Tag Archives: Series 24

Nontraded REITs may be a suitable way for investors to earn good returns while diversifying their portfolios. However, FINRA is concerned about the way these programs are being marketed, particularly to retail investors. Many investors may not understand the risks of nontraded REITs, especially their lack of liquidity and the difficulty in valuing their shares. Other issues for investors are high fees (as much as 15%) and the fact that dividend payments may be confused with returns of capital.

What Are REITs? 

A real estate investment trust (REIT) is an entity that invests in real estate projects or real estate-related assets, such as shopping centers, office buildings, apartment buildings, hotels, and mortgages. REITs are designed to make it possible for individuals to invest in large-scale real estate projects. Their benefits include regular dividend income and the potential for capital appreciation.

A REIT is structured in a way that avoids paying corporate income taxes on its earnings. In order to qualify, a REIT must distribute 90% of its income to its shareholders each year in the form of dividends. Individual investors are responsible for paying taxes at ordinary income rates on the dividends they receive.

In order for an entity to qualify as a REIT and avoid corporate taxes, it must:

  • Be structured as a corporation, trust, or association
  • Be managed by a board of directors or trustees
  • Not be a financial institution or insurance company
  • Issue shares that are fully transferable
  • Have a minimum of 100 shareholders
  • Have no more than 50% of its shares held by five or fewer individuals during the last half of the taxable year
  • Pay out at least 90% of its taxable income in the form of shareholder dividends
  • Invest at least 75% of its total assets in real estate
  • Derive at least 75% of its gross income from rent or mortgage interest
  • Have no more than 20% of its assets invested in the stocks in taxable REIT subsidiaries

Different Types and Different Advantages and Disadvantages

Many REITs are public companies registered with the SEC and listed on a major exchange. Nontraded REITs are public offerings that are registered with the SEC, but their shares are not listed on any of the exchanges. Note that there are also private REITs, which are issued as private placements under Regulation D—they are not registered with the SEC or listed on an exchange. Generally, only accredited investors may purchase private REITs.

A publicly traded REIT has certain advantages for investors who can easily determine the value of their shares and can liquidate them quickly. Of course, this does not protect them from steep losses if the market is not doing well, but at least investors have a quick exit. The disadvantage is that listed REITs may pay lower dividends than unlisted ones.

Most nontraded REITs are finite investments—they are not designed to last forever. After a certain number of years, they either list their shares on an exchange or liquidate (a liquidity event). In either case, there is no guarantee what the value of the investor’s shares will be at this point—they may be worth more than the original investment but they may also be worth less.

Investors in nontraded REITs will find it difficult to redeem their shares early. Often, the investor’s only avenue is to sell his shares back to the REIT itself. Some programs do offer early redemption options but the terms vary depending on the REIT and may be very limited—only a small percentage of shares may be redeemed each year, and/or the price may be below the purchase price or current estimated value. Investors must be prepared to hold their shares for as long as eight years, or until a liquidity event occurs.

Valuation Issues

The shares of a nontraded REIT are difficult to value precisely. Often, the only way to value the shares is through an expert appraisal of its underlying real estate holdings. For this reason, FINRA has special rules about how REITs may be presented on client account statements.

If the REIT’s annual report includes an estimated value of its shares, then the firm must include this information on the client’s account statement unless it is either outdated (more than 18 months old) or the firm has reason to believe that the estimate is inaccurate. The account statement must identify the source of the estimate and how it was developed. The statement must also explain that REITs are generally illiquid securities and the investor will not necessarily receive the estimated value if he wants to sell his shares.

A client account statement that does not include an estimated value of a REIT’s shares must state that REITs are generally illiquid, that the value of the securities may differ from their purchase price and, if applicable, that no accurate valuations are available.

Most nontraded REITs are currently issued at a nominal price of $10 per share. Annual reports may show this value for many years. FINRA has proposed a new rule that would require these programs to deduct the cost of fees from these valuations and make other changes in the way the valuations are calculated.


