The Traps in Section Two of the Exam: Bonds, Stocks, Pooled Funds, Options and Insurance Products

Series 65 investment vehicles questions come from the second section of the exam, Investment Vehicle Characteristics. It carries 25% of the exam, or 32 of the 130 scored questions, and its traps test whether you know how each product really works, not just what it is called.

This guide covers the traps in that section, from bonds and money market instruments to stocks, pooled funds, options and annuities, with practice questions at the end. It is part of FRC’s guide to Series 65 exam traps and common mistakes, which covers all four sections of the exam.

Preparing for your exam? Watch FRC’s Series 65 playlist on YouTube, with exam traps called out in every topic.

What Section Two Covers

The investment vehicles section tests the features, risks and tax treatment of the products an adviser recommends. It covers cash equivalents, fixed income, equities, pooled investments such as mutual funds and ETFs, derivatives, alternative investments and insurance-based products.

Most traps here come from two sources. The first is a feature attached to the wrong product, and the second is a calculation where one input is swapped for another.

Where to Start Your Preparation

Product questions are easier when you learn each product family in order, because later products build on earlier ones. FRC’s Series 65 Exam Preparation course works through fixed income, equities, funds, options and insurance products, with the exam traps flagged as you go.

If you are also heading toward a broker-dealer role, the SIE Examination Preparation course covers the same product families at an introductory level. Every FRC course can be spread across interest-free monthly payments, so cost is no reason to delay your exam date.

Cash and Money Market Traps

Trap 1: Money Market Funds Are Not Bank Deposits

Money market funds aim to keep a stable value and invest in short-term, high-quality debt, but they are securities, not bank deposits. They are not covered by FDIC insurance.

Bank certificates of deposit, by contrast, are generally FDIC-insured up to $250,000 per depositor, per bank, per ownership category. The trap is giving a money market fund the protection that only a bank deposit has.

Trap 2: Treasury Bills Pay No Coupon

Treasury bills are sold at a discount to their face value and mature at face value, so the investor’s return is the difference. They pay no periodic interest.

The trap is an answer describing semiannual interest on a T-bill. Semiannual coupons belong to Treasury notes and bonds.

Fixed Income Traps

Trap 3: Price and Yield Move in Opposite Directions

When market interest rates rise, the prices of existing bonds fall, and when rates fall, prices rise. Longer-maturity and lower-coupon bonds are generally the most sensitive to rate changes.

Questions often ask which bond will fall most when rates rise. The answer is usually the one with the longest maturity and the lowest coupon, which is why zero-coupon bonds are the most sensitive of all.

Trap 4: The Yield Order on Premium and Discount Bonds

For a bond trading at a premium, the order from highest to lowest is nominal yield, current yield, yield to maturity and then yield to call. For a discount bond, the order is reversed.

Candidates who memorize one order and forget it flips lose this mark every time. FRC’s guides to yield to call vs yield to maturity and callable vs non-callable bonds explain the logic and the risk a call creates.

Trap 5: Macaulay and Modified Duration

Macaulay duration is the weighted average time, in years, until a bond’s cash flows are received. Modified duration converts that into an estimate of how much the bond’s price changes for a 1% change in yield.

If the question asks about price sensitivity, it wants modified duration. FRC’s guide to Macaulay duration vs modified duration also shows why a zero-coupon bond’s Macaulay duration equals its maturity.

Trap 6: Phantom Income on Zero-Coupon Bonds

A zero-coupon bond pays no interest until maturity, but the investor generally owes federal tax each year on the interest that accrues. This is often called phantom income, because tax is due on money the investor has not received.

The trap is assuming no tax is due until maturity. That is why zero-coupon bonds are often held inside tax-advantaged accounts such as IRAs.

Trap 7: Inflation-Protected Treasuries

Treasury Inflation-Protected Securities, or TIPS, adjust their principal value with inflation, and the fixed coupon rate is paid on the adjusted principal. The upward adjustment to principal is generally taxable each year, even though it is not received until maturity.

The trap is thinking the coupon rate itself rises with inflation. The rate stays the same; the principal it applies to changes.

Trap 8: Which Bonds Carry the Government’s Guarantee

U.S. Treasury securities and Ginnie Mae securities are backed by the full faith and credit of the U.S. government. Securities from Fannie Mae and Freddie Mac are not explicitly backed in the same way, even though they are often seen as low risk.

Treasury interest is exempt from state and local income tax, while Ginnie Mae, Fannie Mae and Freddie Mac interest is generally taxable at every level. FRC’s guide to agency bonds vs Treasury bonds covers the details.

Trap 9: General Obligation and Revenue Bonds

A general obligation municipal bond is backed by the issuer’s taxing power, and it usually needs voter approval. A revenue bond is backed only by the income from a specific project, such as a toll road or a water system.

