CFA level I Exam Companion: The Fitch Learning / Wiley Study Guide to Getting the Most Out of the CFA Institute Curriculum

Study Session 1: Ethics and Professional Standards

The big picture

Just as ethics are an important part of investment management, analysis, and research, they are an important part of the CFA examination and curriculum. Included along with ethics are the Global Investment Performance Standards (GIPS), which are principles detailing how performance results are measured and reported.

The ethics section is 15% of the syllabus by weighting, yet is often overlooked by delegates who focus on the calculations later in the syllabus. It is a purely written section mostly testing the CFA Institute professional practice handbook, but the questions are usually scenario based and as such can often be quite tricky.

Whereas ethics comprises 15% of the Level I exam, it is 10% of the Level II and Level III exams. In other words, the effort expended to learn about the Code of Ethics, the Standards of Professional Conduct, and GIPS is well worth it – because you will see it again. And again.

Code of Ethics and Standards of Professional Conduct

Candidates are responsible for not only being able to recite the Code of Ethics and the Standards of Professional Conduct [keywords: describe, state, explain] but also for understanding how the Code and Standards are applied in investment management and research [keywords: demonstrate, distinguish, recommend]. Be sure to practice the application of these to different situations.

Whereas the Code of Ethics provides the broad framework for conduct, the Standards are more specific with respect to how the Code is operationalized for CFA Institute members and CFA candidates. For example, the Code of Ethics states Place the integrity of the investment profession and the interests of clients above their own personal interests, and the Standards expand on III. Duties to Clients with explanations on Loyalty, Prudence, and Care, Fair Dealing, Suitability, Performance Presentation, and Preservation of Confidentiality.

The key to the Code and Standards is to remember:

The Code and Standards apply to both CFA Institute members and CFA candidates

Always put the client, the profession, and one's employer ahead of oneself

Be professional, knowledgeable, and objective

Comply with securities laws

GIPS

The basic idea of GIPS is to facilitate the comparison of investment performance. The beneficiaries of GIPS are investors and investment management firms, with the benefits arising primarily from the clear, understandable, and comparable results. Investment management firms comply on a voluntary basis, but they can also employ a third party to verify their claim on compliance to GIPS. A key element of GIPS is that they form the ethical principles of performance reporting.

Reading 1: Code of Ethics and Standards of Professional Conduct

Learning outcome statements

Knowledge learning outcome statements

1a Describe the structure of the CFA Institute Professional Conduct Program and the process for the enforcement of the Code and Standards

The program is fundamental to the values of the CFA Institute. The key points to note are:

The program is a model for measuring the ethics of investment professionals globally

All members and candidates must abide by the Code and Standards

They are encouraged to notify their employer of this responsibility

Violations of the Code and Standards may result in disciplinary sanctions by the CFA Institute. Sanctions include:

Revocation of membership

Revocation of candidacy in the CFA program

Revocation of right to use the CFA designation

1b State the six components of the Code of Ethics and the seven Standards of Professional Conduct

The Code of Ethics

"Members of CFA Institute and candidates for designation must:

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 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 on 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"

Standards of Professional Conduct

I. Professionalism

A. Knowledge of the Law

B. Independence and Objectivity

C. Misrepresentation

D. Misconduct

II. Integrity of Capital Markets

A. Material Non-public Information

B. Market Manipulation

III. Duties to Clients

A. Loyalty, Prudence, and Care

B. Fair Dealing

C. Suitability

D. Performance Presentation

E. Preservation of Confidentiality

IV. Duties to Employers

A. Loyalty

B. Additional Compensation Arrangements

C. Responsibilities of Supervisors

V. Investment Analysis, Recommendations, and Actions

A. Diligence and Reasonable Basis

B. Communication with Clients and Prospective Clients

C. Record Retention

VI. Conflict of Interest

A. Disclosure of Conflicts

B. Priority of Transactions

C. Referral Fees

VII. Responsibilities as a CFA Institute Member or CFA Candidate

A. Conduct as Members and Candidates in the CFA Program

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

Program

1c Explain the ethical responsibilities required by the Code and Standards, including the sub-sections of each Standard

This simply requires knowledge of the Standards and the Code, ready to apply to scenarios in Reading 2.