The illiquid nature of nontraded REITs means that they are not suitable for short-term investors. Registered representatives should always inform their clients that their capital will be locked up for many years and their shares difficult to value. Generally, only a small portion of an investor’s portfolio—usually no more than 10%—should be invested in nontraded REITs or other illiquid investments such as limited partnerships. Massachusetts and some other states have incorporated this limit into their regulations.

Investors in nontraded REITs must receive copies of the prospectus, along with any other relevant disclosure documents. These documents will explain the nature of the assets or projects in which the REIT invests along with its risks.

Thanks for spending time with us. We hope you found it worthwhile.

—Securities Training Corporation

There are a number of important regulatory issues concerning sales practices associated with municipal fund securities and, therefore, 529 plans. The cornerstone of the securities industry is the principle that brokers, dealers, and municipal securities dealers conduct their business fairly with all persons and not engage in a deceptive, dishonest, or unfair practice. (The MSRB’s Rule G-17 is at the core of its customer protection rule.) This simple statement contains the underlying premise that sales activities may not mislead the public and that errors of omission or misstatements of fact are contrary to fair and equitable trade practices. Therefore, if a customer purchasing a Section 529 plan can benefit from an unlimited state tax benefit, then not informing the client of this fact violates MSRB and FINRA rules.

In fact, the MSRB stated in 2006 that dealers have an affirmative obligation to make the following disclosures to any client purchasing an out-of-state 529 plan.

• Depending on the state in which either the client or the plan’s beneficiary resides, favorable state tax treatment may only be available only if the client invests in his home state’s 529 plan.

• Potential state tax benefits are one of many factors that the client should consider in making a decision.

• The client should consult with his financial or tax adviser about his particular situation to determine the advantages and limitations of investing in his home state’s 529 plan. He may also want to contact his home state and other states to learn more about their plans.

One of the ways of fulfilling this “out-of-state disclosure obligation” is to include these disclosures in the plan’s official statement (program disclosure document). If this is the case, however, they may not be buried in the fine print—they must be included in a way that they are “reasonably likely to be noted by the investor.” The client must also receive the official statement no later than the time the sale takes place.

If these disclosures are not included in the official statement, then the dealer must provide them separately either before or at the time of the transaction.

In its guidelines concerning communications with the public, FINRA states that member communications must be clear and not overly complex or technical in order to avoid confusion. In such cases, a lengthy, highly technical explanation may be more confusing than shorter, less technical information. Sales material and advertising should also take into account the audience who receives the information. Different levels of explanation may be necessary for varied categories of clients, and it may be difficult to limit the audience to a particular piece of information. When using promotional material, it is important to state the potential tax implications associated with a particular product. General references to tax-exempt or tax-free may not be sufficient unless the product is in fact both federal and state tax-free. An indication should be made as to which taxes apply, if any, or which taxes do not apply. A registered representative should act prudently when recommending a particular 529 savings plan to an investor. Consideration should be given as to why the investor is purchasing the plan, when the funds will be needed, the risk of loss of principal, and market performance failing to meet expectations. A determination should be made as to the ultimate goal, i.e., how much money needs to be invested in order to achieve the desired result and whether the individual can sustain the program over the necessary time frame. The commissions that the registered representative expects to earn from the sale should not be part of this analysis.

Thanks for spending time with us. We hope you found it worthwhile.

—Securities Training Corporation


Hi Everyone,

FINRA Rule 4370Business Continuity Plans and Emergency Contact Information, is an item that can appear on the Series 24 and Series 99. We thought we would provide an overview here for you today.

The essence of this proactive rule is preparing for unpredictable events—requiring that a member implement and maintain a written and updated business continuity plan identifying reasonable procedures the member will take in responding to a significant business disruption (SBD) in meeting its obligation to customers, and communicating these procedures to these customers. The plan could include a statement that the member intends to stay in business, or discontinue business temporarily and for how long, or even go out of business permanently. A member stating in its plan that it might need to go out of business would be required to disclose to customers how it would afford them prompt access to their funds and securities under those circumstances.

