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CFAI Mission
To lead the investment profession globally by promoting the highest standards of ethics, education, and professional excellence for the ultimate benefit of society.
Code of Ethics
Promote the integrity and viability of the global capital markets for the ultimate benefit of society.
IV.(C)Duties to Employers -Responsibilities of Supervisors
Members and Candidates must make reasonable efforts to ensure that anyone subject to their supervision or authority complies with applicable laws, regulations, and the Code and Standards.
V.(B)Investment Analysis, Reccomendations, and Actions -Communication with Clients and Prospective Clients
Members and Candidates must:<br></br><ol><li>Disclose to clients and prospective clients the basic format and general principles of the investment processes they use to analyze investments, select securities, and construct portfolios and must promptly disclose any changes that might materially affect those processes.</li><li>Disclose to clients and prospective clients significant limitations and risks associated with the investment process.</li><li>Use reasonable judgement in identifying which factors are important to their investment analyses, reccomendations, or actions and include those factors in communications with clients and prospective clients.</li><li>Distinguish between fact and opinion in the presentation of investment analysis and reccomendations.</li></ol>
V.(A) Investment Analysis, Reccomendations, and Actions - Diligence and Reasonable Basis
Members and Candidates must:<br></br><ol><li>Exercise diligence, independence, and thoroughness in analyzing investments, making investment reccomendations, and taking investment actions.</li><li>Have a reasonable and adequate basis, supported by appropriate research and investigation, for any investment analysis, reccomendation, or action.</li></ol>
V.(C)Investment Analysis, Reccomendations, and Actions -Record Retention
Members and Candidates must develop and maintain appropriate records to support their investment analysis and reccomendations.
I.(A) Professionalism - Knowledge of the Law
Members and Candidates must understand and comply with all applicable laws, rules, and regulations (including the CFA Institute Code of Ethics and Standards of Professional Conduct) of any government, regulatory organization, licensing agency, or professional association governing their professional activities. In the event of conflict, Members and Candidates must not knowingly participate or assist in and must dissociate from any violation of such laws, rules, and regulations.
I.(B) Professionalism - Independence and Objectivity
“Members and Candidates must use reasonable care and judgement to achive and maintain independence and objectivy in their professional activites. Members and Candidates must not offer, solicit, or accept any gift, beneift, compensation, or consideration that reasonably could be expected to compromise their own or another’s independence and objectivity.”
I.(C)Professionalism - Misrepresentation
Members and Candidates must not knowingly make any misrepresentations relating to investment analysis, reccomendations, actions, or other professional activities.<br></br><ul><li><b>Firm canissue</b> future reports without providing attribution to prior analysts</li><li><b>Member / candidate cannot</b> reissue previously released report solely under his or her name</li><li><b>Member / candidate cannot</b> cite quotations without specifically referencing name of analyst</li><li><b>Member / candidatecannot</b> copy computerized spreadsheets / algorithms without cooperation / authorization of creators</li><li><b>Member / candidate </b>must disclose use of third-party reports (not necessary to disclose use of third-party brokerage)</li></ul>
I.(D)Professionalism - Misconduct
Members and Candidates must not engage in any professional conduct involving dishonesty, fraud, or deceit or comitt any act that reflect adversly on their professional reputation, integrity, or competence.
II.(A) Integrity of the Capital Markets -Material Nonpublic Information
Members and Candidates who posses material nonpublic information that could affect the value of an investment must not act or cause others to act on the information.
II.(B) Integrity of the Capital Markets - Market Manipulation
Members and Candidates must not engage in practices that distort prices or artificially inflate trading volume with the intent to mislead market participants.
III.(A) Duties to Clients - Integrity of the Capital Markets -Loyalty, Prudence, and Care
“Members and Candidate have a duty of loyalty to their clients and must act with reasonable care and excercise prudent judgement. Members and Candidates must act for the benefit of their clients and place their clients’ interest before their employer’s of their own interests.<br></br><ul><li>Member / candidate with control of client’s assest must 1) submit to client <b>quarterly </b>itemized statement showing funds, securities, debits, credits, and transactions, 2) disclose where assets are maintained, 3) seperate client’s assets from other party’s assets (including member / candidate’s)</li><li>Investments judged in context of <b>entire portofolio</b>(not by individual investments in portfolio)</li><li>"”Soft dollars”” / ““soft commissions”” <b>OK if provides value to client </b>(not OK if no value provided to client)</li><li>Member / candidate doesn’t need to participate in proxy voting if <b>no benefit provided to client</b> (must disclose proxy-voting policies)</li><li>Members / candidate must seek ““best execution”” unless client <b>explicity writes</b> not to seek ““best execution””</li></ul><br></br>”
III.(B)Duties to Clients -Fair Dealing
Members and Candidates must deal farily and objectively with all clients when providing investment analysis, making investment reccomendations, taking investment action, or engaging in other professional activities.
