2014 Level II I Book SchweserNotes'·"' for the CFA®Exam Ethical and Professional Standards, Quantitative Methods, and Economics ® I{ A p LA N SCHOOL OF PROFESSIONAL AND CONTINUING EDUCATION BooK - ETHICAL AND PROFESSIONAL STANDARDS, QUANTITATIVE METHODS, AND ECONOMICS Readings and Learning Outcome Statements Study Session - Ethical and Professional Standards 13 Study Session - Ethical and Professional Standards: Application 110 Self-Test - Ethical and Professional Standards 128 Study Session - Quantitative Methods for Valuation 138 Self-Test - Quantitative Methods for Valuation 258 Study Session - Economics for Valuation 264 Self-Test - Economics for Valuation 341 Formulas 346 Appendices 51 Index 356 SCHWESERNOTES™ 2014 CFA LEVEL II BOOK 1: ETHICAL AND PROFESSIONAL STANDARDS, QUANTITATIVE METHODS, AND ECONOMICS ©2013 Kaplan, Inc All rights reserved Published in 2013 by Kaplan, Inc Printed in the United States of America ISBN: 978-1-4277-4910-9 I 1-4277-4910-8 PPN: 3200-4011 If this book does not have the hologram with the Kaplan Schweser logo on rhe back cover, ir was distributed wirhour permission of Kaplan Schweser, a Division of Kaplan, Inc., and is in direcr violarion of global copyrighr laws Your assisrance in pursuing porenrial violarors of chis law is grearly appreciared Required CFA Institute disclaimer: "CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute CFA Institute (formerly the Association for Investment Management and Research) does not endorse, promote, review, or warrant the accuracy of the products or services offered by Kaplan Schweser." Certain materials contained within this text are the copyrighted property of CFA Institute The following is the copyright disclosure for these materials: "Copyright, 2013, CFA Institute Reproduced and republished from 2014 Learning Outcome Statements, Level I, II, and III questions from CFA® Program Materials, CFA Institute Standards of Professional Conduct, and CFA lnstitute's Global Investment Performance Standards with permission from CFA Institute All Rights Reserved " These materials may not be copied without written permission from the author The unauthorized duplication of these notes is a violation of global copyright laws and the CFA Institute Code of Ethics Your assistance in pursuing potential violators of this law is greatly appreciated Disclaimer: The Schweser Notes should be used in conjunction with the original readings as set forth by CFA Institute in their 201 CFA Level II Study Guide The information contained in these Notes covers topics contained in the readings referenced by CFA Institute and is believed to be accurate However, their accuracy cannot be guaranteed nor is any warranty conveyed as to your ultimate exam success The authors of the referenced readings have not endorsed or sponsored these Notes Page ©2013 Kaplan, Inc WELCOME TO THE 2014 LEVEL ScuwESERN OTES™ II Thank you for trusting Kaplan Schweser to help you reach your goals We are all very pleased to be able to help you prepare for the Level II CFA Exam In this introduction, I want to explain the resources included with the SchweserNotes, suggest how you can best use Schweser materials to prepare for the exam, and direct you toward other educational resources you will find helpful as you study for the exam Besides the SchweserNotes themselves, there are many educational resources available at Schweser.com Log in using the individual username and password that you received when you purchased your SchweserNotes SchweserNotesTM These consist of five volumes that include complete coverage of all 18 Study Sessions and all Learning Outcome Statements (LOS) with examples, Concept Checkers (multiple-choice questions for every topic review), and Challenge Problems for many topic reviews to help you master the material and check your progress At the end of each major topic area, we include a Self-test Self-test questions are created to be examlike in format and difficulty in order for you to evaluate how well your study of each topic has prepared you for the actual exam Practice Questions Studies have shown that to retain what you learn, it is important that you quiz yourself often We offer CD, download, and online versions of the SchweserPro™ QBank, which contains thousands of Level II practice questions, item sets, and explanations Questions are available for each LOS, topic, or Study Session Build your own quizzes by specifying the topics and the number of questions you choose SchweserPro QBank is an essential learning aid for achieving the depth of proficiency needed at Level II It should not, however, be considered a replacement for practicing "exam-type" questions as found in our Practice Exams, Volumes & and our mock exam Practice Exams Schweser offers six full 6-hour practice exams: Practice Exams Volume and Volume each contain three full 120-question exams These are important tools for gaining the speed and skills you will need to pass the exam Each book contains answers with full explanations for self-grading and evaluation By entering your answers at Schweser.com, you can use our Performance Tracker to