Each member needs to conduct its own risk exposure analysis to determine specific vulnerability points not only within itself but also within firms it depends on to function, e.g., software suppliers and data backup. A senior management official who is also a registered principal must approve the plan. Procedures must be updated whenever there is a material change in the member’s business. There is also a requirement for an annual review.

The BCP must be tailored to the nature of its business—no one template fits all. The plan should take into account such considerations as size (one building with few employees or numerous buildings spread out over many states with a large number of employees?), location (hurricane or earthquake country?), type of business (introducing firm only or full-service?), and the businesses with which it has ongoing commercial relationships (e.g., counter-parties, banks, and vendors).


Disclosing how a firm intends to meet an emergency is an important requirement of the rule. Customers must be provided with enough information to make informed decisions about whether they want to do business with a firm. “Is this a firm I am comfortable enough with to handle my funds and securities now and in an emergency?”

Required Elements of the Plan

While the components of a BCP are flexible, there are 10 critical elements that must be addressed. If a member feels an element is not applicable to its business model, it need not address that category; however, it must document the rationale for not including it. Members that rely on another entity to address any of these elements are required to supply the details of this arrangement.

  1. Data Backup and Recovery—Hardcopy and Electronic
  2. All Mission Critical Systems
  3. Financial and Operational Assessments
  4. Alternate Communications between Customers and the Member
  5. Alternate Communications between the Member and Its Employees
  6. Alternate Physical Location of Employees
  7. Critical Business Constituent, Bank, and Counter-Party Impact
  8. Regulatory Reporting
  9. Communications with Regulators
  10. Assurance of Customers’ Access to Funds and Securities in the Event that the Member Is Unable to Continue Its Business


While Rule 4370 does not specifically require that a business plan be tested, it is the final step in assuring continuity of service to customers. It is through testing that we determine whether our plan is practical or theoretical, whether we are addressing our vulnerability to disasters—man-made or natural—or simply adding pages to our compliance manual. You do not want to find out during an emergency that your backup systems are not backing you up, or your servers are unable to service your needs.

Thanks for spending time with us. We hope you found it worthwhile.

—Securities Training Corporation

Taking a regulatory exam can be a stressful experience. However, if you know what to expect beforehand, it will not be a traumatic one.

The FINRA Regulatory Examination Committee has zero tolerance for cheating. It goes to great lengths to prevent it, and has fined and suspended associated persons caught cheating from working with a FINRA member.

When you arrive at the examination center, you will be asked for up-to-date, government-issued picture identification such as a driver’s license or passport. A locker will be provided for coats, purses, phones, and other belongings. The only possessions permitted in the testing room are identification and locker key.

You will be fingerprinted, scanned with a metal detector, and instructed to empty your pockets. When you enter the testing room, you’ll be provided with a basic calculator that does basic addition, subtraction, multiplication, division but no exponent capability, as well as writing materials. The materials are usually a fine-tip, dry-erase marker and some form of dry-erase board. It’s usually three sheets of the dry-erase paper on a key ring, so you may need to flip back and forth if you make notes.

People will be taking different types of exams. While the room will be quiet, some centers supply headphones for those who are easily distracted. Centers usually videotape their testing room, so expect to see cameras.

Before starting, you will be given a tutorial on how the system works, how to choose answers, and how to grade your exam. A few students have commented that the fonts and feel of the software seem dated but, aesthetics aside, the functions (e.g., mark for review) will be similar to your STC Practice Exams.

You are allowed restroom breaks during the exam. However, the exam timer does not stop. If you finish all the questions early, you are allowed to leave, although the time you save does not carry over to an afternoon session. Each time you take a break, you will be required to place your fingers in the scan and show identification.

There is a maximum 60-minute break between the two parts of the Series 7 Examination. During this time, you are permitted to leave the building. Most students don’t wander far, often returning before the time is up. The two parts are like two separate exams. You can’t go back to Part One to revisit the questions, and you don’t learn your final score until you complete the second part.

