CFA level 1 study note book1 2014

Introduction to the Global Investment Performance Standards GIPS*The candidate should be able to: a.. Members and Candidates who possess material nonpublie information that could affcct

Levell I Book 1

SchweserNotes'" for the CFA· Exam

and Quantitative Methods

BOOK 1 - ETHICAL AND PROFESSIONAL

STANDARDS AND QUANTITATIVE

METHODS

SCHWESERNOTES'" 2014 CFA LEVEL I BOOK I: ETHICAL AND

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following i•• he cop,.np di.do.u", for these ma.erials: ·Cop>";gh t,2013.CFA 1.lIi.u.e Reproduced and "Publi.hed hom 2014Leunin, Oeeeeeee S lrmc Lnd I II and III quell ion from CFA'"

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Inve.tmCft( Performance Standards with permission (rom CfA Institute All Rishts

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Disclaimer: The Schwncr Notes should be wed in conjunction with the ocipruJ Radings as act COrtA

by CFA In"i"'le in their201 CFALn.11 Scudy Guide The i.fOrmation contained in these No.CI

covers topics eorawncd in the readings referenced by CFA mslitate and is beltcvcd to be accurate Hown-cr their acc:uncy c.atlftot beguarant~ nor is any warra.nty coawyt'd as to your ultimate exam sueecsl The authors of the referenced rcadin,p ,have not encloned or s_ponlORd these Notn.

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Practice Exams

Schweser offeessix full 6-hour practice exams Practice Exams Volume 1 and Volume 2each contain three full 240-<juestion exams These arc imponant tools for gaining thespeed and skills you will need to pass the exam Each book contains answers with fullexplanations for self-grading and evaluation By entering your answers at Sehweser.eom,you can usc our Performance Tracker to lind out how you have performed compared toother Schweser Level I candidate s,

Schwaer Library

We have created reference videos some of which are available to allSchwcscrNotespurchasers Schweser Library volumes are typically between 20 and 60 minutes in lengthand cover such topics as: ·CFA Level I Exam Overview," ·Calculator Basics," "Code andStandards Overview," and "Time Value of Money_' The full Schwcscr Library is includedwith our 16-week live or online classes and with our video instruction (online or CDs)

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The Levell CFA exam is a formidable challenge (63 topic reviews and more than 500Learning Outcome Statements), and you must devote considerable time and effort

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I Exam IntrolQuanri,ativ M••hods S52 9 Financial Repcrriag &AnalY'is 5510

2 Quantitative Me.hods 553 10 Corpora te Finance S511

5 Financial Roporting& Analysis 5S7 13 Fixed Income 5516

6 Financial Roponing & Analysis SS8 14 Derivatives 5517

7 Financial R.porting & Analysis S58 9 15 Portfolio Managom.m &Almna,i ve

Investments SS12 18

8 Financial R.poning & Analysis S59 16 Ethical and Professional Standards SSI

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READING ASSIGNMENTS AND

LEARNING OUTCOME STATEMENTS

TM flllDwinl mau,ial is a m,;~w oftM Ethkal and Profillional S/4111ia,dsand

QUlt1ltitatilJeM~thods prin(ipks d~siln~d to addrrss th~ kaming out(o_ stat~m~1Its Itt forth '" CFA /mti(Uu.

STUDY SESSION 1

Reading Assignmcnu

Ethkal and Profissional Standards and Quantitatiw M~thods CFA Progn.m Levell 2014

Curriculum Volume 1 (CFA Institute, 2013)

3 Introduction to the Globallnvcstment Performance Standards (GIPS®) page 82

5. The TIme Value of Money

6 Discounted Cash Flow Applications

7 Statistical Concepts and Market Returns

8 Probability Concepts

page 98page 138page 163page 201STUDY SESSION 3

Reading Assignmcnu

Ethical and ProfilliDllIll Sta"da,ds and Quantitatiw Mnhods CFA Progn.m Levell 2014

Curriculum Volume 1 (CFA Instirutc, 2013)

9. Common Probability Distributions

10 Sampling and Estimation

11 Hypothesis Testing

12 Technical Analysis

page 245page 281page 304page 344

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Book 1 - Elhical and Prof ional SCllIciardsand Quanli live M.lhods

IUadinsAssignme"u IUIdUaming OUlcome Scalemenu

LEARNING OUTCOME STATEMENTS (LOS)

STUDY SESSION 1

Th« topieal clI",ragt ClI"'SPDn4swith tht fl,u,wing cr~Institute assigne'rtading:

I Code of Emics and Standards ofProfcssionai ConductThe candidate should be able to:

a describe the structure of the CFA Institute Professional Conduct Program andthe proeess for the enforeement of the Code and Standards (page 13)

b stare the six components of the Code of Ethics and the seven Standards ofProfessional Conduct (page 14)

Co explain the ethical responsibilities required by the Code and Standards,including the sub-sections ofeach Standard (page: 15)

2 GuidlUlee for Standard I-VIIThe candidate should be able to:

a demonstrate the application of the Code of Ethics and Standards of ProfessionalConduct to situations involving issues of professional integrity (page: 18)

b distinguish between conduct that conforms to the Code and Standards andeon duet that violates the Code and Standards (page 18)

Co recommend practices and procedures designed to prevent violations of the: Code

of Ethics and Standards of Professional Conduct (page 18)

3 Introduction to the Global Investment Performance Standards (GIPS*)The candidate should be able to:

a explain why the: GIPS standards were created what parties the GIPS standardsapply to, and who is served by the standards (page 82)

b explain the construetion and purpose of composites in performance reporting.(page: 83)

Co explain the requirement> for verification (page 83)

4 The GIPS StandardsThe candidate should be able to:

a describe the kcy features of the GIPS standards and the fundamentals ofcompliance (page 84)

b describe the scope: of the GIPS standards with respect to an investment firm'sdefinition and historieal performance record (page: 86)

Co explain how the GIPS standards are implemented in countries with existingstandards for performance reporting and describe the appropriate response whenthe GIPS standards and local regulations eonRiet (page 86)

d describe the nine major sections of the GIPS standards (page 86)

STUDY SESSION 2

5. The Time Value of Money

The candidate should be able to:

a interpret interest rates as required rates of return, discount rates, or opportunitycosts (page 100)

b explain an interest rate as the sum of a real risk-free rate, and premiums thatcompensate investors for bearing distinct types of risk (page 101)

Co calculate and interpret the effective annual rate, given the stated annual interestrate and the frequency of compounding (page 101)

nook 1 - Ethical and Prof ionol Standards and Quantitative Methods

RndiDg Assipmenu aDd !Aaming OUlcome SI"lfnlents

d solve time value of moncy problems for different frequencies of compounding

(page 103)

e calculate and interpret the future value (FV) and present value (PV) of a single

sum of moncy, an ordinary annuity, an annuity due, a perpetuity (PV only), and

a series of unequal cash flows (page 104)

f. demonstrate the usc of a time line in modeling and solving time value of moncy

problems (page 118)

6 Discounted Cash Flow Applications

The candidate should be able to:

a calculate and interpret the net present value (NPV) and the internal rate of

return (IRR) of an investment (page 138)

b contrast the NPV rule to the IRR rule, and identify problems associated with

the IRR rule (page 141)

c calculate and interpret a holding period return (total return), (page 143)

d calculate and comparc the moncy-weightcd and time-weighted rates of return of

a portfolio and evaluate the performance of portfolios based on these measures

(page 143)

e calculate and interpret the bank discount yield, holding period yield, effective

annual yield, and moncy market yield for u.s.Treasury biDs and other money

market instruments (page 147)

f convert among holding period yields, moncy market yields, effective annual

yields, and bond equivalent yields (page 150)

7 Statistical Concepts and Market Returns

The candidate should be able to:

a distinguish between descriptive statistics and inferential statistics, between

a population and a sample, and among the types of measurement scales

(page 163)

b define a parameter, a sample statistic, and a frequency distribution (page 164)

c calculate and interpret relative frequencies and cumulative relative frequencies,

given a frequency distribution (page 166)

d describe the properties of a data set presented as a histogram or a frequency

polygon (page 168)

e calculate and interpret measures of central tendency, including the population

mean, sample mean arithmetic mean, weighted average or mean, geometric

mean, harmonic mean, median, and mode (page 169)

f calculate and interpret quarriles, quintiles, deciles, and percentiles (page 174)

g calculate and interpret 1) a range and a mean absolute deviation and 2) the

variance and standard deviation of a population and of a sample (page 175)

h calculate and interpret the proportion of observations falling within a specified

number of standard deviations of the mean using Chebyshev's inequality

k describe the relative locations of the mean, median and mode for a unimodal,

nonsymmetrical distribution (page 183)

