11.

05 Ethics Application

Question 1
Zhang Li, CFA, is a portfolio manager who manages a mutual fund and a hedge fund for an
investment company. Li conducts thorough due diligence of Coffee Cup Inc., which she believes
will revolutionize the industry, and finds that the stock is suitable for both funds. Li places a limit
order for 100,000 shares at $35 and instructs the broker to allocate 90% to the mutual fund and
10% to the hedge fund, based on the funds' sizes and investment objectives and given that
neither fund requires a minimum allocation.
On the same day, Coffee Cup announces it has received a new patent and the stock price
quickly increases to $40 per share. Later, Li sees that her order has been only partially filled and
she has received only 10,000 shares. Li decides that she would prefer the hedge fund have a
full allocation, so she instructs the broker to allocate all 10,000 shares to the hedge fund and
cancels the rest of the order. Does Li's conduct most likely comply with Standard III(B) Fair
Dealing?
A. No, since she favored one client over another.
B. Yes, since the hedge fund received its full allocation, but no more.
C. Yes, since a pro rata allocation would have been too small for either client.

Question 2
Wang Pei Han, CFA, is an independent investment consultant. Among her clients are the
investment fund for Bright Life Insurance (BLI) and the personal investment account for the
fund's manager, Li Jie. Wang is contacted by the CFA Institute Professional Conduct Program
(PCP) regarding her own potentially unethical, but not illegal, activity. The PCP is requesting
information about the fund and Li's investment account to support its investigation. Local law
requires that information about illegal activity be disclosed to authorities but does not mandate
any specific action otherwise. Given that BLI and Li are clients, to comply with Standard III(E)
Preservation of Confidentiality, Wang's most appropriate action is to provide the PCP
information about:
A. only BLI's investment fund since Li is an individual investor.
B. both BLI's investment fund and Li's personal investment account.
C. neither BLI's investment fund nor Li's personal investment account.

Question 3
Fulvio Lombardi, CFA, a research analyst, recently left Primo Investment, where he had
published research on Breve Latte Inc. (BLI). Lombardi joins Risultati Research and uses
publicly available information and material from management's latest earnings release to create
a new research report on BLI based on updated information. The public information includes
material from Twitter posts and online blogs by BLI's chief executive officer and chief financial
officer. Lombardi verifies the information in the social media sources when possible and feels
comfortable including them in his analysis. Since these tweets and blogs are hosted on
electronic servers and are easily accessible, Lombardi does not see the need to maintain them
in his files, yet he keeps documentation of personal notes, articles, and other research
documents. Lombardi publishes the report without obtaining permission from or citing his former
employer. Which of Lombardi's actions are most likely in compliance with Standard V(C)
Record Retention?
A. Only his documentation of research sources
B. Only the publishing of the research report on BLI at Risultati
C. Both his documentation of research sources and publishing of the report on BLI at Risultati

Question 4
Aditi Kumar is a Level II Candidate and a performance measurement and attribution analyst for
an investment manager. On a quarterly basis, Kumar produces performance reports that include
the firm's composites for each investment strategy.
Raheem Khan, CFA, the portfolio manager of the firm's large-cap equity strategy approaches
Kumar regarding the large-cap equity composite for the most recent quarter. Kumar explains
that several accounts in the composite should be excluded from this quarter's performance
report due to a software issue that resulted in numerous accounts not being fully invested. The
resulting cash drag caused the composite to underperform the benchmark index for the quarter
and year.
Khan explains that he should not be held responsible for a software error. Kumar agrees and
produces new reports without the affected accounts. According to Standard I(C)
Misrepresentation, it is most likely that:
A. no violation occurred.
B. only Kumar violated the Standard.
C. both Kumar and Khan violated the Standard.

Question 5
Marcos Silva, CFA, and Clara Neves, CFA, are analysts at Alpha Capital, an independent
research firm. Silva reads a blog post about Northwest Bank that details several fresh insights
on company-specific growth. After doing his own thorough research on Northwest, Silva agrees
with the blogger's analysis, although he expects this growth to take longer than the blogger
predicts.
Silva then writes a research report on Northwest and includes a restatement of the blogger's
insights. Since he has changed some of the wording and the expected time horizon for growth,
he does not reference the blog.
Neves proofreads the report at Silva's request and agrees with his conclusion about the bank.
With Silva's approval, Neves adds a chart from the US Federal Reserve, which is not
copyrighted, that shows expected growth in bank reserves over the next year. She properly cites
the US Federal Reserve as the source. According to the Code and Standards:
A. both Silva and Neves have violated the Standards.
B. Silva has violated the Standards, but Neves has not.
C. Neves has violated the Standards, but Silva has not.
Question 6
Clem Benson, CFA, is the chief investment officer at Sterling Hospital. Sterling's board asks
Benson for fundraising ideas. Benson suggests that if Sterling refers past contributors to him, he
will conduct a personalized investment review for a fee of $1,000. In return, Benson will donate
50% of that fee to Sterling. After receiving board approval, Sterling promotes the fundraising
campaign to its past contributors, informs them of Benson's arrangement, and refers 50 clients
to Benson. The fundraiser raises $25,000 for Sterling. According to Standard VI(C) Referral
Fees, has Benson most likely violated the Standard?
A. No.
B. Yes, since Benson receives income from the referrals.
C. Yes, since Benson receives the tax deduction for the donation instead of the contributors.

