Stripped Securities .................................................................................8-5
Accrued Interest ..........................................................................................8-5

TABLE OF CONTENTS
Chapter 8 (Cont.)
The Primary Market for U.S. Treasury Securities.........................................8-6

Federal Reserve Auctions ......................................................................8-6
Agency Securities ........................................................................................8-7
Federal Agencies ...................................................................................8-7
Government-Sponsored Enterprises ......................................................8-7
Mortgage-Backed Securities ........................................................................8-8
Pass-Through Certificates ......................................................................8-8
Federal Home Loan Mortgage Corporation (FHLMC) ............................8-9
Federal National Mortgage Association (FNMA) ....................................8-9
Government National Mortgage Association (GNMA) ............................8-9
Prepayment Risk .........................................................................................8-10
Agency Security─Investor Profile ..........................................................8-10
Collateralized Mortgage Obligations (CMOs)...............................................8-11
Regulation and Taxation ........................................................................8-11
Average Life ...........................................................................................8-11
Types of CMOs ......................................................................................8-12
Private Label CMOs ...............................................................................8-14
Collateralized Debt Obligations (CDOs).......................................................8-14
Taxation.......................................................................................................8-14
Investor Profile .......................................................................................8-15
Conclusion .............................................................................................8-15
CHAPTER 9 Investment Companies

Types of Investment Companies ................................................................9-1
Open-End Management Companies (Mutual Funds) .............................9-1
Additional Disclosure: The Statement of
Additional Information (SAI) .................................................................9-3
The Organization of a Mutual Fund ........................................................9-4
Types of Mutual Funds ................................................................................9-6

TABLE OF CONTENTS
Chapter 9 (Cont.)
High Risk Category ................................................................................9-6

Moderate Risk Category ........................................................................9-6
Low Risk Category .................................................................................9-8
Buying and Selling Mutual Fund Shares ......................................................9-10
Net Asset Value .....................................................................................9-10
Fees and Charges .................................................................................9-12
Classes of Shares ..................................................................................9-13
Methods of Reducing Sales Charges .....................................................9-14
Prohibited Sales Practices .....................................................................9-16
Mutual Fund Taxation ............................................................................9-19
Other Types of Investment Companies .......................................................9-21
Face-Amount Certificate Company ........................................................9-21
Unit Investment Trust .............................................................................9-21
Closed-End Investment Companies .......................................................9-21
Exchange-Traded Funds (ETFS) ...........................................................9-22
Conclusion .............................................................................................9-24
CHAPTER 10 Variable Products

Annuities......................................................................................................10-1
Fixed versus Variable Annuities...................................................................10-1
Fixed Annuities ......................................................................................10-2
Variable Annuities ..................................................................................10-2
How Deferred Annuities Work......................................................................10-4
Accumulation Period ..............................................................................10-4
Annuity Charges and Expenses .............................................................10-5
Annuity Period........................................................................................10-6
Factors Used to Determine the Number of Annuity Units .......................10-6
Taxation of Variable Annuities .....................................................................10-9
During the Accumulation Period .............................................................10-9

TABLE OF CONTENTS
Chapter 10 (Cont.)
During the Annuity Period ......................................................................10-9

Death Benefit Taxation...........................................................................10-10
Variable Product Regulation ........................................................................10-10
Variable Annuities─Suitability and Compliance Issues ..........................10-11
Variable Life Insurance ..........................................................................10-13
Variable Universal Life Insurance ...........................................................10-14
Taxation of Life Insurance Policies .........................................................10-14
Voting Rights..........................................................................................10-14
Conclusion .............................................................................................10-15
CHAPTER 11 Alternative Investments

Real Estate Investment Trusts (REITs)........................................................11-1
Regulation ..............................................................................................11-1
Investment Attributes .............................................................................11-1
Direct Participation Programs (DPPs) ..........................................................11-2
Advantages of Limited Partnerships .......................................................11-3
Disadvantages of Limited Partnerships ..................................................11-3
Forming a Limited Partnership .....................................................................11-4
General Partners....................................................................................11-5
Limited Partners .....................................................................................11-6
DPP Offering Practices ..........................................................................11-7
Tax Treatment of Individual Partners .....................................................11-9
Types of Limited Partnerships .....................................................................11-12
Real Estate Limited Partnerships ...........................................................11-12
Oil and Gas Limited Partnerships...........................................................11-13
Sharing Arrangements ...........................................................................11-14
Equipment Leasing Programs ................................................................11-15
Hedge Funds .........................................................................................11-15

TABLE OF CONTENTS
Chapter 11 (Cont.)
Investor Suitability .......................................................................................11-16

Conclusion .............................................................................................11-17
CHAPTER 12 Options
Overview of Options ....................................................................................12-1
Option Terminology ....................................................................................12-1
Buyers and Sellers ................................................................................12-1
Categorization of Options ......................................................................12-2
Covered and Uncovered Options Writers ...............................................12-3
Components of an Option .....................................................................12-3
Intrinsic Value and Time Value...............................................................12-4
Breakeven ...................................................................................................12-7
Adjustments to an Option Contract ..............................................................12-8
The Options Clearing Corporation ...............................................................12-10
Position and Exercise Limits ..................................................................12-10
Long-Term Equity Anticipation Securities (LEAPS) ................................12-11
Clearing Options Contracts ....................................................................12-12
Option Events ..............................................................................................12-12
Options Strategies–Buying Calls ............................................................12-14
Selling Calls ...........................................................................................12-16
Buying Puts ............................................................................................12-18
Selling Puts ............................................................................................12-20
Formulas for Basic Options Positions ..........................................................12-22
Multiple Option Strategies............................................................................12-24
Straddles ................................................................................................12-24
Long Straddles .......................................................................................12-25
Short Straddles ......................................................................................12-27
Combinations .........................................................................................12-30
Spreads .......................................................................................................12-30

TABLE OF CONTENTS
Chapter 12 (Cont.)
Classifying Spreads ...............................................................................12-30

Net Debit Spreads ..................................................................................12-32
Net Credit Spreads ................................................................................12-35
Spread Strategies ..................................................................................12-38
Butterfly Spreads .........................................................................................12-39
Using Options as a Hedge (Protection) .......................................................12-40
Long Stock + Long Put (Protective Put) .................................................12-41
Short Stock + Long Call (Protective Call) ...............................................12-43
Using Options to Generate Income ........................................................12-45
Long Stock + Short Call (Covered Call) .................................................12-46
Ratio Writing ..........................................................................................12-48
Short Stock + Short Put .........................................................................12-48
Summary of Categories ...............................................................................12-50
Buying Options.......................................................................................12-50
Writing Options ......................................................................................12-50
Straddles ................................................................................................12-50
Spreads .................................................................................................12-51
Protective Purchases .............................................................................12-51
Covered Writing—Income Generation....................................................12-52
Non-Equity Options .....................................................................................12-52
Stock Index Options ...............................................................................12-53
Index Options Strategies ........................................................................12-54
VIX Options ............................................................................................12-54
Foreign Currency Market .......................................................................12-55
Foreign Currency Options ......................................................................12-56
Contract Specifications ..........................................................................12-56
Exercise Provisions of Foreign Currency Options ..................................12-57
Hours and Method of Trading.................................................................12-57
Exercise Prices and Premiums ..............................................................12-57

TABLE OF CONTENTS
Chapter 12 (Cont.)
Trading Concepts and Strategies ...........................................................12-58

Yield-Based Options ..............................................................................12-59
Taxation of Options ................................................................................12-63
Hedging—Buying Stock and Buying Puts ..............................................12-65
Conclusion .............................................................................................12-66
CHAPTER 13 Offerings
Capital Formation ........................................................................................13-1
Offering Securities to Investors .............................................................13-1
The Role of an Underwriter/Investment Banker ..........................................13-2
Underwriting Commitments ...................................................................13-2
Distribution of Securities .......................................................................13-4
Securities Act of 1933 ..................................................................................13-5
The Registration Process ............................................................................13-7
The Preregistration (Prefiling) Period ....................................................13-7
The Cooling-Off Period .........................................................................13-8
The Post-Effective Period ......................................................................13-9
Crowdfunding .........................................................................................13-10
Prospectus Delivery Requirements ........................................................13-10
The New Issue Rule ....................................................................................13-11
New Issue Definition ..............................................................................13-11
Preconditions for Sale ............................................................................13-12
Prohibited Sales and Restricted Persons ...............................................13-12
General Exemptions...............................................................................13-13
Issuer-Directed Securities ......................................................................13-13
Exempt Securities........................................................................................13-14
Exempt Offerings .........................................................................................13-14
Regulation A (A+) ........................................................................................13-14
Rule 147 and Rule 147A ........................................................................13-15

TABLE OF CONTENTS
Chapter 13 (Cont.)
Regulation D ..........................................................................................13-17
Rule 144 ................................................................................................13-18
Rule 144A ..............................................................................................13-19
Rule 145 ................................................................................................13-20
Regulation S ..........................................................................................13-20
Additional Primary Market Regulations ........................................................13-21
Conflicts of Interest Regarding Public Offerings .....................................13-21
Secondary Market Trading of New Issues ...................................................13-23
Green Shoe Clause................................................................................13-23
Regulation M ..........................................................................................13-23
Stabilization............................................................................................13-23
Penalty Bids and Syndicate Covering Transactions ...............................13-24
The Primary Market for Municipal Bonds .....................................................13-24
Issuing GO Bonds ..................................................................................13-24
Issuing Revenue Bonds .........................................................................13-25
New Issue Underwritings .......................................................................13-25
Forming a Syndicate ..............................................................................13-25
Conclusion .............................................................................................13-31
Primary Markets Documentation..................................................................13-32
Contents of a Typical Notice of Sale ......................................................13-32
Content of a Typical Official Statement ..................................................13-32
CHAPTER 14 Account Disclosures, Risks, and Returns

Required Disclosures...................................................................................14-1
Disclosures Made Prior to Execution .....................................................14-1
Compensation and Disclosure on Equity Trades....................................14-1
Soft-Dollar Arrangements ............................................................................14-3
Client Notifications .......................................................................................14-4
Account Statements and Other Notifications ..........................................14-4

TABLE OF CONTENTS
Chapter 14 (Cont.)
Broker-Dealer Financial Information .......................................................14-5

Confirmations Statements ......................................................................14-5
Updating Account Information ................................................................14-5
Books and Records .....................................................................................14-6
Recordkeeping Formats .........................................................................14-6
Financial Exploitation of Specified Adults – FINRA Rule 2165 .....................14-7
ACATS—Transferring Accounts ..................................................................14-9
Investment Risks .........................................................................................14-10
Systematic (Non-Diversifiable) Risk .......................................................14-11
Unsystematic (Diversifiable) Risk ...........................................................14-12
Investment Returns .....................................................................................14-14
Calculating Current Yield (Dividend Yield) .............................................14-14
Calculating Bond Yields .........................................................................14-14
Cost Basis, Capital Events, and Return of Capital .......................................14-16
Additional Tax Considerations................................................................14-16
Conclusion .............................................................................................14-17
CHAPTER 15 Portfolio and Market Analysis

Suitability and a Customer’s Financial Objectives .......................................15-1
Know Your Customer and Suitability .....................................................15-2
Asset Allocation ..........................................................................................15-2
Forms of Analysis .......................................................................................15-9
Modern Portfolio Theory ........................................................................15-10
Indexes and Averages ...........................................................................15-12
Capital Asset Pricing Model (CAPM) .....................................................15-13
Information Sources for Municipal Bond Market Participants .......................15-14
Technical Analysis ......................................................................................15-16
Trading Volume......................................................................................15-17
Technical Market Theories .....................................................................15-17

TABLE OF CONTENTS
Chapter 15 (Cont.)
Charts and Patterns ...............................................................................15-19

Conclusion .............................................................................................15-22
CHAPTER 16 Fundamental Analysis

Fundamental Analysis .................................................................................16-1
The Balance Sheet ................................................................................16-1
Components of the Balance SheetAssets ..........................................16-3
The Liabilities Section ............................................................................16-3
The Stockholders’ Equity Section...........................................................16-4
The Income Statement ...........................................................................16-4
Components of the Income Statements .................................................16-5
Analyzing Financial Statements ...................................................................16-6
Liquidity Ratios.......................................................................................16-6
Capitalization Ratios ..............................................................................16-8
Book Value per Common Share.............................................................16-9
Financial Transactions and the Balance Sheet ......................................16-12
Sources of Financial InformationAnnual Reports (10-K) ....................16-14
Summary of Formulas .................................................................................16-15
CHAPTER 17 Orders and Trade Executions

Trading Overview ........................................................................................17-1
Secondary Market Trading—From Order.....................................................17-1
Capacity of the Firm ...............................................................................17-1
NYSE and Other Traditional Exchanges ......................................................17-3
The Role of the Designated Market Maker (DMM) .................................17-3
Dealer-to-Dealer Markets .......................................................................17-5
Nasdaq Trading .....................................................................................17-5
Market Maker Requirements ..................................................................17-6

TABLE OF CONTENTS
Chapter 17 (Cont.)
The Nasdaq Market Center Execution System.......................................17-8

OTC Equities—Non-Nasdaq Securities..................................................17-8
Other Execution Methods and Venues ...................................................17-9
The Consolidated Quotation System (CQS)...........................................17-10
Alternative Trading Systems (ATS) ........................................................17-10
Components of an Order Ticket ...................................................................17-10
Processing a Transaction .......................................................................17-11
Trade Routing ........................................................................................17-11
Types of Transactions .................................................................................17-12
Regulation SHO and the Locate Requirement .......................................17-12
Types of Orders ...........................................................................................17-13
Market Orders ........................................................................................17-13
Limit Orders ...........................................................................................17-13
Stop (Loss) Orders .................................................................................17-15
Order Qualifiers......................................................................................17-15
Regulation NMS (National Market System) .................................................17-17
Prohibited Trading Practices ........................................................................17-17
Fair Prices and Commissions—The 5% Markup Policy..........................17-19
The Market-Wide Circuit Breakers .........................................................17-20
Conclusion .............................................................................................17-20
CHAPTER 18 Margin
Margin .........................................................................................................18-1
Regulation T ................................................................................................18-1
Marginable Securities.............................................................................18-1
Non-Marginable Securities .....................................................................18-1
Reg. T Call .............................................................................................18-2
Loan Value .............................................................................................18-3

TABLE OF CONTENTS
Chapter 18 (Cont.)
Opening a Margin Account ..........................................................................18-3

Basics of Long Margin Positions ..................................................................18-3
Excess Equity Due to Appreciation ........................................................18-5
Special Memorandum Account (SMA) ...................................................18-5
Restricted Account .................................................................................18-7
Minimum Maintenance Requirement – Long Positions...........................18-8
Initial Equity Requirement – Long Positions ...........................................18-9
Basics of Short Margin Positions .................................................................18-9
Establishing a Short Position..................................................................18-9
Excess Equity Due to Depreciation ........................................................18-10
Minimum Maintenance Requirement – Short Positions ..........................18-11
Initial Equity Requirement – Short Positions ..........................................18-11
Combined Long and Short Positions ...........................................................18-12
Margin Requirements for Other Securities ...................................................18-12
Other Margin Customers ............................................................................18-13
Pattern Day Traders ...............................................................................18-13
Portfolio Margin Customers—Institutional Accounts ...............................18-14
Conclusion .............................................................................................18-16
CHAPTER 19 Clearing, Settlement, and Regulatory Reporting

Trading Systems and Their Functions ........................................................19-1
Order Audit Trail Systems (OATS) .........................................................19-1
Automated Confirmation Transaction (ACT)
Technology Platform ............................................................................19-2
Trade Reporting Facility (TRF) ...............................................................19-2
OTC Reporting Facility (ORF) ................................................................19-3
Trade Reporting and Compliance Engine (TRACE) ...............................19-3
Real-time Reporting Transaction System (RTRS) (Rule G-14) ..............19-3
MSRB’s Electronic Municipal Market Access (EMMA) System ..............19-4

TABLE OF CONTENTS
Chapter 19 (Cont.)
Clearing and Settlement – An Overview ......................................................19-4
Settlement Methods ...............................................................................19-4
Settlement Dates ...................................................................................19-6
Customer Payment Versus Settlement ..................................................19-7
Delivery of Physical Securities .....................................................................19-7
Paper Settlement ...................................................................................19-7
Death of an Account Owner ...................................................................19-9
Additional Settlement Issues .......................................................................19-9
Dividends ...............................................................................................19-9
Settlement and Delivery for Equity Option Exercise.....................................19-11
Deadlines for Standardized Option Contracts ........................................19-11
Clearing Options Contracts ....................................................................19-13
Conclusion .............................................................................................19-13
CHAPTER 20 Resolving Disputes and Suitability

Errors...........................................................................................................20-1
Execution Errors ....................................................................................20-1
Error Account .........................................................................................20-1
Cancel and Rebill ...................................................................................20-1
Trade Reporting Errors ..........................................................................20-2
Clearly Erroneous Transactions .............................................................20-2
Resolving Problems .....................................................................................20-4
Complaints .............................................................................................20-4
Code of Procedure .................................................................................20-4
Dispute Resolution—Code of Arbitration ................................................20-6
Mediation ...............................................................................................20-7
Disclosures Under Code of Arbitration – Updating Form U4 ........................20-8
Suitability .....................................................................................................20-11
Conclusion .............................................................................................20-31
INDEX

INTRODUCTION
Introduction
Securities Training Corporation’s Series 7 Examination Training Program is designed to assist students in
passing the examination regardless of their prior experience or educational level. Each phase of the
program has been designed carefully to present concepts in a simple manner and logical sequence. Since this
examination is under constant revision, we recommend that you visit our website at www.stcusa.com to
see if there have been changes or supplemental materials created.
In order to obtain registration as a General Securities Representative, candidates must pass both the Series
7 Exam and a general knowledge co-requisite, the Securities Industry Essentials (SIE) Exam.
This Introduction explains the various parts of the program and gives valuable information about the
Series 7 Examination. Please read this entire section before beginning the program.
About the Series 7 Examination

The Series 7 Examination is administered on a computerized testing system and consists of 125 multiple-
choice questions that are scored. However, each examination includes 10 additional experimental
questions that don’t count for or against the candidate. These 10 questions are randomly distributed
throughout the examination and are not identified as experimental. Therefore, the examination is actually
135 questions and 3 hours and 45 minutes are allotted to complete it. Each question on the examination
has four choices: A, B, C, or D. Since all questions are given equal weighting, every question should be
answered. There is no additional penalty for answering a question incorrectly. The minimum required
passing score is 72%.
Equating of Test Scores Since no two examinations are alike, the examinations may vary slightly in
difficulty. To account for these slight variations, the candidate’s examination is statistically equated to a
standard form of the examination. The purpose of statistical equating is to place all examinations on equal
ground. Equating ensures that no candidate who takes a slightly more difficult test would be at a
disadvantage, or conversely, no candidate would receive an unfair advantage by taking a slightly easier
test. Therefore, candidates with comparable ability will be given the same opportunity to pass the
examination regardless of the slight variations of difficulty of the forms of the examination that are
administered to them. Equated scores are not the actual number of test questions correct or percentage
correct.
Copyright © Securities Training Corporation. All Rights Reserved. S7 Intro - 1

INTRODUCTION
The following table provides a breakdown of the number of test questions on the Series 7 Examination based
on the job function of a registered representative (RR):
Major Job Functions Percentage of Test Questions Number of Questions

1. Seeks Business for the Broker-Dealer from
7% 9
Customers and Potential Customers
2. Opens Accounts after Obtaining and Evaluating
Customers’ Financial Profile and Investment 9% 11
Objectives
3. Provides Customers with Information about
Investments, Transfers Assets, and Maintains 73% 91
Appropriate Records
4. Obtains and Verifies Customer’s Purchase and Sales
Instructions and Agreements; Processes, Completes, 11% 14
and Confirms Transactions
TOTAL 100% 125
A detailed listing of topics tested may be accessed on FINRA’s website at the link below:
www.finra.org/web/groups/industry/@ip/@comp/@regis/documents/industry/p124292.pdf
Course Materials
STC’s Series 7 Examination Training Program consists of the following materials:
1. 20-chapter study manual
2. Final examinations with explanations
Study Manual and Exam Breakdown

The study manual, which represents the first phase of your exam preparation, consists of 20 chapters that
cover the topics tested on the Series 7 Examination. After reading each chapter, STC strongly suggests that
students go to their my.stcusa.com dashboard and create a 10-question Custom Exam that contains only
questions pertaining to the chapter just completed.
The Custom Exam may be taken with or without the explanations shown after each question is answered.
Students shouldn’t proceed to the next chapter until they fully understand the explanation for any
questions that were answered incorrectly.
S7 Intro - 2 Copyright © Securities Training Corporation. All Rights Reserved.

INTRODUCTION
Final Examinations
The final examinations and corresponding explanations represent the most important part of your test
preparation. These examinations will assist you in applying the information that you learned in the study
manual to questions that are posed in the multiple-choice format and used in the Series 7 Examination.
An examination should first be taken with the SHOW EXPLANATIONS turned on. As you read a
question, try to answer it. However, whether your answer is correct or incorrect, read the entire
explanation. You may find it helpful to highlight or take notes on any facts you didn’t know for use in
future studying.
Studying each explanation is a crucial step to passing the Series 7 Examination. By concentrating only on
the correct response and disregarding the explanation, you run the risk of memorizing answers without
fully understanding the underlying concepts.
After completing all of the examinations with SHOW EXPLANATIONS switched on, and if time permits
based on the calendar you’re following, begin the process over again by retaking each examination without
the explanations shown. If taking the test for the second time, you should strive to achieve a score of 85%
or better to show maximum retention of the material.
Registering for the Examination

To register for the Series 7 Examination, you must complete the Form U4 application. Your sponsoring
firm will then send both Form U4 and your fingerprints to FINRA for processing. Give yourself ample
time for processing to be completed. Once your information has been processed, a confirmation will be sent to
your firm.
Taking the Exam

In order to take an exam, you will need to make a test appointment. Please use the following information
to schedule an appointment and/or to learn more about the examination center:
Prometric Exam Centers
www.prometric.com/finra/
800.578.6273S
The website will provide you with the most up-to-date information regarding “Test Center Security” and
“Test Break Policies.” At the testing facility, you will be provided with:
 A four-function calculator
 Two dry-erase boards
 Dry-erase pen
For more information regarding scheduling an exam, what to expect on the day of your exam, and what
happens after your exam, please use the following link which provides information from FINRA:
www.finra.org/sites/default/files/external_apps/proctor_tutorial.swf.html

INTRODUCTION
Sample Question Formats

There are four basic multiple-choice formats found on the Series 7 Examination.
1. The Incomplete Sentence Format

This type of format requires you to choose the best conclusion to complete the sentence.
Example
The Financial Industry Regulatory Authority (FINRA) is considered:
a. An exchange
b. A self-regulatory organization
c. A U.S. government agency
d. The primary regulator of the futures industry
(The correct answer is b.)
2. The Closed Stem Format

In this format, you are asked a question and then must select the best response.
Example
Mutual funds may be described as which of the following?
a. Open-end management companies
b. Closed-end management companies
c. Face-amount certificate companies
d. Unit investment trusts
(The correct answer is a.)
3. The EXCEPT Format

This format requires you to select the one incorrect response from the choices presented.
Example
All of the following are characteristics of Treasury bills, EXCEPT:
a. They have a maximum maturity of twelve months
b. They are sold at weekly and monthly auctions
c. They are interest-bearing securities
d. They are sold at a discount
(The correct answer is c.)

INTRODUCTION
4. The Roman Numeral Format

This format is used when there is more than one correct response. Do all possible eliminations before trying
to answer the question. The answer will usually include either two choices or all four choices.
Example
Which TWO of the following are true regarding an investor who buys call options?
I. The investor has limited profit potential
II. The investor has unlimited profit potential
III. The investor has limited loss potential
IV. The investor has unlimited loss potential
a. I and II
b. I and III
c. II and III
d. II and IV
(The correct answer is c.)
Standardized Test-Taking Tips

As with any standardized test, you may be able to increase your score by employing good test-taking
techniques. An efficient technique will ensure an overall understanding of the question while helping to
avoid careless errors. It will also help you to stay alert throughout the entire exam. The following list is a
step-by-step approach that may work well for you:
Step 1: Read the question the first time through without trying to answer it. At this point, merely
form an understanding of the substance of the question.
Step 2: Carefully read the four choices. Remember, since a multiple-choice examination actually gives
you the answer, your job is to recognize the correct choice from among the distractors. By keeping these
choices in mind when you reread the question, you will be able to pinpoint the important information and
filter out any extraneous material.
Step 3: Reread the question slowly and stop at the end of each sentence to absorb the information.
You may need to exaggerate this in the beginning as you get used to applying the intense concentration
required to assure that you recognize all of the important facts and catch the misleading words or phrases
(e.g., not, except, etc.).
Step 4: Make sure that you fully understand what the question is asking. You cannot possibly answer a
question correctly before you know what it’s asking. You may need to look back to the question for
additional facts before you are ready to choose your answer.
Step 5: Read each choice a second time. As you read a choice, decide whether it’s a possible answer. If
you’re able to eliminate three of the four choices, then you have your answer. However, if you only
eliminate one or two, it will still help you narrow it down to your best choices. Reconsider the remaining
choices by comparing their differences and decide which answer is more correct. Once you have made
your decision, DON’T LOOK BACK!

INTRODUCTION
It’s important that you practice your technique so that you become proficient by the time you sit for the
Series 7 Examination. The best place to practice is on the simulated final examinations. Not only will this
practice build your technique, it will also help you to identify potential problem areas. A list of common
test-taking problems follows.
Test-Taking Pitfalls
Reading the Question Too Fast Part of the battle in attempting to pass a standardized examination is
determining what a question is asking. Regardless of how many times you read a question, you cannot
absorb the information if you read the question too quickly.
Changing Answers Going back and changing an answer means that you are second-guessing yourself.
If you employ a good test-taking strategy, there is nothing you will gain from going back to a question for
a second time. If you think you are likely to obtain the information you need from another question,
remember that this examination is written by expert test writers who are not going to give anything away.
Formulating an Answer Too Quickly When you are ready to answer a question, make sure to consider
all four of the choices that are given. Don’t formulate an answer on your own and merely look for that
choice while disregarding the others. Remember, there will often be more than one correct choice and,
while your choice may be right, it may not be the best response.
Making Careless Errors Don’t form preconceived notions when reading a test question. Always read
what is written, not what you expect to see. By keeping an open mind, reading the questions slowly, and
reading them at least two times through, you should be able to avoid these types of errors.
Study Calendars
Following this Introduction, STC has included sample study calendars. These study calendars are designed
to help students in organizing their time and allowing for a manageable amount of daily study. View each
calendar and choose the one that best fits your needs. Remember, these calendars are simply suggestions
for how you may plan your studies. Feel free to make any modifications that you deem appropriate.

Securities Training Corporation
Series 7 Top-Off 2-Week Training

MONDAY TUESDAY WEDNESDAY THURSDAY FRIDAY
To complete each chapter: Complete Chapters 4 Complete Chapter 7-8 Complete Chapters 10-12 Complete Chapters 13-15
1. Watch the On-Demand
Lecture for the chapter Take Progress Exams Take Progress Exams Take Progress Exams (Approx. 7.5 hours)
2. Read the chapter in the 1 A and B 2 A and B 3 A and B
study manual
WEEK 1
3. Build a 10-question custom Complete Chapters 5-6 Complete Chapter 9 (Approx. 8.5 hours)
exam for the chapter *
4. Create a custom flashcard
(Approx. 8.5 hours) (Approx. 8.5 hours)
deck for the chapter
Complete Chapters 1-3
(Approx. 7.5 hours)
Complete Chapter 16 Complete Chapters 19-20 Take Final Exam 1 Take Final Exam 4 Take Final Exam 7
Take Progress Exams Take Final Exam 2 Take Final Exam 5 Take Final Exam 8
Take Progress Exams 5 A and B
4 A and B
WEEK 2
Take Final Exam 3 Take Final Exam 6 Take Greenlight 2

Take Greenlight 1
Complete Chapters 17-18 (Approx. 6 hours) (Approx. 6 hours) (Approx. 6 hours)
(Approx. 8 hours)
(Approx. 8.5 hours)
* To create a Custom Exam:

Log in to my.stcusa.com. From your Dashboard, select Final Exams, then scroll down and select Create a Custom Exam. Now, select the appropriate
chapter number and, at the bottom of the screen, enter 10 in the Number of Questions box, and then selects Build Exam. You can choose whether or
not to have the explanation appear after each question is answered.
For the Final Exams: An examination should first be taken with the SHOW EXPLANATIONS turned ON. After completing all of the examinations with
SHOW EXPLANATIONS switched on, begin the process over again by retaking each examination without the explanations shown.
Copyright © Securities Training Corporation. All Rights Reserved. Customer Service 800 STC – 1223 Press 1 │Instructor Hotline 800 782 – 3926

To complete each chapter: Complete Chapters 3-4 Complete Chapters 5-6 Complete Chapters 7-8 Complete Chapters 9-10
1. Watch the On-Demand
Lecture for the chapter Take Progress Exams (Approx. 5 hours) Take Progress Exams (Approx. 5 hours)
2. Read the chapter in the
1 A and B 2 A and B
study manual
WEEK 1
(Approx. 6 hours) (Approx. 6 hours)

3. Build a 10-question custom
(Approx. 5 hours)
Complete Chapter 11-12 Complete Chapters 13-14 Complete Chapters 15-16 Complete Chapters 17-18 Complete 19-20
WEEK 2
Take Progress Exams (Approx. 5 hours) Take Progress Exams (Approx. 5 hours) Take Progress Exams
3 A and B 4 A and B 5 A and B
(Approx. 6 hours) (Approx. 6 hours) (Approx. 6 hours)
Take Greenlight 1 Take Final Exam 2 Take Final Exam 4 Take Final Exam 6 Take Final Exam 8
WEEK 3
Take Final Exam 1 Take Final Exam 3 Take Final Exam 5 Take Final Exam 7 Take Greenlight Exam 2
(Approx. 4 hours) (Approx. 4 hours) (Approx. 4 hours) (Approx. 4 hours) (Approx. 4 hours)


To complete each chapter: Complete Chapters 3-4 Take Progress Exams Complete Chapters 6-7 Complete Chapter 8
1 A and B
1. Watch the On-Demand (Approx. 5 hours) (Approx. 5 hours) Take Progress Exams
Lecture for the chapter Complete Chapter 5 2 A and B
2. Read the chapter in the
study manual (Approx. 3.5 hours) (Approx. 5 hours)
WEEK 1
3. Build a 10-question custom

(Approx. 5 hours)
Complete Chapters 9-10 Complete Chapters 11-12 Take Progress Exams Complete Chapters 14-15 Complete Chapters 16
3 A and B
(Approx. 5 hours) (Approx. 5 hours) (Approx. 5 hours) Take Progress Exams
Complete Chapters 13 4 A and B
WEEK 2
(Approx. 3.5 hours) (Approx. 3.5 hours)


Complete Chapters 17-18 Complete Chapter 19-20 Take Greenlight 1 Take Final Exam 2 Take Final Exam 4
(Approx. 5 hours) Take Progress Exams Take Final Exam 1 Take Final Exam 3 (Approx. 2 hours)
5 A and B
WEEK 3
(Approx. 4 hours) (Approx. 4 hours)

(Approx. 6 hours)
Take Final Exam 5 Take Final Exam 6 Take Final Exam 7 Take Final Exam 8 Take Greenlight 2
(Approx. 2 hours) (Approx. 2 hours) (Approx. 2 hours) (Approx. 2 hours) (Approx. 2 hours)
WEEK 4

CHAPTER 1
Building an Investor
Profile
Key Topics:
 Financial Factors
 Personal Characteristics
 Financial Objectives and Goals
 Know Your Customer

CHAPTER 1 – BUILDING AN INVESTOR PROFILE
Prior to initiating trades with a prospective customer, an RR must collect detailed information about
the customer in order to comply with both federal laws and SRO rules. Also, since each customer is
unique, an RR must develop a customer profile prior to any recommendation(s) being made. This
profile must be updated regularly due to any changes in a customer’s circumstances and needs. RRs
have a responsibility to their customers to make recommendations that are suitable in terms of type,
size, and frequency. The recommended investments must be appropriate in relation to the customer’s
needs, financial circumstances, and investment objectives.
This chapter describes how an RR develops a customer profile and addresses some of the common
customer investment objectives and concerns. Subsequent chapters will connect these objectives to
the appropriate products and/or investment strategies that best meet the customers’ needs.
Ultimately, the ability to match a customer’s objective with the most suitable product(s) is a critical
component of passing the Series 7 Examination.
Developing a Customer Profile

For RRs, the first step in creating a profile is to determine the type of customer with whom they’re
working. In some cases, an RR may be dealing with the same person who is acting in more than one
capacity. For example, a customer may be a business owner using an RR to manage the business account
as well as the owner’s personal cash management account.
Another potential scenario involves an RR managing the assets of an elderly customer. Some of the
customer’s assets are intended to fund his retirement, while he intends to bequeath the remainder of the
assets to his grandchildren. Although the RR may be dealing with the same person, the investment
recommendations would differ for the assets the customer intends to use to fund his retirement versus the
assets he intends to bequeath.
While the exam may include questions about many different types of customers—including large
institutions—the primary focus will be on the RR’s relationships with individual (retail) customers. Prior
to establishing a customer relationship, an important initial step is to determine the current state of the
prospect’s finances. Without this financial profile, an RR is unable to determine whether her advice and
recommendations are suitable.
Some customers may be reluctant to disclose all of their financial information. If a customer refuses to
provide certain information, the RR may not make assumptions about the customer’s finances. Instead, an
RR may only make recommendations based on information that has been disclosed by the customer. In
some cases, a firm may decide not to open an account based on a customer’s unwillingness to provide
sufficient background information.
Copyright © Securities Training Corporation. All Rights Reserved. S7 1-1

In order to obtain the required background information, asking customers the right questions is critical. For
financial professionals, both financial and non-financial considerations are important when constructing
appropriate investment strategies.
Financial Considerations
Most RRs initiate a profiling process by gathering financial information about their customers. This
information includes the following:
Occupation
The wide range of customer occupations will affect how RRs will deal with customers. Some customers
may have a stable job that provides a steady, reliable income. Others may have a job with fluctuating
income that’s volatile and unpredictable which may require the customer to establish a sizable cash reserve
in order to survive periods of little or no work.
In certain cases, a customer’s occupation may trigger additional regulatory obligations. For example, if a client
is employed by another FINRA member firm or a publicly traded company, special reporting rules apply.
Income
A customer’s income includes salary, wages, alimony, investment income, and qualified withdrawals from
retirement plans. As a general rule, the greater a person’s income, the more investment risk he’s able to
tolerate; and, the lower the income, the more conservative the investment strategy should be. However, the
source and reliability of the income are also important. For example, a teacher’s income is considered
steady, while the income of a commission-based salesperson may fluctuate significantly.
As part of the overall profiling process, an RR may need to assist a potential customer in creating an
income statement to determine the customer’s cash flow. Cash flow refers to the movement of cash into
and out of an account or business. Once the customer’s cash flow has been determined, an RR is then able
to calculate the customer’s discretionary or net income by adding up the total income and subtracting all
taxes and required payments (bills).
S7 1-2 Copyright © Securities Training Corporation. All Rights Reserved.

The following is an example of a personal income statement:
AN INVESTOR’S PERSONAL INCOME STATEMENT
MONTHLY INCOME
Salary $8,000
Investment Income 500
Other Income 1,000
TOTAL MONTHLY INCOME $9,500
MONTHLY EXPENDITURES
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
This statement is useful for several reasons. First, it shows the sources from which the person’s income is
derived. Second, it provides details regarding the customer’s lifestyle—how much money he spends and the
items on which he spends it. Finally, subtracting a customer’s monthly expenditures from his gross income
results in the customer’s discretionary income—in other words, the amount of money he has left each month
after essential expenses are met. Generally, persons with a greater amount of discretionary income may
adopt more aggressive investment strategies.
Now let’s take a closer look at four basic forms of income.
Earned or Ordinary Income Earned income is compensation a person receives for providing goods or
services and includes salaries, commissions, and wages earned through employment (including self-
employment). Earned income is taxed at what’s often referred to as the customer’s tax bracket. In
technical terms, this tax bracket is considered the customer’s marginal tax rate.
Marginal Tax Rate A person’s marginal rate represents the tax rate that applies to any additional dollars
of taxable income earned. Since the U.S. income tax system is progressive, a person’s tax rate rises as his
taxable income rises through two or more tax brackets.

A person’s marginal tax rate is the rate he pays on the taxable income that falls into the highest bracket
reached (e.g., 10%, 12%, 22%, 24%, 32%, 35% and 37%).
For instance, if a person has taxable income that falls into three brackets, he will pay at the 10% rate on the
first portion, the 12% rate on the next portion, and the 22% federal tax rate on only the third portion.
Therefore, his marginal tax rate is 22%.
Passive Income This category of income is derived from a business venture in which an investor
doesn’t not have an active role. Income received from a limited partnership (a type of direct participation
program) is an example of passive income. Passive income is taxed in the same manner as both earned and
investment income. The difference is that passive losses may only be used to offset other passive income
or gains, but may not be used to offset earned income or portfolio (investment) income.
Investment Income Investment income is the income derived from owning various types of investments.
Of particular importance is the understanding of the local, state, and federal tax consequences of each type of
investment income. Although a brief overview of each form of investment income will be provided, the
details of each form will be covered in the subsequent chapters that are devoted to specific products.
Dividend Income This form of investment income is paid to owners of equity securities. Since
dividends may be paid in cash or in additional shares of stock, each form of payment is treated differently
for tax purposes.
 A cash dividend is typically paid out quarterly or semiannually. These payments are taxable in the
year of receipt.
 A stock dividend is paid in the form of additional shares. These payments are not taxable at the time of
receipt. Rather than declaring the additional shares as income, the stockholder must adjust the cost
basis per share of her position in the stock.
Interest Income This form of investment income is derived from the ownership of certain debt securities
(bonds). The tax treatment of interest that’s received by investors differs according to the bond’s issuer.
Although the tax treatment of each type of bond will be covered more thoroughly in later chapters, the
following is a summary of three of the more popular types of bond investments:
Issuer Federal Taxation State and Local Taxation

Corporations YES YES
U.S. Government YES NO
Dependent on issuer and the

Municipalities NO
customer’s state of residency

Deferred Income Deferred income is the earned income in an account which requires that taxes be paid at
a later date. The earnings derived from retirement plans and annuities, such as IRA, Keogh, and 401(k) plans,
or other retirement accounts, are not currently taxed. Instead, taxes are deferred until withdrawals are taken
from the account. These withdrawals are taxed as ordinary income at the individual’s current tax bracket.
Taxation
Tax implications must be taken into account when making recommendations to customers. Frequently,
customers will ask registered representatives to recommend specific investments that will suit their tax
status. Although taxation is an important consideration, it should not be the sole factor in the
recommendations being made.
Types of Taxes Taxes may be classified as either progressive (graduated) or regressive (flat). Progressive
tax is a system in which a person with a higher income will pay taxes at a higher percentage of her income
than a person with a lower income. Progressive examples include income tax, gift tax, or estate tax. On the
other hand, a regressive tax has the same rate regardless of the amount of income which means that it hits
lower-income individuals harder. Regressive examples include sales tax, excise tax, or Social Security tax.
The laws concerning U.S. taxation are complex and constantly changing. In addition to paying taxes to the
U.S. government (federal taxes), individuals may also need to pay taxes to the state, county, and/or city in
which they live. The remainder of this section will focus primarily on those areas of the tax code that affect
securities and securities transactions.
Taxation of Investment Income The manner in which income is taxed is often a function of the source
of that income. Most earned, passive, deferred, and investment (portfolio) income is taxed as ordinary
income which is based on an individual’s tax bracket.
Special Tax Treatment for Qualifying Cash Dividends A qualified dividend is a type of dividend that’s
taxed at the same rate as long-term capital gains, rather than at an investor’s ordinary rate. Generally, most
regular dividends from U.S. companies that have normal company structures (i.e., corporations) are
qualified. However, dividends that are received from a real estate investment trust (REIT) are still taxed at
ordinary income rates since an REIT doesn’t pay corporate income tax if it distributes a minimum
percentage of its income.
Alternative Minimum Tax The Alternative Minimum Tax (AMT) was introduced as a method of
calculating tax liability to ensure that wealthy individuals who derived income from certain types of
investments pay at least a specified minimum amount of taxes. By applying the AMT, investors are not
able to avoid paying taxes altogether.
For purposes of calculating the AMT, some taxpayers are required to adjust their taxable income based on
their investment in assets that produce certain tax-preference items. Tax-preference items may include
interest on certain municipal bonds, various depreciation expenses, and a variety of events that result from
owning limited partnership interests.

Under AMT rules, these taxpayers must compute their income taxes twice. They must first calculate their
taxes using the standard method, and then they must recalculate their tax liability using the AMT method.
The taxes due will be the greater of the two calculations.
Estate and Gift Taxes Individuals may transfer assets or give a gift of up to $15,000 per year to any
number of persons (related or unrelated) without incurring gift taxes. A married couple may combine their
individual gifts for a total of $30,000 per recipient. For gifts over $15,000 per person, per year, the donor
is required to file a gift tax return. If the value of a person’s estate exceeds a certain amount, an estate tax
return is required to be filed and a tax may be assessed.
A married couple with a significant net worth is interested in providing gifts to their 10
grandchildren. In order to not be subject to gift tax or be required to file a gift tax return,
how much may be given to each grandchild?
The couple may give each of their grandchildren $30,000 per year without being subject to gift
tax or being required to file a gift tax return. Therefore, with 10 grandchildren, a total of $300,000
per year may be given.
The marital deduction allows a husband and wife to give each other an unlimited amount of property
without incurring gift taxes. The spouse who dies first may also leave an unlimited amount to the survivor
without incurring estate taxes.
Capital Gains and Capital Losses

If appreciated assets are later sold, there may be a resulting taxable event. For profits on sales, the length
of time the asset was held will determine the amount of tax that must be paid.
Capital Gains Capital gains are generated when an investment is sold for a greater value than its cost
basis. If the investment had been held for one year or less at the time of the sale, the gain is considered
short-term and is taxed at the same rate as ordinary income. However, if the investment had been held for
more than one year, the gain is considered long-term and is taxed at a maximum rate of 20%.
Capital Losses Capital losses are generated when an investment is sold for less value than its cost basis.
As with capital gains, if an investment had been held for one year or less at the time of the sale, the loss is
considered short-term. If the asset had been held for more than one year, the loss is considered long-term.
Capital losses are not taxed; instead, the IRS requires capital losses and capital gains to be netted. The
netting of capital losses against capital gains may be done with no maximum dollar limitation. The result
will be a net capital gain (taxable) or a net capital loss. Greater detail on the treatment of gains and losses
will be covered later.

Filing Tax Returns

Unmarried taxpayers may file a tax return marked single or, if they maintain a household for their
dependents, they may file a return marked head of household. Head of household filing qualifies the
individual for lower rates and a higher standard deduction.
Married couples may either file a return marked jointly or as married filing separately. Since filing jointly
provides more tax benefits, this is usually the best option for married couples. A person’s filing status is
dependent on her marital situation on December 31 in the year for which the return is being filed. Therefore,
if a couple is divorced as of December 31, 20XX, each person is considered unmarried for the entire year.
Taxation—Series 7 Application
The exam may include customer profile questions that contain limited information. For example, if the
customer is a doctor who is seeking bond interest to supplement his earned income, a person must be able
to tie together the ideas that the doctor is likely in a high tax bracket and that a tax-free bond may be the
most desirable. Conversely, if the customer is a conservative retiree who is seeking bond income, the best
choice may be a U.S. Treasury security. The reasoning for this choice is the assumption that the retiree’s
tax bracket is lower and safety of principal is likely a primary concern. Keep in mind, U.S. Treasury
securities are considered to have very low credit risk.
Personal Balance Sheet

Of course, income and its potential taxation is only one part of an individual’s financial picture. An RR
should also document what a customer owns (total assets) and what she owes (total liabilities). By listing the
customer’s total assets and subtracting her total liabilities, the RR can create a personal balance sheet and
calculate the customer’s net worth.
Simply put, Total Assets – Total Liabilities = Net Worth.

The following is an example of a balance sheet:
AN INVESTOR’S PERSONAL BALANCE SHEET
ASSETS
Tangible Property
House $500,000
Automobiles 40,000
Furniture and Jewelry 20,000
Investments
Stocks and Bonds $200,000
401(k) Plan 50,000
Pension Plan 100,000
Savings
Checking Account $2,000
Savings Account 3,000
Total Assets: $915,000
LIABILITIES
Home Mortgage $350,000
Car Loans 20,000
Credit Cards 5,000
Total Liabilities: $375,000
NET WORTH $540,000
Assets The asset component of the net worth equation represents what a customer owns and includes:
 Primary residence and other real estate
 Automobiles
 Personal possessions (e.g., furniture, jewelry, and clothing)
 Government and corporate bonds
 Stocks
 Mutual funds and annuities
 Pension plans and 401(k) plans
 Individual retirement accounts
 Money-market funds and CDs
 Savings accounts
 Cash in checking accounts

In order to analyze a customer’s financial portfolio more effectively, there are a variety of ways to list a
customer’s personal assets. For example, assets may be classified as:
 Tangible assets (e.g., real estate and personal possessions)
 Investments (e.g., stocks, bonds, and retirement plans)
 Savings (e.g., money-market funds, checking and savings accounts)
By asking a customer to list her assets, an RR is able to determine her current holdings and investment
strategies. Knowing the composition of a customer’s current portfolio is as important as knowing her net
worth. Without this information, it’s difficult for the RR to recommend investments and adequately
diversify the customer’s portfolio.
There are several ways in which an RR’s recommendations may be affected by the customer’s current
portfolio. For instance, a significant portion of a customer’s liquid net worth may be concentrated in the
stock of his employer. This is a common situation for customers who have worked for the same
corporation for a number of years and whose compensation has included stock options. In these
circumstances, an RR may recommend that the customer sell a portion of the shares in her company’s
stock and diversify her portfolio by purchasing other securities.
Liabilities The liabilities component of the net worth formula represents what a customer owes to her
creditors and includes:
 Mortgages and home equity loans
 Automobile loans
 Credit card balances
 Student loans
 Debit balances used to buy stock on margin
Net Worth A customer’s wealth is usually equated to her net worth. As illustrated on the personal balance
sheet, the customer’s net worth is the difference between what she owns and what she owes. A person’s
wealth is difficult to determine without her full financial profile. A person with a high income is not
necessarily wealthy since she may also be carrying a large amount of debt. Another person with modest income
may have accumulated a significant amount of money over her lifetime because she made wise investment
decisions, saved a substantial part of her income, or had little or no debt.
As a general rule, the greater a person’s net worth, the more investment risk she’s able to tolerate. And
conversely, the lower the net worth, the more conservative the investment strategy should be.
Liquid Net Worth It’s important to remember that the net worth figure represents everything a person
owns. However, a more realistic assessment of a person’s worth may be her liquid net worth.
Liquid net worth excludes assets that are not readily convertible into cash such as real estate, limited
partnership interests, and stock in small companies. When analyzing a customer’s financial profile, RRs
must consider her liquid net worth (e.g., stocks, bonds, mutual funds, and savings accounts) to accurately
evaluate her financial position.

Non-Financial Considerations
Developing a comprehensive picture of a customer’s financial circumstances and investment goals is a
very important role for an RR. However, there are other personal characteristics of the customer that are
also relevant.
Age In general, investors who are farther from the typical retirement age are able to tolerate more risk in
their portfolios than those closer to retirement. A person who is just starting his career has many years left
to earn additional money and more years to replace potential losses. However, investors who are in the
latter part of their careers are generally at their peak earning potential. These customers may be nearing
retirement and will have fewer opportunities to replace losses. Some long-term investments (e.g., equities)
are generally not appropriate for aging investors who will likely not outlive the benefit. One general
approach that’s used by many professionals is to subtract a client’s age from 100 to determine the
percentage of assets that should be invested in stocks. The assumption is that the older the client, the less
the risk tolerance, and therefore the less money that should be invested in equities.
Time Horizon Time horizon represents the amount of time that a customer has available to achieve his
financial goals. In general, the longer an investor’s time horizon, the more volatility (fluctuation) the
portfolio can tolerate. Investors with short time horizons usually require more stable, conservative
investments since they will need their money sooner.
For example, a 35-year-old investor who is planning for retirement will normally have a time horizon of
25 to 30 years, while a 55-year-old investor will usually have a much shorter period before retirement.
Also, the parents of an infant may have nearly 18 years to save for college, while the parents of a teenager
will have far less time.
Frankie and Larry are colleagues at an advertising agency who are both interested in
planning for retirement. Frankie is single, is in his mid-20s, and has an annual salary of
$75,000. Larry, is married with two children in college, is in his mid-50s, and is a senior
vice president earning $250,000. Based on the information provided, which person has
the shorter time horizon?
Without additional information, the assumption is that Larry has a shorter time horizon since he’s
in his mid-50s and closer to retirement. Based on the number of years he has left before he retires,
his portfolio will typically be more conservative than Frankie’s.
Investment Experience (Sophistication) Previous investment experience provides insight about a

customer’s ability to understand an RR’s investment recommendations and the accompanying risks. An
experienced investor is more likely to be able to understand the reason for certain recommendations being
made. Also, an investor who has purchased specific products in the past is likely able to comprehend the
risks and benefits of the recommendations of similar investments.

Risk Risk is defined as the chance taken that an investment’s actual return may be different from its
expected return. Customers will react differently to the concept of risk. The fact that a customer is able to
afford losses doesn’t mean that an investment is suitable. Regulatory agencies and courts have made it
extremely clear that, given all of the circumstances, suitability is dependent on whether the investment was
appropriate for the customer, not simply on whether the customer is able to afford the losses.
Risk Tolerance The ability of customers to tolerate risk is not based solely on their financial resources; it also
considers their values and attitudes. Two customers with the same financial resources could perceive risk
differently. An RR needs to pay careful attention to what investors say about their tolerance for risk, since an
investment that goes against a customer’s expressed wishes is never suitable.
Doug is a 28-year-old single lawyer who studies the market on his own. He enjoys
finding and researching high-risk investments for his portfolio. Is Doug’s desire for
aggressive investments appropriate?
Since Doug is at the early stage of his career and has no wife or children, he obviously feels that
he can assume greater risks in his portfolio. However, if Doug’s entire portfolio is composed of
aggressive investments, there’s a significant potential for loss. Doug’s RR should try to convince
him that placing all of his money in risky, long-term investments is not appropriate.
Susan is a 28-year-old doctor who just opened her own practice. In an interview with
an RR, Susan makes it clear that she’s disturbed by the thought of taking risks with her
money. Since Susan doesn’t have a high tolerance for risk, should she pursue an
aggressive investment strategy?
Although Susan and Doug are the same age, the RR should recommend a conservative program
for Susan that’s based on her specific risk tolerance.
Unfortunately, some customers may have uncertainty about their attitude toward risk, especially if
they’re new to investing. In these situation, some RRs use questionnaires to help the customers
understand their risk preferences. The customer’s answers are then compiled to form a psychological
profile regarding risk tolerance.
Social Values In addition to financial return, many investors are concerned about the social and
environmental impacts of the companies in their investment portfolios. Companies’ policies and practices
with respect to issues such as human rights, global warming, and ethical labor standards are among the
many elements that customers prioritize. Investors may request that the RR follow socially responsible
investment strategies. However, an RR should explain that this may require the exclusion of some
investments and strategies. Based on these restrictions, an RR may not be able to take advantage of the
same market trends or opportunities that would otherwise be available with other strategies.

Financial Goals and Investment Objectives

In addition to understanding the current financial profile of his customers, an RR needs to determine their
financial goals. While certain customers may have a wide range of unique goals, there are a large number
of common goals. The financial services industry usually classifies customer goals into broad categories of
investment objectives.
Capital Reserve As a general rule, most persons should commit to establishing a cash reserve that’s
equal to at least three months’ living expenses. In situations where a customer’s income is unpredictable, it
may be wise to maintain a larger cash reserve. Capital reserves should be kept in a safe, liquid investment
such as a money-market fund.
Preservation of Capital Investors who are concerned with the potential loss of capital will invest in
securities that provide safety. Although achieving a return on their investment is desired, they’re more
concerned with preservation of capital. In other words, they don’t want to put their principal at great risk.
Customers with this objective often invest in U.S. government securities, insured certificates of deposit, or
money-market funds.
Liquidity Some investors have a significant need to be able to access their funds within a short period
—in other words, they desire liquidity. While money-market mutual funds and T-bills provide a lower
return than other investments, these products are relatively safe and allow investors to have ready access
to their capital.
Current Income Investors whose primary investment goal is current income are interested in investments
that produce a steady, reliable stream of cash. Investors typically need this income to defray daily living
expenses, particularly during retirement. Some examples of income-producing investments include most
bonds, preferred stocks, and fixed annuities. The downside to income investments is that they usually produce
little, if any, growth of the original amount invested. This may be a problem over time, since inflation erodes the
purchasing power of the income.
Growth Customers whose main objective is growth want their capital to appreciate. These customers
usually expect that the capital will grow at a higher rate than other investments, ultimately outpacing the
rate of inflation. Growth investments are often used to increase assets in the long term for some future use,
such as retirement or college expenses. However, these investments involve a greater risk to principal than
income-oriented investments. Common stocks and equity mutual funds are examples of growth investments.
College Funding Many customers begin an investment program to provide for their children’s college
education. Parents (and grandparents) have some flexibility in their investment choices. Funds may be
invested in Uniform Gifts/Uniform Transfers to Minors Act (UGMA/UTMA) accounts to be used for
education expenses; however, other options include Coverdell Education Savings Accounts and college
savings programs, such as 529 Plans.

Retirement Funding Today, since life expectancy has increased, a significant goal for many investors is to
have money available for retirement. Investors who plan to retire in their mid-60s will need a retirement
portfolio that will last 20 years or more. When a person is planning for retirement, he should avoid
constructing a portfolio that’s so focused on income and preservation of capital that he risks having
inflation seriously erode the purchasing power of his retirement income over time. In other words, a client
who is focusing on his retirement goals needs to be careful about avoiding one risk (loss of principal) only
to be faced with another (inflation).
The RR should also determine whether the investor is taking advantage of available retirement plans. Usually,
the best strategy for investors is to maximize their contributions to a tax-deferred retirement plan, such as a
401(k), before they consider investing retirement assets elsewhere.
The goal of saving enough money to live comfortably during retirement is complicated by two factors—
first, income ceases once people retire, and second, even modest inflation may have a significant impact on the
long-term purchasing power of their retirement assets.
Although this is a generalization, most people will need an income that’s equivalent to 70% of their
current pre-tax income when they retire. Keep in mind that individual circumstances may make this
number higher or lower.
In order to help customers achieve their retirement goals, the government has passed legislation creating a number
of different retirement plans that allow investors to save money for retirement on a tax-deductible and/or tax-
deferred basis. These retirement plans will be addressed in a later chapter.
Speculation Investors who indicate speculation as an investment objective are seeking investments that
have the potential for above-average returns. RRs are responsible for disclosing to a customer that
investments offering greater profit potential also carry a higher degree of risk. With these investments, it’s
possible for a customer to lose his entire principal. Some of the speculative activities may involve day
trading in margin accounts or investing in asset classes such as derivatives, hedge funds, and small- or
micro-cap stocks.
RRs should be cautious when recommending speculative investments to customers. The RR must make certain
that customers (1) have sufficient financial resources to bear the loss, (2) understand the risks involved,
and 3) have portfolios that are diversified with less risky investments.
Tax Relief As previously described, some investors have substantial incomes that are subject to tax at
high marginal rates. These customers often search for investments that will provide them with tax relief. Some
investments, such as municipal bonds, produce income that’s tax-exempt (i.e., the investor is not required to
pay federal taxes on the interest). Other investments, such as annuities, traditional IRAs, and employer-
sponsored retirement plans, are tax-deferred (i.e., the investor is not required to pay taxes on the income
that’s produced until a later date).

Another potential advantage offered by a small number of investments (e.g., limited partnerships) is that
they may provide the customer with tax credits or deductions. A tax credit provides a dollar-for-dollar
reduction of the investor’s tax liability, while a deduction simply reduces an investor’s taxable income.
Meeting Fiduciary Obligations At times, assets are being invested for the benefit of a third party, such
as a child or incapacitated relative. In these cases, the RR must look at the profile and objective of the
beneficiary, not the person making the ultimate investment decisions.
Regulation of Customer Interactions

Once a customer’s objectives have been established, it’s imperative that the account be handled in a
manner that conforms to accepted industry practices and the rules and regulations of the various regulatory
bodies. The purpose and objectives of these rules are to accomplish the following goals:
 Promotion and enforcement of just and equitable principles of trade and business
 Maintenance of high standards of commercial honor and integrity by member firm personnel
 Prevention of fraudulent and manipulative activities and procedures
 Prevention of unreasonable profits, commissions, or other charges
 Protection of investors and the public interest
 Collaboration with governmental and other agencies to promote fair practices and eliminate fraud and,
in general, to carry out the purpose of FINRA and other registered securities organizations
Know Your Customer and Suitability

Once an RR has collected all of the background information on his customers, he may begin to formulate
his recommendations. Under industry rules, all recommendations must be suitable based on the facts
disclosed by the customers regarding their other securities holdings, financial situation, and needs. Remember,
the determinant of fair dealings with customers is suitability, not profitability. A recommendation that
results in a significant profit may still be viewed by regulators as unsuitable. Conversely, a
recommendation that results in a significant loss may, in fact, have been suitable.
A broker-dealer must use reasonable diligence to learn the important facts regarding every customer. This
obligation also extends to any person who is authorized to act on behalf of a customer, including an RR
who has been given the authority to enter orders in a customer’s account. Only after a registered
representative understands the financial needs of his customers may the proper investment
recommendations be made.
Suitability Broker-dealers have a suitability obligation to each of their customers. For non-institutional (retail)
customers, broker-dealers and their registered persons must have a reasonable basis for recommending a
transaction or investment strategy. These recommendations must be based on the information obtained from
the customers which is then used to identify their investment profile.

As a review, a customer’s investment profile includes the following items:

 Age
 Other investments
 Financial situation and needs
 Tax status
 Investment objectives and experience
 Investment time horizon
 Liquidity needs
 Risk tolerance
 Any other information obtained from the customer
While information pertaining to a customer’s investment expertise and prior experience are important in
determining suitability, information regarding a customer’s educational background is not.
The suitability requirements apply to both any recommended transaction (e.g., the purchase of a specific
security) and any investment strategy (e.g., day trading or margin trading). An investment recommendation
should be in the customer’s best interest. Simply receiving the customer’s acceptance of a recommendation
doesn’t relieve the firm of its suitability obligation. This prohibits RRs from placing their own interests ahead
of their customers’ interests. Some examples of potential suitability violations include:
 An RR whose motivation for recommending one product over another is to receive a large commission
 An RR whose mutual fund recommendations are designed to maximize commissions, rather than
establishing a portfolio for his customers
 An RR attempting to increase his commissions by recommending the use of margin
 An RR recommending a new issue that’s being heavily promoted by his firm in order to keep his job
FINRA’s suitability rule has the following three main obligations:

1. The reasonable-basis obligation—which requires a member firm and its RRs to have a reasonable
basis to believe that a recommendation is suitable for at least some investors. If the firm or its RRs
don’t understand a product, it shouldn’t be recommended to customers.
2. The customer-specific obligation—which requires a member firm and its RRs to have a reasonable
basis to believe that a recommendation is suitable for a particular customer based on the customer’s
investment profile.
3. The quantitative obligation—which requires a member firm and its RRs to have a reasonable basis to
believe that a series of recommended transactions, even if suitable for a customer, are not excessive
when the customer’s investment profile is taken into consideration.

Institutional Suitability When dealing with institutional customers, the suitability obligations may vary
based on the nature of the institution. Some of these customers are sophisticated and manage billions of
dollars, while others may be relative novices in the investment process. For a broker-dealer to determine the
extent of its suitability obligations to an institutional customer, it must consider the following two guidelines:
1. The firm and the RRs servicing the account must have a reasonable basis to believe that the institutional
customer is capable of evaluating investment risks independently, both in regard to the specific securities
and the different investment strategies.
2. The institutional customer must affirmatively state that it’s exercising independent judgment in evaluating
the recommendations.
When conducting business with institutional customers, the reasonable basis and quantitative obligations
standards still apply, but the customer-specific obligation standard does not.
Verification of Investor Accreditation of Sophistication Certain investments require investors to

have a minimum net worth or level of earnings, as well as an understanding of the level of risk and reward.
Investors who satisfy these standards are deemed accredited and sophisticated. Broker-dealers must verify
that customers meet these standards before recommending and allowing them to invest. Many of these
investments generally fall under the guidelines of the SEC’s Regulation D.
Using a principal-based approach, the SEC provides issuers and any broker-dealers that act on behalf of
the issuers with a number of factors to consider when determining the status of the investor. Some of these
factors include the nature of the purchaser and the type of accredited investor it claims to be, the amount
and type of information that the issuer has about the purchaser, and the nature of the offering (e.g., the
minimum investment amount).
The SEC has created the following suggested methods to use when verifying an investor’s accredited status:
 To review previously filed IRS tax forms and other tax forms (e.g., Form W-2 and Schedule K-1) in
order to determine the investor’s income
 To review bank and brokerage account statements and other statements of assets for the prior three
months to determine the investor’s net worth
 To obtain written confirmation of the investor’s accredited status from broker-dealers, registered
investment advisers, attorneys, and accountants (CPAs)
The SEC doesn’t stipulate that any one of these methods must be used; instead, the requirement is to
take reasonable steps to ensure that the persons to whom the solicitations are being directed are
accredited investors.
Conclusion
This concludes the chapter on the profiling of prospective customers to determine their objectives and to
ensure that all subsequent recommendations are suitable. The next chapter will proceed to an examination
of the documentation requirements to be followed when opening customer accounts and the various additional
issues that impact existing customer relationships.

CHAPTER 2
Customer Accounts
Key Topics:
 Customer Account Registrations
 Account Types and Characteristics
 Retirement Accounts
 Account Changes and Required Documents
 Account Approval and Restrictions

CHAPTER 2 – CUSTOMER ACCOUNTS
Chapter 1 described the need for RRs to profile potential customers properly in order to better
understand their needs and desires regarding potential investments. Remember, under the industry’s
Know Your Customer rules, RRs cannot make recommendations prior to having a solid
understanding of their customers’ financial status, investment experience, investment objectives, and
attitudes toward risk. This chapter will cover the documentation process involved in both the
onboarding of new clients to the firm and the different accounts that may be established.
New Account Documentation

For a registered representative, compliance with securities industry requirements often begins with
collecting and documenting customer information—both when opening and maintaining an account.
Proper record-keeping protects the interests of the customer, the firm, and the registered representative.
When opening a new account, certain information regarding the products a customer may purchase must
be obtained to comply with industry regulations. Also, the USA PATRIOT Act (discussed later in this
chapter) imposes requirements on firms that relate to both the verification of potential clients’ identities and
subsequent monitoring to ensure compliance with anti-money laundering regulations.
Customer information is collected on a new account form to satisfy regulatory requirements, but also to
help the registered representative and the firm in understanding the client’s investment objectives and to
ensure that suitability concerns are addressed. Industry rules include the know your customer (KYC)
standards that RRs must follow prior to making any recommendations.
It’s to be expected that every firm’s new account form will be slightly different, but all broker-dealers
must collect certain minimum information in order to meet industry standards. As a general rule, the more
an RR is able to determine about a client, the more likely she and the firm will be able to avoid charges of
unsuitable recommendations.
Traditionally, clients open cash accounts in which all trades are paid for in full. If a client wishes to trade
on credit, he will need to open a margin account. Depending on the account being opened (e.g., a margin
account), there may be additional documentation required. Also, depending on the products being
purchased, there may be additional approval or documentation procedures required (e.g., options or certain
low-priced securities).

Following is an example of a new account form:

Required and Requested Information

When opening a new account for a customer, FINRA requires the following information to be obtained:
 The customer’s name and residence
− Although an account may not be opened with a P.O. box as the address, correspondence may be
sent there if a written request is received from the customer
 Whether the customer is of legal age
 The name of the registered representative who is responsible for the account. If multiple RRs are
responsible for the account, a record indicating the scope of each person’s responsibilities is required.
(This provision doesn’t apply to an institutional account.)
 If the customer is a corporation, partnership, or other legal entity, the names of any persons authorized
to transact business on its behalf
 The signature of the partner, officer, or manager (principal) denoting acceptance of the account
Prior to the settlement date of the initial transaction, a registered representative must also make a
reasonable effort (a request must be made) to obtain the following information:
 Social Security number or taxpayer identification number (TIN)
 Customer’s occupation and the employer’s name and address
 Whether the customer is associated with another member firm
 Financial information, such as annual income and net worth
 Investment objectives
The above section (requested information) doesn’t apply to institutional accounts and accounts in which
the transactions are limited to non-recommended investment company shares (e.g., mutual fund shares).
An institutional account is defined as an account of a bank, savings and loan association, insurance
company, registered investment company, a registered investment adviser, or any person with total assets
of at least $50 million.
For discretionary accounts, a firm is also required to maintain a record of the manual signature of each
named natural person and the date on which the person was authorized to exercise discretion.
In practice, FINRA generally considers all of the previous information to be necessary prior to opening a
customer account. However, if a prospective customer refuses to supply any of the requested information,
the RR should (as a matter of good business practice) document the fact that an effort was made to obtain
the data by writing “refused” in the appropriate space. Principals may decide not to approve an account if
they feel a prospect has supplied insufficient information for their firm to adequately assess a client’s
investment objectives and/or suitability issues.

Required Signatures For standard brokerage cash accounts, only the approving principal must sign a
new account form. Although many broker-dealers have internal house rules that require customers’
signatures, industry rules do not require clients to sign a new account form when opening a cash account.
However, for clients who intend to open either an option or margin account, their signatures are required.
Predispute Arbitration Clause Today, many new account forms contain a clause that obligates
customers to submit all disputes with their RR or their firm to binding arbitration. If arbitration clauses are
included in the form, industry rules require them to appear in a certain format with specific wording. If a
firm elects to include a predispute arbitration clause in its new account form, it must be highlighted and
must be preceded by the following disclosures:
 Arbitration is final and binding on the parties.
 The parties are waiving their right to seek remedies in court, including the right to a jury trial.
 Prearbitration discovery is generally more limited than, and different from, court proceedings.
 It’s not required that the arbitrators’ award include factual findings or legal reasoning, and any party’s
right to appeal or seek modification of rulings by the arbitrators is strictly limited.
 Typically, the panel of arbitrators includes a minority of arbitrators who were or are affiliated with the
securities industry.
Immediately before the signature line, there must be a highlighted statement that the agreement contains a
predispute arbitration clause. A copy of the agreement must be given to the customer and the customer
must acknowledge its receipt either directly on the agreement or on a separate document.
Numbered and Nominee Accounts In order to protect privacy, clients are permitted to trade under
nominee names or use an account number in lieu of their name. However, firms are required to maintain
records regarding the beneficial owners of all such accounts.
Recordkeeping Requirements Both the SEC and FINRA require member firms to retain a record of
any customer account information that’s subsequently updated for at least six years after the update is
made. Firms must preserve a record of the last update to any customer account information, or the original
information if no updates have been made, for at least six years after the date the account was closed.
Account Registration—Forms of Account Ownership

During the process of a broker-dealer collecting all necessary information, a client must specify the type of
account to be opened. Some of the different forms of account ownership require documentation that goes beyond
the new account form.
Individual Accounts An individual account is opened by and for one person. That person is the only one
who may direct activity in the account unless a third party has been authorized. For example, if a married
person opens an individual account, his spouse is not authorized to execute trades in the account unless he
has granted third-party trading authorization to the spouse.

Joint Accounts Joint accounts have more than one owner of record. In most cases, any joint owner may
initiate activity in the account. However, when signatures are required (e.g., to transfer securities), all
owners are normally required to sign and any check made payable to the account may only be drawn in
joint names (as the account is titled). New account information should be obtained for each account owner,
not solely for the person filling out the application.
State law generally dictates the forms of joint ownership available, such as:
 Joint Tenancy with Right of Survivorship (JTWROS)
 Tenancy in Common (TEN COM)
 Community Property
Joint Tenancy with Right of Survivorship and Tenancy in Common are the most common forms of joint
ownership. JTWROS accounts are owned by at least two people, where all tenants have an equal right to
the account’s assets and are afforded survivorship rights in the event of the death of another account holder
(often created by spouses). Therefore, if one tenant dies, the ownership of the account will pass to the
remaining tenant without being subject to probate. In a TEN COM account, each owner has a percentage
of ownership and, at the time of death, the deceased person’s interest passes to his estate.
Community Property Accounts are essentially the same as accounts that are established as JTWROS, but
are only permitted between legally married couples. A Community Property Document must be completed
and these accounts are subject to the laws of the state in which the couple resides.
Be aware that although background information is collected on each owner, all tax reporting data is listed
under one designated tax ID number that belongs to only one of the account owners.
Corporate Accounts For a corporate account to be opened, a registered representative must be assured
that the person opening the account is authorized to do so. This is evidenced by means of a corporate
resolution. The resolution is a document created by the board of directors which appoints one or more
persons to operate the account. (Note: the customer is the corporation, not the person opening the account.)
If a corporation intends to open a margin or options account, a copy of the corporate charter must also be
obtained. The charter is the document that certifies whether the corporation is authorized to have such an account.
Activity Corporate Resolution Corporate Charter

Cash Account Trading Yes No
Margin Trading Yes Yes
Options Trading Yes Yes

Unincorporated Association Accounts These accounts are opened in the name of the owner, which can
be a business name. The ownership of the account is subject to creditors’ claims.
Sole Proprietorship Accounts Sole proprietorships are businesses that are often opened under the name
of the individual owner, although they may in a different business name. Regardless of the naming, the
account is held by the individual and vulnerable to the owner’s personal creditors.
Partnership Accounts To open an account for a partnership, a member firm must collect certain
information from each general (managing) partner. This information includes their name, address,
citizenship, and tax identification number. A partnership agreement must be created which will specify the
partners who are authorized to execute transactions on behalf of the partnership. For record-keeping
purposes, member firms are required to maintain a copy of the partnership agreement in the account file.
Fiduciary Accounts A fiduciary is defined as a person who acts on behalf of, and for the benefit of,
another person. Examples include executors or administrators of estates, trustees, guardians, receivers in
bankruptcy, committees or conservators for incompetents, and custodians for minors. In most cases,
fiduciaries are required to provide documentation of their authority.
In the past, fiduciaries were obligated to follow either the Prudent Person Standard or legal lists that states
created to identify acceptable investments. Much of the focus of these previous approaches was on what
investments a prudent person of discretion and intelligence would choose for income and preservation of
capital. Today, the Uniform Prudent Investor Act (UPIA) acknowledges that there should be no
categorical restrictions on investments and, instead, it focuses on identifying investors’ objectives and
appropriately diversifying their portfolios.
Trusts In a trust, one person (the trustee) is put in charge of managing the assets for the benefit of
another (the beneficiary). The trustee has legal control of the trust assets, but must manage it in the interest
of the beneficiary. To open a trust account, an RR must obtain the following:
 Evidence of the trustee’s authority to transact business in the account
 A copy of the trust agreement—the legal document that establishes the trust account
The level of control that the individual (creator) has over the assets in the trust is determined by the type of
trust – whether it’s revocable or irrevocable.
 Revocable – Also referred to as a living or inter vivos trust, the individual has the ability to make any
changes in the trust, even cancelling it. The assets don’t transfer until death. This type of trust doesn’t
reduce taxes, but does avoid probate when funded prior to the grantor’s death.
 Irrevocable – Once assets are deposited into the account, the grantor is no longer able to modify or
cancel the trust. This type of trust reduces the donor’s estate taxes and avoids probate.

Client Authorizations Permitting Third Parties to Trade

There are several other items that may appear on either the new account form itself or in a separate document.
Trading Authorizations
For another person to be permitted to execute trades in an account (other than the account owner),
additional information and documentation are required. This type of situation may arise if a client wants to
assign a third party to have trading authority.
Examples of third parties frequently include:

 Family members, such as spouses or adult children
 Attorneys
 Investment advisers
 Registered representatives
Trading authorization is a power of attorney (POA) that allows the authorized person to trade the account.
The customer may decide to offer this person either full or limited authorization.
Limited versus Full POA A limited trading authorization permits the authorized person only to place
orders for the account, but not to make withdrawals. With full trading authorization, in addition to placing
buy and sell orders, the authorized person is able to withdraw money and securities from the account. In
either case, the broker-dealer must receive written trading authorization that’s signed by the account owner
prior to permitting the authorized person to trade the account. The firm should also obtain the signature of
each authorized person and the date that the trading authority was granted.
Durable POA Regular (non-durable) power of attorney terminates if the grantor becomes incapacitated;
however, with durable power of attorney, the third party’s power to manage another person’s financial
affairs continues even if that person becomes incapacitated. Ultimately, if an account owner becomes
incapacitated by a mental or physical ailment, it’s durable power of attorney that must be in place for
another person to be able to exercise discretion in the account. However, either type of POA is terminated
in the event of the grantor’s death.
Discretionary Accounts
When a registered representative is the authorized third party, the account is generally referred to as a
discretionary account. Some firms don’t permit registered representatives to accept discretionary authority,
while most others will permit the RR to accept only limited trading authorization. If the firm permits
discretionary accounts, a principal must accept the discretionary authorization in writing before it becomes
effective. Each discretionary order must be approved by a principal promptly (i.e., on the day of the trade)
and the account’s activity must be reviewed frequently.

One area of concern in discretionary accounts is excessive trading—also referred to as churning. When
investigating allegations of excessive trading, the most important element in the process is to examine the
investment objectives of the customer, followed by the number and size of transactions. A customer’s
investment objectives are instrumental in guiding a registered representative’s decisions and should always
be considered prior to making recommendations. Frequent trading may be acceptable in the account of a
day trader, but inappropriate for many other investors. Remember, to determine if there’s evidence of
churning it’s the frequency of trading that matters, not whether the client lost money.
With discretionary accounts, the authorized third party generally is not required to obtain the account
holder’s permission prior to executing any transactions. However, if a member firm is selling its own stock to
the public and it wishes to place some of the stock in the account of a customer for whom the member firm
holds discretionary authorization, it must obtain prior written consent from the customer to execute the trade.
Time/Price Exception In some cases, a registered representative may accept a customer’s verbal
authorization to make certain decisions without it being considered discretionary. If a customer indicates
(1) the specific security (asset), (2) whether it’s to be bought or sold (action), and (3) the number of shares
or other units to be bought or sold (amount), but leaves discretion only as to the time and/or price of
execution, this is not considered a discretionary order and written authorization is not required. Remember, if
a customer specifies the three order details that start with the letter “A” (asset, action, and amount), the
order is not considered discretionary.
These orders that provide time and/or price discretion, often referred to as not-held orders, are limited to the
trading day for which the order was placed and must be noted on the order ticket. A client must give her RR
written instructions if the not-held order is to remain in effect for more than one day.
Authorized Activities Document Required
Trades Only Limited POA
Trading, deposits, and/or

Full POA
withdrawals of funds
Not-Held Orders (for one day) None
In addition to the previously described industry rules that pertain to the opening of a new account,
federal law has obligations and procedures with which firms are expected to comply. These
requirements will be covered next.

Special Client Arrangements

Pattern Day Trading Account
Special rules apply to accounts of pattern day traders. A pattern day trader is any customer who executes
four or more day-trades over a five-business-day period. Day trading is defined as the purchasing and
selling—or the selling and purchasing—of the same security, on the same day, in a margin account. An
exception is made for (a) a long position that’s held overnight and sold the next day prior to any new
purchase of the same security, or (b) a short position that’s held overnight and purchased the next day prior
to any new sale of the same security. Day-trading buying power is limited to four times the trader’s
maintenance margin excess, which is determined as of the close of the previous day.
If a customer meets the definition of a pattern day trader, but the number of day trades is 6% or less of
total trades for the five-business-day period, the customer will not be considered a pattern day trader. On
the other hand, if the broker-dealer knows or has a reasonable basis to believe that a customer opening an
account or resuming day trading will engage in a pattern of day trading, the firm may impose the special
day-trading margin requirements immediately.
Advertising Day-Trading Broker-dealers are permitted to advertise or promote the benefits of day
trading on their website. This advertisement is defined as a retail communication, subject to principal
approval and filing with FINRA, and a copy of it must be retained for three years. Broker-dealers must
deliver to their customers a special written disclosure document and must post the disclosure on their
website in a clear and conspicuous manner. If a customer opens an account at a firm that promotes a day-
trading strategy, he’s permitted to engage in other activities if he signs a written agreement that he doesn’t
intend to use the account for the purpose of engaging in a day-trading strategy.
Prime Brokerage Accounts One service that may be offered by some brokerage firms is the prime
brokerage arrangement. This prime brokerage service involves a clearing firm offering a bundled package
of services to sophisticated clients. The clearing firm acts as a centralized location for holding the
customer’s securities positions that are created by several executing firms through which the client trades.
Prime brokerage clients include hedge funds, institutions, and high net worth individual clients. Prior to
prime brokerage, these clients were required to open separate accounts at each executing broker-dealer that
they used. For all trades that were executed, the broker-dealers would then provide confirmations and
statements to the client. The client would ultimately be required to combine the information it received
from its various accounts to understand its overall position.
In a prime brokerage arrangement, a client selects one firm as its prime broker to essentially consolidate
the bookkeeping process. The client still uses several broker-dealers for reasons such as their execution
capabilities, research services, and access to IPOs, but all trades are ultimately handled through an account
that’s maintained with its prime broker.

The following picture provides a simplified example of the prime brokerage relationship:
Benefits Prime brokerage provides several benefits to large, active customers. It enables clients to
centralize their clearing and custodial services, and allows them to receive one set of comprehensive reports
regarding their portfolios. For those customers who use margin accounts, the concentration of margin
positions in one single account lowers the client’s cost of funds.
DVP/RVP Accounts At times, clients may use a bank to centralize their bookkeeping when trades are
executed through various firms. Each brokerage firm is instructed to provide the bank with trade details. The
bank will either pay the broker-dealer for client purchases or send securities to the broker-dealer for client sales.
DVP refers to delivery versus payment and RVP refers to receive versus payment. DVP and RVP
transactions are settled directly with a third-party agent bank or other custodial financial institution for the
client. These transactions are also referred to as POD (payment on delivery) and COD (collect on delivery)
and are most often used by smaller mutual funds, institutional accounts, and private, high net worth investors.

Investment Adviser Accounts Most investment advisers are registered with the SEC or at least one
state and are often referred to as registered investment advisers (RIAs). Investment advisers that provide
portfolio management services often buy and sell securities for their clients on a discretionary basis. An
RIA may open one account with a broker-dealer that contains all of its advisory clients’ assets or it may
have each client establish a separate account with a broker-dealer and have the client provide the adviser
with third-party trading authorization. In either case, the client must provide written authorization for the
adviser to transact business in the account.
Wrap Accounts The term wrap account refers to an account in which one fee—usually ranging from 1
to 3% annually—is charged by a broker-dealer for a number of services being provided. The fee is used to
cover administrative, portfolio management, and transaction costs. A wrap account is usually offered by a
broker-dealer, but managed by an investment adviser. The appropriate client for a wrap account is a person
who is interested in trading frequently.
The Employee Retirement Income Security Act (ERISA)

Certain work-sponsored plans are governed by a body of federal law referred to as ERISA. The purpose of
ERISA is to prevent the misuse and mismanagement of pension plan funds, especially by the managers of
these plans. To accomplish this goal, ERISA sets standards of conduct for all persons who deal with
pension plans. In particular, ERISA has established two special categories of persons that are held to very
high standards—parties in interest and fiduciaries. Investment advisers that provide services to pension
plans are usually considered both parties in interest and fiduciaries.
ERISA generally covers all employee benefit plans except government plans, church plans, plans required
under both workers’ compensation and unemployment and disability insurance laws, and plans established
outside the United States for the benefit of non-U.S. citizens. However, ERISA doesn’t apply to IRAs and
other individual retirement plans that are not established or maintained by an employer.

Fiduciary Responsibility Investment advisers have a fiduciary duty to all of their clients, but this duty
is even greater when the client is a qualified pension plan that’s subject to the provisions of ERISA. Under
ERISA, a fiduciary is any person that exercises discretionary authority or control involving the
management or disposition of plan assets, renders investment advice for compensation, or has
discretionary authority or responsibility for the administration of the plan. ERISA places many restrictions
and obligations on fiduciaries. Consequently, advisers to qualified pension plans must be careful to not
inadvertently violate the provisions of ERISA.
Suitable Investments Based on its fiduciary obligation, the plan manager should seek to maximize the
returns for the plan’s participants. Investments must be chosen carefully, with conservative investments
being considered a priority. Although aggressive derivative strategies are prohibited, certain conservative
option strategies, such as covered call writing, are permissible. Since the plan grows tax-deferred, the
manager should avoid including tax-free investments (e.g., municipal securities) in the plan.
Transfers and Rollovers An investor may transfer funds from one retirement plan to another retirement
plan of the same type. For example, from one 401(k) to a new 401(k) without incurring taxes. A transfer is a
situation in which plan assets move directly from one trustee to another. There’s no limit to the number of
these transactions that may be effected annually.
An investor may also roll over distributions from qualified retirement plans (e.g., ,a 401(k) plan), into
IRAs without incurring taxes. In order to avoid a tax penalty, the rollover must be completed within 60
days and may only be done once every rolling 12 months.
Tax Ramifications A withholding tax of 20% may apply if a person transfers funds from one
retirement account into another and receives a check that’s made payable to her name (this transfer is
considered a rollover). However, withholding tax may be avoided if funds are transferred directly from
one retirement account to another and the check is made payable to the new trustee (this is considered a
trustee-to-trustee transfer).
Combined Withdrawals If an investor maintains a retirement account in which both pre-tax and after-
tax contributions have been made and begins withdrawals, the IRS considers the withdrawals to come
from both sources. Therefore, a portion of the withdrawal is taxable and the other portion is tax-free.
Early Withdrawals from Retirement Plans An investor who withdraws money from a retirement plan
before reaching the age of 59 1/2 will be required to pay a 10% tax penalty on the amount withdrawn, in
addition to being liable for ordinary income taxes on the withdrawal. The amount of the early withdrawal
will be added to the investor’s taxable income for that year.
For example, a 40-year-old individual who earns $45,000 per year decides to take a $5,000
withdrawal from her retirement plan. She will need to pay a $500 tax penalty (10% of $5,000)
for the early withdrawal and her taxable income for that year will be $50,000. Assuming that
she’s in the 28% tax bracket, this will increase her tax liability by $1,400 (28% of $5,000).

Investors who are under the age of 59 1/2 will not be subject to a tax penalty for early withdrawals from a
retirement plan if any of the following exceptions apply:
 The account owner becomes disabled
 The account owner dies and the money is withdrawn by the beneficiary
 The withdrawals are set up as a series of substantially equal periodic payments that are taken over the
owner’s life expectancy
 The money is used to pay certain medical expenses that are not covered by insurance
For early withdrawals from IRAs, a tax penalty will not be assessed if the withdrawals are used for:
 Medical insurance premiums when the owner is unemployed
 Expenses related to being a qualified first-time home buyer (limited to $10,000)
 Expenses related to the birth or adoption of a child (up to $5,000)
 Paying qualified higher education expenses (including tuition, fees, books, and room and board) for
the account holder or a member of her immediate family
Although investors who fall under these exceptions and those who are 59 1/2 or older will avoid a tax
penalty, they will still be required to pay ordinary income taxes on the amounts withdrawn. If an investor
is under the age of 59 1/2 and withdraws money from a retirement plan due to a financial hardship, she
will still be subject to the 10% tax penalty.
Required Minimum Distributions (RMDs) Investors who wait too long to begin taking withdrawals
from their traditional IRAs may also incur a tax penalty. The IRS will levy this penalty if the investor
doesn’t start taking withdrawals by April 1 following the year in which the person reaches the age of 72.
(The age was increased from 70 1/2 to 72 as a result of the passage of the SECURE Act in 2019.) Please
note that this RMD provision doesn’t apply to Roth IRAs (since Roth IRAs are funded after-tax).
Employer-Sponsored Retirement Plans—Qualified Plans

Qualified retirement plans meet both IRS and ERISA requirements and receive favorable tax treatment. To
be qualified, a plan must be established in writing and must adhere to the following standards:
1. Eligibility Requirements The plan must cover all employees who are age 21 or older and have worked
for the employer for at least one year. For purposes of determining full-time employment, working
1,000 hours or more during the year equates to full-time.
2. Vesting This is the schedule under which employees’ rights to receive the benefits contributed to a
plan by their employers gradually become guaranteed based on their years of service. At a minimum,
all participants must be either fully vested after five years or 20% vested after three years with full
vesting after seven years of service. However, employees are always 100% vested in the contribution
they have made to a plan on their own behalf.
3. The Investment of Contribution and Determination of Benefits The investment of plan assets, as
well as other plan activities, is governed by strict fiduciary guidelines.

Employers that wish to establish qualified retirement plans may seek advance determinations from the IRS to
ensure that the plans meet the required standards. Alternatively, employers may adopt an existing IRS-approved
master or prototype plan provided by a financial institution. The plan must satisfy the IRS standards both in
terms of the way it’s designed and in the way it actually operates.
If established correctly, a qualified plan will provide the following benefits:

 Pre-tax contributions: Employer contributions to a qualified plan are generally able to be made on a
pre-tax basis. In other words, no income tax is paid on the amounts contributed by employers until the
money is withdrawn from the plan. Also, employee contributions are made on a pre-tax basis.
 Tax-deferred growth: Investment earnings (e.g., dividends and interest) on all contributions are tax
deferred; therefore, income tax is not paid on the earnings until the money is withdrawn from the plan.
 Payments received at retirement may qualify for special tax treatment.
Taxation of Retirement Plans

As mentioned earlier, Series 7 candidates must have a strong understanding of the tax implications of
retirement and education savings accounts. There are three distinct phases in each of these plans
—contributions, growth of investment, and distribution. Retirement and education savings plans are not
subject to preferential, long-term tax rates and any portion of the distribution that’s taxable will be taxed at
the same rate as the person’s ordinary income.
Taxation of Contributions Contributions to these plans are generally made on a pre-tax basis. If the
contribution is made pre-tax, it means that the funds are removed directly from the client’s gross income and
will not count as part of her taxable income. For example, if a client earned gross income of $100,000 per year,
but made pre-tax contributions of $10,000, the IRS will tax her only on the $90,000 of net income. In effect, the
client is avoiding income taxes on the $10,000 in the year in which it’s earned. On the other hand, if a client
makes an after-tax contribution, it means that the funds were taxed prior to the contribution being made.
The tax implications will differ based on how the contributions have been made. In the pre-tax scenario,
the contributions had not yet been taxed; therefore, these funds will be taxed at the time of withdrawal. If a
plan is funded solely with pre-tax contributions, it’s said to have a zero-cost basis (i.e., the funds have not
yet been subject to tax). However, if the contributions are made post-tax, these contributions are
considered a part of the plan’s basis and may be withdrawn without being subject to tax.
Taxation of Income and Trading Events During the Plan’s Life The plan investments may generate
income in the form of dividends and/or interest. Also, clients may decide to buy and sell various investments
within the plan. From a tax standpoint, none of these events matter since all activity within these plans is tax-
sheltered (tax-deferred).

Taxation of Distributions As described earlier, distributions of pre-tax monies are typically taxable at
ordinary income rates as will all of the income and trading profits that occurred over the life of the plan. All
distributions of post-tax monies will be free from taxation since these funds have already been taxed.
To summarize, the general rule of thumb is that:

1. Post-tax contributions are not taxed upon distribution
2. Pre-tax contributions are taxable at ordinary rates upon distribution
3. All account earnings (i.e., interest, dividends, and trading profits) are taxable at ordinary income tax
rates upon distribution*
* Note: The government may even allow the owners of certain plans, such as Roth IRAs and 529 college
savings plans, to avoid taxation on the plan growth as long as the assets are used for the purpose for which
they were intended and held within the plan for a minimum prescribed period.
Contribution Tax Effect of Cost Tax Implication

Type Contributions Basis of Distributions
Pre-Tax Reduces reportable income Not included Distributions are taxable
Post-Tax No effect on reportable income Included Distributions are tax-free
Employer-Sponsored Retirement Plans—Non-Qualified Plans

Non-qualified retirement plans are not required to meet ERISA standards regarding employee coverage,
contribution limits, and vesting. Although employers may not deduct contributions made, the income
contributed to these plans will accumulate on a tax-deferred basis until withdrawn. Rather than being made
available to all employees, non-qualified plans are designed to meet the specialized retirement needs for
key executives and other select employees. These plans are exempt from the discriminatory and top-heavy
requirements which apply to qualified plans.
Types of Non-Qualified Plans

457 Plans A 457 plan is a non-qualified, deferred compensation plan. However, it’s a tax-advantaged
defined contribution plan that may be established by state and local governmental employers, including
state universities and local school districts, as well as certain non-governmental (non-profit) employers. As
with 401(k) and 403(b) plans, 457 plans allow for pre-tax (deductible) contributions to be made by
employees; however, the maximum annual contribution amount is determined by the IRS (inflation
adjusted). For employees who are age 50 or older, an additional amount may be contributed annually.
Unlike 401(k) and 403(b) plans, the contributions to 457 plans are not coordinated among the other plans;
instead, they may be set up separately.
Another benefit provided by a 457 plan is that the 10% penalty for withdrawals taken prior to age 59 1/2
doesn’t apply; however, any withdrawal is subject to ordinary income tax.

The following guidelines/restrictions apply to non-governmental 457 plans:

 ERISA states that non-governmental 457 plans must be limited to higher compensation employees.
Although the level of compensation is not specified by ERISA, it must be based on an ascertainable
standard that’s set by the employer. These plans are usually restricted to specific classes of employees,
such as officers and directors, and are occasionally referred to as Top Hat plans.
 Any money invested in a non-governmental 457 plan may not be rolled over into any other type of tax-
qualified plan. However, governmental 457 plans allow their funds to be rolled over into other qualified
plans, such as 401(k) and 403(b) plans, or even IRAs.
 Any non-vested money that’s contributed to a non-governmental 457 plan must remain as the property
of the employer, not the employee. Unlike the contributions made to 401(k) or 403(b) plans, these
contributions that are made by the employer are not set aside in a trust for the exclusive benefit of the
employee. Therefore, the assets held in these plans are subject to claims by general creditors of the
employer.
Profit-Sharing Plans Profit-sharing plans are funded by employers and allow for discretionary annual
contributions from company profits. If the company is not doing well, the employer may skip that year’s
contribution entirely. The decision as to whether contributions will be directed to the plan is made by the
board of directors of the employer. Ultimately, providing this employee benefit may have a positive
impact on an employer’s ability to recruit and retain quality employees.
If a company does decide to contribute funds to the plan, it must allocate these funds to the employees in
accordance with a predetermined formula. Generally, each participant receives a certain percentage of his
salary. For example, if a company decides to contribute 10% of each employee’s salary for one year, then
an employee earning $30,000 will receive a $3,000 contribution. Companies with unpredictable cash flows
may find profit-sharing plans work well with their business.
Limitations on Contributions The employer contributions are tax-deductible and the earnings grow on
a tax-deferred basis; however, the maximum annual contribution amount is determined by the IRS
(inflation adjusted).
Employee Stock Ownership Plans (ESOP) These are employee benefit plans in which the company
contributes its stock or money to purchase its stock to the plan. The stock generally comes from retiring or
departed employees. When an individual retires, he or she usually doesn’t receive stock, but the cash
equivalent of the value of the stock.
Payroll Deduction Plans Payroll deduction plans allow employees to purchase life insurance, mutual
funds, and variable annuities by having after-tax deductions taken from their paychecks. Although not
required, employers may match employee contributions. The sales charges assessed are often lower than
what the employees would pay if they purchase these products individually.

Deferred Compensation Plans Deferred compensation plans are contracts that are entered into between
employers and employees with the employers agreeing to pay a certain amount of compensation to the
employees at a later date. The employees agree to defer the receipt of the funds until retirement, disability,
death, or termination. One advantage of deferred compensation plans is that income taxes are deferred until a
time at which the employee is presumably in a lower tax bracket.
Deferred compensation plans may either be funded or unfunded. In a funded plan, the plan is secured by
specific assets that are protected from the employer’s creditors. An unfunded plan is backed only by the
employer’s promise. Since deferred compensation plans are non-qualified plans, the employer is able to
discriminate and include only selected employees in the plan.
Account Registration Changes and Internal Transfers

Account Registration Changes Situations may require a change to the registration of an account. This
could be the result of death, divorce, or simply the transfer of securities to another individual. Changes
may require the following:
 Changes resulting from a marriage or divorce require a marriage certificate, divorce decree, or court
document. Driver’s licenses are usually not acceptable due to the risk of fraud.
 In order to add or remove a person from an account, the birth date, social security number, and contact
information for the person being added is required. In addition, both parties must sign and submit the
appropriate forms.
 A principal must approve and document all changes before any transactions are executed in the account.
Internal Transfers There are times when customers may want to transfer securities to another
individual’s account. When doing so, a stock transfer must be completed and all parties on the account
must approve of the transfer.
Customer Screening
The Bank Secrecy Act (BSA) is the primary U.S. anti-money laundering (AML) law and has been
amended to include certain provisions of the USA PATRIOT Act to detect, deter, and disrupt terrorist
financing networks. The Act imposes a number of new regulatory obligations on broker-dealers including
verifying the identity of individuals who intend to open accounts.
Customer Identification Program (CIP) As a part of their AML compliance program, broker-dealers
must create a customer identification program in order to verify the identity of any person who seeks to
open an account. Firms must also maintain records of information that’s used to verify a person’s identity
and determine whether the person is listed as a known or suspected terrorist or an affiliated organization.

Individuals on Governmental Lists Firms and their representatives must make certain that they’re not
doing business with anyone on a list that’s maintained by the Treasury Department Office of Foreign
Assets Control (OFAC). The OFAC List identifies known and suspected terrorists, other criminals, as well
as pariah nations. Doing business with any of these individuals or entities is prohibited. If a firm discovers
that one of its clients is on the OFAC List, it must block all transactions immediately and inform the
federal law enforcement authorities.
Broker-dealers are required to exercise special due diligence when opening private banking accounts for
foreign nationals. They’re also prohibited from maintaining correspondent accounts for foreign shell banks
(i.e., banks with no physical presence in any country).
Customer Verification A broker-dealer must verify a customer’s identity within a reasonable period
either before or after the customer’s account is opened. Under the new regulations, the following minimum
information is required to be obtained from a customer (the information is slightly different from what
FINRA requires):
 Name
 Date of birth (for an individual, not a business)
 Address (For an individual this must be a residential or street address. For other corporate accounts, it
must be a principal place of business or local office.)
 An identification number:
− For U.S. citizens: taxpayer ID number (e.g., Social Security number or employer
identification number)
− For non-U.S. citizens: taxpayer ID number, passport number and country of issuance, alien
identification card number, or government-issued identification showing nationality,
residence, and photograph
A broker-dealer may use documentary or non-documentary methods in order to verify the identity of a
customer.
Taxpayer ID Exception A broker-dealer that receives an application to open an account may waive the
obligation of obtaining a taxpayer ID number provided the person has applied for, but not yet received, the
number. However, in lieu of the number, the broker-dealer must retain a copy of the person’s taxpayer
identification application.
Record Retention A broker-dealer must maintain records of the methods it used to verify a customer’s
identity for five years following the closing of the account.
Registered representatives don’t need to actually know about a money laundering scheme or even participate
in it to be prosecuted. Instead, RRs and their firms may be held liable for being willfully blind to the activity.

Verification of Client Information

Account Information
To ensure that an RR has characterized a client’s profile and investment objective properly, copies of the
account record or documentation of the information collected must be sent to the customer either within 30
days of opening the account or at the time the client’s next statement is sent. Periodic updates of account
information must be sent to the customer at least every 36 months thereafter. Definitions of any terms that
are used to describe investment objectives should also be included in these mailings.
Tax Information Securities industry rules state that a registered representative must request a client’s
Social Security or tax ID number. However, if a client fails to provide this number, he may be subject to
backup withholding. Many firms have their own house rules that prohibit the opening of an account
without this number.
Interestingly, customers are typically asked to sign a W-9 certification which may be a separate document or a
part of the new account form. This certification attests to the fact that the Social Security or tax ID number
being provided is accurate and that the customer is not subject to backup withholding. Under IRS rules, any
customers who are subject to backup withholding are responsible for informing the broker-dealer of this
fact. Non-resident aliens and foreign entities that are not subject to backup withholding must complete IRS
Form W-8 (Certificate of Foreign Status).
SEC Regulation SP
Privacy of Consumer Financial Information In November 1999, the Gramm-Leach-Bliley Act was
enacted to require institutions that are engaged in certain financial-related activities to (1) establish privacy
policies with regard to information they collect regarding customers, (2) notify customers of those privacy
policies, and (3) give customers the right to opt-out of any disclosures of their
non-public personal information to certain third parties (i.e., customers may instruct the financial
institution that their information may not be disclosed to unaffiliated third parties). The SEC adopted rules
to implement these privacy requirements under Regulation SP which applies to all broker-dealers,
investment companies, and SEC-registered investment advisers.
Scope of Information That Must Be Protected Remember, Regulation SP is protecting a customer’s

non-public, personal information which includes information obtained from the customer or from
customer lists that are created from personally identifiable information (i.e., personal financial and account
information). However, disclosure of a customer’s publicly available information is not restricted under
the regulation. Publicly available information includes that which is lawfully available to the general
public from official public records, information from widely distributed news media (e.g., generally
accessible websites or newspapers), and information that’s required to be disclosed to the general public
by federal, state, or local law.

Privacy Notice Under Regulation SP, firms must provide their customers with a description of their
privacy policies (a privacy notice). Among other things, these privacy notices must state the types of
personal information that the firm collects and the categories of both affiliated and unaffiliated third
parties to whom the information may potentially be disclosed.
The timing of the notice depends on the client’s relationship with the firm. Regulation SP divides clients
into two categories—customers and consumers. A customer is a person who has an ongoing relationship
with the firm. A consumer is a person who is in the process of providing information to the firm in
connection with a potential transaction.
For example, if John has a meeting with a financial adviser from ABC Securities
about establishing a financial plan, he’s a consumer (a potential customer).
However, if John opens an account with ABC Securities, he’s a customer.
Firms must initially provide every customer with a privacy notice at the time the relationship is first
established. Thereafter, they must follow up with an updated version of this notice annually. For
consumers, a firm must provide a privacy notice before it discloses non-public, personal information to
any unaffiliated third party. However, if the firm doesn’t intend to disclose any consumer information to
an unaffiliated third party, then a notice is not required to be provided.
The notice must disclose to customers-consumers that they have the right to opt out of having their
information shared with unaffiliated third parties and the process for opting out. The opt out method being
used by a broker-dealer must be reasonable. Acceptable methods include electronic responses or a toll-free
telephone number for customers to call; however, requiring a customer to write a letter is unreasonable.
Identity Theft Prevention—FTC Red Flags Rule The Federal Trade Commission’s (FTC) Red Flags
Rule requires many financial institutions, such as banks and broker-dealers, to create and implement a
written Identity Theft Prevention Program. The program must be designed to detect, prevent, and mitigate
identity theft. Each firm must have policies and procedures that address the appropriate actions to take if
identity theft is suspected and/or detected. The intent of the rule is to assist firms in quickly spotting
suspicious activities (red flags) with the goal of preventing the theft of their clients’ assets. All of the
policies and procedures that are found under these programs must be referenced in a firm’s Written
Supervisory Procedures documentation.
Use of Stockholder Information for Solicitation As indicated by Regulation SP and the FTC Rule,
firms and their RRs are responsible for protecting their client’s information. That being said, may a firm
that’s acting as a trustee for a corporation use a shareholder list to cold-call or prospect in other matters?
Generally, this practice is a violation of industry rules. SRO rules don’t allow a trustee to use stockholder
information for solicitation purposes unless the member firm is specifically directed to do so by, and for
the benefit of, the corporation.

Reporting Requirements and Limitations on Insiders

As defined by the Securities Exchange Act of 1934, an insider is any director, officer, or owner of more
than 10% of the voting stock of a corporation and his immediate family members. Within 10 days of
becoming an insider, a person is required to report to the SEC on Form 3. An insider is required to file
Form 4 to report any changes in his stock position by the second business day following the change.
Trading Limitations Insiders are not permitted to keep short-swing profits in any stock of a corporation
for which they’re insiders. A short-swing profit is the result of an insider selling her stock at a profit within
six months of its acquisition. For violations of the rule, the corporation may sue for recovery of the profit
(a process that’s referred to as disgorgement). This restriction also applies if an insider sells stock that was held
longer than six months and then, within six months of the sale, repurchases it at a lower price than the
previous sale price.
Insiders are not permitted to sell short the stock of the company for which they’re insiders. However, on
certain occasions, some insiders may use a technique referred to as shorting against the box (i.e., executing
a short sale against a long position that’s held elsewhere) to ensure the timely delivery of securities that may
be in legal transfer.
Insiders may write (sell) covered calls (i.e., selling calls against stock that they already own), but may not
sell calls that are uncovered. On the other hand, corporations may not sell calls on their own stock under
any circumstances.
Accounts at Other Broker-Dealers and Financial Institutions

For supervisory reasons, member firms are required to monitor the personal accounts that their employees
(both clerical and registered persons) open or establish with a firm other than the one at which they’re
employed. For example, if a registered person of ABC Brokerage approaches another financial institution
in an attempt to open an outside (away) account to trade securities, both the employee and the firm must
observe special rules prior to the account being opened. For purposes of this rule, the term financial
institution refers to a broker-dealer, investment advisor, bank, insurance company, trust company, or
investment company.
Employee Requirements Employees who intend to open outside accounts in which securities
transactions may be executed are required to obtain the prior written consent of their firm. In addition,
before an outside account is opened, the employees are required to provide written notification to the
executing firm of their association with another member firm.
Related and Other Persons This rule also applies to any account in which securities transactions can be
executed and in which the employee has beneficial interest, including any account that’s held by:
 The employee’s spouse
 The employee’s children (provided they reside in the same household as, or are financially dependent
on, the employee)

 Any related person over whose account the employee has control, and
 Any other individual over whose account the employee has control and to whose financial support the
employee materially contributes
Previously Opened Account If an employee had opened an account prior to the time that he became
associated with a broker-dealer, the employee is required to obtain the written consent of his employer within
30 days of the beginning of his employment in order to maintain the account. Also, the employee is required
to provide written notification to the executing firm of his employment with another broker-dealer.
Once an account has been opened for a member firm employee, the executing firm is not required to
obtain the employing firm’s approval prior to the entry of each order. However, the employee’s activities
are subject to any rules or restrictions that have been established by his employing firm.
Executing Broker-Dealer Requirements Upon written request, the executing firm is required to
send duplicate copies of confirmations, statements, or any other transactional information to the
employee’s broker-dealer.
Exemptions The requirements of this rule don’t apply to accounts that are limited to transactions
involving redeemable investment company securities (mutual fund shares), unit investment trusts, variable
contracts, or 529 plans.
Approving Customer Accounts

All new accounts must be approved in writing by a registered principal. The type of securities being purchased
in the account will dictate the principal who approves the account. For example, a General Securities Principal
(Series 24) is responsible for approving accounts in which corporate securities, mutual funds, and variable
annuities are being purchased. In addition, the General Securities Principal is also responsible for monitoring
and enforcing the firm’s written supervisory procedures (WSP). When municipal securities are being
purchased, a Municipal Securities Principal (Series 53) must approve and monitor the account. For accounts in
which options will be purchased, a Registered Options Principal (Series 4) is responsible for approving and
monitoring the activity in the account.
Account Restrictions
In certain situations, restrictions may need to be placed on a customer’s account. This may be due to
conflicts of interest that don’t allow the individual to establish long or short positions in certain securities.
Other circumstances may arise due to the client’s failure to pay or deliver securities on a timely basis.
The Federal Reserve Board (FRB) requires that payment be made for purchases in a cash and margin
accounts within two business days of settlement (S + 2), which is also considered no more than four
business days after the trade date (T + 4). If a valid reason exists, payment extensions can be granted by
FINRA. However, if no payment is made and no extension granted, the position is closed on the third
business day following settlement. As a result, the account is frozen for 90 days, during which payment or
delivery must be obtained prior to accepting an order.

CHAPTER 3
Customer
Communications
Key Topics:
 Communication Standards
 Types of Communications
 Product Specific Advertisements
 Research Reports
CHAPTER 3 – CUSTOMER COMMUNICATIONS
This chapter will explain the general standards that apply to customer communications, the different
types of communications, as well as the approval and filing requirements. Details regarding the
disclosures related to specific products (e.g., mutual funds, variable products, and options) will also
be reviewed. The chapter will end by examining the rules regarding the preparation and distribution
of research reports by third parties.
Communication Standards
In their efforts to protect the public, regulators have strict rules governing the use of advertising, sales
literature and other means of promoting the products and services of broker-dealers. These 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
While all securities are subject to the same essential standards, each SRO adopts specific rules that focus
on the securities under its regulations. These will be reviewed these throughout this chapter.
FINRA’s Communication Rules

FINRA divides communications with the public into three major categories—correspondence,
institutional communication, and retail communication. For exam purposes, part of the challenge is being
able to distinguish between the different forms in situational questions.
Correspondence Traditionally, correspondence has been viewed as any communication being sent to
one person. However, FINRA’s current definition is more precise. Correspondence is defined as written or
electronic messages that are sent by a member firm to 25 or fewer retail investors within any 30-calendar-
day period. The 25 or fewer investors may be any type of retail client (i.e., existing or prospective). The
typical delivery methods include physical (paper) written letters, text messages, and e-mail.
Institutional Communications This category includes any type of written or electronic communication
that’s distributed or made available only to institutional investors, but doesn’t include a member firm’s
internal communications. FINRA defines institutional investors as:
 Banks, savings and loans, insurance companies, registered investment companies, and registered
investment advisers
 Government entities and their subdivisions
 Employee benefit plans, such as 403(b) and 457 plans, and other qualified plans with at least 100
participants

 Broker-dealers and their registered representatives

 Individuals or entities with total assets of at least $50 million
 Persons acting solely on behalf of these institutional investors
Under FINRA rules, a member firm must establish policies and procedures that are designed to prevent
institutional communications from being forwarded to retail investors. One acceptable method is placing a
legend on the communication stating “For Use by Institutional Investors Only.” If a member firm becomes
aware that an institutional investor (e.g., another broker-dealer) is making institutional communications
available to retail investors, the firm is required to treat future communications to that institutional investor
as retail communications.
Retail Communications This category is defined as written or electronic communications that are
distributed or made available to more than 25 retail investors within a 30-calendar-day period. A retail
investor is considered any person who doesn’t meet the definition of an institutional investor.
Retail communications are the broadest category and include both advertising and sales literature. All
materials that are prepared for the public media in which the ultimate audience is unknown are considered
retail communications including:
 Television, radio, and billboards
 Magazines and newspapers
 Certain websites and online interactive electronic forums, such as chat rooms, blogs, or social
networking sites (assuming retail investors have access to these sites)
 Telemarketing and sales scripts
 Independently prepared reprints (e.g., newspaper or magazine articles) that are sent to more than 25
retail investors
E-Mail and Instant Messaging A challenging aspect to e-mail and instant messages is that they may
ultimately be considered correspondence, retail communications, or institutional communications. For
example, e-mail that’s sent only to registered investment advisers (i.e., institutional investors) is considered
institutional communication. E-mail that’s sent to 25 or fewer retail investors is considered correspondence,
and finally, e-mail that’s sent to more than 25 retail investors is considered retail communication.
Social Media Sites Social media sites fall under the requirements of a public appearance and certain
disclosures may be required. Since firms may be unable to monitor their RRs’ activities on these sites, most
firms don’t permit their representatives to use them for communicating with customers or conducting business.

Communications—Internal Review Procedures

Internal Review and Retention Rules Correspondence and institutional communications are required
to be supervised and monitored by the member firm, but need not be approved by a principal prior to use.
However, as a general rule, retail communications must be approved by a qualified principal. This
principal approval must be obtained either before the communications are released to the public or before
they’re filed with FINRA—whichever event comes first.
Firms are not only required to maintain a file containing all approved communications for three years after
the last date of use, but these communications must also be maintained in an easily accessible location for
the first two years. The file must contain copies of the communications, the dates of first and last use, the
name of the approving principal, and the date on which approval was given. In the event that a specific
form of retail communication is not required to receive principal preapproval, the name of the person who
prepared or distributed the communication must be maintained by the member firm for three years from
the date of last use.
Retail Communications Approval Remember, many retail communications must be approved prior to
first use by an appropriately approved and qualified registered principal (typically a Series 24 or Series 9/10
registered person). A Supervisory Analyst, who is qualified with a Series 16 registration, may approve
research reports concerning debt and equity securities as well as other research-related communications.
Certain other forms of retail communications must be approved by supervisors who have specific
registrations. For example, any communication that pertains to options will require the approval of an
options principal (a Series 4 registered person).
In the following circumstances, retail communications don’t require principal pre-approval:

 Another firm has previously filed the communications with FINRA and it has not been materially altered.
 The communication was posted on an online interactive electronic forum (social media).
 The communication doesn’t make a financial or investment recommendation, it doesn’t promote the
firm’s products or services, and it’s not a research report.
This last exception applies to most routine communications between registered representatives and their
customers and to market letters since they’re not considered research reports. Although they’re not
required to be pre-approved, firms must still monitor these retail communications in the same way that
they handle correspondence. Generally, if retail communications are not required to be pre-approved, then
they’re also not required to be filed with FINRA.
FINRA Filing and Review Requirements

Correspondence and institutional communications are not required to be filed with FINRA, but they’re
subject to spot-checking by FINRA. However, more emphasis will be placed on the handling of retail
communication.

Retail Communications Depending on the content of retail communications, some are required to be
filed with FINRA 10 business days prior to their first use, while others are required to be filed within 10
business days of their first use. If pre-use filing is required, firms may not use the material until it’s in a
form that’s acceptable to FINRA.
For its first year as a FINRA member, a new brokerage firm is required to file with FINRA all broadly
disseminated retail communications 10 business days prior to their first use. The term broadly
disseminated refers to materials that have been created for generally accessible websites, the print media,
or television or radio. FINRA may also require any firm that has had disciplinary issues to file some or all
of its communications 10 business days prior to use.
Some of the additional forms of retail communications that must be filed with FINRA at least 10 business days
prior to their first use include materials that pertain to:
 Registered investment companies that include rankings or comparisons which have been created by the
investment company itself
 Security futures
 Bond mutual funds that include volatility ratings
On the other hand, retail communications that pertain to the following products must be filed with FINRA
within 10 business days of being published:
 Registered investment companies (provided the material doesn’t include fund-created rankings or
comparisons). This category includes mutual funds, closed-end funds, exchange-traded funds, unit
investment trusts, and variable products.
 Publicly traded direct participation programs (DPPs)
 SEC-registered collateralized mortgage obligations (CMOs)
 Any security that’s registered with the SEC and derived from or based on a single security, a basket of
securities, an index, a commodity, a debt issuance, or a foreign currency. This includes publicly offered
structured products (e.g., exchange-traded notes [ETNs]).
Filing of Television or Video Retail Communications If a broker-dealer has previously filed a draft
version or storyboard of a television or video retail communications, it must also file the final filmed
version within 10 business days of first use or broadcast.
Date of First Use and Approval Information With each filing that’s made to FINRA, a member firm
is required to provide the name, title, and Central Registration Depository (CRD) number of the registered
principal who approved the retail communications along with the date on which the approval was given.
Spot-Check Procedures All of the written and electronic communications that are created by a member
firm may be subject to spot-check procedures. FINRA may request that certain communications be submitted
within a time frame that’s specified by FINRA’s Advertising Department.

Exclusions from the Filing Requirements

The following types of communications are not required to be filed with FINRA:
 Correspondence and institutional communications
 Retail communications that have been previously filed with FINRA’s Advertising Department and are
being used without material changes
 Retail communications that don’t make a financial or investment recommendation and don’t promote
a product or service of the member firm. This broad category is also exempt from the principal pre-use
approval requirement and includes:
– Recruitment advertising
– Advertising that relates to changes in a broker-dealer’s name, personnel, electronic or postal
address, ownership, office, business structure, officers or partners, or telephone number
– Advertising that relates to a merger with or acquisition by another member firm
 Retail communications that simply identify a member firm’s national securities exchange symbol,
identify a security for which the member is a registered market maker, or identify that the member
firm offers a specific security at a stated price
 Tombstone advertisements, mutual fund profiles, and prospectuses that have been filed with the SEC
 Press releases that are made available only to the media
 Any reprint or excerpt of an article or report that’s issued by a publisher, provided the publisher is not
affiliated with the member firm or issuer of the securities that’s being mentioned in the reprint and
neither the member firm nor the issuer of the securities that’s being mentioned in the reprint has
commissioned the reprint
 Communications that simply refer to types of investments as part of a listing of products and services
that are offered by the member firm
Communications Regarding Investment Companies

There are numerous requirements regarding communications with the public that relate to investment
companies. This section details the provisions that are most likely to be encountered by a Series 7 candidate.
Omitting Prospectuses (Rule 482) Under specific conditions, there are investment company
advertisements that may be published because they technically meet the definition of a prospectus. These
advertisements are referred to as omitting prospectuses. This form of prospectus omits in part or
summarizes the information that’s contained in the statutory prospectus. As was true of tombstone
advertisements, this form of prospectus may not contain an application to invest. Essentially, Rule 482 is
the primary advertising rule for mutual funds and, in particular, mutual fund performance may be included
in the advertisement if specific standards are followed.