1 explain measures of sample skewness and kurtosis (page 184)

m compare the use of arithmetic and geometric means when analyzing investment

returns (page 186)

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Book I - Elhical and Prof ionai SCllIdards and Quanli tivr Methods

IUadinsAuignmonu ""d Uaming OUlromo Slalomonu

S Probability ConccpuThe candidate should be able to:

a define a random variable an outcome an event mutually exclusive events, andexhaustive events (page 201)

b state the two defining properties of probability and distinguish among empirical,subjective and a priori probabilities (page 201)

Co state the probability of an c:vc:ntin terms of odds for and against the event.(page 202)

d distinguish between unconditional and conditional probabilities (page 203)

e explain the multiplication addition and total probability rules (page 203)

f. calculare and interpret 1) the joint probability of two events 2) the probabilitythat at least one of twoevents will occur given the probability of each and thejoint probability of the two events and 3) a joint probability of any number ofindependent events (page 204)

g distinguish between dependent and independent events (page 207)

h calculate and interpret an unconditional probability wing the tOW probabilityrule (page 20S)

I. explain the usc of conditional expectation in investment applications (page 212)

j explain the usc of a tree diagram to represent an investment problem (page 212)

k calculate and interpret covariance and correlation (page 213)

I calculate and interpret the expected value variance and standard deviation of arandom variable and of returns on a portfolio (page 217)

m calculate and interpret covariance given a joint probability function (page 21S)

n calculate and interpret an updated probability using Bayes' formula (page 222)

o identify the most appropriate method to solve a particular counting problem,and solve counting problems using factorial, combination, and permutationconcepts (page 224)

Co interpret a cumulative distribution function (page 247)

d calculate and interpret probabilities for a random variable, given its cumulativedistribution function (page 247)

e define a discrete uniform random variable a Bernoulli random variable and abinomial random variable (page 24S)

f. calculate and interpret probabilities given the discrete uniform and the binomialdistribution functions (page 24S)

g construct a binomial tree to describe stock price movement (page: 251)

h calculate and interpret tracking error (page 253)

i define the continuow uniform distribution and calculate and interpretprobabilities given a continuous uniform distribution (page 253)

j explain the key properties of the normal disuibution (page 255)

k distinguish between a univariate and a multivariate distribution and explain therole of correlation in the multivariate normal distribution (page 255)

nook 1 - Ethical and Prof ion:ol Standardsand Quanulllive Methods

ReadiDg AS$ipmeDu and Lurning OUlcome S,a,ONeDu

I determine the probability that a normally distributed random variable lies inside

a given interval (page: 256)

m define the standard normal distribut.ion, explain how to standardize a random

variable, and calculate and interpret probabilities using the standard normal

distribution (page 258)

n define shortfall risk, calculate the safety-fint ratio, and select an optimal

portfolio using Roy's safety-fint criterion (page: 261)

o explain the relationship between normal and lognormal distributions and why

the lognormal distribution is used to model asset prices (page 263)

p distinguish between discretely and continuously compounded rates of return,

and calculate and interpret a continuously compounded rate of return, given a

specific holding period return (page 264)

q explain Monte Carlo simulation and describe its major applications and

limitations (page:266)

r compare Monte Carlo simulation and historical simulation (page 267)

10 Sampling and Estimation

The candidate should be able to:

a define simple random sampling and a sampling distribution (page 281)

b explain sampling error (page 281)

c distinguish between simple random and stratified random sampling (page 282)

d distinguish between time-series and cross-sectional data (page 283)

e. explain the central limit theorem and its importance (page 283)

f calculate and interpret the standard error ofthe sample mean (page 284)

g identify and describe desirable properties of an estimator (page 286)

h distinguish between a point estimate and a confidence interval estimate of a

population parameter (page: 286)

i describe properties of Student's r-distribution and calculate and interpret its

degrees of freedom (page 286)

j calculate and interpret a confidence interval for apopulation mean, given a

normal distribution with I) a known population variance, 2) an unknown

population variance, or 3) an unknown variance and a large sample size

(page 288)

k describe the issues regarding selection of the appropriate sample size

data-mining bias sample selection bias, survivonhip bias, look-ahead bias and

time-period bias (page 293)

11 Hypothesis Testing

The candidate should be able to:

a define a hypothesis, describe the steps of hypothesis testing and describe and

interpret the choice of the null and alternative hypotheses (page 304)

b distinguish between one-tailed and two-tailed tests of hypotheses (page 305)

c explain a test statistic, Type Iand Type IIerrors, a significance level, and how

signifieance level are used in hypothesis testing (page 309)

d explain a decision rule the power of a test, and the relation between confidence

intervals and hypothesis tests (page 311)

e distinguish between a statistical result and an economically meaningful result

(page 313)

f explain and interpret the p-vaIue as it relates to hypothesis testing (page 314)

g identify the appropriate test statistic and interpret the results for a hypothesis

test concerning the population mean of both large and small samples when

the population is normally or approximately distributed and the variance is I)

known or 2) unknown (page 315)

Book I - Elhical and Pmf ional SCllIciards and Quanti tive M.thod,

IUadinsAssignmenu IUIdUaming Outcome Stat.menu

h identify the appropriate tot statistic and interpret the results for a hypothesistest concerning the equality of the population means of two at least

approximately normally distributed populations based on independent randomsamples with 1)equal or 2) unequal assumed variances (page 318)

i identify the appropriate tot statistic and interpret the results for a hypothesistest concerning the mean difference of two normally distributed populations.(page 322)

j identify the appropriate tot statistie and interpret the results for a hypothesistest coneerning 1) the variance of a normally distributed population and 2) theequality of the variances of two normally distributed populations based on twoindependent random samples (page 326)

k distinguish between parametric and nonparametrie tests and describe situations

in which the usc of nonparametric tests may be appropriate (page 333)

12.Tcchnical AnalysisThe candidate should be able to:

a explain principles of technical analysis its applications and its underlyingassumptions (page 344)

b describe the construction of different typo of technical analysis charts andinterpret them (page 345)

Co explain usesof trend support resistance lines and ehange in polarity

(page 348)

d describe common chart patterns (page 349)

e describe common tcchnical analysis indicators (price-based momentumoscillators sentiment and 80w of funds) (page 351)

f explain how technical analysts usc cycles (page356)

g describe the kcy tenets of Elliott Wave Theory and the importance of Fibonaccinumbers (page 356)

h describe intermarket analysis as it relates to technical analysis and assetallocation (page357)

The foilowiAC II a rnicw of the Ethical and Profcnional Su.ndatdl principle dalcntd to addresl the

lamiA, outcome tatemcnu let lorth br CFA Iftllitute Thit topic i alto eereeed in:

CFA INSTITUTE CODE OF ETHICS AND

STANDARDS OF PROFESSIONAL CONDUCT

GUIDANCE FOR STANDARDS I-VII

Study Session 1

In addition to reading this review of the ethics material we strongly recommend that

allcandidates for the CFAe examination read the StllWrtis ofPrIl<tirt Hllndbook 10th

Edition (2010) multiple times.1u a Level I CFA candidate it is your responsibility to

comply with the CoaL IIna Stllwrds The complete COM IIna StIlWrtis are reprinted in

Volume 1 of the CFA Program Curriculum

LOS La: Describe the structure of the CFA Institute Professional Conduct

Program and the process for the enforcement of the Code and Standards

CFAe Progrrzm Curriculum VolumL 1.P"KL 8

The CFA Institute Professional Conduct Program is covered by the CFA Institute

Bylaws and the Rules of Procedure for Proceedings Related to Professional Conduct The

Program is based on the principles of fairness of the process to members and candidates

and maintaining the confidentiality of the proceedings The Disciplinary Review

Committee of the CFA Institute Board of Governors has overall responsibility for the

Professional Conduct Program and enforcement of the Code and Standards

The CFA Institute Designated Officer through the Professional Conduct staff, conducts

inquiries related to professional conduct Several circumstances can prompt such an

inquiry:

1 Self-disclosure by members or candidates on their annual Professional Conduct

Statements of involvement in civil litigation or a criminal investigation, or that the

member or candidate is the subject of a written complaint

2 Written complaints about amember or candidate's professional conduct that arc

received by the Professicnsl Conduct staff

3 Evidence of misconduct by a member or candidate that the Professional Conduct

staff received through public sources such as a media article or broadcast,

4. A report by a CFA exam proctor of a poS$ible violation during the examination

Once an inquiry has begun, the Professional Conduct staff may request (in writing) an

explanation from the subject member or candidate and may: (1) interview the subject

Study S ion 1

Cross- ~fmDce toCFAlrutitute Aui£ned Readings" &c2 - Standards ofPnetice Handbook

member or candidate, (2) interview the complainant or other third parries, andlor(3) collect documents and records relevant to the invatigation

The Designated Officer may decide: (I) that no disciplinary sanctions are appropriate,(2) to issue a cautionary Ienet, or (3) to discipline the member or candidate In a casewhere the Designated Officer 6nds a violation has occurred and proposes a disciplinarysanction the member or candidate may accept or reject the sancrion If the member

or candidate chooses to reject the sanction, the matter will be referred to a panel ofCFA Institute members for a hearing Sanctions imposed may include condemnation

by the member's peel$ or suspension of candidate's continued participation in the CFAProgram

LOS l.b: State the six components of the Code of Ethics and the seven Standards of Professional Conduct.

cr-A® l'rDgram Currin.lum ""fumt 1.P"lt 14

CODE OF ETHICS

Members ofCFA Institute [including Chartered Financial Analyst® (CFA®)chanerholders) and candidates for the CFA designation ("Members and Candidates"]must:'

o Act with integrity competence, diligence respect, and in an ethical manner withthe public clients prospective clients employers employees colleagues in theinvestment profession and other participants in the global capital markets

o Place the integrity of the investment profession and the interests of c1ienu abovetheir own personal interests

o Usc reasonable care and exercise independent professional judgment whenconducting investment analysis making investment recommendations takinginvestment actions and engaging in other professional activities

o Practice and encourage others to practice in a professional and ethical manner thatwill reRect credit on themselves and the profession

o Promote the integrity of and uphold the rules governing capital markeu

o Maintain and improve their professional competence and strive to maintain andimprove the competence of other investment professionals

THE STANDARDS OF PROFESSIONAL CONDUCTI: Professionalism

II: Integrity ofCapiraJ MarkeuIII: Duties to Clients

IV: Duties to EmployersV: Investment Analysis Recommendaricns, and ActionsVI: ConRiets of Inrerese

VII: Responsibilities as a CFA Institute Member or CFA Candidate

1. Copyriglll2010 CFA Institute Reproduced and republished from 'The Code orEthics,"fromSt",,""rrIs DfPrrm;u HttntlbD.lt lOth EtI.•2010 with permission fromCFA Institute,All righu reserved

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Study Seuion 1Cross·Rd'~mtce to CFA Inaitut~ Auignod Rudings II &:2 - Sw>dani of Praetiee Handbook

LOS Lee Explain the ethical responsibilities required by the Code and

Standards, including the sub-sections of each Standard

A Knowledge of the Law Membcn and Candidates must understand and

comply with all applicable laws, rules, and tegulations (including the CFA

Institute COM ofEthies and Standards ofProftssio1l41 um"uct) of any

government, regulatory organization, licensing agency, or professional

association governing their professional activities In the c:vcnt of conflict,

Members and Candidates must comply with the more strict law, rule, or

regulation Members and Candidates must not knowingly participate or assist

in a.ny violation of laws, rules, or regulations and must disassociate themselves

from any such violation

B Independence and Objc:ctivity Members and Candidates must use reasonable

care and judgment to achieve and maintain independence and objectiviry in

their prof'cssional activities Members and Candidates must not offer, solicit, or

accept any gift, benefit, compensation, or consideration that reasonably could

beexpected to compromise their own or anothers independence and

objc:ctiviry

C Misrepresenution Member and Candidates must not knowingly make any

misrepresentations relating to investment analysis, recommendations, actions,

or other professional activities

D Misconduct Members and Candidates mull not engage in any professional

conduct involving dishonesry, fraud, or deceit or commit any act th:u reflects

adversely on their professional reputation, integrity, or competence

A Material Nonpublic Information Members and Candidates who possess

material nonpublie information that could affcct the value of an investment

must not act or cause others to act on the information

B. Market Manipulation Members and Candidates must not engage in practices

that distort prices or artificially inflate trading volume with the intent to

mislead market participants

A Loyalry, Prudence, and Can: Members and Candidates have a duty of loyalty

to their clients and must act with reasonable care and exercise prudent

judgment Members and Candidates must act for the benefit of their clients

and place their clients' interests before their employer's or their own interests

2 Ibid

Study St.';"n I

Cro, s- lUrereDC>eto CFAInstiltlle AssiGned Readings '1 &c2 - Standards or p",c:tice Handbook

B Fair Dealing Members and Candidates must deal fairly and objectively with

allclients when providing investment analysis, malcing investmentrceommendations, taking investment action, or engaging in other professional

b Determine that an investment is suitable to the client's financialsituation and consistent with the client's wrinen objectives, mandates,and constraints before making an investment recommendation ortaking investment action

c Judge the suitability of investments in the context of the client's totalponfolio

2 When Members and Candidates arc responsible for managing a portfolio to

a specific mandate strategy, or sryle, they must make only investmentrecommendations or take investment actions that are consistent with thestated objeedves and constraints of the portfolio

D Performance Presentation When communicating investment performanceinformation, Members or Candidates must make reasonable drons to ensurethat it is fair, accurate, and complete

E Preservation of Confidentiality Members and Candidates must keepinformation about current, former, and prospective clients confidential unless:

1 The information concerns illegal activities on the part of the client orprospective client,

2 Disclosure is required by law, or

3 The client or prospective client permits disclosure of the information

A Loyalty In matters related to their employment Members and Candidatesmust act for the benefit of their employer and not deprive their employer of theadvantage of their skills and abilities divulge confidential information, orotherwise cause harm to their employer

B Additional Compensation Arrangements Members and Candidates must notaccept gifts benefits, compensation, or consideration that competes with or

Study Session I Ctoss-~f~rence 10CFA Inaitutt Assigntd IUadings II &: 2 - Sw>danisof Practice Handbook

might teasonably be expected to create a conBict of intereat with their

employ.,,'s interest unless they obtain written consent from all parties involved

C Responaibilities of Supervisors Members and Candidates must make

reasonable drom to detect and ptt"VCntviolations of applicable laws rules

regulations and the Code and Standards by anyone subject to their supervision

or authority

A Diligen ee and Reasonable Basis Members and Candidates must:

1 Exercise diligen ce, independence and thoroughness in analyzing

investments, making investment recommendations and taking investment

actions

2 Have a reasonable and adequate basis supported byappropriate research

and investigation for any invcsunent analysis, recommendation or action

B Communication with Clients and Prospective Clients Members and

Candidates must:

1. Disclose to clients and prospective clients the basic format and gener.tl

principles of the investm"nt proc""cs used to analyz" invt"Stm"nts selec t

securiti es, and construct portfolios and must promptly disclosc any changes

that might materially afl'=thoseprocesses,

2 Usc reasonable judgment in id"ntifying whim factors are important to their

investment analyses recommendations or actions and include those f.actors

in communications with c1i"nts and prospective clients

3 Distinguish between f.act and opinion in the presentation of investment

analysis and recommendations

C Record Retention Members and Candidates must develop and maintain

appropriate records tosuppon their invesunent analysis recommendations,

actions and other investment-related communications with clients and

prospective clients,

A Disclosure of ConBicts Members and Candidates musr make full and f.air

disclosure of all matters that could reasonably be cxpeeted to impair rheir

Independence and objectivity or interfere with respective duties to their clients

prosp ec rive clients, and employer, Members and Candidates must ensure that

such disclosures are promin"nt are delivered in plain language and

communicate the relevant information dfeetively

B Priority ofTransactions.lnvcstment transactions for c1i"nts and employers

must have priority over investmenr transactions in whim a Memb"r or

Candidate is the b"n,,6cial owner

StudyS.""'n I

Cross-lU(ereDC>eto CFA lrutiwte Assigned Readings'l &c 2 - Standards o(P",c:tice Handbook

C Refaral Fees Members and Candidates must disclose to their employer.clients and prospective eliene asappropriate any compensation

consideration or benefit received from or paid to others for therecommendation of products or services

CANDIDATE

A Conduct a.sMembers and Candidates in the CFA Program Members andCandidates mwt not engage in any conduct that compromises the reputation

or integrity of CFA Institute or the CFA designation or the integrity validity

or security of the CFA examinations

B Reference to CFA Institute the CFA Designation and the CFA Program.When referring to CFA Institute CFA Institute membership the CFAdesignation or candidacy in the CFA Program Members and Candidates mustnot misrepresent or <X2ggeratethe meaning or implications of membership inCFA Institute holding the CFA designation or candidacy in the CFAProgram

LOS 2.a: Demonstrate the application of the Code of Ethics and Standards of Professional Conduct to situations involving issues of professional integrity.

