2023 CFA L2 Book 4 PM Ethics

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JuiceNotes 2023
Portfolio Management| Ethics
Chartered Financial Analyst - Level II

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INDEX
Portfolio Management
Name of Reading
38 Exchange Traded Funds: Mechanics & Applications 5
39 Using Multifactor Models 10
40 Measuring And Managing Market Risk 13
41 Backtestibg and Simulation 17
42 Economics And Investment Markets 19
43 Analysis Of Active Portfolio Management 22
44 Trading Costs and Electronic Markets 25
Ethics
Name of Reading
45 Ethics and Trust in Investment Profession 39
46 Code of Ethics 40
47 Guidance of Standards I-VII 41
48 Required Vs Recommended 64
Portfolio Managements
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Notes Notes
Exchange Traded Funds: Mechanics &

Applications
LOS a Factors for Rising popularity of ETFs
Ÿ Low cost
Ÿ Exchange access
Ÿ Holdings transparency
The Creation/Redemption Process
ETF Creation Process ETF Redemption Process
Step 1: AP acquires securities Step 1: AP exchanges ETF

in creation basket shares for underlying
from public markets basket of securities
or own inventory with ETF manager
Step 2 : Securities basket Step 2: AP sells securities

delivered to ETF basket or redemption
manager in exchange basket in public
for equal number of market
ETF shares at market
close.
LOS b Describe how ETFs are traded in secondary markets
Ÿ All trades in US are submitted to NSCC
Ÿ NSCC becomes guarantor of a stock transaction between two parties
Ÿ Trades are settled and cleared centrally within 2 business days.
European trading and settlement:
ª Trading is similar to the US
ª Trading & settlement system are fragmented which may lead to wider spreads & trading
costs.
5
Describe sources of tracking error for ETFs
LOS c Describe sources of tracking error for ETFs
Expense Ratios Index Tracking/Tracking Error
Types of index tracking for ETF:

Ÿ Daily differences
Ÿ Periodic tracking
ETFs charge lower fees compared to
Sources of tracking error:
mutual funds
Ÿ Fees and expenses
Managing ETFs’ costs depend on:
Ÿ Representative
Ÿ Portfolio complexity sampling/optimization
Ÿ Depository receipts and ETFs
Ÿ Issuer size, economies of scale
Ÿ Index changes
Ÿ Competitive landscape Ÿ Fund accounting practices
Ÿ Regulatory and tax requiremets
Ÿ Asset manager operations
LOS d Describe factors affecting FTFs bid-ask spreads
Driver of ETF bid-ask spreads are market structure and liquidity of underlying
securities held
ETF bid-ask spreads are Bid/ask spreads

ETF bid-ask spreads
generally less than or are narrow for
with
equal to
Ÿ +Creation/redemption fees
and other direct trading
costs
Ÿ Amount of ongoing order
flow (measured by daily Ÿ +Bid-ask spreads
share volume) securities held in the ETF
Ÿ Amount of competition Ÿ +Compensation (to the

Ÿ Large, actively traded ETFs
among market makers for market maker or liquidity
the ETF provider) Ÿ Liquid ETFs
Ÿ Costs and risks for the Ÿ +Market maker’s desired

liquidity provider profit spread
Ÿ -Discount related to the

likelihood of receiving an
offsetting ETF order in a
short time frame
6
LOS e Describe sources of ETF premiums & discounts to NAV
Ÿ End-of-day ETF premium or discount (%) =(ETF price - NAV per share) / NAV per share
Ÿ Intradary ETF premium or discount (%) = (ETF price - iNAV per share) / iNAV per share
Factors driving premiums/discounts:
Ÿ Timing differences
Ÿ Stale pricing
LOS f Describe costs of owning an ETF
Types of costs of ETF ownership (TOTT):

Ÿ Transaction costs : incurred at purchase & sale regardless of holding period
Ÿ Ongoing Costs : Management fees, portfolio turnover, security lending proceeds
Ÿ Trading costs : Bid ask spreads & commissions : incurred only at purchase or sale and return impact
diminishes over longer holding periods
Ÿ Tracking error: an implicit cost, can be positive or negative
Ÿ Other implicit trading costs-portfolio turnover costs: reflected in fund returns and incurred when
portfolio manager buys/sell securities to execute investment strategy
Total cost = Round-Trip Trading Cost +Management fees
Round-Trip Trading Cost = Round - Trip Commission +Spread
LOS g Describe types of ETF Risk
Counterparty Risk Fund Closures Expectation related risk.
ETFs based on complex

