2017 smart summary, study session 1, reading

2017 Study Session # 1, Reading # 1

“CODE OF ETHICS AND STANDARDS
OF PROFESSIONAL CONDUCT”
M&C = Members & Candidates
COE = Code of Ethics
SOPC = Standards of
Professional conduct
BOG=Board of Governors
PDP=Professional Development
Program

Los1.a

CFAI PCP ⇒ covered by CFAI Bylaws & Rules for Procedures Related to
Professional Conduct.
PCP is based on principles of fairness to M&C& confidentiality of
proceedings.
DRC of CFAI BOG ⇒ responsible for PCP & enforcement of code & standards.

CFAI = CFA Institute
PCP = Professional Conduct
Program
DRC = Disciplinary Review
Committee
PCS = Professional Conduct
Statement

Circumstances Which Can Prompt Inquiry
Self disclosure by member/candidate on PCS which
comprehensively questions professional conduct such as

involvement in civil litigation, criminal investigation or any complaint
(written) against the member/candidate etc.
Written complaints about member/candidate received by professional
conduct staff.
Evidence of misconduct by member/candidate received by professional
conduct staff through public source.
A report by CFA proctor of a possible violation during examinations.
CFAI designated officer conducts inquiries.
Professional conduct staff (in writing) may request explanation from subject
member/candidate & may:
Interview the subject member/candidate.
Interview the complainant / third party.
Collect relevant documents& records.
Designated officer may decide:
That disciplinary sanctions are not required.
To issue a cautionary letter.
To discipline the member/candidate.
If disciplinary sanction is proposed, the subject member/candidate may
accept the sanction.
If sanction is rejected ⇒ matter may be referred to CFAI panel for hearing.
Sanctions may include.
Condemnation by member’s peers.
Suspension of candidate’s continued participation in CFAI program.

Los1.b
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.

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2017 Study Session # 1, Reading # 1
Standards of Professional Conduct

1. Professionalism

2. Integrity of Capital Markets

3. Duties to Clients

6. Conflicts of Interest

Los1.c

4. Duties to Employers

5. Investment Analysis,
Recommendations& Actions

7. Responsibilities as a CFAI Member or CFAI Candidate

1. Professionalism

A. Knowledge of Law

B. Independence & Objectivity

C. Misrepresentation

D. Misconduct

2. Integrity of Capital Markets

A. Material Non-Public Information

B. Market Manipulation

3. Duties to Clients

A. Loyalty,
Prudence, and Care

B. Fair Dealing

C. Suitability

D. Performance
Presentation

E. Preservation of
Confidentiality

4. Duties to Employers

B. Additional Compensation
Arrangements

A. Loyalty

C. Responsibility of
Supervisors

5. Investment Analysis, Recommendations& Actions

A. Diligence & Reasonable
Basis

B. Communication with
Clients & prospective
Clients

C. Record Retention

6. Conflicts of Interest

A. Disclosure of conflicts

B. Priority of Transactions

C. Referral Fees

7. Responsibilities as a CFAI Member or CFAI Candidate

A. Conduct as Members and Candidates in
the CFA Program

B. Reference to CFA Institute, the CFA
Designation, and the CFA Program

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2017, Study Session # 1, Reading # 2
M&C = Members &
Candidates
COE = Code of Ethics
SOPC = Standards of
Professional conduct
BOG=Board of
Governors
PDP=Professional
Development
Program

“GUIDANCE FOR STANDARDS I-VII”
1. Professionalism
1 A. Knowledge of Law
M&C must understand & comply with all applicable laws, rules& regulations (including COE & SOPC).
These rules & regulations pertain to any govt, regulatory organization, licensing agency or
professional association governing their professional activities.
Must comply with more strict law in case of conflict.
M&C must not knowingly participate or assist & must dissociate from any violation of laws.

Guidance ⇒ Code & Standards VS Local Law
Members must know laws & regulations related to their professional activity in all countries where
they conduct business.
Adhere to more strict rule while deciding b/w local laws & Codes & Standards of CFAI.
Must comply with local laws related to professional activity.
Never violate Codes & Standards even if activity is otherwise legal.

Guidance ⇒ Participation in or Association with Violation by Others
Members must dissociate or separate themselves from any ongoing client or employee activity
which is illegal or unethical.
In extreme case they may have to leave the employer.
May, at first, confront the individual involved.
Approach supervisor or compliance department.
Inaction with continued association may be construed as knowing participation.

Recommended Procedures for Compliance-Members
Members must keep themselves updated with applicable laws, rules & regulations.
Compliance laws must be reviewed on an ongoing basis in order to ensure that they address
prevailing laws, CFAI standards & regulations.
Members should maintain current reference material for employees in order to keep them up-todate on laws, rules & regulations.
In doubt, members should seek advice of counsel or their compliance department.
Members must document any violation when they disassociate from any prohibited activity.
Members must encourage their employers to end such activity.
Under some circumstances, it may be advisable or otherwise required by the law to report violations
to governmental authorities.
Standards (CFAI) do not require members to report violations to governmental authorities.
CFAI encourages members, clients & public to submit written report against a CFA member or
candidate involved in violation of the CFA Code & Standards

Recommended Procedure for Compliance-Firms
Members should encourage their firms to:
Develop and/or adopt a code of ethics.
Highlight applicable laws and regulations to employees.
Establish written procedures for reporting suspected violation of laws, regulations or company
policies.
Members incharge of supervision, creation and maintenance of investment services should:
Be aware of and comply with regulations and laws in their country of origin.
They must be aware of and comply with regulations of countries where products/services will
be sold.