III.(C)Duties to Clients -Suitability
“<ol><li>When Members and Candidates are in an advisory relationship with a client, they must:</li></ol><ul><li>Make a reasonable inquiry into a client’s or prospective client’s investment experience, risk and return objectives, and financial constraints prior to making any investment reccomendation or taking investment action and must reasses and update this information regularly.</li><li>Determine an investment is suitable to the client’s financial situtation and consistent with the client’s written objectives, mandates, and constraints before making an investment reccomendation or taking investment action.</li></ul><li>When Members and Candidates are responsibile for managing a portfolio to a specific mandate, strategy, or style, they must make only investment reccomendations or take only investment actions that are consistent with the stated objectives and constraints of the portfolio.</li>”
III.(D)Duties to Clients -Performance Presentation
When communicating investment performance information, Members and Candidates must make reasonable efforts to ensure that it is fair, accurate, and complete.<br></br><ul><li>Member / candidate <b>not required to attribute source</b> of data from recognizd financial / statistical reporting sources (<b>government websites</b>)</li></ul>
III.(E)Duties to Clients -Preservation of Confidentiality
Members and Candidates must keep information about current, former, and prospective clients confidential unless:<br></br><ol><li>The information concerns illegal activities on the part of the client or prospective client,</li><li>Disclosure is required by law, or</li><li>The client or prospective client permits disclosure of the information.</li></ol>
IV.(A) Duties to Employers - Loyalty
In matters related to their employment, Members and Candidates must act for the benefit of their employer and not deprive their employer of the advantage of their skills and abilities, divulge confidential information, or otherwise cause harm to their employee.
IV.(B)Duties to Employers -Additional Compensation Arrangements
“Members and Candidates must not accept gifts, benefits, compensation, or consideration that competes with or might reasonably be expected to create a conflict of interest with their employer’s interest unless they obtain written consent from all parties involved.”
VI.(A) Conflicts of Interest - Disclosure of Conflicts
Members and Candidates must make full and fair disclosure of all matters that could reasonably be expected to impair their independence and objectivity or interfere with respective duties to their clients, prospective clients, and employer. Members and Candidates must ensure that such disclosures are prominent, are delivered in plain language, and communicate relevent information correctly.
VI.(B)Conflicts of Interest -Priority of Transactions
Investment transactions for clients and employers must have priority over investment transactions in which a Member or Candidate is the beneficial owner.
VI.(C)Conflicts of Interest - Referral Fees
Members and Candidates must disclose to their employer, clients, and prospective clients, as appropriate, any compensation, consideration, or benefit received from or paid to others for the reccomendation of products or services.
VII.(A) Responsibilities as a CFA Institute Member or CFA Candidate - Conduct as Participants in CFA Institute Program
Members and Candidates must not engage in any conduct that compromises the reputation or integrity of CFA Institute or the CFA designation or the integrity, validity, or security of CFA Institute programs.
VII.(B)Responsibilities as a CFA Institute Member or CFA Candidate -Reference to CFA Institute, the CFA Designation, and the CFA Program
When referring to CFA Institute, CFA Institute membership, the CFA designation, or candidacy in the CFA Program, Members and Candidates must not misrepresent or exagerrate the meaning or implications of membership in CFA Institute, holding the CFA designation, or candidacy in the CFA Program.
