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Discounted Cash Flow Applications
#analyst #has-images #notes #quantitative-methods-basic-concepts

Holding Period Return


When analyzing rates of return, our starting point is the total return, or holding period return (HPR). HPR measures the total return for holding an investment over a certain period of time, and can be calculated using the following formula:

  • Pt = price per share at the end of time period t
  • P(t-1) = price per share at the end of time period t-1, the time period immediately preceding time period t
  • Pt - Pt-1 = price appreciation of the investment
  • Dt = cash distributions received during time period t: for common stock, cash distribution is the dividend; for bonds, cash distribution is the coupon payment.

It has two important characteristics:

  • It has an element of time attached to it: monthly, quarterly or annual returns. HPR can be computed for any time period.
  • It has no currency unit attached to it; the result holds regardless of the currency in which prices are denominated.

Example

A stock is currently worth $60. If you purchased the stock exactly one year ago for $50 and received a $2 dividend over the course of the year, what is your holding period return?

Rt = ($60 - $50 + $2)/$50 = 0.24 or 24%

The return for time period t is the capital gain (or loss) plus distributions divided by the beginning-of-period price (dividend yield). Note that for common stocks the distribution is the dividend; for bonds, the distribution is the coupon payment.

The holding period return for any asset can be calculated for any time period (day, week, month, or year) simply by changing the interpretation of the time interval.

Return can be expressed in decimals (0.05), fractions (5/100), or as a percent (5%). These are all equivalent.

Learning Outcome Statements

c. calculate and interpret a holding period return (total return);

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Subject 1. The functions of the financial system
#market-organization-and-structure
Helping People Achieve Their Purposes in Using the Financial System

The financial system helps people:

  • Save money for the future. Saving here means buying notes, CDs, bonds, stocks, mutual funds or real estate assets.
  • Borrow money for current use. This is the opposite of the first purpose above. Individuals, companies and governments may need money to spend now (consumption, investment, paying taxes, expenses etc).
  • Raise equity capital. Companies can sell ownership rights to raise equity capital they need.
  • Manage risks. People can use financial contracts to offset risks.
  • Exchange assets for immediate (in spot markets) and future (in the futures markets) deliveries.
  • Trade on information. Information-motivated traders can (or they believe they can) use the financial system to earn a return in excess of the fair rate of return because they have information whose value declines over time (as it becomes recognized by other market participants).

Determining Rate of Return

The price in the financial system is the rate of return. It is the interaction of the broad forces of supply and demand.

There are many different prices (rates of return) as there are many different types of assets in the financial system. For example, equities have higher rates of return than T-bills. All of these rates are determined in the financial system.

Prices rapidly adjust to new information. The prevailing price is fair because it reflects all available information regarding the asset.

Capital Allocation Efficiency

In the financial markets investors distinguish good firms from bad firms. This lets the market channel capital to good firms and away from problem firms.

Timely and accurate information is available on the price and volume of past transactions and the prevailing bid-price and ask-price. Such information facilitates the rapid flow of capital to its highest value uses.
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Subject 1. The functions of the financial system
#analyst #market-organization-and-structure
Helping People Achieve Their Purposes in Using the Financial System

The financial system helps people:

  • Save money for the future. Saving here means buying notes, CDs, bonds, stocks, mutual funds or real estate assets.
  • Borrow money for current use. This is the opposite of the first purpose above. Individuals, companies and governments may need money to spend now (consumption, investment, paying taxes, expenses etc).
  • Raise equity capital. Companies can sell ownership rights to raise equity capital they need.
  • Manage risks. People can use financial contracts to offset risks.
  • Exchange assets for immediate (in spot markets) and future (in the futures markets) deliveries.
  • Trade on information. Information-motivated traders can (or they believe they can) use the financial system to earn a return in excess of the fair rate of return because they have information whose value declines over time (as it becomes recognized by other market participants).

Determining Rate of Return

The price in the financial system is the rate of return. It is the interaction of the broad forces of supply and demand.

There are many different prices (rates of return) as there are many different types of assets in the financial system. For example, equities have higher rates of return than T-bills. All of these rates are determined in the financial system.

Prices rapidly adjust to new information. The prevailing price is fair because it reflects all available information regarding the asset.

Capital Allocation Efficiency

In the financial markets investors distinguish good firms from bad firms. This lets the market channel capital to good firms and away from problem firms.

Timely and accurate information is available on the price and volume of past transactions and the prevailing bid-price and ask-price. Such information facilitates the rapid flow of capital to its highest value uses.
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Subject 1. The functions of the financial system
#analyst-notes #market-organization-and-structure
Helping People Achieve Their Purposes in Using the Financial System

The financial system helps people:

  • Save money for the future. Saving here means buying notes, CDs, bonds, stocks, mutual funds or real estate assets.
  • Borrow money for current use. This is the opposite of the first purpose above. Individuals, companies and governments may need money to spend now (consumption, investment, paying taxes, expenses etc).
  • Raise equity capital. Companies can sell ownership rights to raise equity capital they need.
  • Manage risks. People can use financial contracts to offset risks.
  • Exchange assets for immediate (in spot markets) and future (in the futures markets) deliveries.
  • Trade on information. Information-motivated traders can (or they believe they can) use the financial system to earn a return in excess of the fair rate of return because they have information whose value declines over time (as it becomes recognized by other market participants).

Determining Rate of Return

The price in the financial system is the rate of return. It is the interaction of the broad forces of supply and demand.

There are many different prices (rates of return) as there are many different types of assets in the financial system. For example, equities have higher rates of return than T-bills. All of these rates are determined in the financial system.

Prices rapidly adjust to new information. The prevailing price is fair because it reflects all available information regarding the asset.

Capital Allocation Efficiency

In the financial markets investors distinguish good firms from bad firms. This lets the market channel capital to good firms and away from problem firms.

Timely and accurate information is available on the price and volume of past transactions and the prevailing bid-price and ask-price. Such information facilitates the rapid flow of capital to its highest value uses.
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Subject 2. Assets and contracts
#analyst-notes #market-organization-and-structure

There are many different ways one can use to classify assets and contracts. The most common way is to classify them into one of these categories: debts, equities, currencies, derivatives (contracts), commodities, and real estate. In this subject we briefly describe the numerous assets and contracts available and provide a brief overview of each.

Fixed-Income Investments

They have a contractually mandated payment schedule. Their investment contacts promise specific payments at predetermined times. Investors who acquire fixed-income securities are really lenders to the issuers. Specifically, you lend some amount of money, the principal, to the borrower. In return, the borrower promises to make periodic interest payments and to pay back the principal at the maturity of the loan.

Bonds, notes, bills, CDs, commercial paper, repo agreements, loan agreements, and mortgages are examples of fixed-income investments.

Preferred stock is classified as a fixed-income security because its yearly payment is stipulated as either a coupon (e.g. 5% of the face value) or a stated dollar amount. Although preferred dividends are not legally binding as are the interest payments on a bond, they are considered practically binding because of the credit implications of a missed dividend.

Equities

Equities differ from fixed-income securities because their returns are not contractual. They represent residual ownership in companies after all claims - including any fixed-income liabilities of the company - have been satisfied.

Common stocks represent ownership of a firm. Owners of the common stock of a firm share in the company's successes and problems.

A warrant allows the holder to purchase the firm's common stock from the firm at a specified price for a given time period. It provides the firm with future common stock capital when the holder exercises the warrant.

Pooled Investments

Rather than directly buying an individual stock or bond, you may choose to acquire these investments indirectly by buying shares in an investment company that owns a portfolio of individual stocks, bonds, or a combination of the two. People invest in pooled investment vehicles to benefit from the investment management services of their managers. Examples of these pooled investments include money market funds, bond funds, stock funds, balanced funds, etc.

Currencies

The currency market is a worldwide decentralized over-the-counter financial market for the trading of currencies. The market participants include commercial banks, central banks, retail brokers, etc.

Contracts

Financial contracts include the following:

  • Forward contracts allow buyers and sellers to arrange for future sales at pre-determined prices. It is a commitment to buy or sell.
  • Futures contracts are standardized forward contracts guaranteed by clearing house. They are traded on a futures exchange.
  • Swap contracts are derivative securities in the form of agreements between two counterparties to exchange cash flows over a period of time, depending on the values of specified market variables.
  • Options are rights to or sell an underlying instrument at a specified price within a designated time period.

Commodities

Commodities include agricultural products, energy, metals, etc. Commodities complement the investment opportunities offered by shares of corporation that extensively use these raw materials in their production processes.

Real Assets

Real assets include tangible assets such as real estate, airplanes, machinery, or lumber stands. They are often illiquid and have high transaction costs compared to stocks and bonds.
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Subject 3. Financial intermediaries
#analyst-notes #market-organization-and-structure
Financial intermediaries are institutions that function as the line of communication between buyers and sellers in the financial system. Functioning as a middleman, a financial intermediary seeks to match investors who have specific financial goals with investments opportunities that can aid in the achievement of those goals.

Brokers, Exchanges, and Alternative Trading Systems

A broker executes trade orders on behalf of a customer. A block broker helps fill larger orders.

Investment banks help their corporate clients raise capital by issuing shares or bonds. They also help their corporate identify and acquire other companies.

An exchange is like a market where stocks, bonds, options and futures, and commodities are traded. Most exchanges offer different categories of membership and regulate their members' behavior when trading on the exchange. They also regulate the issuers that list their securities on the exchange.

Alternative trading systems (ATSs) are non-exchange trading venues that bring together buyers and sellers of securities. ATSs do not exercise regulatory authority over their subscribers and do not discipline subscribers other than exclusion from trading. For example, an electronic communication network (ECN) connects major brokerages and individual traders so that they can trade directly between themselves without having to go through a middleman. Dark pools are ATSs that don't display the orders which are usually very large.

Dealers

A dealer trades for its own accounts. Individual dealers provide liquidity to investors by trading the securities for themselves. They buy or sell with one client and hope to do the offsetting transaction later with another client.

In practice, most brokerages are in fact broker-dealer firms. That is, as a broker, the brokerage conducts transactions on behalf of clients, and, as a dealer, it trades on its own account.

In the U.S. most broker-dealers must register with the SEC.

Securitizers

Securitization is a structured finance process that distributes risk by aggregating assets in a pool (often by selling assets to a special purpose entity), then issuing new securities backed by the assets and their cash flows. The securities are sold to investors who share the risk and reward from those assets.

In most securitized investment structures, the investors' rights to receive cash flows are divided into "tranches": senior tranche investors lower their risk of default in return for lower interest payments, while junior tranche investors assume a higher risk in return for higher interest.

Financial intermediaries securitize many assets such as mortgages, car loans,, credit card receivables, and banks loans.

Depository Institutions and Other Financial Corporations

They accept monetary deposits from savers and investors, and then lend these deposits to borrowers. Both the depositors and borrowers benefit from the services they provide. Depository institutions also provide other services such as transaction services, credit services, etc.

Insurance Companies

Insurance involves pooling funds from many insured entities (e.g. policyholders) in order to pay for relatively uncommon but severely devastating losses which can occur to these entities. The insured entities are therefore protected from risk for a fee. In other words, risks are transferred from these entities to the insurance company. The insurance company connects customers who want to insure risks with investors who are willing to bear those risks.

Insurance companies make money in two ways:

  • Through underwriting, the process by which insurers select the risks to insure and decide how much in premiums to charge for accepting those risks;
  • By investing the premiums they c
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Subject 4. Positions
#analyst-notes #market-organization-and-structure
A long position is owning or holding securities or contracts. For example, an owner of 100 shares of Apple common stock is said to be "long the stock". Being long indicates an expectation of rising share/contract prices.

A short sale allows investors to profit from a decline in a security's price if they believe the security is overpriced. In this procedure an investor (the seller) borrows shares of stock from another investor (the lender) through a broker and sells the shares. The lender keeps the proceeds of the sale as collateral. Later, the investor (the short seller) must repurchase the shares in the market in order to return the shares that were borrowed (covering the short position) to the lender. If the stock price has fallen, the shares will be repurchased at a lower price than that at which they were initially sold, and the short seller reaps a profit equal to the drop in price times the number of shares sold short.

For options, to be long means you are the buyer of the option. To be short means you are the seller of the option. Since the put option contract holder (long) has the right to sell the underlying to the option writer, he or she is actually short the underlying instrument.

The profit in short selling is limited to the value of the security, but the loss is theoretically unlimited. In practice, as the price of a security rises the short seller will receive a margin call from the broker, demanding that the short seller either to cover his short position (by purchasing the security) or to provide additional cash in order to meet the margin requirement for the security, which effectively places a limit on the amount that can be lost.

Leveraged Positions

Margin transactions occurs when investors who purchases stocks borrow part of the purchase price of the stock from their brokers, and leave purchased stocks with the brokerage firm because the securities are used as collateral for the loan. The interest rate of the margin credit charged by the broker is typically 1.5% above the rate charged by the bank making the loan. The bank rate (called the call money rate) is normally about 1% below the prime rate. The market value of the collateral stock minus the amount borrowed is called the investor's equity.

Investors can achieve greater upside potential, but they also expose themselves to greater downside risk. The leverage equals 1/margin%.

Buying stocks on margin increases the investment's financial risk and thus requires a higher rate of return.

  • Percentage margin. The ratio of the net worth, or "equity value" of the account to the market value of the securities.

  • Maintenance margin. The required proportion of your equity to the total value of the stock. It protects the broker if the stock price declines.