Reading 1 sample question

(Answers available here)

The Standard covering Communication with client and prospective clients is least likely to require that:

(A) Analysts distinguish between fact and opinion in their reports

(B) Clients must be informed promptly about any changes to the investment process

(C) Analysts always show at least ten years of historic information in their reports

Reading 2: Guidance for Standards I–VII

Learning outcome statements

Application learning outcome statements

2a Demonstrate the application of the Code of Ethics and Standards of Professional Conduct to situations involving issues of professional integrity

2b Distinguish between conduct that conforms to the Code and Standards and conduct that violates the Code and Standards

2c Recommend practices and procedures designed to prevent violations of the Code of Ethics and Standards of Professional Conduct

The emphasis in this reading is on applying the Standards to situations that members face, rather than being able to recite the Standards from the handbook. As such, spend your review time here with the case studies and examples that are shown throughout the handbook rather than learning the names and numbers of each Standard.

Within each Standard there are several examples of how the Standard would be applied in specific situations. Make sure you understand each example and the rationale for the conclusions reached. There are then plenty of practice questions at the end of the reading that you should complete.

Reading 2 sample question

(Answers available here)

A discretionary fund manager of an equities fund invests new cash received in T-bills. Is this necessarily a breach of the Code and Standards?

(A) Yes, as it is an equities fund

(B) No, as the T-bills may be a temporary investment

(C) No, as the fund manager is only guided towards, not legally bound to, equity investments

Reading 3: Introduction to the Global Investment Performance Standards

Learning outcome statements

Knowledge learning outcome statements

3a Explain why the GIPS standards were created, what parties the GIPS standards apply to, and who is served by the standards

Why were the GIPS standards created?

Global Investment Performance Standards were devised for the following reasons:

The investment community had great difficulty making meaningful comparisons on the basis of accurate investment performance data

Misleading practices hinder comparability

Representative accounts

Reporting only top-performing accounts

Survivorship bias (i.e. ignoring performance of funds that no longer exist)

Presenting an average performance history

Excluding poor-performing portfolios

Varying time periods

Selecting time periods to favor results

Practitioner-driven set of ethical principles

Establish a standardized, industry-wide approach for calculating and presenting historical investment results

Help avoid misrepresentation of performance by investment firms

Who can claim compliance?

Any investment management firm may choose to comply with GIPS

Voluntary compliance

Not typically required by legal or regulatory authorities

Investment firm

Must manage assets

Plan sponsors and consultants

Cannot make a claim of compliance

Can claim to endorse the GIPS

Software vendors

Cannot be compliant

Firm-wide process

Cannot be achieved on a single product or composite

Two options:

Comply or do not comply

Who benefits from compliance?

Benefits two main groups:

1 Investment management firms

2 Prospective clients

Provide reassurance to prospective clients about track record of the investment management firm

Record is complete and fairly presented

Allows global competition for compliant firms

Investors have a greater level of confidence in integrity of performance management

Can more readily compare firms

3b Explain the construction and purpose of composites in performance reporting

Composites

Key concepts:

Required use of composites

An aggregation of discretionary portfolios into a single group that represents a particular investment objective or strategy

Must include all actual, fee-paying discretionary portfolios managed in accordance with the same investment objective or strategy

Firms cannot choose portfolios to include or exclude

Establish criteria on an ex-ante basis (before the fact, not after)

3c Explain the requirements for verification

Verification

Firms are responsible for their claim of compliance and for maintenance of the claim

Firms self-regulate

Firms may voluntarily hire an independent third party to verify claim

Primary purpose

Provide assurance that a firm has adhered to the GIPS on a firm-wide basis

Verification

Entire firm; not on specific composites

Has the firm complied with all the composite construction requirements of GIPS on a firm-wide basis?

Are the firm's processes and procedures designed to calculate and present performance results in compliance with the GIPS standards?

Performed only by qualified independent third parties

Reading 3 sample question

(Answers available here)

Abraham Management was established five years ago and has complied with GIPS in presenting information about the performance of its assets under management for this time. The firm has commissioned its internal audit department to test whether the firm has complied with composite construction criteria firm-wide and has the policies and procedures to calculate performance in accordance with GIPS. It put a note on its marketing materials stating Abraham Management have complied with GIPS standards and have had the compliance verified. Abraham Management is:

(A) in full compliance with GIPS

(B) in violation of GIPS because it has not presented at least ten years' information

(C) in violation of GIPS because the firm cannot provide its own verification

Reading 4: Global Investment Performance Standards

Learning outcome statements

Knowledge learning outcome statements

4a Describe the key features of the GIPS standards and the fundamentals of compliance

4b Describe the scope of the GIPS standards, with respect to an investment firm's definition and historical performance record

4c Explain how the GIPS standards are implemented in countries with existing standards for performance reporting, and describe the appropriate response when the GIPS standards and local regulations conflict

4d Describe the nine major sections of the GIPS standards

Note that the examinable portion of Reading 4 is actually very short. There is a large optional section, denoted with blue lines, that is not examinable. The key to this reading is to memorize the main components of the GIPS framework. These are listed in detail in the early part of the reading before the optional section.

