FinQuiz curriculum note, study session 1, reading

Code of Ethics and Standards of Professional Conduct

Due to the nature of this reading, FinQuiz recommends reading it directly from the CFA
Institute’s Curriculum.
Reference:
CFA Level III, Volume 1, Reading 1.

Team –FinQuiz

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FinQuiz Notes 2 0 1 7

Reading 1


The Behavioral Finance Perspective

1.

INTRODUCTION

Behavioral finance focuses on human behavior and
psychological mecahnisms involved in financial
decision-making and seeks to understand and predict
the impact of psychological decision-making on the
financial markets.
According to efficient market hypothesis, financial
markets are rational and efficient and the abnormal
returns are either by chance or due to statistical
problems associated with analyzing stock returns e.g.

neglecting common risk factors etc.
According to behavioral finance, although financial
markets are rational and efficient, but it is not necessary
that all the market participants will be rationale in their
decision making due to various behavioral biases
(particularly cognitive biases). This results in the
mispricing of securities and thus results in the market
anomalies.
The basic idea of behavioral finance is that since
investors are humans,
2.

• Investors are imperfect and can make irrational
decisions.
• As a result, investors may have heterogeneous
beliefs regarding asset's value.
Normative analysis: Normative analysis involves
analyzing how markets and market participants should
behave and make decisions. Traditional finance is
regarded as normative.
Descriptive analysis: Descriptive analysis involves
analyzing how markets and market participants actually
behave and make decisions. Behavioral finance is
regarded as descriptive.
Prescriptive analysis: Prescriptive analysis seeks to
analyze how markets and market participants should
behave and make decisions so that the achieved
outcomes are approximately close to those of normative
analysis. Efforts to use behavioral finance are regarded
as prescriptive.

BEHAVIORAL VERSUS TRADITIONAL PERSPECTIVES

Traditional finance assumes that:
• Market participants are rational;
• Market participants make decisions consistent with
the axioms of expected utility theory (explained
below);
• Market participants accurately maximize expected
utility;
• Market participants are self-interested;
• Market participants are risk-averse and thus, the
utility function is concave in shape i.e. exhibits a
diminishing marginal utility of wealth.
• Stock prices reflect all available and relevant
information.
• Market participants revise expectations consistent
with Bayes’ formula (explained below).
• Market participants have access to perfect
information;
• Market participants process all available information
in an unbiased way i.e. make unbiased forecasts
about the future.
However, in reality, these assumptions may not hold.
Behavioral finance assumes that:
• Market participants are “normal” not rational;
• Market participants do not necessarily always
process all available information in decision making;
• In some circumstances, financial markets are
informationally inefficient.

Two dimensions of Behavioral Finance:
1) Behavioral Finance Micro (BFMI): BFMI seeks to
understand behaviors or biases of market participants
and their impact of financial decision-making. It is
primarily used by wealth managers and investment
advisors to manage individual clients.
2) Behavioral Finance Macro (BFMA): BFMA seeks to
understand behavior of markets and market
anomalies that are in contrast to the efficient markets
of traditional finance. It is primarily used by fund
managers and economists.
Categories of Behavioral Biases:
1) Cognitive errors: Cognitive errors are mental errors
including basic statistical, information-processing, or
memory errors that may result from the use of
simplified information processing strategies or from
reasoning based on faulty thinking.
2) Emotional biases: Emotional biases are mental errors
that may result from impulse or intuition and/or
reasoning based on feelings.
2.1.1) Utility Theory and Bayes’ Formula
Under the utility theory, an individual always chooses the
alternative for which the expected value of the utility
(EXPECTED utility) is maximum, subject to their budget
constraints. In other words, an individual tends to
maximize the PV of utility subject to the PV of budget
constraint.

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FinQuiz Notes 2 0 1 7

Reading 5


Reading 5

The Behavioral Finance Perspective

• Utility refers to the level of relative satisfaction
received from consuming goods and services. Unlike
price, utility depends on the particular
circumstances and preferences of the decision
maker; as a result, it may vary among individuals.
Expected utility = Weighted sums of the utility values of
outcomes
Expected utility = Σ (Utility values of outcomes ×
Respective probabilities)
• The value of an item is based on its utility rather than
its price.
• According to the Expected utility theory, individuals
are risk-averse and thus, utility functions are concave
in shape and exhibit diminishing marginal utility of
wealth.
Subjective expected utility of an individual
=Σ [u (xi) × P (xi)]
Where,
u (xi) = Utility of each possible outcome xi
P (xi) = Subjective probability

Axioms of Utility Theory: The four basic axioms of utility
theory are as follows:
1) Completeness: Completeness assumes that given any
two alternatives, an individual can always specify and
decide exactly between any of these alternatives.
Axiom: Given alternatives A and B, an individual
• Prefers A to B
• Prefers B to A
• Is indifferent between A and B
2) Transitivity: Transitivity assumes that, as an individual
decides according to the completeness axiom, an
individual also decides consistently. According to
transitivity, the decisions made by an individual are
internally consistent.
Axiom: Given alternatives A, B and C, if an individual
• Prefers A to B
• Prefers B to C
Then an individual prefers to A to C.
If an individual
• Prefers A to B
• Is indifferent between B and C
Then an individual prefers to A to C.
If an individual
• Is indifferent between A and B
• Prefers A to C
Then an individual prefers to B to C.
3) Independence: Independence also assumes that
individuals have well-defined preferences and when

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a 3rd alternative is added to two alternatives, the
order of preference remains the same as when two
alternatives are presented independently.
Axiom: Given three alternatives A, B and C, if an
individual prefers A to B and some amount of C (say x) is
added to A and B, then an individual will prefer (A + xC)
to (B + xC).
IMPORTANT TO NOTE:
• If the utility of A depends on availability of
alternative C, then utilities are NOT additive.
4) Continuity: Continuity assumes that indifference
curves* are continuous, implying that an individual is
indifferent between all the points on a single
indifference curve.
Axiom: Given three alternatives A, B and C, if an
individual prefers A to B and B to C, then there should be
a possible combination of A and C on the indifference
curve in which an individual will be indifferent between
this combination and the alternative B.
Implication of axioms of utility theory: When an
individual makes decisions consistent with the axioms of
utility theory, he/she is said to be rational.
*Indifference curve (IC): An indifference curve shows
combinations of two goods among which the individual
is indifferent i.e. those bundles of goods provide same
level of satisfaction.
• The IC shows the marginal rate of substitution i.e. the
rate at which a consumer is willing to trade or
substitute one good for another, at any point.

• The indifference curve that is within budget
constraints and furthest from the origin provides the
highest utility.
• For perfect substitutes: IC represents a line with a
constant slope, implying that a consumer is willing to
trade or substitute one good for another in fixed
ratio.
• For perfect complements: IC curve is an L-shaped
curve, implying that no incremental utility can be
obtained by an additional amount of either good as
goods can only be used in combination.
Bayes’ formula: Bayes’ formula is used for revising a
probability value of the initial event based on additional
information that is later obtained.
Rule to apply Bayes’ formula: All possible events must be
mutually exclusive and must have known probabilities.
The formula is:
P (A|B) = [P (B|A) / P (B)]× P (A)
Where,
P(A|B) = Conditional probability of event A given B. It
represents the updated probability of A given
the new information B.


Reading 5

The Behavioral Finance Perspective

P(B|A) = Conditional probability of event B given A. It
represents the probability of the new

information (event) B given event A.
P(B)
= Prior (unconditional) probability of information
(event) B.
P(A)
= Prior (unconditional) probability of information
(event) A.

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• Risk-seeking individuals have convex utility functions,
reflecting that utility increases at an increasing rate
with increase in wealth (i.e. increasing marginal utility
of wealth).

In summary: In traditional finance, when market
participants make decisions under uncertainty, they
1. Act according to the axioms of utility theory.
2. Make decisions by assigning a probability measure
to possible events.
3. Process new information according to Bayes’
formula.
4. Select an alternative that generates the maximum
expected utility.

