2022 CFA Program Curriculum Level II Volumes 1-6
Quantitative Methods and Economics
Title Page
Contents
How to Use the CFA Program Curriculum
Background on the CBOK
Organization of the Curriculum
Features of the Curriculum
Designing Your Personal Study Program
CFA Institute Learning Ecosystem (LES)
Prep Providers
Feedback
Quantitative Methods
Study Session 1 Quantitative Methods (1)
Reading 1 Introduction to Linear Regression
Simple Linear Regression
Estimating the Parameters of a Simple Linear Regression
The Basics of Simple Linear Regression
Estimating the Regression Line
Interpreting the Regression Coefficients
Cross-Sectional vs. Time-Series Regressions
Assumptions of the Simple Linear Regression Model
Assumption 1: Linearity
Assumption 2: Homoskedasticity
Assumption 3: Independence
Assumption 4: Normality
Analysis of Variance
Breaking down the Sum of Squares Total into Its Components
Measures of Goodness of Fit
ANOVA and Standard Error of Estimate in Simple Linear Regression
Hypothesis Testing of Linear Regression Coefficients
Hypothesis Tests of the Slope Coefficient
Hypothesis Tests of the Intercept
Hypothesis Tests of Slope When Independent Variable Is an Indicator Variable
Test of Hypotheses: Level of Significance and p-Values
Prediction Using Simple Linear Regression and Prediction Intervals
Functional Forms for Simple Linear Regression
The Log-Lin Model
The Lin-Log Model
The Log-Log Model
Selecting the Correct Functional Form
Summary
Practice Problems
Solutions
Reading 2 Multiple Regression
Testing the Whole Multiple Linear Regression Model and Adjusted R-square
Adjusted R2
Multiple Linear Regression Assumptions, Testing Coefficients, and Prediction
Multiple Linear Regression
Dummy Variables in a Multiple Linear Regression
Defining a Dummy Variable
Visualizing and Interpreting Dummy Variables
Testing for Statistical Significance
Violations of Regression Assumptions: Heteroskedasticity
Heteroskedasticity
Violations of Regression Assumptions: Serial Correlation
The Consequences of Serial Correlation
Testing for Serial Correlation
Correcting for Serial Correlation
Violations of Regression Assumptions: Multicollinearity
The Consequences of Multicollinearity
Detecting Multicollinearity
Correcting for Multicollinearity
Heteroskedasticity, Serial Correlation, Multicollinearity: Summarizing the Issues
Model Specification Errors
Principles of Model Specification
Misspecified Functional Form
Time-Series Misspecification (Independent Variables Correlated with Errors)
Other Types of Time-Series Misspecification
Multiple Linear Regression with Qualitative Dependent Variables
Models with Qualitative Dependent Variables
Summary
Practice Problems
Solutions
Reading 3 Time-Series Analysis
Introduction to Time-Series Analysis and Challenges of Working with Time Series
Challenges of Working with Time Series
Linear Trend Models
Linear Trend Models
Log-Linear Trend Models
Trend Models and Testing for Correlated Errors
Autoregressive (AR) Time-Series Models and Covariance-Stationary Series
Covariance-Stationary Series
Detecting Serially Correlated Errors in an Autoregressive Model
Mean Reversion and Multiperiod Forecasts and the Chain Rule of Forecasting
Multiperiod Forecasts and the Chain Rule of Forecasting
Comparing Forecast Model Performance
Instability of Regression Coefficients
Random Walks
Random Walks
The Unit Root Test of Nonstationarity
Moving-Average Time-Series Models
Smoothing Past Values with an n-Period Moving Average
Moving-Average Time-Series Models for Forecasting
Seasonality in Time-Series Models
Autoregressive Moving-Average Models and Autoregressive Conditional Heteroskedasticity Models
Autoregressive Conditional Heteroskedasticity Models
Regressions with More Than One Time Series
Other Issues in Time Series and Suggested Steps in Time-Series Forecasting
Suggested Steps in Time-Series Forecasting
Summary
Practice Problems
Solutions
Study Session 2 Quantitative Methods (2)
Reading 4 Machine Learning
Introduction
Machine Learning and Investment Management
What is Machine Learning
Defining Machine Learning
Supervised Learning
Unsupervised Learning
Deep Learning and Reinforcement Learning
Summary of ML Algorithms and How to Choose among Them
Overview of Evaluating ML Algorithm Performance
Generalization and Overfitting
Errors and Overfitting
Preventing Overfitting in Supervised Machine Learning
Supervised Machine Learning Algorithms: Penalized Regression
Penalized Regression
Support Vector Machine
K-Nearest Neighbor
Classification and Regression Tree
Ensemble Learning and Random Forest
Voting Classifiers
Bootstrap Aggregating (Bagging)
Random Forest
Case Study: Classification of Winning and Losing Funds
Data Description
Methodology
Results
Conclusion
Unsupervised Machine Learning Algorithms and Principal Component Analysis
Principal Components Analysis
Clustering
K-Means Clustering
Hierarchical Clustering: Agglomerative and Dendrograms
Dendrograms
Case Study: Clustering Stocks Based on Co-Movement Similarity
Neural Networks, Deep Learning Nets and Reinforcement Learning and Neural Networks
Neural Networks
Deep Learning Nets, Reinforcement and Learning
Reinforcement Learning
Case Study: Deep Neural Network–Based Equity Factor Model
Introduction
Data Description
Experimental Design
Results
Choosing an Appropriate ML Algorithm
Summary
Practice Problems
Solutions
Reading 5 Big Data Projects
Introduction and Big Data in Investment Management
Big Data in Investment Management
Steps in Executing a Data Analysis Project: Financial Forecasting with Big Data
Data preparation and Wrangling
Structured Data
Unstructured (Text) Data
Text Preparation (Cleansing)
Text Wrangling (Preprocessing)
Data Exploration Objectives and Methods and Structured Data
Structured Data
Unstructured Data - Text Exploration
Exploratory Data Analysis
Feature Selection
Feature Engineering
Model Training, Structured and Unstructured Data, Method Selection
Structured and Unstructured Data
Performance Evaluation
Tuning
Financial Forecasting Project - Classifying and Predicting Sentiment for Stocks, and Text Curation, Preparation and Wrangling
Text Curation, Preparation, and Wrangling
Data Exploration
Exploratory Data Analysis
Feature Selection
Feature Engineering
Model Training
Method Selection
Performance Evaluation and Tuning
Results and Interpretation
Summary
Practice Problems
Solutions
Economics
Study Session 3 Economics
Reading 6 Currency Exchange Rates: Understanding Equilibrium Value
Introduction
Foreign Exchange Market Concepts
Arbitrage Constraints on Spot Exchange Rate Quotes
Forward Markets
The Mark-to-Market Value of a Forward Contract
A Long-Term Framework for Exchange Rates: International Parity Conditions
International Parity Conditions
Covered Interest Rate Parity, Uncovered Interest Rate Parity, & Forward Rate Parity
Uncovered Interest Rate Parity
Forward Rate Parity
Purchasing Power Parity
The Fisher Effect, Real Interest Rate Parity and Tying the International Parity Conditions Together
International Parity Conditions: Tying All the Pieces Together
The Carry Trade
The Impact of Balance of Payments Flows: Current Account Imbalances and the Determination of Exchange Rates
Current Account Imbalances and the Determination of Exchange Rates
Capital Flows and the Determination of Exchange Rates and Equity Market Trends and Exchange Rates,
Equity Market Trends and Exchange Rates
Monetary and Fiscal Policies
The Mundell–Fleming Model
Monetary Models of Exchange Rate Determination
The Portfolio Balance Approach
Exchange Rate Management: Intervention and Controls
Warning Signs of a Currency Crisis
Summary
Appendix
Practice Problems
Solutions
Reading 7 Economic Growth
An Introduction to Growth in the Global Economy: Developed vs. Developing Economies
Growth in the Global Economy: Developed vs. Developing Economies
Factors Favoring and Limiting Economic Growth
Financial Markets and Intermediaries
Political Stability, Rule of Law, and Property Rights
Education and Health Care Systems
