CFA Level 1 (2009) - 1

Self-Test: Ethical and Professional Standards

22.Mary Herbst, CFA, a pension fund manager at GBH Investments, is reviewing some of FreeTime, Inc.'s pension fund activities over the past years. Which of

the following actions related to FreeTime, Inc.'s pension fund is least likely to be a breach of her fiduciary duties?

A. Paying higher-than-average brokerage fees to obtain research materials used in the management of other funds by the investment group.

B. Trading with selected brokers so that the brokers will recommend GBH's managers to potential clients.

e. Selectively choosing brokers for the quality of research provided for managing FreeTime's pension.

23.Eugene Nieder, CFA, has JUSt accepted a new job as a quantitative analyst for Paschal Investments, LLP. Nieder developed a complex model while working for his previous employer and plans to recreate the model for Paschal. Nieder did not make copies of the model or any supporting documents since his employer refused to grant him permission to do so. Nieder will recreate the model from memory. \X/hich of the following statements is most like!]' correct~

A.Nieder can recrcate thl' model without violating the Cod\: alld Sralld:lrlb as long as he also generates supporring documentation.

B.Nieder can recreate the model without violating the Code and Standards

research from Baker. Clients and prospects of Hern are not made aware of the agreement, but clients unanimously rave about the high quality of the research provided by Baker. As a result of the research, many clients with

non-discretionary accounts have earned substantial returns on their portfolios. Managers at Hern have also used the research to eam outstanding returns for the firm's discretionary accounts. Which of the following statements is most like~l' correct? Hern:

A. has not violated the Code and Standards.

B. has violated the Code and Standards by using third-party research in disctetionary accounts.

C. has violated the Code and Standards by failing (0 disclose the referral agreement with Baker.

Self-Test: Ethical and Professional Standards

25.Frist Investments, Inc. has just hired Michael Pulin to manage institutional

portfolios, most of which are pension related. Pulin has just taken the Level III CFA exam and is awaiting his results. Pulin has over 15 years of investment management experience with individual c1itnts but has never managed an

institutional portfolio. Pulin joined the CFA Institute as an affiliate member two years ago and is in good standing with the organization. Which of the following statements would be most appropriate for Frist to use in advertising Pulin as a new member of the firm? Pulin:

A. has many years of investment experience which, along' with his participation in the CFA program, will allow him to deliver superior investment performance relative to other managers.

B. is a CFA Level III and passed the first two exams on the first attempt. He is an affiliate member of the CFA Institute. We expect him to become a regular member if he passes the Level III examination.

C. is a Level III CFA candidate and has many years of excellent performance in the invesrment management industry. Pulin is an affiliate member of the CFA Institute and will be eligible to become a CFA charterholder and regular member if he passes the Le\',~1 III CFA Exam.

26.Before joining Mitsui Ltd. as an analyst covering the electrical equipment manufacturing industry, Pam Servais, CFA, worked for Internet Security Systems (ISS) where she had access to nonpubliL information. While at ISS, Servais learned of a severe environmental problem ar two firms handling boronbased components. It is common knowledge that seven firms in the industry woridwide use the same boron handling rechnique. The two firms for which Servais has knowledge announced the problem last week and had immediate stock price declines of 11 % and 17%, respectively. The other five firms have not made an announcement. Servais issues a report recommending Mitsui clients sell shares of the remaining five firms. Servais' issuance of this recommendation:

A.is not a violation of CFA Institute Standards.

B.is a violation of CFA Institute Standards because it fails to distinguish

between opinion and fact.

e. constitutes a violation of the Standard pertaining to the use of material non public information.

27.Zanuatu, an island nation, does not have any regulations precluding the use of non-public information. Alfredo Romero has a friend and fellow CFA

charterholder there with whom he has shared nonpublic information regarding firms outside of his industry. The information concerns several firms' internal earnings and cash flow projections. The friend may:

A.trade on the information under the laws of Zanuatu, which govern her behavior.

B.not trade on the information under CFA Institute Standards, which govern her behavior.

C.trade on the information under CFA Institute Standards since the firms concerned are outside of Romero's industry.

