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Problem Solving Session
Harvard Extension SchoolMGMT E-2900bCFA Exam Level I
March 23, 2010
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Rich GibbleLecturer
Tray SpilkerTeaching Assistant
Fixed Income I Problem Solving Session
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Fixed Income
Topic Area Weights for the CFA ExamTopic Area Level I
Ethical and Professional Standards (total) 15 Quantitative Methods 12 Economics 10 Financial Reporting and Analysis 20 Corporate Finance 8 Investment Tools (total) 50 Equity Investments 10 Fixed Income 12 Derivatives 5 Alternative Investments 3 Asset Classes (total) 30 Portfolio Management and Wealth Planning (total) 5
Total 100
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Features of Debt SecuritiesOverview of Bond Sectors & Instruments
Repayment & Prepayment Provisions
Fixed Income I Problem Solving Session
Study Session 15Readings 60 & 62
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Fixed Income - Basic Concepts
1. A bond’s indenture:
A. outlines interest and principle components B. is the same as a debentureC. contains its covenants
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Fixed Income - Basic Concepts
1. A bond’s indenture:
A. outlines interest and principle components B. is the same as a debentureC. contains its covenants
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Bond Indenture
A bond indenture specifies all rights and obligations of the issuer and bondholder.
Contains: negative covenants or restrictions on the
borrower/issuer affirmative covenants, or obligations of the borrower.
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Fixed Income - Basic Concepts
2. A five-year bond, after paying no interest for the first two years, pays $103.76 and $25 semiannually for the remaining three years until maturity. At maturity it pays $1,000. Which of the following bonds types is the closest to the bond described?
A. Accrual bondB. Deferred-coupon bondC. Step-up note
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Fixed Income - Basic Concepts
2. A five-year bond, after paying no interest for the first two years, pays $103.76 and $25 semiannually for the remaining three years until maturity. At maturity it pays $1,000. Which of the following bonds types is the closest to the bond described?
A. Accrual bondB. Deferred-coupon bondC. Step-up note
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Coupon Rate Structures Accrual Bonds: pay no periodic coupon before maturity,
but are sold at par and pay-out par plus accrued at maturity.
Deferred Coupon Bonds: Initial coupon payments are deferred for some period; the accrued coupons are paid at the end of the period, before resuming normal couponing until maturity.
Step-Up Notes: have coupon rates that increase over time at a specified rate.
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Fixed Income - Basic Concepts
3. From the perspective of the bond issuer, which of the following pairs of options would add value to a straight bond?
A. Prepayment option, put optionB. Call option, accelerated sinking fund provisionC. Conversion option, put option
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Fixed Income - Basic Concepts
3. From the perspective of the bond issuer, which of the following pairs of options would add value to a straight bond?
A. Prepayment option, put optionB. Call option, accelerated sinking fund provisionC. Conversion option, put option
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Provisions for Bond Retirements
Call options, sinking fund provisions, caps on floaters, and prepayment options favor the issuer.
Put options, conversion options, and floors on floaters favor the bondholder.
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Fixed Income - Basic Concepts
4. A bond with a $2,500 par value and a coupon rate of 7% makes semiannual payments. What is the dollar amount of each semiannual coupon payment?
A. $87.50B. $70.00C. $175.00
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Fixed Income - Basic Concepts
4. A bond with a $2,500 par value and a coupon rate of 7% makes semiannual payments. What is the dollar amount of each semiannual coupon payment?
A. $87.50B. $70.00C. $175.00
$2,500 (0.07/2) = $87.50
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Fixed Income - Basic Concepts
5. A $1,000 five-year semiannual 5% coupon bond issued when the market requires a yield of 6% will sell at (a) _______ for a total price of _______?
A. Par, $1,000B. Premium, $1,043.76C. Discount, $957.35
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SS 15: Fixed Income - Basic Concepts
5. A $1,000 five-year semiannual 5% coupon bond issued when the market requires a yield of 6% will sell at (a) _______ for a total price of _______?
A. Par, $1,000B. Premium, $1,043.76C. Discount, $957.35
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Fixed Income - Basic Concepts
N=10, I/Y=3%, PMT=$25, FV=$1,000 compute PV = $957.35
Since the bond sells for less than face value, it sells at a discount
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Fixed Income - Basic Concepts
6. A $5 million floating-rate semiannual note is issued with a reference and spread of 6-month LIBOR + 250bps. The rate was most recently reset on January 1 when LIBOR was 6% and the risk free rate was 1.5%. How much will the next semiannual coupon payment be?
