CFA level 1 study note book1 2014

2014
Levell

I

Book 1

SchweserNotes'" for the CFA· Exam
Ethical and Professional Standards
and Quantitative Methods

rz-: I{ A P LAN
\!.)

SCHOOL OF PROFESSIONAL
AND CONTINUING EDUCATION



BOOK

1-

ETHICAL AND PROFESSIONAL

STANDARDS AND QUANTITATIVE
METHODS
Reading Assignmcnts and L:arning Outcomc Statcmcnts

7

Study Session 1 - Ethical and Profcssional Standuds

13

Self-Tcst - Ethical and Profcssional Standard

91

Study Scssion 2 - Quantitativc

Mcthods: Basic Concepts

98

Study Scssion 3 - Quantitativc

Mcthods: Application

Self-Tcst - Quantitativc

Mcthods

245
363

Formulas

368

Appcndices

372

Inda

380

020 13 Kaplan, Inc.

~1


SCHWESERNOTES'"
2014 CFA LEVEL I BOOK I: ETHICAL AND
PROFESSIONAL STANDARDS AND QUANTITATIVE METHODS
02013

Kaplan. Inc. All rights reserved.

Published in 2013 by Kaplan. Inc.
Printed in the United States of America.
ISBN: 978-1-4277-4905-511-4277-4905-1
PPN: 3200-4006

If.bi. book docs eee hm: che hologram with the Kaplan Sch..e scr logo on .he back COYic,..,.
discributcd without permission of Kaplan Seb,",«, a Division of Kaplan. Ine., and is in direct viola~ion
of global copyright 1.1"". Your usilm.ftCC in purruinc potential violatoR of this Jaw is Ircatly appreciated.

Requirod CFA In"i,ule dlsdaimer: -CFA'" and Chane",d FiDanciaiAnal)·.. '" ue uodemulu..."cd

by
CFA Institutc. CFA lrutitutc (formerly the Association for Investment Manaccmcnt and Research) doC'S
not cMonc. promote. rninv~or warrUlt the .ccuney of the produ.cu or services offered by KapLa.a
SchWCSCf,-

CC'n&inmaterial, contained within this (ClOt 1ft tht copyrighted property of CFA lrutitutc. The
following i•• he cop,.np. di.do.u", for these ma.erials: ·Cop>";gh t, 2013. CFA 1.lIi.u.e. Reproduced
and "Publi.hed hom 2014 Leunin, Oeeeeeee S.. lrmc .... Lnd I. II. and III quell ion. from CFA'"
rropun ~b.criaIs, CFA IMci""e Sundard, of rror..,io.aI Conduec. and CFA In.. iune·, Global
Inve.tmCft( Performance Standards with permission (rom CfA Institute. All Rishts Rcscrrcd.These materials Play not

be eopied

without written penniss.ion

from the author. The uDau.thori-zed

duplication of these note. is a ";,,Iation of global copyright law, and the CFA 1.... icu.e Code of Ethic•.
Your ass~stance in punuins potential violators of this law is pady appr«iatcd.
The Schwncr Notes should be wed in conjunction with the ocipruJ Radings as act COrtA
by CFA In"i"'le in their 201. CFA Ln.11 Scudy Guide. The i.fOrmation contained in these No.CI
Disclaimer:

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

02013 Kaplan. Inc.

WELCOME TO THE
SCHWESERN"OTES™

2014

Thank you for trusting Kaplan Schweser to help you reach your goals. We are all ""ry
pleased to be able to help you prepare for the Level I CFA Exam. In this introduction.
I want to explain the resources included with the SehwnerNotes. suggest how you
can best usc Schweser materials to prepare for the exam, and direct you toward other
educational resources you will lind helpful as you study for the exam.
Besides the Schwcsc:rNot.,. themselves, there arc many educational resources available at
Schweser.eom. Just log in using the individual username and password that you received
when you purchased the SehweserNotes.
SchwcserNotes no
These consist of live volumes that include complete coverage of allIS Study Sessions
and all Learning Outcome Statements (LOS) with examples. Concept Checkers
(multiple-choice questions for every topic review). and Challenge Problems for many
topic reviews to help you master the material and check your progress. At the end of
each major topic area. we include a Self-test. Self-test questions arc created to be examlike in format and difficulty in order for you to evaluate how well your study of each
topic has prepared you for the actual exam.
Practice Quenions
To retain what you learn, it is important that you ~iz yourself often. We off'er CD,
download, and online versions of the SchwcserPro
QBank. which contains thousands
of Level Ipractice questions and explanations. Quizzes arc available for each LOS. topic.
or Study Session. Build your own exams by specifying the topics and the number of
questions you choose.
Practice Exams
Schweser offees six full 6-hour practice exams. Practice Exams Volume 1 and Volume 2
each contain three full 240-

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explanations for self-grading and evaluation. By entering your answers at Sehweser.eom,
you can usc our Performance Tracker to lind out how you have performed compared to
other Schweser Level I candidate s,
Schwaer Library
We have created reference videos. some of which are available to all SchwcscrNotes
purchasers. Schweser Library volumes are typically between 20 and 60 minutes in length
and cover such topics as: ·CFA Level IExam Overview," ·Calculator Basics," "Code and
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Usc your Online Access to tell us when you will start and what days of the week you can
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monitor your progress through the curriculum.
02013 Kaplan. Inc.


W.k'Om.

