CFA Level 1 (2009) - 1

Self-Test: Ethical and Professional Standards

has fully complied with Standard V(B), Communication with Clients and Prospective Clients. Under the Standard. it is not necessary to include every detail about a potential investment in a report. Members and candidates are expected to use their judgment and identify the most important factors to include.

19. B This is not necessarily a violation. Firms can offer different levels of service to clients as long as this is disclosed to all clients. The largest institutional clients would likely be paying higher fees for a greater level of service. Also note that the analyst's brother's account in choice C should be treated the same as any other client account.

20.C Members and candidates must give clients adequate opportunity to act on new or changed recommendations before taking investment action in their own non-firm accounts or other non-client accounts in which they have a beneficial interest. One week is likely an acceptable waiting period.

21.B In the other choices, Olson violates Standard I(C) by misrepresentating the services

thar she or her firm arc capable of performing. her qualifications, her academic or professional credentials. or the firm's credenrial.\. The firlll is small and most likely cannot perf;lrm all investment services the c1icnt mal' require. The firnl cannot guarantee furure olltperformanc<:' of th<' market indexes. The firm JO<'sn'! hal'c a long history (only six months),

.., ') C Standard III(A), Loyalty, Prudence, and Care. Herbst is acting as a fiduciary for the pe:lsion plan beneficiaries. Choosing brokers based on quality of services provided is reasonable. She Illay pay higher-than-average brokerage fees so long. as doing so benefits rhe fJension beneficiaries, not other clients. Trading with selected brokers solely to gain refarals is not likely to be in the pension beneficiaries' besr interest since it docs not take in to account other important factors for selecting brokerage firms.

23.A Nieder must not take models or documents from his previous employer without explicit permission LO do so, or he would violate Standard IV(A), Loyalty. He is allowed, however, to reproduce the model from memory bur must recreate the supporting documentation to maintain compliance with Standard V(C), Record Retention.

24.C According to Standard VI(C), Referral Fees, Hem must disclose the referral arrangement between itself and Baker so that potential clients can judge the true cost of Hem's services and assess whether there is any partiality inherent in [he recommendation of servIces.

25.C Standard VII (B) governs acceptable methods of referencing the CFA Institute, CFA designation, and CFA Program. Candidates may reference their candidacy if they

are enrolled for or waiting for the results of a CFA exam. Pulin may also reference his membership status wilh the CFA Institute as weIl as his remaining eligibility requirements to become a CFA charterholder.

26.A There is no indication that Servais has inside information pertaining to the situation at the five firms in question-only the twO firms that have already gone public with the information. It is common knowledge that the other five firms follow the same boron handing procedures. She is, therefore, in compliance with Standard II(A)

concerning the use of material non public information in the issuance of the investment recommendation.

27. B Even though the laws of Zanuatu would not preclude trading on the information, as

a CFA Charterholder the friend is bound by the CFA Institute Code and Standards.

(C)200R K:mbn Sc:hwf'_~f'r

Self-Test: Ethical and Professional Standards

38.B The recommended procedure in Standard IIl(D), Performance Presentation, is to present the performance of a composite as a weighted average of the performance of similar portfolios rather than using a single representative account.

39.B The recommended procedure according to Standard lII(B), Fair Dealing, is to disseminate new recommendations to all clients who express an inrerest or for whom the investment is suitable. Not all clients need to be informed but the selection should be based on suitability of rhe specific investment. The other rwo are main headings in the "Recommendations" section of the Standard.

40.C It is required under Standard V(A), Diligence and Reasonable Basis, that third-pany research assumptions be reviewed and both the independence and objectiviry of rhe research and recommendarions be evaluated. The orher choices are recommended policies and procedures under rhe Srandard.

41.B Srandard VI (8). Prioriry of Transacrions, recommends rhat memhers and candidares avoid rhe appearance of conflicr of interesr by nor participaring in IPOs. If a family memher is a fee'-paving cliellt, the member or candidate should rreat rhem likc' all\'

orher c1iellt, nOl giving allY adv~lllrage or disadvanrage to rhe'ir accounrs. Tht' facl t!J;u a member or candidate has a henelicial imnesr in a client ~h.COUlll lloes not preclude' trearing ir like anv other fee-I'a:'ing accoullt.