A. $112,500B. $425,000C. $212,500
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Fixed Income - Basic Concepts
6. A $5 million floating-rate semiannual note is issued with a reference and spread of 6-month LIBOR + 250bps. The rate was most recently reset on January 1 when LIBOR was 6% and the risk free rate was 1.5%. How much will the next semiannual coupon payment be?
A. $112,500B. $425,000C. $212,500
$5 mln [(0.06 + 0.025)/2] = $212,500
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Fixed Income - Basic Concepts
7. Which statement regarding caps and floors on floating rate bonds is least accurate?
A. Caps are a disadvantage to the bondholder, while floors are a disadvantage to the issuer
B. Floors are a disadvantage to the bondholder, while caps are a disadvantage to the issuer
C. Caps are an advantage to issuers, while floors are an advantage to bondholders
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Fixed Income - Basic Concepts
7. Which statement regarding caps and floors on floating rate bonds is least accurate?
A. Caps are a disadvantage to the bondholder, while floors are a disadvantage to the issuer
B. Floors are a disadvantage to the bondholder, while caps are a disadvantage to the issuer
C. Caps combined with floors are called collars
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Caps & Floors on Floating-Rate Bonds
Caps: if rates move above the cap rate, the issuer only pays the cap rate advantage issuer
Floors: if rates move below the floor rate, the issuer still pays the floor rate advantage bondholder
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Fixed Income - Basic Concepts
8. A 5% semiannual, $1,000 face value bond is quoted at a 2.7% discount to par. The quote is made mid-way between coupon payment dates. What is the bond’s clean price, dirty price and accrued interest?
A. $960.50, $973.00, $12.50B. $973.00, $985.50, $12.50 C. $950.00, $1,000.00, $50.00
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Fixed Income - Basic Concepts
8. A 5% semiannual, $1,000 face value bond is quoted at a 2.7% discount to par. The quote is made mid-way between coupon payment dates. What is the bond’s clean price, dirty price and accrued interest?
A. $960.50, $973.00, $12.50B. $973.00, $985.50, $12.50 C. $950.00, $1,000.00, $50.00
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Bond Quotes and Accrued Interest
Full Price = Clean Price + Accrued Interest
• Full (Dirty) Price = quoted or selling price = $1,000(1 – 0.027) x = $973
• Accrued Interest = $1,000(0.05/4) = $12.50• Clean Price = Full Price – Accrued Interest
= $973 – $12.50 = $960.50
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Fixed Income - Basic Concepts
Questions 9 – 12:
Consider a 15-year, $10 million par value, 7.5% coupon bond issued on Jan 1, 2010. The bonds are callable but non-refundable at 105 for the first five years and 103 thereafter until maturity. There is a sinking fund provision requiring redemptions of $666,667 of the principal per year at par. Current market rates for comparable bonds are 7%.
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Fixed Income - Basic Concepts
Questions 9 – 12:9. Based on the above, investors can conclude:
A. they will pay a premium for the call optionB. the bonds were issued at a premiumC. the bonds do not have call protection
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Fixed Income - Basic Concepts
9. Based on the above, investors can conclude:
A. they will pay a premium for the call optionB. the bonds were issued at a premiumC. the bonds do not have call protection
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Fixed Income - Basic Concepts
9. Based on the above, investors can conclude:
A. they will pay a premium for the call option Benefit of call option accrues to the issuer
B. the bonds were issued at a premium Indeterminable: call option calls for a discount while
coupon variance calls for a premium
C. the bonds do not have call protection The call calendar begins from the date of issuance;
The bonds are callable but non-refundable at 105 for the first five years and 103 thereafter until maturity.
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Fixed Income - Basic Concepts
Questions 9 – 12 (cont.):10.Based on the above, which of the following
statements is least accurate regarding the sinking fund provision?
A. The bonds have an accelerated sinking fund provision.B. An investor would not benefit if their bonds were
redeemed under the provision.C. The issuer would benefit if they delivered cash against
the provision.
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Fixed Income - Basic Concepts
10. Based on the above, which of the following statements is least accurate regarding the sinking fund provision?
A. The bonds have an accelerated sinking fund provision.
B. An investor would not benefit if their bonds were redeemed under the provision.
C. The issuer would benefit if they delivered cash against the provision.
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Fixed Income - Basic Concepts
10. Explained• There was no provision for an accelerated
sinking fund.• Bond will be trading at a premium because
coupon rate > current market rate. Thus, a call at par would not benefit the investor.