Question 7
Maria Perez, CFA, is a portfolio manager for a small family office, Powell Investment Partners.
Powell's investment policy does not allow managers to invest in individual hedge funds, but
Perez gets approval to invest in funds of hedge funds. Perez decides to invest in Ashvale
Group, a fund of hedge funds operated by a former colleague, Jose Rivera. She sees that
Ashvale has posted strong returns in each of the past five years and remembers Rivera being
highly diligent in his investment decisions when they worked together. Perez knows that
fund-of-hedge-funds managers perform due diligence on each individual hedge fund in which
they invest, so she feels comfortable with her decision. Has Perez violated Standard V(A)
Diligence and Reasonable Basis?
A. Yes
B. No, since she worked with Rivera and is familiar with his work
C. No, since fund-of-hedge-funds managers do the due diligence on behalf of investors

Question 8
Morena Villalba, CFA, and Franco Aquirre, a Level I CFA candidate, both work in the private
wealth department of a major bank and often work with the same clients. Villalba becomes
aware that Aquirre receives compensation for each referral he makes to the bank's brokerage
department that results in commissions but does not disclose that fact to clients. Also, she
learns that Aquirre and a colleague have been able to hide the arrangement and fees from the
firm. Villalba researches local law and believes that Aquirre's arrangement is illegal. She reports
the situation to her supervisor, but after some time has passed, Villalba notices that Aquirre
continues to benefit from his referrals, and she is not sure what to do next. According to
Standard I(A) Knowledge of the Law, which of the following actions is Villalba's most appropriate
next step?
A. Resign from her employment at the bank
B. Request a transfer to another department of the bank
C. Remain in her role to document stronger evidence to present later
Question 9
Calvin Wurtz, CFA, is the founder and CEO of Florenz Equities, an asset management firm
specializing in small-cap stocks. The firm's marketing materials display its average compounded
returns over 5, 10, and 15 years. The materials include the following statements:
Statement 1: "Average returns for each time period shown in these materials include
returns from both currently active accounts and accounts that were terminated during
that period."
Statement 2: "We present average return data gross of management fees."
The materials do not specify the dates when accounts were terminated. The materials state that
the firm does not comply with Global Investment Performance Standards (GIPS).
Has Wurtz violated Standard III(D) Performance Presentation with respect to Florenz's
marketing materials?
A. Yes, only regarding terminated accounts.
B. Yes, only regarding average return data.
C. Yes, regarding both terminated accounts and average return data.

Question 10
Gerry Walsh, CFA, trades only cryptocurrencies through an account at Mayday Securities. Since
the account was opened in January 20X7, Walsh has earned an average monthly return of
3.5%. However, returns have been very volatile, and the monthly gains and losses often exceed
10%. In January 20X8, Walsh starts a subscriber-based online investment newsletter providing
information on his experience with cryptocurrencies and monthly returns. In the newsletter,
Walsh suggests similar long-term average returns are possible for others if they follow his
strategies. He states that cryptocurrency trading can generate large gains, but adds that it
carries the potential for high volatility and significant losses. Although Walsh wants more
subscribers, he fully discloses the account's performance in 20X7 and notes that cryptocurrency
investments may not be appropriate for all investors. Based on the actions described, does
Walsh violate Standard I(C) Misrepresentation by issuing the newsletter?
A. No.
B. Yes, since he presents performance for only 20X7.
C. Yes, since he knows cryptocurrencies are not appropriate for all subscribers.

Question 11
Matt Fabiano, CFA, is the senior portfolio manager at Marco Investment Advisors (MIA). All of
MIA's clients gave Fabiano discretion over their accounts and, as part of his service, he directs
trades to a number of brokerage firms. Fabiano discovers that if he trades exclusively with
Strollo Brokerage Inc. (SB), MIA could participate in SB's client referral program, allowing MIA to
serve more clients. Based on MIA's analysis, Fabiano concludes that clients are neither harmed
by nor benefit from using SB as a broker. With respect to Standard III(A) Loyalty, Prudence, and
Care, if Fabiano trades exclusively with SB, most likely he:
A. does not violate the Standard since he has discretion.
B. violates the Standard since clients do not receive a benefit.
C. does not violate the Standard since he does not receive a benefit.
1. Which of the following companies will most likely employ the greatest amount of debt relative to its equity?

