NASD Series 7

Exam Preparation Manual

Professional Training Services, Inc.

579 N 1st Bank Drive, Suite 150
Palatine, IL 60067
(847) 705-3838
Table of Contents
Series 7 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Series 7 SuccessTrak Workbook. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Exam Alerts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Study Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Topics Covered . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Series 7 Exam . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Exam Center . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Series 7 Exam Results Fasimile. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Study Process Help. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Series 7 Exam Breakdown . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Successful Test Taking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Test Taking Techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Time Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Calculator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Changing Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Guessing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Final Thoughts on Test Taking Techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Corporate Securities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
General Information. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Investment Securities Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Corporate Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Liquidation Order . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Safety of Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Stock Certificate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
CUSIP Numbers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Negotiability. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Issuance of Shares (Capitalization Process) . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Primary Offering Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Treasury Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Ownership in the Corporation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Stock Quotes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Shareholder Rights and Features . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Due Bill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Voting Rights. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Non-Voting Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
Preemptive Rights. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
Right . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Stock Splits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Reverse Stock Split. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
 Benefits of Owning Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Short Sale Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Growth. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Risks of Owning Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Market Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Decreased or No Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Final Right to Assets (Known as Residual Claims) . . . . . . . . . . . . . . . . . . . . . . 27
Classifying Stocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
Growth Stocks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
Income Stocks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
Blue Chip Stocks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
Defensive Stocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
Cyclical Stocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
Seasonal Stocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
Preferred Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Preferred Stock Defined . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Preferred Stock vs. Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Dividend Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Dividend Preference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Fixed Rate of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Adjustable-Rate Preferred . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
No Maturity Date . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
Types of Preferred Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
Straight Preferred . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
Cumulative Preferred . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
Convertible Preferred . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Conversion Ratio. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
Conversion Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
Callable Preferred . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Participating Preferred . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Interest Rate Issues and Preferred Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Investment Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
Total Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
Calculating Total Return of Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
Current Yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
Cash Dividend . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
Stock Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
Additional Corporate Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Warrants. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
American Depository Receipts (ADR) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Major Risks of Owning ADRs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Real Estate Investment Trusts (REITs) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
Important Corporate Persons . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
Transfer Agent. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
Registrar. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
Corporate Review Questions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
Review Explanations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
Primary Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
Regulatory Issues for New Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
Securities Act of 1933 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
Underwriting Phase. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
Registration Phase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
Cooling-Off Phase. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
Due Diligence Phase. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
Statutory Prospectus. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
Advertising New Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
Investment Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
Participants in a New Issue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
Issuer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
Investment Banker . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
Underwriter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
Selling Syndicate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
Selling Group . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
Example of a Syndicate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
Public Offerings vs. Private Offerings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
Types of Offerings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
Underwriting Agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
Types of Underwriting Agreements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
Underwriting Compensation (Review) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
Industry Rules on Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
Stabilization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
Stabilization Rules. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
Market Out Clause. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
Allocation of Orders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
Western vs. Eastern Underwriting. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
Western Account. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
Eastern Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
Exempt Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
Exempt Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
Regulation A Offering . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
Rule 147 Offering . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
Regulation D Offering . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
Control Stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
Rule 144 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
.Rule 144 Rules. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
Antifraud Provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
 New Issues Review Questions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
New Issues Review Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
Debt Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
Issuers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
Maturities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76
Serial Bond Issue Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76
Debt Instruments Terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
Bond Certificate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
Types of Registrations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
Coupon (Bearer) Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
Fully Registered Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
Registered as to Principal Only. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
Book-Entry Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
Par value/Principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
Indenture (Deed of Trust) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
Maturity Date (Bond Redemption) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
Coupon/Nominal Yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
Callable Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
Call Features. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
Call Premium. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
Refunding (Similar to calling in an issue) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
Tender offers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
Put Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
Lengths of Debt Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
Bond Ratings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
Bond Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
Bond Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
Premium Bond (Secondary market trading) . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
Discount Bond (Secondary market trading) . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
Points vs. Basis Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
Pricing of Different Types of Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
Corporate Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
U.S. Government Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83
Municipal Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83
Interest Rates and Yields . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83
Market Interest Rates Affecting Bond Prices . . . . . . . . . . . . . . . . . . . . . . . . . . 84
Yield/Price Fulcrum . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
Nominal Yield (NY) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
Current Yield (CY). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
Yield to Maturity (YTM - Basis) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
Yield to Call (YTC) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
Example #3: Discount Bond . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86
Bond Pricing Exam Examples. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
 Convertible Bond Features . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
Conversion Ratio. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
Conversion Price. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
Parity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
Additional Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
Forced Conversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
Advantages to the Issuer for a Conversion . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
Advantages to the Investor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
Disadvantages to the Issuer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
Disadvantages to the Investor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
Pricing of Convertible Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
Corporate Debt Obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
Trust Indenture Act of 1939 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
Secured Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
Types of Senior Bonds/Secured Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
Other Bonds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
Unsecured Bonds (Known as Debentures). . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
Zero Coupon Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
Income Bonds (Adjustment Bonds). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
Speculative Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
Eurobonds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
Eurodollar Bonds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
Secondary Trading of Corporate Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
Newspaper Listing Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
Accrued Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
Accrued Interest Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
Accrued Interest Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
Corporate Bond Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
Corporate Bond Accrued Days . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
U.S. Government Bond Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98
U.S. Government Securities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
Marketable Government Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
Treasury Bills . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
Treasury Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
Treasury Bonds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
Secondary Market Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
Taxation of Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
Treasury Receipts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
STRIPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
Treasury Inflation Protection Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
Non-Marketable Government Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
Series EE Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
Series HH Savings Bonds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
U.S. Government Agency Obligations . . . . . . . . . . . . . . . . . . . . . . . . 105
Agency Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
Yields and Maturities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
Reinvestment Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
Ginnie Maes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
Farm Credit System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
Federal Home Loan Mortgage Corporation . . . . . . . . . . . . . . . . . . . . . . . . . . 106
Federal National Mortgage Association . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107
Student Loan Marketing Association . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107
Reading Debt Instrument Financial News . . . . . . . . . . . . . . . . . . . . . 109
Treasury Bills. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
Treasury Notes and Bonds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110
Government Agency Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110
Collateralized Mortgage Obligations (CMOs). . . . . . . . . . . . . . . . . . . 111
CMO Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
CMOs Average Life . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
Tranches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112
Modern CMOs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112
Planned Amortization Class (PACs) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112
Targeted Amortization Class. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
Yield Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
Normal Yield Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
Flat Yield Curve. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116
Inverted Yield Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117
Debt Instruments & Related Items Review . . . . . . . . . . . . . . . . . . . . . . . . . . . 117
Debt Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
Review Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123
Money Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
Money Market Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
Liqudity and Safety . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
Money Market Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
Repurchase Agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
Reverse Repurchase Agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
Bankers Acceptances. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
Commerical Paper . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
Negotiable Certificates of Deposit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
Money Market Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
 Review Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
Tax Advantaged Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
Municipal Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
Municipal Securities Overview. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
Legal Opinion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132
Bond Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132
Municipal Bond Ratings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
Types of Municipal Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
General Obligation Bonds (GO) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
Double-Barreled Bonds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134
Analyzing GO Bonds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134
Revenue Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
Features of Revenue Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
Revenue Bond Income Examples. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
Analyzing Revenue Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
Feasibility Study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
Facility Use Charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
Number of Users . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
Protective Covenants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
Flow of Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
Types of Revenue Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138
Other Municipal Bond Issues. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138
Municipal Notes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139
Municipal Issue Documents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140
Official Statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140
Bond Authorizing Resolution. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
Bond Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
Underwriters Counsel. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
Municipal Securities Sources of Information . . . . . . . . . . . . . . . . . . . . . . . . . 142
Bond Buyer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
Indexes compiled in the Bond Buyer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
Munifacts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
Blue List . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
Issuing Municipal Securities
(Primary Market). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
Negotiated Offering . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
Competitive Offering . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
Formation of the Underwriting Syndicate . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144
Syndicate Agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
Types of Syndicate Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
Due Diligence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
Allocation of Municipal Orders (New Issue) . . . . . . . . . . . . . . . . . . . . . . . . . . 146
Disclosure of Orders. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147
Additional Municipal Trading Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147
Brokers Broker . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147
 When Issued Basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147
Dated Date . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
Round Lot . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
Secondary Municipal Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
Types of Trades . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
Types of Municipal Bond Quotes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
Commissions and Markups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149
Trade Confirmations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149
Principal versus Agency Trade Confirmation . . . . . . . . . . . . . . . . . . . . . . . . . 150
Yield Disclosed on Confirmation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
Variable Rate Municipal Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
Zero Coupon Municipal Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
Municipal Securities General Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
Anti-reciprocal Rule. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
Customer Accounts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
Control Disclosure Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
Municipal Securities Rulemaking Board (MSRB) . . . . . . . . . . . . . . . 153
Municipal Securities Rulemaking Board Overview . . . . . . . . . . . . . . . . . . . . 153
MSRB Rules Enforcement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
MSRB Numbering System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
Municipal Securities Tax Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
Municipal Securities Tax Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
State Tax Free Issues (Double Tax Free). . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
Taxable Equivalent Yield (TEY) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
Bond Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
Amortization and Accretion of Premium. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
Premium Bond . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
Discount Bond. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161
Direct Participation Programs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
Business Entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
Corporation? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
Partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
Direct Participation Programs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
Limited Partnership History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
Limited Partnership Formation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
Certificate of the Limited Partnership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
Partnership Certificate Changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
Partnership Agreement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
Rights of the General Partner . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
Obligations of the General Partner . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
Rights of Limited Partners. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
Obligations of the Limited Partner. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
Asset Distribution Upon Dissolution. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
 Tax Qualifying a Partnership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
Four Characteristics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167
Tax Return Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167
Partnership Basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167
Items that Establish the Basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
Items that Increase the Basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
Items that Reduce the Basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
Basis Test Question Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169
Real Estate Partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170
Major Tax Issues. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170
Raw Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170
New Construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170
Existing Housing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
Government Assisted Housing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
Oil and Gas Programs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172
Exploratory Program . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172
Developmental Programs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172
Income Programs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172
Combination Oil and Gas Programs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
General Partner Sharing Arrangements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
Evaluating a Limited Partnership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
Subscription Agreement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
Suitability Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
Sponsor Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
Miscellaneous Partnership Issues. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
Final Test Point . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
More Limited Partnerships Tax Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
Deductible Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
Costs Recovered Over Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
Depletion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
Prepaid Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
Organization Fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
Tax Credits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
Alternative Minimum Tax (AMT). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
Tax Advantaged Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . 179
Rules Review Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183
Investment Companies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187
Investment Companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187
Types of Investment Companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188
Unit Investment Trust . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188
Face Amount Certificate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188
Management Company (Majority of test questions) . . . . . . . . . . . . . . . . . . . . 188
Closed-end . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189
Open-end . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189
Diversified and Non-Diversified Company . . . . . . . . . . . . . . . . . . . . . . . . . . . 190
Diversified Investment Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190
Non-diversified Investment Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190
Open-End Mutual Funds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191
Fund Diversification. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192
Professional Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192
Investment Objectives of the Fund . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193
Securities in a Portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193
Timing of Investment Decisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193
Tax Status of Fund Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193
Taxable Mutual Funds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193
Tax-Free Mutual Funds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
Financial/Economic Research and Analysis . . . . . . . . . . . . . . . . . . . . . . . . . 194
Fund Shares. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195
Full and Fractional Shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195
Continual Offering and Fund Redemption. . . . . . . . . . . . . . . . . . . . . . . . . . . . 195
Voting Rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195
Board of Directors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196
Underwriters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197
Transfer Agent. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198
Custodian Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198
Investment Advisor (Fund Manager) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198
Cost of Operating a Mutual Fund. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199
Rights of Shareholders. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199
Types of Fund Distributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
Net Investment Income Per Share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
Capital Gains. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
Return of Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
Unrealized Appreciation/Depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
Distribution Alternatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
Convenience and Services Provided to Investors . . . . . . . . . . . . . . . . . . . . . 201
Systematic Withdrawal Plans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
Minimum Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
Potential Exhaustion of Principal. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
Types of Withdrawal Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
Mutual Funds by Investment Objective. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204
Growth Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204
Aggressive Growth Fund. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204
Conservative Growth Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204
Income Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205
Growth and Income Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205
Specialized Funds (Sector) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205
Asset Allocation Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206
Tax-Exempt Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206
Mutual Funds by Underlying Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206
 Money Market Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206
Bond and Preferred Stock Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207
Common Stock Funds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207
Municipal Bond Funds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207
Government Securities Funds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207
GNMA Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208
Option Funds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208
Foreign Securities Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208
Precious Metal Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208
Important Factors in Comparison of Funds . . . . . . . . . . . . . . . . . . . . . . . . . . 209
Basis of Comparison . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
Investment Objectives. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
Investment Policies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
Issues to be compared;. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
Quality of Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210
Risk Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210
Performance Statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210
Expense Ratio. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
Sources of Performance Statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212
Selling Fund Shares to the Public . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212
Fund to Underwriter to Dealer to Investor . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212
Fund to Underwriter to Investor. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212
Fund to Investor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213
Price of Mutual Fund Shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213
Net Asset Value (NAV) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213
Changes in the NAV . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213
Ex-Dividend. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214
Selling Dividends Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214
Redemption Fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214
Fees and Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214
Sales Charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214
Sales Charges and Class A Shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215
Class A Shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216
Contingent Deferred Sales Charge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216
Level Load (C Class Shares) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216
Distribution Plans/SEC Rule 12b-1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217
Newspaper Quotes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218
Reading the Chart . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218
Mutual Fund Symbols . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218
Reduced Sales charges/Quantity Discounts . . . . . . . . . . . . . . . . . . . . . . . . . 219
Letter of Intent (LOI) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220
Rights of Accumulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220
Dollar Cost Averaging. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221
Redemption of Mutual Funds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222
Redemption methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223
Basis for the Redemption Price. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223
 Prospectus. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223
SEC No Approval Clause . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224
Contractual Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
Contractual Plan Characteristics. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
Contractual Plan Elements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
Prospectus Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
Operation of Contractual Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226
Front-End and Spread Load Features . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226
Front-end load. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226
Spread Load . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226
Terminating a Plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226
Right to Refund . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226
18 Month Surrender Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
Contractual Plan Surrender Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
Example #2: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228
Exchange Traded Funds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
Advantages of ETFs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
Disadvantages of ETFs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
List of Exchange Traded Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
Opening a Mutual Fund Account. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231
Required Minimum Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231
Dividend/Capital Gains Election . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231
Account Documentation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231
Types of Special Accounts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232
Corporate Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232
Partnership Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232
Trust & Fiduciary Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232
Investment Advisor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233
Forms of Ownership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233
Individual Ownership. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233
Joint Ownership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233
Uniform Gift/Transfer to Minors Act. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234
Mutual Fund Tax Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235
Tax Consequences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235
Regulated Investment Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235
Tax Treatment of Capital Gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235
Tax Treatment of Income Distributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 236
Reinvested Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 236
Fund Switching . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 236
Tax Consequences of Investors Activities . . . . . . . . . . . . . . . . . . . . . . . . . . 236
Net Capital Gain/Loss Computation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 236
Tax Basis of Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237
Offering Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237
 Exchange of Securities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237
Reinvestment of Dividends and Capital Gains. . . . . . . . . . . . . . . . . . . . . . . . 237
Section 529 Savings Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 238
Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239
Review Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249
Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255
Option Defined. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255
Some Reasons to Trade Options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255
The Options Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255
Synonymous Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255
The Buyer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256
The Seller . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256
Types of Option Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256
Call Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256
Put Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256
Option Class . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256
Option Series . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256
The Anatomy of a Long Call Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257
The Anatomy of a Short Call Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257
The Anatomy of a Long Put Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 258
The Anatomy of a Short Put Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 258
Single Option Strategies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259
Basic Market Strategy Review (Know all of these) . . . . . . . . . . . . . . . . . . . . . 260
Market Attitude Review (Know all of these) . . . . . . . . . . . . . . . . . . . . . . . . . . 260
In, Out and At the Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260
In-the-Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260
At-the-Money. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261
Out-of-the-Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261
Exercise Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
Intrinsic Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
Makeup of A Premium. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
Time Value (Premium). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
Breakeven . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
Breakeven for Calls. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
Breakeven for Puts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264
Important Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264
Miscellaneous Option Terminology. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264
Sample Option Chart. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 265
Option Review One . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266
Option Review One Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267
Options Rules and Regulations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269
Options Clearing Corporation (OCC) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269
Adjustments To Option Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270
 Option Exchange Persons . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271
New Options Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271
Option Tax Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271
Option Review Two Questions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273
Option Review Two Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 274
Equity Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275
T-Charts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275
Buying Calls. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275
Call Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275
Buying Puts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279
Put Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279
Terminology and Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280
Exercising Option Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280
Open Interest: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281
Writing (Selling) Options (Income Strategy) . . . . . . . . . . . . . . . . . . . . . . . . . . 281
Option Review Three. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283
Option Review Three Answers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285
Multiple Option Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287
Straddles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287
Long Straddle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287
Short Straddle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
Combinations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
Breakevens for Straddles & Combinations . . . . . . . . . . . . . . . . . . . . . . . . . . . 289
Straddle/Combination Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 291
Spreads . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293
Spreads Defined . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293
Spread Reminders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294
Risk Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295
Spread Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296
Example 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297
Example 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 298
Spread Narrowing or Widening of Premiums . . . . . . . . . . . . . . . . . . . . . . . . . 299
Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299
Multiple Options Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301
Multiple Options Review Answers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303
Hedging Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
Hedging Options Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
Protecting a Stock Position . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
Long Stock Position . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
Short Stock Position . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306
Option Collar . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 307
Collar Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 307
Non Equity Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 309
Index Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 309
Broad-based Index Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310
Narrow-based Index Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310
Index Option Features. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310
Capped Index Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310
LEAPs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311
Interest Rate Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311
Price-Based Option Features . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311
Yield-Based Option Features . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312
Foreign Currency Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312
Foreign Currency Option Features . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313
OptionReview Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315
Option Review Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316
Customer Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319
New Account Form . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319
Suitability Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319
NYSE Know Your Customer Rule. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319
Options Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
Day Trading Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321
New Account Approval . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321
Opening the New Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322
Account Approval . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322
Mailing Instructions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322
Cash Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323
Margin Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323
Margin Account Features (Detail Discusssed Later). . . . . . . . . . . . . . . . . . . . 323
Types of Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325
Retirement Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325
Joint Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325
Joint Tenancy With Rights of Survivorship (JTROS) . . . . . . . . . . . . . . . . . . . 325
Joint Tenancy in Common . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325
Transfer on Death (TOD). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325
Corporate Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326
Partnership Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326
Fiduciary Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326
Fiduciary Account Features . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326
Trust Account Required Paperwork . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327
Guardian Account Required Paperwork . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327
Power of Attorney . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327
Types of Trading Authorizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328
Discretionary Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328
Uniform Gifts to Minors Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329
 Kiddie Tax Rule. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330
Minors Death . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330
Accounts for Investment Advisers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330
Opening An Omnibus Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330
Investment Adviser Account Features . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330
Numbered Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331
Account Maintenance Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331
Transfer or Closing of Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332
Account Transfer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332
Death of a Customer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333
Margin Accounts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335
Margin Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335
Margin Agreement Terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335
Advantages of Margin Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 336
Marginable Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 336
Types of Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337
Cash Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337
Arbitrage Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337
Margin Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337
Initial Margin Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 338
Margin Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339
Long Account Terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339
Long Margin Account Mechanics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340
NASD/NYSE Minimum Maintenance Requirement. . . . . . . . . . . . . . . . . . . . . 343
Margin Call Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 344
Short Account Terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 344
Short Margin Account Mechanics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345
NASD/NYSE Minimum Maintenance Requirement. . . . . . . . . . . . . . . . . . . . . 347
Combined Margin Accounts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 347
Question: What is the net equity of this margin account? . . . . . . . . . . . . . . . . 347
Margin Review Questions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 349
Margin Review Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351
Brokerage Support Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353
Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353
Processing of an Order. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353
Order Department . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353
Purchase and Sales Department . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353
Margin or Credit Department. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353
Cashiering Department . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353
Clearing Firms. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354
Reorganization Department . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354
Dividend Department . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354
Proxy Department . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354
Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 356
 Order Tickets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 356
Execution Report. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357
Trade Confirmations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 358
Customer Account Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359
Financial Condition Disclosure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359
Charges for Services Performed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359
Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 361
Review Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 362
Trading Securities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365
Introduction to Trading. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365
Securities Markets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365
First Market (Listed Market) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365
Second Market (Unlisted Market) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365
Third Market (OTC-Listed) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 366
Fourth Market (Institutions) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 366
Options Trading. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 366
NYSE Bond Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 366
Trading Halts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 366
Role of the Broker-Dealer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367
Broker . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367
Dealers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367
Ways to Fill an Order . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367
Dealer Quotes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 368
Active vs. Thinly Traded Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 368
New York Stock Exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 368
Auction Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369
Types of Traders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369
Floor Broker . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369
Two-Dollar Broker . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369
Registered Trader . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369
Specialist. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369
Volatile Trading Conditions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 370
Stopping Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 370
Types of Orders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371
Order Qualifiers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371
Day Order . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371
Good Till Canceled . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371
At-the-Open. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371
At-the-Close . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371
Not Held Order . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371
Fill or Kill (FOK). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371
Immediate or Cancel (IOC) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371
All or None (AON) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371
Either/Or . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
 Market Order . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
Limit Order . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
Buy Limit Order . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
Sell Limit Orders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 373
Stop Orders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 373
Sell Stop Orders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 373
Sell Stop Limit Orders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 374
Buy Stop Orders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375
Buy Stop Limit Orders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376
More on Buy Stop Orders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377
Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 381
Review Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 382
Exchange Trades . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 383
Long and Short Sale Rules. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 383
Long Sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 383
Short Sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 383
Specialists Book. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 385
Specialists Book Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 385
Consolidated Tape . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 386
Network A - NYSE. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 386
Network B - AMEX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 386
Stock Symbols . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 386
Trading Block . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 386
NYSE Trading Tape Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 387
Over the Counter Market (OTC) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 389
OTC Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 389
NASDAQ. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 389
Financial News Sources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 390
Pink Sheets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 390
Yellow Sheets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 390
Blue List . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 390
OTC Operations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 390
Inside Market. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 391
Backing Away . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 392
Types of Quotes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 392
Front Running . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 392
Computerized Order Routing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 392
New York Stock Exchange SuperDot . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 392
NASD SOES System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 393
NASDAQ SuperMontage (Not currently tested) . . . . . . . . . . . . . . . . . . . . . . . 393
Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 395
Review Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 396
Transaction Settlement Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 397
 Settlement Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 397
Regular Way Settlement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 397
Settlement Rules for Specific Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 397
Cash Way Settlement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 397
Good Delivery of Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 397
When, As, and If Issued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 398
Comparisons and DK Notices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 398
Comparison Details. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 399
Rejection and Reclamation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 399
Retirement Plans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 403
Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 403
Retirement Planning Choices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 403
ERISA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 403
Qualified Retirement Plans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 404
Nonqualified Retirement Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 404
Traditional Individual Retirement Account . . . . . . . . . . . . . . . . . . . . . . . . . . . 405
Purpose, Funding and Eligibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 405
Other Features and Rules. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 405
Exceptions to taking a distribution prior to age 59 without a penalty include; 405
IRA Transfers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 406
IRA Rollovers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 406
Non-Allowable IRA Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 406
Allowable IRA Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 406
Roth IRA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 406
Simplified Employee Pension Plan (SEP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 407
SEP Eligibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 407
SEP Participation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 407
Keogh/HR-10 Plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 407
Eligibility Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 408
Keogh Features. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 408
Corporate Pension Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 408
Defined Contribution Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 408
Defined Benefit Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 408
Types of Defined Contribution Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 409
Profit-Sharing Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 409
401(k) Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 409
Employee Stock Ownership Plan (ESOP) . . . . . . . . . . . . . . . . . . . . . . . . . . . 410
403(b) Plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 410
Section 529 Savings Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 411
Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 413
Review Explanations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 415
Annuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 417
Defining an Annuity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 417
Fixed Annuity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 417
 Variable Annuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 417
Variable Annuity Features . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 418
Combination Annuity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 419
Types of Variable Annuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 419
Comparing Variable Annuities to Mutual Funds . . . . . . . . . . . . . . . . . . . . . . 419
Purchasing Annuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 420
Annuity Phases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 420
Receiving Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 420
How AIR Works. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 421
Annuity Payout Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 422
Straight Life Annuity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 422
Life Annuity with a Period Certain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 422
Joint and Last Survivor Life annuity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 423
Other Contractual Provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 423
Mortality Guarantee. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 423
Expense Guarantee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 423
Taxation of Annuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 423
Annuity Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 425
Variable Annuity Review Answers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 426
Economics. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 431
Economics Module Overview. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 431
Economics Defined . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 431
Business Cycle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 431
Features of a Business Cycle Expansion . . . . . . . . . . . . . . . . . . . . . . . . . . . . 432
Features of a Business Cycle Downturn . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 432
Economic Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 432
Recession (Bad) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 432
Depression (Worse) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 433
Gross Domestic Product (GDP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 433
Consumer Price Index (CPI) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 433
Producer Price Index (PPI) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 433
Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 433
Deflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 434
Economic Indicators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 434
Leading Economic Indicators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 434
Coincident Economic Indicators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 434
Lagging Economic Indicators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 435
Economic Theories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 435
Keynesian Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 435
Supply Side Theory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 436
Monetarist Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 436
Fiscal Policy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 436
Expenditure Programs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 436
Monetary Policy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 437
Money Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 437
 Federal Reserve Board . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 438
FRBs Influence on the Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 438
FRB Tools . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 438
Fiscal & Monetary Policy Effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 441
Securities Markets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 441
Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 441
Disintermediation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 443
International Monetary factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 443
Balance of Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 443
Balance of Payments Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 444
Economics Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 445
Economic Review Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 446
Fundamental Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 447
Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 447
Fundamental Analyst . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 447
Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 447
Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 447
Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 449
Stockholders Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450
Balance Sheet Terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450
Income Statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 452
Components of the Income Statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 453
Statement of Changes to Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . 453
Analyzing Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 454
Liquidity Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 454
Capitalization Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 456
Additional Financial Formulas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 457
Evaluation of Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 458
Price Earnings Ratio (P/E) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 460
Sources of Financial Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . 461
Annual Reports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 461
Newspaper Listings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 461
Stock Table Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 462
Financial Formulas Recap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 465
Exam Overview of Financial Formulas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 465
Liquidity Formulas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 465
Capitalization Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 465
Coverage Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 465
Use of Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 465
Profitability. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 466
Evaluation of Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 466
Fundamental Analysis Review Questions . . . . . . . . . . . . . . . . . . . . . 467
 Review Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 469
Technical Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 471
Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 471
Market Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 471
Indexes and Averages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 471
Trading Volume . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 472
.Weekly Volume by Markets of NYSE Stocks . . . . . . . . . . . . . . . . . . . . . . . . . 473
Technical Market Theories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 473
Technical Analysis Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 473
Short Interest Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 474
The Odd-Lot Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 474
Advance-Decline Theory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 475
Dow Theory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 476
Charts and Patterns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 477
Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 477
Trendlines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 477
Resistance & Support Lines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 478
Breakout . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 479
Reversals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 479
Saucer Patterns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 479
Reverse Saucer Pattern . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 480
Technical Analysis Review Questions . . . . . . . . . . . . . . . . . . . . . . . . 481
Technical Analysis Review Answers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 482
Portfolio Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 483
Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 483
Factors Affecting Investment Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . 483
Specific Examples. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 483
Portfolio Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 484
Systematic Risk. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 484
Non-Systematic Risk. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 484
Capital Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 484
Timing Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 484
Selection Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 484
Legislative Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 484
Liquidity Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 484
Purchasing Power (Inflationary) Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 485
Interest Rate Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 485
Reinvestment Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 485
Call Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 485
Portfolio Management Policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 485
Active Asset Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 486
Passive Asset Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 486
 Portfolio Theory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 486
Portfolio Diversification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 486
Capital Asset Pricing Theory (CAPT) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 487
Asset Allocation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 488
Portfolio Construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 489
Traditional Portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 489
Strategic Asset Allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 489
Tactical Asset Allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 490
Asset Classes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 490
Alpha and Beta Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 490
Alpha . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 490
Beta. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 491
Portfolio Analysis Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 492
Portfolio Analysis Review Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 493
Federal Securities Acts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 497
Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 497
Federal Securities Acts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 497
Securities Act of 1933 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 497
Securities Exchange Act of 1934 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 499
Anti-Fraud Provision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
Securities Investor Protection Corporation (SIPC) . . . . . . . . . . . . . . . . . . . . 500
SIPC Coverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 501
Trust Indenture Act of 1939 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 501
Trust Indenture Act Rules Apply to; . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 502
Investment Company Act of 1940 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 502
Investment Advisors Act of 1940 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 502
Insider Trading and Securities Fraud Enforcement Act of 1988. . . . . . . . . . 502
Federal Telephone Consumer Protection Act . . . . . . . . . . . . . . . . . . . . . . . . 503
Anti-Money Laundering Rules (Patriot Act) . . . . . . . . . . . . . . . . . . . . . . . . . . 503
Anti-Money Laundering Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503
Penny Stock Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505
Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507
Review Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 508
Registration and Regulation of Broker-Dealers. . . . . . . . . . . . . . . . . 509
Securities and Exchange Commission (SEC) . . . . . . . . . . . . . . . . . . . . . . . . 509
Fingerprinting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509
Self-Regulatory Organizations (SRO) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509
NASD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510
Purpose of the NASD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510
NASD Districts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510
NASD Dues and Assessments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511
NASD Membership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511
Application. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511
NASD Manual . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 512
 Associated Person Registration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513
Qualification Examinations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514
Limited Representative License (Series 6) . . . . . . . . . . . . . . . . . . . . . . . . . . . 514
General Securities Representative (Series 7). . . . . . . . . . . . . . . . . . . . . . . . . 514
Assistant Representative-Order Processor (Series 11) . . . . . . . . . . . . . . . . . 514
General Securities Principal (Series 24) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514
Limited Principal (Series 26) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515
Series 9 and 10 (formerly Series 8) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515
Ineligibility and Disqualifications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515
Continuing Education Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516
Regulatory Element. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516
Firm Element. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516
Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 517
Review Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518
Advertising and Sales Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519
Advertising Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519
Advertising. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519
Sales Literature . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519
Approval . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520
Filing Advertising with the NASD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520
Exclusions from Filing Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520
Truthful Advertisements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520
Advertising Disclosure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521
Other Advertising Rules and Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521
Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 523
Review Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 524
Conduct Rules. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525
Conduct Rules Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525
Suitability Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525
Suitability Inquiries to Customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525
Conduct Violations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525
Office of Supervisory Jurisdiction (OSJ) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 527
Supervisory Rules. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 527
Recent Mutual Fund Sales Rules. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 528
Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 529
Review Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 530
Code of Procedure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 531
Code of Procedure Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 531
Regular Complaint Procedure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 531
Complaint Procedure Violations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 531
Settlement Offer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 531
Potential Penalties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 531
Summary Complaint Procedure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 532
Uniform Code of Arbitration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 533
Uniform Code of Arbitration. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 533
Matters Eligible for Submission. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 533
Arbitration Issues and Procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 533
National Arbitration Committee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 534
Arbitration Awards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 534
Composition of Arbitration Panels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 534
Simplified Arbitration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 534
Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 535
Review Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 536
NYSE Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 537
NYSE. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 537
Rep Training Period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 537
Registration of Personnel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 537
Moonlighting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 537
Notification to the NYSE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 538
Correspondence Approval . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 538
Truthfulness of Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 539
Binding Arbitration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 539
Gift Limit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 539
NYSE Customer Account Rules. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 539
NYSE Prohibited Activities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 541
Limitations on Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 541
Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 542
Review Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 543
Abbreviations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 547
Glossary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 551
Introduction
 Series 7 Introduction

Section 2: Series 7 Introduction

Welcome to the Professional Training Services Series 7 SuccessTrak License
Exam Workbook. Please read this entire Section prior to beginning your course
studies.
2 . 1 S E R I E S 7 S U C C E S S TR A K W O R K B O O K
This workbook consists of subject content, subject review questions, commonly
used abbreviations and an extensive glossary. The workbook is structured with
General Subject Modules with Specific Subject Sections within each Module. In
addition to this workbook, a Series 7 exam review CD disk is also included. This
CD disk contains subject reviews, final review exams and a final timed review
exam.
2.2 EXAM ALERTS
Pay close attention to Exam Alerts throughout this workbook. They emphasize
highly testable material in a manner similar to Series 7 exam questions.
2.3 STUDY TIME
We highly recommend that you study these course materials between 90 - 100
hours prior to taking the Series 7 exam. Your actual time may vary depending on
your study habits and professional background . Select a time and place for study-
ing that will allow you to concentrate. There is a lot of information to learn, so be
sure to give yourself enough time to understand the material. There is a direct
relationship between study time and scores attained on the actual exam.
2 . 4 TO P I C S C O V E R E D
The Series 7 exam and SuccessTrak Series 7 Workbook address the following
topics: (Specific areas covered can be found in the Table of Contents)
Module 1: Corporate Securities
Module 2: Debt Instruments
Module 3: Tax Advantaged Products
Module 4: Investment Companies
Module 5: Options
Module 6: Customer Accounts
Module 7: Trading Securities
Module 8: Retirement Plans and Annuities
Module 9: Economics and Analysis

Page 3 NASD Series 7

Series 7 Introduction

Module 10: Federal Securities Acts, Rules and Regulations

Module 11: Glossary
2.5 SERIES 7 EXAM
The Series 7 exam is given in two 3 hour sessions consisting of 125 questions for
each session for a total of 250 questions that count. There is an additional 10 trial
questions total asked on the exam which do not count towards your final score.
They are asked for a number of reasons such as learning about your general
knowledge and possibly testing potential future questions.
You must score at least 70% on the Series 7 exam in order to pass and become
eligible for registration as a general securities representative.
2.6 EXAM CENTER
To take the exam make an appointment with a Prometric Registration Center as
far in advance as possible of the date on which you would like to take the test. You
may contact Sylvan Learning Centers at 1-800-578-6273.
Take one form of personal identification with your signature and photograph as
issued by a government agency. You are not allowed to take reference materials
or anything else into the testing area. While you are allowed to use your own cal-
culator, calculators are available upon request at the test center.
Prometric Examination Center (Owned by Sylvan Learning Centers)
Upon arrival at the test center you will sign in and a thumb print will be taken. Be
prepared to show a picture ID as well as another form of ID. Only calculators
capable of basic math functions such as addition, subtraction, multiplication and
division are permitted. You will be provided with pencils and four or five sheets of
scratch paper which must be returned upon completion of the exam.
After completing all the questions, assuming you do not run out of time, you will be
asked if you have completed the exam. Upon affirmation of this the exam is
graded automatically in seconds. Shortly thereafter, your score along with a
breakdown of each of the seven sections will appear on your screen.
Upon completion of the exam you will be asked to complete an examination cen-
ter survey. You will also receive a hard copy of your test results which will be
available for you upon leaving. A copy of your test results will be sent to the NASD
and they will forward the results to your sponsoring broker-dealer.

Go to the next page!

NASD Series 7 Page 4

 Series 7 Introduction

2.7 SERIES 7 EXAM RESULTS FASIMILE

The following is an example of the exam report form received by those testing at
the test center. The report is broken down into seven distinct areas of concentra-
tion.

NASD Proctor Certification Testing Centers/NYSE

New York Stock Exchange, Inc.

Exam Title: General Securities Representative Examination

Exam Series: 7
Name: Bill Bob Holcomb
ID Number: 127890
Date: Wednesday April 30, 2003
Score: No. Correct : 211 Pct. Correct: 84% Pass
********************************************************************************************
Section Analysis Candidates Score Range
1. The registered representative and the customer . . . . . . . . . . . . . . Above 90%
2. Brokerage Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .76 - 85%
3. Derivative Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76 - 85%
4. Opening, handling & closing of customer accounts . . . . . . . . . . . . . 76 - 85%
5. The securities markets & regulation of the markets . . . . . . . . . . . . . .76 - 85%
6. Order entry, confirmation and settlement . . . . . . . . . . . . . . . . . . . . . .50 - 60%
7. Factors affecting security value and investment decisions . . . . . . .Above 90%

2.8 STUDY PROCESS HELP

Professional Training Services is here to help you with every step of your study
process. If you have any questions about your study materials, please contact us
by e-mail at S7help@pts-training.com.
It would be most efficient if you would state your specific questions as an instruc-
tor will e-mail you back within 24 hours. If after 5:00 pm CST Friday through 8:00
am Monday an answer will be e-mailed Monday by 5:00 pm CST.

Page 5 NASD Series 7

Series 7 Introduction

2.9 SERIES 7 EXAM BREAKDOWN

While the exam report displays results in only seven general areas it is important
that you understand that the exam is really testing you in twelve general catego-
ries. The purpose of providing you with these general categories is to give you an
insight into these subjects to help you allocate your study time more effectively.

Approximate Number of Questions for each Topic

Approximate
Subject Number of
Questions

Municipal Securities 50
Types of Municipal Securiites, Primary and Secondary Mar-
ket, MSRB rules
Options (Derivative Products) 50
Strategies and Product Knowledge
New York Stock Exchange 15
Types of Orders, Floor Procedures, Tape Reading
Customer Accounts 15
Opening and Maintaining Customer Accounts
Regulations 15
Securities Acts, NASD Rules
Direct Participation Programs 15
Formation and Regulation, Types of Programs
Corporate Securities 15
Common and Preferred stock, Corporate Bonds
Packaged Securities 20
Mutual Funds, Variable Annuities, REITS
Securities and Economic Analysis 15
Technical and Fundamental Analysis, Economics

NASD Series 7 Page 6

 Series 7 Introduction

Approximate Number of Questions for each Topic

Approximate
Subject Number of
Questions

U.S. Government Securities 15

Treasury and Agency Securities, CMOs
Margin 10
Regulations, Formulas and Computations
Taxation and Retirement Plans 15
Taxation of Securities, Qualified and Non-qualified Plans

Total Questions 250

2 . 1 0 S U C C E S S F U L TE S T TA K I N G
Recommended Study Method
The best way to approach your studies with the Series 7 is to review each of the
Modules independently, page by page. Upon completion of each section complete
the review questions with at least a score of 80% or better before moving on to
the next section. Upon completing each section you should review the Section
Questions on the computer CD Rom attached to the inside of the back cover.
The questions in each of the computer CD Roms sections relate to the modules
of this workbook. (CD Rom exam review installation instructions can be
found towards the back of this workbook)
Theres an extensive Glossary and commonly used Abbreviations located in the
last module of this workbook. Whenever you are stumped or need to verify a
definition you should immediately turn to the glossary for help.
Upon completion of all modules and review questions in this workbook and com-
pletion of the chapter review questions on the computer CD disk, you should then
complete the final exams also located on the computer CD disk. The goal is to
attain scores of at least 80% or preferably 90% to be ready to take the NASD
Series 7 Exam.

Page 7 NASD Series 7

Series 7 Introduction

2.10.1 Test Taking Techniques

Reading comprehension is an important part of being successful with all NASD
exams. It is imperative that you develop and/or improve appropriate test taking
techniques including the following:
2.10.1.1 Understanding what they are asking
It is important that you read each question at least three times prior to
choosing your answer. It is important that you do not jump to conclusions.
It is not unusual that a question starts with what appears to be a specific
set of facts but changes midstream to other facts. If you jump to a conclu-
sion without adequate review you may choose the false answer fitting
those beginning facts.
Look out for clauses or qualifiers such as if, all, not, none and except.
They are often used in NASD questions. Obviously, the use of these
clauses would require a different answer than if the question was asked
without them.
2.10.1.2 Examples
Lets take a look at an example:
Question 1
All of the following are characteristics of mutual funds EXCEPT;
I. They are known as open-ended
II. The are managed companies
III. They are guaranteed
IV. The are very safe investments
A. I and II
B. I and III
C. II and III
D. III and IV
If you failed to read the word EXCEPT, you would have chosen choice
A represented by I and II as they are correct characteristics of mutual
funds.
Dont panic even though you may see questions that initially look unfamil-
iar. In a number of questions you are going to have to interpret a set of
facts and come to a conclusion in the form of a test answer. At the same
time you may be asked, in these type of questions, combination subjects
such as the following example;

NASD Series 7 Page 8

 Series 7 Introduction

Question 2
When the economy experiences an upward trend due to inflation
what is the general effect on interest rates?
A. Rates go up
B. Rates go down
C. Rates stay the same
D. Rates wont vary with inflation
This question is asking you the result of an increase in inflation, not what
inflation is. The correct response is A, interest rates go up with inflation.
This of course will cause the Federal Reserve Board to take action sooner
or later and they will increase rates even further which ultimately will
cause the values of debt instruments to decrease. See what we mean?
Just look at all the results that can be the subject of test questions regard-
ing the subject of inflation.
Eliminate Roman Numeral Type Question Choices
These types of questions are quite popular on NASD exams. However, if
analyzed properly they can work in your favor. Always attempt to eliminate
one or more of the available choices. If successful you may be able to nar-
row down your options to the correct answer or minimally down to 50% of
the choices. (There are anywhere between 30% - 45% of these type ques-
tions on the exam)
Question 3
An owner of common stock has the right to;?
I. Determine the amount of dividends issued
II. Determine when dividends will be issued
III. Vote at the stockholders meeting or by proxy
IV. Buy redeemed shares before they are offered to the public
A. I, III and IV
B. II, III and IV
C. III
D. II and IV
If you were able to eliminate choice IV as common stock shares are
NOT redeemed but sold in the open markets, C would be the only
possible choice as IV is present in choices A, B and D.
Make sure you understand the intent of the question
Very often in NASD exams, including the Series 7, questions have so
much information that you lose track of what is being asked. Not only that,
the irrelevant facts in the question may cause you to make an incorrect
choice because of not following and understanding what is being asked.

Page 9 NASD Series 7

Series 7 Introduction

Look for clues in the body of the question and be prepared to disregard
irrelevant facts and issues.
Question 4
Today at 2:00 pm Bill Bob a cousin of Peggy Sue, who is a registered
representative calls you and wants to purchase 100 shares of the
Good Will Mutual Funds Aggressive Stock Fund. The fund closed
the other day with a NAV of $10 and POP of $10.50. Billy Bob wants
to purchase the shares immediately. What is Billy Bobs cost?
A. $1,000
B. $1,025
C. $1,050
D. 100 times the offering price that will be calculated at the end of todays
close of business by the New York Stock Exchange.
You needed to recognize that choices A, B and C are bogus numbers
based on yesterdays close of the NAV, POP and somewhere in between.
But the rules state that shares will be purchased or sold on a forward pric-
ing basis which is based on the next close of the New York Stock
Exchange. All the other information in the question was irrelevant and
meant to throw you off.
2.10.2 Time Management
You will find that 3 hours is plenty of time to complete each of the two Series 7
exam sessions. However, at the same time, when taking practice questions
watch your timing. If you encounter a question containing an issue which you
do not immediately recognize, looks difficult, or requires a lot of mathematical
computations mark it for review and complete it after completing all the other
questions. This will help prevent losing track of time and then panicking and
rushing through the end of the exam questions.
2.10.3 Calculator
For the most part, the Series 7 exam will not require the use of a calculator.
Most of the questions are written so that any math required is basic.
2.10.4 Changing Answers
If you are unsure of an answer, your first hunch is most likely to be correct. Do
not change answers on the exam without good reason. If you do you will gener-
ally be wrong 85% of the time.
2.10.5 Guessing
If you absolutely do not know the answer to a definitional type question, select
the choice that has the largest number of words.

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 Series 7 Introduction

2.10.6 Final Thoughts on Test Taking Techniques

Pace yourself
Read the questions over and over until you understand what they are ask-
ing of you prior to making a choice
Read all of the materials in this workbook
Practice all furnished test questions with the goal of scoring between 80
90% prior to taking the exam
Understand concepts dont memorize questions, but memorize all defini-
tions
Dont whine about questions or the exam
Practice, practice, practice test questions
Pay close attention to those sections marked Exam Alert. There is an
excellent chance you will be tested on that exact point.

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Series 7 Introduction

NASD Series 7 Page 12

Corporate Securities
Primary Market
 Module 4: Corporate Securities

Section 4: Corporate Securities

General Information
4.1 INVESTMENT SECURITIES OVERVIEW
Defined: A security is defined as an investment in an enterprise for profit, with a
third party or company performing the management of the enterprise. The various
types of securities tested on will be discussed. If an offering, as an example, is
defined as a security, it must be registered in the states before it can be offered to
the general public, unless the security is exempt from registration.

Corporate Securities
Exam Alert: The Series 7 exam will test your knowledge about various corporate
securities such as common stock, preferred stock, debt issues, rights, warrants,
options, mortgage backed and collateralized mortgage obligations known as
CMOs. You need to know everything there is about all securities that a Series 7
registered representative can sell to the retail public.
4.2 LIQUIDATION ORDER
If a public corporation goes out of business and is forced to liquidate, the following
represents the order of who stands in line from first to last to get a share of any
remaining assets:
IRS
Secured bondholders
Debentures (unsecured bonds)
General creditors
Preferred shareholders
Common shareholders
4.3 SAFETY OF INVESTMENTS
Considering the liquidation order in case a corporation has financial problems, it
should be evident that owning shares of common stock can be the riskiest type
of investment. It should also be as obvious that debt instruments such as
secured bonds and even debentures can be safer than owning common stock.
Finally, as preferred stock stands in front of common shareholders to get at the
assets of a corporation, preferred stock can be a safer investment than common
stock.

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Module 4: Corporate Securities

4.4 COMMON STOCK

Common stock, also known as equities, is sold by corporations to raise money.
The process of raising funds by selling securities is known as capitalization.
Some of the features of common stock include the following;
Represents ownership in the corporation
Limited liability for the investor
Freely transferable in the secondary stock market
May pay a dividend which is not guaranteed
Rights attached to owning common stock include: voting, preemptive rights,
transferability, and the inspection of the corporate books

4.5 STOCK CERTIFICATE

Stock Certifi-
cate Example
Cusip Number
Same as ID Number of
Number Shares

Name of
Corporation

The stock certificate is a receipt for the shares of a corporation a person owns.
Most certificates are for round lot numbers (number of shares divisible by 100
as one round lot is equal to 100 shares). Odd lots are for share amounts less than
100 shares. As illustrated above, a stock certificate identifies the name of the cor-
poration, number of shares, and the CUSIP (ID) number.
4.5.1 CUSIP Numbers
Cusip numbers are universal security identification numbers. Each issue of
common stock, preferred stock, corporate and municipal bonds has its own
CUSIP number. This number can help identify and track the stock certificate in
the event it is lost or stolen. The CUSIP number is also used on trade confirma-
tions.

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 Module 4: Corporate Securities

4.5.2 Negotiability
Shares of stock are negotiable in that a holder of stock can give, transfer,
assign or sell shares owned with few or no restrictions. To transfer or sell
shares of stock the holder must sign the stock certificate exactly how the
shares are registered (even if the name is misspelled). As an alternative, a
stock power can be signed in lieu of signing the actual stock certificate.
4.6 ISSUANCE OF SHARES (CAPITALIZATION PROCESS)
Important Terminology
Charter: The corporate Charter is the corporate document that contains
information regarding all corporate matters including how many shares of
stock can be sold to the general public. (States oversee corporations) The
Board of Directors make the final decision as to how many of those shares
will actually be sold to the public during an IPO, Initial Public Offering.
Par Value: At the time stock is issued to the general public each share of
common stock must be given a par value. Par value is an arbitrary amount
which is usually set at a low amount for accounting purposes. It doesnt really
matter the exact amount for Series 7 purposes, but just understand it can be
$1 or $ .01 or any other value.
The par value of a share of stock never changes with one exception. The
one exception is when a stock splits. As an example, if there is a 2:1 stock
split the par value will be cut in half. Sometimes, an exam question may men-
tion the term stated value. For test purposes, stated value is the same as par
value.
Capital Surplus: The difference between the Current Market Value (value
of the stock in the secondary market) and the par value is known as Capital
Surplus. (To be reviewed in the Economics Section)
Book Value is an estimated value of the corporations assets and is used if
a company ceases doing business and intends to sell off their assets. The
book value is often referred to as the theoretical liquidating value or even
known as corporations net worth.
Stockholders Equity is arrived at by taking the companys total assets and
subtracting out total liabilities. (Total assets - total liabilities = Shareholders
equity)
Public Offering Price is the price established for each share of common
stock that will be sold to the public during an IPO.
Current Market Value (CMV) is the current price that a person can buy or
sell shares in the open market place, known as the secondary market.

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Module 4: Corporate Securities

4.7 PRIMARY OFFERING EXAMPLE

Lets take a look at the following chart which displays the issuance of common
stock. The Corporate Charter indicates that there are 10,000,000 shares of com-
mon that are authorized to be issued. The Board of Directors decided that they
will initially issue 6,000,000 of those shares. Become familiar with the following
terminology!

PTS Inc.

Board of Directors

Authorized, Issued and Authorized but Not Issued Shares

Outstanding Shares (4,000,000 Shares)
(6,000,000 Shares)

Review of Example:
PTS Inc. through its Board of Directors has decided to issue 6,000,000
shares of common stock to the public.
These are known as authorized, issued and outstanding shares. Out-
standing stock is issued stock less treasury stock. (You must remember
this terminology for the exam).
The remaining 4,000,000 shares are authorized but NOT issued to the pub-
lic and therefore are not outstanding. PTS may decide to issue these through
a secondary offering sometime in the future.
Authorized in the corporate charter, these Outstanding Shares represent
capital invested by the firms shareholders and owners, and may be all or
only a portion of the number of shares authorized.
4.7.1 Treasury Stock
From time to time a corporation may decide to purchase back outstanding
shares of common stock. These shares are known as Treasury Stock which is

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 Module 4: Corporate Securities

held in the corporate treasury. A Company generally buy back its own stock
when the stock, in the companys opinion, is undervalued or when the company
needs more stock for its employee pension plan, employee bonuses or even
for future company acquisitions.
However, you must remember that treasury stock doesnt have the same
rights as outstanding common stock such as dividends and voting rights. Also,
treasury stock is purchased back from the issued and outstanding stock, not
from the non-issued shares. Anticipate a test question right on this point!
4.7.1.1 Exam Question Example
PTS.com has 1,000,000 outstanding shares of common and 500,000
of unissued shares. If PTS.com needs 100,000 shares of common for
its ESOP plan (company stock plan) which of the following would be
true?
A. The total number of authorized shares would now total 1,600,000.
B. The total number of outstanding shares would now total 900,000.
C. The total number of outstanding shares would now total 1,100,000.
D. The total number of outstanding shares would now total 1,400,000.

Answer: Choice B. As pointed out, stock repurchased as treasury stock

would be deducted from the issued and outstanding shares. It has no
effect on the total of authorized shares which would remain as 1,500,000
shares. (1,000,000 - 100,000 = 900,000)
4.8 OWNERSHIP IN THE CORPORATION
Lets suppose you purchase 100 common shares of PTS Inc. (100 shares equals
1 round lot). As a holder of these 100 shares you are an owner of PTS Inc. A small
owner, but an owner none the less. Your percentage ownership is based upon
whatever percent 100 shares represent of the total outstanding shares.
4.9 STOCK QUOTES
All stock exchanges and the NASDAQ quote equities using the decimal format.
While retail customers buy at the Ask and sell at the Bid, traders do the oppo-
site. A trader buys the stock at the Bid from a retailer customer and sells to the
retail customer at the Ask.

Stock Quote Example

PTS Stock
Bid: $10.12 Ask: $10.21

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4.10 SHAREHOLDER RIGHTS AND FEATURES

Limited Liability
As the owner of common stock you will have the benefit of limited liability. If
something happens to PTS Inc., such as a failure of a product causing injuries to
end users, you personally would not be liable. Injured parties may litigate against
the corporation but they would not be able to reach your financial pockets. The
most an investor can lose is his/her original investment.
Limited Access and Inspection to Corporate Books
Common shareholders have a right to a limited inspection of corporate books
at the regular business place that corporate books are kept.
Transferability
As long as the company is still in business and listed on an exchange or trading in
the over-the-counter market, investors can sell their shares on any given business
day. Trading takes place in the Secondary Market which includes the various
stock exchanges and the over-the-counter market place.
4.10.1 Dividends
Shareholders have a right to receive dividends, assuming the Board of
Directors declares one. Remember, the Board of Directors makes this
decision, not the shareholders. Dividends are paid from the companys
earnings and usually paid quarterly. Dividends are based on a per share
basis such as $ .50 per share, not percentage ownership.
Corporations are not required to pay out all the earnings as dividends. In
fact, growth companies typically pay little or no dividends as the earn-
ings are reinvested back into the company for growth purposes. On the
other hand, companies such as Utilities tend to pay more of their earn-
ings in dividends than others. This is known as a higher payout ratio.
Dividends are typically paid in cash (by check) from the companys earn-
ings but can also be paid in other acceptable forms such as stock and distri-
butions of product. The logistics involving the distributions of dividends will
be reviewed in the Rules Section of this workbook.

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 Module 4: Corporate Securities

4.10.1.1 Corporate Dividend Distribution Procedures

Declaration Date: The day the Board of Directors declares a dividend to
be paid.
Record Date: The date on which the corporation takes the shareholder
names and addresses from the transfer agent records for mailing the div-
idend.
Payable Date: The date the dividend checks will be mailed by the corpo-
rations transfer agent.
4.10.1.2 Ex-Dividend Date
Ex-Dividend Date is defined as the day in which the buyer of this stock
would NOT be entitled to the dividend. Only the holder of the stock on
this day would be entitled to the current dividend.
The Ex-Dividend date applies only to distribution of dividends for holders
of stock, not mutual funds. (Remember this for the exam)
The Ex-Dividend date rule is an NASD rule, not a corporate rule.
The Ex-Dividend date is established two business days prior to the
record date.

4.10.1.3 Mechanics of Paying a Dividend

Record Date: Friday October 10th.
Ex-Dividend Date: Wednesday October 8th (2 business days prior to
the record date).
To be an owner of the stock and to receive a dividend, the investor must
buy the stock no later than Tuesday October 7th.

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Module 4: Corporate Securities

If the stock is bought after this date, the trade will settle after the record
date and no dividend is received.
If a current owner of the stock wants to sell his/her shares but still
wants the currently declared dividend he/she can first sell the shares
on ex-dividend day of Wednesday October 8th.
4.10.1.4 Cash Way Settlement Rules
Normally, transactions settle using Regular Way Settlement rules.
However, if on the exam you are told that the transaction is going to set-
tle Cash Way, then the rules change.
Trades settle the same day when cash way settlement is used.
Ex-Dividend day for a cash way settlement is always one business
day after the record date.
If a trade settles cash way then the stock must be bought no later than
the business day prior to the ex-dividend day which is the Record
Date.
Using the calendar on the prior page and assuming a cash way settle-
ment, what will be the last day the stock could be purchased in order to
receive the currently declared dividend?
- The answer would be Friday October 10th as this is the business
day before ex-dividend day. Remember, in order to get the current div-
idend the purchaser must own the stock by the record date.
4.10.2 Due Bill
A Due Bill is used to claim any payment due, especially when an investor pur-
chases stock close to the record date. A Due Bill will be mailed to the owner
of record indicating that the investor is entitled to the current dividend in
case the dividend actually goes to the prior owner by mistake.
4.10.3 Voting Rights
Shareholders have a right to vote for vacancies on the Board of Directors
stock splits, acceptances of buy-outs, stock dividends and issuance of addi-
tional new securities. Shareholders do not have to attend an annual meeting to
vote. Instead, a document known as a Proxy is mailed to all shareholders on
record of owning voting common stock.

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 Module 4: Corporate Securities

4.10.3.1 Proxy
A Proxy Solicitation takes place when a company sends proxies to
shareholders, usually for a specific meeting. The company must provide
detailed and accurate information to the shareholders about the proposals
to be voted on. Before making a proxy solicitation, the company must sub-
mit this information to the SEC for review.
Shareholders on record get to vote one vote for each share owned.
There are two types of voting that you must know, Statutory and Cumula-
tive voting.
Lets suppose that you currently own 1,000 shares of PTS Inc. common.
Therefore, you are entitled to a total of 1,000 votes as applied below to
the two different voting types.
Statutory Voting: You get to cast your 1,000 votes for each vacant seat
on the board. If there were three vacancies to be voted on you can cast
1,000 votes for each of the three vacancies. Your only restriction is the
maximum of 1,000 votes per vacancy.
Cumulative Voting: Cumulative voting allows the minority (small)
shareholder to get representation on the board. Using the same exam-
ple, cumulative voting allows the investor to combine the 1,000 votes
for each vacancy into one voting block for a total of 3,000 votes which
can be voted in any way as long as you dont go over the 3,000 votes.
Exam Alert: On the exam, multiply the number of board vacancies (in the
above example there are 3) times the number of shares owned. In the
above example you would therefore have a total of 3,000 votes to cast any
way you want, unlike statutory which would place a maximum of 1,000
votes per vacancy.
Exam Question Example: PTS.com has four vacancies on its board of direc-
tors. Billy Bob owns 2,000 shares of common stock. He receives a proxy and
decides to vote, even though he knows that not all shareholders vote as voting
is a right not a mandatory requirement. The proxy indicates that PTS.com
requires Cumulative Voting rather than Statutory Voting. The following are the
individuals running to fill the four vacancies.
Director A
Director B
Director C
Director D

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Module 4: Corporate Securities

Which of the following statements would NOT be true?

A. Billy Bob must cast 2,000 votes maximum for a director
B. Billy Bob can cast 8,000 shares for any one of the four directors
C. Billy Bob can cast 2,000 shares for each of the four directors
D. Billy Bob can cast 4,000 votes for Director A and 4,000 votes for Director B
Answer: Choice A as it is an incorrect statement. B, C and D are correct state-
ments regarding cumulative voting rights. Remember, 8,000 shares can be
voted anyway the investor chooses.
4.10.4 Non-Voting Stock
Non-voting stock allows a company to raise additional capital while maintaining
management control and continuity without diluting present ownership of voting
stock shareholders. Voting and non-voting stocks are usually differentiated by
using different issues such as Class A voting stock and Class B non-voting
stock.
4.10.5 Preemptive Rights
This right allows current shareholders to maintain their percentage owner-
ship in the corporation. If the company decides to issue additional stock this
percentage may be reduced if the current shareholders werent allowed to pur-
chase their proportionate share of the new stock prior to it being sold to the
public.
Therefore, under current law or by corporate charter this right is extended to all
current shareholders of common stock.
Example: Peggy Sue owns 3% of the outstanding shares of XYZ Corpora-
tion. XYZ decides to issue 1,000,000 additional shares of common stock.
Peggy Sue has the right to purchase 30,000 shares of the new offering,
which is 3% of the 1,000,000 new shares being issued.
It should be noted that investors do NOT have to purchase any of the new
shares being offered. However, if not, the investors current ownership per-
centage would be diluted.
The issuance of additional shares is done through a process known as a
Rights Offering. A rights offering involves the issuance of a security known
as a Right.

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 Module 4: Corporate Securities

4.10.6 Right
A Right as a security has the following features;
Short-term in duration, usually a maximum of 30 days
Each Right has a value
Can be sold to the company in lieu of purchasing shares of the new stock
issue
Shareholders receive one Right for each share owned
4.10.6.1 Value of a Right Formula (Memorize the formula)
(With cum-rights, which means the value of a right prior to x-day)
M-S
= Value of a Right
N+1
M = Current Market Value of stock
S = Subscription price of new issue
N = # of Rights it takes to buy one new share of stock

Exam Question Example

CMV = $45 S = $30 N=5
M S = 45 30 = 15
N+1 = 5 + 1 = 6 = $2.50 (Value of one Right)

Value of a Right Formula (After x-rights day)

Use the same formula as above but do not add 1 to the value of N.
4.10.6.2 Rights Agent
If an investor chooses to purchase any of the new stock he/she would
notify the Rights Agent, not the transfer agent, at the corporation. If the
investor chooses not to purchase any of the shares then the shares would
be turned over to a Standby Underwriter to sell the shares to the pub-
lic during a secondary public offering. (To be discussed later in the New
Issue Market section)
4 . 11 S T O C K S P L I T S
From time to time a company may declare a stock split to make the stock price
more attractive to a wider base of investors. A stock split increases the number of
shares but at the same time reduces the market price and par value.

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Module 4: Corporate Securities

4.11.1 Reverse Stock Split

A reverse split acts the opposite of a regular stock split. After a reverse split
investors own less shares which are worth more per share.
Exam Question Example: Investor currently owns 1,000 shares with a CMV of
$100 and Par Value of $1.
The following represents four different scenarios:

Stock Split Examples

Type of Split New No. Shares CMV Par Value

2 for 1 2,000 $50 $.50

4 for 1 4,000 $25 $.25
5 for 2 2,500 $40 $.40
1 for 2 500 $200 $2.00
1 for 4 250 $400 $4.00

4.11.1.1 Stock Split Calculation Clues

Take the total shares owned (1,000) and multiply it by the first number of
the announced split, then divide that number by the second number of
the announced split.
No matter what, after any split the investor is in the same financial posi-
tion as before, not better, not worse. In the above examples the investor
started with an economic value of $100,000. All the splits still result with
$100,000 CMV.
4.12 BENEFITS OF OWNING COMMON STOCK
4.12.1 Short Sale Strategy
Generally investors buy shares of stock in the hope of price appreciation,
income or both. Those buying shares of stock are considered to have a long
position or sometimes known as long the stock.
When selling shares of stock not owned, the intent is to buy them back when
the stock depreciates in value at sometime in the future. This transaction is
known as selling short. In order to accomplish the sales portion of this strat-
egy, the investor must borrow shares from a brokerage firm. The proceeds of
this short sale MUST be placed into a margin account. An investor who sells

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 Module 4: Corporate Securities

borrowed shares is considered short the stock until the stock is bought and
then returned to the lender of the shares.
4.12.2 Growth
An increase in the market price of shares owned is known as capital apprecia-
tion. As an example, Billy Bob purchases 100 shares of PTS Inc. stock at $12
and six months later the shares are worth $36 each. This represents a 200%
increase in market price.
4.12.3 Income
There are many companies that pay dividends on a quarterly basis. As a com-
panys profitability increases the Board of Directors may raise that quarterly div-
idend. These dividends can provide investors with a source of needed income.
4.13 RISKS OF OWNING STOCK
4.13.1 Market Risk
The risk of owning stock when the price has fallen and the investor needs to
sell the shares at this time. Stock prices can vary day to day and even minute
by minute on days of high volatility. Investors have no assurance that they will
be able to recoup any investment losses at any point in time.
Exam Alert: The longer an investor is in the market the higher the market
risk. Therefore, short-term securities tend to have less market risk than
long term investments.
4.13.2 Decreased or No Income
Another risk is the possibility that a stock dividend may be decreased or elimi-
nated by the companys Board of Directors. If a company has lower earnings or
during bad times, a dividend is generally reduced or eliminated as a first step in
reducing costs.
4.13.3 Final Right to Assets (Known as Residual Claims)
If a company goes out of business, holders of common stock have the final
right to any assets left, assuming there are any assets left. Therefore, common
shareholders have a low priority at dissolution.

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Module 4: Corporate Securities

4.14 CLASSIFYING STOCKS

4.14.1 Growth Stocks
These companies are usually aggressive and are typically involved with a
large degree of research.
Retains most or all of its earnings.
Typically pays small or no dividends.
Companies expand faster than the general economy.
For test purposes, do NOT select a growth stock if a client is in need of
income.
4.14.2 Income Stocks
Companies that usually pay higher than average dividends.
This type of stock is attractive to those persons who are in need of income
such as the elderly and retired.
Utility stocks are examples of income stocks.
4.14.3 Blue Chip Stocks
High-grade stock of major companies.
Long and unbroken records of earnings and dividend payments.
Well-established, stable and mature companies with great financial
strength.
4.14.4 Defensive Stocks
Stocks that usually resist inflation.
In a declining economy they generally have a degree of stability.
Examples are industries such as utilities, food, tobacco and pharmaceuti-
cals.
These are not representative of stocks in the Defense Industry such as
companies that manufacture military related products.

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 Module 4: Corporate Securities

4.14.5 Cyclical Stocks

Earnings fluctuate with the business cycle.
When business conditions improve, the companys profitability is increased
and the share prices will rise.
When conditions deteriorate, business for the company falls off and its prof-
its are diminished causing share prices to decline.
Examples include industries such as steel, machine tools and automobiles.
4.14.6 Seasonal Stocks
Earnings have a tendency to fluctuate with the years seasons.
The best examples are retail companies as their sales and profits will gen-
erally increase at certain times of the year such as Christmas and Back to
School.
Notes

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Module 4: Corporate Securities

Notes

NASD Series 7 Page 30

 Module 5: Preferred Stock

Section 5: Preferred Stock

5.1 PREFERRED STOCK DEFINED
Preferred stock is considered an equity security for purposes of structure. How-
ever, because it has a fixed dividend rate it looks more like a debt instrument
than an equity because of the influence of its value by interest rate moves. They
are also known as senior securities as holders of preferred stock stand in front of
holders of common stock to get at the assets of the corporation in case of a liqui-
dation.
5.2 PREFERRED STOCK VS. COMMON STOCK
Although preferred stock typically does not have the same growth potential as
common stock, preferred shareholders generally have the following advantages
over common shareholders:
Preferred shareholders have a priority over common shareholders when a
dividend is declared by the Board of Directors. Preferred shareholders MUST
always get their dividends prior to common shareholders receiving theirs.
If a corporation goes bankrupt, preferred shareholders have a priority claim
over common shareholders on any remaining assets.
With some rare exception, preferred stock does not have voting or preemp-
tive rights.

5.3 DIVIDEND ISSUES

5.3.1 Dividend Preference
Dividends, when declared by the Board of Directors, are paid first to holders of
preferred stock and then to those holding common shares. If the preferred
shareholders do not receive their regular dividend then common share-
holders wont receive theirs.
Exam Alert: If the exam question indicates that a dividend was paid to the
common shareholders you must therefore assume the preferred share-
holders received their dividends also.
5.4 FIXED RATE OF RETURN
As mentioned, preferred stock dividends are fixed as to the percentage of par
value that will be paid as a dividend. The par value is usually fixed at $100 for pre-
ferred stock. Therefore, if a preferred stock has a 5% fixed dividend it will pay 5%

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Module 5: Preferred Stock

of $100 or $5 annually. However, just like common stock, dividends are typically
paid quarterly.
The Board of Directors declares dividends which are based on company earnings
which can go up or down. However, preferred share dividends remain fixed,
unlike common stocks, which may vary according to the earnings picture.
If a company performs poorly neither the common shareholders nor preferred
shareholders can force the company to pay a dividend.
5.5 ADJUSTABLE-RATE PREFERRED
Some preferred stocks are issued with adjustable or variable dividend rates.
These dividends are typically tied to the rates of other interest rate benchmarks
such as Treasury Bills and money market rates and can be adjusted as often as
quarterly.
5.6 NO MATURITY DATE
Unlike bonds, preferred stock has no maturity date and is considered to be a
long-term security.
5 . 7 TY P E S OF PREFERRED STOCK
Its important that you review and understand the differences between the various
types of preferred stock issues. Categories of preferred stock may differ in the div-
idend rate and in other ways. Preferred stock may have one or more of the follow-
ing characteristics:
5.7.1 Straight Preferred
The following are common to all types of preferred stock;
Fixed dividend stated as a percent (e.g. 6%)
Dividend is paid prior to common stock dividends
Preference over common shareholders if a company liquidation
No claim for any missed dividends
5.7.2 Cumulative Preferred
Cumulative preferred acts just like the straight preferred with one very impor-
tant EXCEPTION. Cumulative shareholders are entitled to receive prior
skipped dividends before common shareholders receive their regular dividend.
However, this doesnt mean that cumulative preferred shareholders can
demand the dividends immediately.

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 Module 5: Preferred Stock

Example: Billy Jo purchased PTS Inc. 5% cumulative preferred stock. The

stock, based on 5% of par value or $100, pays $1.25 quarterly. During the
first quarter the Board of Directors suspend all dividends to both common
and preferred shareholders because of a lack of earnings. When the sec-
ond quarter rolled around the Board decided to reinstate dividends. The test
questions will ask who gets paid first.
Answer: The correct order for receiving dividends is as follows;
All preferred shareholders will receive the current stated dividend for the sec-
ond quarter of $1.25. Then, only cumulative preferred shareholders will
receive the dividend owed from the first quarter. Next, if funds are available,
commons shareholders will be paid.

5.7.3 Convertible Preferred

A convertible preferred works just like any other preferred but is convertible into
common stock at the discretion of the investor, NOT the company. Therefore,
investors have the best of both worlds, a fixed dividend security and potentially
the growth potential of common stock.
5.7.3.1 Convertible Preferred Terms to Know
Parity Price: Lets suppose PTS Inc. preferred stock has a current mar-
ket value of $50 and is convertible into 5 shares of common stock. You
then learn that the common shares have a current market value of $10
each. Therefore, the preferred stock, valued at $50 is equal, if converted
to common stock shares valued at $50 (5 shares times $10 each). In this
situation the preferred is selling at Parity with the common shares.
Based on the prior information it would make NO economic sense to
have a client convert from the preferred to common shares as there is no
difference in the current market values.
Exam Alert:
If a test question indicates that common shares are selling at a 10% premium
to the parity price, than it would make sense to convert the preferred to com-
mon as the common shares would have a higher economic value.

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Page 33 NASD Series 7

Module 5: Preferred Stock

5.7.4 Conversion Ratio

Preferred stock is issued with a par value of $100. You may be asked how
many shares of common stock an investor receives when converting a share of
preferred. You calculate the conversion ratio by dividing par value of $100 by
the conversion price given in the test question.
5.7.5 Conversion Examples
5.7.5.1 Example #1 (Conversion Ratio)
A conversion price of $20 is given in a test question. To calculate the num-
ber of shares that the preferred is convertible into is the same as the con-
version ratio. Take par value of $100 and divide it by the conversion
price of $20. Each share of preferred, in this example, would be convert-
ible into 5 shares of common stock or stated in a ratio, 5:1.
5.7.5.2 Example #2 (Conversion Price)
Instead of asking for the conversion ratio or the number of common
shares that a preferred is convertible into you could be asked to calculate
the conversion price. If they do, they must give you the number of com-
mon shares that a preferred is convertible into. So, in the test question
they tell you that a convertible preferred is convertible into 10 shares of
common. They then ask the value of the conversion price. Take the par
value of $100 and divide it by the number of shares, 10 giving you a con-
version price of $10.
5.7.5.3 Example #3 (Market Price for Parity)
Another type of question involves calculating where the market price of
common shares have to be to be at parity with the preferred shares.
As an example, the test question indicates that the preferred issue is sell-
ing at $50 which is convertible into 2 shares of common stock. You are
then asked the following question; Where does the preferred stock
have to be selling at to be at parity with the common shares?
Solution: With the preferred issue convertible into two shares of com-
mon stock take the current market value of the convertible preferred
stock of $50 and divide it by 2, the number of common shares that this
preferred is convertible into. ($50 divided by 2 = $25). Therefore, to be at
parity with the current market value of the convertible preferred stock, the
common stock would have to have a current market value of $25.

Go to the next page!

NASD Series 7 Page 34

 Module 5: Preferred Stock

5.7.6 Callable Preferred

Some preferred issues may be callable. The callable feature means the pre-
ferred can be called back by the issuer company and works for the benefit of
the company, not the investor. Shares would be called when interest rates
decline. This same feature is also found in callable bonds.
A callable feature is not attractive for an investor that is relying on interest pay-
ments as the reason for the call is the falling of interest rates. It gets worse! If
interest rates fall, the company calls in the preferred and now the investor will
have to reinvest in a lower yielding security, a double whammy. This is also
known as Reinvestment Risk.
5.7.7 Participating Preferred
Another type of preferred stock is participating preferred. While all other types of
preferred stock are only entitled to the stated dividend, participating preferred
shareholders are also entitled to any extra ordinary dividends that are paid to
common shareholders. Were not talking about the regular declared common divi-
dends but rather an extra ordinary dividend. If there are no extra dividends paid to
the common shareholders beyond their regular quarterly dividends, participating
preferred shareholders would not receive any additional benefits.
5.8 INTEREST RATE ISSUES AND PREFERRED STOCK
The effects of interest rate changes on convertible preferred and debt instru-
ments, such as bonds, is reviewed in the Debt Instrument Module. However, for
right now it is important that you understand that the value of debt instruments can
rise and fall depending on the direction of interest rates.
Interest rates work inversely to the value of preferred and debt instruments. If
interest rates rise, the value of preferreds and debt instruments fall. If inter-
est rates fall, the value of preferreds and debt instruments increase.

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Module 5: Preferred Stock

Notes

NASD Series 7 Page 36

 Module 6: Investment Returns

Section 6: Investment Returns

6 . 1 TO T A L R E T U R N
The total return is a combination of the dividend income as well as price apprecia-
tion or price decline over a given period of time.
6.1.1 Calculating Total Return of Investment
To calculate the total return on a stock investment add any dividends paid dur-
ing the full year (four quarters) to any change in the stocks price and then
divide the resulting number by the price paid for the stock.
Example: If the annual dividends paid for PTS Inc. is $1 while the stock
originally cost $20 with the current market value at $25, the return for PTS
Inc. is 30%. ($1 dividend plus difference of $25 CMV and original stock
price of $20 or $5 equals $6. Then take the $6 and divide it by the original
stock price of $20).

6 . 2 CU R R E N T YI E L D
The current yield represents the yield to a customer purchasing the security. You
compute the current yield by taking the annual dividends and dividing it by the
price paid.
Exam Alert: You will be required to compute the current yield of securities for
the exam. To get the current yield (CY) take the annual dividend or interest paid
(income) and divide it by the cost of the security.
As an example, if a stock paid a quarterly dividend of $ .25 and cost $25 the CY
is 4%. (Quarterly dividend of $ .25 times 4 quarters equals the annual dividend of
$1. Take the $1 and divide it by the $25, the cost.)
6.3 CASH DIVIDEND
Cash dividends are paid by the corporation in the form of a check directly to the
owner or deposited into a brokerage account if the stock is kept in Street
Name. (held in the name of the brokerage firm to facilitate trading)
6.4 STOCK DIVIDENDS
The Board of Directors may decide to use earnings for corporate projects so
instead of declaring a cash dividend the Board may declare a stock dividend.
Under these circumstances the company would issue additional shares of com-
mon stock to its current shareholders.

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Module 6: Investment Returns

Exam Alert: A stocks market price and par value decline after a stock divi-
dend, just like a stock split, but the companys current market value (CMV)
remains the same unlike with a stock split when the current market value drops.

NASD Series 7 Page 38

 Module 7: Additional Corporate Securities

Section 7: Additional Corporate Securities

7 . 1 WA R R A N TS
A Warrant is a certificate granting its owner the right to purchase a share of
stock from the issuer at a specified price, normally higher than the current mar-
ket value, before the warrant expires. Unlike a Right, a warrant is usually a long-
term instrument sometimes 20 or 30 years out in time.
All stocks that trade do not necessarily have warrants attached. Warrants are
usually offered to the public as a sweetener in connection with an Initial
Public Offering (IPO) of a new stock issue. These offerings are often bundled
as units.
Example: Widget Inc. is coming out with a new stock offering. In order to
get the public to purchase shares of Widget Inc., the issuing corporation
bundles five shares of common stock with 5 warrants for future stock pur-
chase, in one unit. As there are 100 shares in a round lot the investor
would purchase 20 units resulting in 100 shares of Widget.com common
stock and 100 warrants which could be redeemable for 100 additional
shares of common stock at some time in the future.
If the common stock increases in value the warrant will also increase.
Investors can choose to trade the warrants themselves in the secondary mar-
ket rather than exercising them for the common stock. If the investor chooses
to exercise the warrants the Warrant Agent at the corporation must be noti-
fied.
7.2 AMERICAN DEPOSITORY RECEIPTS (ADR)
The purpose of ADRs is to facilitate the trading of foreign stocks in U.S. mar-
kets. An ADR is a negotiable security that represents ownership in foreign stock
without really owning that stock.
ADRs are bought and sold on the exchanges or on the NASDAQ system. An
American depository bank located in a foreign country actually owns the foreign
stock and then issues the ADRs. As investors purchasing ADRs do not own the
actual foreign stock they do not have voting or preemptive rights.
7.2.1 Major Risks of Owning ADRs
Currency Exchange Risk: The foreign company declares dividends, if
any, in their foreign currency while the dividends are paid in American
dollars.

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Module 7: Additional Corporate Securities

Political Risk: There is always a risk that the foreign country may take over
the company or the current government could fall apart and investors would
lose it all.

7 . 3 R E A L E S T A T E I N V E S T M E N T TR U S T S ( R E I TS )
A REIT is a company that manages a portfolio of real estate investments. These
investments can take the form of mortgages or land. A REIT pools capital in a
manner similar to a mutual fund. Shareholders receive dividends from investment
income or capital gains distributions.
REITs are organized as corporations or trusts where investors purchase shares or
certificates of beneficial interest either on stock exchanges or NASDAQ. Under
the guidelines of Subchapter M of the IRS 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 percent or more of its taxable income to shareholders.
Exam Alert: REITs have the purpose of generating cash to investors with-
out any tax write-offs or tax benefits.

NASD Series 7 Page 40

 Module 8: Important Corporate Persons

Section 8: Important Corporate Persons

8 . 1 TR A N S F E R A G E N T
The transfer agent for a corporation is responsible for the following:
Cancels old and issues new stock certificates
Ensures the issuing of securities in the correct owners name
Maintains records of ownership
Resolves problems relating to lost, stolen or destroyed certificates
Decides what securities are acceptable and what is good delivery
- Correct number of shares sold
- Certificates in good condition
- Must be delivered in round lots of 100 or certificates divisible into
100. (e.g. 400 share delivery can be one certificate for 400 shares,
Four 100 share certificates, Eight 50 share certificates but not five 80
share certificates as 80 share certificates cannot be put together to
form 100 share lots
Delivers additional shares in the event of stock splits
Acts as the Rights agent during a rights offering
Acts as the Warrant agent for any warrant exercises
8.2 REGISTRAR
Ensures that a corporation does not have more shares outstanding than
have been authorized
Responsible for certifying that a bond represents a legal debt of the issuing
corporation
Unlike the transfer agent, must be independent of the issuing corporation
and is usually a bank or trust company
Safekeeping of securities

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Module 8: Important Corporate Persons

Notes

NASD Series 7 Page 42

 Module 9: Corporate Review Questions

Section 9: Corporate Review Questions

1. Which of the following is NOT a feature of common stock?
A. Represents ownership
B. Transferable
C. Unlimited liability
D. Voting rights
2. Common stock is also known as a(an);
A. Debt instruments
B. Preferred stock
C. Rights
D. Equity
3. Which of the following values is assigned to a share of common stock at
the time of public issuance?
A. Par
B. Stated
C. CMV
D. A or B
4. Shares issued to the general public are known as;
A. Issued but not outstanding
B. Authorized and not issued
C. Issued and outstanding
D. Reacquired stock
5. Which of the following is true of Treasury Stock?
A. Treasury stock comes from unissued stock.
B. Treasury stock comes from issued and outstanding stock
C. They have voting rights
D. They have a right to receive dividends
6. Which of the following are shareholder rights?
A. Limited liability
B. Transferability of shares
C. Voting rights
D. All of the above

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Module 9: Corporate Review Questions

7. Mason, a current shareholder of PTS Inc., owns 1,000 shares of common

stock. Upon receiving a proxy, Mason soon discovers that there are three
vacancies on the board which he has a right to vote to fill them. He also
learned that PTS Inc. allows cumulative voting. Which of the following is a
true statement regarding his voting rights?
I. Cumulative voting allows shareholders to cumulate their votes together
which could benefit a minority shareholder.
II. Cumulative voting limits the shareholder to a maximum vote equal to the
number of shares owned for any one director vacancy.
III. Mason can apply 3,000 votes to any one director on the proxy.
IV. Mason can apply 1,000 votes to each director on the proxy.
A. I only
B. II only
C. I and II
D. I, III and IV
8. A right is a;
A. Long-term security
B. Short-term security
C. Is not marketable
D. Has no value
9. Which of the following requires shareholder approval?
A. Stock splits
B. Management decisions
C. Officer appointment
D. Review of annual audits
10. PTS.com decided to pay a 5% common stock dividend to its sharehold-
ers. The Board of Directors decided to distribute treasury stock to pay the
dividend. Which of the following concerning the stock dividend is correct?
A. This stock is not entitled to receive future dividends.
B. This stock is not entitled to vote.
C. This stock will be entitled to vote and to receive future dividends.
D. This stock is entitled to voting rights but not to future dividends
11. Preferred stock looks like which of the following securities?
A. Common stock
B. Bonds
C. Options
D. Warrants

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 Module 9: Corporate Review Questions

12. During the first quarter the Board of Directors of PTS.com suspended
the dividend payable to preferred shareholders. Which of the following
statements would be true?
A. Common shareholders will still get their dividend.
B. Common shareholders will receive any missed dividends during the next
quarter.
C. Common shareholders will not receive any dividends until preferred sharehold-
ers receive theirs.
D. Both A & B
13. Which of the following are benefits of owning preferred stock?
I. Fixed dividend
II. Dividend paid prior to common stock dividends
III. Preference over common shareholders in case of a company liquidation
A. I only
B. II only
C. II and III
D. I, II and III
14. Which of the following are types of preferred stock issues?
A. Convertible
B. Participating
C. Callable
D. All of the above
15. If the conversion price of a preferred is $5, how many shares of common
is the preferred convertible into?
A. 2
B. 5
C. 15
D. 20
16. Corporations need shareholder approval for which of the following?
A. Declare a 20% stock dividend
B. Declare a cash dividend
C. Issue additional bonds for capital improvements
D. Repurchase outstanding stock for the employee stock purchase plan

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Module 9: Corporate Review Questions

17. Which of the following represents ownership (equity) in a company?

I. Preferred stock
II. Common stock
III. Corporate bonds
IV. REITS
A. I and IV
B. II and III
C. I and II
D. I, II, III, IV
18. Shareholders preemptive rights include which of the following?
A. Right to maintain proportionate ownership interest in the corporation.
B. Right to a subscription price on the new stock being issued
C. Right to serve on the Board of Directors
D. Right to be appointed as an officer of the company
19. Which of the following securities dont receive dividends?
A. Common stock
B. Convertible preferred stock
C. Preferred stock
D. Warrants
20. Which of the following securities provides cash flow without any tax
benefits?
A. Limited partnerships
B. REITS
C. Municipal bonds
D. Tax free bonds
21. Which of the following represents the serial number for securities?
A. Security ID Number
B. CUSIP
C. Anatomical Number
D. Securities Information Data Number

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 Module 9: Corporate Review Questions

22. In which of the following ways can a corporation declare dividends?

I. Cash
II. Stock
III. Product
IV. Stock of another corporation
A. I and II
B. III and IV
C. II and IV
D. I, II, III, IV
23. Put the following securities in order from the shortest in duration to the
longest in duration.
I. Warrants
II. Rights
III. Options
A. III, I, II
B. II, III, I
C. I, II, III
D. II, I, III
24. The current market price of PTS Inc. is $50. PTS Inc. is about to issue
additional common stock. Its going to take 4 rights to purchase one share
of common stock. The subscription price of the new issue is $35. What is
the value of a Right?
A. $15.00
B. $ 3.75
C. $ 3.00
D. None of the above
25. PTS Inc. currently has earnings of $5 and pays a $.50 quarterly dividend.
The current market price of PTS Inc. is $48. What is the current yield?
A. 4.2%
B. 2.1%
C. 1.1%
D. 1.0%

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Module 9: Corporate Review Questions

Notes

NASD Series 7 Page 48

 Module 9: Corporate Review Questions

Review Explanations
1. (C) While choices A, B and D are correct, C is not. Owning common stock has
limited liability. The most an investor can lose is the investment dollars.
2. (D) Equities or common stock represent ownership in the corporation.
3. (D) A par value or stated value, are both defined as an arbitrary amount
assigned to a share of stock prior to the initial public offering. The CMV or current
market value represents the price a share of stock is being bought or sold at in the
secondary market.
4. (C) Once shares are sold to the public they are known as authorized, issued
and outstanding. Authorized and not outstanding pertains to unissued stock. Trea-
sury stock is known as authorized, issued but not outstanding stock.
5. (B) Treasury stock must come from the issued and outstanding stock which is
stock currently in the publics hands.
6. (D) All are shareholder rights.
7. (D) Statements I, III and IV are all true statements. Mason owns 1,000 shares of
common. There are three vacancies allowing an accumulation amounting to 1,000
times the three vacancies or 3,000 votes that can be voted anyway Mason wants.
This would include 1,000 across the board or putting them together as suggested
in choice III.
8. (B) A Right is a short-term security (usually lasts 30 days), has a value and cer-
tainly is marketable.
9. (A) Shareholder approval is needed for stock splits, additional issues, board
vacancies, acceptance of a buy-out and a stock dividend.
10. (C) While treasury stock is NOT entitled to receive dividends nor have voting
rights, once the stock is reissued it becomes issued and outstanding and once
again has rights of receiving future dividends and to vote.
11. (B) Because of the stated interest rate, preferred stock looks more like a debt
instrument than an equity.
12. (C) Until preferred shareholders receive their regular dividends, and the cumu-
lative preferreds receive theirs, common shareholders will not receive any divi-
dends.
13. (D) All choices are benefits of owning preferred stock.
14. (D) Convertible, participating, callable and cumulative are all types of pre-
ferred issues.

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Module 9: Corporate Review Questions

15. (D) Take the par value of a preferred stock of $100 and divide it by the conver-
sion price of $5. This equals choice D of 20 shares of common.
16. (C) Shareholders are entitled to vote on whether to issue bonds because
bonds have a priority claim to corporate resources over common stock. The other
choices are made by the Board of Directors and would not require shareholder
approval.
17. (C) Owning either common or preferred stocks represent ownership or equity
in a corporation. REITs are cash producing securities and do not represent owner-
ship. Corporate bonds, like other bonds, are debt instruments and not equities
and therefore do not represent ownership in the company.
18. (A) By definition! If, as an example, a shareholder owns 3% of the outstanding
stock then this shareholder has the right to purchase 3% of the new stock being
issued.
19. (D) A warrant is not evidence of ownership in a corporation qualifying for divi-
dends. It gives the holder of the warrant the right to purchase securities from the
issuer at a stipulated price prior to the warrant expiration.
20. (B) REITs are cash producing securities without any tax benefit and can possi-
bly be obtained with limited partnerships.
21. (B) Thats what a CUSIP is.
22. (D) A corporation can declare dividends in cash, stock, product and stock of
other companies. Stock of other companies is considered a property dividend.
23. (B) Rights have the shortest duration and warrants the longest duration.
Therefore, options would fall in between both.
24. (C) Using the formula, M S divided by N + 1 equals; M (market price) equals
$50 minus S (subscription price) $35 equals $15. Divide the $15 by N (number of
rights it takes to purchase one share of stock) 4 and add 1 for a total of 5. $15
divided by 5 equals $3.00.
25. (A) Current Yield equals the annual dividends, $2.00 (.50 X 4) divided by the
price paid for the security (CMV = $48) 2 divided by 48 = 4.2% (rounded off).

NASD Series 7 Page 50

 Module 10: Primary Market

Section 10: Primary Market

10.1 REGULATORY ISSUES FOR NEW SECURITIES
The following Acts were passed which help regulate the issuance of new securi-
ties. They are as follows;
10.1.1 Securities Act of 1933
The Securities Act of 1933 regulates new issues of corporate securities sold
to the public. The Act requires issuers of new securities to provide enough
information for investors to make fully informed buying decisions. This informa-
tion must be registered with the federal government and published in a pro-
spectus. Obviously the Act prohibits any fraudulent activity in connection with
the underwriting and issuing of all securities.
This Act is also referred to as the Paper Act, Full Disclosure Act, New Issues
Act and Prospectus Act. This Act protects investors who buy new issues by
requiring the following;
Registration of new issues that are to be distributed interstate. Intrastate
(distribution within one state are exempt from registration)
Provide full and fair disclosure about itself and the offering
Regulating the underwriting and distribution of primary and secondary
issues
Providing criminal penalties for fraud in the issuance of new securities
10.1.1.1 Registration Statement
Issuers must file with the SEC under the Act of 1933 a registration state-
ment disclosing material information about the issue. Part of this regis-
tration document becomes the Prospectus.
This registration statement must contain;
Names and addresses of company officers and directors.
Salaries and a five-year business history of the officers and directors.
Description of the issuers business.
Companys capitalization including both equity and debt.
Amount of corporate securities that company officers and directors own.
Identification of investors who own 10% or more of the company.

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Module 10: Primary Market

Description of how the proceeds will be used.

Any legal proceedings in which the company is involved.
The issuer is responsible for the accuracy and adequacy of the required
information no matter who assists the issuer in preparing and filing of the
registration statement.
10.1.1.2 State Registration
State securities laws, known as Blue Sky Laws, require state registration
of securities, broker-dealers and registered representatives. Details of
state registrations are tested on the Series 63 and generally not on the
Series 7.
However, the following are the three basic ways of registering securi-
ties with the states;
Filing (Notification): Some states allow some issues to register with
them by having the issuer notify the state of the issuers SEC registra-
tion. However, this registration is only good for seasoned companies, not
new companies.
Coordination: This type of registration is typically used by IPOs. The
issuer registers simultaneously with the state and the SEC. Both regis-
trations become effective on the same date.
Qualification: This is the most difficult of all registrations. It is typically
used for intrastate offerings (exempt transaction) and for new companies
who dont qualify under Filing or Coordination.
10.2 UNDERWRITING PHASE
There are three phases of the underwriting process that takes place when a new
issue is processed through the Primary Market.
These three phases follow;
10.2.1 Registration Phase
In this phase the issuer files a registration document with the SEC for their
review. The SEC neither approves nor disapproves the registration docu-
ments. In fact, there is a requirement that the SEC No Approval Clause be
printed on the cover page or page one of the prospectus.
Instead, the SEC reviews the materials to see if the information is adequate
and whether the appropriate disclosures are made so that investors can make
an informed decision as to whether or not they should purchase the new secu-
rity.

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 Module 10: Primary Market

10.2.2 Cooling-Off Phase

During the cooling-off period no-one can solicit sales. However, indications of
interest can be solicited with a Tombstone Ad and a Preliminary Prospec-
tus, known as the Red Herring.
The cooling-off period lasts a minimum time period of 20 days. On the
Series 7 exam you will see this phase as the 20 day cooling-off period.
Keep in mind that the 20 days can extend longer if amendments are
needed as well as required additions and corrections required by the SEC.
The Preliminary Prospectus (Red Herring) can be used as a prospecting
tool, allowing underwriters and selling group members to measure inves-
tor interest and gather indications of interest. The Red Herring does
NOT contain the final price of the security as it wont be available until the
SEC allows the security to be sold.
If an investor shows an indication of interest a preliminary prospectus
should be sent. Indications of interest are NOT binding on the customer or
brokerage firm as both the firm and customer may change their minds.
During the cooling-off-period, underwriters cannot;
- Make offers to sell the securities
- Take orders
- Distribute sales literature
- Distribute advertising material
During the cooling-off period, underwriters can;
- Take indications of interest
- Distribute preliminary prospectuses
- Publish tombstone ads to provide information about the potential
availability of the securities coming to market
10.2.3 Due Diligence Phase
Near the end of the cooling-off period, the underwriter holds a due diligence
meeting and discusses various information about the upcoming new issue.
This required meeting is meant to provide brokers with information about the
issue, the issuers financial background and the intended use of the proceeds.
Representatives of the issuer and the underwriter attend these meetings and
answer questions from brokers, securities analysts and top institutional
accounts.

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The following can be discussed at the due diligence meeting;

Studies
Investigations
Meetings
Research
Information about the corporation
Proposed new issue details and pricing
10.2.3.1 Investment Banker Responsibilities
As part of the due diligence process, the investment banker for the new
issue must;
Perform financial analysis and feasibility studies
Determine the companys stability
Examine the use of the proceeds from the sale of the new stock
Determine whether the risk is reasonable
10.2.4 Statutory Prospectus
The statutory prospectus is also known as the Final Prospectus. When
the registration statement becomes effective, the issuer amends the prelimi-
nary prospectus and adds information. The new information added includes the
final offering price and the underwriting spread (to be discussed) for the
final prospectus.
Registered representatives may then take orders from those customers who
indicated interest in buying during the cooling-off period.
The final prospectus is a document that includes all relevant information
about the new issue. The prospectus should include all of the following;
Description of the offering
Offering price
Selling discounts
Use of the proceeds
Offering date
Risks to the purchasers

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 Module 10: Primary Market

Description of the underwriting

History of the business
Description of the management
Material financial information
Legal opinion concerning the formation of the corporation
Stabilization disclosure (method used by underwriters to stabilize the IPO
offering price of the new issue).
10.2.4.1 SEC No Approval Disclaimer Clause
The SEC clause must be printed with bold print on the cover or on the first
page of the final prospectus.
The following is a typical SEC disclaimer clause;

These securities have not been approved or disapproved by the Securities

and Exchange Commission or by any State Securities Commission nor has
the Securities and Exchange Commission or any State Securities Commis-
sion passed upon the accuracy or adequacy of this prospectus. Any repre-
sentation to the contrary is a criminal offense.

10.2.4.2 No Approval Clause Highlights

SEC does not guarantee the accuracy of the prospectus
SEC does not judge the merits of the new issue
SEC does not approve securities
SEC does not recommend securities
10.2.4.3 Prospectus Requirements
For Initial Public Offerings prospectuses must be kept on file for initial
IPOs 90 days after the effective date of the new offering.
For any additional issue offerings 40 days, instead of 90.
A prospectus must be given to a potential buyer prior to or at the time
of solicitation.

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10.3 ADVERTISING NEW ISSUES

Advertising and sales literature include any notice, circular, advertisement, letter
or other communication published or transmitted to any person. The only adver-
tising allowed during the cooling-off period is a Tombstone which is a simple
statement of facts regarding the new issue.
The tombstone ad announces a new issue but does not offer the securities for
sale. The tombstone may appear before or after the effective date. Issuers are not
required to publish tombstones.
Advertising copy and other sales materials need not be filed with the SEC as part
of the registration statement.
10.4 INVESTMENT BANKING
An investment banker is generally a securities broker-dealer that may also spe-
cialize in underwriting new issues. Most, if not all, of the larger brokerage firms
such as Merrill Lynch would have an investment banking division.
An investment banks functions will usually include;
Advising corporations as to the best ways to raise long-term capital.
Raising capital for issuers by distributing new securities.
Buying securities from issuers and reselling them to the public.
Helping issuers with their registration documents so that the issuers comply
with securities laws.
Distributing large blocks of stock to the public and to institutions.
10.5 PARTICIPANTS IN A NEW ISSUE
There are a number of participants involved with a new issue.
10.5.1 Issuer
This is the party selling the securities to raise money through the process of
capitalization. The Issuer would be responsible for;
Filing the registration statement with the SEC which is required by the
Securities Act of 1933.
Filing a registration statement with the states in which it intends to sell secu-
rities. This is also known as blue-skying the issue.
Negotiating the price of the securities for sale and the amount of the
spread (split between members of the selling group) with the underwriter.

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10.5.2 Investment Banker

The investment banker assists with registration and distribution of the new
security and may advise the corporate issuer on the best way to raise capi-
tal.
Specific advise includes how to raise money, how many shares they should
issue, how many bonds, the market price of the new issue and more.
Investment banks deal with new issues only.
Any broker-dealer with an investment banker division must establish a
Chinese Wall. This means that there must be a separation between the
investment banking department (new issues) and the broker-dealer depart-
ment within a brokerage firm.
10.5.3 Underwriter
Underwriters are utilized to assist the investment banker and even to
assume some financial risk associated with the new offering. The underwrit-
ers often buy shares of the new issue and sells them to the public through a
selling group of broker-dealers. However, if the security doesnt do well there is
a chance of substantial financial losses.
10.5.4 Selling Syndicate
A selling syndicate is formed which is made up of the Investment Banker,
Underwriters and the Selling Group. The larger the financial risk, the larger
the number of new issue shares, the more likely the selling syndicate would
increase in size.
A Syndicate Agreement is a legal written document in which all parties within
the selling syndicate must sign and agree to follow the terms.
10.5.5 Selling Group
The selling group is a group of firms, usually broker-dealers that help the sell-
ing syndicate sell new issues to the public. The selling group does NOT buy
securities from the issuer as underwriters might do. Therefore, they assume
no financial risk. The syndicate may negotiate with other firms (broker-deal-
ers) to help them with the selling.

Go to the next page for a Selling Syndicate Example

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10.5.6 Example of a Syndicate

The following is an example of a new issue coming to the IPO market.
The name of the issuer is PTS Inc.
They negotiated with Peace of Mind Investment Bankers of Palatine, Illi-
nois.
The agreed upon price to the public will be $20 per share of common
stock.
The issuer has agreed to take $18 of the $20 which leaves $2 to be split by
the syndicate members for each share sold. This is known as the Total
Spread
Remember, syndicates do not have the same per share compensation as
our example even though they generally do have the same participants.
This represents an example only!

Selling Syndicate Participants Total Spread Example

Amount
Syndicate Member Explanation
Paid

The investment banker manages

Investment Banker/ the selling syndicate and is entitled
$ .25
Manager to a fee for each share sold. This is
known as the management fee.
This is known as the Underwriters
Underwriter $ 1.75
Concession.
Broker-dealers who sell shares will
Selling Member/Bro- receive a Selling Concession of
$ 1.00
ker Dealer $1.00 which is part of the under-
writers concession.
If additional help is needed to sell
Non-Member Sellers
shares, a broker-dealer can bring in
(permission of the
$ .50 a non-member seller. His fee of $.50
syndicate manager is
is known as the Reallowance and is
needed to bring in)
part of the selling concession.

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10.6 PUBLIC OFFERINGS VS. PRIVATE OFFERINGS

Corporate securities are sold to investors through public offerings or private
placements.
In a public offering, securities are sold to the investing public through bro-
ker-dealers.
A private placement occurs when the issuing company sells securities to
private investors as opposed to the general investing public.
Private placement buyers tend to be institutional investors and/or wealth-
ier individuals.
Private placements are generally exempt from the registration requirements
of the Securities Act of 1933 (to be covered later).
Private placements cannot be advertised in any public media as it is a pri-
vate, not a public, offering.
1 0 . 7 TY P E S OF OFFERINGS
New Issues: The new issue market is comprised of companies going public
by selling common stock to the public for the first time in an initial public offer-
ing (IPO).
Additional Issues: The additional issues market is made up of new securi-
ties issued by companies that are already publicly owned.
Primary Offering: A primary offering is one in which the underwriting pro-
ceeds go to the issuing corporation. This is the process of capitalization
and can be repeated as long as the corporation does not exceed the amount
of stock authorized by the corporate charter.
Secondary Offering: One or more major stockholders in the corporation sell
all or a major portion of their holdings. The underwriting proceeds are paid to
the stockholders rather than to the corporation itself.
Split Offering: A split offering is a combination of a primary and secondary
offering.
Shelf Offering (Rule 415): An issuer can register a new securities issue
without selling the current issue all at once. The issuer can sell portions
of a registered shelf offering over a two-year period without having to rereg-
ister the security. However, a supplemental prospectus must be filed before
each sale. Shelf offerings can be used for both equity and debt offerings.

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10.8 UNDERWRITING AGREEMENT

This is an agreement between the issuer and the managing underwriter. This
agreement details each underwriters commitment and liability for shares to be
sold as well as responsibility when allotted shares are not sold.
Prior to the finalization of forming the selling syndicate there is an agreement
between the underwriters and issuer as to what type of underwriting offering
will take place a well as the details that will be written into the underwriting agree-
ment.
10.8.1 Types of Underwriting Agreements
The following are the main types of underwriting agreements that are made
between the underwriters and the issuer;
Firm Commitment
Best Efforts
10.8.1.1 Firm Commitment (Underwriter acts as a Principal)
A firm commitment underwriting is the type of underwriting in which the
syndicate (underwriters) purchases the entire issue from the issuer. This
increases the risk of loss for the underwriters in that any shares not sold
would belong to the underwriters.
Standby Underwriting: A standby underwriting is a form of a firm com-
mitment. During a rights offering, if any current shareholders decide not
to purchase any of the newly issued stock, a standby underwriter pur-
chases the stock to offer it to the general public.
10.8.1.2 Best Efforts (Underwriter acts as an Agent)
A best efforts offering has less risk for the underwritings as they do NOT
purchase the shares from the issuer. Instead, they do the best job they
can in selling the shares offered.
All or None Underwriting: The entire offering must be sold or the deal
is off. While money is being raised the funds are placed into an escrow
account pending final disposition of the underwriting.
Mini-Max Underwriting: A mini-max offering specifies a minimum
amount to be sold for the offering NOT to be canceled. The underwriter
must locate enough interested buyers to support the minimum issuance
requirement.

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- Once the minimum number is met, the underwriter can expand the
offering up to the maximum amount of shares the issuer wishes to
sell.
10.9 UNDERWRITING COMPENSATION (REVIEW)
The price received by the issuer is known as the underwriting proceeds.
The price investors pay for the shares is the public offering price (POP).
The underwriting spread is the difference between the underwriting pro-
ceeds and the public offering price.
The lead underwriter gets a management fee to manage the books for the
selling syndicate. The management fee is generally the smallest portion of
the total spread.
The underwriting fee is paid for assuming the risk of buying securities from
the issuer without assurance that the securities can be resold.
The selling concession is paid to selling group members such as the bro-
ker-dealers for placing the securities with investors. The selling concession is
usually the largest portion of the total spread.
10.9.1 Industry Rules on Compensation
The NASDs Committee on Corporate Finance relies on industry standard prac-
tices when evaluating underwriting spread for fairness and reasonableness.
The amount of the spread varies by issue and can be influenced by any of
the following;
Type of underwriting commitment, firm commitment or best efforts.
Marketability of the security: Safer securities such as an AAA bond will
have a smaller spread than a speculative offering.
Size of the offering: A very large offering provides the underwriters with
the opportunity to spread costs over a larger number of shares.
Issuers business: A stable utility stock usually has a smaller spread than
a more volatile stock.

Go to the next page!

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10.10 STABILIZATION
Stabilization is the process in which the underwriters agree to buy back shares of
the new issue in order to control the market price from falling any further. This
protects the syndicate and investors in case the market price of the security starts
dropping quickly in the secondary market.
Prices fall when the demand for the stock in the secondary market is consider-
ably less than supply for the new issue.
Exam Alert: There will be a question on the exam as follows;
Which of the following bids can be placed by the lead underwriter for an IPO
stock which had a $15 POP and a $14.25 current market value in the second-
ary market?
I. 15.25
II. 15.00
III. 14.25
IV. 13.00
A. I and IV
B. I and II
C. II and III
D. II and IV
Remember, the bid placed by the lead underwriter cannot go over the original
IPO price of 15. Therefore, the answer is (C). Both $15 and $14.50 would be
acceptable. $13.00 is too far away.
10.10.1 Stabilization Rules
The right to stabilize must be in the prospectus.
Stabilization bids may be entered at or slightly below the market price but
never above the IPO original price.
There is no time limit for stabilizing
There can only be one bid placed at any one time and this is usually done
by the lead underwriter.

1 0 . 11 M A R K E T O U T C L A U S E
The purpose of a market out clause is to allow the underwriters to withdraw from
the IPO offering when market conditions are negative.

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10.12 ALLOCATION OF ORDERS

When a new issue is brought into the Primary Market by the Investment Banker a
priority of orders is established. This priority is as follows;
P = Pre-sale orders
S = Syndicate orders
D = Designation orders
M = Member orders
You just need to know the order, not a detailed explanation of each type of order.
Try using the acronym, Please Send David Money.
10.13 WESTERN VS. EASTERN UNDERWRITING
A syndicate agreement can be set up for either a Western or Eastern type of
account. The difference between the two represents the amount of risk the
underwriters are willing to accept.
10.13.1 Western Account
The Western Account is known as a divided account. If a syndicate member
sells its entire allotment of shares, it does NOT have to assist other syndicate
members in selling unsold shares.
10.13.2 Eastern Account
The Eastern Account is known as the undivided account. If a syndicate mem-
ber sells its entire allotment of shares it is still responsible for a percentage of
the securities left unsold by the other members.
As an example, lets assume all the underwriting members are responsible for
selling 25% of the total shares available. One of the four underwriters doesnt
sell all of the allocated shares. The other members now have to sell 25% of the
remaining shares of that underwriter. This goes on and on until all of the shares
are sold.

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10.14 EXEMPT SECURITIES

There are securities which are exempt from registration under the Securities Act
of 1933. The reason for their exemption is based on the type of security.
The following securities are exempt from SEC registration;
U.S. Government Securities such as T-bills, T-notes, T-bonds, GNMA and
T-strips.
Municipal Securities such as GO Bonds and Revenue bonds
Commercial paper and bankers acceptances that have maturities of less
than 270 days (9 months).
Insurance policies
Fixed annuity contracts (not variable contracts)
Non Profit Organizations
National and State bank securities (holding companies not included)
Charitable, religious and educational issues.
1 0 . 1 5 E X E M P T TR A N S A C T I O N S
The following transactions are exempt from registration from the Securities Act of
1933 because of how the security is being sold, not because of the type of
security;
10.15.1 Regulation A Offering
Known as a small size offering.
Maximum offering of $5,000,000 total value or less within a 12 month
period.
This allows a small company access to the capital market to raise a small
amount of money without incurring prohibitive costs.
Uses an offering circular instead of a prospectus. While the offering circu-
lar is similar to a prospectus, it is used in Reg A offerings.
10.15.2 Rule 147 Offering
Known as the Intrastate Offering.
Offers securities only within the issuers home state. Because of this the
security must be registered in that state only and not with the SEC.

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The issuer must have its principal office in that state and receive at least
80% of its income in that state.
Securities cannot be sold out of the state for at least 9 months.
A legend (mark) is placed on the certificates stating the restrictions that it
cannot be sold to investors out of state.
10.15.3 Regulation D Offering
Known as a Private Placement offering.
Reg D offering does not have to file a registration statement with the SEC.
In order to keep its exempt status, the company may not have more than 35
unaccredited (small) investors investing in this offering.
However, the offering can be made to an unlimited number of accredited
investors.
10.15.3.1 Accredited Investors
Accredited investors, known as sophisticated investors, are defined as
follows;
Has a net worth of $1 million or more; or
Has had an annual income of $200,000 or more in each of the two most
recent years. If the account is with a spouse the requirement increases
to $300,000. There needs to be a reasonable expectation of reaching the
same income level in the current year.
Reg D Stock is also known as Restricted Stock as it is purchased through
a private placement. Reselling restricted stock is subject to Rule 144 (dis-
cussed below).
Restricted stock cannot be sold for at least one year. The only exception is
Rule 144A which allows the resale of restricted stock during the first year if
the stock is purchased by certain qualified institutional buyers.
During the second year, a limited quantity of restricted stock can be sold.
This is also dictated by Rule 144.
After the second year there is no longer any restrictions on the sale of
restricted stock.

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10.16 CONTROL STOCK

Control stock is registered stock that is controlled by corporate insiders. On
another note, corporate insiders cannot short corporate stock because of their
access to inside information.
Examples of those persons considered to be insiders include;
Officers
Directors
Shareholders holding 10% or more or the stock
Spouses of the above
10.17 RULE 144
This rule covers the resale of restricted (Reg D) stock as well as resale of con-
trol stock (stock held by corporate insiders). This rule stipulates the holding
period, quantity limitations, manner of sale and filing procedures.
Only restricted stock is subject to the first and second year holding periods, not
stock owned by corporate insiders with control stock. But, both types of stock
are subject to the resale rules of Rule 144.
10.17.1 .Rule 144 Rules
Form 144 must be completed which is good for a period of 90 days
Under Rule 144, the greater of 1% of the outstanding shares or the aver-
age weekly trading volume for the previous four weeks, can be sold by
restricted stockholders during year 2 and sold anytime for unrestricted
stock held by corporate control persons.
10.17.1.1 Rule 144 Example
Facts: Billy Bob, a director of PTS Inc., desires to sell some of his PTS
stock that hes accumulated over time. PTS Inc. has 10,000,000 shares of
common stock outstanding. The most recently reported weekly trading
volumes for PTS Inc. stock are as follows;
1 week ago - 120,000 shares traded
2 weeks ago - 110,000 shares traded
3 weeks ago - 120,000 shares traded
4 weeks ago - 110,000 shares traded
5 weeks ago - 80,000 shares traded

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Question: What is the maximum number of shares that Billy Bob can
sell based on Rule 144?
A. 110,000
B. 115,000
C. 100,000
D. 108,000
Answer Rationale: 1% of the total outstanding shares only came to
100,000 (1% of 1 million). Taking the average of the last 4 trading weeks,
not 5 as listed, is 115,000 (add the last four weeks of trading and divide by
four). Therefore the answer to the questions would be Choice B, 115,000,
the larger of the two amounts.
10.18 ANTIFRAUD PROVISIONS
Even though a security may be exempt from registration and prospectus require-
ments, no offering is exempt from the antifraud provisions of the Securities
Act of 1933 or any other securities act, including the Securities Exchange Act of
1934.

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Notes

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10.19 NEW ISSUES REVIEW QUESTIONS

1. The cooling off period for a new issues last approximately how long?
A. 10 days
B. 20 days
C. 30 days
D. 90 days
2. All of the following securities are exempt, EXCEPT;
A. Debentures
B. Private placements
C. US Government Bonds
D. Fixed Annuities
3. All of the following are types of underwritings, EXCEPT;
A. Standby
B. AON
C. Best efforts
D. Mini-max
4. Which of the following statements about a red herring is false?
A. The final offering price does not appear
B. Used to obtain indications of interest from prospective investors
C. A registered representative may send a copy of the companys research report
with the red herring.
D. Additional information may be added to a red herring at a later date.
5. If the SEC has cleared an issue for sale, which of the following statements
is TRUE?
A. The SEC has endorsed the issue
B. The SEC has guaranteed the issue
C. The underwriter has filed a standard registration statement
D. The SEC has guaranteed the accuracy of information in the prospectus
6. The principal functions of an investment banker are to;
I. Provide a secondary market
II. Advise the issuer about alternatives in raising capital
III. Distribute securities to the public
IV Provide financing for an individual
A. I and II only
B. II and IV only
C. II and III only
D. I, II and IV only

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Notes:

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10.20 NEW ISSUES REVIEW ANSWERS

1. (B): The SEC requires a minimum time period of 20 days, known as the 20 day
cooling off period, to review the registration documents.
2. (A): Debentures are non-exempt securities, meaning they have to be registered
under the Securities Act of 1933. Choice B is exempt as it is an exempt transac-
tion. Choice C is an exempt security. Choice D is not a security and therefore
exempt from registration.
3. (B): AON (all or none) is a type of trade order in the secondary market, not a
type of underwriting as the other choices are.
4. (C): This is a no no! While a red herring can be sent out for purposes of indica-
tions of interest, research reports are not permitted during the cooling off period.
5. (C): The SEC does not endorse the issue, guarantee the issue or even guaran-
tee the accuracy of the information furnished by the issuer.
6. (C): Choice A is incorrect as an investment banker is found in the primary mar-
ket, not the secondary market. The job of an investment banker is to advise the
issuer and help distribute shares to the public. It is also not the job of an invest-
ment banker to provide financing for the issuer.

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NASD Series 7 Page 72

 Debt Instruments
Corporate Debt Obligations
Accrued Interest
U.S. Government and Agency Debt
Reading Debt Financial News
Collateralized Mortgage Obligations
Yield Curves
Money Markets
 Module 12: Debt Instruments

Section 12: Debt Instruments

12.1 OVERVIEW
This Section will review all debt instruments which can be issued by Corporations,
the U.S. Government, U.S. Government Agencies and Municipalities. What they
all have in common is that they represent an investors loan to an issuer. There-
fore, investors become creditors of the issuer, not owners as a holder of common
stock would be.
The borrowers make two very important promises:
1 They promise to pay interest as determined by the type of debt instrument.
Most bonds pay interest twice a year while U.S. Government Agencies pay
monthly.
2 They promise to redeem the bonds at face value when the bonds mature.
Typically face value or par is $1,000 per bond.
Exam Alert: At redemption, the bond holder receives the face value as
indicated in #2 above as well as the last six months of interest. Do not for-
get this for the exam.
Bondholders also take the position of a Senior Securities holder. This
becomes important if a corporation, as an example, goes out of business and a
line to get at the assets form. Bondholders stand in front of both preferred and
common stock holders.
12.2 ISSUERS
Corporations issue bonds to raise working capital to pay for such things as new
equipment, expansion or even plant construction. Corporate bonds are commonly
referred to as Funded Debt. Funded debt is any long-term debt payable in five
years or more.
Exam Alert: The Federal Government is the nations largest borrower as
well as the most secure credit risk.
The U.S. Government issues Treasury Bills, Notes and Bonds which are
backed by the full faith and credit of the U.S. Government with its unlimited
taxing powers.
Municipal Securities are the debt obligations of state and local governments
and their agencies. Most of these type of bonds are issued to raise capital to
finance public works or construction projects that benefit the general public.

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12.3 MATURITIES
On the maturity date, the face amount of the bond is repaid to the investor. This
may be more or less than the investor originally paid. (To be discussed later).
The following represents the three basic types of bond maturities;
Term Maturity: A term bond is structured so that the principal of the whole
issue matures at once. This type of issue can be riskier than others
because of the financial demand on the company of all the bonds maturing at
once. Therefore, most corporations establish a Sinking Fund in which to
accumulate excess operating income which would be used to call in bonds
prior to maturing.
Serial Maturity: A serial bond issue is structured so that portions of the prin-
cipal mature at intervals over a period of years. In a way, this type of issue
is safer than a term maturity issue as all bonds are not due at the same time.
12.3.1 Serial Bond Issue Example
Serial Bond Issue Example
Amount to be
Maturity Interest Rate
Issued

2010 5.00% $300,000

2011 5.10% $300,000
2012 5.20% $300,000
2013 5.30% $300,000
2014 5.40% $300,000
2015 5.50% $300,000

Note that each maturity has a different coupon rate.

The longer the maturity, the higher the interest rate.
After all, if investors are expected to hold bonds for
longer periods of time they should be rewarded
more.

Series Issues: Instead of placing all of its bonds in the hands of investors
at one time, any bond issuer may spread out its borrowing over several
years as its needs dictate by issuing the bonds in separate series.

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Balloon Maturity: A balloon maturity involves an issuer which schedules

its bonds maturity using elements of both serial and term maturities.
The issuer repays a part of the bonds principal before the final maturity
date, as with a serial maturity, but pays off the major portion of the bond
at maturity. This bond has a balloon, or serial and balloon, maturity.
1 2 . 4 D E B T I N S T R U M E N T S TE R M I N O L O G Y
12.4.1 Bonds
These are long-term debt instruments. Bonds can be purchased from corpo-
rations, municipal governments, US Government and even foreign govern-
ments. They are also known as funded debt.
12.4.2 Bond Certificate
The bond certificate is evidence that designates the bonds ownership and
characteristics. Note that the U.S. Government no longer issues Treasury Cer-
tificates. Instead, ownership is registered in Book Entry form which is the
name and tax number registration of the holder which is then kept in a U.S.
Government registration book.
Each bond certificate contains the following information:
Name of the issuer
Type of bond
Principal amount
Issue date
Date of maturity
Call features, if any
Coupon rate (interest rate)
Interest payment dates
Reference to the trust indenture
1 2 . 5 TY P E S OF REGISTRATIONS
12.5.1 Coupon (Bearer) Bonds
These are bonds with the actual coupon attached. Investors would tear off
the actual interest rate coupon, take it to their local bank and collect the semi-
annual interest. Bearer bonds do not have any names on the registration.

