Series 7 Exam Questions & Answers (SIA Instructor Verified)

The SEC handles civil and administrative actions, often against those involved with insider trading. In a civil case involving insider trading, the maximum penalties tend to be no higher than three times (treble) the damages involved. For other administrative actions, the SEC and FINRA set no limits on how high the maximum monetary fine may be set against those who violate the rules and regulations of the securities industry.

The convertible bond’s market price is affected by rising interest rates as are other bonds. However, if the underlying stock is also rising, that will tend to cancel out the effects of rising interest rates for a convertible bond. After all, whatever the underlying shares to which it converts are worth determines the market price of the bond, regardless of interest rates. If the bond converts to, say, 20 shares of stock, it has to be worth something at least close to what those 20 shares are now worth.

Let’s say ABC is trading at $50 per share and the option in the question is an ABC Apr 50 call @3.  In this case, the buyer pays the seller $300 per contract, or $3 per share. That also means the seller starts out winning while the buyer starts out losing. How  much? Three dollars per share.

If the stock rises to $51, the seller is still winning. Same thing at $52. What about at $53? At this point, the call option must be worth at least $3 a share. Neither the seller nor the buyer is winning, as this is the “breakeven” point. That means the seller could buy the contract back, and the buyer could sell his contract, for exactly $3—no gain or loss.

So, the seller starts out winning $3 and will only lose money if the stock rises by more than $3. The buyer starts out losing $3 and will only win money if the stock rises by more than $3. If the stock moves exactly $3, both are at the breakeven point, which is the strike price plus the premium for call options.

The balance sheet is often described as a “snapshot of the company’s financial condition,” which is a great way to define it. A balance sheet shows assets and liabilities as of the time the report is compiled. The higher the value of assets relative to the liabilities, the higher the net worth/stockholders’ equity the company has. The balance sheet does not show what happened over a reporting period. For that, we look to the income statement, which shows revenue—the top line—minus all expenses to arrive at the bottom line—net income after tax. To see if a business was profitable over a financial quarter or fiscal year, the income statement is consulted by fundamental analysts. The income statement is where profits and profit margins are expressed.

Systematic risks affect securities system-wide, whereas unsystematic risks affect only certain market sectors or companies at any given time. Diversification spreads unsystematic risks among many issuers and industry groups. It has no effect on the first type, systematic risk. Market risk is a type of systematic risk that affects securities across the board. Market risk is the risk that an investment will lose value due to an overall market decline. No one can predict the next war, pandemic, or banking crisis, but when events like that take place, they can have a devastating effect on the overall market for stocks and bonds. 

Whether they panic because of war, weather, or whatever, when investors panic, securities prices drop. So, even if an investor holds shares in several solid companies, when securities holders all try to sell at the same time, the market prices of securities across the board drop. 

Unfortunately, diversification does not help in this case. If the overall market is going down, it does not matter how many different stocks or bonds we own. They are all going down. That is why we would have to bet against the overall market to protect against market risk. The S&P 500 index is generally used to represent the overall stock market. Therefore, investors use options, futures, and ETFs based on such indexes to bet the overall market will drop. 

While diversification does not reduce the systematic risks we just examined, it does reduce the unsystematic risks we will look at now. Unlike systematic risk, unsystematic risk applies to a specific issuer or industry space as opposed to the overall market. For instance, the risk that the EPA will increase regulations on the automobile industry is not system-wide. Rather, it affects only a few issuers and industries and therefore represents an unsystematic risk. 

Diversifying a portfolio reduces these specific risks by spreading them among stocks of different issuers operating in different sectors. A diversified stock portfolio holds securities in different issuers that operate in different industry spaces. Microsoft, Toyota, Starbucks, and Wells Fargo operate in unrelated industries. Therefore, the portfolio containing them is more diversified than a portfolio holding positions in Starbucks, McDonald’s, Cheesecake Factory, and Dunkin’ Donuts. These four companies are all in the same industry space—the restaurant space, and so, if the restaurant group declined, the portfolio made up of these would likely drop more than a diversified portfolio would.

When completing Form U4, the applicant must disclose any felony conviction and any charge of a felony violation, no matter how long ago it occurred. No matter how minor—or serious—the felony may seem, it is treated as a felony, whether for theft, burglary, rape, or homicide. After 10 years, an individual with a homicide conviction would not be precluded from associating with a member firm under FINRA rules based solely on that. Would a broker-dealer hire the individual? That is a different question, of course, and not one that can be answered across-the-board. Some firms may view a homicide conviction with less concern than they would view a conviction for armed robbery or embezzlement. Others may choose not to hire convicted felons, period.