Tax and Regulatory Systems
Free Trade and Unrestricted Capital Flows
Summary of Factors Limiting Growth in Developing Countries
Why Potential Growth Matters to Investors
Determinants of Economic Growth: Production Function and Growth Accounting
Production Function
Growth Accounting
Extending the Production Function
Capital Deepening vs. Technological Progress
Natural Resources
Labor Supply
Population Growth
Labor Force Participation
Net Migration
Average Hours Worked
Labor Quality: Human Capital
Capital: ICT & Non-ICT, Technology and Public Infrastructure
Technology
Public Infrastructure
Summary of Economic Growth Determinants
Theories of Growth, Classical and Neoclassical Economic Models and Balanced or Steady State Rate of Growth
Classical Model
Neoclassical Model
Implications of Neoclassical Model
Extension of Neoclassical Model
Endogenous Growth Model
Convergence Hypotheses
Growth In An Open Economy
Summary
Practice Problems
Solutions
Reading 8 Economics of Regulation
Introduction
Economic Rationale for Regulation
Rationale for the Regulation of Financial Markets
Regulation of Commerce
Antitrust Regulation and Framework
Classification of Regulations and Regulators
Classification of Regulations and Regulators
Regulatory Interdependencies
Regulatory Tools
Cost-Benefit Analysis
Basic Concepts of Cost–Benefit Analysis
Analysis of Regulation
Assessment of the likelihood of regulatory change
Assessment of the impact of regulatory change on a sector
Summary
Practice Problems
Solutions
Appendices
Glossary
Financial Statement Analysis
Title Page
Contents
How to Use the CFA Program Curriculum vii
Background on the CBOK
Organization of the Curriculum
Features of the Curriculum
Designing Your Personal Study Program
CFA Institute Learning Ecosystem (LES)
Prep Providers
Feedback
Financial Statement Analysis
Study Session 4 Financial Statement Analysis (1)
Reading 9 Intercorporate Investments
Introduction
Basic Corporate Investment Categories
Investments In Financial Assets: IFRS 9
Classification and Measurement
Reclassification of Investments
Investments In Associates And Joint Ventures: Equity Method of Accounting, Basis Principles
Equity Method of Accounting: Basic Principles
Investment Costs That Exceed the Book Value of the Investee, Amortization of Excess Purchase Price, Fair Value Option and Impairment
Amortization of Excess Purchase Price
Fair Value Option
Impairment
Transactions with Associates and Disclosure
Disclosure
Issues for Analysts
Business Combinations: Acquisition Method and Impact of the Acquisition Method on Financial Statements Post-Acquisition
Acquisition Method
Impact of the Acquisition Method on Financial Statements, Post-Acquisition
The Consolidation Process
Business Combination with Less than 100% Acquisition
Non-controlling (Minority) Interests: Balance Sheet
Non-controlling (Minority) Interests: Income Statement
Goodwill Impairment
Financial Statement Presentation Subsequent to the Business Combination
Variable Interest and Special Purpose Entities
Securitization of Assets
Additional Issues in Business Combinations That impair Comparability
Contingent Assets and Liabilities
Contingent Consideration
In-Process R&D
Restructuring Costs
Summary
Practice Problems
Solutions
Reading 10 Employee Compensation: Post-Employment and Share-Based
Introduction
Pensions and Other Post-Employment Benefits
Types of Post-Employment Benefit Plans
Measuring a Defined Benefit Pension Plan's Obligations
Financial Statement Reporting of Pension Plans and Other Post-Employment Benefits: Defined Contribution Pension Plans
Defined Contribution Pension Plans
Financial Statement Reporting of Pension Plans: Balance Sheet Reporting for Defined Benefit Pension Plans
Balance Sheet Presentation
Financial Statement Reporting of Pension Plans: Periodic Pension Costs for Defined Benefit Pension Plans
More on the Effect of Assumptions and Actuarial Gains and Losses on Pension and Other Post-Employment Benefit Costs
Calculation of Defined Benefit Pension Obligation and Current Service Costs
Disclosures of Pension and Other Post-Employment Benefits: Assumptions
Assumptions
Disclosures of Pension and Other Post-Employment Benefits: Net Pension Liability (or Asset) and Periodic Pension Costs
Total Periodic Pension Costs
Periodic Pension Costs Recognised in P&L vs. OCI
Classification of Periodic Pension Costs Recognised in P&L
Disclosures of Pension and Other Post-Employment Benefits: Cash Flow Information
Share-Based Compensation
Stock Grants
Stock Options
Other Types of Share -Based Compensation
Summary
Practice Problems
Solutions
Reading 11 Multinational Operations
Introduction and Foreign Currency Transactions: Foreign Currency Transaction Exposure to Foreign Exchange Risk and Analytical Issues
Foreign Currency Transactions
Disclosures Related to Foreign Currency Transaction Gains and Losses
Translation of Foreign Currency Financial Statements and Translation Conceptual Issues
Translation Conceptual Issues
Translation Methods
Foreign Currency Is the Functional Currency
Parent’s Presentation Currency Is the Functional Currency
Translation of Retained Earnings
Highly Inflationary Economies
Illustration of Translation Methods (Excluding Hyperinflationary Economies)
Translation Analytical Issues
Translation When a Foreign Subsidiary Operates in an Hyperinflationary Economy
Companies Use Both Translation Methods at the Same Time and Disclosures Related to Translation Methods
Disclosures Related to Translation Methods
Multinational Operations and a Company's Effective Tax Rate
Additional Disclosures on the Effects of Foreign Currency
Disclosures Related to Sales Growth
Disclosures Related to Major Sources of Foreign Exchange Risk
Summary
Practice Problems
Solutions
Reading 12 Analysis of Financial Institutions
Introduction to Financial Institutions
What Makes Financial Institutions Different?
Global Organizations
Individual Jurisdictions’ Regulatory Authorities
Analyzing a Bank: the CAMELS Approach
The CAMELS Approach
Analyzing a Bank: non-CAMELS Factors
Banking-Specific Analytical Considerations Not Addressed by CAMELS
Analytical Considerations Not Addressed by CAMELS That Are Also Relevant for Any Company
Analyzing a Bank: Example of CAMELS Approach
Capital Adequacy
Asset Quality
Management Capabilities
Earnings
Liquidity Position
Sensitivity to Market Risk
Overall CAMELS Assessment
Analyzing Property and Casualty Insurance Companies
Property and Casualty Insurance Companies
Analyzing Life and Health Insurance Companies
Life and Health Insurance Companies
Summary
Practice Problems
Solutions
Study Session 5 Financial Statement Analysis (2)
Reading 13 Evaluating Quality of Financial Reports
Introduction
Quality of Financial Reports: Conceptual Framework
Conceptual Framework for Assessing the Quality of Financial Reports
Potential Problems that Affect the Quality of Financial Reports and Reported Amounts and Timing of Recognition
Reported Amounts and Timing of Recognition
Classification
Quality Issues and Mergers and Acquisitions & Financial Reporting that Diverges from Economic Reality Despite Compliance with Accounting Rules
Financial Reporting that Diverges from Economic Reality Despite Compliance with Accounting Rules
Evaluating the Quality of Financial Reports: General Steps
General Steps to Evaluate the Quality of Financial Reports
Quantitative Tools to Assess the Likelihood of Misreporting
Beneish Model
Other Quantitative Models
Limitations of Quantitative Models
Earnings Quality Indicators and Recurring Earnings
Indicators of Earnings Quality
Earnings Persistence and Related Measures of Accruals
Mean Reversion in Earnings, Beating Benchmarks and External Indicators of Poor-Quality Earnings
Beating Benchmarks
External Indicators of Poor-Quality Earnings
Evaluating the Earnings Quality of a Company - Revenue Recognition Case: Sunbeam Corporation
Revenue Recognition Case: Sunbeam Corporation
Revenue Recognition Case: MicroStrategy, Inc.
Multiple-Element Contracts
Cost Capitalization Case: WorldCom Corp.
