Figure it out

Far too many license exam candidates labor under a misconception about the exams; they think they are supposed to know the answer as soon as they read the question. Unfortunately, for most questions, your job is to figure it out. For example, take a look at the following:

Parents often use zero coupon bonds such as Treasury STRIPS to fund future educational needs. Which of the following is an inaccurate statement of such investments?
A. they lock in a rate of return for the life of the bonds
B. taxation is deferred until maturity
C. their market price volatility is higher compared to interest-paying debt securities
D. they require lower capital commitments

Maybe you already know the answer, but your approach should be to take each choice and try to eliminate it--the choice you can't eliminate must be your answer. Also, it helps to remember that you're eliminating the three TRUE statements in this one. Right? Ok, so do zero coupon bonds lock in a rate of return for the life of the bond? Don't try to picture an imaginary flash card here--ask yourself how zero coupons work. Why are they called "zero coupon" bonds in the first place? Because they make exactly zero coupon payments--therefore, the investor does not reinvest coupon payments at varying rates along the way (reinvestment risk), so I guess the return is "locked in for the life of the bonds." See how much thought it can take to eliminate just one answer choice? Good--two more need to be eliminated, and then we're done. Taxation is deferred until maturity--is that true? Many people have memorized this, but even if so, don't choose this answer yet. Not until you eliminate the other two. Put this one on hold--it looks good, but maybe one of the other choices looks even gooder. What about the "market price volatility," does that make sense? Well, if you remember all that we've said about "duration" and how zero coupons have high "durations," you know it's true. If you don't remember it, figure it out--why would their price be volatile? Probably because there's no cash flow being paid to make the investor feel better about holding the thing. That's true, so we eliminate it, and we sit 50-50 at this point. Either B or D is going to be our answer--getting tired and frustrated? Suck it up, people--you have 260 questions to answer on your Series 7 exam. Okay, Choice D says that zero coupon bonds somehow "require lower capital commitments." And here is where we separate those who will pass the first time and those who might pass on their second or third attempt. The candidates who get frustrated now and start squirming like a little kid have little chance of getting it right. So, take a deep breath and figure it out. Why would the zero coupon require a lower capital commitment? Well, how are they purchased? At a deep discount to the par value--aha! If you can buy $100,000 par value of STRIPS for just $50,000 or $60,000, I'd say that represents a "lower capital commitment," whether I've ever thought of it that way or not. Choice D is eliminated, along with Choice A and Choice C. What's the right answer? The one that is not A, C, or D.