Investment Company

Products/Variable Contracts
Limited Representative Exam
Series 6 | 10th Edition

Securities License Exam Manual

 Investment Company
Products/Variable Contracts
Limited Representative Exam
Series 6
10th Edition

Securities License Exam Manual

Series 6 [Link] 1 6/8/2016 [Link] PM

 At press time, this edition contains the most complete and accurate
information currently available. Owing to the nature of license examinations,
however, information may have been added recently to the actual test that
does not appear in this edition. Please contact the publisher to verify that you
have the most current edition.

This publication is designed to provide accurate and authoritative information

in regard to the subject matter covered. It is sold with the understanding
that the publisher is not engaged in rendering legal, accounting, or other
professional services. If legal advice or other expert assistance is required, the
services of a competent professional should be sought.

SERIES 6 INVESTMENT COMPANY PRODUCTS/VARIABLE

CONTRACTS LIMITED REPRESENTATIVE EXAM LICENSE EXAM
MANUAL, 10TH EDITION
©2016 Kaplan, Inc.

The text of this publication, or any part thereof, may not be reproduced in any
manner whatsoever without written permission from the publisher.

If you find imperfections or incorrect information in this product, please visit

[Link] and submit an errata report.

Published in June 2016 by Kaplan Financial Education.

Printed in the United States of America.

ISBN: 978-1-4754-0793-8

Series 6 [Link] 2 6/8/2016 [Link] PM

 Contents

1 Securities Markets, Investment Securities,

and Economic Factors  1

1.1 What Is a Security?  3 1.3 Debt Securities  30

Equity and Debt  ■ Function Characteristics of Bonds  ■ 
and Regulation of Securities  ■  Bond Yields  ■  U.S. Government
Important Definitions in the and Agency Securities  ■ 
Securities Industry   ■  Securities Municipal Bonds  ■  Corporate
and Business Bonds  ■  Tracking Corporate
Bonds  ■  The Money Market
1.2 Equity Securities  6
Common Stock  ■  Tracking 1.4 Economic Factors  66
Equity Securities  ■  Preferred Gross Domestic Product
Stock  ■  American Depositary (GDP)  ■  Economic Policy
Receipts  ■  Rights and
Warrants   ■  Options

iii

Series 6 [Link] 3 6/8/2016 [Link] PM

 iv Contents

2 Product Information: Investment Company Securities and

Variable Contracts  85

2.1 Investment Company 2.5 Mutual Fund Purchase and

Offerings 87 Withdrawal Plans  130
Investment Company Mutual Fund Investment Plans
Purpose   ■  Types of Investment
Companies  ■  Special 2.6 Tracking Investment
Investment Securities Company Securities  135
Newspaper Quotes  ■ 
2.2 Investment Company Investment Services
Registration  96
SEC Registration and Public 2.7 Annuity Plans  138
Offering Requirements  ■  Types of Annuity Contracts  ■ 
Registration of Investment Purchasing Annuities  ■ 
Company Securities  ■  Accumulation Stage   ■ 
Restrictions on Operations Receiving Distribution from
Annuities   ■  Variable Annuity
2.3 Management of Investment Suitability
Companies 101
Board of Directors  2.8 Life Insurance  151
■ Investment Adviser 
Whole Life Insurance 
■  Variable Life Insurance 
■ Custodian ■  Transfer
■  Deductions From the
Agent (Customer or
Shareholder Services Agent)  ■  Premium  ■  Deductions From
Underwriter   ■  Information the Separate Account  ■ 
Distributed to Investors Assumed Interest Rate and
Variable Death Benefit  ■ 
2.4 Characteristics of Mutual Hypothetical Illustrations  ■ 
Funds  108 Loans  ■  Contract Exchange  ■
The Mutual Fund Concept  ■  Sales Charges and Refunds  ■ 
Price of Mutual Fund Shares  ■  Voting Rights ■  Life Settlements 
Sales Charges  ■  Investment ■  Life Insurance Settlement

Objectives  ■  Comparing Options

Mutual Funds

Series 6 [Link] 4 6/8/2016 [Link] PM

 Contents v

3 Securities and Tax Regulations  173

3.1 Financial Industry 3.7  Mutual Fund Distributions

Regulatory Authority and Taxation  216
(FINRA) 175 Taxation  ■  Distributions from
Districts  ■  Terms of Mutual Funds
Membership  ■  Use of FINRA’s
Corporate Name  ■ FINRA 3.8 Taxation of Variable
Rules  ■  FINRA Membership Contract Products  227
and Registration  ■ Information Taxation of Annuities  ■ 
Provided to Investors Taxation of Life Insurance

3.2 Qualification 3.9 Retirement Planning  230

Examinations 183 Nonqualified Retirement
Registered Representatives  Plans  ■ (Traditional)
■  Registered Principals  ■ 
Individual Retirement
Ineligibility and Disqualifications  Accounts (IRAs)  ■ Self-
■ Examinations
Employed Plans  ■ 403(b)
Plans  ■  Corporate Retirement
3.3 Issuing Securities  189 Plans  ■  Employee Retirement
Investment Banking  ■  Types of Income Security Act of 1974
Underwriting Commitments (ERISA)

3.4 The Regulation of New 3.10 Securities Investor

Issues  192 Protection Corporation
The Securities Act of (SIPC)  247
1933  ■  Registration of Protection of Customers ■ 
Securities  ■  FINRA Rule 5130 Advertising SIPC Membership
■  Fidelity Bonds
3.5 Trading Securities  200
Securities Markets  ■  Role of 3.11 Insider Trading and
the Broker-Dealer  ■ Brokerage Securities Fraud Enforcement
Office Procedures Act of 1988 (ITSFEA)  249
Written Supervisory
3.6 The Regulation of Procedures  ■ Penalties
Trading 211
The Securities Exchange Act 3.12 Regulation S-P  251
of 1934  ■  The Investment Disclosures  ■  Right to Opt Out
Advisers Act of 1940

Series 6 [Link] 5 6/8/2016 [Link] PM

 vi Contents

4 Marketing, Prospecting, and Sales Presentations  267

4.1 Communications with the 4.2 Mutual Fund

Public  269 Marketing  291
Institutional Communications  ■  Methods of Marketing Mutual
Retail Communication  ■  Fund Shares  ■  Reductions in
Correspondence  ■  Other Sales Charges  ■  Redemption of
Communications  ■  Fund Shares
General Communication
Standards  ■  Performance
Data  ■  Recordkeeping
and Filing Requirements  ■ 
Communications Regarding
Variable Contracts  ■  Telephone
Communications with the Public

5 Opening and Servicing Customer Accounts  309

5.1 Opening Accounts  311 5.3 Ethics in the Securities

Account Ownership  ■  Trading Industry 325
Authorization  ■  Payment Ethical Business Practices  ■ 
Method  ■  Securities Business Outside the Firm  ■ 
Traded  ■  Documenting New Violations of Fair Dealing  ■ 
Accounts  ■  Opening Accounts Criminal Penalties
for Employees of Other Broker-
Dealers 5.4 Code of Procedure and
Code of Arbitration
5.2 Types of Accounts  317 Procedure  335
Individual Accounts  ■ Joint Code of Procedure  ■  Code of
Accounts  ■  Power of Arbitration Procedure
Attorney  ■ Discretionary
Accounts  ■  Custodial 5.5 USA PATRIOT Act of
Accounts  ■  Transferring 2001  341
Customer Accounts Between Currency Transaction Reports
Broker-Dealers (CTRs)  ■  Suspicious Activity
Reports (SARs)  ■ Anti-Money
Laundering Rules

Series 6 [Link] 6 6/8/2016 [Link] PM

 Contents vii

6 Suitability and Risk  353

6.1 Know Your Customer: 6.2 Analyzing Financial Risks

Suitability Issues  355 and Rewards  362
Customer Profile: Financial Suitability  ■  Investment Risks
Investment Considerations  ■ 
Customer Profile: Nonfinancial
Investment Considerations  ■ 
Customer Investment Objectives

Mutual Fund Customer Suitability Quiz  375

Common Abbreviations  381

Calculations  383

Glossary  385

Index  415

Series 6 [Link] 7 6/8/2016 [Link] PM

Series 6 [Link] 8 6/8/2016 [Link] PM
 Introduction

❚ INTRODUCTION
Thank you for choosing this exam preparation system for your educational needs and wel-
come to the Series 6 License Exam Manual. This manual has applied adult learning principles
to give you the tools you’ll need to pass your exam on the first attempt.

Why do I need to pass the Series 6 exam?

Financial Industry Regulatory Authority (FINRA), a self-regulatory organization, requires
its members and employees of its members to pass a qualification exam to become registered as
an Investment Company Products/Variable Contracts Limited Representative. You must pass
the Series 6 exam to be qualified to sell investment company securities and variable contracts.

Are there any prerequisites?

There are no prerequisite exams to pass before sitting for the Series 6 exam.

What is the Series 6 exam like?

The Series 6 is a 135-minute, 105-question exam (100 questions scored) administered
by FINRA. It is offered as a computer-based exam at Prometric testing centers around the
country.

What score must I achieve to pass?

You need a score of at least 70% on the Series 6 exam to pass (70 correct out of the 100
questions that count). Pass the exam and you become eligible for registration as an Investment
Company Products/Variable Contracts Limited Representative.

ix

Series 6 [Link] 9 6/8/2016 [Link] PM

 x Introduction

What topics will I see on the exam?

The questions you will see on the Series 6 exam do not appear in any particular order. The
computer is programmed to select a new, random set of questions for each exam taker, select-
ing questions according to the preset topic weighting of the exam. Each Series 6 candidate will
see the same number of questions on each topic, but a different mix of questions. The Series 6
exam is divided into four critical function areas:

# of Questions % of Exam
Regulatory fundamentals and business development 22 22%
Evaluates customers’ financial information, identifies investment 47 47%
objectives, provides information on investment products, and
makes suitable recommendations
Opens, maintains, transfers and closes accounts and retains 21 21%
appropriate account records
Obtains, verifies, and confirms customer purchase and sale 10 10%
instructions

When you complete your exam, you will receive a printout that identifies your perfor-
mance in each area.

❚ PREPARING FOR THE EXAM

How is the License Exam Manual organized?
The License Exam Manual is organized in units. There is also a glossary that can help clar-
ify unfamiliar terms you come across and an index that makes it easy to locate content within
the LEM. In addition to the regular text, each unit ends with a test. Look for unique features
created to help you understand and comprehend the material. When additional emphasis is
critical to your success, the following distinctions are made.

✓
TA K E N O T E Each Take Note provides special information designed to amplify important
points.

TEST TOPIC ALERT

! Each Test Topic Alert reviews content that is especially likely to appear on the
exam.

*
EXAMPLE Examples provide practical applications that convert theory into understanding.

Series 6 [Link] 10 6/8/2016 [Link] PM

 Introduction xi

Q
QUICK QUIZ Quick Quizzes are a quick interactive review of what you just read. These ensure
you understand and retain the material.

Additional Study Resources

To accompany and supplement your License Exam Manual, your study package may con-
tain additional study resources. Be sure to spend some time on your homepage, view the best
practices video, and understand all that is available to help you study.

SecuritiesProTM Qbank

Coordinating with the LEM, the SecuritiesProTM QBank includes a large number of ques-
tions that are similar in style and content to those you will encounter on the exam. You may
use it to generate tests by a specific unit or combination of units. The QBank also allows you to
create Weighted Mock Exams that mimic your test. There is no limit to the number of QBank
exams you can create.
One thing you should know about the SecuritiesProTM QBank is that the answer choices
are scrambled each time you take a test. That is, if the first time you saw a specific question,
the correct answer was choice A, that statement might be choice D the next time. Please keep
this in mind if you need to contact us regarding that question.

Practice and Mastery Exams

Depending on the study package purchased, you may also have a fixed Practice Exam or a
fixed Practice and Mastery Exam. These exams are designed to closely replicate the true exam
experience, both in terms of the degree of difficulty and topical coverage. They provide scores
and diagnostic feedback, but you will not be given access to, or be able to obtain from Kaplan,
correct answers or question explanations. The Practice and Mastery Exams are sound indica-
tors of potential actual exam scores—the better you do on these exams, the more likely you
are to pass your actual exam. These may be taken just once each.

Video Library

You may also have access to various topics from our video library. These short, engaging
videos cover key topics from your manual. If your package includes access to our video library,
please review the topics as you complete your reading assignments in the study manual.

Exam Tips & Content Updates Link

Don’t forget to monitor your Exam Tips & Content Updates (located on your homepage).
When rules and regulations change, or when we want to share new information regarding your
exam, it’s posted there.
In addition, try as we may, in a text this large, errors are difficult to avoid. When we
become aware of them, we acknowledge them in the Corrections tab, also located on your
dashboard.

Series 6 [Link] 11 6/8/2016 [Link] PM

 xii Introduction

What topics are covered in the course?

The License Exam Manual consists of six Units, each devoted to a particular area of study
that you will need to know to pass the Series 6. Each Unit is divided into study sections
devoted to more specific areas with which you need to become familiar.
The Series 6 License Exam Manual addresses the following topics:

Unit Topic
1 Securities Markets, Investment Securities, and Economic Factors
2 Product Information: Investment Company Securities and
Variable Contracts
3 Securities and Tax Regulations
4 Marketing, Prospecting, and Sales Presentations
5 Opening and Servicing Customer Accounts
6 Suitability and Risk

How much time should I spend studying?

Plan to spend approximately 70–90 hours reading the material and carefully answering
the questions. Spread your study time over the 4–5 weeks before the date on which you are
scheduled to take the Series 6 exam. Your actual time may vary depending on your reading
rate, comprehension, professional background, and study environment.

What is the best way to structure my study time?

The following schedule is suggested to help you obtain maximum retention from your
study efforts. Remember, this is a guideline only, because each individual may require more or
less time to complete the steps included.

Step 1. Read a Unit and complete the Unit Test. Review rationales for all questions
whether you got them right or wrong (2–3 hours per Unit).

Step 2. On the SecuritiesProTM QBank, create a minimum of two 40 question exams for
each unit as you go. Carefully review all rationales. Use the reference number to locate ad-
ditional or related information on the test topic in your LEM if needed (2–3 hours per Unit).
■■ Do not become too overwhelmed or bogged down in any one unit. You don’t want to lose
sight of the finish line because you’re having trouble with one hurdle. Keep moving for-
ward. It’s a steady pace that wins the race.
■■ View rationales after each question initially and spend time studying each rationale in
order to learn the concepts. Later, you will want to create exam scenarios in which scores
and rationales are viewed at the end of each exam.
■■ Perfection is not the goal during the reading phase; scores in the mid- to high-60s is good
initially.

Step 3. When you have completed all the Units in the License Exam Manual and their
Unit Tests, using the Securities Pro QBank, concentrate on comprehensive exams covering
all the material. With your comprehensive testing, it is best to view correct answers and

Series 6 [Link] 12 6/8/2016 [Link] PM

 Introduction xiii

rationales only after the test is completed. Plan to spend at least one week testing prior to a
scheduled class (about 2 hours for every 100 questions).
■■ You should complete at least 10 Weighted Mock Exams prior to class. Review your answers
and rationales. Also, review your LEM and video library as needed.
■■ Your goal is to consistently score in the 80s.

Step 4. Complete online Practice and Mastery exams. You should complete each exam
while observing the time limits for the actual exam. Upon completing the exam, you will
receive a diagnostic report that identifies topics for further review (about 2 hours per exam).
We recommend taking the Practice Exam prior to a scheduled class and the Mastery Exam
afterward. Remember, you will not see the answer key and rationale, but the detailed di-
agnostic breakdown will provide you with clear guidance on areas where further study is
required.

How well can I expect to do?

The exams administered by FINRA are not easy. You must display considerable under-
standing and knowledge of the topics presented in this course to pass the exam and qualify for
registration.
If you study diligently, complete all sections of the course, and consistently score in the 80s
on the tests, you should be well prepared to pass the exam. However, it is important for you
to realize that merely knowing the materials will not enable you to pass unless you can apply
your knowledge to the questions you are given and understand the essence of the information
behind the question.

❚ TEST-TAKING TIPS
Passing the exam depends not only on how well you learn the subject matter, but also on
how well you take exams. You can develop your test-taking skills—and improve your score—by
learning a few test-taking techniques:
■■ Read the full question
■■ Avoid jumping to conclusions—watch for hedge clauses
■■ Interpret the unfamiliar question
■■ Look for key words and phrases
■■ Identify the intent of the question
■■ Memorize key points
■■ Use a calculator
■■ Beware of changing answers
■■ Pace yourself

Each of these pointers is explained below, including examples that show how to use them
to improve your performance on the exam.

Series 6 [Link] 13 6/8/2016 [Link] PM

 xiv Introduction

Read the full question

You cannot expect to answer a question correctly if you do not know what it is asking. If
you see a question that seems familiar and easy, you might anticipate the answer, mark it, and
move on before you finish reading it. This is a serious mistake. Be sure to read the full question
before answering it. Mistakes are often made when assuming too much (or too little).

Avoid jumping to conclusions—watch for hedge clauses

The questions on FINRA exams are embellished with distractors as choices. To avoid
being misled by seemingly obvious answers, make it a practice to read each question and
each answer twice before selecting your choice. Doing so will provide you with a much better
chance of doing well on the exam.
Watch out for hedge clauses embedded in the question. (Examples of hedge clauses
include the terms if, not, all, none, and except.) In the case of if statements, the question can
be answered correctly only by taking into account the qualifier. If you ignore the qualifier, you
will not answer correctly.
Qualifiers are sometimes combined in a question. Some that you will frequently see
together are all with except and none with except. In general, when a question starts with all or
none and ends with except, you are looking for an answer that is opposite to what the question
appears to be asking.

Interpret the unfamiliar question

Do not be surprised if some questions on the exam seem unfamiliar at first. If you have
studied your material, you will have the information to answer all the questions correctly. The
challenge may be a matter of understanding what the question is asking.
Very often, questions present information indirectly. You may have to interpret the mean-
ing of certain elements before you can answer the question. Be aware that the exam will
approach a concept from different angles.

Look for key words and phrases

Look for words that are tip-offs to the situation presented. For example, if you see the word
prospectus in the question, you know the question is about a new issue. Sometimes a question
will even supply you with the answer if you can recognize the key words it contains. Few ques-
tions provide blatant clues, but many do offer key words that can guide you to selecting the
correct answer if you pay attention. Be sure to read all instructional phrases carefully. Take
time to identify the key words to answer this type of question correctly.

Identify the intent of the question

Many questions on FINRA exams supply so much information that you lose track of what
is being asked. This is often the case in story problems. Learn to separate the story from the
question.
Take the time to identify what the question is asking. Of course, your ability to do so
assumes you have studied sufficiently. There is no method for correctly answering questions if
you don’t know the material.

Series 6 [Link] 14 6/8/2016 [Link] PM

 Introduction xv

Memorize key points

Reasoning and logic will help you answer many questions, but you will have to memorize
a good deal of information. Some memorization will be automatic as you go over the material
and answer questions; some you will simply have to do systematically.

Use of a calculator
For the most part, there are only a few questions that will require the use of a calculator.
Any math will be simple math; add, subtract, multiply, and divide. We recommend using a
calculator for math. You may ask for a calculator or ask if you can use your own. If using your
own, only simple math functions are allowed (add, subtract, multiply, and divide).

Avoid changing answers

If you are unsure of an answer, your first hunch is the one most likely to be correct. Do not
change answers on the exam without good reason. In general, change an answer only if you:
■■ discover that you did not read the question correctly; or
■■ find new or additional helpful information in another question.

Pace yourself
Some people will finish the exam early and some do not have time to finish all the ques-
tions. Watch the time carefully (your time remaining will be displayed on your computer
screen) and pace yourself through the exam.
Do not waste time by dwelling on a question if you simply do not know the answer. Make
the best guess you can, mark the question for Record for Review, and return to the question if
time allows. Make sure that you have time to read all the questions so that you can record the
answers you do know.

❚ THE EXAM
How do I enroll in the exam?
To obtain admission to a FINRA-administered exam, your firm must electronically apply
for and pay a fee to FINRA through its Central Registration Depository, better known as the
Web CRD®. To take the exam, you must make an appointment with a Prometric or Pearson
VUE Testing Center as far in advance as possible to get the date you would like to sit for the
exam.

[Link]
1-800-578-6273

[Link]
1-866-396-6273

Series 6 [Link] 15 6/8/2016 [Link] PM

 xvi Introduction

You may schedule your appointment 24 hours a day, 7 days a week, on the websites. You
may also reschedule or cancel your exam, locate a test center, and get a printed confirmation
of your appointment.
You must have your Central Registration Depository (CRD) number available when
scheduling your exam. This unique personal identification number should be provided to you
by your employing member firm. On a cautionary note, failure to show for an examination will
be permanently recorded on your examination history on the Web CRD®.

What should I take to the exam?

Take one form of personal identification with your signature and photograph as issued by
a government agency. You may not take reference materials or anything else into the testing
area. Calculators are available upon request. Scratch paper and pencils will be provided by the
testing center, although you may not take them with you when you leave.

Additional trial questions

During your exam, you may see extra trial questions. These are potential exam-bank ques-
tions being tested during the course of the exam. These questions are not included in your final
score and you will be given extra time to answer them.

Exam results and reports

At the end of the exam, your score will be displayed, indicating whether you passed. The
next business day after your exam, your results will be mailed to your firm and to the self-
regulatory organization and state securities commission specified on your application.

Series 6 [Link] 16 6/8/2016 [Link] PM

 u n i t

1
Securities Markets,
Investment Securities,
and Economic Factors

T
his Unit encompasses a wide discussion of different types of securities,
the markets in which they trade, and basic economics. Though fewer
questions are asked in this Unit than in other Units, the securities
industry fundamentals discussed here will be important for success in
future sections. Be sure to acquire a sound understanding of the differences
between equity and debt securities and the marketplaces in which they
trade. Additional emphasis has been placed on economics and its effects on
securities, as well as factors that affect currency rates and how they influence
securities prices. You can expect at least one question on the effects of
economics on currencies, or the effect of currencies on economics.
The Series 6 exam will include 10–20 questions on the topics covered in
this Unit. ■

Series 6 [Link] 1 6/8/2016 [Link] PM

 OBJECTIVES

When you have completed this Unit, you should be able to:

■■ explain the basic features of common stock and other equity securities;

■■ recognize the types of preferred stock and their unique features;

■■ recognize the basic features of corporate, federal, agency, and municipal bonds as well
as other debt securities;

■■ demonstrate the relationship of yields;

■■ list and describe common money market instruments;

■■ identify the four phases and key characteristics of the business cycle;

■■ describe fundamental economic policies;

■■ distinguish the four major interest rates in the United States;

■■ assess currency exchange rates and their effects on importers and exporters.

Series 6 [Link] 2 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 3

1. 1 WHAT IS A SECURITY?
A security constitutes an investment of money, in a common enterprise, with the expec-
tation of profits to be derived primarily from the efforts of a person other than the investor. A
security may represent either an ownership (equity) interest in a company or a creditor relation-
ship (through a debt obligation) with a company. Equity is most commonly represented by the
various forms of stock. Debt is most commonly represented by bonds and notes. Instruments
that give enhanced access to securities, such as rights, warrants, and options, are also considered
equity securities.

1. 1. 1 EQUITY AND DEBT

Corporations issue equity and debt securities as a means of raising capital in order to
implement ideas such as expanding operations or funding a merger or acquisition.
Investing in equity securities is perhaps the most visible and accessible means of creating
wealth. Individual investors become owners of a publicly traded company by buying stock in
that company. In doing so, they can participate in the company’s success over time. They also
share in the risk of operating a business; they can lose their investment.
When a corporation issues equity securities, it is conservative for the issuer and risky for
investors; once the corporation has an investors’ money, it is under no obligation to give any
of it back.
On the other hand, when investors purchase a company’s debt, they lend money to the
company and as a creditor of the company, the company is obligated to pay investors back.
Therefore, when a corporation issues debt, it is considered risky for the issuer and conservative
for investors.

1. 1. 2 FUNCTION AND REGULATION OF SECURITIES

Securities markets within the United States are regulated as a whole by the Securities and
Exchange Commission (SEC), which was created by the Securities Exchange Act of 1934.
Under the SEC, the exchanges regulated themselves. The Maloney Act of 1938 gave the
SEC authority to establish other self-regulatory organizations (SROs), the first of which was
the National Association of Securities Dealers (NASD). This was a membership, like that
of the exchanges, and comprised the broker-dealer firms that engage in the securities business
and whose function was to regulate the securities industry within assigned jurisdictions.
The Financial Industry Regulatory Authority (FINRA) is a Registered Securities
Association and is the successor to the NASD; it is the SRO that regulates participants in the
over-the-counter market (OTC) in securities, as well as members of the New York Stock
Exchange (NYSE). The Municipal Securities Rulemaking Board (MSRB) and the Chicago
Board Options Exchange (CBOE) are other SROs within the industry. Note that SROs are
not themselves federal agencies but are membership organizations that enforce federal securities
laws on their members and are accountable to the SEC.
Once issued in a primary offering (also known as a primary market transaction), securities
typically trade between investors in what are known as secondary market transactions. These
trades take place on stock exchanges, in the over-the-counter (OTC) market, or, in the case
of some securities, both. Exchange-listed securities, like those listed on the New York Stock
Exchange (NYSE), are priced by auction on the trading floor. Brokerage houses purchase the
securities for their customers at the lowest available asked or offering price (established by open
outcry), or they sell securities for their customers at the highest available bid price.

Series 6 [Link] 3 6/8/2016 [Link] PM

 4 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

Because there is no centralized trading location, over-the-counter securities, on the other

hand, are priced not by open outcry at an auction, but by negotiation. Within this market,
regulated by FINRA, broker-dealers called market makers maintain inventories of OTC
securities and sell to other broker-dealers out of their inventory for their asked or offering price,
or they buy from other broker-dealers for their inventory at their bid price. Thus, market makers
serve as a source for securities that customers wish to buy through their broker-dealers and as a
repository for securities that customers wish to sell through their broker-dealers. It is important
to remember that market makers buy and customers sell at the bid price and that market makers
sell and customers buy at the ask price. Competition among market makers ensures the customer
of the lowest ask price available if the customer is buying or the highest bid price available if the
customer is selling.

1. 1. 3 IMPORTANT DEFINITIONS IN THE SECURITIES

INDUSTRY

1. 1. 3. 1 Member
A member of FINRA is any individual, partnership, corporation, or legal entity admitted
to membership in FINRA.

1. 1. 3. 2 Associated Person (AP) of a Member

An associated person is any employee, manager, director, officer, or partner of a member
broker-dealer or another entity (issuer, bank, etc.) or any person controlling, controlled by, or
in common control with that member.

1. 1. 3. 3 Broker
(1) A broker includes: an individual or a firm that charges a fee or commission for execut-
ing buy and sell orders submitted by another individual or firm; (2) the role of a brokerage
firm when it acts as an agent for a customer and charges the customer a commission for its
services; and (3) any person engaged in the business of effecting transactions in securities for
the accounts of others that is not a bank.

1. 1. 3. 4 Dealer
(1) A dealer includes: the role of a brokerage firm when it acts as a principal in a particu-
lar trade. A firm acts as a dealer when it buys or sells a security for its own account and at its
own risk, then charges the customer a markup or markdown; and (2) any person engaged in
the business of buying and selling securities for their own account, either directly or through
a broker, that is not a bank.

1. 1. 3. 5 Customer
A customer is any individual, person, partnership, corporation, or legal entity that is not a
broker, dealer, or municipal securities dealer—that is, the public.

Series 6 [Link] 4 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 5

1. 1. 3. 6 Security
Under the Securities Exchange Act of 1934, any note, stock, bond, investment contract,
variable annuity, profit-sharing or partnership agreement, certificate of deposit, option on a
security, or other instrument of investment is commonly known as a security.

1. 1. 3. 7 Sale and Offer to sell

The term “sale” or “sell” shall include the disposition of a security or interest in a security,
for value. The term “offer to sell,” “offer for sale” or “offer” shall include every attempt or offer
to dispose of, or offer to buy, a security or interest in a security, for value.

1. 1. 3. 8 Prospectus
Generally, the term “prospectus” means any prospectus, notice, circular, advertisement,
letter, or communication, written or by radio or television, which offers any security for sale
or confirms the sale of any security. There are several types of prospectuses defined throughout
the license exam manual.

1. 1. 4 SECURITIES AND BUSINESS

Stock represents equity or ownership in a company, and bonds are a loan to a company. A
company discloses the composition of its total capitalization—debt and equity—by publishing
a balance sheet. The balance sheet summarizes the company’s:
■■ assets—what the company owns: cash in the bank, accounts receivable (money it is owed),
investments, property, inventory, etc.;
■■ liabilities—what the company owes: accounts payable (current bills it must pay), short-
term and long-term debt and other obligations; and
■■ net worth, or shareholders’ equity—the excess (let us hope) of the value of assets over the
value of liabilities.

A company’s net worth is computed by subtracting all liabilities from the value of total
assets. This computation is summarized by the basic balance sheet equation and may be repre-
sented two different ways:

Assets – liabilities = net worth,

or
Assets = liabilities + net worth.

A company’s total capitalization is its net worth plus its long-term debt.

Assets Liabilities

Net worth

Series 6 [Link] 5 6/8/2016 [Link] PM

 6 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

Q
QUICK QUIZ 1.A Match the following terms with the appropriate description below.
A. Dealer
B. Associated person
C. Member
D. Broker

—— 1. A firm must apply to become one of these.

—— 2. Compensated by a commission in securities transactions.

—— 3. Compensated by a markup/markdown in securities transactions.

—— 4. Someone controlling or controlled by a member firm.

Quick Quiz answers can be found at the end of the Unit.

Terms and Concepts Checklist

✓ ✓
†† Security †† Broker
†† Equity †† Dealer
†† Debt †† Associated person
†† Assets †† Customer
†† Liabilities †† Primary offering
†† Net worth †† Secondary transaction
†† Self-Regulatory Organization †† FINRA
(SRO)

1. 2 EQUITY SECURITIES
This section discusses the following equity securities:
■■ Common stock
■■ Preferred stock
■■ Related equity securities

Corporations may issue two types of stock: common stock and preferred stock. When
speaking of stock, people generally refer to common stock.

1. 2. 1 COMMON STOCK
A company issues common stock as its primary means of raising capital. All corporations
issue common stock. Investors who buy the stock buy a share of ownership in the company’s
net worth. Whatever a business owns (its assets) less its creditors’ claims (its liabilities) belongs
to the business owners (its stockholders).

Series 6 [Link] 6 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 7

✓
TA K E N O T E
An individual’s stock ownership represents his proportionate interest in
a company. If a company issues 100 shares of stock, each share represents an identi-
cal Z\z// (or 1%) ownership position in the company. A person who owns 10 shares of
stock owns 10% of the company; a stockholder with 50 shares of stock owns 50% of
the company.

Each share of common stock entitles its owner to a portion of the company’s profits, dis-
tributed, usually quarterly, as dividends, and an equal vote on directors and other important
matters. Most corporations are organized in such a way that their common stockholders regu-
larly vote for and elect candidates to a board of directors to oversee the company’s business. By
electing a board of directors, stockholders have some say in the company’s management but
are not involved with the day-to-day details of its operations.
Common stock can be classified in four ways: authorized, issued, treasury, and
outstanding.

1. 2. 1. 1 Authorized Stock
As part of its original charter, a corporation receives authorization from the state to issue,
or sell, a specific number of shares of stock. Often, a company sells only a portion of the
authorized shares, raising enough capital for its foreseeable needs. The company may sell the
remaining authorized shares in the future or use them for other purposes. Should the company
decide to sell more shares than are authorized, it must amend its charter through a stockholder
vote that approves more shares.

1. 2. 1. 2 Issued Stock
Once authorized, issued stock can be distributed to investors. As already stated, when a
corporation issues or sells fewer shares than the total number authorized, it normally reserves
the unissued shares for future needs, including:
■■ raising new capital for expansion;
■■ paying stock dividends;
■■ providing stock purchase plans for employees or stock options for corporate officers;
■■ investors converting convertible bonds or convertible preferred stock to common stock; or
■■ satisfying the exercise of outstanding stock purchase warrants.

Authorized but unissued stock does not carry the rights and privileges of issued shares
(such as voting rights and the right to receive dividends) and is not considered in determining
a company’s total capitalization.

1. 2. 1. 3 Treasury Stock
Treasury stock is stock a corporation has issued and subsequently repurchased from the
public. The corporation can hold this stock indefinitely or can reissue or retire it. A corpora-
tion could reissue its treasury stock to fund employee bonus plans, distribute it to stockholders
as a stock dividend or, under certain circumstances, redistribute it to the public in an addi-
tional offering. Treasury stock does not carry the rights of outstanding common shares, such as
voting rights and the right to receive dividends.

Series 6 [Link] 7 6/8/2016 [Link] PM

 8 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

TEST TOPIC ALERT

! Treasury stock:
■■ was outstanding stock before it was repurchased by the issuer;

■■ has no voting rights;

■■ does not receive dividends; and

■■ can be reissued or retired.

A corporation buys back its stock for reasons that include:

■■ increase earnings per share;

■■ have an inventory of stock available to distribute as stock options, fund an

employee pension plan, etc.; or

■■ use for future acquisitions.

1. 2. 1. 4 Outstanding Stock
Outstanding stock includes any shares that a company has issued but has not repur-
chased—that is, investor-owned stock.

TEST TOPIC ALERT

! On the exam, you might see a question like this:
ABC company has authorized 1 million shares of common stock. It issued
800,000 shares one year ago. It then purchased 200,000 shares for its treasury. How
many shares of ABC stock are outstanding?

The solution requires you to know a basic formula:

Issued stock – Treasury stock = Outstanding stock; thus,

800,000 – 200,000 = 600,000.

ABC company has 600,000 shares of common stock outstanding.

This question illustrates another point about FINRA exams. The question gives
the number of shares of authorized stock, but this information is unnecessary. Many
questions give more information than you need. The Series 6 exam requires you to
know concepts well enough that you can determine both what is and what is not es-
sential to solving a problem.

1. 2. 1. 5 Common Stock Values

1. 2. 1. 5. 1 Market Value
The most familiar measure of a stock’s value is its market price, or current market value
(CMV). It is the price investors must pay to buy the stock. Market value is influenced by a
company’s business prospects and the consequent effect on supply (the number of shares avail-
able to investors) and demand (the number of shares investors want to buy).
Although a stock’s market price is the most meaningful measure of its value, other mea-
sures include par value and book value.

Series 6 [Link] 8 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 9

1. 2. 1. 5. 2 Book Value
A stock’s book value per share is a measure of how much a common stockholder could
expect to receive for each share if the corporation were liquidated. Most commonly used by
fundamental analysts, the book value per share is the difference between the historical value of
a corporation’s tangible assets and liabilities, divided by the number of shares outstanding. The
book value per share can (and usually does) differ substantially from a stock’s market value.

1. 2. 1. 5. 3 Par Value
For investors, a common stock’s par value is meaningless. It is an arbitrary value the com-
pany gives the stock in its articles of incorporation, and it has no effect on the stock’s market
price. If a stock has been assigned a par value for accounting purposes, such as $1 or $.01, it is
usually printed on the face of the stock certificate.
When the corporation sells stock, the money received exceeding par value is recorded on
the corporate balance sheet as capital in excess of par, also known as paid-in surplus, capital
surplus, or paid-in capital.

!
TEST TOPIC ALERT The three methods of common stock valuation do not result in the same amount.
■■ Market value = supply and demand price (most familiar to investors)
■■ Book value = current hypothetical liquidation value of a share
■■ Par value = an arbitrary accounting value

Q
QUICK QUIZ 1.B Match the following items to the appropriate description below:
A. Outstanding stock
B. Authorized stock
C. Book value
D. Par value

—— 1. Number of shares that a corporation is permitted to issue

—— 2. Dollar amount assigned to a security by its issuer

—— 3. Hypothetical net worth of each share of common stock

—— 4. Equity securities in the hands of the public

1. 2. 1. 6 The Privileges of Common Stock Ownership

Because common stockholders are owners of a company, they have certain rights that
protect their ownership interests.

1. 2. 1. 6. 1 Voting Rights
Common stockholders exercise control of a corporation by electing a board of directors
and by voting at annual meetings on important corporate policy matters, such as:
■■ issuance of convertible securities or additional common stock;

Series 6 [Link] 9 6/8/2016 [Link] PM

 10 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

■■ substantial changes in the corporation’s business, such as mergers or acquisitions; and

■■ election of board of directors.

Shareholders do not vote on anything that has to do with dividends, such as when they
are declared and how much they will be. Shareholders do vote on stock splits, membership on
the Board of Directors, and issuance of additional securities like common stock and convert-
ible bonds.

Calculating the Number of Votes.  A stockholder can cast one vote for each share of
stock owned for each item on the ballot. Depending on the company’s bylaws and applicable
state laws, a stockholder may have a statutory or cumulative vote.
Statutory voting allows a stockholder to cast one vote per share owned for each item on
a ballot, such as seats on the board of directors. A board candidate needs a simple majority to
be elected.
Cumulative voting allows stockholders to allocate their votes in any manner they choose.
Cumulative voting may be advantageous for small shareholders by giving them a greater oppor-
tunity to offset the votes of large shareholders by combining all their shares on a single seat.

*
EXAMPLE An investor owns 100 shares of stock in the ABC Company. An election of the
board of directors is coming up, and several candidates are running to fill three seats.
The investor thus has a total of 300 votes—100 for each seat. Under statutory voting,
he would allocate 100 votes to each of the three candidates he prefers. Under cumu-
lative voting, he could, if he wished, allocate all 300 of his votes to a single candidate
for just one of the seats.

Proxies.  Most stockholders find it difficult to attend the annual stockholders’ meeting
and so vote on company matters by means of a proxy, a form of absentee ballot. Once re-
turned to the company, a proxy is cancelled if the stockholder attends the meeting, authorizes
a subsequent proxy, or dies.

1. 2. 1. 6. 2 Preemptive Rights
When a corporation raises capital through the sale of additional common stock, it may
be required by law or its corporate charter to offer the securities to its common stockholders
before the general public; this is known as an antidilution provision. Stockholders then have
a preemptive right to buy enough newly issued shares to maintain their proportionate owner-
ship in the corporation.

✓
TA K E N O T E
Preemptive rights give investors the right to maintain a proportionate interest in a
company’s stock.

*
EXAMPLE ABC, Inc., has 1 million shares of common stock outstanding. Shareholder X
owns 100,000 shares of ABC common stock, or 10%. If ABC issues an additional
500,000 shares, Shareholder X will have the opportunity to buy 50,000 of those
shares before the shares are offered to the public, and often at a discount.

Series 6 [Link] 10 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 11

1. 2. 1. 6. 3 Limited Liability
Stockholders cannot lose more than the amount they have paid for a corporation’s
stock. Limited liability protects stockholders from having to pay a corporation’s debts in
bankruptcy.

!
TEST TOPIC ALERT Limited liability means a shareholder of common stock cannot lose more than
what was invested—a shareholder can lose the original value of his stock only. An-
other way to refer to limited liability is to state that common stock is non-assessable.
You may see the term assessable common stock on your exam; there is no such thing
as assessable common stock in today’s marketplace.

1. 2. 1. 6. 4 Inspection of Corporate Books

Stockholders have the right to receive annual financial statements and obtain lists of
stockholders. Inspection rights do not include the right to examine detailed financial records
or the minutes of directors’ meetings.

1. 2. 1. 6. 5 Residual Claims to Assets

If a corporation is liquidated, the common stockholder, as owner, has a residual right to
claim corporate assets after all debts and holders of more senior securities have been satisfied.
The common stockholder is at the bottom of the liquidation priority list. This makes common
stock the most junior security.

1. 2. 1. 7 Bullish and Bearish Stock Positions

Generally, and throughout this course, we assume an investor buys or owns shares of stock
with the intent of selling them at a higher price at some point in the future—buy low now, sell
high later. An investor who buys shares is considered long the stock, and is bullish—that is,
expects the stock to increase in price. Long is the act of buying.
An investor may also sell shares he has borrowed, with the intent of buying them back at
a lower price in the future for return to the owner (sell high now, buy back low later). Such
a transaction, known as a short sale, involves borrowing shares to sell that the investor must
eventually replace. An investor who sells borrowed shares is short the stock until he buys and
returns the shares to the lender, and is bearish—that is, expects the stock to go down in price.
Short is the act of selling.

1. 2. 1. 8 Benefits of Common Stock Ownership

Investors generally expect to receive capital growth, income, or both from common stock
investments.