'0

the 201~ SchweKrl'o, ••TM

Additional Resource.
Purchasers of the &sential Self-Study or Premium Instruction Packages also receive
aceess to our Instructor-led Office Hours. Office Hours allow you to get your questions
about the curriculum answered in real time and to sec others' questions (and instructor
answers) as well. Office Hours is a text-based live interactive online chat with our team
of Level I experts. Archives of previous Office Hours sessions can be sorted by topic or

date and are posted shonly after each session.
The Levell CFA exam is a formidable challenge (63 topic reviews and more than 500
Learning Outcome Statements), and you must devote considerable time and effort
to be properly prepared. There is no shortcut! You must learn the material, know the
terminology and techniques, understand the conccpu, and be able to answer 240
questions quickly and (at least 70%) correctly. Fifteen to 20 hours per week for 20 weeks
is a good estimate of the study time required on average, but some candidates will need
more or less time, depending on their individual backgrounds and experience.
To help you master this material and be weU prepared for the CFA Elwn, we offer
several other educational resources, including:
Live Weekly Classroom Programs
We offe.r weekly classroom program. around the world. Please check Schweser.eom for
locations, dates, and availability.
IG-Wcck Online Class
Our 16-Wcck Online Classes arc available at New York time (6:30-9:30 pm) or London
time (6:00-9:00 pm) beginning in January and July. The approximate schedule for the
16-Week Online Classes (3-hour sessions) is as follows:
Class'
Class'
I Exam IntrolQuanri,ativ. M••hods S52 9 Financial Repcrriag & AnalY'is 5510
2 Quantitative Me.hods 553
10 Corpora te Finance S511
3 Economics 55-1,5

II Equicy Investments 5513, 14

4 Economics 555. 6

12 Fixed Income 5515

5 Financial Roporting & Analysis 5S7
6 Financial Roponing & Analysis SS8

13 Fixed Income 5516
14 Derivatives 5517

7 Financial R.porting & Analysis S58. 9

15 Portfolio Managom.m & Almna,i ve
Investments SS12. 18

8 Financial R.poning & Analysis S59

16 Ethical and ProfessionalStandards SSI

Archived classes are available for viewing at any time throughout the season. Candidates
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video instruction in the Schweser Library and an e-mail address to use to send questions
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02013 Kaplan. Ine,


Wdc:ometo tho 2014 SchwesuNotH ™

Late: Season Review
Whether you usc self-study or in-class, online. or video inmuction to learn the CFA
curriculum. a late-season review and exam practice can make all the difference. Our
most complete: late-season review course is our residence program in Windsor. Ontario
(WindsorWeek) where we cover the entire curriculum over seven days (May 3-9) at

all three levels. We also offer 3-Day Exam Workshops in many cities (and online)
that combine curriculum review with an equal component of hands-on practice with
hundreds of questions and problem-solving techniques. Our Dallas/Fort Worth review
program extends to five days (May 12-16). PIC2Sevisit us at Scbweser.cem for complete
listings and course descriptions for all our late-season review offerings.
Mock Exam and Multimedia Tutorial
On May 24. 2014, and November 22.2014. the Schweser Mock Exam will be offered
live in over 60 cities around the world and as an online exam as weU.The optional
Multimedia Tutorial provides extended explanations and topic tutorials to get you
exam-ready in topic areas where you miss questions on the Mock Exam. PIC2Sevisit
Schweser.com for a listing of cities and lccaticns.
Topic Weighting
In preparing for the exam, you must pay attention to the weights assigned to each topic
within the curriculum. The LC\",I I topic weights arc as follows:
Topir

Eum Wtitht

Ethical and ProfessionalStandard,

15%

Quantitati ve M.thods

12%

Economia

10%

Financial Reporting and Analysis

20%

Corporate Finanee

8%

Portfolio Managtm.nt

5%

Equity lnvesunenu

10%

Fixed Income Invesunenu

12%

Derivatives

5%

Alternative Investments

3%

Total

100%

How to Succeed
There arc no shortcuts; depend on the fact that CPA Institute will test you in a way
that will reveal how weU you know the Level Icurriculum. You should begin early and
stick to your study plan. You should first read the SchweserNotes and complete the
Concept Checkers and Challenge Problems for each topic review. You should prepare
for and attend a live class an online class. or • study group each ·...eek, You should take
quiucs often using SchwcserPro Qbank and go back to review previous topics and Study
Sesslons as well. At the end of each topic area, you should take the Self-test to check
your progress. You should finish the overaU curriculum at least four weeks (preferably
five weeks) before the Level I exam so that you have sufficient time for Practice Exams
and for further review of those topics that you have not yet mastered.

02013 Kaplan. Inc.


Welcome 10 the 201~ Schweoerl'ote.™

I would like to thank Craig Prochaska. CFA. Content Specialist and Jared Heintz, Lead
Copy Editor. for their contributions to producing the 2014 Levell SehweserNotcs for
rhe CFA Exam.
Best regard ••

Dr. Douglas Van Eaton, CFA

SVP of CFA Education and Level I Manager
Kaplan Schweser

02013 Kaplan. Inc.

READING ASSIGNMENTS AND
LEARNING OUTCOME STATEMENTS

TM flllDwinl mau,ial is a m,;~w oftM Ethkal and Profillional S/4111ia,dsand
QUlt1ltitatilJeM~thods prin(ipks d~siln~d to addrrss th~ kaming out(o_ stat~m~1ItsItt forth
'" CFA /mti(Uu.

STUDY SESSION 1
Reading Assignmcnu
Ethkal and Profissional Standards and Quantitatiw M~thods. CFA Progn.m Levell 2014
Curriculum. Volume 1 (CFA Institute, 2013)
1. Code of Ethies and Standards of Professional Conduct
page 13
2. Guidance for Standards I-VII
page 13
3. Introduction to the Globallnvcstment Performance Standards (GIPS®) page 82
4. The GIPS Standards
page 84
I

STUDY SESSION 2
Reading Assignmcnu
Ethkal and ProfissiDnalStandards and Quantitatiw Mnhods. CFA Program Levell 2014
Curriculum. Volume 1 (CFA lnstinne, 2013)
5. The TIme Value of Money
page 98
6. Discounted Cash Flow Applications
page 138

7. Statistical Concepts and Market Returns
page 163
8. Probability Concepts
page 201

STUDY SESSION 3
Reading Assignmcnu
Ethical and ProfilliDllIll Sta"da,ds and Quantitatiw Mnhods. CFA Progn.m Levell 2014
Curriculum. Volume 1 (CFA Instirutc, 2013)
9. Common Probability Distributions
page 245
10. Sampling and Estimation
page 281
11. Hypothesis Testing
page 304
12. Technical Analysis
page 344