LOS 2.b: Distinguish between conduct that conforms to the Code and Standuds and conduct that violates the Code and Standards.

LOS 2.c: Recommend practices and procedures designed to prevent violations

of the Code of Ethics and Standards of Professional Conduct.

cr~~Progftlm CII"iC'Ulllm Yo/11m I pag 19

I (A) Knowle of the Law.Members and Candidatcs must undcmand andcomply with all applicable laws rules and regulations (including the CFA InstituteCode of Ethics and Standards of Profasional Conduct) of any government, regulatoryorganization licensing agency or professional a.ssociation governing their prokssionalactivities Inthe event of conRia Members and Candidates must comply with themore strict law rule or regulation Members and Candidates must not knowinglypanicipaa: or assist in and must diuociate (rom any violation of such laws rules orregulations

~ Profnso,j Nst«: Whik w us th term "mtmbtn" in tht following not« that all

~ oftht Stanu,J, apply to canJitltttn 41 wtlL

Study Session 1 c.o.s·~f~rence to CFA Institutt AIIigntd Rudings II &: 2 - Sw>dani of Practice Handbook

G ;a,mc_Cotle Anti StAntlArtis lIS. LDcAI Lalli

Members must know the laws and regulations relating to their professional activities in

aUcountries in which they conduct business, Members must comply with applicable

laws and regulations relating to their professional activity Do not violate Code or

Standards even if the activity is otherwise legal Always adhere to the most strict rules

and requirements (law or CFA Institute Standards) that apply

GviaAnc_PArticipA,ion orAssociAtion Wi,h Violations by Othen

Members should dissociate or separate themselves from any ongoing client or employee

aaivity that is ilkgal or unethical even if it involves leaving an employer (an extreme

case) While a member may confront the involved individual first he must approach

his supervisor or compliance department Inaaion with continued association may be

construed as knowing participation

Ruommentletl ProeeJlU'u for CompliAnc_MemHrs

• Members should have procedures to keep up with changes in applicable laws rules

and regulations

• Compliance procedures should be reviewed on an ongoing basis to assure that they

address current law CFAI Standards and regulations

• Members should maintain current reference materials for employees to access in

order to keep up to date on laws rules and regulations

• Members should seck advice of counsel or their compliance department when in

doubt

• Members should document any violations when they disassociate themselves from

prohibited activity and encourage their employers to bring an end to such activity

• There is no requirement under the Standards to report violations to governmental

authorities but this may be advisable in some circumstances and required by law in

others

• Members are strongly encouraged to report other members' violations of the Code

and Standards

Recomme"Jetl ProeetllU'esfor CompliAnc_Firms

Members should encourage their firms to:

• Develop andlor adopt a code of ethics

• Make available to employees information that highlights applicable laws and

regulations

• Establish written procedures for reporting suspected violation of laws regulations or

company policies

Members who supervise the creation and maintenance of investment services and

produas should be aware of and comply with the regulations and laws regarding such

services and produas both in their country of origin and the countries where they wiU

be sold

Study St""'n I

Cross-lUfereDC>eto CFA lrutitute Aui£ntd lUadings'l &c 2 - Standards ofP",ctla: Handbook

Applic.tilln "lSUI"".,d I(A) Knl1",/~dg~IIIth~ LIIu?

Example I:

Michael Allen works for a brokerage firm and is responsible for an underwriting ofsecurities Acompany official gives Allen information indicating that the financialstatements Allen filed with the regulator overstate the issuer's carnings Allen seeks theadvice of the brokerage firm's general counsel, who states that it would be difficult forthe regulator to provc that Allen has been involved in any wrongdoing

Comment:

Although it is recommended that members and candidates seck the advice of legalcounsel, the reliance on such advice does nor absolve a member or candidate from therequirement to comply wilh the law or regulation Allen should cepon this siruation tohis supervisor, seck an independent legal opinion, and determine whether the regulatorshould be nerified of the error

Example 2:

Kamisha Washington's firm advcnis esils pasl performance record by showing the year rerurn of a eomposiee of its client accounts However, Washington discovers that thecomposite omits Ihe performance of accounts that havc lefl the firm during the 10-yearperiod and that this omission has led ro an inRaled performance figure Washington

10-is asked ro we promotional material that includes the erroneous performance numberwhen soliciting bwiness for the firm

Comment:

Misreprcsenring performance is a violation of the Code and Standards Although she didnot calculate the performance herself, Washington would be assisting in violating thisstandard if she were to UJe the inRated performance number when soliciting clients Shcmust dissociate hcrself from the activity She can bring the misleading number to theattention of the person responsible for calculating performance, her supervisor, or thecompliance department at her firm If her firm is unwilling to recalculate performance,she must refrain from using the misleading promotional material and should notifythe firm of her reasons Ifthe firm insists that she usc the material she should considerwhether her obligation to dissociate from the activity would require her to seck otheremployment

Example 3:

An employee of an investment bank is working on an underwriting and finds out theissuer hasaltered their financial statements to hide operating losses in one division.These missrated dara are included in a preliminaty prospecrus that has already beenreleased

Comment:

The employee should report the problem to his supervisors If the firm doesn't get themisstatement fixed the employee should dissociate from the underwriting and further.seek legal advice about whether he should undercake additional reponing or otheractions

3 Ibid

Study SessioD I ero ·~f~rence to CFA ID.ututt Auignod Rudingt II &: 2 - Sw>dani of Practice Handbook

Example 4:

Laura Jameson, a U.S citizen, works for an investment advisor based in the United

States and works in a country where investment managers are prohibited from

panicipating in IPOs for their own accounts

Comment:

Jameson must comply with the srrietest requirements among U.S law (where her firm

is based), the CfA Institute Code and Standards, and the laws of the country where she

is doing business In this case that means she must not panicipate in any IPOs for her

personal account

Example 5:

A junior porrfolio manager susp«ts that a broker responsible for new business from

a foreign country is being allocated a portion of the firm's payments for third-party

research and suspeas that no research is being provided He believes that the research

payments may be inappropriate and unethical

Comment:

He should foUow his firm's procedures for reporting possible unethical behavior and try

to get better disclosure of the nature of these payments and any research that is being

provided

I(B) IndcpeDcImcc aad Objectivity Members and CandidalCl mUll UJC reuonable

care aad judgment to achieve aad mainaain independence aad objectivity in their

professional activities Members and Candidates must not ofli:r solicit, or accept any

gift, beneSt compensation or consideration that reasonably could be espeeeed to

compromisc their own or another's independence and objc:aivity

G"iJllnee

Do not let the investment process be in8uenced by any external sources Modest gifts

are permitted Allocation of shares in oversubscribed IPOs to personal accounts is

NOT permitted Distinguish between gifts from clients and gifts from entities seeking

in8uence to the detriment of the client Gifts must be disclosed to the member's

employer in any case, either prior to acceptance if possible, or subsequently

G"iunce-Inlllltmmt Bllnlrinl /ullltiQnshipl

Do not be pressured by sell-side firms to issue favorable research on current or

prospective investment-banking clients It is appropriate to have analysts work with

investment bankers in "road shows· only when the con8ias are adequately and

effectively managed and disclosed Be sure there are effective "firewalls· between

research/investment management and investment banking activities

Gllithnc_Buy-SiJe C/U",.