Property/Capital Expenditures Analysis
Bankruptcy Prediction Models: Altman Model, Developments in Bankruptcy Prediction Models
Altman Model
Developments in Bankruptcy Prediction Models
Cash Flow Quality
Indicators of Cash Flow Quality
Evaluating Cash Flow Quality
Balance Sheet Quality
Sources of Information about Risk and Limited Usefulness of Auditor's Report
Limited Usefulness of Auditor’s Opinion as a Source of Information about Risk
Risk-Related Disclosures in the Notes
Management Commentary (MD&A), Other Required Disclosures, Financial Press
Other Required Disclosures
Financial Press as a Source of Information about Risk
Summary
Practice Problems
Solutions
Reading 14 Integration of Financial Statement Analysis Techniques
Introduction
Case Study 1: Long -Term Equity Investment: Early Phases of the Analysis
Phase 1: Define a Purpose for the Analysis
Phase 2: Collect Input Data
Phases 3 & 4: DuPont Analysis: Isolating "Pure Nestle"
Phase 3: Process Data and Phase 4: Analyze/Interpret the Processed Data
Phases 3 & 4: DuPont Decomposition
Phases 3 & 4: Adjusting for Unusual Charges
Phases 3 & 4: Asset Base Composition
Asset Base Composition
Phases 3 & 4: Capital Structure Analysis
Capital Structure Analysis
Phases 3 & 4: Segment Analysis: Earnings & Capital
Segment Analysis and Capital Allocation
Phases 3 & 4: Segment Analysis: Cash Flow & Capital
Phases 3 & 4: Segment Analysis by Product Group
Phases 3 & 4: Accruals and Earnings Quality
Phases 3 & 4: Cash Flow Relationships
Phases 3 & 4: Decomposition and Analysis of the Company's Valuation
Phases 5 & 6: Develop and Communicate Conclusions and Recommendations and Follow-up
Phase 5: Develop and Communicate Conclusions and Recommendations (e.g., with an Analysis Report)
Phase 6: Follow-up
Summary
Practice Problems
Solutions
Glossary
Corporate Issuers and Equity
Title Page
Contents
How to Use the CFA Program Curriculum
Background on the CBOK
Organization of the Curriculum
Features of the Curriculum
Designing Your Personal Study Program
CFA Institute Learning Ecosystem (LES)
Prep Providers
Feedback
Corporate Issuers
Study Session 6 Corporate Issuers (1)
Reading 15 Capital Structure
Introduction
Modigliani-Miller Proposition I without Taxes: Capital Structure Irrelevance
Proposition I without Taxes: Capital Structure Irrelevance
Modigliani-Miller Proposition II without Taxes: Higher Financial Leverage Raises the Cost of Equity
Modigliani-Miller Propositions with Taxes: Taxes, Cost of Capital and Value of the Company
Other Capital Structure Cost Considerations: Costs of Financial Distress
Other Capital Structure Costs: Agency Costs and Costs of Asymmetric Information
Costs of Asymmetric Information
Optimal Capital Structure: Static Trade-Off Theory
Capital Structure Policy: Practical Issues and Evaluation
Debt Ratings
Evaluating Capital Structure Policy
International Capital Structure Differences: Country-specific Factors
Institutional and Legal Environment
Financial Markets and the Banking Sector
Macroeconomic Environment
Conclusions
Summary
Practice Problems
Solutions
Reading 16 Analysis of Dividends and Share Repurchases
Dividends: Forms and Effects on Shareholder Wealth and Financial Ratios
Dividends: Forms and Effects on Shareholder Wealth and Issuing Company’s Financial Ratios
Dividend Policy and Company Value: Theory
Dividend Policy Does Not Matter
Dividend Policy Matters: The Bird in the Hand Argument
Dividend Policy Matters: The Tax Argument
Other Theoretical Issues: Clientele Effect and the Information Content of Dividend Actions: Signaling
The Information Content of Dividend Actions: Signaling
Agency Costs and Dividends as a Mechanism to Control Them
Other Theoretical Issues: Agency Costs and Dividends as a Mechanism to Control Them and Dividend Theory: Summary
Factors Affecting Dividend Policy in Practice
Investment Opportunities
The Expected Volatility of Future Earnings
Financial Flexibility
Tax Considerations
Flotation Costs
Contractual and Legal Restrictions
Factors Affecting Dividend Policy: Summary
Payout Policies
Stable Dividend Policy
Constant Dividend Payout Ratio Policy
Global Trends in Payout Policy
Share Repurchases, Methods and Financial Statement Effects
Share Repurchase Methods
Financial Statement Effects of Repurchases
Valuation Equivalence of Cash Dividends and Share Repurchase: The Baseline
The Dividend versus Share Repurchase Decision
Analysis of Dividend Safety
Summary
Practice Problems
Solutions
Study Session 7 Corporate Issuers (2)
Reading 17 Environmental, Social, and Governance (ESG) Considerations in Investment Analysis
Introduction
Ownership Structures and Their Effects on Corporate Governance
Dispersed vs. Concentrated Ownership
Conflicts within Different Ownership Structures
Types of Influential Shareholders
Effects of Ownership Structure on Corporate Governance
Evaluating Corporate Governance Policies and Procedures
Board Policies and Practices
Executive Remuneration
Shareholder Voting Rights
Identifying ESG-Related Risks and Opportunities
Materiality and Investment Horizon
Relevant ESG-Related Factors
Evaluating ESG-Related Risks and Opportunities
ESG Integration
Examples of ESG Integration
Summary
Practice Problems
Solutions
Reading 18 Mergers and Acquisitions
Introduction
Mergers and Acquisitions: Definitions and Classifications
Motives for Mergers
Synergy
Growth
Increasing Market Power
Acquiring Unique Capabilities and Resources
Unlocking Hidden Value
Tax Considerations
Cross-Border Motivations
Diversification
Managers’ Personal Incentives
Bootstrapping Earnings
Mergers and the Industry Life Cycle
Merger Transaction Characteristics
Form of Acquisition
Method of Payment
Mindset of Target Management
Takeovers and Their Defense Mechanisms
Pre-Offer Takeover Defense Mechanisms
Post-Offer Takeover Defense Mechanisms
Regulation and Competition Law
Target Company Valuation: Discounted Cash Flow Analysis
Target Company Valuation
Target Company Valuation: Comparable Company and Comparable Transaction Analysis
Comparable Transaction Analysis
Merger Bid Analysis
Benefits from Mergers
Corporate Restructuring
Summary
Practice Problems
Solutions
Reading 19 Capital Budgeting
Introduction
Cash Flow Projections
Table Format with Cash Flows Collected by Year
Table Format with Cash Flows Collected by Type
Equation Format for Organizing Cash Flows
More on Cash Flow Projections
Effects of Inflation on Capital Budgeting Analysis
Project Analysis and Evaluation
Mutually Exclusive Projects with Unequal Lives
Capital Rationing
Risk Analysis of Capital Investments - Stand Alone Methods
Sensitivity Analysis
Scenario Analysis
Simulation (Monte Carlo) Analysis
Real Options
Common Capital Budgeting Pitfalls
Summary
Practice Problems
Solutions
Equity Valuation
Study Session 8 Equity Valuation (1)
Reading 20 Equity Valuation: Applications and Processes
Introduction and Value Definitions
Value Definitions and Valuation Applications
Applications of Equity Valuation
The Valuation Process, Understanding the Business and Industry and Competitive Analysis
Understanding the Business
Analysis of Financial Reports and Sources of Information
Sources of Information
Considerations in Using Accounting Information
Forecasting Company Performance, Selecting the Appropriate Valuation Method, Absolute and Relative Valuation Models
Selecting the Appropriate Valuation Model
Valuation of the Total Entity and Its Components and Issues in Model Selection and Interpretation
Issues in Model Selection and Interpretation
Converting Forecasts to a Valuation and Applying the Valuation Conclusion: The Analyst's Role and Responsibilities
Applying the Valuation Conclusion: The Analyst’s Role and Responsibilities
Communicating Valuation Results
Contents of a Research Report
Format of a Research Report
Research Reporting Responsibilities
Summary
Practice Problems
Solutions
Reading 21 Return Concepts
Return Concepts
Return Concepts
Equity Risk Premium: Historical and Forward-Looking Estimates
Historical Estimates
Forward-Looking Estimates
Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model
Multifactor Models for Equity Return
The Fama–French Model
Extensions to the Fama–French Model
Macroeconomic and Statistical Multifactor Models
Build-Up Method Estimates of the Required Return on Equity
Build-Up Approaches for Private Business Valuation
Bond Yield Plus Risk Premium
The Required Return on Equity: International Issues
Weighted Average Cost of Capital (WACC)
