20 Cash Equivalents & Fixed Income Practice Questions & Answers

1. 1. Assume federal deposit insurance covers $250,000 per depositor, per insured bank, per ownership category. A client holds three separate certificates of deposit of $150,000 each, all in her individual name, at the same insured bank. How much of that $450,000 is protected if the bank fails?

   • A.$450,000, because each certificate of deposit is separately insured up to the per-depositor limit
   • B.$300,000, because the coverage doubles when a depositor keeps more than two accounts at one bank
   • C.$250,000, because the limit applies to all of her individually owned accounts at that one bank✓ Answer
   • D.$150,000, because coverage is capped at the value of the single largest deposit account she owns

   Deposit insurance is calculated per depositor, per insured bank, per ownership category, and all single-ownership accounts at one bank are added together before the limit is applied. Splitting the same name's money among several CDs at the same bank therefore adds no coverage; using a second insured bank or a different ownership category would.

   Source: FDIC deposit insurance coverage rules, 12 C.F.R. Part 330Report a problem with this question

2. 2. A client moves her emergency cash out of a bank money market deposit account and into a money market mutual fund at a brokerage firm because the fund quotes a higher yield. What should the adviser explain about the change in protection?

   • A.The fund is covered by federal deposit insurance in the same manner as the bank account she left
   • B.The fund carries a federal guarantee that its share price will never fall below one dollar a share
   • C.The fund is insured by the sponsoring fund company for the entire balance of the client's account
   • D.The fund is a securities investment whose share value is not protected by federal deposit insurance✓ Answer

   A money market deposit account is a bank deposit and is insured within the standard limits, while a money market mutual fund is a registered investment company whose shares are securities. Its share price is a net asset value that can move, and no deposit insurance or federal guarantee stands behind it, which is the trade-off for the higher quoted yield.

   Source: SEC Investor.gov investor education on money market funds; FDIC deposit insurance rules, 12 C.F.R. Part 330Report a problem with this question

3. 3. A client holds a brokered certificate of deposit and needs the money two years before it matures, so the adviser explains that it must be sold in the secondary market. Which statement about that sale is correct?

   • A.The sale proceeds are guaranteed by deposit insurance at full face value plus the interest accrued
   • B.The price depends on current interest rates, so the client can receive less than the amount deposited✓ Answer
   • C.The issuing bank is required to buy the certificate back at par because deposit insurance stands behind it
   • D.The brokerage firm must credit full face value and then claim the difference from the insurance fund

   Deposit insurance protects a brokered CD against failure of the issuing bank; it does not promise a price. Selling before maturity is an ordinary secondary-market transaction, so the proceeds reflect where rates have moved since purchase, and a rise in rates since issuance means the certificate changes hands below the deposited amount.

   Source: SEC Office of Investor Education and Advocacy, Investor Bulletin on brokered certificates of depositReport a problem with this question

4. 4. An adviser is reviewing a callable certificate of deposit held by a retired client who relies on its interest income. Which statement accurately describes how the call feature works?

   • A.The bank may redeem it early only when rates rise, which preserves the client's original yield
   • B.The client may redeem it early at par whenever prevailing market rates rise above the stated coupon rate
   • C.Either party may force early redemption at par once the stated call protection period has passed
   • D.The bank may redeem it early, usually after rates fall, leaving the client to reinvest at lower yields✓ Answer

   A call provision on a CD belongs to the issuing bank alone, never to the depositor. Banks exercise it when rates have fallen and they can fund themselves more cheaply, which is exactly when the client must replace the income at a lower yield, so a callable CD is a poor match for someone depending on a predictable interest stream.

   Source: SEC Investor.gov investor education on certificates of deposit, callable CD featuresReport a problem with this question

5. 5. A corporation wants to raise short-term funds by selling unsecured promissory notes to institutional buyers without registering the offering under the Securities Act of 1933. What must be true of the notes for that exemption to apply?

   • A.They must mature within nine months of issuance and finance current transactions, with no rollover✓ Answer
   • B.They must mature within twelve months of issuance and carry an investment-grade rating at the offering
   • C.They must mature within five years of issuance and be sold only to buyers inside the issuer's state
   • D.They must mature within two years of issuance and be secured by the company's accounts receivable

   Section 3(a)(3) of the Securities Act exempts short-term paper whose maturity at issuance does not exceed nine months, that arises out of current transactions, and that is not automatically rolled over. That statutory condition is the reason commercial paper is conventionally issued for 270 days or less; paper written for a longer term loses the exemption and must be registered.