Self-Test: Ethical and Professional Standards

28.Samantha Donovan, CFA, is an exam proctor for the Level II CFA exam. The

day before the exam is to be administered, Donovan faxes a copy of one of the questions to two friends, James Smythe and Lynn Yeats, who are Level II

candidates in the CFA program. Donovan, Smythe, and Yeats had planned the distribution of an exam question months in advance. Smythe used the fax to prepare for the exam. Yeats, however, had second thoughts and threw the fax away without looking at its contents. Which of the following statements is most likely correct?

A.Smythe violated the Code and Standards but Yeats did not.

B.Donovan violated the Code and Standards but Smythe did not.

e.Donovan and Yeats both violated the Code and Standards.

29.Julia Green, CFA, has friends from her previous employer who have suggested that she receive information from them via an Internet chat room. In this way, she receives news about an exciting new product being developed by a firm in Singapore that has the potential to double the firm's revenue. The firm has nor revealed any information regarding the product to the public. According to the' Code and Standards, this information is:

A.both material and nonpublic and Green may not trade on it in Singapore. but may trade on it elsewhere.

B.both material and non public and Green may not trade on it ir1 any jurisdiction.

e. public by virtue of its release in the chat room and Green may trade on it.

30.Sally Albright, CFA, works full-time for frank & Company, an investment management firm, as a fixed-income security analyst. Albright has been asked

by a business contact at KDG Enterprises to accept some analytical work from KDG on a consulting basis. The work would entail investigating potential distressed debt securities in the small-cap market. Albright should most appropriately:

A.accept the work as long as she obtains consent to all the terms of the engagement from Frank & Company.

B.not accept the work as it violates the Code and Standards by creating a conflict of interest.

e.accept the work so long as she obtains written consent from KDG and does it on her own time.

Self-Test: Ethical and Professional Standards

31.Beth Bixby, CFA, uses a quantitative model to actively manage a portfolio of stocks with an objective of earning a greater return than the market. Over the last three years, the returns to a portfolio constructed using the model

have been greater than the returns to the S&P index by between 2% and 4%. In promotional materials, Bixby states: "Through our complex quantitative approach, we select a portfolio that has similar risk to the S&P 500 Index but

will receive a return between 2% and 4% greater than the index." This statement

IS:

A.permissible since prior returns to the firm's model provide a reasonable and adequate basis for the promotional material.

B.permissible since the statement describes the basic characteristics of the fund's risk and return objectives.

C.not permissible since Bixby is misrepresenting the investmeIH performance her firm can reasonably expect to achieve.

32.Josef Karloff, CFA. acts as liaison between Pinnacle Financial (an investment

managel1lem firm) and Summit Inc. (an investment banking bOlltiCJlIl' srcciali7.in~ in I'CIll1l' ~tock.)). \X'hen Summit underwrite.) ;\11 11'0,I\:arloff routinely has Pinnacle issue vague statements implying thar the firm has cash flows, financial resources, and growth prospects that are better than is the case in reality. This action is a violation of the section of the Standards concerning:

A.fair dealing.

B.non-public intormation.

C. misconduct.

33.Shane Matthews, CFA, is a principal at Carlson Brothers, a leading regional investment bank specializing in initial public offerings of small to

mid-sized biotech firms. Just before many of the IPOs are offered to the general

public, Matthews arranges for 10% of the shares of the firm going public to be distributed to management. This action is a violation of the Standard

concernmg:

A.additional compensation.

B.disclosure of conflicts of interest.

C.fair dealing.

34.Will Hunter, CFA, is a portfolio manager at NY Asset Managers in Baltimore, which specializes in managing labor union pension fund accounts. A friend of Hunter's who is an investment banker asks Hunter to purchase shares in their new 1P05 in order to support the price long enough for insiders to liquidate their holdings. HUIHer realizes that the price of the shares will almost certainly fall dramatically after his buying support ceases. NY management "strongly suggests" that H lImer "nor rock rhe boat" and honor the investment banker's request since NY has had a long-standing relationship with the investment bank. Hunter agrees to make the purchases. Hunter has:

A.not violated the Code and Standards.

B.violated the Code and Standards by attempting to distort prices.

C.violated the Code and Standards by failing to place orders in the appropriate transaction priority.