1. 2. 1. 8. 1 Growth
An increase in the market price of shares is called capital appreciation. Historically, owning
common stock, with its associated capital appreciation, has provided investors with high real
returns compared to other types of investments.

Series 6 [Link] 11 6/8/2016 [Link] PM

 12 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

✓
TA K E N O T E
When an investor sells a security for more than it was purchased for, the profit is
defined as a capital gain; if money is lost on the sale, the loss is defined as a capital
loss. If the investor does not sell the stock, the investor has an unrealized gain (or
loss). Capital gains are taxable only when they are realized.

1. 2. 1. 8. 2 Income
Many corporations pay regular quarterly cash dividends to stockholders based upon the
company’s earnings. A company’s dividends may increase over time as profitability increases.
Dividends, which can be a significant source of income for investors, are another reason many
people invest in stocks.

✓
TA K E N O T E
A company that earns $1 per share may elect to pay a portion of those earnings
to shareholders in dividends. As earnings increase over time, the company may
increase its dividend as well. Investors who receive dividends must generally pay
15% dividend tax. (Until recently, investors paid ordinary income taxes on dividend
income.) The IRS makes no exceptions for individuals, but corporations receive a 70%
exclusion on dividend income.

*
EXAMPLE Ten years ago, an investor bought 100 shares of ABC Corp. for $20 per share,
for a total investment of $2,000. At the time, the company’s business was profitable,
earning $3 per share of which it paid $1 per share in dividends to shareholders and
reinvested the rest in growing the business. Ten years later, after moderate but con-
sistent growth, the company earns $12 per share and pays $4 in dividends per share.
The stock price has consistently increased with the earnings growth and now sells for
$80 per share ($8,000 total value for our investor’s 100 shares). The investor has had
to pay income taxes each of the past 10 years on the dividend income he received but
will only have to pay capital gain taxes if he sells the stock. If he sold the stock now,
his taxable capital gain would be $60 per share ($80 current value – $20 original cost
= $60 capital gain).

1. 2. 1. 9 Risks of Common Stock Ownership

Regardless of their expectations, investors have no assurances that they will receive the
returns they expect from their investments. Any description of the benefits and advantages of
owning stock (or any security) must be accompanied by a discussion of the risks.

1. 2. 1. 9. 1 Market Risk
The chance that a stock will decline in price at a time that the investor needs the money
is a risk of owning common stock. The tendency for securities to move with the market is mar-
ket risk. When the market is rising, stocks have a tendency to increase in value. Conversely,
most stocks tend to fall with declines in the overall market. Often, a move in the market is
prefaced by some change in the economic environment such as was the case in 2008.

Series 6 [Link] 12 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 13

A long investor’s losses are limited to his total investment in a stock. A short seller’s losses
are theoretically unlimited because there is no limit to how high a stock’s price may climb
before an investor can close his position by purchasing the stock he originally sold.

1. 2. 1. 9. 2 Business Risk
Business risk, or the level of risk of the specific business, includes the speculative nature
of the business, the management of the business, the philosophy of the business, and so on.
Different types of businesses will have different levels of risk. For instance, searching for oil is
generally riskier than operating a grocery store.
However, each has unique risks associated with that type of business. Business risk can
also be thought of as the uncertainty of operating income. Utility companies have relatively
stable and predictable income streams and, therefore, have lower business risk. Because cycli-
cal companies, such as auto manufacturers, have business risk unsteady or fluctuating operat-
ing income levels, they have higher business risk. Business risk relates to the activities of the
company.

1. 2. 1. 9. 3 Decreased or No Income
Another risk of stock ownership is the possibility of dividend income decreasing or ceasing
entirely if the company has business reverses.

1. 2. 1. 9. 4 Low Priority at Dissolution

If a company declares bankruptcy, holders of its bonds and preferred stock have prior-
ity over common stockholders. A company’s debt and preferred shares are senior securities.
Common stockholders have only residual rights to corporate assets upon dissolution.

✓
TA K E N O T E Common shareholders are last in line when a corporation’s assets are liquidated,
so common stock is often referred to as a junior security.

Q
QUICK QUIZ 1.C 1. Which of the following represent ownership (equity) in a company?
I. Corporate bonds
II. Common stock
III. Preferred stock
IV. Mortgage bonds
A. I and II
B. I and III
C. II and III
D. III and IV

Series 6 [Link] 13 6/8/2016 [Link] PM

 14 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

2. Which of the following statements describe Treasury stock?

I. It has voting rights and is entitled to a dividend when declared.
II. It has no voting rights and no dividend entitlement.
III. It has been issued and repurchased by the company.
IV. It is authorized but unissued stock.
A. I and III
B. I and IV
C. II and III
D. II and IV

3. Stockholders’ preemptive rights include the right to

A. serve as an officer on the board of directors
B. maintain proportionate ownership interest in the corporation
C. purchase Treasury stock
D. examine the corporation’s books

4. At the annual meeting of ABC Corporation, 5 directors are to be elected. Under

the cumulative voting system, an investor with 100 shares of ABC would have a
total of
A. 100 votes to be cast for each of 5 directors
B. 500 votes to be cast in any way the investor chooses for 5 directors
C. 500 votes to be cast for each of 5 directors
D. 100 votes to be cast for only 1 director

5. Cumulative voting rights

A. benefit the large investor
B. aid the corporation’s best customers
C. give preferred stockholders an advantage over common stockholders
D. benefit the small investor

6. What is the basic formula of the balance sheet?

A. Assets = liabilities – net worth
B. Assets + liabilities = net worth
C. Assets = net worth
D. Assets = liabilities + net worth

7. All of the following are privileges or benefits of stock ownership EXCEPT

A. dividends
B. growth
C. guaranteed income
D. voting rights

8. Which of the following factors are disadvantages of investment in common stock,

compared with fixed income securities, such as bonds?
I. No assurance of return
II. Lower priority of income payment
III. No voting rights
IV. Less inflation protection
A. I and II
B. I and III
C. II and IV
D. III and IV

Series 6 [Link] 14 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 15

1. 2. 2 TRACKING EQUITY SECURITIES

Common and preferred stock prices are listed in the financial sections of daily newspapers
and in other financial publications. A stock’s market price is quoted in whole dollars, also
known as points, plus fractions of a dollar expressed in cents. Note the column labeled Sales
100s in the following table lists the number of round lots that traded the day before. A round
lot is 100 shares.

NYSE Composite Transactions

New York Stock Exchange Composite Prices

Tuesday, January 13, 2009

52 Weeks Yld PE Sales

High Low Stock Div % Ratio 100s High Low Last Chg

80 40 ABC Corp .75 1 12 3329 78 71 73 - 1.50

EXPLANATORY NOTES
High-Low: High-low numbers are the highest and lowest prices for the stock in the last 52 weeks, not
including yesterday’s trading.
Stock: Stocks are listed alphabetically, by the company’s full name (not by its abbreviation). Company
names that are made up of initials appear at the beginning of the letter’s list.
Div: Current annual dividend rate paid on stock, based on the latest quarterly or semiannual
declaration, unless otherwise footnoted.
PE Ratio: Closing price of the stock divided by the company’s earnings per share for the latest
12-month period reported. No P/E shown for stocks with no profit or for preferred stocks.
Last: The price at which the stock was trading when the exchange closed for the day.
Chg: The loss or gain for the day, compared with previous session’s closing price. No change at the
close is indicated by ... mark.

pf: Preferred stock. Dividends paid to preferred shareholders take precedence over those on common
stock. rt: Rights. wi: When and if issued. Stock may be authorized but not yet issued; it may be a new
issue; or it may have been split. wt: Warrant. The right to buy a set number of shares at a specific price
and until a certain date. x: Ex-dividend, meaning the seller of the stock, not the buyer, receives the
latest declared dividend. z: Sales total is given in full, not in hundreds.

* This sample comprises formats, styles, and abbreviations from a variety of currently available
sources and has been created for educational purposes.

✓
TA K E N O T E The exam may ask you to determine the cost of a round lot of stock in whole
dollars from its quoted price.

*
EXAMPLE If ABC corporation common stock is purchased at its trading day low, how much
does an investor pay for a round lot? For the price of a round lot, multiply the trading
day low price of $71 by 100.

$71 x 100 = $7,100

✓
TA K E N O T E
Calculators are available at the test center, but do not expect a lot of math.
Typically, the entire exam has fewer than five calculations.

Series 6 [Link] 15 6/8/2016 [Link] PM

 16 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

1. 2. 2. 1 Exchange-Listed Stocks
In order to trade on an exchange, a security must meet the listing requirements of the
exchange such as maintaining a certain price and trading activity. These listed securities will
then trade on the exchange.
The model exchange for your exam is the NYSE; however, it is not the only exchange.
There are several regional exchanges in the U.S. but you don’t need to know them by name
for your exam. Exchanges have physical locations and are considered an auction market; there
is a trading floor where buyers and sellers compete for trades.
In addition to trading on exchanges, listed securities may also trade over-the-counter
(OTC) (in the third market, discussed later).

1. 2. 2. 1. 1 Nasdaq
Nasdaq stands for National Association of Securities Dealers Automated Quotation
system. Nasdaq is an electronic stock market and it originated in 1971. Nasdaq does not have
a physical trading floor that brings together buyers and sellers; it is an automated computerized
information system that provides price and inventory information for market makers of
securities traded over-the-counter (OTC).

1. 2. 2. 1. 2 Nasdaq Markets
Nasdaq stocks that don’t meet the listing requirements of an exchange or choose not to
trade OTC are unlisted securities. Most securities that trade are unlisted.

1. 2. 2. 1. 3 Non-Nasdaq
Thousands of securities trade in the OTC market that are not part of Nasdaq. These
securities are termed non-Nasdaq securities and trade on the over-the-counter bulletin board
(OTCBB) or the Pink Sheets and tend to be the most speculative of all equity securities.

✓
TA K E N O T E
OTC Markets Group, Inc., formerly known as Pink OTC Markets, Inc., operates
OTC Link, an electronic quotation system that displays quotes from broker-dealers for
many OTC securities. These quotes at one time were printed on pink sheets of paper
and distributed to broker-dealers. Though Pink Sheets don’t exist today, the term is
still referred to when discussing unlisted, non-Nasdaq securities.

1. 2. 3 PREFERRED STOCK
Preferred stock is an equity security because it represents ownership in the corpora-
tion. However, it does not normally offer the appreciation potential associated with common
stock.
Like a bond, a preferred stock is issued with a fixed (stated) rate of return. In the case of the
preferred stock, it is a dividend rather than interest that is being paid. As such, these securities
are generally purchased for income. Although the dividend of most preferred stocks is fixed,
some are issued with a variable dividend payout known as adjustable rate preferred stock. Like

Series 6 [Link] 16 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 17

other fixed income assets such as bonds, preferred stock prices tend to move inversely with
interest rates. Most preferred stock is nonvoting and maintains no preemptive rights.
Although preferred stock does not typically have the same growth potential as common
stock, preferred stockholders generally have two advantages over common stockholders.
■■ When the board of directors declares dividends, owners of preferred stock must receive
their stated dividend in full before common stockholders may be paid a dividend.
■■ If a corporation goes bankrupt, preferred stockholders have a priority claim over common
stockholders on the assets remaining after creditors have been paid.

Because of these features, preferred stock appeals to investors seeking income and safety.

✓
TA K E N O T E
Preferred stock has preference over common stock in payment of dividends and
in claim to assets in the event the issuing corporation goes bankrupt.

Fixed Rate of Return. A preferred stock’s fixed dividend is a key attraction for income-
oriented investors. Normally, a preferred stock is identified by its annual dividend payment
stated as a percentage of its par value, which is usually $100 on the Series 6 exam. (A pre-
ferred stock’s par value is meaningful to the investor, unlike that of common stock.) A pre-
ferred stock with a par value of $100 that pays $6 in annual dividends is known as a 6%
preferred. The dividend of preferred stock with par value other than $100 is stated in a dollar
amount, such as a $6 preferred.
The stated rate of dividend payment causes the price of preferred stock to act like the price
of a bond: prices and interest rates have an inverse relationship. In addition to the following
example, inverse relationship is presented later in this Unit under debt securities.

*
EXAMPLE Consider a 6% preferred. If interest rates are at 8% and you want to sell your
preferred, you will have to sell at a discounted price. Why would a buyer pay full
value for an investment that is not paying a competitive market rate? But if interest
rates fall to 5%, the 6% preferred will trade at a premium. Because it is offering a
stream of income above the current market rate, it will command a higher price.

Limited Ownership Privileges. Except for rare instances, preferred stock does not have
voting or preemptive rights.

!
TEST TOPIC ALERT Preferred stock represents ownership in a company like common stock, but its
price is sensitive to interest rates—just like the price of a bond.

No Maturity Date or Set Maturity Value. Although it is a fixed-income investment, pre-

ferred stock, unlike bonds, has no preset date at which it matures and no scheduled redemp-
tion date or maturity value.

Series 6 [Link] 17 6/8/2016 [Link] PM

 18 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

1. 2. 3. 1 Categories of Preferred Stock

Separate categories of preferred stock may differ in the dividend rate, profit participation
privileges, or other ways. All, however, maintain a degree of preference over common stock.
One or several of the features described below may characterize issues of preferred stock.

1. 2. 3. 1. 1 Straight (Noncumulative)
Straight preferred has no special features beyond the stated dividend payment. Missed
dividends are not paid to the holder. The year’s stated dividend must be paid on straight pre-
ferred if any dividend is to be paid to common shareholders.

✓
TA K E N O T E
Preferred stock with no special features is known as straight preferred.

1. 2. 3. 1. 2 Cumulative Preferred
Buyers of preferred stock expect fixed dividend payments. The directors of a company in
financial difficulty can reduce or suspend dividend payments to both common and preferred
stockholders. With cumulative preferred, any dividends in arrears must be paid prior to paying
a common dividend.

✓
TA K E N O T E
Any special feature attached to preferred, such as a cumulative feature, has a
price. The cost for such a benefit is less dividend income. Cumulative preferred typi-
cally has a lower stated dividend than straight preferred (less risk equals less reward).

All dividends due to cumulative preferred shareholders accumulate on the company’s

books until the corporation can pay them. When the company can resume full payment of
dividends, cumulative preferred stockholders receive their current dividends plus the total
accumulated dividends—dividends in arrears—before any dividends may be distributed to
common or other straight preferred stockholders. Therefore, cumulative preferred stock is
safer than straight preferred stock.

*
EXAMPLE RST Corp. has both common stock and cumulative preferred stock outstand-
ing. Its preferred stock has a stated dividend rate of 5% (par value $100). Because of
financial difficulties, no dividend was paid on the preferred stock last year or the year
before. If RST wishes to declare a common stock dividend this year, RST is required to
first pay how much in dividends to the cumulative preferred shareholders?
RST must pay missed dividends to cumulative preferred (as well as the current
dividend) before dividends are paid on common stock. RST must pay $5 for the year
before last, $5 for last year, and $5 for this year, for a total of $15.
For noncumulative preferred stock outstanding, the answer would have been
$5. Only the current year dividend would need payment before common because
noncumulative preferred is not entitled to dividends in arrears.

Series 6 [Link] 18 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 19

1. 2. 3. 1. 3 Convertible Preferred
A preferred stock is convertible if the owner can exchange each preferred share for shares
of common stock. The price at which the investor can convert is a preset amount and is noted
on the stock certificate. Because the value of a convertible preferred stock is linked to the
value of the issuer’s common stock, the convertible preferred’s price fluctuates in line with the
common.
Convertible preferred is often issued with a lower stated dividend rate than nonconvert-
ible preferred because the investor may have the opportunity to convert to common shares
and enjoy capital gains. In addition, the conversion of preferred stock into shares of common
increases the total number of common shares outstanding, which decreases earnings per com-
mon share and may decrease the common stock’s market value. When the underlying com-
mon stock has the same value as the convertible preferred, it is said to be at its parity price.

*
EXAMPLE XYZ Company’s convertible preferred stock, with a par value of $100 and a
conversion price of $20, can be exchanged for five shares of XYZ common stock
($100 ÷ $20 = 5). This is true, no matter what the current market value of either the
preferred or the common stock. Thus, if an investor bought the preferred for $100
per share and the common stock rises in price eventually to more than $20 per share,
the preferred stockholder could make a capital gain from converting.

1. 2. 3. 1. 4 Participating Preferred
In addition to fixed dividends, participating preferred stock offers owners a share of cor-
porate profits that remain after all dividends and interest due other securities are paid. The
percentage to which participating preferred stock participates is noted on the stock certificate.
Before the participating dividend can be paid, a common dividend must be declared.

*
EXAMPLE If a preferred stock is described as “XYZ 6% preferred participating to 9%,” the
company could pay its holders up to 3% in additional dividends in profitable years, if
the board so declares.

1. 2. 3. 1. 5 Callable Preferred
Corporations often issue callable, or redeemable, preferred, which a company can buy
back from investors at a stated price after a specified date. The right to call the stock allows the
company to replace a relatively high fixed dividend obligation with a lower one.
When a corporation calls a preferred stock, dividend payments and conversion rights
cease on the call date. In return for the call privilege, the corporation usually pays a premium
exceeding the stock’s par value at the call, such as $103 for a $100 par value stock.

Series 6 [Link] 19 6/8/2016 [Link] PM

 20 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

✓
TA K E N O T E
Callable preferred stock is unique because of the risk that the issuer may buy it
back and end dividend payments. Because of this risk, callable preferred has a higher
stated rate of dividend payment than straight, noncallable preferred.
Issuers are likely to call securities when interest rates are falling. Like anyone, an
issuer would prefer to pay a lower rate for money. Issuers call securities with high
rates and replace them with securities that have lower fixed rate obligations.

1. 2. 3. 1. 6 Adjustable-Rate Preferred
Some preferred stocks are issued with adjustable, or variable, dividend rates. Such divi-
dends are usually tied to the rates of other interest rate benchmarks, such as Treasury bill and
money market rates, and can be adjusted as often as semiannually.

TEST TOPIC ALERT

! Below are several test points on preferred stock:

1. Which of the following types of preferred stock typically has the highest stated
rate of dividend (all other factors being equal)?
A. Participating
B. Straight
C. Cumulative
D. Callable

Answer: D. When the stock is called, dividend payments are no longer made. To
compensate for that possibility, the issuer must pay a higher dividend.

2. Which of the following would you expect to have the higher stated rate?
A. Straight
B. Cumulative

Answer: A. Cumulative preferred is safer, and there is always a risk-reward trade-

off. Because straight preferred has no special features, it will pay a higher stated
rate of dividend.

Q
QUICK QUIZ 1.D 1. Which of the following types of preferred stock is most influenced by the price of
an issuer’s common stock?
A. Participating
B. Straight
C. Convertible
D. Callable

Series 6 [Link] 20 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 21

2. Which of the following types of preferred stock might pay a dividend that is
higher than that printed on the certificate?
I. Straight preferred
II. Cumulative preferred
III. Participating preferred
IV. Callable preferred
A. I and III
B. I and IV
C. II and III
D. II and IV

3. In which of the following ways does preferred stock differ from common stock as
an investment?
A. Lower dividends
B. Greater sensitivity to interest rate fluctuation
C. Lower priority of dividend payment
D. Greater voting rights

1. 2. 3. 1. 7 Dividends and Splits

Both common and preferred dividends are distributions from a company’s profits to its
stockholders. Investors who buy stock are entitled to dividends only when the company’s
board of directors votes to make such distributions. Stockholders are automatically sent any
dividends to which their shares entitle them.

✓
TA K E N O T E
Dividends are never guaranteed to shareholders. This distribution of corporate
profits is made only when declared by the BOD.

Cash Dividends. Cash dividends are normally distributed by check if an investor holds
the stock certificate or are automatically deposited to a brokerage account if the shares are
held in street name—that is, held in a brokerage account in the firm’s name to facilitate
payments and delivery. Dividends are usually paid quarterly and taxed as dividend income
in the year they are received.

Stock Dividends. If a company must use its cash for business purposes rather than to pay
cash dividends, its board of directors may declare a stock dividend. This is typical of many
growth companies that invest their cash resources in research and development. Under
these circumstances, the company issues shares of its common stock as a dividend to its
current stockholders. A stock’s market price per share declines after a stock dividend, but
the company’s total market value remains the same.

Stock Splits. A company will sometimes change the number of outstanding shares by
means of a stock split. The total value of the outstanding stock must be the same before and
after the split. Thus if the XYZ Corporation did a 2‑for-1 stock split, an investor who owned
100 XYZ shares worth $20 per share before the split would own 200 shares worth $10 per
share after the split. If the company did a 1-for-2 reverse split, an investor with 100 shares
worth $20 per share before the split would own 50 shares worth $40 per share after the split.
Note that although the individual share value changes as a result of a split, the total value of
the stock remains the same. Since they change the trading characteristics of a stock, share-
holder approval must be obtained for stock splits.

Series 6 [Link] 21 6/8/2016 [Link] PM

 22 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

✓
TA K E N O T E
Stock dividends, unlike cash dividends, are not taxed when received. There are
no tax consequences incurred until the investor chooses to liquidate the shares and
realize the gains or losses.

1. 2. 3. 1. 8 Calculating Dividend Yield/Current Yield

The dividend yield is the annual dividend (four times the quarterly dividend) divided by
the current price of the stock. A stock’s dividend yield may also be referred to as its current
yield.

TEST TOPIC ALERT

! You might be asked to calculate dividend yield on the exam.

Annual dividend
= Dividend yield, or Current yield
Current market value of the stock

*
EXAMPLE RST stock has a current market value of $50. Total dividends paid during the year
were $5. What is the dividend yield? The solution is found by dividing $5 by $50. The
yield is 10%.
Be alert for a slightly tricky approach to this question. The question might state
that RST has a current market value of $50. The most recent quarterly dividend paid
was $1.25. What is the dividend yield?
The solution is found by annualizing the quarterly dividend (multiplying by 4)
first. $1.25 × 4 = $5. $5 ÷ $50 = a 10% dividend yield—remember to use annual
dividends in calculating yield.

TEST TOPIC ALERT

! You may see a question that asks about the priority of dividend payments made
by a corporation. The order of payment is as follows:
1. Dividends in arrears paid to cumulative shares
2. Stated dividends paid to all preferred shares
3. Common dividend

1. 2. 3. 2 Total Return (Individual Securities)

An investment’s total return is a combination of the dividend income (for equity invest-
ments) or interest paid (for debt investments) and price appreciation or decline over a given
period of time.

*
EXAMPLE A common stock purchased for $20 with an annual dividend of $1 is sold after
one year for $24. The total return on the investment is $5, $1 in dividends plus $4 in
capital appreciation. The total return, then, is 25% ($5 ÷ $20 = 25%).

Series 6 [Link] 22 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 23

1. 2. 3. 3 Transferability of Ownership
The ease with which stocks and other securities can be bought and sold contributes to
the smooth operation of the securities markets. When an investor buys or sells a security, the
exchange of money and ownership requires little or no additional action on the investor’s
part.

1. 2. 3. 3. 1 The Stock Certificate

A stock certificate is evidence of ownership for the shares of a corporation a person
owns. The vast majority of stock transactions are for round lot numbers of shares (share
amounts evenly divisible by 100). Odd lot transactions are share amounts of fewer than 100
shares, such as 4 or 99. Individual stock certificates may be issued for any number of shares.

*
EXAMPLE An investor who buys 100 shares of ABC, Inc., would receive one certificate for
100 shares.

Stock certificates identify the company’s name, number of shares, and investor’s name,
among other things. Each certificate is printed with the security’s CUSIP number (an identi-
fication or tracking number).

1. 2. 3. 3. 2 Negotiability
Shares of stock are negotiable; that is, a stockholder can give, transfer, assign, or sell shares
the stockholder owns with few or no restrictions.

Q
QUICK QUIZ 1.E Match the following items to the appropriate description below.
A. 100
B. Preemptive right
C. Current yield
D. Quarterly

—— 1. Typical frequency of dividend payment on common stock

—— 2. Number of shares in a standard trading unit of stock

—— 3. Stockholders may maintain proportionate ownership by purchasing newly

issued shares before they are offered to the public

—— 4. Annualized dividend divided by current market price

Series 6 [Link] 23 6/8/2016 [Link] PM

 24 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

1. 2. 4 AMERICAN DEPOSITARY RECEIPTS

American depositary receipts (ADRs), also known as American depositary shares
(ADSs), facilitate the trading of foreign stocks in U.S. markets. An ADR, typically issued by
a bank that has bought the foreign stock, is a negotiable security that represents a receipt for
shares of stock in a non-U.S. corporation (one ordinary share = one ADR). ADRs are bought
and sold in the U.S. securities markets like stock.

✓
TA K E N O T E
ADRs allow domestic investors to buy foreign securities more easily. Many inves-
tors include foreign issues in their portfolios for diversification.

1. 2. 4. 1 Rights of ADR Owners

Actual share certificates of the foreign company are held by a U.S. depository bank. The
U.S. bank then issues the receipts for the shares. The investor purchases the ADR with U.S.
dollars, receives dividends through the bank in U.S. dollars, and may sell the ADR on the
open market for U.S. dollars.
It is important to remember that the stock represented by the ADR is originally traded in a
foreign currency, and that dividends are initially paid by the foreign company in that currency;
the dividends are simply exchanged for dollars before being passed on to the ADR holder.
Thus, ADR holders face not only the normal business risks characteristic of stock ownership,
but currency risks as well, should the foreign currency decline in value.
The ADR holder has no preemptive rights and generally, no voting rights but does have
the right to exchange the ADRs for the actual foreign share certificates.

TEST TOPIC ALERT

! The following question identifies nearly all of the testable points on ADRs:

Which of the following statements about ADRs is TRUE?

A. Owners of ADRs have premptive rights.
B. ADRs allow foreign investors to buy domestic issues of stock.
C. Owners of ADRs receive dividends in foreign currency.
D. ADR owners are subject to currency risk.

 nswer: D. Owners of ADRs face currency risk. The exchange rate between the
A
foreign currency of the ADR issuer and the U.S. dollar causes the dividend pay-
ment to rise and fall in dollar value. Owners of ADRs have no preemptive rights.
ADRs allow domestic investors to purchase foreign issues, not the reverse. ADR
owners receive dividends in dollars.

Q
QUICK QUIZ 1.F 1. ADRs are used to facilitate
A. the foreign trading of domestic securities
B. the foreign trading of U.S. government securities
C. the domestic trading of U.S. government securities
D. the domestic trading of foreign securities

Series 6 [Link] 24 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 25

2. The owner of an ADR is likely to receive which of the following?

A. Dividends
B. Capital gains or losses
C. Both dividends and capital gains or losses
D. Neither dividends nor capital gains or losses

1. 2. 5 RIGHTS AND WARRANTS

In addition to issuing stock, a company can issue securities that allow the owner to buy its
stock under certain conditions. A company can issue rights to existing stockholders that allow
the owner to buy stock at a favorable price for a short period of time. A company can issue
warrants, normally in conjunction with the issue of another security, that allow the holder to
buy the stock at a set price (higher than at time of issue) for a long period of time, typically
two to five years.

1. 2. 5. 1 Rights
Preemptive rights allow existing stockholders to maintain their proportionate ownership
in a company by buying newly issued shares before the company offers them to the general
public. A rights offering allows stockholders to purchase common stock below the current
market price. The rights are valued separately from the stock and trade in the secondary mar-
ket during the subscription period. A stockholder who owns rights may:
■■ exercise the rights to buy stock by sending the rights certificates and a check for the
required amount to the rights agent;
■■ sell the rights and profit from their market value (rights certificates are negotiable securi-
ties); or
■■ let the rights expire and lose their value.

1. 2. 5. 1. 1 Approval for an Additional Stock Issue

The board of directors must approve decisions to issue additional stock through a rights
offering. If the additional shares would increase the stock outstanding beyond the amount
authorized in the company charter, the stockholders must vote to amend the charter. A rights
offering can give shareholders an incentive to vote their approval for the additional stock.

1. 2. 5. 1. 2 Characteristics of Rights
Once a rights offering has been issued, the rights may be bought or sold in the secondary
market just as stock is bought and sold. If the holder of a right does not sell it, the holder may
exercise it to buy the stock specified in the right or let it expire.

Subscription Right Certificate. A subscription right is a certificate representing a short-

term (typically 30 to 45 days) privilege to buy additional shares of a corporation. One right is
issued for each common stock share held by the investor.

Terms of the Offering. The terms of a rights offering are stipulated on the subscription
right certificates mailed to stockholders. The terms describe how many new shares a stock-
holder may buy, price, the date new stock will be issued, and a final date for exercising the
rights. The stock is often offered to rights holders at a discount.

Series 6 [Link] 25 6/8/2016 [Link] PM

 26 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

Standby Underwriting. If the current stockholders do not subscribe to all the additional
stock, the issuer may offer unsold shares to a broker-dealer in a standby underwriting. A
standby underwriting is done on a firm commitment basis, meaning the broker-dealer or
underwriter buys all unsold shares from the issuer and then resells them to the general public.

1. 2. 5. 2 Warrants
A warrant is a certificate granting its owner the right to buy securities from the issuer at a
specified price, normally higher than the market price when issued. Unlike a right, a warrant is
usually a long-term instrument, giving the investor the choice of buying shares at a later date
at the exercise price.

1. 2. 5. 2. 1 Origination of Warrants
Warrants are usually offered to the public as sweeteners (inducements) in connection with
other securities, such as debentures or preferred stock, to make the securities more attractive;
such offerings may be bundled as units.
Warrants may be detachable or nondetachable from other securities. If detachable, they trade
in the secondary market in line with the common stock’s price. When first issued, a warrant’s
exercise price is set well above the stock’s market price. If the stock’s current market price
increases, the owner can exercise the warrant and buy the stock at the exercise price or sell
the warrant in the market.

Comparison of Rights and Warrants

Rights Warrants
Short term Long term
Exercisable below market value Exercisable above market value
May trade with or separate from the May trade with or separate from the units
common stock
Offered to existing shareholders with Often offered as a sweetener for another
preemptive rights security
One right issued per share outstanding Number issued is determined by
corporation

TEST TOPIC ALERT

! Rights: Short-term instruments, exercise price is below market price; issued to
current shareholders only, who may exercise them, sell them on the open market, or
let them expire
Warrants: Long-term instruments; exercise price is above market price at time of
issue; used as sweeteners with issues of more speculative corporate bonds; also, own-
ers of warrants are not entitled to dividends, though they may sell the warrant on the
open market

Series 6 [Link] 26 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 27

Q
QUICK QUIZ 1.G 1. Which of the following statements regarding warrants is TRUE?
A. Warrants are offered to current shareholders only.
B. Warrants have longer terms than rights.
C. Warrants do not trade in the secondary market.
D. At the time of issuance, the exercise price of a warrant is typically below the
market price of the underlying stock.

2. Which of the following statements about rights is TRUE?

A. Common stockholders do not have the right to subscribe to rights offerings.
B. Preferred stock is not subject to rights offerings.
C. Rights are long-term instruments.
D. The exercise price of rights is greater than the current market price of the
stock at the time of issuance.

3. Rights and warrants are similar in that they

A. are both long-term instruments
B. afford access to stock under possibly favorable conditions
C. are both used to sweeten another securities offering
D. both pay relatively low dividends

1. 2. 6 OPTIONS
An option is a contract that gives the buyer a right to do something with an underlying
security over time, usually nine months. The right will be to buy or sell the underlying security
at a stated price; the seller of the contract is obligated to fulfill the terms of the contract if it
is exercised.
An option is also a type of derivative because the value of the contract is primarily based
on the value of the underlying security. Buying and selling option contracts can expose inves-
tors to elevated and even unlimited financial risk, therefore, before an investor can open an
options trading account, it must be determined to be suitable for the investor. An options
disclosure document must be delivered prior to opening the account. This document is mostly
educational in nature and reviews basic options terminology, definitions, and risks.
The buyer is the owner of the contract and the seller is often referred to as the writer of
the contract.

1. 2. 6. 1 Calls and Puts

Listed option contracts are issued in standardized formats by the Options Clearing
Corporation (OCC) and traded on the Chicago Board Options Exchange (CBOE) or another
exchange. Because the CBOE and other exchanges provide forums to trade, and the OCC
stands behind option contracts in the event of a firm’s failure, options are easily tradable.
There are two basic types of option contracts: calls and puts.
■■ A call option gives the buyer the right to call (buy) a security away from someone. You can
buy that right for yourself, or you can sell that right to someone else, and thus take on an
obligation to sell the stock, if the call option is exercised.
■■ A put option gives the buyer the right to put (sell) a security to someone. You can buy that
right for yourself, or you can sell that right to someone else, and thus take on an obligation
to buy the stock, if the put option is exercised.

Series 6 [Link] 27 6/8/2016 [Link] PM

 28 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

Each stock option contract covers 100 shares (a round lot) of stock which may be exer-
cised (bought in the case of a call, sold in the case of a put), at a specific price, called the strike
price, before a specific date, called the expiration date. In general, the maximum life of an
option is nine months. This makes them longer term than stock rights but shorter than war-
rants. An option’s cost is called the premium. Premiums are quoted in dollars per share.

*
EXAMPLE A premium of $3 means $3 for each share × 100 shares, or $300.

1. 2. 6. 1. 1 Exercise Prices
An option’s exercise or strike price is the price at which the option owner is entitled to
buy or sell the underlying security and the price at which the option seller has agreed to sell
or buy the security.

1. 2. 6. 1. 2 Leverage or Income
Option contracts provide purchasers with leverage: a relatively small cash outlay allows an
investor to control an investment that would otherwise require a much larger sum. If a stock
is currently $20 per share, 100 shares would cost $2,000, but a call on 100 shares might cost
only $200 to $300.
As the seller of an option contract, there is one main objective: Income.
The writer sells the contract, collects the premium, and hopes the contract expires so they
can keep the premium.

✓
TA K E N O T E In a call: the buyer of the call has the right to buy; the seller of the call has the
obligation to sell.
In a put: the buyer of the put has the right to sell; the seller of the put has the
obligation to buy.

Series 6 [Link] 28 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 29

!
TEST TOPIC ALERT The exam will have very few questions about options. You should be well pre-
pared if you know the information in the following table.

Buy Sell

Right to buy Obligation to sell

Call
Bullish Bearish

Right to sell Obligation to buy

Put
Bearish Bullish

Be prepared to answer the following questions.

Which options positions are bearish? Long put, short call
Which options positions are bullish? Long call, short put
Which positions buy stock at exercise? Long call, short put
Which positions sell stock at exercise? Long put, short call
Which positions have rights? Long call, long put
Which positions have obligations? Short call, short put

Q
QUICK QUIZ 1.H 1. Who of the following are bearish?
I. Call buyer
II. Call writer
III. Put buyer
IV. Put writer
A. I and III
B. I and IV
C. II and III
D. II and IV

2. Upon exercise of an option, who of the following would buy stock?

A. The call buyer because he is obliged to.
B. The put seller because he is obliged to.
C. The call seller because he elects to.
D. The put buyer because he elects to.

Series 6 [Link] 29 6/8/2016 [Link] PM

 30 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

3. Who of the following have acquired an obligation?

I. Call buyer
II. Call writer
III. Put buyer
IV. Put writer
A. I and III
B. I and IV
C. II and III
D. II and IV

Terms and Concepts Checklist

✓ ✓ ✓
†† Common stock †† Preferred stock †† Bull, bullish
†† Authorized †† Fixed income †† Bear, bearish
†† Issued †† Straight preferred †† Cash dividends
†† Treasury †† Cumulative preferred †† Dividend yield
†† Outstanding †† Callable preferred †† Stock dividends
†† Current market value †† Convertible preferred †† Growth
(CMV) †† Participating †† Investment risk
†† Par value preferred †† Return on investment
†† Book value †† Adjustable rate †† Exercise price or strike
†† Statutory voting preferred price
†† Cumulative voting †† ADR †† Leverage
†† Exchange listed †† (Preemptive) rights †† Long or short call
†† OTC †† Warrant †† Long or short put
†† Option contracts †† Expiration date

1. 3 DEBT SECURITIES
So far, we have been discussing equity securities, those that confer actual ownership in a
company upon its holder. These securities, as we have seen, take the form of common and pre-
ferred stock. A second major form of security, debt securities, can be issued not only by corpo-
rations, but by federal, state, or local governmental bodies as well. Corporate debt instruments
can be secured or unsecured. Secured bonds are backed by some form of collateral, discussed
later. A debt instrument issued by a state or local government takes the form of a municipal
bond or note. A debt instrument issued by the federal Treasury takes the form of a Treasury
bill, note, or bond. A debt instrument issued to fund a government-sponsored enterprise takes
the form of an agency issue.
Bonds, whether issued by corporations, municipalities, the U.S. government, or its agen-
cies, are debt securities. As the borrower, the issuer promises to repay the debt on a specified
date and to pay interest on the loan amount.
Because the interest rate the investor receives is set when the bond is issued, it is a fixed-
income security. Individual bonds usually have a par (principal or face) value of $1,000.

Series 6 [Link] 30 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 31

!
TEST TOPIC ALERT An investor who buys stock in a company is an owner or has equity in the
company. An investor who buys bonds is owed money by the issuer. Bondholders are
creditors of the issuer. Like any other borrower, the bond issuer pays interest for the
use of the money to the bondholder.

1. 3. 1 CHARACTERISTICS OF BONDS
As creditors, bondholders receive preferential treatment over common and preferred
stockholders if a corporation files for bankruptcy. Because creditor claims are settled before the
claims of stockholders, bonds are considered senior securities. Therefore, stockholder interests
are subordinate to those of bondholders.

1. 3. 1. 1 Issuers
Corporations issue bonds to raise working capital or funds for capital expenditures such as
plant construction or equipment and other major purchases. Corporate bonds are commonly
referred to as funded debt. Funded debt is any long-term debt payable in five years or more.
The federal government is the nation’s largest borrower and the most secure credit risk.
Treasury bills (maturities of 52 weeks or less), notes (2- to 10‑year maturities), and bonds
(greater than 10-year maturities) are backed by the full faith and credit of the government and
its unlimited taxing powers.
Municipal securities are the debt obligations of state and local governments and their
agencies. Most are issued to raise capital to finance public works or construction projects that
benefit the general public.

✓
TA K E N O T E Generally, bonds issued by the federal government have the lowest default risk,
followed by agency issues of the federal government, municipal bonds, then corpo-
rate bonds. Because corporate bonds are the riskiest, they provide the highest poten-
tial income to investors.

1. 3. 1. 2 The Trust Indenture Act of 1939

The Trust Indenture Act requires corporate bonds of $50 million or more and greater than
270 days to maturity to be issued under a trust indenture, a legal contract between the bond
issuer and a trustee representing bondholders. The face of a bond certificate mentions the trust
indenture, but it is not automatically supplied to bondholders. The trust indenture specifies
the issuer’s obligation and the bondholders’ rights and also identifies the trustee.

1. 3. 1. 2. 1 The Trustee
The Trust Indenture Act of 1939 requires a corporation to appoint a trustee—usually a
commercial bank or trust company—for its bonds. The trustee ensures compliance with the
covenants of the indenture and acts on behalf of the bondholders if the issuer defaults.

Series 6 [Link] 31 6/8/2016 [Link] PM

 32 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

Exemptions. Federal and municipal governments are exempt from the Trust Indenture
Act provisions, although municipal revenue bonds are typically issued with a trust indenture
to make them more marketable.

1. 3. 1. 3 Interest
Both the interest rate an issuer pays its bondholders and the timing of payments are set
when a bond is issued. The interest rate, or coupon, is calculated from the bond’s par value.
Par value, also known as face value, is normally $1,000 per bond, meaning each bond is sold
for $1,000 at issue and will be redeemed for $1,000 when it matures. Interest on a bond accrues
daily and is paid in semiannual installments over the life of the bond.

1. 3. 1. 4 Maturities
On the maturity date, the loan principal is repaid to the investor. Each bond has its own
maturity date. The most common maturities fall in the five- to 30-year range.

1. 3. 1. 5 Bond Certificates
All bond certificates contain basic information including the following:
■■ Name of issuer
■■ Interest rate and payment date
■■ Maturity date
■■ Call features
■■ Principal amount (par value)
■■ CUSIP number for identification
■■ Dated date—the date that interest starts accruing
■■ Reference to the bond indenture

1. 3. 1. 6 Registration of Bonds
Bonds are registered to record ownership should a certificate be lost or stolen. Tracking a
bond’s ownership through its registration has been common in the United States only since
the early 1970s.