After you choose to grade the exam, it takes approximately 30 to 40 seconds for the computer screen to display your score. As you leave the testing room, the center will collect the calculator and writing materials and will give you a paper copy of your grade—hopefully a passing one.

For more information, go to https://www.prometric.com/en-us/Pages/home.aspx

Thanks for spending time with us. We hope you found it worthwhile.

—Securities Training Corporation

In July 2012, the new FINRA Suitability Rule 2111 became the standard for all broker-dealers to adhere to. Suitability is a large component of the Series 7 Examination and may also be covered on the Series 6, 10, 24, and 26 Examinations. With this in mind, let’s review FINRA Rule 2111. The rule is divided into parts A (retail investors) and B (institutional investors). We will discuss Part A only as it relates to your regulatory examination.

The rule states: “A member or an associated person must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile. A customer’s investment profile includes, but is not limited to,

  1. The customer’s age
  2. Other investments
  3. Financial situation and needs
  4. Tax status
  5. Investment objectives
  6. Investment experience
  7. Investment time horizon
  8. Liquidity needs
  9. Risk tolerance
  10. Any other information the customer may disclose to the member or associated person in connection with such recommendation”


Clearly, the Rule 2111 list is long and specific. However, since FINRA acknowledges that some firms currently ask customers for this information without using these specific terms, the rule does not dictate the use of specific terminology or a method for obtaining this information.


If a firm decides to exclude any of these factors as irrelevant, it needs to explain in writing why it is not requesting the information. (Age, for example, would not be relevant for clients that are entities.)


FINRA confirms that nothing in the rule changes the long-standing practice that suitability becomes an issue as soon as the firm or one of its associated personnel makes a recommendation.

FINRA spells out several guiding principles for determining whether a communication is a recommendation.

  • Content, context, and presentation are important—e.g., would it be reasonably viewed as a suggestion to take or not take action?
  • The more individually tailored a communication is, the more likely it will be classified as a recommendation.
  • Although a series of actions that, considered individually, may not be considered a recommendation, may collectively be viewed as one.
  • A recommendation does not need to come from a live person—it may be computer-generated.

FINRA also notes that a recommendation is not suitable just because the client agreed to act upon it, and that a firm (and its personnel) may not avoid liability for unsuitable investments by using disclaimers.

Rule 2011 identifies three main suitability obligations: reasonable-basis, customer-specific, and quantitative suitability. Each one must be addressed with regard to recommendations to clients.

Reasonable-Basis Suitability: Is it appropriate for anyone?  According to FINRA, “Reasonable-basis suitability requires a broker to have a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors.”

In general, the amount of diligence that a firm or its associated personnel is required to undertake will vary depending on the complexity and potential risks of the investment product or strategy, and how familiar the firm or its personnel are with the product or strategy. The firm and its personnel must understand the potential risks and rewards associated with recommendations made to clients.

Customer-Specific Suitability: Is it appropriate for that client? FINRA states “Customer-specific suitability requires that a broker have a reasonable basis to believe that the recommendation is suitable for a particular customer based on that customer’s investment profile. …. The new rule requires a broker to attempt to obtain and analyze a broad array of customer-specific factors.”

Quantitative Suitability:  Are you trading too much? The third and final obligation under the new suitability rules addresses discretion. It is called quantitative suitability and requires a registered representative “who has actual or de facto control over a customer account to have a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer when taken together in light of the customer’s investment profile.”

While FINRA does not state how many questions may appear on a given topic, we believe that you should be prepared to answer a number of questions covering the various aspects of suitability.

Thanks for spending time with us. We hope you found it worthwhile.

—Securities Training Corporation

Following FINRA’s changes to the Series 7 Content Outline in late 2011, exchange-traded funds (ETFs) became a topic that is a potential test item students may see on their exam. You can read more about ETFs in our Study Manual, but let’s visit them briefly here.