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Because of security reasons as well as tax issues, these bonds are no longer
issued. However, they still do exist as secondary bonds.
12.5.2 Fully Registered Bonds
This is the most common form of issued bond which is registered in the inves-
tors name. Interest is sent by the transfer agent to the bondholders automati-
cally.
12.5.3 Registered as to Principal Only
These are known as partially registered bonds as they are registered in the
investors name with coupons attached just like bearer bonds. Then the investor
has to clip the coupons to get their interest payments. Like bearer bonds they
are no longer issued.
12.5.4 Book-Entry Bonds
The investor does not receive certificates or coupons. Rather, the transfer
agent maintains the securitys ownership records. The trade confirmation
serves as evidence of book-entry bond owners. Most U.S. Government bonds
are available only as book-entry.
12.6 PAR VALUE/PRINCIPLE

The par value of most bonds is $1,000. This means that at maturity, the holder will
be paid $1,000 for each bond held. Different types of debt instruments can have
different par values, also known as the principal or face value. As an example, the
face value of Municipal Bonds is $5,000 as these bonds can only be bought and
sold in five bond increments. (Look out! This exam tends to quiz you on differ-
ent terms which mean the same thing)
12.7 INDENTURE (DEED OF TR U S T )
An Indenture is found on the face of a bond and is considered to be a legal agree-
ment between the issuer and the trustee. Corporate bonds are guided by the
Trust Indenture Act of 1939. Lets take a look as to what is found on an
indenture:
Date of maturity
Par value
Coupon rate
Any collateral securing the bond such as real estate or other types of
collateral

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Name of the Trustee (Trustee makes sure interest is paid twice a year and
face value when the bond is redeemed)
12.8 MATURITY DATE (BOND REDEMPTION)
Debt instruments specify a time when the issuer has to repay the loan when the
bond matures through the process of redemption. At this time the face value, also
known as the principal, must be repaid. The investor will also receive the last
six months of interest. (Remember that for the test)
1 2 . 9 C O U P O N / N O M I N A L YI E L D
All debt instruments are issued with an interest rate stated on the face of each
security. This stated interest rate is known as the Coupon Rate or Nominal Yield
which never changes, no matter what. While general interest rates and market
values may change, the coupon rate/nominal yield will not. Investors receive
income based on the coupon rate.
Example: A 7% corporate bond pays interest twice a year. The bond pays 7%
of par or $70 annually. But bonds pay semi-annually so this bond would pay
$35 every six months.
12.10 CALLABLE BONDS
Callable bonds are those that are redeemed prior to maturity by the issuer.
Always remember, this works for the benefit of the issuer, not the investor. A
company generally call bonds when interest rates fall or possibly to improve the
rating of any outstanding bonds. After all, why should the company pay the higher
coupon rates when market interest rates have fallen?
Bonds have what is known as a call provision attached. It is an agreement
between the issuer and its bondholders, or even preferred stockholders, giving
the issuer the option to redeem their securities at a specified price prior to
maturity and under certain conditions.
12.10.1 Call Features
These are found in the agreement a bond issuer makes with a buyer, called the
Indenture, describing the schedule and price of redemptions before maturity.
Most corporate and municipal bonds have 10-year call features. This 10-year
period, in which bonds are not called, is known as Call Protection. Call protec-
tion is good for the investor as during that time period the bonds cannot be
called back by the issuer.
The Call Date is the date on which a bond may be redeemed before matu-
rity. If called, the bond may be redeemed at par or at a slight premium to par.
When buying a bond it is important to know the bonds call dates, because an

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investor cannot be assured that he/she will receive interest from that bond
beyond the call date.
12.10.2 Call Premium
This is the amount over par that the issuer pays for calling bonds. A call pre-
mium is usually paid when bonds are called during the earlier years. As an
example, a bond called in the 5th year pays 101. This is 101% of par value or
$1,010 which represents a $10 premium over par value of $1,000.
12.10.3 Refunding (Similar to calling in an issue)
This is the process of raising money by selling a new bond issue first when
interest rates have fallen. Then the proceeds are used to call in the current
more expensive debt. Refunding is used when the issuer doesnt have
enough cash to purchase and call the current more expensive debt.
1 2 . 11 T E N D E R OFFERS

Tender offers involve calling in a bond issue because interest rates have fallen
and the issuer wishes to redeem callable and noncallable bonds and replace them
with bonds paying less interest. To replace noncallable bonds the issuer will most
likely offer a premium price as an inducement to bondholders to tender their
bonds.
12.12 PUT BONDS
Some bonds, known as put bonds, are puttable back to the issuer after a certain
number of years at par value. In essence, this gives the investor the right to sell
these bonds back to the issuer prior to maturity. If interest rates rise, as an
example, the value of bonds fall and this would be a good time to exercise the put
option.
12.13 LENGTHS OF DEBT INSTRUMENTS
Short-term: Debt maturing in one year or less. Short-term instruments are
typically more liquid and are more active than long-term bonds. Their cou-
pon rates are usually lower than long-term bonds because the investment
is not tied up for a long period of time.
Intermediate: Debt maturing in one to five years
Long-term: Also known as funded debt which typically matures in more
than five years. Long-term bonds usually have higher yields (coupon rates)
because of inflation and the fact that investors have their investments tied up
for a longer period of time.

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12.14 BOND RATINGS

Bonds are rated for their credit risk by two rating services, Standard and Poors
and Moodys. Credit ratings are based on the capability of the issuer to pay inter-
est when due and the face value at redemption. Note that not all bonds are rated
as there is a fee to get a rating and smaller issues dont want to spend the money
for a rating. The higher the rating letter the higher the rating.

Bond Ratings Comparison

Bond Rating Standard & Poors Moodys

Highest Quality AAA Aaa

Very Strong AA Aa
More susceptible to adverse
A A
conditions
Slightly Speculative BBB Baa
Speculative (Junk Bonds) BB Ba
Missed more than one pay-
B B
ment
No interest being paid C Caa
Issuer is in Default D D

Referring to the above Bond Rating chart the highest four ratings are con-
sidered investment grade which means the issuer has enough resources to
pay interest and the face amount upon redemption.
Bonds rated BB or lower have a higher risk associated with them.
Exam Alert: All thing being equal, bonds with higher ratings would have
the lower coupon rate while lower rated bonds would have higher coupon
rates. This is a result of Risk and Reward concepts which need to be
applied when working with debt instruments.
1 2 . 1 5 B O N D VO L A T I L I T Y
Interest rate movement, up or down, effects pricing, demand and volatility of
bonds. Conceptually, discount bonds are more volatile than par or premium
bonds. The larger the discount, the more volatile the bond. Also, the lower the
quality of the bond the greater the price volatility. Overall, short-term premium

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bonds are the most stable while deep discount and zero-coupon bonds have the
greatest price volatility.
12.16 BOND PRICES
Bonds are issued with a face or par value of $1,000. Par represents the dollar
amount of the investors loan to the issuer, and it is the amount repaid when the
bond matures along with the last six months of interest. As an example, a bond
selling at 90 means 90% of par value or $900. Another example, 105 means
105% of par or $1,050.
Exam Alert: If you forget about bond pricing on the exam just add a
zero (0) onto the bond price. (95 = $950; 101 = $1,010)
12.16.1 Premium Bond (Secondary market trading)
A premium bond is a bond that is selling at a price above par value of $1,000.
An example would be a bond priced at 110. This bond is trading at 110% of par
value of $1,110.
12.16.2 Discount Bond (Secondary market trading)
A discount bond is a bond that is selling at a price below par value of $1,000.
An example would be a bond priced at 90. This bond is trading at 90% of par
value or $900.
12.16.3 Points vs. Basis Points
1 point = $10 (par value times 1%)
1 basis point = $ .10 (There are 100 basis points in 1 point)
Example: A bond increases in value by point. This means the bond has
increased in value by $5. Another way of asking this type of question is as fol-
lows; A bond increases in value by 50 basis points, how much does it
increase? $5 same answer but another way of asking it.
12.17 PRICING OF D I F F E R E N T TY P E S OF BONDS
12.17.1 Corporate Bonds
Corporate bonds are priced and quoted in eighths (1/8th) of ten dollars. In
other words, if a discount corporate bond is quoted at 97 3/8, the dollar price
of the bond is 97 and 3/8ths of ten dollars or 97 plus 3.75 or $973.75.
Now for a premium bond example: 103 5/8 equals 103 plus 5/8ths of ten dol-
lars or 103 plus 6.25 or $1036.25 per bond.

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12.17.2 U.S. Government Bonds

Unfortunately the pricing of U.S. government bonds are different. These
bonds are quoted in thirty-seconds of ten dollars versus eighths.
A discount bond quoted at 97.18 or 97:18 (U.S. Government bonds can
also be seen using a colon instead of a period) is being quoted as 97 and
18/32 or 97 plus 18 thirty-seconds of $10 (place a 10 for $10 in your calcu-
lator, divide it by 32 and then multiply the resultant number by 18) equals 97
plus 5.625 or $975.625 per bond.
A premium bond quoted at 103:15 has a dollar price of? As you did for a
discount bond, take the 103 plus 15/32nds of $10. This would result in 103
plus 4.6875 of $1034.6875 rounded off to $1034.69.
12.17.3 Municipal Bonds
Municipal bonds can look the same as government bonds but be aware they do
not calculate the same way. Municipal bonds are quoted using decimals as a
percent of par. A discount bond quoted at 96.8 really means 96.8% of par
value or 96.8% of $1,000 or $968.00.
A premium bond quoted at 101.45 is 101.45% of par or $1,014.50.
12.18 INTEREST RATES AND YI E L D S
For purposes of this exam, interest rates and yields will be used synonymously.
The following is one of the most important concepts to remember for this exam.
Interest rates/yields have a direct relationship upon the value of debt
instruments.
Test Point: In fact, the above is known as an Inverse Relationship.
(Memorize for the exam)
Heres how the Inverse Relationship works;
If interest rates decrease, the value of debt instruments increase. These
are known as Premium Bonds. They are selling at a price that is higher than
par value (above $1,000) See chart on the next page!
If interest rates increase, the value of debt instruments decrease. These
are known as Discount Bonds. They are selling at a price that is below par
value (below $1,000) See chart on the next page!

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12.18.1 Market Interest Rates Affecting Bond Prices

12.18.2 Yield/Price Fulcrum

Example #1: Par Bond (Bond sold at par normally a new bond). As you can
see, all yields are the same as the coupon rate.

$ PRICE CY YTM YTC

N
Y
7%

12.18.3 Nominal Yield (NY)

Nominal yield is also known as the coupon rate or the stated interest. As an
example, if a new bond is issued with a 7% coupon, the nominal yield or stated
interest is 7%.
Exam Alert: The nominal yield never ever changes. In the above example,
this bond will pay 7% interest annually in two six month installments of
$35 each. 7% of par value of $1,000 is $70 divided by two.

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12.18.4 Current Yield (CY)

The current yield is a relationship between the annual interest and the price
paid for the bond. Using the facts of the above bond, as this is a new bond the
investor paid par value or $1,000. The bond pays $70 in annual interest. There-
fore, take the $70 and divide it by $1,000 which will equal 7%. As you can see,
a par bond (sold at par) will result with the same yield as the nominal yield and
equal yields across the board.
12.18.5 Yield to Maturity (YTM - Basis)
The yield to maturity reflects the annualized return of the bond if held to
maturity and considers the coupon rate, market price and years to maturity.
Exam Alert: By understanding the concept of YTM and its relationship to
the other yields as shown on the Fulcrum you will be able to answer
related test questions. Examples will be shown shortly.
12.18.6 Yield to Call (YTC)
The Yield to Call calculates and reflects the early redemption date and conse-
quent acceleration of a discount gain or premium loss from the purchase price.
Once again, understanding the relationship of all the yields using the Fulcrum
is most important for this exam.
The theory behind the YTC is that;
The sooner premium bonds are called, the sooner the premium the
investor paid to purchase the bond is lost making the YTC lower than the
YTM.
The same principal applies to a discount bond, only the opposite direction,
as the YTC compensates for the discount the investor received when
purchasing the bond which would be accelerated, thereby making the YTC
greater than the YTM.

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Example #2: Premium Bond

$ PR
ICE

CY
YT M
N YT C
Y
7%

As you can see, a premium bond purchased above par value, results
with a lower CY, YTM and YTC when compared to the nominal yield. There-
fore, you should know that the three yields on the right side of the fulcrum
MUST be less than 7%. This will help you answer questions on the
exam.
Test Clue: You may be asked which is the lowest of the YTM or YTC when a
customer purchases a premium bond. As you can clearly see from the
interest rate fulcrum above, the answer would be the YTC.
Test Clue: The yield order for a premium bond from lowest to highest is the
YTC, YTM, CY and NY.
12.18.7 Example #3: Discount Bond

YTC
YTM
CY
CE
$ PRI N
Y
7%
As you can see, with a discount bond (purchased at less than par), all three
yields on the right side of the Fulcrum are higher than 7%, the nominal
yield. Also, if asked, and you will, the YTM is the lower of the YTM and
YTC.

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Exam Alert: The yield order for discount bonds from lowest to highest
would be the NY, CY, YTM and YTC
12.18.8 Bond Pricing Exam Examples
Test Clue: You will need to read and understand the following bond
pricing lines and its components which all or part of will be seen on
your Series 7 exam. In other words, you will be asked to identify all parts
of the following technical bond descriptions.
1. 5s30@6.40 basis (YTM): Is this a discount or premium bond and what do
the individual numbers mean?
Analysis
The 5, to the left of the s, represents the nominal yield (coupon rate)
The s is just used as a separator, nothing more.
The 30 represents the bond maturity. In this example the year 2030
The 6.40 basis represents a bond priced to the YTM as the word basis is
used on the exam to show YTM.
Exam Alert: Always use the Fulcrum! When you get to the test center,
draw a picture of what the Fulcrum looks like with both discount and pre-
mium bonds. This will help you answer anywhere from 18 25 questions
on the exam.

Y TC
Y TM
CY
CE
$ PRI
N
Y
5%

In the above example, the YTM of 6.40 is clearly higher than the coupon
rate of 5.00%. Therefore, the above Fulcrum shows the YTM higher than
the coupon rate (nominal yield) and is a Discount Bond.

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2. 10s20@ 6.20 basis (YTM) Is this a discount or premium bond and what
do the individual numbers mean?
Analysis
The 10 to the left of the s, represents the nominal yield (coupon rate)
The s is just used as a separator, nothing more.
The 20 represents the bond maturity. In this example the year 2020
The 6.20 basis represents a bond priced to the YTM as the word basis is
used on the exam to show YTM.
Lets use the Fulcrum to answer the question as to whether this is a dis-
count or a premium bond.

$ PR
ICE
CY
YTM
YTC
N
Y
10%

In the above example, the YTM of 6.20 is clearly lower than the coupon
rate of 10.00%. Therefore, the above Fulcrum shows the YTM lower than
the coupon rate (nominal yield) and is a Premium Bond.

12.19 CONVERTIBLE BOND FEATURES

These bonds are issued with convertible features, just like the features already
discussed with Convertible Preferred Stock. Remember, they have features of
both a debt instrument as well as common stock.
These securities are appropriate for investors who would like higher income
than is available from common stock.
Together with greater appreciation potential than regular bonds offer.
From the issuers perspective, the convertible feature is usually designed as
a sweetener to enhance the marketability of the preferred stock or bond.

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12.19.1 Conversion Ratio

Bonds are issued with a par value of $1000. You may be asked how many
shares of common stock an investor gets when converting a bond.
You compute the conversion ratio by dividing par value of $1000 by the
conversion price given in the test question.
12.19.2 Conversion Price
This is the price it costs an investor to convert a bond to common stock.
This price is based on a relationship between the par value of the instru-
ment and the conversion price which is stated on the indenture.
As an example lets use $50 as the conversion price. This amount would
be stated on the face of the indenture. Par value of $1,000 would be
divided by the conversion price of $50 which would result with 20 shares of
common stock. (Be prepared to do this calculation on the Series 7
Exam)
12.19.3 Parity
When parity exists both the market price of the convertible security and the
market price of the common shares if converted are the same. Therefore,
there would be no benefit to the investor to convert the security.
Example:
A bond with a current market value of 110 ($1,110) is convertible into 20
shares of common stock. In order to be at parity with this bond each share of
common stock would have a market value of $55.50 ($1,110 divided by 20
shares of common).
If the stock on the other hand had a current market value of $60.00 per
share then the stock would be selling at a premium to its parity and the cli-
ent should be advised to convert the bond into the stock. This is an
example of an arbitrage situation.
Arbitrage can be achieved in this instance by converting the bond and
then simultaneously selling the common stock. Arbitrage is also
defined as the simultaneous purchase and sale of the same security in dif-
ferent markets in an attempt to profit from short-term price disparities
between two markets. (e.g. NYSE and the Pacific Exchange)

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12.19.4 Additional Examples

Example #1 (Calculate Number of Shares)
A conversion price of $50 is given in a test question. To calculate the number
of shares that a bond is convertible into is the same as computing the conver-
sion ratio. Take par value of $1000 and divide it by the conversion price of
$50. Each bond in this example would be convertible into 20 shares of com-
mon stock or stated as a ratio, 20:1.
Example #2 (Calculate the Conversion Price)
Instead of asking for the conversion ratio or the number of common shares that
a bond is convertible into you could be asked to calculate the conversion
price. If they do, they must give you the number of common shares that a
bond is convertible into. So, in the test question they tell you that a convertible
bond is convertible into 20 shares of common. They then ask you to compute
the conversion price. Take the par value of $1000 and divide it by the number
of shares, 20 giving you a conversion price of $50.
Example #3 (Calculate Parity Market Price of Common)
Another type of question involves calculating where the market price of com-
mon shares have to be, to be at parity with the convertible bonds.
Lets suppose the test question indicates that convertible bonds are selling
at 105 or $1,050 and is convertible into 20 shares of common stock. You
are then asked the following question; where does the common stock
have to be selling at to be at parity with the convertible bond?
Solution: Take the current market value of the convertible bond, 105 or
$1,050 and divide it by the number of common shares it is convertible
into, 20 shares. (1050 divided by 20 = $52.50).
If the common shares were selling at $52.50 they would be at parity with
the current market price of the convertible bond.
If the common stock were selling at a higher price then it would be eco-
nomically smart to convert.
12.19.5 Forced Conversion
A client is forced to convert when an issuer calls the bond being held at a
price that is less than parity to the common stock. In this instance the client is
forced to convert because it makes economic sense to do so.

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12.19.6 Advantages to the Issuer for a Conversion

Lower yield: Because the investor has the opportunity to convert the bond
by investor choice, the issuer can issue this type of bond with a lower cou-
pon rate.
Reduction of Debt: If and when a bond is converted to common stock the
long-term debt of the corporation is reduced and interest on the bond would
not have to be paid any longer.
12.19.7 Advantages to the Investor
Flexibility: The investor makes the choice as to holding the bond with a
interest bearing coupon rate or converting when convenient.
Safety of Bonds: Holding a bond is safer then holding common stock.
Even though interest rates may change and the current value of the bond
may go up and down, at maturity the bond can be redeemed at par value.
12.19.8 Disadvantages to the Issuer
Additional shares of common stock: Upon conversion there will be more
outstanding common stock and because of supply and demand there may
be a drop in the market price.
12.19.9 Disadvantages to the Investor
Lower Yield: Because of the benefit of a convertible security the coupon
rate will be lower when compared to a traditional coupon bond.
Potential of Dilution: If the price of the common stock increases dramati-
cally, investors will probably convert resulting with more outstanding com-
mon shares in the market bringing down the price of the common.
12.19.10 Pricing of Convertible Securities
Convertible securities are typically priced in the market place based on
any of the following;
The current market price of the common stock
The face value of the bond (usually $1,000)
The current market price of the convertible security
The conversion price of the convertible security
Current market rates of interest
Quality of the instrument

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Notes

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 Module 13: Corporate Debt Obligations

Section 13: Corporate Debt Obligations

1 3 . 1 TR U S T I N D E N T U R E A C T OF 1939
Federal law requires all corporate bonds and other corporate securities to be
issued under an Indenture agreement approved by the Securities and Exchange
Commission and providing for the appointment of a qualified trustee free of con-
flict of interest with the issuer. The main thrust of this Act is to provide protection
for the corporate investor to insure that interest is paid on a timely basis as well
as principal at bond maturity.
13.2 SECURED BONDS
Secured bonds, also known as senior bonds, are backed by a pledge of collat-
eral, a mortgage or other type of lien. The terms and nature of the security is
spelled out in the Indenture that is attached to the bond. Secured bonds are dis-
tinguished from unsecured bonds, also known as Debentures.
13.2.1 Types of Senior Bonds/Secured Bonds
Mortgage Bonds: Mortgage bonds are issued and secured by a mortgage on
the issuers property, the lien on which is conveyed to the bondholders by a
deed of trust. These bonds enjoy a preferred position relative to unsecured
bonds and stand in front of unsecured bonds in the case of a corporate liquida-
tion to get at the remaining assets.
Equipment Trust Bonds: These are usually issued by a transportation com-
pany such as a railroad or shipping line and used to pay for new equipment.
The certificate gives the bondholder the first right to the equipment in the event
that interest and principal are not paid when due.
Collateral Trust Bonds: This form of corporate debt security is backed by
other securities, usually held by a bank or other trustee.
13.3 OTHER BONDS
13.3.1 Unsecured Bonds (Known as Debentures)
Unsecured bonds are obligations not backed by a pledge of specific collateral.
There are more debentures outstanding than secured obligations.
13.3.2 Zero Coupon Bonds
Zero coupon bonds are securities that make no periodic interest payments,
no coupons, but instead are sold at a deep discount from its face value. The
buyer of these bonds receives the rate of return by the gradual appreciation of
the security which is redeemed at Face Value on a specified maturity date.

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For tax purposes, the IRS maintains that the holder of a zero-coupon bond
owes income taxes on the interest that has accrued each year, even though
the bondholder does not actually receive the cash until maturity.
Because zero-coupon securities bear no interest, they are the most vola-
tile of all fixed-income securities. Since zero-coupon bondholders do not
receive interest payments, zeros fall more dramatically than bonds paying
out interest on a current basis when interest rates rise. However, when
interest rates fall, zero-coupon securities rise more rapidly in value than full
coupon bonds, because the bonds have locked in a particular rate of rein-
vestment that becomes more attractive the further rates fall.
There are many types of zero-coupon bonds. Many brokerage firms
strips the interest rate coupons off bonds and sell the underlying value and
the coupons separately.
This technique is used frequently with Treasury bonds and marketed
under the following names;
CATS: Certificates of Accrual on Treasury Securities
TIGERS: Treasury Investors Growth Receipt
STRIPS: Separate Trading of Registered Interest and Principal of
Securities
13.3.2.1 Municipal Zero-Coupon Securities
Buying a municipal zero frees the purchaser of the worry about paying
taxes on imputed interest, since the interest is tax-exempt.
13.3.2.2 Zero Coupon Certificate of Deposit
The CD holder receives face value at maturity but no monthly payments.
13.3.2.3 Uses of Zero Coupon Bonds
Zero-coupon securities are frequently used to plan for a specific invest-
ment goal. For example, parents knowing their child will enter college in
10 years can buy a zero that will mature in 10 years, and thus be assured
of having money available for tuition. People planning for retirement in 25
years can buy 25-year zeros, assuring them that they will get the money
when they need it.
13.3.3 Income Bonds (Adjustment Bonds)
This a debt security that normally does not pay any income/interest. The com-
pany needs to have substantial earnings in order to pay any interest on these
bonds. Typically these bonds are issued when the company has experienced

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 Module 13: Corporate Debt Obligations

financial difficulty and is attempting to reorganize. Generally speaking, income

bonds trade flat (without accrued interest). These are high risk bonds!
13.3.4 Speculative Bonds
Rated below investment grade bonds.
Carry a high level of risk exposure.
Bond analysts are skeptical about the issuers ability to pay interest and
repay principal.
Normally offer higher yields than those offered by investment grade issues.
Investors demand higher returns due to the greater risk inherent in the
investment.
13.3.5 Eurobonds
Sold in a country other than the one in whose currency the bond is denomi-
nated.
U.S. investors must anlayze their return by forecasting foreign currency
movements, as interest and principal paymetns would have to be converted
into U.S. dollars to be spendable.
13.3.6 Eurodollar Bonds
Pay principal and interest in U.S. dollars.
Used primarily in Europe.
Used by multinational corporations, foreign governments and international
agencies.
Bonds are not registered in the United States and cannot trade in the U.S.
for at least three months after issuance.
Pay initerest annually.
Pay either a fixed or floating variable rate.
1 3 . 4 S E C O N D A R Y TR A D I N G OF CORPORATE BONDS
Most corporate bonds are listed on an exchange. However, a great number of cor-
porate bonds issues are not listed securities. Therefore, they would trade in the
over-the-counter marketplace.

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13.4.1 Newspaper Listing Example

1 2 3 4 5

Current Sales in Net

Bond Last
Yield $1000 Change

BASF 8s08 7.1 210 85 3/8 + 3/8

BCE 7s12 cv 92 63 -3
BP zr14 ----- 150 20 1/4 -----
BRO 6s09f ----- 12 66 1/8 -----

Column 1: Shows the name of the issuer, coupon rate and year of maturity.
For example, BASF 8s08 is the BASF 8% bond due in 2008. BP zr14 is the BP
zero coupon bond due in 2014. BRO 6s09f is trading flat (f) which means that
interest payments are not being made on the bond.
Column 2: Shows the current yield based on the current market price. The
symbol cv means that the bond is convertible. The table does not show the
conversion parice or conversion ratio.
Column 3: Shows the par value of bonds sold. For example, there were 210 or
$210,000 par value of BASF 8s08 sold for the day.
Column 4: Shows the closing market price for the bonds. For example, the
BASF 8s08 closed at 85 3/8. This is equivalent to a market price of $850.375
($1,000 x 85 3/8%).
Column 5: Shows the net change from the previous days closing price. For
example, the BASF 8s08 closed at 85 3/8 up 3/8 from the previous day. There-
fore the previous days close was 85.

Accrued Interest
13.5 ACCRUED INTEREST OVERVIEW
When bonds are traded they trade with accrued interest. This means that the
buyer of the bonds pay the agreed price for the bonds plus any accued interest.
This is true because the seller is probably entitled to some of the accrued inter-
est prior to the trade. The buyer will receive the entire six months of interest on the
next interest payment date (remember, bond interest is paid semi-annually).

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 Module 13: Corporate Debt Obligations

The Series 7 exam will have questions about the number of accrued days of
interest as well as the amount of accrued interest. In the non-exam world this
information is provided at the time of the trade and will be displayed on the trade
confirmation.
13.6 ACCRUED INTEREST RULES
Interest accrues up to but does not include settlement date
Regular way settlement for corporate bonds and municipal bonds is three
(3) business days while regular way settlement for U.S. government securi-
ties is only one (1) day.
Interest starts to accrue from the Dated Date.
There are 30 days in each month for corporate and municipal bonds.
Actual days in each month are used for U.S. government securities.
13.6.1 Corporate Bond Example
A 7% corporate bond pays interest 4/1 and 10/1. The bond trades on June
15th. What are the number of acrrued days and the amount of accrued
interest.
To answer these questions you must first calculate the number of days of
accrued interest. It is recommended that you use the following method in
calculating the number of accrued days of interest.
13.6.1.1 Corporate Bond Example Solution
Step 1: Write down the Settlement date for this security. If the bond trades
on June 15th then the settlement date would be 3 days after or June 18th.
Step 2: Then subtract the date of the last interest payment date. In this
example the last date interest was paid was April 1st.
13.6.2 Corporate Bond Accrued Days
Calculation
6 / 18
- 4 / 01
Subtract 4 from 6 which equals 2 months. Two months times 30 days
each month equals 60 days.
Now subtract 01 from 18 for a total number of 17 days.
Therefore, the total number of accrued days would be 77 days

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13.6.2.1 Calculation of the Accrued Interest

This is a 7% bond which means it pays 7% of par or $70 annually.
To calculate the daily accrued interest take the $70 and divide it by the
number days in a corporate year (360).
70 divided by 360 would give a daily accrued interest of .1944.
Finally, take the daily rate of $ .1944 and multiply it times the number of
accrued days in this example of 77. (77 times .1944 equals $14.97).
The buyer would pay the agreed price of the bond plus the $14.97 of
accrued interest.
13.6.3 U.S. Government Bond Example
Remember, U.S. Government Bonds settle the next day, not in three days and
also use the actual number of days in a month versus 30 days as corporates
and municipal bonds would use.
A 6% U.S. Government bond pays interest 1/1 and 7/1. The bond trades
on May 16th. What are the number of acrrued days and the amount of
accrued interest.
To answer these questions you must first calculate the number of days of
accrued interest. It is recommended that you use the following method in
calculating the number of accrued days of interest.
13.6.3.1 Government Example Solution
Step 1: Write down the Settlement date for this security. If the bond trades
on May 16th then the settlement date would be 1 day after or May 17th.
Step 2: Then subtract the date of the last interest payment date. In this
example the last date interest was paid was January 1st.
13.6.3.2 Government Bond Accrued Days
Calculation
5 / 17 (U.S. Government bond settles in 1 day, not 3 days)
- 1 / 01
Subtract 1 from 5 which equals 4 months. Four months times 30 days
each month equals 120 days
Now subtract 01 from 17 for a total number of 16 days. (go to next page)

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 Module 13: Corporate Debt Obligations

The total number of accrued days appears to be 136 days (120 + 16).
Now because it is a government bond adjustments would have to be
made for each of the 4 months (See Below).

Government Bond Accrued Days Adjustment Chart

Actual Days in Adjustment to Days in
Month
Month Month

January 31 +1
February 28 -2
March 31 +1
April 30 None

As you can see in the above chart, the number of days needed to adjust
for the government bond is none. There were a total of adding 2 days
and subtracting 2 days. Therefore, there are a total number of accrued
days of 136.
13.6.3.3 Calculation of the Accrued Interest
This is a 6% bond which means it pays 6% of par or $60 annually.
To calculate the daily accrued interest take the $60 and divide it by the
number days in a government year (365).
60 divided by 365 would give a daily accrued interest of .1644.
Finally, take the daily rate of $ .1644 and multiply it times the number of
accrued days in this example of 136. (136 times .1644 equals $22.36).
The buyer would pay the agreed price of the bond plus the $22.36 of
accrued interest..
Notes

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Module 13: Corporate Debt Obligations

NASD Series 7 Page 100

 Module 14: U.S. Government Securities

Section 14: U.S. Government Securities

14.1 MARKETABLE GOVERNMENT SECURITIES
Marketable government securities include Treasury securities such as
Treasury Bills (T-bills), Treasury Notes (T-notes) and Treasury Bonds (T-
bonds).
Purchasing Treasuries also provide a tax benefit in that any interest paid is
only subject to federal taxes, not state or local.
The term marketable means that there is an active secondary market for
these securities where buyers and sellers can trade them. This market is sim-
ilar to the secondary stock market where buyers and sellers also trade their
securities known as equities.
14.1.1 Treasury Bills
T-bills have the shortest length of maturity of all the Treasuries.
T-bills are sold at a discount to their face value, just like zero coupon
bonds. Large U.S. government securities dealers submit bids for large
blocks of T-bills at weekly auctions. The Treasury awards the bills to the
highest bidders (those that bid the lowest interest rates).
Noncompetitive bids can also be submitted to the Treasury. If accepted
the bidder agrees to pay the average of the competitive bids accepted at
the auction.
The amount of the discount is the difference between the discounted price
and the value at maturity (e.g. T-bill costs $9,500 and will mature in six
months at $10,000).
Treasury bills do not have a coupon rate and therefore would not have
interest distributions to investors. Therefore, when answering questions on
the exam, make sure you do not select T-bills for a customer who is looking
for current income as an objective.
14.1.1.1 T-Bills Maturities and Denominations
T-bills are issued in denominations of $1,000 to $1 million with maturities
of 13 and 26 weeks.
The bid and ask quotes are discounts from the par value. If a six month
$10,000 T-bill had a bid of 5.00, an investor would receive 10,000 minus
5% or $9,500.

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Module 14: U.S. Government Securities

An ask price of 4.75 means that the investor would purchase the T-bill at
a discount of 4.75% or $9,525. ($10,000 - 4.75% or $9,525)
14.1.2 Treasury Notes
T-notes are next in line for length of maturity. T-notes mature between 2-10
years.
Unlike T-bills, however, they have a coupon rate and pay interest semi-
annually.
T-notes are issued in denominations of $1,000 to $1 million.
T-notes are issued, quoted and traded in 1/32 of a percentage of par.
14.1.3 Treasury Bonds
T-bonds also have a coupon rate and pay intereset semi-annually.
They are the longest in maturities from 5 - 20 years.
T-bonds are priced from $1,000 to $1 million.
T-bonds are issued, quoted and traded in 1/32 of a percentage of par.

Marketable Government Securities Review

Registration
Type Maturity Pricing
Form

Issued at a
90 days - 6 months discount;
T Bills Book Entry
(short term) priced on a
discount basis
Priced at a
2 - 10 years
T Notes percentage of Book Entry
(intermediate term)
par
Priced at a
Usually 20 years
T Bonds percentage of Book Entry
(long term)
par

1 4 . 2 S E C O N D A R Y M A R K E T TR A D I N G
Government securities are not listed on an exchange. Instead, they trade in the
over-the-counter market. They are typically traded in large block size among insti-
tutional investors.

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 Module 14: U.S. Government Securities

1 4 . 3 TA X A T I O N OF INTEREST
Interest earned on Treasuries is considered ordinary income and is subject to
federal taxation but exempt from state and local taxation.
Interest earned on T-bills must be reported in the year that the T-bill matures.
The interest earned on T-notes and bonds must be reported in the year
received.
Although Treasury STRIPS so not pay interest until maturity, the interest must
be accrued each year and reported as if it had been received.
1 4 . 4 TR E A S U R Y R E C E I P TS
These are created by broker-dealers by selling separate receipts against the
principal and coupon payments from T-notes and T-bonds.
Treasury Receipts are not backed by the full faith and credit of the U.S. Gov-
ernment.
They are priced at a discount to its face value so they look like zero coupon
bonds.
14.5 STRIPS
STRIPS stand for Separate Trading of Registered Interest and Principal of
Securities.
These are a result of Treasury issues being stripped into interest and prin-
cipal components.
They work just like a zero coupon bond but are backed by the U.S. Govern-
ment because of the underlying Treasuries.
Exam Alert: STRIPS are backed by the U.S. Government but Treasury
Receipts are not.

1 4 . 6 TR E A S U R Y I N F L A T I O N P R O T E C T I O N S E C U R I T I E S
These are known as TIPS
They help protect investors against purchasing power risk.
These bonds are issued with a fixed interest rate but the principal amount is
adjusted semi-annually by an amount equal to the change in the Consumer
Price Index (CPI).
Interest is received semi-annually.

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Module 14: U.S. Government Securities

The amount of interest is the fixed amount times the newly adjusted principal.
In times of inflation the interest payments increase, while in times of defla-
tion, the interest payments fall.
TIPS are sold at lower interest rates than conventional fixed rate Treasury
bonds because of their adjustble nature.
14.7 NON-MARKETABLE GOVERNMENT SECURITIES
Non-marketable government securities include U.S. Government Savings
Bonds. They are non-marketable as there is no secondary market maintained
for them. So, if a person is interested in selling their savings bonds they would
have to redeem them back to the U.S. Government.
14.7.1 Series EE Bonds
Buy at a discount to face value
Matures at face value
Minimum interest rate guarantee
Taxed at maturity or annually (investor choice)
14.7.2 Series HH Savings Bonds
Bought at par value ($1,000)
Provides semi-annual interest because of coupon rate
The only way to purchase HH bonds is to trade in EE Savings Bonds

NASD Series 7 Page 104

 Module 15: U.S. Government Agency Obligations

Section 15: U.S. Government Agency

Obligations
15.1 AGENCY ISSUES
The term agency is sometimes used to refer to entities that are not technically
government agencies, but that do have ties to the government such as;
Federal Home Loan Mortage Corporation (FHLMC or Freddie Mac)
Federal National Mortgage Association (FNMA or Fannie Mae)
Student Loan Marketing Association (SLMA or Sallie Mae).
There are two agencies, however, that Congress authorized to issued debt secu-
rities. They would be;
Farm Credit Administration
Government National Mortgage Association (GNMA).
15.1.1 Yields and Maturities
Agency issues have higher yields than direct obligations of the federal
government, but lower yields than corporate debt securities (higher risk).
Maturities range from short term to long term.
They trade in active secondary markets just like the Treasuries.
15.1.2 Taxation
Government agency issues as well as Fannie Mae and Freddie Mac securities
are taxed at the federal, state and local levels.
15.1.3 Reinvestment Risk
All agencies would be subject to reinvestment risk. When interest rates fall,
mortgage holders will refinance or pay off their mortgages early which causes a
prepayment of principal to holders of mortgage backed securities. Now the
investor will have to reinvest in another interest bearing instrument with lower
interest rates.
Agencies are also subject to Prepayment Risk which is the risk of the invest-
ment being prepaid because of lower interest rates. This would not be good for
investors depending on current income.

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Module 15: U.S. Government Agency Obligations

15.2 GINNIE MAES

This government owned corporation supports the Department of Housing and
Urban Development. Ginnie Maes are backed by the full faith and credit of the
government. (Important to remember for the exam - safest of all agencies)
GNMA buys FHA and VA mortgages and auctions them to private lenders
which pool the mortgages to create pass-through certificates for sale to
investors.
Monthly principal and interest payments from the pool of mortgages pass
through to investors.
Principal represented by a GNMA certificate constantly decreases as the
mortgages are paid down.
GNMAs pay higher interest rates than the Treasuries yet are guaranteed by
the federal government.
Risk of default is nearly zero because of being backed by the government.
If interest rates fall the average life of the GNMA will be reduced as more
principal would be returned to the investors.
GNMAs have significant reinvestment risk.
GNMAs are sold in minimum denominations of $25,000.
15.3 FARM CREDIT SYSTEM
This is a national network of lending institutions that provides agricultural
financing and credit.
The system is privately owned but government sponsored and raises loan-
able funds through the sale of Farm Credit Securities to investors.
15.4 FEDERAL HOME LOAN MORTGAGE CORPORATION
Known as Freddie Mac and FHLMC
Created to promote the development of a nationwide secondary market in
mortgages by purchasing residential mortgages from financial institutions
and packaging them into mortgage-backed securities for sale to investors.
They are also pass-through certificates
Income subject to both federal and state taxation.
Minimum of $25,000

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 Module 15: U.S. Government Agency Obligations

15.5 FEDERAL NATIONAL MORTGAGE ASSOCIATION

Known as Fannie Mae
Publicly held corporation that provides mortgage capital.
FNMA purchases conventional and insured mortgages from agencies
such as the FHA and VA.
Securities created are backed by FNMAs general credit, not by the U.S. gov-
ernment.
FNMA stock also trades on the NYSE.
Interest is paid semi-annually.
FNMA issues debentures, short-term discount notes and mortgage-backed
securities.
$10,000 minimum
15.6 STUDENT LOAN MARKETING ASSOCIATION
Known as SLMA.
Provides liquidity to student loan makers and financing for state student
agencies.
Authorized to deal in student loans insured in the federal Guaranteed Student
Loan Program as well as uninusred student loans.
Capitalized by a common stock issue that is publicly traded.
Not guaranteed by the U.S. Government.
Interest earned is subejct to federal tax but exempt from state and local tax.

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Module 15: U.S. Government Agency Obligations

Notes

NASD Series 7 Page 108

 Module 16: Reading Debt Instrument Financial News

Section 16: Reading Debt Instrument

Financial News
1 6 . 1 TR E A S U R Y B I L L S
Treasury Bill Chart (Basis Points - hundreths) Oct 10, 2002
Date Days to Change Ask Yield
Bid Ask
2002 Maturity (Bid) (YTM)

Oct 09 1 4.87 4.77 +0.24 4.94

Oct 16 8 4.77 4.67 +0.10 4.84
Oct 23 15 5.33 5.23 +0.05 5.42
Oct 30 22 4.80 4.70 +0.06 4.98
Nov 07 29 5.02 4.98 +0.09 5.24

Column 1: Shows the date of maturity for the T-bills.

Column 2: Shows the number of days to maturity
Column 3: Shows the discount yield that government dealers are willing
to buy at that day. This is the discount yield from par value.
Column 4: Shows the discount yield that government dealers are willing
to sell at that day. The yield is a discount from par value.
Column 5: Shows how much the bid price has changed from the prior
day stated in basis points. (Oct 09 - 24 basis points)
Column 6: Shows the yield an investor gets holding the T-bill to maturity
(YTM). This would be higher than the discount yield as the YTM is a com-
pounded yield.
Exam Alert: While you will not have to compute rates and discounts for
the Series 7 exam you will have to show that you can read the financial
news by answering questions about the various financial charts.

Go to the next page for the Treasury Note and Bond Chart!

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Module 16: Reading Debt Instrument Financial News

1 6 . 2 TR E A S U R Y N O T E S AND BONDS
Treasury Notes & Bonds Chart
Mo/Yr Change Ask Yield
Rate Bid Ask
Maturity 32nds (YTM)

5 1/4 Feb07n 99:22 99:24 -2 6.23

5 1/8 Feb08n 98:19 98:21 -4 7.27
5 Feb08n 96:10 96:12 -6 8.08
8 5/8 Aug08-13 100:23 100:25 -5 8.90
12 5/8 Jun20 126:18 126:22 -8 8.97

Column 1: Shows the interest rate.

Column 2: Shows the maturity.
Column 3: Shows the dealers bid price. The dealer is willing to buy at this
price.
Column 4: Shows the dealers ask price. The dealer is willing to sell at this
price.
Column 5: Shows how much the bid has changed from the prior day. As
an example, in the 5 1/4 Note (n) the bid fell by 2/32. This indicates that
interest rates have increased that day since the price has fallen.
Column 6: Shows the yield to maturity on the security. As you can see,
the 5 1/4 Note is priced at a discount. It makes sense that the YTM is higher
than the nominal yield. (Remember the inverse relationship as shown
with the Fulcrum).
16.3 GOVERNMENT AGENCY SECURITIES
Agency securities are quoted in identical fashion to long term U.S. Government
securities as shown in the above chart for T-Notes and T-Bonds.

NASD Series 7 Page 110

 Module 17: Collateralized Mortgage Obligations (CMOs)

Section 17: Collateralized Mortgage

Obligations (CMOs)
17.1 CMO OVERVIEW
CMOs are mortgage-backed securities just like the pass-through obligations that
Ginnie Mae and Fannie Mae issue.
The following are features of CMOs;
CMOs are issued by corporations, not by the U.S. Government even though
they are collateralized (backed) with U.S. Government Agency mortgage-
backed securities. They are also known as derivative securities.
Because they are corporate issued they are not considered as safe as
those issued by government agencies. However, because of the underlying
collateral they are usually rated AAA.
A pool of mortgages is structured into maturity classes called tranches.
CMOs pay principal and interest from the mortgage pool monthly, just like
GNMAs and FNMAs.
Changes in interest rates affect the rate of mortgage prepayments, and this
affects the flow of interest payment and principal repayment to the CMO
investor.
CMOs usually trade in increments of $1,000.
1 7 . 2 C M O S AV E R A G E LI F E
CMOs were developed to eliminate or minimize prepayment risk when interest
rates drop and extension of time risk (average life is longer) when interest
rates rise. CMOs do not view mortgage pools as a means of passing through pay-
ments to certificate holders in exactly the same form as received.
Mortgage payments received are looked at on a cash flow basis. On the basis
of expected cash flows to be received over the life of the pool, separate classes of
securities called tranches are created.
The particular tranche an investor owns determines the priority of his principal
repayment. The time to maturity, amount of interest received, and amount of prin-
cipal returned are not guaranteed.

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Module 17: Collateralized Mortgage Obligations (CMOs)

17.2.1 Tranches
Each tranch has an expected life
30 year mortgages can be transformed into any number of tranches with a
different expected life for each tranch. (See example of 10 Tranches
below)
As monthly interest payments are received, the interest is distributed pro-
rata to all the tranches.
However, as principal is repaid, the principal payments are first applied to
Tranch 1 until it is retired. After Tranch 1 is retired, principal repayments
then are used to retire Tranch 2 and on and on it goes. These are known as
Plain Vanilla CMOs.

Tranch Structure Example

Tranch Interest Rate Estimated Life in Years

1 5.200 1-3
2 5.400 4-6
3 5.600 7-9
4 5.875 10-12
5 6.250 13-15
6 6.500 16-18
7 6.650 19-22
8 6.750 23-25
9 6.850 26-28
10 7.00 29-30

17.3 MODERN CMOS

Modern CMOs are structured differently than the plan vanilla CMOs. The following
are examples of these new type CMOs;
17.3.1 Planned Amortization Class (PACs)
They have targeted and more certain maturity dates
They are retired first

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 Module 17: Collateralized Mortgage Obligations (CMOs)

They offer protection from prepayment risk and extension risk

Changes in prepayments are transferred from the PAC to Companion
Tranches (also known as Support Tranches). Therefore, principal repay-
ments made earlier than that required to retire the PAC at its maturity are
applied to the Companion class. Also, principal repayments made later
than expected are applied to the PAC maturity before payments are made
to the Companion class.
17.3.2 Targeted Amortization Class
This structure transfers prepayment risk only to companion tranches
They do not offer protection from extension risk
Investors accept the extension risk and the resulting greater price risk in
exchange for a slightly higher interest rate

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Module 17: Collateralized Mortgage Obligations (CMOs)

Notes

NASD Series 7 Page 114

 Module 18: Yield Curves

Section 18: Yield Curves

18.1 OVERVIEW
When different maturities of debt instruments are plotted against the correspond-
ing yield for each maturity, the resulting graph is known as a Yield Curve.
The Series 7 exam has a number of questions about the types of yield
curves as well as client recommendations.
18.1.1 Normal Yield Curve
The Normal Yield Curve is also known as an Upward Sloping or Ascend-
ing Yield Curve. (See graph below)
Here, yields generally increase as maturities lengthen.
This yield curve would show lower yields in the shorter maturities and
higher yields in the longer maturies.
Therefore, if a client is looking for the highest yielding debt instrument it
would be necessary to purchase them with longer maturity dates.
Short-term instruments would pay the lowest interest rates.
Normal Yield Curve

Yield In
8
Percent

5 10 15 20 25 30
Maturity

Go to the next page

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Module 18: Yield Curves

18.1.2 Flat Yield Curve

This yield curve reflects when short-term bonds and long-term bonds have
approximately the same yield. (See graph below)
Typically it indiates that short-term yields are rising faster than long-term
yields.
An inverted yield curve, short-term rates are higher than long-term rates.
usually follows a flat yield.
With this yield curve it is probably better to recommend short-term debt
instruments instead of long-term debt instruments.

Flat Yield Curve

Yield In
Percent 8

5 10 15 20 25 30
Maturity

Go to the next page!

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 Module 18: Yield Curves

18.1.3 Inverted Yield Curve

This curve is also known as a negative, descending or downward slop-
ing curve.
The inverted yield curve occurs when interest rates have just increased.
This is an unusual situation.
Short-term debt instruments are yielding more than long-term bonds.
This yield curve generally does not last for a very long time.
With an inverted yield yield curve you would recommend clients to pur-
chase short-term debt instruments than long-term.

Inverted Yield Curve

9

Yield In 8
Percent

5 10 15 20 25 30
Maturity

18.2 DEBT INSTRUMENTS & RELATED ITEMS REVIEW

Bonds are long-term debt obligations
Face value of a bond is known as the face amount, principal or par value
Typically, the par value of most bonds are $1,000
Bonds have a stated interest rate which is known as referred to as the cou-
pon, coupon rate or nominal Yield.
Repayment of the principal amount of the bond occurs at maturity
Bonds pay interest semi-annually.
Coupon rates on bonds remain fixed for the life of the bond.

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Module 18: Yield Curves

If interest rates rise, the value (price) of an existing bond will decline since
it is worth less than a new bond with a higher coupon.
If interest rates decline, the value (price) of an existing bond will rise since
it is worth more than a new bond with a lower coupon.
For a bond selling at par, the nominal yield (coupon rate), current yield and
yield-to-maturity are equal.
For a bond selling below par (discount bond) the nominal yield is less than
the current yield which is less than the yield-to-maturity.
For a bond selling above par (premium bond) the nominal yield is more than
the current yield which is more than the yield-to-maturity.
Normal yield curves show lower yields in the shorter maturities and higher
yields in the longer maturities.
Inverted yield curves show higher yields in the longer maturities and lower
yields in the shorter maturities.
Discount debt instruments are more volatile than premium debt instruments.
Long-term yields are more volatile (amount of the change) than short-term
yields.
Short-term yields change more often than long-term yields.
Call features benefits the issuer, not the holder.
If called, the amount above par value is known as the call premium.

NASD Series 7 Page 118

 Module 19: Debt Review Questions

Section 19: Debt Review Questions

1. A corporation will call in its debt during a period of;
A. Volatile interest rates
B. Stable interest rates
C. Rising interest rates
D. Declining interest rates
2. The difference between a par and a lower market price on a bond is called
the;
A. Premium
B. Discount
C. Coupon
D. Composition
3. If interest rates are changing, which of the following terms would best
describe the relationship between prices and yields for corporate bonds?
A. Coterminous
B. Covariant
C. Reverse
D. Inverse
4. How do you calculate the current yield on a bond?
A. Annual interest payments divided by the par value.
B. Annual interest payments divided by the cost of the bond.
C. Yield to the call divided by the par value.
D. Yields to the maturity divided by the par value.
5. A bond at par has a coupon rate;
A. Higher than the current yields.
B. Less than the current yield.
C. The same as the current yield.
D. Less than yield to maturity.
6. The price of an existing bond will do which of the following when interest
rates drop?
A. Stay the same
B. Go up
C. Go down
D. Go sideways

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Module 19: Debt Review Questions

7. In case of a bankruptcy, debentures rank with which of the following?

A. Senior securities
B. Unsecured bonds
C. Equipment trust bonds
D. IRS
8. A trust indenture spells out the covenants between;
A. The trustee and the issuer for the issuers benefit
B. The Issuer and the broker-dealer selling the bond
C. The trustee and the issuer for the benefit of the bondholder
D. The bondholder and the issuer
9. The largest borrower is;
A. Bank-One
B. Corporations
C. U.S. Government
D. Europe
10. Par value for most bonds is;
A. $100
B. $1,000
C. $5,000
D. $100,000
11. Which of the following never changes;
A. Nominal yield
B. YTM
C. YTC
D. CY
12. Bonds are rated for their;
A. Insurable risk
B. Inflation risk
C. Buying power risk
D. Credit risk
13. All of the following are features of convertible bonds, EXCEPT;
A. Greater appreciation potential
B. Sometimes used as a sweetner to enhance the marketability
C. Features of both a debt instrumnet and a common stock
D. Works just like an call option

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 Module 19: Debt Review Questions

14. A convertible bond with a conversion price of $50 has a conversion

ration of;
A. 10:1
B. 20:1
C. 50:1
D. 100:1
15. Which of the following Acts provide protection for the corporate investor
when buying bonds?
A. Securities Act of 1933
B. Securities Act of 1934
C. Trust Indenture Act of 1939
D. Investment Act of 1940
16. Unsecured bonds are known as;
A. Debentures
B. Senior debt
C. Inflation fighting debt
D. Income bonds
17. All of the following are examples of secured bonds EXCEPT;
A. Morgage bonds
B. Collateral trust bonds
C. Income bonds
D. Equipment trust bonds
18. Which uses actual days in the calculation of accrued interest?
A. Corporate bonds
B. U.S. Government bonds
C. Municipal bonds
D. Income bonds
19. Treasury bills have a maximum maturity of;
A. 3 months
B. 6 months
C. 9 months
D. 12 months
20. Which of the following is NOT a mortgage backed security?
A. CMO
B. GNMA
C. SLMA
D. FNMA

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Module 19: Debt Review Questions

21. If a bonds yield-to-maturity equals its nominal yield, the bond is being
offered at:
A. 100
B. Less than 100
C. More than 100
D. Cant determine.
22. The yield of a bond has increased by 3/4%. This means that the yield has
increased by:
A. 10 basis points
B. 25 basis points
C. 50 basis points
D. 75 basis points.
23. A 5% bond maturing in five years and selling at 102 has a current yield of
4.9%. The approximate yield-to-maturity for this bond is:
A. 3.50%
B. 5.00%
C. 5.65%
D. 6.00%
24. Which of the following debt intstruments would you recommend when
the yield curve is inverted?
A. Short-term
B. Long-term
C. Mid-term
D. Not enough information
25. Which of the following is more volatile?
A. 30 year par bonds
B. 25 year premium bonds
C. 25 year discount bonds
D. 20 year premium bonds

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 Module 19: Debt Review Questions

Review Answers
1. (D): When interest rates decline the chance of bonds getting called increases.
The issuing company would choose to call a bond issue so as to reduce their
interest costs.
2. (B): When a bond sells for less than par value this is known as a discount. If a
bond were selling at a price higher than par it would be known as a premium.
3. (D): This is known as the inverse relationship. Take a look at the fulcrum in this
module and observe how the inverse relationship works.
4. (B): The current yield (CY) is calcualted by taking the annual interest or divi-
dend paid by the security and dividing by the investors cost.
5. (C): When a bond is at par, all the various yields are the same as the coupon
rate.
6. (B): This is an example of the inverse relationship at work. When interest rates
fall the value of the bond increases. If interest rates rise then the value of bonds
would fall.
7. (B): Debentures are unsecured bonds.
8. (C): The Trust Indenture Act of 1939 is meant to protect the investor. The cove-
nants are between the issuer and the trustee with the trustee looking out for the
benefit and rights of investors.
9. (C): The largest borrower of debt is the U.S. Government.
10. (B): Par value of bonds is $1,000 while par value of preferred stock is $100.
Municipal bonds have a par value of $5,000.
11. (A): The nominal yield is another name for the coupon rate. Once a bond is
issued, this yield never changes.
12. (D): The purpose of rating bonds by the rating services is to measure their
credit worthiness.
13. (D): Choices A, B and C are all features of a convertible bond.
14. (B): Take par value of $1,000 and divide it by the conversion price of $50.
15. (C): The Trust Indenture Act of 1939 requires corporations to hire independent
trustees to protect investors.
16. (A): Unsecured bonds are also call debentures.
17. (C): Choices A, B and D are all examples of secured bonds. Income bonds
are high risk bonds that hardly ever pay interest.

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18. (B): The U.S. Government uses actual days when computing days of accrued
interest. Corporate and municipal bonds use 30 day months when computing
days of accrued interest.
19. (B): The maximum duration for T-bills is now 6 months.
20. (C): Sallie Maes (SLMA) are used for student loans. Choices A, B and D are
all examples of mortgage backed securities.
21. (A): For a bond selling at par (100), the nominal yield (coupon rate), current
yield and yield-to-maturity are the same.
22. (D): There are 100 basis points in one bond point. Therefore, a bond increas-
ing by 3/4 of a point is the same as 75 basis points.
23. (A): When a bond is purchased at a premium, the yield-to-maturity will always
be less than the nominal yield (coupon rate) and the current yield. The nominal
yield is given as 5.0% and the current yield is given as 4.9%. Therefore, of the
choices given, only 3.5% could possibly be correct. The other choices are greater
than the current yield and the nominal yield and are therefore incorrect.
24. (A): Short-term rates are higher than long-term rates when the yield curve is
inverted.
25. (C): Discount bonds are always more volatile than par or premium bonds.

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 Module 20: Money Markets

Section 20: Money Markets

20.1 MONEY MARKET OVERVIEW
There are basically two types of financial market involving financing. First, the
capital market, which serves as a source of intermediate-term to long-term financ-
ing which is usually in the form if equity or debt securities with maturities of more
than one year.
The second, money markets, which provide short-term funds to corporations,
municipalities and the U.S. Government. Money market securities are debt issues
with maturities of one year or less.
20.2 LIQUDITY AND SAFETY
Fixed income securities with short-term maturities, typically one year or less
HIghly liquid
Relatively high degree of safety because they are short-term
Have very little chance of default
20.3 MONEY MARKET SECURITIES
Examples of money market securities are:
Repurchase Agreements
Reverse Repurchase Agreements
Bankers Acceptances
Commercial Paper
Negotiable Certificates of Deposit (CDs)
Money Market Funds
20.3.1 Repurchase Agreements
In a repurchase agreement (known as repo), a dealer raises cash by tempo-
rarily selling some of the securities it holds with an agreement to buy back the
securities at a later date. So, a repo is simply an agreement between a buyer
and a seller to conduct a transaction (purchase), then to reverse that transac-
tion (repurchase) in the future.

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20.3.1.1 Primary Uses of repos

U.S. Government and municipal securities dealers financing their inven-
tories.
Commercial banks raising short-term funds
Federal Reserve adjusting member bank reserves
20.3.2 Reverse Repurchase Agreement
In a repo, a dealer agrees to sell its securities to a lender and buy them back at
a higher price in the future. In a reverse repurchase agreement a dealer agrees
to buy securities from an investor and sell them back later at a higher price.
The difference between repos and reverse repos is that the dealer initiates the
sale in a repo and an investor initiates the sale in a reverse repo.
20.3.3 Bankers Acceptances
A Bankers Acceptance (BA) is a short-term term draft with a specified payment
date drawn on a bank used to facilitate foreign trade. It is essentially a post-
dated check or line of credit. The maximum payment date of a BA is 270 days
(nine months).
BAs are used extensively to finance international trade in that they pay for
goods and services in a foreign country.
They are actively traded in the money market and are considered high qual-
ity since they are secured by a guarantee from a large bank and also by the
goods originally purchased by the importer.
20.3.4 Commerical Paper
Commercial paper is short-term unsecured corporate date with a maximum
maturity of 270 days (nine months).They are primarily used to raise cash to
finance accounts receivable and seasonal inventiry gluts. Commercial paper
interest rates are lower than bank loan rates.
Primary buyers of commercial paper are money-market funds, commercial
banks, pension funds, insurance companies, corporations and nongovern-
mental agencies.
Normally issued in book entry form.
Usually issued by companies with excellent credit ratings.
Moodys and standard and Poors issue ratings for commercial paper.

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 Module 20: Money Markets

20.3.5 Negotiable Certificates of Deposit

Large commercial banks can borrow money by issuing CDs. These are short-
term, interest bearing securities backed by the general credit of the issuing
bank.
Known as jumbo CDs with minimum denominations of $100,000
Typically trade in denominations of $1,000,000 or more
A normal negotiable CD would not be insured by the FDIC if its size is
greater than $100,000 as it would exceed the FDICs insurance limit
Accrued interest is included in the price of a negotiable CD
20.3.6 Money Market Funds
A money market is a type of open-end investment company (known as a
mutual fund) that invests in short-term debt securities and money market secu-
rities.
Must be registered under the Securities Act of 1933 and the Investment
Company Act of 1940.
Must be sold with a prospectus.
Minimum initial investments will be stated in the prospectus.

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Review Questions
1. Which of the following money market securities is issued to assist a cor-
poration in managing its cash flow?
A. Commercial paper
B. Treasury bill
C. Bankers Accpetance
D. Certificate of Deposit
2. Which of the following is (are) short-term money market instrumetns
which are guaranteed by a bank in order to provide exporters with capital to
operate and which are traded in the secondary market at prices that are dis-
counted from the face value?
A. ADRs
B. CDs
C. Commercial Paper
D. Bankers Accpetances

Review Answers
1. (A) Corporations issue commercial paper for cash flow purposes. Commerical
paper is unsecured and has a maximum maturity of 270 days. It may be sold to
investors by the corporation which is known as directly placed or through a bro-
ker-dealer which is known as dealer placed.
2. (D) BAs are used to faciliate foreign trade.

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 Tax Advantaged Products
Municipal Securities
MSRB Rules
Tax Issues
Direct Participation Programs
 Module 22: Tax Advantaged Products

Section 22: Tax Advantaged Products

Municipal Securities
22.1 MUNICIPAL SECURITIES OVERVIEW
Test Clue: There are a large number of Series 7 questions asked about
municipal securities and the MSRB rules.
Municipal securities are debt instruments that are for the most part exempt from
federal taxation while some issues are also exempt from state and local taxation.
Municipal bonds are issued by state or local government of U.S. Territories,
authorities and special districts.
Investors purchasing these securities are actually lending money to the issuers for
the purpose of public works and construction projects such as;
Hospitals
Roads
Civic Centers
Sewer Systems
Airports
Lets take a look at some general features of Municipal Securities;
Interest is exempt from Federal taxation. This is based on the Doctrine of
Reciprocal Immunity which was established by a Supreme Court Decision in
1895. The doctrine specifies that a level of government can only tax the inter-
est of its own issues. So, municipal securities may be taxed by the municipal
level such as state and local governments, but not the federal government.
Capital gains are always taxable even though the interest may not be
Because of the inherent tax reduction of municipal securities, they tend to
pay lower interest rates than do corporate issuers or U.S. Government
issues.
Municipal securities can be issued as fully registered in certificate form or by
Book Entry, similar to U.S. Government Treasuries
All municipal bonds must have a Legal Opinion printed on the face of the
bond. This opinion is issued by legal counsel hired by the issuer to make sure
that the bond issued is legally binding on the issuer and the interest is exempt
from Federal tax.

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- A Qualified Opinion by bond counsel is not desirable as the opinion

is indicating there may be a problem. An example could be that inter-
est from the bond may be taxable under new Federal tax rulings.
- Most long-term bonds are issued as serial issues with interest paid
semi-annually.
Broad categories of municipal securities include general obligation bonds
(GO), revenue bonds, special types of bonds and short-term notes.
22.2 LEGAL OPINION
The issuer hires a bond counsel, also known as a bond attorney to write a legal
opinion on the bond issue. The responsibilities of the bond counsel are as follows;
Examine the indenture and securities laws
Determine that the issue is valid and binding on the issuer.
Determine that the issue is tax exempt.
Issues an unqualified or qualified legal opinion.
- Unqualified: This is the good one. It means that the issuer meets all
conditions without any restrictions. This is sometimes called a clean
legal opinion as there are no contingencies that would keep the issue
from being valid or tax exempt.
- Qualified: This means that the issuer meets conditions with certain
restrictions. Restrictions can result because of a lien on the property
or a pending lawsuit, as examples.
22.3 BOND INSURANCE
Municipal bonds that are insured guarantee the timely payment of principal and
interest by a number of different insurance agencies. If a municipality was unable
to pay its debt, the insurance company would.
As an insured bond is an additional benefit for investors, coupon rates on insured
bonds tend to be lower than non-insured bonds.
Some example of companies that insure municipal bonds are as follows;
AMBAC - American Municipal Bond Assurance Corporation
MBIA - Municipal Bond Insurance Association Corporation
FGIC - Financial Guaranty Insurance Corporation
FSA - Financial Security Assurance Corporation

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22.4 MUNICIPAL BOND RATINGS

Municipal Bond Ratings Examples
S & P (+ or -) Moodys (1,2 or 3)
High AAA Aaa
AA + Aa 1
AA Aa 2
AA - Aa 3
A+ A1
Low A A2

2 2 . 5 TY P E S OF MUNICIPAL SECURITIES
22.5.1 General Obligation Bonds (GO)
General obligation bonds are generally issued to fund non-revenue producing
facilities such as schools, libraries, police, fire and more. These bonds are also
known as full faith and credit bonds meaning there is reliance on the taxing
ability of the issuing municipality to help pay for the debt service (interest owed
bond holders).
22.5.1.1 Features of General Obligation Bonds
Backed by the full, faith and credit of the issuers taxing power, this type
of municipal bond allows the municipality to raise taxes as much as
needed to pay off the bonds.
The amount of debt municipal government may incur can be limited by
state or local statutes to protect taxpayers from excessive taxes. Debt
limits can also make a bond safer for investors. The lower the debt limit,
the less risk of excessive borrowing and default by the municipality.
Because taxes back GOs, most municipalities require a vote of the tax-
payers to approve new GO issues.
Unlimited ad valorem taxes (property taxes) which are the largest
source of backing for GO bonds. Some states limit property taxes to a
certain percentage of the assessed property value or to a certain per-
centage increase in any single year.
-If necessary, taxes are raised to pay bondholders

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-Taxes based on the assessed value of the property, not the market
value
-Taxes are based on millage. One Mill is equal to .001. As an
example, if the property has an assessed value of $100,000 and the
Mill Rate is .006, multiply .006 times $100,000 to get the ad valorem
tax of $600.
Test Clue: Remember, use the assessed value not the market value to
compute the ad valorem tax.
States do NOT collect property taxes, local and county municipalities do.
GO bonds have a constitutional debt limit. In order to issue bonds
beyond this limit requires voter approval.
State issues are usually backed by income and sales taxes
All things being equal, general obligation bonds are considered the saf-
est of all municipal securities because of the taxing power backing up
these bonds.
A limited tax bond has more credit risk than a GO issued with no debt
limits. The issuer cannot raise taxes beyond the maximum rate and could
put bondholders at risk if collections are insufficient.
Limited tax bonds, therefore, sell with a higher interest rate.
22.5.2 Double-Barreled Bonds
A double-barreled bond is a combination of a revenue and a general obligation
bond. However, for test purposes, they are GO bonds first and then they can
also rely on income generated from any revenue being produced. With two
sources of revenue they can be safer than regular GO or regular Revenue
bonds.
22.6 ANALYZING GO BONDS
All of the following items would be important to investors of municipal general obli-
gation bonds. Since GO bonds are backed by the taxing power of the municipality,
the more money being paid to the municipality and the less money owed by the
municipality, the higher the bond rating.
Tax Base: This includes the population, average income, assessed property
value, condition of the economy etc. The better the tax base the higher the
credit rating.
Government Efficiency: If the government does not handle the money well
and spends it foolishly, the rating of the bond would be lower.

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Direct Debt: Debt that the municipality has issued in its own name. Debt that
the municipality is directly responsible for.
Overlapping Debt: Debt that the municipality will assist the higher govern-
ments in paying off. Several taxing authorities that draw from the same tax-
payers can also issue debt instruments. These authorities would issue bonds
that tap the same taxpayer pocketbooks and are known as coterminous
debt. Coterminous debt refers to two or more taxing agencies that share the
same geographic boundaries and are able to issue debt separately. An
example would be a school district shared by three towns. A bond issued by
this school district is known as overlapping or coterminous debt. Overlapping
debt is based on assessed property value.
Overall debt: Direct debt + Overlapping debt. All the debt that the municipal-
ity is responsible for.
Debt per Capita: This is a measure of debt per person.
- Question: If the population of Palatine is 10,000,000 persons and the
overall debt was $100,000,000, what is the debt per capita?
- Solution: Divide the $100,000,000 debt by the 10,000,000 persons.
Palatine would have a debt per capita of $10. ($100,000,000 divided
by 10,000,000 = $10.00)
Other Fees: Traffic fines and licensing fees are used to help pay off the
bonds.
22.7 REVENUE BONDS
Revenue bonds are backed by a specific source of revenue. Municipalities
issuing revenue bonds cannot use their taxing powers. Unlike GOs, revenue
bonds are not subject to statutory debt limits and therefore would not require
voter approval.
22.7.1 Features of Revenue Bonds
Revenue bond issues are self-supporting and therefore not as safe as
general obligation bonds.
A feasibility study prepared by outside consultants must be completed to
insure that the proposed project makes economic sense.
They have a greater credit risk than GO bonds as they only have one
source of funding. This means that all things being equal, revenue bonds
will have a higher coupon rate than GO Bonds.

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Debt service payments for issued revenue bonds do not come from gen-
eral or real estate taxes and are not backed by the municipalitys full faith
and credit.
22.7.2 Revenue Bond Income Examples
Housing
Water, sewer and electric revenue (utilities)
Hospitals
Colleges
Airports
Toll Roads
Student loans
Sports facilities
22.8 ANALYZING REVENUE BONDS
Since revenue bonds are backed by a revenue producing facility and not taxes,
they would have their own key items that would either strengthen or weaken their
credit. As a retail stock broker, you are expected to have the knowledge to
research and analyze municipal debt for your clients that are considering an
investment in municipal securities.
Analyzing municipal issues should contain the following;
22.8.1 Feasibility Study
The feasibility study is an engineering report conducted by independent con-
sultants to determine if the proposed revenue producing facility makes sense
and can support the bonds that are to be issued.
22.8.2 Facility Use Charges
These are the charges for using the revenue producing facility. Are they suffi-
ciently high enough to pay off the bonds to be issued?
22.8.3 Number of Users
The question to be asked is if there will be enough users of the facility to make
enough revenues to support the bond issue.

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22.8.4 Protective Covenants

In the trust indenture of a revenue bond the municipality agrees to abide by cer-
tain protective covenants which are really promises to protect bondholders. A
trustee appointed in the indenture supervises the issuers compliance with the
bond covenants.
The following are types of covenants which are typically found in most
trust indentures;
Maintenance Covenant: A promise to maintain the equipment and facili-
ties
Rate Covenant: A promise to maintain rates sufficient to pay expenses
and debt service (payment of interest)
Insurance Covenant: A promise to insure any facility built
Segregation of Funds Covenant: Promise to keep the revenues collected
separate from those used to run the facility from other municipal accounts.
Non-Discrimination Covenant: Promises to treat all users equally.
Sinking Fund: Money is used to pay off interest and principal obligations.
This is generally held as a positive for the bond issuer.
Catastrophic Clause: A promise to use insurance proceeds to call bonds
and repay bondholders if a facility is destroyed.
Additional Bonds Test: If more bonds are issued, can the municipality still
pay any debt service (interest to bond holders)? An open-end indenture
allows the issuer to issue more bonds while a closed-end indenture does
not.
Books and Records Covenant: This covenant requires an outside audit of
records and financial reports.
Note: The use of any trust indenture for municipal securities is clearly voluntary
as the Trust Indenture Act of 1939 only applies to corporate issues. However, if
used, a trust indenture can enhance the marketability of the issue.
22.8.5 Flow of Funds
The flow of funds represents the priority of funds collected and disbursed. In
other words, how they spend their money. First, it needs to be determined if a
particular revenue bond contains a Gross Revenue Pledge or a Net Revenue
Pledge.
Gross Revenue Pledge: The first priority of income received from the facil-
ity would be to pay off the debt service (principal and interest) on the out-

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standing bonds. After the debt service was paid, then money would go
towards operation and maintenance of the facility. The remainder of the
income received would go towards the reserve fund and then the renewal
and replacement fund.
Net Revenue Pledge: The facility would pay operation and maintenance
before any debt service. Always assume that the municipality is using a net
revenue pledge unless otherwise stated in the test question.
- Reserve Fund: This is used to pay off principal and interest for the
next two years.
- Renewal and Replacement Fund: For improvements or expansions
2 2 . 9 TY P E S OF REVENUE BONDS
Industrial Development Revenue Bonds
- Used to construct facilities or to purchase equipment which is then
leased to a corporation.
- The municipality uses the money from the lease payments to pay the
principal and interest on the bonds.
- Note, that for test purposes the responsibility for payment of the
principal and interest rests with the corporation, not the munici-
pality. Therefore, this type of bond carries the greatest amount of
risk.
- These bonds carry the debt rating of the corporation.
- IDRs generally remain tax exempt because the funds were used for
the general benefit of the public. But, proceeds from these bonds
make investors subject to AMT taxation (Alternative Minimum Tax).
22.10 OTHER MUNICIPAL BOND ISSUES
Moral Obligation Bonds: These are state or state agency issued revenue
bonds. If revenues generated are insufficient to pay the debt service, the
state legislature has the authority to appropriate funds to make the pay-
ments. This type of bond is generally more marketable than regular reve-
nue bonds. But remember, this is only a moral obligation, not a legal one.
Special Tax Bonds: These bonds are backed by Excise Taxes (regressive
taxes) such as gasoline, alcohol and tobacco.
Special Assessment Bonds: Backed by charges on the property that bene-
fits with repairs, sidewalks, sewers etc.

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Public Housing Authority Bonds (PHAs): These are special bonds backed
by U.S. Government subsidiaries. They are no longer issued, even though
you may get a test question on them. But, they can still be found in the sec-
ondary marketplace. There is also a tax break on these as they are still con-
sidered a municipal security. In theory they are the safest municipal bond
because of the backing by the federal government.
Variable Rate Municipals (Variable Rate Demand Obligations): These
bonds or notes are issued with variable or floating rates of interest. They offer
interest payments that are tied to the movements of another specified interest
rate, much like an adjustable rate mortgage. These bonds are sometimes
called reset bonds because their coupon is usually reset to the market rate
of interest every six months while their market prices generally remain stable.
2 2 . 11 M U N I C I P A L N O T E S
Municipal notes are short-term securities (usually three months to three years)
that are used by municipalities in need of financing municipal projects but dont
have the current revenue or funds needed. Instead, they sell short-term notes to
temporarily fund the current projects and then repay the holders of these notes in
the near future when tax or revenue dollars are available.
Municipal notes are rated by Moodys ratings. They are as follows from highest
to lowest. As with regular bonds, the higher the credit rating the safer the security
and the more likely the investor is to get his/her principal at maturity.
Examples of MIG ratings are as follows;
MIG - 1
MIG - 2
MIG - 3
MIG - 4
Municipal notes are as follows;
Bond Anticipation Notes (BANs): BANs are sold as interim financing for
projects that will ultimately be paid for by long-term bonds. However, it takes
a while for new bonds to be issued. So, to get the funds now BANs are sold.
Once the new bonds are issued, the proceeds will be used to buy back the
notes sold.
Tax Anticipation Notes (TANs): These are issued in anticipation of future
tax collections.

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Revenue Anticipation Notes (RANs): Issued in anticipation of future reve-

nue collections such as receiving highway funds from the federal govern-
ment.
Tax and Revenue Anticipation Notes (TRANs): Combination of the charac-
teristics of both TANs and RANs.
Construction Loan Notes (CLNs): Issued to provide interim financing for
new projects.
Project Notes (PNs): Project notes provide interim financing for public hous-
ing projects.
22.12 MUNICIPAL ISSUE DOCUMENTS
The following represent various types of documents associated with the
issuance of municipal securities;
22.12.1 Official Statement
An official statement is the exempt equivalent to the non-exempt prospectus
required by the Securities Act of 1933. As municipal securities are exempt from
registration under this Act prospectuses are not required but Official State-
ments are required.
The official statement serves as a disclosure document and contains any mate-
rial information an investor may need to make a reasonable decision as to
whether the security should or should not be purchased.
Some more stuff to remember about official statements;
The Official Statement does NOT have to be filed with the SEC.
It must be sent along with any advertisements or sales literature sent to a
prospective customer.
If there are no changes from the preliminary version, a final version does
not need to be prepared.
Prepared by the issuer, the official statement identifies the issues purpose.
The source from which the interest and principal will be repaid is identified.
Issuers and communitys financial and economic backgrounds will be pro-
vided.
The creditworthiness will be indicated.

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The following will also be found in official statements;

Offering terms
Authorization of bonds
Security of bonds
Summary statement
Description of bonds
Project feasibility statement
Regulatory matters
Legal proceedings
Tax status
Credit enhancements
22.12.2 Bond Authorizing Resolution
The municipality authorizes the issue and sale of its securities through the
bond resolution. This resolution contains a description of the issuers size,
maximum interest and cost legality.
22.12.3 Bond Contract
This is a contract between the municipal issuer and the underwriters of, and
investors in, its securities. The contract is a collection of legal documents that
includes the above resolution, a trust indenture, applicable state and national
law as well as any other legal documents pertaining to that particular issue and
issuer. In essence, the issuer has agreed to abide by the terms and covenants
contained in the various documents that compose the bond contract.
22.12.4 Underwriters Counsel
An underwriters counsel may be hired by the managing underwriter for legal
reasons other than for giving a legal opinion regarding the bonds tax status.
This counsel is employed to represent the underwriters interests, not the
issuers.

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22.13 MUNICIPAL SECURITIES SOURCES OF INFORMA-

TION

22.13.1 Bond Buyer

The bond buyer is published every business day and serves as an authoritative
source of information on primary market municipal bonds. The Thursday edi-
tion publishes the 30-day visible supply (the total dollar volume of municipal
offerings, not including short-term notes) expected to reach the market in the
next 30 days. Also printed on Thursdays are the Placement Ratio Indexes
which shows the percentages of the previous weeks new issues that have
been purchased from the underwriters.
- It should be noted that if the visible supply is exceptionally large, inter-
est rates are likely to rise in order to attract investors to the larger
number of bonds available. On the other hand, a small visible supply
is an indication that interest rates are likely to fall.
22.13.2 Indexes compiled in the Bond Buyer
Bond Buyer Indexes Compiled
Index Features of the Index

Daily price index of 40 GO and revenue bonds with

an average maturity of 20 years. A rise in the index
40 Bond Index
indicates bond prices are rising and yields are fall-
ing.
Weekly index of 20 GO bonds with 20 years to
20 Bond Index
maturity, rated A or better.
Weekly index of 11 of the 20 bonds from the 20
11 Bond Index
Bond Index; rated AA or better.
Weekly index of 25 revenue bonds with 30 years to
Revdex 25
maturity, rated A or better.

22.13.3 Munifacts
This is a subscription wire service of the Bond Buyer that supplies prices, infor-
mation about proposed new issues and general news relevant to the municipal
bond market. This publication provides the most up-to-the minute information
about general information relevant to the bond market.

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22.13.4 Blue List

This is a daily industry publication that provides comprehensive and is the best
source of municipal security information for outstanding municipal bonds found
in the Secondary Market.
The Blue LIst displays the following;
Issuers
Par value
Interest rates
Maturity dates
Prices or yields
Offering dealers
Note: The Blue List can and does show other types of bonds in the sec-
ondary market such as new housing authority bonds and more. Also,
while quotes listed are firm at the time the list is published, they may
change at any time in response to market conditions.
22.14 ISSUING MUNICIPAL SECURITIES
(PRIMARY MARKET)
When issuing new municipal securities the issuer must first obtain a preliminary
legal opinion which determines whether and how the bonds may be offered and
how they will be offered. Next, the terms of the offering must be established.
There are two types of offerings for municipal securities;
1 Negotiated Underwriting
2 Competitive Offering
22.14.1 Negotiated Offering
An issuer would select this offering directly with no competition from other
underwriters. Most revenue bonds, IDRs and even corporate bonds are issued
through a negotiated offering.
22.14.2 Competitive Offering
When the issuer chooses the syndicate to underwrite through an auction it is
usually done on a competitive basis. Bidding procedures are announced in a
Notice of Sale. The winner of the bid is determined by the lowest interest
cost to the issuer.

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22.14.2.1 Notice of Sale

The Notice of Sale is an advertisement that is placed in the Bond Buyer
by municipalities that are interested in soliciting competitive bids for a new
issue of bonds.
The following are features of a Notice of Sale;
Used only for competitive offerings
Investment bankers prepare bids for the securities based on information
in the notice of sale, comparable new issue supply and demand and
general market conditions.
Includes the amount of Good Faith Deposit (entry fee) required by
each firm participating in the auction.
Good faith deposit from the winner of the auction counts against money
necessary to buy bonds.
Losers of the auction get their deposit back.
Good faith deposit cannot be used to cover any losses incurred during
the underwriting.
The good faith deposit may be lost if the syndicate fails to honor the
agreement.
The following is NOT in the Notice of Sale;
The bonds rating and underwriters name are not included in a notice of
sale because they have yet to be determined.
Coupon rates and market prices as they will be determined by the syndi-
cate in the future.
Re-offering yields (offering scale) which are yields to maturity that the
syndicate reoffers to investors.
22.15 FORMATION OF THE UNDERWRITING SYNDICATE
Once an issuers notice of sale has circulated, those investment bankers inter-
ested in placing competitive bids for an issue form syndicates. A syndicate is an
account that helps spread the risk of underwriting an issue among a number of
underwriters.
A firm makes the decision to participate as a syndicate member after it considers
the following factors;
Scale (list of the bond issues different maturities) and spread

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Potential demand for the security

Ability to sell the issue
Determination and extent of liability
Existence of presale orders
22.15.1 Syndicate Agreement
Syndicate participants then sign a syndicate letter or syndicate agreement in a
competitive bid or a syndicate contract or agreement among underwriters in a
negotiated underwriting.
Once the issue is awarded, the syndicate manager sends the syndicate letter
or contract to each participating firm for an authorized signature. The members
signature indicates its agreement with the offering terms.
Syndicate agreements include the following;
Each member firms level of participation or commitment
Priority of order allocation
Duration of the syndicate account
Fee for the managing underwriter and breakdown of the spread
Appointment of the manager(s) as agent(s) for the account
Member expenses
Good faith deposits
Observance of offering terms
Liability for unsold bonds
22.15.2 Types of Syndicate Accounts
The type of syndicate account ultimately determines the financial liability for
each underwriter. Underwriting syndicates use two arrangements, Western
account and Eastern account.
Western Account: The Western account is a divided account. Each under-
writer is responsible only for its own underwriting allocation.
Eastern Account: An Easter account is an undivided account. Each under-
writer is allocated a portion of the issue. After the issue has been substan-
tially distributed, each underwriter is allocated additional bonds
representing its proportionate share of any remaining bonds. It is important
to note that the Eastern account has more liability than the Western

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account as an underwriters financial liability might not end when it has dis-
tributed its initial allocation.
- Example: A syndicate is underwriting a $16 million municipal bond
issue. There are four syndicate members, each with equal participa-
tion of $4 million (25%), including the Peace of Mind Brokerage Firm.
The Peace of Mind sells its entire allocation, but bonds worth $2 mil-
lion remain unsold by the other syndicate members.
- Question 1: If this is a Western account, what is the Peace of Minds
liability?
- Answer 1: In a Western account the Peace of Mind Brokerage Firm
would have no remaining liability because its entire share was sold.
- Question 2: If this is an Eastern account, what is the liability of the
Peace of Mind Brokerage Firm?
- Answer 2: In an Eastern account, the unsold amount is divided
among all syndicate members based on their initial participation. In
this example the Peace of Mind would be allocated 25% of any
remaining bonds.
22.15.3 Due Diligence
Municipal underwriters must investigate an issuers financing proposals thor-
oughly. With revenue bonds, this due diligence investigation is conducted
through a feasibility study, which focuses on the projected revenues and
costs associated with the project and an analysis of competing facilities.
22.16 ALLOCATION OF MUNICIPAL ORDERS (NEW
ISSUE)
A syndicates allocation priority becomes especially important when a bond issue
is oversubscribed. The normal priority is as follows;
For test purposes use the acronym, P G D M - Please Give David Money
P = Presale Order: A presale order is entered before the bonds pricing
terms have been finalized, before the order period.
G = Group Net Order: A syndicate member that wants a customers order to
receive priority enters the order as a group net order.
D = Designated Order: The next highest priority for orders received during
the order period is assigned to designated orders. They are usually from insti-
tutions who wish to allocate profits to certain syndicate members.
M = Member Order and Member Related Order: This is the lowest priority
for orders which goes to members.

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22.17 DISCLOSURE OF ORDERS

Every municipal securities dealer that submits an order to a syndicate or syndi-
cate member must make a disclosure of capacity. The disclosure identifies
whether securities are being purchased for an account that the dealer controls or
has a financial interest in, including;
Its dealer account
An accumulation account
A related portfolio account
A municipal securities investment trust it sponsors
2 2 . 1 8 A D D I T I O N A L M U N I C I P A L TR A D I N G TE R M S
22.18.1 Brokers Broker
Trades with institutional customers and with other municipal brokers only
Does not trade with the retail public
Helps other muni-dealers place unsold portions of new bond issues
Does not disclose the identity of the customers they represent
May hold securities in its own investment account but does not keep an
inventory of securities to sell at a later date
Must comply with the best execution requirement
Occasionally acts as a principal to protect the customers or other brokers
identity
Charges a fee, not commission
22.18.2 When Issued Basis
New municipal bond issues are usually sold on a when-issued basis. This
means that the securities are authorized, but not yet issued. When the bonds
are ready, the syndicate manager gives notice of the settlement date. The syn-
dicate members, in turn, gives notice of the settlement date to the purchasers.
On the settlement date the newly issued bonds are delivered to the underwrit-
ers with a final legal opinion, and the underwriters pay for the bonds on deliv-
ery.

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22.18.3 Dated Date

The dated date is the date on which interest begins to accrue. An investor must
pay any interest that has accrued from the dated date up to, but not including,
the settlement date. The buyer starts receiving interest on the settlement date.
22.18.4 Round Lot
A round lot of municipal bonds is usually considered to be $100,000 face
amount or 100 bonds.
2 2 . 1 9 S E C O N D A R Y M U N I C I P A L TR A D I N G
Municipal trades settle in clearinghouse funds 3 business days after the trade
date, as does corporate securities. General speaking, municipal bonds trade in
the over-the-counter market.
Special trading issues are as follows;
Municipal bonds are generally not sold short as the trading market for
most issues is too thin to allow for the covering of the short position.
Municipal bonds are usually priced and offered for sale on a yield to matu-
rity (YTM) basis instead of a dollar price. This is called a basic quote.
Municipal bonds with serial maturities are usually quoted based on their
yield to maturity.
Dollar bonds are quoted on a percentage of par dollar basis rather than
YTM. Dollar bonds are usually term bonds, callable before maturity.
22.19.1 Types of Trades
Retail: Trading between the broker-dealer and the customer
Inter-dealer Market: Trading between the broker-dealer and a bank-dealer
which is a bank that sells securities from its own inventory and is a member
of the MSRB.
Institutional: Trading between the broker-dealer and a financial institution.
22.19.2 Types of Municipal Bond Quotes
Firm Quote: This is a firm and definite quote such as 103 (103% of par)
Subject (nominal quote): This is not a firm quote but rather one that is
subject to something. This quote is for informational purposes only and indi-
cates a dealers estimate of a securitys market value.

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 Module 22: Tax Advantaged Products

Workable Indication: This is a likely bid price that an investor will receive
when selling his municipal securities. The dealer buys the securities from
another bond dealer.
Firm with a Recall Option: Used to give another dealer a chance to sell
the bonds on behalf of the firm. An example of this would be when Broker
John offers the bonds to Broker Mary for one hour with a 5 minute recall.
- Broker Mary controls the bonds for 1 hour
- The price cannot be changed (firm quote)
- At any time within the hour, Broker John can cut the time down to 5
minutes and remove the offer.
22.20 COMMISSIONS AND MARKUPS
If a dealer arranges trades for customers and charges commissions the
dealer is acting as an agent.
A markup is charged for principal transactions when it sells securities and a
markdown is taken when it buys securities from customers.
The following factors are taken into consideration when taking a markup or
markdown;
- Expense of effecting the transaction
- Dealers best judgment of fair market value
- Dealer is entitled to make a profit
- Total dollar amount of the transaction
- Value of security traded
The following factors are taken into consideration when charging a commis-
sion for an agency transaction;
- Expense of trade execution
- Availability of the security
- Value of dealer services rendered
- Amount of any other compensation received
2 2 . 2 1 TR A D E C O N F I R M A T I O N S
A written trade confirmation of all municipal transactions entered must be mailed
to customers by settlement date. Confirmation must contain certain items such as

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a description of the security, trade date, settlement date, amount of accrued inter-
est and more. Details will be discussed in the MSRB rules that follow.
22.21.1 Principal versus Agency Trade Confirmation
If the trade is done on a principal basis, markup or markdown, the muni dealer
need not disclose the source or amount or the markup or markdown. However,
if the trade is done as an agency, the commission must be disclosed.
22.22 YI E L D DI S C L O S E D ON CONFIRMATION
The MSRB requires that trade confirmations for a municipal bond trade include
the price and the lowest potential yield the customer might receive. In other
words, the customer is entitled to know the worst case scenario regarding bond
yield returns.
22.22.1 Variable Rate Municipal Securities
Because a variable-rate municipal bond offers interest payments that are tied to
the movement of another specified interest rate, confirmations must disclose
that both the rates of interest and the yields to maturity are variable.
22.22.2 Zero Coupon Municipal Securities
The trade confirmation must indicate an interest rate of 0% and state that
accrued interest is not calculated.
22.23 MUNICIPAL SECURITIES GENERAL RULES
22.23.1 Anti-reciprocal Rule
A dealer cannot solicit trades in municipal securities for an investment com-
pany in return for sales by the dealer of shares in the investment company. In
other words, a muni dealer cannot be selected to execute the funds portfolio
trades based only on the firms promise that its registered representatives will
increase sales of the mutual funds shares.
22.23.2 Customer Accounts
Dealers may not guarantee customers against loss
Dealers cannot share in the profits or losses of a customers account unless
a joint account is opened with the customer
A transaction is allowed if the firm discloses any potential conflicts of inter-
est to the customer in writing.

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22.23.3 Control Disclosure Issues

Any municipal securities firms that has a control relationship with respect to
a municipal security is subject to additional disclosure requirements
If the dealer controls, is controlled by, or is under common control with a
securitys issuer, a control relationship exists.
A dealer that underwrites a new issue of securities or has some other finan-
cial interest in a new issue is being controlled and this requires disclosure to
all parties.
Disclosures must be made at or before the transaction settlement date.

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NASD Series 7 Page 152

 Module 23: Municipal Securities Rulemaking Board (MSRB)

Section 23: Municipal Securities Rulemaking

Board (MSRB)
23.1 MUNICIPAL SECURITIES RULEMAKING BOARD
OVERVIEW
The MSRB is an independent self-regulatory organization (SRO) which governs
the issuing and trading of municipal securities. MSRB rules apply to all firms and
individuals engaged in the conduct of municipal securities business.
23.1.1 MSRB Rules Enforcement
As the MSRB makes rules but does not have the authority to enforce them, the
NASD and SEC enforce the rules for them. With banks, the Office of the Comp-
troller of the Currency enforces MSRB rules. The Federal Reserve Board
(FRB) enforces MSRB rules governing any non-national bank that are mem-
bers of the Federal Reserve System. The FDIC enforces MSRB rules for non-
national banks that are not members of the Federal Reserve System.
23.2 MSRB NUMBERING SYSTEM
MSRB rules are identified with a G-number such as G-1 or G-2. For Series 7 pur-
poses it is not necessary to memorize those G-numbers, just the rules them-
selves. Use caution here, there are a lot of MSRB rules on the Series 7 exam.
Rule G-1. Any bank that has a separate identifiable department engaged in
municipal securities is classified as a municipal securities dealer and must
comply with MSRB rules. Municipal securities related activities include under-
writing, trading, selling or acting as an issuers financial adviser.
Rule G-2 and G-3. Anyone working in this industry must be MSRB qualified.
Qualification exams need to be successfully completed by principals, finan-
cial and operations principals and municipal securities representatives.
- To qualify as a municipal securities representative the Series 52
(Municipal Securities Representative Qualification Exam) or the
Series 7 (General Securities Registered Representative Exam) must
be passed successfully.
- To qualify as a municipal principal the Series 53 (Principal Qualifica-
tion Exam) must be passed.
- Dealers may not engage in any municipal securities business unless
those firms and all persons associated with them are qualified in
accordance with MSRB rules.

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- Persons performing ministerial duties and clerical functions such

as reading approved quotes, providing trade reports, recording and
entering orders are excluded from the above licensing rules.
- A 90-day apprenticeship is required of persons entering the securi-
ties industry. During this time period those persons may not engage
in municipal business with the public. Therefore, they cannot collect
commissions which would have been based on municipal sales.
They can, however, work with other bond dealers and other bond
firms. Time spent as a general securities representative counts for this
90-day period.
Rule G-4. Member firms and registered representatives are disqualified from
membership if they have been expelled or suspended from any securities
exchange or another SRO, if they have been convicted of any securities
related crime or violated any part of securities legislation.
Rule G-5. Anyone engaged in the municipal securities business must follow
all rules.
Rule G-6. Blanket fidelity bonds (for theft) must be maintained.
Rule G-7. Specific information about associated persons must be kept on file.
This includes employment history, disciplinary actions, residence and per-
sonal data contained in U-4 (entry form) and U-5 (exit form) forms.
Rule G-8. The following original records must be maintained;
- Trade blotters
- Account records
- Securities records
- Transactions records
- Customer confirmation copies
- Financial records
- Customer complaints
- Official delivery receipts
Rule G-9. All required records must be kept in an easily accessible place
for at least two years. Most records must be kept for 3 years while complaints
must be kept for 6 years. Test Point: The exam usually asks for time lim-
its on advertising (3 years) and customer complaints (6 years)
Rule G-10. Complaints must be entered in a complaint file indicating what
action, if any, the firm has taken and that a copy of the MSRBs Investor
Brochure was delivered to that customer.

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 Module 23: Municipal Securities Rulemaking Board (MSRB)

Rule G-11. Syndicates must establish a priority for allocating orders.

Rule G-12. Outlines procedures for settling transactions between municipal
securities firms. This rule also requires the following;
- Cash trades settle on the trade date
- Regular way trades settle on the third business day after the trade
date
- When, as and if issued trades settle on the date on which both parties
agree but not sooner than three business days after the confirmation
- Confirmations for dealer trades are sent by the next business day
- Confirmations for retail customers are sent by settlement day
- For bearer bonds delivery is made in denominations of $1,000 or
$5,000
- Registered bonds are delivered in multiples of $1,000 par value, with
a maximum par value on any one certificate of $100,000
- Mutilated certificates are not good delivery unless the transfer agent
validates the security.
- Syndicate manager must return any good faith deposits to the syndi-
cate members within two business days of settling with the issuer
Rule G-13. Dealers can publish quotations only for bona fide bids or offers.
Rule G-14. Dealers must report transactions in a timely manner. Fictitious,
deceptive or manipulative reports are not allowed
Rule G-15. Confirmations of trades must include the following;
- Broker-dealer name, address and telephone number
- Customers name and address
- Description of the security
- Issuer, interest rate, maturity, callable or not etc.
- Trade date and time of execution
- Settlement date
- CUSIP number
- Yield and dollar price
- Accrued interest
- Total principal

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- Total dollar amount

- Firm acting as a broker or a dealer
- Dated date (Date that interest starts to accrue on the bond)
- Type of registration (fully registered etc.)
- Anything special for the bonds traded
Rule G-16. Municipal broker-dealers must be examined at least every 24
months to ensure they are in compliance with MSRB rules, SEC rules and
the Securities Exchange Act of 1934. The NASD will conduct these exami-
nations at broker-dealers as the MSRB only makes rules, they do not
enforce them.
Rule G-17. Dealers must deal fairly with everyone and must not engage in
deceptive, dishonest, unfair or manipulative practices.
Rule G-18. Dealers and broker-brokers must attempt to obtain prices for cus-
tomers that are reasonable and fairly related to the market.
Rule G-19. When making recommendations to clients, registered representa-
tives must obtain as much information as possible and must have reasonable
grounds for recommending any particular security or transaction. Recom-
mendations cannot be made if the customer has not disclosed financial
and suitability information. However, unsolicited trades can be con-
ducted.
Rule G-20. Gifts valued more than $100 cannot be given to any person in
one year other than their own employees. Gifts of occasional meals or tickets
to sporting events (not season tickets) are allowed.
Rule G-21. All advertising must be truthful and not false or misleading.
The firms municipal or general securities principal must approve each
advertisement in writing before first use.
Rule G-22. Clients must be informed if a control relationship exists
between a municipal firm and an issuer.
Rule G-23. Firms must disclose the advisory relationship and compensation
to customers in writing between themselves and issuers. If a firm acting in a
financial advisory capacity wants to participate in the issue on which it has
advised, it must get written consent from the issuer to submit a competitive
bid. If a negotiated bid, the advisory contract must be terminated and the
issuer must give written consent.
Rule G-24. Municipal firms may not use confidential information to solicit
trades except with an issuers express account.

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 Module 23: Municipal Securities Rulemaking Board (MSRB)

Rule G-25. Cannot misuse securities or money held for customers. Firms
cannot guarantee customers against losses.
Rule G-26. If a customer account is transferred from one firm to another, both
firms must communicate and coordinate their procedures to make sure that
the transfer happens smoothly.
Rule G-27. Each firm must designate a principal to supervise the firms regis-
tered representatives and must create and maintain a written supervisory
procedures manual. The following must be approved by the designated prin-
cipal;
- Opening of new accounts
- All municipal transactions
- Actions taken on customer complaints
- Correspondence regarding municipal securities
Rule G-28. If an employee of a municipal securities firm opens a brokerage
account, MSRB rules require the firm opening the account to notify the
employer in writing and to send duplicate confirmations to the employer. This
also applies when an account is opened for a spouse or child of an
employee.
Rule G-29. A copy of MSRB regulations must be kept at every municipal
securities dealers office for review by any customer.
Rule G-30. Markups and markdowns must be fair and reasonable.
Rule G-31. Firms may not solicit business from an investment company
based on the broker-dealers record of sales of the investment companys
shares.
Rule G-32. When municipal securities are purchased, a copy of the official
statement must accompany or precede the delivery. A preliminary official
statement can be used if the new issue is not ready yet. A final official state-
ment must be delivered to all buyers when it is made available.
Rule G-33. Municipal bonds, like corporates, use a 360-day year with 30-day
months. Municipal dealers must calculate accrued interest when a municipal
security trades and interest. (Price of bond plus accrued interest)
Rule G-34. A firm that is managing an underwriting for a new issue usually
applies for a CUSIP number.
Rule G-35. MSRB arbitration rule covers disputes between participants in the
municipal securities business.

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Rule G-36. Underwriters of new issues must send two copies of the official
statement to the MSRB.
Rule G-37. Maximum political contributions cannot exceed $250.
Rule G-38. Municipal firms that engage consultants must have written agree-
ments with those consultants. A consultant is any person a dealer pays to
obtain or retain municipal securities business by communicating with an
issuer on the dealers behalf.
Rule G-39. Telemarketers cannot call persons before 8:00 A.M. or after
9:00 P.M. in the called persons time zone. Callers must disclose their
names, firm names, firm telephone numbers or addresses and state the pur-
pose for the solicitation. This is the same rule as the Telephone Solicitation
Act (Cold Call Act).

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 Module 24: Municipal Securities Tax Issues

Section 24: Municipal Securities Tax Issues

2 4 . 1 M U N I C I P A L S E C U R I T I E S TA X I S S U E S
Interest on municipal bonds is federally tax free. Capital gains, on the other
hand, are fully taxed as is true of any security. Because of the tax savings with
municipal bonds, the tax-free bond may be more attractive than a taxable bond
with a higher interest rate. Higher tax bracket investors benefit more with munici-
pals than persons with lower tax brackets.
24.1.1 State Tax Free Issues (Double Tax Free)
Interest payments from municipal bonds may also be state tax free if;
Investing in a municipal bond issued within the investors home state.
Investing in U.S. protectorates such as Puerto Rico, Guam and the US Vir-
gin Islands. These bonds become triple tax free, free from federal, state
and local taxes.
24.1.2 Taxable Equivalent Yield (TEY)
When an investor is comparing the coupon rates of a tax-free bond versus a
taxable bond the following formula is used to compute the taxable equivalent to
the tax-free coupon rate.
Step 1: Take the tax-free coupon rate
Step 2: Divide the tax-free coupon rate by the reciprocal of the taxpayers tax
bracket (100 - tax bracket)
Example: Diana Lynne received a call from a stock broker in New York and
offered her a municipal bond with a tax-free yield of 4%. Also, another stock
broker from Florida called her with a corporate bond offering of 6%. Diana is in
the 31% tax bracket. The test question would ask which bond is better
for Diana?
Solution: Take the tax-free yield of 4% and divide it by the reciprocal of
Dianas tax bracket (100 - 31%) or 69. So, 4 divided by 69 = 5.8%. The 5.8% is
the TEY to the tax-free bond. Therefore, to answer the test question, Diana
would be better off buying the corporate bond with a taxable coupon rate of 6%
than the tax-free bond offering 4%. In order to do better than the 4% tax-free
Diana had to find a taxable bond paying more than 5.8% and in this case did.
24.1.3 Bond Swaps
The purpose of swapping bonds is to generate tax losses, improve yields or
quality or change the maturity of an investors portfolio. Procedurally, the inves-

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tor swaps by selling bonds owned and buying other bonds that better meet his/
her investment objectives.
To create the tax loss with a bond swap, an investor sells bonds being held at a
loss and then buys similar bonds. However, it is important to avoid giving the
IRS the impression of a wash sale.
To avoid looking like a wash sale the replacement bonds purchased must differ
in some significant respect from those sold. A tax loss is disallowed if the inves-
tor sells a bond at a loss and purchases the same or a substantially identical
bond within 30 days before or after the trade date establishing the loss.
24.2 AMORTIZATION AND ACCRETION OF PREMIUM
When bonds trade the amount of the discount must be accreted on a straight-
line basis over the life of the bond. This rule also applies to bonds trading at a pre-
mium in which the amount of the premium must be amortized on a straight-line
basis over the life of the bond.
Premium Bond - 110 ($100 premium)
109
y r1
108
yr 2
107
yr 3
106
yr 4
105
yr 5
10 Year Maturity

r 5
95 y
r4
94 y
r 3
93 y
r2
92 y
r1 Discount Bond - 90 ($100 discount)
91 y

24.2.1 Premium Bond

As seen in the display above, the premium bond costs the investor 110 (110%
of par) which represents a dollar cost of $1,100 and a $100 premium. The
bond matures in 10 years. All premium bonds must have a tax basis of 100

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 Module 24: Municipal Securities Tax Issues

(bond talk for $1,000), which is par value, at maturity. The annual amortized
amount of the bond is $10 per year ($100 divided by 10 years).
24.2.1.1 Amortization Example
Lets suppose that the bond is resold in five years at 106. This represents
a bond price of 106% of par or $1.060. However, because the tax basis
after five years is 105, under IRS rules the investor must report a $10 cap-
ital gain even though this is a municipal bond.
24.2.2 Discount Bond
As seen in the display on the prior page, the discount bond costs the investor
90 (90% of par) which represents a dollar cost of $900 and a $100 discount.
The bond matures in 10 years. All discount bonds must have a tax basis of 100
(par) at maturity. The annual accretion amount of the bond is $10 per bond
($100 divided by 10 years).
The issue of whether the accretion is taxable depends on whether this is an
OID (Original Issue Discount) Municipal Bond or a Secondary Municipal Bond.
Accretion accumulated on an OID municipal bond is taxable. However, accre-
tion accumulated annually on a Secondary Municipal Bond is taxed as ordinary
income.
Test Taking Note: The exam question must tell you if they are talking about an
OID municipal bond. If OID is not mentioned in the test question then assume it
is a regular Secondary Municipal Bond and is taxable.
24.2.2.1 Accretion Example
Lets suppose that the bond is resold in five years at 95. This represents a
bond price of 96% of par or $960. However, because the tax basis after
five years is 95, under IRS rules the investor must report a $10 capital
gain per bond even though this is a municipal bond.
The only other decisions to make is whether the annual $10 accretion is
taxable or not. As there is no indication that this is an OID municipal bond
the accretion is taxable. Therefore, in this example, each bond would have
a $50 taxable accretion per bond ($10 per year for 5 years).
If this were an OID municipal bond, there would be a $10 capital gain and
$50 of accretion but the accretion would not be taxable.
Test Taking Note: The Series 7 exam will present questions on amortiza-
tion and accretion just like the above examples.

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Notes

NASD Series 7 Page 162

 Module 25: Direct Participation Programs

Section 25: Direct Participation Programs

25.1 BUSINESS ENTITIES
25.1.1 Corporation?
Under IRS rules, a C Corporation is a taxable entity. If the corporation has
any net income, the corporation pays tax on that income. If the corporation dis-
tributes cash to its shareholders, dividends are paid out of after tax income.
The shareholder receiving the dividends must include them on his/her tax
return and tax is paid again on the same dollars. This is one of the situations in
which the same money, in this case dividends, are said to be double taxed.
On the other hand, if the corporation has a net loss, no tax is owed for that year
but it cannot distribute any of the losses to its shareholders.
25.1.2 Partnerships
Under IRS rules, partnerships, unlike corporations, are not taxable as a busi-
ness entity. Net income or loss is not computed at the partnership level and
taxed. Instead, each partner upon receipt of his/her pro-rata share of income
and/or losses must include same on his/her tax return.
25.1.3 Direct Participation Programs
These programs allow investors to directly participate in the profit and loss from
the business entity such as a Subchapter S Corporation, Limited Liability Com-
panies and Partnerships, unlike regular C type Corporations.
25.2 LIMITED PARTNERSHIP HISTORY
Many years ago partnerships were established as tax shelters as their primary
purpose. When the Tax Reform Act of 1986 was passed, the majority of these tax
shelters lost their tax benefits and became very costly taxable investments for
their investors. Today, investors would purchase limited partnerships for many
reasons but not just because of some tax saving advantages.
25.3 LIMITED PARTNERSHIP FORMATION
A limited partnership requires at least one general partner (GP) and at least one
limited partner (LP). The general partner is the active manager of the venture
and with that assumes unlimited liability. The limited partner, on the other hand, is
the passive investor (not actively involved with management of the investment)
whose liability is generally limited to his/her investment. Note: there are a number
of limited partnerships which may require the investor to deposit additional sums
of investment dollars after the initial investment is made.

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25.3.1 Certificate of the Limited Partnership

To be a legal entity in a state, a certificate of limited partnership must be
filed. The primary purpose of this certificate is to have a public record of all part-
ners and their percentage interest in the partnership. Therefore, creditors of the
partners can always find the partners if they have legal claims against the part-
nership.
The following must be included in the certificate;
Name of the Partnership
Type of business
Mailing address
Each partners name, address and percentage ownership
Each partners share of income and losses
Date the partnership is to be terminated
Upon termination the priority of distribution of any assets
25.3.2 Partnership Certificate Changes
If any of the certificate requirements above change, such as the address of the
partnership, the certificate must be amended. Typically, certificates are
amended annually to reflect any changes. The only exception would be a dra-
matic change such as an additional general partner, as an example, in which
case the partnership certificate would be changed immediately.
25.4 PARTNERSHIP AGREEMENT
The partnership agreement spells out the rights and obligations of the general
and limited partners. This agreement must be signed by limited partners as well
as the general partners.
Test Point: A new investor does not become a limited partner until the
partnership application is signed, the partnership agreement is signed
and the general partner also signs the partnership application indicating
the final acceptance of the limited partner.
25.4.1 Rights of the General Partner
The partnership agreement should contain all of the following rights of
the general partner of the partnership;
Makes all business decisions

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Charge a management fee to manage the partnership

Power to bind the partnership into contracts
Decides whether cash distributions are made to the partners
Decides which limited partners are allowed in the partnership
Any transfer of a partnership interest by a limited partner must be approved
by a a general partner
Entitled to a yearly share of partnership income and loss
Entitled to a share of net partnership assets upon dissolution of the partner-
ship venture
25.4.2 Obligations of the General Partner
The partnership agreement should contain all of the obligations of the
general partner of the partnership which can include;
Fiduciary responsibility to the partnership
Must make all decisions in the best interest of the partnership
Must maintain at least a 1% interest in partnership gain or loss
Cannot compete with the partnership unless specifically allowed by the
partnership agreement.
If more than one general partner and one dies, partnership law requires that
the partnership be dissolved and a new agreement be drawn up with the
remaining partners.
If a partnership is dissolved, the other general partners cannot continue to
run the existing partnership unless specifically authorized in the agreement.
If a legal judgment is entered against the partnership, a general partner
cannot consent to the judgment without approval of the limited partners.
25.4.3 Rights of Limited Partners
Once again, the partnership agreement must also contain all the rights of
limited partners. They are as follows;
Right to inspect the books and records of the partnership
Right to yearly pro-rata share of partnership income and loss
Right to share of net partnership assets upon dissolution

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Can sue the general partner for damages if the general partner does not
abide by the agreement
Has the right to vote on the admission of any new general partners (Known
as partnership democracy)
Has the right to vote for a sale of partnership assets
Test Point: If the limited partner exceeds any of the above activities such
as participating in the actual management of the partnership the limited
partner will be considered to be a general partner and takes on unlimited
liability.
25.4.4 Obligations of the Limited Partner
Just like the rights of a limited partner, obligations also apply. They are
as follows;
Pay an initial capital contribution
Liable for any recourse notes signed. A recourse note means the lender
has recourse to the signer directly to pay off an obligation.
Can be required to pay any additional assessments as determined by the
general partner.
Can compete with the partnership as he/she is simply a passive investor in
the partnership.
25.5 ASSET DISTRIBUTION UPON DISSOLUTION
The following represents the priority of any assets upon the dissolution of
the partnership;
1 Secured creditors
2 General creditors
3 Limited partners
4 General partners
2 5 . 6 TA X Q U A L I F Y I N G A PARTNERSHIP
The IRS has very strict rules regarding the tax advantages of a partnership. Under
certain circumstances, even though a business may call itself a partnership, the
IRS may not recognize it as a partnership with no tax liability but instead consider
the business is operating as a corporation which is a taxable entity.

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There are 4 characteristics which are evaluated to determine the tax status of
the enterprise. If the business entity has 3 or more, it will be taxed as a corpora-
tion but 2 or less qualifies for partnership tax treatment. For a partnership it is
most important that 2 of the 4 characteristics are avoided.
25.6.1 Four Characteristics
Exam Alert: It is important to avoid at least 2 of the following 4 character-
istics for IRS purposes so as to avoid being taxed as a corporation. You
MUST memorize them.
Continuity of Life: Corporations have an indefinite life while partnerships
do not. In every partnership agreement and partnership certificate a fixed
life is found to be assigned to the partnership. By having a fixed life this
characteristic is avoided.
Free Transferability of Shares: Corporate shareholders can trade their
shares without restriction as shares of stock are generally negotiable. Part-
nership certificates must state that the general partner must approve trans-
fer of partnership shares. By restricting the free transfer of partnership
shares this characteristic is also avoided.
Limited Liability: Corporate and partnership shareholders are subject to
limited liability. That is, limited to their invested dollars in either the corpora-
tion or the partnership. So, this characteristic is impossible to avoid.
Centralization of Management: Corporate shareholders have no partici-
pation in management decisions. This would be the same for partnership
shareholders. Therefore, once again, this characteristic is impossible to
avoid.
25.6.2 Tax Return Information
While a partnership is not a tax paying entity, the general partner prepares and
files with the IRS an annual informational tax return (Form 1065). Attached to
this return are K-1 forms for each partner. The K-1 details the partners share
of income and loss for the year. Investors do NOT file K-1s with their tax return.
The K-1 is a report that provides gains and losses and how it should be
reported on various tax forms.
25.7 PARTNERSHIP BASIS
An investors basis is the valuation of the invests interest in the partnership for tax
purposes. The higher the basis the better for the investor (know this)!. Put
another way, investors want the highest basis possible because the basis estab-
lishes the limit of tax deductions for that year.

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25.7.1 Items that Establish the Basis

Contributing cash
Contributing property
Assuming recourse debt. Remember, the investor signs a note with a
lender for which the investor is personally liable with the funding coming
from the lender. If the partnership does not pay for the note, the investor is
at-risk for that amount and that is why recourse debt is added to the
basis.
Assuming non-recourse debt. This can only apply to real estate partner-
ships. The mortgage amount is included in the basis. The lender has no
recourse to the partners if the loan is not repaid, he/she can only foreclose
on the property.
25.7.2 Items that Increase the Basis
After the basis is established certain items will increase it. Remember, the
higher the basis the better for the investor. These items are as follows;
Additional contributions of cash
Additional contributions of property
Additional non-recourse debt taken on for real estate
Additional recourse debt
Phantom Income - A distributive share of net income that the partnership
decides to keep and does distribute the income to investors. As the investor
had the right to receive the income from the partnership, but did not, the
amount would increase the basis.
25.7.3 Items that Reduce the Basis
Any of the following reduces the investors basis. On the exam remember,
if the investor receives anything good like a tax deduction or income, the basis
would be reduced by that amount.
Distributions of cash
Distributions of property
Repayment of recourse debt
Repayment of non-recourse debt for real estate only
Distributive share of net losses allocated during the year. Net losses can
include any of the following;

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- Operating expenses
- Interest expense
- Depreciation
- Depletion
- Any other tax deductions
25.7.4 Basis Test Question Example
Billy Bob invests in a real estate limited partnership by investing $25,000. The
partnership obtains a mortgage on the property, with the partners share being
$25,000. After the first year of operations, the partner is distributed $5,000 of
cash by the partnership and his K-1 shows his distributive share of partnership
income as $10,000 (not received) and losses of $95,000.
Typical questions that can be anticipated for the Series 7 Exam.
Question 1: What is the basis at year end?

To establish the basis

Dollar Amount Item

+ $25,000 Cash contribution

+ $25,000 Non recourse financing (real estate only)
+$50,000 Beginning basis
+$10,000 Net income during the year but not received
$60,000 Highest basis during the year
-$5,000 Cash distribution
$55,000 Remaining Basis
-$55,000 Deductible portion of Net Losses
$0 End of year basis (Can never be below 0)

Question 2: How much loss can be carried forward?

Solution: Total losses this year of $95,000. Since $55,000 can only be
deducted this year, the remaining portion of $40,000 of unused losses are
carried forward to next year. As these are passive losses which means
they can only be deducted against other passive income.

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25.8 REAL ESTATE PARTNERSHIPS

There are a number of real estate limited partnerships available. They vary from
raw land to new construction to existing housing to low income housing. Each of
these important programs will be discussed. It is important for you to understand
not only the differences between these programs but also their features.
25.8.1 Major Tax Issues
The major tax issues of real estate programs are as follows;
Occupied property can be depreciated on a straight-line basis, not on an
accelerated basis. This means that each year an amount can be deducted
on the investors tax return based on the total value divided by a set number
of years.
Mortgage interest is deductible
Non-recourse financing is included in the basis. This increases the overall
level of deductions available to the partner without being personally at risk
for that financing.
Tax credits are available for qualified low income housing and certified
historic structure rehabilitations.
25.8.2 Raw Land
Raw land programs buy vacant land as an investment for purposes of realizing
future capital gains. The goal is to purchase vacant land which will be sold to
land developers in the future at a profit.
25.8.2.1 Features of Raw Land
Very little, if any, tax shelter benefits.
Land cannot be depreciated.
Substantial negative cash flow.
Risk of zoning changes.
Risk of swamp or bad land.
Probably the highest risk real estate limited partnership.
25.8.3 New Construction
New construction programs lend money to developers to build new homes, as
an example. The goal of new construction programs is to build new homes, sell
them and profit from any capital gains made on the sale.