  • Margin call. If the percentage margin falls below the maintenance margin, the broker issues a margin call requiring the investor to add new cash or securities to the margin account. If the investor fails to provide the required funds in time, the broker will sell the collateral stock to pay off the loan.

Example

Suppose an investor initially pays $6,000 toward the purchase of $10,000 worth of stock ($100 shares at $100 per share), borrowing the remaining from the broker. The maintenance margin is set to be 30%. The initial percentage margin is 60%. If the price of the stock falls to $57.14, the value of his stock will be $5,714. Since the loan is $4,000, the percentage margin now is (5,714 - 4,000) / 5714 = 29.9%. The investor will get a margin call.

When investors acquire stock or other investments on margin, they are increasing the financial risk of the investment beyond the risk inherent in the security itself. They should increase their required rate of return accordingly.

R...
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Subject 5. Orders
#analyst-notes #market-organization-and-structure
Orders are instructions to trade. They always specify instrument, side (buy or sell), and quantity.

  • Bid price: the highest price that a buyer wants to pay for the instrument. The best bid is the highest bid in the market.
  • Ask price: the lowest price a seller is willing to accept for the instrument. Also called offer price. The best offer is the lowest in the market.
  • Bid-ask spread: the difference between the best bid and the best offer.

Orders usually also provide several other instructions.

Execution Instructions

They indicate how to fill the order.

Market orders are simple buy or sell orders that are to be executed immediately at current market prices. They provide immediate liquidity for someone willing to accept the prevailing market price.

A limit order is an order that sets the maximum or minimum at which you are willing to buy or sell a particular stock. For instance, if you want to buy stock ABC, which is trading at $12, you can set a limit order for $10. This guarantees that you will pay no more than $10 to buy this stock. Once the stock reaches $10 or less, you will automatically buy a predetermined amount of shares. On the other hand, if you own stock ABC and it is trading at $12, you could place a limit order to sell it at $15. This guarantees that the stock will be sold at $15 or more.

The primary advantage of a limit order is that it guarantees that the trade will be made at a particular price; however, it's possible that your order will not be executed at all if the limit price is not reached.

Traders choose order submission strategies on the basis of how quickly they want to trade, the prices they are willing to accept, and the consequences of failing to trade.

Validity Instructions

They indicate when the order may be filled.

A day order (the most common) is a market or limit order that is in force from the time the order is submitted to the end of the day's trading session.

A good-till-canceled order requires a specific canceling order. It can persist indefinitely (although brokers may set some limits, for example, 90 days).

An immediate-or-cancel order (IOC) will be immediately executed or canceled by the exchange. Unlike a fill-or-killorder, IOC orders allow for partial fills.

An order may be specified on the close or on the open, then it is entered in an auction but has no effect otherwise.

Different types of orders allow you to be more specific about how you'd like your broker to fulfill your trades. When you place a stop or limit order, you are telling your broker that you don't want the market price (the current price at which a stock is trading), but that you want the stock price to move in a certain direction before your order is executed.

With a stop order, your trade will be executed only when the security you want to buy or sell reaches a particular price (the stop price). Once the stock has reached this price, a stop order essentially becomes a market order and is filled. For instance, if you own stock ABC, which currently trades at $20, and you place a stop order to sell it at $15, your order will only be filled once stock ABC drops below $15. Also known as a "stop-loss order", this allows you to limit your losses. However, this type of order can also be used to guarantee profits. For example, assume that you bought stock XYZ at $10 per share and now the stock is trading at $20 per share. Placing a stop order at $15 will guarantee profits of approximately $5 per share, depending on how quickly the market order can be filled.

Stop orders are particularly advantageous to investors who are unable to monitor their stocks for a period of time, and brokerages may even set these stop orders for no charge.

One disadva...
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Subject 6. Primary security markets
#analyst-notes #market-organization-and-structure
The primary markets are those in which new issues of bonds, preferred stock, or common stock are sold by government units, municipalities, or companies to acquire new capital.

  • New issue.
  • Key factor: issuer receives the proceeds from the sale.

Two important rules in the primary capital markets:

  • Rule 415 allows large firms to register security issues and sell them in piecemeal over the following two years. Such issues are called shelf-registration. It allows a single registration document to be filed that permits the issuance of multiple securities.
  • Rule 144A allows corporations (including non-U.S. firms) to place securities privately with large, sophisticated investors. The issuer of a private placement reduces issuing costs because it does not have to complete the extensive registration documents. However, investors will require a higher return since no secondary market exists and thus the liquidity risk is high.

New stock issues are divided into two groups:

  • Initial public offerings (IPOs). These are new shares that a firm offers to the public for the first time. They are typically underwritten by investment bankers through negotiated arrangements (the most common form), competitive bids and best-effort arrangements (investment bankers act as brokers, not taking the price risk).
  • Seasoned equity issues. These are new shares issued by firms that already have stocks outstanding.

A rights issue is an option that a company can opt for to raise capital under a secondary market offering or seasoned equity offering of shares to raise money. It is a special form of shelf offering or shelf registration. With the issued rights, existing shareholders have the privilege to buy a specified number of new shares from the firm at a specified price within a specified time.

Government bond issues are sold at Federal Reserve auctions.
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Subject 7. Secondary security market and contract market structures
#analyst-notes #market-organization-and-structure

The secondary markets permit trading in outstanding issues; that is, stocks or bonds already sold to the public are traded between current and potential owners.

  • Existing owner sells to another party.
  • Issuing firm does not receive proceeds and is not directly involved.

Secondary markets support primary markets.

  • The secondary market provides liquidity to the individuals who acquired these securities, and the primary market benefits greatly from the liquidity provided by the secondary market because investors would hesitate to acquire securities in the primary market if they thought they could not subsequently sell them in the secondary market.

  • Secondary markets are also important to issuers because the prevailing market price of the securities is determined by transactions in the secondary market. New issues of outstanding securities (seasoned securities) in the primary market are based on the prices in the secondary market. Forthcoming IPOs in the primary market are priced based on the prices of comparable stocks in the public secondary market.

Trading Sessions

Securities exchanges differ in when the stocks are traded.

In a call market, trading for individual stocks takes place at specified times. The intent is to gather all the bids and asks for the stock and attempt to arrive at a single price where the quantity demanded is as close as possible to the quantity supplied.

  • This trading arrangement is generally used during the early stages of development of an exchange when there are few stocks listed or a small number of active investors/traders.
  • Call markets also are used at the opening for stocks on the NYSE if there is an overnight buildup of buy and sell orders, in which case the opening price can differ from the prior day's closing price.
  • The concept is also used if trading is suspended during the day because of some significant new information. The mechanism is considered to contribute to a more orderly market and less volatility in such instances because it attempts to avoid major up and down price swings.

In a continuous market, trades occur at any time the market is open. Stocks are priced either by auction or by dealers. In an auction market, there are sufficient willing buyers and sellers to keep the market continuous. In a dealer market, enough dealers are willing to buy or sell the stock.

Please note that dealers may exist in some auction markets. These dealers provide temporary liquidity and ensure market continuity if the market does not have enough activity.

Although many exchanges are considered continuous, they (e.g. NYSE) also employ a call-market mechanism on specific occasions.
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Subject 8. Well-functioning financial systems
#analyst-notes #market-organization-and-structure
Well-functioning financial systems have the following characteristics:

  • Complete markets. The instruments needed to solve investment and risk management problems are available to trade.

  • Liquidity. As asset can be bought and sold quickly (that is, it has marketability, which means an asset's likelihood of being sold quickly.) at a price close to the prices for previous transactions (price continuity), assuming no new information has been received. In turn, price continuity requires depth, which means the numerous potential buyers and sellers must be willing to trade at prices above and below the current market price.

  • Operational efficiency. Low transaction costs (as a percentage of the value of the trade) include the cost of reaching the market, the actual brokerage costs, and the cost of transferring the asset. This attribute is often referred to as internal efficiency.

  • Informational (or external) efficiency. Timely and accurate information is available on the price and volume of past transactions and the prevailing bid-price and ask-price. Prices rapidly adjust to new information; thus the prevailing price is fair because it reflects all available information regarding the asset. Prices will be most informative in liquid markets because information-motivated traders will not invest in information and research if establishing positions based on their analysis is too costly.

A well-functioning financial system promotes wealth by ensuring that capital allocation decisions are well made. It also promotes wealth by allowing people to share the risks associated with valuable products that would otherwise not be undertaken.
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Subject 9. Market regulation
#analyst-notes #market-organization-and-structure
Regulators generally seek to promote fair and orderly markets in which traders can trade at prices that accurately reflect fundamental values without incurring excessive transaction costs. Governmental agencies and self-regulating organizations of practitioners provide regulatory services that attempt to make markets safer and more efficient.

The objectives of market regulation are to:

  • control fraud. Customers may not know how to protect themselves since the financial markets are quite complex.
  • control agency problems. Financial agents often have different goals from their customers. How to effectively measure the services they provide?
  • promote fairness. For example, insider trading is prohibited in most markets as it offends basic notions of fairness.
  • set mutually beneficial standards. Common financial standards allow investors to compare companies easily.
  • prevent undercapitalized financial firms from exploiting their investors by making excessive risky investments.Regulators generally require that financial firms to maintain minimum levels of capital to reduce the probability that these firms will fail and hurt their customers.
  • ensure that long-term liabilities are funded. Insurance companies and pension funds need to maintain adequate reserves to ensure they can pay their liabilities when due.
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Subject 1. Index definition and calculations of value and returns
#analyst-notes #has-images #security-market-indices
A security market index is a means to measure the value of a set of securities in a target market, market segment or asset class. The constituent securities selected for inclusion in the security market index are intended to represent the target market.

There are usually two versions of the same index:

  • The price return takes into account only the capital gain on an investment. A price return index reflects only the prices of the constituent securities. The income generated by the assets in the portfolio, in the form of interest and dividends, is ignored.

    The value of a price return index is calculated as:

    ni: the number of units of security i in the index portfolio.
    Pi: the unit price of security i.
    D: the value of divisor.

  • The total return takes into account not only the capital appreciation on the portfolio, but also the income received. A total return index reflects the prices and the reinvestment of all income received since the inception of the index.

Single Period Returns

The single period price return of an index is the weighted average of price returns of the individual securities:

or,

Since the total return of an index includes price appreciation and income, we need to add the weighted average of income to the above formula to calculate the single period total return:

or,

Multiple-Period Returns

The single period returns should be linked geometrically.

Similarly, to calculate the total return over multiple periods:

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Subject 2. Index construction and management
#analyst-notes #has-images #security-market-indices
The steps to construct and manage a security market index:

  • To construct an index the first decision is to identify the target market. Which market should the index represent?

  • The second decision is to select specific securities to include in the index. How many securities to include? Which ones? The following factors are important:

    • The size: the larger, the better - but eventually the costs of taking a larger sample will outweigh the benefits.
    • The breadth of the sample: the sample must represent the total population.
    • The source of the sample: samples must be taken from each different segment of the population.

  • The third decision is to determine the weight to be allocated to each security in the index (discussed below).

  • When should the index be rebalanced?

  • When should the security selection and weighting decisions be re-examined?

Price Weighting

It is an arithmetic average of current prices. Index movements are influenced by the differential prices of the components.

The weight of each security is calculated using this formula:

The index itself is computed by:

  • Adding up the market price of each stock in the index, then
  • Dividing this total price by the number of stocks in the index: price-weighted series = sum of stock prices / number of stocks in the series.

Example

The shares of firm A sells for $100, and the shares of firm B sells for $25. The initial price index is (100 + 25) / 2 = 62.5. The divisor is therefore 2.

  • Normal situation. Suppose that A increases by 10% to $110, and B increases by 20% to $30, the price index would be (110 + 30) /2 = 70. The rate of return would be: (70 - 62.5) / 62.5 = 12%.
  • Stock split. If A were to split two for one, and its share price were therefore to fall to $50, we would not want the average to fall since that would incorrectly indicate a fall in the general level of market prices. Following a split the divisor must be reduced to a value that leaves the average unaffected by the split. The new divisor is: (50 + 25) / 62.5 = 1.2, which will make the initial value of the average unaffected.

Price-weighting is simple, but a price-weighted index has a downward bias.

  • High-priced stocks have greater impact on the index than low-priced stocks, as the scheme assumes that an investor purchases an equal number of shares for each stock in the index.
  • Large, successful firms consistently lose weight within the index since high-growth companies tend to split their stocks more often. Over time, low growth, small firms with high prices will dominate the index.

Both Dow Jones Industrial Average (DJIA) and Nikkei-Dow Jones Average use this method to weight an index.

Equal Weighting

All stocks carry equal weight regardless of their price or market value. A $1 stock is as important as a $10 stock, and a firm with $200 million market value is the same as one with $200 billion.

The actual movements in the index are typically based on the arithmetic average of the percent changes in price or value for the stocks in the index: each percent change has equal weight. Such an index can be used by individuals who randomly select stock for their portfolio and invest the same dollar amount in each stock.

The weight of each security is calculated using this formula:
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Subject 3. Uses of market indices
#analyst-notes #security-market-indices
Security market indices are used:

  • For predicting future market movements by technicians. Technicians believe past price changes can be used to predict future price movements. For example, to project future stock price movements, technicians would plot and analyze price and volume changes for a stock market series like the DJIA.

  • To measure market rates of return in economic studies.

  • As a proxy for the market portfolio of risky assets. When calculating the systematic risk of an asset, it is necessary to relate its returns to the returns for an aggregate market index that is used as a proxy for the market portfolio of risky assets.