Exchange-traded funds are investment companies, either open-end or unit investment trusts, that differ from mutual funds in the way they are issued, traded, and redeemed. Investors can buy ETFs that track essentially every sector of the equities markets, as well as ones for fixed-income securities, commodities, currencies, metals, and hedge funds. Most recently, ETFs have been created that are leveraged 2 or 3 times to an index, as well as ones that are leveraged to the inverse of an index. We will discuss leveraged and inverse ETFs and the concerns they raise in a separate blog. For now, we will focus on traditional ones and the ways they differ from mutual funds.

One disadvantage of a mutual fund is that there is no secondary market for its shares. Shares can be redeemed only by the mutual fund company. Since shares must be redeemed at the fund’s closing net asset value (forward pricing), the investor does not know the full redemption value of the shares until the market closes for that day.

The inconvenience of forward pricing may be apparent especially in circumstances where an investor is engaging in a same-day substitution, selling a mutual fund with the intention of using the proceeds for the purchase of another securities product. If the full redemption price of the mutual fund is not known, it is difficult to invest in another product simultaneously with the sale of the fund. This problem is most critical in a tax-deferred account where the customer may have limited funds to invest without making additional contributions.

ETFs do not have forward pricing. They trade in the secondary market and can be purchased or sold anytime throughout the trading day. Therefore, the liquidation value is known immediately and the investor can reinvest the proceeds without delay. It is easy to move in and out of most ETF positions. However, this ease of purchasing and selling ETF shares can cause inexperienced individuals to make inappropriate trading decisions. They may find themselves entering and exiting a position more frequently than necessary, generating excessive commissions that outweigh any gains they may have realized.

There are management fees and administrative costs associated with both mutual funds and ETFs. These fees and costs increase the expense ratios of both. Active management results in higher management fees and administrative costs. Actively managed mutual funds have the highest expense ratios. Passively managed index mutual funds have expense ratios that are lower than actively managed funds because management fees and administrative costs are lower.

Since mutual funds are purchased and redeemed directly from the issuer, they may not be sold short. Selling short and rapidly covering is attractive to the short-term trader, and also to a money manager who wants to take short positions in overvalued sectors to hedge long bets made on stocks. Since ETFs may be sold short, they have an advantage over mutual funds.

Mutual funds may not be purchased on margin. ETFs may, and, in the hands of experienced investors, can enhance returns. If the wrong investment decisions are made, however, margin can amplify losses and have a negative impact on an investor’s portfolio. Consequently, the use of margin may be suitable for some investors but not for others.

An actively managed fund will produce capital gains as its managers buy and sell stocks, which the fund must pass on to its shareholders once each year. This means that investors may incur capital gains taxes even if the net asset value of the mutual fund has actually declined in value or remained the same.

As with index funds, ETFs tend to minimize capital gains taxes since their turnover is usually low. ETFs can be redeemed the same way, minimizing the purchase and sale of securities within the fund. Traditional ETFs will remove securities and replace them only when the underlying index changes and the fund must rebalance its holdings.

While FINRA does not state how many questions may appear on a given topic, we believe that you should be prepared to answer a small number of questions about ETFs.

Thanks for spending time with us. We hope you found it worthwhile.

—Securities Training Corporation

Recently, U.S. equity markets updated their market-wide circuit breakers rule. For those unfamiliar with circuit breakers, they are used to protect investors from a huge decline in overall stock prices.

STC has written a summary of the updated rules.

The changes in the circuit breaker rules, which are designed to address extraordinary volatility across securities markets, include (1) replacing the DJIA with the S&P 500® Index as the reference index, (2) recalculating the values of the triggers on a daily basis rather than quarterly, (3) reducing the market decline trigger percentages, (4) shortening the length of the trading halts associated with each market decline level, and (5) modifying the times when a trading halt may be triggered.