General Required Disclosures A 482 advertisement must disclose:

 That investors must carefully consider the investment objectives, risks, charges, and expenses of a
mutual fund before investing.
 That the prospectus contains these details about the mutual fund.
 That the prospectus should be read carefully before investing.
 The source from which an investor may obtain a prospectus.
Performance Information Disclosures If a 482 advertisement includes performance information, it

must disclose:
 That the performance data being quoted represents past performance and that past performance
doesn’t 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.
 Either a toll-free phone number or a website from which an investor may obtain performance data
that’s current to the most recent month-end.
 Whether a sales load or other non-recurring fee is charged, the maximum amount of the load or fee
and, if not reflected, that the performance data doesn’t reflect the sales load deduction.
All of the required performance information and fee disclosures must be clearly and prominently displayed.
Also, standardized performance information must be presented in a font size that’s at least as large as that
which is used for non-standardized performance information. For fund advertisements that show average
annual total return, they must present the following time periods:
 One year for investment companies in existence for at least one year
 One and five years for investment companies in existence for at least five years, and
 One, five, and 10 years for investment companies in existence for at least 10 years

Below is an example of an omitting prospectus:
ACROPOLIS INTERNATIONAL GROWTH FUNDS

Taking a global point of view can help you reach the investing summit.*
1 Year 5 Years 10 Years

22.31% 14.75% 10.57%
Please ask for a prospectus with more complete information, including charges,
expenses, and minimums. Be sure to read it carefully before you invest or send money.
Average annual total returns as of 12/31/14. Past performance is no guarantee of future

results. The performance of the fund may be different than the figures shown due to market
volatility.
Unusually favorable market conditions prevailed during the period shown. The performance
of the fund might not be repeated or consistently achieved in the future. Data represented
reinvestment of all dividends and capital gains distributions. Performance shown is for Class A
shares. For more information about other share classes, consult the prospectus. Investment
returns and principal value will fluctuate, and redemption value may be more or less than
original cost.
For a free prospectus, call * International investments are

1-800-555-1212 or contact subject to special risks such as
your registered representative. currency fluctuations or political
instability.
SEC Rule 156—Investment Company Sales Literature

Once an investment company’s registration is declared effective, it may use written sales materials,
provided the materials are accompanied by, or preceded by, a current prospectus. Any sales literature
that’s used by an investment company must meet the standards of SEC Rule 156.
Under Rule 156, sales literature is defined as any communication that offers to sell or induces the sale of
shares in an investment company. This includes all written materials, as well as anything prepared for
television, radio, or the Internet. Communications between issuers, underwriters, and dealers may also be
considered sales literature if there’s a reasonable expectation that the materials may be directed to
prospective investors, or that the information contained in these communications may be given to investors
in the course of selling the fund’s shares.
Rule 156 states that it’s unlawful for an investment company to sell its shares using sales literature that’s
materially misleading. Sales literature is considered materially misleading if it:
 Contains an untrue statement of a material fact or
 Omits a material fact that’s necessary to prevent the statement from being misleading

Whether a particular statement is misleading is determined by the context in which it’s made. Sales
literature may be misleading if it fails to properly explain, qualify, or limit the claims that it makes about
the investment, or fails to mention the importance of general economic or financial conditions. Funds must also
ensure that all of their sales literature is current, complete, and accurate.
Past Performance If not properly qualified, representations about a fund’s past or future performance
may easily mislead investors. Providing portrayals of the income that a fund has generated in the past or of
the way its assets have grown may also be misleading. To avoid this problem, most investment company
sales literature discloses that past performance is not indicative of future returns.
Generally, funds are required to report one-, five-, and 10-year performance figures. However, if a fund
has not been in existence for 10 years, it must show one-year, five-year, and life of the fund performance
figures. Performance figures are always reported after fees are deducted, but before taxes are paid.
Characteristics and Attributes Statements about the characteristics or attributes of an investment company
may also be misleading. Therefore, positive statements about possible benefits must be balanced with
equally prominent statements about risks or limitations. Funds should not make exaggerated or
unwarranted claims about the skill of their managers or their investment techniques. Also, they should not
make unwarranted or insufficient comparisons between the fund and other investments or indexes.
Statements about a fund’s investment objectives may lead investors to believe that these goals are certain
to be achieved. For this reason, funds often disclose that there’s no guarantee that their investment
objectives will be met.
Misleading Fund Names The SEC amended the Investment Company Act to prohibit fund names that
were likely to mislead investors. Under these rules, a registered investment company whose name suggests
that it focuses on a particular type of security or industry must invest at least 80% of its assets in those
securities. For example, a fund that’s listed as the ABC Stock Fund must invest 80% of its assets in stocks,
while a fund listed as the XYZ Bond Fund must invest at least 80% of its assets in bonds.
Under normal circumstances, a fund with a name implying that it concentrates on the securities of a specific
country or geographic region must invest at least 80% of its assets in the securities of that country or
region. Also, a fund with a name suggesting that its distributions are tax-exempt must invest at least 80%
of its assets in tax-exempt investments.
Finally, these rules prohibit funds from using names suggesting that they have the guarantee or approval of
the U.S. government. A name that uses the words guaranteed or insured, or anything similar in
conjunction with United States or U.S. government, is considered misleading and deceptive.

Use of Investment Companies’ Rankings in Retail Communications

Investment companies that receive superior performance rankings relative to their peers may decide to
emphasize this fact in their retail communications. FINRA has created guidelines on the use of rankings in
communications with the public to prevent the misuse of this type of information. If an investment
company uses a ranking symbol rather than a number in its communications, the symbol must be explained.
These rules don’t apply to a reprint or excerpt of an article or report that’s issued by a publisher, provided
the publisher is not affiliated with the member firm or issuer of the securities mentioned in the reprint and
neither the member firm nor the issuer of the securities mentioned in the reprint has commissioned the
reprint (i.e., independently prepared reprints).
Ranking Entity Members firms may not use investment company rankings in retail communications
other than (1) rankings created and published by ranking entities, or (2) rankings created by an investment
company or an investment company affiliate, but based on the performance measurements of a ranking
entity. A ranking entity is defined as an organization that provides the public with general information
about an investment company, is independent of the investment company and its affiliates, and has not
been hired by the investment company or its affiliates to assign the fund a ranking (e.g., Morningstar).
SEC Standardized Yields For rankings based on yield, the SEC has established two standardized
yields that must be used. Money-market funds are required to use a seven-day standardized yield, while
bond funds are required to use a 30-day standardized yield. In addition, any rankings that are based on total
return must be accompanied by these yield rankings.
Required Disclosures Headlines or other prominent statements in any form of communication are
prohibited from stating that an investment company or investment company family is the best performer in a
category unless it’s actually ranked first in the category. All retail communications containing an investment
company ranking must disclose:
 The name of the category (e.g., growth, asset allocation, balanced)
 The number of investment companies in the category
 The name of the ranking entity
 The length of the period (or the beginning and ending date of the period)
 The criteria (total return or yield) on which the rankings are based
 The fact that past performance is no guarantee of future results
 For investment companies that assess front-end sales loads, whether the ranking takes those loads
into account
 Whether the ranking is based on total return or the current SEC standardized yield
 The publisher of the ranking data (i.e., the name of the magazine), and
 Whether the ranking consists of a symbol (a star system) rather than a number, and if so, an
explanation of the symbol’s meaning must be provided (e.g., a five-star ranking indicates that the
fund is in the top 10% of all investment companies)

Multiple Class/Two-Tier Funds If investment company rankings are being used for more than one
class of investment with the same portfolio (Class A and B shares), the retail communication must provide
a prominent disclosure of this fact.
Bond Mutual Fund Volatility Ratings

Bond mutual fund volatility ratings are descriptions that are issued by an independent third party to
measure how sensitive a bond fund’s NAV is to changes in economic and market conditions. The
evaluation is based on objective factors, such as the credit quality of the fund’s individual portfolio
holdings, the market price volatility of the portfolio, the funds’ performance, and specific risks (e.g.,
interest-rate risk, prepayment risk, and currency risk).
A firm may only use bond volatility ratings in its supplemental sales literature, but not in advertisements
that are intended for public dissemination. However, the supplemental sales literature may only be used if
a prospectus for the bond mutual fund has been or will be sent to the customer and if the following
conditions are satisfied:
 The rating may not identify or describe volatility as a risk rating
 The supplemental sales literature must incorporate the most recently available ratings
 The criteria and methodology used to determine the rating must be based exclusively on objective and
quantifiable factors
 The entity that issued the rating must provide detailed disclosure on its rating methodology to investors
through a web site or toll-free number
The sales literature must also contain a disclosure statement that includes the following information:
 The name of the rating entity
 The most current rating and the date of the current rating
 A description of the rating that includes the methodology behind the rating, whether the fund paid for
the rating, and the types of risks the rating measures
The disclosure statement must also indicate that (1) there’s no standard method for determining bond fund
volatility ratings, (2) the fund’s portfolio may have changed since the date of the rating, and (3) there’s no
guarantee that the fund’s rating will remain the same.

Communications Regarding Variable Products

FINRA has established special guidelines for written materials that are used to sell variable products to the
public. Since registered representatives often prepare customized illustrations for customers who are
interested in variable products, these guidelines also apply to individual communications that are provided
to clients such as letters, e-mails, and computer-generated illustrations.
Identification as an Insurance Product All communications with clients must clearly identify the
product being described as a variable annuity or variable life insurance policy. Many companies use
proprietary names for their products which may inadvertently confuse investors about the product they’re
buying. For example, if an insurance company issues a variable life insurance policy and calls it the “Still
Standing Policy,” the company is required to include a statement in its advertising to clearly identify this
product as life insurance. However, if the policy was called the “Still Standing Variable Life Insurance
Policy,” then no additional description is necessary.
Since there are significant differences between variable products and mutual funds, presentations to
customers should never state or imply that variable products are mutual funds.
Liquidity Customers who withdraw funds from variable products after a short period often incur
significant surrender charges and/or tax penalties; therefore, these products should never be described as
short-term, liquid investments. A presentation implying that an investor may easily access her cash value
either through loans or other means must also clearly describe the negative impact of early withdrawals.
For a variable life insurance policy, all disclosures regarding loans and withdrawals must also include an
explanation of the impact that these actions may have on a policy’s cash value and death benefit.
Guarantees An insurance company that issues a variable product will often guarantee some of its
features. For example, an insurance company may guarantee that a variable life insurance policy will
always have a minimum death benefit if the policyholder continues to pay all the required premiums.
These guarantees should not be overemphasized or exaggerated since they ultimately depend on the
insurance company’s solvency.
Material that’s provided to clients should never represent or imply that these guarantees apply to the separate
account. With the exception of a fixed-account option offered by some companies, neither the principal
value of the separate account nor its investment returns are ever guaranteed. Similarly, clients should not be
told that the ratings given to the insurance company (AAA, BBB, etc.) apply to the separate account.
Hypothetical Illustrations of Variable Life Insurance Policies FINRA strictly prohibits its member
firms from projecting or predicting investment results. However, life insurance companies customarily
provide their clients with hypothetical illustrations that assume various rates of return in order to
demonstrate how their policies work.

Both the SEC and FINRA allow the use of hypothetical illustrations, provided the following guidelines are met:
 An assumed rate of return may not exceed 12%.
 One of the assumed rates of return must be 0%.
 The assumed rates of return must be reasonable based on current market conditions.
 The cash values and death benefits must reflect the policy’s maximum mortality and expense charges
for each of the assumed rates of return.
The illustration must also include a prominent statement explaining that (1) its purpose is to show how the
performance of the underlying subaccounts could affect the policy’s cash values and death benefits, (2) it’s
hypothetical, and (3) it doesn’t project or predict investment results. Generally, the illustration should not
compare the hypothetical returns of a variable life insurance policy to another product. However, provided
certain conditions are met, comparisons with term policies are acceptable.
Options Communications
Options Disclosure Document
The options disclosure document (ODD)—also referred to as the Characteristics and Risks of Standardized
Options—is the brochure that offers investors a description of the options market and discusses the relevant
terminology, tax implications, transaction costs, margin requirements, and trading risks. Investors must be
provided with a copy of the ODD either at or before their options account is opened.
Regulation of Communications
All options-related retail communication must be pre-approved by a Registered Options Principal (ROP);
however, this pre-approval requirement doesn’t apply to correspondence. Instead, options correspondence
is subject to the same review and general supervision requirements that apply to all forms of
communication with the public.
In addition to ROP approval, all options-related retail communications that are used prior to the delivery of the
options risk disclosure document must be submitted for approval to an exchange
(e.g., the CBOE) or to FINRA at least 10 calendar days prior to initial use. However, if a firm issues sales
material that’s only being sent to existing clients, it will not need to be filed since all existing clients would
have already received the options disclosure document. Since options advertising is a form of retail
communication, a member firm must at least offer to provide customers with the options disclosure
document. For any options‐related retail communications that discuss projections, they must be pre-
approved by a ROP and preceded or accompanied by an options disclosure document.

MSRB Rules—Communications
Advertising
The term advertisement is defined as any material, other than listings of offerings, published or used in any
electronic or other public media, or any written or electronic promotional literature distributed or made
generally available to customers or the public. Examples include notices, circulars, reports, market letters,
form letters, telemarketing scripts, seminar texts, and press releases concerning the products or services of
the member firm.
Broker-dealers are prohibited from publishing an advertisement that’s false, omits material facts, or is
misleading in content. Any advertisements that are related to municipal securities and municipal fund
securities (529 Plans) must be approved by a Municipal Securities Principal or a General Securities
Principal prior to its initial use.
Official Statement Summary Preliminary and final official statements are not considered advertising
since they’re either prepared by or for the issuer. However, a summary/abstract of an official statement is
considered advertising since the official statement has been altered by a municipal securities firm. As a result
of the alteration, the summary of an official statement must be approved by a Municipal Securities Principal.
SEC Rule 15c2-12: Municipal Securities Disclosure

SEC Rule 15c2-12 assists an underwriter in meeting its obligation to have a reasonable basis when
recommending a municipal security. According to this rule, an underwriter:
 Must obtain and review an official statement prior to bidding for or purchasing the securities. The
official statement must be considered to be in final form by the issuer at that time. Since the following
information might not yet be known, it can be omitted:
– Offering price, interest rate, selling compensation, aggregate principal amount
– Principal amount per maturity, delivery dates, ratings, and identity of the underwriter(s)
 Must send to customers the most recent copy of the preliminary official statement, if any, within one
business day of request (for negotiated offerings)
 Must contract with the issuer to receive sufficient quantities of the final official statement within seven
business days after the agreement to purchase, offer, or sell the securities
Continuing Disclosure Requirements After the initial issuance of municipal bonds and the obligation to
send clients an official statement is satisfied, what type of additional disclosure is required? Although
municipal issuers are exempt from most SEC rules, SEC Rule 15c2-12 indicates that an issuer or another
obligated person may enter into a contract to provide continuing disclosure information to the MSRB’s
Electronic Municipal Market Access (EMMA) website. An obligated person is defined as any other entity that
has legally agreed to support part or all of the payment of the issue of securities. These disclosures usually
contain financial or operating information and notices of material events. An underwriter is required to disclose
to the MSRB whether the issuer or other obligated persons have agreed to provide continuing disclosure
information under SEC Rule 15c2-12.

Advertisements for Municipal Fund Securities

When preparing advertising related to municipal fund securities (529 plans), certain disclosures must be
provided. Chief among these are statements that:
 Advise the investor to consider the investment objectives, risks, and charges and expenses associated
with municipal fund securities before investing
 Explain that more information about municipal fund securities is available in the issuer’s official statement
 Identify the firm as an underwriter of one or more of the issues of municipal fund securities if the firm
publishes the advertisement and will supply the official statement
 The official statement should be read carefully before investing
When advertising Section 529 college savings plans, a statement should be included to advise the investor
to consider, before investing, whether the investor’s or designated beneficiary’s home state offers any state
tax or other benefits that are only available for investments in that state.
Performance Indicators
When incorporating performance data in advertising, the following cautionary statement must be presented:
Past performance does not guarantee future results and investment return will fluctuate.
Therefore, the investor’s shares when redeemed may be worth more or less than their
original cost. Additionally, current performance may be lower or higher than the data
contained in the advertisement.
If the advertisement doesn’t include total return quotations, calculated to the most recent month and
ending within seven business days prior to the date of the advertisement, the firm must include either a
toll-free (or collect) telephone number or a website from which an investor can obtain total return
quotations for the most recent month-end.
If a sales load or non-recurring fee is charged, the maximum amount of the load or fee should be stated. If
the charge is not reflected in the performance data, a statement to that effect must be included and should
also indicate that the performance data would be lower if the load or fee had been included.
When calculating tax-equivalent yields or after-tax returns, the firm must assume that any distributions
that are not reinvested will be used in the manner intended in order to qualify for the federal tax exemption
provided by Section 529. The ad should provide a general description of how federal law addresses such
distributions and that yields would be lower if the funds are not used for their intended purpose.
Generic Advertisements Generic advertisements may not refer to a specific fund by name, but may
describe the general nature of 529 plans as well as the various investment objectives of the different types
of plans. A generic advertisement may contain an invitation for further information, provided that an
official statement is provided.

A blind advertisement doesn’t identify a municipal securities broker or dealer, but may include the name
of the issuer of the municipal security and/or the contact information for the issuer, as well as the
method by which an official statement may be obtained. A logo or trademark of the municipal fund
security may be used.
Communication Regarding Collateralized Mortgage Obligations

FINRA has created specific rules that member firms must follow when providing CMO communications
to retail investors.
Disclosure Standards and Required Education Materials

All retail communications (material distributed to more than 25 retail investors) and correspondence
(material distributed to 25 or fewer retail investors) must include the term collateralized mortgage obligation
within the name of the product and must disclose that any applicable government agency backing relates only
to the face value of the securities, not to any premium paid. Claims about safety, guarantees, product
simplicity, and predictability must be accurate and not misleading. Due to their unique characteristics,
CMOs may not be compared to any other types of investments, such as certificates of deposit. A statement
must be included to indicate that a CMO’s yield and average life (expected return of principal) will
fluctuate depending on (1) the actual rate at which holders prepay the mortgages underlying the CMO, and
(2) changes in current interest rates.
The following disclosure is an example of what must be included in all written or electronic retail
communications and correspondence, as well as in oral statements in radio/television advertisements
regarding CMOs:
“The yield and average life being shown considers prepayment assumptions that may
or may not be met. Changes in payments may significantly affect yield and average life.
Please contact your representative for information on CMOs and how they react to
different market conditions.”
FINRA has prepared a standardized CMO print advertisement format; however, even if a member firm
uses that format, it must still submit the advertisement to FINRA. If a member firm chooses to create its
own advertisement, it must contain the same information as the standardized advertisement. Additionally,
radio and television advertisements must meet the same general standards as print advertisements.
Broker-dealers must offer to provide retail investors with educational material about the features of CMOs
and the material must include:
 A discussion of the structure of a CMO that explains the different types, tranches, and risks associated
with each type of security. It’s also important to explain to a client that although two CMOs may have
the same underlying collateral, their prepayment risk and interest-rate risk may be different.

 A discussion of the characteristics and risks of CMOs that details how changing interest rates may
affect prepayment rates and the average life of the security, tax considerations, credit risk, minimum
investments, liquidity, and transactions costs
 An explanation of the relationship between mortgage loans and mortgage securities
 Questions that a CMO investor should ask before investing
 A glossary of terms that are applicable to mortgage-backed securities
Retail communications related to CMOs must be approved before initial use by a principal and filed with
FINRA within 10 business days of first use.
Research Analysts and Research Reports

Research reports are another method by which member firms communicate with prospects and current
customers. Both the publication and distribution of research reports are covered under FINRA rules.
FINRA rules regarding research analysts and research reports concentrate on the following areas:
 The restricted relationship between the research department and other departments of the broker-dealer
 Restrictions on the communication between the research department and the subject company
 Restrictions on publishing research reports and making public appearances
 Restrictions on the personal trading of research analysts
 Disclosure requirements in research reports and public appearances
Investment Banking and Research Department Control Issues

The information barriers that separate research and investment banking departments must be reinforced
through the supervision of these areas, including a member’s written supervisory procedures. A member
firm’s investment banking department is restricted from exercising any control over its research
department, particularly as it relates to the preparation of research reports.
The supervision and approval of research reports must be conducted exclusively by supervisory personnel
in the research department. These supervisors are required to hold a Supervisory Analyst (Series 16)
designation and are responsible for approving research reports prior to their distribution. Review and
approval mechanisms, which provide a member firm’s investment banking department or any other non-
research department with review or veto power over research reports, are strictly prohibited.
At times registered representatives may prepare reports for distribution to their customers. Although an RR
may not hold the Research Analyst designation, these reports are still considered research reports and must
follow the same review and approval requirements.

To prevent the misuse of confidential information, communications between research and investment
banking departments and other non-research departments are severely limited. Communications are
prohibited if they’re not related to information verification or are not being conducted to avoid conflicts.
The details of these prohibitions must be included in a firm’s written supervisory procedures.
Research Reports and Public Appearances Disclosures

Research Reports Research report disclosures may not be written in reduced typeface and must appear
on the first page of the publication (or must refer to the page on which they appear). However, if a member
firm publishes a report that makes recommendations on six or more subject companies, the report may
clearly and prominently direct the readers as to where the required disclosures may be found in either an
electronic or written format.
The mandatory research report disclosures must include the following information:
 Whether the analyst (or a member of the analyst’s household) has a financial interest in the securities
of the subject company (i.e., holds shares, warrants, or options contracts of the subject company)
 Whether the firm has ownership of the subject security and whether such ownership is 1% or greater
of the outstanding stock of the subject company. Ownership must be determined as of the end of the
month directly preceding publication of the research report and allow for a 10-day calculation period.
If the report is published less than 10 days from the end of the month, a member may ascertain
ownership based on the second-most-recent month.
 Whether the firm makes a market in the subject security
 Any material conflict of interest about which the analyst or member firm knows or has reason to know
 Whether the member firm has received compensation for investment banking activity from the subject
company during the 12 months preceding publication, or expects to receive or seek compensation in
the three months following publication
 Whether the analyst or any member of the analyst’s household is an officer, director, or advisory board
member of the subject company
Public Appearances A public appearance is defined as any conference call, seminar, or public
speaking engagement being delivered to 15 or more persons or one or more representatives of the media
by means of a radio, TV, or print media interview in which a research analyst makes a recommendation or
offers an opinion concerning an equity security. The justification for including TV and radio interviews as
public appearances is to assure that adequate disclosures are made. A television interview is considered a
public appearance regardless of the number of persons who are interviewing the analyst. However, an
internal meeting is not a public speaking engagement and is not considered a public appearance.

The disclosures that are required during public appearances, including television and radio interviews
during which predictions may be made, include:
 Whether the subject company is an investment banking client of the member
 Whether the analyst (or a member of the analyst’s household) has a financial interest in the security
that’s the subject of the report (subject security)
 Whether the member firm has 1% or greater ownership of the outstanding stock of the subject company
 Whether the analyst or any member of the analyst’s household is an officer, director, or advisory board
member of the subject company
 Any material conflict of interest about which the analyst or member firm knows or has reason to know
Members must develop a procedure for disclosing the required information at the same time that any
public appearance is held. One way to address this issue is to draft a planned script for such appearances
that include the appropriate disclaimers. After the appearance, a thorough review of the transcript of the
actual broadcast must be completed to verify that such disclosures were made. In any case, each member
firm whose analysts engage in such public appearances must address the disclosure requirements in its
written supervisory procedures.
Seminars Given by Registered Representatives RRs often engage in seminars in an attempt to increase
their client base. When conducting a seminar, RRs must make a record of the date, topic, and sponsor of the
seminar. Ultimately, member firms need this information for supervisory purposes.
New Issues—Limitations on Research

Firms may have internal conflicts between the goals of their investment banking departments and the
requirement to provide customers with fair and balanced research. To further delineate investment banking
business from research recommendations, rules have been created to establish a quiet period that follows
an initial public offering or a secondary offering. During this period, the investment banking client may
not be the subject of a research report or public appearance. This provision is designed to prevent an
analyst from providing a favorable rating or public appearance simply because her firm was the manager
or co-manager of a recent offering for the issuer.
Also, during this quiet period, the participating broker-dealers may not publish research reports
regarding the subject security and its analysts are not permitted to make public appearances regarding
the issuer of the security.

As shown below, the length of the quiet period depends on the nature of the transaction as well as the
entity that’s issuing the research.
 For initial public offerings, the quiet period is 10 days following the offering. This 10-day
period applies regardless of whether the broker-dealer is a manager, syndicate member, or
selling group member.
 For follow-on offerings, the quiet period is three days following the offering. This three-day
period only applies to the managers and co-managers of the offering.
For Initial Public Offerings (IPOs)

Quiet Period for Manager/Co-manager Quiet Period for All Other Participating Firms
10 calendar days 10 calendar days
For Follow-On (Secondary) Offerings

Quiet Period for Manager/Co-manager Quiet Period for All Other Participating Firms
Three calendar days No restriction
Under the hot news exception, research may be published during the quiet period if the issuer is subject to
certain unexpected news events.
Externally Prepared Research Reports Externally prepared research reports that are distributed by
broker-dealers will fall into one of two distinct categories:
 Third-party research or
 Independent third-party research
A third-party research report is one that has been prepared by an affiliate of the broker-dealer. This form
of research report must be approved by a supervisory analyst or an approved supervisory person of the
broker-dealer (e.g., general securities principal).
Additionally, third-party research must include the following disclosures:

 Whether the broker-dealer has received compensation from the subject company within the preceding 12
months, or expects to receive compensation in the upcoming three months for investment banking services
related to the subject company
 Whether the broker-dealer makes a market in the subject company
 Whether the broker-dealer owns 1% or more of the subject company’s equity securities
 Any other material conflicts of interest
For example, in order to provide research on several companies to its customers, a
broker-dealer has requested analytical reports from an affiliated analysis-provider.
The reports are classified as third-party research reports and must be approved by a
supervisory analyst or approved supervisory person of the broker-dealer.

An independent third-party research report is one that has been prepared by a person or firm that 1) has
no affiliation or contractual relationship with the disturbing member, and 2) makes content determinations
without any input from the distributing member or that member’s affiliates. Since the distributing broker-
dealer has no editorial control over the content of the report, approval by a principal of the broker-dealer is
not required. Any required disclosures within the report must be based on the firm preparing the report,
rather than the firm that’s distributing it.
For example, a broker-dealer that intends to provide information to its interested
customers has requested research on the biotech industry from an unaffiliated analysis-
provider. If the broker-dealer has no influence or editorial control over the content of the
reports, the reports are considered to be independent third-party research and don’t
require the approval of a supervisory analyst of the broker-dealer.

CHAPTER 4
Equity Securities
Key Topics:
 Common Stock
 Preferred Stock
 Rights, Warrants and ADRs
 Auction Markets
 Equity Transaction Tax Treatment

CHAPTER 4 – EQUITY SECURITIES
The opening section of this chapter will examine equity securities—those that represent an ownership
interest in a business. These holdings include both common and preferred stocks. Later in the
chapter, there’s a brief description of derivative securities—the investments that track the value of a
related security. Finally, the chapter will discuss the tax treatment of various equity transactions.
The Corporation
Many businesses are organized as corporations. As a legal entity, a corporation may legitimately do many
of the same things that a natural person is able to do. For example, it may buy property, obtain loans, sue,
and be sued. Although a corporation is owned by its shareholders, the business is considered a separate
person under the law and, therefore, an individual shareholder generally is not held personally responsible
for the corporation’s debts. If a business fails, the most a shareholder may lose is her original investment—
this feature is referred to as limited liability.
Corporate Organization
Corporations vary greatly in both size and complexity—ranging from enormous international conglomerates to
small family businesses. However, the basic structure remains the same. The shareholders of the company elect
a board of directors who are responsible for overseeing the company. The board of directors, in turn, appoints
the company’s senior managers who run the company.
In many cases, certain senior executives of the corporation, such as the CEO and the president, also serve
on the board of directors. These persons are referred to as affiliated directors. Non-affiliated directors
(outside directors) are the persons who are not otherwise connected to the corporation. In small
corporations, a limited group of people often owns all of the stock and also serves as the corporation’s
directors and managers. Since there’s no public market for the stock of these companies, these corporations
are referred to as closed or privately held.
Raising Capital—Financing the Corporation

It’s inevitable that at some point a corporation may need to raise additional capital to fund its operations.
There are two basic methods used by corporations to raise money—debt financing and equity financing.
When an issuer sells bonds (debt), it’s borrowing money from the investors who buy the bonds. The funds
are borrowed for a predetermined period with interest being paid over the course of the loan. Bondholders
have no ownership interest in the corporation and no influence in its management. For bond investors,
their returns are limited to the interest that the corporation pays them for the use of their money.
Another way for a corporation to raise money is to issue stock. In contrast to bondholders, investors who
purchase stock become part owners of the corporation. Since the investors are provided with an ownership
interest in the corporation, these instruments are referred to as equity securities. Unlike when bonds are
issued, the corporation is not required to pay interest on these equity securities and there’s no maturity date.

So what’s the upside for equity investors? If a company prospers, shareholders can expect to share in its
profits in the form of cash or stock distributions (dividends) and an increase in the value of their shares.
However, if a company fails, shareholders are more likely than other investors to lose their entire
investment. This is due to the fact that bondholders and other creditors have a higher claim against the
company’s assets at liquidation.
Common Stock
Common stock is (1) the basic unit of corporate
ownership, (2) the most widely issued type of stock,
and (3) the first type of stock that a corporation issues.
For bookkeeping purposes, common stock is usually
issued with a par value that’s a nominal amount used
for the company’s financial statement. There’s no
relationship between the par value of an equity security
and its market value.
Authorized Shares At the time of incorporation, a

company is authorized to issue a certain number of
Investors provide capital and, Investors provide capital and, shares. Although the original number of shares is
in turn, may receive: in turn, receive:
arbitrary, it may be changed only by a majority vote of
 Dividends  Interest
 Potential capital  Principal at maturity the stockholders and by revising the corporate charter.
appreciation  Liquidation preference Most firms issue fewer shares than authorized, thereby
over stockholders keeping a certain amount of stock available for future
 Creditor status use by the corporation.
Issued Shares Issued shares represent the amount of stock that has actually been sold by the
corporation. Any shares that have not been sold or distributed are referred to as unissued shares.
Treasury Stock For various reasons, many corporations may ultimately reacquire some of their issued
shares. When stock is issued and subsequently repurchased by the company, it’s referred to as treasury stock.
As long as the stock remains in the treasury, it has no voting rights and doesn’t receive dividends. Treasury
stock appears as an informational item on the corporation’s balance sheet.
Outstanding Stock The term outstanding stock refers to the number of shares that have been issued to
the public, less stock that has been reacquired by the company (treasury stock).
Issued Stock – Treasury Stock = Outstanding Stock

Outstanding stock receives dividends and has voting rights. Many market professionals use the term
market capitalization which is found by multiplying the current market price of the stock by the number of
outstanding shares.
Shareholder Rights
As specified in a corporation’s charter and bylaws, all shareholders are provided with certain rights which
may include the following types:
 Right to Evidence of Ownership
 Right of Transfer
 Right of Inspection
 Right to Vote
 Right to Receive Dividends
Right to Evidence of Ownership Shareholders have the right to receive one or more stock certificates
as proof of ownership. The certificate states the name of the corporation, the name of the owner, and the
number of shares owned by the stockholder. The certificate must also show the names of both the transfer
agent and registrar and include the signature of an authorized corporate officer. As with a check, a stock
certificate must be endorsed by the owner when sold to be considered in good deliverable form.
Right of Transfer Stockholders have the right to freely transfer their shares by selling them, giving them
away, or bequeathing them to heirs. This right may be limited for stockholders who are also employees of the
company and acquired their stock directly from the company as part of their compensation. There are some
cases in which shares are not freely transferable. These restricted shares often carry a legend that’s printed on
the face of the certificate to indicate that the shares are ineligible for transfer.
Right of Inspection Stockholders have the right to inspect certain books and records of the company,
including the stockholders’ list and the minutes of stockholders’ meetings. This right is usually exercised
through the receipt of an annual audited report.
Right to Vote The ability to vote is a right that’s typically associated with common stockholders. They
may attend annual shareholder meetings and vote on important issues including the election of members to
the board of directors and whether the company is able to merge with or acquire another company. It’s
important to remember that shareholders also vote on stock splits, but not on cash and stock dividends.
Instead, decisions on cash and stock dividends fall under the authority of the board of directors. The
number of votes available to each shareholder is determined by the number of shares the person owns.
Therefore, ownership of 100 shares will provide 100 votes.
Although shareholders are entitled to vote in person, most choose to vote by proxy. By signing a proxy,
shareholders give another person the authority to vote the shares on their behalf. Broker-dealers that hold
securities in street name are responsible for forwarding these proxies to the beneficial owners.

Voting Methods The two different voting methods that may be used by a company are statutory and
cumulative. With statutory voting, a shareholder is given one vote, per share owned, per voting issue.
Therefore, the more shares a person owns, the greater her voting power. For that reason, statutory voting is
considered to be beneficial for the larger, more substantial (majority) shareholders.
With cumulative voting, shareholders are able to multiply the number of shares that they own by the
number of voting issues. The result of that calculation is the total number of votes that shareholders may
cast in any manner that they choose. Cumulative voting tends to favor the smaller, less substantial
(minority) shareholders.
Example: XYZ Corporation is holding an election for it board of directors. There are three
seats available, but five potential candidates. With three seats available, this represents
three voting issues. If shareholders are required to use statutory voting, an investor who
owns 1,000 shares is able to cast a maximum of 1,000 votes to three of the five candidates.
On the other hand, if cumulative voting is required, an investor who owns 1,000 shares is
able to cast 3,000 votes in any manner that she chooses (1,000 shares x 3 voting issues),
which is a significant benefit if she really favors one of the five candidates.
The following diagram shows the difference between statutory and cumulative voting:
Candidates
1 2 3 4 5
Statutory: 1,000 votes 1,000 votes 1,000 votes
Cumulative: 3,000 votes
Please note, the statutory voter could have chosen to cast votes for only two of the directors,
but would still be limited to a maximum of 1,000 votes for each. The cumulative voter’s
3,000 votes could have been cast in multiple ways
(e.g., 1,500 votes for 2 candidates or 1,000 votes for 3 directors).
Right to Receive Dividends Although not guaranteed, companies will often pay out some of their
profits to common and preferred shareholders in the form of dividends.
Corporate Actions
Spin-Off Transactions Spin‐off transactions occur when a parent company distributes shares of a
subsidiary company to the parent company’s shareholders. In a spinoff, each shareholder of the parent
retains her original shares, but is also given shares in the newly created entity. There are no immediate tax
consequences to the recipient of the new shares. Spinoffs are used by sellers in the hopes that the
combined valuation that the market assigns to the two (now) separate companies will be greater than that
of the single combined entity.

Consolidations or Transfers Certain types of securities are the result of a reclassification, including:
 An issuer that substitutes one security for another
 A merger or consolidation in which the securities of one corporation are exchanged for the securities
of another corporation
 A transfer of assets from one corporation to another
Stock splits, reverse stock splits, or changes in par value are not considered reclassifications. The most
common reclassifications are acquisitions or mergers. For example, a merger is planned between the
Predator Corporation and the Prey Company. The negotiations are being carried out by the boards of the
two companies. After the merger, Prey Company will be dissolved and its shareholders will then receive
shares in Predator, the surviving company.
Tender Offer A tender offer occurs when an entity offers to buy a corporation’s shares, typically for the
purpose of acquiring control of the company. The price being offered is usually at a premium to the current
market price. According to SEC rules, a customer may not tender shares that he’s short since the stock has
been temporarily borrowed and doesn’t belong to the customer.
Leveraged Buyout A leveraged buyout (LBO) is defined as the acquisition of a company by primarily
using debt to finance the purchase. The assets of the acquired company are generally used as collateral for
the borrowed funds. This type of acquisition allows the acquiring company, which is referred to as a
private equity (PE) firm, to make the purchase without using much of its own equity. In many
circumstances, since a large amount of borrowed funds are used to make the purchase, they’re usually
non-investment-grade.
Preferred Stock
Preferred stock is usually issued by established companies that already have common stock outstanding.
These shares are suitable for investors who are more interested in income than capital appreciation—the same
type of investors who might otherwise purchase bonds. Remember, preferred stockholders don’t usually
have voting rights.
Preferred stock is normally issued with a par value of $100, which corresponds to its initial market price,
and carries a specified dividend. For example, a 5% preferred stock is expected to yield an annual dividend
of $5 (5% of the par value of $100). However, the dividend rate for preferred stock may also be stated as a
dollar amount. For example, $3 preferred stock is expected to pay a 3% annual dividend.
A preferred stock’s dividend rate represents the maximum amount that the preferred stockholders will
receive. If a company is not doing well, its board of directors may choose to pay less than the full amount
or may choose to pay nothing at all. Let’s examine the different types of preferred stock.

Cumulative Preferred Stock

What happens if a corporation fails to pay the full dividend on its preferred stock? If the preferred stock is
cumulative, then all the preferred dividends that are in arrears (owed) must be paid before the common
stockholders may receive dividends. Most preferred stock is cumulative.
Assume that Widget, Inc. has issued 5% preferred cumulative stock. Over the last three years the widget
market has been in turmoil due to the introduction of the gidget—a cheaper foreign-made substitute. As a
result, Widget, Inc. has paid only the following dividends to its preferred stockholders:
Dividends Paid Dividends in Arrears

Year 1 $2 $3
Year 2 $2 $3
Year 3 $3 $2
In Year 4, the widget market rebounds after several gidgets spontaneously combust. Now Widget, Inc. has
sufficient earnings to pay dividends to both its preferred and common stockholders. Before the common
stockholders may receive any dividend payments, the company must pay $13 to the preferred shareholders
(the missing amounts of $3 for Year 1, $3 for Year 2, $2 for Year 3, and the full stated $5 for Year 4).
Non-Cumulative Preferred Stock

If preferred stock is non-cumulative, the dividends in arrears are not paid to stockholders. Instead, only the
current year’s dividend must be paid before common stock dividends may be paid.
Now, assume that Widget, Inc. has issued 5% non-cumulative stock. Again, the widget market has been in
turmoil for the last three years and, as a result, the company has paid only the following dividends:
Dividends Paid
Year 1 $2
Year 2 $2
Year 3 $3
In Year 4, if the widget market rebounds, how much must Widget, Inc. pay to its non-cumulative preferred
shareholders if it also wants to pay a common dividend? Only $5 since the preference is limited to the
current year’s dividend for non-cumulative preferred stock. Remember, non-cumulative preferred stock is
not entitled to any dividends in arrears.

Participating Preferred Stock

For preferred stock, the stated return is typically the maximum annual income that an investor may expect
to receive. However, an investor who purchases participating preferred stock may receive a higher
dividend if the company is doing well and its common dividends exceed a specified amount. For example,
if the stock is a 5% preferred, but participating to 8%, it will normally pay a 5% dividend, but could
receive up to 8% if the common stock dividends reach a specified level.
Callable Preferred Stock

A company that issues callable preferred stock has the right to repurchase the stock (i.e., to call it back) at
a specified price at some time in the future. In order to induce investors to buy the stock, the call price is
typically higher than the stock’s par value.
Convertible Preferred Stock

This type of stock appeals to investors who want higher, more secure income than common stocks
typically provide, but also want the higher potential for capital appreciation that common stocks offer. The
trade-off is a lower dividend rate than what’s offered by other types of preferred stock.
Investors who purchase convertible preferred stock are able to, at their discretion, convert the par value of
the preferred stock into a predetermined number of common shares at a specified price
—which is the stated conversion price.
For an investor to determine his conversion ratio (i.e., the number of shares to which he’s entitled), the par
value of the preferred stock ($100) is divided by its conversion price. For example, if the conversion price
is $25, then the conversion ratio is 4-for-1 ($100 par value ÷ $25). The preferred stockholder will receive
four shares of common stock for every one share of preferred stock.
A feature that an issuer may add to convertible preferred stock is to make the stock callable. Whether or
not a customer decides to convert the stock depends on the relative value of the common stock he would
obtain through conversion as compared to the call price. The preferred stock will typically trade at a value
which reflects the best choice for the customer.
For example, a notice is published stating that RMO 5% convertible preferred stock will be
called at $102 per share. The preferred is convertible into 2 shares of common stock and
RMO’s common stock is selling in the market at $60 per share. After the notice appears,
the price of the preferred stock will most likely trade in the market at a price near $120.
Why is this the case? Since the converted preferred stock has a value of $120 ($60 per common share x
2 conversion ratio) and the fact that the call price is only $102, the market price of the preferred stock
will reflect the increased value of the common stock.

Variable/Adjustable Rate Preferred Stock

For variable/adjustable rate preferred stock, its dividend rate adjusts under a predetermined formula and is
based on a benchmark, often T-bill rates. The market prices of variable rate preferred stock is typically
more stable than those of fixed rate preferred stock.
K Shares Preferred Stock

These shares begin with a fixed rate, but after a certain amount of time (approximately five years), they
switch to a floating or adjustable rate. K shares have the following additional characteristics:
 They’re depository shares and represent a larger basket of an issuer’s preferred stock
 They have a wide range of par values
 They generally have no voting rights
 Their dividends are non-cumulative, but are qualified for tax purposes (taxed at a maximum rate of 20%)
Common versus Preferred Stock

Common Stock Preferred Stock
Ownership stake in the company  
More likely to receive regular dividend payments 
Higher priority in the event of bankruptcy 
Greater potential for capital appreciation 
Typically has voting rights 
Issued with a specific dividend rate 
Penny Stock Regulations

Due to some firms using high-pressure, cold-calling techniques in an effort to sell securities of
questionable value, the SEC has adopted several rules regarding the solicitation and sale of low-priced OTC
stock (i.e., penny stock). These securities are often quoted in the OTC Bulletin Board (OTCBB) and Pink
Marketplace. The rules were created to prevent certain types of abusive sales practices and to ensure that
investors are being provided with information about the penny stock market.
Definition of Penny Stock

According to SEC rules, a penny stock is defined as an unlisted equity security that has a bid price below
$5.00 per share.

The following list indicates the exceptions to the penny stock definition:
 Exchange-traded equities (e.g., NYSE or Nasdaq) regardless of the price at which they’re quoted
 Investment company securities
 OCC-listed puts and calls
 Securities with a market value of at least $5 per share
 Securities whose issuer has net tangible assets exceeding $2 million if it’s been in continuous
operation for at least three years, net tangible assets exceeding $5 million if it’s been in continuous
operation for less than three years, or average revenue of at least $6 million for the last three years
Penny Stock Disclosure Rules

SEC Rules 15g-1 through 15g-6 require that customers be provided with specific information if broker-
dealers intend to execute penny stock transactions for them. Prior to any penny stock transactions being
executed, the broker-dealer must provide the customer with a specific penny stock risk disclosure
document. The document must contain language that’s specified by the SEC to describe the risks involved
in penny stock investing and to summarize other disclosures the broker-dealer must make to the customer.
In addition, for each penny stock transaction, the broker-dealer must disclose to the customer:
 The current quote for the security
 The compensation that the broker-dealer will receive for the transaction
 The compensation that the registered representative will receive for the transaction
As of the last trading day of any month, if a broker-dealer has sold a security to a customer that meets the
definition of a penny stock, the broker-dealer must deliver a monthly statement to the customer provided
the security is held in the customer’s account. The statement must include the identity and the number of
shares of each penny stock being held in the customer’s account and, to the extent that it’s able to be
determined, the estimated market value of the security.
Exemptions Securities that are sold in the following transactions are NOT subject to the penny stock
disclosure rules:
 Transactions with institutional accredited investors. In this case, institutional refers to accredited
investors that are not individuals (defined by Regulation D for private placements).
 Private placements
 Transactions with the issuer, officers, directors, general partners, or 5% owners of the company’s stock
 Transactions that are not recommended by the broker-dealer
 Transactions that are executed by a broker-dealer whose commissions and markups from penny stocks
don’t exceed 5% of its total commissions and markups

Sales Practice Requirements for Penny Stocks

According to SEC Rule 15g-9, prior to the purchase of a penny stock by a customer, a broker-dealer must
approve the person’s account for penny stock transactions and obtain from the customer a written
agreement that indicates the identity and quantity of the penny stock to be purchased.
Account Approval Procedures To approve a customer’s account for transactions in penny stocks, the
broker-dealer must:
 Determine that penny stock transactions are suitable for the customer based on information about the
customer’s financial situation and investment objectives
 Deliver to the customer a written statement regarding this suitability determination
 Obtain from the customer a manually signed and dated copy of the statement
The list of exemptions from the account approval procedures of Rule 15g-9 are identical to the exemptions
from the disclosure rules; however, one additional exemption is provided for:
 Transactions with established customers – those for whom the broker-dealer (or its clearing firm) carries
an account and who has:
‒ Executed a securities transaction or deposited funds into his account more than one year prior to
the penny stock transaction, or
‒ Made three purchases of penny stocks which occurred on three separate days and involved three
separate issues
Derivative Securities
Derivative securities are special types of investments that track the value of common stock or some other
underlying asset. For example, imagine a security which provides the owner with the opportunity to buy
100 shares of IBM at $105 per share regardless of how high the stock may rise in the near future. This is
the position in which the buyer of a call option will find himself. If IBM rises above $105, the call option
has value since the investor is entitled to buy the shares at a price below the current market price. On the
other hand, if IBM declines in value to below $105, the call option will have little value since the stock
could be purchased in the market at a better price than what’s available with the call option.
The following section will examine three types of derivatives—rights, warrants, and options. Remember,
of the three derivative types, the Series 7 Examination will require test takers to have the most in-depth
level of understanding of options. However, this chapter will only provide a brief introduction to options
for the purpose of comparing them to the other two derivative types.
Preemptive Rights
An exclusive privilege of common stockholders is that they may be entitled to preemptive rights. When a
corporation intends to issue additional shares of stock, a rights offering may be conducted to provide current
shareholders with the opportunity to buy the shares before they’re offered to the public.

In doing so, the current shareholders are able to maintain their proportionate ownership interest in the
company. If shareholders choose not to subscribe to the offering, their percentage of ownership and ability
to control the company’s future will be diluted by the new stock offering.
Rights Offering and Subscription Price In a rights offering, all existing common stockholders
automatically receives one right for every one share they own. However, the number of rights required to
buy one new share of stock, the price at which the shares may be acquired, and the available period for
exercising the rights will vary. Usually, the offer is good only for a limited number of days and the preset
purchase price is below the current market value of the stock. This preset exercise price is referred to as
the subscription price.
For example, Widget Inc. has 1,000,000 shares of outstanding stock and plans to issue an
additional 1,000,000 shares to the public. An investor who currently owns 100,000 shares
(10% of the outstanding stock) will receive 100,000 rights. These rights will allow her to
purchase 100,000 shares at a favorable price and maintain her 10% ownership in the
company. If she doesn’t exercise her rights within a certain period, the rights will expire.
Investors who acquire rights have two viable options. First, the holder may choose to exercise the rights by
tendering them to the issuer’s transfer agent. Second, the rights may be freely transferred (traded) since
they usually trade in the same market as the underlying stock.
Warrants
A warrant is another type of equity security that may be issued by corporations. Like rights, warrants give
the holder the ability to buy the issuer’s common stock at a specified price (the subscription price) in the
future. However, unlike stock rights that have a relatively short life, warrants have a maturity that’s often
set years in the future. In fact, some warrants have a perpetual (endless) life.
Another way that warrants differ from stock rights is that a warrant’s subscription price is usually set at a
price that’s higher than the current market price of the stock. Therefore, if a stock later increases in value
(above the subscription price), the holder of the warrant will be in a position to realize a profit. Companies
typically issue warrants in connection with an offering of stock or bonds. By including the warrants,
investors are given an added incentive to purchase these issues. Warrants are usually able to be detached
from the securities with which they were originally issued and sold separately.
Intrinsic Value If the stock’s market price rises above the warrant’s subscription price, then the warrant
has intrinsic value. For example, if the stock’s market price is $33 and the warrant’s subscription price is
$30, then the warrant has intrinsic value of $3. However, to reflect the possibility that the stock’s price
may increase further before the warrant expires, the actual value of the warrant may be even higher.

Rights Warrants
Purchasers of the issuer’s
Issued to: Existing common stockholders
preferred stock or bonds
Price: Below current market value Above current market value
Maturity: Short-term (30-45 days) Long-term (Years, not days)

Allows existing stockholders to A sweetener attached to the
Purpose maintain their proportionate issuance of stocks or bonds to
interest in a company encourage a purchase
American Depositary Receipts (ADRs)

ADRs facilitate the trading of foreign stocks in the United States. An ADR represents a claim to foreign
securities with the actual shares being held by U.S. banks abroad. ADRs trade in U.S. markets, either on
an exchange or over-the-counter, and are priced and pay dividends in U.S. dollars rather than in a foreign
currency. Although they’re priced in U.S. dollars, since ADRs represent indirect ownership of foreign
securities, holders are still exposed to foreign currency risk.
An ADR may be sponsored or unsponsored. For a sponsored ADR, the company whose stock underlies the
ADR pays a depositary bank to issue ADR shares in the U.S. This sponsorship permits the company to raise
capital in the U.S. and list the ADR on the NYSE or Nasdaq. Many of the largest ADRs are sponsored.
For an unsponsored ADR, the company doesn’t pay for the cost associated with trading in the U.S.;
instead, a depositary bank issues the ADR. Unsponsored ADRs trade in the over-the-counter market and
are usually quoted on the OTC Bulletin Board (OTCBB) or the Pink Marketplace.
Sponsored Unsponsored
Issued in cooperation with the foreign company Issued without the involvement of the foreign company
Generally trade in the OTC market

May trade on U.S. exchanges (NYSE or Nasdaq)
(OTCBB or Pink Marketplace)
NYSE and Nasdaq-Listed Securities

Securities that are eligible for trading on either the New York Stock Exchange (NYSE) or the National
Association of Securities Dealers Automated Quotation (Nasdaq) system are referred to as listed
securities. On the NYSE, every security is assigned to one designated market maker (DMM)—formerly a
specialist—to be responsible the security’s fair and orderly trading. However, securities that are listed on
Nasdaq can have multiple market makers quoting their stock.

Originally, the NYSE and other regional exchanges offered a centralized trading venue that functioned as
an open outcry auction market. Today, the NYSE employs hybrid trading methods that include both
personal face-to-face trading on a physical floor as well as electronic linkages.
To facilitate the trading of all Nasdaq-listed securities, members utilize the Nasdaq Market Center
Execution system. In addition to providing automatic executions at firm quotes, this automated, electronic
system also provides for trade reporting. The Nasdaq system is considered a negotiated dealer market.
OTC Equities—Non-Exchange Securities

An OTC equity security is generally defined as any equity that’s not listed or traded on a national
securities exchange (e.g., NYSE or Nasdaq). OTC equities include domestic and foreign equity issues,
warrants, units, American Depositary Receipts (ADRs) and direct participation programs (DPPs). Prices of
OTC equities may be obtained from two sources—the OTC Bulletin Board (OTCBB) and the OTC
Markets Group Pink Marketplace (described in a later chapter).
Electronic Communication Networks (ECNs)

ECNs are market centers that allow for the quoting and trading of exchange-listed securities (including
Nasdaq). The objective of an ECN is to provide an electronic system for bringing buyers and sellers together
(matching). These systems allow subscribers to disseminate information about orders, execute transactions both
during the trading day and after-hours, and buy and sell anonymously. ECNs charge subscribers a fee for using
their system and act in only an agency, not principal, capacity.
Dark Pools
A dark pool is a system that provides liquidity for large institutional investors and high-frequency traders,
but it doesn’t disseminate quotes. The name is derived from the fact that the details of the quotes are
concealed from the public. The objective is to allow these investors to trade with the least amount of
market impact and with low transaction costs.
Tax Issues Associated with Equity Securities

Next, we will look at some specifics regarding the taxation of equity investments. There are two issues that
are of primary concern, (1) the tax status of the securities’ periodic dividend payments, and (2) the
resulting capital event at the time of resale.
Dividends—Cash Dividends
Dividends may be paid in the form of cash or additional shares of stock. Cash dividends are taxable in the
year in which they’re received by the shareholder. Individuals must pay tax on the full amount of all cash
dividends received, even if those dividends are subsequently reinvested with the issuer.

Corporate Dividend Exclusion Corporations are given preferential tax treatment on any dividends that
they receive from other corporations. The corporate exclusion is available for cash dividends paid on
common and preferred stock. In general, if a corporation owns less than 20% of the distributing corporation,
50% of the dividend income will be excluded from corporate income. If the corporation owns 20% or more
of the distributing corporation, the exclusion is 65% of the total dividends received.
For example, ABC Corporation owns 1,000 shares of ATT (less than 20% of the company)
and receives dividends of $2,000. Since the dividend qualifies for the corporate dividend
exclusion, $1,000 ($2,000 x 50%) will be tax-free. The corporation will be taxed on only
the remaining $1,000.
Dividends from REITs don’t qualify for the dividend exclusion. Also, depending on the portfolio’s
composition, dividends paid on mutual fund shares may not qualify for the corporate exclusion. If a
mutual fund invests in fixed-income securities (such as money-market funds or bond funds), all or part of
the dividend will not qualify. The fund must inform a corporate investor as to whether a dividend
distribution qualifies for the exclusion.
Dividends on Foreign Securities Dividends and interest paid to a U.S. investor on foreign securities,
such as ADRs, may be subject to a withholding tax by the country from which they were paid. If an
investor owns securities and the dividend and/or interest payments were subject to foreign tax, her broker‐
dealer will send her a form that reports the gross amount of the dividends or interest and the amount of tax
withheld by the foreign government. The amount of the foreign tax paid may be claimed by the investor as
a deduction against income (a relatively easy process) or may be applied as a credit against U.S. income tax
(requires complex filings). However, the investor still owes U.S. income tax on the net dividend.
Stock Dividends Stock dividends are not taxable at the time of receipt because, although the
shareholder is receiving more shares, they will have a reduced basis per-share. With stock dividends, the
taxable event occurs when the acquired shares are eventually sold.
For example, Ms. Black originally purchased 100 shares of stock at $11 for a cost basis of
$1,100 total cost, but then received a 10% stock dividend. Due to the stock dividend, her cost
per share is adjusted by dividing the original total cost of $1,100 (100 shares x $11 per share)
by the new total number of shares of 110 (100 x 10% = 10 extra shares). This results in a
new cost basis of $10 per share ($1,100 ÷ 110).
The gain or loss from any subsequent sales is calculated by using the new cost basis of $10 per share.
Therefore, if 50 shares were later sold at a price of $15 per share, Ms. Black will have a profit of $5 per
share ($15 – $10) for a total gain of $250 (50 shares x $5).
Stock Splits
For tax purposes, stock splits and stock dividends receive the same tax treatment. The shares received from
either action are not taxable at the time of receipt. The only action required is for the investor to adjust his per
share cost basis in the security. A gain or loss will result from any subsequent sale of the shares.

Again, with a forward stock split, the number of shares owned will increase and the cost basis per share
will decrease. With a reverse stock split, the number of shares owned will decrease and the cost basis per
share will increase.
Rights Offerings
When a corporation sells additional shares of stock through a rights offering, it will distribute stock rights
to its shareholders. As with stock dividends and stock splits, rights are not immediately taxable, but will
instead be used in calculating the cost basis of any stock purchased through the offering. However, if the
shareholder were to sell his rights in the open market, the proceeds would be taxable as ordinary income.
Cost Basis of Securities

The cost basis of a security is the total price paid to acquire the security including any transaction costs
(e.g., commissions). If Mr. Smith purchased 100 shares of ABC at a cost of $10 per share, his cost basis
will be $1,000. As explained previously, his cost basis will be adjusted proportionately for stock splits or
stock dividends. For tax purposes, an investor’s profit or loss is calculated based on the difference between
the cost basis and the proceeds from the sale.
Identifying Shares Sold Investors who have made multiple purchases of the same stock over time will
generally have a different basis for each purchase. If any portion of the shares are subsequently sold, the
investor may choose to designate which shares are being sold. If specifically designated, the brokerage
firm will mark the confirmation "versus purchase of . . ." and insert the desired purchase date. However, if
a designation is not made, the IRS will automatically assume that the taxpayer is using the first-in, first-out
(FIFO) method to determine the position being sold. For sales, the use of specific identification or FIFO
may have a significant influence over whether the investor has a resulting gain or loss.
For example, Mr. Jones has executed the following transactions in the same year:
On May 1, he bought 100 shares of XYZ at $60
On September 1, he bought 100 shares of XYZ at $90
On October 15, he sold 100 shares of XYZ at $89
For Mr. Jones to be able to apply the October 15 sale of 100 XYZ at $89 to his
September 1 purchase at $90 (creating a $100 loss), the sell order ticket must be marked
"versus purchase of September 1, 20XX." If not designated, the IRS will apply the
October 15 sale to the May 1 purchase (FIFO), thereby creating a $2,900 capital gain.

Cost Basis of Inherited Securities When securities are inherited, the recipient’s cost basis is equal to the
market value of the securities at the time of the deceased’s death. This is referred to as a step-up in cost basis.
Regardless of the deceased’s actual holding period, the recipient’s holding period is considered long-term.
For example, on July 30, Joe’s uncle purchased 100 shares of TPA stock at $15,
but subsequently passed away on August 18 when the market value of TPA was
$22. If Joe inherits the TPA stock, he will have a cost basis in the stock of $22
(the market value at the time of his uncle’s death). Although his uncle owned the
stock for less than one month, Joe’s holding period is considered long-term.
Cost Basis of Gifted Securities When securities are received as a gift, the recipient’s cost basis is the
lesser of the security’s market value or the donor’s cost. If the market value is higher than the donor’s cost,
the recipient’s cost basis is equal to the donor’s cost basis. However, if the market value is less than the
donor’s cost, the recipient’s cost basis is equal to the market value of the securities at the time of the gift.
The holding period of the recipient will be the same as the holding period of the giver.
For example, Charles bought 100 shares of STC at $15 on May 25 and gives the stock to
Bruce on August 14 when the market price is $20. Since the market price on the day the gift
is made ($20) is higher than Charles’ cost ($15), Bruce’s cost basis for the stock is $15. On
the other hand, if the market price on August 14 was $12, then Bruce’s cost basis would be $12.
Capital Gains and Losses

Recognition of Gains and Losses
Securities such as stocks, bonds, and options are considered capital assets. For an investor, any sale of
these assets will likely produce either a capital gain or capital loss. These gains or losses are typically
recognized in the year in which the asset was sold. If a capital asset is sold for more than its cost, it’s
considered a capital gain. On the other hand, if a capital asset is sold for less than its cost, the result is
considered a capital loss. When the holding period for the asset exceeds one year, the gain or loss is
considered long-term. However, if the holding period for the asset is one year or less prior to its sale, any
gain or loss is considered short-term.
Whether a capital gain is classified as short-term or long-term may have significant tax implications for
investors. Due to tax law changes enacted in 2013, long-term capital gains are taxed at a maximum rate of
20%, while short-term capital gains are taxed at the same rate as ordinary income. Any gains or losses that
are generated from short sales are typically treated as short-term capital gains or losses since a holding
period for the security is not established.
Netting Gains and Losses An investor who has a combination of capital gains and losses involving
securities with short-term and long-term holding periods will need to net those activities to determine the
applicable tax treatment. Netting refers to using capital losses to offset capital gains on a dollar-for-dollar
basis. The process of netting effectively reduces (or possibly eliminates) the tax liability that normally
exists when capital gains are created.

Net short-term capital gains or net long-term capital gains are taxed at the rates previously specified.
However, if an investor has both net long-term gains and net short-term losses, these two figures must be
netted before the 20% tax rate applies.
If gains exceed losses, the tax liability is dependent on the category into which the remaining gains fall.
For example, if an investor has a $12,000 short-term capital gain and a $7,000 long-term capital loss, the
result is a net $5,000 capital gain which will be taxed at the short-term rate. If capital losses exceed capital
gains, a maximum of $3,000 of those losses may be used in the current tax year as a deduction against
ordinary income. Thereafter, any unused losses are able to be carried forward for use in subsequent years
until the excess net losses have been offset by net gains or ordinary income.
For example, an investor with $5,000 in long-term gains and $10,000 in short-term losses
will net these two results and be left with a $5,000 short-term loss ($10,000 – $5,000).
The investor will then deduct $3,000 from their ordinary income and carry forward the
remaining $2,000 loss to the next tax year.
Wash Sale The IRS doesn’t allow an investor to claim a deduction for a capital loss on an investment
if he purchases “substantially the same security” within 30 days of the sale. The period covered by the
wash sale rule is actually 61 days since it includes the date of sale and 30 days both before and after the
date of sale.
If a security is sold for a loss, the seller must wait a minimum of 31 days before repurchasing the same or
similar security. If a wash sale is determined to have occurred, the loss is denied and will be added to the
cost basis of the new purchase.
For example, an investor bought stock at $24 per share and later sold the stock at
$21 per share—claiming a $3 loss per share. If, 10 days after the sale (within 30
days), the investor buys the same stock at $23, the $3 loss will be disallowed and his
new cost basis will be $26 ($23 + $3).
For purposes of the wash sale rule, what does the IRS consider to be substantially the same? For common
stock, in addition to the stock itself, convertible bonds, convertible preferred stocks, or call options of the
same company are considered “substantially the same” since they’re able to be converted into the shares.
For debt securities, bonds of a different issuer, or with a different coupon, or with a different maturity will
not be considered “substantially the same.” However, if a bond is purchased and subsequently sold with
only different accrued interest amounts, this will not be considered a relevant difference for avoiding the
wash sale rule.

Short sales are also covered by the wash sale rule. If a short seller closes his position by buying the
borrowed security and subsequently shorts the same security within a 30-day period, he will trigger the
wash sale rule.
Wash Sale Zone

In this zone, any purchase of the
Purchase Purchase
security will trigger a wash sale
allowed allowed
30 days 30 days
Sale at
a loss
Conclusion
This ends the chapter on equities. Keep in mind that equities represent an investor’s ownership in a
corporation and, with ownership, the investor is entitled to certain rights and privileges. The next series of
chapters will focus on debt securities. With debt securities, investors are allowing issuers to borrow their
money and, in return, receive the issuer’s pledge that it will repay the bond’s principal plus interest.

CHAPTER 5
Fundamentals of
Debt Instruments
Key Topics:
 Basic Structure
 Bond Yields
 Retiring Debt
 Tax Implications
CHAPTER 5 – FUNDAMENTALS OF DEBT
This chapter will focus on the basics of bonds (debt securities). When an investor buys a bond, he is lending
money to the issuer (e.g., corporation, government, or municipality). In return, the issuer agrees to pay a
specific rate of interest over the bond’s life and to repay the face value of the bond at its maturity date.
Although bonds are classified based on the entity that issues them, they all have common fundamental traits.
This chapter will examine these characteristics, while subsequent chapters will cover the specific details of
corporate bonds, U.S. government bonds, and municipal bonds.
Fixed-Income Securities
As described in the previous chapter, there are two methods a corporation may use to raise capital through
the sale of securities—issuing bonds and issuing stock. Many large corporations use both methods to
finance their operations. Unlike investors who buy stock, bond investors don’t become part owners of the
company; instead, they become creditors.
Basic Characteristics of Bonds

A bond is a contract between an issuer and an investor. As stated previously, the investor lends money to
the issuer and the issuer (debtor) promises to repay debt service. Debt service represents the total of all of
the interest payments over the bond’s life and the bond’s par value at maturity. The issuer must stand
ready to make payments since, if any payments are missed, it’s considered to be in default.
For an issuer, raising capital through debt is referred to as leverage financing since the issuer is borrowing
against its net worth. Actually, when a corporation has more debt than equity outstanding, it’s considered a
leveraged issuer.
Let’s now examine some of the key terms used when analyzing bonds.
Par Value The par value of a bond (also referred to as the principal or face value) is the amount that the
issuer agrees to pay the investor when the bond matures. An investor who buys a bond with a par value of
$1,000 expects to receive $1,000 when the bond reaches maturity. Regardless of the amount an investor pays
for a bond, if it’s held to maturity, the issuer is obligated to pay the par value. Most bonds are issued in
multiples of $1,000, but some (e.g., U.S. Treasury securities) may be issued in denominations as small as $100.
Coupon Rate Obviously, investors don’t buy bonds just to receive their principal back at some future
date. The issuer must also agree to pay investors interest on the loan until the bond matures. The rate of
interest is generally fixed at the time the bond is issued and, with some exceptions, remains the same for
the life of the bond. This fixed rate of interest is also referred to as the bond’s coupon rate. The interest
paid is calculated based on the bond’s $1,000 par value, not the actual price paid for the bond.

In order to determine the amount of interest that the investor will receive annually, the bond’s par value
($1,000) is multiplied by its stated interest rate. For example, if a client purchases a 6% corporate bond, she
will receive $60 per year ($1,000 x 6% = $60). Since bonds usually pay interest twice per year
(semiannually), the investor will receive two $30 payments every year ($60 ÷ 2 = $30).
The bond’s maturity date is important in determining when an investor will receive her interest payments. One
of the payment dates is the actual maturity date, while the other is six months from that date. Therefore, if
the investor’s 6% corporate bond matures on June 1, 2030, she will receive two payments—one every
June 1 and the other every December 1.
Fixed or Variable Rates As previously mentioned, a bond’s interest rate is set at the time of issuance
and generally remains fixed for the life of the bond. However, in some cases, as interest rates move up or
down, the coupon rate will be adjusted to reflect market conditions. These adjustable rate bonds are sometimes
referred to as variable or floating rate securities.
Initial Interest Payment Traditionally, bonds pay interest on the 1st or 15th of the month to ease
paperwork issues. However, newly issued bonds pay interest from the dated date (the date from which
interest begins to accrue), which may not fall on the 1st or 15th. For this reason, the very first coupon on a
newly issued bond may be for more or less than the traditional six-month period as the issuer tries to get
synchronized with the 1st or 15th payment date. If the first coupon is for more than six months, it’s referred
to as a long coupon; if the first coupon is for less than six months, it’s referred to as a short coupon.
Accrued Interest Since bond interest is paid semiannually, a bondholder who sells a bond between
interest payments is usually entitled to the interest earned during the period when he still owned the bond.
This accrued interest is the amount of interest the seller is entitled to receive and the amount the buyer is
required to pay.
Corporates and Municipals Interest on corporate and municipal bonds accrues on the basis of a 360-day
year with each month having 30 days. The amount of accrued interest is calculated from the last interest
payment date up to, but not including, the settlement date.

The following example shows the calculation of accrued interest:

On Thursday, September 15, using regular-way settlement, an investor purchases $10,000
face value of a 6% corporate bond that matures on December 1, 20XX. How many days
have accrued and what dollar amount of accrued interest is the investor required to pay?
Remember, interest is paid every six months on dates that are based on the maturity date.
In this example, interest will be paid each June 1 and December 1. Therefore, accrued interest
will be calculated from June 1 (the last interest payment date).
Since regular-way settlement on corporate bonds occurs two business days after the trade
date, this bond trade will settle on Monday, September 19. Accrued interest on the purchase is
calculated up to, but not including, the settlement date of September 19.
The number of days of accrued interest owed includes:

June 30 days
July 30 days
August 30 days
September 18 days
Total 108 days of accrued interest
The dollar amount of accrued interest is calculated as follows:
Days of Interest
Amount of interest = Principal x Rate x
360
108
= $10,000 x 6% x
360
= $180.00
The buyer will pay the seller $180.00, which is the amount of interest that has accrued since
the last interest payment was made. On December 1, the buyer (now the bondholder) will
receive the entire interest payment of $300 (one-half of the yearly interest). This amount
represents a return of the $180.00 paid in accrued interest (the seller’s share) plus the
$120.00 which is the buyer’s share of the interest that has accrued since September 19.
Note: If a coupon date is on the 15th of the month for a corporate or municipal bond, there will be 16 days
remaining in that month. This is because the calculation begins at the date of the last coupon payment and
goes up to, but doesn’t include, the settlement date.

Treasuries Accrued interest on Treasury bonds and Treasury notes is calculated on the basis of a 365-day
year with actual days in each month. Treasury-bills don’t pay accrued interest since they have no coupon.
When a bond trades without accrued interest, it’s referred to as trading flat. Examples of issues that trade
flat include T-bills, zero-coupon bonds, and issues in default.
Maturity Date This is the date on which the bondholder will receive the $1,000 return of principal from
the issuer. The maturity or due date will be identified on the face of the bond.
Serial versus Term Issues Corporations and other entities routinely issue millions of dollars worth of
bonds at the same time. There are several ways that the issuer may structure its loan repayment. Two of
the common forms are term and serial.
If all of the bonds of an offering are due to mature on the same date, it’s referred to as a term bond issue. On
the other hand, if the bonds of an offering will mature sequentially over several years, it’s referred to as a
serial bond issue. For example, an issuing corporation may sell $50 million par value of bonds with $10
million coming due each year over a five-year period. With serial issues, an investor could purchase a quantity
of bonds that mature at the same time or, if she wishes, she could purchase bonds with different maturities.
A serial bond may be structured so that principal and interest payments represent more or less equal annual
payments over the life of the offering, which is referred to as level debt service.
Why Bond Prices Fluctuate from Par

The par value of a bond can differ greatly from the price the investor pays to purchase the bond (i.e., the
market price). Although most bonds are initially sold at their 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, while a bond that’s sold for more than its par value is selling at a premium.

Discounts and Premiums

The reasons for these discounts or premiums typically relate to the changes in prevailing market interest
rates (i.e., interest-rate risk) or concerns about the creditworthiness of the issuer (i.e., credit risk). Let’s
carefully analyze these two risk factors.
Interest-Rate Risk Investors who purchase bonds assume the risk that the bond’s market value may
decline if market interest rates rise. Interest-rate risk implies that as market rates increase, investors will not
be interested in purchasing existing bonds at par since they’re able to obtain higher yields by purchasing new
bonds. Therefore, existing bonds will need to be offered at a discount in order to attract purchasers.
Credit Risk Credit risk is a recognition that an issuer may default and may not be able to meet its
obligations to pay interest and principal to the bondholders. Not surprisingly, issuers that are considered high
credit risks must pay a higher rate of interest in order to induce investors to purchase their bonds.
Generally, if a company is perceived as risky, the prices of its bonds will fall; however, if a company is
viewed as improving, its bond prices tend to rise.
Measuring Credit Risk Securities issued by the U.S. government have the lowest possible credit risk since
the government’s risk of defaulting is virtually zero. This is due to the fact they’re backed by the full faith
and credit and taxing authority of the U.S.
Credit risk is more difficult to evaluate when the bonds are issued by a corporation or a municipality. Most
investors rely on an organization that specializes in analyzing the credit of bond issues. Some of the
prominent credit rating companies that provide bond ratings are Moody’s, Standard and Poor’s (S&P), and
Fitch Investors Service. Each company evaluates the possibility that an issuer may default and assigns the
issue a credit rating. Later, this rating may be raised or lowered depending on subsequent events. A lowered
credit rating may cause a bond’s market price to drop significantly.

Below are the ratings of Moody’s, Standard and Poor’s, and Fitch from the highest to the lowest:
Moody’s S&P Fitch

Best Quality Aaa AAA AAA
Investment High Quality Aa AA AA
Grade Upper Medium A A A
Medium Baa BBB BBB
Ba BB BB
B B B
Speculative Caa CCC CCC
Grade Ca CC CC
C C C
D DDD
DD
D
For bonds issued by corporations, Moody’s further subdivides each major rating category by using a 1, 2,
or 3, with 1 being the highest. For example, Aa1 is higher than Aa2, however, Aaa3 is higher than Aa1.
Standard & Poor’s uses a plus (+)and minus (-) to further distinguish between ratings. For example, A+ is
better than A; however, A- is better than BBB+.
It’s important to note that only relatively large issues are rated. This doesn’t necessarily mean that an
unrated issue is of poor quality; instead, it may suggest that an issue may be too small to apply for and be
given a rating.
Call Risk Another risk that influences the prices of certain bonds is that they may be retired before their
maturity. Decreasing interest rates will increase the likelihood of existing bonds being called by the issuer
prior to maturity. If bonds are called, it occurs at a specific price and on a specific date. Call features will
be described in greater detail later in this chapter.
Bond Pricing
A bond’s price is usually stated as a percentage of its par value. For example, a bond with a price of 100 is
selling at 100% of its par value, or $1,000 (100% of $1,000). A bond with a price of 90 is selling at a
discount equal to 90% of its par value, or $900. A bond with a price of 110 is selling at a premium
equivalent to 110% of its par value, or $1,100.
A bond’s price may also be expressed in terms of points. Each point is equal to 1% of the bond’s par
value, or $10. So basically, 99 points is equal to $990 (99 points x $10 per point = $990). A bond selling at
100 is selling for 100 points or $1,000. If the bond’s price increases to 101, it’s now selling for $1,010
(101% of the par value).

Bond Price Percentage of Par Value Price in Dollars

99 99% $990 Discount
100 100% $1,000 Par
101 101% $1,010 Premium
Following are some additional pricing examples:
Corporate and Municipal Bonds:

87 1/8 = 87.125 = $871.25
100 7/8 = 100.875 = $1,008.75
103 3/8 = 103.375 = $1,033.75
Prices and Yields: An Inverse Relationship

A bond’s coupon (interest rate) is generally fixed for its life. As market interest rates change, new bonds
will be issued with either higher or lower coupon rates than what existing bonds pay. In order to be able to
keep pace with current interest rates, the value of existing bonds will need to change.
As interest rates rise, the value (price) of existing bonds will fall since the demand for existing bonds that
offer lower interest rates will decline. If interest rates fall, the value (price) of existing bonds will rise since
they’re worth more than a new bond issued with a lower coupon. So essentially, there’s an inverse
relationship that exists between market interest rates and existing bond prices.
PRICE
MARKET
RATES
To summarize, as interest rates increase, the prices of existing bonds decrease and,
as interest rates decrease, the prices of existing bonds increase.

Calculating Bond Yields

As with any other investor, a bondholder is interested in determining her investment’s return or yield.
There are three different measures for determining a bond’s yield—nominal yield, current yield, and
yield-to-maturity.
Nominal Yield A bond’s nominal yield is the same as its coupon rate. If a bondholder purchases a
6% bond, then her nominal yield is 6%.
Current Yield Current yield essentially measures what a bond investor receives for what she pays. While
the nominal yield is based on a bond’s par value, current yield is based on the bond’s current market price.
Current yield is calculated by dividing the bond’s annual interest payment by the bond’s current market price.
Annual Interest
Current Yield =
Current Market Price
If an investor purchases a 6% bond that has a par value of $1,000 for $800, what’s her current yield?
1. The bond’s annual interest payment is calculated by multiplying the par value by its nominal yield.
$1,000 x 6% = $60.
$60 annual interest
2. Current Yield = = .075 or 7.5%
$800 market price
Yield-to-Maturity (YTM) Yield-to-maturity takes into account everything that an investor receives from a
bond from the time she purchases it until the bond matures. This includes the bond’s regular interest
payments, plus the difference between what the investor paid for the bond and what she receives when the
bond matures (the bond’s par value). An investor who purchased a bond at a discount will have a profit since
she paid less for the bond than its face value. An investor who purchased a bond at a premium will have a
loss since she paid more than the bond’s par value. Yield-to-maturity also assumes that an investor will
reinvest any coupon payments at the original yield-to-maturity rate, which compounds the investor’s return.
Basis When a bond’s yield-to-maturity is being described, it may also be referred to as the yield or basis.
Therefore, a 7.44% yield-to-maturity, a 7.44% yield, and a 7.44 basis are synonymous.
The term basis is derived from one method of expressing yield. One basis point is equal to 1/100 of 1%;
therefore, a 1% difference in yield equals 100 basis points. The term basis points may be used to compare
the yields of two different bonds. For example, if Bond A is trading at a 4.55 basis and Bond B is trading at
a 4.95 basis, then Bond B is trading 40 basis points higher than Bond A. If an investor purchased Bond B
with a 4.95 basis, it would provide a pick-up yield of 40 basis points over Bond A.

From the current yield example above, the investor purchased a 6% bond that has a par value of $1,000 for
$800 (at a discount). If the bond matures in 10 years, the bond’s yield-to-maturity will include:
1. The bond’s semiannual interest payments for the next 10 years, plus
2. The $200 gain that she will receive when the bond matures ($1,000 par value – $800 market price), plus
3. The interest earned from reinvesting the semiannual coupon payments
Since the investor purchased this bond at a discount, the bond’s yield-to-maturity will be greater than both
its nominal yield and current yield.
Assume now that the investor purchased the same 10-year, 6% bond for $1,200 (at a premium). In this
case, the yield-to-maturity will include:
1. The bond’s semiannual interest payments for the next 10 years, minus
2. The $200 loss that she will incur when the bond matures ($1,200 market value – $1,000 par value), plus
3. Interest earned from reinvesting the semiannual coupon payments
Since the investor purchased the bond at a premium, the yield-to-maturity will be less than both its
nominal yield and current yield. If she had purchased the bond at par, then its yield-to-maturity would be
the same as its nominal yield and current yield.
Dollar Price Nominal Yield Current Yield Yield-to-Maturity

$1,000 (par) 6% 6% 6%
$800 (discount) 6% 7.5% Greater than 7.5%
$1,200 (premium) 6% 5% Less than 5%
In the diagram below, since the nominal yield is fixed, it’s always placed at the top of the triangle. The
yield-to-maturity is always placed at the far end, while the current yield will always be placed in between
the nominal yield and the yield-to-maturity.
PRICE NY CY YTM

To determine the relationship of yields on a discount or premium bond, just imagine the slope of the line
and remember the order in which yields are plotted. For illustration purposes, the following diagrams will
use the yields shown on the previous page:
$1,000 6% 6% 6%
>7.5% $1,200
7.5%
6% 6%
5%
$800 <5%
To summarize:
 If an investor purchases a bond at par, the nominal yield, current yield, and yield-to-maturity will all
be equal.
 If an investor purchases a bond at a discount, the highest yield will be the yield-to-maturity, followed
by the current yield, with the nominal yield as the lowest.
If an investor purchases a bond at a premium, the highest yield will be the nominal yield, followed by the
current yield, with the yield-to-maturity as the lowest.
Yield-to-Call Since it’s unknown whether a callable bond will actually be called, both the yield-to-call
and yield-to-maturity must be calculated. This is specifically required when quoting yields to a client.
Regulations stipulate that the yield being disclosed to the client must be the lower of the two yields. This
conservative return estimate is referred to as a bond’s yield-to-worst.
In general:
 If callable at par, a bond that’s selling at a discount will be quoted on a yield-to-maturity basis
 A bond selling at a premium will be quoted on a yield-to-call basis
 A prerefunded bond will be quoted on a yield-to-call basis (since it will not reach maturity)

Redeeming Bonds
When a bond reaches its maturity date, the bondholder will redeem it to the issuer and receive the bond’s
par value plus her last interest payment. At this point, the issuer’s obligation to the bondholder has ended
and the debt is considered retired. However, some bonds are redeemed before they mature.
Call Provisions
If a bond offering has a call feature attached, the issuer has the ability to redeem the outstanding bonds
before the ultimate maturity. If called, the investor receives the full return of principal plus any accrued
interest. For the issuer, the benefit is that it’s no longer required to make periodic interest payments once
the bond issue has been called.
Call Protection and Call Premium To make callable bonds more marketable to investors, most
offerings will provide a call protection period. This is the period during which the bonds cannot be called,
which is typically 5 to 10 years after the date of issuance. If the bonds are subsequently called, the issuer is
often required to pay the bondholders more than the par value in order to compensate them for the early
redemption of the bonds. This additional amount is referred to as a call premium.
For example, in January 20XX, an issuer sold bonds that mature in 20 years. Beginning
10 years after issuance, the bonds are callable at 102. If a bondholder buys one of these
bonds and the issuer calls it back after 10 years, she will receive $1,020 ($20 more than
the bond’s par value). The call protection gives the investor the assurance of knowing
that her bond cannot be called for 10 years.
Issue Date First Call Date Maturity Date

Jan 20XX 10 years later 10 years later
Bond has call Bond may

protection be called
Call Types Some calls are in-whole, which means that the entire issue is being called at one time.
Another type is a partial (lottery calls), which means the some of the bonds will be retired early, while
others will remain outstanding. A call feature that may be exercised at any time after the first call date is a
referred to as a continuous call. Some calls may be exercised only on particular dates such as one of the
bond’s interest payment dates. Finally, selected types of bonds may have catastrophe call provisions which
are enacted only if a bond’s underlying collateral is destroyed.
For example, a bond is issued to generate funds which will be used to construct a bridge.
If later, due to severe flooding, the bridge washes into the water, the issue may be called
with the bondholders being paid back with insurance proceeds.

Both partial and in-whole calls must be disclosed to a client prior to a bond’s purchase and noted on the
confirmation. However, due to the unlikelihood of occurrence, catastrophe calls are exempt from the
disclosure requirement.
Refunding Refunding involves an issuer selling a new bond and using the proceeds to pay off a bond
that’s currently outstanding. Refunding usually benefits issuers by providing them with the option of
calling back the outstanding bonds due to a decline in interest rates. Due to the decline in interest rates, the
issuers are able to refinance their debt at a lower rate of interest. This is similar to the process that
homeowners may use to refinance their mortgages once mortgage interest rates drop. With bonds, if an
issuer’s outstanding bonds have a 9% stated rate of interest, but current market interest rates have fallen to
6%, the issuer may reduce its interest costs by calling back the 9% bonds and issuing new bonds with a 6%
interest rate. On the other hand, if interest rates rise, the issuer is not likely to call the bonds.
Since issuers tend to redeem bonds early due to falling interest rates, the bondholders are unlikely to be
able to reinvest their money and achieve the same rate of return that they had been receiving. For example
if an investor’s 9% bond was called, she may be forced to invest her money in a bond paying only 6% or
seek a riskier investment in order to continue generating the same return. For that reason, early payment
(call risk) also exposes an investor to reinvestment risk.
Prerefunding If an issuer intends to lock in a lower rate prior to a scheduled call date, it may choose to
prerefund its outstanding issue. (Prerefunding is also referred to as advance refunding.) The new issue
being sold is called the refunding issue. The proceeds of this new issue are usually invested in government
securities and are deposited in a bank. An escrow agreement is signed and the bank ensures that the
securities on deposit, along with their earnings, will be available to pay the interest and principal on the
outstanding issue. At this point, the original issue is considered to be prerefunded.
Since the original issue is now secured by government securities that are held in escrow, the issuer is no
longer responsible for payment of interest and principal on these bonds. Also, the original rights and liens
the bondholders had under the indenture (bond agreement) are eliminated. This elimination of the issuer’s
responsibility for the offering and the elimination of the bondholder’s rights is referred to as defeasance.
Since the prerefunded bond is now secured by U.S. government securities, the creditworthiness of the
offering is enhanced. Ultimately, this results in an increase in the bond’s market value due to its
increased quality.
Escrowed-to-Maturity (ETM) and Escrowed-to-Call (ETC) When money is deposited into an escrow
account and used to pay off a bond at its maturity date, it’s referred to as being escrowed-to-maturity.
However, if it’s being paid off at a call date, it’s referred to as being escrowed-to-call.

Crossover Refunding Crossover refunding is a form of advance refunding in which the revenue stream
originally pledged to secure the refunded bonds continues to be used to pay debt service on the refunded
bonds until they mature or are called. At that time, the pledged revenues “crossover” to pay debt service
on the refunding bonds and escrowed securities are used to pay the refunded bonds. During the period
when both the refunded and the refunding bonds are outstanding, debt service on the refunding bonds is
paid from interest earnings on the invested proceeds of the refunding bonds.
Sinking Funds Many issuers establish a special fund—a sinking fund—into which they deposit funds
each year in order to redeem their bonds. The funds may be used to either redeem bonds early or when
they mature. The bond indenture may require the establishment of a sinking fund or the issuer may choose
to set one up independently.
A sinking fund ensures that the debt will be retired in an orderly fashion and enhances the safety and the
liquidity of the issue. A disadvantage for investors is the same as any call—the issuer may redeem the
bonds at a time when interest rates are low, making it difficult for the bondholders to reinvest their money
and receive a comparable rate of return.
Issuers that have term bonds outstanding are more likely to establish a sinking fund since they may be
interested in starting to save money to satisfy a large debt coming due in 10, 20, or 30 years.
Put Provisions
A bond may also be issued with a put provision, which is the opposite of a call provision. This feature
gives the bondholder the right to redeem her bond on a specified date (or dates) prior to maturity. The
bondholder usually receives a return of the bond’s par value, but the bond may also be redeemable at a
discount or premium. A put provision is a benefit to bondholders, since it allows investors to redeem the
bonds if interest rates rise and to reinvest their funds elsewhere.
In an effort to entice investors to buy callable bonds, the yields on callable bonds are higher than those of
non-callable bonds. However, for bonds which offer the put feature, their yields are generally lower since
the bondholders are given the ability to redeem their bonds in the event that interest rates rise.
Tax Issues Associated with Debt Securities

Finally, let’s examine some specifics regarding the tax implications of taxable debt securities. Two of the
primary concerns are 1) how the interest is received and taxed, and 2) how will the gains or losses that are
generated by the sale or retirement of the bonds be treated.

Capital gains and losses are determined in a manner that’s similar to what was addressed in the Equities
chapter. In other words, gains and losses are based on the bond’s cost basis compared to the proceeds
received from the sale. However, when bonds are purchased at prices other than par, the IRS may require
that the cost basis be adjusted over the life of the bond. These unique situations will be addressed below.
Taxation of Interest
The interest received from an investment in a corporate bond is taxed at the same rate as the investor’s
ordinary income. The interest is subject to federal, state, and local taxation and taxable in the year in which
it’s received.
If a corporate bond is sold in the secondary market, the seller must include the amount of accrued interest
received and treat it as ordinary income. When reporting income, the buyer must include the amount of the
interest payment minus any accrued interest paid at the time of purchase.
Taxation of Zero Coupon Bonds Under IRS rules, investors who purchase certain low-coupon or
zero-coupon bonds are typically required to adjust their cost basis annually. On an annual basis, the
discount must be accounted for by using an adjustment method that’s referred to as accretion. For
example, if a zero-coupon bond is purchased at 60 with 20 years to maturity, the bond’s cost basis is
adjusted upward each year by 2 points (the 40-point discount from par is divided by the 20 years to
maturity). Since this accreted amount is treated as ordinary income, taxes must be paid accordingly despite
the fact that no physical funds were received. For this reason, many investors purchase zero-coupon issues
within tax-deferred accounts to avoid this phantom income taxation. If the bond is sold prior to maturity,
any capital gain or loss is calculated by using the bond’s accreted cost basis.
Constant Yield Method The preceding example used the straight-line accretion method, which is the
same process used for questions on the examination. However, the actual method of accretion used by
accountants is referred to as the constant yield method or constant interest method. For exam purposes, test
takers are not expected to perform this more difficult calculation.
Taxation of Premium Bonds Investors who purchase corporate bonds at a premium must also adjust their
cost basis through a process that’s referred to as amortization. For example, if a bond is purchased at 110
and it has 10 years to maturity, the bond’s cost basis will be adjusted downward by 1-point each year (the
10-point premium is divided by 10 years). If this bond had a coupon of 6%, then each year the investor
would be taxed on 5% since the 1-point of amortization is claimed against the income received. At
maturity, the bond’s basis will be adjusted down to par and the investor will have neither a gain nor a loss
on the transaction. If the bond is sold prior to maturity, any capital gain or loss will be calculated against
the bond’s adjusted cost basis.
Conclusion
This ends the fundamentals of bonds. The next three chapters will examine the three different bond
issuers—corporations, municipalities, and the U.S. government.

CHAPTER 6
Corporate Debt
Key Topics:
 Types of Corporate Bonds
 Convertible Bonds
 Equity-Linked Securities
CHAPTER 6 – CORPORATE DEBT
Corporations use the funds they raise from issuing bonds for a variety of purposes, from building
facilities, to purchasing equipment, to expanding their business. The advantage to issuing bonds over
stock is that the corporation doesn’t give up partial control of the company or give up a portion of its
profits. The downside is that it’s required to repay the money borrowed with interest. The
requirement to make semiannual interest payments will lower the corporation’s profits for as long as
it has debt outstanding.
This chapter will focus on the unique features that are connected to both corporate bonds and money-
market securities. Additionally, convertible bonds and the process of determining conversion parity
will be described. The end of this chapter will consider the characteristics of structured products,
including reverse convertibles, equity-linked securities, and exchange-traded notes.
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 full faith and credit of the issuer, secured bonds are additionally
backed by specific corporate assets.
Secured Bonds
With secured bonds, if the issuer falls into bankruptcy, an appointed trustee will take possession of the assets
and liquidate them on the bondholders’ behalf. Therefore, secured bondholders have a higher degree of
protection if the company defaults.
The following are the major types of secured bonds that companies issue:
Mortgage Bonds Mortgage bonds are secured by a first or second mortgage on real property; therefore,
bondholders are given a lien on the property. Normally, mortgage bonds are issued serially over a number
of years. In other words, as one group of bonds are paid off, the company will issue a new group to be
secured by a mortgage on the same piece of property.
Equipment Trust Certificates Equipment trust bonds are secured by a specific piece of equipment
that’s owned by the company and used in its business. The trustee holds legal title to the equipment until
the bonds are paid off. These bonds are usually issued by transportation companies and the collateral that’s
used by these companies is often referred to as rolling stock (i.e., assets that move) and includes railroad
cars, airplanes, and trucks.
Collateral Trust Bonds Collateral trust bonds are secured by third-party securities that are owned
by the issuer. The securities (stocks and/or bonds of other issuers) are placed in escrow as collateral
for the bonds.

Type of Secured Bond Collateral

Mortgage Real Estate
Equipment Trust Equipment
Collateral Trust Stocks or Bonds
Unsecured Bonds
When corporate bonds are backed by only the corporation’s full faith and credit, these forms of unsecured
debt are referred to as notes and debentures. If the issuer defaults, the holders of these securities will have
the same claim on the company’s assets as any other general creditor—which means before the
stockholders, but after secured bondholders.
Occasionally, companies issue unsecured bonds that have a junior claim on their assets compared to its
outstanding unsecured bonds. These bonds are referred to as subordinated debentures. In case of default, the
claims of these bondholders are subordinate to those of the other bondholders, but still before the stockholders.
Order of Liquidation
1. Wages
2. Taxes
3. Secured creditors, including secured bonds
4. General creditors, including debentures
5. Subordinated creditors, including subordinated debentures
6. Preferred stockholders
7. Common stockholders
High-Yield (Junk) Bonds Corporate bonds that are rated below investment grade (below BBB by S&P
or below Baa by Moody’s) are referred to as high-yield or junk bonds. The lower rating indicates that bond
analysts are uncertain about the issuer’s ability to make timely interest payments and to repay the
principal. In other words, these bonds carry a higher-than-normal credit risk. High-yield bonds must pay
higher coupons in order to compensate investors for the added degree of risk that’s associated with these
investments. Essentially, these bonds are suitable only for speculative investors.
If bonds start out with an investment-grade rating, but are later lowered to below investment grade, they’re
referred to as fallen angels.

Income Bonds Income bonds are normally issued by companies in reorganization (bankruptcy). The
issuer promises to repay the principal amount at maturity, but does NOT promise to pay interest unless it
has sufficient earnings. Since interest payments are not promised, income bonds trade flat (without
accrued interest), sell at a deep discount (well below par), and are considered speculative investments.
Despite their name, income bonds (also referred to as adjustment bonds) are not suitable for the typical
income-seeking bond investor.
Guaranteed Bonds A guaranteed bond is one that, along with its primary form of collateral, is secured by
a guarantee of another corporation. The other corporation promises that it will pay interest and principal if
necessary. A typical example is a parent company guaranteeing a bond that’s issued by a subsidiary company.
Stepped Coupon Bonds A stepped coupon bond is issued with a low coupon that increases at regular
intervals. The issuer generally reserves the right to call the bond on the dates that the coupon is reset.
These are also referred to as dual coupon or step-up coupons.
Zero-Coupon Bonds As the name suggests, zero-coupon bonds don’t pay periodic interest. Instead, an
investor purchases a zero-coupon at a deep discount from its par value, but is able to redeem the bond for
its full face value at maturity. The difference between the purchase price and the amount that the investor
receives at maturity is considered the bond’s interest. Typically, the longer the zero coupon bond’s
maturity, the deeper its discount from par value.
Investors who purchase zero-coupon bonds often do so knowing that they’re going to need a lump sum of
money at some future date.
For example, an investor knows that she will need $20,000 in 20 years to pay for her
daughter’s first year of college; therefore, she buys a zero-coupon bond with a par value of
$20,000. The investor pays $5,000 for the bond and, although she will not receive periodic
interest payments, she will receive $20,000 when the bond matures in 20 years.
Accretion Although a zero-coupon bond doesn’t provide the purchaser with semiannual interest
payments, the basis (value) of the bond must be upwardly adjusted each year over its life. The adjusted
dollar value of the bond is referred to as its accreted value (or accumulated value to date). The increase
in the bond’s value is considered phantom income and, for tax purposes, considered taxable interest
income. A bond’s accreted value may be higher or lower than the market value of the bond.
Zero-coupon investments are often placed into tax-protected accounts, such as IRAs or other retirement
accounts to avoid the taxation of the phantom interest. However, if the bond is placed in a taxable account,
the increase in value (accretion) would become taxable income each year even though the customer has
not received any actual interest. This tax implication should be discussed with a client prior to the
purchase of any specific zero-coupon bond. Please note that not all zero-coupon instruments are subject to
this taxation. For example, a zero-coupon municipal bond is not subject to this liability due to the tax
exemption afforded to municipal bond interest.

Interest Bearing Bonds Zero Coupon Bonds

Pay interest at regular intervals Interest paid as a lump sum when bond matures
For investors who desire current income For investors who desire a lump sum at some future date
For exam purposes, if any reference is made to a capital appreciation bond (CAB), it’s a bond that’s
similar to a zero-coupon bond. CABs don’t pay periodic interest and are unsuitable for investors who are
seeking income. Their cost basis equates to the compound accreted value (CAV), which is calculated by
adding the initial principal amount to the accreted value to date.
Non-U.S. Market Debt

Eurodollar Bonds
A Eurodollar is a dollar-denominated deposit that’s made outside of the United States. Eurodollar bonds
pay their principal and interest in U.S. dollars, but are issued outside of the U.S. (primarily in Europe). The
issuers of Eurodollar bonds include foreign corporations, foreign governments, and international agencies,
such as the World Bank. These bonds are not registered with the SEC and, consequently, may not be sold
in the U.S. until 40 days have elapsed from the date of issuance. For this reason, they’re bought primarily
by foreign investors. As with domestic U.S. bonds, movements in U.S. interest rates can greatly affect the
prices of Eurodollar bonds.
Yankee Bond
Another common type of bond that’s denominated in U.S. dollars is a Yankee bond. Yankee bonds allow
foreign entities to borrow money in the U.S. marketplace. These bonds are registered with the SEC and
sold primarily in the United States.
Eurobond
As opposed to a Eurodollar bond, a Eurobond is one that’s sold in one country, but denominated in the
currency of another country. In fact, the issuer, currency, and primary market may all be different. For
example, a Russian mayonnaise manufacturer could sell bonds that are denominated in Swiss francs in
London. This type of bond, referred to as a foreign pay bond, can be greatly affected by interest-rate
movements in the country in which it’s denominated.
Sovereign Bond
Sovereign bonds represent debt that’s issued by foreign national governments. Although government
debt is generally considered quite safe, the credit rating of these bonds is based on the current standing
of the issuing government. Ultimately, the issuer’s ability to repay the principal and interest is reflected
in the bond’s yield.

Money-Market Securities
Short-term debt instruments with one year or less to maturity are referred to as money-market securities.
There are a significant number of securities that trade in the money market with issuers including the U.S.
government, government agencies, banks, and corporations. There’s also a diverse group of participants that
utilize the money market including the Federal Reserve Board, banks, securities dealers, and corporations.
Money-market transactions provide an avenue for both acquiring money (borrowing) and investing
(lending) excess funds for short periods. Typically, the investment period ranges from overnight to a few
months, but may be as long as one year.
Investor Profile
Essentially, money-market instruments may be viewed as a safe haven for investors. For example, if a
customer has liquidated a long-term investment position and is evaluating different investment options,
investing in a money-market instrument may be a good idea. Alternatively, if an investor intends to make a
large purchase in the near future (e.g., a home or a business), the funds may be invested in money-market
instruments since they normally have very stable prices. Remember, the sooner an investor needs access to
funds, the less risk she can take with her principal.
With exam questions, an important point to consider is the objectives of the investor. An investor who is
interested in capital preservation may seek a money-market equivalent that’s backed by the U.S. government,
such as a T-bill. A high income investor may seek a money-market equivalent that’s tax-free. Investors may
also obtain access to these types of securities by making an investment in a money-market mutual fund.
Types of Money-Market Securities

Examples of money-market securities and related instruments include:
 Commercial paper
 Bankers’ acceptances
 Negotiable certificates of deposit
 Federal funds
 Money-market funds
 Repurchase agreements (Repos)
Money-market instruments are classified as a separate asset class and are referred to as cash equivalents. Cash
equivalents are investments of such high quality and safety that they’re considered to be nearly the same as
cash. The separation of this asset class from other debt instruments is due to the fact that their returns are
relatively uncorrelated to bonds.
Commercial Paper When corporations need long-term financing, they issue bonds; but when they need
short-term financing, they issue commercial paper. Commercial paper is short-term, unsecured corporate
debt which typically matures in 270 days or less.

Due to its short maturity, commercial paper is exempt from the registration and prospectus requirements of the
Securities Act of 1933. Similar to T-bills, commercial paper is usually issued at a discount; however, some
issues are interest bearing. Typically, the minimum denomination is $100,000.
Since commercial paper is typically issued by corporations with high credit ratings, it’s considered very
safe. Standard & Poor’s, Fitch, and Moody’s issue credit ratings for commercial paper.
S&P will assign ratings from A1 (highest) to A3, and Fitch will assign ratings from F1+ (highest) to F3.
The highest rating that Moody’s will assign to commercial paper is P-1 (also called Prime 1) with
intermediate ratings of P-2 and P-3. Speculative commercial paper receives a rating of NP (not prime).
There are two methods by which commercial paper may be sold:

1. Directly placed commercial paper – The issuer of commercial paper sells its issues directly to the
public using its own sales force.
2. Dealer-placed commercial paper – The issuer sells to a large commercial paper dealers that then resells
the issue to the public.
Bankers’ Acceptances (BAs) Bankers’ acceptances are instruments that are used to facilitate foreign
trade. For example, an American food company is importing French snails. The American company may
wish to pay for the snails after delivery and, therefore, it issues a time draft (i.e., a check that’s good at a
future date) which is secured by a letter of credit from a U.S. bank as payment. The French snail
manufacturer is able to hold the draft until its due date and receive the full amount or may cash it
immediately at a bank for a discounted amount. At that point, the bank has the draft guaranteed by the
issuing bank and it becomes a banker’s acceptance. Now, the bank may choose to hold it until its due date
or sell it in the market.
BAs are actively traded and are considered quite safe since they’re secured both by the issuing bank and
by the goods that were originally purchased by the importer.
Negotiable Certificates of Deposit (CDs) Banks and savings and loans issue the original certificates of
deposit which are time deposits that carry fixed rates of interest and mature after a specified period.
Negotiable CDs have the following characteristics:
 They’re short-term instruments that have maturities that range from two weeks to one year.
 They have a minimum denomination of $100,000, but often trade in denominations of $1,000,000 or
more (also referred to as jumbo CDs).
 The Federal Deposit Insurance Corporation (FDIC) provides insurance of up to $250,000 per depositor.
The typical purchasers of negotiable CDs are wealthy individuals and institutions, such as corporations,
insurance companies, pension funds and mutual funds. These instruments attract investors who are seeking a
return on their cash in a low-risk and liquid investment.
If investors hold negotiable CDs to maturity, they receive the face amount from the issuer and the CDs expire.
However, if the investors choose not to hold them to maturity, they can sell them in the secondary market
without penalty.

Long-Term CDs Long-term or brokered CDs generally have maturities that range from two to 20 years
and are not considered money-market securities. They also may carry additional risks that are not
associated with traditional bank-issued CDs, including:
 Either limited or potentially no liquidity
 The possibility of experiencing a loss of principal if the CD is sold prior to maturity
 The potential existence of call features that limit capital appreciation and subject the investor
to reinvestment risk
 The fact that FDIC insurance may not apply
 Unique features that may affect future interest payments such as variable rates, step-ups, and
step-downs
These long-term CDs are issued by banks and, although sold by broker-dealers, they’re insured up to
certain limits by the FDIC in the event the issuing bank declares bankruptcy. The amount of FDIC
insurance and tax considerations are different depending on whether the CD is purchased in a retirement
account. Additionally, if the broker-dealer that sold the brokered CD to the client declares bankruptcy,
SIPC coverage will apply since these products are considered securities.
Broker-dealers or deposit brokers that offer long-term CDs must ensure that potential customers
understand the difference between these products and traditional bank-issued CDs and must also disclose
any potential risks that are relevant to the client. Additional disclosures include details of the features that
establish the interest rate of the security, such as an index of fixed-income or equity securities.
For example, a step-down, long-term CD will offer an investor an interest rate that’s initially higher than
current market rates. Subsequent interest rates that are paid to investors will be lower and may be adjusted
more than once. An RR should disclose to the client that he will not receive the higher interest rate for the
life of the CD. Another example is a step-up, long-term CD which offers an investor an interest rate that’s
lower than current market rates for a similar maturity. However, the coupon will be subsequently adjusted
upward (stepped-up). A broker-dealer is not required to maintain a secondary market or act as a market
maker in a CD that was sold to the client. This will limit the liquidity of the security if the client needs the
funds prior to maturity.
If a brokered CD is callable, the following disclosures should be made:

 At its sole discretion, the issuer may decide to call in the CD prior to maturity.
 If a CD is called prior to maturity, the client may be unable to reinvest the funds at a comparable rate
of interest (if rates have declined).
 A CD that’s called prior to maturity may offer a client a return that’s less than its yield-to-maturity.
 If the CD is not called by the issuer, the client may be required to hold the security until maturity.
Federal Funds (Fed Funds) The funds that are borrowed overnight on a bank-to-bank basis are referred
to as fed funds. This interbank borrowing is usually done to allow a bank to meet the reserve requirement
that’s set by the Federal Reserve. A bank with excess reserves may lend to a bank that’s in need of reserves.
This allows the bank with excess reserves to earn interest on funds that would otherwise remain idle.

The rate charged on these overnight loans is referred to as the fed funds rate. The rate fluctuates on a daily basis
and is a leading indicator of interest-rate trends since it reflects the availability of funds in the system.
Although the Federal Reserve doesn’t set the fed funds rate, it will attempt to influence the rate through its
purchases and sales of government securities in the secondary market.
Other short-term interest rates tend to follow changes in fed funds. A bank charges the prime rate when
providing loans to a corporation that’s among the bank’s best credit-rated customers. Other corporations may
be charged a higher rate, but the rate will be based on the prime rate. The London Interbank Offered Rate
(LIBOR) is the average rate that banks charge each other on loans for London deposits of Eurodollars.
Repurchase Agreements (Repos) In a repurchase agreement (repo), a dealer sells securities (usually
T-bills) to another dealer and agrees to repurchase them at both a specific time and price. In effect, the first
dealer is borrowing money from the second dealer and securing the loan with securities (a collateralized
loan). In return for making the loan, the second dealer (the lender) receives the difference between the
purchase price and the resale price of the securities.
If a dealer purchases securities and agrees to sell them back to the other dealer at a specific date and price,
this is referred to as a reverse repo or matched sale. In this situation, the first dealer loans money (with
securities as collateral) to the second dealer and earn the difference in sales prices. Many corporations,
financial institutions, and dealers engage in repos and reverse repos. These types of transactions are
typically short-term, with most being overnight transactions.
Convertible Bonds
In order to offer investors more of an incentive to buy its bonds, a corporation with a weak credit rating
may issue convertible bonds. Similar to convertible preferred stock that was covered earlier, a convertible bond
allows an investor to convert the par value of the bond into predetermined number of shares of the company’s
common stock. For the purchaser, the tradeoff for this opportunity is that convertible issues traditionally
offer lower coupons than similar non-convertible issues. If the bonds are converted, the debt becomes
equity and the issuers’ capital structure will be significantly altered.
Market Trading If interest rates are stable, most bond prices will have little movement. However, a
convertible debenture could show significant price appreciation or depreciation if the underlying common stock
changes in value. The conversion feature essentially links the bond’s value to the underlying stock’s value.
If the underlying stock appreciates, the bond will trade at a price based on its potential conversion value.
However, if the price of the underlying stock declines to the point where the conversion feature offers no
advantage, the bond will simply trade at a price that’s based on its inherent value as a bond.
Converting Bonds to Stock The bond’s conversion price is set at the time it’s issued. To determine
the conversion ratio (i.e., the number of shares the investor will receive at conversion), the par value of the
bond ($1,000) is divided by the conversion price.

Par Value of Bond

Conversion Ratio =
Conversion Price
For example, if Widget Inc. issues 10% convertible subordinate debentures with a
conversion price of $40, the conversion ratio is 25 shares for each bond.
$1,000 Par Value

Conversion Ratio = = 25 shares per bond
$40 Conversion Price
In this example, the bondholder is able to exchange the bond and, in return, receive
25 shares of stock.
Prior to trying to solve a computational question regarding convertibles, the first step should be to double-
check the conversion price and conversion ratio. An important fact is that if the conversion price is
multiplied by the conversion ratio, it should always equal $1,000. For example:
Conversion Price Conversion Ratio Price x Ratio

$10 100 $1,000
$20 50 $1,000
$40 25 $1,000
$50 20 $1,000
$100 10 $1,000
Whether it’s worthwhile for investors to convert their bonds into stock depends largely on the price of the
underlying stock. The aggregate market value of the stock that the investor receives at conversion is called
the conversion value. If Widget’s stock is convertible at $40 and is selling for $30 a share, then the
conversion value is $750 ($30 x 25 shares). Since this is well below the $1,000 par value of the bond, the
bondholder is unlikely to convert.
The Effect of Stock Splits and Stock Dividends Both the conversion price and conversion ratio are
established at the time the bonds are issued and will not change unless there’s a change in the underlying
stock. Two types of corporate actions that create the need to adjust the conversion price and conversion ratio
include are stock splits and the declaration of a stock dividend. The adjustment may be required due to an
existing non-dilutive feature or covenant in the bond’s indenture.

Remember, forward stock splits don’t change a stock’s absolute value; instead, they create more shares
that are worth proportionately less. Let’s use an example of a bond that’s originally convertible at $40,
resulting in a conversion ratio of 25 shares. If the stock is split 2-for-1, then:
 The conversion ratio will increase to 50 shares (25 x 2/1) and
 The conversion price will decrease to $20 ($40 x 1/2)
Again, using a bond that’s convertible at $40, if the company declares a 20% stock dividend, then:
 The conversion ratio will increase by 20% to 30 shares (25 x 20% = an extra 5 shares) and
 The conversion price will decrease to $33.33 ($1,000 ÷ 30 shares)
Parity If a convertible bond’s conversion value (the market value of the stock received at conversion) is
equal to its market price, then the bond is considered to be trading at parity. Most bonds trade at a
premium to parity, which means that the market price of the bond is higher than the aggregate market
value of the stock the investor will receive if he converted.
For example, if the conversion value of Widget’s 10% subordinated debentures is $750
($30 x 25 shares) and its market price is $900, then the bond is selling at a 20% premium
to parity (20% of $750 is $150).
Conversion Example 1 A corporation has issued convertible bonds with a conversion price of $50 per
share. If the common stock is selling at $60 per share, at what price does the bond need to be trading for it
to be at parity with the common stock?
Step 1: Determine the conversion ratio:
Par Value of Bond $1,000

Conversion Ratio = = = 20 shares
Conversion Price $50
Step 2: Determine the conversion value of the stock if the bond is converted. To be at parity, the bond
and the stock should be of equal value.
Conversion Value
Parity Price of Bond =
(Number of shares x Price Per Share)
Parity Price of Bond = 20 shares x $60 = $1,200
With the stock trading at $60, the bond should be selling at $1,200 to be at parity
with the stock.

At what value will the bond need to trade to be at a 10% premium to parity? To find a 10% premium to
parity, simply multiply the parity price of $1,200 by 10%, which is $120. The $120 is then added to the
$1,200, which equals $1,320.
Conversion Example 2 A corporation issues a convertible bond with a conversion price of $25 per
share. If the current market price of the bond is 120 ($1,200), then at what price will the stock need to be
trading at to be at parity with the bond?

Remember, parity is realized when the market value of the bond equals the aggregate market value of the
stock (shares x price) that will be received at conversion (the conversion ratio).
Step 2: Determine the price at which the stock must be trading to be at parity with the bond.
(To determine the parity price for the stock, the market value of the bond must be
divided by the conversion ratio.)
Market Value of Bond $1,200

Parity Price of Stock = = = $30
Conversion Ratio 40
If the market value of the bond is $1,200, the stock needs to be selling at $30 per
share to be at parity with the bond (40 shares x $30 = $1,200).
Advantages and Disadvantages of Convertible Bonds Convertible bonds allow corporations to

borrow money at a lower rate (lower coupon) since the convertible feature is attractive to investors.
Investors are willing to accept the lower interest rate in exchange for the opportunity to convert the bonds
into common stock. Convertible bonds provide investors with a greater degree of safety than preferred or
common stock, but also offer them the potential for capital appreciation if the underlying stock rises in
value. In addition, the investor has some downside protection because, even if the price of the stock falls,
the convertible bond still has inherent value as a bond.
A disadvantage to convertible bonds is that if all of the bonds are converted into stock, then the number of
outstanding shares may increase dramatically. This will cause the stockholders’ equity to be diluted and
the earnings per share (EPS) to decrease. At this point, the company will need to divide the earnings over a
larger group of shareholders, thereby giving each of them a smaller percentage. In order to reflect this
possibility, a company’s EPS may need to be restated as fully diluted EPS—a figure that assumes all
conversions have been made.

From the issuer’s point of view, conversion adjusts the mandatory debt obligation into equity and
deleverages the corporation’s balance sheet. This deleveraging is useful because it removes both the
near-term and long-term debt service obligations. Remember, dividend payments to common shareholders
are voluntary, while interest payments to bondholders are mandatory. Therefore, after conversion, the
former bondholders are no longer owed money at maturity. The bonds are eliminated and will be
replaced with an ownership interest.
Forced Conversion Most convertible issues are callable which provides the issuer with the ability to
(at its option) redeem the bonds prior to maturity. However, if the call (redemption) price of the bonds is
less than the conversion value, the bondholder could be forced to either convert the bond immediately or
accept less than its conversion value. This possibility, referred to as forced conversion, may be a
disadvantage for investors.
For example, Rob owns a corporate bond that’s convertible at $40. With the underlying
stock currently selling at $50 per share, the corporation calls in the bonds at 105 ($1,050).
If Rob asks his RR what action to take, what should she tell him?

Step 2: Figure out what Rob will receive after the bond is converted and the stock is sold:
Conversion Value = Number of shares x Price Per Share
Conversion Value = 25 shares x $50 = $1,250
Rob’s RR should recommend that he convert the bond to stock since the shares
will be worth $1,250, while he will receive only $1,050 if he allowed the bond
to be called.
Arbitrage Arbitrage is a technique that involves profiting from price differentials in the same or similar
security. There are times when the market price of a convertible bond doesn’t reflect the value of the
common stock that will be received if the bond was converted into stock. If this situation occurs, the
convertible bond will be selling at a discount to parity and arbitrageurs could profit from this differential.

For example, a convertible bond has a conversion ratio of 40 shares and is selling at
$1,350 while the stock is priced at $35. Although conversion parity is $1,400 ($35 x 40
shares per bond), an arbitrageur could buy the bond at $1,350 and convert it into stock
worth $1,400, yielding a profit of $50 per bond. This profit potential will exist until the
bond’s price increases to at least $1,400.
Conversion is NOT Taxable If the owners of convertible bonds or convertible preferred stock convert
those securities into the common stock of the corporation, the conversion is NOT a taxable event. When
these securities are converted, the cost basis for the common stock that’s received will be based on the cost
basis of the original security.
For example, an investor purchased a convertible RFQ corporate bond for $1,200 and
converted the bond into 40 shares of common stock. The investor’s overall cost basis will be
$1,200, while her cost basis per share will be $30 ($1,200 divided by 40 shares). If the stock
was later sold for $32 per share, she would report a capital gain of $2 per share, or $80.
Structured Products
Structured products are derivative securities that may be linked to a variety of underlying (reference) assets
including a stock index, foreign currency, commodity, basket of securities, change in spread between asset
classes, single security, or an interest-rate and inflation-linked product. A structured product is typically
built around a fixed-income instrument (a note) and a derivative product. While the note pays a specified
rate of interest to the investor at defined intervals, the derivative component establishes the amount of
payment at maturity.
These products are considered a form of corporate debt and are typically created by major financial
services institutions. Structured products are usually registered as securities with the SEC; however, clients
must receive disclosure that these products are NOT bank deposits and are NOT insured by the Federal
Deposit Insurance Corporation (FDIC).
Exchange-Traded Notes (ETNs)

An exchange-traded note (ETN) is a type of unsecured debt security, but differs from other types of fixed-
income securities since ETN returns are often linked to the performance of an index (some ETN returns
may be linked to a commodity or currency). ETNs don’t usually pay an annual coupon (they’re zero-
coupon-like) or specified dividend; instead, all gains are paid at maturity. These securities are traded on an
exchange, such as the NYSE, and may be purchased on margin and sold short. Investors may also choose
to hold the debt security until maturity.
A significant characteristic of ETNs is that they carry issuer risk which is tied to the creditworthiness of
the financial institution backing the note. With an ETN, an investor is merely buying a promise from the
issuing institution that it will pay the index’s return, minus any fees.

Therefore, the investor is not only taking a chance on the performance of the benchmark index, she’s also
assuming the risk that the issuer may fail to make good on its promise. If the issuer’s financial condition
deteriorates, it could negatively impact the value of the ETN, regardless of how its underlying index performs.
Reverse Convertible Securities

Despite their name, these derivative products are NOT like typical corporate bonds; instead, they’re a form
of structured product. Reverse convertible securities are short-term notes that are issued by banks and
broker-dealers. Although often described as debt instruments, they’re far more complex than traditional
bonds and involve elements of options trading. Reverse convertibles usually pay a coupon rate that’s set
above prevailing market rates; however, in return, the buyer may be required to take possession of the
shares of an underlying asset. In other words, the issuer agrees to pay a higher coupon in return for the
ability to repay principal to the investor in the form of a set amount of the underlying asset (rather than in
cash). This will happen if the price of the underlying asset drops below a predetermined price (also
referred to as the knock-in level). Essentially, the knock-in level is the point at which the security’s unique
features are triggered. For a reverse convertible, the underlying asset may be an equity security of a
company that’s unrelated to the issuer, a basket of stocks, or an index.
Higher Coupon, Higher Risk From an investor’s perspective, he’s betting that the value of the
underlying asset will remain stable or rise, while the issuer is betting that the value will fall. In the typical
best case scenario, if the value of the underlying asset stays at or slightly above the knock-in level, he will
receive a high coupon for the life of the investment as well as the return of the full principal in cash.
However, in the worst case, if the value of the underlying asset drops below the knock-in level (which may
be 70 to 80% of the original value), the issuer is able to pay back the principal in the form of the
depreciated asset. The result is a potential loss of some, or all, of the original principal.
Suitability Issues Obviously, these derivative securities are only suitable for investors who understand
the inherent risks of the products. While the higher-than-average coupon may be appealing, reverse
convertible investors must understand the potential loss of principal on their investment. Remember, if the
underlying asset falls in value, the investor may be forced to take the underlying asset in exchange for the
par value at maturity. Also, for the higher coupon, investors sacrifice any upside appreciation in the value
of the underlying asset.
Conclusion
This concludes the chapter on corporate debt. The next chapter will examine the securities that are issued
by municipalities.

CHAPTER 7
Municipal Debt
Key Topics:
 Types of Municipal Debt
 Municipal Notes and Municipal Fund Securities
 Tax Considerations
CHAPTER 7 – MUNICIPAL DEBT
Municipal bonds are issued by states, territories, and possessions of the United States, as well as
other political subdivisions (e.g., counties, cities, or school districts) and public agencies (e.g.,
authorities and commissions). Unlike U.S. Treasury securities, these debt instruments carry some
level of default risk since municipal bonds are not backed by the U.S. Treasury.
Municipal issues are exempt from the filing provisions of the Securities Act of 1933 and are exempt
from state and federal registration requirements. However, municipal issues are not exempt from
antifraud provisions of any securities law.
For most investors, the primary advantage of municipal bonds is that the interest received is typically
exempt from federal tax. Another advantage is that most states don’t tax the interest from bonds that
are issued within their borders. For this reason, investors tend to buy in-state bonds to avoid
potential federal, state, and (in some cases) local taxes.
Types of Municipal Bonds

Municipal bonds are classified into two major categories—general obligation bonds (GOs) and revenue
bonds. GO bonds may be issued to meet any and all needs of the issuer. In a sense, GO bonds are issued
for general purposes. Unlike a revenue issue, the source of the funds that the GO issuer uses to back the
bonds may come from various sources. Conversely, revenue bonds are typically issued to fund a specific
project or facility, such as a bridge or road. For revenue bonds, the cash flows generated by the specific
project (e.g., tolls, usage fees) are used to repay bondholders.
General Obligation (GO) Bonds

A general obligation bond is secured by the full faith, credit, and taxing power of the issuer. Therefore,
only issuers that have the ability to levy and collect taxes may issue general obligation bonds. State or
local governments are able to issue general obligation bonds based on their statutory or constitutional
powers. However, prior to issuing general obligation bonds, issuers must obtain voter approval.
Essentially, this requirement is due to the fact that taxpayer money is being used to pay debt service.
Authority to Issue A statutory power is a law passed by a state or local government which allows for
the issuance of securities. These laws may be amended by legislative action. The constitutional powers
to issue general obligation bonds are derived from the state constitution. These statutory and
constitutional powers may also limit the amount of debt that an issuer is able to incur. This restriction is
referred to as a debt ceiling.
Backing State general obligation bonds are usually secured by income tax, sales tax, gasoline tax,
excise tax, and other taxes collected at the state level. For local jurisdictions, such as counties and cities,
the most common source of tax revenue is from levies on real property. School taxes are also assessed at
the local level and are normally a significant portion of a person’s real estate tax assessment.