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25.8.3.1 Features of New Construction

High risk
Construction failures and cost overruns
No buyers
During construction all buildings are capitalized and cannot be recovered
until the building is ready for occupancy.
No deductions during the building period.
Substantial negative cash flow
New construction has more risk than existing housing but greater appre-
ciation potential.
25.8.4 Existing Housing
Existing housing programs are generally less risky than raw land and new con-
struction as current tenants and cash flow are known. These investments rely
on income generated from rent being pad by current tenants.
25.8.4.1 Features of Existing Housing
Known rental income
Depreciation deductions can begin immediately
Expense history known
Tenant stability unknown
Maintenance costs unknown
25.8.5 Government Assisted Housing
These programs purchase housing properties that are U.S. Government subsi-
dized. They are also known as Section 8 or low income housing. This is one of
the programs that qualify for tax credits for high income investors.
25.8.5.1 Features of Government Assisted Housing
Government subsidizes tenant rents.
Depreciable on a straight-line basis.
Rehabilitation of the property qualifies for an additional tax credit
Low appreciation potential
High maintenance costs

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25.9 OIL AND GAS PROGRAMS

Oil and gas programs borrow money from limited partnership investors so as to
invest in all aspects of oil and gas production. There are a number of various tax
write-offs available for those investing in the various programs.
25.9.1 Exploratory Program
In an exploratory oil drilling program, the partnership drills in areas that have
never been drilled before. This type of drilling is also known as wild cat
drilling.
25.9.1.1 Features of Exploratory Programs
MIneral rights costs are low.
Intangible drilling costs (IDC) (costs of drilling holes) are very high and
are deductible to investors.
High risk
HIgh potential return
25.9.2 Developmental Programs
In these programs, wells are drilled near an existing oil field. Therefore, there is
a greater chance of finding oil. Wells drilled in developmental programs are
known as step-out wells since the drillers are stepping out from adjacent
fields.
Mineral rights costs are higher because of the strong probability of
finding oil.
Intangible drilling costs are lower because drilling contractors are work-
ing nearby. Deductions for IDC (intangible drilling costs) would not be
available.
Tangible drilling costs are also lower because existing pipelines and
storage facilities are nearby.
Risk is moderate, as is potential return.
25.9.3 Income Programs
With oil income programs investors buy producing oil wells with proven
reserves in the ground. This is clearly the safest of all three types of oil and gas
programs.

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25.9.3.1 Features of Income Programs

Minerals rights cost is the highest.
No intangible drilling cost deductions.
Main benefit is the tax shelter provided by the percentage depletion
deduction as the oil is sold.
Risk is the lowest.
Potential return is the lowest.
25.9.4 Combination Oil and Gas Programs
These programs combine all three programs into one. Those looking for risk
diversification might have an interest in this program.
25.9.5 General Partner Sharing Arrangements
As the majority of general partners in oil and gas ventures are persons with
expertise in that field, they expect to receive a share of partnership income
without necessarily contributing anything to the cost of finding and producing
the oil and/or gas.
25.9.5.1 Specific Arrangements
Overriding Royalty Interest: The general partner gets a percentage of
revenue from the first barrel of oil sold, without regard to the cost of pro-
ducing the oil. This is a disadvantage to the limited partners but may be
demanded by the general partners with great track records.
Subordinated Royalty Interest: General partner does not get a per-
centage of oil revenues until all costs paid by the limited partners are
recovered. This is obviously a better deal for the limited partners.
Net Profits Interest: General partner gets a percentage of the net profits
instead of gross sales revenues.
Working Interest: General partners may agree to pay for some of the
costs of finding and producing the oil. In return for contributing to the
costs, the general partner takes a greater percentage.
Disproportionate Sharing: The general partner bears the proportionate
share of all costs for a greater percentage of oil revenues.
Functional Allocation: General partner agrees to bear the costs that
cannot be immediately deducted. These are tangible costs which are
recovered through depreciation. This arrangement gives the limited part-
ner the greatest first year deduction.

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25.10 EVALUATING A LIMITED PARTNERSHIP

It is important that registered representatives carefully evaluate these programs to
determine suitability for investors. The number one evaluation point is the
economic merits of the program.
The following are important evaluation factors to be considered;
Economic soundness of the program (Most important)
Reasonable program objectives matched to investor objectives
Blind pool of unknown program properties versus the increased safety of
existing properties. Some investors may not feel comfortable investing in a
limited partnership with properties to be identified in the future.
Sponsors track record
Sponsors compensation- Is it reasonable or unreasonable?
Any conflicts of interest between the general partner(s) and partnership prop-
erty with another limited partnership.
Adjacent leases in oil and gas programs. General partner may use investor
dollars to develop adjacent land.
Cross-Over Point - Test Point: A cross-over point question is generally
included in all Series 7 exams. When evaluating a partnership program
there will be a point when the programs projected income rises, while tax
deductions diminish. This is when the program begins to generate net tax-
able income and is known as the cross-over point.
2 5 . 11 S U B S C R I P T I O N A G R E E M E N T
Most limited partnerships are offered as new issues of registered securities sold
under a prospectus. The general partner in essence selects those investors that
he/she feels are appropriate for the program.
The investor completes a subscription agreement and submits it to the general
partner with a check. If the general partner accepts the subscription agreement
he/she will sign it and the investor becomes a limited partner.
The following is generally required in the subscription agreement;
Investor name and address
Investor net worth and annual income
Investor tax bracket
Ability of investor to contribute additional funds if needed

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Ability of investor to commit funds for long periods of time without any liquidity
25.12 SUITABILITY ISSUES
Regulatory agencies require that when a direct participation program is recom-
mended, the member firm through its registered representatives, have reasonable
grounds to believe, on the basis of information obtained from the investor such as
objectives, finances etc. that;
The investor is in a financial position to purchase the limited investment
The investor is in the appropriate tax bracket to take advantage of any tax
benefits of the program
The investor has a net worth sufficient to sustain a total loss in the program
The investor has a net worth sufficient to sustain the risks inherent in the
program
The investor can economically sustain the possibility of lack of liquidity
25.13 SPONSOR COMPENSATION
The NASD generally limits sponsor compensation of up to 10% of the public
offering price. This is based on a spread just like any other new issue being
offered to the public.
Any up-front costs taken from the investors investment are not deductible to
the partner.
Sponsor compensation cannot be unreasonable
25.14 MISCELLANEOUS PARTNERSHIP ISSUES
Master Limited Partnership (MLP): Some limited partnerships are negotia-
ble. These are known as Master Limited Partnerships and trade on an
exchange or NASDAQ.
Limited Trading Market: Once an offering is placed there usually is no or a
very limited secondary market for partnership units. This is basically the case
because of IRS restrictions on transferability of units/shares.
2 5 . 1 5 F I N A L TE S T P O I N T
If a potential investor for a limited partnership refuses to furnish adequate per-
sonal financial information or personal investment objectives, registered represen-
tatives cannot accept the investors investment! This would be in violation of
suitability rules. In fact, the order cannot even be taken as an unsolicited invest-
ment as could shares of stock.

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More Limited Partnerships Tax Issues

25.16 DEDUCTIBLE COSTS
The following costs in partnerships are immediately deductible;
Ordinary and necessary business expenses
Salaries and wages
Interest expenses on loans
Taxes paid
Intangible Drilling Costs (IDC) in oil exploration programs
Management fees paid to the general partner
25.17 COSTS RECOVERED OVER TIME
Depreciation of equipment over time
Modified Accelerated Cost Recovery System (MACRS) allows depreciation of
certain property on an accelerated basis which increases deductions in the
earlier years.
Real property, excluding land, is depreciated on a straight-line basis (set
number years) and cannot be accelerated
Construction costs are capitalized into the cost of the building. When the
building is ready for occupancy, the total cost is recovered through straight-
line depreciation.
25.18 DEPLETION
Mineral rights costs are recovered by depleting a mine or well over its life. Deple-
table resources include oil, gas, minerals, gravel and timber. Crops are not deple-
table since they can be renewed annually.
25.19 PREPAID EXPENSES
Prepaid expenses such as rent, insurance and interest need to be amortized over
the life of the prepayment.
25.20 ORGANIZATION FEES
Organization fees such as partnership fees which might include accounting and
legal fees must be capitalized and amortized over 5 years.

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2 5 . 2 1 TA X C R E D I T S
Certain limited partnerships such as low income housing and historic rehabilitation
programs provide tax credits. While tax deductions reduce taxable income, tax
credits are a direct dollar-for-dollar reduction of taxes due.
2 5 . 2 2 A L T E R N A T I V E M I N I M U M TA X ( A M T )
Taxpayers must compute the alternative minimum tax and if this amount is higher
than his/her regular tax bill, the higher amount is paid. The AMT way of computing
taxes requires the addition of tax preference items as income and then a flat per-
centage tax rate is applied.
The main tax preference items are as follows;
Accelerated depreciation amounts in excess of straight-line.
Excess intangible drilling cost deductions.
Excess percentage depletion deductions.
Municipal interest income from industrial development revenue bonds.

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Notes

NASD Series 7 Page 178

 Module 26: Tax Advantaged Review Questions

Section 26: Tax Advantaged Review

Questions
1. All of the following are general features of municipal securities EXCEPT;
A. Capital gains are never taxable.
B. Tend to pay lower interest rates as compared to corporate debt securities.
C. Interest is exempt from federal taxation.
D. Municipal bonds must have a legal opinion attached.
2. Most municipal bonds pay interest;
A. Annually
B. Semi-annually.
C. Quarterly.
D. Monthly.
3. All of the following are examples of municipal bond insurers EXCEPT;
A. AMBAC
B. MBIA
C. FGIC
D. NASD committee on tax-free stuff
4. Which type of municipal bond relies on ad valorem taxes?
A. GOs
B. Revenue
C. IDR
D. Notes
5. A double barreled bond is first a;
A. GOs
B. Revenue
C. IDR
D. Notes
6. Which of the following municipal bonds are considered the safest?
A. GO
B. Revenue
C. IDR
D. Income
7. A feasibility study is generally required with which of the following?
A. GOs
B. Revenue

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C. IDR
D. Notes
8. Which covenant promises to maintain the equipment and facilities?
A. Rate Covenant
B. Sinking Fund Covenant.
C. Maintenance Covenant.
D. Catastrophic Clause.
9. Which type of special bond is backed by U.S. Government subsidiaries?
A. GO
B. Revenue
C. Public Housing Authority
D. Special Notes
10. Municipal notes are rated by;
A. Standard & Poors
B. Dianas Rating Service
C. Moodys Ratings
D. Munifacts
11. All of the following are correct regarding Official Statements, EXCEPT;
A. Must be sent with advertisements
B. Creditworthiness will be indicated
C. Must be filed with the SEC
D. Prepared by the issuer
12. All of the following indexes are compiled in the Bond Buyer, EXCEPT;
A. 40 Bond Index
B. 20 Bond Index
C. 11 Bond Index
D. 9 Bond Index
13. Which of the following are the types of municipal securities offerings?
I. Negotiated
II.Competitive
III.Sharing
IV.Fungible
A. I only
B. I and II only
C. II and III only
D. I, II, III and IV

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14. Which of the following is the underwriting syndicate that is known as the
undivided account?
A. Eastern
B. Northern
C. Southern
D. Western
15. Which of the following is the correct allocation of orders for a new
municipal offering?
A. PSDM
B. PGDM
C. GDMP
D. SGPM
16. When a broker-dealer acts as an Agent, compensation would be a;
A. Commission
B. Markup
C. Markdown
D. Cross trade sum
17. An apprenticeship of how many days is required by persons entering the
securities industry when selling municipals?
A. 30 days
B. 45 days
C. 60 days
D. 90 days
18. Municipal bonds issued by Puerto Rico are generally;
A. Taxable
B. Federally tax-free
C. Double tax-free
D. Triple tax-free
19. When a bond is sold to generate a tax loss and the same bond is pur-
chased back in 10 days, what has been violated?
A. Back tax rule
B. Wash sale rule
C. Clean sale rule
D. Capital gain rule

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20. If a bond is purchased at 110, what is the tax basis according to the IRS
after 5 years?
A. 115
B. 110
C. 108
D. 105
21. Which of the following tax characteristics are impossible to avoid?
I. Continuity of life
II. Free transferability of shares
III.Limited liability
IV.Centralization of Management
A. I and II only
B. II and III only
C. III and IV only
D. I and IV only
22. What is the Form number that reports all tax consequences when invest-
ing in limited partnerships?
A. 8K
B. 10K
C. K-1
D. 10Q
23. All of the following items increase the basis, EXCEPT:
A. Contributions of cash
B. Contributions of property
C. Distributions of cash
D. Recourse debt
24. Which of the following is NOT a feature of an investment in Raw Land?
A. Substantial cash flow
B. No depreciation of land
C. Risk of swamp land
D. Risk of zoning changes
25. New Construction is;
A. Low risk
B. High risk
C. No risk
D. Risk-free

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 Module 26: Tax Advantaged Review Questions

Rules Review Answers

1. (A) Capital gains are always taxable, even for tax-free bonds. The tax-free
refers to the income received from the coupon only. Choices B, C and D are fea-
tures.
2. (B) Like most bonds, interest is paid twice a year or semi-annually.
3. (D) Choices A, B and C are companies that insure municipal bonds. FSA is also
an insurer of municipal bonds.
4. (A) Ad valorem taxes are real estate taxes that support payment of interest for
General Obligation (GO) bonds.
5. (A) While a double barreled bond is a combination of a revenue and a general
obligation bond, for test purposes they are GO bonds first.
6. (A) GO bonds are generally considered the safest because of the ability to raise
the ad valorem taxes.
7. (B) Feasibility studies are generally required with revenue bonds.
8. (C) The Maintenance Covenant promises to maintain the equipment and facili-
ties.
9. (C) Public Housing Authority bonds are backed by the U.S. Government.
10. (C) Moodys rate municipal notes.
11. (C) On the contrary, the Official Statement does NOT have to be filed with the
SEC.
12. (D) The Bond Buyer compiles all the choices except Choice D. The Bond
Buyer also compiles the Revdex 25 Index.
13. (B) There are two types of municipal offerings, Negotiated and Competitive.
14. (A) The Eastern syndicate is known as the undivided account.
15. (B) The correct allocation for orders is P G D M. In corporate bond issues the
acronym changes to P S D M. For exam purposes, just learn these acronyms.
16. (A) Agents charge a commission while dealers charge a markup or mark-
down.
17. (D) 90 days by rule.

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18. (D) Generally, municipal bonds are only exempt from federal taxation. Some
states offer double tax free bonds (free from both federal and state) while bonds
issued by U.S. possessions are all triple tax free (free from federal, state and
local).
19. (B) This is clearly a violation of the Wash Sale Rule.
20. (B) A bond bought at a premium of 100 dollars would amortorize over its life
until maturity. With a bond amoritizing over a 10 year period, the annual change to
the tax basis would be $10 per bond. So, after five years the bond has decreased
in tax basis by $50 (5 years times $10 per bond) to 105.
21. (C) Limited liability and centralization of management are impossible for a
partnership to avoid.
22. (C) The K-1 reports all tax consequences for limited partnerships.
23. (C) Most distributions of dividends or tax benefits reduces the current tax
basis.
24. (A) Not hardly! There generally is NO cash flow.
25. (B) New construction is considered high risk because of its potential inherent
problems.

NASD Series 7 Page 184

Investment Companies
Contractual Plans
 Module 28: Investment Companies

Section 28: Investment Companies

28.1 INVESTMENT COMPANIES
Investment companies are regulated by the Investment Company Act of 1940.
An investment company is a corporation or trust in which investors can invest in
large, diversified portfolios of securities by pooling their funds with the other inves-
tors. This type of investment offers a number of advantages for investors such as
diversification, access to professional money managers, lower transaction costs
and more.
Under the Investment Company Act of 1940, all investment companies must reg-
ister with the SEC. Before it can register, an investment company must have a
minimum net worth of at least one-hundred thousand ($100,000), one hundred
(100) shareholders and clearly stated investment objectives.
Before discussing specifics of the three different types of investment compa-
nies and how they work, lets take a look at the following chart which graphically
shows a breakdown of them.

Investment Companies

Face Amount Management Unit Investment

Certificates Companies Trusts

Fixed UIT Plan Company

Open-end Closed Separate Account

Mutual Fund End Variable Annuities

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2 8 . 2 TY P E S OF INVESTMENT COMPANIES
28.2.1 Unit Investment Trust
The UIT, under the Investment Company Act of 1940, purchases a fixed port-
folio of securities such as corporate, municipal or government bonds, mort-
gage-backed securities, and even common or preferred stock.
Units in the trust are sold to investors by brokers, just like mutual funds, for
a sales charge that is typically 4% for traditional municipal bond trusts and
1% - 2% for equity trusts, which feature reduced sales charges when the
trusts are rolled over into new ones.
Trusts expire when bonds mature or, in the case of equity funds, at a speci-
fied future date.
Bond trusts typically pay monthly, quarterly or semi-annual interest to
investors. As bonds mature or get called, investors will also receive a princi-
pal payment along with the interest.
Unit investment trusts, similar to mutual funds, can be redeemed through
the UIT company and NOT SOLD on a public stock exchange.
Exam Alert: One of the major differences between UITs and open-end
management companies is that the UIT is NOT actively managed and
therefore does not have fund managers or a management fee.

28.2.2 Face Amount Certificate

This is a debt security issued by face-amount certificate companies. The holder
makes periodic payments or a lump sum to the issuer in exchange for a prede-
termined rate of interest, and the issuer promises to pay the purchaser the face
value at maturity or a surrender value if the certificate is presented prior to
maturity. These securities are no longer issued.
28.2.3 Management Company (Majority of test questions)
A management company is a firm that, for a management fee, invests the
pooled funds of small investors in securities appropriate for its stated invest-
ment objectives.
It offers participants more diversification, liquidity and professional manage-
ment service than would normally be available to investors as individuals.

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There are two basic types of management companies:

28.2.4 Closed-end
Like a corporation, a closed-end fund has a fixed number of outstanding
shares that are traded like a stock, often on the New York and American
Stock Exchanges.
Unlike open-end mutual funds, closed-end funds do not stand ready to
issue and redeem shares on a continuous basis.
They tend to have specialized portfolios of stocks, bonds, convertibles or
combinations thereof, and may be oriented toward income, capital gains or
a combination.
Closed-end shares are offered just like any other new issue through an
IPO and selling syndicate. Just like other stocks, after the completion of the
IPO, investors can buy and sell shares on a stock exchange or in the over-
the-counter marketplace.
Share price, therefore, is based on supply and demand just like any other
stock and not based on the net asset value (NAV).
If more investors start buying vs. selling the closed-end fund the price will
rise, while the price would fall if more investors sell the fund vs. buying the
fund.
While a closed-end fund has a net asset value based on the value of the
underlying portfolio, the selling price is based on supply and demand so
closed-end funds can be trading at a discount (less) or premium (more) to
its NAV.
28.2.5 Open-end
Known as a mutual fund, has a floating number of outstanding shares and
stands prepared to sell or redeem shares at their current net asset value.
Therefore, shares are always available for additional investors.
There is no secondary market for open-end shares so shares must be
redeemed through the fund company and not on an exchange or in the
OTC.
Shares are offered at the Net Asset Value, which is computed daily at the
close of the New York Stock Exchange.
The NAV is computed by taking the asset value of a fund, subtracting out its
liabilities and dividing by the number of outstanding shares.

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If the fund is loaded (front-end sales charges) the fund is bought at the Pub-
lic Offering Price (POP) which is computed by taking the NAV and adding
the appropriate sales charges.
Shares MUST always be redeemed at the Net Asset Value. When inves-
tors redeem their shares the mutual funds capital is reduced.
Exam Alert: The major difference between an open-end and closed-
end fund is the capitalization structure. Open-end funds always have
shares available while closed-end funds only have a limited number
of shares available.

28.3 DIVERSIFIED AND NON-DIVERSIFIED COMPANY

Diversification is defined as the spreading of risk by putting assets in several
categories of investments such as stocks, bonds, money market instruments, pre-
cious metals etc.
Investing in companies of several industries involves greater diversification than
buying securities in only one industry, because the probability of one industry sus-
taining losses is greater than the probability that several industries will all sustain
losses at the same time.
28.3.1 Diversified Investment Company
Memorize the following numbers!
A diversified investment company mutual fund or unit investment trust invests
in a wide range of securities. Under the Investment Company Act of 1940, a
diversified investment company must meet the following test:
Invest at least 75% of its assets in such a way;
That no more than 5% of their total assets can be used to purchase any
one stock and;
When purchasing stock no more than 10% of the outstanding voting
stock can be purchased
28.3.2 Non-diversified Investment Company
A non-diversified investment company fails to meet the above 75%-5%-
10% tests.
Most mutual funds are registered as diversified management companies.

Exam Alert: Any and all information regarding open-end and closed-
end funds can be found in the funds prospectus which is the docu-
ment which discloses risks and a lot more.

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Comparing Open-End and Closed-End Companies

Characteristics Open-End Closed-End

Unlimited, continuous
Capitalization
shares available
Shares Full or fractional
Common stock only.
Can issue
No debt securities
Sell at the NAV.
Buy at the NAV plus sales
Pricing charges if a loaded fund.
Pricing structures found in
the prospectus.
Sold and redeemed only.
Trading Continuos offering.
Must redeem shares.
Ex-Dividend Date Set by Board of Directors
Shareholder Dividends when declared.
Rights Voting.
Fixed, single offering
Full only
Common, preferred and
debt securities
Price determined by
supply and demand.
Current market value
plus commission.
Initial Public Offering.
Secondary trading on an
exchange or OTC.
No redemption.
Set by the NYSE or
NASD
Dividends when
declared.
Voting.
Preemptive.

28.4 OPEN-END MUTUAL FUNDS

An open-end mutual fund sells mutual funds to the public. The term arises from
the fact that the firm continually creates new shares on demand, although an
open-end fund may close itself to new investors when its management decides
that it is too large.
Mutual fund shareholders buy the shares at the Public offering Price and
can redeem them at any time at the prevailing NAV, which may be higher or
lower than the price at which the investor bought them out. The shareholders
funds are invested in stocks, bonds, money market instruments etc., depend-
ing on the type of mutual fund company.

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Exam Alert: Mutual fund shares cannot be purchased on margin

because of the continuous offering of shares concept but can be
used as collateral. Borrowing against funds in a margin account is
allowed after 30 days.
28.4.1 Fund Diversification
Funds can diversify by purchasing many companies in many industries.
Additional diversification can be accomplished by a fund purchasing different
types of securities within a particular fund such as common stock, preferred
stock, different bonds etc.
Further diversification can be accomplished by buying securities from many
types of issuers and from different geographic areas such as municipal
bonds from municipalities on the west coast and then some on the east
coast.
28.4.2 Professional Management
A professional investment manager manages the portfolio of individual
mutual funds. Sometimes the investment managing is done by an individual
and other times by an investment committee.
The job of the investment adviser is to manage the fund by buying and
selling underlying securities so as to meet the funds objectives and to max-
imize returns for the investors.
The Board of Directors of the fund is ultimately responsible for the actions
of the investment adviser.
-The adviser is hired by the Board of Directors under an initial two-
year contract.
-Renewal of the contract must be approved annually by a majority
vote of the shares or a majority of the Board of Directors.
-Some funds require approval by both the Board of Directors and the
shareholders.
The investment management contract must be in writing with the com-
pensation to be paid spelled out. The annual amount of the fee will be set
and noted in the funds prospectus

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28.5 INVESTMENT OBJECTIVES OF THE FUND

Investment objectives can be found in the funds prospectus.
Some examples of investment objectives may include the following:
Safety of principal
Preservation of capital
Income
Growth
Aggressive growth
Capital gains
Tax-free
If a fund wanted to change their stated investment objectives it would take a
majority vote of all outstanding shares.
28.5.1 Securities in a Portfolio
The investment objectives of each fund will determine the type of securities that
will be purchased and placed into the portfolios.
For example, a municipal bond fund will consist of tax-free bonds, while a
common stock fund will have common stock as the underlying securities.
28.6 TIMING OF INVESTMENT DECISIONS
Timing an investment decision is trying to pick the best time to make a decision.
For example, market timing involves the analysis of fundamental and techni-
cal data to decide when to buy or sell stocks, bonds or mutual funds.
One of the major goals of the investment adviser is to time their buying and
selling of investments so as to make the most advantageous trades.
2 8 . 7 TA X S T A T U S OF FUND DISTRIBUTIONS
28.7.1 Taxable Mutual Funds
Dividends whether received directly or reinvested is a taxable event. They
are taxable at the investors tax bracket as ordinary income, not capital
gains.
Capital gains distributed at years end is a taxable event even if reinvested.

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Capital gains created by the investor when buying and selling is a taxable
event.
Capital gain rates are based on time held. Anything held less than one
year and a day is short-term and based on the investors tax bracket.
Anything held at least a year and a day is long-term with a maximum cap-
ital gain rate of 20% or for those in the 15% tax bracket. it is a maximum of
10%.
Income is taxed as ordinary income at the investors tax bracket.
Tax consequences are reported on a 1099 Form.
28.7.2 Tax-Free Mutual Funds
Dividends from tax-free municipal funds are not federally taxable.
Capital gains from tax-free municipal funds are taxable.
28.8 FINANCIAL/ECONOMIC RESEARCH AND ANALYSIS
Investment advisers managing mutual funds analyze securities and their compa-
nies prior to purchase. Various types of analysis can be done. On approach is the
Fundamentalist who looks within the company and looks at such things as:
Management team
Earnings
Market share of the companys product
Financial statement review
Stock price movement forecasts
Inventories
Another type of analyst is known as a Technical Analyst who looks at the
following:
Trading volume
Price studies
Uses charts
Project price trends in a market
Short-term predictions
Not concerned with the financial condition of the company

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28.9 FUND SHARES

28.9.1 Full and Fractional Shares
Buyers generally purchase a set dollar amount of a fund, unlike stock buyers
who purchase a number of shares, not dollars. So, mutual fund shares are
available in full and fractional shares so as to meet the demand of the dollar
purchaser. When selling shares, full and fractional shares can be redeemed.
28.9.2 Continual Offering and Fund Redemption
Open-end management companies always offer new shares. There is no limit
as to the number of shares available, unlike closed-end shares which have a
limited number of shares for sale. Shares can also be redeemed through the
fund company on any business day by the investor.
2 8 . 1 0 VO T I N G R I G H T S
Mutual funds are corporations and shareholders get to vote on a number of
issues such as:
Investment objective changes
Investment adviser contract renewal
Borrowing money by the fund company
Discontinuing of 12b-1 fees
Board of Director vacancies
Voting is accomplished through a proxy, just like any other corporation

Go to the next page for a chart of a typical

Mutual Fund Company structure!

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Mutual Fund Structure

Board of Directors
Fund Sponsor Transfer Custodian Investment
(Underwriter) Agent Bank Adviser

Investment
Forms selling group Issues shares Holds assets
decisions
Registers fund with Makes distribu- Paid fee by the Paid a percent of
the SEC tions fund NAV
Earns selling com- Keeps list of
Clerical duties
mission shareholders
Distributes shares Transfers shares Payables/
and capital gains and funds Receivables
Receives
Other Distributions Redeems shares
income

2 8 . 11 B O A R D OF DIRECTORS
The job of the Board of Directors is to establish investment policies for the fund
and supervise the operations.
The Board of Directors is elected by the shareholders on an annual basis.
Officers are appointed by the Board of Directors to conduct the daily activities
of the fund.
The Investment Company Act of 1940 requires that forty percent (40%) of
the Board of Directors, in order to be diversified, must be made up of non-
interested directors. This means they cannot be associated with the fund
company in any way.
The Board of Directors does not manage the investment portfolio as thats the
job for the investment manager.
- However, they do define the type of funds to offer such as growth,
income, growth and income etc. as well as defining the objectives of
those funds. Also, they ultimately approve the custodian, investment
adviser, transfer agent and officers of the company.
The board also establishes the funds dividend and capital gains policy
and will declare them when appropriate.

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Exam Alert: Remember for the exam, the Act of 1940 requires at least
40% of the directors to be independent or noninterested persons.

In summary, the board of directors will;

Establish investment policies
Select and oversee the investment adviser
Select the transfer agent and custodian
Vote for 12b-1 fees
Establish dividend and capital gains policies
Declare dividends and capital gains
Appoint officers
28.12 UNDERWRITERS
Underwriters are also known as sponsors or distributors
Mutual fund companies have underwriters whose main responsibility is to sell
shares to the general public.
They are appointed by the Board of Directors and receive a fee for selling
and marketing the shares to the public.
They actually purchase the shares from the fund company then sell them to
the general public directly through a selling force or to independent broker-
dealers to sell the shares to the public.
The actual compensation paid to the underwriters is based on the public
offering price which is calculated by adding a sales charge to the net asset
value.
Example: The NAV of the Stuff Growth Mutual Fund is $10 while the Pub-
lic Offering Price (POP) is $10.50. Take the difference of the POP and the
NAV to compute the sales load, which is also known as the under-
writers concession. The resulting difference of $.50, is known as the
selling concession which is part of the underwriters concession and
goes to the broker-dealer to be shared with the registered representative
that sold the fund.

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2 8 . 1 3 TR A N S F E R A G E N T
It should be noted that the transfer agent can also serve in the capacity of the fund
custodian. The fund itself pays the transfer agent for services rendered.
The transfer agent is responsible for:
Issuing, redeeming and canceling share certificates
Name changes for the fund
Mailing trade confirmations to the customer
Fund distributions
Keeps a list of shareholders
28.14 CUSTODIAN BANK
Under the Investment Company Act of 1940 a fund company must appoint a cus-
todian to hold the assets of the funds. Besides holding the assets, the custodian
takes care of most of the investment companys clerical functions. In most cases
the custodian is a commercial bank.
The custodian bank is responsible for:
Safeguarding the assets of the fund company
Can act as transfer agent
Performing clerical duties
Segregation of investment companys assets
Following SEC rules for withdrawal of funds
Receiving interest and dividends from underlying securities
The custodian will earn a custodial fee
28.15 INVESTMENT ADVISOR (FUND MANAGER)
The investment advisor, sometimes known as the investment (fund) manager, can
be an individual or even a separate company.
Initially, the Board of Directors contracts with the investment advisor for a
period of two years. After that, the contract is reviewed and renewed annu-
ally with shareholder approval.
The investment advisory agreement must be in writing and specify the com-
pensation to be paid as a management fee. The management fee is usually
a set annual percentage of the value of the funds assets.

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The investment adviser:

Manages the funds portfolio
Follows the funds investment objectives and Boards policies
Makes investment decisions
The investment advisor gets paid a percentage of the net asset value
Manages daily trading activities
Provides investment advice in conformity with Federal securities and tax law
28.16 COST OF OPERATING A MUTUAL FUND
The following are some of the costs in operating a mutual fund:
Custodial fees
Transfer agent fees
Legal fees
Accounting fees
Management fee (paid as a percentage of asset value)
Sales expense (paid out of underwriting concession)
Advertising fees (paid by the funds underwriter and by 12b-1 fees)
28.17 RIGHTS OF SHAREHOLDERS
Mutual fund shareholders have the right to vote on certain issues. They
would normally do this with a document mailed by the fund company called a
Proxy.
The proxy is also used by public corporations for purposes of shareholder
voting and approval of certain issues.
Voting is based on the number of shares owned by a shareholder, not the
number of shareholders in a fund.
The following are some of the issues that shareholders get to vote for:
Changes in the funds investment objectives
Changes in borrowing
Issuing or underwriting other securities
Selecting underwriters to issue future securities

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Becoming a 12b-1 fund company and approving 12b-1 fees

Termination of a 12b-1 plan
Increase 12b-1 expenses
Approve investment advisory agreement
Elect directors
Annual and semiannual reports (annual must be audited)
Changing sales load charges
2 8 . 1 8 TY P E S OF FUND DISTRIBUTIONS
28.18.1 Net Investment Income Per Share
Net investment income is income received by an investment company from
dividends and interest on their underlying securities during an accounting
period, less management fees and administrative expenses and then divided
by the number of outstanding shares.
When dividend and interest income is received by the investment company, the
shareholders are then paid the net investment income in the form of dividends
prorated according to each holders share in the total portfolio.
In arriving at the net investment income the following operating expenses
are deducted from the gross dividends and interest received;
Management fees (Usually the largest of the fees)
Taxes
Overhead expenses
Brokerage trading fees
12b-1 fees
Legal and audit fees
28.18.2 Dividends
Dividends are paid to shareholders just like any other corporation that pays div-
idends to its shareholders. Dividends are paid from the mutual funds net
investment income.

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28.18.3 Capital Gains

Capital gain distributions are derived from realized gains and are usually
made only annually and are considered to be long-term capital gains. Short-
term capital gains are usually distributed with dividends.
28.18.4 Return of Capital
A return of capital is NOT a taxable event as the distribution does not come
from income, dividends, and capital gains or from the funds investments. A
return of capital will reduce the shareholders basis in fund shares for purposes
of calculating gains or losses at the time of a later sale of fund shares.
28.18.5 Unrealized Appreciation/Depreciation
When share prices go up investors do not realize a profit until the fund is
finally sold. Until then it is known as unrealized appreciation. If fund shares go
down this is known as unrealized depreciation and would not be realized until
the shares are sold. When shares are sold any gains or losses would be real-
ized with a tax consequence.
28.18.6 Distribution Alternatives
One of the benefits of purchasing mutual fund shares is the flexibility of divi-
dend and capital gains distributions. Shareholders can make any of the follow-
ing choices:
Reinvest both dividends and capital gains
Take the dividends in cash for income and reinvest the capital gains
Take both the dividends and capital gains in cash
28.19 CONVENIENCE AND SERVICES PROVIDED TO
INVESTORS
There are many benefits associated with investing in mutual funds. All of the fol-
lowing are such benefits and conveniences:
Investment managers make the day-to-day investment decisions to maxi-
mize returns.
The fund company is responsible for the safekeeping of mutual fund shares
so investors dont have to worry about them.
Investors can exchange shares from one fund to another fund in the same
fund family usually without a sales charge. However, this may result in a tax
consequence.

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Investors can purchase full and fractional shares so specific sums of

money can be invested.
Portions of an entire mutual fund investment may be liquidated while still
maintaining benefits of diversification.
Mutual fund shares can be used as collateral for loans.
Ease of diversification due to the nature of mutual funds investing in a num-
ber of industries and companies.
Ease of account inquiry as shareholders can call the funds toll free number
to gain any information about their accounts usually 24 hours a day.
Ease of purchasing shares with a dollar amount either by mutual fund appli-
cation or through a broker-dealer.
Automatic reinvestment of dividend and capital gain distributions without
any sales charges.
- Ease of share redemption by;
- Telephone redemption
- Broker-dealer redeeming shares
- Can be redeemed on any given business day
- If physical share certificates have been delivered to the investor than
those certificates must be returned to the mutual fund company in
order to redeem them.
Systematic withdrawal plans
Redeeming shares on a regular basis
Systematic investment plan
Investing additional sums on a regular basis
Simplified tax information furnished by fund company on form 1099
explaining taxability of distributions
Check writing services with some funds
Telephonic account and client services offered by fund company
- Value of shares
- Latest fund information
- Research
- Investment objectives

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- Telephone redemption of shares

28.20 SYSTEMATIC WITHDRAWAL PLANS
A systematic withdrawal plan is a mutual fund option whereby the shareholder
receives specified withdrawal amounts at specified intervals.
28.20.1 Minimum Investment
Fund companies usually require a minimum investment prior to allowing a
systematic withdrawal plan to be effective. The minimum usually ranges from a
$5,000 to a $10,000 investment.
28.20.2 Potential Exhaustion of Principal
Exam Alert:
It is the responsibility of registered representatives to notify share-
holders that enrolling in a systematic withdrawal plan may involve
the liquidation of shares beyond any earnings being credited to the
account with dividends and capital gains. Taking out more than is
being earned, over time, may cause the principal to be depleted or
exhausted.

28.20.3 Types of Withdrawal Plans

Fixed dollar plan
Fixed percentage plan
Fixed share plan
Fixed time plan
28.20.3.1 Fixed Dollar Plan
A fixed dollar withdrawal plan is one in which the investor specifies an
amount of money to be withdrawn each period, i.e. monthly. The fund
company will liquidate enough shares to provide the required dollars.
28.20.3.2 Fixed Percentage Plan
Under a fixed percentage plan a fixed percentage of shares will be liqui-
dated each period. The investor needs to specify that specific percentage
such as 2% a month, as an example. With this plan the dollar amount will
vary as fund share prices fluctuate.

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28.20.3.3 Fixed Share Plan

Very similar to the fixed percentage plan, a specific number of shares are
liquidated each time period. The dollar amount will vary as fund share val-
ues fluctuate.
28.20.3.4 Fixed Time Plan
Under a fixed time withdrawal plan, customers liquidate their holdings
over a fixed period of time.
For example, if an investor wants to receive proceeds monthly for a
period of five years, the fund sends an initial check for 1/60th of the cur-
rent account value.
Because of the fixed time, this type of withdrawal plan is considered self-
exhausting and in this example will be liquidated in five years.
28.21 MUTUAL FUNDS BY INVESTMENT OBJECTIVE
28.21.1 Growth Funds
By definition, growth funds invest in growth stocks. The goal is to provide capi-
tal appreciation for the funds shareholders over the long term. Growth funds
are more volatile than more conservative income or money market funds. They
tend to rise faster than conservative funds in bull markets and to drop more
sharply in bear markets.
28.21.2 Aggressive Growth Fund
This is a mutual fund that holds stocks of rapidly growing companies.
While these companies may be large or small, they all share histories of
and prospects for above average profit growth.
Aggressive growth funds are designed solely for capital appreciation,
since they produce little or no income from dividends.
These funds are typically more volatile than the overall stock market, mean-
ing its shares will rise far more than the average stock during bull markets
and will fall much farther than the typical stock in a bear market.
28.21.3 Conservative Growth Funds
Securities in these growth funds are typically more established and better
known companies where there is a more moderate potential for growth in
earnings than in an aggressive growth fund.

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28.21.4 Income Funds

An income mutual fund is designed to produce current income for share-
holders. They may also include secondary objectives of preservation of capital.
Some examples of income funds are;
Government
Mortgage-backed
Municipal
International bonds
Junk bond funds (higher risk corporate bonds).
Several kinds of equity based funds also can have income as their primary
investment objective such as;
Utility companies
Equity income funds which can include blue chip stocks as well as pre-
ferred stocks
28.21.5 Growth and Income Funds
These are mutual funds that seek earnings growth as well as income. These
funds invest mainly in the common stock of companies with a history of capital
gains but that also have a record of consistent dividend payments.
28.21.6 Specialized Funds (Sector)
A mutual fund concentrating on one industry. Buy so doing, shareholders
have a concentrated play on the fortunes of that industry, for better or worse.
Some of the many industries with specialized mutual funds include;
Banking
Biotechnology
Chemicals
Energy
Environmental
Natural resources
Precious metals
Technology

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Telecommunications
Utilities
These funds tend to be more volatile than funds holding a diversified portfolio of
stocks in many industries. They are also known as Sector or Specialty
Funds.
28.21.7 Asset Allocation Funds
Asset allocation funds switch between stocks, bonds and money market securi-
ties to maximize shareholders returns while minimizing risk.
Such funds, which have become extremely popular in recent years, relieve
individual shareholders of the responsibility of timing their entry or exit into
different markets, since the fund manager is making those decisions.
Theoretically, asset allocation funds provide a built-in buffer against declin-
ing stock and bond prices because the manager can move all the funds
assets into safe money market instruments.
On the other hand, the investment manager has flexibility to invest aggres-
sively in international and domestic stocks and bonds if he or she sees bull
markets ahead for those securities.
28.21.8 Tax-Exempt Funds
Mutual funds that invest exclusively in tax-exempt securities provide tax-free
income to investors.
While a funds dividends would be entirely tax-exempt on a shareholders
federal tax return, they would be free from state income tax only in propor-
tion to the amount of interest income derived from the taxpayers home
state, assuming no interstate reciprocity arrangements pertain.
The return to investors from a tax-exempt bond is less than that from a cor-
porate bond, because the tax exemption provides extra compensation.
The higher the tax bracket of the investor, the more attractive the tax-free
alternative becomes.
28.22 MUTUAL FUNDS BY UNDERLYING INVESTMENT
28.22.1 Money Market Funds
A mutual fund money markets goal is to obtain a reasonable interest yield
through money market instruments with high liquidity and safety of princi-
pal. Yields on money market funds closely reflect short-term interest rates
which may fluctuate quite a bit.

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Money market funds typically provide check writing privileges, have no sales
charges and attempt to maintain a $1 net asset value. These funds invest in the
following types of securities;
Commercial Paper (maximum maturity of 270 days)
Bankers Acceptances
Repurchase Agreements
Government Securities
Certificates of Deposit
28.22.2 Bond and Preferred Stock Funds
Bond and preferred stock funds attempt to provide income to investors. They
do this through the use of the following type of securities;
Corporate bonds
Government bonds
Preferred stocks
Municipal bonds (tax-free)
International bonds
28.22.3 Common Stock Funds
These are funds that invest only in common stock. These funds work best dur-
ing bull markets.
28.22.4 Municipal Bond Funds
As a tax-free bond fund these funds invest mostly, if not all, in tax-free revenue
and general obligation bonds. High yield municipal bonds may invest in the
more risky industrial development revenue bonds. They provide higher rates
but risk of loss also increases.
28.22.5 Government Securities Funds
U.S. Government securities funds invest in debt instruments issued by the fed-
eral government and its agencies.
The following are examples of the underlying securities that can be found in a
Government Securities Fund;
Treasury Bills
Treasury Notes

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Treasury Bonds
FNMAs
GNMAs
FHLMCs
28.22.6 GNMA Funds
GNMA funds contain GNMA Maes as the underlying security. The GNMAs are
issued by the Government National Mortgage Association and are guaranteed
by the U.S. Government. GNMAs contain pools of mortgages and provide
monthly pass through of interest and/or principal to investors. As more mort-
gages are paid off, the amount of mortgages left in any particular pool of mort-
gages will decrease, and principal payments to investors will increase.
28.22.7 Option Funds
Option mutual funds either buy or sell options in order to increase the value of
fund shares. Option mutual funds may be either conservative or aggressive.
For instance, a conservative fund may buy stocks and increase shareholders
income through the premium earned by selling put and call options on the
stocks in the funds portfolio. This is known as an option income fund.
An aggressive option growth fund may buy puts and calls on stocks that the
fund manager thinks are about to fall or rise sharply. The leverage that options
provide makes it possible to multiply the return on invested funds many times
over.
28.22.8 Foreign Securities Funds
There are three types of funds that invest in securities outside the United
States. They are International Funds that invest in the securities of foreign
countries only, Global Funds that invest in the securities of both the United
States as well foreign countries and Single Country Funds which invest in
securities of only one country such as the Japan Fund, Korea Fund and Ger-
many Fund.
28.22.9 Precious Metal Funds
Precious metal funds invest in companies that mine and/or produce different
precious metals (as well as the precious metals themselves) and futures con-
tracts for precious metals.
Precious metal examples are:
Gold

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Silver
Platinum
Palladium
28.23 IMPORTANT FACTORS IN COMPARISON OF FUNDS
Prior to purchasing funds, investors should make comparisons of the various
types so as to make sure they are compatible and suitable for them. Once
these comparisons are made the investor would be ready to make a purchase.
28.23.1 Basis of Comparison
The following information about specific mutual funds should be
reviewed and compared;
Investment objectives
Investment policies
Quality of management
Risk factors
28.23.2 Investment Objectives
An investor needs to compare the investment objectives of similar types of
funds to insure the objectives are compatible with his/her financial goals and
objectives and make the final choices.
In review, some investment objectives include;
Growth
Income
Growth and Income
Saving taxes
Preservation of principal
28.24 INVESTMENT POLICIES
28.24.1 Issues to be compared;
Risk taking
Aggressive or conservative
Investment turnover

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Performance
Taxation issues
Costs and expenses
Services offered
Sales charges
28.24.2 Quality of Management
How an investment manager manages a fund, the type of management, and
investment results can help determine which funds are closer to the investors
goals and objectives.
The following should be considered when comparing various funds with
the same investment objectives;
Management style
Management by individual or by committee
Tenure of the manager
Investment manager turnover
Performance results
28.24.3 Risk Factors
Comparing the risk factors of various funds is quite important in the decision
making process. It is important that investors match their own risk tolerance
to the perceived risk policies of funds being compared.
28.24.4 Performance Statistics
Prior to purchasing funds investors should also review the performance statis-
tics of potential funds that are being considered for purchase.
The following items should be used for purposes of comparing potential
funds.
The total return of a fund would include share appreciation and dividends
paid by the fund.
Standardized yields are a uniform method of calculating yields for a spec-
ified period of time such as one year, five years, ten years, etc.
The current distribution rate is calculated by taking the annualized cur-
rent dividends paid by the mutual fund and dividing it by the current net
asset value of the shares at the time of computation.

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Typically, the current distribution rate is based on the most current 30 day
month.
As the share price and/or the dividend amount changes, the current distri-
bution rate will also change.
28.24.5 Expense Ratio
The funds expense ratio puts together the management fees and operating
expenses of the fund and then calculates the ratio by dividing a funds
expenses by its average net assets.
As an example, if the fund has an expense ratio of 1.48 percent it means
that the fund charges $1.48 per year for every $100 invested.
When comparing one mutual fund to another keep in mind that expense
ratios of various funds vary depending on the type of funds being com-
pared.
As an example, an aggressive growth funds expense ratio is usually higher
than a highly rated corporate bond funds expense ratio because more trad-
ing occurs in the growth funds portfolio.
Over history, stock funds generally have expense ratios between 1 per-
cent and 1 percent of a funds average net assets. Bond funds, on the
other hand, have expense ratios between.5 percent and 1 percent.
28.24.5.1 Other Factors
When comparing funds to each other factors should be considered
besides those already discussed. These include;
Systematic Investment plans
Withdrawal plans
Check writing privileges
Retirement account availability
Fund conversion privileges
Telephone transfers
Minimum purchase requirements
Sales and distribution charges

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28.25 SOURCES OF PERFORMANCE STATISTICS

Knowing what available sources can be used for fund comparison statistics pur-
poses is quite important.
Some of those sources are as follows;
Prospectus
Shareholder reports (semi-annual)
Advertising and sales literature
Financial periodicals
Information services for mutual funds such as Weisenberger, Lipper Analyti-
cal and Morningstar
28.26 SELLING FUND SHARES TO THE PUBLIC
Mutual fund companies can use any one particular method of delivering their
fund shares to the public or a combination of methods. You will be tested on
the various selling methods that are available to the fund companies in
delivering shares.
28.26.1 Fund to Underwriter to Dealer to Investor
This is the typical method used when shares are marketed to the public
through a broker-dealer.
The mutual fund company sells shares to its underwriter then the under-
writer sells the shares to the broker-dealer then the broker-dealer sells
the shares to the retail customer.
Part of the public offering price (POP) to the retail customer is the Under-
writers Concession (The difference between the POP and the NAV). The
broker-dealer shares part of the underwriters concession, known as the
Selling Concession, with the funds underwriter.
28.26.2 Fund to Underwriter to Investor
Here the underwriter acts as a broker-dealer and sells the shares pur-
chased from the mutual fund company directly to investors through its
own sales force.
So, the fund company sells its shares to the underwriter at the NAV and the
underwriters sales force sells the shares to the general public at the POP.

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28.26.3 Fund to Investor

The mutual fund company sells its shares directly to investors without using
its underwriters or broker-dealers. This would be done without any sales
charges and therefore are known as no-load funds.

Exam Alert: Shares sold to the general public must be made at the
public offering price which can be a loaded or no-load fund (no sales
charges). Only members of the NASD, including registered represen-
tatives, can purchase shares at a discount (without any sales
charges) at the NAV.
28.27 PRICE OF MUTUAL FUND SHARES
28.27.1 Net Asset Value (NAV)
Per share basis (Sometimes stated as the Bid Price)
The NAV of fund shares is calculated by mutual fund companies after the
close of the exchanges each day by taking the closing market value of all
the underlying securities owned plus all other assets such as cash, sub-
tracting all liabilities and dividing that number by the total number of shares
outstanding.
The number of shares outstanding can vary each day depending on the
number of purchases and redemptions.
In no-load funds, the NAV, market price and offering price are all the same
figure, which the public pays to buy shares.
Loaded funds purchased at the offer (POP) price are quoted after adding
the sales charge to the net asset value.
28.27.2 Changes in the NAV
If the portfolio securities increase in value or the fund receives investment
income, the NAV per share will also increase.
If the portfolio securities decrease in value or when portfolio income and
capital gains are paid to shareholders, the NAV per share will decrease.
The NAV does not change just because fund shares are sold or redeemed
or when securities are both bought and sold because they are replaced with
cash or cash is used to purchase additional securities. Therefore, the total
net assets would probably remain unchanged.

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28.27.3 Ex-Dividend
The ex-dividend date for mutual funds is set by the Board of Directors of the
fund, not the NASD as it would be with common stock. On this date the NAV
per share is reduced by the value of the distribution. In order to be able to get
the current dividend, shares must be purchased prior to ex-dividend day.
28.28 SELLING DIVIDENDS RULE
It is against NASD conduct rules to Sell Dividends. This means that you can-
not call your clients and tell them a fund will be paying a dividend and that they
should purchase shares now so as to be able to get the dividend. You would be
guilty of selling dividends!
Dont forget that on ex-dividend day the NAV will fall in value by the amount of
the distribution. Besides a fall in the NAV the client may now have an untimely tax
consequence by owing taxes on the distribution. So the investor would now own
fund shares which have fallen in value and also have to pay taxes on the divi-
dends.
28.29 REDEMPTION FEES
These are fees charged by a mutual fund to shareholders who sell fund shares
within a short time period.
The time limit and size of the fee vary among funds, but the redemption fee
usually is a relatively small percentage such as 1% - 2% of the amount with-
drawn.
The intent of the redemption fee is to discourage rapid-fire shifts from one
fund to another in an attempt to time swings in the stock or bond market.
This fee is often confused with the contingent deferred sales charge or back-
end sales charge imposed when selling Class B shares.
28.30 FEES AND EXPENSES
All fund company fees and expenses can be found in the prospectus and is listed
in a Tabular (Column) Presentation Method.
28.31 SALES CHARGES
A sales charge is a fee paid to a fund company by a buyer of mutual fund shares
in a loaded mutual fund.
Normally the sales charge for a mutual fund averages 4.5% to 5% of the cap-
ital invested and decreases as the size of the investment increases because
of reaching the fund familys breakpoints.

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Example: A $10,000 investment into an equity fund may have a sales

charge of 8% while an investment at the next breakpoint level of $25,000
will have a sales charge of 7 1/2%. Breakpoint schedules vary from fund
family to fund family and is printed in the funds prospectus)
The maximum sales charge permitted is 8.5% of the POP (sometimes stated
as the ASK Price) of customers mutual fund purchases.
With contractual plan purchases (discussed later), however, the maximum
sales charge permitted is 9% of the POP over the life of the contract.
The reality is that most mutual fund companies do not charge the full 8.5%
but rather an amount somewhere around 5%.
The information regarding sales charges can be found in the funds prospec-
tus.
Sales charges are normally stated as a percentage of the offering price
(Ask), NOT a percentage of the per share NAV. (This is an Exam Question)
The maximum sales charge of 8.5% cannot be charged and will be reduced
to 6.25% when a mutual fund company does NOT allow dividend reinvest-
ment at the NAV and does not allow rights of accumulation or breakpoints.
28.32 SALES CHARGES AND CLASS A SHARES
Formula #1: Computing Sales Charge Percent
As the sales charge percent is based on the Ask price, the formula for
determining the sales charge percent is;
Sales Charge Percent = POP (Ask) NAV (Bid) divided by the POP
Question: What is the sales charge % for the Acme Growth & Income
Fund with a NAV of $31.87 and a POP of $33.78?
Answer: 33.78 31.87 = 1.91 divided by 33.78 = 5.65% Sales Charge

Formula #2: Computing the Offering Price

The offering price or POP for the public is computed as follows;
POP = NAV divided by (1.00 - Sales Charge %)
Question: What is the offering price for the Acme Growth & Income Fund
with a NAV or $31.87 and Sales Charge of 5.65%?
Answer: 31.87 (NAV) divided by (1.00 .0565 or .9435) = $33.78 POP

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28.33 CLASS A SHARES

Class A shares are purchased at the public offering price which means the
NAV plus any applicable sales charges.
They have lower 12b-1 fees than do Class B shares.
Shares are always sold at the NAV.
Shares are also known as having front-end loads (up-front sales charges)
28.34 CONTINGENT DEFERRED SALES CHARGE
These are also known as Class B shares as well as a Back-End Load.
There is a sales charge levied by a mutual fund if a customer sells fund
shares within a specified number of years. Instead of charging a traditional
Front End Load of 5%, as an example, a brokerage firm may offer the same
fund with a contingent deferred sales load.
As an example, each year the potential redemption charge declines by one
percentage point until there is no fee for selling any of the fund shares after
the sixth year.
The average Class B share company has redemption charges over 5 - 6
years on a declining basis such as 6% - 5% - 4% - 3% - 2% - 1% - 0%.
After the surrender charge years end, most Class B shares automatically
convert to Class A shares. The reason for this is that Class A shares typi-
cally have lower 12b-1 fees (marketing and advertising fees) as well as other
lower fees.
There are no breakpoints with Class B shares. Breakpoints are only found
with Class A shares
Class B shares are purchased at the NAV, just like a no-load fund.
28.35 LEVEL LOAD (C CLASS SHARES)
A level sales charge that does not change over time. Level load shares are
called Class C shares. These can be used for short-term savings reasons
A level load will typically be 1% to 2% of the value of the fund each year,
which is usually lower than a front-end loaded fund.
Though the level load may be lower than up front or back-end loads, an
investor can end up paying higher sales charges if the fund is held for many
years.

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Contingent Deferred Sales Charge Example

Deferred Sales
Year Fund Sold
Charge Percent

1 6%
2 5%
3 4%
4 3%
5 2%
6 1%

28.36 DISTRIBUTION PLANS/SEC RULE 12B-1

A mutual fund assesses shareholders for some of its marketing and promotion
expenses. These fees are also used to help pay for some of the costs associated
with the distribution of fund shares.
Rule 12b-1 provides mutual funds and their shareholders with an asset-
based alternative method of covering sales and marketing expenses.
The predominant use of 12b-1 fees is in funds sold through brokers, insur-
ance agents, and financial planners.
12b-1 fees must be approved initially and reapproved at least annually by
a majority of the outstanding shares, the Board of Directors and those direc-
tors who are non-interested persons. Expenses charged as 12b-1 fees
must be Reviewed quarterly by the Board of Directors.
These fees can be terminated at any time by a majority vote of the non-inter-
ested directors or by a majority vote of outstanding shares.

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28.37 NEWSPAPER QUOTES

Series 7 Registered Representatives are expected to be able to read mutual fund
quotes from newspaper financial columns.
Following is an example of quotes for the Acme Mutual Fund Company
funds.
Buy at the POP (Ask)
Sell at the NAV (Bid)
The Chg column reflects the change of the NAV from the prior closing day,
i.e. down $.01

Newspaper Quotes Example

NAV POP
Fund Name Chg
Bid Ask

Acme Funds
Acme Balanced A $11.94 $12.65 -.01
Acme GthInc nl $31.87 $31.87 -.06
AIM Funds
BlChip B r (1%) $12.15 $12.28 -.08

28.37.1 Reading the Chart

Acme Balanced Fund is a Class A share fund with a front-end load
The Acme Growth and Income fund is a no-load fund as indicated by nl
The AIM Blue Chip fund has Class B shares with a redemption fee of 1%
28.37.2 Mutual Fund Symbols
You are responsible in learning how to read mutual fund charts in the
financial newspapers.
The following symbols, can be found next to listings of mutual funds.
- nl = no-load fund (see Acme GthInc above)
- r = contingent deferred sales charges
- p = 12b-1 marketing fees
- t = contingent deferred sales charges and 12b-1 fees

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28.38 REDUCED SALES CHARGES/QUANTITY DIS-

COUNTS

The maximum sales charge for mutual funds is 8.5% which can be reduced when
investors known as Persons qualify for volume purchases. Volume purchases
are listed in a funds prospectus and are known as Breakpoints. Investors qualify
for these breakpoints even when purchasing various funds as long as they are in
the same Fund Family. (i.e. Aim Fund Family)
Persons (groups) qualifying for breakpoints via Letters of Intent and/or
Rights of Accumulation can be defined as any one or more of the following;
Individuals
Individuals, their spouses and minor children
Corporations
Institutions
Pension plans
Trustees
Employee benefit plans

Exam Alert: Investment Clubs do NOT qualify for reduced sales

charges

Breakpoint Schedule Example Found in a Prospectus

Amount Invested Sales Charge

$0 - $9,999 8.5%
$10,000 - $19,000 8.0%
$20,000 - $49,999 7.5%
$50,000 and higher 7.0%

Example #1: Suppose that an investor wants to purchase $8,000 and the
fund has the above breakpoint schedule. The sales charge for this pur-
chase would be 8.5%. However, because the purchase is close to a
breakpoint, $10,000, you as a registered representative must disclose to
the investor that if another $2,000 was invested at this time the sales
charge would be reduced to 8% instead of 8.5%.

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Example #2: If an investor wants to invest $10,000 but the registered rep-
resentative advises the investor to place only $5,000 in this fund family
and the other $5,000 into another fund family an NASD violation occurs
known as a Breakpoint Sale. The obvious purpose here was to collect
the higher commission instead of spreading the $10,000 between any of
the funds within the same fund family.

28.38.1 Letter of Intent (LOI)

The investor promises to invest a specified sum of money to reach a breakpoint
qualifying the investor for a reduced sales charge. The LOI is basically a one-
sided agreement as there is no penalty per se if the investor fails to invest the
required dollar amount. If the investor did not purchase the amount indicated by
his/her LOI by the 13th month, the fund company would sell off a certain
amount of shares. This amount would be the difference between what the sales
charges should have been on the actual amount invested versus the sales
charges he/she paid based on the larger purchase as indicated in the LOI.
Elements of the Letter of Intent are as follows;
Investor promises to invest enough to reach the selected breakpoint level.
Breakpoint purchase must be completed within 13 months. If the invest-
ment is not completed then the investor will be charged the higher sales
charge by selling fund shares.
The LOI can be backdated during the first 90 days. In other words, an
investor has a period of 90 days to sign the LOI and if the investor does the
discounted sales charge will be backdated to the original trade date.
Only actual investment dollars count in meeting the LOI, not the appreci-
ated value of the investment.
- As an example, using facts in example #1, the $8,000 investment
grows to $10,000 in three months. This will NOT count as meeting the
LOI requirement. The investor must physically add at least $2,000 to
fulfill the requirement.
28.38.2 Rights of Accumulation
Rights of Accumulation, just like an LOI, allow mutual fund investors to qualify
for reduced sales charges by reaching breakpoint levels.
The major differences between an LOI and rights of accumulation are;
Rights of accumulation are not available for initial transactions
They are based on subsequent investments
There are no time limits

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Accumulation levels are tracked automatically by the fund companies and

sales charges are reduced as these levels are reached
Investors can reach breakpoint levels by adding new investments to prior
investments and/or adding the new investment to share appreciation. The
accepted method for each fund family would be indicated in the funds pro-
spectus.

28.38.2.1 Rights of Accumulation Examples

Example #1: Apply the following facts to the breakpoint schedule dis-
played on the prior page. Billy Bob invests $8,000 but did not sign an LOI.
Four months later he invests an additional $2,000. The new investment
added to the initial investment equals $10,000 and reaches a break-
point. Therefore, Billy Bobs new purchase will be based on a discounted
sales charge of 8% rather than 8.5%.
Example #2: Some fund families allow the new investment to be added to
the appreciated NAV and not the original investment for purposes of
breakpoint discounts. Lets suppose Billy Bobs original investment grew
to $18,000 because of a strong bull market. He then invests an additional
$2,000. If the fund familys policy is to base rights of accumulation on the
appreciated value Billy Bob would now qualify for a discount of 7.5%
instead of 8%.

Exam Alert: Read the question carefully so as to know if the default of

the initial investment is to be used or the appreciated NAV.

2 8 . 3 9 D O L L A R CO S T AV E R A G I N G
Dollar Cost Averaging is an investment strategy for purchasing shares over
a long period of time.
Investment discipline is needed to invest a fixed dollar amount at regular
time intervals no matter what happens in the stock market.
With market fluctuations an investor buys more shares when the prices
decrease and less shares when they increase.
Bottom line, an investor engaged in dollar cost averaging will never average
the highest share price nor the lowest share price, but be somewhere in
between

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Dollar Cost Averaging Example

Price per No. of Shares
Month Investment
Share Purchased

1 $100 5.00 20.00

2 $100 5.50 18.18
3 $100 5.00 20.00
4 $100 6.00 16.67
5 $100 6.25 16.00
6 $100 5.50 18.18
7 $100 5.00 20.00
8 $100 4.50 22.22
9 $100 4.00 25.00
10 $100 4.25 23.53
11 $100 4.50 22.22
12 $100 5.00 20.00
12 Investments
$1,200 $60.50 242
Totals

Potential exam questions: Use the DCA example on the prior page;
1. Dollar Cost Average (DCA) = $1200 divided by 242 = $4.96 per share
2. Highest price per share = $6.00 and the lowest price per share $4.00
3. Average Market Price = $60.50 (total from price per share column)
divided by the number of the investments (12) = $5.04
28.40 REDEMPTION OF MUTUAL FUNDS
Mutual fund shares, as an open-end management company, must be redeemed
versus being sold in a stock market. Shares must be redeemed ultimately through
the mutual fund company by a number of methods.

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Mutual fund companies must redeem an investors shares and payment sent to
the investor within seven business days. Once the shares are redeemed they
are destroyed.
28.40.1 Redemption methods
Shares sold directly back to the fund company by written request
Telephonic redemption if the account was originally set up for this type of
redemption
Depleting the value of the account, i.e. a money market, by writing a check
when the account has check writing privileges
Sell shares to a broker-dealer which then redeems them with the mutual
fund company (shares must be in the investors account)
If the customer is in receipt of the physical fund certificates, he/she must
sign the certificates and get a signature guarantee.
28.40.2 Basis for the Redemption Price
28.40.2.1 Forward Pricing
The Securities and Exchange Commission requires that open-end invest-
ment companies, whose share price is always determined by the NAV of
the outstanding shares, base all incoming buy and sell orders on the next
net asset valuation of fund shares.
Example: If an investor wishes to sell her shares on Monday at 1:00 pm,
the NAV will be established at the close of Mondays business and the
investor will get the newly established NAV as her redemption price.

28.41 PROSPECTUS
A prospectus is also known as the Statement of Additional Information (SAI). A
funds prospectus provides all relevant information about the mutual fund being
considered. The prospectus is required to be given to all persons considering a
mutual fund purchase prior to or at the time of solicitation.
The following information is generally provided in a funds prospectus;
Funds history
Background of the investment managers
Fund objectives
Financial statements

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Fund policies and restrictions

Sales loads and fees
Front-end load fee descriptions
Contingent deferred sales charges
12b-1 fee information
Redemption fee information
Management fees
Other expenses
An expense table
Breakpoints, rights of accumulation and LOI information
Exchange privileges within the family of funds
Per-share income and capital changes
Methods of sale
Methods of redemption
Investment and withdrawal plans
28.41.1 SEC No Approval Clause
The Securities and Exchange Commission reviews all prospectuses to ensure
that there is sufficient disclosure for investors to make an informed investment
decision. However, the SEC doesnt guarantee the future success of the fund
nor do they guarantee the provided information. This clause must appear on
the Front Cover or First Page of all prospectuses.

No Approval Clause Wording

These securities have not been approved or disapproved by the Securi-
ties and Exchange Commission or by any State Securities Commission,
nor has the SEC or any State Securities Commission passed upon the
accuracy of this prospectus. Any representation to the contrary is a crimi-
nal offense.

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 Module 29: Contractual Plans

Section 29: Contractual Plans

29.1 CONTRACTUAL PLAN CHARACTERISTICS
A contractual plan is also known as a Periodic Payment Plan. This plan allows a
person to invest in a mutual fund on a periodic basis over a fixed period of time.
The plan also allows an investor to invest smaller amounts than is normally
allowed under their minimum investment rules.
29.2 CONTRACTUAL PLAN ELEMENTS
Investor decides on a fixed monthly amount he/she can afford to invest.
This may be $10, $50, $100 or even $500 or $1,000 a month.
A contractual agreement is signed in which the investor promises to make
their contribution monthly for the length of the contract. While the agreement
is signed it is not binding on the investor, but the investor may incur penal-
ties if the plan is terminated before completion.
A fixed length of the contract is established which can be 10 years, 15 years
or even 20 years.
Plan companies have their own custodians who are responsible for holding
shares as well as also acting as the transfer agent and keeping the books for
investors. Custodial fees are charged against the returns to investors and are
fixed.
Sales charges are fixed (to be discussed later)
All dividends and capital gain distributions are automatically reinvested into
the plan.
Partial liquidations and reinstatement privileges are allowed.
Plan companies are organized as Unit Investment Trusts
Customers pay money into the plan which forms units, then the plan com-
pany takes the dollars from the units and buys shares from the mutual fund
company.
Lump sum investments (single pay) may be made into the plan and if large
enough may qualify for breakpoint discounts.
29.3 PROSPECTUS REQUIREMENTS
Two prospectuses are required:
One prospectus for the underlying mutual fund

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The other prospectus on the plan company offering the contractual plan
29.4 OPERATION OF CONTRACTUAL PLANS
The underlying assets of the contractual plans sold would be mutual funds.
The plan company is also known as the plan sponsor.
Section 27 of the Investment Company Act of 1940 allows contractual plan
companies to offer a Periodic Payment Plan and charge an overall 9% in
sales charges over the life of the plan.

Example: If an investor chooses a $100 per month plan for 15 years the
total investment would be $18,000. The total sales charges for this plan
would be 9% of $18,000 or $1,620.

29.5 FRONT-END AND SPREAD LOAD FEATURES

29.5.1 Front-end load
The Investment Company Act of 1940 allows the plan company to collect sales
charges of up to 50% of an investors deposits in the first year.

Example: Investor chooses a plan of $100 monthly for 15 years. The first
years investment represent $1,200 ($100 x 12 months) with maximum
sales charges of 50% or $600

29.5.2 Spread Load

A spread load, authorized by the Investment Company Act Amendment of
1970, Section 27-H, allows a plan company to charge the following sales
charges;
Up to 20% of an investors deposit in any one year
As long as the average charge over the first four years does not exceed
16% annually
2 9 . 6 TE R M I N A T I N G A PLAN
Under the provisions of the Investment Company Act of 1940 both front-end
and spread load plans must allow investors to change their minds and pur-
chase decisions.
29.6.1 Right to Refund
For both the front-end and spread load plans, a customer has a right to
request a refund after receiving the 45 day Withdrawal Letter. This is also
known as the 45-day free look.

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The 45 day letter must be sent within 60 days of the date a contractual plan
certificate is issued to the customer. At that time the customer may termi-
nate the plan within 45 days from the mailing date of the custodians writ-
ten notice.
If the customer surrenders the plan certificate he/she is entitled to:
A 100% refund of all sales charges paid
Plus the investments current NAV.
Remember, this doesnt mean the customer gets back all of their invest-
ment dollars because of the potential of NAV fluctuations.
29.6.2 18 Month Surrender Rule
Once the 45 day withdrawal notice has expired the 18 month surrender rule
may apply. Here are the rules;
The 18 month surrender rule applies to front-end plans ONLY.
The 18 month surrender rule does NOT apply to spread loads.
It allows the investor to receive the current NAV plus any sales charges.
However, it allows a deduction of 15% of the total dollars invested as a pen-
alty.
29.6.3 Contractual Plan Surrender Examples
Example #1: Bobbie Jo signs up for a $100 per month front-end contractual
plan for 15 years in hopes of saving for his retirement. After making two
monthly payments totaling $200 he reads the 45 day right of withdrawal and
decides to terminate the plan. At the time of termination the NAV is $75. What,
if anything, does he get?
Solution
First Bobbie Jo gets the total sales charges paid of $100 (2 months of $100
= $200 less 50% sales charges of $100)
Next he gets the current NAV or $75
So, Bobbi Jo gets a total of $175 upon termination

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29.6.4 Example #2:

Same facts as Example #1 but Bobbie Jo decides to terminate after six
months but hasnt made any additional investments.
Solution
Still gets the $100 of sales charges
Still gets the current NAV of $75
BUT, he receives a penalty of 15% of his original investment of $200 or $30
which is subtracted from the two above items
Therefore, Bobbie Jo receives $145 instead of $175 because of the penalty

Exam Alert: If in the test question you see the words front-end con-
tractual plan the maximum sales charge is 50% of all the first years
deposits with sales charges of 9% allowed over the LIFE of the con-
tract. If in the test question you see 20% and/or 16% they are talking
about a Spread Load contractual plan which also has a maximum
sales charge of 9% that can be applied over the life of the plan

Turn to the next page for the

Sales Charge Comparison Review for Plan Companies!

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 Module 29: Contractual Plans

Sales Charge Comparison Review for Plan Companies

1970 Act
1940 Act
Terms Spread-Load or
Front-End Load
Section 27-H

Max Sales Charges over life 9% 9%

Max Sales Charge in any one
50% 20%
year
Max Sales Charge over 4
None 16% annual average
years
Refund of current Refund of current NAV
45 day free look letter NAV plus any plus any sales
sales charges charges
Refund of current
NAV plus any
Termination within 18
sales charges in Refund of NAV ONLY
months
excess of 15% of
total payments

2 9 . 7 E X C H A N G E TR A D E D F U N D S
In short, Exchange Traded Funds, known as ETFs, are similar to index mutual
funds but are traded more like a stock. As their name implies, ETFs represent a
basket of securities that are traded on an exchange.
As with all investment products, exchange traded funds have their share of advan-
tages and disadvantages.
29.7.1 Advantages of ETFs
ETFs can be bought and sold throughout the trading day, allowing for intra-
day trading which is rare with mutual funds.
Traders have the ability to short or buy ETFs on margin.
Low annual expenses
Tax efficiency

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29.7.2 Disadvantages of ETFs

Like stocks, ETFs require commissions.
They must be purchased through broker-dealers and cannot be purchased
directly.
Unlike mutual funds, ETFs dont necessarily trade at the net asset values of
their underlying holdings. ETFs can trade above or below the value of the
holdings.
There is a bid-ask spread, just like stocks which means the spread is
earned by an exchange specialist/trader.
29.7.3 List of Exchange Traded Funds
The most popular ETFs trading is found in the following chart:

Exchange Traded Funds

ETF Type Full Name Tracks

Dow Jones Industrial

DIAMONDS Diamonds Trust Series
Average
Fixed income exchange
FITRs Various treasuries
traded securities
Holding company deposi- Narrow industry
HOLDRs
tory receipts groups
Group of ETFs mar-
IShares - possibly index
iShares keted by Barclays
shares
Global Investors
QUBEs Nasdaq 100 (QQQ) Nasdaq 100 Index
Standard and Poors Track a variety of
Spiders Depository Receipts Standard & Poors
(SPDRs) indexes
Vanguard Index Participa- Several Vanguard
VIPERS
tion Receipts Index funds
Various indexes,
StreetTracks State Street Global Advisor including Dow Jones
and Wilshire indexes

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 Module 30: Opening a Mutual Fund Account

Section 30: Opening a Mutual Fund Account

30.1 REQUIRED MINIMUM INVESTMENT
Most mutual fund companies have established minimum dollar amounts to
open an account. They range from a low of $25 to a high of $5,000. As the
amount varies from fund company to fund company it is important for you to
research these amounts to make sure they fit your customers profile. Also, IRA
accounts tend to have lower minimum investment requirements.
When mutual funds are purchased, Regulation T of the Federal Reserve Board
prohibits the use of margin (using credit to purchase securities). However, after
30 days, mutual funds can be used for margin loan purposes. This rule also
applies to stocks purchased as an IPO.
Exam Alert: Remember: No margin for new mutual fund purchases
or new stock (IPOs) for a period of 30 days.

30.2 DIVIDEND/CAPITAL GAINS ELECTION

When an account is opened, investors need to make a decision as to what they
are going to do with any potential dividend and capital gains distributions. The
account is set up for automatic reinvestment of the dividends, and/or the capital
gains or to take both the dividends and capital as income.
The following would represent automatic investor choices;
Growth: If the investors goal is growth it would be appropriate to reinvest
both the dividends and capital gain distributions.
Income: If the investor is in need of income the recommendation would be
to keep the dividends and capital gains instead of reinvesting them.
Growth and Income: The recommendation would be to keep the dividends
for income and reinvest the capital gains for growth.
30.3 ACCOUNT DOCUMENTATION
The following information is required when opening a securities account;
Customer name(s): If a joint account all names must be listed. Important:
while the dates of birth(s) are not required, proof of legal age is. Also, cus-
tomer signatures are not required by law, but may be required by individual
brokerage firms.
Residence: A legal address is required, not a P.O. Box.

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Tax ID number of Social Security Number: As an IRS requirement the

brokerage firm must make a reasonable effort to obtain this number. If not,
the IRS will require extra withholding of any distributions.
Occupation and Name and Address of Employer: These are required for
not only suitability purposes but also to determine if the person is associ-
ated with a NASD member firm because of hot issue rules.
Whether associated with another NASD member: Permission would be
needed from the other NASD firm to open or maintain this account.
Discretionary Account Data: This is defined as allowing the brokerage
firm through a registered representative to buy and sell without the clients
prior knowledge or consent. Brokerage firms require additional powers of
attorney to be signed granting the broker and brokerage firm this authority.
Trading Powers: Those authorized to act for the investor
- Limited authorization: This limited power of attorney allows a person
to act for the account holder in buying and selling securities. However,
any proceeds must be sent to the holder of the account, not to the
holder of the power.
- Full authorization: Same as the limited authorization but also allows
the holder of this power to physically receive distributions.
3 0 . 4 TY P E S OF SPECIAL ACCOUNTS
30.4.1 Corporate Accounts
Corporate new account form
Corporate resolution indicating the person or persons that have authority to
represent the corporation for trading activities
Documentation to establish that there really is a corporation
30.4.2 Partnership Accounts
New account form
Copy of the partnership agreement with an indication as to who has trading
authority
30.4.3 Trust & Fiduciary Accounts
New account form
Copy of trust with person indicated who has trading authority

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 Module 30: Opening a Mutual Fund Account

30.4.4 Investment Advisor

New account form
Usually done through a special account known as an Omnibus Account to
handle management of their clients investments
30.5 FORMS OF OWNERSHIP
30.5.1 Individual Ownership
An account is opened in the name of one person. The following informa-
tion will be asked because of suitability issues and regulatory require-
ments;
Full name
Age (to establish legal age Date of birth is NOT required)
Legal residence
Occupation
Employer with address
Social Security or Tax ID Number
Citizenship
Established income and net worth
Investment objectives
Investment experience
Bank and brokerage references
Whether associated with a member firm or insurance company
Whether owns a corporation and/or a director of a public company
Powers of attorney, if any
30.5.2 Joint Ownership
An account is opened in the names of two or more persons on the account.
The same information shown above is also required here. There are two differ-
ent types of joint ownership accounts.
They are as follows;
Joint Tenancy with Rights of Survivorship: All owners under JTWROS
own all of the investment. The investment is NOT divided into equal shares

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or into percentages. If one person were to die, the remaining joint owners
own all of the investment(s) and nothing passes to a beneficiary or to the
estate of the deceased.
Tenancy in Common: Unlike JTWROS, all of the joint owners own a cer-
tain percentage of the account. It does not have to be the same percentage
of ownership. If a person dies, their portion is taken from the account and
placed into the deceaseds estate for distribution. The remaining owners of
the account keep what is left.
30.5.3 Uniform Gift/Transfer to Minors Act
The UGMA/UTMA Acts were enacted to provide a simple way to transfer prop-
erty to a minor without the complications of a formal trust. An UGMA/UTMA
account is managed by a custodian appointed by the donor of the gift.
The following are characteristics of the UGMA/UTMA gift.
One child per account
Once custodian per account
Childs social security number must be used
This is an irrevocable gift and goes to the child on the day of majority which
varies from state to state (usually age 18)
No commodities allowed
No margin allowed
All securities must be fully paid for
Custodian may not charge a custodial fee
Custodian may use the property in the account in any way he/she deems
proper for the minors support, education, maintenance, general use or
benefit.
The account is registered in the name of the custodian for the benefit of the
minor

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 Module 31: Mutual Fund Tax Issues

Section 31: Mutual Fund Tax Issues

3 1 . 1 TA X C O N S E Q U E N C E S
In general, distributions from mutual funds as dividends are almost always tax-
able. Some exceptions may include distributions within a qualified plan or an IRA
or even from a federally tax-free mutual fund.
31.2 REGULATED INVESTMENT COMPANY
Mutual funds are organized as corporations under state law in the state of
incorporation.
While corporations are normally taxable entities, mutual fund companies
under the Conduit Theory, also known as the Pipeline Theory under Sub-
chapter M of the IRS Code may not be.
However, in order to avoid total corporate taxation the mutual fund company
MUST distribute their net investment income (net investment income
includes gross investment income of dividends and interest paid from the
underlying fund securities minus operating expenses) to shareholders by
year end.
Fund companies generally do this in the form of annual capital gains and div-
idends. In order to escape this taxation, fund companies must make distribu-
tions of at least 90% of their investment income. If not, they will have to pay
taxes on 100 percent of their net investment income.
3 1 . 3 TA X TR E A T M E N T OF CAPITAL GAINS
Capital gains distributions are based on realized gains with the funds under-
lying securities.
When the mutual fund sells any securities, the gain or loss is realized and will
affect shareholders.
If the security was held for at least one year and a day it will receive long-term
capital gain treatment. However, if the fund held the security for less than one
year the distribution will be treated as ordinary income, taxable at the tax-
payers regular tax bracket.
Any share appreciation or depreciation is known as unrealized gains and
unrealized losses as long as the securities werent sold. Therefore, no initial
tax consequences.

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3 1 . 4 TA X TR E A T M E N T OF INCOME DISTRIBUTIONS
Dividends, usually distributed quarterly by the various mutual funds, are paid from
the mutual funds net investment income. Dividends received by shareholders
are taxed at their regular tax brackets without any special capital gain treatment.
31.5 REINVESTED DISTRIBUTIONS
Whether or not distributions are taken or reinvested, a tax consequence applies.
When distributions are made the fund company will identify whether it is from
income or capital tax transactions. Form 1099 will be sent to each shareholder
after the end of the tax year detailing any tax transactions related to the distribu-
tions.
31.6 FUND SWITCHING
When one fund is sold, even in the same fund family, and another one purchased,
the IRS treats the sale as a taxable event. This can result in either a gain or a
loss depending on the net results.
3 1 . 7 TA X C O N S E Q U E N C E S OF I N V E S T O R S A C T I V I T I E S
Mutual fund shareholders are the ultimate persons held responsibility for reporting
all gains, losses and income to the IRS and States. While shareholders will
receive annual 1099s the responsibility does not shift to the fund company from
the shareholder for the reporting responsibility.
31.8 NET CAPITAL GAIN/LOSS COMPUTATION
When shares of a fund are purchased an investor establishes his/her initial Cost
Basis (cost of shares). If dividends and capital gains are distributed and rein-
vested in the fund and new shares are purchased, the cost basis will increase as
the distributions were taxable.
The following is included in calculating the cost basis;
Amount of money originally invested
Any additional contributions invested
Reinvestment of dividends and/or capital gains distributions

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 Module 31: Mutual Fund Tax Issues

Tax Treatment of Realized Net Capital Gains/Capital Losses

Step 1: Take the cost basis for the fund sold
Step 2: Take the difference between the sales price and the cost basis
Step 3: If the difference is a positive number it is a gain - If the difference is a
negative number it is a loss
Step 4: Add up all the gains and all the losses separately
Step 5: Take the difference between the gains and losses. This will establish
the net gain or net loss.
Step 6: If a net loss, you may offset up to $3,000 of the losses against earned
income for that year and then carryover remaining losses, if any, to the fol-
lowing year for further treatment. Currently, losses may be carried over indef-
initely to be used in future years.
3 1 . 9 TA X B A S I S OF SECURITIES
31.9.1 Offering Price
Mutual funds are purchased at the Offering Price, also known as the Public
Offering Price, which establishes for tax purposes the tax basis. If the fund pur-
chased is a front-end loaded fund the sales charges portion also becomes part of
the tax basis (cost of the fund shares).
31.10 EXCHANGE OF SECURITIES
While an exchange between funds within a family of funds is permitted by the
mutual fund company without any charges the IRS treats the exchange as a tax
consequence as the switch is considered a sell and a purchase of the other fund.
This means that there could be a gain or loss depending on the investment
results.
NOTE: The Current Market Value (CMV) is used synonymously with the Fair
Market Value (FMV).
3 1 . 11 R E I N V E S T M E N T OF DIVIDENDS AND CAPITAL
GAINS
When an investor chooses to reinvest dividend and capital gain distributions and
purchases additional shares, the cost of the shares become the tax basis for
future sales.

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31.12 SECTION 529 SAVINGS PLANS

Section 529 Plans are established by each State. Generally, a Section 529
account can be opened for any resident of that State, typically by a parent for a
minor child however there are many plans that allow non-residents to establish
accounts, including corporations.
Contributions are NOT deductible
Earnings in the account build tax deferred
Distributions to pay for higher education expenses are NOT taxable
Distributions are made directly by the plan to the educational institution,
which can be in any State.
The Plan trustee contracts with an investment adviser, such as a mutual fund
company, to manage the monies in the trust, with the asset mix chosen by
the adviser which is based on the childs age. (e.g. a greater allocation in
equities for younger children and a greater allocation in fixed-income securi-
ties for older children.
Account is used to pay for higher education expenses until it is exhausted,
including payments to colleges, universities, and vocational schools and any
other accredited postsecondary educational institution.
Any unused funds can be transferred to another eligible beneficiary that is,
a family member.
Distributions for any other reason are taxable
Municipal bonds are not suitable in this plan.
T-bills and conventional corporate bonds are not great choices.
Zero coupon bonds, STRIPS and corporate stocks are really a good choice.

NASD Series 7 Page 238

 Module 32: Review Questions

Section 32: Review Questions

1. Investment companies are regulated by which of the following?
A. Investment Advisors Act of 1970
B. Investment Company Act of 1940
C. SIPC
D. Securities Act of 1934
2. All of the following are investment companies EXCEPT:
A. Face amount certificates
B. Unit investment trusts
C. Mutual funds
D. Management companies
3. Which of the following is one of the major differences between an open-
end company and a unit investment trust?
A. Regulated by the Investment Company Act of 1940
B. Redemption of shares
C. One of the investment companies
D. Portfolio not actively managed
4. Which of the following are management companies?
I. Face amount certificates
II. Open-end companies
III. Unit investment trusts
IV. Closed-end companies
A. II and IV
B. I and III
C. II and III
D. I, II, III, IV
5. Selling closed-end shares can be accomplished by;
A. Redemption through the fund company
B. Redemption through a broker-dealer
C. Trading in the stock markets
D. Trading with the mutual fund company

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6. The major difference between an open-end company and a closed-end

company is the;
A. Net Asset Value
B. Capitalization
C. Public Offering Price
D. Investment Company Act of 1940
7. A diversified investment company cannot own more than what percent of
the voting stock of a corporation?
A. 5%
B. 10%
C. 50%
D. 75%
8. Detailed information about a fund can be found in the;
A. Prospectus
B. Company guidelines
C. Broker-dealers charter
D. Corporate charter
9. Open-end fund shares can be purchased by investors with what type of
shares?
A. Fractional only
B. Full only
C. Full and fractional
D. Margined
10. Which of the following are examples of fund investment objectives?
I. Safety of principal
II. Income
III. Capital gains
IV. Preservation of capital
A. I and II
B. I and IV
C. II, III, IV
D. I, II, III, IV
11. Which type of analyst looks inside the company before making any rec-
ommendations?
A. Fundamentalist
B. Technical analyst
C. Fund specialist
D. Chartist

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 Module 32: Review Questions

12. The principal underwriter of an open-end investment company is also

known as the;
A. Registrar
B. Transfer agent
C. Custodian
D. Sponsor
13. Under the Investment Company Act of 1940, shareholders must receive
financial reports;
A. Quarterly
B. Annually
C. Semi-annually
D. Monthly
14. The fees earned by the investment manager depends on the;
A. Net profit of the fund
B. Salary earned
C. Net assets of the fund
D. Volume of new shares purchased during a 30 day period
15. Who in a corporation establishes dividend and capital gain policies?
A. Corporate officers
B. Board of Directors
C. Shareholders
D. NASD
16. Who is responsible for issuing, redeeming and canceling share
certificates?
A. Custodian bank
B. Board of Directors
C. Transfer agent
D. Corporate officers
17. The holder of money for a mutual fund company is usually a;
A. Savings and loan company
B. Another mutual fund company
C. Commercial bank
D. Broker-dealer

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18. Shareholders get to vote through the use of a;

A. Proxy
B. Certificate of election
C. Broker-dealer voting form
D. Corporate certification
19. Which of the following is NOT an issue that shareholders get to vote
for?
A. Changes in the funds investment objectives
B. Appointment of corporate officers
C. Board of Directors
D. Eliminating 12b-1 fees
20. When selecting a board of directors what percent can be interested
persons?
A. 20%
B. 40%
C. 50%
D. 60%
21. When calculating net investment income per share, the investment com-
pany includes;
A. Both gross dividends and gross interest
B. Capital gains
C. Both gross dividends and gross interest minus operating expenses
D. Only dividends
22. A return of capital;
A. Is not a taxable event
B. Is a taxable event
C. Is not available with mutual fund distributions
D. Is the same as a capital gains distribution
23. When share prices increase, but shares are not sold yet, the investor
has;
A. Realized appreciation
B. Realized depreciation
C. Unrealized appreciation
D. Unrealized depreciation

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 Module 32: Review Questions

24. Investment companies distribute capital gains;

A. Monthly
B. Quarterly
C. Semi-annually
D. Annually
25. Which of the following is NOT an advantage of a mutual fund
investment?
A. Exchange privilege between the different funds of a fund family
B. Fund company safekeeping of shares
C. Use of fund shares as collateral for a bank loan
D. Investor decides which of the underlying securities are to be purchased with his
invested dollars.
26. A mutual funds expense ratio is its expenses divided by;
A. Income
B. Average net assets
C. Net asset value
D. Public offering price
27. Which of the following is NOT an example of an income fund?
A. Municipal bond fund
B. International bond fund
C. Equity fund
D. GNMA fund
28. Which of the following equity based funds also have income as their pri-
mary investment objective?
A. Utility companies
B. Aggressive equity
C. Equity income
D. A & C

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29. Which of the following is (are) examples of a mutual fund concentrating

on one industry?
I. Energy
II. Biotech
III. Blue chip
IV. Banking
V. S&P Index
A. I and II
B. I, II, III
C. I, II, IV
D. II, III, IV, V
30. Which of the following is NOT an example of a security found in money
markets?
A. Bankers Acceptances
B. CDs
C. Commercial paper with a maximum maturity of 310 days
D. Repos
31. Municipal bond funds are generally:
A. Double tax free
B. Federal tax free
C. Triple tax free
D. Taxable
32. Which type of foreign securities fund can invest in companies residing
in the United States?
A. International fund
B. Global fund
C. Korea fund
D. No foreign fund can have U.S. securities
33. Precious metals funds can include which of the following?
I. Gold
II. Brass
III. Silver
IV. Platinum
V. Copper
A. I, II, III
B. II, IV, V
C. III, IV, V
D. I, III, IV

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 Module 32: Review Questions

34. Tax exempt bond funds may invest in which of the following?
A. Common stock
B. Preferred stock
C. Municipal bonds
D. Commercial paper
35. Which of the following fund delivery methods represents sales by bro-
kerage firms?
A. Fund to underwriter to dealer to investor
B. Fund to underwriter to investor
C. Fund to investor
D. Fund to fund
36. The NAV is also known as the;
A. Offer price
B. Bid price
C. Public Offering Price
D. Sales price
37. Peggy Sue signed an LOI stating that she would purchase $20,000 worth
of the PTS Growth Fund. After 13 months she had invested only $17,000.
What effect will her actions have?
A. She must pay the additional dollars or risk a law suit
B. She will be charged the maximum possible of 8 %
C. She will be charged whatever sales charge she is entitled to for the actual
amount she invested
D. Her account will immediately be closed and subject to federal penalty
38. The maximum sales charge allowed for regular mutual funds is;
A. 5%
B. 8%
C. 8%
D. 9%
39. Letters of intent can be backdated up to how many days?
A. 30
B. 45
C. 60
D. 90

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40. With the NAV at $11.00 and the POP at $11.50, what will an investor
receive when redeeming 1000 shares?
A. $11,000
B. $11,500
C. $11,250
D. $11,000 less a redemption fee
41. As a registered representative wanting to help your clients make the
most money possible you call 10 of your best clients to tell them about a
dividend being paid in two weeks by a mutual fund. You suggest strongly
that they purchase the fund now to take advantage of the dividend being
paid. Which of the following statements best describes this situation?
A. Your suggestion is great as its in the best interest of your clients
B. You are violating the selling dividends rule
C. You must limit the sales to only 5 clients a month
D. It is not against NASD rules to sell dividends
42. The ex-dividend day for mutual funds is set by the;
A. NASD
B. SEC
C. Mutual fund
D. Investment Company Act of 1940
43. Sales charges are stated as a percentage of the;
A. Bid price
B. Offering price
C. NAV
D. Average of the bid and offering price
44. Contingent deferred sales charges are found in what class shares?
A. A
B. B
C. C
D. D
45. Which share class is known as level load?
A. A
B. B
C. C
D. D

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 Module 32: Review Questions

46. With rights of accumulation, any quantity of securities an investor owns

could be based on which of the following?
I. Total purchase of shares of the actual public offering prices
II. Current net asset value of the securities
III. Current value of all redeemable securities with the same fund family
IV. Current public offering price of the securities
A. I and II only
B. II and III only
C. II only
D. I, II, III and IV
47. Billy Bob wishes to redeem 1000 shares of the PTS Aggressive Growth
Fund. The closing NAV is $12 while the POP is $12.38. The fund has a
redemption fee of 1%. What is the net amount Billy Bob will receive from
the fund company?
A. $12,000
B. $12,380
C. $11,880
D. $12,256
48. Which of the following newspaper symbols indicates a 12b-1 marketing
fee?
A. nl
B. r
C. p
D. t
49. Which of the following would not qualify for breakpoints under the defi-
nition of a person?
A. Corporations
B. Pension fund
C. Investment club
D. Employee benefit plan
50. Class A shares of a mutual fund have a;
A. Asset based fee
B. Front-end fee
C. Level load fee
D. Back-end fee

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Module 32: Review Questions

NASD Series 7 Page 248

 Module 32: Review Questions

32.1 REVIEW ANSWERS

1. (B) Investment Company of 1940 by definition.
2. (C) Use caution on the exam! Investment companies consist of Face Amount
Certificates, Unit Investment Trusts and Management Companies. Management
companies are made up of open-end and closed-end funds. Mutual funds are not
mentioned anywhere in the Investment Company Act of 1940. Open-end compa-
nies have been given the name mutual funds many years ago by marketing firms.
3. (D) One of the major differences between open-end companies and unit
investment trusts is that UITs are NOT managed. A portfolio of investments are
selected but not managed.
4. (A) All four are investment companies but only two are management compa-
nies, the open-end and closed-end companies as they are actively managed.
5. (C) While open-end shares are redeemed through the mutual fund company,
closed-end shares are bought and sold in the secondary stock markets after the
initial public offering.
6. (B) The major difference between open-end and closed-end companies is the
capitalization structure. Open-end always have shares to offer but closed-end
funds have a limited number of shares available, just like stocks.
7. (B) To be diversified a mutual fund company must invest at least 75% of its
assets in such as way that no more than 5% of its assets can purchase the stock
of any one company and when it does buy stock of a company it cannot own more
than 10% of its voting stock.
8. (A) All information about a fund can be found in the prospectus.
9. (C) One of the flexible benefits of owning mutual fund shares is being allowed
to purchase with a specific dollar amount versus a number of shares. By purchas-
ing with a specific dollar amount full and fractional shares can be purchased.
10. (D) All are examples of fund investment objectives.
11. (A) The Fundamentalist looks inside a company to gather information while
the Technical Analyst (Chartist) uses outside factors to make their recommenda-
tions.
12. (D) The principal underwriter is also known as the sponsor or distributor.
13. (C) Semi-annually reports with the annual report needing to be audited.
14. (C) Fees earned by the investment manager are based on the assets of the
fund.

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15. (B) The Board of Directors is responsible for establishing dividend and capital
gain policies.
16. (C) The Transfer Agent is responsible for issuing, redeeming and canceling
share certificates.
17. (C) The custodian of the funds assets is usually a commercial bank.
18. (A) Proxies are used by all corporate shareholders.
19. (B) Appointment of officers is a function for the Board of Directors.
20. (D) The Investment Company Act of 1940 requires that 40% of the board of
directors be noninterested leaving 60% as interested members.
21. (C) To arrive at the net investment income a fund company takes the gross
dividends and gross interest and subtracts the operating expenses.
22. (A) A return of capital is NOT a taxable event as it is neither a dividend or cap-
ital gain.
23. (C) If share prices go up but are not sold yet the investor has unrealized
appreciation. If share prices are lower but not sold yet the investor has unrealized
depreciation. Realized appreciation or depreciation can only be determined once
the shares are sold.
24. (D) Fund companies are required to distribute long-term capital gains annu-
ally. Short-term capital gains (capital gains representing less than a year), taxed
like dividends (at the investors tax bracket), can be distributed monthly, quarterly,
semi-annually or annually.
25. (D) Investors cannot make investment decisions regarding individual securi-
ties purchased within a fund as this is the job of the fund manager.
26. (B) By definition, the expense ratio is calculated by taking its expenses and
dividing them by the average net assets.
27. (C) Choices A, B and D are examples of bond funds while choice C is an
example of an equity fund.
28. (D) Utility companies and equity income funds are made up of stock as the
underlying security. However, they also have income as their primary investment
objective. An aggressive equity fund has growth and not income as its primary
objective.
29. (C) Energy, biotech and banking are examples of sector funds, also known as
specialized funds which concentrate on one industry. Blue chip and the S&P 500
are well diversified funds with no concentration in only one industry.

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30. (C) To be in a money market as a short-term debt instrument, commercial

paper must have a maximum maturity of 270 days, not 310 days. All the others
can be found in a money market.
31. (B) Municipal bond funds are typically only federally tax free. Some states
allow a double tax free status but the investor must be a resident of that state and
the bonds issued there also. Triple tax free bonds are issued by the possessions
of the United States such as Guam, Puerto Rico and the Virgin Islands.
32. (B) Global funds can invest in any country in the world, including the United
States, while International funds must invest in companies outside the United
States. The Korea fund is an example of a Single Country fund which will invest in
countries outside the United States.
33. (D) Gold, silver and platinum and palladium are examples of precious metals
that can be found in precious metal funds. Brass and copper are not considered
precious metals.
34. (C) Municipal bonds are usually federally tax free while the others are not.
35. (A) The fund sells shares to their underwriters who in turn sell the shares to a
brokerage firm and the brokerage firm sells shares to retail customers. Choice B
indicates a sale to the funds underwriter and then the in-house brokers sell
shares directly to the customers without using a brokerage firm. Choice C indi-
cates a no-load situation where the fund company sells shares directly to the cus-
tomers. Choice D is not valid.
36. (B) The NAV is also known as the bid price while the POP is also known as
the ask price.
37. (C) This is a non-binding contract. Therefore, Peggy Sue will get a discount
if she has reached any of the breakpoint levels. If not, she will pay the full sales
charge.
38. (C) 8 % is the maximum allowed as long as rights of accumulation, rein-
vesting at the NAV and LOIs are allowed. If not, the maximum sales charge is
6%. Contractual plans allow a maximum of 9%.
39. (D) 90 days by definition.
40. (A) Funds are redeemed at the NAV. The NAV is $11 times 1,000 shares
which equals $11,000.
41. (B) Selling dividends is prohibited by the NASD. On ex-dividend day the
NAV of the fund will fall the amount of the dividend and your client will have a
potential tax consequence.
42. (C) The ex-dividend for mutual funds is set by the fund company while the
NASD establishes the ex-dividend day for stocks.

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43. (B) By definition

44. (B) Contingent deferred sales charges are found in Class B shares.
45. (C) Level load shares are Class C
46. (D) Actually any of the choices would be okay as long as the mutual fund
company approves the method.
47. (C) Shares are redeemed at the NAV. The NAV of $12 times 1,000 shares
equals $12,000. Next the redemption fee of 1% is deducted before the investor
receives the distribution of $12,000 minus 1% or $11,880.
48. (C) P indicates a 12b-1 fee while nl is a no-load, r is a redemption fee and t
represents a redemption fee plus a 12b-1 plan in effect.
49. (C) Investment clubs never qualify for mutual fund breakpoints.
50. (B): Class A shares have a front-end load feature. This means the sales
charge is deduted directly from the investment at the time of purchase.

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 Options
Options Rules & Regulations
Hedging Strategies
 Module 34: Options

Section 34: Options

34.1 OPTION DEFINED
Options are also known as derivatives and for many Series 7 students presents
one of the most challenging types of securities to learn. However, this module will
present options in such a way that instead of worrying about this subject you will
beg for more option questions on the exam.
Keep in mind, because of the large number of option questions, you must master
this subject. Understand the terminology first, then the basic concepts and the rest
will fall in place.
The majority of test questions will be based on equity options which are options
derived from equities (stock). There will also be questions on nonequity options
such as indexes, interest rates, yield and foreign currencies.
34.2 SOME REASONS TO TR A D E O P T I O N S
Control 100 shares of stock at a fraction of the cost of owning them.
Speculation of market moves with equities, interest rates, debt instruments,
foreign currencies, indexes and more.
Earn income.
Protecting (insuring) stock positions.
Hedging portfolios.
Diversification
34.3 THE OPTIONS CONTRACT
An option is a contract between a buyer and seller with specified terms. This kind
of contract, from a legal sense, is not really different from a contract formed when
purchasing a home or automobile. In any legal contract the buyer usually receives
certain rights as he/she pays a fee while the seller has the obligation to comply
with the buyers rights as the seller receives the fee.
34.3.1 Synonymous Terms
The following represents the terms used for investors when buying or writing
options;
Buy = hold = long = owner
Sell = write = short

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34.3.2 The Buyer

The buyer receives certain rights from the seller of options contract because
he/she pays the seller a premium. The buyer has the right to exercise his/her
position by buying or selling stock depending on whether the options is a call or
put.
34.3.3 The Seller
The seller has the obligation to comply with the buyers rights because he/
she received the premium. The seller has the obligation to buy or sell stock as
determined by the buyer of the option contract.
3 4 . 4 TY P E S OF OPTION CONTRACTS
There are only two types of option contracts, calls and puts.
34.4.1 Call Contract
The call contract allows the holder to buy a security (exercise) from the writer
of the option at a fixed price known as the strike price at any time during the
life of the option. The usual contract size is 100 shares of the underlying secu-
rity.
A call seller (writer) has the obligation to sell 100 shares of the underlying
security at the strike price if the buyer exercises the contract.
34.4.2 Put Contract
The put contract allows the buyer to sell 100 shares of the underlying stock at
the strike price before the expiration if he/she chooses to exercise.
The seller of a put contract has the obligation to buy 100 shares of the under-
lying stock at the strike price if the buyer exercises the contract.
Remember: Buyers always have the rights while the sellers must comply
with those rights because they receive the premiums.
34.5 OPTION CLASS
An option class consists of one type of option (call or put) and one issue (one
underlying stock). e.g. Motorola Calls - this is an example of an option class.
34.6 OPTION SERIES
An option series consists of multiple option contracts with the same strike price
and same expirations and same issue (stock). e.g. 2 IBM Sep 60 calls or 3 Dell
Oct 30 puts. Each of those two examples are an option series.

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34.7 THE ANATOMY OF A LONG CALL CONTRACT

Lets take a look at an equity based option contract and learn about all the
contract components.
Long 1 PTS Jan 30 call @ $1.00
Long: Investor has purchased the call and has the right to exercise the contract
1 = Number of option contracts
PTS = The underlying equity security
Jan = Month of Expiration: All equity contracts expire on the Saturday following
the third Friday of the month of expiration at 11:59 PM EST.
30 = Strike Price: Price at which the contract can be exercised (shares bought by
buyer from the writer)
call = Type of contract (calls or puts). Calls allow investors to purchase 100
shares of the underlying stock at the Strike Price. The 100 shares is also known
as the multiplier. On occasion an exam question might require you to assume the
multiplier to be 200. In this case you would multiply 200 times the premium,
instead of 100.
$1.00 = The premium: This is the value of one share. Therefore, the price of the
contract is $1.00 times 100 shares for a total of $100.00. The buyer of the contract
pays the premium while the writer of the contract receives the premium.
34.8 THE ANATOMY OF A SHORT CALL CONTRACT
Short 1 PTS Jan 30 call @ $1.00
Short: Investor sold this option contract in return for the premium. Therefore,
the seller has no rights but instead has the obligations to comply with the buyers
rights.
1 = Number of option contracts
PTS = The underlying equity security
Jan = Month of Expiration: All equity contracts expire on the Saturday following
the third Friday of the month of expiration at 11:59 PM EST.
30 = Strike Price: Price at which the contract can be exercised (shares sold to
buyer by the writer of the contract)
call = Type of contract (calls or puts). Short Calls require investors to purchase
100 shares of the underlying stock at the Strike Price from the buyer. The 100
shares is also known as the multiplier. On occasion an exam question might

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require you to assume the multiplier to be 200. In this case you would multiply 200
times the premium, instead of 100.
$1.00 = The premium: This is the value of one share. Therefore, the price of the
contract is $1.00 times 100 shares for a total of $100.00. The buyer of the contract
pays the premium while the writer of the contract receives the premium.
34.9 THE ANATOMY OF A LONG PUT CONTRACT
Long 1 PTS Jan 30 put @ $1.00
Long: Investor has purchased the put and has the right to exercise the contract by
selling 100 shares of the underlying stock to the seller of the contract.
1 = Number of option contracts
PTS = The underlying equity security
Jan = Month of Expiration: All equity contracts expire on the Saturday following
the third Friday of the month of expiration at 11:59 PM EST.
30 = Strike Price: Price at which the contract can be exercised by the buyer (sell
shares to the writer).
Put = Type of contract (calls or puts). Puts allow investors to sell 100 shares of
the underlying stock at the Strike Price. The 100 shares is also known as the
multiplier. On occasion an exam question might require you to assume the multi-
plier to be 200. In this case you would multiply 200 times the premium, instead of
100.
$1.00 = The premium: This is the value of one share. Therefore, the price of the
contract is $1.00 times 100 shares for a total of $100.00. The buyer of the contract
pays the premium while the writer of the contract receives the premium.
34.10 THE ANATOMY OF A SHORT PUT CONTRACT
Short 1 PTS Jan 30 put @ $1.00
Short: Investor sold this option contract in return for the premium. Therefore,
the seller has no rights but instead has the obligations to comply with the buyers
rights.
1 = Number of option contracts
PTS = The underlying equity security
Jan = Month of Expiration: All equity contracts expire on the Saturday following
the third Friday of the month of expiration at 11:59 PM EST.

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30 = Strike Price: Price at which the contract can be exercised by the buyer.
(holder must buy shares from the buyer of the contract)
Short Put = Type of contract (calls or puts). Short puts require investors to pur-
chase 100 shares of the underlying stock at the Strike Price from the buyer. The
100 shares is also known as the multiplier. On occasion an exam question might
require you to assume the multiplier to be 200. In this case you would multiply 200
times the premium, instead of 100.
$1.00 = The premium: This is the value of one share. Therefore, the price of the
contract is $1.00 times 100 shares for a total of $100.00. The buyer of the contract
pays the premium while the writer of the contract receives the premium.
Test Point: Remember, a large number of test questions can be answered by
knowing;
Buyers have rights
Sellers have obligations
Investors sell options for the INCOME
3 4 . 11 S I N G L E O P T I O N S T R A T E G I E S
There are only four basic strategies available to options investors;
1 Buying calls
2 Writing (selling) calls
3 Buying puts
4 Writing (selling) puts
Now lets apply the four basic options transactions to market direction;
Buy a Call Write a Call

Buy a Put Write a Put

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This represents an UP market. This represents a Down market.

34.11.1 Basic Market Strategy Review (Know all of these)
An investor buys a call hoping there is a bull market (up market)
An investor sells a call for income hoping that the market goes down or
stays the same
An investor buys a put hoping there is a bear market (down market)
An investor sells a put for income hoping that the market goes up or stays
the same
34.11.2 Market Attitude Review (Know all of these)
A call buyer is a bullish investor because the investor wants the market to
rise.
A call writer (seller) is a bearish investor or an investor looking for income
and wants the market to stay the same or fall in value.
A put buyer is a bearish investor because the investor wants the market
to fall.
A put writer (seller) is a bullish investor or an investor looking for income
and wants the market to stay the same or rise in value.
34.12 IN, OUT AND AT THE MONEY
The premium of an active option contract represents the value of the options con-
tract. Contributing to this value is whether the option contract is in, out or at the
money.
This concept is based on the relationship between the strike price of the contract
and the current market value of the underlying stock. The following definitions
should help clarify this concept.
34.12.1 In-the-Money
A call option is in the money when the current market price of the underly-
ing security exceeds the strike price. If so, a buyer will exercise calls that are
in-the-money at expiration. Remember for the exam, buyers want options to
be in-the-money while sellers do not.
Example: The strike price of a call option is 50 while the current market price of
the underlying security is 53. As the market price is more than the strike price
this option is in-the-money by 3 points.

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A put option is in the money when the market price of the underlying secu-
rity is less than the strike price of the underlying security. If so, a buyer will
exercise puts that are in-the-money at expiration. Remember for the exam,
buyers want in-the-money contracts while sellers dont.
Example: The strike price of a put option is 50 while the current market price of
the underlying security is 47. As the market price is less than the strike price
this option is in-the-money by 3 points.
34.12.2 At-the-Money
A call option is at-the-money when the market price of the underlying secu-
rity equals the strike price. A buyer will not exercise these contracts at expi-
ration. Remember for the exam, sellers want at-the-money contracts while
buyers do not.
Example: The strike price of a call option is 50 while the current market price of
the underlying security is 50. As the market price equals the strike price this
option is at-the-money.
A put option is at-the-money when the market price of the underlying secu-
rity equals the strike price. A buyer will not exercise these contracts at expi-
ration. Remember for the exam, sellers want at-the-money contracts while
buyers do not.
Example: The strike price of a put option is 50 while the current market price of
the underlying security is 50. As the market price equals the strike price this
option is at-the-money.
34.12.3 Out-of-the-Money
A call is out of the money when the market price of the underlying security
is less than the strike price. A buyer will not exercise these calls at expiration.
Remember for the exam, sellers want contracts to be out-of-the-money while
buyers do not. Sellers keep the premium without obligation to perform.
Example: The strike price of a call option is 50 while the current market price of
the underlying security is 45. As the market price is lower than the strike price,
this option is out-of-the-money by 5 points.
A put is out-of-the-money when the market price of the underlying security
is higher than the strike price. A buyer will not exercise puts that are out-of-
the-money at expiration. Remember for the exam, sellers want out-of-the-
money contracts while buyers do not.
Example: The strike price of a put option is 50 while the current market price of
the underlying security is 55. As the market price is higher than the strike price,
this option is out-of-the-money by 5 points.

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34.12.4 Exercise Time

Now its your turn to practice what you learned with In, At or Out of the
Money.

Mark In, At or Out of the Money as Well as Who is Happier?

Who is
Call or Current Market In, At, or Out
Strike Price happier?
Put Value of Stock of the Money
Buyer or Seller

1. Call 40 48
2. Call 40 35
3. Put 40 32
4. Put 40 48

34.12.4.1 Answers
1. In the money by 8 (CMV is higher than the strike price) - Buyer
2. Out of the money by 5 (CMV is lower than the strike price) - Seller
3. In the money by 8 (CMV is lower than the strike price) - Buyer
4. Out of the money by 8 (CMV is higher than the strike price) - Seller
3 4 . 1 3 I N T R I N S I C VA L U E
Intrinsic value is equal to the amount of money an option contract is in-the-
money.
A call has intrinsic value when the market price is above the strike price. The
amount of intrinsic value is found by subtracting the strike price from the market
price. As no negative numbers are allowed, the lowest intrinsic value possible
would be zero.
A put has intrinsic value when the market price is below the strike price. The
amount of intrinsic value is found by subtracting the market price from the strike
price. Once again, no negative numbers allowed. Zero is the lowest intrinsic value
possible.

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 Module 34: Options

34.14 MAKEUP OF A PREMIUM

The premium of all option contracts are made up of three components. They are
as follows;
1 Intrinsic Value (Amount in the money)
2 Time Value (Amount attributable to time left in the contract)
3 Volatility (Cannot be measured for exam purposes)
Test Alert: You will be tested on the amount of Intrinsic Value and/or the
amount of Time Value of an option contracts premium. You will not be
asked to compute the amount of volatility, however.
When asked, use the acronym P = I + T. Premium is equal to the total of the
Intrinsic plus any Time Value. You will get some practice shortly.
3 4 . 1 5 T I M E VA L U E ( P R E M I U M )
Some portion of an outstanding option contracts premium can be attributable to
time value as long as the option contract has not expired. Option contract premi-
ums can have no time value, some time value or perhaps all time value.
Example: Bobbie Dee purchases 1 Mot Feb 30 call @ 6. The current market
price of Motorola common stock is 32. What is the intrinsic and/or time value?
Using P = I + T: Premium = 6; Intrinsic value is 2 (amount the option contract is
the money); therefore the remaining portion of the premium, 4, must be made up
of time value. 6 (P) = 2 (I) + 4 (T).
34.16 BREAKEVEN
All option contracts have a breakeven point. This is the point at which the investor
neither makes or loses money. Breakevens are computed differently for calls and
for puts. For computation and exam purposes remember;
Call Up - When computing a call option call up will apply (adding).
Put Down - When computing a put option put down will apply (subtract).
34.16.1 Breakeven for Calls
Take the strike price and add the premium (call up).
Example: 1 Bud Mar 25 call @ 3: The breakeven is? Take the strike price of
25 and add the premium of 3 for a total of 28. If the stock goes above this price
the option will be profitable. Remember, you want calls to go up.

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34.16.2 Breakeven for Puts

The breakeven for a put is found by taking the strike price and subtracting the
premium (put down).
Example: 1 IBM Jun 80 put @ 4: The breakeven is? Take the strike price of
80 and subtract the premium of 4 for a total of 76. If the stock goes below this
price the option will be profitable. Remember, you want puts to go down.
34.16.3 Important Points
It is imperative for test purposes to remember the following points about
breakevens of options;
The breakeven is for one share ONLY.
Also, it doesnt matter if the option is bought or sold. The breakeven is
based on the contract itself, not the investors.
The breakeven is the point above which, for a call, and below which, for
a put, that the option contract becomes profitable.
For a call the breakeven is calculated by taking the strike price and adding
the premium.
For a put, the breakeven is calculated by taking the strike price and sub-
tracting the premium.
Breakevens for multiple strategies will be discussed later along with those
strategies.
3 4 . 1 7 M I S C E L L A N E O U S O P T I O N TE R M I N O L O G Y
The following are additional terms and definitions for you to memorize for
the exam;
Option Style: There are two option styles you need to become familiar with.
The first is known as an American Style option and the second is known as
a European style option.
American Style Option: Holders of calls and puts can exercise this type of
option on any business day prior to expiration. Equity based options are all
American style options.
European Style Option: Holders of calls and puts can only exercise this type
of option on the day preceding expiration, not on any business day.
All option transactions require both an Opening and Closing position (to
be discussed later).

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34.18 SAMPLE OPTION CHART

Chicago Board Options Exchange (CBOE)
Option &
Strike
NY Stock Calls - Last Puts - Last
Price
Close

Jan Feb Mar Jan Feb Mar

DLS 20 1 1.50 r 2 3.26 4.50

18.25 22.50 .25 1.12 1.50 4.75 5.86 9.25
18.25 25 r .36 .63 6.12 7.92 10.56
PTS 40 1.36 3.62 r .18 .62 .75
41.25 45 .75 1.25 2.12 r r r
41.25 50 r .25 1.50 .06 .12 .50

Option Type Last Trade of

Calls and Puts the Day
Option Class
Closing Price Shaded Area
DLS Stock All calls of one issue Option Series
Options of one issuer with
the same class, exercise
Option Not Traded and expiration

1. From the chart, find the premium for the Dell Feb 25 call.
2. How much is the difference between the PTS Jan 45 call and the PTS
March 25 call?
3. Why is there a difference between the premiums in Question 2?

there is more time value in the premium.

3. The second contract expires in March. Therefore
2. The difference between the premiums is 1.37
1. Premium = .36
Answers

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34.19 OPTION REVIEW ONE

This would be a good place to review and reinforce the various option points
youve learned by completing the following quiz questions. The answers will follow
at the end of the last question. Your goal is to answer all the questions without
looking at the answers.
1. A customer is long 1 XYZ Feb 40 call @ 5. The CMV of XYZ is 43. This
contract is;
A. Out of the money
B. In the money
C. At the money
D. No idea
2. The breakeven for the option contract in Question #1 is;
A. 35
B. 48
C. 45
D. 38
3. What is the Time Value for the option contract in Question #1?
A. 2
B. 3
C. 4
D. 5
A customer buys 1 Dell Jun 30 put @ 4 when Dell closes at 27. Use this
option contract to answer the next 2 questions.
4. The intrinsic value of the contract is;
A. 1 point
B. 2 points
C. 3 points
D. 5 points
5. The time value of the contract is;
A. 1 point
B. 2 points
C. 3 points
D. 5 points

Go to the next page for answers and rationale

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34.19.1 Option Review One Answers

1. (B) As the market price is at 43 and the strike price at 40, this option contract
is in the money by 3 points, the difference between the strike price and current
market value of the underlying security.
2. (C) When calculating a breakeven for a call, take the strike price and add
(call up) the premium. The strike price is 40 and the premium is 5 giving a total
breakeven of 45.
3. (A) Use the acronym P = I + T. This option is in-the-money by 3 points (strike
price of 40 and a current market value of 43). Intrinsic value is the same as in-
the-money. So, with a premium of 5, P = I + T, 5 = 3 + 2 (time value).
4. (C) A put with a strike price of 30 and a current market value of 27 would be
in the money (intrinsic value) by 3 points (30 - 27).
5. (A) Once again use P = I + T (4 = 3 + 1 (time value).

