Direct Participation Program

An investor needs cash and tries to sell a bond that rarely trades. The only bids available sit well below the last reported price. This exposure is best described as:

1. A.Liquidity risk, the risk of being unable to sell promptly at a fair price.Correct. Thin trading forces a seller to accept a discount, which is precisely what marketability risk describes.
2. B.Credit risk, the risk that the issuer fails to make its scheduled payments.Wrong. Nothing in the facts suggests the issuer has missed a payment or is likely to miss one.
3. C.Market risk, the risk that the entire bond market declines in value together.Wrong. A broad market decline would move prices for everyone, while the problem here is finding any buyer at all.
4. D.Reinvestment risk, the risk of having to put proceeds back to work at a lower rate.Wrong. That risk arises after a sale or a maturity, when the proceeds have to be put back to work.

Why: Liquidity risk is the risk that a holder cannot convert a position into cash quickly without surrendering value. It is driven by how many buyers and sellers are active in that particular instrument, which is why thinly traded municipal issues, private placements and limited partnership interests carry so much of it. The discount the seller must accept reflects that scarcity rather than any judgment about the issuer's finances. An investor who may need money at short notice should keep enough of the portfolio in instruments with deep and continuous markets.

A customer has 40,000 dollars set aside that he expects to need within the next twelve months and asks about an oil and gas direct participation program. The representative should explain that the program is unsuitable primarily because:

1. A.DPPs are prohibited for investors with less than 100,000 dollars to investNo such flat prohibition exists. Suitability standards, not a fixed dollar bar, govern.
2. B.DPPs pay no distributions during the first yearDistribution timing varies by program and is not the disqualifying issue here.
3. C.DPP interests are illiquid and cannot reliably be sold on short noticeCorrect. Illiquidity is the direct conflict with a twelve-month need for the funds.
4. D.Limited partners are personally liable for the program's debtsLimited partners have limited liability. This misstates the structure.

Why: DPP interests have no active secondary market. An investor who needs the money on a short timetable may be unable to sell at all, or may only sell at a steep discount. Illiquidity is the disqualifying feature here.

Which investment carries the greatest liquidity risk?

1. A.A listed large-cap common stockExchange-listed shares sell readily at posted prices.
2. B.A money market mutual fundMoney market funds are designed for immediate redemption.
3. C.An interest in a non-traded direct participation programCorrect. There is no active secondary market, so exiting promptly at fair value is difficult.
4. D.A Treasury billTreasury bills trade in the deepest, most liquid market there is.

Why: A direct participation program interest has no active secondary market, so an investor may be unable to sell promptly at a fair price. Listed stocks, Treasury bills, and money market funds are all readily converted to cash.

A direct participation program (DPP), such as a limited partnership, is characterized by:

1. A.Daily exchange tradingLimited partnership interests are illiquid and are not listed for continuous trading; investors typically exit through a sponsor repurchase or a thin secondary market. Daily exchange trading describes a listed security, not a DPP.
2. B.Flow-through of income and losses to investorsCorrect - DPPs are flow-through entities.
3. C.Double taxation like a C-corpThis is precisely what the partnership structure exists to avoid. A C-corp is taxed on its earnings and shareholders again on dividends, while DPP income is taxed once, at the investor level.
4. D.Guaranteed dividendsA partnership distributes only the cash the venture actually generates, and nothing about that is guaranteed. Dividends are corporate vocabulary; partners receive distributions and are allocated income or loss.

Why: DPPs pass income, gains, losses, and deductions through to investors (flow-through taxation).