1. 3. 1. 6. 1 Coupon (Bearer) Bonds

Many years ago, most bonds were issued in coupon, or bearer, form. Issuers kept no records
of purchasers, and securities were issued without an investor’s name printed on the certificate.
Because coupon bonds are not registered, whoever possesses them can collect interest on and
either sell or redeem the bonds.
Interest coupons are attached to bearer bonds, and holders collect interest by clipping the
coupons and delivering them to an issuer’s paying agent. Individual coupons are payable to
the bearer. When a bond matures, the bearer delivers it to the paying agent and receives his
principal. No proof of ownership is needed to sell a bearer bond. Bearer bonds have not been
issued in the United States since 1982; however, the term coupon is still used to describe inter-
est payments received by bondholders.

Series 6 [Link] 32 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 33

1. 3. 1. 6. 2 Registered Bonds
Registered bonds may be issued as fully registered or registered as to principal only.
Fully Registered. When bonds are registered as to both principal and interest, the transfer
agent maintains a list of bondholders and updates this list as bond ownership changes. Inter-
est payments are automatically sent to bondholders of record. The transfer agent transfers
a registered bond whenever a bond is sold by cancelling the seller’s certificate and issuing a
new one in the buyer’s name. Today, if a bond is issued with a certificate, it will be fully reg-
istered.
Registered as to Principal Only. Principal-only registered bonds have the owner’s name
printed on the certificate, but the coupons are in bearer form.
When bonds registered as to principal only are sold, the names of the new owners are
recorded (in order) on the bond certificates and on the issuer’s registration record. Like bearer
bonds, bonds registered as to principal only are no longer issued.

1. 3. 1. 6. 3 Book-Entry Bonds
Book-entry bond owners do not receive certificates. Rather, the transfer agent maintains
the security’s ownership records. The names of buyers of both registered and book-entry bonds
are recorded (registered), but the book-entry bond owner does not receive a certificate—the
registered bond owner does. The trade confirmation serves as evidence of book-entry bond
ownership. All U.S. government and municipal bonds are available only in book-entry form.

!
TEST TOPIC ALERT Bonds issued today must be fully registered or book-entry, not bearer or reg-
istered as to principal only bonds—the issuer must have the name of the investor
entitled to both principal and interest payments on its ownership list.

Remember that bonds are senior to stock, meaning they must be paid first. Thus, bond
interest must be paid before dividends may be paid. Similarly, just as preferred stock is senior
to common stock, secured bonds are senior to unsecured bonds (debentures), which are in turn
senior to subordinated debt. The general order thus described may be illustrated with the other
obligations of a company by means of the priority of payment upon liquidation.

1. 3. 1. 7 Liquidation Priority
In the event a company goes bankrupt, the hierarchy of claims on the company’s assets
are as follows.
1. Unpaid wages

2. IRS, state, and county (taxes)

3. Secured debt (bonds and mortgages)

4. Unsecured bonds (debentures) and general creditors of the issuer

5. Subordinated debt

6. Preferred stockholders

7. Common stockholders

Series 6 [Link] 33 6/8/2016 [Link] PM

 34 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

TEST TOPIC ALERT

! Be ready for a question on liquidation priority. Secured debt is safest, followed by
unsecured bonds, then subordinated debt. Common stock is always last in line. Bonds
are frequently called senior securities because of their priority in this hierarchy.

1. 3. 1. 8 Pricing
Once issued, bonds are bought and sold in the secondary market at prices determined by
market conditions.

1. 3. 1. 8. 1 Par, Premium, and Discount

Most bonds are issued with a face, or par value of $1,000. Par represents the dollar amount
of the investor’s loan to the issuer, and it is the amount repaid when the bond matures.
In the secondary market, bonds can sell for any price—at par, below par (at a discount),
or above par (at a premium). The two primary factors affecting a bond’s market price are the
issuer’s financial stability and overall trends in interest rates. If an issuer’s credit rating remains
constant, interest rates are the only factor that affects the market price.
Bond quotes are commonly stated as percentages of par. A bid of 100 means 100% of par,
or $1,000. A bond quote of 98¹⁄8 means 98¹⁄8% (98.125%) of $1,000, or $981.25.
Sample Corporate Bond Pricing

A Price of: Means . . . Or . . .

 92   92% of $1,000 $ 920.00

 931/8  931/8% of $1,000 $ 931.25

 941/4  941/4% of $1,000 $ 942.50

 953/8  953/8% of $1,000 $ 953.75

 961/2  961/2% of $1,000 $ 965.00

 975/8  975/8% of $1,000 $ 976.25

 983/4  983/4% of $1,000 $ 987.50

 997/8  997/8% of $1,000 $ 998.75

100 100% of $1,000 $1,000.00

105 105% of $1,000 $1,050.00

Bond price changes are quoted in newspapers in points. One point is 1% of $1,000 (or
$10), and ¼ point is $2.50. The minimum variation for most corporate bond quotes is ¹⁄₈
(.125%, or $1.25).

Example:
Bid Ask
98 ¾ 98 ⅞

The term basis point may be used on your exam. A basis point is ¹⁄₁₀₀ of 1%. 100 basis
points equals 1%. Therefore 75 basis points is .75%, 50 basis points is .50%, and so on.

Series 6 [Link] 34 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 35

!
TEST TOPIC ALERT It is important to remember that one bond point is equal to $10 and one stock
point is equal to $1. For example, when a bond is selling at a 2% premium, it is selling
at 102% of par, or $1,020 (2 points over par).

✓
TA K E N O T E Just like preferred stock, bond prices are inversely affected by interest rates. As
interest rates fall, bond prices rise; as interest rates rise, bond prices fall. This inverse
relationship affects all debt securities.
Long-term bond prices fluctuate more than short-term bond prices because the
longer length of time to maturity magnifies price movement. The risk of rising inter-
est rates reducing the value of fixed income investments such as preferred stock or
bonds is called interest rate risk.

Bond Price/Yield Relationship

Yield

Price

Q
QUICK QUIZ 1.I 1. All of the following issue bonds EXCEPT
A. sole proprietorships
B. the U.S. government
C. municipalities
D. corporations

2. Which of the following entities are exempt from the Trust Indenture Act of 1939?
I. Any large corporation
II. The U.S. government
III. Municipalities
IV. A corporation issuing a bond for $40 million
A. I and II
B. I and IV
C. II and III
D. II and IV

3. Which of the following are found on a bond certificate?

I. Names of the chief officers of the corporation
II. The corporation’s credit rating
III. Call features, including first call date, if any
IV. Interest rate and payment dates
A. I and II
B. I and III
C. II and IV
D. III and IV

Series 6 [Link] 35 6/8/2016 [Link] PM

 36 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

4. The excess of par over the market price of a bond is called

A. the premium
B. the discount
C. the amount owed
D. the overage

1. 3. 1. 9 Rating and Analyzing Bonds

Rating services, such as Standard & Poor’s and Moody’s, evaluate the credit quality of
bond issues and publish their ratings. Standard & Poor’s and Moody’s rate both corporate and
municipal bonds and base their bond ratings primarily on an issuer’s creditworthiness—that is,
the issuer’s ability to pay interest and principal as they come due.
In the following chart, two of the major rating services’ criteria are compared:
Bond Ratings
Standard & Poor’s Moody’s Interpretation
Bank-grade (investment-grade) bonds:
AAA Aaa Highest rating. Capacity to repay principal and
interest judged high.
AA Aa Very strong. Only slightly less secure than the
highest rating.
A A Judged to be slightly more susceptible to ad-
verse economic conditions.
BBB Baa Adequate capacity to repay principal and
interest. Slightly speculative.
Speculative (noninvestment-grade) bonds:
BB Ba Speculative. Significant chance that issuer
could miss an interest payment.
B B Issuer has missed one or more interest or prin-
cipal payments.
C Caa No interest is being paid on bond at this time.
D D Issuer is in default. Payment of interest or
principal is in arrears.

✓
TA K E N O T E
Speculative (noninvestment-grade) bonds are commonly referred to as high-yield
bonds or junk bonds, they must offer high yields to compensate investors for the
elevated risk that the bond may default.

TEST TOPIC ALERT

! You might be asked to choose the bond with the highest rating. Ratings are like
report cards—the more As up front, the better.

Series 6 [Link] 36 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 37

*
EXAMPLE Which of the following bonds is considered to be the safest?
A. A rated mortgage bond
B. Baa rated equipment trust certificate
C. AA rated unsecured debenture
D. B rated funded debt

Answer: C. The safest of the bonds listed is the AA rated unsecured debenture.
You don’t need to be concerned with the type of bond; the rating takes into ac-
count all features of the security when rating the credit risk.

1. 3. 1. 10 Comparative Safety of Debt Securities

1. 3. 1. 10. 1 Relationship of Rating to Yield
Generally, the higher a bond’s rating, the lower its yield. Investors will accept lower returns
on their investments if their principal and interest payments are safer. Bonds with low ratings
due to the issuer’s financial condition pay higher rates because of the risks to principal and
interest associated with such uncertainties.

Qualitative Analysis. In addition to financial statistics, qualitative factors such as an

industry’s stability, the issuer’s management, and the regulatory climate are considered when
bonds are rated.

1. 3. 1. 11 Liquidity
Liquidity is the ease with which a bond or any other security can be sold. Many factors
determine a bond’s liquidity, including:
■■ quality;
■■ rating;
■■ maturity;
■■ call features;
■■ coupon rate and current market value;
■■ issuer; and
■■ existence of a sinking fund (an account to insure payment of principal).

✓
TA K E N O T E
The terms liquidity and marketability are synonymous. Know that either term
refers to how quickly a security can be converted into cash.

1. 3. 1. 12 Maturity
The longer the term to maturity, the greater the risk to bondholders. Bonds with lon-
ger terms to maturity experience greater fluctuation in price, or volatility, than short-term
bonds.

Series 6 [Link] 37 6/8/2016 [Link] PM

 38 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

1. 3. 1. 13 Debt Retirement
The schedule of interest and principal payments due on a bond issue is known as the debt
service.

1. 3. 1. 13. 1 Redemption
When a bond’s principal is repaid, the bond is redeemed. Redemption usually occurs on
the maturity date. When redeemed at maturity, the redemption equals the last semi-annual
interest payment plus the principal of the bond.

*
EXAMPLE The redemption amount for a 6%, $1,000 par corporate bond equals the last
semi-annual interest payment of $30, plus the principal of $1,000, for a total amount
due of $1,030.

Sinking Fund. To facilitate the retirement of its bonds, a corporate or municipal issuer
sometimes establishes a sinking fund operated by the bonds’ trustee. The trust indenture
often requires a sinking fund, which can be used to call bonds, redeem bonds at maturity, or
buy back bonds in the open market.
To establish a sinking fund, the issuer deposits cash in an account with the trustee.
Because a sinking fund makes money available for redeeming bonds, it can aid the bonds’
price stability.

1. 3. 1. 13. 2 Calling Bonds

Bonds are often issued with a call feature or provision. A call feature allows the issuer to
redeem a bond issue before its maturity date, either in whole or in part (in-whole or partial
calls). The issuer does this by notifying bondholders that it will redeem the bonds at a particu-
lar price on a certain date.

Call Premium. The right to call bonds for early redemption gives issuers flexibility in their
financial management. In return, an issuer that calls a bond before its maturity date usually
pays bondholders a premium, a price higher than par, known as a call premium. Various
municipal bonds, corporate bonds, and preferred stocks are callable at some point over their
terms.

Advantages of a Call to the Issuer. Callable bonds can benefit issuers in several ways.
■■ If general interest rates decline, the issuer can redeem bonds with a high interest rate and
issue new bonds with a lower rate.
■■ An issuer can call bonds to reduce its debt.
■■ The issuer can replace short-term debt issues with long-term issues, and vice versa.
■■ The issuer can call bonds as a means of forcing the conversion of convertible corporate
securities.

Term bonds, which all mature on the same date, are generally called by random drawing.
Serial bonds, which are issued with a sequence of maturities, are usually called in reverse order
of their maturities, because longer maturities tend to have higher interest rates. Calling the
longest term maturities lowers the issuer’s interest expense by the largest amount.

Series 6 [Link] 38 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 39

If a bond issue’s trust indenture does not include a call provision, the issuer can buy bonds
in the open market, a practice known as tendering, to retire a portion of its debt.

Call Protection. Bonds are called when general interest rates are lower than they were
when the bonds were issued. Investors, therefore, are faced with having to replace a relatively
high fixed-income investment with one that pays less; this is known as call risk.
A newly issued bond normally has a call protection period of five or 10 years to provide
some safety to investors. During this period, the issuer may not call any of its bonds. When
the call protection period expires, the issuer may call any or all of the bonds, usually at a pre-
mium. A call protection feature is an advantage to bondholders in periods of declining interest
rates.
Callable bonds generally have slightly higher coupons than comparable noncallable bonds
because of the increased risk to investors.

!
TEST TOPIC ALERT 1. Under what economic circumstances do issuers call bonds?

Bonds are typically called when interest rates are declining. Consider the issuer’s
side: would you want to pay more interest for the use of money than you need
to?

2. Investors who purchase callable bonds face what types of investment risk?

Call risk is the risk that the bonds will be called and the investor will lose the
stream of income from the bond. Remember that bonds don’t pay interest after
they have been called. The call feature also causes reinvestment risk. If interest
rates are down when the call takes place, what likelihood does the investor have
of reinvesting the principal received at a comparable rate?

Both call risk and reinvestment risk apply to callable bonds.

3. Which of the following would an investor prefer in a bond she is purchasing?

A. A long call protection period when interest rates are high
B. A long call protection period when interest rates are low
C. A short call protection period when interest rates are high
D. A short call protection period when interest rates are low

Answer: A. Investors want to lock in the highest possible rate of interest for the
longest period of time. During the call protection period the issuer may not call
the bonds away.

1. 3. 1. 13. 3 Refunding Bonds

Refunding is the practice of raising money to call a bond. Specifically, the issuer sells a new
bond issue (with a lower rate) to buy back an old bond issue (with a higher rate). Refunding,
like a call, can occur in full or in part. Generally, an entire issue is refunded at once. Refunding
is common for bonds approaching maturity because an issuer may not have enough cash to pay
off the entire issue. Or, it may choose to use its cash for other needs.

Series 6 [Link] 39 6/8/2016 [Link] PM

 40 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

✓
TA K E N O T E
Refunding can be thought of as issuer refinancing. Homeowners are familiar with
this: when interest rates drop, it makes sense to replace a high-interest mortgage with
a new mortgage at a more competitive rate. An issuer can accomplish the same thing
by refunding.

Q
QUICK QUIZ 1.J 1. Match the following terms to the appropriate description below.
A. Call protection
B. Premium
C. Debt service
D. Sinking fund

—— 1. Account established so that an issuer has the money to redeem its bonds

—— 2. Contractual promise stating that the bond issue is not callable for a certain
period of time

—— 3. The schedule of interest and principal payments due on a bond issue

—— 4. Difference between the higher price paid for a bond and the bond’s face
amount at issue

5. Which of the following AA rated corporate bonds would be expected to have the
lowest market price?
A. A bond with 20 years to maturity when interest rates have risen
B. A bond with 20 years to maturity when interest rates have dropped
C. A bond with 10 years to maturity when interest rates have risen
D. A bond with 10 years to maturity when interest rates have dropped

1. 3. 2 BOND YIELDS
A bond’s yield expresses the cash interest payments in relation to the bond’s value. Yield
is determined by the issuer’s credit quality, prevailing interest rates, time to maturity, and call
features. Bonds can be quoted and traded in terms of their yield as well as their price, expressed
as a percentage of par dollar amount.

1. 3. 2. 1 Comparing Yields
Because bonds most frequently trade for prices other than par, the price discount or pre-
mium from par is taken into consideration when calculating a bond’s overall yield. Many
investors judge the value of a bond by comparing various yields. You can look at a bond’s yield
in several ways.

1. 3. 2. 1. 1 Nominal Yield
A bond’s nominal yield, is set at issuance and printed on the face of the bond.

Series 6 [Link] 40 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 41

Nominal yield is a fixed percentage of the bond’s par value and is also known as the cou-
pon or stated yield.

*
EXAMPLE A coupon of 6% indicates the bondholder is paid $60 in interest annually ($30
every six months) until the bond matures.

6% × $1,000 (par) = $60

✓
TA K E N O T E
Recognize that different names exist for a bond’s nominal yield. It can be called
the coupon rate, the fixed rate, or the stated rate of the bond. The nominal rate of
interest will always be paid to the bondholder, regardless of whether the bond’s price
changes.

1. 3. 2. 1. 2 Current Yield
Current yield (CY) measures a bond’s annual interest relative to its market price, as shown
in the following equation:
Annual interest ÷ market price = current yield
Bond prices and yields move in opposite directions: as a bond’s price rises, its yield declines,
and vice versa. When a bond trades at a discount, its current yield increases; when it trades at
a premium, its current yield decreases.

*
EXAMPLE What is the current yield of a 6% bond trading for $800?
Current yield (CY) = annual interest ÷ current market price
Find the solution as follows: $60 ÷ $800 = 7.5%. Note that this bond is trading
at a discount. When prices fall, yields rise. The current yield (7.5%) is greater than the
nominal yield (6%) when bonds are trading at a discount.

*
EXAMPLE What is the current yield of a 6% bond trading for $1,200? Find the solution as
follows: $60 ÷ $1,200 = 5%. This bond is trading at a premium. Price is up, so the
yield is down. The current yield (5%) is less than the nominal yield (6%) when bonds
are trading at a premium.
The diagram below is effective in helping master the relationships in bond yields.
Be sure to understand the inverse relationship between price and yield.

Inverse Bond/Yield Relationship Chart

CY YTM

Premium

Par

Discount
Coupon

Series 6 [Link] 41 6/8/2016 [Link] PM

 42 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

1. 3. 2. 1. 3 Yield to Maturity
A bond’s yield to maturity (YTM) reflects the annualized return of the bond if held to
maturity and is the most comprehensive measure for comparison of bond yields. In calculating
yield to maturity, the bondholder takes into account the difference between the price paid for
a bond and par value.
If the bond’s price is less than par, the discount amount increases the return (if held to
maturity). If the bond’s price is greater than par, the premium amount decreases the return (if
held to maturity).
Follow the lines on the chart to identify these concepts:
1. When bonds are at par, coupon and current yield are equal. (The point of inter-
section on the CY line is neither higher nor lower than the coupon on the line
that represents par.)
2. When bonds are at a premium, the CY is less than the coupon. (The point of
intersection on the CY line is below the coupon on the line that represents pre-
mium.)
3. When bonds are at a discount, the CY is greater than the nominal yield. (The
point of intersection on the CY line is above the coupon on the line that repre-
sents discount.)

You can also compare a bond’s yield to maturity to its coupon and current yield.

✓
TA K E N O T E
When a bond is trading at a premium, its YTM is less than its current yield. The
point of intersection on the YTM line is below the current yield on the line that rep-
resents premium. Use the chart to keep these important relationships in mind. When
you take the Series 6 exam, draw this chart for reference on a piece of scratch paper.

1. 3. 2. 2 Types of Debt Securities

1. 3. 2. 2. 1 U.S. Government and Agency Securities

The highest degree of safety is in securities backed by the full faith and credit of the U.S.
government. Such securities include:
■■ U.S. Treasury bills, notes, and bonds, and Series EE, HH, and I bonds;
■■ New Housing Authority bonds (NHAs); and
■■ Securities of the Government National Mortgage Association (GNMA or Ginnie Mae).

1. 3. 2. 2. 2 Issues of Agency-Like Organizations

The second highest degree of safety is in securities issued by government-sponsored
corporations, although the U.S. government does not back the securities. These organizations
include:
■■ Federal Farm Credit Banks (FFCBs);
■■ Federal Home Loan Mortgage Corporation (Freddie Mac); and
■■ Federal National Mortgage Association (FNMA or Fannie Mae).

Series 6 [Link] 42 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 43

1. 3. 2. 2. 3 Municipal Issues
Generally, the next level of safety is in securities issued by municipalities. General obliga-
tion bonds (GOs), backed by the taxing power of the issuer, are usually safer than revenue
bonds. Revenue bonds are backed by revenues from the facility financed by the bond issue.

1. 3. 2. 2. 4 Corporate Debt
Corporate debt securities cover the spectrum from very safe (AAA corporates) to very risky
(junk bonds, also known as speculative, or high-yield bonds). Corporate bonds are backed, in
varying degrees, by the issuing corporation.
Usually, these securities are ranked from safe to risky, as follows:
1. Secured bonds
2. Debentures
3. Subordinated debentures
4. Income (adjustment) bonds

However, these rankings serve only as a general guideline.

✓
TA K E N O T E
Income (adjustment) bonds are issued by companies emerging from bankruptcy.
Interest will only be paid if the issuer has the money (as determined by the board of
directors). On your exam, never recommend an income bond to an investor that is
seeking income.

Q
QUICK QUIZ 1.K Match the following terms with the appropriate description below.
A. Premium
B. Discount
C. Par

—— 1. YTM is greater than coupon.

—— 2. CY is less than coupon.

—— 3. YTM is greater than CY.

—— 4. YTM is equal to nominal.

—— 5. CY is less than YTM.

—— 6. YTM is less than coupon.

—— 7. YTM is equal to CY.

Series 6 [Link] 43 6/8/2016 [Link] PM

 44 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

Match the following terms with the appropriate description below.

A. Nominal yield
B. Investment grade
C. Book entry
D. Current yield
E. Yield to maturity

—— 8. Percentage return reflecting the annualized return of the bond if held to

maturity

—— 9. Stated on the face of the bond certificate

—— 10. Annual interest divided by today’s market price

—— 11. Bondowner’s name stored in records kept by the issuer or transfer agent

—— 12. Bonds rated BBB/Baa or above

Q
QUICK QUIZ 1.L 1. A new bond contains a provision that it cannot be called for 5 years after the
date of issuance. This call protection would be most valuable to a recent pur-
chaser of the bond if interest rates are
A. falling
B. rising
C. stable
D. fluctuating

2. What is the calculation for determining the current yield on a bond?

A. Annual interest ÷ par value
B. Annual interest ÷ current market price
C. Yield to maturity ÷ par value
D. Yield to maturity ÷ current market price

3. A customer purchased a 5% U.S. government bond yielding 6%. A year before

the bond matures, new U.S. government bonds are being issued at 4%, and the
customer sells the 5% bond. The customer probably
I. bought it at a discount
II. bought it at a premium
III. sold it at a discount
IV. sold it at a premium
A. I and III
B. I and IV
C. II and III
D. II and IV

4. Which yield to maturity would be higher?

A. 10% nominal yield bond with a premium price
B. 10% nominal yield bond with a discount price
C. 10% nominal yield bond with a price at par
D. 10% current yield bond with a price at par

Series 6 [Link] 44 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 45

5. In a comparison of long-term bonds with short-term bonds, all of the following

are characteristics of long-term bonds EXCEPT
A. they usually have higher yields than short-term bonds
B. they usually provide greater liquidity than short-term bonds
C. they are more likely to be callable
D. they will fluctuate in price more than short-term bonds in response to inter-
est rate changes

6. When interest rates are falling or rising, the price fluctuations of which of the fol-
lowing will be the greatest?
A. Short-term bonds
B. Long-term bonds
C. Money market instruments
D. Common stock

1. 3. 3 U.S. GOVERNMENT AND AGENCY SECURITIES

The U.S. Treasury Department determines the quantity and types of government securi-
ties it must issue to meet federal budget needs. The marketplace determines the interest rates
those securities will pay. In general, the interest that government securities pay is exempt from
state and municipal taxation but is subject to federal taxation.
The federal government is the nation’s largest borrower as well as the best credit risk.
Interest and principal on securities issued by the U.S. government are backed by its full faith
and credit, which is based on its power to tax.
Government securities are issued in book-entry form, meaning no physical certificates
exist.
Marketable government securities trade in the secondary market (OTC). Nonmarketable
government securities have no secondary market and, therefore, are only redeemable through
the federal government.

1. 3. 3. 1 Marketable Government Securities

Marketable Treasury debt securities available to individual investors include bills, notes,
bonds, and TIPS. Denominations for these securities have all transitioned to purchase incre-
ments of $100. Purchases can be made via the federal government at [Link],
a bank, or a broker-dealer.

1. 3. 3. 1. 1 Treasury Bills (T-Bills)

T-bills are short-term obligations and, unlike most other debt securities, are issued at a
discount from par (or face amount). Rather than making regular cash interest payments, the
return on a T-bill is the difference between the price the investor pays and the par value
received when the bill matures.

*
EXAMPLE An investor buys a T-bill for 975 ($975) and receives $1,000 when the bill ma-
tures in six months. The $25 difference ($1,000 – $975) is the investor’s return.

Series 6 [Link] 45 6/8/2016 [Link] PM

 46 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

Maturities. Treasury bills are issued and mature in 4, 13, 26, or 52 weeks.

TEST TOPIC ALERT

! Treasury bill maturities are expressed in weeks, or one year in the case of the 52-
week bill.

Pricing. Once they are issued, T-bill bid and ask quotes in the secondary market are
stated in terms of the annualized interest rates that the discount from par value will yield.

*
EXAMPLE Note the following quote:

U.S. Treasury Bills

Mat. Date
12/15
Bid
5.00
Ask
4.90

T-bills are quoted on a yield basis and sold at a discount from par. They are zero-
coupon securities. The bid reflects the yield buyers want to receive. The ask reflects
the yield sellers are willing to accept.
The exam will not require you to calculate the bid and ask prices of T-bills.
Because T-bills are quoted in yield, a T-bill quote has a bid higher than its ask,
which is the reverse of bid-ask relationships for other instruments.

1. 3. 3. 1. 2 Treasury Notes (T-Notes)

Unlike Treasury bills, T-notes pay interest every six months.

Maturities. T-notes are intermediate-term bonds maturing in 2 to 10 years. T-notes ma-

ture at par (face amount), or they can be refunded (called). If a T-note is refunded, the gov-
ernment offers the investor a new security with a new interest rate and maturity date as an
alternative to a cash payment for the maturing note. Bondholders may always request their
principal in cash.

Pricing. T-notes are issued, quoted, and traded in ¹⁄32 of a percentage of par. A quote of
98.24 can be expressed as 98-24 or 98:24. On a $1,000 note, this means that the note is selling
for 98²4⁄32% of its $1,000 par value. In this instance, .24 designates ²4⁄32 of 1% (1% = $10). A
quote of 98.24 equals 98.75% of $1,000, or $987.50.

*
EXAMPLE
A Bid of …
98.01
98.02
98.03
98.10
Means …
98 /32% of $1,000
1

982/32% of $1,000
98 /32% of $1,000
3

9810/32% of $1,000
Or…
$980.3125
$980.6250
$980.9375
$983.1250
98.11 9811/32% of $1,000 $983.4375
98.12 98 /32% of $1,000
12
$983.7500

Series 6 [Link] 46 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 47

1. 3. 3. 1. 3 Treasury Bonds (T-Bonds)

T-bonds are long-term securities that pay interest every six months.

Maturities. Treasury bonds are issued and mature in more than 10 years.

Pricing. T-bonds are quoted exactly like T-notes.

Callable. Some Treasury bonds have optional call dates, ranging from three to five years
before maturity. The Treasury department must give bondholders four months’ notice before
calling the bonds.

Marketable Government Securities: T-bills, T-notes, and T-bonds

Type Maturity Pricing Form

T-bill 4 to 52 weeks; short Issued at discount; Book entry
term priced on discount basis
T-note Two to 10 years; Priced at percentage Book entry
intermediate-term of par
T-bond More than 10 years Priced at percentage Book entry
of par

1. 3. 3. 1. 4 Treasury Inflation Protection Securities (TIPS)

A type of Treasury issue, known as Treasury Inflation Protection Securities (TIPS),
helps protect investors against purchasing power risk. They are issued with a fixed interest
rate, but the principal amount is adjusted semiannually by an amount equal to the change in
the Consumer Price Index (CPI), the standard measurement of inflation. These issues are
sold at lower interest rates than conventional fixed-rate Treasury securities because of their
adjustable nature.
TIPS are also purchased in minimum increments of $100. Interest on TIPS, like other
U.S. government issues, is exempt from state and local income taxes but is subject to federal
taxation.

1. 3. 3. 1. 5 Treasury STRIPS
The Treasury Department designates certain Treasury issues as suitable for stripping. These
securities are known as STRIPS (Separate Trading of Registered Interest and Principal of
Securities). STRIPS are a type of zero coupon created from U.S. Treasury notes and bonds
when the Treasury sells separate receipts against the principal and coupon payments. The
securities underlying Treasury STRIPS are the U.S. government’s direct obligation.
STRIPS are not issued or sold directly to investors. STRIPS can be purchased and held
only through financial institutions and government securities brokers and dealers.
The minimum face amount needed to strip a fixed-principal note or bond is $100 and any
par amount to be stripped above $100 must be in a multiple of $100.

Series 6 [Link] 47 6/8/2016 [Link] PM

 48 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

1. 3. 3. 2 Nonmarketable Government Securities

Nonmarketable government securities are savings bonds and include Series EE, HH, and
I Bonds. These bonds are nonmarketable (or nonnegotiable), that is, they don’t trade in a
secondary market. They are purchased from the Treasury Department and can be redeemed
with the Treasury Department only by the purchaser or a beneficiary. Savings bond interest is
exempt from state and local taxation but is subject to federal taxation.

✓
TA K E N O T E As of January 1, 2012, paper savings bonds are no longer sold at financial institu-
tions. This action supports the Treasury’s goal to increase the number of electronic
transactions with citizens and businesses. In other words, savings bonds may only be
purchased directly through the Treasury, specifically the Treasury’s Website
[Link].

Series EE bonds are sold at face value starting at a minimum of $25, in increments as
small as a penny. An investor could purchase a $40.54 EE bond. EE bonds earn a fixed rate
of interest, credited monthly and paid at redemption. The maximum amount an investor can
purchase in one calendar year is $10,000.
The tax on accrued interest can be paid annually or deferred until the bonds mature.
If an investor redeems EE Bonds in the first five years, he will forfeit the three most recent
months’ interest. If an investor redeems them after five years, she won’t be penalized.
Series HH bonds are no longer issued as of September 1, 2004; however, billions of dol-
lars of them are still outstanding. HH bonds are considered current-income securities and pay
a fixed rate of interest every six months until maturity or redemption, whichever comes first.
Maturity is 10 years with an additional 10-year extension during which interest continues to
be paid.
Interest is reportable for tax purposes in the year it is earned.
Series I bonds are a low-risk, liquid savings product designed to protect investors from
inflation risk. I bonds may be purchased electronically or paper I bonds may be purchased via
an investor’s IRS tax refund.
Electronic I bonds are sold at face value starting at a minimum of $25, to the penny. An
investor could purchase a $40.54 I bond. The maximum purchase in one calendar year is
$10,000.
Paper I bonds are sold at face value in denominations of $50, $75, $100, $200, $500,
$1,000, and $5,000, with $5,000 being the maximum purchase in one calendar year.
I bonds have an annual interest rate that reflects the combined effects of a fixed rate and
a semiannual inflation rate. Interest is added to the bond monthly and is paid when the bond
is redeemed.
The tax on accrued interest can be paid annually or deferred until the bonds mature.

1. 3. 3. 3 Agency Issues
Certain federal government agencies and agency-like organizations issue debt securities
to finance public sector operations. The following will review mortgage-backed issues of the
Government National Mortgage Association, the Federal Home Loan Mortgage Corporation,
and the Federal National Mortgage Association.
Mortgage-backed securities use pools of mortgages as collateral for the issuance of securi-
ties. They represent an ownership interest in mortgage loans made by financial institutions to

Series 6 [Link] 48 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 49

finance the purchasers of homes or other real estate. As the homeowners pay off the mortgages,
investors receive interest and principal payments.
Agency and agency-like securities have higher yields than direct obligations of the federal
government but lower yields than corporate debt securities. They are considered very safe
when it comes to default risk and are actively traded in the secondary market.
Interest on these issues is taxed at the federal, state, and local level.

1. 3. 3. 3. 1 G
 overnment National Mortgage Association (GNMA, or commonly
known as Ginnie Mae)
Ginnie Mae is a government-owned corporation within the Department of Housing and
Urban Development. Ginnie Maes are guaranteed by the full faith and credit of the U.S.
government.
GNMA buys Federal Housing Administration (FHA) and Veterans Administration
(VA) mortgages and auctions them to private lenders, who pool the mortgages to create pass-
through certificates for sale to investor. Thus, monthly interest and principal payments from
the pool of mortgages pass through to investors.

✓
TA K E N O T E
Unlike a traditional bond that pays interest every six months and returns an
investor’s principal in one lump sum at maturity, Ginnie Maes pay interest and return
a portion of principal to investors each month.

With virtually no default risk, the primary risk in Ginnie Maes has to do with changes in
interest rates in general. If interest rates fall, homeowners tend to pay off their mortgages early,
which accelerates the certificate maturities. If interest rates rise, certificates may mature more
slowly.
GNMAs are issued in minimum denominations of $25,000. Because few mortgages last
the full term, yield quotes are based on a 12-year prepayment assumption (i.e., that a mortgage
balance will be prepaid in full after 12 years of normally scheduled payments).

!
TEST TOPIC ALERT Of agency securities, GNMAs are the most testable.
Important points to remember:
■■ Ginnie Maes are the only agency security backed in full by the
U.S. government

■■ Ginnie Mae issues pass-through certificates

■■ Investors receive interest and principal on a monthly basis; investors buy

Ginnie Maes to satisfy income objectives

■■ Yields on Ginnie Maes are slightly higher than on Treasuries

■■ Ginnie Maes are subject to interest rate and prepayment risk

1. 3. 3. 4 Agency-Like Organizations
Government-sponsored enterprises (GSEs) such as Federal Home Loan Mortgage
Corporation (FHLMC, also known as Freddie Mac), or Federal National Mortgage Association

Series 6 [Link] 49 6/8/2016 [Link] PM

 50 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

(FNMA, also known as Fannie Mae), are chartered by acts of Congress but owned by stock-
holders. The U.S. government does not officially back these; however, many investors under-
stand they carry an implied government backing.

1. 3. 3. 4. 1 Federal Home Loan Mortgage Corporation (FHLMC, Freddie Mac)

Freddie Mac was chartered by Congress in 1970 to provide liquidity, stability, and afford-
ability to the nation’s housing market. Freddie Mac is backed by its own issuing authority. As a
pass-through certificate, Freddie Mac distributes principal and interest payments semiannually.

1. 3. 3. 4. 2 Federal National Mortgage Association (FNMA, Fannie Mae)

Fannie Mae was founded in 1938 during the Great Depression as part of the New Deal. It
provides mortgage capital, allowing lenders to reinvest their assets into more lending and, in
effect, increasing the number of lenders in the mortgage market by reducing reliance on savings
and loan associations. Fannie Mae distributes principal and interest payments semiannually.

✓
TA K E N O T E The creation of a pass-through security begins with a pool of mortgages. This
pool is packaged together and a single security is created. The important distinction
between a pass-through and any other mortgage backed security (MBS) such as col-
lateralized mortgage obligations (discussed next) is that the pass-through is the only
security created from the pool of mortgages. Other types of mortgage-backed securi-
ties could start with the same mortgages but create numerous different securities.

✓
TA K E N O T E
Ginnie Mae is the only agency that is backed by the U.S. government. Freddie
Mac, Fannie Mae, and other agencies are backed by their own issuing authority and
are considered moral obligations of the U.S. government. On September 7, 2008,
the Federal Housing Finance Agency (FHFA) established a conservatorship for Fannie
Mae and Freddie Mac. As the conservator, the FHFA has taken over the assets and
assumed all the powers of shareholders, directors, and officers. It may take any neces-
sary action to restore the firms to a sound and solvent condition. The conservatorship
will end when the FHFA finds that a safe and solvent condition has been restored.
For test purposes, you should consider agency issues (in general) to be second
only to issues of the U.S. government in terms of safety from default.

1. 3. 3. 5 Collateralized Mortgage Obligations (CMOs)

Collateralized mortgage obligations (CMOs) are securities created from pools of mort-
gages. This type of mortgage-backed security was developed to provide investors a greater
range of timeframes and a greater cash-flow certainty than previously offered by MBS pass-
through securities.
The difference between a CMO and a traditional pass-through is that in a CMO structure,
many different securities are created from pools of mortgages by redirecting the cash flows
of principal and interest. The issuer collateralizes a pool of various class mortgage loans and
creates a tranche. A tranche segregates portions of the cash flows from the CMO in order
to redirect its principal and interest payments to other tranches based on a predetermined

Series 6 [Link] 50 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 51

distribution schedule established when the CMO was created. One CMO may be entitled to
receive a certain amount of principal from the pool before all the others.
CMOs are issued by private sector financing corporations and are often backed by GNMA,
FNMA and FHLMC pass-through securities.

✓
TA K E N O T E You could see the term asset-backed security (ABS) on your exam. An ABS is
essentially the same thing as a mortgage-backed security, except that the securities
backing it are assets such as leases, loans, receivables, credit card debt, royalties and
so forth. In other words, an ABS is not backed by mortgage-based securities.

1. 3. 3. 5. 1 CMO Characteristics
Because mortgages back CMOs, they are considered relatively safe. However, their suscep-
tibility to interest rate movements and the resulting changes in the mortgage repayment rate
mean CMOs carry several risks.
The rate of principal repayment varies.
■■ If interest rates fall and homeowner refinancing increases, principal is received sooner than
anticipated, and fewer interest payments are made. This is known as prepayment risk.
■■ If interest rates rise and refinancing declines, the CMO investor may have to hold his
investment longer than anticipated, although he does receive more interest payments.
This is known as extension risk.

Yields. CMOs yield more than Treasury securities and normally pay investors interest and
principal monthly. Principal repayments are made in $1,000 increments to investors in one
tranche before any principal is repaid to the next tranche.

Taxation. Interest from CMOs is subject to federal, state, and local taxes.

Liquidity. An active secondary market exists for CMOs, but the market for CMOs with
more complex characteristics may be limited or nonexistent. Certain tranches of a given
CMO may be riskier than others, and some CMOs or certain tranches carry the risk that
repayment of principal may take longer than anticipated (called extension risk).

Denominations. CMOs are issued in $1,000 denominations.

Suitability. Some varieties of CMOs may be particularly unsuitable for small or unsophis-
ticated investors because of their complexity and risks. Customers may be required to sign a
suitability statement before buying high-risk classes.

Series 6 [Link] 51 6/8/2016 [Link] PM

 52 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

Q
QUICK QUIZ 1.M Match the following items to the appropriate description below.
A. Treasury bill
B. GNMA pass-through certificate
C. Collateralized mortgage obligation
D. Separate Trading of Registered Interest and Principal of Securities (STRIPS)

—— 1. Zero-coupon bond issued and backed by the Treasury Department

—— 2. Marketable U.S. government debt with a maturity of one year or less

—— 3. Security representing an interest in a pool of mortgages that is guaranteed

by the full faith and credit of the U.S. government

—— 4. Mortgage-backed corporate security that attempts to return interest and

principal at a predetermined rate

5. CMOs are backed by

A. mortgages
B. real estate
C. municipal taxes
D. full faith and credit of U.S. government

6. The term tranche is associated with which of the following investments?

A. FNMA
B. CMO
C. GNMA
D. SLMA

1. 3. 4 MUNICIPAL BONDS
A bond issued by a form of government other than the federal government or agency of
the federal government is a municipal bond. Municipal bond issuers include states, counties,
cities, townships, villages, school districts, and transportation authorities.
Municipal bonds (securities) are generally considered very safe; only U.S. government and
U.S. government agency securities are safer in terms of default risk. Of course, the degree of
safety varies among issues and among municipalities.
Municipal bonds pay interest semiannually. The interest payment schedule is set when the
bonds are issued.

1. 3. 4. 1 Tax Benefits
The federal government, with some exceptions, does not tax the interest from debt obli-
gations of municipalities, but any capital gains from municipal transactions are taxable. This
tax-advantaged status of municipal bonds allows municipalities to pay lower interest rates on
their bond issues.
Municipal securities are more appropriate for investors in high tax brackets than those
in low tax brackets because the amount of tax savings for high tax-bracket investors is larger.

Series 6 [Link] 52 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 53

1. 3. 4. 1. 1 Calculating Tax Benefits

In comparing a corporate with a municipal bond, the tax-equivalent yield gives the equiv-
alent yield of a corporate bond to that of a municipal bond; the tax-free equivalent yield gives
the equivalent yield of a municipal bond to that of a corporate bond.