Discount Rate Selection in Relation to Cash Flows
Summary
Practice Problems
Solutions
Study Session 9 Equity Valuation (2)
Reading 22 Industry and Company Analysis
Introduction and Income Statement Modeling: Revenue
Financial Modeling: An Overview
Income Statement Modeling: Operating Costs
Modeling Operating Costs: COGS and SG&A
Selling, General, and Administrative Expenses
Modeling Non-operating Costs and Other Items
Financing Expenses
Corporate Income Tax
Income Statement Modeling: Other Items
Balance Sheet and Cash Flow Statement Modeling
Scenario Analysis and Sensitivity Analysis
The Impact of Competitive Factors in Prices and Costs
Inflation and Deflation
Sales Projections with Inflation and Deflation
Cost Projections with Inflation and Deflation
Technological Developments
Long-Term Forecasting
Case Study: Estimating Normalized Revenue
Building a Model: Industry Overview and Company Overview
Industry Overview
Company Overview
Construction of Pro Forma Income Statement
Revenue Forecast
Cost of Goods Sold
Selling, General, and Administrative (SG&A) Expenses
Operating Profit by Division
Non-Operating Expenses
Corporate Income Tax Forecast
Construction of Pro Forma Cash Flow Statement and Balance Sheet and Valuation Inputs
Capital Investments and Depreciation Forecasts
Working Capital Forecasts
Forecasted Cash Flow Statement
Forecasted Balance Sheet
Valuation Inputs
Conclusions and Summary
Practice Problems
Solutions
Reading 23 Discounted Dividend Valuation
Introduction and Present Value Methods
Present Value Models
The Dividend Discount Model
The Expression for a Single Holding Period
The Expression for Multiple Holding Periods
The Gordon Growth Model: The Gordon Growth Model Equation and chThe Links Among Dividend Growth, Earnings Growth, and Value Appreciation
The Gordon Growth Model Equation
The Links among Dividend Growth, Earnings Growth, and Value Appreciation in the Gordon Growth Model
Share Repurchases and The Implied Dividend Growth Rate
The Implied Dividend Growth Rate
The Present Value of Growth Opportunities, Gordon Growth Model and the Price-to-Earnings Ratio, and Estimating a Required Return Using the Gordon Growth Model
Gordon Growth Model and the Price-to-Earnings Ratio
Estimating a Required Return Using the Gordon Growth Model
The Gordon Growth Model: Concluding Remarks
Multistage Dividend Discount Models: Two-Stage Dividend Discount Model and Valuing a Non-Dividend Paying Company
Two-Stage Dividend Discount Model
Valuing a Non-Dividend-Paying Company
The H-Model and Three-Stage Dividend Discount Models
Three-Stage Dividend Discount Models
General Modeling and Estimating a Required Return Using Any DDM
Estimating a Required Return Using Any DDM
Multistage DDM: Concluding Remarks
The Financial Determinants of Growth Rates: Sustainable Growth Rate and Dividend Growth Rate, Retention Rate, and ROE Analysis
Sustainable Growth Rate
Dividend Growth Rate, Retention Rate, and ROE Analysis
Financial Models and Dividends
Summary
Practice Problems
Solutions
Glossary
Equity and Fixed Income
Title Page
Contents
How to Use the CFA Program Curriculum
Background on the CBOK
Organization of the Curriculum
Features of the Curriculum
Designing Your Personal Study Program
CFA Institute Learning Ecosystem (LES)
Prep Providers
Feedback
Equity Valuation
Study Session 10 Equity Valuation (3)
Reading 24 Free Cash Flow Valuation
The Introduction to Free Cash Flows and FCFF and FCFE Valuation Approaches
FCFF and FCFE Valuation Approaches
Forecasting Free Cash Flow and Computing FCFF from Net Income
Computing FCFF from Net Income
Computing FCFF from the Statement of Cash Flows
Additional Considerations in Computing FCFF
Classification of Certain Items on the Statement of Cash Flow
Adjustments to Derive Operating Cash Flow from Net Income
Adjustments to Derive Operating Cash Flow from Net Income That May Merit Additional Attention from an Analyst
Computing FCFE from FCFF
Finding FCFF and FCFE from EBITA or EBITDA
FCFF and FCFE on a Uses-of-Free-Cash-Flow Basis
Forecasting FCFF and FCFE
Other Issues in Free Cash Flow Analysis
Analyst Adjustments to CFO
Free Cash Flow versus Dividends and Other Earnings Components
Free Cash Flow and Complicated Capital Structures
Free Cash Flow Model Variations: An International Application of the Single-Stage Model and Sensitivity Analysis of FCFF and FCFE Valuations
An International Application of the Single-Stage Model
Sensitivity Analysis of FCFF and FCFE Valuations
Two-Stage Free Cash Flow Models
Fixed Growth Rates in Stage 1 and Stage 2
Declining Growth Rate in Stage 1 and Constant Growth in Stage 2
Three-Stage Free Cash Flow Models
Integrating ESG in Free Cash Flow Models
Non-operating Assets and Firm Value
Summary
Practice Problems
Solutions
Reading 25 Market-Based Valuation: Price and Enterprise Value Multiples
Introduction to Market-Based Valuation
Price and Enterprise Value Multiples in Valuation
Price to Earnings: the Basics
Price to Earnings
Price to Earnings: Valuation based on Forecasted Fundamentals
Justified P/E
Predicted P/E Based on Cross-Sectional Regression
Price-Earnings: Using the P/E in Valuation
Peer-Company Multiples
Industry and Sector Multiples
Overall Market Multiple
Own Historical P/E
P/Es in Cross-Country Comparisons
Using P/Es to Obtain Terminal Value in Multistage Dividend Discount Models
Price to Book Value
Determining Book Value
Valuation Based on Forecasted Fundamentals
Valuation Based on Comparables
Price to Sales
Determining Sales
Valuation Based on Forecasted Fundamentals
Valuation Based on Forecasted Fundamentals
Valuation Based on Comparables
Price to Cash Flow
Determining Cash Flow
Valuation Based on Forecasted Fundamentals
Valuation Based on Comparables
Price to Dividends and Dividend Yield
Calculation of Dividend Yield
Valuation Based on Forecasted Fundamentals
Valuation Based on Comparables
Enterprise Value to EBITDA
Enterprise Value to EBITDA
Other Enterprise Value Multiples
Enterprise Value to Sales
Price and Enterprise Value Multiples in a Comparable Analysis: Some Illustrative Data
International Considerations when Using Multiples
Momentum Valuation Indicators
Valuation Indicators: Issues in Practice
Averaging Multiples: The Harmonic Mean
Using Multiple Valuation Indicators
Summary
Practice Problems
Solutions
Reading 26 Residual Income Valuation
Introduction and Residual Income
Residual Income
The Residual Income Model and The General Residual Income Model, and Fundamental Determinants of Residual Income
The General Residual Income Model
Fundamental Determinants of Residual Income
Single-Stage Residual Income Valuation and Multistage Residual Income Valuation
Multistage Residual Income Valuation
Residual Income Valuation in Relation to Other Approaches
Strengths and Weaknesses of the Residual Income Model
Broad Guidelines for Using a Residual Income Model
Accounting and International Considerations and Violations of the Clean Surplus Relationship
Violations of the Clean Surplus Relationship
Accounting Considerations: Other
Intangible Assets
Non-recurring Items
Other Aggressive Accounting Practices
International Considerations
Summary
Practice Problems
Solutions
Reading 27 Private Company Valuation
Introduction, the Scope and Definitions of Private Company Valuation
The Scope of Private Company Valuation
Private Company Valuation Approaches, Earnings Normalization and Cash Flow Estimation Issues
Earnings Normalization and Cash Flow Estimation Issues
Income Approach Methods and Required Rate of Return: Models and Estimation Issues
Required Rate of Return: Models and Estimation Issues
Free Cash Flow, Capitalized Cash Flow and Excess Earnings Methods
Capitalized Cash Flow Method
Excess Earnings Method
Market Approach Methods and the Guideline Public Company Method
Guideline Public Company Method
Guideline Transactions and Prior Transaction Methods
Prior Transaction Method
Asset Based Approach
Valuation Discounts and Premiums
Lack of Control Discounts
Lack of Marketability Discounts
Summary
Practice Problems
Solutions
Fixed Income
Study Session 11 Fixed Income (1)
Reading 28 The Term Structure and Interest Rate Dynamics
Spot Rates, Forward Rates, and the Forward Rate Model
Spot Rates and Forward Rates
Yield-to-Maturity in Relation to Spot and Forward Rates
Yield Curve Movement and the Forward Curve
Active Bond Portfolio Management
The Swap Rate Curve
Swap Rate Curve
Why Do Market Participants Use Swap Rates When Valuing Bonds?