   Source: Securities Act of 1933, Section 3(a)(3)Report a problem with this question

6. 6. A 30-year-old client keeps her entire retirement account in Treasury bills and bank certificates of deposit because she dislikes seeing any decline in account value. Over a multi-decade horizon, which risk is she most exposed to?

   • A.Purchasing power risk, because rising consumer prices erode the real value of a stable principal✓ Answer
   • B.Business risk, because rolling maturing instruments over depends on each issuer's operating results
   • C.Default risk, because short-term instruments are repaid out of whatever cash the issuer has left
   • D.Liquidity risk, because short maturities must be sold at a concession before their stated maturity

   Cash equivalents deliver liquidity and principal stability, not growth, and their nominal return has historically trailed inflation by only a small margin or not kept up with it at all. Over decades the compounding shortfall means the account buys less even though its stated balance never falls, which is the classic suitability error for a long time horizon.

   Source: NASAA Series 65 Test Specifications, cash and cash equivalents and inflation (purchasing power) riskReport a problem with this question

7. 7. Assume a client pays a 6% state income tax and a 24% federal income tax. She is comparing a Treasury note yielding 4.00% with a similar-maturity corporate bond yielding 4.15%. Setting credit quality aside, why might the Treasury note still be the better after-tax choice?

   • A.Treasury interest is exempt from federal income tax, so only the state tax reduces what she keeps
   • B.Treasury interest is exempt from state and local income tax, so less of the yield is lost to taxes✓ Answer
   • C.Treasury interest is exempt from every income tax once the note has been held for twelve months
   • D.Treasury interest is taxed at long-term capital gain rates instead of as ordinary interest income

   Federal law exempts obligations of the United States from state and local income taxation, while their interest remains fully taxable at the federal level. Corporate interest is taxable at every level, so for a client in a state that taxes income the corporate bond's slightly higher stated yield can still leave her with less after tax.

   Source: 31 U.S.C. 3124(a), exemption of United States obligations from state and local taxationReport a problem with this question

8. 8. A client buys Treasury Inflation-Protected Securities and a prolonged stretch of falling consumer prices then pushes the inflation-adjusted principal below the original amount. What does the Treasury pay the client at maturity?

   • A.The original principal, but only if the security has been held for at least five years since issue
   • B.The average of the adjusted and the original principal, measured across the full holding period
   • C.The reduced adjusted principal, because downward index adjustments are permanent once applied
   • D.The original principal, because the security pays the greater of the adjusted or original amount✓ Answer

   The principal of an inflation-protected Treasury is adjusted with the consumer price index in both directions, so deflation does reduce it while the security is outstanding. At maturity, however, the Treasury pays the greater of the adjusted principal or the original principal, which places a floor at par and is why deflation cannot cut the redemption below face.

   Source: TreasuryDirect, Treasury Inflation-Protected Securities (TIPS) principal adjustment and maturity payment termsReport a problem with this question

9. 9. An adviser must decide whether to hold Treasury Inflation-Protected Securities in a client's taxable brokerage account or in her traditional IRA. Which consideration most supports placing them in the IRA?

   • A.Coupon payments on these securities are taxed at a higher rate than ordinary interest income is
   • B.Principal adjustments lose their exemption from state income tax when the securities sit in a taxable account
   • C.Upward principal adjustments are federally taxable in the year they accrue, with no cash received✓ Answer
   • D.Losses from downward principal adjustments become deductible only if the securities are held in a taxable account

   The inflation adjustment to principal is treated as current income for federal purposes in the year it accrues, even though the holder receives that money only at maturity. That mismatch between a tax bill and the cash to pay it is eliminated inside a tax-deferred account, which is the standard asset-location argument for these securities.

   Source: IRS Publication 550, inflation-indexed debt instruments and current inclusion of the inflation adjustmentReport a problem with this question

10. 10. A client holds mortgage-backed pass-through certificates. Market interest rates rise sharply and homeowners in the pool slow their prepayments considerably. What is the effect on the client?

    • A.The certificates are redeemed at par by the pool sponsor because the pool has missed its target life
    • B.The expected life of the certificates shortens, returning principal that must be reinvested lower
    • C.The coupon rate on the certificates is adjusted upward to match prevailing mortgage rates in the market
    • D.The expected life of the certificates lengthens, holding money in a below-market yield for longer✓ Answer

    Pass-through cash flows depend on how fast the underlying mortgages are repaid. When rates rise, refinancing stops being attractive, principal comes back more slowly than assumed, and the holder stays invested at the old below-market coupon; that is extension risk, the mirror image of the prepayment risk that appears when rates fall.