02013 Kaplan. Inc.


Book 1 - Elhical and Prof....ional SCllIciardsand Quanli .. live M.lhods
IUadins Assignme"u IUIdUaming OUlcome Scalemenu
LEARNING OUTCOME STATEMENTS (LOS)

STUDY SESSION 1
Th« topieal clI",ragt ClI"'SPDn4swith tht fl,u,wing

cr~Institute

assigne'rtading:

I. Code of Emics and Standards ofProfcssionai Conduct
The candidate should be able to:
a. describe the structure of the CFA Institute Professional Conduct Program and
the proeess for the enforeement of the Code and Standards. (page 13)
b. stare the six components of the Code of Ethics and the seven Standards of
Professional Conduct. (page 14)
Co
explain the ethical responsibilities required by the Code and Standards,
including the sub-sections of each Standard. (page: 15)
2. GuidlUlee for Standard. I-VII
The candidate should be able to:
a. demonstrate the application of the Code of Ethics and Standards of Professional
Conduct to situations involving issues of professional integrity. (page: 18)
b. distinguish between conduct that conforms to the Code and Standards and
eon duet that violates the Code and Standards. (page 18)
Co
recommend practices and procedures designed to prevent violations of the: Code
of Ethics and Standards of Professional Conduct. (page 18)
3. Introduction to the Global Investment Performance Standards (GIPS*)
The candidate should be able to:
a. explain why the: GIPS standards were created. what parties the GIPS standards
apply to, and who is served by the standards. (page 82)
b. explain the construetion and purpose of composites in performance reporting.
(page: 83)
Co
explain the requirement> for verification. (page 83)
4. The GIPS Standards
The candidate should be able to:

a. describe the kcy features of the GIPS standards and the fundamentals of
compliance. (page 84)
b. describe the scope: of the GIPS standards with respect to an investment firm's
definition and historieal performance record. (page:86)
Co
explain how the GIPS standards are implemented in countries with existing
standards for performance reporting and describe the appropriate response when
the GIPS standards and local regulations eonRiet. (page 86)
d. describe the nine major sections of the GIPS standards. (page 86)

STUDY SESSION 2
5. The Time Value of Money
The candidate should be able to:
a. interpret interest rates as required rates of return, discount rates, or opportunity
costs. (page 100)
b. explain an interest rate as the sum of a real risk-free rate, and premiums that
compensate investors for bearing distinct types of risk. (page 101)
Co
calculate and interpret the effective annual rate, given the stated annual interest
rate and the frequency of compounding. (page 101)

Page 8

02013 Kaplan, Inc.


nook
d.

6.

solve time value of moncy problems for different frequencies of compounding.
(page 103)
e. calculate and interpret the future value (FV) and present value (PV) of a single
sum of moncy, an ordinary annuity, an annuity due, a perpetuity (PV only), and
a series of unequal cash flows. (page 104)
f. demonstrate the usc of a time line in modeling and solving time value of moncy
problems. (page 118)
Discounted Cash Flow Applications
The candidate should be able to:
a. calculate and interpret the net present value (NPV) and the internal rate of
return (IRR) of an investment. (page 138)
b. contrast the NPV rule to the IRR rule, and identify problems associated with
the IRR rule. (page 141)
c. calculate and interpret a holding period return (total return), (page 143)
d. calculate and comparc the moncy-weightcd and time-weighted rates of return of
a portfolio and evaluate the performance of portfolios based on these measures.
(page 143)
e. calculate and interpret the bank discount yield, holding period yield, effective
annual yield, and moncy market yield for
Treasury biDs and other money
market instruments. (page 147)
f. convert among holding period yields, moncy market yields, effective annual
yields, and bond equivalent yields. (page 150)
Statistical Concepts and Market Returns
The candidate should be able to:
a. distinguish between descriptive statistics and inferential statistics, between
a population and a sample, and among the types of measurement scales.
(page 163)
b. define a parameter, a sample statistic, and a frequency distribution. (page 164)

c. calculate and interpret relative frequencies and cumulative relative frequencies,
given a frequency distribution. (page 166)
d. describe the properties of a data set presented as a histogram or a frequency
polygon. (page 168)
e. calculate and interpret measures of central tendency, including the population
mean, sample mean. arithmetic mean, weighted average or mean, geometric
mean, harmonic mean, median, and mode. (page 169)
f. calculate and interpret quarriles, quintiles, deciles, and percentiles. (page 174)
g. calculate and interpret 1) a range and a mean absolute deviation and 2) the
variance and standard deviation of a population and of a sample. (page 175)
h. calculate and interpret the proportion of observations falling within a specified
number of standard deviations of the mean using Chebyshev's inequality.
(page 179)
i, calculate and interpret the coefficient of variation and the Sharpe ratio.
(page 180)
,. explain skewness and the meaning of a positively or negatively skewed return
distribution. (page 182)
k. describe the relative locations of the mean, median. and mode for a unimodal,
nonsymmetrical distribution. (page 183)
1. explain measures of sample skewness and kurtosis. (page 184)
m. compare the use of arithmetic and geometric means when analyzing investment
returns. (page 186)

u.s.

7.

1 - Ethical and Prof ... ionol Standards and Quantitative Methods
RndiDg Assipmenu aDd !Aaming OUlcome SI"lfnlents

02013 K2plan, Inc.


Book I - Elhical and Prof....ionai SCllIdards and Quanli .. tivr Methods
IUadins Auignmonu ""d Uaming OUlromo Slalomonu
S.