Ad Valorem Tax Ad valorem tax (property tax) is determined based on the assessed value of property
multiplied by the tax rate levied (expressed in terms of mills). One mill expressed as a percentage is 0.1%
or, if expressed as a decimal, it’s 0.001. Ultimately, if a rate of one mill is used for tax purposes, it equates
to a tax of $1 per $1,000 of assessed value.
For example, a taxpayer owns property that’s assessed at a value of $300,000 and
is subject to a tax of 7 mills. This means that property tax of $2,100 is owed
($300,000 x .7% or $300,000 x .007).
In addition to property taxes, sales taxes, and income taxes, other non-tax revenue, such as parking fees,
park and recreational expenses, and licensing fees, may be used to pay the debt service on GO bonds.
Certain governmental entities, such as school districts, may have an imposed legal limit on the tax rate at
which they may assess. Bonds issued by these entities are called limited tax general obligation bonds since
the taxing power of the issuer is limited to a specified maximum rate. Unlimited tax general obligation
bonds are issued by government units that have no legal limitation on their taxing power. Most local
general obligation bonds are unlimited tax bonds; therefore, the issuers have the ability to levy ad valorem
taxes without limitation as to the rate or the amount.
Analyzing General Obligation Bonds

Unlike U.S. Treasury debt, municipal securities do carry a level of default risk. When evaluating the risk
of default for a general obligation bond, analysts will consider the following factors:
 The overall economic health of the community including changes in property values, its largest
employers, average income, and demographic factors
 The tax burden and source of payments
 The budgetary structure and financial condition of the issuer
 The issuer’s existing debt using measures such as debt per capita and overlapping debt
Demographics The make-up of the population of the issuing municipality is an important indicator of a
bond’s quality. Since many general obligation bonds are dependent on property tax revenues, a growing
population is a sign of economic strength; however, a declining population is most likely a sign of a
deteriorating tax base. Keep in mind, although a city may lose some of its population to its suburbs, it still
may retain its economic strength as a place of employment.
The specific industries that constitute a community’s employment is another important demographic factor
to examine. Diversification of economic activity signals economic strength and also indicates that a
municipality is not dependent on any one industry (e.g., computer technology). When analyzing a general
obligation issue, a mixture of new, growing companies along with reliable, established companies is a
desirable combination.
Nature of the Issuer’s Debt Examining the fiscal responsibility of the issuer’s past attitudes toward debt
is often an indicator of the issuer’s present, and possibly future, ability to engage in fiscally sound
behavior. Some important considerations include whether the issuer has maintained a balanced budget
over the last five years and how well the issuer has maintained fund reserves.

Any analysis must also review a municipality’s debt trend. If a community has used debt to support the
growth of its suburbs (such as building roads and schools that are needed to support that growth), the debt
is not necessarily bad. Conversely, if debt has been issued to finance budget deficits or to increase
spending in a weak local economy, this may be an indication of an unwise fiscal policy.
Repayment Schedule: Serial versus Term Another factor in the analysis of the debt is the schedule of
debt repayment. A serial bond issue (one with maturities that are staggered) provides greater flexibility when
meeting debt requirements than a term issue (one with a single maturity date). This flexibility is due to the
fact that serial maturities may be organized to coincide with expected tax revenues.
Future financing also plays a part in general obligation bond analysis. Issuers that borrow early to finance
school improvements or new water systems for expected future increases may ultimately be better off than
a municipality that waits until it’s too late to support an overburdened infrastructure.
Fiscal Responsibility The soundness of the budget process is critical because it shows how well a
particular governmental entity is managing its fiscal affairs. Fiscal responsibility may be shown in a variety
of ways such as balancing the budget, creating rainy-day funds for use in business cycle downturns when
fewer tax receipts are collected, having a string of budget surpluses over five years, and reducing
expenditures by monitoring the conditions on which services are provided.
Financial Condition How well public officials manage in times of economic and financial stress is
particularly important to the credit quality of an issuer. A sound financial condition indicates that the
governmental entity is able to meet all of its obligations to creditors, employees, taxpayers, suppliers, and
others, on a timely basis. Measuring the financial resources that are required to make payments will
determine the issuer’s financial condition.
Unfunded Pension Liabilities Another factor which must be examined is a municipality’s pension
fund. The existence of unfunded pension liabilities (i.e., the financial reality that the money available may
be less than the amount required to pay projected pensions) will have a negative impact on the quality of
the issuer’s debt.
Ability to Collect Taxes A community’s tax limitations and budgetary considerations must also be
reviewed. Attempts to limit the maximum amount of debt that a municipality may carry will positively
influence general obligation bonds since the projected revenues will be directed to service the already-
issued debt. In this way, fiscal responsibility is imposed and the creditworthiness of the issuer is enhanced.
Since most general obligation issues are secured by property taxes, the tax collection record of the
community is an essential component of quality analysis. A poor collection record may be a red flag that’s
indicative of an inefficient local government which may result in bonds with low credit ratings.

Other red flags or negative trends that may affect an issuer’s credit are property taxes that are increasing in
the face of a declining population, an increasing tax burden on the community in comparison to other
regions, or general obligation debt that’s increasing while property values remain stagnant.
Other Considerations If a community is involved in a lawsuit, any liability that a municipality is

obligated to pay will place a financial burden on the community. Such litigation will generally have a
negative effect on the community’s ability to pay the debt service on outstanding bonds. Conversely, the
receipt of non-tax revenues, such as federal payments for education, may serve to enhance the
community’s ability to pay the required debt service.
Tracking trends in real estate valuation provides a good indication of a community’s health. Analysts often
concentrate more on the market value of real estate as opposed to the assessed value. Estimating the
revenues available to a general obligation bond includes the community’s full evaluation, the percentage of
assessed value that’s taxable, and the tax (millage) rate.
For example, a community that has a full valuation of $250,000,000, a 40% basis of assessment,
and a millage rate of 20 will produce $2,000,000 in property tax (as calculated below):
$250,000,000 (full valuation) x 40% (basis of assessment) = $100,000,000

$100,000,000 x .02 = $2,000,000 (Remember, 1 mill = .001 or 0.1%.)
The Debt Statement A critical tool available to those analyzing the debt of a municipality is the debt
statement. The various components of the debt statement are:
Direct Debt: All the debt (bonds and notes) that’s been issued by the municipality
Net Direct Debt: The direct debt (all issues) minus any self-supporting debt, such as revenue and note
issues. In general, the net direct debt is only the general obligation debt (bonds supported by taxes).
Overlapping Debt: This is the result of multiple authorities in a given geographic area having the ability
to tax the same residents (examples below).
Total Bonded Debt: The sum of both the long- and short-term debt of a municipality, plus its applicable
share of overlapping debt.
The following examples illustrate the concept of overlapping debt:

Example 1) Broward County, Florida issues a general obligation bond that’s secured
by the assessed value (property tax) within Broward County. Since the city of Fort
Lauderdale lies within Broward County, part of the assessed value that secures the
county debt lies in Fort Lauderdale. Due to the fact that the county’s debt overlaps Fort
Lauderdale, Fort Lauderdale is ultimately responsible for a portion of the county’s debt.

Example 2) The debt of a school district is comprised of one or more cities or

towns. If a city and school district lie within the same boundaries, they’re said to be
coterminous and, when examining the debt of the city, the school district’s debt must
be shown as overlapping debt.
To assist analysts in comparing the debt of different communities, the ratio of debt to a number of different
factors may be used. Typically, the analyst will use the ratio of net direct debt plus overlapping debt (net
overall debt) to assessed value or to population (debt per capita).
An analyst might also use the ratio of annual debt service to tax and other income to assess the quality of a
GO issue. In this case, a high ratio is indicative of a decreasing margin of safety in the issuer’s ability to
repay principal and interest. If the debt service increases and tax and other income remains stagnant or
decreases, there are less funds available to pay the debt service.
Revenue Bonds
Revenue bonds are issued for either projects or enterprise financings in which the issuer pledges to repay the
bondholders using the revenues generated by the financed project. Issuers of revenue bonds may be authorized
political entities (e.g., state or local governments), an authority (e.g., the Port Authority of New York and New
Jersey), or a commission created to issue bonds for purposes of building and operating a project.
Revenue bonds may be used to finance airports, water and sewer systems, bridges, turnpikes, hospitals, and
many other facilities. Concessions, tolls, and user fees that are associated with the use of these facilities are
used to make interest and principal payments on the bonds. Revenue bonds are generally considered riskier
than GO bonds since the generated revenues may prove to be insufficient to fund debt service.
Another source of revenue could originate from rental or lease payments. For example, a state may create
a non-profit authority to issue revenue bonds in order to build a school. The local government using the
school will lease the facility from the authority and the lease payments will be used by the issuer to pay
interest and principal.
Revenue bonds may be issued when voter approval for general obligation bonds cannot be obtained. Also,
revenue bonds may be issued to finance capital projects when statutory or constitutional debt limitations
prevent a municipality from issuing general obligation bonds.
Types of Revenue Bonds

Revenue bonds are generally characterized by the project the bond is financing or by the source(s) backing
the bond. The following list represents some of the more common types of revenue issues.

Housing Revenue Bonds These are issued by state or local housing finance agencies in an effort to help
fund single family or multifamily housing and are normally for low or moderate income families. In some
cases, the proceeds of the bond offering are lent to the real estate developers that are constructing the property.
In other situations, the money being raised through the offering is used to support the mortgage markets.
Dormitory Bonds These are issued to build housing for students at public universities and are repaid
from a portion of student tuition payments.
Health Care Revenue Bonds These are used for the construction of non-profit hospitals and health
care facilities. These bonds typically pay their debt service out of gross revenue. With a gross revenue
payment process, all revenues received will be used to pay debt service prior to deductions being taken for
any costs or expenses. In some cases, the existence of nearby competing facilities will influence the
quality of the bonds.
Utility Revenue Bonds These are issued to finance gas, water and sewer, and electric power systems
that are owned by a governmental unit. The bonds are normally backed by the user fees that are charged to
customers. When assessing the credit risk, important considerations include environmental factors and the
growth rate of the area being served by the utility.
Transportation Bonds These are used to finance projects such as bridges, tunnels, toll roads, airports, and
transit systems. User fees (e.g., tolls) are used to pay the debt service on these bonds. When analyzing bridge,
tunnel, or turnpike bonds, the availability of fuel and the existence of competing non-toll facilities are factors
that must be investigated. In addition, for airport revenue bonds, an examination of the level of tourism in an
area, fuel costs, and competing airports must be conducted.
Special Tax Bonds These bonds are backed by special taxes (e.g., taxes on tobacco, gasoline,
hotel/motel stay) for a specific project or purpose, but not by ad valorem taxes. For example, highway
bonds that are payable from an excise tax on gasoline are considered special tax bonds.
Special Assessment Bonds These bonds are payable only from an assessment on those who directly
benefit from the facilities. Examples include bonds issued to develop/improve water and sewer systems,
sidewalks, and streets.
Moral Obligation Bonds These bonds are first secured by the revenues of a project; however, if
revenues are insufficient to pay debt service requirements, the state (or a state agency) is morally obligated
(but not legally required) to provide the needed funds. Prior to issuing the bonds as moral obligation bonds,
the legislative approval of the state government must be obtained.
Education Bonds These may be secured by the repayment of loans by students, by the money
contained in a fund that was required to be established by the bond’s indenture, or by insurance payments
made by the state or federal government.

Lease Rental Bonds These offerings involve one municipal entity that leases a facility from another. For
example, a state building authority may issue bonds to build a college dormitory and then the authority will
lease the dorm to the college. The bond issued by the building authority will be paid from the revenues
generated through lease payments received from the college. If the lease payment is subject to an annual
budgeting process, credit risk is tied to the willingness of the issuer to budget these payments annually.
Certificates of Participation (COPs) A Certificate of Participation (COP) is a type of lease financing

agreement that’s usually issued in the form of a tax-exempt municipal revenue bond. COPs have been used
as a method of monetizing existing surplus real estate. This financing technique provides long-term
funding through a lease that doesn’t legally constitute a loan and, therefore, eliminates the need for a
public referendum or vote.
Industrial Development Bonds (IDBs) These bonds are issued by a municipality and secured by a lease
agreement with a corporation. The purpose for the offering is to build a facility for a private company. The
security’s credit rating is based on the corporation’s ability to make lease payments since the municipality
doesn’t back the bonds. An important potential detail is that if the holder of an IDB is a substantial user of the
facility, then the federal tax exemption on the interest earned will not apply.
Private Activity or Alternative Minimum Tax (AMT) Bonds If 10% or more of the bond proceeds
will be used to finance a project for a private entity (e.g., a corporation or professional sports team) and if
10% or more of the bond proceeds will be secured by property used in the private entity’s business, the
bonds are referred to as private activity bonds. The interest earned on a private activity bond may be
subject to the AMT and the bond’s interest may be taxed at the federal level. Due to the potential tax
implication, these bonds may trade with a higher yield than issues that are not subject to this rule.
Alternative Minimum Tax The alternative minimum tax is a method of calculating a return to ensure that
wealthy taxpayers pay at least a minimum amount of tax. When calculating the AMT, various adjustments
are made. Some income is added which may not have been subject to regular tax, while some deductions
are adjusted downward or eliminated entirely. One of the factors that may trigger an AMT liability is the
receipt of interest on private activity municipal bonds, where the proceeds of municipal offerings go to
benefit or finance a facility for use by a private business. Since the purchase of a private activity bond
could lead to potential AMT liability, the MSRB requires an RR to disclose the bond’s details on a
confirmation. For any client who is subject to the AMT, an RR must ensure that any recommendations
being made are suitable.
For example, a client who is in the 35% tax bracket and subject to the AMT is able to purchase an AMT
municipal bond yielding 4.70% or a non-AMT municipal bond yielding 4.35%. Which bond will offer the
highest after-tax yield?
 For the AMT bond, the after-tax yield is calculated as follows: 4.70% x (1.00 – 35%) = 3.05%.
 For the non-AMT bond, the after-tax yield is 4.35% (and higher than the AMT bond).

Taxable Municipal Bonds In certain cases, a municipality may not be able to issue bonds that are exempt
from federal income tax. This may occur when the bonds are issued to finance projects that don’t provide a
significant benefit to the general public. Some examples of situations in which a bond may lose its tax
exemption include 1) an offering where the proceeds are being used to build a sports facility or certain types
of housing, or 2) an offering designed to allow an issuer to borrow funds in order to replenish its unfunded
pension liabilities. Since these bonds will have higher yields, they may be suitable for investors who are
unconcerned about the tax status of the investment (e.g., pension funds and retirement accounts).
Build America Bonds (BABs) Build America Bonds are taxable municipal bonds that were issued
under the American Recovery and Reinvestment Act of 2009 (ARRA). Although the program officially
ended in 2010, a student should still be aware of their fundamental characteristics. BABs were intended to
help state and local governments finance capital projects at a substantially lower cost. Examples of capital
projects include creating public infrastructure (e.g., public schools and roads) and transportation
infrastructure (e.g., rail, bridges and ports, and public buildings). The objective was to broaden the appeal
of municipal securities to taxable, fixed-income investors.
One form of BAB is a Direct Payment bond which was issued by municipalities to raise capital for all the
traditional purposes except for refundings, private activities, and 501(c)(3) borrowers. To help defray the
cost of borrowing, the Direct Payment BABs provided issuers with a reimbursement (subsidy) from the
U.S. Treasury for 35% of the interest paid on the bonds.
For example, if a municipality issues a BAB at a taxable rate of 6.25%, the issuer will
receive 2.19% (6.25% x 35%) annually from the U.S. Treasury. Therefore, the net
amount of interest being paid by the issuer is 4.06% (6.25% – 2.19%).
Although taxable, BABs were issued by municipal governments and subject to MSRB rules. Broker-
dealers involved in the underwriting of these bonds were required to provide official statements to
purchasers and all sales activities were supervised by Municipal Securities Principals.
Double-Barreled Bonds These are backed by a specific revenue source (other than property taxes)
as well as the full faith and credit of an issuer with taxing authority (a GO issuer). Essentially, a
combination of tax dollars and revenue dollars from the project being constructed will be used to pay
the debt service on the bonds.
Advance-Refunded Bonds These bonds, also referred to as prerefunded or defeased bonds, are
outstanding debt obligations that have been collateralized by U.S. government securities. These bonds will
usually be paid off on their next available call date and carry high credit ratings.
Escrowed-to-Maturity (ETM) Bonds These bonds are secured in the same manner as refunded bonds;
however, they don’t have a call feature. Due to the fact that they’re not callable, these bonds will remain
outstanding until their maturity. Similar to advance-refunded bonds, ETM bonds have high credit ratings.

Parity Bonds A parity bond exists when two or more issues of revenue bonds are backed by the same
pledged revenues.
Legal Opinion
Every municipal issue must be issued with a legal opinion. The legal opinion is written by a recognized bond
counsel that’s hired by the issuer to attest to the validity and tax exempt status of the bond issue. Essentially,
the legal opinion assures investors that the issuer has the legal right to issue the bonds. If there are no existing
situations that could adversely affect the legality of an issue, the bond counsel renders an unqualified legal
opinion. Potential adverse situations include an issuer of a revenue bond not having a clear title to a property
or an issuer that’s violating local, state, or federal statutes when developing a project.
Delivery of certificates without legal opinions or other documents that are legally required to accompany the
certificates will not constitute good delivery unless they’re identified as ex-legal at the time of the trade.
Analyzing Revenue Bonds

When analyzing a revenue bond issue, it’s not necessary to examine the tax base or the tax collection record
of the issuer because taxes are not the source of payments to the bondholders. Remember, for revenue bonds,
investors are repaid from the cash flows generated by the project that was constructed. Therefore, for revenue
bond analysis, a key factor is the comparison of the money being collected from users of a facility to the
amount of debt service that must be paid to the bondholders.
Feasibility Study The municipality must hire a consulting engineer to study the project and present a
report to identify whether the project will be able to bring in the necessary revenues. This report examines
the need for the proposed project and whether the project is a sound economic investment. Other factors
involved in the feasibility study include comparing the cost of using the proposed service to other
alternatives available within the project’s area to ensure that the project will be competitive and generate
revenue. An accounting firm is usually retained to help determine if the revenues will be sufficient to
cover expenses and debt service.
Debt Service Coverage Nearly all revenue issues pledge a project’s net revenue to pay the
bondholders their debt service. A net revenue pledge indicates that operating and maintenance expenses
are deducted from the gross project revenues before the revenues are applied to debt service. On the other
hand, a gross revenue pledge indicates that debt service is paid prior to operating and maintenance
expenses being deducted.
When analyzing a revenue issue, one of the most important factors is the debt service coverage ratio. This
ratio measures the amount of available revenue compared to the amount of revenue needed to satisfy the
debt service requirement.

For example, a revenue issue shows the following financial data:

Annual Gross Revenue: $8,000,000
Annual Debt Service: $3,000,000
Annual Operating and Maintenance Expenses: $2,000,000
To determine the net revenue, subtract operating and maintenance expenses from the gross revenue
($8,000,000 revenues – $2,000,000 O/M expenses = $6,000,000 net revenue).
The debt service coverage ratio is then found by dividing the net revenue by the debt service
($6,000,000 net revenue ÷ $3,000,000 debt service). Therefore, the debt service coverage ratio is 2
to 1, which is considered adequate coverage.
Trust Indenture Covenants In addition to the debt service coverage ratio, there are various provisions
that are found in the bond’s indenture that should be examined when analyzing revenue bonds. The
indenture is also referred to as the bond resolution or trust agreement.
The indenture is a contract between the issuer and the trustee that has been appointed to represent the
bondholders’ interests. The indenture includes a variety of provisions that establish the issuer’s
responsibilities and the bondholders’ rights. Since the indenture describes the legal protections that are
afforded to bondholders, it’s essential to analyze some of the various covenants (promises). The typical
covenants include:
Rate Covenant The issuer’s pledge to maintain rates at a level that’s sufficient to meet operation and
maintenance costs, debt service, and certain reserve funds.
Maintenance Covenant The issuer’s pledge to maintain the project in good working order.
Insurance Covenant The issuer’s pledge to carry insurance on the property.
Financial Reports and Audits The issuer’s pledge that it will maintain proper records and that an
accounting firm will be retained to do an outside audit. This pledge is designed to avoid the possibility of
funds being misused.
Issuance of Additional Bonds If there’s a closed-end indenture, no additional bonds that have an equal
claim on the pledged revenues may be issued against the same security. However, if there’s an open-end
indenture, additional bonds may be issued in the future for expansion of the project. Typically, before any
additional bonds may be issued, the project must meet certain earnings tests.
Non-Discrimination Covenant This represents the issuer’s pledge that no special rates will be granted to
any person or group.
Catastrophe Call This provision provides municipalities with insurance against natural disasters. It allows
for the early redemption of the bond if a catastrophic event occurs that severely damages the project which is
financed by the bond offering.

Credit Enhancements Credit from entities other than the issuer may be obtained to provide security for
the debt financing. This may come in the form of bond insurance, letter of credit, or state (or other)
government guarantees.
Flow of Funds The flow of funds establishes the order and priority of handling, depositing, and
disbursing pledged revenues, as set forth in the bond contract. Generally, when received, pledged revenues
are deposited into a general collection account or revenue fund that’s established under the bond contract
for subsequent disbursement into the other accounts that are established under the bond resolution. These
other accounts provide for payment of the costs of debt service, debt service reserve deposits, operation
and maintenance costs, renewal and replacement, and other required amounts.
Revenues that are generated by the project fill each of the funds to a prescribed level and then flow to the
next fund. The flow of funds described below is typical of most revenue bonds.
Revenue Fund This is the account into which all receipts and income (gross revenues) are deposited
and recorded.
Operating and Maintenance Fund This is the account into which a prorated amount of the revenue is
deposited to meet the costs of operating and maintaining the project. Occasionally, there’s an excess of
funds which allows for the creation of a reserve fund.
Debt Service (Bond Service) Fund This is the fund into which an amount of revenue is deposited that
will be sufficient to pay semiannual interest and maturing principal.
Debt Service Reserve Fund This is the fund into which revenue is deposited after annual debt service is
ensured. These funds are only used if the debt service fund itself is insufficient to meet annual payments.
Reserve Maintenance Fund This is the fund into which revenue is directed in order meet any
unexpected maintenance expenses.
Replacement and Renewal Fund In the event that there’s a demand based on an engineer’s report, this
is the fund into which revenue is deposited to meet new equipment and repair costs.
Sinking Fund This is the fund into which revenue is accumulated in order to retire bonds prior to
maturity. If there’s a mandatory sinking fund provision in the indenture, this fund will receive money prior
to the replacement fund. An offering with a mandatory sinking fund will retire a portion of the debt prior
to its stated maturity. Since the entire offering will not reach maturity, it will have an average life that’s
shorter than the stated maturity.
Surplus Fund This is the fund into which excess money will be placed for use in emergencies.
Construction Fund This is the fund into which money is allocated to use for future construction.

The order of the first three funds is very important. As described earlier, if net revenues (gross revenues
minus operating and maintenance expenses) are pledged to pay debt service, the bond is referred to as a
net revenue issue. On the other hand, if gross revenues are pledged to pay debt service (debt service is paid
before the operation and maintenance expenses), it’s known as a gross revenue issue. (For exam purposes,
a net revenue pledge is the assumed flow of funds method.) After the first three funds, the order may vary;
however, the following diagram shows the typical flow of funds for a net revenue issue.
Refer to the following summary chart for quick summary of the differences between GO and revenue
bonds:
General Obligation Bonds (GOs) Revenue Bonds
Issuer: States and local municipalities States or local governments, authorities
Required for
Voter approval Feasibility study
issuance:
Taxes Collected revenues generated by a financed
 State GOs: Secured by income, sales, project
Source of the funds
backing the bonds: and other state-collected taxes  Concessions
 Local GOs: Secured by property tax (ad  Tolls or user fees
valorem tax on assessed property value)  Rental or lease payments
Paying the general operating expenses of a Construction of airports, water and sewer
Use of the funds: municipality and for capital improvement systems, bridges, toll roads/turnpikes,
projects (e.g., roads, parks, schools) hospitals, etc.
 Economic character of community  Debt service coverage ratio
 Assessed property values  Bond’s indenture
What analysis  Employment rates  Covenants
should consider:  Industries that constitute the  Flow of funds
community’s employment
 Existence of unfunded pension liabilities

Now that we have analyzed both GO and revenue bond issues, let’s discuss shorter-term municipal
instruments.
Municipal Notes
Municipal notes are short-term issues that are normally issued to assist in financing a project. The notes
may also be issued to help a municipality manage its cash flow. Municipal notes are interest-bearing
securities that ultimately pay interest at maturity.
Tax Anticipation Notes (TANs) These are issued to finance current municipal operations in
anticipation of future tax receipts from property taxes. They’re usually general obligation securities.
Revenue Anticipation Notes (RANs) These are issued for the same purpose as TANs except that the
anticipated revenues are typically federal or state subsidies. Like TANs, they’re usually general obligation
securities.
Tax and Revenue Anticipation Notes (TRANs) These are created when TANs and RANs are issued
together.
Bond Anticipation Notes (BANs) These are issued to obtain financing for projects that will eventually
be financed through the sale of long-term bonds.
Grant Anticipation Notes (GANs) These are issued in expectation of receiving funds (grants) from the
federal government.
Construction Loan Notes (CLNs) These are issued by municipalities to provide funds for construction
of a project that will eventually be funded by a bond issue.
Ratings for Municipal Notes

As explained in the Bond Fundamentals Chapter, Moody’s and Standard and Poor’s issue ratings for
fixed-income securities. Both organizations also have a rating system for municipal notes.
Moody’s has four rating categories for municipal notes and variable rate demand obligations (VRDOs).
The first three ratings are considered Moody’s Investment Grade (MIG) ratings, with the fourth considered
a speculative grade. VRDOs, which will be described below, receive ratings based on a variation of the
MIG scale—the Variable Municipal Investment Grade (VMIG) system.
MIG 1 (VMIG 1): Superior credit quality

MIG 2 (VMIG 2): Strong credit quality
MIG 3 (VMIG 3): Acceptable credit quality
SG: Speculative grade credit quality

Standard and Poor’s has the following four rating categories for municipal notes:
SP-1+: Very strong capacity to pay principal and interest
SP-1: Strong capacity to pay principal and interest
SP-2: Satisfactory capacity to pay principal and interest
SP-3: Speculative capacity to pay principal and interest
Other Municipal Securities

Auction Rate Securities
Auction rate securities (ARSs) are long-term investments that have a short-term twist—the interest rates or
dividends they pay are reset at frequent intervals through auctions. Investors who purchase ARSs are typically
seeking a cash-like investment that pays a higher yield than available from money-market mutual funds or
certificates of deposit. Generally, there are two types of ARSs, bonds with long-term maturities (20 to 30 years)
and preferred shares with a cash dividend. Both the interest rate on the bonds and the dividend on the preferred
shares will vary based on rates that are set through auctions for a specified short period that’s usually measured
in days—7, 14, 28, or 35. This is unlike a traditional bond that’s issued with an interest rate that’s set for its life
or preferred stock that specifies the dividend rate for its life. Auction rate bonds are issued by entities such as
corporations, municipalities, student loan authorities, and museums, while auction rate preferred shares are
issued by closed-end funds.
The interest rate/dividend rate is determined through a Dutch auction process. Before each auction, current
ARS investors may request to hold their existing position at the new interest/dividend rate that’s established
by the auction, hold their existing position at a specified interest/dividend rate, or sell their ARSs. The size of
any given auction will depend on how many current ARS investors want to sell and how many want to hold
at a certain minimum rate. Essentially, the auction procedures that are set forth in most offering documents
allow for a variety of different types of auction orders to be placed with an auction dealer.
An existing holder of ARSs may choose to place the following orders:

 Hold at Market: this order indicates the amount of the security he wishes to continue to hold regardless
of the clearing rate that’s set by the auction. Additionally, if an owner doesn’t place an order, the
assumption is that he has elected to continue to hold the securities regardless of the clearing rate.
 Hold at Rate or Bid: this order indicates the holder’s bid to continue to hold an existing position at a
specified minimum rate.
 Sell: this order indicates the holder’s desire to sell an existing position regardless of the rate that’s set
by the auction.
A potential buyer has the option to place a:

 Buy order: this indicates a new investor’s desire to buy a new position at a specified minimum rate
(this order may be entered by new buyers or existing holders who are interested in adding to their
position at a specified rate).

The Auction Process Each bid and order size is ranked from the lowest to the highest minimum bid
rate. The lowest bid rate at which all of the securities may be sold at par establishes the interest/dividend
rate, otherwise referred to as the clearing rate. This is the rate that’s paid on the entire issue for the
upcoming period. Investors who bid a minimum rate above the clearing rate receive no securities;
however, those whose minimum bid rates were at or below the clearing rate receive the clearing rate for
the next period.
ARS auctions may fail when supply exceeds demand or, put another way, when there are not enough bids to
purchase all of the securities being offered for sale in the auction. When an ARS auction fails, existing
holders will continue to hold their securities and will generally receive an interest/dividend rate that’s set
above market rates for the next holding period (up to a maximum that’s disclosed in the offering documents).
These securities are usually sold as an alternative to other short-term money-market instruments. A
member firm must disclose to its clients that if the auction fails, the clients may not have immediate access
to their funds. Member firms also have a duty to disclose to their clients all material facts relating to the
specific features of the auction rate securities and must evaluate all customers’ liquidity needs when
recommending this type of product.
Variable Rate Demand Obligations (VRDOs)

Another long-term security that’s marketed as a short-term investment is a variable rate demand obligation
(VRDO). A VRDO’s interest rate is adjusted at specified intervals (daily, weekly, monthly) and, in many
cases, this adjustment allows the owner to sell or put the security back to the issuer or a third party on the
date that a new rate is established. If this is done, the investor will receive the par value plus accrued interest.
it’s important to understand the difference between a VRDO and a municipal ARS. Although they’re both
long-term securities with short-term trading features, only VRDOs have a put feature that permits the
holder to sell the securities back to the issuer or third party. If an ARS auction fails, the investor may not
have immediate access to his funds. ARSs use an auction process to reset the interest rate on the
securities; however, VRDOs have an interest rate that’s reset by the dealer at a rate that allows the
security to be sold at par value.
Investors who are interested in short-term investments may also purchase other tax free money-market
instruments such as tax-exempt commercial paper and tax-free money-market funds. Tax-exempt
commercial paper has a maximum maturity of 270 days and is normally backed by a bank line of credit.

Municipal Fund Securities

Section 529 College Savings Plans
The Economic Growth and Tax Relief Reconciliation Act of 2001 expanded the federal tax treatment of state-
run 529 plans, which are also referred to as municipal fund securities. As with Coverdell ESAs, 529 plans are
not retirement accounts; instead, they’re savings vehicles created to meet the expenses of higher education.
The beneficiary, who may include the donor, is able to be changed in the future. Under federal law,
contributions are made with after-tax dollars, but any earnings grow on a tax-deferred basis. If withdrawals are
used to pay for higher education, they’re considered qualified withdrawals and are tax-free. States that offer
529 plans are responsible for determining the specific plan rules such as allowable contributions, investment
options (e.g., mutual funds), and the deductibility of contributions for state tax purposes.
Contribution Limits Although current tax law allows a tax-free gift of up to $15,000 to any one person in
any given tax year, a 529 plan may be front-loaded with an initial gift of $75,000 which is treated as if it’s
being made over a five-year period (five contributions of $15,000 each). Individuals may contribute these
same amounts to 529 plans that are maintained for more than one beneficiary.
In other words, if an individual has five grandchildren, she’s able to contribute $75,000 to each grandchild’s
529 plan without incurring federal gift taxes. This amount is doubled for a married couple funding multiple
529 plans. The aggregate amount able to be contributed to a 529 plan is determined by the state. Most states
use a total that’s sufficient to pay for an undergraduate degree.
Rollovers Under IRS rules, a rollover of a 529 plan is permitted once every rolling 12 months. In rolling
over funds from this plan, an investor is moving the funds to another state’s plan. Conveniently, there are
generally no residency requirements for a 529 plan. A 529 plan may not be rolled over to a Coverdell ESA.
In a 529 plan, the donor is not permitted to choose the individual securities to own; instead, the donor
chooses among the investment options that are stipulated in the plan. The donor may change the selected
investment option no more than twice every 12 months (based on calendar year).
Disclosure Requirement When promoting 529 plans, an RR is required to:

 Disclose the risks and costs (both fees and maximum sales charges) involved with the different
types of plans
 Provide a disclaimer stating that, prior to investing in a plan, customers should read the official
statement (disclosure document)
 Recommend that clients check with their home state to discover if it offers tax benefits for investing
in its plan.
There’s no requirement to provide the name and contact information of the Municipal Securities Principal
who will approve customers’ investments in the plan.

Expanded Use of 529 Plans Tax law has expanded the use of 529 plans. Although originally intended
to accumulate funds to only pay for college educational expenses, the funds in these plans may now also be
used for expenses related to elementary and secondary schools at public, private, or religious institutions.
Individuals can take annual distributions of up to $10,000 from their 529 plans to pay for private school
tuition and books for grades K through 12—in addition to using their account proceeds for college costs.
Additionally, individuals are now permitted to withdraw up to $10,000 (lifetime limit) on a tax-free
basis (a qualified withdrawal) to repay qualified student loans as well as expenses for certain
apprenticeship programs.
The assets in plans may be transferred to another family member (a change in beneficiary) if the original
beneficiary doesn’t need or use the funds for qualifying education expenses.
529 ABLE Plans

Achieving a Better Life Experience (ABLE) plans (also referred to as 529A ABLE plans) are municipal fund
securities that can be purchased to help support individuals with disabilities without jeopardizing their
disability payments received from Social Security, Medicaid, or private insurance. The maximum
contribution is $15,000 per year and front-loading is not permitted. The individual’s other disability
payments will continue if the account’s value doesn’t exceed $100,000. Distributions from the plans are tax-
free if they’re used to pay qualified expenses.
Local Government Investment Pools (LGIPs)

LGIPs are investment pools that are created by state and local governments to provide municipal entities a
place to invest funds. Although municipalities are generally prohibited from investing in money market
funds, these pools are structured in a manner that’s similar to money market funds. The pools provide both
liquidity and minimal price volatility, but are not open to the public.
Tax Considerations
When engaging in securities transactions, it’s important to consider the tax implications of any particular
investment. Since tax consequences differ from one investment to another, and the level of tax aversion
differs from one customer to another, registered representatives must make recommendations that suit
their customers’ overall tax situations.
U.S. tax laws are complex and constantly changing. In addition to being subject to federal tax, individuals
may also be required to pay taxes to the state, county, and/or city in which they live. The final section of
this chapter will primarily focus on the areas of the tax code that affect municipal bonds and municipal bond
transactions. This will include the taxation of interest and the capital events that are associated with these
instruments. Before examining how to determine whether a municipal bond is an appropriate choice for a
client based on her tax situation, let’s address some larger tax issues.

Preference for Local Issues

The primary benefit of purchasing a municipal security is the fact that the interest is either fully or
partially tax-free to the investor. If an investor buys an in-state municipal bond, the interest earned is
exempt from federal, state, and local income taxes. However, if an investor buys an out-of-state municipal
security, the interest earned is still exempt from federal tax, but usually subject to state and local taxes.
Triple-Tax-Exempt Issues The interest earned on bonds that are issued by a territory or possession of the
U.S., such as Puerto Rico, the U.S. Virgin Islands, Guam, and American Samoa, are not subject to federal, state,
or local taxes. These securities are referred to as triple-tax-exempt bonds.
Bank-Qualified (BQ) Issues To encourage banks to invest in municipal securities, some issues are
specified as being bank-qualified. Banks that invest in these bonds are permitted to deduct 80% of the
interest cost being paid to depositors on the funds that are used to purchase the bonds. In addition, the
interest income on the bonds is tax-free.
One limitation is that bank-qualified issues may not be private activity bonds. Issuers may designate bonds
as being bank-qualified if they reasonably anticipate that the amount of such obligations will not exceed
$10,000,000 in a calendar year.
Treasury Arbitrage Restrictions Due to the tax exempt status of municipal bond interest,
municipalities are normally able to issue bonds with coupon rates that are below those of Treasury
securities. This could present an arbitrage opportunity since a municipality could borrow money at a low
rate of interest and invest the funds in higher yielding, risk-free Treasury securities. Treasury Arbitrage
Restrictions were enacted to prohibit state and local governments from refinancing their debt and placing
the proceeds into an escrow fund that invests in Treasuries with yields above a certain rate.
Bond Taxation
The manner in which income is taxed is often a function of the source of that income. Some of the sources
of income include earned, passive, deferred, and investment (portfolio) income. Most income is taxed as
ordinary income and is based on the individual’s particular tax bracket. Ordinary income includes wages,
interest, and qualified withdrawals from retirement plans. Assets that are bought and subsequently sold
result in either capital gains or capital losses and have separate tax implications.
Remember, interest earned on corporate securities is subject to federal, state, and local taxes (fully taxed).
On the other hand, interest earned on U.S. government obligations is subject to federal tax, but is exempt
from state and local taxes.

The following chart provides a summary of the tax implication of interest income on the different
types of bonds:
Bond Type Subject to Federal Tax Subject to State Tax

Corporate Bonds Yes Yes
U.S. Government Bonds Yes No
Municipal Bonds No Possibly *
Territorial Bonds No No
* In most states, taxpayers don’t pay state and local tax on bonds issued by municipal
entities that are located in the states in which they reside.
Municipal Bonds—The Target Market

In many cases, corporate bonds and Treasury securities have a higher coupon than municipal bonds of
similar maturity. An investor must have a way of comparing the taxation differences between these
security types. The main reason that this is important is the fact that investors are most concerned with
determining how much money they will be able to keep after paying all of the taxes that are due.
The benefit of investing in tax-exempt securities increases along with an investor’s tax bracket. A high
tax-bracket investor usually pays a greater percentage of his earnings in taxes; therefore, the higher the
investor’s marginal rate, the greater the benefit of receiving a tax-free coupon.
Conversely, municipals are unsuitable for investors who receive special tax considerations. For example,
since the earnings in a pension fund accrue on a tax-deferred basis, the fund doesn’t derive any additional
benefit from investing in tax-exempt municipal bonds. Municipal bonds are also generally unsuitable
investments for an individual’s IRA and 401(k) accounts.
Net (After-Tax) Yield Calculating a bond’s net yield is especially important when an investor is
considering the possibility of buying a taxable corporate bond and wants to know what she will be able to
keep after taxes are paid. Since the interest on a corporate bond is taxable, the investor will realize a lower
net (after-tax) return. To determine the net yield of a taxable investment, use the following formula:
Net Yield = Taxable Yield x (100% – Tax Bracket %)

Consider the following two examples:

Example 1: An individual who is in the 20% tax bracket purchases a 10% corporate bond at par.
What’s her bond’s net (after-tax) yield?
Net Yield = 10% x (100% – 20%)
= 10% x 80%
= 8.0%
For this investor, the 10% corporate bond is equivalent to a municipal bond yielding 8.0%.
Example 2: An individual who is in the 28% tax bracket purchases a 10% corporate bond at par.
What’s his bond’s net (after-tax) yield?
Net Yield = 10% x (100% – 28%)
= 10% x 72%
= 7.2%
For this investor, the 10% corporate bond is equivalent to a municipal bond yielding 7.2%.
Taxable Equivalent Yield Now, let’s examine the issue from the other point of view. If a customer is
considering the possibility of purchasing a tax-free bond and wants to calculate what he needs to earn on a
taxable issue to achieve an equivalent return, the taxable equivalent yield calculation is used. To determine
the taxable equivalent yield of a tax-exempt investment, the formula is:
Municipal Yield
Taxable Equivalent Yield =
(100% – Tax Bracket %)
Consider the following two examples:

Example 1: An individual who is in the 25% bracket purchases a 6% municipal bond at par. What will
the individual need to earn on a fully taxable instrument (e.g., a corporate bond) to equal the tax-free
yield on the municipal bond?
6% 6%
Taxable Equivalent Yield = = = 8%
(100% – 25%) 75%
In other words, if a client buys the 8% taxable bond, but is required to pay 25% of his earnings in
taxes, he will be left with a net (after-tax) return of 6%. For this investor, an 8% taxable issue and
the 6% tax-free issue are equivalent.

Example 2: An individual who is in the 35% tax bracket purchases the same 6% municipal bond at
par. What’s the bond’s taxable equivalent yield?
6% 6%
Taxable Equivalent Yield = = = 9.23%
(100% – 35%) 65%
This example shows that the same 6% bond is more attractive to an individual who is in a higher tax
bracket. This 35% tax-bracket investor will need to find a taxable bond that yields 9.23% to be
equivalent to the 6.00% tax-free issue.
The State Tax Effect Depending on the situation, it may be necessary to adjust the taxable equivalent
yield calculation if a question provides information about a customer’s state income tax rate. The key to
solving these more complicated taxable equivalent yield calculations is to adjust the divisor in the formula
to account for any additional potential tax exemption. Since investors who purchase in-state municipal
issues are exempt from both federal and state taxes, this combined tax liability is subtracted from 100% to
calculate the divisor. Investors who purchase out-of-state municipal issues are still subject to state tax;
therefore, only the federal liability is subtracted from 100% to calculate the divisor. Essentially, the divisor
in the taxable equivalent yield calculation is 100% minus any tax liability from which the bond’s interest is
exempt for a given investor.
Consider the following examples:

Example 1: A California resident who is in the 25% federal bracket and is subject to a 3% state
income tax purchases a 4% City of Sacramento municipal bond at par. What will this investor need to
earn on a fully taxable instrument to equal the tax-free yield on the municipal bond?
Since the bond was purchased by a resident of California, its interest is also exempt from California
state tax. Therefore, the state tax rate is factored into the equation (25% + 3%).
4% 4%
(100% – 28%) 72%
Example 2: A Wisconsin resident who is in the 25% federal bracket and is subject to a 3% state
income tax purchases a 4% City of New York municipal bond at par. What will this investor need to
earn on a fully taxable instrument to equal the tax-free yield on the municipal bond?
Since the bond was not purchased by a resident of the state of issuance (i.e., New York), interest is
subject to Wisconsin state tax. Therefore, the state tax rate is NOT included in this calculation.
4% 4%
(100% – 25%) 75%

Capital Gains and Losses on Municipal Issues

It’s important to understand the differences between the taxation of interest on municipal bonds and the
potential capital events associated with these securities. Securities such as stocks, bonds, and options are
considered capital assets and, if a capital asset is sold for less than its cost, the result is considered a capital
loss. On the other hand, if a capital asset is sold for more than its cost, it’s considered a capital gain.
Although the interest on municipal bonds is exempt from federal taxation, any resulting capital gain
from the sale or redemption of a municipal bond is subject to tax. In some cases, the gain is reported
as ordinary income.
Municipal bonds are identified based on the circumstances surrounding their purchase. The following are the
three different classifications of municipal issues:
1. Original Issue Discount Bonds
2. Secondary Market Discount Bonds
3. Premium Bonds
Let’s separately examine the tax implications of each classification.
Original Issue Discount Bonds Some bonds that are initially issued at a deep discount are classified
by the IRS as original issue discount (OID) securities. The appreciation in the value of an OID (the
amount of the discount) is treated differently for tax purposes than a municipal bond that’s purchased in
the secondary market at a discount. The discount on an OID must be accreted. Therefore, each year a
portion of the discount is treated as interest for tax purposes and is added to the bondholder’s cost basis.
For example, if an OID bond is purchased at 60 and it has 10 years to maturity, the bond’s cost basis is
accreted by 4 points each year. To determine the accretion amount, the 40 point difference between the
purchase price and par is divided by the 10 years remaining until maturity. Since this annual accretion is
not taxable, these issues are suitable for customers who don’t wish to incur a tax liability.

OID Held to Maturity Since the accreted amount of a municipal OID is treated as interest, this upward
adjustment in the bond’s value is tax-exempt. Each year, the bondholder’s cost basis is increased and, at
maturity, the cost basis reaches par. At maturity, since the cost basis is equal to the redemption price (par),
there’s no capital gain.
OID Sold Prior to Maturity If an OID bond is sold prior to maturity, the cost basis (adjusted to reflect the
accretion) is used to calculate gains or losses. Based on the example above, if an investor buys an OID
municipal bond at a price of 60 with 10 years to maturity, the bond will accrete by 4 points each year.
Therefore, after three years, the bond’s basis has accreted by 12 points to a basis of 72.
If the bond’s adjusted basis is 72:

 A sale at a market price of 75 creates a 3-point capital gain (75 market price – 72 adjusted cost).
 A sale at a market price of 70 creates a 2-point capital loss (70 market price – 72 adjusted cost).
 A sale at a market price of 72 creates no capital gain or loss (72 market price – 72 adjusted cost).
Constant Yield Method The preceding diagram used the straight-line accretion method, which is the
same process used for questions on the examination. However, the actual method of accretion used by
accountants is referred to as the constant yield method or constant interest method. Students are not
expected to perform this more difficult calculation.
Note: If an exam question references a zero-coupon municipal bond, it should be considered an OID.
Therefore, the discount is treated in the same manner as previously described.
Secondary Market Discount (SMD) If a municipal bond is purchased at a discount in the secondary
market (a discount caused by market conditions) and held to maturity, there will be a taxable gain at
maturity. The gain is reported as ordinary income.
For example, a municipal bond was originally issued at par. A customer buys the bond in
the secondary market for $920 with 8 years to maturity. The bond’s value will be accreted
upwards 1 point ($10) per year (8 points divided by the bond’s remaining 8-year life).

SMD Held to Maturity In the case of an SMD bond, the accreted amount is treated as ordinary income
and is taxable. Each year the bondholder’s cost basis is increased; however, this increase is viewed as
ordinary income and is taxable. At maturity, the $80 difference between the purchase price and par value
is reported as ordinary income and is subject to federal taxation.
SMD Sold Prior to Maturity As was the case with an OID, if a secondary market discount bond is sold
prior to maturity, the adjusted cost basis (which reflects the accretion) is used to calculate gains or losses.
Let’s assume the client sold the SMD bond in year 4. Although the bond’s original cost was 92, its
adjusted cost basis is now 96. This adjusted basis is based on the fact that the bond’s basis has been
accreted by 1 point each year over the four years.
If the bond’s adjusted basis is 96 and it’s subsequently sold, this will result in two events:
 If it’s sold at a market price of 99, the two results are 1) $40 of ordinary taxable income, and 2) a 3-
point capital gain (99 market price – 96 adjusted basis).
 If it’s sold at a market price of 90, the two results are 1) $40 of ordinary taxable income, and 2) a 6-
point capital loss (90 market price – 96 adjusted basis).
 If it’s sold at a market price of 96, the two results are 1) $40 of ordinary taxable income, and 2) no
capital gain or loss (96 market price – 96 adjusted basis).
Again, similar to an OID, it’s the adjusted (accreted) basis, NOT the original purchase price, that’s used to
calculate the capital gain or loss on any subsequent sale.
Premium Bonds If a bond is purchased at a premium (above par), the premium amount must be
amortized each year. Essentially, amortization is the process used to reduce the bond’s premium over the
remainder of its life.
For example, a municipal bond was purchased in the secondary market for $1,200
with 10 years to maturity. The bond’s value will be amortized downward by 2 points
($20) each year (20 points divided by the bond’s remaining 10-year life).
Amortized Value

Premium Bond Held to Maturity The amortized amount is subtracted from the bondholder’s cost
basis each year. For a municipal bond, the amortization is not deductible for tax purposes. If the bond is
held to maturity, the cost basis will have been reduced to the redemption price of par and there will be no
loss for tax purposes.
Premium Bond Sold Prior to Maturity Each year a premium bond’s cost basis will be adjusted down to
reflect amortization. If the bond is sold prior to maturity, the adjusted cost basis (original cost minus
amortization) will be used to calculate a gain or a loss.
Based on the diagram above, let’s assume the client sold the premium bond in year 7. Although the bond’s
original cost was 120, its adjusted cost basis is now 106. This adjustment is due to the fact that the bond’s
basis has been amortized downward by 2 points each year over the 7-year holding period.
If the bond’s adjusted basis is 106:

 A sale at a market price of 109 creates a 3-point capital gain (109 market price – 106 adjusted basis).
 A sale at a market price of 101 creates a 5-point capital loss (101 market price – 106 adjusted basis).
 A sale at a market price of 106 creates no capital gain or loss (106 market price – 106 adjusted basis).
The following chart summarizes the tax treatment of OID, SMD, and premium municipal bonds:
If Sold Prior to Maturity If Held to Maturity

Sale versus Accreted cost basis
OID Bond No capital gain or loss
will determine capital gain or loss
SMD Bond Sale versus Accreted cost basis Accretion is taxable as ordinary income
Sale versus Amortized cost basis
Premium Bond No capital gain or loss
will determine capital gain or loss
Tax Swaps
Some investors who hold municipal bonds that have declined in value may wish to sell them to realize the
loss. However, if they’re concerned about changing the overall nature of their portfolio, a tax swap may be
appropriate. A tax swap is executed by selling a bond at a loss and, either before or shortly after the sale,
repurchasing a similar bond.
For example, an investor purchases some 5% Oregon GO bonds at par that mature in
2027. Let’s assume that interest rates rise after the bonds are purchased and it causes
the market value of the bonds to fall to $800. The investor sells the Oregon bonds and
realizes a $200 capital loss per bond. However, he subsequently uses the sales proceeds
to buy some similarly rated 4 7/8% state of Washington GOs that also mature in the year
2027 and are trading at $800. With these transactions, the investor’s portfolio has
changed only slightly, and he’s able to deduct the $200 capital loss per bond.

In order to avoid the wash sale rule, the investor must be sure to repurchase bonds that have material
differences from the bonds that were originally sold at a loss. Relevant factors to consider include the
bond’s issuer, or the coupon rate, or the maturity date.
Swapping may also be done for non-tax reasons, such as to change a portfolio’s maturity or to enhance its
quality or yield.
Quotations
Municipal bonds are typically quoted (bid or offered) on a yield basis. However, some term issues are
referred to as dollar bonds since they’re quoted at a dollar price (percentage of par), rather than on a yield-
to-maturity basis. Consider the following example:
100M New York State 4.00 7-1-40 @ 6.25 – 1/2 C30 @ 100
The offering is for $100,000 face value of 4.00% New York State general obligation bonds which mature July
1, 2040 and are callable beginning July 1, 2030 at 100. The bonds are assumed to be GOs since no description
beyond the name is indicated. For revenue bonds, the project’s designation is made.
Out Firm and Recall

Out firm is a quotation that a dealer is committed to honor, usually for a set period. The firm providing the
quote may also establish a specific recall period. For example, Dealer A offers bonds to Dealer B on a firm
basis for one hour, with a five-minute recall. In this case, Dealer A cannot offer the bonds to any entity but
Dealer B without giving Dealer B the first opportunity to take the bonds. Since the recall period is five
minutes, if Dealer A recalls Dealer B, Dealer B is given five minutes to take the bonds, otherwise Dealer
A is free to sell the bonds to another party.
The following order qualifiers may be used by investors when they seek to sell municipal bonds:
 All or none (AON) is a type of order which indicates that the prospective purchaser must buy all of the
securities being offered if it wants to buy.
 Fill or kill indicates that the prospective purchaser must act immediately and purchase the securities at
the offering price or the quotation will be withdrawn.
Multiple Markets in the Same Security

Occasionally, firms participate together in joint accounts for the purpose of selling municipal securities in
an arrangement that’s referred to as a secondary market trading account. This form of a joint account is
allowed to have only one price at which it’s offering a specific security at a particular time. Participants in
joint accounts are prohibited from distributing or publishing different quotations for the same security. As
with a new issue, there may be an order period and a takedown (member’s discount).
Conclusion
This concludes our chapter on municipal bonds. The next chapter will focus on U.S Treasury and
government agency debt.

CHAPTER 8
U.S. Treasury
and Government
Agency Debt
Key Topics:
 U.S. Treasury Securities
 Issuing Treasury Securities
 U.S. Government Agency Debt
 CMOs and CDOs

CHAPTER 8 – U.S TREASURY AND GOVERNMENT AGENCY DEBT
This chapter examines the debt instruments which are issued by the U.S. Treasury and the other federal
government entities that have the ability to issue or guarantee securities. The primary attribute of these
securities is safety since most possess little or no default risk. Investors who purchase these issues are
willing to accept relatively modest yields in return for the peace of mind of knowing that the issuers are
of such high quality.
Types of Treasury Securities

United States government securities include both the direct debt obligations of the federal government
(Treasuries) and securities issued by agencies of the U.S. government. Treasury securities are considered the
safest type of fixed-income investment and are suitable for the most conservative investors. Since the
securities are backed by the full faith and credit of the U.S. government, they have virtually no credit risk.
Consequently, they’re the benchmark against which the credit ratings of all other issuers are measured.
The U.S. government issues securities in order to finance its operations. The securities may be divided into
two major groups—non-marketable (non-negotiable), which includes savings bonds and marketable
(negotiable), which includes Treasuries. Savings bonds are considered non-negotiable because they cannot
be sold in the secondary market; instead, they may be redeemed only by the U.S. government.
Marketable securities are negotiable because investors are able to sell their securities to other investors after
they’re issued. Of the two groups, Treasuries are much more important since they may be freely transferred
after they’re issued. Negotiable instruments include the following:
 Treasury bills
 Treasury notes
 Treasury bonds
 Treasury Separate Trading of Registered Interest and Principal Securities (T-STRIPS)
 Treasury Inflation-Protected Securities (TIPS)
 Treasury Cash Management Bills (CMBs)
From this point on, when the word Treasuries is used, it will refer to marketable/negotiable securities
only. The three most prevalent types of these marketable issues are T-bills, T-notes, and T-bonds. Let’s
begin our discussion with the interest-bearing Treasury securities and move on to other instruments that
are non-interest-bearing.
Interest-Bearing Securities
Treasury Notes (T-Notes) and Treasury Bonds (T-Bonds)
Treasury notes and Treasury bonds are interest-bearing securities and have all of the attributes of traditional
fixed-income investments. Each pays a fixed rate of interest semiannually and investors receive the face
value at maturity.

CHAPTER 8 – U.S. TREASURY AND GOVERNMENT AGENCY DEBT
Treasury notes have initial maturities that range from two to 10 years, while Treasury bonds are issued with
maturities of more than 10 years. T-notes and T-bonds are both sold in minimum denominations of $100;
however, most examples in this manual will use a par value of $1,000.
Book-Entry Issuance Both notes and bonds are currently issued in book-entry form which means that an
investor never receives the actual paper security. Instead, the Federal Reserve Bank enters the names of the
owners in its records. Don’t confuse the term book-entry issuance with street-name holding. Any reference to
street-name holding suggests that a security is being held in the name of a broker-dealer at a depositary, such as
the Depository Trust & Clearing Corporation (DTCC). In many cases, a street-name security may be
reregistered in a client’s name and, if requested, delivered to the client.
Prices As is true for other types of bonds, prices for Treasury notes and bonds are quoted as a percentage
of their par value. However, government securities are quoted in increments of 1/32 nds of a point, while most
other bonds are quoted in increments of 1/8 ths of a point. For example, a U.S. government bond that’s
quoted at 97.08, actually means 97 8/32. A price of 97 8/32 equates to 97.25% of par, or $972.50.
Below are some additional pricing examples:
T-Bond and T-Note Pricing

Displayed Price Fractional Price Decimal Price Dollar Price
99.12 = 99 32
12/ = 99.375 = $993.75
100.16 = 100 16/32 = 100.50 = $1,005.00
103.24 = 103 24/32 = 103.75 = $1,037.50
A simplified example of T-note and T-bond listings is shown below and is followed by an explanation of the
information displayed:
1 2 3 4 5
Rate Maturity Bid Asked Chg Ask Yld.
4.25 Feb 20n 106-17 106-18 -11 3.26
6.50 Feb 30 119-04 119-06 -11 4.65
Column 1 shows coupon rates. For example, 4.25 indicates that an investor will receive interest of $42.50 each
year ($1,000 par x 4.25%).
Column 2 shows the month and year of maturity. The symbol n is an indicator of a Treasury note. For
example, Feb 20n refers to a Treasury note that matures in February of 2020.

Column 3 shows the bid and asked quotations on a percentage-of-par basis. The number to the right of the
dash represents 32nds of a point. For example, 106-18 represents 106 18/32. When rewritten as a decimal, it
equals 106.5625% of par, or $1,065.63 per bond. In a quote, the separator between the percentage of par and
the number of 32nds may be a dash (-), a point (.), or a colon (:).
Column 4 shows the bid price’s change in 32nds of a point from the previous day’s close. The change of -11
means that the bonds decreased by 11/32 from the previous day’s bid quotation.
Column 5 shows the bond’s yield-to-maturity based on the asked price.
Treasury Inflation-Protected Securities

One of the primary concerns for bond investors is how inflation (a rise in prevailing prices) affects the
purchasing power of the dollars received. This is somewhat amplified since bond investor often need to wait
years for their return of principal. So how is a Treasury investor able to protect himself? One answer may be
to acquire protection by investing in Treasury Inflation-Protected Securities (TIPS). TIPS are interest-
bearing, marketable securities.
The interest rate on TIPS is fixed; however, the principal amount on which that interest is paid may vary based
on the change in the Consumer Price Index (CPI). During a period of inflation (a rise in CPI), the principal
value will increase. However, if deflation occurs (a decline in CPI), the principal value will decrease. TIPS are
issued in book-entry form in $100 increments and are available in 5-, 10-, and 30-year terms.
For example, an investor buys a 10-year TIPS note at an initial face amount of $1,000, and
a coupon of 4%. Six months later, the face amount has been adjusted to $1,010 to reflect a
1% increase in CPI. Given the 4% coupon, the investor’s semiannual interest payment will
be $20.20 (as shown below).
Based on the 1% increase in the CPI, the principal value rises to $1,010. Therefore,
$1,010 x 4% = $40.40. However, since the interest is paid semiannually, the amount
paid will be $20.20 (40.40 ÷ 2).
TIPS may be offered as notes or bonds and are auctioned periodically during the year. The total inflation-
adjusted principal will be paid at maturity. Although the face amount that’s used to calculate interest
payments may fall below $1,000, TIPS will pay at least $1,000 at maturity. In any year in which a principal
adjustment is made, the annual adjustment will be taxed at the federal level as ordinary income.
Additionally, any interest paid will be taxable at the federal level.
Non-Interest-Bearing Securities
This next section will describe various forms of Treasuries that are non-interest-bearing. These securities are
issued at a discount and mature at face value.

Treasury Bills (T-Bills)

Treasury bills are short-term securities that mature in one year or less. Currently, an investor may purchase
T-bills with maturities of one month (4 weeks), three months (13 weeks), six months (26 weeks), and one year
(52 weeks). T-bills are only issued in book-entry form and are sold in minimum denominations of $100, with
subsequent multiples of $100.
T-bills are always sold at a discount from their face value and, unlike Treasury bonds and notes, T-bills
don’t make semiannual interest payments. The difference between a T-bill’s purchase price and its face
value at maturity represents the investor’s interest. Consequently, T-bills are referred to as discount
securities or non-interest-bearing securities.
Prices T-bills are quoted on a discounted yield basis, not as a percentage of their par value. The yield
represents the percentage discount from the face value of the security.
The dynamic of the bid and asked quotation of T-bills is a distinguishing characteristic when comparing them
to other government securities. Since the bid’s higher yield represents a larger discount (a lower price), the
bid will appear to be greater than the asked.
For example, consider the sample quotations found in the newspaper and refer to the T-bills
that mature on February 20, 20XX.
Treasury Bills
DAYS TO ASK
MATURITY BID ASKED CHG
MAT. YLD
Jan 30 XX 3 1.13 1.12 -0.01 1.14
Feb 06 XX 10 1.14 1.13 -0.02 1.15
Feb 13 XX 17 1.11 1.10 -0.02 1.12
Feb 20 XX 24 1.12 1.11 -0.01 1.13
Feb 27 XX 31 1.11 1.10 -0.01 1.12
Mar 06 XX 38 1.11 1.10 -0.01 1.12
Mar 13 XX 45 1.11 1.10 -0.02 1.12
As shown in the table, these bills were scheduled to mature in 24 days. The quotation is:
Bid Asked Ask Yld

1.12 1.11 1.13
Although the bid (1.12 discount yield) is numerically higher than the asked (1.11 discount
yield), remember, its higher yield actually represents a lower price.
Along with the bid and asked quotation, the column titled ask yld signifies the bond or coupon
equivalent yield.

The bond equivalent yield allows investors to compare the yields available on T-bills with the yields available
on notes, bonds, and other interest-bearing securities. The bond equivalent yield takes into account the fact that
the interest being earned is on the amount invested, not on the face amount. For example, if a 26-week Treasury
bill has a face value of $10,000 and is purchased at $9,800, the $200 of interest is earned on $9,800, not
$10,000. As a result, a T-bill’s bond equivalent yield is always greater than its discount yield.
Stripped Securities
In the 1980s, several broker-dealers began stripping the interest payments and final principal payments from
Treasury notes and bonds and then repackaged and resold them as zero-coupon bonds. Although these
stripped securities were not issued by the Treasury, their cash flows were very secure since the underlying
securities are direct obligations of the U.S. government. Thereafter, a group of dealers began to issue generic
stripped securities—referred to as Treasury Receipts (TRs). An important distinction is that Treasury
Receipts are backed by Treasury securities that are owned by the issuing broker-dealer; they’re not directly
backed by the U.S. Treasury.
Treasury STRIPS In order to facilitate the stripping of securities, the Treasury created its Separate
Trading of Registered Interest and Principal Securities (STRIPS) program. Dealers are now able to purchase
T-notes and T-bonds and separately resell the coupon and principal payments as zero-coupons (discounted
securities) after requesting this treatment through a Federal Reserve bank. The difference between an
investor’s purchase price and the bond’s face value is interest. STRIPS are backed by the full faith and credit
of the U.S. Treasury and are quoted on a yield basis, not as a percentage of their par value.
Cash Management Bills (CMBs) CMBs are unscheduled, short-term debt offerings that are used to
smooth out Treasury cash flows. CMBs are issued at a discount, but will mature at their face amount. The
duration of CMBs may be as short as one day.
Accrued Interest
As mentioned previously, when an investor buys an existing bond in the secondary market, he’s often
required to pay the seller an amount of accrued interest. Interest on T-bonds and T-notes is paid semiannually
and accrues (is earned) on the basis of actual days in each month and a 365-day year. The following example
explains the method for calculating the number of days of accrued interest for a Treasury security.
On Tuesday, March 8, an investor purchases a $10,000 face value 7.5% Treasury bond
that matures on December 1, 2034. Assuming regular-way settlement, how many days of
accrued interest does the buyer owe the seller?
Interest is paid every six months on dates that are based on the bond’s maturity date.
In this example, interest is paid each June 1 and December 1. Accrued interest on the
purchase is calculated by starting at December 1 (the last interest payment).

Regular-way settlement on the transaction is Wednesday, March 9 (the next business day, or
T+1). Remember, accrued interest on the purchase is calculated up to, but not including, the
settlement date of March 9.
The number of days of accrued interest owed includes all of December (31 days), January
(31 days), February (28 days), and 8 days in March, which results in 98 days of accrued interest.
Since both Treasury bills and Treasury STRIPS trade at a discount and are non-interest-bearing, they trade
without accrued interest.
The Primary Market for U.S. Treasury Securities

U.S. government securities are exempt from registration under state and federal securities laws and
government issuers are not subject to the SEC’s filing requirements.
Federal Reserve Auctions

The government sells Treasuries through auctions that are conducted by Treasury Direct. Weekly auctions
are currently conducted for the three- and six-month T-bills every Monday and for the four-week T-bills
every Tuesday. The auctions for the 12-month T-bills are held on a monthly basis. All T-bills are issued on
the Thursday following the auction. Many investment professionals pay close attention to these weekly
auctions for changes in T-bill yields in order to anticipate trends in interest rates. Variable-rate mortgages
and floating-rate bonds are often tied to T-bill rates.
Two- and five-year T-notes are sold monthly, while 10-year T-notes are sold quarterly (usually February,
May, August, and November). T-bonds are generally issued four times per year.
Competitive versus Non-competitive Tenders When Treasury auctions are held, securities firms
compete with each other by submitting their bids to buy Treasuries through an automated system. These bids
are called competitive tenders since they specify the price and/or yield at which the firm is willing to buy
the Treasuries. If an individual wants to purchase Treasuries, she usually submits a non-competitive tender.
Non-competitive bids are filled first; however, the bidders must agree to accept the yield and price as
determined by the auction.
Non-competitive bidders agree to pay the lowest price of the accepted competitive tenders. Although all non-
competitive tenders are accepted (awarded) first, the yield that the investors will receive is determined after
the competitive tenders are accepted. Therefore, all purchasers of Treasury securities through this auction
process will pay the same price. This single price auction process is referred to as a Dutch auction.

Summary of Treasury Auctions

Treasury Type Frequency Auction Date Issue Date
4-week bill Weekly Tuesday Thursday
13- and 26-week Weekly Monday Thursday
52-week bill Every four weeks Tuesday Thursday
2-, 3-, and 5-year note Monthly Varies End of month

Feb., May, Aug., &
10-year note Quarterly 15th of the month
Nov.
Feb., May, Aug., &
30-year bond Quarterly 15th of the month
Nov.
Agency Securities
Agency securities include debt instruments that are issued and/or guaranteed by federal agencies and by
government-sponsored enterprises (GSEs). Although agency securities are not direct obligations of the U.S.
government, their credit risk is still considered low. The prevailing presumption is that since the federal
government created these entities, it will not allow them to default on their obligations. Therefore, although
actually unrated, agency debt may be considered to be AAA rated. Also, as with U.S. Treasury securities,
agency debt is issued in book-entry form and is quoted in increments of 1/32nds of a point.
Investors are attracted to agency securities due to their perceived safety and the fact that yields are slightly
higher than the yields of corresponding U.S. Treasury securities.
Federal Agencies
Since federal agencies are direct extensions of the U.S. government, the securities that they issue or
guarantee are backed by the full faith and credit of the U.S. government. This category includes the
Government National Mortgage Association (GNMA). GNMA securities will be examined when mortgage-
backed securities are covered.
Government-Sponsored Enterprises
Government-sponsored enterprises (GSEs) are publicly chartered, but privately owned organizations.
Congress allowed for their creation to provide low-cost loans for certain segments of the population.
The enterprise issues securities through a selling group of dealers with the offering’s proceeds provided to a bank
(or other lender). The bank then lends the money to an individual who is seeking financing (e.g., students,
homeowners, or farmers).

Although GSE securities are not backed by the U.S. government, they do have an implicit guarantee from the U.S.
government. GSE securities are considered to have minimal default risk. GSE examples include:
 Federal Farm Credit Banks (FFCBs)
 Federal Home Loan Banks (FHLBs)
 Student Loan Marketing Association (SLMA or Sallie Mae)
Federal Farm Credit Banks (FFCBs) The Federal Farm Credit Banks provide funds for three separate entities—
Banks for Cooperatives, Intermediate Credit Banks, and Federal Land Banks. These organizations make
agricultural loans to farmers. The Federal Farm Credit Consolidated Systemwide Banks issue short-term
discount notes and interest-bearing bonds with both short and long maturities. Interest received on these
obligations is subject to federal tax, but is exempt from state and local taxes.
Federal Home Loan Banks (FHLBs) The 12 Federal Home Loan Banks help to provide liquidity for the
savings and loan institutions that may need extra funds to meet seasonal demands for money. The two types
of securities that they issue are discount notes and consolidated bonds. Discount notes have maturities of one
year or less, while consolidated bonds have maturities that range from one to 30 years. The securities that are
issued by FHLBs are not backed by the U.S. government; however, the Treasury is allowed to buy up to $4
billion of FHLB issues. As with FFCB debt, interest received on these securities is subject to federal tax, but
is exempt from state and local taxes.
Student Loan Marketing Association (SLMA) The Student Loan Marketing Association, or Sallie Mae,
provides liquidity to student loan makers as well as financing for state student loan agencies. Sallie Mae is
authorized to deal in student loans that are both insured in the federal Guaranteed Student Loan Program
(GSLP) and those that are uninsured. Sallie Mae is also able to lend funds directly to educational institutions.
Although originally created as a GSE, Sallie Mae is now a private company without
government backing and its stock is listed on Nasdaq. Interest earned on Sallie Mae securities
is subject to federal tax, but whether state and local taxation applies is determined by the state.
Mortgage-Backed Securities
As the name implies, mortgage-backed securities are debt instruments that are secured by pools of home
mortgages. The agencies that issue these securities include the Government National Mortgage Association
(GNMA or Ginnie Mae), the Federal National Mortgage Association (FNMA or Fannie Mae), and the
Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac).
Pass-Through Certificates
The most common security issued by government agencies is a mortgage-backed pass-through certificate.
The simplest method of creating a pass-through certificate is for an agency to purchase a pool of mortgages
that contains mortgages with similar interest rates and maturities. Interests in the pool are then sold to
investors as pass-through certificates. Each certificate represents an undivided interest in the pool and the
owners are entitled to share in the cash flow that’s generated by the pool.

On a monthly basis, the homeowners in the pool make their mortgage payments and, after certain administrative
charges are deducted, the bulk of these payments are passed through to investors every month. Each payment
includes a portion of both interest and principal.
Pass-through certificates are fully negotiable, which means that investors may sell them to other investors in
the secondary market.
Federal Home Loan Mortgage Corporation (FHLMC)

The purpose of the Federal Home Loan Mortgage Corporation, or Freddie Mac, is to provide liquidity to
federally insured savings institutions that are in need of extra funds to finance new housing. Essentially,
Freddie Mac will purchase residential mortgages from the savings institutions. This typically occurs when
credit is tight.
Freddie Mac raises money for its operations by issuing mortgage-backed bonds, pass-through certificates,
and guaranteed mortgage-backed certificates. These securities are not backed by the U.S. government;
instead, they’re backed by other agencies and the mortgages that are purchased by Freddie Mac. Interest
earned on Freddie Mac securities is subject to federal, state, and local tax (i.e., it’s fully taxable).
Federal National Mortgage Association (FNMA)

The Federal National Mortgage Association, or Fannie Mae, raises money to buy insured Federal Housing
Administration (FHA), Veterans Administration (VA), and conventional residential mortgages from lenders
such as banks and savings and loan associations. Rather than being backed by the U.S. government, FNMA
issues are backed by its authority to borrow from the Treasury. Interest earned on FNMA securities is subject
to federal, state, and local taxes (i.e., it’s fully taxable).
Government National Mortgage Association (GNMA)

Unlike FHLMC and FNMA, the GNMA is a part of the Department of Housing and Urban Development.
Since it’s a true government agency, it’s backed by the full faith and credit of the U.S. Treasury. Ginnie Mae’s
purpose is to provide financing for residential housing. Although Ginnie Mae securities are direct obligations of
the U.S. government, any interest earned on the securities is subject to federal, state, and local taxes.

GNMA issues mortgage-backed securities and participation certificates, but its most popular securities are
modified pass-through certificates. A modified pass-through certificate is backed by a pool of FHA and/or
VA residential mortgages. As the homeowners in the pool make their mortgage payments (consisting of
principal and interest), a portion of those payments is passed through to the investors who purchased the
certificates from GNMA.
GNMA guarantees monthly payments to the owners of the certificates, even if it’s not been collected from
the homeowners. The mortgages in the pool have maturities that range from 25 to 30 years. However, due to
prepayments, foreclosures, and refinancings, the average life of the pool tends to be anywhere from 12 to 14
years, or even shorter during periods of declining interest rates.
Prepayment Risk
In addition to the risks inherent in all fixed-income investments (e.g., interest-rate, credit, and liquidity risk),
mortgage-backed securities are subject to a special type of risk that’s referred to as prepayment risk. This is the
risk that’s tied to homeowners paying off their mortgages early. When interest rates fall, homeowners have an
incentive to refinance and pay off their existing mortgages. These prepayments are passed through to the
pools that hold the old mortgages. At this point, the pass-through investors will need to reinvest this large
amount of principal at a time when interest rates have declined.
Since any mortgage in the pass-through pool may be paid off at any time, the cash flows from these
investments can be highly unpredictable. As it relates to mortgage-backed securities, there are two terms
with which a person should be familiar—prepayment rate and average life. The prepayment rate measures
the speed at which mortgages in the pool are being paid off or how quickly prepayments of principal are
being received. The prepayment rate usually rises when interest rates fall since this is the time that
homeowners refinance their mortgages. Average life measures the average number of years that each dollar
of principal is expected to remain outstanding.
The pass-through securities of the preceding entities are all subject to prepayment risk. However, Fannie
Mae and Freddie Mac also issue bonds and notes that pay interest semiannually and have a fixed maturity
date. These notes and bonds have no prepayment risk.
Agency Securities—Investor Profile

Agency securities are suitable for conservative customers due to their relative safety. GNMA securities are
direct obligations of the U.S. government and are viewed as default-free, while others (e.g., FNMA
securities) are still considered to be of excellent credit quality. Agency securities are also quite liquid with
little, if any, marketability risk.
The primary reason that an investor may choose an agency security over a Treasury security is that many of
these instruments provide monthly payments. Investors often use them to supplement their income from
corporate pensions and/or Social Security. Traditionally, the yield on an agency security is somewhat higher
than what’s offered by a Treasury security. The downside is the maturity of a pass-through security is
unknown due to potential prepayments from the underlying collateral.

Collateralized Mortgage Obligations (CMOs)

A collateralized mortgage obligation is essentially a mortgage-backed security that takes the principal and
interest payments from underlying mortgages and separates them into various classes of bonds that are referred to
as tranches (slices). Each tranche has a different rate of interest, repayment schedule, and priority level.
CMOs have become very popular since investors are able to choose the yield, maturity structure, and risk
exposure that best meets their needs. CMOs help minimize the prepayment risk that’s associated with
traditional mortgage-backed securities by repackaging their principal and interest payments.
During a period of declining interest rates, homeowners usually prepay their mortgages either because they
sell their home or they wish to refinance. Prepayments make the average life of a mortgage-backed security
much shorter than the initial maturity. The result is that the investor ends up with an early return of principal
and, in turn, must reinvest at lower interest rates. A unique feature of CMOs is that they spread the
prepayment risk of the underlying securities among the various tranches. Generally, tranches with the
highest risk offer investors the highest yield.
CMOs are usually secured by FNMA, GNMA, and FHLMC pass-through securities, but may also be backed
by pools of mortgage loans. Assets are placed in a protective trust for the exclusive benefit of the bondholders.
Since the value of a CMO is based on the underlying mortgage-backed securities, it may be classified as a
derivative. CMOs usually have high ratings due to the quality of the underlying collateral and the safety
provided by the trust. Like many other types of bonds, CMOs are issued in denominations of $1,000.
Regulation and Taxation

CMOs are privately issued corporate securities and, unlike Treasuries and agencies, their issuance is subject
to registration under the Securities Act of 1933 and the Trust Indenture Act of 1939 (a corporate debt
regulation). Additionally, ongoing filings may be required under the Securities Exchange Act of 1934.
Interest payments are generally paid monthly and are subject to federal, state, and local taxes; however, the
principal payments are considered a return of capital and are not taxable.
Average Life
The maturities of CMOs are difficult to measure because of the likelihood that prepayment rates will
fluctuate. One common way of estimating the maturity of CMOs is by determining their average life.
The average life method compares CMOs to other types of fixed-income securities and essentially provides
an average maturity for each tranche. Using a specific prepayment speed assumption, it represents the
average amount of time that each dollar of principal that’s invested in the bonds is expected to be
outstanding. A change in prepayment speeds will ultimately have an impact on the average life.

PSA Model The Public Securities Association (PSA), an association of securities firms (now SIFMA),
created the PSA Model to estimate the prepayment rate for mortgage-backed securities as measured against a
benchmark. If a CMO is assigned a PSA number that is:
 Equal to 100—the assumption is that the prepayment speed will remain stable
 Greater than 100—the assumption is that the prepayment speed will be faster than normal
 Less than 100—the assumption is that the prepayment speed will be slower than normal
If interest rates decline, homeowners often refinance which increases the prepayment of mortgages;
however, if interest rates increase, there will be a decline in the prepayment of mortgages.
Types of CMOs
CMO issues may be structured in a number of different ways. In the simplest form, often referred to as plain
vanilla or sequential pay, each tranche receives monthly interest payments, but only one tranche receives
principal repayments at a time. In the example below, Tranche B doesn’t receive any principal until all of the
required principal has been repaid to Tranche A. Tranche C doesn’t receive principal repayments until
Tranche B is paid up, etc.
A B C
B C

Planned Amortization Class (PAC) Another popular structure is the Planned Amortization Class (PAC).
This form is designed for more risk-averse investors and provides a predetermined schedule of principal
repayments, but it’s based on mortgage prepayment speeds remaining within a certain range. This greater
predictability of maturity is accomplished by establishing a sinking-fund type of schedule. The PAC tranche has
top priority and receives principal payments up to a specified amount. Thereafter, any excess principal payments
are directed to a companion or support tranche, which has lower priority.
Targeted Amortization Class (TAC) Similar to PACs, TACs were also developed to provide investors
with greater protection from prepayment risk than a plain vanilla bond. However, TACs generally provide
protection only from contraction risk (a shorter maturity schedule), not extension risk (a longer maturity
schedule). The degree of protection that’s offered by a specific TAC tranche will depend on the existence of
PAC and TAC tranches that have higher priorities.
Companion or Support Bonds As mentioned with PACs, companion or support tranches absorb the
prepayments from the PAC and TAC tranches. Once the scheduled payments have been made to the PAC or
TAC tranches, any excess or shortfall is reflected in the companion tranche. Therefore, support tranches have
greater volatility of cash flow and a high variability of average life. Generally, holders are compensated for
this risk with higher yields.
Z-Tranches Z-tranches, or Z-bonds, are deferred-interest bonds that have the longest average life of any
tranche. During the initial phase of a Z-tranche’s life, the bond provides no cash flow. Instead, similar to a
zero-coupon bond, interest will compound. Only after all of the other tranches have been retired will interest
and principal payments be made to the Z-tranche.
Principal Only (PO) Securities Principal only (PO) mortgage bonds are created by stripping the interest
payments from the underlying mortgages. The POs are then sold at a deep discount to their face value.
Ultimately, the face value is paid to the investors through both scheduled and early payments of principal.
Faster prepayments lead to a more rapid return of principal and, therefore, a higher yield.
Interest Only (IO) Securities Interest only (IO) bonds receive some or all of the interest portion of the
underlying collateral and little or no principal. As the principal amount is paid on the underlying mortgages,
the cash flow declines on the IO since the interest payment will be based on a lower principal amount. Once
the principal amount declines to zero, no further payments are made on the IO. At high rates of prepayment,
it’s possible to get less money back than originally invested. On the other hand, IOs increase in value when
prepayments are slow.
Floating-Rate Tranches Some tranches may offer interest rates that fluctuate with an interest-rate index,
such as the London Interbank Offered Rate (LIBOR) or the Cost of Funds Index (COFI). The interest rate is
reset periodically to a margin above the index, but is subject to a maximum rate (cap) and minimum rate
(floor). If the interest rate is adjusted by more than the change in the index, it’s referred to as a super-floater. If
the interest rate moves in the opposite direction to the designated index, it’s referred to as an inverse floater.

Private Label CMOs

Some private institutions, such as subsidiaries of investment banks, financial institutions, and home builders
also issue mortgage-backed securities. When issuing these securities, the institutions often issue non-agency
mortgage pass-through securities with the underlying collateral typically including different or specialized
types of mortgage loans or mortgage loan pools that don’t qualify as agency securities. These non-agency or
so-called private-label mortgage securities are the sole obligation of the issuer and are not guaranteed by one
of the GSEs or the U.S. government. Below are the some important points to remember regarding these
private label CMOs:
 They have a higher degree of risk
 They typically don’t carry a AAA rating
 An independent agency will base the rating on their structure, issuer, and collateral
Collateralized Debt Obligations (CDOs)

A collateralized debt obligation is a type of privately issued asset-backed security which is sold as a bond
that’s backed (collateralized) by a pool of bonds, loans, and various other assets. CDOs are similar in structure to
collateralized mortgage obligations. Ownership of this type of security is also typically in the form of
tranches (slices), with any given tranche carrying a different maturity and risk level. The return that an
investor may expect to receive from this type of investment is based on the credit quality of the underlying
assets that are contained in the pool. Due to their highly complex nature, CDOs are generally not suitable for
retail investors. As corporate issues, CDOs are subject to the filing and registration requirements of the
Securities Act of 1933, Securities Exchange Act of 1934, and Trust Indenture Act of 1939. Any interest
received on these securities is fully taxable.
Taxation
As addressed earlier, the interest earned on all Treasury securities is subject to federal tax, but exempt from
state and local taxes. This may be an important consideration for investors who live in states with high state
income tax rates. The interest earned on T-bills must be reported in the year in which the T-bill matures, while
interest on T-notes and T-bonds must be reported in the year in which it’s received. As with other zero-coupon
bonds, the interest on T-STRIPS must be accreted and reported on the investor’s tax return each year.
Obviously, there are many options available for investors interested in Treasury securities, government
agency securities, and derivative securities (e.g., CMOs). The tax treatment of each type of instrument
varies. Generally, Series 7 candidates can assume that the interest from all of these securities is, at a
minimum, subject to federal taxes; however, state and local tax liability differs depending on which product
is being discussed.

Below is a summary table to assist in identifying the tax status of each product:
Security Federally Taxable State/Local Taxable

T-Bill Yes No
T-Note/T-Bond Yes No
TIPS Yes No
STRIPS Yes No
Government National Mortgage Association (GNMA) Yes Yes
Federal National Mortgage Association (FNMA) Yes Yes
Federal Home Loan Mortgage Corporation (FHLMC) Yes Yes
Federal Farm Credit Banks (FFCBs) Yes No
Federal Home Loan Banks (FHLBs) Yes No
Student Loan Marketing Association (SLMA) Yes Varies
CMOs Yes Yes
CDOs Yes Yes
Investor Profile
Treasury and agency securities are typically appropriate investment choices for risk-averse investors. Although
the returns on these issues are relatively modest, an investor can feel somewhat content knowing that all of
her principal will be returned since default risk is virtually nonexistent. Keep in mind that Treasury and
agency securities are still subject to interest-rate risk. To summarize, if investors have:
 A capital preservation goal—they may opt for the shorter maturity instruments since interest-rate risk is
lessened on these issues
 Inflation concerns—they may want to consider TIPS
 A desire to obtain monthly income and are willing to accept slightly greater risk—they may consider either
pass-through certificates or CMOs (provided they understand the complexities of these products)
Limited Tax Relief Remember, the interest earned on Treasury and agency securities is subject to federal
tax. Therefore, for investors with higher-incomes, an investment in municipal securities (covered in the next
chapter) may be appropriate since the interest earned on these issues is typically exempt from federal tax.
Conclusion
This concludes the examination of the securities that are issued by the U.S. government and its agencies.
Again, the primary reason an investor considers Treasuries is the safety afforded by their default-free status.

CHAPTER 9
Investment Companies
Key Topics:
 Types of Investment Companies
 The Organization of a Mutual Fund
 Categories of Mutual Funds
 Buying and Selling Mutual Fund Shares
 Other Types of Investment Companies

CHAPTER 9 – INVESTMENT COMPANIES
This chapter will examine different investment company products such as mutual funds, closed-end
funds, unit investment trusts (UITs), and exchange-traded funds (ETFs). Although each of these
products has different characteristics, they have one element in common—they provide investors
with an efficient way to quickly buy or sell a group of underlying stocks and/or bonds. Series 7
candidates should place special emphasis on both suitability concerns and tax issues that
surround these investments.
Types of Investment Companies

Let’s begin by defining the topic of this chapter—investment companies. An investment company pools
funds from numerous investors and purchases securities that are held in a portfolio for the benefit of those
investors. The method by which investment companies are organized and operated is governed by the
Investment Company Act of 1940. The Act of 1940 identifies three different types of investment
companies—face-amount certificate companies, unit investment trusts, and management companies. The
Act further divides the management companies into closed-end and open-end companies. Open-end
management companies are more commonly referred to as mutual funds.
Types of
Investment Companies
Face Amount Management Unit Investment

Certificate Companies Companies Trusts (UITs)
Open-End Closed-End
Open-End Management Companies (Mutual Funds)

Open-end management companies are by far the most popular type of investment company. The basic idea
is that, for a cost, a mutual fund provides a means for investors with similar goals (e.g., long-term growth)
to pool their money and invest in a portfolio of securities. As with other companies, this investment pool
elects a board of directors (BOD). A mutual fund’s BOD will hire an expert (i.e., an investment adviser) to
perform the security selection and trading functions.

Some of the advantages offered by mutual funds include the following:
Diversification Essentially, the diversification in a mutual fund is exemplified by the adage, “don’t put
all your eggs in one basket.” Diversification allows investors to reduce their risk by spreading their money
among many different investments.
Diversified versus Non-Diversified A management company may be either diversified or non-

diversified. In order to qualify as a diversified company, the portfolio must be invested in the following
specific manner:
1. At least 75% of the assets must be invested.
2. No more than 5% of the invested assets may be invested in any one company.
3. No more than 10% of the voting stock of any one company may be owned.
A diversified company must meet these standards at the time of initial investment; however, subsequent
market fluctuations or consolidations will not nullify its diversified status.
Professional Management Most retail investors don’t have the time or expertise to manage their own
investments adequately and cannot afford to hire their own professional manager. By investing in mutual
funds, the investors receive the services of professional managers for much less than they would need to
pay individually. These money managers must be registered as investment advisers under the Investment
Advisers Act of 1940.
Liquidity Liquidity is defined as the ability to sell an asset at a reasonable price within a short period.
Mutual funds are highly liquid investments; however, unlike standard stocks, mutual fund shares are not
traded throughout the day. Instead, mutual fund shares are issued and able to be redeemed at the end of
each trading day.
Exchanges at Net Asset Value Another benefit is that shareholders may often exchange their shares
own in one fund for shares of another fund within the fund family at the net asset value (the fundamental
value of the shares). No sales charges will be assessed on the reallocation.
Convenience A person who wants to invest a fixed sum of money every month may arrange to have the
funds automatically deducted from their checking accounts. Investors are also able to have their income
dividends and capital gains reinvested automatically.
Recordkeeping Mutual funds provide a number of services that make investing easy. The fund takes
care of most of the record-keeping and ensures that shareholders receive regular reports that show their
purchases and redemptions as well as end-of-the-year tax summaries (Form 1099-DIV). Mutual funds also
must send detailed financial reports to their shareholders at least twice per year. These semiannual and
annual reports provide the shareholders with the most current information about the fund’s finances and
holdings as of a particular date.

SEC Registration The Investment Company Act of 1940 requires every investment company that has
more than 100 shareholders to register with the Securities and Exchange Commissions (SEC). (There’s
an exception if all of the shareholders meet certain financial tests that make them qualified investors.)
Also, a fund must have a minimum net worth of $100,000 in order to offer its shares to the public.
The Prospectus The fund’s prospectus is the primary disclosure document for potential investors. This
document includes the following information about the fund:
 Investment objectives
 Investment policies and restrictions
 Principal risks of investing in the fund
 Performance information (whether the fund made money)
 The fund’s managers
 Operating expenses (the costs that are deducted from the fund’s assets on an ongoing basis)
 Sales charges (what investors pay in commissions when they buy shares in the fund)
 Classes of shares the fund offers
 How the fund’s NAV is calculated
 How investors redeem or purchase shares
 Exchange privileges (whether the investor can exchange shares in one fund for shares of another fund)
Prospectus Delivery Requirement Any offer to sell a fund’s shares must either be preceded by or
accompanied by the current prospectus. The delivery may be made in physical or electronic form. Dealers
must have systems in place to ensure that clients receive this document before any purchase orders are
processed. Also, RRs are not permitted to alter a prospectus in any way. This restriction prohibits a
salesperson from underlining or highlighting the information he considers to be the most relevant.
Mutual Fund Terminology Since mutual fund disclosure documents use specialized language, a list of
substitute terms is provided below:
 The sales charge is also referred to as the sales load.
 The net asset value (NAV) is also referred to as the redemption or bid price.
 The public offering price (POP) is also referred to as the net asset value plus the sales charge (if any).
Additional Disclosure: The Statement of Additional Information (SAI)

The Statement of Additional Information provides more detailed information than the prospectus about a
fund and its investment policies and risks. Unlike the prospectus, the SAI is not required to be given to any
person who simply expresses an interest in purchasing the fund’s shares. However, the fund is required to
provide a copy of the SAI to anyone who requests it.

Structure of a Mutual Fund
Shareholders The Fund Board of Directors
Investment Custodian Transfer Principal Service

Adviser Bank Agent Underwriter Providers
The Organization of a Mutual Fund

Although most mutual funds are organized as corporations, some are established as trusts. In many ways,
the structure of a mutual fund resembles a regular corporation. It has a board of directors that’s
responsible for administering the fund for the benefit of the shareholders. The shareholders are the persons
who invest money in the mutual fund.
Board of Directors The board of directors of a mutual fund is elected by its shareholders. The board’s
main functions are to protect the shareholders’ interests and to be responsible for:
 Establishing the fund’s investment policy (any fundamental changes in the policy must be approved by
shareholders)
 Determining when the fund will pay dividends and capital gains distributions to shareholders
 Appointing the fund’s principal officers who run the fund on a day-to-day basis (e.g., the investment
adviser that manages the fund’s portfolio)
 Selecting the fund’s custodian, transfer agent, and principal underwriter
Investment Adviser The fund’s investment adviser manages the fund’s portfolio in accordance with its
investment objectives and the policies established by its board of directors. The adviser researches and
analyzes financial and economic trends and then decides which securities the fund should buy or sell in
order to maximize its performance. The adviser is also responsible for ensuring that the fund’s assets are
properly diversified and for tracking the tax status of the fund’s distributions to its shareholders.
For these services, the investment adviser is paid a management fee that’s based on the assets under
management, but not on performance. The management fee is the largest expense incurred by an
investment company.
Fund advisors are typically prohibited from employing certain aggressive trading strategies such as short
selling and the use of margin.

Custodian Bank In order to prevent the theft or loss of a fund’s assets, the Investment Company Act
requires the fund to either appoint a qualified bank as its custodian or maintain its assets under a very strict
set of rules. Most funds choose to appoint a bank to act as their custodian.
The custodian is responsible for safeguarding the fund’s cash and securities and collecting dividend and interest
payments from these securities. However, the custodian doesn’t guarantee the fund’s shareholders against
investment losses, nor does it sell shares to the public. A fund’s custodian may also serve as its transfer agent.
Transfer Agent The fund’s transfer agent performs a number of record-keeping functions for the fund,
such as issuing new shares and canceling the shares that investors have redeemed. Today, most of these
securities functions are done electronically without physical certificates changing hands. The transfer agent
also distributes capital gains and income dividends to the fund’s shareholders, and often handles the mailing
of required documents such as statements and annual reports. A transfer agent may be a broker-dealer or
have a broker-dealer as a subsidiary. If this is the case, any information that the broker-dealer or its
representatives acquire regarding the fund(s) for which it serves as a transfer agent may not be used without
the permission of, and on behalf of, the fund itself.
Principal Underwriter Most funds use a principal underwriter, also referred to as the sponsor,
wholesaler, or distributor, to sell their shares to the public. An underwriter may sell shares directly to the
public or it may employ intermediaries (dealers) such as a discount or full-service brokerage firm. Many
funds use a network of dealers to market their funds to investors. The dealers are essentially brokerage
firms that have a written contract with the underwriter and are compensated for selling shares of the fund
to investors. A FINRA member firm may not sell fund shares at a discount to a nonmember firm since
only member firms may receive sales charges.
Three Distribution Methods

Dealers
1) Fund Principal Underwriter Dealers Investors
Dealers
2) Fund Principal Underwriter Investors
3) Fund Investors

Types of Mutual Funds

Now that the technical aspects of mutual funds have been examined, let’s review the different types of
funds and the clients for whom they’re suitable. While there are thousands of mutual funds available in
today’s marketplace, the key is finding the fund or funds that best meet your client’s objective. Not every
mutual fund is suitable for every investor. Different mutual funds will be appropriate for different clients,
depending on their investment objectives and risk tolerance.
High Risk Category

Aggressive Growth Funds These funds invest in small companies and often participate in the initial
public offerings of these companies’ shares. The stocks of these companies can be very volatile, but
historically they have also produced high returns for long-term investors. These funds are best suited for
younger, risk-taking investors who can tolerate the swings in value and the fact that these holdings
generally don’t provide income (dividends).
Specialized or Sector Funds Some funds concentrate their investments to stocks in a particular industry
(e.g., high tech stocks or pharmaceuticals) or in a particular geographic location. Specialized funds invest in
companies that are undergoing some type of change, such as bankruptcy. Although specialized funds are
riskier than more diversified funds, they allow fund managers the opportunity to take advantage of unusual
situations. These funds are most appropriate for investors who are seeking to speculate on a given sector of
the economy (e.g., gold, housing, etc.) For example, precious metal funds invest in companies whose values
are connected to gold, silver, or other precious metals, or may invest directly in the actual metals.
International and Global Funds Mutual funds that focus on foreign securities are often the easiest
way for U.S. investors to invest abroad. International funds invest primarily in the securities of countries
other than the United States. They include funds that invest in a single country and regional funds that
invest in a particular geographic region (e.g., Europe or the Pacific Basin). On the other hand, global funds
invest all around the world, both in the U.S. and abroad.
International funds have more risks than purely domestic funds, but also have the potential to provide higher
returns and allow U.S. investors to diversify their portfolios. One particularly volatile type of international fund
is an emerging markets fund. These funds invest in the stocks and bonds of emerging market countries that are
evolving from an undeveloped agricultural economy to a modern industrial one (e.g., Brazil), or from a
socialist economy to a free market system (e.g., Eastern Europe and Russia).
Moderate Risk Category

Growth Funds Capital appreciation is the main objective of a growth fund. The advisers of these funds
invest in stocks that they believe will show above-average growth in share price. Growth stocks are more
volatile than other securities and are more vulnerable to market risk; however, they also have a higher
potential for long-term appreciation. These funds are most suitable for investors with long-term investment
objectives and those able to tolerate fluctuations in their principal.

Equity Income Funds Equity income funds invest in companies that pay high dividends in relation to
their market prices. These funds usually hold positions in mature companies that have less potential for
capital appreciation, but are also less likely to decline in value than growth companies.
Growth and Income Funds These funds have both capital appreciation and current income as their
investment objectives. Growth and income funds invest in companies that are expected to show more
growth than a typical equity income stock and higher dividends than most growth stocks. However, the
trade-off is that they usually offer less capital appreciation than pure growth funds, and lower dividends
than income funds.
Bond Funds The main objectives of bond funds are current income and preservation of capital. Since the
portfolio consists of bonds only, many of these funds are susceptible to the same risks as direct investments
in bonds, including credit risk, call risk, reinvestment risk, and some degree of interest-rate risk.
Bond funds are grouped into subcategories according to the type of bonds that they purchase for their
portfolio. Government bond funds invest in Treasury securities; mortgage-backed bond funds usually
contain mortgage-backed pass-through securities that are issued by government agencies (e.g., Ginnie Mae
or Fannie Mae); and municipal bond funds create portfolios that exclusively consist of municipal bonds.
Actually, some municipal bond funds invest only in the municipal bonds issued by one state which
provides residents of that state with triple-tax-exempt income.
Corporate bond funds invest in bonds from a variety of corporate issuers and, since even highly rated
corporate bonds have more credit risk than government bonds, the yields from these funds are normally
higher. Some corporate bond funds buy investment-grade bonds only. On the other hand, high-yield bond
funds invest in bonds that are rated below investment grade—commonly referred to as junk bonds. High-
yield bond funds have the potential to pay higher returns, but also have much greater credit risk.
The funds will pass through the interest payments that they receive from the bonds in their portfolio’s to
the holders of the bond funds—either monthly, quarterly, or semiannually. One of the major differences
between investing in actual bonds versus bond funds is that the actual bonds have a maturity date, while
the bond funds don’t. Instead, the manager of a bond fund will adjust the portfolio with new bonds. In
order to receive principal in a bond fund, an investor is required to sell or redeem her shares of the fund.
Only by investing in actual bonds is an investor able to have her principal returned in one lump sum
when the bonds mature.
Index Funds Index funds have become increasingly popular in recent years. An index fund creates a
portfolio that mirrors the composition of a particular benchmark stock or bond index, such as the S&P 500
Index. The fund attempts to produce the same return as the index; therefore, investors cannot expect the
fund’s returns to outperform the relevant benchmark. Nevertheless, index funds have historically
outperformed a large percentage of actively managed funds.

Since index funds don’t require active management, they’re considered to be passively managed. These
funds generally have much lower fees than actively managed funds and are often used by investors who
believe markets are efficient and that active management is unlikely to produce superior returns.
Balanced Funds Balanced funds maintain some percentage of their assets in stocks, bonds, and money-
market instruments (cash equivalents). Although the percentages will vary from time to time as market
conditions change, a portion of the portfolio will always be invested in each type of security. Balanced
funds tend to show less volatility than common stock funds by falling less in periods of market declines
and rising less in periods of market advances.
Asset Allocation Funds Similar to balanced funds, these funds also invest in stocks, bonds, and
money-market instruments. Fund managers determine the percentage of the fund’s assets to invest in each
category based on market conditions. The proper proportion of each asset class is often determined by a
computer model used by the manager. Unlike balanced funds, the percentage of the portfolio that’s
invested in any of the three asset classes may drop to zero for a period based on the model’s projections.
Low Risk Category

Money-Market Funds Money-market funds invest in short-term debt (money-market) instruments that
typically have maturities of less than one year. The two principal benefits for investors in money-market
funds are liquidity and safety. Investors are able to withdraw funds at any time, often by means of
receiving a check. These funds are designed to maintain a constant net asset value of $1 per share;
however, this is not guaranteed. Returns vary along with short-term interest rates, while dividends are
typically declared daily with payment made on a monthly basis.
Money-markets funds are often used by investors as a safe haven. If an investor is uncomfortable with the
current state of the stock and/or bond market, he may choose cash equivalents as his investment. This
approach is most likely accomplished through a money-market investment. Not all money markets are
alike; some hold only U.S. Treasury-backed instruments, others may hold commercial paper, and still
others hold short-term municipal debt. Ensuring that the money market instruments selected matches the
clients’ risk tolerance and tax situation is extremely important for RRs. High tax bracket clients are
typically placed in tax-free funds, while extremely risk-averse clients may be better served in U.S.
government money-market funds.

Types of Funds
Type Portfolio Suitable For
Growth Funds Common stocks

Long-term investors who are seeking capital
 Conservative Growth Funds Blue-chip, large-cap stocks appreciation
 Aggressive Growth Funds Small- and mid-cap stocks
Investors who want income along with some
Equity Income Funds Common and preferred stocks
small potential for capital appreciation
Investors who want both capital appreciation
Growth and Income Funds Stocks
and income
Investors who are primarily interested in
Bond Funds Debt securities
current income
Investors who want income and a high degree
 U.S. Government Funds Treasury securities
of safety
 Municipal Bond Funds Municipal securities Investors who want tax-exempt income
 Corporate Bond Funds Investment-grade corporate bonds Investors who need income
Non-investment-grade corporate bonds Investors who want high income and are
 High-Yield Funds (junk bonds) willing to accept a high degree of capital risk
Stocks, bonds, and cash equivalents (money-
market instruments). Investors who are interested in having an
Balanced Funds The mix of assets is adjustable, but the fund investment in all three classes of assets
will always have some of each asset.
Stocks, bonds, and cash equivalents.
Investors who want to diversify among asset
Asset Allocation Funds The proportions may be changed and the
classes in a single fund
percentage in any class could drop to zero.
Securities that are selected to mirror a Investors who want to pursue a passive
Index Funds particular index investment strategy that offers low fees
Investors who are willing to assume more risk
Specialized or Sector Funds Securities of one industry or geographic area
in exchange for a higher potential return
Investors who are willing to assume extra risk
Foreign Funds Non-U.S. securities and who want to diversify using securities
outside of U.S. markets
 Emerging Markets Funds Securities of emerging market countries Aggressive investors only
Cash equivalents (T-bills, commercial paper, Short-term investors who want liquidity and
Money-Market Funds negotiable CDs, and bankers= acceptances) safety

Buying and Selling Mutual Fund Shares

Mutual fund shares are purchased at their public offering price (POP) and redeemed at their intrinsic net
asset value (NAV). The difference between these two values is the sales charge.
Net Asset Value + Sales Charge = Public Offering Price
The equation above is used to determine the purchase price of the shares of a traditional front-end load
fund (Class A shares). In this case, the investor pays an up-front sales charge that’s added to the NAV at
the time of purchase. Fractional shares may be purchased if the amount being deposited is not sufficient to
purchase an even number of whole shares. If a client intends to sell (redeem) his shares, he receives the next
calculated NAV. Other share classes and pricing methods exist and will be described later in this chapter.
Net Asset Value

The NAV of a mutual fund (or any other investment company) is determined by dividing its total net assets
(securities valued at their current market price, plus cash, minus total liabilities) by the total number of
shares outstanding.
Total Net Assets

Net Asset Value =
Number of Outstanding Shares
The net asset value of a mutual fund must be computed at least once a day. A fund’s prospectus discloses
the cutoff time used for purchases and redemptions of shares and explains how its NAV is calculated. The
net asset value is normally computed daily as of the close of trading on the NYSE.
End of Day Pricing Orders to buy and sell fund shares are based on the next price to be computed. This
is referred to as forward pricing since purchases and redemptions are based on the next calculated price.
For example, if an individual places an order to purchase shares at 11:00 a.m., the purchase price will not
be known until the net asset value is computed after the close of business on that day. If a client places an
order at 4:10 p.m. on Wednesday (after the close), the order will not be executed until the close of business
on Thursday. This end of day pricing is an important distinction between mutual funds and other types of
funds, such as ETFs. ETFs trade throughout the day and use intraday pricing in a manner that’s identical to
individual stocks.
Settlement of Transactions Mutual fund transactions typically settle on the same day as the purchase/
redemption. Unlike stocks, the ex-dividend date for a mutual fund is determined by the fund or its principal
underwriter. Typically, a mutual fund’s ex-dividend date is the business day following the record date.

Sales Charges—Front-End Loads When mutual fund shares are purchased with a front-end load
(Class A shares), investors must pay the public offering price which consists of the NAV plus a sales
charge. The maximum sales charge permitted under FINRA rules is 8.5%; however, breakpoints (reduced
sales charges) are often available to investors who purchase a significant amount of Class A shares. The
sales charge of a mutual fund share is stated as a percentage of the POP and the percentage is calculated
using the following formula:
POP – NAV
Sales Charge % =
POP
For example, if the XYZ fund has an NAV of $17.25 and a POP of $18.40, the sales
charge percentage is 6.25% (the difference in values of $1.15 ÷ $18.40).
Back-End Loads and Contingent Deferred Sales Charges Rather than assessing a sales charge at the
time of purchase, some funds allow investors to buy shares at the NAV and will then assess a sales charge
when the investors redeem their shares. Usually, the longer the investor owns the shares, the greater the
amount the back-end load will decrease. This is referred to as a contingent deferred sales charge (CDSC). If
the investor holds the shares long enough, there may be no sales charge imposed at the time of redemption.
The following is a hypothetical example of a contingent deferred sales charge scale:
Years Since the CDSC as a Percentage of

Purchase was Made the Dollar Amount Invested
0–1 4.0%
1–2 3.0%
2–3 2.0%
3–4 1.0%
Greater than 4 None
Confirmation Disclosure For any transaction that involves the purchase of shares of an investment
company that imposes a deferred sales charge on redemption, FINRA’s Conduct Rules require a written
disclosure which includes the following statement: "On selling shares, an investor may pay a sales charge.
For details on the charge and other fees, see the prospectus." Although there’s no sales charge assessed at
the time of purchase, registered representatives may not attempt to sell Class B shares as no-loads.
No-Load Funds Not all mutual funds assess sales charges. No-load funds sell open-end investment
company shares to the public at simply their net asset value; there’s no added sales charge. Therefore, with
these funds, the net asset value and public offering price are equal. Most no-load funds are purchased directly
from the fund’s distributor without any compensation being paid to salespersons.

To be marketed as a no load fund, a fund may not assess a front-end load, a deferred sales load, or a 12b-
1 fee (described next) that exceeds .25% of the fund’s average annual net assets.
Fees and Charges

Prior to purchasing mutual fund shares, investors must review the total cost of fund ownership since, in
addition to sales loads, investors usually incur annual fees that are based on the NAV of their holdings
including those listed below.
12b-1 Charges In a 12b-1 arrangement, mutual funds may pay for distribution expenses by having
them deducted from the portfolio’s assets. These deductions are referred to as 12b-1 charges. These fees
are used to pay the costs of distributing the fund’s shares to the public and will cover expenses such as
concessions and the costs associated with advertising and the printing of the prospectus.
Before a mutual fund is able to pay its distribution expenses out of its portfolio, it must have a 12b-1 plan
in place. This plan permits the board to enter into a contract with the principal underwriter that involves
payments to the underwriter. The 12b-1 charges are based on an annual rate, but may be accrued and paid
over shorter periods.
A 12b-1 fee is an ongoing asset-based charge that’s deducted from the customer’s account on a quarterly
basis. Typically, 12b-1 fees range between .25% and 1%, but the maximum permissible 12b-1 fee is an
annualized 1% of the fund’s assets.
Service Fees Service fees are charges that are deducted under a 12b-1 plan and used to pay for personal
services or the maintenance of shareholder accounts. Trailing commissions (trailers) are an example of a
service fee. When RRs have sold fund shares to customers, they may be entitled to trailers in the years
following the original sale as compensation for continuing to service the clients’ accounts.
Administrative Charges Administrative charges are deducted from the net assets of an investment
company and used to pay various costs that are associated with operating the fund. These charges include
payments made to custodian banks and/or transfer agents. In the front of its prospectus, a mutual fund is
required to disclose all of its fees using a standardized table.
Expense Ratio The expense ratio is defined as the percentage of a fund’s assets used to pay its
operating costs. The ratio is calculated by dividing the fund’s total expenses by the average net assets in
the portfolio. The expense ratio consists of the management fee, administrative fees, and 12b-1 fees, but
doesn’t include sales charges.
Total Expenses
Expense Ratio =
Average Net
A t

If a fund has total expenses of $1 million and average net assets of $100 million, its expense ratio is 1%
($1 million ÷ $100 million = .01 or 1%). Expense ratios typically range between .20% and 2% of a fund’s
average net assets and must be disclosed in the fund’s prospectus. Ultimately, the expense ratio varies
based on the fund and the share class selected by the investor.
Classes of Shares
Today, most funds offer investors the choice of multiple classes of shares, usually referred to as Class A,
Class B, Class C, etc. The differences in classes are the ways in which the sales charges and distribution
charges are assessed. Investors may choose between shares with front-end loads and varying 12b-1 fees
(marketing fees), back-end loads with higher 12b-1 fees, or some other combination.
Although the specifics of the different classes that each fund sells may vary widely, most funds offer the
following classes of shares:
Class A Shares (Front Load) Class A shares usually have front-end loads, but have small or
nonexistent 12b-1 fees. In addition, investors who purchase large amounts of shares within the same fund
family may be able to take advantage of reduced sales charges through the use of breakpoints or rights of
accumulation. The disadvantage of Class A shares is that not all of the investor’s money is directed into the
portfolio. For example, if an investor purchases $1,000 worth of Class A shares of a common stock fund
that has a 5% sales charge, only $950 is actually invested in the fund. The $50 is deducted as a sales
charge and benefits the selling brokers.
Class B Shares (Back Load)) Although Class B shares generally have no up-front sales charges, higher
12b-1 fees are usually assessed. Investors are subject to contingent deferred sales charges (CDSC) if the shares
are redeemed before a certain period has elapsed. Once the specified number of years has passed and the
back-end charge is reduced to zero, most funds will convert their Class B shares to Class A shares. Unlike
Class A shares, large purchases of Class B shares don’t qualify for breakpoint discounts of sales charges.
Class C Shares (Level Load) Class C shares assess an up-front sales charge, which is usually 1%, plus
they have an annual 12b-1 fee or level load that’s usually equal to 1% of the fund’s assets. In some cases,
an investor may also pay a contingent deferred sales charge if the shares are sold within 12 to 18 months after
being purchased.
Other Classes Many funds also offer additional classes of shares for employees of broker-dealers,
institutional investors, retirement plans, or other special categories of investors. In its prospectus, a fund
must fully disclose each class of shares it offers and the different sales charges and applicable 12b-1 fees.

Shares Class Summary

Class A Class B Class C
Contingent deferred sales May have a front-end load, or
Sales Charges: Front-end load charge assessed if held less a contingent deferred sales
than 6 to 8 years charge, or both
Higher than for Class A

Higher than for Class A
12b-1 Fees: Low or none shares, generally the same as
shares
for Class B shares
Often convert to Class A

Breakpoints available for No conversion to Class A
Other: shares after 6 to 8 years; no
large purchases shares
breakpoints available
Appropriate Share Class Recommendations Recommending that a customer should buy one class of
shares instead of another is acceptable provided there’s a reasonable basis for believing that the
recommendation is suitable. The suitability of a share class with a particular sales charge/fee mix is often
based on the length of time the customer intends to hold the investment and the amount of money the
customer intends to invest.
Methods of Reducing Sales Charges

Investors who purchase Class A shares have a variety of different methods to reduce their sales charges.
Typically, these reduced sales charges apply to all purchases made within a fund family.
Fund Families The term fund families or fund complexes is used when defining a single investment
company or mutual fund company that offers many different types of mutual funds under its brand
name. The objective is to provide a large number of mutual funds that provide a broad range of
investment options for investors. A customer may be able to invest a large sum of money with one fund
family, receive a sales breakpoint (reduced sales charge), diversify his assets, and be allowed to switch
between mutual funds.
Breakpoints Mutual fund shares must be quoted at the maximum sales charge percentage that the fund
charges. However, most mutual funds offer sales breakpoints on shares that are purchased with a front-end
load. Breakpoints are dollar levels at which the sales charge is reduced (the mutual fund industry’s version of a
volume discount). The breakpoint is set by the fund’s distributer and may not be negotiated by individual broker-
dealers. A fund’s breakpoints must be clearly stated in its prospectus.

The following is an example of a breakpoint table:

Sales Charge As a Percentage
Amount Deposited
of the Offering Price
Less than $25,000 5.0%
$25,000, but less than $50,000 4.25%
$50,000, but less than $100,000 3.75%
$100,000, but less than $250,000 3.25%
$250,000, but less than $500,000 2.75%
$500,000, but less than $1 million 2.0%
$1 million and more 0.0%
For this fund, a person who invests between $100,000 and $250,000 will pay a reduced percentage sales
charge (3.25%).
Determining the Offering Price Since breakpoints affect the purchase price of mutual fund shares,
investors should be able to determine a mutual fund’s offering price based on the sales charge percentage.
The POP may be determined by using the following formula:
NAV
POP =
(100% – Sales Charge %)
For example, if the XYZ Fund has an NAV of $10 and a person invests $100,000 into the fund,
it will entitle him to a 3.25% breakpoint. What’s the offering price for the investor?
$10.00 $10.00
POP = = = $10.34
(100% – 3.25%) 96.75%
In this example, the investor is able to purchase 9,671.18 shares ($100,000 ÷ 10.34).
Variations in sales loads are allowed if:

 The fund applies the variations uniformly to all of the potential purchasers of its shares
 Adequate information concerning scheduled variations is given to shareholders and
prospective investors
 The prospectus is revised if schedules are changed
 The company advises its existing shareholders of any new variations within one year

Letter of Intent (LOI) A letter of intent enables an investor to qualify for a discount made available
through breakpoints without initially depositing the entire amount required. The letter indicates the
investor’s intention to deposit the required money over the next 13 months and is able to be backdated
for 90 days.
Since letters of intent are non-binding, an investor will not be penalized for failing to make the additional
investments. However, if investors fail to make the additional investments, they’re charged the amount
that equals the higher sales charge that applied to the original purchase. Basically, if a person fails to
invest the amount stated in the LOI, the fund will retroactively collect the higher fee.
Rights of Accumulation (ROAs) Rights of accumulation give investors the ability to receive cumulative
quantity discounts when purchasing mutual fund shares. The reduced sales charge is based on the total
investment made within a family of funds (fund complex) provided the shares are purchased in the same
class. Rather than using the original purchase price, the current market value of the investment plus any
additional investments is used to determine the applicable sales charge.
Availability of Breakpoints and Rights of Accumulation Breakpoints, letters of intent, and rights of
accumulation may be made available to any of the following:
 An individual purchaser
 A purchaser’s immediate family members (i.e., spouse and dependent children)
 A fiduciary for a single fiduciary account
 A trustee for a single trust account
 Pension and profit-sharing plans that qualify under the Internal Revenue Code guidelines
 Other groups, such as investment clubs, provided they were not formed solely for the purpose of
paying reduced sales charges
Remember, only purchasers of Class A shares are eligible for breakpoints; therefore, large purchasers of
funds should not be placed into Class B shares.
Before mutual fund shares are purchased by a client, an RR must inquire as to whether the client owns
other mutual funds within the same fund family in a related account—even if the account is held by
another broker-dealer. For example, a minor’s account, a joint account, and an IRA could be combined
with an individual account when determining the appropriate breakpoint on a new purchase.
Letters of Intent Rights of Accumulation
The investor is able to add up all of the purchases

Investors receive the benefit of a breakpoint without made in the same fund complex. Once a breakpoint
immediately depositing all of the required funds. is reached, all future purchases are entitled to the
reduced sales charge.

For a fund to assess the maximum allowable sales charge of 8.5%, it must offer investors both breakpoints
and rights of accumulation. If the fund omits either of these features, the maximum sales charge it’s
permitted to assess is lowered according to a set schedule.
Dividend Reinvestment Most mutual funds make dividends and capital gains distributions to their
shareholders on an annual basis. Once a distribution is made, the investor must then choose to either take the
monies or reinvest them. Most mutual funds allow investors to reinvest dividends and other distributions at
the NAV. Note; even if reinvested, the distribution is taxable but will add to the client’s cost basis.
Dollar Cost Averaging (DCA) Dollar cost averaging is a popular method of investing in mutual funds in
which a person invests a fixed-dollar amount at regular intervals, regardless of the market price of the
shares. An investor who uses dollar cost averaging is ultimately buying more shares when the price is low
and fewer shares when the price is high. The result is that the investor’s average cost per share is lower than
the average of the prices at which the investor purchased shares.
For example, an investor commits to purchasing $100 worth of XYZ Fund shares each
month for three months. In month one, the shares are trading at $25 and four shares are
purchased. In month two, the shares are trading at $20 and five shares are purchased.
Finally, in month three, the shares are again trading at $25 and four shares are purchased.
What’s the average cost per share and the average price per share?
Finding average cost per share: Finding average price per share:
Amount invested $300 Total of all prices $70

= = $23.08 = = $23.33
Shares acquired 13 Total time period 3 mo.
When discussing dollar cost averaging in reference to a periodic payment plan, the following points must
be made clear:
 At redemption, investors will sustain a loss if the market value of the shares is below the total cost of
the shares.
 Investors must take into account their ability to continue the plan in periods of low prices and their
willingness to continue the plan regardless of price levels.
 The plan doesn’t protect investors against losses in steadily declining markets.
Dollar cost averaging lessens the risk of investing a significant amount of money at the wrong time and is
considered particularly appropriate for long-term investors, such as those investing for retirement.
Redeeming Shares An investor who currently owns shares in a mutual fund may redeem (sell) those
shares back to the fund on any business day. Since shares are redeemed at the NAV, a fund must calculate
its NAV at least daily; however, some funds may do the pricing more frequently. The Investment
Company Act of 1940 requires mutual funds to pay the redemption proceeds to their investors within
seven calendar days.

