AIP Investment Products & Financial Instruments 2 — Questions and Answers
Question 1: A callable bond gives the issuer the right to redeem the bond before maturity. How does this feature typically affect the bond's yield compared to a non-callable bond with identical characteristics?
- Callable bonds offer lower yields to compensate for call risk
- Callable bonds offer higher yields to compensate investors for call risk (Correct answer)
- Callable bonds offer the same yield because call risk is negligible
- Callable bonds offer lower yields because they are less risky for investors
Correct answer: Callable bonds offer higher yields to compensate investors for call risk
Callable bonds offer higher yields than comparable non-callable bonds because investors demand compensation for the risk that the bond may be redeemed early, typically when interest rates fall.
Question 2: Which of the following best describes a Real Estate Investment Trust (REIT)?
- A mutual fund that invests exclusively in mortgage-backed securities
- A company that owns, operates, or finances income-producing real estate and distributes at least 90% of taxable income as dividends (Correct answer)
- A government agency that insures real estate loans
- A limited partnership that pools capital to purchase undeveloped land
Correct answer: A company that owns, operates, or finances income-producing real estate and distributes at least 90% of taxable income as dividends
REITs are companies that own income-producing real estate and must distribute at least 90% of taxable income to shareholders as dividends to maintain their tax-advantaged status.
Question 3: An investor purchases a Treasury Inflation-Protected Security (TIPS). As inflation rises, what happens to the principal value of the TIPS?
- The principal decreases to reflect purchasing power loss
- The principal remains fixed but the coupon rate increases
- The principal adjusts upward with inflation, increasing interest payments (Correct answer)
- The coupon rate decreases as the principal rises
Correct answer: The principal adjusts upward with inflation, increasing interest payments
TIPS principal adjusts upward with inflation (as measured by CPI), which in turn increases the dollar amount of each fixed coupon payment, protecting investors from inflation erosion.
Question 4: A structured note that offers 80% participation in S&P 500 gains with full principal protection at maturity is best described as which type of instrument?
- A convertible bond
- A principal-protected note (PPN) (Correct answer)
- A leveraged ETF
- A collateralized debt obligation (CDO)
Correct answer: A principal-protected note (PPN)
A principal-protected note (PPN) guarantees return of principal at maturity while providing partial upside participation in an underlying index, achieved by combining a zero-coupon bond with options.
Question 5: Which statement about exchange-traded funds (ETFs) versus mutual funds is CORRECT?
- ETFs can only be purchased directly from the fund company, not on an exchange
- ETFs are priced once per day at net asset value, just like mutual funds
- ETFs trade on exchanges throughout the day and may trade at a premium or discount to NAV (Correct answer)
- ETFs are always actively managed, while mutual funds can be passive or active
Correct answer: ETFs trade on exchanges throughout the day and may trade at a premium or discount to NAV
Unlike mutual funds that price once daily at NAV, ETFs trade continuously on exchanges and can trade at prices above (premium) or below (discount) their underlying net asset value.
Question 6: A put option with a strike price of $50 on a stock currently trading at $45 is said to be:
- At-the-money
- Out-of-the-money
- In-the-money (Correct answer)
- Deep out-of-the-money
Correct answer: In-the-money
A put option is in-the-money when the stock price is below the strike price; here $45 < $50 means the put has $5 of intrinsic value.
Question 7: Which of the following is a key characteristic of a zero-coupon bond?
- It pays interest monthly but no principal at maturity
- It is issued at par and redeemed at a discount
- It is issued at a deep discount and pays full face value at maturity with no periodic interest (Correct answer)
- It pays variable interest tied to a benchmark rate
Correct answer: It is issued at a deep discount and pays full face value at maturity with no periodic interest
Zero-coupon bonds are issued at a significant discount to face value and pay no periodic interest; the investor's return comes entirely from the appreciation to face value at maturity.
AIP Investment Products & Financial Instruments 2
A callable bond gives the issuer the right to redeem the bond before maturity.
How does this feature typically affect the bond's yield compared to a non-callable bond with identical characteristics?