 A. A real estate developer during its initial growth phase

B. A cyclical car manufacturer during an economic downturn

C. A consulting firm that uses highly paid consultants and few physical assets

Explanation

A firm will typically increase the proportion of debt in its capital structure as it matures through its life cycle. In early (ie, start-up) stages,
businesses have very limited access to debt due to high operating risk and unstable cash flows. In general, as a business gradually matures,
more funds can be borrowed since increased revenues and stable cash flows are opening the firm to more potential lenders. However, there are
exceptions to this tendency for capital-intensive, capital-light, and cyclical businesses.

Capital-intensive firms (eg, companies operating in real estate, utilities, or transportation) require relatively high levels of debt financing to
purchase fixed assets during any stage of the life cycle. For example, a real estate developer would most likely have a lot of debt, even in its
early stages.

Capital-light firms (eg, consulting firms, software companies) have fewer capital expenditures. Such companies often require little debt
financing throughout the life cycle (Choice C).

Cyclical firms (eg, car manufacturers, mining companies) have more volatile revenues and cash flows that fluctuate with economic cycles. This
volatility reduces their debt capacity, especially during an economic downturn (Choice B).

Things to remember:
Generally, firms will borrow more funds as they mature and thus have proportionately more debt in their capital structure. However, exceptions to
this tendency exist for capital-intensive, capital-light, and cyclical businesses.

Explain factors affecting capital structure and the weighted-average cost of capital
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2. Analysts most appropriately use the company's weighted average cost of capital to determine a project's:

 A. value.

B. future cash flows.

C. investment opportunity schedule.

Explanation

A company's weighted average cost of capital is the rate the company pays for new capital to fund new projects, which typically require cash
outflows to generate cash inflows. Inflows and outflows may occur throughout the project's life. The project's value is the net present value of
its cash inflows and outflows. The discount rate used to find that the present value is the WACC. Therefore, analysts use the WACC to
calculate a project's value.

(Choice B) A project's future cash flows are estimated by making assumptions about the project's need for cash (ie, outflows) and its ability to
generate cash (ie, inflows). The WACC is then used to discount those cash flows to find the project's net present value.

(Choice C) The investment opportunity schedule (IOS) is a graph of all the company's projects ranked from highest to lowest return against the
cumulative amount of new capital needed for each project. A company's WACC does not determine the IOS.

Things to remember:
A company's weighted average cost of capital (WACC) is the rate the company pays for new capital to fund new projects, which typically require
cash outflows to generate cash inflows. The project's value is the net present value of its cash inflows and outflows. The discount rate used to
find that present value is the WACC, so analysts use the WACC to find a project's value.

Calculate and interpret the weighted-average cost of capital for a company

LOS

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3. An analyst wants to calculate a company's weighted average cost of capital (WACC) and compiles the following data:

Weight of debt 20%

Market yield on similar BBB debt 8%

Corporate tax rate 30%

Weight of preferred stock 10%

Preferred dividend £2.00

Preferred stock share price £40.00

Weight of common stock 70%

Last common dividend £1.90

Expected common dividend £2.00

Common dividend growth rate 5%

Common stock share price £50.00

The analyst believes that the company's debt should be rated BBB. If the analyst uses the debt-rating approach to calculate the cost of debt and
the dividend discount model (DDM) approach to calculate the cost of equity, the WACC is closest to:

A. 7.79%

 B. 7.92%

C. 8.40%

Explanation

The weighted average cost of capital (WACC) for a company is the weighted average cost of the different sources of capital. Suppliers of capital
require risk-adjusted returns. The most common sources of capital include equity, preferred stock, and debt.

Calculate costs of each capital source:

Insert variables to calculcate WACC:

Calculate and interpret the weighted-average cost of capital for a company LOS
4. All else equal, if a firm maintains a larger proportion of equity in its actual capital structure than in its target structure, the most likely reason is
that:

A. the stock is currently trading at a historic low price.

 B. the stock will be included in an index once it reaches a greater market capitalization.

C. management is raising capital for an infrastructure project that produces stable cash flows.

Explanation

Reasons for deviations from target capital structure

Debt ratings can deteriorate with more debt

Target capital structure may use book values
Type of capital may depend on investment cash flows
Market conditions (stock price, interest rates)
Aspirations to list stock on an index
Information asymmetry/information signaling

A firm's stated capital structure (ie, mix of debt and equity) policy is often based on how much debt the firm can assume. Mature companies
typically prefer to issue debt since debt is cheaper than equity and its market value is more predictable. Debt such as tax shields (from interest
deductions) can enhance a firm's value, but debt may also reduce the value by increasing the risk of financial distress and bankruptcy.

In theory, an optimal (ie, target) capital structure results in the lowest WACC and the highest firm valuation. At this optimal ratio of debt to equity,
the difference between the expected benefits and costs of debt is maximized.

