© CFA Institute For candidate use only Not for distribution ETHICAL AND PROFESSIONAL STANDARDS, QUANTITATIVE METHODS, AND ECONOMICS CFA® Program Curriculum 2020 ã LEVEL II ã VOLUME â CFA Institute For candidate use only Not for distribution © 2019, 2018, 2017, 2016, 2015, 2014, 2013, 2012, 2011, 2010, 2009, 2008, 2007, 2006 by CFA Institute All rights reserved This copyright covers material written expressly for this volume by the editor/s as well as the compilation itself It does not cover the individual selections herein that first appeared elsewhere Permission to reprint these has been obtained by CFA Institute for this edition only Further reproductions by any means, electronic or mechanical, including photocopying and recording, or by any information storage or retrieval systems, must be arranged with the individual copyright holders noted CFA®, Chartered Financial Analyst®, AIMR-PPS®, and GIPS® are just a few of the trademarks owned by CFA Institute To view a list of CFA Institute trademarks and the Guide for Use of CFA Institute Marks, please visit our website at www.cfainstitute.org This publication is designed to provide accurate and authoritative information in regard to the subject matter covered It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service If legal advice or other expert assistance is required, the services of a competent professional should be sought All trademarks, service marks, registered trademarks, and registered service marks are the property of their respective owners and are used herein for identification purposes only ISBN 978-1-946442-82-6 (paper) ISBN 978-1-950157-06-8 (ebk) 10 © CFA Institute For candidate use only Not for distribution CONTENTS How to Use the CFA Program Curriculum Background on the CBOK Organization of the Curriculum Features of the Curriculum Designing Your Personal Study Program Feedback ix ix x x xii xiii Ethical and Professional Standards Study Session Ethical and Professional Standards Reading Code of Ethics and Standards of Professional Conduct Preface Evolution of the CFA Institute Code of Ethics and Standards of Professional Conduct Standards of Practice Handbook Summary of Changes in the Eleventh Edition CFA Institute Professional Conduct Program Adoption of the Code and Standards Acknowledgments Ethics and the Investment Industry Why Ethics Matters CFA Institute Code of Ethics and Standards of Professional Conduct Preamble The Code of Ethics Standards of Professional Conduct 5 6 10 10 11 11 15 15 15 16 Guidance for Standards I–VII Standard I: Professionalism Standard I(A) Knowledge of the Law Guidance Recommended Procedures for Compliance Application of the Standard Standard I(B) Independence and Objectivity Guidance Recommended Procedures for Compliance Application of the Standard Standard I(C) Misrepresentation Guidance Recommended Procedures for Compliance Application of the Standard Standard I(D) Misconduct Guidance Recommended Procedures for Compliance Application of the Standard 21 21 21 21 26 27 30 30 35 36 43 43 46 48 53 53 54 54 Reading indicates an optional segment ii © CFA Institute For candidate use only Not for distribution Contents Standard II: Integrity of Capital Markets Standard II(A) Material Nonpublic Information Guidance Recommended Procedures for Compliance Application of the Standard Standard II(B) Market Manipulation Guidance Application of the Standard Standard III: Duties to Clients Standard III(A) Loyalty, Prudence, and Care Guidance Recommended Procedures for Compliance Application of the Standard Standard III(B) Fair Dealing Guidance Recommended Procedures for Compliance Application of the Standard Standard III(C) Suitability Guidance Recommended Procedures for Compliance Application of the Standard Standard III(D) Performance Presentation Guidance Recommended Procedures for Compliance Application of the Standard Standard III(E) Preservation of Confidentiality Guidance Recommended Procedures for Compliance Application of the Standard Standard IV: Duties to Employers Standard IV(A) Loyalty Guidance Recommended Procedures for Compliance Application of the Standard Standard IV(B) Additional Compensation Arrangements Guidance Recommended Procedures for Compliance Application of the Standard Standard IV(C) Responsibilities of Supervisors Guidance Recommended Procedures for Compliance Application of the Standard Standard V: Investment Analysis, Recommendations, and Actions Standard V(A) Diligence and Reasonable Basis Guidance Recommended Procedures for Compliance Application of the Standard Standard V(B) Communication with Clients and Prospective Clients Guidance indicates an optional segment 56 56 56 60 63 68 68 69 73 73 73 77 78 82 82 84 86 90 90 93 94 97 97 98 98 101 101 103 103 105 105 105 109 109 116 116 116 116 118 118 120 122 126 126 126 130 130 137 138 Contents Reading © CFA