FinQuiz curriculum note, study session 1, reading

Correct Answer: A Standard III B Fair Dealing requires members and candidates “to deal fairly and objectively with all clients when providing investment analysis, making investment reco

Reading 1 Code of Ethics and Standards of Professional Conduct

Reading 5 The Behavioral Finance Perspective

Behavioral finance focuses on human behavior and

psychological mecahnisms involved in financial

decision-making and seeks to understand and predict

the impact of psychological decision-making on the

financial markets

According to efficient market hypothesis, financial

markets are rational and efficient and the abnormal

returns are either by chance or due to statistical

problems associated with analyzing stock returns e.g

neglecting common risk factors etc

According to behavioral finance, although financial

markets are rational and efficient, but it is not necessary

that all the market participants will be rationale in their

decision making due to various behavioral biases

(particularly cognitive biases) This results in the

mispricing of securities and thus results in the market

anomalies

The basic idea of behavioral finance is that since

investors are humans,

• Investors are imperfect and can make irrational decisions

• As a result, investors may have heterogeneous

beliefs regarding asset's value

Normative analysis: Normative analysis involves

analyzing how markets and market participants should behave and make decisions Traditional finance is

regarded as normative

Descriptive analysis: Descriptive analysis involves

analyzing how markets and market participants actually behave and make decisions Behavioral finance is

regarded as descriptive

Prescriptive analysis: Prescriptive analysis seeks to analyze how markets and market participants should behave and make decisions so that the achieved outcomes are approximately close to those of normative analysis Efforts to use behavioral finance are regarded

as prescriptive

2 BEHAVIORAL VERSUS TRADITIONAL PERSPECTIVES

Traditional finance assumes that:

•Market participants are rational;

• Market participants make decisions consistent with

the axioms of expected utility theory (explained

below);

• Market participants accurately maximize expected

utility;

• Market participants are self-interested;

•Market participants are risk-averse and thus, the

utility function is concave in shape i.e exhibits a

diminishing marginal utility of wealth

• Stock prices reflect all available and relevant

information

• Market participants revise expectations consistent

with Bayes’ formula (explained below)

• Market participants have access to perfect

information;

• Market participants process all available information

in an unbiased way i.e make unbiased forecasts

about the future

However, in reality, these assumptions may not hold

Behavioral finance assumes that:

•Market participants are “normal” not rational;

Two dimensions of Behavioral Finance:

1) Behavioral Finance Micro (BFMI): BFMI seeks to understand behaviors or biases of market participants and their impact of financial decision-making It is primarily used by wealth managers and investment advisors to manage individual clients

2) Behavioral Finance Macro (BFMA): BFMA seeks to understand behavior of markets and market anomalies that are in contrast to the efficient markets

of traditional finance It is primarily used by fund managers and economists

Categories of Behavioral Biases:

1) Cognitive errors: Cognitive errors are mental errors including basic statistical, information-processing, or memory errors that may result from the use of simplified information processing strategies or from reasoning based on faulty thinking

2) Emotional biases: Emotional biases are mental errors that may result from impulse or intuition and/or reasoning based on feelings

2.1.1) Utility Theory and Bayes’ Formula Under the utility theory, an individual always chooses the

Reading 5 The Behavioral Finance Perspective FinQuiz.com

•Utility refers to the level of relative satisfaction

received from consuming goods and services Unlike

price, utility depends on the particular

circumstances and preferences of the decision

maker; as a result, it may vary among individuals

Expected utility = Weighted sums of the utility values of

outcomes Expected utility = Σ (Utility values of outcomes ×

Respective probabilities)

• The value of an item is based on its utility rather than

its price

•According to the Expected utility theory, individuals

are risk-averse and thus, utility functions are concave

in shape and exhibit diminishing marginal utility of

wealth

Subjective expected utility of an individual

=Σ [u (xi) × P (xi)]

Where,

u (xi) = Utility of each possible outcome xi

P (xi) = Subjective probability

Axioms of Utility Theory: The four basic axioms of utility

theory are as follows:

1) Completeness: Completeness assumes that given any

two alternatives, an individual can always specify and

decide exactly between any of these alternatives

Axiom: Given alternatives A and B, an individual

• Prefers A to B

• Prefers B to A

• Is indifferent between A and B

2) Transitivity: Transitivity assumes that, as an individual

decides according to the completeness axiom, an

individual also decides consistently According to

transitivity, the decisions made by an individual are

• Is indifferent between B and C

Then an individual prefers to A to C

If an individual

• Is indifferent between A and B

• Prefers A to C

Then an individual prefers to B to C

3) Independence: Independence also assumes that

a 3 rd alternative is added to two alternatives, the order of preference remains the same as when two alternatives are presented independently

Axiom: Given three alternatives A, B and C, if an individual prefers A to B and some amount of C (say x) is added to A and B, then an individual will prefer (A + xC)

Implication of axioms of utility theory: When an individual makes decisions consistent with the axioms of

utility theory, he/she is said to be rational

*Indifference curve (IC): An indifference curve shows combinations of two goods among which the individual

is indifferent i.e those bundles of goods provide same level of satisfaction

• The IC shows the marginal rate of substitution i.e the

rate at which a consumer is willing to trade or substitute one good for another, at any point

• The indifference curve that is within budget constraints and furthest from the origin provides the highest utility

• For perfect substitutes: IC represents a line with a constant slope, implying that a consumer is willing to trade or substitute one good for another in fixed ratio

• For perfect complements: IC curve is an L-shaped curve, implying that no incremental utility can be obtained by an additional amount of either good as goods can only be used in combination

Bayes’ formula: Bayes’ formula is used for revising a probability value of the initial event based on additional information that is later obtained

Rule to apply Bayes’ formula: All possible events must be

mutually exclusive and must have known probabilities The formula is:

P (A|B) = [P (B|A) / P (B)]× P (A) Where,

P(A|B) = Conditional probability of event A given B It

represents the updated probability of A given

Reading 5 The Behavioral Finance Perspective FinQuiz.com P(B|A) = Conditional probability of event B given A It

represents the probability of the new

information (event) B given event A

P(B) = Prior (unconditional) probability of information

(event) B

P(A) = Prior (unconditional) probability of information

(event) A

In summary: In traditional finance, when market

participants make decisions under uncertainty, they

1 Act according to the axioms of utility theory

2 Make decisions by assigning a probability measure

2.1.2) Rational Economic Man

Rational economic man (REM) pursues self-interest (sole

motive) to obtain the highest possible economic

well-being (i.e the highest utility) at the least possible costs

given available information about opportunities and

constraints on his ability to achieve his goals In sum,

• REM is Rational

• REM is Self-interested

• REM is Labor averse

• REM possesses perfect information

2.1.4) Risk Aversion Risk averse: An individual who prefers to invest to

receive an expected value with certainty rather than

invest in the uncertain alternative with the same

expected value is referred to as risk averse

•Risk-averse individuals have concave utility functions,

reflecting that utility increases at a decreasing rate

with increase in wealth (i.e diminishing marginal

utility of wealth)

• The greater the curvature of the utility function, the

higher the risk aversion

Risk neutral: An individual who is indifferent between the

two investments is called risk-neutral

•Risk-neutral individuals have linear utility functions,

reflecting that utility increases at a constant rate with

• Risk-seeking individuals have convex utility functions,

reflecting that utility increases at an increasing rate with increase in wealth (i.e increasing marginal utility

of wealth)

Certainty Equivalent: It refers to the maximum amount of money an individual is willing to pay to participate or the minimum amount of money an individual is willing to accept to not participate in the opportunity

Risk premium = Certainty equivalent – Expected value

See: Exhibit 2, Volume 2, Reading 5

2.2.1) Challenges to Rational Economic Man

In reality, financial decisions are also governed by human behavior and biases This implies that:

• Individuals may sometimes behave in an irrational manner

• Individuals are not perfectly self-interested

• Individuals do not have perfect information and many economic decisions are made in the absence

2.2.3) Attitudes toward Risk

An individual’s (investor’s) attitude toward risk depends

on his/her wealth level and circumstances This implies that the curvature of an individual’s utility function may Practice: Example 1,

Volume 2, Reading 5

Reading 5 The Behavioral Finance Perspective FinQuiz.com risk-aversion behavior (i.e at points A and C) This

implies that

• At low level of wealth (point A), people may prefer

low probability, high payoff risks (e.g lottery)

• Once certain reasonable level of wealth is reached

(point C), the individual becomes risk averse in order

to maintain this position

2 At moderate wealth (income) level, utility functions

tend to exhibit convex shape, reflecting risk-seeking

behavior (i.e between points B and C)

• This implies that individuals with moderate level of

wealth tend to prefer small, fair gambles

Double inflection utility function: A utility function that

changes with changes in the level of wealth is called

double inflection utility function (as shown above)

Risk versus uncertainty:

•Risk refers to randomness with knowable

probabilities Risk is measurable

•Uncertainty refers to randomness with unknowable

probabilities Uncertainty is not measurable

Neuro-economics is a combination of neuroscience,

psychology and economics It seeks to explain the

influence of the brain activity on investor behavior and

attempts to understand the functioning of the brain with

respect to judgment and decision making

Criticism of neuro-economics: It is argued that the brain

activity or chemical levels in the brain are unlikely to

have an impact on economic theory

Decision theory deals with the study of methods for

determining and identifying the optimal decision (i.e

with highest total expected value) when a number of

alternatives with uncertain outcomes are available

• Both Expected utility and decision theories are

normative

• The decision theory facilitates investors to make

Assumptions of Decision Theory:

• Decision maker possess all relevant and available information;

• Decision maker has the ability to make accurate quantitative calculations;

• Decision maker is perfectly rational;

Expected value versus Expected Utility: Expected value

is not the same as expected utility

• Expected value of an item depends on its price and price is equal for everyone

• Expected utility of an item depends on an individual’s circumstances and it may vary among individuals

3.2 Bounded Rationality

Bounded rationality relaxes the assumption that an individual processes all available information to achieve

a wealth-maximizing decision

According to bounded rationality, an individual behaves

as rationally as possible given informational, intellectual, and computational limitations of an individual As a

result,

• Individuals do not necessarily make perfectly rational decisions;

• Individuals tend to satisfice rather than optimize

while making decisions i.e individuals seek to

achieve satisfactory and adequate decision

outcomes (given available information and limited cognitive ability) rather than optimal (best)

outcomes given informational, intellectual, and computational limitations and the cost and time associated with determining an optimal (best) choice

Volume 2, Reading 5

Reading 5 The Behavioral Finance Perspective FinQuiz.com

• According to prospect theory,

o Individuals prefer a certain gain more than a

probable gain with an equal or greater expected

value and the opposite is true for losses

o Individuals evaluate gains and losses from a

subjective reference point

• Both Prospect theory and bounded rationality are

descriptive

Three critical aspects of the value function of a Prospect

theory:

1. Value is assigned to changes in wealth (i.e

gains/losses) rather than to absolute level of wealth;

and instead of probabilities, decision weights are

used in the value function

2. The value function is S-shaped (see Figure below),

and predicted to be concave for gains(indicating risk

aversion) above the reference point and convex for

losses(indicating risk-seeking) below the reference

point

3. The value function is steeper for losses than for gains

(See Figure below) This means that the displeasure

associated with the loss is greater than the pleasure

associated with the same amount of gains

•This implies that individuals are loss-averse not

averse In addition, an individual tends to be

risk-seeking in the domain of losses while risk-averse in

the domain of gains

o People are risk averse for gains of moderate to

high probability and losses of low probability

o People are risk seeking for gains of low probability

and losses of moderate to high probability

•Loss aversion bias refers to the tendency of an

individual to hold on to losing stocks while selling

winning stocks too early It is also known as

“disposition effect”

Phases of decision making in Prospect Theory:

According to Prospect Theory, individuals go through

two distinct phases when making decisions about risky

and uncertain options

1) Editing or Framing phase: In this phase, decision

Six Operations in the Editing process:

1 Codification: Coding refers to categorizing outcomes (prospects) in terms of gains and losses rather than in terms of final absolute wealth level depending on the reference point i.e

• Outcomes below the reference point are viewed as losses

• Outcomes above the reference point are viewed as gains

o Prospects are coded as (Gain or loss, probability; Gain or loss, probability;…)

o Initially, the sum of probabilities = 100% or 1.0

2 Combination: Combination refers to adding together the probabilities of prospects with identical gains or losses to simplify a decision E.g winning 200 with 25%

or winning 200 with 25% can be simply reformulated

as winning 200 with 50%

3 Segregation: In this step, the decision maker

separates the riskless component of any prospect from its risky component E.g segregating the

prospect of winning 300 with 80% or 200 with 20% into

a sure gain of 200 with 100% and the prospect of winning 100 with 80% or nothing (0) with 20% The same process is applied for losses

4 Cancellation: Cancellation refers to discarding similar outcomes probability pairs between prospects E.g if

pairs are (200, 0.25; 150, 0.40; 30, 0.35) and (200, 0.3;

150, 0.40; -50 0.3), they will be simplified as (200, 0.25;

6 Detection of dominance: It involves rejecting (without further evaluation) outcomes that are extremely dominated

2) Evaluation phase: In this phase, once prospects are edited or framed, the decision maker evaluates these edited prospects and chooses between them This phase is composed of two parts i.e

Reading 5 The Behavioral Finance Perspective FinQuiz.com

and convex for losses

• The value function is steeper for losses than for gains,

reflecting "loss aversion”

b) Weighting function: It involves assigning decision

weights (rather than subjective probability) to those

prospects Decision weights represent empirically

derived assessment of likelihood of an outcome In

As a result, unlikely outcomes have unduly more

impact on decision making

Perceived value of each outcome = Value of each

outcome × Decision weight

U = w (p 1 ) v (x 1 ) + w (p 2 ) v (x 2 ) + … + w (p n ) v (x n ) Where,

x i = potential outcomes

p i = respective probabilities

v = Value function that assigns a value to an outcome

w = probability weighting function

• The decision makers select the prospect with the

highest perceived value

IMPORTANT TO NOTE:

• Codification, combination and segregation operations are applied to each prospect individually; whereas, cancellation, simplification and detection of dominance operations are applied

to two or more prospects together

4 PERSPECTIVE ON MARKET BEHAVIOR AND PORTFOLIO

CONSTRUCTION

4.1.1) Review of the Efficient Market Hypothesis

An informationally efficient market (an efficient market)

is a market in which,

• Prices are informative i.e they immediately, fully,

accurately and rationally reflect all the available

information about fundamental values

•The market quickly and correctly adjusts to new

information

• Asset prices reflect all past and present information

• The actual price of an asset will represent a good

estimate of its intrinsic value at any point in time

•Investors cannot consistently earn abnormal returns*

by trading on the basis of information

*Abnormal return = Actual return – Expected return

Assumptions of Efficient Market Hypothesis (EMH):

• Markets are rational, self-interested, and make

optimal decisions;

• Market participants process all available information;

• Markets make unbiased forecasts of the future;

However, EMH is NOT universally accepted

NOTE:

Grossman-Stiglitz paradox: Markets cannot be

strong-form instrong-formationally efficient because costly instrong-formation

will not be gathered and processed by agents unless

they are compensated in the form of trading profits

(abnormal returns)

Inefficient market: When active investing can earn

information acquisition costs, it is referred to as an inefficient market

Forms of market efficiency:

There are three forms of market efficiency

1) Weak-form market efficiency: It assumes that security prices fully reflect all the historical market data i.e past prices and trading volumes Thus, when a market

is weak-form efficient, all past information regarding price and trading volume is already incorporated in

the current prices, implying that technical analysis will not generate excess returns

• However, it is possible to beat the market and earn superior profits in the weak-form of efficient market

by using the fundamental analysis or by insider trading

2) Semi-strong form market efficiency: It assumes that security prices fully reflect all publicly available

information, both past and present Thus, technical

and fundamental analysis will not generate excess returns However, insider traders can make abnormal profits in semi-strong form of efficiency

3) Strong-form market efficiency: It assumes that security prices quickly and fully reflect all the information including past prices, all publicly available information, plus all private information (e.g insider information) Thus, when a market is strong-form efficient, it should not be possible to consistently earn abnormal returns from trading on the basis of private

or insider information

Reading 5 The Behavioral Finance Perspective FinQuiz.com

4.1.2) Studies in Support of the EMH

A Support for the Weak Form of the EMH: Weak form of

the efficient market hypothesis is supported and it is

NOT possible to consistently outperform the market

using technical analysis because it has been

observed that

• Daily changes in stock prices have almost zero

positive correlation

• Market prices follow random patterns and thus,

future stock prices are unpredictable

B Support for the Strong Form of the EMH:

Semi-strong form of the efficient market hypothesis is

supported and it is NOT possible to consistently

outperform the market using fundamental analysis

• A common test to examine whether a market is

semi-strong efficient is event study i.e analyzing

similar events of different companies at different

times and evaluating their effects on the stock price

(on average) of each company

C Support for the Strong Form of the EMH: Strong form of

the efficient market hypothesis is NOT supported,

implying that it is possible to consistently earn

abnormal returns using non-public/insider information

4.1.3) Studies Challenging the EMH: Anomalies

Market movements that are inconsistent with the

efficient market hypothesis are called market anomalies

Market anomalies result in the mispricing of securities

• However, these market anomalies result in inefficient

markets only if they are persistent and consistent

over reasonably long periods; and thus, can

generate abnormal returns on a consistent basis in

the future

•If these anomalies are not consistent, they may

occur as a result of statistical methodologies used to

detect the anomalies, for example due to use of

inaccurate statistical models, inappropriate sample

size, data mining/data snooping (it involves over

analyzing the data in an attempt to find the desired

results), and results by chance etc

Major Types of Market Anomalies:

There are three major types of identified market

anomalies:

1) Fundamental anomalies: A fundamental anomaly is

related to the fundamental assessment of the stock’s

o Stocks with high dividend yield tend to outperform

the market and generate more return

However, it has been evidenced that value effect anomalies do not represent actual anomalies because they result from use of incomplete models of asset pricing