Buy-side clients may try to pressure sell-side analysts Portfolio managers may have largepositions in a particular security, and a tating downgrade may have an effect on theportfolio performance Iu a portfolio manager, there is a responsibility to respecr andfoster intellectual honesry of sell-side research

Guithnc_Fllntl Mllnllger /Ufilliomhips

Members responsible for selecting outside managers should not accept gifts,entertainment, or travel that might be perceived as impairing their objectivity

Gllithnc-Crrtlit RIlling Agencin

Members employed by credit rating firms should make sure that procedures preventundue inlluencc: by the firm issuing the securities Members who usc credit ratingsshould be aware of this potential conllict of interest and consider whether independentanalysis i warranted

Guithnc_lsslln'-P"iJ Reltllrt:h

Remember that this type of research is fraught with potential conllicts Analysts'compensation for preparing such research should be limited, and the preference is for alIat fee, without regard to condusions or the report's recommendations

Gllithnc_Trlll1d

Best practice is for analysts to pay for their own commercial travel when attendinginformation events or tours sponsored by the firm being analyzed

/UcommenMtl Proudllrn for (Ampfumee

• Protect the integrity of opinions-make sure they are unbiased

• Create a restricted list and distribute only factual information about companies onthe lisr

• Restrict special cost arrangements-pay for one's own commercial transportationand hotel; limit usc of corporate aircraft to cases in which commercial transportation

is not available

• Limit gifts-token items only Customary, business-related entertainment is okay

as long as its purpose is not to inlluence a member's professional independence orobjectivity Firms should impose clear value limits on gifts

• Restrict employee investments in equity IPOs and private placements, Require approval of IPO purchases

pre-• Review procedures-have effective supervisory and review procedures

Study Session 1Ctoss·~f~rence to CFA InAitutt Assigntd Rndings II &:2 - Sw>danis of Practice Handbook

• Firms should have formal written policies on independence and objectivity of

research

• Firms should appoint a compliance officer and provide clear procedures for

employee reporting of unethical behavior and violations of applicable regulations

ApplNtltion ofSttlnUrd I(B) Intkpentkncr tiM Objrm,,;ty

&ample 1:

Steven Taylor, a mining analyst with Bronson Brokers, is invited by Precision Metals to

join a group of his peers in a tour of mining facUities in several western U.S states The

company arranges for chartered group Rights from site to site and for accommodations

in Spartan Motels, the only chain with accommodations near the mines, for three nights

Taylor allows Precision Metals to pick up his tab, as do the other analysts with one

exception-John Adams an employee of a large trust company who insists on foUowing

his company's policy and paying for his hotd room himself

Comment:

The policy of the company where Adams works complies closely with Standard I(B) by

avoiding even the appearance of a conAict of interest, but Taylor and the other analysts

wen: not necessarily violating Standard I(B) In general, when allowing companies to pay

for travel and/or accommodations under these circumstances, members and candidates

must use their judgment keeping in mind that such arrangements must not impinge

on a member or candidate's independence and objectivity In this example, the trip was

strictly for business and Taylor was not accepting irrelevant or lavish hospitality The

itinerary required chartered Rights, for which analysts were not expected to pay The

accommodations were modest These arrangements are not unusual and did not violate

Standard I(B) so long as Taylor's independence and objectivity were not compromised

In the final analysis members and candidates should consider both whether thcy can

remain objective and whether their integrity might be perceived bytheir clienrs to have

been compromised

&ample 2:

Walter Fritz is an equity analyst with Hilton Brokerage who covers the mining industty

He has concluded that the stock ofMetals & Mining is overpriced at its current level

but he is concerned that a negative research report willhurt the good relationship

between Metals & Mining and the investment-banking division of his firm In faCt a

senior manager of Hilton Brokerage has just sent him a copy of a proposal his firm has

made to Metals & Mining to underwrite a debt offering Fritz needs to produce a report

right away and is concerned about iSluing a less-than-favorable rating

Comment:

Fritz's analysis of Metals & Mining must be objective and based solely on consideration

of company fundamentals Any pressure from other divisions of his firm is inappropriate

This conRict could have been eliminated if, in anticipation of the offering, Hilton

Brokerage had placed Metals & Mining on a restricted list for its sales force

Example 3:

Tom Wayne is the investment manager of the Franklin City Employees Pension Plan

He recently completed a successful search for firms to manage the foreign equity

allocation of the pian's diversified portfolio He followed the pian's standard procedure

02013 Kapbn Inc

Study ~uion I

Cros$-lUfereoC>e to CFA lrutitu~ Auij;ntd lUadings'l &c2 - Standards ofPnctice Handbook

of seeking presentations ITom a number of qualified firms and recommended that hisboard select Penguin Advisors because of iu experience, well-defined investment strategy,and performance record, which was compiled and verified in accordance with theCFA Institute Global Investment Performance Standards Following the plan selection

of Penguln, a reporter from the Franklin Ciry Record called to ask if there was anyconnecrion between the action and the fact that Penguin was one of the sponsors of an

"investment fact-finding trip to Asia" that Wayne made earlier in the yc:ar.The trip wasone of several conducted by the Pension Investment Academy, which had arranged theitinerary of meetings with economic, government and corporate officials in major cities

inseveral Asian countries The Pension Investment Academy obtains support for the cost

of these trips from a number of investment managers, including Penguin Advisors; theAcademy then pays the travel ~xpenscs of the various pension plan managers on the tripand provides all meals and accommodations The president of Penguin Advisors was one

of the travclers on the trip

CommeDt:

Although Wayne can probably put to good use the knowledge he gained from the trip

in selecting portfolio managers and in other areas of managing the pension plan, hisrecommendation of Penguin Advisors may be tainted by the possible conRict incurredwhen he participated in a trip paid for partly by Penguin Advisors and when he was inthe daily company of the president of Penguin Advisors To avoid violating StandardI(B), Wayne's basicexpenses for travcl and accommodation.s should have been paid

by his employer or the pension plan; contact with the president of Penguin Advisorsshould have been limited to informational or educational events only; and the trip, theorganizer, and the sponsor should have been made a matter of public record Even ifhisactions were not in violat.ion of Standard 1(B), Wayne should have been sensitive to thepublic perception of the trip when reported in the newspaper and the extent to whichthe subjective elements of his decision might have been affected bythe familiariry thatthe daily contact of such a trip would ~ncourage This advantage would probably not beshared by competing firms

Example 6:

A money manager receives a gift of significant value from a client as a reward for goodperformance over the prior period and informs her employer of the gift

02013 Kaplan Inc.

StudySeuiOD 1Ctou·~f~rence toCFA ID itute Auigntd Rudingt II &:2 - Sw>dani of Praaic~ HandbookComment:

No violation here because the gift is from a client and is not based on performance going

forward but the gift must be disclosed to her employer If the gift were contingent on

future performance the money manager would have to obtain permission from her

employer The reason for both the disclosure and permission requirements is that the

employer must ensure that the money manager docs not givc advantage to the client

giving or offering additional compensation to the detriment of other clients

Example 7:

An analyst enters into a coneract to write a research report on a company, paid for

by that company for a Ratfee plus a bonus based on attracting new investors to the

security

Comment:

This is a violation because the compensation structure makes tocal compensation depend

on the conclusions of the report Co.favorable report will attract invcstors and increase

compensation) Accepting the job for a Ratfcc that docs not depend on the report's

conclusions or its impact on share price is permitted, with propcr disclosure of the fact

that the report is funded by the subject company.

Example 8:

A trust managcr at a bank selects mucual funds for client accounts based on the profits

from "service fees' paid to the bank by the mutual fund sponsor.

