Chapter 2 — Products and What Can Go Wrong With Them

2.1Equity Securities

Equity means ownership. When you buy an equity security, you're buying a slice of the company itself — not a promise of repayment, like a bond, but a claim on whatever's left after everyone else with a stronger claim gets paid. That single fact — where equity sits in the pecking order — explains almost everything about how these products behave.

Common stock: the baseline ownership claim

Common stockholders own the company, which comes with real upside — if the business does well, so does the stock, with no ceiling — and real downside exposure. Two protections matter here: limited liability means a shareholder can never lose more than what they invested, no matter how much debt the company racks up; and voting rights give common shareholders a say in major corporate decisions (electing the board, approving mergers), typically one vote per share.

But common stock sits at the very bottom of the claim structure. If the company goes bankrupt and starts liquidating assets, common shareholders are paid last — after every creditor and after preferred shareholders. In practice, that usually means common shareholders recover little or nothing in a liquidation. This is the trade the market makes: unlimited upside, last-in-line downside.

Preferred stock: fixed income wearing an equity costume

Preferred stock behaves more like a bond than like common stock, even though it's technically equity. It pays a fixed dividend — stated as a percentage of par value — and that dividend must be paid before common shareholders get a dime. In a liquidation, preferred sits ahead of common but behind all debt. Because its price behaves like a bond's, preferred stock is sensitive to interest rate changes in the same inverse way bonds are.

Preferred stock comes in several flavors you're expected to distinguish:

Rights and warrants: the "buy more later" instruments

Rights are short-term instruments a company issues to its existing shareholders, giving them the option to buy additional shares — usually at a discount to the market price — before the company sells those shares to the public. They exist to let current shareholders maintain their ownership percentage (their proportional stake) when a company issues new stock. Rights typically expire within a few weeks.

Warrants serve a similar "buy more stock later" purpose but on a much longer timeline — often years — and are usually attached to a bond or preferred stock offering as a sweetener to make the deal more attractive, rather than issued to existing shareholders to protect their stake.

American Depositary Receipts (ADRs)

An ADR is how U.S. investors buy shares of a foreign company without dealing with a foreign exchange directly. A U.S. bank holds the foreign shares in custody overseas and issues a receipt — the ADR — that trades on a U.S. exchange in U.S. dollars. ADR holders get exposure to the foreign company's performance, but they also take on currency risk: if the foreign currency weakens against the dollar, the ADR's value can fall even if the underlying foreign stock is flat or rising in its home currency.

Control and restricted stock

Stock held by a company insider — an officer, director, or anyone owning more than 10% — is control stock, and its resale is restricted regardless of how it was acquired. Restricted stock is unregistered stock, typically acquired through a private placement, and it also carries resale limits. SEC Rule 144 governs how both types can eventually be resold — it sets a holding period and caps the volume that can be sold in any given period, preventing insiders from dumping large blocks and distorting the market.

2.2Debt Instruments

A bond is a loan, structured as a security. The issuer borrows money from investors and promises two things in return: periodic interest payments (the coupon) and repayment of the original amount (par value, usually $1,000 per bond) at a set future date (maturity). Everything else in this section is detail layered on top of that basic promise.

The universe of issuers

The price/yield seesaw

This is the single most important relationship in the fixed-income world, and the SIE will test it from a dozen different angles: bond prices and yields move in opposite directions. When prevailing interest rates rise, existing bonds with lower fixed coupons become less attractive, so their price falls to compensate — pushing their effective yield up to stay competitive with new issues. When rates fall, the opposite happens.

The vocabulary of a bond

Bonds also carry optional features that shift risk between issuer and investor. A callable bond lets the issuer redeem it early — typically when rates have fallen and the issuer wants to refinance more cheaply, which is precisely when the investor least wants to give up their higher-coupon bond. A convertible bond lets the investor exchange it for common stock, trading some yield for upside potential. Ratings agencies (Moody's, S&P, Fitch) grade issuers on creditworthiness, splitting the market into investment-grade and high-yield ("junk") tiers — the lower the rating, the higher the yield needed to compensate for added credit risk.

How municipal bonds get sold

A negotiated underwriting means the issuer directly selects and negotiates terms with an underwriter — common for revenue bonds, where the issuer's specific credit story matters. A competitive underwriting puts the deal out for bid, and the underwriter offering the lowest cost to the issuer wins — more common for GO bonds, where the credit is more standardized (backed by taxing power). Treasury securities, meanwhile, are sold through a formal auction process open to the public and institutions alike.

2.3Options

An option is a contract, not ownership of anything. It gives the buyer the right — but not the obligation — to buy or sell an underlying security at a fixed price within a fixed window. That asymmetry between right and obligation is the whole concept: the buyer can walk away and lose only the premium paid; the seller (writer) has no such escape and must perform if assigned.

The two building blocks

A call gives the buyer the right to buy the underlying at the strike price — calls gain value as the underlying rises, so buying a call is a bullish bet. A put gives the buyer the right to sell the underlying at the strike price — puts gain value as the underlying falls, so buying a put is a bearish bet.

In-the-money vs. out-of-the-money

A call is in-the-money (ITM) when the underlying's market price is above the strike — the right to buy at a lower price than the market has real, immediate value. A put is ITM when the market price is below the strike — the right to sell at a higher price than the market has value. When the relationship is reversed, the option is out-of-the-money (OTM) and has no immediate exercise value, only whatever time value remains before expiration.