Funds may close due to following strategies (e.g., inverse or
reasons: leveraged ETFs) may
introduce the investor to
Ÿ Settlement risk Ÿ Regulation risks that they may not
fully comprehend (i.e., the
Ÿ Security lending Ÿ Competition
outcomes may differ from
Ÿ Corporate actions investors expectations).
Ÿ Soft closures - do not involve These complex ETFs might

actual fund closing such as use derivative products to
creation halts or changes in implement their investment
investment strategy: strategy that must reset
daily (i.e. have daily
settlement).
7
LOS e Identify and describe portfolio uses of ETFs
ETF Strategies
Primary applications of ETFs include:
Ÿ Protfolio efficiency
Ÿ Asset class exposure management
Ÿ Active and factor Investing
Asset Class Exposure Management
Types of ETF exposures based on asset class
Equity Commodity Fixed Income
Ÿ Domestic small cap

Ÿ Gold Ÿ Government or corporate
Ÿ Domestic large cap debt of various maturities
Ÿ Other metals
Ÿ Sectors Ÿ Emerging market debt
Ÿ Broad commodity indexes
Ÿ Dividend growth Ÿ Bank loans
Ÿ Agriculture Products
Ÿ Momentum Ÿ Floating interest rate
Ÿ Oil strategies
Ÿ Industries
Ÿ International regions or
countries with/without
currency exposure
8
Active and Factor Investing
Ÿ Factor (smart beta) ETFs: Factor ETFs are benchmarked to an index with predefined rules for
screening and/or weighting constituent securities
Ÿ Risk Management : Some smart beta ETFs focus on achieving higher or lower risk relative to their
asset class benchmark
Ÿ Alternatively, weighted ETFs :ETFs which use weighting schemes other than market capitalization
for constituent stocks can be used to implement investment views.
Ÿ Discretionary active ETFs : Largest actively managed ETFs are in fixed income where passive
management is less prominent compared to equities.
Ÿ Liquid alternative ETFs : Attempt to deliver absolute return performance and/or risk diversification
of stock and bond holdings
Ÿ Dynamic asset allocation and multi-asset strategies : Dynamic asset allocation strategies may
allocate holdings on the basis of their risk contribution while others are return focused, but all
strategies involve adjustments back to target weights. These strategies are either implemented in-
house or by hiring external managers offering multi asset strategies.
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9
An Introduction To Multifactor Models

LOS a Arbitrage pricing theory (APT)
ª Alternative to CAPM
ª Linear model with factors that capture systematic risk
ª No fixed number of factors
Assumptions
ª Returns are generated using a factor model
ª Unsystematic risk can be eliminated in a portfolio
ª No arbitrage opportunities exist
APT equation:
Rp = RFR + β1 × Factor risk premium1 + β2 × Factor risk premium2 + .... + βn × Factor risk premiumn
Pure factor portfolio:

Rp = RFR + β1 × Factor risk premium1
Unlike CAPM, APT does not require one of the factors to be ERP
LOS b Arbitrage opportunity

Eg. Portfolio Factor beta Expected return
A 2 20%
B 1 12%
C 1.5 14%
W1 × 2 + W2 × 1 = 1.5 2 1
W1 = 50%, W2 = 50%
1.5
0.5 × 20% + 0.5 × 12% = 16%
Take long position on portfolio A and B and short 0.5 0.5

position on portfolio C to earn an arbitrage of 2%
LOS c Calculate factor risk premium

Eg. Stock Factor beta Expected return
A 0.9 17%
B 1.7 25%
Calculate RFR and factor risk premium

Œ Use DATA function (2nd 7)
Enter X values as beta and Y values as expected return
Ž Use STAT function (2nd 8) → a = 8% (RFR)
Expected return = RFR + (β × FRP) 17 = 8 + 0.9 × FRP FRP = 10%

10
LOS d Types of multifactor models
Macroeconomic Fundamental Statistical

factor models factor models factor models
Factors are firm-specific and

Factors are surprises in stated as returns (not
macroeconomic variables surprises)
Statistical methods are applied
Factors: Factors:
to historical returns to
Interest rates, credit spread, P/E ratio, P/B ratio, market
determine factors that explain
inflation risk, and cyclical risk cap, financial leverage
the observed returns
Surprise: Betas are standardized
Types:
Actual value − Estimated value
Analysis models: Factors are
Standardized beta:
portfolios that explain
Intercept ‘E(Ra)’ is derived - (Actual value − Mean value)/σ
covariance in returns
from APT model
Standardization allows us to
Principal component models:
Equation: use fundamental factors
Factors are portfolios that
Ra = E(Ra) + β1F1 + β2F2+ .... + measured in different units in
explain variance in returns
βnFn + ε the same factor model
ε: Firm-specific surprise Intercept is not interpreted as

the expected return
LOS e Active return: Return on portfolio (Rp) − Return on benchmark (RB)

Active risk: SD of active return
Aka tracking error or tracking risk
Active return
Information ratio:
Active risk
LOS f Uses of multifactor models
Performance attribution Risk analysis
Return attribution Risk attribution
Active Active
Factor Security
factor specific
return selection
risk risk
Multifactor models are useful in both active and passive management