    Source: SEC Investor.gov investor education on mortgage-backed securities; NASAA Series 65 Test Specifications, U.S. government and agency securitiesReport a problem with this question

11. 11. A client asks what she would actually own if she bought an asset-backed security collateralized by a pool of automobile loans. Which description is most accurate?

    • A.A claim on the cash flows of the loan pool, receiving principal and interest as borrowers pay✓ Answer
    • B.A general obligation of the sponsoring finance company, ranking with its other unsecured creditors
    • C.An equity interest in the finance company's lending division, entitled to a share of pool profits
    • D.A bullet obligation that pays interest only until a single principal payment at the final maturity

    An asset-backed security is serviced primarily from a segregated pool of receivables rather than from the sponsor's general credit, and holders receive principal and interest as the underlying borrowers pay. Because principal is returned throughout the life of the deal, the cash-flow pattern is not the level coupon-then-par shape of a conventional corporate bond.

    Source: SEC Regulation AB, definition of asset-backed security, 17 C.F.R. 229.1101Report a problem with this question

12. 12. A non-callable corporate bond carrying a 5% coupon is trading at a discount to par. Which ordering of its yields, from lowest to highest, is correct?

    • A.Yield to maturity, then nominal yield, then current yield
    • B.Current yield, then nominal yield, then yield to maturity
    • C.Nominal yield, then current yield, then yield to maturity✓ Answer
    • D.Yield to maturity, then current yield, then nominal yield

    The nominal yield is fixed against par, so when the price is below par the same coupon dollars represent a larger percentage of the amount invested and current yield exceeds it. Yield to maturity adds the gain from buying below par and recovering face at maturity, which places it above both of the other two.

    Source: NASAA Series 65 Test Specifications, fixed income valuation factors including coupon, current yield and yield to maturityReport a problem with this question

13. 13. A client who lives in one state buys general obligation bonds issued by a municipality located in a different state. How is the interest generally treated for income tax purposes?

    • A.Taxable at the federal level but exempt from income tax in the client's own state of residence
    • B.Exempt from federal income tax and also exempt from tax in the client's own state of residence
    • C.Exempt from federal income tax but generally taxable by the state where the client is a resident✓ Answer
    • D.Exempt from federal and state income tax for as long as the client continues to hold the bonds

    Interest on state and local bonds is excluded from gross income for federal purposes regardless of which state issued them. The state-level exemption is a separate matter granted by each state to its own residents for its own issues, so out-of-state municipal interest is ordinarily taxed by the state where the investor lives.

    Source: Internal Revenue Code Section 103, exclusion of interest on state and local bondsReport a problem with this question

14. 14. A client wants municipal interest that escapes federal, state and local income tax no matter which state she happens to live in. Which issuer's bonds generally fit that description?

    • A.Bonds of a municipality in her own state that are insured by a private bond insurance company
    • B.Bonds of a state transportation authority whose project is financed with federal highway grants
    • C.Bonds of a United States territory such as Puerto Rico, Guam or the U.S. Virgin Islands✓ Answer
    • D.Bonds of the United States Treasury carrying maturities longer than twenty years from issuance

    Federal statutes governing the U.S. territories provide that their bonds are exempt from taxation by the United States, by any state, and by any local authority, which is what the phrase triple tax-free describes. An in-state municipal bond is triple tax-free only for residents of that state, and Treasury interest stays fully taxable at the federal level.

    Source: 48 U.S.C. 745 and parallel organic act provisions for U.S. territories; Internal Revenue Code Section 103Report a problem with this question

15. 15. An adviser recommends high-grade municipal bonds inside a client's traditional IRA, pointing to their tax-exempt interest as the reason. Why is that recommendation unsound?

    • A.Municipal bonds are prohibited investments in retirement accounts under the rules governing IRAs
    • B.Earnings in the account are already tax-deferred, so the client accepts a lower yield for nothing✓ Answer
    • C.Municipal interest permanently loses its exemption once the bonds move into a brokerage account
    • D.Retirement accounts may hold only securities whose principal is guaranteed by a federal agency

    Municipal bonds yield less than comparable taxable bonds precisely because their interest is exempt, so the investor is paying for a tax benefit in the form of foregone yield. Inside a traditional IRA every dollar of earnings is already tax-deferred and is ultimately taxed as ordinary income on distribution, so the exemption buys the client nothing.

    Source: Internal Revenue Code Section 103; NASAA Series 65 Test Specifications, municipal bonds and tax implicationsReport a problem with this question

16. 16. A client compares two otherwise identical revenue bonds, one of which carries insurance from a municipal bond insurer. What should the adviser explain about the insured bond?