2) Technical anomalies: A technical anomaly is related

to past prices and volume levels It includes:

• Moving averages: Under this strategy, a buy signal is generated when short period averages rise above long period averages and sell signal is generated when short period averages fall below the long

period averages

• Trading range break (Support and Resistance):

Under this strategy, a buy signal is generated when the price reaches the resistance level, which is maximum price level and a sell signal is generated when the price reaches the support level which is minimum price level

o However, in practice, it is generally not possible to earn abnormal profits based on technical

anomalies after adjusting for risk, trading costs etc

3) Calendar anomalies: Calendar anomalies are related

to a particular time period For example,

• January Effect: According to January effect anomaly, stocks (particularly small cap stocks) tend

to exhibit a higher return in January than any other

month

• Turn-of-the-month effect: According to month effect, stocks tend to exhibit a higher return

turn-of-the-on the last day and first four days of each mturn-of-the-onth

Conclusion: In reality, markets are neither perfectly efficient nor completely anomalous

4.1.3.5 Limits to Arbitrage Theory of limited arbitrage: Under certain situations, it may not be possible for rational, well-capitalized traders

to correct a mispricing or to exploit arbitrage opportunities, at least not quickly, due to the following reasons:

• It is often risky and/or costly to implement strategies

to eliminate mispricing

• Constraints on short-sale may exist due to which the arbitrageur cannot take a large short position to

Reading 5 The Behavioral Finance Perspective FinQuiz.com These risks and costs create barriers, or limits, for

arbitrage As a result, markets may remain inefficient or

in other words, the EMH does not hold

4.2 Traditional Perspectives on Portfolio Construction

From a traditional finance perspective, a portfolio that is

mean-variance efficient is said to be a “rational

portfolio” A rational portfolio is constructed by

considering

• Investors’ risk tolerance

• Investor’s investment objectives

• Investor’s investment constraints

• Investor’s circumstances

Limitation of Mean-variance efficient Portfolio: It may not

truly incorporate the needs of the investor because of

behavioral biases

4.3 Alternative Models of Market Behavior and

Portfolio Construction 4.3.1) A Behavioral Approach to Consumption

and Savings Traditional life-cycle model: The life-cycle hypothesis is

strongly based on expected utility theory and assumes

that people are rational i.e they tend to spend and

save money in a rational manner and do not suffer from

self-control bias as they prefer to achieve long-term

goals rather than short-term goals

Behavioral life-cycle theory: The behavioral life-cycle

theory considers self-control, mental accounting, and

framing biases and their effects on the

consumption/saving and investment decisions

Mental accounting bias: According to the behavioral

life-cycle theory, people treat components of their

wealth as “non-fungible” or non-interchangeable i.e

wealth is assumed to be divided into three “mental”

accounts i.e

i Current income

ii Currently owned assets

iii Present value of Future income

Marginal propensity to spend (consume)or save varies

according to the source of income e.g

•Marginal Propensity to spend tends to be greatest for

current income and least for future income

•Marginal propensity to save tends to be greatest for

future income and least for current income

•With regard to spending from currently owned

assets, people consider their liquidity and maturity

i.e short-term liquid assets (e.g cash and checking

accounts) are spent first while long-term assets (e.g

home, retirement savings) are less likely to be

liquidated

saved is re-classified as current assets or future income

Framing: Framing bias refers to the tendency of

individuals to respond differently based on how questions are asked (framed)

Self-control: It is the tendency of an individual to

consume today (i.e focus on short-term satisfaction) at the expense of saving for tomorrow (i.e long-term goals)

4.3.2) A behavioral Approach to Asset Pricing Behavioral stochastic discount factor-based (SDF-based) asset pricing model: It is a type of behavioral asset pricing model

• According to this model, asset prices reflect

investor’s sentiments relative to fundamental value

• Sentiments refer to the erroneous beliefs or systematic errors in judgment about future cash flows

and risks of asset

Risk premium in the behavioral SDF-based model: In the behavioral SDF-based model, risk premium is composed

of two components i.e

Risk premium = Fundamental risk premium + Sentiment

• It has been observed that there is an inverse

relationship between the price of the security and the dispersion among analysts’ forecasts i.e

o The greater (lower) the dispersion
the higher (lower) the sentiment premium
the greater (lower) the risk premium,
the higher (lower) the discount rate* (required rate of return) and thus the lower (higher) the perceived value of an asset

• A low dispersion is associated with a consensus among the analysts and investors on firms’ future prospects and more credible information

• It is evidenced that dispersion of analyst’ forecast is statistically significant in a Fama-French multi-risk- factor framework i.e the dispersion of analysts’

forecasts is greater for value stocks; thus, return on

value stocks is higher than that of growth stocks

*Discount rate or Required rate of return in the behavioral SDF-based model: In the behavioral SDF-based model, discount rate is composed of three components i.e Discount rate OR required rate of return =

Risk free rate (reflecting time value of money) + Fundamental risk premium (reflecting efficient prices) +

Reading 5 The Behavioral Finance Perspective FinQuiz.com

• When the subjective beliefs of an investor about the

discount rate are the same as that of traditional

finance, the investor is said to have zero sentiment

o When sentiment is zero  market prices will be

efficient i.e prices will be the same as prices

determined using traditional finance approaches

• When the subjective beliefs of an investor about the

discount rate are different from that of traditional

finance, the investor is said to have non-zero

sentiment

o When sentiment is non-zero  market prices will be

inefficient (or mispriced) i.e prices will deviate from

prices determined using traditional finance

approaches

Important to Note: It must be stressed that investors can

earn abnormal profits by exploiting sentiment premiums

only if they are non-random in nature i.e systematically

high or low relative to fundamental value; otherwise, it

may not be possible to predict them and thus, mispricing

may persist

4.3.3) Behavioral Portfolio Theory (BPT)

BPT versus Markowitz’s portfolio theory:

•BPT uses a probability-weighting function whereas

the Markowitz’s portfolio theory uses the real

probability distribution

• The optimal portfolio of a BPT investor is constructed

by identifying the portfolios with the highest level of

expected wealth for each probability that wealth

would fall below the aspiration level (i.e a safety

constraint).The BPT optimal portfolio may not be

mean-variance efficient

• In contrast, the perfectly diversified portfolio of

Markowitz is constructed by risk-averse investors by

identifying portfolios with the highest level of

expected wealth for each level of standard

deviation

•Under BPT, investors treat their portfolios not as a

whole, as prescribed by mean-variance portfolio

theory, but rather as a distinct layered pyramid of

assets where

o Layers are associated with goals set for each layer

i.e bottom layers are designed for downside

protection, while top layers are designed for

upside potential

o Attitudes towards risk vary across layers i.e

investors are more risk-averse in the downside

protection layer whereas less risk-averse in the

upside potential layer In contrast, mean-variance

investors have single attitude toward risk

The BPT optimal portfolio construction is composed of

following five factors:

downside protection layer) will be greater

2) The asset allocation within a layer depends on the goal set for the layer i.e

• If the goal is to earn higher returns, then risky or speculative nature assets will be selected for the layer

3) The number of assets chosen for a layer depends on the shape of the investor’s utility function or risk attitude i.e

• The greater (lower) the concavity or the higher (lower) the risk-aversion, the greater (smaller) the number of securities included in a layer, reflecting a diversified (concentrated or non-diversified)

portfolio

4) The optimal portfolio of a BPT investor may not necessarily be well-diversified For example, when investors believe to have informational advantage with respect to the securities, they may tend to hold a concentrated portfolio composed of those few securities

5) Higher loss-averse investors may allocate higher amount to the lowest downside protection layer (i.e may hold cash or invest in riskless assets) and may tend to suffer from loss-aversion bias

4.3.4) Adaptive Markets Hypothesis (AMH) The AMH is a revised version of the efficient market hypothesis and it attempts to reconcile efficient market theories with behavioral finance theories

Practice: Example 3, Volume 2, Reading 5

Reading 5 The Behavioral Finance Perspective FinQuiz.com

According to the AMH, success depends on the ability

of an individual to survive rather than to achieve highest

expected utility

The AMH is based on the following three principles of

evolution:

1) Competition: The greater the competition for scarce

resources or the greater the number of competitors in

the market, the more difficult it is to survive

Competition drives adaptation and innovation

2) Adaption: Individuals make mistakes, learn and

adapt The less adaptable the market participants

under high competition circumstances and changing

environment conditions, the lower the likelihood of

surviving

3) Natural selection: Natural selection shapes market

ecology

Five implications of the AMH:

1) The equity risk premium varies over time depending

on the recent stock market environment and the

demographics of investors in that environment e.g

changes in risk preferences, competitive environment

etc

• E.g risk aversion may decrease with an increase in

competition among market participants

2) Arbitrage opportunities do arise in the financial markets from time to time which can be exploited (e.g by using active management) to earn excess returns (i.e alpha)

3) Any particular investment strategy will not consistently

do well; this implies that any investment strategy experiences cycles of superior and inferior performance in response to changing business conditions, the adaptability of investors, number of competitors in the industry and the magnitude of profit opportunities available

4) The ability to adapt and innovate is critically essential for survival

5) Survival is ultimately the only vital objective

Practice: End of Chapter Practice Problems for Reading 5 & FinQuiz Item-set ID# 16837