Systematic Withdrawal Plans Many mutual funds offer investors the opportunity to withdraw their
money systematically. If investors elect to begin a systematic withdrawal plan, they will receive regular
payments from their accounts, typically on a monthly or quarterly basis. To participate in a systematic
withdrawal plan, investors must have a minimum amount in their accounts (generally at least $5,000).
Payments are first made from dividends and then capital gains; however, if these are not sufficient, the fund
will redeem the investor’s shares until the principal in the account is exhausted.
Investors who choose systematic withdrawal plans have three payout options—fixed-dollar, fixed-
percentage, or fixed-time. With fixed-dollar payout plans, investors will receive the same amount of
money with each payment. For example, a person who has $25,000 worth of shares could request that the
fund send her $200 per month until all of the funds are exhausted.
Investors may also request that their fund liquidate a fixed-percentage of their shares at regular intervals—
for example, 1% each month or 3% each quarter (using a fixed-percentage payout plan). With this payout
option, the exact dollar amount to be received by the client will vary based on the NAV of the shares at the
time they’re sold.
The third choice for investors is to have their holdings liquidated over a fixed-time (using a fixed-time
payout plan). A client who chooses this method must provide the fund with an exact ending date. Once the
date is set, the fund will liquidate the client’s shares in amounts that will exhaust the account by the date
specified by the client.
Redemption Fees When mutual fund shares are redeemed, some funds deduct a small redemption fee
from the amount paid to the investor. Redemption fees have a range of .5% to approximately 2% and are
returned to the fund’s portfolio. Ultimately, the fee, which is separate from any deferred charge that may
apply, is designed to discourage investors from redeeming shares too quickly. Some funds waive
redemption fees after the shares have been held for a specific period.
Prohibited Sales Practices

FINRA has established rules that address different violations relating to the sale of investment company
securities. Some of FINRA’s concerns involve RRs who ignore the best interests of their clients and
attempt to maximize their sales commissions by ignoring discounts that may be available to clients.
Below are some of the violations that may be encountered on the Series 7 Examination:
Breakpoint Sales RRs who induce clients to purchase shares at a level just below the dollar value at
which a breakpoint is available are engaging in a prohibited practice that’s referred to as a breakpoint sale.
Instead, clients should be reminded that LOIs may be used if all of the funds are not currently available.
Also, RRs should avoid allocating a client’s investments into several different fund families. This practice
may result in the client not receiving a breakpoint that would have been available if all the funds were
allocated to a single family.

Selling Dividends RRs are prohibited from pressuring clients to immediately purchase mutual fund
shares in order to capture an impending dividend. Essentially, there’s no economic benefit for a customer
since, once the dividend is paid, the fund’s NAV will fall. Also, by receiving the dividend, the customer
will be required to pay taxes on the distribution.
Switching Regulators are always on the lookout for abusive sales practices. When an RR recommends
that a client sell the existing mutual fund shares she owns of one fund family and invest the proceeds into a
fund of another family, a new sales charge will be levied. The concern is that the movement between
different fund families is being recommended by an unscrupulous RR who is seeking to generate income
at the client’s expense. Remember, the movement between funds of the same family is not typically a sales
practice concern since the client is not required to pay an additional sales charge.
Purchasing Large Quantities of Class B Shares RRs should not recommend buying Class B shares
to a client who intends to place a large order. The client would derive a greater benefit by purchasing Class
A shares since only these shares qualify for breakpoints.
Mutual Fund Taxation

Subchapter M of the IRS Code provides beneficial tax treatment to regulated investment companies
(RICs) that operate on a conduit or pass-through basis by distributing a substantial percentage of their
income to shareholders. To qualify as an RIC, an investment company must pass through at least 90% of
its net investment income (defined as dividends, plus interest, minus expenses) to shareholders. If the fund
qualifies, it will only be taxed on the portion of income that it retains. Therefore, the burden of paying
taxes on net investment income is primarily borne by the shareholders. Investment income, whether
reinvested in the fund or received as cash, is taxable to the investor. It’s important to remember that
investors are taxed appropriately based on the type of security that generates the income.
Cost Basis A mutual fund investor’s cost basis represents his original investment along with all subsequent
reinvestments. When calculating gains and losses on liquidated positions, investors are permitted to use their
average cost basis. Average cost basis is calculated by dividing the total assets invested (including reinvested
dividends) by the total number of shares owned.
For example, by making an initial investment of $20,000 in a high-yield bond fund, an

investor acquires 702 shares. Over the next five years, the customer deposits another
$25,000 and reinvests $14,000 of distributions all of which allows him to acquire an
additional 1,240 shares. If the fund is currently valued at $27.11, what’s the customer’s
cost basis if the average cost method is used?
In this example, the investor deposited a total of $59,000 and acquired a total of 1,942 shares.
The average cost is $30.38 ($59,000 ÷ 1,942). Coincidentally, the current NAV of the
shares is irrelevant.

Income Any distribution of taxable bond interest and cash dividends on common stock must be
reported as ordinary income and is taxed at an appropriate rate. Realized short-term capital gains are
included with mutual fund dividends on an investor’s tax return and are taxed as ordinary income.
Capital Gains and Losses As with other capital assets, capital gains and losses on mutual fund shares
are calculated by subtracting the cost basis of the shares from the sales proceeds received when they’re
sold (redeemed). Of course, unrealized gains or losses are not included in this calculation. An investor who
redeems mutual fund shares receives a report of the sales proceeds at the year-end on Form 1099-B. Using
her account records (e.g., confirmations and statements), the investor is responsible for determining the
cost basis of the shares being sold. Whether a gain or loss is deemed to be long-term or short-term is based
on the length of time the investor owned the shares prior to sale (redemption).
On the other hand, whether a capital gains distribution made by a mutual fund is deemed to be long-term
or short-term is based on the length of time the fund held the individual position prior to their sale. Since
this situation involves the fund selling shares in its portfolio, the investor’s holding period is irrelevant.
Reinvested Dividends and Distributions Many investors choose to reinvest the dividends and
other distributions paid by mutual funds rather than taking the payments in cash. However, investors
must still report these dividends and other distributions as taxable income in the year in which they’re
reinvested. The cost basis of shares purchased through reinvestment is equal to the purchase price at
the time of the reinvestment.
Exchange of Shares The exchange of shares is considered the sale of one fund’s shares and the
purchase of another. An exchange could result in a gain or loss and will represent a taxable event for the
investor. The capital gain or loss is calculated based on the cost basis of the shares being redeemed from
the first fund.
As it relates to mutual funds, the following events are taxable:
 Receiving dividends
 Reinvesting dividends
 Exchanging shares (within a fund family)
 Switching shares (outside a fund family)

Other Types of Investment Companies

Although mutual funds are by far the most common type of investment company, there are others.
Let’s now examine the other varieties of investment companies.
Face-Amount Certificate Company

This type of investment company is very rare today. A face-amount certificate company issues debt
certificates that pay a predetermined rate of interest. Investors purchase these certificates in either periodic
installments or by depositing a lump sum and then receive a fixed amount if they hold the certificates until
maturity. However, investors who cash in their certificates early will receive a lesser amount—referred to
as a surrender value.
Unit Investment Trust

Unit investment trusts (UITs) are formed under a legal document called an indenture and have trustees
rather than boards of directors. UITs invest in a fixed portfolio of income-producing securities, such as
bonds or preferred stocks.
UITs issue only redeemable securities that are referred to as units or shares of beneficial interest (SBIs)
that are generally sold in minimum denominations of $1,000. Each unit entitles the holder to an undivided
interest in the UIT’s portfolio that’s proportionate to the amount of money invested.
Since the portfolio of a UIT generally remains static until the trust is dissolved, there’s no need for an
adviser to manage the trust. Since securities are not consistently being purchased or sold, UITs don’t have
an associated management fee. Without management, there’s no management fee that applies. Because of
this structure, UITs are considered to be supervised—not managed.
Closed-End Investment Companies

Along with open-ends, closed-end investment companies are the other type of management company.
Unlike open-end management companies (mutual funds), closed-end funds usually issue common shares
to the public on a one-time basis. Although they may issue additional shares later, they don’t continuously
issue new shares or stand ready to redeem their shares for cash. While it’s typical for closed-end funds to
issue common shares, some may issue senior securities (i.e., preferred stock or bonds).
Once a closed-end investment company issues shares, these securities trade in the secondary market.
Therefore, if an investor wants to purchase shares in a closed-end investment company, he will need to
buy them on a traditional exchange (e.g., the NYSE or Nasdaq). There’s no prospectus delivery
requirement that applies to secondary market trades of closed-end funds.
The price that an investor pays for his shares is determined by the market forces of supply and demand.
Unlike mutual funds, closed-end funds may trade at prices that are at a discount or a premium to their
NAV. When closed-end funds are purchased or sold in the secondary market, the investors are subject to
commissions rather than sales charges.

Below is a table that compares open-end to closed-end management companies:
Open-End Funds Closed-End Funds

Continuously issue new shares Issue a fixed number of shares
May issue common shares or senior securities, such as
May issue only common shares
preferred stock and bonds
Price is determined by market forces which result in
Sold at NAV + sales charge (if any) shares selling at discounts or premiums to the NAV
 Commissions are paid on purchases and sales
Fund sponsor stands ready to redeem shares at the next
Fund sponsor doesn’t stand ready to redeem shares
calculated NAV
Shares don’t trade in the secondary market Shares are traded in the secondary market
Prospectus delivery is required No prospectus delivery requirement
Exchange-Traded Funds (ETFs)

ETFs issue shares each of which represent an interest in an underlying basket of securities that mirror a
specific index. Some ETFs may also be linked to indexes that represent the securities of a particular
country or industry.
Some examples of ETFs include:

 SPDRs (Spiders), which tracks the S&P 500 Index
 QQQs (Cubes), which tracks the Nasdaq 100 Index
 DIA (DIAMONDS), which tracks the Dow Jones Industrial Average
Many investors actively trade ETFs because they think they’re better able to estimate the overall direction
of the market or a sector, instead of trying to do the same for an individual stock that’s more susceptible to
unexpected news events.
There are a number of ways that ETFs are unlike mutual funds, such as the fact that they’re traded on an
exchange, have prices that are determined continuously by the forces of supply and demand, have lower
expenses, may be sold short, and may be purchased on margin. Additionally, rather than being assessed
sales charges, investors pay commissions whenever ETFs are purchased or sold.
An ETF may be an appropriate investment for customers who are investing a lump-sum and are seeking
diversification and low costs. They may also be suitable for investors intending to implement asset
allocation plans.
Lately, specific types of ETFs—inverse and leveraged ETFs—have become popular among investors.
Inverse ETFs attempt to go up when the market drops or go down when the market rises. Leveraged ETFs
seek to provide a multiple of the return on a benchmark index.

Inverse ETFs An inverse ETF is designed to perform as the inverse of the index it’s tracking. This
reverse tracking is accomplished through the use of short selling the underlying investments in the index
and other advanced strategies using futures and derivatives. The goal of the inverse ETF is to yield
performance that’s equivalent to short selling the stocks in the index. For example, if the S&P 500 falls by
1.5% on a given day, the inverse ETF should rise by approximately 1.5%. These products are often used
by long investors to hedge against a bear market.
Inverse ETFs provide investors with a benefit over traditional short selling strategies. When selling short,
an investor is exposed to a potential unlimited loss; however, with an inverse ETF, the investor is only
exposed to a potential loss of the instrument’s purchase price (i.e., ETFs offer limited liability).
Leveraged ETFs Leveraged ETFs are products that use debt instruments or financial derivatives such as
swaps, futures, and options to amplify the returns of a specific index. These leveraged products may be
constructed to either track the specified index or an inverse of the index. For example, a leveraged long
ETF may be designed to deliver 2 times or 3 times the performance of the S&P 500 (referred to as double-
long or triple-long ETFs). A leveraged bear ETF may be designed to deliver the inverse of 2 times or 3
times the performance of the S&P 500 (referred to as double-short or triple-short ETFs).
Inverse and Leveraged ETFs are Short-Term Investment Products Most inverse and leveraged ETFs
reset their portfolios daily in an effort to meet their objectives. In other words, all price movements are
calculated on a percentage basis for that day only. On the next day, everything will start all over.
For example, an investor pays $100 for one share of an inverse ETF based on an index with a
value of 10,000. On that day, the index falls by 10% and closes at 9,000. As a result, the
investors ETF share increases by 10% to $110. Rather than selling at the end of the day, the
investor stays invested. On the next day, the index opens at 9,000, but rises during the day to
close at 10,000, representing an increase of 11.11% (1,000 ÷ 9,000). The inverse ETF will
decrease by the same percentage and, as a result, the investor’s share goes down from $110 to
$97.78 (11.11% of $110 = a reduction of $12.22). Although the index ended up exactly where it
started, the investor’s ETF is down 2.22% because it was held over multiple trading sessions.
Due to this daily resetting process, an inverse or leveraged ETF’s performance may not provide true
tracking of the underlying index or benchmark over longer periods. For this reason, leveraged ETFs and
inverse ETFs are best used for short-term trading strategies such as attempting to take advantage of
intraday price swings on a given index.

Comparison of Investment Companies

Secondary Market
Product Portfolio Marginable
Trading
Mutual Fund No Adjustable No
Closed-end Fund Yes Adjustable Yes
ETF Yes Generally Fixed Yes
UIT (redeemable) Yes Fixed No
Conclusion
This concludes the analysis of packaged products. The next chapter will examine variable products.

CHAPTER 10
Variable Products
Key Topics:
 Insurance versus Annuities
 Variable Annuities
 Suitability
 Variable Life Insurance

CHAPTER 10 – VARIABLE PRODUCTS
This chapter will focus on annuities and variable products. These hybrid investments are issued by
insurance companies and are often offered through other financial intermediaries, such as banks and
broker-dealers. As with all of the other products introduced in this manual, Series 7 candidates
should become familiar with both the taxation and suitability issues that surround these products.
Annuities
An annuity is an agreement between a contract owner and an insurance company. The owner gives the
insurance company a specific amount of money and, in return, the company promises to provide a person
(i.e., the annuitant) with income either immediately or at some point in the future. The contract owner may
designate any person as the annuitant; however, the annuitant and the contract owner are usually the same
person. Most annuitants choose to start receiving their income payments when they retire.
Annuities are typically considered long-term investments which many clients use to supplement their
work-sponsored retirement plans and/or their IRAs. A significant benefit offered by annuities is that the
growth in the accounts is tax-deferred. However, two drawbacks are that purchasers of these investments
often have long holding periods and they may be subject to significant surrender charges and/or tax
liabilities if assets are withdrawn too quickly. From an investor’s standpoint, many of these contracts have
features that can be confusing.
Tax Issues The majority of annuities are non-qualified, which means that the contract owner invests
money on an after-tax basis. However, remember, the money will still accumulate tax-deferred. In
other words, an annuitant is not required to pay taxes on the increases on her investment until she
begins taking distributions or withdraws funds from the account. If an annuitant withdraws money from
an annuity before the age of 59 1/2, she may be subject to a penalty and also be taxed on any increase in
the value of her investment.
As is the case with retirement plans, these contracts don’t generate capital events. If any portion of a
withdrawal is subject to taxation, it’s taxable at ordinary rates.
Fixed versus Variable Annuities

There are two sub-categories of annuity contracts—fixed and variable. With a fixed contract, the
investment risk is borne by the insurance company; however, with a variable contract, the owner of the
policy assumes all of the investment risk. For this reason, fixed contracts are not considered securities and
are governed under state insurance law only. On the other hand, variable contracts are considered
securities and are subject to SEC, FINRA, and state insurance regulation. As is the case with all variable
products, a prospectus must be delivered prior to completing the sale of any variable annuity.

Fixed Annuities
For a fixed annuity, the money being contributed is invested by the insurance company in its general
account. This general account is the portion of an insurance company’s asset base into which traditional
policies such as whole life, term life, and other lower-risk investments are placed. With fixed annuities,
insurance companies guarantee a minimum rate of return and agree, if the customer chooses, to provide
fixed-dollar payments for potentially the rest of the annuitant’s life.
Fixed Contract Suitability Since the insurance company is obligated to pay the annuitant regardless of
how its investments perform, the insurance company assumes all the investment risk in a fixed annuity. An
annuitant must feel secure in knowing that she will regularly receive the same amount of money for the
remainder of her life (assuming the insurance company remains financially healthy). These fixed contracts
are best suited for conservative investors who are seeking predictable tax-deferred growth. Again,
registered representatives must clearly disclose that an annuity is a long-term investment since significant
surrender fees may be incurred if assets are not held in the contract for a minimum prescribed period.
A significant disadvantage to a fixed annuity is that the fixed-dollar payments being received by the
annuitant tend to not keep pace with inflation. Income that may seem sufficient today may become inadequate
after 20 to 30 years of rising prices (inflation).
Regulation Since fixed annuities are not securities, these contracts are typically not subject to regulation
by either the SEC or FINRA. However, all annuities are governed by state insurance regulations. Lastly,
there’s no prospectus delivery requirement with fixed annuities and any person who sells them must have
an insurance license, but need not obtain securities registration.
Variable Annuities
Variable annuities are a more complex product. Rather than receiving a fixed interest rate or fixed dollar
amount as offered by fixed contracts, variable annuity investors are able to choose from a menu of
investment options. Contributions are invested in the insurance company’s separate account with a rate of
return that’s not guaranteed. The investor’s motivation for choosing a variable annuity is the hope that the
contract will consistently grow in order to counteract the effects of inflation during retirement.
The Separate Account The separate account feature is unique to variable products. As the name
implies, the assets in an insurance company’s separate account are segregated from the insurance
company’s general account. A separate account and its underlying subaccounts must be registered with the
SEC as investment companies. All of the income and capital gains that are generated by the investments
are credited to the separate account. Additionally, any capital losses that are incurred based on investment
activity are charged to the separate account. However, the separate account is not affected by any other
losses or gains that the insurance company incurs in its general account.

Separate
Account
Subaccount A Subaccount B Subaccount C Subaccount D

Growth Income Long-Term Bonds Aggressive Growth
Subaccounts In a typical variable annuity, the separate account contains a number of different
underlying portfolios (subaccounts) into which a contract owner may allocate his payments according to
his investment objectives. Also, the contract owner may generally transfer money from one subaccount
to another as his investment goals change. These transfers are not subject to tax and additional sales
charges are not assessed.
The table below provides a summary of the differences between fixed and variable annuities:
Fixed Annuity Variable Annuity

Provides a specified fixed payment for the Provides variable payments at regular
Payments:
contract term intervals for the contract term
Rate of Return: A guaranteed minimum No guaranteed minimum
Risk: Assumed by the insurance company Assumed by the annuitant
Hedge Against
No Yes
Inflation:
Classification: Not considered a security Considered a security
Prospectus Delivery: Not required Required
Types of Variable Annuities A variable annuity may be classified according to the point at which annuity
payments are to begin. The two classifications are immediate annuities and deferred annuities.
Immediate Annuities These annuities begin payments to the annuitant one payment period after a lump-sum
deposit has been made to fund the annuity. If the contract calls for monthly payments, these payments to
the annuitant will begin one month after the date of purchase. If the contract calls for annual payments,
these payments will begin one year after the date of purchase. An immediate annuity may only be funded
with a single premium since the payments will begin shortly after the contract is purchased.

Deferred Annuities These annuities delay payments to the annuitant for an undetermined period after the
date of purchase. The first payment may begin several years after the money is deposited. A deferred
annuity may also be funded with a single premium, but most are funded with periodic payments. Premiums
may be deposited in the annuity monthly, quarterly, semi-annually, or annually.
For Series 7 Examination purposes, if not specified, it should be assumed that the questions are referring to
non-qualified deferred contracts which are funded with after-tax dollars.
How Deferred Annuities Work

Most variable annuities consist of two phases—the accumulation period and the annuity period.
Accumulation Period
During the accumulation, funding or pay-in period, the owner makes payments to the insurance company and
the value of the annuity account begins to grow (accumulate) on a tax-deferred basis. While mutual fund
investors buy shares, customers investing in variable annuities buy accumulation units. Accumulation units
are an accounting measurement used to determine the annuitant’s ownership interest in the separate account.
The value of each unit is tied to the performance of the separate account. If the separate account performs
well, then the units will increase in value. If performance is poor, the value of the units will decrease.
Accumulation Units Clients buy accumulation units at their net asset value (NAV), but are normally
subject to a deferred sales charge. The NAV of the subaccount units is calculated in the same manner as
the NAV of a mutual fund.
Total Net Assets

NAV Per Unit =
Total Units Issued
The NAV of each unit is calculated at the end of every business day (usually at the close of trading on the
NYSE). As with mutual funds, both liquidations and purchases of annuities use the same end-of-day
forward pricing method. To find the current value of a person’s interest in the separate account, the
number of accumulation units owned is multiplied by the current value of each accumulation unit.
Tax Treatment Provided an investor doesn’t withdraw money from her annuity, she has no tax liability
from either the dividends or interest generated by the securities positions within the subaccounts. Also, any
switches executed between subaccounts are tax-free.
Cash Surrender Value At any time during the accumulation period, a contract owner may cancel
(surrender) her variable annuity and be returned its current value. She may also simply choose to withdraw
a portion of its value (a partial surrender).

If withdrawals are taken, the contract owner is required to pay taxes on any increases in the value of her annuity
and may be subject to a tax penalty (if she’s under the age of 59 1/2) on all amounts withdrawn.
Death Benefit Although variable annuities are not life insurance policies, they often provide a death
benefit. The contract owner designates a beneficiary and, if the annuitant dies during the accumulation
period, the beneficiary receives the greater of either (1) the sum of all of the contract owner’s payments to
the annuity or (2) the value of the annuity on the day the annuitant dies. Because mutual funds lack this
feature, this is one reason that clients may prefer to purchase annuity contracts despite the fact that they’re
relatively more expensive.
Annuity Charges and Expenses

In an annuity, the entire contribution is not invested since purchases are subject to various sales charges and
fees. Registered representatives must explain each of these costs to their clients prior to carrying out a sale.
Sales Charges The prospectus for a variable annuity must clearly disclose all of the charges and
expenses that are associated with the annuity. Today, the majority of companies impose a form of
contingent deferred sales charge (also referred to as a surrender charge or withdrawal charge) which is
similar to what’s assessed on Class B mutual fund shares. Although FINRA rules specify a maximum sales
charge of 8 1/2% for mutual fund sales, there’s no statutory maximum sales charge on variable products.
Instead, sales charges for variable annuities must be reasonable.
Expenses As to be expected, insurance companies that issue variable annuities have expenses. These
expenses are deducted from the investment income that’s generated in the separate account. Expenses
include the costs of contract administration, investment management fees, and mortality risk charges.
Management Fee Each of the subaccounts will usually assess an investment management fee. This is
the fee that the subaccount’s investment adviser receives for managing the assets.
Expense Risk Charges When an insurance company issues a variable annuity, it usually guarantees
that it will not raise its costs for administering the contract beyond a certain level (referred to as the
expense guarantee). The expense risk charge compensates the company if the expenses incurred for
administering the annuity turn out to be more than estimated.
Administrative Expenses Administrative expenses are associated with the costs of issuing and
servicing variable annuity contracts including record-keeping, providing contract owners with information,
and processing both their payments and requests for surrenders and loans.
Mortality Risk Under this provision, an insurance company guarantees that it will make payments to the
annuitant for the rest of her life. When calculating these payments, the company considers the annuitant’s
expected life span and promises to provide the annuitant with lifetime income even if she lives longer than
expected (referred to as the mortality guarantee).

Annuity Period
The annuity, benefit, or pay-out period begins if/when an annuitant elects to receive income payments from
the annuity. Up to this point (during the accumulation period), a contract owner is permitted to surrender the
annuity for its current value or take random withdrawals at any time. However, once the annuitant initiates the
annuity period, he may not surrender the annuity or withdraw money from it. Instead, he may only receive
income payments based on the value of annuity units.
Annuity Units At the point at which a contract owner decides to annuitize, the insurance company
converts his accumulation units into a fixed number of annuity units. Annuity units are the accounting
measurement used to determine the amount of each payment to the annuitant. At annuitization, these units
become the property of the insurance company.
A significant concept is that, at annuitization, the number of annuity units on which each payment is based
is fixed, but the value of the units will fluctuate. The insurance company calculates the annuitant’s first
payment by considering the following details about the annuitant and the contract:
 Age and gender
 Life expectancy
 Selected settlement (payout) option
 Projected growth rate, referred to as the assumed interest rate (AIR)
Factors Used to Determine the Number of Annuity Units

Age and Life Expectancy Since an annuity typically promises a payment for life, the insurance company
needs to use a person’s current age and gender to estimate how long the payments will need to be made. For
example, on average, it may be assumed that a 65-year-old woman will live for another 20 years. If payments
are to be made monthly, it would require 240 monthly payments. Therefore, the insurance company credits
the account with 240 annuity units. The value of those units is then based on how the funds in the account
have accumulated and the manner in which they will be paid out.
On the other hand, if an 80-year-old man decides to annuitize, his remaining life expectancy will be much
shorter. The insurance company may assume he will live for only five years and, correspondingly, his
annuity payments will be much larger than the 65-year-old’s for a given amount of accumulated assets.
Payout Option There are several methods for receiving payments from an annuity. An annuitant may
choose from any of the following options to receive benefit payments from the contract:
Straight-Life Annuity A straight-life annuity is a contract in which an annuitant receives monthly

payments for as long as she lives, but this method makes no provision for a designated beneficiary.
Therefore, no payments are made after the annuitant’s death, even if only one payment had been made
before the person’s death. Remember, the contract’s death benefit ceases once the holder makes the
decision to annuitize. This payment option carries the most risk, but also provides the annuitant with the
highest payout of all of the options.

Life Annuity with Period Certain A life annuity with period certain is an option that will provide monthly
or other periodic payments to the annuitant for life. However, if the client dies prior to the end of the
specified period, the payments will continue to be made in either a lump-sum or in installments to a
designated beneficiary until the end of the period certain.
For example, an investor chooses a 15-year period certain life annuity, but dies after
receiving payments for five years. The annuity company will continue to pay the named
beneficiary for the remaining 10 years on the contract. However, if the investor had lived for
18 years, the annuity company’s payment obligations would have continued up until his
death. Since his death occurred three years after the end of the period certain, the annuity
company is relieved of the obligation to make any payments to a beneficiary.
Unit Refund Life Annuity Under a unit refund life annuity, periodic payments are made during the
annuitant’s lifetime. If the annuitant dies before an amount equal to the value of the annuity units is paid out,
the remaining units will be paid to a designated beneficiary. This payment may be made either in a lump-
sum or over a given period.
Joint and Last Survivor Life Annuity A joint and last survivor life annuity is an option in which
payments are made to two or more persons. If one person dies, the survivor continues to receive only her
payments. However, upon the death of the last survivor, payments cease.
For example, a grandfather establishes an annuity that will provide lifetime payments to
both his son and grandson. A joint and last survivor life annuity is the best payout option
for the grandfather’s needs because it provides lifetime income to both persons.
The settlement options are summarized in the table below:
Settlement Option Description

 Annuitant receives payments for life
Straight-Life Annuity  Provides the highest possible payout
 Payments stop at annuitant’s death (no beneficiary)
Life Annuity with  Payments are guaranteed for a certain period
Period Certain  If the annuitant dies before the end of the period, a beneficiary
receives the remaining payments
Unit Refund Life  Certain amount of payments is guaranteed
Annuity  If the annuitant dies before receiving all of the payments, a beneficiary
receives the balance of the payments
Joint and Last  Annuitants receive payments for life
Survivor Life Annuity  Payments end upon the last person’s death

Assumed Interest Rate (AIR) Once the insurance company determines its future payout requirements, it
uses an assumed interest rate to project the return over the payout (annuity) period. The AIR is NOT a
minimum or guarantee—it’s simply used as part of the actuarial calculation. The AIR is the rate of interest
that’s stated in the contract and used to determine the first annuity payment. Going forward, it then
becomes the benchmark for determining subsequent payments.
Annuitants are able to choose from various assumed interest rates when annuitizing their contracts. The
maximum AIR is regulated by the state. If a high AIR is chosen, the challenge is that it will be more
difficult to achieve a return that exceeds the AIR. If the AIR exceeds the account’s actual performance, the
annuity payment will decrease.
After the initial payment, the insurance company calculates each subsequent monthly payment by
multiplying the fixed number of annuity units on which the client is receiving payments by the current
value of an annuity unit (a fluctuating value). The actual value of the annuity units will change based on
the performance of the investments in the separate account. The annuitant’s future payments depend on the
relationship between the AIR and the actual performance of the separate account as summarized below:
 If separate account performance is equal to the AIR, the annuitant’s payment will remain the
same as the previous payment.
 If separate account performance exceeds the AIR, then the payment will be higher than the
previous payment.
 If separate account performance is less than the AIR, the payment will be lower than the
previous payment.
For example, an individual’s contract has an AIR of 5% and the insurance company uses this
rate to determine the first monthly payment of $500. Over time, the separate account
performs at different rates and provides fluctuating payments as shown below:
An individual annuitizes his contract and receives his first monthly payment of $500 based on an AIR of 5%
Separate Account Separate Account Performance Monthly Payment Actual Payment
Performance: Compared to the AIR: Will Be: (illustration only):
Month 2 10% Performance is greater than AIR Greater than previous month $523.81
Month 3 8% Performance is greater than AIR Greater than previous month $538.78
Month 4 5% Performance is equal to AIR The same as previous month $538.78
Month 5 3% Performance is less than AIR Less than previous month $528.16
Month 6 1% Performance is less than AIR Less than previous month $508.04

Taxation of Variable Annuities

For tax purposes, the IRS divides all annuities into two types—qualified and non-qualified. Qualified plans
limit the type of person who may make contributions and the amount that a person may contribute. On the
other hand, any person may purchase a non-qualified annuity and contribute an unlimited amount of money
because the contributions are made with after-tax dollars. Any money invested on an after-tax basis will not
be taxed again when it’s withdrawn; only the earnings will be taxed at withdrawal. Therefore, in a non-
qualified variable annuity, the investor’s cost basis represents the total amount of the contributions.
During the Accumulation Period

In a non-qualified contract, any capital gains and dividends earned during the accumulation period grow
on a tax-deferred basis and are used to purchase more accumulation units.
Withdrawals Withdrawals may be taken from the contract and will be taxed in accordance with how the
withdrawal is made. For both initial and subsequent withdrawals, the IRS requires a last-in, first-out
(LIFO) method. This means that any earnings are withdrawn first and are treated as taxable ordinary
income. Ultimately, if all of the earnings have been withdrawn, the additional amounts are treated as tax-
free withdrawals of after-tax contributions.
For example, a customer has made total contributions of $50,000 to a non-qualified
variable annuity. The account currently has a value of $150,000 and the customer chooses
to take a random withdrawal of $20,000. Using the LIFO method, the earnings come out
first; therefore, the entire withdrawal is taxable as ordinary income.
If an investor chooses to take a lump-sum withdrawal of the entire amount, the portion that represents
earnings is taxable, while the amount equal to the investor’s contribution is a non-taxable return of her cost
basis. In other words, if the entire $150,000 is withdrawn, the $100,000 which represents earnings is
taxable as ordinary income, while the remaining $50,000 is considered a non-taxable return of capital.
During the Annuity Period

Annuitizing a Non-Qualified Contract When a non-qualified contract is annuitized, the
annuitant begins to receive periodic payments. For tax purposes, these payments are divided into the
following two parts:
1. An amount that represents the original investment in the annuity
2. The remainder which represents investment income
On each annuity payment, the annuitant is only taxed at her ordinary rate on the amount of the payment
that represents investment income. Once the total amount of non-taxable income received equals the
investor’s cost basis, the entire amount of any future payments is taxable as ordinary income.

Annuitizing a Qualified Contract A qualified annuity is funded with pre-tax contributions that are
deducted from the employee’s paycheck. These funds subsequently grow on a tax-deferred basis.
Therefore, when a qualified contract is annuitized, the entire payment will be taxable as income.
Remember, since the contributions were made pre-tax, the contract holder has a zero cost basis.
Death Benefit Taxation

If an annuitant (e.g., a husband) dies during the accumulation period, the annuity’s value will be included
in his estate for the purpose of calculating federal estate taxes. The beneficiary (his wife) will also be
required to pay ordinary income taxes on anything she receives in excess of the cost basis. The death
benefit of a variable annuity skips the probate process which is a lengthy legal process that involves
settling an estate according to the terms of a will.
Variable Product Regulation

FINRA rules that govern the sale of variable products are similar to those for investment companies. As
mentioned previously, although variable products are issued by insurance companies, they’re considered
securities and are regulated by federal securities laws and must be delivered with a prospectus. Persons
who market these products must hold a valid Series 6 or Series 7 registration as well as a state insurance
license. The separate accounts of variable products are generally required to be registered as investment
companies under the Investment Company Act of 1940.
Selling Agreements FINRA members that are the principal underwriters of variable products may not sell
them through another broker-dealer unless that firm is also a FINRA member. As is the case with mutual fund
trades, there must be a selling agreement in effect between the underwriter and the broker-dealer. This
agreement must state that if a client cancels the contract within seven business days after the application is
accepted, the broker-dealer will return the sales commission to the insurance company that issued the contract.
Applications and Premium Payments A FINRA member must promptly transmit all applications for
variable life insurance policies or variable annuities to the insurance companies that are issuing the
contracts. A firm must also promptly send the issuer the portion of a client’s premium (purchase)
payments that are supposed to be credited to the contract.
The exact price (NAV) of the shares of a subaccount being purchased by a policy owner must be
determined after the issuer receives the owner’s premium payment. The NAV calculation must be done in
accordance with the product’s contract, its prospectus, and the Investment Company Act of 1940.
Cash Surrender A FINRA member firm is prohibited from selling variable contracts that are issued by an
insurance company that doesn’t promptly pay clients who surrender (cash in) all or part of their contracts.

Variable Annuities—Suitability and Compliance Issues

Since variable contracts don’t provide a known amount of retirement income, these contracts are best suited
for investors who can deal with the fluctuation in value and payment stream and understand the risks inherent
with equity investments. The hope is that the contract will continually grow at an average rate that’s above
the AIR and that the payments will increase to provide a hedge against inflation risk. Since deferred variable
annuities contain both insurance and investment attributes, they’re considered a complex investment option
for clients. When a person makes a recommendation regarding the purchase of a variable annuity contract,
FINRA stresses the need for suitability determination.
Generally, variable annuities are not suitable for senior investors; instead, they’re appropriate only for
people with long-term investment goals who don’t anticipate needing access to their money for at least
five to seven years. While variable annuity contracts have features that are similar to mutual funds, what
makes them unique is that they provide tax-deferred growth. However, many annuities impose significant
charges on investors who surrender their contracts early. If an annuitant withdraws funds prior to reaching
the age of 59 1/2, he’s required to pay taxes on any increases in the value of his annuity plus he’s subject to
a 10% tax penalty.
Under FINRA rules, prior to making a variable annuity recommendation, salespersons must make
reasonable efforts to obtain certain client-related information including their age, annual income, financial
situation and needs, investment experience, investment objectives, and investment time horizon (most
contracts have CDSCs), the intended use of the deferred variable annuity, existing assets (including outside
investment and life insurance holdings), liquidity needs, liquid net worth, risk tolerance, and tax status.
Any RR who recommends deferred variable contracts must have a reasonable basis to believe that:
1. The customer has been informed of, and understands, the various features of the contract such as
surrender periods, potential surrender charges and tax penalties for redemptions prior to age 59 1/2,
mortality and expense fees, investment advisory fees, and the features associated with various riders
available with a given policy.
2. The customer will benefit from some feature(s) of the contract (e.g., tax-deferred growth, annuitization,
death benefits, etc.). These potential benefits should be weighed against the additional costs
associated with annuities compared to mutual funds or other investments.
3. The contract has subaccount choices and other features that make it suitable (as a whole) based on
the client’s objectives, tax situation, and age.
Principal Approval Once a registered representative has collected the required information on
a potential deferred variable annuity customer, this complete and correct application package and the
customer’s non-negotiable check (payable to the issuing insurance company) must be promptly forwarded to
the representative’s Office of Supervisory Jurisdiction for approval. Typically, once received, the
approving principal at the OSJ will review the application and determine whether the proposed transaction
is suitable. The broker-dealer has up to seven business days from its receipt of the application package to
make this determination.

If the proposed transaction is deemed to be suitable, the paperwork and funds are transmitted to the issuing
company. If not, the funds must be returned to the customer. The broker-dealer is required to maintain a
copy of all checks and record the date(s) on which the funds were received. Additionally, the firm must
record the date(s) the funds were either forwarded to the insurance company for purchase of the contract or
returned to the customer for transactions that were not approved.
Review of 1035 Exchanges While many persons use new funds to contribute to annuities, registered
representatives may also suggest moving client assets from existing contracts. Managers must be extremely
vigilant when examining the validity of a proposed transfer which is typically accomplished through a 1035
Exchange. Named after IRS Section 1035, this provision permits the exchange of annuity contracts
without creating a taxable event. A principal should determine if the proposed customer transfer will result
in the client incurring a surrender charge, being subject to a new surrender period, losing existing benefits
(e.g., death, living, or other contractual benefits), or incurring increased fees or charges (e.g., mortality and
expense fees, investment advisory fees, or charges for riders).
The central issue that managers must consider is the cost of the exchange compared to the benefit(s) being
received by the client from the new contract. Firms and their approving principals must look for patterns
of unsuitable transfers and are required to implement surveillance procedures for determining whether any
of their salespersons have excessive rates of deferred variable annuity exchanges. An exchange is often
viewed as inappropriate if the client has made another 1035 deferred variable annuity transfer within the
previous 36 months.
In order to protect against abusive transfers, many individual states and brokerage firms require the
registered representatives who recommend transfers to provide disclosure and acknowledgement forms to
customers. These documents often provide a comparison of the features and costs of an existing contract to
a proposed replacement contract and may highlight the costs of the exchange. Generally, these
acknowledgment/disclosure forms must be signed by both the firm and the client.
FINRA Concerns—Series 7 Application Historically, some RRs have sold annuities to the wrong investors
and/or recommended inappropriate exchanges within contracts. For Series 7 Exam purposes, it’s possible for
candidates to encounter red flag questions concerning inappropriate transfers (1035 exchanges) and/or
evaluation scenarios addressing suitability concerns that are based on a client’s advanced age or tax
situation. A person must be prepared for questions concerning variable annuity recommendations being
made to clients who may have less costly alternatives available in order to save for retirement (e.g., IRAs
or qualified work-sponsored plans).
Remember, although not specifically prohibited, recommending the purchase of annuity contracts within a
tax-deferred account (e.g., an IRA) deserves special scrutiny since variable annuity contracts already grow
tax-deferred. Additionally, annuities generally have higher expenses than similar mutual funds that could
instead be placed within a retirement account.

Individuals saving for retirement should normally exhaust all of their opportunities to contribute to
employer-sponsored retirement plans (e.g., a 401(k) or IRA) before investing in a variable annuity. The
benefit to employer-sponsored plans is that they’re funded with deductible (pre-tax) contributions.
Although the earnings in a non-qualified variable annuity grow on a tax-deferred basis, the contributions
are made with after-tax dollars.
Variable Life Insurance

It may seem strange that life insurance may be addressed on the Series 7 Examination, but remember, if
the term variable is a part of the policy’s name, it’s considered a security. Although the actual exam will
not include a large number of insurance questions, there are some details that must be examined.
Variable life insurance policies are a form of permanent insurance which requires fixed premiums, but
have death benefits and cash values that may vary based on the performance of the investment options.
Variable life insurance policies are regulated by state and federal securities laws and must be registered
with the SEC under the Securities Act of 1933. Any offers to sell variable life insurance policies to clients
must be accompanied by or preceded by a prospectus.
Only an insurance company that’s licensed and regulated by the state may issue a variable life insurance
policy. The company that sells the policy must be a broker-dealer that’s registered with the SEC and is a
FINRA member. The agents who sell variable life insurance policies are required to hold both a state
insurance license and either Series 6 or Series 7 securities registration.
In a variable life insurance policy, the policy owner, not the insurance company, decides how the premium
payments will be invested. However, an important feature of this type of insurance is that the death benefit
generally may not decrease below a certain guaranteed minimum.
Variable life insurance policies are not appropriate for all clients. A suitable client is one who has a
sufficient level of sophistication and knowledge to understand the available investment options. He must
be able to tolerate the fact that the policy’s cash value may fluctuate greatly.
Variable Life Insurance Characteristics Variable life insurance policyholders make premium
payments to the insurance company that issued the policy. The company first deducts various charges and
expenses such as sales charges and the cost of the insurance. The company then deposits the remainder
(the net premium payments) in its separate account.
Separate Accounts Similar to variable annuities, these insurance policies also utilize separate accounts
and their associated subaccounts. Since each of the subaccounts contains different types of securities and
investment objectives, the policyholders are able to select the account(s) that best suit their needs.

Cash Value Variable life policies build cash value by requiring policyholders to pay higher premiums
since part of the premium pays for the death benefit coverage, while the other part goes toward the
policy’s cash value. Policyholders are able to use the cash value as a tax-sheltered investment (the interest
and earnings on the policy are not taxable). Over time, the cash value is considered a fund from which
policyholders may borrow and as a means to pay policy premiums later in life, or they may pass the funds
on to their heirs.
Death Benefit Most variable life insurance policies are sold with a fixed death benefit. However, the death
benefit may increase depending on the performance of the subaccounts in which the policy owner invests.
The death benefit may not fall below a certain minimum—the face value of the policy.
Riders A life insurance rider is an additional feature/benefit added to a life insurance policy. These could
include disability income benefits, waiver of premium, guaranteed insurability, or accidental death
benefits. Each rider adds to the cost of the policy above the standard cost of insurance. Riders are often
selected at time of contract issuance, but some may be added after a contract has been issued.
Advantages of Variable Life Insurance Policies A significant advantage of variable life insurance
policies is the ability to invest some of the premium payments into subaccounts that contain stocks or other
assets that have historically paid high returns over the long term. These types of investments give
policyholders the potential to grow their cash value and death benefits, and may help protect policyholders
and their beneficiaries from the negative effects of inflation.
Variable Universal Life Insurance

Once insurance companies started to separately issue both universal and variable life policies, the next
progression was the combined variable universal life (VUL) policy.
Variable universal life policies combine the flexibility of universal life policies with the investment aspect of
variable life policies. Policyholders may adjust their premiums and death benefits to meet their changing
circumstances. The owners may also decide how their net premiums are invested among the subaccounts
that the insurance company offers in its separate account.
Taxation of Life Insurance Policies

The death benefit of a life insurance policy passes tax-free to the beneficiary. However, if the deceased
person owned the policy, the death benefit is included in his estate for the purpose of calculating estate
taxes. In order to avoid this problem, many tax advisers recommend that the insurance policy be placed in
the name of the beneficiary or in an irrevocable life insurance trust.
Voting Rights
Variable contracts (both variable annuities and variable life insurance policies) provide contract owners
with the ability to vote on certain issues that affect the separate account. These rights are similar to the
voting rights that are available to mutual fund shareholders.

For example, the contract owners elect the Board of Managers (similar to the board of directors for a
mutual fund) that administers the separate account and approves any changes in the separate account’s
investment objectives or policies. The board also authorizes the selection of an independent accountant
who audits the separate account.
Conclusion
This concludes our chapter on variable products. Although these products are complex, they’re becoming
more popular with investors. Remember, the primary attraction to these products for many investors is
their tax benefit. The costs of acquiring these benefits typically include a long-term holding period and
potentially significant surrender fees.

CHAPTER 11
Alternative Products
Key Topics:
 Real Estate Investment Trusts
 Limited Partnerships
 Hedge Funds
CHAPTER 11 – ALTERNATIVE PRODUCTS
This chapter will examine alternative investments including real estate investment trusts (REITS),
direct participation programs (DPPs), and hedge funds. As part of the analysis, focus will be placed
on understanding the advantages and disadvantages of these alternative investments, the tax
treatment of each product, and offering practices surrounding these securities.
Real Estate Investment Trusts (REITs)

Regulation
Although real estate investment trusts have features that are similar to investment companies, these
products are not categorized under the Investment Company Act of 1940. However, the Securities Act of
1933 regulates REITs as securities and requires the sending of prospectuses to any investors who acquire
the shares through public offerings conducted in the primary market.
Investment Attributes
REITs create a portfolio of real estate investments from which investors may earn profits. REITs invest in
many different types of residential and commercial income-producing real estate, such as apartment buildings,
shopping centers, office complexes, storage facilities, hospitals, and nursing homes. Income is received from
the rental income being paid by tenants that leases the real estate which is owned by the REIT. These
investments are actually suitable for both retail and institutional investors.
The three types of REITs are listed below:

1. Mortgage REITs Mortgage REITs provide funding to real estate purchasers by acting in the same
capacity as a bank. Mortgage REITs borrow funds from investors and then invest the funds in
mortgages and typically earn income based on the difference between these two rates of interest
(which is referred to as the spread).
2. Equity REITs Equity REITs own and operate income-producing real estate, such as apartment
buildings, commercial property, shopping malls, vacation resorts, and other retail properties.
3. Hybrid REITs These business structures are a combination of mortgage REITs and equity REITs.
By purchasing a hybrid REIT, the investor can take advantage of buying a security that invests in
the actual equity ownership of real estate as well as investing in an interest-rate sensitive security
(i.e., the mortgage REIT).
Liquidity There are three varieties of REITs. The first are those that are sold under Regulation D as
private placements and not registered with the SEC. The other two are registered and are either listed or
non-traded (unlisted).
REITs
Unregistered; private Registered; listed Registered; unlisted

Most REITs are exchange-listed, traded each business day, and are reported on customer account
statements at their current market value per share. On the other hand, private REITs and non-traded REITs
are illiquid and are as difficult to price as hedge fund or limited partnership investments. These non-traded
REITs are reported on customer account statements at their estimated market value per share.
Tax Treatment of REITs The benefit of qualifying as a real estate investment trust is the favorable tax
treatment that’s provided under the Internal Revenue Code. Unlike other corporations, there’s no double
taxation on the dividends that a REIT pays to its shareholders. If 90% of the ordinary income generated from
the portfolio is distributed to investors, the income will only be taxed once (at the investors’ levels). The REIT
avoids paying taxes on distributed income in substantially the same manner as a regulated investment
company. However, unlike DPPs, REITs don’t pass-through operating losses.
To qualify for the special tax treatment, a REIT must satisfy the following three income tests:
1. At least 95% of its gross income must be derived from dividends, interest, and rents from real property.
2. At least 75% of its gross income must be derived from real property income (e.g., rents or interest).
3. No more than 30% of its gross income may be derived from the sale or disposition of stock or securities
that have been held for less than 12 months.
Tax Treatment for the Investor Real estate investment trusts offer investors a stable dividend based on
the income they receive, which is the reason that most investors purchase these securities. The dividends
that REITs pay to their shareholders don’t qualify for the reduced 20% tax rate that’s given to the dividend
distributions paid on common and preferred stock. Instead, the dividends received by REIT investors are
taxed as ordinary income. However, based on the 2018 tax reforms, the following additional benefits are
provided:
 20% of the income that’s distributed by REITs is deductible (excluded from tax).
 The maximum tax rate on ordinary income has been lowered to 37% (from 39.6%).
Direct Participation Programs (DPPs)

A direct participation program is a type of investment in which the results of the business venture (cash
flow, profits, and losses) directly flow through to the investors. Although DPPs come in different forms,
such as general partnerships, joint ventures, and Subchapter S Corporations, the Series 7 Exam tends to
focus its questions on limited partnerships.
At a minimum, a limited partnership simply requires two partners—one general partner and one limited
partner. The general partner (GP) is responsible for managing the program and must contribute at least
1% of the program’s capital. The limited partner (LP) is a passive investor who has no control over
managerial decisions. Instead, limited partners are typically relied on to contribute a large amount of the
program’s capital.

Advantages of Limited Partnerships

Some of the benefits of this ownership structure include:
Favorable Tax Treatment Unlike corporations, partnerships are not taxable entities. Instead, the
partnership’s income (or loss) is allocated directly to the partners for tax treatment on their personal income tax
returns (i.e., it’s passed through and reported as passive). Any passive income that’s distributed is taxed as
ordinary income. However, beginning in 2018, the new tax law impacts the taxation of passive income by
providing the same two benefits that investors receive with REITs:
1. Of the income passed through by the partnership, 20% of it is deductible (excluded from tax).
2. The maximum tax rate on ordinary income has been lowered to 37% (from 39.6%).
Therefore, since 20% of the passive income from partnerships is deductible, the effective tax rate for
investors who are in the highest tax bracket is 29.6% (37 x 80% = 29.6%).
Since the business doesn’t pay tax, limited partners may receive more income from a profitable DPP than from
a profitable corporation. This is due to the fact that a corporation’s dividends are paid as after-tax
distributions. Essentially, the corporate level of taxation is removed from the tax equation.
Limited Liability Another benefit of structuring a program as a limited partnership is limited liability for
the LPs. Limited partners assume financial risk only to the extent of their investment in return for a share
in the project’s income and deductions. In other words, limited partners cannot lose more than the amount
that they have at risk.
Diversification Many limited partnerships invest in assets that have little or no correlation to the stock and
bond markets. These programs may provide an investor with a level of diversification that may not be available
from traditional packaged product offerings (e.g., mutual funds).
Disadvantages of Limited Partnerships

Some of the drawbacks to this form of investment include:
Lack of Control Limited partners may have no managerial authority regarding the daily business of the
partnership. Unlike a traditional corporation, there may be very little oversight of the management by an
independent board of directors. Also, any attempt to take control of the management of the enterprise may
adversely affect an investor’s legal status.
Illiquidity Since a limited partner’s investment is normally unable to be sold quickly, it’s considered an
illiquid investment. In most cases, there’s no actively traded public market for these investments and often
limited partners are required to obtain the permission of the general partner to be allowed to sell. For these
reasons, partnerships should be recommended only to clients who have sufficient liquid assets and are
willing to accept a potentially long-term holding period.

Tax Issues Owning a limited partnership will likely complicate a client’s year-end tax filing.
Since many partnerships are constructed in such a way to take advantage of certain benefits that exist
in the U.S. tax code, any change in tax laws or adverse IRS rulings could negatively affect a limited
partner’s future returns.
Possible Capital Call Unlike any other investment previously described, investors in limited
partnerships may be asked to contribute additional funds subsequent to their initial investment. Failure to
make the additional contribution may result in the investor forfeiting his interest in a project. Also, partnerships
may request that the LPs sign a recourse loan agreement. With recourse loans, the LP is essentially co-signing
on a loan arranged by the partnership. Therefore, in the event of the partnership defaulting, the LP may be
wholly or partially liable for the borrowings.
Alternative Minimum Tax An investment in an oil and gas limited partnership may result in excess
depletion and depreciation as well as excess intangible drilling costs. Since these are considered tax
preference items, an LP may ultimately be subject to the alternative minimum tax (AMT). These items,
though able to be deducted when a person calculates her regular tax liability, are added back when
calculating the AMT.
Forming a Limited Partnership

The creation and subsequent operation of the partnership is established within three documents
—the Certificate of Limited Partnership, the Agreement of Limited Partnership, and the
subscription agreement.
Certificate of Limited Partnership The purpose of the Certificate of Limited Partnership is to set forth
the terms of the business relationship that’s been created. Some of the information contained this
document includes:
 The name and purpose of the partnership
 The name and address of each general and limited partner
 The conditions under which the partnership will be terminated
 Priority provisions in the event of partnership liquidation
Typically, the procedures for forming limited partnerships are governed by state law. The certificate is a
public record that must be filed at a designated state office in order for the partnership to be considered created
and must be amended if substantial changes are made.
Agreement of Limited Partnership The Agreement of Limited Partnership is a contract between the
general and limited partners and may be contained in the Certificate of Limited Partnership or may be a
separate document. The document defines the relationship between the general partner and the limited
partners and typically contains the following information:
 The rights and obligations of the general partner
 The rights and obligations of the limited partners

 Sharing arrangements for profits and losses

 Withdrawal terms for limited partners
 Priority provisions in the event the partnership is liquidated
The Subscription Agreement The subscription agreement is the document that specifies:
 The amount required to be invested
 To whom all checks must be made payable and who must sign the agreement
 Suitability standards for the investment
 A statement that attests to the investor’s ability to meet the financial requirements of the investment
 The parties who must sign the agreement
The acceptance of a limited partner is generally recognized when the general partner signs the subscription
agreement. A signed copy of this document is sent to the limited partner to serve as a confirmation of the sale
of an interest in a direct participation program.
If sales are executed by an underwriter (syndicator), they must be accepted by the general partner to be
valid. At times, GPs may themselves act as syndicators or they may hire an investment banker to assist in
the distribution. In either case, the maximum underwriting compensation for a public offering is 10% of
the gross dollar amount of the securities being sold.
Suitability Obligation According to industry rules, a representative who sells the offering must make
inquiries to ensure that a purchaser understands the ramifications of the investment. This assurance may be
accomplished through the subscription agreement which normally states that the purchaser:
 Has read the prospectus or offering memorandum
 Understands the risks associated with the investment
 Has access to advice
 Has met all net worth, income, and suitability requirements
The subscription agreement also specifies which parties must sign the contract. In most cases, this is both
the general partner and the limited partner. By signing the agreement, the customer is verifying that she
meets all suitability standards. Subsequently, the customer is often required to furnish documents, such as
past tax returns and a statement of net worth, to demonstrate that she meets the eligibility thresholds for
investment purposes.
General Partners
General partners have unlimited liability and are responsible for all management affairs of the partnership.
GPs also assemble investors’ capital, collect fees for overseeing the partnership’s operations, keep the
partnership books, and direct the investment of the partnership’s funds.
General partners have a fiduciary relationship to the limited partners in these programs. By acting as a
fiduciary, a general partner has the authority to bind the partnership in its business dealings.

However, a GP is restricted from engaging in the following activities:

 Competing with the partnership
 Testifying against the partnership
 Changing the business or structure of the partnership
 Commingling partnership assets with the GP’s own assets or of other partnerships
 Borrowing money from the partnership (GPs may lend money to the partnership at prevailing rates)
 Adding or substituting another GP
Limited Partners
Limited liability is a major advantage for limited partners; however, to qualify for this advantage, the
limited partners must be passive investors and avoid day-to-day management decisions. If limited partners
take on an active role in the management of the programs, they may be considered general partners and
have unlimited liability.
Although prohibited from engaging in daily management, partnership agreements often provide certain
rights to limited partners through partnership democracy provisions. Normally, LPs have the right to:
 Inspect and copy the books of the partnership
 Call for the dissolution of the partnership by court decree
 Restrict the general partner from discharging some duties
 Sue a general partner for damages and, in some cases, vote to remove the general partner
 Engage in business that competes with the partnership (unlike general partners)
 Receive profits and compensation as stated in the certificate
A limited partner who has committed capital may also extend a loan to the partnership. If the partnership
declares bankruptcy, the LP is considered a limited partner for the capital contribution and a general
creditor for the amount of the loan.
At dissolution of a partnership, state law provides the following priority for settling accounts:
1. Secured creditors
2. General creditors
3. Limited partners
4. General partners

Limited Partnership Summary

Formed by filing a Certificate of Limited Partnership with the state
General Partner Limited Partner
Day-to-day manager with unlimited personal liability Passive investor with limited liability
Must have at least a 1% interest Contributor of capital
Fiduciary toward limited partner Has the right to:

 Lend to the partnership
 Inspect books
 Compete
Last in priority at liquidation: Ways to endanger “limited” status:

 Secured Creditor  Negotiate contracts
 General Creditor  Hire/fire employees
 Limited Partner  Lend her name
 General Partner
DPP Offering Practices

To raise money, the general partner (also referred to as the program’s sponsor) may conduct either a public
or private securities offering. In a public offering, the general partner will register the DPP’s interests with the
SEC. The sponsor will then hire an underwriter (also referred to as a syndicator) to market the program to
the public. Disclosure is made to investors through an offering prospectus.
In a private placement, the sponsor will attempt to locate investors without the assistance of an underwriter.
These types of offerings are conducted under Regulation D of the Securities Act of 1933 and are exempt
from registration. Disclosure is made to investors through an offering memorandum.
Managed versus Non-managed Offerings In a managed offering, the underwriter may form a
syndicate by soliciting other broker-dealers to sell the securities. In a non-managed offering, the sponsor
hires a wholesaler to market the program. The wholesaler markets the program to broker-dealers rather than
the public. Also, the wholesaler is responsible for educating broker-dealers that sign on to sell the program.
Registered representatives who act as wholesalers must be supervised by their firm. In some cases, the
wholesaling activities of a registered representative may cause the supervising broker-dealer to be
considered an underwriter. Wholesaling arrangements must be disclosed in the offering prospectus or
offering memorandum.
Many DPP offerings are conducted on a mini-maxi basis which requires a minimum amount of money to
be raised by a specified date. If these parameters are not met, the offering will be cancelled and investors
will receive a full refund of their investment.

Managed Offerings Non-Managed Offerings

Program Sponsor Program Sponsor
Managing Underwriter Wholesaler
Syndicate Broker-Dealer Broker-Dealer
Public Public
Tax Considerations
Most investors purchase limited partnership interests because of the various tax advantages offered by these
investments. Investors receive both cash flow and any tax losses that the program generates. It’s extremely
important for investors to fully analyze all of the tax aspects of a program prior to making the investment.
Motivation Although investors may welcome the tax advantages of a DPP, the primary goal must be to
make a profit. If a partnership is formed purely to shelter income, regardless of profit, the IRS may declare
that the partnership is offering an abusive tax advantage. If this is the case, the partners may be subject to
recapture, back taxes, interest, penalties, and possible prosecution for fraud. Essentially, the primary
reason to purchase a partnership must be the underlying economic viability of the business, NOT the
potential tax advantages available to the investor. Since tax laws are subject to change, unless a given
partnership has a sound economic foundation, there’s no reason to consider its purchase.
Depreciation Since real property (e.g., a building and equipment) loses some of its value each year due
to normal use, the IRS allows a business to claim this wear and tear on the assets as a deduction against
income. This deduction, referred to as depreciation, may be calculated by using either the straight-line or
accelerated method. The purpose of depreciation is to spread the cost of the asset over its useful life.
Under the straight-line method, the same amount of depreciation is claimed each year. This is the only
method allowed for real estate. On the other hand, the accelerated method allows for a larger depreciation
deduction than straight-line in the asset’s earlier years. The current method of accelerated depreciation is
known as the Accelerated Cost Recovery System (ACRS) or Modified Accelerated Cost Recovery Systems
(MACRS). Depreciation deductions may not be claimed for land or for any natural resources found on the
land. However, natural resources (with the exception of raw land) do qualify for a form of deduction that’s
referred to as depletion.

Depletion Depletion is a deduction against income that’s generated by a natural resource. Oil and gas,
mineral, and timber programs all use depletion on their recoverable reserves.
There are two methods of calculating the depletion deduction—cost and percentage. The items that are
required to calculate cost depletion are:
 Adjusted property basis
 Number of recoverable units
 Number of units sold
Under percentage depletion, a flat percentage of the income generated by the units sold is attributed to depletion.
Tax Credits A tax credit is applied after an individual’s tax liability has been computed. For investors,
tax credits are preferred over simple deductions because credits reduce the taxes owed on a dollar-for-
dollar basis. For example, if an individual owes $10,000 in taxes, but has a $1,500 tax credit, he will only
owe taxes of $8,500.
Tax Credits for Historical Rehabilitation Projects The cost of rehabilitating both commercial property
placed in service before 1936 and certified historic structures qualifies for tax credits. One other activity
that qualifies for tax credits is the involvement in construction or rehabilitation of government assisted
(low-income) housing.
Disposition of Property When depreciable property is sold (or otherwise disposed), the cost basis of the
property is adjusted for depreciation deductions when the gain or loss from the sale is calculated.
For example, property that costs $100,000 is sold after ACRS deductions totaling $45,000
have been taken. Therefore, when computing the gain or loss from the sale, the $55,000
adjusted cost basis of the property is used. If the property is subsequently sold for $75,000,
the gain from the sale is $20,000 ($75,000 sale price minus $55,000 adjusted cost basis).
When partnership property is sold, a portion of the gain may be required to be treated as ordinary income
rather than as a capital gain through a process that’s referred to as recapture. The portion that’s treated as
ordinary income (recaptured) represents any depreciation, depletion, and tax credits that were claimed, but
were later disallowed by the IRS.
Tax Treatment of Individual Partners

Passive Activities Passive activities are investments in which an owner of a business doesn’t
materially participate in the operations throughout the year. Investments in direct participation programs
and all rental activities are considered passive activities.
Losses that are generated by passive activities may only be deducted against income from passive
activities. If passive losses exceed passive income, the excess passive losses may be carried forward
indefinitely to offset passive income in future years.

For example, let’s assume a taxpayer receives a $12,000 passive loss from a limited
partnership investment, while for the year, passive income from all activities totaled
$7,000. In this case, all of the passive income is offset against the passive loss and the
excess $5,000 in passive losses are carried forward to offset future passive income.
As an added benefit, when the interest in a passive activity is sold, the taxpayer is allowed to deduct all
passive losses that are carried forward against any form of income—passive or non-passive.
For example, a limited partner sells his interest in a limited partnership which generates a
$9,000 gain. At the time of the sale, there were $11,000 in passive losses being carried forward.
The entire gain is offset with the carried forward passive losses and the remaining $2,000 in
passive losses may be used as a deduction against other passive or non-passive income.
Portfolio Income Portfolio income (i.e., dividends, interest, and capital gains) is income that’s not
generated in the ordinary course of business; therefore, it may generally not be offset with passive losses.
Any portfolio income that’s produced by a passive activity must be kept separate from all other items of
the activity and is treated as non-passive income.
A Partner’s Basis A partnership will keep an ongoing record of a limited partner’s investment in the
program (i.e., her tax basis). A partner’s basis represents the amount that she has at risk which is also the
maximum loss that she could experience. Generally, a partner’s tax basis consists of:
 Cash contributed to the partnership
 The tax basis of property that’s been contributed to the partnership by the partner
 Partnership gains or losses that are not realized by the partner
 Partnership debt for which the investor is personally liable (recourse debt)
 A portion of non-recourse debt in real estate programs
Recourse Debt For a partnership, recourse debt exists when a limited partner accepts responsibility for
the repayment of the partnership’s debt. In other words, the lender has recourse to the limited partner for
the required funds. For this reason, a recourse loan is always added to a partner’s basis.
Non-Recourse Debt In some cases, the lender has no recourse to the individual partners in the event
of the entity defaulting on the loan. This is referred to as a non-recourse loan because the lenders would
only be able to make a claim on the partnership’s assets. A non-recourse loan is typically secured by assets
of the partnership.
Generally, any distribution of passive losses that are claimed by a partnership will reduce the partner’s
basis. Remember, limited partners may only claim losses from the partnership’s operations to the extent
that they’re at risk in the program (i.e., losses may equal their basis).

Cost Basis Adjustments

Additions Reductions
 Original contributions of cash or property  Passive losses claimed

 Additional contributions of cash or  Dividends or income distributed
property  Sales proceeds distributed by
 Recourse loans * partnership
 Reinvestments of income
 Reinvestments of sales proceeds
*In certain real estate programs, a percentage of non-recourse loans may be considered part of the investor’s basis.
Cash Flow Analysis A major benefit of a DPP is the cash that it generates for the investors. Although
projections don’t provide a guarantee as to a project’s profitability, they do give potential limited partners an
idea of the program’s financial goals.
Cash flow is calculated by adding non-cash expenses (e.g., depreciation and depletion) back to the income
(or loss) that’s generated by the business. Normally, a program will distribute its cash flow to the investors.
For example, a limited partner has a $50,000 basis in a DPP. The following list shows
his portion of all partnership income and expenses for the year:
$35,000 Revenues
$32,000 Operating expenses
$ 5,000 Depreciation expense
The limited partner receives a pass through of program losses totaling $2,000
($37,000 total expenses – $35,000 revenues). The losses are considered passive losses
and may only be deducted against his other passive income. However, the program
actually generated positive cash flow of $3,000 for the limited partner as shown below:
($2,000) Loss from operations
+ $5,000 Depreciation expense
+ $3,000 Cash flow
Since depreciation and depletion allowances are non-cash expenses (i.e., no money is being paid
out), they reduce the amount of taxable income without affecting cash flow.

Types of Limited Partnerships

Historically, limited partnerships have been established to allow for investment in a wide variety of
assets including timber, minerals, farming, ranching, real estate, and energy. The Series 7 Examination
will primarily focus on three types of programs—real estate, oil and gas, and equipment leasing. Let’s
examine the details of each of these programs.
Real Estate Limited Partnerships

The primary advantage for investing in real estate is the fact that land is a commodity for which supply is
fixed, but demand is constantly increasing. There are various types of real estate programs that include raw
land, new construction, existing properties, and government-assisted housing.
Raw Land For the purpose of land speculation, limited partnerships may purchase large tracts of raw
(undeveloped) land. Investments in raw land offer no depreciation deductions and little or no periodic
income from the real estate. Instead, the motivation behind speculation in raw land is the potential capital
appreciation to be achieved after selling property that has significantly increased in value.
While land in its raw or predeveloped state has a great potential for profit, investing in raw land also has its
drawbacks. Due to potential expenses and little or no periodic income being generated by the land, raw land
investments don’t offer tax advantages or positive cash flow to the investor. Financing (principal and
interest) and carrying costs (taxes) are usually the largest expenses associated with raw land. Since there’s
little cash flow to cover these expenses, a raw land investor may be required to provide additional funds due
to the potentially prolonged holding period. For these reasons, raw land partnerships are typically the riskiest
form of real estate investments and should only be recommended to investors with ample risk tolerance and
very long investment time horizons.
New Construction Generally, the objective of an investment in new construction is capital

appreciation; however, there may be some cash flow if the properties are leased to tenants after
construction. A real estate construction program involves a large financial commitment which is usually
accomplished through leverage. The use of leverage (borrowing) could potentially magnify any errors in
judgment or miscalculations in the economics of the project.
A general characteristic of a construction program is its long duration. Investors in these types of programs
should realize that the assumptions on which building decisions are based may be affected by changes in
the economy, government policy, or tax laws. New projects are subject to the risks of fluctuating building
costs, changes in the cost and availability of financing, and the rising costs of property operation.
Another risk that an investor should investigate before committing funds to a construction program is
overbuilding. This occurs when many similar projects are undertaken in the same area and the subsequent
result is an excess supply of space.

Existing Properties Certain programs are formed primarily to purchase existing commercial properties
and apartments. The major benefit of these programs is that the projections for the anticipated returns of
the project are predictable and offer a high degree of certainty. Two benefits for investors include the
immediate cash flow from rentals and the fact that depreciation allowances will reduce taxable income.
Depreciation is typically the largest tax advantage for investors in existing properties. These factors make
existing property partnerships generally safer than both raw land or construction ventures.
Government-Assisted Housing Government-assisted housing projects are created to provide low-cost

housing for low-income families. The current generations of federally subsidized housing programs are
part of the Section 8 Program which is administered by the Department of Housing and Urban Development
(HUD)—a government agency. The costs of construction, rehabilitation, or acquisition of low-income
housing qualify for tax credits and it’s these credits that are the major benefit of public housing
partnerships. The federal subsidy will also provide some income to the partnership.
Government-assisted housing programs also have some disadvantages. A primary concern related to
subsidized housing is its historic lack of appreciation potential. Many of the tax advantages offered by the
program will become negated if the project is a failure. There can also be a high risk of foreclosure
associated with these programs.
Blind Pools In some DPPs, the property or land to be purchased is not specified in the partnership
agreement. In these situations, the investments are referred to as blind pools.
Oil and Gas Limited Partnerships

Oil and gas programs are formed for the exploration, drilling, or development of oil and natural gas.
Management typically provides the technology and organization, while the limited partners provide a
major portion of the capital. In certain circumstances, the areas to be drilled are not specifically defined at
the time that management creates the program.
The four basic types of oil and gas programs are:
1. Exploratory programs
2. Developmental programs
3. Balanced programs
4. Income program
Exploratory Program Exploratory drilling, also referred to as wildcatting, involves searching for oil
and gas in unproven areas. Due to the uncertainty involved, these programs are considered high-risk
ventures. The expectation is that the high risk involved in an exploratory program correlates to high potential
rewards due to the lower cost of purchasing land in unproven areas. However, the actual return of such wells
cannot be determined until they’re actually drilled.

This type of program is also characterized as one that provides significant tax advantages. Intangible
drilling and development costs (IDCs) represent a major portion of the initial start-up expenses for a well
and are best explained as items that have no salvage (residual) value. Examples of IDCs include drill site
preparation costs, labor utilized in drilling wells, chemicals, testing and core analysis costs, and the cost of
supplies. Since a large portion of IDCs may be expensed as incurred, exploratory programs are suitable for
investors seeking passive write-offs and are also willing to assume a high degree of risk.
Developmental Program In a developmental program, leases are acquired for the right to drill in
proven areas. Although this type of program has high deductibility, its lower risk equates to a lower
potential return than possible through a successful wildcat program. The lower risk is based on the belief
that a productive exploratory well should be surrounded by equally productive drilling locations. When
drilling is being conducted just outside an area of proven reserves, it’s referred to as step-out drilling.
Balanced Program A balanced drilling program involves a combination of both exploratory and
developmental drilling. The exploratory drilling provides the potential for high yields, while the
development drilling offsets the high risks that are associated with the exploratory drilling.
Income Program An income program acquires interests in already producing wells. These sites are
acquired from oil and gas operators that have completed the drilling and prefer to sell the reserves rather than
hold and operate the sites for the life of the production. Since there’s little drilling, there are few intangible
costs to deduct. Instead, the program is cash-flow-oriented and is expected to produce passive income for the
investor. However, there are depletion allowances that may be used to reduce any reported income. Since
income programs are the most conservative oil and gas offerings, they may be suitable for clients who are
somewhat risk-averse and are seeking to diversify a stock or bond portfolio with an income objective.
Deductions Expenses that are incurred by the program include intangible drilling costs, depletion
deductions, and depreciation allowances that are claimed on the equipment that’s purchased by the program.
When determining income or loss from the property’s operations, program expenses are deducted from the oil
and gas property’s income. Again, depletion deductions are normally the largest tax benefit provided by
oil and gas programs.
Sharing Arrangements
The method of allocating both costs and revenues in an oil and gas program is defined in the sharing
arrangement. Usually, it’s through this agreement that the sponsor will receive a major portion of its
compensation. The four basic types of sharing arrangements are:
1. Functional allocation
2. Overriding royalty interest
3. Reversionary or subordinated working interest
4. Disproportionate sharing

In a functional allocation agreement, the deductible program expenditures are charged to the investors,
with all of the non-deductible costs being borne by the sponsor.
In an overriding royalty interest arrangement, the sponsor doesn’t share in any of the program’s costs, but
will share in revenues from the point at which the well begins to produce. This interest is normally small
and may be in the range of 5% to 10% of the gross production.
In a reversionary working interest arrangement, the sponsor doesn’t share in any of the program’s
costs; however, the sponsor also doesn’t share in production revenues until the investors have
recovered their costs.
Under a disproportionate sharing arrangement, the sponsor is responsible for a percentage (usually up to
25%) of the program’s costs in return for a percentage (usually 50%) of the program’s revenues. In this
case, the sponsor assumes risk for a portion of the venture’s expenditures. This agreement does require the
investor to share in both deductible and non-deductible costs.
Equipment Leasing Programs

Due to the high cost of purchasing major equipment and the risk of owning obsolete equipment as a result of
technological advancements, a more economically viable option for the user may be to lease the equipment
rather than making an outright purchase. Partnerships are typically formed to lease transportation equipment
(e.g., airplanes and railroad cars), machinery, or computer equipment.
Under a typical leasing arrangement, a manufacturer will sell the equipment to a syndicate that had
obtained the capital for the purchase from investors and bank borrowing. The equipment is then leased for
a fixed rental fee. The rental payments made to the program will allow the lessor to meet its loan
obligation to the bank as well as provide some cash flow to investors. The equipment may also qualify for
accelerated depreciation.
Deductions In equipment leasing programs, investors normally receive substantial tax benefits through
depreciation expenses; however, there are no depletion allowances in these types of programs.
Additionally, investors in these programs should not expect to obtain capital appreciation due to the fact
that the leased equipment is not their property.
The advantages of equipment leasing programs are consistent income from the lease payments and the
ability to deduct depreciation expense. In these programs, the major disadvantage is that the equipment
underlying the lease will not appreciate in value.
Hedge Funds
Hedge funds are private investment pools that are not required to register with the SEC under the Investment
Company Act of 1940. These investments are often sold under a Regulation D (private placement)
exemption and their purchasers are typically institutional and high net worth investors that can understand
the unique risks associated with these products, such as their lack of liquidity and the potential use of
leverage by the fund managers. These funds typically have high minimum initial investment requirements
(often $1 million or greater).

Unregulated Since hedge fund offerings are generally limited to accredited investors, these products qualify
for exemptions from the federal regulations that govern short selling, use of derivatives, leverage, fee
structures, and the liquidity of the investment. Due to these exemptions, hedge funds may use strategies that
are prohibited for more heavily regulated investment entities (e.g., mutual funds). Ultimately, hedge funds
are more complex and may expose investors to many different types of investment risk.
Illiquid Unlike mutual funds, hedge funds are not required to publish their net asset value daily and they
impose restrictions on withdrawals which make these assets less liquid. Since hedge funds don’t offer investors
the ability to redeem at the NAV on a daily basis, these products are unsuitable for investors who are seeking
liquidity. In addition, most hedge funds raise capital by offering investors limited partnership units, which will
also limits their liquidity.
Compensation Mutual funds cannot assess a sales charge that exceeds 8.5% of the fund’s public
offering price; however, hedge funds often impose higher and more complex fees. One typical
arrangement is a two-and-twenty fee which involves a hedge fund manager charging a 2% management fee
and then taking 20% of any of the profits.
Fund of Hedge Funds A fund of hedge funds consists of a portfolio of shares in different hedge funds.
Rather than investing directly in securities, the fund of hedge funds diversifies among multiple hedge
funds. The benefit gained through diversification is the decrease in overall risk, while the disadvantages
include higher fees and the limitations that each fund may place on withdrawing money.
Business Development Companies (BDCs)

A business development company (BDC) is a type of publicly traded investment company that’s designed
to aid in the process of capital formation (raising money) for small and middle-market companies. Since
BDCs raise money through public offerings, there’s no requirement for investors to meet the
sophistication, income, or net worth requirements.
Liquidity Most BDCs are listed on an exchange (e.g., the NYSE or Nasdaq). Unlike mutual funds that
offer end-of-day redemption at NAV, BDCs trade throughout the day at prices that are based on supply
and demand (similar to ETFs and closed-end funds).
Regulation Legally, BDCs are a form of investment company that were created under an amendment to
the Investment Company Act of 1940. BDCs are typically required to meet all of the registration
requirements that are prescribed under the Securities Act of 1933 and all of the reporting requirements that
are found within the Securities Exchange Act of 1934.
Taxation BDCs are treated as regulated investment companies (RICs) under IRS Subchapter M
provided they act as conduits and distribute at least 90% of their taxable income as dividends to investors.
By doing so, BDCs avoid much of their corporate tax liability and are only required to pay taxes on the
earnings they choose to retain.

Investor Suitability
As a conclusion to this chapter, let’s consider the suitability issues that surround the products that have
been described. For an individual, the suitability of an investment in a limited partnership is dependent on
both financial and psychological considerations. Financially, an individual must meet all of the applicable
requirements of the particular states involved which prohibit investments being made by certain account
types (e.g., UGMAs or UTMAs). Since DPPs are normally illiquid, the investor must have staying power
(i.e., the ability to commit money for long periods). For this reason, it’s important that potential DPP
investors have sufficient liquid assets in the event the need arises for immediate cash. There’s also the risk
of a delay in reaching the crossover point. The crossover point is reached once the program’s revenues
exceed its expenses and it begins to generate profits for the partners.
Investors should be aware of the various risk components that are inherent in limited partnership investments.
Investors should evaluate the relative degree of risk that each component contributes to the overall risk of the
investment. Some of the risk considerations include:
 Management ability of the general partners  Ability of investors to pay future assessments
 Illiquid nature of the limited partnership units  Rising operating costs
 Possible loss of capital  Availability of good properties or leases
 Unpredictability of income  Changes in tax laws and government regulations
Investor Certification Prior to executing sales, registered representatives are required to certify that they
have informed their customers of all relevant facts relating to the lack of marketability and lack of liquidity of
the limited partnership. In addition, after obtaining information about their customers’ investment objectives,
financial and tax status, other investments, and future financial needs, the RRs must have reasonable grounds
to believe their customers have sufficient net worth and income to withstand the potential loss of their entire
investment. RRs must certify that their customers are financially and psychologically suited for investing in
limited partnerships. This certification is usually accomplished by having customers sign a disclosure form
and verify that they have the financial resources to participate in the offering.
Discretionary Accounts Due to the complexity of these products and the requirement to certify the
eligibility of investors prior to purchase, RRs are not permitted to exercise discretion when recommending
a DPP. An RR may not purchase a direct participation program in a discretionary account without the
customer’s prior written approval. No blanket approvals are permitted; instead, the written approval must
be obtained for each individual investment.
Conclusion
Now that the chapter on DPPs is concluded, Series 7 candidates should remember that it’s not enough to
simply understand the features and benefits of these programs. The exam may also test a person’s ability to
match a given client to the best type of partnership. As a general rule, partnerships should be recommended
only to investors who are able to benefit from some of the tax features that are available through
partnerships and who are able to tolerate the illiquid nature of these products.

CHAPTER 12
Options
Key Topics:
 Buyers versus Sellers
 Life of an Option
 Basic Strategy
 Advanced Strategy
 Non-Equity Options and Taxation

CHAPTER 12 – OPTIONS
An option is a derivative security that may be used to speculate on the movement of an underlying asset,
to protect an existing position, or to generate income in a portfolio. This chapter will examine the
different options positions that are tested on the Series 7. Although much of the following content is
somewhat technical, the chapter will remain focused on ensuring that students are able to identify an
option position and answer four standard questions—(1) the strategy, (2) the breakeven price (i.e., the
price at which the underlying asset must be trading so that the investor neither makes nor loses money),
(3) the maximum gain, and (4) the maximum loss. The chapter will also cover spreads, straddles, non-
equity options, the Options Clearing Corporation, and the tax implications of option positions.
Overview of Options
The first part of this chapter will cover the four basic equity option positions—buying a call, selling a
call, buying a put, and selling a put. These four strategies may be used to make simple directional bets on
a variety of underlying assets, such as an individual security or an index.
Option Terminology
Let’s start with answering the question, what is an option? An option is a derivative security and, in the
simplest terms, is a contract with a value that’s derived from the movement of an underlying stock, bond,
index, currency, or other asset. These derivatives trade in markets that are very similar to those in which
stocks and bonds trade. As noted in the introduction above, there are many different reasons to use
options as part of an investment portfolio; however, before examining the uses of these derivatives,
certain terms must be defined.
Buyers and Sellers

An option is a contract that’s entered into by two parties. On one side of the contract is the buyer, owner,
or holder of the option, who is also considered long the option. The buyer pays the option’s premium (i.e.,
the contract’s market price) and receives the right to exercise the contract. Depending on the type of contract
that’s purchased, the holder has the right to either buy or sell the underlying security.
On the other side of the contract is the writer or seller of the option, who is also considered short the
option. The seller receives the option’s premium and assumes an obligation if the contract is exercised in
the future. Depending on the type of contract that’s sold, the writer may be obligated to either buy or sell
the underlying security.

Remember, buyers pay the up-front premium and receive the right to exercise. If the option expires
worthless, the premium paid represents the buyer’s maximum loss.
Sellers receive the up-front premium and assume an obligation if exercised against. If the option
expires worthless, the premium received represents the seller’s maximum gain.
Synonymous Terms
Buyer Seller
Owner Writer
Holder Short
Long
Categorization of Options
Options may be categorized according to their type, class, and series.
Type: The two types of options are calls and puts.

 A call option gives the owner the right to buy the underlying security. In other words, a call buyer is
able to call the security away from the writer at a fixed price. The writer of the call has the
corresponding obligation to sell the security at the fixed price if the owner exercises the contract.
Simply stated, the owner of a call has the right to buy stock, while the writer of the call has the
obligation to sell stock.
 A put option gives the owner the right to sell the underlying security. In other words, a put buyer is
able to put the security to the writer at a fixed price. The writer of the put has the corresponding
obligation to buy the security at the fixed price if the owner exercises the contract. Ultimately, the
owner of a put has the right to sell stock, while the writer of the put has the obligation to buy stock.
The following table summarizes the rights and obligations of the two sides of each type of option:
Long Short
Call Right to Buy Obligation to Sell
Put Right to Sell Obligation to Buy
Class: Options are deemed to be of the same class if they’re of the same type with the same
underlying asset.
 For example, all calls on General Electric stock are of the same class, while all puts on General
Electric stock are of a different class.

Series: An option series represents all of the options of the same class, with the same expiration date,
and the same exercise price.
 For example, all IBM January 140 calls represent one series, all IBM January 150 calls represent
another series, and all IBM January 160 calls represent a third series of IBM options.
Covered and Uncovered Options Writers

If the seller of a call already owns the underlying stock, she’s said to be covered on the transaction since
the shares that she’s long would be available for delivery if she’s exercised against. On the other hand, if
the writer doesn’t own the shares, she’s considered to be exposed, uncovered, or naked. These terms
indicate that the writer is at risk of being required to buy shares at an unknown market price to be able to
make delivery due to being exercised against by the call buyer. Uncovered call writing is far more
dangerous than covered writing and may only be executed in a margin account.
Components of an Option
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. An option contract is described by the name of the underlying security, the
expiration month of the contract, the exercise (strike) price, and the type of option. For example, let’s
assume that an investor purchased one call option on XYZ stock, with a May expiration, an exercise price
of $30, and a premium of 3. The contract will appear as follows:
Number of Underlying Expiration Exercise Option

Investor is: Premium
Contracts Security Month Price Type
Long 1 XYZ May 30 Call 3
The individual components of this option contract represent the following:
Underlying Security — XYZ Each equity option represents the right to buy or sell one round lot of the
underlying stock, based on a standardized contract size. Typically, there are 100 shares of stock (one
round lot) underlying each option contract.
Expiration Month — May All listed options (those that trade on an exchange) have fixed expiration
dates. The holder of an option has the right to buy or sell the underlying stock at any time until the
expiration date. If an option has not been exercised prior to its expiration, it expires (ceases to exist). In our
example, the buyer of the call has the right to purchase 100 shares of XYZ stock from the writer until the
expiration date in May. The exact date of an option’s expiration is standardized and will be covered later
in this chapter.
Exercise (Strike) Price — 30 The exercise price, also referred to as the strike price, is the price at
which the call owner may buy stock from the writer. For put options, it’s the price at which the put owner
may sell stock to the writer.

Strike prices are determined by the exchange on which the option contract is listed. They’re set at prices
above and below the market price of the stock. New strike prices are created as the market price of the
stock moves up and down. Once created, the contract remains open for trading until it expires.
For example, if the current market price of XYZ is 42, the strike prices for XYZ options
may be listed as follows:
50
45
42 market
40
35
Type of Option — Call Remember, a call option gives the owner of the contract the right to buy the
stock, while the seller accepts the obligation to sell the stock if exercised against. In our example, the call
buyer has the guaranteed ability to purchase 100 shares of XYZ at a price of $30, regardless of how high
the price of XYZ increases between the time the option is purchased and the expiration in May.
Premium — 3 The current market value of this option contract is 3 points or $3 per share. Since the
contract is for 100 shares, the purchase price is $300 ($3 x 100 shares). This is the amount that a buyer
pays to the seller for the rights conveyed by the contract.
Again, as derivatives, the market values (premiums) of call and put options are determined by changes in
the prices of the underlying securities. As the market value of the underlying stock rises and falls, so too
does the option premium.
The premium is the only component of the option that’s not standardized. Instead, it’s determined in the
secondary market between buyers and sellers and is constantly changing. The premium is influenced by
the price and volatility of the underlying asset (i.e. the stock price).
Intrinsic Value and Time Value

The premium of an option is potentially made up of two components—intrinsic value and time value.
Intrinsic value is the amount by which an option is in-the-money, while time value is the portion of an
option’s premium that exceeds its intrinsic value.
For calculation purposes, remember than an option will only have INtrinsic value if it’s IN-the-money.
Option Premium = Intrinsic Value + Time Value

In-, At-, and Out-of-the-Money The relationship between the strike price of an option and the current
market price of the underlying security determines whether an option is in-, at-, or out-of-the-money.
For call options, the relationships may be summarized as follows:

 Calls are IN-THE-MONEY if the stock’s market price is
above the strike price of the option.
 Calls are AT-THE-MONEY if the stock’s market price is
the same as the strike price of the option.
 Calls are OUT-OF-THE-MONEY if the stock’s market price is
below the strike price of the option.
For put options, the relationships are the opposite:

 Puts are IN-THE-MONEY if the stock’s market price is
below the strike price of the option.
 Puts are AT-THE-MONEY if the stock’s market price is
the same as the strike price of the option.
 Puts are OUT-OF-THE-MONEY if the stock’s market price is
above the strike price of the option.

The following illustrations summarize when options are in-, at-, and out-of-the-money:
32 2 pts. in-the-money
31 1 pt. in-the-money
For an XYZ May 30 call If XYZ = 30 At-the-money
29 1 pt. out-of-the-money
28 2 pts. out-of-the-money
32 2 pts. out-of-the-money
31 1 pt. out-of-the-money
For an XYZ May 30 put If XYZ = 30 At-the-money
29 1 pt. in-the-money
28 2 pts. in-the-money
Keep in mind, the intrinsic value of an option will either be a positive amount or zero. There’s no
negative intrinsic value. If an option is in-the-money, it has positive intrinsic value; however, if an option
is at-the-money or out-of-the-money, it has zero intrinsic value.
Determining Time Value Since it’s only in-the-money options that have intrinsic value, any premium
associated with at- or out-of-the-money options will consist only of time value.
For in-the-money options, the time value may be determined by simply subtracting the intrinsic value
from the premium. Using the earlier example, let’s assume the XYZ May 30 call has a premium of 3 at a
time when the stock is trading at $32 per share. The premium of 3 consists of the 2 points of intrinsic
value (from 30 to 32), with the remainder being 1 point of time value.
Premium of: 3
Or, put another way: – Intrinsic Value of: 2
Time Value of: 1

If the XYZ May 30 call has a premium of 3, but the stock is trading at $30 per share, how is the premium
determined? With the stock at $30, a 30 call option is at-the-money. This means that the option has zero
intrinsic value, and therefore, the entire 3-point premium is time value.
Generally, the longer the time until an option expires, the greater its time value. If it’s currently January,
an XYZ August 30 call will trade at a higher premium than an XYZ May 30 call since the August option
has more life remaining than the May option.
An option’s time value will diminish with the passage of time and, at expiration, it will have no
remaining time value. On the final day prior to a contract’s expiration, an in-the-money option will be
trading very close to its intrinsic value, while an out-of-the-money option will be essentially worthless.
Intrinsic Value Does Not Assure Profitability If an investor is long an XYZ 30 call for which he
paid a premium of 2 and XYZ is currently trading for $31 per share, is the call in-the-money? Yes, the
call is in-the-money by $1 per share; however, the investor is still losing money because the stock is not
trading at a price higher than the amount of premium paid.
An important concept to remember is that an option’s premium is disregarded when determining whether
the option is in-, at-, or out-of-the-money. Option contracts are considered in-, at-, or out-of-the-money,
NOT investors. It’s when determining an investor’s gains or losses on option positions that the premium
paid or received is actually considered. An option being in-the-money doesn’t necessarily mean that an
investor is going to gain or lose money.
Intrinsic Value is Good for Buyers An option will be in-, out- or at-the-money regardless of whether
an investor is the buyer or seller. If XYZ stock is trading at $42, an XYZ 30 call is 12 points in-the-
money. Assuming the buyer of the option paid less than 12 for the contract, he’s likely happy because the
contract’s $30 strike price will allow him to acquire stock at 12 points below the stock’s market price.
However, the writer is likely unhappy because, according to the contractual agreement, she may be
required to buy the stock in the market at a price of $42 and then sell it at the strike price of $30.
So essentially, intrinsic value is good for buyers, but bad for sellers.
Breakeven
Although the in-the-money concept disregards the premium of an option, it’s a vital component in
calculating an investor’s breakeven point. The breakeven point represents the price at which a stock must
be trading so that an investor will neither make nor lose money.
 For buyers of options, breakeven represents the amount they need the underlying stock to move in
their favor to be returned the premium paid.
 For sellers of options, breakeven represents the amount they can afford the underlying stock to move
against them because they received the premium.

While the maximum gain or maximum loss on an option position is a total dollar figure (e.g., $4,300), the
breakeven point is simply a stock price (e.g., $43). As the chapter continues and specific option positions
are analyzed, breakeven will be covered in greater detail.
Adjustments to an Option Contract

If a corporation executes a stock split or pays a stock dividend, its option contracts must be adjusted. In
some cases, an adjustment is made to the number of option contracts, while in other cases, it’s the number
of shares underlying the contract that must be changed. However, in all cases, the exercise price of the
option will be adjusted proportionately. Ultimately, regardless of the terms being changed within the
contract, the aggregate value of the contract will remain the same.
Even Stock Split Any split for one (e.g., 2 for 1, 3 for 1, etc.) is referred to as an even stock split. When
a corporation executes an even stock split, the adjustments made to existing option contracts are an
increase in the number of option contracts an investor owns and a decrease in the exercise price of the
contracts. The number of shares underlying each option is not adjusted for the split.
For example, if XYZ stock is split 2-for-1, an investor who currently owns:
 1 XYZ May 30 call will now own 2 XYZ May 15 calls with each contract still
representing 100 shares. Notice that the original 100 shares x $30 equals $3,000 and
the adjusted 2 contracts for 100 shares x $15 also equal $3,000.
To adjust the number of contracts, multiply 1 contract by the 2-for-1 split ratio
(1 x 2/1 = 2 contracts). To adjust the exercise price, multiply the $30 exercise
price by the inverse of the split ratio ($30 x 1/2 = $15 exercise price).
Remember, the only time the number of contracts changes is if the corporation executes an even split.
Odd Stock Splits When an odd split is executed (e.g., 3 for 2, 5 for 4, etc.), the adjustments made to
existing option contracts are an increase in the number of shares underlying the contracts and a decrease in
the exercise price of the contracts. In this case, the number of contracts doesn’t change.
For example, if XYZ stock is split 3-for-2, an investor who currently owns:
 1 XYZ May 30 call (representing 100 shares) will now own 1 XYZ May 20 call
(representing 150 shares). Notice that the original 100 shares x $30 equals $3,000
and the adjusted contract for 150 shares x $20 also equals $3,000.
To adjust the number of shares, multiply 100 shares by the 3-for-2 split ratio
(100 x 3/2 = 150 shares). To adjust the exercise price, multiply the $30 exercise

Reverse Stock Split In an effort to increase the market price of its stock, a corporation may choose to
execute a reverse stock split. With a reverse stock split, the adjustments made to existing option contracts
are a reduction in the number of shares the contract represents and an increase in the exercise price of the
contract. Again, the contract’s aggregate value will be the same before and after the adjustment.
For example, if ABC stock is split 1-for-5, an investor who currently owns:
 1 ABC October 10 call (representing 100 shares) will now own 1 ABC 50 call
(representing 20 shares)
To adjust the number of shares, multiply 100 shares by the 1-for-5 split ratio
(100 x 1/5 = 20 shares). To adjust the exercise price, multiply the $10 exercise
Stock Dividend An option contract is also adjusted for a stock dividend on the ex-dividend date.
The adjustments made are identical to those made for an odd stock split (i.e., the number of shares per
contract increases and the exercise price decreases proportionately).
For example, if XYZ declares a 25% stock dividend, an investor who currently owns:
 1 XYZ May 30 call (representing 100 shares) will now own 1 XYZ May 24 call
(representing 125 shares)
The additional number of shares is determined by multiplying the original contract

size of 100 shares by the stock dividend percentage (100 x 25% = 25 additional
shares). Therefore, the new contract size for the option is 125 shares. Since the
aggregate value of the contract must remain constant, the adjusted exercise price is
determined by dividing the original aggregate exercise price of $3,000 (100 x $30)
by the adjusted number of shares (125).
$3,000
= $24 adjusted strike price
125
Cash Dividend Cash dividends are considered the property of the investor who owns the stock as of the
record date. The holder of a call will receive the dividend on the underlying security as long as the option is
exercised before the ex-dividend date. The owner of a put option who holds the underlying stock must wait
to exercise the option until the ex-dividend or after in order to retain the dividend on the stock. The exercise
price of a listed option will not be affected by the payment of an ordinary cash dividend.

The chart below summarizes the adjustments that must be made to an option contract for splits and
dividends:
Adjusting 1 XYZ May 30 Call Option

Type of Number of Number Strike
Adjustment Contracts of Shares Price
Even Split Increase Unchanged Decrease

(e.g., 2 for 1) 1 x 2 /1 = 2 100 shares per contract $30 x 1/2 = $15
Unchanged Increase Decrease

Odd Split
100 shares x 3/2
(e.g., 3 for 2) 1 contract $30 x 2/3 = $20
= 150 shares per contract
Increase
Stock Dividend Unchanged Decrease
(e.g., 25% dividend) 100 shares x 125%
1 contract $3,000 ÷ 125 = $24
= 125 shares per contract
Unchanged Unchanged Unchanged
Cash Dividend
1 contract 100 shares per contract $30
The Options Clearing Corporation

Listed options are issued and guaranteed by the Options Clearing Corporation (OCC). The OCC is
regulated by the Securities and Exchange Commission and is proportionately owned by the exchanges on
which listed options trade.
The OCC acts as the third party in all options transactions and functions in a similar capacity to that of
the DTCC in equity and bond markets. The OCC handles the exercise of option contracts and removes
counterparty risk in the event that a writer is unable to fulfill its obligation. Broker-dealers deal directly
with the OCC rather than with each other. When customers buy options contracts, their broker-dealers
must settle the transactions with the OCC within one business day. Also, selling firms will receive a
credit for the sale of the option on the next business day.
Position and Exercise Limits

Both the Options Clearing Corporation and the options exchanges limit the number of contracts that an
investor, or group of investors that are acting in concert, may accumulate on the same underlying
security. These position limits differ for each underlying security.
An equity security is assigned a maximum position limit based on its trading volume and outstanding
shares. The status of the underlying security is reviewed every six months in order to determine the
appropriate limit.

Along with position limits, investors are subject to exercise limits (based on the same numerical limit).
An exercise limit represents the maximum number of contracts that an investor may exercise within five
consecutive business days.
The limitations apply to contracts on the same side of the market—bullish on one side and bearish on the
other. The bullish side of the market includes long calls and short puts, while the bearish side of the
market includes long puts and short calls.
Bullish Bearish
Long Calls Long Puts
Short Puts Short Calls
For example, ABC Company has a 75,000 contract position limit. If an investor
owns 50,000 ABC calls and is short 25,000 ABC puts, he has reached the maximum
on the bullish side of the market. The investor may not buy additional ABC calls or
write additional ABC puts.
However, the investor is permitted to buy ABC puts and or sell ABC calls up to a total of 75,000 contracts
since these transactions are on the bearish side of the market. Also, because the limits apply to each
underlying security, the investor is allowed to purchase calls or write puts on another underlying stock.
Long-Term Equity Anticipation Securities (LEAPS)

LEAPS® are equity options with expirations of up to 39 months that operate in the same manner as
other standard listed equity options. Some of the significant advantages of these long-term options
include that they:
 Lose their time value at a much slower pace than standard options
 Offer long-term protection against unfavorable movement in the market value of an underlying
stock position
 Provide a long-term opportunity to participate in the price movement of a security
Currently, long-term equity options are traded on a large number of underlying stocks including
Microsoft, IBM, and General Electric.

The contract specifications for LEAPS options are generally the same as those of traditional equity
options and are summarized in the following table:
Underlying Value 100 shares of the underlying security
Expirations are in January and occur on the third Friday of the month; new
Expiration
expirations are added once per year
Exercise American style, with delivery of the underlying stock in three business days
Premiums Every one point equals $100
At the time of listing, one strike price is set above the market price of the stock,
Strike Prices
one at the market price of the stock, and one below the market price of the stock
Settlement Next business day
Clearing Options Contracts

The Options Clearing Corporation is responsible for clearing option trades. Additionally, the OCC
guarantees that a buyer will be able to exercise her right in the event of a deficiency (e.g., bankruptcy) on
the part of a writer. In essence, the OCC removes counterparty risk from standardized options
transactions by acting as a seller for every buyer and a buyer for every seller.
Option Events
Since an option is a security with a fixed life, the contract will eventually be subject to one of three
possibilities. The contract may be liquidated, it may be exercised, or it may expire. Let’s review each of
these potential outcomes.
Liquidate, Trade, or Close-out Liquidating (trading) an option position is an alternative to exercising

the option. To liquidate an option, an investor (either the buyer or seller) executes an opposite transaction
on the same option contract.

Since there’s an active and liquid secondary market for listed option contracts, an investor who is long an
XYZ May 30 call may close out the position by selling it. On the other hand, an investor who is short an
XYZ May 30 call may close out that position by buying it. The difference between what an investor pays
and what he receives is the profit or loss.
For example, an investor bought (opening purchase) an XYZ May 30 call at 3. Later, XYZ
stock rose to $40 and the investor liquidates the position (closing sale) for its adjusted
premium of 11 (10 points of intrinsic value and 1 point of remaining time value). Since the
investor originally paid $300, but later sold the call for $1,100, his resulting gain is $800.
When options are traded, an order ticket must expand on the purpose of both the buy and sell orders.
Basically, orders are entered either to open a new position or to close a previously opened position.
Opening Purchase Is liquidated by a: Closing Sale

Investor reduces or eliminates a long position
Investor creates or increases a long position.
by selling an equivalent contract
Opening Sale Is liquidated by a: Closing Purchase
Investor reduces or eliminates a short
Investor creates or adds to a short position.
position by purchasing an equivalent contract
Exercise The second event that will close an option position is an exercise. The investor who is long
an option has the exclusive right to exercise that option. The two styles of exercise are American and
European.
 Options using American style exercise may be exercised at any time up to the day on which they
expire. All listed equity options use American style exercise.
 Options using European style exercise may only be exercised at a specified point in time, usually on
the day of expiration. European style exercise is prevalent with index and currency options.
If an investor is long an XYZ May 30 call and the underlying stock is trading at $38 per share, the call
holder could exercise the option and buy the stock at the strike price of $30 per share. Thereafter, the
investor could sell the stock in the market for $38 per share, which results in a gain of $8 per share
(actual gain is less the premium paid).
Similarly, an investor who is long an XYZ May 30 put may choose to exercise that contract if the stock is
trading at $22. Assuming the investor did not currently own the stock, he could buy it in the secondary
market for $22 per share, and then immediately sell the stock at the strike price of 30. The purchase at $22
and subsequent sale at $30 will result in a gain of $8 per share (actual gain is less the premium paid).

If a buyer exercises an option, the seller is required to fulfill his obligation. For this reason, the seller
is considered to have been assigned an exercise notice. If the seller of a May 30 call is exercised
against, he must deliver 100 shares of XYZ at a price of $30 per share, regardless of the market value
of the stock at that time. The seller of a put has an opposite obligation. If the seller of an XYZ May 30
put is exercised against, he must buy 100 shares of XYZ stock for $30 per share, even if the stock is
actually worth much less.
Expiration The last event that will close an option position is the expiration of the contract. If an
option is at- or out-of-the-money on the expiration date, the holder of the contract has no incentive to
exercise the contract. Also, since there’s no time remaining on the contract, there will be no willing
buyers. The result is that the contract expires worthless and the seller retains the premium. This
expiration triggers the maximum profit for the seller of a call or put (i.e., the premium initially received).
Conversely, the expiration of an option triggers the maximum loss that the buyer of the call or put could
experience (i.e., the premium paid).
Buyers’ and Writers’ Perspectives Based on all of the preceding information, the following two basic
assumptions can be made:
1. Option buyers want contracts to become in-the-money (the more, the better) so that they can sell
(trade) them or exercise them for a profit. However, option writers want the contract to be either at-
or out-of-the money and expire worthless.
2. The seller’s maximum profit is the premium she received when the option was initially sold and the
buyer’s maximum loss is the premium paid when the option was purchased.
Options Strategies – Buying Calls

An investor who is bullish on a stock (believes it will go up in value) could buy a call to try to profit from
that possibility. Buying a call allows investors to employ leverage to gain control of the stock since a
smaller outlay of money is required than if they bought the stock outright.
Given the wide range of potential outcomes for an option, investors need to understand the tradeoff
between risk and return. One way to do this is to examine the breakeven, maximum potential gain, and
maximum potential loss for a particular option transaction.
For the buyer of a call option, the breakeven point is equal to the strike price plus the premium paid
for the contract. Any price above the breakeven point will generate a point-for-point profit for the
holder of the option. Theoretically, the buyer’s potential profit is unlimited since the increase in the
price of a stock is infinite.
One way to determine the gains and losses in an option transaction is to track the inflows and outflows of
cash. If an investor buys something, it results in cash being taken out of his account (a debit) and, if an
investor sells something, it results in cash being directed into his account (a credit).

Let’s consider the different potential outcomes for a call option:
Close the Position

Cash Out Cash In
1) An investor buys an XYZ May 30 call for a premium of $2. (Debit) (Credit)
2) Later, at expiration, the stock rises to 37 and the investor closes out the 1) $200
2) $700
call position by selling it for its intrinsic value.
(Stock Price 37 – Strike Price 30 = $7/share or $700) $200 $700
3) As a result, the investor has a net gain of $500.
($700 In – $200 Out = $500 In) 3) $500 gain
Using the same example, let’s assume the investor instead chooses to exercise the call, buy the stock, and
then sell the stock in the secondary market.
Exercise and Sell the Stock
1) An investor buys an XYZ May 30 call for a premium of $2. Cash Out Cash In
(Debit) (Credit)
2) The stock rises to 37 and the investor exercises their right to buy the 1) $200
stock at the strike price.
2) $3,000
3) $3,700
3) The investor then sells the stock in the market for $37/share. $3,200 $3,700
4) $500 gain
4) Again, the gain is $500. ($3,700 In – $3,200 Out = $500 In)
Notice that whether the option is traded or exercised, the gain is the same. These results have not taken
into consideration transaction costs or the difference between the bid and ask prices in the secondary
market. Although they’re important variables that affect investors, they’re unknown, cannot be
controlled, and will not be considered in our calculations.
With a call option, for every $1 that the underlying stock price increases, the option’s intrinsic value will
increase by $1. For this reason, the theoretical maximum gain on a long call option is unlimited.

Let’s examine a situation in which the investor is not as fortunate.
Expiration
Cash Out Cash In
1) An investor buys an XYZ May 30 call for a premium of $2. (Debit) (Credit)
1) $200
2) $0
2) The stock price falls to 26, and the option expires worthless.
$200 $0
3) The investor has a net loss of $200. ($200 Out – $0 In = $200 Out) 3) $200 loss
Even if the price of XYZ stock fell to $0, the investor’s maximum loss is limited to the premium paid, in
this case $200. Therefore, if the stock doesn’t go up in value, the call buyer may simply choose to allow
the call to expire unexercised.
Finding Breakeven
An investor buys an XYZ May 30 call for a premium of $2. The breakeven is
simply the strike price plus the premium. 30 + 2 = 32 breakeven.
Breakeven Explanation
1) An investor buys an XYZ May 30 call for a premium of $2 Cash Out Cash In
(Debit) (Credit)
2) The owner exercises the call and buys the stock at the strike price of 30.
1) $2
3) The investor has total cash out of 32. 2) $30
3) $32 4) $32
4) The investor must sell the stock at 32 in order to breakeven.
To reach the breakeven point, the buyer of the call will need to recoup the premium paid. Therefore,
for the buyer to breakeven, the contract will need to be in-the-money by an amount equal to the
premium paid ($30 + $2 = $32).
Selling Calls
Investors who sell calls believe that the price of the underlying stock is going to decline or remain stable.
Therefore, they’re bearish and are seeking the premium income on the sale of the option. Sellers of calls
calculate the breakeven point in the same manner as buyers of calls—strike price plus the premium.
Remember, sellers have a maximum gain that’s limited to the premium. This maximum gain is realized if
the option expires worthless. If exercised against, call writers are considered uncovered (naked) if they don’t
own the stock that they’re required to deliver. This is an extremely risky position that presents a potential
unlimited loss since the amount by which the stock’s price may increase against the writer is infinite. From a
risk standpoint, selling a naked call is very similar to shorting stock. Due to the inherent risk of both of these
strategies, they must be executed in a margin account.

Note: For exam purposes, unless specified in a question, it should be assumed that the writer of an option
is uncovered. The use of the terms covered or uncovered (naked) is exclusive to the writers of options.
Closing the Position

Cash Out Cash In
1) An investor sells an XYZ May 30 call for a premium of $2. (Debit) (Credit)
2) Later, with life remaining and the stock trading at 37, the investor closes 1) $200
the call position for its current premium of 8 (7 points of intrinsic value + 1 2) $800
point of time value), or $800.
$800 $200
3) The result is that the investor has a net loss of $6 per share, or $600.
($800 Out – $200 In = $600 Out) 3) $600 loss
Using the same example, let’s assume that the investor receives an exercise assignment. If the call writer
doesn’t currently own the stock, she will be required to buy the stock in the market and then deliver the
stock at the strike price stipulated in the contract.
Exercise
1) An investor sells an XYZ May 30 call for a premium of $2. Cash Out Cash In
(Debit) (Credit)
2) The stock rises to 37, the investor receives an exercise notice, and 1) $200
immediately buys the stock in the market. 2) $3,700
3) $3,000
3) The investor satisfies the obligation to sell the stock at the 30 strike price.
$3,700 $3,200
4) The loss is $500. ($3,700 Out – $3,200 In = $500 Out) 4) $500 loss
The loss could have been far greater than $500 since the increase in a stock’s price is theoretically infinite. A
seller’s potential loss increases for every dollar the stock rises above the breakeven point.
Now let’s consider a situation in which the seller of the call makes a profit.
Expiration Cash Out Cash In

(Debit) (Credit)
1) An investor sells an XYZ May 30 call for a premium of $2.
1) $200
2) $0
2) The stock’s price falls to 28 and the option expires worthless.
$0 $200
3) The investor has a net gain of $200. ($200 In – $0 Out = $200 In) 3) $200 gain
Even if XYZ’s price decreases to $0, the maximum gain for an option seller is the premium received
—in this case, $200.

Finding Breakeven
An investor sells an XYZ May 30 call for a premium of $2. The breakeven is
simply the strike price plus the premium. 30 + 2 = 32 breakeven.
1) An investor sells an XYZ May 30 call for a premium of $2.
2) If exercised against, the seller of the call may purchase the stock at 32 Cash Out Cash In
(2 points higher than the strike price) and breakeven due to having (Debit) (Credit)
received the premium.
1) $2
3) The investor then satisfies the obligation to sell XYZ at the 30 strike 2) $32
price. 3) $30
4) $32 $32
4) The breakeven point of 32 shows that the cash out equals the cash in.
It’s important to note that the breakeven point is the same for both the buyer and the seller. To be returned
the premium paid, buyers need the stock to rise above the strike price by an amount equal to the premium
(strike price + premium). On the other hand, sellers can afford to have the stock rise above the strike price
by an amount equal to the premium received (strike price + premium).
Buying Puts
An investor who is bearish (believes that the price of a stock is going to decline) may speculate by
purchasing a put on that stock. For a put buyer, the formula for calculating the breakeven point is strike
price minus the premium paid. The investor’s profit begins once the stock’s price falls below the
breakeven price; with the greatest profit being realized if the stock’s price drops to zero and the put is
exercised. Therefore, the strike price minus the premium (i.e., the breakeven), times 100 shares, is the
investor’s maximum gain.
For an option buyer, the maximum loss is limited to the premium paid. If the stock’s price doesn’t decline
in value, the put buyer may simply choose to allow the put to expire unexercised. However, if this
happens, the buyer will lose his entire investment (premium).
For an investor who is bearish on a particular stock, buying a put is often an alternative to selling the
stock short. However, there are two significant differences—one is the time aspect and the other is the
amount of risk being assumed. For short sellers, there’s no required time limit for closing the position,
while for buyers of puts, the stock price must decline at some point before the option expires. The risk for
short sellers is that the stock’s potential increase is unlimited, while buyers of puts are risking only the
cost of the premium.

Closing the Position

Cash Out Cash In
1) An investor buys an XYZ May 30 put for a premium of $2. (Debit) (Credit)
2) The stock price drops to 26, and the investor closes the position by 1) $200
2) $400
selling the put at its intrinsic value.
(Strike Price 30 – Stock Price 26 = $4/share or $400) $200 $400
Using the same example, let’s assume that the investor chooses to exercise the put and therefore buys the
stock in the secondary market and then sells it at the strike price.
Exercise
1) An investor buys an XYZ May 30 put for a premium of $2.

Cash Out Cash In
2) The stock price drops to 26, the investor exercises the put, and buys the (Debit) (Credit)
stock in the market in order to make delivery. 1) $200
2) $2,600 3) $3,000
3) The investor completes his right and sells the stock at the 30 strike price.
$2,800 $3,000
4) The gain is $200. ($3,000 In – $2,800 Out = $200 In) 4) $200 gain
The gain for the investor could have been far greater than $200. For each $1 that the stock’s price
decreases, the intrinsic value of the option will increase by $1. However, the lowest price to which the
stock could fall is zero. Therefore, the maximum gain on this long put option is $2,800, which is
determined using the following calculation: the strike price ($30) minus the premium paid ($2) multiplied
by 100 shares [($30 – $2) x 100 sh.].
Now, let’s assume the underlying stock actually rises and the option expires out-of-the-money.
Expiration
Cash Out Cash In
1) An investor buys an XYZ May 30 put for a premium of $2. (Debit) (Credit)
1) $200
2) Later, at expiration, the stock is trading at 34 and the option expires 2) $0
worthless.
$200 $0

Even if the stock’s price increases to $100 per share, the maximum loss is the $200 premium. Remember,
buyers of options cannot lose more than the premium paid.
Finding Breakeven
An investor buys an XYZ May 30 put for a premium of $2. The breakeven is
simply the strike price minus the premium. 30 – 2 = 28 breakeven.
1) An investor buys an XYZ May 30 put for a premium of $2.
Cash Out Cash In
2) The owner of the put must be able to buy the stock in the market at 28 to (Debit) (Credit)
breakeven.
1) $2
3) After buying the stock at 28 and subsequently selling it at 30, the put
buyer receives a return of the premium paid. 2) $28
3) $30
4) To confirm the breakeven, the total cash out must equal the total cash in. 4) $30 $30
In order to breakeven, the buyer of the option needs to recover the premium paid. Therefore, the put
buyer needs to the stock to decrease below the strike price by an amount equal to the premium.
Selling Puts
Selling puts is an appropriate strategy for an investor who is bullish on a stock and is seeking to generate
income. At expiration, if the underlying stock is at or above the strike price, the option will expire
worthless and the seller will realize the maximum gain of the premium received. On the other hand, if the
stock falls and the put is exercised, the investor is obligated to buy the stock at a price that’s higher than
its current market value. The maximum potential loss is based on the stock falling to zero. The maximum
loss calculation is from the strike price (to zero) minus the premium received for selling the put. To
breakeven, a put writer needs the underlying stock to decline below the strike price by an amount equal to
the premium received.
Closing the Position Cash Out Cash In

1) An investor sells an XYZ May 30 put for a premium of $2. (Debit) (Credit)
1) $200
2) Later, with life remaining and the stock trading at 26, the investor closes
2) $500
the put position for its current premium of 5 (4 points of intrinsic value + 1
point of time value), or $500. $500 $200

Using the same example, let’s assume that the investor receives an exercise assignment. The assumption
is also made that the put writer, once he fulfills the obligation to buy the stock at the strike price, will
immediately sell the stock in the market.
Exercise and Sell Stock
1) An investor sells an XYZ May 30 put for a premium of $2.

Cash Out Cash In
2) The stock drops to 26, the seller is exercised against, and is obligated to (Debit) (Credit)
buy the stock at the strike price of 30. 1) $200
2) $3,000
3) $2,600
3) The investor subsequently sells the stock at the market price of 26.
$3,000 $2,800
4) The loss is $200. ($3,000 Out – $2,800 In = $200 Out) 4) $200 loss
The loss for this put seller could have been far greater than $200 since the value of the underlying stock could
decline to zero. If exercised against, a put seller is obligated to buy stock at the strike price; however, in the
worst case, the stock could be worthless. Therefore, the maximum loss for the seller of the XYZ May 30 put
who received a premium of 2 is $2,800—the strike price at which the stock must be purchased ($30/share)
minus the option’s premium ($2/share), multiplied by 100 shares.
Now let’s consider a situation in which the seller makes a profit.
Expiration Cash Out Cash In

(Debit) (Credit)
1) $200
2) $0
2) The stock rises to 32 and the option expires worthless.
$0 $200

Even if the price of the stock increases to $100, the maximum gain for an option seller is the premium
received, in this case, $200.
Finding Breakeven
An investor sells an XYZ May 30 put for a premium of $2. The breakeven is
simply the strike price minus the premium. 30 – 2 = 28 breakeven.
2) If exercised against, the put seller is obligated to buy the stock at the
Cash Out Cash In
strike price of 30. (Debit) (Credit)
1) $2
3) If the stock is able to then be sold at 28 (2 points lower than the strike 2) $30
price), the investor will breakeven due to the premium received. 3) $28
Once again, the breakeven point is the same for both the buyer and the seller. For put buyers to get their
money back, they need the stock to fall below the strike price by an amount equal to the premium paid
(strike price – premium). On the other hand, since put sellers are credited with the premium upfront,
they can afford to have the stock fall below the strike price by an amount equal to the premium received
(strike price – premium).
Formulas for Basic Options Positions

Consider this final section of basic options as a reference guide to simplify the process of handling
options and a review of the details regarding the four basic option positions. When an investor buys an
option, there’s cash taken out of his account (a debit). A buyer wants his option to become in-the-money
and generate intrinsic value. If the underlying stock moves in the buyer’s favor and the option is either
exercised or liquidated, the intrinsic value is essentially cash to be received. The difference between the
cash in and the cash out is the investor’s net gain or loss.
On the other hand, an option seller doesn’t want her contract to be in-the-money; instead, she wants it to
expire worthless so that she’s able to retain the premium income received from the sale (a credit). If the
underlying stock moves against the seller and the option is either exercised or liquidated, the intrinsic
value will actually result in cash being removed from her account. Once again, the difference between the
cash in and the cash out is the investor’s net gain or loss.
The Opposite Effect for Buyers and Sellers On a given contract, the profit and loss potential for the
buyer will always be the opposite of the profit and loss potential for the seller. Remembering this
opposite effect may be helpful since most students are able to grasp options from the buyer’s perspective,
but struggle with the concepts from the writer’s perspective.

