Study guide
This chapter carries a 25 percent weighting, about 32 of the 130 scored questions. It surveys the entire product shelf: cash instruments, bonds, stocks, funds, derivatives, alternatives, and insurance-based products, with emphasis on how each is priced, taxed, and where its risks hide.
Cash Equivalents and the Fixed-Income Menu
Cash and equivalents trade return for safety and liquidity. Demand deposits and bank certificates of deposit carry FDIC insurance up to $250,000 per depositor, per bank, per ownership category; jumbo negotiable CDs above that amount carry the excess uninsured. Money market instruments are short-term, high-quality debt: commercial paper is unsecured corporate debt issued at a discount with maturities up to 270 days, and Treasury bills are U.S. government obligations of one year or less sold at a discount, serving as the exam's risk-free benchmark. Longer-term U.S. government securities include Treasury notes (2 to 10 years) and Treasury bonds (20 to 30 years), paying semiannual interest that is taxable federally but exempt from state income tax. Treasury Inflation-Protected Securities (TIPS) adjust principal with the CPI and pay a fixed coupon rate on that adjusted principal; because the annual principal adjustments are taxable even though not received in cash, TIPS fit best in tax-deferred accounts. Asset-backed and mortgage-backed securities pool loans and add prepayment and extension risk. Corporate bonds range from secured issues to unsecured debentures. Municipal bonds come in two main types: general obligation bonds backed by the issuer's taxing power (usually requiring voter approval) and revenue bonds backed only by a specific project's income. Municipal interest is federally tax-exempt and often state-exempt for residents, so munis suit high-bracket investors in taxable accounts; compare them using tax-equivalent yield, the muni yield divided by one minus the tax rate. Foreign sovereign and corporate bonds add currency and political risk on top of credit risk.
Bond Characteristics, Pricing, and Valuation
The unshakable rule: bond prices and interest rates move inversely. A bond issued at par ($1,000) trades at a discount when rates rise above its coupon and at a premium when rates fall below it. Four yields describe a bond. The nominal yield is the fixed coupon rate. Current yield is annual interest divided by current market price. Yield to maturity (YTM) accounts for the price paid, coupons, and the gain or loss at maturity. Yield to call (YTC) does the same to the call date. For a discount bond the order is nominal, then current yield, then YTM, then YTC, lowest to highest; for a premium bond the order reverses exactly. Duration measures price sensitivity to rate changes: the longer the maturity and the lower the coupon, the higher the duration and the bigger the price swing. A zero-coupon bond's duration equals its maturity, making zeros the most volatile bonds; they are bought at deep discounts, pay no coupons, and the accreted interest is taxed annually as phantom income. Call features favor the issuer, who calls bonds when rates fall, sticking investors with reinvestment risk; call protection periods and call premiums soften the blow. Credit ratings run from AAA down to BBB- (Moody's Baa3), the investment-grade floor; anything below is high-yield or junk. Widening credit spreads mean falling prices for risky debt. Convertible bonds can be exchanged for the issuer's stock: the conversion ratio equals par divided by the conversion price, and conversion value equals that ratio times the stock price; investors accept a lower coupon for the equity upside. Fundamentally, a bond is worth the discounted present value of its remaining coupons and principal.
Equity Securities: Types, Rights, and Valuation
Common stockholders own the residual claim on a corporation, with limited liability, voting rights, and possible dividends declared at the board's discretion. Statutory voting gives one vote per share per director seat; cumulative voting lets a shareholder pile all votes on one candidate, helping minority holders. Preemptive rights let existing holders buy new shares before the public to avoid dilution. Preferred stock pays a fixed dividend, typically has no maturity or voting rights, and behaves like a bond, falling when rates rise; cumulative preferred must have missed dividends paid in arrears before common holders get anything, convertible preferred can swap into common, and floating-rate preferred is less rate-sensitive. American Depositary Receipts (ADRs) let U.S. investors buy foreign shares in dollars on U.S. markets; dividends arrive in dollars, but the underlying dividends are declared in foreign currency, so currency risk remains, and ADR holders often lack preemptive rights. Restricted stock is unregistered; under SEC Rule 144 it generally requires a six-month holding period for reporting companies, with volume limits for affiliates. Employee stock options come in two flavors: nonqualified options (NQSOs) create ordinary income on the spread at exercise, while incentive stock options (ISOs) defer regular tax until sale but the exercise spread is an alternative minimum tax preference item. Valuation approaches include fundamental analysis (financial statements, industry, and economy to find intrinsic value), technical analysis (price and volume charts, support and resistance), the dividend discount model (present value of expected dividends), and discounted cash flow. New equity reaches the market through initial public offerings, follow-on or secondary offerings, and SPACs, which are blank-check shell companies that raise cash in trust to acquire an unidentified business, carrying sponsor-conflict and no-deal risk.