Tax-equivalent Yield:
(Municipal yield) ÷ (1 – investor tax rate %) = Equivalent corporate yield
Tax-free Equivalent Yield:
(Corporate yield)×(1 – investor tax rate %) = Equivalent municipal yield

*
EXAMPLE Two investors, one in a 15% tax bracket and one in a 30% tax bracket, consider
purchasing a new municipal bond with a 7% coupon at par. Comparable corporate
bonds are currently being issued at 8.5%.
The investor in the 15% tax bracket would receive a tax-equivalent yield of
8.2%. To calculate this, divide 7% by (100% minus his tax rate of 15%), or 7%
divided by 85% (.85), which equals 8.2%. The municipal bond would not be a good
choice for this investor because he could get a higher rate of return by investing in
corporates.
If the investor chooses a corporate bond paying $85 a year, he would pay taxes
of $12.75 per bond ($85 × 15%), leaving him with $72.25 after taxes, which is more
than the $70.00 he would get from the municipal bond.
The investor in the 30% tax bracket would receive a tax-equivalent yield of 10%
(7% divided by 100% minus his 30% tax rate, or 7% divided by 70% = 10%). He
would receive a higher after-tax yield from the municipal bond.
If the investor chooses a corporate bond paying $85 a year, he would pay taxes
of $25.50 ($85 × 30%), leaving him with $59.50 after taxes, which is less than
$70.00 tax free.

!
TEST TOPIC ALERT The most important point about municipal debt is that interest earned on these
securities is exempt from federal taxation. They are most suitable for high tax-bracket
investors and generally unsuitable for investors in low tax brackets or within retire-
ment plans.
Note that interest may also be tax-exempt at the state and local level if the bond
holder is a resident of the state in which the bond is issued.

1. 3. 4. 2 General Obligation Bonds (GOs)

GOs are also known as full faith and credit bonds because the interest and principal pay-
ments are backed by the full faith and credit of the issuer. GOs are used to raise funds for munic-
ipal capital improvements that benefit the entire community—public schools, a library, a jail,
a bridge, or a courthouse, for instance. These facilities typically do not produce revenues.

Series 6 [Link] 53 6/8/2016 [Link] PM

 54 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

1. 3. 4. 2. 1 Sources of Funds
GO bonds issued by states are backed by income taxes, license fees, and sales taxes. GO
bonds issued by towns, cities, and counties are backed by property taxes, license fees, fines, and
other sources of funds to the municipality. School and park districts may issue municipal bonds
backed by property taxes.
Because GOs are backed by a municipality’s taxing power, voter approval is required prior
to issue.

1. 3. 4. 3 Revenue Bonds
Revenue bonds can be used to finance any municipal facility that generates enough income
to support its operations and debt service. A feasibility study will be completed to ensure the
facility can generate the money needed. Because taxes are not being levied to a specific group
of taxpayers to support the bond, voter approval is not required prior to issue.

1. 3. 4. 3. 1 Sources of Revenue
The interest and principal payments of revenue bonds are payable to bondholders only
from the specific earnings and net lease payments of revenue-producing facilities such as:
■■ utilities (water, sewer, electric);
■■ housing;
■■ transportation (airports, toll roads);
■■ education (college dorms, student loans);
■■ health (hospitals, retirement centers); and
■■ industrial (industrial development, pollution control).

Debt service payments do not come from general or real estate taxes and are not backed by
the full faith and credit of the municipality.

1. 3. 4. 3. 2 Special Revenue Bonds

Industrial development revenue bonds (IDRs or IDBs) are issued by a municipality for
the benefit of a private sector corporation. These are sometimes referred to as private purpose
bonds and may be issued to construct facilities or purchase equipment which is then leased
to a corporation. The municipality uses the money from lease payments to pay the principal
and interest on the bonds. The ultimate responsibility for the payment of principal and inter-
est rests with the corporation; therefore, the bonds carry the corporation’s debt rating and are
generally considered riskier than a GO bond (resulting in a higher coupon).
Under the Tax Reform Act of 1986, the interest on these bonds is often taxable because
the act reserves the tax exemption for public purpose bonds.

1. 3. 4. 4 Legal Opinion
Attached to every bond certificate (unless the bond is specifically stamped ex-legal) is a
legal opinion written and signed by the bond counsel, an attorney specializing in tax-exempt
bond offerings. The legal opinion states that the issue conforms with applicable laws, the state
constitution, and that the interest is tax free at the federal level.

Series 6 [Link] 54 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 55

Q
QUICK QUIZ 1.N True or False?

—— 1. Municipal securities are issued by federal and state governments.

—— 2. Capital gains from the profitable sale of municipal securities are not
exempt from taxation.

—— 3. Municipal revenue bonds are generally backed by taxes collected by the

municipality.

—— 4. The interest on IDRs is typically taxable at the federal level.

—— 5. Bonds issued by school, road, and park districts are examples of GOs.

—— 6. Municipals generally pay less interest than corporate issuers.

1. 3. 5 CORPORATE BONDS
Corporate bonds are issued to raise working capital or capital for expenditures such as
plant construction and equipment purchases.

1. 3. 5. 1 Types of Corporate Bonds

The two primary types of corporate bonds are secured and unsecured. Other terms used
to describe bonds are also discussed in this section: guaranteed bonds, income bonds, and zero-
coupon bonds.

1. 3. 5. 1. 1 Secured Bonds
A bond is secured when the issuer has identified specific assets as collateral for interest and
principal payments. A trustee holds the title to the assets that secure the bond. In a default,
the bondholder can lay claim to the collateral.

Mortgage Bonds. Mortgage bonds have real property (real estate) pledged as collateral.
While mortgage bonds, in general, are considered relatively safe, individual bonds are only as
secure as the assets that secure them and are rated accordingly. In this manner, their safety is
similar to a home mortgage—if the property value is sufficient to support the loan, the bond
is safer than one where property values have fallen.

Collateral Trust Bonds. Collateral trust bonds are usually issued by corporations that own
securities of other companies as investments. A corporation issues bonds secured by a pledge
of those securities as collateral. The trust indenture usually contains a covenant requiring
that a trustee hold the pledged securities. Collateral trust bonds may be backed by one or
more of the following securities:
■■ stocks and bonds of partially or wholly owned subsidiaries (or even the company’s own
stock);
■■ another company’s stocks and bonds;

Series 6 [Link] 55 6/8/2016 [Link] PM

 56 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

■■ installment payments or other obligations of the corporation’s clients; or

■■ U.S. Treasuries.

Equipment Trust Certificates. Railroads, airlines, trucking companies, and oil companies
use equipment trust certificates (or equipment notes and bonds) to finance the purchase of
capital equipment. Title to the newly acquired equipment is held in trust, usually by a bank,
until all certificates have been paid in full. Because the certificates normally mature before
the equipment wears out, the amount borrowed is generally less than the full value of the
property securing the certificates.

1. 3. 5. 1. 2 Senior vs. Junior Debt

Secured bonds are said to be senior to unsecured bonds, called junior debt because it fol-
lows senior debt. This simply means that the claims of senior debt are honored before those of
unsecured debt.

✓
TA K E N O T E
Holders of secured bonds do not have a specific claim on any of the other assets
of the corporation in a liquidation.

1. 3. 5. 1. 3 Unsecured Bonds
Unsecured bonds have no specific collateral backing and are classified as either deben-
tures or subordinated debentures.

Debentures. Debentures are backed by the general credit of the issuing corporation, and
a debenture owner is considered a general creditor of the company. Debentures are junior to
secured bonds and senior to subordinated debentures and preferred and common stock in the
priority of claims on corporate assets.

Subordinated Debentures. The claims of subordinated debenture owners are junior to

the claims of all creditors. Subordinated debentures generally offer higher income than either
straight debentures or secured bonds due to their subordination, therefore riskier, status, and
they often have conversion features. Subordinated debentures are often subject to the lower
ratings that classify them as high-yield or junk bonds.

1. 3. 5. 1. 4 Guaranteed Bonds
Guaranteed bonds are backed by a company other than the issuer, such as a parent com-
pany. This effectively increases the issue’s safety because someone other than the issuer is
guaranteeing timely payment of interest and principal. It is not uncommon to find municipal
bonds that carry insurance as the guarantee.

1. 3. 5. 1. 5 Income Bonds
Income bonds, also known as adjustment bonds, are used when a company is reorganizing
and coming out of bankruptcy. Income bonds pay interest only if the corporation has enough
income to meet the interest payment and the board of directors declares a payment. Because
missed interest payments do not accumulate for future payment, these bonds are not suitable
investments for customers seeking income.

Series 6 [Link] 56 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 57

1. 3. 5. 1. 6 Zero-Coupon Bonds
Bonds are normally issued as fixed-income securities. Zero-coupon bonds are debt obliga-
tions that do not make regular interest payments. Instead, zeros are issued at a deep discount
from their face value. The difference between the discounted purchase price and the full face
value at maturity is the return (accreted interest) the investor receives. The price of a zero-
coupon bond reflects the general interest rate climate for similar maturities.
Zero-coupon bonds are issued by corporations, municipalities, and the U.S. Treasury
and may be created by broker-dealers from other types of securities.

Advantages and Disadvantages of Zero-Coupon Bonds. A zero-coupon bond requires a

relatively small investment—perhaps $100 to $200 per bond—and matures at $1,000. They
offer investors a way to speculate on interest rate moves. Because they sell at deep discounts
and offer no cash interest payments to the holder, zeros are substantially more volatile than
traditional bonds; their prices fluctuate widely with changes in interest rates. Moreover, the
longer the time to maturity, the greater the volatility. When interest rates change, a zero’s
price changes much more as a percentage of its market value than an ordinary bond’s price.

Taxation of Zero-Coupon Bonds. Although zeros pay no regular interest income, an in-
vestor who owns taxable (government or corporate) zeros owes income tax each year on the
amount by which the bonds have accreted, just as if the investor had received it in cash. The
income tax is due regardless of the direction of the market price. Because the annual interest
is not prorated in equal amounts, the bond issuer must send each investor an Internal Rev-
enue Service (IRS) Form 1099 annually showing the amount of interest subject to taxation.

✓
TA K E N O T E
When a bond doesn’t pay interest, it is said to trade flat. Zero-coupon bonds,
income (adjustment) bonds, and any bond in default is considered to trade flat.

!
TEST TOPIC ALERT If asked which security has no reinvestment risk, look for a zero. This is because
there are no semiannual interest payments to reinvest. Also, buying a zero is the only
way to lock in a rate of return.
When the exam asks you to select an investment that provides for a certain dol-
lar amount in the future, zeros are a good choice because investors know they will
receive the face amount at maturity.

*
EXAMPLE
A suitability question asks what you would recommend to a couple who wishes
to have $100,000 available in a college education fund in 10 years. Choose a zero
coupon.

1. 3. 5. 2 Convertible Bonds
Convertible bonds are corporate bonds that may be exchanged for a fixed number of
shares of the issuing company’s common stock. Because they are convertible into common
stock, convertible bonds pay lower interest rates than nonconvertible bonds and often trade in

Series 6 [Link] 57 6/8/2016 [Link] PM

 58 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

line with price movements of the common stock. They are bonds with fixed interest payments
and maturity dates, so convertible bonds are less volatile than common stock. Issuers add con-
vertible features to bonds or preferred stock to make these issues more marketable.

1. 3. 5. 2. 1 Considerations

From the issuer’s perspective, when a bond is convertible, it is more marketable to the pub-
lic and, as such, can be issued with a lower coupon than bonds without this privilege. Investors
will buy a bond with a lower coupon because of the bond’s convertibility. The lower coupon
reduces the cost of debt for the issuer and is a big advantage for the issuer; however, for inves-
tors looking for income, convertible bonds may not be appropriate.
On the other hand, convertible bonds offer the safety of the fixed-income market and the
potential appreciation of the equity market, providing investors with several advantages.
■■ As a debt security, a convertible debenture pays interest at a fixed rate and is redeemable
for its face value at maturity, provided the debenture is not converted. As a rule, interest
income is higher and surer than dividend income on the underlying common stock. Simi-
larly, convertible preferred stock usually pays a higher dividend than does common stock.
■■ If a corporation experiences financial difficulties, convertible bondholders have priority
over common stockholders in the event of a corporate liquidation.
■■ In theory, a convertible debenture’s market price tends to be more stable during market
declines than the underlying common stock’s price. Current yields of other competitive
debt securities support the debenture’s value in the marketplace.
■■ Because convertibles can be exchanged for common stock, their market price tends to
move upward if the stock price moves up. For this reason, convertible securities are more
volatile in price during times of steady interest rates than are other fixed-income securi-
ties.

Conversion of a senior security into common stock is not considered a purchase and a sale
for tax purposes. Thus, the investor incurs no tax liability on the conversion transaction.

TEST TOPIC ALERT

! On your exam, if an investor’s main objective is income, don’t recommend a
convertible bond!

1. 3. 5. 2. 2 Calculating Conversion Parity

Parity is the state of a convertible bond (or preferred stock) when its price is equal to the
market price of the underlying stock. It means that two securities are of equal dollar value.

The following formulas calculate the parity prices of convertible securities and their under-
lying common shares:

Market price of the bond

= Parity price of common stock, or
Conversion ratio (# of shares)

Market price of common × conversion ratio = Parity price of convertible bond.

Series 6 [Link] 58 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 59

*
EXAMPLE RST convertible bond has a conversion price of $50. If the bond has a current
market value of $1,200, what is the parity price of the underlying common stock?

Par value: $1,000

Conversion price: $50
Current market value (CMV) of the bond: $1,200

Calculate parity price of the common stock.

Step one: Calculate the conversion ratio:

$1,000 ÷ $50 = 20 shares of common stock

Step two: Divide the CMV by the conversion ratio to determine the parity value
of the common stock:

$1,200 ÷ 20 = $60

If the stock is trading at $60, the value of the equity position (20 x $60 = $1,200)
is equal to the CMV of the bond ($1,200). Parity exists.

*
EXAMPLE RST convertible bond has a conversion price of $50. If the current market value
of the underlying common stock is $40, what is the parity price of the bond?

Par value: $1,000

Conversion price: $50
Current market value (CMV) of common stock: $40

Calculate the parity price of the bond.

S tep one: Calculate the conversion ratio: $1,000 / $50 = 20 shares of common
stock.

S tep two: Multiply the CMV of common stock by the conversion ratio to determine
parity of the bond:
$40 x 20 = $800

If the stock is trading at $40, the value of the equity position ($40 x 20 = $800) is
equal to the CMV of the bond ($800). Parity exists.

1. 3. 5. 2. 3 Antidilution Provision
An antidilution provision gives the owner of convertible securities such as a convertible
preferred stock or bond, the right of the owner to maintain the same conversion ratio in the
event of a stock split or stock dividend. For example, if a convertible bond may be exchanged
for 50 shares of common stock and there is a 2-for-1 stock split, the same convertible bond can
be exchanged for 100 shares. This provision keeps the investor whole.

1. 3. 5. 3 Duration
Duration is another useful tool in bond calculations; it is a measure of the amount of time
a bond will take to pay for itself. Each interest payment is taken to be part of a discounted cash

Series 6 [Link] 59 6/8/2016 [Link] PM

 60 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

flow, so there is more to the calculation than simply adding up the interest payments. For the
Series 6, remember that duration is often used to assess the sensitivity of a bond in response
to interest rate changes—the longer the duration, the greater the sensitivity, and thus greater
interest rate risk in an environment of changing interest rates. Remember also that the dura-
tion of an interest-paying bond is always shorter than the time to its maturity because the
interest payments can be reinvested and earn additional interest. By way of comparison, the
duration of a zero-coupon bond is always equal to the time to its maturity because there is only
one payment—the one made when the bond matures.

Q
QUICK QUIZ 1.O True or False?

—— 1. Corporate bonds are quoted in points and 1/8s.

—— 2. T-bills are short-term obligations.

—— 3. T-bonds pay interest quarterly.

—— 4. STRIPS are zero-coupon bonds issued by the Treasury.

—— 5. STRIPS are backed directly by the Treasury.

1. 3. 6 TRACKING CORPORATE BONDS

Bonds are listed in newspapers and other financial publications such as Barron’s and The
Wall Street Journal.

Corporate Bond Quotations

New York Exchange Bonds

Quotations as of 4 pm Eastern Time
Tuesday, January 8, 2013
Corporation Bonds
Volume $45,198,000
Cur Net
Bonds Yld Vol High Low Close Chg

AlaP 9s 2019 8.9 18 100 3/4 100 5/8 100 3/4 +1/4
AlldC zr 22 ... 10 91 1/2 91 1/8 91 1/2 –1/8

EXPLANATORY NOTES
Yield is current yield. cld: Called. cv: Convertible bond. dc: Deep
discount. f: Dealt in flat. m: Matured bonds, negotiability impaired by
maturity. na: No accrual. r: Registered. zr: Zero coupon. vi: In
bankruptcy or receivership or being reorganized.

This sample comprises formats, styles, and abbreviations from a variety of

currently available sources and has been created for educational purposes.

Series 6 [Link] 60 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 61

*
EXAMPLE Alabama Power 9s 2019 (AlaP): The description of its 9s 2019 bond indicates
the bond pays 9% interest and matures in the year 2019. The current yield is given
as 8.9%, which indicates the bond is selling at a premium. The “Vol” (volume, or
sales) column states how many bonds traded the previous day (the day being re-
ported). In this case, 18 bonds, or $18,000 par value, were traded in Alabama Power
9s 2019 on Tuesday, January 8, 2013 (this is Wednesday’s newspaper showing the
trading for the previous day).
The next three columns explain the high, low, and closing prices for the day.
For AlaP, the high was 100¾, the low was 1005⁄8, and the bonds closed at (last
trade) 100¾. Net change (the last column) refers to how much the bond’s closing
price was up or down from the previous day’s close. AlaP 9s of 2019 closed up ¼ of
a point, or $2.50. AlaP closed the previous day (Monday, January 7) at 100½.
(100¾ – ¼).

Note that the Allied Chemical (AlldC) zr bonds have ellipses in the current yield column;
these are zero-coupon bonds that do not pay interest.

!
TEST TOPIC ALERT You might be asked to determine the price of a bond from a bond quote; 1 bond
point = $10. If the bond’s quote is 105, its price is $1,050.
If a bond is quoted at 975⁄8, find its price in three steps:
1. 97 × 10 = $970
2. 5/8 = .625 × 10 = $6.25
3. $970 + $6.25 = $976.25

Q
QUICK QUIZ 1.P Match the following items to the appropriate description below.
A. Zero-coupon bonds
B. Parity
C. Guaranteed bonds
D. Subordinated debenture

—— 1. Claims are junior to those of other creditors

—— 2. Party other than the issuing corporation promises to maintain payments of

principal and interest

—— 3. Dollar amount at which a convertible security is equal in value to its cor-

responding stock

—— 4. Investor receives Form 1099 and reports interest for taxation even though
no interest income has been received

Series 6 [Link] 61 6/8/2016 [Link] PM

 62 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

Match the following items to the appropriate description below.

A. Collateral trust bond
B. Income bond
C. Mortgage bond
D. Convertible

—— 5. Debt obligation secured by a pledge of real property

—— 6. Debenture that can be exchanged for common stock at specified prices or

rates

—— 7. Secured bond backed by stocks or bonds of another issuer

—— 8. Interest payment must be declared by issuer’s board of directors and only

if earnings are enough to support the payment

9. ABC, Inc., has filed for bankruptcy. Parties will be paid off in which order?
I. Holders of secured debt
II. Holders of subordinated debentures
III. General creditors
IV. Preferred stockholders
A. I, III, II, IV
B. III, I, II, IV
C. I, II, III, IV
D. IV, I, II, III
10. Moody’s Bond Page lists the following:

GMAC ZR ’32 54¼

Ogden 5s ’33 78M\,
The annual interest on 50 Ogden bonds is
A. $93
B. $500
C. $930
D. $2,500

11. Which of the following statements regarding convertible bonds is NOT true?
A. Coupon rates are usually higher than nonconvertible bond rates of the same
issuer.
B. Convertible bondholders are creditors of the corporation.
C. Coupon rates are usually lower than nonconvertible bond rates of the same
issuer.
D. If the underlying common stock should decline sharply, the bonds will sell at
a price based on their inherent value as bonds, disregarding the convertible
feature.

12. A bond is convertible to common stock at $20 per share. If the market value of
the bond is $800, what is the parity price of the stock?
A. $12
B. $16
C. $25
D. $40

Series 6 [Link] 62 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 63

13. A convertible bond is purchased at a discount and is convertible at $125. What is

the conversion ratio?
A. 2
B. 8
C. 12
D. 20

1. 3. 7 THE MONEY MARKET

In the financial marketplace, a distinction is made between the capital market and the
money market. The capital market serves as a source of intermediate- to long-term financing
usually in the form of equity or debt securities with maturities of more than one year.
The money market, on the other hand, provides very short-term funds to corporations,
municipalities, and the U.S. government. Money market securities are debt issues with matur-
ities of one year or less.

✓
TA K E N O T E
The money market is the source for short-term financing, while the capital
market is the source for medium- to long-term financing. Money market funds are
short-term, liquid debt obligations.

1. 3. 7. 1 Money Market Instruments

Money market instruments provide businesses, financial institutions, and governments a
means to finance their short-term cash requirements.

1. 3. 7. 1. 1 Liquidity and Safety

Money market instruments are debt securities with short-term maturities, typically one
year or less.
Because they are short-term instruments, money market securities are highly liquid. Money
market securities also provide a relatively high degree of safety because most issuers have high
credit ratings.
Money market securities issued by the U.S. government and its agencies include the
following:
■■ Treasury bills that trade in the secondary market
■■ Treasury and agency securities with remaining maturities of one year or less
■■ Short-term discount notes issued by various smaller agencies

Money market portfolios that include municipal securities are considered tax-exempt
money market instruments.
Corporations and banks have a number of ways to raise short-term funds in the money
market, such as:
■■ bankers’ acceptances (time drafts);
■■ commercial paper (prime paper);
■■ negotiable certificates of deposit;

Series 6 [Link] 63 6/8/2016 [Link] PM

 64 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

■■ federal funds loans; and

■■ loans to broker-dealers.

1. 3. 7. 1. 2 Banker’s Acceptance (BA)

A banker’s acceptance (BA) is a short-term time draft with a specified payment date
drawn on a bank—essentially a postdated check or line of credit. The payment date of a BA is
normally between one and 270 days.
American corporations use bankers’ acceptances extensively to finance international
trade—that is, a BA typically pays for goods and services in a foreign country. They are issued
at a discount and mature at par.

1. 3. 7. 1. 3 Commercial Paper
Corporations issue short-term, unsecured commercial paper, or promissory notes, to raise
cash to finance accounts receivable and seasonal inventory overages. Commercial paper inter-
est rates are lower than bank loan rates. Commercial paper maturities range from one to 270
days, although most mature within 90 days. Commercial paper is issued at a discount from face
value.
Typically, companies with excellent credit ratings issue commercial paper. The primary
buyers of commercial paper are money market funds, commercial banks, pension funds, insur-
ance companies, corporations, and nongovernmental agencies.

1. 3. 7. 1. 4 Negotiable Certificates of Deposit (CDs)

Negotiable CDs (jumbo CDs) are time deposits banks offer. They have minimum face val-
ues of $100,000, but most are issued for $1 million or more. Any amount issued that is greater
than FDIC insurance ($250,000) is an unsecured promissory note of the bank.
Most negotiable CDs mature in one year or less, with the maturity date often set to suit
a buyer’s needs. Because the CDs are negotiable, they can be traded in the secondary market
before their maturity and are considered money market securities.

TEST TOPIC ALERT

! Know the features of each money market instrument listed below.

Banker’s Acceptance
■■ Time draft or letter of credit for foreign trade
■■ Maximum maturity of 270 days
Commercial Paper
■■ Issued by corporations
■■ Unsecured promissory note
■■ Maximum maturity of 270 days
Negotiable CDs
■■ Issued by banks
■■ Minimum face value of $100,000
■■ Mature in one year or less
■■ Unsecured
■■ Interest bearing

Series 6 [Link] 64 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 65

Q
QUICK QUIZ 1.Q 1. All of the following are money market instruments EXCEPT
A. Treasury bills
B. banker’s acceptance
C. commercial paper
D. newly issued Treasury bonds

2. The maximum maturity of commercial paper is how many days?

A. 90
B. 180
C. 270
D. 360

3. Which of the following statements regarding negotiable CDs are TRUE?

I. The issuing bank guarantees them.
II. They are callable.
III. Minimum denominations are $1,000.
IV. They can be traded in the secondary market.
A. I and II
B. I and IV
C. II and III
D. III and IV

4. Commercial paper is
A. a secured note issued by a corporation
B. a guaranteed note issued by a corporation
C. a promissory note issued by a corporation
D. none of the above

5. Which money market instrument finances imports and exports?

A. Eurodollars
B. Bankers’ acceptances
C. ADRs
D. Commercial paper

Series 6 [Link] 65 6/8/2016 [Link] PM

 66 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

Terms and Concepts Checklist

✓ ✓ ✓
†† Bond †† Trust Indenture Act †† Negotiable CD
†† Par, premium, †† Trustee †† Interest
discount †† Secured bond †† Maturity
†† Coupon yield †† Mortgage bond †† Liquidation priority
†† Current yield †† Collateral trust †† Income bond
†† Yield to maturity certificate †† Bond rating
†† Inverse relationship †† Equipment trust †† Liquidity
†† Note certificate
†† Call
†† Fixed income security †† Debenture
†† Call protection
†† Agency issues †† Subordinated debenture
†† Call premium
†† Redemption †† Zero coupon bond
†† Coupon
†† Refunding †† Convertible bond
†† Fully registered
†† Duration †† Conversion price
††  egistered as to
R
†† T-bills, T-notes, †† Conversion ratio principal only
T‑bonds †† Conversion parity †† Book entry
†† STRIPS †† Senior, junior security †† GNMA
†† Municipal bond †† IDR, IDB †† Agency-like
†† GO bond †† Legal opinion organization
†† Revenue bond †† Money market †† FNMA
†† Sinking Fund †† Banker’s acceptance †† FHLMC
†† Commercial paper †† CMO

1. 4 ECONOMIC FACTORS
Economics is the study of supply and demand. When people want to buy an item that is in
short supply, the item’s price rises. When people do not want an item that is in plentiful sup-
ply, the price declines. This simple notion—the foundation of all economic study—is true for
bread, cars, clothes, stocks, bonds, and money. Economic activity reflects the overall health of
a country’s economy. Economists attempt to measure and predict the economy’s cycles and the
effect on various industries and corporations.
The economic climate has an enormous effect on the condition of individual compa-
nies and the securities markets. A company’s earnings and business prospects, business cycles,
changes in the money supply, Federal Reserve Board (FRB) actions, and a host of complex
international factors affect securities prices and trading.

1. 4. 1 GROSS DOMESTIC PRODUCT (GDP)

A nation’s annual economic output, all of the goods and services produced within it, is
known as its gross domestic product (GDP). The U.S. GDP includes personal consumption,
government spending, gross private investment, foreign investment, and the total value of
exports.

Series 6 [Link] 66 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 67

1. 4. 1. 1 Price Levels
When comparing the economic output of one period with that of another, analysts must
account for changes in the relative prices of products that have occurred during the interven-
ing time. Economists adjust GDP figures to constant dollars rather than compare actual dol-
lars. This allows economists and others who use GDP figures to compare the actual purchasing
power of the dollars instead of the dollars themselves.

1. 4. 1. 2 Consumer Price Index (CPI)

The most prominent measure of general price changes is the Consumer Price Index
(CPI). The CPI measures the rate of increase or decrease in a range of consumer prices (e.g.,
food, housing, transportation, medical care, clothing, electricity, entertainment, and services).
The CPI is the most commonly used tool to measure the rate of inflation.

1. 4. 1. 3 Inflation
Inflation is a general, continual increase in prices at the consumer level. Another way
of stating this is a persistent decline in the purchasing power of money. In other words, your
dollars won’t purchase as much this year as they did last year, and things will cost more next
year. Mild inflation can encourage economic growth because gradually increasing prices tend
to stimulate business investments. High inflation reduces the buying power of a dollar and
hurts the economy. Gold prices usually rise during periods of high inflation. Increased inflation
drives up interest rates of fixed-income securities, which drives down bond prices. Decreases in
the inflation rate have the opposite effect: as inflation declines, bond yields decline and prices
rise.

If . . . And . . . Then . . . Thus . . .

inflation interest rates bond prices bond yields
increases go up go down go up
inflation interest rates bond prices bond yields
decreases go down go up go down

1. 4. 1. 3. 1 Deflation
Though rare, deflation is a general decline in prices. Deflation usually occurs during severe
recessions when unemployment is on the rise.

1. 4. 1. 4 Business Cycles
Periods of economic expansion are historically followed by periods of economic contrac-
tion in a pattern called the business cycle. Business cycles go through four stages:
■■ Expansion
■■ Peak
■■ Contraction (decline)
■■ Trough (and then the cycle repeats)

Series 6 [Link] 67 6/8/2016 [Link] PM

 68 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

Expansion is characterized by increased business activity—increasing sales, manufactur-

ing, and wages—throughout the economy. For a variety of reasons, an economy can grow for
only so long, and will reach its upper limit, or peak. When business activity declines from its
peak, the economy is contracting.
Recessions occur when the GDP declines for six consecutive months (two quarters).
When business activity stops declining and levels off, it is known as a trough. According to
the U.S. Commerce Department, the economy is in a depression when a decline in real out-
put of goods and services (the GDP) lasts for six consecutive quarters.

!
TEST TOPIC ALERT Know the order of the four phases of the business cycle: expansion, peak,
contraction, trough.

✓
TA K E N O T E
Inflation causes purchasing power risk. Today’s dollars can buy fewer goods to-
morrow. A constant dollar adjustment must be made to compare dollars from year to
year that have been affected by inflation.

The Four Stages of the Business Cycle

Peak

Expansion Contraction

Trough

In the normal course of events, some industries or corporations prosper as others fail. So
to determine the economy’s overall direction, economists consider many aspects of business
activity.
Expansions are characterized by:
■■ increases in industrial production;
■■ bullish (rising) stock markets;
■■ rising property values;
■■ increased consumer demand for goods and services;
■■ increasing GDP; and
■■ low unemployment.

Downturns in the business cycle tend to be characterized by:

■■ rising numbers of bankruptcies and bond defaults;
■■ higher consumer debt;
■■ bearish (falling) stock markets;

Series 6 [Link] 68 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 69

■■ rising inventories (a sign of slackening consumer demand in hard times);

■■ decreasing GDP; and
■■ high unemployment.

Q
QUICK QUIZ 1.R Match the following terms to the appropriate description below.
A. Recession
B. Inflation
C. Economics
D. CPI
E. Trough

—— 1. The study of supply and demand

—— 2. Money loses buying power

—— 3. Contraction lasting at least 6 consecutive months

—— 4. Followed by expansion

—— 5. Quantifies price changes

1. 4. 2 ECONOMIC POLICY
The Federal Reserve Board (the Fed) conducts monetary policy by influencing the money
supply, which in turn affects interest rates and the economy. The President and Congress
implement fiscal policy by influencing the economy through Congress’s powers to tax and
spend.

1. 4. 2. 1 Monetary Policy
Most people think of money as cash in their pockets. Economists take a much broader
view and include loans, credit, and an assortment of other liquid instruments. To a monetarist,
the rate of expansion or contraction of the money supply is the most important element in
determining economic health. The Federal Reserve Board determines monetary policy.
Because the FRB determines how much money is available for businesses and consumers
to spend, its decisions are critical to the U.S. economy. The FRB affects the money supply
through its use of three policy tools:
■■ changes in reserve requirements;
■■ changes in the discount rate (on loans to member banks); and
■■ open-market operations (buying and selling Treasury securities).

1. 4. 2. 1. 1 Reserve Requirements
Commercial banks must deposit a certain percentage of their depositors’ money with the
Federal Reserve. This is known as the reserve requirement. All money deposited by commer-
cial banks at Federal Reserve Banks, including money exceeding the reserve requirement, are
called federal funds.

Series 6 [Link] 69 6/8/2016 [Link] PM

 70 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

When the Fed raises the reserve requirement, banks must deposit more funds with the Fed
and, thus, have less money to lend, which drives up interest rates and contracts the economy.
Reducing the reserve requirement has the opposite effect.
Even a small change in the reserve requirement impacts so much money that reserve
requirements are rarely changed. When a small change in reserve requirements has an exag-
gerated result in terms of the money supply, it is known as a multiplier effect.
To compensate for shortfalls in its reserve requirement, a bank may borrow excess reserves
(federal funds) from another member bank. The interest rate banks charge each other for such
loans is called the federal funds rate.
The federal funds rate fluctuates daily and is, therefore, the most volatile interest rate in
the economy. A rising rate usually indicates that member banks are more reluctant to lend
their funds and, therefore, want a higher rate of interest in return. A higher rate usually results
from a shortage of funds to lend and probably indicates that deposits, in general, are shrinking.
A falling federal funds rate usually means that the lending banks are in competition to loan
money and are trying to make their own loans more attractive by lowering their rates. A lower
rate often results from an excess of deposits.

1. 4. 2. 1. 2 Discount Rate

Banks can also borrow money directly from the Fed at its discount rate, the interest rate
the Fed charges its members for short-term loans. The discount rate is the only interest rate set
by the Fed. (The Fed targets the federal funds rate and sets the discount rate.) Lowering the
discount rate reduces the cost of money to banks, which increases the demand for loans and
expands the economy. Raising the discount rate increases the cost of money and reduces the
demand for loans and contracts the economy.

1. 4. 2. 1. 3 Open-Market Operations
The Fed buys and sells U.S. government securities in the open market to expand and con-
tract the money supply. The Federal Open Market Committee (FOMC) was created to direct
the FRB’s open market operations. When the FOMC buys securities, it increases the supply of
money in the banking system, and when it sells securities, it decreases the supply of money in
the banking system.
When the Fed wants to expand (or loosen) the money supply, it buys securities from banks.
The banks receive direct credit in their reserve accounts. The increase of reserves allows banks
to make more loans and effectively lowers interest rates. Thus, by buying securities, the Fed
pumps money into the banking system, expanding the money supply.
When the Fed wants to contract (or tighten) the money supply, it sells securities to banks.
Each sale is charged against a bank’s reserve balance. This reduces the bank’s ability to lend
money, which tightens credit and effectively raises interest rates. By selling securities, the Fed
pulls money out of the system, contracting the money supply.
When the Fed buys securities, bank excess reserves go up; when the Fed sells securities,
bank excess reserves go down. When the Fed buys, it expands the money supply; when the
Fed sells, it contracts the money supply. Because most of these transactions involve next-day
payment, the effects on the money supply are immediate, making open market operations the
Fed’s most efficient and frequently used tool.

Series 6 [Link] 70 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 71

!
TEST TOPIC ALERT When it comes to monetary policy, moving reserve requirements is the least used
tool and Federal Open Market Committee Operations is the most frequently used
tool.

1. 4. 2. 2 Fiscal Policy
Fiscal policy refers to legislative decisions of Congress and the President, which basically
involves the ability to tax and spend and can include increases or decreases in:
■■ federal spending;
■■ money raised through taxation; and
■■ federal budget deficits or surpluses.

Fiscal policy is based on the assumption that the government can influence the levels of
unemployment and inflation by adjusting overall demand for goods and services.
If an expanding economy results in inflationary pressure, fiscal policy would dictate increas-
ing taxes and/or reducing government spending in order to reduce inflation by contracting the
economy (money is tight resulting in less demand for goods and services).
On the other hand, in a contracting economy, unemployment rises and, in order to get
people back to work, fiscal policy would dictate reducing taxes and/or increasing government
spending in order to reduce unemployment by expanding the economy (discretionary income
increases, improving the demand for goods and services and, therefore, more people are hired
to meet demand).
Ideally, monetary and fiscal policies work together in a fluctuating economy to keep infla-
tion and unemployment low—if only it were so simple!

1. 4. 2. 3 Economic Policy and the Stock Market

Fiscal and monetary policies have considerable influence on the market. If the FRB eases
interest rates, the money supply increases, making credit easier to obtain and increasing over-
all liquidity.
Similarly, lower tax rates can stimulate spending because they leave more spendable dol-
lars in the hands of individuals and businesses. Like easier credit, lower tax rates are bullish
for the stock market. Raising taxes has the opposite effect; it reduces the amount of money
available to businesses and consumers for spending and investment.
Because the political process determines fiscal policy, it takes time for conditions and solu-
tions to be identified, negotiated, and implemented; fiscal policy is considered an inefficient
way to solve short-term economic problems.

1. 4. 2. 4 Interest Rates
The cost of doing business is closely linked to the cost of money; the cost of money is
reflected in interest rates. The money supply, general economic conditions, and inflation lev-
els within the economy determine the level of interest rates. Major U.S. interest rates include
the following:
■■ Federal funds rate—Interest rate charged on reserves traded among member banks for
overnight use in amounts of $1 million or more; changes daily in response to the borrow-
ing banks’ needs. This is considered the most volatile of all money rates, not because it
changes drastically, but because it changes every day.

Series 6 [Link] 71 6/8/2016 [Link] PM

 72 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

■■ Prime rate—Base rate on corporate loans at large U.S. money center commercial banks;
the prime rate changes when banks react to changes in FRB policy
■■ Discount rate—Charge on loans to depository institutions set by the Federal Reserve
Bank (FRB) in New York
■■ Broker call loan rate—Charge on loans to broker-dealers with stock as collateral (as in
margin accounts for their clients)
■■ LIBOR—London InterBank Offered Rate is the average interest rate charged when banks
in the London interbank market borrow unsecured funds from each other. The LIBOR
rates are generally accepted as the internationally recognized benchmark for short-term
loans.

1. 4. 2. 5 International Monetary Factors

Fiscal and monetary policy are not the only influences on the economy. In today’s global
marketplace, international monetary factors include the balance of payments and currency
exchange rates.

1. 4. 2. 5. 1 Balance of Payments
The flow of money between the United States and other countries is known as the bal-
ance of payments. The balance of payments may be a surplus (more money flowing into the
country than out) or a deficit (more money flowing out of the country than in). A deficit may
occur when interest rates in another country are high as money flows to where it will earn the
highest return.
The largest component of the balance of payments is the balance of trade—the export
and import of merchandise. On the U.S. credit side are sales of American products to foreign
countries. On the debit side are U.S. purchases of foreign goods that cause U.S. dollars to flow
out of the country. When debits exceed credits, a deficit in the balance of payments occurs;
when credits exceed debits, a surplus exists.

1. 4. 2. 5. 2 Currency Exchange Rates

Exchange rates among world currencies have a profound effect on profitability in interna-
tional trade and, of course, on individuals, mutual funds, and others that invest in that trade.
Importers profit if their own currency becomes stronger relative to other currencies. If the U.S.
dollar strengthens in value from 1.3 Swiss francs to 1.4, then goods priced in Swiss francs will
look cheaper to a U.S. importer of Swiss goods. Exporters, on the other hand, profit if their
own currency becomes weaker. If the U.S. dollar weakens in value from 1.3 Swiss francs to
1.2, then goods priced in U.S. dollars look less expensive to Swiss buyers and a U.S. exporter
will be able to sell more.

✓
TA K E N O T E Importers like their own currency to be strong (or, similarly, foreign currencies to
be weak). Exporters like their own currency to be weak (or, similarly, foreign curren-
cies to be strong).