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CFAI = CFA Institute
PCP = Professional
Conduct Program
DRC = Disciplinary
Review Committee
PCS = Professional
Conduct Statement


2017, Study Session # 1, Reading # 2
1 B. Independence & Objectivity
M&C must use reasonable care & judgment to achieve & maintain independence &
objectivity in professional activities.
Do not accept any gift, or any type of consideration that may compromise their own or
another’s independence & objectivity.

Guidance

Investment process must not be influenced by any external sources.
Modest gifts by clients are permitted.
Allocation of shares in oversubscribed IPO to personal accounts is not permitted.
Distinguish b/w gifts from clients & entities seeking influence to the detriment of the client.
Gifts must be disclosed to the member’s employer either prior to acceptance or
subsequently.

Guidance-Investment Banking Relationships
Do not get pressurized from sell-side analyst to issue favorable research on current or
prospective investment-banking client.
Disclose conflicts and manage these appropriately while working with investment bankers
in “road shows”.
Ensure effective “firewalls” b/w research/investment management & investment banking
activities.

Guidance-Public Companies
Do not limit research to discussions with company management.
Use sources like:
Suppliers
Customers
Competitors
Analyst must not be pressured to issue favorable research by the companies they follow.

Guidance-Buy Side Clients
Responsibility of portfolio managers to respect and foster intellectual honesty of sell side
research.
Portfolio managers must not pressurize sell side analysts.
They may have large positions in particular securities. Rating downgrade may
adversely affect portfolio performance.
Guidance-Fund Manager Relationships

Members responsible for selecting outside managers should not accept gifts,
entertainment or travel that might be perceived to impair member’s independence and/or
objectivity.
Guidance-Credit Rating Agency
Members employed by credit rating agencies make sure they prevent undue influence by
security issuing firms.
Members using credit ratings must be aware of potential conflicts of interest& therefore
may consider independent validation of the rating granted.

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2017, Study Session # 1, Reading # 2
Guidance-Issuer Paid Research
Analyst’s compensation for such researches should be limited.
Preference is flat fee.
No reward must be attached with report’s recommendation.

Guidance-Travel
Best practice ⇒ analysts pay their own commercial travel while attending
information events or tours sponsored by the firm being analyzed.

Recommended Procedures for Compliance
Protect the integrity of opinions (unbiased opinion of the analyst) & design proper compensation systems.
Create a restricted list (remove the controversial company from research universe).
Restrict special cost arrangements (limit the use of corporate aircraft to situations in which commercial
transportation is not available).
M&C should pay for commercial transportations & hotel charges.
Limit the acceptance of gratuities and/or gifts to token items only.
Develop formal policies related to employee purchases of equity or equity related IPOs (strict limits on private

placements).
Effective supervisory & review procedures.
Ensure that research analysts are not supervised or controlled by any department that could compromise the
independence of analyst.
Appoint a senior officer with oversight responsibilities for compliance with firm’s COE & all regulations
concerning its business.

1 C. Misrepresentation
M&C must not knowingly make any misrepresentations relating to investment
analysis, recommendation, actions or other professional activities.

Guidance
Misrepresentation causes mistrust.
Do not give false impressions in oral, written& electronic communication.
Misrepresentation includes.
Guaranteeing investment performance.
Plagiarism.
Plagiarism ⇒ using someone else’s work without giving him credit.
Misrepresentation also includes deliberately omitting information that could
affect investment decision.
Models and analysis developed by others at firm are the property of firmmembers can use them without attributing to developers.
A report written by another analyst employed by the firm cannot be released as
another analyst’s work.

Recommended Procedure for Compliance
Firms should provide employees who deal with clients a written list of firm’s
available services and its qualifications.
Employee qualification should be accurately presented as well.
To avoid plagiarism, firm must keep record of all sources and cite them.
Generally understandable and factual information need not to be cited.

Members should encourage firms to establish procedures for verifying
marketing claims of third parties whose information the firm provides to
clients.

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2017, Study Session # 1, Reading # 2
1 D. Misconduct
M&C must not involve in dishonesty, fraud, deceit or commit any act that reflects adversely on
their professional reputations, integrity or competence.

Guidance
CFAI discourages unethical behavior in all aspects of members’ and candidates’ lives.
Do not abuse CFAI PCP by seeking enforcement of this standard to settle personal, political or
other disputes not related to professional ethics.

Recommended Procedures for Compliance
Firms are encouraged to adopt these policies and procedures to:
Develop and adopt a code of ethics and make clear that unethical behavior will not be tolerated.
Give employees a list of potential violations and sanctions including dismissal.
Check references of potential employees.

2. INTEGRITY OF CAPITAL MARKETS
2 A. Material Non-Public Information
M&C must not act or cause others to act on the
information that is material nonpublic (affect the value of
investments).
Guidance
Material information ⇒ if disclosure would impact price of security.