Comment:

This is a violation because the trust manager has allowed the fees to affect hi, objectivity

Example 9:

An analyst performing sensitivity analysis for a security docs not usc only scenarios

ccnsistent with recent trends and historical norms

Comment:

This is a good thing and is not a violation

Study s.uton I

ero, lUfereDC>eto CFA Institute Auign.d lU ungs '1 &c 2 - Standards of Practice Handbook

ICC) Mun:pn:ocatatioa Membcn and Canclidac:a must not knowingly make anymisrepreKntations relating toinvcstmc:nt analysis, recommendations, ac:tions, orother professional activilic:s

Gui""nee

Trust is a foundation in the investment profession Do not make any misrepresentations

or give f21seimpressions This includes oral and electronic communications

Misrepresentations include guaranteeing investment performance and plagiarism.Plagiarism encompasses using someone else's work (reports, forecasu, models, ideas,charts, graphs, and spreadsheet models) without giving them credit Knowingly omittinginformation that could affect an investment decision is considered misrepresentation

Models and analysis developed by others at a member's firm an: the propc:rty of the firmand can be used without attribution Areport written by another analyst employed bythe firm cannot be released as another analyst's work

RNommentkJ PrtJeeJureIfl,(Amplilmee

Agood way to avoid misrepresentation is for firms to provide employees who deal withclients or prospecu a written list of the firm's available services and a description of thefirm's qualifications Employee qualifications should be accurately presented as well

To avoid plagiarism, maintain records of all materials used to generate repons or otherfirm products and properly cite sources (quotes and summaries) in work products.Information from recognized financial and statistical reporting services need not becited

Members should encourage their firms to establish procedures for verifying marketingclaims of third parties whose information the firm provides to clients

Applieotion of Sum"",J Ire)Mis"p"lentlltwn

Example I,Allison Rogers is a partner in the firm of Rogers and Black, a small firm offeringinvestment advisory services She assures a prospective: client who has just inherited

$1 million that "we can perform all the financial and investment services you need."Rogers and Black is well equipped to provide investment advice but, in fact, cannotprovide asset allocation assistance or a full array of financial and investment services.Comment:

Rogers has violated Standard I(C) by orally misrepresenting the services her firm canperform for the prospective: client She must limit herself to describing the range ofinvestment advisory services Rogers and Black can provide and offer to help the clientobtain elsewhere the financial and investment services that her firm cannot provide.Example 2,

Anthony MeGuire is an issuer-paid analyst hired by publicly traded companies toelectronically promote their stocks McGuire creates a website that promotes his

02013 Kaplan, Inc

Study Ses.iOD 1Cross·~f~rence toCFA ID.ututt Assilllltd Rudings II &2 - Sw>danI of Practice Handbook

research dfom as a seemingly independent analyst McGuire postS a profile and a strong

buy recommendation for each company on the website indicating that the stock is

expected to increase in value He docs not disclose the contractual relationships with the

companies he covers on his website in the research reports he issues or in the statements

he makes about the companies on Internet chat rooms

Comment:

McGuire has violated Standard I(C) because the Internet site and e-mails arc misleading

to potential investors Even if the recommendations arc valid and supported with

thorough research his omissions regarding the true relationship between himself and the

companies he covers constitute a misrepresentation McGuire has also violated Standard

VI(C) by not disclosing the existence of an arrangement with the companies through

which hereceives compensation in exchange for his services

Example 3:

Claude Browning a quantitative analyst for Double Alpha Inc • returns in great

excitement from a seminar In that seminar, Jack Jorrely, a ell-publicized quantitative

analyst at a national brokerage firm, discussed one of his new models in great detail,

and Browning is intrigued by the new concepts He proceeds to test this model, making

some minor mechanical changes but retaining rhe concept, until he produces some

very positive results Browning quickly announces to his supervisors at Double Alpha

that he has discovered a new model and that clients and prospective clients alike should

be informed of this positive finding as ongoing proof of Double Alpha's continuing

innovation and abiliry to add value

Comment:

Although Browning tested Jorrely's model on his own and even s1ighdy modified it, he

must still acknowledge the original source of the idea Browning can certainly take credit

for the final, practical results; he can also support his conclusions with his own test The

credit for the innovative thinking, however, must be awarded to Jorrely

Example 4:

Paul Ostrowski runs a 2-person investment management firm Ostrowski's firm

subscribes to a service from a large investment research firm that provides research

reports that can be repackaged by smaller firms for those rums' clients Ostrowski's firm

distributes these reports to clients as its own work

Comment:

Ostrowski can rely on third-party research that has a reasonable and adequate basis,

but he cannot imply that he is the author of the report Otherwise, OStrowski would

misrepresent the extent of his work in a way that would mislead the firm's clients or

prospective clients

Example S:

A member makes an error in preparing marketing materials and misstates the amount of

assets his firm has under management

Comment:

The member must attempt to stOp distribution of the erroneous material as soon as

the error is known Simply malting the error unintentionally is not a violation, but

Study~n I

CroS$-lUfereDC>eto CFA lrutitu~ Assij;ntd lUadings'l &c 2 - Standanis ofPnc:tice Handbook

continuing to distribute material known to contain a significant misstatement of factwould be

Example 6:

The marketing department states in sales literature that an analyst has received an MBAdegree but be bas not The analyst and other members of the firm bave distributed tbisdocument for years_

Comment:

The analyst bas violated the Standards as be sbould bave known of thismisrepresentation after baving distributed and used the materials over a period of years.Example 7:

A member describes an interest-only collateralized mortgage obligation as guaranteed bythe U.S government because it is a claim against the casb Rows of a pool of guaranteedmortgages a1thougb the payment stream and the market value of the security arc notguaranteed

Comment:

To the extent that the candidate used information and interpretation from the financialpublication without citing it the candidate is in violation of the Standard The

candidate sbould either obtain the report and reference it directly or if he relies soldy

on the financial publication should cite both sources

Study SessiOD1Croos·RJ~rence 10 CFA ID.Ilitut~ Auign~ JUadings II &:2 - Sw>cIanI of Practice Handbook

I(D) Mucoaduc:t Membcl1l and CandidateS mUll not enpIC in any pro6:uional

conduct inyolving dishonesty, fraud,or dcc:cit or commit any act chat reRects

adv.:rsdy on their professional reputation, integrity, or competence

Gwuunce

CFA Institute discourages unethical behavior in all aspects of members' and candidates'

Iivcs Do not abuse CFA Institute's Professional Conduct Program byseeking

enforcement of this Standard to settle personal, political, or other disputes that arc not

related to professional ethics,

Recomme aeJ ProceJUIYIsfor Complu,nc.

Firms arc encouraged to adopt these policies and procedures:

• Develop and adopt a code of ethics and make clear that unethical behavior will not

be tolerated,

• Give employees a list of potential violations and sanctions, including dUmissal

• Check references of potential employees

Applirlltion ofStllntUrJ leD) MisCtJnJllct

Example 1:

Simon Sasserman is a trust investment officer at a bank in a small a!Ruent town He

enjoys lunching evcry day with friends at the country club, where his clients havc

observed him having numerous drinks Back at work after lunch, he clearly is intoxicated

while making investment decisions His colleagues make a point of handling any

business with Sasserman in the morning because they distrust his judgment after lunch

Comment:

Sasserman's excessive drinking at lunch and subsequent intoxication at work constitute

a violation of Standard 1(0) because this conduct has raised questions about his

professionalism and competence His behavior thus reRects poorly on him, his employer,

and the investment industry

Example 2:

Carmen Garcia manages a mutual fund dedicated to socially responsible investing She is

also an environmental activist As the result of her participation at nonviolent protesu,

Garcia has been arrested on numerous occasions for trespassing on the properry of a

large petrochemical plant that is ace used of damaging the environment

Comment:

GeneraUy, Standard 1(0) i not meant to Cover legal transgressions resulting from acts

of civil disobedience in support of personal beliefs becawe such conduct docs not reflect

poorly on the member or candidate's professional reputation, integriry, or competence

Example 3:

A member intentionally includes a receipt that is not in his expenses for a company trip

Tho member has bccn dishonest and misrepresented the facts of the situation and has,therefore, violated the Standard

II(A) Material Nonpublic IDror_ion Members and CandidateS who POlS""material nnnpublic informatinn that could affi:ct the value of lIDinvestment mwt notact or caUK others to act on the informatinn

GuiJ"1fU

Information is "material" if its disclosure would impact the price of a security or ifreasonable investors would want the information before making an investment decision.Ambiguous Information, as far as its likely cffect on price may not be consideredmaterial, Information is"nonpublic" until it has been made available to tho marketplace

An analyst conference caU is not public disclosure Sclcctivdy disclosing information bycorporations creates the potential for insidor-trading violations The prohibition againstacting on material nonpublic information extends to mutual funds containing thosubject securities as weU as related swaps and options contracts,

GuiJ4"e~MlJuUc Th,lJry

Thoro is no violation when a perceptive analyst reaches an investment condusion about

a corporate action or event through an analysis of public information together withiterru of nonmaterial nonpublic information

RlclJmmm"'J Pro.,Jurn for o,mpluIIJ"

Make reasonable effons to achieve public dissemination of the infonnation Encouragefirms to adopt procedures to provent misuse of material non public information Usc a

"fircwall" within the firm with elements including:

• Substantial control of rclevant interdepartmental communications through aclearance area such as the compliance or kgal department,