find out how you have performed compared to other Schweser Level II candidates Schweser Library We have created reference videos, some of which are available to all SchweserNotes purchasers Schweser Library volumes range from 20 to 60 minutes in length and cover such topics as: "Introduction to Item Sets," "Hypothesis Testing," " Foreign Exchange Basics,'' "Ratio Analysis," and "Forward Contracts." The full Schweser Library is included with our 16-week live or online classes and with our video instruction (online or CD) ©201 Kaplan, Inc Page Welcome to the 2014 Level II SchweserNotes™ Online Schweser Study Planner Use your Online Access to tell us when you will start and what days of the week you can study The online Schweser Study Planner will create a study plan just for you, breaking each study session into daily and weekly tasks to keep you on track and help you monitor your progress through the curriculum Additional Resources Purchasers of the Essential Self-Study or Premium Instruction Packages also receive access to our Instructor-led Office Hours Office Hours allow you to get your questions about the curriculum answered in real time and to see others' questions (and instructor answers) as well Office Hours is a text-based live interactive online chat with our team of Level II experts Archives of previous Office Hours sessions can be sorted by topic or date and are posted shortly after each session The Level II CFA exam is a formidable challenge (60 topic reviews and 477 Learning Outcome Statements), and you must devote considerable time and effort to be properly prepared There is no shortcut! You must learn the material, know the terminology and techniques, understand the concepts, and be able to answer 120 questions quickly and mostly correctly Fifteen to 20 hours per week for 25 weeks is a good estimate of the study time required on average, but some candidates will need more or less time, depending on their individual backgrounds and experience To help you master this material and be well prepared for the CFA Exam, we offer several other educational resources, including: Live Weekly Classroom Programs We offer weekly classroom programs around the world Please check Schweser.com for locations, dates, and availability 16-Week Online Classes Our 16-Week Online Classes are available at New York time (6:30-9:30 pm) or London time (6:00-9:00 pm) beginning in January The approximate schedule for the 16-Week Online Classes (3-hour sessions) is as follows: Class# 1) Exam Intro/Quantitative M ethods SS 2) Economics for Valuation SS 3) Financial Reporting & Analysis SS 4) Financial Reporting & Analysis SS 5) Financial Reporting & Analysis SS 6) Corporate Finance SS 7) Corporate Finance & Equity SS 9, 10 8) Equity SS 11, 12 Class# 9) Equity SS 12 10) Alternative Inves tments SS 13 11) Fixed Income SS 14 12) Fixed Income SS 15 13) D erivatives SS 16 14) Derivatives SS 17 15) Portfolio Management SS 18 16) Ethical Standards SS 1, Archived classes are available for viewing at any time throughout the season Candidates enrolled in the 16-Week Online Classes also have full access to supplemental on-demand video instruction in the Schweser Library and a link for sending questions to the instructor at any time Page ©2013 Kaplan, Inc Welcome to the 2014 Level II SchweserNotes™ Late Season Review Whether you use self-study or in-class, online, or video instruction to learn the CFA curriculum, a late-season review and exam practice can make all the difference Our most complete late-season review course is our residence program in Windsor, Ontario (WindsorWeek), where we cover the entire curriculum over seven days (May 3-9) We also offer 3-day Exam Workshops in many cities (and online) that combine curriculum review with hands-on practice using hundreds of questions and problem-solving techniques Our Dallas/Fort Worth (DFW) review program extends curriculum review and hands-on practice to five days (May 12-16) Please visit us at Schweser.com for complete listings and course descriptions for all our late-season review offerings Mock Exam and Multimedia Tutorial On May 24, 2014, the Schweser Mock Exam will be offered live in over 60 cities around the world and as an online exam as well The included Multimedia Tutorial provides extended explanation and topic tutorials to get you exam-ready in areas where you miss questions on the Mock Exam Please visit Schweser.com for a listing of cities and locations How to Succeed There are no shortcuts; the CFA Institute will test yo u in a way that will reveal how well you know the Level II curriculum You should begin early and stick to your study plan Read the SchweserNotes and complete the Concept Checkers and Challenge Problems for each topic review Prepare for and attend a live class, an online class, or a study group each week Take quizzes often using SchweserPro Qbank and go back to review previous topics and Study Sessions regularly At the end of each topic area, take the Self-test to check your progress You should finish the overall curriculum at least four weeks before the Level II exam so that you have sufficient