Volume II behavioral finance, individual investors, and institutional InvestorsCFA level 3finquiz item set answers, study session 1, reading 2

Standard V A Diligence and Reasonable Basis requires members and candidates to exercise thoroughness, independence, and diligence when conducting investment analysis, making investment r

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FinQuiz.com

CFA Level III Item-set - Solution

Study Session 1 June 2018

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FinQuiz Level III 2018 – Item-sets Solution

Reading 2: Guidance for Standards I–VII

1 Question ID: 10529

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

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:

client category A has a short-term time horizon, significant liquidity requirements, and a low risk tolerance level;

client category B has significant liquidity requirements;

client category E has a below average risk tolerance; making such an investment highly

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

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 context of the advertisement

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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

The code of ethics requires members and candidates to:

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

Place the integrity of the investment profession and the interests of clients above their own personal interests

Use reasonable care and exercise independent professional judgment when conducting investment analysis, making investment recommendations, taking investment actions, and engaging in other professional activities

Practice and encourage others to practice in a professional and ethical manner that will reflect credit on themselves and the profession

Promote the integrity of and uphold the rules governing capital markets

Maintain and improve their professional competence and strive to maintain and improve the 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]

When managing accounts to a specific mandate, strategy or investment style, the CFA Institute Standards of Professional Conduct require members and candidates to, “make investment

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

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

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

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

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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

standard

Standard II (A) Material Nonpublic information prohibits members and candidates from trading on material non-public information or causing others to trade on such information

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

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

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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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

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

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 research as well as higher execution speed (relative to the current broker) justify the fees Thus by appointing Mace Brokerage, Delgado will not be violating this standard but instead will be providing Mighty-You Inc with greater benefits (i.e execution)

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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

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

Policy 1:

Standard II (A) Material Nonpublic Information requires members and candidates to establish a firewall between the investment banking and investment research divisions to prevent the flow of material nonpublic information Interdepartmental communication must preferably pass through a clearance area within the firm in either the compliance or legal department Allowing unsupervised communication between the two departments (investment banking and counseling, in the firm’s case) makes Policy 1 inconsistent with this CFA Institute Standards of Professional Conduct standard Policy 2:

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

By allocating highly risky securities to the investment portfolios of his risk-averse clients (which require less risky securities), Strickland has clearly violated the standard, III (C) Suitability

Additionally, Strickland’s statement does not justify the addition of these securities to the portfolios The expected decrease in market and securities’ volatility is merely a prediction which may not materialize after the quoted six-month period Thus by basing the purchase decision on a mere

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

Presentation

Standard VI (A) Disclosure of Conflicts requires members and candidates “to make full and fair disclosures 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.” The disclosures need to be prominent, delivered in plain language and communicated effectively

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

or causing others to act on the information There is lack of evidence to suggest that Howell may have not independently arrived at a buy recommendation or used insider information to arrive at the

recommendation A mere speculation by Thackeray does not necessarily mean Howell has used

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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

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

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

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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