42.C GIPS apply to investmenr managemeur firms. They arc inrended [(1 serve prospective and exisring clients 01 invesrmellt tlrms and consultanrs who advise these clients.

43.B GIl'S were creared lO reduce ambiguiry of performance reponing among invesrmenl firms. Pasr abuses of performance reponing include represcntative accounrs (showing only lOp performers), survivorship bias (delering poor performers), and varying rime period (showing only rhe rime period wirh rhe besr performance).

44.C A single verification report is issued wirh respecr lo the whole firm: GIPS verificarion cannor be carried our for a single composite.

45.A Verification is nor currently required under GIPS. Firms thar choose to undergo rhc verificarion process arc encouraged, but not required, to make a specific verificarion disclosure in composite presenrarions and advertisements rhat reference rhc firm's GII'S verificarion. When the firm has discrcrion over rhe selecrion of suh-advisors, the firm musr include portfolios managed by sub-advisors in its composires. The firm musr provide a list of composircs and their descriptions [0 any prospect who requests ir. This list musr include any composires that have been discontinued wirhin rhe pasr five years. Upon requesr, rhe firm must provide a compliant presentarion for any composire on the firm's lisr.

46.B Firms cannor alrer hisrorical performance records of composires simply because of a reorganization of the firm. This is a currenr requiremenr of GIPS. The orher answer choices are nor currenrly required.

47. A There arc no GIl'S relared directly to rhe qualificarions of employees managing assets at an invesrment firm wherher ir claims compliance wirh GIl'S or nor. The major seerions of GIl'S arc as follows: fundamentals of compliance, in pur dara, calculation methodology, composire construcrion, disclosures, presentarion and reponing, real estare, and privare equiry.

Self-Test: Ethical and Professional Standards

48.C Composites are groups of portfolios that represent a similar investment strategy, objective. or mandate. Clearly. grouping all portfolios managed to mirror the S&P 500 Index rerum constitutes a composite according to this definition. Organizing composites by office or by a generic active management category is not acceptable as these categories do not reflect any sort of strategy, objective, or mandate.

49. B GIPS seek to promote global self regulation through voLuntary acceptance and adherence ro the srandards. The other starements correcdy srate objectives of GIPS.

50.B GIPS verification ml!st be performed by an independent third party. The SEC audit does not constitute a GIPS verification.

The foUowing is a review of the Quantitative Methods: Basic Concepts principles designed to address the learning outcome statements set forth by CPA Institute@. This topic is also covered in:

THE TIME VALUE OF MONEY

Study Session 2

EXAM Focus

...

TIl\IE VALUE OF MONEY CONCEPTS AND ApPLICATIONS

TJlc'concept of compound inreresr or interest (In inrerest il; d~epl:: embedded in time nlue' of moncy (TVlvf) procedure.s. \\.'hel~ an invemncnr is subjecred to compound interesr. rhe growrh In the valu(' oj" ,he I\1\,CStmelll from period to penod r,~flects nor onhthe interesr earned on the original principal amount bur also on the interest earned on the previous period's interest earning,i~tht· IIHereS[ on inlerest,

TVM applications frequently calJ for determining rhe future value (FV) of an Investment's cash flows as a result of the effects of compound interest. Computing FV involves projecting the cash flows forward, on the basis of an appropriate compound interest rate, to rhe end of the investmem's life:, The computation of thc present ,"alue (p\,) works in the opposite dircnion-i, bring' thf clsh flows From ;In investment bacL to rhe beg;lI1ning of the investment's jjfe IlaS('d ()Ii an appropriate compound ratc of return.

Being able to measure the PV and/or FV of an investment's cash flows becomes useful when comparing investment alternatives because the value 01 rhe investment's cash flows must he measured at some common point in time. typically" at the end of the investmenr horizon (FV) or at the beginning of the invesrmen r horizon (PV).

Using a Financial Calculator

It is very important that you be able to use a financial calculator when working TVM problems because the exam is constructed under the assumptIOn that candidates have the ability to do so. There is simply no ether way thar you will have time to solve TVM problems. CPA institute allows only two types ofcalwlaton to be used for the exam-the Tl BAlI .Plus® (including the BAil Plus PrOfeHZ01uZl) and the HP 12C® (incLuding the Hfl

Srudy Session 2

Cross-Reference to CFA Institute Assigned Reading #5 - The Time Value of Money

12C Platinum), This topic review is written primarily with the Tl BAIl Plus in mind.

don't already own 11 calculator, go out and buy a Tl BAll Plus! However, if you already own the HP 12C and are comfortable with it, by all means continue to use it.