Practice: Example 1,
Volume 2, Reading 5

Certainty Equivalent: It refers to the maximum amount of
money an individual is willing to pay to participate or the

minimum amount of money an individual is willing to
accept to not participate in the opportunity.
Risk premium = Certainty equivalent – Expected value
See: Exhibit 2, Volume 2, Reading 5.

2.1.2) Rational Economic Man
Rational economic man (REM) pursues self-interest (sole
motive) to obtain the highest possible economic wellbeing (i.e. the highest utility) at the least possible costs
given available information about opportunities and
constraints on his ability to achieve his goals. In sum,
•
•
•
•

REM is Rational
REM is Self-interested
REM is Labor averse
REM possesses perfect information
2.1.4) Risk Aversion

Risk averse: An individual who prefers to invest to
receive an expected value with certainty rather than
invest in the uncertain alternative with the same
expected value is referred to as risk averse.
• Risk-averse individuals have concave utility functions,
reflecting that utility increases at a decreasing rate
with increase in wealth (i.e. diminishing marginal
utility of wealth).
• The greater the curvature of the utility function, the

higher the risk aversion.
Risk neutral: An individual who is indifferent between the
two investments is called risk-neutral.
• Risk-neutral individuals have linear utility functions,
reflecting that utility increases at a constant rate with
increase in wealth.
Risk-seeking: An individual who prefers to invest in the
uncertain alternative is called risk-seeking.

2.2.1) Challenges to Rational Economic Man
In reality, financial decisions are also governed by
human behavior and biases. This implies that:
• Individuals may sometimes behave in an irrational
manner.
• Individuals are not perfectly self-interested.
• Individuals do not have perfect information and
many economic decisions are made in the absence
of perfect information.
• REM fails to consider that people may suffer from
self-control bias i.e. it may be difficult for individuals
to prioritize between short-term versus long-term
goals (e.g. spending v/s saving).
Despite the limitations of REM, REM concept is useful as it
helps to define an optimal outcome.
Conclusion:
• Individuals are neither perfectly rational nor perfectly
irrational; rather, they tend to have diverse
combinations of rational and irrational
characteristics.
2.2.3) Attitudes toward Risk

An individual’s (investor’s) attitude toward risk depends
on his/her wealth level and circumstances. This implies
that the curvature of an individual’s utility function may
vary depending on the level of wealth and
circumstances.
1. At both low and high wealth (income) level, utility
functions tend to exhibit concave shape, reflecting


Reading 5

The Behavioral Finance Perspective

risk-aversion behavior (i.e. at points A and C). This
implies that
• At low level of wealth (point A), people may prefer
low probability, high payoff risks (e.g. lottery).
• Once certain reasonable level of wealth is reached
(point C), the individual becomes risk averse in order
to maintain this position.
2. At moderate wealth (income) level, utility functions
tend to exhibit convex shape, reflecting risk-seeking
behavior (i.e. between points B and C).
• This implies that individuals with moderate level of
wealth tend to prefer small, fair gambles.

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Assumptions of Decision Theory:
• Decision maker possess all relevant and available

information;
• Decision maker has the ability to make accurate
quantitative calculations;
• Decision maker is perfectly rational;
Expected value versus Expected Utility: Expected value
is not the same as expected utility.
• Expected value of an item depends on its price and
price is equal for everyone.
• Expected utility of an item depends on an
individual’s circumstances and it may vary among
individuals.
3.2

Bounded Rationality

Bounded rationality relaxes the assumption that an
individual processes all available information to achieve
a wealth-maximizing decision.

Double inflection utility function: A utility function that
changes with changes in the level of wealth is called
double inflection utility function (as shown above).
Risk versus uncertainty:
• Risk refers to randomness with knowable
probabilities. Risk is measurable.
• Uncertainty refers to randomness with unknowable
probabilities. Uncertainty is not measurable.
2.3

Neuro-economics

Neuro-economics is a combination of neuroscience,
psychology and economics. It seeks to explain the
influence of the brain activity on investor behavior and
attempts to understand the functioning of the brain with
respect to judgment and decision making.
Criticism of neuro-economics: It is argued that the brain
activity or chemical levels in the brain are unlikely to
have an impact on economic theory.
3.1

According to bounded rationality, an individual behaves
as rationally as possible given informational, intellectual,
and computational limitations of an individual. As a
result,
• Individuals do not necessarily make perfectly rational
decisions;
• Individuals tend to satisfice rather than optimize
while making decisions i.e. individuals seek to
achieve satisfactory and adequate decision
outcomes (given available information and limited
cognitive ability) rather than optimal (best)
outcomes given informational, intellectual, and
computational limitations and the cost and time
associated with determining an optimal (best)
choice.
NOTE:
Satisfice refers to achieving satisfactory and adequate
decision rather than an optimal (best) decision.

Practice: Example 2,
Volume 2, Reading 5

Decision Theory

Decision theory deals with the study of methods for
determining and identifying the optimal decision (i.e.
with highest total expected value) when a number of
alternatives with uncertain outcomes are available.
• Both Expected utility and decision theories are
normative.
• The decision theory facilitates investors to make
better decisions.

3.3

Prospect Theory

The Prospect theory relaxes the assumptions of expected
utility theory. It seeks to explain the behavior of
individuals to perceive prospects (alternatives) based on
their framing or reference point i.e. people respond
differently depending on how choices are framed e.g. in
terms of gains or losses.


Reading 5

The Behavioral Finance Perspective

• According to prospect theory,
o Individuals prefer a certain gain more than a
probable gain with an equal or greater expected
value and the opposite is true for losses.
o Individuals evaluate gains and losses from a
subjective reference point.
• Both Prospect theory and bounded rationality are
descriptive.
Three critical aspects of the value function of a Prospect
theory:
1. Value is assigned to changes in wealth (i.e.

gains/losses) rather than to absolute level of wealth;
and instead of probabilities, decision weights are
used in the value function.
2. The value function is S-shaped (see Figure below),
and predicted to be concave for gains(indicating risk
aversion) above the reference point and convex for
losses(indicating risk-seeking) below the reference
point.
3. The value function is steeper for losses than for gains
(See Figure below). This means that the displeasure
associated with the loss is greater than the pleasure
associated with the same amount of gains.
• This implies that individuals are loss-averse not riskaverse. In addition, an individual tends to be riskseeking in the domain of losses while risk-averse in
the domain of gains.
o People are risk averse for gains of moderate to
high probability and losses of low probability.
o People are risk seeking for gains of low probability
and losses of moderate to high probability.

• Loss aversion bias refers to the tendency of an
individual to hold on to losing stocks while selling
winning stocks too early. It is also known as
“disposition effect”.

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Six Operations in the Editing process:
1. Codification: Coding refers to categorizing outcomes

(prospects) in terms of gains and losses rather than in
terms of final absolute wealth level depending on the
reference point i.e.
• Outcomes below the reference point are viewed as
losses.
• Outcomes above the reference point are viewed as
gains.
o Prospects are coded as (Gain or loss, probability;
Gain or loss, probability;…)
o Initially, the sum of probabilities = 100% or 1.0.
2. Combination: Combination refers to adding together

the probabilities of prospects with identical gains or
losses to simplify a decision. E.g. winning 200 with 25%
or winning 200 with 25% can be simply reformulated
as winning 200 with 50%.
3. Segregation: In this step, the decision maker

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

prospect of winning 300 with 80% or 200 with 20% into
a sure gain of 200 with 100% and the prospect of
winning 100 with 80% or nothing (0) with 20%. The
same process is applied for losses.
4. Cancellation: Cancellation refers to discarding similar

outcomes probability pairs between prospects. E.g. if
pairs are (200, 0.25; 150, 0.40; 30, 0.35) and (200, 0.3;
150, 0.40; -50. 0.3), they will be simplified as (200, 0.25;
30, 0.35) and (200, 0.30; -50, 0.30).
• Cancellation operation fails to consider components
that distinguish prospects.
• Cancellation operation may give rise to isolation
effect because different choice problems can be
decomposed in different ways which may lead to
inconsistent preferences.
5. Simplification: Simplification operation involves

mathematical rounding of probabilities and/or
discarding (i.e. assigning probability of 0) very unlikely
prospects. E.g. if a prospect is coded as (49, 0.51), it is
simplified as (50, 0.50).
6. Detection of dominance: It involves rejecting (without

further evaluation) outcomes that are extremely
dominated.
Phases of decision making in Prospect Theory:
According to Prospect Theory, individuals go through
two distinct phases when making decisions about risky
and uncertain options.