    • A.It usually carries a higher rating and a higher yield, since the insurance premium is passed to holders
    • B.It usually carries a higher rating and a lower yield, and the insurance covers default, not price declines✓ Answer
    • C.It usually carries the same rating and yield, since insurers guarantee only the repayment of principal at maturity
    • D.It usually carries a higher rating and a lower yield, and the insurance also covers market price declines

    Bond insurance substitutes the insurer's credit for the issuer's, which lifts the rating, and a better-rated bond must pay investors less, so the insured issue yields less than the uninsured twin. The guarantee runs to timely payment of principal and interest if the issuer defaults; it does nothing about a price decline caused by rising rates.

    Source: NASAA Series 65 Test Specifications, municipal bonds including insured issues; MSRB investor education on bond insuranceReport a problem with this question

17. 17. A U.S. client wants exposure to the debt of foreign corporations but does not want to take on exchange-rate risk. Which choice fits that constraint?

    • A.A sovereign bond of an emerging-market government denominated in that government's own currency
    • B.A bond issued by a foreign corporation in its home market and denominated in that local currency
    • C.A bond of a foreign corporation denominated in a basket of currencies weighted by trading volume
    • D.A Yankee bond, sold in the United States by a foreign corporation and denominated in U.S. dollars✓ Answer

    Currency risk arises from the denomination of the payments, not from the nationality of the issuer. A Yankee bond is registered and sold in the United States and pays principal and interest in dollars, so the U.S. investor keeps the foreign issuer's credit and political exposure while removing the exchange-rate effect on the cash flows.

    Source: NASAA Series 65 Test Specifications, foreign-issued bonds and currency riskReport a problem with this question

18. 18. A bond has a modified duration of 7 and market yields on comparable bonds rise by one percentage point. Approximately what happens to the bond's price?

    • A.It rises by about 7%, because a longer duration lets the bond capture the higher market yield
    • B.It falls by about 7%, because price moves inversely to yield by roughly duration times the change✓ Answer
    • C.It falls by about 0.7%, because duration is divided by ten to convert it to a percentage change
    • D.It falls by about 1%, because duration measures only the years remaining until final maturity

    Modified duration estimates the percentage price change for a small change in yield, so the approximate move equals the negative of duration multiplied by the change in yield: seven times one percentage point is roughly a 7% decline. This is also why longer maturities and lower coupons, which raise duration, make a portfolio more rate-sensitive.

    Source: NASAA Series 65 Test Specifications, duration as a fixed income valuation factorReport a problem with this question

19. 19. A client is shown a callable municipal bond that is trading at a premium to par. Which yield should the adviser present as the most conservative measure of the client's likely return?

    • A.The yield to call, because on a premium bond redeemed early it is the lowest of the quoted yields✓ Answer
    • B.The nominal yield, because the stated coupon is the only return contractually promised to a holder
    • C.The yield to maturity, because the entire coupon stream is collected on a bond priced above par
    • D.The current yield, because it reflects the cash the client actually collects on the amount invested

    On a bond bought above par, the premium is amortized away over whatever time the bond remains outstanding, so an early call concentrates that loss into fewer years and produces the lowest return of the yields quoted. Presenting the lower of yield to call and yield to maturity is the yield-to-worst convention a fiduciary should use.

    Source: NASAA Series 65 Test Specifications, yield to call and yield to maturity (yield to worst)Report a problem with this question

20. 20. During an economic contraction investors shift money out of corporate bonds and into Treasury securities. What happens to the yield spread between corporate bonds and comparable-maturity Treasuries?

    • A.It widens, because investors demand more compensation for credit risk while bidding Treasury prices up✓ Answer
    • B.It widens, because the Treasury must raise its coupon rates to attract the incoming safety-seeking money
    • C.It narrows, because falling Treasury yields pull corporate yields down by exactly the same amount
    • D.It stays fixed, because rating agencies set the spread from each issuer's published credit rating

    A credit spread is the extra yield a corporate issuer must pay over a Treasury of the same maturity, and it is a price for perceived default risk. In a downturn that risk is judged higher while a flight to quality bids Treasury prices up and their yields down, so the two yields move apart and the spread widens.

    Source: NASAA Series 65 Test Specifications, credit spread as a fixed income valuation factorReport a problem with this question

Practice questions written from the NASAA Series 65 Test Specifications and the Uniform Securities Act. Not affiliated with or endorsed by NASAA, FINRA or Prometric. Dollar thresholds, fee figures and contribution limits change; where one matters the question supplies it. Confirm current requirements with NASAA before testing. NASAA exam content outline →