If reasonable investor would want the information before making an investment
decision.
Nonpublic information ⇒ non-available to the marketplace.
Analyst conference call is not public disclosure.
Selective disclosure causes insider trading.
Prohibition against acting on material non public information extends to securities,
swaps, and option contracts.
Guidance-Mosaic Theory
No prohibition on reaching an investment decision through public and non-material
nonpublic information.

Recommended Procedures for Compliance
Make reasonable efforts to achieve public dissemination of information.
Encourage firms to adopt procedures to prevent misuse of material nonpublic information.
Use a “firewall” within the firm with
Substantial control of relevant interdepartmental communication  through a clearance
like compliance/legal department.
Review employee trades maintain watch, rumor, and restricted lists.
Monitor & prohibit proprietary trading-if a firm is in possession of material non-public
information.
Prohibiting all proprietary trading may send a signal to the market firm should take the contra
side of only unsolicited customers trade.

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2017, Study Session # 1, Reading # 2
2B. MARKET MANIPULATIONS
M&C must not engage in practices that mislead
market participants (distort prices or artificially

inflate trading volume).
Guidance
Spreading false rumors is prohibited (which can distort market).
Standard applies to transactions that deceive market.
By distorting the price-setting mechanism of financial investments.
Securing a controlling position to manipulate the price of a related derivative or
the asset.

3. DUTIES TO CLIENTS

3 A. Loyalty, Prudence & Care
M&C:
Have a duty of loyalty to clients & must act with reasonable care & exercise prudent judgment.
Must act for the benefits of clients & place clients’ interests above employers’ or their own interests.

Guidance
M&C must exercise same level of prudence, judgment & care as in management & disposition of their own interests in similar
circumstances.
M&C should manage pool of assets in accordance with the terms of governing documents (e.g. trust documents).
Determine the identity of “client’” to whom duty of loyalty is owed. (May be an individual or plan beneficiaries in case of
pension plan or trust).
M&C must follow any guidelines set by their clients for the management of their assets.
Investment decisions are judged in the context of total portfolio rather than individual investments.
Conflict arises when “soft dollars” are not used for the benefit of clients.
Cost-benefit analysis may show that voting all proxies may not a beneficial strategy for clients.

Recommended Procedures of Compliance

M&C with control of client assets should submit to each client, at least quarterly, a statement showing funds & securities.
In doubt, M&C should disclose the questionable matter in writing to client & obtain client approval.

M&C should address & encourage their firms to address the following regarding duties to client;
Follow all applicable rules & laws.
Establish the investment objectives of the clients.
Consider all the information when taking actions.
Diversify investments to reduce risk of loss.
Carry out regular reviews.
Deal fairly with all clients with respect to investment actions.
Disclose conflict of interest & compensation arrangements.
Maintain confidentiality & seek best execution.

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2017, Study Session # 1, Reading # 2
3B. Fair Dealing
M&C must deal fairly & objectively with clients (when providing investment analysis,
making recommendations, taking action or engaging in other professional activities).

Guidance

No discrimination among clients while disseminating recommendations or taking investment decision.
Fairly does not mean equally ⇒ difference in timings of emails & fax received by clients are normal
course of business.
Different services levels are okay as far as they do not adversely affect any client.
Disclose different levels of services to all clients and prospects.
Premium services should be available to all those who are willing to pay for them.

Guidance-Investment Recommendation

All clients must be given fair opportunity to act upon every recommendation.

Clients unaware of the change in recommendation  should be advised before the order is
accepted.
Guidance-Investment Actions

Clients must be treated fairly in the light of their investment objectives and circumstances.
Both institutional and individual clients must be treated in a fair & impartial manner.
Member/candidates should not take advantage of their position to disadvantage clients
(e.g., in IPOs).

Recommended Procedures for Compliance

Firms are encouraged to establish compliance procedures to treat customers & clients fairly.
Communicate recommendations simultaneously within the firm & to customers.
M&C should consider the following:
Limit the no. of people who are aware that a recommendation is going to be disseminated.
Shorten the time frame b/w decision & dissemination.
Publish guidelines for pre-dissemination behavior.
Simultaneous dissemination (treat all clients fairly).
Maintain a list of clients & their holdings.
Develop & document trade allocation procedures.
Disclose trade allocation procedures (must be fair & equitable).
Establish systematic account review (no preferential treatment to any client or customer).
Disclose level of services (different levels of services are possible for same or different fees).

3 C. SUITABILITY

2. M&C are in advisory relationship

Make inquiry into
client’s investment

experience, risk &
return objectives,
financial
constraints &
reassess & update
this information
regularly.

Determine
investment’s
suitability with
reference to
client’s objective &
constraints &
mandate.

Judge the
investment
suitability in the
context of client’s
total portfolio.

1. When M&C are responsible for a portfolio
with a specific mandate, strategy or style,
they must take actions according to the
objectives & constraints of the portfolio.

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2017, Study Session # 1, Reading # 2

Guidance
Develop IPS at beginning of the relationship.
Consider client’s needs, circumstances & risk tolerance.
Consider whether use of leverage is suitable for the client or not.
Make sure to abide by the stated mandate.