  • As benchmarks to evaluate the performance of professional money managers. A basic assumption when evaluating portfolio performance is that any investor should be able to experience a rate of return comparable to the market return by randomly selecting a large number of stocks from the total market. Therefore, a stock-market index can be used as a benchmark to judge the performance of professional money managers.

  • To create and monitor an index fund or an exchange-traded fund (EFT). An index fund is created to track the performance of the specific market series (index) over time.
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Subject 4. Different types of security market indices
#analyst-notes #security-market-indices
Equity Indices

There are different types of equity indices.

A broad market index represents an entire given equity market. Examples are Russell 3000, Wilshire 5000 Total Market Index, etc.

Local indices of individual countries lack consistency in sample selection, weighting, or computational procedures. Global equity indexes are created to solve this comparability problem. A multi-market index represents multiple security markets. For example, the Dow Jones World Stock Index includes 2,200 companies in 33 countries.

A sector index measures the performance of a narrow market segment, such as biotechnology sector. It can be used to determine if a portfolio manager is good at sector allocation or not. It can also be used to track the performance of sector-specific funds.

Style strategies focus on the underlying characteristics common to certain investments. Growth is a different style than value, and large capitalization investing is a different style than small stock investing. A growth strategy may focus on high price-to-earnings stocks, and a value strategy on low price-to-earnings stocks. Style indices are created to represent such securities.

Fixed Income Indices

The creation and computation of bond-market indices is more difficult than a stock market series.

  • The universe of bonds is much broader than that of stocks.
  • The universe of bonds is changing constantly because of new issues, bond maturities, calls and bond sinking funds.
  • The volatility of prices for individual bonds and bond portfolios changes because bond price volatility is affected by duration, which is changing constantly.
  • Pricing individual bonds is more difficult compared to the current and continuous transactions prices available for most stocks used in stock indexes.

All bond indices indicate total rates of return for the portfolio of bonds, including price change, accrued interest, and coupon income reinvested. They are relatively new and not widely published. Most of indices are market-value weighted.

Bond indices can be categorized based on their broad characteristics, such as type of issuer, currency, maturity and credit rating. For example, there are different indices for government bonds, high-yield bonds, corporate bonds and mortgage-backed securities.

Commodity Indices

There are five major commodity sectors: energy, grains, metals, food and fiber and livestock.

A commodity price index is a fixed-weight index of selected commodity prices, which may be based on spot or futures prices. It is designed to be representative of the broad commodity asset class or a specific subset of commodities, such as energy or metals.

  • Different commodity indices have different weighting methods which result in different risk and return profiles.
  • A commodity index may track commodities directly, or indirectly by tracking futures contracts for certain commodities. For example, commodity indices may track energy products or currencies, or may tracks futures contracts in either of those. For a commodity index that consists of futures contracts on the commodities, the index returns are affected by factors such as the prices of the underlying commodity, risk-free interest rate, and the roll yield.

Real Estate Investment Trust Indices

The types of real estate indices include appraisal indices, repeat sales indices, and REIT indices which track the performance of public traded REITs.

Hedge Funds Indices

There are many indices that track the hedge fund industry. Since hedge funds are illiquid, heterogeneous and ephemeral, it is really hard to construct a satisfactory index.

Funds' participation in an index is voluntary, leading to self-selection bias because those funds that choose to report may not be...
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Subject 1. The concept of market efficiency
#analyst-notes #market-efficency

An efficient capital market is one in which security prices adjust rapidly to the arrival of new information and the current prices of securities reflect all information about the security. Therefore, it is also called an informationally efficient capital market.

Why should capital markets be efficient? Competition is the source of efficiency, and price changes should be independent and random.

  • A large number of competing profit-maximizing participants analyze and value securities, each independently of the others.
  • New information regarding securities comes to the market in a random fashion, and the timing of the announcement is generally independent of others.
  • The competing investors attempt to adjust security prices rapidly to reflect the effect of new information. The price adjustment is unbiased: sometimes the market will over-adjust and other times it will under-adjust, but you cannot prefect its behavior.

In an efficient market, the expected returns implicit in the current price of the security should reflect its risk. Investors buying the security should receive a return that is consistent with the perceived risk of the security.

In an efficient capital market the majority of portfolio managers cannot beat a buy-and-hold policy on a risk-adjusted basis. An index fund which simply attempts to match the market at the lowest cost is preferable to an actively managed portfolio.

Market Value versus Intrinsic Value

  • Intrinsic value is the true, actual value of an asset. It is what the asset is really worth.
  • Market value is the price of an asset. It is what buyers are willing to pay for the asset.

In an efficient market, the two values should be very close or the same. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value. Though market value and the intrinsic value may differ across time, the discrepancy will get corrected as new information arrives.

In an inefficient market, the two may differ significantly.

Factors Affecting a Market's Efficiency

Some factors contribute to and impede the degree of efficiency in a financial marke
  • The number of market participants. The more investors and analysts that follow a financial market, the more efficient it becomes.
  • Information availability and financial disclosure. All investors should have access to the necessary information to value securities. This should promote market efficiency.
  • Limits to trading. Some researchers argue that restrictions on short selling impede market efficiency.

Transaction costs and information-acquisition costs should also be considered when evaluating market efficiency.
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Subject 2. Forms of market efficiency
#analyst-notes #market-efficency
There are three versions of the Efficient Market Hypothesis (EMH); they differ by their notions of what is meant by the term "all available information".

  • The weak-form hypothesis asserts that stock prices already reflect all information that can be derived by examining market trading data such as the history of past prices, trading volume, or short interest. This implies that trend analysis is fruitless: if such data ever conveyed reliable signals about future performance, all investors would have learned such signals already.

  • The semistrong-form hypothesis states that all publicly available information regarding the prospects of a firm must be reflected already in the stock price. Such information includes, in addition to past prices, fundamental data on the firm's product line, quality of management, balance sheet composition, patents held, earning forecasts, and accounting practices. Obviously this version encompasses the weak-form EMH. This hypothesis implies that an investor cannot achieve risk-adjusted excess returns using important publicinformation.

    Event studies examine how fast stock prices adjust to specific significant economic events. The results for most of these studies have supported the semistrong-form EMH. About the only mixed results come from exchange listing studies.

  • The strong-form hypothesis states that stock prices reflect all information (from public and private sources) relevant to the firm, even include information available only to company insiders. This version of EMH encompasses both the weak-form and the semistrong-form EMH. It is quite extreme. It implies that no investor has monopolistic access to information that influences prices. Thus, no investor can consistently derive risk-adjusted excess returns. In fact, the strong-form EMH assumes perfect markets, in which all information is cost free and available to everyone at the same time. In contrast, in an efficient market prices adjust rapidly to new public information.

Implications of EMHs

Technical Analysis

The assumptions of technical analysis directly oppose the notion of efficient markets.

  • The process of disseminating new information takes time.
  • Stock prices move to new equilibriums in a gradual manner.
  • Hence, stock prices move in trends that persist.

Therefore, technical analysts believe that good traders can detect the significant stock price changes before others do. However, as confirmed by most studies, the capital market is weak-form efficient as prices fully reflect all market information as soon as the information becomes public. Though prices may not be adjusted perfectly in an efficient market, it is unpredictable whether the market will over-adjust or under-adjust at any time. Therefore, technical analysts should not generate abnormal returns and no technical trading system should have any value.

Fundamental Analysis

Fundamental analysts believe that

  • At any time, there is a basic intrinsic value for the aggregate stock market, various industries, or individual securities;
  • These values depend on underlying economic factors such as cash flows and risk variables;
  • Though market price and the intrinsic value may differ across time, the discrepancy will get corrected as new information arrives.

Therefore, by accurately estimating the intrinsic value, a fundamental analyst can achieve abnormal returns by making superior market timing decisions or acquiring undervalued securities.

Fundamental analysis involves aggregate market analysis, industry analysis, company analysis and portfolio management. However, using historical data to estimate the relevant variables is as much an art and a product of hard work as it is a s...
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Subject 3. Market pricing anomalies
#analyst-notes #market-efficency
Are the hypotheses supported by the data? Are there market patterns that lead to abnormal returns more often than not?

A market anomaly is a security price distortion in the market that seems to contradict the efficient market hypothesis. There are different categories of market anomalies.

Time-Series Anomalies

Calendar anomalies question whether some regularities exist in the rates of return during the calendar year that would allow investors to predict returns on stocks.

The January anomaly, also called small-firm-in-January effect, says that many people sell stocks that have declined in price during the previous months to realize their capital losses before the end of the tax year. Such investors do not put the proceeds from these sales back into the stock market until after the turn of the year. At that point the rush of demand for stock places an upward pressure on prices that results in the January effect. The effect is said to show up most dramatically for the smallest firms because the small-firm group includes stocks with the greatest variability of prices during the year (and the group therefore includes a relatively large number of firms that have declined sufficiently to induce tax-loss selling).

Another possible reason for January effect on stock markets is strategic selling by institutional investors at the end of their reporting periods. Portfolio managers may be reluctant to report holdings of stocks in their annual reports that have performed poorly in the previous period. Therefore, the managers sell these stocks at the end of their accounting periods (usually end of December). This so-called window-dressing was suggested as a source of the January effect by Haugen and Lakonishok (1988).

Despite numerous studies, the January anomaly poses as many questions as it answers.

Other calendar studies include monthly effect, weekend or day of the week effect, and intraday effect.

Momentum and Overreaction Anomalies. The debate surrounding investor overreaction and contrarian investing is one of the most extensive and controversial areas of research in finance. The overreaction anomaly, evidenced by long-term reversals in stock returns, was first identified by De Bondt and Thaler (1985), who showed that stocks which perform poorly in the past three to five years demonstrate superior performance over the next three to five years compared to stocks that have performed well in the past. The study provided evidence that abnormal excess returns could be gained by employing a strategy of buying past losers and selling short past winners, or the contrarian strategy.

Although the overreaction anomaly and market momentum do seem to exist, researchers have argued that the existence of momentum is rational, and the additional return (based on the contrarian investment strategy) would come simply at the expense of increased risk.

Cross-Sectional Anomalies

If the semi-strong EMH is true, all securities should have equal risk-adjusted returns because security prices should reflect all public information that would influence the security's risk. Using public information, is it possible to determine what stocks will enjoy above-average, risk-adjusted returns?

The size effect relates to the impact of size (measured by the total market value) on risk-adjusted rates of return. Some researchers found that the small firms outperformed the large firms after considering risk and transaction costs.

Basu's study concluded that publicly available P/E ratios possessed valuable information, and the risk-adjusted returns for stocks in the lowest P/E ratio quintile were superior to those in the highest P/E ratio quintile. This is known as the value effect.

Fama and French found that both size and BV/MV ratio are significant when included together, and they dominate other ratios. The dramatic dependence o...
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Subject 4. Behavioral finance
#analyst-notes #market-efficency
Some investors behave highly irrationally and make predictable errors. Behavior finance is a field of finance that proposes psychology-based theories to explain stock market anomalies. Within behavioral finance, it is assumed that the information structure and the characteristics of market participants systematically influence individuals' investment decisions as well as market outcomes. There have been many studies that have documented long-term historical phenomena in securities markets that contradict the efficient market hypothesis and cannot be captured plausibly in models based on perfect investor rationality. Behavioral finance attempts to fill the void.

Loss Aversion

It is a theory that people value gains and losses differently and, as such, will base decisions on perceived losses rather than perceived gains. Thus, if a person were given two equal choices, one expressed in terms of possible losses and the other in possible gains, people would choose the former.

Overconfidence

Most people consider themselves to be better than average in most things they do. For example, 80% of drivers contend that they are better than "average" drivers. Is that really possible? Studies show that money managers, advisors, and investors are consistently overconfident in their ability to outperform the market. Most fail to do so, however.

Other behavior theories include representativeness, gambler's fallacy, mental accounting, etc.

Information Cascades

Information cascading is defined as a situation in which an individual imitates the trades of other market participants and completely disregards his or her own private information. A related concept is herding, which is clustered trading that may or may not be based on information. Some researchers argue that institutional investors trade together because they receive correlated private information or infer private information from previous trades, and institutional herding helps prices to more quickly reflect market information and improve market efficiency. The result is that trading does not incorporate information and prices can move away from fundamentals.

Some researchers argue that information cascades help promote market efficiency.
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Subject 1. CFA Institute Professional Conduct Program
#analyst-notes #code-of-ethics-and-standards-of-professional-conduct
The basic structure for enforcing the Code and Standards: Rules of Procedure.

The Disciplinary Review Committee (DRC) enforces the Code and Standards.

Professional Conduct staff monitor compliance through Professional Conduct Statements, public complaints, public information, and media reports.

The rules related to information-gathering and conviction follow a criminal justice system approach. The procedures require a careful investigation of the charges followed by a hearing, findings and appeal.

An overview follows:

  • Grounds for Discipline. Any act which violates the Code and Standards.

  • Investigation by Designated Officer (DO). The officer may conclude the inquiry with no disciplinary sanction, issue a cautionary letter, or continue proceedings to discipline the member or candidate. If the investigation determines that a violation occurred, a disciplinary sanction is recommended. The member or candidate may accept the recommended sanction or proceed to a hearing panel.

  • Hearing. If the member rejects the proposed sanction, a case against the member will be prepared and take place in front of a hearing panel of three or more members.