For example, an investor who buys a 50 call option for 3 has a maximum potential loss of $300
(the premium), but a maximum potential gain of an unlimited amount. Conversely, the naked
writer of this call has a maximum potential gain of $300 (the premium), but a maximum potential
loss of an unlimited amount. Since it’s a call option, both the buyer and seller of the contract will
breakeven at 53 (strike plus premium).
In any basic option scenario, following the cash in and cash out will be useful in determining the
final outcome. There are also formulas that may be applied universally to certain option scenarios.
The following information summarizes the breakeven, maximum gain, and maximum loss for the
four basic option positions:
Buying Calls Selling Calls

Breakeven = strike price + premium paid Breakeven = strike price + premium received
Maximum Gain = unlimited Maximum Gain = premium received
Maximum Loss = premium paid Maximum Loss = unlimited
Buying Puts Selling Puts

Breakeven = strike price – premium paid Breakeven = strike price – premium received
Maximum Gain = strike price – premium x 100 shares Maximum Gain = premium received
Maximum Loss = premium paid Maximum Loss = strike price – premium x 100 shares
When examining the four basic positions, there are several patterns that emerge:
 The buyer’s maximum gain is the same as the seller’s maximum loss.
 The buyer’s maximum loss (the premium paid) is the same as the seller’s maximum gain (the
premium received).
 Buyers and sellers have the same breakeven point
− For calls: strike plus premium
− For puts: strike minus premium
 Buyers of calls and sellers of puts are bullish.
 Sellers of calls and buyers of puts are bearish.
The strategy of each position can be illustrated as follows:
Buyer Seller
Call Bullish  Bearish 
Put Bearish  Bullish 

It’s important to gain a reasonable understanding of these four basic option positions before moving on to
other option strategies. Keep in mind that investors may buy or sell more than one option, the strike
prices may be more than two digits, the premiums may include amounts of less than $1, and the actual
gains or losses may be less than the potential maximums.
The following example illustrates these points:

An investor is short 3 October XYZ 230 calls at 6.25. Later, XYZ stock is trading at $235 and
the investor closes out the calls at their intrinsic value. What’s the actual gain or loss?
Closing the Position Cash Out Cash In

1) An investor sells 3 XYZ October 230 calls each with a premium of $6.25. (Debit) (Credit)
1) $625 per
2) Later, with the stock trading at 235, the investor closes the position at its 2) $500 per contract
intrinsic value (Stock price of 235 – Strike price of 230) contract
3) The investor has a net gain of $125 per contract. However, since the 3) $125 x 3
investor sold 3 call options, the total gain is $375 ($125 x 3 contracts). gain
Multiple Option Strategies

Certain option strategies are more complex than the simple purchase or sale of a call or a put. Straddles,
combinations, and spreads are strategies that involve the use of two or more options. Although these
complex positions may seem daunting at first, analyzing them is based on the same general rules that
were used to analyze basic option positions.
Straddles
A straddle is established with either the purchase of both a call and a put or the sale of both a call and
a put. Each option will have the same underlying security, the same exercise price, and the same
expiration date. If an investor buys both options, the position is referred to as a long straddle and, if
the investor writes both options, it’s referred to a short straddle. Each individual option position is
often referred to as a leg of the straddle.
Long Straddle Short Straddle

Buy 10 ABC May 60 calls Sell 10 XYZ July 40 calls
Buy 10 ABC May 60 puts Sell 10 XYZ July 40 puts
The purpose of either buying or writing a straddle is to speculate on the potential price movement (or lack
thereof) in the underlying security. The buyer of a straddle expects the price of the underlying stock to be
volatile, while the seller of a straddle expects the price of the underlying security to be stable (no volatility).

Long Straddles
An investor who buys a straddle anticipates that there will be substantial movement in the price of the
underlying security, but is uncertain as to the specific direction of that movement. Since a long straddle
involves buying both a call and a put, the investor has the opportunity to profit from any subsequent
increase or decrease in the price of the underlying security. The following example will illustrate a long
straddle’s the maximum gain, maximum loss, and breakeven:
ABC Incorporated is a small pharmaceutical company that believes it has found a cure for
the common cold. Before releasing this new product, it must first be tested and receive
governmental approval. If the product is approved, the company’s stock is expected to
experience tremendous gains. On the other hand, if the product is found to be unsafe,
disappointed investors may seek to sell the stock, thereby causing the stock’s price to fall
dramatically. Since the investor believes ABC’s market price has the potential to either rise
or fall dramatically, he enters an order to buy an ABC May 60 straddle at a premium of 5.
Creating a Long Straddle Position Cash Out Cash In

1) An investor buys 1 ABC May 60 call at a premium of 3. (Debit) (Credit)
1) $300
2) The investor also buys 1 ABC May 60 put at a premium of 2. 2) $200
3) The investor’s total (gross) premium is $500. 3) $500
Breakeven Since the buyer of a straddle is buying two options and paying two premiums, he must
recover the cost of both premiums in order to breakeven. A straddle has two breakeven points—one for
the call option and one for the put option. The calculation for finding the breakeven point on the call is
the strike price plus the total premium, while the calculation for finding the breakeven point on the put is
the strike price minus the total premium. In the example above, the buyer’s breakeven on the call is 65
(the 60 strike price plus the total premium of 5), while the breakeven on the put is 55 (the 60 strike price
minus the total premium of 5). In other words, to breakeven, the buyer of the straddle needs the price of
the stock to either rise or fall by 5 points in order to recover the cost of the total premiums paid. Any
additional movement up or down beyond the breakeven points will generate a profit for the buyer.
65 Call Breakeven

Strike Price 60

55 Put Breakeven
Maximum Gain The call leg of the straddle appreciates if the underlying stock increases, while the put
leg of the straddle appreciates if the underlying stock decreases. However, the long straddle will only be
profitable if the movement in the underlying stock exceeds the combined premium paid for the straddle.

If the stock’s market price rises above 65 (the breakeven point of the call) or falls below 55
(the breakeven point of the put), the investor will begin to experience a profit.
With a straddle, the only way one of the options will not be in-the-money is if the underlying stock’s
price remains at the strike price. The buyer of a straddle has an unlimited gain potential due to the long
call leg, while the potential gain on the put leg is based on the possibility that the stock’s price could fall
to $0. Let’s move the market value of the stock to examine an investor’s potential gains.
If ABC’s stock is trading at $50, the 60 call is out-of-the-money, but the 60 put is in-the-money by
10 points. If the investor closes out the positions at their intrinsic values, the net gain is $5/share, or
$500 as shown below:
Calculating a Gain on Falling Stock

1) An investor buys 1 ABC May 60 call at a premium of 3.
Cash Out Cash In
(Debit) (Credit)
2) $200
3) $0
3) The stock falls to $50 and the 60 call expires worthless (0 intrinsic value).
4) $1,000
4) With the stock at $50, the 60 put is closed out for its intrinsic value of 10. $500 $1,000
In other words, the investor sells 1 ABC May 60 put at a premium of $10.
5) $500 gain
5) The net gain is $500 ($1,000 In – $500 Out).
If ABC’s stock is trading at $72, the put is out-of-the-money, but the call is in-the-money by 12 points.
If the investor closes out the positions at their intrinsic values, the net gain is $7/share, or $700 as
shown below:
Calculating a Gain on Rising Stock

Cash Out Cash In
(Debit) (Credit)
2) $200 3) $0
3) The stock rises to $72 and the 60 put expires worthless (0 intrinsic value).
4) $1,200
4) With the stock at $72, the 60 call is closed out for its intrinsic value of 12. $500 $1,200
In other words, the investor sells 1 ABC May 60 call at a premium of $12.
5) $700 gain
5) The net gain is $700 ($1,200 In – $500 Out).

Maximum Loss The maximum loss on the position will be realized if the options expire with the stock
price equal to the strike price. In other words, if the stock neither rises above nor falls below the strike price,
both options will expire worthless and the investor will experience the maximum loss of the total (gross)
premium. Remember, an investor who buys a straddle is expecting volatility.
Maximum Loss Cash Out Cash In

(Debit) (Credit)
1) $300
2) The investor also buys 1 ABC May 60 put at a premium of 2. 2) $200 3) $0
3) At expiration, if ABC’s market value is at $60, both options expire 3) $0
worthless. $500 $0
4) The buyer’s maximum loss is the total (gross) premium of $500. 4) $500 loss
As mentioned repeatedly for the buyers of basic option positions, the maximum loss for the buyers of
straddles is the total premium paid.
Buy 1 ABC May 60 Call at 3

Buy 1 ABC May 60 Put at 2
 Maximum profit potential is unlimited if ABC rises above $65

Call
65
Breakeven

60 Loss Range

Put
55
Breakeven
 Maximum profit potential is $5,500 if ABC falls to $0
Short Straddles
An investor who writes a straddle is seeking to generate income from both the call and put premiums.
The seller is neither bullish nor bearish; instead, the seller expects there to be little or no fluctuation in the
market price of the underlying stock. In other words, the seller of a straddle is expecting stability.

The process for calculating the breakeven points for the seller of a straddle is the same as used for the
buyer—the strike price plus and minus the total (gross) premium. However, the seller of the straddle will
profit if the stock’s market price stays within the range of these two breakeven points.
For example, XYZ Company is in the packaged food industry and its stock is
considered defensive. An investor feels that XYZ will not be volatile over the upcoming
months and, therefore, enters an order to write an XYZ July 40 straddle at a premium of 6.
Creating a Short Straddle Position

Cash Out Cash In
1) An investor sells 1 XYZ July 40 call at a premium of 4. (Debit) (Credit)
1) $400
2) The investor also sells 1 XYZ July 40 put at a premium of 2. 2) $200
3) The investor’s total (gross) premium is $600. 3) $600
Breakeven Since the seller of a straddle has received both premiums, she’s able to sustain the risk of
the stock either rising above, or falling below, the strike price by an amount equal to the total (gross)
premium received. The breakeven on the call is 46 (the strike price of 40 plus the total premium of 6),
while the breakeven on the put is 34 (the strike price of 40 minus the total premium of 6). Any additional
movement above or below the breakeven points will generate a loss for the seller of the straddle.
46 Call Breakeven

Strike Price 40

34 Put Breakeven
Maximum Gain The gain for the seller of a straddle is based on the market price of the stock remaining
between the breakeven points. Ultimately, the seller’s maximum gain is the total premium received which
is realized if both options expire at-the-money. In the above example, at expiration, if the market price of
XYZ’s stock is $40 (the same as the strike price), both options will be worthless and the maximum gain
is the premium of $6/share, or $600.
Maximum Gain
1) An investor sells 1 XYZ July 40 call at a premium of 4. Cash Out Cash In
2) The investor also sells 1 XYZ July 40 put at a premium of 2.
(Debit) (Credit)
1) $400
3) Later, at expiration, XYZ’s market price is $40 and both options expire 2) $200
worthless. The seller realizes the maximum gain of the $600 total (gross)
3) $600
premium.

Maximum Loss With a short straddle, there’s a very limited potential gain (the total premium), but a
significant potential loss. Using the example above, if the stock’s price moves anywhere outside of the
breakeven points—above 46 or below 34—the investor will lose money. Since the investor is short a call
option and the stock’s potential increase is infinite, the maximum loss is unlimited. Though not as
significant as the short call, the short put leg presents a maximum potential loss of $3,400 if the stock
declines to $0.
To demonstrate calculating a loss, let’s assume that XYZ’s stock is trading at $52 at expiration. At this
point, the put is out-of-the-money and expires worthless, but the call is closed out at its intrinsic value of
12 points. Based on the actions of the seller of the straddle, the net loss is $6/share, or $600.
Calculating a Loss on Rising Stock

1) An investor sells 1 XYZ July 40 call at a premium of 4 Cash Out Cash In
(Debit) (Credit)
2) The investor also sells 1 XYZ July 40 put at a premium of 2. 1) $400
3) $0 2) $200
3) The stock rises to $52 and the put expires worthless (0 intrinsic value).
4) $1,200
4) With the stock at $52, the 40 call is closed out for its intrinsic value of 12. $1,200 $600
In other words, the investor buys 1 XYZ July 40 call at a premium of $12.
5) $600 loss
5) The net loss is $600 ($1,200 Out – $600 In).
Sell 1 XYZ July 40 Call at 4

Sell 1 XYZ July 40 Put at 2
 Maximum loss potential is unlimited if XYZ rises above $46

Call Breakeven 46

40 Gain Range

Put Breakeven 34
 Maximum loss potential is $3,400 if XYZ falls to $0

0

Combinations
A combination is simply a straddle position with contracts that have different exercise prices and/or
different expiration months. The following is an example of a long combination:
Buy 5 DEF March 50 Calls at 3

Buy 5 DEF March 40 Puts at 1
The process for determining an investor’s strategy, breakeven point, maximum gain, and maximum loss
for a combination is the same as with a straddle.
For the above position, each combination was purchased for a total (gross) premium of 4.
The breakeven point for the calls is $54 (the call strike price of $50 plus the total premium
of 4), while the breakeven point for the puts is $36 (the put strike price of $40 minus the
total premium of 4). This strategy will be profitable if DEF either increases above $54 or
decreases below $36. Since the position above involves multiple contracts, the total
premiums paid and the maximum loss are determined by multiplying by the number of
combinations created. Therefore, the total premium paid is $2,000 ($400 x 5) which also
represents the maximum loss for the buyer. Of course, the maximum gain remains
unlimited (on the long call).
Spreads
The next combined option position to examine is a spread. Spreads are option positions in which investors
are willing to accept a limited gain for the assurance of knowing that they have a limited loss. Spreads
involve the simultaneous sale and purchase of two calls, or two puts, on the same underlying security;
however, the expiration months and/or strike prices will be different. For exam purposes, it’s important to
become familiar with the different types of spread positions and to be able to classify them.
Classifying Spreads
The first classification of a spread is simply whether both options are calls (a call spread) or both options
are puts (a put spread). Once that determination is made, it’s important to analyze the differences between
the two options based on the strike price and/or expiration of each option.

Price Spread When the two options of the spread have the same expiration month, but different strike
prices, it’s referred to as a price, dollar, or vertical spread. The term vertical is based on the concept of
strike prices being listed on a chart vertically. It’s only on vertical spreads that the Series 7 Exam will
require detailed analysis.
Buy 1 ABC March 30 call
Write 1 ABC March 40 call
Time Spread When the two options of the spread have the same strike price, but different expiration
months, it’s referred to as a time, calendar, date, or horizontal spread. The term horizontal is based on
the concept of time always being measured on the horizontal.
Write 1 ABC June 30 call
Note: For horizontal spreads, the option with the longer expiration will have the larger premium.
Diagonal Spread If the two options of the spread have different strike prices and different expiration
months, it’s referred to as a diagonal spread. The term diagonal is based on the merging of both a vertical
and horizontal spread.
Write 1 ABC June 40 call
Notice that when a spread is created, an investor is receiving a premium for the option being sold as well as
paying a premium for the option being purchased. For this reason, the result is referred to as a net premium.
While students are still required to determine an investor’s strategy, breakeven point, maximum gain, and
maximum loss, spreads also require some additional analysis. To begin the process of analyzing a spread, the
first step is to identify the dominant leg. The dominant leg is simply the option that has the largest premium.
By recognizing the dominant leg of the spread, a person is able to determine:

 Whether the investor is a buyer or seller
 Whether the position is a debit or credit
 Whether the investor wants the spread to widen or narrow
 Which strike price to use to determine the breakeven point
 Whether the investor is bullish or bearish on the underlying security
 The maximum gain and loss on the position

Net Debit Spreads

Let’s consider the following example:
Buy 1 ABC March 40 Call at 3
Sell 1 ABC March 45 Call at 1
Step 1: Which leg is dominant? In this example, the purchase of the 40 call is the dominant leg since
the premium of 3 is larger than the premium of 1.
Step 2: Is the investor a buyer or seller? Because the dominant leg is the buy leg, the investor is
considered the buyer of the spread.
Step 3: Is it a debit or credit spread? The sale and purchase will result in either a net debit spread
(more money paid out than taken in) or a net credit spread (more money taken in than paid out). In this
example, since the investor bought the option that has the higher premium and sold the option that has the
lower premium, he has established a net debit spread. An investor who creates a net debit spread is
considered the buyer of the spread or long the spread.
Creating a Net Debit Spread

Cash Out Cash In
1) An investor buys 1 ABC March 40 call at a premium of 3.
(Debit) (Credit)
2) The investor also sells 1 ABC March 45 call at a premium of 1. 1) $300
2) $100
3) Since the investor paid out 3, but received 1, the net debit is 2.
(3 Out – 1 In). 3) $200
Step 4: Does the investor want the spread (difference) between the premiums to widen or narrow?
For the buyer of a spread to achieve a profit, he needs the spread to widen. The concept of the widening
or narrowing of the difference between the premiums relates to calculating an investor’s gain or loss if
the options are subsequently closed out.

Let’s move the market price of ABC stock to describe how the buyer profits from the widening of the
spread.
The Spread Widens

1) An investor buys 1 ABC March 40 call at a premium of 3.
2) The investor also sells 1 ABC March 45 call at a premium of 1.
3) At expiration, ABC rises to $46 and the investor closes out the long call
for its intrinsic value of 6. In other words, the investor sells 1 ABC March Cash Out Cash In
40 call at a premium of $6. (Debit) (Credit)
1) $300
4) The short call is also closed out for its intrinsic value of 1. In other words, 2) $100
the investor buys 1 ABC March 45 call at a premium of $1. 3) $600
5) When closing out the options, the 40 call that was bought for 3 is later 4) $100
sold for 6, and the 45 call that was sold for 1 is later bought for 1. The $400 $700
spread between the premiums widened from the initial difference
5) $300 gain
of 2 to a difference of 5, resulting in a $300 gain.
A helpful coincidence is that the words buyer, debit, and widen each have five letters.
Step 5: Which strike price is used to determine the breakeven point? The breakeven point for a
vertical spread will always be located in between the two strike prices. The challenge is selecting the
right strike price when calculating the breakeven point. The selection process is made easier by
identifying that the 40 call is the dominant leg. Since the example is a call spread, the net premium of 2 is
added to the strike price of 40. Therefore, the breakeven point for the investor is 42 (which falls between
the strike prices of 40 and 45).
45
42 Breakeven
40
A helpful tip is to remember that for call spreads, the dominant leg will always be the call with the lower
strike price. In other words, the lower the strike price of the call, the higher its premium.
Step 6: Is the investor bullish or bearish on the underlying stock? By recognizing that the dominant leg
of the spread is the purchase of the 40 call, it’s easy to determine that the investor is bullish on ABC stock.
In the example, the investor bought the 40 call in hopes of the stock rising moderately. By selling the 45
call, the investor received the premium which serves to lower his cost of creating the bullish position.

Step 7: What’s the investor’s maximum gain? Since the buyer of the call spread is bullish, he will
profit if the stock rises. Remember, the investor needs the stock to rise to 42 in order to breakeven, but he
will realize a gain if it goes higher. However, the gain on a spread (even on a call spread) is limited.
Although the stock may continue to rise, the investor’s gain will not continue if the stock increases
beyond the price of 45.
In the example, the buyer of the call spread has the right to buy ABC stock at 40, but also has an
obligation to sell ABC stock at 45 if exercised against. Therefore, the maximum gain is the difference in
the strike prices (5 points) minus the net premium paid (2 points), which is 3 points, or $300.
Step 8: What’s the investor’s maximum loss? The investor is the buyer of the spread and, as was true
for basic option positions, the maximum loss for a buyer is the premium paid. The only modification
required for debit spreads is to recognize that the maximum potential loss is the net premium paid. For
this example, the investor’s maximum loss is the net premium of $2, or $200.
For the buyer of a spread, the loss is based on the options expiring unexercised. In this example, if the
stock doesn’t rise, but instead stays at 40 or lower, both options will expire and the investor will lose the
net premium.
$300 maximum gain

45
Gain
42 Breakeven
Loss
40
$200 maximum loss
The diagram above summarizes the possibilities for this example. The investor’s strategy is bullish and he
needs the stock to increase by the net premium of 2 in order to breakeven. If the stock rises, he could
profit from 42 to the higher strike price of 45, resulting in a $300 gain. However, the gain doesn’t
continue beyond 45 since he has the right to buy the stock at 40, but if exercised against, he’s obligated to
sell the stock at 45. The investor will lose money if the stock is below the breakeven of 42. The maximum
loss of the $200 net premium is realized if the stock is at or below 40 and the options expire worthless.
Remember, spreads provide a limited potential gain as well as a limited potential loss. For a debit spread,
the maximum gain is determined by the difference in the strike prices minus the net premium. The
subsequent maximum loss is the net premium.

The following is a summary of maximum gain, loss, and breakeven for a net debit spread:
Debit Spreads
Profitability: Spread widens
For call spreads:
 The lower strike price + the net premium
Breakeven:
For put spreads:
 The higher strike price – the net premium
Maximum Gain: The difference between the strikes – the net premium
Maximum Loss: The net premium (or net debit)
Net Credit Spreads

Sell 1 XYZ October 65 Put at 7
Buy 1 XYZ October 55 Put at 1
Step 1: Which leg is dominant? In this example, the sell leg is dominant since the premium of 7 is
larger than the premium of 1.
Step 2: Is the investor a buyer or seller? Because the dominant leg is the sell leg, the investor is
considered the seller of the spread.
Step 3: Is it a debit or credit spread? The sale and subsequent purchase results in a net credit spread
(more money taken in than paid out). In this example, since the investor sold the option that has the
higher premium and bought the option that has the lower premium, he has established a net credit spread.
An investor who creates a net credit spread is considered the seller of the spread or short the spread.
Creating a Net Credit Spread

Cash Out Cash In
1) An investor sells 1 XYZ October 65 put at a premium of 7.
(Debit) (Credit)
2) The investor also buys 1 XYZ October 55 put at a premium of 1. 1) $700
2) $100
3) Since the investor received 7, but paid out 1, the net credit is 6.
(7 In – 1 Out). 3) $600
Step 4: Does the investor want the spread (difference) between the premiums to widen or narrow?
For the seller of a spread to achieve a profit, he needs the spread to narrow. Again, the concept of whether
an investor wants the difference between the premiums to widen or narrow relates to calculating an
investor’s gain or loss if the options are subsequently closed out.

Let’s move the market price of XYZ stock to describe how the buyer profits from the narrowing of the
spread.
The Spread Narrows

1) An investor sells 1 XYZ October 65 put at a premium of 7.
2) The investor also buys 1 XYZ October 55 put at a premium of 1.
3) At expiration, XYZ is at $64 and the investor closes out the short put for
its intrinsic value of 1. In other words, the investor buys 1 XYZ October 65
put at a premium of $1. Cash Out Cash In
(Debit) (Credit)
4) With the stock at $64, the 55 put has 0 intrinsic value and, therefore, it
1) $700
expires worthless. In other words, the investor is not able to to sell 1 XYZ 2) $100
October 55 put for profit. 3) $100
4) $0
5) When closing out the options, the 65 put that was sold for 7 is later bought $200 $700
for 1, and the 55 put that was bought for 1 later expires worthless. The
spread between the premiums narrowed from the initial difference 5) $500 gain
of 6 to a difference of 1, resulting in a $500 gain.
In this case, a helpful coincidence is that the words seller, credit, and narrow each have six letters.
Step 5: Which strike price is used to determine the breakeven point? Remember, the breakeven point
for a vertical spread will always be located in between the two strike prices. By recognizing that the 65
put is the dominant leg, it’s at the 65 strike price that the calculation begins. Since this is a put spread, the
net premium of 6 is subtracted from the strike price of 65. Therefore, the breakeven point for the investor
is 59 (which falls between the strike prices of 65 and 55).
65
59 Breakeven
55
When dealing with put spreads, the dominant leg will always be the put with the higher strike price. In
other words, the higher the strike price of the put, the higher its premium.
Step 6: Is the investor bullish or bearish on the underlying stock? By recognizing that the dominant
leg of the spread is the sale of the 65 put, it’s easy to determine that the investor is bullish on XYZ stock.
In the example, the investor sold the 65 put with the belief that the stock will rise moderately. By
purchasing the 55 put, the investor has limited the potential loss of the stock actually declining in value.

Step 7: What’s the investor’s maximum gain? The same rule that applied to basic option positions
remains true with spreads—the maximum gain for a seller is the premium received. Again, the only
modification required for credit spreads is to recognize that the maximum potential gain is the net
premium received. For this example, the investor’s maximum gain is the net premium of $6, or $600.
For the seller of a spread, the gain is based on the options expiring unexercised. In this example, if the
stock doesn’t fall, but instead stays at 65 or higher, both options will expire and the investor will retain
the net premium.
Step 8: What’s the investor’s maximum loss? Since the seller of the put spread is bullish, he will
experience a loss if the stock declines. Remember, the investor can afford the stock declining to 59 (the
breakeven point) because of the 6 points of premium received, but he will begin to lose money if the
stock falls below 59. However, it’s important to remember that the loss on a spread is limited. Although
the stock’s price may decline more, the investor’s loss will not continue even if the stock’ price decreases
lower than the price of 55.
In this example, if exercised against, the seller of the put spread has an obligation to buy XYZ stock at
65, but also has the right to sell XYZ stock at 55. In other words, if the stock is put to him at 65, he’s able
to put it to another person at 55. Therefore, the maximum loss is the difference in the strike prices (10
points) minus the net premium received (6 points), which is 4 points, or $400.
$600 maximum gain

65
Gain
59 Breakeven
Loss
55
$400 maximum loss
The diagram above summarizes the possibilities for this example. The investor’s strategy is bullish;
however, as a seller, he can afford having the stock’s price decrease by an amount equal to the net
premium of 6 and still breakeven. The investor will make money if the stock is above the breakeven of
59. The maximum gain of the $600 net premium is realized if the stock is at or above 65 and the options
expire worthless. If the stock falls below the breakeven point of 59, the investor could lose down to the
strike price of 55, resulting in a $400 loss. However, the loss doesn’t continue beyond 55 since, if
exercised against, he has the obligation to buy the stock at 65, but also has the right to sell the stock at 55.
Remember, spreads provide a limited potential gain as well as a limited potential loss. For a credit
spread, the maximum gain is the net premium. The maximum loss is determined by the difference in the
strike prices minus the net premium.

The following is a summary of maximum gain, loss, and breakeven for a net credit spread:
Credit Spreads
Profitability: Spread narrows
For call spreads:
 The lower strike price + the net premium
Breakeven:
For put spreads:
 The higher strike price – the net premium
Maximum Gain: The net premium (or net debit)
Maximum Loss: The difference between the strike prices – the net premium
Spread Strategies
The goal of this section on spreads is to provide students with some basic tools in order to quickly answer
exam questions. By identifying the dominant leg of the spread (the option with the larger premium), much of
the mystery is eliminated. As it relates to questions of whether an investor is bullish or bearish, remember the
basic options chart:
Buyer Seller
Bullish Strategy Bearish Strategy
Call
(right to buy) (obligation to sell )
Bearish Strategy Bullish Strategy
Put
(right to sell) (obligation to buy)
A particular challenge that the exam may introduce is a spread example that doesn’t indicate the premiums
associated with the two options. To address these questions, it becomes imperative to remember that the
lower the strike price of a call spread, the higher the premium; and the higher the strike price of a put spread,
the higher the premium.
Let’s consider the following four examples without premiums and determine as much as possible from the
given information:
Example 1: Buy 1 XYZ May 30 call
Sell 1 XYZ May 40 call
Since the investor bought the 30 call (lower strike), he’s bullish. Also, as a buyer, the investor has created a
debit spread and wants the spread to widen. Notice the five letter theme with the words buyer, debit, and
widen.
Example 2: Buy 1 XYZ May 80 call
Sell 1 XYZ May 70 call
Since the investor sold the 70 call (lower strike), she’s bearish. Also, as a seller, the investor has created a
credit spread and wants the spread to narrow. Notice the six letter theme with the words seller, credit, and
narrow.

Example 3: Buy 1 XYZ May 50 put

Sell 1 XYZ May 40 put
Since the investor bought the 50 put (higher strike), he’s bearish. Also, as a buyer, the investor has created a
debit spread and wants the spread to widen. Again, buyer, debit, and widen.
Example 4: Buy 1 XYZ May 20 put

Sell 1 XYZ May 30 put
Since the investor sold the 30 put (higher strike), she’s bullish. Also, as a seller, the investor has created a
credit spread and wants the spread to narrow. Again, seller, credit, and narrow.
Working with Vertical Spreads

Identify the “dominant leg” – the option with the larger premium
This dominant leg determines whether an investor is a buyer or seller and, therefore, the
investor’s strategy
 For Calls, this will be the lower strike price
 For Puts, this will be the higher strike price
Calculate the net premium (the larger premium minus the smaller premium)
 For a buyer, this is the maximum loss

 For a seller, this is the maximum gain
Determine the breakeven point
From the strike price of the dominant leg, either add or subtract by an amount equal to the
net premium
 For Calls, strike price plus the net premium
 For Puts, strike price minus the net premium
Butterfly Spreads
A butterfly spread consists of two spreads that are established simultaneously —one is a bullish spread
and the other is a bearish spread. The resulting position is neutral, with the investor realizing a profit if
the stock is stable.
An investor creates the following butterfly spread:
Long 1 ABC June 90 call at 4,
Short 2 ABC June 80 calls at 7 each, and
Long 1 ABC June 70 call at 13

Butterfly spreads are established at a net debit and have two breakeven points. The maximum profit will
occur if the stock is at the middle strike price at expiration; however, some profit will be earned as long
as the stock’s price remains between the two breakeven points. If the stock rises above or falls below the
breakeven points, the losses are limited to a specific amount.
If it’s assumed that the intervals between the strike prices are equal (such as the 10-point intervals in this
example), the key properties of the butterfly spread are as follows:
Maximum Loss = Net Debit
Maximum Gain = Interval between Strike Prices – Net Debit
Lower Breakeven = Lowest Strike Price + Net Debit
Higher Breakeven = Highest Strike Price – Net Debit
From the previous example, the net debit is 3.
Buy 70 Call 13.00 Sell 80 Call 7.00

Sell 80 Call 7.00 Buy 90 Call 4.00
Net Debit: 6.00 Net Credit: 3.00 Total Net Debit: 3.00
In other words, if an investor pays out a total of 17 in premiums, but receives 14, he will have a net debit
of 3 which represents the maximum loss. The maximum gain is 7, which is the 10-point strike price
interval minus the net debit of 3. The lower breakeven point is 73 (70 + 3) and the higher breakeven point
is 87 (90 – 3).
Since there are three positions that must be established—the separate purchases of the 70 call and the 90
call and the sale of two 80 calls—a disadvantage to this strategy is the relatively high commissions
involved.
Using Options as a Hedge (Protection)

Previously, the assumption was made that the investors who bought or sold options on an underlying stock
did not actually have an existing stock position. On the long side, buyers of options could quickly lose their
entire premium, while on the short side, uncovered (naked) option writers could suffer substantial losses
(e.g., unlimited for short calls) if the position moves against them. For these reasons, many investors believe
that options are only suitable for clients who are interested in speculation or those with an aggressive risk
profile. However, options may also be used to reduce risk. Hedging (protection) strategies are created by
investors who are either long or short stock and buy an option to protect their existing stock positions
against the risk of adverse movement.
When a person wants to insure or protect his life, home, or car, he purchases an insurance policy.
Similarly, if a person has a long or short stock position and wants to hedge or protect against potential
risk, he may purchase an option.

For example, if a customer has a long stock position, he’s generally concerned about the stock declining
in value and his need to lock in the price at which he can resell the stock. By purchasing a put on the
underlying long stock position, it will give the investor the right to sell the stock at a fixed price.
However, as to be expected, this right comes at a cost, which is the option’s premium.
Conversely, if a client has a short stock position, her risk is that the stock will rise in value and her cost of
covering (buying back) the stock position will be at an unknown market price. If the investor buys a call
on the stock, she will have the right to buy back the short stock position at a fixed price. Again, the
comfort of locking in a purchase price comes at a cost, which is the option’s premium.
As explained above, both of the investors have essentially purchased insurance policies in the event that
the stock position moves in the wrong direction. Each investor paid the option’s premium to obtain the
right to exit their existing stock position at a predetermined price. Essentially, the purchase of the option
doesn’t change the unlimited upside potential of their stock position. It’s important to note that the core
stock position determines the direction in which the investor wants the stock to move. The option is of
secondary importance and is bought to simply hedge (protect) the core stock position.
The following chart summarizes the two basic hedging strategies:
Hedging Strategy Reasons

 Provides the right to sell
If Long Stock Buy a Put
 Protects downside risk
 Provides the right to buy
If Short Stock Buy a Call
 Protects upside risk
Now let’s examine the mechanics of each strategy.
Long Stock + Long Put (Protective Put)

A protective put is purchased as an insurance policy against a possible decline in an investor’s long stock
position. For example, due to a bullish outlook on ABC stock, an investor executes the following:
Purchases 100 shares of ABC at $91 and, since she’s worried about a potential price
decline in the stock, she also buys an ABC November 90 put at 2.
The immediate impact is that her cost for the position has increased to $93 (the $91 cost per share for the
stock plus the $2 cost per share for the option). The combination of the stock’s purchase price plus the
cost of the option (91 + 2 = 93) is also the investor’s breakeven point on the total position. If the stock is
subsequently able to be sold at $93 per share, the investor will receive a full return of her investment.

Finding Breakeven
An investor buys 100 shares of ABC at $91/share and buys 1 ABC November
90 put at $2. The breakeven is simply the cost of the stock plus the premium.
91 + 2 = 93 breakeven.
1) An investor buys 100 shares of ABC at $91/share. Cash Out Cash In
(Debit) (Credit)
2) The investor also buys 1 ABC November 90 put at $2.
1) $91
3) The investor has total cash out of $93. 2) $2
3) $93 4) $93
4) The investor must sell the stock at $93 in order to breakeven.
If the stock rises above 93, the investor will begin to profit on the overall position. Remember, since the
investor is still bullish on her stock position, the maximum gain is unlimited due to the upside potential of
the stock.
Maximum Gain Cash Out Cash In

(Debit) (Credit)
1) An investor buys 100 shares of ABC at $91/share.
1) $9,100
2) The investor also buys 1 ABC November 90 put at $2. 2) $200
3) Since the stock could increase an infinite amount, the maximum gain is 3) Theoretically
$9,300
unlimited. unlimited
Protecting Capital The importance of buying the put really becomes evident if the stock declines in
value. The purchase of the put guarantees that the investor will be able to sell her stock at $90 per share.
Therefore, if the option is exercised, her potential loss is limited to $300 ($9,300 cost basis – $9,000
proceeds on the sale of the stock) as shown below.
Maximum Loss
1) An investor buys 100 shares of ABC at $91/share. Cash Out Cash In
(Debit) (Credit)
2) The investor also buys 1 ABC November 90 put at $2. 1) $9,100
2) $200
3) Later, ABC stock drops to $80/share, the put is exercised, and stock is 3) $9,000
subsequently sold at the $90 strike price. $9,300 $9,000
4) The maximum loss is $300 ($9,300 Out – $9,000 In) 4) $300 loss

Regardless of how low the stock’s price declines (even to zero), the maximum loss on the position is $300.
However, it’s important to remember that the hedge will only be effective for as long as the option has life
remaining. Essentially, the put purchase provides the investor with what amounts to term insurance. If the
stock is trading at $90 per share or higher at expiration, the option will expire unexercised and the investor
will lose the $200 premium and will need to purchase another put to keep the position hedged.
Another possibility is that the investor could buy a put with a strike price that’s lower than 90. For
instance, if she buys a put with an $85 strike, the option will be cheaper to purchase since it’s more out-of-
the-money, but the potential loss on the stock is greater (from $91 to $85 plus the premium).
In our example, although the investor bought a put, she’s actually bullish because her focus is on the
stock position. The long stock position offers an unlimited gain potential since the potential increase in
the stock’s price is infinite.
Preserving Profits In addition to being used to limit loss, puts may protect a gain in a long stock
position. For example, a client buys 100 shares of RSR at $50 per share. Several months later, with the
stock trading at $74 per share, the investor may choose to buy an RSR July 70 put for a premium of 1.
For the investor, the put purchase locks in a sale price of $70 per share; therefore, even if the price of
RSR declines to $60 per share, the investor is able to exercise the put and secure a net profit of $1,900 (as
shown below).
Preserving Profit
Cash Out Cash In
1) An investor buys 100 shares of RSR at $50. (Debit) (Credit)
2) Months later, the investor buys an RSR July 70 put at $1. 1) $5,000
2) $100
3) Later, the stock falls to $60 and the investor exercises the put and sells 3) $7,000
the stock at the strike price of $70. $5,100 $7,000
4) The investor has a net gain $1,900. ($7,000 In – $5,100 Out) 4) $1,900 gain
Short Stock + Long Call (Protective Call)

Options may also be used to hedge an investor’s short stock position. When selling stock short, investors
borrow stock and sell it in anticipation of a price decline. A short seller is bearish and, if the stock price
does fall, the investor is able to buy the stock at a lower price and close out the position. The difference
between the proceeds generated by the short sale and the cost of buying the stock back will be the
investor’s resulting gain or loss.
A protective call is purchased as an insurance policy against a possible increase in the market value of the
stock that has been sold short. For example, an investor executes the following:
Sells short 100 shares of XYZ at 48 and, out of fear that the price of XYZ stock may
rise, he buys an XYZ November 50 call at a premium of 3.

The investor’s net proceeds are 45 (48 sale price – 3 premium), which also represents the investor’s
breakeven point on the position. Essentially, the investor needs the stock’s price to fall 3 points in order
to recover the call premium.
Finding Breakeven
An investor sells short 100 shares of XYZ at $48/share and buys 1 XYZ
November 50 call at $3. The breakeven is simply the proceeds from the short
sale minus the premium. 48 – 3 = 45 breakeven.
1) An investor sells short 100 shares of XYZ at $48/share.
Cash Out Cash In
2) The investor also buys 1 XYZ November 50 call at $3. (Debit) (Credit)
1) $48
3) To recover the cost of the premium and ultimately breakeven, the investor 2) $3
needs to be able to purchase the stock at 45. 3) $45
If the stock’s price falls below $45, the investor will begin to profit on the overall position. Ultimately,
the maximum gain is realized if the stock price falls to $0, which essentially means that the investor could
deliver worthless stock to cover the short position. If this happens, the investor retains all of the short sale
proceeds of $4,800 minus the call premium of $300, for a net gain of $4,500.
Maximum Gain
Cash Out Cash In
(Debit) (Credit)
2) The investor buys 1 XYZ November 50 call at $3. 1) $4,800
2) $300
3) Later, if the stock falls to $0, the short seller is able to acquire 100 shares 3) $0
at no cost and deliver worthless shares to cover the short position. $300 $4,800
4) The maximum net gain is $4,500 ($4,800 In – $300 Out). 4) $4,500 gain
A loss is realized if the stock rises in value and the investor exercises the call. By exercising the call,
the investor will be able to acquire the shares that are needed to cover the short position at the $50
strike price. Regardless of how high the stock rises above $50, the maximum net loss on the position
is $500. Essentially the loss of $500 is derived from the fact that the 100-share stock position will be
purchased at a price that’s 2 points higher than the price at which it was sold plus he paid a 3-point
premium that’s not recovered.

Maximum Loss
Cash Out Cash In
(Debit) (Credit)
2) The investor buys 1 XYZ November 50 call at $3. 1) $4,800
2) $300
3) Later, when the stock rises to $58/share, the investor exercises the call 3) $5,000
and buys the stock at the strike price of $50. $5,300 $4,800
4) The maximum net loss is $500 ($300 Out and $5,000 Out – $4,800 In). 4) $500 loss
To summarize, an unhedged short stock position has an unlimited potential loss since the stock’s price
could increase by an infinite amount. However, regardless of how high the price rises, the purchase of a
call provides the investor with a guaranteed maximum covering purchase price (i.e., the strike price).
Although the investor purchased a call, he remains bearish on XYZ stock based on the fact that he sold it
short. The investor will begin to profit on a dollar-for-dollar basis if the stock falls below the breakeven
point of $45. The purchase of the call simply serves as an insurance policy in the event that the stock rises
against him.
Using Options to Generate Income

When investors have established either long or short stock positions and wish to generate additional
income, they may sell options against their stock position to collect premium. These income generating
strategies are referred to as covered option positions. Determining which type of option to sell will
depend on whether an investor’s core stock position is long or short. These option writers are considered
covered because they have either the existing stock position or the existing cash position that’s required
to meet their obligation if exercised against on the option.
Income at the Expense of Profit Potential For the writer of a covered option to receive the benefit
of the premium income, she gives up a portion of the potential gain generated by her long or short stock
position moving in her favor. Essentially, the covered writer is willing to accept a lower potential gain in
the stock’s movement and, instead, focuses on the premium income received from the option that was
sold. Again, the existing stock position determines the investor’s overall strategy, with the option simply
generating additional income on the stock position.
The following chart summarizes the two basic covered writing strategies:
Income Strategy Reason

To generate income when
If Long Stock Write a Call
moderately bullish on stock
To generate income when

If Short Stock Write a Put
moderately bearish on stock

Now let’s examine the mechanics of each strategy.
Long Stock + Short Call (Covered Call)

Covered call writing allows investors to increase the return on their portfolios and also provides a partial
hedge against their stock’s price falling. For example, an investor has the following positions:
Owns 100 shares of XYZ stock for which she paid $30 per share and
Writes an XYZ June 35 call at a premium of 1 against the stock position.
If the price of the stock remains the same and the call is not exercised, the investor will earn an
additional $100 on this position ($1 premium x 100 shares). It’s important to remember that the
investor’s primary concern is the stock position with the option simply being used as a source of
additional income and a minimal hedge.
As done with other positions, let’s consider the investor’s breakeven point, maximum loss, and
maximum gain.
If the stock declines in value, the premium received from the call actually reduces the investor’s potential
loss. If XYZ drops to $29 per share, the $100 loss on the stock position is offset by the $100 premium
received from the option and the investor will breakeven. Therefore, the formula for determining the
breakeven point on a covered call is the stock’s purchase price minus the premium received from the sale
of the option. The client also has a hedge, but only to the amount of premium collected. Let’s review this
scenario using the cash out/cash in account.
Finding Breakeven
An investor owns 100 shares of XYZ at $30/share and sells 1 XYZ June 35
call at 1. The breakeven is simply the purchase price of the stock minus the
premium received (30 – 1 = 29 breakeven).
1) An investor owns 100 shares of XYZ at $30/share.
Cash Out Cash In
2) The investor then sells 1 XYZ June 35 call at a premium of $1. (Debit) (Credit)
1) $3,000
3) If the investor is able to sell the shares at $29, she will breakeven on the 2) $100
position. 3) $2,900
4) $3,000 $3,000
4) To confirm the breakeven, the total cash out must equal the total cash in.
The investor’s maximum loss is realized if the stock declines to $0. At this point, the capital loss is
realized by the investor liquidating the worthless stock position which will seemingly result in a $3,000
loss. However, because this is a covered call, the $100 premium limits the ultimate loss to $2,900. For
this reason, covered call writing is considered only a partial hedge.

Maximum Loss
Cash Out Cash In
1) An investor buys 100 shares of XYZ at $30/share.
(Debit) (Credit)
2) The investor then sells 1 XYZ June 35 call at a premium of $1. 1) $3,000
2) $100
3) Later, the stock price falls to $0 and, in order to claim the loss for tax 3) $0
purposes, the stock is liquidated at no value. $3,000 $100
4) The maximum net loss is $2,900 ($3,000 Out – $100 In). 4) $2,900 loss
Not only does covered call writing offer a limited hedge (the premium collected), it also limits the
maximum gain on the stock position. If the stock’s price rises above the option’s strike price and the call
is exercised, the investor’s maximum gain is the premium plus the profit realized by selling the stock at
its strike price. In the example, if the stock’s price rises above 35, the call will be exercised and the
investor’s total return will be $600 (the $500 gain realized on the sale of the stock plus the $100 premium
received from the option).
Maximum Gain
Cash Out Cash In
1) An investor buys 100 shares of XYZ at $30/share.
(Debit) (Credit)
2) The investor then sells 1 XYZ June 35 call at a premium of $1. 1) $3,000
2) $100
3) Later, the stock price rises to $40, the call is exercised, and the writer 3) $3,500
fulfills the obligation to sell 100 shares at the strike price of $35/share. $3,000 $3,600
4) The maximum net gain is $600 ($3,500 In and $100 In – $3,000 Out). 4) $600 gain
Although the underlying stock’s price may rise infinitely, if exercised against, the investor is obligated to
sell the shares at the strike price. Remember, a covered call writer sacrifices the future upside potential of
the stock for the immediate receipt of the premium.
To summarize this example, the investor’s maximum gain is $600 since, regardless of how high the stock
price rises, she’s obligated to sell the stock $35. The breakeven point is $29 (the stock’s purchase price
minus the premium on the call). The profit on the call is constant (the premium) and, therefore, the
protection is limited to the amount of the premium. Ultimately, if the stock’s price falls to $0, the investor
will lose her entire investment ($3,000) minus the premium received ($100), or $2,900.
Covered Call Writer is Bullish to Neutral When writing a covered call, the investor’s potential
upside gain on the stock position is limited. The maximum gain, which is limited to the strike price plus
the premium minus the initial cost of the stock, is realized if the stock’s price rises above the strike price
and the investor’s stock position is called away. For this reason, the strategy is used only by an investor
who is neutral to mildly bullish on the short-term prospects for the stock. The sale of the option
effectively limits the profit on the long stock position.

Ratio Writing
Ratio writing is considered an aggressive option strategy that involves a long stock position with an
unequal number of calls written against it. For example, an investor may:
Buy 100 shares of XYZ stock at $78 and
Sell 2 XYZ October 80 calls for a combined premium of 8.
This client is not only writing a covered call, he’s also writing an uncovered call which results in a
maximum loss that’s potentially unlimited. The objective is to increase the income from writing more calls
than the number of shares of stock owned. Assuming the stock’s market price remains at or below the
strike price of $80 and the options expire worthless, the writing of two calls will generate a profit of
$800, rather than $400.
The breakeven point on the position is found by using the purchase price of $78 and subtracting the
combined premium of 8, which equals $70. The maximum profit is realized if the stock rises slightly and
the call writer is exercised against. The maximum gain of $1,000 is calculated based on the $2 difference
between the strike price of $80 at which the stock is sold and the stock’s original purchase price of $78 plus
the $8 in total premium received for writing the call options. However, since the investor is short the
additional call, he will begin to lose money if the stock rises above $80.
Short Stock + Short Put

When an investor sells stock short and also sells a put, it’s referred to as covered put writing. This
strategy allows the investor to increase the return on his portfolio, but also partially hedges the short stock
position against rising prices. For example, an investor may execute the following:
Sell short 100 shares of MNO at $35 per share and
Write an MNO October 30 put at a premium of 3.
The option premium received offsets a portion of the loss in the event that the stock’s price increases.
Therefore, the breakeven point for the covered put writer represents the total amount of money he has
received (i.e., the proceeds generated by the short sale plus the premium). Again, even if the short stock
position rises in value by 3 points (bad for the short seller), the investor will breakeven since he collected
the premium of 3 when he sold the put.

Finding Breakeven
An investor sold short 100 shares of MNO at $35/share and wrote 1 MNO
October 30 put at 3. The breakeven is simply the proceeds generated by the
short sale plus the premium (35 + 3 = 38 breakeven).
1) An investor sells short 100 shares of MNO at $35/share. Cash Out Cash In
(Debit) (Credit)
2) The investor then writes 1 MNO October 30 put at a premium of 3.
1) $3,500
3) If the stock rises and is purchased at $38, the investor will breakeven. 2) $300
3) $3,800
4) To confirm the breakeven, the total cash out must equal the total cash in. 4) $3,800 $3,800
The writer of a covered put has protection against upside movement in the stock, but that protection is
limited to the $300 option premium. However, the maximum loss is potentially unlimited since the
increase in the stock’s price is theoretically infinite.
Maximum Loss
1) An investor sells short 100 shares of MNO at $35/share.
Cash Out Cash In
(Debit) (Credit)
2) The investor then writes 1 MNO October 30 put at a premium of 3. 1) $3,500
2) $300
3) Since the stock’s price could increase an infinite amount and thereby cost
the short seller an unknown amount to cover the position, the maximum 3) Theoretically
unlimited $3,800
loss is unlimited.
Finally, by writing a covered put, the investor sacrifices the potential gain on the declining value of the
stock. Even if the stock’s price falls to $0, the put will be exercised and the investor will be obligated to
buy the stock at the strike price of $30. By using the purchased stock to cover the short position, he will
realize a maximum gain of $800 (5 points on the stock plus the 3-point premium).
Maximum Gain Cash Out Cash In

1) An investor sells short 100 shares of MNO at $35/share. (Debit) (Credit)
1) $3,500
2) The investor then writes 1 MNO October 30 put at a premium of 3. 2) $300
3) $3,000
3) Later, the stock’s price falls to 25 and the writer of the put is exercised $3,000 $3,800
against (obligated to buy at $30).
4) $800 gain
4) The maximum net gain is $800 ($3,500 In and $300 In – $3,000 Out).

From a strategy standpoint, the covered put writer is considered neutral to mildly bearish on the short-
term prospects for the stock. If the investor was primarily interested in hedging the short stock position,
he should have purchased a call instead.
Key Points to Remember About Writing Covered Options for Income

 If an investor writes a covered option, the underlying stock position (NOT the option)
determines the investor’s moderate bullish or bearish strategy.
 The writer has a partial hedge that’s limited to the amount of premium collected.
 In return for the income generated by the sale of the option, the option writer limits her
potential gain based on the stock moving in her favor. She may be moderately bullish,
bearish, or neutral on the stock.
Summary of Strategies
Buying Options
Buying Calls Buying Puts
Breakeven: Strike Price + Premium Breakeven: Strike Price – Premium
Strategy: Bullish Strategy: Bearish
Maximum Gain: Unlimited Maximum Gain: Strike Price – Premium (x 100 sh.)
Maximum Loss: Premium Maximum Loss: Premium
Writing Options
Writing Uncovered Calls Writing Uncovered Puts
Breakeven: Strike Price + Premium Breakeven: Strike Price – Premium
Strategy: Bearish Strategy: Bullish
Maximum Gain: Premium Maximum Gain: Premium
Maximum Loss: Unlimited Maximum Loss: Strike Price – Premium (x 100 sh.)
Straddles
Long Straddle Short Straddle
Breakeven: Strike Price + and – Total Premium Breakeven: Strike Price + and – Total Premium
Strategy: Volatility Strategy: Stability (Neutrality)
Maximum Gain: Unlimited Maximum Gain: Total Premium
Maximum Loss: Total Premium Maximum Loss: Unlimited

Spreads
Debit Spread
Profitability: Difference in Premiums Must Widen
For Call Spreads: Lower Strike Price + Net Premium
Breakeven:
For Put Spreads: Higher Strike Price – Net Premium
For Debit Call Spreads: Bullish
Strategy:
For Debit Put Spreads: Bearish
Maximum Gain: Difference in Strike Prices – Net Premium
Maximum Loss: Net Premium
Credit Spread
Profitability: Difference in Premiums Must Narrow
For Call Spreads: Lower Strike Price + Net Premium
Breakeven:
For Put Spreads: Higher Strike Price – Net Premium
For Credit Call Spreads: Bearish
Strategy:
For Credit Put Spreads: Bullish
Maximum Gain: Net Premium
Maximum Loss: Difference in Strike Prices – Net Premium
Protective Purchases
Buying a Put to Hedge (Protect) a Long Stock Position
Breakeven: Cost of Stock + Premium
Strategy: Bullish
Maximum Gain: Unlimited
Maximum Loss: Cost of stock + Premium – Strike Price (x 100 sh.)
Buying a Call to Hedge (Protect) a Short Stock Position

Breakeven: Short Sale Proceeds – Premium
Strategy: Bearish
Maximum Gain: Short Sale Proceeds – Premium (x 100 sh.)
Maximum Loss: Strike Price + Premium – Short Sale Proceeds (x 100 sh.)

Covered Writing—Income Generation

Writing a Covered Call
Breakeven: Cost of Stock – Premium
Strategy: Neutral to Moderately Bullish (with a Partial Hedge)
Maximum Gain: Strike Price + Premium – Cost of Stock (x 100 sh.)
Maximum Loss: Cost of stock – Premium (x 100 sh.)
Writing a Covered Put

Breakeven: Short Sale Proceeds + Premium
Strategy: Moderately Bearish (with a Partial Hedge)
Maximum Gain: Short Sale Proceeds + Premium – Strike Price (x 100 sh.)
Maximum Loss: Unlimited
Non-Equity Options
This section will focus on the following types of non-equity options:
 Stock index options
 Foreign currency options
 Yield-based options
Bullish and Bearish Many of the concepts and strategies related to these options are similar to those
examined for individual equity contracts. Regardless of the instrument underlying the contract, bullish
investors buy calls and sell puts, while bearish investors buy puts and sell calls. The value of call options
increases as the value of the asset underlying the contracts increases. On the other hand, the value of put
options increases as the value of the asset underlying the contracts decreases.
Breakeven Conveniently, regardless of whether call options are tied to the performance of a particular
stock, foreign currency, or the yield of a bond, the calculation for their breakeven point remains the strike
price of the option plus the premium. For put options, the calculation for their breakeven point is still the
strike price of the option minus the premium.
Contractual Differences There are certain contractual differences between equity and non-equity
options that must be noted. First, all listed equity option contracts use American style exercise, while
some non-equity options use European style exercise. Keep in mind, the different styles refer to when the
buyer is able to exercise his option; however, any contract (either American or European style) may be
closed-out (traded) prior to its expiration.
The second difference is that index and currency options use a multiplier of $100, rather than 100 shares.
Although it’s based on dollars, the calculation is essentially the same as an equity option.

Stock Index Options

As described previously, equity options provide investors with the opportunity to profit from the
increases or decreases in the value of a particular stock. Rather than being limited to the movement of a
particular stock, index options provide investors with the opportunity to either speculate on, or hedge
against, the movement of the market.
There are two types of indexes—broad-based and narrow-based. A broad-based index is composed of a
group of stocks that reflects the performance of the entire market (e.g., the S&P 500 [SPX] or S&P 100
[OEX]). A narrow-based index measures the performance of a particular market segment or industry
group (e.g., pharmaceuticals).
Index options may be used to assist in reducing two specific risks that are associated with investing in
equity securities:
1. The risk associated with the specific industry in which a corporation operates
2. The risk associated with how a specific corporation will react to trends in the stock market
The first risk (industry risk) may be partially reduced with the use of index options of a specific
industry (e.g., narrow-based index options). The second risk may be limited through the use of
broad-based index options.
Contract Specifications—Dollar Value and Premiums The price of an index option contract is
based on the index value multiplied by $100. For example, if an index has a value of 242.00, the dollar
value is equal to $24,200 (242.00 x $100). This is similar to equity option contracts in which each
contract is based on 100 shares of the underlying security.
As with equity options, index option premiums are expressed in points and decimals, with each point
equaling $100 (1 x the multiplier of $100). For example, a premium of 3.13 equals $313 (3.13 x $100).
Exercise An important point to remember with an index option is that, if the option is exercised,
there’s no exchange of physical securities; instead, the exercise results in a cash settlement. If the option
is in-the-money, the buyer receives a cash amount equal to the difference between the strike price of the
option and the closing value of the index on the day the option is exercised. Of course, if exercised
against, the writer of the option is obligated to pay this amount.
For example, an OEX May 800.00 call option is exercised when the underlying index
closes at 808.00. The call is in-the-money by 8 points; therefore, the writer is obligated
to pay the buyer $800 (8 points x $100).
Index option buyers must be careful when they exercise their option contracts since exercise is based on
the closing index value for that day. Therefore, if an index option is exercised during the day and
ultimately closes out-of-the-money, the buyer may experience a loss due to being required to pay the
writer the out-of-the-money amount.

For example, the owner of an OEX March 240 call enters an exercise notice at 2:00
p.m. when the index is at 245.00; however, the index ultimately closes at a value of
238.00. Since the closing index value (238.00) is less than the strike price of the call
(240.00), the option is 2 points out-of-the-money and the buyer is required to deliver
$200 to the writer as settlement for the exercise.
Index Options Strategies

Buying Index Calls An investor who is bullish on either the market or a segment of the market could
buy index calls. Separately purchasing the stocks that comprise the index will cost the investor a
significant amount of money and also subject her to a great deal of risk. As the value of the underlying
index increases above the strike price, the intrinsic value of the option increases. If the index closes above
the breakeven point, the investor may choose to liquidate or exercise the contract for a profit.
Writing Index Calls An investor who is bearish and believes that an index will decline or stay below a
certain level could profit by selling index call options. If the index is at or below the exercise price and the
option expires, the writer of the call will recognize the premium received as his maximum gain.
Buying Index Puts The buyer of an index put option is bearish on the index. As the value of the
underlying index decreases below the strike price, the intrinsic value of the option increases. If the index
closes below the breakeven point, the investor may choose to liquidate or exercise the contract for a profit.
Writing Index Puts Another bullish strategy is to write index puts. If the underlying index increases or
stays above the strike price, the writer of the put will profit. If the index is at or above the exercise price
and the option expires, the writer of the put will recognize the premium received as her maximum gain.
VIX Options
The CBOE’s Volatility Market Index (VIX) option is a broad-based index option that’s calculated using
the bid and ask quotes of the S&P 500 Index options. The VIX weighs both the nearby and second nearby
options that have at least eight days to expiration to produce a 30-day measure of the volatility of the
S&P 500 Index. Below are some of the characteristics of VIX options:
Trading Hours: 9:30 a.m. to 4:15 p.m. ET

When Trading Commences: For each trading sessions, only once the SPX rotation is completed
Position and Exercise Limits: Currently unlimited
Exercise Style: European style, with settlement in cash
Strike Price Intervals: 2 ½ points
Premium Quotation: Each full point is equal to $100

For example, since VIX options use a multiplier of $100, the purchase of a
VIX August 11.00 call at a premium of 3.25 will cost $325. The call is in-the-
money if the VIX Index is above 11.00.
The expiration cycle for VIX options is different than used by other index options. VIX options expire on
the Wednesday that’s 30 days prior to the third Friday of the following calendar month. The cash amount
of settlement will represent the difference between the exercise-settlement value and the strike price of
the option multiplied by $100.
The VIX is often considered to be a gauge of investors’ sentiments or fears of expected stock market
volatility over the next 30 days. The VIX will typically move inversely to the S&P 500 Index—the VIX
rises when the S&P 500 Index falls and falls when the S&P 500 Index rises. Investors will buy VIX calls
when they expect the market to decline and volatility to increase or, conversely, they will buy VIX puts
when they expect the market to rise and volatility to decrease. Another possibility is that investors may
buy VIX call options as a hedge against a possible decline in the market.
VIX options give traders a way to trade volatility without being required to factor in the price changes of
the underlying instrument, dividends, interest rates, or the time remaining to expiration. An increase in
volatility often occurs during a declining equity market and, rather than using index options, a trader may
purchase VIX call options as a hedge.
Foreign Currency Market

Foreign currency options allow investors to speculate on, or hedge against, changes in the exchange rates
of foreign currencies. The exchange rate is the price at which one country’s currency may be exchanged
for another country’s currency. Most developed countries have a floating exchange rate which means that
their currencies don’t have a fixed value, but rather a value that fluctuates relative to other currencies.
The Interbank Market Foreign exchange rates are established in the Interbank Market—the market in
which the purchases and sales of foreign currencies occur between commercial banks. The banks will take
positions for their own accounts and act as brokers for other banks and commercial customers.
Interestingly, there’s no specific location or organized exchange where these foreign currency transactions
take place; therefore, the Interbank Market is both decentralized and unregulated. Given the non-physical
nature of the Interbank Market, it has unlimited trading hours.
Spot and Forward Transactions The most common types of transactions that take place in the
Interbank Market are spot and forward transactions. Spot transactions settle two business days after the
trade date, while forward transactions settle in more than two days.
The rate at which spot or forward transactions are executed is agreed to on the trade date. Since the
majority of transactions are done on a spot basis, the established exchange rate is commonly referred to
as the spot rate or spot price. The spot rate is the current market price for the cash currency. The Federal
Reserve Board will disseminate closing spot prices for different foreign currencies on a daily basis.

Factors that affect the supply or demand of a country’s currency play a major role in establishing its spot
rate. These factors include:
 Demand for a country’s products and/or raw materials
 A country’s balance of payments
 The level of affluence of a country’s population
 The level of foreign investment by the country
 Government monetary and fiscal policy
 Direct government intervention
 Prevailing interest rates
Other factors such as a country’s political atmosphere, the existence or threat of war, and trade embargoes
may contribute to the strength or weakness of a foreign currency.
Foreign Currency Options

Currency options allow investors to take a position based on the value of a foreign currency as it
compares to the U.S. dollar. These contracts are U.S. dollar-settled, which means that there’s no delivery
or receipt of foreign currency occurs. Also, contracts are quoted in terms of the number of U.S. dollars
required to purchase one unit of the foreign currency. In the U.S., there are no calls or puts available on
the U.S. dollar; instead, investors take option positions on a foreign currency with the U.S. dollar on the
other side of the contract. An investor’s gain or loss is based on this inverse relationship between value of
the foreign currency and the value of the U.S. dollar.
Before examining the mechanics of foreign currency options, let’s consider the primary users of these
contracts. Obviously, individuals and corporations that engage in international trade are included, but
retail investors may also have a need for these products. Remember, although a financial instrument may
be denominated in U.S. dollars, if the underlying assets are not U.S.-based, currency risk exists for the
investor. Other instruments include foreign stocks and bonds, ADRs, and dollar-denominated global,
international, and country funds.
Contract Specifications
The Series 7 Examination recognizes world currency options that trade on the Philadelphia Stock
Exchange (PHLX) and currently tests the following six currencies:
Currency Ticker Symbol Units/Contract
Australian dollar XDA 10,000
British pound XDB 10,000
Canadian dollar XDC 10,000
Euro XDE 10,000
Swiss franc XDS 10,000
Japanese yen XDN 1,000,000

Exercise Provisions of Foreign Currency Options

On the PHLX, if an investor trades call options, his contract will be in-the-money if the foreign currency
strengthens as compared to the U.S. dollar over the life of the contract. Conversely, if an investor trades
put options, his contract will be in-the-money if the foreign currency weakens as compared to the U.S.
dollar during the life of the contract. The following examples illustrate the exercise process:
Example 1 An investor exercises a long British pound call with a strike price of 190.00 and a contract
size of 10,000 units of the British pound. If the settlement value of the pound is 192.25, the call option
is in-the-money by 2.25 points. Each point has a dollar value of $100; therefore, the holder of the
exercised contract will receive $225 (2.25 x $100).
Example 2 A trader is short 5 euro put contracts with a strike price of 147.50. If the settlement value
of the euro is 141, the put options are in-the-money by 6.5 points. Each point has a dollar value of
$100; therefore, the writer of the exercised contract is required to pay $3,250 (6.5 x $100 x 5 contracts).
Example 3 An investor writes 3 Swiss franc Nov 87.50 calls at a premium of 1.15. If the option
contracts are exercised with a settlement value of 90.50, they’re each in-the-money by 3 points. Each
point has a dollar value of $100; therefore, the writer of the option is required to pay $900 (3.0 x $100
x 3 contracts). Since the writer received $345 in total premiums (1.15 x $100 x 3 contracts), the
investor’s net loss is $555 ($900 Out – $345 In).
Foreign currency options use European style exercise which again means that they may only be exercised
on the day of expiration.
Hours and Method of Trading

On the PHLX, the hours of trading in foreign currency options are from 9:30 a.m. to 4:00 p.m. ET. As with
equity options, these options are issued and guaranteed by the Options Clearing Corporation (OCC).
Exercise Prices and Premiums

Exercise prices for the Australian dollar, British pound, Canadian dollar, Swiss franc, and euro option
contracts are stated in cents per unit, while exercise prices on the Japanese yen option contracts are stated in
hundredths of a cent per unit. For most currency options, the contract’s exercise price may be converted into
U.S. terms by moving its decimal point two places to the left (e.g., a strike price of 160 for a British pound
contract becomes $1.60). However, for the exercise price on a Japanese yen contract, the decimal point must
be moved four places to the left (e.g., a strike price of 98 for a Japanese yen contract becomes $.0098).

Conveniently, each point of a foreign currency option’s premium is equal to $100, which effectively
eliminates the need to move the decimal point for conversion purposes. Therefore, a premium of 2.00 is
equal to $200 and a premium of 2.25 is equal to $225.
For example, an investor believes the British pound is due to strengthen as compared to the
U.S. dollar; therefore, she buys an XDB June 170 call at a premium of 2.14. What’s the result if
the British pound rises to 178 and the contract is closed out at its intrinsic value?
The Result
Cash Out Cash In
1) An investor buys 1 XDB June 170 call at a premium of 2.14. (Debit) (Credit)
2) The British pound rises to 178, which means the 170 call is in the money 1) $214
by 8 points. (178 – 170). The investor is able to sell the 170 call for a 2) $800
premium of 8, or $800. $214 $800
3) The net gain is $586 ($800 In – $214 Out). 3) $586 gain
Trading Concepts and Strategies

The most basic assumption in assessing foreign currency movements is their relationship to the U.S.
dollar. A strong dollar indicates a weak foreign currency, and conversely, a weak dollar indicates a strong
foreign currency.
If the U.S. Dollar Then the Foreign Currency
Strengthens Weakens
Weakens Strengthens
The value of a foreign currency option contract is determined by the relationship between the price of the
underlying currency and the strike price of the option. The following table summarizes how an option’s
premium is affected by the value of the underlying currency:
A Call Premium Will: A Put Premium Will:

If the value of the underlying
Increase Decrease
currency increases
If the value of the underlying
Decrease Increase
currency decreases:
Basic Strategy—Calls The owner of a foreign currency call option is bullish on the foreign currency
and has the right to exercise and receive cash that’s based on the in-the-money amount of the option. On
the other hand, the seller of the option is bearish and, if exercised against, is obligated to deliver cash that’s
based on the in-the-money amount of the option. The maximum gain for the owners of calls is unlimited;
however, their maximum loss is limited to the premium paid.

Basic Strategy—Puts The owner of a foreign currency put option is bearish on the foreign currency and
has the right to exercise and receive cash that’s based on the in-the-money amount of the option. On the
other hand, the seller of the option is bullish and, if exercised against, is obligated to deliver cash that’s
based on the in-the-money amount of the option. The maximum gain for the owners of puts is based on the
underlying currency decreasing and is calculated from the strike price minus the premium paid; however,
their maximum loss is limited to the premium paid.
Speculation Investors may participate in the foreign currency options market in order to speculate.
Correctly assessing future currency exchange rates could result in significant profits for investors. However,
if currency exchange rates move adversely for buyers, their losses are limited to the premium paid.
Hedging Foreign currency options may also be used to hedge the risk of loss due to the fluctuation of
currency values. One potential strategy is purchasing foreign currency puts to protect existing long
currency positions. If the value of the currency position decreases, it will cause the value of the long put
to increase and offset any losses on the currency position.
Another strategy involves purchasing calls as protection against upside risk when specific currencies
need to be delivered to settle an import/export transaction. If the value of the currency position
increases, it will cause the value of the long call to increase and offset any losses incurred when
covering the currency position.
For example, a U.S. importer has a contract to purchase material from an exporter in Germany and is
required to deliver euros to settle the contract in two months. Since the importer will eventually need to
acquire euros, it’s concerned about the potential rise in their value. To hedge against any increase in the
euro, the importer could buy euro call options.
Yield-Based Options
A yield-based option is a form of debt instrument-based option that derives its value from the difference
between the exercise price and the value of the yield of the underlying debt instrument. In other words, the
value of these options is based on yield rather than price. The options are based on the yields of the most
recently issued Treasuries (shown with their option ticker symbols):
 13-week Treasury bills (IRX)
 Five-year Treasury notes (FVX)
 10-year Treasury notes (TNX), and
 30-year Treasury bonds (TYX)
Features of Yield-Based Options To determine the actual yield of a yield-based option, the strike
price is divided by ten. For example, a 20-year 71.50 T-bond option represents a yield of 7.15%, while a
13-week T-bill option with a strike price of 36.00 represents a discount yield of 3.60%.

Settlement Similar to the system used for index options, yield-based options settle on a cash basis with
no physical delivery of a Treasury security. If exercised against, the writer is required to pay the buyer a
dollar amount equal to the option’s in-the-money amount. The final settlement value is determined by the
quotes that are reported by the Federal Reserve Bank of New York. Yield-based options may only be
exercised at expiration (i.e., they use European style exercise).
Contract Specifications Conveniently, the premiums of yield-based options are quoted in the same
manner as index and currency options, using a $100 multiplier.
For example, an investor buys a July 75 call based on the 30-year T-bond yield for a
premium of 2 ($200). At expiration, if the settlement value is 79.50 (7.95%) and the call
is exercised, the investor will have a profit of $250 per contract (as shown below):
The Result
1) An investor buys a yield-based July 75 call on the 30-year T-bond at a
premium of $2. Cash Out Cash In
(Debit) (Credit)
2) At expiration, the settlement value is 79.50, or 7.95% (79.50 ÷ 10). When
1) $200
the settlement value of 79.50 is compared to the call strike price of 75, or
7.5% (75 ÷ 10), the option is in-the-money by 4.5 points. Remember, 2) $450
each point equals $100; therefore, the seller pays the buyer $450. $200 $450
Remember, since the T-bond yield increased, the call owner earned a profit.
On the other hand, if, at expiration, the yield on the most recently issued 30-year T-bond is at or below 75
(or 7.50%), the call will expire worthless—resulting in a $200 loss.
Now let’s try an example using a yield-based put.

An investor buys an August 36 put on a 13-week T-bill discount yield for a premium of
1.75 ($175). At expiration, if the settlement value is 33.5 (3.35%) and the put is
exercised, the investor will have a profit of $75 per contract (as shown below):
The Result
1) An investor buys a yield-based August 36 put on the 13-week T-bill at a
premium of $1.75. Cash Out Cash In
2) At expiration, the settlement value is 33.5, or 3.35% (33.5 ÷ 10). When
(Debit) (Credit)
the settlement value of 33.5 is compared to the call strike price of 36, or 1) $175
3.6% (36 ÷ 10), the option is in-the-money by 2.5 points. Remember, 2) $250
each point equals $100; therefore, the seller pays the buyer $250. $175 $250

Remember, since the T-bill discount yield decreased, the put owner earned a profit.
On the other hand, if, at expiration, the discount yield on the most recently issued 13-week T-bill is at or
above 36 (3.6%), the put will expire worthless—resulting in a $175 loss.
Although these options may only be exercised at expiration, investors are able to close out (liquidate)
their positions at any time during the life of the contract. If closed out, the profit or loss will be
determined by comparing the premiums of the opening and closing transactions.
Strategies Using Yield-Based Options The strategy employed by the buyer or writer of a yield-
based option is determined by the anticipated direction of bond yields, not bond prices. The following
table will illustrate the appropriate position to take based on the direction in which an investor believes
yields will move:
If an Investor Believes: She Should:

- Buy yield-based calls or
Yields (interest rates) will increase
- Sell yield-based puts
- Buy yield-based puts or
Yields (interest rates) will decline
- Sell yield-based calls
Take a moment to review the option summary chart on the next page which includes the strategies
described in this chapter. Again, for the Series 7 examination, it’s not enough to be able to compute profit
and loss for each position; a person must be able to understand the underlying rationale as to why an
investor will employ a given strategy.

Summary of Option Strategies

If An Investor Is: Suggested Option Position:
Buy a Call (limited risk) or
Bullish
Sell a Put (substantial risk)
Buy a Put (limited risk) or

Bearish
Sell a Call (unlimited risk)
Long stock and wants protection Buy a Put
Long stock and wants to generate income Sell a Covered Call
Short stock and wants protection Buy a Call
Short stock and wants to generate income Sell a Covered Put
Long portfolio of stock and wants protection Buy a Broad or Narrow-Based Index Put
Long portfolio of stock and wants to generate

Sell a Broad or Narrow-Based Index Call
income
Expecting volatility Buy a Straddle or Combination
Expecting stability Sell a Straddle or Combination
Mildly bullish, wants to assume limited risk, and is

Debit Call Spread or Credit Put Spread
willing to accept limited gain
Mildly bearish, wants to assume limited risk, and is

Credit Call Spread or Debit Put Spread
willing to accept limited gain

Taxation of Options
The tax treatment of an option depends on the manner in which the option is disposed. As covered earlier,
the holder (owner) of an option may dispose of the option through any of the following means:
1. Expiration
2. Liquidation
3. Exercise
Expiration of Options If an option ultimately expires unexercised, the premium will represent either a
capital gain or capital loss for tax purposes. For a buyer, the premium paid is a capital loss; however, for
a seller, the premium received is a capital gain.
Since most option positions are short-term (have a maturity of less than one year), the capital gain or loss
is considered short-term. An exception is made for the purchase of LEAPS since their expirations may be
as long as 39 months. However, since the writers of uncovered options (even LEAPS) don’t own an asset
on which to establish a holding period, their capital gains are always considered short-term.
Liquidation of Options When an investor executes an opposite transaction on the same option, the
result is a realized capital gain or capital loss. Remember, an opening purchase is offset with a closing
sale and an opening sale is offset with a closing purchase.
For example, if a September 50 Call is purchased at a premium of 5 on June 3 and
later sold at a premium of 8 on September 14, the gain is calculated as follows:
Liquidate (Close) the Position

Cash Out Cash In
1) An investor buys 1 XYZ September 50 call for a premium of $5.
(Debit) (Credit)
2) Later, the investor sells 1 XYZ September 50 call for a premium of $8. 1) $500
2) $800
3) As a result, the investor has a net short-term gain of $300.
($800 In – $500 Out = $300 In) 3) $300 gain
Exercising of Options Depending on whether an investor is in a position to buy stock or sell stock
due to the exercise of an option, the exercise may result in the need to determine the investor’s basis or
sales proceeds. Since buyers of calls and sellers of puts are in a position to acquire stock as the result of
exercise, they’re required to calculate cost basis (the total cost to acquire). On the other hand, since
buyers of puts and sellers of calls are in a position to deliver stock as the result of exercise, they’re
required to calculate sales proceeds (the total money received on delivery).

Exercising Calls For call options that are exercised, the calculation of either basis or sales proceeds is
simply strike price plus the premium. When a call is exercised, the owner of the call has the right to buy
the underlying stock and must determine his cost basis.
For example, on May 3, an investor purchases an XYZ August 50 call at a premium of 5.
If the call is exercised on August 14 when the stock is trading at $58, what’s the
investor’s cost basis to acquire the 100 shares?
Exercised and stock is purchased at the strike price of $50 $5,000

Plus the premium paid for the call + 500
Total cost basis: $5,500
If exercised against, the writer of a call is obligated to sell the underlying stock at the strike price. The
total sales proceeds to be received include the strike price plus the premium.
For example, on May 3, an investor sells an XYZ August 50 call at a premium of 5.
If the call is exercised on August 14 when the stock is trading at $58, what are the
total sales proceeds for the investor when the shares are delivered?
Exercised against and stock is sold at the strike price of $50 $5,000
Plus the premium received for the call + 500
Total sales proceeds: $5,500
Keep in mind, the exercise or assignment of a call option creates a cost basis or sales proceeds that are
calculated in the same manner as the investors’ breakeven point (i.e., strike price + premium).
Exercising Puts For put options, the calculation of basis or sales proceeds is simply strike price minus
premium. When a put is exercised, the owner of the put has the right to sell the underlying stock and must
determine his sales proceeds.
For example, on April 3, an investor purchases an ABC July 50 put at a premium of 5.
If the put is exercised on July 14 when the stock is trading at $42, what are the total
sales proceeds for the investor when the shares are delivered?
Exercised and stock is sold at the strike price of $50 $5,000

Minus the premium paid for the put – 500
Total sales proceeds: $4,500

If exercised against, the writer of a put is obligated to buy the underlying stock at the strike price. The
calculation for determining the cost basis to acquire the stock is the strike price minus the premium.
For example, on April 3, an investor sells an ABC July 50 put at a premium of 5.
If the put is exercised on July 14 when the stock is trading at $42, what’s the
investor’s cost basis to acquire the 100 shares?
Exercised and stock is purchased at the strike price of $50 $5,000

Minus the premium received for the put – 500
Total cost basis: $4,500
The exercise or assignment of a put option creates a cost basis or sales proceeds that are calculated in the
same manner as the investor’s breakeven point (i.e., strike price – premium). As always, an investor’s
gain or loss is determined by comparing the individual’s cost basis to the sale proceeds.
Holding Period of Acquired Shares When an options investor is in a position to acquire stock, his
holding period begins when the option is exercised and the stock transaction settles.
For example, On March 12, an investor bought an XYZ October 60 call for a premium of 3.
On October 18 of the same year, she exercised the option. On May 12 of the following year,
the investor sold her shares for $70. What’s the tax implication of these trades?
According to IRS rules, the client’s holding period begins with the exercise, NOT the purchase of the
option. In this example, the investor’s cost basis is 63 (strike price of 60 plus the premium of 3) and her
holding period will be considered short-term. The short-term holding period is based on the fact that the
investor acquired the underlying shares in October and sold them eight months later. There’s no credit
given for the time during which she owned the option itself.
Hedging—Buying Stock and Buying Puts

As covered earlier, clients often buy puts in order to hedge a long stock position. The timing of the
hedging put purchase affects the client’s tax situation. Following are the three resulting possibilities:
1. The hedge is put in place on the same day that the stock is purchased.
2. The hedge is put in place after the stock is purchased (the next day or later), but prior to establishing
a long-term period in the stock.
3. The hedge is put in place more than one year after the stock is purchased.
Puts Bought on Day One—Married Puts An investor who buys shares of stock and, on the same
day, buys a put option on that stock has created a married put position. If this is the case, the investor’s
cost basis in the stock represents the cost of the stock plus the cost of the option.
For example, an investor buys 100 shares of MWR at $34 per share and, on the same day,
purchases an MWR December 30 put at a premium of 3. The investor’s cost basis in the
MWR stock is $37 per share ($34 + $3).

Puts Bought After Day One Put options that were not purchased on the same day, but prior to the
establishment of a long-term holding period in the stock, are treated separately for tax purposes. If the
investor has owned a stock for less than one year and then buys a put on that stock, the stock’s holding
period will be terminated. The holding period in the stock will not restart at day one until the put is no
longer associated with the stock. To achieve a long-term holding period, a stock must be held at risk
(unhedged) for longer than one year.
For example, a customer buys a stock at $40 and has held it for eight months. The
customer then buys a put on the stock that will expire in six months for a premium of 3.
Although the intention of the investor is to lock in a sales price with the put and stretch the
stock’s holding period beyond the 12 months required for long-term capital gains
treatment, the tax laws stipulate otherwise. The investor’s holding period on the stock is
terminated when the put is purchased.
In this example, if the put is exercised even four to six months after its purchase, the
capital gain on the stock will be treated as short-term. If the put ultimately expires, the
investor will then begin a new holding period on the stock, since the original holding
period was terminated by the purchase of the put.
Puts Bought After One Year If an investor buys shares of stock and establishes a long-term holding
period, a subsequent put purchases doesn’t affect the client’s holding period in the stock. Under IRS
rules, if a stock’s holding period has been established as long-term (i.e., held for more than one year), it’s
considered long-term regardless of subsequent hedging actions.
For example, an investor buys 100 shares of MWR at $34 per share. Two years later,
the stock rises to $65 and the client decides to buy an MWR December 60 put at a
premium of 3. Since the investor’s holding period has already been locked in, the
option and the stock are treated separately for tax purposes.
Conclusion
This concludes the discussion on options. Having a strong grasp of the information contained in
this chapter is critical for Series 7 candidates since the material is both technically challenging and
heavily tested.

CHAPTER 13
Offerings
Key Topics:
 Primary Market and Underwriting Commitments
 The Securities Act of 1933
 Exempt Securities and Transactions
 Municipal Offerings
CHAPTER 13 – OFFERINGS
This chapter will focus on the concept of corporations and municipalities raising capital.
Corporation can issue equity and/or debt securities, but this chapter will focus on equity securities
and especially initial public offerings. Exempt securities, exempt offerings, and rules relating to new
issues will also be examined. Lastly, the process used by municipal issuers to raise capital and
applicable MSRB Rules will be described.
Capital Formation
As previously detailed, when a corporation intends to raise capital, it usually does so by issuing securities
through a formal offering.
Offering Securities to Investors

Public versus Private Securities Offerings (Private Placements) Securities may be offered or
issued in two ways—private placements and public offerings. The main advantage of a public offering is
the large number of investors (both retail and institutional) who are permitted to participate. The
disadvantages include both the costs involved and the length of time needed to undertake this type of
offering due to the requirements of the Securities Act of 1933.
In some cases, institutional investors, (e.g., venture capitalists or private equity investors) provide start-up
capital to new companies. The capital is typically raised through a form of non-public offering referred to as
a private placement. The primary advantage of a private placement is that it’s faster and less costly than a
public offering. However, a disadvantage faced by an issuer engaged in a private placement is that there are
limits related to whom the offering may be directed and/or the number of investors that may participate.
An Initial Public Offering Versus a Follow-On Offering When an issuer offers securities to the
public for the first time, the process is referred to as its initial public offering (IPO). However, if a
company has already gone public and intends to raise additional capital through a sale of common stock,
it’s conducting a follow-on offering. In a follow-on offering, the company itself is issuing new shares
which dilute the ownership of existing shareholders. Keep in mind, these offerings are still considered
primary distributions since the proceeds of the offering are being directed to the issuer.
Combined (Split) Offerings In a combined offering, some of the shares are offered by the issuer, while
the remainder are offered by selling shareholders. The shares being sold by the company are newly
created and constitute a primary offering. The company issuing the securities receives the proceeds of
that portion of the sale. When the company’s existing shares are sold by its current shareholders, it’s
considered a secondary offering with the proceeds of this portion of the offering being directed to the
individual sellers, not the issuer.

If the offering is split, it’s imperative for the underwriters to disclose to any purchaser that a portion of the
offering’s proceeds will be paid to the selling shareholders. Selling shareholders may include officers of
the company or early-entrance investors (institutional investors) who are seeking to either cash out or scale
back their holdings in the company.
Private Investment in Public Equity (PIPE) A PIPE offering is a private placement of securities in
which a broker-dealer assists an issuer by distributing restricted (i.e., unregistered) securities to a small
group of accredited investors, such as hedge funds. The issuer of the securities already has publicly traded
securities outstanding. These restricted securities are purchased at a price that’s below the current price of
the common stock at the time of the announcement. Once the PIPE offering is announced, the company’s
share price will often decline. This price decline is in part a reflection of the increase in the number of
shares outstanding (potential dilution), but also due to the perception that the company not only is in need
of capital, but that it has limited means available to raise the capital. Often PIPE investors hold the restricted
securities for a short period and will then quickly resell them in the public marketplace.
The Role of an Underwriter/Investment Banker

An underwriter is a broker-dealer that helps corporations or municipalities that are interested in raising capital
through the distribution of their stocks or bonds. When acting as an underwriter, an investment banker may
assume risk by buying the new issue from the issuing corporation and reselling it to the public. The
investment banking function is an extremely important one since it brings the issuer and potential buyers
together. The responsibility of an investment banker is to ensure that an issuer is able to raise capital under the
most advantageous terms. The proceeds of these offerings may represent new funds to the issuer or they may
be used to refinance its capital structure.
Underwriting Commitments
The sale of a public offering is typically conducted through a group of broker-dealers known as an
underwriting syndicate. The responsibilities of the syndicate members are dependent on the type of
underwriting commitment involved. The term syndicate implies that a financial commitment is being
made by the underwriters.
Firm-Commitment If a syndicate is acting for its own account and risk by agreeing to purchase the
entire issue and absorb any securities that are not sold, it’s engaging in a firm-commitment underwriting.
Therefore, the syndicate is firmly committing itself to the issuing corporation for the entire amount of the
offering, regardless of whether it’s able to sell the securities.
For example, a corporation wants to sell $10,000,000 of stock, but the syndicate is only
able to sell $8,000,000 of it. In a firm commitment, the syndicate members will absorb
the $2,000,000 of unsold stock for their own accounts.
Best-Efforts In a best-efforts underwriting, underwriters agree to sell as much of the new offering as
they’re able to, with the stipulation that they can return any unsold securities to the issuer.

In this case, the underwriters are acting in the capacity of an agent for the issuer, rather than as a principal
for their own accounts. The agreement requires that they make a bona fide effort to sell the entire issue;
however, if unsuccessful, they will return the unsold portion to the issuer without penalty.
For example, a corporation wants to sell $10,000,000 of stock, but the underwriters are
able to sell only $8,000,000 of it. In a best-efforts underwriting, the syndicate will return
the $2,000,000 of unsold stock to the corporation.
Under certain circumstances, a corporation may require a specific minimum amount of capital to be raised.
The issuing corporation may determine that raising a lesser amount will not permit it to accomplish its
objectives. Therefore, if the minimum contingency is not met, the offering will be cancelled.
All-or-None One such contingency is the best-efforts all-or-none. As in the straight best-efforts
arrangement, the underwriters act as agents for the issuer and attempt to sell as much of the offering as
possible. However, if the entire issue is not sold, all sales that were made must be cancelled and the money
must be returned to the subscribers.
Mini-Maxi Another variation of a best efforts underwriting is the mini-maxi underwriting. With this form,
there’s a minimum threshold of sales that must be met in order for the offering to avoid cancellation.
However, once that minimum is met, additional sales may be made up to a specified maximum amount.
For example, a corporation intends to sell $10,000,000 of stock. Based on the company’s
capital needs, it requires that at least 70% of the offering be sold. Therefore, a minimum of
$7,000,000 of the stock must be sold or the entire issue will be cancelled. Once the minimum
sales level has been satisfied, the underwriters will continue to sell the remaining securities
($3,000,000) without the risk that the offering will be cancelled.
Standby Agreements If a corporation wishes to sell additional shares, it may conduct a preemptive
rights offering. In this process, the current shareholders will be granted the opportunity to purchase
additional shares before the offering is made public. In a standby underwriting arrangement, the syndicate
(in return for a fee) agrees to purchase any unsubscribed shares from the rights offering. In other words, if
the current shareholders fail to subscribe to the stock available through the rights offering, the investment
banker will purchase the residual shares on a firm-commitment basis.

Type of Underwriting Comments Liability for Unsold Shares
Firm-Commitment Syndicate must absorb losses on unsold shares Syndicate
Best-Efforts Unsold shares are returned to issuer Issuer
Best-Efforts All-or-None Offering is cancelled if all shares are not sold Issuer
Best-Efforts Mini-Maxi Offering is cancelled if set minimum is not sold Issuer
Syndicate agrees to buy any shares not purchased

Standby Syndicate
by existing stockholders in a rights offering
Market-Out Clause If the written agreement entered into by the underwriting syndicate and the issuer
contains a market-out clause, the syndicate may be able to cancel the agreement. The justification for
cancelling the commitment is based on certain events occurring that make marketing the issue difficult or
impossible. Examples of these events include a material adverse circumstance that affects the (proposed) issuer
or a general disruption in financial markets caused by external forces.
Distribution of Securities
A broker-dealer that’s contemplating the possibility of becoming the manager in a distribution of securities
must perform due diligence on both the issuer and the issue. This due diligence process is completed by
examining the issuer’s history, the quality of the company’s management, labor relations, financial and
operational data, legal matters, and comparable companies in the same field to determine the viability of
the distribution and the price at which to market the issue.
Syndicate The managing broker-dealer will then form a syndicate by inviting other broker-dealers to
participate in the distribution and share in liability. The written agreement between the manager and
syndicate members—referred to as the syndicate letter or agreement among underwriters—is signed by
the participants and specifies their rights and obligations.
Selling Group In some cases, the syndicate will recruit other broker-dealers to assist in the sale of the
offering. These firms are selling group members that don’t assume financial liability for the offering, but
instead act as placement agents. Any shares that are not sold by the selling group are retained by the
syndicate due to the fact that it remains financially liable for any unsold shares. To join a selling group, a
broker-dealer must sign a selling group agreement which describes the relationship/responsibilities between
the selling group and the syndicate manager.
Each firm that participates in a new issue distribution must review its transactions for suitability. However,
the syndicate manager is under no obligation to review trades executed by selling group members.
Additionally, a broker-dealer that’s participating in a distribution of securities (primary or secondary) may
not pay any third party or unregistered person (e.g., an accountant, finder, or attorney) to solicit another
person to purchase the security.

Syndicate Practices Either on or immediately prior to the effective date of an offering, the underwriters
will assess the demand for the issue and will determine its public offering price (POP). If the offering price is
satisfactory to the issuing corporation, the new issue distribution will proceed. Syndicate members are
required to maintain the public offering price and, unless they’re released from this commitment by the
managing underwriter, they may not sell the issue at a lower price. Since the syndicate requirements remain
in effect until terminated by the syndicate manager, all investors will pay the same price (the POP).
Determining the Public Offering Price The price set for a primary offering is fixed and applies to all
sales made to the public. For an IPO, the underwriters will take various factors into account including
corporate earnings, dividend payouts, the prices of similar companies currently trading in the secondary
markets, indications of interest, and current market conditions. For subsequent offerings, the underwriters are
conveniently able to use the current market price of the existing shares.
Underwriting Spread The underwriting spread is the difference between the amount paid by the
investing public and the amount received by the issuing corporation. This spread represents the syndicate’s
gross profit. Depending on how the shares are sold, the spread may be shared by the manager, syndicate
members, and selling group members.
The spread consists of the following components:

 Manager’s Fee—the portion that’s paid to the managing underwriter for each share of the offering
 Member’s/Underwriter’s Fee—the portion paid to the syndicate member that’s assuming the risk or
liability for the shares
 Concession—the portion that’s paid to the firm selling the shares
 Reallowance – a portion of the concession paid to selling broker-dealers that are not syndicate members
Example: The Distribution of an Underwriting Spread
Member’s/Underwriter’s
Public Offering Price:
Fee: $.45
$20.00
Manager’s Fee: $.15 Concession: $.80
Proceeds to Issuer: $18.60

Syndicate Compensation In the example above, the corporation is issuing stock to the public at $20 per
share, with a total spread of $1.40 per share. Of the $1.40 spread per share, $.15 is allocated to the
manager’s fee, $.45 is allocated underwriter’s fee (also referred to as underwriting risk) and $.80 is
allocated to the firm that sells (concession).
Selling Group Compensation Remember, the selling group is comprised of broker-dealers that don’t
assume financial liability. Therefore, if a selling group member sells the shares, it’s only entitled to the
$.80 selling concession per share. Broker-dealers that sell shares and are not a part of the selling group will
receive the reallowance.
Since there are different possibilities for how the shares may be sold, let’s consider how the spread is
distributed for each of them.
If the Manager If a Syndicate If a Selling Group

Sells Shares Member Sells Shares Member Sells Shares
Manager’s Compensation $1.40 $.15 $.15
Syndicate Member’s
.00 $1.25 $.45
Compensation
Selling Group Member’s
.00 $.00 $.80
Compensation
As is illustrated in the table above, if the syndicate manager sells the shares to its customers, it’s entitled to
the total spread of $1.40 per share. This is due to the fact that the firm was not only the manager, but also
the firm with liability for the shares, and ultimately the seller of the shares.
If a syndicate member sells the shares, the manager is entitled to its fee of $.15 per share, but the syndicate
member is entitled to both the liability or underwriter’s risk ($.45) and the concession ($.80) components
of the spread, which totals $1.25 per share.
And finally, if a selling group member sells the shares, the manager is entitled to its fee of $.15 per share,
the syndicate member that received the allocation of shares is entitled to $.45 per share for its liability, and
the selling group is entitled to the selling concession of $.80 per share. There’s certainly a financial
incentive for syndicate members to sell the shares they receive since they will receive both the
underwriter’s fee and the selling concession. However, if the syndicate members utilize selling groups,
they sacrifice the concession to the selling group.
Securities Act of 1933

The Securities Act of 1933 attempts to prevent fraud in the sale of new issues by requiring that investors
be provided with enough relevant information about the offering to make an informed investment decision.
This information is provided through the registration statement which is a public document that issuers
file with the SEC.

The registration statement is designed to provide full disclosure of all material information about both the
issuer and the offering. Issuers are also required to prepare a prospectus for distribution to potential purchasers.
The prospectus is essentially an abbreviated version of the registration statement.
The SEC simply reviews the information contained in the prospectus; it doesn’t attest to its accuracy.
Since both the issuer and the managing underwriter have liability for any omissions and/or inaccuracies in
the documents it provides to shareholders, the managing underwriter must review all disclosure
documentation. This review process is required as a part of the underwriter’s due diligence obligation.
The Registration Process

Next, let’s examine the registration process for securities. The process includes the following three phases:
1. The preregistration period
2. The cooling-off (waiting) period
3. The post-effective period
The Preregistration (Prefiling) Period

During the preregistration phase, an issuer prepares its registration statement. When the registration
statement is completed, the issuer files it with the SEC. The date on which it’s filed marks the end of the
preregistration period. An underwriter will often assist the issuer during this process; however, the
underwriter may not yet discuss the new issue with its customers. This is the point at which the due
diligence process begins for the managing underwriter.
Registration Statement Under the Securities Act of 1933, a registration statement must contain
detailed information about the issuer, its business, its owners, and its financial condition. The required
information includes:
 The character of the issuer’s business
 A balance sheet created within 90 days prior to the filing of the registration statement
 Financial statements that show profits and losses for the latest fiscal year and for the two preceding
fiscal years
 The amount of capitalization and use of the proceeds of the sale
 Monies paid to affiliated persons or businesses of the issuer
 Shareholdings of senior officers, directors, and underwriters, and identification of individuals holding
at least 10% of the company’s securities
Shelf Registration Under certain circumstances, securities may be sold on a delayed or continuous
basis. This could include securities to be issued on behalf of the issuing company or selling shareholders
(insiders) to raise additional capital, for employee benefit plans, or for securities that must be issued upon
conversion of other securities.

Registration is allowed only for an amount that may reasonably be sold within three years after the initial
date of registration. The advantage of the delayed distribution is that it provides the issuing company and
its underwriters with the flexibility to sell the securities when market conditions are the most favorable.
The Cooling-Off Period

The second phase in the registration process is the 20-day cooling-off or waiting period. During this time, the
SEC reviews the issuer’s registration statement to determine if it’s complete and that it contains no misleading
statements. However, the SEC doesn’t judge the investment merits of the issue or the appropriateness of the
pricing of the issue. The cover of a prospectus will include the SEC’s no-approval clause to indicate that the
SEC doesn’t approve, nor disapprove, of the securities being offered. If the SEC believes the registration
statement to be incomplete or misleading, it sends a deficiency letter to the issuer. The issuer must then refile an
amended registration statement for SEC review.
Red Herring During the cooling-off period, broker-dealers are able to send a condensed form of the
registration statement to potential buyers. This document is referred to as the preliminary prospectus or red
herring. The red herring has a statement on its cover page (in red writing) to indicate that a registration
statement has been filed with the SEC, but has not yet become effective. Also, the final offering price is not
included in the red herring; instead, it may indicate a price range (e.g., $14 to $17 per share).
During the cooling-off period, underwriters are permitted to:

 Discuss the issue
 Provide the red herring to potential purchasers
 Record the names of persons providing an indication of interest (the indications are not binding for
either party)
During this period, underwriters are not permitted to:

 Accept payment for the new issue in advance
 Sell the new issue (since the deal is not effective and has not been priced)
Prospectus Alterations A prospectus is the primary source of information for most retail investors. This
document may not be amended or altered in any way, including highlighting and/or underlining relevant
portions of the document, unless the changes are filed with the SEC. Essentially, an RR may discuss
certain portions of the prospectus with the client, but should not make any marks on the document.
State or Blue-Sky Laws In addition to satisfying SEC registration requirements, issuers are required
to comply with applicable state registration laws. This process is conducted during the cooling-off period.
State securities laws are established under the Uniform Securities Act (USA) and are often referred to as
Blue-Sky Laws.

The three methods of state securities registration include:

1. Notification (also referred to as filing)—Although not allowed in all states, this method simply
involves submitting an application with the state Administrator requesting approval to offer securities
in the state.
2. Coordination—This form is completed simultaneously with a federal registration and generally
becomes effective at the same time.
3. Qualification—This method involves meeting the specific requirements of one state and becomes
effective at the discretion of the state Administrator.
Along with securities, states also require the registration of both broker-dealers and their agents (RRs) in
each state in which they plan to do business. If broker-dealers and their agents are not properly registered
or if they violate state securities regulations, the state Administrator may take action against them.
Firms should have systems and procedures in place to ensure that securities are being sold only in states in
which they’re registered. Safeguards may include account coding in an effort to prevent transactions in
states where no valid registration exists for the securities.
Due Diligence Just prior to the determination of the effective date, a bring down due diligence meeting
is held. The participants at this meeting include the underwriters, syndicate members, officers of the
issuer, attorneys, and accountants. The purpose of the meeting is to review the different aspects of the
planned underwriting, including certifying that the issuer and its underwriters have satisfied state and
federal laws. If the parties involved don’t exercise due diligence, they could find themselves as
defendants in stockholder lawsuits.
Effective Date The effective date represents the end of the cooling-off period and the beginning of the
post-effective period. Generally, a registration statement’s effective date is 20 days after the filing or the last
amendment in response to a deficiency letter. If a written request is received from the issuer or its underwriters,
the SEC may accelerate this process.
The Post-Effective Period

By the morning of the effective date, the public offering price (POP) is usually set by the underwriters and it’s
at this point that sales of the offering may begin. Purchasers must be provided with a copy of the final
prospectus which will now include the public offering price. This final prospectus must be delivered to
purchasers no later than the time a sale is confirmed.
Broker-dealers are required to take reasonable steps to fulfill written requests for a prospectus. During
the cooling-off period, the preliminary prospectus is sent; however, after the effective date, a final
prospectus must be supplied. In many cases, a client may request that disclosure documents be provided
in an electronic format. Under SEC rules, providing clients with electronic access equates to the delivery
of the relevant documentation.

Actions by RR After the Effective Date Once an offering is declared effective, a broker-dealer will be
notified of its allocation. The firm’s RRs should then contact all of its clients who received a preliminary
prospectus to determine if they have made a purchase decision. If the client acknowledges his interest and
places an order, the order is binding. All broker-dealers are required to provide a final prospectus to
purchasers in the primary market, even those who already received the preliminary prospectus.
Crowdfunding
The Jumpstart Our Business Startups (JOBS) Act established the provisions that allow small businesses to
raise capital using the internet through a process that’s referred to as crowdfunding. This process gives
certain members of the general public the ability to invest in start-up companies. Suitability is of great
consideration due to the potential risks of investing in these types of companies. For this reason, there’s a
limit to the amount that these individuals are permitted to invest based on their annual income and/or net
worth. Investments can only be made through the online platform of a broker-dealer or a funding portal. The
broker-dealer and the funding portal must be registered with the SEC and be a FINRA member. Funds
cannot be sent directly to the company or the broker-dealer.
Prospectus Delivery Requirements

Although many often assume prospectus delivery is a primary market requirement, depending on the type of
company issuing the security, a dealer may be required to satisfy an aftermarket prospectus delivery requirement.
Non-Listed Companies Non-listed companies are those whose stocks don’t trade on exchanges such as the
NYSE or Nasdaq. A dealer selling an IPO that will not be listed is required to continue to deliver the
prospectus for 90 days. However, if that same unlisted company conducts a follow-on offering, the requirement
is shortened to 40 days.
Listed Companies Companies whose stock trades on an exchange, such as the NYSE or Nasdaq, are
referred to as listed companies. These listed companies are also referred to as reporting companies since
they’re required to file financial statements with the SEC. In some cases, a dealer selling securities may be
required to deliver a prospectus even after the deal has closed. For an offering involving an issuer that’s
not a reporting company prior to filing (such as an IPO issuer), but will be listed on an exchange or on
Nasdaq as of the effective date, an aftermarket delivery requirement applies for 25 days. In the case of a follow-
on offering for an issue that’s NYSE- or Nasdaq-listed, there’s no prospectus delivery requirement for dealers
once the deal has closed.
Summary of Prospectus Delivery Requirements

Security Time Frame
For a non-listed IPO 90 days
For a non-listed follow-on offering 40 days
For an IPO of a security to be listed on the NYSE or Nasdaq 25 days
For an NYSE or Nasdaq-listed follow-on offering No requirement

The following graphic is a summary of the typical registration process:
- Prepare registration statement - Extends for 20 days from - Final prospectus issued
- No discussions with customers amendment, unless accelerated - Sales confirmed
- Preliminary prospectus delivered - 25/40/90-day aftermarket prospectus
- Blue-Sky the issue requirement for dealers
- Hold due diligence meeting
- Accept indications of interest
Free Writing Prospectus When most investors use the term prospectus, they think of the large
disclosure document that’s used when an issuer is offering securities. In fact, what they’re imagining is a
statutory prospectus. The SEC also permits frequent issuers of securities to use other types of abbreviated
disclosure documents that are referred to as free writing prospectuses (FWP). An FWP is any
communication that doesn’t meet the standards of a statutory prospectus, but is considered a solicitation of
an offer to buy a security. Examples include term sheets, marketing materials, and press releases whether
prepared by the issuer (which is usually the case) or an underwriter. The SEC requires that a legend be
included within the free writing prospectus to indicate whether the issuer will file a registration statement
and how a prospectus may be obtained.
The New Issue Rule

Under the New Issue (Equity IPO) Rule, a FINRA member firm is required to make a bona fide offering of new
issues to the public and may not withhold shares for its own account, the accounts of any of its employees,
or for accounts of industry insiders. However, an exemption exists that allows personnel of a limited
broker-dealer to purchase shares of a new issue. A limited broker-dealer is a firm that restricts its business
to investment company/variable contract securities or direct participation programs.
New Issue Definition

New issues include all initial public offerings (IPOs) of equity securities that are sold under a registration
statement or offering circular. The following securities are not considered new issues and may be sold to
restricted persons:
 Secondary offerings
 All debt offerings, including convertible and non-investment-grade
 Private offerings
 Preferred stock and rights offerings
 Investment company offerings
 Exempt securities as defined under the Securities Act of 1933
 Real estate investment trusts (REITs)
 Direct participation programs (DPPs)

Preconditions for Sale

Prior to selling a new issue to an account, a firm must satisfy the preconditions for sale requirement. In other
words, the firm must obtain verification from an account holder or any authorized party for the account that
states that the account is eligible to purchase new issues in accordance with the New Issue Rule before
distributing a new issue to that account. The representation from the account holder may be in the form of an
affirmative written statement or electronic communication (but not oral statements) that positively declares
that the account is eligible. Thereafter, a member firm must re-verify eligibility at least every 12 months and
must retain copies of all information and records that are used for verification for at least three years.
Member firms may satisfy the re-verification requirement by sending the client a negative consent letter
which requires the client to notify the firm if he disagrees with the information in the letter.
Prohibited Sales and Restricted Persons

A member firm or any person associated with a member firm is prohibited from offering or selling a new
issue to any account in which a restricted person has a beneficial interest of more than 10%. According to
the New Issue Rule, all of the following are considered restricted persons:
 Member firms and all associated persons (i.e., employees) of the member firm
 An immediate family member * of a member firm employee if any one of the following three
conditions apply:
(* Immediate family members include a person’s spouse, children, parents, siblings, in-
laws, and any other person to whom the member firm employee provides material support.
However, aunts, uncles, and cousins are not defined as immediate family members and
are, therefore, not considered restricted persons.)
1. The employee gives/receives material support to/from the immediate family member. (Material
support is defined as providing more than 25% of the person’s income or living in the same
household as the person who is associated with the member firm.)
2. The employee is selling the new issue to the immediate family member through his firm.
3. The employee has the ability to control the allocation of the new issue.
Example 1, if John is employed by ARW Investment Bank and supports his brother, his
brother is considered a restricted person.
Example 2, Keith is employed by NJF Investment Bank and the firm is the managing
underwriter of Mattco’s IPO. Due to Keith’s employment with a member firm, his immediate
family members are restricted from purchasing shares in the Mattco IPO from NJF.
Other restricted persons include the following individuals:

 Finders and fiduciaries (e.g., attorneys and accountants) who are involved in the offering of the new
issue and anyone they materially support.
 Portfolio managers who are purchasing for their own accounts. This provision includes persons who
typically buy or sell securities on behalf of institutional investors (e.g., banks, investment companies,
investment advisers, and insurance companies). The reason for their restricted status is that these persons
are in a position to direct future business to the firm.

 Persons who own a broker-dealer. This generally incorporates persons who have 10% or more ownership of
a brokerage firm and requires them to report their restricted person status on Form BD.
General Exemptions
The New Issue Rule exemptions allow equity IPOs to be sold to the following accounts:
 An investment company registered under the Investment Company Act of 1940
 The general or separate account of an insurance company
 A common trust fund
 An account in which the beneficial interest of all restricted persons doesn’t exceed 10% of the
account. (This de minimis exemption allows an account that’s partially owned by restricted persons to
purchase a new issue if their combined ownership is 10% or less.)
 Publicly traded entities, other than a broker-dealer or its affiliates, that engage in the public offering of
new issues
 Foreign investment companies
 ERISA accounts, state and local benefit plans, and other tax-exempt plans under IRS Code 501(c)(3)
Another exemption under the rule allows a broker-dealer to purchase shares of a new issue if the offering
is undersubscribed. This provision allows an underwriter that has entered into a firm commitment
agreement with an issuer to purchase shares for its own investment account if it’s unable to sell them to the
public. However, this exemption doesn’t allow an underwriter to sell shares of an undersubscribed issue to
other restricted persons.
The rule also contains an anti-dilution provision that allows restricted persons who already own shares of
the security to purchase shares of a new issue, but only if doing so will keep their equity interest at the
same level. Under this provision, the buyer must have owned the shares for at least one year prior to the
offering and the new shares may not be resold for three months following the effective date.
Issuer-Directed Securities
The clear intent of the New Issue Rule is to eliminate the selling of equity IPOs to certain purchasers. The
prohibitions will not apply to securities that are specifically directed by the issuer to persons that are
restricted under the Rule; however, the securities directed by the issuer may not be sold to or purchased by:
 A broker-dealer
 An account in which any restricted person has beneficial interest, unless the person, or a member of
his immediate family, is an employee or director of the issuer, the issuer’s parent, or a subsidiary of
the issuer
For example, a partnership has recently decided to incorporate and, with the help of an underwriter, is
planning to conduct an equity IPO. Jerry, one of the founding partners who was recently appointed as the
new company’s CEO, wants to ensure his family is able to share in this investment opportunity. Will Jerry’s
mother and father be allowed to purchase the new issue or are they restricted?

Since Jerry is an officer of the issuer, he’s able to have the underwriter allocate shares to his parents.
Is Jerry’s brother, who happens to be a registered representative of a broker-dealer, allowed to
purchase the securities? Yes. The issuer-directed sale provision allows an otherwise restricted person
(e.g., an RR) to purchase the securities provided he or his immediately family member is an employee
or director of the issuer.
Exempt Securities
Now that the registration process is complete, it may be obvious that there’s a significant time and cost savings
for issuers that qualify for an exemption from registration. The SEC has determined that the following
securities are exempt from the registration and prospectus requirements of the Act of 1933:
 U.S. government and U.S. government agency securities
 Municipal securities
 Securities issued by non-profit organizations
 Short-term corporate debt instruments that have a maturity not exceeding 270 days
(e.g., commercial paper)
 Securities issued by domestic banks and trust companies
 Securities issued by small business investment companies
Although these securities are exempt from the registration and prospectus requirements of the Securities Act of
1933, they’re not exempt from the antifraud provisions of the Act. This means that, in the event that fraud occurs,
the SEC may prosecute offenders regardless of the status of the security sold.
Exempt Offerings
In some cases, it’s the manner in which securities are being offered that provides the exemption from the
registration requirements of the Act. The SEC will only provide an exemption if it feels that there’s a good
reason for doing so. Some examples of exempt offerings are based on (1) issuers limiting the amount of capital
being raised, (2) securities being offered in only one state, and (3) securities being offered privately.
Regulation A (A+)
Under Regulation A, if an issuer offers a new issue of securities valued at $50 million or less sold over a
12-month period, the offering is exempt under the Act. However, it’s not a complete exemption since the
issuer must file an offering statement with the SEC and provide an offering circular to prospective
purchasers. Advantages of conducting a Regulation A offering rather than a full registration include lower
legal and filing fees and a shorter time needed to prepare documents.
The JOBS Act expanded Regulation A (which was originally $5 million) into two tiers and changed the
title to Regulation A+.

 Tier 1 – Sales of up to $20 million are permitted within a 12-month period. Of that amount, no more
than $6 million may be sold on behalf of selling shareholders.
− The offerings are subject to both SEC and blue sky review
− Continuing disclosure information must be filed
 Tier 2 – Sales of up to $50 million are permitted within a 12-month period. Of that amount, no more
than $15 million may be sold on behalf of selling shareholders.
− The offerings are subject to SEC review, but not Blue Sky review
− Has stricter continuing disclosure information and filing requirements
The following chart summarizes Regulation A rules:
Registration Exemptions
Regulation A+ Tier 1 Regulation A+ Tier 2
Maximum offering size $20 million $50 million
Time period 12 months 12 months
Maximum amount that may be
$6 million $15 million
offered by existing shareholders
Required audited financial
No Yes
statements/ongoing reporting
Additional Information Regarding Regulation A:

 Current SEC reporting companies may not use Regulation A
 Both U.S. and Canadian companies are eligible
 The offerings may be for either equity or debt securities
Rule 147 and Rule 147A

Rule 147 was created as a safe harbor under the statutory intrastate offering exemption which is provided
by the Securities Act of 1933. The rule (also referred to as the intrastate exemption) allows companies to
raise capital from their in-state investors. Typically, companies that are selling new securities are required
to register their securities with the SEC; however, under Rule 147, if a company is conducting an offering
and only selling its securities to its state residents, the offering is exempt from registration. Today, the
strict issuer eligibility requirements and developments in both company business practices and
communications technology have made Rule 147 outdated.
Amendments to the existing Rule 147 and the implementation of a new rule—Rule 147A—became effective
on April 20, 2017. These new rules are designed to update and modernize the existing intrastate offering
framework and permit a company to raise money from investors who reside within its state without being
required to register the offers and sales at the federal level.

Although it’s similar to Rule 147, the new Rule 147A will allow for multi-state offers (not sales), which
means that:
 Issuers will be permitted to use general solicitation and publicly available websites to locate potential
in-state investors. Although offers are able to be made outside of the state, all sales must still be
limited to in-state residents.
 Companies will be able to be incorporated or organized outside of the state in which they conduct the
offering as long as they have their principal place of business in that state. Principal place of business
is defined as the location from which the principal officers, manager, or partners primarily direct,
control, and coordinate the activities of the issuer.
− For example, ABC is incorporated in Delaware, but its principal business is conducted in New
Jersey. Under Rule 147A, ABC will be allowed to sell securities to residents of New Jersey.
Both the amended Rule 147 and the new Rule 147A include the following provisions:
 For an issuer to sell securities in a state, it must have its principal office (under Rule 147) or principal
place of business (under Rule 147A) in that state and satisfy one of four “doing business”
requirements. By satisfying one of the four new requirements, the issuer can avoid having to comply
with all three of the 80% tests for assets, revenue, and proceeds of the offering.
− If a Rule 147 or 147A issuer subsequently changes its principal place of business after issuing
securities, it will not be able to conduct another intrastate offering under these rules in another state
for a period of six months from the date of last the sale in the previous state.
− An issuer is considered to be “doing business” in a state as long as it meets just one of the following
four new requirements:
1. At least 80% of its consolidated gross revenues are derived from the operation of a business or
of real property that’s located in the state or territory or from the rendering of services within the
state or territory;
2. At least 80% of its consolidated assets are located within the state or territory at the end of its
most recent semi-annual fiscal period prior to the first offer of securities under the exemption;
3. At least 80% of the net proceeds from the offering are intended to be used by the issuer, and are
in fact used in connection with the operation of a business or of real property, the purchase of
real property located in, or the rendering of services within the state or territory; or
4. A majority of the issuer’s employees are based in the state or territory (this fourth requirement
was not included in the original Rule 147)
 An issuer must utilize a reasonable belief standard when determining the residency of the purchaser at
the time of the sale of securities. This standard is supported by the requirement that the issuer obtain a
written representation from all purchasers as to their residency.
− If the purchaser is a legal entity (e.g., a corporation, partnership, trust, or other form of business
organization), residency is defined as the location where, at the time of the sale, the entity has its
principal place of business.

 Resales to persons who reside outside of the state in which the offering is conducted are restricted for
a period of six months from the date of the sale by the issuer to the purchaser (formerly nine months).
− A legend requirement applies in order to notify offerees and purchasers about the resale restriction.
Regulation D
Regulation D is a safe harbor which permits securities offerings to be sold as private placements without
SEC registration. Many securities professional use the term exempt transactions when referring to these
offerings since their exemption is based primarily on the method being used to offer these securities, not on
the type of securities being offered. Under Regulation D, an issuer’s private placement of securities qualifies
for an exemption provided the following conditions are met:
 The issuer must have reason to believe that the buyer is a sophisticated investor (i.e., one who is
experienced enough to evaluate any risks involved)
 The buyer must have access to the same financial information that is normally be included in a
prospectus. This information is provided in a document that’s referred to as a private placement
memorandum.
 The issuer must be assured that the buyer doesn’t intend to make a quick sale of the securities. This is
usually accomplished by means of an investment letter (also called the lock-up agreement).
 The securities are sold to no more than 35 non-accredited investors.
Accredited Investor For private placements, there’s no restriction on the number of accredited
investors. An accredited investor includes any of the following:
 Financial institutions (e.g., banks), a large tax-exempt plans, or private business development companies
 Directors, executive officers, or general partners of the issuer
 Individuals who meet either one of the following criteria:
– Have a net worth of at least $1,000,000 or
– Have gross income of at least $200,000 (or $300,000 combined with a spouse) for each of the past
two years with the anticipation that this level of income will continue
Restricted Securities—Lock-Up Agreements and Legends A lock-up agreement dictates the amount of
time that pre-IPO investors, such as private placement buyers, management, venture capitalists, and other
insiders, must wait to sell their shares once the company has gone public. Although a lock-up agreement will
generally expire six months following the closing of the company’s IPO, there’s no statutory time limit. The
lock-up is designed to prohibit management and venture capitalists that initially funded the company from
immediately liquidating their shares once the issue goes public.
The lock-up period also restricts or limits the supply of shares being sold in the market. Shares subject to a
lock-up agreement will carry a restrictive legend that’s printed across the face of the certificate to indicate
that the securities have not been registered with the SEC and are not eligible for resale unless the legend is
removed. In many cases, the removal of the legend is accomplished under SEC Rule 144.

Rule 144
Rule 144 regulates the sale of restricted securities and control (affiliated) securities. Restricted securities are the
unregistered securities that are typically acquired by investors through private placements. Control securities
are registered securities that are acquired by control (affiliated) persons in the secondary market. Control
persons may include officers, directors, or other insiders (more than 10% ownership) and their respective
family members. Both restricted securities and control securities must be sold according to Rule 144.
There are five basic requirements of Rule 144; however, not all requirements apply to every sale. The
requirements are:
1. Current public information
2. Holding period
3. Notice of sale
4. Volume limitations
5. Manner of sale
Affiliates of the issuer must comply with all five of the requirements. However, sellers who are non-
affiliates are only subject to (1) the current public information and (2) the holding period requirements. To
qualify as a non-affiliate, a person must not be an affiliate of the issuer at the time of sale and must not
have been an affiliate during the preceding three months.
Current Public Information In order to take advantage of the exemption afforded by Rule 144,
adequate public information must be available regarding the issuer before the sale can be made. For
reporting companies, this generally means that the companies have complied with the periodic reporting
requirements of the Securities Exchange Act of 1934.
Holding Period For restricted securities of a reporting company (one that’s subject the reporting
requirements of the Securities Exchange Act of 1934), the purchaser must hold the securities for
six months before he may dispose of them. The six-month holding period starts from the time the securities
were fully paid for (no margin) by the original purchaser. The holding period doesn’t apply to control
securities. Since securities that are acquired in the public market are not restricted, there’s no mandatory
holding period for an affiliate that purchases the securities in the marketplace. However, the resale of an
affiliate’s shares as control securities is subject to other conditions of the rule.
For restricted securities of a non-reporting company, the purchaser must hold the securities for
one year after having fully paid for the securities before he may dispose of them.
Notice of Sale Under Rule 144, a person that intends to sell either restricted or control securities must notify
the SEC by filing Form 144 at the time the sell order is placed with the broker-dealer. If the securities being sold
under the provisions of Rule 144 have not been sold within 90 days of the date the notice was filed with the
SEC, an amended notice must be filed. If the seller (e.g., a charity) was given stock by a restricted person who
had held the shares for at least six months, it’s still subject to all provisions of Rule 144. An exemption from the
notice of sale requirement is available if the amount of the sale doesn’t exceed 5,000 shares or securities with a
value that doesn’t exceed $50,000.