Recommended Procedures for Compliance
Develop written IPS of each client & take the following into consideration:
Client identification.
Investor objectives.
Investor constraints.
Performance measurement benchmark
Objectives & constraints should be maintained & reviewed periodically to reflect any changes in
clients’ circumstances.
Suitability test policies.

3 D. Performance Presentations

M&C must communicate fair, accurate & complete investment performance information.

Guidance
Members must avoid misstating performance or misleading clients about investment performance
of themselves or their firms.
Members should not misrepresent past performance or reasonably expected performance.
Members should not state or imply the ability to achieve a rate similar to that achieved in the past.
Indicate if presentation has offered limited information.
Brief presentations should be supplemented with information that detailed report is available on
request.

Recommended Procedures for Compliance

Apply GIPS standards.
Consider the knowledge of audience to whom performance presentation is addressed.
Performance of composite rather than single account.
Include performance history of terminated accounts.
Disclosures that fully explain the performance results should be reported.
Maintain data & record used to calculate the performance being presented.

3 E. Preservation of Confidentiality
M&C must keep information about current, former &
prospective clients confidential unless:
Information concerns illegal activity.
Disclosure is required by law.
Client or prospective client permits disclosure.

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2017, Study Session # 1, Reading # 2

Guidance

If a client is involved in illegal activitiesmembers may have an obligation
to report to the authorities.
This standard extends to former clients as well.
Standards do not prevent members from cooperating with CFA PCP
investigation.

Recommended Procedures for Compliance

Avoid disclosing information received from client except to the authorized
colleagues working for the same client.
Follow firm’s procedures for storing electronic data.
Recommend adoption of such procedures if they are not in place.

4. Duties to Employers

A. Loyalty
M&C:
Must act for the benefit of their employer.
Not deprive employer of the advantage of their skills &abilities, divulge confidential
information or otherwise cause harm to their employer.

Guidance

Do not indulge in the activities that may injure the firm deprive it of profit or
advantage of employee’s abilities & skills.
Though clients’ interests have priority than firm’s interests but consider the effects
of actions on the firm’s integrity and sustainability.
A careful balance b/w managing interests of employer & family manage such
obligations with work obligations.

Guidance-Employer Responsibility
Should not have incentive or compensation system that encourages unethical
behavior.
Members are encouraged to give their employers a copy of Code & Standards.

Guidance-Independent Practice
Independent practice for compensation is allowed.
Provide employer notification fully describing all aspects of service.

Compensation details
Duration
Nature of activities
Employer’s consent is required.

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2017, Study Session # 1, Reading # 2

Guidance-Leaving an Employer
Continue to act in employer’s best interest until resignation is effective.
Activities that may constitute a violation include:
Misappropriation of trade secrets
Misuse of confidential information
Soliciting employer’s client prior to leaving
Self-dealing
Misappropriation of client lists.
Employer records on home computers, PDA, cell phones or any other medium
are property of firm.
After leaving the organization, simple knowledge of names and existence of
former clients is not confidential.
Member/candidate can use the experience or knowledge gained with former
employer at any other organization.

Guidance Whistle-blowing
In exceptional cases, duty to the employer may be violated in order to protect
a client for upholding the integrity of capital markets.
Whistle- blowing cannot be done for personal gains.

Guidance-Nature of Employment

If members/candidates are independent contractors, they still have duty to abide
by the terms of the agreement.

Recommended Procedures for compliance

Competition policy (employer restrictions on offering similar services outside
the firm).
Termination policy (how termination is disclosed to clients & staff).
Incident-reporting procedures.
Employee classification (e.g. full time, part time).

4 B. Additional Compensation Arrangements

M&C must not accept 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 parties involved.

Guidance
Compensation includes both direct & indirect form.
Additional benefits are also included.
Written consent from employer also includes email communication.

Recommended Procedures for Compliance
Immediately report to employer in written format detailing any
proposed compensation and services.
Performance incentives should be verified by the offering party.

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2017, Study Session # 1, Reading # 2

4 C. Responsibility of Supervisors

M&C must make efforts to detect & prevent violations of applicable
laws, rules & regulations and Code & Standards by any one subject to
their supervision or authority.
Guidance
Members must take steps to prevent subordinates from violating
laws, rules, regulations or code & standards.
Make reasonable efforts to detect violations.
Members with supervisory responsibility must ensure that policies
regarding investment or non-investment behavior are enforced
equally.

Guidance-Compliance Procedures
Members with supervisory responsibility must bring an inadequate
compliance system to the firm’s attention and recommend
corrective action.
While investigating a violation it is appropriate to limit suspected
employee’s activities.
Unless adequate procedures are adopted by the firm, a member
must decline in writing from accepting supervisory responsibility.

Recommended Procedures for Compliance
M&C should recommend their employers to adopt a COE.
Separate the COE from compliance procedures.
Adequate compliance procedures:

Clearly written & accessible manual.
Designate a compliance officer to implement compliance procedures.
Implement system of checks & balances.
Describe the hierarchy of supervision.
Outline scope of procedures & permissible conduct.
Once a compliance program is in place, a supervisor should:
Disseminate program contents to appropriate personnel & educate them regarding
compliance procedures.
Professional conduct evaluation as part of employee’s performance review.
Review employee’s actions & identify violation.
Once a violation is discovered, supervisor should respond promptly, conduct thorough
investigation & increase supervision.