Institute For candidate use only Not for distribution iii Recommended Procedures for Compliance Application of the Standard Standard V(C) Record Retention Guidance Recommended Procedures for Compliance Application of the Standard Standard VI: Conflicts of Interest Standard VI(A) Disclosure of Conflicts Guidance Recommended Procedures for Compliance Application of the Standard Standard VI(B) Priority of Transactions Guidance Recommended Procedures for Compliance Application of the Standard Standard VI(C) Referral Fees Guidance Recommended Procedures for Compliance Application of the Standard Standard VII: Responsibilities as a CFA Institute Member or CFA Candidate Standard VII(A) Conduct as Participants in CFA Institute Programs Guidance Application of the Standard Standard VII(B) Reference to CFA Institute, the CFA Designation, and the CFA Program Guidance Recommended Procedures for Compliance Application of the Standard Practice Problems Solutions 140 141 146 146 147 148 149 149 149 152 152 157 157 158 160 162 162 162 162 165 165 165 167 Application of the Code and Standards: Level II Introduction QuantHouse Case Questions JR and Associates Case Questions Magadi Asset Management Case Questions Edvard Stark Duties to Clients Duties to Employers Investment Analysis, Recommendations, and Actions Conflicts of Interest Subath Agarway Professionalism Conflicts of Interest 205 205 206 207 211 212 217 219 223 224 225 226 227 228 229 230 indicates an optional segment 170 170 172 173 175 193 iv © CFA Institute For candidate use only Not for distribution Contents Quantitative Methods Study Session Quantitative Methods (1) 235 Reading Introduction to Linear Regression Introduction Linear Regression Linear Regression with One Independent Variable Assumptions of the Linear Regression Model The Standard Error of Estimate The Coefficient of Determination Hypothesis Testing Analysis of Variance in a Regression with One Independent Variable Prediction Intervals Limitations of Regression Analysis Summary Practice Problems Solutions 237 238 238 238 243 246 248 250 259 262 264 265 267 278 Reading Multiple Regression Introduction Multiple Linear Regression Assumptions of the Multiple Linear Regression Model Predicting the Dependent Variable in a Multiple Regression Model Testing whether All Population Regression Coefficients Equal Zero Adjusted R2 Using Dummy Variables in Regressions Violations of Regression Assumptions Heteroskedasticity Serial Correlation Multicollinearity Heteroskedasticity, Serial Correlation, Multicollinearity: Summarizing the Issues Model Specification and Errors in Specification Principles of Model Specification Misspecified Functional Form Time-Series Misspecification (Independent Variables Correlated with Errors) Other Types of Time-Series Misspecification Models with Qualitative Dependent Variables Summary Practice Problems Solutions 283 284 284 290 295 297 299 300 304 305 311 315 Time-Series Analysis Introduction to Time-Series Analysis Challenges of Working with Time Series Trend Models Linear Trend Models 375 376 378 379 379 Reading indicates an optional segment 318 319 319 320 328 332 332 335 339 364 Contents © CFA Institute For candidate use only Not for distribution v Log-Linear Trend Models Trend Models and Testing for Correlated Errors Autoregressive (AR) Time-Series Models Covariance-Stationary Series Detecting Serially Correlated Errors in an Autoregressive Model Mean Reversion Multiperiod Forecasts and the Chain Rule of Forecasting Comparing Forecast Model Performance Instability of Regression Coefficients Random Walks and Unit Roots Random Walks The Unit Root Test of Nonstationarity Moving-Average Time-Series Models Smoothing Past Values with an n-Period Moving Average Moving-Average Time-Series Models for Forecasting Seasonality in Time-Series Models Autoregressive Moving-Average Models Autoregressive Conditional Heteroskedasticity Models Regressions with More than One Time Series Other Issues in Time Series Suggested Steps in Time-Series Forecasting Summary Practice Problems Solutions 382 388 389 390 391 394 395 398 400 403 403 407 411 412 414 416 422 423 426 430 431 432 436 452 Study Session Quantitative Methods (2) 461 Reading Machine Learning Introduction Machine Learning and Investment Management What Is Machine Learning? Defining Machine Learning Supervised Learning Unsupervised Learning Deep Learning and Reinforcement Learning Summary of ML Algorithms and How to Choose Among Them Overview of Evaluating ML Algorithm Performance Generalization and Overfitting Errors and Overfitting Preventing Overfitting in Supervised Machine Learning Supervised Machine Learning Algorithms Penalized Regression Support Vector Machine K-Nearest Neighbor Classification and Regression Tree Ensemble Learning and Random Forest Unsupervised Machine Learning Algorithms