Volume Limitation Under Rule 144, the maximum amount of securities of an exchange-listed company
that may be sold over any 90-day period is the greater of 1% of the total shares outstanding or the average
weekly trading volume during the four weeks preceding the filing.
For example, an issuer has 7,000,000 shares outstanding and the average weekly
trading volume for the past four weeks was 60,000 shares. Since 1% of the total shares
outstanding is 70,000 shares and the four-week average is 60,000 shares, the holder
could sell the greater of these two amounts, which is 70,000 shares.
For over-the-counter (non-listed) equities, the maximum that may be sold is 1% of the total shares
outstanding.
Manner of Sale The broker-dealer that handles Rule 144 sales may do so through brokers’ transactions
or through transactions that are made directly with market makers. Brokers’ transactions are defined as
transactions being made on an agency basis only and don’t involve solicitations. However, a broker may
make inquiry in the following two cases:
1. If a customer has indicated an unsolicited interest in the securities within the preceding
10 business days
2. If another broker has indicated an interest in the security within the preceding 60 days
Rule 144A
Under Rule 144A, sales of restricted securities are permitted to sophisticated investors without being
subject to the conditions imposed by Rule 144. Ultimately, Rule 144A creates a more liquid private
placement market. The securities offered under Rule 144A may be equity or debt securities and may be
offered by either a domestic or foreign issuer. After the issuance, the securities may be immediately resold
to a qualified institutional buyer.
Qualified Institutional Buyers (QIBs) QIBs must satisfy a three-part test.

1. First, only certain types of investors are eligible, including:
 Insurance companies
 Registered investment companies
 Small business development companies
 Private and public pension plans
 Certain bank trust funds
 Corporations, partnerships, business trusts, and certain non-profit organizations
 Registered investment advisers
2. The buyer must be purchasing for its own account or for the account of another QIB.
3. The buyer must own and invest at least $100 million of securities of issuers that are not affiliated
with the buyer.
Certain buyers are subject to special alternative tests to the three-part rule listed above. For example, broker-
dealers are considered QIBs if they own and invest $10 million of securities of issuers that are not affiliated
with the dealer or if they act in a riskless principal capacity for other QIBs.

However, under no circumstances is an individual (even one who meets the standard of being an
accredited individual investor) considered to be a QIB.
Notification In a Rule 144A transaction, it’s the purchaser that must be a QIB. Although the seller is not
required to be a QIB, the seller must reasonably believe that the buyer is qualified. In addition, the seller
(or its agent) must notify the buyer that it’s relying on the Rule 144A exemption.
Disclosure Information In order to be eligible under Rule 144A, issuers must be willing to provide owners
and prospective purchasers with any requested current financial information. This disclosure requirement
doesn’t apply to issuers that are reporting companies under the Exchange Act of 1934, foreign private issuers
that are exempt from Exchange Act reporting, or certain foreign governments.
Ineligible Securities Certain securities are ineligible for Rule 144A transactions such as offers or sales
of securities that are of the same class as those listed on the NYSE or Nasdaq, including certain
convertibles and warrants. Also ineligible for this exemption are securities that are issued by registered
investment companies (e.g., mutual funds).
Rule 145
Rule 145 considers certain types of securities reclassifications as sales and determines that they’re subject
to the registration and prospectus requirements of the Securities Act of 1933. The reclassifications include:
 An issuer that substitutes one security for another
 A merger or consolidation in which the securities of one corporation are exchanged for the securities
of another corporation
 A transfer of assets from one corporation to another
Under Rule 145, a registration filing is required for all transactions. However, stock splits, reverse stock
splits, or changes in par value are not considered reclassifications and are therefore not subject to the rule.
Rule 145 is most often relevant in the case of an acquisition or merger.
Subject to Rule 145 Not Subject to Rule 145

 Substitutions  Stock splits
 Mergers/Consolidations  Reverse stock splits
 Transfers of assets  Changes in par value
Regulation S
When foreign companies issue securities in their home country, they’re subject to all of the laws of that
country; however, they would clearly not be subject to U.S. regulations. For many years, what was not so
clear was whether U.S. securities laws applied to U.S. companies that issue securities outside of the
country. The SEC provided clarification for this situation by issuing Regulation S. If a U.S. company
issues securities according to Regulation S, the securities are not required to be registered under the
Securities Act of 1933.

According to Regulation S, a U.S. company may efficiently issue an unlimited number of securities
outside of the country without filing any documentation with the SEC. Also, there are no restrictions as to
the type of non-U.S. investors who may purchase the security.
To qualify for a Regulation S exemption, the transaction must be executed offshore. An offshore transaction
is one in which no offer is made to a person in the U.S. and either (1) at the time the buy order is originated,
the buyer is outside the United States, or (2) the transaction is executed through the facilities of a designated
offshore securities market. Additionally, there may not be a directed selling effort in the U.S. which therefore
precludes activities such as the sending of printed materials to investors in the U.S., conducting promotional
seminars in the U.S., or advertising the offering in the U.S. (e.g., using radio, TV, or print media).
Only a non-U.S. person may buy an overseas offering sold under Regulation S. A U.S. person is defined as
any individual who is a resident of the U.S., as well as any partnership, estate, or account that’s held for
the benefit of a U.S. resident. If a U.S. citizen is traveling or resides outside of the U.S. for a significant
part of the year, he’s still classified as a U.S. investor.
An overseas investor who acquires securities pursuant to Regulation S may immediately sell the securities
overseas through a designated offshore securities market. However, if a purchaser intends to resell the securities
in the U.S., the following distribution compliance period (holding period) is imposed by Regulation S:
 40 days for debt securities
 One-year for equity securities
Additional Primary Market Regulations

Conflicts of Interest Regarding Public Offerings
At times, member firms that participate in the distribution of securities find themselves facing conflicts of
interest. In these cases, to ensure that the conflicts of interest are handled properly, member firms must
follow specific FINRA guidelines.
Essentially, if a member firm is participating in a public offering, conflicts of interest exist if any of the
following conditions apply:
 The member firm is the issuer of the securities
 The issuer controls or is under the control of the member firm
 At least 5% of the net proceeds, not including the underwriting compensation, are intended to reduce
or retire the balance of a loan extended by the member firm
Definitions of Terms As they relate to member firms distributing their own securities, there are three
terms that should be defined—affiliate, control, and common control.
 Affiliate is any entity that controls, is controlled by, or is under common control with the member.

 Control is considered having ownership of 10% or more of the common or preferred equity
or subordinated debt of another entity or having a right to 10% or more of the profits or
losses of a partnership.
 Common control refers to a situation in which the same person or entity controls two or more entities.
Therefore, a conflict exists if a member firm is underwriting its own securities, the securities of an entity
in which it has a 10% ownership, the securities of an entity which owns 10% or more of the member
firm, or the securities of an entity in which another company owns 10% or more of both the member
firm and the issuer.
A member firm is not permitted to participate in a public offering in which it has a conflict of interest unless
a qualified independent underwriter participates or at least one of the following three conditions are met:
1. The member firm that’s primarily responsible for managing the offering may not have a conflict of
interest and may not be an affiliate of any member that does have a conflict, or
2. The securities offered must have a bona fide public market, or
3. If they’re fixed-income securities, they must be investment-grade
Qualified Independent Underwriter One of the critical responsibilities of any underwriter is

performing a due diligence investigation. However, if the underwriter is selling its own stock or that of an
affiliate, it may be difficult for the member to perform the investigation objectively. Therefore, in self-
underwritings or underwritings for affiliates, FINRA may require the participation of another broker-
dealer that acts as a qualified independent underwriter (QIU). The QIU cannot have any conflicts of
interest and will participate in the preparation of any offering documents and also verifying the validity of
the public offering price.
To be considered a QIU, the firm must have served as a manager or co-manager for at least three public
offerings of a similar size and type during the three-year period preceding the filing of the registration
statement. If a QIU is used, there must be a prominent disclosure in the prospectus or offering document to
explain the conflicts of interest and a statement indicating the name and the role of the qualified
independent underwriter.
Disclosure of a Control Relationship If a broker-dealer that’s controlled by a public company has a

customer who wants to purchase the stock of that company, the broker-dealer must disclose the control
relationship to the customer prior to accepting the order. If the initial disclosure was made verbally, then
written disclosure must also be provided prior to settlement (i.e., completion of the transaction). If the
control relationship transaction involves a discretionary client, the client’s specific written permission
must be obtained prior to each transaction.

Secondary Market Trading of New Issues

After an issuer conducts a primary offering—either an IPO or follow-on offering—the new securities will
begin to trade in the secondary market. Both FINRA and the SEC have rules governing this transition.
Green Shoe Clause

If a new issue is underpriced and in great demand because of its growth prospects, the offering is considered
oversubscribed. In these instances, there may be more investors wanting to acquire the stock than
originally projected by the underwriters. Underwriters typically have a period of 30 days to request the use
of the provision that’s referred to as the Green Shoe Clause. This clause allows the underwriters to
purchase additional shares (a maximum of 15%) from the issuer or selling shareholders so that they can be
sold in order to meet the demand.
Regulation M
Most aspects of new securities offerings are governed by the Securities Act of 1933. However, the
Securities Exchange Act of 1934 contains some provisions that affect the sale of new issues, particularly
the activities of the underwriters that participate in follow-on offerings. Before major federal securities
laws were passed in the 1930s, syndicate members often conditioned the market for new issues that they
were about to sell. After these underwriters sold their allotments and stopped their behind-the-scenes
activities, the stocks involved will experience a significant decline and cause unassuming investors to
suffer large losses.
In order to regulate trading practices involving new issues and the firms that initially profit from the sale
of new issues, the SEC enacted Regulation M. The rule covers both IPOs and existing issuers that are
offering additional securities to the public.
Under Regulation M, the SEC restricts distribution participants (such as underwriters and issuers) from
bidding for or making secondary market purchases of a stock that’s currently being offered in a
distribution. This restriction is in effect for a limited period that revolves around the effective date.
Regulation M attempts to prevent upward price manipulation before the pricing of the deal since this
practice generally results in the issuer receiving more proceeds and the underwriters receiving greater fees.
However, certain exceptions are permitted when the SEC believes the chances of manipulation are low.
The Commission makes exceptions under specific conditions for market makers and syndicate members
that intend to support (stabilize) the price of the new issue. This action is designed to protect the new
issue’s price from dropping substantially.
Stabilization
Some issues lack the level of investor interest to cause the price of a new stock offering to rise. To prevent
an immediate decline in the price of the stock during its distribution period, the SEC permits stabilization.

Stabilization is considered a form of price manipulation since the managing underwriter intervenes in the
secondary market by placing a bid for the securities at or below the public offering price. It’s important to
note that stabilization is the only form of price manipulation permitted by the SEC.
For example, a new offering of ABC Corporation common stock is being issued at
$18 per share. The managing underwriter is permitted to enter a stabilization bid at
$18 or any price below $18 (such as $17.94), provided the bid price is not higher
than the highest independent bid that’s already in the marketplace. The stabilization
bid may not be entered above the $18 public offering price.
The ability to utilize stabilization must be disclosed in the prospectus and, once implemented, the
stabilizing firm must submit periodic reports with the SEC. The stabilization process may be discontinued
at any time.
Penalty Bids and Syndicate Covering Transactions

As it relates to the original offering of shares, a penalty bid is placed by a managing underwriter to reclaim
a selling concession from a syndicate member. The name penalty bid is derived from the fact that the
syndicate manager will not pay a selling group member if its customer buys a new issue and then
immediately sells it back to the syndicate at the stabilizing bid.
Prior to imposing a penalty bid, the syndicate manager must provide FINRA with written notice that includes:
 The identity of the security and its Nasdaq symbol, and
 The date the member firm intends to impose the penalty bid
The Primary Market for Municipal Bonds

As shown earlier, municipal securities are exempt from the registration and prospectus requirements of the
Securities Act of 1933. Although exempt, the underwriting process for municipal securities follows many of
the same guidelines that are used for corporate underwritings. The MSRB, which is the self-regulatory
organization (SRO) for firms that deal in municipal securities, formulates and interprets the rules and
regulations that relate to municipal underwritings. Remember, even if a specific security is exempt, the
antifraud provisions of the Securities Act of 1933 apply to all securities. Let’s examine the primary market
issuance process for municipal securities.
Issuing GO Bonds
Since GO bond issues are backed by taxes, the following two requirements must be satisfied:
Voter Approval The issuance of general obligation bonds usually requires voter approval since the funds
that are generated by taxing citizens which will be used to repay the debt. The indenture (bond resolution) for
a general obligation bond will usually include the statutes which permit the issuer to levy taxes.

Debt Ceiling Limitations A GO issue is generally subject to debt limitations that are placed on the
municipality by a voter referendum or by statutes. Prior to the issuance of the bonds, these legal
obligations must be upheld. A municipality is not permitted to issue bonds in excess of its debt limitation
since doing so will exceed its debt ceiling.
Issuing Revenue Bonds

Since revenue bonds are backed by the user fees that are generated by a project or facility, and not by
taxes, they don’t require voter approval. However, there are special procedures to be followed and
requirements to be met prior to issuing revenue bonds, including a feasibility study.
New Issue Underwritings

Once a municipal issuer has determined that there’s a need for a bond issue and has followed the
preliminary steps required to offer a bond (e.g., obtaining voter approval for a GO issue or completing a
feasibility study for a revenue issue), it may continue the process of issuance. To do so, a municipality will
normally seek the assistance of an underwriter (investment banker).
Role of the Underwriter A municipal underwriter plays an important role in the offering of the
securities. The underwriter acts as a vital link between the issuer and the public by assisting the issuer in
pricing the securities, structuring the financing, and preparing the official statement (disclosure document).
Selecting an Underwriter In some cases, the issuer will simply appoint its underwriter using a process
that’s referred to as a negotiated sale. Another method involves requesting that interested underwriters
submit proposals through a bidding process that’s referred to as a competitive sale.
Negotiated Sale With a negotiated sale, an issuer brings its issue to market by selecting the lead
underwriter or senior manager that will sell the issue to the public. The size of the issue, the coupon rate,
possible call provisions, and other details are generally decided during this negotiation process. Typically,
the lead underwriter forms an underwriting syndicate with other broker-dealers to facilitate the placement
of the securities. Many revenue issues are sold on a negotiated basis.
Competitive Sale Rather than selecting its underwriter, an issuer may invite interested underwriters to
compete against one another by submitting bids for the issue. The syndicate that submits the best bid is
awarded the bonds. The best bid is typically the one that presents the issuer with the lowest interest cost
over the life of the issue. GO issues are often sold on a competitive basis.
Forming a Syndicate
Traditionally, a number of broker-dealers will combine to form a bidding syndicate, with one firm acting
as the syndicate manager (lead underwriter). The syndicate is essentially a group of underwriters that share
the responsibility for selling a certain percentage of the new bonds. In this way, the responsibility of
selling the entire issue and the liability for any unsold bonds is dispersed with the risk being reduced for
each individual underwriter.

Although the composition may change, the syndicate is usually comprised of firms that have worked
together in the past. Since municipal issues are typically sold on a firm-commitment basis, firms that are
asked to join the syndicate must be financially strong enough to absorb unsold bonds if there are problems
distributing the issue. Due to the liability assumed in this type of distribution, underwriters are acting in a
principal capacity.
Responsibilities of Syndicate Manager The manager generally takes the largest underwriting
commitment and keeps track of sales and the number of bonds that are available. The manager also presides
over the preliminary pricing meeting in which all of the members are asked to submit their pricing scale.
Syndicate Letter The syndicate manager will invite other firms to participate by sending a syndicate
letter which will bind the members together. The syndicate letter will identify the specific obligations and
participation level of the members. For example, the syndicate letter may indicate the preliminary amount
of bonds to be underwritten by each member, how long the syndicate will last, an acknowledgment that the
bid and offering terms will be set by a majority of the members, the type of syndicate to be formed, and
the priority of orders.
The syndicate letter also establishes that the syndicate is not a partnership, but rather a joint venture in
which the liability of each member is detailed. Each member must sign and return a copy of the syndicate
letter to the manager to indicate its acceptance of the specific obligations.
For negotiated sales, the document is referred to as the agreement among underwriters, rather than the
syndicate letter.
Committee on Uniform Securities Identification Procedures(CUSIP Numbers) Since many issues

have similar features and maturities and may be confused with one another, CUSIP numbers are intended
to assist in both the identification and clearance of securities. For new issues that are underwritten through
a syndicate, the managing underwriter must apply for the number. However, in the secondary market,
dealers must apply for new CUSIP numbers if anything is done which alters the security or source of
payment for part of the outstanding issue. These alterations include acquiring or arranging bond insurance,
letters of credit, or adding a put feature on the bonds. The new CUSIP number helps other dealers and
clearing agencies distinguish the altered bonds from the remainder of the issue.
Syndicate Liability The syndicate may be formed as either a divided or undivided account. The
difference between the two types relates to a member’s level of liability for any bonds left unsold.
Divided Account In a divided or Western account, each member is responsible for a specific
percentage of the issue. If the member sells its portion of the issue, it will not be responsible for any
part of the unsold balance.
For example, if a member assumes liability for 10% of a $10,000,000 issue, its
responsibility will end once it had sold $1,000,000 of the issue. On the other hand, if the
member sold only $750,000, it’s still responsible for the remaining $250,000.

Undivided Account In an undivided or Eastern account, each member is responsible for a specific
percentage of the unsold balance, regardless of how much it actually sold.
For example, if a member assumes liability for 10% of a $10,000,000 issue and sold
$1,000,000 of the issue, it’s still be responsible for 10% of any remaining unsold balance.
Therefore, if the syndicate had $2,000,000 of unsold securities at the time it dissolved, a 10%
participant will receive $200,000 (10%) of these unsold securities.
Selling Group Members At times, the lead underwriter will invite additional firms into a deal as agents
that will simply assist in placing the securities. These broker-dealers, referred to as selling group members,
don’t assume liability for any unsold bonds since they’re not members of the syndicate. Selling group
members are able to purchase bonds from the syndicate at the offering price minus the concession, but will
then sell the bonds to the public at the offering price.
Determining the Bid Once the syndicate is formed, it must determine the bid that it will submit to the
issuer. The bid represents the dollar amount that the syndicate is willing to pay per bond to the issuer. After
the preliminary scale or pricing schedule is set, syndicate members will distribute the scale to their traders
and salespeople in an effort to gauge investor interest. As orders are being solicited, it’s possible that some
orders will be received before the actual bid is submitted to the issuer.
Reoffering Scale The syndicate will profit from its ability to buy the offering from the issuer at one
price and sell it to the public at a higher price. To determine this profit, the syndicate will first establish the
reoffering yields for the issue. These are the yields that future bondholders will receive.
Using the bid limitations set for coupon rates and bid price, the syndicate will establish the complete reoffering
scale which will list each maturity, the corresponding coupon and yield, and the amount of selling profit. If the
offering is structured with a serial maturity, the yields for each maturity will need to be established.
Final Pricing Meeting At the final pricing meeting (held just prior the bid’s due date), the syndicate
manager will announce the pricing scale, the size of the underwriting spread, and the interest rates the
members believe will make the issue attractive to potential investors. At this point, the bid is completed
and submitted to the issuer.
Spread The winning syndicate will purchase the bonds from the issuer and sell them to the public at the
public offering price. The syndicate manager and its members make a profit by selling the bonds at a
higher price than the price they paid to the issuer. The difference between the price paid to the issuer (the
syndicate’s bid) and the price at which the bonds are sold to the public (the reoffering price) is referred to
as the underwriting spread. For example, if a bond is purchased from the issuer at 99 and sold to the
public at par (100), the underwriters will have a 1-point ($10) profit per $1,000 face amount sold.
A small portion of the spread will be used to cover syndicate expenses and the syndicate manager’s fee. The
remainder (the spread minus the manager’s fee and expenses) is referred to as the total takedown. When a
member of the syndicate sells bonds, it’s entitled to the total takedown.

However, the total takedown is divided into two parts—the additional takedown and concession. If a
syndicate member uses the services of a selling group to sell bonds, the syndicate member is entitled to
only the additional takedown portion, with the concession going to the selling group.
The following diagram illustrates the components of the underwriting spread:
(1/8) (3/8) (1/2)
Administration Liability Selling
1/ point + 3/8 point + 1/2 point = 1 point ($10) Spread

8
Let’s consider the different possibilities of how bonds may be sold to a customer:
1. The syndicate manager sells bonds to a customer—In this case, the manager handled the
administration of the syndicate, assumed the liability for the bonds, and ultimately sold
the bonds. Therefore, the manager earns the entire spread of 1 point ($10 per bond).
2. A syndicate member sells bonds to a customer—In this case, the manager handled the
administration of the syndicate and earns its fee of 1/8 of a point ($1.25 per bond), while
the member assumed liability and sold the bonds and earns the total takedown of 7/8 of a
point ($8.75 per bond).
3. A broker-dealer that’s part of the selling group sells bonds to a customer—In this case,
the manager handled the administration of the syndicate and earns its fee of 1/8 of a point
($1.25 per bond), the member assumed liability and earns the additional takedown of 3/8
of a point ($3.75 per bond), and the broker-dealer that sold the bonds earns the
concession of 1/2 of a point ($5 per bond).
Priority of Orders Once the orders are given to the syndicate manager, the manager allocates the bonds
to the members. Allocation is done according to the priority of orders which is disclosed in the syndicate
letter. The purpose of the priority is to give the maximum benefit to the entire syndicate versus any one
particular member.

The priority of orders is normally:

1. Presale orders Orders placed prior to the actual awarding of the issue to the syndicate are given the
highest priority since they’re the most beneficial to the syndicate. Knowing that it has commitments for
a part of the offering allows the syndicate to enter a more aggressive bid.
2. Group net orders These are orders in which the profit is shared by all members of the syndicate.
3. Designated orders These are orders in which the profit is directed to the dealers that were designated
by the customer.
4. Member orders These are orders in which only one member earns the total takedown.
The priority of orders will neither be shown on a customer confirmation, nor included in the official
statement. However, if requested, it must be provided to a customer. The syndicate manager is permitted
to change the priority of orders if, in its opinion, it’s in the syndicate’s best interest to do so. If a change is
made, the manager must be able to justify the change to the members.
Related Portfolio Order MSRB rules require a syndicate member to disclose to the syndicate manager
whether an order is being entered for a unit investment trust (UIT) or for an accumulation account to be
used for a UIT. The disclosure is accomplished by entering the order as a related portfolio order.
Underwriting Documentation The following list identifies some of the documents that may be utilized
during a primary distribution of municipal bonds.
Notice of Sale When an issuer intends to sell bonds through a competitive sale, it will advertise by
publishing a Notice of Sale. The Notice of Sale will usually contain essential information that an
underwriter will need in order to submit a bid such as the size of the offering, its maturity date, the coupon
rate, and the details related to the bidding process. (A more complete listing of the information found in a
Notice of Sale is included at the end of the chapter.)
Bond Counsel and the Legal Opinion Every municipal bond offering must be issued with a legal
opinion. The legal opinion is written by a recognized bond counsel that’s hired by the issuer to attest to the
validity and tax exempt status of the bond issue. Essentially, the legal opinion assures investors that the
issuer has the legal right to issue the bonds. If there are no existing situations that could adversely affect
the legality of an issue, the bond counsel renders an unqualified legal opinion. Potential adverse situations
include an issuer of a revenue bond not having a clear title to a property or an issuer that’s violating local,
state, or federal statutes when developing a project.
Delivery of certificates without legal opinions will not constitute good delivery unless they’re identified as
ex-legal at the time of the trade.
Official Statement The disclosure document that’s used in municipal offerings (both negotiated and
competitive) is referred to as the official statement. This document essentially takes the place of a
prospectus; however, it’s not required to be filed with the SEC since municipal issuers are exempt from
the Act of 1933.

The official statement contains detailed information about both the issuer and the offering and, if
produced, must be distributed to investors. As is the case with a prospectus, there’s both a preliminary and
final version of the official statement. (A more detailed summary of this document is included at the end of
the chapter.)
Electronic Municipal Market Access (EMMA) EMMA is the MSRB’s dataport through which municipal
bond underwriters and issuers submit specific documents. EMMA provides free public access to issuer’s
official statements, trade data, 529 plan disclosure documents, educational materials, and other information
about the municipal securities market. EMMA presents the information in a manner that’s specifically tailored
for retail, non-professional investors who may not be experts in financial or investing matters.
If an official statement has been submitted to EMMA, a broker-dealer may send a notice to any customers
who purchase a new issue of municipal securities which advises them as to how an official statement may
be obtained from EMMA. This process may be used in lieu of sending the official statement to a customer.
The notice must include the statement that a copy of the official statement will be provided by the broker-
dealer upon request. Therefore, if a customer contacts the broker-dealer and requests a printed copy of an
official statement, it must be sent.
New Issue Settlement The issuer and its underwriting syndicate will determine the final settlement
date for an offering. Settlement represents the date that the issuer delivers the bonds to the syndicate and
the syndicate pays the issuer for the bonds. New issues of municipal bonds usually settle within 30 days
after the securities are awarded to the underwriter.
Until the settlement date is established, the bonds will trade on a when issued (WI) basis and any
purchaser of the new issue will receive a when-issued confirmation. At this time, the buyer will not know
the final dollar amount due since the amount of accrued interest cannot be calculated without a settlement date.
For a new issue of municipal securities, the when-issued period extends from the original date of sale by
the issuer to the date that the securities are delivered to the underwriter.
Dated Date Typically, accrued interest is calculated by going back to the last interest payment date
and counting the number of days that have accrued to which a seller is entitled. However, on a new
issue, accrued interest must be calculated from the dated date since there was no previous interest
payment date. The first interest payment on a new issue may be for a period that’s different from the
normal six-month period. If it’s for more than six months, it’s a long coupon; however, if it’s for less
than six months, it’s a short coupon.
Customer Documentation MSRB rules require that a copy of the official statement be sent to each
purchaser of a new issue. A confirmation must be sent on every transaction, regardless of whether the
trade involves a new issue or is done in the secondary market. However, a copy of the indenture and a list
of the syndicate members are not required to be sent.

New Issue Confirmations Each customer who purchases bonds at the time of the new issuance must be
provided with a final confirmation and a copy of the official statement by no later than the settlement date. For
a negotiated sale, by no later than the settlement date, the following information must be disclosed to the
customer either separately or included in the official statement:
 The amount of the underwriting spread
 The amount of any fee received by the broker-dealer for acting as agent for the issuer
 The initial reoffering price for each maturity in the offering
Conclusion
This ends the chapter of offerings. This significant chapter focused on the primary market and the issues
related to underwriting securities, the Securities Act of 1933, exempt securities and exempt transactions,
and also the process by which municipal securities are distributed. The next chapter will examine account
disclosures, investment risks, and investment returns.

Primary Markets Documentation

Contents of a Typical Notice of Sale
1. Date, time, and place of sale
2. Name and description of issuer
3. Type of bond
4. Terms and conditions
5. Bidding restrictions
6. Interest payment dates
7. Dated date, interest accrual date, first coupon payment date
8. Maturity structure
9. Call provisions
10. Denominations and registration provisions
11. Expenses to be borne by the purchaser or issuer
12. Paying Agent and/or Trustee
13. Name of the attorney providing the legal opinion
14. Details of the delivery
15. Right of rejection
16. Criteria for the award
Content of a Typical Official Statement

1. Offering terms
2. Summary statement
3. Purpose of the issue
4. Authorization of the bonds
5. Security of the bonds
6. Description of the bonds
7. Description of the issuer
a) Organization
b) Economic area
c) Financial summary
8. Construction program
9. Project feasibility
10. Regulatory matters
11. Specific provisions of the Indenture and/or the Resolution
a) Funds and accounts
b) Investment of funds
c) Additional bonds
d) Insurance
e) Events of default
12. Legal proceedings
13. Tax status
14. Continuing disclosure certification
15. Appendix
a) Various consultant reports
b) Legal opinion
c) Financial statements and audit

CHAPTER 14
Investment Risks,
Returns and Disclosures
Key Topics:
 Account Disclosures
 Account Transfers
 Systematic vs. Unsystematic Risks
 Investment Returns
CHAPTER 14 – INVESTMENT RISKS, RETURNS AND DISCLOSURES
Customers must be fully informed of the risks associated with specific securities before any
investments are made. This includes the various fees that are associated with different investments,
as well as costs incurred when executing transactions. In addition to the required disclosures, this
chapter will address the documents that must be provided to customers and the process of
transferring accounts between broker dealers. Finally, the chapter will examine the different types
of risks and returns related to various investments.
Required Disclosures
Disclosures Made Prior to Execution
When discussing various investments with clients it’s imperative for a registered representative to inform the
client of the risks associated with those investments. As described in a previous chapter, this includes
discussing risks involving options, penny stocks, junk bonds, etc. Potential conflicts of interest, investment
limitations of the firm, as well as costs and fees that influence the return on the investments must be disclosed.
Some of the costs and fees include the sales charges on different mutual fund share classes, potential
redemption fees, and the additional fees to which clients are subject when investing in annuities. Lastly, careful
consideration is required to determine whether a customer is suitable for non-discretionary, fee-based accounts
(i.e., whether her level of trading is sufficient to bear the fee).
Time of Trade Disclosures (MSRB Rule G-47) A municipal securities dealer is required to disclose to
a client all material information that’s either known or reasonably accessible to the market. These time of
trade disclosures are required to be made at or prior to the time of the trade and can be made either
verbally or in writing. The main purpose of this rule is to require dealers to disclose to clients all of the
relevant information concerning the securities that they’re considering purchasing or selling. Many
municipal securities have unique features and characteristics that should be disclosed to a client.
Additionally, the disclosure rules apply regardless of whether the transaction is recommended or unsolicited,
occurs in the primary market or secondary market, or is a principal or agency transaction. The rule states
that information is considered material if there’s a substantial likelihood that a reasonable investor will
consider the information to be important or significant when making an investment decision. A municipal
securities dealer may NOT satisfy its disclosure obligation by simply directing a customer to an
established industry source or through a disclosure that’s made in general advertising materials.
Compensation and Disclosure on Equity Trades

Broker-dealers act in different capacities when executing customer trades. However, a firm may act in
only one capacity in a single customer transaction, which includes acting as agent, principal, riskless
principal, or on a net basis. The required disclosures are determined by the firm’s capacity.

Agency Trade An agency transaction occurs when the broker-dealer buys or sells securities in the
marketplace on behalf of a customer. The firm charges the client a commission, which is disclosed on the
customer’s confirmation.
Dual Agency Cross In an agency cross, the broker-dealer matches a sale from one of its clients with a
purchase from another client and charges both a commission. Commission must be disclosed on the
confirmations that are sent to both customers.
Principal Trade In a principal transaction, the broker-dealer sells securities out of its inventory or buys
securities into inventory when executing a customer order. The broker-dealer is exposed to risk in its inventory
value. Transaction prices are based on the market price of the security, rather than the inventory value of the
dealer. In the case of a customer purchase, the firm charges the customer a markup above the market price of
the security. When the customer sells, the dealer marks down the proceeds received by the customer.
Riskless Principal When a firm buys into inventory to fill preexisting customer orders, its capacity is
that of a riskless principal. For instance, in quick succession, a dealer receives 10 customer market orders to
each purchase 100 shares of stock. The firm may choose to buy 1,000 shares as principal and then resell
the securities to its customers at the same price, plus a markup. The firm must disclose its capacity as riskless
principal, since the purchase by the firm and sale to the customers did not expose the dealer to price risk.
Net Basis If the dealer in the previous example had sold the securities to the customers at a different price
than the price paid by the dealer, the executions are described as occurring on a net basis. In a net-basis trade,
the dealer profits by charging a different price for the securities, rather than charging a markup. FINRA rules
place disclosure and consent requirements on dealers executing net-basis trades with customers.
The profit obtained in the net transaction is not disclosed on the customer’s confirmation, which contrasts with a
riskless principal transaction, where the markup is disclosed. Both legs of a net-basis transaction will be
reported as principal since they occurred at different prices. If a firm intends to execute a net-basis
transaction with a customer, it must disclose the conditions for handling the order and obtain the client’s
permission prior to the execution of the trade. The rule applies to transactions between a dealer and a
customer, rather than dealer to dealer.
The following conditions apply to net-basis transactions:

 For non-institutional (retail) customers, written consent must be obtained on an order-by-order basis,
prior to the execution of net trades.

 For institutional customers, the firm may obtain consent in one of three different ways:
1. Oral permission before each net-basis transaction, or
2. Written permission before each net-basis transaction, or
3. Blanket permission through the delivery of a negative consent letter. The letter discloses the terms
and conditions of handling the order and gives the client an opportunity to opt out. If the client
doesn’t express any objections, the dealer may interpret this as permission to execute net-basis
trades in the future.
 For fiduciaries, the broker-dealer must:

– Provide disclosure to the party that’s been granted trading authorization
– Obtain permission from the party that’s been granted trading authorization
– Follow the same disclosure and consent requirements that apply to institutional customers if the
fiduciary is an institution
Soft-Dollar Arrangements
Soft-dollars are broadly defined as commission rebates that money managers (IAs) receive for channeling
some or all of their trades through certain brokerage firms. When an adviser uses soft dollars to obtain
products or services, its clients are paying for more than simple execution and, accordingly, using soft dollars
may result in clients paying a higher commission on their trades.
Section 28(e) of the Securities Exchange Act of 1934 recognizes soft-dollar arrangements as an acceptable
means of conducting business (safe harbor). However, to rely on the safe harbor, the following three
conditions must be satisfied:
1. The adviser must be exercising investment discretion over the accounts of others.
2. The broker-dealer must provide the adviser with services that assist the adviser in making investment
decisions for client accounts.
3. The adviser must determine that the value of these services is reasonable in relation to the
commissions being charged by the brokerage firm.
The key is that the service(s) received by the adviser as part of a soft-dollar arrangement must benefit its
clients and be reasonable in relation to commissions paid. Provided the investment adviser is using soft
dollars to purchase items (e.g., research reports) that assist them in the investment process and clients
receive full disclosure, the SEC permits the arrangement.

The following chart provides details regarding the acceptable and unacceptable uses of soft-dollar
arrangements:
Soft-Dollar Arrangements
May be used to acquire: May NOT be used to acquire:
 Traditional research reports and related  Payments for advertising and marketing
publications  Travel expense reimbursement (including meals
 Discussions with research analysts and entertainment)
 Software for analyzing portfolios  Overhead and administrative expenses
 Certain types of trading software  Employee salaries
 Market and economic data services  Accounting and professional licensing fees
 Coverage of attendance fees for a  Computer terminals
conference/seminar where company executives  Correction of trading errors
discuss their company’s performance
For example, a trader solicits an advisory firm to send its securities trades to his
broker-dealer. In exchange for the business, the trader agrees to pay bonuses to
IA employees using a portion of the commissions. Is this practice acceptable?
No. The practice of using earned commissions to pay bonuses to the IA’s employees is an
unacceptable form of soft-dollar rebating. These actions don’t directly benefit the
advisory client; instead, they benefit the IA and its employees.
Client Notifications
Once an account is opened, broker-dealers are required to provide their clients with information such as trade
confirmations, statements, and other miscellaneous mailings. The SEC mandates the frequency and timing
of the delivery of this information.
Account Statements and Other Notifications

At least quarterly, broker-dealers are required to provide customers with a statement of account. Also, the
typical practice is to provide monthly statements for any account in which activity has occurred. At a
minimum, the account statement must contain:
 A description of all security positions
 All money balances
 All account activity since the last statement
Account activity includes purchases, sales, interest credits or debits, charges or credits, dividend payments,
transfer activity, securities receipts or deliveries, and/or journal entries relating to securities or funds in the
possession or control of the broker-dealer.

Broker-Dealer Financial Information

Additionally, SEC regulations require a brokerage firm to provide a current financial statement (balance
sheet with net capital computation) to a customer on request. The justification for this requirement is that
customers have the right to know the financial condition of the company with which they’re doing
business. Financial statements are typically sent to customers annually. Although a balance sheet must be
provided, the firm’s income statement (or P&L) is not required.
From time to time, customer accounts may be transferred internally. This can be the case when an RR leaves a
firm and his customer accounts are transferred to another RR of the firm. Account records must be amended
whenever an internal transfer of an account is made. However, this change doesn’t require the reapproval of
the customer, the completion of a new account form, or the notification of a regulatory authority.
Confirmations Statements
The SEC requires broker-dealers to provide customers with a detailed confirmation of each purchase or
sale. The confirmation must be given or sent at or before the completion of any transaction—which is
generally the settlement date. The confirmation must include the following information:
 The identity and price of the security bought or sold
 The number of shares, units, or principal amount
 The date of the transaction, as well as the time of execution (or a statement that the time will be
furnished on written request)
 The capacity in which the broker-dealer acted, such as:
− Agent for the customer
− Agent for another person
− Agent for both the customer and another person (referred to as a cross)
− Principal for its own account
 The dollar price and yield information on debt securities
 Whether a security is callable and a statement that more information will be provided on request
 The settlement date
Even if an RR has discretion over a customer’s account, confirmations for all transactions must be sent to
the customer. Trade confirms may be sent to an investment adviser or other third party, but only if the
written consent of the customer is obtained.
Updating Account Information

Not only is it important to fill out a new account form correctly, it’s also very important to keep the
information up-to-date. This updating obligation is one of the most overlooked areas of account
documentation. If a customer’s situation changes, the regulatory concern is that unsuitable transactions
may be executed in the account. Although any of the items on the form could change, there are several
items which are of special importance.

Address Changes If a customer’s address changes, it’s important to note whether she now lives in a
different state. In order to conduct business in the new state, both the registered representative and his firm
must be properly registered in the new state. State registration requirements are contained in a set of rules
that are referred to as the Blue-Sky laws.
Also, if a request is made to change a customer’s address, member firms must send notification of the
change to both the previous address on file and to any registered personnel who are responsible for the account.
Financial Background For better or for worse, a customer’s financial picture can change very quickly. It’s
important for representatives to occasionally verify that the customer’s information on file is accurate. While
some customers may keep the firm well-informed of any changes, others may not be as forthcoming. Changes
in the patterns of purchases and sales may indicate a different financial situation.
Updated Objectives Over time, almost all customers will change or modify their investment
objectives. This is especially true as customers grow older, since their investment time horizons, tax
situations, and goals may change. All such changes should be documented.
FINRA Updating Requirement If a customer provides a broker-dealer with updated account

information, the broker-dealer must send a copy of the revised account record to the customer within 30
days after it received notification of the change or at the time the next statement is mailed to the customer.
Examples of account record modifications include items as simple as changes to a customer’s name,
address, or investment objective.
Books and Records

Recordkeeping Formats
Broker-dealers must maintain records for a certain number of years after creation. The SEC allows for the
maintenance of records in forms other than paper. For example, firms may maintain their files on micrographic
media or electronic storage media. Micrographic media includes microfilm, microfiche, or similar methods,
while electronic storage media includes methods of digital storage (e.g., CD-ROM).
If a firm decides to use electronic storage media, it must notify its primary regulator prior to the beginning of its
use. Also, if a firm changes the form of electronic storage media that it’s currently using, it must notify its
regulator at least 90 days prior to using the other method.
When maintaining records using electronic storage media, the firm must:
 Maintain records in non-rewriteable and non-erasable formats
 Automatically confirm the quality and accuracy of the media recording process
 Maintain records in serial form with time and date information that documents the required retention period
for the information stored
 Be able to download the indexes and records maintained to any medium that’s accepted by the SEC or
other SRO of which the firm is a member

In addition to the aforementioned requirements, a firm that uses micrographic or electronic storage media
must establish a location from which the SEC and the firm’s SRO can immediately review stored files and
have duplicates of the files available. All duplicates of the files being maintained must be kept separate
from original records. The records (original and duplicates) must be accurately organized and indexed.
The indexes are required to be duplicated, kept separate from originals, and made available for
examination by regulators if a review is requested.
FINRA and the MSRB also have recordkeeping requirements for any books and records that were not
specifically referenced under SEC Rules. For FINRA, the requirements are found in Rule 4511; however,
for the MSRB, the requirements are found in Rule G-8 (the records that must be kept) and Rule G-9 (how
long the records must be kept).
Financial Exploitation of Specified Adults – FINRA Rule 2165

FINRA created a hotline for seniors who had questions or concerns about their brokerage accounts. One of
the major issues that was highlighted by these investors was suspected financial exploitation. In order to
address this issue, FINRA created Rule 2165 which is titled Financial Exploitation of Specified Adults.
Specified Adults According to FINRA’s rule, the term specified adult is defined as:
 Any person who is age 65 or older
 Any person who is age 18 or older and who the firm reasonably believes has a mental or physical
impairment that renders the person unable to protect his own interests. This determination should be based
on the facts and circumstances that are observed in the firm’s business relationship with the person.
To assist these specified adults, FINRA also established a process by which a firm could respond to
situations in which it has a reasonable basis to believe that financial exploitation has occurred, is occurring,
has been attempted or will be attempted. The process includes the appointment of a trusted contact person.
Trusted Contact Person Firms may now contact a customer’s designated trusted contact person and,
when appropriate, place a temporary hold on a disbursement of funds or securities from a customer’s
account. A trusted contact person must be age 18 or older and is essential in assisting the firm in protecting
the customer’s account and its assets and also responding to possible financial exploitation.
The trusted contact person’s name and contact information (mailing address, phone number and email
address) will be a part of the customer account information that should be obtained when a member firm
opens or updates an account. Although the trusted person’s contact information is not required to open the
account, a firm should make a reasonable effort to obtain it.

Financial Exploitation According to FINRA’s rule, financial exploitation includes:

 Wrongful or unauthorized taking, withholding, appropriation, or use of a specified adult’s funds or
securities; or
 Any act or omission taken by a person, including through the use of a power of attorney, guardianship,
or any other authority, regarding a specified adult, to:
‒ Obtain control, through deception, intimidation, or undue influence, over the specified adult’s
money, assets or property; or
‒ Convert the specified adult’s money, assets or property
Temporary Hold The rule permits a firm to place a temporary hold on the disbursement of a specified
adult’s funds or securities, but not to their transactions in securities. Although the hold will not apply to
a customer’s sell orders, if there’s a reasonable belief of the existence of financial exploitation, it will
apply to any request for the proceeds of a sale to be sent to another person. The temporary hold will
apply to both a single disbursement and a transfer of an entire account. However, if the firm places a
hold on an account, it must allow disbursements if there’s no reasonable belief of financial exploitation
(e.g., normal bill paying).
Account Movement Between Accounts at the Same Firm The temporary hold also applies to the transfer of
assets from one account to another account at the same brokerage firm. For example, the temporary hold
applies when a relative or friend of an account owner is attempting financial exploitation and initiates the
transfer of assets to her account which is held at the same brokerage firm.
Reasons for the Hold If a member firm places a temporary hold, the rule requires the firm to immediately
initiate an internal review of the facts and circumstances that caused it to reasonably believe that financial
exploitation of the specified adult has occurred, is occurring, has been attempted or will be attempted.
Notification of the Hold By no later than two business days after the date that the member first placed the
temporary hold on the disbursement of funds or securities, the member firm must provide notification,
either orally or in writing (which may be electronic), of the temporary hold and the reason for the hold.
The notification must be provided to:
 All parties who are authorized to transact business in the account, unless a party is unavailable or the
firm reasonably believes that one party has engaged, is engaged, or will engage in the financial
exploitation of the specified adult; and
 The trusted contact person(s), unless this person is unavailable or the firm reasonably believes that the
trusted contact person(s) has engaged, is engaged, or will engage in the financial exploitation of the
specified adult
The intent of the rule is to prohibit a firm from dealing with the person(s) who might be exploiting the
specified adult. For example, if the adult child of a senior investor is the trusted contact person who might
be misappropriating funds, it’s not prudent for this person to be contacted.

Before placing a temporary hold, it’s recommended for the firm to first attempt to resolve the situation with
the customer. However, if the temporary hold is placed, the firm is required to notify the trusted contact
person. Once a temporary hold is initiated, the firm is permitted to terminate it only after contacting either the
customer or the trusted contract person and discussing the situation. The customer’s objection to the
temporary hold or information obtained during the discussion with the customer or trusted contact person
may be used by the firm when determining whether the hold should be placed or lifted.
Period for the Temporary Hold A temporary hold will expire by no later than 15 business days after the
date that it was first placed on the account, unless it was otherwise terminated or extended by another
authorized regulatory entity. If a member firm’s internal review of the facts and circumstances supports its
reasonable belief that the financial exploitation of the specified adult has occurred, is occurring, has been
attempted or will be attempted, the firm may extend the temporary hold for an additional 10 business days,
unless otherwise terminated or extended by another authorized regulatory entity.
ACATS—Transferring Accounts
If a customer wants to transfer an account from one member firm (the carrying firm) to another member
firm (the receiving firm), the customer must provide written instructions to the receiving firm. When both
the carrying member and the receiving member are participants in a registered clearing agency that has
automated customer securities account transfer capabilities, they must use that system. An example is the
National Securities Clearing Corporation’s Automated Customer Account Transfer Service (ACATS). Both
member firms are required to coordinate their activities in order to expedite the transfer.
The receiving firm must submit the transfer request to the carrying firm immediately at the time of receipt
from the customer and, within one business day, the carrying firm must either validate the instructions or
take exception to the transfer.
Protesting a Transfer If the transfer is protested, the carrying and receiving parties must resolve their
differences promptly. A carrying party may take exception to a transfer if:
 It has no record of the account on its books
 The account is flat and contains no assets
 The transfer instructions are incomplete
 The transfer instructions contain an invalid signature
Validating a Transfer When validating transfer instructions, the carrying party must freeze the account.
At this point, all open orders must be cancelled and new orders may no longer be accepted. Within three days
following the validation, the carrying party must complete the transfer of the account to the receiving party.

Non-Transferable Assets The customer must be informed, either in writing on the transfer instructions or
on a separate document, whether any of the assets in the account cannot be readily transferred or cannot be
transferred within the time frame of the rule. The following situations could result in customer assets not
being transferable from one firm to another:
 The asset is a proprietary product of the carrying member
 The asset is a product of a third party (mutual fund) and the receiving firm doesn’t maintain the
necessary relationship to receive the assets (it has no selling agreement with distributor)
 The asset of a bankrupt issuer is held by the customer and the carrying member doesn’t possess the
proper denominations to complete delivery and no transfer agent is available to reregister the shares
 The asset is a limited partnership interest
If an asset is non-transferable, the brokerage firm must provide the customer with written notification and
await instructions regarding its disposition, which may include:
 Liquidation
 Retention
 Transfer and delivery to the customer
 Transfer to a third party
If a non-transferable asset is liquidated, distributions must be made within five business days of the
customer’s liquidation instructions.
Residual Credits Any cash or securities which have been received by the carrying firm that were not
included in the original account transfer request (through ACATS) are referred to as residual credits. The
carrying firm is required to continue to transfer these residual credit balances for a period of six months
from the processing of the original transfer request. These transfers must be made within 10 business days
of any credit balance(s) accruing in the client’s account.
Interfering with the Transfer of Customer Accounts Under FINRA rules, member firms and their
employees are prohibited from interfering with a customer’s account transfer request. Transfer requests often
stem from the departure of an RR to a new member firm. Member firms are prohibited from seeking court
orders to restrict the movement of the customer assets once the client has given his written consent to
transfer the account.
Investment Risks
When recommending specific securities or financial plans to clients, financial professionals are required to
consider various factors. Among these factors are the client’s financial holdings, risk tolerance, investment
objectives, and related risk factors. This section will outline some of the key risk factors that registered persons
should discuss with clients prior to making recommendations. The concept of diversification will also be
described, which in simple terms means not putting all of your eggs (investment dollars) in one basket.

One example of utilizing diversification is purchasing shares of a mutual fund that owns a large collection
of stocks, rather than purchasing the stock of one company. To expand on the concept of diversification,
let’s begin a deeper discussion of risk. Investment risk is divided into two major categories—non-
diversifiable and diversifiable.
Systematic (Non-Diversifiable) Risk

Systematic risk is caused by factors that affect the prices of virtually all securities. Interest rates, recession, and
wars all represent sources of systematic risk since they affect all securities markets to some degree and cannot
be avoided through diversification. The following are different types of systematic risk.
Market Risk Market risk represents the day-to-day potential for an investor to experience losses due
to market fluctuations in securities’ prices. Any security being bought and sold can decline as it’s traded
in the market. In a prolonged bear market, most stocks will trade down regardless of the company’s
individual prospects.
Interest-Rate Risk As mentioned in Fundamentals of Debt, interest-rate risk primarily affects existing
bondholders, since the market value of their investments will decline if interest rates rise. If rates do rise, new
potential investors will not be interested in purchasing existing bonds at par ($1,000) due to the fact that they
can obtain higher yields by purchasing newly issued bonds with higher coupon rates. For that reason, the prices
of existing bonds will need to be lowered to attract purchasers.
Diversification A diversified portfolio of bonds from different issuers with different coupon rates,
maturity dates, and geographic locations will provide protection against some risks, but not against
interest-rate risk. In other words, since all bonds have some exposure to interest-rate risk, it’s considered
systematic or non-diversifiable.
Duration Bonds with longer maturities tend to be more vulnerable to interest-rate risk than bonds with
shorter maturities. Also, bonds with lower interest rates are more sensitive to interest-rate risk than bonds
with similar maturities and higher coupon rates. Duration measures the sensitivity of a bond or portfolio of
bonds to a given change in interest rates. Duration is measured in years, but for practical purposes, a
bond’s change in price is based on its duration. For example, if a bond’s duration is 10 years, a 1%
increase in interest rates will cause a 10% decrease in the bond’s price. Some investors will spread out
(ladder) their bond maturities to minimize the impact of interest-rate risk by having a portion of their
holdings in shorter term bonds.
Interest Rates and Equities Stock prices may also be influenced by interest rate changes. For example,
when interest rates are rising, utilities stocks will be adversely affected because these companies are heavy
borrowers (leveraged). However, stocks of cosmetic companies (defensive stocks) are not as affected by rising
interest rates, which is due to the nature of their business and the low cost of their products. If interest rates
rise, preferred stocks will react in a manner that’s similar to debt securities. In other words, preferred stock
prices have an inverse relationship to interest rate changes.

Inflation (Purchasing-Power) Risk Inflation (purchasing-power) risk is experienced by investments

that provide fixed payments (e.g., bonds and fixed annuities). Inflation is the rising price levels of goods
and service as measured by the Consumer Price Index (CPI). Ultimately, inflation diminishes the real
value of a dollar by decreasing its purchasing power.
Historically, equity securities, variable annuities, investments in real estate, or precious metals (e.g., gold
and silver) have provided the best protection against inflation. Inflation hurts bondholders in two ways, 1)
inflation leads to rising interest rates which causes the market prices of their existing bonds to fall, and 2)
the purchasing power of their interest payments decreases.
Many market professionals measure an investment’s real rate of return (for bond’s, it’s also referred to as
the real interest rate). The formula for calculating real rate or return is an investment’s return minus the
rate of inflation (as measured by CPI). For example, if an investment has an 8% return and CPI is 3%, the
real rate of return is 5%.
Event Risk Event risk is the risk that a significant event will cause a substantial decline in the market
value of all securities (e.g., the 9/11 terrorist attack).
Unsystematic (Diversifiable) Risk

In contrast to systematic risk, unsystematic risk is based on circumstances that are unique to a specific
security and may be managed by diversifying the assets in a portfolio (i.e., by selecting stocks possessing
different risk-return characteristics). The following are different types of unsystematic risk.
Business Risk Business risk is the risk that certain circumstances or factors may have a negative
impact on the operation or profitability of a specific company. For example, a company’s prospects may
suffer due to either increased competition or decreased demand for its goods or services.
Beta and Alpha Beta measures how volatile an investment is relative to the market as a whole. However,
alpha measures the risk that’s specific to a particular company. Using beta, investors can predict a stock’s rate
of return. Thereafter, alpha can be calculated by taking what the stock actually earned and subtracting its
expected return. For example, based on its beta, a stock is expected to earn 5%. If the stock actually earned 8%,
then alpha was 3% (8% – 5%). On the other hand, if the stock only earned 4%, the alpha is -1% (4% – 5%).
Regulatory Risk Regulatory risk is the risk that regulatory changes may have a negative impact on an
investment’s value. For example, an FDA announcement denying approval of a new drug may cause the
price a pharmaceutical company’s stock to decline.
Legislative Risk Legislative risk is the risk that new laws may have a negative impact on an investment’s
value. Changes in the law can occur at any level of government and can potentially affect all sorts of investments.
For example, an increase in the legal drinking age could hurt the sales of a beer producer.

Political Risk Political risk is simply defined as the risk that foreign investors will lose money due to
changes that occur in a country’s government or regulatory environment. This risk is typically associated with
emerging markets countries and may include acts of war, terrorism, and military coups.
Liquidity Risk Liquidity risk is the risk that investors may be unable to dispose of a securities position
quickly and at a price that’s reasonably related to recent transactions. This type of risk tends to increase as the
amount of trading in a particular security decreases. For instance, the shares of large blue-chip companies are
highly liquid, while the stocks of small companies are typically less liquid. Investments which are not traded
in the market, such as hedge funds, private placements, direct participation programs (limited partnerships),
and real estate have a significant lack of liquidity.
Opportunity (Cost) Risk Opportunity cost or opportunity risk represents the possibility that the return
of a selected investment is lower than another investment that was not chosen. For example, an investor
may be planning to hold a bond until maturity and is therefore unconcerned with the potential decline in its
price if interest rates rise.
After all, as long as there’s no issuer default, he will receive the bond’s par value at maturity. Of course
the problem with this approach is that it fails to take into account the higher return that the investor could
have possibly earned from an alternative investment.
Reinvestment Risk Reinvestment risk is the risk that an investor will not be able to reinvest her
principal at the same interest rate after a bond matures or is called. This situation typically occurs when
interest rates have fallen. At this point, the investor typically has two choices, 1) accept a lower rate of
return, or 2) assume a higher degree of risk to keep her returns stable. Reinvestment risk is also evident
if market interest rates have declined and a bond investor is forced to reinvest her bond’s interest
payments at a lower rate.
Currency (Exchange-Rate) Risk Currency or exchange-rate risk is the possibility that foreign
investments will be worth less in the future due to changes in exchange rates. For example, an American
investor owns a British stock that pays a quarterly dividend. The real value of the dividend to the investor
will decline if the British pound weakens against the U.S. dollar. This is because the British pounds
received will buy fewer American dollars when converted. Foreign securities, global funds, international
funds, and ADRs all have a high degree of exchange-rate risk.
Currency risk may also impact the price of a company that’s based in the U.S. if it earns revenue in a
foreign country. For example, a U.S. company sells its products and services in Europe and earns revenue
in euros. If the U.S. dollar increases or strengthens in value, the euro will decline and cause the dollar
value of this revenue to fall. In addition, if the dollar strengthens, this company’s products will be less
competitive in Europe and result in the company exporting less.
Capital Risk Capital risk is the risk that an investor could lose all or a portion of her investment.
Purchasers of options are significantly impacted by capital risk because, if the options purchased expire
worthless, the investor will lose 100% of his capital. On the other hand, if an investor buys a stock at
$50 and it declined to$40, his loss of capital is 20% (10 point loss ÷ $50 purchase price).

Credit Risk Credit risk or default risk is the risk that a bond issuer will not make payments as promised.
U.S Treasuries are assumed to have virtually no credit (default) risk. The ratings companies that were
described in an earlier chapter provide information to market participants concerning the credit risk of an
issuer’s bond offering.
Call Risk Call risk is the risk that an issuer may decide to pay back its bondholders prior to maturity.
Bonds are typically called when interest rates fall; therefore, bondholders receive their money back early and
are unable to earn the same return when searching for a replacement investment.
Prepayment Risk In addition to the risks inherent in all fixed-income investments (e.g., interest-rate,
credit, and liquidity risk), mortgage-backed securities are subject to a special type of risk that’s referred to as
prepayment risk. This risk is tied to homeowners paying off their mortgages early. When interest rates fall,
homeowners have an incentive to refinance and pay off their existing mortgages.
These prepayments are passed through to the pools that hold the old mortgages. At this point, the
pass-through investors will need to reinvest this large amount of principal at a time when interest
rates have declined and will likely have difficulty matching their existing coupon rates and returns
when seeking new investments.
Investment Returns
Calculating Current Yield (Dividend Yield)
For stock, the current yield is its annual return based on its annual dividend and current price (as opposed
to its original price or face value). The formula for calculating a stock’s current yield is its annualized
dividend divided by its current market price.
For example, if XYZ stock is trading at $50 per share and the stock has a quarterly dividend
of $0.25, its current yield is 2%. Since dividends are typically paid quarterly, the $0.25
dividend must be multiplied by four to determine the annualized dividend income.
$0.25 x 4 $1.00
= = 2%
$50 $50
Calculating Bond Yields

As with any other investors, bondholders are interested in determining their investment’s return or yield.
As described in the Fundamentals of Debt chapter, the three different measures for determining a bond’s
yield are nominal yield, current yield, and yield-to-maturity.
Nominal Yield A bond’s nominal yield is the same as its coupon rate. If a bondholder purchases a 6%
bond, her nominal yield is 6% regardless of the price she paid. Nominal yield is the simplest measurement
of return; however, since it fails to account for the fact that the bond may have been purchased at a
premium or discount, it’s simply a place to begin the yield discussion.

Current Yield Current yield essentially measures what a bond investor receives each year based on her
(potential) purchase price. While the nominal yield is based on a bond’s par value, current yield is based
on the bond’s current market price. The only difference between calculating a stock’s current yield versus
a bond’s current yield is that the bond’s annual interest is used as the numerator.
Annual Interest
Current Yield =
For example, an XYZ corporate bond has a 5 1/2 % coupon and is priced at $975.
What’s the bond’s current yield?
$55
= 5.64%
$975
Determining and analyzing a bond’s current yield allows an investor to gain a better understanding of what
she’s earning on the bond. However, current yield fails to take into consideration the payment at maturity.
If an investor buys a bond at a price other than par, the difference between the price paid (premium or
discount) and the par value paid at maturity must be factored in to determine the bond’s overall yield.
Yield-to-Maturity (YTM) Yield-to-maturity, also referred to as a bond’s basis, takes into account
everything that an investor receives on a bond from the time she purchases it until the bond ultimately
matures. This includes the bond’s interest payments plus the difference between what the investor paid for
the bond and what she receives at maturity (par).
An investor who purchases a bond at par will get her money back at maturity. An investor who purchases a bond
at a discount will have a profit since she paid less for the bond than its par value. An investor who purchases a
bond at a premium will have a loss since she paid more than the bond’s par value.
Note: The calculation of YTM is complex and not required to be calculated for exam
purposes. Instead, the goal should be to gain an understanding of the concept.
Taxable Equivalent Yield Municipal bonds generally provide investors with tax-exempt interest. This
allows purchasers to retain more interest than if the bond was taxable. If a customer is considering the
possibility of purchasing a tax-free bond and wants to calculate what he needs to earn on a taxable issue to
earn an equivalent return, the taxable equivalent yield calculation is used. To determine the taxable
equivalent yield of a tax-exempt investment, the formula is:
Municipal Yield
Taxable Equivalent Yield =
(100% – Tax Bracket %)

Cost Basis, Capital Events, and Return of Capital

At this point, the primary focus has been on the effect of interest and dividend payments for investors. But,
what happens if the value of investors’ underlying investment rises or falls? If the investor has not yet
sold, there’s no taxable event. In other words, these unrealized capital gains or losses (paper profits or
losses) have no impact on the investor’s tax situation. On the other hand, if the gains or losses are realized,
they must be reported on the investor’s tax filing.
Cost Basis The term cost basis refers to the total amount that an investor has paid to purchase a security.
The calculation typically includes the commissions or other fees which are paid to the brokerage firm when
the securities are purchased. Some securities make distributions that can be reinvested to purchase additional
securities. The investor’s total cost basis will increase since he’s required to pay tax on the distribution.
Brokerage firms assist investors with calculating cost basis by sending an IRS Form 1099 which provides
useful tax related information.
Capital Gains Capital gains are generated when an investment is sold for a greater value than its cost
basis. If the investment had been held for one year or less prior to its sale, the gain is considered short-term
and is taxed at the same rate as the investor’s ordinary income (marginal tax rate). However, if the
investment had been held for more than one year prior to its sale, the gain is considered long-term and is
taxed at a lower rate. Currently, the maximum rate at which long-term gains are taxed is 20%.
Capital Losses Capital losses are generated when an investment is sold for lower value than its cost
basis. As with capital gains, if an investment had been held for one year or less prior to its sale, the loss is
considered short-term. If the asset had been held for more than one year prior to its sale, the loss is
considered long-term. Capital losses are used as reductions against capital gains.
Return of Capital A return of capital occurs when an investor receives a portion of her original investment
back. Since this payment is not considered either income or a capital gain, it’s not a taxable event. Any return
of capital will lower an investor’s cost basis since she now has less money at risk.
Additional Tax Considerations

Unified Gift and Estate Tax Credit This credit is the amount that can be left in an estate without
having to incur estate taxes. The lifetime amount is adjusted for inflation. Currently, $15,000 can be gifted
each year to as many individuals as desired without tax to the donor. Amounts that are gifted in excess of
the yearly exclusion reduce the lifetime unified credit. Unlimited amounts may be gifted between spouses.

Cost Basis of Inherited Securities When securities are inherited, the recipient’s cost basis is equal
to the market value of the securities at the time of the deceased’s death. This is referred to as a step-up in
cost basis. Regardless of the deceased’s actual holding period, the recipient’s holding period will be
considered long-term.
For example, on July 30, Joe’s uncle purchased 100 shares of TPA stock at $15, but
subsequently passed away on August 18 when the market value of TPA was $22. If Joe
inherits the TPA stock, he will have a cost basis in the stock of $22 (the market value at
the time of his uncle’s death). Although his uncle owned the stock for less than one month,
Joe’s holding period is considered long-term.
Cost Basis of Gifted Securities When securities are received as a gift, the recipient’s cost basis is the
lesser of the security’s market value or the donor’s cost. If the market value is higher than the donor’s cost,
the recipient’s cost basis is equal to the donor’s cost basis. However, if the market value is less than the
donor’s cost, the recipient’s cost basis is equal to the market value of the securities at the time of the gift.
The holding period of the recipient will be the same as the holding period of the giver.
For example, on May 25, Charles bought 100 shares of STC at $15 and gives the stock to
Bruce on August 14 when the market price is $20. On the day of the gift, since the market
price ($20) is higher than Charles’ cost ($15), Bruce’s cost basis for the stock is $15. On the
other hand, on August 14, if the market price was $12, then Bruce’s cost basis will be $12.
Conclusion
This ends the chapter addressing the importance of keeping client’s informed as to the status of their accounts,
the different risks to which they’re exposed, as well as the tax implications on their investments. The next
chapter will discuss the different methods used to evaluate the performance in a portfolio.

CHAPTER 15
Portfolio and
Market Analysis
Key Topics:
 Investment Selection
 Asset Allocation
 Technical Analysis
CHAPTER 15 – PORTFOLIO AND MARKET ANALYSIS
This chapter will focus on the factors that influence the selection of investments for a customer.
To learn about constructing optimal portfolios for customers, consideration will be given to how
different asset classes can be used. Finally, the chapter will review the different tools that can be
used to indicate the direction of price and the market movements.
Suitability and a Customer’s Financial Objectives

This chapter begins by examining a challenge that many students face—determining the most suitable
investment(s) for a given customer. Due to the importance of making appropriate recommendations, this
manual has provided information regarding taxation, economics, suitability, the risks associated with
different products, as well as a general understanding of the dynamic of risk and reward. Using all of those
factors, an RR is able to determine the best approach to investing customers’ assets.
An earlier chapter in this manual examined the process of profiling customers and described the need to
collect a significant amount of financial information using tools such as personal balance sheets and
income statements; however, this process extends beyond the collection of these quantitative
measurements. Many firms also use questionnaires to better gauge a specific client’s attitude toward risk
and to help define her investment objectives. Ideally, all of this information will be available prior to
making a recommendation, but during the Series 7 Examination, much of this detailed background
information may be unavailable.
Candidates may be presented with brief and incomplete client profiles that contain limited information and
will be required to tie together both the obvious facts presented in the client descriptions (e.g., age, tax
bracket, risk tolerance) with clues or inferences that may be less obvious. For example, if a question
introduces a 57-year-old doctor who is seeking a fixed-income investment, the candidate may be forced to
assume that the doctor is in a high tax bracket and will be best served by a municipal bond investment.
To answer that question correctly, a candidate must be able to tie together the doctor’s likely high tax bracket
with the federally tax-exempt status of municipal bonds. The challenge being issued by the test writers is that
candidates must understand all of the features of a product (e.g., riskiness, tax attributes, liquidity) and be able
to match these features to a client’s investment objective and risk tolerance.
Conversely, if a candidate is presented with the profile of a 60-year-old janitor, a better selection is likely a
U.S. Treasury or high-grade corporate security. This answer is based on the assumption that the customer
may have a lower tax bracket and is less concerned with the tax status of the interest payments.
Remember, corporate bonds typically provide higher yields than Treasuries, but their coupons are fully
taxable. If a client’s statutory tax bracket is provided in a question, the test writers are likely trying to
determine whether the candidate is able to perform a net yield or tax equivalent yield calculation to
compare the returns on a taxable and tax-free issue.
Before examining some application questions that are related to investment selection for clients, let’s
review the suitability obligations that RRs must follow.

Know Your Customer and Suitability

As suggested earlier, only after an RR has collected all of the background information on her client is she able
to make a recommendation. Under industry rules, all of the recommendations provided to customers must be
suitable based on the facts that customers disclose regarding their other securities holdings and their financial
situation and needs. Remember, suitability is the determinant of fair dealings with customers, not profitability.
Even if a recommendation results in a significant profit, it may still be viewed by regulators as unsuitable.
Conversely, even if a recommendation results in a significant loss, it may have actually been suitable.
A broker-dealer must use reasonable diligence to obtain the important facts regarding every customer.
In other words, for firms to provide appropriate services, it’s vital that they follow the know your
customer policy. This obligation extends to any person who is authorized to act on behalf of a customer
(e.g., an investment adviser that has been given the authority to enter orders in a customer’s account).
Only after registered representatives understand the financial needs of their customers may the proper
investment recommendations be made.
Remember, suitability is not based solely on the investment selected; another consideration is how large the
purchase is that’s being recommended. For aggressive accounts, recommending a risky stock may be suitable;
however, recommending that a client place 100% of his assets in a risky stock is considered unsuitable.
Asset Allocation
Bonds as Part of an Asset Allocation For suitability purposes, exam questions may ask the question,
what percentage of a client’s portfolio should be allocated to bonds? Given the tradeoff between risk and
reward, the general guideline is that customers should have an amount invested in debt (as a percentage of
their overall portfolio) that’s approximately equal to their age. Or, put another way, simply subtract a
person’s age from 100 to arrive at the percentage that should be invested in equities. For example, a 30-
year-old may have 70% of her portfolio allocated to equities (100 – 30 = 70) and 30% allocated to bonds.
The following are sample allocation applications that are based on the age of a customer:
 A 25-year-old may want 25% of his portfolio allocated to fixed-income investments, with
75% allocated to equity securities
 A 45-year-old may want 45% of his portfolio allocated to fixed-income investments, with
 An 80-year-old may want 80% of his portfolio allocated to fixed-income investments, with

Keep in mind, these percentages may need to be adjusted based on the financial profile and risk tolerance
of an individual customer.
25-Year Old 45-Year Old 80-Year Old

(Aggressive) (Moderate) (Conservative)
25% 20%
Bonds Equities
45%
Bonds 55% 80%
75% Equities
Equities Bonds
Customer Profile An RR’s clients are a husband and wife who are both in their 20s and have jobs
that pay well. If they’re considering several asset allocations to create a long-term retirement savings
portfolio, what’s an appropriate investment mix?
Choice A - An asset allocation of 80% stock and 20% bonds

Choice B - An asset allocation of 100% stock
Investment Selection 80% stock and 20% bonds placed into IRAs
Rationale To accumulate the assets that they‘ll need at retirement, the couple should include a
significant allocation of common stocks in their portfolio. Placement of the investments into an IRA will
serve to defer any taxes due. Although a portfolio that’s predominately allocated to bonds will be safer,
it’s unlikely to produce the required long‐term returns.
Customer Profile During an initial interview with a successful 45-year-old doctor who has her
own practice, she makes it clear to her RR that she’s disturbed by the thought of taking risks with
her money, but realizes that the stock market provides the best long-term returns. What should the
RR recommend for this customer?
Choice A - A portfolio consisting of 60% equity and 40% fixed-income

Choice B - A portfolio primarily consisting of municipal bonds with a small to moderate
(20 to 25%) allocation of equities
Investment Selection A mix that’s weighted heavily toward municipal bonds or municipal bond funds and a
small allocation of individual equity securities and/or equity funds.

Rationale Based on the asset allocation approximation rule, the recommended portfolio may appear to
hold too little equity. However, in this case, the increased bond allocation is appropriate given the
customer’s risk aversion. A customer’s ability to tolerate risk is not based solely on her financial resources,
but also on her values and attitudes. Two customers who have the same financial resources may perceive
risk differently. An RR should pay careful attention to what investors say about their tolerance for risk since
an investment recommendation that goes against a client’s expressed wishes is never suitable.
For this client, the majority of the assets are being allocated to a safe investment (municipal bonds) since
the client is uncomfortable with risk. With the client’s consent, the RR may allocate a small portion of the
client’s portfolio to equities in order to provide some growth potential. Ultimately, this portion may be
increased over time if the client becomes more comfortable with the fluctuations of the stock market and
provides permission.
Customer Profile The client is a New York advertising agency executive who is interested in making a
mutual fund investment. The client is 30-years-old, single, has an annual salary of $250,000, and recently
received a sizable bonus to be used as the down payment to purchase a home within the next year.
What’s the most appropriate recommendation?
Choice A - An asset allocation of 70% equity and 30% debt

Choice B - An asset allocation of 100% money-market funds and/or short-term bonds
Investment Selection A portfolio of money-market funds and/or short-term bonds
Rationale It may initially seem as though this client is the perfect candidate for a growth portfolio; however,
his investment time horizon is not long enough.
Before designing an investment program for a customer, an RR must determine the investor’s time horizon
(i.e., the amount of time that a client has available to achieve his financial goals). Generally, the longer an
investor’s time horizon, the more volatility (fluctuation) the portfolio can tolerate. Investors with short time
horizons usually require more stable, conservative investments since they will need their money sooner.
Based on this client’s short time horizon, equity investments are unsuitable. The client will need liquid
assets to purchase his home and cannot afford fluctuations in value; therefore, a money-market or short-
term bond fund is the most suitable.
For example, a 35-year-old investor who is planning for retirement will normally have a time
horizon of 25 to 30 years, while a 55-year-old investor will usually have a much shorter period
before retirement. Also, the parents of an infant will have 18 years to save for college, while the
parents of a teenager will have far less time.

Client Profile A 35-year-old small business owner, who is single and appears to be doing well
financially, informs an RR that he wants to day-trade. Fearing identity theft, the client refuses to provide
the RR with background information beyond what’s required under AML rules (e.g., name, Social
Security number, date of birth). What should the RR recommend for this client?
Choice A - A collection of small capitalization equities and some long options

Choice B - Nothing
Investment Selection Nothing
Rationale Some clients may be reluctant to disclose their complete financial information. If a client
refuses to provide certain information, an RR may not make assumptions about the client’s finances.
An RR may only make recommendations that are based on the information that has been disclosed by
the client. In some cases, a firm may decide not to open an account due to a client’s unwillingness to
provide sufficient background information.
Customer Profile A high-income, high-net-worth investor is seeking income and safety of principal.
What’s the appropriate allocation recommendation for this customer?
Choice A - A mix of U.S. Treasuries and high-grade corporate bonds

Choice B - A mix of investment-grade municipal bonds
Investment Selection Investment-grade municipal bonds
Rationale Safety of principal refers to a customer’s desire to be able to preserve or retain the initial amount
of her investment over its life. Many bonds offer this benefit to investors. The higher the rating of the debt
instrument, the greater the likelihood that investors will achieve the safety of principal that they desire.
Investment‐grade municipal bonds offer safety of principal and also offer tax-exempt income to investors
who are in a high tax bracket. In this case, although the Treasury securities and corporate bonds will provide
income, the income is federally taxable. Remember, since investors who have significant taxable income will
typically have a higher marginal rate of taxation, they’re good candidates for tax-free bonds.
Customer Profile An RR’s client is an elderly customer who is seeking preservation of his capital.
What investment should an RR recommend to this customer?
Choice A - U.S. Treasury bonds

Choice B - U.S. Treasury bills
Investment Selection U.S. Treasury bills

Rationale Investors who are concerned about the potential loss of their capital will invest in securities that
provide safety. Although they want to achieve a return on their investment, these investors don’t want to put
their principal at risk. Although T-bonds are not subject to default risk, they do expose customers to interest-
rate risk. On the other hand, T-bills protect clients against both default risk and interest-rate risk. Older
clients with a preservation of capital objective often invest in short-term instruments, such as U.S.
government T-bills, insured certificates of deposit, or money-market funds.
Customer Profile An RR’s client is a recent college graduate who has just landed his first full-time job
and has recently moved out of his parents’ home. If the investor wants to allocate 10% of his salary to stock
market investments, what’s an appropriate recommendation?
Choice A - A variable annuity

Choice B - A work-sponsored retirement plan
Investment Selection Prior to investing the client’s assets, the appropriate step is to have the client investigate
whether his employer offers a retirement plan, such as a 401(k) plan.
Rationale Employer-sponsored retirement plans typically grow on a tax-deferred basis and are often the
first choice to consider when making an investment. Generally, these plans permit pre-tax investments (which
reduce current taxable income) and normally offer a wide range of low-cost investment choices.
Customer Profile The client is a retired school teacher who is seeking current income and a
portfolio that provides some inflation protection. If she’s willing to accept a moderate level of risk,
what should an RR recommend?
Choice A - A collection of high-grade convertible corporate bonds

Choice B - A high-yield bond fund
Investment Selection High-grade convertible corporate bonds
Rationale Investors with a primary investment goal of current income want investments that produce a
steady, reliable stream of cash. These investors typically need this income in order to defray daily living
expenses, especially during retirement years. Some examples of income investments include most bonds,
preferred stocks, and fixed annuities. Often, the downside to income investments is that they produce little, if
any, growth in principal (the original amount invested). Over time, this may present a problem due to the fact
that inflation erodes the purchasing power of the income.
Investment‐grade (highly rated) convertible corporate bonds offer investors both the safety of income and
the potential for appreciation if the underlying equity increases in value. Although U.S. Treasury securities
are safer, they don’t offer the equity upside potential of a convertible issue. If clients demand an even
greater degree of safety, TIPS are an appropriate choice.

It’s unlikely that the high-yield bond fund is the best choice for this customer. Although these products
provide income, they do so at greater risk and offer no inflation protection.
Customer Profile An RR’s client has been using a 529 plan to save for her child’s college education and
her child will be attending college in a few years. What asset allocation should an RR recommend?
Choice A - A mix of 80% equities and 20% fixed-income securities

Choice B - A mix of 20% equities and 80% fixed-income securities
Investment Selection 20% equity securities and 80% fixed-income securities
Rationale Although the student is young, she will soon need to access the funds for college. As a
child approaches college age, a suitable investment strategy is to move from growth-oriented securities
(e.g., equities) to income‐oriented securities (e.g., bonds and money-market funds). Once a child begins
to attend college, most of the funds should be invested in money‐market funds or other types of short‐
term investments that offer liquidity and limited capital risk. In this case, since there are a few years
remaining for the assets to grow, a minimal percentage of the account should be invested in equities.
Customer Profile A registered representative’s customers are a husband and wife who are in their
early 70s and are retired. They live on a small pension from the post office and also collect Social
Security benefits. If the couple has assets of $355,000 to invest and they’re in the lowest tax bracket,
what portfolio allocations are most suitable?
Choice A - A mix of 25% domestic equities, 60% bonds, 10% cash, 5% international equities
Choice B - A mix of 75% high-grade municipal bonds and 25% equities
Investment Selection 25% domestic equities, 60% bonds, 10% cash, 5% international equities
Rationale Considering the customers’ ages and limited incomes, investing a greater portion of their
assets in bonds will provide additional income, while the assets invested in equities will provide the
potential for growth. As explained previously, one approach that’s used by many professionals is to
subtract a client’s age from 100 to determine the percentage of assets that should be invested in equities.
The general assumption is that as clients get older, they have less risk tolerance and, therefore, less money
should be invested in equities. Only a small percentage of a client’s assets should be allocated to the
international marketplace. Remember, clients who are in the lowest tax bracket are generally not good
candidates for municipal investments.
Customer Profile A customer in his early 50s has recently received a sizable bonus and has an
investment objective of growth. The customer has an existing large portfolio of equities and fixed-income
securities. Now the customer is seeking additional diversification into real estate, but wants access to his
funds if an emergency arises. What should be recommended to this customer?

Choice A - A REIT
Choice B - A new construction DPP
Investment Selection A REIT
Rationale Since the customer already has a large, existing portfolio of equity and fixed-income
investments, some exposure to alternative asset classes is appropriate. Both DPPs and REITs provide this
type of diversification. However, it’s important to notice that the customer requires liquidity. When
comparing REITs to DPPs, most REITs are exchange-traded and provide liquidity, while DPPs are not
exchange-listed and often have multi-year holding periods.
Customer Profile A newly married couple in their early 20s is interested in investing a portion of the
money they received as wedding gifts. The couple has very little savings and virtually no investment
experience. If they have just purchased a new home and are eager to begin making money in the stock
market, what’s the appropriate recommendation?
Choice A - A mix of index mutual funds and corporate bonds

Choice B - Short-term bonds or money-market securities and a small allocation of equity
Investment Selection Short-term bonds or money-market securities and a small allocation of equity
Rationale As a general rule, most investors should have a cash reserve equal to at least three months’ living
expenses. In certain circumstances, such as when a client’s income is unpredictable, it may be wise to maintain a
larger cash reserve. These capital reserves should be kept in a safe, liquid investment such as a money-market
fund. Although this couple is ready and willing to invest in the stock market, until they establish sufficient cash
reserves, only a small portion of their assets should be allocated to equities.
Customer Profile An RR’s customer is a biotech engineer who believes that biotechnology will be a
leading industry in the 21st century. He wants some exposure to this area of investing that offers high-
risk with the potential for high-reward and is seeking to maximize his returns by utilizing margin.
What investment should be recommended to this customer?
Choice A - A biotechnology sector ETF

Choice B - A biotechnology mutual fund
Investment Selection A biotechnology sector ETF
Rationale Both the biotechnology ETF and the biotechnology mutual fund provide exposure to this
market segment. A sector ETF concentrates its investments in a given industry, such as mining,
biotechnology, or computer technology. While these funds are certainly more risky than other diversified
offerings, they provide exposure to a given industry for any investors who seek it. The key to this question
is that the customer intends to use margin to maximize his returns. Remember, ETFs are marginable, but
mutual funds are not.

Customer Profile The customer is an accredited investor who consistently invests in high-risk
ventures. He’s a seasoned stock market investor who enjoys trading both options and leveraged
products. The customer is also the custodian for his 6-year-old niece’s UGMA account. What
investment(s) should be recommended for the UGMA account?
Choice A - Hedge funds, since these products offer the potential for significant returns
Choice B - A broad collection of equity securities
Investment Selection A broad-based portfolio of high-quality stock funds or good quality

individual stocks
Rationale In some cases, assets are being invested for the benefit of a third party such as a child or
infirmed relative. In these cases, the RR must examine the profile and objective of the beneficiary, not the
person who is making the ultimate investment decisions. In this case, a high-quality equity portfolio is a
suitable recommendation for the niece’s account. Hedge funds are illiquid investments and are
inappropriate for placement in a UGMA account.
As shown by reviewing these customer profile examples, choosing an appropriate investment mix for a
customer can be a difficult process. RRs must weigh the client’s objective, profile, tax situation, and the current
market conditions prior to making a recommendation.
Forms of Analysis
Growth Analysis This method of analysis is used by investors who are concerned with a company’s future
earnings potential. The investors are seeking companies with rapidly growing earnings in the hope that this
growth will continue. Growth investors believe that if the company’s earnings are outperforming the market,
the stock’s price will continue to increase. Also, as long as the company controls its costs and increases sales,
the value of the business will increase and the stock price will grow along with future earnings.
Growth investors usually purchase stocks that have high price-to-earnings (P/E) ratios, a high level of
retained earnings, and low dividend payout ratios. Remember, growth companies tend to retain most of their
earnings to finance expansion of operations rather than paying dividends to shareholders.
Value Analysis The value analysis method is used by investors (or funds) that are interested in stocks of
companies that are intrinsically undervalued or trading at a discount to their book value. If the market is efficient
and the issuing companies continue to generate profits, these stocks are attractive to long-term investors since
their depressed prices make them a good value. Value stocks are characterized by a low P/E ratio, a history of
profits, a high dividend yield, and a low market-to-book ratio.
Value investors are most concerned with the fundamental value of businesses as opposed to their current
share price and believe that companies that are out of favor and underperforming may be overlooked.
Many of these investors have very long-term time horizons and seek out companies that are undergoing a
fundamental change such as a restructuring or shift in leadership.

Top-Down Analysis When following the top-down analysis approach, a broad analysis of the economy
is conducted first and then specific industries are identified that seem to benefit from the anticipated future
economic conditions. Ultimately, particular companies are chosen from within those industries.
Bottom-Up Analysis The bottom-up analysis focuses on fundamental analysis and the evaluation of
companies based on a number of factors. The goal is to find stable companies that have a history of profits and
to determine whether a company is undervalued relative to its peers. The analysis will also consider the
economic climate to further validate the investment decision.
Momentum Investing Momentum investors often move rapidly from one sector of the market to
another—essentially in an effort to chase money flows. For example, if gold stocks are in favor, they will
overbuy in that area; however, if auto stocks are subsequently moving higher, they will change focus
rapidly. Many of these investors use sector specific ETFs to accomplish this rapid movement from one
sector to another.
Indexing The index approach basically concedes that most investors don’t outperform the market. The goal
of indexing investors is to find the least expensive and most tax-efficient products that reconcile with their
objectives. These investors often choose to go it alone since they believe registered representatives or financial
advisers lack the knowledge to beat the market. Investment choices may include index funds and ETFs since
both of these products offer a low-cost and tax-efficient way to gain broad exposure to the market.
Modern Portfolio Theory

Regardless of the method being employed, investors are constantly seeking to construct the perfect
portfolio. But ultimately, how does a person measure perfection? Is it the absolute return or is it small or
non-existent losses? To adequately answer the question, the goal must be reviewed—to generate the
maximum return for a given level of risk.
Prior to the middle of the last century, theories about investing focused mainly on the strengths and
weaknesses of individual securities. According to these approaches, good analysts constructed portfolios
that contained only the strongest performing stocks or other securities. But beginning in the 1950s, a
number of financial analysts revolutionized the approaches to investing. These advances are grouped under
the heading the Modern Portfolio Theory (MPT).
One of the basic assumptions of the Modern Portfolio Theory is that investors are risk-averse. Essentially,
investors prefer the lowest risk possible to obtain a given level of return. Or, put another way, investors
want the highest return possible given a specific level of risk.
Constructing Optimal Portfolios MPT shifted investors’ attention away from individual securities
toward a total portfolio that consists of various classes of assets. For example, a simple portfolio may contain
three basic asset classes in various proportions. One mix may be 60% stocks, 30% bonds, and 10% cash
equivalents, while another mix may be 20% stocks, 20% bonds, and 60% cash equivalents.

MPT suggests that there’s actually a whole series of possible mixes that are optimal. An optimal portfolio
is one that provides the greatest return for a given amount of risk. A graph of these optimal portfolios
(shown below) produces a diagram that’s referred to as an efficient frontier.
Efficient
Frontier
B
Same risk,
C but higher return
Same A
return, but
less risk
Return
Risk
(Volatility of Returns)
Any point behind the frontier, such as Point A, represents a portfolio that’s not optimal. There are
portfolios that offer better returns than A for the same level of risk (Portfolio B). Also, there are portfolios
that offer the same return as A, but with less risk (Portfolio C). The lesson is that portfolios on the efficient
frontier are better than those behind it.
A more challenging issue is deciding between Portfolios B and C. Is one better than the other? The decision
depends on an investor’s risk tolerance. If Portfolio B is chosen, the investor expects to achieve a better
return than C, but with more risk. While it’s clear that when given a choice an investor should not choose
Portfolio A, the selection of either between B or C is a matter of investor preference and risk tolerance.
Asset Allocation MPT has found that the key to optimal portfolios is the degree of correlation between asset
classes. Finding asset classes that don’t show a high degree of positive correlation produce the best results.
Ideally, investors would like assets that showed strong negative correlations, but this desire is not always
realistic. Although most financial assets show some degree of positive correlation, excellent results may still
be produced with investments that show a modest lack of correlation.
The preceding aspects of Modern Portfolio Theory are the basis for asset allocation approaches to investing.
After assessing a client’s goals and objectives (to determine an appropriate expected return) and risk
tolerance (to determine the level of volatility with which the client feels comfortable), an investment adviser
may use computer software to construct an appropriate mix of assets for the client’s recommended portfolio.

The asset classes to be used will depend on the investments that are available and suitable for a particular
client. For example, an adviser may choose to construct a portfolio with a mix of U.S. large-capitalization
stocks (or mutual funds), U.S. small-capitalization stocks, international stocks, domestic bonds,
international bonds, and money-market funds (as a cash equivalent). As decisions are being made, the
adviser and/or the client may choose to put constraints on the percentage of assets in each class (e.g., at
least 5% of the portfolio in each asset class, but no more than 25% in any one asset class).
There are many different methods that may be used to help determine the proper allocation among
different asset classes. Many financial professionals begin by using the investor’s age, while others use
time horizon and risk tolerance. Investors may accomplish proper asset allocation on their own by
investing in mutual funds or exchange-traded funds.
Below is an asset allocation table that’s posted on FINRA’s website:
Investment Horizon Stocks Bonds Cash
20 to 30 years until retirement 80% 15% 5%
10 to 20 years until retirement 60% 30% 10%
Five years until retirement 40% 40% 20%
At retirement age and beyond 30% or less 40 to 80% 20% or more
Indexes and Averages

Indexes and averages monitor the performance of a group of securities. Some are intended to reflect the
entire market and are referred to as broad-based, while others measure only a market segment or particular
industry and are referred to as narrow-based.
The Dow Jones Averages The Dow Jones Averages are the most widely quoted measurements of the
stock market. The Dow Jones Composite Average consists of 65 stocks and is broken down into the
following three subaverages:
 Dow Jones Industrial Average – consisting of 30 stocks
 Dow Jones Transportation Average – consisting of 20 stocks
 Dow Jones Utility Average – consisting of 15 stocks
Of the three Dow Jones Averages, the Dow Jones Industrial Average (DJIA) is the most commonly quoted.
The DJIA contains 30 of the leading blue-chip companies that represent the backbone of industry in the
U.S., such as General Electric, AT&T, and IBM.

The Standard & Poor’s 500 Index The S&P 500 Composite Index consists of mainly NYSE stocks,
but also some NYSE Mkt LLC (formerly AMEX) and Nasdaq stocks. This index gives a broader measure
of the market as compared to the Dow Jones Averages. The S&P 500 Index consists of approximately:
 400 industrial stocks
 20 transportation stocks
 40 financial stocks
 40 utility stocks
The New York Stock Exchange Composite Index The NYSE Composite Index contains all of the
common stocks that are listed on the New York Stock Exchange. As with the S&P 500 Index, this index is
also divided into four sub-indexes for industrial, transportation, financial, and utility issues.
The Wilshire Associates Equity Index The Wilshire Associates Equity Index consists of stocks that
trade on the New York Stock Exchange, the NYSE Mkt LLC, and Nasdaq. The index represents the dollar
value of all of the stocks and is considered the broadest of all indexes and averages.
Other Indices Some of the other indices that are widely used include the Major Market Index which
consists of 20 well-known highly capitalized stocks, the Nasdaq Composite Index which consists of all
Nasdaq-listed securities, and the Nasdaq 100 which consists of 100 of the largest companies listed on
Nasdaq. The Morgan Stanley Capital International Europe, Australasia, and Far East (MSCI EAFE) Index
follows the equity performance of the developed markets, but excludes the U.S. and Canada. Lastly, the
FTSE Index mostly follows the stocks of companies that trade on the London Stock Exchange. (The FTSE
acronym is derived from its two parent companies—the Financial Times and the London Stock Exchange.)
Capital Asset Pricing Model (CAPM)

The original ideas of Modern Portfolio Theory have been extended in a number of directions. One of these
extensions is the Capital Asset Pricing Model (CAPM). CAPM attempts to describe how the market values
(prices) investments and provides insights into the nature of risks.
Types of Risk Although there are a number of ways to categorize investment risks, CAPM simplifies
the analysis of risks by classifying them into two types—diversifiable and non-diversifiable risk.
Diversifiable Risk This risk, which is also referred to as non-systematic risk, is associated with owning
the securities of specific companies. CAPM suggests that this risk is able to be avoided or even
eliminated by holding a diversified portfolio of securities. Since it’s avoidable, investors are not
compensated for assuming diversifiable risk.

Non-Diversifiable Risk This risk, which is also referred to as market risk or systematic risk, is associated
with the overall movement of the market. Since this risk is not able to be avoided through diversification,
investors are rewarded for assuming it. The greater the non-diversifiable risk, the greater the potential reward.
Measuring Non-Diversifiable Risk Avoiding diversifiable risk is as simple as constructing a portfolio of

relatively uncorrelated assets; however, non-diversifiable risk must be approached differently. The reason for
this is that the amount of risk being assumed by a portfolio is directly related to its expected return.
Beta The amount of non-diversifiable risk associated with a particular portfolio or asset is measured as
beta (β). The value of beta describes the risk of a portfolio or asset as compared to the total market, which
is measured as volatility. The total market is assigned a β value of 1; however, some representation of the
total market (usually the S&P 500 Index) is commonly employed.
For example, if Investment Z has a β of 1.5, this suggests that it’s 50% more volatile than
the market as a whole. Therefore, if the market rises by 10%, Investment Z is expected to
rise by 15% (10% x 1.5). Conversely, if the market declines by 10%, Investment Z is
expected to decline by 15% (10% x 1.5).
An investment with a β of less than 1 is not as volatile as the total market and is expected to fall less in
declining markets than the average security, but also rise less in bull markets. When beta is calculated for
an entire portfolio, the weighted average of the betas of the component parts (securities) is used.
Alpha While a stock’s beta measures its performance related to the overall market, alpha measures the
portion of a stock’s return that’s achieved independent of the market. Alpha is influenced by factors that
are unique to the company and its industry group.
As a risk-adjusted return, alpha represents the difference between an asset’s expected return (as implied by
beta) and its actual return. If a security’s actual return is higher than its beta, the security has a positive
alpha; however, if the return is lower, it has a negative alpha.
Information Sources for Municipal Bond Market Participants

There are several sources of information regarding primary and secondary market municipal bond
transactions. These sources include:
The Bond Buyer The Bond Buyer is the online newspaper of the municipal industry that contains news
that’s pertinent to both the municipal market and the financial community in general. It also contains
announcements such as notices of sale, call notices, and a new issue calendar.
The Bond Buyer includes a variety of statistics that relate to the municipal bond market. The following
section will list and explain a number of these metrics and indexes.

Visible Supply The 30-day Visible Supply is compiled on a daily basis (with weekly average shown)
by adding together the total dollar value of all municipal securities being underwritten on a competitive
and negotiated basis which are expected to reach the market over the next 30 days. Issues that are due to
mature in 13 months or more are included in the totals. The visible supply gives an indication of the
supply side of the market.
Visible Supply
Date Competitive Negotiated Total
2/26 1,864,011 5,563,282 7,427,293
2/19 1,929,628 4,326,210 6,255,838
2/12 1,866,907 6,338,906 8,205,813
2/5 1,516,746 6,723,046 8,239,792
1/29 2,432,014 8,472,323 10,904,337
1/22 2,385,365 9,315,425 11,700,790
1/15 961,388 4,945,078 5,906,466
The Bond Buyer Placement Ratio The placement ratio is compiled on a weekly basis at the close
of business on Friday. The ratio represents the dollar amount of bonds that were sold by underwriting
syndicates over the week as a percentage of the amount of bonds that were issued that week. To be
included, an offering must be for $1 million or more. The placement ratio gives an indication of the
demand side of the market.
Placement Ratio
No. Total Amt. Sales from Placement
New New Accts. New Accts. Ratio
Accts. ($000s) ($000s) (%)
2/26 14 434,102 408,297 94.1

2/19 19 714,685 668,240 93.5
2/12 11 290,175 248,870 85.8
2/5 11 474,075 423,680 89.4
1/29 19 2,002,188 1,977,803 98.8
1/22 8 435,192 431,392 99.1
1/15 11 754,395 754,395 100.0

Bond Buyer Indexes The Bond Buyer compiles information regarding different indexes that are widely
watched in the municipal bond industry. These indexes provide an indication of the average weekly yields
for both general obligation and revenue bonds.
Bond Buyer Indexes

Average Municipal Bond Yields—Compiled Weekly
20 G.O. Bonds 11 G.O. Bonds 25 Revenue Bonds Treasury Bonds

May 21 8.31 8.17 8.68 9.00
May 14 7.82 7.70 8.20 8.72
May 7 7.86 7.74 8.20 8.64
Apr. 30 7.85 7.72 8.13 8.44
Apr. 23 7.82 7.96 8.16 8.53
The 20 Bond Index This index shows the average yield on 20 general obligation bonds with 20-year
maturities and has an average rating that’s equivalent to Aa2 for Moody’s and AA for S&P.
The 11 Bond Index This index shows the average yield on 11 of the 20 bonds that are in the 20 Bond
Index and has an average rating that’s equivalent to Aa1 for Moody’s and AA+ for S&P.
The Revenue Bond Index This index shows the average yield on 25 revenue bonds with 30-year
maturities and has an average rating that’s equivalent to A1 for Moody’s and A+ for S&P.
Bond Buyer Municipal Bond Index This index represents the average of the prices of 40 recently issued
and actively traded municipal bonds. The prices are calculated based on quotations that are obtained from
municipal broker’s brokers. The index is published daily and the components of the index are adjusted
twice per month.
The SIFMA Index This index is a seven-day market index of Variable Rate Demand Obligations
(VRDOs) with at least $10 million outstanding.
The Municipal Market Data (MMD) Curve This is the yield curve of the highest-rated (AAA) municipal
bonds and it’s published by Thomson Reuters.
Technical Analysis
Technical analysis involves the study of indexes, averages, theories, price trends, and charts in an effort to
predict the direction of both the overall market and specific stocks. Technical analysts tend to ignore the
fundamental approach and assume that markets are efficient and all information (both public and private)
has already been incorporated in a security’s price. These analysts consider the past history of both
securities and the markets to formulate their opinions.

Technical analysts seek to identify market trends as early as possible and they advise their clients regarding
which investments will likely profit from the trend until there’s a reversal. To do this, technical analysts
follow the markets, individual securities, and an assortment of market data.
Trading Volume
Trading volume is reported daily by both the exchanges and FINRA with volume figures showing the total
number of shares traded for each security and the market. Analysts monitor these figures carefully since,
historically, volume tends to lead a trend in prices.
A trendline is a solid line that traces the lows of a stock as it moves in an upward direction, or the highs of
a stock as it moves in a downward direction. Once a trendline has been established, the price movement of
a stock will usually follow the trendline.
Analysts consider it normal for stock prices to rise on increasing volume, but don’t feel that it signifies a
reversal in the market’s trend. However, a small price rise that’s accompanied by decreasing volume is
often considered the reversal of a trend and is, therefore, bearish.
The term market momentum is used to describe a situation in which prices are moving in a certain
direction along with a high level of trading volume. There’s also an expectation that this pattern will
continue in the near future. For example, if the S&P 500 Index has been trading either up or down
significantly over a period of days along with heavy trading volume, some traders will anticipate that this
pattern may continue for a few more days. Market neutral refers to the strategy of attempting to profit by
buying some securities while at the same time selling short other securities.
Technical Market Theories

Other tools that are available to technical analysts include the various theories concerning market activity.
These theories refer to certain historical patterns in the market that, when properly identified, may signal a
bullish or bearish investment environment. When a bullish signal is identified, analysts will issue a
recommendation to buy securities; however, with a bearish signal, the recommendation will be to either sell
existing positions or to sell securities short.
The Short Interest Theory Short interest refers to the amount of a company’s common stock that’s
been sold short, but has not yet been covered (closed out). Periodically, the NYSE and the Nasdaq
Market System compile a list of various companies’ short interest.
Although it may appear that an increase in short interest from one month to another is a bearish indicator,
those who follow the short interest theory normally consider rising or large short interest to be a bullish
indicator. According to the short interest theory, short sellers must eventually cover their short sales and, as
they purchase the stock, it will cause the market price to increase. Other short sellers, fearing future
increases in the stock’s price, will cover their short sales and create additional upward pressure on the
stock (commonly referred to as a short squeeze).

Put/Call Ratio The put/call ratio is a technical market indicator that’s found by dividing the volume
of all put transactions by the volume of all call transactions on a daily basis. Technical analysts view the
put/call ratio as a contrarian indicator. Although a high ratio indicates that the mood of investors is
bearish, from an analyst's point of view it reflects an oversold market and a higher probability that the
market will reverse course and turn bullish. The opposite is true for a low put/call ratio, which is viewed
as a bearish indicator.
The Odd-Lot Theory The odd-lot theory focuses on the trading activity of small investors. Small public
investors are commonly referred to as odd-lotters due to their purchases and sales typically being in
amounts that are less than 100 shares (i.e., odd-lots).
The theory suggests that small investors are usually incorrect in their market timing. In other words, they
purchase when the market is at its highest and sell when the market is at its lowest. Statistics are kept that
track odd-lot purchase and sell orders and are published on a daily basis.
Technical analysts often advise their clients to buy when odd-lot sell orders increase relative to odd-lot buy
orders. A sell recommendation will be issued by analysts when odd-lot buy orders increase relative to odd-lot
sell orders. Basically, technical analysts advise investors to do the opposite of whatever action is taken by
small public investors.
The Advance-Decline Theory Advance-decline figures measure the number of stocks that have
increased compared to the number that have decreased during a trading session or other period. This
data, which is intended to show the direction of the market as well as the breadth of a market
movement, is published daily.
NYSE Nasdaq
Issues Traded: 3,164 2,582
Advances: 718 543
Declines: 2,351 1,961
Unchanged: 95 78
New Highs: 287 183
New Lows: 40 19
According to this theory, it’s a bullish indicator if there’s a positive advance-decline figure (i.e., more
advancing issues than declining issues). However, it’s considered bearish if the market averages
(e.g., the Dow Jones Industrial Average) are up, but the advance-decline figures are negative.
The Dow Theory The Dow Theory attempts to determine changes in the underlying trend of the market.
Historically, Dow theorists have looked to the Dow Jones Averages for this information. According to this
theory, a major trend is confirmed only when both the Dow Jones Industrial Average and Dow Jones
Transportation Average reach a new high or new low. Without this confirmation, the belief is that the
market will drift back to its previous trading pattern.

Charts and Patterns

A major part of technical analysis is the use of charts to uncover trends in the price of a security or the
direction of the market. These price patterns will be used to make buy and sell recommendations to investors.
Resistance and Support Levels Over time, a stock tends to trade within a certain price range. In some
cases, there’s an increase to a particular price level at which heavy selling pressure is encountered. This is
referred to as an area of resistance. At this point, prices are too expensive and it causes buying to cease. For
this reason, analysts describe the market as being overbought.
In other cases, there’s a decline to a particular price level that causes investors to purchase at the attractive
lower price. This buying stops the price decline and is referred to as an area of support. Ultimately,
prices become so enticing that selling stops and buying begins. For this reason, analysts describe the
market as being oversold.
The following diagrams illustrate areas of support and resistance:
Levels A and B show an area of resistance. At this level, selling pressure tends to prevent the security’s
price from continuing to increase. In some cases, investors feel that previous buying has left prices too
high and will consider the price level to be overbought.
Levels C and D show an area of support. At this level, buying pressure tends to prevent the security’s
price from continuing to decline. In some cases, investors feel that previous selling has left prices at an
attractive level and will consider the price level to be oversold.
Breakout A breakout occurs when the stock’s price either increases above a resistance level or declines
below a support level. When this happens, technical analysts believe the price of the stock will continue
on its course.
A breakout above the resistance level is considered a bullish signal. To profit from this, investors may enter a
buy stop order slightly above the resistance level. As the stock’s price increases above resistance, the order will
be executed and investors will profit as the stock continues to increase in value. Another alternative is for
investors to purchase call options on the stock once the breakout has occurred.

A breakout below the support level is a bearish signal. To profit from this, investors may enter a sell stop
order slightly below the support level. As the stock’s price decreases below support, the order will be
executed (essentially a short sale) and investors will profit as the stock continues to decrease in value.
Another approach is to purchase put options on the stock.
Head and Shoulders Patterns A head and shoulders formation indicates the reversal of a trend. There
are two types of formations—head and shoulders top and head and shoulders bottom. Let’s first analyze
the head and shoulders top formation.
Head and Shoulders Top

B
Head
A C
Shoulder Shoulder
Neckline
D
Head and Shoulders Top Formation In the diagram above, the stock rises in price (to Point A), but then
declines to form the left shoulder. The stock again increases in price to a point above the previous high (to
Point B), only to fall back to the previous low. The stock once again increases (to Point C), but fails to
reach a new high. The last indication occurs when the stock falls to the level of the previous low point and
then declines further (to Point D).
After observing a head and shoulders top formation and believing that it represents the reversal of an
upward trend and a bearish indicator, technical analysts may instruct their clients to either sell their
existing position to avoid a large loss on the stock or to profit by selling the stock short.
Head and Shoulder Bottom

D
Neckline
A C
Shoulder Shoulder
B
Head

Head and Shoulders Bottom Formation The diagram above, which depicts the head and shoulders
bottom formation (also referred to as the inverted head and shoulders), is the opposite of a head and
shoulders top. This pattern is the reversal of a downward trend and is considered a bullish indicator.
Saucer Pattern A saucer is a chart pattern used by technical analysts that indicates that a stock has
formed a bottom in its trading cycle and is ready to rise. The bottom of the saucer pattern is a bullish
indicator for the stock. As shown in the exhibit below, when the stock reaches $30 per share, it will begin to
rise and cause a buying opportunity.
The reverse of the saucer pattern is the inverse saucer, where the stock forms a top in its pattern and is
expected to fall. Following the logic used in the saucer, the reverse is a bearish indicator.
Both fundamental and technical analyses are based on the assumption that the future performance of a
security (or the market) is predictable by using current and past information. However, there’s another
school of thought that disagrees with this premise—the Random Walk Theory.

The Random Walk (Efficient Market) Theory The Random Walk Theory states that security
analysis doesn’t produce investment recommendations that will allow investors to consistently
outperform a randomly selected portfolio. Therefore, a professionally managed portfolio will perform
just as well as a portfolio that’s selected in a non-discriminatory fashion (e.g., throwing darts at a
newspaper listing of stock prices).
The theory also states that stock prices represent all of the available information regarding a company’s
performance. Essentially, the theory suggests that it’s futile to try to identify undervalued securities
through the use of either fundamental or technical analysis.
Conclusion
This concludes the chapter on Portfolio and Market Analysis. The next chapter will examine an alternative
way of evaluating investments—fundamental analysis.

CHAPTER 16
Fundamental Analysis
Key Topics:
 Balance Sheet
 Fundamental Tools
 Income Statement
 Earnings Per Share

CHAPTER 16 – FUNDAMENTAL ANALYSIS
This chapter will examine a method of evaluating investments, called fundamental analysis.
Fundamental analysis relies on reviewing financial statements and other forms of traditional
research to ascertain the prospects of a given securities issuer.
Fundamental Analysis
Securities analysts seek to predict the future performance of marketable securities. Fundamental analysis
focuses on analyzing individual companies and their industry groups. Important items for a fundamental
analyst include a company’s financial statements (e.g., its balance sheet and income statement), details
regarding the company’s product line, the experience and expertise of the company’s management, and the
outlook for the company’s industry. Obviously, the general condition of the economy will also affect the
prospects for a given company.
A subgroup of fundamental analysts, referred to as value investors, attempt to gauge the intrinsic value of
a company. When a stock’s market value is less than its perceived value, they accumulate shares due to the
assumption that eventually the markets will come back to the correct pricing. By their nature, many value
investors tend to be very long-term holders.
Conversely, technical analysis focuses on market sentiment or trading trends. Investors who subscribe to
technical analysis tend to be more short-term oriented and may even attempt to time markets as a security
fluctuates in value.
The Balance Sheet

The balance sheet (also called a statement of financial condition) represents the financial picture of a
company as of a specific date. The balance sheet is divided into three major sections—Assets, Liabilities,
and Stockholders’ Equity. The name balance sheet is derived from the fact that the total assets must
always equal the sum of the total liabilities plus the stockholders’ equity. Therefore, the basic formula is:
Assets = Liabilities + Stockholders’ Equity (Net Worth)
This could also be shown as:
Assets – Liabilities = Stockholders’ Equity (Net Worth)
Assets represent all of the items that are owned by a corporation, while the liabilities section contains all of
the items that are owed by the corporation. The difference between a corporation’s total assets and its total
liabilities is stockholders’ equity (also referred to as net worth).

The exhibit below represents a sample balance sheet:
National Corporation Balance Sheet

For period ending December 31, 20XX
ASSETS LIABILITIES
Current Assets Current Liabilities
Cash $ 43,000 Accounts Payable $188,000
Marketable Securities 62,000 Interest Payable 27,000
Accounts Receivable 270,000 Dividends Payable 40,000
Inventories 330,000 Taxes Payable 72,000
Total Current Assets: $705,000 Total Current Liabilities: $327,000
Fixed Assets Long-Term Liabilities

Land $ 64,000 9% Debentures due 2035 $300,000
Plant and Equipment 630,000
Furniture and Fixtures 280,000 TOTAL LIABILITIES $627,000
Less: Accumulated
Depreciation (220,000)
Total Fixed Assets: $754,000
Intangible Assets STOCKHOLDERS’ EQUITY

Goodwill $ 30,000 6% Preferred Stock,
$100 par value,
500 shares outstanding $ 50,000
Common Stock,
$3.00 par value,
300,000 shares authorized,
200,000 shares outstanding 600,000
Capital Surplus 52,000
Retained Earnings 160,000
Total Stockholders’ Equity: $862,000

TOTAL LIABILITIES AND
TOTAL ASSETS $1,489,000 STOCKHOLDERS’ EQUITY $1,489,000

Components of the Balance Sheet—Assets

There are three basic subsections to the asset category—current assets, fixed assets, and intangible assets.
Current Assets Current assets represent cash and other items that may be converted into cash within a
short period (usually one year). The assets that may be converted into cash include marketable securities,
accounts receivable, and inventories.
It’s important to examine the method being used for valuing the inventory. In most cases, either the LIFO
(last-in, first-out) or FIFO (first-in, first-out) method is used. Using LIFO, the cost of the last item
produced is applied to the price of the first item sold from inventory. The FIFO method applies the cost of
the first item produced to the money received from the first item sold.
In a period of rising prices, FIFO results in a greater earnings before interest expense and taxes (EBIT)
because a lower cost basis is used for the units that are being sold. Therefore, the company would report
greater profits and pay a greater amount of taxes. If LIFO is used during an inflationary period, it results in
lower profits and taxes.
Fixed Assets Fixed assets are items that are used by the company in its day-to-day operations to
create its products. This section will list the company’s physical property, such as land, buildings,
equipment, and furniture.
Depreciation With the exception of land, fixed assets lose some of their value each year due to normal
use. The IRS allows a company to claim this wear and tear on assets as a depreciation deduction against
income. On the balance sheet, fixed assets are shown at a value which represents their original cost less
accumulated depreciation.
Intangible Assets Although intangible assets don’t have physical value, they add substantial value to a
company. Some intangible assets differentiate the company from its competitors and are proprietary such
as patents, intellectual property, trademarks, franchises, and copyrights. Goodwill is another intangible
asset that’s created when a company buys or mergers with another company. It represents the amount that
was paid above the fair market value to acquire a company.
The Liabilities Section

The liabilities section identifies the company’s debts. Some of the debts must be paid in a short period
(current liabilities), while others are not required to be repaid for many years (long-term liabilities).
Current Liabilities Current liabilities are debts that become due in less than one year and are easily
identified by the word payable. Included in this section are accounts payable (the amount a company owes
for goods and services that are purchased on credit), dividends payable, interest payable, notes payable,
and taxes payable.

Long-term Liabilities Long-term liabilities are debts incurred by a corporation that become payable in
one year or more, such as bonds and long-term bank loans.
The Stockholders’ Equity Section

The stockholders’ equity section represents the company’s net worth and also indicates the shareholders’
ownership interest. The items listed in this section include the different classes of stock, retained earnings,
and capital surplus.
Preferred stock is listed in the balance sheet at the par value of the company’s outstanding shares. The
usual par value for preferred stock is $100. Common stock is listed in the balance sheet based at a par
value that’s arbitrarily set and is used only for bookkeeping purposes. The par value set for common stock
doesn’t influence the market price of the stock.
Capital surplus, or paid-in capital, is the amount of premium above the par value that’s paid by shareholders
for the shares that are sold to the public by the corporation. For example, if a company’s IPO is priced at $15
per share and the par value is $10 per share, then $5 is added to the capital surplus in the stockholders’ equity
section of its balance sheet. Capital surplus doesn’t include the funds that the company derives from business
profits. Earnings that are generated, but not distributed, are referred to as retained earnings or earned surplus.
The retained earnings entry represents net profits that have been retained for future use by the corporation.
Typically, dividends that are paid by a corporation come from its retained earnings.
The Income Statement

The other significant financial document used in fundamental analysis is the income statement—also called the
profit and loss statement. The income statement shows a company’s financial performance during a
specified period and provides detailed information about the company’s revenues and expenses. If
revenues exceed expenses, the difference represents the company’s net income. However, if expenses
exceed revenues, the result for the company is a net loss.
The exhibit on the next page represents an example of an income statement:

National Corporation Income Statement

For period ending December 31, 20XX
Sales $660,000
Less:
Operating Expenses:
Cost of Goods Sold 240,000
Selling and Administrative Expenses 120,000
300,000
Less:
Depreciation Expense 80,000
Operating Income 220,000
Plus:
Other Income 30,000
Earnings Before Interest and Taxes 250,000
Less:
Bond Interest Expense 27,000
Earnings Before Tax 223,000
Less:
Taxes (34% Rate) 75,820
Net Income or (Loss) $147,180
Notice that while interest expenses are deducted before taxes are paid, dividends are paid from net
(after-tax) income.
Components of the Income Statement

Sales (revenues) represent the total money received and the amounts billed (although not yet collected)
from the company’s primary source of business. Sales are reduced by day-to-day operating expenses to
arrive at operating income. Operating expenses reflect the daily costs of doing business and include the
amount claimed for the depreciation of fixed assets.
There are two ways of accounting for depreciation expenses; straight-line and accelerated. Straight-line
depreciation produces a constant depreciation expense and a constant decline in the carrying value of an
asset. On the other hand, accelerated depreciation allows for a faster rate of decline in the value of an asset
in the early years of ownership, leading to a greater depreciation charge.

Operating income is adjusted for other forms of income (or expenses) that are not generated by normal
operations, leaving earnings before interest expense and taxes (EBIT). Other income usually represents
income generated by investments (dividends and interest). However, other income may also reflect
extraordinary items, such as earnings from the sale of assets or losses incurred by discontinuing a part of
the business. EBIT is first reduced by bond interest and then taxes to arrive at net income or net loss.
Measuring Profitability The operating profit margin is used as a measurement of a corporation’s

profitability. The calculation for operating profit margin is net operating income divided by sales. Another
formula which may be determined using the income statement is the bond coverage ratio, which is
calculated by dividing EBIT by interest expense.
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) Margin EBITDA may
be used to analyze the profitability between companies and industries by eliminating the effects of bonds and
accounting decisions (e.g. depreciation) which allows for comparisons between companies. EBITDA
represents the earnings of a company before the deduction of interest expenses, taxes, depreciation, and
amortization. Although often referred to as operational cash flow, EBITDA doesn’t represent cash earnings.
EBITDA is an effective metric to evaluate profitability, but not cash flow, since it ignores the capital
expenditures (e.g. research and development) that are necessary to maintain and grow a business. EBITDA
margin is the EBITDA (i.e., operating profits) divided by the company’s sales. EBITDA margin provides a
stable indication of operating income to each dollar of sales.
Analyzing Financial Statements

A fundamental analyst uses the information from a company’s financial statements to determine the
financial strengths and weaknesses of a corporation. This analysis will also seek to compare the
company’s performance to other companies within the same industry.
To conduct fundamental analysis, analysts will use various calculations and ratios. These formulas will
reveal information regarding the company’s liquidity, capitalization, ability to meet fixed costs, and
profitability. To illustrate the use of financial analysis, the balance sheet and income statement of National
Corporation that were shown previously will be used to calculate the financial formulas that follow.
Liquidity Ratios
Liquidity ratios are used to determine a company’s ability to meet its short-term debts as well as its ability
to convert its current assets into cash. Liquidity is normally analyzed by calculating the company’s:
 Net Working Capital
 Current Ratio
 Quick Asset Ratio
 Cash Flow

Net Working Capital Working capital represents the difference between a company’s current assets and
its current liabilities. Positive working capital indicates that a company’s current assets are sufficient to
cover its current liabilities and is calculated using the following formula:
Net Working Capital = Total Current Assets (CA) – Total Current Liabilities (CL)
Since National Corporation’s total current assets are $705,000 and its total current
liabilities are $327,000, the working capital is $378,000 ($705,000 – $327.000).
Current Ratio The current ratio is indicative of a company’s ability to pay its current liabilities by
using its current assets. A low current ratio may indicate a working capital problem. The following
formula may be used to calculate the current ratio:
Total Current Assets

Current Ratio =
Total Current Liabilities
Since National Corporation has total current assets of $705,000 and total
current liabilities of $327,000, its current ratio is:
$705,000
= 2.16 to 1
$327,000
Essentially, this means that there are $2.16 of current assets for each $1.00 of current liabilities.
Many analysts believe that a current ratio of 2-to-1 indicates safety. However, since inventory is the least
liquid current asset, analysts take its size into account when interpreting the current ratio. In some cases, what
appears to be a safe current ratio may be distorted by a high, illiquid inventory. Normally, companies with
small inventories and easily collectible accounts receivables are able to operate with a low current ratio.
Quick Asset (Acid Test) Ratio The quick asset ratio or acid test ratio is more stringent than current
ratio when measuring a company’s liquidity. In this calculation, the company’s inventory is subtracted
from its current assets to arrive at its quick assets.

The quick assets ratio is calculated as follows:
Total Current Assets – Inventory

Quick Asset Ratio =
National Corporation has total current assets of $705,000 and total current liabilities
of $327,000. If the corporation’s total current assets include inventory of $330,000,
its quick asset ratio is:
$705,000 – $330,000
= 1.15 to 1
$327,000
A quick asset ratio of more than 1-to-1 is generally considered safe because it indicates that the
company will be able to pay its bills for a short period without having to borrow money which
ultimately increases its liabilities.
Cash Flow Cash flow reflects the amount of money that’s generated by a company’s operations.
Fundamental analysts tend to look at this figure to assess a company’s ability to meet its current expenses
as well as to pay dividends. To find cash flow, the annual depreciation expense is added back to net
income (or net loss). Based on figures taken from the income statement, a company’s cash flow is
calculated using the following formula:
Cash Flow = Net Income (or Loss) + Annual Depreciation
National Corporation’s cash flow is $227,180 ($147,180 net income + $80,000 depreciation expense).
A positive cash flow indicates that a company has sufficient income to pay its expenses and possibly make
dividend distributions. On the other hand, a negative cash flow suggests that the company is losing money
and may have trouble meeting its short-term obligations. Many market professionals use earnings before
interest, tax, depreciation, and amortization (EBITDA) as an estimate of operating cash flow.
Inventory Turnover The inventory turnover ratio indicates how often a company sells the goods that it
produces and also implies a time frame for processing its goods. A longer time for processing materials
indicates a greater amount of capital being tied up in the processing stage, while a shorter time frame
indicates that the company is selling its inventory faster. In some cases, inventory turnover is calculated by
using sales as the numerator; however, a preferred method may be to use the cost of goods sold since it
excludes implied profits from sales.

