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Ethical and Professional Standards 【Reading 8】Sample

Which of the following statements is least accurate? It is permissible under the Standards to allocate trades:
A)
on a pro rata basis over all suitable accounts based upon account value.
B)
on a pro rata basis over all accounts.
C)
on a pro rata basis over all suitable accounts on the basis of an advance indication of interest and indicated order size.



Allocating trades on a pro rata basis, pro rata based upon order size (when there are too few shares to fill all orders, e.g., filling 2/3 of all orders actually submitted), or pro rata based upon an advance indication of interest are all permissible. However, accounts must be checked for suitability.

When a firm seeks to allocate a disproportionate number of shares of a hot IPO to performance-based fee accounts this constitutes a violation of the Standard concerning:
A)
additional compensation arrangements.
B)
fiduciary duty.
C)
priority of transactions.



The allocation of a disproportionate number of shares to performance-based fee accounts constitutes a violation of fiduciary duty, in addition to being a violation of the Standard concerning fair dealing.

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Alba Vasquez allocates trades of hot new IPOs as follows: m×p/(p+s) shares to performance-based fee accounts, m×s/(p+s) shares to standard fee accounts, where there are p suitable performance based fee accounts, s suitable standard fee accounts, and m shares available. This action is:
A)
not permissible since it effectively favors the performance-based fee accounts.
B)
not permissible since it is based upon a formula that is not inherently fair.
C)
permissible since it effectively amounts to a strict pro rata basis of allocation.



The formula shown above is nothing more than a simple pro rata basis of allocation (assuming that the shares are then subsequently allocated in the same fashion over all of the sub accounts by category). Hence, this is permissible.

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Concerning Standard III(B), Fair Dealing, which of the following statements is CORRECT? The Standard:
A)
concerns the dissemination of investment recommendations and the taking of investment action.
B)
concerns the dissemination of investment recommendations but is not concerned with the taking of investment action.
C)
is not concerned with the dissemination of investment recommendations so long as the taking of investment action is inherently fair.



Standard III(B), Fair Dealing is concerned with both the dissemination of investment recommendations and with the taking of investment action. It follows that this concern is irrespective of whether or not there has been a prior recommendation on the securities in question

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Mohawk Asset Management buys on-the-run Treasuries at auction for its standard fee accounts. When these move off-the-run, they are placed in performance-based accounts via in-house cross-trades at prevailing market prices, and replaced in the standard fee accounts with new on-the-run issues. Which standard is violated, if any?
A)
The Standard concerning Priority of Transactions.
B)
No Standard is violated.
C)
The Standard concerning Fiduciary Duty.



In addition to being a violation of the Standard concerning Fair Dealing, this constitutes a violation of Mohawk’s Fiduciary Duty. Why? Because the on-the-run issues are benchmarks and trade at lower yields than the off-the-run issues. In essence, the off-the-run issues have marginally higher returns, and this will boost the returns in the performance-based fee accounts. Mohawk is allocating trades based upon compensation arrangements, and this is not permissible under the Code and Standards.

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Rey Sanchez, CFA, covers the specialty chemical industry for Rock Advisory Associates. Until today he has had a buy recommendation on ChemStar, and many of the firm’s customers have purchased shares based upon his recommendation. The firm’s client accounts are divided into two fundamental categories: trading and buy-and-hold accounts. The firm holds discretionary trading authority over the trading accounts, but not the buy-and-hold accounts. Sanchez has recently come to believe that the fundamentals are changing for the worse at ChemStar, and is preparing a sell recommendation. He calls a meeting of the firm’s portfolio managers with accounts holding ChemStar and tells them of the pending release of the sell recommendation. On this basis, the portfolio managers sell all positions in the discretionary accounts but not in the buy-and-hold accounts. Sanchez completes and mails the report to all clients two days later, and, shortly thereafter, many of the buy-and-hold accounts sell their ChemStar positions. With regard to these actions, Sanchez is:
A)
in violation of the Standard on Fair Dealing; the portfolio managers are in violation of the Standard on Fair Dealing.
B)
not in violation of the Standard on Fair Dealing; the portfolio managers are in violation of the Standard on Fair Dealing.
C)
in violation of the Standard on Fair Dealing; the portfolio managers are not in violation of the Standard on Fair Dealing.



Sanchez is in violation of the Standard III(B), Fair Dealing, since he has disseminated his recommendation preferentially to the portfolio managers in advance of making the report available to all clients who hold shares of ChemStar. The portfolio managers are in violation of the Standard since they are effectively giving preferential treatment to the trading accounts over the buy-and-hold accounts in the placement of orders based upon the change in recommendation

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Rickard Advisors recently had a trading error in a customer account that was subsequently covered by Rickard. The firm felt embarrassed by the disclosure of this error, and, in order to induce the client to continue its relationship, Rickard offers the client preferential access to a new issue that is expected to be “hot.” Which Standard is violated, if any?
A)
The Standard concerning Fiduciary Duty.
B)
The Standard concerning Fair Dealing.
C)
The Standard concerning Independence and Objectivity.



Rickard is in violation of the Standard concerning Fair Dealing by offering the client preferential access to a “hot” new issue. There is no obvious violation of Fiduciary Duty, since there is no evidence that Rickard is placing its own financial interest ahead of the client.

TOP

Which of the following statements regarding allocating trades is CORRECT? It is:
A)
never permissible to deviate from a proportional account value weighting method of trade allocation, unless this is done on the basis of an advance indication of interest in the issue.
B)
never permissible to deviate from a pro rata basis, unless this is done on the basis of an advance indication of interest in the issue.
C)
permissible under the standards to allocate trades on the basis of a predetermined formula that may deviate from a pro rata basis but is inherently fair.



If the firm has developed an allocation procedure that is formula-based, inherently fair, and the details are disclosed to clients, it is possible to deviate from a pro rata allocation basis.

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Pro rata allocation on the basis of an advance indication of interest means each account for which the shares are suitable:
A)
and which has expressed an advance indication of interest, shall receive m/n shares, where there are m shares available and indications of interest for n shares.
B)
shall receive m/n shares, where there are m shares available and n such accounts.
C)
and which has expressed an advance indication of interest, shall receive w*m shares, where w is the account's proportional value of all such accounts and there are m shares available.



Pro rata allocation on the basis of an advance indication of interest means that all accounts that have expressed an interest in the issue shall receive m/n shares, where there are m shares available and indications of interest for n shares.

TOP

Which of the following trade allocation procedures is improper? Allocation:
A)
based upon past participation in IPOs.
B)
on a strict pro rata basis over all suitable accounts.
C)
based upon a predetermined formula.



Participation in prior IPOs does not insure suitability for subsequent IPOs. Moreover, this method of allocation could result in a fairness problem, since larger accounts are more likely to have had a greater level of participation in past IPOs.

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