1) Editing or Framing phase: In this phase, decision
makers edit or simplify a complicated decision. The
ways in which people edit or simplify a decision vary
depending on situational circumstances. Decisions
are made based on these edited prospects.

2) Evaluation phase: In this phase, once prospects are
edited or framed, the decision maker evaluates these
edited prospects and chooses between them. This
phase is composed of two parts i.e.
a) Value function: Unlike expected utility theory function,
prospect theory value function measures gains and
losses rather than absolute wealth and is referencedependent. The value function is s-shaped.
• The value function is generally concave for gains


Reading 5

The Behavioral Finance Perspective

and convex for losses.
• The value function is steeper for losses than for gains,
reflecting "loss aversion”.
b) Weighting function: It involves assigning decision
weights (rather than subjective probability) to those
prospects. Decision weights represent empirically
derived assessment of likelihood of an outcome. In
general,
• People tend to underweight moderate and highprobability outcomes.
• People tend to overweight low-probability

outcomes.
As a result, unlikely outcomes have unduly more
impact on decision making.
Perceived value of each outcome = Value of each
outcome ×
Decision weight
4.

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U = w (p1) v (x1) + w (p2) v (x2) + … + w (pn) v (xn)
Where,
xi
pi
v
w

=
=
=
=

potential outcomes
respective probabilities
Value function that assigns a value to an outcome
probability weighting function

• The decision makers select the prospect with the
highest perceived value.
IMPORTANT TO NOTE:

• Codification, combination and segregation
operations are applied to each prospect
individually; whereas, cancellation, simplification
and detection of dominance operations are applied
to two or more prospects together.

PERSPECTIVE ON MARKET BEHAVIOR AND PORTFOLIO
CONSTRUCTION

4.1.1) Review of the Efficient Market Hypothesis
An informationally efficient market (an efficient market)
is a market in which,
• Prices are informative i.e. they immediately, fully,
accurately and rationally reflect all the available
information about fundamental values.
• The market quickly and correctly adjusts to new
information.
• Asset prices reflect all past and present information.
• The actual price of an asset will represent a good
estimate of its intrinsic value at any point in time.
• Investors cannot consistently earn abnormal returns*
by trading on the basis of information.
*Abnormal return = Actual return – Expected return

Assumptions of Efficient Market Hypothesis (EMH):
• Markets are rational, self-interested, and make
optimal decisions;
• Market participants process all available information;
• Markets make unbiased forecasts of the future;
However, EMH is NOT universally accepted.

NOTE:
Grossman-Stiglitz paradox: Markets cannot be strongform informationally efficient because costly information
will not be gathered and processed by agents unless
they are compensated in the form of trading profits
(abnormal returns).
Inefficient market: When active investing can earn
excess returns after deducting transaction and

information acquisition costs, it is referred to as an
inefficient market.
Forms of market efficiency:
There are three forms of market efficiency.
1) Weak-form market efficiency: It assumes that security
prices fully reflect all the historical market data i.e.
past prices and trading volumes. Thus, when a market
is weak-form efficient, all past information regarding
price and trading volume is already incorporated in
the current prices, implying that technical analysis will
not generate excess returns.
• However, it is possible to beat the market and earn
superior profits in the weak-form of efficient market
by using the fundamental analysis or by insider
trading.
2) Semi-strong form market efficiency: It assumes that
security prices fully reflect all publicly available
information, both past and present. Thus, technical
and fundamental analysis will not generate excess
returns. However, insider traders can make abnormal
profits in semi-strong form of efficiency.
3) Strong-form market efficiency: It assumes that security

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


Reading 5

The Behavioral Finance Perspective

4.1.2) Studies in Support of the EMH
A. Support for the Weak Form of the EMH: Weak form of
the efficient market hypothesis is supported and it is
NOT possible to consistently outperform the market
using technical analysis because it has been
observed that
• Daily changes in stock prices have almost zero
positive correlation.
• Market prices follow random patterns and thus,
future stock prices are unpredictable.
B. Support for the Semi-Strong Form of the EMH: Semistrong form of the efficient market hypothesis is
supported and it is NOT possible to consistently
outperform the market using fundamental analysis.
• A common test to examine whether a market is
semi-strong efficient is event study i.e. analyzing
similar events of different companies at different
times and evaluating their effects on the stock price

(on average) of each company.
C. Support for the Strong Form of the EMH: Strong form of
the efficient market hypothesis is NOT supported,
implying that it is possible to consistently earn
abnormal returns using non-public/insider information.
4.1.3) Studies Challenging the EMH: Anomalies
Market movements that are inconsistent with the
efficient market hypothesis are called market anomalies.
Market anomalies result in the mispricing of securities.
• However, these market anomalies result in inefficient
markets only if they are persistent and consistent
over reasonably long periods; and thus, can
generate abnormal returns on a consistent basis in
the future.
• If these anomalies are not consistent, they may
occur as a result of statistical methodologies used to
detect the anomalies, for example due to use of
inaccurate statistical models, inappropriate sample
size, data mining/data snooping (it involves over
analyzing the data in an attempt to find the desired
results), and results by chance etc.
Major Types of Market Anomalies:
There are three major types of identified market
anomalies:
1) Fundamental anomalies: A fundamental anomaly is
related to the fundamental assessment of the stock’s
value. It includes:
• Size effect: According to size-effect anomaly, stocks
of small-cap companies tend to outperform stocks
of large-cap companies on a risk-adjusted basis.

• Value Effect: According to value-effect anomaly,
value stocks tend to outperform growth stocks i.e.
o The stocks with low price-to-earnings (P/E) ratios,

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low price-to-sales(P/S) ratios, and low market-tobook (M/B) ratios tend to generate more returns
and outperform the market relative to growth
stocks (i.e. with high P/E, P/S and M/B ratios).
o Stocks with high dividend yield tend to outperform
the market and generate more return.
However, it has been evidenced that value effect
anomalies do not represent actual anomalies because
they result from use of incomplete models of asset
pricing.
2) Technical anomalies: A technical anomaly is related
to past prices and volume levels. It includes:
• Moving averages: Under this strategy, a buy signal is
generated when short period averages rise above
long period averages and sell signal is generated
when short period averages fall below the long
period averages.
• Trading range break (Support and Resistance):
Under this strategy, a buy signal is generated when
the price reaches the resistance level, which is
maximum price level and a sell signal is generated
when the price reaches the support level which is
minimum price level.
o However, in practice, it is generally not possible to
earn abnormal profits based on technical

anomalies after adjusting for risk, trading costs etc.
3) Calendar anomalies: Calendar anomalies are related
to a particular time period. For example,
• January Effect: According to January effect
anomaly, stocks (particularly small cap stocks) tend
to exhibit a higher return in January than any other
month.
• Turn-of-the-month effect: According to turn-of-themonth effect, stocks tend to exhibit a higher return
on the last day and first four days of each month.
Conclusion: In reality, markets are neither perfectly
efficient nor completely anomalous.
4.1.3.5 Limits to Arbitrage
Theory of limited arbitrage: Under certain situations, it
may not be possible for rational, well-capitalized traders
to correct a mispricing or to exploit arbitrage
opportunities, at least not quickly, due to the following
reasons:
• It is often risky and/or costly to implement strategies
to eliminate mispricing.
• Constraints on short-sale may exist due to which the
arbitrageur cannot take a large short position to
correct mispricing.
• Liquidity constraints i.e. the potential for withdrawal
of money by investors may force managers to close
out positions prematurely before the irrational pricing
corrects itself.


