Understanding Products and Their Risks

Why it matters on this exam

Forty-four percent. If you are behind on everything, be behind on something else. The outline's own structure tells you how to study it: each product is listed, then a "Knowledge of" block underneath sets out what you must know about it. Work through those blocks rather than reading around the product.

Key concepts

• Equities. Common and preferred stock, rights, warrants and ADRs. The knowledge block is ownership and order of liquidation, limited liability, voting rights, convertibility, and control and restrictions under SEC Rule 144.
• Debt. Treasuries, agency including asset-backed and mortgage-backed, corporates, and municipals split into general obligation and revenue bonds. Money market instruments, CDs, bankers' acceptances and commercial paper sit here too. The knowledge block is maturities, coupon, par, yield, ratings, callable and convertible features, and the relationship between price and interest rate — which is the single most reusable fact in the section.
• The yield ranking. At a discount: yield to call, then yield to maturity, then current yield, then nominal yield. At a premium the order reverses. At par they converge. Knowing the ranking answers a family of questions without arithmetic.
• Options. Puts and calls, equity versus index. Expiration, strike, premium, in and out of the money, covered versus uncovered, American versus European, exercise and assignment, and the Options Disclosure Document. Listed options clear through the OCC.
• Packaged products. Investment companies split into closed-end funds, open-end funds, unit investment trusts and variable contracts. Then the sales-charge machinery: loads, share classes, NAV, breakpoints, rights of accumulation, letters of intent and surrender charges.
• Municipal fund securities — 529 prepaid tuition and savings plans, local government investment pools, ABLE accounts. Owner versus beneficiary, restricted use of assets, tax advantages.
• DPPs, REITs, hedge funds, ETPs. The recurring themes are liquidity and tax treatment: DPPs are unlisted, generally illiquid and pass through tax; REITs avoid double taxation; hedge funds are partnerships with a minimum investment and generally illiquid; ETNs are notes, not funds.
• Risk types. Capital, credit, currency, inflationary or purchasing power, interest rate and reinvestment, liquidity, market or systematic, non-systematic, political, prepayment. Mitigation is diversification, portfolio rebalancing and hedging — and diversification addresses non-systematic risk, not market risk.

Common mistakes

• Answering that diversification reduces market risk. Systematic risk is what remains after diversification; that is what makes it systematic.
• Reading "yield" as one number. Nominal, current, yield to maturity and yield to call are four different figures that only coincide when the bond trades at par.

Worked example

A bond with a 5 percent coupon and a $1,000 par value is priced at $950 (a quote of 95). The nominal yield is fixed at 5 percent. Current yield is 50 divided by 950, about 5.26 percent. Because the bond is at a discount, the investor also collects the $50 discount (5 points) at maturity, so yield to maturity is higher again. The ranking — yield to maturity above current yield above nominal yield — follows from the discount alone, and reverses for a premium bond without any calculation.