\(+\) Bid-ask spreads of the underlying securities held in the ETF
\(+\) Compensation (to market maker or liquidity provider) for the risk of hedging or carrying positions for the remainder of the trading day
\(-\) Market maker's desired profit spread (subject to competitive forces)
\(-\) Discount related to the likelihood of receiving an offsetting ETF order in a short time frame"
EOD NAV → Preferred NAV used to calculate returns"
- Fees and expenses
- Representative sampling/optimization → Funds hold only a subset of index securities (median value becomes unpredictive of future median values; overperformance and underperformance in certain market regimes)
- Depositary receipts and other ETFs
- Index changes
- Fund accounting practices
- Regulatory and tax requirements
- Asset manager operations → ETF issuers offset costs via security lending (enhances performance) or foreign dividend recapture
iNav → 'Indicated NAV' used to value an ETF during trading hours; based on the creation basket of the day"
- A factor model describes asset returns
- With many assests to choose from, investors can form well-diversified portfolios that eliminate asset-specific risk
- No arbitrage opportunities exist among well-diversified portfolios
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- 'Expected reward' is defined differently across models (Carhatt 4-factor vs. Economic)
- Factors → portfolios of securities defined by portfolio weight
- Model types → 1) Factor analysis: factors defined as portfolio of securities that best explain return covariances; 2) Principal components: factors are portfolios of securities that best explain return variances
- Advantage: Minimal assumptions
- Disdavantage: Difficult interpretation
- Factors → stated as returns; intercept equates expected asset-specific risk as zero
- Factor sensitivities → attributes of a security expressed using standardized beta
- Uses: Performance attribution, return attribution, and risk attribution
- Annualizing daily tracking error based on daily returns → Multiply TE by (250 days)½
- Annualizing monthly tracking error based on monthly returns → Multiply TE by (12 months)½
- s → sample standard deviation
- Expressed as a variance for due to additive properties
- wai = active weighting
- $2.2 million is the minimum expected loss 5% of the time
- 5% of the time, a loss of would be at least $2.2 million is expected
- 95% of the time, a loss of no more than $2.2 million is expected
- Average loss conditional on exceeding the VaR cutoff → ""How much can I expect to lsoe if VaR is exceeded?""
- Best derived for historical and Monte Carlo methods
- The change in a portfolio VaR resulting from a change in a position's size relative to the remaining positions.
- In a diversified portfolio, MVaR determines the contribution of each asset to the overall VaR
- Measures the degrees to which the performance of a given investment might deviate from its benchmark
- Portfolio is calculated as (portfolio holdings - holdings in the specified benchmark)
- I → real interest rate
- θ → inflation
- y → real GDP
- The rate on the fixed leg of an interest rate swap
- Derived using short-term lending rates rather than default-risk-free rates
- Countries with illiquid gov't bond market > 1 year maturity → Swap curve is the benchmark for interest rates
- Countries where private sector > public sector → Swap curve more relevant measure of time value
- Swap spread = swap rate - 'on-the-run' gov't security → must be of the same maturity
- Swap spread captures liquidity and credit risk premium
- The spread between a bond's YTM and an equal maturity swap rate
- I-Spread = Bond YTM - Swap Rate
- Constant basis point spread added to each spot rate (or swap rate) so that DCF of bond = current price
- G-spread = credit-risk issuer yield curve - spot curve
- 3 month USD Libor - 3 month T-Bill rate
- Rising TED spread indicates liquidity is being withdrawn
- Measure of credit and liquidity risk in the general economy
- Libor-OIS spread = 3-month Libor - 3-month OIS spread
- Secured Overnight Financing Rate → Market determined, collateralized by US Treasury Bills
- Daily, volume-weighted index of repo transactions, influenced by supply/demand for secured overnight funding
- Forward rates are unbiased predictors of future spot rates
- Bonds of any maturity are perfect substitutes
- Assumes investor risk neutrality (e.g. uncertainty in inflation expectations for longer maturity bonds are disregarded by investors)
- Expected return of all bonds = risk-free rate over short time periods but not over longer periods
- However, empirical evidence shows → demand for 90-day Treasury Bills > demand for 30-year Treasury Bill → 90-day returns on 90-day TBills < 90-day returns on 30-year TBills
- Liquidity premiums exist → interest rate risk is compensated for when lending long term → premiums increase with maturity
- Liquidity in this sense means having to sell the bonds on some uncertain price (NOT A LACK OF A MARKET)
- Predicts an updward sloping yield curve → forward rates, as expectation of future spot rates, are biased upward by the liquidity premium
- Each maturity segment can be thought of as a segmented market in which yields are determined independently from the yields that prevail in other maturity segments
- Forward rates are not an expectation of future spot rates or liquidity premiums
- Market participants unwilling/unable to invest in anything other than securities of their preferred maturity
- Borrowers and lenders have a preference for a particular maturity, but yeilds at different maturities are not determined independently
- The sensitivity of a bond's price to the changing shape of the Yield Curve
- 3-factor model based on principal-component analysis: 1) level, 2) steepness, 3) curvature
