Investment Company and Variable Contracts Products Representative (Series 6)Practice Exam

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What does the term 'principal' refer to in the context of a firm-commitment underwriting?

The investor
The broker-dealer
The underwriter
The securities exchange

The correct answer is: The broker-dealer

In the context of firm-commitment underwriting, the term 'principal' refers specifically to the broker-dealer. In this underwriting arrangement, the underwriter buys the entire issue of securities from the issuer and then takes on the responsibility of selling those securities to the public. As a principal, the broker-dealer assumes the risk of buying the securities upfront, and it is obligated to sell them, thereby becoming the owner of the securities until they are sold to investors. This is different from a best-efforts underwriting, where the underwriter does not take on the risk of ownership and instead sells the issuer's securities on a commission basis. The role of the broker-dealer as a principal in firm-commitment underwriting is crucial, as it plays a key part in the initial distribution of securities and bears the financial risks involved in that process.