Reading 5

The Behavioral Finance Perspective

These risks and costs create barriers, or limits, for
arbitrage. As a result, markets may remain inefficient or
in other words, the EMH does not hold.
4.2

Traditional Perspectives on Portfolio Construction

From a traditional finance perspective, a portfolio that is
mean-variance efficient is said to be a “rational
portfolio”. A rational portfolio is constructed by
considering
•
•
•
•

Investors’ risk tolerance
Investor’s investment objectives
Investor’s investment constraints
Investor’s circumstances

Limitation of Mean-variance efficient Portfolio: It may not
truly incorporate the needs of the investor because of
behavioral biases.
4.3

Alternative Models of Market Behavior and
Portfolio Construction

4.3.1) A Behavioral Approach to Consumption
and Savings

Traditional life-cycle model: The life-cycle hypothesis is
strongly based on expected utility theory and assumes
that people are rational i.e. they tend to spend and
save money in a rational manner and do not suffer from
self-control bias as they prefer to achieve long-term
goals rather than short-term goals.
Behavioral life-cycle theory: The behavioral life-cycle
theory considers self-control, mental accounting, and
framing biases and their effects on the
consumption/saving and investment decisions.
Mental accounting bias: According to the behavioral
life-cycle theory, people treat components of their
wealth as “non-fungible” or non-interchangeable i.e.
wealth is assumed to be divided into three “mental”
accounts i.e.
i. Current income
ii. Currently owned assets
iii. Present value of Future income
Marginal propensity to spend (consume)or save varies
according to the source of income e.g.
• Marginal Propensity to spend tends to be greatest for
current income and least for future income.
• Marginal propensity to save tends to be greatest for
future income and least for current income.
• With regard to spending from currently owned
assets, people consider their liquidity and maturity
i.e. short-term liquid assets (e.g. cash and checking

accounts) are spent first while long-term assets (e.g.
home, retirement savings) are less likely to be
liquidated.
• It is important to note that any current income that is

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saved is re-classified as current assets or future
income.
Framing: Framing bias refers to the tendency of
individuals to respond differently based on how
questions are asked (framed).
Self-control: It is the tendency of an individual to
consume today (i.e. focus on short-term satisfaction) at
the expense of saving for tomorrow (i.e. long-term
goals).
4.3.2) A behavioral Approach to Asset Pricing
Behavioral stochastic discount factor-based (SDF-based)
asset pricing model: It is a type of behavioral asset
pricing model.
• According to this model, asset prices reflect
investor’s sentiments relative to fundamental value.
• Sentiments refer to the erroneous beliefs or
systematic errors in judgment about future cash flows
and risks of asset.
Risk premium in the behavioral SDF-based model: In the
behavioral SDF-based model, risk premium is composed
of two components i.e.
Risk premium = Fundamental risk premium + Sentiment
risk premium

In the behavioral SDF-based model, dispersion of
analysts’ forecasts serves as a proxy for the sentiment risk
premium as it represents a source of risk (e.g. a
systematic risk factor) that is not captured by other
factors in the model.
• It has been observed that there is an inverse
relationship between the price of the security and
the dispersion among analysts’ forecasts i.e.
o The greater (lower) the dispersion
the higher
(lower) the sentiment premium
the greater
(lower) the risk premium,
the higher (lower) the
discount rate* (required rate of return) and thus
the lower (higher) the perceived value of an asset.
• A low dispersion is associated with a consensus
among the analysts and investors on firms’ future
prospects and more credible information.
• It is evidenced that dispersion of analyst’ forecast is
statistically significant in a Fama-French multi-riskfactor framework i.e. the dispersion of analysts’
forecasts is greater for value stocks; thus, return on
value stocks is higher than that of growth stocks.
*Discount rate or Required rate of return in the behavioral
SDF-based model: In the behavioral SDF-based model,
discount rate is composed of three components i.e.
Discount rate OR required rate of return =
Risk free rate (reflecting time value of money) +
Fundamental risk premium (reflecting efficient prices) +
Sentiment risk premium (reflecting sentiment-based risk)

Reading 5

The Behavioral Finance Perspective

• When the subjective beliefs of an investor about the
discount rate are the same as that of traditional
finance, the investor is said to have zero sentiment.
o When sentiment is zero
market prices will be
efficient i.e. prices will be the same as prices
determined using traditional finance approaches.
• When the subjective beliefs of an investor about the
discount rate are different from that of traditional
finance, the investor is said to have non-zero
sentiment.
o When sentiment is non-zero
market prices will be
inefficient (or mispriced) i.e. prices will deviate from
prices determined using traditional finance
approaches.
Important to Note: It must be stressed that investors can
earn abnormal profits by exploiting sentiment premiums
only if they are non-random in nature i.e. systematically
high or low relative to fundamental value; otherwise, it
may not be possible to predict them and thus, mispricing
may persist.
4.3.3) Behavioral Portfolio Theory (BPT)
BPT versus Markowitz’s portfolio theory:

• BPT uses a probability-weighting function whereas
the Markowitz’s portfolio theory uses the real
probability distribution.
• The optimal portfolio of a BPT investor is constructed
by identifying the portfolios with the highest level of
expected wealth for each probability that wealth
would fall below the aspiration level (i.e. a safety
constraint).The BPT optimal portfolio may not be
mean-variance efficient.
• In contrast, the perfectly diversified portfolio of
Markowitz is constructed by risk-averse investors by
identifying portfolios with the highest level of
expected wealth for each level of standard
deviation.
• Under BPT, investors treat their portfolios not as a
whole, as prescribed by mean-variance portfolio
theory, but rather as a distinct layered pyramid of
assets where
o Layers are associated with goals set for each layer
i.e. bottom layers are designed for downside
protection, while top layers are designed for
upside potential.
o Attitudes towards risk vary across layers i.e.
investors are more risk-averse in the downside
protection layer whereas less risk-averse in the
upside potential layer. In contrast, mean-variance
investors have single attitude toward risk.
The BPT optimal portfolio construction is composed of
following five factors:
1) The allocation of funds among layers depends on the

degree of importance assigned to each goal i.e.
• If high importance is assigned to an upside potential
goal (downside protection goal), then the allocation
of funds to the highest upside potential layer (lowest

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downside protection layer) will be greater.
2) The asset allocation within a layer depends on the
goal set for the layer i.e.
• If the goal is to earn higher returns, then risky or
speculative nature assets will be selected for the
layer.
3) The number of assets chosen for a layer depends on
the shape of the investor’s utility function or risk
attitude i.e.
• The greater (lower) the concavity or the higher
(lower) the risk-aversion, the greater (smaller) the
number of securities included in a layer, reflecting a
diversified (concentrated or non-diversified)
portfolio.
4) The optimal portfolio of a BPT investor may not
necessarily be well-diversified. For example, when
investors believe to have informational advantage
with respect to the securities, they may tend to hold a
concentrated portfolio composed of those few
securities.
5) Higher loss-averse investors may allocate higher
amount to the lowest downside protection layer (i.e.
may hold cash or invest in riskless assets) and may

tend to suffer from loss-aversion bias.

Practice: Example 3,
Volume 2, Reading 5.

4.3.4) Adaptive Markets Hypothesis (AMH)
The AMH is a revised version of the efficient market
hypothesis and it attempts to reconcile efficient market
theories with behavioral finance theories.
The Adaptive Markets Hypothesis implies that the degree
of market efficiency and financial industry evolution is
related to environmental factors that shape the market
ecology i.e. number of competitors in the market, the
magnitude of profit opportunities available, and the
adaptability of the market participants.


Reading 5

The Behavioral Finance Perspective

According to the AMH, success depends on the ability
of an individual to survive rather than to achieve highest
expected utility.
The AMH is based on the following three principles of
evolution:
1) Competition: The greater the competition for scarce
resources or the greater the number of competitors in
the market, the more difficult it is to survive.
Competition drives adaptation and innovation.

2) Adaption: Individuals make mistakes, learn and
adapt. The less adaptable the market participants
under high competition circumstances and changing
environment conditions, the lower the likelihood of
surviving.
3) Natural selection: Natural selection shapes market
ecology.
Five implications of the AMH:
1) The equity risk premium varies over time depending
on the recent stock market environment and the
demographics of investors in that environment e.g.
changes in risk preferences, competitive environment
etc.
• E.g. risk aversion may decrease with an increase in
competition among market participants.