Authorized sanctions include suspension or revocation of membership/designation, private/public censure, and private reprimand.
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Subject 2. The Six Components of the Code of Ethics
#analyst-notes #code-of-ethics-and-standards-of-professional-conduct
Members and Candidates 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 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 Code of Ethics establishes the framework for ethical decision-making in the investment profession.

It applies to CFA Institute's members, CFA charterholders and CFA candidates.
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Subject 3. The Seven Standards of Professional Conduct
#analyst-notes #code-of-ethics-and-standards-of-professional-conduct

I. PROFESSIONALISM

A. Knowledge of the Law. Members and candidates must understand and comply with all applicable laws, rules, and regulations (including the CFA Institute Code of Ethics and Standards of Professional Conduct) of any government, regulatory organization, licensing agency, or professional association governing their professional activities. In the event of conflict, members and candidates must comply with the more strict law, rule, or regulation. Members and candidates must not knowingly participate or assist in and must dissociate from any violation of such laws, rules, or regulations.

B. Independence and Objectivity. Members and candidates must use reasonable care and judgment to achieve and maintain independence and objectivity in their professional activities. Members and candidates must not offer, solicit, or accept any gift, benefit, compensation, or consideration that reasonably could be expected to compromise their own or another's independence and objectivity.

C. Misrepresentation. Members and candidates must not knowingly make any misrepresentations relating to investment analysis, recommendations, actions, or other professional activities.

D. Misconduct. Members and candidates must not engage in any professional conduct involving dishonesty, fraud, or deceit or commit any act that reflects adversely on their professional reputation, integrity, or competence.

II. INTEGRITY OF CAPITAL MARKETS

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

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

III. DUTIES TO CLIENTS

A. Loyalty, Prudence, and Care. Members and candidates have a duty of loyalty to their clients and must act with reasonable care and exercise prudent judgment. Members and candidates must act for the benefit of their clients and place their clients' interests before their employer's or their own interests.

B. Fair Dealing. Members and candidates must deal fairly and objectively with all clients when providing investment analysis, making investment recommendations, taking investment action, or engaging in other professional activities.

C. Suitability.

  • When members and candidates are in an advisory relationship with a client, they must:
    a. Make a reasonable inquiry into a client's or prospective client's investment experience, risk and return objectives, and financial constraints prior to making any investment recommendation or taking investment action and must reassess and update this information regularly.
    b. Determine that an investment is suitable to the client's financial situation and consistent with the client's written objectives, mandates, and constraints before making an investment recommendation or taking investment action.
    c. Judge the suitability of investments in the context of the client's total portfolio.
  • When members and candidates are responsible for managing a portfolio to a specific mandate, strategy, or style, they must only make investment recommendations or take investment actions that are consistent with the stated objectives and constraints of that portfolio.

D. Performance Presentation. When communicating investment performance information, members or candidates must make reasonable efforts to ensure that it is fair, accurate, and complete.

E. Preservation of Confidentiality. Members and candidates must keep information about current, former, and prospective clients confidential unless:

  • The infor
...
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Subject 1. Standard I (A) Knowledge of the Law
#analyst-notes #guidance-for-standards-i-vii
I. PROFESSIONALISM

A. Knowledge of the Law.

Members and Candidates must understand and comply with all applicable laws, rules, and regulations (including CFA Institute's Code of Ethics and Standards of Professional Conduct) of any government, regulatory organization, licensing agency, or professional association governing their professional activities. In the event of conflict, Members and Candidates must comply with the more strict law, rule, or regulation. Members and candidates must not knowingly participate or assist in and must dissociate from any violation of such laws, rules, or regulations.

This standard adopts principles that apply to the general activities of members and candidates. As with any service there are certain rules and regulations that members and candidates need to abide by, although they are not required to have detailed knowledge of all laws.

A. Relationship between the Code and Standards and local law.

Members and candidates should always aspire to the highest level of ethical conduct. This statement assists members in avoiding legal and ethical traps and violations of the Code of Ethics.

In general, members in all countries should comply at all times with the Code and Standards. Since laws in different countries may establish different standards, the rule of thumb is to choose the stricter regulations.

  • If the laws are tougher than the Code and Standards, adhere to the laws.
  • If there are no laws, or if the Code and Standards are tougher, adhere to the Code and Standards.
  • If a member or candidate lives or works in a foreign country, or works for foreign firms outside of his or her own country, he or she should comply with the strictest of his/her country's laws, the foreign country's laws, and the Code and Standards.

Example

You are working in the foreign office of a U.S.-based firm. Analysts in this foreign country routinely solicit insider information and use it as the basis for trading decisions. You are told that this is not illegal in this country. In this case, the Code and Standards are stricter. They prohibit use of material nonpublic information. You should refrain from trading on the basis of insider information.

B. Don't participate or assist in violations.

Don't knowingly break or help others break laws. If a member:

  • Feels that a standard or law has been violated (e.g., receiving information contradictory to a registration statement), he or she should seek the advice of the firm's counsel. If the member believes that the counsel is both competent and unbiased and he or she follows the counsel's advice, there is no violation.
  • Knows that a standard or law has been violated (e.g., discovering that a client has knowingly misstated information on a prospectus), he or she should report the incident to the appropriate supervisory person in the firm. If the situation is not remedied, the member should disassociate from the situation. He or she may also seek legal advice to see if other actions should be taken.

Note:

  • Members are not required by the Code and Standards to report violations to the appropriate governmental or regulatory organizations. However, if the law requires an individual to report, he or she must do so.
  • Members are encouraged, but not required, to report violations to CFA Institute.

Example

An associate of yours is engaging in illegal trading practices and he tells you to refrain from disclosing this because it will make the firm look bad and it is highly profitable. You should choose one of the three actions above. If you seek legal counsel and are told that the activity is actually not illegal, you have met your obligation. This assumes that you believe the legal counsel to be competent. If you report your associa...
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Subject 2. Standard I (B) Independence and Objectivity
#analyst-notes #guidance-for-standards-i-vii

I. PROFESSIONALISM

B. Independence and Objectivity.

Members and Candidates must use reasonable care and judgment to achieve and maintain independence and objectivity in their professional activities. Members and Candidates must not offer, solicit, or accept any gift, benefit, compensation, or consideration that reasonably could be expected to compromise their own or another's independence and objectivity.

Every member must avoid situations that may result in a potential conflict of interest. External sources may try to influence the investment process by offering investment managers a variety of perks. Excessive gifts or lavish investor relation functions could prejudice a member's opinions about a sponsor. One type of benefit is the allocation of shares in oversubscribed IPOs to investment managers for their personal accounts. Every member shall avoid situations that might cause or be perceived to cause a loss of independence or objectivity in recommending investments or taking investment action.

Modest gifts and entertainment are acceptable. For example, gifts that do not exceed $100 may be accepted, as well as entertainment.

Gifts from clients can be distinguished from gifts given by other parties seeking to influence a member to the detriment of clients. Gifts from clients are deemed less likely to impair a member's independence than gifts from other parties seeking to influence the member's outlook. Members and candidates must disclose to their employers any such benefits from clients.

Example 1

You are an analyst for the banking industry. The head of investor relations for one of the larger firms in this industry offers to take you to dinner at a posh restaurant and discuss the upcoming quarterly earnings figures. He provides you with a new state-of-the-art titanium golf club as his limo drops you off at the end of the evening. He calls you the next day to ask if your report on his firm is progressing and indicates that there is a job waiting for you at the bank if you decide to leave your current position. First, the bank officer may have violated his fiduciary duty to his shareholders if he provided you with material nonpublic information. Regardless, you have been wined and dined and received a gift and a job offer from a senior officer of a firm you evaluate. Even if these inducements do not compromise your independence and objectivity, they may provide that perception. This violates the standard.

Example 2

An analyst follows the stock of company XYZ. He is invited by XYZ for a visit to the company. XYZ pays all travel expenses for him. In general, when allowing companies to pay for expenses, analysts should ensure that such arrangements do not impinge on their independence and objectivity. In this case, as long as the trip is strictly for business without lavish hospitality, such payment is acceptable.

Example 3

An analyst is asked by a firm's executives to issue favorable recommendations to secure the client's business. The analyst should conduct the review and make the recommendation based on his or her own independent and objective view. Note that members may experience pressure from their own firms to issue favorable reviews of certain companies. In a full-service investment house, the corporate finance department may be an underwriter for a company's securities and be loath to antagonize that company by publishing negative research reports.

Example 4

Steve, a portfolio manager, directs a large amount of his commission business to a London brokerage house. In appreciation for all the business, the London brokerage house gives Steve two tickets to travel anywhere in Europe. Steve fails to disclose receiving this package to his supervisor. Steve has violated the standard because accepting these perks, worth more than $100, may hinder his independence and objectivity.

Procedur...
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Subject 3. Standard I (C) Misrepresentation
#analyst-notes #guidance-for-standards-i-vii
I. PROFESSIONALISM

C. Misrepresentation.

Members and Candidates must not knowingly make any misrepresentations relating to investment analysis, recommendations, actions, or other professional activities.

Members and candidates shall not make any statements, orally or in writing, that misrepresent:

  • The services that they or their firms are capable of performing.
  • Their qualifications or the qualifications of their firms.
  • Their academic or professional credentials.

A misrepresentation is any untrue statement of a fact or any statement that is otherwise false or misleading. This standard relates to misrepresentations by members about their qualifications and services, and it disallows any misleading guarantees about investments and their returns.

Members and candidates shall not make or imply, orally or in writing, any assurances or guarantees regarding any investment except to communicate accurate information regarding the terms of the investment instrument and the issuer's obligations under the instrument. It prohibits statements or assumptions that an investment is "guaranteed," or that superior returns can be expected based on the member's past success.

This standard applies to oral representations, advertising, electronic communications (including web pages and emails) and written materials (whether publicly disseminated or not).

Note: This standard does not rule out correct statements that some investments are actually guaranteed in some way with guaranteed returns. Examples of these types of investments would be insurance contracts or short-term treasury securities.

This standard also prohibits plagiarism in the preparation of material for distribution to employers, associates, clients, prospects or the general public. Plagiarism involves copying or using substantially the same materials as those prepared by others without acknowledging the source of that material. The only exception is copying factual information, as published by several recognized financial institutions, as well as statistical information.

  • Members and candidates should always attribute quotations, projections, data, model/product ideas, and methodologies to their sources and/or authors.
  • This standard applies to written materials, oral communications, visits with clients, use of audio/video media, and electronic data transfer.
  • Members and candidates can use recognized sources (S&P, Moody's) of factual information (information that is already in the public realm) without acknowledgement.
  • Situations to which this Standard applies also depend on whom the member is representing. Members are not required to attribute ideas, methodologies, etc. developed by people within their firms when speaking with clients and prospects.
  • Members and candidates should keep copies of materials used in preparing research reports.

In ethical terms, a member or candidate indulging in plagiarism is not conducting himself or herself with integrity. By plagiarizing, he or she is not only stealing the ideas of others, but also exposing himself or herself to violations of other standards by making recommendations that may not have a reasonable basis and may not avoid material misrepresentations.

Procedures for compliance

Members can prevent unintentional misrepresentations of the qualifications of services the member or the member's firm is capable of performing if each member understands the limit of the individual's or firm's capabilities and the need to be accurate and complete in presentations.

Firms can provide guidance for employees who make written or oral presentations to clients or potential clients by providing a written list of the firm's available services and a description of the firm's qualification, and compensations that are both accurate and suitab...
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Subject 4. Standard I (D) Misconduct
#analyst-notes #guidance-for-standards-i-vii
I. PROFESSIONALISM

D. Misconduct.

Members and Candidates must not engage in any professional conduct involving dishonesty, fraud, or deceit, or commit any act that reflects adversely on their professional reputations, integrity, or competence.

Members and candidates shall not compromise the integrity of the CFA designation, or the integrity or validity of the CFA examinations.

Standard I (A) states the obligation to comply with all applicable laws and regulations. This standard addresses personal behavior that will reflect poorly on the profession as a whole. Any act that involves lying, cheating, stealing, or other dishonest conduct, if the offence reflects adversely on a member or candidate's professional (not personal) activities, would violate the standard.

Procedures for compliance

Members and candidates should encourage their employers to:

  • Adopt a Code of Ethics to which every employee must subscribe. Make clear that any personal behavior that reflects poorly on the individual involved, the institution as a whole, or the investment industry will not be tolerated.
  • Disseminate to all employees a list of potential violations and associated disciplinary sanctions, up to and including dismissal from the firm.
  • Conduct background checks on potential employees to ensure that they are of good character and not ineligible to work in the investment industry because of past infractions of the law.

Example 1

An investment advisor executes excessive trading volume to generate fees. He tells clients that the high level of trading in their discretionary accounts is needed to maintain proper diversification. If this statement is misrepresentative, the advisor is clearly engaging in professional misconduct.

Example 2

A portfolio manager has three martinis at lunch and returns to the office to resume his regular duties. If the manager's judgment is impaired and he is engaging in investment decision-making activities, he is in violation of this standard.
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Subject 5. Standard II (A) Material Nonpublic Information
#analyst-notes #guidance-for-standards-i-vii
II. INTEGRITY OF CAPITAL MARKETS

A. Material Nonpublic Information.

Members and Candidates who possess material nonpublic information that could affect the value of an investment must not act or cause others to act on that information.