In reality, capital structures often deviate from their optimal targets for the reasons shown in the table above. For example, investors may
desire an increase in a company's market cap to satisfy index listing requirements. In response, the company may issue more public equity, which
can cause the actual capital structure to deviate from the target.

(Choice A) Firms tend to issue equity when the share price is high, not low. When the share price is low, the proceeds from the issuance will also
be low.

(Choice C) The type of capital raised for a project depends largely on the project's nature. An infrastructure project with stable cash flows is well
suited to servicing debt, so the firm in this instance would more likely increase the proportion of debt, not equity, in its capital structure.

Things to remember:
In theory, an optimal (ie, target) capital structure results in the lowest WACC and the highest firm valuation. In reality, firms often deviate from their
target capital structures. A firm may issue more equity to have its stock listed in an index, causing a deviation from the target capital structure.

Explain factors affecting capital structure and the weighted-average cost of capital
LOS

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5. Based on the pecking order theory, when a company issues equity, management is most likely signaling that:

 A. the stock is overvalued.

B. the company can pay larger dividends.

C. they have confidence in meeting future commitments.

Explanation

Information asymmetry arises from the fact that a company's managers know more about the company and its prospects than the company's
investors. Investors realize this and try to interpret signals based on how management conducts the business, including raising capital.

The pecking order theory suggests that managers prefer to raise capital through methods that require the least amount of disclosure, thus
providing investors with the least amount of information necessary. Based on this theory, issuing equity is the least preferred method since it
requires significant disclosure and is scrutinized by investors. Equity issues may indicate that managers believe:

the company's prospects are not encouraging. If prospects were better, managers would hesitate to dilute their ownership.

the stock is overvalued and therefore a good form of financing to fund projects or acquisitions. Managers would be reluctant to issue stock if
they thought it was undervalued.

(Choice B) The pecking order theory does not link the method of financing to dividend payments. However, since equity issues indicate future
prospects are not encouraging, they are unlikely to indicate that the company can pay larger dividends.

(Choice C) The issuance of debt would indicate that management has confidence in meeting future commitments since additional debt commits
the company to future obligations.

Things to remember:
The pecking order theory suggests that managers prefer raising capital through methods that provide investors with the least amount of
information necessary. Issuing equity is the least preferred method since it indicates to investors that management believes the company's
prospects are not encouraging or that the stock is overvalued.

Explain factors affecting capital structure and the weighted-average cost of capital
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1. The original issue discount tax provision most likely applies to a(n):

A. floating-rate note.

B. index-linked bond.

 C. zero-coupon bond.

Explanation

Original issue discount (OID)

Tax treatment for bonds originally issued at a discount to par

Description The OID is the difference between par value and the issue price
Zero-coupon bonds are a common example

Prorated portion of the discount is taxed as income each year

Prorated portion is added to the cost basis
Tax treatment
No capital gains taxes at maturity
Not applicable in all jurisdictions

The original issue discount (OID) is a tax provision that applies to bonds that were originally issued at a discount to par. OID is not applicable
in all tax jurisdictions, but where it is, a prorated portion of the discount is taxed as income every year. This prorated portion is also added to
the cost basis of the bond, such that no capital gains taxes are due at maturity.

A zero-coupon is a classic example of an OID bond since it is issued at a significant discount to par and pays no coupon interest. The bond's
only cash flow occurs at maturity, when the investor receives its face value. The difference between par value and the purchase price represents
the OID on the bond.

(Choice A) Floating-rate notes (FRN) are bonds whose coupon interest fluctuates based on a specified reference rate, such as LIBOR. FRN are
issued at par since the coupon rate is set at the market rate at issuance.

(Choice B) Index-linked bonds are issued at par. The interest and/or principal payments for index-linked bonds vary based on changes to a
specific index, such as a commodity index or an inflation index.

Things to remember:
The original issue discount (OID) is a tax provision that applies to bonds that were originally issued at a discount to par. A prorated portion of the
discount is taxed as income every year and added to the cost basis of the bond, such that no capital gains taxes are due at maturity. A zero-
coupon bond is a classic example of an OID bond.

Describe how legal, regulatory, and tax considerations affect the issuance and trading of fixed-income securities
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2. Which of the following statements is most accurate regarding convertible bonds?

A. The conversion value equals the conversion price multiplied by the conversion ratio.

B. The issuer pays higher coupon rates relative to an otherwise similar option free bond.

 C. The value of the issuer's straight bond provides a price floor for its convertible bond price.

Explanation

A convertible bond, a hybrid security with both debt and equity characteristics, gives the bondholder (ie, investor) the option to convert the bond
into shares of the issuer's common stock. The conversion option benefits the investor in multiple ways.

If the stock price appreciates, the investor can convert the bond into common stock and enjoy the potentially higher equity upside.