How Do Market Participants Use the Swap Curve in Valuation?
The Swap Spread and Spreads as a Price Quotation Convention
Spreads as a Price Quotation Convention
Traditional Theories of the Term Structure of Interest Rates
Expectations Theory
Liquidity Preference Theory
Segmented Markets Theory
Preferred Habitat Theory
Yield Curve Factor Models
A Bond’s Exposure to Yield Curve Movement
Factors Affecting the Shape of the Yield Curve
The Maturity Structure of Yield Curve Volatilities and Managing Yield Curve Risks
Yield Volatility
Managing Yield Curve Risks Using Key Rate Duration
Developing Interest Rate Views Using Macroeconomic Variables
Summary
Practice Problems
Solutions
Reading 29 The Arbitrage-Free Valuation Framework
Introduction to Arbitrage-Free Valuation
The Meaning of Arbitrage-Free Valuation
The Law of One Price
Arbitrage Opportunity
Implications of Arbitrage-Free Valuation for Fixed-Income Securities
Arbitrage-Free Valuation for an Option-Free Bond
The Binomial Interest Rate Tree
The Basics of Creating a Binomial Interest Rate Tree
Determining the Value of a Bond at a Node
Calibrating the Binomial Interest Rate Tree to the Term Structure
Valuing an Option-Free Bond with a Binomial Tree
Valuing an Option-Free Bond with Pathwise Valuation
The Monte Carlo Method
Term Structure Models
Model Choice
Equilibrium Models
Arbitrage-Free Models
Modern Models
Summary
Practice Problems
Solutions
Study Session 12 Fixed Income (2)
Reading 30 Valuation and Analysis of Bonds with Embedded Options
Introduction and Overview of Embedded Options
Overview of Embedded Options
Valuation and Analysis of Callable and Putable Bonds
Relationships between the Values of a Callable or Putable Bond, Straight Bond, and Embedded Option
Valuation of Default-Free and Option-Free Bonds: A Refresher
Valuation of Default-Free Callable and Putable Bonds in the Absence of Interest Rate Volatility
Effect of Interest Rate Volatility on the Value of Callable and Putable Bonds
Interest Rate Volatility
Level and Shape of the Yield Curve
Valuation of Default-Free Callable and Putable Bonds in the Presence of Interest Rate Volatility
Valuation of a Callable Bond with Interest Rate Volatility
Valuation of a Putable Bond with Interest Rate Volatility
Valuation of Risky Callable and Putable Bonds
Option-Adjusted Spread
Effect of Interest Rate Volatility on Option-Adjusted Spread
Bonds with Embedded Options: Effective Duration
Duration
One-Sided and Key Rate Duration
Key Rate Durations
Effective Convexity
Valuation and Analysis of Capped and Floored Floating-Rate Bonds
Valuation of a Capped Floater
Valuation of a Floored Floater
Valuation and Analysis of Convertible Bonds: Defining Features and Analysis of a Convertible Bond
Defining Features of a Convertible Bond
Analysis of a Convertible Bond
Valuation of a Convertible Bond and Comparison of Risk–Return Characteristics
Comparison of the Risk–Return Characteristics of a Convertible Bond, the Straight Bond, and the Underlying Common Stock
Summary
Practice Problems
Solutions
Reading 31 Credit Analysis Models
Introduction
Modeling Credit Risk and the Credit Valuation Adjustment
Credit Scores and Credit Ratings
Structural and Reduced-Form Credit Models
Valuing Risky Bonds in an Arbitrage-Free Framework
Interpreting Changes in Credit Spreads
The Term Structure of Credit Spreads
Credit Analysis for Securitized Debt
Summary
Practice Problems
Solutions
Reading 32 Credit Default Swaps
Introduction
Basic Definitions and Concepts
Types of CDS
Important Features of CDS Markets and Instruments, Credit and Succession Events, and Settlement Proposals
Credit and Succession Events
Settlement Protocols
CDS Index Products
Market Characteristics
Basics of Valuation and Pricing
Basic Pricing Concepts
The Credit Curve and CDS Pricing Conventions
CDS Pricing Conventions
Valuation Changes in CDS during Their Lives
Monetizing Gains and Losses
Applications of CDS
Managing Credit Exposures
Valuation Differences and Basis Trading
Summary
Practice Problems
Solutions
Glossary
Derivatives, Alternative investments, and Portfolio Management
Title Page
Contents
How to Use the CFA Program Curriculum
Background on the CBOK
Organization of the Curriculum
Features of the Curriculum
Designing Your Personal Study Program
CFA Institute Learning Ecosystem (LES)
Prep Providers
Feedback
Derivatives
Study Session 13 Derivatives
Reading 33 Pricing and Valuation of Forward Commitments
Introduction to Pricing and Valuation of Forward Commitments
Principles of Arbitrage-Free Pricing and Valuation of Forward Commitments
Pricing and Valuing Generic Forward and Futures Contracts
Carry Arbitrage
Carry Arbitrage Model When There Are No Underlying Cash Flows
Carry Arbitrage Model When Underlying Has Cash Flows
Pricing Equity Forwards and Futures
Equity Forward and Futures Contracts
Interest Rate Forward and Futures Contracts
Pricing Fixed-Income Forward and Futures Contracts
Comparing Forward and Futures Contracts
Pricing and Valuing Swap Contracts
Interest Rate Swap Contracts
Pricing and Valuing Currency Swap Contracts
Pricing and Valuing Equity Swap Contracts
Summary
Practice Problems
Solutions
Reading 34 Valuation of Contingent Claims
Introduction and Principles of a No-Arbitrage Approach to Valuation
Principles of a No-Arbitrage Approach to Valuation
Binomial Option Valuation Model
One-Period Binomial Model
Binomial Model: Two-Period (Call options)
Binomial Model: Two-Period (Put options)
Binomial Model: Two-Period (Role of Dividends & Comprehensive Example)
Interest Rate Options & Multiperiod Model
Multiperiod Model
Black-Scholes-Merton (BSM) Option Valuation Model, Introduction and Assumptions of the BSM Model
Introductory Material
Assumptions of the BSM Model
BSM Model: Components
BSM Model: Carry Benefits and Applications
Black Option Valuation Model and European Options on Futures
European Options on Futures
Interest Rate Options
Swaptions
Option Greeks and Implied Volatility: Delta
Delta
Gamma
Theta
Vega
Rho
Implied Volatility
Summary
Practice Problems
Solutions
Alternative Investments
Study Session 14 Alternative Investments
Reading 35 Real Estate Investments
Section A. Overview of Types of Real Estate Investment
Introduction and Basic Forms of Real Estate Investment
Real Estate Market Size
Real Estate Investment: Basic Forms
Characteristics
Risk Factors
Economic Value Drivers, Role in Portfolio, and Risk/Return of Real Estate Investments Relative to Stocks and Bonds
Economic Drivers
Role of Real Estate in an Investment Portfolio
Real Estate Risk and Return Relative to Stocks and Bonds
Classifications
Investment Characteristics by Property Type
Considerations in Analysis and Due Diligence
Indexes
Appraisal-Based Indexes
Transaction-Based Indexes
Advantages and Disadvantages of Appraisal-Based and Transaction-Based Indexes
Real Estate Security Indexes
Section B. Investments in Real Estate through Private Vehicles
Introduction to Valuation Approaches
Highest and Best Use
The Income Approach to Valuation: Discount Rates and the Direct Capitalization of NOI and DCF Methods
Similarities in Approaches
The Direct Capitalization Method
The DCF Method, the Relationship between Discount Rate and Cap Rate, and the Terminal Capitalization Rate
The Relationship between the Discount Rate and the Cap Rate
The Terminal Capitalization Rate
Private Market Real Estate Debt
Section C. Investments in Real Estate Through Publicly Traded Securities
Types of Publicly Traded Real Estate Securities
REIT Structures
Market Size
Benefits and Disadvantages of Investing in REITs
Valuation: Net Asset Value Approach
Accounting for Investment Properties
Net Asset Value per Share: Calculation
Net Asset Value per Share: Application
Valuation: Relative Value (Price Multiple) Approach
Relative Value Approach to Valuing REIT Stocks
Funds from Operations and Adjusted Funds from Operations
P/FFO and P/AFFO Multiples: Advantages and Drawbacks
REIT Mini Case Study: Example of Disclosures and Valuation Analysis
Selection of Valuation Methods
Private vs. Public: A Comparison
Summary
General Characteristics of Real Estate
Private Equity Real Estate
Publicly Traded Real Estate Securities
Practice Problems
Solutions
Reading 36 Private Equity Investments
Introduction
Introduction to Valuation Techniques in Private Equity Transactions
How Is Value Created in Private Equity?