Information is material if its disclosure may affect the price of a security, or if reasonable investors would want to know the information before investing. Topics which should be considered material in an insider trading context include:

  • A forthcoming dividend declaration or mission.
  • Corporate reorganizations or takeovers.
  • The acquisition or loss of a major contract.
  • A major purchase or sale of company assets.
  • An event of default.
  • Knowledge of forthcoming press coverage of a company's affairs, whether positive or negative.
  • Substantial increases or decreases in earnings projections.

The source or relative reliability of the information also determines materiality. The less reliable a source, the less likely the information provided would be considered material.

Information is nonpublic if it has not been disseminated to the marketplace in general, or if investors have not had an opportunity to react to the information. Note that disclosing the information to a selected group of analysts does not make it public. For example, a disclosure made to a room full of analysts does not make the disclosed information "public."

Note that this standard prohibits use of material nonpublic information, not:

  • Nonmaterial public information.
  • Nonmaterial nonpublic information.
  • Material public information.

Members are prohibited from seeking out or using any inside information in analyzing investments, making investment recommendations, or making investment decisions if:

  • Such trading would breach a duty.
  • The information is misappropriated.
  • The information relates to a tender offer.
  • Members receive material information in confidence.

Mosaic Theory

Insider trading violations should not result when a perceptive analyst reaches a conclusion about a corporate action or event through an analysis of public information and items of nonmaterial nonpublic information (i.e., a "mosaic" of information).

Under mosaic theory, financial analysts are free to act without risking liability. That is, a financial analyst may use nonpublic information as the basis for investment recommendations and decisions even if that conclusion would have been material inside information had it been communicated directly to the analyst by a company.

Procedures for compliance

If members receive inside information in confidence, they shall make reasonable efforts to achieve public dissemination of material nonpublic information disclosed in breach of duty. This effort usually means encouraging the issuing company to make the information public.

Members and their firms should adopt written compliance procedures designed to prevent trading while in the possession of material nonpublic information. The most common and widespread approach to preventing insider trading by employees is an information barrier known as a "fire wall." The purpose of a fire wall is to prevent communication of material nonpublic information and other sensitive information from one department of a firm to other departments. The minimum elements of such a precaution include the following:

  • Substantial control (preferably by the compliance department) of relevant interdepartmental communications.
  • Review of employee trading through effective maintenance of some combination of "watch," "restricted," and "rumor" lists.
  • Documentation of the procedures designed to limit the flow of infor
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Subject 6. Standard II (B) Market Manipulation QUIZ 1
#analyst-notes #guidance-for-standards-i-vii

II. INTEGRITY OF CAPITAL MARKETS

B. Market Manipulation.

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

Market manipulation is a deliberate attempt to interfere with the free and fair operation of the market. It includes practices that distort security prices or trading volume with the intent to deceive people or entities that rely on information in the market.

Market manipulation examples include:

  • Price manipulation. Placing buy or sell orders (or both) into the trading system in order to change or maintain the price of a stock. The motives for attempting to do this vary: to increase the value of a position in the market for finance or accounting purposes, to be able to issue new shares at a higher price or to cause such a price rise that other investors are attracted to the stock, creating demand that the manipulator can sell into (called "pump and dump").

  • Marking the close or ramping. Making a purchase or sale of a security near the close of the day's trading, with the objective of affecting published prices, particularly the reported closing price. This might be done to avoid margin calls (when the trader's position is not self-financed) to support a flagging price or to affect the valuation of a portfolio (called "window dressing"). A common indicator is trading in small parcels of the security just before the market closes.

  • Wash trades and pre-arranged trading. A wash trade is a trade in which there is no change in the beneficial ownership of the securities - the buyer is, in reality, also the seller. A pre-arranged trade involves two parties trading on the basis that the transaction will be reversed later, or with an arrangement that removes the risk of ownership from the buyer. "Pooling or churning" can involve wash sales or pre-arranged trades executed in order to give an impression of active trading, and therefore investor interest, in the stock.

  • False or misleading information. Companies can be tempted to re-release information or present information in an over-optimistic manner, in order to generate interest in the company's securities or help a flagging market. In some cases this includes unrealistic, unsubstantiated, or incorrect data, projections or evaluations. When the perpetrators use the demand generated by the false information they have spread to sell their own shares, the operation is known as "hype and dump."

  • Capping and pegging. This involves activity on both the stock market and the derivatives market. A trader writes an option, which obliges the trader to sell to (in the case of a call option) or buy from (in the case of a put option) the option holder a specified number of shares at a specified price. The trader then trades in the shares covered by the option in order to affect the share price in a direction that will make the option unprofitable to exercise.

The intent of the action is critical to determining whether it is a violation of this standard. The standard does not prohibit legitimate trading strategies that exploit a difference in market power, information, or other market inefficiencies. It also does not prohibit transactions done for tax purposes (e.g., selling and immediately buying back a particular stock).
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Subject 7. Standard III (A) Loyalty, Prudence, and Care
#analyst-notes #guidance-for-standards-i-vii
III. DUTIES TO CLIENTS

A. Loyalty, Prudence, and Care.

Members and Candidates have a duty of loyalty to their clients and must act with reasonable care and exercise prudent judgment. Members and Candidates must act for the benefit of their clients and place their clients' interests before their employer's or their own interests.

This standard relates principally to members who have discretionary authority over the management of client's assets.

Fiduciary duty refers to the obligations of loyalty and care in regard to the responsibility of managing someone else's assets. A fiduciary duty is a position of trust.

  • A fiduciary is someone with the duty of acting for the benefit of another party.
  • Loyalty is owed to clients and prospects.
  • Clients' interests come before yours.
  • A heightened level of fiduciary duty arises if the fiduciary has "custody" or effective control of the client's assets.
  • Governing documents (e.g., trust documents and investment management agreements) are primary determinants of a fiduciary's powers and duties.

Fiduciary standards apply to a large number of persons in varying capacities, but exact duties may differ in many respects, depending on the nature of the relationship with the client or the type of account under which the assets are managed. The first step in fulfilling a fiduciary duty is to determine what the responsibility is and the identity of the "client" to whom the fiduciary duty is owed.

  • When managing personal assets of an individual, the investment manager owes loyalty to that individual (i.e., the client).
  • When managing the portfolios of a pension plan or trust, the investment manager owes loyalty to beneficiaries of the plan or trust (i.e., the "client"), not the person who hires the manager.

A fiduciary must make investment decisions in the context of the portfolio as a whole rather than by individual investments within the portfolio. The fiduciary should thoroughly consider the risk of loss, potential gains, diversification, liquidity and returns.

Often a manager may direct clients' trades through a particular broker because an investment manager often has discretion over the selection of brokers. The broker may provide research services that provide a broad benefit to the manager. The manager has thus used "soft dollars" to purchase beneficial services through brokerage, which is an asset to the manager's clients. Since the manager would expect to purchase research services anyway, the soft dollar arrangement is not necessarily inappropriate. The manager must seek the best price and execution, and disclose any soft dollar arrangements.

Procedures for compliance

  • Follow all the applicable laws and rules.
  • Establish the investment objectives of the client, taking into account:

    • The client's needs and circumstances.
    • The investment's basic characteristics.

  • Diversification. All portfolios should be adequately diversified, unless the plan guidelines state otherwise.
  • Deal fairly with all clients.
  • Conflicts of interest. All conflicts must be disclosed.
  • Disclose compensation agreements.
  • Proxy solicitations. Proxies must be voted in the best interest of the beneficiaries.
  • Confidentiality. Members must maintain the confidentiality of their dealings at all times.
  • Best execution. The best execution that is reasonably available should be provided to all clients.
  • Loyalty - members must always act in the best interest of their clients.

Example 1

A client anxiously tells you that he needs to liquidate a bond portfolio immediately because he needs funds to pay for an operation for a relative. The bonds are highly liquid, but ...
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Subject 8. Standard III (B) Fair Dealing
#analyst-notes #guidance-for-standards-i-vii
III. DUTIES TO CLIENTS

B. Fair Dealing.

Members and Candidates must deal fairly and objectively with all clients when providing investment analysis, making investment recommendations, taking investment action, or engaging in other professional activities.

"Fairly" implies that members must not discriminate against or favor any clients. Fairness shall be maintained in quality and timing of services, and allocation of investment opportunities. The term "fairly," rather than "equally,", is used because it would be physically impossible to reach all customers at the same exact instant, and not all recommendations or investment actions are suitable for all clients.

Members and candidates are NOT required to give the same level of services to all clients. For example, you can give more information and research to discretionary clients than to transaction-only clients.

Members and candidates are required to adhere to the standard in:

  • Dissemination of recommendations: Establish procedures for simultaneous dissemination of recommendations; all clients must be informed at approximately the same time.

    An investment recommendation is any opinions on buying, selling, or holding a security or other investment. Good business practice dictates that initial recommendations be made available to all customers who indicate interest. Although a member need not communicate a recommendation to all customers, the selection process by which customers receive information should be based on suitability and known interest, not on any preferred or favored status. A common practice to ensure fair dealing is to communicate recommendations within the firm and to customers simultaneously.

    A material change in a firm's recommendation is one that could be expected to affect a client's judgment. A change in the recommendation from buy to sell is a material change; this standard needs to be abided by in disseminating the change.

  • Investment actions: Develop trade allocation procedures to ensure fairness to clients (both in priority of execution and allocation of price obtained on block trades), timeliness of execution, accuracy of trade records, and client positions.

    Clients in discretionary accounts should be treated the same as those who are not in discretionary accounts. Note that investment action can affect the market value of a security.

    If an issue is oversubscribed, members should forgo any sales to themselves or their immediate families. Members must disclose to clients or prospects the allocation procedures, and how they can affect the clients or prospects. Members shall not withhold "hot issue" securities for their own benefits or use such securities as rewards or incentives for others. Members shall not trade ahead of the dissemination of research reports or recommendations to clients.

Procedures for compliance

  • Limit the number of people involved.
  • Shorten the time frame between decision and dissemination.
  • Publish personnel guidelines for pre-disseminations.
  • Disseminate information simultaneously to all parties.
  • Maintain a list of clients and their holdings.
  • Develop and disclose written trade allocation procedures.
  • Establish systematic account review.
  • Disclose levels of service.

Members and their firms are required to take the following steps to ensure that adequate trade allocation practices are followed:

  • Obtain advance indications of client interest for new issues.
  • Allocate new issues by client rather than by portfolio manager.
  • Adopt a pro rata or similar objective method or formula for allocating trades.
  • Treat clients fairly in terms of both trade execution order and price.
  • Execute orders in an efficient and
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Subject 9. Standard III (C) Suitability
#analyst-notes #guidance-for-standards-i-vii
III. DUTIES TO CLIENTS

C. Suitability.

1. When Members and Candidates are in an advisory relationship with a client, they must:
a. Make a reasonable inquiry into a client or prospective client's investment experience, risk and return objectives, and financial constraints prior to making any investment recommendation or taking investment action and must re-assess and update this information regularly.
b. Determine that an investment is suitable to the client's financial situation and consistent with the client's written objectives, mandates, and constraints prior to making an investment recommendation or taking investment action.
c. Judge the suitability of investments in the context of the client's total portfolio.

2. When Members and Candidates are responsible for managing a portfolio to a specific mandate, strategy, or style, they must only make investment recommendations or take investment actions that are consistent with the stated objectives and constraints of the portfolio.

Members must always consider the appropriateness and suitability of the client's investment action and match this up against the needs and circumstances of the particular client in order to determine the suitability of the investment for the client.

In the event that a new client is obtained or an existing client's previous investment matures, the member need not immediately obtain client information if he or she first re-invests these funds in some form of cash equivalent. The member will then obtain the client's investment preferences. He or she will need to determine from the client the level of risk that the client is prepared to accept (in other words, the client's risk tolerance level). This needs to be ascertained before any investment action is taken.

You are required to:

  • Know the type and nature of your clients'.
  • Know the return objectives and risk tolerance of your clients.
  • Know the liquidity needs, expected cash flows, investable funds, time horizon, tax considerations, regulatory and legal circumstances, and other constraints of your clients.

You are NOT required to change an existing client portfolio as soon as it comes under your discretion; it is best to take a bit of time, plan and implement actions in an organized way.

Procedures for compliance

A written investment policy statement should be developed.

  • Client identification: Identify the type and nature of clients, and the existence of separate beneficiaries.
  • Investor objectives:

    • Return objectives (income, growth in principal, maintenance of purchase power).
    • Risk tolerance (suitability and stability of values).

  • Investor constraints: Liquidity needs, expected cash flows (patterns of additions and/or withdrawals), investable funds (assets and liabilities or other commitments), time horizon, tax considerations, regulatory and legal circumstances, investor preferences, circumstances, unique needs, and proxy voting responsibilities and guidance.
  • Performance measurement benchmarks.

The investor's objectives and constraints should be maintained and reviewed periodically to reflect any changes in the client's circumstances. Annual review is reasonable unless business or other reasons dictate more or less frequent review.

Example 1

After a five-minute interview, you advise a client how to invest a substantial proportion of her wealth. You have violated the "Know your customer" rule. You do not have adequate basis to make a detailed recommendation.

Example 2

An analyst tells a client about the upside potential, without discussing the downside risks. He violates the standard because he should discuss the downside risks as well.

Example 3

When recomm...
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Subject 10. Standard III (D) Performance Presentation
#analyst-notes #guidance-for-standards-i-vii

III. DUTIES TO CLIENTS

D. Performance Presentation.

When communicating investment performance information, Members and Candidates must make reasonable efforts to make sure that this information is fair, accurate, and complete.