Passive management → Tracking portfolio
Passive management → Factor portfolio
An investor can achieve better diversified and efficient portfolio by
using SMB, HML, and WML factors
11
LOS g Potential benefits for investors in using a multifactor model
Generally, an investor gains from accepting above-average (below-average) risk that
he has comparative advantage (comparative disadvantage) in bearing
12
Measuring And Managing Market Risk

LOS a Value at risk (VaR)
It is the estimate of minimum loss that is expected over a certain time period
Can be expressed in currency units or % of portfolio value
VaR can be daily, weekly, monthly or any other period
5% monthly VaR of $1 mln means that there is a 5% probability that the

company will experience a loss of at least $1 mln in one month
VaR
LOS b & c Methods for estimating VaR
Historical Monte Carlo

Parametric
simulation simulation
Aka variance-covariance Based on users assumptions

method of distribution for each risk
factor
Generally assumes risk
factors are normally Simulation must also take
distributed Based on the actual changes correlation of assets into
in risk factors experienced account
Uses estimated variances during the lookback period
and covariances of portfolio This method will produce
securities Advantages: same result as the
Based on actual events parametric method, if
VaR is estimated using No assumption of normality sample size is extremely
expected return and SD for Can be used when portfolio large
each risk factor contains options
Advantages:
σp = (W1σ1)2 + (W2σ2)2 Weakness: No certainty that Flexible to handle more
√
+ 2W1σ1W2σ2 x r historical event will re-occur complex distributions
No assumption of normality
Advantage: Simple to use
Weaknesses:
Weakness: Not useful when Complex calculation
portfolio contains options Time consuming process
Lookback period: Time period used to estimate expected return and SD for each risk factor
13
LOS d Advantages and limitations of VaR
Advantages Limitations
Easy to understand Subjective method
Using normal distribution leads to

Easy to communicate
understatement of downside risk
VaR could be understated if some assets in a

Useful in comparing risks across asset classes
portfolio are illiquid
Correlation risk can understate potential

Helps in capital allocation decisions
losses
If the lookback period has low volatility, VaR

Can be used for performance evaluation
will appear to be low
Needs to be supported by additional risk

Reliability can be verified by backtesting
measures
Widely accepted by regulators Ignores right tail events
LOS e Extensions of VaR

CVaR: Conditional VaR
Aka expected tail loss or expected shortfall
Calculates average loss beyond the VaR cutoff
IVaR: Incremental VaR
Change in VaR for a given change in the size of
portfolio position
MVaR: Marginal VaR

Similar to IVaR except that MVaR uses formulas
derived from calculus to reflect the change in VaR
for a given change in the size of portfolio position
Approximately equals to change in VaR for $1
or 1% change in portfolio position
Relative VaR: Aka Ex ante tracking error
VaR of the difference b/w the return on portfolio
and the return on benchmark portfolio
LOS f & g Other risk measures

Sensitivity Scenario risk
risk measures measures
Used to estimate the change in portfolio value Used to estimate the change in portfolio value
for a given change in risk factor for changes in multiple risk factor
For equity: Beta Hypothetical scenario: Extreme movements

that have not occurred previously can be used
For bonds: Duration and convexity
Historical scenario: Based on movements that
For options: Delta, Gamma, and Vega have actually occurred in the past
14
LOS h Use of sensitivity risk measures and scenario risk measures
Sensitivity risk measures and scenario risk measures allow a
risk manager to hedge appropriately
Stress testing: Using extreme changes to examine the

expected effects on a portfolio or the organization
Reverse stress testing: Targeting most significant exposures

and assessing their behavior in various environment
LOS i Advantages and limitations of sensitivity

risk measures and scenario risk measures
ª VaR, sensitivity analysis, and scenario analysis complement each other
ª Sensitivity and scenario risk measures provide estimates of change in value of

portfolio, but no estimate of the probability of changes in risk factors
LOS j Applications of risk measures
Pension fund
Banks Life insurers
managers
Banks use risk measures Pension fund managers use

for: risk measures for:
Pension fund managers use
risk measures for:
Œ Asset-liability mismatch Œ Asset-liability mismatch
Leverage Surplus at risk
Œ Sensitivities
Ž Sensitivities Ž Glide path
Asset-liability mismatch
Overall risk to economic Interest rate and curve
capital risk
Asset
P&C insurers
managers
Asset managers use risk

measures for:
Banks use risk measures
for:
Œ Position limits
Sensitivities
Œ Sensitivities
Ž Liquidity
Economic capital
Redemption risk
Probability of losses
15
LOS k Constraints used in managing market risks
Risk budgeting: Allocation of total risk to different activities,
strategies or asset classes
Scenario limits: Limits on estimated loss for a given scenario
Stop loss limits: Require reduction in size of a portfolio, if losses
exceed a specified amount in a specified period
Position limits: Limit on allocations to securities within an asset class
LOS l Application of risk measures in capital allocation decisions