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2017, Study Session # 1, Reading # 2
5. Investment Analysis, Recommendations and Actions
5 A. Diligence & Reasonable Basis

1. M&C must exercise diligence,
independence & thoroughness in
investment analysis,
recommendations & actions.

2. M&C must have a reasonable &
adequate basis for investment
analysis, recommendation or action
(supported by research &
investigation).

Guidance-Reasonable Basis
Level of research for due diligence depends on product/service offered.
Prior to making recommendation or investment action consider;
Firm’s financial results, operating history & business cycles stage.
Mutual fund’s fee & past performance.
Limitation of any quantitative methods used.
Appropriateness of peer group comparisons.

Guidance-Using Secondary or Third-Party Research

To periodically review quality of third party research use the following:
Review assumptions used.
How rigorous was the analysis.
How timely the research is.
Evaluate objectivity & independence of recommendations.

Guidance-Quantitative Research
Able to explain the nature of quantitative methods used.
Consider scenarios which are not typically used to assess downside risk.
Ensure that both positive & negative results have been used.

Guidance-External Advisers
Ensure advisors have adequate compliance and internal controls.
They present correct return information.
Do not deviate from stated strategies.

Guidance-Group Research & Decision Making
If the group research has a reasonable basis, do not refuse to
be identified with the report merely on the basis of

disagreement with the consensus view.
Recommended Procedures for Compliance
Policy requiring that research reports, credit ratings & investment recommendations have a reasonable & adequate basis.
Develop written guidance for analysts, supervisory analysts & review committees.
Develop measureable criteria for research report quality assessment.
Written guidance for computer-based models used in developing rating & evaluating financial instruments.
Develop measurable criteria for assessing outside providers.
Standardized criteria for evaluating the adequacy of external advisers.

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2017, Study Session # 1, Reading # 2
5 B. Communication with Clients and Prospective Clients

M&C must:
Disclose to clients & prospective clients the basic format & general principal of
investment process& disclose any change that materially affects that process.
Identify important factors (related to investments) & communicate with clients &
prospective clients.
Distinguish b/w fact & opinion (in investment analysis& recommendations).

Guidance
Always include basic characteristics of security identified.
Distinguish b/w facts and opinions.
Illustrate investment decision making process utilized.
All means of communication should be included not only the research reports.
Communicate any specific risk factors associated with securities.
Clearly communicate potential gains & losses.
Failing to illustrate model’s limitations may be considered as violation.

Recommended Procedures for Compliance
Able to supply additional information if requested maintain
relevant information.

5 C. Record Retention

M&C must develop & maintain appropriate records that support investment analysis,
recommendations, actions & other investment related communications with clients&
prospective clients.

Guidance
Maintain records that support conclusion or any investment action.
Such records are property of the firm.
If regulatory requirements do not recommend, keep records for 7
years.
Members who change firms must recreate analysis related
documentation – not rely on memory or material created at previous
firms.

Recommended Procedures for Compliance
Record-keeping is generally firm’s
responsibility.

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2017, Study Session # 1, Reading # 2
6. Conflicts of Interest
6 A. Disclosures of Conflicts
M&C must:

Make full & fair disclosure of all matters that impair independence & objectivity or interfere
with respective duties to clients, prospective clients & employers.
Disclosures should be prominent, delivered in plain language & communicate information
effectively.

Guidance-Disclosure to Clients
Disclose all potentially conflicting areas to existing and prospective clients to let them judge
any potential bias themselves.
If servicing as a board member disclose.
Disclosure of broker/dealer market making activities is included.
Disclosure of holdings in companies that member recommends or clients hold.
Members’ compensation structure, if perceived to gain any client must be disclosed.
Members working in advisory capacity.
Update disclosure in case of significant change in compensation structure.

Guidance –Disclosure of Conflicts to Employers
Give employers enough information to judge the impact of conflict.
Take reasonable steps to avoid conflict  report promptly if they occur.

Recommended Procedures for Compliance
Special compensation arrangements (bonus, commission etc.) should be disclosed.

6 B. Priority of Transaction
Investment transaction priority flow:
Clients
⇓
Employers
⇓
Employees

Guidance
Prioritize client’s transactions over personal transactions& made on behalf of the member’s firm.
Personal transactions may be undertaken after clients and member’s employers have been given
adequate opportunity.
Personal transaction – member is a “beneficial owner”.
Family member accounts should not be disadvantaged to client accounts.
Information about pending trades should not be acted upon for personal gains.

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2017, Study Session # 1, Reading # 2

Recommended Procedures for Compliance
Limited participation in equity IPOs by investment personnel.
Restrictions on private placements for investment personnel.
Establish blackout/restricted periods for investment personnel.
Reporting requirements for investment personnel.
Disclosure of holdings in which the employee has a beneficial interest.
Provide duplicate confirmations of transaction.
Preclearance procedures.
Disclosure of policies regarding personal investing.

6 C. Referral Fees
M&C must disclose to employer, clients & prospective clients, as appropriate, any
compensation, consideration or benefit received from or paid to others for
recommendation of products& services.