 Trigger Value Time Action (all times Eastern Time)

 Level 1: 7% decline between 9:30 a.m. and 3:25 p.m.—15 minute trading halt

Level 2: 13% decline between 9:30 a.m. and 3:25 p.m.—15 minute trading halt

Level 3: 20% decline anytime trading halts for the remainder of the day

 At or after 3:25 p.m., trading will continue unless there is a Level 3 halt.

The Dow Jones Industrial Average (DJIA) was used as the benchmark for the old circuit breaker rule. It’s actually one of the oldest financial benchmarks in the world, created at the end of the Nineteenth Century. It was named after the persons who created it, Charles Dow and Edward Jones. Their intent was to create an overview of U.S. stock prices. There was actually a transportation index created before the industrial index, creatively called the Dow Jones Transportation Index.

The industrial index was composed primarily of industrial companies. Dow and Jones may have been financial pioneers, but they lacked pizazz when naming things. Anyway, the index originally had companies dealing with rubber, coal, electricity, and natural gas (i.e., industrials). The index is now comprised of industrial juggernauts such as Disney, Microsoft, and Bank of America, which aren’t really industrial companies so the name really doesn’t fit anymore. Nowadays, the Dow Jones Industrial Average is really 30 of the best companies in the U.S., regardless of the industry they’re in.

The most important aspect of the DJIA is how the value is calculated. It is price-weighted. To determine the value, the prices of all 30 companies are added and the result is then divided by the number of companies in the index.* The denominator, also known as the Dow Divisor, started off as the number of companies in the index, which created the average** that most people are familiar with. Over the years, the Dow Divisor needed to be updated for spinoffs, stock splits, and stock dividends. We’ll skip the adjustment calculation, but today the divisor is about 0.13, which means the index value is greater than the sum of the prices of the stocks. It doesn’t look much like a typical average.

The other issue with the Dow (and really any price-weighted index) is that it doesn’t reflect changes in total value or market capitalization of the index. Let’s simplify things a bit and say the DJIA only has two stocks. Company A is relatively small, has only100 shares outstanding, and a market value of $100. Company B has 1,000,000 shares outstanding and a market value of $10. Company A has a market cap of $10,000 (100 shares x $100) and Company B’s market cap is $10 million (1 million shares x $10). Economically speaking, Company B is contributing much more to the total value of the U.S. stock market. However, changes in Company A’s price will have a larger effect on the index because one of its shares is worth 10 times as much as Company B’s ($100 compared to $10). In short, price-weighted indexes (e.g., DJIA) make no adjustment for the total value of a company. They simply consider the value of a single share.

*Formula form:

(Σ (Stock Price))/(Number of Companies in the Index)


(Σ (Stock Price))/(Dow Divisor)

**It’s officially an arithmetic average in case the math police are reading this.

The flaw in a price-weighting index became a bigger issue as U.S. equity markets became more valuable. Industry analysts began using a new index valuation method—market-value indexing. Market value (capitalization-weighted) indexes use a weighted average to calculate the index’s value. To derive the value of a market-weighted index, add the number of shares outstanding multiplied by the market price of the shares for each company in the index and divide by the total number of shares for each company in the index.***  I’ll admit that’s a bit of a simplification. In reality, the denominator, the number of shares, will need to be adjusted for spinoffs, stock splits, and stock dividends, much like the Dow Divisor. By taking a weighted approach, price-weighted indexes tend to more accurately represent the total value of the shares in the index. Small companies no longer have a large effect on the value of the index, unlike the DJIA.

***Formula form:

(Σ (Price x Quantity))/(Σ Number of Shares)


(Σ (Price x Quantity))/Divisor

There are quite a few market-weighted indexes. In fact, the Dow is somewhat unique as a price-weighted index. The circuit breaker rules now use the S&P 500, which tracks some of the 500 largest market cap stocks in the U.S. The specific companies that make up the index are chosen by a committee. The methodology can be read about here. While the S&P is a broader index than the Dow, its goal is the same—to provide a summary of the U.S. stock market. The S&P 500 Index is also calculated a bit differently than described in the previous paragraph. Instead of using the total number of shares issued, the S&P uses only the number of shares freely available (public float), which is known as float-adjusted weighting. In finance, creativity is never wasted on naming things. The difference is sometimes significant, but won’t really change the basic understanding of market value indexing.