• Review employee trades-e-maintain "watch," "restricted," and "rumor"lists

• Monitor and restrict proprietary trading while a finn is in possession of materialnonpublie information

Study SeuiOD ICross·Rd'~reneetoCFA ID.utut~ AuignM IUadings II &:2 - StaDcIanIsof Practicx Handbook

Prohibition of all proprietary trading while a firm is in possession of material non public

information may be inappropriate because it may send a signal to the market In these

cases, firms should take the contra side of only unsolicited customer trades

App/iellti"" o/Stll,"",rJ II(A) Mlluri.l Nonp"b/ie Informlltion

Example 1:

Josephine Walsh is riding an elevator up to her office when she overhears the chief

financial officer (CFO) for the Swan Furniture Company tcll the president of Swan

that he has JUStcalculated the company's earnings for the past quarter, and they have

unexpectedly and significantly dropped The CFO adds that this drop will not be

released to the public until nat week Walsh i.mmediately calls her broker and tells him

to sell her Swan stock

Commcnt:

Walsh has sufficient infotmation to determine that the information is both material and

nonpublic By trading on the inside information, she has violated Standard 1I(,A)

Example 2:

Samuel Peter, an analyst with Scotland and Pierce, Inc., is assisting his firm with a

secondary offering for Bright Ideas Lamp Company Peter participates, via telephone

conference call, in a meeting with Scotland and Pierce investment-banking employees

and Bright Ideas' CEO Peter is advised that the company's earnings projections for

the nat year have significantly dropped Throughout the telephone conference call,

several Scotland and Pierce salespeople and portfolio managers walk in and out of

Peter's office, where the telephone call is taking place.A!; a result, they are aware of the

drop in projected earnings for Bright Ideas Before the conference call is concluded,

the salespeople trade thc stock of the company on behalf of the firm's clients, and other

firm personnel tradc the stock in a firm proprietary account and in employee personal

accounts

Comment:

Peter violated Standud II(A) because he failed to prcvent the transfer and misuse of

material nonpublic information to others in his firm Peter's firm should have adopted

information barriers to prevent the communication of nonpublic information between

departments of the firm The salespeople and portfolio managers who traded on the

information have also violated Standard II(A) by trading on inside information

Example 3:

Elizabeth Levenson is based in Taipei and covers the Taiwancse market for her

firm, which is basod in Singapore She is invited to mcct the finance director of a

manufacturing company, along with the other ten largest sharcholders of the company

During the meeting, the finance director states that the company apects its workforce

to strike next Friday, which will cripple productivity and distribution Can Levenson usc

this information as a basis to changc her rating on the company from ·buy· to ·sell"?

Comment:

Levenson must first determine whether the material information is public If the

company has not made this information public (a small-group forum docs not qualify

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as a method of public dissemination), she cannot usc the information according toStandard Il(A)

Example 4:

Jagdish Teja is a buy-side analy" covering the furniture industry Looking for anattractive company to recommend as a buy, he analyxed several furniture makers bystudying their financial reports and visiting their operations He also talked to somedesigners and retailers to find out which furniture styles arc trendy and popular

Although none of the companies that he analyxed turned out to be a clear buy, hediscovered that one of them, Swan Furniture Company (SFC) might be in trouble.Swan's extravagant new designs were introduced at substantial costs Even thoughthese: designs initially attracted attention, in the long run, the public is buying moreconservative furniture from other makers Based on that and on P&c.Lanalysis, Tejabelieves that Swan's nen-quarter earnings will drop substantially He then issues a sellrecommendation for SFC Immediately after receiving that recommendation, investmentmanagc:rs start reducing the stock in their ponfolios

Example 5:

A member's dentist, who is an active investor tells the member that based on hisresearch he believes that Acme, Inc., will be bought out in the near future by a largerfirm in the industry The member investigates and purchases shares of Acme

Example 7:

A member is having lunch with a ponfolio manager from a mutual fund who is knownfor his neck-picking ability and often inBuenccs market prices when his stock purchasesand sales arc disclosed The manager teUs the member that he is selling all his shares inAble, Inc • the next day The member shorts the stock

Study SessioD1Crou·Rd'~"'nce toCFAIn itute Assigned Rudings II &:2 - Sw>danis of Practice HandbookComment:

The fact that the fund will sdl its shares of Able is material because news of it willlikdy

cause the shares to fall in price Because this is also not currently public information, the

mcmber has violated the Standard by acting on the information

Example 8:

A broker who is a member receives the sell order for the Able, Inc., shares from the

portfolio manager in the previous example The broker sells his shares of Able prior

to entering the sdl order for the fund, but because his personal holdings arc small

compared to the stock's trading volume, his trade docs not affect the price

Comment:

The broker has acted on material nonpublic information (the fund's sale of shares) and

has violated the Standard

PrDfmDri Now Th« m.mb" also lIiolatttJ StanJarrJ VI(B) Priority of

Tralllarriolll byftont-rllnning tht dienr trad with a Irad in hi own account,

Had tht mtmbtr soiJ his sham afltr txtcuting tht fond mult, ht still would

b lIiolating StanJard II(A) byacting on hi knowledge Dfth fond trau,

which WDUiJstill not bt public information at that point.

Example 9:

A member trades based on information he gets by seeing an advance copy of an article

that will be published in an inRuential magazine next week

Comment:

This is a violation as this is nonpublic information until the article has been published

1I(8} Market Manipulation MembeR and Candidates must not cnpse in practices

that distort pria:s or artifiaaDy ineate trading volume with the intent to mislead

marker participants

G i4ance

This Standard applies to transactions that deceive the market by distorting the

price-setting mechanism of financial instruments or by securing a controlling position to

manipulate the price of a related derivative andlor the asset itself Spreading false rumors

is also prohibited

Application ofStanUrd II(B) Marlttt Manip Uuion

Example 1:

Matthew Murphy is an analyst at Divisadero Securities & Co., which has a significant

number of hedge funds among its most important brokerage clients Two trading days

before the publication of the quarter-end report, Murphy alerts his sales force that he

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is about to issue a lUearch report on Wircwolf Semiconductor, which will include hisopinion that:

Quarterly revenues an: likely to fall shon of managemcnt's guidance

Earnings will be as much as 5 cents per share (or more than 10%) below consensus.Wirewolf's highly respected chief financial officer may be about to join anothercompany

Knowing that Wirewolf had already entered its declared quarter-end "quiet period"before reporting earnings (and thus would be reluctant to respond to rumors, etc.),Murphy times the release of his research report specifically to sensationalize the negativeaspeCts of thc message to create significant downward pressure on Wircwolf's stock tothe distinct advantage of Divisadero's hedge fund clients The report's conclusions arcbased on speculation, not on fact The next day, the research report is broadcast to all ofDivisadero's clients and to the usual ncwswire services

Murphy violated Standard II(B) by trying to create artificial price volatility designed tohave material impact on the price of an issuer's stock Moreover, bylacking an adequatebasis for the recommendation, Murphy also violated Standard V(A)

Eumplc2:

Sergei Gonchar is the chairman of the ACME futures Exchange, which seeks to launch

a new bond furures contract In order to convince investors, traders, arbitragers, hedgers,and so on, to usc its contract, the exchangc attempts to demonstrate that it has thebest liquidity To do so, it enters into agreements with members so that they commit

to a substantial minimum trading volume on the new contract over a specific period inexchange for substantial reductions on their regular commissions

Comment:

Formal liquidity on a market is determined by the obligations set on market makers,but the aerualliquidity of a market is better estimated bythe actual trading volumeand bid-ask spreads Attempts to mislead participants on the actual liquidity of themarket constitute a violation of Standard JJ(B) In this example, investors have beenintentionally misled to believe they chose the molt liquid instrument for some specificpurpose and could evcntually sec the acrualliquidity of the contract dry up suddenlyaftet the term of the agreement if the "pump-prlmlng" strategy fails If ACME fullydiscloses its agreement with members to boost transactions over some initial launchperiod, it docs not violate Standard II(B) ACME's intent is not to harm investors but onthe contrary to give them a better service For that purpose, it may engage in a liquidity-pumping strategy, but it must be disclosed

Example 3:

A member isseeking to sell a large position in a fairly illiquid stock from a fund hemanages He buys and sells shares of the stock between that fund and another he alsomanages to create an appearance of activity and stock price appreciation, so that the sale

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Study Session 1 Cross·~f~renc:e to CFA IMlitutt Auignod Ruding1 II &: 2 - Sw>dani of Practice Handbook

of the whole position wiU have less market impact and he will realize a be ncr return for

the fund's shareholders

Comment:

The trading activity is meant to mislead market participants and is, therefore, a violation

of the Standard The fact that hi fund shareholders gain by this action does not change

the faa that it is a violation

Example 4:

Amember posts false information about a firm on internet bulletin boards and stock

char facilities in an attempt to cause the firm's stock to increase in price

Comment:

This is a violation of the Standard

III Duties to Clic:nts

III(Al Loyalty Prudence andCare Mcmbm and Candidates have a duty ofloyalty

10their clients and must act with tQSonabie care and exercise: prudent judsmcnt

Members and Candidates must act fot the benefit of their clients and place their

clients' interests before their employer's or their own interests

GviJllnce

Client interests always come first

• Exercise the prudence, care, skill, and diligence under the circumstances that a

person acting in a like capacity and familiar with such maners would usc

• Manage pools of client asseu in accordance with the terms of the governing

documents, such as trust documents or investment management agrccmcnu.