Self-Test: Ethical and Professional Standards

35.Neiman Investment Co. receives brokerage business from Pick Asset Management in exchange for referring prospective clients to Pick. Pick advises clients-in writing at the time the relationship is established-of the nature of its arrangement with Neiman. With regard to this practice, Pick has:

A. complied with the Code and Standards.

R.violated the Code and Standards by failing to preserve the confidentiality of the agreement with Neiman.

C.violated the Code and Standards by inappropriately negotiating an agreement that creates a conflict of interest.

36.Fred Johnson, CFA, a financial analyst and avid windsurfer, has begun an investment survey of the water spons leisure industry. His brother sells windsurfing gear in Tampa and tells him that Swordfish9 is the "hottest windsurfing rig on the market and will b<.: highly profitable for Swordfish Enterprises." Johnson had never heard of Swordfish previously but after testing the board bimself became very excited abOUt the Swordfisb9 and issued an ill\'estl11,nr recommendation of "buy" on Swordfish ElHerprises. As a result of issuing the recommendation, Johnson Las:

A.not I'iolated the Code and Standards.

13.violared the Code and Standards by failing to establish a reasonable and adequate basis.

C.violared the Code and Standards by failing rn consider the suitability of the inv('stment for his clients.

C.disclose the situation to his employer and, if then asked to prepare a report, also disclose the situation in the report.

38.Which of the following is least likely one of the recommendations included in rhe Standards of Practice Handbook with regard to Performance Presentation?

A.Include terminated accounts in past performance history.

B.Present the performance of a representative account to show how a composite has performed.

C.Consider the level of financial knowledge of the audience to whom rhe performance is presented.

Self-Test: Ethical and Professional Standards

39.Which of the following is least likely a recommended procedure of the Standard regarding Fair Dealing?

A.Develop written procedures for trade allocation.

B.Disseminate ini tial recommendations to all clients.

C.Review accounts systematically to ensure that no client is given preferred treatment.

40.Which of the following actions is a required, rather than recommended, action under the Standard regarding diligence and a reasonable basis for a firm's research recommendations?

A.Have a policy requiring that rescarch reports and recommendations have a basis that can be substantiated as reasonable and adequate.

B.Compensate analysts based on measurable criteria to assess the quality of their research.

C.Review the assumptions used and evaluate the objectivity of externally generated research rer0rts.

41.Ralph SaUey, a Ll:vtl I candidare in rhe CFA Program, is explaining Srand,lrd VI(B), Priority ofTransacrions. to his supervisor. Salley states, "The Standard recommends, but does not require, that members and candidates should not participate in initial public offerings. The Standard also recommends that trades for accounts of family members be made after those for other clients, hut bcf(;j"I' those for the account of rhe members and candidatcs responsibk for execl\tin:-:. the transactions." Salley's explanation of rhe Standard is:

A.correct.

B.incorrect, because the Standard does not recommend that trades for family members be made after those for othcr clients.

C.incorrect, because the Standard requires that members and candidates not parricipate in initial public offerings.

42.Which of the following statements most accurately describes the parries that GIPS are intended to apply to and serve? GIPS apply to:

A.consultants and serve their existing and prospective clients.

B.firms that issue securities and serve investment management firms.

C.investment management firms and serve their existing and prospective clients.

43.At a regional conference for institutional portfolio managers, Jason Morris makes three comments in a presentation centered on explaining the reasons for the creation of GIPS. Which of Morris' comments is least likely correct? GIPS were created:

A.to reduce historical performance inflation caused by excluding results of terminated portfolios.

B.to encourage investment firms to select representative accounts when presenting investment results.

C.in response to performance reporting abuses which included only reporting results over periods of exceptional returns.

Pa~e 86

Self-Test: Ethical and Professional Standards

44.Which of the following statements most accurately describes verification under GIPS? Verification:

A.may be performed on single composites.

B.is required for a firm to claim GIPS compliance.

C.requires a verification report to ~e issued for the entire firm.

45.Benson Asset Management Inc. is seeking to become compliant with GIPS. The firm has hired an independent consultan t to assist in ensuring that Benson's policies and procedures conform to the standards. Which of the following recommendations made by the consultant is least likely required under GIPS?

A.Benson must disclose the results of an independent verification process in its composite presentations.

B.All of Benson's accounts managed by third parry advisers selected by Benson must be included in the firm's composites.