Thanks for spending time with us. We hope you found it worthwhile.

—Securities Training Corporation

Tricky Question Episode 1

There are always some practice exam questions that students bring to our attention. These questions are generally confusing to them, even after reading the explanation. In this and upcoming posts, we’ll try to shed light on the more difficult exam questions we’ve written. If you have suggestions for future questions, let us know. Today we’re discussing a favorite from our Series 7 Course.

An investor who wishes to hedge a portfolio of preferred stocks would buy which TWO of the following options?

I.            Yield-based option calls

II.            Yield-based option puts

III.            Interest-rate option calls

IV.            Interest-rate option puts

A. I and III
B. I and IV
C. II and III
D. II and IV

The person who came up with Roman numeral questions deserves a spot in the test-writing hall of fame. This type of question is a very effective way to test your full understanding of a concept within the confines of a single question. Many students, however, dislike them with a passion.

The best way to approach them is to ignore the choices (a), (b), (c), and (d) at first and to focus on the Roman numerals (I), (II), (III), and (IV). Think about which numerals you feel may be correct and which ones may be incorrect. From there, you can usually eliminate choices and make a better decision or, in some cases, a better guess. For example, if you know that (I) is correct in the above question, you can eliminate choices (c) and (d), since neither choice includes (I).

As you analyze the stem of the question, you see that it states that an investor wishes to hedge preferred stock. This question requires that you know how preferred stock is priced—specifically, that its price is derived mostly from interest rates, just as with bonds. In general, preferred stock and bonds are much more alike than preferred and common stock. Preferred and bonds both pay fixed income. Both have a higher priority in the event of liquidation, and both prices move in the opposite direction of interest rates.

Remember, if interest rates are rising, preferred (or bond) prices are declining and vice versa. If an investor owns preferred stock (or bonds), she is concerned that the price of her shares will decline and interest rates will rise. To summarize, this investor needs to protect against (1) preferred stock/bond prices declining and (2) interest rates rising.

There are two types of options that will help protect the investor. The complicated part in answering the question is knowing that interest-rate options are price-based and yield options are yield-based. They’re sort of opposites of one another. Interest-rate options are really just bond options.* If you buy an interest-rate call, upon exercise you’re buying a Treasury bond. This is exactly how a stock option works. So, if you think the price of Treasury bonds will rise, buying an interest-rate call is a profitable strategy. This is why they’re called price-based options. In the question, though, we’re trying to profit (hedge against) when the price is falling, so we need to buy an interest-rate put option.** Now we’re closing in. Buying interest-rate puts is choice (IV), thereby eliminating choices (a) and (c).

*Which is why the term interest-rate options is a misleading name. They should’ve named them bond options.

**Buying options is typically the best hedge. Shorting options, while fun, is not a good hedge since the trader loses control if the option is exercised.

What about numerals (I) and (II), the yield-based options? Yield-based options are based on the yield. As a reminder, bond yields move in the same direction as interest rates. Investors who think yields or interest rates will rise should buy yield-based calls. This is why yield-based options are based on interest rates and yields.

How does an investor exercise these options? In theory, someone who buys a yield-based call, and then exercises it, would buy the yield. But, you can’t really do that. Those yields don’t exist tangibly like a bond exists. They’re just numbers.*** These options have some existential issues.

To work around the small issue of yields not existing, the exchanges have made them cash-settled. Cash-settled options are a lot like gambling. The buyer of a yield-based call, instead of buying anything, will simply receive money from the seller if yields rise. The amount he gets is simply the difference in the actual yield and the strike yield (i.e., the in-the-money amount).