Using Market Data in Valuation
Contrasting Venture Capital and Buyout Investments
LBO model for valuation of Buyout Transactions
The LBO Model
VC Method for valuation of Venture Capital Transactions
Expected Exit Valuation
Required Rate of Return
Option Pools
Stage Financing
Exit Routes: Return Cash to Investors
Exit Routes: Summary
Risks and Costs of investing in Private Equity
What Are the Risks and Costs of Investing in Private Equity?
Private Equity Fund Structures and Terms
Economic Terms
Corporate Governance Terms
Due Diligence Investigations by Potential Investors
Private Equity Fund Valuation
Evaluating Fund Performance and Concept in Action: Evaluating a Private Equity Fund
Analysis of IRR since Inception
Analysis of Return Multiples
Concept in Action: Evaluating Private Equity Fund Performance
Summary
Practice Problems
Solutions
Reading 37 Introduction to Commodities and Commodity Derivatives
Introduction
Commodity Sectors
Commodity Sectors
Life Cycle of Commodities
Energy
Industrial/Precious Metals
Livestock
Grains
Softs
Valuation of Commodities
Commodities Futures Markets: Participants
Futures Market Participants
Commodity Spot and Futures Pricing
Theories of Futures Returns
Theories of Futures Returns
Components of Futures Returns
Contango, Backwardation, and the Roll Return
Commodity Swaps
Total Return Swap
Basis Swap
Variance Swaps and Volatility Swaps
Commodity Indexes
S&P GSCI
Bloomberg Commodity Index
Deutsche Bank Liquid Commodity Index
Thomson Reuters/CoreCommodity CRB Index
Rogers International Commodity Index
Rebalancing Frequency
Commodity Index Summary
Summary
Practice Problems
Solutions
Portfolio Management
Study Session 15 Portfolio Management (1)
Reading 38 Exchange-Traded Funds: Mechanics and Applications
Introduction
ETF Mechanics
The Creation/Redemption Process
Trading and Settlement
Understanding ETFs
Expense Ratios
Index Tracking/Tracking Error
Tax Issues
ETF Trading Costs
Total Costs of ETF Ownership
ETF Risks
Counterparty Risk
Fund Closures
Investor-Related Risk
ETFs in Portfolio Management
ETF Strategies
Efficient Portfolio Management
Asset Class Exposure Management
Active and Factor Investing
Summary
Practice Problems
Solutions
Reading 39 Using Multifactor Models
Background and Uses of Multifactor Models
Multifactor Models and Modern Portfolio Theory
Arbitrage Pricing Theory and Multifactor Models
Types of Multifactor Models
Factors and Types of Multifactor Models
The Structure of Fundamental Factor Models
Fixed-Income Multifactor Models
Macroeconomic Factor Models
Fundamental Factor Models
Factor Models in Return Attribution
Factor Models in Return Attribution
Factor Models in Risk Attribution
Factor Models in Portfolio Construction
Factor Models in Strategic Portfolio Decisions
Summary
Practice Problems
Solutions
Reading 40 Measuring and Managing Market Risk
Introduction, Understanding Value at Risk Value at Risk: Formal Definition
Understanding Value at Risk
Estimating VaR
The Parametric Method of VaR Estimation
The Historical Simulation Method of VaR Estimation
The Monte Carlo Simulation Method of VaR Estimation
Advantages and Limitations of VaR and Extensions of VaR
Advantages of VaR
Limitations of VaR
Extensions of VaR
Other Key Risk Measures - Sensitivity Risk Measures
Sensitivity Risk Measures
Scenario Risk Measures
Historical Scenarios
Hypothetical Scenarios
Sensitivity and Scenario Risk Measures and VaR
Advantages and Limitations of Sensitivity Risk Measures and Scenario Risk Measures
Using Constraints in Market Risk Management
Risk Budgeting
Position Limits
Scenario Limits
Stop-Loss Limits
Risk Measures and Capital Allocation
Applications of Risk Measures, Market Participants and the Different Risk Measures They Use
Market Participants and the Different Risk Measures They Use
Pension Funds and Insurers
Insurers
Summary
Practice Problems
Solutions
Reading 41 Backtesting and Simulation
Introduction
The Objectives of Backtesting
The Backtesting Process
Step 1: Strategy Design
Step 2: Historical Investment Simulation
Step 3: Analysis of Backtesting Output
Backtesting Multifactor Models
Step 1: Strategy Design
Step 2: Historical Investment Simulation
Step 3: Output Analysis
Commons Problems in Backtesting
Survivorship Bias
Look-Ahead Bias
Data Snooping
Historical Scenario Analysis
Simulation Analysis
Historical Simulation
Monte Carlo Simulation
Sensitivity Analysis
Summary
Practice Problems
Solutions
Glossary
Portfolio Management and Ethical and Professional Standards
Title Page
Contents
How to Use the CFA Program Curriculum
Background on the CBOK
Organization of the Curriculum
Features of the Curriculum
Designing Your Personal Study Program
CFA Institute Learning Ecosystem (LES)
Prep Providers
Feedback
Portfolio Management
Study Session 16 Portfolio Management (2)
Reading 42 Economics and Investment Markets
Introduction
Framework for the Economic Analysis of Financial Markets: The Present Value Model
The Present Value Model
Expectations and Asset Values
The Discount Rate on Real Default-Free Bonds: Real Default-Free Interest Rates
Real Default-Free Interest Rates
The Discount Rate on Real Default-Free Bonds: Uncertainty and Risk Premiums
The Discount Rate on Real Default-Free Bonds: Risk Premiums on Risky Assets
Default-Free Interest Rates and Economic Growth
Real Default-Free Interest Rates and the Business Cycle
Economic Growth and Real Yields
Real Default-Free Interest Rate Summary
The Yield Curve and the Business Cycle: Short-Term Nominal Interest Rates
Short-Term Nominal Interest Rates and the Business Cycle
Treasury Bills and the Business Cycle
Short-Term Interest Rate Summary
Conventional Government Bonds and Break-even Inflation Rates
Break-Even Inflation Rates
The Default-Free Yield Curve and the Business Cycle
The Slope of the Yield Curve and the Term Spread
The Term Spread and the Business Cycle
Evidence on Risk Premiums for Default-Free Bonds
Other Factors
Credit Premiums and the Business Cycle
Credit Spreads and the Credit Risk Premium
Industry-Specific and Company-Specific Credit Quality
Company-Specific Factors
Sovereign Credit Risk
Credit Premium Summary
Equities and the Equity Risk Premium
Equities and Bad Consumption Outcomes
Earnings Growth and the Economic Cycle
How Big is the Equity Risk Premium?