Following the optional section is a set of sample disclosures – these provide an excellent interactive way of committing the GIPS rules to memory.

Reading 4 sample question

(Answers available here)

Ames Capital is a global financial services firm incorporated in the United States of America. Each overseas branch of the firm operates through separate legal entities under the name Ames Capital except for in Europe where the company operates through a single subsidiary called Europa Wealth. Europa Wealth has head offices in Geneva but branches in 15 other European countries. For the purposes of GIPS compliance the definition of the firm includes:

(A) all legal entities called Ames Capital only

(B) all legal entities called Ames Capital and the head office of Europa Wealth

(C) all legal entities called Ames Capital, the head office of Europa Wealth and all of Europa Wealth's branches

Study Session 2: Quantitative Methods: Basic Concepts

The big picture

Investment managers must be prepared to grapple with both valuation and uncertainty, the latter requiring a working knowledge of probability and statistics. The Quantitative Methods segment of the curriculum covers these, plus the topic of technical analysis. With the exception of technical analysis, candidates must be familiar with and understand the underlying concepts [keywords: define, distinguish, identify, explain], but also – and this is most important – apply the many tools and concepts developed in these readings [keywords: calculate, solve, demonstrate]. The majority of the learning outcomes in this topic pertain to the application of these many tools and concepts.

Though candidates are expected to use the time value of money functions in the BAII or the HP12C calculator, knowing the concepts behind the math will help you remember the calculations, verify your answers, and figure out how to work a problem that doesn't fit neatly in the calculator functions.

In addition to being able to calculate the present value and future value of a single amount, an annuity, and a series of uneven cash flows (i.e. net present value), candidates need to be able to solve for the rate of return (i.e. the internal rate of return (IRR)) and must be aware of the potential problems when applying IRR.

Setting the stage for applications of performance measurement in Level II and Level III, candidates must be able to calculate returns, both money-weighted and time-weighted. And setting the stage for returns in the context of fixed income, candidates must be able to calculate different yields: the bank discount yield, the holding period yield, the money-market yield, and the bond-equivalent yield.

The key to mastery of these learning outcomes is practice, practice, practice.

Statistical concepts

Ultimately, when we view market prices or behavior, we look at samples and infer from these samples whether we are looking at a sample mean, comparing means, or looking specifically at a sample variance. Before one can infer anything, there must be an understanding of probability, sampling, and hypothesis testing. You must be able to select the appropriate test statistic to use in a particular situation.

You should recognize that just because something is statistically significant, it does not mean that it is economically significant. For example, a test of a trading rule may produce statistically significant results that are not economically meaningful once you consider transactions costs.

Technical analysis

Despite the emphasis on efficient markets throughout the CFA curriculum, candidates must have a working knowledge of what technical analysis is, be able to identify common indicators from a basic description or from a chart, and be able to describe specific technical analysis approaches. Keep in mind that you don't have to become an expert in technical analysis, but you do need to recognize its existence, know the common approaches, and be able to distinguish it from fundamental analysis.

Reading 5: The Time Value of Money

Quantitative Methods is an important area and the first two readings are particularly crucial. They rely heavily on being familiar with your calculator (although strangely the readings are very careful not to mention calculator use). You can save valuable time by being speedy on your calculator so it is vital you go through the calculator tutorial on the Fitch Learning portal. This is not for normal calculator functions but the time value of money buttons on the third row of the Texas Instruments BAII or the top row for the Hewlett Packard 12C.

In addition this reading looks at interest rate manipulation and jargon, which are important for your understanding of later studies.

Learning outcome statements

Application learning outcome statements

5c Calculate and interpret the effective annual rate, given the stated annual interest rate and the frequency of compounding

It is crucial that you understand these terms and how to calculate one or the other. The assumption about the stated annual interest rate in particular will be used throughout your studies.

