AIP Investment Products & Financial Instruments 4 — Questions and Answers
Question 1: An investor writes (sells) a covered call on 100 shares of XYZ stock they own. What is the PRIMARY risk of this strategy?
- Unlimited downside risk if the stock price falls to zero
- The obligation to sell the shares at the strike price, capping upside gains (Correct answer)
- The potential for the premium received to be taxed as ordinary income only
- Margin calls if the stock price rises above the strike price
Correct answer: The obligation to sell the shares at the strike price, capping upside gains
When writing a covered call, the investor collects a premium but must sell shares at the strike price if exercised, limiting participation in any stock price appreciation above the strike.
Question 2: Which of the following private equity strategies focuses on acquiring established companies using significant amounts of borrowed capital?
- Venture capital
- Mezzanine financing
- Leveraged buyout (LBO) (Correct answer)
- Growth equity
Correct answer: Leveraged buyout (LBO)
Leveraged buyouts (LBOs) use substantial debt financing — typically 60–80% of the purchase price — to acquire mature companies, with the target's assets and cash flows serving as collateral for the debt.
Question 3: A bond's duration is best described as:
- The number of years until the bond's final maturity date
- A measure of the bond's weighted average time to receive cash flows, indicating interest rate sensitivity (Correct answer)
- The difference between a bond's coupon rate and its yield to maturity
- The number of coupon payments remaining until maturity
Correct answer: A measure of the bond's weighted average time to receive cash flows, indicating interest rate sensitivity
Duration measures the weighted average time to receive all cash flows and serves as a key indicator of a bond's price sensitivity to interest rate changes — higher duration means greater price volatility.
Question 4: A commodity swap in which an oil producer receives a fixed price per barrel and pays the floating market price is primarily used to:
- Speculate on rising oil prices
- Hedge against falling oil prices by locking in revenue (Correct answer)
- Convert commodity exposure into equity exposure
- Reduce credit risk associated with counterparty defaults
Correct answer: Hedge against falling oil prices by locking in revenue
By receiving a fixed price and paying the floating market price, the oil producer hedges downside risk — if prices fall, the swap's fixed leg compensates for lost revenue.
Question 5: Which statement about closed-end funds is CORRECT?
- They continuously issue new shares as investors buy in, like open-end mutual funds
- They trade on exchanges at prices that can differ significantly from NAV due to fixed share counts (Correct answer)
- They must redeem shares daily at NAV upon investor request
- They are prohibited from using leverage in their investment strategies
Correct answer: They trade on exchanges at prices that can differ significantly from NAV due to fixed share counts
Closed-end funds issue a fixed number of shares in an IPO and trade on exchanges, where supply and demand can push prices to persistent premiums or discounts relative to the fund's net asset value.
Question 6: Mezzanine financing in a corporate capital structure is characterized by which of the following?
- It is senior secured debt with the lowest risk and lowest yield in the structure
- It is unsecured or subordinated debt often paired with equity warrants, offering higher yields (Correct answer)
- It represents common equity ownership with no debt characteristics
- It is short-term commercial paper used for working capital needs
Correct answer: It is unsecured or subordinated debt often paired with equity warrants, offering higher yields
Mezzanine financing sits between senior debt and equity, is typically unsecured or subordinated, and often includes equity warrants or conversion features to compensate investors for its higher risk with higher yields.
Question 7: A variable annuity differs from a fixed annuity primarily because variable annuities:
- Guarantee a specific monthly payment regardless of market conditions
- Allow the insurance company to retain all investment gains
- Invest premiums in subaccounts tied to market performance, with returns and income varying accordingly (Correct answer)
- Are not subject to any surrender charges or fees
Correct answer: Invest premiums in subaccounts tied to market performance, with returns and income varying accordingly
Variable annuities invest in market-linked subaccounts (similar to mutual funds), so the account value and eventual income payments fluctuate based on investment performance, unlike fixed annuities with guaranteed rates.
AIP Investment Products & Financial Instruments 4
An investor writes (sells) a covered call on 100 shares of XYZ stock they own.
What is the PRIMARY risk of this strategy?