Optimal capital allocation is the allocation that maximizes the firm’s expected return
but portfolio manager should also consider risk exposure for each use of capital
16
BackTesting & Simulation

LOS a Describe objectives in backtesting an investment strategy
Techniques used to evaluate investment strategies
Back Testing Historical scenarios Simulation Sensitivity

Analysis
Tests a strategy Tests a strategy Tests a strategy To uncover the

in in in impact of
a historical a specific a hypothetical changing key
environment historical environment assumptions
environment
LOS b&c Describe steps and procedures in back testing an investment strategy
Step 1 - Strategy design Step 2 - Historical Step 3 - Analysis of

simulation backtesing output
Specify investment Form investment

hypothesis and goals portfolios for each period
according to the rules
Calculate portfolio
Determine investment specified in previous step
statistics and other key
rules and process metrics
Rebalancing the portfolio
Decide key parameters periodically based on
pre-specified rules
LOS d Identify the problems in backtesing
Problems in a backtesting of an investment

strategy
Survivorship Look ahead

Data Snooping
Bias Bias
Using information that was

Deriving conclusions from the Making inference after looking
unknown or unavailable during
data that reflect only those at statistical results rather
the historical period over
entities that have survived to than testing the data prior
which the backtest is
that date inference
conducted
LOS e Evaluate and interpret a historical scenario analysis
Historical scenario analysis is a type of backtesting that explores the performance

and risk of an investment strategy in different structural regimes.
Eg of structural regimes - Changes from economic expansion to recession
LOS f&g Contrast historical and Monte carlo simulation approaches
Historical Simulation Monte Carlo Simulation
Ÿ Implement a strategy at some past Ÿ Each key variable is assigned a statistical

date and collecting results as the distribution and observations are drawn
strategy runs over time at random from the assigned
distributions.
Ÿ This approach assumes “Past asset
returns provides some guidance about Ÿ It is highly flexible and an array of
future returns” different distributions can be used across
variety of key variables
Ÿ Particularly used by banks for market
risk analysis Ÿ This kind of Simulation is especially
useful in measuring the downside risk of
investment strategies
Ÿ It is complex and computationally

intensive.
LOS h Use of sensitivity analysis
It is a Techniques for exploring how a target variable is affected by changes in input variables
For eg. Changes in beta affect the value of equity portfolio
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Economics And Investment Markets

LOS a Components of the discount rate
Œ Real rate
Expected inflation
Ž Risk premiums reflecting uncertainty about the CF
More uncertain the CFs, higher the discount rate
Value of an asset will change if;

RFR changes, or
CF forecasts change, or
Risk premiums change
Risk premiums vary across assets (and asset classes),

as well as with changes in investors’ risk perception
LOS b Role of expectations in market valuation

Market prices reflect current expectations. Only changes in
expectations cause market price to change
LOS c Relationship between GDP growth and volatility

of GDP growth with short-term interest rates
Interest rates are positively related to GDP growth and to the volatility in GDP
growth due to a higher risk premium
Marginal utility of consumption in future

Inter-temporal rate of substitution (mt):
Marginal utility of consumption today
Marginal utility of consumption in future < Marginal utility of consumption today
mt is used to obtain the real rate
1 − P0
Real rate:
P0
Lower the value of mt, higher the real rate
Higher the utility for current consumption, higher the real rate
Investors’ marginal utility of consumption declines as wealth increases
Marginal utility of consumption is higher during economic contraction
If investors expect higher incomes in the future, their expected marginal utility
of future consumption is decreased relative to current consumption
If expected returns are high or there is high uncertainty about future income,
there will be an increase in savings
Investors experience a larger loss of utility for a loss in wealth as compared with
a gain in utility for gain in wealth. This is called as risk-aversion
Risk aversion can be explained by the covariance of investor’s inter-temporal
marginal rate of substitution and expected returns on savings
19
LOS d Effects of business cycle phases
Interest rate for short-term securities: Real rate + Expected inflation
Interest rate for long-term securities: Real rate + Expected inflation + Risk premiuminflation
Investor expectation about higher future GDP growth leads to +ve slope of yield curve
Central bank’s policy rate according to Taylor rule:

Rn + InflationCurrent + 0.5(InflationCurrent – InflationTarget) + 0.5(GDP growthCurrent – GDP growthTarget)
Rn = Neutral real rate
Policy rates tend to be lower in recessionary environment and higher in expansionary environment
Yield curve is +ve because normal term spread (YTM on long-term bond – YTM on short-term bond) is +ve
LOS e Factors that affect yield spreads between non-inflation

adjusted and inflation-indexed bonds
Break-even inflation rate (BEI): YTM on non-inflation-adjusted bond – YTM on inflation-indexed bond
Or Expected inflation + Risk premiuminflation
LOS f Effects of business cycle phases on credit spreads