Valuation Multiples
Commercial Real Estate
Regular Cash Flow from Commercial Real Estate Investments
The Pricing Formula for Commercial Real Estate
Commercial Real Estate and the Business Cycle
Summary
Practice Problems
Solutions
Reading 43 Analysis of Active Portfolio Management
Introduction
Active Management and Value Added
Choice of Benchmark
Measuring Value Added
Decomposition of Value Added
Comparing Risk and Return, The Sharpe Ratio and The Information Ratio
The Sharpe Ratio
The Information Ratio
Constructing Optimal Portfolios
Active Security Returns and The Basic Fundamental Law of Active Management
Active Security Returns
The Basic Fundamental Law
The Full Fundamental Law, Ex Post Performance Measurement
Ex Post Performance Measurement
Applications of the Fundamental Law and Global Equity Strategy
Global Equity Strategy
Fixed-Income Strategies
Practical Limitations
Ex Ante Measurement of Skill
Independence of Investment Decisions
Summary
Practice Problems
Solutions
Reading 44 Trading Costs and Electronic Markets
Costs of Trading
Costs of Trading
Effective Spreads and Volume-Weighted Cost Estimates
Implementation Shortfall
VWAP Transaction Cost Estimates
Development of Electronic Markets
Electronic Trading
Advantages of Electronic Trading Systems
Electronification of Bond Markets
Market Fragmentation
Effects on Transaction Costs
Types of Electronic Traders
The Major Types of Electronic Traders
Electronic Trading System: Characteristics and Uses
Why Speed Matters
Fast Communications
Fast Computations
Advanced Orders, Tactics, and Algorithms
Select Examples of How Electronic Trading Changed Trading Strategies
Electronic Trading Risks
The HFT Arms Race
Systemic Risks of Electronic Trading
Detecting Abusive Trading Practices
Summary
Practice Problems
Solutions
Ethical and Professional Standards
Study Session 17 Ethical and Professional Standards
Reading 45 Code of Ethics and Standards of Professional Conduct
Preface
Evolution of the CFA Institute Code of Ethics and Standards of Professional Conduct
Standards of Practice Handbook
Summary of Changes in the Eleventh Edition
CFA Institute Professional Conduct Program
Adoption of the Code and Standards
Acknowledgments
Ethics and the Investment Industry
Why Ethics Matters
CFA Institute Code of Ethics and Standards of Professional Conduct
Preamble
The Code of Ethics
Standards of Professional Conduct
Reading 46 Guidance for Standards I–VII
Standard I(A): Professionalism - Knowledge of the Law
Standard I(A) Knowledge of the Law
Guidance
Standard I(A): Recommended Procedures
Members and Candidates
Distribution Area Laws
Legal Counsel
Dissociation
Firms
Standard I(A): Application of the Standard
Example 1 (Notification of Known Violations):
Example 2 (Dissociating from a Violation):
Example 3 (Dissociating from a Violation):
Example 4 (Following the Highest Requirements):
Example 5 (Following the Highest Requirements):
Example 6 (Laws and Regulations Based on Religious Tenets):
Example 7 (Reporting Potential Unethical Actions):
Example 8 (Failure to Maintain Knowledge of the Law):
Standard I(B): Professionalism - Independence and Objectivity
Guidance
Standard I(B): Recommended Procedures
Standard I(B): Application of the Standard
Example 1 (Travel Expenses):
Example 2 (Research Independence):
Example 3 (Research Independence and Intrafirm Pressure):
Example 4 (Research Independence and Issuer Relationship Pressure):
Example 5 (Research Independence and Sales Pressure):
Example 6 (Research Independence and Prior Coverage):
Example 7 (Gifts and Entertainment from Related Party):
Example 8 (Gifts and Entertainment from Client):
Example 9 (Travel Expenses from External Manager):
Example 10 (Research Independence and Compensation Arrangements):
Example 11 (Recommendation Objectivity and Service Fees):
Example 12 (Recommendation Objectivity):
Example 13 (Influencing Manager Selection Decisions):
Example 14 (Influencing Manager Selection Decisions):
Example 15 (Fund Manager Relationships):
Example 16 (Intrafirm Pressure):
Standard I(C): Professionalism – Misrepresentation
Guidance
Standard I(C): Recommended Procedures
Factual Presentations
Qualification Summary
Verify Outside Information
Maintain Webpages
Plagiarism Policy
Standard I(C): Application of the Standard
Example 1 (Disclosure of Issuer-Paid Research):
Example 2 (Correction of Unintentional Errors):
Example 3 (Noncorrection of Known Errors):
Example 4 (Plagiarism):
Example 5 (Misrepresentation of Information):
Example 6 (Potential Information Misrepresentation):
Example 7 (Plagiarism):
Example 8 (Plagiarism):
Example 9 (Plagiarism):
Example 10 (Plagiarism):
Example 11 (Misrepresentation of Information):
Example 12 (Misrepresentation of Information):
Example 13 (Avoiding a Misrepresentation):
Example 14 (Misrepresenting Composite Construction):
Example 15 (Presenting Out-of-Date Information):
Example 16 (Overemphasis of Firm Results):
Standard I(D): Professionalism – Misconduct
Guidance
Standard I(D): Recommended Procedures
Standard I(D): Application of the Standard
Example 1 (Professionalism and Competence):
Example 2 (Fraud and Deceit):
Example 3 (Fraud and Deceit):
Example 4 (Personal Actions and Integrity):
Example 5 (Professional Misconduct):
Standard II(A): Integrity of Capital Markets - Material Nonpublic Information
Standard II(A) Material Nonpublic Information
Guidance
Standard II(A): Recommended Procedures
Achieve Public Dissemination
Adopt Compliance Procedures
Adopt Disclosure Procedures
Issue Press Releases
Firewall Elements
Appropriate Interdepartmental Communications
Physical Separation of Departments
Prevention of Personnel Overlap
A Reporting System
Personal Trading Limitations
Record Maintenance
Proprietary Trading Procedures
Communication to All Employees
Standard II(A): Application of the Standard
Example 1 (Acting on Nonpublic Information):
Example 2 (Controlling Nonpublic Information):
Example 3 (Selective Disclosure of Material Information):
Example 4 (Determining Materiality):
Example 5 (Applying the Mosaic Theory):
Example 6 (Applying the Mosaic Theory):
Example 7 (Analyst Recommendations as Material Nonpublic Information):
Example 8 (Acting on Nonpublic Information):
Example 9 (Mosaic Theory):
Example 10 (Materiality Determination):
Example 11 (Using an Expert Network):
Example 12 (Using an Expert Network):
Standard II(B): Integrity of Capital Markets - Market Manipulation
Guidance
Standard II(B): Application of the Standard
Example 1 (Independent Analysis and Company Promotion):
Example 2 (Personal Trading Practices and Price):
Example 3 (Creating Artificial Price Volatility):
Example 4 (Personal Trading and Volume):
Example 5 (“Pump-Priming” Strategy):
Example 6 (Creating Artificial Price Volatility):
Example 7 (Pump and Dump Strategy):
Example 8 (Manipulating Model Inputs):
Example 9 (Information Manipulation):
Standard III(A): Duties to Clients - Loyalty, Prudence, and Care
Standard III(A) Loyalty, Prudence, and Care
Guidance
Standard III(A): Recommended Procedures
Regular Account Information
Client Approval
Firm Policies
Standard III(A): Application of the Standard
Example 1 (Identifying the Client—Plan Participants):
Example 2 (Client Commission Practices):
Example 3 (Brokerage Arrangements):
Example 4 (Brokerage Arrangements):
Example 5 (Client Commission Practices):
Example 6 (Excessive Trading):
Example 7 (Managing Family Accounts):
Example 8 (Identifying the Client):
Example 9 (Identifying the Client):
Example 10 (Client Loyalty):
Example 11 (Execution-Only Responsibilities):
Standard III(B): Duties to Clients - Fair Dealing
Guidance
Standard III(B): Recommended Procedures
Develop Firm Policies
Disclose Trade Allocation Procedures
Establish Systematic Account Review
Disclose Levels of Service
Standard III(B): Application of the Standard
Example 1 (Selective Disclosure):
Example 2 (Fair Dealing between Funds):
Example 3 (Fair Dealing and IPO Distribution):
Example 4 (Fair Dealing and Transaction Allocation):
Example 5 (Selective Disclosure):
Example 6 (Additional Services for Select Clients):
Example 7 (Minimum Lot Allocations):
Example 8 (Excessive Trading):
Example 9 (Limited Social Media Disclosures):
Example 10 (Fair Dealing between Clients):
Standard III(C): Duties to Clients – Suitability
Guidance
Standard III(C): Recommended Procedures
Investment Policy Statement
Regular Updates
Suitability Test Policies
Standard III(C): Application of the Standard
Example 1 (Investment Suitability—Risk Profile):
Example 2 (Investment Suitability—Entire Portfolio):
Example 3 (IPS Updating):
Example 4 (Following an Investment Mandate):
Example 5 (IPS Requirements and Limitations):
Example 6 (Submanager and IPS Reviews):
Example 7 (Investment Suitability—Risk Profile):
Example 8 (Investment Suitability):