Pooled Investments: Mutual Funds, ETFs, UITs, REITs, and Private Funds
Open-end mutual funds continuously issue and redeem shares at net asset value (NAV) using forward pricing: every order is filled at the next NAV calculated after receipt. Share classes differ by cost: Class A charges a front-end load reduced by breakpoints (with letters of intent good for 13 months and rights of accumulation); Class B carries a declining contingent deferred sales charge and converts to A; Class C charges a level annual load, cheaper for short holding periods but expensive over decades. All classes bear the expense ratio, possibly including 12b-1 distribution fees. Closed-end funds sell a fixed number of shares in an IPO and then trade on exchanges at premiums or discounts to NAV; investors pay market price plus commission. Exchange-traded funds also trade intraday, but an in-kind creation and redemption mechanism keeps market prices near NAV; most track indexes passively, with low expenses and strong tax efficiency, and they can be sold short or bought on margin. Unit investment trusts hold a fixed, unmanaged, self-liquidating portfolio with no board or portfolio manager, and units are redeemable. Real estate investment trusts must distribute at least 90 percent of taxable income to shareholders; listed REITs are liquid while non-traded REITs are illiquid with high fees, and REIT dividends are generally taxed as ordinary, non-qualified income. Private funds (hedge funds, private equity, venture capital) use leverage, short selling, and lock-ups, typically charge management plus performance fees, and are limited to accredited or qualified investors. Compare pooled products on benchmarks, manager tenure, style consistency, changes in investment policy, fees, liquidity, and taxes, remembering that fund capital gains distributions are taxable even when reinvested.
Derivatives, Alternatives, and Insurance-Based Products
An option is a contract: a call is the right to buy at a strike price, a put the right to sell. Buyers pay a premium and receive rights, with maximum loss limited to that premium; writers collect the premium and take on obligations, and an uncovered call writer faces unlimited risk. Covered calls generate income on stock already owned but cap upside; protective puts insure a long position. Warrants are long-term rights to buy the issuer's own stock, created by the company itself, often attached to bond offerings as sweeteners and issued out of the money. Futures are obligations, not rights, to buy or sell an asset at a set price and date, exchange-traded and marked to market daily, used by hedgers and speculators. Exchange-traded notes are unsecured debt of the issuing bank that merely promise an index's return, so the holder bears the issuer's credit risk even if the index performs. Leveraged and inverse funds multiply or invert an index's daily return; daily resetting causes compounding drift, making them unsuitable as long-term holdings. Structured products are complex, often illiquid, and carry issuer credit risk. Limited partnerships pass income and losses through to investors but are illiquid, with the general partner managing and bearing unlimited liability. Commodities and precious metals can hedge inflation but produce no income. Digital assets may be securities under the Howey test depending on the facts, with extreme volatility and custody risk. Annuities: fixed annuities pay guaranteed rates from the insurer's general account and are insurance, not securities; variable annuities invest in separate-account subaccounts, are securities, grow tax-deferred, and tax earnings as ordinary income with a 10 percent penalty before age 59 1/2; indexed annuities credit index-linked interest subject to caps and participation rates. Life insurance parallels this: term (pure protection), whole (guaranteed cash value), universal (flexible premiums), and variable life, which is a security.
Key terms
- Duration
- — A measure of a bond's price sensitivity to interest rate changes, higher for longer maturities and lower coupons.
- Yield to maturity (YTM)
- — The total annualized return earned if a bond is held to maturity, accounting for price, coupons, and redemption at par.
- TIPS
- — Treasury securities whose principal adjusts with CPI inflation, with the fixed coupon rate applied to the adjusted principal.
- General obligation bond
- — A municipal bond backed by the issuer's full taxing power rather than a specific project's revenue.
- Debenture
- — An unsecured corporate bond backed only by the issuer's promise to pay, not by collateral.
- American Depositary Receipt (ADR)
- — A dollar-denominated receipt for foreign shares that trades on U.S. markets while retaining currency risk.
- Net asset value (NAV)
- — A fund's assets minus liabilities divided by shares outstanding, the price at which open-end funds are bought and redeemed.
- Closed-end fund
- — A fund with a fixed number of shares that trades on an exchange at a premium or discount to NAV.
- Exchange-traded note (ETN)
- — An unsecured bank debt obligation that tracks an index, exposing holders to the issuer's credit risk.
- Real estate investment trust (REIT)
- — A pooled real estate vehicle that must pay out at least 90 percent of taxable income and whose dividends are generally ordinary income.
- Warrant
- — A long-term right issued by a company to buy its own stock at a set price, often attached to bond offerings.
- Variable annuity
- — An insurance contract funded through separate-account subaccounts, regulated as a security, with tax-deferred growth and ordinary-income taxation of earnings.
Exam tips
- Memorize the yield ladder: for a discount bond, nominal < current yield < YTM < YTC; a premium bond reverses it exactly. And when rates rise, the longest-maturity, lowest-coupon bonds (zeros above all) fall hardest.
- Security or insurance? Variable annuities and variable life are securities because value depends on a separate account; fixed annuities and whole life are not because the insurer's general account guarantees them. The word 'guaranteed' points to insurance.
- Pricing mechanics distinguish funds: open-end funds always transact at the next-computed NAV (forward pricing); closed-end funds and ETFs trade at market prices that can sit above or below NAV.
- Leveraged and inverse funds reset daily, so any question describing one as a long-term buy-and-hold position is flagging an unsuitable recommendation.
- Options buyers have rights and can lose only the premium; writers have obligations, and uncovered call writers face unlimited loss. Warrants differ from calls because the issuing company itself creates them with long expirations. An ETN's hidden risk is the bank's credit, not the index.