The TI BAIl Plus comes preloaded from the factory with the periods per year function (PlY) set to 12, This automatically converts the annual interest rate (I/Y) into monthly rates. While appropriate for many loan-type problems, this feature is not suitable for the vast majority of the TVM applications we will be studying, So prior to using our Srudy Nores, please set your PlY key to "1" using the following sequence of keysrrokes:

[2nd] [PlY] "1" [ENTER] [2nd] [QUIT]

As long as you do nor change the PlY setting, it will remain set at one period per year uncil the battery from your calculator is removed (it does not change when you rum the

Before we hegin workin~ \\'I[!l r1n;IIlCi:l1 ulcularnr;" :'OUshocdd familiarize \'()ursc,l! \',1[1. 1"()[)r TI l)\' joca~i Il~ rhl' 1'\'\1kc:''. nOted helo\'; These are rhe onh' key' \'O)! I1C~c! [(, Lnov.- [0 work vil'tuall:' all TV;\! proolel1ls,

Time Lines

It is often a good idea to draw ;1 rime line before you start to solve a TVM problem, A time line is simply a diagram of the cash f10vvs associated with a TVM problem, A cash fJow thar occurs in rhe preselH ((Oda)') is pur ar rime zero, Cash outflows (paymenrs) are given J negative sign, and cash inflows (receiprs) are given a positive sign, Once rhe cash flows are assigned to a time line, rhey may be moved to the beginning of the investment period to calculate the PV through a process called discounting or to rhe end of the period to calculate the FV using a process called compounding,

Study Session 2

Cross-Reference to CFA Institute Assigned Reading #5 - The Time Value of Money

Figure 1 illustrates a time line for an investment that costs $1,000 today (outflow) and will rerum a stream of cash payments (inflows) of $300 per year at the end of each of the next five years.

Figure 1: Time Line

- 1,000 + 300 + 300 + 300 + 300 + 300

Please recognize that the cash flows occur at the end of the period depicted on the time line. Furthermore, note that the end of one period is the same as the beginning of the next period. For example, the end of the second year (r =c 2) is the same as the beginning of the third vear, so a cash flow at the beginning of year 3 appears at time t = 2 on the time lint:. I(eeping [hi, convelHion in mind will help you keep things straight when you are serring up TVM problems.

o Professor:, Note: Throughout the problems in tll/'s rCllicw, rtiuudiuf(. diffcrcnces J111l)' ocmr between the IISC ofdiffirent calculaton or tCc!JIliquCJ prcscnted in t!Ji~' dOCUJ11C1lt. So dOIl't panic ifyo II are a few cents of/ill your calclilatioll.'.

LOS 5.a: Interpret interest rates as required rate of return, discount rate or opportunity cost.

Interest rates are our measure of the time value of money, although risk differences in financial securities lead to differences in their equilibrium interest rates. Equilibrium interest rates are the required rate of return for a particular investment, in the sense that the market rate of return is the return that investors and savers require to get them to willingly lend their funds. Interest rates are also referred to as discount rates and, in fact, the terms are often used interchangeably. If an individual can borrow funds at an interest rate of 10%, then that individual should discount payments to be made in the future

at that rate in order to get their equivalent value in current dollars or other currency. Finally, we can abo view interest rates as the opportunity cost of current consumption. If the market rate of interest on one-year securities is 5%, earning an additional 5%

is the opportunity forgone when current consumption is chosen rather than saving (postponing consumption).

LOS 5.b: Explain an interest rate as the sum of a real risk-free rate, expected inflation, and premiums that compensate investors for distinct types of risk.

The real risk-free rate of interest is a theoretical rate on a single period loan that has no expectation of inflation in it. When we speak of a real rate of return, we are referring

to an investor's increase in purchasing power (after adjusting for inflation). Since

Study Session 2

Cross-Reference to CFA Institute Assigned Reading #5 - The Time Value of Money

expected inflation in future periods is not zero, the rates we observe on U.S. Treasury bills (T-bills), for example, are risk-free rates but not real rates of return. T-bill rates are nominal risk-free rates because they contain an inflation premium. The approximate relation here is:

nominal risk-free rate = real risk-free rate + expected inflation rate

Securities may have one or more types of risk, and each added risk increases the required rate of return on the security. These types of risk are:

•Default risk. The risk that a borrower will not make the promised payments in a timely manner.