Rate of return for credit risky bonds:
Real rate + Expected inflation + Risk premiuminflation + Risk premiumcredit risk
Credit spreads tend to rise during the times of economic weakness and
fall during expansions
When credit spread narrows (widens), credit risky bonds outperform

(underperform) risk-free bonds
LOS g Effects of characteristics of the markets for a

company’s products on company’s credit quality
ª Spreads differ among sectors and over time
ª Spreads differ due to differences in industry products

and services and the financial leverage of the firms
LOS h Effects of business cycle phases on short-term

and long-term earnings growth expectations
ª Cyclical industries tend to be extremely sensitive to the phase of business cycle.
Their earnings rise during expansion and fall during contraction
ª Non-cyclical industries tend to be stable throughout the business cycle
LOS i Relationship between the consumption-hedging properties of equity and ERP

Equity prices are generally cyclical
They have poor consumption hedging property
Discount rate = Real rate + Expected inflation + Risk premiuminflation + Risk premiumcredit risk + ERP
Because equities have poor consumption hedging property, ERP is +ve
20
LOS j Cyclical effects on valuation multiples
Multiples rise during expansion and fall during contraction (factoring in expected growth)
Price multiples are positively correlated with expected earnings growth rates and
negatively correlated with required returns
LOS k Application of economic analysis in sector rotation strategies
An investors would generate superior returns if he could rotate out of the under-performing
sector and into the better performing sector right before the change in performance
Understanding the relationship b/w equity market performance of different sectors and the
business cycle would help analysts enhance their sector rotation strategies
Ex post risk premiums on equity = Average return on a sector − Short term RFR
LOS l Economic factors affecting investment in commercial real estate

ª Commercial real estates have both bond-like and equity-like characteristics
ª Discount rate:
Real rate + Expected inflation + Risk premiuminflation + Risk premiumcredit risk + ERP + Risk premiumilliquidity
ª Rental income is relatively stable across business cycles, but property values tend to be very cyclical
ª Similar to equities, real estates have poor consumption hedging property
21
Analysis Of Active Portfolio Management

LOS a Measuring value added by active management
Active return: Return on portfolio (Rp) − Return on benchmark (RB)
∑(Active weights × Return)
Can be measured ex-ante (based on forecasted returns) or ex-post (based
on actual returns)
Active return can be decomposed into two parts:
Sector allocation (changing weights) return and security selection return
Active weights: Weight of security in portfolio (Wp) − Weight of security in benchmark (WB)
Overweighted securities: +ve active weights
Underweighted securities: −ve active weights
LOS b
Information ratio (IR) Sharpe ratio (SR)
Active return
Active risk Rp − RFR
σp
Generally;
Ex-ante ratio is +ve, and Unaffected by the
Ex-post ratio is −ve addition of cash or use of
leverage in the portfolio
Affected by the addition
of cash or use of leverage Sharpe ratio of a
in the portfolio portfolio with optimal
level of active risk:
Unaffected by the
aggressiveness of the SR2P = SR2B + IR2, Or
active weights (for SR2P = SR2B + TC2IR2
unconstrained portfolio)
ª Closet index fund: An actively managed fund that closely tracks the benchmark index
ª They have low IR, low active risk and Sharpe ratio that is similar to the benchmark index
ª Fund with zero systematic risk that uses RFR as a benchmark: IR = SR
ª Optimal level of active risk (σA): IR/SRB × σB Or IR/SRB × σB × TC
ª Total risk of the portfolio (σ2P): σ2A + σ2B
22
LOS c Fundamental law of active portfolio management
Forecasted
active return
In
C)
fo
(T
rm
Cor (μi/σi, ∆Wiσi) Cor (RAi/σi, μi/σi)
at
en
io
(Correlation b/w (Correlation b/w
ci
n
ffi
forecasted returns and realized active returns
co
oe
effi
risk adjusted weights) and forecasted returns)
c
er
ci
sf
en
an
t
(I
Tr
C)
Active Realized
weights active return
Value added
E(RA) = IR × σA
IR = IC × √BR
Or
IR = TC × IC × √BR
Grinold rule: μ = IC × σi × Si
N
Breadth (BR):
1 + (N − 1) × r
μi σA
Optimal weight for a security (∆Wi): 2
×
σ i
IC × √BR
E(RA/ICR): TC × IC × √BR × σA
RA: E(RA/ICR) + Noise
TC2 1 − TC2
LOS d Uses of information ratio (IR)
Investors choose combination of risk-free asset and an optimal risky portfolio

