Study guide
This is the heavyweight of the SIE: Section 2 of the official outline carries 44% of the exam (33 of 75 scored questions). It tests the features, benefits and risks of equity, debt, municipal, options and packaged products, plus the vocabulary of investment risk and how to mitigate it.
Equity Securities
Common stock represents ownership in a corporation. Holders have limited liability (they can lose only what they invested), vote for directors and on major corporate issues, and stand last in a liquidation, behind secured creditors, general creditors, bondholders and preferred stockholders. Under statutory voting a shareholder casts an equal number of votes per board seat, while cumulative voting allows concentrating all votes on one candidate, which benefits small shareholders. Preemptive rights let existing holders maintain their percentage ownership when new shares are issued. Common dividends are never guaranteed. Preferred stock is an equity security that behaves like a fixed-income investment: it pays a stated dividend based on its typical $100 par value, has priority over common stock for dividends and in liquidation, generally carries no voting rights, and its price is sensitive to interest rates. Cumulative preferred accrues any missed dividends, which must be paid before common holders receive anything; participating preferred can share in additional dividends; convertible preferred can be exchanged for common shares; callable preferred can be redeemed by the issuer, usually when rates fall. Rights are short-term instruments issued to existing shareholders allowing purchase of new shares below the current market price. Warrants are long-term, are priced above the market at issuance, and are often attached to bond or preferred offerings as sweeteners. American Depositary Receipts (ADRs) are dollar-denominated receipts for foreign shares held abroad by a U.S. bank's custodian; they trade and pay dividends in U.S. dollars, but the investor still bears currency risk, and ADR holders typically do not receive preemptive rights. Resales of restricted and control stock are governed by SEC Rule 144.
Debt Instruments and Bond Math
A standard bond has $1,000 par value, a fixed coupon (nominal yield) and a maturity date. Bond prices and market interest rates move inversely: when rates rise, existing bond prices fall. A bond trading below par (at a discount) has a current yield and yield to maturity higher than its coupon; a premium bond reverses that order, and if it is callable, its yield to call is the lowest figure of all. Long maturities and low coupons mean greater price volatility. Ratings from S&P, Moody's and Fitch measure default (credit) risk: BBB-/Baa3 and above is investment grade, and anything below is high-yield, or junk. Callable bonds are typically called when rates fall, creating reinvestment risk; convertible bonds can be exchanged for the issuer's common stock and therefore pay lower coupons. Treasury securities carry the full faith and credit of the United States, and their interest is exempt from state and local tax: bills mature in one year or less and are sold at a discount with no coupon; notes run two to ten years; bonds run twenty to thirty years; TIPS adjust principal for inflation; STRIPS are zero-coupon Treasuries. Among agency securities, Ginnie Mae (GNMA) mortgage-backed pass-throughs are the only ones backed by full faith and credit; Fannie Mae and Freddie Mac securities are not. Mortgage-backed securities pay monthly interest and principal and carry prepayment risk because homeowners refinance when rates fall. Corporate debt ranges from secured mortgage and equipment trust bonds to unsecured debentures and subordinated debentures. Money market instruments are short-term, high-quality debt: commercial paper (unsecured corporate notes of 270 days or less), negotiable jumbo CDs, and banker's acceptances that finance international trade.
Municipal Securities and Municipal Fund Securities
Municipal bonds are issued by states, cities and other political subdivisions. Their defining feature is interest that is generally exempt from federal income tax, and often from state tax for in-state residents, which is why they suit investors in high tax brackets; capital gains on municipal bonds remain fully taxable. General obligation (GO) bonds are backed by the issuer's full faith, credit and taxing power, usually require voter approval, and are analyzed by looking at the issuer's tax base and overall debt. Revenue bonds are backed only by revenue from a specific facility, such as tolls, airport fees or utility charges; they require no voter approval and are analyzed with feasibility studies and debt service coverage ratios. Short-term municipal notes such as tax anticipation notes bridge timing gaps in an issuer's cash flow. New issues are sold by competitive bid, where GO issuers award the bonds to the syndicate offering the lowest cost, or by negotiated underwriting, which is common for revenue bonds. Municipal securities are exempt from SEC registration; investors instead receive an official statement, and the MSRB writes the conduct rules for dealers. Municipal fund securities are investment products issued by municipal entities that are not bonds. Section 529 plans come in two forms: prepaid tuition plans lock in future tuition credits, while savings plans invest contributions that grow federally tax-free when used for qualified education expenses. The account owner, not the beneficiary, controls the assets, and plans are sold directly or through advisers. ABLE accounts offer tax-advantaged savings for disability-related expenses without jeopardizing certain government benefits, and local government investment pools (LGIPs) let government entities invest short-term funds.