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2) Arbitrage opportunities do arise in the financial
markets from time to time which can be exploited
(e.g. by using active management) to earn excess
returns (i.e. alpha).
3) Any particular investment strategy will not consistently
do well; this implies that any investment strategy
experiences cycles of superior and inferior
performance in response to changing business
conditions, the adaptability of investors, number of
competitors in the industry and the magnitude of
profit opportunities available.
4) The ability to adapt and innovate is critically essential

for survival.
5) Survival is ultimately the only vital objective.

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


Reading 2

Guidance for Standards I–VII

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FinQuiz.com
CFA Level III Item-set - Solution
Study Session 1
June 2017

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Reading 2

Guidance for Standards I–VII

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FinQuiz Level III 2017 – Item-sets Solution
Reading 2: Guidance for Standards I–VII
1. Question ID: 10529
Correct Answer: A
Standard II (A) Material Nonpublic Information prohibits members/candidates who possess material
nonpublic information, which could affect the value of the security, from act or causing others to
act/trade on the information. Information is considered to be nonpublic until it has been publically
made available in the marketplace. This standard does not prohibit members/candidates to use items
of non-material or material and public information to form an opinion regarding a potential corporate
action. This holds true even if the member/candidate’s analysis leads him/her to producing
conclusions which comprise of material nonpublic information. This is termed as the mosaic theory.
By using his observations of Y.T. Automobiles’ production site to produce his conclusion, Webber
has not violated this standard (with the information obtained from the observations constituting items
of material, public information as well as non-material non-public information). This holds true
despite the fact that Webber used the information to conclude that the manufacturer could be at risk of
being acquired in a takeover or could file for bankruptcy (which itself can be considered material
nonpublic information that investors would like to know). Furthermore the discussions with industry
experts and representatives from different manufactures as well as the industry information used as
part of the analysis do not violate this standard. In short, Webber has used mosaic theory to arrive at
his conclusion and has thus not violated this standard.
Standard V (A) Diligence and Reasonable Basis requires members and candidates to exercise
thoroughness, independence, and diligence when conducting investment analysis, making investment
recommendations and taking investment action. Additionally the standards require members to have a
reasonable and adequate basis supported by an appropriate level of research and thorough
investigation. Webber’s conclusion is backed by thorough research and investigation and is thus in
compliance with this standard.
2. Question ID: 10530
Correct Answer: C
Standard II (B) Market Manipulation prohibits members and candidates from “engaging in practices

that distort prices or artificially inflate trading volume with the intent to mislead market participants.”
Transactions that artificially distort prices or volume to give the impression of activity or price
movement in a financial instrument reflect violations.
By transferring stocks, possessing a low level of liquidity, from the distressed fund to the developed
equity fund, Bridges has violated this standard. This is because he has transferred stocks to the latter
fund to artificially increase the demand for these stocks. Although this action has been done to
improve the value of stocks which may benefit potential investors, such an activity deceives potential
investors into believing the stocks they are buying are highly liquid and attractively priced.
Standard III (C) Suitability requires members and candidates, in advisory roles, to make a reasonable
inquiry into the client’s investment experience, risk and return objectives, and financial constraints
and must reassess and update this information regularly. The standard also requires recommending
investments and taking investment actions which are consistent with the client’s financial constraints,

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Guidance for Standards I–VII

Reading 2

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risk and return objectives, constraints, and written mandates. Additionally members/candidates must
judge the suitability of the investment in the context of the client’s total portfolio.
The process of transferring securities from the former to the latter fund does not violate this standard
as these stocks are not owned by any clients nor recommended at the time of the transfer.
3. Question ID: 10531
Correct Answer: A
Webber has described distressed securities as possessing a low level of liquidity. In addition such
stocks of distressed companies are generally highly risky and require a long-term investment horizon.

These securities are suitable for those investors with high risk tolerances; sufficient liquidity
reserves/low liquidity requirements; and an intermediate to long-term investment horizon making
them capable of tolerating the associated risks.
Based on standard III (C) Suitability’s requirements, recommending these stocks to client categories
A, B and E violate this standard. This is because:
client category A has a short-term time horizon, significant liquidity requirements, and a low risk
tolerance level;
client category B has significant liquidity requirements;
client category E has a below average risk tolerance; making such an investment highly
unsuitable for all three categories.
Additionally by sending out the recommendation to existing clients only as opposed to suitable
prospective clients and existing clients, standard III (B) Fair Dealing has been violated. This standard
requires members and candidates to deal fairly with clients when disseminating investment
recommendations and in their professional activities.
4. Question ID: 10532
Correct Answer: C
All the three client categories to receive the recommendation should not have received such an
investment recommendation (see the solution to Part 3(10531)).
5. Question ID: 10533
Correct Answer: B
Standard III (D) Performance Presentation requires members and candidates to make every
reasonable effort to ensure that the performance they present is fair, accurate, and complete. Members
and candidates should not mislead clients by misrepresenting their past performance or reasonably
expected future performance.
By presenting the performance attained by Emerson at Denver Associates as being attained at Holler
and Brookes Associates, the advertisement has violated this standard.
Standard V (C) Record Retention requires members and candidate to “develop and maintain
appropriate records to support their investment analysis, recommendations actions and other
investment related communications with clients and prospects.” This standard is not relevant in the
context of the advertisement.

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Guidance for Standards I–VII

Reading 2

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Standard VII (B) Reference to CFA Institute, the CFA Designation, and the CFA Program requires
members and candidates to avoid misrepresenting or exaggerating the “meaning or implications of
membership in CFA institute, holding the CFA designation or candidacy in the CFA Program.”
Additionally, there is no such thing as a partial designation.
Forecasting that Emerson will successfully complete and pass the Level III examinations violates this
standard. Additionally indicating that Emerson will achieve the completion status following the
upcoming June examinations violates this standard as there is no such designation.
6. Question ID: 10534
Correct Answer: B
The code of ethics requires members and candidates to:
Act with integrity, competence, diligence, respect, and in an ethical manner with the public,
clients, prospective clients, employers, employees, colleagues in the investment profession, and
other participants in the global capital markets.
Place the integrity of the investment profession and the interests of clients above their own
personal interests.
Use reasonable care and exercise independent professional judgment when conducting investment
analysis, making investment recommendations, taking investment actions, and engaging in other
professional activities.
Practice and encourage others to practice in a professional and ethical manner that will reflect
credit on themselves and the profession.

Promote the integrity of and uphold the rules governing capital markets.
Maintain and improve their professional competence and strive to maintain and improve the
competence of other investment professionals.
The requirement that members and candidates/investment professionals must exercise diligence,
independence, thoroughness and independence when analyzing investments, making
recommendations or taking investment actions is covered by the CFA Institute’s Standards of
Professional Conduct [Standard V (A) Diligence and Reasonable Basis].
7. Question ID: 10543
Correct Answer: B
When managing accounts to a specific mandate, strategy or investment style, the CFA Institute
Standards of Professional Conduct require members and candidates to, “make investment
recommendations or take investment actions that are consistent with the stated objectives and
constraints of the portfolio.’
Based on the investment policy of Grace Incorporated’s pension plan, Peltier will need to assure he
does not make allocations to growth stocks, and chooses securities which bring industry
diversification (belongs to industries distinct from Grace Incorporated) and are securities of stable
companies.
Based on the data provided, Peltier should ignore stock B altogether as it belongs to the same industry
as the surgical manufacturer.
Peltier cannot choose stock A as its high P/E and P/B ratio (11.2 and 13.4, respectively) indicate it is
a growth stock. Similarly the high projected EPS growth further confirm that it is a growth stock.
Thus Peltier should not consider stock B for inclusion to the plan’s investment account.