Probability Conccpu
The candidate should be able to:
a. define a random variable. an outcome. an event. mutually exclusive events, and
exhaustive events. (page 201)
b. state the two defining properties of probability and distinguish among empirical,
subjective. and a priori probabilities. (page 201)
Co
state the probability of an c:vc:ntin terms of odds for and against the event.
(page 202)
d. distinguish between unconditional and conditional probabilities. (page 203)
e. explain the multiplication. addition. and total probability rules. (page 203)
f. calculare and interpret 1) the joint probability of two events. 2) the probability
that at least one of two events will occur. given the probability of each and the
joint probability of the two events. and 3) a joint probability of any number of
independent events. (page 204)
g. distinguish between dependent and independent events. (page 207)
h. calculate and interpret an unconditional probability wing the tOW probability
rule. (page 20S)
I.
explain the usc of conditional expectation in investment applications. (page 212)
j. explain the usc of a tree diagram to represent an investment problem. (page 212)
k. calculate and interpret covariance and correlation. (page 213)
I. calculate and interpret the expected value. variance. and standard deviation of a

random variable and of returns on a portfolio. (page 217)
m. calculate and interpret covariance given a joint probability function. (page 21S)
n. calculate and interpret an updated probability using Bayes' formula. (page 222)
o. identify the most appropriate method to solve a particular counting problem,
and solve counting problems using factorial, combination, and permutation
concepts. (page 224)

STUDY SESSION 3
9.

Page 10

Common Probability Disuibutions
The candidate should be able to:
a. define a probability distribution and distinguish between discrete and
continuous random variables and their probability functions. (page 245)
b. describe the set of possible outcomes of a specified discrete random variable.
(page 245)
Co
interpret a cumulative distribution function. (page 247)
d. calculate and interpret probabilities for a random variable, given its cumulative
distribution function. (page 247)
e. define a discrete uniform random variable. a Bernoulli random variable. and a
binomial random variable. (page 24S)
f. calculate and interpret probabilities given the discrete uniform and the binomial
distribution functions. (page 24S)
g. construct a binomial tree to describe stock price movement. (page: 251)
h. calculate and interpret tracking error. (page 253)
i. define the continuow uniform distribution and calculate and interpret
probabilities. given a continuous uniform distribution. (page 253)

j. explain the key properties of the normal disuibution. (page 255)
k. distinguish between a univariate and a multivariate distribution. and explain the
role of correlation in the multivariate normal distribution. (page 255)

02013 Kaplan. Inc.


nook 1 - Ethical and Prof ... ion:ol Standards and Quanulllive Methods
ReadiDg AS$ipmeDu and Lurning OUlcome S,a,ONeDu

I.

determine the probability that a normally distributed random variable lies inside
a given interval. (page:256)
m. define the standard normal distribut.ion, explain how to standardize a random
variable, and calculate and interpret probabilities using the standard normal
distribution. (page 258)
n. define shortfall risk, calculate the safety-fint ratio, and select an optimal
portfolio using Roy's safety-fint criterion. (page: 261)
o. explain the relationship between normal and lognormal distributions and why
the lognormal distribution is used to model asset prices. (page 263)
p. distinguish between discretely and continuously compounded rates of return,
and calculate and interpret a continuously compounded rate of return, given a
specific holding period return. (page 264)
q. explain Monte Carlo simulation and describe its major applications and
limitations. (page: 266)
r. compare Monte Carlo simulation and historical simulation. (page 267)
10. Sampling and Estimation
The candidate should be able to:
a. define simple random sampling and a sampling distribution. (page 281)

b. explain sampling error. (page 281)
c. distinguish between simple random and stratified random sampling. (page 282)
d. distinguish between time-series and cross-sectional data. (page 283)
e. explain the central limit theorem and its importance. (page 283)
f. calculate and interpret the standard error of the sample mean. (page 284)
g. identify and describe desirable properties of an estimator. (page 286)
h. distinguish between a point estimate and a confidence interval estimate of a
population parameter. (page: 286)
i. describe properties of Student's r-distribution and calculate and interpret its
degrees of freedom. (page 286)
j. calculate and interpret a confidence interval for a population mean, given a
normal distribution with I) a known population variance, 2) an unknown
population variance, or 3) an unknown variance and a large sample size.
(page 288)
k. describe the issues regarding selection of the appropriate sample size. datamining bias. sample selection bias, survivonhip bias, look-ahead bias. and timeperiod bias. (page 293)
11. Hypothesis Testing
The candidate should be able to:
a. define a hypothesis, describe the steps of hypothesis testing. and describe and
interpret the choice of the null and alternative hypotheses. (page 304)
b. distinguish between one-tailed and two-tailed tests of hypotheses. (page 305)
c. explain a test statistic, Type I and Type II errors, a significance level, and how
signifieance level. are used in hypothesis testing. (page 309)
d. explain a decision rule. the power of a test, and the relation between confidence
intervals and hypothesis tests. (page 311)
e. distinguish between a statistical result and an economically meaningful result.
(page 313)
f. explain and interpret the p-vaIue as it relates to hypothesis testing. (page 314)
g. identify the appropriate test statistic and interpret the results for a hypothesis
test concerning the population mean of both large and small samples when
the population is normally or approximately distributed and the variance is I)

known or 2) unknown. (page 315)
02013 Kaplan. Inc.

Page 11


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

IUadins Assignmenu

IUIdUaming

Outcome Stat.menu

h.

identify the appropriate tot statistic and interpret the results for a hypothesis
test concerning the equality of the population means of two at least
approximately normally distributed populations. based on independent random
samples with 1) equal or 2) unequal assumed variances. (page 318)
i. identify the appropriate tot statistic and interpret the results for a hypothesis
test concerning the mean difference of two normally distributed populations.
(page 322)
j. identify the appropriate tot statistie and interpret the results for a hypothesis
test coneerning 1) the variance of a normally distributed population. and 2) the
equality of the variances of two normally distributed populations based on two
independent random samples. (page 326)
k. distinguish between parametric and nonparametrie tests and describe situations
in which the usc of nonparametric tests may be appropriate. (page 333)
12. Tcchnical Analysis