If the stock price drops, the investor holds onto the convertible bond just like a straight bond (ie, regular nonconvertible bond); therefore, the
price of the straight bond serves as the minimum value (ie, price floor) for the convertible debt.

Due to the conversion option, bondholders are willing to accept lower coupon payments from issuers (ie, borrowers) (Choice B).

(Choice A) Conversion value equals current share price multiplied by conversion ratio.

Things to remember:
A convertible bond gives the bondholder (ie, investor) the option to convert the bond into shares of the issuer's (ie, borrower's) common stock.
Investors are willing to pay a higher price and receive lower coupons than on otherwise similar nonconvertible bonds.

Describe common cash flow structures of fixed-income instruments and contrast cash flow contingency provisions that benefit issuers and
investors.
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3. A five-year amortizing bond has a face value of $1,000. If it was issued at par with a yield-to-maturity of 5.18% and pays investors $160
annually at the end of Years 1 through 4, the total payment in Year 5 is closest to:

A. $360

B. $532

 C. $560

Explanation  HP 12c  TI BA II Plus

An amortizing bond has equal periodic payments. Each payment combines some amount of interest and principal. A fully amortizing bond's
payment is calculated so that the final payment at maturity repays the bond entirely. A home mortgage is analogous to a fully amortizing bond
since most residential mortgages are structured for the last payment to completely pay off the loan.

A partially amortizing bond works similarly, but the periodic payments are insufficient to completely repay the bond at maturity. The final payment
consists of the periodic payment plus the additional amount required to repay the bond in its entirety.

The bond in this question is an example of a partially amortizing bond. It has a maturity of five years, so all payments must be completed by the
end of Year 5. The table above demonstrates that Year 5's beginning balance is $532. The interest payment for Year 5 is $28, so the total
payment required to completely pay principal and interest is $532 + 28 = $560.

(Choice A) $360 represents the difference between the $1,000 face value and the sum of the first four payments ($160 × 4 = $640).

(Choice B) $532 is the amount owed at the beginning of Year 5 without accounting for the interest owed on this amount.

Things to remember:
An amortizing bond makes equal payments each period, and each payment is divided into principal and interest. The principal amount is
completely repaid by the time the bond matures. A partially amortizing bond is similar, but some amount of principal remains to be paid along with
the final periodic payment at maturity.

Describe common cash flow structures of fixed-income instruments and contrast cash flow contingency provisions that benefit issuers and
investors.
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4. Which of the following statements least likely applies to an original issue discount (OID) bond on an annual basis?

A. Income is taxable.

B. The bond's cost basis increases.

 C. Unrealized capital gains are taxable.

Explanation

Original issue discount (OID)

Tax treatment for bonds originally issued at a discount to par

Description The OID is the difference between par value and the issue price
Zero-coupon bonds are a common example

Prorated portion of the discount is taxed as income each year

Prorated portion is added to the cost basis
Tax treatment
No capital gains taxes at maturity
Not applicable in all jurisdictions

The original issue discount (OID) is a tax provision that applies to bonds which were originally issued at a discount to par. OID is not
applicable in all tax jurisdictions, but where it does apply, a prorated portion of the discount is taxed as income each year, not as capital gains
(Choice A). A prorated portion is also added to the cost basis of the bond, such that no capital gains taxes are due at maturity (Choice B). A
zero-coupon bond is a classic example of an OID bond.

Things to remember:
The original issue discount (OID) is a tax provision that applies to bonds which were originally issued at a discount to par. OID is not applicable in
all tax jurisdictions, but where it does apply, a prorated portion of the discount is taxed as income each year, not as capital gains. A prorated
portion is also added to the cost basis of the bond, such that no capital gains taxes are due at maturity.

Describe how legal, regulatory, and tax considerations affect the issuance and trading of fixed-income securities
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Question 1

Which of the following best describes the purpose of the Code of Ethics for the global
investment profession?

A To build trust with all market participants

B To set the basis for laws and regulations
C To determine minimally acceptable behaviors

Question 2

Stella Smith, CFA, works for Aqua Investment Consulting. She is invited to share her
economic outlook at a conference hosted by Zenat Securities Corp., an investment
management firm used by Aqua. Zenat pays all speakers' travel expenses and entices
speakers by offering a free spa day during the conference. Smith most likely violates
Standard I(B) Independence and Objectivity if she accepts Zenat's offer for:

A only her travel.

B only the spa day.
C both her travel and the spa day.

Question 3

Mina Pappas, CFA, is the sole proprietor of Milos Capital, providing financial advice to high-net-
worth clients. Pappas invests client's equity assets through a separately managed account
strategy consisting of a portfolio of 20 equally weighted, large-cap stocks. Part of Pappas'
sales pitch to clients and prospects is that she invests "alongside" her clients by investing her
own assets in the same strategy.