- Level → dominant effect that explains most of the total changes in yields
- Steepness → short-term rates moving more than long-term rates; explains less than level
- Curvature → short / long maturity rates falling, intermediate maturity rates unchanged / rising; smallest impact of all three factors
- Price volatility will depend on duration
- Short rates are more volatile → more strongly linked to uncertainty regarding monetary policy
- Long rates are less volatile → more strongly linked to uncertainty regarding the real economy and inflation
- Sensitivity of bond price to a interest rate change at a specific maturity segment
- Short and intermediate → 2/3 of variation explained by inflation; 1/3 of variation explained by GDP growth and monetary policy
- Long → 2/3 of variation explained by monetary policy; 1/3 affected by inflation
- Bear flattener caused by central bank raising interest rates during expansions → short-term rates rise
- Bull steepner caused by central bank lowering interest rates during recessions → short-term rates fall
- Beer steepner caused by rising long-term inflation expectations; OR, caused by flight to quality (capital looks for lower risk assets) → long-term rates rise
- Bull flattener caused by QE, which pushes capital to higher risk assets → long-term rates fall
- The value of the whole should equal the sum of the value of the parts
- Profit is realized immediately; no profit in the future
- Profit comes at a future point in time; no profit immediately
- Describe of how interest rates evolve
- Used for valuation / hedging of fixed-income securities and their derivatives
- Interest rate (one-period rate) as the only factor → implies all rates move in the same direction
- Interest rate process is stochastic (drift term + stochastic term)
- Drift term may be constant or mean-reverting
- Stochastic term is the randomness term, which can be stationary, indepedent, normally distributed increments
- Begins with current term structure derived from a reference set of financial instruments
- Assumes priced correctly
- Model is calibrated so that it generates the observed reference rates (model price = markert price → arb-free)
- Doesn't attempt to explain the observed yield curve, takes it as given
- Ho-Lee and KWF models
- Describe term structure dynamics using fundemental economic variables that are assumed to affect interest rates
- Parameters are not forced to values that produce current bond prices (models are not consistent with market prices, only with other models)
- Parsimonius
- Cox-Ingersoll-Ross (CIR) and Vasicek
- CIR → negative rates not allowed
- Vasicek → negative rates allowed
- Ho-Lee → negative rates not allowed
- KWF → negative rates allowed
- Structure: CEO/Chair seperation; Chair should be independent
- Board independence: percentage or number
- Board committees: Audit, governance, renumeration, nomination, risk/compliance
- Board skills/experience: appropriate given nature of the business, tenure > 10 years is ideal
- Board composition: diversity (age, gender, tenure); number (smaller is more efficient)
- Other considerations: board evaluation (self or external review)
- Proprietary: analysts use own judgement/firm's method
- ESG data providers: MSCI, Sustainalytics
- Not-for-profit industry organization/initiatives: provide data/insight on industry issues (International Integrated Reporting Council, Global Reporting Initiative)
- Equity: examine oppurtunities and downside risk
- Fixed income: generally only focused on downside risk
- Global Reporting Initiative (globalreporting.org): sustainability reporting standards with list of business activity groups and relavant sustainability topics that correspond to each group
- Sustainable Accounting Standards Board (sasb.org): uniform accounting standards with list of ESG-related, sector-specific factors that are deemed material
- Proceeds: Proceeds used to fund projects that have enviromental benefits
- Costs: Issuers incur more monitoring and reporting costs (may sell at premium if institutional demand is high)
- Nature: Resemble an issuer's conventional bonds, with same credit rating and bondholder recourse
- Statuory merger: target ceases to exist
- Subsidiary merger: target becomes a subsidiary due to strong brand
- Consolidation: both target and acquirer cease to exist and become NewCo
- Horizontal merger: merging companies in the same business (economies of scale, market power)
- Vertical merger: acquirer buys another company in the same production chain (greater control over resources)
- Backward integration: supplier
- Forward integration: customer/distributor
- Synergy: reduce costs/enhance revenues
- Growth: external growth (M&A) when organic growth not sufficient and external growth is less risky
- Increase market power: especially when competitive landscape is concentrated by few players; horizontal integration allows for greater influence over market prices; vertical integration allows for securing key suppliers/lock out from competitors
- Acquiring unique capabilities/resources: technology, skilled personnel
- Diversification: not as legitimate as before since investors can diversify
- Manager's personal incentives: executive compensation linked to firm size
- Tax considerations: target may have loss carryforward balance
- Unlocking hidden value: acquire then reorganize (assuming acquistion cost < break-up value; or, acquisition cost < development cost)
- Cross-border motivations: market entry
- Exploiting market imperfections: differences in labour costs
- Overcoming adverse gov't policy: tarriffs, quotas, barriers to trade
- Technology transfers
- Product differentiation
- Following clients
- Bootstrapping earnings