Series 6 [Link] 72 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 73

!
TEST TOPIC ALERT Monetary Policy:
■■ Policy of the Federal Reserve Board (FRB)

■■ Discount rate

■■ Reserve requirement (multiplier effect)

■■ Open market operations (most frequently used)

Fiscal Policy:
■■ Actions of Congress and the President

■■ Government spending and taxation

Q
QUICK QUIZ 1.S 1. When the FOMC purchases T-bills in the open market, which of the following
scenarios are likely to occur?
I. Secondary bond prices will rise
II. Secondary bond prices will fall
III. Interest rates will rise
IV. Interest rates will fall
A. I and III
B. I and IV
C. II and III
D. II and IV

2. Which of the following situations could cause a fall in the value of the U.S. dollar
in relation to the Japanese yen?
I. Japanese investors buying U.S. Treasury securities
II. U.S. investors buying Japanese securities
III. Increase in Japan’s trade surplus over that of the United States
IV. General increase in U.S. interest rates
A. I and III
B. I and IV
C. II and III
D. II and IV

3. To tighten credit during inflationary periods, the Federal Reserve Board can take
any of the following actions EXCEPT
A. raise reserve requirements
B. change the amount of U.S. government debt held by institutions
C. sell securities in the open market
D. lower taxes

4. The effective federal funds rate is

A. the daily average rate charged by the largest money center banks
B. the daily rate charged by Federal Reserve member banks
C. the weekly average rate charged by the largest money center banks
D. the weekly average rate charged by Federal Reserve member banks

Series 6 [Link] 73 6/8/2016 [Link] PM

 74 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

5. Which of the following interest rates is considered the most volatile?

A. Discount rate
B. Federal funds rate
C. Prime rate
D. LIBOR

Terms and Concepts Checklist

✓ ✓
†† GDP †† FRB
†† Business cycle †† Reserve requirement
†† Expansion, peak, contraction, trough †† Discount rate
†† CPI †† FOMC
†† Inflation †† Open market operations
†† Fiscal policy †† Federal funds rate
†† Monetary policy †† Broker call loan rate
†† Balance of payments †† Prime rate
†† Currency exchange rates †† Constant dollar adjustment

Series 6 [Link] 74 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 75

U N I T T E S T

1. Which of the securities listed below is issued 5. The Federal Reserve Board can manage the money
without a stated rate of return? supply with all the following tools EXCEPT
A. Treasury bond A. open market operations
B. Treasury bill B. discount rate
C. Preferred stock C. income tax rate
D. Treasury note D. bank reserve requirements

2. Which of the following statements describing 6. The Federal Open Market Committee is con-
current yield is TRUE? cerned with rising inflation. To counteract this
A. The terms current yield and total return are concern the FOMC should
identical. A. increase the reserve requirement
B. Current yield is calculated by dividing the B. sell U.S. Treasury securities in the open
annual interest or dividend received from an market
investment by its current market price. C. increase the federal funds rate
C. Current yield compares an investment’s D. increase the discount rate
current price to its price at the end of the
previous year. 7. All of the following types of securities trade in the
D. Current yield can be used to express the secondary market EXCEPT
income return on a bond but not on a stock or A. debentures
a mutual fund. B. EE bonds
C. common stock
3. Where are securities that are NOT listed on an D. municipal bonds
exchange traded?
A. Unlisted securities trade on FINRA 8. Which of the following are characteristics of a
B. On the over-the-counter market corporate zero-coupon bond?
C. On a regional exchange in the same state I. The bond pays interest on a semiannual basis.
where the security was issued II. The bond is purchased at a discount from its
D. All securities must be listed in order to trade face value.
publicly III. The investor has locked in the rate of return.
IV. Income tax is paid only at the bond’s maturity.
4. Which of the following types of preferred stock
A. I and III
may pay a single dividend that is greater than the
B. I and IV
dividend stated on the face of the certificate?
C. II and III
I. Straight D. II and IV
II. Cumulative
III. Convertible
IV. Participating
A. I and II
B. I and III
C. II and III
D. II and IV

Series 6 [Link] 75 6/8/2016 [Link] PM

 76 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

9. Which of the following statements about bid and 13. Which of the following are characteristics of gen-
asked prices are TRUE? eral obligation (GO) municipal bonds?
I. Market makers buy at the bid and sell at the I. They are backed by the revenue generated
asked. from the facility that was built with the
II. Market makers buy at the asked and sell at the proceeds of the bond issue.
bid. II. Interest paid is tax free at the federal level.
III. Customers buy at the bid and sell at the asked. III. They are issued by agencies of the federal
IV. Customers buy at the asked and sell at the bid. government.
A. I and III IV. They are backed by the taxing power of the
B. I and IV issuing municipality.
C. II and III A. I and III
D. II and IV B. I and IV
C. II and III
10. Which of the following generally provides the D. II and IV
right to buy a corporation’s stock for the longest
period of time? 14. A convertible corporate bond that has an 8%
A. Warrant coupon yielding 7.1% is available but may be
B. Long put called some time this year. Which feature of this
C. Long call bond would probably be least attractive to your
D. Preemptive right client?
A. Convertibility
11. An investor owns 100 shares of common stock in B. Coupon yield
ABC Corporation. ABC Corporation allows for C. Current yield
statutory voting in board of directors elections. If D. Near-term call
there are 5 positions to be voted on for the board,
the investor has 15. All of the following statements about preferred
A. 500 votes for each of the positions stock and bonds are true EXCEPT
B. a total of 500 votes which may be cast in any A. they are both debt instruments
manner B. they both have a fixed rate of return
C. 100 votes for each of the 5 positions C. they are both senior to common stock at the
D. 20 votes for each of the 5 positions dissolution of a corporation
D. the prices of both are directly influenced by
12. Which of the following would be considered interest rates
money market instruments?
I. A Treasury bond with 11 months to maturity 16. If the economy experiences an increasing GDP, it
II. 10 shares of preferred stock sold within 270 is said to be in
days A. an expansion
III. An American depository receipt (ADR) held B. a peak
for less than 1 year C. a decline
IV. A $200,000 negotiable certificate of deposit D. a trough
A. I and III
B. I and IV
C. II and III
D. III and IV

Series 6 [Link] 76 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 77

17. Which of the following statements regarding Gin- 19. Which of the following statements describes the
nie Maes are TRUE? discount rate?
I. They are not taxable at the state level. A. Charge on loans to brokers on stock exchange
II. They are directly backed by the federal collateral.
treasury. B. Charge on loans to member banks set by the
III. The minimum certificate at issue is $1,000. New York Federal Reserve Bank.
IV. Investors receive a monthly check C. Base rate on corporate loans at large U.S.
representing both interest and a return of money center commercial banks.
principal. D. Rate charged on reserves traded among
A. I and III commercial banks for overnight use in
B. I and IV amounts of $1 million or more.
C. II and III
D. II and IV 20. If the Swiss franc has depreciated relative to the
U.S. dollar, then goods produced in
18. The best time for an investor seeking returns to I. Switzerland become less expensive in
purchase long-term, fixed-interest-rate bonds is the United States
when II. Switzerland become more expensive in
A. long-term interest rates are low and beginning the United States
to rise III. the United States become less expensive
B. long-term interest rates are high and in Switzerland
beginning to decline IV. the United States become more expensive
C. short-term interest rates are high and in Switzerland
beginning to decline A. I and III
D. short-term interest rates are low and beginning B. I and IV
to rise C. II and III
D. II and IV

Series 6 [Link] 77 6/8/2016 [Link] PM

 78 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

A N S W E R S A N D R A T I O N A L E S

1. B. Treasury bills are not issued with a stated 6. B. The FOMC buys and sells U.S. Treasury
coupon rate. Instead, they are sold securities to impact the money supply. To
through auctions at a discount to their counteract inflation, the FOMC needs to
par value of $1,000. They then mature remove dollars from the money supply.
to their face amount and the discount By selling U.S. Treasury securities, the
represents the interest earned. Treasury FOMC requires payment which removes
bonds and Treasury notes are issued with money from the economy, causing interest
a stated rate of interest, and interest is rates to rise. The FOMC does not set the
paid semiannually. Preferred stock has a reserve requirement or the discount rate;
stated rate of dividend; however, it is not these are tools of the Federal Reserve Board
guaranteed. The stated rate of dividend (FRB). The federal funds rate is determined
is only paid if declared by the board of by market supply and demand of excess
directors. reserves between banks.

2. B. Current yield is calculated by dividing 7. B. EE bonds do not trade on the secondary

the annual income distribution from market.
an investment (interest for bonds and
dividends for stock or mutual funds) by the 8. C. Zero-coupon bonds are bought at a discount
current market value (price) of the security. from their face value. The investor has
The current return calculation does locked in a rate of return because the
not factor price movement over time or maturity value of the bond is known at the
reinvestment of distributions, and thus does time of purchase. A corporate zero-coupon
not express an investment’s total return. bond pays no interest each year but is taxed
as if it did.
3. B. Securities not listed on an exchange are
traded on the over-the-counter market. 9. B. Customers buy stock at the asked price,
FINRA is the securities industry’s regulatory which means that market makers must sell
authority. The location of the issue has no at the asked price. Customers sell to market
bearing on whether the issue is listed on a makers at the bid price, which is the price
regional exchange. that a market maker will pay to buy the
customer’s stock. Remember that customers
4. D. Cumulative preferred stockholders have buy at the ask. Then remember that market
the right to receive skipped dividends of makers do the opposite and easily solve
the corporation and can receive a dividend questions like this.
in arrears plus the current year’s dividend.
Participating preferred stockholders have 10. A. A warrant allows an investor a long-
the right to receive a share of the common term right to buy an issuer’s stock. The
dividend. expiration period of a warrant is generally
5 years. Long calls are options that give the
5. C. The Federal Reserve Board uses several holder the right to buy stock, but typically
tools to manage the money supply, expire within 9 months. Preemptive rights
including bank reserve requirements, open are short-term rights to buy stock and
market operations (trading government usually expire within 30–45 days. Long puts
securities), and the discount rate. Income are rights to sell.
tax rates are set by Congress.

Series 6 [Link] 78 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 79

11. C. Statutory voting allows investors 1 vote for 16. A. An economic expansion occurs when the
each share of stock they own per open- GDP (Gross Domestic Product) increases.
director position. This investor has 100 The high point in an economic cycle is
votes for each of the 5 voting positions on known as the peak. When the GDP falls
the board of directors. from one period to the next, the economy is
in a state of decline. A trough occurs at the
12. B. Money market securities are high grade and bottom of the decline.
liquid debt securities with less than 1 year
to maturity. Preferred stock and ADRs are 17. D. Government National Mortgage
equity securities. The T-bond with less than Association (GNMA) pass-through
1 year to maturity and a negotiable CD are certificates are directly backed by the
money market instruments. federal treasury. Each monthly check is
part interest, part principal. The minimum
13. D. General obligation bonds are backed certificate at issue is $25,000 and the
by the full faith and credit (and taxing interest portion of the check is taxable at
authority) of the issuing municipality. The both the federal and the state level.
interest that is paid on municipal bonds is
exempt from taxation at the federal level. 18. B. The best time to buy long-term bonds
Municipal revenue bonds are backed by is when interest rates have peaked. In
revenues generated from the use of the addition to providing a high initial return,
facility. Municipal bonds are issued by as interest rates fall, the bonds will rise in
government levels other than the federal value.
government.
19. B. The discount rate is the charge on loans
14. D. The near-term call would mean that no to member banks by the New York Federal
matter how attractive the bond’s other Reserve Bank. The prime rate is the base
features, the client may not have very long rate on corporate loans at large U.S. money
to enjoy them. center commercial banks. The federal funds
rate is the rate charged on reserves traded
15. A. Preferred stock is an equity instrument among commercial banks for overnight use
because it represents an ownership interest in amounts of $1 million or more. The call
in a corporation. However, because of its rate, or broker call loan rate, is the charge
fixed dividend rate, the price of preferred on loans to brokers for margin loans.
stock (like the price of bonds) is directly
influenced by changes in interest rates. 20. B. If the Swiss franc falls in value relative
Debt securities and preferred stock are to the U.S. dollar, goods produced by the
senior to common stock in corporate United States become more expensive
dissolutions. in Switzerland. Goods produced in
Switzerland become less expensive in the
United States.

Series 6 [Link] 79 6/8/2016 [Link] PM

 80 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

Q U I C K Q U I Z A N S W E R S

Quick Quiz 1.A 4. B. With cumulative voting rights, this investor

may cast 500 votes for the 5 directors in any
1. C. way the investor chooses.
2. D. 5. D. The cumulative method of voting, like the
statutory, gives an investor 1 vote per share
3. A.
owned, times the number of directorships
4. B. to be elected. For instance, if an investor
owns 100 stock shares, and there are 5
Quick Quiz 1.B directorships to be elected, the investor will
have a total of 500 votes. Under cumulative
1. B. voting, however, the stockholder may cast all
of his votes for 1 candidate, thereby giving
2. D. the small investor more voting power.
3. C. 6. D. The basic formula of the balance sheet is
assets = liabilities + net worth. By the same
4. A.
algebra, a company’s shareholder equity can
Quick Quiz 1.C be calculated as such: net worth = assets –
liabilities.
1. C. Owning either common or preferred stocks
represents ownership (or equity) in a
corporation. The other two choices represent 7. C. Although stocks often pay regular dividends,
debt instruments. Clients purchasing they are not guaranteed. If the board decides
corporate or mortgage bonds are considered the company cannot afford to pay a dividend
lenders, not owners. this quarter, no dividend will be paid.

2. C. Treasury stock is stock a corporation has 8. A. Unlike bond interest, dividends on stock
issued but subsequently repurchased from are not promised or ensured and need not
investors in the secondary market. The be paid. Also, when money is to be paid
corporation can either reissue the stock at out, whether as income to the investor or as
a later date or retire it. Stock that has been return of capital at dissolution, common stock
repurchased by the corporation has no voting has the lowest priority. On the bright side,
rights and is not entitled to any declared common stock, unlike debt instruments, gives
dividends. its owner the right to vote on the important
decisions of the issuing company and has
3. B. Preemptive rights enable stockholders to historically offered better inflation protection
maintain their proportionate ownership than fixed income securities.
when the corporation wants to issue more
stock. If a stockholder owns 5% of the Quick Quiz 1.D
outstanding stock and the corporation wants
to issue more stock, the stockholder has the 1. C. Because convertible preferred shares can be
right to purchase enough of the new shares exchanged for common shares, its price can
to maintain a 5% ownership position in the be closely linked to the price of the issuer’s
company. common and is less influenced by changes in
interest rates.

Series 6 [Link] 80 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 81

2. C. Cumulative preferred might pay dividends Quick Quiz 1.H

in arrears in addition to the fixed dividend.
Participating preferred might pay part of the 1. C. The call writer expects the stock to decrease
common dividend, over and above the fixed in price, and that the call will therefore not
dividend. be exercised. This permits him to keep the
premium. The put buyer thinks the stock will
3. B. As a fixed income security, preferred stock go down in price, and thus reserves to himself
has markedly greater price sensitivity to the right to sell it at the higher put strike
interest rates than does common stock. price.

Quick Quiz 1.E 2. B. The put seller has sold another investor the
right to sell stock to him at the put strike
1. D. price. Thus, if the put is exercised, he will be
obliged to buy the stock.
2. A.
3. D. The call seller is obliged to sell stock, and the
3. B.
put seller is obliged to buy stock, should the
4. C. option be exercised.

Quick Quiz 1.F Quick Quiz 1.I

1. D. ADRs are tradable securities issued by 1. A. Corporations, municipalities, and the U.S.
banks, with the receipt’s value based on the government issue bonds. Sole proprietorships
underlying foreign securities held by the assume debt by borrowing from a bank.
bank.
2. C. Government issues at the federal and
2. C. An ADR represents ownership of a foreign municipal level are both exempt from the
corporation. The ADR holder receives Trust Indenture Act of 1939. The Act applies
a share of the dividends and capital to corporate bonds issuing for $5 million or
appreciation (or capital loss) when sold. more in a 12-month period with maturities
exceeding 270 days.
Quick Quiz 1.G
3. D. Bond certificates contain basic information
1. B. Warrants are issued with long-term regarding the bond itself, such as the name
maturities. They may be used as sweeteners of the issuing corporation, call features, the
in an offering of the issuer’s preferred stock coupon rate, and the principal amount of
or bonds. Warrants are not offered only to the bond. There is no requirement that the
current shareholders. The exercise price of a corporation’s officers be named, or that its
warrant is always above the market price of credit rating be given.
the stock at the time of issue.
4. B. If par is greater than (in excess over) the
2. B. Preferred stockholders have no right to market price of a bond, the bond must be
maintain a percentage of ownership when selling at a discount.
new shares are issued (no preemptive rights).
However, they do receive preference in Quick Quiz 1.J
dividend payment and company liquidation.
1. D.
3. B. Rights afford access to new stock, often at
2. A.
a discount, before it is offered to the public.
Warrants afford access to stock at a fixed 3. C.
price for a long period of time.
4. B.

Series 6 [Link] 81 6/8/2016 [Link] PM

 82 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

5. A. Market prices of existing bonds drop when 5. B. Long-term bonds are not as liquid as short-
interest rates rise. The longer the bond has to term obligations.
go to maturity, the greater the effect.
6. B. Long-term debt prices fluctuate more than
Quick Quiz 1.K short-term debt prices as interest rates rise
and fall. Common stock prices are not
1. B. directly affected by interest rates.
2. A. Quick Quiz 1.M
3. B. 1. D.
4. C. 2. A.
5. B. 3. B.
6. A. 4. C.
7. C. 5. A. CMOs are collateralized by mortgages on
real estate. They do not own the underlying
8. E.
real estate, so they are not considered to be
9. A. backed by it.

10. D. 6. B. Collateralized mortgage obligations are a

type of mortgage-backed security. A CMO
11. C. issue is divided into several tranches, which
set priorities for payments of principal and
12. B. interest.
Quick Quiz 1.L Quick Quiz 1.N

1. A. Call protection is most valuable to a 1. F. Municipal securities are issued by state and
purchaser when interest rates are falling. local governments.
Bonds tend to be called in a falling interest
rate environment. 2. T. Capital gains from the profitable sale of
municipal securities are not exempt from
2. B. Annual interest ÷ current market price = taxation.
current yield.
3. F. Revenue bonds are self-supporting and are
3. B. The customer purchased the 5% bond when backed by income from the use of the facility.
it was yielding 6%, therefore at a discount. GOs are backed by taxes.
The customer sold the bond when other
bonds of like kind, quality, and maturity were 4. T. The interest on IDRs is typically taxable at
yielding 4%. The bond is now at a premium the federal level.
because the 5% coupon is attractive to other
investors. The customer, therefore, made a 5. T. Bonds issued by school, road, and park
capital gain on the investment. districts are examples of GOs.

4. B. With the same nominal yield, the discount 6. T. Municipals generally pay less interest than
bonds will generate higher yields. In addition corporate issuers.
to the interest payments received on an
ongoing basis, the investor receives the
amount of the discount at maturity.

Series 6 [Link] 82 6/8/2016 [Link] PM

 Unit 1  Securities Markets, Investment Securities, and Economic Factors 83

Quick Quiz 1.O 11. A. Coupon rates are not higher; they are lower
because of the value of the conversion
1. T. Corporate bonds are quoted as a percentage feature. The bondholders are creditors, and
of par. One point is $10, and Z\, of a point is if the stock price falls, the conversion feature
$1.25. will not influence the bond’s price.
2. T. T-bills are issued with maturities of 4, 13, 12. B. The calculations are: $1,000 ÷ $20 = 50
and 26 weeks. Anything 1 year or less is shares for one bond. $800 bond price ÷ 50
considered short term. shares = $16 parity price.
3. F. T-bonds pay interest semiannually. 13. B. $1,000 par ÷ $125 conversion price = 8
shares per bond.
4. T. STRIPS are issued by the Treasury in
strippable form, for sale by broker-dealers to Quick Quiz 1.Q
the public.
1. D. Newly issued Treasury bonds have a
5. T. STRIPS are directly backed by the U.S. minimum maturity of more than 10 years.
Treasury. Money market instruments have a maximum
maturity of one year.
Quick Quiz 1.P
2. C. Commercial paper is normally issued for a
1. D.
maximum period of 270 days.
2. C.
3. B. Negotiable certificates of deposit are issued
3. B. primarily by banks and are backed by, or
guaranteed, by the issuing bank.
4. A.
4. C. Commercial paper is a short-term promissory
5. C. note issued by a corporation.

6. D. 5. B. Bankers’ acceptances are used in

international trade to finance imports and
7. A. exports. Euro-dollars and ADRs are not
money market instruments.
8. B.
Quick Quiz 1.R
9. A. The order in a liquidation is as follows:
wages, the IRS (and other government 1. C.
agencies), secured debt holders, unsecured
debt holders, general creditors (in most 2. B.
cases, unsecured debt holders are given
a slight priority over all but the largest 3. A.
creditors), holders of subordinated debt,
4. E.
preferred stockholders, and then common
stockholders. 5. D.
10. D. Ogden 5s means 5% bonds. Five percent of
$1,000 par = $50 interest per bond annually.
For 50 bonds, the annual interest is $2,500.

Series 6 [Link] 83 6/8/2016 [Link] PM

 84 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

Quick Quiz 1.S 3. D. To curb inflation, the Fed can sell securities
in the open market, thus changing
1. B. When the Federal Open Market Committee the amount of U.S. government debt
purchases T-bills in the open market, it pays institutions hold. It can also raise the reserve
for the transaction by increasing the reserve requirements, discount rate, or margin
accounts of member banks, the net effect of requirements. The Fed has no control
which increases the total money supply and over taxes, which are raised or lowered by
signals a period of relatively easier credit Congress.
conditions. Easier credit means interest rates
will decline and the price of existing bonds 4. B. The federal funds rate reflects the rate
will rise. charged by member banks lending funds to
member banks that need to borrow funds
2. C. U.S. money being invested abroad would overnight to meet reserve requirements.
weaken the dollar, as would a negative
economic event, such as an unfavorable 5. B. The federal funds rate is the interest rate
balance of trade. that banks with excess reserves charge other
banks that are associated with the Federal
Reserve System and that need overnight
loans to meet reserve requirements. Because
the federal funds rate changes daily, it is
the most sensitive indicator of interest rate
direction.

Series 6 [Link] 84 6/8/2016 [Link] PM

 u n i t

2
Product Information:
Investment Company
Securities and Variable
Contracts

I
nvestment company products may offer a diversified portfolio of securi-
ties, professional management, and reduced transaction costs. Because
of these attractive features, they are very popular with investors. Mutual
funds, one form of investment company, currently manage trillions of dollars
for investors.
Insurance companies also offer products, known as variable contracts,
which are classified as securities. Variable annuities are a popular retirement
instrument that may invest in mutual funds or may invest directly in
individual securities for the purpose of funding a customer’s retirement.
Variable life insurance permits a customer to assume some of the investment
risk inherent in insurance coverage in order to obtain inflation protection
for his contract’s death benefit.
The Series 6 exam will include 20–25 questions on the topics covered in
this Unit. ■

85

Series 6 [Link] 85 6/8/2016 [Link] PM

 OBJECTIVES

When you have completed this Unit, you should be able to:

■■ list the three types of investment companies defined by the Investment Company Act of
1940;

■■ distinguish the characteristics of open- and closed-end management companies;

■■ summarize how investment companies and investment company securities register;

■■ classify five significant roles involved in the management of an investment company;

■■ describe disclosure documents distributed to investors of mutual fund shares;

■■ summarize various types of mutual funds and investment objectives;

■■ identify pricing and costs associated with mutual funds;

■■ explain mutual fund accumulation plans, including contractual plans, and mutual fund
withdrawal plans;

■■ list characteristics of annuities;

■■ explain the phases of the annuity contract; and

■■ differentiate the features of traditional whole life, variable life, and universal variable life
policies.

86

Series 6 [Link] 86 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 87

2. 1 INVESTMENT COMPANY OFFERINGS

An investment company is a corporation or trust that pools investors’ money and then
invests that money in securities on their behalf. By investing these pooled funds as a single
large account jointly owned by every investor in a company, the investment company man-
agement attempts to invest and manage funds for people more efficiently than the individual
investors could themselves. Additionally, it is expected that a professional money manager
should be able to outperform the average investor in the market.

2. 1. 1 INVESTMENT COMPANY PURPOSE

Like corporate issuers, investment companies raise capital by selling shares to the pub-
lic. Investment companies must abide by the same registration and prospectus requirements
imposed by the Securities Act of 1933 on other issuers. Investment companies are subject to
regulations regarding how their shares are sold to the public, and they are regulated by the
Investment Company Act of 1940.

2. 1. 2 TYPES OF INVESTMENT COMPANIES

Investment
Companies

Face Amount Management Unit

Certificate Investment Investment
Company (FAC) Company Trust (UIT)

Fixed UIT Nonfixed UIT

Open-End
Closed-End
(Mutual Fund)

Diversified Nondiversified Diversified Nondiversified

The Investment Company Act of 1940 classifies investment companies into three broad
types: face-amount certificate companies (FACs), unit investment trusts (UITs), and manage-
ment investment companies.

Series 6 [Link] 87 6/8/2016 [Link] PM

 88 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

2. 1. 2. 1 Face-Amount Certificate Companies (FACs)

A face-amount certificate (FAC) is a contract between an investor and an issuer in which
the issuer guarantees payment of a stated (face amount) sum to the investor at some set date in
the future. In return for this future payment, the investor agrees to pay the issuer a set amount
of money either as a lump sum or in periodic installments. If the investor pays for the certifi-
cate in a lump sum, the investment is known as a fully-paid face-amount certificate.
Issuers of these investments are face-amount certificate companies. Very few face-amount
certificate companies operate today.

TEST TOPIC ALERT

! You will see no more than one or two questions involving face-amount certificate
companies on the Series 6 exam. Face-amount certificate companies:
■■ are classified as investment companies;
■■ pay a fixed rate of return; and
■■ do not trade in the secondary market but are redeemed by the issuer.

2. 1. 2. 2 Unit Investment Trusts (UITs)

A unit investment trust (UIT) is an investment company organized under a trust inden-
ture. Unit investment trusts DO NOT:
■■ have boards of directors (they have trustees);
■■ employ investment advisers; or
■■ actively manage their own portfolios (trade securities).

UIT managers create a portfolio of debt or equity securities designed to meet the com-
pany’s objectives. They then sell redeemable interests, also known as units or shares of
beneficial interest, in their portfolio of securities. Each share is an undivided interest in the
entire underlying portfolio. Because UITs are not managed, all proceeds must be distributed
when any securities in the portfolio are liquidated.
A UIT may be fixed or nonfixed. A debt fixed UIT typically purchases a portfolio of bonds
and terminates when the bonds in the portfolio mature. An equity fixed UIT purchases a portfolio
of stocks and, because stocks don’t have a maturity date, terminates at a pre-determined date. A
nonfixed UIT purchases shares of an underlying mutual fund. Shares of fixed and nonfixed UITs
do not trade on exchanges or over-the-counter. If an investor wishes to sell his interest in a UIT, it
is redeemable through the issuer.

✓
TA K E N O T E
A UIT is very similar to a mutual fund—up to a point. Both fixed UITs and mutual
funds are comprised of a pool of securities in which investors own a proportionate
share. The most significant difference between UITs and mutual funds is that mutual
funds actively trade their portfolios and a portfolio manager gets paid a fee to meet
the objectives of the fund.
UIT portfolios usually are not traded; they are fixed trusts. The advantage to the
investor is that they own a diversified interest but do not pay a management fee—the
biggest expense of mutual fund ownership. The downside is that the UIT portfolio is
not traded in response to market conditions.

Series 6 [Link] 88 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 89

!
TEST TOPIC ALERT ■■ UITs are investment companies as defined under the Investment Company Act
of 1940.
■■ UIT shares (units) are not traded in the secondary market; they must be redeemed
by the trust.
■■ UITs are not actively managed; there is no board of directors or investment
adviser.

2. 1. 2. 3 Management Investment Companies

The most familiar type of investment company is the management investment company,
which actively manages a securities portfolio to achieve a stated investment objective. A
management investment company is either closed-end or open-end. Both closed- and open-
end companies sell shares to the public in an initial public offering; the primary difference
between them is that a closed-end company’s initial offering of shares is limited (it closes after
its authorized number of shares number have been sold) and an open-end company is perpetu-
ally offering new shares to the public (it is continually open to new investors).

2. 1. 2. 3. 1 Closed-End Investment Companies

A closed-end investment company will raise capital for its portfolio by conducting a com-
mon stock offering, much like any other publicly traded company that raises capital to invest
in its business. In the initial offering, the company registers a fixed number of shares with the
SEC and offers them to the public with a prospectus for a limited time through underwriters.
Once all the shares have been sold, the fund is closed to new investors. Many times, a fund
elects to be a closed-end company because the sector in which it intends to invest has a lim-
ited amount of securities available. Closed-end investment companies may also issue bonds
and preferred stock.
Closed-end investment companies are often called publicly traded funds. After the stock
is sold in the initial offering, anyone can buy or sell shares in the secondary market (i.e., on
an exchange or OTC) in transactions between private investors. Supply and demand deter-
mine the bid price (price at which an investor can sell) and the ask price (price at which an
investor can buy). Closed-end fund shares may trade above (at a premium to) or below (at
a discount to) the shares’ net asset value (NAV). The bid price is also known as the NAV,
and the ask price is also known as the POP (public offering price). When buying and selling
closed-end investment companies in the secondary market, there will be a commission paid
to execute the trade.

*
EXAMPLE The ABC New York Municipal Bond Fund, a closed end fund, issued 25 million
shares of stock priced at $20 per share, raising a total of $500 million. When all of the
shares were sold, the fund closed to new investors. The fund manager then invested
the proceeds of the offering in tax-exempt bonds issued by the state of New York.
Although the shares have a net asset value of about $20 per share, an investor that
decides to sell may receive more or less than that on the secondary market.

Series 6 [Link] 89 6/8/2016 [Link] PM

 90 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

✓
TA K E N O T E
A Series 6 limited registered representative may only sell closed-end investment
company securities in the primary market, not the secondary market!

2. 1. 2. 3. 2 Open-End Investment Companies

An open-end investment company (mutual fund) only issues one class of security and
that’s common stock. It does not specify the exact number of shares it intends to issue but
registers an open offering with the SEC. In other words, mutual funds conduct a continuous
primary offering of common stock. You should understand that mutual funds can purchase
common stock, preferred stock, and bonds for their investment portfolios, but as an investor
that invests in the ABC Bond Fund, or any mutual fund, one purchases common stock of the
fund. With this registration type they can raise an unlimited amount of investment capital
by continuously issuing new shares. Conversely, when investors want to sell their holdings in
a mutual fund, the fund itself redeems those shares. Mutual fund shares do not trade in the
secondary market.
The shares an open-end investment company sells are redeemable securities. When an
investor sells shares back to the fund, the fund sends the investor money for the investor’s
proportionate share of the fund’s net assets. Therefore, a mutual fund’s capital shrinks when
investors redeem shares but so does the number of outstanding shares; the value of each share
does not fall as a result of the redemption.

Comparison of Open-End and Closed-End Investment Companies

Open-End Closed-End
Capitalization Unlimited; continuous offering of Fixed; single offering of shares
shares
Issues Common stock only; no debt securities; May issue common and preferred
permitted to borrow stock and debt securities
Shares Full or fractional Full only
Offerings and Trading Sold and redeemed by the fund only; Initial primary offering; secondary trad-
continuous primary offering; must ing OTC or on an exchange; does not
redeem shares redeem shares
Pricing Selling price determined by formula in CMV + commission; price determined
the prospectus by supply and demand
Shareholder Rights Dividends (when declared); voting Dividends (when declared); voting;
preemptive rights
Ex-Date Set by BOD Set by SRO

✓
TA K E N O T E
The ex-date, also known as the ex-dividend date, is the first day one can trade
for a security and not be entitled to receive a dividend distribution previously declared
by the issuer. (Covered in Unit 3)

Series 6 [Link] 90 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 91

✓
TA K E N O T E
You are likely to see three to four questions on the Series 6 exam that require
understanding the features of a closed-end company. Think in terms of what would
be true for any corporate security and examine the following chart.

Where do shares of closed- In the secondary market

end companies trade?

What types of securities Common stock, preferred

may closed-end companies stock, and bonds
issue?

Can fractional shares be Like corporations: Only full shares can be

purchased? purchased

When must a prospectus be Only in the IPO (no

used? prospectus is given when
the shares are purchased in a
secondary market transaction)

Who sets the ex-date? FINRA

Q
QUICK QUIZ 2.A Determine whether each statement describes an open-end or a closed-end
company. Write O for open-end and C for closed-end.

—— 1. Trades in the secondary market

—— 2. Investors may purchase fractional shares

—— 3. May issue common stock, preferred stock, and bonds

—— 4. Are sold with prospectus during IPO only

—— 5. Issues a fixed number of shares

—— 6. Ex-date is set by the board of directors

—— 7. Do not trade in the secondary market; shares are redeemable

—— 8. Price is set by supply and demand

—— 9. Usually called mutual funds

—— 10. Selling price usually includes a sales charge

Quick Quiz answers can be found at the end of the Unit.

2. 1. 2. 4 Diversified and Nondiversified

Diversification provides risk management that makes mutual funds popular with many
investors. However, not all investment companies feature diversified portfolios.

Series 6 [Link] 91 6/8/2016 [Link] PM

 92 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

2. 1. 2. 4. 1 Diversified
Under the Investment Company Act of 1940 a diversified investment company is one
that meets the requirements of the 75-5-10 test:
■■ At least 75% of the fund’s total assets must be invested in securities issued by companies
other than the investment company itself or its affiliates.
■■ The 75% must be invested in such a way that:
—— no more than 5% of the fund’s total assets are invested in the securities of any one
issuer, and
—— no more than 10% of the outstanding voting securities of any one issuer is owned (by
the 75%).

TEST TOPIC ALERT

! Remember, for testing purposes, the 5% and 10% limitations are part of the
75% invested. There are no conditions attached to the remaining 25%.

TEST TOPIC ALERT

! If a security represents 5% or less of the fund’s total assets at the time of pur-
chase and thereafter exceeds 5% due to capital appreciation, no action is required in
order to maintain a diversified status.

2. 1. 2. 4. 2 Nondiversified
A nondiversified investment company does not meet the 75-5-10 test. An investment
company that specializes in one industry is not necessarily a nondiversified company. Some
investment companies choose to concentrate their assets in an industry or a geographic area,
such as health care stocks, technology stocks, or South American stocks; these are known as
specialized funds or sector funds. Sector funds must have at least 25% of assets invested in
a particular sector of the economy or geographic area. A sector fund can still be diversified,
provided it meets the 75-5-10 test.

TEST TOPIC ALERT

! Both open- and closed-end companies can be diversified or nondiversified.

2. 1. 3 SPECIAL INVESTMENT SECURITIES

Hedge funds, exchange-traded funds (ETFs), and real estate investment trusts (REITs)
have unique characteristics making them a little different than traditional investment com-
pany securities.

2. 1. 3. 1 Hedge Funds
Many companies rely on one of the exceptions from the definition of investment com-
pany. These companies are commonly known as private investment companies. Some private
investment companies are commonly known as hedge funds.
Hedge funds are a type of equity security with similarities to a mutual fund. One difference
is that the hedge fund does not currently have to register with the SEC. Hedge funds typi-

Series 6 [Link] 92 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 93

cally have high minimum initial investment requirements and are only available to accredited
investors (discussed in Unit 3). Such funds are free to adopt far riskier investment policies than
those available to ordinary mutual funds, such as arbitrage strategies and massive short posi-
tions during bearish markets. An important consideration for investors to understand about
hedge funds is their lack of liquidity; they often have several restrictions when an investor
wants to redeem their investment. Hedge funds are indirectly available to ordinary investors
through mutual funds called funds of hedge funds.
A fund of hedge funds will have restrictions on redemption because the investment in the
underlying hedge funds have restrictions on redemption.

2. 1. 3. 2 Exchange-Traded Funds (ETFs)

This type of fund, also an equity security, invests in a specific group of stocks in deliberate
mimicry of a particular index, such as the S&P 500. In this way, an ETF is similar to an index
mutual fund. The difference is that the exchange-traded fund trades like a stock on the floor of
an exchange and, in this way, is similar to a closed-end investment company. Technically ETFs
are registered as either an open-end fund or as a UIT, but obviously nontraditional in nature.
The inves­tor can take advantage of intraday price changes that are due to the market, rather
than just the underlying value of the stocks in the portfolio. And, unlike mutual funds, ETFs
can be purchased on margin and sold short. Expenses tend to be lower than those of mutual
funds. The management fee is quite low, and since the portfolio is designed to track an index,
there is little trading activity. This generally results in greater tax efficiency for the investor.
On the other hand, every time a person purchases or sells shares, there is a commission,
and those charges can add up over a period of time.

2. 1. 3. 2. 1 Leveraged ETFs
Leveraged ETFs seek to deliver multiples of the performance of the index or benchmark
they track. Inverse ETFs seek to deliver the opposite of the performance of the index or
benchmark they track. Inverse ETFs often are marketed as a way for investors to profit from,
or at least hedge their exposure to, downward-moving markets.
Leveraged inverse ETFs seek to achieve a return that is a multiple of the inverse perfor-
mance of the underlying index. An inverse ETF that tracks a particular index, for example,
seeks to deliver the inverse of the performance of that index, while a 2x (two times) leveraged
inverse ETF seeks to deliver double the opposite of that index’s performance. To accomplish
their objectives, leveraged and inverse ETFs pursue a range of investment strategies through
the use of swaps, futures contracts, and other derivative instruments.
Most leveraged and inverse ETFs “reset” daily, meaning that they are designed to achieve
their stated objectives on a daily basis. Their performance over longer periods of time—over
weeks, months, or years—can differ significantly from the performance (or inverse of the per-
formance) of their underlying index or benchmark during the same period of time. This effect
can be magnified in volatile markets.

2. 1. 3. 3 Real Estate Investment Trusts (REITs)

A real estate investment trust (REIT, pronounced reet) is a company that manages a
portfolio of real estate, mortgages, or both to earn profits for shareholders. Many REITs are
registered with the SEC and are publicly traded on a stock exchange. These are known as
publicly traded REITs. In addition, there are REITs that are registered with the SEC but are
not publicly traded. These are known as nontraded REITs (also known as nonexchange traded

Series 6 [Link] 93 6/8/2016 [Link] PM

 94 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

REITs). A REIT pools capital in a manner similar to an investment company. Shareholders

receive dividends from investment income or capital gains distributions. REITs normally:
■■ own commercial property (equity REITs);
■■ own mortgages on commercial property (mortgage REITs); or
■■ do both (hybrid REITs).

REITs are organized as trusts in which investors buy shares or certificates of beneficial
interest either on stock exchanges or in the over-the-counter market.
Under the guidelines of Subchapter M of the Internal Revenue Code, a REIT can avoid
being taxed as a corporation by receiving 75% or more of its income from real estate and dis-
tributing 90% or more of its net investment income to its shareholders.

TEST TOPIC ALERT

! The following are four important points to remember about REITs.
■■ An owner of REITs holds an undivided interest in a pool of real estate investments.
■■ REITs trade on exchanges and over the counter.
■■ REITs are not investment companies (open or closed-end).
■■ REITs offer dividends and gains to investors but do not pass through losses like
limited partnerships and, therefore, are not considered to be direct participation
programs (DPPs).

2. 1. 3. 4 Direct Participation Programs (DPPs)

Direct participation programs are a unique form of business that raises money to invest in
real estate, oil and gas, equipment leasing, and so on. The most common DPP in the securities
industry is a limited partnership. DPPs are not taxed directly; the income or losses are passed
directly through to the owners/investors. These are illiquid investments as there is virtually no
secondary market in which they trade. A Series 6 cannot facilitate any transaction involving
DPPs.

✓
TA K E N O T E
A Series 6 limited registered representative is not eligible to sell hedge funds,
exchange-traded funds, real estate investment trusts or DPPs as they are not classified
as traditional investment company securities. A Series 6 is, however, eligible to sell
funds of hedge funds.

Q
QUICK QUIZ 2.B 1. Which of the following are covered under the Investment Company Act of 1940?
I. All broker-dealers
II. Municipal bond brokers
III. Open-end management companies
IV. Closed-end management companies
A. I and II
B. I and III
C. II and IV
D. III and IV

Series 6 [Link] 94 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 95

2. Which of the following investment companies has no provision for redemption of

outstanding shares?
A. Open-end company
B. Closed-end company
C. Unit investment trust
D. Mutual fund

3. Which of the following statements regarding the 75-5-10 test of diversified man-
agement companies are TRUE?
I. They may own no more than 5% of the voting stock of a single company.
II. No more than 5% of their assets are invested in any one company.
III. They may own no more than 10% of the voting stock of any one company.
IV. If they own more than 25% of a target company, they do not vote the stock.
A. I and II
B. I and III
C. II and III
D. III and IV

4. According to the Investment Company Act of 1940, an investment company with

a fixed portfolio, redeemable shares, and no management fee is
A. a face-amount certificate company
B. a management company
C. a unit investment trust
D. a closed-end investment company

5. Which of the following statements are TRUE regarding open-end, but not closed-
end, investment companies?
I. They may make continuous offerings of shares provided the original registra-
tion statement and prospectus are periodically updated.
II. They may be listed on registered national exchanges.
III. They do not redeem their shares.
IV. They may issue only common stock.
A. I and II
B. I and IV
C. II and III
D. III and IV

6. Hedge funds and mutual funds are similar in that

A. both are required to register with the SEC
B. neither may take short positions for profit in a bearish market
C. both offer professional investment management
D. neither is available to ordinary investors

Series 6 [Link] 95 6/8/2016 [Link] PM

 96 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

Terms and Concepts Checklist

✓ ✓
†† Investment company †† Unit, share
†† Face amount certificate company †† Continuous primary offering
†† Unit investment trust †† Public offering price
†† Fixed trust †† Exchange traded fund (ETF)
†† Management company †† Hedge fund
†† Open-end investment company †† Funds of hedge funds
†† Closed-end investment company †† 75-5-10 test
†† Direct participation programs †† Diversified
†† Real estate investment trusts †† Nondiversified

2. 2 INVESTMENT COMPANY REGISTRATION

A company must register with the SEC as an investment company if:
■■ the company is in the business of investing in, reinvesting in, owning, holding, or trading
securities; or
■■ 40% or more of the company’s assets are invested in securities (government securities
and securities of majority-owned subsidiaries are not used in calculating the 40% require-
ment).