In the past there have been several practices that have hindered performance presentation and comparability, such as:

  • Representative accounts - only the best results are presented.
  • Survivorship bias - accounts that have been terminated are excluded from the results presented.
  • Portability of investment results - results from previous employment are disclosed.
  • Varying time periods - only the results for the good time periods are reflected.

A firm cannot claim that they are/were in compliance with CFA Institute's standards unless they comply in allmaterial respects with CFA Institute's standards.

Procedures for compliance

Misrepresentations about the investment performance of the firm can be avoided if the member maintains data about the firm's investments performance in written form and understands the classes of investments or accounts to which those data apply and the risks and limitations inherent in using such data. In analyzing information about the firm's investment performance, the member should ask the following questions:

  • How many years of past performance does this information reflect?
  • Does it reflect performance for the prior year only, after several years of poor performance, or an average of several years of performance?
  • Has the performance been measured in accordance with CFA Institute's standards?
  • Does investment performance vary widely among different classes of funds or accounts? If so, the member must describe investment performance by classes rather than by an overall average figure and accurately explain what the performance figures represent.

Example

Your bond fund has generated a below average performance for four of the past five years. You use this as the basis for expectations of an above-average performance for the upcoming year. If your average or expected performance is properly determined, you should have a 50% probability of meeting or exceeding that average. Thus, it is inappropriate to declare that because performance was below average last year it is likely to be above average next year.
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Subject 11. Standard III (E) Preservation of Confidentiality
#analyst-notes #guidance-for-standards-i-vii
III. DUTIES TO CLIENTS

E. Preservation of Confidentiality.

Members and Candidates must keep information about current, former, and prospective clients confidential unless:

  • The information concerns illegal activities on the part of the client or prospective client.
  • Disclosure is required by law.
  • The client or prospective client permits disclosure of the information.

The analyst must preserve confidentiality when the following two criteria are met:

  • The analyst must be in a relationship of trust with the client who has engaged him or her.
  • The information received must result from or be relevant to the portion of the client's business that is the subject of the confidential relationship.

You are required to:

  • Avoid discussing any information received from a client, except to fellow employees working with the same client.
  • Ask yourself if the disclosure is necessary and beneficial to the client in cases where you have to disclose information.
  • Forward confidential information to the PCP (CFA Institute's Professional Conduct Program) if the PCP requests, even if the client and you have a settlement agreement with confidentiality clauses. This is because any information turned over to the PCP is kept in the strictest confidence. Members and candidates who will not provide necessary information because of confidentiality will be seen as failing to co-operate with the investigation and will be subject to summary suspension of membership under CFA Institute's bylaws.

However, if the information concerns illegal activities by the client, the analyst may be required to consult with his supervisor and with legal counsel before deciding whether to report the activities to the appropriate governmental organization.

Procedures for compliance

The simplest, most conservative, and most effective way to comply with this standard is to avoid disclosing any information received from a client except to authorized fellow employees who are also working for the client. In some instances, however, a member may want to disclose information received from clients that is outside the scope of the confidential relationship and does not involve illegal activities. Before making such a disclosure, a member should ask the following questions:

  • In what context was the information disclosed?
  • If disclosed in a discussion of work being performed for the client, is the information relevant to the work?
  • Is the information background material that, if disclosed, will enable the member to improve service to the client?

Example 1

You work in the trust department of a large bank. A client tells you that she must sell a significant portion of her personal stock portfolio in order to generate cash to meet the payroll of her small business. Shortly after the meeting, a colleague in the commercial lending department of the bank mentions seeing you with the client. She has applied for a large business loan. He asks you if you have any information that could help the bank with the loan decision. You cannot disclose the content of your meeting with the client. If the colleague wants additional information, he should contact your client directly.

Example 2

The employer of a client asks to meet with you. The employer suspects your client of embezzling funds from his place of work. You are aware that the client has made several substantial additions into his discretionary account during the past two months. It may be appropriate to provide information if it pertains to illegal activities. However, you are expected to preserve client confidentiality unless there is a clear indication of these activities. Contact your supervisor or legal counsel before providing information about your client.

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Subject 12. Standard IV (A) Loyalty
#analyst-notes #guidance-for-standards-i-vii
IV. DUTIES TO EMPLOYERS

A. Loyalty.

In materials related to their employment, Members and Candidates must act for the benefit of their employer and not deprive their employer of the advantage of their skills and abilities, divulge confidential information, or otherwise cause harm to their employer.

Independent practice

Members shall not undertake any independent practice that could result in compensation or other benefit in competition with their employer unless they obtain written consent from their employer.

  • "Practice" means any service that the employer currently makes available for payment.
  • "Undertake" means that the member actually has to participate in such activities while the member is still employed in order to violate this standard.

If members and candidates plan to engage in independent business while still employed, they must provide a written statement to their employer describing the types of services, the expected duration, and the compensation.

Note: Members have to participate in the activities. They do not actually have to receive any remuneration for this standard to apply.

Leaving an employer

Until their resignation becomes effective, members and candidates must continue to act in the employer's best interest, and must not engage in any activities that would conflict with this duty. A member can make preparations (but not undertake competitive business) to begin a competitive business as a departing employee, provided that the preparations do not breach the employee's duty of loyalty. Examples of this would be finding office space to rent for a member's future business.

Nature of employment

You can be exempt from the standard if you are an independent contractor.

Definition of employee: someone in the service of another who has the power to control and direct the employee in the details of how work is to be done. An employee is not a contractor (you cannot control the details of how a contractor does a job). Employment relationship does not require written or implied contract or actual receipt of monetary compensation.

Violations

  • You get a new job, but before leaving your current job you solicit your employer's clients (for both current and potential clients).
  • Misuse of confidential information or misappropriation of trade secrets (e.g., taking home client lists, investment statements, marketing presentations, and buy lists).
  • You provide consulting services on your own time. You must get written consent from your employer.
  • Copying your employer's computer models and other property.
  • Encouraging colleagues to leave your employer to join your new company.

Example 1

You agree to serve as an investment advisor to a non-profit institution run by a friend. Your firm provides similar services, but you elect to do this on your own for a very modest fee. Even if no fee was involved, you are obliged to obtain written consent from your employer.

Example 2

An independent investment advisor is hired by a brokerage firm. However, she wants to keep her existing clients for herself. In this case, she must get the employer's written consent.
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Subject 13. Standard IV (B) Additional Compensation Arrangements
#analyst-notes #guidance-for-standards-i-vii
IV. DUTIES TO EMPLOYERS

B. Additional Compensation Arrangements.

Members and Candidates must not accept gifts, benefits, compensation, or consideration that competes with, or might reasonably be expected to create a conflict of interest with, their employer's interests unless they obtain written consent from all parties involved.

Outside compensation/benefits may affect loyalties and objectivity and create potential conflicts of interest. These include direct compensations from clients and indirect compensations or other benefits from third parties.

Note: Accepting gifts is allowed, but you must inform your employer in writing before accepting.

Procedures for compliance

Members should make an immediate written report to their employer specifying any compensation they receive or propose to receive for services in addition to compensation or benefits received from their primary employer. Disclosure in writing means any form of communication that can be documented (e.g., email). This written report should state the terms of any oral or written agreement under which a member will receive additional compensation. Terms include the following:

  • Nature of the compensation.
  • Amount of compensation.
  • Duration of the agreement.

Example 1

In an attempt to increase portfolio performance, a firm's client offers the portfolio manager an incentive, such as a free vacation. A conflict of interest exists in this case and the portfolio manager must inform the firm beforeaccepting the arrangement.

Example 2

One of your firm's clients manages a ski resort in Colorado. She has told you that as long as you are managing her assets, you are entitled to complimentary lift tickets at the resort. To be in compliance with this standard, you must report this in writing to your employer. The employer will want to ensure that this client receives no special consideration as a result of the arrangement.

Example 3

Steve sits on the board of directors of ABC Inc. As a result, he obtains unlimited membership in ABC Inc.'s services. Steve does not disclose this relationship to his employer, because he does not receive monetary compensation. Steve has violated this standard by not disclosing the benefits he receives to his employer.
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Subject 14. Standard IV (C) Responsibilities of Supervisors
#analyst-notes #guidance-for-standards-i-vii
IV. DUTIES TO EMPLOYERS

C. Responsibilities of Supervisors.

Members and Candidates must make reasonable efforts to detect and prevent violations of applicable laws, rules, regulations, and the Code and Standards by anyone subject to their supervision or authority.

If you supervise large numbers of employees, you may not be able to evaluate the conduct of each employee. In this case, you may delegate supervisory duties; however, such delegation does not replace supervisory responsibilities.

A supervisory member should rely on reasonable procedures to detect and prevent violations. The presence of a compliance policy manual and/or compliance department, however, does not remove his or her supervisory responsibilities.

Procedures for compliance

A supervisor complies with Standard IV (C) by identifying situations in which legal violations or violation of the Code and Standards are likely to occur, and establishing and enforcing compliance procedures to prevent such violations.

If a firm does not have a compliance system, or the system is not adequate, members or candidates should decline in writing to accept supervisory responsibility until the firm adopts reasonable procedures to allow them to adequately exercise such responsibility.

Adequate compliance procedures should:

  • Be drafted so that the procedures are easy to understand.
  • Designate a compliance officer and clearly define the officer's authority and responsibility.
  • Outline the scope of the procedures.
  • Outline permissible conduct.
  • Delineate procedures for reporting violations and sanctions.

Once a compliance program is in place, a supervisor should:

  • Disseminate the contents of the program to appropriate personnel.
  • Periodically update procedures to ensure that the measures are adequate under the law.
  • Continually educate personnel regarding the compliance procedures.
  • Issue periodic reminders of the procedures to appropriate personnel.
  • Incorporate a professional conduct evaluation as part of the employee's performance reviews.
  • Review the actions of employees to ensure compliance and identify violators.
  • Take the necessary steps to enforce procedures once a violation has occurred.

Once a violation is discovered, a supervisor should take the following actions:

  • Respond promptly.
  • Conduct a thorough investigation of the activities to determine the scope of the wrong-doing.
  • Increase supervision or place appropriate limitations on the wrongdoer pending the outcome of the investigation.

If a supervisory member was unable to detect violations, he or she may not violate the standard if he or she takes steps to institute an effective compliance program AND adopts reasonable procedures to prevent and identify violations.

Example 1

A supervisor in an investment management firm concludes that since all five equity analysts working for her are CFA charterholders, she can trust them to refrain from violations of laws, regulations, and the Code and Standards. While she can trust them to refrain from such violations, this does not constitute reasonable supervision.

Example 2

You are offered a promotion to supervise all investment managers involved in discretionary trading. You are told that there have been instances of improper trading in some accounts and that at least one manager is likely performing additional investment services for several of his clients. However, the operation is highly profitable, so senior management has no immediate concern regarding these issues. You are responsible for prevention of violations of the Code and Standards. If there are known violations and little or no control over the investment process, you should decline ...
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Subject 15. Standard V (A) Diligence and Reasonable Basis
#analyst-notes #guidance-for-standards-i-vii
V. INVESTMENT ANALYSIS, RECOMMENDATIONS, AND ACTIONS

A. Diligence and Reasonable Basis.

Members and Candidates must:

  • Exercise diligence, independence, and thoroughness in analyzing investments, making investment recommendations, and taking investment actions.
  • Have a reasonable and adequate basis, supported by appropriate research and investigation, for any investment analysis, recommendation, or action.

Members must perform the diligent and thorough investigations necessary to make an investment recommendation or to take investment action. Three factors determine the nature of the diligence, thoroughness of the research, and level of investigation required by the standard:

  • Investment philosophy followed.
  • The role of the member or candidate in the investment decision-making process.
  • The support and resources provided by the employer.

Members must establish a reasonable basis for all investment recommendations and actions. Diligence must be exercised to avoid any material misrepresentation. In other words, members cannot be quick or negligent in making investment recommendations.

Example

You are very excited about a small high-tech firm that is developing a new method of making Internet connections more efficient. You advise your clients to buy this security and tell them that a full report will be available shortly. Your recommendation is neither diligent nor thorough. You have not provided reasonable basis for the recommendation. It is impossible to distinguish between fact and opinion without further information.

Using secondary or third-party research

Secondary research: research conducted by someone else in the member or candidate's firm.
Third-party research: research conducted by entities outside the member or candidate's firm.

Members and candidates should check if research is sound. Examples of criteria include the assumptions used, the rigor of analysis, the timeliness of the research, and the objectivity and independence of recommendations. If the research is suspected to lack a sound basis, members and candidates should refrain from relying on it.

Applications:

  • A quantitative analyst recommends an out-of-favor stock based on analysis of its 3-year records: the recommendation is not based on thorough quantitative work. A longer time period should be covered.

  • Because of restrictions from the firm's executives, an analyst cannot obtain the information necessary to perform analysis: the analyst must let the client know when he/she is "conflicted" or "restricted."

  • Because of the lack of sufficient research resources, an analyst decides to estimate IPO prices based on the relative size of each company and justify the pricing later when she has time: her analysis is not based on thorough research with reasonable basis. She should take on the work only when she can adequately handle it.

  • An investment banker presses a securities issuer to project the maximum production level. He then uses these numbers as the base-case production levels during sales pitches: he misrepresents the chances of achieving that production level. He should have given a range of production scenarios during the pitch.

  • An analyst recommends purchasing what the market, in general, has christened "hot" stocks without further research: conventional wisdom of the markets does not form a reasonable and adequate basis.