time for Practice Exams and for further review of those topics that you have not yet mastered I would like to thank Kent Westlund, CFA Content Specialist, and Jared Heintz, Lead Copy Editor, for their contributions to the 2014 Level II SchweserNotes for the CFA Exam Best regards, Dr Bijesh Tolia, CFA, CA VP of CFA Education and Level II Manager Kaplan Schweser ©2013 Kaplan, Inc Page READINGS AND LEARNING OUTCOME STATEMENTS READINGS The following material is a review ofthe Ethical and Professional Standards, Quantitative Methods, and Economics principles designed to address the learning outcome statements set forth by CFA Institute STUDY SESSION Reading Assignments Ethical and Professional Standards, CFA Program Curriculum, Volume 1, Level II (CFA Institute, 2013) Code of Ethics and Standards of Professional Conduct page 13 Guidance for Standards I-VII page 13 CFA Institute Soft Dollar Standards page 91 CFA Institute Research Objectivity Standards page 100 STUDY SESSION Reading Assignments Ethical and Professional Standards, CFA Program Curriculum, Volume 1, Level II (CFA Institute, 2013) The Glenarm Company page 110 Preston Partners page 112 Super Selection page 115 Trade Allocation: Fair Dealing and Disclosure page 118 Changing Investment Objectives page 120 10 Prudence in Perspective page 121 STUDY SESSION Reading Assignments Quantitative Methods for Valuation, CFA Program Curriculum, Volume 1, Level II (CFA Institute, 2013) 11 Correlation and Regression page 138 12 Multiple Regression and Issues in Regression Analysis page 173 13 Time-Series Analysis page 221 Page ©2013 Kaplan, Inc Book - Ethical and Professional Standards, Quantitative Methods, and Economics Readings and Learning Outcome Statements STUDY SESSION Reading Assignments Economics for Valuation, CFA Program Curriculum, Volume 1, Level II (CFA Institute, 2013) 14 Currency Exchange Rates: Determination and Forecasting 15 Economic Growth and the Investment Decision 16 Economics of Regulation page 264 page 308 page 329 LEARNING OUTCOME STATEMENTS (LOS) The CFA Institute Learning Outcome Statements are listed below These are repeated in each topic review; however, the order may have been changed in order to get a better fit with the flow ofthe review STUDY SESSION 1 The topical coverage corresponds with the following CFA Institute assigned reading: Code of Ethics and Standards of Professional Conduct The candidate should be able to: a describe the six components of the Code of Ethics and the seven Standards of Professional Conduct (page 13) b explain the ethical responsibilities required of CFA Institute members and candidates in the CFA Program by the Code and Standards (page 14) The topical coverage corresponds with the following CFA Institute assigned reading: Guidance for Standards I-VII The candidate should be able to: a demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by applying the Code and Standards to specific situations (page 17) b recommend practices and procedures designed to prevent violations of the Code of Ethics and Standards of Professional Conduct (page 17) The topical coverage corresponds with the following CFA Institute assigned reading: CFA Institute Soft Dollar Standards The candidate should be able to: a define soft-dollar arrangements, and state the general principles of the Soft Dollar Standards (page 91) b evaluate company soft-dollar practices and policies (page 92) c determine whether a product or service qualifies as "permissible research" that can be purchased with client brokerage (page 95) The topical coverage corresponds with the follo wing CFA Institute assigned reading: CFA Institute Research Objectivity Standards The candidate should be able to: a explain the objectives of the Research Objectivity Standards (page 100) b evaluate company policies and practices related to research objectivity, and distinguish between changes required and changes recommended for compliance with the Research Objectivity Standards (page 101) ©2013 Kaplan, Inc Page Book - Ethical and Professional Standards, Quantitative Methods, and Economics Readings and Learning Outcome Statements STUDY SESSION The topical coverage corresponds with the following CFA Institute assigned reading: The Glenarm Company The candidate should be able to: a evaluate the practices and policies presented (page 11 O) b explain the appropriate action to take in response to conduct that violates the CFA Institute Code of Ethics and Standards of Professional Conduct (page 110) The topical coverage corresponds with the following CFA Institute assigned reading: Preston Partners The candidate should be able to: a evaluate the practices and policies presented (page 112) b explain the appropriate action to take in response to conduct that violates the CFA Institute Code of Ethics and Standards of Professional Conduct (page 112) The topical coverage corresponds with the following CFA I nstitute assigned reading: Super Selection For each of these cases, the candidate should be able to: a evaluate the practices and policies presented (page 115) b explain the appropriate action to take in response to conduct