Guidance
Must inform employers, clients and prospects of benefits received for referral of

customers and clients.
All types of consideration must be disclosed.

Recommended Procedures for Compliance
Encourage firms to adopt clear procedures regarding compensation for referrals.
M&C should update the employer (at least quarterly) regarding nature and value
of referral compensation received. The clients should also be notified about
approved referral fee programs.

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2017, Study Session # 1, Reading # 2

7. Responsibilities as a CFAI Member or CFAI Candidate
7 A. Conduct as Members and Candidates in the CFA Program

M&C must not:
Engage in any conduct that compromise reputation or
integrity of CFAI or CFA designation.
Violate integrity, validity or security or the CFA
examinations.

Guidance

Must not engage in any activity that undermines the integrity of CFA charter.
Standard applies to:
Cheating in CFA or any exam.
Revealing anything about the contents & topics of exam.
Not following exam related rules & polices of CFA program.

Disclosing confidential exam related information to candidates or to public.
Improperly using the designation.
Misrepresenting information on PCS or CFAI PDP.
Members can express their opinion regarding the CFA exam or program but without disclosing
actual exam specific information.
Members voluntarily participating in the administration of the CFA exam must not solicit or
reveal information about:
Exam questions
Grading process
Scoring of questions

7 B. Reference to CFA Institute, the CFA Designation, and the CFA Program

M&C must not misrepresent or exaggerate the meaning or implication of
membership in CFA institute, holding the CFA designation or candidacy in CFA
program.
Guidance

Do not over-promise individual competence.
Do not over promise future investment result.
Sign PCS annually.
Pay CFAI membership dues annually.
Do not misrepresent or exaggerate the meaning of the designation.
No partial designation exists.
Acceptable to state candidate successfully completed the program in 3 years ⇒claiming
superior ability is not permitted.
In written/oral communications.
The chartered financial analyst and CFA marks must be used as adjectives or after the
charterholder’s name.
Prohibited to be used as nouns.

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2017, Study Session # 2, Reading # 4

“ASSET MANAGER CODE OF PROFESSIONAL CONDUCT”
THE ASSET MANAGER CODE

There are six risk components to the asset manager code.
Ethical responsibilities related to six components are:
Always act ethically & professionally.
Act independently & objectively.
Perform actions using skill, diligence & competence.
Act in best interest of the client.
Communicate with clients on a regular & accurate manner.
Legal & regulatory compliance.

PREVENTING VIOLATIONS

Loyalty to Clients

Put the client’s interest before your own.
Maintain confidentiality.
Do not accept any gift that affects your judgment&
objectivity.
Design salary arrangements that align the interests of the
client with those of the manager.

Trading

Investment Process & Actions

Take actions that would not cause any harm to the client.
Never engage in market manipulation of security prices.
Fair dealing with all clients.
Thoroughly investigate & research different investment
options.

Risk Management, Compliance & Support

Do not trade or cause others to trade on insider information.
Seek best execution for all trades & equitable allocation
among clients.
Use soft $ commission to provide products & services that
aids the portfolio manager in investment decision making
process.
Place client’s trades before your own.

Develop policies & procedures for complying with codes &
standards & regulatory requirements.
Appoint a compliance officer & establish a firm wide system
for identifying & measuring manager’s risk position.
Complete & accurate portfolio information disseminated to
clients.
Maintain records.
Contingency plan in the event of a natural disaster.

Performance & Valuation

Report investment results in an accurate manner without
misrepresentation. Use fair MV.
Guideline ⇒ follows GIPS.
In order to avoid conflict of interest, transfer the
responsibility of valuing asset accounts to an independent
third party.

Disclosure

Disclose the following to the client:
Any information needed to make an informed decision
regarding the investment manager or the organization.
Potential conflict of interest.
Any regulatory or disciplinary action taken against the
manager or its personnel.
The investment decision-making process & fee
schedule.
Discussion about soft $ commission.
Trade allocation procedures & firm-wide risk
management processes.

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2017, Study Session # 3, Reading # 5

“THE BEHAVIORAL FINANCE PERSPECTIVE”
REM = Rational Economic Man
1. INTRODUCTION

2. BEHAVIORAL VERSUS TRADITIONAL PERSPECTIVES

Traditional VS Behavioral Finance

Traditional Finance

Behavioral Finance

Grounded in neoclassical economics.
Individuals are assumed to be
rational, risk averse & utility
maximizers.
Traditional finance believes in EMH.

Grounded in psychology.
Based on observed financial behavior
rather than idealized financial
behavior.

Classification

Behavioral Finance Micro

Describe decision making process of
individuals.
Cognitive errors & emotional biases.

Behavioral Finance Macro

Consider anomalies that distinguish

market from efficient markets.

2.1 Traditional Finance Perspectives on Individual Behavior

Traditional finance assumes:
Investors are risk averse & self interested.
Investors make decisions based on utility theory &
revise expectations consistent with Bayes’ formula.
Efficient Markets.