- When a company's earnings increase as a result of the merger transaction itself (rather than synergies, scale effects)
- Effect occurs when shares of the acquirer trade at a higher P/E than the target AND the acquirer's P/E does not decline post-merger
- If markets are efficient, then post-merger P/E equals weighted-average of acquirer's and target's earnings; market usually reconigzes bootstrapping effect and post-merger P/Es adjust accordingly (see formula sheet for calculation)
- Congolomerate mergers - Pioneering Development, Stabilization Maturity, Decline
- Horizontal mergers - All stages
- Vertical mergers - Mature Growth, Decline
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- Assets hit BS at purchase price, no goodwill
- Target company pays taxes on capital gains
- Acquirer avoids assumption of liabilities
- Shareholder approval not needed (if <50% total assets)
- Assets hit BS at FMV; there's potential for goodwill
- Target company has no tax implications
- Shareholder approval required required (if >50% or more)
- Acquirer gets all assets and liabilities (including tax loss carryforwards)
- Poison pills
- Flip-in pill: target shareholders can buy target's shares at a discount once the acquirer reaches a threshold of ownership; acquirer gets no rights and suffers dilution
- Flip-over pill: - target shareholders get the right to buy post-merger acquirer's shares at a discount
- Just say no: mgmt. must make the 'no' case if acquirer bypasses to Board or shareholders
- Litigation: delays, but doesn't stop takeover
- Greenmail: target pays acquirer to stop takeover
- Share repurchase: target bids for own shares, forcing acquirer to raise their bid; potential use to leverage/become private company
- Leveraged recapitalization: target remains public but changes capital structure
- Crown Jewel defense: target sells what acquirer seeks (acquirer can usually stop in court)
- Pac-Man defense: target makes counteroffer to acquire the acquirer
- White Knight defense: target seeks a friendlier 3rd party to buy the company instead
- White Squire defense: target seeks a 3rd party to buy substantial majority stake (enough to block takeover without selling company)
- Equity carve-out: sell a segment/division by the creation of a new legal entity and sale of equity
- Spin-off: shareholders of parent company receive a proportional # of shares in a new entity; two seperate, related entities
- Split-off: some of parent company's shareholders are given shares in a newly created company in exchange for their shares of the parent company; two seperate, unrelated entities and such shareholders don't own parent company shares anymore
- Liquidation: breaking up a company, division, or subsidiary and selling off its assets piecemeal
- MACRS: modified accelerated cost recovery system
- 3, 5, 7, 10-yr: 2x declining; OR, straight-line in the years depreciation expense is larger
- 15, 20-yr: 1.5x declining; OR, straight-line in the years depreciation expense is larger
- 27.5, 39-yr: real property
- Refer to formula sheet for example
- Least Common Multiple of Lives
- Equivalent Annual Annuity Approach
- For all 3 methods, must calculate a base-case, meaning NPV must be calculated as-is
- Sensitivity analysis → estimates a range for NPV, changing one variable at a time
- Scenario analysis → changes in several variables at the same time
- Simulation (Monte Carlo) Analysis
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- Not incorporating economic responses into the investment analysis (e.g. competitor response)
- Formulaic appraoch to budgeting for projects/investments (e.g. not considering specific attributes of each projects)
- Management pet projects
- Focusing too much on Net Income, EPS, or ROE → tends to bias project selection to short-term, fast payback investments
- Basing decisions on IRR → IRR should only be used for independent projects with conventional cash flows
- Bad accounting for cash flows (e.g. not considering oppurtunity cost)
Settlement risk - for funds that use OTC derivatives, such as swaps (settled on weekly/daily basis to minimize this type of risk); ETNs are unsecured senior debt obligations
Security lending - ETF issuers, mutual fund managers, and institutions lend their underlying securities to short sellers, earnings additional income for the fund's investors and crediting back to shareholders; generally, overcollateralized so risk to investors is low
2. Fund closures - In event of closure, fund generally sells its underlying position and returns cash to its investors. Reasons for closure include regulations, competition, corporate actions, creation and redemption halts (soft closure), and change in investment strategy (soft closure).
3. Investor-related risk - primarily associated with ETFs with complex asset classes/strategies (e.g. leveraged/geared, inverse)
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- Portfolio liquidity management - cash flow management to minimize cash drag (fund's mistracking relative to its index that results from holding uninvested cash)
- Portfolio rebalancing - allows investors to adjust portfolios when deviations from target weight
- Portfolio completion strategies - allows investors to temporarily fill in gap in exposure to asset class, sector, or investment theme/factor (e.g. when manager takes an active view that moves portoflio out of investor's desired exposures)
- Transition management - the process of hiring/firing managers or making changes to allocations with existing managers
- Potentially able to negotiate lower fees for a dedicated seperately managed account (SMA)
- SMA can be customized to the investment goals/needs of investor
- Regulation requiring large ETF holdings to be disclosed to the publc