Example

A three-year investment has an interest rate (yield) quoted of 6% but interest is paid quarterly:

Compound rate (effective annual rate or EAR) given by:

Notice in Section 3.2, the reading also discusses continuous compounding (i.e. the compounding period is infinitely small). You won't use this much in your studies (derivative valuations at Level II mostly) but you're meant to know it and it might give the odd question. Don't spend too long worrying about it if you're puzzled: it's not worth the time. Using the example above, there is no period rate – we go straight from quoted to EAR:

(ex is a button on your calculator – underneath LN)

It is less common in questions, as it is less useful in practice, but you should be able to see how to go the other way, i.e. from EAR to quoted rate.

Example

5d, e Solve time value of money problems for different frequencies of compounding; calculate and interpret the future value (FV) and present value (PV) of a single sum of money, an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows

There is a good likelihood that you will get some questions on these areas; they are also used elsewhere in the Level 1 syllabus so you will score in Corporate Finance, Fixed Income and Financial Reporting and Analysis as well if you get to grips with this.

There are lots of examples in the reading to take you through this, and it is a good idea to make sure you follow the numbers used to demonstrate the techniques, rather than trying to memorize formulae.

An annuity is when we have a series of identical cash flows at regular intervals of time; although we could find the present value by using the formula, it is often easier to use the financial calculator you are allowed in the exam. The reading is careful not to mention calculator use as this might endorse a particular model, but it is crucial you practice these calculations. Our website has a step-by-step guide to using the Texas BAII which will save you time on these questions. It is particularly useful when trying to find the discount rate (I/Y) when we have the cash flows, but we could find PV, FV, periodic cash flow, number of periods or yield, given the other values. The calculator (third row of buttons for these calculations) will easily cope with regular annuities or annuities due by switching between ‘END' and ‘BGN' modes. Without the calculator some of these would be a very longwinded calculation so you must be familiar with how to use it. [Caution: Be sure to toggle back to END when you finish an annuity problem.]

If there are unequal cash flows for a finite number of periods (i.e. not an annuity), we must discount or compound each one individually before adding them. Again, this can be quicker on your calculator using the second row this time. This really comes into its own when trying to find the yield (this is the IRR and comes in the next reading).

Knowledge learning outcome statements

5a, b Interpret interest rates as required rates of return, discount rates, or opportunity costs; explain an interest rate as the sum of a real risk-free rate and premiums that compensate investors for distinct types of risk

This is going to be of more use in Corporate Finance, in which we look at the return investors require. Here it's enough to notice that the return required by any investor is made up of three parts:

The risk premium can be sub-divided into risk relating to:

Default (default risk premium)

Loss if sold quickly (liquidity premium)

Sensitivity of value (maturity risk)

This return required is the rate used by an investor to discount any future cash flows to give the present value. An investor that uses the money for immediate consumption is forgoing this return; it could, therefore, be viewed as an opportunity cost.

5f Demonstrate the use of a timeline in modeling and solving time value of money problems

It's difficult to see how this would be tested in its own right. It's a useful technique to make sure we get the time between cash flows right and hence discount or compound by the correct number of periods.

Reading 5 sample questions

(Answers available here)

1 A repayment mortgage of $120,000 is taken out over 20 years. What is the annual repayment required at the end of each year if the rate of interest is fixed at 6.5%?

(A) $6,390.00

(B) $10,111.13

(C) $10,890.76

2 Jennifer takes out a 25-year loan for $10,000. The loan is repayable via 25 annual installments, due at the year end. The interest on the loan is 6% per annum. Which of the following is closest to the interest due for the second year and the amount of the loan outstanding at the end of the second year?

(A) $589 and $9,625 respectively

(B) $600 and $9,818 respectively

(C) $782 and $9,625 respectively

Reading 6:Discounted Cash Flow Applications

This carries on from Reading 5 and looks at the present value and yield of an investment with uneven cash flows. Again, the calculator is crucial (the second row this time) and again the reading makes no mention of it (calculating the IRR without the calculator would be a nightmare).

The money-weighted and time-weighted rates of return are favorite exam topics (and are used in later levels) so you should make sure you can both calculate them and remember which is which.

Learning outcome statements

Application learning outcome statements

6a, b Calculate and interpret the net present value (NPV) and the internal rate of return