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 Module 35: Options Rules and Regulations

Section 35: Options Rules and Regulations

35.1 OPTIONS CLEARING CORPORATION (OCC)
Clearing Agent: The OCC is the clearing agent for listed options contracts
(listed on an exchange) and is owned by the exchanges that trade options.
Standardize Contracts: The OCCs primary functions are to standardize,
guarantee performance of, and issue option contracts.
New Option Contracts: The OCC determines when new option contracts
should be offered.
The OCC designates the strike prices and expiration months.
The market determines the premium for the contracts.
The OCC guarantees the exercise of any option contract on any business
day prior to its expiration.
Exercise (Calls - buyers buy 100 shares of stock) - (Puts - buyers sell
100 shares of stock): OCC assigns exercise notices on a random basis to
clearing firms. The clearing firms then notify broker-dealers. Broker-dealers
then assigns to customers on a random basis, FIFO (first in first out) or any
other fair method.
Customers must receive an OCC options disclosure document prior to
opening an options account.
Settlement: Option transactions settle the next business day.
Equity options covers 100 shares of the underlying security.
Option Expiration: Equity options expire on the Saturday following the
third Friday of each month at 11:59 pm EST. (Note: You must memorize
this exactly)
Trading Hours: Normal trading hours for listed options are 9:30 am - 4:02
pm EST.
Last Exercise: The last day to exercise equity options is on the Friday prior
to expiration at 5:30 pm EST.
Option Expiration Cycle: Equity options contracts are assigned to an expi-
ration cycle. However, equity options can also be issued on the current trad-
ing month (known as spot month) and for the next month and then the cycle
starts.

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There are three option expiration cycles;

- Cycle 1: Jan, Apr, Jul, Oct
- Cycle 2: Feb, May, Aug, Nov
- Cycle 3: Mar, Jun, Sep, Dec
Equity option contracts have a maximum contract life of 9 months.
Strike Price Intervals: New contracts can only be issued at prices nearest to
the existing market price. The rules are as follows;
- Stock priced under $25: 2.50 point intervals
- Stock priced over $25 but below $200: 5.00 point intervals
- Stock priced over $200: 10.00 point intervals
Position Limits: The OCC limits the number of option contracts that can be
held by any one party for any one side of the market.
- The two sides of the market are up or down. The up market consists
of Long Calls and Short Puts while the down market consists of Long
Puts and Short Calls.
- For the most heavily traded equity options contracts, position limits
are 75,000 contacts for any one side of the market.
3 5 . 2 A D J U S T M E N T S TO O P T I O N C O N T R A C T S
Cash Dividend Paid: Option contracts are not adjusted for cash dividends.
When a stock goes ex-dividend, the strike prices are left alone.
Whole Stock Splits & Stock Dividends: Contracts are adjusted for stock
splits and stock dividends. For whole share splits, the strike price is reduced
and the number of contracts is increased.
- Example: PTS stock does a 2:1 split. Current option contract reads
1 PTS Jun 80 Call. The new option position would be 2 PTS Jun 40
Calls.
Fractional Stock Split: For fractional splits and for stock dividends the strike
price is reduced and the number of shares covered for the contract is
increased.
- Example: PTS stock pays a 20% stock dividend. The current option
contract reads 1 PTS Jun 80 Call. The new option position would be 1
PTS Jun 66.67 call (80 divided by 1.20) but now it would cover 120
shares (20% addition) and not the regular 100 shares. (aggregate
value of the contract doesnt change)

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35.3 OPTION EXCHANGE PERSONS

Most option activity takes place on the Chicago Board of Options Exchange
(CBOE) located in Chicago. The following are the key persons on the CBOE;
Order Book Official (OBO): Also known as the board broker, the OBO is an
employee of the exchange. They keep limit order books and ensure the auc-
tion process runs smoothly. They cannot trade for their own accounts.
Market Makers: They are registered with the exchange to trade for their own
accounts. They must stand ready to buy or sell options in which they make
markets to maintain an orderly market.
Floor Brokers: These are a broker-dealer (firm) representatives on the floor
of the exchange. They execute orders on behalf of the firm and its customers.
35.4 NEW OPTIONS ACCOUNT
A new account form and options form must be submitted to the brokerage
firm for determination of suitability.
The registered representative must provide the new options client with the
OCC disclosure document prior to opening the account.
The Registered Options Principal (ROP) must approve the account
The customer must sign an options account agreement and return it within 15
days after the approval of the account. If the signed account form is not
returned within the 15 day time frame the brokerage firm can;
- Deny any new opening transactions
- However, the brokerage firm cannot close any already opened new
positions nor sell off any of those positions.
3 5 . 5 O P T I O N TA X I S S U E S
As options are capital assets, capital gains tax rules apply to option transactions.
Expirations: The buyer loses the premium while the seller profits from the
premium. So, the buyer reports a capital loss equal to the premium amount
and the seller reports a capital gain equal to the premium amount.
LEAPS (Long term options): LEAP buyers report long-term losses but LEAP
sellers must report short-term capital gains at expiration.
Trading (closing out): This generates a capital gain or loss equal to any price
difference of buying and selling. Gain or loss should be reported on the date
of the closing transaction.

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Exercise: The exercise itself does NOT generate any tax consequence. A
long call exercised results in buying 100 shares of stock for they buyer. This
price gets added to the cost of the option to form the cost basis of the
stock. An exercised put results with selling 100 shares so the cost of the put
option is deducted from the price received for the stock to form the cost basis
Stock Holding Periods: If stock has ben held 12 months or less prior to the
purchase of a pout or sale of a call, the gain will be classified as short-term.

Tax Consequences of Option Strategies

Position
Option
Strategy Option Exercised Closed at
Expires
Intrinsic Value

Capital Strike price = premium = cost Capital gain or

Buy a call
Loss Basis loss
Capital Strike price + premium = sale Capital gain or
Sell a call
Gain proceeds loss
Capital Strike price - premium = sale Capital gain or
Buy a put
Loss proceeds loss
Capital Strike price - Premium = cost Capital gain or
Sell a put
gain basis loss

Exam Alert: You will get a number of option tax questions on the exam,
most of which will require defining profit or loss. (Use T charts which
will be discussed later)

Notes

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3 5 . 6 O P T I O N R E V I E W TW O Q U E S T I O N S
Lets review option rules, regulations and tax issues.
1. Which of the following guarantees and standardizes option contracts?
A. NASD
B. OCC
C. SEC
D. FRB
2. Options settle in;
A. 1 day
B. 2 days
C. 3 days
D. 5 days
3. Equity options expire on the;
A. Third Friday
B. Third Friday after the third Saturday
C. Saturday following the third Friday
D. Third Saturday
4. Equity options have a technical maximum contract life of;
A. 8 months
B. 9 months
C. 11 months
D. 12 months
5. Rocky Road Inc. declares a 3:1 split. Jo Bob owns 1 Rocky Road Mar 75
Call. The new position would be which of the following?
A. 1 Rocky Road Mar 75 call with 300 underlying shares.
B. 3 Rocky Road Mar 75 calls
C. 4 Rocky Road Mar 75 calls
D. 2 Rocky Road Mar 75 call with 200 underlying shares each
6. Which of the following cannot trade for their own accounts?
A. OBO
B. Market makers
C. ROPs
D. Floor specialists

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35.6.1 Option Review Two Answers

1. (B) The Options Clearing Corporation guarantees and standardizes option
contracts.
2. (A) Equity option contracts settle in one business day.
3. (C) You must memorize this! Equity options expire on the Saturday following
the third Friday.
4. (B) Equity options have a maximum contract life of 9 months.
5. (B) With an even stock split the number of contracts with 100 shares of
underlying shares would increase.
6. (A) Order Book Officials cannot trade for their own account.

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 Module 36: Equity Options

Section 36: Equity Options

3 6 . 1 T- C H A R T S
To be successful with option test questions it is imperative that you use T-charts
for calculation. In fact, using T-charts for almost all option questions can only help.
The T chart is set up as follows;

The Out column represents money coming out of your account while the In
column represents money going into your account. So, if an investor buys an
option the premium goes on the Out column and when the investor sells an
option the premium goes on the In column.
The key is to make sure that you place the correct number on the correct
side. If you do it is just a matter of simple math.
36.2 BUYING CALLS
Call buyers are bullish on the underlying stock. By buying calls an investor can
profit from an increase in a stocks price while investing a relatively small amount
of money.
36.2.1 Call Contract
Buy 1 XYZ Mar 40 Call @ 2
36.2.1.1 Contract Rights
This option contract gives the holder the right to purchase 100 shares of
XYZ stock at $40 per share prior to the expiration on the Saturday follow-
ing the third Friday in March. The premium of the contract was 2, so the
total cost of the contract was $200.
36.2.1.2 Maximum Gain, Maximum Loss and Breakeven
There are a large number of questions on the exam for all option strate-
gies that ask for the maximum gain or maximum loss or breakeven of the
option contract.

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Test Note: Anytime you see a blank column in a T-chart it means that
the maximum gain or loss is unlimited.
Contract: Buy 1 XYZ Mar 40 Call @ 2
Step 1: Draw the T-Chart.

Step 2: Enter the information from the contract. In this case, the investor
purchased the option contract at 2, so the contract cost $200. Place the
$200 in the Out column as money is going out of the account.

200

Now you can answer questions regarding your option account. Lets start with
maximum gain, loss and the breakeven then we will discuss the various ways
this option contract can be closed.
Remember, you bought the option to open and the contract must be closed
by one of the available methods. (Expire, exercise or trade)
Maximum Gain: Look at the T-chart and you see an empty column. With
only one exception this means unlimited. Therefore the maximum poten-
tial gain (in column) is unlimited.
Maximum Loss: Now look at the out column which represents potential
losses. Therefore, the maximum potential loss for this contract is $200.
Breakeven: To get to the breakeven of a single call take the Strike Price (40)
and add (call up) the premium (2) for a breakeven of 42.

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Isnt that great, youve answered three potential questions. On the actual
exam you will not have to answer all three with one set of facts. They will ask
you only one question per set of facts.
36.2.1.3 Closing the Option Position
There are three ways of closing your opening option position. They are as
follows;
1. Let the option expire worthless. (Buyer loses - seller wins)
2. Exercise the option: Call: Buy 100 shares of stock from the option
writer; Put: Sell 100 shares of stock to the option writer.
3. Trade the Option: (If open by buying then close by selling at the value
of the premium or intrinsic value)
Lets work with all three of these ways to close the currently open option
position.
1. Letting the option expire worthless. (Buyer loses the $200 while the
seller keeps the income of $200)

200 0

2. Exercising the option position (Call: Buying 100 shares at the

strike price).
Exercise: The exercise price is based on the strike price times the num-
ber of shares which is usually 100 shares for
one contract.
Remember, place the exercise dollars in the
same column as the option premium as
calls match.
200
4000 In this example you would take the strike price
of 40 times 100 shares or $4,000 which is the
cost for the buyer to exercise the option con-
tract. This also closes the investors position.
We now have paid out $4,200 and have 100 shares of XYZ in the account
from the exercise.

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3. Trading the Option Contract - Buy 1 XYZ Mar 40 Call @ 2

CMV of XYZ = 43
Trading means to close the contract by selling (if bought when opening) or
close the contract by buying (if sold when opening).
In this case, the investor opened by buying the contract. Therefore the
investor must sell when closing. Lets set up the T-chart to reflect the
opening and closing positions and also show the net gain or loss.
(Test question)
Step 1: Buy contract for $200

200 300
Step 2: The option is in the money by 3 points
(CMV of 43 with a strike price of 40). So, the
option has intrinsic value of 3 points. The inves-
tor would sell the option for its intrinsic value of 3
points times 100 shares or $300.

Step 3: Establish the net gain or loss: The investor spent $200 but brought
in $300. This gives the investor a net gain of $100. This is treated as a
capital gain, not ordinary income. Remember, options result in capital
gains and/or losses, not ordinary income.
36.2.1.4 Accomplishments
Learned to use T-charts
Learned that money out of pockets go on the out column while money
that goes pockets go on the in column.
Learned about buying calls
Learned how to use the T-chart in calculating maximum gains and maxi-
mum losses.
Learned to calculate the breakeven for calls (strike plus the premium)
Learned that an empty side of the T-chart usually results in an unlimited
gain or loss.
Learned to close the opening option position by letting the options expire
(not good unless youre the seller), trading the option and finally exercis-
ing the option.
Learned to exercise the open position
Learned to trade the open option position at its intrinsic value.

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36.3 BUYING PUTS

Put buyers are bearish on the underlying stock. By buying puts an investor can
profit from a decrease in a stocks price while investing a relatively small amount
of money.
36.3.1 Put Contract
Buy 1 ABC Jun 50 Put @ 3
36.3.1.1 Contract Rights
This option contract gives the holder (buyer) the right to sell 100 shares of
ABC stock at $50 per share prior to the expiration on the Saturday follow-
ing the third Friday in June. The premium of the contact was 3, so the total
cost of the contract was $300.
36.3.1.2 Maximum Gain, Maximum Loss and Breakeven
Step 1: Draw the T-Chart
Step 2: The contract was purchased for 3 points
times 100 shares or $300. The $300 is placed in the 300
out column.
Step 3: Take a look at the T-chart to see if there are
any blank columns. In this case the In column is
blank. Normally this would indicate and unlimited
potential gain. However, because the stock can only fall to zero there cant
really be an unlimited gain.
Maximum Gain: The strike price is 50 so the stock can potentially only
go down to zero which is a 50 point drop and is a gain for the put holder
(put down). But, because it cost the investor 300 or 3 points to purchase
the option contract the maximum gain can only be 47 (50 minus 3).
Maximum Loss: Now look at the out column which represents poten-
tial losses. Therefore, the maximum potential loss for this contract is
$300.
Breakeven: To get to the breakeven of a single put take the Strike Price
(50) and subtract (put down) the premium (3) for a breakeven of 47.
36.3.1.3 Closing the Option Position
Once gain, there are three ways that an open option position can be
closed. They are as follows;
1. Letting the option expire worthless (bad); 2. Exercising the option or
3. Trading the option at its intrinsic value (amount its in the money)

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36.3.1.4 Accomplishments
Reinforced use of the T-chart
Reinforced uses of the In and Out T-chart columns
Learned about buying puts
Learned to calculate maximum gains and maximum losses for puts
Learned to calculate the breakeven for puts
Reviewed the ways to close open option positions
3 6 . 4 TE R M I N O L O G Y AND STRATEGIES
36.4.1 Exercising Option Contracts
As a review, when a call buyer exercises a call option contract, he/she has the
right to purchase 100 shares of the underlying stock at the strike price. A put
buyer has the right to sell 100 shares of the underlying stock to the option writer
by exercising the contract.
You are about to be shown a method when using a T-chart to ensure you place
the exercise price (strike times 100 shares) in the correct column, In or Out.
Use this method whenever you exercise an option contract no matter what the
strategy or number of option contracts. It works 100% of the time
Calls Match: This means you place the exercise dollars in the same
(match) T-chart column as the options premium.
Puts Cross: This means you place the exercise dollars in the T-chart col-
umn across (cross) from the column that has the options premium.
36.4.1.1 Examples
1. Buy 1 IBM Jun 50 call @ 5
As you can see the option has a premium of 5 so the contract cost the
buyer $500 which is placed in the Out column.
Now exercise the contract! Remember this is a call
option so calls match. Take the exercise dollars
(strike price of 50 times 100 shares) of $5,000 and
500
place it in the same column as the options pre-
mium. 5000

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2. Buy 1 PTS 30 Mar put @ 6

As you can see the option has a premium of 6 so the contract cost the
buyer $600 which is placed in the Out column.
Now exercise the contract! Remember this
is a put option so puts cross. Take the
exercise dollars (strike price of 30 times 100
shares) of $3,000 and place it in the oppo- 600 3,000
site column (across) from the options
premium.
Dont forget, whenever you need to exercise
an option contract remember, Calls Match
and Puts Cross.
36.4.2 Open Interest:
Open interest is defined as the number of open option contracts. If both the
holder and writer opened a position at the same time, the open interest in that
contract has been increased by 1 contract, not 2.
36.4.3 Writing (Selling) Options (Income Strategy)
The following are the reasons as to why investors write options;
Investors generally sell options for one major reason, income.
Income is provided by the premium of the option contract.
The premium is the maximum gain for an investor selling options.
36.4.3.1 Naked Option Writing (Income Strategy)
Naked option writing involves writing (selling) calls or puts that are not
covered. This strategy requires the use of a margin account to protect the
brokerage firm. The calculation of the amount of the margin requirement
for naked option writing is NOT required for the Series 7 exam. For test
purposes remember, investors writing naked options must use a
margin account.
36.4.3.2 Writing Covered Call Options (Income Strategy)
Covered call options is a very popular conservative strategy for investors
who own stock and would like to earn income while holding the stock.
Lets take a look at some of the features of covered call writing;
Margin is not needed as the call contracts are covered. This means
that if the call(s) are exercised by the buyer the stock is readily available
from the writer of the contracts.

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The income is provided to the writer of the contract(s) from the pre-
mium paid by the buyer of the contract(s).
Generally speaking, this type of strategy works better when the market is
expected to be stable. If the market price of the underlying stock goes
up the writer may lose the stock. If the market price of the underlying
stock goes down, the writer will lose in the decreased value.
Investors that already hold stock use this strategy as well as those inves-
tors who speculate by buying the stock and then writing call options
against the stock for the income.
36.4.3.3 Writing Puts (Income Strategy)
This is another income strategy used by option writers. The following are
the features of writing puts;
Writer of the contract(s) receives the premium as income
The writer has the obligation to buy shares at the strike price prior to
expiration if the holder exercises the contracts).
Therefore, the writer must come up with cash, not additional stock.
Therefore, it is very difficult to have a covered put writing position
because of the cash demand. Most put writers cannot cover their posi-
tions and therefore must use a margin account to protect the broker-
age firm.
The only real way to cover a short put position is to purchase the same
put from another writer with the same strike price or higher for at least as
long. Common sense tells you that if a writer of one put contract buys
another put contract it is virtually impossible to make a profit. Therefore a
margin account would be necessary because of the naked position.
There is one more potential use for writing put options. This use would
be to purchase the stock if it falls below the strike price of the put
option. This strategy provides the writer whose investment goal is to
obtain the stock below the current market value as well as to earn
income from the premium.

Go to the next page for Review Three!

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 Module 36: Equity Options

36.5 OPTION REVIEW THREE

The purpose of the following questions is to review all the aspects of equity
options which were provided in the Equity Options Section.
1. An investor buys 1 Dell May 50 call @ 4.50. The investors maximum
potential gain is;
A. $450
B. $4,550
C. $5,000
D. Unlimited
2. Using the option contract in Question 1, what is the investors potential
maximum loss?
A. $450
B. $4,550
C. $5,000
D. Unlimited
3. Using the option contract in Question 1, what is the breakeven?
A. 50
B. 54.50
C. 4.50
D. Unlimited
4. In buying call options as compared to buying the underlying stock, which
of the following is NOT an advantage?
A. Buying a call allows greater leverage than buying the underlying stock.
B. Buying a call would require a smaller capital commitment.
C. Buying a call has a lower dollar loss potential than buying the stock.
D. The call has a time value beyond an intrinsic value that gradually dissipates.
5. An investor buys 1 PTS Dec 40 put @ 3. What is the investors maximum
potential loss?
A. $300
B. $5,000
C. $4,700
D. $5,300

Continued on the next page

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6. The holder of a long put will realize a profit upon exercise of the option if
the price of the underlying stock;
A. Falls below the exercise price
B. Falls below the exercise price minus the premium paid
C. Exceeds the exercise price
D. Exceeds the exercise price plus the premium paid
7. All of the following ways can be used to close an option position EXCEPT;
A. Exercise
B. Expire worthless
C. Trade the option contract
D. Attaching the contract
8. Which of the following ways to close an option position is usually based
on intrinsic and time value?
A. Exercise
B. Expire worthless
C. Trade the option contract
D. Attaching the contract
9. Billy Bob sells 1 GM Mar 35 put @ 3. What is Billy Bobs maximum poten-
tial gain?
A. $3,500
B. Unlimited
C. $300
D. $3,200
10. Mary Jane, one of your best clients, wants to purchase Dell stock, cur-
rently trading at 28. She expects that the price of Dell stock will rise slowly
in the near future. But, she doesnt want to pay the current market value.
Instead, she wants to own the stock below its market value. Which of the fol-
lowing strategies would you recommend?
A. Buy a put and exercise the option
B. Write a put at 25 and buy the stock
C. Buy a call and exercise the option
D. Write a call at 25

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36.6 OPTION REVIEW THREE ANSWERS

1. (D) Anytime a call is purchased the maximum gain is unlimited as shown in the
T-chart below.
Out In

450 Unlimited
2. (A) The most any invest can lose when purchasing an option is the premium
paid. This is displayed in the above T-chart in the out column.
3. (B) The breakeven for call options is found by taking the strike price (50) and
adding (call-up) to it the premium of 4.50 for a total of 4.50. A breakeven is always
found on a one share basis, not times 100.
4. (D) Statements A, B and C are all true statements as to why buying a call would
be advantageous over buying the underlying stock. However, choice D is not an
advantageous as options are wasting assets and the life of a call or put will end at
a set date.
5. (A) Once again, the most an investor can lose when buying an option is the pre-
mium. In this question the premium is 3 so the maximum that can be lost is $300.
6. (A) When buying a put the investor would be happy if the price of the underlying
security would fall. The more it falls below the strike price the happier the investor
will be as the put premium increases.
7. (D) The three ways of closing an option contract is to let the contract expire
worthless, trade the option or exercise the option. There is no such thing as
attaching the contract.
8. (C) The value of an option contract for trading purposes is based on the pre-
mium. The premium is made up of intrinsic value (amount the contract is in the
money) and any time value (time for something to happen). Volatility also contrib-
utes to the value of the premium but cannot be measured for exam purposes.
9. (C) The maximum potential gain for any option writer is the premium.
10. (B) This is the classic example of a reason to write puts, hoping to buy the
stock below market price. Writing the put gives the investor a chance of buying the
stock at the strike price of 25 if the stock falls in value and the put is exercised by
the holder of the put. In addition the writer gets the premium so if the contract is
exercised the writer will own the stock less than the strike price of 25.

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NASD Series 7 Page 286

 Module 37: Multiple Option Strategies

Section 37: Multiple Option Strategies

Multiple option strategies involve multiple option contracts and/or option contracts
and stock positions used for investors to help reach their investment goals and
objectives.
37.1 STRADDLES
A straddle is composed of a call and a put with the same strike price and expi-
ration months. Straddles can be long (buy) or short (sell). Straddles are used by
investors to speculate on the price movement of stock.
37.1.1 Long Straddle
Investors buying a straddle are doing so because they anticipate a
volatile market, both up and down. If the market goes up the investor wins
with the call. If the market goes down the investor wins with the put. If the mar-
ket doesnt go up or down the straddle could expire worthless.
Maximum Gain: Unlimited
Maximum Loss: Total premiums paid
37.1.1.1 Long Straddle Example #1
Buy 1 PTS Mar 40 call @ 3 300

Buy 1 PTS Mar 40 put @ 4 400

Look at the T-chart to determine maximum

gains and losses.
Maximum Gain: Unlimited (blank side)
Maximum Loss: $700 (both premiums)

37.1.1.2 Long Straddle Example #2

Buy 1 Dell Apr 30 call @ 2
200
Buy 1 Dell Apr 30 put @ 3
300
Look at the T-chart to determine maximum
gains and losses.
Maximum Gain: Unlimited (bland side)
Maximum Loss: $500 (both premiums)

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37.1.2 Short Straddle

Investors shorting a straddle do so for income. These investors anticipate a flat
market, neither going up nor down. If the market goes up and or down instead
the writer may end up with a losing position.
Maximum Gain: Premiums paid
Maximum Loss: Unlimited
37.1.2.1 Short Straddle Example #1
Write 1 PTS Mar 40 call @ 3 300
Write 1 PTS Mar 40 put @ 4 400
Look at the T-chart to determine maximum
gains and losses.
Maximum Gain: $700 (both premiums)
Maximum Loss: Unlimited (blank side)

37.1.2.2 Short Straddle Example #2

Write 1 Dell Apr 30 call @ 2
200
Write 1 Dell Apr 30 put @ 3
300
Look at the T-chart to determine maximum gains
and losses.
Maximum Gain: $500 (both premiums)
Maximum Loss: Unlimited (blank side)

37.1.3 Combinations
A combination is composed of a call and a put with different strike prices
and/or different expiration months. Combinations can be long (buy) or short
(sell). Combinations, like straddles, are used by investors to speculate on the
price movement of the underlying security.
37.1.3.1 Long Combinations
Investors buying a combination are doing so because they anticipate a
volatile market, both up and down (just like straddles). The difference
between combinations and straddles involves strike prices and/or expira-
tion months. If the market goes up the investor wins with the call. If the
market goes down the investor wins with the put. If the market doesnt go
up or down the straddle could expire worthless.

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 Module 37: Multiple Option Strategies

Maximum Gain: Unlimited

Maximum Loss: Total premiums paid

37.1.3.2 Long Combination Example

Buy 1 Dell Apr 30 call @ 2 200
Buy 1 Dell Jun 35 put @ 3 300

Look at the T-chart to determine maximum

gains and losses.
Maximum Gain: Unlimited (blank side)
Maximum Loss: $500 (both premiums)

37.1.3.3 Short Combination

Investors shorting a combination do so for income. These investors antic-
ipate a flat market, neither going up nor down. If the market goes up and
or down instead the writer may end up with a losing position.
Maximum Gain: Premiums paid
Maximum Loss: Unlimited

37.1.3.4 Short Combination Example

Write 1 Dell Apr 30 call @ 2 Out In

Write 1 Dell Jun 35 call @ 3 200

300
Look at the T-chart to determine maximum gains and losses.
500
Maximum Gain: $500
Maximum Loss: Unlimited (Blank Out column)

37.1.4 Breakevens for Straddles & Combinations

The Series 7 exam consists of a large number of breakeven questions for
straddles and combinations. Calculating the breakeven is the same for both
strategies. In fact, there are two (2) breakevens for a straddle or combination.
If you forget, the question choices will remind you as there will be two numbers
for each choice.
Examples follow on the next page!

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37.1.4.1 Breakeven Calculations

Call: Take the strike price and add the premiums (call up) from both the
call and put contracts.
Put: Take the strike price and subtract the premiums (put down) from
both the call and put contracts.
Remember: For Straddles and Combinations ONLY, there are two
breakevens for the call and the put!
37.1.4.2 Breakeven Examples
Buy 1 Dell Dec 25 call @ 2
Buy 1 Dell Dec 25 put @ 3

- Call: = 25 (strike price) + 5 (both premiums) = 30 (breakeven of call)

- Put: = 25 (strike price) - 5 (both premiums) = 20 (breakeven of put)
Now its your turn!

Buy 1 PTS Nov 20 call @ 3

Buy 1 PTS Jan 25 put @ 5

What is the breakeven of the above?

A. 23, 20
B. 17, 28
C. 28, 17
D. 20, 23
If you chose C you would be correct. Be careful of an additional exam
trap. While the breakevens in both choices B and C appear to be the
same, they are not because the order is different. Always take the choice
that has the option contracts in the same chronological order as given in
the exam question, just like the above example.
Rationale
Call: 20 (strike price) + 8 (both premiums) = 28
Put: 25 (strike price) - 8 (both premiums) = 17
Final Note: For breakeven purposes it doesnt matter whether the
straddle or combination is long or short as the breakeven is based
on the contract itself, not whether it was bought or sold.

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 Module 37: Multiple Option Strategies

Straddles and Combinations Summary

Long Straddle or Short Straddle or
Calculation
Combination Combination

Max Gain Unlimited Total Premiums Paid

Max Loss Total premiums received Unlimited
Call: strike + both premiums Call: strike + both premiums
Breakevens
Put: strike - both premiums Put: strike - both premiums

37.1.5 Straddle/Combination Review Questions

1. Your customer buys a PTS Apr 30 call. To establish a straddle your
customer would;
A. Buy a PTS Apr 30 put
B. Sell a PTS Apr 30 call
C. Buy a PTS Apr 30 call
D. Sell a PTS Apr 30 put
2. A long straddle is profitable in a:
I. Rising market
II. Falling market
III. Stable market
A. I only
B. II only
C. III only
D. I and II
Use the following information to answer the next 3 questions.
Your best customer, Diana Lynne, buys 1 GE Mar 30 call @ 5 and
buys 1 GE Mar 30 put @ 4 when the market price of GE is 31.
3. The maximum gain for this position is;
A. $900
B. $300
C. $3,100
D. Unlimited

Go to the next page!

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4. The maximum loss for this position is;

A $900
B. $300
C. $3,100
D. Unlimited
5. Using the same facts, what are the breakeven points?
A. 21, 39
B. 35, 26
C. 39, 21
D. 26, 35
37.1.5.1 Straddle/Combination Review Answers
1. (A) A long straddle is made up of a long call and a long put with the
same strike price and same expiration month.
2. (D) For a long straddle to be profitable the investor would want the mar-
ket to go up for the call and go down for the put.
3. (D) Use the T-chart. As you can see the premi-
ums cost $900 (Out) which would be the maxi-
mum loss while the maximum gain would be
unlimited as indicated by the blank side (In). 500
4. (A). As explained in Answer #3 above, the 400
most an investor can lose in a long position are
the premiums paid.
5. (C) The breakeven for the call is 30 (strike
price of the call) plus 9 (both premiums) for a total of 39. The breakeven
for the put is 30 (strike price of the put) minus 9 (both premiums) for a total
of 21.

You should now be ready to move on to another multiple option strategy

known as Spreads. Please turn to the next page!

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 Module 37: Multiple Option Strategies

37.2 SPREADS
The Derivative portion of the Series 7 exam generally asks more questions
about spreads than other types of option strategies. Therefore, it is impera-
tive that you know how to work with spreads inside and out.
37.2.1 Spreads Defined
A spread is the simultaneous purchase of one option and sale of another
option of the same class. Translated, this means;
A call spread is a long call and a short call
A put spread is a long put and a short put
There are many types of spreads that you must be able to define, work with
and calculate the maximum gain, maximum loss and breakevens. The other
types of spreads are as follows; (Memorize them)
Credit spread: Bringing more money into the account then taking out.
Buy 1 LEX Jan 50 call @ 2 Out In
Sell 1 LEX Mar 55 call @ 3 200 300

Debit spread: Taking more money out of the account then bringing in.
Buy 1 LEX Jan 50 call @ 3 Out In
300 200
Sell 1 LEX Mar 55 call @ 2

Bullish spread: Bullish on the market. Buy the low strike and sell the high
strike.
Buy 1 LEX Jan 50 call @ 2
Sell 1 LEX Mar 55 call @ 3
Bearish spread: Bearish on the market. Buy the high strike and sell the
low strike.
Buy 1 LEX Mar 60 Call @ 3
Sell 1 LEX Jul 55 Call @ 4
Diagonal spread: Different strike prices and different expiration months.
Buy 1 Bud Jan 50 call @ 2
Sell 1 Bud Mar 55 Call @ 3

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Note: The following Vertical Spread, Cost Spread and Price Spread
are synonymous terms (Same structure, different terms)

Vertical spread: Different strike prices and same expiration months.

Buy 1 Bud Jan 50 call @ 4
Sell 1 Bud Jan 55 Call @ 2
Cost spread: Different strike prices and expiration months the same.
(Same as the Vertical Spread above)
Price spread: Different strike prices and expiration months the same.
(Same as the Vertical Spread above)
Note: The following Calendar Spread, Horizontal Spread and Time
Spread are synonymous terms (Same structure, different terms).

Calendar spread: Different expiration months and same strike prices.

Buy 1 Bud Jan 50 call @ 4
Sell 1 Bud Mar 50 call @ 6
Horizontal spread: Different expiration months and same strike prices.
(Same as the Calendar Spread above)
Time spread: Different expiration months and same strike prices
(Same as the Calendar spread above)

37.2.2 Spread Reminders

Vertical, cost and price spreads are the same. These are spreads that
have different strike prices but the expiration months are the same. They
were named vertical because option charts found in the financial newspa-
pers have strike prices listed vertically.
Calendar, horizontal and time spreads are the same. These are spreads
that have different expiration months but the strike prices are the same.
They were named horizontal because option charts found in the financial
newspapers have expiration months listed horizontally.

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 Module 37: Multiple Option Strategies

37.2.3 Risk Issues

You will be confronted on the exam with questions about levels of risks for vari-
ous option positions. To help you answer those questions it is recommended
you remember the following;
Spread positions are generally less risky.
Buying options would also be less risky as the most that the investor can
lose is the premium paid.
Covered call writing would be less risky because the option contracts are
covered by stock being held by the investor.
Short combinations and short straddles are generally high risk
strategies.

Exam Question Example

Which of the following option strategies is the riskiest?
A. Short spread
B. Long call
C. Covered call write
D. Short straddle
Answer and Rationale
(D). This is the typical question you will be asked. Choice A is not the correct
choice as spreads are never the riskiest. Choice B is not correct as buying
options is not the riskiest. Choice C is not correct as the option is covered and
therefore not high risk. Short straddles/combinations will be the riskiest.
Exam Note: Most of the spread questions will be maximum gain, maxi-
mum loss and breakeven. There also are questions that will ask whether
it would beneficial for the investor to have the premiums narrow or widen
or whether the contracts should be or should not be exercised. There are
also a few spread miscellaneous questions of the different types of
spreads and offsetting dollars for long and short spreads.
The following pages will reflect working with different types of spreads
and calculating the maximum gain, maximum loss and breakeven.

Turn to the next page!

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37.2.4 Spread Examples

37.2.4.1 Example 1
Buy 1 PTS Apr 30 put @ 3 300 500

Write 1 PTS Apr 35 put @ 5

Debit or Credit: Credit as more was brought into
the account than went out.
Bullish or Bearish: Bullish as the lower strike price was bought.
Step 1: Look at the T-chart and ask yourself, which column has the larger
number, out or in? In this spread the in has the larger number. There-
fore this would represent the Maximum Gain (In column larger). To com-
pute the actual gain take the difference between the 500 and 300 equaling
200. So, 200 is the maximum gain of this spread position.
Step 2: To calculate the Maximum Loss you must exercise both options.
As a reminder, when exercising you take the strike price and multiply it by
100. Then you must place that number into the correct column of the T-
chart. Dont forget what you learned earlier, Calls Match and Puts Cross
when exercising option contracts.
Exercise the first put: Take the strike price of 30 times 100 which equals
3000. Then place the 3,000 in the In Column of the T-chart as puts
cross so the exercise dollars must be placed across from the column that
represents the options premium.
Exercise the second put: Take the
strike price of 35 times 100 which
equals 3500. Place the 3,500 in the Out
300 500 Column of the T-chart as puts cross so
3500 3000
the exercise dollars must be placed
across from the column that represents
the options premium.
Now take the difference between the
Out and In columns for the maximum
loss of $500.
Step 3: To calculate the Breakeven for a Put Spread (2 puts) use the
acronym PUSH which represents the following;
For Put Spreads (PU), subtract (S) from the higher (H) strike price the
difference of the two premiums (net premium). In this example the higher
strike is 35. So take 35 and subtract the net premium of 2 (5 - 3) for a
breakeven of 33.

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37.2.5 Example 2
Buy 1 GE Jan 50 Call @ 7 Out In
Write 1 GE Jan 60 Call @ 3 700 300

Debit or Credit? Debit as more went out of the account than came in.
Bullish or Bearish? Bullish as the low strike price was bought and the higher
strike price was sold.
Step 1: Look at the T-chart and ask yourself, which column has the larger
number, out or in? In the above spread, the out has the larger number.
Therefore, this would represent the Maximum Loss (Out column larger). To
calculate the actual loss take the difference between the 700 and 300 which
equals 400. So, 400 is the maximum loss of this spread position.
Step 2: To calculate the Maximum Gain, you must exercise both options. As a
reminder, when exercising you take the strike price and multiply it by 100. Then
you must place that number into the correct column of the T-chart. Dont forget,
what you learned earlier, Calls Match and Puts Cross when exercising option
contracts.
Exercise the first call: Take the strike price of 50 times 100 which equals
5,000. Then place the 5,000 in the out column of the T-chart as calls match
so the exercise dollars must be placed in the same (match) column of that
options premium.
Exercise the second call: Take the strike price of
Out In
60 times 100 which equals 6,000. Place the 6000 in
700 300 the in column of the T-chart as calls match so the
exercise dollars must be placed in the same (match)
5000 6000 column that represents the options premium.
5,700 6,300 Now take the difference between the Out and In col-
umns for the maximum gain of $600.

Step 3: To calculate the Breakeven for a Call Spread (2 calls) use the acro-
nym C.A.L.S. which represents the following;
For Call spreads (C), add (A) to the lower (L) strike (S) price the difference
of the two premiums (net premium). In this example the lower strike price is 50.
So take 50 and add the net premium of 4 (7 - 3) for a breakeven of 54.

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37.2.6 Example 3
Buy 1 PTS Jan 60 Call @ 6 Out In
Write 1 PTS Jan 65 Call @ 4 600 400
Debit or Credit? Debit as more went out of the account than came in.
Bullish or Bearish? Bullish as the low strike price was bought and the higher
strike price was sold.
Step 1: Look at the T-chart and ask yourself, which column has the larger
number, out or in? In the above spread, the out has the larger number.
Therefore, this would represent the Maximum Loss (Out column larger). To
calculate the actual loss take the difference between the 600 and 400 which
equals 200. So, 200 is the maximum loss of this spread position.
Step 2: To calculate the Maximum Gain, you must exercise both options. As a
reminder, when exercising you take the strike price and multiply it by 100. Then
you must place that number into the correct column of the T-chart. Dont forget,
what you learned earlier, Calls Match and Puts Cross when exercising option
contracts.
Exercise the first call: Take the strike price of 60 times 100 which equals
6,000. Then place the 6,000 in the out column of the T-chart as calls match
so the exercise dollars must be placed in the same (match) column of that
options premium.
Exercise the second call: Take the strike
Out In price of 65 times 100 which equals 6,000. Place
600 400 the 6500 in the in column of the T-chart as
calls match so the exercise dollars must be
6,000 6,500 placed in the same (match) column that repre-
6,600 6,900 sents the options premium.
Now take the difference between the Out and
In columns for the maximum gain of $300.

Step 3: To calculate the Breakeven for a Call Spread (2 calls) use the acro-
nym C.A.L.S. which represents the following;
For Call spreads (C), add (A) to the lower (L) strike (S) price the difference
of the two premiums (net premium). In this example the lower strike price is 60.
So take 60 and add the net premium of 2 (6 - 4) for a breakeven of 62.

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 Module 37: Multiple Option Strategies

37.3 SPREAD NARROWING OR WIDENING OF PREMIUMS

There are a number of Series 7 questions that ask whether the client would be in
a better position (profitable position) if the two premiums of a spread narrowed
or widened. In addition, questions also ask whether the client would be in better
position if the option contracts were exercised or remained unexercised.
Remember our goal! Complete option questions using the dont think too
much method. You should be more interested in answering option questions cor-
rectly without looking for detailed explanations as to why etc.
The key to whether the premium should widen or narrow or if the contracts
should or should not be exercised is with the following two acronyms;
WED
NUC
The last letter of WED and NUC represents whether the spread is a Debit or
a Credit spread.
The first letter stands for widen (W) or narrow (N).
The middle letter stands for exercise (E) the options or let the contracts
remain unexercised (U).
If the spread is a Debit Spread then it would be in the clients best interest for
the premiums to widen and the option contracts exercised.
If the spread is a Credit Spread then it would be in the clients best interest
for the premiums to narrow and the option contracts to remain unexercised.
37.3.1 Examples
Out In
Example 1
600 300
Buy 1 Dell Jan 50 call @ 6
Sell 1 Dell Jan 60 call @ 3
As you can see, this would be a Debit Spread (more in the out column than in
the in column). Therefore the analysis to this set of facts is as follows;
As a Debit Spread you would use the acronym WED
The client would be better off if the premiums would widen and the option
contracts exercised.

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Example 2
Out In
Buy 1 PTS Jan 50 call @ 3 300 1200
Write 1 PTS Jan 60 call @ 12

As you can see, this would be a Credit Spread (more in the in column than in
the out column). Therefore the analysis to this set of facts is as follows;
As a Credit Spread you would use the acronym NUC
The client would be better off if the premiums would narrow and the option
contracts remain unexercised.

Go to the next page for Spread Practice Questions

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 Module 37: Multiple Option Strategies

37.4 MULTIPLE OPTIONS REVIEW QUESTIONS

1. Which of the following is(are) horizontal spreads?
I. Long 1 PTS Jan 50 call
Write 1 PTS Jan 50 call
II. Long 1 PTS Jan 50 call
Short 1 PTS Jan 60 call
III. Long 1 PTS Jan 50 call
Short 1 PTS May 50 call
IV. Long 1 PTS Jan 50 call
Short 1 PTS May 60 call
A. I only
B. II only
C. III and IV only
D. II and IV only
Use the following set of facts to answer the following 5 questions.
On the same day a customer buys 1 Dell Mar 70 call @ 5 and sells 1 Dell Mar
80 call @2 when the market price of Dell is 71.
2. The maximum potential loss is;
A. $200
B. $300
C. $500
D. $700
3. The maximum potential gain is;
A. $200
B. $300
C. $500
D. $700
4. The breakeven point is;
A. 70
B. 73
C. 75
D. 77

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5. The position will be profitable if;

I. Both contracts expire
II. Both contracts are exercised
III. The spread widens
IV. The spread narrows
A. I and III
B. I and IV
C. II and III
D. II and IV
6. A customer buys 1 IBM Sep 40 call and sells 1 IBM Feb 40 call. This is a;
A. Calendar debit spread
B. Calendar credit spread
C. Vertical debit spread
D. Vertical debit spread
7. A customer buys 1 PTS Mar 40 call and sells 1 PTS Aug 50 call. This is a;
A. Horizontal spread
B. Diagonal spread
C. Vertical spread
D. Horizontal credit spread
Use the following facts to answer the next 2 questions.
A customer on the same day buys 1 Stuff Feb 80 put @ 6 and sells 1 Stuff
Feb 90 put @10 when the market price of Stuff is 85.
8. The maximum potential gain is;
A. $400
B. $600
C. $1,000
D. $1,600
9. The maximum potential loss is;
A. $400
B. $600
C. $1,000
D. $1,600
Go to the next page for Review Answers

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 Module 37: Multiple Option Strategies

37.5 MULTIPLE OPTIONS REVIEW ANSWERS

1. (C) Horizontal spreads have different expiration months. This would include
spreads III and IV only. Options I is not a spread as both the expiration months
and strike prices are the same. In order to be a spread the months and/or expira-
tion months must be different. Option II is a Vertical Spread as the strike prices are
different but the months the same. If both the months and strike prices were differ-
ent it would be a Diagonal Spread.
2. (B) Set up your T-chart. Out In
500 200

Look at the T-chart to see which column is larger. In this case the out column is
larger, therefore reflecting the maximum loss. Just take the difference of the num-
bers in both columns which gives you the maximum loss of $300.
3. (D) To find the other maximum, in this case the maximum gain, you must exer-
cise both option contracts. The key is to place the exercise dollars into the correct
column. Remember, use Calls Match and Puts Cross to determine which col-
umn to place the exercise dollars into.
This is a call spread so you will use Calls Match which means place the exer-
cise dollars into the column that has the premium for that option contract.

Out In Step 1: Exercise the Mar 70 call (70 x 100) = 7,000. As calls
match place the 7,000 into the Out column as this is the col-
500 200
umn with this contracts premium.
7000 8000
Step 2: Exercise the Mar 80 call (80 x 100) = 8,000. As calls
7500 8200 match place the 8,000 into the In column as this is the column
with this contracts premium.
Step 3: Take the difference between the Out and In columns,
which is 700
4. (B) To calculate the breakeven point for a call spread use the acronym C.A.L.S.
In other words, if you have a call spread (C) add (A) to the lower strike (L.S.) price
the difference of the spread premiums. So take the lower strike price of 70 and
add (call up) the difference of the two premiums (5 - 2 = 3) 3.
5. (C). This is a debit spread (look at the diagram in answer #2) because the out
column is larger than the in column (You spent more than you brought in). Now
use the acronym WED (D for debit) and the answer would be choice C as it would
be more profitable for a client if the contracts are exercised (E) and the spread
widens (W).

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6. (B). Since the September call expires prior to the February call (first option
contract listed in the question is the first in time), the investor is buying the less
expensive contract and selling the more expensive contract. Therefore this would
be a credit spread (more in than out). As the months are different this would also
be a calendar spread. The strike prices are the same so this spread cannot be a
vertical spread.
7 (B) When both the strike prices and expiration months are different the spread is
called a Diagonal Spread.
8. (A). Set up your T-chart! As you can see below the column containing the larger
number would be the in column. Take the difference (1000 - 600 = 400) and this
would be the maximum potential gain for this option spread.
Out In
600 1000

9. (B) To calculate the maximum loss, in this example, you would have to exer-
cise both contracts. Remember Puts Cross so take the exercise dollars and
place them in the column across from their contract premium.
Add the columns and take the difference for the answer.
Out In
600 1000
9000 8000
9600 9000

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 Module 38: Hedging Strategies

Section 38: Hedging Strategies

38.1 HEDGING OPTIONS OVERVIEW
In this section we will be discussing various hedging strategies involving combina-
tions of both options and equities. The Series 7 exam will test you on the reason
for these strategies, the maximum potential gain, maximum potential loss and
breakevens.
As we go through the strategies, remember the procedures you already learned
for spreads, combinations and straddles as they will be most helpful to you.
38.2 PROTECTING A STOCK POSITION
Investors with established stock positions can use options to help protect against
the risk of the position. The addition of the option can help insure the investor
against some of the possible loss from owning the stock position.
38.2.1 Long Stock Position
With a long stock position an investor would hope for the market price of the
stock to increase. The risk of owning stock would be a potential market
decline in the value of the equity.
By buying a Put Option, the risk of the decline in stock value would be offset
by the put or possibly the sale of a call (not the best hedge as the investor
would only received the premium so only limited protection would be received).
38.2.1.1 Long Stock and Put Hedge Out In

Buy 100 shares of ABC shares @ 70 7000

Buy 1 Aug 70 ABC Put @ 4
400
Breakeven
To establish the breakeven of a stock and option position, take the differ-
ence between the value of the two columns. As you can see, the value of
the Out Column for one share is 74 (70 + 4), while the value of the In
Column for one share is Zero (0). Therefore, the difference between 74
and 0 is 74. So, 74 would be the breakeven!
Maximum Gain
Look at the T-chart. As there is a blank side, as before, there would be an
unlimited potential gain for this position.

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Maximum Loss
Now that the maximum gain has been established for this option position,
you need to calculate the maximum loss. Just like spread positions, to
get to the other maximum, in this case the maximum loss, you need to
exercise the option contract in the T-chart.
Out In
7000 7000
400

Remember, puts cross, so you take the exercise dollars of $7,000 (100
shares times the strike price of 70) and place it into the In column
across from that option contracts premium of 400.
Now its just a simple matter of adding both columns and taking the differ-
ence which gives the maximum loss of $400 (7400 minus 7000)
38.2.2 Short Stock Position
With a short stock position an investor would hope for the market price of the
stock to decrease. The risk of shorting stock would be a potential market
increase in the value of the equity.
By buying a Call Option, the risk of the decline in stock value would be offset
by the call or possibly the sale of a put (not the best hedge as the investor
would only received the premium so only limited protection would be received).
38.2.2.1 Short Stock and Call Hedge
Out In
Sell short 100 shares of ABC shares @ 42 500 4200
Buy 1 Aug 40 ABC Call @ 5
Breakeven
To establish the breakeven of a stock and option
position, take the difference of the column totals for one share. As you
can see, the Out Column value for one share is 5 while the In Column
value for one share is 42. The difference between 32 and 5 is 37. That
would be the breakeven!
Maximum Gain
Look at the T-chart. As you can see there is no blank side. Therefore, just
like you did with Spreads, look at the columns and select the column with
the largest number. This would be the In Column which indicates the
establishment of the Maximum Gain. Take the difference of 4200 and 500
which represents the maximum gain of 4700.

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 Module 38: Hedging Strategies

Maximum Loss
Now that the maximum gain has been established for this option position,
you need to calculate the maximum loss. Just like spread positions, to
get to the other maximum, in this case the maximum loss, you need to
exercise the option contract in the T-chart. Out In
500 4200
4000
Remember, calls match, so you take the exercise dollars of $4,000
(100 shares times the strike price of 40) and place it into the Out col-
umn which is the same column as that option contracts premium of 500.
Now its just a simple matter of adding both columns and taking the differ-
ence which gives the maximum loss of $300 (4500 - 4200)
38.3 OPTION COLLAR
Essentially, an option collar is a hedge to protect a stock position. This hedge
can be used to protect a downside risk on a long stock position for no out-of-
pocket costs. This is different from the other hedges discussed as the option
hedge had a cost.
This type of hedge is popular when an investors stock has appreciated substan-
tially but the investor feels that any near term upside potential for appreciation is
unlikely but doesnt want to sell the stock at this point in time.
38.3.1 Collar Example
George B bought 100 shares of PTS stock @ 35. PTS has appreciated to
$60 a share. George doesnt want to sell the stock today although hes thinking
that with market conditions the way they are, additional upside appreciation
may be limited. and buys a 55 put at 2 and sells a 65 call at 2. George decides
that if the stock falls he would want to sell it at $55. But, he wants to do this
without any substantial cost. Georges financial advisor advises George to
place an option collar position around his stock to accomplish this objective.
George buys 1 PTS Mar 55 Put (out of the money by 5 points and where
George is willing to sell his stock) at $2. At the same time George sells 1 PTS
Mar 65 Call @ $2.
The net cost of the collar is zero.
If the stock falls, George can exercise the put and sell the stock at $55 no
matter how low the stock goes with a locked in profit of $20. (55-35)
If the stock rises above 65 the stock will be called at $65 giving George a
total profit of $30. (65 - 35)

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NASD Series 7 Page 308

 Module 39: Non Equity Options

Section 39: Non Equity Options

Nonequity options work almost the same as equity options. One important thing to
remember, however, is that nonequity options cannot settle in shares as the
underlying instruments are not shares of stock as equity options would be. There-
fore, nonequity options always settle in cash, whether the option contract is exer-
cised or traded.
Additional differences between nonequity options and equity options can be con-
tract size, exercise rules and expiration times.
39.1 INDEX OPTIONS
Options on indexes allow investors to profit from the movement of various mar-
kets. Indexes would include both broad-based and narrow-based indexes. Broad-
based indexes are meant to track the market as a whole while narrow-based
indexes are meant to reflect the movement in a particular industry group.
Index options may be used to speculate on movement of the market over-
all.
Hedging a portfolio is an important use of index options.
If a portfolio manager holds a diverse portfolio of equities, a put can be pur-
chased on the index to offset loss if the market value of the stocks fall.
The use of index puts is known as portfolio insurance.
Index options protect against the risk of the market overall, which is known
as systematic or systemic risk.
Portfolio managers have also written index options in the past to help gen-
erate income for a portfolio.
Exam Alert: There are a number of Series 7 questions about hedging
positions with index options. Make sure you apply the correct index to
the investors position.
As an example, the facts state that a mutual fund money manager manag-
ing a high tech fund is concerned with a decrease of the portfolios value.
Which of the following would you recommend? When answering this type
of question make sure you match the portfolio your trying to hedge with
the appropriate index. If the portfolio is made up of blue chip stocks then
a broad-based index such as the S&P 500 would be appropriate. If the
portfolio is made up of technology equities only then a hedge needs to be
made with a narrow-based index.

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39.1.1 Broad-based Index Examples

S&P 500 (known as the SPX)
S&P 100 (known as the OEX)
XMI (AMEX major market index)
39.1.2 Narrow-based Index Examples
Technology
Pharmaceuticals
Oil
Gold
39.1.3 Index Option Features
Multiplier: Index options typically use a multiplier of $100. The premium
amount is multiplied by $100 to calculate the options cost. To determine
the dollar value of the index the strike price is multiplied by $100.
Settlement: Index options settle in cash rather than in delivery of securi-
ties. The cash must be delivered on the next business day.
Exercise: If an option is exercised, the writer of the option delivers cash
equal to the intrinsic value (In the money) of the option to the buyer.
Settlement Price: When exercised their settlement price is based on the
closing value of the index on the day of exercise, not the value at the time
of exercise.
Expiration Dates: Index options are issued for a maximum of four (4)
months and expire on the Saturday following the third Friday of the expi-
ration month.
39.1.4 Capped Index Options
Capped index options are kind of unique as they are automatically exercised
when the cap price is reached. The cap interval is normally set at 30 points
above the market for calls and 30 points below the market for puts. The inves-
tor cannot make any more than the cap amount. If the cap is not reached nor
automatically exercised it can be exercised at expiration, but not before.
39.1.4.1 Capped Index Features
No unlimited gains or losses
Only available on the SPX and OEX

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 Module 39: Non Equity Options

Automatically exercised when option is 30 points in the money

European Way Exercise: If not automatically exercised can only be
exercised on the business day prior to expiration
Example: Long1 OEX Mar 420 Call @ 7 1/2. If the OEX goes up to 470
what is the investors profit? While the OEX grew by 50 points the inves-
tor is capped at 30 points at which point the option would have been
exercised and settled in cash.
39.2 LEAPS
Long-Term Equity Anticipation Securities, known as LEAPs are long-term
equity options. Underlying securities for LEAPs include equities and the SPX.
Features include;
Three year expirations as compared to equity options with a maximum life
of nine months.
LEAPs can be exercised on any business day prior to expiration, just like
equity options. This is known as an American Style option contract.
If a LEAP expired worthless the tax consequence would be a long-term cap-
ital loss.
39.3 INTEREST RATE OPTIONS
Interest rate options, issued by the Philadelphia Stock Exchange, allow inves-
tors to speculate on or protect against fluctuations in interest rates. However,
there are two types of interest rate options.
One known as Price-Based which is based on the value of a debt instru-
ment. These are sometimes also known as Debt Options.
The other known as a Yield-Based option which is based on the direction
(changes) of interest rates, not the value of debt instruments.
39.3.1 Price-Based Option Features
100 units in a contract
T-notes and T-bonds have a contract size of $100,000
T-bills have a total size of $1,000,000
Strike prices are quoted as a percentage of their face value. As an
example, if a 97 call was exercised the investor would have the right to pur-
chase $100,000 worth of notes or bonds for 97% of face value or $97,000.

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Premiums of T-note and T-bond options are quoted in 32nds, just like the
securities themselves.
Premiums of T-bill options are quoted as a percentage of face value.
Strategies: Portfolio managers and investors who expect interest rates to
rise buy puts or write calls on T-bonds, notes or bills. If interest rates are
expected to fall, buying calls or writing puts would be appropriate.
Remember the fulcrum, bond prices move inversely with interest rates.
39.3.2 Yield-Based Option Features
Yield-based options are also based on T-bills, notes and bonds. However,
while price-based options are based on the value of those debt instruments,
yield-based options are based on the direction of the interest rates them-
selves.
Yield based strike prices reflect yields. As an example, a yield-based
option with a strike price of 45 reflects a yield of 4.5%. If an investor buys
this option, and interest rates rise to 7.5%, the investor receives cash equal
to the intrinsic value of 30 points in this scenario. The multiplier for yield-
based options is $100. 30 points of intrinsic value multiplied by $100 totals
$3,000.
If a portfolio manager expects interest rates to fall, he/she could purchase
a yield-based put as the option is based on the direction of interest rates,
not the value of the instrument.
If a portfolio manager expects interest rates to rise, he/she could pur-
chase a yield-based call as the option is based on the direction of interest
rates, not the value of the instrument.
39.4 FOREIGN CURRENCY OPTIONS
Investors can speculate on the performance of currencies other than the U.S.
dollar. Currency options are available on;
British Points
Canadian Dollars
Australian Dollars
German Marks
French Francs
Swiss Francs
Japanese Yen

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 Module 39: Non Equity Options

39.4.1 Foreign Currency Option Features

Issued by the Philadelphia Stock Exchange
Strike Prices: Usually quoted in U.S. cents (.01). There are two excep-
tions, one being the French Franc which is quoted as .001 (French Franc
has two Fs so remember two zeros). The other exception is the Japa-
nese Yen which is quoted as .0001 (Yen has three letters so remember
three zeros).
Contract Size: This will be given to you in the exam question. As an
example, the contract size for a British Pound contract covers 31,250
pounds. Each currency has its own contract size.
Expiration Date: Foreign currency options expire on the Friday preceding
the third Wednesday of the month.
Settlement Date: Fourth business day after tender of the expiration
notice.
Strategies: If an investor believes the value of a currency is going to rise,
he/she would buy calls or sell puts on the currency. If an investor expects
the value of currency to fall, puts would be bought and calls can be sold.
39.4.1.1 Foreign Currency Inverse Relationship
It is important to remember for both option, hedging and economic exam
questions that there is an inverse relationship between foreign curren-
cies and the U.S. dollar.
If the dollar is rising, foreign currencies are falling, so buy puts on the
foreign currency. Remember, there are no options available on the U.S.
dollar.
If the dollar is falling, foreign currencies are rising, so buy calls on the
foreign currency.
39.4.1.2 Foreign Currency Option Examples
1. A Canadian Dollar currency option is quoted at a premium of .5. If
50,000 Canadian Dollars underlie the contract, what dollar price does
the premium represent?
Take the premium of .5 and multiply it times the 50,000 contract size and
multiply the results times the strike price of .01. Answer is $250.

Go to the next page

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2. A U.S. importer must pay for Swiss Widgets in Swiss francs within
four months. The importer is fearful that the value of the dollar will
fall. Using foreign currency options what should this investor do?
If the importer believes the U.S. dollar will fall, then the Swiss franc will
rise in value. The investor should buy calls on the Swiss franc to lock in
the purchase price for the francs needed at the end of the four months.
Remember, you cannot buy options on the U.S. dollar so dont even
think about buying puts on the U.S. dollar!

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 Module 39: OptionReview Questions

Section 39: OptionReview Questions

1. Peggy Sue sells short 100 shares of Stuff Inc. at $50 per share. She
believes that the stock will fall and is speculating by taking this position.
However, she is concerned that the market may rise, forcing her to cover at
a large loss and she wants to hedge against this possibility. So, Peggy Sue
buys 1 Stuff Mar 50 call @ $4 for a hedge. What is Peggy Sues maximum
gain?
A. $5,000
B. $4,600
C. $500
D. $400
2. Billy Bob buys 100 shares of Dell stock at $25 and buys 1 Dell Nov 25 put
@ $5. Dell stock falls to $20 and just prior to expiration, Billy Bob exercises
the put, delivering the stock position. Billy Bob;
A. Broke even
B. Lost $500
C. Gained $500
D. Has unlimited loss potential
3. Using the facts in the above question, what was Billy Bobs breakeven?
A. 5
B. 20
C. 25
D. 30
4. Using the same facts, what was Billy Bobs maximum potential gain?
A. $3,000
B. $2,700
C. $2,000
D. Unlimited
5. Which of the following hedges would be used when protecting a long
stock position?
A. Sell stop order
B. Buy calls
C. Sell puts
D. Buy puts

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39.1 OPTION REVIEW ANSWERS

1. (B): Out In Looking at the T-chart you can see that the In column
400 5000 is larger than the Out column. Just like spreads, this
tells you maximum potential gain. To calculate the gain
take the difference between the columns, $4,600.

2. (B): Your T-chart should have the $2,500 and the $500 in the Out column.
When the option is exercised the exercise price of $2,500 is placed into the In
column because puts cross (across from the options premium). You now should
have 3,000 Out and $2,500 In which provides a capital loss of $500.
Out In
2500 2,500
500

3. (D): To get the break even, look at the T-chart and make the column with the
smaller number (right column has a value of zero) equal to the column with the
larger number, for one share (30). That is the breakeven for this strategy.
Out In
2500
500
3,000

4. (D): As you can see in the above T-chart, the In column has a blank side. That
means the potential gain is unlimited.
5. (D): With a long stock position, buying puts would offer a hedge in case the
market prices start to fall. The premium of the put would increase as the stock
price falls.

NASD Series 7 Page 316

 Customer Accounts
Margin
Brokerage Support Services
 Customer Accounts

Section 41: Customer Accounts

41.1 NEW ACCOUNT FORM
Customer accounts are the foundation of the brokerage business. The purpose of
a new account is to document the basic information about the account and it must
be kept on file with the broker-dealer as long as the account remains open. The
registered representative is responsible for collecting the necessary information
and filling out the form itself.
The following information is required on the new account form;
Customer name and address
Home phone and business phone
Occupation, employer and type of business
Citizenship
Whether customer is legal age or not. The date of birth is NOT required
Social Security or Tax ID number
Estimated income and net worth
Investment objectives
Investment experience
Bank reference (bank name - address - account number)
Tax bracket (required by the MSRB)
Whether customer is an employee of another broker-dealer
Whether customer is an officer, director or 10% shareholder of a public corpo-
ration
41.2 SUITABILITY ISSUES
41.2.1 NYSE Know Your Customer Rule
This rule states that the registered representative and the member firm use
due diligence to learn the essential facts relative to every customer, every
order and every cash and margin account carried by the member firm.
If a customer refuses to furnish any of the essential information the firm can
still open the account if it believes that the customer has the financial
resources necessary to support the account.

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A Registered representative can only make recommendations if all the

essential information is furnished.
If all the essential information is NOT furnished the registered representa-
tive can still place a trade even if he/she believes the trade is unsuitable for
the customer as long as the trade ticket is marked Unsolicited.
41.2.1.1 Investment Objectives
The registered representative should ask the client if he/she is inter-
ested in growth, income, protection of capital, retirement etc.?
Also, is the customer willing to assume risk for a potentially greater
return?
41.2.1.2 Investment Experience
Questions need to be asked about prior investment experience includ-
ing the types of securities; i.e. length of time investor has been trading a
particular type of security.
41.2.1.3 Existing Portfolio
The registered representative should learn about what securities are cur-
rently being held and whether further diversification is needed.
41.2.1.4 Tax Status and Tax Bracket
Are municipal or tax sheltered investments appropriate for the customer?
41.3 OPTIONS ACCOUNTS
A separate options agreement must be filled out, signed and approved by the
broker-dealer. This is a requirement of the Chicago Board of Options Exchange
(CBOE).
Before the account can be opened (prior to the first trade) the customer must
receive the latest Options Disclosure Document. This document is similar to a
prospectus and describes options including risks. The date that the customer was
sent the disclosure document must be indicated on the new account form.
The CBOE requires that the customer must return the signed Options
Agreement to the firm no later than 15 days after the account is opened.
If the agreement is not received from the customer within 15 days, no new
trades can be initiated in the account. However, closing transactions are
allowed.
If the customers financial situation materially changes the CBOE requires
the option agreement to be amended to reflect those changes.

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 Customer Accounts

The registered representative must sign the new account form indicating
that the registered representative believes that the information is true and
accurate.
The branch office manager of a NYSE firm or principal of an NASD firm
(Series 24) must also sign the form accepting the account before trading can
begin.
4 1 . 4 D A Y TR A D I N G A C C O U N TS
Those who day trade do so with the intent to engage in many trades during a day.
They do not carry positions over night, hence the name day trade. The NASD
requires much more detailed information about day traders than regular investors.
Prior to opening an account, the member firm must furnish the customer
with a disclosure that generally states the following;
Day trading can be extremely risky
Day trading requires knowledge of the securities markets as well as the firms
operations
Day trading will general substantial commissions to the firm promoting the
strategy
Potential day traders should be wary of exaggerated claims about the poten-
tial profits of day trading
Day trading on margin can result in losses greater than ones investment
Persons who day trade for others must be registered as an Investment Advi-
sor or a Broker-Dealer.
41.5 NEW ACCOUNT APPROVAL
Managers or supervisors signing a new account form for approval purposes must
be licensed to do so.
The NYSE requires that a NYSE Branch Manger sign the new account form.
This person has passed the Series 9/10 exam which was formerly known as
the Series 8 exam.
The NASD requires that new accounts at non-NYSE firms be approved by a
General Securities Principal. This person must have passed the Series 24
exam.
The CBOE requires that a Senior Registered Options Principal (SROP)
sign the new options account agreement prior to trading by a customer. This

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Customer Accounts

person must have passed the Series 4 (SROP) exam or the Series 9/10
exam.
The MSRB requires that a Registered Municipal Securities Principal sign
the form if municipal bonds are to be traded. This person must have passed
the Series 53 Municipal Principal exam or the Series 9/10 exam.
While the registered representative and appropriate supervisor must sign a
new account form, there is NO requirement that a customer sign the form.
The customers signature may be needed on an Options Agreement or Mar-
gin Agreement, however.
41.6 OPENING THE NEW ACCOUNT
In most cases any competent person of legal age may open a brokerage
account. There are different types of accounts available, different procedures and
even different payment and delivery instructions after the account is open.
Regarding payment and delivery instructions, customers can select any of the fol-
lowing;
Transfer and Hold in Safekeeping: Securities are registered in the cus-
tomers name, and the broker-dealer holds them in safekeeping.
Transfer & Ship: Securities are registered in the customers name and
shipped to him/her.
Hold in Street Name: Securities are registered in the broker-dealers
name and held by the broker-dealer. Although the broker-dealer is the securi-
ties normal owner, the customer is their beneficial owner. When dividends
are paid by corporations owned by the customer, the dividends are sent to
the broker-dealer for distribution to the clients that are entitled to them.
Delivery vs. Payment (DVP): DVP securities are delivered to a bank or
depository against payment. This type of account is normally used for institu-
tional accounts. Instead of regular settlement this is a cash-on-delivery
(COD) settlement.
41.6.1 Account Approval
A partner or principal of a broker-dealer must approve every new account in
writing on the account form before or promptly after the completion of the first
transaction in the account.
41.6.2 Mailing Instructions
When opening a new account a customer needs to give specific mailing
instructions for statements and trade confirmations.The customer can elect to

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 Customer Accounts

send duplicate statements and trade confirmations to someone who holds a

power of attorney or to anybody else.
41.7 CASH ACCOUNTS
A cash account is the basic account that can be opened. Anyone eligible to open
an investment account can open a cash account. In the cash account customers
pay in full for any securities purchased.
Certain accounts can only open cash accounts (margin not permitted). These
cash only accounts include;
IRA
TSA
Keogh
Tax sheltered annuities
Corporate retirement accounts
Custodial accounts (UGMA/UTMA)
41.8 MARGIN ACCOUNTS
In a margin account the customer deposits a portion of the funds to buy a security
and the balance is borrowed by the customer from the broker-dealer.
41.8.1 Margin Account Features (Detail Discusssed Later)
Interest is charged on the loan by the broker-dealer
Collateral is needed for the loan (securities purchased). A Hypotheca-
tion Agreement is signed for this purpose.
Margin securities are held in street name
If the loan isnt paid, the brokerage firm has the right to sell the securi-
ties and use the proceeds to repay the loan
Credit agreement needs to be reviewed and signed by the customer
A loan consent agreement gives the firm permission to lend securities
held in the margin account to other brokers, usually for short sales. It is
NOT mandatory for the customer to sign the loan consent agreement.

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NASD Series 7 Page 324

 Types of Accounts

Section 42 Types of Accounts

42.1 RETIREMENT ACCOUNTS
Each type of personal and corporate retirement account has its own forms and
applications. The most important are those that establish the firms custodial
relationship with the retirement account owner. This is necessary for IRS reporting
purposes.
42.2 JOINT ACCOUNTS
When more than one person is named on an account a joint account needs to be
opened. There are two options to choose from when registering joint accounts.
They are;
42.2.1 Joint Tenancy With Rights of Survivorship (JTROS)
With JTROS, each party owns an undivided interest in the account.
If one party dies, the other person is the sole owner of the account.
This ownership option is most common for husband and wife
42.2.2 Joint Tenancy in Common
Each person specifies a percentage interest in the account.
If a person dies, his/her percentage interest is included in his/her estate.
The interest can be passed by will to any named person.
This ownership option is most common for business partners.
4 2 . 3 TR A N S F E R ON DEATH (TOD)
This type of registration allows one person to maintain full control over the
account.
The registration transfers to the name of the beneficiary only upon death.
This also helps to avoid probate since the estate is bypassed.
The TOD is being used by elderly parents and a married child. If a divorce
takes place with the child, the elderly parent can still get control over the
account.
TODs are also used in second marriages in which the adults have children
from their first marriage.

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42.4 CORPORATE ACCOUNT

Corporate accounts must include a corporate resolution authorizing the account
and identifying which members of the corporation may trade in the account. The
resolution needs to be signed by the secretary of the corporation identifying offic-
ers authorized to make transactions.
42.5 PARTNERSHIP ACCOUNT
A copy of the partnership agreement must be obtained. The agreement will have
a clause allowing the opening of the account and naming specific partners autho-
rized to trade. An amended partnership agreement must be obtained each year,
if changes have been made.
42.6 FIDUCIARY ACCOUNTS
Fiduciary accounts, also known as custodial accounts, contain securities in
which a person other than the owner initiates the trades. The most familiar exam-
ple of a fiduciary account is a trust account. The manager or trustee is known as
the fiduciary.
The types of fiduciary accounts are;
Trust accounts
Guardian accounts
Executor of Estate
Administrator of an Estate
Conservator for Incompetent
Receiver in Bankruptcy
42.6.1 Fiduciary Account Features
A fiduciary or custodial account allows a person other than the owner to initiate
trades. The most popular example of a fiduciary account is a trust account. The
manager of the account is known as a fiduciary.
In a fiduciary account the investments exist for the owners beneficial interest
even though the owner may have little or no legal control over them. The fidu-
ciary makes all of the investment, management and distribution decisions.
However, the fiduciary must manage the account in the owners best inter-
ests.

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 Types of Accounts

While a fiduciary may be reimbursed for reasonable expenses incurred in

managing the account he/she cannot use the accounts contents for his/her
own benefit.
Some more features of a fiduciary account;
Fiduciary accounts cannot be opened unless the proper documentation
appointing the fiduciary is received by the broker-dealer.
Generally prohibited from margin transactions unless the trusts documents
appointing the fiduciary specifically authorizes margin transactions.
Some states prohibit certain types of investments.
The fiduciary is held to the prudent person rule when trading securities.
42.6.2 Trust Account Required Paperwork
Copy of the trust agreement must be obtained.
Agreement needs to specify the types of transactions that the trustee is
allowed to perform.
Accounts cannot use margin unless specifically authorized by the trust
agreement.
42.6.3 Guardian Account Required Paperwork
Legal guardian is a person appointed by a court to protect the assets of a
minor or an incompetent adult.
A copy of the court order appointing the guardian must be obtained.
Account cannot be opened only in the name of the minor or incompetent
but can be added to the guardians name; i.e. Robert Green Custodian
for Johnny Green UTMA
42.7 POWER OF ATTORNEY
A power of attorney is generally used to allow non-account holders to trade in an
account belonging to another. The trading authorization usually takes the form of
a power of attorney. The authorization must be given in writing and must be
signed by the customer. The authorization stays in force unless revoked in writ-
ing by the customer or if the customer dies.

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42.7.1 Types of Trading Authorizations

Limited Trading Authorization
A limited trading authorization allows an individual to have some, but not
total, control over an account. The document usually specifies the level of
access the person may exercise.
This limited power allows the entering of buy and sell orders but does not
alone the withdrawal of funds frome the account. To withdraw funds a full
trading authorization would be required.
Full Trading Authorization
This type of power allows someone who is not the owner of the account to
deposit or withdraw cash or securities and/or
Make investment decisions for the account owner.
42.8 DISCRETIONARY ACCOUNTS
The purpose of a discretionary account is to allow a customer to give the broker-
dealer via the registered representative trading authorization.
Because of the type of Series 7 Exam questions you will encounter it is quite
important that you first understand what consists of a discretionary trade. Dis-
cretion as defined by the regulatory authorities is when the registered representa-
tive decides;
What security should be bought or sold
The number of shares to be bought or sold
If the customer, on the other hand, tells the broker what to buy or sell and how
many shares but leaves the time and day of execution to the broker then the
trade would NOT be considered discretionary and special paperwork would not be
needed.
Some regulatory stuff to consider about discretionary accounts;
Each discretionary order must be identified as such at the time it is entered
for execution.
A firms principal must approve orders promptly, frequently and systemat-
ically in order to avoid the possibility of churning the account, suitability and
excessive size violations.
A record must be kept of all transactions.

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 Types of Accounts

42.9 UNIFORM GIFTS TO MINORS ACCOUNTS

There are two types of gifts to minors accounts. One is known as Uniform Gifts
to Minors Act (UGMA) and the other is the Uniform Transfers to Minors Act
(UTMA). For Series 7 purposes they both have the same features. The states
make the decision as to which act they will follow.
As an example, the State of Illinois follows the UTMA act, not the UGMA act.
Features of the UGMA/UTMA accounts;
The person making a gift of securities to a minor under these acts is known
as the donor.
Any adult can open a custodial account.
All securities must be registered in the name of the account.
Free credit balances are not permitted. Any cash sitting in an account should
be swept into a money market.
One custodian per account.
One minor per account.
Margin is NOT permitted in the account, cash only.
Gifts are irrevocable. Once a gift is given it cannot be taken back.
The Social Security of the minor is required.
Custodian must act as a prudent person when trading in the account.
Investment decisions must take into account a minors age and the custodial
relationship.
Commodities futures, naked options and other high-risk securities are exam-
ples of inappropriate investments.
At legal age the account must be transferred into the name of the new adult.
Third party trading is not authorized in these accounts.
Custodian cannot borrow money from the account.

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42.9.1 Kiddie Tax Rule

The minors social security must be on the account.
The minor must file an annual income tax return and pay taxes on any
income exceeding $1,500 produced by the UGMA/UTMA at the parents top
marginal tax rate until the minor reaches the age of 14.
When the minor reaches age 14 the account will be taxed at the minors tax
rate, not the parents.
42.9.2 Minors Death
If the minor beneficiary of an UGMA/UTMA dies, the securities in the
account pass to the minors estate, not to the parents or custodians estate.
In the event of the custodians death or resignation, either a court of law or
the donor must appoint a new custodian.
42.10 ACCOUNTS FOR INVESTMENT ADVISERS
An investment adviser is a person that a person entrusts to manage his/her
money and/or securities. The investment adviser opens an account with a broker-
dealer to perform trades for that customer.
It is not uncommon for an adviser to have hundreds, even thousands of custom-
ers. Special accounts called Omnibus accounts are established to handle
investment adviser clients.
42.10.1 Opening An Omnibus Account
Individual new account forms must be filled out for each customer
Third party trading authorizations must be signed as the customers are
giving power of attorney to the investment adviser.
All the investment advisers clients are grouped together under one mas-
ter account (omnibus).
42.10.2 Investment Adviser Account Features
Clients are generally charged an annual management fee based on the
value of the assets under management.
Confirmations of trades and statements are sent to both the customer and
the investment adviser.
These accounts are generally referred to as wrap accounts as all account
services are included under the annual management fee.

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 Types of Accounts

4 2 . 11 N U M B E R E D A C C O U N T S
Those customers that wish to keep their names confidential would open up num-
bered accounts. Order tickets and other customer records do not show customer
names. However, if numbered accounts are used, the broker-dealer is obligated
to keep on file the name of the customer and a written statement signed by the
customer showing that the customer owns the account.
42.12 ACCOUNT MAINTENANCE RULES
Trade confirmations must be mailed out no later than the day after the trade.
Brokerage firm statements must be mailed to customers at a minimum of
quarterly. However, if there is any activity in the account such as trades or
receiving dividends, as an example, statements must be mailed monthly.
Under NYSE rules, customer mail must be sent to the customers address
on the new account form or to a post office box designated by the customer.
Mail cannot be held by the brokerage firm, nor can it be directed to the regis-
tered representatives office.
If a customer will be traveling and requests in writing that the mail be held,
this is allowed.
Mail can only be held for two months if the customer is traveling in the
United States and three months if traveling out of the country.
Registered representatives must keep the following records under the NYSE
rules;
- Copy of the new account form
- Chronological record of trades
- Current account statement showing positions
Accounts are the property of the broker-dealer. Typically when a registered
representative leaves the firm, the branch manager will distribute that per-
sons accounts to other representatives in the branch.
If given a new account which a former registered representative had, it is
imperative for the current representative to contact the customer to review
the information on the new account form and update the form as necessary.
The branch manager must approve of all transfers of accounts made within
the branch.

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If a customers confirmation contains an accidental error a new corrected

confirmation will be sent to the customer. The correct terms of the trade will
prevail.
If there is an error in trade execution, the firm is obligated to make good on
any order that was mistakenly executed. As an example, if a customer put in
a trade for 500 shares @ $10 and the order was filled by buying only 100
shares, the firm is obligated to make good on the order and provide the cus-
tomer with the 500 shares, not just 100 shares, assuming that the market
price would have allowed that particular order to be executed.
4 2 . 1 3 TR A N S F E R OR CLOSING OF ACCOUNT
If a customer wants an account closed a signed letter must be sent to the broker-
dealer by the customer. The same would apply if a client wants the account trans-
ferred to another broker-dealer.
42.13.1 Account Transfer
The customer fills out and signs a transfer instruction form at the new
firm detailing all positions in the account.
The new firm that will receive the account must immediately submit the
instructions to the firm that currently carries the account.
When the carrying firm receives the transfer form, it must freeze the
account to be transferred. The broker on the account is notified and all
open orders must be canceled with no new orders accepted.
Upon receipt of the transfer form, the old firm that currently carries the
account has three business days (regular way settlement) to verify the
positions and validate them or take exception to the listing.
If exceptions are found, they must be resolved promptly.
Upon validation of the transfer instructions, the carrying member must
return the transfer form to the new firm, with an attachment indicating all
securities and money positions of that customer.
Within three business days of validation, the transfer must be completed
to the new firm. At this point, the new firm has taken physical possession of
the securities.
If a position cannot be transferred, such as a proprietary mutual fund sold
by the current firm, the customer needs to be notified to sell the fund so
the sales proceeds can be transferred as directed.

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 Types of Accounts

42.14 DEATH OF A CUSTOMER

If a registered representative learns that a customer has died, the broker-
dealer must;
Cancel all open orders
Freeze the account
Note that the customer is deceased with the date on the new account form
Await further instructions from the executor of the estate
Notes

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Notes

NASD Series 7 Page 334

 Margin Accounts

Section 43: Margin Accounts

43.1 MARGIN OVERVIEW
The purpose for margin accounts is to have the ability to purchase securities on
credit just like using a credit card to make purchases in stores etc. Instead of bor-
rowing money from a bank, however, money is borrowed from the broker-
dealer. The use of margin provides investors with the capability of using leverag-
ing to maximize potential returns. Leveraging magnifies the customers rate of
return or rate of loss in when experiencing adverse market conditions. In other
words, margin provides the use of other peoples money to finance the purchase
of securities.
4 3 . 2 M A R G I N A G R E E M E N T TE R M I N O L O G Y
This is the best place to start. When opening a margin account the customer signs
a margin and credit agreement.
Credit Agreement: This agreement discloses the terms of the credit
extended by the broker-dealer, including the method of interest computation
and situations under which interest rates may change. This form MUST be
signed by the customer.
Hypothecation: Customer pledge their securities to the broker-dealer in
return for the loan. This is known as Hypothecation. This form MUST be
signed by the customer.
Rehypothecation: Broker-dealers take the customers pledged securities
to its bank and borrows money against the securities which is then used as
loans for margin customers.
Loan Consent Form: If the customer signs this form, the loan consent form
gives permission to the firm to loan customer margin securities to other cus-
tomers or broker-dealers, usually for short sales. This form does NOT have to
be signed by the customer.
The broker-dealer provides the customer with a loan which will pay for a por-
tion of the purchase price
The loan to the customer is known as the Debit Balance.
The brokerage firm holds the securities in Street Name (in the name of the
broker-dealer).
Regulation T of the Federal Reserve Board regulates credit between bro-
ker-dealers and customers. Current Reg T is 50% for equities. This means
that customer must provide 50% of the purchase price as initial Reg T equity.

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- As an example, if an investor purchases $10,000 of stock in a margin

account, 50% or $5,000 must be provided by the investor as the initial
Reg T equity. The other $5,000 is provided as a loan by the broker-
dealer and becomes the debit portion of the margin account.
- Broker-dealers and clearing firms can increase the amount required
as Reg T margin, but can never lower the Fed approved amount of
50%. This is known as the House margin rule.
- During volatile markets some house margin rules require additional
margin totaling 65%, 75% and even 100% of the value of the security
when market conditions warrant the increase.
Regulation U of the Federal Reserve Board regulates credit between broker-
dealers and banks.
Reg T does NOT apply to exempt securities such as U.S. Governments,
Agency Issues, Municipal Issues and Commercial Paper. As Reg T does not
apply there is no Reg T requirement when using margin to purchase these
securities.
- In other words, 100% can be charged in a margin account. How-
ever, exchanges can apply minimum maintenance margin rules to
these exempt securities.
43.3 ADVANTAGES OF MARGIN ACCOUNTS
Customers can purchase more securities with a lower initial cash outlay.
Customers can leverage investments by borrowing a portion of the purchase
price.
Broker-dealers can generate interest income for the firm from margin
accounts.
Broker-dealer customers typically trade larger positions because of increased
trading capital, generating higher commissions for the firm.
43.4 MARGINABLE SECURITIES
Generally speaking, only actively traded securities are marginable. These secu-
rities would include;
Securities listed on a stock exchange
NASDAQ issues
Specific OTC issues not included in the NASDAQ but have sufficient vol-
ume to be included on the OTC Margin List published by the Federal
Reserve (Fed).

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Note: New securities and mutual funds being sold are not marginable for a
period of 30 days.
Which securities are marginable or not is determined by the Fed,
Exchanges or the NASD
Exam Alert: Broker-dealers cannot determine which securities are mar-
ginable or not. Broker-dealers do not make the rules, they must follow
them.
4 3 . 5 TY P E S OF ACCOUNTS
Regulation T defines the types of accounts in which transactions can take
place as well as the procedures for collecting funds for those accounts.
There are three types of accounts that you need to become familiar with for the
Series 7 exam.
43.5.1 Cash Account
Any security can be purchased in a cash account.
Payment must be made in full by Settlement date. For equities this is 3
business days. US Governments and options settle the next business day.
There are basically no penalties for settlement date violations.
However, Reg T rules require payment for purchased equities by the (5th)
fifth business day. If payment is not made by this date the following
actions can be taken by a broker-dealer;
- Apply for a Reg T extension: A Reg T extension can be requested
from the Exchange where the stock trades, the Fed or the NASD. A
Reg T extension is good for another 5 business days.
- Freeze the account for 90 days: When an account is frozen the cus-
tomer cannot buy unless paid for with cold cash. If the account is
straightened out the 90 day freeze is removed.
- Sell off any unpaid positions to cover broker-dealer losses.
43.5.2 Arbitrage Account
An arbitrage transaction is the simultaneous buying and selling short of the
same security for purposes of achieving a profit due to a disparity in prices.
43.5.3 Margin Account
Customers can buy a security or sell short in a margin account as long as
Reg T initial margin is met for each transaction. If margin is not used then the

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trades must be paid for by the Reg T deadline of 5 business days or stated
another way, settlement plus 2 (S + 2).
43.6 INITIAL MARGIN REQUIREMENTS
Customers are required to deposit a minimum amount of equity for their
first purchase in a margin account.
The initial deposit for margin accounts is $2,000 under the NYSE/NASD
rules. However, for long (buy) account purchases, if the initial amount of the
trade is under $2,000, 100% of the trade purchase must be paid for.
- Long Example: Billy Jones wants to purchase $1,200 of ABC stock in
a new margin account. Because the purchase is under $2,000, Billy
will have to pay 100% of the purchase or $1,200. In other words, the
use of margin is not allowed.
Short Margin Accounts: For short (sell) accounts, if the initial short sell is
under $2,000 the value of the account must be brought up to the $2,000
level.
- Short Sell Example: Billy Jones now decides to sell short stock with
a total value of $1,200. Because the short sell is under $2,000, unlike
a long margin account, Billy will have to bring up the value of the
account to $2,000. In other words, $800 will have to be deposited into
the margin account by Billy to bring the account up to the $2,000 level.
Day Trading Accounts: For day trading accounts the NYSE and NASD have
set a higher margin minimum of $25,000 because of the higher risks that day
trading is associated with.
Cheap Stock Rule: An additional margin requirement is set if a customer
wants to sell short (not buy) those stocks that are categorized as penny
stocks. The higher margin requirement was put in place to discourage these
short sales. Anticipate at least one question on the following;

Cheap Stock Margin Requirement

Stock Value Margin Requirement

Up to $2.50 $2.50 per share or $2,000 whichever is higher

100% of share value until the share value goes
$2.50 - $5.00
over $5.00
30% of the current market value (CMV) or $5 a
Above $5.00
share, whichever is greater.

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Margin Accounting
4 3 . 7 L O N G A C C O U N T TE R M I N O L O G Y
Long Market Value: This is the current market value of the stock position
that was purchased by the investor.
Debit Account: This is the amount that the broker-dealer loaned the inves-
tor. Each day, interest is charged on the debit balance which increases the
amount owed by the customer. Short-term interest rates apply to debit loans.
Exam Alert: For exam purposes, assume the Debit Balance never
changes unless more securities are charged on margin or the debit
balance is paid down or paid off.
Equity Account: This is the customers net worth in the margin account. It
represents the portion of the securities the customer fully owns.
The Long account equation is LMV (CMV) = Debit (DR) + Equity (EQ).
Another way of stating this is LMV - Debit = Equity. When calculating
answers for long margin account exam questions remember that the total of
the equity and debit is equal to the market value of the account. The LMV will
fluctuate as market conditions change.
SMA (Special Memorandum Account): This is also known as excess
equity which represents the amount of equity in excess of the minimum
equity required by the margin account. For exam purposes compare the SMA
to the credit line of a charge card that you use and remember the following;
- The amount of SMA in a margin account never decreases, just like
the credit line for your charge card.
- If you use all your SMA you wont be able to use anymore, just like
you wouldnt be able to charge any more on your credit card if you
max out your credit line.
SMA can always be used except for the following;
1. Using SMA would place the margin account below the minimum
maintenance threshold which would create a margin call.
2. Using SMA would cause the amount of equity to drop below $2,000.
3. Using SMA to meet a minimum maintenance margin call.
Restricted Account: A margin account that falls below the required Reg T
equity level is known as a Restricted Account.

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Margin Call: A margin call or minimum maintenance call or minimum margin

call is created when the equity in the margin account falls below the NASD/
NYSE minimum maintenance level of 25% of the long market value.
Buying Power: Using SMA to purchase additional securities in a margin
account without having to add any additional cash or equity.
Mark to the Market: Positions in margin accounts are valued at the closing
market price. In addition, as the market value changes during regular market
hours, the equity in the account changes as well.
43.8 LONG MARGIN ACCOUNT MECHANICS
We would recommend using the following setup procedure when dealing with
margin questions on the exam;
Reg T =
CMV =
Debit =
Equity =

The following exercise with explanation will take a long margin account from the
opening position to an increase in value, to a decrease in value and finally to a
margin call.
43.8.0.1 Part 1: Opening a Long Margin Account
Facts: A margin account is opened with a LMV (CMV) of $50,000 with
Reg T at 50%. (You are expected to remember that Reg T is 50%. Nor-
mally they will not give you the Reg T unless they change the value)
Reg T = 50%
CMV = $50,000
Debit = $25,000 (broker-dealer loan to the investor)
Equity = $25,000 (50% Reg T deposit)
43.8.0.2 Part 2: CMV increases to $60,000
CMV = $60,000
Debit = $25,000 (Debit never changes unless charges more or pays down
the loan)
Equity = $35,000 (Remember, $60,000 - $25,000 = $35,000)

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43.8.0.3 Part 3: Establishing Initial SMA

Whenever a long account increases in value there will be excess equity,
which is the same as SMA.
Lets take a look at the Part 2 results to determine the amount of the
SMA.
CMV = $60,000
Debit = $25,000 (Debit never changes unless charges more or pays down
the loan)
Equity = $35,000 (Remember, $60,000 - $25,000 = $35,000)
At this point in the margin problem you need to know how to calculate
how much equity is required according to FED rules. Once you establish
this requirement, any equity in excess of the requirement represents
SMA. If the actual equity level is below the requirement, the account
becomes Restricted.
Use the following lyric to help you establish the required equity level!
- Reg T times the CMV, tells me where my equity needs to be.
Applying the above lyric to the current margin account, Reg T times the
CMV is (50% times $60,000) $30,000. This means that FED rules
require this account to have a minimum of equity of $30,000. But the
account has $35,000. Therefore, the SMA in this account is $5,000.
43.8.0.4 Part 4: Uses of SMA
The Series 7 exam will also test your knowledge as to the various
uses for SMA (excess equity).
Use 1 - Loan: Take the SMA out of the account and use it as cash. If the
investor takes this course of action, the SMA taken out of the account
becomes an additional loan and the amount is added to the debit bal-
ance.

The following is how the margin account would be effected;

CMV = $60,000 New CMV = $60,000 (Not effected)
Debit = $25,000 New Debit = $30,000 ($5,000 SMA loan)
Equity = $35,000 New Equity = $30,000 ($5,000 reduction)

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Use 2 - Buying Power: The SMA can be taken out of the account and
used as buying power to purchase additional securities without taking a
penny out of the investors pocket. Because the cash is being taken out of
the account, just like in the prior example on the preceding page, the
amount of the new purchase is also added to the debit balance.
Exam Alert: There are a number of questions on the Series 7 exam
which will require to calculation of the buying power of available
SMA in an investors account.
Calculating the Buying Power: Use the acronym S M A R T. take the
SMA of 50% and divide it by Reg T. Using the current SMA of $5,000,
divide it by Reg T of 50%. This would equal $10,000. If you thought it
should be $2,500 you multiplied instead of divided. (Use your calculator
even for the simplest calculations)
The above results mean that the investor could purchase $10,000 of
additional securities without taking a penny out of his/her pocket.
Use 3 - Leave the SMA in the account: Remember, no matter what hap-
pens to the market value of the margin account, once SMA is established
it can never decrease in value.
43.8.0.5 Part 5: CMV Increases in Value (Good)
CMV = $60,000 New CMV = $70,000
Debit = $25,000 New Debit = $25,000 (no change)
Equity = $35,000 New Equity = $45,000 (CMV - Debit = Equity)
Establish New SMA: Reg T (50%) times the CMV ($70,000) or $35,000
tells me where my equity needs to be. This account has an equity of
$45,000 but only needs $35,000. Therefore, the SMA has increased to
$10,000.
43.8.0.6 Part 6: CMV Decreases in Value (Not Good)
CMV = $70,000 New CMV = $40,000
Debit = $25,000 New Debit = $25,000 (no change)
Equity = $45,000 New Equity = $15,000 (CMV - Debit = Equity)
Apply lyric to determine minimum Reg T equity requirement. Reg T
(50%) times the CMV ($40,000) or $20,000, tells me where my equity
needs to be.
This account only has $15,000 in equity. Therefore, the account under
FED rules is now Restricted.

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43.8.0.7 Part 7: Restricted Account Rules

Buying Additional Stock: When buying stock in a restricted account
the investor must meet the regular Reg T deposit of 50% of the current
market value just like any purchase in a margin account.
SMA: SMA can even be withdrawn or be used as buying power from the
account unless it places the account into a margin call situation or brings
the equity below $2,000.
Retention Rule: This is the meat of the restricted account rules. When
a sale is made from a restricted account the FED requires that 50%
(coincidental with Reg T 50%) of the proceeds be retained by the broker-
dealer to help pay down the debit balance.
Buying and Selling: If the same amount of stock is bought and sold
from a restricted account the results are a wash. Therefore, there are
no additional requirements. (example: Buy $10,000 and sell $10,000)
Net Sell: If an investor bought and sold stock in a restricted account
resulting with a net sell then 50% of the proceeds from the net sell must
be retained by the broker-dealer to help pay down the debit balance.
- Purchase $10,000 and Sell $20,000. This results with a net sell of
$10,000 (20,000 - 10,000). 50% of the sales proceeds, $5,000 must
be retained to reduce the debit balance.
43.8.1 NASD/NYSE Minimum Maintenance Requirement
While the FED can restrict accounts with the Restricted Account rules, the
NASD and NYSE established the minimum margin, also known as the mini-
mum maintenance requirement.
In a long margin account, the minimum maintenance rule states that 25%
of the current market value must be maintained as equity at all times.
If the equity falls below the maintenance requirement, the investor
receives a maintenance call, also known as a margin call.
43.8.1.1 Part 8: Application of the Minimum Maintenance Rule
CMV = $30,000
Debit = $25,000
New Equity = $5,000
Take 25% of the CMV of $30,000 which is 7,500. However, the equity in
this account is only $5,000. Therefore a margin call will be issued in this
account for $2,500. Under FED rules the account is still restricted.

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43.8.2 Margin Call Rules

The margin (maintenance) call must be paid IMMEDIATELY.
If not paid, the firm must sell out securities to pay for the call.
Cash or marginable stock can be used to meet the margin call, but not
the use of SMA.
Marginable stock can be used to meet the call. The dollar amount of mar-
ginable stock required is twice the amount of the margin call.
- Example: If a margin call is for $5,000 an investor can provide mar-
ginable stock with a current market value of double that amount of
$10,000. The reason for this is that the stock has a 50% loan value
according to Reg T.
4 3 . 9 S H O R T A C C O U N T TE R M I N O L O G Y
Short Market Value: This is the current market value of the stock position
that was purchased by the investor.
Equity Account: This is the customers net worth in the margin account. It
represents the portion of the securities the customer fully owns.
Credit Balance: The Credit Balance represents the sum of the short market
value (CMV or SMV) and the equity. The credit balance does NOT change
unless additional short positions are opened or the account is closed.
The Short account equation is SMV (CMV) + Equity (EQ) = Credit (CR).
Another way of stating this is Credit - SMV = Equity. When calculating
answers for short margin account exam questions remember that the total of
the equity and current market value is equal to the credit. The SMV will fluctu-
ate as market conditions change.
SMA (Special Memorandum Account): This is also known as excess
equity which represents the amount of equity in access of the minimum
equity required by the margin account.
- The amount of SMA in a margin account never decreases, just like
the credit line for your charge card.
- If you use all your SMA you wont be able to use anymore, just like
you wouldnt be able to charge any more on your credit card if you
max out your credit line.
Restricted Account: A margin account that falls below the required Reg T
equity level is known as a Restricted Account.

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 Margin Accounts

Margin Call: A margin call or minimum maintenance call or minimum margin

call is created when the equity in the margin account falls below the NASD/
NYSE minimum maintenance level of 30% of the short market value. Notice
here that the short account has a higher minimum maintenance requirement
than does a long account. This is because of the additional risk of a short
account when compared to a long account.
Shorting Power: Using SMA to sell short additional securities in a margin
account without having to add any additional cash or equity.
43.10 SHORT MARGIN ACCOUNT MECHANICS
We would recommend using the following setup procedure when dealing
with margin questions on the exam;
Reg T =
CMV =
Equity =
Credit =

43.10.0.1 Part 1: Opening a Short Margin Account

Facts: A margin account is opened with a short sell value (SMV) of
$10,000 with Reg T at 50%. (For test purposes you are expected to
remember that Reg T is 50%. Normally the test will not give you the Reg T
unless it is other than 50%)
Reg T = 50%
CMV = $10,000
Equity = $5,000 (50% Reg T deposit)
Credit = $15,000 (CMV plus the equity)
43.10.0.2 Part 2: CMV decreases to $8,000 (good)
CMV = $8,000
Equity = $7,000 (Credit - CMV = Equity)
Credit = $15,000 (Remember, credit stays the same)

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43.10.0.3 Part 3: Establishing Initial SMA

Whenever a short account decreases in value there will be excess equity,
which is the same as SMA.
Lets take a look at the Part 2 results to determine the amount of the
SMA.
CMV = $8,000
Equity = $7,000
Credit = $15,000
At this point in the margin problem you need to know how to calculate
how much equity is required according to FED rules. Once you establish
this requirement, any equity in excess of the requirement represents
SMA. If the actual equity level is below the requirement, the account
becomes Restricted.
As a reminder use the following lyric to help you establish the required
equity level!
- Reg T times the CMV, tells me where my equity needs to be.
Applying the above lyric to the current margin account, Reg T times the
CMV is (50% times $8,000) $4,000. This means that FED rules require
this account to have a minimum equity of $4,000. But the account has
$7,000. Therefore, the SMA in this account is $3,000.
43.10.0.4 Part 4: CMV Increases in Value (Not Good)
CMV = $8,000 New CMV = $13,000
Equity = $7,000 New Equity = $2,000 (CR - CMV)
Credit = $15,000 New Credit = $15,000 (Stays the same)
Apply lyric to determine minimum Reg T equity requirement. Reg T
(50%) times the CMV ($10,000) or $5,000, tells me where my equity
needs to be.
This account only has $2,000 in equity. Therefore, the account under
FED rules is now Restricted.

Go to the next page

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43.10.1 NASD/NYSE Minimum Maintenance Requirement

While the FED can restrict accounts with the Restricted Account rules, the
NASD and NYSE established the minimum margin, also known as the mini-
mum maintenance requirement.
In a short margin account, the minimum maintenance rule states that
30% of the current market value must be maintained as equity at all times.
If the equity falls below the maintenance requirement, the investor
receives a maintenance call, also known as a margin call.
43.10.1.1 Part 5: Application of the Minimum Maintenance Rule
CMV = $13,000
Equity = $2,000
Credit = $15,000
Take 30% of the CMV of $13,000 which is 3,900. However, the equity in
this account is only $2,000. Therefore a margin call will be issued in this
account for $1,900. Under FED rules the account is still restricted.
4 3 . 11 C O M B I N E D M A R G I N A C C O U N T S
Be prepared to answer a number of questions on the Series 7 exam asking you to
calculate the Net Equity of a long and short margin position.
You will first be shown the textbook method and then an alternate method which
we believe is simpler. However, the choice will be yours.
43.11.1 Question: What is the net equity of this margin account?
Long market value = $30,000
Short market value = $20,000
Debit Balance = $8,000
Credit Balance = $19,000
43.11.1.1 Textbook Method
Long Account Short Account
LMV = 30,000 SMV = 20,000
Debit = 8,000 Equity = -1,000 (Credit - SMV)
Equity = 22,000 (CMV - Debit) Credit = 19,000

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Net Equity = Long equity of $22,000 plus Short equity of - $1,000 which
equals $21,000.
43.11.1.2 Alternative Method
Long market value = $30,000
Short market value = $20,000
Debit Balance = $8,000
Credit Balance = $19,000
Using the same facts as above, you will be subtracting what you
Owe from what you Own as follows;

Alternative Method (We believe easier)

Own Owe

Long market value - 30,000 Short market value - 20,000

Credit balance - 19,000 Debit balance - 8,000
Total Own = 49,000 Total Owe = 28,000

Total own of $49,000 minus Total Owe of $28,000 = Net Equity of $21,000

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43.12 MARGIN REVIEW QUESTIONS

1. John D buys 500 shares of PTS Inc. at $50 in a margin account with Reg T
at 50%. After making the deposit, what is the investors debit balance?
A. $25,000
B. $12,500
C. $13,000
D. $50,000
2. Credit from bank to broker is controlled under;
A. Regulation A
B. Regulation T
C. Regulation U
D. Regulation Z
3. Generally, new issues cannot be margined for;
A. 10 days
B. 20 days
C. 30 days
D. 60 days
4. What are initial and maintenance margins for stock positions in a long
margin account?
A. 50 / 50
B. 50 / 35
C. 50 / 30
D. 50 / 25
5. An investor opens a new margin account and buys 400 shares of PTS @
25. What is the investors initial margin requirement?
A. $5,000
B. $7,500
C. $8,000
D. $10,000
6. An investor has an established margin account with a CMV of $5,000 and
a debit balance of $2,000. How much equity does the investor have in the
account?
A. $500
B. $2,500
C. $1,000
D. $3,000

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7. A customer sells short 2000 shares of PTS stock at $10, as the initial
transaction in a new margin account. The customer must deposit;
A. $5,000
B. $2,000
C. $10,000
D. $20,000
8. An investor buys 1,000 shares of PTS at $100 in a margin account. If PTS
drops to $66 what is the maintenance call?
A. $0
B. $500
C. $1,000
D. $2,000
9. A customer has a restricted margin account with a LMV of $33,500. If the
customer wishes to sell $15,000 of securities which of the following is true;
A. Do nothing special
B. Limit the sale to 50% of the LMV
C. Broker-dealer retains 7,500 of the proceeds
D. Pays a special fee of 25%
10. The approval to open a new margin account is given by the;
A. Customer
B. Registered representative
C. General securities principal
D. NASD

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43.13 MARGIN REVIEW ANSWERS

1. (B): The CMV is $25,000. Therefore the required Reg T deposit of 50% or
$12,500. The debit balance (loan) is also $12,500.
2. (C): Reg U regulates credit between banks and broker-dealers while Reg T reg-
ulates credit between broker-dealers and customers.
3. (C): New issues cannot be margined for a period of 30 days.
4. (D): For long accounts the initial margin is Reg T of 50% while the NASD/NYSE
minimum maintenance rule requires maintaining 25% of the CMV as equity at all
times. For short accounts the numbers are 50 / 30 (not 25).
5. (A): The Reg T requirement is 50% of the purchase value of $10,000 or $5,000.
6. (D): With a CMV of 5,000 and a Debit of $2,000 the Equity would be $3,000.
7. (C): The short market value is $20,000. Therefore the investor must place into
the account the Reg T requirement of 50% or $10,000.
8. (B): The long market value initially was $100,000. Therefore, both the debit and
equity was $50,000 each. With the LMV dropping to $66,000, the debit stays the
same so the equity decreases to $16,000. The NASD/NYSE minimum mainte-
nance rule states that there must be a minimum of 25% of the LMV as equity.
Well, 25% of $66,000 is $16,500 and the equity is only $16,000. Therefore there
will be a margin (maintenance) call of $500.
9. (C): When an account is restricted the broker-dealer must retain 50% of the
proceeds to apply to the debit balance.
10. (C): Initially, the general securities principal of an NASD firm or branch man-
ager of NYSE firm must sign the margin account along with the registered repre-
sentative.

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Notes

NASD Series 7 Page 352

 Brokerage Support Services

Section 44: Brokerage Support Services

44.1 OVERVIEW
Brokerage firms are required to follow strict procedures for maintaining accurate
and thorough client information. The Series 7 exam expects you to know all there
is about broker-dealer services that supports the sales efforts.
44.2 PROCESSING OF AN ORDER
It is just as important to learn about the various broker-dealer departments that
support sales orders as it is to process the order.
Lets take a look at the various broker-dealer departments that has to do
with the routing of orders;
44.2.1 Order Department
The order department is also known as the Wire Room and Order Room.
This department transmits orders to the proper markets for trade execu-
tion.
Completed trade tickets are sent to the registered representatives who
initiated the trades as well as to the Purchase and Sales Department.
44.2.2 Purchase and Sales Department
Records all transactions in a clients account
Handles all billing
Computes the dates on which clients must deposit money and the deposit
amount
44.2.3 Margin or Credit Department
Activities involving credit for cash and margin accounts
Computes the dates on which clients must deposit money and the deposit
amount
44.2.4 Cashiering Department
Receiving and delivering of securities and money
Issues payment only if the margin department instructs it to do so
Sends certificates to transfer agents to be transferred and registered

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Forwards certificates to clients

44.2.5 Clearing Firms
A clearing firm such as National Financial Services (NFS) or US Clearing or
Prudential etc. helps simplify the process by providing specialized compari-
son clearance and settlement services. In fact, a clearing firm acts as a
bookkeeper for many broker-dealers.
Most independent brokerage firms are also know as correspondence firms
which means the clearing firms of their choice also holds client accounts and
records.
44.2.6 Reorganization Department
Handles transactions that represents a change in the securities outstand-
ing.
Exchanging or transmitting customer securities involved in the following;
- Tender offers (company buying back outstanding securities)
- Bond calls
- Redemptions of preferred stock
- Redemptions of bonds
- Mergers
- Acquisitions
44.2.7 Dividend Department
Credits customer accounts with dividends and interest payments for
securities held in the firms name. Remember, when securities are held in
Street Name, corporations send the dividends to the brokerage firm, not
the customer. This department now must redistribute the dividends to the
correct customers.
44.2.8 Proxy Department
Sends proxy statements to customers whose securities are held in the
firms name.
It also sends out financial reports and other publications received from
the issuer for its stockholders.
Maintains the ledger that lists each stock owner and the certificates loca-
tion.

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44.2.8.1 Route of an Order

Customer
Cashiering
1 6 Department
Registered
Representative 9

2 5 8 Purchases
and Sales
Order Department Department
7
(Wire Room)
9
3 4
Margin
Market Department

44.2.8.2 Route of an Order Detail

1. Customer places the order with a registered representative.
2. The registered representative sends the order to the order depart-
ment, also known as the wire room.
3. The order department sends the order to the appropriate market,
such as the NYSE, for execution.
4. The trading market sends a wire report of execution back to the order
department.
5. The order department sends a report of execution back to the regis-
tered representative.
6. The registered representative calls the customer to report the execu-
tion of the order.
7. The order department sends the report to the purchases and sales
department.
8. The purchases and sales department sends a confirmation to the
customer and a copy of the confirmation to the registered represen-
tative.
9. The Purchases and sales department processes the trade for settle-
ment through the Margin Dept. (if credit) and Cashiering depart-
ments which delivers the securities and exchanges payment.

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4 4 . 3 TR A N S A C T I O N S
When a registered representative accepts a buy or sell order from a customer,
the registered representative must be assured that the customer can pay for or
deliver the securities.
44.3.1 Order Tickets
For many years registered representatives have entered customer orders by
manually filling out order tickets and then processing the orders through a
manual routing of orders.
In todays brokerage environment most trade tickets are processed electroni-
cally on computers. The orders are then sent to the wire room which transmits
each order to the proper market for execution.
Registered representative still prepares the trade ticket (manually or electron-
ically) and a general securities principal for NASD firms or branch manager
for NYSE firms must approve all trades by the end of the same day.
44.3.1.1 Required Information for Trade Tickets
The following information is required on trade order tickets;
Customer account number
Registered representative rep number
Description of the security along with the symbol
Quantity of securities traded
Where the security is traded (NYSE or Nasdaq etc.)
Action (buy, sell long, sell short)
Options (buy, write, opening, closing, covered, naked)
Price qualifications (market, limit, day order, GTC)
Type of account (cash or margin)
Settlement instructions
Security instructions
Payment instructions
Location of certificates sold

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44.3.1.2 Trade Ticket Example

44.3.2 Execution Report

Registered representatives receive reports after trades are executed.
The representative should check the execution report against the order
ticket to make sure that everything was done as the customer requested.
If everything is in order the trade is reported to the customer.
If an error exists, the rep should report it to a supervisor or manager
immediately.

Go to the next page

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44.3.3 Trade Confirmations

This is a printed document that confirms a trade and associated required
information. For each transaction, a customer must be sent or given a written
confirmation of the trade at or before the completion of the transaction which
would be by settlement date.
Trade confirmations include the following information;
Trade Date: Day on which the transaction is executed.
Settlement Date: Date that the trade settles. For corporate securities
the settlement date would be the third business day after the trade date.
RR No: Registered representatives identification number.
Trade Action: Bought (BOT) or Sold (SLD)
Quantity: Number of shares of stock or the par value of bonds bought or
sold by a customer.
Description: Specific security bought or sold by the customer.
Yield: Indicates the lower of the YTC or YTM .The Current Yield would
also be included.
CUSIP Number: Applicable Committee on Uniform Securities Identifica-
tion Procedures number, if any, for the security traded.
Price: Price per share for stock or bonds before any charge or deduc-
tion.
Amount: Price paid or received before commissions and other charges.
Commission: Added to buy transactions and subtracted from sell trans-
actions completed on an agency basis. A commission will not appear on
the confirmation if a markup has been charged in a principal transaction.
Regulation Fee (Reg.): SEC registration fee subtracted from the sales
made on exchanges and postage.
Net Amount: Obtained on purchases by adding expenses such as
commissions and postage to the principal amount. Whether the transac-
tion is a purchase or sale, interest is always added whenever bonds
are traded with accrued interest.
Disclosure of Capacity: The confirmation must also show the capacity
in which the broker-dealer acts, agency or principal. Firms can never
act as an agent and a principal in the same transaction.

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44.4 CUSTOMER ACCOUNT STATEMENTS

Firms must send each customer an account statement as least quarterly.
If activity takes place then statements are mailed monthly.
Statements must show the following;
- All activity in the account since the previous statement
- Securities positions both long and short
- Account balances, debit or credit
If a customer has a cash balance the firm may hold it in the account. How-
ever, the statement must advise the customer that these funds are available
on request.
44.5 FINANCIAL CONDITION DISCLOSURE
Upon written request, a member firm must deliver a copy of its most recently pre-
pared balance sheet to;
Any customer with securities or cash held by the member; or
A member firm with cash or securities on deposit or transacting business with
the member
44.6 CHARGES FOR SERVICES PERFORMED
Broker-dealer fees and charges must be reasonable
Charges must relate to the work performed, transaction entered or advi-
sory services given.
Charges cannot be unfairly discriminatory between customers.
Most broker-dealers print fee and service charges on each customers
monthly statement
A reasonable fee is one that is not excessive when compared to the fees
other broker-dealers or investment advisers charge for similar services.

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Notes

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44.7 REVIEW QUESTIONS

1. Which department in a brokerage firm would handle applications for
credit?
A. Margin
B. Purchases and sales
C. Sales order
D. Reorganization
2. According to current regulations, customer statements should be sent
how often to clients with inactive accounts?
A. Weekly
B. Monthly
C. Quarterly
D. Annually
3. Trade confirmations must be sent to the client;
A. Daily
B. By the trade date
C. By the settlement date
D. Quarterly
4. Who reports the trade execution to the customer?
A. Supervisor
B. Registered representative
C. Margin department
D. Sales department
5. Which department sends confirmations to customers?
A. Order department
B. Margin department
C. Purchases and sales department
D. Wire room

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44.8 REVIEW ANSWERS

1. (A): The margin department will review customer applications for credit when
buying or selling short securities.
2. (C): If theres no activity then statements should be mailed at least quarterly.
With activity, statements are mailed monthly.
3. (C): Trade confirmations must be sent to the client by the end of the trade which
is the settlement date.
4. (B): The registered representative reports the trade execution to his/her client.
5. (C): Thats the job of the purchases and sales department.

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 Trading Securities
Types of Orders
Stock Exchange Trades
Over-the-Counter Market
Transaction Settlement Rules
 Module 46: Trading Securities

Section 46: Trading Securities

46.1 INTRODUCTION TO TR A D I N G
This Section will review trading activities on the exchanges and over-the-
counter. It is imperative that you understand this area as it is expected that you
have a working knowledge of the markets, trading and associated strategies.
46.2 SECURITIES MARKETS
The market in which securities are bought and sold after the primary market and
IPOs, is known as the Secondary Market. All securities transactions take place in
one of four trading markets.
These four markets are as follows;
First Market: Exchanges
Second Market: NASDAQ - Over-the-Counter
Third Market: (Listed trading on the OTC)
Fourth Market: Institution to Institution
46.2.1 First Market (Listed Market)
The First Market in the Secondary Market is known as the exchange market.
This market is composed of the NYSE and other exchanges on which listed
securities are traded. The term listed security refers to any security listed for
trading on an exchange.
Some of the Regional Stock Exchanges are;
Chicago
Pacific
Philadelphia
American
Boston
46.2.2 Second Market (Unlisted Market)
The Second Market is the NASDAQ or Over-the-Counter market. This market
is known as a Negotiated Market as traders and market makers negotiate
trades over the NASDAQ computerized trading network. Thousands of securi-
ties are traded OTC, including stocks, bonds and all municipal and U.S. gov-
ernment securities.

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46.2.3 Third Market (OTC-Listed)

This market is used as a trading market in which exchange listed securities,
normally found in the First Market, are traded in the OTC market. Broker-deal-
ers registered as OTC market makers in listed securities arrange third market
transactions. Trades must be reported on the Consolidated Tape within 90
seconds of execution.
This market is also used for after hours trading. In theory, this market
remains open 24 hours a day. However, investors need to know that after
hours trading is much less liquid and order flow is very limited. This means
that getting an execution is much more difficult and can be more costly.
46.2.4 Fourth Market (Institutions)
This market provides trading of securities between institutions without using
a broker-dealer. They usually trade large blocks of stock, both listed and
unlisted in privately negotiated transactions. Most transactions are placed
through the Instinet Network. Instinet includes a large number of mutual funds
and other institutional investors among its subscribers.
4 6 . 3 O P T I O N S TR A D I N G
Options trade on exchange floors. The largest option exchange is the Chicago
Board of Options Exchange (CBOE). Notice that the NYSE does NOT trade
options.
The exchanges that trade options are;
Chicago Board of Options Exchange (CBOE)
American Stock Exchange (AMEX)
Philadelphia Stock Exchange (PHLX)
Pacific Stock Exchange (PSE)
4 6 . 4 N Y S E B O N D TR A D I N G
Bonds usually trade in the OTC market. However, the NYSE does limited trading
of corporate bonds for those companies listed on the NYSE. Examples include
bonds issued by IBM, GE etc.
4 6 . 5 TR A D I N G H A L TS
If a trading halt is called for a security, all trading in the security stops in the
market where the halt was declared. Remember, however, even if trading in a
stock is halted, options can be exercised as the strike price determines the
exercise, not the market price of the underlying security.

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46.6 ROLE OF THE BROKER-DEALER

Firms engaged in buying and selling of securities for the public must register as
broker-dealers. While firms act as both brokers and dealers it is important for you
to understand the difference between the two words.
46.6.1 Broker
Brokers are agents that arrange trades for clients and charge commissions
which must be disclosed to the client. Brokers do not buy or sell shares but sim-
ply arrange trades between buyers and sellers.
46.6.2 Dealers
Dealers are known as principals and buy and sell securities for their own
accounts. This is often called position trading and means that the securities
are brought into the firms own securities inventory. Instead of charging a com-
mission, dealers either mark-up the price (known as the net price) of the
security when selling the security to a customer or marks down the price of a
security when purchasing the security from a customer.