Options Fundamentals
An option is a contract between a buyer (holder) and a seller (writer) covering, for equity options, 100 shares of the underlying stock. A call gives the holder the right to buy the underlying at the strike (exercise) price; a put gives the right to sell. The buyer pays a premium and receives rights; the writer collects the premium and takes on obligations if assigned. Call buyers are bullish, put buyers are bearish, and writers take the opposite side, typically seeking premium income. The maximum loss for any option buyer is the premium paid. A covered call writer owns the underlying shares; a naked (uncovered) call writer faces theoretically unlimited loss because there is no ceiling on a stock's price. Moneyness ignores the premium: a call is in the money when the market price is above the strike, and a put is in the money when the market is below the strike. Breakeven for a call is strike plus premium; for a put, strike minus premium. Standard equity options expire on the third Friday of the expiration month. American-style options can be exercised any time before expiration; European-style options only at expiration, and index options typically settle in cash rather than delivery of shares. Options serve hedging (buying a put protects a long stock position) or leveraged speculation. Example: Dana buys 1 KLM Oct 50 call at 3, giving her the right to buy 100 shares at $50 with breakeven at $53; if KLM is at $40 at expiration, the call expires worthless and she loses $300. The Options Clearing Corporation issues and guarantees listed options, and customers must receive the Options Disclosure Document (ODD) at or before account approval.
Packaged Products, Alternatives and Investment Risks
Investment companies under the Investment Company Act of 1940 pool investor money. Open-end funds (mutual funds) continuously issue redeemable shares priced once daily at net asset value (NAV); forward pricing means an order receives the next price calculated. Class A shares add a front-end sales charge that drops at breakpoints for larger purchases; a letter of intent gives 13 months to reach a breakpoint, and rights of accumulation count existing holdings. Selling just below a breakpoint to earn a higher commission is a prohibited breakpoint sale. Class B shares carry declining contingent deferred sales charges, Class C shares charge level annual fees, and 12b-1 fees cover distribution costs. Closed-end funds sell a fixed number of shares and then trade on exchanges at premiums or discounts to NAV. Unit investment trusts hold a fixed, unmanaged portfolio and issue redeemable units. Variable annuities are insurance contracts whose value depends on separate account performance; they offer tax-deferred growth and a death benefit but often carry steep surrender charges. ETFs trade intraday like stocks and are often passively indexed with low expenses; ETNs are unsecured debt of the issuing bank, adding issuer credit risk. REITs must distribute at least 90% of taxable income, avoiding double taxation, but do not pass through losses, and non-traded REITs are illiquid. Direct participation programs (limited partnerships) pass through both income and losses but are unlisted and illiquid, and hedge funds are private, lightly regulated, high-minimum and illiquid. Know the risk vocabulary: capital, credit, currency, inflation (purchasing power, worst for fixed income), interest rate, reinvestment, liquidity, market (systematic), non-systematic (issuer-specific), political, and prepayment risk. Diversification, rebalancing and hedging mitigate risk, but diversification cannot eliminate systematic risk.
Key terms
- Warrant
- — A long-term instrument to buy an issuer's stock at a price set above the market at issuance, often attached to bonds as a sweetener.
- American Depositary Receipt (ADR)
- — A dollar-denominated receipt for foreign shares that trades in U.S. markets but still exposes the holder to currency risk.
- Debenture
- — A corporate bond backed only by the issuer's full faith and credit rather than specific collateral.
- Yield to maturity (YTM)
- — The total annualized return earned if a bond is held to maturity, reflecting coupon income and any discount or premium.
- General obligation (GO) bond
- — A municipal bond backed by the issuer's taxing power that typically requires voter approval.
- Revenue bond
- — A municipal bond repaid solely from the earnings of a specific facility and evaluated with feasibility studies.
- Call option
- — A contract giving the holder the right to buy 100 shares of the underlying at the strike price before expiration.
- Premium
- — The price the option buyer pays the writer, and the maximum possible loss for any option buyer.
- Net asset value (NAV)
- — A fund's assets minus liabilities divided by shares outstanding, calculated once daily for mutual funds.
- Breakpoint
- — A purchase level at which a mutual fund's front-end sales charge is reduced.
- Exchange-traded note (ETN)
- — An unsecured debt obligation of a bank that tracks an index, exposing holders to the issuer's credit risk.
- Systematic risk
- — Market-wide risk that affects nearly all securities and cannot be eliminated through diversification.
Exam tips
- Yield order is a favorite: for a discount bond, coupon < current yield < YTM; for a premium bond the order flips, and yield to call is lowest on a premium callable bond. Rates up means prices down, with long-term, low-coupon bonds swinging the most.
- Rights vs. warrants: rights are short-term, priced below market, and go to existing shareholders; warrants are long-term, priced above market at issuance, and are used as sweeteners.
- The most-tested options fact: a naked call writer has unlimited maximum loss, while any option buyer can lose only the premium paid.
- If a question says a fund 'trades at a discount to NAV' or trades intraday on an exchange, it is a closed-end fund (or ETF), never an open-end mutual fund, which is bought and redeemed at the next-computed NAV.
- GO bonds mean taxes and voter approval; revenue bonds mean user fees and feasibility studies. And remember municipal tax benefits apply to interest only; capital gains are still taxable.