that violates the CFA Institute Code of Ethics and Standards of Professional Conduct (page 115) The topical coverage corresponds with the following CFA Institute assigned reading: Trade Allocation: Fair Dealing and Disclosure The candidate should be able to: a evaluate trade allocation practices, and determine whether they comply with the CFA Institute Standards of Professional Conduct addressing fair dealing and client loyalty (page 118) b describe appropriate actions to take in response to trade allocation practices that not adequately respect client interests (page 119) The topical coverage corresponds with the following CFA Institute assigned reading: Changing Investment Objectives T he candidate should be able to: a evaluate the disclosure of investment objectives and basic policies, and determine whether they comply with the CFA Institute Standards of Professional Conduct (page 120) b describe appropriate actions needed to ensure adequate disclosure of the investment process (page 120) The topical coverage corresponds with the following CFA Institute assigned reading: 10 Prudence in Perspective The candidate should be able to: a explain the basic principles of the new Prudent Investor Rule (page 121) b explain general fiduciary standards to which a trustee must adhere (page 122) c distinguish between the old Prudent Man Rule and the n ew Prudent Investor Rule (page 123) d explain key factors that a trustee should consider when investing and managing trust assets (page 123) Page ©2013 Kaplan, Inc Book - Ethical and Professional Standards, Quantitative Methods, and Economics Readings and Learning Outcome Statements STUDY SESSION The topical coverage corresponds with the following CFA Institute assigned reading: 11 Correlation and Regression The candidate should be able to: a calculate and interpret a sample covariance and a sample correlation coefficient, and interpret a scatter plot (page 138) b describe limitations to correlation analysis (page 142) c formulate a test of the hypothesis that the population correlation coefficient equals zero, and determine whether the hypothesis is rejected at a given level of significance (page 143) d distinguish between the dependent and independent variables in a linear regression (page 144) e describe the assumptions underlying linear regression, and interpret regression coefficients (page 146) f calculate and interpret the standard error of estimate, the coefficient of determination, and a confidence interval for a regression coefficient (page 150) g formulate a null and alternative hypothesis about a population value of a regression coefficient, and determine the appropriate test statistic and whether the null hypothesis is rejected at a given level of significance (page 152) h calculate the predicted value for the dependent variable, given an estimated regression model and a value for the independent variable (page 153) calculate and interpret a confidence interval for the predicted value of the dependent variable (page 153) J· describe the use of analysis of variance (ANOVA) in regression analysis, interpret ANOVA results, and calculate and interpret the F-statistic (page 155) k describe limitations of regression analysis (page 160) The topical coverage corresponds with the following CFA Institute assigned reading: 12 Multiple Regression and Issues in Regression Analysis The candidate should be able to: a formulate a multiple regression equation to describe the relation between a dependent variable and several independent variables, and determine the statistical significance of each independent variable (page 174) b interpret estimated regression coefficients and their p-values (page 175) c formulate a null and an alternative hypothesis about the population value of a regression coefficient, calculate the value of the test statistic, and determine whether to reject the null hypothesis at a given level of significance (page 176) d interpret the results of hypothesis tests of regression coefficients (page 17 6) e calculate and interpret 1) a confidence interval for the population value of a regression coefficient and 2) a predicted value for the dependent variable, given an estimated regression model and assumed values for the independent variables (page 180) f explain the assumptions of a multiple regression model (page 182) g calculate and interpret the F-statistic, and describe how it is used in regression analysis (page 182) h distinguish between and interpret the R2 and adjusted R2 in multiple regression (page 184) ©2013 Kaplan, Inc Page Self-Test: Economics Economics for Valuation Growth in potential GDP = E(GDP growth rate) = E(technology growth) [E(growth in labor)] = 0.2% = 1.76% + (0.64) (1.77%) ©201 Kaplan, Inc + + a [E(growth in capital)] + (I - a ) (0 36)(1.2%) Page 345 FORMULAS STUDY SESSION 3: QUANTITATIVE METHODS Covariance and Correlation n l:(Xj - X)(Yj - sample covariance: covXY Y) = ~i=_I- - - - - n- sample correlation coefficient: rXY t-test for correlation coefficient: t COVXY = -~~ (sx)(sy) = r,Jn-2 J17 with n - df Simple Linear Regression COVXY sl ope coe fificient: b1 - - - A -