AIP Investment Products & Financial Instruments 3 — Questions and Answers
Question 1: An investor in a 35% tax bracket receives $1,000 in qualified dividends from a stock investment. Assuming the qualified dividend tax rate is 15%, what is their after-tax income from these dividends?
- $650
- $850 (Correct answer)
- $750
- $900
Correct answer: $850
Qualified dividends are taxed at preferential rates (15% for this investor), so after-tax income = $1,000 × (1 - 0.15) = $850.
Question 2: A collateralized mortgage obligation (CMO) differs from a standard mortgage-backed security (MBS) primarily because CMOs:
- Are backed by commercial mortgages only, while MBS use residential mortgages
- Divide mortgage cash flows into tranches with different prepayment risk and maturities (Correct answer)
- Guarantee principal repayment by the U.S. government
- Offer fixed interest rates regardless of underlying mortgage terms
Correct answer: Divide mortgage cash flows into tranches with different prepayment risk and maturities
CMOs restructure mortgage cash flows into tranches with varying priorities for receiving principal payments, allowing investors to choose tranches matching their prepayment risk tolerance and maturity preferences.
Question 3: Which of the following instruments would provide an investor with the MOST protection against rising interest rates?
- A 30-year fixed-rate bond
- A floating-rate note (FRN) tied to SOFR (Correct answer)
- A long-duration zero-coupon bond
- A 10-year Treasury bond
Correct answer: A floating-rate note (FRN) tied to SOFR
Floating-rate notes reset their coupon payments periodically based on a benchmark rate like SOFR, so as interest rates rise, the coupon increases, maintaining the note's value near par.
Question 4: A hedge fund uses a long/short equity strategy. This strategy involves:
- Buying undervalued stocks and purchasing put options as insurance
- Buying stocks expected to rise and short-selling stocks expected to fall (Correct answer)
- Investing only in stocks with long operating histories and short earnings cycles
- Holding long-term bonds and short-term equities simultaneously
Correct answer: Buying stocks expected to rise and short-selling stocks expected to fall
A long/short equity strategy simultaneously buys stocks expected to outperform (long positions) and short-sells stocks expected to underperform, aiming to profit from relative price movements.
Question 5: Which statement about preferred stock is MOST accurate?
- Preferred stockholders vote on corporate matters before common stockholders
- Preferred stock dividends must be paid before common stock dividends, and cumulative preferred stocks accumulate unpaid dividends (Correct answer)
- Preferred stocks always convert to bonds after five years
- Preferred stock ranks senior to all debt in liquidation
Correct answer: Preferred stock dividends must be paid before common stock dividends, and cumulative preferred stocks accumulate unpaid dividends
Preferred stockholders receive dividends before common stockholders, and cumulative preferred stock requires all missed dividends to be paid in arrears before common dividends can be distributed.
Question 6: A currency forward contract differs from a currency futures contract primarily in that forwards are:
- Traded on organized exchanges and marked to market daily
- Standardized contracts with exchange-specified terms
- Customized OTC contracts with flexible terms and no daily mark-to-market (Correct answer)
- Always settled in cash rather than physical delivery of currency
Correct answer: Customized OTC contracts with flexible terms and no daily mark-to-market
Currency forwards are over-the-counter instruments customized between counterparties with flexible amounts, dates, and settlement terms, unlike standardized exchange-traded futures with daily mark-to-market.
Question 7: What is the primary purpose of a sinking fund provision in a corporate bond indenture?
- To allow bondholders to sell bonds back to the issuer at any time
- To require the issuer to periodically retire a portion of the outstanding bond issue, reducing default risk (Correct answer)
- To increase the coupon rate if the issuer's credit rating falls
- To establish a reserve for paying interest during periods of financial distress
Correct answer: To require the issuer to periodically retire a portion of the outstanding bond issue, reducing default risk
A sinking fund provision requires the issuer to retire portions of the bond issue over time through repurchases or lottery calls, reducing the outstanding principal and lowering default risk for remaining bondholders.
AIP Investment Products & Financial Instruments 3
An investor in a 35% tax bracket receives $1,000 in qualified dividends from a stock investment.
Assuming the qualified dividend tax rate is 15%, what is their after-tax income from these dividends?