Standard III(D): Duties to Clients - Performance Presentation
Guidance
Standard III(D): Recommended Procedures
Apply the GIPS Standards
Compliance without Applying GIPS Standards
Standard III(D): Application of the Standard
Example 1 (Performance Calculation and Length of Time):
Example 2 (Performance Calculation and Asset Weighting):
Example 3 (Performance Presentation and Prior Fund/Employer):
Example 4 (Performance Presentation and Simulated Results):
Example 5 (Performance Calculation and Selected Accounts Only):
Example 6 (Performance Attribution Changes):
Example 7 (Performance Calculation Methodology Disclosure):
Example 8 (Performance Calculation Methodology Disclosure):
Standard III(E): Duties to Clients - Preservation of Confidentiality
Guidance
Standard III(E): Recommended Procedures
Communicating with Clients
Standard III(E): Application of the Standard
Example 1 (Possessing Confidential Information):
Example 2 (Disclosing Confidential Information):
Example 3 (Disclosing Possible Illegal Activity):
Example 4 (Disclosing Possible Illegal Activity):
Example 5 (Accidental Disclosure of Confidential Information):
Standard IV(A): Duties to Employers – Loyalty
Standard IV(A) Loyalty
Guidance
Standard IV(A): Recommended Procedures
Competition Policy
Termination Policy
Incident-Reporting Procedures
Employee Classification
Standard IV(A): Application of the Standard
Example 1 (Soliciting Former Clients):
Example 2 (Former Employer’s Documents and Files):
Example 3 (Addressing Rumors):
Example 4 (Ownership of Completed Prior Work):
Example 5 (Ownership of Completed Prior Work):
Example 6 (Soliciting Former Clients):
Example 7 (Starting a New Firm):
Example 8 (Competing with Current Employer):
Example 9 (Externally Compensated Assignments):
Example 10 (Soliciting Former Clients):
Example 11 (Whistleblowing Actions):
Example 12 (Soliciting Former Clients):
Example 13 (Notification of Code and Standards):
Example 14 (Leaving an Employer):
Example 15 (Confidential Firm Information):
Standard IV(B): Duties to Employers - Additional Compensation Arrangements
Guidance
Standard IV(B): Recommended Procedures
Standard IV(B): Application of the Standard
Example 1 (Notification of Client Bonus Compensation):
Example 2 (Notification of Outside Compensation):
Example 3 (Prior Approval for Outside Compensation):
Standard IV(C): Duties to Employers - Responsibilities of Supervisors
Guidance
Standard IV(C): Recommended Procedures
Codes of Ethics or Compliance Procedures
Adequate Compliance Procedures
Implementation of Compliance Education and Training
Establish an Appropriate Incentive Structure
Standard IV(C): Application of the Standard
Example 1 (Supervising Research Activities):
Example 2 (Supervising Research Activities):
Example 3 (Supervising Trading Activities):
Example 4 (Supervising Trading Activities and Record Keeping):
Example 5 (Accepting Responsibility):
Example 6 (Inadequate Procedures):
Example 7 (Inadequate Supervision):
Example 8 (Supervising Research Activities):
Example 9 (Supervising Research Activities):
Standard V(A): Investment Analysis, Recommendations, and Actions - Diligence and Reasonable Basis
Standard V(A) Diligence and Reasonable Basis
Guidance
Standard V(A): Recommended Procedures
Standard V(A): Application of the Standard
Example 1 (Sufficient Due Diligence):
Example 2 (Sufficient Scenario Testing):
Example 3 (Developing a Reasonable Basis):
Example 4 (Timely Client Updates):
Example 5 (Group Research Opinions):
Example 6 (Reliance on Third-Party Research):
Example 7 (Due Diligence in Submanager Selection):
Example 8 (Sufficient Due Diligence):
Example 9 (Sufficient Due Diligence):
Example 10 (Sufficient Due Diligence):
Example 11 (Use of Quantitatively Oriented Models):
Example 12 (Successful Due Diligence/Failed Investment):
Example 13 (Quantitative Model Diligence):
Example 14 (Selecting a Service Provider):
Example 15 (Subadviser Selection):
Example 16 (Manager Selection):
Example 17 (Technical Model Requirements):
Standard V(B): Investment Analysis, Recommendations, and Actions - Communication with Clients and Prospective Clients
Guidance
Standard V(B): Recommended Procedures
Standard V(B): Application of the Standard
Example 1 (Sufficient Disclosure of Investment System):
Example 2 (Providing Opinions as Facts):
Example 3 (Proper Description of a Security):
Example 4 (Notification of Fund Mandate Change):
Example 5 (Notification of Fund Mandate Change):
Example 6 (Notification of Changes to the Investment Process):
Example 7 (Notification of Changes to the Investment Process):
Example 8 (Notification of Changes to the Investment Process):
Example 9 (Sufficient Disclosure of Investment System):
Example 10 (Notification of Changes to the Investment Process):
Example 11 (Notification of Errors):
Example 12 (Notification of Risks and Limitations):
Example 13 (Notification of Risks and Limitations):
Example 14 (Notification of Risks and Limitations):
Standard V(C): Investment Analysis, Recommendations, and Actions - Record Retention
Guidance
Standard V(C): Recommended Procedures
Standard V(C): Application of the Standard
Example 1 (Record Retention and IPS Objectives and Recommendations):
Example 2 (Record Retention and Research Process):
Example 3 (Records as Firm, Not Employee, Property):
Standard VI(A): Conflicts of Interest - Disclosure of Conflicts
Standard VI(A) Disclosure of Conflicts
Guidance
Standard VI(A): Recommended Procedures
Standard VI(A): Application of the Standard
Example 1 (Conflict of Interest and Business Relationships):
Example 2 (Conflict of Interest and Business Stock Ownership):
Example 3 (Conflict of Interest and Personal Stock Ownership):
Example 4 (Conflict of Interest and Personal Stock Ownership):
Example 5 (Conflict of Interest and Compensation Arrangements):
Example 6 (Conflict of Interest, Options, and Compensation Arrangements):
Example 7 (Conflict of Interest and Compensation Arrangements):
Example 8 (Conflict of Interest and Directorship):
Example 9 (Conflict of Interest and Personal Trading):
Example 10 (Conflict of Interest and Requested Favors):
Example 11 (Conflict of Interest and Business Relationships):
Example 12 (Disclosure of Conflicts to Employers):
Standard VI(B): Conflicts of Interest - Priority of Transactions
Guidance
Standard VI(B): Recommended Procedures
Standard VI(B): Application of the Standard
Example 1 (Personal Trading):
Example 2 (Trading for Family Member Account):
Example 3 (Family Accounts as Equals):
Example 4 (Personal Trading and Disclosure):
Example 5 (Trading Prior to Report Dissemination):
Standard VI(C): Conflicts of Interest - Referral Fees
Guidance
Standard VI(C): Recommended Procedures
Standard VI(C): Application of the Standard
Example 1 (Disclosure of Referral Arrangements and Outside Parties):
Example 2 (Disclosure of Interdepartmental Referral Arrangements):
Example 3 (Disclosure of Referral Arrangements and Informing Firm):
Example 4 (Disclosure of Referral Arrangements and Outside Organizations):
Example 5 (Disclosure of Referral Arrangements and Outside Parties):
Standard VII(A): Responsibilities as a CFA Institute Member or CFA
Candidate - Conduct as Participants in CFA Institute Programs
Standard VII(A) Conduct as Participants in CFA Institute Programs
Guidance
Standard VII(A): Application of the Standard
Example 1 (Sharing Exam Questions):
Example 2 (Bringing Written Material into Exam Room):
Example 3 (Writing after Exam Period End):
Example 4 (Sharing Exam Content):
Example 5 (Sharing Exam Content):
Example 7 (Discussion of Exam Grading Guidelines and Results):
Example 6 (Sharing Exam Content):
Example 8 (Compromising CFA Institute Integrity as a Volunteer):
Example 9 (Compromising CFA Institute Integrity as a Volunteer):
Standard VII(B): Responsibilities as a CFA Institute Member or CFA Candidate - Reference to CFA Institute, the CFA Designation, and the CFA Program
Guidance
Standard VII(B): Recommended Procedures
Standard VII(B): Application of the Standard
Example 1 (Passing Exams in Consecutive Years):
Example 2 (Right to Use CFA Designation):
Example 3 (“Retired” CFA Institute Membership Status):
Example 4 (Stating Facts about CFA Designation and Program):
Example 5 (Order of Professional and Academic Designations):
Example 6 (Use of Fictitious Name):
Practice Problems
Solutions
Reading 47 Application of the Code and Standards: Level II
Introduction
Serengeti Advisory Services
Case Questions
Banco Libertad
Case Questions
Quanthouse
Case Questions
JR and Associates
Case Questions
Magadi Asset Management
Case Questions
Edvard Stark
Duties to Clients
Duties to Employers
Investment Analysis, Recommendations, and Actions
Conflicts of Interest
Subath Agarway
Professionalism
Conflicts of Interest
Glossary
EULA