If the investor owns no long position in ABC, this represents a “naked call.” As with someone who sells stock short, this investor profits if the market price of ABC drops and loses if the market price rises. Because the maximum market price is unlimited, so is the potential loss. The investor in the question you cite collects $300 to take on the obligation to sell 100 shares of ABC common stock for $55 a share. How much will the investor pay for those 100 shares when/if the contract is exercised?

That is unknown/unlimited, as it is for a short seller who may have to buy the stock in a hurry at whatever the market price happens to be. Remember that writing naked calls and selling stock short both lead to limited gains and unlimited losses. Buying calls and buying stock, on the other hand, are associated with limited losses and unlimited gains.

If the investor owned the underlying stock as you suggest the investor’s maximum loss would be calculated as the difference between what the investor paid to purchase the shares of ABC minus the premium received for selling the 55 call. IF the investor purchased ABC at $52 and sold the 55 call for a premium of $3 the investor’s maximum loss would be $49, calculated as follows: $52-$3 =$49. The investor only received partial protection by employing a covered call strategy. ABC could fall to zero and the investor would suffer their maximum loss of $49 per share. Our videos have entire sections dedicated to showing students how to master option hedging. We provide step by step instructions detailing exactly how to set up these questions so they are very easy to understand.

The Securities Act of 1933 focuses on the offering of securities to public investors, requiring issuers to register their offerings with the SEC before even trying to sell their securities to the public. Because of this law investors must be provided with full disclosure of everything they might need to know about the company issuing the securities. A typical path for a technology company is to raise various rounds of venture capital investments, which are exempt transactions under the Securities Act of 1933. If the company hits its financial targets, it may choose to go public. At that point, it will contract with an underwriter and register the IPO with the Securities and Exchange Commission.

When the offering is completed, the stock starts trading on the secondary market, and the company becomes a reporting company under the Securities Exchange Act of 1934. That means at a minimum the issuer will file three quarterly and one annual report with the SEC going forward. The quarterly reports are known as 10Qs and the annual report is known as the 10K. 

Keep in mind that The Securities Act of 1933 regulates the primary market. This consists exclusively of issuer to investor transactions. It is only concerned with full and fair disclosure. 

The Securities and Exchange Act of 1934 regulates the secondary market. Everything that takes place after the stock has become public. It regulates investor to investor transactions. And of course It created the Securities and Exchange Commission as the ultimate securities industry regulator. 

Once the number of annuity units has been determined, that number is fixed and, so, for example, every month an annuitant would be paid the value of 101 annuity units.

What is the monthly value of an annuity unit? That depends on the investment performance of the subaccounts compared to the expectation of performance known as AIR, or assumed interest rate.

If the returns are higher than the assumed rate, the units increase in value. If the account returns are exactly as expected, the unit value remains the same. And, if the account returns are lower than expected, the unit value drops from that it held in the previous month. 

It is all based on the assumed interest rate (AIR) —typically 3, 4, or 5%. If the AIR is set at 5%, the subaccount investments are expected to grow each month at an annualized rate of 5%. If the account has a 6% annualized rate of return one month, the payout increases. If the account grows at the anticipated 5% rate of return during the next month, that month’s payout remains the same. And, if the account has only a 4% rate of return during the next month, the payout will decrease.

If the AIR is 5%, here is how it might work:

When the account receives a 7% return, the account increases. Then, when it has only a 6% return in the following month, that is 6% of a larger account and is 1% more than expected. 

Thus, if the actual return is larger, so is the monthly payout. If it is smaller, so is the payout. If the actual return is the same as the AIR, the payout stays the same.

Yield represents the income an investor receives as a percentage of either market value or of the purchase price of the investor’s shares. For example, if an investor buys $10,000 worth of the ABC equity income fund and receives dividend distributions of $500, that investor’s yield is 5%.

Whereas yield is always a positive number, total return can be positive or negative. Total return includes both the income received by the investor and the increase or decrease in market value the investment experiences. For example, if the investor in the ABC equity income fund also receives a capital gains distribution of $200, that is factored into the total return, as is the increase or decrease in market value of the investor’s investment. If the investment has dropped to $9,200, the total return is negative. We add $500 to $200 but subtract $800 for the market decline. The investor is down $100 on a $10,000 investment, resulting in a total return of -1%.

Securities regulators insist that agents do not try to conceal a fund’s negative total performance by quoting only its yield. Yield is always a positive number, as some amount of money is received by investors, which is then divided by the NAV. Total return, on the other hand, can be positive or negative. Therefore, securities agents must not quote yield without also quoting total return to an investor and clearly explaining the difference.