Understanding Products and Their Risks practice questions

Answer: B) Usually the parent or other person who opened it

• AIncorrect. The owner usually controls it.
• BCorrect. The beneficiary can be changed.
• CIncorrect. The account owner controls it.
• DIncorrect. The account owner controls it.

Answer: B) The stock price is below the strike price

• AIncorrect. That's out of the money.
• BCorrect. The holder can sell above market.
• CIncorrect. That's at the money.
• DIncorrect. That's time, not moneyness.

Answer: A) Falling rates lead homeowners to refinance, so principal returns early and must be reinvested at lower rates

Prepayment risk is the risk that falling rates prompt refinancing, which returns MBS principal early and forces reinvestment at lower rates. Its opposite, extension risk, happens when rising rates slow prepayments.

• ACorrect. SEC staff identify refinancing as the main driver of prepayments. Borrowers tend to prepay when rates fall, which is the worst time for investors, because the returned principal must be reinvested at lower yields.
• BIncorrect. This describes extension risk, the opposite situation: the security pays back later than expected when rates rise.
• CIncorrect. This describes default (credit) risk, not the risk that principal is repaid early.
• DIncorrect. This describes general interest rate (market) risk, which applies to all fixed-income securities and is not specific to early principal repayment.

Answer: B) Surrender charge

• AIncorrect. That isn't a charge.
• BCorrect. Charges usually decline over a set period.
• CIncorrect. That's a margin term.
• DIncorrect. That's a bond term.

Answer: B) Qualified education

• AIncorrect. Non-qualified withdrawals are taxed and penalized.
• BCorrect. Withdrawals for qualified education costs are tax-free.
• CIncorrect. This isn't qualified.
• DIncorrect. This isn't qualified.

Answer: B) Triple tax-exempt

• AIncorrect. They are exempt.
• BCorrect. Interest is exempt from federal, state and local tax.
• CIncorrect. They are exempt federally.
• DIncorrect. They are exempt.

Answer: A) Import/export trade

• ACorrect. It is a short-term money market instrument.
• BIncorrect. That uses mortgage loans.
• CIncorrect. That's not its use.
• DIncorrect. That's not its use.

Answer: B) Exchanging a whole life insurance policy for a new deferred annuity contract

Section 1035 allows tax-free exchanges of life insurance for life insurance, endowment, annuity or qualified LTC contracts, and of annuities for annuities or qualified LTC contracts. It does not allow annuity-to-life exchanges or exchanges into non-insurance products.

• AIncorrect. Section 1035(a) lets an annuity be exchanged tax-free only for another annuity or a qualified long-term care contract, not for a life insurance policy.
• BCorrect. Section 1035(a)(1) lets a life insurance contract be exchanged for another life insurance, endowment, annuity or qualified long-term care contract with no gain recognized.
• CIncorrect. A mutual fund is not an insurance or annuity contract, so moving out of the annuity is a taxable distribution of any gain.
• DIncorrect. A fund-family exchange privilege may waive sales charges, but for tax purposes it is a sale and purchase, and Section 1035 does not cover it.

Answer: D) Fall

• AIncorrect. This is false.
• BIncorrect. They usually fall.
• CIncorrect. Prices adjust.
• DCorrect. Bond prices and yields move in opposite directions.

Answer: A) Shareholders may combine votes and cast them all for one director

• ACorrect. It helps minority shareholders.
• BIncorrect. That's statutory voting.
• CIncorrect. Common holders vote.
• DIncorrect. Shareholders vote.