C.Compliant presentations for discontinued composites must be made ;l\'ailable to any prospect requesting one up to five years after discon ti n uation.

46.Vivian Iv1LiUer, compliance director for ABC Investments. is reviewing CIllS compliance policies pur in place by her employees. Which of the following' policies is currently required to comply with GIPS?

A.Calculation of composite returns must be done based on monthly asset weighted returns of the underlying portfolios.

B.Restructuring of the firm's organization cannot he used as a basis TO change the historical performance results of a composite.

C.Performance presentation for carve-our returns is only permitted for portfolios managed separately with their own cash babnces.

47.Which of the following is least likely an accurate statement abour the major components ofGIPS?

A.GIPS cover the professional qualifications of those responsible for managing assets at a firm claiming compliance.

B.GIPS cover the way investment firms calculate composite returns as well as the method used to create the composite itself.

C.GIPS apply to many categories of portfolio assets including stocks, bonds, real estate, and private equity.

48.Mason Smith is trying to decide which of the following composite definitions, submitted by his junior analysts, would be considered a viable composite according to GIPS. Which composite will meet the standards? A composite that includes:

A.all accoullts that are managed directly from the firm's Hong Kong office.

B.all actively managed portfolios but excludes passively managed portfolios.

C.all portfolios that are managed to provide a rerum approximately equal to that of the S&P 500 Index.

Self-Test: Ethical and Professional Standards

49.Mack Stevens has assembled several articles written about GIPS. Each article has listed at least one objective of GIPS. Which of the following statements collected from the articles least likely describes objectives of GIPS accurately?

A. GIPS attempt to gain worldwide acceptance of performance calculation and presentations standards in a fair format with full disclosure.

B.GIPS try to provide an opportunity for large and small firms to compete on an equal footing by imposing external rules and regulations on performance presentation.

C. GIPS seek to encourage equitable competition among investment firms in all markets without stifling new market entrants in the process.

50.An investment management firm, Investco, Inc., was recently audited by the United States Securities and Exchange Commission (SEC). InvestcD included the following statement in its performance presentation report: "This report has heen verified as GIPS compliant by Investco's Compliance Department and rhe Unired Stares Securities and Exchange Commission." Does this constitll[(' acceprable verificarion under GIllS?

A. ~l>, only one parry may perform C;IPS verificarion.

R.No, neither party involved in the audir consritutes an ~).cceptableGIPS verification.

C. Yes, because an audit was performed implicirlv by the SEC and explicitly h" rhe firm's internal audit ream.

Self-Test: Ethical and Professional Standards

SELF-TEST ANSWERS: ETHICAL AND PROFESSIONAL

STANDARDS

1.A Hutchins' pcrsonal bankruptcy may reflect poorly on her professional reputation if it resulted from fraudulent or deceitful business activities. There is no indication of this. however. and the bankruptcy is thus not a violation. Smith has not violated the Code and Standards by refusing to invest with Hutchins in what turned out to be bad investment opportunities. By reporting Smith to CFA Institute for a violation,

Hutchins has misused the Professional Conduct Program to settle a dispute unrelated to professional ethics and has thus violated Standard 1(0), Misconduct.

2.C According to Standard I(A), informing her supervisor or firm's compliance department is appropriate. Dissociating herself would be prcmature. She should report her suspicions to a supervisory pcrson and attempt to remedy thc siruation.

,). B According III Standard \(A). since she h;!s takcn Sleps to SlOp the illegal Kti\'ities and thl' hoard has ignorcli her, )lllles must disSlki,uc' from the hoard and seek lcg,i1 acll·icc' a, III what other actions would be appropriate in this instance. Shc may need to inform legal or rcgulatory authorities of thc illegal activities.

"/. C According to Standard II(A), mcmbers and candidatcs are under no circumstanccs allowed to usc matcrial nonpublic information to trade securities. Carlson must abide b\, the Code and Standards. which is the most strict regulation in the scenario.

-). B The intent of Green Brothets' actions is to manipulate market liquidity in order to attract investment to its own funds. The increased trading activity was not based on markct fundameIHals or an actual trading stratcgy to benefit investors. It was merely an attempt to mislcad market panicipants in order to increase assets under Green Brothers' management. The action violates Standard II(B), Market Manipulation.