The trap is assuming every municipal bond is backed by taxes. Municipal offerings also use an official statement rather than a prospectus, and FRC’s guide to official statement vs prospectus explains why.

Trap 10: Investment Grade and High Yield

Bonds rated BBB- or higher by S&P, or Baa3 or higher by Moody’s, are investment grade. Anything below that is high yield, sometimes called junk.

The trap is placing the dividing line at A or at BB. FRC’s guides to investment-grade vs high-yield bonds and what happens when a bond is downgraded cover ratings and their effect on price.

Trap 11: Senior Loans and Floating Rates

Senior loans are usually floating-rate, so their interest payments rise when rates rise, which gives them less interest rate risk than fixed-rate bonds. They are usually issued by companies with below-investment-grade credit, so they still carry significant credit risk.

The trap is treating low interest rate risk as low risk overall. FRC’s guide to senior loans vs high-yield bonds compares the two.

Trap 12: Convertible Bonds and Parity

A convertible bond’s conversion ratio is its par value divided by the conversion price. Parity is the stock price at which converting is worth exactly the same as holding the bond, found by dividing the bond’s market price by the conversion ratio.

The trap is using par value instead of market price when calculating parity. FRC’s guides to convertible bonds and how to calculate conversion parity walk through both.

Trap 13: Asset-Backed Securities and Prepayment

Asset-backed and mortgage-backed securities pass the payments from a pool of loans through to investors. When interest rates fall, borrowers refinance, and the investor gets money back early just when reinvestment rates are low.

This is prepayment risk, and it is the trap in most questions about mortgage-backed securities and falling rates. FRC’s guide to why investors buy asset-backed securities covers the trade-offs.

Equity Traps

Trap 14: Preferred Stock and Liquidation

Preferred stock usually has no vote but has priority over common stock for dividends and in liquidation. Cumulative preferred stock goes further, because any missed dividends must be paid before common shareholders receive anything.

In liquidation, secured creditors are paid first, then unsecured creditors, then subordinated debt, then preferred shareholders and finally common shareholders. FRC’s guide to common stock vs preferred stock explains the full ranking.

Trap 15: The Ex-Dividend Date

To receive a dividend, an investor must buy the stock before the ex-dividend date. An investor who buys on or after the ex-dividend date does not receive that dividend; it goes to the seller.

Since the move to T+1 settlement in May 2024, the ex-dividend date and the record date usually fall on the same business day. The trap is assuming that buying on the record date is early enough.

Trap 16: Rights and Warrants

Rights are short-term, typically issued to existing shareholders so they can buy new shares below the current market price and keep their proportionate ownership. Warrants are long-term, and their exercise price is usually set above the market price when they are issued, often as a sweetener attached to a bond.

The trap is swapping the two. Short-term and below market means rights; long-term and above market means warrants.

Trap 17: American Depositary Receipts

An American depositary receipt lets U.S. investors own shares of a foreign company in U.S. dollars on a U.S. market. It removes the need to trade abroad, but not the currency risk.

If the foreign currency weakens against the dollar, the value of the ADR and its dividends fall in dollar terms. The trap is an answer claiming ADRs eliminate exchange rate risk.

Trap 18: Restricted and Control Stock

Restricted stock describes how shares were acquired, through an unregistered private sale, while control stock describes who holds them, an affiliate such as a director. The two labels can overlap, but they are not the same thing.

FRC’s guide to control stock vs restricted stock covers Rule 144’s holding periods and volume limits.

Pooled Investment Traps

Trap 19: Open-End and Closed-End Funds

Open-end funds continuously issue and redeem shares, and investors buy at the public offering price and redeem at net asset value. Closed-end funds issue a fixed number of shares that trade on an exchange, often at a premium or discount to net asset value.

The trap is saying a closed-end fund can be redeemed with the fund company. FRC’s guide to open-end vs closed-end funds sets out every difference.

Trap 20: ETFs Trade During the Day

Exchange-traded funds trade on an exchange throughout the day at market prices, so investors can use limit orders, stop orders and margin. Traditional mutual funds are priced once a day, at the next calculated net asset value after the order is received.

The trap is an answer saying an investor can buy a mutual fund at a specific price during the trading day. That describes an ETF.

Trap 21: Unit Investment Trusts

A unit investment trust holds a fixed portfolio that is not actively managed, and it has a set termination date. Its units are redeemable with the trust.

The trap is describing a unit investment trust as having an investment adviser making ongoing changes. It has no ongoing management of that kind.

Trap 22: REITs and Direct Participation Programs

A real estate investment trust avoids corporate tax on the income it distributes, provided it pays out at least 90% of its taxable income. It cannot pass losses through to investors.

A direct participation program, such as a limited partnership, can pass both income and losses through to its investors. The trap is treating a REIT as a source of tax losses.

