Knowledge of Capital Markets

Why it matters on this exam

Twelve items is not many, but this section is almost entirely definitional, which makes it the highest return per hour on the exam. It also supplies the vocabulary that sections 3 and 4 assume you already have.

Key concepts

• The SEC and the SROs. The SEC's definition, jurisdiction and authority; then self-regulatory organisations and what an SRO actually is, with FINRA, the CBOE and the MSRB named in the outline as examples.
• The other regulators. The Treasury and IRS, state regulators such as NASAA, the Federal Reserve, and two insurance schemes that are routinely confused: SIPC protects customers of failed broker-dealers; FDIC insures bank deposits. They are not interchangeable and the exam knows it.
• Market participants. Investors split into accredited, institutional and retail; broker-dealers split into introducing, clearing and prime; then investment advisers, municipal advisors, issuers and underwriters, traders and market makers, custodians and trustees, transfer agents, and the depositories and clearing corporations — the DTCC and the OCC.
• Four markets. Primary is issuance. Secondary is trading between investors, whether on an exchange, over the counter or electronically. The third market is exchange-listed securities traded over the counter. The fourth market is institution to institution, without an intermediary.
• Monetary versus fiscal policy. Monetary policy is the Federal Reserve: open market operations and the interest rate, discount rate and federal funds rate. Fiscal policy is taxation and government spending. The exam wants the distinction and the direction of the effect.
• The business cycle — contraction, trough, expansion, peak — and the indicator types: leading, lagging, coincident and inflation. Then the basic effects on bond and equity markets, and the cyclical, defensive and growth classifications.
• Offerings. Public versus private, IPO versus secondary versus follow-on, best efforts versus firm commitment, shelf registrations, and the offering documents: prospectus, official statement, program disclosure document.

Common mistakes

• Treating SIPC as a guarantee against losses. It protects customers when a broker-dealer fails; it does not insure against a security falling in value.
• Mixing up the third and fourth markets. Third = listed securities traded OTC. Fourth = institution to institution directly.

Worked example

An underwriter agrees to buy an entire issue from the issuer and resell it, taking the risk of any unsold shares. That is a firm commitment, and the underwriter is acting as principal. Under a best efforts arrangement the underwriter acts as agent instead, selling what it can and returning the rest, with the issuer carrying the risk. The exam tests the distinction through who bears the risk, which is also what decides the capacity the firm is acting in.