(portfolio with the highest Sharpe ratio)
Portfolio that has the highest IR will also have the highest SR
Therefore, investors will choose the active portfolio manager with the highest IR
IR can also be used to determine the expected active return
LOS e Uses of fundamental law of active management
ª Information coefficient (IC) for a market timer: 2(% correct) – 1
ª The fundamental law of active management can be used to evaluate

security selection, market timing and sector rotation strategies
23
LOS f Strengths and limitations of the fundamental law of active management
Components of fundamental law of active management:
Œ Skill (measured by IC)
Portfolio structuring (measured by TC)
Ž Breadth (measured by number of independent decisions per year)
Aggressiveness (measured by active risk)
Strengths: Can be used to evaluate security selection, market timing,

and sector rotation strategies
Limitations: Uncertainty about ex ante IC and definition of breadth
24
Trading Costs and Electronic Markets

LOS a Explain the components of execution costs, including explicit and
implicit costs
Trading costs include fixed costs and variable costs . Fixed trading costs for buy-and-hold
institutions include costs of:
Ÿ Hiring buy and hold traders
Ÿ Equipping them with proper trading tools
Ÿ Office space
Variable transaction costs include:
Explicit costs : Represent direct costs of trading (broker commission costs, transaction costs, stamp
duties, and fees paid to exchanges)
Implicit costs : Indirect costs caused by market impact of trading (price concessions traders make to
complete their trades is known as market impact costs)
Sources of implicit costs:
Bid ask spread : Spread = Ask price - bid price
Market impact : Effect of trade on transaction prices. Larger orders have greater market impact than
smaller orders
Ÿ Delay costs (also called slippage): Arise from the inability to complete the desired trade immediately
Ÿ Opportunity costs (or unrealized profit/loss): Arise due to a failure to execute a trade promptly
LOS b Calculate and interpret effective spreads and VWAP transaction cost
estimates
Ÿ Dealers provide liquidity to other traders who want to buy/sell securities by trading from their own
account’s inventory.
Ÿ When buying interest > selling interest, dealers raise ask prices to discourage buyers and raise bid
prices to encourage sellers
Ÿ When buying interest < selling interest, dealers lower ask price to encourage buyers and raise bid
price encourage sellers.
Ÿ Dealers are useful in markets which are infrequently traded because they are always willing to take
the other side of the trade and thus makes market more continuous
25
Bid-Ask Spreads and Orders Books
ª Bid price: Price at which dealer will buy securities

ª Ask (or offer) price: Price at which dealer will sell securities
ª Bid ask spread = Ask price - bid price
ª Best bid or inside bid: Offer to Buy with the highest bid price
ª Best offer or inside ask: Offer to sell with the lowest ask price
ª Inside or market bid-ask spread: Best ask price -best bid price
ª Midquote price : (Market bid+Market ask price)/2
Ÿ Inside bid-ask spread will be lower than the individual dealer spreads if the dealer with the highest bid
price is not the dealer with the lowest ask price.
Ÿ Large orders may not fill at a specific bid or ask price and will have price impact as they move down the
limit order book.
Implicit Transaction Cost Estimates

Investment mangers use the following methods to estimate implicit Transaction Costs:
Ÿ Effective spread
Ÿ Implementation shortfall
Ÿ Volume-weighted average price (VWAP)
Effective Spreads
Market spread is a measure of trade execution costs and measures how much traders would lose per
quantity traded if they simultaneously submit buy and sell market orders at respective bid and ask prices.
Ask
Effective Spread : = Trade size xTrade price - Bid+ For Buy Orders
2
Ask
Effective Spread : = Trade size x Bid+ -Trade price For Sell Orders
2
26
When a buy order is filled at the ask,

Implicit cost of trading = [(Ask – Bid)/2] Effective spread = Implicit cost of trading x 2
Effective spread = Market spread if buy orders are submitted at ask prices or sell orders are submitted at
bid prices
Price improvement occurs when buy order fills at a price lower than ask price or sell order fills at a price
higher than offer price and when effective spread < quoted spread.
Effective spread > quoted spread when order fills at a price outside quoted spread and trade execution
prices are worse than quoted prices
Shortcomings of effective spread
Effective spread is a poor estimate of transaction costs for large trades which must be split for
execution over time. This increases market impact
Effective spreads do not measure delay (or slippage) costs.
Delay costs: Arise from the inability to complete desired trade immediately because size > available
market liquidity
Opportunity cost
Costs associated with unfilled orders when there are delays in order execution.
Eg.: Order to buy 10 contracts with a limit price of 99.00 which is good for one day when the market
quote is 99.01 to 99.04. If order doesn’t execute and contract closes at 99.80, the order could have
been filled at 99.04 and opportunity cost per contract is 0.76 (99.80 – 99.04).
VWAP Transaction Cost Estimates

