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Series 7 Sample Question Explanations

1. On Monday, April 8, James Clark has purchased an ABC 7.0% corporate bond. The bond last paid interest on February 1. How many days of accrued interest have will Mr. Clark be required to pay to the seller of the bond?

a) 68

b) 69

c) 70

d) 71

2. The Arlene Art Supply Company imports oil paint from Canada. The company is required to make payments in Canadian dollars. The CFO of Arlene is worried that lower levels of U.S. industrial production may result in a weaker dollar. She wishes to hedge using listed option contracts. Which of the following strategies would you recommend in order to hedge against a weaker U.S. dollar?

a) Buy Canadian dollar calls

b) Buy U.S. dollar calls

c) Buy Canadian dollar puts

d) Buy U.S. dollar puts

3. Which of the following would comprise the greatest risk associated with an oil and gas exploratory drilling program?

a) Depleted reserves

b) Declining oil prices

c) Recapture

d) Dry holes

4. When a broker-dealer is conducting securities transactions for the benefit of a customer, rather than for its own account, it is acting as a(n):

a) Broker

b) Principal

c) Underwriter

d) Dealer

5. Sergio Perez, the business manager of Hulkenburgh, PA, believes inflation rates are going to trend higher, resulting in higher interest rates for the foreseeable future. If Hulkenburgh needs to raise money through an issue of bonds, Mr. Perez would probably seek to issue securities with:

a) Short-term maturities

b) Intermediate-term maturities

c) Long-term maturities

d) Call provisions

(c) This question requires the candidate to apply numerous facts associated with corporate securities to determine the answer:

Corporate bonds use a standard 30-day month and 360-day year
Interest accrues from the last interest payment date, up to, but not including settlement date
Regular-way settlement is three business days for corporate bonds

The customer’s purchase date of Monday, April 8 and will settle three business days later (T+3) on Thursday, April 11. The method of calculating accrued interest would add 30 days of interest for each of the months of February and March (30 + 30 = 60). Additionally, since interest accrues up to, but not including settlement, 10 days of interest have accrued in April. A total of 70 days of interest have accrued.

(a) In this example, the CFO is concerned that the U.S. dollar will decline in value against the Canadian dollar. This is a legitimate concern, since the company will have to make payments for imports from Canada in Canadian dollars. One of the features necessary to correctly answer this question is to realize that listed option contracts for the U.S. dollar do not exist; therefore, any hedge must be based on the foreign currency, in this case, the Canadian dollar. If the CFO is bearish on the U.S. dollar, she is bullish on the Canadian dollar. The best hedge would be to purchase Canadian dollar calls.

(d) An exploratory drilling program attempts to find oil in an area that has no proven reserves. The most significant risk in the program is drilling for oil and finding none. This is known as hitting a dry hole. Depleted reserves and the risk of declining oil prices are features associated with income producing oil wells. Recapture is associated with the sale of a depreciable asset before the end of its IRS-defined life. A portion of the depreciation claimed may be subject to recapture (as ordinary income) and therefore be taxable.

(a) When a broker-dealer purchases or sells securities on behalf of its customer, it is acting in an agency capacity and has acted as a broker. When a broker-dealer buys into inventory, or sells out of inventory, it has acted in a principal capacity (a dealer). An underwriter is a broker-dealer who is facilitating the sale of a new issue in the primary market.

(c) If interest rates are expected to rise over time, issuers will attempt to lock-in rates at current lower levels by issuing securities with long-term maturities. This would be of greater financial advantage than issuing bonds with short-term, or intermediate-term maturities. Call provisions will benefit issuers who expect interest rates to decline over time, affording the issuer the opportunity to call in the issuer and re-issue bonds at a lower rate of interest. Callable bonds generally require a higher coupon rate than non-callable bonds, as such, the bonds described in the question are not likely to include a call provision.