• Make investment decisions in the con tat of the total portfolio

• Vote proxies in an informed and responsible manner Due to cost benefit

considerations, it may not be necessary to vote all proxies

• Client brokerage, or "soft dollars" or "soft commissions" must be used to benefit the

client

• The "client" may be the investing public as a whole rather than a specific entity or

person

JUctlmmtnJeJ PrDceJlUYIstlfCtlmplillnce

Submit to clients, at least quarterly, itemized statements showing all securities in custody

and all debits, credits, and transactions

Encourage firms to address these topics when drafting policies and procedures regarding

fiduciary duty:

• Follow applicable rules and laws

• Establish investment objectives of client Consider suitability of portfolio relative to

client's needs and circumstances, the investment's basic characteristics, or the basic

characteristics of the tOtal portfolio

• Diversify

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Cross-lUfereDC>eto CFA lrutitllte Assi£ntd Rudin,,'1 &c 2 - Standards ofPnc:tlce Handbook

• Deal fairly with all clients in regards to investment actions

• Disclose conflicts

• Disclose eompensat.ion arrangements

• Vote proxies in the best interest of clients and ultimate beneficiaries

• Maint:lin confidentiality

• Seek best execution

• Place client interests first

AppiieAtion ofStAtulArJ II/(A) loyAlty PruJmce Anti CAre

Example 1:

First Country Bank serves as trustee for the Miller Company's pension plan Miller

is the target of a hostile takeover attempt by Newton Inc In attempting to ward offNewton MiUer's managers persuade Julian Wiley an investment manager at FirstCountry Bank to purchase Miller common stock in the open market for the employeepension plan Miller's officials indicate that such action would befavorably received andwould probably result in other aecounts being placed with the bank Although Wileybelieves the stock to be overvalued and would not ordinarily buy it he purchases thestock to support Miller's managers to maintain the eompany's good favor and to realizeadditional ncw business The heavy stock purchases cause Miller's market price to rise tosuch a level that Newton retracts its takeover bid

Comment:

Standard III(A) requires that a member or candidate in evaluating a takeover bid, actprudently and solely in the interests of plan participants and beneficiaries To meet thisrequirement, a member or candidate must carefully evaluate the long-term prospects ofthe company against the short-term prospects presented by the takeover offer and bythe ability to invest elsewhere In this instance Wiley, acting on bchalf of his employer.the trustee clearly violated Standard IlI(A) by using the pension plan to perpetuateexisting management perhaps to the detriment of plan participants and the company'sshareholders, and to benefit himself Wiley's responsibilities to the plan participantsand beneficiaries should take precedence over any tics to corporate managers and sdf-interest A duty exists to examine such a takeover offer on its own merits and to make

an independent decision The guiding principle is the appropriateness of the investmentdecision to the pension plan not whether the decision benefits Wiley or the oompanythat hired him

Example 2:

Emilie Rome is a trust officer for Paget Trust Company Rome's supervisor is responsiblefor reviewing Rome's trust aeeount transactions and her monthly reports of personalstock transactions Rome has been using Nathan Gray a broker almost exelusively fortrust account brokerage transactions Where Gray makes a market in stocks he has beengiving Rome a lower price for personal purehases and a higher price for sales than hegives to Rome's trust accounts and other investors

Study SessiOD Ic.o ·Rd'~"'nce 10CFAIDStitut~Asaignod Rudings III &: 2 - Sw>dani of Practice HandbookExample 3:

A member uses a broker for client-account trades that has relatively high prices and

average research and execution In rerum, the broker pays for the rent and other

overhead expenses for the member's firm

Comment:

This is a violation of the Standard because the member used client brokerage for services

that do not benefit clients and failed to get the best price and execution for his clients

Example 4:

In return for receiving account management bwiness from Broker X,a member directs

trades to Broker Xon the accounts referred to her by Broker X.as well as on other

accounts as an incentive to Broker X to send her more account business

Comment:

This isa violation if Broker X does not offer the best price and execution or if the

practice of directing trades to Broker X is not disclosed to clients The obligation to seek

best price and execution is always required unless clients provide a written statement that

the member is not to seek best price and execution and that they are aware of the impact

of this decision on their accounts

Example 5:

Amember docs more trades in client accounts than are necessary to accomplish client

goals because she desires to increase her commission income

Comment:

The member is using client assets (brokerage fees) to benefit hetself and has violated the

Standard

III(B) Fair Dnling Mcmbm and CandidalCS mUlt deal fairly and objectively with

all clients when providing in"Cstment •.wysis.mUing in_tment recommendations,

taking in"Cstment action or engaging in other pro6:ssionaJ activities

GvitJ."u

Do not diseriminate against any clients when disseminating recommendations or taking

investment action Fairly docs not mean equally In the normal course ofbwiness,

there will be differences in the time e-mails, faxe., etc., are received by different clients

Different service levels are okay but they must not negatively affect or disadvantage

any clients Disclose the different service 1C\'Clsto all clients and prospects and make

premium level of service available to all who wish to pay for them

GvitJ."u-/"",stmmt &commmtJ.tionl

Give all clients a fair opporruniry to act upon every recommendation Clients who

arc unaware of a change in a recommendation should be advised before the order is

accepted

JUCDmmmtkJ ProuJU"' fl,CtJmplu.nu

Encourage firms to establish compliance procedures rcquiring proper dissemination ofinvestment recommendations and &ir treatment of all customers and clients Considcrthese points when establishing &ir dealing compliance procedures:

• Limit the number of people who arc aware that a change in recommendation will bemade

• Shorten the time frame between decision and dissemination

• Publish personnel guidelines for pre-dissemination-have in place guidelinesprohibiting personnel who have prior knowledge of a recommendation fromdiscussing it or taking action on the pending recommendation

• Simultaneous dissemination of new or changed recommendations eo all clients whohave expressed an interest or for whom an investment is suitable

• Maintain list of clients and holdings-use to ensure that :lII holders are treated fairly

• Develop written trade allocaelon proecdures-<:nsure fairness to clients, timcly andefficient order execution, and accuraey of cliene positions

• Disclose trade allocation procedures

• Establish systemaric account review-c-ensure that no client is given preferredtreatment and that investment actions arc consistent with the account's objectives

• Disclose available levels of service

Applic.tion of SIII""",J 1l1(B) F"i, D~.ling

Example 1:

Bradley Ames, a well-known and respected analyst, follows the computer industry Inthe course of his research, he finds that a small, relatively unknown company whoseshares arc traded over the counter has just signed significant contracts with somc of thecompanies he follows After a considerable amount of investigation, Ames decides towrite a research report on the company and recommend purchase Whilc the report isbeing reviewed by thc company for factUal accuracy, Ames schedules a luncheon withseveral of his best clients to discuss the company At the luncheon, he mentions thepurchase recommendation scheduled to be sent early the following week to :lI1the firm',clients

Comment:

Ames violated Standard lII(B) by disseminating the purchase recommendation to theclients with whom he had lunch a week before the recommendation was sent to :lI1clients

Example 2:

Spencer Rivers, president ofXYZ Corporation, moves his company's growth-orientedpension fund to a particular bank primarily because of the excellent investmentperformance achieved by the bank's commingled fund for the prior 5-ycar period A