A company must meet certain minimum requirements before it may register as an invest-
ment company with the SEC. An investment company may not issue securities to the public
unless it has:
■■ net assets of at least $100,000; and
■■ a clearly defined investment objective.

If the investment company does not have at least $100,000 in net assets, it may still register
a public offering with the SEC if it can meet these requirements within 90 days of registration.
The company must clearly define an investment objective under which it plans to oper-
ate. Once defined, the objective may be changed only by a majority vote of the company’s
outstanding shares.

2. 2. 1 SEC REGISTRATION AND PUBLIC OFFERING

REQUIREMENTS
Investment companies must file registration statements with the SEC, provide full disclo-
sure, and generally follow the same public offering procedures required of other corporations
when issuing securities. In filing for registration, an investment company must identify:
■■ the type of management investment company it intends to be (e.g., open- or closed-end);
■■ plans the company has to raise money by borrowing;
■■ the company’s intention, if any, to concentrate its investments in a single industry;

Series 6 [Link] 96 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 97

■■ plans for investing in real estate or commodities;

■■ conditions under which investment policies may be changed by a vote of the shares;
■■ the full name and address of each affiliated person;
■■ a description of the business experience of each officer and director during the preceding
five years; and
■■ provide semiannual reports to shareholders, one of which must be audited. Semiannual
reports to shareholders must include a balance sheet, list and value of securities owned
and a statement of income.

✓
TA K E N O T E
Because an investment company is a corporate issuer, it is subject to the Securities
Act of 1933’s full and fair disclosure rules, just like any other corporation. A registra-
tion statement, which includes the prospectus, must be filed with the SEC and cleared
for sale before securities may be sold to the public.

In filing for registration, an investment company must identify the overall investment
intentions of the fund as well as background information on affiliated persons, officers, and
directors.

2. 2. 1. 1 Continuous Public Offering Securities

The SEC treats the sale of open-end investment company shares as a continuous public
offering of shares, which means all sales must be accompanied by a prospectus. The financial
information (statements) in the prospectus must be current. A prospectus may not contain
information more than 16 months old.

!
TEST TOPIC ALERT Three important points regarding the investment company prospectus:
■■ Mutual funds must always be sold with a prospectus because they are
continuous primary offerings. New securities must always be sold with a
prospectus.

■■ Closed-end funds must be sold with a prospectus in their IPO only. When
they are trading in the secondary market, closed-end funds need not be sold
with a prospectus.

■■ Financial information in a prospectus may be no more than 16 months old.

The Securities Act of 1933 requires that information disclosed to an investor
is reasonably current.

2. 2. 1. 2 Purchasing Mutual Fund Shares on Margin

Because a mutual fund is considered a continuous primary offering, SEC rules prohibit the
purchase of mutual fund shares on margin. Margin is the use of money borrowed from a bank
through a brokerage firm to purchase securities. However, under the provisions of Regulation
T, mutual fund shares may be used as collateral in a margin account if they have been held
fully paid for more than 30 days.

Series 6 [Link] 97 6/8/2016 [Link] PM

 98 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

✓
TA K E N O T E
In margin accounts, investors borrow money from broker-dealers to purchase
securities. Broker-dealers acquire funds to loan by pledging customer securities to a
bank as collateral. Mutual shares (as long as they have been owned at least 30 days)
may be used in this way but may not be purchased using borrowed funds. Mutual
funds are considered new issues, and SEC rules proscribe the purchase of new issues
on margin.

2. 2. 1. 3 Open-End Companies
The Investment Company Act of 1940 requires open-end companies to:
■■ issue no more than one class of security; and
■■ maintain a minimum asset-to-debt ratio of 300%.

Because open-end investment companies may issue only redeemable common stock, they
may borrow from banks provided their asset-to-debt ratio is not less than 3:1—that is, debt
coverage by assets of at least 300%, or no more than one-third of assets from borrowed money.

✓
TA K E N O T E
Mutual funds may borrow money from banks but not from investors. When bor-
rowing money from the bank, the fund must have at least $3 of total assets for every
$1 borrowed.

TEST TOPIC ALERT

! Be cautious of questions that ask about the asset-to-debt ratio described above.
If a question specifically asks about the asset-to-debt ratio, the answer to the ques-
tion is 3:1, or 300%. But, if it asks about the debt-to-asset ratio, the correct answer
would be 1:3, or 33 1/3%.

2. 2. 2 REGISTRATION OF INVESTMENT COMPANY

SECURITIES
After filing as an investment company under the Investment Company Act of 1940, the
investment company must register with the SEC any securities it intends to sell. The registra-
tion of shares takes place under the Securities Act of 1933.

2. 2. 2. 1 Registration Statement and Prospectus

The registration statement an investment company must file consists of two parts. Part
1 is the prospectus that must be furnished to every person to whom the company offers the
securities. Part 1 is also called an N1-A prospectus. It is important to note that a mutual
fund prospectus must have a concise summary, in plain English, of the information contained
within the prospectus, to aid investors in making a sound investment decision.
Part 2 is the document containing information that need not be furnished to every pur-
chaser but must be made available for public inspection. Part 2 is called the statement of
additional information (SAI).

Series 6 [Link] 98 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 99

The prospectus must contain any disclosure that the SEC requires. The fact that all pub-
licly issued securities must be registered with the SEC does not mean that the SEC in any way
approves the securities. For that reason, every prospectus must contain a disclaimer similar to
the following on its front cover:

These securities have not been approved or disapproved by the Securities and Exchange
Commission nor has the Commission passed on the accuracy or adequacy of this prospectus.
No state has approved or disapproved this offering. Any representation to the contrary is a
criminal offense.

2. 2. 3 RESTRICTIONS ON OPERATIONS

2. 2. 3. 1 Investment Practices
The SEC prohibits a mutual fund from engaging in the following activities unless the fund
meets stringent disclosure and financial requirements:
■■ Purchasing securities on margin
■■ Selling securities short
■■ Selling uncovered call options
■■ Participating in joint investment or trading accounts

The fund must specifically disclose these activities, and the extent to which it plans to
engage in these activities, in its prospectus.

✓
TA K E N O T E
Short selling is a securities industry practice that involves selling shares that are
not owned. Investors borrow shares from the broker-dealer by putting up collateral
in a margin account. The borrowed shares are sold with the hope that their market
price will fall. If the market price does fall, the short seller can buy back the borrowed
shares at a lower price to repay the broker-dealer. The difference in the price at
which the shares are sold and the lower price at which they are bought to repay the
broker-dealer is the investor’s profit. But if the price goes up, the potential for loss is
unlimited.
Investors usually buy low, then sell high for a profit; a short sale involves the
same steps in a different order. In a short sale, investors borrow and sell high, then
buy back low.

!
TEST TOPIC ALERT The exam may ask which mutual fund trading activities may be prohibited by the
SEC. The correct answer choices include margin account trading, short selling, joint
account trading, and naked (uncovered) options trading strategies. Covered option
transactions are permissible, but naked strategies are considered too risky.

Series 6 [Link] 99 6/8/2016 [Link] PM

 100 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

2. 2. 3. 2 Shareholder Right to Vote

Before any change may be made to a fund’s published bylaws or objectives, shareholder
approval is mandatory. In voting matters, it is the majority of shares voted for or against a
proposition that counts, not the majority of people voting. Thus, one shareholder holding
51% of all the shares outstanding can determine a vote’s outcome.
The changes that require a majority vote of the shares outstanding include:
■■ issuing or underwriting other securities;
■■ purchasing or underwriting real estate;
■■ making loans;
■■ changing subclassification (e.g., from open-end to closed-end or from diversified to non-
diversified);
■■ changing sales load policy (e.g., from a no-load fund to a load fund);
■■ changing the nature of the business (e.g., ceasing business as an investment company);
■■ changing investment policy (e.g., from income to growth or from bonds to small capital-
ization stocks); and
■■ changes in fees or auditors.

In addition to the right to vote on these items, shareholders retain all rights that stock-
holders normally possess.

!
TEST TOPIC ALERT When answering questions, discern between shares voting and shareholders vot-
ing in mutual fund matters. A majority vote of the outstanding shares is required to
approve such actions as sales load or investment company objectives changes, not a
majority vote of shareholders.

Q
QUICK QUIZ 2.C True or False?

—— 1. Mutual funds are generally prohibited from using covered options strategies.

—— 2. A majority vote of the outstanding shareholders is required to change the

investment objectives of a mutual fund.

—— 3. Mutual fund shares may be purchased on margin but may not be used as
collateral in margin accounts.

—— 4. Open-end companies must have at least $100,000 of net assets before

they may operate as an investment company.

—— 5. Mutual funds are required to file registration statements with the SEC
before shares are sold to the public.

—— 6. Mutual funds make continuous secondary offerings of securities.

—— 7. Open-end investment companies must maintain a 3:1 debt-to-asset ratio.

—— 8. Closed-end companies are generally considered mutual funds.

Series 6 [Link] 100 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 101

Terms and Concepts Checklist

✓ ✓
†† Prospectus †† Affiliated person
†† Registration statement, N1A †† Shareholder voting rights
prospectus, summary prospectus †† Purchase on margin
†† Statement of additional †† Short sale
information (SAI)

2. 3 MANAGEMENT OF INVESTMENT COMPANIES

Up to five parties work together to help an investment company operate: a board of directors,
an investment adviser, a custodian, a transfer agent, and, depending on how the investment com-
pany is organized, an underwriter.

2. 3. 1 BOARD OF DIRECTORS
Like publicly owned corporations in general, a management investment company has a
CEO, a team of officers, and a board of directors (BOD) to serve the interests of its investors.
The officers and directors deal with policy and administrative matters. They do not manage
the investment portfolio. As with other types of corporations, the shareholders of an invest-
ment company elect the BOD to make decisions and oversee operations.
A management investment company’s board of directors pulls together the different parts
of a mutual fund. The BOD:
■■ defines the type of funds to offer (e.g., growth, income, sector);
■■ defines the fund’s objective; and
■■ approves/hires the transfer agent, custodian, and investment adviser.

Organizational Structure of a Fund

Board of Directors
• Handles administrative
matters
• Elected by shareholders
• Paid a stipend for
service

Underwriter Transfer Agent Custodian Investment Advisor

• Distributes fund shares • Customer service • Safekeeper of funds • Trades the portfolio
• Paid by sales charge • Redeems shares and securities • Adheres to portfolio
• Paid from fund income • Paid from fund income objectives
• Paid from fund income
• Fee is largest fund
expense

Series 6 [Link] 101 6/8/2016 [Link] PM

 102 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

The Investment Company Act of 1940 restricts who may sit on an investment compa-
ny’s board of directors. At least 40% of the directors must be independent or noninterested
persons. Noninterested persons are only connected with the investment company in their
capacity as director. A noninterested person is not connected with the investment company’s
investment adviser, transfer agent, or custodian bank. This means that no more than 60% of
the board members may be interested persons, including attorneys on retainer, accountants,
and any persons employed in similar capacities with the company. A shareholder who owns
5% or more of the investment company shares is interested.
Also, no individual who has been convicted of a felony of any type or a misdemeanor
involving the securities industry may serve on a BOD, nor may anyone who has been either
temporarily or permanently barred from acting as an underwriter, a broker, a dealer, or an
investment company by any court.

✓
TA K E N O T E
Investment companies may never borrow or lend money with the board of direc-
tors or any other interested or affiliated person.

2. 3. 2 INVESTMENT ADVISER
An investment company’s BOD contracts with an investment adviser or portfolio man-
ager to invest the cash and securities in the fund’s portfolio, implement investment strategy,
and manage the portfolio’s day-to-day trading. Advisers must adhere to the objectives stated
in the fund’s prospectus and may not transfer the responsibility of portfolio management to
anyone else.
The investment adviser earns a management fee, which is paid from the fund’s income.
This fee is typically a set annual percentage of the portfolio asset value. In addition, an invest-
ment adviser who consistently outperforms a specified market performance benchmark can
usually earn an incentive bonus.
An investment company may not contract with an investment adviser who has been
convicted of a felony unless the SEC has granted an exemption. In addition, an investment
company may not lend money to its investment adviser.

!
TEST TOPIC ALERT Some facts and responsibilities of mutual fund’s investment adviser:
■■ Trades the portfolio to meet the investment objectives, but may not change them
■■ Is given an initial (maximum) two-year contract by the BOD that must be approved
by both the BOD and a majority vote of the outstanding shares, but the contract
is subject to annual approval by the BOD or a majority vote of the outstanding
shares
■■ The adviser’s fee (management fee) is typically the largest single expense associ-
ated with fund ownership and is a percentage of the assets managed
■■ Must inform shareholders of the tax status of fund distributions
■■ Responsibilities may not be transferred to a third party
■■ Must be registered with the SEC according to the Investment Advisers Act of
1940

Series 6 [Link] 102 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 103

2. 3. 3 CUSTODIAN
To protect investor assets, the Investment Company Act of 1940 requires each investment
company to place its securities in the custody of a registered custodian, invariably a bank, but
some broker-dealers qualify. The bank or broker-dealer performs an important safekeeping role
as custodian of the company’s securities and cash and receives a fee for its services. Often, the
custodian handles most of the investment company’s clerical functions.
The custodian may, with the consent of the investment company, deposit the securities
it is entrusted to hold in one of the systems for the central handling of securities established
by FINRA. These systems make it easier to transfer securities. Once securities are placed in
the system, most transfers can be accomplished with a simple bookkeeping entry rather than
physical delivery of the securities.
Once an investment company designates a custodian and transfers its assets into the cus-
todian’s safekeeping, the custodian must:
■■ keep the investment company’s assets physically segregated at all times;

■■ allow withdrawal of assets only under SEC rules; and

■■ restrict access to the account to certain officers and employees of the investment com-
pany.

✓
TA K E N O T E
Investment companies must maintain a surety bond for all persons who have ac-
cess to monies or securities.

!
TEST TOPIC ALERT The custodian:
■■ is generally a commercial bank;
■■ is the safekeeper of the assets of the fund;
■■ maintains asset records;
■■ periodically audits the fund’s assets to assure that they are properly accounted for;
and
■■ is paid a fee from the income of the fund.

2. 3. 4 TRANSFER AGENT (CUSTOMER OR SHAREHOLDER

SERVICES AGENT)
The transfer agent’s functions include:
■■ issuing, redeeming, and cancelling fund shares;
■■ handling name changes for the fund;
■■ maintaining customer records and providing customer service;
■■ sending customer confirmations and fund distributions;
■■ recording outstanding shares for proper distribution; and
■■ is paid a fee from the income of the fund.

The transfer agent may be the fund custodian or a separate service company. The fund
pays the transfer agent a fee for its services.

Series 6 [Link] 103 6/8/2016 [Link] PM

 104 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

2. 3. 5 UNDERWRITER
A mutual fund’s underwriter, often called the sponsor or distributor, is appointed by the
board of directors and receives a fee for selling and marketing the fund shares to the public.
The open-end investment company sells its shares to the underwriter at the current NAV, but
only as the underwriter needs the shares to fill customer orders.
The underwriter is prohibited from maintaining an inventory of open-end company
shares. The underwriter is compensated only by a sales charge levied when the shares are sold
or redeemed. The underwriter may not be an expense to the fund.
In general, a mutual fund may not act as its own distributor or underwriter. However, there
is an exception to this rule for no-load funds. In other words, a no-load fund may sell shares
directly to the public without an underwriter.

!
TEST TOPIC ALERT Fund underwriters:
■■ are also called the sponsors or distributors;
■■ must be FINRA member firms;
■■ may not inventory mutual fund shares;
■■ are compensated only from the sales charge;
■■ use compensation to pay for advertising and other selling expenses; and
■■ may never be treated as an expense to the fund.

✓
TA K E N O T E All parties that work together in the operation of a mutual fund are paid from the
income of the fund except the underwriter. The underwriter’s compensation comes
from sales charges.

2. 3. 6 INFORMATION DISTRIBUTED TO INVESTORS

Investors must be provided with specific information when purchasing and tracking
mutual funds.

2. 3. 6. 1 Prospectus (Statutory)
This is the full and fair disclosure document that provides a prospective investor with the
material information needed to make a fully informed investment decision. If using a statu-
tory prospectus to solicit a sale, it must be distributed to an investor before or during the
solicitation. The front of a mutual fund prospectus must contain key information to appear
in plain English in a standardized order. Information in this clear and concise format includes
the fund’s objective, investment policies, sales charges, management expenses, and services
offered. It also discloses one-, five-, and 10-year performance histories, or performance over the
life of the fund, whichever is shorter.

Series 6 [Link] 104 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 105

!
TEST TOPIC ALERT If a fund has been in existence for eight years, it will show performance for one,
five, and eight years; if it has been in existence for four years, it will show one and
four years.
The delivery of sales literature is a solicitation of sale and must be accompanied or
preceded by the delivery of a prospectus.
A prospectus may not be altered in any way, which means no highlighting or
writing in any prospectus.

2. 3. 6. 2 Summary Prospectus
Under SEC Rule 498, a fund may provide a summary prospectus to investors that may
include an application investors can use to buy the fund’s shares.
The summary prospectus is a standardized summary of key information in the fund’s statu-
tory (full) prospectus. Investors who receive the summary have the option of either purchasing
fund shares using the application found therein or requesting a statutory prospectus.

!
TEST TOPIC ALERT An investor who purchases fund shares on the basis of the summary prospec-
tus must be able to access the statutory prospectus online. Customers may always
request a paper copy.

2. 3. 6. 3 Statement of Additional Information (SAI)

Mutual funds and closed-end funds are required to have a statement of additional infor-
mation (SAI) available to investors upon request without charge. Investors can obtain a copy
by calling or writing to the investment company, via a company website, contacting a broker
that sells the investment company shares, or contacting the SEC.
While a prospectus is always sufficient for the purpose of selling shares, some investors may
seek additional information not found in the prospectus. This additional information is not
mandatory to make an informed investment decision but may be useful to the investor.
The SAI affords the fund an opportunity to have expanded discussions on matters such as
the fund’s history and policies. It will also typically contain the fund’s consolidated financial
statements, including:
■■ the balance sheet;
■■ statement of operations;
■■ an income statement; and a portfolio list at the time the SAI was compiled.

Series 6 [Link] 105 6/8/2016 [Link] PM

 106 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

Mutual Fund Sale Disclosure Summary

Document Purpose Contains Presented
Summary Rule 498 Summary of key infor- Prior to or with the solici-
Prospectus Short form that mation in the prospec- tation
may be used to tus
make the sale
Prospectus Sale document Full and fair disclosure Prior to or with solicitation
(statutory) of all material facts for or if a summary prospec-
investment decision tus is used, no later than
confirmation of the sale.
Statement of SAI Additional details about Within 3 business days of
Additional More data for the the fund not necessary customer request
Information investor for the prospectus

2. 3. 6. 4 Financial Reports
The Investment Company Act of 1940 requires that shareholders receive financial reports
at least semiannually. One of these must be an audited annual report. The reports must
contain:
■■ the investment company’s balance sheet;
■■ a valuation of all securities in the investment company’s portfolio as of the date of the
balance sheet (a portfolio list);
■■ the investment company’s income statement;
■■ a complete statement of all compensation paid to the board of directors and to the advi-
sory board; and
■■ a statement of the total dollar amount of securities purchased and sold during the
period.

In addition, the company must send a copy of its balance sheet to any shareholder who
requests one in writing between semiannual reports.

2. 3. 6. 5 Additional Disclosures
The SEC requires the fund to include the following in its prospectus or annual reports:
■■ A discussion of factors and strategies that materially affected its performance during its
most recently completed fiscal year
■■ A line graph comparing its performance to that of an appropriate broadbased securities
market index
■■ The name(s) and title(s) of the person(s) primarily responsible for the fund portfolio’s
day-to-day management

✓
TA K E N O T E
Keep the financial reports of the fund and shareholder account statements
separate. The fund must distribute financial reports to shareholders semiannually. The
annual report must be audited; semiannual reports may be unaudited.
Account statements are typically sent monthly to shareholders with active ac-
counts, quarterly to inactive accounts.

Series 6 [Link] 106 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 107

Q
QUICK QUIZ 2.D 1. The custodian of a mutual fund usually
A. approves changes in investment policy
B. holds the cash and securities of the fund and performs clerical functions
C. manages the fund
D. markets the fund to the public

2. Investment company financial statements are sent to shareholders

A. monthly
B. quarterly
C. semiannually
D. annually

3. The role of a mutual fund’s underwriter is to

A. hold the fund’s assets and perform clerical responsibilities
B. determine when dividends should be distributed
C. market shares
D. provide investment advisory services

4. To change the name of a recently married shareholder on her registered shares of

the fund, the shareholder should contact
A. the custodian
B. the transfer agent
C. her registered representative
D. the investment adviser

5. Typically, the largest single expense of a mutual fund is

A. the custodian fee
B. the registration fee
C. the management fee
D. the brokerage fee

Terms and Concepts Checklist

✓ ✓
†† Board of directors †† Investment adviser
†† Interested persons †† Custodian
†† Noninterested persons †† Transfer agent
†† Financial reports †† Underwriter, sponsor, distributor
†† Disclosures †† N1-A prospectus
†† Statement of additional
information (SAI)

Series 6 [Link] 107 6/8/2016 [Link] PM

 108 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

2. 4 CHARACTERISTICS OF MUTUAL FUNDS

A mutual fund is a pool of investors’ money invested in various securities as determined
by the fund’s objective. Mutual funds have several unique characteristics as detailed in this
section.

2. 4. 1 THE MUTUAL FUND CONCEPT

Unlike most other securities, mutual funds offer guaranteed marketability; if an investor
wants to sell his shares in a mutual fund, it is the mutual fund that stands ready to buy them
back. Mutual funds, therefore, are redeemable securities; that is, they do not trade in any
secondary market.
Each investor in the mutual fund’s portfolio owns an undivided interest in the portfolio.
All investors in an open-end fund are mutual participants; no one investor has a preferred
status over any other investor because mutual funds issue only one class of common stock.
Each investor shares mutually with other investors in gains and distributions derived from the
investment company portfolio.
Each investor’s participation in the fund’s performance is based on the number of shares
owned. Mutual fund shares may be purchased in either full or fractional units, unlike corporate
stock, which may only be purchased in full units. Because mutual fund shares can be fractional,
the investor can think in terms of dollars rather than number of shares owned.
An investment company portfolio is elastic. Money is constantly being invested or paid
out when shares are redeemed. The mutual fund portfolio’s value and holdings fluctuate as
money is invested or redeemed and as the value of the securities in the portfolio rises and
falls. The investor’s account value fluctuates proportionately with the mutual fund portfolio’s
value.

!
TEST TOPIC ALERT Other mutual fund characteristics include the following.
■■ A professional investment adviser manages the portfolio for investors.

■■ Mutual funds provide diversification by investing in different companies.

■■ Most funds allow a minimum investment, often $500 or less, to open an

account and they allow additional investment for as little as $25.

■■ An investment company may allow investments at reduced sales charges by

offering breakpoints through larger deposits, a letter of intent, or rights of
accumulation (discussed later).

■■ An investor retains voting rights similar to those extended to common

stockholders, such as the right to vote for changes in the BOD, approval of
the investment adviser, changes in the fund’s investment objective, changes
in sales charges, and liquidation of the fund.

■■ New mutual funds being formed today must offer reinvestment of dividends
and capital gains without a sales charge.

■■ An investor may liquidate a portion of his holdings without disturbing the

portfolio’s balance or diversification.

Series 6 [Link] 108 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 109

■■ Tax liabilities for an investor are simplified because each year the fund
distributes a Form 1099 explaining taxability of distributions.

■■ A fund may offer various withdrawal plans that allow different payment
methods at redemption.

■■ Funds may offer reinstatement provisions that allow investors who withdraw
funds to reinvest up to the amount withdrawn within 30 days with no new
sales charge. This provision must be in the prospectus and is available one
time only.

Comparison of Common Stock and Mutual Fund Shares

Common Stock Mutual Fund Shares
Dividends from corporate profits Dividends from net investment income
Price of stock determined by supply Price of share determined by forward pric-
and demand ing—the next price calculated as determined
by the fund’s pricing policy
Traded on an exchange or the OTC Purchased from and redeemed by the in-
market vestment company; no secondary trading
Sold in full shares only Full or fractional shares may be purchased
First security issued by a public cor- Only security issued by a mutual fund
poration
Carries voting rights Carries voting rights
May carry preemptive rights Does not carry preemptive rights
Ex-dividend: 2 business days before Ex-dividend: typically the day after record
record date as set by the SRO date as set by the BOD

Q
QUICK QUIZ 2.E True or False?

—— 1. Mutual fund shareholders own a divided interest in the fund’s portfolio.

—— 2. A mutual fund shareholder’s account value fluctuates proportionately

with the mutual fund’s portfolio value.

—— 3. The transfer agent holds the mutual fund’s assets for safekeeping.

—— 4. Mutual funds issue only one class of common stock.

—— 5. The reinstatement provision allows reinvestment of withdrawn funds

within 60 days at no load.

—— 6. To open an account, most funds require a minimum investment.

—— 7. Mutual fund shareholders are allowed to vote on the frequency of divi-

dend distributions.

Series 6 [Link] 109 6/8/2016 [Link] PM

 110 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

2. 4. 2 PRICE OF MUTUAL FUND SHARES

Because mutual funds don’t trade in the secondary market, the value of shares is not deter-
mined by supply and demand, but rather by a formula. Everything begins with net asset value
(NAV) per share.
To calculate the NAV of a fund share, the fund starts with its total assets and subtracts out
its liabilities (such as amounts due for securities purchased, but not yet paid for):

Total Assets − Liabilities = Net Assets of the fund.

The fund then divides the Net Assets by the number of shares outstanding. This gives the
Net Asset Value per share (NAV) of the fund:

Net Assets
= NAV.
Shares Outstanding

*
EXAMPLE
The ABC fund has total assets of $100 million and $5 million in liabilities. If it has
10 million shares outstanding, what is its NAV per share?

Net Assets: $100 million − $5 million = $95 million, and

NAV: $95 million ÷ 10 million shares outstanding = $9.50 per share.

The NAV of a fund share is the amount the investor receives upon redemption. It must
be calculated at least once per business day. A typical fund calculates its NAV at 4:00 pm
ET every business day, since that is when the New York Stock Exchange closes. The price
the customer receives is the next NAV calculated after receipt of his redemption request.
This practice is known as forward pricing; we always have to wait until the next available
calculation to determine the value of shares redeemed or, for that matter, the number of shares
purchased.
The purchase price of a fund share is called the public offering price, or POP. For the class
of fund shares known as front-end loaded shares, it is simply the NAV plus the sales charge.
The sales charge is paid as compensation for marketing the shares. As we will see, sales charges
can be levied at the time of purchase (front-end load), at the time of redemption (back-end
load), or there can simply be no sales charge (no-load), meaning that shares are purchased at
NAV.

✓
TA K E N O T E
It is extremely rare that a mutual fund share price is a round number such as $10;
virtually all mutual fund shares are priced in fractions such as $10.7653. Therefore,
when purchasing mutual funds, investors don’t indicate the number of shares they
wish to purchase but rather the dollar amount they wish to purchase.

*
EXAMPLE
Mr. Jones writes a check to purchase $10,000 of the ABC mutual fund. After
entering the order, the next available POP is $10.7653. Mr. Jones buys 928.91048
shares of the ABC mutual fund.
$10,000 ÷ $10.7653 = 928.91048 shares purchased

Series 6 [Link] 110 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 111

2. 4. 2. 1 Changes in NAV
The NAV can change daily because of changes in the market value of a fund’s portfolio.
Any of the events in the following chart may change a fund’s NAV per share.
Changes in NAV

Increases Decreases Does not change

Market value of securities Market value of securities Manager buys or sells
increases declines securities
Fund receives dividends Fund distributes dividends Fund issues shares

Fund receives interest Fund distributes capital Fund redeems shares

gains
Liabilities decline Liabilities increase

!
TEST TOPIC ALERT

Expect to see questions similar to the following:

Under which of the following circumstances does NAV per share decrease?

I. Portfolio securities decrease in value.

II. Dividends are distributed from the portfolio to shareholders.
III. New shares are issued.
IV. Shares are redeemed.

The correct choices are I and II. NAV per share decreases when the portfolio se-
curities decline in value or when an income distribution is made from the portfolio to
the shareholders. NAV does not change when shares are issued or redeemed. When
shares are purchased, new money paid to the fund is offset by a greater number of
shares outstanding; when shares are redeemed, the decrease in portfolio assets is
offset by a decrease in shares outstanding.

2. 4. 3 SALES CHARGES
FINRA prohibits its members from assessing sales charges in excess of 8.5% of the POP
on customers’ mutual fund purchases. Mutual funds are free to charge lower rates and most do,
provided they specify those rates in the prospectus.

✓
TA K E N O T E
A mutual fund’s maximum sales charge is based on the POP—not the NAV. The
maximum load for mutual fund shares is 8.5% of the POP.
Most funds today charge somewhat lower sales loads. 5 to 6% is a typical maxi-
mum load for equity funds; 4 to 5% is a typical maximum load for bond funds.

Series 6 [Link] 111 6/8/2016 [Link] PM

 112 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

2. 4. 3. 1 Closed-End Funds
After the initial public offering, closed-end funds do not have a sales charge embedded
in the share price. In the secondary market, an investor pays a brokerage commission (in an
agency transaction) or pays a markup or markdown (in a principal transaction). Closed-end
funds may trade at a premium (above) or discount (below) relative to their NAV.

2. 4. 3. 2 Open-End Funds
All sales commissions and expenses for an open-end fund are embedded in the POP or
other fees. Sales expenses include commissions for the managing underwriter, dealers, brokers,
and registered representatives, as well as all advertising and sales literature expenses. Mutual
fund distributors use different methods to collect the fees for the sale of shares and one to
compensate reps on an ongoing basis (trailer commissions):
■■ Front-end loads (difference between POP and NAV)
■■ Back-end loads (contingent deferred sales loads)
■■ Level loads (asset-based fees—provide trail commissions to the registered representative
servicing the account)

2. 4. 3. 2. 1 Front-End Loads
Shares sold with a front-end load are called Class A shares. Front-end sales loads are
the charges included in a fund’s public offering price. The charges are added to the NAV at
the time an investor buys shares. Front-end loads are the most common way of paying for the
distribution services a fund’s underwriter and broker-dealers provide.

*
EXAMPLE An investor deposits $10,000 with a mutual fund that has a 5% front-end load.
The 5% load amounts to $500, which is deducted from the invested amount. In this
example, $9,500 is invested in the fund’s portfolio on the investor’s behalf.

2. 4. 3. 2. 2 Back-End Loads
Shares sold with a back-end load are called Class B shares. A back-end sales load (con-
tingent deferred sales charge or CDSC) or redemption fee is charged if and when an investor
redeems mutual fund shares. The sales load, a declining percentage charge that is reduced
annually (e.g., 6% the first year, 5% the second, 4% the third, etc.), is applied to the proceeds
of any shares sold in that year. The back-end load is usually structured to drop to zero after an
extended holding period, such as six or seven years. The sales load schedule is specified in a
fund’s prospectus.

✓
TA K E N O T E
With a back-end load, when an investor deposits $10,000 in a mutual fund, the
full $10,000 is invested in the portfolio on the investor’s behalf. The sales load is de-
ducted only if the investor withdraws the money before the CDSC expires. This type
of sales charge is intended to discourage frequent trading in mutual fund accounts.

Series 6 [Link] 112 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 113

2. 4. 3. 2. 3 Level Loads
Class C shares typically have a one year, 1% CDSC, a .75% 12b-1 fee (discussed below),
and a .25% shareholder services fee. Because these fees are relatively high and never go away,
C shares are commonly referred to as having a level load. Class C shares are appropriate for
investors that have short time horizons as they become quite expensive to own if investing for
more than four to five years.

2. 4. 3. 2. 4 12b-1 Asset-Based Fees

12b-1 fees are often referred to as asset-based distribution fees. Named after the SEC
rule that allows them, 12b-1 fees are used to cover the costs of market­ing and distributing
the fund to investors. 12b-1 fees are also used to compensate registered representatives for
servicing an account (trailer commissions) but shouldn’t be confused with sales charges. The
fee is deducted quarterly as a percentage of the fund’s average total NAV. If a mutual fund has
adopted a 12b-1 plan, the board of directors, including those members considered to be nonin-
terested, must review the expenditures made under the plan quarterly. Furthermore, the board
must determine whether or not to renew the plan on an annual basis. The fee is disclosed in
the fund’s prospectus. Requirements for 12b-1 fees include the following.
■■ The maximum 12b-1 fee is .75% for distribution and promotion.
■■ The fee must reflect the anticipated level of distribution services.

Board of Directors. If the fund charges a 12b-1 fee, a simple majority must be noninter-
ested persons, not just 40%.

Approval. The 12b-1 plan must be approved initially by a majority of the outstanding
voting securities, the board of directors, and those directors who are noninterested persons.
Thereafter, the plan, together with any related agreements, is reapproved at least annually
by a vote of the board of directors of the company and of the directors who are not interested
persons of the company and have no direct or indirect financial interest in the operation of
the 12b-1 plan or in any related agreements.
Termination. The 12b-1 plan may be terminated at any time by a majority vote of the
noninterested directors OR a majority vote of outstanding voting securities.
Misuse of No-Load Terminology. A fund that has a deferred sales charge or an asset-based
12b-1 fee of more than .25% of average net assets may not be described as a no-load fund. To
do so violates the Conduct Rules; the violation is not alleviated by disclosures in the fund’s
prospectus.

!
TEST TOPIC ALERT Expect several questions about 12b-1 fees and know the following points.
■■ 12b-1 fees are charged and reviewed quarterly.

■■ To implement 12b-1 fees approval requires three votes: a majority of the

outstanding voting securities, the full board, and the noninterested members
of the board.

■■ Renewal (done annually) requires two votes: a majority of the total board
and a majority of the noninterested members of the board.

■■ Termination requires either a majority of the outstanding voting securities or

the noninterested members of the board.

Series 6 [Link] 113 6/8/2016 [Link] PM

 114 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

■■ Charges covered by 12b-1 fees include advertising, sales literature, and

prospectuses delivered to potential customers, not fund management
expenses.

■■ In order for a fund to market itself to the public as a no load fund, the fund
may not charge more than .25% of average net assets for 12b-1 fees.

■■ The maximum allowable 12b-1 charge under FINRA rules is .75% (75 basis
points).

■■ FINRA does permit an additional .25% charge for shareholder services

(25 basis points), but that is treated separate from the 12b-1 charge.

2. 4. 3. 3 Computing the Sales Charge Percentage

When the NAV and the POP are known, the sales charge percentage can be determined.

POP ($10.50) – NAV ($10) = sales charge dollar amount ($.50)

Sales charge dollar amount ($.50)

= sales charge percentage (4.8%)
POP ($10.50)

If the dollar amounts for the NAV and sales charges are specified, the formula for deter-
mining the POP of mutual fund shares is:

NAV ($10) + sales charge dollar amount ($.50) = POP dollar amount ($10.50)

A mutual fund prospectus must contain a formula that explains how the fund computes
the NAV and how the sales charge is added. The sales charge is always based on the POP, not
on the NAV.
If the dollar amount of the NAV and the sales charge percent are specified, the formula to
determine POP is to divide the NAV by 100% minus the sales charge percentage.

NAV ($10)
= POP ($10.50)
100% – sales charge percentage (4.8%)
Because of the sales charge, loaded funds should be recommended for long-term investing.

*
EXAMPLE NAV = $20 and POP = $21.00. What is the sales charge percentage?
The sales charge percentage is calculated by finding the sales charge amount
($21.00 – $20.00) and dividing by the POP. Remember, sales charge is a percentage
of the POP, not the NAV.
$1.00 ÷ $21.00 = 4.8% (when rounded)
Assume a NAV of $20 and a sales charge of 5%. What is the POP?
POP is found by dividing the NAV by 100% minus the sales charge percentage.
$20 ÷ .95 = $21.05
In determining the POP when provided with the NAV, the answer has to be more
than the NAV. If such a question has only one choice with a higher POP than the
NAV, the correct answer should be immediately apparent.

Series 6 [Link] 114 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 115

!
TEST TOPIC ALERT You may be given two quotes using NAV and POP and be asked to identify each
as either closed-end or open-end funds. Remember this!
Closed-end
■■ NAV can equal POP
■■ NAV may be greater than POP
■■ NAV may be less than POP
If the spread between NAV and POP is greater than 8.5%, it must be closed-end.
Open-end
■■ NAV can equal POP
■■ NAV can never be greater than POP
■■ NAV may be less than POP
The spread between NAV and POP must be 8.5% or less.

*
EXAMPLE #1 ABC fund has a NAV of $11.65 and a POP of $13.04

ABC fund must be closed-end, the sales charge (SC) exceeds 8.5%.

POP – NAV = SC dollar amount

$13.04 – $11.65 = $1.39

SC dollar amount ÷ POP = SC%

1.39 ÷ 13.04 = 10.7%

#2 XYZ fund has a NAV of $28.65 and a POP of $27.88

XYZ fund must be closed-end, the NAV is greater than the POP

2. 4. 3. 3. 1 No-Load Funds
As the name implies, this means that the fund does not charge any type of sales load.
However, not every type of shareholder fee is a sales load. No-loads may charge fees that are
not sales loads. For example, a no-load fund is permitted to charge purchase fees, account fees,
exchange fees, and redemption fees, none of which is considered to be a sales load. (Although
a redemption fee is deducted from redemption proceeds just like a deferred sales load, it is not
considered to be a sales load.) In addition, under FINRA rules, a fund is permitted to pay its
annual operating expenses and still call itself no-load. However, the combined amount of the
fund’s 12b-1 fees or separate shareholder service fees cannot exceed 0.25% of the fund’s aver-
age annual net assets.

Q
QUICK QUIZ 2.F True or False?

—— 1. 12b-1 fees are levied quarterly and renewed annually.

—— 2. An open-end fund’s NAV may not be less than its POP.

Series 6 [Link] 115 6/8/2016 [Link] PM

 116 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

—— 3. A back-end load is often called a CDSC.

—— 4. 12b-1 fees may not exceed .25% of average net assets.

—— 5. Closed-end funds generally have higher yields than open-end funds.

2. 4. 4 INVESTMENT OBJECTIVES
Once a mutual fund defines its objective, the portfolio is invested to meet it. The objective
must be clearly stated in the mutual fund’s prospectus and may only be changed by a majority
vote of the fund’s outstanding shares.

!
TEST TOPIC ALERT Name Rule. The name rule was really instituted to prevent abuse, such as the
ABC Government Bond Fund having only half of its assets in U.S. Government bonds,
but the implication is that it carries the minimal credit risk of Treasury Bonds. This
name rule requires a registered investment company with a name suggesting that the
company focuses on a particular type of investment such as stocks, bonds, federal or
municipal debt (e.g., ABC Stock Fund, the XYZ Bond Fund, or the QRS U.S. Govern-
ment Bond Fund) invest at least 80% of its assets in the type of security indicated by
its name. A small-cap, mid-cap, or large-cap fund seeking maximum flexibility with
respect to its investments would be free to select a name that does not connote a
particular investment emphasis.

2. 4. 4. 1 Stock Funds
Common stock is normally found in the portfolio of any mutual fund that has growth as a
primary or secondary objective. Equity funds have historically outpaced inflation over most
10-year time horizons.
Bonds, preferred stock, and blue-chip stocks are typically used to provide income to mutual
funds with income objectives.

2. 4. 4. 1. 1 Growth/Value Funds
Growth funds invest in stocks of companies whose businesses are growing rapidly. Growth
companies tend to reinvest all or most of their profits for research and development rather
than pay dividends. Growth funds are focused on generating capital gains rather than income.
Growth managers may consider stocks that many feel are overvalued because there may still
be upside potential. As such, funds managed for growth tend to have elevated levels of risk.
Blue-chip or conservative growth funds invest in established and more recognized com-
panies to achieve growth with less risk. Generally these funds own shares of companies with
fairly large market capitalization. Market cap, as it is usually referred to, is the total number
of shares of common stock outstanding multiplied by the current market value per share. So a
listed company with 300 million shares outstanding where the share price is $50 would have a
market cap of $15 billion and would be considered a large-cap stock. Funds investing in stocks
like this are sometimes called large-cap funds (their portfolio consists of companies with a
market capitalization of more than $10 billion). These types of funds can be more stable and
less volatile in a turbulent market.