Broker vs. Dealer

Broker Dealer

Acts as an agent, transacting orders Acts as a principal, dealing in securities

on the clients behalf
Charges a commission
Is not a market maker
Must disclose its role to the client
and the amount of its commissions
for its own account and at its own risk
Charges a markup or markdown
May make markets and take long or
short positions in securities
Must disclose its role to the client, but
not necessarily the amount or source of
markup or markdown

46.6.3 Ways to Fill an Order

The broker may act as the clients agent by finding a seller of the securi-
ties and arranging a trade
The dealer may buy the securities from a market maker, mark up the price
and resell them to the client
If the dealer has the securities in its own inventory, the dealer may sell the
shares to the client from that inventory

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46.7 DEALER QUOTES

Quotes on securities are in terms of a Bid and Ask. The Ask price is the
price at which the dealer will sell the security to the retail public.
The Bid price is the price at which the dealer will buy the security from a
retail customer who is selling.
As there are no free lunches, the dealer needs to make a profit. The
dealers profit, when acting as a market maker (dealer), is based on the
spread between the Bid and Ask prices.
Bid Ask
PTS 15.25 15.75
As you can see in the above example, there is a $ .50 spread between
the Bid and Ask prices. The dealer makes 50 cents in this example for
each share traded.
Keep in mind that if the broker-dealer was acting as a broker, instead, a
commission would be charged and the spread would have gone to the
market maker of the stock.
46.7.1 Active vs. Thinly Traded Stock
The more active the trading market, the narrower the spread between the
Bid and Ask become. This makes the market more efficient which is better
for customers.
Large spreads are usually found in stock trades that are thinly traded.
An example of this is;
Bid = 15.25
Ask = 17.50
4 6 . 8 N E W YO R K S T O C K E X C H A N G E
The NYSE is the most widely known stock exchange. The NYSE is sometimes
known as the big board. The NYSEs primary objectives are to monitor opera-
tions, facilitate an orderly market and prevent fraudulent practices.
Stocks listed on the NYSE can also be listed on regional exchanges like the Chi-
cago Exchange. However, NYSE listed stocks cannot be listed on the American
Stock Exchange (AMEX).
Stocks listed on the NYSE must meet stringent listing requirements which are
more stringent than registering securities on the other exchanges.

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46.8.1 Auction Market

Securities that are bought and sold on exchanges are done so on an auction
basis. This means auctions are held to buy or sell stock in trading pits in
which specialists conduct the auction eye-to-eye. Exchange markets are
also sometimes referred to as double auction markets as both buyers and
sellers call out their bet bids and offers in an attempt to transact business at the
best possible price.
46.8.1.1 Decimals
The start of decimal trading on the exchanges took place in January
2001. Now, all equity securities as well as options on these securities
trade in increments of one cent (.01).
4 6 . 9 TY P E S OF TR A D E R S
There are four types of traders who can trade on the floor of the NYSE.
46.9.1 Floor Broker
Floor Brokers also known as Commission House Brokers execute orders for
clients and for their firms accounts.
46.9.2 Two-Dollar Broker
If commission brokers get too busy to execute all of a firms orders the Two
Dollar Brokers can be used to execute orders for them.
46.9.3 Registered Trader
These are members of the NYSE who trade primarily for their own accounts. If
they accept a public customers order from a floor broker, they must give that
order priority. They cannot execute their own trades while holding an unfilled
public order.
46.9.4 Specialist
Specialists facilitate trading in specific stocks.
Their main function is to maintain a fair and orderly market in those
stocks. In fulfilling this function, they act as both brokers and dealers.
Must stand ready to buy and sell for his/her own account, if necessary, to
maintain a fair and orderly market.
They act as dealers when they execute orders for their own accounts and
as brokers when they execute orders other members leave with them.
There are about 20 specialist firms handling the approximately 3000
NYSE listed issues.

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Each specialist firm handles about 150 different stocks.

The specialist is the sole market maker in that stock.
Specialist firms are prohibited from dealing with the public.
46.9.4.1 Priority, Precedence and Parity
When more than one broker enters the same bid or offer, the specialist
awards the trade in the following order;
Priority: First order in
Precedence: Largest order of those submitted
Parity: Random drawing
If two orders were received at the same time for the same amount of
shares and only a limited number of shares were available the specialist
would flip a coin to determine who gets the trade fill. This process is
known as Matching.
46.9.5 Volatile Trading Conditions
The NYSE has two rules, Rule 80A and 80B which are intended to protect
against rapid uncontrolled drops in the market.
Currently, program trading (computerized trading by institutions like
mutual fund companies) and index arbitrage (computerized program trad-
ing involving differences in equity indexes) transactions are curbed if the
Dow Jones Industrial Average increases or decreases by 50 points in one
day.
If there is a market decline of 10%, a one-hour halt is imposed.
A market decline of 20% results in a two-hour halt.
A market decline of 30% results in a halt for the remainder of the day.
46.9.6 Stopping Stock
This is a courtesy provided by the specialist for the floor broker. The special-
ist guarantees a price for a public order and stops the completion of the trade
at that price. Now a floor broker who feels that a better price can be obtained,
goes into the crowd to attempt to get a better Bid or Ask.
The worst case scenario for the public client is the guaranteed price by the
specialist. If the broker cannot get a better price, the order with the specialist
will be placed at the stopped price.

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 Module 47: Types of Orders

Section 47: Types of Orders

47.1 ORDER QUALIFIERS
47.1.1 Day Order
A trade order placed as a day order will expire at the end of the trading day
unless filled that day.
47.1.2 Good Till Canceled
A good till canceled order is an open order that is good for a period of six
months. However the orders must be renewed by the last day in April and/or
by the last day in October. The brokerage firm is responsible for the canceling
of any good till canceled orders.
47.1.3 At-the-Open
This order requires the execution at the opening of the trading day after the
order is placed or canceled.
47.1.4 At-the-Close
This order requires the execution as close as possible to the close of trading
on the day the order is placed.
47.1.5 Not Held Order
A not held order is to be filled at whatever time and price the trader thinks
best. But, it must be completed that day. Market orders do not carry over to the
next day.
47.1.6 Fill or Kill (FOK)
Either the entire order is filled on the first try or the order is canceled. There
can be no extra attempts at executing the order.
47.1.7 Immediate or Cancel (IOC)
This type of order must be executed immediately in full or in part. Any part of
the order that remains unfilled is canceled.
47.1.8 All or None (AON)
Either the entire order is filled or the order is not executed. Depending on
the duration specified in the order, a trader is free to attempt an entire execu-
tion again and again until the order expires. These are sometimes known as an
alternative order.

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47.1.9 Either/Or
This type of order specifies two possible trades for a specific total number of
shares, not more.
As an example:
Buy 800 PTS GTC at $50 or Buy 800 PTS GTC Buy Limit 55
As you can see in the above order, the client wants to buy a total of 800
shares of PTS, not 1,600 shares. If one side is filled in total then the other
side would be canceled.
But thats not how youre going to get the test question. The facts will indicate
that one side is partially filled and they will ask how the order appears in the
Specialists Book?
Lets suppose that 200 shares were filled at $50 by the specialist. Both sides
MUST be reduced by the fill. Therefore, the remaining order would indicate
600 shares for both sides of the either/or order, not 800.
47.2 MARKET ORDER
Market orders are placed to buy or sell a security immediately at the best price
available. Market orders guarantee a fill but does not guarantee a specific
price. The customer may be filled at the current market price, at a higher price or
even a lower price, but always at the best Bid and best Ask prices available.
47.3 LIMIT ORDER
Limit orders specify a price at which to buy or sell. There are Buy Limit orders
and Sell Limit orders. A limit order does not guarantee a fill, like a market order,
but does guarantee a specific price or better, if filled.
47.3.1 Buy Limit Order
A limit order to buy is placed below the current market value. The investor
wants to purchase the security but not at the current price.
Buy 100 PTS @ 75 GTC when the CMV of PTS is 78.
- The above order has been placed and will be filled if the stock falls to
75 or lower
- This order will be canceled, if not filled, when the GTC order ends. If
the order was a day order only, the order would be canceled at the
end of the trading day.

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47.3.2 Sell Limit Orders

A limit order to sell is placed above the current market value. The investor
wants to sell the security but not at the current price.
Sell 100 PTS @ 75 GTC when the CMV of PTS is 72.
- The above order has been placed and will be filled if the stock rises
to 75 or higher.
- This order will be canceled, if not filled, when the GTC order ends. If
the order was a day order only, the order would be canceled at the
end of the trading day.
47.3.2.1 Risks & Disadvantages of Limit Orders
Customers who enter limit orders risk missing the chance to buy or sell,
especially if the market moves away from the limit price.
The market may never go as low as the buy limit price or as high as the
sell limit price.
Sometimes a limit order is not filled even if the market price of the secu-
rity matches the stated limit price. This can be the result of other limit
orders that are in front of the non-filled order. (First come first serve)
47.4 STOP ORDERS
For the most part, stop orders are designed to protect a profit or prevent a loss
if the stock begins to move in the wrong direction. Stop orders either become a
market order or a limit order depending on the type of stop order placed.
Stop orders are designed with two steps;
1 Trigger: The trigger transaction at or through the stop price activates (wakes
up) the stop order and becomes either a market or a limit order.
2 Execution: The stop order is executed and the trade is completed.
47.4.1 Sell Stop Orders
The Stop on a sell stop order tells the trader that this order cannot be exe-
cuted until the market touches the specified price or passes below and a trade
takes place which then triggers the order (stop comes off) and becomes a
market order for immediate execution.
Note: The danger of this type of order is that the stock may be sold at a lower
price than the investor anticipated. Remember, a market order only guarantees
a fill not a guaranteed price

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Exam Facts Example #1: Billy Bob bought stock 6 months ago at $25 a share.
Today the stock has a current market value of $65. Billy Bob doesnt really want
to sell the stock but is worried about the recent volatile market. Billy Bob
decides to enter a Sell Stop 53 order. By doing this Billy Bob is saying that if
the value of the stock falls to 53 or lower he wants out.
The Series 7 exam question will provide a trading tape and will ask one or
both of the following questions;
Trading Tape: 65, 65.12, 53.50, 52.12, 52, 51.75, 55, 56
Question 1: The stop order will be triggered at?
To trigger the order, the stock must trade at the stop price of 53 or lower.
Therefore this stop order is triggered at 52.12, which means the order is awak-
ened and then becomes a market order.
Question 2: The trade will be executed at?
As the order is now a market order it will execute immediately on the next
trade. Therefore, according the trading tape above, the order is traded/exe-
cuted at 52.

47.4.2 Sell Stop Limit Orders

The Stop on a sell stop limit order tells the trader that this order cannot be
executed until the market touches the specified price or passes below and a
trade takes place at that price or higher (better) which then triggers the order
(stop comes off) and becomes a limit order for purposes of execution.
Note: The danger of this type of order is that the stock may never be sold as
the current value may fall and stay below the limit price in the order. Remem-
ber, unlike a market order, a limit order only guarantees a specific price, not
a fill.
Exam Facts Example #2: Billy Bob bought stock 6 months ago at $25 a share.
Today the stock has a current market value of $65. Billy Bob doesnt really want
to sell the stock but is worried about the recent volatile market. Billy Bob
decides to enter a Sell Stop Limit 53 order. By doing this Billy Bob is saying
that if the value of the stock falls to 53 or lower he wants to sell the stock but
would accept nothing less than 53.

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The Series 7 exam question will provide a trading tape and will ask one or
both of the following questions;
Trading Tape: 65, 65.12, 53.50, 52.12, 52, 51.75, 55, 56
Question 1: The stop order will be triggered at?
To trigger the order, the stock must trade at the stop price of 53 or lower.
Therefore this stop order is triggered at 52.12, which means the order is awak-
ened and then becomes a limit order of 53.
Question 2: The trade will be executed at?
As the order is now a limit order it will only execute if the stock rises to 53
or higher. Therefore, according the trading tape above, the order is traded/
executed at 55. (53 or higher)
47.4.3 Buy Stop Orders
A buy stop order protects a profit or limits a loss in a short stock position.
The buy stop is always entered at a price above the current offering price,
and is triggered when the market price touches or goes through the buy stop
price.
Generally, buy stop orders are popular for investors who sell short stock
and who want to buy insurance in case their position goes in the wrong
direction.
Remember, selling short transactions are for those persons who believe
a stock is going to fall in value. If theyre correct the stock would fall in
value and they close their position by buying the stock so as they can return
the borrowed shares to their broker-dealer at a reduced price.
However, if the stock value goes up instead, a buy stop order will automat-
ically fill if the stock rises to a certain price. This protects the investor in
case the price of the stock increases dramatically.
The other reason for a buy stop order is when an investor using technical
analysis determines that if a stock breaks out of its trading range it
should increase in value. If the stock remains in its trading range, how-
ever, the stock is not desirable to own.
Buy Stop Orders need to be triggered first and then become market
orders.
Buy Stop Limit Orders need to be triggered first and then become limit
orders.

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The Stop on a buy stop order tells the trader that this order cannot be exe-
cuted until the market touches the specified price or passes higher and a
trade takes place which then triggers the order (stop comes off) and
becomes a market order for immediate execution.
Note: The danger of this type of order is that the stock may be bought at a
higher price than the investor anticipated. Remember, a market order only
guarantees a fill not a guaranteed price.
Exam Facts Example #3: Billy Bob sold short stock at $25 a share. He antici-
pates the stock to fall so as to end up with a profit. In case the stock goes up in
value, instead, he wants to protect his short position.
Billy Bob decides to enter a Buy Stop 30 order. By doing this Billy Bob is say-
ing that if the value of the stock goes against him for his short position and rises
to 30 or higher he wants to buy in the stock so as to limit any further losses.
The Series 7 exam question will provide a trading tape and will ask one or
both of the following questions;
Trading Tape: 25, 25.12, 24.75, 28, 29, 30.50, 31, 29.87
Question 1: The stop order will be triggered at?
To trigger the order, the stock must trade at the stop price of 30 or higher.
Therefore this stop order is triggered at 30.50, which means the order is awak-
ened and then becomes a market order.
Question 2: The trade will be executed at?
As the order is now a market order it will execute immediately on the next
trade. Therefore, according the trading tape above, the order is traded/exe-
cuted at 31.
47.4.4 Buy Stop Limit Orders
The Stop on a sell stop limit order tells the trader that this order cannot be
executed until the market touches the specified price or passes above and a
trade takes place at that price or higher which then triggers the order (stop
comes off) and becomes a limit order for purposes of execution.
Note: The danger of this type of order is that the stock may never be bought as
the current value may rise and stay above the limit price in the order. In order
to have a fill the price of the stock must be at the limit price or better (lower).
Remember, unlike a market order, a limit order only guarantees a specific
price, not a fill.

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Exam Facts Example #4: Billy Bob sold short stock at $25 a share. He antici-
pates the stock to fall so as to end up with a profit. In case the stock goes up in
value, instead, he wants to protect his short position.
Billy Bob decides to enter a Buy Stop Limit 30 order. By doing this Billy Bob is
saying that if the value of the stock goes against him for his short position and
rises to 30 or higher he wants to buy in the stock so as to limit any further
losses.
Because this is a limit order, not a market order, after the order is triggered
there can only be a fill if the stock is trading at 30 or less (better). If the stock
remains above 30 the order will not be filled.
The Series 7 exam question will provide a trading tape and will ask one or
both of the following questions;
Trading Tape: 25, 25.12, 24.75, 28, 29, 30.50, 31, 29.87
Question 1: The stop order will be triggered at?
To trigger the order, the stock must trade at the stop price of 30 or higher.
Therefore this stop order is triggered at 30.50, which means the order is awak-
ened and then becomes a limit order of 30.
Question 2: The trade will be executed at?
As the order is triggered and is now a limit order it will only execute if the
stock trades at 30 or lower. Therefore, according the trading tape above, the
next trade at 30 or lower is 29.87 and now can be traded/executed.

47.4.5 More on Buy Stop Orders

Investors can also use stop orders to profit from market price movements.
Technical analysts use stock price movements and trading volumes to deter-
mine when to buy and sell. They are often called chartists because of the
charts that they use to analyze stock price movements.

Go to the next page for an example!

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47.4.5.1 Using Charts for Stop Orders

Resistance Level

25
Stock Ticks
Market Price
20 Support Level

Preceding Five Months

Exam Question Example
John B, an astute technical analyst investor, has been charting the above
stock for almost five months. As you can see, this stock is in a five point
trading range. It goes up to about 25 and then falls back down to 20 or
less.
John does not want to own the stock if it stays in this trading range. How-
ever, John believes that if the stock breaks out above the trading range
it will go up at least 20 points.
So, John enters a buy stop 26 order. If the stock breaks out and hits 26
or higher he wants to own the stock immediately.
The Series 7 exam question will provide a trading tape and will ask one or
both of the following questions regarding the above facts;
Trading Tape: 24, 24.12, 25, 25.50, 26.50, 27, 26.75, 27.87
Question 1: The stop order will be triggered at?
To trigger the order, the stock must trade at the stop price of 26 or higher.
Therefore this stop order is triggered at 26.50, which means the order is awak-
ened and then becomes a market order.
Question 2: The trade will be executed at?
As the order is now a market order it will execute immediately on the next
trade. Therefore, according the trading tape above, the order is traded/exe-
cuted at 27.
Exam Alert: Be prepared to see at least 4 - 5 stop order trading questions
on your Series 7 Exam. A helpful chart showing the differences between
Buy Stop Orders and Sell Stop Orders can be found on the next page.

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 Module 47: Types of Orders

Buy Stop Orders vs. Sell Stop Orders

Buy Stop Orders Sell Stop Orders

Protect against loss in a short stock
position
Protect a gain from a short stock
position
Establish a long position when a
breakout occurs above the line of
resistance
Protect against loss in a long stock
position
Protect a gain from a long stock
position
Establish a short position when a
breakout occurs below the line of
support

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 Module 47: Types of Orders

47.5 REVIEW QUESTIONS

1. A customer asks you to sell 100 shares of PTS if the market falls to 40, but
she does not want to sell for less than 35. The proper order is;
A. Sell 100 PTS @ 40 Stop Limit
B. Sell 100 PTS @ 35 Stop Limit 40
C. Sell 100 PTS @ 40 Stop Limit 35
D. Sell 100 PTS @ 35 Stop Limit
2. The above order is known as a;
A. Limit order
B. Stop order
C. Split order
D. Stop limit order
3. In a falling market which of the following orders will be executed?
I. Open Buy Limits
II. Open Sell Limits
III. Open Buy Stops
IV. Open Sell Stops
A. I and IV
B. I and III
C. II and IV
D. II and III
4. Billy Bob has a gain on a long stock position which he wishes to protect.
The appropriate order is;
A. Market order
B. Buy stop order
C. Sell Limit order
D. Sell stop order
5. An order to sell at 38.65 Stop Limit is entered before the opening of the
market. The subsequent trades are 39, 38.75, 38.12, 38, 39, 39.12. Which of
the following is the order triggered and executed?
A. 38.75, 39.12
B. 38.12, 39
C. 38.75, 39
D. 39, 39.12

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47.6 REVIEW ANSWERS

1. (C): The customer wants to sell if the price falls to 40 or less but is not willing to
accept anything less than 35. So the proper order would be 40 Stop Limit 35.
2. (D): This is known as a Stop Limit Order.
3. (A): With a falling market Open Buy Limits and Open Sell Stops may be exe-
cuted. Open Buy Limits indicate that the order was already triggered but didnt fill
because the market didnt fall to the limit price. A falling market could in fact exe-
cute this type of order. With Open Sell Stops the order hasnt been triggered yet. A
falling market could result in a trigger of the stop order and then it turns into a mar-
ket order with immediate execution.
4. (D) Sell stop orders would be appropriate to protect a gain on a long stock posi-
tion. The stock price would have to fall to the stop price for a trigger and then the
order turns into a market order for immediate execution.
5. (B) 38.12, 39: First the market price has to fall at or below the stop of 38.65.
The trade tape indicates that 38.12 is the first trade which meets this criteria. The
Stop order is now triggered and becomes a limit order of 38.65. This means the
trade will not be executed unless the price rises to 38.65 or higher (better). The
trading tape indicates a price of 39 which qualifies for the execution.

NASD Series 7 Page 382

 Module 48: Exchange Trades

Section 48: Exchange Trades

48.1 LONG AND SHORT SALE RULES
48.1.1 Long Sale
When an investor buys shares of stock it is known as a long position. When the
investor sells those shares of stock it is known as a long sale as the stock is
held long in the brokerage account.
48.1.2 Short Sale
Selling short is a technique to profit from the decline in a stocks price. The
following are features of a short sale;
The short seller initially borrows stock from a broker-dealer to sell at the
market.
The investor expects the stock price to decline enough to allow him/her
to buy shares at a lower price and replace the borrowed stock at a later
date.
Unless the stock price declines to zero, the short seller is obligated to buy
the stock and replace the borrowed shares to close the short position.
Short sales are generally risky and requires the use of a margin account.
If the stock price rises instead of falls, the investor still must buy the shares
to replace the borrowed stock. As a stocks price can rise without limit, the
position has unlimited risk. This is why they Buy Stop Order can help
reduce this kind of risk.
48.1.2.1 Exchange Short Sale Rules
The SEC and exchange plus tick rules are designed to block a short
seller from trading into a declining market which could held drive the
stocks price lower.
An order to sell a listed security short may be executed on either a plus
tick or a zero-plus tick. A plus tick is a price higher than the last different
price. As an example, a stock trades at 30 then trades at 30.12.
A zero-plus tick occurs when the last trade for the security was made at
the same price at the trade before, but that trade was higher than the
previous trade.
The plus or minus tick carries over from the previous days trading.

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48.1.2.2 Up Tick Rule Example

20.12 20.12

20 20 20 20

19.50
Plus tick. Plus tick. Zero plus Down Zero down
Opening Down Short Short tick. tick. tick. Short
Sale Tick. sales sales Short Short sales not
Short permitted permitted sales sales not permitted
sales not permitted permitted
allowed

48.1.2.3 Short Sale Regulations

The Securities Exchange ACt of 1934 prohibits directors, officers and
principal stockholders known as insiders from selling short stock in their
own companies.
Sell order tickets must be identified as to whether the investor is selling
from a long position or is selling short.

Notes

Go to the next page

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4 8 . 2 SP E C I A L I S T S B O O K
The specialists book keeps track of stop and limit orders. Market orders are not
kept in this book. Since stop and limit orders are not executed immediately, the
specialist must keep track of the outstanding orders in a book. This book is usually
electronic or computerized.
48.2.1 Specialists Book Example

NYSE Specialists Book

Buy 51 Sell

50.875 200 RJames GTC

50.750 300 Edwards GTC
50.675 600 Prudential Day
50.500
50.375
200 Merrill Lynch GTC 50.250
300 Goldman GTC 50.125
500 SalSmith Day 50.000

Current Specialists quote is Bid - 50.375 Ask - 50.50

if the price moves down, the specialist will buy the stock for Merrill Lynch,
then Goldman and finally Salomon Smith Barney.
If the price moves up, the specialist will sell the stock for Prudential, E G
Edwards and Raymond James.
48.2.1.1 Other Specialist Book Rules
The specialist will only accept Day orders and Good Till Canceled
orders on the book.
On ex-dividend date the stock is reduced by the amount of the divi-
dend. So is ABC goes x-dividend for a .25 dividend the market value of
the stock also falls .25.
The specialist must adjust any open orders in the specialists book in
order to avoid any filled orders due to a dividend being paid.

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You need to know what type of orders are adjusted when a stock is going
to pay a dividend. Remember BLiSS - Buy Limit and Sell Stop orders get
adjusted by the exchange specialist.
If a customer decides not to have his/her stock order adjusted by the
specialist then the order would be market with a DNR (Do Not Reduce).
4 8 . 3 C O N S O L I D A T E D TA P E
The Consolidated Tape is a NYSE service designed to deliver real-time reports of
securities transactions to subscribers as they occur on the various exchanges.
The sell side of the trade must report the trade within 90 seconds.
They tape is called Consolidated because trades in the NYSE listed issues
that take place in any market are reported to tape via computer linkups.
48.3.1 Network A - NYSE
This tape reports all NYSE listed trades.
48.3.2 Network B - AMEX
This tape reports all American Stock Exchange listed trades.
48.3.3 Stock Symbols
Stock symbols appear in the trading tapes. A round lot is 100 shares.
SLD = Trade is being reported out of sequence. Make sure you remember
that if you see the symbol SLD in a trade tape for a stop order question, do
NOT use that trade for purposes of a trigger or execution.
OPD = There was a delayed opening with this stock. This can occur when
good or bad news is released prior to the opening of the new trade day.
48.3.3.1 Round Lots
Round lots of 100s are indicated on a trade tape using the symbol s. If
the trading tape has a 3s a trade took place for 300 shares.
Round lots of 10s is represented by the symbol s/s. These stocks
trade in round lots of 10 shares.
48.3.4 Trading Block
A trading block is made up of 10,000 shares. The full amount of the block is
printed on the tape with a s following such as 10,000s GE. Remember, this
means 10,000 shares not 10,000 trading units.
Trade Tape Example on the Next Page

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 Module 48: Exchange Trades

48.3.5 NYSE Trading Tape Example

. . . IBM . . . . . . . GE . . . . . . . GM . . . . . . . . F . . . . . . . . SLD. . . . .BAC

22.50 3s 68 25s 43.12 97s 45 5s 31.12

48.3.5.1 Tape Explanation

1 round lot or 100 shares of IBM traded at $22.50
3 round lots or 300 shares of GE traded at $68
25 round lots or 2500 shares of General Motors traded at $43.12
97 round lots or 9700 shares of Ford traded at $45
5 round lots of 500 shares of Bank America traded out of sequence at
$31.12

Notes

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Notes

NASD Series 7 Page 388

 Module 49: Over the Counter Market (OTC)

Section 49: Over the Counter Market (OTC)

49.1 OTC OVERVIEW
The OTC market is the market in which broker-dealers negotiate trades directly
with on another.
The following securities are traded or issued in the OTC market;
OTC stocks
New issues through an IPO
Corporate bonds not listed on an exchange
U.S. Government
Government Agency debt
Municipal bonds
Money market instruments
Bank issues
Insurance issues
American Depository Receipts (ADR)
Closed end investment companies
49.2 NASDAQ
The NASDAQ, NASD Automated Quotation service, is an electronic quotation
system that shows the bid and ask prices of the more actively traded OTC
stocks.
There over 10,000 stocks that trade OTC.
Larger issues such as MCI and Microsoft qualify for listing on the NASDAQ
Stock Market which includes approximately 4,000 issues.
Smaller NASDAQ issues are the small capitalization issues
Bulletin Board (OTCBB) stock is too small for the NASDAQ or the small cap-
italization issues. There are no listing requirements for these stocks.NNM
The Nasdaq National Market (NNM) represents the larger and most
actively traded stocks trading OTC.

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49.3 FINANCIAL NEWS SOURCES

49.3.1 Pink Sheets
The smallest issues, also known as penny stocks, are quoted in the Pink
Sheets. The Pink Sheets is a weekly paper for OTC quotes to which dealers
can subscribe.
The quotes found in the Pink Sheets are on a wholesale basis. This means
the broker-dealers trader buying stock would have to mark the price up to build
in a profit.
49.3.2 Yellow Sheets
The Yellow Sheets is a daily printing of wholesale quotes for OTC Corporate
Bonds.
49.3.3 Blue List
The Blue List is a daily printing of quotes for Municipal Bonds. They are pri-
marily municipal bonds that are available in the secondary market, but can
also include other types of secondary bonds.
49.4 OTC OPERATIONS
Any OTC member is allowed to register as a market maker in an issue if
minimum requirements are met.
Retail broker-dealers are allowed to act as OTC market makers.
NASDAQ traders, market makers, broker-dealers and even registered repre-
sentatives are connected to the NASDAQ system.
There are three (3) levels to the NASDAQ system in which you need to
become familiar with
Level 1 is a summary of Level II which is known as the Inside Market,
best bid and best ask prices. This level is seen by registered representa-
tives.

NASDAQ Level II Screen for Dell Computer Stock (DELL)

Market Maker Bid Ask

A. G. Edwards 20 20.50
Prudential 20.12 20.58
Sal Smith Barney 20.25 20.58
Wachovia 20.08 20.65

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Level II shows all the market makers making a market in a particular stock.
Each market maker posts its own bid and ask prices based on their inter-
pretation of the market.
Level II also has Firm Quotes which means the individual market makers
guarantee their quotes as shown in Level II. Firm quotes have no qualifica-
tions or restrictions.
49.4.1 Inside Market
Inside market quotes are found in Level I which is a summary of Level II. In
other words, the best bid (price stock is sold at) and the best ask (price stock
is bought at) from all the market makers are only shown on this screen.
When an order comes in the trading desk will buy from the dealer offering
the best price. In this case, the best Ask is 20.50 as it is the lowest.

NASDAQ Level II Screen for Dell Computer Stock (DELL)

Market Maker Bid Ask

A. G. Edwards 20.00 20.50

Prudential 20.12 20.58
Sal Smith Barney 20.25 20.58
Wachovia 20.08 20.65

The best Bid, price stock is sold at, is the Sal Smith Barney quote of
$20.25 which is the highest price available of all the market makers when
selling stock.
49.4.1.1 Level 1 NASDAQ (Inside Quote)
Based on the above Level II screen the inside quote is as follows;
Bid Ask
20.25 20.50
49.4.1.2 Level III NASDAQ
Level III is a mirror of Level II with one addition. Market makers actually
making a market in a particular stock have the capability of physically
going into the Level III system and change its bid and/or ask prices to
reflect any change in market conditions. If any changes take place, quotes
in both Level II and the inside market (Level I) change appropriately.

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49.4.2 Backing Away

The NASD prohibits backing away from a quote, that is, giving a firm quote
and then failing to honor that quote.
49.4.3 Types of Quotes
Firm Quote: A firm quote is the price at which a market maker or broker-
dealer stands ready to buy or sell at least 100 shares of stock at the quoted
price with other NASD member firms. When an OTC firm makes a market in
a security, the broker-dealer must be willing to buy or sell at least 100
shares of the security at its firm quote.
Subject Quote: A subject quote means the quote is subject to confirma-
tion and tentative. The quote is an approximate price and can be changed.
Therefore, subject quotes are not firm quotes.
Nominal Quote: A nominal quote is not even a quote. It is a dealers
guess or assessment at the current price, but the dealer is not wiling to
trade at that quote.
Workout Quote: A workout quote is an approximate quote with the dealer
working out the exact price at which he/she will trade later on. A workout
quote is not a firm quote.
49.4.4 Front Running
The NASD prohibits front running a customers order. When the firm is hold-
ing an order from a customer, the firm executes an equivalent transaction for its
own account before executing the customers order. Customer orders have
priority.
49.5 COMPUTERIZED ORDER ROUTING
While each exchange has developed their own electronic systems, automated
order routing systems link the specialists from each exchange through the
Intermarket Trading System ITS.
49.5.1 New York Stock Exchange SuperDot
SuperDot processes nearly 75% of all orders going through the NYSE
each day.
Broker-dealers use this computerized order routing system to choose an
orders destination.
An order can be routed directly to the appropriate specialist or sent to the
brokerage firms house booth for handling by the commission broker.

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 Module 49: Over the Counter Market (OTC)

Once the specialist or commission broker receives the order, it is presented

in the auction market.
Orders can be sent through the system either on a preopening or post-
poning basis.
The computer automatically pairs preopening orders received before
the opening of trading with other orders and executes them at the opening
market.
Any order that cannot be matched before the opening is given the special-
ist to handle.
For a postponing order it is sent directly to the specialist post and pre-
sented to the crowd.
All NYSE listed stocks are eligible for trading on SuperDot subject to
limits which you do NOT need to know for the exam.
49.5.2 NASD SOES System
The NASD has implemented two automated trading systems for NASDAQ
issues.
1. Super SOES: This system is for automated trades of NASDAQ NNM
issues
2. Small Cap SOES: This system is for automated trading of NASDAQ
Small Cap issues.
49.5.2.1 SOES Advantages
It is time efficient as a trader does not have to telephone to execute the
trade as all trades are effected through touch screens automatically.
SOES is cost efficient as it is less expensive to effect trades through
SOES than to handle the trade over the phone.
Trading errors are reduced because trading is automated and the
matching of dealer confirmations are also automated.
49.6 NASDAQ SUPERMONTAGE (NOT CURRENTLY TESTED)

Sometime in the near future the new NASD SuperMontage system will be replac-
ing both Super SOES, Small Cap SOES and NASDAQ Levels, I, II and III.
SuperMontage provides the ability for firms to list multiple quotes and
orders for the same security and creates a central limit order book. This
means it combines the information that was shown on NASDAQ Level, I

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(Inside Market), Level II (Market Maker Quotes) and the trade execution sys-
tem of SuperSoes
System will display the total amount of trading interest at the best prices
and will be known as the National Best Bid and Offer).

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 Module 49: Over the Counter Market (OTC)

49.7 REVIEW QUESTIONS

1. Which of the following is a firm quote?
A. 10 - 10.12 workout
B. 10 - 10.12 subject
C. 10 - 10.12 nominal
D. 10 - 10.12
2. Which of the following persons trades securities over-the-counter?
A. Market maker
B. Specialist
C. Registered Representative
D. Two Dollar Broker
3. Who needs to report trades in NASDAQ stocks?
A. The buy side of the trade
B. The sell side of the trade
C. The registered representative
D. The supervising Series 24
4. What is the inside quote as based on the following Level II service?

Dell Computers Level II NASDAQ Service

Market Maker Bid Ask

Prudential 18.000 18.250

Wachovia 18.120 18.250
Sal SmithBarney 17.875 18.210
Merrill 18.010 18.320

A. 18.00 - 18.32
B. 18.12 - 18.21
C. 17.87 - 18.32
D. 18.01 - 12.25
5. What is the name of the NASD automated order execution system?
A. SuperDot
B. Brokerage support system
C. SOES
D. Big Board System

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49.8 REVIEW ANSWERS

1. (D): A firm quote is one without anything attached or qualified. All the others are
not firm.
2. (A) Market makers make markets and trade securities in the over-the-counter
market.
3. (B) The sell side of a trade must report the trade within 90 seconds.
4. (B) A firm quote is taken from all the market makers making a market which is
indicated on the Level II system. Take the best bid (price sell at) of $18.12 and the
best offer (price buying at) of $18.21 and voila, the inside quote.

NASD Series 7 Page 396

 Module 50: Transaction Settlement Rules

Section 50: Transaction Settlement Rules

50.1 SETTLEMENT OVERVIEW
The Settlement Date is the date on which ownership changes between buyers
and sellers. This is the date on which broker-dealers are required to exchange the
securities and funds involved in the transaction and the date on which customers
are requested to pay for securities bought and deliver securities sold.
50.2 R EG UL AR WAY S E TT L EM EN T
Regular way settlement for most securities is three business days after the trade
date. If the seller delivers before the settlement date, the buyer may either accept
the security or refuse it without prejudice.
50.2.1 Settlement Rules for Specific Securities
Corporate stocks and bonds - 3 business days
Municipal securities - 3 business days
US Government securities - 1 business day
Options - 1 business day
5 0 . 3 C A S H WA Y S E T T L E M E N T
Cash way settlement means same day settlement for all securities. This rule
requires delivery of securities from the seller and payment from the buyer on the
same day a trade is executed.
50.4 GOOD DELIVERY OF SECURITIES
On settlement day, the securities are delivered and paid for. However, the securi-
ties must be delivered in good form to the buyer. If the securities are not in
good form they can be rejected and settlement will not take place.
Registered securities must be endorsed on the back by the registered
owner in exact name. This is known as an assignment.
Instead of signed the certificate itself, a document known as a Stock
Power can be used instead.
Signature guarantees are required by transfer agents for the transfer to be
effective. Signature guarantees can be made by commercial banks and
NYSE firms.
Bearer bonds must be delivered with all unpaid coupons attached.

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Stock certificates must be delivered in round lots of 100 shares or multiples

of 100 on the certificate. If certificates of less than 100 shares are used, they
must add up to units of 100. If the certificates cannot be combined into units
of 100 then good delivery can NOT occur.
Example: For a 600 share trade any of the following would be
acceptable;
1 certificate for a 600 shares
6 certificates of 100 shares each
12 certificates of 50 shares each (two 50s = 100)
24 certificates of 25 shares each (four 25s = 100)
Example of bad delivery of 500 shares
10 certificates of 60 shares (whoops - cant combine 60 share certificates
to make units of 100)
Securities cannot be accepted if mutilated unless they are accompanied with
a validation letter from the transfer agent or issuer stating that the securities
would be accepted.
Municipal bonds must be delivered with a legal opinion unless identified at
the time of the trade as ex-legal. this means coming without the legal opin-
ion.
Insured municipal bonds must be delivered with proof of insurance.
50.5 WHEN, AS, AND IF ISSUED
When, as and if issued is used for new securities whose issuance is announced,
but the certificates are not yet available for trading.
If there is a problem and the issue is canceled, the trades are canceled as
well.
A confirmation is sent out specifying the price and trade date but there is no
settlement date since the securities arent available as yet.
50.6 COMPARISONS AND DK NOTICES
Comparisons must be sent to the broker on the other side of the trade, known as
the contra broker. The contra broker (Firm B) receives a comparison from the
firm A while Firm A receives a comparison from Firm B.
The above comparison is then matched against the trading record to see if all
the terms agree so that settlement can proceed. Comparisons must be sent no
later than the day after the trade.

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 Module 50: Transaction Settlement Rules

50.6.1 Comparison Details

The information on the comparison details the specifics of the trade such as
the trade date, settlement date, size of trade, security traded, execution price
and the CUSIP number.
50.6.1.1 Example
Your broker-dealer receives a comparison for a trade executed at $100
per share and the comparison shows the trade at $90 per share. To clear
the record, your firm will DK (Dont Know) the comparison and send it
back with its record of the trade.
The two firms then review the trading records and clear the discrepancy
so that regular way settlement can take place.
The last day to DK is the business day prior to settlement.
If a cash settlement is performed, comparisons must be delivered that
same day.
50.7 REJECTION AND RECLAMATION
A rejection occurs when securities are delivered to a brokerage firm upon
settlement and are refused for a valid reason.
A reclamation occurs when a brokerage firm accepts delivery of securities
on settlement and later determines that the delivery was not good.
50.7.0.1 Reclamation Example
The Peace of Mind Brokerage firm accepts a large shipment of securities
and is accepted by a principal of the company. It is later determined that
some of the securities did not represent good delivery.
Only those defective securities are reclaimed under reclamation. The
entire shipment is NOT reclaimed.

End of Module

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NASD Series 7 Page 400

Retirement Plans
Annuities
 Module 52: Retirement Plans

Section 52: Retirement Plans

52.1 OVERVIEW
Of all the investment objectives selected by investors, retirement planning may be
the number one important long-term objective. While there are many rules involv-
ing retirement plans and issues, the Series 7 generally asks a limited number of
questions. As a retail stock brokers exam the majority of the questions will be
about basic retirement issues, especially in the area of Individual Retirement
Accounts.
52.2 RETIREMENT PLANNING CHOICES
Your client may accomplish their retirement planning objective(s) through
any of the following combination of plans and strategies;
IRAs
Corporate pension plans
401(k) plans
403(b) plans
Defined benefit plans
Defined contribution plans
Keogh plans
Profit sharing plans
SEP IRA plans
SIMPLE Plans
Annuities
Individual investments
Mutual funds
52.3 ERISA
The purpose of ERISA, Employee Retirement Income Security Act, was to estab-
lish standards for the various types of qualified retirement plans. ERISA only
applies to private employers, not the U.S. Government or state plans.

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52.4 QUALIFIED RETIREMENT PLANS

Meets ERISA standards
Eligible for special income tax advantages such as;
-Employee deductions of contributions
-Employees are not taxed on contributions
-Earnings grow on a tax-deferred basis
-Employers can deduct contributions made for employees
52.5 NONQUALIFIED RETIREMENT PLANS
Does not meet ERISA standards
Not eligible for special income tax advantages of a qualified plan
Generally, employers cannot deduct contributions to a nonqualified plan
Contributions are made with after tax dollars into a nonqualified plan
It is possible that assets in a nonqualified plan can grow on a tax-deferred
basis
Usually have Deferred Compensation Plans in nonqualified plans
- Key employees forgo receipt of compensation and defer it until
retirement
- Biggest danger is that the company has financial problems and the
key employees assets being held in the nonqualified plan are subject
to creditor action

Qualified vs. Non-Qualified Retirement Plan Comparison

Features Qualified Non-Qualified

Contributions Tax deductible Not tax deductible

IRS Plan Approval Approved Not approved
Plan Discrimination Not allowed Not allowed
Tax deferred to employee
Tax Deferral Tax deferred
but not to employer
Excess over cost base
Withdrawal Taxation All withdrawals taxed
taxed

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5 2 . 6 TR A D I T I O N A L I N D I V I D U A L R E T I R E M E N T A C C O U N T
52.6.1 Purpose, Funding and Eligibility
IRAs were created to encourage people to save something for their retirement.
IRAs are personal, tax deferred retirement accounts that persons with earned
income can set up with a deposit limited to $3,000 per year or $6,000 for mar-
ried couples filing jointly, whether or not both spouses work. When distributions
are taken, ordinary income tax rates are applied rather than capital gain treat-
ment.
IRA contributions are deductible regardless of income if neither the taxpayer
nor the taxpayers spouse is covered by a qualified plan or trust. If there is a
qualified plan at work and the joint or single income is above certain limits the
IRA contribution may not be deductible. (Note: You will not be tested on
those limits which would make the IRAs non-deductible)
52.6.2 Other Features and Rules
Individuals may establish IRAs up until the time the persons tax return is
due which is usually April 15th for any given year.
Excess contributions are subject to a 6% excise tax
Distributions must be taken out by April 1st following the year the IRA
holder turns 70.
If a mandatory distribution is not taken there is a penalty of 50% of the pay-
ment that should have been taken
IRA holders can take distributions at age 59 without any penalties. If a
distribution is taken prior to age 59 the distribution may be subject to a
10% excise tax in addition to the regular tax owed.
52.6.3 Exceptions to taking a distribution prior to age 59 without a
penalty include;
Death
Total disability
First home maximum of a lifetime of $10,000 and must not have pur-
chased a new home in the last two years
Medical expenses in excess of 7.5% of adjusted gross income
Distributions are made on a periodic basis over the life expectancy of the
owner

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Qualified higher education expenses

52.6.4 IRA Transfers
Transfers take place when one custodian directly transfers IRA assets to
another custodian without the holder ever touching the funds. There is no limit
as to how many times IRA accounts can be transferred from one custodian to
another.
52.6.5 IRA Rollovers
A Rollover, on the other hand, is when an IRA holder physically takes a distri-
bution. A rollover can only be done once a year. If the funds are not rolled over
into an IRA within 60 days a 10% penalty will apply as well as tax on the distri-
bution.
52.6.6 Non-Allowable IRA Investments
Commodities
Land
Collectibles
Insurance
52.6.7 Allowable IRA Investments
Gold
Silver
Platinum
Palladium
Stocks, mutual funds, variable annuities, bonds, reits and other types of regu-
lar securities.
52.7 ROTH IRA
The Tax Relief Act of 1997 created the Roth IRA, named after Congressman
Roth. The major benefit of the Roth IRA is Tax-Free withdrawals.
Roth IRA features are;
Tax-free withdrawals if assets held in account for at least five years
No tax deduction allowed for contributions
Mandatory distributions are never required, including at age 70

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Maximum contribution of $3,000 annually or 100% of compensation, which-

ever is lower.
Income limits apply for contributions. If the investor has over $150,000 in joint
income a Roth IRA contribution is not allowed
Rollovers from traditional IRAs can be made to a Roth IRA if the taxpayer has
no more than $100,000 in adjusted gross income
Qualified distributions can take place without any tax consequence if assets
held for at least five years and;
-The owner reaches the age 59
-Death
-Disability
-Qualified first-time home buyer
52.8 SIMPLIFIED EMPLOYEE PENSION PLAN (SEP)
SEPs are for those self-employed persons who do not want to be involved with
the more expensive and more complicated pension plans. A SEP is a qualified
plan that allows an employer to contribute for the benefit of both the employer
and employees
52.8.1 SEP Eligibility
To be eligible, am employee must be at least 21 years of age, worked for the
employer during at least three of the last five years and have received at least
$400 in compensation from the employer in the current year.
52.8.2 SEP Participation
SEP rules require the employer and all eligible employees to participate. Any
contributions made for the owners must also be made for the eligible employ-
ees.
Contributions are based on the percentage of contributions, not the dollar
amount (25% under current tax laws up to a maximum of $40,000). SEPs
are vested immediately which means 100% of any contributions made into an
employees account belongs to the employee immediately and if the employee
leaves the company he/she can take the full value of the account.
52.9 KEOGH/HR-10 PLAN
Keogh plans, also known as HR-10 plans are intended for self-employed per-
sons and employees. As with all qualified plans, only earned income is eligible
and the plan grows on a tax-deferred basis.

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52.9.1 Eligibility Rules

Full time employees: Employees working at least 1,000 hours are eligible
Tenure: Employees working for at least one or more years are eligible
Age: All employees 21 years or older are eligible
52.9.2 Keogh Features
The maximum contribution for Keogh plans is 100% of compensation or
$40,000 whichever is lower.
For test purposes, the Keogh Plan allows a maximum contribution of 20%
of pretax income or $40,000, whichever is less. For example, if an indi-
vidual earns 100,000, his/her maximum contribution would be $20,000.
Distributions can begin as early as 59.
If taken prior to age 59 without an IRS exception a 10% penalty would
apply.
Distributions are taxed as ordinary income as all distributions from quali-
fied plans are.
52.10 CORPORATE PENSION PLANS
52.10.1 Defined Contribution Plans
A formula specifies the amount of the employers annual contributions by
percentage but does not specify the future retirement benefit
Future retirement benefits will be the result of the contributions and invest-
ment earnings
The employer sets a contribution level
Benefits the younger employee
Grows on a tax-deferred basis
Maximum contribution is 100% of compensation or $40,000, whichever is
less
Investment risk is on the employees
Distributions are taxed as ordinary income
52.10.2 Defined Benefit Plans
Promises to pay the employee a specified amount of money (benefit) each
year once the employee retires.

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Prescribes a formula for an employees retirement benefits which is usually

based upon age, years of service and salary history.
Once the benefits have been established contributions are made to fund
them. These plans allow for a larger maximum contribution than defined
contribution plans.
Benefits the older highly compensated employees in a company as a
defined benefit plan generally will allow the maximum amount of tax-
deferred retirement saving.
Employers are responsible to fund the plans and to make up for any short-
falls as the employers have the investment risk
Distributions are taxed as ordinary income
5 2 . 11 T Y P E S OF DEFINED CONTRIBUTION PLANS
52.11.1 Profit-Sharing Plans
Defined contribution plan
Flexible without having to specify a fixed percentage for contributions
Employer contributions can be discretionary and do not have to contribute
annually
Maximum contribution is 100% of earnings or $40,000 whichever is lower
Investment earnings accumulate tax-deferred and distributions are taxed as
ordinary income
Contributions made by the employer are tax deductible
52.11.2 401(k) Plans
Defined contribution plan
Employees direct the investments, usually into a series of different mutual
funds
Known as a CODA Cash or Deferred Arrangement
Employee reduces their gross income with contributions which is known as
the salary reduction feature
Employee contributions are immediately vested which means if the
employee left all of his/her contributions can be taken
Employers can match contributions. As an example, dollar for dollar up to
3% or 4% or more of the employees compensation.

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Employer contributions may be subject to a vesting schedule which

means if an employee leaves the company the matching dollars or some
part of it may not be taken by the parting employee and will be left to the
remaining employees.
Loans may be permitted if the plan allows it
Investments grow on a tax-deferred basis until withdrawals are taken
which will be subject to ordinary income treatment.
Premature withdrawals are subject to a 10% penalty
The current maximum contribution is $11,000 for 2003.
52.11.3 Employee Stock Ownership Plan (ESOP)
Provides benefits similar to those of a profit-sharing plan except that
employer contributions are invested in the stock of the employer.
An advantage to the employer is the ability to receive a tax deduction based
on the fair market value of the stock without making a cash outlay.
Another advantage is that it improves employee morale and motivation.
However, the employee-stockholders also incur the risk of declining share
values.
52.11.4 403(b) Plan
These are tax-deferred plans directed towards employees of certain non-profit
organizations such as school systems and 501(c) organizations which include
charities, hospitals, churches, colleges and universities.
They are also known as Tax Deferred Annuity (TDA) plans as well as Tax
Sheltered Annuities (TSA) plans.
Contributions are typically invested in fixed and variable annuity contracts
Independent contractors are not eligible to contribute
Other investments such as mutual funds, stocks, bonds and even CDs can
also be purchased but through a custodial account
Employees make contributions just like in a 401(k) plan through a salary
reduction plan
Direct transfers can occur between different 403(b) plans when an
employee changes employers
Investment earnings are not subject to current taxation

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Withdrawals, like other qualified retirement plans, are subject to ordinary

income tax treatment and a penalty occurs if premature distributions are
taken
52.12 SECTION 529 SAVINGS PLANS
Section 529 Plans are established by each State. Generally, a Section 529
account can be opened for any resident of that State, typically by a parent for a
minor child however there are many plans that allow non-residents to establish
accounts, including corporations.

Contributions are NOT deductible

Earnings in the account build tax deferred
Distributions to pay for higher education expenses are NOT taxable
Distributions are made directly by the plan to the educational institution,
which can be in any State.
The Plan trustee contracts with an investment adviser, such as a mutual fund
company, to manage the monies in the trust, with the asset mix chosen by the
adviser which is based on the childs age. (e.g. a greater allocation in equities
for younger children and a greater allocation in fixed-income securities for
older children.
Account is used to pay for higher education expenses until it is exhausted,
including payments to colleges, universities, and vocational schools and any
other accredited postsecondary education institution.
Any unused funds can be transferred to another eligible beneficiary that
is, a family member.
Distributions for any other reason are taxable
Municipal bonds are not suitable in this plan.
T-bills and conventional corporate bonds are not great choices.
Zero coupon bonds, STRIPS and corporate stocks are a really good choice.

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Notes

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 Module 52: Retirement Plans

52.13 REVIEW QUESTIONS

1. Doris Learned $100,000 as an independent real estate agent. She is inter-
ested in making a large contribution for her retirement. As a self-employed
person, she comes to you for help. Which of the following would you recom-
mend?
A. Roth IRA
B. Traditional IRA
C. Keogh (HR-10)
D. 401(k) plan
2. Which of the following investors are eligible to establish a traditional
IRA?
I. Nursing student who earned $1,300 in a part-time job
II. A day trader whose sole source of income is $115,000 per year in invest-
ment income
III. Paco, who earned almost $4,000 selling home made vases and whose
spouse is covered by a company qualified plan
A. I and II
B. I and III
C. II and III
D. I, II, and III
3. If a mandatory distribution is not taken from an IRA what is the IRS
penalty?
A. 6%
B. 10%
C. 15%
D. 50%
4. IRA rollovers can take place how many times a year?
A. 1
B. 2
C. 6
D. Unlimited
5. To remain tax-free, how many years must an investor keep assets in a
Roth IRA?
A. 5
B. 10
C. Until age 70
D. No minimum number of years

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6. Who would not be eligible for a TSA account?

A. Student at a private college
B. Professor at the University of Illinois
C. Custodian at the Barrington High School
D. Clerk at the Carpentersville Elementary School
7. Qualified profit-sharing plans have all of the following features, EXCEPT;
A. Contributions are taxable when received
B. Contributions are deductible for the employees
C. Employer contributions are flexible
D. Investment earnings accumulate on a tax-deferred basis
8. Excessive contributions to an IRA could result in penalty of;
A. 5%
B. 6%
C. 10%
D. 50%
9. Which of the following plans benefit the older corporate employee?
A. IRA
B. Roth IRA
C. Defined Benefit plan
D. Defined Contribution plan
10. Doctor Joyce earned $110,000 last year. What is the maximum contribu-
tion that can be made to a Keogh Plan?
A. $27,500
B. $30,000
C. $40,000
D. $25,000

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52.14 REVIEW EXPLANATIONS

1. (C) Keogh plans are for self-employed persons like Doris L. She could have an
IRA but that would not maximize her potential contribution. 401(k) plans are for
corporate employees.
2. (B) Choice II, the day trader, would not be eligible to have an IRA as he does
not have any earned income. Investment income does not count. Both of the oth-
ers have some sort of earned income. The nursing student will not be able to con-
tribute the maximum in an IRA but could still contribute her earnings.
3. (D) Mandatory distributions must be taken by the IRA holder by April 1st follow-
ing the year he/she turned 70.
4. (A) Rollovers can only take place once a year while transfers can be made for
an unlimited number of times.
5. (A) To remain tax-free, contributions in a Roth IRA must remain there for at
least five years.
6. (A) The student is not working so no contribution to a plan. All the others can
make contributions.
7. (B) Contributions into a profit sharing plan can be made by the employer, not
the employee. All the other choices are features of profit sharing plans.
8. (B) Excessive contributions into an IRA may result in a 6% penalty if not taken
out by tax filing day.
9. (C) Defined benefit plans benefit the older employee while defined contribution
plans benefit the younger employees.
10. (C) With $110,000 gross income you can contribute 100% of earnings or
$40,000, whichever is less under the TRA 2001 tax laws.

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 Module 53: Annuities

Section 53: Annuities

53.1 DEFINING AN ANNUITY
An annuity is not life insurance but is a product of a life insurance company. An
annuity is really a contract which provides for a stream of income payments that is
guaranteed for life.
The person who receives the payments is called the annuitant.
There are two types of annuities offered by insurance companies;
Fixed Annuities
Variable Annuities
53.2 FIXED ANNUITY
Investors, known as annuitants, pay premiums to an insurance company
which is then invested in the insurance companys General Account. Unfor-
tunately creditors have access to the General Account and may prove to be a
problem if the insurance company is financially impaired.
The fixed annuity insurer guarantees the following;
- Rate of return
- Principal
The most significant risk with fixed annuities is known as purchasing
power risk, also known as inflation risk.
To sell annuities an insurance producer (agent) license is required.
5 3 . 3 VA R I A B L E A N N U I T I E S
Over the years the variable annuity has become a popular retirement planning
product. With tax deferred growth, a guaranteed minimum death benefit, access
to different professional mutual fund money managers, a wide choice of payout
options along with favorable tax benefits the variable annuity is a likely item for
the Series 7 examiners.

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5 3 . 4 VA R I A B L E A N N U I T Y F E A T U R E S
Investor assumes investment risk as investors make the investment deci-
sions.
A variable annuity is considered a security as well as an insurance product.
Therefore, those selling this product must have both a securities and insur-
ance agent license.
Maximum mortality expenses (minimum death benefit) and maximum
administrative expenses are guaranteed not to go higher.
Premium goes into separate accounts. Each separate account represents
different types of investments such as common stock, bonds, mutual funds
and more.
Monthly payouts include income for life but the amount of the payments will
vary as determined by the separate accounts performance.

Fixed vs. Variable Annuity

Fixed Annuity Variable Annuity

Payments made with after-tax dollars
Payments go into the General
Account
Fixed-income securities/real estate
Insurer assumes investment risk
Not a security
Guaranteed rate of return
Income guaranteed for life
Monthly payment guaranteed
Purchasing power risk
Subject to insurance regulation
Payments made with after-tax dollars
Payments invested in the Separate
Account
Equity, debt or mutual funds
Annuitant assumes investment risk
Is a security
Return not guaranteed and is based on e
separate account performance
Income guaranteed for life
Monthly payments fluctuate and not
guaranteed
Adds protection against purchasing
power risk
Subject to insurance and securities
regulation

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53.5 COMBINATION ANNUITY

Investors purchasing a combination annuity receives the advantage of both the
fixed and variable annuities. The investor contributes to both the general and sep-
arate accounts, which provides for guaranteed payments as well as inflation pro-
tection.
53.5.1 Types of Variable Annuities
A variable annuity can be classified according to when annuity payments are to
begin. The major classifications are immediate annuities and deferred annu-
ities.
53.5.1.1 Immediate Annuity
Begin payments to the annuitant one payment period after a lump-sum
deposit has been made in the annuity contract.
If the contract is for monthly payments, payments to the annuitant will
begin one month after the date of purchase.
If the contract calls for annual payments, payments will begin one year
after the date of purchase.
53.5.1.2 Deferred Annuity
A deferred annuity delays payments to the annuitant for a period of time
after the date of purchase.
The first payment can begin several years after money is deposited.
A deferred annuity may be funded with a single premium but can also be
funded with periodic payments.
Premiums may be deposited into the annuity monthly, quarterly, semi-
annually or annually.
5 3 . 6 C O M P A R I N G VA R I A B L E A N N U I T I E S TO MUTUAL
FUNDS
The separate account of the variable annuity consists of purchasers funds
pooled together and invested in a diversified portfolio of stocks, bonds and
mutual funds.
Investors own a proportionate share of the securities.
The value of investors shares rise and falls based on the performance of
the securities in the pool.

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The separate account of a variable annuity is operated and regulated just

like a mutual fund.
If the investment manager of the insurance company passes the portfolio
management responsibility to another party, the separate account is indirectly
managed and must register as a Unit Investment Trust under the Invest-
ment Company Act of 1940.
53.7 PURCHASING ANNUITIES
Investors are offered a number of options when purchasing annuities. The
choices are as follows;
Single Premium: Purchased with a lump sum, but payment of benefits is
delayed until a later date, if at all, selected by the annuitant.
Periodic Payment Deferred: This choice allows investments over time. Pay-
ments of benefits are always deferred until a later date selected by the annu-
itant.
Immediate Annuity: Purchased with a lump sum, and the payout of benefits
usually commences within 30 days.
53.8 ANNUITY PHASES
Growth Phase: This is known as the Accumulation Phase as the investor is
making investments. The investments form units known as Accumulation
Units.
Annuity Phase: When and if the investor chooses to take income from the
account by annuitizing the contract, the value of the accumulation units is
converted into a fixed number of Annuity Units. These annuity units are then
liquidated to provide monthly income guaranteed for the life of the annuitant.
However the amount of each monthly payment will vary as based on the
value of the underlying securities.
53.9 RECEIVING DISTRIBUTIONS
If annuitization is chosen by the investor, the entire annuitys principal value
is turned over to the insurance companys control and the insurance com-
pany now owns the entire value of the annuity.
At the time of annuitization an Assumed Interest Rate (AIR) is assigned to
the variable annuity contract. AIR represents a conservative projection of the
performance of the separate account over the estimated life of the contract. It
only has relevance in the payout phase (customer selects a payout option)

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Exam Alert: The Series 7 exam will also have questions as to whether an
annuitants monthly check will go up in value or down in value each
month while receiving monthly payments.
53.9.1 How AIR Works
Apply the following rules when asked whether an annuitants check will
increase or decrease when compared to the prior month. Always look at the
AIR assigned to the variable contract and compare that rate to the actual rate
given to you in the exam question.
If the separate account performance is greater than the AIR, the monthly
check paid in 30 days will be more than the previous months payment.
If the separate account performance is equal to the AIR, the monthly
check paid in 30 days will be the same as the previous months payment.
If the separate account performance is less than the AIR, the monthly
check paid in 30 days will be lower than the previous months payment.
Example: Billy Bob annuitizes a variable annuity and selects income for
life. The AIR assigned to the contract is 5%. Assume that the first monthly
check received by Billy Bob was $100
Month 2: The actual performance of the separate account, annualized,
is 5.7%. The next checks direction will go up, stay the same, or go
down?
- Answer: As the actual performance was more than the AIR then the
next check will be higher in value.
Month 3: The actual performance of the separate account, annualized,
is 5.5%. The next checks direction will go up, stay the same, or go
down?
- Answer: As the actual performance was more than the AIR, even
though lower than the actual return the month before, the next check
will be higher in value.
Month 4: The actual performance of the separate account is 4.9%. The
next checks direction will go up, stay the same, or go down?
- Answer: As the actual performance was less than the AIR, the next
check will be less in value than the check from the month before.

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Separate Account and AIR

Month Month Month Month Month
2 3 4 5 6

AIR 5% 5% 5% 5% 5%
Separate
6% 5.5% 4.5% 4.9% 5%
Account Return
Equal to
Effect on Income Up Up Down Down previous
month

53.10 ANNUITY PAYOUT OPTIONS

When and if an annuitant decides to annuitize the annuity contract in return for
monthly income a choice of one of the following payout options will have to be
made.
Exam Alert: This is a popular area for exam questions.

53.10.1 Straight Life Annuity

This option provides the annuitant with income for life. When the annuitant
dies, however, any remaining sums stay with the insurance company as a
beneficiary is not permitted to be selected.
This payout option is a choice for those persons who want the highest
monthly income.
53.10.2 Life Annuity with a Period Certain
This option also provides income for life. However, the annuitant would
also choose a period certain like 5 years, 10 years or even more.
If the annuitant dies within that period certain, monthly payments would
be provided to the beneficiary until the end of that period. Once the
period of time ends the insurance company would no longer be responsible
for monthly payments.

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53.10.3 Joint and Last Survivor Life annuity

Guarantees payments over two lives.
Often used for husbands and wives.
If one spouse dies the other spouse would continue to receive payments
as long as he/she lives.
5 3 . 11 O T H E R C O N T R A C T U A L P R O V I S I O N S
Most annuity contracts contain provisions pertaining to the length, termination and
expenses associated with the annuity.
53.11.1 Mortality Guarantee
The annuity company guarantees that it will make payments as long as the
annuitant lives.
If mortality assumptions should change, the company is still obligated to
make the payments.
53.11.2 Expense Guarantee
When calculating the amount that the annuity company will pay to a client
over a period of time, the company is also required to project its own
expenses for administering the plan.
If the cost of administration should increase, the annuity company is solely
responsible for the greater cost and may not pass this cost on to the annu-
itant.
5 3 . 1 2 TA X A T I O N OF ANNUITIES
All contributions to annuities are made with after-tax dollars, unless the
annuity is used in a qualified retirement plan.
If the contributions are after-tax dollars the amount would be considered the
investors cost basis and are not taxed when withdrawn.
If the annuity is qualified then all distribution dollars are taxed when
taken.
All qualified annuity distributions are treated as ordinary income (based
on the investors tax bracket) and not given beneficial capital gains treatment.
Withdrawal taken out prior to an investor reaching age 59 1/2 may be subject
to a 10% penalty as well as taxed as ordinary income.

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If an investor annuitizes a contract part of the monthly payment is consid-

ered a return of his/her cost basis and partly earnings. Only the earnings
portion would be taxable.
The IRS treats non-qualified annuities on a LIFO, last-in-first-out, basis.
This means that any distribution first represents earnings and would be
taxed first. After all the earnings have been withdrawn there is no additional
taxation because the cost basis has already been taxed

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53.13 ANNUITY REVIEW QUESTIONS

1. Distributions from a variable annuity are subject to which of the following
forms of taxation?
A. Not taxed because of the special investment
B. Short-term capital gains
C. Ordinary income
D. Long-term capital gains
2.Variable annuity salespersons must register with the;
I. NYSE
II. NASD
III. State insurance department
IV.State real estate department
A. I and II only
B. III and IV only
C. II and III only
D. II and IV
3. A variable annuity contract guarantees a;
I. Fixed administrative expense
II. Fixed mortality expense
III.Rate of return
A. I only
B. II only
C. III only
D. I and II only
4. A variable contract has an AIR of 7%. The current months actual perfor-
mance was 7.2%. The annuitants monthly check as compared to the prior
months check will;
A. Go down in value
B. Stay the same
C. Go up in value
D. Not enough information
5. Which of the following payout options provides the highest monthly pay-
out?
A. Life annuity
B. Life annuity with a period certain
C. Joint survivorship
D. Life annuity with a 20 year period certain

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5 3 . 1 4 VA R I A B L E A N N U I T Y R E V I E W A N S W E R S
1. (C): Distributions from all variable annuities, whether qualified or non-qualified
are taxed as ordinary income. They do not have favorable capital gain treatment.
2. (C): As a variable annuity is both a securities and an insurance product, the
salesperson must have both a securities and insurance license.
3. (D): A variable annuity guarantees both expenses and mortality risks. This
means that the amount of these costs are limited and if they go higher they will be
paid by the insurance company, not the annuitant. A rate of return, however, is
never guaranteed in a variable annuity as the investor makes the investment
choices, not the insurance company.
4. (C). Remember, if the actual return is higher than the AIR the next check will go
up in value. If the actual return was less than AIR the next check would go down in
value. If the actual return was the same as the AIR the next check would stay the
same.
5. (A): The life annuity option provides the highest monthly income.

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 Economics
Fundamental Analysis
Sources of Financial Information
Financial Formulas Recap
Technical Analysis
Portfolio Analysis
 Customer Accounts 55: Economics

Section 55: Economics

55.1 ECONOMICS MODULE OVERVIEW
You must be prepared to be tested on fundamental concepts about economic per-
formance and the monetary policy of this country. This will include phases of the
business cycle, indicators, economic theories, fiscal policy, tools of the Federal
Reserve Board (Fed), fundamental and technical analysis, balance sheets and
income statements.
55.2 ECONOMICS DEFINED
Economics is a study of supply and demand. In basic form, when people do not
want to buy an item that is in plentiful supply, the price declines. This same con-
cept applies when people want an item badly but the supply is low. Here the price
of that item would increase.
Whats key to remember is that the economic climate has an enormous effect on
the conditions of individual companies and therefore, the securities markets. Also,
earnings and business prospects, changes in the business cycle, money supply
and the Feds actions affect securities prices and trading.
55.3 BUSINESS CYCLE
Periods of economic expansion have been followed by periods of economic con-
traction in the business cycle. Business cycles go through four cycles;
1 Expansion
2 Peak (prosperity)
3 Contraction (Recession)
4 Trough (Bottom)
Expansion: This is characterized by business activity with increasing sales,
manufacturing and wages. For a variety of reasons, an economy can expand
for only so long. When it reaches its upper limit it has peaked.
Peak (Prosperity Reached): The top of the business cycle is the peak. It
represents a limit of the initial expansion.
Contraction: When business activity declines from its peak, the economy
is contracting. Mild short-term contractions are known as recessions. Longer
more severe contractions are known as depressions.
Trough: When business activity stops declining and levels off, it is known
as a trough or bottom. As the economy recovers a new expansion period
begins.

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Four Stages of the Business Cycle

Peak

Contraction Expansion

Trough Business Cycle Repeats

55.3.1 Features of a Business Cycle Expansion

Increased consumer demand for goods and services
Rising stock prices
Increases in industrial production
Increasing Gross Domestic Product (GDP)
Rising property values
55.3.2 Features of a Business Cycle Downturn
Higher consumer debt
Rising number of bankruptcies
Falling stock prices
Decreasing Gross Domestic Product (GDP)
Rising inventories
55.4 ECONOMIC DEFINITIONS
55.4.1 Recession (Bad)
The economy, according to the U.S. government, is in a recession when a
decline in real output of goods and services lasts for six months (two quarters)
or more.

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55.4.2 Depression (Worse)

If a recession continues for at least 18 months, then the downturn has become
a depression.
55.4.3 Gross Domestic Product (GDP)
Nations annual economic output
All of the goods and services produced within the nation
Includes personal consumption, government spending, gross private
investment, foreign investment and the total value of export
For exam purposes you may see the GDP as the GNP, Gross National
Products. For exam purposes they are both the same.
55.4.4 Consumer Price Index (CPI)
Most prominent measure of general price changes.
Market basket of selected goods and services in various cities across the
country.
Measures the rate of increase or decrease in a broad range of consumer
prices, such as food, housing, transportation, medical care, clothing, elec-
tricity, entertainment and services.
Computed monthly.
55.4.5 Producer Price Index (PPI)
The PPI is an Index of the price of various items such as farm products and
industrial commodities.
The leading indicator of inflation trends is the PPI.
As producer costs rise, they are passed on to consumers and ultimately
reflected in the CPI.
55.4.6 Inflation
Inflation is defined as a general increase in prices for the same output.
Mild inflation can encourage economic growth because gradually increas-
ing prices tend to stimulate business investments.
Increased inflation drives up interest rates because of the Feds reaction to
inflation.
As interest rates rise, the value of debt securities fall.

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55.4.7 Deflation
The opposite of inflation.
If prices drop for the same unit of output, deflation results.
This is probably a rare event.
Deflation usually occurs during severe recessions when unemployment is
on the rise.
55.5 ECONOMIC INDICATORS
There are certain aspects of economic activity that serve as measures or indica-
tors of business cycle phases. For this section on the exam you will need to rec-
ognize the main leading, lagging and coincidental indicators.
55.5.1 Leading Economic Indicators
These indicators provide statistics that indicate how the economy is going to
do. They are basically spot checks of business activity that reliably help predict
trends in the economy. Positive changes in these indicators predict economic
improvement while negative changes predict economic contraction.
The following list provides the major leading indicators;
Money Supply (in particular M2 - see following pages)
Stock prices (indexes measure the performance of a group of stocks)
Building permits (housing starts)
Average weekly initial claims for state unemployment compensation
New orders for consumer goods
Changes in inventories of durable goods (durable goods orders reflect the
new orders placed with domestic manufacturers for immediate and future
delivery of factory hardgoods)
Unemployment
55.5.2 Coincident Economic Indicators
These indicators indicate how the economy is performing right now. In other
words, while leading indicators reflect where the economy is going, coincident
indicators confirm where it is. They are measurable factors that vary directly
and simultaneously with the business cycle.

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The following list provides the major Coincident Indicators;

Industrial production
Personal Income
Employment levels
Nonagricultural employment
Gross Domestic Product (GDP)
55.5.3 Lagging Economic Indicators
Lagging indicators mirror the leading indicators but reach their peaks and
troughs at a later date. They help analysts differentiate long-term trends from
short-term reversals that occur in any trend. In essence, they are factors that
change after the economy has begun a new trend and serve as confirmation of
the new trend.
The following list provides the major Lagging Indicators;
Prime rate (rate banks charge their best customers)
Corporate profits
Average duration of unemployment
Ratio of inventories to sales
Credit card debt
55.6 ECONOMIC THEORIES
The following are various theories reflecting different views that effect the
economy.
55.6.1 Keynesian Theory
Active government involvement in the economy is vital to the health and
stability of a nations economy.
Keynesians believe that demand for goods ultimately controls employment
and prices.
Insufficient demand for goods causes unemployment.
Too much demand causes inflation.
The government should stay active through spending and intervention to
ensure economic growth.

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55.6.2 Supply Side Theory

Government should allow market forces to determine prices of all goods.
Supply-siders believe the federal government should reduce government
spending as well as taxes.
Sellers of goods will price them at a rate that allows them to meet market
demand and still sell them profitably.
Bottom line, the government should remain relatively inactive and the econ-
omy will grow by itself.
55.6.3 Monetarist Theory
The money supply needs to be properly controlled by the economy to pros-
per.
The Federal Reserve Board controls the money supply.
Too many dollars chasing too few goods leads to inflation.
Too few dollars chasing too many goods leads to deflation.
Well-controlled, moderately increasing money supply leads to price stability.
55.7 FISCAL POLICY
The fiscal policy is the governments use of taxation and expenditure programs to
maintain a stable, growing economy.
The Fiscal Policy is set by the President and Congress.
This policy generally refers to governmental budget decisions which can
include an increase or decrease with the following;
- Money raised through taxes
- Federal budget deficits or surpluses
- Federal spending
The political process determines the fiscal policy of this country. Therefore, it
takes time for conditions and solutions to be identified and implemented. Because
of the time necessary to negotiate political decisions, the fiscal policy is an ineffi-
cient means to solve short-term economic problems.
55.7.1 Expenditure Programs
The government may spend money to create programs hoping to stimulate the
economy. When the government spends more than it collects in taxes, it is
forced to borrow the difference. This is known as deficit spending and may
cause the level of interest rates to rise.

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55.8 MONETARY POLICY

The monetary policy of this country is regulated by the Federal Reserve Board
while the fiscal policy is regulated by Congress and the President. The primary
focus of the monetary policy is the control of inflation.
55.8.1 Money Supply
While most persons think of money as cash in their pockets, economists take a
much broader view and would include credit, loans and other liquid instru-
ments. The money supply in the United States is divided into three categories.
The money supply categories are as follows;
55.8.1.1 M-1
M-1 includes currency in circulation, checking (demand) deposits and
NOW accounts (interest bearing checking accounts). Demand deposits
is one in which the depositor retains the right to withdraw the deposit at
any time (on demand) without giving prior notice.
This category is known as fast money as the funds can be accessed
and used quickly.
55.8.1.2 M-2
M-2 includes everything in M-1 plus savings (time) deposits (less than
$100,000) and money market accounts (short-term debts). Time deposit
is one in which the depositor agrees to leave money in the bank for a
period of time and, for doing so, receives interest.
These time deposits include savings accounts, nonnegotiable CDs and
overnight repurchase agreements (see following pages).
55.8.1.3 M-3
An even broader money definition.
Includes M-2 plus time deposits over $100,000
Repurchase Agreements with terms longer than one day
55.8.1.4 L
M-3 plus other liquid assets such as term Eurodollars held by non-bank
U.S. residents.
Bankers acceptances
Commercial paper

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Treasury bills
U.S. Savings Bonds
55.9 FEDERAL RESERVE BOARD
Also known as the FRB, the Board consists of 12 regional Federal Reserve Banks
and hundreds of national and state banks. The FRB determines monetary policy
and takes actions to implement its policies which include;
Acting as an agent of the U.S. Treasury
Setting reserve requirements for members
Regulating the U.S. money supply
Supervising the printing of the currency
Examining members to ensure compliance with federal regulations
Clearing fund transfers throughout the system
55.9.1 FRBs Influence on the Economy
The Federal Reserve Board has great power to influence the supply of money
in the economy. Every month the FED meets to analyze trends in the economy
and to decide what actions, if any, are necessary to influence the current
money supply.
55.9.2 FRB Tools
55.9.2.1 Reserve Requirements
Commercial banks must deposit a certain percentage of their deposi-
tors money with the Federal Reserve.
All money commercial banks deposit at Federal Reserve Banks, includ-
ing money exceeding the reserve requirement, is known as Federal
Funds.
When the Fed raises the reserve requirement, banks must deposit
more funds with the Fed with a result of having less money to lend
(money supply tightens).
When the Fed lowers the reserve requirement, banks can take back
funds with a result of having more money to lend (money supply loos-
ens).
To expand credit during a recession in order to stimulate a slow economy
the Fed would lower the reserve requirements.
To tighten credit to slow economic expansion in order to prevent inflation
the Fed would raise reserve requirements.

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55.9.2.2 Discount Rate

The discount rate for Series 7 purposes is the interest rate that the Fed-
eral Reserve charges member banks for loans, using government secu-
rities or eligible paper as collateral. This provides a floor on interest rates,
since banks set their loan rates a notch above the discount rates.
To compensate for shortfalls in its reserve requirement, a bank may bor-
row money directly from the Fed at its discount rate or borrow the excess
reserves (Federal Funds) from another member bank.
The interest rate commercial banks charge each other for such loans is
called the Federal Funds Rate.
This rate fluctuates daily and is the most volatile of the interest rates.
Prime Rate is the interest rate charged by member banks to their best
customers. The prime rate generally follows the direction of the discount
rate.
55.9.2.3 Margin Rate
The Fed sets initial margin rates for securities under Reg. T.
To tighten credit, the Fed can increase margin rates.
To loosen credit, the Fed can decrease margin rates.
The current rate of 50% has not changed since 1969.
55.9.2.4 Open Market Operations
The Federal Reserve trading desk in New York adjusts credit availabil-
ity daily through repurchase and reverse-repurchase agreements with
government dealers.
The Fed buys and sells U.S. government securities (repurchase agree-
ments) in the open market to expand and contract the money supply.
The Federal Open Market Committee (FOMC) meets regularly to direct
the governments open market operations.
When the FOMC buys securities, it increases the supply of money in the
banking system.
When the FOMC sells securities, it decreases the supply of money in
the banking system.

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55.9.2.5 Repurchase Agreements

These are known as REPOs.
Contract entered into by the Fed to purchase U.S. Government securi-
ties from dealers, at a fixed price, with provisions for their resale back to
the dealer at the same price plus a negotiated rate of interest.
By doing the above, the Fed is lending money and therefore increases
bank reserves. This may cause a temporary decline in short-term
rates such as the Fed Funds rate.
55.9.2.6 Reverse REPO
Occurs when the Fed sells securities to dealers with the intention of buy-
ing the securities back at a future date.
This has a short-term affect of absorbing funds from the money supply
and may cause a temporary increase in the federal funds rate.

Effects of the FRBs Activities Review

Effect on Money Impact on
Activity Supply & Credit General Interest
(loan) Availability Rate Levels

Raise bank reserve requirements Decrease Raise

Raise the discount rate Decrease Raise
Raise margin requirements Decrease Raise
Sell government Securities in the
Decrease Raise
open market
Lower bank reserve require-
Increase Lower
ments
Lower the discount rate Increase Lower
Lower margin requirements Increase Lower
Buy government securities in the
Increase Lower
open market

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55.10 FISCAL & MONETARY POLICY EFFECT

55.10.1 Securities Markets
As the economy moves through the different phases of the business cycle,
the bond and equity (stock) markets react to these changes.
In the bond markets, prices of bonds move inversely to interest rates. As
interest rates increase, bondholders sustain losses as the prices of their
bonds fall. If interest rates fall, bondholders will benefit from rising prices.
Both have an influence on the Stock Market.
Interest rate sensitive stocks, such as those issued by utilities, react to
changes in interest rates. Since utility companies are highly leveraged, it
becomes more expensive for these companies to raise money when inter-
est rates increase.
Cyclical stocks are those stocks that move with the business cycle. If
the economy is in a period of prosperity, these companies prosper. How-
ever, as the economy falters, cyclical stocks decline. Examples of cyclical
stocks would be construction companies and machine tool companies.
Stocks of defensive companies react less to changes in the business
cycle than cyclical stocks. Defensive industries include;
- Utilities, tobacco, food and drugs
If the Fed eases interest rates, the money supply increases, making credit
easier to obtain which will increase overall liquidity.
Lower tax rates can stimulate spending by leaving more spendable dollars
in the hands of individuals and businesses.
Like easier credit, lower tax rates are bullish for the stock market.
Raising taxes reduces the amount of money available to businesses and
consumers for spending and investment.
55.10.2 Interest Rates
A loans interest rate is the cost of the money.
The supply and demand of money determines interest rates.
When the money available for loans exceeds demand, interest rates fall.
When the Fed tightens the money supply, interest rates rise.
The Fed influences the money supply in several ways that can and will
influence interest rate levels.

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55.10.2.1 Fed Raises Interest Rates

This will curb a high inflation rate as inflation occurs when companies
raise the price of their products because people are spending too freely.
Helps raise the value of the U.S. Dollar in relation to foreign currencies.
If interest rates are high, the U.S. is in a tight money situation where the
U.S. dollar is harder to get.
The U.S. dollar is also subject to supply and demand.
If the U.S. dollar is strong, people will be able to buy more foreign
goods with the same amount of money.
High interest rates hurt the market because investor dont have the
extra money to spend.
A bearish market may prevail.
Businesses are effected as they would have to pay more interest on
loans which will result with lower earnings.
The economy will slow down because the U.S. dollar would be strong
in relation to foreign currency. Therefore, it would be cheaper for U.S. cit-
izens to buy their goods and cheaper for foreigners to buy their own
goods.
55.10.2.2 Fed Lowers Interest Rates
This would help the U.S. avoid or get out of a recession.
A recession is a mild 6 month economic decline.
A bullish market may prevail.
Low interest rates stimulate the market because people have more
money to invest.
Businesses are also effected because they would not have to pay as
much interest to borrow money.
U.S. exports would increase because foreign currency would be strong
as compared to the U.S. dollar.
It would be cheaper for foreigners to buy U.S. products.
U.S. dollar would decline in relation to foreign currencies.
If the U.S. dollar is weak, imports would be more expensive.
Lower interest rates would lead to higher inflation.

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55.10.3 Disintermediation
Disintermediation is defined as the flow of money out of low yielding sav-
ings accounts and investing in higher yielding investments.
Disintermediation occurs during periods of tight money.
5 5 . 11 I N T E R N A T I O N A L M O N E T A R Y FACTORS

55.11.1 Balance of Payments

This is the flow of money between the United States and other countries.
55.11.1.1 Surplus
The balance of payments may be a surplus, in which case there is more
money flowing into the country than out.
55.11.1.2 Deficit
A deficit is caused by more money flowing out of the country than
coming in. (Imports increase)
A deficit may occur when interest rates in another country are high
because money flows to where it earns the highest return.
Exports decrease
Foreign tourists visiting the U.S. decrease.
U.S. tourists visiting foreign countries increase.
Dividends and interest paid on U.S. securities held by foreigners
increase.
Dividends and interest paid on foreign securities held in the U.S.
decrease.
Foreign purchases of U.S. securities decrease.
U.S. purchases of foreign securities increase.
55.11.1.3 Deficit Summary
If any activity causes the U.S. dollar to be sold the value of the dollar
will decrease which will add to the trade deficit.
If any activity causes the U.S. dollar to be bought then the value of the
dollar increases which will add to the trade surplus.

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55.11.2 Balance of Payments Review

When debits exceed credits, a deficit in the balance of payments occurs.
When credits exceed debits surplus in the balance of payments occurs.

Debit (Deficit) vs. Credit (Surplus)

Debit Items Credit Items

Imports
U.S. spending abroad
U.S. investments abroad
U.S. bank loans abroad
U.S. foreign aid
Exports
Foreign spending in the U.S.
Foreign investments in the U.S.

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55.12 ECONOMICS REVIEW QUESTIONS

1. Which is considered to be a coincident economic indicator?
A. Corporate profits
B. Stock market prices
C. Orders for machinery
D. Index of industrial production
2. An easing of money and credit in the economy will probably be the
result of;
I. Increasing the discount rate
II. Increasing reserve requirements
III.Decreasing reserve requirements
IV.Decreasing the discount rate
A. I and II only
B. II and III only
C. III and IV only
D. I and IV only
3. All of the following tools are used by the Federal Reserve to control the
money supply EXCEPT;
A. Setting reserve requirements
B. Open market operations
C. Setting the discount rate
D. Setting the prime rate
4. Cyclical changes in the business cycle would most likely have the great-
est affect on a;
A. Utility company
B. Machine tool company
C. Tobacco company
D. Food company
5. A six-month mild decline in economic activity is a(an);
A. Expansion
B. Upsurge
C. Recession
D. Depression

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55.13 ECONOMIC REVIEW ANSWERS

1. (D): Corporate profits show what happened in the preceding quarter so they are
a lagging indicator. Stock market prices are a leading indicator. Orders for machin-
ery show production to come and are a leading indicator. The index of industrial
production shows current production levels and is a coincident indicator.
2. (C): An easing of money and credit in the economy (more money would be
available) would be the result of a decrease in the discount rate and a discount in
reserve requirements. Both would cause an increase in the free reserves of banks
that could be loaned out.
3. (D): Monetary policy tools of the Fed include setting reserve requirements, the
discount rate and margin rates. The prime rate is set by Fed member banks which
is offered to their best customers.
4. (B): The stock of a machine tool company is cyclical and fluctuates with the
business cycle. The other choices are necessities or staples and are considered
defensive due to their resistance to recession.
5. (C): A recession is a decline in the GDP for 2 consecutive quarters or more.

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 Customer Accounts 56: Fundamental Analysis

Section 56: Fundamental Analysis

56.1 OVERVIEW
This section will review fundamental analysis which includes balance sheets,
income statements, financial events, financial ratios, analysis of a companys
earnings and how to interpret information found in a stock table.
56.2 FUNDAMENTAL ANALYST
The fundamental analyst makes his/her investment decisions based on the fun-
damentals of corporations. The analyst will generally examine the following;
Outlook for the industry
Management of the companies
Product lines of the companies
Market share of the companies
Anticipated introduction of new products by the companies
Companies issue quarterly and annual financial reports to their stockholders
that include a companys balance sheet and income statement.
56.3 BALANCE SHEET
The balance sheet provides a snapshot of a companys financial position at a spe-
cific point in time. It identifies the value of the companys assets (what it owns) and
its liabilities (what it owes). The difference between the assets and the liabilities is
the corporations equity or net worth.
It is called a balance sheet because the total assets will always equal the sum
of the total liabilities plus the stockholders equity as show below;
56.3.1 Assets
Assets are broken up into Current Assets which are made up of cash and
assets easily convertible into cash as well as other assets which include fixed
assets (that could eventually be sold) and other assets (usually intangible and
only of value to the corporation owning them).
56.3.1.1 Current Assets
Cash and equivalents: cash and short-term safe investments, such as
money-market instruments, that can be sold easily as well as other mar-
ketable securities.

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Accounts receivables: Money owed to the company by customers who

purchased goods and have not yet paid. The company would expect to
receive these funds within one to three months.
Inventory: The cost of raw materials, work in process and finished
goods ready for sale. Of the current assets, inventories are the least liq-
uid since they can be difficult to dispose of at full value.
- Last in First Out (LIFO): A method of valuing an inventory. Under
LIFO, the cost of the last item produced is applied to the price of the
first item sold from inventory. Using LIFO during an inflationary period
would result in lower profits and lower taxes.
- First In First Out (FIFO): Also a method of valuing an inventory.
Under FIFO, the cost of the first item produced is applied to the
money received from the first item sold. FIFO would result in a greater
profit because a lower cost basis is used. Therefore, the company
would report larger profits and pay a larger amount of taxes.
Prepaid Expenses: Items a company has already paid for, but has not
yet benefited from, such as prepaid advertising, rents, taxes and operat-
ing supplies.
56.3.1.2 Fixed Assets
Fixed assets are items used by the company in its day-to-day operations
to create its products. These assets are not intended to be sold or con-
verted into cash. They are typically property, plant and equipment.
Unlike, current assets, they are not easily converted into cash.
Fixed assets, with the exception of land, lose some of their value each
year due to normal use. The IRS allows a company to claim this wear and
tear on assets as a deduction against income. This deduction is known as
depreciation.
On a balance sheet, fixed assets are shown at a value of their original
cost less accumulated depreciation which is the amount of depreciation
claimed on the asset to date.
56.3.1.3 Depreciation Methods
Straight-Line Method: The same amount of depreciation is claimed
each year. It is calculated by dividing the cost of the asset by its useful
life. The useful life of an asset is set by the IRS Code.
Accelerated Method: This method allows larger depreciation deduc-
tions than straight-line in the assets earlier year. These larger deduc-
tions would have the effect of reducing the companys taxable income.

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56.3.1.4 Other Assets

Other assets such as intangible assets do not have any physical value
but they do add substantial value to a company. Some intangible assets
differentiate the company from competitors and are proprietary such as
patents, trademarks, franchises and copyrights.
Goodwill is another example of an intangible asset. Goodwill represents
the amount that was paid above the value of the assets to acquire the
company. Factors contributing to goodwill would be a companys potential
earning power due to its reputation in the marketplace, customer relations
and skilled staff.
56.3.2 Liabilities
Total liabilities on a balance sheet represent all financial claims by creditors
against the corporations assets (corporate debts). The liabilities portion of the
balance sheet is listed by Current Liabilities and Long-Term Liabilities.
56.3.2.1 Current Liabilities
Those debts that will become due in less than one year.
Examples of current liabilities include;
- Accounts Payable: The amount a company owes for goods and ser-
vices purchased on credit.
- Accrued Wages Payable: Unpaid wages, salaries, commissions and
interest.
- Notes Payable: Short-term loans from banks and other financial insti-
tutions.
- Dividends Payable: Cash dividends that have been declared by the
Board of Directors but have not been paid.
- Taxes Payable: The amount of tax that is owed to the government.
- Interest Payable: The amount of interest the company owes on its
long-term debt.
56.3.2.2 Long-Term Liabilities
Long-term debts are financial obligations due for payment after twelve
months.
Long-term examples include;
Bonds (known as funded debt)
Long-term bank loans

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56.3.3 Stockholders Equity

The stockholders equity is also known as net worth or owners equity.
- It represents the stockholders claims on a companys assets after all
of its creditors have been paid.
- It represents the shareholders ownership interest.
- Shareholders equity equals total assets less total liabilities.
56.3.3.1 Types of Stockholders Equity
Preferred Stock: Listed on the balance sheet based upon the par value
of the outstanding shares. The usual par value for preferred stock is
$100. In some cases, the preferred stock dividend may be expressed as
a percentage of its par value.
Common Stock: Common stock is listed on the balance sheet based
upon the par value of the companys outstanding common stock. The
par value of a stock is only used for bookkeeping purposes. The com-
mon stocks par value does not influence the market price of the stock.
Market prices reflect such factors as supply and demand for the shares
as well as the companys management and profitability.
Capital Surplus: The amount of premium paid by shareholders above
par value for shares sold to the public by the corporation. It is also
referred to as paid-in capital or paid-in surplus.
Retained Earnings (earned surplus): Retained earnings represents net
profits that have been retained for future use by the corporation. Divi-
dends are normally paid from retained earnings.
56.3.4 Balance Sheet Terminology
Capitalization: This is the combined sum of its long-term debt and equity
accounts.
Liquidity
Working capital is the amount of capital or cash a company has available.
Therefore, working capital is a measure of a firms liquidity, its ability to
quickly turn assets into cash to meet its short-term obligations.
The formula for working capital is:
- Current Assets - Current Liabilities = Working Capital

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Stuff Inc. Corporation

Balance Sheet
December 31, 200X
Assets (000) Liabilities (000)

Current Assets Current Liabilities

Cash $ 5,300 Accounts Payable $10,000
Marketable Securities $ 6,700 Interest Payable $ 2,800
Accounts Receivable $25,000 Notes Payable $ 11,200
Inventories $13,700 Taxes Payable $ 2,000
Total Current Assets $50,700 Total Current Liabilities $26,000

Fixed Assets Long-Term Liabilities

Long-term liabilities 7%
Land $15,700 $40,000
Debentures due 2020
Plant and Equipment $5,700
Furniture & Fixtures $1,200 Total Liabilities $66,000
Less: Accumulated
$(5,300)
Depreciation
Total Fixed Assets $17,300 StockHolders Equity
5% Convertible Preferred
Stock $100 par. 100,000 $10,000
shares issued (cp=20)
Intangible Assets Common Stock $1 par $1,000
Capital in Excess of Par
Goodwill $25,000 $4,000
(Capital Surplus)
Retained Earnings $12,000
Total Net Worth $27,000
Total Liabilities &
Total Assets $93,000 $93,000
Stockholders Equity

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56.4 INCOME STATEMENT

The income statement details all sources of revenue and expenses for the year.
It is also known as a profit and loss statement. The purpose of this statement is
to detail the companys net income (or net loss). This is accomplished by offset-
ting the revenues by expenses.
Below is a sample income statement and retained earnings statement for Stuff
Inc. Corporation

Stuff Inc. Corporation Income Statement

For Period ending December 21, 200X (000)
Sales $76,000
Less:
Operating Expenses:
Cost or Goods Sold 10,000
Selling & Administrative Expenses 6,000
60,000
Less:
Depreciation Expense 5,000
Operating Income 55,000
Earnings Before Interest & Taxes 55,000
Less:
Bond Interest Expense 2,800

Earnings Before Tax 52,200

Less:
Taxes (34% Rate) 17,748
Net Income or Loss $34,452

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56.4.1 Components of the Income Statement

Sales: Represents the total money received from the companys primary
source of business.
Operating Expenses: Reflect the daily costs of doing business. Included
here is the amount claimed for the depreciation of fixed assets.
Operating Income: Is a result of sales minus operating expenses.
Other Income: If there is other income (not in the income statement on the
prior page) it would be added to the Operating Income. Other income
includes income generated by investments (dividends and interest).
Earnings before Interest and Taxes (EBIT): This is the result of Operat-
ing Income plus Other Income. EBIT is reduced by bond interest and taxes
to arrive at net income or net loss.
Bond Interest Expense: Bond interest must be paid regardless of the
companys profitability. If it cannot be paid, the company is in default. The
amount of interest paid is found by multiplying the total par value of the
bonds by the coupon rate. Also note that interest is paid prior to taxes.
Taxes: Taxes are then paid and deducted (rate indicated on the Income
Statement).
Net Income or Loss: This is the result of all of the above.
56.4.2 Statement of Changes to Retained Earnings
The Statement of Retained Earnings shows all changes to Retained Earn-
ings during the year.
Net income increases retained earnings
Dividend distributions decrease retained earnings

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Statement of Changes to Retained Earnings for the year ending

December 31, 200X (000)
Beginning of Year Retained Earnings 4,000 (from prior year)
Add:
34,452 (Taken from the
Net Income for the Year
Income Statement)
Deduct:
Preferred Dividends 125
Common Stock 800

End of Year Retained Earnings $37,527

56.5 ANALYZING FINANCIAL STATEMENTS

The fundamental analyst uses the information from a companys financial state-
ments to determine the financial strengths and weaknesses of a corporation.
Then the analysis will also seek to compare the companys performance to other
companies within the same industry.
Various financial ratios and formulas will reveal information regarding the com-
panys liquidity, capitalization, ability to meet fixed costs and profitability.
To illustrate the use of financial analysis, refer to the balance sheet and income
statement of Stuff Inc. Corporation found on the previous pages for the financial
formulas that follow.
56.5.1 Liquidity Ratios
Liquidity ratios will indicate a companys ability to meet its short-term debts as
well as convert current assets into cash.
Liquidity is normally analyzed by calculating the following;
56.5.1.1 Net Working Capital
Companies need working capital to finance its daily operations.
This money is usually used to bridge the gap between production and
sales

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Maintaining a comfortable level of working capital is important.

Working capital will enhance the companys ability to meet its current
obligations, expand its production and take advantage of opportunities.
Net working capital = Total Current Assets - Total Current Liabilities
56.5.1.2 Current Ratio
This ratio indicates the companys ability to pay its current liabilities by
using current assets.
A low current ratio may indicate a working capital problem.
Current Ratio = Total Current Assets divided by Total Current Liabilities
Using the financial statements: $50,700,000 (Current assets) divided
by $26,000,000 (Current Liabilities) = 1.95 to 1.
Therefore, there are $1.95 of current assets for each $1.00 of current lia-
bilities.
Most analysts feel that a current ratio of at least 2 to 1 indicates safety.
56.5.1.3 Quick Asset (Acid Test) Ratio
The quick asset ratio is a more stringent measure of liquidity than the
current ratio as it subtracts out the companys inventory.
Quick Assets = Total Current Assets minus inventory divided by the
current liabilities
Using the financial statements: $50,700,000 minus $13,700,000
(inventory) divided by $26,000,000 = 1.42 to 1.
Therefore, there are $1.42 of current assets for each $1.00 of current lia-
bilities.
A quick asset greater than 1 to 1 is normally considered safe
because it indicates that the company would be able to pay its bills for a
short period of time without any revenues or sales.

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56.5.1.4 Cash Asset Ratio

This is the most stringent test of a companys ability to meet its current
obligations.
Fundamental analysts tend to look at this number to assess the com-
panys ability to meet current expenses and dividends.
Cash Flow = Net Income (or loss) plus Depreciation Expense
Using the Income Statement: $34,452,000 + $5,000,000 =
$39,452,000
A positive cash flow indicates that the company has sufficient income
to pay expenses and possibly make dividend distributions.
A negative cash flow means that the company is losing money and
may have trouble meeting its short-term obligations.
56.5.2 Capitalization Ratios
Capitalization ratios are used by most analysts to assess the companys risk of
bankruptcy.
The first step is to calculate the Total Long-Term Capital. This consists of the
entire stockholders equity section plus long-term liabilities.
For example, Stuff Inc. Corporations long-term capital is calculated as follows;

Total Long-Term Capital (000)

Long-Term Liabilities
7% Debentures due 2020 $ 40,000

+ Stockholders Equity
5% Preferred Stock at Par 10,000
Par Value of Common Stock 1,000
Capital Surplus $4,000
Retained Earnings 12,000

Total Long-Term Capital $67,000

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56.5.2.1 Bond Ratio

This ratio indicates the percentage of long-term capital that is attributable
to bonds.
Bond Ratio = Par Value of Bonds divided by Total Long-Term Capital
Using the Balance Sheet:$40,000,000 / $67,000,000 = 60%
This means that 60% of the capitalization was sales of bonds.
56.5.2.2 Preferred Stock Ratio
This ratio shows the portion of long-term capital that comes from preferred
stock.
Preferred Stock Ratio = Par Value of Preferred Stock divided by the
Total Long-Term Capital
Using the Balance Sheet: $10,000,000 / $67,000,000 = 15%.
This means that 15% of the capitalization was sales of preferred stock.
56.5.2.3 Common Stock Ratio
This ratio shows the portion of long-term capital that comes from common
stock.
Common Stock Ratio = Common stock at Par + Capital Surplus +
Retained Earnings divided by the Total Long-Term Capital
Using the Balance Sheet: $1,000,000 + $4,000,000 + $12,000,000
divided by $67,000,000 = 25%
This means that 25% of the capitalization were sales of common stock.
Test Alert: In the above examples, the capital structure of Stuff Inc.
Corporation consists of 60% of bonds, 15% of preferred stock and
25% of common stock.
A company with a high percentage of bonds (debt) outstanding is
considered to be highly leveraged. This type of companys earnings
or profitability is greatly affected by changes in interest rates.
56.5.3 Additional Financial Formulas
56.5.3.1 Debt-to-Equity Ratio
This ratio compares securities with fixed charges (bonds and preferred
stock) to those securities without fixed charges (common stock). It is used
to evaluate the credit strength of the corporation.

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Debt-to-Equity Ratio = Bonds + Preferred Stock divided by Common

Stock at Par + Capital Surplus + Retained Earnings
56.5.3.2 Return on Common Equity
This formula compares the amount of income available to the common
shareholders each year to the value of the companys common stock.
Return on Common Equity = Net Income - Preferred Dividends
divided by Common Stock at Par + Capital Surplus + Retained
Earnings
56.5.3.3 Inventory Turnover
The inventory turnover rate indicates the companys efficiency in manag-
ing its inventory level.
A low turnover may indicate that the companys inventory is too large,
representing an inefficient use of the companys assets.
A high turnover normally shows that products sell quickly and cost of
storing the inventory is low.
Inventory Turnover Rate = Cost of Goods Sold divided by the Inventory
56.5.3.4 Book Value per Common Share
Analysts look to the balance sheet to determine the amount of assets that
back the securities issued by a company. This figure is called the book
value per common share.
Book Value Per Common Share = Total Assets - Intangibles - Total
Liabilities - Preferred Stock divided by the Number of Outstanding
Common Shares.
56.5.4 Evaluation of Earnings
56.5.4.1 Earnings per Share (EPS)
Contributes to the market price of a stock.
Calculation indicates the amount of earnings available to the common
stockholder.
EPS = Net Income - Preferred Dividends divided by the Number of Out-
standing Shares
Using the Stuff Inc. Corporations Income Statement and Balance
Sheet: Net Income of $34,452,000 - Preferred Dividends of $125,000
divided by 1,000,000, the number of outstanding common shares (com-
mon stock at par divided by par value) = $34.33.

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56.5.4.2 Earnings per Share on a Fully Diluted Basis

If a corporation has rights, warrants, convertible preferred stock or con-
vertible bonds outstanding, the earnings per share (EPS) could be diluted
(decreased) by an increase in the number of shares of common outstand-
ing.
In other words, if the same amount of earnings available to common
shareholders were allocated to more shares of stock, earnings would be
less for each share.
So, the EPS after dilution assumes that all convertible securities have
been converted into the common.
Facts Needed to Calculate the EPS on a Fully Diluted Basis:
Stuff Inc.s primary EPS is $34.33 (see prior page)
$10,000,000 of 5% Preferred Stock (Conversion Price = 20)
34% tax rate
1,000,000 common shares outstanding

Step 1: Calculate Net Income

Earnings Before Interest & Taxes $55,000,000
Bond Interest ($40,000,000 x 7%) - 2,800,000
Earnings Before Tax 52,200,000
34% Tax Rate -17,748,000
Net Income $34,452,000

Step 2: Calculate the EPS (as shown on the prior page)

EPS = $34,452,000 (Net Income) minus $125,000 (Preferred Divi-
dends) divided by 1,000,000 shares (outstanding shares) = $34.33
Step 3: If the convertible preferred stock were to be converted the EPS
would be lower because of the additional outstanding common shares
from the conversion.
With the conversion price - CP = 20, each preferred share would be con-
vertible into 5 shares of common stock. Mathematically, its easier to take
the $10,000,000 in preferred stock and divide it by the CP of 20. This
results in 500,000 of additional shares of common.

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Step 4: Calculate the new earnings available for common. Add back
the $125,000 of preferred dividends as the preferred shares no longer
exist (converted to common) = $34,452,000. (original net income)
Step 5: Take the Earnings Available for Common of $34,452,000 and
divide it by the new number of shares of common (1,500,000) = $22.97.
This is the EPS on a fully diluted basis.
56.5.5 Price Earnings Ratio (P/E)
The P/E ratio is widely used as it provides investors with a rough idea of
the relationship between the prices of different common stocks compared to
the earnings that accrue to one share of stock.
The P/E ratio is calculated by taking the Current Market Price of the com-
mon stock and divided it by the Earnings Per Share (EPS).
A P/E ratio of 12 means that the stock is selling at 12 times its earnings.
Whether this is good or not requires comparing this stock to other stocks in
the same industry.

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 Customer Accounts 57: Sources of Financial Information

Section 57: Sources of Financial Information

57.1 ANNUAL REPORTS
A report that goes to all its stockholders which contains all of the important
financial data needed by a financial analyst.
The balance sheet and income statement will be presented and analyzed by
the companys management.
Footnotes to financial statements are also included which will note such
items as the;
- Methods of depreciation
- Inventory valuation used
- Market price of securities
- Fully diluted earnings per share
- Any other data needed to make the presented data understandable
and complete
57.2 NEWSPAPER LISTINGS
Stock and bond prices are listed each day in the financial section of the
newspaper.
Investors are able to monitor their investments, as well as the performance
of companies.
Information found in the newspaper are generally applicable to both funda-
mental and technical analysis.
Daily stock tables will provide the following to investors;
- Closing market price
- Dividend
- Yield
- P/E ratio
- Trading volume

Turn the page for an example of a daily stock table along with
explanations and analysis of its content!

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57.2.1 Stock Table Example

57.2.1.1 Clorox Stock Explained

Clorox Stock Chart
1 2 3 4 5 6 7 8 9 10

52 Weeks Yield Sales Net

Stock Dvd. P/E HIgh Low Close
High/Low % 100s Chg.
60.38/44.00 Clorox 1.52 2.9 14 722 51.88 50.75 51.88 -.13

Column 1: Highest and lowest price during the last 52 weeks

Column 2: Company name - if an s next to it, it means a split or stock dividend
Column 3: Reflects current annual dividend
Column 4: Represents the current yield
Column 5: Reports the price/earnings ratio.
Column 6: Shows volume in hundreds of shares (722,000 Clorox shares)
Column 7,8,9: Indicates the high, low and closing price for the day
Column 10: Shows the price change from the previous days closing price. The closing price was
down.13 cents.

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 Customer Accounts 57: Sources of Financial Information

Exam Alert: The Series 7 exam will ask some questions as to what would
be effected on the balance sheet when certain events take place. The fol-
lowing section reflects the financial events that can be tested.

Paying a cash dividend: Cash, a current asset, and dividends payable, a

current liability, are both reduced by equal amounts. This will have NO
effect on net working capital or stockholders equity.
Declaring a cash dividend: Retained earnings (part of stockholders
equity) is reduced and dividends payable (part of current liabilities) is
increased. This will reduce net working capital since current liabilities and
current assets remain unchanged.
Stock Dividends: Only the stockholders equity portion of the balance
sheet is affected. The number of common shares increases, retained
earnings is decreased, and an adjustment to capital surplus may be made.
Stock Split: Only stockholders equity is affected. The number of com-
mon shares and the par value per share are changed based on the stock
split but the total par value remains the same.
Buying Equipment or Machinery for Cash: Cash, a current asset, is
reduced and equipment, a fixed asset, is increased by a corresponding
amount. This will reduce net working capital because current assets are
reduced and current liabilities remain the same.

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Notes

NASD Series 7 Page 464

 Customer Accounts 58: Financial Formulas Recap

Section 58: Financial Formulas Recap

58.1 EXAM OVERVIEW OF FINANCIAL FORMULAS
While the current format of the Series 7 exam is not heavy with mathematical
financial formulas, you are responsible for learning them. In recent times the
financial formula questions have focused on questions about which balance sheet
accounts are effected when a financial event takes place. However, we dont want
you to be surprised if a couple of financial formula questions are asked.
58.1.1 Liquidity Formulas
(+) add (-) subtract (/) divide (=) equals
Net Working Capital = Total current assets - Total current liabilities
Current Ratio = Total current assets / Total current liabilities
Quick Asset Ratio = Total current assets - Inventory / Total current liabilities
Cash Flow = Net Income (or loss) + Annual Depreciation
58.1.2 Capitalization Ratios
Bond Ratio = Par value of bonds / Total long-term capital
Preferred Stock Ratio = Par value of preferred stock / Total long-term capital
Common Stock Ratio = Common stock at par + Capital surplus + Retained
earnings / Total long-term capital
Debt to Equity Ratio = Bonds + Preferred stock / Common stock at par + Cap-
ital surplus + Retained earnings
58.1.3 Coverage Ratios
Bond Interest Coverage = Earnings before interest & taxes / Annual bond
interest expense
Preferred Dividend Coverage = Net income / Preferred dividends
58.1.4 Use of Assets
Inventory Turnover Rate = Cost of goods sold / Inventory
Book Value per Common Share = Total assets - Intangibles - Preferred stock
/ Number of outstanding shares

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58.1.5 Profitability
Operating Profit Margin = Operating income / Net sales
Net Profit Margin = Net income / Net sales
Return on Common Equity = Net income - Preferred dividends / Common
stock at par + Capital surplus + Retained earnings
58.1.6 Evaluation of Earnings
Earnings per share = Net income - Preferred dividends / Number of outstand-
ing shares
Price/Earnings Ratio = Market price / Earnings per share
Dividend Payout Ratio = Annual dividend paid on common stock / Earnings
per share
Current Yield = Annual dividend per common share / Current market price

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 Customer Accounts 59: Fundamental Analysis Review Questions

Section 59: Fundamental Analysis Review

Questions
1. When a corporation declares a dividend:
I. Current assets decrease
II. Current liabilities decrease
III. Stock holders equity decreases
IV. Current liabilities increase
A. I and II only
B. II and III only
C. III and IV only
D. II, III and IV only
2. Which of the following ratios would be used by an analyst examining the
capital structure of a wine producing corporation?
A. The acid-test ratio
B. The current ratio
C. The debt-to-equity ratio
D. The price/earnings ratio
3. A corporation issues new common stock. Which of the following are
affected?
I. Current Assets
II. Total liabilities
III. Net worth
IV. Retained earnings
A. I and II only
B. III and IV only
C. I, III, IV only
D. I and III only
4. A corporation buys some office furniture and fixtures, paying cash. Which
of the following are affected?
I. Current Assets
II. Total liabilities
III. Net worth
IV. Working capital
A. I and III only
B. II and III only
C. I and IV only
D. I, II, III and IV

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5. A customer reading the newspaper notes that a corporation has a PE

ratio of 9 and a market price of $27. The earnings per share of the company
is approximately.
A. $1.50
B. $3.00
C. $18.00
D. $36.00
6. An investor may find all of the following financial information in a corpo-
rations balance sheet EXCEPT the:
A. Expense ratios of the corporation
B. Assets of the corporation
C. Book value of the corporation
D. Long-term funds received from all sources
7. If total assets remain the same, but stockholders equity decreases, this
means that;
A. Retained earnings increased
B. Total liabilities increased
C. Capital in excess of par increased
D. Accrued expenses decreased
8. All of the following are examined by a fundamental analyst EXCEPT;
A. Balance sheets
B. EPS
C. Industry
D. Timing
9. The interest rate that banks charge each other for overnight loans is the;
A. Discount rate
B. Fed Funds rate
C. Prime rate
D. Call loan rate
10. The interest rate charged in margin accounts is the;
A. Discount rate
B. Fed Funds rate
C. Prime rate
D. Call loan rate

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 Customer Accounts 59: Fundamental Analysis Review Questions

59.1 REVIEW ANSWERS

1. (C): When a corporation declares a dividend, stockholders equity (retained
earnings) is decreased and current liabilities are increased. When the corporation
pays the dividend, current assets are decreased and current liabilities are
decreased.
2. (C): The capital structure of a corporation is the dollar amount of the corpora-
tions capitalization (equity and debt securities). An analyst would therefore be
interested in the debt to equity ratio. This is actually the ratio of those securities
creating fixed charges (bonds plus preferred stock) to common stock.
3. (A): If new common stock is issued, cash increases (from the proceeds of the
sale) as well as common stock at par and capital in excess of par. There is no
effect on retained earnings - which change due to profits, losses, and dividend
payouts.
4. (C): If furniture is bought with cash, then cash goes down (current asset) and
property, plant and equipment increases (long-term asset). If current assets drop,
then working capital drops. There is no effect on current liabilities because the fur-
niture is fully paid. Net worth is only affected by a profit, loss, dividend payout, or
capital structure change.
5. (B): The price/earnings ratio (PE) is found by dividing the earnings per share
into the market price of the stock. When given the market price and the P/E ratio,
the approximate earnings per share may be found by dividing the market price by
the P/E ratio ($27 market price divided by 9 = $3.00)
6. (A): Expense ratios cannot be determined from the balance sheet. All expenses
are found in the income (profit and loss) statement. All of the other items men-
tioned can be determined from the balance sheet.
7. (B): The basic balance sheet equation is: total assets = total liabilities + stock-
holders equity. If total assets remain the same and stockholders equity
decreases, total liabilities must have increased.
8. (D): A fundamental analyst determines what to buy by examining the income
statement, balance sheet, industry, and management of the company. A technical
analyst determines when to buy (timing).
9. (B): The Fed Funds rate is the interest rate that commercial banks charge each
other for overnight loans and is the most volatile of all interest rates.
10. (D): The call loan rate is the interest rate charged in margin accounts by bro-
kerage firms and is the highest of all loan rates.

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Notes

NASD Series 7 Page 470

 Customer Accounts 60: Technical Analysis

Section 60: Technical Analysis

60.1 OVERVIEW
Technical analysts do not use the fundamentals of a company as a basis for
deciding whether to buy or sell securities. Instead, they use indexes, averages,
theories, trends and charts to predict the direction of both the overall market and
specific stocks. Technical analysts look at the past history of securities and the
markets to formulate their opinions.
Exam Alert: Technical analysis is used for Short-Term forecasts, not
long-term forecasts.
60.2 MARKET DATA
Technical analysts look to identify market trends as early as possible.
They advise clients as to the investments which should profit from the trend
until there is a reversal.
Technical analysts accomplish the above by following the markets and indi-
vidual securities by watching an assortment of market data.
60.2.1 Indexes and Averages
Indexes and averages monitor the performance of a group of securities. Some
reflect the entire market and are known as broad-based. Others, known as nar-
row-based, measure only a market segment or a particular industry.
60.2.1.1 Dow Jones Averages
The Dow Jones averages are the most widely quoted measurements of
the stock market. The Dow Jones Composite Average consists of 65
stocks. The Composite is broken down into the following averages;
Dow Jones Industrial Average: Consists of 30 stocks
Dow Jones Transportation Average: Consists of 20 stocks
Dow Jones Utility Average: Consisting of 15 stocks
The Dow Jones Industrial Average (DJIA) is the most commonly quoted
measure of the stock market. It contains 30 of the leading blue chip com-
panies that represent the backbone of industry of the United States.

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60.2.1.2 Standard & Poors 500 Index

This Composite Index contains mostly NYSE stocks with some AMEX and
Nasdaq stocks. This gives a broader measure of the market when com-
pared to the Dow Jones Averages. This index consists of;
400 industrial stocks
20 transportation stocks
40 financial stocks
40 utility stocks
60.2.1.3 New York Stock Exchange Composite Index
The NYSE Composite Index contains all of the common stocks that are
listed on the New York Stock Exchange. It is divided into four subindexes;
Industrial
Transportation
Financial
Utility
60.2.1.4 The Wilshire Associates Equity Index
This index consists of stocks which trade on the NYSE, AMEX and in the
over-the-counter market. The index represents the dollar value of all of the
stocks. The Wilshire index is considered the broadest of all indexes and
averages.
6 0 . 3 T R A D I N G VO L U M E
Trading volume is reported daily by the exchanges and the NASD.
Volume figures show the total number of shares traded for each security
and the market.
Analysts monitor these figures carefully because, historically, volume tends
to lead a trend in prices.
Analysts consider it normal for stock prices to rise on increasing volume.
This occurrence does not signify a reversal in the markets trend.
A small price rise that is accompanied by decreasing volume is often con-
sidered the reversal of a trend and is therefore bearish.
For NYSE listed securities, trading volume is broken down to show the
activity at all regional exchanges as shown on the Weekly Volume by Mar-
kets in NYSE-Listed Stocks on the next page.

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 Customer Accounts 60: Technical Analysis

60.3.1 .Weekly Volume by Markets of NYSE Stocks

(Shares in
thousands) Last Week Previous Week Year Ago
By Market

NYSE 4,801,945 6,601,481 5,360,562

CBOE 0 0 0
Chicago 228,819 299,791 264,740
Pacific 23,513 31,459 3,079
Nasdaq (NASD) 617,987 755,346 629,716
Philadelphia 34,517 48,649 26,472
Boston 108,7961 151,452 136,588
Cincinnati 36,314 54,672 30,508
Total 5,851,890 7,942,849 6,451,669

Note: Third market trading (NYSE listed stock traded in the Nasdaq mar-
ket) is shown in the Nasdaq listing.
6 0 . 4 TE C H N I C A L M A R K E T T H E O R I E S
These theories represent another set of tools for a technical analyst. Theories
concentrate on the concerns of market activity. These theories refer to certain
historical patterns in the market that may signal a bullish or bearish investment
environment.
Keep in mind though, according to many experts, using technical analysis is like
looking through a rear view mirror.
60.4.1 Technical Analysis Conclusions
When a bullish signal is present, analysts will issue a recommendation to
buy securities.
For a bearish signal, the recommendation will be to either sell existing
positions or to sell securities short.

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60.4.2 Short Interest Theory

Short interest refers to the number of shares that have been sold short.
Because short positions must be repurchased eventually, some analysts
believe that short interests reflects mandatory demand, which creates a
support level for stock prices. High short interest is a bullish indicator, and low
short interest is a bearish indicator.
The term short interest refers to the amount of a companys shares of
common stock that have been sold short and have not yet been covered
(closed out).
Each month, the NYSE, AMEX and the National Market System compile a
list of various companies short interest.
60.4.2.1 Short Interest Highlights Example
Short Interest Highlights Example
Largest Short Positions - 2003
Rank Feb 14 Jan 15 Change

1. Nasdaq-100 Trust 203,718,540 167,090,046 36,628,494

2. SPDR 500 SPY 60,371,623 44,579,619 15,792,004
3. Diamond Tr 14,517,019 11,750,519 2,766,500
4. Nabors Industries 9,450,232 5,740,166 3,710,066
5. Devon Energy Corp 7,417,158 6,673,370 743,788
6. Ivax Corp 4,084,673 4,824,337 -739,664

Some analysts believe that an increase of a short interest position as

in the Nasdaq 100 Trust, is indicative of a bullish trend in sight. They
believe this because short sellers must eventually cover their short sales.
As they purchase the stock, this will cause the market price to increase.
Historically, a high short interest has been considered a bullish indicator
by a technical analyst.
60.4.3 The Odd-Lot Theory
Typically small investors engage in odd-lot trading. This theory focuses on the
trading activity of small investors. They tend to buy and sell odd-lot amounts
(less than 100 shares).

