Module 2: Investment Vehicle Characteristics

• Topic 01

  Cash and Cash Equivalents

  85 questions
• Topic 02

  Fixed Income Securities

  74 questions
• Topic 03

  Equity Securities

  80 questions
• Topic 04

  Pooled Investment Vehicles

  93 questions
• Topic 05

  Derivative Securities

  83 questions
• Topic 06

  Alternative Investments

  92 questions
• Topic 07

  Insurance-Based Products

  92 questions

A few questions from this unit, with the answer and a full explanation. The complete bank is available when you start practising.

1. A client has a 6-month investment horizon and needs capital preservation above all else. They are choosing between: a 6-month T-bill, a 6-month CD at an FDIC-insured bank (deposit is $180,000), and a prime money market mutual fund. Rank these from most to least appropriate given the client's objective.

   • A
     Prime MMMF (most appropriate) because it is regulated by Rule 2a-7 and therefore safer than bank CDs
   • B
     Prime MMMF (most appropriate) because it offers instant liquidity and higher yield than T-bills
   • C
     T-bill or bank CD (tied first, most appropriate) — both offer capital preservation with government backing; prime MMMF (least appropriate) — not FDIC insured and could theoretically break the buck
     Correct answer
   • D
     All three are equally appropriate for a capital preservation objective with a 6-month time horizon
   Explanation

   For a 6-month horizon with capital preservation priority: T-bill: Backed by full faith and credit of the U.S. government; purchased and held to maturity = zero default risk, zero price risk (for a 6-month instrument). Bank CD ($180,000): FDIC insured (under $250,000 individual limit); at maturity, the client receives exactly the principal plus stated interest. Both are extremely appropriate. Prime MMMF: Not FDIC insured; NAV historically stable but not guaranteed; the Reserve Primary Fund breaking the buck in 2008 demonstrates real (if rare) principal risk. The yield advantage of the MMMF is not worth the capital preservation risk. For a taxable investor in a high-tax state, the T-bill has an additional advantage: exempt from state and local taxes, improving after-tax yield relative to the CD.

2. How is SEC vs. CFTC jurisdiction over digital assets determined?

   • A
     The CFTC regulates all digital assets except stablecoins, which are under Federal Reserve oversight
   • B
     The SEC and CFTC have reached a formal agreement assigning each asset to one regulator permanently
   • C
     Jurisdiction is determined by the total market capitalisation of the digital asset
   • D
     The SEC has jurisdiction over digital assets that qualify as securities (apply Howey Test); the CFTC has jurisdiction over digital assets that are commodities or underlying assets for futures/derivatives (e.g., Bitcoin, Ether futures)
     Correct answer
   Explanation

   Regulatory jurisdiction over digital assets in the US is fragmented: (1) If a digital asset is a security (Howey Test), the SEC regulates its offering, exchange trading, and adviser management. (2) If a digital asset is a commodity (no identifiable 'efforts of others'), the CFTC regulates futures, options, and derivatives on it. (3) Bitcoin and ETH futures are CFTC-regulated; spot Bitcoin ETFs (approved 2024) are SEC-regulated because ETFs are securities. Many tokens fall into grey areas.

3. What is prepayment risk for mortgage-backed securities (MBS), and when is it most likely to occur?

   • A
     Prepayment risk affects only government-backed (GNMA) MBS; private-label MBS do not have prepayment risk
   • B
     Prepayment risk is the risk that borrowers default on their mortgages; it occurs when interest rates rise and monthly payments become unaffordable
   • C
     Prepayment risk is the risk of slower-than-expected principal repayment; it occurs when interest rates fall because fewer homeowners buy new homes
   • D
     Prepayment risk is the risk that borrowers pay off their mortgages early; it most commonly occurs when interest rates FALL (homeowners refinance), forcing MBS investors to reinvest at lower rates
     Correct answer
   Explanation

   Prepayment risk for MBS: When mortgage borrowers pay off their loans early (through refinancing when rates fall, or selling their homes), the principal is 'passed through' to MBS investors earlier than expected. Why this hurts MBS investors: (1) When rates fall and prepayments accelerate, investors receive principal back when reinvestment opportunities are POOR (because rates are low). (2) The MBS effectively gets 'called away' at par — investors lose the above-market coupon they were earning. (3) The average life of the MBS shortens unexpectedly. Contrast with extension risk: occurs when rates RISE, prepayments slow, and the MBS life extends. Investors are stuck holding below-market yields for longer than expected. Prepayment risk and extension risk are the two sides of MBS-specific risk that make MBS harder to analyse than regular bonds.