SIE Products and Their Risks: What Section 2 Covers

Section 2 of the SIE is Understanding Products and Their Risks. It carries 44% of the exam, or 33 of the 75 scored questions. Sections 1 and 4 together add up to 19 of those questions, so this one section outweighs both.

Every question here asks one of two things. What is this product, and what can go wrong for its owner. Study a product without its risks and you answer half the questions on it.

This guide covers them in outline order: equity, debt, packaged products, options, and risk.

Equity: who gets paid, and in what order

Common stock gives you a share of ownership and, in most cases, a vote. Limited liability caps your loss at the amount you paid. A $5,000 stake can fall to zero, and zero is the floor.

Common stock also holds the residual claim, whatever is left after everyone else is paid. The exam asks that order directly:

• Secured creditors, who hold specific collateral
• Unsecured creditors, including debenture holders
• Subordinated debt holders
• Preferred stockholders
• Common stockholders

Every debt holder is paid before any stockholder. The exam hides preferred stock among the bonds to see whether you promote it above debt.

Preferred stock pays a fixed dividend, stated as a percentage of par. Par is normally $100, so a 6% preferred pays $6 a share each year. A board can vote to skip that dividend, and skipping is not a default. Cumulative preferred stores skipped dividends as arrears, and the company clears them plus the current year before common gets anything.

The preferred dividend never changes, so preferred prices fall when rates rise. Preferred is equity that carries interest rate risk.

A right and a warrant both let you buy stock at a set price. A right goes to shareholders at no cost, prices below the market, and expires in weeks. A warrant comes attached to a bond, prices above the market, and lasts years.

An ADR (American Depositary Receipt) is a U.S. bank receipt for shares of a foreign company, traded and paid in U.S. dollars. If the home currency falls against the dollar, the holder loses money even when the foreign share price holds steady.

Debt: one rule, then the details

Bond prices move opposite to interest rates, and longer maturities move the most. Apply it before you read the answer choices.

Type	Issuer	What the exam tests
T-bills	U.S. Treasury	A year or less, sold at a discount, no coupon
T-notes and T-bonds	U.S. Treasury	Notes 2 to 10 years, bonds 20 to 30, paid every six months
Agency securities	Ginnie Mae, Fannie Mae, Freddie Mac	Only Ginnie Mae has full faith and credit
Corporate bonds	Companies	Investment grade stops at BBB- (Baa3)
Municipal bonds	States, cities, counties	GO bonds rest on taxing power, revenue bonds on one project
Money market	Treasury, banks, corporations	A year or less; only the negotiable CD pays interest

Three more rules do heavy work. A discount bond puts every yield above the coupon rate, and a premium bond puts every yield below it. The issuer decides whether to call a bond, and the investor decides whether to convert one. Most municipal interest escapes federal tax, though a capital gain on the sale is taxable.

Packaged products: the fees are the question

A mutual fund, also called an open-end fund, issues and redeems shares continuously at net asset value. A closed-end fund sells a fixed share count once, then trades on an exchange at a premium or a discount to NAV. When a question puts a market price next to NAV, the product is closed-end. Under forward pricing, a buyer gets the next NAV the fund computes after the order arrives.

Sales charges come up constantly:

• Class A charges a front-end load and the lowest annual fees.
• Class B charges a contingent deferred sales charge that declines over time, plus higher annual fees.
• Class C charges a level annual fee with a 1% CDSC in year one.
• Breakpoints cut the front-end load at set investment levels.
• A letter of intent looks forward to a breakpoint within 13 months, and rights of accumulation look back at shares already owned.

A variable annuity holds its investments in a separate account and registers with the SEC. An early withdrawal pays a surrender charge that starts around 7% and steps down yearly. Inside an IRA it adds no tax benefit, because the account already defers the tax.

Municipal fund securities are 529 plans, LGIPs, and ABLE accounts. A municipal bond is not one of them.

A DPP passes income and losses to investors on a Schedule K-1. A REIT distributes at least 90% of its taxable income, and shareholders pay ordinary income rates on those dividends. An ETF holds the actual securities. An ETN is unsecured bank debt, so it carries the issuer's credit risk.

Options: a right on one side, an obligation on the other

The holder has the right and no obligation. The writer has the obligation and no right. If a question says a person must buy or must sell, it describes a writer.

Every contract names an underlying security, a strike price, and an expiration date. A call is in the money above the strike, and a put is in the money below it.

Equity options deliver shares and use American-style exercise. Index options settle in cash and mostly use European-style exercise. The OCC assigns exercise notices at random, so no writer can predict assignment.

Six new terms arrive at once, so options cost more time than their weight suggests. See the hardest SIE exam questions.

The eleven risks

Risk questions give you a short scenario and ask you to name the risk. Learn each one by its trigger.

Risk	Trigger	Products that carry it
Market risk	The whole market drops	Stocks, stock funds
Non-systematic risk	One issuer stumbles	A single company's stock
Capital risk	You lose what you invested	Any investment
Credit risk	The issuer misses a payment	Corporate and municipal bonds
Interest rate risk	Rates rise and bond prices fall	Bonds, preferred stock
Reinvestment risk	Rates fall and income earns less	Coupon-paying bonds
Prepayment and call risk	Rates fall and principal returns early	Mortgage-backed securities, callable bonds
Inflation risk	Prices rise faster than a fixed payment	Long-term bonds, money market
Liquidity risk	No ready market at a fair price	DPPs, non-traded REITs, hedge funds
Currency risk	The exchange rate moves against you	ADRs, foreign holdings
Political risk	Government action cuts your return	Foreign holdings

Systematic risk comes from the market and moves nearly every security at once. Non-systematic risk comes from one company or one industry. Diversification removes non-systematic risk and never removes market risk, so any answer claiming otherwise is wrong.

Read the direction of rates first. Rates up points to interest rate risk. Rates down points to reinvestment risk, call risk, or prepayment risk.

Three methods cut risk. Diversification spreads money across issuers and asset classes. Rebalancing returns a portfolio to its target mix. Hedging takes a second position that gains when the first one loses, as a protective put does.

Why this section earns the most study time

Section 2 outweighs capital markets and the regulatory framework combined, and it outweighs trading and customer accounts.

It carries the most new vocabulary too. Debentures, breakpoints, arrears, and moneyness arrive together, and each has a near neighbour the exam can swap it with.

Risk knowledge also reaches into Section 3, where suitability questions ask which product fits a customer. Time here pays twice. For difficulty across the whole exam, see SIE exam difficulty.

How to work through it

Read one product at a time, then answer questions on it the same day. Recognition fades fast, and testing yourself fixes a definition in place.

The free SIE course covers Section 2 in eleven lessons, from common stock through the risk list. Each takes twelve to sixteen minutes. Then work the matching set in the practice question bank, which holds 750 questions with a written explanation on every one.

Take the free practice test or a timed set from the practice tests directory for a read on your level. The section breakdown shows whether products need your next block of time. For a schedule, read how to study for the SIE exam.

FINRA publishes the content outline and rule updates on its SIE exam page. For plain definitions of the products above, investor.gov is a good free reference.