Pappas decides to sell one of the holdings and replace it with her best new idea. Pappas
enters the buy and sell orders for all clients, including herself, and executes the trades. All
clients receive the same execution prices, including Pappas. According to Standard VI(B)
Priority of Transactions, Pappas most likely:

A is in full compliance with the Standard.

B violated the Standard by not adhering to a blackout period.
C violated the Standard by not executing the client's trades first.

Question 4

Joanna Krakowski, CFA, is the chief compliance officer (CCO) at Universal Investment
Managers (UIM). Krakowski recently hired John Smith, CFA, as a compliance manager. Smith
will report directly to Krakowski, who believes the current compliance systems and procedures
are adequate.

As Smith settles into his new position, he discovers numerous deficiencies including outdated
software, excessive manual processes, a compliance manual that has not been updated in four
years, and inadequately trained and understaffed compliance personnel.

Smith meets with Krakowski to address these shortcomings, as he does not believe he can
adequately perform his duties given the circumstances. Krakowski informs Smith that there is
no money in the budget for new software or additional employees. Smith's most
appropriate action is to:

A improve the compliance program using his best efforts, given his duty is to his employer.
B decline his supervisory responsibilities in writing until the compliance systems are improved.
C immediately submit a written resignation from UIM, since the compliance program is deficient.
Question 5

If a firm chooses to verify its compliance with the GIPS standards, the verification must be
performed by:

A an independent third party.

B the firm's chief compliance officer.
C the local securities market regulatory authority.

Question 6

Which of the following best describes the need for high ethical standards in investment
management?

A To preserve the trust that supports the industry

B To increase the prestige of working in the industry
C To establish consistency across global laws and regulations

Question 7

Ishani Gupta works in the manufacturing industry and wants to transition into a financial
services role. She believes a CFA charter can help with this transition. Gupta recently sat for
Level III of the CFA exam and is excited to update her resume to send to potential employers,
although she has not yet received her results. Which of the following statements can
she most appropriately use on her resume to adhere to the Standards?

A "The knowledge gained from the CFA program makes me a superior candidate."
B "I will be eligible for a CFA charter after completing my required work experience."
C "My studies in the CFA program have enhanced my knowledge and skills in finance."

Question 8

GIPS standards prevent firms from using misleading performance measurement practices such
as presenting:

A average returns that exclude terminated portfolios.

B fewer periods of returns than exist for an investment strategy.
C returns of investment strategies that consist of a single portfolio.

Question 9

A client names a Member in a written complaint involving potential misconduct and files the
complaint with the Member's firm. At a minimum, CFA Institute's Code and Standards require
that the Member:

A self-disclose the incident on the annual Professional Conduct Statement.

B immediately disclose the incident to CFA Institute's Professional Conduct Program staff.
self-disclose the incident on the annual Professional Conduct Statement only if the firm finds
C wrongdoing.
Question 10

A fixed income investment firm specializes in trading relative value opportunities among
domestic and international corporate bonds. One of the firm's clients does not want exposure
to international securities, which hinders the implementation of the firm's strategy, so the firm
manages the client's portfolio by investing exclusively in domestic fixed income. According to
GIPS standards, can the firm appropriately include the client's portfolio in its composites?

A No
B Yes, since the client is still trading in fixed income
C Yes, since the firm has investment management responsibility for the portfolio

Question 11

Marcos Silva, CFA, and Clara Neves, CFA, are analysts at Alpha Capital, an independent
research firm. Silva reads a blog post about Northwest Bank that details several fresh insights
on company-specific growth. After doing his own thorough research on Northwest, Silva
agrees with the blogger's analysis, although he expects this growth to take longer than the
blogger predicts.

Silva then writes a research report on Northwest and includes a restatement of the blogger's
insights. Since he has changed some of the wording and the expected time horizon for
growth, he does not reference the blog.

Neves proofreads the report at Silva's request and agrees with his conclusion about the bank.
With Silva's approval, Neves adds a chart from the US Federal Reserve, which is not
copyrighted, that shows expected growth in bank reserves over the next year. She properly
cites the US Federal Reserve as the source. According to the Code and Standards:

A both Silva and Neves have violated the Standards.

B Silva has violated the Standards, but Neves has not.
C Neves has violated the Standards, but Silva has not.

Question 12

Eric Saul, CFA, is a portfolio manager with Skye Group. He reads several social media posts
from industry experts about the health benefits attributed to a new herbal tea made with rose
petals. Based on these posts, Saul reviews industry publications and finds several articles that
speculate herbal rose tea will be the next big beverage craze. Saul visits a senior vice
president of Gamma Company, a conglomerate with a significant market share in the beverage
industry, who confirms that the market for herbal tea has considerable potential. After
reviewing Gamma's financial statements and public disclosures, Saul uses industry-standard
financial models to determine the intrinsic value of Gamma's stock. He concludes that Gamma
will introduce an herbal tea made with rose petals. Based on this conclusion, Saul buys
Gamma stock for all suitable client portfolios. A few weeks later, Gamma announces a new
line of herbal rose tea. Did Saul most likely violate Standard II(A) Material Nonpublic
Information?