•Maturity risk. As we will cover in detail in the section on debt securities, the prices of longer-term bonds are more volatile than those of shorter-term bonds. Longer maturity bonds have more maturity risk than shorter-term bonds and require ;J. mall1ri,~' risk premium.

Each of these risk factors is associated with a risk premium that we add to the nominal risk-free rate [0 adjust for greater default risk, less liquidity, and longer maturity relative to a very liquid, short-term, default risk-free rate such as that on T-bills. We can write:

required interest rate on a security = nominal risk-free rate

+ default risk premium + liquidity premium

+ mamrity risk premium

LOS S.c: Calculate and interpret the effective annual rate, given the stated annual interest rate and the frequency of compounding, and solve time value of money problems when compounding periods are other than annual.

Financial instimtions usually quote rates as stated annual interest rates, along with a compounding frequency, as opposed to quoting rates as periodic rates-the rate of interest earned over a single compounding period. For example, a bank will quote

a savings rate as 8%, compounded quarterly, rather than 2% per quarter. The rate of interest that investors actually realize as a result of compounding is known as the effective annual rate (EAR). EAR represents the annual rate of remrn actually being earned after adjustments have been made fo1" different compounding periods.

EAR may be determined as follows:

EAR = (I + periodic rate)m - 1

©2008 Kanbn Srhwt><t>r

Study Session 2

Cross-Reference to CFA Institute Assigned Reading #5 - The Time Value of Money

Obviously, the EAR for a stated rate of 8% compounded annually is not the same as the EAR for 8% compounded semiannually, or quarterly. Indeed, whenever compound inrerest is being used, the stated rate and the actual (effective) rate of inrerest are equal only when interest is compounded annually. Otherwise, the greater the compounding frequency, the grearer rhe EAR will be in comparison to the stated rate.

The computation of EAR is necessary when comparing investments rhar have differenr compounding periods. It allows for an apples-to-apples rare comparison.

Example: Computing EAR

Compute EARjf the stared annual rate is 12%, compounded quarrerly.

This solution uses rhe ()'""j key on your financial calculator. The exact keystrokes on the TI for the above computation are 1.03 [yX] 4 [=]. On the HP, the Strokes are 1.03 (ENTER] 4 [y"].

Example: Computing EARs for a range of compounding frequencies

Using a stated rate of 6%, compute EARs for semiannual, quarterly, monthly, and daily compounding.

Notice here that the EAR increases as the compounding frequency increases.

The limit of shorter and shorrer compounding periods is called continuous compounding. To convert an annual stated rate to the EAR with continuous compounding, we use the formula ef - 1 = EAR.

For 6%, we have eO.06 - 1 = 6.1837%. The keystrokes are 0.06 [2nd] [eX] H 1 [=]

0.061837.

Srudy Session 2

Cross-Reference to CFA Institute Assigned Reading #5 - The Time Value of Money

LOS 5.d: Calculate and interpret the future value (FV) and present value (PV) of a single sum of money, an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows.

Future Value of a Single Sum

Future value is the amouni: to which a current deposit will grow over time when it is placed in an account paying compound interest. The FV, also called the compound value, is simply an example of compound interest at work.

The formula for the FV of a single cash flow is:

FV = PV(l + IIy)N

In this expression, the investment involves a single cash outflow, PV, which occurs roday, Jt { = 0 on the time line. The single sum fV formula will determine the value of an investment at the end of N compounding periods. given that it can earn a fully compounded rate of return. I1Y, over all of the periods.

The facror (1 + I1y)N represents the compounding rat<: on an investment and is frequently referred ro as the future value factor, or the future value interest factor, for a single cash flow at IIY over N compounding periods. These are the values that appear in interest factor tables, which we will not be using.

Example: FV of a single sum

Answer:

To solve this problem with your calculator, input the relevant data and computeFY:

N = 10; IIY = 8; PV =-300; CPT ~FV = $647.68

~Professor's Note: Note the negati,v: sign on PV This is notnecessary,b~~ it;

~makes the FV come out as a posztzve number. Ifyou enter PV as a posztzve .