The candidate should be able to:
a. explain principles of technical analysis. its applications. and its underlying
assumptions. (page 344)
b. describe the construction of different typo of technical analysis charts and
interpret them. (page 345)
Co
explain uses of trend. support. resistance lines. and ehange in polarity.
(page 348)
d. describe common chart patterns. (page 349)
e. describe common tcchnical analysis indicators (price-based. momentum
oscillators. sentiment. and 80w of funds). (page 351)
f. explain how technical analysts usc cycles. (page 356)
g. describe the kcy tenets of Elliott Wave Theory and the importance of Fibonacci
numbers. (page 356)
h. describe intermarket analysis as it relates to technical analysis and asset
allocation. (page 357)

Page 12

02013 Kaplan. Inc.


The foilowiAC II a rnicw of the Ethical and Profcnional Su.ndatdl principle. dalcntd to addresl the
lamiA, outcome .tatemcnu let lorth br CFA Iftllitute. Thit topic i. alto eereeed in:

CFA INSTITUTE CODE OF ETHICS AND
STANDARDS OF PROFESSIONAL CONDUCT
GUIDANCE FOR STANDARDS I-VII
Study Session 1

ExA.'\f Focus
In addition to reading this review of the ethics material. we strongly recommend that
all candidates for the CFAe examination read the StllWrtis ofPrIlEdition (2010) multiple times.1u a Level I CFA candidate. it is your responsibility to
comply with the CoaL IIna Stllwrds. The complete COM IIna StIlWrtis are reprinted in
Volume 1 of the CFA Program Curriculum.

LOS La: Describe the structure of the CFA Institute Professional Conduct
Program and the process for the enforcement of the Code and Standards.
CFAe Progrrzm Curriculum. VolumL 1. P"KL 8
The CFA Institute Professional Conduct Program is covered by the CFA Institute
Bylaws and the Rules of Procedure for Proceedings Related to Professional Conduct. The
Program is based on the principles of fairness of the process to members and candidates
and maintaining the confidentiality of the proceedings. The Disciplinary Review
Committee of the CFA Institute Board of Governors has overall responsibility for the
Professional Conduct Program and enforcement of the Code and Standards.
The CFA Institute Designated Officer. through the Professional Conduct staff, conducts
inquiries related to professional conduct. Several circumstances can prompt such an
inquiry:
1. Self-disclosure by members or candidates on their annual Professional Conduct
Statements of involvement in civil litigation or a criminal investigation, or that the
member or candidate is the subject of a written complaint.

2. Written complaints about a member or candidate's professional conduct that arc
received by the Professicnsl Conduct staff.

3. Evidence of misconduct by a member or candidate that the Professional Conduct
staff received through public sources. such as a media article or broadcast,

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

Once an inquiry has begun, the Professional Conduct staff may request (in writing) an
explanation from the subject member or candidate and may: (1) interview the subject

02013 Kaplan. Inc.

Page 13


Study S... ion 1
Cross- ~fmDce to CFA lrutitute Aui£ned Readings"

&c 2 - Standards ofPnetice Handbook

member or candidate, (2) interview the complainant or other third parries, andlor
(3) collect documents and records relevant to the invatigation.
The Designated Officer may decide: (I) that no disciplinary sanctions are appropriate,
(2) to issue a cautionary Ienet, or (3) to discipline the member or candidate. In a case
where the Designated Officer 6nds a violation has occurred and proposes a disciplinary
sanction. the member or candidate may accept or reject the sancrion. If the member
or candidate chooses to reject the sanction, the matter will be referred to a panel of
CFA Institute members for a hearing. Sanctions imposed may include condemnation
by the member's peel$ or suspension of candidate's continued participation in the CFA
Program.

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

cr-A® l'rDgram Currin.lum.

""fumt 1. P"lt 14

CODE OF ETHICS

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

o

o

o

o
o

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 c1ienu above
their own personal interests.
Usc 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 reRect credit on themselves and the profession.
Promote the integrity of. and uphold the rules governing. capital markeu.
Maintain and improve their professional competence and strive to maintain and
improve the competence of other investment professionals.

THE STANDARDS OF PROFESSIONAL CONDUCT

I:

II:
III:
IV:
V:
VI:
VII:

1.

Professionalism
Integrity ofCapiraJ Markeu
Duties to Clients
Duties to Employers
Investment Analysis. Recommendaricns, and Actions
ConRiets of Inrerese
Responsibilities as a CFA Institute Member or CFA Candidate

Copyriglll 2010. CFA Institute. Reproduced and republished from 'The Code or Ethics,"
from St",,""rrIs DfPrrm;u HttntlbD.lt. lOth EtI.• 2010. with permission from CFA Institute,
All righu reserved.
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Study Seuion 1
Cross·Rd'~mtce to CFA Inaitut~ Auignod Rudings II &: 2 - Sw>dani. of Praetiee Handbook

LOS Lee Explain the ethical responsibilities required by the Code and
Standards, including the sub-sections of each Standard.

STANDARDS OF PROFESSIONAL CONDUCT2

I.

PROFESSIONAUSM
A. Knowledge of the Law. Membcn and Candidates must understand and
comply with all applicable laws, rules, and tegulations (including the CFA
Institute COM ofEthies and Standards ofProftssio1l41 um"uct) of any
government, regulatory organization, licensing agency, or professional
association governing their professional activities. In the c:vcnt of conflict,
Members and Candidates must comply with the more strict law, rule, or
regulation. Members and Candidates must not knowingly participate or assist
in a.ny violation of laws, rules, or regulations and must disassociate themselves
from any such violation.
B. Independence and Objc:ctivity. Members and Candidates must use reasonable
care and judgment to achieve and maintain independence and objectiviry in
their prof'cssional activities. Members and Candidates must not offer, solicit, or
accept any gift, benefit, compensation, or consideration that reasonably could
be expected to compromise their own or anothers independence and
objc:ctiviry.
C. Misrepresenution.
Member. and Candidates must not knowingly make any
misrepresentations relating to investment analysis, recommendations, actions,
or other professional activities.
D. Misconduct. Members and Candidates mull not engage in any professional
conduct involving dishonesry, fraud, or deceit or commit any act th:u reflects

adversely on their professional reputation, integrity, or competence.

II.