6.A Quigley's trades are most likely an attempt to take advantage of an arbitrage opportunity that exists between Craeger's common stock and its put options. She is not manipulating the prices of securities in an attempt to mislead market participants, which would violate Standard II(B), Market Manipulation. She is pursuing a legitimate investment strategy.

ParticipaI1ts in her hedge fund arc aware of the fund's investment strategy, and thus Quigley did not violate the Code and Standards by not disclosing this specific set of trades in advance of trading.

7C According to Standard I(A), in some instances reporting a legal violation to governmental or regulatory officials may be appropriate, but this isn't always necessary, and it isn't required under Standard I(A).

R.B According to Standard VfI(B), any explanation of the designation in print form should be a concise description of the requirements or of CPA Institute. The other statements contain violations of Standard VII(B), in particular the presentation of the letters CFA.

AJso, she may not imply superior performance as a result of being a CFA charterhoJder.

9.B Standard III(C), Suitability, requires that before taking investment action, members and candidates must make a reasonable inquiry into a client's or prospect's investment objectives and constraints as well as their prior investment experience. Byrne cannot assume that because the brothers have similar lifestyles and are close in age that they should have similarly managed portfolios. Byrne should have interviewed Cliff directly before investing his portfolio.

Page 89

Self-Test: Ethical and Professional Standards

10.B According to Standard I(C), Misrepresentation, factual data from a recognized statistical reporting service need not be cited.

II. B By failing to include terminated portfolios in the perform1!'.ce presentation, the performance will have an inherent upward bias, making results appear better than they truly are. By excluding the terminated portfolios, DNR misleads its potential investors and thus violates Standard III(D), Performance Presentation, which prohibits any "practice that would lead to misrepresentation of a member or candidate's performance record."

12.C According to Standard IV(A), Loyalty, members and candidates are expected to act for the benefit of the employer and not deprive the employer of their skills. Fletcher is performing work similar to the services that her employer provides for a fee. Although

the position is a volunteer position, Fletcher will receive compensation in the form of a free parking space. In light of the circumstances, Fletcher must disclose the details of the position and get written permission before accepting the volunteer position.

13.C According. [(l St~\ndard jV(Cl. Responsibilities of Supervisors. reporting. thl' vioiation :lIld \o\·arning. thc cml)lovce to cease :lctivities that vjnl.Ht" the la\\' or the Code and Standard, arc nOl cnough. The supervisor must takc steps (such as limiting employee aCtivity' or increasing the level of employee moniroring) [() preveIH further violations while he conducts :In investigation.

14.C According to Standard IV(C). because he is aware that the firm's compliance procedures arc not being monirored and followed and because he has repc.Hedl!· tried to get comp:lnv management to correct the situation, Blair should decline supervisory responsibility unril adequate procedures to detect and prevent violations of laws,

regulations, and the Code and Standards are adopted and followed. If he does not do so,

he will be in violation of the Code and Standards.

15.A Standard 1(8), Independence and Objectivity, requires that members and candidates reject offers of gifts or compensation that could compromise their independence or objectivity. Schleifer has appropriately rejected the offer of the botel accommodations and the use of ChemCo's jet. He may accept the desk clock since this gift is of nominal value and is unlikely to compromise his independence and objectivity. Schleifer cannot accept the tickets to the dinner, however. Since it is a formal high-society dinner, the tickets are most likely expensive or hard to come b)·. Even though he has disclosed

the gift to his employer and he plans to use the dinner as a marketing opportunity for his firm, the gift itself may influence Schliefer's future research in favor of ChemCo. Allowing such potcntial influence is a violation of Standard I(B).

16.C Standard I(B) recommends, but does not require, that an analyst have his firm pay for ordinary travel expenses [Q visit companies that are the subject of research. The other choices are requircd by thc Standards.

17.A Anderson must maintain the confidentiality of client information according to Standard

IIJ(E). Confidentiality may be broken in instances involving illegal activities on the parr of the client, but the client's information may only be relayed to proper authorities. Anderson did not have the right to inform th.e investment bank of her clien t's investigation.

18.A Historical growth can be cited as a fact since it actually happened. Stefano states that her firm expects further growth and profitability, which is an opinion. She does not claim that these are facts. In addition, Stefano identifies relevant factors and highlights in particular the most significant risks of investing in South American utilities. She