2.1.1 Utility Theory and Bayes’ Formula

People maximize the PV of expected utility subject to their budget constraints.
Expected utility = weighted sum of the utility values of outcomes × Probabilities.
A rational investor make decision based on following axioms of utility theory:
Completeness ⇒ an individual has well defined preferences & can decide b/w two alternatives.
Transitivity ⇒ as an individual decides according to completeness axiom, an individual decides consistently.
Independence⇒ assumes preference order of two choices combined with third choice maintains the same preference order.
Continuity ⇒Indifferent curves (IC) are smooth & unbroken (continuous).
Bayes’ formula:
New information is assumed to update beliefs about probabilities according to Bayes’ formula.
Application of conditional probability.
Assumes that events are mutually exclusive & exhaustive with known probabilities.
ܲሺ‫ܣ‬⁄‫ܤ‬ሻ = ቂ

௉ሺ஻⁄஺ሻ
௉ሺ஻ሻ

ቃ ܲሺ‫ܣ‬ሻ

Where P (A/B) & (P (B/A)) = conditional probability of event A, (B) given B, (A).
P (B) = prior probability of event B.
P (A) = prior probability of event A.

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2017, Study Session # 3, Reading # 5

2.1.2 Rational Economic Man

REM:
Maximize utility given budget constraints & available information.
Selfishly seek the personal utility maximizing decision.
Tries to minimize economic cost.
Govern by perfect rationality, perfect self-interest & perfect
information principles.

2.1.3 Perfect Rationality, Self-Interest, & Information

Prefect rationality ⇒ REM is a rational thinker (ability to reason & make
beneficial judgments).
Prefect self interest ⇒ REM is perfectly selfish.
Perfect information ⇒ REM has perfect knowledge of every subject.

2.1.4 Risk Aversion

Risk Attitudes

Risk Averse

Risk Neutral

Investors who prefer a certain
alternative over an uncertain one
(same expected value).
Diminishing marginal utility of
wealth (concave utility function).

Investors are indifferent b/w a
certain & uncertain alternative.
Constant marginal utility of wealth.
Linear utility function.

Risk Seeking

Investors who prefer to invest in
uncertain alternatives.
Increasing marginal utility of wealth
(convex function).

Expected utility theory assumes that investors are risk averse
(utility functions are concave & diminishing marginal utility of
wealth).
Certainty equivalent ⇒ max sum of money a person would pay
to participate or minimum amount of money a person would
accept to not participate in an event with uncertain outcome.

2.2 Behavioral Finance Perspectives on Individual Behavior

Behavioral finance challenges assumptions of traditional finance
on the following grounds:
Investors may be unable to make decisions based on utility
theory & revise expectations consistent with the Bayes’
formula.
Perfect rationality, self interest & prefect information
principles’ violation.

2.2.1 Challenges to Rational Economic Man

Bounded rationality ⇒ individual’s choices are subject to
knowledge & cognitive limitations.
REM ignores the fact that people can have difficulty prioritizing
short term v/s long term goals.

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2017, Study Session # 3, Reading # 5
2.2.2 Utility Maximization and Counterpoint

An IC depicts all possible combination of two goods amongst which an individual is indifferent.
For perfect substitutes (complements), the IC is a line with constant slope (L-shaped).
IC analysis fails to consider exogenous factors (e.g. risk aversion, individual’s circumstances etc).

2.2.3 Attitudes toward Risk

Risk evaluation depends on the:
Wealth level
Circumstances of the decision maker.

Double inflection utility function ⇒ utility function that changes based on level of
wealth.
Investors are risk averse at & income levels.
Investors are risk seeking at moderate income levels.
Prospect theory ⇒ Shape of a decision maker’s value function differs for G&L.
Value function is normally concave for gains, convex for losses & steeper for
losses than for gains.

2.3 Neuro-economics

Explain how humans make economic decisions under uncertainty.
Neuro-economics explains:
Overconfidence & market overreaction.
A panicked rather than analytical response after falling market.

3. DECISION MAKING

Prospect theory & bounded rationality are based on how people do behave & make
decisions(behavioral finance based).
Expected utility & decision theories are based on how people should& make decisions
(traditional finance based).

3.1 Decision Theory

Indentify values, probabilities & other uncertainties relevant to a decision & using that
information to arrive at a theoretically optimal decision.
Based on expected value & traditional finance assumptions.
Expected utility can vary from person to person (based on the worth assigned by the
decision maker).
Expected value is same for every one (based on price).

3.2 Bounded Rationality

Subjective expected utility theory ⇒ probability distributions of all relevant variables can be provided by the decision makers.
Bounded rationality & satisfice ⇒ situation where people gather some available information, use heuristics to analyze the
information & stop at a satisfactory decision.
Satisficing ⇒ finding an acceptable solution as opposed to optimizing.
Investor takes steps to achieve intermediate goals, as long as they advance the investor towards the desired goals.

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2017, Study Session # 3, Reading # 5

3.3 Prospect Theory

Investors analyze risk relative to possible gains & losses rather than relative to expected return.
Investors are more concerned with the change in wealth & place greater value on a loss than on a
gain of same amount.
Phases to Making a Choice

Editing Phase

3.3.1 Evaluation Phase

Prospects are framed as gains or losses
using heuristics.

Steps in Editing

Codification

Investors identify & code outcomes as
gains or losses & assign a probability to
each.