Reading 2 Guidance for Standards I–VII FinQuiz.com

FinQuiz.com

CFA Level III Item-set - Solution

Study Session 1 June 2017

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Reading 2 Guidance for Standards I–VII FinQuiz.com

FinQuiz Level III 2017 – Item-sets Solution

Reading 2: Guidance for Standards I–VII

Correct Answer: A

Standard II (A) Material Nonpublic Information prohibits members/candidates who possess material nonpublic information, which could affect the value of the security, from act or causing others to act/trade on the information Information is considered to be nonpublic until it has been publically made available in the marketplace This standard does not prohibit members/candidates to use items

of non-material or material and public information to form an opinion regarding a potential corporate action This holds true even if the member/candidate’s analysis leads him/her to producing

conclusions which comprise of material nonpublic information This is termed as the mosaic theory

By using his observations of Y.T Automobiles’ production site to produce his conclusion, Webber has not violated this standard (with the information obtained from the observations constituting items

of material, public information as well as non-material non-public information) This holds true despite the fact that Webber used the information to conclude that the manufacturer could be at risk of being acquired in a takeover or could file for bankruptcy (which itself can be considered material nonpublic information that investors would like to know) Furthermore the discussions with industry experts and representatives from different manufactures as well as the industry information used as part of the analysis do not violate this standard In short, Webber has used mosaic theory to arrive at his conclusion and has thus not violated this standard

Standard V (A) Diligence and Reasonable Basis requires members and candidates to exercise

thoroughness, independence, and diligence when conducting investment analysis, making investment recommendations and taking investment action Additionally the standards require members to have a reasonable and adequate basis supported by an appropriate level of research and thorough

investigation Webber’s conclusion is backed by thorough research and investigation and is thus in compliance with this standard

Correct Answer: C

Standard II (B) Market Manipulation prohibits members and candidates from “engaging in practices that distort prices or artificially inflate trading volume with the intent to mislead market participants.” Transactions that artificially distort prices or volume to give the impression of activity or price

movement in a financial instrument reflect violations

By transferring stocks, possessing a low level of liquidity, from the distressed fund to the developed equity fund, Bridges has violated this standard This is because he has transferred stocks to the latter fund to artificially increase the demand for these stocks Although this action has been done to

improve the value of stocks which may benefit potential investors, such an activity deceives potential investors into believing the stocks they are buying are highly liquid and attractively priced

Standard III (C) Suitability requires members and candidates, in advisory roles, to make a reasonable inquiry into the client’s investment experience, risk and return objectives, and financial constraints and must reassess and update this information regularly The standard also requires recommending investments and taking investment actions which are consistent with the client’s financial constraints,

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risk and return objectives, constraints, and written mandates Additionally members/candidates must judge the suitability of the investment in the context of the client’s total portfolio

The process of transferring securities from the former to the latter fund does not violate this standard

as these stocks are not owned by any clients nor recommended at the time of the transfer

Correct Answer: A

Webber has described distressed securities as possessing a low level of liquidity In addition such stocks of distressed companies are generally highly risky and require a long-term investment horizon These securities are suitable for those investors with high risk tolerances; sufficient liquidity

reserves/low liquidity requirements; and an intermediate to long-term investment horizon making them capable of tolerating the associated risks

Based on standard III (C) Suitability’s requirements, recommending these stocks to client categories

A, B and E violate this standard This is because:

tolerance level;

unsuitable for all three categories

Additionally by sending out the recommendation to existing clients only as opposed to suitable prospective clients and existing clients, standard III (B) Fair Dealing has been violated This standard requires members and candidates to deal fairly with clients when disseminating investment

recommendations and in their professional activities

Correct Answer: C

All the three client categories to receive the recommendation should not have received such an

investment recommendation (see the solution to Part 3(10531))

Correct Answer: B

Standard III (D) Performance Presentation requires members and candidates to make every

reasonable effort to ensure that the performance they present is fair, accurate, and complete Members and candidates should not mislead clients by misrepresenting their past performance or reasonably expected future performance

By presenting the performance attained by Emerson at Denver Associates as being attained at Holler and Brookes Associates, the advertisement has violated this standard

Standard V (C) Record Retention requires members and candidate to “develop and maintain

appropriate records to support their investment analysis, recommendations actions and other

investment related communications with clients and prospects.” This standard is not relevant in the

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Standard VII (B) Reference to CFA Institute, the CFA Designation, and the CFA Program requires members and candidates to avoid misrepresenting or exaggerating the “meaning or implications of membership in CFA institute, holding the CFA designation or candidacy in the CFA Program.” Additionally, there is no such thing as a partial designation

Forecasting that Emerson will successfully complete and pass the Level III examinations violates this standard Additionally indicating that Emerson will achieve the completion status following the upcoming June examinations violates this standard as there is no such designation

Correct Answer: B

The code of ethics requires members and candidates to:

clients, prospective clients, employers, employees, colleagues in the investment profession, and other participants in the global capital markets

personal interests

analysis, making investment recommendations, taking investment actions, and engaging in other professional activities

credit on themselves and the profession

competence of other investment professionals

The requirement that members and candidates/investment professionals must exercise diligence, independence, thoroughness and independence when analyzing investments, making

recommendations or taking investment actions is covered by the CFA Institute’s Standards of

Professional Conduct [Standard V (A) Diligence and Reasonable Basis]

recommendations or take investment actions that are consistent with the stated objectives and

constraints of the portfolio.’

Based on the investment policy of Grace Incorporated’s pension plan, Peltier will need to assure he does not make allocations to growth stocks, and chooses securities which bring industry

diversification (belongs to industries distinct from Grace Incorporated) and are securities of stable companies

Based on the data provided, Peltier should ignore stock B altogether as it belongs to the same industry

as the surgical manufacturer

Peltier cannot choose stock A as its high P/E and P/B ratio (11.2 and 13.4, respectively) indicate it is

a growth stock Similarly the high projected EPS growth further confirm that it is a growth stock Thus Peltier should not consider stock B for inclusion to the plan’s investment account

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Peltier may select stock C for inclusion into the plan’s investment account The low P/E ratio and high P/B ratios (3.8 and 13.6, respectively) indicate the stock is a balanced stock Additionally, stock

C belongs to the automobile manufacturing industry which indicates it will bring industry

diversification to the plan’s account By allocating stock C to the investment account, Peltier does not violate the standards

Thus by selecting stock B for the plan’s investment account, Peltier has violated standard III(C) Suitability as he has not followed the plan’s mandate pertaining to industry diversification

Correct Answer: A

Standard III (B) Fair Dealing requires members and candidates “to deal fairly and objectively with all clients when providing investment analysis, making investment recommendations, taking investment action, or engaging in other professional activities.” By allocating 80% of the purchased shares to suitable client accounts, Lawson has not violated this standard However by not allocating the 20% portion to interested clients and holding them back for an eight-month period, Lawson has violated this standard as she has denied the interest clients of these oversubscribed corporation shares

Standard III (C) Suitability requires members and candidates to make a reasonable inquiry into the client’s circumstances, risk and return objectives and financial constraints prior to making any

investment recommendation or taking investment action, determining whether the investment is suitable to the client’s financial situation and consistent with the client’s written objectives, and judging the suitability of investments in the context of the client’s total portfolio There is nothing in the case which indicates Lawson has violated the standard

There is nothing to indicate that standard III (A) Loyalty, Prudence and Care has been violated Additionally standard VI (B) Priority of Transactions requires members and candidates to place investment transactions of clients and employers ahead of transactions in which a member and

candidate is the beneficial owner By depositing 20% of the oversubscribed corporation’s shares in her account for a period of eight months, instead of the investment accounts of interest clients,

Lawson is benefitting from any potential increase in the stock’s value

Correct Answer: C

Should Lawson accept the round trip cruise offer, Lawson will be violating standard I (B)

Independence and Objectivity which requires members and candidates not to “accept any gift, benefit, compensation or consideration that reasonably could be expected to compromise their independence and objectivity.” The condition (to allocate 40% of the shares to Schmidt’s account in exchange for a reward) attached the cruise trip will itself impair Lawson’s independence and objectivity since, after accepting the offer, she will favor Schmidt and allocate a portion of the corporation’s shares to his account only rather to the accounts of other individuals who have expressed an interest in the shares The allocation of the 40% shares solely to Schmidt’s account additionally suggests that Lawson has violated the standard, III (B) Fair Dealing Schmidt should have allocated the shares proportionally to those accounts expressing an interest, for which the investment is suitable, as well as distribute amongst suitable accounts on a pro-rata basis

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expected to create a conflict of interest with their employer’s interest unless they obtain written consent from all parties involved Unless Lawson does not obtain consent for the trip, she will violate this standard She has informed her employer, MIA, of the offer and thus does not violate this

A problem with the source code of a software development corporation’s major product line is a piece

of material information However it is not necessary that the problem may lead to the discontinuation

of the corporation’s major product line and result in a drop in forecasted product revenues The two retirees are merely speculating and sharing this information with others (either with his friend or fellow portfolio manager) does not result in Brewer violating this standard