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 Customer Accounts 60: Technical Analysis

Followers of this theory believe that these small investors invariably buy
and sell at wrong times.
When odd-lot traders buy, odd-lot analysts are bearish.
When odd-lot traders sell, odd-lot analysts are bullish.
Statistics are kept that track the buy and sell orders of odd-lot transac-
tions and are published daily. (See chart below)
60.4.3.1 NYSE Odd-Lot Trading
NYSE Odd-Lot Trading Example
(Shares in Thousands)
2/18 2/19 2/20
Daily

Purchases 12,691,000 7,006,900 8,052,800

Short Sales 861,977 908,264 891,831
Other Sales 9,161,300 11,713,400 10,365,600

60.4.4 Advance-Decline Theory

This theory measures the number of stocks that have increased versus the
number of decreasing issues for a trading session or other period of time.
This data is published daily and tends to show the direction of the market
as well as the breadth of a market movement.
If there are more advancing issues than declining issues a bullish market
is indicated.
If the market averages such as the Dow Jones Industrial Average are up
but the advance-decline figures are negative, analysts consider this as a
bearish indicator.

Go to the next page for an Advance-Decline example!

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Customer Accounts 60: Technical Analysis

Market Advance/Decline Totals Example

Weekly comp. NYSE AMEX Nasdaq

Total Issues 3,527 993 3,742

Advances 2,354 565 2,240
Declines 1,086 360 1,367
Unchanged 87 78 135
New Highs 105 19 144
New Lows 139 44 194

60.4.5 Dow Theory

Analysts generally use the Dow Theory to confirm the end of a major trend
as well as changes in the underlying trend of the market.
Historically, Dow theorists have looked to the Dow Jones averages for this
information.
A major trend is confirmed only when both the Dow Jones Industrial Aver-
age and Transportation Average reach a new high or new low.
Without this information, the market will drift back to its previous trading pat-
tern.

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 Customer Accounts 61: Charts and Patterns

Section 61: Charts and Patterns

61.1 OVERVIEW
Technical analysis attempts to predict the direction of prices based on historic
price and trading volume patterns when laid out graphically on charts. Price pat-
terns are generally used to make buy and sell recommendations to investors.
Technical analysts are often called chartists because of their use of charts plot-
ting stock price movements in determining market moves.
61.1.1 Trendlines
While a stocks price may spike up or down daily, over time its price
tends to move in one direction.
Technical analysts identify patterns in the trendlines of individual stocks
from graphs as they do patterns in the overall market.
They base their buy or sell recommendations on a stocks price
trendline.
- An upward trendline is bullish
- A downward trendline is bearish

Upward Trend Downward Trend

Bullish Bearish

Go to the next page!

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61.1.2 Resistance & Support Lines

Over periods of time, the market or stock tends to trade within a certain range.
In some cases, there is an increase to a particular price level where heavy sell-
ing pressure is encountered. This is known as an area of resistance. Prices
are too expensive causing buying to cease. This is sometimes referred to as an
overbought market.
At other times there is a decline to a particular price level causing investors to
purchase at the attractive lower price. This buying stops the price decline. This
is known as an area of support. Prices become so enticing that selling stops
and buying begins. This is sometimes referred to as an oversold market.

Resistance Level

A B X Y

Support Level

Levels A and B Levels X and Y

Shows an area of Resistance
At this level, selling pressure
tends to prevent the market or
security from increasing.
In some cases, investors feel
that previous buying has left
prices too high and will con-
sider the price level to be over-
bought.
Shows an area of Support
At this level, buying pressure
tends to prevent the further
decline of the market or
security.
In some cases, investors feel
that previous selling has left
prices at an attractive level
and will consider the price
level to be oversold.

Go the next page!

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 Customer Accounts 61: Charts and Patterns

61.1.3 Breakout
A breakout occurs when the stocks price either increases above a resis-
tance level or declines below a support level.
When this happens, a technical analyst believes the price of the stock will
continue on its course.
A breakout above the resistance level is considered a bullish signal. To
profit from this, investors would enter a buy stop order slightly above the
resistance level. As the stocks price increased above resistance, the order
will be executed.
A breakout below the support level is a bearish signal. Investors would
want to sell short slightly below the support level. This could be accom-
plished by entering a sell stop order below the support level.
61.1.4 Reversals
Head Head and Shoulders Bottom
Shoulder Shoulder
Consolidation

Head

Head and Shoulders Top

Shoulder Shoulder
Indication of a bearish reversal of Indication of a bullish reversal of an
an uptrend downtrend

A reversal indicates that an upward or a downward trendline has halted

and the stocks price is moving in the opposite direction.
In between two trendlines, a period of consolidation occurs, and the stock
price levels off. This would be a sideways movement, neither up nor down.
61.1.5 Saucer Patterns
A saucer is a chart pattern used by technical analysts which indicates that a
stock has formed a bottom in its trading cycle and is ready to rise. The bottom
of the saucer pattern is a bullish indicator for the stock.

Reverse Saucer

Saucer

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61.1.6 Reverse Saucer Pattern

The reverse of the saucer pattern is the inverse saucer, where the stock forms
a top in its pattern and is expected to fall. Following the logic used in the sau-
cer, this is a bearish indicator.

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 Customer Accounts 62: Technical Analysis Review Questions

Section 62: Technical Analysis Review

Questions
1. When analyzing a corporations stock, a technical analyst would be
LEAST concerned with its;
A. Chart pattern
B. Short interest
C. Trading volume
D. Debt-to-equity ratio
2. A technical analyst who monitors stock advances against declines sub-
scribes to the;
A. Dow Theory
B. Efficient Market Theory
C. Odd Lot Theory
D. Breath of Market Theory
3. A head and shoulder top formation is:
I. Bullish
II. Bearish
III. Reverse Upward Trend
IV. Reverse Downward Trend
A. I and III
B. II and III
C. I and IV
D. II and IV
4. An extended period where there is no discernible trend in prices is
termed;
A. Consolidation
B. Resistance
C. Support
D. Overbought
5. The market price average is increasing daily. However, the level of
advances relative to declines is falling. The market is reaching a(an);
A. Breakout on the upside
B. Overbought condition.
C. Oversold condition.
D. Breakout on the downside.

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6 2 . 1 TE C H N I C A L A N A L Y S I S R E V I E W A N S W E R S
1. (B): A technical analyst would not be concerned with a corporations debt-to-
equity ratio. A fundamental analyst would examine the debt-to-equity ratio to ana-
lyze a companys capitalization.
2. (D): An analyst who charts advances relative to declines is measuring the
breadth of the market movement as an indicator of future market direction.
3. (B): A head and shoulder top formation is bearish since the market has topped
out and is trending down. It is an uptrend that has reversed itself.
4. (A): The market is said to be consolidating when prices are not moving in any
direction for a long period after a price rise or fall.
5. (B): The market averages are rising, but the strength of the market is weaken-
ing because advancing issues are declining relative to falling issues. The market
is reaching an overbought condition, and is approaching a peak.

Go to the next page!

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 Customer Accounts 63: Portfolio Analysis

Section 63: Portfolio Analysis

63.1 OVERVIEW
The Series 7 exam expects you to understand the basics about portfolio analysis.
This includes;
Changing factors that affect customers investment objectives.
Portfolio management policies
Portfolio theory and its application to security selection.
63.2 FACTORS AFFECTING INVESTMENT OBJECTIVES
When involved with making recommendations for constructing portfolios it is
imperative that you consider all the factors that may cause a change in the portfo-
lio currently or in the future. When changes are necessary you need to discuss
your recommendations with your clients and agree to what changes should be
made and the timing.
63.2.1 Specific Examples
Age
Marital status
Family responsibilities
Education
Investment experience
Changes in marital status
Completion of college education
Loss of a job
Serious medical condition
Disability
Death in the family
Divorce
Retirement
Speculative vs. Safe money
Income needs

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63.3 PORTFOLIO RISKS

There are a number of risks that may effect a portfolio or securities.
63.3.1 Systematic Risk
This is the risk of a general market decline affecting the portfolio.
This is known as Market Risk.
Market risk cannot be diversified away.
63.3.2 Non-Systematic Risk
This is the risk of a single investment going bad.
This is also known as Selection Risk.
By diversifying the portfolio, this risk is minimized.
63.3.3 Capital Risk
This is the risk that the amount invested may not be fully recovered.
63.3.4 Timing Risk
The risk that buying and selling occur at disadvantageous price levels due
to poor market timing.
63.3.5 Selection Risk
The risk of choosing a security that does not perform well when given a
choice of many different suitable securities.
63.3.6 Legislative Risk
Risk that the profit potential from a securities investment may be adversely
affected by new or revised legislation.
This can occur at the federal, state or local level and relates to all securities.
A prime example of this is the Tax Reform Act of 1986 which dramatically
changed the tax benefits of limited partnerships.
63.3.7 Liquidity Risk
The investors ability to sell a security without a substantial loss.
This type of risk tends to increase as the quality of an investment
decreases.

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63.3.8 Purchasing Power (Inflationary) Risk

The risk that, due to inflation, the value of the dollar will decline over time
causing a decline in the purchasing power of a dollar.
Historically, equities and variable annuities provide the best protection
against this type of risk.
Fixed income products such as bonds and fixed annuities have a high
degree of purchasing power risk because their income is fixed and will be
eroded by inflation.
63.3.9 Interest Rate Risk
The risk that if interest rates rise, the price or value of an investors bond
holdings will decline.
Longer maturities tend to have a greater interest rate risk than shorter
maturities.
63.3.10 Reinvestment Risk
The risk that a bondholder will be unable to reinvest interest payments at a
rate equaling the current rate of return.
Zero-coupon bonds have no reinvestment risk since there are no interest
payments to reinvestment.
63.3.11 Call Risk
The risk that bondholders will have their investments redeemed (called) by
the issuer prior to the stated maturity date.
If a bond has a coupon rate that is higher than is currently available in the
market, the bond may be called.
The bondholder would then lose the high coupon bond and have to invest
in other bonds which offer the current lower yield.
63.4 PORTFOLIO MANAGEMENT POLICIES
Portfolio management policies provide whether specific portfolios are aggressive,
defensive or even a combination between the two. Prior to forming a specific port-
folio, the financial services person must form an agreement with the client as to
how the portfolio will be constructed.
An investors risk tolerance and financial objectives will contribute heavily to what
assets are selected in the construction of a portfolio.

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63.4.1 Active Asset Management

Based on the belief that fundamental analysis performed by an analyst can
identify undervalued securities and produce a superior return within that
asset class.
This strategy seeks to find inefficiencies in market pricing of specific securi-
ites.
63.4.2 Passive Asset Management
This form of portfolio management is based on the belief that the market is
efficient in pricing securities.
An index fund can be used for each class.
Therefore, the desired diversification can be achieved with minimum annual
expenses.
63.5 PORTFOLIO THEORY
There are various approaches to the construction of investment portfolios. They
vary as to risk, management philosophy and diversification methods.
63.5.1 Portfolio Diversification
Portfolio diversification is based on the maxim of do not put all your eggs in
one basket (Reduction of risk). Some ways to diversify are as follows;
- Type of instrument (equity, debt, packaged etc.)
- Industry
- Companies within an industry
- Length of maturity
- Investment rating
- Geography
Proper diversification must take at least three factors in account.
- Time factor: A persons choice of investments should partly depend
on his/her investment time horizon. For example, if the individual
requires the funds within six months, then the investment should be
planned using short-term investment vehicles.
- Amount of Return Required and Risk Tolerance: These two factors
are tied together. Investors must decide how much return they want to
aim at and what kind of risk tolerance they have towards the invest-
ment. This step is important, because it will help facilitate the types of

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 Customer Accounts 63: Portfolio Analysis

investment that are suitable to the investors needs and help them
avoid the most common investment mistakes.
In simple terms, diversification is the process of combining securities in
such a way that the variability of independent factors tends to be canceled
out which also helps reduce risk.
Some investors say that a portfolio can be diversified by including assets
across all asset classes. However, investors then need to answer the ques-
tion as to how much should be invested in each asset class?
Some investors say that a portfolio can be diversified on one asset class
such as common stock. However, investors then need to answer the ques-
tion as to which corporations should be purchased?
Through diversification, if any one asset sector gives lower than expected
or negative returns, this will not impact the portfolio as strongly, and other
sectors might perform better than expected to offset such an event.
63.5.2 Capital Asset Pricing Theory (CAPT)
Under modern portfolio theory this theory looks at portfolio performance based
upon a combination of its assets risk and return. This theory provides a frame-
work for helping the individual understand the relationship between risk and
return.
63.5.2.1 Capital Asset Pricing Model (CAPM)
This model relates the risk as measured by beta to the required rate of
return or expected level of return on a security. (Beta will be discussed
later)
The CAPM breaks down an investments return into a risk-free rate of
return (rate of a security only having systematic risk) plus a risk premium
(unsystematic risk component).
63.5.2.2 Efficient Market Theory
This theory holds that securities prices instantaneously and fully reflect all
available information. Because of this, random selection of a portfolio
should provide a return that is as good as a selection by any other analyti-
cal method.
63.5.2.3 Efficient Frontier
Choices of securities are graphically plotted using the securities rate
of return and risk factors.

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Once the securities are plotted, a line is drawn known as the efficient
frontier line.
Only portfolios that lie on or below the efficient frontier should be con-
structed.
The area above the line represents very high returns at low risk which
are unattainable.
63.5.3 Asset Allocation
Asset Allocation is the process of determining optimal allocations for the
broad categories of assets such as stocks, bonds, cash, real estate etc. that
suit an investors time horizon and risk tolerance.
While this process can be performed on any portfolio with two or more
assets, it is most commonly applied to asset classes. This allocation is
probably the most important decision and may account for more than 80%
of the return of the portfolio.
Each asset class will generally have different levels of return and risk.
They also behave differently. At the time one asset is increasing in value,
another may be decreasing or not increasing as much and vice versa.
The major decision to be made for a client is the allocation of portfolio
assets between equity investments and interest bearing investments. This
decision will establish the basic risk (volatility of the return) versus rate of
return characteristics of the portfolio.
63.5.3.1 Equities vs. Debt
A portfolio needs to be balanced between interest bearing and equity
investments. The basic trade-off between the two types of investments is;
Interest Bearing Investments: These have lower credit risk and no vol-
atility of return for fixed income investments. But, the return is suscepti-
ble to market risk and purchasing power risk.
Equity Investments: They have higher credit risk and much greater vol-
atility of return. But, they have proven over time to be able to grow at a
faster rate than inflation (purchasing power).
63.5.3.2 Time Horizon Issues
Long-Term Time Horizon: Over the long-term, inflation has proven to
be the greatest risk. This makes equity investments the better choice for
long-term time horizons.

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 Customer Accounts 63: Portfolio Analysis

Short-Term Time Horizon: Over the short-term, equity returns can be

much more volatile and can be negative as well. This makes interest
bearing securities the better vehicle.
63.5.3.3 Liquidity Needs
Another factor to consider in portfolio construction is portfolio liquidity.
A portion of the portfolio needs to remain liquid to meet anticipated or
even unanticipated cash needs.
63.6 PORTFOLIO CONSTRUCTION
Creating an investment portfolio involves the following steps:
1 Selecting which asset classes will be represented in the portfolio.
2 Determining the target percentage of the portfolio to allocate to each
asset class.
3 Specifying for each asset class the allowable range by which the allocation
can be changed to take advantage of market conditions.
4 Selection of the securities within each of the asset classes.

63.6.1 Traditional Portfolio

The normal asset allocation, selected by the manager, is based on the clients
investment objectives and risk (volatility) tolerance of the customer.
The traditional portfolio is one that consists of;
U.S. Government Treasury Bills
Long-Term Corporate Bonds
Large Company Stocks
63.6.2 Strategic Asset Allocation
The allocation is the proportion to be invested in different types of securi-
ties.
The proportion of assets of each asset class is termed the Portfolio Bal-
ance or the Normal Asset Allocation.
The target weights chosen will depend on the customers investment
objective, time horizon, risk tolerance, etc.
The objective is to achieve the highest expected return versus risk (vola-
tility) assumed by the client.

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63.6.3 Tactical Asset Allocation

Minimum and Maximum limits are set for each asset classs portfolio pro-
portion.
This allows the portfolio manager to take advantage of market conditions,
within the parameters set by the minimum and maximum percentages.
This is the market timing aspect of portfolio construction.
If conditions favor one asset class over another, the manager can time
the market within the allowed percentages.
The idea behind the tactical minimum and maximum percentages is that it
allows the investment manager to shift portfolio emphasis based upon
market conditions.
63.6.4 Asset Classes
Treasury Bills
Treasury / Agency Bonds
International Bonds
Large Cap Stocks
Mid Cap Stocks
Small Cap Stocks
International Stocks
REITs
Micro-Cap Stocks
63.7 ALPHA AND BETA CONSIDERATIONS
Portfolio theorists measure risk through Alpha and Beta.
63.7.1 Alpha
A measure of stock price volatility based on the specific characteristics of
that company.
The higher the Alpha, the higher the stock specific risk.
For example, an alpha of +1 means that the stock is not projected to rise
at all, based on the fundamental factors for that company and industry.

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 Customer Accounts 63: Portfolio Analysis

However, an alpha of +1.75 means that the stock is expected to rise 75%
in price based on those fundamental factors.
Alpha is not widely followed in the real marketplace.
63.7.2 Beta
A measure of stock price volatility based solely on general market move-
ments.
The higher the beta, the more volatile the stock relative to the market.
Beta solely measures price volatility of a stock relative to the market,
while the fundamental characteristics of that stock are ignored when com-
puting beta.
For example, a beta of +1 means the stock is exactly as volatile as the
market. (up or down)
The usual market indicator is the Standard and Poors 500 Average.
If the beta is +3, this indicates that the stock moves three times as fast as
the market. (up or down)
If the beta is -1, this means that when the market moves up, this stock
moves down at exactly the same rate. (Very few negative beta stocks)
A completely diversified portfolio would have a beta of 1. This indicates
that its movements match that of the overall market. A portfolio with a beta
of 1 would only be subject to systematic risk. All non systematic risk has
been diversified away.
A portfolio with a beta of greater than 1 indicates that non systematic risk
is still present in the portfolio.
High beta stock examples include technology and automobile companies.
These stocks are quite volatile because their earnings fluctuate substan-
tially.
Low beta stock examples include utilities and drug companies. Because
their earnings are more consistent form year to year, their prices generally
move more slowly than the market overall.

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63.8 PORTFOLIO ANALYSIS REVIEW QUESTIONS

1. Market risk is the same as;
A. Selection risk
B. Credit risk
C. Systematic risk
D. Non-systematic risk

2. The measure of stock specific risk is;

A. Delta
B. Alpha
C. Beta
D. Pita

3. A portfolio with a beta of +1 has;

A. No risk
B. Unsystematic risk
C. Systematic risk
D. Both systematic and unsystematic risk

4. Passive asset management is

A. Using index funds as the investments for each asset class.
B. Buying securities positions and holding them to the liquidation date of the port-
folio.
C. Selecting securities to be purchased for each asset class based upon funda-
mental analysis.
D. Buying securities positions and holding them until pre-established prices are
reached.

5. The use of multiple asset classes when constructing a portfolio reduces;

A. Purchasing power risk
B. Regulatory risk
C. Market risk
D. Interest rate risk

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 Customer Accounts 63: Portfolio Analysis

63.9 PORTFOLIO ANALYSIS REVIEW ANSWERS

1. (C): Market risk is the same as systematic risk. This risk cannot be diversified
away.
2. (B): Alpha measures the risk peculiar to an individual security. Beta measures a
securitys volatility relative to the market.
3. (C): A portfolio with a beta of +1 is one that moves in the same direction and at
the same rate as the market. Thus, this portfolio only has market risk which is also
known as systematic risk. This is the risk that cannot be diversified away.
4. (A): Passive asset management does not mean that there is no management.
Passive asset management is the use of index funds (which are managed to mir-
ror a chosen index benchmark) as the security selections within an asset class.
Thus, the actual specific security selection and management is embedded within
the index fund chosen for investment.
5. (C): The use of multiple asset classes when constructing a portfolio reduces
market risk.

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NASD Series 7 Page 494

 Federal Securities Acts
Regulation of Broker-Dealers
Advertising & Sales Rules
Conduct Rules
Code of Procedure
NYSE Rules
 Module 65: Federal Securities Acts

Section 65: Federal Securities Acts

65.1 OVERVIEW
Both federal and state securities laws and regulations were put into place to
protect investors by requiring adequate disclosure and establish procedures to
safeguard against fraud and misrepresentations.
The Securities Act of 1933 and the Securities Exchange Act of 1934 were the
first two major federal acts established. Additional protection at the state level
consist of laws, rules and regulations and are known as Blue-Sky Laws.
65.2 FEDERAL SECURITIES ACTS
65.2.1 Securities Act of 1933
This was the first major act created by the federal government with the primary
purpose of protecting investors. This act deals with new issues coming to mar-
ket that are not exempt from registration and all associated paperwork (IPOs).
Thats why this act is known as the paper act. This set of laws basically out-
laws fraud committed in connection with the underwriting and issuing of all
securities.
65.2.1.1 Features of the Securities Act of 1933
All new nonexempt issuers must send a securities registration to the SEC for
review. An issuer can be a corporation, as an example, that is selling their
stock to the public for the first time through an IPO. (Initial Public Offering)
This is also known as the act of full disclosure
A prospectus must be furnished to all interested investors
As you recall from the new issues chapter, a selling syndicate is put together
by the investment banker by placing underwriters into the syndicate. The
underwriters are financially responsible for the selling of new securities to the
general public.
While the investment registration package is at the SEC, an issuer or issuer
representative (broker-dealer) can place an ad in a financial newspaper to
alert potential investors of the new issue that will be coming out soon. This ad
is known as a Tombstone Ad.
The purpose of the tombstone ad is to generate indications of interest from
the public. When inquiries are made, broker-dealers should send those inter-
ested parties a document known as a Preliminary Prospectus, also known

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as a Red Herring. It is called red herring because of the red writing found on
its cover.
The preliminary prospectus may be missing important information and even
the final price of the new security as this is not the final prospectus.
The time period the SEC takes to review the new registration package for
adequate disclosure is called the 20-day Cooling Off Period. For a minimum
of 20 days the registration package will be reviewed by the SEC. It is a mini-
mum number of days, not a maximum.
No sales may take place until the SEC clears the security for sale and then
the sale must be made by the final prospectus, known as the Statutory Pro-
spectus.
The SEC No Approval Clause indicating that the SEC neither approves nor
disapproves of any new issue must be printed on the cover or first page of
the statutory prospectus in bold print.
A prospectus is NOT considered advertising under the NASD advertising
rules because the prospectus is regulated by the Securities Act of 1933.
Therefore, they are not subject to the NASD advertising rules. Remember
this point as it does appear on the Series 7 exam.
After release by the SEC a meeting is held with the issuer and selling syndi-
cate. This is known as the Due Diligence Meeting in which all questions
about the new offering can be answered.
Freeriding and withholding of hot issues are not permitted. Hot issues are
public offering securities that sell at an immediate premium over the public
offering price in the secondary market. A members failure to make a bona
fide offering at the public offering price is considered freeriding and withhold-
ing under the NASDs Rules of Fair Practice.
65.2.1.2 Hot Issue Rules
A hot issue is a new stock being sold through an IPO in which there are
expectations that the value of the stock will immediately increase in value
when it starts to trade in the secondary markets.
Hot issues cannot be held back by the broker-dealer
Hot issues cannot be purchased by registered representatives or their
immediate family. (Family members living with the registered representative
and who are dependent for the reps support)
Hot issues cannot be sold to any employee or officer of a member firm
unless the firm itself is issuing its own stock.

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 Module 65: Federal Securities Acts

65.3 SECURITIES EXCHANGE ACT OF 1934

While the Securities Act of 1933 regulated paper and new issues coming to
market, the Securities Exchange Act of 1934 deals with people, the exchanges,
broker-dealers and registration issues.
Securities Exchange Act of 1934 Features
Created the Securities and Exchange Commission (SEC)
Regulates the secondary stock exchanges and the persons operating them
Regulates broker-dealers by requiring registration of broker-dealers and
their registered representatives
Regulates credit rules by the Federal Reserve Board (FRB) such as Regu-
lation T which requires investors place into a margin account a minimum of
50% of the value of the assets being purchased
Regulation T: regulates the extension of credit by broker-dealers to retail
customers
Regulation U: regulates the extension of credit by banks.
Regulation G: regulates extension of credit by anyone else.
Margin or credit cannot be used for any new security coming to market,
including mutual funds, for an initial period of 30 days.
Regulates insider transactions by persons who are defined as directors,
officers or shareholders owning 10% and their spouses. They are also pro-
hibited to act on any insider information they become aware of as an insider.
Both tippers and tippees would be liable.
Makes the omission of a material fact a violation
Requires customer statements to be sent to retail customer quarterly.
Requires trade confirmations to be mailed to buyers and sellers of securities
by the settlement date of the trade.
Potential conflicts of interest must be disclosed to customers.
Requires broker-dealers to fingerprint employees, directors, officers and
partners. However, some broker-dealer employees such as those just
involved with clerical functions or non-sales persons do not have to get their
fingerprints submitted as long as they;
- Are not involved in securities sales
- Do not handle or have access to cash or securities

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- Do not supervise other employees engaged in these activities

Requires broker-dealers, not reps, to maintain a certain level of net capital in
order to protect customers.
65.3.1 Anti-Fraud Provision
Under the Securities Act of 1934 fraud and/or deceptive practices are not per-
mitted when selling securities to the public. This provision would apply for both
exempt and nonexempt securities.
65.4 SECURITIES INVESTOR PROTECTION CORPORATION
(SIPC)
Established by Congress under the Securities Investor Protection Act of 1970.
The ACT insures the securities and cash in customer accounts of member bro-
kerage firms against the failure of those firms.
All broker-dealers registered with the SEC and with national stock exchanges
are required to be members of SIPC.
SIPC acts in a similar way to the FDIC.
When a brokerage firm fails, SIPC will first try to merge it into another broker-
age firm. If this fails SIPC will liquidate the firms assets and pay account
holders up to an overall maximum of $500,000 per customer, with a limit of
$100,000 in cash.
The SIPC does not protect investors against market risk and market losses.
The term SIPC must not appear larger than the firms own name with signs
posted on the front door of the brokerage firm, on business cards and station-
ary indicating membership to the SIPC.
Blanket fidelity bonds must be purchased by broker-dealers to indemnify
against losses for fraudulent trading, check forgery and lost securities.

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Example: Consider the following brokerage accounts belonging to vari-

ous members of the Holcomb family!

SIPC Brokerage Firm Example

Account Registration Assets

$200,000 stock and

Billy Holcomb Individual
Peggy Sue Individual
Peggy Sue and Billy Joint
Account
Billy Holcomb IRA
Peggy Sue IRA
Billy Holcomb Margin
Account
$125,000 in cash
$100,000 securities and
$75,000 in cash
$250,000 securities and
$150,000 in cash
$50,000 securities
$50,000 securities
$400,000 securities and
$50,000 in cash

65.4.1 SIPC Coverage

There are 5 separate accounts above which would be covered by SIPC as
they have different registrations. The Billy Holcomb margin account, how-
ever, needs to be combined with his regular account for purposes of SIPC
as they are considered to be one account.
The regular Billy account combined with the margin Billy account would
have a total of $600,000 in securities and $175,000 in cash. The maximum
of $500,000 would apply to this account of which only $100,000 can be in
cash.
The joint account would be covered for $250,000 in securities but only
$100,000 of its cash for a total of $350,000.
Both IRAs would be covered for $50,000 each.
6 5 . 5 TR U S T I N D E N T U R E A C T OF 1939
The Act was passed to protect bondholders and requires that issuers of these
bonds appoint a trustee to ensure that promises, or covenants, between the
issuer and the bondholders are carried out.

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65.5.1 Trust Indenture Act Rules Apply to;

New bond issues with more than $5 million within 12 months and
New bond issues which have a maturity of nine months or more
65.6 INVESTMENT COMPANY ACT OF 1940
This Act defines and regulates investment companies such as mutual funds. The
Act requires that investment companies;
Register with the SEC before selling shares to the public
State clear investment objectives
Have a net worth of at least $100,000 before offering shares to the public
Be owned by a minimum of 100 shareholders
Comply with standards on pricing, public sale and reporting requirements
6 5 . 7 I N V E S T M E N T A D V I S O R S A C T OF 1940
This Act requires that any person who is in the business of giving advice con-
cerning the purchase and sale of securities must register with the SEC. A person
must register as an investment advisor if that person;
Provides advice or issues reports regarding securities
Is in the business of providing such service
Provides services for compensation which can include commissions and/or
fees
6 5 . 8 I N S I D E R TR A D I N G A N D S E C U R I T I E S F R A U D
ENFORCEMENT ACT OF 1988
This Act supplemented and expanded the original insider trading rules under the
Securities Act of 1934. Insider information is any information that has not been
disseminated to, or is not readily available to the general public.
Exam Clue: Our best advice is to remember the following statement and
apply it to any potential exam questions regarding insider trading informa-
tion:
Anyone who uses or passes on nonpublic information goes to jail.
A slip of the tongue can cause a violation.
Proof and investigations are not subject to a test question, only recogni-
tion of the violation.

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The SEC may seek civil and criminal penalties against anyone it believes has vio-
lated this Act. Anyone guilty is liable for civil penalties of up to the greater of $1
million or 300 percent of profits made or losses avoided.
6 5 . 9 F E D E R A L TE L E P H O N E C O N S U M E R P R O T E C T I O N
ACT
Customers of brokerage firms and almost any consumer are protected against
unsolicited telephone calls under this Act. This is also known as the cold call-
ing rule.
The following rules apply;
Unsolicited telephone calls are prohibited prior to 8:00 am and after 9:00 pm
local time. This means the time zone of the person being called.
Callers must identify themselves and give their name, firm, address and/or
telephone number prior to making their presentation
If persons called indicate that they want their names off of the calling list the
caller must not only remove their names from the list but also place their
names in a do not call folder. This folder is subject to audit by the NASD
and/or other self regulatory organizations (SRO) such as the New York Stock
Exchange.
65.10 ANTI-MONEY LAUNDERING RULES (PATRIOT ACT)
65.10.1 Anti-Money Laundering Requirements
Establish written anti-money laundering program.
Provide ongoing training to all employees in procedures to detect and pre-
vent money laundering.
Report suspicious transactions and activity.
When opening an account for a customer, the firm must independently ver-
ify the customers name and address as given.
The Act requires broker-dealers to file Suspicious Activity Reports
(SARs). Such as;
- Potential client has an unusual concern with the firms compliance
with government reporting requirements
- Is being reluctant to reveal information about his or her business activ-
ities
- Furnishes unusual or suspect identification or business documents.

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- Wishing to engage in transactions that lack business sense or that are

inconsistent with the customers investment strategy.
- Acting as agent for another entity but is evasive or reluctant about pro-
viding information about that entity.
- Having difficulty describing his or her business or lacking general
knowledge of his or her industry.
Customer acts which are indicators of potential money laundering related to
account activity
- Attempting to make frequent or large deposits of currency or cash
- Engaging in cash transactions structured to be under the $10,000
reporting limit
- Engaging in multiple transfers of funds or wire transfers to countries
that are considered to be non-cooperative by Federal Agencies.
- Engaging in sudden and unexplained extensive wire activity.
- Making a funds deposit followed by an immediate request that the
funds be transferred to another party without any apparent business
purpose.
- Making a funds deposit for the purpose of making a long-term invest-
ment followed shortly thereafter by a request to liquidate the position
and transfer the proceeds out of the account.
- Having multiple accounts under single or multiple names with a
large number of transfers
- Exhibiting a total lack of concern regarding risks, commissions and
other transaction costs
65.10.1.1 The brokerage firm should monitor account activity,
specifically looking for unusual;
-Wire transfer activity
-Deposits of cash aggregating in excess of $10,000
-Deposits of cash, cashiers checks, money orders and travelers checks,
to detect structuring of such deposits
65.10.1.2 Layering
Money launderers could use mutual fund accounts to layer their funds by
sending and receiving money and wiring it quickly through several
accounts and multiple institutions or by redeeming fund shares purchased

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with illegal proceeds and then reinvesting the proceeds received in

another fund.
Layering could also involve purchasing funds in the name of a fictitious
corporation or an entity designed to conceal the true owner.
Mutual funds could also be used for integrating illicit income into legiti-
mate assets. Integration occurs when illegal proceeds appear to have
been derived from a legitimate course.
For example: If an individual were to redeem fund shares that were pur-
chased with illegal proceeds and direct that the proceeds be wired to a
bank account in the persons own name, the transfer would appear legit-
imate to the receiving bank.
6 5 . 11 P E N N Y S T O C K R U L E S
The SEC adopted this rule to prevent certain abusive sales practices involving
high risk securities sold to unsophisticated investors. These securities have
been identified as non-Nasdaq equity securities traded in the OTC market for
prices less than $5 per share. These shares are frequently referred to as penny
stocks and are considered highly speculative.
The rules state the following;
Registered representative must first determine suitability based on informa-
tion about the buyers financial situation and financial objectives.
The customer must sign and date this suitability statement before the penny
stock trades can be effected.
The broker-dealer must also disclose the following;
- Name of the penny stock
- Number of shares to be purchased
- Current quotation
- Amount of commission that the firm and the registered representative
received
Established customers are exempt from this rule but not from the disclo-
sure requirements.
An established customer is someone who has;
- Opened an account with a broker-dealer
- Made a deposit of funds or securities and;

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- Made a securities transaction within the last year; or

- Has made at least three penny stock purchases of different issuers
on different days.

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65.12 REVIEW QUESTIONS

1. Which of the following securities transactions are subject to the anti-
fraud provisions of the Securities and Exchange Act of 1934?
I. Corporate Stock sales
II. U.S. Treasury Notes
III. Municipal Bonds
A. I only
B. I and II
C. II and III
D. I, II and III
2. Freeriding and withholding applies to which of the following?
A. New issues that sell at a premium
B. New issues that sell at a discount
C. All securities no matter how they sell
D. None of the above
3. The time period during which the SEC reviews new registration packages
is known as the;
A. Due Diligence Meeting
B. 20-day cooling off period
C. 90 day cooling off period
D. Blue-sky timer period
4. To which security market does the Securities Act of 1933 apply?
A. Primary
B. Secondary
C. Third
D. Fourth
5. Maximum protection for SIPC accounts is;
A. $500,000 in securities plus $100,000 in cash
B. $500,000 with any combination of securities and cash
C. $500,000 total which includes a maximum of $100,000 in cash
D. $500,000 in securities and no cash protection

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65.13 REVIEW ANSWERS

1. (D) All securities and all transactions are subject to the anti-fraud provision of
the Securities Act of 1934.
2. (A) New issues selling at a premium are known as hot issues. Freeriding and
withholding applies to hot issues.
3. (B) All new registration packages are reviewed by the SEC for a minimum of 20
days. This is known as the 20-day cooling off period.
4. (A) The Securities Act of 1933 applies to the registration of new nonexempt
issues.
5. (C) SIPC provides protection up to $500,000 which includes a maximum of
$100,000 in cash.

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Section 66: Registration and Regulation of

Broker-Dealers
66.1 SECURITIES AND EXCHANGE COMMISSION (SEC)
The primary regulatory body of the securities industry is the SEC. Broker-dealers
that transact securities business with customers or with other broker-dealers must
have an approved registration with the SEC.
Broker-dealers that do not comply with the SEC would be subject to;
Censure
Suspension of registration
Revocation of registration
Fine
Penalties
Any associated person who is barred from the business is not allowed to associ-
ate with a broker-dealer without the SECs express permission. If a member bro-
ker-dealer (firm) suspends a registered representative, the firm must report the
suspension to the exchanges where the firm is a member.
66.1.1 Fingerprinting
Registered broker-dealers must have fingerprint records made for most of their
employees, all directors, officers and partners.
The following would be exempt from this fingerprinting requirement;
Those not involved in the sale of securities
Those that do not handle or have access to cash or securities or to the
books relating to money and securities
Those who do not supervise other employees engaged in the above activi-
ties
66.2 SELF-REGULATORY ORGANIZATIONS (SRO)
There are a number of self-regulatory organizations that function under the SECs
oversight. Each SRO is accountable to the SEC for enforcing federal securities
laws as well as supervising securities practices within an assigned jurisdiction.

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The largest of these SROs are as follows;

NASD: Regulates all matters relating to investment banking, trading in the
OTC market and to the conduct of NASD member firms and associated per-
sons.
New York Stock Exchange (NYSE): Regulates all matters related to trading
in NYSE listed securities and to the conduct of NYSE member firms and
associated persons.
Municipal Securities Rulemaking Board (MSRB): Regulates all matters
related to the underwriting and trading of state and municipal securities.
Remember for the exam, the MSRB can only make rules, they cannot
enforce them. The NASD enforces MSRB rules at broker-dealers. These
rules are reviewed in the Tax Advantaged Module!
66.3 NASD
The NASD is the NASDAQs/OTC industrys self-regulatory organization. The
NASD is incorporated as a corporation and is managed by the NASDs Board of
Governors. They establish rules, regulations and membership eligibility stan-
dards.
66.3.1 Purpose of the NASD
Promote investment banking and securities business
Standardize principles and practices
Promote high standards of commercial honor
Encourage observance of federal and state securities laws
Promote self discipline among members
Investigate complaints and grievance between the public and members and
between members
Provide a medium for communication both among its members and
between its members, the government and other agencies
66.3.2 NASD Districts
The NASD divides the United States into eight districts for its operations. Each
district elects a district committee to administer NASD rules. Chicago, as an
example, is District #8.

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66.3.3 NASD Dues and Assessments

The NASD is supported through the brokerage firm network to include all mem-
ber firms and their registered representatives. This support is in the nature of
assessments, registration fees and annual fees.
The annual fees include;
Basic membership fee
Assessments based on gross income
Charge for each branch office
Fee for each principal and registered representative
66.4 NASD MEMBERSHIP
66.4.1 Application
In order to apply for membership in the NASD a firm must be actively engaged
in the securities or banking industry.
The following requirements need to be complied with;
Submit the application to the NASD
Agree to pay any fees and assessments
Agree to follow the NASD by-laws, directives and regulations
The District Committee will review the firms application
The Board of Governors will also review the application
The firm must provide certain documents to the NASD;
List of firms officers, directors, partners, employees and associated
persons
Description of the applicants intended business activities
Financial information such as a balance sheet
Computation of net capital
Applicants written supervisory procedures

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66.4.1.1 Pre-membership interview

The NASD requires all new broker-dealers to participate in a pre-mem-
bership meeting with review of the following;
Applicant must demonstrate the appropriateness of its membership
Applicants business plan will be reviewed and discussed
Applicants adequacy of the following will be discussed;
- Net capital
- Record keeping systems
- Compliance procedures
- Familiarity with NASD rules
- Knowledge of state and federal laws
66.4.2 NASD Manual
The NASD manual, which must be placed in every branch office, specifies
NASD policies, rules, and procedures. It also describes the various codes and
rules by which the NASD supervises the NASDAQ/OTC market.
The manual is broken down into the following components:
Rules of Fair Practice: Also known as the Conduct Rules, they set out
fair and ethical trade practices that member firms and their registered repre-
sentatives must follow when dealing with the general public.
Code of Procedure: This section describes how the NASD hears and
resolves member violations of the Rules of Fair Practice.
Uniform Practice Code: The Code establishes the Uniform Trade Prac-
tices which include settlement, good delivery, confirmations, ex-dates and
other guidelines for broker-dealers.
Code of Arbitration Procedure: The Code of Arbitration governs the
resolution of disputes and claims between members, registered repre-
sentatives and the public. Arbitration addresses monetary claims, not
disciplinary actions.

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66.4.3 Associated Person Registration

All persons associated with an NASD member firm must be registered with
the NASD as an associated person and sponsored by a member firm. Associ-
ated persons must meet certain requirements before becoming registered.
Qualifications Investigated: Prior to submitting an application the mem-
ber firm is obligated to ascertain the persons business reputation, charac-
ter, education, qualifications and experience. The member firm must certify
that it has made an investigation and that the candidates credentials are in
order.
Failure to Register Personnel: If a member firm fails to register an
employee who performs any of the registered representatives functions,
there will be some form of NASD disciplinary action.
Changing Firms: Your NASD registration is nontransferable. If you leave
your current firm to join another firm, you must terminate registration at your
current firm on a U-5 Form and reapply for registration with the new
employing firm on a U-4 Form.
Terminating a Position: If a registered representative terminates registra-
tion with one firm, he/she must register with another firm within two years
or requalification by exam will become necessary.
Continuing Commissions: If a registered representative leaves a member
firm for reasons such as retirement, as an example, he/she may continue to
receive commissions on business placed while employed. However, a
written contract with these terms must be in place.
Termination: If an associated person voluntarily ends employment with a
member, his/her NASD registration will cease 30 calendar days from the
date the NASD receives written notice from the employing firm. This 30 day
rule is effective when any registered persons employment is terminated.
- If a registered representative is under investigation for federal securi-
ties law violations or has disciplinary action pending from the NASD or
another SRO, a member firm may not terminate its business relation-
ship with that person until the issues have been resolved.
NASD Notification of Disciplinary Action: A member firm must notify the
NASD if any associated person has been subject to disciplinary action by
any of the following;
- Stock exchange
- Clearing firm
- Federal or state regulatory commissions

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- Commodity futures agency

Exemptions from Registration: The following persons are exempt from
registration with the NASD:
- Clerical persons who are not involved with securities or cash
- Corporate officers who are not involved with the members investment
banking business
- Exchange floor traders
State Registration: In addition to the NASD registration, broker-dealers
and registered representatives must also register in each state in which
they intend to do business
66.5 QUALIFICATION EXAMINATIONS
66.5.1 Limited Representative License (Series 6)
The Series 6 allows a registered representative to sell mutual funds, new
issues of closed-end investment companies and variable insurance products.
However, to sell variable products an insurance license is also required.
66.5.2 General Securities Representative (Series 7)
The Series 7 allows a registered representative to sell all types of securities
except commodities. To sell commodities a Series 3 registration would be
required.
66.5.3 Assistant Representative-Order Processor (Series 11)
The Series 11 allows a registered person to accept unsolicited customer orders
for submission to members for execution. Series 11 persons may not solicit
transactions nor open new accounts, nor receive commissions. Also, they may
not hold any other type of registration.
66.5.4 General Securities Principal (Series 24)
This registration is required by any person actively engaged in managing a
members securities business especially Series 7 registered representatives. A
prerequisite of a Series 7 or Series 62 is required in order to sit for the Series
24 exam.
Persons managing a firm doing any of the following must take the Series
24 exam;
Supervision
Solicitation

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Conducting business
Training persons
66.5.5 Limited Principal (Series 26)
This registration entitles a principal to supervise the solicitation, purchase or
sales of mutual funds and variable annuities. The Series 6 is a prerequisite for
the Series 26 exam.
66.5.6 Series 9 and 10 (formerly Series 8)
This registration is a requirement of the NYSE for supervising principals of
NYSE member firms. These would include branch managers and/or sales
managers that supervise sales activities.
66.5.7 Ineligibility and Disqualifications
Persons cannot register as a registered representative or a principal unless
they meet the NASDs eligibility standards with training, experience and com-
petence.
The following can disqualify persons and/or applicants from NASD
registration;
Disciplinary actions by another SRO (Self Regulatory Organization)
Disciplinary actions by the SEC
Expelled or suspended by another SRO
Under an SEC order denying, suspending or revoking the broker-dealers
registration
SEC or other SRO barring the individual from association with a broker-
dealer
Willful misstatements made in an application for registration or member-
ship
Felony conviction within the previous ten years or a misdemeanor involv-
ing securities or money also within the last ten years
Court injunctions prohibiting the individual from acting as a broker-dealer
or other capacity in the financial services industry

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66.6 CONTINUING EDUCATION REQUIREMENTS

There are two continuing education elements adopted by the NASD, the
Regulatory Element and the Firm Element. They are;
66.6.1 Regulatory Element
After qualifying for your first registration you will enter the continuing education
regulatory element cycle. After your second year and every three years there-
after you will have to take the regulatory element exam.
This exams features are as follows;
Three hour exam
Multiple choice questions involving regulations, rules, laws and suitability
issues
There is no pass or fail
The requirement is to complete the exam within the time period allotted
Wrong answers are replaced with new questions
66.6.2 Firm Element
This element is for any registered representative who has direct contact with
retail customers in connection with securities transactions. The member firm
must provide an individual plan for each registered representative to enhance
their knowledge, skills, and professionalism.
Each member firm must evaluate its training needs annually and develop a
written training plan which will be reviewed and audited by the NASD.

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66.7 REVIEW QUESTIONS

1. The NASD is known as a(an);
A. Federal agency
B. State agency
C. SRO
D. A legal arm of the SEC
2. Annual NASD fees would include;
I. Branch office charges
II. Basic membership fee
III. Assessments for NYSE stock transactions based on gross income
IV. Fees for each registered representative
A. I and II
B. II and III
C. III and IV
D. I, II and IV
3. Which of the following is also known as the Conduct Rules?
A. Rules of Fair Practice
B. Code of Procedure
C. Uniform Practice Code
D. Code of Arbitration
4. When filing for a position with a broker-dealer you must file which of the
following forms?
A. U-5
B. U-4
C. U-3
D. U-2
5. A registered representatives termination is normally effective after;
A. 15 days
B. 30 days
C. 45 days
D. 60 days

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66.8 REVIEW ANSWERS

1. (C) The NASD is a Self Regulatory Organization (SRO) for the securities
industry.
2. (D) All are correct except assessments for NYSE stock transactions. The NASD
does not supervise the NYSE as the New York Stock Exchange is regulated by
their own rules. Therefore, the NASD is not allowed to assess trades which take
place on the NYSE.
3. (A) The Rules of Fair Practice are also known as the Conduct Rules which sets
out fair and ethical trade practices that member firms and their registered repre-
sentatives must follow when dealing with the general public.
4. (B) The U-4 is the initial regulatory form that must be filed with the NASD. Upon
leaving a brokerage firm a U-5 must be filed.
5. (B) All terminations are effective 30 days after the date of notice.

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 Module 67: Advertising and Sales Rules

Section 67: Advertising and Sales Rules

67.1 ADVERTISING OVERVIEW
The purpose of this section is to review the differences between advertising and
sales literature as well as the rules associated with both. Under the Securities Act
of 1933 and Securities Exchange Act of 1934 the SEC has been given authority to
make and regulate advertising rules.
67.2 ADVERTISING
Advertising are materials that are intended for use in the mass media. Advertising
can include graphics, print and any support materials with the intention for use in
the following:
Radio
Television
Newspapers
Magazines
Signs
Motion picture
Billboards
Telephone directories
Prerecorded telephone messages
Seminars
67.3 SALES LITERATURE
Sales literature, unlike advertising, is any written or electronic communication
meant to be distributed to a limited number of persons. These are usually
directed to limited persons with the sole purpose of inducing a sale.
Some examples of sales literature would include:
Market letters
Research reports
Form letters
Seminar texts

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Circulars
Option worksheets
Telemarketing scripts
67.3.1 Approval
All advertising and sales literature must be approved by a registered principal
of the brokerage firm prior to use. As with other regular records, advertising
and sales literature must be kept on file for a period of three years. These
records must include who prepared the advertising and sales literature as well
as who approved them for use.
67.3.2 Filing Advertising with the NASD
New brokerage firms must file all advertising with the NASD ten days prior to
first use with the NASD Advertising Department. After one year the require-
ment is to file mutual fund, variable contracts and unit investment trust adver-
tising ten days AFTER first use.
67.3.3 Exclusions from Filing Requirements
The following are excluded from filing requirements as they are regulated by
the SEC and the Securities Act of 1933 and not the NASD.
Statutory Prospectuses
Preliminary Prospectus
Offering Circulars
67.3.4 Truthful Advertisements
All advertising must be truthful, promote fair dealing, be delivered in good
faith and not be misleading to the public. Communications by NASD members
and registered representatives must conform to the following:
Communications which contain exaggerated, unwarranted or misleading
statements are strictly prohibited.
Communications should provide a sound basis for evaluating the facts in
regard to the product or service promoted.
Material facts may not be omitted.
Same standards apply to members making personal appearances for
speaking engagements.

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67.3.5 Advertising Disclosure

Advertisements must contain the following;
Name of the NASD firm
Date material first used
Person or firm preparing the material
If material is not current that fact must be stated in the material
67.3.6 Other Advertising Rules and Issues
Any registered person must have a reasonable basis for customer recom-
mendations
Investment recommendations must be suitable
Recommendations can be supported by past recommendations but only if
all recommendations are included over the last year
Cannot imply that guarantees accompany any recommendation
Cannot imply or predict future performance
Recommendations must be accompanied by current prices
Disclose if the broker/dealer is also a market maker in the security recom-
mended
Cannot make any fraudulent or misleading statements
May not offer free service unless the service is really free with no strings
attached
Can only advertise services which can be delivered
Recruiting advertising is held to the same standards as advertising to the
public. A member must neither exaggerate the earning potential of the posi-
tion nor make unwarranted claims about available opportunities.
Communications regarding periodic investment plans must disclose that
such a plan does not assure a profit and does not protect against loss in a
declining market
References to the NASD or other SROs must not be made with the aim of
leading people to believe that a brokerage firm acts with the endorsement
and approval of the NASD or one of the other SROs

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When the NASD name and logo is used on business cards, stationary or
signs, it must not appear in a typeface larger or more prominent than the
one used for the members own name
Testimonials and endorsements by celebrities related to specific recom-
mendations must not mislead or suggest that past performance indicates
future performance. If a fee is paid for a testimonial the firm must disclose
this fact
Generic ads need not be accompanied by a prospectus
If a sales load is charged, the advertisement must disclose the maximum
amount of the load fee
If a mutual fund shows a yield in it advertising, the fund must show a cur-
rent yield quotation. The current yield must be computed according to stan-
dardized procedures such as over a 30 day period.

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67.4 REVIEW QUESTIONS

1. The SEC has been given authority to make advertising rules under which
of the following Acts?
I. Securities Act of 1933
II. Securities Exchange Act of 1934
III. Telephone Solicitation Act of 1998
IV. Brokerage Firm Act of 1939
A. I only
B. I and II
C. III and IV
D. I, II, III and IV
2. Which of the following is NOT an example of Advertising?
A. Motion pictures
B. Television
C. Form letters
D. Seminars
3. New brokerage firms must file advertisements with the NASD;
A. Within 10 days after first use
B. After 10 days from the first use
C. Prior to use
D. After use
4. Mutual fund advertising by an existing brokerage firm must be filed
within;
A. Ten days after first use.
B. Within 10 days prior to first use
C. Prior to use
D. Never because the brokerage firm is experienced
5. All of the following are true regarding advertising issues EXCEPT?
A. Recommendations must be suitable
B. Generic ads must be accompanied by a prospectus
C. NASD name must be smaller than the firms name when printed on business
cards
D. Advertising must disclose maximum amount of a loaded fee fund

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67.5 REVIEW ANSWERS

1. (B) By definition
2. (C) Form letters are an example of sales literature, not advertising.
3. (C) For new firms in business for under one year all advertising must be submit-
ted for pre-approval by the NASD prior to first use.
4. (A) Mutual fund, variable contracts and unit investment trust advertising for a
seasoned brokerage firm needs to be filed within 10 days after first use.
5. (B) Generic advertising need NOT be accompanied by a prospectus because it
is generic and not a specific product.

NASD Series 7 Page 524

 Module 68: Conduct Rules

Section 68: Conduct Rules

68.1 CONDUCT RULES OVERVIEW
The following conduct rules contain regulations that are called Rules of Fair Prac-
tice. These rules are intended to protect investors by setting certain standards
for registered firms and persons. The goal of the NASD is to require members to
observe high standards when dealing with the general public.
68.2 SUITABILITY RULES
Recommendations made by registered representatives to customers must be
suitable. In other words, a member must have reasonable grounds for believing
that the recommendations as to a purchase or sale is suitable as based on the
facts disclosed by the customer.
68.2.1 Suitability Inquiries to Customers
Prior to making any investment recommendations the registered repre-
sentative must inquire into the following;
Investment objectives
Income and debts
Current investments
Tax status and bracket
Life insurance
68.3 CONDUCT VIOLATIONS
Recommending speculative low-price securities without obtaining or under-
standing the customers financial situation
Borrowing money from the customer
Recommending securities that are too risky or beyond the customers
understanding
Excessive trading activity (churning)
Unauthorized trading
Fraudulent transactions
Using manipulative or deceptive devices

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Sharing profits in a client account Note: Under the rules this would be per-
mitted if the registered representative became a joint account holder with the
customer and the broker-dealer approves.
Giving discounts in mutual funds to non-members
Sharing commissions with unlicensed persons
Charging excessive sales charges
Selling dividends recommending the purchase of a mutual fund or a stock
prior to x-dividend day for the purpose of inducing the customer to buy the
shares
Payment of continuing commissions of mutual fund trailer commissions with-
out a written agreement
Trading of mutual funds short-term buying and selling of fund shares.
Mutual funds are meant for long-term investing
Paying sales concessions to non registered representatives
Violating the $100 gift per person per year rule
Not making available a broker-dealers latest balance sheet and net capital
computation when requested by a customer
Violating the Anti-Reciprocal Rules Trading favors with a mutual fund
company to get them to do trades through the registered representatives
brokerage firm
Breakpoint Sales Recommending purchases just below a breakpoint in
order to get the higher sales charges
Misrepresentations of the following:
- Qualifications
- Experience
- Education
- Nature of services offered
- Fees to be charges
When using research reports prepared by others it must be disclosed that
the brokerage firm did not prepare them
Must disclose any potential conflict of interest
Guarantee a customer against a loss

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 Module 68: Conduct Rules

Violating the confidentiality of customer information received

68.4 OFFICE OF SUPERVISORY JURISDICTION (OSJ)
Maintains custody of customers funds and/or securities
Executes customer orders
Approves new accounts
Reviews customer orders
Approves advertising
Supervises branch offices
68.5 SUPERVISORY RULES
All brokerage firms must maintain at each branch office and Office of Super-
visory Jurisdiction (OSJ) a copy of the firms written supervisory rules.
Branch offices must have a supervisor on-site (registered principal) respon-
sible for the supervision of registered representatives.
Every registered representative must be assigned to a specific registered
principal
At least annually, each registered representative must participate in a meet-
ing conducted by the designated supervisory principal to discuss compliance
matters
Annual branch office inspections and review of client records are required
to detect any irregularities and to insure compliance
All security transactions must be reviewed by a principal by the end of the
day
Registered representative correspondence to customers must be reviewed
and approved prior to sending out the correspondence. A copy of the corre-
spondence must be maintained in each branch office for inspection by the
NASD
Registered representatives cannot open a brokerage account with another
broker-dealer without written permission.
The following procedures need to be adhered to when opening or maintaining
a brokerage account at a brokerage firm other than your employer broker-
age firm:
- Registered representative needs to let the account holding brokerage
firm know that he/she is a registered representative

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- The brokerage firm marks the account classified and sends a letter to
the reps member firm asking permission to hold the registered repre-
sentatives account
- The members broker-dealer, if agrees, sends the other firm a letter
authorizing the account and can request duplicate trade confirma-
tions and statements
- This rule does not apply to mutual funds or variable contract accounts
Selling Away is not permitted. Selling away consists of a registered repre-
sentative selling unregistered securities, private placements or securities for
another member firm without permission from the employing brokerage firm.
Secondary Employment is not allowed unless the registered representative
provides the employing brokerage firm with a written notice for permission to
do so. The employing brokerage firm must approve the non-brokerage
employment for the registered representative to continue.
68.6 RECENT MUTUAL FUND SALES RULES
The NASD and the SEC are concerned that some broker-dealers and registered
representatives have not been charging investors the correct sales loads espe-
cially when a letter of intent has been signed and/or rights of accumulation was
applicable.
In order to ensure that customers are receiving the most beneficial (lowest)
front-end charge percentage, the following information is required to be collected
and adhered to by registered representatives:
Dollar size of anticipated transactions
Amounts previously invested in specific funds
Breakpoint information must be entered correctly
Broker-dealers cannot rely on mutual fund companies to furnish correct
breakpoint information
Registered representatives must understand each of the available mutual
fund share classes and apply them property with clients
Bottom line - customers must receive correct sales charges and the broker-
dealer and registered representative will be held liable if incorrect sales
charges are applied.

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 Module 68: Conduct Rules

68.7 REVIEW QUESTIONS

1. Churning refers to which of the following?
A. Freeriding in at least five customer accounts
B. Excessive trading in a customers account for purposes of generating commis-
sions
C. Mixing one pound of butter and one quart of milk
D. Manipulation
2. An OSJ does all of the following EXCEPT:
A. Execute customer orders
B. Review all trades prior to the order being placed
C. Approve new accounts
D. Approve advertising
3. Which of the following is NOT required as a suitability inquiry?
A. Investment objectives
B. Tax status
C. Date of Birth
D. Current investments
4. Which of the following is NOT a violation?
A. Misrepresentation
B. Breakpoint sales (Recommending a purchase just shy of reaching a break-
point)
C. Short-term buying and selling of mutual funds (Trading mutual funds)
D. Not selling dividends
5. Registered principals must review all trade tickets;
A. As the trade is made
B. Each morning
C. By the end of the day
D. Once a week

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68.8 REVIEW ANSWERS

1. (B) By definition
2. (B) Trades must be reviewed by a principal by the end of the day, not prior to
each trade. All other choices are correct.
3. (C) The date of birth is never required. Inquiry into age of majority is required.
Other choices should be part of all suitability inquiries.
4. (D) Selling dividends is a violation, so not selling dividends is not a violation. All
the other choices are violations.
5. (C) The requirement is for registered principals to review all trade tickets by the
end of the day.

NASD Series 7 Page 530

 Module 69: Code of Procedure

Section 69: Code of Procedure

69.1 CODE OF PROCEDURE OVERVIEW
The NASDs Code of Procedure, COP for short, is a guide to settle complaints
that arise between members, among members, associated persons and custom-
ers.
Most complaints are filed by NASD examiners when auditing member firms.
69.2 REGULAR COMPLAINT PROCEDURE
Initial complaints are filed with the District, formerly known as the District
Business Conduct Committee (DBCC)
The decision of the District can be appealed by the registered representative
to the National Adjudicatory Council (NAC), formerly known as the
National Business Conduct Committee (NBCC).
The decision of the NAC can be appealed to the Securities and Exchange
Commission (SEC)
The final review in the appeals process lies with the federal court system
and the Supreme Court.
69.3 COMPLAINT PROCEDURE VIOLATIONS
Sanctions can be imposed from the regular complaint procedure for the fol-
lowing violations;
Federal securities laws violations
NASD rules violations
Failure to honor arbitration award
Failure to abide by a decision of the NAC
Failure to submit to arbitration when required to do so
69.4 SETTLEMENT OFFER
A member or associated person may offer to make a settlement at any time. How-
ever, the offer may not be accepted by the NASD.
69.5 POTENTIAL PENALTIES
Censure
Unlimited fines

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Suspension
Expulsion
Barring of associate from association with all members
Note: The public can obtain copies of registered representatives disciplinary
records from the Central Records Depository (CRD) or even from the NASD
Web Site.
69.6 SUMMARY COMPLAINT PROCEDURE
The summary complaint procedure is used to settle minor rules violations. In
these situations the complainant usually has enough evidence to support the
complaint that a violation has occurred. In essence, the facts are true with nothing
to contest.
If the registered representative agrees, a written acknowledgement of the
wrongdoing must be furnished as well as the following;
Rep must sign and return a letter of acceptance, waiver and consent
The rep must agree to forfeit the right of appeal
The rep must agree to honor any sanctions or other disciplinary actions and
penalties
Exam Alert: The maximum penalty that can be imposed under a sum-
mary complaint is $2,500 and/or public censure.

NASD Series 7 Page 532

 Module 70: Uniform Code of Arbitration

Section 70: Uniform Code of Arbitration

70.1 UNIFORM CODE OF ARBITRATION
The Uniform Code of Arbitration is a dispute resolution mechanism designed to
help aggrieved parties recover damages. In arbitration, an impartial person or
panel hears all sides of the issues as presented by the parties, evaluates the evi-
dence, and decides how the matter should be resolved. Arbitration is final and
binding with no right of appeal.
70.2 MATTERS ELIGIBLE FOR SUBMISSION
Dispute or controversy arising out of the business of NASD members.
Exam Alert: For test purposes remember the following statement regard-
ing arbitration issues:
Anyone can bring anyone to arbitration with one exception. A pub-
lic customer can never be brought to arbitration by a member firm or
registered representative unless the customer signed a prior written
agreement agreeing to arbitration.
70.3 ARBITRATION ISSUES AND PROCEDURES
A statement of claim is filed with the NASDs National Arbitration Commit-
tee. A statement of claim and submission agreement must be submitted
within six years of its occurrence.
Internal disputes among member firms and associated persons must be
submitted for resolution and settlement in arbitration.
Customers are under no obligation to submit to arbitration unless a prior
written agreement was signed.
No appeal to the court system is allowed after an arbitration decision
becomes final.
Arbitration decisions are final.
Members refusing to arbitrate violate the NASD Conduct Rules and are sub-
ject to disciplinary action and fines.
Arbitration can be heard by a single arbitrator or a panel containing 3 but not
more than 5 arbitrators.

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70.4 NATIONAL ARBITRATION COMMITTEE

The NASD maintains a pool of arbitrators consisting of industry people and public
representatives. Arbitration panels are formed as needed to hear cases.
70.5 ARBITRATION AWARDS
The arbitration panel attempts to render a decision within 30 business days.
70.6 COMPOSITION OF ARBITRATION PANELS
Claims of $50,000 or less: Panel will consist of one non-public arbitrator,
unless the parties agree to the appointment of a public arbitrator.
If a claim is between $25,000 and $50,000 three arbitrators can be
appointed if requested by any of the parties.
If a claim is over $50,000 three arbitrators will be appointed unless the par-
ties agree to a different panel composition.
70.7 SIMPLIFIED ARBITRATION
A single arbitrator hears claims that do not exceed a claim for $25,000.
The arbitrator is knowledgeable in the securities business
A hearing is generally not held unless one is requested by the customer or
the arbitrator
The procedures cover documentary evidence only without testimony

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 Module 70: Uniform Code of Arbitration

70.8 REVIEW QUESTIONS

1. Who can make a complaint against a registered representative?
A. A client
B. The NASD
C. Brokerage firm
D. Any of the above
2. Binding arbitration is required against all of the following EXCEPT:
A. Registered rep against a brokerage firm
B. Brokerage firm against another brokerage firm
C. Client against a registered representative
D. Brokerage firm against a client
3. Arbitration decisions are;
A. Subject to court review within 90 days
B. Final
C. Subject to review by the SEC
D. Subject to review by the county courts
4. Summary complaint procedure can result in which of the following?
A. Maximum fine of $25,000
B. Maximum fine of $2,500
C. Censure
D. B & C
5. Initial complaints are filed with the;
A. National Adjudicatory Council
B. District
C. SEC
D. Federal Courts

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70.9 REVIEW ANSWERS

1. (D) Any of them
2. (D) Anyone can bring anyone to arbitration with one exception. A customer can-
not be brought to arbitration unless they agreed in a prior written agreement.
3. (B) They are final.
4. (D) Maximum punishment is a $2,500 fine and or censure.
5. (B) Initial complaints are filed with the District which was formerly the DBCC.

NASD Series 7 Page 536

 Module 71: NYSE Rules

Section 71: NYSE Rules

71.1 NYSE
The New York Stock Exchange regulates itself, as does other stock exchanges.
The SEC oversees the NYSE. Most NYSE rules are the same as rules youve
already seen with the NASD and the MSRB.
Any repetition of the following rules will help to reinforce them in your memory
bank so as to improve your success in passing the Series 7 exam.
7 1 . 2 R E P TR A I N I N G P E R I O D
The NYSE requires a four-month training period during which a newly hired per-
son cannot solicit customer orders. This training period must take place before
candidates can even take the Series 7 exam.
71.2.1 Registration of Personnel
The NYSE considers a registered representative to be an employee of a
member firm involved in soliciting orders for the purchase or sale of securi-
ties.
A member firm may not allow any person to act in the capacity of registered
representative unless the person is acceptable to and registered with the
Exchange.
Member firms are required to thoroughly investigate the past record of per-
sons they intend to register with the NYSE.
Candidates for registration must sign an agreement stating that they will
abide by the Constitution and Rules of the Exchange.
71.3 MOONLIGHTING
Generally speaking, a registered representative must work full-time for his NYSE
firm and cannot take outside work without that firms permission. The outside work
taken cannot lead to compromises in the representatives occupation as a broker.
The NYSE requires that registered representatives receive written approval
from their firm to;
Engage in another business
Be employed by another person or firm
Become an officer, director, or partner of another organization

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Module 71: NYSE Rules

Obtain a controlling interest in another member firm whose shares are not
publicly traded.
71.4 NOTIFICATION TO THE NYSE
A report must be sent to the NYSE if an employee;
Has violated any of the Securities Acts.
Is the subject of a written customer complaint involving forgery, theft or mis-
appropriation of funds
Denied registration or is suspended or expelled by another SRO
Named as a defendant in any legal proceeding under the Securities Act of
1934
Is arrested, indicted or convicted of any criminal offense (not traffic viola-
tions)
Is the subject of a customer claim for damages exceeding $15,000 which has
been settled or disposed of by award.
71.5 CORRESPONDENCE APPROVAL
All correspondence directed to customers must be approved by a principal in
writing. This rule would include e-mails and faxes. Standard form letters do not
require individual approval since the principal must approve the form itself before
it is used.
The NYSE will waive the above if it can show that the firm maintains a communi-
cations compliance program that includes the education and training of personnel
regarding the member firms policies and procedures relating to correspondence.
According to the NYSE, communications include;
Advertisements
Market letters
Sales literature
Research reports
Electronic communications
Internal memos that are available to customers
Communications to the press

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 Module 71: NYSE Rules

71.5.1 Truthfulness of Advertising

All communications must adhere to standards of truthfulness and good taste
and may not contain any untrue statements, omit any material fact, or be false
or misleading. Communications must be dated and any significant information
that is not current (usually six months or older) must be indicated.
71.6 BINDING ARBITRATION
Any dispute between a registered representative and his/her firm must be
resolved by binding arbitration. Appeals are not allowed from arbitration.
Remember, customers can never be brought to arbitration unless they signed a
prior written agreement.
71.7 GIFT LIMIT
Registered representatives are prohibited from giving gifts in excess of $100 per
person per year to anyone employed by another member firm, non-member firm,
financial institution or the news media.
Note that the gift limit does not in any way prohibit business entertainment as long
as it is not too excessive or too frequent.
71.8 NYSE CUSTOMER ACCOUNT RULES
Know your customer: A registered representative must use due diligence to
learn every essential fact about every customer order. Before any account is
opened it must be approved in writing by a branch office manager.
Discretionary Accounts: If discretion is going to be exercised by the regis-
tered representative, a power of attorney must be signed by the customer
and received by the firm. If the registered representative is solely choosing
price and timing of trade executions, not the number of shares and choice
of company, trades would NOT be considered discretionary.
Brokerage Firm Used by Registered Representative: If an employee of a
firm wants to open an account at another broker-dealer, prior approval of the
employer is required. Duplicate confirmations and statements must be sent to
the employer.
Guarantee of Account: Registered representatives cannot guarantee cus-
tomer accounts against gains or losses.
Sharing in Customer Accounts: Registered representatives are prohibited
from sharing in any profits or losses in a customers account. An exception is
made if a joint account has received the member firms prior written approval

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and the registered representative shares in the profits and losses only to the
extent of his/her proportionate contribution to the joint account.
Borrowing and Lending: Registered reps and investment advisers must not
borrow money or securities from a customer unless the customer is a bank, a
broker-dealer, or another financial institution in the business of lending
money. Registered reps and investment advisers cannot lend money or secu-
rities to a customer. This does not preclude a broker-dealer extending margin
privileges to the customer as part of their normal business practices.
Day Trading Accounts: There are more stringent margin rules for those per-
sons who engage in day trading defined as 4 or more trades a day in a 5
business day period.
Order Ticket Stamping: Order tickets must be time stamped with the time it
was transmitted to the exchange floor and the time it was executed.
Record Retention: Records must be kept on file for 3 years with two excep-
tions. Customer complaints, blotters and registers for money and securities
must be kept for 6 years. Business entity records such as corporate minutes
must be kept on file for the life of that company.
Trade Execution Errors: If an order is executed erroneously, any loss is
the responsibility of the firm, not the customer. This would assume the
trade was not what the customer agreed to. However, NYSE rules state that
the price at which an order is executed is binding even if an erroneous
report is rendered to a customer and is NOT binding on the member firm.
Mailing Statements: Customer account statements must be sent out at least
quarterly, but if there is activity in any month, a statement must be sent for
that month. Also, customer mail cannot be held by a company and must be
mailed to the last address given to the firm in writing by the customer.
- The only exception to this rule is when a customer is on vacation and/
or traveling and makes a written request that the mail be held. If the
customer is traveling in the United States it can be held for 2 months
or 3 months if traveling outside the United States.
Corporate Proxies: Proxies must be forwarded to customers at no charge.
NYSE Voting Rules: The NYSE requires listed companies to have share-
holder approval for any of the following;
- Declaring a stock split
- Declaring a reverse stock split
- Issue convertible bonds or convertible preferred stock

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 Module 71: NYSE Rules

- Issue stock options to officers on a preferential basis

The NYSE does NOT require shareholder approval for;
- Declaring a cash dividend
- Declaring a stock dividend
- Declaring a rights distribution
- Repurchase treasury shares
Account Transfers: If a customer wishes to transfer an account from one
brokerage firm to another, the customer must complete a transfer of account
form at the new firm. This form must detail all positions held at the former
firm.
- Upon receipt of a transfer form the former firm must freeze the
account and all open orders must be canceled.
- The former firm receiving the transfer request must validate the posi-
tions against its records and return the form to the new firm within 3
business days. The actual transfer must then be completed within
another 4 business days.
71.9 NYSE PROHIBITED ACTIVITIES
Circulating rumors
Effecting trades which are excessive
Executing trades at successively higher or lower prices to create false or mis-
leading activity or pricing in the stock
Loaning funds without a margin agreement
Borrowing money from a customer
71.10 LIMITATIONS ON TR A D I N G
To protect investors and the market, the NYSE imposes restrictions on trading if
certain key market indexes rise or fall specified amounts.
Program trading and index arbitrage strategies are restricted if the Dow
Jones Industrial Average changes by 2% from the previous days close.
The levels at which halts take place are reset on a quarterly basis and, at the
time of the reset, will equal 10%, 20% and 30% of the DJIA.
In general, when the Dow is down 10%, a one-hour trading halt will take
place, when down 20%, trading will halt for two hours, and if the DJIA falls by
30%, the market will close for the day.

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7 1 . 11 R E V I E W Q U E S T I O N S
1. Under NYSE rules, before a registered representative may take a second
job (moonlight), he/she must obtain written permission from the;
A. SEC
B. NASD
C. NYSE
D. Reps broker-dealer
2. Under NYSE rules, for firms that do not have a communications compli-
ance program, a registered representative must get approval of the Branch
Manger to;
I. Send options advertising to customers
II. Send a prospecting letter to customers
III. Mail a prospectus to a customer
IV. Conduct a seminar on options strategies
A. I and II only
B. I, II and III only
C. I, II and IV only
D. I, II, III and IV
3. A registered representative has written a research report about bank
stocks that she wishes to mail to customers. Which statement is true?
A. The report must be approved by a supervisory analyst dealing with bank stocks
B. The report must be approved by a Branch Manager
C. The report must be approved by the NASD
D. No prior approval is required
4. If there is activity in a customers account, a statement must be mailed;
A. That month
B. That quarter
C. Twice a year
D. Annually
5. Copies of order tickets must be kept for;
A. 1 year
B. 2 years
C. 3 years
D. 5 years

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 Module 71: NYSE Rules

71.12 REVIEW ANSWERS

1. (D): If a rep chooses to take a second job, prior written approval must be
obtained from the employing broker-dealer.
2. (C): Under the NYSE rules, a firm that does not have a communications compli-
ance program requires manager approval for a prospecting letter, advertising or
even giving a speech. All of these fall under the definition of communications with
the public. There is no requirement for prospectus approval as a prospectus is a
requirement under the Securities Act of 1933.
3. (A): Believe it or not, under NYSE rules research reports must be either written
or approved by a Supervisory analyst as this person had to pass a qualification
exam specifically for that purpose. There is no requirement for NYSE approval,
NASD approval or Branch Manager approval.
4. (A): Generally, the minimum requirement for mailing statements is quarterly.
However, if there is activity in the customers account a statement must be mailed
for that month.
5. (C): This is a record retention rule. Most records must be kept for 3 years. This
is one of those records that would be kept for the 3 year period. Complaint letters,
blotters and registers must be kept for six years while copies of corporate min-
utes, as an example, must be kept for life.

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NASD Series 7 Page 544

 Series 7 Abbreviations
Financial Terms Glossary
 Abbreviations

Section 73: Abbreviations

The Series 7 tends to use abbreviations whenever possible. To help with
your success you should be familiar with the following abbreviations:
ACRS: Accelerated Cost Recovery Sys- CR: Credit Balance (cr)
tem
CROP: Compliance Registered Options
ADR: American Depositary Receipt Principal
AE: Account Executive CUSIP: Committee on Uniform Securities
Identification Procedures
AIR: Assumed Interest Rate
DBCC: District Business Conduct Commit-
AMBAC: AMBAC Indemnity Corporation
tee
AMEX: American Stock Exchange
DK: Dont Know
AMT: Alternative Minimum Tax
DNR: Do Not Reduce
AON: All or None
DOT: Designated Order Turnaround
BA: Bankers Acceptance
DPP: Direct Participation Program
BAN: Bond Anticipation Note
DR: Debit Balance (dr)
B/D: Broker-dealer
DVP: Delivery vs. Payment (COD)
BOM: Branch Office Manager
EBIT: Earnings Before Interest and Taxes
CATS: Certificates of Accrual on Treasury
EPS: Earnings per Share
Securities
ERISA: Employment Retirement Income
CBOE: Chicago Board of Options
Security Act
Exchange
ESOP: Employee Stock Ownership Plan
CD: Certificate of Deposit
FDIC: Federal Deposit Insurance Corpora-
CFP: Certified Financial Planner
tion
CFTC: Commodity Futures Trading Com-
FFCB: Federal Farm Credit Bank
mission
FGIC: Financial Guaranty Insurance Com-
CLN: Construction Loan Note
pany
CMO: Collateralized Mortgage Obligation
FHA: Federal Housing Administration
CMV: Current Market Value
FHLB: Federal Home Loan Bank
COD: Cash on Delivery
FHLMC: Federal Home Loan Mortgage
CPA: Certified Public Accountant Corporation
CPI: Consumer Price Index FIFO: First-in, First-out
CQS: Consolidated Quotations System FINOP: Financial and Operations Principal

Page 547 NASD Series 7

Abbreviations

FLB: Federal Land Bank M2: Money Supply

FNMA: Federal National Mortgage Associ- M3: Money Supply
ation
MBIA: Municipal Bond Insurance Associa-
FOK: Fill or Kill tion
FOMC: Federal Open Market Committee MIG: Moodys Investment Insurance Asso-
ciation
FRB: Federal Reserve Board
MKT: Market
GNMA: Government National Mortgage
Association MSRB: Municipal Security Rulemaking
Board
GDP: Gross Domestic Product
NASD: National Association of Securities
GNP: Gross National Product
Dealers
GO: General Obligation Bond
NASDAQ: NASD Automated Quotation
GTC: Good-till-Canceled System
HR10: Keogh Plan NAV: Net Asset Value
HUD: Department of Housing and Urban NFA: National Futures Association
Development
NH: Not Held
IDB: Industrial Development Bond
NHA: New Housing Authority
IDC: Intangible Drilling Costs
NNM: Nasdaq National Market
IDR: Industrial Development Bond
NR: Not Rated
IOC: Immediate or Cancel
NYSE: New York Stock Exchange
IPO: Initial Public Offering
OBO: Order Book Official
IRA: Individual Retirement Account
OCC: Options Clearing Corporation
IRS: Internal Revenue Service
OEX: S&P 100 Index (ticker symbol)
JTWROS: Joint Tenants with Rights of
OID: Original Issue Discount
Survivorship
OPD: Delayed Opening (ticker symbol)
L: Money Supply
OS: Official Statement
LBO: Leveraged Buyout
OSJ: Office of Supervisory Jurisdiction
LIBOR: London Interbank Offered Rate
OTC: Over-the-Counter
LIFO: Last-in, First-out
PAC: Planned Amortization Class
LOI: Letter of Intent
P/E: Price-Earnings Ratio
LP: Limited Partnership
PHA: Public Housing Authority
LV: Loan Value
PHLX: Philadelphia Stock Exchange
M1: Money Supply

NASD Series 7 Page 548


P&L: Profit and Loss Statement
POP: Public Offering Price
PSE: Pacific Stock Exchange
RAN: Revenue Anticipation Note
REIT: Real Estate Investment Trust
REORG: Reorganization
REPO: Repurchase Agreement
RIA: Registered Investment Adviser
ROP: Registered Options Principal
RR: Registered Representative
SBA: Small Business Administration
SEC: Securities and Exchange Commis-
sion
SEP: Simplified Employee Pension Plan
SIPC: Securities Investor Protection Cor-
poration
S&L: Savings and Loan
SLD: Delayed Report (ticker symbol)
SLMA: Student Loan Marketing Associa-
tion
Page 549
Abbreviations
SMA: Special Memorandum Account
SOES: Small Order Entry System
S&P: Standard & Poors
SRO: Self Regulatory Organization
TA: Trading Authorization
TAC: Targeted Amortization Class
TAN: Tax Anticipation Note
TIC: Tenants in Common
TIGER: Treasury Investment Growth
Receipt
UGMA: Uniform Gift to Minors Act
UIT: Uniform Investment Trust
ULPA: Uniform Limited Partnership Act
UTMA: Uniform Transfer to Minors Act
VA: Veterans Administration
WI: When Issued
YTC: Yield to Call
YTM: Yield to Maturity
ZR: Zero Coupon Bond
NASD Series 7
Abbreviations

NASD Series 7 Page 550


Section 74: Glossary
A Accretion of Bond Discount: An
AAA & Aaa: The highest rating given
by bond rating agencies, indicating that
the bond is a very safe investment.
Accelerated Depreciation: A deduc-
tion taken from income to reflect the
using up over time of a fixed asset such
as machinery or buildings. This method
allows for larger deductions in the ear-
lier years of an assets life, compen-
sated for by smaller deductions in the
later years of the assets life.
Account Executive: Also known as a
broker or registered representative
employed by a broker-dealer to handle
customer accounts.
Accrued Interest: The interest accu-
mulated on a bond or debenture since
the last interest payment date. While
most bonds accrue interest and then
distribute the interest semi-annually, T-
bills and zero coupon bonds accrue
interest but do not pay interest.
Account Executive (AE): Same as a
registered representative.
Account Statement: A record of trans-
actions and their effect on account bal-
ances over a specified period of time,
for a given account. The SEC requires
that statements be mailed to clients at
least quarterly.
Accredited Investor: A wealthy inves-
tor who meets certain SEC require-
ments for net worth and income as they
relate to some restricted offerings.
Some limited partnerships accept only
accredited investors.
Page 551
Glossary
accounting process whereby the initial
cost of a bond purchased at a discount
is increased annually to reflect the
basis of the bond as it gets closer to
maturity. The IRS requires that the
increased face value (accretion) be
taxed each year until maturity even
though the gain will not be realized until
maturity.
Accrued Interest: The interest that has
accumulated since the last interest pay-
ment up to, but not including, the settle-
ment date and that is added to a bond
transactions contract price.
Accumulation Unit: Money deposited
in an annuity form accumulation units.
Acid-Test Ratio: A measure of a cor-
porations liquidity, calculated by adding
cash, cash equivalents and accounts
and notes receivable, and dividing the
result by total current liabilities.
Acquisition Fee: The total charges
and commissions paid by any party in
connection with the selection or pur-
chase of property by a direct participa-
tion program.
Active Asset Management: The pur-
suit of investment returns in excess of
the specific benchmark return. Active
asset managers believe that underval-
ued stocks exist in the marketplace,
and that by investing in them, they can
surpass the performance of a similar
index fund.
Active Market: Heavy volume for a
specific security or an entire exchange.
NASD Series 7
Glossary
Additional Paid in Capital: This is also
called capital surplus or capital in
excess of par value, the amount above
par value paid for the common shares
by an investor on the initial public offer-
ing.
Additional Takedown: That portion of
the total takedown on a municipal bond
new issue that a syndicate member
receives when a selling group member
sells a bond.
Advance Refunding: Companies
issues a bond with a later maturity in
order to pay off a bond issued earlier to
take advantage of a drop in interest
rates.
Adjustable Rate: An interest rate
which is adjusted periodically, usually
based on a standard market rate out-
side the control of the bank or savings
institution, such as the Treasury bill or
the prime interest rate.
Adjustable Rate Preferred: A pre-
ferred stock whose dividend is adjusted
periodically to reflect interest rate
changes. The rate may change
monthly, quarterly or annually.
Adjusted Basis: The value attributed
to an asset or security that reflects any
deductions taken on, or capital
improvements to, the asset or security.
Adjusted Gross Income (AGI): The
amount used in the calculation of an
individuals income tax liability; ones
income after certain adjustments are
made, but before standardized and
itemized deductions and personal
exemptions are made.
NASD Series 7
Adjustment Bond: Known as an
income bond, this debt security pays
interest only if the company earns the
interest. These are usually issued by a
corporation trying to reorganize its capi-
talization in order to avoid bankruptcy.
This is a high risk bond.
Administrator: Every state has a secu-
rities administrator responsible for the
administration of state security laws.
Ad Valorem Tax: Property tax based
on the assessed value of real estate.
Advance/Decline Line: A technical
analysis tool representing the total of
differences between advances and
declines of security prices. This is con-
sidered the best indicator of market
movement as a whole.
Advance Refunding: When interest
rates have dropped, a municipal issuer
who has sold bonds that are non-call-
able, can issue new bonds with a lower
coupon rate and use the proceeds to
buy other bonds. The income from the
escrowed U.S. Governments pays the
interest on the older high rate outstand-
ing municipal debt and when the U.S.
Government securities mature, the pro-
ceeds are used to retire the old, out-
standing municipal issue.
Affiliated Person: A person who is
able to exert influence on a corporation,
often as a result of minority ownership.
After-Hours Trading: The trading of
securities while the exchanges are
closed. It used to be done primarily by
institutional investors on special com-
puter systems such as the Instinet. Now
many on-line brokerage firms have
begun offering after-hours trading.
Page 552

Agency Bond (Agency Securities):
Bonds issued by U.S. government
agencies such as Government National
Mortgage Association, Federal Home
Loan Mortgage Corporation, and
FNMA.
Agency Issue: A debt instrument
issued by an authorized agency of the
federal government. Such an issue is
backed by the issuing agency itself, not
by the full faith and credit of the U.S.
government (except GNMA).
Agency Transaction: A transaction in
which a broker-dealer acts for the
accounts of others by buying or selling
securities on behalf of customers.
Agent: Any individual who represents a
broker-dealer or issuer in effecting
securities transactions. An investment
dealer operates as an agent when it
acts on behalf of a buyer or a seller, and
does not own title to the securities at
any time during the transactions.
Agents charge a commission versus
marking it up or down as a principal in
the transaction.
Aggregate Indebtedness (AI): An
accounting of all money a broker-dealer
owes to customers, other broker-deal-
ers, banks and other lenders, business
suppliers and vendors and anyone who
does business with or works for the
firm.
Aggressive Growth Fund: Mutual
fund that invests in new and/or risky
industries and start-up companies with
unproven earnings. This type of fund
tends to have a higher risk than a blue
chip fund, as an example.
Page 553
Glossary
Agreement Among Underwriters:
The agreement that sets forth the terms
under which each member of an under-
writing syndicate will participate in a
new issue offering and states the duties
and responsibilities of the underwriting
manager.
All or None Order (AON): An order
that instructs the floor broker to execute
the entire order in one transaction. If
the order cannot be executed in its
entirety, it is allowed to expire.
All or None Underwriting: A form of
best efforts underwriting in which the
underwriter agrees that if it is unable to
sell all the shares, the issuer will cancel
the offering.
Alpha Coefficient: A measure of the
projected rate of change in a securitys
price independent of market-related
factors but based instead on such indi-
cators as the strength of the companys
earnings and the expected level of
sales.
Alternative Minimum Tax (AMT): An
IRS mechanism created to ensure that
high-income individuals, corporations,
trusts and estates pay at least some
minimum amount of tax, regardless of
deductions, credits or exemptions. It
operates by adding certain tax-prefer-
ence items back into adjusted gross
income.
AMBAC Indemnity Corporation
(AMBAC): A corporation that offers
insurance on the timely payment of
interest and principal obligations of
municipal securities. Bonds insured
under AMBAC receive a AAA rating.
NASD Series 7
Glossary
American Depository Receipt (ADR):
A security, created by a U.S. bank that
evidences ownership to a specified
number of shares of a foreign security
held in a depository in the issuing com-
panys country of domicile.
American Stock Exchange (AMEX):
A private, not-for-profit corporation
located in New York City that handles
approximately one-fifth of all securities
trades within the United States.
American Style Option: A call or put
option that can be exercised at any
point from the time it is purchased until
its expiration.
Amortization: The paying off of debt in
regular installments over a period of
time.
Amortization of Bond Premium: An
accounting process whereby the initial
cost of a bond purchased at a premium
is decreased to reflect the basis of the
bond as it approaches maturity.
Analyst: An employee of a brokerage
firm, advisor or mutual fund who studies
companies and makes buy and sell rec-
ommendations, often specializing in a
single sector or industry.
Annual Compliance Review/Meet-
ing: The annual meeting that all regis-
tered representatives must attend. The
purpose of this meeting is to review
compliance issues.
NASD Series 7 Page 554
Annual Gift Exclusion: The maximum
amount that a person is allowed to give
another person without incurring Fed-
eral gift tax. The current annual exclu-
sion is $11,000 per year per recipient,
indexed to inflation. There is no limit on
the number of these gifts you can make
to different people in a year. To qualify,
a gift must be of a present interest,
meaning that the recipient can make
use of the gift immediately, and the
donor must not have any control over
the asset after it is given.
Annual Meeting: The company gather-
ing, usually held at the end of each fis-
cal year, at which the previous year and
the outlook for the future are discussed
an directors are elected by sharehold-
ers.
Annual Report: Audited document
required by the SEC and sent to a pub-
lic companys or mutual funds share-
holders at the end of each fiscal year,
reporting the financial results for a year.
This report includes the balance sheet
and income statement.
Annuitant: A person who is entitled to
receive benefits from an annuity.
Annuitize: To begin to receive pay-
ments from an annuity.
Annuitization: The conversion of accu-
mulation units to a fixed number annuity
units by the insurance company that
issued the variable annuity contract.
Annuitization occurs when the investor
is ready to begin receiving payments
from the annuity at retirement.
Annuity: A contract between the owner
of an annuity and the insurance com-
pany that provides for payments over
the life of a contract.

Annuity Unit: An accounting measure
used to determine the amount of each
payment during an annuitys distribution
stage.
Anti-dilutive: A convertible security
which could increase a corporations
earnings per share if exercised or con-
verted into common stock.
Appreciation: The increase in value of
an asset.
Arbitrage: Attempting to profit by
exploiting price differences of identical
or similar financial instruments, on dif-
ferent markets or in different forms.
Arbitration: The arrangement whereby
the NYSEs Board of Arbitration or a
designated arbitration association
hears and settles disagreements
between members member organiza-
tions and their employees. Decisions
are binding and cannot be appealed.
Ascending Yield Curve: A graph of
the yields of fixed income securities of
the same type such as U.S. Govern-
ments, Corporates or Municipals, by
maturity. As the maturity lengthens, the
yield increases, so the curve ascends.
This is a normal yield curve shape,
showing that investors will accept lower
yields for short maturities but demand
higher yields for longer maturities
because of the higher risk.
Ask Price: The lowest price that any
dealer has declared that he/she will sell
a security for. In mutual funds, the ask
is the net asset value plus any sales
charges. The retail customer buys at
the ask price while the trader sells it to
the retail customer at that price.
Page 555
Glossary
Arbitration: A process in which a dis-
agreement between two or more parties
is resolved by impartial individuals,
called arbitrators, in order to avoid
costly and lengthy litigation.
Assessed Value: The value of a prop-
erty as appraised by a taxing authority
for the purpose of levying taxes.
Assessment: An additional amount of
capital that a participant in a direct par-
ticipation program may be called upon
to furnish beyond the subscription
amount.
Asset: Any item of economic value
owned by an individual or corporation,
especially that which could be con-
verted to cash. Examples are cash,
securities, accounts receivable, inven-
tory, house, car and more.
Asset Allocation Fund: A mutual fund
that splits its investment assets among
stocks, bonds and other types of securi-
ties in an attempt to provide a consis-
tent return for the investor.
Asset Backed Securities: Bonds or
notes backed by loan paper or
accounts receivable originated by
banks, credit card companies, or other
providers of credit, not mortgages.
Asset Class: The categorization of
investments into groupings with similar
risk and return characteristics. Money
market instruments are an asset class,
large capitalization common stocks are
an asset class.
Assignment: A document accompany-
ing or part of a stock certificate that is
signed by the person named on the cer-
tificate for the purpose of transferring
the certificates title to another persons
name.
NASD Series 7
Glossary
Assumed Interest Rate (AIR): An
assumption of a reasonable rate of
return assigned to all variable contracts.
The AIR forms the basis for projecting
payments, but is not guaranteed.
At-the-Close: A notation placed on an
order instructing the floor broker on the
exchange floor to execute the order in
the final 30 seconds of the market, usu-
ally during the ringing of the closing
bell.
At-the-Money: Used to describe an
option when the underlying stock is
trading precisely at the exercise price of
the option.
At-the-Open: An order that specifies it
is to be executed at the opening of the
market or of trading in that security or
else it is to be canceled. This order
does not have to be executed at the
opening price, however.
Auction Market: A system in which
buyers enter competitive bids and sell-
ers enter competitive offers simulta-
neously, as opposed to the over-the-
counter market, where trades are nego-
tiated. Examples are the NYSE and the
AMEX, also called double auction mar-
ket.
Audited Financial Statement: A finan-
cial statement of a program, a corpora-
tion or an issuer that has been
examined and verified by an indepen-
dent certified public accountant.
Authorized Shares: The maximum
number of shares of stock that a com-
pany can issue. Its specified initially in
the companys charter, but it can be
changed with shareholder approval,
also called authorized shares or shares
authorized.
NASD Series 7
Automatic Investment Plan: A pro-
gram that allows an individual to have a
set amount electronically transferred
from one account to another at a speci-
fied frequency. Examples include stock
and mutual fund reinvestment pro-
grams, defined contribution plans,
mutual fund contribution programs and
automatic withdrawal plans.
Automatic Reinvestment Plan: An
arrangement in which mutual fund divi-
dends or capital gains are used to pur-
chase additional fund shares, rather
than being distributed.
Average Basis: An accounting method
used when an investor has made multi-
ple purchases at different prices of the
same security. The method averages
the purchase prices to calculate an
investors cost basis in shares being liq-
uidated.
Average Life: The length of time that
will pass before one-half of a debt obli-
gation has been retired.
Average Price per Share: The most
common method for calculating taxes
owed on mutual fun redemptions, in
which the average cost per share is
found by taking the total cost of all the
fund shares and dividing by the total
number of shares owned.
Averages and Indexes: Statistical
tools that measure the state of the stock
market or the economy, based on the
performance of stocks, bonds or other
components. The Dow Jones Industrial
Average is a well known example.
Averaging Down: A strategy through
which an investor lowers the average
price paid for each share of stock by
purchasing more shares when the price
declines.
Page 556

B Balanced Fund: A management com-
Back-end Load: A sales charge or
commission paid when an individual
sells an investment, such as a mutual
fund or an annuity. This is also known
as a contingent deferred sales charge.
Backing Away: Offering a quote that is
not honored.
Back-End Load: A commission or
sales fee that is charged when mutual
fund shares or variable annuity con-
tracts are redeemed. It declines annu-
ally, decreasing to zero over an
extended holding period as described
in the prospectus.
Backup Withholding: An IRS proce-
dure designed to ensure that a taxpayer
who does not have a Social Security
number will still have taxes withheld on
his/her income.
Balanced Fund: A mutual fund that
buys a combination of common stocks,
bonds and short-term bonds to provide
both income and capital appreciation
while avoiding excessive risk.
Balance of Trade: The largest compo-
nent of a countrys balance of pay-
ments. It concerns the export and
import of merchandise. A balance of
payments surplus means that the U.S.
is exporting more than it is importing
while a balance of payments deficit
means that the U.S. is importing more
than it is exporting.
Balance Sheet: A summary of a com-
panys financial condition at a specific
point in time, including assets, liabilities
and net worth.
Page 557
Glossary
pany that invests in common stocks for
growth and preferred stocks and bonds
for income to achieve a balance of
both.
Balloon Maturity: A repayment sched-
ule for an issue of bonds wherein a
large number of the bonds come due at
a prescribed time, normally at the final
maturity date.
Bankers Acceptance (BA): A short-
term credit investment which is created
by a non-financial firm and whose pay-
ment is guaranteed by a bank. Often
used in importing and exporting, and as
a money market fund investment.
Basis: Purchase price, including com-
missions and other expenses used to
determine capital gains and capital
losses for tax purposes. Also known as
the cost basis or tax basis. For test pur-
poses when the basis is used with bond
calculations, assume it means yield to
maturity.
Basis Point: A term used to describe
differences in bond yields with one
basis point equal to $.10 or one hun-
dredth of a percentage point.
Basis Quote: The price of a security
quoted in terms of the yield the pur-
chaser can expect to receive.
Bear Call Spread: The sale of a lower
strike price call option and the purchase
of a higher strike price call option on the
same underlying security.
Bear Market: A prolonged period of
falling prices, usually by 20% or more,
accompanied by widespread pessi-
mism. This would be the opposite of a
bull market.
NASD Series 7
Glossary
Bear Put Spread: The purchase of a
higher strike price put option and the
sale of a lower strike price put option on
the same underlying security.
Bear Spread: An option strategy
involving buying and selling calls simul-
taneously on the same stock or buying
an selling puts simultaneously on the
same stock in anticipation of a
decrease in the price of the underlying
stock.
Bearer Bonds: A fully negotiable,
unregistered bond with bearer coupons
attached. Neither the bondholders
name nor the principal amount are reg-
istered with the issuer so both are pay-
able to the bearer.
Bell Shaped Yield Curve: An unusual
yield curve shape that looks like a bell
shape, also called a hump shaped yield
curve. Here, yields for medium term
maturities are higher than yields for
both short term and longer term issues,
indicating a demand-supply imbalance
in the medium term issues.
Beneficial Owner: The real owner of a
security.
Beneficiary: An individual, institution,
trustee, or estate which receives or may
become eligible to receive, benefits
under a will, insurance policy, retire-
ment plan, annuity, trust or other con-
tract.
Best Efforts Offering: An underwriting
in which an investment bank, acting as
an agent, agrees to do its best to sell
the offering to the public, but does not
buy the securities outright and does not
guarantee that the issuing company will
receive any set amount of money.
NASD Series 7 Page 558
Beta: A measure of the volatility of a
stock relative to the overall market. A
beta of less than one indicates lower
risk than the market while a beta of
more than one indicates higher risk
than the market.
Bid: An indication a trader or a dealer
of a willingness to buy a security. A Bid
is also the price at which an investor
can sell to a broker-dealer.
Big Board: Known as the New York
Stock Exchange.
BIGI: Bond Investors Guaranty Insur-
ance Corp., is a private company that
insures the timely payment of interest
and principal on a bond issue.
Blanket Bond: Insurance that broker-
dealers are required to carry in order to
cover losses due to illegal incidents
such as theft or securities forgery. This
is not a security.
Blind Pool: A form of limited partner-
ship which doesnt specify what invest-
ment opportunities the general partner
plans to pursue.
Blind Trust: A trust in which the benefi-
ciaries do not have knowledge of the
trusts specific assets, and in which a
fiduciary third party has complete man-
agement discretion.
Block Trade: A large amount of securi-
ties being held or traded, typically at
least 10,000 shares of stock or
$200,000 in bonds.
Blotter: A book of original entry in
which a broker-dealer records on a
daily basis every transaction, move-
ment of securities and cash receipt and
disbursement.

Blue Chip Stock: These are shares in
older, established companies such as
IBM, AT&T and GM. They have a long
history of growth dividend distribution.
The 30 Dow Jones Industrial Average
stocks are all blue chips.
Blue List: A daily publication that lists
current municipal bond offerings traded
in the secondary market by banks and
brokers nationwide. However, also
includes the secondary market of most
other types of bonds.
Blue-Sky: To register securities in a
particular state. Register by Filing, qual-
ification or coordination.
Blue Sky Laws: State regulations gov-
erning the sale of securities and mutual
funds, designed to safeguard investors
form being lured into fraudulent deals.
Board of Directors: Individuals elected
by a corporations shareholders to over-
see the management of the corpora-
tion.
Bona Fide Quote: An offer from a bro-
ker-dealer to buy or sell securities. It
indicates a willingness to execute a
trade under the terms and conditions
accompanying the quote.
Bond: A corporate, government or
municipal debt security.
Bond Anticipation Note (BAN): A
short-term municipal debt security to be
paid from the proceeds of long-term
debt when it is issued.
Bond Basis Book: A reference book
that gives yield-to-maturity tables for
bonds, arranged according to coupon
rates, times to maturity and prices.
Page 559
Glossary
Bond Buyer: Sometimes called the
Daily Bond Buyer, the daily newspaper
of the municipal bond market which
contains articles primarily about the
new issue marketplace and its partici-
pants, official notices of sale, bond
redemption notices, and statistics about
interest rates and trading activity.
Bond Buyer Indexes: Indexes of yield
levels of municipal bonds, published
daily by the Bond Buyer. The indexes
are indicators of yields that would be
offered on AA- and A-rated general
obligation bonds with 20-year maturities
and revenue bonds with 30-year matu-
rities.
Bond Counsel: Known as the bond
attorney, the lawyer or law firm that pre-
pares all the legal documents for a new
issue municipal bond, trust indenture,
and official statement. The bond coun-
sel also renders the legal opinion attest-
ing to a bonds legality, validity and tax-
exempt status.
Bond Fund: A mutual fund which
invests in bonds, typically with the
objective of providing stable income
with minimal capital risk.
Bond Interest Coverage Ratio: An
indication of the safety of a corporate
bond. It measures the number of times
by which earnings before interest and
taxes exceeds annual interest on out-
standing bonds.
Bond Quote: One of a number of quo-
tations listed in the financial papers that
provides representative bid prices from
the previous days bond market.
Bond Rating: A measure of the quality
and safety of a bond, based on the
issuers financial condition.
NASD Series 7
Glossary
Bond Ratio: A tool used by bond ana-
lysts to assess the degree of safety
offered by a corporations bonds. It
measures the percentage of the corpo-
rations capitalization that is provided by
long-term debt financing, calculated by
dividing the total face value of the out-
standing bonds by the total capitaliza-
tion.
Bond Resolution: The contract
between the issuer and the bondholder
that details all of the covenants (prom-
ises) to which the issuer must adhere in
return for the loan from the bondholder.
Bond Swap: The simultaneous sale of
one bond issue and the purchase of
another, to stretch out maturities or for
tax reasons.
Bond Yield: The annual rate of return
on a bond investment.
Book Entry: Ownership of a security
evidenced by an accounting entry with
no physical certificate.
Book Value: A companys common
stock equity as it appears on a balance
sheet, equal to total assets minus liabil-
ities, preferred stock and intangible
assets such as goodwill. Also, the value
of an asset as it appears on a balance
sheet, equal to cost minus accumulated
depreciation.
Borrowed Stock: Used in a short sale.
Boston Stock Exchange: The third
oldest stock exchange in the United
States and the first exchange to provide
membership to foreign broker-dealers.
Branch Office: Any location identified
to the public as a place where a regis-
tered broker-dealer conducts business.
NASD Series 7 Page 560
Branch Officer Manager: A NYSE
license designation for an individual
who has passed the Series 9/10 (for-
merly the Series 8) examination.
Approves new accounts, transactions in
accounts and correspondence to cus-
tomers.
Breadth-of-Market Theory: A techni-
cal analysis theory that predicts the
strength of the market according to the
number of issues that advance or
decline in a particular trading day.
Breakeven Point: The point at which
gains equals losses.
Breakout: A price rise to, and through,
a resistance level that results in a sub-
stantial further price advance, or a price
decline to, and through, a support level
that results in a substantial further price
decline.
Breakpoint Sale: The sale of mutual
fund shares in an amount just below the
level at which the purchaser would
qualify for reduced sales charges. This
violates the NASD Conduct Rules.
Broad Based Index: An index whose
purpose is to reveal the performance of
the entire market, such as the S&P 500
or the AMEX Major Market Index.
Broad Tape: News wires that continu-
ously provide price and background
information on securities and commodi-
ties markets.
Broker: An individual or firm who acts
as an intermediary between a buyer
and seller, usually charging a commis-
sion.

Broker-Dealer: A firm which is in the
business of buying and selling securi-
ties for itself and others. Called an
agent or broker when buying securities
and a principal or dealer when selling
them. Broker-dealers must register with
the SEC as well as with the states in
which they conduct business.
Brokered CD: A large denomination
CD sold by a bank to a brokerage firm
which then divides it into smaller pieces
for sale to its customers.
Broker Loan Rate: Known as the call
loan rate, the interest rate that banks
charge brokerage firms for loans collat-
eralized by marketable securities (mar-
gin loans). This rate is lower than the
prime rate (the rate that banks charge
their best business customer for unse-
cured loans) because marketable secu-
rities are placed with the bank as
collateral.
Brokers Broker: A specialist executing
orders for a commission house broker
or another brokerage firm.
Brokers Loan: Money loaned to a bro-
kerage firm by a commercial bank or
other lending institution for financing
customers margin account debit bal-
ances.
Brokers Wire: A newswire service
which gives information about the
municipal marketplace, primarily about
issues in the secondary market and
general economic information.
Bull Call Spread: The purchase of a
lower strike price call option and the
sale of a higher strike price call option
on the same underlying security.
Bull Market: When the price of stocks
generally rises over the long term.
Page 561
Glossary
Bull Put Spread: The sale of a higher
strike price put option and the purchase
of a lower strike price put option on the
same underlying security.
Bull Spread: An option strategy involv-
ing buying and selling calls simulta-
neously on the same stock or buying
and selling puts simultaneously on the
same stock in anticipation of an
increase in the price of the underlying
stock.
Business Cycle: A predictable long-
term pattern of alternating periods of
economic growth (recovery) and
decline (recession), characterized by
changing employment, industrial pro-
duction and interest rates. This is also
known as the economic cycle.
Business Day: Those days when most
corporate and government offices are
open for business, usually any day
except Saturday, Sunday and legal holi-
days.
Business Risk: Risk associated with
the unique circumstances of a particular
company, as they might affect the price
of that companys securities.
Buy: To obtain ownership of a security
or other asset in exchange for money or
value.
Buyers Option: A settlement contract
that calls for delivery and payment
according to a number of days specified
by the buyer.
Buy-In: The procedure that the buyer
of a security follows when the seller
fails to complete the contract by deliver-
ing the security. The buyer closes the
contract by buying the security in the
open market and charging the account
of the seller for transaction fees and
any loss caused by changes in the mar-
kets.
NASD Series 7
Glossary
Buying on Margin: A risky technique
involving the purchase of securities with
borrowed money, using the shares
themselves as collateral. Usually done
using a margin account at a brokerage
firm and subject to fairly strict SEC reg-
ulations.
Buying Power: The amount of fully
margined securities that a margin client
can purchase using only the cash,
securities and special memorandum
account balance (SMA) and without
depositing additional equity.
Buy Stop Order: An order to buy a
security that is entered at a price above
the current offering price and that is trig-
gered when the market price touches or
goes through the buy stop price.
C specific stock within a specified time.
Cabinet Trade: On the NYSE, stocks
that trade infrequently or stocks that are
vary high priced. They are placed here
until executed.
Calendar Spread: An option spread
position, where simultaneously the
same type of option is bought and sold
with the same strike price and different
expirations.
Call Buyer: An investor who pays a
premium for an option contract and
receives, for a specified time, the right
to buy the underlying security at a spec-
ified price.
Call Date: The date, specified in the
prospectus of every callable security,
after which the securitys issuer has the
option to redeem the issue at par or at
par plus a premium.
Call Feature: Gives the issuer the flexi-
bility to call the bond in and retire the
debt prior to maturity.
NASD Series 7 Page 562
Call Loan: A collateralized loan of a
brokerage firm having no maturity date
that may be called (terminated) at any
time. The loan has a fluctuating interest
rate that is recomputed daily. Generally
the loan is payable on demand the day
after it is contracted. If not called, the
loan is automatically renewed for
another day.
Call Loan Rate: The rate of interest a
brokerage firm charges its margin
account clients on their debit balances.
Call Money Rate: The rate of interest a
bank or lender charges brokerage firms
on stock exchange collateral.
Call Option: An option which gives the
holder the right, but not the obligation,
to buy a fixed number of shares of a
Calls are purchased when the investor
feels the market is going up.
Call Premium: The amount above par
that an issuer will pay a preferred stock-
holder or bondholder to call in the secu-
rity early.
Call Price: The price, usually a pre-
mium over the issues par value, at
which preferred stocks or bonds can be
redeemed before an issues maturity.
Call Protection: A characteristic of
some callable bonds in which the bonds
may not be called for a specified initial
period, usually up to five years.
Call Provision: A clause in a bonds
indenture granting the issuer the right to
buy back all or part of an issue prior to
the maturity date.
Call Risk: the cash flow risk resulting
from the possibility that a callable bond
will be redeemed before maturity.

Call Spread: An option investors posi-
tion in which the investor buys a call on
a security and writes a call on the same
security but with a different expiration
date, exercise price or both.
Call Writer: An investor who receives a
premium and takes on, for a specified
time, the obligation to sell the underly-
ing security at a specified price at the
call buyers discretion.
Callable: Securities which may be
redeemed upon due notice by the secu-
ritys issuer. This is done when interest
rates fall and it benefits the issuer, not
the investor.
Callable Bond: A type of bond issued
with a provision allowing the issuer to
redeem the bond before maturity at a
predetermined price.
Callable Preferred Stock: Preferred
stock issued with a provision allowing
the corporation to call in the stock at a
certain price and retire it.
Called Away: Term describing a call
option or a put option which is exer-
cised, or a bond which is redeemed
before maturity, or a delivery which is
required on a short sale.
Capital: Money; the financial assets
owned that can be invested.
Capital Appreciation: The rise in value
of a security, such as stock. If you buy a
share of stock for $10 and it increases
in value to $25, the capital appreciation
is $15.
Capital Asset: All tangible property,
including securities, real estate and
other property, held for the long term.
Capital Contribution: The amount of a
participants investment in a direct par-
ticipation program, not including units
purchased by the sponsors.
Page 563
Glossary
Capital Gain: The amount by which an
assets selling price exceeds its initial
purchase price. A realized capital gain
is an investment that has been sold at a
profit. An unrealized capital gain is an
investment that hasnt been sold yet but
would result in a profit if sold.
Capital Gains Distribution: Payments
to mutual fund shareholders of profits
from the sale of securities in a funds
portfolio. Capital gains distributions, if
any, are made annually.
Capital Gain Tax: A tax assessed on
profits realized from the sale of a capital
asset, such as stock.
Capital In Excess of Par: Also known
as capital surplus or additional paid in
capital, the amount by which the price
paid by a purchaser of the common
stock on the initial public offering
exceeds the stated par value of the
issue.
Capital Loss: The decrease in the
value of an investment or asset. Oppo-
site of a capital gain.
Capital Market: A market where debt
or equity securities are traded.
Capital Risk: The potential for an
investor to lose all money invested
owing to circumstances unrelated to an
issuers financial strength. For example,
derivative instruments such as options
carry risk independent of the underlying
securities changing value.
Capital Stock: All of a corporations
outstanding preferred stock and com-
mon stock, listed at par value.
Capitalization or Capital Structure:
Total dollar amount of all money
invested in a company, such as bonds,
preferred stock, common stock and
retained earnings of a company.
NASD Series 7
Glossary
Capital Surplus: The money a corpo-
ration receives in excess of the stated
value of stock at the time of first sale.
Same thing as paid-in capital and paid-
in surplus.
Capped Index Option: A type of index
option issued with a capped price at a
set interval above the strike price for a
call and below the strike price for a put.
The option is automatically exercised
once the underlying index reaches the
capped price.
Cash Account: A brokerage account in
which the customer is required to pay
the full amount due by settlement date.
IRAs and custodial accounts must be
cash accounts as margin is not permit-
ted.
Cash Assets Ratio: The most stringent
test of liquidity, calculated by dividing
the sum of cash and cash equivalents
by total current liabilities.
Cash Basis Accounting: A method of
reporting income when received and
expenses when paid, as opposed to
reporting income and expenses when
incurred.
Cash Dividend: A dividend paid in the
form of cash. Dividends are taken out
the companys earnings or accumulated
profits.
Cash Equivalents: Highly liquid, very
safe investments which can be easily
converted into cash, such as Treasury
bills and money market funds.
Cash Flow: The money received by a
business minus the money paid out.
Cash flow is also equal to net income
plus depreciation or depletion.
NASD Series 7 Page 564
Cashiering Department: The depart-
ment within a brokerage firm that deliv-
ers securities and money to and
receives securities and money from
other firms and clients of the brokerage
firm.
Cash Market: Transactions between
buyers and sellers of commodities that
entail immediate delivery of and pay-
ment for a physical commodity.
Cash Trade: Buyer pays cash and
receives immediate delivery of the
securities.
Cash Transaction: A settlement con-
tract that calls for delivery and payment
on the same day the trade is executed.
Catastrophe Call: The redemption of a
bond by an issuer owing to disaster
such as a fire that burns down the
entire company.
CBOE: Chicago Board of Options
Exchange. An exchange where stock
options, equity LEAPS, index options
and interest rate options are traded.
Central Bank: A body established by a
national government to regulate cur-
rency and monetary policy on a national
and international level. In the United
States it is the Federal Reserve Board.
Central Registration Depository
(CRD): This is the NASDs database of
information on each registered repre-
sentative, including each registered
representatives disciplinary history.
Certificate: A formal printing of a fact,
such as a stock certificate, CD, certifi-
cate of incorporation, mortgage-backed
security or even an American Deposi-
tary Receipt.

Certificate of Accrual on Treasury
Securities (CATS): One of several
types of zero-coupon bonds issued by
brokerage firms and collateralized by
Treasury securities.
Certificate of Deposit (CD): A fixed
income debt security issued by most
chartered banks, usually in minimum
denominations of $1,000 with typical
maturity terms of one to six years with
the possibility of even longer maturities.
Certificate of Limited Partnership:
The document, filed with the state, that
is a public record of all partners and
their percentage interest in a direct par-
ticipation program.
Change: For an index or average, the
difference between the current value
and the previous days market close.
For a stock or bond quote, the differ-
ence between the current price and the
last trade of the previous day.
Charting: Capturing the patterns of a
stocks price and volume movements
on a line, bar, point-and-figure, or mov-
ing average graph.
Chartist: A securities analyst who uses
charts and graphs of the past price
movements of a security to predict its
future movements.
Cheap Stock Rule: A NYSE/NASD
regulation that sets the minimum mar-
gin to sell short cheap stocks (stocks
under $5) at the greater of 100% of the
securitys market value of $25.0 per
share.
Chicago Board of Trade (CBOT): An
exchange where grain, gold and Trea-
sury bond futures and options are
traded.
Page 565
Glossary
Chicago Board Options Exchange
(CBOE): The largest listed options trad-
ing market in the United States.
Chicago Mercantile Exchange
(CME): An exchange where financial
futures, foreign currency futures, com-
modity futures, and futures options are
traded. Also called the Merc.
Chicago Stock Exchange (CHX):
Regional stock exchanged located in
Chicago, Illoinois. Provides a listed
market for smaller businesses and new
enterprises.
Chinese Wall: A term used to describe
procedures enforced within a securities
firm that separate the firms depart-
ments to restrict access to non-public,
material information, in order to avoid
the illegal use of inside information.
Churning: Excessive trading in a cli-
ents account by a broker seeking to
maximize commissions regardless of
the clients best interests, in violation of
NASD rules. Also known as twisting or
overtrading.
Cincinnati Stock Exchange (CSE):
Operates the National Securities Trad-
ing System, the nations only auto-
mated auction system for unlisted
securities.
Circuit Breaker: NYSE Rule 80B that
requires the market to be shut for spec-
ified time periods if the market drops by
a large amount.
Class: Options of the same type, all
calls or all puts on the same underlying
security.
NASD Series 7
Glossary
Class A and Class B Stock: Names
used by companies to distinguish
between two classes of common stock.
Class A stock may receive cash divi-
dends while Class B may receive stock
dividends. There also could be a differ-
ence in voting rights.
Class A Mutual Fund Shares: Shares
issued with a front-end sales load.
Class B Mutual Fund Shares: Shares
issued with a back-end load.
Class C Mutual Fund Shares: Shares
issued with a level sales load.
Class D Mutual Fund Shares: Shares
issued with a level sales load and a
back-end load.
Clearing Broker-Dealer: A broker-
dealer that clears its own trades as well
as those of introducing brokers. Can
hold customers securities and cash.
Clearing Firms: An agency associ-
ated with an exchange to handle confir-
mation, delivery and settlement
transactions.
Clearinghouse Funds: Funds repre-
sented by a personal or business check
that pass between Federal Reserve
System banks prior to approval of
credit. They are used to clear non-fed-
eral security transactions.
Close: The price of the last transaction
for a particular security on a particular
day.
Close a Position: To eliminate an
investment from ones portfolio by sell-
ing a long position or covering a short
position.
NASD Series 7 Page 566
Closed-end Covenant: A provision of
a bond issues trust indenture stating
that any additional bonds securities by
the same assets must have a subordi-
nated claim to those assets.
Closed-end Fund: A type of manage-
ment company that issues a fixed num-
ber of shares of stock to the public.
These shares are not redeemable with
the fund, as is the case with an open-
end management company (mutual
fund). Share prices may be at, above,
or below the shares net asset value
depending on investor sentiment
towards the fund.
Closed-end Investment Company:
An investment company that issues a
fixed number of shares in an actively
managed portfolio of securities. They
are traded in the secondary market-
place, either on an exchange or over
the counter. The market price is deter-
mined by supply and demand and not
by net asset value.
Closed-end Mortgage Bond: A
secured bond issue in which a corpora-
tion issues the maximum number of
bonds authorized in the trust indenture
as first-mortgage bonds.
Closely Held: A corporation for which
most of the voting stock is held by a
small number of shareholders, but
which is still publicly traded.
Closing Purchase: An options trans-
action in which the seller buys back an
option in the same series. The two
transactions effectively cancel each
other out and the position is liquidated.
Closing Sale: An options transaction in
which the buyer sells an option in the
same series. The two transactions
effectively cancel each other out and
the position is liquidated.