  • After a discussion with the vice president of a company, a senior analyst discovers that there is a good chance that this company will be awarded a large contract (thus pushing up the stock price). The analyst then publishes a report to his clients indicating that they must all purchase the stock ba
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Subject 16. Standard V (B) Communication with Clients and Prospective Clients
#analyst-notes #guidance-for-standards-i-vii
V. INVESTMENT ANALYSIS, RECOMMENDATIONS, AND ACTIONS

B. Communication with Clients and Prospective Clients.

Members and Candidates must:

  • Disclose to clients and prospective clients the basic format and general principles of the investment processes used to analyze investments, select securities, and construct portfolios and must promptly disclose any changes that might materially affect those processes.
  • Use reasonable judgment in identifying which factors are important to their investment analyses, recommendations, or actions and include those factors in communications with clients and prospective clients.
  • Distinguish between fact and opinion in the presentation of investment analysis and recommendations.

All important factors relating to the investment recommendation must be included in the report. Members must include known limitations in the analysis and conclusions in the report and consider all risks associated with the investment.

Members should consider including the following information in research reports:

  • Expected annual rate of return, taking into account cash flows and expected price changes during the holding period.
  • Annual amount of income expected (current and future).
  • Current rate of income return or yield to maturity.
  • Degree of uncertainty associated with cash flows.
  • Degree of marketability / liquidity.
  • Business, financial, political, sovereign, and market risks.

A report can be given in many forms: a written report, in-person communication, telephone conversation, media broadcast, or transmission by computer (e.g., on the Internet or by email).

Opinions should be distinguished clearly from facts. Specifically:

  • Past should be separated from future. Past represents facts, while forecast on future represents opinions.
  • In the case of quantitative analysis, facts should be separated from statistical conjecture.

Procedures for compliance

  • The selection of relevant factors is an analytical skill, and determination of whether a member is in compliance depends heavily on case-by-case review. To assist the after-the-fact review of a report, the member must maintain records indicating the nature of the research and should, if asked, be able to supply additional information to the client (or any user of the report) about factors not included.
  • Members must take reasonable steps to assure themselves of the reliability, accuracy, and appropriateness of the data included in each report. If the data has been processed in any way (e.g., into financial ratios), a member should ascertain that such processing has been done in a manner consistent with the member's analytical purposes.
  • Acknowledgment of the source(s) should be made when appropriate.

Example 1

To simplify his report, an analyst leaves out details of the valuation models. He violates this standard because clients need to fully understand the analyst's process and logic in order to implement the recommendation.

Example 2

An analyst issues a "buy" recommendation on a stock, mainly based on his optimistic assessment of the company's operation. He violates this standard by failing to distinguish between opinions and facts; his optimistic assessment of the company is his own opinion.

Example 3

An analyst issues a report promoting a firm's new investment strategy. The report stresses the likelihood of high returns. However, it does not describe the strategy in detail. The analyst violates this standard because his report fails to describe properly the basic characteristics of the investment strategy.

Example 4

An analyst has a duty to gather information about a company in o...
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Subject 17. Standard V (C) Record Retention
#analyst-notes #guidance-for-standards-i-vii
V. INVESTMENT ANALYSIS, RECOMMENDATIONS, AND ACTIONS

C. Record Retention.

Members and Candidates must develop and maintain appropriate records to support their investment analysis, recommendations, actions, and other investment-related communications with clients and prospective clients.

Members and candidates should maintain files to support investment recommendations. In addition to furnishing excellent reference materials for future work, research files play a key role in justifying investment decisions under later scrutiny. Files can serve as the ultimate proof that recommendations and actions, good or bad, were made based on the same methodology that drove the analyst's decisions.

  • Records can be maintained either in hardcopy or electronic form (soft copy).
  • CFA Institute recommends maintaining records for at least seven years.
  • Records are the property of the member's or candidate's firm.

Example

If an analyst writes investment recommendations based on many sources, such as stock exchange data, interviews with senior management, onsite company visits, and other third party research, he or she should document and keep copies of all the information that goes into recommendations.
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Subject 18. Standard VI (A) Disclosure of Conflicts
#analyst-notes #guidance-for-standards-i-vii
VI. CONFLICTS OF INTEREST

A. Disclosure of Conflicts.

Members and Candidates must make full and fair disclosure of all maters that could reasonably be expected to impair their independence and objectivity or interfere with respective duties to their clients, prospective clients, and employers. Members and Candidates must ensure that such disclosures are prominent, are delivered in plain language, and communicate the relevant information effectively.

Conflicts can occur between the interest of clients, the interests of employers, and the member's or candidate's own personal interest. In the investment industry, a conflict or the perception of a conflict often cannot be avoided and full disclosure is required.

1. Disclosure to Clients

Members shall disclose to their clients and prospects all matters, including beneficial ownership of securities or other investments, that reasonably could be expected to impair the members' ability to make unbiased and objective recommendations.

A member must disclose to clients/prospects the following conflicts:

  • Material ownership in the member's firm's investment account.
  • Market-making activities.
  • Corporate finance relationships.
  • Directorships.

The most obvious conflict that arises is when members own stocks in a company that they recommend to their clients.

  • Sell-side members must disclose any material beneficial ownership in a security. A sell-side analyst working for a broker or dealer may be enticed, for example, by corporate issuers to write research reports about certain companies.
  • Buy-side members should disclose their procedures for reporting requirements for personal transactions. A buy-side analyst will be faced with similar conflicts as banks exercise their underwriting and security-dealing powers. The marketing division may ask an analyst to recommend the stock of a certain company in order to obtain business from that company.

Service as a director of another firm poses three possible conflicts:

  • A possible conflict between the director's fiduciary duty to his or her clients and the director's duty to the shareholders of the firm.
  • A director may receive options to purchase securities or actual securities in his or her firm as part of a remuneration package. This may entice the director to push up the price of the firm's securities.
  • A director is likely to become aware of material nonpublic information, which may place him or her in a position of possible conflict.

Members should also disclose, with approval from their employers, special compensation arrangements with the employer that might conflict with clients' interests, such as bonuses based on short-term performance, commissions, performance fees, incentive fees, and referral fees.

Procedures for compliance

Many firms require employees and their families to report all transactions by employees and their families for purposes of detecting conflicts of interest and trading on material nonpublic information. Whether such requirements exist or not, members should report to employers, clients, and prospective clients any material beneficial interest they may have in securities and any corporate directorships or other special relationships they may have with the companies they are recommending. Members should make the disclosures before they make any recommendations or take any action regarding such investments.

There are two approaches to avoid potential conflicts of interest:

  • Avoidance: Personal investment through "blind trust" or "mutual fund," in which you have no influence on investment decisions.
  • Disclosures: As soon as the member has made full disclosure of the potential conflict, the client has all the relevant information to allow
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Subject 19. Standard VI (B) Priority of Transactions
#analyst-notes #guidance-for-standards-i-vii
VI. CONFLICTS OF INTEREST

B. Priority of Transactions.

Investment transactions for clients and employers must have priority over investment transactions in which a Member or Candidate is the beneficial owner.

This standard is designed to prevent any potential conflict of interest or even the appearance of a conflict of interest with respect to the analyst's personal transactions. Transactions for clients and employers shall have priority over transactions in securities or other investments in which a member is the beneficial owner so that such personal transactions do not operate adversely to clients' or employers' interests. If members make a recommendation regarding the purchase or sale of a security or other investment, they shall give their clients and employer adequate opportunity to act on their recommendations before acting on their own behalf.

For purposes of the Code and Standards, a member is a "beneficial owner" if the member has:

  • A direct or indirect pecuniary interest in the securities.
  • The power to vote or direct the voting of the shares of the securities or investments.
  • The power to dispose or direct the disposition of the security or investment.

This standard applies to all access persons. Personal transactions include those made for the member's own accounts, family accounts, and accounts in which the member has a direct or indirect pecuniary interest. Note that family accounts that are also client accounts should be treated like any other firm accounts. Neither special treatment nor disadvantage should be given to such accounts.

Procedures for compliance

Members should encourage their firms to prepare and distribute a Code of Ethics and compliance procedures, applicable to principals and employees, emphasizing their obligation to placing the interests of clients above personal and employer interests. The form and content of such compliance procedures depend on the size and nature of each organization and the laws to which it is subject. In general, however, the code and procedures should do the following:

  • Limited participation in equity IPOs.
    Members and candidates should not benefit from the position that their clients occupy in the marketplace - through preferred trading, the allocation of limited offerings, and/or oversubscription.

  • Restriction on private placements.
    As participants in private placements have an incentive to recommend these investments to clients, members and candidates should not be involved in these transactions, which could be perceived as favors or gifts designed to influence future judgment or to reward past business deals.

  • Establish blackout/ restricted periods.
    Managers or employees involved in the investment decision-making process should be prevented from initiating trades in a security for which their firms have a pending "buy" or "sell" order within a specific period before the order is executed or cancelled. They should not be allowed to do "front running."

  • Reporting requirements.

    • Disclosure of holdings in which the employee has a beneficial interest.
    • Providing duplicate confirmations of transactions. Investment professionals should ask their brokers to supply duplicate copies to their firms of all their personal securities transactions and copies of periodic statements.
    • Pre-clearance procedures. Investment professionals should clear all personal investments, to identify possible conflicts before the execution of personal trades.

  • Disclosure of policies.

Example 1

You receive a news release that a small firm in the industry that you follow has obtained a major contract with a multinational firm. The contract will doub...
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Subject 20. Standard VI (C) Referral Fees
#analyst-notes #guidance-for-standards-i-vii
VI. CONFLICTS OF INTEREST

C. Referral Fees.

Members and Candidates must disclose to their employers, clients, and prospective clients, as appropriate, any compensation, consideration, or benefit received by or paid to others for the recommendation of products or services.

Such disclosure should help the client evaluate any possible partiality shown in any recommendations of services as well as evaluate the full cost of services.

Members and candidates are required to:

  • Disclose the existence and terms of any referral fee agreements to all clients or prospects who have been referred under such agreements.
  • Describe the nature of the consideration and its estimated dollar value in this disclosure. Consideration includes all fees, whether paid or not (in cash, in soft dollars, or in kind).
  • Consult a supervisor and legal counsel concerning any prospective arrangement regarding referral fees.

Example 1

You provide investment counseling on a fee-for-services basis. You encourage all of your clients to place trades through a particular broker: Richard Jones. You have known Mr. Jones for many years and feel that he is an excellent broker with fees and services that are competitive for the type of clients you typically work with. Mr. Jones also provides you with a "finder's fee" for each client you refer to him. Even if the services recommended are reasonable and appropriate, you must still disclose the referral fee.

Example 2

ABC Firm has an agreement with XYZ Firm that ABC will recommend prospective pension clients to XYZ and in return XYZ will give ABC free research. ABC does not disclose the arrangement to prospective clients. ABC violates this standard for not disclosing the arrangement to prospective clients.
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Subject 21. Standard VII (A) Conduct as Members and Candidates in the CFA Program
#analyst-notes #guidance-for-standards-i-vii
VII. RESPONSIBILITIES AS A CFA INSTITUTE MEMBER OR CFA CANDIDATE

A. Conduct as Members and Candidates in the CFA Program.

Members and Candidates must not engage in any conduct that compromises the reputation or integrity of CFA Institute or the CFA designation or the integrity, validity, or security of the CFA examinations.

This standard applies to anyone who cheats, or helps other people to cheat, on the CFA examination or any other examination. Improperly using the CFA designation is also prohibited by this standard.

Example

Melissa White, CFA, runs her own investment advisory firm and serves as a proctor for the administration of the CFA examination in her city. She receives copies of the Level II CFA examination many days before the exam day. On the evening prior to the exam, she provides information concerning the examination questions to two stressed candidates whom are also her best-performing advisors.

White and the two candidates violated the standard. Although it does not involve clients' money or an investment recommendation, White and the two members undermined the integrity and validity of the examination.
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Subject 22. Standard VII (B) Reference to CFA Institute, the CFA Designation, and the CFA Program
#analyst-notes #guidance-for-standards-i-vii
VII. RESPONSIBILITIES AS A CFA INSTITUTE MEMBER OR CFA CANDIDATE

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

When referring to CFA Institute, CFA Institute membership, the CFA designation, or candidacy in the CFA Program, Members and Candidates must not misrepresent or exaggerate the meaning or implications of membership in CFA Institute, holding the CFA designation, or candidacy in the CFA Program.

CFA Institute's members, CFA charterholders, and candidates in the CFA program must utilize their designation in the correct manner so as not to mislead the investing public. Since achievement of the CFA charter signifies a certain degree of knowledge, the public and clients expect a certain degree of knowledge when encountering the CFA designation.

CFA Institute membership

Requirements to be granted the right to use the CFA or Chartered Financial Analyst designation:

  • Pass all three levels of the CFA program.
  • Receive the charters.
  • Make an ongoing commitment to abide by the requirements of CFA Institute's Professional Conduct Program (including filing an annual professional conduct statement).
  • Due-paying (every year) and good standing.

If a member fails to meet any of these requirement, he or she cannot claim him- or herself to be a member.

Members should reference membership in a dignified and judicious manner; if necessary, this would include an accurate explanation of the requirements for obtaining membership.

Using the Chartered Financial Analyst designation

CFA charterholders may use the term "Chartered Financial Analyst" or "CFA" in a proper, dignified, and judicious manner (if necessary, with an accurate explanation of the requirements for obtaining the right to use the designation).