Correct Answer: C

Standard III (C) Suitability requires members and candidates to make investment recommendations and take investment actions which are consistent with the client’s investment account and risk and return objectives as well as constraints However members and candidates can only make suitable investment recommendations or take investment actions provided clients are forthcoming in

providing the relevant information to their portfolio managers

The chief investment officer's claims are not valid This is because the officer has not prohibited the portfolio manager from avoiding emerging market stocks Additionally, the chosen stocks meet the socially responsible criteria Thus by including such stocks, Brewer has not violated this standard Additionally, Brewer has not violated III (B) Fair Dealing

Correct Answer: C

Standard IV (C) Responsibility of Supervisors requires members and candidates to prevent and detect any violations of the codes and standards, laws, rules and/or regulations by anyone subject to their supervision or authority

As the portfolio manager of The Senior Citizen Endowment’s portfolio, Brewer has not violated any standards (See the solution to Part 5) Thus there are no violations which Peltier need to prevent and/or detect Thus as supervisor he has not violated this standard

Standard III (C) Suitability is not relevant in this context

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Correct Answer: C

Standard II (A) Material Nonpublic Information prohibits members and candidates, “who possess material nonpublic information that could affect the value of the security, from taking action on it or causing others to take action on the information.” Although the information on the G&J’s expansion plans may be material and nonpublic, the discussion between Sutton and Mullins does not violate this standard as no effort was made to act or cause someone to act on the information

Standard III (E) Preservation of Confidentiality requires members and candidates to keep information about current, former, and/or prospective clients confidential unless the client permits disclosure; disclosure is required by law; or the information concerns illegal activities on part of the client As the investment banker of G&J, Sutton has the obligation to preserve the confidentiality of any

information received on his client’s expansion plans, which he has exclusively received Thus by sharing these plans with Mullins, he has violated this standard

Standard IV (C) Responsibility of Supervisors requires members and candidates to make reasonable efforts to prevent and detect any violations of any applicable laws, codes and standards, rules and regulations by anyone subject to their supervision or authority This responsibility includes

implementing adequate compliance procedures, making reasonable efforts to ensure these procedures are monitored and enforced By implementing a structure to control the interaction between the two departments (investment banking and investment counseling/management departments) and not monitoring the effectiveness of the structure nor ensuring the flow of information between the

departments is limited, Herrera as a senior compliance officer has violated this standard

Correct Answer: A

Standard I (B) Independence and Objectivity requires members and candidates to use reasonable care and judgment to achieve and maintain independence and objectivity in their professional activities Any recommendations should be independently arrived at If investment recommendations are made following instructions, which conflict with the member/candidate’s recommendations, the member or candidate is in violation of this standard

The best action for Mullins to undertake would be to develop a research report and conclude it with a recommendation solely based on his analysis of G&J’s future prospects Since Mullins believes G&J’s expansion plans may not succeed, he will probably produce a different recommendation to the buy recommendation instructed by Herrera

Correct Answer: B

Standard III (A) Loyalty, Prudence and Care requires members and candidates to act for the benefit of their clients and place client interests first The standard also requires members and candidates to maintain their duty of loyalty to their clients, act with reasonable care, and exercise prudent judgment

In the course of their duty to their clients members and candidates should seek best price and

execution

Although Mace Brokerage charges fees higher than the existing broker, the access to global and local

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Although Harold and Haroon Associates charges fees lower than the existing broker the execution speeds are relatively slower Additionally the firm provides access to local research only Thus the relatively slow execution speed makes this broker unsuitable for Mighty-You Inc Thus the

appointment of this broker-candidate will violate the standard in question as Delgado will not be providing its client with best execution

Correct Answer: B

Standard III (C) Suitability requires members and candidates, in an advisory relationship, to make investment recommendations which are suitable to the individual client’s financial situation, risk and return objectives, and written investment mandates Additionally, members and candidates must judge the suitability of the investment in the context of the total client portfolio

There is a lack of sufficient evidence which may suggest that the firm may have conducted a

suitability analysis prior to implementing the derivative strategy on a portion of the client portfolios

It is possible that such a strategy may not be suitable for or may be expressly prohibited by some clients Thus by implementing a derivative strategy, the firm has violated this standard

Standard V (A) Diligence and Reasonable Basis requires members and candidates to “have a

reasonable and adequate basis, supported by appropriate research and investigation, for any

investment analysis, recommendation or action.” The volatility of the national market, which in turn has substantially increased the risk of several securities in client portfolios, justifies the use of

derivative to offset these risks Thus this standard has not been violated

Under Standard V (B) Communication with Clients and Prospective Clients, member and candidates must disclose to clients the basic format and general principles used to analyze investments, select securities and construct portfolios and promptly disclose any material changes to the processes By delaying the notification to clients (regarding the inclusion of derivatives in their portfolios) for a period of one month, this standard has been violated

Standard III (A) Loyalty, Prudence and Care requires members and candidates to vote proxies in the best interests of clients and their ultimate beneficiaries as well as to vote proxies in an informed and responsible manner A fiduciary who votes blindly with management on non-routine governance issues violates this standard Due to cost and benefits, it is not necessary to vote all proxies Policy 2

is not consistent with this standard as it does not call for voting in the best interests of clients and ultimate beneficiaries This is because the policy calls for taking into account any benefits to the firm,

in addition to clients’ benefits, and ignores the benefits to beneficiaries (accruing to them as a result

of the votes cast) In addition, the policy requires votes to be cast in line the firm’s management

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which hampers the member/candidate’s ability to cast his or her vote in the best interests of its clients and ultimate beneficiaries

Policy 3:

Under Standard V (C) Record Retention members and candidates are required to develop and

maintain appropriate records to support their investment analysis, recommendation, actions and other investment related communications with clients and prospective clients In the absence of any

regulatory requirements, the CFA Institute recommends a holding period of at least seven years By complying with local record retention regulations, policy 3 is consistent with this standard

prediction of a market factor, Strickland has violated the standard V (A) Diligence and Reasonable Basis

There is nothing which may suggest Strickland has been dishonest or engaged in fraudulent practices adversely affected his professional reputation, integrity or competence Thus Strickland has not violated standard I (D) Misconduct

Strickland has not violated Standard I (C) Misrepresentation nor has he violated standard III (A) Loyalty, Prudence and Care The justification statement does not guarantee the volatility will fall from its current levels, but instead uses the term ‘projected’ which implies Strickland has not

guaranteed any expected performance and thus has not violated standard III (D) Performance

Ideally, to avoid the appearance of any conflicts, Howell should not be asked to cover a company with which he may be affiliated Howell’s family relationship with H.O Zone’s executive director must be disclosed in his research report as well as to his employer, Trinity Associates Without taking any steps to minimize this potential conflict and failing to make the relevant disclosures to clients, prospective client and to his employer, Howell has violated this standard

Standard II (A) Material Nonpublic Information requires members and candidates who possess material nonpublic information, which has the potential to affect the value of a security, from acting

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insider information Additionally by using the recommendation, Thackeray has not violated this standard (due to the uncertainty of the information being acquired from insider resources or not) Standard V (A) Diligence and Reasonable Basis requires members and candidates to “have a

reasonable and adequate basis, supported by appropriate research and investigation, for any

investment analysis, recommendation or action.” Additionally when using secondary research it is necessary to make reasonable and diligent efforts in evaluating the objectivity and independence of the recommendations; reviewing the assumptions used, the rigor of analysis performed, and the date/timeliness of the research

The question of whether Howell may have arrived at his buy recommendation using insider sources remains Without thoroughly evaluating the independence and/or objectivity of the recommendations and relying on the recommendation Thackeray has violated this standard

Correct Answer: A

Standard I (C) Misrepresentation prohibits members and candidates from knowingly making any misrepresentations relating to investment analysis, recommendations, actions or other professional activities in oral or written communications The standard requires members and candidates to

identify or acknowledge the source of ideas or material that is not their own Additionally it is

necessary to cite all sources which are used to develop research reports and work products (other than those obtained from recognized statistical and financial reporting sources)

Although Byrd’s model has been considerably modified from the model developed by the

pharmaceutical chief industry executive, Byrd should acknowledge the fact that his model’s structure was inspired by the latter model and continues to use the same factors as those employed by the latter model By not doing so and marketing the model as his own, he has violated the standard

According to this standard, Byrd must cite the annual industry forecasts obtained from discussions with industry experts but not the industry reports published by the local government agency in his research report

Correct Answer: B

Standard VII (B) Reference to CFA Institute, the CFA Designation, and the CFA Program requires members and candidates to avoid misrepresenting or exaggerating the “meaning or implications of membership in CFA institute, holding the CFA designation or candidacy in the CFA Program.” Additionally, there is no such thing as a partial designation

The newsletter has accurately referred to Terry and Sosa as CFA Level III candidates However by stating that Terry will attain a ‘Passed Finalist’ status, the newsletter has incorrectly referenced Terry’s candidacy in the CFA Program and this reflects a violation of this standard This is because there is no such status

Correct Answer: C

Standard I (D) Misconduct prohibits members and candidates from engaging in any professional conduct involving fraud, deceit, dishonesty or committing any act that reflects adversely on their professional reputation, integrity or competence By assuring McFadden that the financial