Code of Arbitration: System con-
cerned with settling disputes between
dealers or brokers and the public.
Code of Procedure: NASD guide for
handling and adjudicating complaints
filed against NASD members under its
Rules of Fair Practice.
Coincident Indicator: A measurable
economic factor that varies directly and
simultaneously with the business cycle,
thus indicating the current state of the
economy. Examples include non-agri-
cultural employment, personal income
and industrial production.
Cold Calling: The practice by brokers
of making unsolicited phone calls to
people they dont know in order to
attract new business.
Collar: A limit for institutional program
trading when the market moves up or
down by a predetermined amount (cur-
rently 2%). In options, a person who
has bought stock and then sells a call at
a strike price just above the market
price of the stock and buys a put at a
strike price just below the market price
of the stock.
Collateral: Securities or other property
pledged by a borrower as a guarantee
for repayment of a loan.
Collateral Mortgage Obligation
(CMO): A mortgage backed, investment
grade bond that separates mortgage
pools into different maturity classes,
called tranches. The underlying securi-
ties are mortgage backed securities
such as GNMA, FNMA and Federal
Home Loan Bank.
Collateral Trust Bond (Certificate): A
bond secured by stocks or bonds of
companies controlled by the issuing
company, or other securities, which are
deposited with a trustee.
Page 567
Glossary
Combination: An option position that
represents a put and a call on the same
stock at different strike prices, expira-
tions or both.
Combination Fund: An equity mutual
fund that attempts to combine the
objectives of growth and current
income by dividing its portfolio between
companies that show long-term growth
potential and companies that pay high
dividends.
Combination Oil and Gas Program:
An oil and gas program that combines
exploratory, developmental and income
programs into one overall combined
program.
Combination Preferred Stock: A type
of preferred stock that combines two or
more of the following preferred stock
features such as participating, cumula-
tive, convertible and callable.
Combined Account: A customer
account that has cash and long and
short margin positions in different secu-
rities.
Combined Margin Account: A margin
account with both long and short posi-
tions. This account is treated basically
as two separate accounts, a long
account and a short account.
Commercial Bank: An institution which
accepts deposits, makes business
loans, and offers related services.
Member banks of the Federal Reserve
System are commercial banks.
Commercial Paper: Short-term unse-
cured negotiable debt securities issued
by non-financial corporations with terms
of a few days to 270 days maximum.
NASD Series 7
Glossary
Commingled Fund: A mutual fund that
includes assets from several accounts,
pooled together, to reduce manage-
ment and administrative costs. Also
called a pooled fund.
Commingling: The mixing of customer
account securities with those in a bro-
kerage firms own accounts and is usu-
ally illegal.
Commission: A fee charged by a bro-
ker or agent for his/her service in facili-
tating a transaction, such as the buying
or selling of securities or real estate.
Commission House Broker: A mem-
ber of an exchange who is eligible to
execute orders for customers of a
member firm on the floor of the
exchange.
Committee on Uniform Securities
Identification Procedures (CUSIP): A
committee that assigns identification
numbers and codes to all securities, to
be used when recording all buy and sell
orders.
Commodities: Products used for com-
merce that are traded on a separate,
authorized exchange. A Series 3
license is required for sale of commodi-
ties.
Common at Par: On a companys bal-
ance sheet, the portion of the price paid
on the initial public offering by share-
holders that equals the stated par value
of the shares.
Common Stock: Securities which rep-
resent ownership in a company and
carry voting privileges. They may be
paid a dividend but only after preferred
shareholders are paid. Common share-
holders are last in line after creditors,
debt holders and preferred sharehold-
ers to claim any of a companys assets
in the event of liquidation.
NASD Series 7 Page 568
Common Stock Equivalent: A secu-
rity that can be converted into common
stock. Convertible bonds and convert-
ible preferred stocks are considered
stock equivalents.
Common Stock Ratio: One of several
tools used by bond analysts to assess
the degree of safety offered by a corpo-
rations bonds. It measures the percent-
age of the corporations total
capitalization that is contributed by the
common stockholders, and is calcu-
lated by adding the par value, the capi-
tal in excess of par and the retained
earnings, and dividing the result by the
total capitalization.
Common Stockholders Equity: The
portion of a companys long-term capi-
tal that, in theory, belongs to the com-
mon shareholders. Common
stockholders equity includes common
at par value, capital in excess of par
value and retained earnings.
Comparison: A dealer-to-dealer confir-
mation of a trade, listing of all relevant
data about the transaction, that a firms
Purchase and Sales department sends
to the contra-broker-dealer.
Competitive Bid Auction: A bid
placed at the yield auction of the U.S.
Government securities in which the bid-
der specifies the interest rate (yield) on
the bid. The winning bids are those with
the lowest interest rates, representing
the lowest interest cost to the U.S. Gov-
ernment. The higher interest rate com-
petitive bids lose, and are not filled.

Competitive Bid Underwriting: A form
of firm commitment underwriting in
which rival syndicates submit sealed
bids for underwriting the issue. Com-
petitive bidding normally is used to
determine the underwriters for issues of
general obligation municipal bonds and
is required by law in most states for
general obligation bonds of more than
$100,000.
Competitive Municipal Bid: In a com-
petitive bid underwriting of a new issue
municipal bond, the specific interest
rates at which an underwriting syndi-
cate proposes to buy the offering from
the issuer. The lowest interest rate bid-
der is awarded the issue. The bid to the
municipality must be submitted with a
good faith check.
Compliance Department: The depart-
ment within a brokerage firm that over-
sees trading and other activities to
ensure that SEC regulations are being
adhered to.
Compliance Officer: A NYSE designa-
tion for an individual who has passed
the Series 14 examination. This person
is responsible for overall firm compli-
ance, and supervises all Branch Office
Managers.
Compliance Registered Options
Principal (CROP): The principal
responsibility for compliance with
options exchange rules and securities
laws. Typically, a CROP may not have
sales functions.
Compound Interest: Interest earned
on an investment at periodic intervals
and added to the original amount of the
investment.
Concession: The discount from the
public price given to the member of a
selling group that is participating in a
new issue underwriting.
Page 569
Glossary
Conduit Theory: This is also known as
the pipeline theory and Subchapter M
of the IRS code. Investment companies
avoid double taxation by passing
investment income such as the interest,
dividend income and capital gains
directly to shareholders. At least 90%
must be passed to the shareholders by
year end.
Confirmation: The written statement
acknowledgement giving details of a
sale or purchase of a security which is
normally mailed to a client by the bro-
kerage firm within 24 hours of an order
being executed.
Consent to Service of Process: Reg-
istered representative agrees to allow
Director of Securities to be served with
any legal papers and it would be the
same as serving the representative.
Conservative Growth: An investment
strategy aimed at long-term capital
appreciation with low risk. It will likely
involve a high percentage of blue chip
stocks with low turnover and infrequent
trading.
Concession: The profit per bond or
share that an underwriter allows the
seller of new issue securities. The sell-
ing group broker-dealer purchases the
securities from the syndicate member
at the public offering price minus the
concession.
Conduct Rules: Regulations designed
to ensure that NASD member firms and
their representatives follow fair and eth-
ical trade practices when dealing with
the public. These rules complement the
Securities Act of 1933, the Securities
Exchange Act of 1934 and the Invest-
ment Company Act of 1940.
NASD Series 7
Glossary
Conduit Theory: A means for an
investment company to avoid taxation
on net investment income distributed to
shareholders. If a mutual fund acts as a
conduit for the distribution of net invest-
ment income, it may qualify as a regu-
lated investment company and be taxed
only on the income the fund retains as
long as 90% of investment income is
distributed to investors.
Confidence Theory: A technical analy-
sis theory that measures the willing-
ness of investors to take risks by
comparing the yields on high-grade
bonds to the yields on lower rated
bonds.
Confirmation: A printed document that
states the trade date, settlement date
and money due from or owed to a cus-
tomer. It is sent or given to the cus-
tomer on or before the settlement date.
Congestion: A technical analysis term
used to indicate that the range within
which a commoditys price trades for an
extended period of time is narrow.
Consolidated Quotation System
(CQS): A quotation and last sale report-
ing service for NASD members that are
active market makers of listed securi-
ties in the third market. It is used by
market makers wiling stand ready to
buy and sell securities for their own
accounts on a continuous basis but that
do not wish to do so through an
exchange.
NASD Series 7 Page 570
Consolidated Tape: A NYSE service
that delivers real time reports of securi-
ties transactions to subscribers as they
occur on the various exchanges. Net-
work A reports transactions on the
NYSE of listed securities. Network B
reports transactions on the American
Stock Exchange (AMEX) of listed secu-
rities transactions as well as reports of
transactions in regional exchange
issues.
Consolidation: The technical analysis
term for a narrowing of the trading
range for a commodity or security, con-
sidered an indication that a strong price
move is imminent.
Constant Dollar Plan: Method of accu-
mulating assets by investing a fixed
amount of dollars in securities at set
intervals.
Constant Ratio Plan: An investment
strategy in which the investor maintains
an appropriate ratio of debt to equity
securities by making purchases and
sales to maintain the desired balance.
Constitutional Debt Limit: A limit
expressed as a percentage of assessed
valuation on the dollar amount of bonds
that a municipality can have outstand-
ing at any one time.
Construction Loan Note (CLN): A
short-term municipal debt security that
provides interim financing for new
projects.
Constructive Receipt: According to
the IRS, the date when a taxpayer
received income, such as a dividend
payment, interpreted as the first date
the taxpayer has the right to claim it,
whether or not that claim was actually
exercised.

Consumer Confidence Index: A lead-
ing economic indicator published by the
Conference Board measuring con-
sumer confidence levels, and hence,
likely future consumer spending levels.
Consumer Price Index (CPI): A major
inflation index that measures the
change in prices of a fixed basket of a
variety of goods and services in the
previous month.
Consumption: A term used by Keyne-
sian economists to refer to the pur-
chase by household units of newly
produced goods and services.
Contingent Deferred Sales Charge: A
back-end load charged if the fund is
sold usually in the first 5 6 years. The
annual charge decreases over the
same time period. Most Class B shares
with deferred sales charges automati-
cally convert to Class A shares at the
end of the same time period as the
reduction of sales charges go to zero.
Contingent Order: An order that is
conditional upon the execution of a pre-
vious order and that will be executed
only after the first order is filled.
Contra Broker: The broker on the buy
side of a sell order or on the sell side of
a buy order.
Contraction: A period of general eco-
nomic decline.
Contractual Plan: Mutual fund con-
tracts for making monthly contributions
over long periods of time.
Contrary Indicators: Information used
to establish the bullish or bearish senti-
ment of the market to which an investor
responds by taking the opposite posi-
tion.
Page 571
Glossary
Control Person: A director, officer of
another affiliate of an issuer and/or a
stockholder who owns at least 10% of
any class of a corporations outstanding
securities.
Control Stock: Stock acquired by an
affiliated person such as an officer,
director or 10% shareholder of that
company.
Conversion: The process of converting
a convertible security, such as a bond
or preferred stock, into common stock.
Conversion Parity: The market value
of a bond is equal to the market value
of the common stock for which it is
exchanged.
Conversion Price: The price, specified
when issued, at which a given convert-
ible can be converted to common stock.
Conversion Privilege: A feature the
issuer adds to a security that allows the
holder to change the security into
shares of common stock.
Conversion Ratio: The number of
shares of common stock per par value
amount that the holder would receive
for converting a convertible bond or
preferred share.
Conversion Value: The total market
value of a common stock into which a
senior security is convertible.
Convertible Adjustable Preferred
Stock: A preferred stock, whose divi-
dend rate changes periodically based
upon changes in market interest rates,
and that can be converted into common
stock.
Convertible Bond: A debt security,
usually in the form of a debenture, that
can be exchanged for equity securities
of the issuing corporation at specified
prices or rates.
NASD Series 7
Glossary
Convertible Adjustable Preferred
Stock: A preferred stock, whose divi-
dend rate changes periodically based
upon changes in market interest rates,
and that can be converted into common
stock.
Convertible Debenture: A bond that
the holder can convert into a fixed num-
ber of common shares. The conversion
ratio is set when the bond is issued.
Convertible Preferred Stock: An
equity security that can be exchanged
for common stock at specified prices or
rates. Dividends may be cumulative or
noncumulative.
Convertible Security: A bond, deben-
ture or preferred stock which may be
exchanged by the owner, usually for the
common stock of the same company.
They are attractive to investors as they
provide the security and income of a
bond, as well as the opportunity to par-
ticipate in the growth of the company
through converting to common shares.
Cooling Off Period: The period after a
companys prospectus has been filed
with the SEC and before the IPO, dur-
ing which the companys relations with
investors are greatly restricted. Usually
lasts 20 days.
Corporate Account: An account held
in a corporations name. The corporate
agreement, signed when the account is
opened specifies which officers are
authorized to trade in the account.
Corporate Bond: A debt security
issued by a corporation. A corporate
bond typically
Corporation: A form of business orga-
nization legally created which has a
legal identity separate from its owners.
Shareholders have limited liability, their
initial investment.
NASD Series 7 Page 572
Corporate Bond: A bond issued by a
corporation. Such bonds usually have a
par value of $1,000, are taxable, have a
term maturity (all bonds mature at the
same time), and traded on major
exchanges.
Correspondent Broker-Dealer: A bro-
ker-dealer that executes transactions
for another broker-dealer in a market or
locale in which the first broker-dealer
has no office.
Cost Basis: The original purchase
price of a security, including sales
charges and commissions.
Cost Depletion: A method of calculat-
ing tax deductions for investments in
mineral, oil or gas reserves.
Coterminous: A term used to describe
municipal entities that share the same
boundaries. Examples include a school
district and a fire district as they may
issue debt separately although the debt
is backed by revenues from the same
tax-payers.
Counter-Cyclical Stock: Moving in the
opposite direction of the overall eco-
nomic cycle, i.e. rising when the econ-
omy is weakening, and falling when the
economy is strengthening.
Country Fund: A management com-
pany that invests in the securities of
companies located in one country,
whose name the fund bears such as
the Europe Fund.
Coupon: Also known as the nominal
yield, the interest rate on a fixed income
security, determined upon issuance and
expressed as a percentage of par. Also,
the term for each interest payment
made to the bondholder. The coupon
rate never changes, once issued.

Covenant: A component of a debt
issues trust indenture that identifies
bondholders rights and other provi-
sions. Examples include rate covenants
that establish a minimum revenue cov-
erage for a bond, insurance covenants
that require insurance on a project and
maintenance covenants that require
maintenance on a facility constructed
by the proceeds of a bond issue.
Cover: A slang term for closing out or
liquidating a short position by buying
back the shares that have been sold
short and delivering them to the lender.
Coverage Ratio: A measure of the
safety of a bond issue, based on how
many times earnings will cover debt
service plus operating and mainte-
nance expenses for a specific time
period.
Coverdell Education Savings
Account: Formerly called an Education
IRA, the Coverdell allows an annual
maximum of $2,000 for the purpose of
paying for a childs higher education
expenses.
Covered Call: The selling of a call
option while simultaneously holding an
equivalent position in the underlying
security.
Covered Option: Term used to
describe a short call or put that is pro-
tected against loss by another security
position or money position.
Covered Call Writer: An investor who
sells a call option while owning the
underlying security or some other asset
that guarantees the ability to deliver if
the call is exercised.
Page 573
Glossary
Credit Agreement: A component of a
customers margin account agreement,
outlining the conditions of the credit
arrangement between broker and cus-
tomer.
Credit Balance (CR): The amount of
money remaining in a customers
account after all commitments have
been paid in full.
Creditor: Any broker or dealer, mem-
ber of a national securities exchange,
or person associated with a broker-
dealer involved in extending credit to
customers.
Credit Risk: The degree of probability
that a bonds issuer will default in the
payment of either principal or interest.
Credit Spread: A futures hedge posi-
tion established when the premium
received for the option sold exceeds the
premium paid for the option bought.
Crossed Market: The situation created
when one market maker bids for a
stock at a higher price than another
market maker is asking for the same
stock, or when one market maker
enters an ask price to sell a stock at a
lower price than another market
makers bid price to buy the same
stock.
Crossed Trade: A practice in which a
broker offsets buy and sell orders with-
out recording the transactions on the
exchange. This is illegal, because it
may prevent an investor from getting
the best possible price on the trade.
Crossing: A securities transaction in
which an OTC trader executes a buy
order and a sell order in the same stock
from different customers at the current
market price, in effect offsetting one
order against the other.
NASD Series 7
Glossary
Crossover Point: The point at which a
limited partnership begins to show a
negative cash flow with a taxable
income.
Cum Rights: A term describing stock
trading with rights.
Cumulative Preferred Stock: A pre-
ferred stock which has a provision that
if one or more of its dividends are omit-
ted, these unpaid dividends accumulate
and must be paid before any dividends
may be paid on the companys common
shares.
Cumulative Voting: A voting system
that gives minority shareholders more
power by allowing them to cast all of
their board of director votes for a single
candidate as opposed to regular or stat-
utory voting in which shareholders must
vote for a different candidate for each
available seat.
Currency Risk: The risk that a busi-
ness operations or an investments
value will be affected by changes in
exchange rates. Also known as cur-
rency exchange risk.
Current Assets: Cash and other
assets that are expected to be con-
verted into cash within the next 12
months. Examples include such liquid
items as cash and equivalents,
accounts receivable, inventory and pre-
paid expenses.
Current Income: Money that is regu-
larly received from investments, such
as dividends and interest.
Current Liabilities: A corporations
debt obligations due for payment within
the next 12 months. Examples include
accounts payable, accrued wages pay-
able and current long-term debt.
NASD Series 7 Page 574
Current Market Value: Value that at
which securities are trading at in the
secondary markets.
Current Ratio: A measure of a corpo-
rations liquidity. It is calculated by divid-
ing total current assets by total current
liabilities.
Current Return or Yield: The annual
income from an investment expressed
as a percentage of the investments
current value. On stock, this is calcu-
lated by dividing yearly dividends by the
market price of the security. On bonds,
this is calculated by dividing yearly
interest by the current price.
CUSIP Number: A number which
uniquely identifies a given security. For
example, the CUSIP number for
Microstate common stock is
594918104.
Custodial Account: An account which
is created for the benefit of a minor with
an adult as a custodian. Known as
UGMA or UTMA accounts.
Custodian (Mutual Fund): An agent,
bank, trust company or other organiza-
tion which holds and safeguards an
individuals mutual funds for mutual
fund companies.
Custodian: An institution or a person
responsible for making all investment,
management and distribution decisions
in an account maintained in the best
interests of another.
Customer Agreement: A document
that a customer must sign when open-
ing a margin account with a broker-
dealer. It allows the firm to liquidate all
or a portion of the account if the cus-
tomer fails to meet a margin call.

Customer Statement: A document
showing a customers trading activity,
positions and account balance. The
SEC requires that customer statements
be sent quarterly, but customers gener-
ally receive them monthly.
Cyclical Stock: Stock in an industry
that is particularly sensitive to swings in
economic conditions, such as mining or
forestry.
D the option bought exceeds the premium
Date of Record: The date on which a
shareholder must officially own shares
in order to be entitled to a dividend.
Dated Date: The date on which interest
on a new bond issue begins to accrue.
Day Order: A buy or sell order which
automatically expires if it is not exe-
cuted during that trading session.
Day Trade: The purchase and sale (or
short sale and cover) of the same secu-
rity on the same day.
Day Trader: Active stock trader who
holds positions for a very short time and
makes several trades each day.
Dealer: An individual or brokerage firm
when it acts as a principal and stands
ready to buy and sell for its own
account. More generally a firm which
buys and sells products and holds an
inventory.
Dealer Paper: Short-term, unsecured
promissory notes that the issuer sells
through a dealer rather than directly to
the public.
Death Benefit: The amount the benefi-
ciary receives from the decedent owner
of an annuity or life insurance policy.
Page 575
Glossary
Debenture: Unsecured debt backed
only by the integrity of the borrower, not
by collateral, and documented by an
agreement called an indenture. Also
known as an unsecured bond.
Debit Balance (DR): The amount of
money a customer owes a brokerage
firm when using a margin account.
Debit Spread: A futures hedge position
established when the premium paid for
received for the option sold.
Debt Financing: Raising money for
working capital or for capital expendi-
tures by selling bonds, bills or notes to
individual or institutional investors. In
return for the loan, the loan, the inves-
tors become creditors and receive the
issuers promise to repay principal and
interest on the debt.
Debt Instrument: A written promise to
repay a debt. Examples include bills,
bonds, notes, CDs, Gigs (guaranteed
interest contracts), commercial paper
and bankers acceptances.
Debt Limit: For municipal general obli-
gation bonds, a statutory or constitu-
tional limit on the dollar amount of
bonds, typically expressed as a per-
centage of assessed value of property,
that may legally be sold by the munici-
pality.
Debt Market: The market for trading
debt instruments.
Debt Retirement: The paying off of a
debt.
NASD Series 7
Glossary
Debt Security: A security representing
an investors loan to an issuer such as
a corporation, municipality, the federal
government or federal agency. In return
for the loan, the issuer promises to
repay the debt on a specified date and
to pay interest.
Debt Service: The series of payments
of interest and principal required on a
debt over a given period of time.
Debt Service Ratio: An indication of
the ability of an issuer to meet principal
and interest payments on bonds.
Debt Service Reserve Fund: The
account that holds enough money to
pay one years debt service on a munic-
ipal revenue bond.
Debt-to-Equity Ratio: The ratio of total
long-term debt to total stockholders
equity. It is used to measure leverage.
Debt Statement: A document that
details all of a municipalitys outstand-
ing debt that is non-self supporting,
thus this debt is being carried by the
taxpayers.
Debt to Population Ratio: Also
referred to as debt per capita ratio. It is
a measure of the credit quality of a gen-
eral obligation bond issue. This is a
municipalitys Net Overall Debt divided
by the population in the municipality
that is the source of taxes that service
the debt.
Decimalization: The process of switch-
ing over the reporting of security prices
and related information from fractions
to decimals.
NASD Series 7 Page 576
Declaration Date: The date on which a
companys directors meet to announce
the date and amount of the next divi-
dend payment. Once the payment has
been authorized, it is called a declared
dividend.
Decreasing Term Life: Life insurance
for which premiums are fixed but the
benefit decreases each year.
Deductible: An item or expense sub-
tracted from adjusted gross income to
reduce the amount of income subject to
tax. Examples include mortgage inter-
est, state and local taxes, unreimbursed
business expenses, and charitable con-
tributions.
Deduction: An item or expenditure
subtracted from adjusted gross income
to reduce the amount of income subject
to tax.
Deep Discount Bond: A bond, origi-
nally issued at or very near par value,
that is currently selling in the market at
a price that is less than 80% of its par
value.
Default: Failure to make required debt
payments on a timely basis or to com-
ply with other conditions of an obliga-
tion or agreement.
Default Risk: The same as credit risk,
this is the risk that an issuer cannot pay
interest and principal as due on an out-
standing debt issue.
Defeasance: The termination of a debt
obligation. A corporation or municipality
removes debt from its balance sheet by
issuing a new debt issue or creating a
trust that generates enough cash flow
to provide for the payment of interest
and principal.

Defensive Industry: Industries that
people need to survive such as utilities,
food and pharmaceuticals.
Defensive Investment Strategy: A
method of portfolio allocation and man-
agement aimed at minimizing the risk of
losing principal. Defensive investors
place a high percentage of their invest-
able assets in bonds, cash equivalents
and stocks that are less volatile than
average.
Defensive Stock: Stock of a company
with continuous dividend payments,
which has demonstrated relatively sta-
ble earnings despite poor economic
conditions.
Deferred Annuity: Payments from the
annuity are delayed for a specified
period of time after the deposit.
Deferred Compensation Plan: A non-
qualified retirement plan whereby the
employee defers receiving current com-
pensation in favor of a larger payout at
retirement or in the case of disability or
death.
Deferred Income Taxes: Income tax
that would otherwise be payable cur-
rently, but which is not paid immedi-
ately.
Deficiency Letter: The SECs notifica-
tion of additions or corrections that a
prospective issuer must make to a reg-
istration statement before the SEC will
clear the offering for distribution.
Defined Benefit Plan: A qualified
retirement plan that specifies the total
amount of money that the employee will
receive at retirement.
Defined Contribution Plan: A retire-
ment plan where the employer is
required to fund a specified contribution
on behalf of each eligible employee.
Page 577
Glossary
Deflation: A decline in general price
levels, often caused by a reduction in
the supply of money or credit and is
opposite of inflation.
Delayed Opening: The occasional
postponement of the start of trading in a
stock until a large imbalance in buy and
sell orders is eliminated.
Delivery: The legal transfer and receipt
of ownership rights.
Delivery vs. Payment (DVP): A trans-
action settlement procedure in which
securities are delivered to the buying
institutions bank in exchange for pay-
ment of the amount due.
Delta: A measure of the responsive-
ness of option premiums to a change in
the price of the underlying asset. Deep
in-the-money options have deltas near
one (1). These show the biggest
response to futures price changes.
Deep out-of-the money options have
deltas near zero.
Demand: A consumers desire and will-
ingness to pay for a good or service.
Demand Deposit: A sum of money left
with a bank or borrowed from a bank
and left on deposit that the depositing
customer has the right to withdraw
immediately.
Depletion: A tax deduction that com-
pensates a business for the decreasing
supply of the natural resource that pro-
vides its income such as oil, gas and
coal. There are two ways to calculate
depletion, cost depletion and percent-
age of depletion.
Depreciation: A tax deduction that
compensates a business for the cost of
certain tangible assets.
NASD Series 7
Glossary
Depreciation Expense: A bookkeep-
ing entry of a noncash expense
charged against earnings to recover the
cost of an asset over its useful life.
Depression: A period during which
business activity drops significantly.
High unemployment rates and defla-
tion often accompany a depression.
Derivative: A financial instrument
whose characteristics and value
depend upon the characteristics and
value of an underlying instrument or
asset, typically a commodity, bond,
equity or currency. Examples are
futures and options.
Descending Yield Curve: A graph of
the yields of fixed income securities of
the same type by maturity. As the matu-
rity lengthens, the yield decreases, so
the curve descends. This is an unusual
yield curve shape, that occurs when the
Fed has tightened credit to slow down
the economy.
Designated Order: In a municipal bond
underwriting, a customer order that is
submitted by one syndicate member
but that specifies more than one mem-
ber to receive a percentage of the take-
down. The size of the order establishes
its priority for subscription to an issue.
Devaluation: A substantial fall in a cur-
rencys value as compared to the value
of gold or to the value of another coun-
trys currency.
Developmental Drilling Program: A
limited partnership that drills for oil, gas
or minerals in areas of proven reserves
or near existing fields.
Diagonal Spread: An option hedge
position established by the simulta-
neous purchase and sale of options of
the same class but with different exer-
cise prices and expiration dates.
NASD Series 7
Diamonds: Shares in a trust represent-
ing all 30 stocks in the Dow Jones
Industrial Average. Traded on the
American Stock Exchange.
Diluted Earnings Per Share: Earnings
per share, including common stock,
preferred stock, unexercised stock
options, and some convertible debt.
Diluted earnings per share are usually a
more accurate reflection of the com-
panys real earning power.
Direct Debt: The total of municipalitys
general obligation bonds, short-term
notes and revenue debt.
Direct Paper: Commercial paper sold
directly to the public without the use of
a dealer.
Direct Participation Program (DPP):
A business organized so as to pass all
income, gains, losses and tax benefits
to its owners and investors. The busi-
ness is usually structured as a limited
partnership. Examples include oil and
gas programs, real estate programs
and condominium programs.
Direct Rollover: A distribution from a
qualified pension plan such as a 401(k)
plan, or 403(b) plan, that is remitted
directly to the trustee, custodian or
issuer of the receiving IRA and is
reported to the IRS as a rollover. This
can be done only once a year. Would
be the same if the investor takes the
cash in hand and then has 60 days to
rollover into another qualified plan or
IRA.
Direct Transfer: The movement of a
tax-deferred retirement asset from one
plan or custodian to another. A direct
transfer is not a withdrawal and does
not incur any taxes or penalties.
Page 578

Director: One of several individual
elected by a corporations shareholders
to establish company policies, including
selection of operating officers and pay-
ment of dividends.
Disability Insurance: Insurance policy
that pays benefits in the event that the
policyholder becomes incapable of
working.
Disclosure: The release of relevant
information.
Discount: The amount by which a
bonds par exceeds its market price.
Also, the amount by which the value of
a closed-end funds holdings exceeds
its market price. Also, anything selling
below its normal price which is the
opposite of premium.
Discount Bond: A bond currently sell-
ing below par value. The amount by
which the par value of a bond exceeds
the market value.
Discount Rate: The interest rate
charged by the 12 Federal Reserve
Banks for short-term loans made to
member banks.
Discount Security: Security that is
purchased below the face or par value.
Discretion: The authority given to
someone other than an accounts bene-
ficial owner to make investment deci-
sions for the account concerning the
security, the number of shares or units
and whether to buy or sell. The author-
ity to decide only timing or price does
NOT constitute discretion.
Discretionary Account: An account
which the holder gives the broker the
authority to buy and sell securities,
either absolutely or subject to certain
restrictions.
Page 579
Glossary
Discretionary Order: An order where
the registered representative selects
the security and the number of shares
for a customer. Discretionary orders
must be marked as such, require that
power of attorney from the customer be
on file, and require extra supervisory
review. A power is not needed if the
broker only selects the price and time of
sale as long as the customer selected
the stock and number of shares.
Disintermediation: The flow of money
from low-yielding accounts in traditional
savings institutions to higher yielding
investments. Typically this occurs when
the Fed tightens the money supply and
interest rates rise.
Disposable Income: The amount of
income left to an individual after taxes
have been paid, available for spending
and saving.
Distribution: Any cash or other prop-
erty distributed to shareholders or gen-
eral partners that arises from their
interests in the business, investment
company or partnership.
Distribution Date: Date on which the
payout of realized capital gains on
securities in the fund portfolio occurred.
Distributor: The principal underwriter
of a mutual fund.
District Hearing Panel: A panel
formed in each of the NASDs districts
to hear customer complaints and take
sanctions against member firms for vio-
lations.
NASD Series 7
Glossary

Diversification: Proper investment Dividend Payout Ratio: A measure of

diversification is intended to reduce the a corporations policy of paying cash
risk inherent in particular securities. dividends, calculated by dividing the
Under the Investment Act of 1940, dividends paid on common stock by the
mutual funds, for diversification pur- net income available for common stock-
poses, must invest at least 75% of their holders. The ratio is the complement of
investment dollars (assets) in such as the retained earnings ratio.
way that when they buy equities of a
Dividend Reinvestment Plan: Known
corporation they cannot use more than
as a DRIP plan whereby a companys
5% of those assets and when they buy
existing shareholders choose to have
stock of a corporation they cannot own
their cash dividend payments automati-
more than 10% of the voting stock.
cally reinvested in additional shares of
Diversified Common Stock Fund: A the companys stock.
mutual fund that invests its assets in a
Dividend Yield: The annual rate of
wide range of common stocks. The
return on a common or preferred stock
funds objective may be growth, income
investment. The yield is calculated by
or a combination of both.
dividing the annual dividend by the
Divestiture: When a company has a stocks purchase price.
line of business or a subsidiary that no
Doctrine of Mutual Reciprocity: The
longer fits into its long range business
agreement that established the federal
plans, it may divert itself of this busi-
tax exemption for municipal bond inter-
ness by selling it to an interested buyer.
est. States and municipalities do not tax
Dividend: A taxable payment declared federal securities or properties, and the
by a companys board of directors and federal government reciprocates by
given to its shareholders out of the exempting local government securities
companys current or retained earnings. and properties from federal taxation.
Usually paid quarterly, given as cash,
Dollar Bond: A municipal bond quoted
stock or product and known as the pay-
in terms of dollar price rather than yield.
out.
Dividend Department: The depart-
Dollar Cost Averaging: An investment
ment within a brokerage firm that is
strategy designed to reduce volatility in
responsible for crediting client accounts
which securities, typically mutual funds,
with dividends and interest payments
are purchased in fixed dollar amounts
on client securities held in the firms
at regular intervals, regardless of what
name.
direction the market is moving.
Dividend Disbursing Agent: The per-
Domicile: A persons place of perma-
son responsible for making the required
nent residence, for tax purposes.
dividend distributions to the broker-
dealers dividend department. Donor: A person who makes a gift of
money or securities to another.
Dividend Exclusion Rule: An IRS pro-
vision that permits a corporation to
exclude from its taxable income 70% of
dividends received from domestic pre-
ferred and common stocks.

NASD Series 7 Page 580


Do Not Reduce Order (DNR): An
order that stipulates that the limit or
stop price should not be reduced in
response to the declaration of a cash
dividend.
Dont Know (DK): A response to a
trade confirmation received form a bro-
ker-dealer indicating a lack of informa-
tion about, or record of, the transaction.
Double Barreled Bond: A municipal
security backed by the full faith and
credit of the issuing municipality, as well
as by pledged revenues.
Double Exempt: Free from both fed-
eral and state income tax liability, such
as a municipal bond.
Dow Jones Averages: The oldest and
most widely used measure of the over-
all condition of the stock market, each
of the four averages is price-weighted
and includes a few dozen widely held
stocks. There are four Dow Jones Aver-
ages: Industrial, Transportation, Utilities
and Composite (all added together)
Dow Jones Composite Average: A
market indicator composed of the 65
stocks that make up the Dow Jones
Industrial, Transportation and Utilities
Averages.
Dow Jones Industrial Average
(DJIA): The most widely used market
indicator, composed of 30 large,
actively traded issues of industrial
stocks.
Dow Jones Transportation Average
(DJTA): A market indicator composed
of 15 utilities stocks.
Page 581
Glossary
Dow Theory: A technical market theory
that long-term trends in the stock mar-
ket can be confirmed by analyzing the
movements of the Dow Jones Industrial
Average and the Dow Jones Transpor-
tation Average.
Down Trend: The downward move-
ment of a stocks price, or the market as
a whole as measured by an average or
index over a period of time.
Down Volume: When a stock closes in
negative territory on the day, the vol-
ume in that stock is considered down
volume. Technical analysts often com-
pare down volume to up volume to look
for buy and sell signals.
Downtick: A stock market transaction
at a price lower than the preceding one
for the same security. Also called a
minus tick.
DRIP: Dividend reinvestment plan. An
investment plan offered by some corpo-
rations enabling shareholders to auto-
matically reinvest cash dividends and
capital distributions, thereby accumulat-
ing more stock without paying broker-
age commissions.
Dual Agency Transaction: A trade in
which the customer sells a security and
uses the proceeds to buy another secu-
rity. Under NASD rules, the separate
commissions are combined and the
total charge is less than if two totally
separate transactions had been per-
formed.
Dual Listing: The listing of a security
on more than one exchange. This can
increase the competition for bid and
offer prices, raise the liquidity of the
security and sometimes increase the
hours when the stock can be traded.
NASD Series 7
Glossary
Dual Purpose Fund: An investment
company that issues two classes of
shares from the same portfolio such as
growth and income shares.
Due Bill: A printed statement showing
the obligation of a seller to deliver secu-
rities or rights to the purchaser. A due
bill is also used as a pledge to deliver
dividends when the transaction occurs
after the record date.
Due Diligence: The process of investi-
gation, performed by investors, into the
details of a potential investment, such
as an examination of operations and
management and the verification of
material facts.
Due Diligence Meeting: A meeting at
which an issuing corporations officials
and representatives of the underwriting
group present information on and
answer questions about a pending
issue of securities. The meeting is held
for the benefit of brokers, securities
analysts and institutional investors.
Durable Power of Attorney: A legal
document that enables an individual to
designate another person, called the
attorney-in-fact, to act on his/her behalf,
even in the event the individual
becomes disabled or incapacitated.
E unsold.
Earned Income: Income earned by
working as an employee or with self-
employment income.
Earned Surplus: Another name for
retained earnings. These are earnings
of the company that have not been paid
to shareholders as a dividend. They
have been retained for use in the busi-
ness.
NASD Series 7 Page 582
Earnings: Also known as profits, they
are the amount of money a company
clears after paying all applicable
expenses.
Earnings for Common: Deducting the
preferred dividend from a corporations
net income after tax leaves earnings for
common. This is the earnings figure
that is used to compute Earnings per
Share (EPS).
Earnings or Income Statement: A
financial statement which shows a com-
panys revenues and expenditures
resulting in either a profit or a loss dur-
ing a financial period.
Earnings Per Common Share (EPS):
The portion of after-tax profits of a com-
pany attributable to a single common
share.
Earnings Per Common Share on a
Fully Diluted Basis: A corporations
earnings per share calculated assum-
ing that all convertible securities have
been converted.
Eastern Account: A securities under-
writing in which the agreement among
underwriters states that each syndicate
member will be responsible for its own
allocation as well as for a proportionate
share of any securities remaining
Economic Growth Rate: The rate,
usually measured annually, at which a
nations, industrys, communitys or
companys income increases.
Economic Indicator: Statistical data
showing general trends in the economy.
Those with predictive value are leading
indicators; those occurring at the same
time are coincident indicators; those
that only become apparent after the
activity are lagging indicators.

Economic Risk: The potential for inter-
national developments and domestic
events to trigger losses in securities.
Economics: The study of how the
forces of supply and demand allocate
scarce resources.
Education IRA (Now known as the
Coverdell Savings Account): A rela-
tively new type of tax-deferred financial
planning vehicle, which enables a per-
son to save money for future education
related expenses.
Effective Date: The date the registra-
tion of an issue of securities becomes
effective, allowing the underwriters to
sell the newly issued securities to the
public and confirm sales to investors
who have given indications of interest.
Efficient Market Theory: A theory
based on the premise that the stock
market processes information effi-
ciently. The theory assumes, that as
new information becomes known, it is
reflected immediately in the price of the
stock and therefore stock prices repre-
sent fair prices.
Either / Or Order: A notation placed on
two contingency orders instructing the
floor broker to execute one or the other.
Key is to adjust down the number of
shares from both orders if a fill takes
place on either side.
Electronic Bulletin Board: the
NASDs electronic version of the Pink
Sheet. The Over-the-Counter Bulletin
Board displays dealer quotes for OTC
issues that are too small to be included
in the Nasdaq.
Page 583
Glossary
Employee Retirement Income Secu-
rity Act of 1974 (ERISA): The law that
governs the operation of most corpo-
rate pension benefit plans. The law set
up the Pension Benefit Guaranty Cor-
poration (PBGC) and established
guidelines for the management of pen-
sion funds.
Employee Stock Ownership Plan
(ESOP): A trust established by a corpo-
ration for the allocation of some of its
stock to its employees over time,
intended to motivate employees, and
often providing tax benefits to the com-
pany. An ESOP is also known as a
stock purchase plan. This type of plan
is like a profit sharing plan whereby
employer contributions are invested in
stock of that company.
Endorsement: The signature on the
back of a stock or bond certificate by
the person named on the certificate as
the owner. An owner must endorse cer-
tificates when transferring them to
another person.
Equipment Leasing Limited Partner-
ship: A direct participation program that
purchases equipment for leasing to
other businesses on a long-term basis.
Tax sheltered income is the primary
objective of such a partnership.
Equipment Trust Certificate: A secu-
rity that is generally issued by a railroad
or airline to pay for new moveable
equipment. It is known as a secured
bond.
Equity: Ownership interest in a corpo-
ration in the form of common or pre-
ferred stock.
NASD Series 7
Glossary
Equity Financing: Raising money for
working capital or for capital expendi-
tures by selling common or preferred
stock to individual or institutional inves-
tors. In return for the money paid, the
investors receive ownership interests in
the corporation.
Equity Fund: A mutual fund that
invests only in common and/or pre-
ferred stock.
Equity Interest: The legal right or title
to a share in a business or property.
Equity Option: A security represent-
ing the right to buy or sell common
stock at a specified price within a speci-
fied time.
Equity REIT: A Real Estate Investment
Trust that buys or leases real estate.
Shareholders dividends are paid from
the lease or rental income from the
property.
Equity Security: A security represent-
ing ownership in a corporation or
another enterprise. Examples of equity
securities include;
Common stock
Preferred stock
Interests in limited partner-
ships
Call and put options
Convertible bonds
Convertible preferred stock
Rights
Warrants
NASD Series 7 Page 584
Equivalent Taxable Yield: The yield
needed on a taxable investment in
order to match the tax-free return
offered on a municipal bond; calculated
by dividing the tax-exempt yield by 1
minus the investors marginal tax rate.
Equity Option: An option contract
which represents 100 shares of a spe-
cific common stock.
ERISA: Employee Retirement Income
Security Act of 1974 which oversees
qualified retirement plans.
Error Report: A message on the Con-
solidated Tape correcting an error in a
report on a previous trade.
Escrow Agreement: The certificate
provided by an approved bank that
guarantees that the indicated securi-
ties are on deposit at that bank. An
investor who writes a call option and
can present an escrow agreement is
considered covered and does not need
to meet margin requirements.
Estate Account: A type of fiduciary
account of a person since deceased
and managed by the executor of the
estate.
Estate Planning: The process of plan-
ning the transfer of all personal assets
at death to chosen beneficiaries.
Estate Tax: Tax imposed on the trans-
fer of property from a deceased to his/
her heirs, legatees or devisees.
Eurobond: A long-term instrument of a
government or corporation that is
denominated in the currency of the
issuers country but is issued and sold
in a different country.

Eurodollar: An American dollar held by
a foreign institution outside the United
States., usually a bank in Europe, often
as a result of payments made to over-
seas companies for merchandise.
Today, countries issue Eurodollar Secu-
rities which pay interest or dividends
using U.S. dollars on deposit in Euro-
pean banks.
European Style Option: A call or put
option that can be exercised only at
expiration.
Excess Equity: The value of money or
securities in a margin account that is in
excess of the federal requirement.
Exchange: Any organization, associa-
tion or group which provides or main-
tains a marketplace where securities,
options, futures, or commodities can be
traded; or the marketplace itself.
Exchange Distribution: A block trad-
ing procedure in which a large number
of shares of stock is crossed with offers
on the floor of the exchange with no
prior announcement on the broad tape.
Exchange Listed Security: A security
that has met certain requirements and
has been admitted to full trading privi-
leges on an exchange. The NYSE, the
AMEX and regional exchanges set list-
ing requirements for volume of shares
outstanding, corporate earnings and
other characteristics.
Exchange Market: All of the
exchanges on which listed securities
are traded.
Exchange Offer: An offer to exchange
one issuers securities for those of
another, often in conjunction with a cor-
porate takeover.
Page 585
Glossary
Exchange Privilege: A feature offered
by some mutual fund families in which
an investor is able to switch from one
mutual fund to another within the same
fund family without having to pay a
sales charge. The IRS treats the
exchange as a sale and purchase for
tax purposes.
Exchange Rate: Rate at which one
currency may be converted into
another.
Exchange Traded Funds: Index funds
such as Spiders (S&P 500 Index Fund
shares), Diamonds (DJIA Index Fund
shares) and Qubes (Nasdaq 100 Index
Fund shares).
Ex-Date: For stock splits, the date that
the share price changes to reflect the
split. For dividends, same as ex-divi-
dend date.
Ex-Rights: Literally without rights, this
term describes the date from which
transactions in the common stock are
no longer accompanied by subscription
rights. On the ex-date, the price of the
stock is reduced for the value of the
rights that no longer accompany the
stock. The rights, at this time, trade
separately in the market, until their
expiration.
Ex-Dividend: This means without divi-
dend. If a share quoted ex-dividend is
purchased, the investor is not entitled to
an upcoming already declared divi-
dend. The seller receives the dividend.
Exchange Rate Risk: The risk of a for-
eign currency value declining when one
is long the currency or of a foreign cur-
rency value increasing when one is
short the currency, due to any of a vari-
ety of factors such as government pol-
icy changes, inflation level changes or
economic performance.
NASD Series 7
Glossary

Execution: The completion of an order Expected Rate of Return: The rate of

to buy or sell securities. return that an investment is expected
to return. It is computed by assigning
Executor: A person giving fiduciary
probabilities to various scenarios for
authorization to manage the affairs of a
that investments potential returns.
decedents estate. An executors
authority is established by the dece- Expense Guarantee: Establishes the
dents last will. maximum amount of administrative
expenses for annuities and variable life
Exempt Securities: Securities which
contracts.
are not subject to certain SEC or Fed-
eral Reserve Board rules. Expense Ratio: A mutual funds oper-
ating expenses, expressed as a per-
Exempt Transaction: A transaction
centage of its average net assets.
that does not trigger a states registra-
Mutual funds with lower expense ratios
tion and advertising requirements under
are able to distribute a higher percent-
the Uniform Securities Act (USA).
age of their total returns to their share-
Exercise: The action taken by the holders.
holder of a call option if he or she
Expiration Cycle: A set of four expira-
wishes to purchase the underlying
tion months for a class of listed options.
security, or by the holder of a put option
An option may have expiration dates of
if he or she wishes to sell the underlying
January, April, July and October; Febru-
security. Also refers to the action taken
ary, May, August and November; or
by a rights or warrant holder.
March, June, September and Decem-
Exercise Limit: A limitation on the ber.
number of option contracts that can be
Expiration Date: The specified date on
exercised during a 5 business day time
which an option buyer no longer has
period established by the Options
the rights specified in the option con-
Clearing Corporation (OCC).
tract.
Exercise Price: The cost per share at
Exploratory Drilling Program: A lim-
which an option or a warrant holder
ited partnership that aims to locate and
may buy or sell the underlying security.
recover undiscovered reserves of oil,
Ex-Legal: A municipal issue that trades gas or minerals. These programs are
without a written legal opinion of coun- considered highly risky investments.
sel from a bond attorney. An ex-legal
Exploratory Well: A well drilled either
issue must be designated as such as
in search of an undiscovered pool of oil
the time of the trade.
or gas or with the hope of substantially
Expansion: A period of increased busi- extending the limits of an existing pool
ness activity throughout an economy. of oil or gas.
Expansion is one of the four states of
Ex-Rights: Stock trading without rights.
the business cycle.
Ex-Rights Date: The date on or after
Expansionary Policy: A monetary pol-
which stocks will be traded without sub-
icy that increases the money supply,
scription rights previously declared.
usually with the intention of lowering
interest rates and combatting deflation.

NASD Series 7 Page 586


Extraordinary Item: Found on a com-
panys income statement. This is a one-
time event that either substantially
increases or reduces the companys
reported income for that year.
Extraordinary Mandatory Call: A call
provision in a bond contract that speci-
fies extraordinary circumstances when
the issuer must call in the bonds, such
as a calamity call.
Ex-Warrants Date: The date on or after
which stocks will be traded without war-
rants previously declared.
F Fannie Mae: The commonly used
5% NASD Policy: A guide to member
firms in establishing fair pricing policies.
401(k) Plan: Employer-sponsored
retirement plan that allows employees
to defer taxes on a portion of their sala-
ries by contributing to a company
investment account, usually invested in
mutual funds.
403(b) plan: Similar to 401(k) plans,
but for employees of universities, public
schools and nonprofit organizations.
Face Amount Certificate: A debt
security issued by a type of mutual fund
called a face amount certificate com-
pany. The debt holder makes payments
periodically to the issuer, and the issuer
agrees to pay to the holder the face
value at maturity or a different amount if
the security is called prior to maturity.
Face Value: Same as par value or
$1,000 for most bonds.
Fail to Deliver: The broker-dealer on
the sell side of a transaction or contract
does not deliver the specified securities
to the broker-dealer on the buy side.
Page 587
Glossary
Fail to Receive: The broker-dealer on
the buy side of a transaction or contract
does not receive the specified securi-
ties to the broker-dealer on the sell
side.
Fair Market Value (FMV): The value of
an asset, under the assumption it is
sold to a willing purchaser by a willing
seller, under normal conditions.
Family of Funds: A group of different
funds with different investment objec-
tives, all sponsored by the same fund
company.
name for the Federal National Mort-
gage Association, FNMA. FNMA is a
privatized agency that makes a second-
ary market in mortgages.
FDIC: Federal Deposit Insurance Cor-
poration that insures deposits in mem-
ber banks and thrifts up to $100,000.
Feasibility Study: Conducted by inde-
pendent consultants, a study performed
to determine if a proposed municipal
revenue bond will be self-supporting.
FED: Short for Federal Reserve Board.
Fed Funds: This is jargon for Federal
Funds, overnight loans of reserves from
one Federal Reserve member bank to
another Federal Reserve member
bank. Loans of Fed Funds are made at
the Federal Funds rate.
Federal Deficit: The amount by which
the governments expenditures exceed
its tax revenues. The difference is made
up for by borrowing from the public
through the issuance of debt.
Federal Deposit Insurance Corpora-
tion (FDIC): The government agency
that provides deposit insurance for
member banks and prevents bank and
thrift failures.
NASD Series 7
Glossary
Federal Funds: Funds deposited by
commercial banks at Federal Reserve
Banks. Designed to enable banks tem-
porarily short of their reserve require-
ment to borrow reserves from banks
having excess reserves.
Federal Funds Rate: The interest rate
that banks charge each other for the
use of Federal Funds overnight. It
changes daily and is a sensitive indica-
tor of general interest rate trends and is
controlled by the FED.
Federal Home Loan Bank (FHLB): A
government regulated organization that
operates a credit reserve system for the
nations savings and loan institutions.
Federal Home Loan Mortgage Corpo-
ration (FHLMC or Freddie Mac): Gov-
ernment chartered corporation which
buys qualified mortgage loans from the
financial institutions that originate them,
securitizes the loans, and distributes
the securities through the dealer com-
munity. The securities are not backed
by the U.S. Government.
Federal Housing Administration: A
government agency whose primary pur-
pose is to insure residential mortgage
loans.
Federal ID Number: A number
assigned to a business for tax reporting
purposes.
Federal National Mortgage Associa-
tion (FNMA or Fannie Mae): A con-
gressionally chartered corporation
which buys mortgages on the second-
ary market, pools them, and sells them
as mortgage-backed securities to
investors on the open market. Monthly
principal and interest payments are
guaranteed by FNMA but not by the
U.S. Government.
NASD Series 7 Page 588
Federal Open Market Committee
(FOMC): A 12 member committee
which sets credit and interest rate poli-
cies for the Federal Reserve System.
Federal Reserve Board (FRB): A
seven member group that directs the
operations of the Federal Reserve Sys-
tem. The President appoints board
members, subject to Congressional
approval.
Federal Reserve Note: Note issued by
Federal Reserve Banks to handle sud-
den increase in the demand for cur-
rency in a particular area. They are
retired as soon as demand returns to a
normal level.
Federal Reserve System: The central
banking system of the U.S., comprised
of the Federal Reserve Board, the 12
Federal Reserve Banks of the nation
and state member banks. Its primary
purpose is to regulate the flow of
money in the country.
Federal Savings & Loan Association:
A federally chartered institution whose
purpose is to collect savings deposits
and provide residential mortgage loans.
Federal Telephone Consumer Pro-
tection Act: Federal legislation
enacted in 1991 that sets requirements
for commercial cold calls over the
telephone. The Act limits the times that
calls can be made, requires identifica-
tion of the caller and requires that Do
Not Call lists be maintained if the cus-
tomer does not wish to be called.
Fictitious Quotation: A bid or an offer
published before being identified by
source and verified as legitimate. A ficti-
tious quote may create the appearance
of trading activity where none exists,
this violates the NASD Conduct Rule.

Fidelity Bond: Insurance coverage
required by the self-regulatory organi-
zations for all employees, officers and
partners of member firms to protect cli-
ents against acts of lost securities,
fraudulent trading and check forgery.
Fiduciary: A person legally appointed
and authorized to hold assets in trust
for another person and manage those
assets for that persons benefit.
FIFO: First in First Out. This is an
inventory method in which inventory is
assumed to be sold in the order in
which it was received. The IRS also
favors this approach when selling parts
of a securities position.
Filing Date: The day on which an
issuer submits to the SEC the registra-
tion statement for a new securities
issue.
Fill: Execute an order to buy or sell.
Fill or Kill Order (FOK): An order that
instructs the floor broker to fill the entire
order immediately. If the entire order
cannot be executed immediately, it is
canceled.
Financial Adviser: In a municipal bond
underwriting, the individual or company
that advises the municipality about the
structuring and marketing of a new
issue, including its backing, maturity
and likely coupon rate.
Financial and Operations Principal:
A license designation for an individual
who has passed the Series 27 exami-
nation. This person is qualified to pre-
pare the member firms accounting
reports that must be filed with the SEC
and the NASD.
Page 589
Glossary
Financial Guarantee Insurance Cor-
poration (FGIC): An insurance com-
pany that offers insurance on the timely
payment of interest and principal on
municipal issues and unit investment
trusts.
Financial Institution: Institution which
collects funds from the public and
places them in financial assets, such as
deposits, loans, and bonds, rather than
tangible property.
Final Prospectus: The prospectus
which supersedes the preliminary pro-
spectus and is accepted for filing by the
applicable provincial securities commis-
sions. The final prospectus shows all
required information pertinent to a new
issue and a copy must be given to each
buyer of the new issue. Sometimes
referred to as the statutory prospectus.
Financial Profile: An assessment of
an investors assets, liabilities, invest-
ment objectives and willingness to
assume risk.
Financial Statements: The generic
name for the balance sheet, income
statement, statement of changes to
retained earnings and flow of funds
statement that a company must file with
the SEC and send to investors regu-
larly.
Firm Commitment Offering: An
arrangement in which an underwriter
assumes the risk of bringing a new
securities issue to market, by buying
the issue from the issuer and guaran-
teeing sale of a certain number of
shares to investors. More common than
best efforts offering.
Firm Order: An order which is not sub-
ject to cancellation.
NASD Series 7
Glossary

Firm Quotation: Any round lot bid or Fixed Asset: A tangible, physical prop-
offer from a market maker other than a erty used in the course of a corpora-
nominal quotation. The dealer cannot tions everyday operations. This
change the price once the quote is includes buildings, equipment and land.
given. Failure to honor a firm quote is
Fixed Income: A security that pays a
known as backing away.
specific interest rate, such as a bond,
First In, First Out (FIFO): An account- money market instrument or preferred
ing method used to assess a com- stock.
panys inventory, in which it is assumed
Fixed Unit Investment Trust: An
that the first good acquired are the first
investment company that invests in a
to be sold. The same method is used by
portfolio of securities in which no
the IRS to determine cost basis for tax
changes are permissible.
purposes.
Flat Bond: A term used to describe
First Market: The Secondary Market is
bonds traded without accrued interest.
subcategorized into the First, Second,
They are traded at the agree-upon mar-
Third and Fourth markets. The First
ket price only.
market is trading of exchange listed
securities on the exchange floor. Flat Yield Curve: A yield curve show-
ing the same yield for short-maturity
Fiscal Policy: Decisions by the Presi-
and long-maturity bonds.
dent and Congress, usually relating to
taxation and government spending, Flexible Premium Policy: A variable
with the goals of full employment, price or whole life insurance contract that
stability and economic growth. permits the holder to adjust the pre-
mium payments and death benefit
Fitchs Ratings: Rates bonds for credit
according to changing needs.
risk.
Floating Debt: An obligation payable
529 (b) Plan: A state sponsored educa-
on demand or having a very short
tion savings plan that allows non-tax
maturity.
deductible contributions to be made to
a trust to pay for a beneficiarys quali- Floaters: A commonly used name for
fied higher education expenses. Maxi- securities with floating (variable) inter-
mum annual contributions and funding est rates.
are set by each state. Earnings build
Floor Broker: Also called a commis-
tax deferred and distributions to pay for
sion house broker, an employee of an
qualified higher education expenses
exchange member firm who executes
are tax-free.
orders for the companys public cus-
Fixed Annuity: An annuity which pays tomers on the exchange floor.
a stated fixed dollar amount based on
Floor Trader: An exchange member
the size of the investment. Most fixed
who executes transactions from the
annuities are not annuitized and
floor of the exchange only for his own
instead are used as a tax-deferred sav-
account.
ings vehicle with a fixed guaranteed
rate of return.

NASD Series 7 Page 590


Flow of Funds: The schedule of pay-
ments disbursed from the proceeds of a
facility financed by a revenue bond. The
flow of funds determines the order in
which the operating expenses, debt
service and other expenses are paid.
Flow-Through: A term that describes
the way income, deductions and credits
resulting from the activities of a busi-
ness are applied to individual taxes and
expenses as though each incurred the
income and deductions directly.
Forced Conversion: A situation in
which a convertible security is called in
by the issuer. This usually happens
when the underlying stock is selling well
above the conversion price. Upon con-
version into common stock, the value of
the bonds becomes part of a corpora-
tions equity, thus strengthening the bal-
ance sheet and enhancing future debt
issuing capabilities.
Forced Sell-Out: The action taken
when a customer fails to meet the
deadline for paying for securities and
no extension has been granted. The
broker-dealer must liquidate enough
securities to pay for the transactions.
Foreign Currency: Money issued by a
country other than the one in which the
investor resides. Options and futures
contracts on numerous foreign curren-
cies are traded on U.S. exchanges.
Form 10K: An annual audited report
that covers essentially all the informa-
tion contained in an issuing companys
original registration statement.
Form 10Q: A quarterly report contain-
ing a corporations unaudited financial
data. Certain nonrecurring events that
arise during the quarterly period.
Page 591
Glossary
Form 144: The public notice filed with
the SEC when the holder of restricted
or control stock wishes to sell. Maxi-
mum sale of 1% of the outstanding
shares of the issuer or the weekly aver-
age of the prior four weeks trading vol-
ume, whichever is larger.
Forward Pricing: The valuation pro-
cess for mutual fund shares, whereby
an order to purchase or redeem shares
is executed at the price determined by
the portfolio valuation calculated after
the order is received. Portfolio valuation
occur at least one per business day.
401(k) Plan: A tax-deferred defined
contribution retirement plan offered by
an employer.
403(B) Plan: A tax-deferred annuity
retirement plan available to employees
of public schools and certain nonprofit
organizations.
Fourth Market: The direct trading of
large blocks of securities between insti-
tutional investors through a computer
network, rather than on an exchange.
Forward Pricing: Pricing method used
by mutual funds which is based on the
next price to be computed for buying
and selling.
Fractional Share: Less than a single
share of stock. Happens with mutual
funds and in a stock dividend reinvest-
ment plan.
Fraud: The deliberate concealment,
misrepresentation or omission of mate-
rial information or the truth, so as to
deceive or manipulate another party for
unlawful or unfair gain.
Freddie Mac: The commonly used
name for mortgage backed securities
issued by the Federal Home Loan Mort-
gage Corporation.
NASD Series 7
Glossary
Free Credit Balance: The cash funds
in customer accounts. Broker-dealers
must notify customers of their free
credit balances at least quarterly.
Free Look Letter: A letter to mutual
fund contractual plan customers
explaining the sales charges and fees
of the contractual plan. The investor
has 45 days to cancel the contractual
plan.
Freeriding: A prohibited practice where
a customer buys securities and then
does not pay on settlement, thus taking
the brokerage firm for a free ride.
Freeriding and Withholding: The
withholding of part of a new securities
issue by a syndicate member, with the
intention of selling it later at a higher
price. The term free riding also applies
to the selling of a security by a broker or
customers without the buyer putting up
personal funds for the purchase. Both
of these are violations of security laws.
Front-End Load: A sales charge paid
when an individual buys an investment,
such as a mutual fund, annuity or insur-
ance policy.
Front Running: An illegal activity in
which a trader takes a position in an
equity in advance of an action which
he/she knows his/her brokerage firm
will take that will move the equitys price
in a predictable fashion.
Frozen Account: An account requiring
cash in advance before a buy order is
executed and securities in hand before
a sell order is executed. An account
holder under such restrictions has vio-
lated SECs Regulation T.
NASD Series 7 Page 592
Full Power of Attorney: A written
authorization for someone other than
an accounts beneficial owner to make
deposits and withdrawals and to exe-
cute trades in the account.
Full Service Brokerage: A brokerage
firm which, in addition to executing
trades for its clients, also provides them
with research and advice. Commissions
are usually more expensive than dis-
count brokerage firms, as discount
firms typically only provide a few other
services.
Full Trading Authority: The ability of a
broker to handle a clients account at
the brokers discretion, without restric-
tions or guidelines from the client
Fully Diluted EPS: A calculation of
earnings per share that assumes that
all outstanding securities that can be
converted into common shares such as
convertibles, rights, warrants and
employee stock options.
Fully Registered Bond: A bond regis-
tered as to principal and interest pay-
ments.
Functional Allocation: A sharing
arrangement whereby the investors in
an oil and gas direct participation pro-
gram are responsible for intangible
costs and the sponsor is responsible for
tangible costs while revenues are
shared.
Fund Family: A mutual fund company
offering many mutual funds, for various
objectives, also called family of funds or
mutual fund family.
Fundamental Analysis: An analysis of
securities based on the fundamental
facts about a company, such as sales,
earnings and dividend prospects. This
is in contrast to technical analysis.

Funded Debt: Same thing as long-term
debt which are usually bonds.
Funds Statement: The part of a corpo-
rations annual report that analyzes why
working capital increased or decreased.
Fungible: Interchangeable, owing to
identical characteristics or value. A
security is fungible if it can be substi-
tuted or exchanged for another security.
G GNMA: Government National Mort-
General Account: The insurance
account that holds all of the companys
assets other than those in separate
accounts.
General Obligation Bond (GO): Bond
issued by a political subdivision that
has the authority to levy and collect
taxes.
General Partner: An active investor in
a direct participation program who is
personally liable for all debts of the pro-
gram and who manages the business
of the program.
General Partnership: An association
of two or more entities formed to con-
duct a Profitable business jointly.
Generic Advertising: Communications
with the public that promotes securities
as investments, but do not refer to any
specific investments.
Ginnie Mae: The commonly used
name for securities issued by the Gov-
ernment National Mortgage Association
(GNMA). GNMA is the only government
agency that is a purchaser of mort-
gages from primary lenders that is still
backed by the unconditional guarantee
of the U.S. Government.
Page 593
Glossary
Glass Steagil Act of 1933: Federal
legislation that forbids commercial
banks to underwrite securities and for-
bids investment bankers to open
deposit accounts or make commercial
loans.
Global Fund: A mutual fund investing
in stocks and bonds throughout the
world, including the U.S., unlike interna-
tional funds.
gage Association is a wholly owned
government corporation that issues
pass through mortgage debt certificates
backed by the full faith and credit of the
U.S. Government.
Good Delivery: Industry terminology
for a dealer to dealer delivery of securi-
ties where the securities are in the
proper form and amount with all
required documentation and signatures
in good order.
Good Faith Deposit: A deposit contrib-
uted by each syndicate in a competitive
bid underwriting for a municipal issue.
The deposit ensures performance by
the low bidder. The amount required to
be deposited is stipulated in the official
notice of sale sent to prospective
underwriters.
Going Public: Performing an initial
public offering.
Good Delivery: Designation indicating
that a certificate has the necessary
endorsements and meets all require-
ments, so that the title can be trans-
ferred by delivery on the settlement
date to the buyer. Shares delivered
must be in good condition and be able
to convert into 100 share lots.
Good Till Canceled Order (GTC): An
order that is left on the specialists book
until it is either executed or canceled.
NASD Series 7
Glossary
Goodwill: An intangible asset that rep-
resents the value that a firms business
reputation adds to its book value.
Green Shoe Clause: A provision in the
underwriting agreement between a cor-
porate issuer and the underwriter that
permits the underwriter to request up to
15% additional shares over the original
size of an issue in response to strong
investor demand for the new issue
security.
Gross Domestic Product (GDP): The
total value of goods and services pro-
duced in the domestic economy during
a year.
Gross Estate: The total value of a per-
sons estate before any deductions are
made for taxes, funeral expenses, attor-
neys fees or administration costs.
Growth Fund: Funds invested in blue
chip companies with a solid earnings
history. Earnings are usually reinvested
back into the company for growth rather
than used to pay investors dividends.
Gross Revenue Pledge: Interest and
scheduled principal repayments on
bonds are paid first, before all other
expenses associated with the issue. A
covenant found in a revenue bond con-
tract and Trust Indenture under which
revenues from a municipal revenue
bond are promised to be allocated in
the following sequence: 1) Debt ser-
vice; 2) Operation and maintenance; 3)
Debt service reserve and 4) Operation
and maintenance reserve account.
Group Net Order: In the underwriting
of a competitively bid new issue munici-
pal bond, an order that is placed for the
benefit of the syndicate account (group
account).
NASD Series 7 Page 594
Growth Stock: Usually a non-dividend
paying common stock of a company
with expansion potential. The corporate
funds that would normally be paid to
shareholders as dividends are put back
into the company to pay for expansion.
Growth stocks have the potential for
capital gains rather than income.
Growth Fund: A fund that buys com-
mon stocks and equivalent securities
that have above average growth poten-
tial with the principal objective of
achieving capital gains.
Growth and Income Fund: A mutual
fund whose aim is to provide both
growth and income, often by investing
in companies which have earnings
growth as well as dividends.
Guarantee: To accept responsibility for
an obligation if the entity with primary
responsibility for the obligation does not
meet it.
Guaranteed Bond: A bond whose
interest and principal payments are
guaranteed by an entity other than the
issuer.
Guardian: A person legally entrusted
with the care of, and managing the
property and rights of another person,
usually a minor.
Guardian Account: A fiduciary
account in which the court appoints a
legal guardian to protect and manage
the assets of a minor or an incompetent
adult.
H
Halt: A message on the Consolidated
Tape indicating that trading in a particu-
lar security has been stopped.

Head and Shoulders: On a technical
analysts trading chart, a pattern that
has three peaks resembling a head and
two shoulders. A head and shoulders
top typically forms after a substantial
rise and indicates a market reversal. A
head and shoulders bottom looks like
an inverted head and shoulders. This
indicates a market advance.
Hedge: An investment made in order to
reduce the risk of adverse price move-
ments in a security, by taking an offset-
ting position in a related security, such
as an option or a short sale. Also known
as insurance.
Hedge Fund: A fund, usually used by
wealthy individuals and institutions,
which is allowed to use aggressive
strategies that are unavailable to
mutual funds, including selling short,
leverage, program trading, swaps, arbi-
trage and derivatives.
Hidden Load: A sales charge which an
investor pays often without realizing it,
such as an insurance policy sales
charge or a mutual fund 12b-1 fee.
High Yield Bond: Also known as junk
bonds, an issue that is below invest-
ment grade that is rated BB or lower
and pays a high rate of interest to com-
pensate for the added credit risk.
Holder: The owner of a security.
Holder of Record: The person whose
name appears as the owner of the
security on the companys books as of
the record date. This person would be
entitled to any declared distributions.
Holding Company: A company orga-
nized to invest in and manage other
corporations.
Page 595
Glossary
Holding Period: A time period signify-
ing how long the owner possesses a
security. It starts the day after a pur-
chase and ends on the day of the sale.
Horizontal Spread: The purchase and
sale of two options on the same under-
lying security and with the same exer-
cise price but different expiration dates.
Hot Issue: Stock, often an IPO, which
is in great demand and anticipated to
sell at a premium over the public offer-
ing price.
HR-10 Plan: Also called a Keogh plan,
a retirement plan for self-employed indi-
viduals based upon their self-employed
income.
Hypothecate: To pledge securities as
collateral for a loan.
Hypothecation Agreement: Another
term for a margin agreement, when a
customer wishes to open a margin
account, the customer must hypothe-
cate (pledge) all of the securities in the
account to the broker-dealer as collat-
eral for the margin loan.
I
Illiquid: That which cannot quickly and
easily be converted into cash, such as
real estate, collectibles and thinly
traded securities. Also, a company
which does not have sufficient cash
flow to meet its operational needs and
its debt obligations. This is opposite of
being liquid.
Immediate Annuity: Payments from
the annuity begin within 30 days follow-
ing a lump-sum deposit into the con-
tract.
NASD Series 7
Glossary
Immediate or Cancel Order (IOC): An
order that instructs the floor broker to
execute it immediately, in full or in part.
Any portion of the order that remains
unexecuted is canceled.
In the Money: In option trading, a
phrase that describes an option that
has intrinsic value.
Incapacity: Inability to act on ones own
behalf.
Income Bond: Generally an income
bond promises to repay principal but
only to pay interest when the company
earns a certain amount of money. High
risk and hardly ever pays income.
Income Fund: A mutual fund which
emphasizes current income in the form
of dividends or coupon payments from
bonds and/or preferred stocks, rather
than growth.
Income Oil and Gas Program: An oil
and gas program that buys existing
older wells, intending to remove the
remaining oil, with the oils revenue
partly sheltered by the depletion deduc-
tion.
Income Statement: The summary of a
corporations revenues and expenses
for a specific fiscal period.
Income Stock: Shares in companies
with a history of paying high dividends
but lacking fast growth. Utility compa-
nies, such as gas and electric firms,
with a constant customer base and
income flow are some of the best
known income stocks.
Income Strategies: In options trading,
any strategy in which the investor
receives more options premium than he
or she pays.
NASD Series 7
Income Tax: Annual tax levied by the
Federal Government, most states and
some local governments on an individ-
uals or corporations net profit.
Index: A comparison of current prices
to some baseline, such as prices on a
particular date. Indexes are frequently
used in technical analysis.
Index Fund: A mutual fund that strictly
invests in shares of a particular stock
index, such as the S&P 500 or Russell
2000. These funds generally have low
costs and fees without any ongoing
management.
Index Option: A security representing
the right to receive, in cash, the differ-
ence between the underlying value of a
market index and the strike price of the
option. The investor speculates on the
direction, degree and timing of the
change in the numerical value of the
index.
Indications of Interest: Orders for a
new securities offering which are
placed prior to final registration and rep-
resent only a tentative interest rather
than a firm commitment to buy.
Individual Retirement Account (IRA):
A special savings account that allows
individuals to contribute money for
retirement without paying taxes on
either the money that is added or the
interest that is generated. In general,
distributions from IRAs cannot be taken
until age 59 without paying a 10%
penalty.
Page 596

Industrial Development Revenue
Bond (IDR): A debt security issued by
a municipal authority which uses the
proceeds to finance the construction or
purchase of facilities to be leased or
purchased by a private company. The
bonds are backed by the credit of the
private company, which is ultimately
responsible for principal and interest
payments.
Inefficient Market: A securities market
that is characterized by low trading vol-
umes and high transaction costs for
effecting trades. This is the typical mar-
ket for very thinly traded securities like
direct participation programs and cer-
tain municipal bond issues.
Inflation: The declining value of money
due to rising prices. When stuff costs
more, your money buys less and less.
Inflation Indexed Bonds: U.S. Trea-
sury IOUs are certificates pegged to the
inflation rate. The value of the bond
increases at the same pace as inflation.
Inheritance Tax: A tax imposed on the
privilege of inheriting something, paid
by the recipient.
Initial Margin Requirement: Amount
of cash from eligible securities required
by the Federal Reserve Board and
ones brokerage firm to be deposited
before buying on margin. Currently the
Reg T margin requirement is 50% for
both long and short stock positions.
Initial Public Offering (IPO): The first
sale of stock by a company to the pub-
lic.
In-Part Call: The redemption of a cer-
tain portion of a bond issue.
Page 597
Glossary
Inside Information: Material informa-
tion that has not been disseminated to,
or is not readily available to the general
public.
Inside Market: The highest bid and the
lowest ask prices made by NASDAQ
Market Makers for their own invento-
ries. When there is an inside market for
a given security, it is called making an
inside market.
Insider: A shareholder who owns more
than 10% of a corporation, or an officer
or director or spouse.
Insider Selling: Selling of a companys
stocks by individual directors, execu-
tives or other employees.
Insider Trading: Trading by insiders; or
illegal trading by insiders who trade
based on insider information.
Insider Trading Act of 1988: Anyone
who uses or passes on non-public infor-
mation goes to jail. (Take this position
on the exam)
Insolvent: Unable to meet financial
obligations when due.
Instinet: Computerized subscriber ser-
vice that serves as a vehicle for the
fourth market. It links a large number of
mutual funds and institutional investors,
allowing subscribers to display bids and
offers and to make trades electronically.
Institutional Investor: Entity with large
amounts to invest, such as investment
companies, mutual funds, brokerages,
insurance companies, pension funds,
investment banks and endowment
funds. Institutional investors are cov-
ered by fewer protective regulations
because it is assumed that they are
more knowledgeable and better able to
protect themselves. They account for a
majority of overall volume.
NASD Series 7
Glossary

Insurance Covenant: A provision of a Interest Rate Risk: The risk associ-

municipal revenue bonds trust inden- ated with investments relating to the
ture that helps ensure the safety of the sensitivity of price or value to fluctuation
issue by promising to insure the facili- in the current level of interest rates.
ties built. With bonds, prices carry interest rate
risk because if bond prices rise, out-
Intangible Asset: A property owned
standing bonds will not remain competi-
that is not physical, such as a formula,
tive unless their yields and prices adjust
a copyright or goodwill.
to reflect the current market.
Intangible Drilling Cost (IDC): Found
Interested Person: As defined under
in an oil and gas limited partnership.
the Investment Company Act of 1940, a
This is a tax deductible cost, usually for
management companys Board of
a non-physical asset such as labor or
Directors cannot have more than 60%
fuel, which does not depreciate. The
of its seats filled by interested per-
cost may be expensed in the year
sons. These are individuals affiliated
incurred or deductions may be amor-
with the sponsor, custodian, transfer
tized over the life of the well.
agent, or firms in the investment com-
Interbank Market: An unregulated, panys selling group.
decentralized international market in
Intermediation: Flow of funds into
which the various major currencies of
financial intermediaries by investor who
the world are traded.
are liquidating direct investments in
Interest: The fee charged by a lender securities.
to a borrower for the use of borrowed
Internal Revenue Service (IRS): The
money, usually expressed as an annual
federal agency responsible for adminis-
percentage of the principal; the rate is
tering and enforcing the Treasury
dependent upon the time value of
Departments revenue laws, through
money, the credit risk of the borrower,
the assessment and collection of taxes,
and the inflation rate. Interest for bonds
determination of pension plan qualifica-
is paid twice a year.
tion and related activities.
Interest Rate: Interest per year divided
Inter Vivos Trust: A revocable trust
by principal amount, expressed as a
created while the donor is still alive to
percentage.
hold property for the benefit of another.
Interest Rate Option: A security repre- This is also known as a living trust.
senting the right to buy or sell govern-
Internal Rate of Return: In a direct
ment debt securities. The investor can
participation program offering the com-
profit from fluctuations in interest rates
putation of the real investment yield
and can hedge the risks created by the
considering the time value of money.
fluctuations.
The return is calculated by finding the
implicit interest rate that discounts that
programs projected annual cash flow to
a present value of zero.
International Fund: A mutual fund
which invests in stocks and bonds of
companies outside of the U.S.

NASD Series 7 Page 598


Internet Fund: A mutual fund which
invests in companies which are related
to the internet.
Interpositioning: Placing a third party
in the middle of a trade between a bro-
ker-dealer and a customer. The prac-
tice violates the NASD Fair Pricing
Rules unless it results in a lower cost to
the customer.
Intestate: Dying without a legal will.
Distribution is overseen by a probate
court. This is also known as intestacy.
In-the-Money: The term used to
describe an option that has intrinsic
value, such as a call option when the
stock is selling above the exercise price
or a put option when the stock is selling
below the exercise price.
Intrastate Offering: An over-the-
counter securities offering limited to
investors residing within one specific
state, often done to avoid SEC registra-
tion requirements.
Intrinsic Value: The perceived actual
value of a security, as opposed to its
market price or book value. Also, the
amount by which an option is in the
money, calculated by taking the differ-
ence between the strike price and the
market price of the underlying security.
Introducing Broker (IB): A broker-
dealer that does not hold customers
money or securities; Instead, it intro-
duces customer accounts to a clearing
broker-dealer, which handles all cash
and securities for those accounts.
Page 599
Glossary
Inventory Turnover Ratio: Ratio of
annual cost of goods sold to year-end
inventory for a company. This ratio
measures how quickly the companys
inventory is being sold and replaced.
The higher the ratio, the more efficient
the company is at managing its inven-
tory levels.
Inverted Yield Curve: An uncommon
situation in which long-term interest
rates have lower yields than short-term
interest rates. Also called a negative
yield curve.
Investment: The purchase or owner-
ship of a security to make money by
gaining income, increasing capital, or
both. Investments may also include
antiques and real estate.
Investment Adviser: A person, who
for compensation, engages in the busi-
ness of advising others in the purchase
or sale of securities.
Investment Adviser Representative:
An employee of an investment adviser
who registers as such with each state
he/she solicits.
Investment Advisers Act of 1940:
Legislation governing who must register
with the SEC as an investment adviser.
Advisors managing $25,000,000 or
more must register with the SEC.
Investment Banker: An individual or
institution which acts as an underwriter
or agent for corporations and municipal-
ities issuing securities, but which does
not accept deposits or make loans.
Investment Company: Firm that
invests the pooled funds of retail inves-
tors for a fee. There are two types:
open-end (mutual funds) and closed-
end (investment trusts).
NASD Series 7
Glossary
Investment Company Act of 1940:
Congressional legislation regulating
companies that invest and reinvest in
securities. The act requires an invest-
ment company engaged in interstate
commerce to register with the SEC.
Investment Grade: Bonds with moder-
ate to low risk, usually with a BBB rating
or above.
Investment Objective: Broad goals of
a mutual fund or other investment. In
general, portfolios seek income, capital
appreciation, safety or some combina-
tion.
Investment Pyramid: A portfolio strat-
egy that allocates investable assets
according to an investments relative
safety. The pyramid base is composed
of low-risk investments, the mid portion
is composed of growth investments and
the pyramid top is composed of specu-
lative investments.
Investor: A person whose principal
concern in the purchase of a security is
the minimizing of risk, compared to the
speculator who is prepared to accept
calculated risk in the hope of making
better than average profits, or the gam-
bler who is prepared to take even
greater risks.
Invitation for Bids: A notice to securi-
ties underwriters soliciting bids for the
issuing of a bond issue. These notices
are published in the Bond Buyer, Muni-
facts, newspapers and journals.
In-Whole Call: The redemption of a
bond issue in its entirety at the option of
the issuer, as opposed to its redemption
based on a lottery held by an indepen-
dent trustee.
NASD Series 7 Page 600
IOC: Abbreviation of an immediate or
cancel order. Customer wants the order
executed at one price and at one time,
but will accept partial execution of the
order.
IPO: Initial public offering which is the
first time that a company issues or sells
its stock to the public.
IRA Rollover: The reinvestment of
assets that an individual receives as a
distribution from a qualified tax-deferred
retirement plan into an IRA within 60
days of receiving the distribution. The
individual may reinvest either the entire
sum or a portion of the sum, although
any portion not reinvested is taxed as
ordinary income.
IRA Transfer: The direct reinvestment
of retirement assets from one qualified
tax-deferred retirement plan to an IRA.
The account owner never takes pos-
session of the assets, but directs that
they be transferred directly from the
existing plan custodian to the new plan
custodian.
Irrevocable Trust: A trust which, once
it is setup, cannot be changed or can-
celed without the consent of the benefi-
ciary.
Issue: Any of a companys securities,
or the act of distributing them. Issued
shares refer to that part of the autho-
rized shares which have been issued
for sale by the corporation. The total
number of authorized shares does not
have to be issued.
Issued Stock: Equity securities autho-
rized by the issuers registration state-
ment and distributed to the public.

Issued and Outstanding: The portion
of a companys authorized shares that
have been distributed to investors,
reduced by any repurchases of shares
for the companys Treasury. These are
the shares which are outstanding in
the hands of the public and which trade
in the market.
Issued Stock: The number of share
out of the total authorized in the corpo-
rate charter that have actually been
issued, such as sold to the public.
Issuer: A company or municipality
offering or having already offered secu-
rities for sale to investors. Examples
include corporations, investment trusts
and government entities.
J high risk.
Joint Account: An account in which
two or more individuals possess some
form of control over the account and
may transact business in the account.
The account must be designated as
either joint tenants in common or joint
tenants with rights of survivorship.
Joint and Last Survivor Life Annuity:
Payments from an annuity are made to
two persons. When one dies payments
continue to be paid to the other.
Joint Return: A U.S. income tax filing
status that can be used by a married
couple, in which income and deduc-
tions for the two individuals are com-
bined.
Joint Tenancy in Common: A form of
joint ownership of an account whereby
a deceased tenants fractional interest
in the account is retained by his/her
estate.
Page 601
Glossary
Joint Tenancy With Rights of Survi-
vorship: Ownership of property by two
or more people in which the survivors
automatically gain ownership of a dece-
dents interest.
Joint Venture: The cooperation of two
or more individuals or enterprises in a
specific business enterprise, rather
than in a continuing relationship, as in a
partnership.
Jumbo CD: A certificate of deposit hav-
ing a denomination of $100,000 or
more.
Junk Bonds: IOUs from companies
that already have high debt and are
therefore more likely to not pay the IOU
back. They offer high interest rates and
K
K-1: The tax reporting from sent annu-
ally by the general partner to each lim-
ited partner that details the limited
partners share of income and loss from
the venture for the tax year.
Keogh Plan: A tax-deferred qualified
retirement plan for self-employed indi-
viduals and their employees.
Keynesian Economics: The theory
that active government intervention in
the marketplace is the best method of
ensuring economic growth and stability.
L
L: One measure or the money supply
that includes M-3 plus longer-term liq-
uid funds such as savings bonds, trea-
sury bills, bankers acceptances and
commercial paper.
Laddering: The selection of bonds into
a portfolio with the maturities arranged
to meet anticipated cash needs in the
future.
NASD Series 7
Glossary
Lagging Indicator: Changes after an
economy has started to follow a particu-
lar pattern or trend. An example would
be the average duration of employ-
ment.
Large Cap: Over $5 billion capitaliza-
tion.
Last-In-First-Out: A method of valuing
inventory which assumes that the last
articles bought are the first used or
sold. The IRS uses this process for dis-
tributions from annuities.
Law of Demand: If supply is held con-
stant, an increase in demand leads to
an increased market price, while a
decrease in demand leads to a
decreased market price.
Law of Supply: If demand is held con-
stant, an increase in supply leads to a
decreased price, while a decrease in
supply leads to an increased price.
Lead Underwriter: The commercial or
investment bank which has primary
responsibility for organizing a given
credit or bond issuance. This bank will
find other lending organizations or
underwriters to create the syndicate,
negotiate terms with the issuer and
assess market conditions.
Leading Indicator: Changes before
the economy starts to follow a particular
pattern or trend. Believed to predict
changes in the economy. An example
would be new orders or durable goods.
LEAP: Acronym for Long-term Equity
Anticipation option which is an
exchange traded American style stock
option with a maximum of 36 month life.
Legal Age: The age at which an indi-
vidual is legally permitted to enter into
contracts without adult consent. Known
as the age of majority.
NASD Series 7 Page 602
Legal Opinion: The statement of a
bond attorney affirming that an issue is
a municipal issue and that interest is
exempt from federal taxation. Each
municipal bond certificate must be
accompanied by a legal opinion of
counsel.
Legislative Risk: The potential for an
investor to be adversely affected by
changes in investment or tax laws.
Letter of Intent: Used for mutual fund
purchasers to take advantage of break-
point sale discounts. Information found
in the funds prospectus. LOI is good for
13 months with a 90 day back dating of
it.
Letter of Rescission: A document
signed by the licensed securities per-
son offering to buy back a security from
a customer to mitigate a situation
between the agent and the customer.
Level Debt Service: A schedule for
debt repayment whereby principal and
interest payments remain essentially
constant from year to year over the life
of the issue.
Level Load: Sales charges which do
not vary.
Level I Quotes: Real time quotes of the
best bid and best ask prices for a given
NASDAQ stock. These are known as
the inside quotes, but are not firm.
Level II Quotes: Real time quotes of
the bid and ask prices for each individ-
ual market maker for a given NASDAQ
stock. These are firm quotes and the
quotes must be honored.
Level III Quotes: Everything in Level II
plus the market makers have access to
change their bid and ask prices.

Leverage: The degree to which an
investor or business is utilizing bor-
rowed money.
Liabilities: These are the debts and
obligations of a company.
LIBOR: London Interbank Offered Rate
is the interest rate charged on overnight
loans of Eurodollars.
Lien: This is the claim against property
pledged or mortgaged to secure perfor-
mance of an obligation.
Life Annuity: A contract which guaran-
tees the plan holder a regular monthly
income for life in exchange for the value
of the annuity. This payout options has
the highest monthly amount. However,
if the annuitant dies the insurance com-
pany keeps any remaining dollars.
Life Annuity With a Period Certain:
Payments for life but during the period
certain payments are guaranteed to go
to a beneficiary if the annuitant dies.
LIFO: Last In, First Out where the most
recently acquired inventory is the first to
be sold. Also, the earnings come out
first in an annuity before the cost basis.
Liquidate: To convert to cash. Also, to
sell all of a companys assets, pay out-
standing debts, and distribute the
remainder to shareholders, and then go
out of business.
Limit Order: An order to buy a security
(buy limit) at a specified price or lower
or to sell a security (sell limit) at a spec-
ified price or higher.
Limited Liability Company (LLC): A
type of company, authorized only in cer-
tain states, whose owners and manag-
ers receive the limited liability and
usually tax benefits of an S Corporation
without having to conform to the S cor-
poration restrictions.
Page 603
Glossary
Limited Partner: An investor in a direct
participation program who does not par-
ticipate in the management or control of
the program and whose liability for part-
nership debts is limited to the amount
invested in the program.
Limited Partnership: An association of
two more partners formed to conduct a
business jointly and in which one or
more partners is liable only to the extent
of the amount of money they invested.
Limited partners receive flow-through of
income and expenses, but no divi-
dends.
Limited Partnership Agreement: The
contract between a partnerships limited
and general partners that provides the
guidelines for partnership operation and
states the rights and responsibilities of
each partner.
Limited Power of Attorney: A written
authorization for someone other than
an accounts beneficial owner to make
certain investment decisions regarding
transactions in the account.
Limited Risk: An investment whose
loss cannot exceed a specific amount,
usually the amount invested.
Limited Tax Bond: A general obliga-
tion municipal bond on which a limit is
placed on the issuers ability to increase
taxes in order to pay off the bond.
Limited Trading Authorization: An
authorization, usually provided by a lim-
ited power of attorney, for someone
other than the customer to have trading
privileges in an account. These privi-
leges are limited to purchases and
sales. Withdrawals of assets are not
authorized.
NASD Series 7
Glossary

Limit Order: An order that instructs the Loan Consent Agreement: An

floor broker to buy a specified security optional contract between a brokerage
below a certain price or sell a specified firm and a margin customer that permits
security above a certain price. the firm to lend the margined securities
to other brokers. This contract is part of
Liquidity: The ease in which an asset
the margin agreement.
can be converted to cash without
losses. Loan Value: In a margin account, the
portion of the market value of a security
Liquidity Ratio: A measure of a corpo-
that can be lent to a customer.
rations ability to meet its current obliga-
tions. The ratio compares current Locked Market: The situation created
assets to current liabilities. when there is no spread between the
bid and the ask on the same security. In
Liquidity Risk: The potential that an
other words, one market maker bids for
investor might not be able to sell an
a stock at the same price that another
investment as and when desired.
market quotes its ask price. This vio-
Listed Option: An option contract that lates the NASD Conduct Rules.
can be bought and sold on a national
London Interbank Offered Rate
securities exchange in a continuous
(LIBOR): The average of the interbank
secondary market. Listed options carry
offered interest rate for dollar deposits
standardized strike prices and expira-
in the London market, based on the
tion dates.
quotations at five major banks.
Listed Stock: Traded on a major
Long: The term used to describe the
exchange such as the NYSE and
owning of a security, contract or com-
AMEX
modity. For example, a common stock
Living Trust: A trust created for the owner is said to have a long position in
trustor and administered by another the stock.
party while the trustor is still alive. Can
Long Call: An option contract to buy
be either revocable or irrevocable.
stock at a fixed price which is good until
Living Will: A document in which one a fixed expiration date.
specifies which life prolonging mea-
Long Call Spread: The purchase of a
sures one does, and does not, want to
lower strike price call option and the
be taken if one becomes terminally ill or
sale of a higher strike price call option
incapacitated.
on the same underlying security.
Load: A sales charge added to the pur-
Long Hedge: Buying puts as protection
chase and/or sales price or some
against a decline in the value of a long
mutual funds and annuities.
securities.
Load Fund: A mutual fund which car-
Long Margin Account: A margin
ries a load.
account in which a customer buys
securities on margin.

NASD Series 7 Page 604


Long Market Value (LMV): The current
market value of stocks held by having a
long position in a brokerage account,
calculated on a daily basis.
Long Position: The state of actually
owning a security, contract or commod-
ity.
Long Put: An option contract that
allows the holder to sell common stock
at a fixed price which is good until a
fixed expiration date.
Long Put Spread: The purchase of a
higher strike price put option and the
sale of a lower strike price put option on
the same underlying security.
Long Sale: The sale of a security that
is owned by a customer, where the cus-
tomer will deliver that security to the
broker on settlement date. The cus-
tomer receives the proceeds from the
long sale of the securities.
Long Straddle: An option investors
position that results from buying a call
and a put on the same stock with the
same exercise price and expiration
month.
Long Term Debt: Loans and obliga-
tions with a maturity of longer than one
year, usually accompanied by interest
payments. Also known as funded debt.
Long-Term Equity Anticipation Con-
tracts (LEAP): An option contract that
has a longer expiration than traditional
equity option contracts. These can last
as long as 36 months.
Long Term Gain or Loss: A capital
gain or loss on an investment which
was held for at least one year and a day
and results in lower tax rate treatment.
Page 605
Glossary
Long Term Liability: Known as long-
term debt on the balance sheet which is
any liability that is payable in more than
one year. This is usually the principal
amount on any long-term outstanding
debt.
Loss Carryover: A capital loss that is
not deductible in the current year
because it exceeds the annual capital
loss ceiling, but may be deductible in
future years.
Lump Sum: A single payment for the
total amount due, as opposed to a
series of periodic payments.
M
M: Following a number, this letter
denotes 1,000. For example, $100M
means $100,000.
M1 Money Supply: All coins and cur-
rency held by the public, travelers
checks, checking account balances,
NOW accounts, automatic transfer ser-
vice accounts and balances in credit
unions.
M2 Money Supply: All of M1 plus sav-
ings and small time deposits, overnight
repos at commercial banks, and non-
institutional money market accounts. A
key indicator used to forecast inflation.
M3 Money Supply: All of M2 plus large
time deposits, repos of maturity greater
than one day at commercial banks and
institutional money market accounts.
Maintenance Call: A demand from a
broker that an investor deposit enough
cash or securities in a margin account
to restore the account to the minimum
maintenance margin.
NASD Series 7
Glossary

Maintenance Covenant: A provision of Maloney Act: An amendment to the

a municipal revenue bonds trust inden- Securities Act of 1934 which allows for
ture that helps ensure the safety of the self-regulation of the over-the-counter
issue by promising to keep the facility market.
and equipment in good working order.
Managed Account: This is similar to a
Maintenance Margin: Another term for discretionary account where a client
minimum maintenance margins set by has given specific written authorization
the NYSE and NYSE. The minimum to a partner, director or qualified portfo-
equity that a customer must maintain in lio manager of an investment dealer to
a margin account. Below this amount select securities and execute trades,
the customer gets a maintenance call to but on a continuing basis and for a fee.
restore the equity in the account to the
Managed Offering: The underwriting
minimum maintenance margin. Mini-
of a limited partnership in which the
mum maintenance margins are 25% for
issuer retains an underwriter to manage
long accounts and 30% for short
the sale of the issue to the public.
accounts.
Management Company: An invest-
Major Market Index (MMI): A market
ment company under the Investment
indicator designed to track the Dow
Act of 1940 which may be diversified or
Jones Industrials. It is composed of 15
non-diversified. The two management
of the 30 Dow Jones Industrials and
companies are open-end and closed-
five other large NYSE listed stocks.
end funds.
Major Market Index Option: An index
Management Fee: A charge paid to a
option that mimics the Dow Jones
mutual funds managers for their ser-
Industrial Average. It consists of 20
vices. Usually also includes fund
stocks in different industries and is
administration costs and investor rela-
traded on the American Stock
tions. Typically a percentage of assets
Exchange under the symbol XMI.
under management.
Majority Ownership: Ownership of
Manager: The person or persons
more than 50% of a companys voting
responsible for the overall strategy and
stock or something less if the remaining
the specific buying and selling deci-
ownership is sufficiently spread out.
sions for a mutual fund, called a fund
Majority Shareholder: A single share- manager, or other financial institution
holder who controls more than half of a called a money manager.
corporations outstanding shares, or
Managing Partner: The general part-
sometimes, one of a small group of
ner of a direct participation program
shareholders who collectively control
that selects the investments and oper-
more than half of a corporations out-
ates the partnership.
standing shares.
Make a Market: To be ready, willing
and able to buy or sell a particular secu-
rity as a dealer. The individual who
does this is called a specialist if the
security is listed, or a market maker if
the security is traded over-the-counter.

NASD Series 7 Page 606


Managing Underwriter: Also called
the lead or head underwriter, the invest-
ment banking firm that has the business
relationship with the issuer of the secu-
rities. The managing underwriter forms
the syndicate, drafts the syndicate
agreement, acts on the syndicates
behalf, allocates the securities to each
syndicate member and charges a man-
agement fee for its services.
Mandatory Call: The redemption of a
bond by an issuer authorized in the
trust indenture and based on a prede-
termined schedule or event.
Margin: Using money borrowed from a
brokerage firm to purchase securities.
Margin Account: An account in which
a client uses credit from the brokerage
firm to buy a security. The client needs
to deposit a margin deposit known as
the Reg T deposit which is currently
50% for equities.
Margin Agreement: Also called a
hypothecation agreement, the docu-
ment an investor must sign when open-
ing a margin account. By signing it, the
investor pledges the securities he or
she purchases in the account as collat-
eral for the margin loan.
Margin Call: The demand that a cus-
tomer deposit a specified amount of
money or securities when a purchase is
made in a margin account. The amount
is expressed as a percentage of the
market value of the securities at the
time of purchase.
Margin Department: The department
within a brokerage firm that computes
the amount of money clients must
deposit in margin and cash accounts.
Page 607
Glossary
Margin Maintenance Requirement:
The minimum equity that must be held
in a margin account, determined by the
broker-dealer and by the NASD or
NYSE. The amount of equity required
varies with the type of security bought
on margin, and the broker-dealers
house requirement is usually higher
than set by the NASD or NYSE.
Margin Rate: The interest rate that a
broker charges for amounts borrowed
for the purpose of buying on margin.
This is also known as the Broker Call
Rate.
Margin Requirement: The percentage
of the purchase of a security that must
be deposited to buy or sell short on
credit. Regulation T of the Federal
Reserve Board sets initial margins at
50% for both long and short stock posi-
tions.
Margin Risk: The potential that a mar-
gin customer will be required to deposit
additional cash if the security position is
subject to adverse price movements.
Margin Security: A security that is eli-
gible for purchase on margin, including
any registered security, OTC margin
stock or bond or Nasdaq National Mar-
ket security.
Marginable Stock: Stock approved for
buying on margin.
Marital Deduction: A tax provision that
allows one spouse to transfer upon
death an unlimited amount of property
to his/her spouse without incurring
estate or gift tax.
Markdown: An amount or percentage
subtracted from the bid price when a
retail customer sells their stock or
bonds to a brokerage firm. This is done
in lieu of charging a commission.
NASD Series 7
Glossary
Marketability: A measure of the ability
of a security to be bought and sold. If
there is an active marketplace for a
security, it has good marketability. Mar-
ketability is similar to liquidity, except
that liquidity implies that the value of
the security is preserved, whereas mar-
ketability simply indicates that the secu-
rity can be bought and sold easily.
Marketable Security: Security that
probably could be converted into cash
quickly and easily.
Market Arbitrage: The simultaneous
purchase and sale of the same security
in different markets to take advantage
of a price disparity between the two
markets.
Market Discount Bond: A bond issued
at par, that is trading for less than par in
the markets.
Market Maker: An authorized trader
employed by a broker-dealer who is
required by the applicable self-regula-
tory organization to maintain reason-
able Liquidity in securities markets by
making firm bids or offers for one or
more designated securities.
Market-On-Close Order: An order that
specifies it is to be executed at, or as
near as possible to the close of the
market or of trading in that security, or
else its canceled.
Market Order: A buy or sell order in
which the broker is to execute the order
at the best price currently available.
While this type of order guarantees an
order fill it does not guarantee a price.
NASD Series 7 Page 608
Market Out Clause: The standard pro-
vision of a firm commitment underwrit-
ing agreement that relieves the
underwriter of its obligation to under-
write the issue under circumstances
that impair the investment qualify of the
securities.
Market Premium Bond: A bond issued
at par, that is trading for more than par
in the markets.
Market Price: A securitys last reported
sale price if on an exchange or its cur-
rent bid and ask prices if over-the-
counter.
Market Risk: Fluctuations in prices for
the market as a whole or in specific
sectors brought on by outside forces.
Market Timer: An investor attempting
to predict future market directions, usu-
ally by examining recent price and vol-
ume data or economic data, and
investing based on those predictions.
Also called timing the market.
Mark to the Market: To adjust the
value of the securities in an account to
the market value of those securities. It
is used to calculate the market value
and equity in a margin account.
Market Value: The market price at
which buyers and sellers trade similar
items in an open marketplace.
Marketability Risk: The risk that a
securities position will be difficult to liq-
uidate. This risk is greatest for thinly
traded securities like direct participation
programs.
Marketable Security: A security that
can be transferred to another party in a
negotiated market.

Markup: An amount or percent added
to the ask price when a retail customer
buys stocks and bonds in lieu of charg-
ing a commission. Markups are used by
brokerage firms when taking stock out
of its own inventory.
Married Filing Jointly: A tax filing sta-
tus indicating that a married couple is
filing a single tax return, with the
income and the deductions of the two
individuals combined.
Married Filing Separately: A tax filing
status indicating that a married couple
is filing two separate tax returns, one for
each individual.
Married Put: the simultaneously pur-
chase of a stock and a put on that stock
specifically identified as a hedge.
Master Limited Partnership: A limited
partnership investment that actually
trades on an exchange or over-the-
counter, just like a stock.
Matching Orders: Simultaneously
entering identical or nearly identical buy
and sell orders for a security to create
the appearance of active trading in that
security. This violates the antifraud pro-
visions of the Securities Exchange Act
of 1934.
Material Fact: An essential fact
needed to make an informed invest-
ment decision.
Material Information: Information
which would be likely to affect a stocks
price once it becomes known to the
public. Examples include a takeover, a
divestiture, significant management
changes and possibly an introduction of
a new product line.
Maturity Date: The date on which a
bond or debenture comes due and is to
be paid off.
Page 609
Glossary
Maximum Loan Value: The percent-
age of market value a broker-dealer is
permitted to lend a margin customer for
the purchase of securities. Loan value
is equal to the complement of the Reg T
requirement. If Reg T is 50%, the maxi-
mum loan value would also be 50%.
MBIA: Abbreviation for Municipal Bond
Insurance Association Corp., a com-
pany to which a municipality pays a fee
to insure the timely payment of interest
and principal on a bond issue. Bond
insurance helps get a better bond rat-
ing.
Medium Term Bond: Generally a bond
maturing in two to ten years.
Member: NYSE exchange owner of a
seat or a firm registered with the NASD.
Member Firm: A brokerage firm which
is a member of the NASD.
Member Order: In the underwriting of a
new issue municipal bond, an order
from a syndicate member of a to buy
the bonds for that members own
account or a related portfolio.
Merger: The act of one company per-
manently joining another to become
one company.
MIG: Acronym for Moodys Investment
Grade, the designation used by
Moodys Investor Service to rate short-
term municipal notes. MIG 1 is the high-
est rating while MIG 3 the lowest.
Mill Rate: Also called the millage rate,
the rate of ad valorem taxation in a
municipality. One mill is equal to .001 or
one-tenth of 1%.
Mineral Rights Cost: The price paid by
a partnership for the right to extract
minerals such as oil and gas from the
ground.
NASD Series 7
Glossary
Mini-Max Underwriting: An underwrit-
ing where the underwriting agreement
specifies that a minimum amount of
securities need to be sold or the deal is
cancelled.
Minimum Death Benefit: With variable
annuities the minimum death benefit is
the original investment or the cash
value, whichever is larger.
Minimum Maintenance Margin: Set
by the NYSE and NASD. The minimum
equity that a customer must maintain in
a margin account. Below this amount
the customer gets a maintenance call to
restore the equity in the account to the
minimum maintenance margin.
Minority Ownership: Less than 50%
ownership of a corporations voting
stock or not enough ownership to con-
trol the company.
Modern Portfolio Theory: A method of
choosing investments that focuses on
the importance of the relationships
among all of the investments in a port-
folio rather than the individual merits of
each investment. The method allows
investors to quantify and control the
amount of risk they accept and return
they achieve.
Modified Accelerated Cost Recovery
System (MACRS): An account method
used to recover the cost of qualifying
depreciable property by taking the
larger deductions in the first years. The
system eliminates the acceleration of
deductions for real property.
Monetarist Theory: An economic the-
ory holding that the money supply is the
major determinant of price levels and
that therefore a well-controlled money
supply will have the most beneficial
impact on the economy.
NASD Series 7 Page 610
Monetary Policy: A policy followed by
the federal government through the
Federal Reserve Board for controlling
credit and the money supply in the
economy.
Money Market: Accounts opened at
financial institutions where the money is
invested into safe, short-term debt
instruments, such as CDs and U.S.
Treasury bills. They usually pay a
higher return than regular savings
account. Mutual fund company money
markets are not insured or guaranteed.
Money Market Fund: A mutual fund
that invests in short-term debt instru-
ments. The funds objective is to earn
interest while maintaining a stable net
asset value of $1 per share. They are
generally sold with no sales charges
and have check writing privilleges.
Money Market Instrument: Debt obli-
gations that mature in less than one
year such as certificates of deposit,
commercial paper or bankers accep-
tances.
Money Market Mutual Fund: An open-
end management company that invests
in short-term, low risk money market
instruments such as T-bills and Com-
mercial paper. There is no sales charge
to invest.
Money Market Preferred: Adjustable
rate preferred whose dividend is
adjusted to reflect short-term interest
rates of money market instruments
such as T-bills and commercial paper.
Money Purchase Plan: A defined con-
tribution retirement plan that specifies a
fixed percentage of income or fixed dol-
lar amount to be contributed into the
plan annually.

Money Supply: The total supply of
money in circulation. There are several
measures for the money supply such as
M1, M2 and M3.
Monthly Statement: A report sent by a
brokerage firm to each of its customers,
providing details on the previous
months transactions, dividends and
interest, and the current account bal-
ance when there is activity. Statements
must be mailed to customers at a mini-
mum of quarterly.
Moodys Investor Service: One of the
best known investment rating agencies
in the United States. Moodys rates
bonds, commercial paper, preferred
and common stock and municipal short-
term issues. An example of a Moodys
rating is Aaa.
Moral Obligation Bond: A municipal
revenue bond for which a state legisla-
ture has the authority, but no legal obli-
gation, to appropriate money in the
event the issuer defaults.
Morningstar Rating System: A sys-
tem created by Morningstar Inc. which
ranks mutual funds based on their risk
adjusted performance over various
periods. 5 stars is the best while 1 star
is worst.
Mortality Guarantee: A guarantee
made by an insurance company to an
annuity purchaser that the annuitant will
receive the annuity payments through-
out his or her entire life, no matter how
long he or she lives.
Mortgage: A contract specifying that
certain property is pledged as security
for a loan. The money is to be repaid in
installments which usually combine
principal and interest payments.
Page 611
Glossary
Mortgage Backed Securities: Similar
to bonds, these securities are backed
by a share in a pool of home mort-
gages. The securities pay monthly
interest and a part of the principal each
month starting in the later years.
Mortgage Bond: A secured corporate
bond that is backed by specific real
estate the company owns.
Mortgage Insurance: Insurance pro-
tecting a lender against loss from a
mortgagors default. Issued by the FHA
or a private mortgage insurer.
Mortgage Reit: A highly leveraged
Real Estate Investment Trust that
makes construction loans to builders
and mortgage loans to buyers of real
estate.
Moving Average Chart: A tool used by
technical analysts to track the price
movements of a commodity.
Multiple: The number of times annual
earnings at which a common stock is
value in the market.
Multiplier: A term used for index option
contracts where there is no physical
underpinning of a fixed number of secu-
rities that must be bought or sold if the
contract is exercised. Instead of the
contract covering 100 shares, the con-
tract is said to have a multiplier of 100.
Municipal Bonds: Investors loan
states and local governments money.
Usually the interest from the bonds is
exempt from federal taxes.
Municipal Bond Fund: A mutual fund
which invests in municipal bonds.
NASD Series 7
Glossary
Municipal Bond Investors Assurance
Corp. (MBIA): A public corporation
offering insurance to the timely pay-
ment of principal and interest on quali-
fied municipal issues. Insured bonds
are generally rated AAA (highest rat-
ing).
Municipal Investment Trust: A unit
investment trust which invests in munic-
ipal bonds and passes the income, usu-
ally tax-free, to its shareholders.
Municipal Note: A municipal security
issued with a short-term maturity.
These can include Bond Anticipation
Notes, Construction Loan Notes, Reve-
nue Anticipation Notes, Tax Anticipation
Notes and Tax and Revenue Anticipa-
tion Notes.
Municipal Securities Principal: An
MSRB license designation for an indi-
vidual who has passed the Series 53
examination. This person can supervise
all activities of a municipal securities
firm.
Municipal Securities Rulemaking
Board (MSRB): They make rules for
municipal securities but cannot enforce
them. The NASD enforces the MSRB
rules.
Munifacts Wire: A news wire service
primarily disseminates market informa-
tion about the price and allocation of
new municipal bond offerings. This is a
product of the Bond Buyer. Current
events affecting the secondary market
for municipal bonds are also distributed
by Munifacts.
NASD Series 7 Page 612
Mutual Funds: These are open-end
funds operated by an investment com-
pany which raises money from share-
holders and invests in a group of
assets, in accordance with a stated set
of objectives. Benefits include diversifi-
cation and professional money man-
agement. Shares are issued and
redeemed on demand, based on the
funds net asset value which is deter-
mined at the end of each trading ses-
sion.
Mutual Fund Custodian: A national
bank, a stock exchange member firm, a
trust company or another qualified insti-
tution that physically safeguards the
securities a mutual fund holds. The cus-
todian does not manage the funds
investments.
N
Naked: The position of an option inves-
tor who writes a call or a put on a secu-
rity he/she does not own. A naked
position generally requires a margin
account. This is also termed as an
uncovered option, a short call or put
option position that is unprotected
against its maximum possible loss in
the market.
Naked Call Writer: An investor who
writes a call option without owning the
underlying stock or other related assets
that would enable the investor to deliver
the stock should the option be exer-
cised.
Naked Put Writer: An investor who
writs a put option without the required
assets that would enable the investor to
purchase the stock should the option be
exercised.

Narrow Based Index: An index that is
designed to reflect the movement of a
market segment, such as a group of
stocks in one industry or a specific type
of investment. An example would be a
technology index.
Narrow Based Index Option: An index
option contract based on a stock index
that includes issuers in only one indus-
try or country.
Narrow Market: Thinly traded market
in which share activity is extremely low.
There is usually a large spread
between the bid and ask prices.
NASD: National Association of Securi-
ties Dealers, Inc. This is the self-regula-
tory organization for the financial
services industry.
NASD Bylaws: The body of rules that
describes how the NASD functions,
defines its powers and determines the
qualifications and registration require-
ments for brokers.
NASD 5 Percent Markup Policy: A
guideline for reasonable markups,
markdowns and commissions for sec-
ondary over-the-counter transactions.
NASD Manual: Publication that out-
lines the NASD policies for regulating
the over-the-counter market, Rules of
Fair Practice, Uniform Practice Code,
Code of Procedure and Code of Arbitra-
tion. A copy of this manual must be kept
at all branch offices.
Nasdaq: National Association of Secu-
rities Dealers Automated Quotations
system which is operated by the NASD.
This is an automated system estab-
lished to facilitate trading by providing
broker-dealers with current bid and ask
price quotes on over-the-counter stocks
and some listed stocks.
Page 613
Glossary
Nasdaq Index: The broadest measure
of over-the-counter trading. This is a
weighted index which includes all the
approximately 4,000 issues that trade
on the Nasdaq system.
Nasdaq Level 1: The first level of the
Nasdaq system. It displays the inside
market for the security. This level is
intended for use by registered repre-
sentatives. It does not display firm
quotes.
Nasdaq Level 2: Displays the quotes of
all market makers in Nasdaq issues
with the quote size. These quotes are
firm quotes.
Nasdaq Level 3: Displays the quotes
from all dealers with the quote size and
allows dealers to change their own
quote. This also displays firm quotes.
Nasdaq National Market (NNM): The
most actively traded over-the-counter
stocks quoted on Nasdaq. These
trades are reported as they occur.
Nasdaq 100: An index of the largest
100 non-financial stocks on Nasdaq,
weighted according to capitalization.
Nasdaq Stock Market: A negotiated
trading market using a network of mar-
ket makers located throughout the
United States to trade mainly smaller
and high technology issues. This is also
known as the Over-the-Counter Market.
National Debt: The sum of all previ-
ously incurred annual Federal Deficits
evidenced by government debt out-
standing.
National Adjudicatory Council: The
body that governs the NASD. It is com-
posed of 27 members elected by both
the NASD general membership and the
Council itself.
NASD Series 7
Glossary
National Association of Securities
Dealers (NASD): The self-regulatory
organization for the over-the-counter
market. The NASD was organized
under the provisions of the 1938 Mal-
oney Act.
National Association of Securities
Dealers Automated Quotation Sys-
tem (Nasdaq): The nationwide elec-
tronic quotation system for up-to-the
minute bid and ask quotations on
approximately 5,500 over-the-counter
stocks.
National Exchange: A stock exchange
such as the NYSE and AMEX.
National Market System (NMS): The
trading system for over-the-counter
stocks under the sponsorship of the
NASD and NASDAQ. Also, the trading
system where prices for stocks and
bonds on the NYSE and the regional
stock exchanges are listed simulta-
neously. This list also represents the
highest volume NASDAQ stocks.
National Quotation Bureau: The pub-
lisher of compiled quotes from market
makers in over-the-counter stocks and
bonds. The Pink Sheets report stock
quotes and the daily Yellow sheets
report bond quotes.
Negotiable Certificate of Deposit
(CD): An unsecured promissory note
issued with a minimum face value of
$100,000. It evidences deposit of funds
with the issuing bank and is guaranteed
by the bank.
Negotiable Order of Withdrawal
Account (NOW): A bank account
through which the customer can write
drafts against money held on deposit.
This is an interest bearing checking
account.
NASD Series 7 Page 614
Negotiable Security: Security that can
be transferred or delivered to another
party. Examples include coupon bonds,
bearer notes, stock certificates and
coupons.
Negotiated Commission: A brokers
commission which is negotiated based
on the details of the trades that are per-
formed. This usually only applies to
large transactions.
Negotiated Market: A securities mar-
ket where traders negotiate a price.
This is the trading method uses for the
Nasdaq market.
Negotiated Underwriting: Underwrit-
ing in which the purchase price and the
public offering price are determined
through negotiations between the
issuer and a single syndicate, as
opposed to through multiple competi-
tive bidding. Most underwritings are
negotiated.
Net Asset Value (NAV): The price of
one share of a mutual fund, calculated
by adding the total investments in a
fund, subtracting costs and dividing by
the total number of shares.
Net Capital Requirement: The SECs
requirement that member firms and
non-member securities brokerage firms
maintain a minimum amount of assets.
Net Change: The difference between a
securitys closing price on the trading
day reported and the previous days
closing price.
Net Debt Per Capita: A measure of the
ability of a municipality to meet its debt
obligations. It compares the debt issued
by the municipality to its property value.