Series 6 [Link] 116 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 117

*
EXAMPLE An investor who is willing to take moderate risk and is willing to invest for a mini-
mum of 5–7 years may be interested in a blue-chip or large-cap growth fund.

Aggressive growth funds are sometimes called performance funds. These funds are willing
to take greater risk to maximize capital appreciation. Some of these funds invest in newer com-
panies with relatively small capitalization (less than $2 billion capitalization) and are referred
to as small-cap funds. Mid-cap funds are somewhat less aggressive and have in their portfolios
shares of companies with a market capitalization of between $2 billion and $10 billion. The
lower the market cap, the greater the volatility.

*
EXAMPLE An investor who is seeking high potential returns with the understanding that
there can also be significant losses and is willing to invest for 10–15 years may be
interested in an aggressive growth fund that focuses on small- or mid-cap companies.

Value funds (and, therefore, value managers) focus on companies whose stocks are cur-
rently undervalued (earnings potential is not reflected in the stock price). These undervalued
companies are expected to perform better than the reports indicate, thus providing an oppor-
tunity to profit. Value stocks typically have dividend yields higher than growth stocks. Funds
managed for value are considered more conservative than funds managed for growth.

*
EXAMPLE An investor that is willing to take moderate risk when investing to purchase a
vacation home in 7–10 years may be interested in a fund that is value oriented.

2. 4. 4. 1. 2 Income Funds
An income fund, also known as an equity income fund, stresses current income over
growth. The fund’s objective may be accomplished by investing in the stocks of companies
with long histories of dividend payments, such as utility company stocks, blue-chip stocks, and
preferred stocks. These are managed for value, not growth.

*
EXAMPLE An investor who is willing to take low to moderate risk and seeks income from
equity investments in the form of dividends with some capital appreciation may be
interested in an equity income fund, utility fund, or preferred stock fund.

Option income funds invest in securities on which call options can be sold (known as
covered calls). They earn premium income from writing (selling) the options. They may also
earn capital gains from trading options at a profit. These funds seek to increase total return by
adding income generated by the options to appreciation on the securities held in the portfolio.

2. 4. 4. 1. 3 Growth and Income Funds

A growth and income fund (combination fund) may attempt to combine the objectives
of growth and current yield by diversifying its stock portfolio among companies showing long-
term growth potential and companies paying high dividends. Often, both value and growth
management styles are utilized.

Series 6 [Link] 117 6/8/2016 [Link] PM

 118 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

*
EXAMPLE An investor seeking dividends and capital appreciation with moderate risk may be
interested in a growth and income fund.

2. 4. 4. 1. 4 Specialized (Sector) Funds

Many funds attempt to specialize in particular economic sectors or geographic areas. These
funds must have a minimum of 25% of their assets invested in their specialties. Sector funds
offer high appreciation potential, but may also pose higher risks to the investor as a result of
the concentration of investments. These funds are speculative in nature. They include gold,
technology, pharmaceutical, and bio-technology funds, but can also be geographic, such as
investing in companies located in the Pacific Basin or Silicon Valley. Sector funds are often
labeled as such in the newspaper listings of mutual fund companies that offer them.
A sector fund can still be diversified, provided it meets the 75-5-10 test.

*
EXAMPLE An investor who believes the pharmaceutical industry is going to outperform the
market over the next 5–10 years and is willing to speculate on the investment may be
interested in a sector fund that focuses on the pharmaceutical industry.

2. 4. 4. 1. 5 Special Situation Funds

Special situation funds buy securities of companies that may benefit from a change within
the companies or in the economy. Takeover candidates and turnaround situations are common
investments. These funds are also speculative (high risk).

*
EXAMPLE An investor believes the banking industry is going to be going through a phase
of mergers and acquisitions. They are willing to take additional risk to possibly profit
from the potential consolidation of the industry. They may be interested in a special
situation fund that specializes in mergers and acquisitions.

2. 4. 4. 1. 6 Blend/Core Funds
Blend/core funds are stock funds with a portfolio comprised of a number of different
classes of stock. Such a fund might include both blue-chip stocks and high-risk/high-potential
return growth stocks. Both growth and value management styles are used. The purpose is to
allow investors to diversify their investment via management and securities in a single fund.

✓
TA K E N O T E
Value funds are considered more conservative than growth or blend/core funds.

2. 4. 4. 1. 7 Index Funds
Index funds invest in securities to mirror a market index, such as the S&P 500. An index
fund buys and sells securities in a manner that mirrors the composition of the selected index.
The index may be broad, such as the S&P 500, or narrow, such as a transportation index. The
fund’s performance tracks the underlying index’s performance. Turnover of securities in an

Series 6 [Link] 118 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 119

index fund’s portfolio is minimal, as the only trades that take place are triggered by a change in
the index (one company is replaced by another company). As a result, an index fund generally
has lower management costs than other types of funds.

*
EXAMPLE An investor does not believe in paying for the professional stock selection of a
managed fund. In other words, the belief is that it is difficult to outperform the mar-
ket as a whole (or in part). Under these circumstances, recommending an index fund
is appropriate.

2. 4. 4. 1. 8 Foreign Stock Funds

Foreign stock funds and international funds invest only in the securities of foreign coun-
tries (companies that have their principal business activities outside the United States). Long-
term capital appreciation is their primary objective, although some funds also seek current
income.
Global and worldwide funds invest in the securities of both U.S. and foreign countries.
The risks involved in a fund concentrating in foreign securities are somewhat different
than that for a domestic fund. When a portfolio has a large percentage of foreign securities,
currency risk and political risk becomes paramount. These risks are elevated when invest-
ing in frontier funds which invest in pre-emerging economies, as accounting and regulatory
schemes are often much less rigorous than what we are used to here in the United States.
Foreign and international stock funds are often purchased in order to diversify an inves-
tor’s portfolio. After all, investing inside and outside the United States provides a more diver-
sified portfolio than just investing within the United States.

*
EXAMPLE An investor has a solid mix of securities, all based in the United States. It is con-
veyed that taking more risk and diversifying the portfolio at the same time is desired.
A foreign stock fund, international fund, or global or worldwide fund may be suggest-
ed with disclosure that the foreign and international funds provide greater diversifica-
tion but have more risk than the global and worldwide funds.

✓
TA K E N O T E
Foreign stock funds are often purchased in order to diversify an investor’s
portfolio.

2. 4. 4. 1. 9 Principal Protected Funds

Principal protected mutual funds offer investors a guarantee of principal, adjusted for fund
dividends and distributions, on a set future date (maturity) while providing opportunities for
higher returns through investment in higher risk and higher expected return asset classes such
as equities. The basic guarantee is that the investor’s return will never be less than the original
investment, less any sales load. The guarantees are sometimes provided by third party insurers
and at other times through investments in U.S. Treasury zero-coupon bonds. These appealing
properties have led to considerable interest on the part of investors who have invested billions

Series 6 [Link] 119 6/8/2016 [Link] PM

 120 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

of dollars in such mutual funds in recent years. The usefulness and attractiveness of these prin-
cipal protected mutual funds is limited by three factors:
■■ These funds are closed to new contributions (i.e., investor share purchases) during their
protected (or guarantee) periods, unlike most mutual funds, which are open to contribu-
tions (i.e., continuously offered) as well as redemptions on an ongoing basis.
■■ These funds protect initial principal for those mutual fund shares that are held to maturity,
but interim gains generated on such principal are not protected.
■■ Not only are they typically front-end loaded, but their operating expense ratios (covered
shortly) tend to be higher than comparable funds.

*
EXAMPLE

2. 4. 4. 2 Balanced Funds
An investor is very risk averse but wishes to invest without the possibility of losing
the principal of the investment. A principal protected fund may be appropriate.

Balanced funds, also known as hybrid funds, invest in stocks for appreciation and bonds
for income. In a balanced fund, different types of securities are purchased according to a for-
mula the manager may adjust to reflect market conditions.

A balanced fund’s portfolio might contain 60% stocks and 40% bonds.

*
EXAMPLE

2. 4. 4. 3 Asset Allocation Funds

A balanced fund may be appropriate for an investor that seeks a conservative
balance between stocks and bonds.

Asset allocation funds split investments between stocks for growth, bonds for income,
and money market instruments or cash for stability. Fund advisers switch the percentage of
holdings in each asset category according to the performance (or expected performance) of
that group. These funds can also hold hard assets, such as precious metals like gold and silver,
and real estate.
A fund may have 60% of its investments in stock, 20% in bonds, and the remaining 20%
in cash. If the stock market is expected to do well, the adviser may switch from cash and
bonds to stock. The result may be a portfolio of 80% in stock, 10% in bonds, and 10% in cash.
Conversely, if the stock market is expected to decline, the fund may invest heavily in cash and
sell stocks.
Many asset allocation funds are target funds that target a specific goal, such as retire-
ment, in a 5-, 10-, 15-, or 20-year period. As the target year gets closer, the mix of investments
becomes more conservative.

*
EXAMPLE An investor seeks an investment for retirement in 20 years that performs well un-
der most market conditions and is diversified by purchasing multiple types of securi-
ties. An asset allocation fund that targets the year of retirement may be appropriate.

Series 6 [Link] 120 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 121

2. 4. 4. 4 Bond Funds
Bond funds have income as their main investment objective. Some funds invest solely
in investment-grade corporate bonds. Others, seeking enhanced safety, invest only in gov-
ernment issues. Still others pursue capital appreciation by investing in lower-rated bonds for
higher yields.

!
TEST TOPIC ALERT Remember:
■■ Bonds pay interest, bond funds pay dividends.

■■ Dividends are typically paid on a quarterly or semiannual basis, but there are
income funds (both equity and debt oriented) that pay monthly dividends.

■■ When interest rates rise, the prices of bonds, and, therefore, bond funds, fall
(and vice versa).

2. 4. 4. 4. 1 Corporate Bond Funds

Corporate bond funds, in general, have higher credit risk than various government issues
but can still be classified as investment grade (safer) or non-investment grade (riskier) port-
folios. The greater the risk, the greater the yield. High-yield bond funds provide the highest
yields due to their increased credit risk and are considered speculative investments.

2. 4. 4. 4. 2 Tax-Free (Tax-Exempt) Bond Funds

Municipal bond funds invest in municipal bonds or notes that produce income (divi-
dends) exempt from federal income tax. These funds are appropriate for investors in a high
marginal tax bracket seeking income.

*
EXAMPLE An investor is in a high marginal tax bracket and seeks income. A municipal bond
fund may be appropriate.

2. 4. 4. 4. 3 U.S. Government Funds

U.S. government funds purchase securities issued by the U.S. Treasury or an agency of
the U.S. government, such as Ginnie Mae. Investors in these funds seek current income and
maximum safety. Agency security funds are not considered quite as safe from default risk as
U.S. government funds; therefore, the yields on agency security funds will be higher than U.S.
government fund yields.

2. 4. 4. 4. 4 Agency Funds

Agencies is a term used to describe two types of bonds: (1) bonds issued or guaranteed
by U.S. federal government agencies, and (2) bonds issued by government-sponsored enter-
prises (GSEs)—corporations created by Congress to foster a public purpose, such as affordable
housing.

Series 6 [Link] 121 6/8/2016 [Link] PM

 122 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

Bonds issued or guaranteed by federal agencies such as the Government National Mortgage
Association (Ginnie Mae) are backed by the “full faith and credit of the U.S. government,”
just like Treasuries. This is an unconditional commitment to pay interest payments and to
return the principal investment in full to you when a debt security reaches maturity.
Bonds issued by GSEs, such as the Federal National Mortgage Association (Fannie Mae)
and the Federal Home Loan Mortgage (Freddie Mac), are not backed by the same guarantee
as federal government agencies.

*
EXAMPLE

2. 4. 4. 5 Funds of Funds
An investor is risk averse and seeks income, but the U.S. government bond fund
yields are too low. An agency security fund may be appropriate.

A fund of funds is a type of mutual fund that invests solely in other mutual funds. These
funds’ strategies and objectives necessarily reflect the strategies of the underlying mutual funds
that make up their portfolios, and they can be pure growth, pure income, or a mixture of two
or more objectives. They are not to be confused with funds of hedge funds.

2. 4. 4. 5. 1 Funds of Hedge Funds

Though hedge funds are available only to certain highly qualified investors, technically
known as accredited investors, there are registered mutual funds available to ordinary inves-
tors that invest in hedge funds. Not surprisingly, they are called funds of hedge funds. They
can diversify among several hedge funds and thus give ordinary investors indirect access to
hedge fund investments. Funds of hedge funds to some extent share the benefits (and risks) of
hedge funds and have lower initial investment requirements, but they also have some peculiar
disadvantages. For instance, the shares are neither traded nor readily redeemable unless the
fund itself offers to redeem them. Thus, it is possible that the investment cannot be liquidated
readily. Expenses and risks also tend to be significantly higher than those of other types of
mutual funds. Finally, according to the SEC, a significant percentage of funds of hedge funds
are NOT registered with them, thereby lessening shareholder protection. Any recommenda-
tions to customers must include full disclosure of these drawbacks.

2. 4. 4. 6 Money Market Funds

Money market funds are open-end (mutual) funds that serve as temporary holding tanks
for investors who are most concerned with liquidity and safety. Today, all money market funds
are no-load, meaning that investors pay no sales charge when shares are purchased. A fund
manager invests the fund’s capital in money market instruments that pay interest and have
short maturities. Interest rates on money market funds are not fixed or guaranteed and change
often, and the interest these funds earn is computed daily and credited as a dividend to custom-
ers’ accounts monthly. Almost all money market funds offer check-writing privileges; however,
some funds impose a requirement that checks must be written for amounts of $500 or more.
The NAV of money market funds is set at $1 per share. Although this price is not guaran-
teed, a fund is managed in order not to “break the buck,” regardless of market changes. Thus,
the price of money market shares does not fluctuate in response to changing market condi-
tions; what fluctuates is yield.

Series 6 [Link] 122 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 123

✓
TA K E N O T E
Though extremely rare, it is possible for investors to lose money in a money mar-
ket mutual fund.

2. 4. 4. 6. 1 Restrictions on Money Market Funds

SEC rules limit the investments available to money market funds and require certain dis-
closures to investors. Restrictions include the following.
■■ The front cover of every prospectus must prominently disclose that an investment in a
money market fund is neither insured nor guaranteed by the U.S. government and that
an investor has no assurance the fund will be able to maintain a stable NAV. This state-
ment must also appear in all literature used to market the fund.
■■ Investments are limited to securities with remaining maturities of no more than 13
months (technically 397 days), although its original maturity many have been longer.
■■ Investments are limited to eligible securities determined to have minimal risk and are
United States–dollar denominated at the time of acquisition. Eligible securities are
defined as those based on, among other things, financial data of the issuer of the portfolio
security or provider of a guarantee or demand feature, if it exists.
■■ Written procedures must require the adviser to provide ongoing review of whether each
security (other than a government security) continues to present minimal credit risks.
■■ Other than securities issued or guaranteed by the U.S. government, no more than 5% of
the fund’s assets may be invested in the securities of any one issuer.

2. 4. 4. 6. 2 Beta
One characteristic of note for money market funds is their low beta coefficient. Beta is a
means of measuring the volatility of a security or portfolio in comparison with the market as
a whole. A beta coefficient of 1.0 indicates a security’s price will move in direct correlation
with the market. A beta greater than 1.0 indicates a security is more volatile than the market,
and a beta less than 1.0 indicates that a security will be less volatile than the market.
Remembering the money market fund portfolio restrictions discussed previously, such as
the limitation to invest in short term, minimal risk securities, and the ability to peg the NAV
at $1 per share, it becomes apparent that no correlation exists between the movements of the
market and the share prices of money market funds.

Series 6 [Link] 123 6/8/2016 [Link] PM

 124 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

✓
TA K E N O T E For suitability questions on the exam, first determine the customer’s primary
objective. In general, the following basic rules apply.

Investor Objective Recommendation

Preservation of capital; safety Government securities or Ginnie Maes
Growth Common stock or common stock mutual funds
Balanced or moderate growth Blue-chip (large-cap) stocks
Aggressive growth/speculation Technology stocks or sector funds
Income Bonds—but not zero-coupons
Tax-free income Municipal bonds or municipal bond funds
High-yield income Corporate bonds or corporate bond funds
Equity income Preferred stock and utility stocks
Liquidity Money market funds (DPPs, CDs, real estate,
annuities not considered liquid)
Keep pace with inflation Stock portfolio

2. 4. 4. 7 Secondary Investment Objectives

The secondary objective of investors must also be taken into account.
■■ Investors who are interested in aggressive growth should consider technology stock funds
or stock funds investing in new companies with new ideas. Aggressive funds or small-cap
funds are usually most suitable for younger investors who have high risk tolerance.
■■ Investors seeking growth but are more conservative should consider balanced growth
funds, which are likely to be large-cap funds. These funds are not as speculative as smaller
cap and aggressive funds.
■■ Investors who are interested in income but want safety of principal should invest in a
government bond fund.
■■ Investors seeking the highest possible income with little concern for risk should invest in
a corporate bond fund.
■■ High tax bracket investors seeking income should invest in a municipal bond fund.
■■ Investors seeking safety of principal with high liquidity should consider a money market
fund.
■■ Investors who wish to invest in a portfolio that mirrors the performance of the stock mar-
ket should consider an index fund.

2. 4. 4. 8 Strategies
Whether an individual investor or a portfolio manager, many things influence the types
of securities purchased and sold including personal preferences, market factors, and goals and
objectives.

Series 6 [Link] 124 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 125

*
EXAMPLE A portfolio of securities appropriate for a 25-year-old unmarried man may not be
appropriate for a 45-year-old married man with two children in college or a 65-year-
old woman facing retirement.

2. 4. 4. 8. 1 Quantitative Risk Management

Portfolio managers use a variety of financial information about the markets, securities,
interest rates, current economic conditions, and the companies and industries themselves in
which they invest in an effort to manage risk. Quantitative risk management can be top-down,
that is, based on general market conditions, interest rates, and price trends in the general
economy to guide portfolio purchases and sales. It can also be bottom-up, that is, based on
direct assessments of a stock’s performance in a universe of 3,000 or more stocks and the
characteristics of the company of investment interest itself. It is important to remember that
risk cannot be eliminated, only managed.

2. 4. 4. 8. 2 Defensive Strategies
Defensive investment strategies are often implemented during economic decline. Investors
may want to invest in securities of industries that tend to perform well in a contracting econ-
omy such as the:
■■ utility industry;
■■ food industry;
■■ clothing industry; and
■■ drug industry.

Defensive strategies may also include the purchase of high quality debt during a volatile
market.

2. 4. 4. 8. 3 Aggressive Strategies
Aggressive investment strategies attempt to maximize investment returns by assuming
higher risks. Such strategies include selecting highly volatile stocks, buying securities on mar-
gin, and using put and call option strategies.

2. 4. 4. 8. 4 Balanced Strategies
Most investors adopt a combination of aggressive and defensive strategies when making
decisions about the securities in their portfolios. A balanced, or mixed, portfolio holds securi-
ties of many types.

2. 4. 4. 8. 5 Style—Growth Versus Value

Portfolio managers generally follow one of the accepted management styles. Of these, two
of the best known are growth and value. Here is what you should know about these.
Growth portfolio managers focus on stocks of companies whose earnings are growing faster
than most other stocks and are expected to continue to do so. Because rapid growth in earn-
ings is often priced into the stocks, growth investment managers are likely to buy stocks that
are at the high end of their 52-week price range. Therefore, in the eyes of some, they might be
buying stocks that are overvalued.

Series 6 [Link] 125 6/8/2016 [Link] PM

 126 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

Value portfolio managers concentrate on undervalued or out-of-favor securities whose

price is low relative to the company’s earnings or book value and whose earnings prospects
are believed to be unattractive by investors and securities analysts. Value investment man-
agers seek to buy undervalued secu­rities before the company reports positive earnings sur-
prises. Value invest­ment managers are more likely to buy stocks that are at the bottom of their
52-week price range.

Q
QUICK QUIZ 2.G Match the investment objective with the most suitable recommendation.
A. Balanced fund
B. Aggressive growth fund
C. Specialized fund
D. Blue-chip stock fund

—— 1. Desires capital growth with minimal risk

—— 2. Wishes to maximize capital gains quickly with high risk tolerance

—— 3. Wishes to diversify securities and is conservative

—— 4. Wishes to invest in medical technology and is not risk averse

Match the objective with the type of fund.

A. Conservative growth fund
B. Money market fund
C. Small-cap fund
D. Balanced fund

—— 5. Capital gains/income/lower risk

—— 6. Capital gains/low risk

—— 7. Liquidity/low risk

—— 8. Capital gains/higher risk

Match the objective with the type of fund.

A. Government bond fund
B. Large-cap fund
C. Asset allocation fund
D. Fund of hedge funds

—— 9. Capital gains/income/lower risk

—— 10. Possibly enhanced growth/high risk

—— 11. Growth/low risk

—— 12. Income/low risk

Series 6 [Link] 126 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 127

Match the description with the type of fund.

A. Ginnie Mae fund
B. Special situation fund
C. Asset allocation fund
D. Index fund

—— 13. Purchase variety of assets to achieve capital gains, income, diversification

—— 14. Mimic stock market indexes to achieve performance comparable to the

market overall

—— 15. Safety of principal with yields slightly higher than government bond fund

—— 16. Seek investments in undervalued companies

Match the description to the type of fund.

A. Municipal bond fund
B. Blend/core fund
C. Fund of funds
D. Foreign stock fund

____ 17. Invests in other mutual funds

____ 18. Often purchased to diversify a portfolio

____ 19. May invest in growth stocks and value stocks

____ 20. Tax-free income

2. 4. 5 COMPARING MUTUAL FUNDS

When comparing mutual funds, investors should select funds that match their personal
objectives. When comparing funds with similar objectives, the investor should review infor-
mation regarding each fund’s:
■■ performance;
■■ costs;
■■ taxation;
■■ portfolio turnover; and
■■ services offered.

2. 4. 5. 1 Performance
Securities law requires that each fund disclose the average annual total returns for one-,
five-, and 10-year periods, or since inception if less than 10 years. Performance must reflect full
sales loads with no discounts. The manager’s track record in keeping with the fund’s objectives
in the prospectus is also important.

!
TEST TOPIC ALERT Fund quotations of average annual return must be for one-, five-, and 10-year
periods, or as long as the fund has operated.

Series 6 [Link] 127 6/8/2016 [Link] PM

 128 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

2. 4. 5. 2 Costs
Sales loads, management fees, and operating expenses reduce investor returns because
they reduce the amount of money available for investment.

2. 4. 5. 2. 1 Sales Loads
Historically, mutual funds have charged front-end loads of up to 8.5% of the money
invested. This percentage compensates a sales force. Many low-load funds charge between
2% and 5%. Other funds may charge a back-end load when funds are withdrawn. Some funds
charge ongoing fees under Section 12b‑1 of the Investment Company Act of 1940. These
funds deduct annual fees to pay for marketing and distribution costs. Sales loads will be cov-
ered in detail later in this unit.

2. 4. 5. 2. 2 Expense Ratio
A fund’s expense ratio relates the management fees and operating expenses to the fund’s
net assets. All mutual funds, load and no-load, have expense ratios. The expense ratio is cal-
culated by dividing a fund’s expenses by its average net assets. An expense ratio of 1% means
that the fund charges $1 per year for every $100 invested. Typically, aggressive funds and inter-
national funds have higher expense ratios.
Stock funds generally have expense ratios between 1% and 1.5% of a fund’s average net
assets. For bond funds, the ratio is typically between .5% and 1%.

!
TEST TOPIC ALERT You may be asked about the factors included in calculating a mutual fund’s
expense ratio. The BOD stipend, investment adviser fee, custodian fee, transfer agent
fee, 12b-1 fee, and legal and accounting expenses are all included. The sales load is
not. The formula for the computation of a mutual fund’s expense ratio is:

Fund expenses ÷ average net assets = expense ratio

*
EXAMPLE
$1 million expenses
$100 million average net assets
= 1% expense ratio

✓
TA K E N O T E
The fund’s expense ratio is found in the prospectus and measures the efficiency
of its management. The largest part of the expense ratio is the investment advisory
fee.

2. 4. 5. 3 Taxation
Mutual fund investors pay taxes on any dividends or capital gains the fund distributes.
Even if the investor elects to reinvest some or all of the distribution, the total amount is tax-
able in the year earned by the fund. There will be a more detailed discussion on mutual fund
taxation in the next Unit.

Series 6 [Link] 128 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 129

2. 4. 5. 4 Portfolio Turnover
The costs of buying and selling securities, including commissions or markups and mark-
downs, are reflected in the portfolio turnover ratio. It is not uncommon for an aggressive
growth fund to reflect an annual turnover rate of 100% or more. A 100% turnover rate means
the fund replaces its portfolio annually. If the fund achieves superior returns, the strategy is
working; if not, the strategy is subjecting investors to undue costs.
The portfolio turnover rate reflects a fund’s holding period. If a fund has a turnover rate of
100%, it holds its securities, on average, for less than one year. Therefore, all gains are likely
to be short-term and subject to the maximum tax rate; a portfolio with a turnover rate of 25%
has an average holding period of four years and gains are likely taxed at the long-term rate.

2. 4. 5. 5 Services Offered
The services mutual funds offer include:
■■ retirement account custodianship;
■■ investment plans;
■■ check-writing privileges;
■■ telephone transfers;
■■ conversion privileges;
■■ combination investment privileges; and
■■ withdrawal plans.

Investors should always weigh the cost of services provided against the value of the ser-
vices to the investor.

Series 6 [Link] 129 6/8/2016 [Link] PM

 130 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

Terms and Concepts Checklist

✓ ✓ ✓
†† Mutual fund concept †† Stock fund †† Dual purpose fund
†† Redeemable security †† Growth fund †† Balanced fund
†† Undivided interest †† Blend/core fund †† Asset allocation fund
†† Guaranteed ††  alue, or special
V †† Bond fund
marketability situation fund †† Corporate bond fund
†† Assets, liabilities, net †† Income fund †† Municipal, tax-free
assets †† Specialized, sector bond fund
†† Shares outstanding fund †† U.S. government
†† NAV †† Stock income fund bond fund
†† Sales charge †† Foreign, or †† Fund of funds
†† POP international fund †† Fund of hedge funds
†† Front end load †† Global fund †† Money market fund
†† Back end load, CDSC †† Quantitative risk †† Performance factors
management
†† Level load, 12b-1 fee †† Sales load
†† Preservation of capital
†† No-load †† Expense ratio
†† Defensive strategy
†† Professional †† Taxation
investment †† Aggressive strategy
†† Portfolio turnover
management †† Balanced strategy
†† Services offered
†† Fractional share
†† Form 1099

2. 5 MUTUAL FUND PURCHASE AND WITHDRAWAL PLANS

Mutual fund investors may select from several methods to purchase mutual fund shares or
withdraw money from the mutual fund account.

2. 5. 1 MUTUAL FUND INVESTMENT PLANS

When an investor opens an account with a mutual fund, he makes an initial deposit and
specifies whether fund share distributions are to be made in cash or reinvested. Regardless of
the choice, all distributions are reported to the IRS on FORM 1099-DIV and are taxable in
that year. Individuals report the dividends on Schedule B of their 1040 and the capital gains
on Schedule D. If the customer elects to receive distributions in cash rather than reinvesting
them, his proportionate interest in the fund is reduced each time a distribution is made. The
customer may make additional investments in an open account at any time and in any dollar
amount; that is, the law sets no minimum requirement, although each fund may set its own.

Series 6 [Link] 130 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 131

2. 5. 1. 1 Accumulation Plans
Mutual funds have a number of arrangements to implement an investment program.
A voluntary accumulation plan allows a customer to deposit regular periodic investments
on a voluntary basis (minimum amounts found in the prospectus). The plan is designed to help
the customer form regular investment habits while still offering some flexibility.
Voluntary accumulation plans may require a minimum initial purchase and minimum
additional purchase amounts. Many funds offer automatic withdrawal from customer checking
accounts to simplify contributions. If a customer misses a payment, the fund does not penalize
him because the plan is voluntary. The customer may discontinue the plan at any time.

✓
TA K E N O T E
In a voluntary accumulation plan, once the account has been opened, contribu-
tion and frequency are very flexible.

Dollar Cost Averaging. One method of purchasing mutual fund shares is called dollar cost
averaging, where a person invests identical amounts at regular intervals. This form of invest-
ing allows the individual to purchase more shares when prices are low and fewer shares when
prices are high. In a fluctuating market and over a period of time, the average cost per share is
lower than the average price of the shares. However, dollar cost averaging does not guarantee
profits in a declining market because prices may continue to decline for some time. In this case,
the investor buys more shares of a sinking investment.

*
EXAMPLE The following illustrates how average price and average cost may vary with dollar
cost averaging:

Month
January
February
Amount Invested
$600
$600
Price per Share
$20
$24
No. of Shares
30
25
March $600 $30 20
April $600 $40 15
Total $2,400 $114 90
The average price per share is the sum of the prices paid divided by the number
of investments: $114 / 4 = $28.50.
The average cost per share is total amount spent divided by the number of shares
purchased: $2,400 / 90 = $26.67.
In this case, the average cost is $1.83 per share less than the average price.

!
TEST TOPIC ALERT It is most important to understand the concept of dollar cost averaging. It involves
investing a fixed amount of money every period, regardless of market price fluctuation.
If the market price of shares is up, fewer shares are purchased; if the market price of
shares is down, more shares are purchased. Over time, if the market fluctuates, dollar
cost averaging will achieve a lower average cost per share than average price per share.

Series 6 [Link] 131 6/8/2016 [Link] PM

 132 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

✓
TA K E N O T E
Dollar cost averaging neither guarantees profit nor protects from loss. It merely
results in a lower cost per share than the average price per share.

2. 5. 1. 2 Contractual Plans
Until recently, periodic payment plans for investment in mutual funds could be purchased
from unit investment trusts known as contractual plan companies. These plans are no longer
sold, but many existing plans are still in effect and can still be the subject of test questions. In
marketing a contract, the sales person supplied the investor with two prospectuses: that of the
contractual plan company itself and that of the mutual fund that the company would purchase
for the investor. The investor would then enter into a nonbinding agreement to make periodic
payments to the plan company (typically monthly payments) for a specific period (typically 10
or 20 years) to be invested in a particular mutual fund. The plan company would, in turn, enter
into a binding agreement to purchase the shares whenever a payment was received.
Plan companies, as investment companies, were not FINRA members and had to pay
POP for their shares. Because they had their own marketing and sales requirements, they were
allowed to make the shares available to the investor at a 9% sales charge, calculated over the
projected life of the contract.

Plan completion insurance. Contractual plans were often sold on military bases with an
option to purchase plan completion insurance (decreasing term life insurance) in the event
the participant died prior to completion of the contract. However, insurance proceeds are
paid to the contractual plan (custodian), not a named beneficiary. The effect of this was that
the plan was immediately paid up (similar to a mortgage life insurance policy paying off the
entire mortgage) and the specified beneficiary(s) of the plan received a fully paid-up plan.

Contractual plan sales charges. Some plan companies were organized under the Invest-
ment Company Act of 1940. They are known as 1940 companies and also as front-end load
companies because of the way they collect their sales charge. They may collect up to 50% of
any given payment as a sales charge and may continue doing so until the equivalent of up to
9% of the total projected payments has been collected. Once the full sales charge has been
collected, further payments are wholly invested.
Other plan companies were organized under the Investment Company Act Amendments
of 1970, which amended paragraph 27(h) of the 1940 Act. They are known as 1970 compa-
nies and also as spread-load companies because of the way they collect their sales charge. They
may collect up to 20% of any given payment as a sales charge, but the average collected over
any 4-year period may not exceed 16%. They may continue to collect sales charges according
to this formula until up to 9% of the total projected payments has been collected. Once the
total sales charge has been collected, further payments are wholly invested.
Contractual plan reimbursements. Investors in contractual plans must be given a 45-day
free-look period to withdraw from the plan. The plan company had 60 days to post a letter
to the investor, called a 45-day free-look letter, which explained how contractual plans
worked and gave the investor 45 days from the posting of the letter to withdraw from his
plan. Both types of plans reimbursed the investor with all sales charges so far collected, plus
the NAV of the mutual fund shares so far purchased if the investor decided to withdraw from
his plan within the 45-day free-look period.

Series 6 [Link] 132 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 133

Contractual Plan Summary

1940 Companies 1970 Companies

(front-end load) (spread load, 27(h))
Total sales charge 9% over the life of the 9% over the life of the
contract contract
Sales charge deductions 50% of any payment during 20% of any payment, but
the first year 4-year average not more
than 16%
Plan termination, 0 to 45 Refund NAV plus all sales Refund NAV plus all sales
days charges charges

!
TEST TOPIC ALERT
Feedback tells us that the most testable information for contractual plans are the
sales charge percentages (see the following Quick Quiz).

Q
QUICK QUIZ 2.H Match the following items to the appropriate descriptions below.
A. 20
B. 50
C. 16
D. 9

—— 1. Maximum sales charge that may be withdrawn in any one year for a
front-end load plan

—— 2. Maximum average sales charge that may be withdrawn over any four
year period with a spread-load plan

—— 3. Maximum sales charge that may be withdrawn in any one year for a
spread-load plan

—— 4. Maximum sales charge percentage over the life of any contractual plan

2. 5. 1. 3 Withdrawal Plans
In addition to lump-sum withdrawals where customers sell all of their shares, mutual funds
offer systematic withdrawal plans (normally a free service). Most mutual funds require a cus-
tomer’s account to be worth a minimum amount of money before a withdrawal plan may
begin. Additionally, most funds discourage continued investment once withdrawals start.
Not all mutual funds offer withdrawal plans, but those that do may offer plans that include
the following.

2. 5. 1. 3. 1 Fixed-Dollar Plan
A customer may request the periodic withdrawal of a fixed-dollar amount. Thus, the fund
liquidates enough shares each period to send that sum. The amount of money liquidated can
be more or less than the account earnings during the period. The amount of each check is
known. How long the checks will last is determined by the performance of the fund and is,
therefore, unknown.

Series 6 [Link] 133 6/8/2016 [Link] PM

 134 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

2. 5. 1. 3. 2 Fixed-Percentage or Fixed-Share Plan

Under a fixed-percentage or fixed-share withdrawal plan, either a fixed number of shares
or a fixed percentage of the account is liquidated each period. Theoretically, a fixed-percent-
age plan has a variable check and no end date, such as 1% of the fund distributed monthly.
A fixed-share plan has a variable check and a variable end date if dividends and capital gains
distributions are reinvested.

2. 5. 1. 3. 3 Fixed-Time Plan
Under a fixed-time withdrawal plan, customers liquidate their holdings over a fixed period
of time such as 10 years (120 months). How long the checks will last is known. The amount of
each check is determined by the performance of the fund and is, therefore, unknown.

2. 5. 1. 4 Withdrawal Plan Disclosures

Withdrawal plans are not guaranteed. With fixed-dollar plans, only the dollar amount to
be received each period is fixed. All other factors, including the number of shares liquidated
and a plan’s length, are variable. For a fixed-time plan, only the period of time is fixed; the
amount of money the investor receives varies each period. Because withdrawal plans are not
guaranteed, a registered representative must:
■■ never promise an investor a guaranteed rate of return;
■■ stress to the investor that it is possible to exhaust the account earlier than expected; and
■■ never use charts or tables unless the SEC specifically clears their use.

✓
TA K E N O T E Mutual fund withdrawal plans are not guaranteed in any way. Charts and tables
regarding withdrawal plans must be cleared by the SEC before use.

Q
QUICK QUIZ 2.I 1. Under which of the following circumstances will dollar cost averaging result in an
average cost per share that is lower than the average price per share?
I. The price of the stock fluctuates over a period of time.
II. A fixed number of shares is purchased regularly.
III. A fixed dollar amount is invested regularly.
IV. A constant dollar plan is maintained.
A. I and II
B. I and III
C. II and III
D. III and IV

2. All of the following statements regarding dollar cost averaging are true EXCEPT
A. dollar cost averaging results in a lower average cost per share
B. dollar cost averaging is not available to large investors
C. more shares are purchased when prices are lower
D. in sales literature, dollar cost averaging cannot be referred to as averaging
the dollar

Series 6 [Link] 134 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 135

3. Which of the following is a risk of a withdrawal plan?

A. The sales charge for the service is high.
B. The cost basis of the shares is high.
C. The plan is illegal in many states.
D. The investor may outlive his income.

4. An investor has requested a withdrawal plan from his mutual fund and currently
receives $600 per month. This is an example of what type of plan?
A. Contractual
B. Fixed-share periodic withdrawal
C. Fixed-dollar periodic withdrawal
D. Fixed-percentage withdrawal

Terms and Concepts Checklist

✓ ✓
†† Accumulation plan †† Contractual plan
†† Periodic payment plan †† Front-end load plan
†† Dollar cost averaging †† Spread load plan
†† Withdrawal plan †† 45-day free-look period
†† Fixed dollar plan †† 45-day free-look letter
†† Fixed time plan †† Terms of withdrawal
†† Fixed percentage, fixed share plan †† Refund, partial refund, of sales charge

2. 6 TRACKING INVESTMENT COMPANY SECURITIES

2. 6. 1 NEWSPAPER QUOTES
Investment company prices, like those for individual securities, are quoted daily in the
financial press. However, because various methods are used to calculate sales charges, the
financial press provides several footnotes to explain the type of sales charge a mutual fund
issuer uses. A registered representative must understand the presentation and meaning of the
footnotes associated with investment company quotes so that he can accurately describe the
quotes to the investing public.
Most newspapers carry daily quotes of the NAVs and offer prices for major mutual funds.
A mutual fund’s NAV is its bid price. The offer price (also called the public offering price or
POP) is the ask price; it is the NAV plus the maximum sales charge, if any. The “NAV Chg”
column reflects the change in NAV from the previous day’s quote.

*
EXAMPLE In the figure, look at the family of funds called The Jefferson Funds. The Jefferson
Growth Fund is a part of this group; its NAV, offering price, and the change in its NAV
per share are listed. As stated previously, when a difference exists between the NAV
and the offering price, the fund is a load fund. A no-load fund is usually identified by
the letters “NL” in the “Offer Price” column.

Series 6 [Link] 135 6/8/2016 [Link] PM

 136 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

Mutual Fund Quotations

Monday, January 19, 2009
Price ranges for investment companies, as quoted by the Financial Industry Regulatory Authority.
NAV stands for net asset value per share. The offering price includes net asset value plus maximum
sales charge, if any.
Offer NAV Offer NAV
NAV Price Chg NAV Price Chg

Jefferson Funds FastTrak Funds

CapApp 4.80 5.04 + .02 App 13.79 14.44 .01
Grwth 6.87 7.21 + .02 CapAp 22.13 23.17 + .15
HiYld 10.28 10.79 + .01 Grwth 18.33 19.24 .10
TaxEx 11.62 12.20 .04

e: Ex-distribution. f: Previous day’s quote. s: Stock split or div. x: Ex-dividend. NL: No load.
p: Distribution costs apply, 12b-1 plan. r: Redemption charge may apply.
* This sample comprises formats, styles, and abbreviations from a variety of currently
available sources and has been created for educational purposes.

The final column shows the change in a share’s NAV since the last trading date.
A plus (+) indicates an upward move and minus (–) indicates a downward turn. From
this information, you can calculate any mutual fund’s sales charge.
Find the FastTrak group of funds in the Mutual Fund Quotations. The first entry
is App.
The sales charge formula:

Public offering price – NAV = sales charge

$14. 44 – $13.79 = $.65

Remember, to calculate the sales charge percentage, use the following formula:

Sales charge ÷ public offering price = sales charge percentage

$.65 ÷ $14.44 = 4.5%

You can also watch the movements of the fund’s share value.

2. 6. 2 INVESTMENT SERVICES
Stock guides such as Standard & Poor’s include summaries of mutual funds for the year.
The graphic on this page shows a portion of a table adapted from a Standard & Poor’s Stock
Guide; you can use it to evaluate mutual funds.
To the right of the third fund listed on the table, Alliance Fund, the following information
is listed:
■■ Principal objective of the fund: “G” means Alliance is a growth fund. Other objectives
might be income, return on capital, and stability; they are listed in the footnotes below
the table.