INTEGRITY

OF CAPITAL MARKETS

A. Material Nonpublic Information. Members and Candidates who possess
material nonpublie information that could affcct the value of an investment
must not act or cause others to act on the information.

B. Market Manipulation.

Members and Candidates must not engage in practices
that distort prices or artificially inflate trading volume with the intent to
mislead market participants.

III.

DUTIES TO CLIENTS
A. Loyalry, Prudence, and Can:. Members and Candidates have a duty of loyalty
to their clients and must act with reasonable care and exercise prudent
judgment. Members and Candidates must act for the benefit of their clients
and place their clients' interests before their employer's or their own interests.

2.

Ibid.
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Study St.';"n I
Cro, s- lUrereDC>eto CFA Instiltlle AssiGned Readings '1 &c 2 - Standards or p",c:tice Handbook
B. Fair Dealing. Members and Candidates must deal fairly and objectively with
all clients when providing investment analysis, malcing investment
rceommendations, taking investment action, or engaging in other professional
activities.

C. Suitability.
1. When Members and Candidatcs arc in an advisory relationship with a
client, they must:
a. Make a reasonable inquiry into a client's or prospective clients'
investment experience, risk and rerum objectives, and financial
constraints prior to making any investment recommendation or talcing
investment action and must reassess and update this information
regularly.
b. Determine that an investment is suitable to the client's financial
situation and consistent with the client's wrinen objectives, mandates,
and constraints before making an investment recommendation or
taking investment action.
c. Judge the suitability of investments in the context of the client's total
ponfolio.
2. When Members and Candidates arc responsible for managing a portfolio to
a specific mandate. strategy, or sryle, they must make only investment
recommendations or take investment actions that are consistent with the
stated objeedves and constraints of the portfolio.
D. Performance Presentation. When communicating investment performance

information, Members or Candidates must make reasonable drons to ensure
that it is fair, accurate, and complete.
E. Preservation of Confidentiality. Members and Candidates must keep
information about current, former, and prospective clients confidential unless:
1. The information concerns illegal activities on the part of the client or
prospective client,
2. Disclosure is required by law, or
3. The client or prospective client permits disclosure of the information.

rv

DUTIES TO EMPWYEaS
A. Loyalty. In matters related to their employment. Members and Candidates
must 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 cause harm to their employer.
B. Additional Compensation Arrangements. Members and Candidates must not
accept gifts. benefits, compensation, or consideration that competes with. or

i>age16

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Study Session I
Ctoss-~f~rence

10 CFA Inaitutt

Assigntd IUadings II &: 2 - Sw>danis of Practice Handbook

might teasonably be expected to create a conBict of intereat with. their
employ.,,'s interest unless they obtain written consent from all parties involved.
C. Responaibilities of Supervisors. Members and Candidates must make
reasonable drom to detect and ptt"VCntviolations of applicable laws. rules.
regulations. and the Code and Standards by anyone subject to their supervision
or authority.
V.

INVESTMENT ANALYSIS. RECOMMENDATIONS, AND ACTIONS
A. Diligen ee and Reasonable Basis. Members and Candidates must:
1. Exercise diligen ce, independence. and thoroughness in analyzing
investments, making investment recommendations. and taking investment
actions.
2. Have a reasonable and adequate basis. supported by appropriate research
and investigation. for any invcsunent analysis, recommendation. or action.
B. Communication with Clients and Prospective Clients. Members and
Candidates must:
1. Disclose to clients and prospective clients the basic format and gener.tl

principles of the investm"nt proc""cs used to analyz" invt"Stm"nts. selec t
securiti es, and construct portfolios and must promptly disclosc any changes
that might materially afl'= those processes,
2. Usc reasonable judgment in id"ntifying whim factors are important to their
investment analyses. recommendations. or actions and include those f.actors
in communications with c1i"nts and prospective clients.
3. Distinguish between f.act and opinion in the presentation of investment
analysis and recommendations.
C. Record Retention. Members and Candidates must develop and maintain
appropriate records to suppon their invesunent analysis. recommendations,

actions. and other investment-related communications with clients and
prospective

VI.

clients,

CONFLICTS OF INTEREST
A. Disclosure of ConBicts. Members and Candidates musr make full and f.air
disclosure of all matters that could reasonably be cxpeeted to impair rheir
Independence and objectivity or interfere with respective duties to their clients.
prosp ec rive clients, and employer, Members and Candidates must ensure that
such disclosures are promin"nt. are delivered in plain language. and
communicate the relevant information dfeetively.
B. Priority ofTransactions.lnvcstment
transactions for c1i"nts and employers
must have priority over investmenr transactions in whim a Memb"r or
Candidate is the b"n,,6cial owner.

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StudyS.""'n
I
Cross-lU(ereDC>eto CFA lrutiwte Assigned Readings'l

&c 2 - Standards o(P",c:tice Handbook

C. Refaral Fees. Members and Candidates must disclose to their employer.
clients. and prospective eliene. as appropriate. any compensation.
consideration. or benefit received from. or paid to. others for the
recommendation of products or services.
VII.

RESPONSIBILITIES
CANDIDATE

AS A CFA INSTITUTE

MEMBER OR CFA

A. Conduct a.s Members and Candidates in the CFA Program. Members and
Candidates mwt not engage in any conduct that compromises the reputation
or integrity of CFA Institute or the CFA designation or the integrity. validity.
or security of the CFA examinations.
B. Reference to CFA Institute. the CFA Designation. and the CFA Program.
When referring to CFA Institute. CFA Institute membership. the CFA
designation. or candidacy in the CFA Program. Members and Candidates must
not misrepresent or CFA Institute. holding the CFA designation. or candidacy in the CFA
Program.

LOS 2.a: Demonstrate the application of the Code of Ethics and Standards of
Professional Conduct to situations involving issues of professional integrity.
LOS 2.b: Distinguish between conduct that conforms to the Code and
Standuds and conduct that violates the Code and Standards.
LOS 2.c: Recommend practices and procedures designed to prevent violations
of the Code of Ethics and Standards of Professional Conduct.