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consultancy department will provide the required tax consultancy services when the firm outsources such services, Terry has been dishonest with her client and has violated this standard

Standard II (B) Market Manipulation prohibits members and candidates from engaging in practices that distort the prices or artificially inflate trading volume with the intent to mislead market

participants However the standard does not prohibit transactions done for tax purposes Thus the loss harvesting strategy recommended by Terry (selling securities which have fallen in value to offset the gains on securities which have risen in value) does not violate this standard

tax-Standard III (A) Loyalty, Prudence and Care requires members and candidates to act in the best interests of clients, place client interest before their own, use reasonable care, and exercise prudent judgment when managing the accounts of their clients As McFadden’s financial consultant, Terry has acted in his client’s best interests Thus she has not violated this standard

Standard I (C) Misrepresentation requires members and candidates to have knowledge of all the services the firm provides and should recommend where a client can obtain the requisite service should the firm not be able to provide it By assuring her client that the firm is able to address her taxation concerns and is able to provide the necessary consultancy services, Terry has violated his standard This is because the firm outsources tax consultancy rather than providing it internally Additionally, Terry has misrepresented the tax-loss harvesting strategy by incorrectly stating that it will help to reduce the portfolio’s taxable base in both the current and future years In reality, tax-loss harvesting reduces the portfolio’s taxable basis in the current year to increase it in the future

Based on standard VI (A) Disclosure of Conflict’s requirements (see the solution to Part 1), a

meeting between some of the firm’s managers after office hours does not constitute a violation of this standard

Thus practice 1 does not reflect any violations of the CFA Institute Standards of Professional

Conduct

Practice 2:

The portfolio managers have complied with standard III (A) Loyalty, Prudence and Care by using the brokerage arrangement to obtain high quality research to directly assist the managers in managing the client portfolio

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parties involved.” The portfolio managers have not received any additional compensation which would require disclosure under this standard Thus this standard has not been violated

Standard VI (C) Referral Fees requires members and candidates to disclose to their employers,

current clients, and prospective clients “any compensation, consideration, or benefit received from, or paid to, others for the recommendation of products or services.” The firm’s portfolio managers have referred their clients to their respective broker and have received research in return This arrangement must be disclosed to their existing clients and/or any prospects who wish to employ any of these portfolio managers to manage his/her investment portfolio By not disclosing the arrangements to their clients, the portfolio managers have violated this standard

Correct Answer: A

With respect to practice 3, Byrd has violated standard I (C) Misrepresentation This is because Byrd should have known about the error in his resume as he has been quoting his experience for several years By quoting his experience incorrectly, Byrd has misrepresented his experience with the two industries and has thus violated this standard

By incorrectly stated his years of experience, Byrd has not violated standard III (D) Performance Presentation, which requires members and candidates to make reasonable efforts to ensure that the performance they present is fair, complete, and accurate Since the error pertains to his industry experience as opposed to performance information, Byrd has not violated this standard

Standard V (C) Record Retention is not relevant in this context and there is a lack of sufficient

evidence to conclude that Byrd has not retained records used to develop research reports and make recommendations

Correct Answer: B

Standard I (A) Knowledge of the Law requires members and candidates to understand and comply with all applicable laws, rules and regulations of any government, regulatory organization, licensing agency, or professional association governing their professional activities In the event of any

conflict, members and candidates must comply with the stricter of the two: applicable laws or code and standards

Standard I (D) Misconduct requires members and candidates to avoid any professional misconduct that may reflect adversely on their professional reputation, integrity, or competence and encourages employers to conduct reference checks on potential employees for any past infractions of laws The law which is applicable to Riku Associates is the local Shimautanian law as opposed to the Japanese law applicable to its parent organization Because employees with past infractions of

securities and/or trading laws of two or more counts are likely to violate such laws again, it is

advisable to avoid hiring such employees Thus the requirements of the Institutes’ codes and

standards govern [I (D) Misconduct] Riku Associates must preferably hire employees with a clean past record

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Correct Answer: A

Standard IV (C) Responsibility of Supervisors requires members/candidates to make every reasonable effort to prevent and detect violations of the laws, rules, regulations, and/or codes and standards by anyone subject to their supervision or authority It is permissible to delegate such responsibility but such delegation does not absolve the member/candidate of his/her responsibilities By instructing Sayuki to review Smith’s portfolio after every 18 months, Sayuki has not complied with this standard

as his instructions violate the requirements of III C Suitability (see below) This is because client portfolios need to be reviewed at least annually and whenever there is a change in client and/or market conditions Any reason given to support this review schedule does not justify such a policy Standard III (C) Suitability requires members and candidates, who are in an advisory role, to make a reasonable inquiry into the client’s investment experience, risk and return objectives, investment constraints and must reassess and update this information regularly Client portfolios must be

reviewed at least annually and whenever a change in client circumstances and/or market

circumstances occurs By instructing Lowery to conduct reviews for a period longer than the

minimum 12-month required, for whatever reason, Sayuki has violated this standard Additionally, Lowery has also violated this standard as he has conducted the reviews as instructed

Standard III (A) Loyalty, Prudence and Care does not address client portfolio reviews has not been violated

Correct Answer: C

Standard III (A) Loyalty, Prudence and Care requires members and candidates to act in their client’s best interests, to exercise prudent judgment, and use reasonable care The client’s interests should always have priority over the firm’s and portfolio manager’s interests By recommending the sale of a stock which is harming the client’s portfolio, Lowery has complied with this standard

Standard III (E) Preservation of Confidentiality requires members and candidates to keep all

information concerning former, current, and prospective clients confidential unless the client permits disclosure; the disclosure is required by law; or the information pertains to illegal activities on the part of clients By sharing information regarding Smith’s portfolio holdings with his family friend, Lowery has violated this confidentiality standard

Correct Answer: A

Standard II (A) Material Nonpublic Information prohibits members and candidates who possess material nonpublic information, that could affect they value of a security, from acting or causing other

to take action on the information

The fact that such information has not yet been disclosed and pertains to the discontinuation of a product line provides sufficient evidence that this piece of information is material and nonpublic Although Conway may discuss this piece of information with his supervisor, Sayuki, his first course

of action should have been to make reasonable efforts to achieve public dissemination of the

information by encouraging Furniture Ltd to make the information public If Furniture Ltd had

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However Conway has not made any such efforts and thus has violated this standard

Standard III (E) Preservation of Confidentiality is not relevant here as the standard covers

confidential client information received by portfolio managers as opposed to the information received

by research analysts on the companies they cover

Correct Answer: C

Standard IV (A) Loyalty requires members and candidates, in matters related to their employment, to act for the benefit of their employer, and not deprive their employer of the advantage of their skills and abilities, or otherwise cause harm to their employer Members and candidates must not take any actions such as appropriating property for themselves, client lists, or any information or material from their employer without their permission Members/candidates must continue to act in their employer’s interest until resignation is effective

In Fukui’s case, participating in an online interview does not violate this standard as she is not

disrupting her duties to the firm as an employee Additionally, since Fukui has not undertaken the potential job opportunity at Howell S Erwin Associates, there is no need to disclose the opportunity

to her employer Thus Fukui has not violated this standard

Although Gifu has complied with this standard by informing the employer of the job opportunity before resigning, he has violated this standard with respect to the backups of past firm information stored on his home computer In order to avoid violating this standard, he should have removed the information from his computer before departing Riku Associates or should have received his

employer’s consent to continue to store the information Even if he believes the information to be obsolete, Gifu has violated this standard

Correct Answer: A

Standard I (B) Independence and Objectivity requires members and candidates to strive to achieve and maintain independence and objectivity in all their professional activities Members/candidates must not accept gifts, benefits, compensation or consideration which could reasonably comprise their independence or someone else’s independence and objectivity Gifts must be disclosed to the

member’s employer whatever the case Fukui has informed her employer of the offer and has thus not violated this standard

Standard III (D) Performance Presentation requires members and candidates to make every

reasonable effort that the performance they present is fair, accurate and complete By intentionally increasing the portfolio return by 0.2% (10.0% – 9.8%) when the portfolio actually achieved a return

of 9.8%, Fukui has clearly violated this standard

Standard IV (B) Additional Compensation Arrangements requires members and candidates not to accept any gifts, benefits, compensation, or consideration that competes with or might reasonably be expected to create a conflict of interest with their employer’s interest unless they obtain written consent from all the parties involved Furthermore, the standard requires members/candidates to disclose the nature of the compensation, the approximate amount of compensation and the duration of the arrangement A simple description of the location of the underwater farm is not a disclosure which meets the requirements of this standard Thus by not disclosing the required details, Fukui has

violated this standard

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Correct Answer: C

Standard I (C) Misrepresentation requires members and candidates to avoid knowingly making any misrepresentations when analyzing, making investment recommendations, and/or taking investment action Among the standard’s requirements is the prohibition imposed on members and candidates from guaranteeing future investment results Youssef has not guaranteed investment results nor has he made any misrepresentations Thus he has not violated this standard