Trap 23: Hedge Funds and Private Funds

Hedge funds are generally sold in private offerings, usually to accredited investors, and they often limit when investors can withdraw money. They can use leverage, short selling and derivatives.

The trap is an answer describing a hedge fund as liquid and suitable for any retail investor. FRC’s guide to Regulation D Rule 504 vs Rule 506 covers the private offerings most of these funds rely on.

Derivative Traps

Trap 24: Bullish and Bearish Options Positions

Buying a call and selling a put are both bullish positions, while buying a put and selling a call are both bearish. The trap is assuming every put is bearish, when the put writer must buy the stock if it falls and wants the price to hold up.

FRC’s guides to call option vs put option and what rho is in option pricing cover the positions and the factors that drive premiums.

Trap 25: The Uncovered Call Writer

Someone who writes a call without owning the stock faces unlimited maximum loss, because there is no ceiling on how high the stock price can rise. A covered call writer owns the shares, so their risk is the stock falling, offset only by the premium received.

FRC’s guides to an uncovered call writer’s maximum risk and covered call vs protective put cover both positions.

Trap 26: Options Give Rights, Futures Create Obligations

The buyer of an option has a right, but not an obligation, to buy or sell the underlying asset. Both parties to a futures contract are obligated to complete the trade at the agreed price on the agreed date.

The trap is describing a futures buyer as having the choice to walk away. FRC’s guide to interest rate swap vs currency swap covers another type of contract that binds both parties.

Insurance-Based Product Traps

Trap 27: Fixed and Variable Annuities

A variable annuity is a security, because the investor bears the investment risk, so selling it requires both a securities registration and an insurance licence. A fixed annuity is an insurance product, and the insurance company bears the investment risk.

During the accumulation phase, a variable annuity investor owns accumulation units, which convert into annuity units when payments begin. FRC’s guides to fixed vs variable annuities and what a 1035 exchange is cover how they work and how they can be exchanged without tax.

Trap 28: Term and Permanent Life Insurance

Term life insurance provides a death benefit for a set period and builds no cash value. Whole life insurance provides lifetime coverage and builds cash value, while variable life insurance invests the cash value in separate accounts and is a security.

The trap is giving term insurance a cash value, or treating variable life as a pure insurance product. FRC’s guide to term vs whole life insurance explains each type.

Practice Questions

Question one: interest rates rise sharply. Which bond’s price will usually fall the most: a five-year 6% coupon bond, a 20-year 6% coupon bond or a 20-year zero-coupon bond? The 20-year zero-coupon bond, because it has the longest duration.

Question two: a bond trades at a premium. Which yield is lowest? Yield to call, followed by yield to maturity, current yield and nominal yield.

Question three: an investor in a high-tax state wants federal government credit quality and freedom from state income tax. Which security fits? A Treasury security, because its interest is exempt from state and local tax.

Question four: a client holds a 15-year zero-coupon bond in a taxable account. When is federal tax due on the interest? Generally each year as the interest accrues, even though no cash is received until maturity.

Question five: which security is typically long-term, with an exercise price above the market price at issue? A warrant.

Question six: an investor wants to buy an index fund at 11:00 a.m. using a limit order. Which product allows this? An exchange-traded fund, because mutual funds are priced once a day at the next calculated net asset value.

How to Study This Section

Learn each product family by asking four questions: who issues it, what backs it, how it is taxed and what risk it carries. Most traps in this section change one of those four answers.

Then practice the calculations that recur, such as current yield, the yield order on premium and discount bonds, conversion parity and tax-equivalent yield. The exam rarely asks for long arithmetic, but it often tests whether you know which number goes where.

Where Section Two Fits With the Rest of the Exam

The investment vehicles section is one of four, and FRC’s main exam traps guide, linked at the top of this guide, covers the economics section too. The guides to Series 65 suitability questions and Series 65 ethics questions cover the client recommendations and laws sections, where many of these products reappear in client scenarios.

The FRC Series 65 playlist linked at the top of this guide pairs each topic with a video. The FRC dictionary is more than a dictionary, with explainer videos, written explanations and on-page quizzes covering the products and rules you are tested on.

Study With FRC

FRC’s programs and memberships are open to everyone. Whether you are preparing for the Series 65 alone or alongside the SIE and Series 7, structured preparation turns product questions from guesswork into reliable marks.

FRC’s Professional Membership adds verified progress and a Digital Profile, so when you apply for roles, employers can see your exam progress and the knowledge you are building, not just read about it on a resume.

Your Next Step

The investment vehicles section is 25% of the Series 65, and its traps reward candidates who know how each product is backed, taxed and priced. Learn those features product by product, and the near-identical answers start to look very different.

Pick the three traps in this guide you feel least sure about and work through them today. Then move on to the next section, until every product on the exam feels familiar.