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Reading 2

Guidance for Standards I–VII

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Peltier may select stock C for inclusion into the plan’s investment account. The low P/E ratio and
high P/B ratios (3.8 and 13.6, respectively) indicate the stock is a balanced stock. Additionally, stock
C belongs to the automobile manufacturing industry which indicates it will bring industry
diversification to the plan’s account. By allocating stock C to the investment account, Peltier does not
violate the standards.
Thus by selecting stock B for the plan’s investment account, Peltier has violated standard III(C)
Suitability as he has not followed the plan’s mandate pertaining to industry diversification.
8. Question ID: 10544
Correct Answer: A
Standard III (B) Fair Dealing requires members and candidates “to deal fairly and objectively with all
clients when providing investment analysis, making investment recommendations, taking investment
action, or engaging in other professional activities.” By allocating 80% of the purchased shares to
suitable client accounts, Lawson has not violated this standard. However by not allocating the 20%
portion to interested clients and holding them back for an eight-month period, Lawson has violated
this standard as she has denied the interest clients of these oversubscribed corporation shares.
Standard III (C) Suitability requires members and candidates to make a reasonable inquiry into the
client’s circumstances, risk and return objectives and financial constraints prior to making any
investment recommendation or taking investment action, determining whether the investment is
suitable to the client’s financial situation and consistent with the client’s written objectives, and
judging the suitability of investments in the context of the client’s total portfolio. There is nothing in
the case which indicates Lawson has violated the standard.
There is nothing to indicate that standard III (A) Loyalty, Prudence and Care has been violated.
Additionally standard VI (B) Priority of Transactions requires members and candidates to place
investment transactions of clients and employers ahead of transactions in which a member and
candidate is the beneficial owner. By depositing 20% of the oversubscribed corporation’s shares in
her account for a period of eight months, instead of the investment accounts of interest clients,
Lawson is benefitting from any potential increase in the stock’s value.
9. Question ID: 10545

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

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Reading 2

Guidance for Standards I–VII

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expected to create a conflict of interest with their employer’s interest unless they obtain written
consent from all parties involved. Unless Lawson does not obtain consent for the trip, she will violate
this standard. She has informed her employer, MIA, of the offer and thus does not violate this
standard.
10. Question ID: 10546
Correct Answer: A

Standard II (A) Material Nonpublic information prohibits members and candidates from trading on
material non-public information or causing others to trade on such information.
A problem with the source code of a software development corporation’s major product line is a piece
of material information. However it is not necessary that the problem may lead to the discontinuation
of the corporation’s major product line and result in a drop in forecasted product revenues. The two
retirees are merely speculating and sharing this information with others (either with his friend or
fellow portfolio manager) does not result in Brewer violating this standard.
11. Question ID: 10547
Correct Answer: C
Standard III (C) Suitability requires members and candidates to make investment recommendations
and take investment actions which are consistent with the client’s investment account and risk and
return objectives as well as constraints. However members and candidates can only make suitable
investment recommendations or take investment actions provided clients are forthcoming in
providing the relevant information to their portfolio managers.
The chief investment officer's claims are not valid. This is because the officer has not prohibited the
portfolio manager from avoiding emerging market stocks. Additionally, the chosen stocks meet the
socially responsible criteria. Thus by including such stocks, Brewer has not violated this standard.
Additionally, Brewer has not violated III (B) Fair Dealing.
12. Question ID: 10548
Correct Answer: C
Standard IV (C) Responsibility of Supervisors requires members and candidates to prevent and detect
any violations of the codes and standards, laws, rules and/or regulations by anyone subject to their
supervision or authority.
As the portfolio manager of The Senior Citizen Endowment’s portfolio, Brewer has not violated any
standards (See the solution to Part 5). Thus there are no violations which Peltier need to prevent
and/or detect. Thus as supervisor he has not violated this standard.
Standard III (C) Suitability is not relevant in this context.

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Reading 2

Guidance for Standards I–VII

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13. Question ID: 10557
Correct Answer: C
Standard II (A) Material Nonpublic Information prohibits members and candidates, “who possess
material nonpublic information that could affect the value of the security, from taking action on it or
causing others to take action on the information.” Although the information on the G&J’s expansion
plans may be material and nonpublic, the discussion between Sutton and Mullins does not violate this
standard as no effort was made to act or cause someone to act on the information.
Standard III (E) Preservation of Confidentiality requires members and candidates to keep information
about current, former, and/or prospective clients confidential unless the client permits disclosure;
disclosure is required by law; or the information concerns illegal activities on part of the client. As the
investment banker of G&J, Sutton has the obligation to preserve the confidentiality of any
information received on his client’s expansion plans, which he has exclusively received. Thus by
sharing these plans with Mullins, he has violated this standard.
Standard IV (C) Responsibility of Supervisors requires members and candidates to make reasonable
efforts to prevent and detect any violations of any applicable laws, codes and standards, rules and
regulations by anyone subject to their supervision or authority. This responsibility includes
implementing adequate compliance procedures, making reasonable efforts to ensure these procedures
are monitored and enforced. By implementing a structure to control the interaction between the two
departments (investment banking and investment counseling/management departments) and not
monitoring the effectiveness of the structure nor ensuring the flow of information between the
departments is limited, Herrera as a senior compliance officer has violated this standard.
14. Question ID: 10558
Correct Answer: A

Standard I (B) Independence and Objectivity requires members and candidates to use reasonable care
and judgment to achieve and maintain independence and objectivity in their professional activities.
Any recommendations should be independently arrived at. If investment recommendations are made
following instructions, which conflict with the member/candidate’s recommendations, the member or
candidate is in violation of this standard.
The best action for Mullins to undertake would be to develop a research report and conclude it with a
recommendation solely based on his analysis of G&J’s future prospects. Since Mullins believes
G&J’s expansion plans may not succeed, he will probably produce a different recommendation to the
buy recommendation instructed by Herrera.
15. Question ID: 10559
Correct Answer: B
Standard III (A) Loyalty, Prudence and Care requires members and candidates to act for the benefit of
their clients and place client interests first. The standard also requires members and candidates to
maintain their duty of loyalty to their clients, act with reasonable care, and exercise prudent judgment.
In the course of their duty to their clients members and candidates should seek best price and
execution.
Although Mace Brokerage charges fees higher than the existing broker, the access to global and local
research as well as higher execution speed (relative to the current broker) justify the fees. Thus by
appointing Mace Brokerage, Delgado will not be violating this standard but instead will be providing
Mighty-You Inc. with greater benefits (i.e. execution).

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Reading 2

Guidance for Standards I–VII

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Although Harold and Haroon Associates charges fees lower than the existing broker the execution
speeds are relatively slower. Additionally the firm provides access to local research only. Thus the
relatively slow execution speed makes this broker unsuitable for Mighty-You Inc. Thus the
appointment of this broker-candidate will violate the standard in question as Delgado will not be
providing its client with best execution.
16. Question ID: 10560
Correct Answer: B
Standard III (C) Suitability requires members and candidates, in an advisory relationship, to make
investment recommendations which are suitable to the individual client’s financial situation, risk and
return objectives, and written investment mandates. Additionally, members and candidates must
judge the suitability of the investment in the context of the total client portfolio.
There is a lack of sufficient evidence which may suggest that the firm may have conducted a
suitability analysis prior to implementing the derivative strategy on a portion of the client portfolios.
It is possible that such a strategy may not be suitable for or may be expressly prohibited by some
clients. Thus by implementing a derivative strategy, the firm has violated this standard.
Standard V (A) Diligence and Reasonable Basis requires members and candidates to “have a
reasonable and adequate basis, supported by appropriate research and investigation, for any
investment analysis, recommendation or action.” The volatility of the national market, which in turn
has substantially increased the risk of several securities in client portfolios, justifies the use of
derivative to offset these risks. Thus this standard has not been violated.
Under Standard V (B) Communication with Clients and Prospective Clients, member and candidates
must disclose to clients the basic format and general principles used to analyze investments, select
securities and construct portfolios and promptly disclose any material changes to the processes. By
delaying the notification to clients (regarding the inclusion of derivatives in their portfolios) for a
period of one month, this standard has been violated.
17. Question ID: 10561
Correct Answer: A
Policy 1:
Standard II (A) Material Nonpublic Information requires members and candidates to establish a
firewall between the investment banking and investment research divisions to prevent the flow of

material nonpublic information. Interdepartmental communication must preferably pass through a
clearance area within the firm in either the compliance or legal department. Allowing unsupervised
communication between the two departments (investment banking and counseling, in the firm’s case)
makes Policy 1 inconsistent with this CFA Institute Standards of Professional Conduct standard.
Policy 2:
Standard III (A) Loyalty, Prudence and Care requires members and candidates to vote proxies in the
best interests of clients and their ultimate beneficiaries as well as to vote proxies in an informed and
responsible manner. A fiduciary who votes blindly with management on non-routine governance
issues violates this standard. Due to cost and benefits, it is not necessary to vote all proxies. Policy 2
is not consistent with this standard as it does not call for voting in the best interests of clients and
ultimate beneficiaries. This is because the policy calls for taking into account any benefits to the firm,
in addition to clients’ benefits, and ignores the benefits to beneficiaries (accruing to them as a result
of the votes cast). In addition, the policy requires votes to be cast in line the firm’s management