Standard V (B) Communication with Clients and Prospective Clients requires members and

candidates, amongst other things, to separate opinion from fact in their research reports and

recommendations By using terms such as ‘will’, Youssef is implying that the political crisis in Kenya will definitely intensify as opposed to stating the probabilities of such an event happening Thus he has violated this standard

Correct Answer: A

Standard V (C) Record Retention requires members and candidates to maintain records indicating the nature of their research recommendations, investment analysis, actions, and other investment related communications with clients and prospects By maintaining a database which contains these records, Youssef has complied with this standard

In addition to requirements presented in the solution to Part 1 standard I (C) Misrepresentation

requires members and candidates to cite all the sources used to generate work products and research reports (recognized governmental and statistical sources need not be cited) By not specifically citing the analysts’ reports, surveys, and quotations used and, instead, making a general statement,

Youssef’s statement (included as part of his database) violates this standard

Standard III (B) Fair Dealing requires members and candidates to deal fairly with clients when

disseminating investment recommendations, taking investment actions or analyzing investments Youssef has discriminated between investors by providing free access to the database to particular investor categories while charging other investors a nominal fee

Correct Answer: C

Standard V (B) Communication with Clients and Prospective Clients defines communication in the form of a recommendation pertaining to an asset allocation, the market, or classes of investments However any brief communications must be supported by background reports or data that can be made available to interested parties on request By issuing the recommendation two days prior to the full-length research report, Youssef has not violated this standard This is because he intends to make the full-length report available as soon as the communication problem abates

Correct Answer: C

Under Standard VII (A) Conduct as Members and Candidates in the CFA Program, members and candidates must not engage in any conduct that compromises the integrity or reputation of the CFA Institute, the CFA designation or the integrity, validity or the security of the CFA examination

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However, standard VII (B) Reference to the CFA Institute, the CFA designation, and the CFA

Program, requires members and candidates not to exaggerate or misrepresent the meaning or

implication of candidacy in the CFA Program, amongst other requirements By implying that

individuals with a certain level of intellect (who are ‘apt’ enough) are likely to succeed in the

program, Hanson has violated this standard

Correct Answer: A

Standard I (B) Independence and Objectivity requires members and candidates to achieve and

maintain independence and objectivity and not to accept gifts, benefits, compensation, or

consideration which could compromise their own or someone else’s independence and objectivity Members and candidates should pay for their own commercial transportation and residence and only use the corporate aircraft offered by a client when commercial transportation is not available

By accepting the residential and transportation arrangements offered by the client and not disclosing these arrangements to his employer, Hanson is in violation of this standard In the course of allowing JTL to make these arrangements, Hanson may have compromised his independence and objectivity Despite his client’s headquarters being half an hour away, Hanson did not make any attempts to explore the transportation alternatives available Additionally despite the residential accommodation being modest, Hanson should have used the residential allowances provided by his employer to seek and pay for his own residence and transportation

Standard IV (A) Loyalty requires members and candidates, in matters related to their employment, to act for the benefit of their employer and not deprive their employer of the advantage of their skills and abilities, divulge confidential information or otherwise harm the employer During his stay in Malaysia, Hanson has not violated this standard

Correct Answer: A

Hanson has not violated Standard I (B) Independence and Objectivity as he will be receiving a flat fee for preparing the research report This makes the research report independent of Hanson’s potential recommendation on the steel manufacturer

By not disclosing the research opportunity offered by the steel manufacturer to Greenwich Limited and seeking permission prior to beginning the assignment, Hanson has violated the standard IV (A) Loyalty which requires members and candidates to disclose all aspects of independent practice and receive employer permission prior to the start of the proposed independence practice

Standard VI (A) Disclosure of Conflicts requires members and candidates to make “full and fair disclosure of all matters that could reasonably be expected to impair their independence and

objectivity or interfere with their respective duties to their clients, prospective clients, and their employer.” By not disclosing the fact that he is an employed research analyst serving Greenwich Limited and misleading the steel manufacturer’s executive to believe that he is an independent

research analyst, Hanson has violated this standard

Reading 2 Guidance for Standards I–VII FinQuiz.com

Correct Answer: C

Standard III (C) Suitability requires members and candidates, in advisory roles, to make a reasonable inquiry into the client’s investment experience, risk and return objectives, financial constraints and reassess and update this information regularly Additionally members and candidates are required to judge the suitability of the investment in context of the client’s total portfolio By instructing portfolio managers to conduct a suitability analysis prior to allocating the emerging market stocks, Russet has complied with this standard

Standard III (A) Loyalty, Prudence and Care requires members and candidates to act in their client’s best interest and exercise prudent judgment and use reasonable care There is no evidence that Russet has violated this standard

Standard IV (C) Responsibility of Supervisors requires members and candidates to make reasonable efforts to prevent and detect any violations of the laws, rules, codes and standards by anyone subject

to their supervision or authority There is no information in the case which may provide evidence that Russet has violated this standard

Correct Answer: C

Standard III (C) Suitability requires members and candidates to undertake a client portfolio review on

an annual basis (minimal) and whenever client circumstances and/or economic circumstances change Rapidly changing economies will require more frequent portfolio reviews as opposed to stable

economies Thus the portfolio review frequency is in compliance with this standard’s guidelines The factors which Russet instructs her portfolio managers to analyze all are factors which have been prescribed by the suitability standard Thus her instructions are in compliance with the standards

Correct Answer: A

Standard II (B) Market Manipulations prohibits members and candidates from engaging in practices that distort prices or artificially inflate trading volume with the intent to mislead market participants However, this standard does not prohibit legitimate trading that exploits a difference in market power, information, or other market inefficiencies

Green did not intentionally manipulate the prices of the crude oil commodity futures traded The heavy futures volume being traded has forced the futures contract prices downward resulting in a (larger than expected) positive roll return when rolling into new futures contracts Thus Green has not violated this standard

Standard V (B) Communication with Clients and Prospective Clients requires members and

candidates to use reasonable judgment in identifying the factors important to investment analysis, recommendations, or actions and include those factors in communications with clients and prospects Additionally members and candidates must disclose the basic principles and general format of the investment process used to analyze investments, select securities, and construct portfolios and

Reading 2 Guidance for Standards I–VII FinQuiz.com

Correct Answer: B

Standard III (E) Preservation of Confidentiality requires members and candidates to keep information concerning present, former and prospective clients confidential unless the client permits disclosure; information concerns illegal activities on part of the client; or disclosure is required by law

By sharing information on Sanchez’s current financial circumstances with the banking consultant, Russet has not respected the confidentiality of her client’s information and has thus violated this standard

Additionally, by not revising Sanchez’s IPS to reflect her changed risk tolerance and liquidity

requirements (which has decreased and increased, respectively following her bankruptcy), Russet has violated the standard, III (C) Suitability, which calls for revising client information whenever client circumstances change Speculative investments in commodity futures are no longer suitable for Sanchez and thus by not liquidating the holdings Russet has violated the suitability standard

Correct Answer: B

Standard III (B) Fair Dealing requires members and candidates to deal fairly with clients and

prospects when disseminating investment recommendations, taking investment actions, and in their general professional activities In case of oversubscribed issues, members and candidates must

allocate them to suitable and interested client accounts on a pro-rata basis

Cooper is in violation of the fair dealing standard on two counts Firstly, relative to other accounts, he has allocated a larger proportion of the trade to his aunt's account Secondly, by delaying the

allocation of the trade to a regular-fee paying client, he has treated his aunt's account unfairly

Standard VI (B) Priority of Transactions requires members and candidates to undertake personal transactions after clients and employers have had a reasonable opportunity to act upon the

recommendation Family accounts which are client accounts should not be disadvantaged and must be treated like any other client account

By allocating the pharmaceutical manufacturer’s stocks to his aunt’s account a day later following the allocation of the issue to his clients’ accounts, Cooper has unfairly treated his aunt’s account and has violated this standard

Reading 4 Asset Manager Code of Professional Conduct FinQuiz.com

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CFA Level III Item-set - Solution

Study Session 2 June 2017

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Reading 4 Asset Manager Code of Professional Conduct FinQuiz.com

FinQuiz Level III 2017 – Item-sets Solution

Reading 4: Asset Manager Code of Professional Conduct

Correct Answer: A

The Asset Manager Code requires managers to conduct stress tests on complex derivate products in order to understand the structure and potential vulnerabilities of such strategies Although a venture capital investment is not a derivative strategy, it is often associated with a high failure rate,

irrespective of the 60% Italian venture capital firms’ success rates (and 80% of those firms exiting through an IPO) Thus it is necessary to conduct a stress test on the investment in order for the

manager to determine the probability of the venture capital failing to generate the promised returns as well as the vulnerability of the investment to failure of the venture capital firm The stress tests should

be conducted prior to the allocation of LeQ-Twon’s stock to the fund’s portfolio Thus by failing to conduct stress tests, Galeazzi has violated the Code

As the portfolio manager of Izraac Inc.’s pension fund, Galeazzi has the responsibility to take

investment actions that are consistent with the pension fund’s investment mandates However he has clearly violated the investment mandate of the pension fund The fund prohibits investments in high risk ventures An investment in LeQ-Twon’s stock generates exactly the type of risk prohibited by the investment mandate Thus Galeazzi has failed to consider the suitability of the investment when making the venture capital investment