People compute a value function based on potential outcomes
& their probabilities.
ܷ = ܹሺܲଵሻܸሺܺଵ ሻ + ܹሺܲଶሻܸሺܺଶ ሻ
Where
ܺଵ , ܺଶ = Potential outcomes
ܲଵ, ܲଶ = Probabilities
W = Probability weighting function.
V
= Function that assigns a value to an outcome.
The value function states:
People overreact (underreact) small (mid-sized & large)
probabilities events.
People are loss averse.
Preferences are determined by attitudes towards gains &
losses.

Combination

Investor combines those outcomes with
identical value.

Segregation

The riskless component of any prospect

is separated from its risky component.

Cancellation

Identical outcomes b/w choices can be
eliminated.

Simplification

Investors will tend not to think in precise
numbers (rounded off the prospects).

Detection of Dominance

Investor will eliminate any choice that is
strictly dominated by another.

Isolation effect⇒ investors focus on one factor or
outcome while eliminating or ignoring others.

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2017, Study Session # 3, Reading # 5
4. PERSPECTIVES ON MARKET BEHAVIOR AND PORTFOLIO CONSTRUCTION
4.1 Traditional Perspectives on Market Behavior

Traditional finance assumes EMH

4.1.1 Review of the Efficient Market Hypothesis

EMH assumes:
Market participants are REM.
Population updates its expectations as new
relevant information appears.
Relevant information is freely available to
all participants.

Forms of Market Efficiency

Weak Form

Semi-Strong Form

Consistently excess return is not
possible using technical analysis.
Reflect all historical price &volume
data.

Strong Form

All publically available information
is fully reflected in securities prices.
Excess return on continuous basis is
not possible using technical &
fundamental analysis.

All public & private information is
fully reflected in securities prices.
Even insiders are unable to

generate excess return on
consistent basis.

Grossman-Stiglitz paradox ⇒prices must offer returns to
information acquisition otherwise the market can’t be
efficient.

4.1.2 Studies in Support of the EMH

4.1.2.1 Support for the Weak Form of the EMH

Test whether security prices are serially correlated or
whether they are random.
Studies conclude that security prices are random,
(support weak form of the EMH).

4.1.2.2 Support for the Semi-Strong Form of the EMH

Event studies.
Announcement of the event (not event itself) appear
to be reflected in prices.

4.1.3 Studies Challenging the EMH: Anomalies

4.1.3.1 Fundamental Anomalies

Investor generates excess return based on some
fundamental characteristics of the firm.
Small cap firms appear to outperform
large cap firms.

Value stocks appear to outperform growth
stocks.

4.1.3.2 Technical

Moving average ⇒ if the short (long) moving
avg prices rise above the long (short) avg prices,
this is an indication of strength (weakness).
Resistance level ⇒ price will climb to the
resistance level & then reverse direction (act
like a ceiling).
Support level ⇒ floor price (price will move
upward after support level reached).

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2017, Study Session # 3, Reading # 5

4.1.3 Studies Challenging the EMH: Anomalies

4.1.3.3 Calendar Anomalies

4.1.3.4 Anomalies: Conclusion

January effect ⇒ stocks deliver abnormally
returns during the month of January.
Turn-of-the month effect ⇒ stocks earn
returns on the last day & 1st four days of each
month.

Markets are neither perfectly efficient not
completely anomalous.

4.1.3.5 Limits to Arbitrage

Uncertain need for liquidity limits the ability of
arbitrage to force prices to their intrinsic values.
Implicit in the limit to the arbitrage idea is that the
EMH does not hold.

4.2 Traditional Perspectives on Portfolio Construction

Rational portfolio:
Meets investor’s objective & constraints.
Choose from mean-variance efficient portfolios.

4.3 Alternative Models of Market Behaviorand Portfolio
Construction

4.3.1 A Behavioral Approach to Consumption and Savings

Behavioral life-cycle theory incorporates:
Self control bias ⇒ short-term satisfaction to the detriment of long-term goals.
Mental accounting ⇒ people ignore the fact that wealth is fungible (interchangeable) & assign different
portions of their wealth to meet different goals.
Framing bias ⇒results in different responses based on how questions are asked (framed).

4.3.2 A Behavioral Approach toAsset Pricing

Behavioral assets pricing model adds a sentiment premium (stochastic discount factor) to discount rate.
Required return on an asset = Rf + fundamental risk premium + sentiment premium.
Sentiment premium ⇒ based on analysts’ forecasts.
The dispersion of analysts’ forecasts, the sentiment premium, the discount rate & the
perceived value of the assets.

4.3.3 Behavioral PortfolioTheory

Uses of probability-weighting function rather than the real probability distribution.
Investor’s structure their portfolio in layers & composition of each layer is
determined by interaction of following five factors.
The importance of the goals.
Required return.
The investor’s utility function.
Access to information.
Loss aversion.
Optimal portfolio ⇒combination of riskless & highly speculative assets (may not be
mean-variance efficient).

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2017, Study Session # 3, Reading # 5

4.3.4 Adaptive Markets Hypothesis

Revised version of the EMH that considers bounded rationality, Satisficing&
evolutionary principles.
The competition & adaptable the participants, the likelihood of not
surviving.

Five implications:
Risk premiums change over time.
Active management can add value.
Consistent outperformance is impossible.
Investors must adapt to survive.
Survival is the essential objective.

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