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Reading 2

Guidance for Standards I–VII

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which hampers the member/candidate’s ability to cast his or her vote in the best interests of its clients
and ultimate beneficiaries.
Policy 3:
Under Standard V (C) Record Retention members and candidates are required to develop and
maintain appropriate records to support their investment analysis, recommendation, actions and other
investment related communications with clients and prospective clients. In the absence of any
regulatory requirements, the CFA Institute recommends a holding period of at least seven years. By

complying with local record retention regulations, policy 3 is consistent with this standard.
18. Question ID: 10562
Correct Answer: A
By allocating highly risky securities to the investment portfolios of his risk-averse clients (which
require less risky securities), Strickland has clearly violated the standard, III (C) Suitability.
Additionally, Strickland’s statement does not justify the addition of these securities to the portfolios.
The expected decrease in market and securities’ volatility is merely a prediction which may not
materialize after the quoted six-month period. Thus by basing the purchase decision on a mere
prediction of a market factor, Strickland has violated the standard V (A) Diligence and Reasonable
Basis.
There is nothing which may suggest Strickland has been dishonest or engaged in fraudulent practices
adversely affected his professional reputation, integrity or competence. Thus Strickland has not
violated standard I (D) Misconduct.
Strickland has not violated Standard I (C) Misrepresentation nor has he violated standard III (A)
Loyalty, Prudence and Care. The justification statement does not guarantee the volatility will fall
from its current levels, but instead uses the term ‘projected’ which implies Strickland has not
guaranteed any expected performance and thus has not violated standard III (D) Performance
Presentation.
19. Question ID: 10571
Correct Answer: A
Standard VI (A) Disclosure of Conflicts requires members and candidates “to make full and fair
disclosures of all matters that could reasonably be expected to impair their independence and
objectivity or interfere with their respective duties to their clients, prospective clients, and their
employer.” The disclosures need to be prominent, delivered in plain language and communicated
effectively.
Ideally, to avoid the appearance of any conflicts, Howell should not be asked to cover a company
with which he may be affiliated. Howell’s family relationship with H.O. Zone’s executive director
must be disclosed in his research report as well as to his employer, Trinity Associates. Without taking
any steps to minimize this potential conflict and failing to make the relevant disclosures to clients,
prospective client and to his employer, Howell has violated this standard.

Standard II (A) Material Nonpublic Information requires members and candidates who possess
material nonpublic information, which has the potential to affect the value of a security, from acting
or causing others to act on the information. There is lack of evidence to suggest that Howell may have
not independently arrived at a buy recommendation or used insider information to arrive at the
recommendation. A mere speculation by Thackeray does not necessarily mean Howell has used

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Reading 2

Guidance for Standards I–VII

FinQuiz.com

insider information. Additionally by using the recommendation, Thackeray has not violated this
standard (due to the uncertainty of the information being acquired from insider resources or not).
Standard V (A) Diligence and Reasonable Basis requires members and candidates to “have a
reasonable and adequate basis, supported by appropriate research and investigation, for any
investment analysis, recommendation or action.” Additionally when using secondary research it is
necessary to make reasonable and diligent efforts in evaluating the objectivity and independence of
the recommendations; reviewing the assumptions used, the rigor of analysis performed, and the
date/timeliness of the research.
The question of whether Howell may have arrived at his buy recommendation using insider sources
remains. Without thoroughly evaluating the independence and/or objectivity of the recommendations
and relying on the recommendation Thackeray has violated this standard.
20. Question ID: 10572
Correct Answer: A
Standard I (C) Misrepresentation prohibits members and candidates from knowingly making any
misrepresentations relating to investment analysis, recommendations, actions or other professional

activities in oral or written communications. The standard requires members and candidates to
identify or acknowledge the source of ideas or material that is not their own. Additionally it is
necessary to cite all sources which are used to develop research reports and work products (other than
those obtained from recognized statistical and financial reporting sources).
Although Byrd’s model has been considerably modified from the model developed by the
pharmaceutical chief industry executive, Byrd should acknowledge the fact that his model’s structure
was inspired by the latter model and continues to use the same factors as those employed by the latter
model. By not doing so and marketing the model as his own, he has violated the standard.
According to this standard, Byrd must cite the annual industry forecasts obtained from discussions
with industry experts but not the industry reports published by the local government agency in his
research report.
21. Question ID: 10573
Correct Answer: B
Standard VII (B) Reference to CFA Institute, the CFA Designation, and the CFA Program requires
members and candidates to avoid misrepresenting or exaggerating the “meaning or implications of
membership in CFA institute, holding the CFA designation or candidacy in the CFA Program.”
Additionally, there is no such thing as a partial designation.
The newsletter has accurately referred to Terry and Sosa as CFA Level III candidates. However by
stating that Terry will attain a ‘Passed Finalist’ status, the newsletter has incorrectly referenced
Terry’s candidacy in the CFA Program and this reflects a violation of this standard. This is because
there is no such status.
22. Question ID: 10574
Correct Answer: C
Standard I (D) Misconduct prohibits members and candidates from engaging in any professional
conduct involving fraud, deceit, dishonesty or committing any act that reflects adversely on their
professional reputation, integrity or competence. By assuring McFadden that the financial

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Reading 2

Guidance for Standards I–VII

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consultancy department will provide the required tax consultancy services when the firm outsources
such services, Terry has been dishonest with her client and has violated this standard.
Standard II (B) Market Manipulation prohibits members and candidates from engaging in practices
that distort the prices or artificially inflate trading volume with the intent to mislead market
participants. However the standard does not prohibit transactions done for tax purposes. Thus the taxloss harvesting strategy recommended by Terry (selling securities which have fallen in value to offset
the gains on securities which have risen in value) does not violate this standard.
Standard III (A) Loyalty, Prudence and Care requires members and candidates to act in the best
interests of clients, place client interest before their own, use reasonable care, and exercise prudent
judgment when managing the accounts of their clients. As McFadden’s financial consultant, Terry
has acted in his client’s best interests. Thus she has not violated this standard.
Standard I (C) Misrepresentation requires members and candidates to have knowledge of all the
services the firm provides and should recommend where a client can obtain the requisite service
should the firm not be able to provide it. By assuring her client that the firm is able to address her
taxation concerns and is able to provide the necessary consultancy services, Terry has violated his
standard. This is because the firm outsources tax consultancy rather than providing it internally.
Additionally, Terry has misrepresented the tax-loss harvesting strategy by incorrectly stating that it
will help to reduce the portfolio’s taxable base in both the current and future years. In reality, tax-loss
harvesting reduces the portfolio’s taxable basis in the current year to increase it in the future.
23. Question ID: 10575
Correct Answer: C
Practice 1:
Standard IV (A) Loyalty requires members and candidates, in matters related to their employment, to
act in their employer’s best interest and not deprive them of the advantage of their skills and abilities
or cause any harm to their employers. Members/candidates must continue to work in their employer’s

best interest until resignation is effective.
A buyout of the firm’s financial consultancy department by the firm managers does not constitute a
violation of this standard. This is because the firm may choose how to respond to such an action.
Thus practice 1 does not reflect a violation of this standard.
Based on standard VI (A) Disclosure of Conflict’s requirements (see the solution to Part 1), a
meeting between some of the firm’s managers after office hours does not constitute a violation of this
standard.
Thus practice 1 does not reflect any violations of the CFA Institute Standards of Professional
Conduct.
Practice 2:
The portfolio managers have complied with standard III (A) Loyalty, Prudence and Care by using the
brokerage arrangement to obtain high quality research to directly assist the managers in managing the
client portfolio.
Standard IV (B) Additional Compensation Arrangements prohibits member and candidates from
accepting any gift, benefits, compensation or consideration “that competes with or might create a
conflict of interest with their employer’s interest unless they obtain a written consent from all the