Covered vs. uncovered (naked)

Writing a covered call means the seller already owns the underlying stock — if assigned, they simply deliver shares they already hold. It's a conservative, income-generating strategy. Writing an uncovered (naked) call means the seller doesn't own the stock — if assigned, they must buy it on the open market at whatever price it's trading, an exposure with theoretically unlimited risk. This distinction is one of the most heavily tested risk concepts in the options section.

Style, use, and oversight

An American-style option can be exercised any time up to expiration; a European-style option can only be exercised at expiration itself. Options can be used to hedge an existing position (buying a put to protect stock you own) or to speculate outright (buying a call with no underlying position, purely betting on direction). Equity options settle in shares of the underlying stock; index options settle in cash, since you can't physically deliver "the S&P 500."

Every options customer must receive the Options Disclosure Document (ODD) before or at account approval, spelling out the risks in plain terms. The Options Clearing Corporation (OCC) is the issuer and guarantor of every listed option contract — it stands behind every trade, which is what makes exercise and assignment reliable rather than dependent on trusting the counterparty directly.

2.4Packaged Products (Investment Companies)

A packaged product bundles many individual securities into one investment, giving a single investor instant diversification they couldn't easily build trade-by-trade. The SIE cares most about the structural differences between the wrapper types.

The cost of getting in: loads and share classes

A sales charge (load) is the fee an investor pays to buy into a fund, and mutual funds package that cost differently depending on share class:

Breakpoints, rights of accumulation, and letters of intent

Fund companies reward larger investments with lower sales charges at set thresholds — called breakpoints. A right of accumulation (ROA) lets an investor count the current value of their existing holdings in the same fund family toward reaching the next breakpoint, rather than starting from zero with each new purchase. A letter of intent (LOI) lets an investor commit — in writing — to investing enough to reach a breakpoint within 13 months, getting the lower sales charge immediately even though the full amount hasn't been invested yet.

Other fee-related terms worth locking in: net asset value (NAV) is a fund's total assets minus liabilities, divided by shares outstanding — its intrinsic per-share value. A net transaction in this context refers to trades executed without an added commission, common with no-load funds. A surrender charge applies specifically to variable annuities — a penalty for withdrawing money within a set number of years after purchase, distinct from a mutual fund's sales charge.

2.5Municipal Fund Securities

These are technically municipal securities, but they function like savings and investment vehicles for individuals — regulated by the MSRB even though they don't look like a typical bond.

Two relationships to keep straight for 529 plans and ABLE accounts: the account has an owner (usually a parent or family member, who controls the account) and a beneficiary (the person the funds are ultimately meant to benefit) — and these are often different people. Funds are subject to restricted use — spend them outside the plan's intended purpose and tax advantages can be lost. Plans can be sold direct (investor buys straight from the plan, no advisor involved) or advisor-sold (through a broker-dealer, typically with sales charges attached).

2.6Direct Participation Programs (DPPs)

A DPP is a business structure — most often a limited partnership, sometimes structured as tenants in common (TIC) — designed to pass both income and losses directly through to investors without the entity itself being taxed. That pass-through tax treatment is the defining feature: profits and losses flow straight to the investor's personal tax return.

The trade-off for that tax treatment is liquidity. DPPs are unlisted — there's no exchange to sell into — and generally illiquid, meaning an investor who needs to exit early may struggle to find a buyer, or may have to accept a steep discount to do so. DPPs are appropriate only for investors who understand they may be committing capital for years with limited ability to get it back early.

2.7Real Estate Investment Trusts (REITs)

A REIT lets investors buy into real estate — either the physical property itself (equity REITs) or mortgages secured by property (debt/mortgage REITs) — without buying and managing buildings themselves. The signature tax benefit: a REIT that distributes the required share of its taxable income to shareholders avoids corporate-level tax, so income is taxed only once, at the shareholder level — avoiding the double taxation that hits a typical corporation and its shareholders.

2.8Hedge Funds

Hedge funds are private investment partnerships built for sophisticated investors, typically requiring a substantial minimum investment that puts them out of reach for most retail investors. Structured much like private equity vehicles, they aren't required to register the way mutual funds are, which gives managers far more flexibility in strategy — but also far less regulatory transparency for investors. Like DPPs, hedge fund interests are generally illiquid, often locking up capital for defined periods with limited redemption windows.

2.9Exchange-Traded Products (ETPs)

ETPs bring the packaged-product idea to the exchange floor — they trade all day like a stock, unlike a traditional open-end mutual fund priced once daily at NAV.

ETFs are commonly framed as a lower-cost, more flexible alternative to traditional mutual funds — many are passively managed (tracking an index) with lower fees than actively managed funds, though actively managed ETFs also exist. Fee considerations matter here just as much as with mutual funds: expense ratios vary widely, and trading an ETF throughout the day (unlike a mutual fund) also means bid-ask spreads and potential commissions come into play.

2.10Investment Risk

Every product in this chapter carries risk — the SIE's real test is whether you can identify which risk applies to a given scenario, and critically, whether that risk can be reduced through diversification or not. That single distinction — systematic vs. non-systematic — is the organizing idea behind this entire section.

Managing risk: the three levers

Diversification spreads capital across many issuers, sectors, and asset classes so that one bad outcome doesn't sink the whole portfolio — it directly targets non-systematic risk. Portfolio rebalancing means periodically buying and selling to bring a portfolio back to its target allocation, preventing any one position (often a winner that's grown too large) from dominating the risk profile by accident. Hedging uses a separate position — commonly an option — to offset potential losses in an existing holding, trading away some upside in exchange for downside protection.