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

19

Profasionalism

I(A)
Knowle.
of the Law. Members and Candidatcs must undcmand and
comply with all applicable laws. rules. and regulations (including the CFA Institute
Code of Ethics and Standards of Profasional Conduct) of any government, regulatory
organization. licensing agency. or professional a.ssociation governing their prokssional
activities. In the event of conRia. Members and Candidates must comply with the
more strict law. rule. or regulation. Members and Candidates must not knowingly
panicipaa: or assist in and must diuociate (rom any violation of such laws. rules. or
regulations.

~
~

Page 18

Profnso,j Nst«: Whik w. us. th. term "mtmbtn" in tht following. not« that all
oftht Stanu,J, apply to canJitltttn 41 wtlL

02013 Kaplan. Inc.

c.o.s·~f~rence

G..;a,mc_Cotle

Study Session 1
to CFA Institutt AIIigntd Rudings II &: 2 - Sw>dani. of Practice Handbook

Anti StAntlArtis lIS. LDcAILalli

Members must know the laws and regulations relating to their professional activities in
aU countries in which they conduct business, Members must comply with applicable
laws and regulations relating to their professional activity. Do not violate Code or
Standards even if the activity is otherwise legal. Always adhere to the most strict rules
and requirements (law or CFA Institute Standards) that apply.

GviaAnc_PArticipA,ion

or AssociAtion Wi,h Violations

by Othen

Members should dissociate. or separate themselves. from any ongoing client or employee
aaivity that is ilkgal or unethical. even if it involves leaving an employer (an extreme
case). While a member may confront the involved individual first. he must approach
his supervisor or compliance department. Inaaion with continued association may be
construed as knowing participation.

Ruommentletl ProeeJlU'u for CompliAnc_MemHrs
•

•
•
•
•
•

•

Members should have procedures to keep up with changes in applicable laws. rules.
and regulations.
Compliance procedures should be reviewed on an ongoing basis to assure that they
address current law. CFAI Standards. and regulations.
Members should maintain current reference materials for employees to access in
order to keep up to date on laws. rules. and regulations.
Members should seck advice of counsel or their compliance department when in
doubt.
Members should document any violations when they disassociate themselves from
prohibited activity and encourage their employers to bring an end to such activity.
There is no requirement under the Standards to report violations to governmental
authorities. but this may be advisable in some circumstances and required by law in
others.
Members are strongly encouraged to report other members' violations of the Code
and Standards.

Recomme"Jetl ProeetllU'esfor CompliAnc_Firms
Members should encourage their firms to:
•
•
•

Develop andlor adopt a code of ethics.
Make available to employees information that highlights applicable laws and
regulations.
Establish written procedures for reporting suspected violation of laws. regulations. or
company policies.

Members who supervise the creation and maintenance of investment services and
produas should be aware of and comply with the regulations and laws regarding such
services and produas both in their country of origin and the countries where they wiU
be sold.

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PaS" 19


Study St""'n I
Cross-lUfereDC>eto CFA lrutitute Aui£ntd lUadings'l

Applic.tilln

"lSUI"".,d

&c 2 - Standards ofP",ctla:

Handbook

I(A) Knl1",/~dg~IIIth~ LIIu?

Example I:

Michael Allen works for a brokerage firm and is responsible for an underwriting of
securities. A company official gives Allen information indicating that the financial
statements Allen filed with the regulator overstate the issuer's carnings. Allen seeks the
advice of the brokerage firm's general counsel, who states that it would be difficult for
the regulator to provc that Allen has been involved in any wrongdoing.
Comment:
Although it is recommended that members and candidates seck the advice of legal
counsel, the reliance on such advice does nor absolve a member or candidate from the
requirement to comply wilh the law or regulation. Allen should cepon this siruation to
his supervisor, seck an independent legal opinion, and determine whether the regulator
should be nerified of the error.
Example 2:
Kamisha Washington's firm advcnis es ils pasl performance record by showing the 10year rerurn of a eomposiee of its client accounts. However, Washington discovers that the
composite omits Ihe performance of accounts that havc lefl the firm during the 10-year
period and that this omission has led ro an inRaled performance figure. Washington
is asked ro we promotional material that includes the erroneous performance number
when soliciting bwiness for the firm.
Comment:
Misreprcsenring performance is a violation of the Code and Standards. Although she did
not calculate the performance herself, Washington would be assisting in violating this
standard if she were to UJe the inRated performance number when soliciting clients. Shc
must dissociate hcrself from the activity. She can bring the misleading number to the
attention of the person responsible for calculating performance, her supervisor, or the
compliance department at her firm. If her firm is unwilling to recalculate performance,
she must refrain from using the misleading promotional material and should notify
the firm of her reasons. If the firm insists that she usc the material. she should consider
whether her obligation to dissociate from the activity would require her to seck other
employment.
Example 3:
An employee of an investment bank is working on an underwriting and finds out the

issuer has altered their financial statements to hide operating losses in one division.
These missrated dara are included in a preliminaty prospecrus that has already been
released.
Comment:
The employee should report the problem to his supervisors. If the firm doesn't get the
misstatement fixed. the employee should dissociate from the underwriting and. further.
seek legal advice about whether he should undercake additional reponing or other
actions.

3.
Page 20

Ibid.
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ero..·~f~rence

to CFA ID.ututt Auignod Rudingt

Study SessioD I
II &: 2 - Sw>dani. of Practice Handbook

Example 4:
Laura Jameson, a U.S. citizen, works for an investment advisor based in the United
States and works in a country where investment managers are prohibited from
panicipating in IPOs for their own accounts.
Comment:
Jameson must comply with the srrietest requirements among U.S. law (where her firm
is based), the CfA Institute Code and Standards, and the laws of the country where she

is doing business. In this case that means she must not panicipate in any IPOs for her
personal account.
Example 5:
A junior porrfolio manager susp«ts that a broker responsible for new business from
a foreign country is being allocated a portion of the firm's payments for third-party
research and suspeas that no research is being provided. He believes that the research
payments may be inappropriate and unethical.
Comment:
He should foUow his firm's procedures for reporting possible unethical behavior and try
to get better disclosure of the nature of these payments and any research that is being
provided.
I(B)
IndcpeDcImcc aad Objectivity. Members and CandidalCl mUll UJC reuonable
care aad judgment to achieve aad mainaain independence aad objectivity in their
professional activities. Members and Candidates must not ofli:r. solicit, or accept any
gift, beneSt. compensation. or consideration that reasonably could be espeeeed to
compromisc their own or another's independence and objc:aivity.