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Reading 2

Guidance for Standards I–VII

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parties involved.” The portfolio managers have not received any additional compensation which
would require disclosure under this standard. Thus this standard has not been violated.
Standard VI (C) Referral Fees requires members and candidates to disclose to their employers,
current clients, and prospective clients “any compensation, consideration, or benefit received from, or

paid to, others for the recommendation of products or services.” The firm’s portfolio managers have
referred their clients to their respective broker and have received research in return. This arrangement
must be disclosed to their existing clients and/or any prospects who wish to employ any of these
portfolio managers to manage his/her investment portfolio. By not disclosing the arrangements to
their clients, the portfolio managers have violated this standard.
24. Question ID: 10576
Correct Answer: A
With respect to practice 3, Byrd has violated standard I (C) Misrepresentation. This is because Byrd
should have known about the error in his resume as he has been quoting his experience for several
years. By quoting his experience incorrectly, Byrd has misrepresented his experience with the two
industries and has thus violated this standard.
By incorrectly stated his years of experience, Byrd has not violated standard III (D) Performance
Presentation, which requires members and candidates to make reasonable efforts to ensure that the
performance they present is fair, complete, and accurate. Since the error pertains to his industry
experience as opposed to performance information, Byrd has not violated this standard.
Standard V (C) Record Retention is not relevant in this context and there is a lack of sufficient
evidence to conclude that Byrd has not retained records used to develop research reports and make
recommendations.
25. Question ID: 10585
Correct Answer: B
Standard I (A) Knowledge of the Law requires members and candidates to understand and comply
with all applicable laws, rules and regulations of any government, regulatory organization, licensing
agency, or professional association governing their professional activities. In the event of any
conflict, members and candidates must comply with the stricter of the two: applicable laws or code
and standards.
Standard I (D) Misconduct requires members and candidates to avoid any professional misconduct
that may reflect adversely on their professional reputation, integrity, or competence and encourages
employers to conduct reference checks on potential employees for any past infractions of laws.
The law which is applicable to Riku Associates is the local Shimautanian law as opposed to the
Japanese law applicable to its parent organization. Because employees with past infractions of

securities and/or trading laws of two or more counts are likely to violate such laws again, it is
advisable to avoid hiring such employees. Thus the requirements of the Institutes’ codes and
standards govern [I (D) Misconduct]. Riku Associates must preferably hire employees with a clean
past record.

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Reading 2

Guidance for Standards I–VII

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26. Question ID: 10586
Correct Answer: A
Standard IV (C) Responsibility of Supervisors requires members/candidates to make every reasonable
effort to prevent and detect violations of the laws, rules, regulations, and/or codes and standards by
anyone subject to their supervision or authority. It is permissible to delegate such responsibility but
such delegation does not absolve the member/candidate of his/her responsibilities. By instructing
Sayuki to review Smith’s portfolio after every 18 months, Sayuki has not complied with this standard
as his instructions violate the requirements of III C Suitability (see below). This is because client
portfolios need to be reviewed at least annually and whenever there is a change in client and/or
market conditions. Any reason given to support this review schedule does not justify such a policy.
Standard III (C) Suitability requires members and candidates, who are in an advisory role, to make a
reasonable inquiry into the client’s investment experience, risk and return objectives, investment
constraints and must reassess and update this information regularly. Client portfolios must be
reviewed at least annually and whenever a change in client circumstances and/or market
circumstances occurs. By instructing Lowery to conduct reviews for a period longer than the
minimum 12-month required, for whatever reason, Sayuki has violated this standard. Additionally,

Lowery has also violated this standard as he has conducted the reviews as instructed.
Standard III (A) Loyalty, Prudence and Care does not address client portfolio reviews has not been
violated.
27. Question ID: 10587
Correct Answer: C
Standard III (A) Loyalty, Prudence and Care requires members and candidates to act in their client’s
best interests, to exercise prudent judgment, and use reasonable care. The client’s interests should
always have priority over the firm’s and portfolio manager’s interests. By recommending the sale of a
stock which is harming the client’s portfolio, Lowery has complied with this standard.
Standard III (E) Preservation of Confidentiality requires members and candidates to keep all
information concerning former, current, and prospective clients confidential unless the client permits
disclosure; the disclosure is required by law; or the information pertains to illegal activities on the
part of clients. By sharing information regarding Smith’s portfolio holdings with his family friend,
Lowery has violated this confidentiality standard.
28. Question ID: 10588
Correct Answer: A
Standard II (A) Material Nonpublic Information prohibits members and candidates who possess
material nonpublic information, that could affect they value of a security, from acting or causing other
to take action on the information.
The fact that such information has not yet been disclosed and pertains to the discontinuation of a
product line provides sufficient evidence that this piece of information is material and nonpublic.
Although Conway may discuss this piece of information with his supervisor, Sayuki, his first course
of action should have been to make reasonable efforts to achieve public dissemination of the
information by encouraging Furniture Ltd to make the information public. If Furniture Ltd had
refused to release the information, his next course of action should have been to disclose the
information to his supervisor or compliance department.

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Reading 2

Guidance for Standards I–VII

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However Conway has not made any such efforts and thus has violated this standard.
Standard III (E) Preservation of Confidentiality is not relevant here as the standard covers
confidential client information received by portfolio managers as opposed to the information received
by research analysts on the companies they cover.
29. Question ID: 10589
Correct Answer: C
Standard IV (A) Loyalty requires members and candidates, in matters related to their employment, to
act for the benefit of their employer, and not deprive their employer of the advantage of their skills
and abilities, or otherwise cause harm to their employer. Members and candidates must not take any
actions such as appropriating property for themselves, client lists, or any information or material from
their employer without their permission. Members/candidates must continue to act in their employer’s
interest until resignation is effective.
In Fukui’s case, participating in an online interview does not violate this standard as she is not
disrupting her duties to the firm as an employee. Additionally, since Fukui has not undertaken the
potential job opportunity at Howell S. Erwin Associates, there is no need to disclose the opportunity
to her employer. Thus Fukui has not violated this standard.
Although Gifu has complied with this standard by informing the employer of the job opportunity
before resigning, he has violated this standard with respect to the backups of past firm information
stored on his home computer. In order to avoid violating this standard, he should have removed the
information from his computer before departing Riku Associates or should have received his
employer’s consent to continue to store the information. Even if he believes the information to be
obsolete, Gifu has violated this standard.
30. Question ID: 10590
Correct Answer: A

Standard I (B) Independence and Objectivity requires members and candidates to strive to achieve
and maintain independence and objectivity in all their professional activities. Members/candidates
must not accept gifts, benefits, compensation or consideration which could reasonably comprise their
independence or someone else’s independence and objectivity. Gifts must be disclosed to the
member’s employer whatever the case. Fukui has informed her employer of the offer and has thus not
violated this standard.
Standard III (D) Performance Presentation requires members and candidates to make every
reasonable effort that the performance they present is fair, accurate and complete. By intentionally
increasing the portfolio return by 0.2% (10.0% – 9.8%) when the portfolio actually achieved a return
of 9.8%, Fukui has clearly violated this standard.
Standard IV (B) Additional Compensation Arrangements requires members and candidates not to
accept any gifts, benefits, compensation, or consideration that competes with or might reasonably be
expected to create a conflict of interest with their employer’s interest unless they obtain written
consent from all the parties involved. Furthermore, the standard requires members/candidates to
disclose the nature of the compensation, the approximate amount of compensation and the duration of
the arrangement. A simple description of the location of the underwater farm is not a disclosure which
meets the requirements of this standard. Thus by not disclosing the required details, Fukui has
violated this standard.

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