Net Debt to Assessed Valuation: A
measure of the financial condition of a
municipality. It compares the municipal-
itys debt obligations to the assessed
value of its property.
Net Direct Debt: The amount of debt
obligations of a municipality, including
general obligation bonds and notes and
short-term notes. Self-supported debt
from revenue bond issues is not
included in the calculation.
Net Domestic Product (NDP): A mea-
sure of the annual economic output of a
nation adjusted to account for deprecia-
tion. It is calculated by subtracting the
amount of depreciation from the gross
domestic product.
Net Investment Income: The source
of an investment companys dividend
payments. It is calculated by subtract-
ing the companys operating expenses
from the total dividends and interest the
company receives from the securities in
its portfolio.
Net Overall Debt: For a municipality,
the total of Net Direct debt plus Over-
lapping debt. Net overall debt is then
compared to the population of the
municipality to get a debt per capita fig-
ure in order to measure the municipal-
itys creditworthiness.
Net Proceeds: The amount of money
received from a direct participation pro-
gram offering less expenses incurred,
such as selling commissions, syndi-
cate fees and organizational costs.
Net Profit Ratio: A measure of a cor-
porations relative profitability. It is cal-
culated by dividing aftertax income by
net sales.
Page 615
Glossary
Net Revenue Pledge: The flow of
funds arrangement in a municipal reve-
nue bond issue pledging that operating
and maintenance expenses will be paid
before debt service. The pledge is con-
tained in the trust indenture.
Net Tangible Assets: All assets of a
company except for intangibles such as
copyrights and patents, equals the tan-
gible assets of a company. Netting out
all liabilities of a company from this
amount equals net tangible assets.
Net Total Debt: The sum of the debt
obligations of a municipalitys net direct
debt to its overlapping debt.
Net Transaction: A transaction, such
as the purchase of a new issue, in
which the buyer is not charged a com-
mission. The buyer is charged a net
price inclusive of any spread to the
underwriter.
Network A: A Consolidated Tape
recording system that provides sub-
scribers with information on transac-
tions in NYSE listed securities.
Network B: A Consolidated Tape
reporting system that provides sub-
scribers with information on transac-
tions in AMEX listed and certain
regional securities.
Net Working Capital: The excess of
current (liquid) assets over current lia-
bilities.
Net Worth: The value of an individual
measured by their total assets less total
liabilities.
NASD Series 7
Glossary
New Account Form: The form that
must be filled out for each new account
opened with a broker-dealer. The form
specifies, at a minimum, the account
owner, trading authorization, payment
method, types of securities appropriate
for the investor and investment goals
and objectives.
New Construction Program: A real
estate direct participation program that
aims to provide capital appreciation
from building new property.
New Housing Authority Bond: A
municipal special revenue bond backed
by the U.S. government and issued by
a local public housing authority to
develop and improve low-income hous-
ing.
New Issue: A security being offered for
sale to the public for the first time. Must
comply with SEC regulations under the
Securities Act of 1933.
New Issue Market: The securities mar-
ket for shares in privately owned busi-
nesses that are raising capital by selling
common stock to the public for the first
time.
New York Stock Exchange (NYSE):
The oldest and largest stock exchange
in the U.S., located on Wall street in
New York City. Responsible for setting
policy, supervising member activities,
listing securities, overseeing the trans-
fer of member seats, and evaluating
applicants. The NYSE is also known as
the Big Board.
NFA: National Futures Association
which regulates commodities.
NASD Series 7 Page 616
Nine Bond Rule: An NYSE rule that
requires orders for nine or fewer listed
bonds to be sent to the floor of the
NYSE before being traded in the over-
the-counter market. (FYI: this rule
doesnt exist any longer but is still
tested)
No-Load Mutual Fund: A mutual fund
that does not impose a sales charge or
load when its bought or sold by the
investor.
No Par Stock: Stock that has no par
value. Because some states tax a cor-
poration on the par value of its stock, a
corporation may choose to assign its
stock a par value of zero in order to
avoid the tax.
Nominal Owner: The person in whose
name securities are registered if that
person is other than the beneficial
owner. This is a broker-dealers role
when customer securities are regis-
tered in street name.
Nominal Quote: In the over-the-
counter market, a dealers approxima-
tion of a price of where the security may
be trading. This is really no quote, since
the dealer is not required to trade at this
price.
Nominal Yield: Coupon rate of a bond.
Non-Accredited Investor: An investor
who doesnt meet the net worth and
income requirements of SEC Regula-
tion D. Accredited investors are
wealthy, sophisticated individuals who
the SEC feels dont need the same
level of protection afforded to less
wealthy investors regarding high-risk
investments.
 Glossary

Non-affiliate: A buyer of an unregis- Non-Exempt Security: Security which

tered public offering security who has is not exempt from the provisions of the
no management or major ownership Securities Act of 1933 and the Securi-
interest in the company being acquired. ties and Exchange Act of 1934. Essen-
Non-affiliates may sell this stock only tially, corporate securities are non-
after a specified holding period. exempt. Government issues, agency
issues, municipal issues are examples
Non-Callable: Not able to be
of exempt securities.
redeemed or called back by the issuer
prior to maturity. Nonmargin Security: A security that
must be purchased in a cash account,
Noncompetitive Bid: An order placed
that must be paid for in full, and that
for Treasury bills in which the investor
may not be used as collateral for a loan.
agrees to pay the average of the com-
Examples include buying put and call
petitive bids and in return is guaranteed
options, rights, insurance contracts and
that the order will be filled.
new issues for a period of 30 days.
Non-Cumulative Preferred: Preferred
Non-Qualified Retirement Plan: A
stock for which unpaid dividends do not
retirement plan that does not meet IRS
accrue.
requirements for favorable tax treat-
Nondiscrimination: In a qualified ment.
retirement plan, a formula for calculat-
Nonrecourse Financing: Debt
ing contributions and benefits that must
incurred for the purchase of an asset
be applied uniformly so as to ensure
which pledges the asset as security for
that all employees receive fair and equi-
the debt but that does not hold the bor-
table treatment.
rower personally liable.
Nondiversification: A portfolio man-
Nonsystematic Risk: The potential for
agement strategy that seeks to concen-
an unforeseen event to affect the value
trate investments in a particular industry
of a specific investment.
or geographic area in hopes of achiev-
ing higher returns. Non-Tax Qualified Plan: A pension or
retirement plan in which the contribu-
Nondiversified Management Com-
tions are not deductible against the
pany: A management company that
contributors taxable income.
does not meet the diversification
requirements of the Investment Com- Nonvoting Stock: Stock which does
pany Act of 1940. not provide the owner with the right to
vote on corporate matters, such as the
Nonequity Option: A security repre-
election of the board of directors.
senting the right to buy or sell an invest-
ment instrument other than a common No-Par Stock: An equity security
stock at a specified price within a speci- issued without a stated value.
fied time period. Examples include for-
Normal Yield Curve: A chart showing
eign currencies, indexes and interest
long-term debt instruments having
rates.
higher yields than short-term debt
instruments.

Page 617 NASD Series 7

Glossary
Notarize: The act of a notary public wit-
nessing a person signing a document.
Note: A short-term debt security, usu-
ally maturing in five years or less.
Not Held Order: An order that gives
the floor broker discretion as to the
price and timing of the orders execu-
tion. Not held orders are often entered
for large amounts of a security.
Numbered Account: An account titled
with something other than the cus-
tomers name. The title might be a num-
ber, symbol or special title. The
customer must sign a form designating
account ownership.
NYSE Composite Index: A weighted
index that includes all of the common
shares (about 3000) that trade on the
NYSE.
O able to purchase shares.
OCC: Options Clearing Corporation
which standardizes option contracts.
Objective: The result desired by an
investor or mutual fund, such as current
income or capital appreciation. Also
known as an investment objective.
Odd Lot: Less than 100 shares of a
stock; or less than 10 shares of a very
thinly traded stock. Some brokerage
firms charge higher commissions for
odd lots.
Odd Lot Theory: A technical analysis
theory based on the assumption that
the small investor is always wrong.
Therefore, small investors are selling
odd lot shares, it is probably a good
time to buy.
OEX: The symbol for stock index
options traded on the Standard and
Poors 100 index.
NASD Series 7 Page 618
Offer to Sell: Any attempt to offer to
dispose of or solicitation to buy a secu-
rity or interest in a security for value.
Offering: The making available of a
new securities issued to the public
through an underwriting. Also known
as a public offering.
Offering Circular: Same as a pro-
spectus but for exempt securities.
Offering Memorandum: Also called a
Private Placement memorandum which
is a disclosure document used in con-
nection with a Regulation D private
placement offering. Because this trans-
action is exempt, no prospectus if
required under the Securities Act of
1933.
Offering Price: In general, same as
ask price, or for an underwriting, the
price at which the first investors are
Office of the Comptroller of the Cur-
rency: The bureau of the U.S. Treasury
Department that is responsible for issu-
ing and enforcing regulations governing
the investing and lending practices of
the nations banks.
Office of Supervisory Jurisdiction
(OSJ): An office designated by a mem-
ber firm as directly responsible for the
supervision of all persons in that office
as well as supervision of branch offices.
Office of Thrift Supervision: This part
of the Department of Treasury inspects
and audits savings and loans for com-
pliance with Federal banking laws.

Official Notice of Sale: The invitation
to bid on a municipal bond issue. The
invitation is sent to prospective under-
writers and specifies, among othre
things, the date, time and place of sale,
description of the issue, maturities, call
provisions and amount of good faith
deposit required.
Official Statement: A document con-
cerning a municipal issue that must be
provided to every buyer. The Official
Statement is prepared by the under-
writer from information provided by the
issuer. Typically included are the offer-
ing terms, descriptions of the bonds
and the issuer, the underwriting spread,
fees received by brokers, initial offering
price and tax status.
Oil and Gas Direct Participation Pro-
gram: A direct participation program
formed to located new oil and gas
reserves, develop existing reserves or
generate income from producing wells.
A high return is the primary objective of
such a program.
Oil Depletion Allowance: An account-
ing procedure that reduces the taxable
portion of revenues from the sale of oil
to compensate for the decreased sup-
ply of oil in the ground. Depletion is the
natural resource counterpart of depreci-
ation.
Omitted Dividend: A dividend which
was expected, but which was not
declared, usually due to financial diffi-
culties.
Page 619
Glossary
Omnibus Account: An account estab-
lished with a brokerage firm by an
investment adviser and used to make
trades for his/her customers. The
accounts are numbered as individual
names are not released to the broker-
age firm. The investment advisor, not
the brokerage firm, is responsible for
mailing of statements, servicing the
accounts etc.
Online Trading: The increasingly pop-
ular activity of buying and selling securi-
ties over the Internet, or to a lesser
extent, through a brokers proprietary
software.
Open-End Covenant: A provision of a
bonds trust indenture allowing the
issuer to use the same collateral back-
ing a bond as collateral for future bond
issues. As a result, new creditors have
the same claim on the collateral as
existing creditors.
Open-End Fund: Same as mutual
fund.
Open-End Management Company:
Investment company that sells mutual
funds to the public, issuing and
redeeming shares on demand.
Open-End Mortgage Bond: A secured
bond issued with a trust indenture that
permits the corporation to issue more
bonds of the same class and with the
same collateral backing at a later date.
Open Interest: A term associated with
the options markets which is the total
amount of long or short positions stand-
ing open in the market. As investors
open new positions, open interest
increases. As investors liquidiate
(close) their positions or as contracts
expire, open interest decreases.
NASD Series 7
Glossary
Open Market Operations: Buying and
selling U.S. Government securities and
other eligible securities, in the open
market by the Federal Reserve. Man-
aged by the Federal Open Market Com-
mittee (FOMC), open market
operations are a tool of monetary policy
that is used every day. The Fed sells
eligible securities to member banks
which drains the banks of cash in order
to tighten the money supply. They will
buy eligible securities from member
banks which injects cash into the banks
in order to loosen the money supply.
Open Order: An order to buy or sell
securities that has not been executed.
Open Position: A position that is not
yet closed.
Opening Purchase: Entering the
options market by buying calls or puts.
Opening Sale: Entering the options
market by selling calls or puts.
Open Market Operations: The buying
and selling of securities, primarily gov-
ernment debt, by the Federal Open
Market Committee to effect control of
the money supply. These transactions
increase or decrease the level of bank
reserves available for lending.
Operating Expenses: The day-to-day
costs incurred in running a business.
Operating Income: The profit realized
form one year of operation of a busi-
ness.
Operating Ratio: The ratio of operating
expenses to net sales which compares
to the margin of profit ratio.
Operations and Maintenance Fund:
The account from which are paid cur-
rent operating and maintenance
expenses on a facility financed by a
municipal revenue bond.
NASD Series 7
Option: A security that represents the
right, but not the obligation, to buy for a
call option or sell for a put option a spe-
cific amount of a given stock at a speci-
fied price known as the strike price
during a specified period of time.
Option Account: Brokerage account
that is approved for options trading.
Option Agreement: The document a
customer must sign within 15 days of
being approved for options trading. In it
the customer agrees to abide by the
rules of the options exchanges and not
to exceed position or exercise limits.
Option Contract Adjustment: An
adjustment made automatically to the
terms of an option on the ex-dividend
date when a stock pays a stock divi-
dend or if there is a stock split or a
reverse split. As an example, if there is
a 2 for 1 split on Dell Stock, instead of
owning 1 option contract the holder
would now own 2 options contracts.
However, the strike price would be cut
in half along with the current value of
the premium.
Option Class: All calls on a single
issuer are one class of options. All puts
on that issuer are another class of
options. As an example, all Dell calls
are a class and all Dell puts are a class.
Option Premium: The amount per
share that an option buyer pays to the
seller.
Options Clearing Corporation (OCC):
The organization that issues options,
standardizes option contracts and guar-
antees their performance. The OCC
guarantees that an option contract can
be exercised on any business day,
even if trading is stopped on the under-
lying security.
Page 620

Options Disclosure Document: A
publication of the Options Clearing Cor-
poration that outlines the risks and
rewards of investing in options. The
document must be given to each cus-
tomer at the time of opening an options
account, and must accompany any
options sales literature sent to a cus-
tomer.
Order: A memorandum of a cus-
tomers specific instructions regarding
buying or selling securities on the cus-
tomers behalf.
Order Book Official (OBO): The title
given to a specialist or market maker
employed on the Pacific, Philadelphia
and Chicago Board Options
exchanges.
Order Department: The department
within a broker-dealer that transmits
orders to the proper market for execu-
tion and returns confirmations to the
appropriate representative.
Order Imbalance: A situation in which
buy orders for a particular security
greatly out numbers sell orders, or vice-
versa. This may result in a temporary
trading halt for that security. Also known
as an imbalance of orders.
Order Period: In a competitive bid
underwriting of a new issue municipal
bond, a short period of time following
the award of the issue to the winning
underwriter. Once the bid is won, all
Pre-sale orders are filled.
Order Ticket: Form completed by a
registered representative of a broker-
age firm upon receiving order instruc-
tions from a client with all the specific
information about the order, including
type of order, security name, number of
shares, and any special instructions.
Page 621
Glossary
Ordinary Income: Income other than
capital gains and taxed at the investors
tax bracket rate.
Ordinary Loss: A loss other than a
capital loss.
Original Issue Discount Bond (OID):
A corporate or municipal debt security
issued at a discount from its face value.
The bond may or may not pay interest.
The discount on a corporate OID bond
is taxed as if accrued annually as ordi-
nary income. The discount on a munici-
pal OID bond is exempt from annual
taxation. However, the discount is
accrued for the purpose of calculating
the new cost basis.
OSS: Abbreviation for Order Support
System, the automated options trading
system used at the Chicago Board
Options Exchange.
OTC: Common abbreviation of the
over-the-counter method.
OTC Bulletin Board: An electronic
quotation system for unlisted, non-
NASDAQ, over the counter securities.
OTC Margin Stock: Any stock trading
in the over-the-counter market that can
be bought on margin under Regulation
T.
OTC Option: An option contract that is
not listed on an exchange. All contract
terms are negotiated between buyer
and seller.
Out-of-the-Money: The term used to
describe an option that has no intrinsic
value, such as a call option when the
stock is selling below the exercise price
or a put option when the stock is selling
above the exercise price.
Outstanding Stock: The number of
issued shares minus any treasury
stock.
NASD Series 7
Glossary
Overbought Market: A technical anal-
ysis term for a market in which more
and stronger buying has occurred than
the fundamentals justify.
Overlapping Debt: A condition result-
ing when property in a municipality is
subject to multiple taxing authorities or
tax districts, each having tax collection
powers and recourse to the residents of
that municipality.
Overnight Repo: A repurchase agree-
ment in which the selling party agrees
to repurchase the securities the next
day. This is the most common duration
of a repurchase agreement.
Overriding Royalty Interest: A shar-
ing arrangement in an oil and gas part-
nership where the general partner
bears none of the costs and the limited
partners bear all the costs.
Oversold Market: A technical analysis
term for a market in which more and
stronger selling has occurred than the
fundamentals justify.
Over-the Counter (OTC): A security
which is not traded on an exchange,
usually due to an inability to meet listing
requirements. For such securities, bro-
ker-dealers negotiate directly with one
another over computer networks and by
phone, and their activities are moni-
tored by the NASD.
Oversubscribed: Term used to
describe a new stock issue in which the
buyers want more shares than are
available.
NASD Series 7 Page 622
P
PAC Tranch: A PAC or Planned Amor-
tization Class Tranch, is buffered by
surrounding companion tranches that
absorb prepayment and extension risk
before these risks affect the PAC
tranch. This tranch has the most certain
repayment date.
Pacific Stock Exchange (PSE): The
only SEC registered stock exchange
west of the Mississippi.
P/E Ratio (Price/Earnings Ratio): The
P/E ratio represents how many times
the current earnings the stock is cur-
rently selling at. So, a P/E ratio of 25
means that the stock is currently selling
at 25 times its earnings.
Paper Loss: Loss which has occurred
but has not yet been realized through a
transaction, such as a stock which has
fallen in value but is still being held.
Also called an unrealized loss.
Par Bond: A bond whose current sec-
ondary market price is equal to its prin-
cipal or face value. This is usually
$1,000 per bond. This bond is neither
trading at a discount or at a premium.
Par Value: The nominal dollar amount
assigned to a security by its issuer. Cor-
porate bonds generally have a par
value of $1,000, municipal bonds
$5,000 and federal bonds from $1,000
to $10,000.
Parity: In an exchange market, a situa-
tion in which all brokers bidding have
equal standing and the winning bid is
awarded by a random drawing.

Parity Price of Common: The dollar
amount at which a common stock is
equal in value to its corresponding com-
mon stock. It is calculated by multiply-
ing the market price of the common
stock by its conversion ratio.
Parity Price of Convertible: The dollar
amount at which a convertible security
is equal to its corresponding common
stock. It is calculated by multiplying the
market price of the common stock by its
conversion ratio.
Partial Call: The redemption by an
issuer of a portion of an outstanding
bond issue prior to maturity.
Participating Dividend: Dividend paid
on participating preferred stock. Can
participate with the common sharehold-
ers in case of an extra ordinary divi-
dend paid by a corporation.
Participating Preferred Stock: An
equity security that offers the holder a
share of corporate earnings remaining
after all senior securities have been
paid a fixed dividend. The payment is
made in addition to the fixed dividend
stated.
Partnership: A form of business orga-
nization in which two or more individu-
als manage the business and are
equally and personally liable for its
debt.
Partnership Account: An account that
empowers the individual members of a
partnership to act on the behalf of the
partnership as a whole.
Partnership Agreement: In a direct
participation program or limited partner-
ship. This is a document that details the
rights and obligations of both the gen-
eral partner and the limited partner.
Page 623
Glossary
Partnership Democracy: The right of
the limited partners to vote on partner-
ship matters, including the admission of
a new general partner to the limited
partnership or the sale of the partner-
ships assets. Also the right to sue the
general partner and to inspect the
books and records of the partnership.
Partnership Management Fee: The
amount payable to the general partners
of a limited partnership, or to other per-
sons for managing the day-to-day part-
nership operations.
Passive Income: Earnings derived
from a rental property, limited partner-
ship or other enterprise in which the
individual is not actively involved. Pas-
sive income does not include earnings
from wages, dividends, interest or capi-
tal gains.
Passive Investor: An investor who
does not play an active role in the busi-
ness such as in limited partnerships.
Passive Loss: A loss incurred through
a rental property, limited partnership or
other enterprise in which the individual
is not actively involved. Passive losses
can be used to offset passive income
only.
Pass-Through Certificate: A security
representing an interest in a pool of
conventional, VA or other agency mort-
gages. The pool receives the principal
and interest payments, which it passes
through to each certificate holder.
Payable Debt: The date, set by the
issuer, on which a cash dividend will be
paid or a stock or rights distribution will
be made to an investor who has pur-
chased the stock before the appropriate
ex date.
NASD Series 7
Glossary
Paying Agent: An agent who makes
dividend payments to stockholders or
principal and interest payments to
bondholders on behalf of the issuer of
those stocks or bonds.
Payment Date: The date on which a
dividend or stock split will be paid to
shareholders by the paying agent.
Payout Ratio: Dividends paid divided
by the companys earnings over some
period of time, expressed as a percent-
age and also called the dividend payout
ratio. Typically, Utility companies pay
out the largest percentage of their earn-
ings as dividends and therefore have a
high dividend payout ratio.
Payroll Deduction Savings Plan: This
is most commonly called a 401(k) plan.
It is a corporate pension plan to which
an employee contributes a percentage
of his or her salary via payroll deduc-
tion. These contributions are made with
pre-tax dollars.
Peak: The end of a period of increasing
business activity throughout the econ-
omy, one of the four states of the busi-
ness cycle.
Penalty Bid: A bid is entered by the
syndicate manager in a new stock offer-
ing to facilitate the stabilization of the
IPO price. If a brokers client sells the
stock during the stated time period, the
penalty bid takes effect and the broker
will not receive any of the selling con-
cession.
Penny Stock: Very low priced, high-
risk, speculative shares in an unproven
company. Many technology companies
are considered penny stocks.
NASD Series 7
Penny Stock Rule: SEC rules that
have been adopted by the NASD
requiring that any customers who are
solicited to buy a non-exchange, non
Nasdaq stock under $5 sign a detailed
suitability statement that prominently
discloses the high risks involved with
such a security, prior to confirmation of
sale.
Pension Benefit Guaranty Corpora-
tion (PBGC): A federal corporation
established by ERISA which insures the
vested benefits of pension plan partici-
pants.
Pension Plan: A qualified retirement
plan set up by a corporation, labor
union, government or other organiza-
tion for its employees.
Percentage Depletion: A method of
tax accounting for a direct participation
program whereby a statutory percent-
age of gross income from the sale of a
mineral resource is allowed as a tax
deductible expense. Percentage deple-
tion is available to small producers only.
Performance Stock: Another name for
growth stocks.
Periodic Payment Plan: The process
of making regular contributions, usually
monthly, to an investment or portfolio.
Permanent Insurance: Life insurance
that pays a death benefit and accumu-
lates a cash value.
Person: As defined by the Uniform
Securities Act, an individual, group or
organization.
Personal Income: An individuals total
earnings derived from wages, passive
business enterprises and investments.
Page 624

PHA Bond: Public Housing Authority
bond which is long-term debt used to
finance the building of public housing.
They are backed by rents, U.S. Govern-
ment subsidies and the guarantee of
the U.S. Government. By the way,
these securities are no longer issued
but still may trade in the secondary
market.
Phantom Income: Reportable or tax-
able income which does not generate
cash flow. One example is taxable
income from zero coupon bonds.
Philadelphia Stock Exchange
(PHLX): The oldest stock exchange in
the United States. Its three trading
floors are devoted to equity securities,
equity options and foreign currencies.
Pink Sheets: A daily listing of bid and
ask prices for over-the-counter stocks
not included in the daily NASDAQ over-
the-counter listings. Shows wholesale
market maker prices and a firms trader
must call to get a firm price on the stock
in question.
Placement Ratio: A ratio compiled by
the Bond Buyer indicating the number
of new municipal issues that have sold
within the last week.
Plan Vanilla CMO Tranch: The sim-
plest form of CMO tranch structure. It
divides the underlying mortgage cash
flows sequentially into a fixed number
of tranches, creating a number of
expected maturities.
Plan Completion Insurance: An insur-
ance contract purchased by a contrac-
tual plan investor naming the plan
custodian as beneficiary. In the event of
the investors death, the insurance pro-
ceeds are used to complete the con-
tractual plan payments.
Page 625
Glossary
Plan Custodian: An institution retained
by a contractual plan company to per-
form clerical duties. the custodians
responsibilities include safeguarding
plan assets, sending out customer con-
firmations and issuing shares.
Plus Tick: A security transactions exe-
cution price that is above the previous
execution price, by a minimum amount.
Plus Tick Rule: The SEC regulation
governing the market price at which a
short sale may be made. No short sale
may be executed at a price below the
price of the last sale.
Point: For bonds, 1% of the face value
(usually $10, 1% of par or $1,000), for
stocks, $1 per share.
Point and Figure Chart: A tool used
by technical analysts to track the effects
of price reversals, or changes in the
direction of prices over time.
Poison Pill: A term to describe a secu-
rity whose features are specifically
designed to defend against a hostile
takeover.
Political Risk: The risk of loss when
investing in a given country caused by
changes in a countrys political struc-
ture or policies such as tax laws or tar-
iffs.
POP: Acronym for Public Offering
Price. This is for new stocks and bonds
sold to the public by their issuer or
underwriters. Bonds and preferred
stock are usually issued at par value.
POP includes the underwriters spread.
For mutual funds, the ask price at which
an investor purchases a mutual fund
share is known as the POP. Dont for-
get, the POP includes any sales
charges imposed by the fund.
NASD Series 7
Glossary
Portfolio: The various investments
owned by an individual or mutual fund,
such as stocks, bonds and money mar-
ket accounts.
Portfolio Income: Earnings from inter-
est, dividends and all nonbusiness
investments.
Portfolio Insurance: A method of
hedging a portfolio of common stocks
against market risk by selling stock
index futures short. The technique is
frequently used by institutional inves-
tors.
Portfolio Manager: The person whos
responsible for the portfolio of an indi-
vidual or institutional investor, such as a
mutual fund.
Portfolio Rebalancing: The realloca-
tion of funds in an asset allocation
model from overperforming asset
classes to those that have underper-
formed. In this manner, the percentage
allocations to each asset class are kept
within the desired range.
Portfolio Tracking: Monitoring a col-
lection of stocks, mutual funds, bonds
and other securities, whether held in a
real or imaginary portfolio.
Position: The amount of a security
either owned (long position) or owed
(short position) by an investor or dealer.
Position Limit: The rule established by
options exchanges that prohibits an
investor from having a net long or short
position of more than a specific number
of contracts on the same side of the
market (up or down). For test purposes,
unless the question tells you different,
assume a maximum contract number of
75,000.
NASD Series 7 Page 626
Position Trader: A dealer who
acquires or sells an inventory in a secu-
rity.
Pour-Over Will: A provision in a will
stating that certain assets are to be
transferred to a trust.
Power of Appointment: A right given
in a written instrument such as a will or
trust, allowing an individual to decide
how to distribute ones property. Called
a general power of appointment if no
restrictions are placed on who the dis-
tributees may be, otherwise called a
limited or special power.
Precedence: In an exchange market,
the ranking of bids and offers according
to the number of shares involved.
Preemptive Right: The right of current
shareholders to maintain their fractional
ownership of a company by buying a
proportional number of shares of any
future issue of common stock.
Preferred Stock: A type of stock that
gets paid dividends first and stands in
line before common stock in case of a
liquidation. These stocks tend not to
fluctuate as greatly in price as common
stock in the same corporation. Pre-
ferred also has a fixed dividend with
dividends paid quarterly.
Preferred Stock Fund: A mutual fund
whose investment objective is to pro-
vide stable income with minimal capital
risk. It invests in income producing
instruments such as preferred stock.
Preferred Stock Ratio: The ratio of a
companys preferred stockholders
equity to total long-term capital. Pre-
ferred stockholders equity is the total
value of preferred at par value.

Preferred Stockholders Equity: The
portion of a companys long-term capi-
tal raised from selling preferred stock,
typically at par value, to shareholders.
Preliminary Official Statement: The
red herring for a new municipal bond
offering that is used by the underwriters
to get an indication of the investor inter-
est in the issue. Potential investors use
this document to make a preliminary
evaluation of the investment quality and
credit worthiness of a new municipal
bond issue.
Preliminary Prospectus: Also known
as a Red Herring, this document is
distributed while the SEC is reviewing
an issuers registration statement. It
contains all of the essential facts about
the forthcoming offering except the
underwriting spread, final public offer-
ing price and date on which the shares
will be delivered.
Premature Distribution: A withdrawal
before 59 1/2 from a qualified retire-
ment plan, usually accompanied by a
penalty.
Premium: The amount by which a
bond or stock sells above its par value.
Also, the amount by which a closed-end
funds market price exceeds the value
of its holdings.
Premium Bond: A bond that sells at a
higher price than its face value.
Prepayment Risk: The possibility that
homeowners will pay off their mortgage
loans early, such as when interest rates
fall and they decide to refinance. Then
principal starts to be paid to investors
owning mortgage bonds.
Page 627
Glossary
Pre-Refunding: When interest rates
have dropped, a municipal issuer who
has sold bonds that are callable, can
issue a new municipal bond with a
lower coupon rate and use the pro-
ceeds to buy other bonds (usually U.S.
Government securities) which are
placed in escrow. The income from the
sale of the new bonds is used to retire
the older outstanding debt.
Pre-Sale Order: An order communi-
cated to a syndicate manager prior to
formation of the underwriting bid of a
new municipal bond issue. If the syndi-
cate wins the bid, the order takes the
highest priority when orders are filled.
Price-Earnings Ratio (PE): A tool for
comparing the prices of different com-
mon stocks by assessing how much the
market is willing to pay for a share of
each corporations earnings. It is calcu-
lated by dividing the current market
price of a stock by the earnings per
share. As an example, a PE ratio of 21
means the stock is selling at 21 times
its earnings.
Price Spread: An option spread posi-
tion, where simultaneously the same
type of option is bought and sold with
different strike prices and the same
expiration.
Primary Dealer: A U.S. Government
securities dealer that has been so des-
ignated by the Federal Reserve. Pri-
mary dealers can trade directly with the
Fed and must participate in the weekly
Treasury auctions. Commercial banks,
foreign banks, and domestic and for-
eign broker-dealers are among the 40
or so designated primary dealers.
Primary Distribution: The sale of a
new issue of stocks or bonds.
Primary Issue: Another name for a
new issue security.
NASD Series 7
Glossary
Primary Market: The market in which
the issuer first offers and sells its secu-
rities to the public with proceeds from
the sale going to the issuing corpora-
tion.
Primary Offering: An offering in which
the proceeds of the underwriting go the
issuing corporation, agency or munici-
pality. The issuer seeks to increase its
capitalization either by selling shares of
stock, representing ownership, or by
selling bonds, representing loans to the
issuer.
Prime Bankers Acceptance: A
bankers acceptance issued by one of
the top credit rated money center banks
that is eligible for trading with the Fed-
eral Reserve in the Feds open market
operations.
Prime Paper: Investment grade com-
mercial paper rated P3 or better. This is
the highest grade of commercial paper,
which is rated by Moodys with MIG rat-
ings.
Prime Rate: The interest rate that com-
mercial banks charge their most credit-
worthy borrowers. The prime rate is a
lagging indicator.
Prime Rate Fund: Mutual fund that
attempts to match the return of the
prime rate, by investing in high quality
corporate debt.
Principal: The amount borrowed, or
the part of the amount borrowed which
remains unpaid. Also, the part of a
monthly payment that reduces the out-
standing balance of a mortgage.
Principal Risk: The risk of losing the
amount invested due to a bankruptcy or
default.
NASD Series 7
Principal Shareholder: Shareholder
owning 10% or more of a companys
outstanding shares.
Principal Transaction: A transaction in
which a broker-dealer either buys secu-
rities from customers and takes them
into its own inventory or sells securities
to customer from its inventory.
Prior Lien Bond: A secured or unse-
cured bond that has priority over their
outstanding bonds.The bonds are usu-
ally issued by companies trying to reor-
ganize in order to avoid bankruptcy.
Priority: In an exchange market, the
ranking of bids and offers according to
the first person to bid or offer at a given
price. Therefore, only individual or firm
can have
priority.
Private Placement: The sale of securi-
ties directly to institutional investors
such as banks, mutual funds, insurance
companies and pension funds. Known
as a Regulation D offering they do not
require SEC registration.
Probate: The review or testing of a will
before a court of law to ensure that the
will is authentic. Also, the process by
which an executor, if there is a will, or a
court-appointed administrator, if there is
no will, manages and distributes a
decedents property.
Proceeds Transaction: A trade in
which the customer sells a security and
uses the proceeds to buy another secu-
rity. Under NASD rules, the separate
commissions or mark-ups are com-
bined and the total charge is less than if
two totally separate transactions had
been performed.
Page 628

Profit Taking: Action by short-term
securities traders to cash in on gains
crated by a sharp market rise, pushing
prices down temporarily.
Profitability: The ability to generate a
level of income and gain in excess of
expenses.
Profit Sharing Plan: An employee
benefit plan established and maintained
by an employer whereby the employ-
ees receive a share of the businesss
profits. The money may be paid directly
to the employees or deferred until
retirement.
Program Trading: A coordinated trad-
ing strategy involving the related pur-
chases or sales of groups of stocks
having a market value of $1 million or
more. Program trading often involves
arbitrage between the stock market and
the futures market. Program trading
often involves arbitrage between the
stock market and the futures market.
Progressive Tax: A tax in which those
who earn higher incomes pay a higher
percentage of their income than those
with lower incomes. A graduated tax is
one example.
Project Note (PN): A short-term munic-
ipal debt instrument issued in anticipa-
tion of a later issuance of New Housing
Authority Bonds.
Proprietary: Something that belongs to
the member firm or that is only sold by
the member firm. An example is a pro-
prietary mutual fund only sold by a spe-
cific broker-dealer.
Page 629
Glossary
Prospectus: A legal document offering
securities or mutual fund shares for
sale, required by the Securities Act of
1933. It must explain the offer, including
the terms, issuer, objectives, historical
financial statements and other informa-
tion that could help an individual decide
whether the investment is appropriate.
Proxy: Written authorization giving
someone else your right to vote at a
shareholders meeting. Often used by
shareholders who simply are unable, or
do not wish to, attend a shareholders
meeting.
Proxy Department: The department
within a broker-dealer that is responsi-
ble for sending proxy statements to
customers whose securities are held in
the firms name, and for mailing finan-
cial reports received from issuers to
their stockholders.
Prudent Man Rule: A legal maxim that
restricts discretion in a fiduciary
account to only those investments that
a reasonable and prudent person might
make.
Public Offering: The sale of an issue
of common stock, either by a corpora-
tion going public or by an offering of
additional shares.
Public Housing Authority Bond
(PHA): Long-term debt used to finance
the building of public housing. They are
backed by rents, U.S. Government sub-
sidies and the guarantee of the U.S.
Government. These securities are no
longer used.
Public Offering Price (POP): The
price of new shares that is established
in the issuing corporations prospectus.
The POP is also the price to investors
for mutual fund shares equal to the net
asset value plus the sales charge.
NASD Series 7
Glossary
Public Purpose Bond: A type of
municipal bond which is exempt from
federal income taxes, provided the ben-
efits to private individuals are very
small. Often used for roads, govern-
ment buildings and similar projects.
Public Company: A company which
has issued securities through an offer-
ing, and which is now traded on the
open market. Also called publicly held
or publicly traded.
Publicly Traded Fund: A closed-end
management company, commonly
known as a publicly-traded or
exchange-traded fund, this type of
investment company issues a fixed
number of negotiable shares to the
public.
Purchase and Sales Department:
Part of a brokerage firms operations or
back office that is responsible for pro-
cessing and reconciling executed
orders. This department records order
executions, computes monies due or
payable, sends out confirmation to cus-
tomers, and compares trades with con-
tra-brokers.
Purchasers Representative: A person
such as an attorney, CPA or financial
services professional who will represent
a client in purchasing a limited partner-
ship.
Purchasing Power Risk: The potential
that , due to inflation, a certain amount
of money will not purchase as much as
the future as it does today.
Put Bond: A debt security requiring the
issuer to purchase the security at the
holders discretion or within a pre-
scribed time.
NASD Series 7 Page 630
Put Buyer: An investor who pays a pre-
mium for an option contract and
receives, for a specified time, the right
to sell the underlying security at a spec-
ified price.
Put / Call Ratio: The ratio of put option
trades to call option trades on a given
day. The ratio is a technical indicator of
market sentiment. If the ratio is very
high, it indicates that the market is over-
sold and is likely to go higher. If the
ratio is very low, it indicates that the
market is overbought and is likely to go
lower.
Put Bond: The holder of a bond with a
put feature can put (sell the bond)
back to the issuer at par value.
Put Option: A contract giving the buyer
the right to sell 100 shares of the under-
lying security to the writer of the con-
tact. Also used by speculators who
expect the underlying security to go
down in value.
Put Spread: An option investors posi-
tion in which the investor buys a put on
a particular security and writes a put on
the same security but with a different
expiration date, exercise price or both.
Put Writer: An investor who receives a
premium and takes on, for a specified
time, the obligation to buy the underly-
ing security at a specified price at the
put buyers discretion.
Q
QQQ: The symbol for the Nasdaq 100
Exchange Traded Fund (ETF), an index
fund traded on the American Stock
Exchange and also on the NYSE. This
security is referred to as the Qube.

Qualified Legal Opinion: The state-
ment of a bond attorney affirming the
validity of a new municipal bond issue
but expressing reservations about its
quality.
Qualified Retirement Plan: A plan that
meets the requirements of IRS Section
401(a) and is thus eligible for favorable
tax treatment.
Qualifying Annuity: An annuity which
is purchased under a qualified plan.
Quarterly Report: Known as the 10 Q,
public companies are required to file
quarterly with the SEC which provides
unaudited financial information.
Quick Assets: A measure of corpora-
tions liquidity that takes into account
the size of the unsold inventory. It is cal-
culated by subtracting inventory from
current assets, and it is used in the acid
test ratio.
Quick Ratio: A stringent measure of a
companys liquidity that excludes inven-
tory and prepaid expenses from the
companys current assets and takes the
ratio of these quick assets (quickly
convertible into cash) to total current
liabilities.
Quote: The highest bid or lowest ask
price available on a security at any
given time.
Quote Machine: A computer that pro-
vides representatives and market mak-
ers with the information that appears on
the Consolidated Tape. The information
on the screen is condensed into sym-
bols and numbers.
Quotron: One of several computerized
financial information systems used by
brokerage firms and market makers.
Page 631
Glossary
R
Random Walk Theory: A market anal-
ysis theory that the past movement or
direction of the price of a stock or mar-
ket cannot be used to predict its future
movement or direction.
Range: A securitys low price and high
price for a particular trading period,
such as the close of a days trading, the
opening of a days trading or a day,
month or year.
Rate Covenant: A provision of a
municipal revenue bonds trust inden-
ture that helps ensure the safety of the
issue by specifying the rates to be
charged the user of the facility.
Rating: An evaluation of a corporate or
municipal bonds relative safety,
according to the issuers ability to repay
principal and make interest payments.
Bonds are rated by various organiza-
tions such as Standard & Poors and
Moodys. Ratings range from AAA or
Aaa on the high side to D, which repre-
sents a company in default.
Rating Service: A company that pub-
lishes ratings for securities such as pre-
ferred stock and debt issues based on
the likelihood of consistent and timely
payments.
Ratio Spread: An option spread in
which the number of calls or puts
bought and sold simultaneously are dif-
ferent.
Ratio Writing: An option hedge posi-
tion in which the investor writes more
than one call option for every 100
shares of underlying stock that the
investor owns. As a result, the investor
has a partly covered position and a
partly naked position.
NASD Series 7
Glossary
Raw Land Program: A real estate par-
ticipation program that aims to provide
capital appreciation by investing in
undeveloped land. This is considered
high risk.
Real Estate Investment Trust (REIT):
A corporation or trust that uses the
pooled capital of many investors to pur-
chase and manage income property
(equity) and/or mortgage loans (mort-
gage). REITS are traded on major
exchanges, just like stocks. They do not
provide investors with any particular tax
benefits, only cash flow.
Real Estate Limited Partnership: A
direct participation program formed to
build new structures, generate income
from existing property or profit from the
capital appreciation of undeveloped
land. Growth potential, income distribu-
tions and tax shelter are the most
important benefits of such a program.
Real Estate Mortgage Investment
Conduit (REMIC): A corporation, trust
or partnership that uses the pooled cap-
ital of many investors to invest in fixed
portfolios of real estate mortgages.
These investments offer tax benefits in
addition to interest and capital gains
distributions.
Real Interest Rate: The yield to matu-
rity of a long-term bond reduced by the
inflation rate. this is the real rate of
return earned on the bond, after factor-
ing out the effects of inflation.
Real Rate of Return: Rate of return
after adjusting for inflation.
Realized Gain: The amount of a tax-
payer earns when he/she sells an asset
that has appreciated in value.
Realized Profit: A capital gain or loss
that is realized because of a sale.
NASD Series 7 Page 632
Real-Time Quotes: Current quotes vs.
20 minute delayed quotes.
Reallowance: In a securities underwrit-
ing, the amount paid to a brokerage firm
who is not part of the syndicate but who
still sells shares in the offering.
Recapitalization: Changing the capital
structure of a corporation by issuing,
converting or redeeming securities.
Recapture: The taxation as ordinary
income of previously earned deductions
or credits. Circumstances that may
cause the IRS to require this tax to be
paid include excess depreciation, pre-
mature sale of an asset or because a
previous tax benefit is now disallowed.
Receivership: A form of bankruptcy in
which a company can avoid liquidation
by reorganizing with the help of a court-
appointed trustee.
Recession: A general economic
decline lasting from six to eighteen
months. Recession is also defined as a
decline in the Gross Domestic Product
for two consecutive quarters.
Reclamation: The right of a seller of a
security to recover any loss incurred in
a securities transaction owing to bad
delivery or other irregularity in the set-
tlement process.
Record Date: Date, set by the issuing
corporation, on which an individual
must own shares in order to be eligible
to receive a declared dividend or capital
gains distribution. The date is also used
by the NASD to set the ex-dividend
date which is two business days before
the record date. This is the rule for
stocks only. Mutual fund companies can
name their own record and x-dividend
dates.

Recourse Financing: Debt incurred for
the purchase of an asset and that holds
the borrower personally liable for the
debt.
Recourse Loan: In a limited partner-
ship, loans to the partnership for which
the limited partner is personally liable. If
the partnership fails, the lender can
make a claim against each limited part-
ner personally for the unpaid loan
amount. These loans are included in
the limited partners tax basis.
Red Herring: Same as a preliminary
prospectus. Its name comes from the
warning, printed in red, that information
in the document is still being reviewed
by the SEC and is subject to change.
Redeemable Bond: Another name for
a callable bond.
Redeemable Security: A security that
can only be bought from and sold back
to the issuer. Examples include mutual
funds, unit investment trusts, Series EE
and Series HH savings bonds.
Redeemable Shares: Shares that may
be redeemed at the option of the issuer
and/or the shareholder.
Redemption: The return of an inves-
tors principal in a security, such as a
bond, preferred stock or mutual fund
shares.
Redemption Fee: Using the proceeds
from a new issue bond to retire an out-
standing bond that has a higher coupon
rate.
Refinancing: Issuing equity, the pro-
ceeds of which are used to retire debt.
Refunding: The issuance of a new
bond issue with the proceeds used to
call an outstanding bond issue with a
higher coupon.
Page 633
Glossary
Regional Exchange: Small, SEC reg-
istered stock exchange located outside
New York City such as the Chicago and
Philadelphia exchanges.
Regional Fund: A mutual fund or
closed-end fund that invests in the
negotiable securities of companies
located in a specific geographic area.
Registered: Describes a security that
prints the owners name on the certifi-
cate. The owners name is stored in
records kept by the issuer or a transfer
agent.
Registered as to Principal Only: The
term describing a bond that prints the
owners name on the certificate, but
that has unregistered coupons payable
to the bearer.
Registered Bond: The name of the
person who owns the bond is recorded
on the books of the issuer or the
issuers registrar. If a bond is fully regis-
tered, then both the principal amount
and the interest payment amounts will
appear in the issuers records. There-
fore this bond is termed registered to
principal and interest. Payments are
sent directly by the paying agent to the
registered holder.
Registered Investment Adviser
(RIA): This is a person who is regis-
tered as an investment adviser with the
SEC and/or the state. Individuals asso-
ciated with RIAs must pass either the
Series 65 or Series 66 examination.
Registered Options Principal (ROP):
The officer of partner of a brokerage
firm who approves in writing accounts
in which options transactions are per-
mitted.
Registered Options Trader: This is a
floor traded on the CBOE who trades
options solely for his own account.
NASD Series 7
Glossary
Registered Principal: All registered
representatives must be assigned to a
registered principal. A Series 26 princi-
pal supervises Series 6 registered rep-
resentatives while a Series 24 principal
would supervise Series 7 registered
representatives.
Registered Representative: A
licensed sales representative that is
registered with the NASD and the
states he/she is working in.
Registrar: The organization, usually a
bank or trust company, that maintains a
registry of the share owners and num-
ber of shares held for a mutual fund,
bond or stock, and makes sure that
more shares are not issued than are
authorized.
Registration: The filing process a com-
pany performs, in accordance with SEC
regulations, prior to offering a new
issue to the public.
Registration by Coordination: Filing
of the SEC disclosure package with the
various states. Its available to an issuer
that files for the securitys registration
under the Securities Act of 1933 and
files duplicates of the registration docu-
ments with the state administrator. The
state registration becomes effective at
the same time the federal registration
statement becomes effective.
Registration by Filing: The least
costly registration method which uses a
prospectus on file with the SEC. Must
be a seasoned company to use this
type of registration.
Registration by Qualification: The
most difficult of all registration types.
Requires full disclosure of the security,
issuing company, parties to the offering
and much more.
NASD Series 7 Page 634
Registration Statement: The legal
document that discloses all pertinent
information concerning an offering of a
security and its issuer.
Regressive Tax: A tax that takes a
larger percentage of the income of low-
income people than high-income peo-
ple. Examples are the sales tax, liquor
and cigarette tax.
Regular Way Settlement: Delivery of
securities in a transaction on the third
business day after the transaction
occurs for corporate and municipal
securities. One day for options and gov-
ernment securities.
Regulated Investment Company:
Investment company eligible under IRS
Regulation M to pass capital gains, divi-
dends and earned interest directly to
shareholders to be taxed at the individ-
ual level.
Regulation A: An SEC regulation that
governs offerings of $1,500,000 or less,
which qualify for simplified registration.
This is an exempt transaction which
means it does not have to be registered
under the Securities Act of 1933.
Regulation D: The provision of the
Securities Act of 1933 that exempts
from registration offerings sold to a
maximum of 35 nonaccredited inves-
tors and an unlimited number of accred-
ited investors during a 12 month period.
Regulation G: A Federal Reserve
Board regulation that governs the
extension of credit for securities trans-
actions by commercial lenders and
nonfinancial corporations.
Regulation T: A Federal Reserve
Board regulation that governs customer
cash accounts and the extension of
credit by broker-dealers to customers to
purchase and carry securities.

Regulation U: A Federal Reserve
Board regulation that limits the amount
of credit a bank can extend to custom-
ers for buying on margin.
Rehypothecation: The pledging of
securities in customer margin accounts
as collateral for a brokerages bank
loan.
Reinvestment: Using the dividends,
interest, or profits from an investment to
buy more of that investment.
Reinvestment Privilege: The privilege
some mutual funds give to their share-
holders to use dividends and/or capital
gains distributions to purchase addi-
tional shares of their fund without pay-
ing a sales charge.
Reinvestment Risk: The risk that the
dividends, interest and principal
received from securities can only be
invested at a lower rate of return than
that earned from the previous invest-
ments.
REIT: Abbreviation for Real Estate
Investment Trust. These trusts are reg-
ulated as a closed-end management
company. REITs purchase different
kinds of real estate investments such
as buildings, mortgages and short-term
construction loans.
Rejection: The right of a buyer of a
security to refuse to accept delivery in
completion of a trade because the
security does not meet the require-
ments of good delivery.
Relative Strength: A stocks price
change over a period of time relative to
that of a market index, such as the S&P
500. Usually measured on a scale from
1 to 100, 1 being worst and 100 being
best.
Page 635
Glossary
REMIC: An acronym for Real Estate
Mortgage Investment Conduit which is
essentially the same as a collateralized
mortgage obligation.
Renewal and Replacement Fund:
The account that is used to fund major
renewal projects and equipment
replacements financed by a municipal
revenue bond issue.
Reoffering Price: The price or yield at
which a municipal security is sold to the
public by the underwriters.
Reoffering Scale: A listing of the
prices or yields by maturity at which a
new issue of municipal serial bonds is
being sold to the public by an under-
writer.
Reorganization Department: The
department within a brokerage firm that
handles transactions that represent a
change in the securities outstanding,
such as trades relating to tender offers,
bond calls, preferred stock redemptions
and mergers and acquisitions.
Repo: The commonly used name for a
repurchase agreement.
Repurchase Agreement (Repo): A
contract in which the seller of securities,
such as Treasury Bills, agrees to buy
them back at a specified time and price.
Required Minimum Distribution
(RMD): The minimum annual required
distribution amount for an IRA holder
who reaches age 70 .
Rescission Offer: The offer to buy
back a security from a customer by an
agent to mitigate an illegal securities
transaction.
Reserve Maintenance Fund: The
account that holds funds that supple-
ment the general maintenance fund of a
municipal revenue bond issue.
NASD Series 7
Glossary
Reserve Requirement: Amount of
money and liquid assets that Federal
Reserve System member banks must
hold in cash or on deposit with the Fed-
eral Reserve System. This is usually a
specified percentage of their demand
and time deposits.
Residual Claim: The right of a com-
mon stockholder to corporate assets in
the event that the corporation ceases to
exist. A common stockholder may claim
assets only after the claims of all credi-
tors and other security holders have
been satisfied.
Resistance Level: A technical analysis
term describing the top of a stocks his-
torical trading range.
Restricted Account: A margin account
in which the equity is less than the Reg-
ulation T initial requirement.
Restricted Securities: Securities that
have limited transferability such as a
Regulation D private placement, Reg A
Offering and any other security or trans-
action exempt from the registration
requirement of the Securities Act of
1933.
Restricted Stock: Stock, usually
issued directly to the officers or direc-
tors of a corporation in a private place-
ment, that has not been registered with
the SEC. These shares are privately
placed under Regulation D, and thus
are exempt from registration.
Retained Earnings: Earnings not paid
out as dividends but instead reinvested
in the core business or used to pay off
debt.
NASD Series 7 Page 636
Retained Earnings Ratio: A measure
of a corporations policy of accumulat-
ing profits, calculated by dividing the
net income available for common stock-
holders by the dividends paid on com-
mon stock. The ratio is the complement
of the dividend payout ratio.
Retention: The percentage of a new
issue that an underwriter holds to sell
directly to its own customers. The secu-
rities that it underwrites but does not
retain are turned back to the syndicate
to be sold by the selling group.
Retention Requirement: The provision
of Regulation T that applies to the with-
drawal of securities from a restricted
account. The customer must deposit an
amount equal to the unpaid portion of
the securities being withdrawn, in order
to reduce the debit balance. The reten-
tion requirement is the reciprocal of the
initial margin requirement.
Retirement Account: A customer
account established to provide retire-
ment funds.
Retiring Bonds: Ending an issuers
debt obligation by calling the outstand-
ing bonds, by purchasing bonds in the
open market, or by repaying bondhold-
ers the principal amount at maturity.
Return: The annual return on an invest-
ment, expressed as a percentage of the
total amount invested. Also known as
the rate of return.
Return of Capital: A distribution of
cash resulting from depreciation tax
savings, the sale of capital asset or
securities, or any other transaction
unrelated to retained earnings.
Return on Common Equity: A mea-
sure of a corporations profitability, cal-
culated by dividing aftertax income by
tangible assets.

Return on Equity: A measure of a cor-
porations profitability, specifically its
return on assets, calculated by dividing
aftertax income by tangible assets.
Return on Investment: The profit or
loss resulting from a security transac-
tion, often expressed as an annual per-
centage rate.
Revdex: A yield to maturity index pub-
lished by the Bond Buyer. It is the aver-
age yields of 25 selected revenue
bonds with 30 years to maturity, all
rated A or better.
Revenue Anticipation Note (RAN): A
short-term municipal debt security
issued in anticipation of revenue to be
received.
Revenue Bond: A bond issued to
finance a project which must rely on the
income generated by that project to pay
the bondholders interest and par value
at redemption.
Revenue Fund: The collection account
provided for under the flow of funds in
a revenue bond trust indenture to col-
lect all monies generated by a revenue
producing
facility.
Revenue Pledge: A protective cove-
nant found in a revenue bond trust
indenture under a revenue pledge, the
issuer pledges the revenues from the
facility to the bondholders, either under
a Gross revenue pledge where bond-
holders have first claim on revenues
prior to paying operation and mainte-
nance, or a net revenue pledge where
the bondholders have a claim on reve-
nues only after operation and mainte-
nance is paid.
Page 637
Glossary
Reverse Mortgage: An arrangement in
which a homeowner borrows against
the equity in his/her home and receives
regular monthly tax-free payments from
the lender.
Reverse Repurchase Agreement: A
purchase of securities with an agree-
ment to resell them at a higher price on
an agreed upon future date. The differ-
ence between the purchase price and
the resale price represents the interest
earned by the investor. These are used
by the Fed when controlling the money
supply.
Reverse Stock Split: A stock split
which reduces the number of outstand-
ing shares and increase the per-share
price proportionately. Usually an
attempt by a company to disguise a fall-
ing stock price.
Revocable Trust: A trust that may be
changed or canceled by its grantor or
by another person. Does not avoid
estate taxes as an irrevocable trust
does.
Right: The name of a security which
offers a privilege allowing existing
shareholders to buy shares of an issue
of common stock shortly before it is
offered to the public, at a specified and
usually discounted price, and usually in
proportion to the number of shares
already owned. This is also known as a
subscription right.
Rights Offering: Offering of common
stock to investors who currently hold
shares which entitle them to buy subse-
quent issues at a discount from the
offering price.
NASD Series 7
Glossary

Rights of Accumulation: Allows Risk Free Rate of Return: The return

mutual fund investors to receive cumu- that can be achieved by investing in an
lative quantity discounts when purchas- asset class that has not risk such as T-
ing mutual fund shares*- within the bill.
same fund family. The discounted sales
Risk Premium: The excess return that
charges are based on the Breakpoint
can be achieved by investing in specific
Schedule found in the funds prospec-
securities as compared to a benchmark
tus.
portfolio.
Rights Agent: An issuing corpora-
Riskless and Simultaneous Transac-
tions agent who is responsible for
tion: The buying or selling by a broker-
maintaining current records of the
dealer of a security for its own account
names of rights certificate owners.
so as to fill an order previously received
Rights Offering: An issue of new from a customer. Although the firm is
shares of stock accompanied by the technically acting as a principal in the
opportunity for each stockholder to trade, the transaction is relatively risk-
maintain a proportionate ownership by less because the purchase and sale are
purchasing additional shares in the cor- consummated almost simultaneously
poration before the shares are offered
Risk/Reward: The tension between
to the public.
preserving your investment and maxi-
Risk: The quantifiable likelihood of loss mizing your profit. In general, the higher
or less-than-expected returns. Exam- the return, the more likely you are to
ples include currency risk, inflation risk, lose your initial investment. Lower risk
principal risk, economic risk, market usually results in less profit.
risk, liquidity risk, opportunity risk,
Rollover: A tax-free reinvestment of a
income risk, interest rate risk, prepay-
distribution from a qualified retirement
ment risk, credit risk, business risk, pur-
plan into an IRA or other qualified plan
chasing power risk and more.
within 60 days.
Risk Adjusted Rate of Return: A mea-
Roth IRA: Established in the Tax Relief
sure of how much an investment
Act of 1997, a special type of IRA which
returned in relation to the amount of risk
allows taxpayers, subject to certain
it took on. Often used to compare a
income limits, to save for retirement
high-risk, potentially high-return invest-
while allowing the savings to grow tax-
ment with a low-risk, lower-return
free. Taxes are paid on contributions,
investment.
but withdrawals, subject to certain
Risk Arbitrage: The purchase of stock rules, are not taxed at all.
in a company that is being acquired and
Round Lot Trade: A trade of minimum
the short sale of stock in the acquiring
normal trading unit size. For common
company, in order to profit from the
and preferred stock, trade of 100
anticipated increase in the acquired
shares. For municipal bonds, a trade of
corporations shares and decrease in
$100,000 face value bonds.
the acquiring corporations shares.

NASD Series 7 Page 638


Roth IRA: A type of IRA that allows an
individual to contribute up to $3,000
annually without any tax deduction for
the contributions. If the investment is
held for at least 5 years and if the per-
son is at least 59 1/2, distributions are
tax-free.
Royalty Interest: The right of a mineral
rights owner to receive a share in the
revenues generated by the resource if
and when production begins. The roy-
alty interest retained is free from pro-
duction costs.
Round Lot: The normal unit of trading
of a security. (100 shares of stock),
(100 bonds)
Rule 144: Requires limitations of stock
sales by insiders and those investors
who participated in a Regulation D pri-
vate offering.
Rule 144A: Provides for the sale of
restricted stock between qualified insti-
tutions during the first year of restric-
tion.
Rule 147: An interstate offering exemp-
tion for securities sold within one state.
Rules of Fair Practice: Rules estab-
lished by the NASD to protect the best
interests of the securities investor.
Russell 2000: The best-known of a
series of market-value weighted indices
published by the Frank Russell Com-
pany. The index measures the perfor-
mance of the smallest 2,000 companies
in the Russell 3000 Index of the 3,000
largest U.S. companies in terms of mar-
ket capitalization.
Page 639
Glossary
S
S Corporation: A form of a corporation
with 75 or fewer shareholders. The
company enjoys the benefits of incorpo-
ration but is not taxed as a corporation
as all income and expenses are passed
directly to the shareholders, just like a
partnership.
s/s: The s/s is usually stacked vertically
without the slash. It is a ticker symbol
which indicates the sale of a 10 share
lot of expensive stock, known as cabi-
net stock. It can also represent shares
that are infrequently traded on the
NYSE.
Sale: A contract to dispose of or sell a
security, or interest in a security, for
value.
Sale Leaseback: A method of raising
cash by selling property to a buyer and
then leasing it back to the seller.
Sales Breakpoint: Dollar levels at
which the sales charges are reduced
according to the Breakpoint Schedule
printed in the prospectus.
Sales Charge: The percentage of the
public offering price that many mutual
funds charge when an investor buys
shares. This percentage is usually
deducted up-front.
Sales Literature: Any written material
a firm distributes to customers or the
public in a controlled manner. Exam-
ples include circulars, research reports,
form letters, market letters, perfor-
mance reports and text used for semi-
nars.
Sales Load: The sales charge that the
buyer pays in order to purchase shares
of a mutual fund. The sales charge var-
ies according to the type of fund and
how it is sold.
NASD Series 7
Glossary

Sales Proceeds: For purposes of com- Schedule 13D: The form that must be
puting a capital gain or loss, the price at filed by an individual after acquiring
which a security is sold, net of any com- beneficial ownership of 5% or more of
missions or mark-downs charged. any nonexempt equity security. It must
be sent within 10 business days to the
Sallie Mae: An U.S. Government
issuing company, the exchange where
Agency issued bond with student loans
the stock is trading and the SEC.
as the underlying securities.
Schedule 13G: An abbreviated Sched-
SAR: The Suspicious Activities Report
ule 13D used principally by a broker-
which must be filed by financial institu-
dealer, bank or insurance company if it
tions when it is suspected that a cus-
acquires a 5% position in the normal
tomer is money laundering.
course of business and not for the pur-
Satellite Office: A member location not pose of changing or influencing control
identified as an office of supervisory of the company.
jurisdiction or a branch office, or held
SEC: Abbreviation for the Securities
out to the public as a place of business
and Exchange Commission established
for the member.
under the Securities Act of 1934.
Saucer Formation: A stock price
Second-to-Die Insurance: A form of
charting that shows a stocks price gen-
insurance which pays a death benefit
tly bottoming out and then gently rising
only upon the death of the last surviving
over time creating a saucer shape. An
insured person. Often used by married
inverted saucer is a stock price charting
persons when involved with the estate
that shows a stocks price gently top-
planning process.
ping out and then gently falling over
time creating an upside-down saucer Second Market: The Second Market is
shape. the over-the-counter market where
securities that are not listed on an
Savings Account: A deposit account
exchange floor trade. The NASD regu-
at a bank or savings and loan which
lates this market.
pays
interest. Second Mortgage Bond: A secured
corporate bond that is backed by a sec-
Savings Bond: A government debt
ond mortgage on real property.
security that is not negotiable or trans-
ferable and that may not be used as Secondary Distribution: A distribu-
collateral. tion with a prospectus that involves
securities owned by major stockhold-
Scale: A list of each of the scheduled
ers. The sale proceeds go to the sellers
maturities in a new serial bond issue.
of the stock, not to the issuer.
The list outlines the number of bonds,
maturity dates, coupon rates and
yields.

NASD Series 7 Page 640

 Glossary

Secondary Market: A market in which Securities Acts Amendments of

investors buy and sell between each 1975: Federal legislation that estab-
other. This market has four markets; lished the Municipal Securities Rule-
first market is known as the listed mar- making Board.
ket; second market as the OTC market;
Securities and Exchange Commis-
third market as the after hours and trad-
sion (SEC): Created by the Securities
ing a listing stock in the OTC market;
Act of 1934, the SEC is a federal
fourth market is used for institutions
agency designed to promote full public
trading between each other in order to
disclosure and to protect the investing
avoid brokerage firm commissions.
public against fraudulent and manipula-
Secondary Offering: A registered tive practices.
offering of a large block of a security
Securities Exchange Act of 1934:
which has been previously issued to the
Federal legislation that established the
public, by a current shareholder. The
SEC. The act aims to protect investors
proceeds of the sale go to the holder,
by regulating the exchanges, the over-
not the issuing company, and the num-
the-counter market, the extension of
ber of shares outstanding does not
credit by the Fed, broker-dealers,
change.
insider transactions, trading activities,
Section 529 Plan: A state sponsored client accounts and net capital require-
education savings plan that allows non- ments.
tax deductible contributions to be made
Securities Industry Association
to a trust to pay for a beneficiarys qual-
(SIA): The principal trade association
ified higher education expenses. Maxi-
and lobbying group for broker/dealers.
mum annual contributions and funding
are set by each state. Earnings build Securities Information Center (SIC):
tax deferred and distributions to pay for The organization designated by the
qualified higher education expenses SEC to act as a central data bank for
are not taxable. records of lost and stolen securities.
Section 8 Housing: Bonds are used to Securities Investor Protection Cor-
build low income housing. poration (SIPC): A non-profit member-
ship corporation established by
Sector Fund: A mutual fund which
Congress which insures securities and
invests entirely or predominantly in a
cash in customer accounts up to
single sector such as healthcare, tech-
$500,000 which includes up to
nology or the Internet.
$100,000 in cash in the event of a bro-
Secured Bond: A debt security backed kerage firm going bankrupt.
by identifiable assets set aside as col-
Securities Fraud: The violation of
lateral. In the event that the issuer
securities investing and trading rules
defaults on payment, the bondholders
and laws, particularly through various
may lay claim to the collateral.
deceptive actions and schemes to
Securities Act of 1933: Federal legis- cheat or take advantage of investors.
lation requiring the full and fair disclo-
sure of all material information about
the issuance of new securities.

Page 641 NASD Series 7

Glossary
Security: An investment instrument,
other than an insurance policy or fixed
annuity, issued by a corporation, gov-
ernment or other organization.
Segregation: Holding customer owned
securities owned by other customers
and securities owned by the brokerage
firm.
Selection Risk: The potential for loss
on an investment owing to the particular
security chosen performing poorly in
spite of good overall market or industry
performance.
Self-Directed IRA: A retirement
account in which an investor desig-
nates an account custodian but still
makes the decisions about what securi-
ties to buy and sell.
Self-Employment Tax: Social Security
tax paid by the self-employed.
Self Insured: Instead of purchasing a
commercial policy the entity insures
itself up to a certain dollar amount. The
saving of insurance premiums can be
used for investing and for other pur-
poses.
Self Regulatory Organization:
Accountable to the SEC for the enforce-
ment of federal securities laws and the
supervision of securities practices
including the NASD. Self-regulatory
organizations include the NASD,
MSRB, NYSE and the Chicago Board
Options Exchange (CBOE).
Self-Supporting Debt: A municipal
revenue bond that pays debt service
(both interest and principal) from the
revenues generated from an enterprise
activity.
Sell: To convey ownership of a security
or another asset for money or value.
NASD Series 7 Page 642
Sell Long: Selling securities that a cus-
tomer owns.
Sell Short: Selling securities in antici-
pation of a market decline. The cus-
tomer borrows the securities to be sold
through his or her broker-dealer with
the intent of buying them back once the
price has declined.
Sellers Option: A settlement contract
that calls for delivery and payment
according to a number of days specified
by the seller.
Selling Away: An associated person
engaging in private securities transac-
tions without the permission of his/her
broker-dealer.
Selling Concession: That portion of
the underwriting spread which the man-
aging underwriter gives to the selling
group members for each new issue
sold directly to the public.
Selling Dividends: Inducing customers
to purchase mutual funds by implying
that an upcoming distribution will bene-
fit them. This is not only illegal but cre-
ates a tax consequence for the client.
Selling Group: A group of investment
bankers who assist a syndicate or an
underwriter in the sale of a new security
issue but who are not responsible for
any unsold securities.
Sell-Out: The procedure that the seller
of a security follows when the buyer
fails to complete the contract by accept-
ing delivery of the security. The seller
closes the contract by selling the secu-
rity in the open market and charging the
account of the buyer for transaction
fees and any loss caused by changes
in the market.

Sell Stop Order: An order to sell a
security that is entered at a price below
the current market price and that is trig-
gered when the market price touches or
goes through the sell stop price.
Selling Long: Selling off stock posi-
tions that an investor owns.
Selling Power: In a short margin
account, the amount of additional secu-
rities that can be sold short without
making a deposit of funds. Selling
power is two times the SMA in the
account.
Senior Lien Debt: A bond issue that
shares the same collateral is backing
other issues but that has a prior claim to
the collateral in the event of default.
Senior Registered Options Principal
(SROP): The principal responsible for
developing and enforcing a program for
supervising customer options accounts.
The SROP must review accounts for
compliance with suitability rules and
must approve all customer correspon-
dence.
Senior Security: A security that has
priority over other securities in the
event of a claim or bankruptcy liquida-
tion. An example would be a secured
bond.
Sentiment Indicators: A measure of
the mood of investors for either being
bullish or bearish.
SEP-IRA: A Simplified Employee Pen-
sion Plan designed especially for small
businesses. This is a pension plan in
which the employer opens an IRA for
each employee and makes contribu-
tions on the investors behalf.
Separate Account: An account estab-
lished and maintained by an insurance
company for their variable contracts.
Page 643
Glossary
Separate Trading of Registered Inter-
est and Principal of Securities
(STRIPS): A zero-coupon bond issue
and backed by the Treasury Depart-
ment.
Serial Bond: A debt security issued
with a maturity schedule in which parts
of the outstanding issue mature at inter-
vals until the entire balance has been
repaid. Most municipal bonds are serial
bonds.
Series: Options of the same class that
have the same exercise price and the
same expiration date.
Series 6: Test that registers an individ-
ual to transact for the sale of mutual
funds, new closed-end funds and vari-
able products (state insurance license
required).
Series 7: The general securities regis-
tered representative license which enti-
tles the holder to sell all types of
securities products with the exception
of commodities futures. The Series 7 is
the most comprehensive of the NASD
representative licenses and serves as a
prerequisite for most of the NASDs
principals exams.
Series 11: This is the Assistant Repre-
sentative Order Processing exam.
Persons passing this exam can only
give quotes and receive unsolicited
orders. Commissions are not permitted.
Series 24: The General Securities Prin-
cipal License, which entitles the holder
to supervise the business of a broker-
dealer. A Series 7 or Series 62 qualifi-
cation is a prerequisite for this license.
Series 26: The investment company/
variable contract products limited princi-
pal license, which entitles the holder to
supervise the sale of investment com-
pany and variable annuity products.
NASD Series 7
Glossary
Series 52: The Municipal Securities
Representative license which entitles
the holder to sell municipal and govern-
ment securities and is used by many
firms that sell primarily municipal debt
products.
Series 62: Known as the Corporate
Securities Limited Representative
license. This exam qualifies an individ-
ual as a representative for the sale of
corporate securities, investment com-
pany securities and REITS.
Series 63: The Uniform Securities
Agent State Law license exam required
by states. This is known as the Blue
Sky Laws Exam.
Series 65: The uniform investment
adviser law exam, which entitles the
successful candidate to sell securities
and give investment advice in those
states that require Series 65 registra-
tion.
Series Bond: A debt security issued in
a series of public offerings spread over
an extended time period. All the bonds
in the series have the same priority
claim against assets.
Series EE Bond: Non-marketable,
interest bearing U.S. Government sav-
ings bond issued at a discount from par.
Series HH Bond: Non-marketable
interest bearing U.S. Government sav-
ings bond issued at par and purchased
only by trading in Series EE Bonds.
Settlement: The completion of a trade
through the delivery of a security or
commodity and the payment of cash or
other consideration.
NASD Series 7 Page 644
Settlement Date: The date specified
for delivery of securities from the seller
and delivery of funds from the buyer to
pay for them. Corporate and municipal
securities have a 3 day settlement while
options and government securities
have a 1 day settlement. Cash way
transactions settle the same day.
Settlement Options: The different
methods for paying out a benefit avail-
able to beneficiaries and annuitants.
Choices can be income for life, a period
certain, a combination of both, joint and
last survivor and more.
Shareholder of Record: The name of
an individual or entity that an issuer car-
ries in its records as the registered
holder of the issuers securities.
Share Identification: Accounting
method that identifies the specific
shares selected for liquidation in the
event an investor wishes to liquidate
shares.
Sharing Arrangement: A method of
allocating the responsibility for
expenses and the right to share in reve-
nues among the sponsor and limited
partners in a direct participation pro-
gram.
Shelf Offering: An SEC provision
allowing an issuer to register a new
issue security without selling the entire
issue at once. The issuer can sell lim-
ited portions of the issuer over a two-
year period without registering the
security or incurring penalties.
Short: The term used to describe the
selling of a security, contract or com-
modity that the seller does not own. for
example, an investor who borrows
shares of stock from a broker-dealer
and sells them on the open market is
said to have a short position in the
stock.

Short Call Spread: The sale of a lower
strike price call option and the purchase
of a higher strike price call option on the
same underlying security.
Short Cover: The closing of a short
stock position by purchasing the shares
in the market and using these to
replace the shares that were borrowed
to effect the short sale.
Short Hedge: Selling options as pro-
tection against a decrease in the value
of a long securities account.
Short Interest: The total level of
uncovered short sales, reported each
month by the exchanges. A very large
short interest indicates that the market
is oversold and is likely to turn
upwards. A very low short interest indi-
cates that the market is overbought
and is likely to turn downwards.
Short Interest Theory: A technical
analysis theory that examines the ratio
of short sales to volume in a stock.
Because the underlying stock must be
purchased to close out the short posi-
tions, a high ratio is considered bullish.
Short Margin Account: A margin
account in which a customer sells short
securities. All short sales must be per-
formed in a margin account.
Short Market Value: The market value
of securities that are sold short in a
margin account. The value of these
securities is marked to market daily.
Short Selling: A strategy used when
one believes the value of a security is
going down. The investor borrows stock
from a brokerage firm, sells the stock
and if the stock does go down in value
a profit may be the result. The investor
must go into the market place to buy
the stock to cover the short position and
return the shares to the brokerage firm.
Page 645
Glossary
Short Put: An option contract that obli-
gates the investor to buy common stock
or another underlying instrument at a
fixed price.
Short Put Spread: The sale of a higher
strike price put option and the purchase
of a lower strike price put option on the
same underlying security.
Short Sale: The sale of borrowed secu-
rities, with the intention of buying back
the securities later at a lower price and
replacing the borrowed shares. Short
sales must take place in a margin
account.
Short Sale Rule (Up-Tick Rule): The
SEC prohibits short-selling when the
price of a stock is moving down. Short
sales of listed and nasdaq securities
can only be effected when the price of a
stock is moving up, on a plus-tick or
zero-plus-tick.
Short Spread: An option spread in
which the investor simultaneously buys
the option with the lower premium and
sells the same type of option with the
higher premium. The net difference
between the lower premium paid and
the higher premium received is the
credit.
Short Straddle: An option investors
position that results form selling a call
and a put on the same stock with the
same exercise price and expiration
month.
Short-Swing Profits: Insiders of a cor-
poration cannot profit by any short-
swing transactions. (Within 6 months)
Short-Term Bond: Debt obligations
with one year or less left to maturity.
NASD Series 7
Glossary

Short-Term Capital Gain: The profit Single Premium Life Insurance:

realized on the sale of a capital asset Whole life insurance requiring one ini-
that has been owned for twelve months tial lump sum payment.
or less. This gain is taxed at the inves-
Sinking Fund: A fund into which a
tors tax bracket.
company sets aside extra operating
Sides of the Market: The market has funds over time in order to retire its
two sides, up and down. bonds and preferred stock.
Signature Guarantee: An authentica- SIPC: Acronym for Securities Investor
tion of a signature in the form of a Protection Corporation.
stamp or seal by a bank, stock
SLD: A message on the Consolidated
exchange or member firm. It is often
Tape indicating that the sale being
required when securities are trans-
reported was not reported on time and
ferred or sold.
is therefore out of sequence.
SIMPLE 401(k) Plan: A retirement sav-
SMA: Abbreviation for Special Memo-
ings plan similar to a conventional
randum Account which is the cus-
401(k) plan but intended for companies
tomers available unused credit line in a
with fewer than 100 employees with
margin account.
some cost savings.
Small Business Investment Com-
Simplified Arbitration: An expedient
pany (SBIC): An exempt issue under
method of settling disputes involving
the Securities Act of 1933. This is an
claims not exceeding $15,000, whereby
investment company formed under the
a panel of arbitrators reviews the evi-
Small Business Administration rules to
dence and renders a decision.
invest in minority businesses.
Simplified Employee Pension IRA
Small Cap: $250 to $1 billion capitali-
(SEP IRA): A retirement program for
zation.
self-employed people of small compa-
nies allowing them to defer taxes on Small Cap SOES: Originally called
investments intended for retirement. SOES, Small Order Execution System,
Must include all eligible employees. the NASDs automated order routing
and execution system for Nasdaq small
Simple Interest: The interest calcu-
capitalization issues.
lated on a principal sum but not com-
pounded. Small Order Execution System
(SOES): The automatic small order
Single Account: An account in which
execution system the NASD uses to
only one individual has control over the
facilitate the trading of public market
investments and may transact busi-
and executable limit orders of 1,000 or
ness.
fewer shares.
Single Premium Deferred Annuity: A
Social Security: The comprehensive
tax-deferred annuity in which an individ-
federal program of benefits providing
ual makes a single payment. Additional
workers and their dependents with
deposits are not permitted.
retirement and disability income.

NASD Series 7 Page 646


Social Security Tax: Federal tax levied
equally on employers and employees,
used to pay for Social Security pro-
grams.
Socially Conscious Fund: A mutual
fund which invests in companies that
meet certain humanitarian standards
such as not polluting the environment.
SOES: Acronym for Small Order Exe-
cution System where orders for Nasdaq
securities are routed and executed.
SOES is divided into Super SOES for
Nasdaq National Market issues and
Small Cap SOES for Nasdaq small cap
issues.
Sole Proprietorship: A business struc-
ture in which an individual and com-
pany are considered a single entity for
tax and liability purposes.
Solvency: The ability of a corporation
both to meet its long-term fixed
expenses and to have adequate money
for long-term expansion and growth.
SPDR: Acronym for the Standard and
Poors 500 Index Exchange Traded
Fund. This is commonly referred to as
the Spider and trades under the sym-
bol SPY.
Special Assessment Bond: A munici-
pal bond that is paid off by tax assess-
ments on the beneficiaries of a
municipal improvement.
Special Memorandum Account
(SMA): A notation on a customers mar-
gin account indicating that funds are
credited to the account on a memo
basis similar to a line of credit with a
bank. An SMA preserves the cus-
tomers right to use excess equity.
Page 647
Glossary
Special Offering: A block trading pro-
cedure in which a large number of
shares of stock is offered for sale after
a prior announcement on the Consoli-
dated Tape.
Special Reserve Bank Account: A
separate account maintained by a bro-
ker-dealer for the exclusive benefit of
customers and for the required deposits
of customer credit balances.
Special Revenue Bond: A municipal
revenue bond issued to finance a spe-
cific project. Examples include indus-
trial development bonds, lease rental
bonds, special tax bonds and New
Housing Authority bonds.
Special Situation Fund: A mutual fund
whose objective is to capitalize on the
profit potential of corporations in nonre-
curring circumstances, such as those
undergoing reorganizations or being
considered as takeover candidates.
Special Tax Bond: A municipal reve-
nue bond payable only from the pro-
ceeds of a tax on certain items, rather
than an ad valorem tax.
Specialist: A stock exchange member
who makes a market for certain
exchange traded securities, maintains
an inventory of assigned stock and
stands ready to buy and sell shares as
necessary to maintain an orderly mar-
ket.
Specialists Book: A journal in which a
specialist records the limit and stop
orders that the specialist holds for exe-
cution. The contents of the journal are
confidential.
Specialty Fund: A mutual fund invest-
ing primarily in the securities of a partic-
ular industry, sector, type of security or
geographic region.
NASD Series 7
Glossary
Speculation: Taking large risks, espe-
cially with respect to trying to predict
the future in the hopes of making quick
large gains.
Spider (SPDR): Exchange traded fund
which invests in S&P 500 stocks.
Spin-Off: A corporation that has a sub-
sidiary that it feels will perform better as
an independent company may spin-off
that business by giving its existing
shareholders the subsidiary as a new
independent company in a separate
stock offering.
Split Offering: A public offering of
securities that combines aspects of
both a primary and a secondary offer-
ing. A portion of the issue is a primary
offering, the proceeds of which go to
the issuing corporation. The remainder
of the issue is a secondary offering the
proceeds of which go to the selling
stockholders.
Sponsor: A fund sponsor is also known
as the distributor and also known as the
fund underwriter.
Spread: The spread for a stock is the
difference between the best bid and
best ask price. For example, if the Bid is
$10 and the Ask is $10.25 the spread
would be $.25.
Spousal IRA: IRA opened in the name
of a non-working spouse.
Spread: The difference between a
securitys bid and ask prices.
Spread Load: A sales charge plan
whereby no more than 20% of any one
payment may be applied to sales fees.
SPX: The symbol for stock index
options on the Standard & Poors 500
index and trades on the CBOE.
NASD Series 7
Stabilization: Used when an IPO stock
falls below the initial offering price. It
allows the selling syndicate to bid up
the price of the stock legally. When sta-
bilizing the lead underwriter must
inform the SEC. Stabilization must be
indicated in the prospectus and there is
no time limit as to how long this process
can last.
Stabilizing Bid: The price, at or just
below a new issues public offering
price, at which the lead underwriter will
repurchase the issue in the secondary
market while he/she is stabilizing the
price of the new issue.
Stand-By Commitment: Used in a
rights offering an underwriting commit-
ment in which an investment banker
makes a firm commitment to stand by,
ready to buy any of the unsold shares
after the issuer attempts to sell its new
shares to existing shareholders who
have been given subscription rights.
Standard & Poors 100 Stock Index
(S&P 100/OEX): A value weighted
index composed of 100 blue chip
stocks. The index is owned and com-
piled by Standard & Poors Corporation.
Standard & Poors 500 (SPX): This is
a European style weight index of 500
stocks that are traded on the major
exchanges. There are a number of
index mutual funds that mirror this
index.
Standard & Poors Ratings: A grade
assigned to a bond that represents the
likelihood the debt will be paid back.
Ratings of BBB to AAA are called
investment grade while those bonds
with a rating of BB or lower are consid-
ered junk bonds and considered more
risky.
Page 648

Standard Deduction: A fixed deduc-
tion allowed to taxpayers who do not
itemize.
Standard Deviation: A statistical mea-
sure of the historical volatility of a
mutual fund or portfolio, usually com-
puted using 36 monthly returns. Also a
measure of the extent to which num-
bers are spread around their average.
Standardized Contract: A futures con-
tract in which all the contract terms are
set by the exchange except for price.
Standby Underwriter: An investment
banker prepared to purchase any
shares of stock that are not subscribed
to by current shareholders under a
rights offering.
State Registration: The act of register-
ing a security with an individual state.
Stated Value: Another term for par
value.
Stated Yield: The stated rate of inter-
est, as a percentage of par value, that
is paid on a fixed income security. This
is the same as the coupon rate or nomi-
nal yield.
Statutory Disqualification: Prohibit-
ing a person from associating with a
self-regulatory organization because
the person has been expelled, barred
or suspended from association with a
member of an SRO or has had his/her
registration suspended, denied or
revoked by the SEC, or has been the
cause of someone elses suspension,
disbarment or revocation or has been
convicted of certain crimes, or has falsi-
fied an application or a report that he/
she must file with or on behalf of a
membership organization.
Page 649
Glossary
Statutory Voting: Voting system in
which shareholders voting for the board
of directors may not give more than one
vote per share to any single nominee.
Sticky Issue: A new issue security that
is not selling well in the primary market.
Stock: A negotiable security represent-
ing ownership of a company and enti-
tling its owner the right to receive
dividends. Both common stock and pre-
ferred stock are issued by corporations
and have different characteristics and
features.
Stockbroker: Broker who deals prima-
rily with stock transactions.
Stock Ahead: Term used to describe
the inability of a specialist to fill a limit
order at a specific price because other
orders at the same price were entered
previously.
Stock Certificate: The document giv-
ing legal ownership of a specific num-
ber of shares in a corporation.
Stock Dividend: Payment of a corpo-
rate dividend in the form of stock versus
cash. Stock dividends are often used to
conserve cash needed to operate the
business. Unlike a cash dividend, they
are not taxed until the stock is sold.
Stock Exchange: An auction market in
which exchange members meet in a
central location to execute buy and sell
orders for individual and institutional
customers. The largest exchange is the
NYSE.
Stock Fund: A mutual fund consisting
of common stock and/or preferred
stock.
NASD Series 7
Glossary
Stock Index Fund: A mutual fund that
invests in a group of securities chosen
to match the composition and weighting
of a particular stock market index such
as the S & P 500 Index.
Stock Life Insurance Company: A life
insurance company owned by share-
holders who share in the earnings.
Stock Loan Agreement: The docu-
ment that an institutional customer
must sign when the broker-dealer bor-
rows stock from the customers
account. The document specifies the
terms of the loan and the rights of both
parties.
Stock Option: An option contract to
either buy or sell stock at a fixed price,
good for a fixed time period.
Stock Option Plan: A corporate pro-
gram whereby employees are allowed
to buy a specific number of stock
options in the company for a specified
period of time. The options usually have
an exercise price equal to the market
price at the time the options were given.
Stock Power: A power of attorney
enabling a person to transfer stock
ownership without signing the back of a
stock certificate.
Stock Quote: A list of representative
prices bid and ask for a stock during a
particular trading day. Stocks are
quoted in decimals such as .25.
Stock Record: A broker-dealers
accounting system that shows sepa-
rately for each security all long and
short positions, as well as the location
of each security, the holdings of all cus-
tomers, and all securities due from or
owed to other broker-dealers.
NASD Series 7 Page 650
Stock Record Department: The
department within a brokerage firm
responsible for maintaining the ledger
that lists the owners of securities and
the location of certificates.
Stock Split: A company, in an effort to
make their shares more marketable, will
declare a stock split. The end result is
that the investor will have more shares
but the current market value will fall so
the end result is no net economic gain.
Stock Symbol: Three letters or less
would indicate an exchange traded
stock such as the NYSE while four or
more would indicate a NASDAQ traded
stock.
Stockholders Equity: A synonym for
net worth. The equity that remains after
a companys total liabilities have been
subtracted from its total assets.
Stop Limit Order: A customer order
that becomes a limit order when the
market price of the security reaches or
passes a specific price.
Stop Loss: A stop order for which the
specified price is below the current mar-
ket price and the order is to sell.
Stop Order: This type of order is used
to buy or sell a certain quantity of a cer-
tain security if a specified price known
as the stop price is reached or passed.
Stopping Stock: The method used by
a specialist to guarantee that a cus-
tomer order will be executed at a spe-
cific price.
Straddle: An option investors position
that results from buying a call and a put
or selling a call and a put on the same
security with the same exercise price
and expiration month.

Straight Life Annuity: A payout option
for an annuitant that pays a monthly
amount for the annuitants life. Upon
death the insurance company keeps
the balance as no beneficiary is
allowed.
Straight-Line Depreciation: Account-
ing method used to recover the cost of
a qualifying depreciable assets,
whereby the owner writes off the cost of
the asset in equal amounts each year
over the assets useful life.
Strangle: An option position that
results form buying a call and a put
when both options are out-of-the
money on either side of the current
price of the underlying security. A stran-
gle can be profitable only if the market
is highly volatile and makes a major
move in either direction.
Strategic Asset Allocation: The deter-
mination of the percentage of assets to
be placed in each asset class under an
asset allocation scheme.
Street Name: The term given to securi-
ties held in the name of a brokerage
firm for the client.
Strike Price: This is also known as the
exercise price which is a fixed price at
which stock or other underlying instru-
ment can be bought or sold when a call
or option is exercised.
Stripped Bond: A debt obligation that
has been stripped of its interest cou-
pons by a brokerage firm, repackaged
and sold at a deep discount. It pays no
interest but may be redeemed at matu-
rity for the full face value.
Page 651
Glossary
STRIPS: Commonly used acronym for
Separate Trading of Registered Interest
and Principal Securities. The U.S. Trea-
sury decided to issue interest only
strips and principal only strips directly
on selected U.S. Government debt
issues.
Structured Settlement: A lawsuit set-
tlement involving specific payments
made over a period of time.
Student Loan Marketing Association
(SLMA): A publicly owned corporation
that purchases student loans from
financial institutions and packages
them for sale in the secondary market,
thereby increasing the availability of
money for educational loans.
Subchapter M: The IRS regulation
governing the taxation of investment
companies and REITS. If a mutual fund
distributes 90% or more of its net
investment income to shareholders,
then it is considered to be a regulated
investment company under Subchap-
ter M and the fund is taxed only on the
retained income. If the corporation dis-
tributes less than 90% all the invest-
ment income will be taxed as a
corporation.
Subchapter S Corporation: A small
business corporation that meets certain
requirements and is taxed as a partner-
ship while retaining limited liability.
Subject Quote: A securities quotation
that does not represent an actual offer
to buy or sell but is tentative, subject to
reconfirmation by the broker-dealer.
Subordinated Debt: Debt that is either
unsecured or has a lower priority than
that of another debt claim on the same
asset or property. (i.e. subordinated
debenture)
NASD Series 7
Glossary
Subordinated Loan: A loan to a bro-
ker-dealer in which the lender agrees to
subordinate its claim to the claims of
the firms other creditors.
Subscription Agreement: A statement
signed by an investor indicating an offer
to buy an interest in a direct participa-
tion program. The investor agrees to
grant a power of attorney to the general
partner and to abide by the limited part-
nership agreement. The sale is final-
ized when the subscription agreement
is signed by the general partner.
Subscription Amount: The total dollar
amount that a participant in a direct par-
ticipation program has invested.
Subscription Price: Lower than a
stocks current market price, the fixed
price at which a companys existing
shareholders can purchase new shares
during a rights offering.
Subscription Right: The right given to
a common shareholder to have the first
claim on any additional common shares
that the company wishes to sell.
Suitability: An SEC requirement for
registered representatives when deal-
ing with clients. Must make sure any
recommendations matches a cus-
tomers objectives and financial capa-
bility.
Summary Complaint Procedure:
Available to agents who do not dispute
any charges and waive their right to a
hearing. The maximum fine is $2,500
and or censure.
Super Designated Order Turnaround
System (SuperDot): The computer-
ized trading and execution system used
by the NYSE.
NASD Series 7 Page 652
Supervision: A system implemented
by a broker-dealer to ensure that its
employees and associated persons
comply with the applicable rules and
regulations of the SEC, the exchanges
and the SROs.
Supervisory Analyst: A NYSE desig-
nation for an individual who has passed
the Series 16 examination. This person
is responsible for writing or approving
any research reports distributed by the
member firm that recommend securi-
ties.
Supply: The total amount of a goods or
services available for purchase by con-
sumers.
Supply Side Theory: An economic
theory holding that bolstering an econ-
omys ability to supply more goods is
the most effective way to stimulate eco-
nomic growth. Supply-side theorists
advocate income tax reduction insofar
as this increases private investment in
corporations, facilities and equipment.
Support Level: A technical analysis
term describing a price level to which a
stock or the market falls and then rises
from repeatedly. Buying increases as a
stocks price approaches this level so
the stock has support against further
downward price moves.
Surety Bond: A bond issued to assure
coverage for the costs of legal fees and
required by the states.
Surplus Capital: Another name for
additional paid in capital. The amount
above par value paid by a common
shareholder to the company for the
stock on the initial public offering.

Surplus Fund: An account that is used
to pay a variety of a municipal revenue
bonds expenses, including redeeming
bonds, funding improvements and mak-
ing tax payments.
Surrender Charge: A fee imposed for
terminating an annuity contract prior to
the end of its surrender period.
Surrender Value: The current value of
the cash account of an annuity less any
fees for selling during the surrender
period.
Survivorship Insurance: Same as
second-to-die insurance.
Switching: Moving money from one
mutual fund to another within the same
family. Generally no sales charges,
however there is a tax consequence.
Sweep Account: A brokerage account
whose cash balance is automatically
transferred into an interest bearing
money market.
Syndicate: A group of investment
bankers which jointly underwrite and
distribute a new security offering.
Syndicate Agreement: A formal, legal
agreement between the syndicate man-
ager and each syndicate member that
details the selling responsibility and lia-
bility of each syndicate manager in the
underwriting of a new issue.
Syndicate Bid: A bid made by a syndi-
cate member in order to stabilize the
price of a new offering.
Page 653
Glossary
Syndicate Manager: Also called the
lead or managing underwriter. The
investment banking firm that has the
business relationship with the issuer of
the securities. The managing under-
writer forms the syndicate, drafts the
syndicate agreement, acts on the syndi-
cates behalf, allocates the securities to
each syndicate member and charges a
management fee for its services.
Syndicate Member: A broker-dealer
who signs a syndicate agreement with
the syndicate manager and by doing so
agrees to share in the selling responsi-
bility and liability for a new issue offer-
ing being underwritten by the syndicate.
Syndicator: Usually the general part-
ner in a limited partnership. This person
forms the partnership, registers it with
the SEC and hires wholesalers to
market the partnership units to broker-
age firms that might have customers for
the program.
Synthetic Option: A combination of a
stock position with an option position
that simulates the risk and return poten-
tial of a single option purchase or sale.
Systematic Risk: The potential for a
security to decrease in value because
the market itself is falling. Neither diver-
sification nor any other investment
strategy can eliminate this risk.
T
T-Bill: The common name for a U.S.
Government Treasury bill which is a
money market instrument that is sold at
a discount. T-bill are quoted in $1,000
increments. Their issued with 1 month,
3 month and 6 months maturities.
NASD Series 7
Glossary

Tactical Asset Allocation: The permit- Tax-Deferred Annuity: Usually called

ted variation from the fixed percentage a 403(b) plan and covers a pension
of assets to be placed in each asset plan specifically for certain tax-exempt,
class given to the asset manager under non-profit organizations, municipalities
an asset allocation scheme. and hospitals. Employees are allowed
to contribute to a tax-deferred annuity
Takedown: The discount from the pub-
via payroll deductions. The amount
lic offering price at which a syndicate
contributed is always made with pre-tax
member buys new issue securities from
dollars and is therefore a salary reduc-
the syndicate for sale to the public.
tion for the employee.
Tangible Asset: An asset such as
Tax Equivalent Yield: An adjustment
machinery or equipment that is move-
made to a tax-free yield on one invest-
able. Such assets are valued on a com-
ment for the purpose of comparing it to
panys balance sheet at net depreciated
a different, taxable investment.
value.
Tax Qualified Plan: A pension or
Target Price: Price at which a holder of
retirement plan in which the contribu-
a stock is hoping to sell the stock.
tions are deductible against the contrib-
Tax and Revenue Anticipation Note utors taxable income. Therefore,
(TRAN): A short-term municipal secu- contributions are made with pre-tax dol-
rity issued in anticipation of future tax lars.
and revenue collections that will be the
Tax Shelter: Any technique which
source of funds to retire the note.
allows one to legally reduce or avoid tax
Tax Anticipation Note (TAN): A short- liabilities.
term municipal security issued in antici-
Tax Swap: The sale of a security that
pation of future tax receipts. Once the
has declined in price since its purchase
tax payments from individuals and cor-
and the simultaneous purchase of a
porations are received, the note is
similar but not identical security, in
retired using the tax collections.
order to realize a loss for tax purposes
Tax Basis: For tax purposes the valua- while maintaining a position.
tion of an investors interest in a direct
Taxable Gain: The portion of a sale or
participation program.
distribution of mutual fund shares sub-
Tax Credit: The direct dollar-for-dollar ject to taxation.
reduction of an individuals tax liability.
Taxable Income: The amount of
Tax deductions only reduce a tax liabil-
money you earn including interest and
ity in proportion to the taxpayers tax
stock sales that you have to pay federal
bracket.
and state taxes on.
Tax Deferred: The right to put off pay-
Tax and Revenue Anticipation Note
ing federal taxes on your investments
(TRAN): A short-term municipal debt
until some time in the future.
security to be paid off from future tax
receipts and revenues.

NASD Series 7 Page 654


Tax Anticipation Note (TAN): A short-
term municipal or government debt
security to be paid off from future tax
receipts.
Tax Basis: The amount that a limited
partner has invested in a partnership.
Tax Credit: An amount that can be sub-
tracted from a tax liability often in con-
nection with real estate development,
energy conservation and research and
development programs. Every dollar of
tax credit reduces the amount of tax
due, dollar for dollar.
Tax Equivalent Yield: The rate of
return a taxable bond must earn before
taxes in order to equal the tax-exempt
earnings on a municipal bond. This
number varies with the investors tax
bracket.
Tax Exempt Bond Fund: A mutual
fund whose investment objective is to
provide maximum tax-free income. It
invests primarily in municipal bonds and
short-term debt.
Tax Liability: The amount of tax pay-
able on earnings, usually calculated by
subtracting standard and itemized
deductions and personal exemptions
from adjusted gross income, then multi-
plying by the tax rate.
Tax Preference Item: An element of
income that receives favorable tax
treatment. The item must be added to
taxable income when computing alter-
native minimum tax. Tax preference
items include accelerated depreciation
on property, research and development
costs, intangible drilling costs, tax-
exempt interest on municipal private
purpose bonds, and certain incentive
stock options.
Page 655
Glossary
Tax-Sheltered Annuity (TSA): An
insurance contract that entitles the
holder to exclude all contributions from
gross income in the year they are
made. Tax payable on the earnings is
deferred until the holder withdraws
funds at retirement. TSAs are available
to employees of public schools, church
organizations and other tax-exempt
organizations.
Technical Analysis: A method of eval-
uating securities by analyzing statistics
generated by market activity, such as
past prices and volume. Technical ana-
lysts do not attempt to measure secu-
ritys internal value.
Telephone Consumer Protection Act
of 1991 (Cold Calling Act): Federal
legislation restricting the use of tele-
phone lines for solicitation purposes.
Tenancy in Common: A type of joint
tenancy of property without rights of
survivorship. Each tenants portion of
ownership is distributable by a will and
will be probated.
Tenancy by the Entirety: A type of
joint tenancy of property that provides
right of survivorship and is available
only to a married couple.
Tender Offer: An offer to buy securities
for cash or for cash plus securities.
Term Bond: A bond that is issued all at
one time and that matures at one time.
Term Life Insurance: Insurance for a
specified period of time which does not
provide for cash savings.
Term Maturity: A repayment schedule
for a bond issue in which the entire
issue comes due on a single date.
Testamentary Trust: A trust created
within a will which does not take effect
until the death of the grantor.
NASD Series 7
Glossary
Testimonial: An endorsement of an
investment or service by a celebrity or
public opinion influencer. The use of
testimonials in public communications
is regulated by the NASD.
Thin Market: A market with few bid and
ask offers. Characterized by low liquid-
ity, high spreads, and high volatility.
Thinly Traded: Traded infrequently and
or in low volumes.
Third Market: The exchange where
listed securities are traded in the over-
the-counter market. Institutional inves-
tors are the primary users of the third
market.
Third Party Account: A customer
account for which the owner has given
power of attorney to a third party for
trading purposes.
Tick: A minimum upward or downward
movement in the price of a security.
Ticker: A scrolling display of current or
recent security prices and/or volume.
Ticker Symbol: A system of letters
used to uniquely identify a stock or
mutual fund. Three or less letters would
be a listed stock on an exchange while
more than three letters would be a
NASDAQ stock. Mutual funds usually
have at least five letters.
Ticker Tape: Service which provides
quote and volume information for each
transaction on the major exchanges.
Time Deposit: A sum of money left
with a bank or borrowed from a bank
and left on deposit that the depositing
customer has agreed not to withdraw
for a specified time period or without a
specified amount of notice.
NASD Series 7 Page 656
Time Horizon: When creating a portfo-
lio for the customer, the time period
necessary to achieve the desired
investment return.
Time Spread: An option spread posi-
tion, where simultaneously the same
type of option is bought and sold with
the same strike price and different expi-
rations.
Time Value: The amount an investor
pays for an option above its intrinsic
value. It reflects the amount of time left
until expiration. The amount is calcu-
lated by subtracting the intrinsic value
from the premium paid.
Timing Risk: The potential for an
investor to incur a loss as a result of
buying or selling a particular security at
an unfavorable time.
TIPS: Abbreviation for Treasury Infla-
tion Protection Securities. These are T-
notes where the principal amount is
indexed for inflation, however the cou-
pon rate is fixed. If the principal amount
is indexed up for inflation, then the
holder will receive a higher semi-annual
interest payment as well.
TOD: Abbreviation for Transfer on
Death. A new type of securities regis-
tration that allows the registered owner
to specify the person in whose name
the security will be transferred upon
death of the owner. Thus, upon death,
the security does not go into the name
of the estate and bypasses probate.
Tombstone: An advertisement in a
business newspaper placed by an
investment banker announcing an offer-
ing and listing the syndicate members.
Total Capitalization: The total long-
term debt, preferred stock and common
stock that comprises a companys capi-
tal structure.

Total Return: The return on an invest-
ment, including income from dividends
and interest, as well as appreciation or
depreciation in the price of the security.
Total Takedown: The largest part of
the spread on a new municipal bond
issue. This is the compensation each
syndicate member receives for each
bond that it sells to the public. The total
takedown is the sum of the additional
takedown and the selling concession.
Trade Comparison: The memorandum
sent by both broker-dealers engaged
on either side of a trade. It confirms the
details of the transaction. Comparison
procedures are established by the
NASDs Uniform Practice Code.
Trade Confirmation: A printed docu-
ment that contains details of a transac-
tion, including the settlement date and
amount of money due from or owed to a
customer. It must be sent to the cus-
tomer on or before the settlement date.
Trade Date: The date on which the
transaction occurs.
Trading: Buying and selling securities
on a short-term basis, hoping to make
quick profits.
Trading Authorization: Written per-
mission given by a customer allowing
another person to trade that customers
account.
Trading Curb: A temporary restriction
in trading, in a particular security, usu-
ally to reduce dramatic price move-
ments.
Trading Halt: A temporary stoppage of
trading, usually for 30 minutes, in a par-
ticular security for a specific reason
such as pending news or an order
imbalance.
Page 657
Glossary
Trading Post: The designated place on
the exchange floor where a particular
stock trades. A specialist is located at
each trading post and manages the
trading crowd at that post.
Tranche: One of the classes of securi-
ties that form an issue of collateralized
mortgage obligations. Each tranche is
characterized by its interest rate, aver-
age maturity, risk level and sensitivity to
mortgage prepayments. Neither the
rate of return nor the maturity date of a
CMO tranche is guaranteed.
Transfer Agent: An agent employed by
a corporation or mutual fund to maintain
shareholder records, including pur-
chases, sales, and account balances.
Transfer and Hold In Safekeeping: A
securities buy order settlement and
delivery procedure whereby the securi-
ties bought are transferred to the cus-
tomers name, but are held by the
broker-dealer.
Transfer and Ship: A securities buy
order settlement an delivery procedure
whereby the securities bought are
transferred to the customers name and
sent to the customer.
Transfer of Assets: Moving all the
assets of one corporation to another
corporation, thus dissolving the first
corporation.
Treasuries: The commonly used name
for U.S. Government securities.
Treasury Bills: Low-risk, low-income
debt instruments of one year or less
issued by the U.S. Treasury Depart-
ment. No interest is paid but the bills
are sold at a discount so interest
accrues.
NASD Series 7
Glossary

Treasury Bonds: U.S. Government Trough: The end of a period of declin-

long-term debt maturing between 10 ing business activity throughout the
20 years. Quoted in $1,000 increments economy, one of the four stages of the
with interest paid semi-annually. business cycle.
Treasury Investors Growth Receipt Trustee: A person legally appointed to
(TIGR): One of several zero-coupon act on a beneficiarys behalf.
bonds issued by brokerage firms and
Trust Account: A fiduciary account in
collateralized by Treasury securities.
which the trustee makes investment
Treasury Notes: Similar to Treasury decisions for a person keeping with the
bonds but with maturities of one to ten terms specified in the trust agreement.
years.
Trust Indenture: A legal contract
Treasury Stock: Stock that was pur- between a corporation and a trustee
chased back by the corporation. It is that represents its bondholders that
known as issued but not outstanding details the terms of a debt issue. The
stock. Treasury stock does not receive terms include the rate of interest, matu-
dividends and does not have voting rity date, means of payment and collat-
rights. eral.
Treasury Strips: Zero-coupon bonds Trust Indenture Act of 1939: The leg-
issued by the U.S. Government. islation requiring that all publicly
offered, nonexempt debt securities be
Trend: In technical terms, the up, down
registered under the Securities Act of
or sideways movement of the overall
1933 and be issued under a trust inden-
market as reflected in an average or
ture that protects the bondholders.
index or a stocks price over a period of
time, usually longer than six months. Trustee: An individual or broker-dealer
or financial institution that manges
Trendline: A tool used by technical
securities or property in a fiduciary
analysts to trace a securitys movement
account for the benefits of another per-
by connecting the reaction lows in an
son.
upward trend or the rally highs in a
downward trend. 12b-1 Fee: This is an annual mutual
fund sales charge levied on invest-
Triple Tax Exempt: Free from federal,
ments for promotion and marketing
state and local taxes. Bonds issued by
costs in the fund. The fee must be rea-
the U.S. Possessions such as Guam
sonable and is typically half of one per-
and Puerto Rico are always triple tax
cent of total assets under management.
exempt.
Triple Witching Hour: The final hour of
the stock market trading session on the
third Friday of March, June, September
and December, when option contracts
and futures contracts expire on market
indexes used by program traders. The
simultaneous expirations often set off
heavy trading volume.

NASD Series 7 Page 658


Twenty Day Cooling off Period: Man-
dated under the Securities Act of 1933.
This is the period of time following the
filing of a registration statement with the
SEC, during which time the issuer and
underwriters are prohibited from selling
the issue, advertising the issue, recom-
mending the purchase of the issue and
soliciting orders to buy the issue. This is
the time period the SEC reviews the fil-
ing for full and fair disclosure.
Twenty G.O. Bond Index: A yield index
compiled by the Bond Buyer each week
consisting of 20 selected municipal
general obligation bonds, rated A or
better, with 20 years to maturity. It is a
reference used by municipal underwrit-
ers to set the coupon rate on a munici-
pal new issue.
Two Dollar Broker: An exchange
member that executes orders for other
member firms when their floor brokers
are especially busy. Two-dollar brokers
charge a commission for their services
while the amount of the commission is
negotiated.
Type: A term that classifies an option
as a call or a put.
U Underwriting Manager: The broker-
UGMA: Uniform Gift to Minors Act
allows adults to contribute to a custodial
account in the minors name without
having to establish a trust or name a
legal guardian.
Uncovered Option: This is also called
a naked option, at term used to
describe a short call or short put posi-
tion in which the writer is unprotected
against the maximum possible loss.
Underlying Securities: Securities that
are bought or sold where an option,
right or warrant is exercised.
Page 659
Glossary
Underwrite: To assume risk, as when
bringing a corporations new securities
issue to the public.
Underwriter: An investment banker
that works with an issuer to help bring a
security to the market and sell it to the
public.
Underwriters Concession: That por-
tion of the underwriting spread which
the managing underwriter concedes or
gives to the syndicate members in a
corporate securities underwriting for
each new issue security they sell
directly to the public.
Underwriting: The procedure by which
investment bankers channel investment
capital from investors to corporations
and municipalities that are issuing
securities.
Underwriting Agreement: Agreement
between the members of a selling syn-
dicate with final decisions made by the
investment manager.
Underwriting Compensation: The
amount paid to a broker-dealer firm for
its involvement in offering and selling
securities.
age firm responsible for organizing a
syndicate, preparing the issue, negoti-
ating with the issuer and underwriters
and allocating stock to the selling
group.
Underwriting Spread: Fee charged by
a selling syndicate equal to the differ-
ence between the gross sales to inves-
tors and the net proceeds received by
the issuer.
NASD Series 7
Glossary
Unearned Income: Income derived
from investments and other sources not
related to employment services. Exam-
ples of unearned income include inter-
est from a savings account, bond
interest and dividends from stock.
Undivided Account: This is another
term for an Eastern syndicate account.
Here, each member has technically
unlimited selling responsibility and
unlimited liability. If any other members
cant sell new issue shares then the
remaining shares are divided amongst
all the members until the issue is sold.
Uniform Gifts to Minors Act (UGMA):
Legislation that permits a gift of money
or securities to be given to a minor and
held in a custodial account that an adult
manages for the minors benefit.
Income and capital gains transferred to
a minors name are taxed at a lower
rate. Some states have the UTMA Act
instead. For exam purposes treat them
the same.
Uniform Practice Code: The NASD
policy that establishes guidelines for a
brokerage firms dealings with other
brokerage firms.
Uniform Securities Act (USA): Legis-
lation for the securities industry regula-
tion at the state level. Each state may
adopt the legislation in its entirety or it
may adapt it to suit its needs. The
Series 63 tests on this material.
Unissued Stock: Unissued stock is
that which is authorized in the com-
panys charger but has never been
issued to the public.
Unit: A share in the ownership of a
direct participation program that entitles
the investor to an interest in the pro-
grams net income, net loss and distri-
butions.
NASD Series 7
Unit Investment Trust: A SEC regis-
tered investment company which pur-
chase a fixed, unmanaged portfolio of
bonds or stocks and then sells shares
in the trust to investors.
Unit Refund Life Annuity: Periodic
payments are made during the annu-
itants lifetime. Any unused portion may
be paid in a lump sum to the benefi-
ciary.
Universal Life Insurance: Life insur-
ance which combines the low-cost pro-
tection of term insurance with a savings
component that is invested in a tax-
deferred account. One of the features is
that the cash value may be available for
a loan to the policyholder.
Unlimited Risk: An investment whose
loss is potentially unlimited. Examples
include short selling and futures trad-
ing.
Unlimited Tax Bond: A municipal GO
bond with no limit on the amount of
taxes that can be levied in order to pay
off the bond.
Unqualified Legal Opinion: The state-
ment of a bond counsel affirming the
compliance of a new municipal bond
issue with municipal statutes and tax
regulations, and expressing no reserva-
tions about its validity.
Unrealized Gain: Amount by which a
security appreciates in value but is not
sold yet.
Unsecured Bond: Also known as a
Debenture, they are backed by the full
faith and credit of the issuer.
Page 660

Unsystematic Risk: Another term for
non-systematic or stock-specific risk or
business risk which can be diversified
out of a portfolio by adding a greater
number of securities to the portfolio
until its composition matches the mar-
ket.
UpTick: An increase in the sale price of
a stock over the last reported regular
way sale price.
UpTick Rule: Another term for the
short sale rule which requires that short
sales of exchange listed stocks and
Nasdaq stocks be effected on either an
up-tick or a zero-plus-tick. Short sales
cannot be effected on a downtick or a
zero-minus tick.
Uptrend: The upward movement of a
stocks price or of the market as a
whole as measured by an average or
index, over a period of time.
U.S. Savings Bonds: Registered, non-
transferable, nonmarketable certificates
sold by the federal government with a
variety of interest and maturity dates.
Must be redeemed as there is no mar-
ket for buying and selling secondary
bonds. There are EE and HH bonds.
UTMA: Uniform Transfer to Minors Act
is basically the same as an UGMA
account but extends the definition of a
gift to include real estate, fine art, royal-
ties and more.
V whole life insurance which combines
Value Investing: The selection of
equity investment based on finding
undervalued issues using fundamental
analysis.
Value Line: An investment advisory
service that rates hundreds of stocks as
to safety, timeliness and projected price
performance.
Page 661
Glossary
Value Line Composite Index: A mar-
ket index composed of 1,700 exchange
and over-the-counter stocks.
Value Stock: A stock that is considered
to be a good stock at a great price,
based on its fundamentals, as opposed
to a great stock at a good price.
Variable Annuity: A life insurance
annuity contract which provides future
payments to the annuitant with the size
of which depends on the performance
of the portfolios securities. Provides a
hedge against inflation and allows
investors to invest in various mutual
fund sub accounts.
Variable Death Benefit: An amount
paid to a decedents beneficiary which
is dependent on the performance of the
insurance companys investment.
Variable Life Insurance: Life insur-
ance for which the amount of the pay-
ments is determined by the
performance of the underlying invest-
ments chosen by the policyholder. To
sell this product, an agent must have a
securities and insurance license.
Variable Rate Municipal Security: A
short-term municipal debt security
issued when either general interest
rates are expected to change or the
length of time before permanent fund-
ing is received is uncertain.
Variable Universal Life: A form of
some features of universal life insur-
ance such as premium and death bene-
fit flexibility, with some features of
variable life insurance.
Venture Capital: Money invested in a
new, unproven and risky business or
enterprise.
NASD Series 7
Glossary
Vertical Spread: The purchase and
sale of two options on the same under-
lying security and with the same expira-
tion date but with different exercise
prices.
Vesting: An ERISA guideline stipulat-
ing that employees must be entitled to
their benefits from a pension fund,
profit-sharing plan or Employee Stock
Ownership Plan within a certain period
of time, even if they no longer work for
that employer.
Visible Supply: The disclosure, pub-
lished in the Bond Buyer, of the total
dollar amount of municipal securities
known to be coming to market within
the next 30 days. Also, all supplies of
goods and commodities that are readily
deliverable.
Volatility: Having a high degree of
large price movements, up or down.
Volume: The number of shares or
bonds traded during a given period, for
a security or an entire exchange.
Volume of Trading Theory: A techni-
cal analysis theory holding that the ratio
of the number of shares traded to total
outstanding shares indicates whether a
market is strong or weak.
Voluntary Accumulation Plan: Plan
allowing a mutual fund shareholder to
accumulate shares on a regular basis
over time through periodic investments.
Voting Right: The right of a common
stock shareholder to vote, in person or
by proxy, for members of the board of
directors and other important matters.
Voting Stock: Stock which carries with
it voting rights.
NASD Series 7 Page 662
Voting Trust: A corporation that
assumes common stock voting power
of a second corporation for a limited
time period, such as during a reorgani-
zation of the second corporation.
Voting Trust Certificate: A certificate
issued in place of a stock certificate to
stockholders of a corporation that is
temporarily managed by a voting trust.
The certificate represents all of the ben-
efits of ownership except the power to
vote. When the corporation resumes
management of its own affairs, it
replaces the voting trust certificate with
a new stock certificate.
W
W-2 Form: A tax form prepared by an
employer and given to an employee to
be filed with his/her 1040 form, listing
wages earned during that year, federal
and state taxes withheld and Social
Security tax information.
W-4 Form: A tax form prepared by an
employee for an employer indicating
the employees exemptions and Social
Security number, and enabling the
employer to determine the amount of
taxes to be withheld for the employee.
W-9 Form: A tax form which certifies an
individuals tax identification number.
This form must be present in a broker-
age accounts files to avoid backup
withholding by the IRS.
Warrant: A certificate, usually issued
along with a bond or preferred stock or
even new IPO common stock. Holder is
entitled to buy a specific amount of
securities at a specific price, usually
above the current market price at the
time of issuance, for an extended
period prior to its expiration.

Wash Sale Rule: IRS rule prohibiting a
taxpayer from claiming a loss on the
sale of an investment if that same
investment was purchased within 30
days before or after the sale date.
Wasting Asset: A security that
becomes worthless on a predetermined
expiration date. Rights, standard war-
rants, and options are securities that
are wasting assets.
Weak Dollar: Dollar that can be
exchanged for only a small or decreas-
ing amount of foreign currency.
Western Account: A securities under-
writing in which the agreement among
underwriters states that each syndicate
member will be liable only for the sale
of the portion of the issue allocated to it.
When, as and if Issued: Transaction
conditional on a security which has
been authorized but not yet issued.
When Issued Security: A trade agree-
ment regarding a security that has been
authorized but is not yet physically
available for delivery. The seller agrees
to make delivery as soon as the secu-
rity is ready, and the contract includes
provisions for marking the price to the
market and for calculating accrued
interest.
Whites Rating: A service that rates
the marketability risk associated with a
municipal issue using a scale from 0 to
1 with 0 denoting an unmarketable
issue and 1 a most liquid issue.
Whole Life Insurance: Life insurance
which provides coverage for an individ-
uals whole life rather than a specified
term. A savings component, called a
cash value account, builds over time
and can be used for wealth accumula-
tion.
Page 663
Glossary
Wholesaler: In a non-managed offer-
ing of a limited partnership, an indepen-
dent agent or employee of the
syndicator who sells partnership inter-
ests to the public through NASD mem-
ber firms. A wholesaler earns a portion
of the spread for each of these sales.
Wildcat Well: A term used in explor-
atory oil and gas programs. Its a well
drilled far away from an existing field.
Will: A legally enforceable declaration
directing the disposal of a decedents
property.
Wilshire Index: Considered the broad-
est measure of the activity and move-
ment of the overall stock market. This
index consists of about 7,000 issues of
companies located in the United States
and that trade on the NYSE, AMEX and
on Nasdaq.
Withholding: An amount of an
employees income that an employer
sends directly to the federal, state or
local tax authority as partial payment for
that individuals tax liability for the year.
Workable Quote: In the municipal
bond market, a bid price at which a
dealer is likely to buy bonds from a
dealer who wishes to sell. The dealer
soliciting the workable is trying to exe-
cute a customers order to sell munici-
pal bonds and is collecting likely prices
at which other dealers would buy the
bonds. Then the selling dealer will go
back to the buying dealer who gave the
best workable to nail down a firm bid
for the bonds.
Workout Quote: In the over-the
counter market an approximate price
range which the dealer will use to work
out a firm quote in a reasonable amount
of time.
NASD Series 7
Glossary
Wrap Account: Account in which a
brokerage firm helps an investor find a
money manager or manages the
account itself in exchange for a quar-
terly or annual fee based on the amount
of assets under management. A Series
65 license is required to sell wrap
accounts.
Writer: The seller of an option contract.
X-Y-Z
XMI: The symbol for stock index option
on the Major Market Index, traded on
the American Stock Exchange.
Yellow Sheets: Published daily by the
National Quotations Bureau, these
sheets show the bid and ask prices of
corporate bonds that trade OTC.
Yield: The amount of money you get
from your investment, stated as a per-
centage of the original investment.
Yield Auction: The commonly used
name for the issuance or sale of U.S.
Government securities via competitive
bid auction without an underwriter. Bids
at this auction are made in terms of
interest rates (yields) instead of prices
with the lowest interest rates winning.
Auctions are conducted by the Fed.
Yield Curve: Graphic representation of
the actual or projected yields of fixed
income securities in relation to their
maturities.
NASD Series 7 Page 664
Yield Spread: The difference in yield
between 2 types of debt securities. A
typical yield spread comparison is the
yield of U.S. Government securities to
AAA rated corporate bonds. Generally
high quality corporate bonds yield 1%
more than equivalent maturity U.S.
Government bonds. If the economy
appears headed for recession, inves-
tors sell corporate bonds and buy U.S.
Governments for safety. This drives the
prices of corporates down relative to
governments. Therefore, corporate
yields rise relative to governments and
the yield spread widens. (Exam Point)
Yield to Call: The rate of return that a
bond would provide if the investor held
it only to a closer call date rather than to
maturity.
Yield to Maturity: The overall return an
investor will receive from a bond if held
to maturity.
Zero Coupon Bond: Sells at a dis-
count to par value. Though no interest
is paid, interest accrues and the bond
gradually increases in value until it
matures at full face value.
Zero Minus Tick: A stock trade at the
same price as the preceding trade
where the trade was at a lower price
than the previous trade.
Zero Plus Tick: A stock trade at the
same price as the preceding trade
where the trade was at a higher price
than the previous trade.