Referencing candidacy in the CFA Program

CFA candidates may reference their participation in the CFA Program, but the reference must clearly state that an individual is a CFA candidate and cannot imply that the candidate has achieved any type of partial designation.

  • To be a candidate, a person's application should have been accepted, and he or she should be enrolled to sit for a specified exam (for which he or she has not received exam results or failed to sit).
  • There is no designation for someone who has passed Level I, II or III of the CFA examinations.
  • Candidates may indicate that they have completed Level I, II or III of the CFA program. However, candidates cannot imply that they have achieved partial designation even if they have passed all three levels of the exam.

About the CFA mark

  • It is registered in many countries (along with Chartered Financial Analyst).
  • It does not serve as an acronym, cannot be used as a noun, and should never be used in the plural or the possessive.
  • Only CFA or Chartered Financial Analyst should appear after the charterholder's name. "John Smith, CFA," or "John Smith, Chartered Financial Analyst," is correct.

Applications

  • Advertisements: can mention that an individual has passed all three exams on the first try, but cannot mention that an individual has accomplished what few others have done, or that the designation implies superior performance capabilities.
  • Placing "CFA Level II Candidate" after a candidate's name implies that this a partial designation, which is a violation.
  • The designation "CFA" cannot be listed in a typeset larger than that used for the charterholder's name.

    Examples:

    • Richard is a CFA (or Chartered Financial Analyst): WRONG!
    • Richard is a CFA charterholder. He earned the right to use the Chartered Financial Analyst designat
...
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Subject 1. Why were the GIPS Standards Created?
#analyst-notes #gips #introduction-to-the-global-investment-performance-standards
The financial markets and investment management industry has become increasingly global in nature. A common problem when reporting investment performance across different borders is that some countries have performance measurements and disclosures that are tailored specifically to them but that differ greatly from those in other countries. Some countries do not even have any standardized approaches for investment firms to follow to ensure fair representation and full disclosure of performance information.

In the past, making meaningful comparisons on the basis of accurate investment performance data was difficult because of some misleading practices, such as:

  • Representative accounts. Only the results of the best portfolio or securities are presented.

  • Survivorship bias. For example, many mutual fund databases provide historical data about only those funds that are currently in existence. As a result, funds that have ceased to exist due to closures or mergers do not appear in these databases. Generally, funds that have ceased to exist have lower returns relative to the surviving funds. Therefore, the analysis of a mutual fund database with survivorship bias will overestimate the average mutual fund return because the database only includes the better-performing funds.

  • Varying time periods. Only the results for profitable time periods are reflected.

The GIPS standards lead investment management firms to avoid misrepresentations of performance and to communicate all relevant information that prospective clients should know in order to evaluate past results.
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Subject 2. Parties Affected by GIPS
#analyst-notes #introduction-to-the-global-investment-performance-standards-gips
1. Firms

The GIPS standards apply primarily to investment management firms. The performance results of firms adopting GIPS will be more readily comparable. However, while firms are encouraged to adopt GIPS, the standards arevoluntary.

2. CFA Institute's Members, CFA Charterholders, and CFA Candidates

  • GIPS are a way of ensuring that no material misrepresentation of performance takes place.
  • GIPS satisfy Standard V (B) Communication with Clients and Prospective Clients.
  • Members, charterholders and candidates should inform employers of GIPS and encourage their adoption (though this is not mandatory).

3. Prospective and Current Clients

  • They are the primary beneficiaries of GIPS.
  • GIPS allow effective comparisons; they can directly compare the performance results of firms adopting GIPS.
  • Clients must still use due diligence.
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Subject 3. Composites
#analyst-notes #introduction-to-the-global-investment-performance-standards-gips
A composite is defined as a group of portfolios that are managed with the same strategy or objective. Rather than presenting the performance of each individual portfolio, the firm can simply disclose the composite return of the portfolios as a group.

The determination of which portfolios to include in the composite should be done according to pre-established criteria (i.e., on an ex-ante basis), not after the fact. This prevents a firm from including only their best-performing portfolios in the composite.

The composite return is the asset-weighted average of the performance results of all the portfolios in the composite.

The following is not required for the Level I candidate but is provided as a reference only.

Composite construction

  • All actual, fee-paying, discretionary portfolios must be included in at least one composite.
  • Firm composites must be defined according to similar investment objectives and strategies.
  • Composites must include new portfolios on a timely and consistent basis soon after the portfolio is being managed.
  • Terminated portfolios must be included in the historical record up to the last full measurement period that the portfolio was under management.
  • Portfolios must not be switched from one composite to another unless this change is documented in the client guidelines or if there is a redefinition of the composite. The historical results must remain with the old composite.
  • Convertible and other hybrid securities must be treated consistently across time and within composites.
  • Before January 1, 2010, if a single asset class was carved out of a multiple-asset portfolio and the returns presented as part of a single-asset composite, cash must be allocated to single-asset returns and the allocation method must be disclosed.
  • From January 1, 2010 on, carved-out returns must not be included in single-asset-class-composite returns unless the assets are actually managed separately and have their own cash allocations.
  • No model or simulated performance may be linked to actual performance. Composites must include only assets under management.
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Subject 4. Verification
#analyst-notes #introduction-to-the-global-investment-performance-standards-gips
Verification refers to the independent review of a firm's performance measurement processes and procedures. Verification applies to the firm as a whole, not to individual composites.

Verification tests:

  • Whether the firm has complied with GIPS composite construction requirements on a firm-wide basis.
  • Whether the firm's processes and procedures are designed to calculate and present GIPS-compliant performance results.

Again, the focus of verification is not on individual composites, but on the processes the firm follows to form composites and calculate and report performance.

At this point, verification is not mandatory, but it is strongly recommended. Firms may claim compliance, but independently-verified compliance adds credibility to those claims. It is recommended that firms have all years for which they are claiming compliance verified.
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Subject 1. Introduction: The Vision Statement, Objectives and Key Characteristics of GIPS Standards
#analyst-notes #global-investment-performance-standards-gips
The overall purpose of GIPS is to provide guidelines for fair and full disclosure of investment performance. This will allow current and potential clients to properly interpret investment results over time and between firms.

There are four goals of GIPS:

  • Bolster investor confidence by ensuring the completeness, fairness, and standardization of calculation and presentation of investment performance on a global basis.
  • Serve as a minimum standard to which all investment managers in the world should adhere.
  • Enable global investment management firms to present performance results that are comparable with firms in other countries.
  • Facilitate communications between investment managers and their prospective clients on evaluating historical performance results and developing future strategies.

In 1999, the Investment Performance Council (IPC) was created to provide an implementation structure for the GIPS standards. All countries are encouraged to adopt the GIPS standards as the common method for calculating and presenting investment performance. When applicable local or country-specific laws or regulations conflict with the GIPS standards, firms should comply with the GIPS standards in addition to those local requirements.

As of January 2010, more than 32 countries had adopted or were in the process of adopting the GIPS standards.

Now IPC is entering its second phase of the convergence strategy to the GIPS standards: to evolve the GIPS standards to incorporate local best practices from all regional standards.

Vision Statement

A global investment performance standard leads to readily accepted presentations of investment performance that

  • present performance results that are readily comparable among investment managers, without regard to geographic location, and
  • facilitate a dialogue between investment managers and their prospective clients about the critical issues of how the manager achieved performance results and future investment strategies.

Objectives

  • Obtain worldwide acceptance of a standard for the calculation and presentation of investment performance in a fair, comparable format that provides full disclosure.
  • Ensure accurate and consistent investment and performance data for reporting, record keeping, marketing, and presentation.
  • Promote fair, global competition among investment firms for all markets without creating barriers to entry for new firms.
  • Foster a notion of industry self-regulation on a global basis.

Key Characteristics

  • Firm definition: a direct business entity.
  • GIPS are ethical standards, not legal standards, for performance presentation. The objective is to present performance results fairly and with full disclosure.
  • Composites: All actual, fee-paying, discretionary portfolios must be included in at least one composite.
  • Calculation and presentation requirements.
  • The integrity of input data.
  • There are two components: requirements and recommendations.
  • Appropriate disclosure when local laws or regulations conflict with the standards.
  • The eight sections of GIPS standards.
  • The standards will evolve to address new aspects of investment performance.
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Subject 2. The Scope of GIPS Standards with Respect to Definition of the Firm, Historical Performance Record, and Compliance
#analyst-notes #global-investment-performance-standards-gips
Definition of the Firm

It is intended that GIPS compliance be available to any firm. A firm must comply with GIPS on a firm-wide basis to claim compliance with the standards. All actual, fee-paying, discretionary portfolios managed by the firm must be included in the performance-measurement process.

To be in compliance, an entity must state how it defines itself as a firm.

  • A firm may be defined as an investment firm, subsidiary or division held out to be a distinct business unit for managing investment assets. It could be part of a larger organization.
  • Total firm assets must be the aggregate of the fair value of all discretionary and nondiscretionary assets under management within the defined firm. This includes both fee-paying and non-fee-paying assets.
  • Firms must include the performance of assets assigned to a sub-advisor in a composite, provided that the firm has discretion over the selection of the sub-advisor.
  • Changes in a firm's organization are not permitted to lead to alteration of historical composite results.

Historical Performance Record

Firms should present their long-term performance records. To be in compliance, a firm must:

  • Initially present a minimum of five years of compliant annual investment performance results, except for composites which have been in existence for less than five years (in which case, composite performance since inception must be presented).
  • Add an additional year of compliant performance results each year until they reach 10 years of results.

The goal is to have 10 years of GIPS-compliant performance results presented. To encourage firms to participate, GIPS only requires five years of data to initially come into compliance, allowing the full 10 years of performance results to be built over time. There is nothing to prevent a firm from initially presenting a full 10 years of compliance results. To maintain compliance, a firm presenting less than 10 years of performance results must increase the number of years of performance results presented.

Claim of Compliance

Which version of GIPS standards should firms comply with?

The revised GIPS standards were adopted in 2010 and became effective on January 1, 2011. Although early adoption of these revised GIPS standards is encouraged, firms can still use the old version for performance presentations that include results through December 31, 2010.

In order to claim compliance, a firm must meet ALL the requirements set forth in GIPS. Firms that fully comply with GIPS may use the following compliance statement in their performance presentations: "[Name of the firm] has prepared and presented this report in compliance with the Global Investment Performance Standards (GIPS)."

With regard to compliance, a firm is either in compliance or not in compliance. Firms may not make any claims to being "in compliance except for..."

Appropriate disclosure when the GIPS standards and local regulations are in conflict:

GIPS standards serve as minimum worldwide standards. If local laws are stricter than GIPS, local laws should be applied. If local laws don't exist or are less strict than the GIPS, the GIPS should apply. In cases of conflicts with GIPS, the standards require that local laws and regulations take precedence over GIPS.

Firms should disclose any conflicts.
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Subject 3. The Nine Major Sections of the GIPS Standards
#analyst-notes #global-investment-performance-standards-gips
Following are the nine sections involved in GIPS. Each section has requirements and recommendations. Allrequirements must be met in order to be fully compliant with the GIPS. Firms are encouraged to adopt and implement the recommendations.

0. Fundamentals of Compliance.

This section deals with firm definition, policies and procedures documentation, compliance claiming, and the fundamental responsibilities of a firm. The definition of a firm and claims of compliance have been covered in the last subject.

Document Policies and Procedures

Firms must document, in writing, the policies and procedures used in establishing and maintaining compliance with all the applicable requirements of the GIPS standards.

Fundamental Responsibilities

  • Firms must provide a compliant presentation for any listed composite, along with a composite description, to all prospective clients.
  • Discontinued composites must be listed for at least five years after discontinuation. Firms cannot alter their performance history by excluding portfolios no longer under management or no longer managed by the same manager, or by including the performance of portfolios managed by current employees before they started working for the firm.
  • Firms should establish procedures to monitor GIPS requirements and the firm's performance measurements and presentations to ensure continued compliance.

1. Input Data.

Input data requirements set standards for the collection of data necessary for calculating performance results that will be comparable across firms. For example, benchmarks and composites should be created / selected on an ex-ante basis, not after the fact.

2. Calculation Methodology.

Achieving comparability among firms' performance presentations requires uniformity in the methods used to calculate returns. The standards mandate the use of certain calculation methodologies for both portfolios and composites. For example, total returns methodology is required for compliance. Total returns include realized and unrealized capital gains/losses, interest (accrued during a valuation period), and dividends paid (considered paid on the ex-date).

3. Composite Construction.

Creating meaningful asset-weighted composites is critical to the fair presentation, consistency, and comparability of results over time and among firms.

4. Disclosure.

Firms must disclose certain information about their performance presentations and policies adopted. Disclosures are considered to be static information that does not normally change from period to period.

5. Presentation and Reporting.

After completing steps one to four, firms should incorporate this information in GIPS-compliant presentations.

6. Real Estate.

This section applies to any real estate investment or management. It applies regardless of a firm's control over the management of the investment, its profitability, or its financing.

7. Private Equity.

This section applies to all private equity investments other than open-end or evergreen funds. Private equity refers to any investment in nonpublic companies. Examples include venture investing, buy-out investing, mezzanine investing, fund-of-funds investing, secondary investing, etc.

8. Wrap Fee/ Separately Managed Account (SMA) Portfolios.

This section applies to wrap fee/ SMA portfolios. A wrap fee is a comprehensive charge levied by an investment manager or investment advisor on a client for providing a bundle of services, such as investment advice, investment research, and brokerage services.
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