A No
B Yes, by purchasing Gamma for clients
C Yes, by acting on information from company management
Question 1

If a company uses a surety bond, it is most likely:

A self-insuring.
B transferring risk.
C pledging collateral for a debt obligation.

Explanation

Risk modification methods

Method Example
Do not operate in a politically unstable country
Avoid or prevent Avoid collection/storage of sensitive customer
data

Set aside capital to absorb losses

Risk acceptance:
Use multiple geographic locations
self-insure or diversify

Purchase insurance
Risk transfer Obtain surety bond

Use derivatives (eg, forward contracts or

Risk shifting options)

Measuring and monitoring risk are key risk management functions. Quantifying risk allows a
company to determine if the expected benefits from a potential activity outweigh the costs.
During the normal course of business, companies often must decide whether to accept or
avoid risk.

Risk transfer occurs when a company has chosen to take on a risk and then transfers some
of that risk to another party by purchasing insurance. By transferring risk to the insurer,
the insured has limited its potential loss to the cost of the insurance policy plus any associated
deductible and/or loss sharing.

A surety bond is a form of insurance, transferring the risk that a third party will fail to
fulfill its contractual obligation. For example, a real estate developer might purchase a surety
bond to ensure that the contractor hired to construct a building satisfactorily completes the
job.

(Choice A) Self-insuring is a form of risk acceptance. Companies may decide to self-insure if

third-party risk modification methods such as risk transfer or risk shifting are either cost
prohibitive or unavailable.

(Choice C) A surety bond is not a type of debt obligation.

Things to remember:
The risk transfer method of risk modification transfers much or all of a risk to a third party.
This method is advantageous when other options are either cost prohibitive or unavailable. A
surety bond is a form of insurance, transferring the risk of a third party failing to fulfill their
contractual obligation.

Describe methods for measuring and modifying risk exposures and factors to consider in choosing
among the methods
LOS
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Question 2

Which function is least likely a responsibility of the audit committee?

A Recommending an external auditor

B Providing oversight of the application of accounting policies
C Monitoring company-wide compliance with all relevant laws and regulations

Explanation

Audit committee responsibilities

Oversee audit and control systems
Monitor financial reporting process and ensure financial accuracy
Oversee application of accounting policies
Ensure integrity of financial statements
Supervise internal audit function
Recommend external auditor
Present annual audit report to board

Board members serve on functional committees, which oversee different areas of a company.
These committees include but are not limited to governance, risk, and investment
committees. The governance committee, not the audit committee, is responsible for
maintaining compliance with laws and regulations.

The audit committee is one of the most common committees on corporate boards. In
addition to its primary function of overseeing a company's reporting process, the audit
committee is charged with mitigating the risk of fraud or misstatements in both accounting
and financial information. The committee maintains independence from company
management and establishes policies and procedures to ensure financial integrity.

(Choices A and B) The audit committee's responsibilities include oversight of both the audit
process (eg, recommending an external auditor) and the application of accounting policies.

Things to remember:
The audit committee maintains independence from management as it oversees a company's
audit and control systems and establishes policies and procedures to ensure financial integrity
(eg, mitigating the risk of fraud or misstatements). The governance committee, not the audit
committee, is responsible for monitoring company-wide compliance with laws and regulations.

Describe corporate governance and mechanisms to manage stakeholder relationships and mitigate
associated risks
LOS
Question 3

Based on the pecking order theory, when a company issues equity, management is most
likely signaling that:

A the stock is overvalued.

B the company can pay larger dividends.
C they have confidence in meeting future commitments.

Explanation

Information asymmetry arises from the fact that a company's managers know more about the
company and its prospects than the company's investors. Investors realize this and try to
interpret signals based on how management conducts the business, including raising capital.

The pecking order theory suggests that managers prefer to raise capital through
methods that require the least amount of disclosure, thus providing investors with
the least amount of information necessary. Based on this theory, issuing equity is the least
preferred method since it requires significant disclosure and is scrutinized by
investors. Equity issues may indicate that managers believe:

the company's prospects are not encouraging. If prospects were better, managers
would hesitate to dilute their ownership.

the stock is overvalued and therefore a good form of financing to fund projects or
acquisitions. Managers would be reluctant to issue stock if they thought it was
undervalued.

(Choice B) The pecking order theory does not link the method of financing to dividend
payments. However, since equity issues indicate future prospects are not encouraging, they
are unlikely to indicate that the company can pay larger dividends.