VWAP represents the most widely used benchmark prices for estimating transaction costs.
VWAP transaction cost estimate = Trade size x Trade VWAP - VWAP Benchmark (For Buy Orders)
VWAP transaction cost estimate = Trade size x VWAP benchmark - Trade VWAP (For Sell Orders)
Advantages of VWAP Disadvantages of VWAP
Easy to interpret Interpreting VWAP transaction cost

estimates are problematic when trades are
Allows trader to determine whether trade a significant portion of VWAP benchmark or
is better or worse than average trading take place at the same rate as of other
price benchmark trades &
VWAP benchmark = Traded VWAP (trades
are not costly)
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LOS c Implementation shortfall approach to transaction cost measurement.
Implementation Shortfall
Implementation shortfall method captures implicit and explicit trading costs. The measure includes:
Ÿ Market impact costs
Ÿ Delay costs
Ÿ Opportunity costs
Measurement of trading costs: Implementation shortfall = Paper Value – Actual Value

Paper value is based on prevailing prices (or generally midquote price) at the time of the trade
decision.
LOS d Factors driving the development of electronic trading systems.

Both exchanges and traders rely on electronic trading systems.
Exchanges relying on Traders relying on Widespread usage of

electronic trading electronic trading electronic trading
systems systems systems
Decrease in trading costs for

Smaller number of traders buy-side traders.
being able to process more
Arrange trades by matching orders and more efficiently Greater efficiencies for
buy and sell orders exchanges and traders
Generate orders that are
Generate orders produced by processed by the exchange Narrow bid-ask spreads as
electronic traders benefits of new technologies
Implement their electronic are passed from arbitrageurs
trading strategies and dealers to buy-side
traders.
ª Electronic bond order-matching systems exist but they primarily serve dealers and not public
investors.
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Advantages of Electronic Trading Systems

Compared with floor-based trading systems, advantages enjoyed by electronic order-matching
systems include:
Ÿ Cheap to operate once built
Ÿ Do not require exchange officials to record and report prices
Ÿ Precisely enforces the exchange’s trading order precedence and pricing rules without error or
exception when properly programmed
Ÿ Have the ability to perfect audit trails
Ÿ Support hidden orders by keeping them perfectly hidden
Ÿ Can operate on a continuous, “around-the-clock” basis
Ÿ Can operate under all weather conditions or events which otherwise prevent workers from
convening on a floor
Ÿ Electronic trading systems have displaced floor-based trading systems in all instruments for which
order-driven markets are viable. These markets are now organized by most exchanges and electronic
communication networks.
Ÿ Computers have come to dominate the implementation of many trading strategies
Electronification of Bond Markets

Most public investors in corporate and municipal bond markets still trade over the counter with
dealers. This market has great potential for electronic trading systems. Limit order book trading
systems will not be successful for these bonds because buyers and sellers are rarely present at the
same time.
Electronic Bond Order-matching systems exist but they primarily serve dealers and not public
investors.
LOS e Market fragmentation
ª Market fragmentation: Trading the same instrument in multiple venues. Market fragmentation
increases potential for price and liquidity differences across venues.
ª For example, trading of exchange-listed equities is now divided among several exchanges, alternative
trading systems, and numerous dealers.
ª Traders respond to market fragmentation by searching for liquidity across multiple venues and time to
control market impact of large trades.
Trading techniques used by traders to manage market fragmentation
Liquidity aggregators: Offer global view of market depth (liquidity) for a given instrument regardless of
trading venue
Smart-order routing algorithms send orders to markets that display the best-quoted prices and sizes
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Effects on Transaction Costs

Growth in electronic trading has the following effects on transaction costs:
Ÿ Numerous studies prove the decline in transaction costs due to electronic trading due to cost
efficiencies
Ÿ Substantial decline in bid-ask spreads which lowers transaction costs for retail traders and
institutions trading small orders
Ÿ Transaction costs have also decreased for large orders
Ÿ One study shows that the implementation shortfall cost of filling thousands of equity orders for US
stocks has dropped.
LOS f Distinguish among types of Electronic Traders

2.1 The Creation/Redemption Process
Ÿ Electronic traders are divided into the following groups:
Ÿ Proprietary traders
Ÿ Buy-side traders
Ÿ Electronic brokers
Proprietary traders are profit-motivated traders and include dealers, arbitrageurs, and various types of
front runners.
Buy-side traders trade to fill orders for investment and risk managers who use the markets to establish
positions for themselves and derive various utilitarian and profit-motivated benefits.
How electronic traders send orders to markets

Ÿ Proprietary traders registered as brokers/dealers directly send their orders to exchanges
Ÿ Proprietary traders who are not brokers/dealers must send their orders to brokers who forward them to
exchanges who give them sponsored access to fast electronic processing systems
ª Electronic proprietary traders include high-frequency traders (HFT) and low-latency traders.
Both must trade very quickly in response to new information.
High Frequency Traders
Complete trades very quickly