The formula for calculating inventory turnover is:
Cost of Goods Sold

Inventory Turnover =
Average Inventory
Capitalization Ratios
Analysts often use capitalization ratios to assess a company’s risk of bankruptcy. All of the capitalization
ratios analyze the components of a company’s long-term capital which is found on the balance sheet.
Long-Term Capital A company’s long-term capital consists of its long-term liabilities plus the entire
stockholders’ equity section (i.e. debt + equity).
National Corporation’s long-term capital is $1,162,000 ($300,000 + $862,000).
Bond Ratio The bond ratio is indicative of the percentage of long-term capital that’s attributable to
bonds and is calculated using the following formula:
Par Value of Bonds

Bond Ratio =
Total Long-Term Capital
$300,000
The bond ratio for National Corporation is: = 26%
$1,162,000
Common Stock Ratio The common stock ratio shows the percentage of long-term capital that’s
attributable to the common stock and is calculated using the following formula:
Common Stock at Par + Capital Surplus + Retained Earnings

Common Stock Ratio =
$600,000 + $52,000 + $160,000 $812,000

The common stock ratio is: = = 70%
$1,162,000 $1,162,000
Therefore, the capital structure of National Corporation consists of 26% bonds, 4% preferred stock, and
70% common stock.

Debt-to-Equity Ratio The debt-to-equity ratio is a measure of a company’s financial leverage to

available common equity. The ratio is used to evaluate the credit strength of a corporation and is
Debt
Debt-to-Equity Ratio = Shareholder Equity (Par Value of Common Stock + Capital
Surplus + Retained Earnings)
National Corporation’s debt-to-equity ratio is:
$300,000 $300,000
= = 37%
$600,000 + $52,000 + $160,000 $812,000
Book Value Per Common Share

An analyst will examine the balance sheet to determine the amount of assets backing the securities that are
issued by a company. This figure is referred to as either the book value per common share or net tangible
asset value and is calculated as follows:
Total Assets – (Intangibles + Total Liabilities + Preferred Stock)

Book Value Per Common Share =
Number of Outstanding Common Shares
For National Corporation, the book value per common share is:
$1,489,000 – ($30,000 + $627,000 + $50,000)

= $3.91
200,000 Outstanding Common Shares
While book value is an estimate of the liquidating value of a company, it should not be treated as an exact
measurement. The actual liquidating value of a company is dependent on the market value a company
receives for selling its assets based on supply and demand.
Return on Common Equity Return on common equity is one of the most important measurements of a
company’s profitability on a year-to-year basis and focuses on comparing the amount of income available
to the common shareholders each year to the value of the company’s common stock.

The formula for calculating return on common equity is:
Net Income – Preferred Dividends

Return on Common Equity =
For National Corporation, the return on common equity is:
$147,180 – $3,000 $144,180

= = 18%
$812,000 $812,000
Earnings Per Share (Primary EPS) A significant factor that contributes to the market price of a stock is
the company’s earnings per share (EPS). A company’s EPS is indicative of the amount of earnings that are
available to the common stockholder and is calculated using the following formula:

Earnings Per Share =
Number of Common Shares Outstanding
For National Corporation, its EPS is: $147,180 - $3,000

= $.72
200,000
In some cases, a corporation may issue various types of convertible securities such as convertible
bonds, convertible preferred stock, warrants, and stock rights. As these securities are converted into
common shares, the company’s outstanding shares increase which causes a dilution (decrease) in the
earnings per share. The calculation of fully diluted EPS assumes that all convertible securities have
been converted into common stock.
Price/Earnings (P/E) Ratio A measurement of the relationship between market price and EPS is the
price/earnings (P/E) ratio. The P/E ratio, which is also referred to as a company’s earnings multiple, is
Market Price
Price/Earnings Ratio =
Earnings Per Share

If it’s assumed that the market price of National Corporation’s common stock is
$20 per share, the P/E ratio is:
$20.00
= 27.77-to-1
$.72
A high P/E indicates that investors are paying a high market price for today’s earnings in expectation of
receiving higher future earnings. Stocks with high P/E ratios (typically growth companies) tend to pay little
or no cash dividends.
Dividend Payout Ratio The dividend payout ratio measures the percentage of net income being paid to
common stockholders in the form of cash dividends. The dividend payout ratio may be calculated using
the following formula:
Annual Dividend Paid on Common Stock

Dividend Payout Ratio =
Earnings Per Share
Assuming that National Corporation pays a $.04 annual dividend, the dividend payout ratio is:
$.04
= 5.6%
$.72
Note that companies are not required to have current earnings in order to pay dividends. Earnings from past
periods that were not distributed (retained earnings) may be used to meet current payments.
Current Yield The current yield for a common or preferred stock expresses the rate of return that
the dividend represents based on the stock’s current market price. The following formula is used to
calculate current yield:
Annual Dividend Per Share

Current Yield =
If the market price of National Corporation is $20 and the annual dividend is $.04,
the current yield is:
$.04
= .2%
$20.00
Keep in mind, if a quarterly dividend is given, it must be multiplied by four to determine the annual
dividend.

Financial Transactions and the Balance Sheet

Financial events that occur during a corporation’s existence will affect its balance sheet differently. However,
after all entries are made by accountants, the following basic balance sheet formula remains constant:
Total Assets = Total Liabilities + Stockholders’ Equity
The following are examples of different financial events and how they affect the balance sheet:
1. Declaring a Cash Dividend The retained earnings (part of stockholders’ equity) is reduced and
dividends payable (part of current liabilities) is increased. The result is a reduction in net working
capital since current liabilities increase, but current assets remain unchanged.
2. Paying a Cash Dividend Cash (a current asset) and dividends payable (a current liability) are both
reduced by equal amounts. This has no effect on net working capital since current assets and current
liabilities are both reduced by the same amount.
3. Buying Equipment or Machinery for Cash Cash (a current asset) is reduced and equipment (a
fixed asset) is increased by an equal amount. The result is a reduction in net working capital since
current assets are reduced, but current liabilities remain the same.
4. Issuing a Stock Dividend or Executing a Stock Split Only the stockholders’ equity portion of the
balance sheet is affected. The number of common shares outstanding and the par value per share are
changed based on the stock dividend or stock split, but the total market capitalization remains the same.
5. Issuing Debt Cash (a current asset) is increased, while the bonds outstanding (a long-term
liability) also increases. There’s a resulting increase to net working capital. When a corporation
issues debt securities, it increases its leverage (use of borrowed monies). Generally, the purpose for
the issuance is to purchase new equipment or expand its business. The expansion of business will
hopefully increase the sales and profits of the company.
6. Calling Bonds Cash (a current asset) is reduced, while the bonds outstanding (a long-term liability)
is also reduced. There’s a resulting decrease to net working capital. When part of an issue of long-term
bonds is called, the effect on the remaining outstanding bonds will be an improvement in their
quality. The quality improves due to the fact that the issuer will have less debt outstanding and will
be paying less in interest charges.
7. Issuing Stock Cash (a current asset) is increased, while stock outstanding (part of shareholders’
equity) is also increased. The result is an increase in the net working capital. The long-term debt
ratio will fall as the equity capital rises.
8. Repurchasing Stock Cash (a current asset) is reduced, while the common stock outstanding
(stockholders’ equity) is also reduced. There’s a resulting decrease to net working capital.
Corporations repurchase their own stock in the open market to increase earnings per share and to have
stock available for stock option plans for key employees. The stock being repurchased becomes
treasury stock and doesn’t have voting rights.

Sources of Financial Information—Annual Reports (Form 10-K)

A company’s annual report to its stockholders contains all of the important financial data that’s needed by
a fundamental analyst. Both the balance sheet and income statement are presented and analyzed by the
company’s management. Also included are the important footnotes to the financial statements.
The footnotes are an addendum to the financial statements that indicate the methods of depreciation and
inventory valuation used, the market price of securities, fully diluted earnings per share, and any other data
that’s needed to make the information being presented understandable and complete.

Summary of Formulas
Net Working Capital = Total Current Assets – Total Current Liabilities
Total Current Assets

Current Ratio =
Total Current Assets – Inventory

Quick Asset Ratio =
Cash Flow = Net Income (or Loss) + Annual Depreciation
Inventory Cost of Goods Sold

Turnover = Average Inventory
Par Value of Bonds

Bond Ratio =
Debt
Debt-to-Equity Ratio =
Total Assets – (Intangibles + Total Liabilities + Preferred Stock)

Book Value Per Common Share =
Number of Outstanding Common Shares

Earnings Per Share =
Number of Common Shares Outstanding
Market Price
Price/Earnings Ratio =
Earnings Per Share
Annual Dividend Paid Per Common Share

Dividend Payout Ratio =
Earnings Per Share
Annual Dividend Paid per Common Share

Current Yield =

CHAPTER 17
Orders and Trade

Execution
Key Topics:
 Overview
 Trade Capacity
 Market Making
 Order Entry
 Regulation
CHAPTER 17 – ORDERS AND TRADE EXECUTIONS
This chapter will examine the secondary market trading of securities that begins after their issuance
in the primary market. Let’s begin by detailing the mechanics of order placement and then move on to a
comparison of the various trading venues. The final part of the chapter will focus on some of the
prohibited trading practices in the secondary market.
Trading Overview
Trading markets are generally broken down into two categories—traditional physical trading venues,
such as the NYSE, or over-the-counter (OTC) marketplaces where trades occur in dispersed dealer-to-
dealer networks that connect participants through phones and/or computers. Today, although they lack
a physical trading floor, many electronic trading venues are classified by the regulators as exchanges
(e.g., Nasdaq). Any equity securities that meet the standards for trading on a national exchange are
referred to as listed securities.
Equities that are not listed on either a physical or electronic exchange are referred to as OTC equities or
non-exchange-traded securities. These issues trade in non-exchange OTC venues, such as the OTC
Bulletin Board (OTCBB) or on a platform created by the OTC Markets Group. Many other securities, such
as U.S. government bonds, some corporate bonds, and certain derivative products, are also traded in the
OTC market through various dealer-to-dealer networks.
Secondary Market Trading—From Order Entry to Settlement

In the secondary market, trades begin with the placement of an order ticket in either a physical or
electronic format. After the order ticket is completed, the Sales Department forwards the order to the
Trading Department. If the order is ultimately executed, the trade is cleared by the broker-dealer’s
Operations Department.
1. Order Entry—The placing of a trade into the system either electronically or using a paper ticket
2. Execution—The occurrence of the trade in the marketplace, such as the NYSE or Nasdaq
3. Clearing—The agreement by executing firms as to the details of a trade
Order Entry An order ticket, also called an order memorandum, is a record of a customer’s instructions
regarding the execution of a buy or sell order. Traditionally, registered representatives filled out paper
order tickets, but today the process is almost exclusively electronic. Essentially, many firms permit clients
to fill out their own tickets through online trading accounts.
Capacity of the Firm

Although Chapter 14 introduced the different capacities in which a broker-dealer can act, this section will
provide greater detail of what it means to acts as either a broker or a dealer in a transaction.

Brokers (Agents) Regardless of whether a client wants to buy or sell a security, a firm that acts as a
broker (agent) is attempting to find the other side of the trade on behalf of its client. If a client wants to buy, a
broker will try to find a seller. On the other hand, if a client wants to sell, a broker will attempt to find a
buyer. The firm is not willing to take the other side of the trade (it assumes no risk) since it doesn’t maintain
an inventory of the security. This action is referred to as brokering a trade.
Commissions When a firm acts in a broker (agent) capacity, it earns a commission for its efforts.
However, if a trade is not executed, no commission is earned.
Agency Cross Occasionally, a broker-dealer may have one client who wants to sell a particular stock
and another client who is seeking to purchase the same security. In this case, the firm may simply choose
to cross the shares internally between the two accounts. This agency cross is often executed between the
bid and offer with both customers paying the firm a commission.
Dealers (Principals) When a firm buys securities for or sells securities from its own inventory, it’s
acting as a dealer (principal). A dealer that always stands ready to buy or sell a specific stock is called a
market maker in that stock and assumes risk by taking the other side of the trade. As both a buyer and a
seller, a market maker provides a two-sided quote—its bid is the price at which it’s willing to buy stock
and its ask (offer) price is the price at which it will sell the stock. For example, if a dealer (market maker)
is quoting a stock at $20.00 - $20.25, it’s willing buy stock at $20 per share and sell it for $20.25 per
share to other dealers. The $.25 difference between the bid of $20.00 and the ask of $20.25 is the
spread—a source of profit for the market maker.
Markups/Markdowns When acting in a dealer capacity, a firm will adjust its prices for retail
customers. Using the above quote of $20.00 - $20.25, if a client wants to sell stock to the dealer, the firm
may pay her $19.95 net per share—a $.05 markdown from the prevailing market price. On the other
hand, if the client wants to buy stock, the dealer may offer to sell her the shares at $20.31—a $.06
markup. The dealer profits by purchasing securities from customers at one price and selling those
securities to other customers at a higher price.

Riskless Principal When a firm buys a security and brings it into its inventory to fill preexisting
customer orders, its capacity is considered to be a riskless principal. For instance, in quick succession, if a
dealer receives 10 customer market orders to purchase 100 shares of stock that the dealer doesn’t maintain
in its inventory, the firm may choose to buy 1,000 shares as principal from another dealer and then resell
the securities to its customers at the same price with a markup included. In this case, the firm must disclose
its capacity as a riskless principal, since the purchase by the firm and sale to the customers doesn’t expose
the dealer to price risk. The firm’s profit (markup) must be disclosed.
Net Basis In the previous example, if the dealer had sold the securities to the customers at a different
price than it paid, the executions are described as occurring on a net basis. In a net-basis trade, rather than
charging a markup, the dealer profits by charging a different price for the securities. Any dealers that
execute net-basis trades with customers are subject to both disclosure and consent requirements. In a net
basis trade, a firm’s profit is not disclosed on the customer’s confirmation; however, in a riskless principal
trade, the markup must be disclosed.
NYSE and Other Traditional Exchanges

Things have changed significantly since the New York Stock Exchange was founded in 1792. The NYSE
was created to facilitate the orderly trading of selected securities. Traditionally, this trading was done at a
single location by members of the exchange that held a seat.
Over time, many other regional exchanges were created to compete with the NYSE. These exchanges
offered a centralized trading venue that functioned as an open outcry auction market. Today, the NYSE
employs hybrid trading methods that include both personal face-to-face trading on a physical floor and
electronic linkages.
The Role of the Designated Market Maker (DMM)

The DMM’s role includes maintaining liquidity, promoting a fair and orderly market, and resolving trade
imbalances that result from a temporary lack of supply or demand in a particular security.

The designated market maker must buy for and sell from its own account (acting as a dealer) to make the
market fair and orderly. In doing so, the DMM must be a buyer when there are no buyers and be a seller
when there are no sellers. The result of these actions is a narrowing of the spread between transactions.
The DMM’s Book Limit orders that are entered away from the market may be directed to the designated
market maker who will then place them in its book for the stock. The DMM may attempt to execute these
orders for the customers who entered them (acting as agent) or may buy and sell stock for its own accounts
(acting as principal). The DMM is the only member that’s allowed to continuously buy and sell stock on a
principal basis (i.e., make a market). In return for this privilege, the DMM must stand ready to buy when
there’s an excess in selling interest.
Open limit orders may be accepted on the designated market maker’s book; however, market orders and
not-held orders may not be accepted on the book (market orders must be immediately executed). The
NYSE currently employs a hybrid system in which small orders are routed to the floor electronically,
while some large orders are still handled by floor personnel. The NYSE utilizes an automated routing
system referred to as the Super Display Book.
DMM Acting as Agent The following example describes the DMM’s role as an agent:
An investor gives a registered representative an order to buy 7,000 XYZ at 40.25. The
order is transmitted to the firm’s floor broker, who enters the trading crowd and
determines that the stock’s current quote is 40.50 - 40.75, 50 by 80. This means that the
highest bid is 40.50 and the lowest offer is 40.75 with the bid representing 5,000 shares
and the offer representing 8,000 shares. Although the floor broker is able to purchase
shares at a price of 40.75, this will not satisfy the conditions of the customer order.
Therefore, the floor broker may leave the order with the DMM. Later, if the inside offer
price drops to 40.25, the DMM will purchase the stock for the customer.
DMM Acting as Principal In the previous example, the DMM acted as agent for the customer by
matching the customer with a counterparty when market conditions allowed. DMMs also act as principals
by trading their own accounts. The trades that DMMs execute for their own accounts must always be done
with a focus on their responsibility to maintain a fair and orderly market.
The term fair and orderly market refers to a market in which there’s price continuity and reasonable depth.
To maintain this type of market, the DMM is required to maintain a reasonably small spread (price
difference) between bids and offers.
For example, an orderly market is more likely to have a bid of 40 and an offer of 40.05,
rather than a bid of 40 and an offer of 41. If the spread becomes too wide, DMMs are
expected to enter the market for their own accounts and raise the bid or lower the offer
to narrow the spread. Also, a fair and orderly market is indicated by a series of trades
with small price changes (ticks) such as 40, 40.05, 40.10, 40.15, rather than large
changes in price from trade to trade, such as 40, 42, 40.10, 41.75. The DMM is expected
to supply stock to the market if there’s a large imbalance between supply and demand
and may be required to sell short to accomplish this.

The additional trading by the DMM that occurs during trade imbalances may be the result of a temporary
lack of supply or demand (buyers and sellers) in a particular security. By trading during imbalances, the
DMM is maintaining liquidity in the market for that stock.
No Competition with Public Orders Since a DMM may not compete with public orders, it may only bid
for stock higher or offer stock lower than the prevailing market price to reduce the spread. For example, if a
quote is 40.00 bid and 40.10 offered, the DMM may bid 40.01 or higher and offer 40.09 or lower.
Stopping Stock A DMM is authorized to engage in a practice that’s referred to as stopping stock, This
activity involves guaranteeing a floor broker that a customer’s order will be executed at a specific price
unless a better price is able to be obtained in the trading crowd. For example, if the current market for a
stock is 24.75 – 25.00, a floor broker with a market order may buy the stock immediately at the offer price
of 25.00. However, if the DMM stops the stock, the broker may attempt to obtain a better execution in the
trading crowd with the comfort of knowing the stock can be purchased for no more than 25.00.
A DMM is able to stop stock if it’s for a public order, but not for its own account or an account for another
member firm. Members are required to report to their customers that the order was stopped if both
members agree to the terms. If an order is executed at a less favorable price than the agreed upon price, the
member that agreed to the stop is liable for the difference.
Dealer-to-Dealer Markets
In many of the markets that lack a centralized meeting place, transactions are conducted over the telephone or
through a computer network. These dealer-to-dealer markets have come to dominate modern securities trading.
One example of a liquid dealer-to-dealer market is the U.S. Treasury market.
Most debt securities trade in these dealer-to-dealer settings (often referred to as over-the-counter [OTC]
markets), including:
 Corporate bonds
 U.S. government and government agency securities
Nasdaq Trading
One of the most well-known dealer-to-dealer trading venues is the National Association of Securities Dealers
Automated Quotation system—or simply referred to as Nasdaq. Non-centralized markets are considered
negotiated markets since broker-dealers that intend to buy or sell a security must negotiate a price with a
market maker. Unlike the NYSE where there’s only one market maker per security (the DMM), there may be
many market makers for Nasdaq equity securities. These dealers stand ready to buy or sell a minimum number
of shares at their two-sided quoted price. The quote size requirement is dependent on the security’s price and
the system in which the market maker displays its quotes.

Broker-dealers are able to select the stocks for which to act as a market maker. Within each broker-dealer,
a position trader is responsible for maintaining the broker-dealer’s inventory as well as trading the firm’s
proprietary account.
Quotations and Backing Away The stated price at which market makers are willing to buy or sell
securities is considered their firm quote. For example, a market maker’s quote is:
Bid Ask Size
16.20 16.40 10 x 5
It’s a violation of industry rules to provide a firm quote and then fail to fill an order on the basis of the
quotation. Such action constitutes a firm-quote violation that’s referred to as backing away. Based on the
quote shown above, if a market maker receives an order from a customer who wants to sell up to 1,000
shares at 16.20 or from a customer who wants to buy up to 500 shares at 16.40, but doesn’t fill the order,
it’s backing away. However, this provision doesn’t preclude a dealer from changing its quotation during
the course of the trading session as market conditions dictate.
If a firm provides a subject quote, it’s indicating that the quote is subject to confirmation and is therefore not
firm. For example, if a dealer acts as a correspondent for another dealer that’s a market maker and is asked
for a quotation, the dealer may respond 30.00 to 30.50 – subject. In this case, the dealer is indicating that
the actual price must be confirmed with the market maker before the order is able to be transacted.
On the other hand, a firm may provide a workout quote when it receives an inquiry regarding the availability of
a block of stock. At the same time, the dealer may have a client who previously indicated an interest in
buying or selling the same stock at a specified price. The dealer may respond 40.00 to 40.75 – workout.
This is done to indicate that, before a firm quote can be given, the client must be contacted to determine if
he’s still interested in buying or selling the stock.
In both cases, the dealer is giving the quote for informational purposes only and is not committed to
buying or selling on the basis of the quote. It’s essential that such quotations be clearly indicated as not
being firm. Remember, unless a specific qualification is given, all quotes are considered firm.
At times, a dealer may wish to sell securities, but will ask the buyer to suggest a purchase price. This
is referred to as a bid wanted (BW). When a dealer asks a seller to make an offer, it’s referred to as an
offer wanted (OW).
Market Maker Requirements

To be a market maker in the Nasdaq system, a dealer must provide regular bids and offers for a security,
meet specific capital requirements, and be registered with FINRA. A registered market maker that enters a bid
and offer in the Nasdaq system must be prepared to buy or sell a minimum unit of trading (100 shares) at its
quoted bid and offer. Transactions in Nasdaq securities must be reported within 10 seconds of execution.

Nasdaq Levels Member firms that are subscribers to the Nasdaq system have terminals that allow them
to electronically obtain current bids and offers for Nasdaq securities. The following information relates to
the three levels in the Nasdaq system:
 Level I access provides subscribers with the highest bid and the lowest offer (i.e., the inside market)
for a security that has at least two market makers. However, actual market makers are not listed.
Level I is typically used by the branch offices of member firms.
 Level II access provides bids, offers, and quotation sizes for all of the market makers that enter quotes
for each security.
 Level III access is exclusive to a market maker in the Nasdaq system and allows it to enter and update
bids and offers for the securities for which the firm is authorized to enter quotes. Once entered in
Level III, these quotations appear on the system immediately.
The Inside Market From the standpoint of a customer who is selling stock, the highest bid is the best (i.e.,
the price at which a market maker will buy); however, for a customer who is buying stock, the lowest offer is
the most desirable (i.e., the price at which a market maker will sell). These two prices are referred to as the
inside market or the National Best Bid and Offer (NBBO). Nasdaq securities are quoted by multiple
market makers. For example, MNOP stock has three market makers that have entered the following quotes:
Market Maker #1 20.25 - 20.85

Market Maker #2 20.10 - 20.75
Market Maker #3 20.50 - 21.00
The best (highest) bid of the three is the 20.50 bid entered by Market Maker #3, while the best (lowest) offer
is the 20.75 offer entered by Market Maker #2. Therefore, the inside market is 20.50 - 20.75. Notice that the
inside market is not necessarily the actual quote of any single dealer, but rather, a composite quote of the best
prices currently available.
Normal Business Hours A Nasdaq market maker must be open for business between the hours of 9:30
a.m. to 4:00 p.m. ET. (All times used in this Study Manual are Eastern Time [ET] unless otherwise indicated.)
A market maker may voluntarily open its quotes to participate in the premarket trading session, which takes
place from 4:00 a.m. to 9:30 a.m. Also, a market maker may reopen its quotes voluntarily after the 4:00 p.m.
close to participate in the aftermarket trading session, which takes place from 4:00 p.m. to 8:00 p.m.
Market makers may or may not wish to participate in the premarket or aftermarket trading sessions.
However, any market makers that participate in the aftermarket session must keep their quotes open until
at least 6:30 p.m. and may continue to quote until 8:00 p.m.

The Nasdaq Market Center Execution System

As trading in Nasdaq securities has increased in volume and speed, electronic systems have been
updated. As a result, the Nasdaq Market Center Execution System provides non-discriminatory access to
quotations as well as order execution that’s immediate and automatic. The system’s maximum quotation
and order execution size is 999,999 shares. Any trades that are automatically reported to the system are
referred to as locked-in.
OTC Equities—Non-Nasdaq Securities

An OTC equity security is generally defined as any equity that’s not listed or traded on a national securities
exchange (e.g., NYSE or Nasdaq). OTC equities include domestic and foreign equity issues, warrants, units,
American Depositary Receipts (ADRs) and direct participation programs (DPPs). Prices of OTC equities
may be obtained from two sources—the OTC Bulletin Board (OTCBB) and the OTC Markets Group.
OTC Bulletin Board (OTCBB) The OTC Bulletin Board is an electronic quotation service for OTC
equity securities that doesn’t have the same listing requirements as Nasdaq or other exchanges. However,
securities may not be quoted on the OTCBB unless the issuer files periodic financial information with the
SEC or another applicable regulator (e.g., a banking or insurance regulator). These issuer filings must
remain current at all times.
On the OTCBB, members may enter a variety of quotations including:

 Two-sided quotes (bid and offer)
 Bid price only
 Offer price only
 Unpriced indications of interest (e.g., bid wanted or offer wanted)
 A bid or offer accompanied by a modifier that reflects unsolicited customer interest
OTC Markets Group As a traditional forum for trading OTC equities, the Pink Sheets were created in
1904 by the National Quotations Bureau (NQB). Originally named for the color of the paper on which the
quotes appeared, the Pink Sheets provided market information about stocks that were traded over-the-
counter. The NQB eventually changed its name to the OTC Markets Group.
In an effort to create clarity in the investment process, the OTC Markets Group organizes its securities into
three tiered marketplaces—OTCQX, OTCQB and OTC Pink. The differences in the tiers are based on the
quality and quantity of the information that the companies make available.
 The OTCQX Best Marketplace is for established investor-focused U.S. and global companies that are
distinguished by the integrity of their operations and diligence with which they convey their
qualifications. To qualify, the companies must meet high financial standards, demonstrate compliance
with U.S. securities laws, and be current in their disclosures.

 The OTCQB Venture Marketplace is for entrepreneurial and development stage U.S. and international
companies that are unable to qualify for OTCQX. To be eligible, the companies must be current in
their reporting and undergo an annual verification and management certification process.
 The OTC Pink Marketplace offers trading in a wide spectrum of equity securities through any broker-
dealer. This marketplace is for all types of companies and their equities are included in this tier by
reasons of default, distress, or design.
The OTC Markets Group lists the name and phone number of the market makers for each stock. Although
many quotes are considered firm, the system may provide indications of bid and ask prices that are subject
to verification. Also, any bids wanted and offers wanted that have been entered by broker-dealers are not
considered firm. OTC Markets Group issues may often be characterized by their infrequent trading and/or
the limited number of outstanding shares.
Other Execution Methods and Venues

Traditionally, most equity orders were either executed by a firm’s floor broker on the NYSE floor or by a
firm’s market making department on Nasdaq. However, in recent years, market participants have created
alternatives to these trade placement methods. Many firms have abandoned their market making
operations and directed orders through third parties. Others have found alternative venues to which they
may direct order flow away from the NYSE and Nasdaq.
The Third Market The third market refers to exchange-listed securities being traded over-the-counter
between broker-dealers and large institutional investors. While most of the trading in listed stocks still occurs
on their primary exchanges, third-market volume has grown in the last several years. The third market brings
together investors that are willing and able to purchase and sell their own securities holdings for cash and
immediate delivery. The prices of securities are often lower due to the absence of commissions.
The Fourth Market The fourth market refers to direct institution-to-institution trading and doesn’t
involve the services of a broker-dealer. While some of this trading includes different portfolio managers
contacting one another by phone, most true fourth-market trades are internal crosses set up by money
managers that handle several institutional accounts. The proprietary trading systems (PTSs) that are set up
to facilitate the institution-to-institution trading are sometimes considered to be part of the fourth market.
However, the SEC doesn’t consider them part of this market since PTSs are either registered as broker-dealers
or operated by broker-dealers.
Electronic Communication Networks (ECNs) ECNs are market centers that allow for the quoting and
trading of exchange-listed securities (including Nasdaq). The objective of an ECN is to provide an
electronic system for bringing buyers and sellers together (matching). These systems allow subscribers to
disseminate information about orders, execute transactions both during the trading day and after-hours,
and buy and sell anonymously. ECNs charge subscribers a fee for using their system and act in only an
agency, not principal, capacity.

Dark Pools A dark pool is a system that provides liquidity for large institutional investors and high-
frequency traders, but it doesn’t disseminate quotes. The name is derived from the fact that the details of
the quotes are concealed from the public. The system may be operated by broker-dealers or exchanges,
and it allows these specific investors to buy and sell large blocks of stock anonymously. The objective is to
allow these investors to trade with the least amount of market impact and with low transaction costs. Some
dark pools provide order matching systems and may also allow participants to negotiate prices.
The Consolidated Quotation System (CQS)

Hopefully this chapter has shown that where a security is listed and where it potentially trades may be
quite different. The Consolidated Quotation System (CQS) is the electronic service that provides
quotations for listed securities that are traded in markets outside of the primary marketplace where the
securities are listed. For example, an NYSE- or AMEX-listed security that also trades in the OTC market
(previously noted as a third-market trade) is quoted on CQS. Please note, OTC Bulletin Board (OTCBB)
and OTC Markets Group equities (OTC equities) are not quoted on the CQS.
Alternative Trading Systems (ATS)

Alternative Trading Systems (ATSs) are SEC-approved, non-exchange trading systems. An ATS provides an
alternative method to trading on an exchange and enhances the liquidity of securities in the marketplace.
Examples of these systems include a broker-dealer’s internal execution system, Electronic Communication
Networks (ECNs) that choose not to register as an exchange, and trade crossing networks. An ATS is
generally required to register with the SEC and FINRA as a broker-dealer, but is not required to be
registered as an exchange. An ATS doesn’t set rules or discipline its subscribers but, due to its registration as a
broker-dealer, it’s subject to FINRA rules and disciplinary action.
Components of an Order Ticket

Although the order tickets used by different broker-dealers may vary slightly in appearance, they have many
common elements. Not all of the information on the ticket will be filled in by the registered representative
who deals directly with the customer. Some of the information will be added at the time of the order’s
transmission or execution. The entries on an order ticket include the following items:
 Whether the order was a purchase, a long sale, or a short sale
 Security name (or symbol) and quantity
 Terms and conditions of the order (e.g., market, limit, day order, etc.)
 Account type (e.g., cash or margin)
 Whether discretion was exercised
 Whether the order was solicited or unsolicited
 Special directions to override standing instructions
 Client identifier
 Trade date
 Registered representative responsible for the account
 Office from which the order originated

Discretionary Order/Discretion Not Exercised If the client has granted discretionary authority to the
registered representative, this should be indicated for each order. It’s important to check off discretion not
exercised if that was the case, since this indicates that the customer consented to that specific trade. (Note
that this is not the same as saying the trade was unsolicited.) If an order was the client’s idea, the ticket
should be marked unsolicited.
A firm’s order-entry system may automatically include additional information to the ticket. Much of this
additional information is based on the customer’s account documentation and may include items such as
the RR of record, negotiated commission rates, standing delivery instructions, trading restrictions,
suitability concerns, etc.
Processing a Transaction
Every transaction that’s executed by a broker-dealer must adhere to the following flow of processing:
1. Order Department (Wire Room)—This department transmits buy and sell orders by allocating them
to a specific exchange or product area.
2. Purchase and Sales Department—After an order is completed, the P&S department records the
transaction and compares the trade details with the broker-dealer on the other side of the trade (the
contrabroker) for the purpose of reconciling possible trade discrepancies.
3. Margin Department—This department enforces customer account rules with regard to payment and
delivery and maintains an account record for each customer and posts all trade activity.
4. Cashiering Department—This is where funds and securities are received and disbursed.
5. Reorganization Department—This department handles all post-settlement issues, such as cash and
stock dividend payments, stock splits, and tenders.
Trade Routing
Once the order has been reviewed and released by the Sales Department the firm must decide how it will
attempt to execute the trade. Depending on where a security trades or the preferences of a firm, orders may
be routed to various locations that include the following:
 An internal trading desk  The OTCBB
 The NYSE  The OTC Link
 Nasdaq  ECNs
 Regional exchanges  Dealer-to-dealer marketplaces
 The third market  An affiliated executing firm (e.g., order-entry firm)

Types of Transactions
As just mentioned, one of the important elements noted on the order ticket is the client’s desired action or
intent, which may include:
 A purchase
 A long sale
 A short sale
When making a purchase, the client must designate whether the trade will be fully paid for or be purchased
with borrowed funds (on margin). Under the SEC’s short selling rules (i.e. Regulation SHO), a broker-
dealer is required to mark all sell order tickets either long or short. This requirement applies to all sales of
equity securities that are traded on an exchange (e.g., NYSE or Nasdaq) or OTC.
What’s the difference between normal selling (a long sale) and short selling? A long sale occurs when
the client owns the securities being sold; however, with a short sale, the client must first borrow the
shares from the firm and then execute a sale. Since short sellers anticipate that the price of the shares
will fall in value, their investment outlook is often referred to as bearish. If the securities may be
purchased at a later time at a lower price, she will realize a profit. However, if the securities increase in
value, the investor may be forced to buy the securities at a price that’s well above the price at which they
were sold short and result in a loss. Since there’s no limit as to how high a security’s price may increase,
the short seller has unlimited risk.
A sell order is marked long if the seller:

 Owns the security being sold and it’s either in the possession or control of the broker-dealer, or
 Owns the security and it’s reasonably expected that the security will be delivered by no later than the
settlement date
 Has exercised a call option or warrant, or has converted a convertible preferred stock or bond
A sell order is marked short if the seller:

 Doesn’t own the security being sold (i.e., she’s effecting a sale by delivering borrowed shares)
 Owns the security being sold, but doesn’t reasonably expect that it will be in the possession or control
of the broker-dealer prior to the settlement date
Regulation SHO and the Locate Requirement

Prior to executing a short sale, a broker-dealer must locate the securities to ensure that they will be
available for delivery by the settlement date. The purpose of this requirement is to protect against
uncovered (i.e. naked) short selling abuses.

A broker-dealer may not accept an order to sell short an equity security for any person unless one of the
following locate conditions is met:
1. The broker-dealer has borrowed the security or entered into an arrangement to borrow the security.
2. The broker-dealer reasonably believes that it’s able to borrow the security for delivery on the date
that delivery is due.
In order to aid in the process of locating securities, the SEC accepts the use of Easy to Borrow lists. These
lists, which must be less than 24 hours old, provide reasonable grounds for the belief that the securities
included on the list will be available for borrowing. The use of Easy to Borrow lists helps to avoid fails to
deliver and to expedite the fulfillment of the locate provision. Broker-dealers also create Hard to Borrow
lists, which include shares that are not on the Easy to Borrow list. While most customers have access to the
Easy to Borrow list, the Hard to Borrow list is typically only available to broker-dealer employees.
Types of Orders
Market Orders
The most basic type of order is a market order. When placing this order, the client doesn’t specify a price.
Instead, the order will be executed at whatever price is available when it reaches the market. While market
orders will always be executed immediately, the client is not assured a specific execution price. Market
orders are often used for stocks that have actively traded (liquid) markets in which buy or sell orders are
unlikely to impact the price.
Limit Orders
When customers wish to buy or sell securities at a specific price, they enter limit orders. A limit order may be
executed only at the specified price or better. A buy limit order may only be executed at the limit price or
lower, while a sell limit order may only be executed at the limit price or higher.
BUY LIMIT ORDER

For example, let’s assume XYZ stock is 40
currently trading at $31. A customer wants to
buy the stock if it drops slightly and, therefore, 35
enters a limit order to buy 100 shares of XYZ at Price 30
$30. The order may not be executed unless the
25
stock is able to be purchased at $30 or below.
EXECUTION AT OR BELOW $30
20
A buy limit order is placed below the current market
price of a security.
Time

Now, let’s assume a client originally bought SELL LIMIT ORDER

stock at $22 and it’s now trading at $29. If the 40
client wants to sell the stock, but only if it rises
EXECUTION AT OR ABOVE $30
slightly, he may place a sell limit order at $30. 35
The order will not be filled unless the stock
Price 30
can be sold at $30 or above.
25
20
A sell limit order is placed above the current
market price of a security.
Time
Since limit orders are entered away from the market price, a person placing a limit order must be patient.
Depending on which way the market moves, he may or may not receive an execution. Assuming an order is
a day order and doesn’t receive execution by the end of the day, the client will receive a nothing done
notification from his firm. This notification indicates that the day order has expired and will need to be
reentered on the following day.
Limit orders are often used for large orders in thinly or infrequently traded securities in which the
customer feels that a market order will likely cause a temporary price fluctuation. Again, the risk with this
type of order is that the customer may receive no execution at all.
Priority of Orders Given the number of orders flooding into a trading location each minute, it’s important
to identify which orders receive priority. Market orders have first priority. Since the buyers or sellers who enter
market orders are not sensitive to price, they’re given the first priority on executions. Remember, with a market
order a customer is willing to transact business at the best prevailing price.
Next, limit orders are ranked based on their price constraints. Buy limits are given priority from high price
to low. For example, if three buy limit orders exist for ABC stock at $30.03, $30.11, and $30.07, the buyer
willing to pay the highest price ($30.11) moves to the front of the buy limit line.
Conversely, sell limits are given priority from low price to high. If three sell limit orders are entered for
XYZ stock at $70.11, $70.23, and $70.07, the seller willing to receive the lowest price ($70.07) moves to
the front of the sell limit line.
If two or more customers enter a limit order at the same price, the order that was entered first receives priority.
To summarize:
1. Market orders have first priority.
2. Limit orders are ranked by price.
3. Limit orders that are placed at the same price are ranked by time of entry.

Stop (Loss) Orders

Customers who enter either market or limit orders want to receive execution; however, stop orders are often
used by customers who are trying to prevent a large loss or protect a profit on an existing stock position. In
certain cases, these customers would rather not receive execution. A stop order becomes a market order to
buy or sell securities if the order’s specified price is reached or passed (i.e., the order is activated). The
specific price set by the investor is called the stop price. Once the order is activated, the investor is guaranteed
execution, but is not guaranteed a specific execution price.
Sell Stop Order A sell stop order is always placed below the current market price of the security and is
used to limit a loss or protect a profit on a long stock position.
For example, a customer purchases 100 shares of XYZ stock at $25 and determines that
she wants to limit any losses to approximately 5 points; therefore, she enters a sell stop
order at $20. If the stock trades at $20 (the stop price) or below, the sell stop order is
triggered and becomes a market order to sell 100 shares of XYZ. With this order, the
customer is attempting to limit the loss on her position.
Rather than XYZ stock declining in price, let’s assume that it appreciates to $35. The customer may decide
that she wants to protect this profit by entering a sell stop order at $33. If the stock subsequently falls and
trades at or through $33, the order will be activated to sell the stock and the customer will have protected a
portion of her profit.
Buy Stop Order A buy stop order is always placed above the current market price of the security and is
used to limit a loss or protect a profit on a short sale. Remember, short sellers anticipate that the security
will fall in value, but they will lose money if the position appreciates.
For example, a customer sells short 100 shares of ABC at $40 and is bearish. However,
he wants to protect his position against a rise in the price of ABC and places a buy stop
order at $45. If ABC stock trades at the stop price of $45 or above, the customer’s order
will be activated and he will buy 100 shares at the market to close out (buy back) the
short position. Once the order is activated, he’s not guaranteed an execution price of
$45, but is guaranteed that the position will be closed out (covered).
Order Qualifiers
Now that we have covered the different types of orders that an investor may enter, let’s examine the
various qualifications that may be used with these orders.
Day Order Unless otherwise specified, every order is a day order and will be subject to market exposure
from 9:30 a.m. to 4:00 p.m. Eastern Time (ET). If not executed, the order is automatically cancelled at the
end of the day.

Extended-Hours Exposure This qualification notifies the firm that the client wants his order exposed
to premarket and/or aftermarket trading sessions. Since trading outside of the normal trading hours of 9:30
a.m. to 4:00 p.m. ET may be very thin (infrequent and with low volume), special disclosures must be given
to customers who seek to trade in these less liquid periods prior to engaging in extended hours trading. The
risk disclosure document may be furnished in either a paper or electronic format and should highlight the
following risks:
 Lower liquidity
 Higher volatility
 Changing prices from the market close of the normal trading session
 Unlinked markets
 News announcements
 Wider spreads
Good-‘Til-Cancelled (GTC) or Open Order This is an order that remains in effect on the DMM’s
order book until it’s executed or cancelled. Any firm that accepts GTC orders should periodically update
them with the DMM. GTC orders must also be updated due to any partial fills. A customer may enter an
order that’s good for a week, a month, or any specified time. If the order is not executed by the end of the
specified time, the brokerage firm is responsible for cancelling it.
At-the-Open Order This is an order to buy or sell at the opening price. If the order is not executed at
the opening, it will be cancelled.
Market on Close (MOC) Order This is an order to buy or sell at or near the closing price.
Limit on Close (LOC) Order This is an order to buy or sell at the close, but only if the closing price is
equal to or better than the preset limit price.
Not-Held (NH) Order This qualification gives the firm discretion as to an order’s time and/or price of
execution. A not-held order is limited to the day on which the order is entered and, therefore, must be
filled at some point before the end of the day or reentered by the client for the next day.
Immediate-or-Cancel (IOC) Order This qualifier indicates that as much of the order as possible must
be executed immediately. Any portion of the order that’s not immediately executed is cancelled.
Fill or Kill (FOK) Order This qualifier indicates that an entire order must be executed immediately.
However, if the order cannot be immediately executed, it’s cancelled.
All-or-None (AON) Order This qualifier indicates that an entire order must be executed, but not
necessarily immediately. If the order cannot be executed in full, it’s typically cancelled at the end of the
trading day.

Regulation NMS (National Market System)

The SEC created Regulation NMS in an effort to modernize the U.S. market for trading equity securities.
The regulation attempts to facilitate linked trading among the competing venues in order to provide
customers with fair and liquid markets.
Quote Increment Rule This rule, also referred to as the Sub-Penny Rule, prohibits accepting and displaying
orders in pricing increments of less than one penny, unless the stock’s value is less than $1.00.
Limit Order Display Rule This rule requires customer orders to compete with those of market makers.
If the customer’s limit price improves the market maker’s quote it must display the customer’s order
within 30 seconds. If the customer’s limit price matches the market maker’s quote and the market maker is
at the inside market, the customer’s order size must be added to the market maker’s displayed size.
Order Protection Rule This rule prohibits the trading-through of a protected quote. A protected quote
represents the highest bid and lowest offer (i.e., the inside market) in a market center that allows electronic
quotations. Manual (non-electronic) quotes are not protected by this rule. A trade-through occurs with an
execution of a buy order at a price that’s above the lowest ask price, or the execution of a sell order at a
price that’s below the highest bid.
For example, the same security is quoted on both the NYSE and Nasdaq. If the NYSE has an ask
price of $34.20 and Nasdaq has an ask price of $34.15, it’s a violation to execute an electronic
buy order at $34.20 on the NYSE since there’s a better price available on Nasdaq.
Prohibited Trading Practices

Interpositioning Interpositioning is generally defined as the insertion of a third party between the
customer and the best market. The practice is specifically prohibited when it’s to the detriment of the
customer. However, the prohibition doesn’t apply if the member firm is able to demonstrate that the
customer received a better price because of the intervention of a third party.
For example, a broker-dealer receives an order from a customer to buy 100 shares of XYZ
at the market and the best offer of any market maker is 40. Rather than buying directly from
the market maker, the B/D interposes another firm that buys the stock at 40 and sells them
to the member firm at 41. The member firm then ultimately sells the stock to the customer at
42 and the two firms share the one-point extra markup charged to the customer. This action
is prohibited since the customer received no benefit.
Trading Ahead of Research FINRA’s rule prohibits a member from establishing, increasing,
decreasing, or liquidating an inventory position in a particular security, or derivative of that security, based
on material, non-public, advance knowledge of the content and timing of a research report in that security.

Without this prohibition, a firm may be tempted to build up a position in a stock right before the
publication of a favorable report or to sell short an issue just prior to an unfavorable release.
Quoting a Security in Multiple Markets Rules permit a market maker to quote the same security in
multiple mediums so long as the quotes are at the same price. However, the firm is not permitted to create
the appearance that one market has better execution by quoting different prices.
Rumors and Tips Some of the more common forms of market manipulation are the spreading of tips
and rumors and distributing information that misrepresents the facts. It’s also unlawful to omit material
facts, since the absence of these facts may make any other statements misleading. If an RR receives
unsubstantiated news (possibly through a rumor), he should take no action until the information becomes
public. At that time, the RR will be in a better position to be able to recommend whether clients should
purchase or sell the stock. If an RR receives material, non-public information on a company, his best
course of action is to contact a principal or compliance person who is associated with his firm.
Front-running This prohibited act involves firms or RRs executing either stock or option trades with the
prior knowledge that other investors are about to execute transactions involving large blocks of stock that
will positively influence their own positions. Another example involves an RR who has a large position in a
stock and recommends the same stock to many of her wealthy clients. Once the purchases are made and the
stock rises, the RR then liquidates the shares for her own personal profit. Keep in mind that it’s unethical for
an RR to put her needs ahead of her clients’ needs.
Marking-the-Close/Marking-the-Opening An example of a manipulative practice is marking-the-close.

In an SEC administrative proceeding against a broker-dealer, the practice was described as follows:
Marking-the-close refers to a series of transactions, at or near the close of trading, (i.e., at or
within minutes of 4:00 p.m.), which either uptick or downtick a security. . . Marking-the-close
represents a possible departure from the normal forces of supply and demand that result in
the fair auction price for a security, and is of concern to those who regulate the markets.
Similar activity at the start of the day is considered marking-the-opening.
Anti-Intimidation/Coordination Interpretation A market maker is not permitted to engage in anti-

competitive or collusive activity. Under FINRA’s and Nasdaq’s Anti-Intimidation/Coordination
Interpretation, it’s considered conduct inconsistent with just and equitable principles of trade for any
member firm, or associated person, to:
 Threaten, harass, coerce, intimidate, or otherwise improperly influence another member or
associated person
 Attempt to influence another member or associated person to adjust or maintain a price or quote
 Refuse to trade with or otherwise retaliate against another market maker that engages in
competitive activities
 Coordinate prices, trades, or trade reports with another member or associated person

However, FINRA and Nasdaq make it clear that the interpretation leaves a market maker free to:
 Unilaterally set its own bid and ask prices
 Unilaterally set its own dealer spread, quote increment, or quantity of shares for its quotations
 Communicate to any person the price or size at which it’s willing to trade any Nasdaq security, for the
purpose of exploring the possibility of negotiating a transaction
 Engage in any underwriting of securities to the extent permitted by federal securities laws
Fair Prices and Commissions—The 5% Markup Policy

FINRA members are prohibited from charging prices or commissions that are unfair or excessive. To
assist members in determining the appropriate level of charges, FINRA has developed the 5% Markup
Policy. Although stated in terms of a markup, the policy applies to markups, markdowns, and
commissions. The guideline (not rule) applies when a broker-dealer is acting in a principal or agency
capacity for transactions involving both exchange-listed and non-exchange listed securities.
Part of the determination regarding an acceptable markup involves the consideration of all relevant factors.
Over the years, FINRA has taken many enforcement actions against firms that it believes have charged
excessive markups. By reviewing those decisions, it has developed some guidelines for determining the
fairness of transaction compensation.
Factors That Influence the Level of Markups Since FINRA emphasizes that 5% is merely a
guideline, it’s possible that certain circumstances will justify higher markups; while conversely, there are
other times when even 5% is too much. The following factors are considered when determining whether a
markup is excessive:
 The type of security involved – Some securities carry higher markups than others as a matter of industry
practice. For example, the markups on common stocks or limited partnership units typically are higher than
the markups on bonds.
 The availability of the security in the market – If more effort is required to locate a particular security and
execute a transaction, then a higher markup is justified.
 The price of the security – The percentage of markup generally increases as the price of the security decreases.
This is due to the fact that lower-priced securities may require more handling and expense.
 The amount of money involved in a transaction – A transaction for a small total dollar amount may require
greater handling expenses on a proportionate basis than a larger transaction.
 Disclosure – Disclosing to the customer that the circumstances may warrant a higher-than-normal markup
helps to make the dealer’s case. However, the circumstances also must justify the charges.
 The pattern of markups – FINRA’s punishment tends to be most severe on firms that show a persistent
pattern of excessive markups. However, the markup in each transaction must be justified on its own merits.
 The nature of the broker-dealer’s business – Firms that offer certain additional services to customers (e.g.,
research) may justify charging higher markups than firms that don’t offer such services. However, if a
firm has high expenses for services that provide no benefit to customers, then these expenses don’t justify
higher charges.

Proceeds Transactions A proceeds transaction is carried out when a customer directs a member firm to
sell a security and use the proceeds of the sale to buy another security. For these types of transactions, the
member firm must follow the 5% policy and compute the markup as if the customer had purchased the
securities for cash and should add the compensation received on the customer’s sale to the compensation
the firm received on the customer’s purchase. In other words, the charge assessed on the liquidation is
added to the charge for the subsequent purchase. For example, a customer instructs her broker-dealer to
sell $5,000 of ABC stock and use the proceeds to purchase $5,000 of XYZ stock. When computing the
markup percentage, the member firm must use its total compensation (from both the customer’s sale and
purchase) as a percentage of $5,000.
Exemptions Securities that require the delivery of a prospectus or offering circular are exempt from the
provisions of the 5% policy because these issues are sold at a specific public offering price. Examples of
the securities that are exempt include initial public offerings and mutual fund shares.
The Market-Wide Circuit Breakers

Due to the U.S. equities markets experiencing potentially great market volatility, circuit breakers have been
created to halt or suspend trading under certain circumstances (e.g., due to natural disaster or terrorist attack).
Once the NYSE created the original circuit breakers, the other markets agreed to honor them. Originally,
the reference index for the circuit breakers was the DJIA; however, it’s now the S&P 500. The SEC-created
levels apply to all National Market System (NMS) securities, regardless of the exchange on which they’re
traded. For example, if a market-wide trading halt is in effect, all NMS stocks listed on the NYSE and those
listed on the other exchanges are required to halt trading. For any NMS stocks that trade in the OTC market,
it’s FINRA’s responsibility to halt their trading.
Trigger Value Time (all times ET) Action

Level 1: 7% decline 9:30 a.m. – 3:25 p.m. 15-minute trading halt
Level 2: 13% decline 9:30 a.m. – 3:25 p.m. 15-minute trading halt
Level 3: 20% decline Any time Trading halts for remainder of the day
At or after 3:25 p.m. ET, trading continues unless there’s a Level 3 halt. These levels are calculated on a
daily basis and are based on the close of the previous day. For example, if the S&P 500 closed at 1,700 on
Wednesday and the index declined by 119 points (a 7% decline) on Thursday at 11:00 a.m., trading in NMS
stocks will halt on all U.S exchanges for 15 minutes.
Conclusion
This chapter described the different methods by which a broker dealer may execute trades and the
importance of documenting the client’s instructions. The next chapter will focus on margin and the
requirements that broker dealers must follow when extending credit to their customers.

CHAPTER 18
Margin
Key Topics:
 Opening Margin Accounts
 Margin Account Valuation
 Other Margin Issues

CHAPTER 18 – MARGIN
This chapter will examine the use of margin, which involves clients borrowing money and /or
securities from their broker-dealer in an effort to increase their purchasing and/or shorting power.
Since margin incorporates the use of leverage (borrowed assets), a client’s potential gain or loss can
be substantially increased. Given the risks, margin is not suitable for conservative accounts and,
under industry rules, it’s actually prohibited for some account types. Series 7 candidates are expected
to be familiar with the regulatory issues that are associated with this activity and to be able to
perform only basic margin calculations.
Margin
A margin account allows investors to increase their purchasing power by means of borrowing cash or
securities from a broker-dealer. The Securities Exchange Act of 1934 granted the Federal Reserve Board
(FRB) with the power to regulate borrowing and it does so through Regulation T. Regulation T governs
the extension of credit by broker-dealers. Although the regulation is established by the FRB, it’s the SEC
that’s charged with the responsibility of enforcing the rules.
Regulation T
Regulation T (Reg. T) applies to corporate securities transactions that are executed in both cash and
margin accounts involving both listed and unlisted securities. Under Reg. T, the FRB determines the types
of securities that may be purchased on margin through a broker-dealer, when payment is due, as well as
the amount of credit that may be extended. For both long purchases and short sales of stock, the current
initial Reg. T margin requirement is 50%.
Marginable Securities
Marginable securities include:
 Securities that are listed on a registered stock exchange
 Securities that are listed on Nasdaq
Non-Marginable Securities
The purpose for restricting the marginability of certain securities is to minimize the potential risk to investors.
The fact that these securities are not marginable doesn’t mean that they cannot be purchased in a margin
account; it simply means that any trades involving these securities must be paid for in full at the time of
purchase. Non-marginable securities include:
 OTC equities—those quoted on the OTC Bulletin Board (OTCBB) or in the OTC Markets Group
Pink Marketplace
 New issues (e.g., IPOs)—although new issues cannot be purchased on margin, the shares become
marginable (have loan value of 50%) if they’ve been held and fully paid for 30 days.

Let’s go through a few questions that many students find confusing about Regulation T.
Does Regulation T Apply to both Cash and Margin Accounts? Yes. Remember, Reg. T determines
the following two components relating to transactions that are executed:
1. The date by which payment is due for a purchase
 Whether the purchase is made in a cash or margin account, payment is due no later than four
business days after the trade (i.e., two business days after settlement).
2. The amount of credit that may be extended by the broker-dealer for a purchase
 In a cash account, no extension may be made; therefore, clients must deposit
100% of the purchase.
 In a margin account, an extension of 50% is allowed; therefore, clients must deposit
50% of the purchase.
Payment Date Credit Extension

No later than four business
Cash Account 0%
days after the trade (T + 4)
No later than four business
Margin Account 50%
days after the trade (T + 4)
With the margin requirement set at 50%, an investor is able to purchase twice the
amount of securities in a margin account than she otherwise would with the same
amount of money in a cash account.
Are Short Sellers Required to Execute Their Trades in Margin Accounts? Yes. The process of
short selling involves the borrowing and subsequently selling of a position that the client doesn’t own. A
short seller hopes that the securities will be able to be repurchased later at a lower price. These short sales
are required to be executed in margin accounts. The mechanics of these bearish transactions will be
covered later in this chapter.
Is the Use of Margin Available to All Investors? No. Not all types of client accounts are permitted to
engage in margin trading. For example, the owners/custodians of IRAs, custodial accounts, and qualified
retirement accounts (e.g., such as 401(k) and 403(b) plans) are prohibited from trading on margin.
Reg. T Call
A customer who initiates a margin transaction will receive a margin (Reg. T) call for 50% of the transaction
amount. According to Regulation T, the customer’s margin requirement must be deposited by no later than
four business days after the trade. Any market price change that occurs during this period will not affect the
amount of the customer’s deposit. In certain cases, if the amount owed is $1,000 or less, the brokerage firm
may choose not to issue the call and, instead, may add it to the amount of the loan in the account.

A customer may meet a Reg. T call by depositing cash equal to the amount of the call or by depositing fully
paid marginable securities. If securities are being used in lieu of cash, the customer must deposit securities
with a market value that’s equal to twice the amount of the call. The justification for the amount of
securities to be deposited is that the loan value of securities is only 50%.
For example, if a customer purchases 1,000 shares of XYZ stock at $40, he will receive
a Reg. T call for $20,000. The customer may deposit $20,000 in cash or marginable
securities with a market value of $40,000. Why $40,000? This is because the securities
have a loan value of only 50%.
Remember, cash is able to be used dollar-for-dollar; however, it takes $2.00 worth of securities to satisfy
every $1.00 owed to the broker-dealer.
Loan Value
Loan value represents the maximum amount that a broker-dealer will lend to a customer based on a
percentage of the current market value of eligible securities. Since Reg. T is currently 50%, marginable
securities have a loan value equal to 50% of their market value (100% – 50%).
For example, Mr. Smith purchases securities with a total market value of $20,000. The
securities have a loan value of $10,000 ($20,000 x 50%), which represents the maximum
amount the brokerage firm may lend to the customer for the purchase. If the securities
rise in value to $24,000, the loan value increases to $12,000 ($24,000 x 50%).
Let’s first review the required documentation for opening a margin account.
Opening a Margin Account

To open a margin account, customers are required to sign a margin agreement which states that they’re
willing to abide by the rules and regulations of the Federal Reserve Board, the SRO, and the brokerage
firm. The margin agreement usually contains the following three separate agreements:
1. The credit agreement
2. The hypothecation agreement
3. The loan consent agreement
Additional paperwork may be required, for example a power of attorney for a discretionary account or a
trust agreement for a trust account.
Credit Agreement The credit agreement is essentially an acknowledgement that a customer is borrowing
funds from the firm and is responsible for both payment of interest and repayment of the loan. The agreement
will disclose all of the credit terms, such as the fact that the interest rate is variable and is typically tied to the
broker call loan rate. The broker call loan rate is the rate that’s charged to a brokerage firm when it borrows
money from a bank to replace the funds being provided to a margin customer. The brokerage firm then charges
the customer an additional percentage above this rate.

When a margin account is opened for a customer, the member firm must send the customer a statement that
indicates the following:
 The conditions under which interest charges will be imposed
 The annual rate(s) that may be imposed
 The method of computing interest
 Whether the rates are subject to change without prior notice and the specific condition(s) under which
they may be changed
 The method of determining the debit balance on which interest will be charged
Hypothecation Agreement The hypothecation or pledge agreement states that the customer is
hypothecating (pledging) his securities to the brokerage firm which, in turn, provides the firm with the
ability to rehypothecate the securities to secure the loan received from a bank. The firm may pledge an amount
equal to 140% of the amount that the customer is borrowing (i.e., 140% of the account’s debit balance). All of
the securities in excess of 140% must be segregated.
For example, in a margin account, a customer purchases securities with a total market
value of $10,000. The customer deposits 50% of the purchase, but borrows the remaining
$5,000. To secure the loan from the bank, the brokerage firm is able to pledge up to
$7,000 of the customer’s securities (140% x $5,000).
Loan Consent Agreement If the loan consent agreement is signed (this is optional), the customer is
signifying that the broker-dealer is entitled to lend the customer’s securities to other customers. The traditional
borrowers of these shares are the short sellers who seek to profit from the decline in a security’s price.
Margin Disclosure Document Because the use of margin entails additional risks, brokerage firms are
required to furnish all margin customers with a risk disclosure document at both the time of the account
opening and annually thereafter. This document must include the following risk disclosures:
 An investor may lose more funds than the amount deposited in the margin account.
 The firm may force the sale of securities or other assets in the account.
 The firm may sell an investor’s securities or other assets without contacting the investor.
 An investor is not entitled to choose which securities or other assets in the account that are being
liquidated or sold to meet a margin call.
 The firm may increase its house maintenance margin requirements at any time and is not required to
provide the investor with advance written notice.
 An investor is not automatically entitled to an extension of time on a margin call.

Basics of Long Margin Positions

A customer who purchases securities in a margin account establishes a long margin position. The three
balances that are used for all computations of a long margin position are the long market value (LMV), the
debit (loan) balance, and the equity (EQ).
The LMV reflects the current market price of the securities in the account and will fluctuate as the total
value of the securities increases and decreases. The market value of the positions purchased must be
marked-to-the-market as of the end of each trading day. This process will determine if a customer is
required to deposit additional cash (if the market value of the long positions drop) or may be able to buy
additional securities (if the market value of the long positions rise).
The debit represents the amount that a customer has borrowed from and currently owes the brokerage firm.
Assuming that there are no additional transactions, and disregarding interest charges, the debit balance will
remain constant. Any subsequent change in the current market value of the securities has no effect on a
customer’s debit balance. Of course any interest charged on the loan by the broker-dealer increases the balance.
The equity represents the investor’s ownership interest in the account and is computed by subtracting the
DR from the LMV.
Long Market Value (LMV) – Debit Balance = Equity (EQ)
For example, with a Reg. T requirement of 50%, an investor purchases 1,000 shares of
XYZ at $20 per share. The total cost of the purchase is $20,000 (the LMV) and the client
must deposit $10,000 (the Reg. T deposit requirement of 50%). The other $10,000 is
provided as a loan by the broker-dealer and represents the debit balance.
After the transaction and subsequent customer deposit, the account will reflect the
following balances:
LMV – DEBIT = EQ
$20,000 $10,000 $10,000
Excess Equity Due to Appreciation

A client who purchases securities is hoping that the stock rises in value. If the long market value of the
securities increases, the equity in the account will increase proportionately. The increase may create a
situation in which the equity in the account is above the initial Reg. T requirement, thereby creating excess
equity in the account.
To determine the amount of excess equity in the long margin position above, the Reg. T requirement (based
on the current market value of the securities) is subtracted from the equity in the account.

For example, after a $4,000 increase in the value of the securities, the investor’s long margin
account shows the following:
LMV – DEBIT = EQ
$24,000 $10,000 $14,000
The excess equity is any amount of equity that exceeds 50% of the new, higher market value of $24,000.
This is calculated as follows:
Current 50% of Current

Excess Equity = –
Account Equity Market Value
$14,000 – ($24,000 x 50%)
$14,000 – $12,000
Excess Equity = $2,000
Essentially, with an LMV of $24,000, the Reg. T equity requirement is $12,000. However, since the
account has actual equity of $14,000, there’s excess equity of $2,000.
Special Memorandum Account (SMA)

If a margin account generates excess equity based on the increase in the LMV, the amount will be
reflected (kept track of) in a Special Memorandum Account (SMA). This amount is often simply referred to
as the SMA. However, SMA is neither cash nor equity; instead, it’s a line of credit that’s established with
the broker-dealer from which funds may be withdrawn. Interestingly, once SMA is established, any
subsequent decrease in market value will have no effect on SMA. In other words, once SMA is created,
the broker-dealer will not take it away due to adverse market conditions. Remember, a broker-dealer
doesn’t want to take away a client’s ability to borrow more money.
Although appreciation in the value of the securities in the account is the most obvious method of
generating SMA, there are others. The following table summarizes the impact that different actions will
have on both the debit balance and the SMA balance:
Account Event Impact on Debit and SMA Balances

 Cash dividends received on stocks in the account
 Debit is reduced by 100% of amount received/deposited
 Interest received on bonds in the account
 SMA is increased by 100% of amount received/deposited
 Voluntary cash deposits made by the customer
 Debit is reduced by 100% of amount received
 Proceeds received from selling securities from the account
 SMA is increased by 50% of the proceeds received

For example, if an investor sells $5,000 of securities from her margin account, her debit
balance will be reduced by the $5,000 of sales proceeds and $2,500 will be credited to
her SMA for potential withdrawal. If the $2,500 is subsequently withdrawn, her debit
balance will increase by this amount.
Withdrawing SMA as Cash An investor is generally permitted to withdraw 100% of the SMA generated.
If a customer does choose to withdraw cash, the debit balance will increase by the amount withdrawn.
However, the withdrawal will also cause the equity in the account to decrease proportionately.
From the previous example, let’s assume that the investor withdraws the $2,000 of SMA
in his account. As shown below, the SMA is reduced to zero and the debit balance will
increase to reflect the additional loan.
LMV – DEBIT = EQ SMA

Previous example: $24,000 $10,000 $14,000 $2,000
SMA of $2,000 is withdrawn: $24,000 $12,000 $12,000 0
Buying Power When a customer’s margin account has existing SMA, it’s considered to have buying
power since the SMA may also be used to purchase additional securities. With a Reg. T requirement of
50%, buying power is equal to two times the SMA balance (SMA x 2). Using the previous example and
assuming that the SMA was not withdrawn, the $2,000 of SMA will allow him to purchase $4,000 in
securities ($2,000 x 2). This will increase the debit balance by $4,000 since the broker-dealer is actually
lending him the entire amount of the purchase. Therefore, the long market value increases by $4,000, but
the equity in the account remains the same.
LMV – DEBIT = EQ SMA

Previous example: $24,000 $10,000 $14,000 $2,000
$4,000 of buying power is used: $28,000 $14,000 $14,000 0
If investors choose to purchase an amount of securities that exceeds their buying power, they will simply
be required to deposit 50% of the net remaining amount.
Restricted Account
While an increase in a margin account’s market value may result in excess equity, a decline may cause the
account to become restricted. A restricted account is one in which the equity is below the 50% Reg. T
requirement.
For example, the securities in an investor’s margin account were originally worth
$20,000, but have since declined in value to $16,000. The decline in the market value
has no effect on her debit balance of $10,000, but causes a decline in the account’s
equity balance (as shown below).

LMV – DEBIT = EQ
Original example: $20,000 $10,000 $10,000
After a $4,000 decline in LMV: $16,000 $10,000 $6,000
According to Reg. T, the account should have equity of $8,000 ($16,000 x 50%); however, since the actual
equity of $6,000 is below the Reg. T requirement, the account is restricted. Although the name restricted
sounds threatening, the broker-dealer will not require funds to be deposited to fix the situation.
Purchases in a Restricted Account When an account is restricted, the customer is able to make
additional purchases in the account and need only meet the initial Reg. T requirement for the new
purchase. There’s no provision that requires the customer to deposit enough cash to bring the entire
account up to the Reg. T requirement.
Same-Day Substitution When an investor purchases and sells securities on the same day in a restricted
account, it’s referred to as a same-day substitution. If the amount being purchased and sold is identical,
then no additional deposit is required. For example, if a customer sold $10,000 worth of ABC stock and
purchased $10,000 worth of XYZ stock, no margin deposit is required.
If the purchase amount is greater than the sale amount, the customer is required to deposit the Reg. T
margin requirement on the difference. For example, if a customer sold $10,000 of ABC stock and
purchased $15,000 worth of XYZ stock, the customer is required to deposit the Reg. T margin requirement on
the $5,000 net difference, which is $2,500.
If the sale amount is greater than the purchase amount, SMA is credited for an amount equal to 50% of the
net sales proceeds. For example, if a customer purchased $10,000 of ABC stock and sold $15,000 worth of
XYZ stock, SMA will increase by $2,500 ($5,000 x 50%).
Minimum Maintenance Requirement – Long Positions

Long margin account customers are not required to maintain a constant 50% equity level; instead, industry rules
set a minimum maintenance requirement for equity to be at least 25% of the LMV. Therefore a restricted
account is one with equity that’s below 50%, but at or above 25% of the LMV.
If the equity drops below 25% of the LMV, a maintenance call is issued and the call must be met promptly.
A client may satisfy the call by depositing cash equal to the amount of the call, by liquidating securities, or
by depositing fully paid securities.
If a margin customer intends to take a withdrawal from SMA, but the withdrawal causes the account’s equity to
fall below the minimum maintenance requirement, he will be unable to withdraw the funds. In this type of
situation, the SMA is referred to as phantom SMA and may only be withdrawn when the equity returns to an
acceptable level.

Initial Equity Requirement – Long Positions

Not all margin customers start with substantial purchases. For that reason, industry rules establish minimum
equity requirements for initial transactions in their margin accounts. For a long position, the customer’s
minimum required deposit is the lesser of $2,000 or 100% of the purchase price. This requirement may
override the 50% Reg. T requirement for initial purchases that are less than $4,000.
Example 1: A customer makes an initial purchase of $1,800 in a margin account.
Although the FRB requires a 50% Reg. T deposit ($900), this amount doesn’t meet the
industry requirement of the lesser of $2,000 or 100% of the purchase price. Therefore,
the customer is required to deposit the full $1,800.
Example 2: A customer makes a $3,000 initial purchase in a margin account. Again,

although the FRB requires a 50% Reg. T deposit ($1,500), this amount doesn’t meet the
overriding industry requirement of the lesser of $2,000 or 100% of the purchase price.
Therefore, the customer is required to deposit $2,000.
Basics of Short Margin Positions

Selling short involves the sale of securities that are not owned by the seller. Short sellers are bearish
investors who borrow the securities from their brokerage firm and execute a sale in anticipation that the
securities will decline in value. If the securities are able to be purchased at a later date for a lower price,
the investors will realize a profit. Essentially, short sellers intend to sell at a high price in hopes of buying
back at a low price.
Since short sellers borrow stock, they’re obligated to return the borrowed shares. However, provided the
account maintains the required minimum equity, there’s no set time by which this must occur. If a cash
dividend is paid on the borrowed stock, the short seller is responsible for paying the dividend to the lender.
Establishing a Short Position

A customer who sells securities short must do so through the use of a short margin account. The three
balances that are used for all computations in a short margin account are the credit balance (CR), the short
market value (SMV), and the equity (EQ).
There are two components which make up the credit balance—the total proceeds generated by the short
sale plus the margin requirement on the value of the sale. For a short sale, the initial Reg. T margin
requirement of 50% is the same as if a margin purchase had been made.
The SMV represents the current market value of the securities that have been sold short and will fluctuate as
the value of the securities increases or decreases. The short seller wants the SMV to decline.
The EQ balance initially represents the amount that has been deposited by the customer. The EQ is the CR
balance minus the SMV.

Credit Balance (CR) – Short Market Value (SMV) = Equity (EQ)
For example, an investor sells short 1,000 shares of ABC at $20 which generates proceeds
of $20,000. The customer must deposit margin of $10,000 ($20,000 x 50%). After making
the deposit, the credit balance is $30,000 ($20,000 of short sale proceeds plus the margin
deposit of $10,000). The account will be established as follows:
CR – SMV = EQ
$30,000 $20,000 $10,000
If the SMV decreases, the EQ will increase; on the other hand, if the SMV increases, the EQ will decrease.
Interestingly, the CR balance (i.e., all of the cash) is not influenced by the fluctuation in the market value;
it remains the same. Due to the potential upside risk, customers may choose to hedge their short positions
by either purchasing calls or placing buy-stop orders.
Excess Equity Due to Depreciation

In a margin account, both long and short positions are marked-to-the-market daily at their 4:00 p.m. market
closing price. The difference between long and short positions is that the equity of a long position increases
when the LMV rises, but the equity of a short position increases when the SMV drops. If any excess equity is
generated, it’s credited to SMA and is able to be withdrawn or used toward other securities transactions. The
amount of excess equity for a short position is determined by the difference between the current equity
balance and the amount of equity that’s required by Reg. T.
Using the previous example, if ABC’s market value declines by $5,000, the account will
appear as follows:
CR – SMV = EQ
After a $5,000 decline in SMV: $30,000 $15,000 $15,000
Current 50% of Current

Excess Equity = –
Account Equity Market Value
$15,000 – ($15,000 x 50%)
$15,000 – $7,500
Excess Equity = $7,500
With the SMV at $15,000, the Reg. T margin requirement is $7,500 ($15,000 x 50%). However, since the
current equity balance is $15,000, there’s excess equity of $7,500 that’s credited to SMA.

With an SMA balance of $7,500, the investor is able to (1) withdraw the excess equity, or (2) buy or short
up to $15,000 in additional securities (using the buying/shorting power of two times the SMA balance), or
(3) take no immediate action since the SMA remains until it’s used. Any subsequent increase in the market
value of ABC stock will not affect the short position’s SMA balance.
Minimum Maintenance Requirement – Short Positions

In the event that the equity drops below the minimum, customers will receive a maintenance call for the
amount that’s needed to bring the equity back up to the required amount.
For a short account, industry rules set a minimum maintenance requirement for equity to be at least 30% of
the SMV. If a client has a short account in which SMA exists, she may not withdraw SMA if the withdrawal
brings the account below the minimum maintenance requirement of 30%.
Using the original example, if ABC subsequently rises in value to $25 per share,
the account will now appear as follows:
CR – SMV = EQ
After SMV rises to $25,000 $30,000 $25,000 $5,000
The concern for the investor is whether the current amount of equity is sufficient given the increase in the
SMV. Based on the SMV’s increase to $25,000, the minimum maintenance requirement is $7,500
($25,000 x 30%). Since the investor’s current equity of $5,000 is less than the maintenance requirement,
she will receive a maintenance call for the $2,500 difference.
Initial Equity Requirement – Short Positions

Since not all short margin customers begin with significant short sales, industry rules establish a minimum
equity requirement for initial transactions in their margin accounts. For a short position, the customer’s
minimum required deposit is the greater of $2,000 or the required Reg. T deposit.
Example 1: A customer’s initial transaction in a margin account is a $1,600 short sale of
stock. Although the FRB requires a 50% Reg. T deposit ($800), this amount doesn’t meet the
industry requirement of the greater of $2,000 or 50% of the transaction. Therefore, the
customer must deposit $2,000.
Example 2: A customer’s initial transaction in a margin account is to sell short $6,000 of
stock. In this case, the FRB’s 50% Reg. T deposit of $3,000 is the initial requirement since
it’s greater than the $2,000 that’s required by industry rules.

Combined Long and Short Positions

Although long and short accounts have been described individually, they’re not actually considered separate
accounts. Both long and short margin transactions are executed in the same account.
If a customer has made both a purchase and a short sale in a margin account, it may be necessary to
compute the combined equity of the account using either one of the two formulas shown below:
LMV + CR – DR – SMV OR (LMV – DR) + (CR – SMV)
For example, a customer has a margin account with a long market value of $15,000, a
debit balance of $8,000, a credit balance of $10,000, and a short market value of $4,000.
The combined equity may be calculated as $15,000 + $10,000 – $8,000 – $4,000 = $13,000
or ($15,000 – $8,000) + ($10,000 – $4,000) = $13,000.
Margin Requirements for Other Securities

Some securities, such as municipal bonds and U.S. Treasuries, are exempt from Reg. T, but may still be
purchased on margin. The margin requirements for these exempt securities are set by the self-regulatory
organizations (SROs) as shown below:
The requirement is set as a percentage of their current market value, based on the
time remaining until maturity.
U.S. Government
 The percentage ranges from 1% if the security has one year left until maturity to a
Securities maximum of 6% if the security has 20 years or more until maturity (these are for
both initial and maintenance)
Municipal Bonds The requirement is 7% of their market value (this is for both initial and maintenance)
The requirement for investment-grade debt is 10% of the market value; however, the
Non-Convertible
requirement for non-investment grade debit is 20% of current market value or 7% of
Corporate Bonds the principal amount – whichever is greater
Convertible
The requirement is 50% of the market value (this is for both initial and maintenance)
Corporate Bonds
If a client is long and short an equal number of shares of the same security, the
Short Against the Box maintenance requirement is 5% of the long position.
New Issues The securities cannot be purchased on margin for 30 days after the offering.
Like new issues, investment company securities (e.g., mutual fund shares and UITs)
Investment
cannot be purchased on margin, but have loan value (may be used as collateral) once
Company Securities they’ve been held for 30 days.
Leveraged ETFs See the information below.

Special Maintenance Requirements on Leveraged ETFs As described in the Investment Companies

chapter, exchange-traded funds (ETFs) are securities that resemble index mutual funds, but trade
throughout the day. Some of these products utilize leverage in an effort to achieve returns that are double
or triple the return of an underlying index. Due to the inherent leverage, these products have special
maintenance requirements that exceed the typical SRO minimum thresholds of 25% on long positions and
30% on short positions.
The margin requirement for these ETFs may be computed by multiplying the portfolio leverage factor by
the standard SRO maintenance requirement. For example, a double long portfolio has a requirement of 50%
(2 x the 25% SRO long minimum maintenance requirement), while a triple short portfolio has a requirement
of 90% (3 x the 30% SRO short minimum maintenance requirement).
What’s the maintenance requirement for a customer who has made a $1 million purchase of a
2x Long Gold Index ETF?
To calculate the maintenance requirement, the standard long requirement of 25% is
multiplied by the leverage factor of 2. Therefore, in this example, the customer must
maintain a 50% margin requirement: $1,000,000 x 50% = $500,000.
What’s the maintenance requirement for a customer who has a $1 million short position
of a 3x Inverse Gold Index ETF?
To calculate the maintenance requirement, the standard short requirement of 30% is
multiplied by the leverage factor of 3. Therefore, in this example, the customer must
maintain a 90% margin requirement: $1,000,000 x 90% = $900,000.
Other Margin Customers

Certain customers are able to operate under more liberal margin requirements due to their sophistication
and/or the type of trading in which they engage. Let’s examine two of these customers—pattern day
traders and portfolio margin customers.
Pattern Day Traders

A pattern day trader is any customer who executes four or more day trades over in a five-business-day period.
A day trade is defined as the purchase and sale—or the sale and purchase—of the same security on the same
day in a margin account. Exceptions to this definition exist for (a) a long position that’s held overnight and
sold the next day prior to any new purchase of the same security, or (b) a short position that’s held overnight
and purchased the next day prior to any new sale of the same security.
If a customer meets the definition of a pattern day trader, but the number of day trades is 6% or less of
total trades for the five-business-day period, the customer is not considered a pattern day trader. On the
other hand, if the broker-dealer knows, or has a reasonable basis to believe, that a customer who is opening
an account or resuming day trading will engage in a pattern of day trading, the firm may immediately
impose special day trading margin requirements.

Minimum Equity Requirement Pattern day traders have a minimum equity requirement of $25,000,
rather than the normal minimum requirement of $2,000. This required minimum must be deposited in the
account before day trading activity begins.
Margin Calls Day trading buying power is limited to four times the trader’s maintenance margin excess,
which is determined as of the close of the previous day. If a day trader exceeds her buying power
limitations, she must meet a day trading margin call within five business days. During the time the margin
call is outstanding, the account is restricted to buying power of two times maintenance margin excess.
Ultimately, if the margin call is not met by the fifth business day, trading in the account is restricted to
a cash-available basis for 90 days or until the call is met. Funds that are deposited to meet the
minimum equity requirement or a day trading margin call must remain on deposit in the account for at
least two business days.
Cross-Guarantees Prohibited Pattern day traders are not permitted to meet day trading margin
requirements through the use of cross-guarantees. In other words, each day trading account must meet the
requirements independently, based only on the resources in that account. This prohibits cross-guarantees not
only between accounts of different customers, but also between different accounts of the same customer.
Day Trading Risk Disclosure Document Since day trading strategies entail additional risks, member firms
must provide a disclosure document to all customers prior to their engaging in day trading. The risk disclosure
document may be offered in paper or electronic form and should highlight the following information:
 Day trading can be extremely risky.
 Clients should be wary of claims of large profits from day trading.
 Day trading requires knowledge of securities markets and a firm’s operations.
 Day trading will generate substantial commissions, even if the per-trade cost is low.
 Day trading on margin or short selling may result in losses beyond the initial investment.
Portfolio Margin Customers—Institutional Accounts

Strategy-Based Margin Traditionally, margin requirements have been calculated based on each portfolio
position individually with long and short stock positions each requiring a 50% Regulation T deposit. Long
option positions require a deposit of 100% of the premium, while uncovered option positions require a
deposit that varies based on the degree to which the position is in-the-money or out-of-the-money.
For example, with a strategy-based margin account, if a stock is purchased at $30 and is hedged by the
purchase of a put with a $25 strike price, these will be evaluated as two separate strategies. Using this
method, the amount at risk (maximum loss) is calculated for each strategy. Ultimately, the client’s net margin
requirement is not based on the reduced loss potential of the hedged position.

Portfolio-Based Margin Portfolio margining (also referred to as risk-based margining) is a more accurate
method of identifying the risk in a margin account. This methodology is based on the assumption that the
combinations of positions being established by investors may have offsetting risk characteristics (e.g., stocks
and hedges, arbitrage pairings, long and short indices and futures). Margin is calculated based on the net
risks of the eligible instruments in a customer’s account. This method is a more sophisticated way of
evaluating the client’s position and the overall net risk of an entire portfolio. For example, if a client creates a
hedged position of long stock and a long put, the portfolio margin approach will only consider the loss
potential of the combined positions.
The benefit of portfolio margining is that it permits clients to use a greater amount of leverage for a given
amount of capital, provided the account is appropriately hedged. Traditionally, hedge funds have been some of
the most frequent users of the additional leverage that’s afforded to portfolio margin customers.
Portfolio margin uses an SEC-approved computer modeling system to perform risk analysis and multiple
pricing scenarios to measure risk in order to calculate the appropriate margin requirements. The scenarios
are designed to measure the theoretical loss of the positions, assuming changes in both the underlying price
and the implied volatility of the model. Essentially, the required margin is based on the greatest loss that
will be incurred in a portfolio if the value of its components move up or down by a predetermined amount.
Each eligible product will have a different theoretical valuation range, including the following:
 Highly capitalized broad-based indices use a potential market increase of 6% and a decrease of 8%.
 Non-highly capitalized broad-based indices use a potential market increase of 10% and a decrease of 10%.
 Equity options, narrow-based index options, and/or security futures use a potential market increase of 15%
and a decrease of 15%.
The goal of portfolio margining is to reduce excess margin calls and to lower the risk of forced position
liquidations. The end result is that, if positions are hedged appropriately, there’s normally a reduction in
net margin requirements.
Eligible Participants Portfolio margin is not available to small retail clients; instead, it’s only allowed
for the following entities:
1. Any broker or dealer that’s registered with the SEC under the Securities Exchange Act of 1934
2. Any member of a national futures exchange to the extent that listed index options, unlisted derivatives,
ETF options, index warrants or other underlying instruments hedge the member’s index futures
3. Any person approved to engage in uncovered option contracts. If a customer intends to trade unlisted
derivatives, the customer must maintain equity of at least $5,000,000 at all times. Prior to offering
portfolio margining methodology, a broker-dealer must develop a profile of customers who are eligible
to use it. The broker-dealer must establish an approval process and implement minimum equity
requirements for customers that are eligible to use portfolio margining.

Risks of Portfolio Margining and Disclosure The portfolio margining method may expose clients to
unexpected risks because of the greater leverage they’re being afforded. If an account falls below the
minimum maintenance margin, all calls must be met within three business days. FINRA requires that
customers using a portfolio margin account receive a disclosure document and sign an acknowledgement
form prior to their initial transaction.
This disclosure document must describe the special risks associated with portfolio margin accounts,
including the following:
 Portfolio margining normally allows for greater leverage in an account, which may lead to larger
losses in the event of adverse market movements.
 Due to the fact that the maximum time for meeting a margin deficiency is shorter than in a standard
margin account, the risk is greater that a customer’s portfolio margin account will be liquidated
involuntarily.
 Due to the extremely sophisticated mathematical calculations and theoretical values being used in
portfolio margining, customers may not be able to predict the size of future margin deficiencies.
Member Firm Operations Professionals

Any employee of a brokerage firm who conducts or functions in one or more of the following areas (often
referred to as a firm’s back office) is required to register as an Operations Professional:
 Margin
 Stock loan; securities lending
 Client on-boarding (account date and document maintenance)
 Receipt and delivery of securities and funds; account transfers
 Settlement, possession, and control of securities
 Trade confirmation and account statements
 Preparing and filing financial regulatory reports
Conclusion
For suitability purposes, it’s important for a registered representative to realize that the use of margin
entails additional risks; therefore, this activity may not be appropriate for all customers. Remember how
important the FRB’s 50% Reg. T requirement is for the computations performed in this chapter. The next
chapter will examine clearing, settlement, and regulatory reporting.

CHAPTER 19
Settlement and
Regulatory Reporting
Key Topics:
 Overview
 Reporting Requirements
 Clearing Trades
 Settling Trades
CHAPTER 19 – SETTLEMENT AND REGULATORY REPORTING
This chapter will focus on what happens after a trade is executed. The beginning of the chapter will
examine the systems through which trades must be reported. In addition, the process of clearing and
settling trades will be reviewed.
Trading Systems and Their Functions

Order Audit Trail System (OATS)
The Order Audit Trail System (OATS) allows FINRA to effectively review market activity that relates to
customer orders within a member firm, to conduct surveillance, and to enforce rules. OATS records the life
of an order from receipt, to routing, to modification if applicable, and cancellation or execution. FINRA rules
concerning these reporting requirements are broken down into three areas: (1) order origination and receipt, (2)
order transmittal, and (3) order modifications, cancellations, and executions. OATS also requires market
participants to synchronize both computerized clocks and mechanical time-stamping devices used in
reporting. Time synchronization is done on a daily basis before the market opens and must be within one
second of the National Institute of Standards and Technology (NIST) standard. As the information is
received, it must be recorded in military time.
Information that must be reported to FINRA in an OATS report includes the following items:
 From whom the order was received (customer or other member)
 The time the order was received from the customer
 Order identifier
 Date and time of receipt
 How the order was received (manually or electronically)
 Terms of the order
– Buy or sell
– Long or short
– Stock
– Shares
– Price
– Whether the order is an intermarket sweep order
– Order type (market, limit, etc.)
– Time in force
– Special handling requests
– Account type
 Where the order was routed for execution
 How it was routed (manually/electronically)
 Whether the order was modified
– Cancelled
– Changed

– Date
– Time
 Execution
– Price
– Partial execution
– Full execution
– Date
– Time
– Capacity (agent, principal, riskless principal)
– The exchange where the trade was reported
 Whether there’s a separate reporting agent for OATS
OATS transmissions must be reported either on the same day that the order was received or the day that such
information first becomes available. OATS reports must be transmitted daily, either in a single submission or
in multiple electronic submissions. All orders in Nasdaq-listed securities and OTC equity securities that are
received or sent by a broker-dealer must be compliant with OATS rules.
OATS defines an order as any oral, written, or electronic instruction to effect a transaction. The definition also
includes an order that’s received by a member from a customer, or that’s originated by a department of the
same member firm or another member firm. OATS rules don’t apply to any transaction that was originated
by the firm’s proprietary trading desk in the ordinary course of business of the firm’s market-making
activities. The member is also required to include whether the order was transmitted or received by an ECN.
Automated Confirmation Transaction (ACT) Technology Platform

FINRA rules require the reporting of transactions in domestic and foreign equity securities. Transactions in OTC
equity securities are reported to the OTC Reporting Facility (ORF). Transactions of Nasdaq-listed and
other exchange-listed securities (NYSE or NYSE American – formerly AMEX) that occur over-the-counter are
reported to the FINRA/Nasdaq Trade Reporting Facility (TRF). Both the OTC Reporting Facility and the
Trade Reporting Facility make use of the Nasdaq ACT Technology Platform. The two separate and distinct
reporting services contract with Nasdaq for the use of its platform. Open hours for both the TRF and the
ORF are from 8:00 a.m. to 8:00 p.m.
Nasdaq’s Automated Confirmation Transaction Technology Platform is a system that facilitates the reporting
and clearing of Nasdaq and OTC transactions by allowing order-entry and market-making firms to enter
priced trades. This information is then used to report, match, and clear transactions.
Trade Reporting Facility (TRF)

As the name suggests, the TRF is a reporting system, not an order-execution system. Trades that are
entered have already been negotiated between the parties or have been executed in another system, such as
the Nasdaq Market Center Execution System. Also, TRF is not a system that’s used to report transactions
on the floor of the NYSE, which is done by the exchange on the Consolidated Tape.

OTC Reporting Facility (ORF)

Although the TRF and the ORF are similar, it’s important to remember that the TRF is used to report
transactions of Nasdaq-listed and other exchange-listed securities that occur in the over-the-counter market,
while the ORF is used to report transactions exclusively in OTC securities that don’t trade on Nasdaq or the
other exchange markets. The OTC Reporting Facility is not an order-execution system. Instead, trades are
entered into the ORF that have already been negotiated between the parties or have been executed in another
system. Also, the ORF is not a system that’s used to report transactions executed on the floor of the NYSE.
The exchange reports these trades to the Consolidated Tape.
Trade Reporting and Compliance Engine (TRACE)

TRACE was created to provide greater transparency in the corporate bond market, but it’s not a quotation
or an execution system. For corporate bonds, it’s broker-dealers that provide quotes and execute
transactions. Unlike for equity securities, there’s no regulatory quote or execution system.
TRACE is a system that members must use to report transactions in eligible, fixed-income securities and
the system then disseminates continuous bond sale information. TRACE-eligible securities are defined as
depository-eligible, U.S. dollar-denominated debt securities such as:
 Investment- and non-investment-grade securities
 Split-rated
 SEC registered debt securities of corporations that are in the U.S. or foreign countries
 Securities issued under the Securities Act of 1933 and purchased or sold according to Rule 144A
 Debt securities issued or guaranteed by either a U.S. government agency or a government-sponsored
enterprise (GSE)
 U.S. Treasury securities
Split-rated securities are those that are considered investment-grade by one nationally recognized
statistical ratings organization (NRSRO) and non-investment-grade by another NRSRO. Standard and
Poor’s, Moody’s, and Fitch are examples of NRSROs.
Securities that are not required to be reported to TRACE include:

 Money-market instruments (with maturities of less than one year)
 Securities issued by foreign governments
 Development bank debt
 Debt securities in physical form
 Repurchase agreements (repos)
Real-time Reporting Transaction System (RTRS) (Rule G-14)

The Real-Time Transaction Reporting System (RTRS) is operated by the MSRB and is open each business
day from 7:30 a.m. until 6:30 p.m. Eastern Time. Transactions that are reported to the system will be made
available to registered securities associations and to other appropriate regulatory agencies in order to assist
in compliance and enforcement of MSRB rules.

Brokers and dealers have an obligation to report trade information promptly, accurately, and completely. If
a broker or dealer uses another agent for reporting purposes, the responsibility for timely and accurate
reporting still lies with the firm that executed the trade. Similarly, the reporting dealer that acts as a
submitter for another dealer is responsible for ensuring that transaction reporting requirements are met for
the items that are under the submitter’s control.
When the report is made, the submitter must include the time of the trade, whether it’s a purchase or sale,
and the quantity and price so that the dissemination of information can be made on a timely basis. The following
transactions don’t need to be reported to RTRS:
 Transactions in securities without CUSIP numbers
 Transactions in municipal fund securities
 Inter-dealer transactions that are not eligible for comparison in a clearing agency registered
with the Commission.
MSRB’s Electronic Municipal Market Access (EMMA) System

As mentioned in the Offerings chapter of this manual, the MSRB has established EMMA as the primary
market disclosure service for official statements, other related primary market documents, and market
information. The EMMA system also contains information related to the continuing disclosure
requirements that are submitted by municipal issuers and secondary market transactions submitted by
municipal securities dealers. The EMMA website can receive documents from issuers and underwriters as
well as transaction information from the MSRB’s Real-Time Transaction Reporting System (RTRS).
EMMA provides free public access to official statements, trade data, credit ratings, and educational
materials and presents it in a manner that’s specifically tailored for retail, non-professional investors who
may not be experts in financial or investing matters.
Clearing and Settlement – An Overview

What happens after a trade occurs? At this point, the buyer and seller must agree on the terms of the
transaction (clear the trade). Ultimately, the buyer is expected to pay for the security and the seller is
expected to deliver the security. This simultaneous payment and delivery process between the two parties
is referred to as settlement. The client-to-broker-dealer payment and delivery (which is not settlement) is
also often handled electronically since clients typically hold positions in street name.
The modern securities clearing process is complicated and involves many parties that are linked together by
various computer and communications systems. In a well-developed capital market (e.g., the U.S. market),
the majority of trades are processed electronically with few paper securities transactions occurring.
Settlement Methods
For most securities, today’s settlement process is handled electronically by the Depository Trust Clearing
Corporation (DTCC); however, some security positions are not DTCC-eligible. Essentially, the DTCC
simply adjusts the security positions and cash balances of the contra-parties on its internal books. Since the
settlement is guaranteed by the DTCC, there’s no contra-party risk.

DTCC Settlement Rules for settlement of contracts between member firms are established under
FINRA’s Uniform Practice Code. Again, settlement represents the day on which the buying firm must pay
for the securities and the selling firm must deliver them and receive the proceeds from the sale. For
example, a stock trade that’s executed for regular-way settlement will settle on the second business day
after the trade (T + 2). As noted earlier, the DTCC simply journals the movement of security positions and
monies between each clearing firm’s account. This process is referred to as book-entry settlement.
Book-Entry Settlement Rather than making physical delivery of securities or cash when settling securities
trades, many firms use book-entry settlement. If a firm intends to use book-entry settlement, all transactions in
depository-eligible securities must be settled through a registered securities depository, such as the DTCC or
the National Securities Clearing Corporation (NSCC). For locked in (affirmed) stock trades, each firm is
actually settling the position with the NSCC—the DTCC subsidiary.
Depository-eligible securities are those that may be deposited at the clearing agency for which ownership can
be transferred through bookkeeping entries rather than through physical delivery of certificates. Cash transfers
are also processed through book entries by the clearing agency, rather than through a bank routing process.
Direct Registration System (DRS) The DRS allows investors to hold securities in book-entry form,
rather than receiving physical delivery. DRS is linked with DTC and electronically transfers assets to and
from the transfer agent and broker dealer. The investor receives periodic statements with dividend or interest
payments and other company documents are mailed directly to the investor.
DK Notice However, with some non-DTCC-eligible securities, dealers still contact each other directly.
Occasionally, a situation may arise in which a broker-dealer sends the contrabroker a confirmation, but
doesn’t receive one in return. If there’s an unrecognized trade and the trade cannot be confirmed, the party
receiving the confirmation is required to promptly notify the confirming party by telephone and, within
one business day, send a written notice with a return receipt requested, indicating non-recognition of the
transaction. Within four business days of the trade, the broker-dealer will then send the contrabroker a DK
(don’t know) notice, questioning whether a trade occurred. The contrabroker must then examine its records
to determine whether the transaction occurred. If a member believes that a transaction is clearly erroneous,
it may cancel the trade once FINRA is notified and FINRA’s approval is obtained.
After verification, if the dealer believes a trade occurred, it should immediately notify the non-confirming
party by telephone and send to the non-confirming party, within one business day, a written notice with a
return receipt requested, indicating the failure to confirm. As soon as it receives the phone call from the
dealer, the non-confirming party should attempt to determine whether a trade occurred. If it determines
that a trade did occur, the non-confirming party should immediately notify the confirming party by phone
and send a written confirmation within one business day. If the trade cannot be confirmed, a written notice
should be sent promptly to the confirming party indicating non-recognition of the transaction.

Settlement Dates
The actual settlement date of a transaction is primarily determined by the securities that are involved in the
trade. Although shown in a previous chapter, let’s review the different methods of settlement.
Regular-Way Most securities settle on a regular-way basis, which refers to the normal number of
days to complete the transaction. For corporate securities (stocks and bonds) and municipal securities
(covered under MSRB Rule G-15), the settlement for regular-way transactions is two business days after the
trade date (i.e., T + 2). For Treasury securities and options transactions, settlement occurs one business
day after the trade date (i.e., T + 1).
Special Settlement If either party seeks to alter the timing of settlement on a trade, the adjusted period
must be agreed to prior to the transaction. For example, if a stock seller is in urgent need of funds and
needs a next-day settlement (rather than T + 2), the buyer must agree to these conditions prior to the
transaction and may offer a slightly lower price for the shares.
Cash Settlement A cash settlement is completed on the same day as the trade. This option, which
requires the agreement of both parties, can be used for any type of security.
Seller’s Option If trade settlement cannot be completed on a regular-way or for-cash basis, the seller may
request a seller’s option settlement. At the time of the transaction, both parties to the trade may agree to a
seller’s option, which gives the selling firm additional time beyond the normal two business days to make
good delivery. Often, a seller’s option is used when the seller needs additional time because of legal
requirements, such as the removal of a legend from a stock certificate.
When Issued On certain occasions securities are authorized, but not yet issued (e.g., new issues, spin-
offs, etc.) These transactions will settle when the security becomes available for delivery.
Settlement Dates
Corporate or
Second business day following the trade (T + 2)
Municipal Bonds
U.S. Government
Next business day (T + 1)
Securities
Cash
Same day (T)
Trade/Settlement
Negotiated settlement, but not earlier than two business days after
Seller’s Option
the trade (i.e., additional time is required)
When Issued As determined by the National Uniform Practice Committee

Customer Payment Versus Settlement

Don’t confuse a customer’s obligation with those of the firms involved in a given trade. Regulation T requires
that customer payment for purchases in cash and margin accounts be made promptly, which typically means by
no later than two business days following regular-way settlement (i.e., S + 2).
Remember, trade settlement refers to the timing of payment and delivery between member firms and is
governed by FINRA’s Uniform Practice Code. The date on which customer payment must be made (Reg. T
payment) is set by the Federal Reserve Board (FRB) and this authority was established under the Securities
Exchange Act of 1934.
To keep these two concepts clear, the differences between them are summarized in the following table:
Settlement versus Customer Payment

Security/Trade Settlement Customer Payment
Corporate Securities in a Two business days Four business days
cash or margin account (T + 2) (T + 4 or S + 2)
Two business days Exempt from Reg. T
Municipal Securities
(T + 2) (generally by settlement)
U.S. Government Next Business Day Exempt from Reg. T
Securities (T + 1) (generally by settlement)
Next Business Day Four business days
Options Trades
(T + 1) (T + 4)
Delivery of Physical Securities

Paper Settlement
In some cases, physical securities may be delivered for settlement. Some reasons for this include the fact that the
client is personally holding the certificates or the security itself is not DTCC-eligible. In either case, the physical
securities must be in proper order and have all of the necessary endorsements before being delivered to the
buyer. If all paperwork is in order, the position is referred to as a good delivery.
FINRA’s Uniform Practice Code establishes the requirements for good deliveries of securities. One of the
purposes of the rule is to ensure that the securities will be acceptable to the transfer agent. The transfer
agent will make the final determination as to whether a security is a good delivery and may be transferred
to the new owner. This section will detail what constitutes good delivery.
CUSIP Numbers One aspect of good delivery is the assurance that the correct security is being
delivered. Many issues have similar features and maturities and may be confused with one another. CUSIP
numbers are similar to bar codes for items in a store and are identifying numbers assigned to each maturity
of an issue. CUSIPs are essential in the identification and clearance of securities.

Endorsements and Assignments A customer who sells shares of stock will typically endorse the stock
certificate by signing the back of the certificate and mailing it to the broker-dealer. In order to safeguard
the certificate while it’s in the mail, the seller could send the certificate by registered mail. An alternate
method is for the customer to send the certificate, unsigned, in one envelope and to send a signed stock
power in a separate envelope. In this way, if the certificate falls into unauthorized hands, it has no value
since it’s non-negotiable.
Units of Delivery For certificates to be acceptable for broker-to-broker delivery, they must be in certain
units. If the selling broker delivers units in multiples other than what’s allowed, the buying broker is not
required to accept the certificates.
Stock Transactions On stock transactions, certificates must be delivered in multiples of 100 shares. For
example, on a transaction involving 500 shares, one certificate for 500 shares, or five certificates for 100
shares each, or two certificates for 200 shares and one certificate for 100 shares are all good delivery since
they’re all in multiples of 100 shares. However, multiples that are not 100 shares, such as two certificates for
250 shares each or one certificate for 450 shares and one certificate for 50 shares, are not good delivery.
Bond Transactions Registered bonds are good delivery if they’re in $1,000 units or multiples thereof.
Additionally, amounts of $100 or multiples aggregating to $1,000 are acceptable, but with no
denomination larger than $100,000.
In addition to denominations, the form of ownership may be a factor.

 Bearer – This a certificate delivery with no owner name noted and interest coupons are
physically attached.
 Registered to Principal Only – This is a physical certificate with the owner’s name, but interest
coupons are physically attached.
 Fully Registered – This is in certificate form with the owner’s name and interest mailed directly
to the evidenced owner.
Restricted Securities Securities that carry a restrictive legend are not considered to be in good delivery
form. Generally, these certificates must have the legend removed, which is the responsibility of the selling
firm. Only a transfer agent has the authority to remove a restrictive legend.
However, the transfer agent will not remove the legend unless the client has obtained the consent of the issuer in
the form of an opinion letter that’s created by the issuer’s counsel. The process of cleaning the certificate
(removing the legend) is typically accomplished under Rule 144.
DVP/RVP Accounts At times, clients may use a bank to centralize their bookkeeping when trades are
executed through various firms. Each brokerage firm is instructed to provide the bank with trade details. The
bank will either pay the broker-dealer for client purchases or send securities to the broker-dealer for client sales.

Death of an Account Owner

Regardless of the account type, a customer’s death requires an RR to follow certain guidelines. If securities
or other instruments were registered in the name of the deceased person, they will usually be transferred by
the executor or administrator of the estate to the name of the estate. Certain documents are required by the
transfer agent before the change may be made. The specific documents will depend on state law, which
governs the way a deceased person’s affairs are handled.
These documents could include any or all of the following:

 Notarized copy of the death certificate
 Copy of the will or court appointment (letters testamentary)
 Affidavit of domicile
 State inheritance tax waiver
Remember, if a customer who had granted a power of attorney to another individual subsequently dies, the
power of attorney is automatically terminated.
At times, registered representatives are asked to provide the executor with information regarding the value
of securities for estate tax purposes. If this is the case, the securities are generally valued as of the date of
death or as of an alternative date that’s six months after the date of death.
Additional Settlement Issues

Occasionally an investor will purchase a security in anticipation of receiving a distribution. The
distribution may be in the form of a cash dividend, stock dividend or rights offering. In order to be entitled
to the distribution the investor must be the documented owner on the record date. Let’s review the process.
Dividends
Common stock doesn’t pay a specific annual dividend; instead, the board of directors decides what
dividends (if any) the company is able to pay to its common shareholders. Dividends are paid on a per-
share basis. As it relates to dividends, there are three important dates that are set by the paying
corporation:
 Declaration date: the date on which the dividend is authorized. If a company’s board declares a
$.10 dividend, its stockholders will receive $.10 for each share that they own.
 Payment date: the date on which the declared dividend will be paid. Dividends are usually paid
quarterly and are taxable in the year in which they’re paid/received.
 Record date: the date on which an investor must officially own the stock to be entitled to receive
the dividend.

For example, on December 1, the board of Widgets Inc. declares a dividend of $1 per share that’s payable on
January 3 to shareholders of record on December 15. Any person who is on Widget Corporation’s records as a
shareholder as of December 15 will receive the $1-per-share dividend on January 3.
Ex-Dividend Rule Although a corporation’s board of directors sets the declaration, payment, and record
date, the ex-dividend date is set by the SRO for the market on which the stock trades (e.g., FINRA). The
ex-dividend date represents the date on which a stock begins to trade without its dividend. A stock will
typically trade ex-dividend one business day prior to the record date (i.e., record date minus one business
day). So ultimately, an individual who purchases a stock for regular-way settlement (trade date + 2
business days, or T + 2) either on or after the ex-dividend date will not be entitled to the quarterly cash
dividend since he will not own the stock by the record date (i.e., the trade will not settle in time).
MAY 20XX
S M T W Th F S
1 2 3 4 5 6 7
8 9 10 11 12 13 14
Ex-Dividend Record
Date Date
On Monday, April 25, the board of directors of XYZ Corporation declares a $.60 dividend
which will be paid on Friday, May 27, to all stockholders of record as of May 12. The stock
will trade ex-dividend on Wednesday, May 11 (one business days prior to the record date).
Assuming a two business day settlement, any trade executed on May 11 will not settle until
May 13 (the day after the record date). Therefore, investors who purchase XYZ stock on or
after May 11 will not be entitled to the dividend.
The ex-dividend date represents the first day that a stock begins to trade without its dividend. Therefore,
on the ex-dividend date, the stock’s price will be reduced by an amount equal to the dividend to be paid.

For example, if a stock paying a $.50 dividend closes at $20 per share on the day before the ex-date, it will
open at a price of $19.50 on the ex-dividend date. For any dividend that’s in a fractional amount, the
reduction must cover the full dividend (i.e., a dividend of $.12 ½ results in a reduction of $.13).
Due Bills If a trade is executed prior to the ex-dividend date, the buyer is entitled to the dividend.
However, if the seller fails to deliver the securities by the record date (and the trade doesn’t settle as it
should), the seller will remain as the shareholder of record for the dividend payment. The seller will
receive the dividend, but not be entitled to it. Therefore, good delivery rules require a due bill to
accompany the stock which creates a liability for the seller and a receivable for the buyer.
Using the calendar from the previous example with a record date of Thursday, May 12, if an investor
purchases stock on Tuesday, May 10, the transaction will settle in two business days—Thursday, May 12.
The buyer will receive the dividend because the transfer agent will be made aware of the name of the new
owner in time to change the shareholder’s record for the upcoming dividend. Because the stock trades ex-
dividend on Wednesday, May 11, from that date forward, the buyer will be able to purchase the stock at a
price that doesn’t include the dividend. A due bill will be required only if the buyer purchases the stock
before the ex-date, but the seller delivers the security after the record date.
A buyer may still obtain the dividend after the normal ex-date by purchasing the security and using a cash
(same day) settlement on a date up to and including the record date. In the preceding example, if the
investor buys for cash as late as Thursday, May 12, she’s entitled to the dividend. Therefore, for a cash
settlement trade, the ex-dividend date is the business day following the record date.
Ex-Rights Similar to ex-dividend, for the buyer of stock with rights attached to be entitled to participate
in the rights offering, the trade must have settled on or before the record date.
Settlement and Delivery for Equity Option Exercise
Deadlines for Standardized Option Contracts

Equity options are typically issued with expirations of up to nine months. All equity options expire at
11:59 p.m. Eastern Time (ET), on the third Friday of the expiration month. An expiring option will cease
trading at 4:00 p.m. ET on the same business day that it expires (Friday). Although the option doesn’t actually
expire until 11:59 p.m., a buyer must express her intent to exercise the option by 5:30 p.m. ET on the same
business day that it expires (also Friday).
These deadlines are summarized on the calendar on the following page.

S M T W T F S
1 2 3 4 5 6 7
Expiration
8 9 10 11 12 13 14 11:59 p.m. ET on the third
15 16 17 18 19 20 21 Friday of the expiration month
22 23 24 25 26 27 28
29 30
Exercise Notice Deadline
5:30 p.m. ET on expiration Friday
Ceasing of Trading
4:00 p.m. ET on expiration Friday
Exercising Options Contracts A member firm is allowed to accept an exercise notice after the OCC’s
cutoff time, but only in cases where errors have made been in good faith or where exceptional
circumstances exist relating to a customer’s ability to communicate with the member firm.
When the OCC receives exercise instructions from the firm that represents the purchaser, it will randomly
assign the exercise notice to a broker-dealer whose account shows a short option position that’s identical
to the long option position being exercised.
If a broker-dealer receives an assignment notice, it must select a client to whom the notice will be assigned.
There are three methods by which this selection may be accomplished—(1) using random selection, (2) using
first-in, first-out (FIFO), or (3) using any other method that’s deemed to be fair and equitable. Every
member firm must notify its clients as to which method is used and how it will be implemented.
An option that has not been exercised by the OCC’s cutoff time will expire worthless. However, at expiration, an
option that’s in-the-money by at least $.01 will be automatically exercised by the OCC.
Assignment Due to Exercise Remember, equity option trades settle on the next business day following
the trade date, or T + 1. On the other hand, since the exercise of an option involves the purchase and sale of
the underlying stock, settlement of an exercised option occurs in two business days (T + 2).
With index options, remember that there’s no physical delivery of shares at the time of exercise. Instead,
the writer of the option pays the buyer of the option an amount of cash that’s equal to the difference
between the contract’s strike price and index value (the in-the-money amount). This cash amount is due
one business day after the option is exercised.

Options Clearing
Corporation (OCC)  Broker-Dealer A
Issues the exercise notice to a broker-
dealer using Random Selection Broker-Dealer B
  Broker-Dealer C
Customer’s
Broker-Dealer 
Assigns the notice to a customer using:
1. Random Selection,
 2. FIFO, or
3. Another fair and equitable method
Long 1 ABC Feb 60 Call Short 1 ABC Feb 60 Call
Clearing Options Contracts

The Options Clearing Corporation is responsible for clearing option trades. Additionally, the OCC guarantees
that a buyer will be able to exercise her right in the event of a deficiency (e.g., bankruptcy) on the part of a
writer. In essence, the OCC removes counterparty risk from standardized options transactions by acting as
a seller for every buyer and a buyer for every seller.
Conclusion
This concludes the discussion on settlement and regulatory reporting. The final chapter will focus on how
errors and disputes with broker dealers are handled.

CHAPTER 20
Resolving Disputes
and Suitability
Key Topics:
 Erroneous Trades
 Customer Complaints
 Dispute Resolution
 Required Disclosures
 Suitability
CHAPTER 20 – RESOLVING DISPUTES AND SUITABILITY
Mistakes happen and, at times, RRs and customers disagree. This chapter will cover the process of trade
corrections and will describe the steps that must occur in the event of a customer complaint. If a
complaint cannot be amicably resolved, the dispute resolution procedures between firms and their
customers will also be examined.
The last section of this chapter will provide an overview of the suitability of recommendations. After
describing the characteristics of the various products throughout this study manual, it’s time to connect
customers to these products. The focus will be on identifying a customer’s needs and objectives and then
offering her the best available securities product(s).
Errors
Execution Errors
After examining a confirmation, either the customer or the registered representative may detect an error.
For example, the RR may have purchased or sold the wrong security or may have bought or sold the
wrong quantity of a given stock. Once the error is discovered, the procedures to be followed depend on
the nature of the error and the firm’s own policies. In general, however, registered representatives
should not make their own decisions as to how to correct the error. Instead, the RR should bring the mistake
to the attention of a supervisor.
Error Account
All broker-dealers are required to record any errors that are made by their RRs and must maintain an
error account. This account is used by a broker-dealer when the firm or an RR executes a trade in error
(e.g., the wrong security or the wrong side of the market). These error accounts are maintained by the firm
and not be the RRs themselves. All adjustments or cancellations that are routed through the error account
must be approved by a principal.
Cancel and Rebill

If a registered representative executes a transaction, but uses the wrong account number, this is an error can
be corrected. The appropriate procedure is to transfer the transaction to the correct account number with the
permission of a registered principal. This transfer process is often referred to as a cancel and rebill. In some
cases, the error is made using the correct account number for the client, but the wrong account (margin
account, rather than an IRA). A similar process is used to correct the error.
If there’s a cancel and rebill, corrected confirmations must be generated. The trade cannot simply be
transferred from one account to another. For example, if a trade was assigned in error to a client’s cash
account and subsequently placed into the client’s Roth IRA, two additional confirmations must be created.
One confirmation that signifies the cancelling of the original trade in the cash account and a second
confirmation placing it into the Roth IRA.

Trade Reporting Errors

Occasionally, an error may occur while completing the paperwork, rather than in the execution of the trade. For
example, if a client sold 1,000 shares of ABVC at $23.00, but the firm printed a confirmation that mistakenly
reported the execution of the sale at $43.00, the actual trade will stand. In other words, the client is
obligated to accept the actual execution. A corrected confirmation will be generated and sent to the client.
Clearly Erroneous Transactions

FINRA provides a mechanism for correcting or voiding transactions if one of the terms of the contract is
clearly in error. This rule was created as the result of a complaint from a FINRA member due to the fact that a
trade was executed 10 points away from the inside market (an obvious mistake), but the contraparty
refused to cancel the trade. Prior to the establishment of this rule, FINRA did not have the authority to adjust
such a transaction, even when the error was obvious.
FINRA defines the term clearly erroneous to refer to an obvious error in any term, such as price,
number or shares or other unit of trading, or identification of the security. FINRA will consider the
circumstances at the time of the transaction, the maintenance of a fair and orderly market, and investor
protection. This rule pertains to disruptions and extraordinary market conditions and not to unauthorized
trading or market manipulation.
The determination of a clearly erroneous execution is based on certain thresholds—one for exchange-listed
securities and another for OTC equity securities.
Numerical Threshold for Exchange-listed Securities

Normal Market Hours (9:30 a.m. to Outside Normal Market Hours
Reference Price: 4:00 p.m. ET) Numerical Guidelines Numerical Guidelines (Subject
Consolidated Last Sale (Subject Transaction’s % Difference Transaction’s % Difference from
from the Consolidated Last Sale) the Consolidated Last Sale)
Greater than $0.00 up to and
10% 20%
including $25.00
Greater than $25.00 up to and
5% 10%
including $50.00
Greater than $50.00 3% 6%
Multistock event – Filings involving
five to 19 securities by the same
10% 10%
member will be aggregated into a
single filing.
Normal market hours numerical Normal market hours numerical
Leveraged ETF/ETN securities guidelines multiplied by the leverage guidelines multiplied by the leverage
multiplier (i.e., 2x) multiplier (i.e., 2x)

FINRA may also expand the numerical guidelines due to a Multi-Stock Event involving 20 or more
securities whose executions occurred within a five-minute period or less. This is done to maintain a fair
and orderly market and to protect investors. For both market hours and outside market hours, FINRA uses
a threshold of 30% away from the reference price.
Numerical Threshold for OTC Equity Securities

Numerical Guidelines (Subject Transaction’s
Reference Price
Percentage Difference From the Reference Price)
$0.9999 and under 20%

Low end of range, minimum 20%
$1.0000 up to and including $4.9999
High end of range, minimum 10%
$5.0000 up to and including $74.9999 10%
$200.0000 up to and including $499.9999 5%
$1,000.0000 and above 3%
FINRA Rule 11893 governs clearly erroneous determinations involving transactions in OTC equity
securities. Although the rule is structured similarly to FINRA Rule 11892 that governs exchange-listed
issues, it uses different numerical guidelines when determining if a transaction is erroneous. Many of these
potentially erroneous transactions occur in periods of extreme market volatility, or are the result of system
malfunctions and/or disruptions.
At times, the determination of whether a given transaction price is erroneous involves more than simply
examining a pricing difference. When making a determination as to whether a given trade price is fair,
while also attempting to maintain fair and orderly markets, FINRA may choose to use alternative reference
prices in unusual circumstances and will examine other factors such as:
1. Whether the security was subject to a stock split or other corporate action,
2. Whether the stock was recently halted or resumed trading, or
3. Whether the security is an IPO
Procedures for Reviewing Transactions A member firm that receives an execution that it believes is
clearly erroneous must submit a written complaint within 30 minutes of the execution time. In the case of an
Outlier Transaction, a request may be made within 60 minutes after the transaction. An Outlier Transaction is a
transaction in the Nasdaq market in which the execution price of the security is greater than three times the
current numerical guidelines. A FINRA officer or Nasdaq official has the authority to declare a transaction null
and void. The officer will generally take action within 30 minutes after becoming aware of a transaction in an
exchange-listed security. In the case of an OTC equity security, the officer will take action as soon as possible,
but in all cases, by 3:00 p.m. on the next trading day.