(Choice C) The issuance of debt would indicate that management has confidence in meeting
future commitments since additional debt commits the company to future obligations.

Things to remember:
The pecking order theory suggests that managers prefer raising capital through methods that
provide investors with the least amount of information necessary. Issuing equity is the least
preferred method since it indicates to investors that management believes the company's
prospects are not encouraging or that the stock is overvalued.
Explain factors affecting capital structure and the weighted-average cost of capital
LOS
Question 4

The capital asset pricing model (CAPM) assumes that all investors can most likely:

A influence security prices.

B invest any amount in an asset.
C plan for a multiple-period holding period.

Explanation

Assumptions of the capital asset pricing model

(CAPM)
Investors are risk averse, utility focused, and rational
Investors have a single-period time horizon
Investors are price takers
Investors have homogeneous expectations since they
analyze securities uniformly with identical methods
and data
Investments are infinitely divisible
No transaction costs and taxes, no restrictions on
short-selling, and investors can lend and borrow
unlimited amounts at the risk-free rate

The capital asset pricing model (CAPM) establishes a direct linear relationship between
the expected return of an asset and its beta, which is a measure of systematic risk. The
beta indicates the sensitivity of the asset's return to the overall market movement.

The CAPM assumes that investments are infinitely divisible, which implies that investors can
invest any amount of capital in a particular asset or investment, and thus rationally maximize
utility and optimize their portfolios. This assumption also allows for ease in mathematical
modeling. By assuming infinite divisibility, the model can use continuous functions, which are
smoother and more mathematically tractable than discrete jump functions.

(Choice A) CAPM assumes that investors are price takers. Therefore, the individual actions
of any single investor do not have a significant impact on the market price of securities.

(Choice C) CAPM assumes that investors plan for the same single-period holding period,
such that all investors have the same time horizon. For this reason, the model presumes that
all investors act rationally within the same investment period.

Things to remember:
The CAPM assumes that investments are infinitely divisible, allowing investors to rationally
maximize utility and optimize their portfolios. This assumption also allows for ease in
mathematical modeling.

Explain the capital asset pricing model (CAPM), including its assumptions, and the security market
line (SML)
LOS
Question 5

Which of the following is most likely a responsibility of a board of director's governance

committee?

A Defining performance criteria for management.

B Overseeing risk and capital management policies.
C Evaluating candidates for executive management positions.

Explanation

A company's board of directors has several roles and is typically organized into committees
that focus on distinct functions. The governance committee, also known as
the nominating committee, implements best practices in the company's policies and
procedures. The governance committee:

Evaluates candidates for board and executive management positions

Sets nomination procedures for board members
Enforces corporate policies, such as a governance code and code of ethics
Ensures compliance with applicable laws and regulations
Recommends remedial actions for legal breaches

(Choice A) Defining performance criteria for management is a function of the remuneration

committee, which is primarily responsible for performance evaluation and compensation
policies related to the company's managers.

(Choice B) Overseeing risk (capital) management policies is a function of the risk

(investment) committee, which is often specific to the financial services (insurance) industry.

Things to remember:
The governance committee implements the best practices found in the company's policies and
procedures. The committee evaluates candidates for board and management positions,
ensures compliance with regulations, and recommends remedial actions for legal breaches,
among other functions.

Describe corporate governance and mechanisms to manage stakeholder relationships and mitigate
associated risks
LOS
Question 6

A manufacturer with industry-average financial leverage is issuing debt to fund expansion of

production capacity. All else equal, the stakeholder group most likely to benefit from the
increase in financial leverage is the company's:

A bondholders.
B common shareholders.
C preferred shareholders.

Explanation

Higher levels of financial leverage increase the potential for conflicts of interest between
shareholders and other stakeholders. Companies use leverage (eg, debt) to increase
expected returns to shareholders through actions such as expanding capacity or
repurchasing shares. However, the potential for higher returns comes with a higher
probability of financial distress and/or bankruptcy since payments to creditors remain an
obligation of the firm even when operating at a loss.

In general, no stakeholder benefits from a firm going bankrupt. However, the risk-return
trade-off of greater financial leverage benefits common shareholders due to their asymmetric
return profile. Successful use of leverage can result in shareholder returns that are a multiple
of their initial investment, whereas their losses normally cannot exceed 100% of the
investment.

(Choices A and C) All else equal, when a firm increases financial leverage by issuing debt,
the probability of bankruptcy increases. This reduces the likelihood of the company meeting
financial commitments to senior security holders. Therefore, bondholders and preferred
shareholders do not benefit from increases in financial leverage.

Things to remember:
Higher levels of financial leverage can increase expected returns for common shareholders but
also increase the probability of company bankruptcy. All else equal, greater financial leverage
benefits common shareholders but does not benefit bondholders and preferred shareholders.

Explain factors affecting capital structure and the weighted-average cost of capital
LOS