Series 6 [Link] 136 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 137

Standard & Poor’s Mutual Fund Summary

Dec. 31, 2013 Net Assets per

Share % of Chg frm $10,000 NAV per Share
Total prev. Dec 31 Invested as of 12-31-13
Net Cash & Max 12-31-03 Price
Prin Assets Equiv at Dec 31 Min Sales Now Record 2013 NAV per Offer
FUND Obj Type (MILS) (MILS) 2011 2012 2013 Unit Chg % Worth High Low Shr. Price
Alliance Fund G C 948.2 19.0 – 5.2 +29.5 + 8.9 $250 5.5 24,661 9.67 6.96 9.45 10.00
Principal Objective: G-Growth; I-Income; R-Return on Capital; S-Stability; E-Objectives treated Equally; P-Preservation of Capital; Listed in order
of importance. Type: B-Balanced; BD-Bond; C-Common; CV-Conv Bond and Prefd Stock; FL-Flexible; GB-Long-term Gov’t; GL-Global; H-Hedge;
L-Leverage; P-Preferred; PM-Precious Metals; O-Options; SP-Specialized; TF-Tax Free; ST-Short-term investments

■■ Type of fund: Alliance Fund is a “C” or common stock fund. Other types of funds are
listed in the footnotes. They include the following:
B — balanced FL — flexible
BD — bond H — hedge
C — common L — leverage
CN — Canadian P — preferred
CV — convertible bond, preferred stock SP — specialized
TF — tax free
■■ Total net assets lists total net assets at market value (assets minus liabilities). Alliance
Fund has total net assets of $948.2 million.
■■ Cash and equivalents includes cash and receivables, short-term government securities,
and other money market instruments less current liabilities. Cash and equivalents are part
of the total net assets.
■■ Percentage change in net assets per share: these columns show a fund’s performance over
a specific period—in this case, from the previous December 31. For instance, on December
31, 2012, Alliance Fund had a 29.5% increase in NAV per share since December 31,
2011.
■■ Minimum unit is the minimum initial purchase of shares (Alliance Fund = $250).
■■ Maximum sales charge: Alliance Fund charges 5.5%. If a fund is a no-load fund, it levies
no sales charge.
■■ Current worth of $10,000 invested December 31, 2003, provides a gauge of a fund’s
performance over several years. In this case, $10,000 invested in Alliance Fund on Decem-
ber 31, 2003, would have more than doubled, growing to $24,661.
■■ Price record: from these columns, you can learn a share’s percentage of appreciation from
its low price of the year. To determine the percentage, subtract the low price from the lat-
est NAV per share, then divide the difference by the low price. For instance, during 2013,
Alliance Fund sold at a low of 6.96. If on the current date, its NAV per share was 9.45, the
appreciation would be computed as follows:

NAV 9.45
Low – 6.96
2.49

2.49 ÷ 6.96 = 35.78% Appreciation

■■ NAV per share shows the current NAV per share and the current POP.

Series 6 [Link] 137 6/8/2016 [Link] PM

 138 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

Q
QUICK QUIZ 2.J Match the following terms to the appropriate description below.
A. POP
B. NAV
C. CN
D. CV
E. G

—— 1. Convertible bond or convertible preferred

—— 2. Growth

—— 3. NAV plus sales charge

—— 4. Net assets ÷ Shares outstanding

—— 5. Canadian security

Terms and Concepts Checklist

✓ ✓
†† Mutual fund investment plans †† Newspaper quotes
†† Contractual plans †† Investment services
†† Withdrawal plans
†† Withdrawal plan disclosures

2. 7 ANNUITY PLANS
An annuity is an insurance contract designed to provide retirement income. The term
annuity refers to a stream of payments guaranteed for some period of time—for the life of the
annuitant, until the annuitant reaches a certain age, or for a specific number of years. The
actual amount to be paid out may or may not be guaranteed, but the stream of payments itself
is. Because an annuity can provide an income for the rest of someone’s life, the contract has
a mortality guarantee. When you think about a retiree’s greatest fear, it is typically outliving
her income. This product can take away that fear.

2. 7. 1 TYPES OF ANNUITY CONTRACTS

Life insurance companies offer fixed and variable annuities. With both, the annuitant
makes after-tax lump-sum or periodic payments to the insurance company, which invests the
money in an account and grows tax-deferred. At retirement, the funds become available for
withdrawal, either as a lump sum or as periodic payments to the annuitant, typically for life.
Withdrawals before the age of 59½ result in a 10% penalty in addition to full income tax on
anything over cost basis taken out of the account. Exceptions to the 10% penalty include
death and annuitization under Rule 72t. Annuitization is discussed later in this unit.
Usually 100% of the money goes into the annuity, however, surrender charges will be
applied if the contract is canceled within a stated number of years such as 7 or 10 years from
issue.

Series 6 [Link] 138 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 139

✓
TA K E N O T E Annuities discussed in this section are non-qualified; that is, they are funded with
after-tax dollars, the money grows tax-deferred, and only the earnings are taxed at
distribution.

2. 7. 1. 1 Fixed Annuities
In a fixed annuity, investors pay premiums to the insurance company that are invested in
the company’s general account. The insurance company is then obligated to pay a guaranteed
amount of payout (typically monthly) to the annuitant based on how much was paid in.
Note that the insurer guarantees a rate of return and, therefore, bears the investment risk.
Because the insurer is the one at risk, this product is not a security. An insurance license is
required to sell fixed annuities, but a securities license is not.
Purchasing power risk (inflation risk) is a significant risk associated with fixed annuities.
The fixed payment that the annuitant receives loses buying power over time due to inflation.

*
EXAMPLE An individual who bought a fixed annuity in 1960 began to receive monthly
income of $375 in 1980. Years later, this amount, which seemed sufficient monthly
income at the time, may no longer be enough to live on.

2. 7. 1. 1. 1 Index Annuity
In an effort to overcome the purchasing power risk of fixed annuities, but without the
market risk of a variable annuity, the industry developed the index annuity.
Index annuities are currently popular among investors seeking market participation but
with a guarantee against loss. Unlike a traditional fixed annuity, an index annuity credits
interest to the owner’s account, using a formula based on the performance of a particular stock
index, such as the S&P 500. If the index does well, the annuitant is credited with a specified
percentage of the growth of the index—typically 80% or 90% of the growth. This is known as
the participation rate. If the index does poorly, the annuitant may receive a guaranteed mini-
mum interest rate such as 1% or 2%.
To give you an idea of how an index annuity might work, consider a participation rate of
80% and a minimum guarantee of 1%. If the index shows growth of 9% during the measure-
ment period, the annuitant would be credited with 7.2% growth (80% of 9%). If the index
performed at –9%, the annuitant would receive the minimum guarantee of 1%.
In addition to the participation rate, there is usually a cap rate. A typical cap might be
12%. This means that if the index annuity was pegged to the S&P 500 and that index increased
30% during the year, your gain would be capped at 12%. One other negative characteristic of
these products is that they tend to have longer surrender charge periods (as long as 15 years)
than other annuities, especially if there is a front-end bonus.

✓
TA K E N O T E The only license required in order to sell index annuities is an insurance license.

Series 6 [Link] 139 6/8/2016 [Link] PM

 140 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

2. 7. 1. 2 Variable Annuities
Insurance companies introduced the variable annuity as an opportunity to keep pace with
inflation. For this potential advantage, the investor assumes the investment risk rather than
the insurance company. Because the investor takes on this risk, the product is considered a
security. It must be sold with a prospectus by individuals who are both insurance licensed and
securities licensed.
The premium payments for variable annuities are invested in the separate account of the
insurer. The separate account is comprised of various subaccounts that behave like mutual
funds (we just can’t call them mutual funds). These accounts will have a variety of investment
objectives to choose from such as growth, income, and growth and income. The returns in the
separate account are not guaranteed and therefore a loss of principal is possible.
As with all recommendations, suitability of any purchase is number one. However, in
light of the large number of cases involving variable annuities where there was failure to
supervise egregious unethical behavior, FINRA Rule 2330 evolved. This rule applies to
recommended purchases and 1035 exchanges (discussed later) of deferred variable annuities
(NOT immediate) and recommended initial subaccount allocations.
The representative and a principal of the firm must believe that the customer has been
informed, in general terms, of various features of deferred variable annuities, such as
■■ the potential surrender period and surrender charge,
■■ potential tax penalty if customers sell or redeem deferred variable annuities before reach-
ing the age of 59½,
■■ mortality and expense fees,
■■ investment advisory fees,
■■ potential charges for and features of riders,
■■ the insurance and investment components of deferred variable annuities, and
■■ market risk

In addition, the firm must inquire to the customer as to whether the customer has had an
exchange of a variable annuity at another broker-dealer within the last 36 months.

Series 6 [Link] 140 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 141

Key Features of Fixed Annuities and Variable Annuities

Fixed Annuity Variable Annuity
Payments made with: after-tax dollars after-tax dollars
Payments invested in: the general account the separate account
Portfolio of: fixed income equity, debt, or mutual
securities and real estate funds
Who assumes Insurer Annuitant
investment risk?
Is it a security? No Yes
Rate of return: guaranteed depends on performance
of separate account
Administrative expenses: fixed fixed
Guaranteed lifetime in- Yes Yes
come option?
Monthly payments: constant may fluctuate up or down
Purchasing power risk No Typically provides some
protection? protection
Regulation? Subject to insurance Subject to insurance and
regulation securities regulation

Although annuitants of variable annuities can choose a guaranteed monthly income for
life, the amount of monthly income received is dependent on the performance of the sepa-
rate account. Monthly income either increases or decreases, as determined by the separate
account’s performance.
Investors may purchase a combination annuity to receive the advantages of both the fixed
and variable annuities. In a combination annuity, the investor contributes to both the general
and separate accounts, which provides for guaranteed payments as well as inflation protection.

!
TEST TOPIC ALERT Whenever you see the term variable, as in variable annuity or variable life (dis-
cussed later), two licenses are required for the sale; an insurance license and a securi-
ties license. Suitability must be determined and a prospectus must be delivered prior
to or with solicitation of the sale.

Series 6 [Link] 141 6/8/2016 [Link] PM

 142 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

Investing Variable Annuity Premium Dollars

Fixed vs. Variable Annuity

Fixed Annuity Combination Annuity Variable Annuity

Payments to General Payments to Separate

Account Accounts
• Open-End Investment
Company
• UIT
Fixed Monthly Payout

Variable Monthly Payout

2. 7. 1. 3 Comparison of Mutual Funds and Variable Annuities

Mutual Funds vs. Variable Annuities

Mutual Fund Variable Annuity

Pricing: NAV calculated once per Unit value calculated once
business day per business day
Share value: Depends on performance Depends on performance
of fund of separate account
Regulated by: Act of 1933, Act of 1934, Act of 1933, Act of 1934,
Investment Company Act Investment Company
of 1940, Investment Advis- Act of 1940, Investment
ers Act of 1940 Advisers Act of 1940
Fees paid to: Portfolio manager Separate account manager

If the investment manager of an insurance company is responsible for selecting the securi-
ties to be held in the separate account, the separate account is directly managed and must be
registered under the Investment Company Act of 1940 as an open-end management invest-
ment company. However, if the investment manager of the insurance company passes the
portfolio management responsibility to another party, the separate account is indirectly man-
aged and must be registered as a unit investment trust under the Investment Company Act
of 1940.
Although there are many similarities between mutual funds and variable annuities, there
are two extremely significant features that differentiate the products: a variable annuity offers
the advantage of guaranteed lifetime income (unlike mutual funds) and the earnings on dol-
lars invested into a variable annuity accumulate tax deferred.
Mutual funds periodically distribute dividends and capital gains, and all of these distribu-
tions are typically taxable in the year of receipt, whether reinvested or taken in cash. Such
distributions are never paid directly to owners of annuities; instead, they increase the value

Series 6 [Link] 142 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 143

of units in the separate account. Tax liability is postponed until withdrawals take place. This
feature of tax-deferred growth has established the annuity as a popular product for retirement
accumulation.

✓
TA K E N O T E
Owners of mutual funds and variable annuities have voting rights. They get to
vote on major decisions like changes in investment objectives and investment advis-
ers. They do not get to vote on day-to-day activities like deciding what securities to
buy or sell within a portfolio.

Q
QUICK QUIZ 2.K 1. Which of the following represent the rights of an investor who has purchased a
variable annuity?
I. Right to vote on proposed changes in investment policy
II. Right to approve changes in the plan portfolio
III. Right to vote for the investment adviser
IV. Right to make additional purchases at no sales charge
A. I and III
B. I and IV
C. II and III
D. II and IV

2. Which of the following are TRUE for both variable annuities and mutual funds?
I. They contain managed portfolios.
II. An owner’s account value typically passes to his estate at the time of the
owner’s death.
III. They are regulated by the Investment Company Act of 1940.
IV. All investment income and realized capital gains are taxable to the owner in
the year they are generated.
A. I and III
B. I and IV
C. II and III
D. II and IV

3. Which of the following most significantly affects the value of annuity units in a
variable annuity?
A. Changes in the Standard & Poor’s Index
B. Cost-of-living index
C. Fluctuations in the securities held in the separate account
D. The amount invested by the annuitant

4. Variable annuity salespeople must register with all of the following EXCEPT
A. SEC
B. state banking commission
C. FINRA
D. state insurance department

Series 6 [Link] 143 6/8/2016 [Link] PM

 144 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

5. A variable annuity contract guarantees

I. a rate of return
II. a fixed mortality expense
III. a fixed administrative expense
IV. a fixed investment risk
A. I and III
B. I and IV
C. II and III
D. II and IV

6. Separate accounts are similar to mutual funds in that both

I. may have diversified portfolios of common stock
II. provide tax-deferred gains
III. give investors voting rights
IV. are designed as retirement instruments
A. I and II
B. I and III
C. II and IV
D. III and IV

2. 7. 2 PURCHASING ANNUITIES
Insurance companies offer a number of purchase arrangements for annuities. The various
purchasing plans are discussed below. Aggregate fees include not only sales charges on the
front-end, but also those levied upon surrender, commonly referred to as Conditional Deferred
Sales Loads, or CDSL. In many cases, there is no load to purchase, but if surrender, other
than through annuitization, occurs during the early years of the contract, the charges can be
significant.
An investor is offered a number of options when purchasing an annuity. Payments to the
insurance company can be made either with a single lump-sum payment or periodically on a
monthly, quarterly, or annual basis.
A single premium deferred annuity is purchased with a lump sum, but payment of ben-
efits is delayed until a later date selected by the annuitant.
A periodic payment deferred annuity allows investments over time. Benefit payments for
this type of annuity are always deferred until a later date selected by the annuitant.
An immediate annuity is purchased with a lump sum, and the payout of benefits usually
commences within 60 days.

!
TEST TOPIC ALERT There is no such thing as a periodic payment immediate annuity.

2. 7. 2. 1 Bonus Annuities
Direct financial benefits are sometimes offered with annuities, called bonus annuities.
These benefits include enhancement of the buyer’s premium, with the insurance company
contributing an additional 3–5% to the premium payment. This comes with a cost, of course,
in the form of higher fees and expenses, and longer surrender periods than the typical 7–10
years of standard contracts. Recommendations to customers must include the additional costs
as well as the benefits of the bonuses and enhancements.

Series 6 [Link] 144 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 145

2. 7. 2. 2 Sale Charges
Although there are no stated maximum sales charges on variable annuities, the SEC has
charged FINRA with the responsibility of ensuring that they are fair and reasonable. As a
practical matter, most annuities, both fixed and variable, are sold with little or no sales charge.
Instead, there is a surrender charge (think CDSC or CDSL) for early termination. This sur-
render period is longer for bonus annuities and generally the longest for index annuities.

2. 7. 3 ACCUMULATION STAGE
The variable annuity has two distinct phases. The growth phase is its accumulation phase,
while the payout phase is its annuity phase. A contract owner’s interest in the separate account
is known as either accumulation units or annuity units depending on the contract phase.
Both accumulation units and annuity units vary in value based on the separate account’s
performance.
When the annuitant decides to begin receiving payments from the annuity, he may choose
to annuitize the contract. Although not required, if annuitized, the owner enters into a con-
tractual obligation with the insurance company for the systematic distribution of the asset.
Once annuitized, the money will be distributed per the payout option chosen (discussed later).
At that point, the accumulation units purchased over time will be converted into a fixed num-
ber of annuity units. This becomes one of the factors used to calculate the payout each month
during retirement.
Annuitization
Accumulation phase -----------------> Annuity phase
Accumulation units -----------------> Annuity units

!
TEST TOPIC ALERT As mentioned earlier in our comparison chart with mutual funds, accumula-
tion unit values are computed daily on a forward pricing basis. As you will soon see,
annuity unit values are computed monthly based on actual performance versus the
assumed interest rate.

2. 7. 4 RECEIVING DISTRIBUTION FROM ANNUITIES

An annuity offers several payment options for money accumulated in the account. The
investor can withdraw the funds randomly, in a lump sum, or annuitize the contract (receive
monthly income).
If the investor chooses annuitization, the amount of the monthly check is dependent on
several factors:
■■ Amount of money in the contract (more money equals a bigger check)
■■ Age (the older one is, the larger the check will be)
■■ Sex (females live longer than males; therefore, the check would be less for a female)
■■ Payout option (reviewed in this segment)
■■ Investment return versus assumed interest rate for variable annuities (see below)

Series 6 [Link] 145 6/8/2016 [Link] PM

 146 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

If the annuity is variable, the actuarial department of the insurance company determines
the initial value for the annuity units and the amount of the first month’s annuity payment. At
this time, an assumed interest rate (AIR) is established. The AIR is a conser­vative projection
of the performance of the separate account over the estimated life of the contract.
The value of an annuity unit and the annuitant’s subsequent monthly income will vary,
depending on separate account performance as compared to the AIR. To determine whether
the monthly payment will increase, decrease, or stay the same as the previous month, the fol-
lowing rules apply.
■■ If separate account performance is greater than the AIR, next month’s payment is more
than this month’s.
■■ If separate account performance is equal to the AIR, next month’s payment stays the same
as this month’s.
■■ If separate account performance is less than the AIR, next month’s payment is less than
this month’s.

*
EXAMPLE Assume an AIR of 4% and that the actuaries have determined the first payment
to be $1,000.
Month 2’s separate account performance is 6%, greater than AIR, so the next
check goes up.
Month 3’s separate account performance is 4%, right at AIR. The next check
received equals the last check received.
Month 4’s separate account performance is 3%, which is below AIR, therefore
the next check received will be less than the last check received.
Month 5’s separate account performance is 3% again, which, although the same
as month 4’s, is still below AIR. The next check is, therefore, less than that of the last.
Month 6’s separate account performance is not shown, but if separate account
performance is above the AIR of 4%, the next check will be more than $950; if it is
below the AIR of 4%, the next check will be less than $950.

AIR = 4% Month 1 Month 2 Month 3 Month 4 Month 5 Month 6

Separate Account Return 6% 4% 3% 3% ?
Monthly Payment $1,000 $1,100 $1,100 $1,000 $950 ?

Effect of Investment Return on Annuity Payments

Separate Account Return Value of Annuity Unit Next Month’s Payment

Above AIR Increases More than this month’s
Same as AIR Stays the same The same as this month’s
Below AIR Decreases Less than this month’s

✓
TA K E N O T E
Consider this: if AIR is 4% and the separate account always returns 4%, the
check would never change!

Series 6 [Link] 146 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 147

Q
QUICK QUIZ 2.L 1. A customer invests in a variable annuity. At age 65, she chooses to annuitize.
Under these circumstances, which of the following statements are TRUE?
I. She will receive the annuity’s entire value in a lump-sum payment.
II. She may choose to receive monthly payments for the rest of her life.
III. The number and value of the accumulation units is used to calculate the total
number of annuity units.
IV. The accumulation unit’s value is used to calculate the annuity unit’s value.
A. I and III
B. I and IV
C. II and III
D. II and IV

2. An investor is in the annuity period of a variable annuity purchased 15 years ago.

During the present month, the annuitant receives a check for an amount that
is less than the previous month’s payment. The payment is smaller because the
account’s performance was
A. less than the previous month’s performance
B. greater than the previous month’s performance
C. less than the assumed interest rate
D. greater than the assumed interest rate

3. An insurance company offering a variable annuity makes payments to annuitants

on the 15th of each month. The contract has an AIR of 3%. In July of this year,
the contract earned 4%. In August, the account earned 6%. If the contract earns
3% in September, the payments to annuitants in October will be
A. greater than the payments in September
B. less than the payments in September
C. the same as the payments in September
D. less than the payments in August

There are several ways to receive money from an annuity.

Surrender. If he wishes, the annuitant may simply cash in his annuity. In this case, his
cost base is the total amount he has invested. He will be liable for income tax on the growth
plus a 10% penalty on the growth if he is under the age of 59½.
Death of annuitant. If the annuitant dies during the accumulation period, the death
benefit takes effect. His beneficiary is guaranteed either the total value of the annuity or the
total amount invested, whichever is greater, and is liable for income tax on any growth.
Annuitization. If the annuitant wishes to receive scheduled payments for life, he may
annuitize, in which case he must select a payout option, such as:
■■ Life annuity (also known as straight life or life only)
■■ Life annuity with period certain
■■ Joint life with last survivor annuity
■■ Unit refund option

Series 6 [Link] 147 6/8/2016 [Link] PM

 148 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

Life Annuity/Straight Life. If an annuitant selects the life income option, the insurance
company will pay the annuitant for life. When the annuitant dies, there are no continuing
payments to a beneficiary. Money remaining in the account reverts to the insurer. Because
there is no beneficiary during the annuitization, this represents the largest monthly check
an annuitant could receive for the rest of their life. (The insurance company has no further
obligation at death.)

✓
TA K E N O T E
The life annuity probably would not have been a good choice if the annuitant
died after receiving only one month’s payment. With the life income option, all
money accumulated that was not paid out at the time of the annuitant’s death would
belong to the insurer.

The following options are a little less risky because they allow for payments to a beneficiary.

Life Annuity With Period Certain. To guarantee that a minimum number of payments are
made even if the annuitant dies, the life with period certain option can be chosen. The con-
tract will specifically allow the choice of a period of 10 or 20 years, for instance. The length
of the period certain is a choice that is made when a payout option is selected. The annuitant
is guaranteed monthly income for life with this option, but if death occurs within the pe-
riod certain, a named beneficiary receives payments for the remainder of the period. Because
there is a named beneficiary for the period certain, the size of this check will be smaller than
a straight life option. (The insurance company is obligated to pay the named beneficiary an
income if death occurs during the period certain.)

✓
TA K E N O T E To illustrate the life annuity with period certain option, assume a client selects a
life annuity with a 10-year period certain. If the annuitant lives to be 150 years old,
annuity payments are still made by the insurer. But, if the annuitant dies after receiv-
ing payments for two years, the beneficiary will receive payments for eight more
years.

Joint Life With Last Survivor Annuity. The joint life with last survivor option guarantees
payments over two lives. It is often used for spouses. Because the insurance company is obli-
gated to pay a check over two lifetimes, this check is considered to be smaller than a life with
period certain option.

*
EXAMPLE If the husband were to die first, the wife would continue to receive payments as
long as she lives. If the wife were to die first, the husband would receive payments as
long as he lives. Typically the payment amount is reduced for the survivor.

Unit Refund Option. If the annuitant chooses this option, a minimum number of pay-
ments are made upon retirement. If value remains in the account after the death of the an-
nuitant, it is payable in a lump sum to the annuitant’s beneficiary. This option may be added
as a rider to one of the others.

Series 6 [Link] 148 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 149

✓
TA K E N O T E The unit refund option is the only lifetime annuitization option that guarantees
all of the money in the contract will be distributed. If unit refund is chosen for a
$100,000 contract, the insurance company guarantees that a minimum of $100,000
will be distributed and also guarantees a monthly check for life. Therefore, more than
$100,000 may be distributed, but never less.
Unit refund is sometimes offered as a rider.
For test purposes, this option represents the smallest check a person could receive
for the rest of his life.

!
TEST TOPIC ALERT There is a risk-reward trade-off with these payout options. The exam is likely to
look at payout options in questions similar to the following.

Which of the following annuity options typically pays the largest monthly
income?
A. Life only
B. Joint life with last survivor
C. Life with 10-year period certain
D. Contingent deferred option

Answer: A. Life only: there is no beneficiary with this option, so that payments
cease with death and money remaining reverts to the insurer.

This question illustrates an important exam-taking principle. The term in D, con-

tingent deferred is a distraction; it refers to surrender charges that may apply when
not annuitizing.

*
EXAMPLE Rank the following annuity options in ascending order from smallest to largest
monthly income:
I.
II.
III.
Life only
Unit refund
Joint and last survivor
IV. Life with 10 year period certain
A. I, IV, III, II
B. II, III, IV, I
C. II, IV, III, I
D. III, II, I, IV

Answer: B.

Series 6 [Link] 149 6/8/2016 [Link] PM

 150 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

Q
QUICK QUIZ 2.M Match the following items to the appropriate description below.
A. Accumulation unit
B. Joint with last survivor annuity
C. Deferred annuity
D. Monthly payment

—— 1. Delays distributions until the owner elects to receive them

—— 2. Determines an annuitant’s interest in the insurer’s separate account during

accumulation stage of an annuity

—— 3. Performance of a separate account determines value

—— 4. Annuity payments continue as long as one of the annuitants is alive

Match the following items to the appropriate description below.

A. Assumed interest rate
B. Immediate annuity
C. Life income with period certain
D. Separate account

—— 5. Contract starts to pay the annuitant immediately following its purchase

—— 6. Forms the basis for projected annuity payments but is not guaranteed

—— 7. Holds funds paid by variable annuity contract holders

—— 8. If the annuitant dies before a specified time expires, payments go to the
annuitant’s named beneficiary

2. 7. 5 VARIABLE ANNUITY SUITABILITY

A variable annuity can be a very important part of one’s financial well being if utilized cor-
rectly. However, there are suitability issues to consider. Variable annuities are meant to bring
supplemental income into the household at a time in one’s life when the income is needed.
Therefore, supplemental income for retirement, not preservation of capital, should be the
catalyst to consider a VA. Here are some general rules of thumb regarding the suitability of
variable annuities.
■■ Variable contracts are considered most suitable for someone who can fund the contract
with cash. In other words, enticements to cash out a life insurance policy or an existing
annuity (either of which might come with high surrender charges) is considered abusive
and not a suitable recommendation. Refinancing a home or withdrawing equity from a
home to fund a purchase could never be considered suitable.
■■ Variable contracts are not suitable for anyone who might need the lump sum of cash
invested in the VA at a later time for any reason. Anticipating buying a home, needing
cash for your children’s college education, or any other upcoming expense would need to
be considered outside the variable annuity investment.
■■ Withdrawals from a VA are tax deferred so there would never be a reason to place one in
a tax-favored account like an IRA.

Series 6 [Link] 150 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 151

■■ Variable annuity contracts are insurance company products that invest in a portfolio of
securities via their separate account. If someone has a low risk tolerance or is wary of the
stock market, a VA is not likely a very suitable recommendation for that individual.
■■ Maximum contributions to all other retirement savings vehicles available to an individual
should be made before a VA is considered a suitable recommendation. In other words, they
are best considered supplements to retirement income one can already anticipate like pen-
sions and IRA or 401(k) distributions.

Terms and Concepts Checklist

✓ ✓ ✓
†† Annuity plan †† Accumulation unit †† General account
†† Fixed annuity †† Annuity stage †† Separate account
†† Equity-indexed †† Annuity unit †† Direct management
annuity †† AIR †† Indirect management
†† Variable annuity †† Life only, straight life †† Immediate annuity
†† Combination annuity †† Life with period †† Single premium
†† Bonus annuity certain deferred annuity
†† Payout options †† Joint with last †† Periodic payment
†† Payout factors survivor deferred annuity

†† Accumulation stage †† Unit refund †† Voting rights

†† Purchasing power risk

2. 8 LIFE INSURANCE
Life insurance provides a death benefit to a named beneficiary in the event of an insured’s
premature death. There are many variations of life insurance which serve different needs. We
will review three types of permanent life policies and focus on those that are also considered
securities. Permanent life insurance is designed to last until at least age 100 or the death of the
insured, whichever occurs first. These policies also accrue cash value that may be borrowed for
living needs. An insurance license is required to sell life insurance.
The premium for life insurance is calculated according to the policyowner’s health, age,
and sex as well as the policy’s face amount at issue.

2. 8. 1 WHOLE LIFE INSURANCE

The foundation for all permanent insurance is whole life (WL) insurance. This policy has
a level premium, and the death benefit and cash value is guaranteed for the life of the policy.
Whole life is not a security; therefore, only an insurance license is required for sale.

2. 8. 1. 1 Cash Values
The cash value of whole life and other permanent policies represents a savings element
for the policyholder. Cash values grow tax-deferred and may be accessed via loan privileges
prior to age 59½ without penalty, while living (discussed later). The cash value of whole life

Series 6 [Link] 151 6/8/2016 [Link] PM

 152 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

increases each year the policy is kept in force. In traditional whole life insurance, the insurance
company invests premiums received in the insurance company’s general assets. General assets
are used to cover current and future obligations of the insurance company and are conserva-
tive investments such as government bonds, investment grade corporate bonds, real estate,
and mortgage loans. By investing conservatively, the insurance company is able to guarantee
the cash value of the policy.

2. 8. 2 VARIABLE LIFE INSURANCE

Variable life (VL) insurance has a fixed, scheduled premium but differs from whole life
insurance in that the premiums paid are split; part of the premium is placed in the general
assets of the insurance company. These general assets are used to guarantee a minimum death
benefit. The balance of the premium is placed in the separate account and represents the cash
value of the policy. Because the cash value is invested in the separate account that fluctuates
in value, cash value is not guaranteed. The policy’s death benefit may increase above the
minimum guaranteed amount as a result of investment results but may never fall below the
minimum (as long as premiums are paid).

✓
TA K E N O T E A variable life insurance policy has a minimum death benefit, the premiums nec-
essary to fund this part of the death benefit are held in the insurer’s general account.
Any policy benefit that is guaranteed is invested in the insurer’s general account.
Any premium above what is necessary to pay for the minimum death benefit is
invested in the separate account. This portion of the premium is subject to investment
risk and, therefore, variable life insurance is also defined as a security. As long as
premiums are paid, the policy remains in force even if the separate accounts lose
money every year.

Once the premium has been determined and the expenses have been deducted, the net
premium is invested in a separate account the policyowner selects.
Universal variable life insurance (UVL) is a type of variable life insurance with flexible
premiums (and an adjustable death benefit). Premiums are invested only in separate accounts
and cash values are not guaranteed, nor is there a guaranteed minimum death benefit. Premiums
may be increased or decreased over time but the policy must maintain a minimum cash value
to pay for expenses or the policy will lapse. The death benefit may be adjusted after issue but
if increasing the death benefit, proof of insurability will be required.

Comparison of Whole Life and Variable Life Policies

Whole Life Variable Life (VLI) Universal Variable Life (UVL)

Scheduled premium Scheduled premium Flexible premium

Fixed death benefit Minimum guaranteed plus No guaranteed minimum

variable death benefit death benefit but does have
an adjustable death benefit

Premiums to general account Premiums to general and Premiums to separate account

separate account

Guaranteed cash value No guaranteed cash value No guaranteed cash value

Series 6 [Link] 152 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 153

!
TEST TOPIC ALERT
If a UVL policy is funded properly, there is a death benefit but, technically, if the
insurance company knows neither when the next premium is coming nor how much
that premium will be, it can’t guarantee a minimum death benefit.
If cumulative premium payments exceed certain amounts specified in the Internal
Revenue Code, the life insurance policy will become a Modified Endowment Con-
tract (MEC). Once defined as a MEC, the status cannot be reversed and cash value
removed from the policy (in excess of premiums paid) in the form of loans, partial
surrenders, or withdrawals, are subject to ordinary income tax and a 10% penalty
(if done prior to the insured reaching age 59½). Distributions from MEC’s use LIFO
(Last-In-First-Out) accounting which means any cash value in excess of premiums
paid are distributed first.

✓
TA K E N O T E Any insurance product that includes the word variable requires both an insurance
license and securities license in order to sell it.

2. 8. 2. 1 Variable Life Prospectus Delivery

Because a variable life insurance policy is considered a security, a prospectus is required
just as with any new issue. The prospectus must be delivered prior to or at the time of solicita-
tion and may not be altered in any way (no highlighting or writing in the prospectus).

2. 8. 3 DEDUCTIONS FROM THE PREMIUM

Charges and expenses are deducted either from the gross premium or from the separate
account. The charges and expenses must be reasonable and described in the contract. When
and how they are collected is important because it affects the amount of premium that may be
invested in the separate account and the separate account’s investment return.
Deductions from the gross premium normally reduce the amount of money invested in the
separate account. Charges deducted from the gross premium include:
■■ the administrative fee;
■■ the sales load; and
■■ state premium taxes.

The administrative fee is normally a one-time charge to cover the cost of processing the
application.

2. 8. 4 DEDUCTIONS FROM THE SEPARATE ACCOUNT

Deductions from the separate account normally reduce the investment return payable to
the policy owner. Charges deducted from the separate account include:
■■ mortality risk fee (cost of insurance);
■■ expense risk fee; and
■■ investment management fee.

Series 6 [Link] 153 6/8/2016 [Link] PM

 154 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

The mortality risk fee covers the risk that the policyowner may live for a period other
than that assumed. The expense risk fee covers the risk that the costs of administering and
issuing the policy may be greater than assumed.

✓
TA K E N O T E
The exam may ask you which charges are deducted from the gross premium and
which are deducted from the separate account (the net premium). Remember the
acronym P.A.S.S. to make it simple. The charges deducted from the gross premium
include the following:
■■ Premium
■■ Administrative fee
■■ Sales load
■■ State premium taxes

Any other charges; such as cost of insurance, expense risk fees, and investment manage-
ment fees, are deducted from the separate account.

2. 8. 5 ASSUMED INTEREST RATE AND VARIABLE DEATH

BENEFIT

The death benefit payable under a variable life insurance policy consists of two parts: a
guaranteed minimum provided by the portion of funds invested in the general account, and
a variable death benefit provided by those invested in the separate account. The guaranteed
minimum does not change, but the variable portion of the death benefit must be recalculated
at least annually.
The effect that a change in earnings has on the contract’s variable death benefit depends
on a comparison of actual account performance and the performance assumed by the insur-
ance company. If the separate account returns are greater than the AIR, these extra earnings
are reflected in an increase in death benefit and cash value. If the separate account returns
equal the AIR, actual earnings meet estimated expenses, resulting in no change in the death
benefit. Should the separate account returns be less than the AIR, the contract’s death benefit
will decrease; however, it will never fall below the amount guaranteed at issue.

✓
TA K E N O T E
The variable death benefit is adjusted annually. If there have been several months
of negative performance, therefore, they must be offset by equivalent positive perfor-
mance before the variable death benefit can be adjusted upward.

2. 8. 6 HYPOTHETICAL ILLUSTRATIONS
The policyowner’s cash values reflect the investments held in the separate account. The
individual policy’s cash value must be calculated at least monthly.
The cash value, like the death benefit, may increase or decrease depending on the separate
account’s performance. If performance has been negative, the cash value may decrease to zero,
even if the contract has been in force for several years.
When illustrating hypothetical returns for variable life insurance cash value, the maximum
gross return is 12% provided a 0% return is also illustrated.

Series 6 [Link] 154 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 155

For scheduled premium policies, cash value may be accessed through surrendering the
policy or taking a loan.

✓
TA K E N O T E
The AIR has no effect on cash value accumulation in a variable life policy. The
cash value will grow whenever the separate account has positive performance. The
AIR, however, does affect the death benefit. Just remember the rules for variable an-
nuities. The rules for the death benefits are analogous.

■■ If the separate account performance for the year is greater than the AIR, the
death benefit will increase.

■■ If the separate account performance for the year is equal to the AIR, the
death benefit will stay the same.

■■ If the separate account performance for the year is less than the AIR, the
death benefit will decrease.

!
TEST TOPIC ALERT You may see a question that asks about the frequency of certain calculations as-
sociated with variable life insurance policies. Know that:

■■ death benefits are calculated annually;

■■ cash value is calculated monthly; and

■■ unit values are calculated daily.

2. 8. 7 LOANS
Like traditional WL, a VL contract allows the insured to borrow against the cash value
that has accumulated in the contract. Loans are not considered constructive receipt of income
and therefore are received income tax free. However, certain restrictions exist. Usually, the
insured may only borrow a percentage of the cash value. The minimum percentage that must
be made available is 75% after the policy has been in force for three years. There is no sched-
uled repayment of a loan. However, if the death benefit becomes payable and a loan is out-
standing, the loan amount is deducted from the death benefit before payment. The interest
rate charged is stated in the policy. If an outstanding loan reduces cash value to a negative
amount, the insured has 31 days to deposit enough into his account to make it positive. If he
fails to do so, the insurance company will terminate the contract. If this happens, the loan, of
course, need not be repaid.

!
TEST TOPIC ALERT Several testable facts about policy loans are as follows.
■■ 75% of the cash value must be available for policy loan after three years.

■■ If, due to poor separate account performance, the loan exceeds the policy
cash value, the policyowner must make payment to the insurer within 31
days.

Series 6 [Link] 155 6/8/2016 [Link] PM

 156 Series 6  Investment Company Products/Variable Contracts Limited Representative Exam

■■ If the insured dies with a loan outstanding, the death benefit is reduced by
the amount of the loan.

■■ If the insured surrenders his contract with a loan outstanding, cash value is
reduced by the amount of the loan.

2. 8. 8 CONTRACT EXCHANGE
During the early stage of ownership, a policyowner has the right to exchange a VL con-
tract for a traditional fixed-benefit WL contract. The length of time this exchange privilege is
in effect varies from company to company, but under no circumstances may the period be less
than 24 months (federal law).
The exchange is allowed without evidence of insurability. If a contract is exchanged, the
new WL policy has the same contract date and death benefit as the minimum guaranteed in
the VL contract. The premiums equal the amounts guaranteed in the new WL contract (as if
it were the original contract).

!
TEST TOPIC ALERT Two testable facts about the contract exchange provision are as follows.

■■ The contract exchange provision must be available for a minimum of two

years.
■■ No medical underwriting (evidence of insurability) is required for the
exchange.

2. 8. 9 SALES CHARGES AND REFUNDS

The separate account that funds VL contracts are defined under the Investment Company
Act of 1940 as periodic payment plans. They normally operate as either front-end load or
spread-load plans.

2. 8. 9. 1 Sales Charges
The sales charges on a fixed-premium VL contract may not exceed 9% of the payments
to be made over the life of the contract. The contract’s life, for purposes of this charge, is a
maximum of 20 years. For those of you familiar with life insurance compensation, the effect of
this is that renewal commissions are earned up to the 20th anniversary of policy issue.

2. 8. 9. 2 Refund Provisions
The insurer must extend a free-look period to the policyowner for 45 days from the execu-
tion of the application or for 10 days from the time the owner receives the policy, whichever
is longer. During the free-look period, the policyowner may terminate the policy and receive
all payments made.
The refund provisions extend for two years from issuance of the policy. If, within the
two-year period, the policyowner terminates participation in the contract, the insurer must
refund the contract’s cash value (the value calculated after the insurer receives the redemp-

Series 6 [Link] 156 6/8/2016 [Link] PM

 Unit 2  Product Information: Investment Company Securities and Variable Contracts 157

tion notice) plus all sales charges deducted in excess of 30% in the first year of the contract
and 10% in the second year. After the two-year period has lapsed, only the cash value need be
refunded; the insurer retains all sales charges.

!
TEST TOPIC ALERT
Several testable facts about sales charges and refunds are as follows.

■■ Because variable life is considered a contractual plan, the maximum sales

charge over the life of the contract is 9%.
■■ A policyowner who wants a refund within 45 days receives all money paid.
■■ Refund provisions are for two years
—— for the first year, the refund is sales charges in excess of 30% of the
premiums paid plus the cash value;
—— for the second year, the refund is sales charges in excess of 10% of the
premium paid plus the cash value; and
—— thereafter, the policyowner has access to the cash value only.

2. 8. 10 VOTING RIGHTS
Contract holders receive one vote per $100 of cash value funded by the separate account.
As with other investment company securities, changes in investment objectives and other
important matters may be accomplished only by a majority vote of the separate account’s
outstanding shares or by order of the state insurance commissioner. Contract holders must be
given the right to vote on matters concerning separate account personnel at the first meeting
of contract holders within one year of beginning operations.

!
TEST TOPIC ALERT Do not confuse the voting rights of variable annuities and variable life. Variable
annuities and mutual funds are the same: one vote per unit (share). Variable life is one
vote per $100 of cash value (fractional votes are allowed).

2. 8. 11 LIFE SETTLEMENTS
Selling a life insurance policy (or the right to receive the death benefit) to an entity other
than the insurance company that issued the policy is a transaction known as a life settlement
(they used to be called viaticals). When the sale involves a variable life insurance policy, vari-
able life settlements are securities transactions that are subject to the federal securities laws
and all applicable FINRA rules. In particular, the regulators are concerned about suitability
an