As portfolio manager, Galeazzi is not required to report the state of the Italian venture capital market

to clients Thus he has not violated the Code in this regard

Correct Answer: B

The Asset Manager Code requires portfolio managers to provide adequate disclosure of a change in their investment style or strategy so that investors can consider whether any proposed changes in the investment style or strategy meet their investment needs well in advance of the change Pate has informed the endowment fund sponsor of the change in investment strategy (focus on emerging market small-cap growth corporate stocks) and thus has complied with the Code in this regard

In context of a material change in investment strategy, clients should be permitted to redeem their investment if desired without incurring any undue penalties A shift in focus to emerging market stocks clearly constitutes a material shift in investment strategy as the endowment fund has retained Pate solely due to his skills in U.S small-cap growth stocks However by imposing a one-year period, Pate has not provided the endowment fund the liberty to exit from the investment at its discretion Additionally it is unclear whether Pate will impose a penalty should the fund liquidate its investment prior to the end of the one-year observation period Thus, irrespective of the absence of withdrawal penalties at the end of the observation period, the ‘waiting’ period indirectly implies a restriction on the client’s investment withdrawal freedom and constitutes a violation of the Code

Pate has adequately disclosed the investment strategy’s risk factors and use of leverage to the fund

He has thus not violated the Code in this regard

Reading 4 Asset Manager Code of Professional Conduct FinQuiz.com

Correct Answer: A

The Code requires asset management firms appoint a chief compliance officer for ’administering the policies and procedures and for investigating complaints regarding the conduct of the Manager or its personnel.’

Depending on the size and complexity of the organization, the manager may appoint an existing employee to serve as the compliance officer, hire a separate individual for that role, or require an entire compliance department Thus Fennini may hire a firm employee to fill the role of the

compliance officer

It is necessary for the compliance officer to be independent from the investment and operations personnel and report directly to the CEO or board of directors With respect to the recommended reporting structure, measure 1 complies with the Code However, reassigning the senior portfolio manager to fulfill the role of the compliance officer is a recommendation which will not comply with the Code This is because the senior portfolio manager may continue to hold personal or professional relations with the investment and/or operations personnel, despite the reassignment, and thus may not effectively carry out his monitoring activities Thus the measure fails to comply with the Code by failing to consider the independence of the reassigned manager

The chief compliance officer and senior management are together responsible for conveying to firm employees the importance of compliance policies and procedures and ensuring compliance

Additionally the compliance officer is responsible for conducting employee training regarding the procedures as well as self-evaluations and working with management on investigating potential breaches of the procedures The potential duties to be carried out by the compliance officer have been accurately addressed by measure 1

Correct Answer: C

The Code requires asset management firms to ‘establish a business-continuity plan to address disaster recovery or periodic disruptions of the financial markets.’

Managers must ensure that the contents of the plan should, as a minimum, include the following:

unavailable;

facility or communication disruption;

and

Measure 2 has addressed procedures for testing the plan on a firm-wide basis by testing for the plan’s integrity and robustness but has failed to address alternative procedures for monitoring, analyzing and

Reading 4 Asset Manager Code of Professional Conduct FinQuiz.com

plans for continuing communication with firm employees and ensuring coverage of critical business functions in the event of a facility or communication disruption

Correct Answer: B

With respect to the fees and costs charged to clients by the Manager the Code requires, at a minimum

for managers to provide clients with gross- and net-of-fees returns and disclose any unusual

expenses A general statement that certain fees and costs will be assessed does not adequately convey the total amount of expenses that investors will incur as a result of investing Managers should also disclose the methods for determining all fixed and contingent fees and costs that will be borne by investors and explain the transactions that will trigger the imposition of these expenses

Additionally managers should disclose to each client the actual fees and other costs charged to them

as well as an itemization of such charges, when requested by clients This disclosure should include the incentive fee, management fee and amount of commissions charged Managers must disclose to prospective clients the average or expected expenses or fees clients are likely to incur

With respect to Macari, David discloses the specific fees charged to Macari upon the client’s request and discloses gross-of-fees to all existing clients (including Macari) on a periodic basis By not disclosing the net-of-fees charged or methods for determining the fees and the transactions which trigger the imposition of the expenses, David’s fee disclosure practices to Macari has violated the Code’s disclosure guidelines

By disclosing estimate fee figures to be charged to prospects, David’s fee disclosing practices comply with the Code’s disclosure guidelines

of the holdings for which no readily available, independent, third-party market quotations are

available The valuation basis should be disclosed to clients, be asset-specific, conducted annually or

as client circumstances or market conditions change, and should be applied consistently

Portfolio holdings valuations based on an internal valuation model does not violate the standard as long as the valuations are conducted in good faith Policy 1 does not violate the Code as the basis for the valuation, its frequency, and valuation-related disclosures comply with the guidelines

Reading 4 Asset Manager Code of Professional Conduct FinQuiz.com

Policy 2 complies with the Code’s guidelines with respect to the issues underlying proxy voting to be disclosed to clients However the information on how shares are voted must be disclosed to all clients

as opposed to only those clients making such a request Thus the policy has not complied with the Code in this regard

Reading 5 The Behavioral Finance Perspective FinQuiz.com

FinQuiz.com

CFA Level III Item-set - Solution

Study Session 3 June 2017

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Reading 5 The Behavioral Finance Perspective FinQuiz.com

FinQuiz Level III 2017 – Item-sets Solution

Reading 5: The Behavioral Finance Perspective

Correct Answer: C

Bounded rationality assumes that individuals identify satisfactory sub-goals and limited objectives and make decisions by applying heuristics that meet these sub-goals The adaptive market hypothesis applies an evolutionary perspective to the framework and states that as experience increases, individuals learn and the heuristics they apply to a situation evolve The AMH considers both bounded rationality and evolutionary principles

Correct Answer: B

Investor A does not construct portfolios consistent with the BPT This is because he/she considers the covariance among the investment layers In BPT, no consideration is given to

covariance of the investment layers since the risk and return of the portfolio as a whole is not

considered Investors B and C make comments consistent with the BPT

Correct Answer: A

The portfolio meets the safety objective (0% probability of falling below $4.5 million), but it does not meet Hart’s aspirational goals (4% return with 70% probability) The portfolio returns only 3.9% with a 65% probability Hence, to meet the aspirational goals, the safety level objective must be lowered (that is, more risk should be taken with the portfolio)

Correct Answer: B

By trying to determine if stock prices move too much to be justified by subsequent changes

in dividends, Cameron is trying to identify a fundamental anomaly (an anomaly that emerges when one considers a stock’s performance based on a fundamental assessment of the stock’s value) By studying capital market seasonality, Cameron is trying to identify calendar

Reading 5 The Behavioral Finance Perspective FinQuiz.com

Correct Answer: A

The decision theory assumes that a decision maker is fully informed, is able to make

quantitative calculations with accuracy, and is perfectly rational The BPT and AMH

consider bounded rationality and the concept of satisficing

Reading 6 The Behavioral Biases of Individuals FinQuiz.com

FinQuiz.com

CFA Level III Item-set - Solution

Study Session 3 June 2017

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Reading 6 The Behavioral Biases of Individuals FinQuiz.com

FinQuiz Level III 2017 – Item-sets Solution

Reading 6: The Behavioral Biases of Individuals

Correct Answer: B

Walter is subject to the confirmation bias since he has established screening criteria, and is ignoring information that is refuting the validity of the criteria This is evident from the fact that Walter is ignoring the investment recommendation made by Bright just because the investment does not meet the screening criteria (and more so, challenges the validity of his criteria)

Reading 6 The Behavioral Biases of Individuals FinQuiz.com

Turner is subject to representativeness bias She is making all her new investments based on the apparent similarities of the stocks with the stock of Agri-Group (a successful investment) without doing research to validate the new investment’s merits She thinks that the stock’s characteristics are

representative of successful companies’ stocks

Correct Answer: B

Regret aversion can lead investors to hold on to investments too long Even though the stock’s price has reached the target Brown set for it, he is still reluctant to sell because he fears that the position will increase in value even more and then he will regret having sold it

Correct Answer: A

Given the low turnover and low frequency of trading, the client seems to be subject to status-quo bias The low frequency of trading seems unintentional (like in a state of inertia), since when Turner brought the issue to the client’s attention, he asked her to sell off all investments that had gained immediately This also demonstrates his loss aversion—he wants to sell profitable investments as soon as possible to realize the gains (a concept also known as the disposition effect)

Correct Answer: B

Client A is subject to availability bias and Client B is subject to loss aversion bias Since availability bias is a cognitive bias, and loss aversion is an emotional bias, given a high level of wealth and low standard of living risk, Client B’s bias should be adapted to, and Client A’s bias should be moderated and adapted to

Correct Answer: C

Brown is subject to regret aversion bias This bias has led to the preference of White Inc.’s stock, even though the risk and return expectations of both stocks are equal By investing in a stock that is backed by well-known institutional investors, Brown is trying to avoid the burden of responsibility of making a poor decision This in turn will reduce the pain of regret he would feel (it seems safe to be with the crowd)