Principal Components Analysis Clustering 463 463 464 465 465 465 467 467 467 471 471 472 474 476 476 477 479 481 484 489 489 492 indicates an optional segment vi Reading Reading © CFA Institute For candidate use only Not for distribution Contents Neural Networks, Deep Learning Nets, and Reinforcement Learning Neural Networks Deep Learning Nets Reinforcement Learning Summary Practice Problems Solutions 499 499 503 504 507 510 514 Big Data Projects Introduction Big Data in Investment Management Steps in Executing a Data Analysis Project: Financial Forecasting with Big Data Data Preparation and Wrangling Structured Data Unstructured (Text) Data Data Exploration Objectives and Methods Structured Data Unstructured Data: Text Exploration Model Training Structured and Unstructured Data Financial Forecasting Project: Classifying and Predicting Sentiment for Stocks Text Curation, Preparation, and Wrangling Data Exploration Model Training Results and Interpretation Summary Practice Problems Solutions 517 517 518 Excerpt from “Probabilistic Approaches: Scenario Analysis, Decision Trees, and Simulations” Introduction Simulations Steps in Simulation An Example of a Simulation Use in Decision Making Simulations with Constraints Issues Risk-Adjusted Value and Simulations An Overall Assessment of Probabilistic Risk Assessment Approaches Comparing the Approaches Complement or Replacement for Risk-Adjusted Value In Practice Conclusion Practice Problems Solutions indicates an optional segment 519 523 524 530 537 538 542 549 550 559 559 563 572 578 582 584 588 591 591 592 592 595 598 599 600 601 602 602 603 604 605 606 609 Contents © CFA Institute For candidate use only Not for distribution vii Economics Study Session Economics 613 Reading 10 Currency Exchange Rates: Understanding Equilibrium Value Introduction Foreign Exchange Market Concepts Arbitrage Constraints on Spot Exchange Rate Quotes Forward Markets The Mark-to-Market Value of a Forward Contract A Long-Term Framework for Exchange Rates International Parity Conditions The Carry Trade The Impact of Balance of Payments Flows Current Account Imbalances and the Determination of Exchange Rates Capital Flows and the Determination of Exchange Rates Monetary and Fiscal Policies The Mundell–Fleming Model Monetary Models of Exchange Rate Determination The Portfolio Balance Approach Exchange Rate Management: Intervention and Controls Warning Signs of a Currency Crisis Summary Appendix Practice Problems Solutions 615 616 616 620 624 628 632 633 648 651 Economic Growth and the Investment Decision Introduction Growth in the Global Economy: Developed vs Developing Economies Savings and Investment Financial Markets and Intermediaries Political Stability, Rule of Law, and Property Rights Education and Health Care Systems Tax and Regulatory Systems Free Trade and Unrestricted Capital Flows Summary of Factors Limiting Growth in Developing Countries Why Potential Growth Matters to Investors Determinants of Economic Growth Production Function Capital Deepening vs Technological Progress Growth Accounting Extending the Production Function Natural Resources Labor Supply Labor Quality: Human Capital Capital: ICT and Non-ICT Technology 695 696 696 699 699 700 700 701 701 702 704 709 709 711 713 715 715 717 722 723 725 Reading 11 indicates an optional segment 652 655 660 661 663 666 669 672 676 681 682 690 viii Reading 12 © CFA Institute For candidate use only Not for distribution Contents Public Infrastructure Summary Theories of Growth Classical Model Neoclassical Model Endogenous Growth Theory Convergence Debate Growth in an Open Economy Summary Practice Problems Solutions 729 729 734 735 735 747 750 754 762 766 773 Economics of Regulation Introduction Economic Rationale for Regulation Rationale for the Regulation of Financial Markets Regulation of Commerce Antitrust Regulation Regulators and Regulatory Tools Classification of Regulations and Regulators Regulatory Interdependencies Regulatory Tools Analysis of Regulation Basic Concepts of Cost–Benefit Analysis Analysis of Regulation Summary Practice Problems Solutions 777 777 778 779 782 783 784 784 788 792 795 795 798 802 805 809 Appendices Glossary 811 G-1 indicates an optional segment ... Agarway Professionalism Conflicts of Interest 20 5 20 5 20 6 20 7 21 1 21 2 21 7 21 9 22 3 22 4 22 5 22 6 22 7 22 8 22 9 23 0 indicates an optional segment 170 170 1 72 173 175 193 iv © CFA Institute For candidate... Institute For candidate use only Not for distribution © 20 19, 20 18, 20 17, 20 16, 20 15, 20 14, 20 13, 20 12, 20 11, 20 10, 20 09, 20 08, 20 07, 20 06 by CFA Institute All rights reserved This copyright... Limitations of Regression Analysis Summary Practice Problems Solutions 23 7 23 8 23 8 23 8 24 3 24 6 24 8 25 0 25 9 26 2 26 4 26 5 26 7 27 8 Reading Multiple Regression Introduction Multiple Linear Regression