• The issuer would likely deliver cash to the trustee (at par) rather than buying bonds at a premium in the open market to satisfy the call.
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Fixed Income - Basic Concepts
Questions 9 – 12 (cont.):11. Based on the above, if the bonds were
called on July 1, 2015, an investor who purchased the entire issuance would receive?
A. $10,300,000B. $10,500,000C. $10,000,000
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Fixed Income - Basic Concepts
11.Based on the above, if the bonds were called on July 1, 2016, an investor who purchased the entire issuance would receive?
A. $10,300,000B. $10,500,000C. $10,000,000
“The bonds are callable but non-refundable at 105 for the first five years and 103 thereafter until maturity.” Call between 1/1/10 – 12/31/15 = 105 x $10mln = $10.5mln Call between 1/1/16 – Maturity = 103 x $10mln = $10.3mln
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Fixed Income - Basic Concepts
Questions 9 – 12 (cont.):12. Based on the above, if the bonds were not
callable and had no sinking fund provision, they would have been issued at a ______ for $_______?
A. Discount, $9,554,269B. Premium, $10,455,395C. Premium, $10,459,801
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Fixed Income - Basic Concepts
12. Based on the above, if the bonds were not callable and had no sinking fund provision, they would have been issued at a ______ for $_______?
A. Discount, $9,554,269B. Premium, $10,455,395C. Premium, $10,459,801
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Fixed Income - Basic Concepts
12. Explained
N = 30, I/Y = 0.07/2 = 3.5%, PMT = 0.075/2 x $10mln = $375,000, FV = $10mln Compute PV = $10,459,801
Unless specified otherwise, bonds are assumed to be semiannual pay
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Fixed Income - Basic Concepts
13. An investor buying bonds on margin:
A. will pay higher funding costs than they would if using a repurchase agreement (repo)
B. pays interest on a loan collateralized by the bonds
C. loans the bonds to an institution “overnight”
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Fixed Income - Basic Concepts
13. An investor buying bonds on margin:
A. will pay higher funding costs than they would if using a repurchase agreement (repo)
B. pays interest on a loan collateralized by the bonds
C. loans the bonds to an institution “overnight”
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Fixed Income - Basic Concepts
13. Explained Margin loans require the payment of interest to
the lender and are typically at higher rates than a repurchase agreement.
A Repurchase agreement allows an institution to sell a security with a commitment to buy it back at a later date. Typically lower implied interest due to the fact that the “lender” holds the collateral during the term.
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Fixed Income - Basic Concepts
14. Which of the following is most likely a provision for the early retirement of debt?
A. A put optionB. A conversion optionC. A prepayment option
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Fixed Income - Basic Concepts
14. Which of the following is most likely a provision for the early retirement of debt?
A. A put optionB. A conversion optionC. A prepayment option
A prepayment option allows the borrower/issuer the right to prepay the loan balance prior to maturity
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Fixed Income - Basic Concepts
15. A mortgage is most likely:
A. an amortizing loanB. characterized by unstable cash flowsC. a bullet maturity loan
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Fixed Income - Basic Concepts
15. A mortgage is most likely:
A. an amortizing loanB. characterized by unstable cash flowsC. a bullet maturity loan Amortizing securities make periodic principle and interest
over the life of the bond, whereas a bullet maturity bond pays periodic interest over the life of the bond and a large principle payment at maturity.
Mortgages often have prepayment options, thus make cash flows unpredictable due to the possibility of prepayment.
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Fixed Income - Basic Concepts
16. A treasury quoted at 95:15 with par value of $100,000 has a dollar equivalent quote of:
A. $95,468.75B. $100,000.00C. $95,150.00
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Fixed Income - Basic Concepts
16. A treasury quoted at 95:15 with par value of $100,000 has a dollar equivalent quote of:
A. $95,468.75B. $100,000.00C. $95,150.00
95(15/32)% x $100,000 = 0.9546875 x $100,000 = $95, 468.75
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Fixed Income - Basic Concepts
17. A $1,000 par value TIPS bond carries a 3% semiannual coupon. If the annual inflation rate is 5%, what is the principal value of the bond and coupon payment after six months.
A. $1,030, $15.45B. $1,025, $15.38C. $1,050, $15.75
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Fixed Income - Basic Concepts
17. A $1,000 par value TIPS bond carries a 3% semiannual coupon. If the annual inflation rate is 5%, what is the principal value of the bond and coupon payment after six months.