G"iJllnee
Do not let the investment process be in8uenced by any external sources. Modest gifts
are permitted. Allocation of shares in oversubscribed IPOs to personal accounts is
NOT permitted. Distinguish between gifts from clients and gifts from entities seeking
in8uence to the detriment of the client. Gifts must be disclosed to the member's
employer in any case, either prior to acceptance if possible, or subsequently

G"iunce-Inlllltmmt

Bllnlrinl /ullltiQnshipl

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

prospective investment-banking clients. It is appropriate to have analysts work with
investment bankers in "road shows· only when the con8ias are adequately and
effectively managed and disclosed. Be sure there are effective "firewalls· between
research/investment management and investment banking activities.

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PaS" 21


Study SHsion I
ero,.. lUfereDceto CFA lrutitute Auiptd

lUadings'l

Gllithnc_PMbfic

&c 2 - Standa.rdsof PRetia. Handbook

(Amp""i"

Analpts should not be pressured to issue favorable research by the companies they
follow. Do not confine research to discussions with company management, but rather
usc a variety of sources, including suppliers, customers, and competitors.

Gllithnc_Buy-SiJe

C/U",.

Buy-side clients may try to pressure sell-side analysts. Portfolio managers may have large

positions in a particular security, and a tating downgrade may have an effect on the
portfolio performance. Iu a portfolio manager, there is a responsibility to respecr and
foster intellectual honesry of sell-side research.

Guithnc_Fllntl

Mllnllger /Ufilliomhips

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

Gllithnc-Crrtlit

RIlling Agencin

Members employed by credit rating firms should make sure that procedures prevent
undue inlluencc: by the firm issuing the securities. Members who usc credit ratings
should be aware of this potential conllict of interest and consider whether independent
analysis i. warranted.

Guithnc_lsslln'-P"iJ

Reltllrt:h

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

Gllithnc_Trlll1d
Best practice is for analysts to pay for their own commercial travel when attending

information events or tours sponsored by the firm being analyzed.

/UcommenMtl Proudllrn for (Ampfumee
•
•
•

•

•
•

Page 22

Protect the integrity of opinions-make
sure they are unbiased.
Create a restricted list and distribute only factual information about companies on
the lisr.
Restrict special cost arrangements-pay
for one's own commercial transportation
and hotel; limit usc of corporate aircraft to cases in which commercial transportation
is not available.
Limit gifts-token
items only. Customary, business-related entertainment is okay
as long as its purpose is not to inlluence a member's professional independence or
objectivity. Firms should impose clear value limits on gifts.
Restrict employee investments in equity IPOs and private placements, Require preapproval of IPO purchases.
Review procedures-have
effective supervisory and review procedures.

02013 Kaplan, Inc.


Ctoss·~f~rence
•
•

Study Session 1
to CFA InAitutt Assigntd Rndings II &: 2 - Sw>danis of Practice Handbook

Firms should have formal written policies on independence and objectivity of
research.
Firms should appoint a compliance officer and provide clear procedures for
employee reporting of unethical behavior and violations of applicable regulations.

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

1:

Steven Taylor, a mining analyst with Bronson Brokers, is invited by Precision Metals to
join a group of his peers in a tour of mining facUities in several western U.S. states. The
company arranges for chartered group Rights from site to site and for accommodations
in Spartan Motels, the only chain with accommodations near the mines, for three nights.
Taylor allows Precision Metals to pick up his tab, as do the other analysts. with one
exception-John
Adams. an employee of a large trust company who insists on foUowing
his company's policy and paying for his hotd room himself.
Comment:
The policy of the company where Adams works complies closely with Standard I(B) by

avoiding even the appearance of a conAict of interest, but Taylor and the other analysts
wen: not necessarily violating Standard I(B). In general, when allowing companies to pay
for travel and/or accommodations under these circumstances, members and candidates
must use their judgment. keeping in mind that such arrangements must not impinge
on a member or candidate's independence and objectivity. In this example, the trip was
strictly for business and Taylor was not accepting irrelevant or lavish hospitality. The
itinerary required chartered Rights, for which analysts were not expected to pay. The
accommodations were modest. These arrangements are not unusual and did not violate
Standard I(B) so long as Taylor's independence and objectivity were not compromised.
In the final analysis. members and candidates should consider both whether thcy can
remain objective and whether their integrity might be perceived by their clienrs to have
been compromised.
&le

2:

Walter Fritz is an equity analyst with Hilton Brokerage who covers the mining industty.
He has concluded that the stock of Metals & Mining is overpriced at its current level.
but he is concerned that a negative research report will hurt the good relationship
between Metals & Mining and the investment-banking division of his firm. In faCt. a
senior manager of Hilton Brokerage has just sent him a copy of a proposal his firm has
made to Metals & Mining to underwrite a debt offering. Fritz needs to produce a report
right away and is concerned about iSluing a less-than-favorable rating.
Comment:
Fritz's analysis of Metals & Mining must be objective and based solely on consideration
of company fundamentals. Any pressure from other divisions of his firm is inappropriate.
This conRict could have been eliminated if, in anticipation of the offering, Hilton
Brokerage had placed Metals & Mining on a restricted list for its sales force.
Example 3:
Tom Wayne is the investment manager of the Franklin City Employees Pension Plan.

He recently completed a successful search for firms to manage the foreign equity
allocation of the pian's diversified portfolio. He followed the pian's standard procedure

02013 Kapbn. Inc.