Appeal Process Under this rule, a decision of a Nasdaq or FINRA officer can be appealed to the
Market Operations Review Committee (MORC) or the Uniform Practice Committee (UPC). The appeal
must be in writing and must be received within 30 minutes after the person making the appeal is given
notification. For exchange-listed securities, the decision will be made as soon as feasible, but generally on
the same trading day. On a request for an appeal made after 3:00 p.m., the decision may not be made later
than the next trading day. For OTC equity securities, the decision will be made as soon as feasible, but no
later than two trading days after the execution under review.
Resolving Problems
Even with the best policies and procedures, disputes still inevitably arise. Often these disputes begin with
the receipt of a customer complaint.
Complaints
FINRA defines a complaint as any written statement that’s made by a customer or any person acting on
behalf of a customer which alleges a grievance involving the activities of any person who is under the
control of a member firm in connection with the solicitation or execution of any transaction or the
disposition of securities or funds of that customer. The complaint may be delivered in any written format,
which includes letters, e-mails, instant messages, and text messages.
Once received, customer complaints must be forwarded to a principal who must review and initial the
complaint. Member firms are required to maintain a separate file of all written complaints in each office of
supervisory jurisdiction (OSJ) for four years. The file must contain a description of the actions taken by
the member as well as any correspondence regarding the complaint. A firm’s response to a customer’s
written complaint may be in either written or oral form. Interestingly, even if a member has not received
complaints, a complaint file (empty) must be maintained by the firm.
Code of Procedure
FINRA’s Code of Procedure describes the disciplinary process used in the event that a member firm or any
of its associated persons violate FINRA rules, SEC rules, or fail to pay dues or assessments.
Disciplinary Proceedings If a rule violation comes to the attention of the Department of Enforcement
and it believes that a member firm or associated person is responsible, the Department may request
authorization from the Office of Disciplinary Affairs to issue a complaint. The firm or person being named
in the complaint is referred to as the respondent. The respondent must file a response to the complaint
within 25 days of receiving it. However, if the respondent fails to answer within the required time, the
Department will issue a second notice. Failing to respond to the second notice within 14 days may be
treated as the respondent’s admission to the allegations in the complaint.

A respondent’s answer to a complaint may be to request a hearing; however, if a hearing is not requested,
the right to one is waived. The requested hearing is held before a Hearing Panel that consists of a Hearing
Officer and two panelists who are appointed by the Chief Hearing Officer. The Hearing Officer is an
attorney who is employed by FINRA, while the other members of the panel are persons who are associated
with, or retired from, member firms. These panelists have an expertise in the area under dispute and have
served on local and/or national FINRA committees. For preparation purposes, the Hearing Officer must
provide the respondent with 28 days advance notice of the hearing.
The Hearing Officer may call a prehearing conference to instruct the parties involved and to make the
process more efficient. Documentary evidence is generally submitted prior to the hearing, but the hearing
provides an opportunity for witnesses to give testimony. All witnesses who are under the jurisdiction of
FINRA must testify under oath. Within 60 days after the Hearing Panel has stopped accepting evidence, a
written decision must be rendered that was arrived at by majority vote.
At any time before the hearing has begun, the respondent may propose an offer of settlement to the
Hearing Panel. If accepted by the panel, the respondent waives the right to appeal. However, if the
respondent’s offer is rejected, the hearing will proceed to a conclusion.
Sanctions A Hearing Panel may impose the following penalties:

 Censuring a member firm or an associated person
 Fining a member firm or an associated person
 Suspending the membership of a firm or an associated person for either a definite period or until
specified conditions are met
 Expelling a member firm or cancelling its membership; revoking or cancelling the registration of an
associated person
 Suspending or barring an associated person from association with any member firm
 Imposing any other fitting sanction
If the registration of an associated person is suspended, cancelled, or revoked, that person may not be
associated with a member firm in any capacity—which includes clerical or ministerial positions.
Other than being barred or expelled, a sanction is effective 30 days after the respondent has received
notice of a final disciplinary action. A bar or expulsion is effective as soon as the decision is served on the
respondent. If a broker-dealer is suspended from membership, member firms must treat the firm in the
same manner that they treat non-members.
Appeals A significant component to the Code of Procedure is the ability to appeal decisions. Once a
decision has been rendered by the Hearing Panel, the respondent has 25 days to file an appeal with
FINRA’s National Adjudicatory Council (NAC). For cases in which the decision of the Hearing Panel is in
the favor of the respondent, the Department of Enforcement also has the same right of appeal to the NAC.
Ultimately, the NAC has both appellate and review jurisdiction. The filing of an appeal halts the decision
until the appeal process is exhausted. Upon review, the NAC has the power to affirm, modify, reverse,
increase, or reduce any sanction, or to impose any other fitting sanction.

A respondent has the right to appeal the NAC’s decision to the SEC. Finally, if dissatisfied with the SEC’s
decision, the matter may be brought before a federal court.
Appeals Process
Hearing Panel NAC SEC Federal Court
Dispute Resolution—Code of Arbitration

The Code of Arbitration establishes the process that’s used for the settlement of disputes between members
and other members, between members and any clearing corporation, or between member firms and persons
associated with a member, but not for disputes between a member firm and FINRA. For any disputes that
involve statutory discrimination or sexual harassment claims, using arbitration is not required.
When a representative signs his application for securities industry registration (Form U4), he agrees to a
statement that indicates, “I agree to arbitrate any dispute, claim, or controversy that may arise between me
and my firm, or a customer, or any other person, that is required to be arbitrated under the rules,
constitutions, or by-laws of the SROs indicated...”
If a public customer has a dispute with a member firm or a person associated with a member, arbitration
may also be used if it’s agreed to by the customer (based on the predispute agreement described below). A
customer may initiate arbitration by filing a Submission Agreement of Claim and paying the required
deposit fee. If arbitration is initiated, respondents may file a counterclaim against the other person.
Predispute Arbitration Clause Many new account forms contain a clause that obligates customers to
submit any disputes that arise with their RR or brokerage firm to binding arbitration. Industry rules require
arbitration clauses to be presented on the form in a certain format and with specific wording. If a firm
includes a predispute arbitration clause in its new account form, it must be highlighted and preceded by the
following disclosures:
 Arbitration is final and binding on the parties.
 The parties are waiving their right to seek remedies in court, including the right to a jury trial.
 Prearbitration discovery is generally more limited than, and different from, court proceedings.
 The arbitrator’s award is not required to include factual findings or legal reasoning, and any party’s
right to appeal or seek modification of rulings by the arbitrators is strictly limited.
 Typically, the panel of arbitrators will include a minority of arbitrators who were or are affiliated with
the securities industry.
Immediately before the signature line, there must be a highlighted statement that the agreement contains a
predispute arbitration clause. Also, a copy of the agreement must be given to the customer and the customer
must acknowledge its receipt either on the agreement or on a separate document.

Depending on the dollar amount of the dispute that arises, the National Arbitration Committee will appoint
a panel of one to three arbitrators to hear the dispute. If a customer is involved, a majority of the arbitrators
must be public arbitrators (those not affiliated with the securities industry) unless the parties agree
otherwise. Once notified of the composition of the panel, the customer has the right to reject the selection
of an arbitrator on a peremptory basis and has an unlimited number of challenges for cause.
After hearing the evidence, the arbitrators will make their determination and make awards as deemed
appropriate. All awards that are granted by an arbitrator must be paid within 30 days of determination or
penalties may be assessed on late payments. Unless the law directs otherwise, the findings of the
arbitrators are final for both members and customers.
Simplified Arbitration Simplified arbitration procedures are used if the amount in dispute doesn’t
exceed $50,000. In a simplified customer arbitration proceeding, one public arbitrator decides the case
based on written evidence and arguments, unless the public customer demands/consents to a hearing or the
arbitrator calls for a hearing. In a simplified industry arbitration proceeding, one public arbitrator decides
the case without a hearing, unless the demand for a hearing is made by either of the parties involved.
Mediation
Although arbitration has been favored as the method for resolving securities industry disputes due to being
less costly and time-consuming than litigation, it has actually become a victim of its own success. As the
process began to be used more frequently, there were increasing delays and, occasionally, a shortage of
qualified arbitrators. To address this issue, FINRA launched a mediation program to help resolve disputes
in an alternative form.
Mediation is an informal process in which the two parties to a dispute attempt to reach a mutually
acceptable resolution without resorting to arbitration or litigation. In addition to the two opposing parties, a
mediator participates as a neutral person who is knowledgeable about the securities industry and attempts to
facilitate the discussions and help the parties reach an agreement.
Once the two parties agree to use mediation, they select a mediator who is acceptable to both sides. Although
FINRA may initially suggest a mediator, the parties may also select one from a list that’s provided by FINRA
or they may select their own based on a mutual agreement. Once the mediator is selected, both parties then
provide the mediator with any information that they consider necessary in order to understand the dispute.
The parties subsequently meet with the mediator in an initial joint session, with each party presenting his
case to the other party and the mediator. Thereafter, the parties meet separately with the mediator in sessions
that are referred to as caucuses. In the caucuses, the mediator’s job is to help each party examine the
strengths and weaknesses of the case, consider the risks involved, and review the possible settlements or
resolutions. Unless authorized to do so, the mediator will not reveal the content of the discussions in a
caucus to the other side since those discussions are confidential.

The mediation process will continue until:

 The parties resolve the dispute through a written settlement
 The mediator declares an impasse in the belief that continuing is futile
 Either party or the mediator withdraws from the process in writing
Partial Success Possible Even if a settlement is not reached through mediation, the process may still be
considered beneficial. Often, the opposing sides reach a clearer understanding of the dispute through the
use of mediation, and any further action (e.g., arbitration) is often shorter and more efficient. Occasionally,
only part of a dispute will be settled through mediation, leaving only the more difficult matters to be
settled through arbitration.
The parties are not required to wait until the completion of the mediation process to begin arbitration;
instead, the two processes may run concurrently. Therefore, if mediation is unsuccessful, the arbitration
proceedings continue. As long as an arbitrator has not made a final decision, the mediation process may even
be started after arbitration has begun.
Arbitration versus Mediation

Arbitration Mediation
A hearing process at which two parties present their cases A negotiation process between two parties
Often more expensive and time-consuming than mediation,

May be less costly and quicker than arbitration
but usually cheaper and quicker than litigation
Parties must be willing to see strengths of the position of
Useful where the position of one or both parties is inflexible
the other side
A more informal process; in addition to evidence, parties
More formal process—testimony under oath
may consider feelings and look for creative solutions
Parties cannot unilaterally withdraw Either party may withdraw from the process
Mediator attempts to facilitate a resolution, but doesn’t

Arbitrator imposes a binding settlement
impose a settlement
Hearings are private, but the decision is public Process is private and any settlement is confidential
Disclosures Under Code of Arbitration – Updating Form U4

Certain arbitration outcomes must be disclosed on a registered person’s Form U4. Disclosure or updating a
Form U4 is required if a person has been convicted or charged, or pled guilty or no contest to any felony
or misdemeanor involving investments or an investment-related business or any fraud, false statements or
omissions, wrongful taking of property, bribery, perjury, forgery, counterfeiting, extortion, or a conspiracy
to commit any of these offenses.

A person who has been arrested, but has not yet been charged with a crime, is not required to report the
event on Form U4 or to FINRA. However, most firms require notification if a registered person was arrested
for any offense.
Form U5 After a registered person resigns or is terminated from a member firm, the firm is required
to notify FINRA within 30 days on Form U5 and must provide the applicable details. A copy of Form
U5, which includes the reason the person has left the firm (voluntary or mandatory), must also be
provided to the person. Within 30 days following termination, if answers to certain questions change,
the form must be updated.
If a broker-dealer receives a written customer complaint after an RR has left the firm, it’s still required
to notify FINRA regardless of how long ago the RR had left the firm. However, there’s no requirement
to send a copy of the complaint to the former RR. If an individual wants to return to a brokerage firm as
a registered representative without having to requalify by examination, she’s required to do so within a
two-year period.
Form U6 Regulators, states, and/or jurisdictions use Form U6 to report disciplinary actions against
an RR or firm. FINRA also uses Form U6 to report final arbitration awards against RRs and firms. As
is the case with Form U4 and U5, any information that’s processed on this form feeds into the Central
Registration Depository system and some of the content may be available to the public through
FINRA’s BrokerCheck system.
The Central Registration Depository (CRD) The CRD system is an automated database that
contains information concerning the employment and disciplinary histories of registered persons. This
system is also used to process both registration and withdrawal applications for agents and broker-dealers
at the state level. If any information on an individual Form U4 changes, an amendment to the CRD
system must be filed promptly.
Release of Disciplinary Information Information about the disciplinary history of a member firm or
registered representative is available to the public through FINRA’s public disclosure program
(BrokerCheck). BrokerCheck provides information on individuals who are currently registered or have been
registered within the last 10 years. This information is on file with the Central Registration Depository and can
be obtained through a toll-free telephone number or the website of FINRA Regulation. The information
provided about individuals includes the following:
 The current employing firm, 10 years of employment history, and all approved registrations
 Certain legal and regulatory charges and actions brought against the RR, such as felonies, certain
misdemeanors and civil proceedings, and investment-related violations
 Pending customer-initiated arbitrations and civil proceedings involving investment-related activities, any
arbitrations or civil proceedings that resulted in an award to a customer, and settlements of $15,000 or
more in an arbitration, civil proceeding, or complaint involving investment-related activities
 Written customer complaints alleging sales practice violations and compensatory damages of $5,000
or more that were filed within the last 24 months

 Formal investigations involving criminal or regulatory matters

 Terminations of employment after allegations involving violations of investment-related statutes or rules,
fraud, theft, or failure to supervise investment-related activities
If a person who is currently registered disagrees with any information found on BrokerCheck, he must file an
amended Form U4 with FINRA. If an individual is not currently registered with FINRA (but was registered
within the last 10 years), he may submit a Broker Comment Request Form with FINRA to provide an update
or add context to the information that’s made available on BrokerCheck.
Investor Education FINRA’s Investor Education and Protection Rule requires member firms, at least
once every calendar year, to provide to each customer with written disclosure of the following:
 FINRA Regulation’s Public Disclosure Program (BrokerCheck) hotline number
 FINRA website address
 A statement regarding the availability of an investor brochure that includes information describing
FINRA BrokerCheck
However, any member that doesn’t carry customer accounts and doesn’t hold customer funds or securities
is exempt from these provisions.
Expungement What happens if information in the CRD system is incorrect? FINRA has established
procedures that arbitrators must follow before the removal (expungement) of customer dispute-related
information in connection to arbitration cases from an RR’s CRD record. This removal of information
from the CRD system is permitted only if:
 The claim, allegation, or information is factually impossible or clearly erroneous.
 The registered person was not involved in the alleged investment-related sales practice violation, forgery,
theft, misappropriation or conversion of funds.
 The claim, allegation, or information is false.
Once information is removed from the CRD system, it’s permanently deleted and is no longer available to
the investing public (through BrokerCheck), regulators, or prospective employers.

Suitability
This final section is designed to provide students with a process that may be used to break down and
decode suitability questions on the Series 7 exam. For exam purposes, the concept of suitability can be
simplified into two important concepts:
1. Know your customer
2. Know your products
When dealing with suitability questions, students must identify the customer’s investment objective(s),
time frame, and appropriate risk level. Additionally, for each of the given product choices, students must
also analyze their purpose, time frame, and risk level.
To handle suitability questions, we suggest the following step-by-step approach:

 Step 1. Review the table which lists various investment objectives and appropriate products.
 Step 2. Review the tables which provide the details of different investment products.
 Step 3. Work through the examples that are provided.
 Step 4. Work through the remaining questions using a blank worksheet.
 Step 5. After breaking down and solving each question, check your answer and review the
explanation which is provided at the end of the section.
To Determine the Suitability of an Investment, Consider the Customer’s:

Investment Objective
 What does the customer want to accomplish with the investment?
− Common objectives include long-term growth, current income, safety of principal, tax benefits,
speculation, and short-term capital preservation.
Time Frame
 Some investments are more suitable for long-term needs, while others are more suitable for
short-term needs.
Risk Tolerance
 Some investors will accept more risk than others when attempting to meet their objectives.
− Risk tolerance is often affected by time frame:
• If the investment period is long, investors can typically afford to take more risk.
• If the investment period is short, investors will typically take less risk.
Age (which impacts both time frame and risk tolerance)
 Younger investors typically take a long-term approach and can afford to take more risk in exchange
for higher long-term returns.
 Older investors have shorter time horizons and therefore should seek more stable investments.
− Equity securities are considered riskier and more appropriate for long-term growth.
− Bonds are considered safer and more appropriate for current income.

− A common rule for determining asset allocation is (100% – Age) = % of growth or equity
investments (with the remaining % as income or bond investments).
− Tax implications for retirement: 10% penalty for withdrawals before age 59 ½; 50% penalty for
failing to take RMD by age 70 ½; etc.
Investment Objectives and Suitable Investments

Long-Term Growth Short-Term Capital Preservation
Longer time horizon; greater volatility Money-Market Instruments
 Common stock  Money-market mutual funds
 Growth stock  T-bill
 ADR  Bankers’ acceptances
 Growth fund  Commercial paper
 Stock fund  For investors in a high tax bracket:
 Index fund − Municipal notes (RAN, BAN, etc.)
 Stock ETF
Tax-Advantaged Investments
High Tax Bracket
Growth and Income  Tax-exempt income
Less volatility; reduced earnings − Municipal bond
 Tax-deferral
 Mix of stocks and bonds − Annuities
 Balanced fund − IRA and retirement plans
 Convertible bond − Education savings plans
 REIT  Tax credits/deductions
− DPPs/limited partnerships
Income Aggressive Growth or Income

Least volatility High risk, high reward
 Income fund  High-yield bond
 Bonds and bond funds  Sector fund
 Preferred stock  CMO support/companion tranche
 Utility stock  Business development company (BDC)
 Wildcatting limited partnership (DPP)
 Raw land limited partnership (DPP)
 Small/micro-cap stocks and funds
Safety
Low Credit Risk Speculation
 U.S. Treasury Active, short-term speculation
 Agency debt  Option strategies
 Investment-grade corporate and  Leveraged ETF
municipal debt  Short stock positions

PRODUCT CHARACTERISTICS SUITABILITY

− Corporate ownership − Suitable for investors seeking long-term
− May pay dividends growth (capital appreciation) and the
 Large Cap: least volatility/least growth opportunity to outpace inflation
Common potential
Stock  Mid Cap: more volatility/more growth
potential − Unsuitable for short-term investors or those
 Small Cap: most volatility/most growth seeking safety of principal
potential
− Pays fixed dividend, but doesn’t share in − Suitable for investors seeking stable dividend
earnings growth income with returns that are comparable to
Preferred − Receives dividends before common long-term bonds
Stock − Has no voting or preemptive rights
− Subject to inflation (purchasing power) risk and − Unsuitable for investors seeking capital
interest-rate risk appreciation
− Suitable for investors seeking long-term

− More volatile (risky) than most stocks; has a growth and retirement savings; good hedge
Growth high beta against inflation
Stock − Offers little or no dividend income
− Low dividend payout ratio and high P/E ratio − Unsuitable for investors seeking income or
short-term investing due to its greater volatility
− Suitable for investors seeking stable dividend
− Company has stable earnings and the stock is income (e.g., older or retired investors)
Utility
less risky than most stocks (has a low beta)
Stock − Unsuitable for investors seeking a growth
− High dividend payout and low P/E ratio
investment
− A receipt of ownership (equity) in a foreign − Suitable for investors seeking to invest in

American corporation foreign companies (similar to U.S. common
Depositary − Trades in the U.S. market and in U.S. dollars stock)
Receipt − Must be SEC registered, unless exempt − Unsuitable for investors unwilling to take on
(ADR) − Subject to market and exchange-rate risk the risk associated with investing in foreign
− May pay dividends companies (e.g., political risk; exchange risk)
− Provides stable (fixed) interest income − Suitable for older and/or more conservative
− Conservative, less risky than equities investors who want consistent income
− Subject to inflation (purchasing power) risk,
Bond
interest-rate (market) risk, default (credit) risk,
reinvestment risk − Unsuitable for investors seeking a growth
− Longer maturities have more risk investment

− May be secured or unsecured − Suitable for investors seeking current income

− Price fluctuation is influenced by length of for a specific period
Corporate
maturity and interest rate/coupon − Unsuitable for investors seeking growth or
Bond
− Interest rate is generally fixed and the interest capital appreciation or those who are in a high
is fully taxable tax bracket
− Suitable for investors seeking income with the
− Convertible into a fixed number of common potential for long-term growth (the relative
shares safety of a bond, with the growth potential of
Convertible
− Offers lower interest rate than non-convertibles the underlying stock)
Bond
− For parity purposes, its price is influenced by
the value of the underlying stock − Unsuitable for investors seeking high income
or those with short-term objectives
− Issued at a deep discount, but matures at par − Suitable for investors seeking an investment
value that’s less risky than equities and provides
− Makes no interest payments predictable growth (used for retirement
− Bond’s basis is accreted and treated as interest planning or college funding)
Zero-Coupon
income
Bond
− Discount is taxed annually for corporates, and
− Unsuitable for investors seeking current
tax-exempt for municipal (OID) bonds
income or if the level of inflation or interest
− Has a high degree of interest-rate and inflation
rates are rising
risk, but no reinvestment risk
− High risk bond with a speculative rating − Suitable for high-risk, speculative investors
High-Yield Bond
− Offers a higher coupon
(Junk Bond)
− Includes Income (Adjustment) Bond − Unsuitable for conservative investors
− Short-term debt (one year or less to maturity) − Suitable for investors seeking conservative
with very low yields investments for short-term needs; used to hold
− Very safe and liquid investments funds safely until needed or invested for a
Money Market
− Examples include commercial paper (CP), longer term
Instruments
bankers’ acceptance (BA), short-term
negotiable CDs, repurchase agreements − Unsuitable for investors seeking long-term
(REPOs) growth and/or income
− Pays federally tax-exempt interest − Suitable for investors in high tax brackets and
− Price fluctuation is influenced by length of seeking tax-exempt interest income
maturity and interest rate
Municipal
− G.O. bonds typically have less credit risk than − Unsuitable for growth investors or those in
Bond
revenue bonds low tax brackets or with low incomes; should
− Due to tax exemption, pays lower coupon than not be included in an IRA or other tax-deferred
a comparable corporate bond account


− Issued by municipalities to help expand − Suitable for investors seeking a higher yielding
economic development municipal bond and are not subject to the
− All or part of the bond proceeds benefit a alternative minimum tax (AMT)
Private Activity/
private entity or corporation
Industrial
− Rating is based on the entity/corporation
Development Bond
− For investors who are subject to the AMT, the − Unsuitable for investors who are subject to the
interest may be taxable; therefore, it typically AMT since the interest may be taxable
pays a higher interest rate
− Safe and liquid short-term municipal debt − Suitable for investors in high tax brackets who
(typically a money market instrument) are investing for short-term needs
Municipal
− Pays federally tax-exempt interest − Unsuitable for investors seeking long-term
Note
− Offers a low yield investments or those who are in low tax
− Examples include: RAN, TAN, BAN, GAN bracket
− Long-term debt with short-term trading features − Suitable for conservative investors seeking
Variable Rate − Lower yield, but greater liquidity than an auction income
Demand rate security
Obligation − Interest rate is reset to current short-term rate
(VRDO) periodically (e.g., weekly or monthly) − Unsuitable for investors seeking growth
− Investor may put bond to issuer at reset
− Low risk of default; low interest payments − Suitable for investors seeking fixed income
− Subject to inflation and interest-rate risk and safety of principal
Treasury Note and − Note maturities are from 2-10 years
Treasury Bond − Bond maturities exceed 10 years
− Interest income is exempt from state and local − Unsuitable for investors seeking growth or
tax (subject to federal) capital appreciation
− Suitable for investors seeking absolute safety

− Short-term and liquid (a money-market of principal who are willing to accept a very low
Treasury instrument) return
Bill − Safe investment with low yield
− Maturities of up to one year − Unsuitable for investors seeking growth or
capital appreciation
− A conservative long-term income investment − Suitable for investors seeking a hedge

which provides protection from inflation against inflation
Treasury Inflation
(purchasing power) risk
Protected Security
− Pays a low rate of interest at a fixed rate, but is
(TIPS) − Unsuitable for investors seeking growth or
based on a principal amount that’s adjusted for
inflation (the income is therefore variable) higher income


− Safe and conservative investment created from − Suitable for investors seeking to receive a
T-notes and T-bonds that had their interest and fixed sum of money to satisfy a future expense
principal payments separated and resold as (for long-term saving, planning for retirement,
Treasury zero-coupon securities or college funding)
STRIPS − Pays a fixed lump-sum at maturity
− Offer a wide range of maturities from 2 to 30 − Unsuitable for investors seeking current
years income or during times where inflation or
− Subject to inflation (purchasing power) risk interest rates are rising
− Pass through debt certificates that make − Suitable for investors seeking safety, monthly
monthly payments of both principal and interest interest income, and a yield that’s slightly higher
(fully taxable) which are derived from residential than U.S. Treasuries
Government
mortgage payments
Agency Mortgage
− Issued by federal agencies or government-
Backed Securities − Unsuitable for investors who want a fixed
sponsored enterprises; considered AAA rated
− Due to prepayment risk (mortgages being paid maturity or stable cash flows
off early), the maturity is uncertain
− Suitable for investors seeking monthly income,

− Privately issued, mortgage-backed bond that and customized prepayment risk
Collateralized
uses the principal and interest collected on
Mortgage
mortgages to fund various bond classes − Unsuitable for investors seeking growth or
Obligation (CMO)
(tranches); provides monthly income less sophisticated investors unfamiliar with
CMO tranches and associated risks
− Suitable for investors seeking monthly income

Planned − A CMO tranche that provides investors with the payments, with predictable payment structure
Amortization most predictable payments (i.e., the least and maturity
Class (PAC) prepayment risk)
− Unsuitable for investors seeking growth or
high yields
− Suitable for investors willing to take on a high

degree of prepayment risk due to changing
Support/ − A CMO tranche which has the most interest rates in exchange for a higher yield
Companion prepayment risk, variability in payments, and
Tranche unpredictable maturity
− Unsuitable for more conservative clients or
those seeking growth


− Suitable for investors with long time horizons
− The last CMO tranche to be paid (longest
and who need future savings
maturity)
Z Tranche
− Receives no payments until all other tranches
− Unsuitable for investors seeking current
have been paid off
monthly income or growth
− Suitable for investors who speculate on short-

− Allows investors to speculate on the price term price fluctuations
Long Options movement of a stock without the capital outlay  Long calls for bullish speculation
(Buying Calls of buying the shares outright  Long puts for bearish speculation
or Puts) − Unlike stock purchases, options are short-term
and may expire worthless − Unsuitable for investors seeking income or
those who cannot afford a total loss of capital
− Option seller accepts potential future obligation − Suitable for sophisticated investors willing to
in exchange for premium income accept substantial risk in exchange for premium
Short Options income
− Income is limited to the premium (if the option
(Selling Calls
expires worthless)
or Puts) − Unsuitable for investors who cannot assume
− Potential future loss may be substantial, or
even unlimited substantial risk
− Buying both a call and a put on the same stock − Suitable for investors seeking to speculate on
to speculate on price volatility short-term price volatility; neither bullish nor
 Straddle = same stock, expiration, and bearish
Long Straddle or strike price
Long Combination  Combination = same stock, with different
expirations and/or strike prices − Unsuitable for investors seeking income or
− Loss of combined premiums occurs if price those who cannot afford loss of capital
remains stable
− Selling both a call and a put on the same stock − Suitable for sophisticated investors
to generate income of the combined premiums speculating on short-term price stability and
 Straddle = same stock, expiration, and able to accept substantial risk
Short Straddle or strikes
Short Combination  Combination = same stock, with different
expirations and/or strikes − Unsuitable for investors who cannot assume
− Potential future loss may be substantial or even substantial risk
unlimited


− The sale and purchase of the same type of − Suitable for investors seeking to speculate on
option on the same stock small, short-term price movements
− The premium paid is greater than the premium  Debit call spreads are bullish
received (creating a net debit)  Debit put spreads are bearish
Debit Spreads
− The net premium is the buyer’s maximum loss,
while the maximum gain is the difference in the
− Unsuitable for investors expecting large price
strike prices minus the net premium (gain and
movement or seeking unlimited gains
loss are limited)
− The sale and purchase of the same type of − Suitable for investors seeking to generate
option on the same stock short-term income with limited risk; greatest
− The premium received is greater than the profit realized if options expire
premium paid (creating a net credit)  Credit call spreads are bearish
Credit Spreads  Credit put spreads are bullish
− The net premium is the seller’s maximum gain,
while the maximum loss is the difference in the
strike prices minus the net premium (gain and − Unsuitable for investors expecting large price
loss are limited) movement or seeking unlimited gains
− Suitable for investors seeking to limit a short-

− A put purchased on a long stock position term loss on the stock position while still
− Used to significantly protect (hedge) the participating in potential gains (gain on stock is
Protective Put downside risk of the stock reduced by premium paid)
− If the stock falls in value, the option position will
gain value − Unsuitable for investors seeking to generate
income
− Suitable for investors seeking a conservative

− A call sold against a long stock position income generating strategy, with risk exposure
− Generates income (the premium) and lowers that’s less than holding the stock without the
the cost of the stock by the premium received option (due to the premium received)
Covered Call
− Upside potential is limited (if the call is
exercised), while the downside risk is still − Unsuitable for investors who believe that the
substantial stock has significant upside potential or those
who want protection
− A call purchased to hedge a short stock − Suitable for investors seeking to limit a short-
position term loss on the short stock position, while still
− Used to significantly protect (hedge) the upside participating in potential gains (downside gain is
Protective Call minimized by the premium paid)
risk of the stock position
− If the stock rises in value, the option position will
− Unsuitable for investors seeking to generate
gain value
income


− The sale of a put against a short stock position
− Generates income, but limits the potential gains
− Suitable only for sophisticated investors who
on the short if it declines and the put is
Covered Put are able to afford the potential loss resulting
exercised
from the rising value of a short stock position
− The potential loss is unlimited since the stock’s
value could rise an infinite amount
− Distributes passive income and passive losses − Suitable for investors who are able to afford
to its partners significant risks and commit capital for the long
Direct Participation
− May provide tax deductions and tax credits term
Program (DPP)
− Offers limited liability to limited partners
Limited
− Illiquid and subject to the adverse effects of tax − Unsuitable for investors with short-term needs
Partnership
law changes for liquidity or who cannot benefit from various
− Risk of IRS recapturing tax benefits tax credits/deduction
− Offers shares of a portfolio that’s diversified

− Suitable for investors seeking to invest in a
based on the type of fund
diversified portfolio of securities rather than
− Less risky and easier than buying individual
creating their own
securities
Mutual Fund − Priced once per day (forward pricing)
− Fund will redeem shares at NAV; there’s no
− Unsuitable for investors who are interested in
secondary market
speculation or short-term trading due to the
− Suitability varies based on objectives and share
associated transaction costs (sales charges)
class
− A managed portfolio consisting of common

stocks which have strong upside potential
− Suitable for investors willing to accept the risk
Growth Fund − May pay little or no dividends
associated with long-term growth
− Risk is determined by types of companies
included (large-, mid-, small-cap)
− A managed portfolio that primarily consists of

bonds, preferred stocks, and possibly high
Income Fund dividend paying common stocks − Suitable for investors seeking current income
− Price is less volatile than growth funds
− Offers a high dividend yield
− A managed portfolio that invests in one specific

Specialized/ industry or geographic area − Suitable only for aggressive investors who are
Sector Fund − The least diversified type of fund seeking a higher return
− Higher risk with higher potential returns


− A diversified and managed portfolio that
Balanced − Suitable for conservative investors seeking
consists of both stocks and bonds
Fund both long-term growth and current income
− Provides both growth and current income
− A managed portfolio that consists of stocks of

International foreign corporations − Suitable for investors seeking to diversify into
Stock Fund − Shares are priced in U.S. dollars, with foreign stocks
dividends paid in U.S. dollars
− A passively managed fund that buys and holds

− Suitable for investors seeking a low-cost
securities that mirror a specific index (e.g., the
Index Fund alternative to more actively managed funds with
S&P 500)
similar objectives
− Low expense ratio
− Suitability is based on the type of ETF
− Offers shares that track an index and trade in
investment made
the secondary market like common stock
 Traditional ETFs are suitable as a low cost
− Unlike mutual funds, shares are priced and
Exchange Traded and long-term investment (like mutual
traded in real-time on an exchange
Fund (ETF) funds)
− May be sold short and purchased on margin
 Non-traditional ETFs (i.e., leveraged and
− Variations include high risk leveraged and
inverse) are suitable for short-term trading
inverse ETFs
and speculation
− Similar to an ETF; however, it’s considered
unsecured debt; subject to default risk
− Suitable for investors seeking to add
Exchange Traded − Often tracks the performance of an exotic mix
diversification in their portfolio and those who
Note (ETN) of assets (e.g., foreign stocks and illiquid
want a speculative investment
markets)
− May be sold short and purchased on margin
− Issues a limited number of shares which are

− Suitable for investors seeking to invest in a
Closed End priced and traded in real-time (not redeemable)
diversified portfolio with short-term trading
Fund − Share price is not based on NAV; instead, it’s
capabilities; similar to ETFs
set in market by supply and demand
− An unregistered closed end investment

− Suitable for aggressive investors who are able
company that invests in developing companies
Business to withstand short-term volatility and/or for
(often private companies and startups that are
Development those seeking an investment that’s often only
not available to the average investor)
Company (BDC) available to large private equity funds; investors
− More volatile than most mutual funds, with high
seeking high dividends
potential reward


− A portfolio consisting of income producing
properties and/or mortgages
− Suitable for investors seeking high dividend
Real Estate − Distributes 90% of its net income to investors,
yield and willing to accept the price volatility
Investment Trust but doesn’t distribute losses
associated with the value of the underlying
(REIT) − Dividends are taxed as ordinary income (non-
properties
qualified)
− Not considered an investment company
− A private investment fund that’s not subject to

the Investment Company Act of 1940 (i.e., NOT − Suitable only for sophisticated investors who
an investment company) can afford the increased risk and potential loss
Hedge Fund
− May use exotic strategies that involve short of capital; must be able to tie up funds for the
selling, leverage, and derivatives long-term
− Doesn’t publish its daily NAV; illiquid
− An investment contract with an insurance − Suitable for investors seeking tax-deferred

company; risk assumed by annuitant retirement savings or the potential for lifetime
− Can be set up to provide periodic payments for payments
life
Variable Annuity − Income grows tax-deferred until paid out
− Risk and return are based on the investments
− Unsuitable for older investors or those seeking
chosen in the separate account (investments
fixed payments
may be adjusted to suit the investor’s age and
risk profile)
− An investment contract with an insurance
− Suitable for investors seeking lifetime income
company, risk assumed by ins. company
payments after retirement, with the
Fixed Annuity − May provide fixed payments for life
understanding that the fixed rate of return may
− Income grows tax-deferred until paid out
not keep up with inflation
− The investment return is at a fixed rate
− A tax deferred investment account; may be − Suitable for persons with earned income who
Individual funded by persons with earned income are saving for retirement
Retirement − Withdrawals are taxed as ordinary income
Account (IRA) − Penalty is assessed for early withdrawal − Unsuitable for persons with no earned income
− RMD applies (e.g., already retired)
− A tax-free investment account available to − Suitable for persons with earned income
persons with earned income (below the limit) who are saving for retirement
− Income limits are imposed on contributors (not and want future tax-free withdrawals
ROTH IRA available for high income persons)
− Qualified withdrawals are tax-free − Unsuitable for persons with no earned income
− Penalty is assessed for early withdrawal (e.g., already retired)
− RMD doesn’t apply

− A tax-free investment account established to

help pay a child’s education expenses
− Income limits are imposed on contributors
Coverdell − Suitable for investors saving for a child’s
− Withdrawals are tax-free if used for qualified
Education Saving education expenses, including elementary,
education expenses (at any level of education)
Account (CESA) secondary, or higher education
− Penalties and taxes are assessed if the funds
are not used for education
− Change of beneficiary is allowed
− A tax-free investment account established to

help pay higher education expenses − Suitable for investors saving for a child’s
− No income limits are imposed on contributors higher education expenses (college funding)
529 College − Withdrawals are tax-free if the funds are used
Savings Plan for qualified higher education expenses
− Penalties and taxes are assessed if the funds − Unsuitable for investors saving for a child’s
are not used for education elementary or secondary school expenses
− Change of beneficiary is allowed

Breaking Down Suitability Questions

Review the Question
1. An investor is in her mid-30s and is interested in saving for retirement. She has a high risk tolerance
and wants to outpace inflation. Which of the following is the most suitable investment?
a. A CMO
b. A zero-coupon bond
c. A utility stock
d. A mid-cap stock fund
Question Stem Breakdown

An investor is in her mid-30s and is interested in saving for retirement. She has a high risk tolerance
and wants to outpace inflation. Which of the following investments is the most suitable?
Q: Ask yourself, what’s the investor’s main investment objective?

A: Saving for retirement (She needs growth, NOT income)
Q: What’s the time horizon?
A: The investor is in her early 30s (Her time horizon is long-term)
Q: What level of risk / return is appropriate?
A: She has a high risk tolerance and wants to outpace inflation.
(She’s willing to accept above average risk to obtain above average returns)
Conclusion: Client needs an aggressive, long-term, growth investment.
Answer Choice Characteristics

a: A CMO
‒ Debt instrument that pays principal and interest on a monthly basis
‒ Income investment with an uncertain maturity
b: A zero-coupon bond
‒ Bond that’s issued at a deep discount and pays par at maturity
‒ Grows at a fixed rate
c: A utility stock
‒ Stable stock which provides a steady dividend
‒ Provides income with low risk
d: A mid-cap stock fund
‒ A mutual fund that holds mid-cap stocks (growth)
‒ Provides long-term growth that’s expected to outpace inflation
Conclusion
Choices (a) and (c) are typically suitable for investors seeking income, not growth. Choice (b) is a more
conservative investment with a higher degree of inflation risk. Therefore, choice (d)—A mid-cap stock
fund—is the best answer since it provides long-term growth and is a good hedge against inflation.

Review the Question

2. An investor has been heavily invested in gold. Now that he has 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?
a. Buying a CMO Z tranche
b. Selling equity options
c. Buying preferred stock
d. Buying common stock

An investor had previously been heavily invested in gold. Now that he has 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?

A: Help to pay expenses (He needs an income investment, not growth)
A: He has retired (He needs income both now and for the foreseeable future)
A: He has retired (He needs a low risk investment/strategy to preserve assets)
Conclusion: Client needs a relatively safe, income-producing investment.

a: Buying a CMO Z tranche
‒ CMO tranche with longest maturity which is last tranche to be paid
‒ Doesn’t provide monthly income
b: Selling equity options
‒ High-risk option strategy that’s used to generate income (the premium)
‒ Provides income, but only good for aggressive investors willing to assume great risk
c: Buying preferred stock
‒ Non-voting stock that provides a stable dividend
‒ Provide a fixed income until they’re sold by the investor (has no maturity)
d: Buying common stock
‒ Voting stock that shares in earning growth as well as possible dividends
‒ Considered a long-term growth investment
Conclusion
Choices (a) and (d) don’t provide regular income. Choices (b) and (c) provide income; however, choice
(b) is extremely risky and unsuitable for most investors (it’s assumed that the options are uncovered).
Therefore, choice (c)—buying preferred stock—is the most suitable since it provides steady income.

Review the Question

3. A customer wants to add cash flow to his portfolio, but doesn’t want to take an excessive amount of
risk. Which of the following should an RR recommend?
a. Income bonds
b. High yield bonds
c. Investment grade debentures
d. T-STRIPS
Question Stem Characteristics

A customer wants to add cash flow to his portfolio, but doesn’t want to take an excessive amount of
risk. Which of the following should an RR recommend?

A: To add cash flow to his portfolio (He needs current income, not growth)
A: Time horizon is immediate
A: He doesn’t want to take an excessive amount of risk (Average to low risk; nothing aggressive)
Conclusion: Client needs an investment grade, fixed-income product
Answer Choice Breakdown

a: Income bonds
‒ A bond that only pays interest if the issuer has sufficient income
‒ Very risky junk bond that’s not suitable for income or growth
b: High yield bonds
‒ A speculative grade bond (junk) which offers a high yield, but with high risk.
‒ Provides high income, but is very risky
c: Investment grade debentures
‒ Unsecured corporate bond of good quality (Investment Grade)
‒ Provides fixed income with average to low risk
d: T-STRIPS
‒ Zero coupon Treasury, no income pays par at maturity
‒ Provides fixed growth for a specific time, not for income
Conclusion
Choice (a) is typically issued by a distressed corporation and is generally only suitable for high risk,
speculative investors. Choice (b) provides high income, but is also high-risk. Since choice (c) is
investment grade, it pays a lower yield, but it also has lower risk. Choice (d) is an investment that
provides predictable growth (similar to a zero-coupon bond), but not income. Therefore, choice (c)—
Investment grade debentures—is the best answer since they provide income without excessive risk.

Review the Question

4. A retired couple has substantial savings in various accounts and tells their RR that they fear running
out of retirement money. They’re hoping to live a long life together and want to be assured that their
money will not run out early. Which of the following recommendations should the RR make?
a. Fund a Traditional IRA
b. Fund a lump-sum immediate annuity
c. Fund a periodic payment deferred annuity
d. Fund a 529 plan

A retired couple has substantial savings in various accounts and tells their RR that they fear running out
of retirement money. They’re hoping to live a long life together and want to be assured that their
money will not run out early. Which of the following recommendations should the RR make?
Q: Ask yourself, what’s the couple’s main investment objective?
A: To be assured that their money will not run out early (They need guaranteed payments for life)
A: They’re hoping to live a long life together (Time horizon is indefinite/lifetime)
A: They’re a retired couple (They need low risk and low volatility)
Conclusion: Clients need an investment that will provide income until death

a: Traditional IRA
‒ Requires one spouse to have earned income
‒ No contributions after age 70 ½
b: Lump-sum, immediate annuity
‒ A lump sum is invested and immediately annuitized
‒ Provides lifetime income (fixed or variable); requires significant lump-sum investment
c: Periodic payment, deferred annuity
‒ Money is invested over time and annuitized in the future
‒ Long-term savings for retirement planning; not started after retirement
d: 529 plan
‒ State-sponsored, college savings plan which offers tax-free earnings
‒ For education savings, not for retirement
Conclusion
Choices (a) and (c) are for retirement savings, but are not funded after retirement. Choice (d) is for
education, not retirement. Therefore, Choice (b)—Lump-sum, immediate annuity—is the best answer
since it can be set up after retirement and funded with the money in other accounts. The investor
provides the lump-sum to the insurance company and the insurance company will pay out a fixed or
variable amount for the life of the investor(s).

Questions
Use the same approach to complete the following sample questions:
1. Interest rates have been rising for several years and the yield curve has recently become inverted. If
an investor believes that this is an indication that rates will begin falling, what’s the best
investment?
a. Long-term bonds
b. Short-term bonds
c. TIPS
d. A laddered bond portfolio
2. A young couple that just had their first child wants to save for her education, but they don’t want to
take excessive risk. They understand that inflation will cause expenses to be higher in the future and
want an investment that will keep up. Which of the following investments is the BEST choice?
a. An REIT
b. Municipal bonds
c. A gold ETF
d. An equity index fund
3. An investor who has several long-term stock positions is worried about negative earnings reports;
however, she doesn’t want to miss out on gains if the reports are positive. What should an RR
recommend to the investor?
a. Buy call options on each of her stocks
b. Buy put options on each of her stocks
c. Sell call options on each of her stocks
d. Sell put options on each of her stocks
4. A married couple are both in their mid-40s and want to know the best way to invest in their IRAs.
They’re willing to take a fair amount of risk to maximize their long-term returns. What’s the most
appropriate portfolio mix for the couple?
a. 100% in growth funds
b. 100% in income funds
c. 70% in growth funds and 30% in income funds
d. 40% in growth funds and 60% in income funds
5. An investor needs monthly income to pay his bills. If he needs the income to be stable and
predictable, which investment is the MOST suitable?
a. PAC
b. TAC
c. Support Tranche
d. Z Tranche

6. An investor is disappointed with bank CD yields. How can she best increase her retirement income,
without incurring a high degree of risk?
a. Commercial paper
b. Laddered corporate bond portfolio
c. T STRIPS
d. Income bonds
7. A recently retired 65-year-old has just rolled over his 401(k) plan into an IRA. The customer’s
objective is to increase retirement income and provide some growth of capital. The investment that
best satisfies these objectives is:
a. Common stock
b. TANs
c. Real estate investment trusts
d. Investment grade bonds
8. An investor with high income wants to maximize her retirement savings. She already contributes the
maximum amount to her employer plan and she wants to save at least another $20,000 per year.
Which of the following funding vehicles is the BEST for her needs?
a. Traditional IRA
b. Variable annuity
c. Roth IRA
d. Fixed annuity
9. A very conservative investor needs a specific amount of capital in exactly 7 ½ years and will not be
withdrawing money before then. If he doesn’t want to pay high fees or be involved in anything
complicated, which investment is the MOST suitable?
a. T-STRIPS
b. Fixed annuity
c. Convertible bonds
d. S&P 500 ETF

Explanations
1. If interest rates fall, bond prices will rise. Ultimately, bonds with the longest maturities will realize the
biggest gains. Since rates are currently high and will be falling, locking in the current high rate for as
long as possible will produce many years of continued high interest payments. Choice (a)—Long-term
bonds—will maximize these benefits as rates decline. Choice (b)—Short-term bonds—will derive
little benefit from falling rates. Choice (c)—TIPS—perform well during inflationary times when
interest rates are rising. Choice (d)—Laddered bond portfolio—will perform well in a stable or rising
rate environment; however, the short-term end of the ladder is not needed if rates are declining.
Therefore, Choice (a) is the best answer—Long-term bonds.
2. Saving for a young child’s education requires a long-term growth investment that will keep pace with
inflation; however, avoiding excessive risk may limit the options. Choice (a)—an REIT—is mainly
for dividend income, but also offers moderate potential for long-term appreciation. Choice (b)—
Municipal bonds—is for tax-exempt income, not growth. Choice (c)—a gold ETF—provides a means
to speculate on the value of gold, but is as easy to trade as common stock. Gold, like most
commodities, is considered a high risk investment. Choice (d)—An equity index fund—represents
ownership interest in an equity index, such as the S&P 500. This investment provides low fees,
diversification, and long-term growth that often beats inflation. Choice (d) is the best investment for
long-term education saving—An equity index fund.
3. The investor’s expectation is that the market may become volatile (the release of earnings reports may
cause large price movements in either direction). Since she already has bullish (long) stock positions,
she needs to protect against bearish conditions. Choice (a)—Buy call options—is bullish and will
generate a profit along with the stocks if their prices rise; however, both will lose value if the prices
fall. Choice (b)—Buy put options—is bearish and will allow the investor to sell her stocks at the set
strike price no matter how far down the prices fall due to bad earnings reports. Also, if the earnings
reports are positive, she will be able to retain her stock positions. Choices (c) and (d) both provide a
small amount of income; however, selling options doesn’t provide protection. In order to obtain
protection, an investor must BUY options. Therefore, Choice (b) is the best answer—Buy put options
on each of the stocks.
4. When determining an appropriate portfolio mix of growth and income, a useful calculation is (100% –
Age). The resulting number will represent the percentage of the portfolio that should be allocated to
growth, while the age represents the percentage to allocate to income. Since the couple are both in
their mid-40s, approximately 55% of the portfolio allocated to growth and 45% allocated to income
would fit the rule. However, considering their willingness to take a fair amount of risk, the mix can be
adjusted to more growth and less income. Choice (a)—100% in growth funds—is too aggressive,
while Choice (b)—100% in income funds—is too conservative. Choice (c)—70% in growth funds and
30% in income funds—is slightly more aggressive than the calculation purely based on the couple’s
ages. Choice (d)—30% in growth funds and 70% in income is quite conservative. Ultimately, Choice
(c) is the most appropriate since the couple is willing to assume risk—70% in growth funds and
30% in income funds.

5. Monthly income can be provided by mortgage backed securities (e.g., CMOs); however, not all CMO
tranches are the same. Choice (a)—PAC—is the most stable and predictable tranche. Choice (b)—
TAC—is somewhat stable, but is less predictable than a PAC. Choice (c)—Support tranche—has the
most unpredictable payments. Choice (D)—Z tranche—is similar to a zero-coupon bond since it will
not receive payments until all of the other tranches are paid off. Therefore, Choice (a) provides the
most stable and predictable monthly payments—PAC.
6. Considering the fact that her previous investments were very conservative, low-risk income
investments will be suitable. Choice (a)—Commercial paper—is short-term debt which offers a very
low yield. Choice (b)—Laddered corporate bond portfolio—provides income with relatively low risk.
Choice (c)—T-STRIPS—is safe, but doesn’t provide income. Choice (d)—Income bonds—are
speculative securities issued by distressed companies and are unsuitable for income-seeking investors.
Therefore, Choice (b) is the best choice for providing income with low risk for retirement—Laddered
corporate bond portfolio.
7. Since the investor’s objectives are both current income and moderate capital growth, a high dividend
paying stock may be the most suitable. Choice (a)—Common stock—provides growth potential, but
offers little or no regular income. Choice (b)—TANs—is a short-term municipal note that provides
safety and liquidity, but very little income and no growth. Choice (c)—Real estate investment trust—
is a high dividend paying investment that also offers growth potential based on the appreciating value
of real estate. Choice (d)—Investment grade bonds—are income producing investments, but don’t
provide for growth. Therefore, the best answer is Choice (c) since it provides current dividend income
with growth potential—Real estate investment trust.
8. Since her desired $20,000 per year investment exceeds the maximum allowable IRA contribution,
Choices (a) and (c) are not appropriate. Both Choices (b) and (d) have no contribution or income
limits; however, the variable annuity provides higher long-term growth potential. Therefore, Choice
(b) is the most suitable investment—Variable annuity.
9. The investor has a very conservative risk profile, but needs an investment that will grow to a specific
amount within a preset period. Choice (a)—T-STRIPS—is very safe and provides a fixed sum at a
specific maturity. T-STRIPS can be purchased with maturities from 30 years to six months. Choice
(b)—Fixed annuity—can be established for a specific period, but it’s somewhat complicated and
comes with high fees. Choice (c)—Convertible bonds—are too volatile for conservative investors.
Choice (d)—S&P 500 ETF—doesn’t fit the risk profile. Therefore, Choice (a) is the best since it can
be purchased with a 7 ½ year maturity and is very safe—T-STRIPS.
Conclusion
This concludes the reading portion of your test preparation. The majority of your remaining study
process should be focused on completing the Final Exams which may be found at www.my.stcusa.com.
These tests will reinforce your understanding of the material and help you to get ready for the actual test.
Best of luck with the remainder of your studies!

Index
A Asset Allocation Funds Stocks 9-9

asset ratio 16-8, 16-15
ACATS (Automated Customer Account Transfer assets
Service) 14-10 fixed 16-2-16-3, 16-5, 16-13
Accelerated Cost Recovery System (ACRS) fund's 9-3-9-5, 9-8, 9-12-9-13
11-8 intangible 16-2-16-3
Account Statements 14-4 assumed interest rate see AIR
accredited investors 13-2, 13-17, 15-9 at-the-money 12-5-12-6
accreted amount 5-20, 7-24 attorney, power of 2-7, 18-3
accretion 5-20, 6-3, 7-23-7-24 auction 7-14-7-15, 8-6
accrued interest 5-3-5-4, 5-6, 5-16, 5-20, 6-3, Auction rate securities (ARS) 7-14-7-15
7-15, 8-5-8-6, 13-30 authority 1-14, 2-6, 4-3, 7-1, 7-5, 7-7, 8-9, 11-
calculation of 5-4 5, 15-2
days of 5-4, 8-5-8-6 authorized shares 4-2
dollar amount of 5-4 Automated Customer Account Transfer Service
Accrued interest on Treasury bonds and (ACATS) 14-10
Treasury notes 5-6 average life 3-15-3-16, 7-11, 8-10-8-11, 8-13
accumulation period 10-4, 10-6, 10-9
acquisition 2-21, 3-5, 4-5, 11-13, 13-20 B
ACRS (Accelerated Cost Recovery System)
11-8 BABs (Build America Bonds) 7-8
ad valorem taxes 7-2, 7-6 balance sheet 1-8, 4-2, 13-7, 14-5, 16-1, 16-3-
additional bonds 7-10, 13-32 16-4, 16-6, 16-9-16-10, 16-13-16-14
Administrative Expenses 10-5, 16-5 Balanced Funds Mixture of Stocks 9-9
ADRs (American Depositary Receipts) 4-12-4- Balanced programs 11-13
14, 12-56 bank-qualified issues 7-18
aftermarket session 17-7 Bankers' Acceptances (BAs) 6-6
agent 13-3, 13-20, 13-27, 14-5, 17-4 banks, issuing 6-6-6-7
agreement BAs (Bankers' Acceptances) 6-6
hypothecation 18-3-18-4 basis 4-15, 5-3, 5-6, 5-12-5-13, 7-4, 7-23-7-
loan consent 18-3 24, 8-4-8-5, 9-3-9-4, 9-19, 9-21, 9-23, 12-
subscription 11-4-11-5 64, 15-11, 15-15, 17-6
Agreement of Limited Partnership 11-4 partner's 11-10
AIR (assumed interest rate) 10-6, 10-8, 10-11 tax-deferred 1-13, 2-15-2-16, 7-19
Alternative Minimum Tax see AMT basis points 5-12-5-13
American Depositary Receipts see ADRs bearish 12-16, 12-18, 12-31, 12-33, 12-36, 12-
AMT (Alternative Minimum Tax) 1-5, 7-7, 11-4 38-12-39, 12-43, 12-45, 12-50-12-52, 12-
analysis, fundamental 15-10, 16-1, 16-4 54, 12-58-12-59, 12-62, 15-17-15-18, 17-
analysts, technical 15-17-15-21 12, 17-15
annuitant 10-1-10-3, 10-5-10-11 beneficiaries, designated 10-7
annuities 1-5, 1-8, 1-13, 10-1-10-9, 10-11-10- bid price 13-24, 13-27
12 bills 1-2, 8-4, 16-8, 19-11
deferred 10-4 board member, advisory 3-17-3-18
annuity contracts 10-12 BOD 9-1
annuity units 10-6-10-8 Bond Buyer 15-16
appeal 2-4, 7-8, 20-7-20-9 Bond Buyer Indexes 15-16
Applications and Premium Payments 10-10 bond funds
arbitration 2-4, 20-9, 20-11, 20-13 corporate 9-7
arbitrators 2-4, 20-9, 20-11, 20-13 municipal 15-3
ARS see Auction rate securities Bond Funds Debt Securities 9-9
Assessed property values 7-12 Bond Index 9-7, 15-16
asset allocation 3-9, 15-2-15-4, 15-7, 15-11- bond interest, municipal 6-3, 7-18
15-12 bond issues
Asset Allocation Funds 9-9 revenue 7-9
©Securities Training Corporation. All Rights Reserved.

serial 7-3 capital losses 1-6, 4-16-4-17, 7-18, 7-22, 7-25,
bondholders, secured 6-1-6-2 10-2, 12-46
bonds long-term 4-17
deferred-interest 8-13 Capital Reserve 1-12, 15-8
government 5-1, 17-1 capital structure 6-8, 13-2, 16-9
in-state 7-1 capital surplus 16-2, 16-4, 16-9-16-10, 16-15
junk 9-7, 9-9 capitalization ratios 16-9
mortgage 6-1, 8-13 CAPM (Capital Asset Pricing Model) 15-13
private activity 7-7-7-8, 7-18 cash account 2-4
secondary market discount 7-24 cash dividends 1-4, 4-13-4-14, 7-14, 9-20, 12-
secured 6-1 9, 16-12-16-13, 18-9
special tax 7-6 cash equivalents 6-5, 9-8-9-9, 15-10
taxable 7-20-7-21 cash flow, customer's 1-2
unsecured 6-2 Cash Management Bills see CMBs
book-entry form 8-3, 8-7 cash reserve 1-12, 15-8
bracket purchases 7-20 cash value 3-11-3-12, 10-13-10-14
branch offices 17-7 policy's 3-11-3-12, 10-13-10-14
breakeven points, investor's 12-46, 12-65 CBOE (Chicago Board Options Exchange) 3-
Breakpoint Sales 9-18 12
breakpoints 9-11, 9-13-9-19 CD 6-6-6-7
British pound 12-57-12-58 CDOs (Collateralized Debt Obligations) 8-14-
broker call loan rate 18-3 8-15
broker-dealers, limited 13-11 CDs (Certificates of Deposit) 1-12, 6-6, 15-6
brokerage 2-10, 4-15, 13-13, 14-5, 17-16, 18- CDs, traditional bank-issued 6-6-6-7
2-18-5, 18-9, 20-9 CDSC see contingent deferred sales charge
brokerage accounts, prime 2-9 Central Registration Depository see CRD
Brokered CDs 6-7 Certificate of Limited Partnership 11-4, 11-7
brokers, prime 2-9 certificates
Build America Bonds (BABs) 7-8 equipment trust 6-1
bullish signal 15-17, 15-19, 15-21 loans issue 6-6
business, broker-dealer's 17-19 Certificates of Deposit see CDs
business day, next 8-6, 19-12 Certificates of Participation (COPs) 7-7
Business development companies see BDCs Chicago Board Options Exchange see CBOE
churning 2-8
C CL see Current Liabilities
class 2-16, 3-10, 9-9, 9-11, 9-13-9-14, 9-16, 9-
CA see Current Assets 19, 12-2-12-3, 13-20, 15-12, 16-4
call feature 5-16, 6-7, 7-8 classes 3-10, 9-3, 9-9, 9-13, 13-20, 15-10, 16-
call premium 5-16, 12-44, 12-58 4
call provisions 5-16, 5-19, 13-25, 13-32 client descriptions 15-1
call risk 5-18, 9-7 Client Profile 15-5
capital client profiles, incomplete 15-1
additional 4-1, 13-1 client purchases 2-10, 5-3
long-term 16-9 clients, existing 3-12
working 16-7, 16-13 closing index value 12-53-12-54
Capital Asset Pricing Model see CAPM CMBs (Cash Management Bills) 8-1, 8-5
capital assets 4-16, 7-22, 9-20 CMOs (Collateralized Mortgage Obligation) 3-
capital gains 1-6, 4-15-4-17, 5-20, 6-13, 7-18, 4, 3-15-3-16, 8-11, 8-14-8-15
7-22-7-25, 9-2, 9-18, 9-20, 10-2, 10-9, 11- COFI (Cost of Funds Index) 8-13
9-11-10, 12-66 collateral, underlying 3-15, 5-16, 8-10-8-11, 8-
long-term 1-5, 4-16-4-17 13
short-term 4-16-4-17 Collateral Trust Bonds 6-1
Capital Gains and Losses 9-20 Collateralized Debt Obligations see CDOs
Capital Gains and Losses on Municipal Issues Collateralized Mortgage Obligation see CMOs
7-22 commercial banks 12-55

commissions 1-3, 1-14-1-15, 4-9, 4-15, 7-5, 9- pretax 2-14-2-15
21, 14-3, 17-2, 17-9, 17-19, 18-14 control persons 13-18
common equity 16-10-16-11 conversion 4-7, 6-8-6-13, 9-14
common shares 4-7, 9-21-9-22, 16-10-16-11, conversion price (CP) 4-7, 6-9-6-11
16-13, 16-15 conversion ratio (CR) 4-7, 6-9-6-13, 18-10
common stock ratio 16-9 conversion value 6-9-6-10, 6-12
common stockholders 4-3, 4-6, 4-10, 4-12, 6- convertible bonds 4-17, 6-8, 6-11-6-13, 16-11
2, 16-11-16-12 issued 6-10
communications 3-2-3-5, 3-7, 3-9, 3-11-3-12, Converting Bonds to Stock 6-8
3-16-3-17 COPs (Certificates of Participation) 7-7
Communications Regarding Investment corporate bonds
Companies 3-5 convertible 15-6
companion 8-13 tax-exempt income Corporate Bond Funds
company Investment-Grade 9-9
annuity 10-7 corporate issues 8-14
closed-end investment 9-21 corporate securities 7-18
diversified 9-2 correspondence 2-3, 3-1-3-3, 3-12, 3-15, 20-5
established 4-5 cost basis
issuing 13-8, 15-9 adjusted 5-20, 7-24-7-25, 11-9
listed 13-10 bondholder's 7-22-7-25
mutual fund 9-14 bond's 5-20, 7-22
parent 6-3, 15-13 customer's 9-19
private 7-7, 8-8 donor's 4-16
public 13-22 investor's 10-9, 12-64-12-65
registered investment 3-1, 3-4, 3-8, 13-19- recipient's 4-16
13-20 zero 2-14
regulated investment 11-2 Cost Basis of Inherited Securities 4-16
small 1-9 Cost Basis of Securities 4-15
small business investment 13-14 cost basis/sale 12-64-12-65
complaint 20-5-20-7 Cost of Funds Index (COFI) 8-13
compliance 2-1, 17-8 coupon payments, semiannual 5-14
concessions 7-5 coupon rate 5-1, 5-3, 5-12, 6-14, 7-18, 7-26,
confirmations 2-9, 4-15, 5-18, 11-5, 13-30, 17- 8-2, 13-25, 13-27, 13-29
6, 19-5 coupons 6-7, 8-3-8-5, 13-25, 13-27, 15-1
conflict of interest 13-22 covered call 2-21
conservative investors 10-2 CP see conversion price
Consolidated Quotation System see CQS CPI (Consumer Price Index) 8-3
construction 7-6, 7-12-7-13, 11-9, 11-12-11-13 CQS (Consolidated Quotation System) 17-10
construction program 11-12, 13-32 CR see conversion ratio
Consumer Price Index see CPI CRD (Central Registration Depository) 3-4
contingent deferred sales charge (CDSC) 9- credit
11, 9-13-9-14, 10-11 extension of 18-1
contrabroker 17-11, 19-5 residual 14-10
contract owner 10-1, 10-3, 10-5-10-6, 10-14- credit agreement 18-3
10-15 credit balance 14-10, 18-9-18-10, 18-12
contract size 12-57 credit risk 3-16, 5-8, 7-6-7-7, 8-1, 8-7, 9-7
contract term 10-3 creditors 1-9, 4-2, 5-1, 7-3, 11-6
contracts general 6-2, 11-6
equivalent 12-13 creditworthiness 5-8, 6-13, 7-3
exercised 12-57 currency risk 3-10, 12-56
existing 10-12 Currency Transaction Reports see CTRs
new 10-12 current assets 16-2-16-3, 16-6-16-7, 16-13
nonqualified 10-9 Current Assets (CA) 16-2-16-3, 16-6-16-7, 16-
contributions 1-13, 2-13-2-16, 7-16, 10-2, 10- 13, 16-15
9, 10-13 current income 1-12, 9-7, 9-9
post-tax 2-15 seeking 15-6

Current Liabilities (CL) 16-2-16-3, 16-7-16-8, deductions 1-14, 4-14, 4-17, 7-6-7-7, 9-12, 11-
16-13, 16-15 3, 11-8-11-10, 11-14-11-15
current ratio 16-7, 16-15 deferred compensation plans 2-17
Current Yield 5-12, 16-12, 16-15 deflation 8-3
custodian 9-4-9-5, 15-9 delivery, good 7-9
customer assets 14-10 Department 3-16, 17-11, 20-5
customer complaints 20-5 Depletion allowance 11-14-11-15
Customer Confirmations 13-29 deposit margin 18-10
customer deposits 9-19, 18-4 deposit requirement 18-5
customer market orders 17-3 depositing 7-11, 9-16, 18-3, 18-8
customer orders, preexisting 17-3 Depository Trust & Clearing Corporation 8-2
Customer Profile 1-1, 15-3-15-9, 18-15 deposits, customer's minimum 18-9, 18-11
customer purchases 7-23, 17-15, 18-3 depreciation 6-8, 11-4, 11-8-11-9, 11-11, 11-
customer purchases securities 18-4 13, 16-2-16-3, 16-5, 16-8, 16-14
customers depreciation expenses 1-5, 11-11, 11-15, 16-
best credit-rated 6-8 5, 16-8
conservative 8-10 designated market maker see DMM
elderly 1-1, 15-5 Developmental programs 11-13
individual 15-3 direct participation programs 1-4, 4-13, 11-5,
institutional 1-16 11-9, 11-17, 13-11
public 20-9 Direct participation programs see DPPs
directors, board of 2-5, 4-1, 4-3, 4-5, 9-1, 9-4,
D 10-15, 19-10
disclosure document 13-9, 13-25, 13-29, 18-
date 14, 18-16
effective 13-5, 13-9-13-10, 13-13, 13-23 Disclosure Requirement 3-16, 3-18
ex-dividend 12-9, 19-10-19-11 disclosure statement 3-10
day trades 18-13 discretionary accounts 2-3, 2-7-2-8, 11-17, 18-
day trading 1-13, 1-15, 2-8, 4-13, 9-2, 18-5, 3
18-13-18-14 distributions 2-12, 2-14-2-15, 3-8, 3-16, 9-17,
dealer profits 17-2-17-3 9-19-9-20, 10-1, 11-5, 11-10, 13-2, 13-4-
dealer purchases securities 6-8 13-5, 13-7, 13-23, 13-26, 14-10
death 2-5, 2-17, 10-7, 10-12 primary 13-1, 13-29
death benefits 3-11-3-12, 10-5, 10-10-10-11, diversification 9-2, 9-22, 11-3, 15-8, 15-14
10-13-10-14 diversify 1-9, 9-6, 9-9, 9-14, 11-14
debentures, subordinated 6-10 dividend exclusion, corporate 4-14
debit balance 1-9, 18-4-18-5, 18-7, 18-12 dividend payments 4-6, 6-12, 14-4, 19-11
customer's 18-5 Dividend Payout Ratio 16-12, 16-15
debt dividend rate 4-5, 7-14
corporation's 4-1 dividends
direct 7-4-7-5 annual 4-5, 16-12, 16-15
general obligation 7-4 common 4-6-4-7
issuer's 7-2-7-3 preferred 4-6, 16-15
non-investment-grade 13-11 Dividends on Foreign Securities 4-14
overlapping 7-2, 7-4-7-5 DJIA see Dow Jones Industrial Average
recourse 11-10 DMM (designated market maker) 17-4-17-5,
debt instruments 6-5, 6-14-7-1, 8-8, 9-23, 15-5 17-16
debt securities 1-4, 4-17, 5-1-5-2, 5-4-5-5, 5- dollar amount 4-5, 12-60, 13-27, 15-15, 20-11
7-5-9, 5-11, 5-13, 5-15-5-19, 6-13, 13-19, dollar cost 9-17
14-5 donor's cost 4-16
corporation issues 16-13 Double-Barreled Bonds 7-8
debt service 5-1, 7-1-7-2, 7-4-7-6, 7-8-7-12 Dow Jones Industrial Average (DJIA) 9-22,
annual 7-10-7-11 15-12, 15-18
Debt Service Coverage 7-9 DPPs (Direct participation programs) 3-4, 4-
debt statement 7-4 13, 11-8-11-9, 11-11, 11-13, 11-16-11-17,
debt-to-equity ratio 16-15 13-11, 15-8

exchange-traded funds see ETFs
E Exchange-Traded Notes see ETNs
exchanges
e-mail 3-1-3-2, 3-11 electronic 17-1
earnings regional 17-3
company's 15-9, 16-11 execution price 2-8, 17-13, 17-15-17-16
retained 15-9, 16-4, 16-9-16-10, 16-12-16- exempt 2-15, 3-5, 5-18, 6-6, 7-1, 7-18, 8-6, 8-
13, 16-15 14, 11-7, 13-14, 13-24, 13-29, 17-20, 18-12
Earnings Before Interest and Taxes see EBIT exempt securities 13-11, 18-12
earnings per share see EPS exercise notice 12-54
EBIT (Earnings Before Interest and Taxes) exercise price 12-3, 12-8-12-9, 12-30, 12-54,
16-5-16-6 12-57, 12-59
ECNs (Electronic Communication Networks) existing bonds 5-8, 5-11
4-13, 17-9 prices of 5-11
Education Savings Account (ESA) 2-14 purchasing 5-8
education savings accounts 2-14 value of 5-11
Effect of Stock Splits and Stock Dividends 6-9 Expense ratios 9-12-9-13
Electronic Communication Networks (ECNs) expenses 1-3, 2-13, 7-6, 7-9-7-10, 7-16, 10-5,
4-13, 17-9 10-13, 11-11-11-12, 11-14, 11-16, 13-27,
Electronic Municipal Market Access (EMMA) 13-32, 16-4, 16-8, 17-19
13-30 total 9-12-9-13, 11-11
eligibility 11-17, 13-12 expiration date 12-3, 12-14
EMMA (Electronic Municipal Market Access) expiration month 12-3, 12-31, 19-12
13-30 Exploratory Program 11-13-11-14
employee benefit plans 2-11, 3-1 extension 15-13, 18-4
Employee Retirement Income Security Act see
ERISA F
employment 1-3
entities 3-2, 3-10, 3-19, 4-4-4-5, 5-1, 5-6, 7-2, FDIC (Federal Deposit Insurance Corporation)
7-14, 7-19, 8-7, 8-10, 13-21-13-22 6-6-6-7, 6-13
EPS (earnings per share) 6-11, 16-11-16-15 FDIC insurance 6-7
equity, combined 18-12 Federal Deposit Insurance Corporation see
equity financing 4-1 FDIC
equity income funds 9-7 Federal Farm Credit Banks see FFCBs
equity investors, private 13-1 Federal Farm Credit Consolidated Systemwide
equity issues, foreign 4-13 Banks issue 8-8
equity options 12-3, 12-53, 12-57, 18-15 federal funds 6-5, 6-7
Equity REITs 11-1 Federal Home Loan Banks see FHLBs
equity securities 1-4, 3-3, 3-17, 4-1-4-2, 4-11, Federal Home Loan Mortgage Corporation see
4-13, 6-14, 12-53, 13-11, 15-2, 15-7, 15-9, FHLMC
17-1, 17-9, 17-12-17-13 Federal National Mortgage Association see
ERISA (Employee Retirement Income Security FNMA
Act) 2-11-2-12, 2-16 Federal Reserve Board see FRB
ESA see Education Savings Account federal taxes 1-5, 7-18, 8-8
estate taxes 1-5 Federal Trade Commission's (FTC) 2-20
ETFs (exchange-traded funds) 3-4, 9-10, 9- FFCBs (Federal Farm Credit Banks) 8-8, 8-15
22-9-24, 15-8, 15-10, 15-12, 18-13 FHLBs (Federal Home Loan Banks) 8-8, 8-15
ETNs (Exchange-Traded Notes) 3-4, 6-13-6- FHLMC (Federal Home Loan Mortgage
14 Corporation) 8-8-8-9, 8-11, 8-15
Eurobonds 6-4 fiduciaries 2-6, 2-11-2-12, 9-16, 11-5, 11-7,
Eurodollar bonds 6-4 13-12
ex-date 19-11 FIFO (first-in, first-out) 4-15, 16-3, 19-12-19-
excess equity 18-5-18-7, 18-10-18-11 13
excess funds 6-5 financial condition 3-8, 7-2-7-3, 13-7, 14-5, 16-
Exchange Act 13-20 1
exchange rates 12-55

Financial Industry Regulatory Authority see Government Funds Treasury Securities People
FINRA 9-9
financial profile 1-1, 1-9, 15-3 Government National Mortgage Association see
financial statements 4-2, 13-7, 13-10, 13-32, GNMA
14-5, 16-1 government regulations 11-17
first-in, first-out see FIFO government securities 1-12, 5-18, 6-8, 7-8, 8-
fiscal policy 12-56 4, 8-6
five business days 18-14 government-sponsored enterprises see GSEs
fixed annuities 1-12, 10-2-10-3, 15-6 GPs see General partners
fixed-income investments 8-1, 15-1, 15-8 gross income 1-3, 2-14, 11-2, 13-17
traditional 8-1 group, selling 8-7, 13-4, 13-6, 13-28
fixed-income securities 4-14, 5-1, 8-11, 15-7 growth, tax-deferred 2-14, 10-2, 10-11
floor broker 17-4-17-5 Growth and Income Funds 9-7
FNMA (Federal National Mortgage Association) Growth and Income Stocks People 9-9
8-8-8-9, 8-11, 8-15 growth companies 9-7, 15-9, 16-12
foreign currency options 12-52, 12-55-12-57, growth funds 9-6-9-7
12-59 growth investors 15-9
Foreign exchange rates 12-55 Growth Stocks 9-6
foreign securities 4-12, 4-14, 9-6 GSEs (government-sponsored enterprises) 8-
Form U4 20-9 7-8-8, 8-14
forward transactions 12-55 GSLP (Guaranteed Student Loan Program) 8-
FRB (Federal Reserve Board) 6-5, 12-55, 18- 8
1, 18-3, 18-9, 19-7 Guaranteed Bonds 6-3
Friday, third 12-12, 12-55, 19-12 Guaranteed Student Loan Program (GSLP) 8-
FTC (Federal Trade Commission's) 2-20 8
fund shares, mutual 4-14, 9-11
funds H
additional 11-4, 11-12
balanced 9-8-9-9 halt, 15-minute trading 17-20
borrowed 4-5, 17-12 hedge 9-23, 10-3, 10-11, 12-40-12-41, 12-43,
closed-end 3-4, 7-14, 9-21-9-22, 9-24 12-46, 12-48, 12-51, 12-53, 12-55, 12-59,
exchange-traded 3-4, 15-12, 18-13 12-65, 18-10, 18-15
flow of 7-11-7-12 hedge funds 1-13, 2-9, 11-2, 13-2, 15-9, 18-15
global 9-6 herring, red 13-8
international 9-6 High-yield bond funds 9-7, 9-19, 15-6-15-7
investment company pools 9-1 High-yield bonds 6-2
maintenance 7-12 highest bid 17-4, 17-7, 17-17
managed 9-7 holding period 4-16, 7-25, 9-20, 12-65-12-66,
person transfers 2-12 13-18, 13-21, 15-8
funds rate 6-8 home equity loans 1-9
G I
general obligation bonds 7-1-7-5, 7-12, 13-24, IAR see investment adviser representative
15-16 IAs see investment advisers
general obligation issue 7-2 IBM 4-10, 12-3, 15-12
General partners (GPs) 4-9, 11-5-11-6, 11-16 IDCs 11-14
Gift Taxes 1-6 illiquid 11-2, 11-16
gift taxes, incurring 1-6 in-the-money 12-5-12-6, 12-14, 12-16, 12-22,
Gifted Securities 4-16 12-53, 12-55, 12-57, 12-60, 18-14, 19-12
gifts 1-6, 4-16 in-the-money amount 12-59
Ginnie Mae 8-8-8-9, 9-7 income
GNMA (Government National Mortgage additional 15-7
Association) 8-7-8-11, 8-15 client's 15-8
government agencies 6-5, 8-8 customer's 1-2, 1-12
government agency securities 8-14, 13-14 non-passive 11-10

operating 16-5 interest payments 4-14, 5-1, 5-3, 5-6, 5-18, 6-
periodic 11-12 12, 8-3, 8-5, 8-11-8-13, 9-5, 9-7, 13-32, 15-
tax-exempt 9-9 1, 18-3
income bonds 6-3 annual 5-12
income funds 9-7 bond's semiannual 5-14
income investments 1-12, 15-6 entire 5-4
income payments 10-6 last 5-3-5-4, 5-16, 8-5
Income programs 11-13-11-14 interest-rate risk 3-10, 3-15, 5-8, 8-15, 9-7, 15-
income statement 1-2, 15-1, 16-1, 16-4-16-5, 6
16-8 interest rates
income taxes 1-5-1-6, 4-14, 7-1-7-2 current 3-15, 5-11
ordinary 2-12-2-13, 2-15, 10-10 fixed 5-2, 8-1, 10-2
personal 11-3 lower 5-11, 6-11, 8-11
indenture 5-18-5-19, 7-10-7-11, 13-24, 13-30, short-term 6-8, 9-8
13-32 intrinsic value 4-11, 12-4, 12-6-12-7, 12-15,
index, underlying 6-14, 9-23, 12-53-12-54, 18- 12-19, 12-22, 12-24, 12-26, 12-29, 12-33,
13 12-36, 12-54, 12-58, 16-1
index funds 9-7, 15-10 inventories 16-2-16-3, 16-7, 16-15, 17-3, 17-6
Index Funds Securities 9-9 inverse 9-23, 12-8-12-9
index option contracts 12-53 investment advisers (IAs) 2-11-2-12, 9-1, 9-4,
index options 12-53-12-55, 12-60, 19-12 13-12, 14-3, 15-2
index value 12-53, 19-12 investment advisers, registered 3-1-3-2, 13-19
indicators 6-8, 7-2, 8-2 investment bankers 11-5, 13-2-13-3, 13-25
Individual Retirement Accounts see IRAs Investment Banking and Research Department
industry rules, violation of 2-20, 17-6 Control Issues 3-16
inflation 1-13, 8-3, 10-2-10-3, 10-14 investment banking client 3-18
rate of 1-12 investment banking departments, member's 3-
information 16
nonpublic 17-18 investment choices 1-12, 15-10
personal 2-20 investment companies 2-19, 3-4-3-5, 3-7-3-9,
required 3-18, 10-11, 13-7 9-1-9-12, 9-14-9-24, 13-12-13-13, 18-13
stockholder 2-20 Investment Companies' Rankings 3-9
information barriers 3-16 Investment Company Act 3-8, 9-1, 13-13
initial public offering see IPOs investment company affiliate 3-9
insiders 2-21, 13-17-13-18 investment company family 3-9
institutional communications 3-1-3-3 investment company rankings 3-9-3-10
institutional investors 3-1-3-2, 11-1, 13-1, 13- investment decisions 15-10
12 investment grade 6-2
instructions, customer's 17-1 investment income 1-2, 1-4-1-5, 9-19, 10-5,
insurance company's asset base 10-2 10-9
Interbank Market 12-55 investment losses 9-5
interest investment objectives 1-1, 1-12, 2-1, 2-19, 3-
annual 5-12 8, 4-10, 10-11, 10-13, 11-17, 14-6, 15-1
best 1-15, 13-29 client's 2-1, 2-3
conflicts of 13-21-13-22 Investment of funds 13-32
financial 3-17-3-18 investment options 6-5, 7-16, 9-14, 10-13
investor's 8-4 investment policies, fund's 9-4
limited partnership 1-5, 1-9 investment portfolios 1-11, 12-1
public 1-14 investment profile 1-14
royalty 11-14-11-15 customer's 1-15
undivided 8-8 investment program 1-12, 15-4
yearly 5-4 investment recommendations 1-1, 1-14-1-15,
interest income 1-4, 7-18 3-3, 3-5, 15-2, 15-4
Interest on T-bonds and T-notes 8-5 investment risk 1-2, 1-9
Interest Only see IO Investment Selection 15-1, 15-3-15-9
investment strategies 1-1-1-2, 1-9, 1-14-1-16

investment time horizon 10-11, 14-6 support 15-19-15-20
investments leverage 11-12, 12-14, 16-13, 18-1, 18-13, 18-
aggressive 1-11 15
client's 9-18, 15-1 Liabilities 1-8-1-9, 16-1-16-2, 16-8
growth 1-12 current 16-2-16-3, 16-7, 16-13
short-term 7-15 long-term 16-2-16-4, 16-9, 16-13
tax-exempt 3-8 total 1-7, 9-10, 16-1-16-2, 16-13, 16-15
investor executes 12-41, 12-43 liability 6-3, 7-4, 13-4-13-7, 13-25-13-28, 19-
investor exercises 12-15, 12-19, 12-43-12-45, 11
12-57 financial 13-4, 13-6
Investor Profile 6-5, 8-10, 8-15 limited 4-1, 11-3, 11-6-11-7
investors life expectancy 1-13, 10-6
bearish 12-52 LIFO (last-in, first-out) 10-9, 16-3
foreign 6-4 limit orders 17-13-17-15
high income 6-5 limited partners 11-3-11-7, 11-10-11-11, 11-13
income-seeking 6-3 Limited partners (LPs) 1-4-1-5, 1-9, 1-14, 11-
long-term 9-6, 9-9, 9-17, 15-9 3-11-7, 11-10, 11-12-11-13, 11-16-11-17,
risk-averse 8-13, 8-15 17-19
short-term 9-9 limited partner's investment 11-10
investor's gain 12-65 limited partnership investments 11-10, 11-16
investors purchase 5-20 limited partnerships 1-4, 1-9, 1-14, 11-3-11-4,
IO (Interest Only) 8-13 11-7, 11-10, 11-12, 11-16-11-17
IPOs (initial public offering) 2-9, 3-18, 13-1, liquidity 1-12, 3-11, 3-16, 4-13, 5-19, 6-7, 7-
13-5, 13-10-13-11, 13-23, 17-20-18-1 15, 8-8-8-9, 9-2, 9-8-9-9, 10-11, 11-17, 15-
IRAs (Individual Retirement Accounts) 1-5, 1- 1, 15-7-15-8, 16-6
8, 2-11-2-12, 6-3, 9-16, 10-1, 10-12-10-13, listed options 12-3, 12-9
15-3, 18-2 LMV (long market value) 18-5-18-8, 18-10,
IRAs, traditional 1-13, 2-13 18-12
IRS 1-6, 2-12-2-14, 4-15, 4-17, 7-22, 10-9, 10- loads, front-end 9-11, 9-13-9-14
12, 11-8-11-9, 16-3 loan amount 18-3
issue revenue bonds 7-5 local governments 7-1, 7-5, 7-12, 7-18
issuer local taxation 7-18, 8-8
bond's 1-4, 7-26 local taxes 7-1, 7-18-7-19, 8-8-8-9, 8-11, 8-14
municipal 13-25, 13-29 London Stock Exchange 15-13
securities of 13-19 long market value see LMV
Issuer-Directed Securities 13-13 Long portfolio of stock 12-62
issuer files 13-7, 17-8 long-term bonds 7-13, 10-3, 16-13
issuer pledges 7-5, 7-10 long-term investments 1-10-1-11, 10-2
Issuers of revenue bonds 7-5 losses
issues trade 17-1 potential 1-10
risk of 12-59
K short-term 4-17
LPs see Limited partners
know your customer (KYC) 1-14, 2-1, 15-2 lump sum 6-3, 9-7
KYC see know your customer
M
L
Mac, Freddie 8-8-8-10
land, raw 11-8, 11-12-11-13 MACRS (Modified Accelerated Cost Recovery
last-in, first-out see LIFO Systems) 11-8
legal opinion 7-9, 13-29, 13-32 Mae, Fannie 8-8-8-10, 9-7
legend 3-2, 4-3, 13-17 maintenance call 18-11
level maintenance expenses 7-9-7-10, 7-12
federal 7-7, 8-3 maintenance requirements 18-11-18-12
local 7-1 management, company's 13-4, 16-1
resistance 15-19 management companies 9-1, 9-21

managing underwriter 11-8, 13-5, 13-7, 13-12, Modified Accelerated Cost Recovery Systems
13-24 (MACRS) 11-8
margin 1-9, 1-15, 2-5, 6-13, 13-18, 15-8, 17- Momentum investors 15-10
10, 17-12, 18-1-18-2, 18-4, 18-12, 18-14- money
18-16 additional 1-10
margin account, customer's portfolio 18-16 investor's 9-13
margin agreement 18-3 money-market 1-12, 6-5, 15-4
margin call 18-4, 18-14 money-market funds 1-9, 1-12, 3-9, 4-14, 9-8,
margin positions, long 18-5 15-4, 15-6, 15-8
margin requirements 18-1-18-2, 18-8-18-10, Money-Market Funds Cash Equivalents 9-9
18-12-18-14 money-market instruments 6-5, 9-9
client's net 18-14 short-term 7-15
margin trading 1-15, 18-2 money-market securities 6-5-6-6, 15-8
marginable securities 18-3 money markets 6-5
market Moody 5-8-5-9, 6-2, 6-6, 7-13, 15-16
current 17-5 mortgage-backed securities 3-16, 8-7-8-8, 8-
dealer-to-dealer 17-5 10-8-12
orderly 17-3-17-4 traditional 8-11
periods of 9-8 MPT (Modern Portfolio Theory) 15-10-15-11,
potential 18-15 15-13
primary 6-4, 8-6, 11-1, 13-10, 17-1 MSRB (Municipal Securities Rulemaking Board)
total 15-14 7-7, 13-24
market center 4-13, 17-17 MSRB rules 7-8, 13-29-13-30
market makers 6-7, 13-19, 13-23, 17-2, 17-5- Municipal Bond Funds Municipal Securities
17-7, 17-9, 17-17 Investors 9-9
market maker's quote 17-6 municipal bonds 1-5, 1-13, 5-1, 5-3-5-4, 5-11,
market orders 17-4-17-5, 17-13-17-15 7-1, 7-19, 7-22-7-25, 13-29-13-30, 15-1,
market participants 17-9 15-3-15-5, 18-12
market price volatility 3-10 municipal issues 7-1, 7-22, 13-26, 13-29
market rates, current 6-7 Municipal Securities Rulemaking Board see
market risk 9-6 MSRB
market value, higher 18-6 municipality 5-1, 5-8, 7-3-7-5, 7-7, 7-9-7-10, 7-
markups 4-9, 17-2-17-3, 17-19-17-20 12-7-13, 7-18, 13-2, 13-25
material, firm issues sales 3-12 municipality issues 7-8
material conflict of interest 3-17-3-18 municipals, investment-grade 15-5
matures 5-4, 8-2, 8-5 mutual fund investments 15-4
maturity date 5-1, 5-4, 5-6, 5-16, 8-5, 9-7, 13-
29 N
maximum, investor's 12-37
maximum loss 11-10, 12-8, 12-23, 12-27, 12- NAC (National Adjudicatory Council) 20-8
29-12-31, 12-34, 12-37, 12-39, 12-42-12- Nasdaq 4-9, 4-12-4-13, 8-8, 9-21-9-22, 13-10,
43, 12-46, 12-48-12-52, 12-59, 18-14 13-20, 15-13, 17-1, 17-8-17-9, 17-12, 17-
maximum profit 12-48 17, 18-1
maximum rate 1-6 Nasdaq Market Center Execution System 17-
maximum sales charge 9-11, 9-14 8
medical expenses, qualified 7-17 Nasdaq market makers 17-7
member orders 13-29 Nasdaq securities 17-6-17-8
membership 20-7 Nasdaq system 17-6-17-7
minimum death benefit 3-11 National Adjudicatory Council see NAC
minimum denomination 6-6, 9-21 National Corporation Income Statement 16-5
minimum equity requirement 18-14-18-15 National Market System (NMS) 17-17, 17-20
minimum maintenance requirement 18-8, 18- NAV (net asset value) 9-2-9-3, 9-10-9-12, 9-
11 15, 9-17-9-18, 9-21-9-22, 10-4, 10-10
MNOP stock 17-7 net, investor's 12-44
Modern Portfolio Theory see MPT net amount 7-8
net asset value see NAV

net assets, total 9-10 option premium 12-4, 12-48
net basis 17-3 options accounts 2-5
net capital losses 1-6 Options Clearing Corporation see OCC
net credit 12-35 options contracts 3-17, 12-57
net gain 4-17, 12-15, 12-17, 12-19, 12-21, 12- options expire 12-27-12-28, 12-34, 12-37, 12-
24, 12-26, 12-43-12-44, 12-58, 12-60 48
net income 1-2, 2-14, 16-5-16-6, 16-8, 16-11- order
16-12, 16-15 day 17-10, 17-14-17-15
net loss 12-16-12-17, 12-19-12-20, 12-29, 16- discretionary 2-7-2-8
4, 16-8 large 9-19, 17-4, 17-14
net premium payments 10-13 not-held 2-8, 17-4, 17-16
net premiums 10-14 priority of 13-26, 13-28-13-29
net revenue issue 7-12 public 17-5
net risks 18-15 order entry 17-1
Net Working Capital 16-15 Order Execution 17-8
New Issue Confirmations 13-31 order placement 17-1
new issue distribution 13-4-13-5 order ticket 2-8, 4-15, 12-13, 17-1, 17-10, 17-
New Issue Rule 13-11-13-13 12
new issues 1-15, 5-18, 13-2, 13-7-13-8, 13- ordinary income 1-3, 1-5-1-6, 4-15-4-17, 5-20,
11-13-13, 13-23, 13-30 7-18, 7-22-7-25, 8-3, 9-20, 10-9, 11-2-11-3,
sale of 13-6, 13-23 11-9
New York Stock Exchange see NYSE ordinary income rates 1-5, 2-15
New York Stock Exchange Composite Index organization, nonprofit 13-14, 13-19
15-13 original issue discount see OID
NMS (National Market System) 17-17, 17-20 Original Issue Discount Bonds 7-22
nonequity options 12-52 OSJ (Office of Supervisory Jurisdiction) 10-11
Nonlisted Companies 13-10 OTC see Over-the-Counter
nonmembers 9-5 OTC Bulletin Board see OTCBB
nonrecourse loans 11-11 OTC equities 4-13, 17-1, 17-10
Nontransferable Assets 14-10 OTC equity securities 17-8
notes, exchange-traded 3-4 OTCBB (OTC Bulletin Board) 17-1, 17-8, 17-
NYSE (New York Stock Exchange) 4-9, 4-12- 10, 18-1
4-13, 6-13, 9-21, 10-4, 13-10, 13-20, 15-13, out-of-the-money 12-5-12-6, 12-53, 18-14
15-17, 17-1, 17-3-17-5, 17-9-17-10, 17-12, outstanding bonds 5-16, 5-18, 7-4
17-17, 17-20 Outstanding Common Shares 16-10, 16-15
Over-the-Counter (OTC) 4-12, 13-19, 17-1,
O 17-5, 17-8-17-9
overnight loans 6-8
obligations ownership interest 4-1, 6-12, 16-4
direct 8-5, 8-7, 8-9-8-10
quantitative 1-15 P
OCC (Options Clearing Corporation) 12-12,
12-57, 19-12-19-13 PAC (Planned Amortization Class) 8-13
occupation, customer's 1-2 Par Value 5-1, 6-9
OEX 12-53-12-54 Par Value of Bond 6-9-6-10, 6-12
offering price 9-15, 13-5, 13-27 Par Value of Bonds 16-9, 16-15
Office of Supervisory Jurisdiction see OSJ Par Value Price in Dollars
officers 2-3, 2-16, 3-5, 3-17-3-18, 4-9, 13-2, Discount/Par/Premium 5-11
13-9, 13-14, 13-18 parity 6-10-6-12
OID (original issue discount) 7-22-7-25 Parity Bonds 7-9
open-end management companies 9-1, 9-21 Parity Price of Bond 6-10
operating expenses 9-3, 11-11, 16-5 parties
option contract 12-3-12-4, 12-8-12-10 confirming 19-5
option expires 12-2, 12-7, 12-16-12-19, 12-21, nonconfirming 19-5
12-54 partners, general 4-9, 11-3-11-7, 11-16
option position 12-13-12-14

partnership 2-3, 2-6, 11-3-11-6, 11-8, 11-10- position trader 17-6
11-11, 11-15, 11-17, 13-13, 13-19, 13-21, positions
13-26 long 2-21, 18-5, 18-9, 18-12-18-13
partnership agreement 2-6, 11-6, 11-13 long-term 12-66
passive income 1-4, 11-10-11-11, 11-14 power
passive investors, unlimited personal liability buying 18-7, 18-14
11-7 purchasing 1-12-1-13, 8-3, 15-6, 18-1
passive losses 1-4, 11-9-11-11 Preferred Dividends Common Stock 16-11
paying taxes 1-5, 11-2 preferred shareholders 4-6
payment date, last interest 5-3-5-4, 13-30 preferred stock 1-12, 4-5-4-7, 4-14, 7-14, 9-
payments 21-9-22, 11-2, 13-11, 15-6, 16-2, 16-4, 16-
first 10-6 9-16-10, 16-12, 16-15
fixed-dollar 10-2 callable 4-7
owner's premium 10-10 convertible 4-7, 4-17, 6-8, 6-13, 16-11
PE (private equity) 4-5, 13-1 premium
penny stocks 4-9-4-10 client's 10-10
pension funds 7-8, 7-19 current 12-17, 12-20
Pension Plan 1-8, 2-11 higher 10-14, 12-7, 12-32, 12-35
performance, company's 15-22 medical insurance 2-13
period, five-business-day 18-13 single 10-3-10-4
periodic payments 10-4, 10-7, 10-9 Premium Bond Sold Prior to Maturity 7-25
person Premium Bonds 5-15, 5-20, 7-24-7-25
associated 13-12, 20-7 premium payments 10-10, 10-13
authorized 2-7 prepayments 8-10-8-11, 8-13
person opening 2-5 pretax 2-12, 2-14
personnel, registered 14-6 price
Philadelphia Stock Exchange 12-56 best 17-7
PHLX 12-56-12-57 bond's market 5-8
physical securities 12-53 closing 17-16, 18-10
physical trading floors 17-1 dollar 8-2, 14-5
PIPE (Private Investment in Public Equity) 13- high 17-14, 18-9
2 high market 16-12
plan assets 2-12 higher 13-27, 17-2
Planned Amortization Class see PAC highest 17-14
plans, nonqualified 2-15 initial market 4-5
PO see Principal Only left 15-19
points limit 17-13
crossover 11-16-11-17 low 9-17, 17-14, 18-9
issuer's 6-12 parity 6-11
points in-the-money 12-7 potential 12-41
policies 1-11, 2-20, 3-2, 3-11, 9-4, 10-1, 10- redemption 7-25
13-10-15, 17-19-17-20 stop 17-15
variable life 10-14 price differentials 6-12
Policy owners 10-10, 10-13-10-14 price/earnings 16-11
policyholders 3-11, 10-13-10-14 Price/Earnings Ratio 16-11, 16-15
POP see public offering price price levels 9-17, 15-19
portfolio particular 15-19
client's 15-2, 15-4 price movement 12-11
current 1-9 price risk 17-3
fund's 3-10, 9-4, 9-18 Prices for Treasury notes and bonds 8-2
large 15-7 pricing 13-8, 13-23, 13-25, 13-27
optimal 15-11 Prime brokerage clients 2-9
portfolio income 11-10 Principal Only (PO) 8-13
portfolio margin accounts 18-16 principal payments 7-5, 8-5, 8-11, 8-13
portfolio margining 18-15-18-16 priority 2-12, 7-11, 11-7, 13-28, 17-14
benefit of 18-15 Priority of Orders 13-28, 17-14

private equity see PE Q
Private Investment in Public Equity (PIPE) 13-
2 QIBs (Qualified Institutional Buyers) 13-19-13-
private placements 4-9, 11-7, 13-1-13-2 20
production 11-14 QIU see Qualified Independent Underwriter
products qualification 17-6, 17-8, 17-16
derivative 6-13-6-14, 17-1 Qualified Independent Underwriter (QIU) 13-
structured 3-4, 6-13-6-14 22
profile 1-1, 1-14, 2-1, 15-1, 15-9 Qualified Institutional Buyers see QIBs
profiling process 1-2 qualified plans 2-14, 3-1
profit Quick Asset Ratio 16-15
investor's 4-15, 12-18 quotations 8-3-8-4, 15-16, 17-6-17-8, 17-10
potential 12-14
profitability 1-14, 12-51, 15-2, 16-6 R
company's 16-10
program RANs (Revenue Anticipation Notes) 7-13
equipment leasing 11-15 rates
gas 11-13-11-14 clearing 7-14
property taxes 7-2-7-4, 7-8, 7-12-7-13 high 8-13
property values 7-2 prepayment 3-16, 8-11
prospect 2-3, 2-20 prime 6-8
prospectus rates of return 3-11-3-12
final 13-9-13-11 ratio, debt service coverage 7-10
preliminary 13-8-13-11 Real Estate Investment Trust 11-2, 13-11
prospectus delivery 9-22, 10-3, 13-10 Real Estate Investment Trusts see REITs
prospectus requirements 6-6, 9-22, 13-11, 13- real estate investments 11-1, 11-12
14, 13-20, 13-24 real estate programs 11-10-11-12
provisions 2-3, 2-12, 3-5, 3-18, 5-19, 7-10, 10- reclassifications 13-20
5-10-6, 10-12, 13-12-13-13, 13-23, 13-32, record, shareholder's 19-11
17-6, 17-13, 17-20, 18-8 record date 9-10, 12-9, 19-10-19-11
proxies 4-3 refinance 5-18, 8-10-8-12, 13-2
public appearances 3-2, 3-16-3-18 Reg, initial 18-5
public offering price (POP) 9-10-9-11, 13-5, Registered Options Principal see ROP
13-9, 13-24, 13-27, 17-20 registered persons 1-14, 3-3
publisher 3-5, 3-9 registrar 4-3
purchase registration 3-3, 6-6, 8-6, 8-11, 10-10, 10-13,
closing 12-13, 12-63 11-7, 13-8-13-9, 13-14, 13-20, 13-24, 20-7
customer's 17-20 registration process 13-7-13-8, 13-11
date of 4-15, 10-3 registration statement 13-6-13-9, 13-11, 13-22
initial 18-9 regulated investment companies (RICs) 9-19
large 6-5, 9-13-9-14 Regulation SHO 17-12
long 18-1 Regulation SP 2-19-2-20
new 4-17, 9-16, 18-8, 18-13 regulations, state securities 13-9
opening 12-13, 12-63 reinvest 5-12, 5-18-5-19, 6-7, 8-10-8-11, 9-19-
9-20
REITs (Real Estate Investment Trusts) 1-5,
11-1-11-2, 13-11, 15-8
REITs, nontraded 11-2
rejection 13-32
repayments, principal 8-12-8-13
Repurchase Agreements 6-8
repurchases 2-21, 4-7, 6-8
Required Minimum Distributions see RMDs
requirements, reserve 6-7
resale 4-13, 13-17
research analysts 3-16-3-17

research reports 3-3, 3-16-3-18, 14-3, 17-17 S
reserves 6-7, 11-14
restricted persons 13-11-13-14, 13-18 SAI (Statement of Additional Information) 9-3
restricted stock 13-18 salaries 1-2-1-3, 2-16, 15-6
retail communications 3-2-3-5, 3-9-3-10, 3-12, sales
3-15-3-16 competitive 13-25, 13-29
options-related 3-12 customer's 17-20
video 3-4 long 17-10, 17-12
retirement accounts 1-5, 2-12, 6-3, 7-16, 10- negotiated 13-25
12 sales area 17-1, 17-11
retirement plans sales breakpoints 9-14
employer-sponsored 1-13, 2-15, 15-6 sales charges 2-16, 9-3, 9-5, 9-10-9-15, 9-17,
qualified 2-12, 2-14 9-21-9-22, 10-5, 10-13
return additional 9-19, 10-3
rate of 3-12, 5-19, 16-12 contingent deferred 9-13-9-14
total 3-9, 12-47 reduced 9-11, 9-13-9-14, 9-16
Return on Common Equity 16-10-16-11 up-front 9-13
return receipt 19-5 sales literature 3-2, 3-7-3-8, 3-10
Revenue Anticipation Notes (RANs) 7-13 most investment company 3-8
revenue bonds 7-1, 7-5, 7-9, 7-12, 13-25, 15- supplemental 3-10
16 sales load 9-3, 9-12
revenue issues 7-1, 7-4-7-5, 7-9-7-10, 13-25 Sales Practice Requirements for Penny Stocks
revenues 7-4-7-7, 7-9-7-11, 11-11, 11-14-11- 4-10
15, 16-4-16-5 sales prices 6-8, 12-66
gross 7-6, 7-10-7-12 sales taxes 1-5, 7-1-7-2
reversal 15-17, 15-20 Savings Account 1-9
RICs (regulated investment companies) 9-19 savings bonds 8-1
rights 2-13, 4-3, 4-11, 4-15, 7-10, 10-14, 11-4, school district 7-2, 7-5
11-6, 12-2, 12-4, 13-3-13-4 secondary market 6-7-6-8, 7-22-7-24, 8-1, 8-
preemptive 4-10, 13-3 9, 9-21-9-22, 12-13, 12-15, 12-19, 13-5, 13-
voting 4-2-4-3, 4-5, 10-14, 16-13 18, 13-23-13-24, 13-30, 17-1
rights of accumulation 9-13, 9-16-9-17 Secondary Market Discount (SMD) 7-23-7-25
risk Secondary Market Trading of New Issues 13-
default 7-1-7-2, 8-1, 8-15, 15-6 23
high 11-13-11-14 sector 9-22, 15-10
marketability 8-10 Sector Funds Securities 9-9
nondiversifiable 15-14 Secured Creditor 11-6
potential 6-7, 12-40, 18-1 securities
prepayment 3-10, 3-15, 8-10-8-11 additional 18-5, 18-7, 18-11
reinvestment 5-18 agency 8-7, 8-10, 8-15
risk disclosure document 18-4, 18-14 auction rate 7-14-7-15
risk tolerance 1-10-1-11, 9-8, 10-11, 11-12, borrowed 4-18
15-1, 15-3, 15-7, 15-11-15-12 company/variable contract 13-11
riskless 13-19, 17-3 company's 13-7
RMDs (Required Minimum Distributions) 2-13 convertible 6-14, 16-11
ROP (Registered Options Principal) 3-12 customer's 18-4
Roth IRAs 2-15 derivative 4-10, 6-13-6-14, 8-14
rules distribution of 13-4, 13-21
customer account 17-11 exchange-listed 4-13
house 2-19 general obligation 7-13
penny stock disclosure 4-9 income-producing 9-21
wash sale 4-17-4-18, 7-26 interest-bearing 7-13, 8-5
investment company 9-18
issued asset-backed 8-14
long-term 7-15
lower-priced 17-19

marketable 8-1, 16-1-16-3 issue ADR 4-12
municipal fund 3-13 issued 4-2
non-exchange-traded 17-1 new 4-4, 4-11, 9-21, 13-13
non-interest-bearing 8-3-8-4 outstanding 4-3, 6-11, 9-10, 16-4, 16-11,
restricted 13-2, 13-17 17-9
stripped 8-5 preferred 7-14
substantially the same 4-17 redeem 9-22
unsold 13-2, 13-27 secondary market 9-22
Securities Act 7-1, 10-13, 11-7, 13-6-13-7, 13- total 13-19
11, 13-14, 13-20, 13-23-13-24 underlying 12-65
Securities analysts 16-1 short calls 12-11, 12-29, 12-33, 12-40, 12-46
Securities and Exchange Commissions 9-3 short interest 15-17
securities dealers 6-5 short interest theory 15-17
Securities Exchange Act 13-23, 18-1, 18-15, short market value see SMV
19-7 short positions 12-13, 12-44, 12-49, 17-15,
securities firms 8-6, 8-12 18-10-18-11, 18-13
securities industry registration 20-9 short sales 2-21, 4-16, 4-18, 12-43-12-44, 12-
securities industry rules 2-19 48-12-49, 12-51-12-52, 15-17, 15-20, 17-
Securities Interest 8-13 10, 17-12, 17-15, 18-2, 18-9-18-10, 18-12
Securities Investor Protection Act see SIPA short sales of stock 18-1
Securities Investor Protection Corporation see short sellers 4-18, 12-18, 12-43-12-44, 12-48-
SIPC 12-49, 15-17, 17-12, 17-15, 18-2, 18-4, 18-
Securities Investors 9-9 9
securities laws 7-1, 17-8 short stock 12-62
federal 8-6, 10-10, 10-13, 13-23 short-term bonds 15-4, 15-8
securities markets 18-14 signatures 2-3-2-4, 2-7, 4-3
designated offshore 13-21 Simplified Employee Pension see SEP
municipal 13-30 SIPC coverage 6-7
securities registration 10-2, 10-13 SLMA (Student Loan Marketing Association)
self-regulatory organizations see SROs 8-8, 8-15
selling group members 13-4-13-6, 13-24, 13- SMA (Special Memorandum Account) 18-6-
27 18-8, 18-10-18-11
selling group members purchase bonds 13-27 SMD (Secondary Market Discount) 7-23-7-25
Separate Trading of Registered Interest and SMV (short market value) 18-9-18-12
Principal Securities see STRIPS Special Memorandum Account see SMA
sessions, aftermarket trading 17-7, 17-16 speculation 1-13, 11-12, 12-40, 12-59
settlement 9-10, 12-54-12-55, 12-60, 13-22, split 12-8, 12-10, 13-1-13-2
13-30, 19-12, 20-7, 20-9, 20-12-20-13 sponsor 3-18, 9-5, 11-7, 11-14-11-15
regular-way 5-4, 19-10 SRO rules 1-1, 2-20
settlement date 5-3-5-4, 8-6, 13-30-13-31, 17- SROs (self-regulatory organizations) 13-24,
12 18-3, 18-12-18-13, 19-10, 20-9
settlement value 12-57, 12-60 State Administrators 13-9
share price 9-6 state insurance regulations 10-1-10-2
company's 13-2 state law 11-4, 11-6
shareholder list 2-20 state level 7-1
shareholders state taxes 7-19, 7-21
common 6-12, 16-10 Statement of Additional Information (SAI) 9-3
current 4-10-4-11, 13-1, 13-3 statements, official 3-13, 7-8, 13-25, 13-29-13-
existing 9-15, 13-1 31
fund's 9-5 stock
selling 13-1-13-2 equity income 9-7
shares issuing 5-1, 13-6, 16-13
borrowed 17-12, 18-9 large-capitalization 15-12
corporation's 4-5 long 12-41, 12-46, 12-62, 18-15
exchange 9-3 outstanding 3-17-3-18, 4-2-4-3, 4-11
fund's 3-7, 9-3, 9-12, 9-20 over-the-counter 13-19

stop 17-5 supervisory procedures, written 3-16-3-18
treasury 4-2, 16-13 surrender charge 10-12
utility 15-13 Suspicious Activity Report see SAR
voting 9-2 symbol, national securities exchange 3-5
stock certificates 4-3 syndicate 11-7, 11-15, 13-2-13-5, 13-24-13-30
stock dividend payments 17-11 syndicate letter 13-4, 13-26, 13-28
stock dividends 1-4, 4-3, 4-14-4-15, 6-9-6-10, syndicate manager 13-4-13-6, 13-24-13-29
12-9-12-10, 16-13 syndicate members 13-2, 13-5-13-6, 13-9, 13-
common 4-6-4-7 23-13-24, 13-27-13-30
stock funds, high-quality 15-9 syndicators 11-5, 11-7
stock indexes 6-13
stock option plans 16-13 T
stock position
long 12-41, 12-43, 12-47-12-48, 12-51, 12- T-bills 1-12, 5-6, 6-5-6-6, 6-8, 8-1, 8-4-8-6, 8-
65, 17-15 14-8-15, 9-9, 15-6
short 12-40-12-41, 12-43, 12-45, 12-48, T-bonds 8-1-8-2, 8-5-8-6, 8-14, 12-60, 15-6
12-50-12-51, 18-14 TACs (Targeted Amortization Class) 8-13
stock rights 4-11, 16-11 TANs (Tax Anticipation Notes) 7-13
stock splits 4-3, 4-14-4-15, 6-9, 13-20, 16-13, Targeted Amortization Class (TACs) 8-13
17-11 Tax Anticipation Notes (TANs) 7-13
even 12-8 tax bracket 1-3, 2-12, 7-7, 7-21, 15-1
reverse 4-15 tax credits 1-14, 11-9
stock transactions tax-exempt 3-8, 7-15
broker-dealers effect penny 4-9 tax-free 2-12, 2-15, 4-14, 6-5, 7-16, 7-18, 7-
penny 4-10 20-7-21, 10-4, 10-14
Stockholder Information for Solicitation 2-20 tax-free bonds 1-7, 7-20, 15-5
stockholders, preferred 4-5-4-7, 6-2 tax-free issue 7-20-7-21, 15-1
Stockholders' Equity 16-1, 16-13 tax-free money-market funds 7-15
stop order 15-19, 17-15 tax issues 10-1, 11-4
straddle 12-24-12-30, 12-50, 12-62 tax penalty 2-12-2-13, 3-11, 10-5, 10-11
long 12-25, 12-50 tax purposes 1-4, 4-14-4-15, 6-3, 7-2, 7-22, 7-
street name 4-3 25, 10-9, 12-47, 12-66
strike 12-3 tax rate 1-3, 4-17, 7-2, 7-4, 11-2
strike price 12-3-12-5, 12-7, 12-12-12-28, 12- tax return, investor's 8-14, 9-20
30-12-31, 12-33-12-34, 12-36-12-39, 12- taxable income 1-3-1-5, 1-14, 2-12, 2-14, 6-3,
42-12-45, 12-47-12-55, 12-57-12-59, 12- 9-20, 11-13
64-12-65, 18-14 taxable issue 7-20
adjusted 12-9 taxation 1-5, 2-15, 4-13, 6-3, 7-17, 8-11, 8-14,
higher 12-34, 12-36, 12-39, 12-51 10-1, 11-3
lower 12-33, 12-35, 12-38-12-39, 12-51 federal 7-1, 7-22, 7-24, 8-14
strike price minus 12-18, 12-20, 12-22, 12-25, Taxation of Premium Bonds 5-20
12-39, 12-59, 12-65 taxes
STRIPS (Separate Trading of Registered foreign 4-14
Interest and Principal Securities) 8-5, 8- incurring 2-12
15 withholding 2-12, 4-14
Student Loan Marketing Association see SLMA taxpayers 1-5-1-6, 4-15, 7-2-7-3, 7-19, 11-10
subaccounts 10-3-10-5, 10-13-10-14 telephone number 3-5
subject company 3-16-3-18 television 3-4, 3-7
subject security 3-17-3-18 time horizon 1-10, 15-4
subscribers 4-13, 13-3, 17-7 investor's 1-10, 15-4
suitability 1-11, 1-14, 2-1, 9-14, 11-16, 13-4, time value 12-4
15-1-15-2, 17-11 TIPS (Treasury Inflation-Protected Securities)
suitability issues 2-3, 6-14, 10-1, 11-16 8-1, 8-3, 8-15, 15-6
suitability obligations 1-14-1-16, 11-5, 15-1 TOD see Transfer on Death
supervision 3-16 Total Current Assets 16-2, 16-7, 16-15
supervisors 3-3, 3-16 Total Current Liabilities 16-2, 16-15

Total Long-Term Capital 16-9, 16-15 U
total market value 18-3-18-4
Total Stockholders' Equity 16-2 UGMA (Uniform Gifts to Minors Act) 11-16
trade date 5-4, 12-55, 19-10, 19-12 UGMA account 15-9
traders 12-55, 12-57, 13-27, 15-17 UITs (unit investment trust) 3-4, 9-1, 9-21, 9-
pattern day 18-13-18-14 24, 13-29
trading underwriters 3-7, 9-4-9-5, 9-12, 10-10, 11-5,
excessive 2-8 11-7, 13-2-13-3, 13-5, 13-7-13-9, 13-13-13-
orderly 17-3 14, 13-22-13-23, 13-25-13-27, 13-29-13-30
trading authority 2-7 principal 9-4-9-5, 9-10, 9-12, 10-10
Trading Authorizations 2-7 underwriting 7-8, 13-22, 13-27-13-28
limited 2-7 underwriting syndicate 13-2, 13-4, 13-25, 13-
trading departments 17-1 30, 15-15
Trading markets 6-8, 17-1 unemployment 2-11
trading of foreign stocks 4-12 Uniform Gifts to Minors Act see UGMA
trading profits 2-15 Uniform Securities Act see USA
trading volume 13-19, 15-17 unit investment trusts 3-4, 9-1, 13-29
Traditional Exchanges 9-21, 17-3 units 2-8, 4-13, 9-21, 10-4, 10-6, 11-9, 12-56-
tranches 3-15, 8-11-8-14 12-57, 14-5, 16-3
transaction costs 4-15, 12-15 USA (Uniform Securities Act) 13-8
transactions user fees 7-5-7-6, 13-25
foreign currency 12-55
initial 2-3, 18-16 V
money-market 6-5
recommended 1-15 value
Transactions in Nasdaq securities 17-6 absolute 6-10
transfer agent 4-3, 9-4-9-5, 9-12, 14-10, 19-11 annuity's 10-10
transfer instructions 14-9-14-10 assessed 7-2, 7-4-7-5
Treasuries 4-2, 5-6, 7-1, 7-8, 7-18, 8-1-8-3, 8- book 15-9, 16-10, 16-15
5-8-6, 8-8-8-9, 8-11, 8-15, 15-1, 15-5, 18- closing 12-53
12 current 10-4, 10-6, 10-8
Treasury bills 8-4, 15-5 dollar 12-53, 12-57, 15-13
Treasury bonds 5-6, 8-1-8-2, 8-4-8-5, 15-16 fundamental 15-9
Treasury Inflation-Protected Securities see TIPS loan 18-3
Treasury notes 8-1-8-2, 8-5 principal 3-11, 8-3
Treasury Receipts (TRs) 8-5 value investors 15-9, 16-1
Treasury securities 1-7, 5-1, 7-1, 7-18-7-19, 8- value stocks 15-9
1, 8-5-8-7, 8-10, 8-14, 9-7, 12-60, 15-5-15- variable annuities 2-16, 3-11, 10-1-10-5, 10-
6 10-10-11, 10-13-10-14, 15-6
government issues 8-1 variable annuity contract 10-11-10-12
interest-bearing 8-1 variable contracts 10-1, 10-14
risk-free 7-18 variable life insurance policies 3-11-3-12, 10-
Treasury Separate Trading of Registered 10, 10-13-10-14
Interest and Principal Securities 8-1 variable products 3-4, 3-11, 10-1-10-3, 10-5,
Treasury STRIPS 8-5 10-10, 10-12
TRs (Treasury Receipts) 8-5 variable rate demand obligations see VRDOs
trust companies 13-14 venture capitalists 13-1, 13-17
Trust Indenture Act 8-11 violations 2-21, 9-18, 17-6, 17-17
trustee 2-6, 2-12, 2-20, 6-1, 7-10, 9-16, 9-21, volatility 1-10, 3-10, 12-24, 12-50, 12-54-12-
13-32 55, 15-4, 15-11
volume 17-8
VRDOs (variable rate demand obligations) 7-
13, 7-15, 15-16
VUL (variable universal life) 10-14

W
when-issued (WI) 13-30

wholesaler 9-5, 11-7-11-8
WI see when-issued
Wilshire Associates Equity Index 15-13
withdrawal plans, systematic 9-18
withdrawals
early 2-12-2-13, 3-11
random 10-6, 10-9
writer 12-1-12-3, 12-7, 12-12, 12-16-12-17,
12-20-12-21, 12-45, 12-47-12-50, 12-53-
12-54, 12-57, 12-60-12-61, 12-64-12-65,
19-12
Written Supervisory Procedures (WSPs) 2-20,
3-16-3-18
WSPs see Written Supervisory Procedures
Yankee Bonds 6-4

yield-based options 12-52, 12-59-12-61
zero-coupon bonds 5-6, 5-20, 6-3, 8-5, 8-13-

8-14
zero-coupon issues 5-20, 6-3

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Series 7

The Final Exams are a critical part of your training.

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CHAPTER 1 Building An Investor Profile

CHAPTER 2 Customer Accounts

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Employer-Sponsored Retirement Plans—Non-Qualified Plans ....................2-15

CHAPTER 3 Customer Communications

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SEC Rule 15c2-12: Municipal Securities Disclosure ..............................3-13

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Penny Stock Disclosure Rules ...............................................................4-9

CHAPTER 5 Fundamentals of Debt

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Put Provisions ........................................................................................5-13

CHAPTER 6 Corporate Debt

CHAPTER 7 Municipal Debt

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Types of Revenue Bonds .......................................................................7-5

CHAPTER 8 U.S. Treasury and Government Agency Debt

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The Primary Market for U.S. Treasury Securities.........................................8-6

CHAPTER 9 Investment Companies

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High Risk Category ................................................................................9-6

CHAPTER 10 Variable Products

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During the Annuity Period ......................................................................10-9

CHAPTER 11 Alternative Investments

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Investor Suitability .......................................................................................11-16

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Classifying Spreads ...............................................................................12-30

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Trading Concepts and Strategies ...........................................................12-58

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CHAPTER 14 Account Disclosures, Risks, and Returns

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Broker-Dealer Financial Information .......................................................14-5

CHAPTER 15 Portfolio and Market Analysis

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Charts and Patterns ...............................................................................15-19

CHAPTER 16 Fundamental Analysis

CHAPTER 17 Orders and Trade Executions

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The Nasdaq Market Center Execution System.......................................17-8

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Opening a Margin Account ..........................................................................18-3

CHAPTER 19 Clearing, Settlement, and Regulatory Reporting

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CHAPTER 20 Resolving Disputes and Suitability

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About the Series 7 Examination

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Major Job Functions Percentage of Test Questions Number of Questions

Study Manual and Exam Breakdown

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Registering for the Examination

Taking the Exam

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