A. $1,030, $15.45B. $1,025, $15.38C. $1,050, $15.75 Adjusted principle = $1,000(1+0.05/2) = $1,025 Coupon = new principle x coupon rate = $1,025(0.03/2)
= $15.375 ≈ $15.38
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Fixed Income - Basic Concepts
18. Ceteris paribus, put the following three equal par value bonds in order from highest to lowest value: (1) a Treasury note (T-note) principal strip that has six months remaining until maturity, (2) a Treasury bond (T-bond) coupon strip with six months remaining until maturity, and (3) a newly issued six-month Treasury bill (T-bill):
A. 1 < 2 < 3B. 3 < 2 < 1C. 1 = 2 = 3
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Fixed Income - Basic Concepts
18. Ceteris paribus, put the following three equal par value bonds in order from highest to lowest value: (1) a Treasury note (T-note) principal strip that has six months remaining until maturity, (2) a Treasury bond (T-bond) coupon strip with six months remaining until maturity, and (3) a newly issued six-month Treasury bill (T-bill):
A. 1 < 2 < 3B. 3 < 2 < 1C. 1 = 2 = 3
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Fixed Income - Basic Concepts
18. Explained: Assume 5% yield.
= =
$975.61 = $975.61 = $975.61
N=1; I/Y=5/2=2.5; PMT=0; FV=1,000CPT PV = $975.61
$1,000 T-Note POw/ 6-mo to
maturity
$1,000 T-Bond CIw/ 6-mo to
maturity
$1,000 6-mo T-Bill
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Fixed Income - Basic Concepts
18. Explained: “The reason why a distinction is made
between coupon strips and the principal strips has to do with the tax treatment by non-U.S. entities…”
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Fixed Income - Basic Concepts
19. Which of the following muni-bonds generally has the lowest risk with subsequently lower yields?
A. Revenue bondsB. Unlimited tax general obligation bondsC. Limited tax general obligation bonds
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Fixed Income - Basic Concepts
19. Which of the following muni-bonds generally has the lowest risk with subsequently lower yields?
A. Revenue bondsB. Unlimited tax general obligation bondsC. Limited tax general obligation bonds
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Fixed Income - Basic Concepts
20. A bond that is back-stopped by a 3rd party is referred to as a:
A. Prerefunded bondB. Double barreled bondC. Insured bond
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Fixed Income - Basic Concepts
20. A bond that is back-stopped by a 3rd party is referred to as a:
A. Prerefunded bondB. Double barreled bondC. Insured bond
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Fixed Income - Basic Concepts
20. Explained: Prerefunded bond: serviced by cash flows
generated from a pool of Treasury securities Double barreled: a special class of G.O. bond
issued with the full taxing authority of the issuer along with other resources: i.e., fees, grants, and special charges.
Insured bond: bond carrying a 3rd party guarantee
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Fixed Income - Basic Concepts
21. Which of the following bond types most closely matches a bond issuance where all bonds are sold at one time, with the same coupon rate and maturity?
A. Medium-term notesB. Corporate debenturesC. Shelf registered, SEC 415 bond
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Fixed Income - Basic Concepts
21. Which of the following bond types most closely matches a bond issuance where all bonds are sold at one time, with the same coupon rate and maturity?
A. Medium-term notesB. Corporate debenturesC. Shelf registered, SEC 415 bond
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Fixed Income - Basic Concepts
21. Explained
Medium-term notes: registered under SEC Rule 415 (shelf registration), meaning that they need not all be sold at one time, and are “shelved” at the discretion of the issuer to be sold over time.
Corporate debentures: an unsecured corporate bond, typically issued all at once, sold on a firm commitment (guaranteed) by the underwriting syndicate, and comprised of bonds with a single coupon rate and maturity.
Shelf registered, SEC 415 bond: a medium-term note.
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Fixed Income - Basic Concepts
22. Compared to bankers acceptances, negotiable CDs:
A. are less likely to defaultB. are more liquidC. have shorter maturities on average
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Fixed Income - Basic Concepts
22. Compared to bankers acceptances, negotiable CDs:
A. are less likely to defaultB. are more liquidC. have shorter maturities on averageNegotiable CDs are typically longer term and pay periodic interest versus shorter term bankers acceptances that pay no periodic interest. Both securities are as good as the credit rating of the issuing bank. CDs can be sold in the secondary market and have more liquidity than BAs.