Cash settlement has been a Pandora’s Box for financial markets, leading to things like this. Back to the question at hand, we need to hedge against interest rates (or yields) rising. So, the best option would be buying a yield-based call—numerals (I) and (IV) are correct, which is choice B. One down, 249 questions left to answer correctly for the regulatory examination.

*** I realize Treasury bonds are book-entry securities and aren’t really tangible either. In any event, the bond is much easier to buy conceptually than the yield is.

Thanks for reading; we hope you found it worthwhile.

-Securities Training Corporation

What is the purpose of a practice exam and how should you use it?

Practice exams are designed to help you understand concepts that are tested on the real thing. Many of these exams have a reputation for being challenging and often poorly worded. Your goal should be to walk into the real exam understanding concepts so well that no matter how a question is worded, you can answer it simply because you understand the concept behind the question. When you first begin taking practice exams, they should:

  1. Prepare you to apply the knowledge you learned reading the study materials
  2. Highlight the areas you have read but do not understand
  3. Improve your ability to focus on relevant parts of a question and discard any details designed to distract you from the right answer.

So what is the key to success with taking the practice exams?

The best recommendation is to take a practice exam in a quiet setting from beginning to end; preferably with no breaks or distractions. Recreate the real exam experience as much as you can. Once you complete the exam and receive your score review the diagnostic breakdowns that we provide with each exam. We show you where your weak areas are in that particular exam.

The next step is to study those week areas in your study manual or in the class notes that you would have from a class that you may have taken already. The most important aspect of this is to make sure you don’t just jump to a brand new exam and try again. If you don’t study your weak areas in between tests you won’t improve your knowledge of a concept and you will continue to perform poorly. As mentioned in a previous blog, avoid retaking the same exam over and over again and believing the increasing scores reflect actual knowledge. In reality, it only demonstrates the fact that a person has memorized this particular exam.

Periodically we talk to people who have taken 5 or 6 exams and are consistently failing them. These people are frustrated and worried that they may fail the real exam since “I just don’t seem to be getting it.” The first question we always ask is about their exam taking habits. Consistently we will hear that they have been reading the explanations to the questions, but nothing else. This means they don’t really understand what areas they aren’t doing well in. They may think they have an understanding, however, their consistent failures prove otherwise. The lesson here is simple. Study in between each exam, based on the diagnostics in our tests. You should see your scores in those weak areas improve with each exam. If after doing this for 2-3 exams you don’t seem to be getting any better, you should call us at our Instructor Hotline for some more support and guidance. That number is 1-800-STC-EXAM.

Thanks for reading; we hope you found it worthwhile.

-Securities Training Corporation

Many times we are asked, “What’s the best way to prepare for my exam?”

Not surprisingly, the starting point of any study program is to read the book first, then complete all the practice exams and, when possible, attend a class. However, we understand that your schedule may not allow for every step, so we modify our advice for those with industry experience. If you have spent years working in securities, you probably don’t need the same preparation that someone who is fresh out of school, without a financial background, does.

We recommend that you briefly review each chapter that covers information you have practical experience with. You should be able to determine quickly areas in which you have no experience and material that is unfamiliar. Once you do this, your study schedule will narrow to what is new.

Next, make sure you have a study calendar. We provide them for those who use our materials. However, it’s easy to make your own. The idea behind a calendar is to organize and discipline yourself, map your progress, and make the best use of your time.

Also, avoid marathon study sessions. You don’t want to read for three hours straight. Remember, you’re reading a textbook, not a page-turning novel. Try reading for half an hour and then take a brief break, 10 to15 minutes, before going back to the material.

Regardless of which regulatory exam you’re taking, there’s always that element of reading material you don’t care about but you need to know to pass the exam. It should come as no surprise that some information on the regulatory exam is less than exciting. Break your reading into small sections so it is more manageable. By tackling it in small pieces, the information is much easier to wrestle with and digest and not such a bear. Pun intended.

We’ll talk about how to approach practice exams in our next blog post.

Thanks for reading. We hope you found the advice worthwhile.

-Securities Training Corporation