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Fixed Income - Basic Concepts
23. Primary market activities for debt securities would most likely include:
A. a best-efforts offeringB. market makingC. over-the-counter transactions
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Fixed Income - Basic Concepts
23. Primary market activities for debt securities would most likely include:
A. a best-efforts offeringB. market makingC. over-the-counter transactions
Best-efforts offering, firm commitment, auction process are all primary market activities. Market making and OTC transactions are secondary activities.
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Fixed Income - Basic Concepts
24. A CDO will least likely be backed by which of the following security types:
A. preferred equitiesB. student loan receivablesC. CDOs
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Fixed Income - Basic Concepts
24. A CDO will least likely be backed by which of the following security types:
A. preferred equitiesB. student loan receivablesC. CDOs
By definition, a CDO is backed by a pool of debt instruments, which may include loans, mortgages, emerging market debt, corporate bonds, and ABS.
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Ethics & Professional Standards
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Fixed Income
Topic Area Weights for the CFA ExamTopic Area Level I
Ethical and Professional Standards (total) 15 Quantitative Methods 12 Economics 10 Financial Reporting and Analysis 20 Corporate Finance 8 Investment Tools (total) 50 Equity Investments 10 Fixed Income 12 Derivatives 5 Alternative Investments 3 Asset Classes (total) 30 Portfolio Management and Wealth Planning (total) 5
Total 100
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L I Ethics Item Set
CFA Sample QuestionsAnthony Buchard, CFA, disclosed a complaint by a former client on his annual professional conduct statement. The CFA Institute Professional Conduct Program sent Buchard a Notice of Inquiry and requested a copy of the client complaint. Buchard provided a copy of the complaint; however, several parts of the complaint were blackened out. Buchard refused to provide a complete copy of the complaint because it contained confidential client information. According to the Standards of Practice Handbook, Buchard should:A. provide a complete copy of the complaint to the Professional
Conduct Program.B. maintain all client information as confidential, including the
information contained in the client complaint.C. sign a confidentiality agreement with the client that requires
Buchard to keep the client complaint confidential.
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L I Ethics Item Set
CFA Sample QuestionsAnthony Buchard, CFA, disclosed a complaint by a former client on his annual professional conduct statement. The CFA Institute Professional Conduct Program sent Buchard a Notice of Inquiry and requested a copy of the client complaint. Buchard provided a copy of the complaint; however, several parts of the complaint were blackened out. Buchard refused to provide a complete copy of the complaint because it contained confidential client information. According to the Standards of Practice Handbook, Buchard should:A. provide a complete copy of the complaint to the Professional
Conduct Program.B. maintain all client information as confidential, including the
information contained in the client complaint.C. sign a confidentiality agreement with the client that requires
Buchard to keep the client complaint confidential.
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CFA Sample QuestionsProfessional Conduct Investigations by CFA Institute: “The requirements of Standard III(E) [Preservation of Confidentiality] are not intended to prevent members and candidates from cooperating with an investigation by CFA Institute’s Professional Conduct Program (PCP). When permissible under applicable law, members and candidates shall consider the PCP an extension of themselves when requested to provide information about a client in support of a PCP investigation into their own conduct.”
- Standards of Practice Handbook, 9th Ed., Pg. 79
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CFA Sample QuestionsBeth Patrick, a fixed income analyst at a brokerage company, assists her company’s traders by developing in-house bond ratings to supplement those of the major bond rating services. The traders use disparities in the ratings to construct profitable investment strategies. Patrick makes inferences from nonmaterial private information and news events, which she reflects in her bond ratings. Patrick’s approach: A. reflects the mosaic theory. B. violates confidentiality rules. C. violates insider trading rules.
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CFA Sample QuestionsBeth Patrick, a fixed income analyst at a brokerage company, assists her company’s traders by developing in-house bond ratings to supplement those of the major bond rating services. The traders use disparities in the ratings to construct profitable investment strategies. Patrick makes inferences from nonmaterial private information and news events, which she reflects in her bond ratings. Patrick’s approach: A. reflects the mosaic theory. B. violates confidentiality rules. C. violates insider trading rules.
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CFA Sample QuestionsMosaic Theory: “…The analyst may use significant conclusions derived from the analysis of public and nonmaterial nonpublic information as the basis for investment recommendations and decisions even if those conclusions would have been material inside information had they been communicated directly to the analyst by a company. Under ‘mosaic theory,’ financial analysts are free to act on this collection, or mosaic, of information without risking violation.”
- Standards of Practice Handbook, 9th Ed., Pg. 39
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