In a typical day, may trade in and out of securities or contracts thousands of times but usually only
in small sizes
Hold positions for periods less than a day.
Low-Latency Traders
Ÿ Include news traders and parasitic traders
ª News traders feed on electronic news feed
ª Parasitic traders are speculators who base their prediction about future prices on
information they obtain about orders which other traders will fill or intend to fill
Ÿ Need to send or cancel orders very quickly when opening or closing positions.
Ÿ May hold positions for as long as a day or even longer in contrast to HFT
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Major Types of Electronic Traders
1 Electronic news traders
Ÿ Subscribe to high-speed electronic news feeds which reports news releases made by corporations,
governments, and other sources
Ÿ Analyze received information quickly to determine whether it will move the market and in which
direction
Ÿ Profit by trading against stale orders, which do not reflect the new information
Ÿ Also process news releases, which do not contain quantitative data, using natural language-processing
techniques.
2 Electronic Dealers
Ÿ Place bids and offers with the expectation to profit from round trips at favourable net spreads
Ÿ When prices move against their position, they immediately take liquidity by executing on the
opposite side of their position to reduce exposure
Ÿ Do not hold large inventory positions in actively traded stocks
Ÿ Often monitor electronic news feeds and may cancel all orders in a security mentioned in a news
report.
Ÿ Often keep track of scheduled news releases like all dealers and cancel orders before releases to
avoid offering liquidity to traders acting faster than them
Ÿ May try to reduce their position before a scheduled release to avoid holding a risky position
3 Electronic Arbitrageurs
Ÿ Seek opportunities to buy an undervalued instrument and sell an overvalued one.

Ÿ Try to construct arbitrage portfolios (comprising under- and over-valued positions) at minimal
cost and risk.
4 Electronic Front Runners
Ÿ Low Latency traders who use artificial intelligence methods to identify when large traders or many
small traders are filling orders on the same side of the market
Ÿ Purchase securities when they perceive an imbalance of buy orders over sell orders will push the
market up and sell securities if the opposite is true
Ÿ Rely on order anticipation strategies to identify predictable patterns in order submission
Ÿ May search for patterns in order submissions, trades, or the relations between trades and other
events
Ÿ In some jurisdictions, dealers and brokers cannot legally front run orders that their clients submit
Ÿ Front runners may look for patterns in executed trades.
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Ÿ To make buy-side electronic trades difficult to detect, brokers:
ª Submit the orders at random times instead of at regular intervals,
ª Submit various sized-orders instead of the same size, and
ª Randomize their strategies.
Ÿ Some front runners examine the relation between trades and other events to predict future trades.
5 Electronic Quote Matchers
Ÿ Attempt to exploit option values of standing orders (limit orders waiting to be filled)
Ÿ Options to trade are valuable because positions can be taken with potentially limited losses.
Ÿ Traders buy (sell) when they can rely on standing buy (sell) orders to get out of their positions.
Ÿ They will stay in a position or contract if prices move in their favour but will exit if prices move
against them.
Ÿ Main risk to quote matchers is that the standing order may be unavailable when needed
6 Buy-Side Traders
Ÿ Large buy-side traders use electronic order management systems (OMSs) to manage their
trading.
Ÿ Traders employ electronic brokers to arrange their trades which support limit or market orders,
advanced orders, trading tactics, and algorithms. Exchange computers may also perform these
functions.
Ÿ OMS: Keeps track of orders that trader’s portfolio manager want to be filled, which orders have
been sent out to be filled, and which fills have been obtained.
LOS g Comparative advantage of low-latency traders.
Electronic traders have three needs for speed

Taking: Electronic traders need to be fast enough to beat others when taking advantage of attractive
trading opportunities
Making: Market events offer attractive opportunities to offer liquidity and electronic traders must act
fast enough to acquire priority in trading.
Cancelling: Traders need to quickly cancel undesired orders because market events have increase the
option values of those orders
The low latency of electronic trading systems comes from electronic traders being faster than their
competitors. With increased competition to acquire orders from electronic traders, electronic order-
handling systems have also grown faster.
Latency: The elapsed time between the occurrence of an event and a subsequent action depending on that
event. For example, the event may correspond to a trade at an exchange and the action may correspond to
a cancellation order sent by a trader to another exchange upon learning of the trade.
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LOS h Characteristics and uses of electronic trading systems
Buy-side traders use electronic brokers for advanced orders, trading tactics, and algorithms
provided by their electronic brokers to search for liquidity.
Advanced order types : Advanced orders are limit orders with limit prices which change as market conditions
change.
Example: Pegged limit orders (sometimes called floating limit orders) are those for which the trader would
like to maintain a bid or offer at a specified distance relative to a benchmark.
Trading Tactics: Trading tactic is a plan for executing a simple function which involves the submission of
multiple orders.
Ÿ Instruction to sweep through every market at a given price to find hidden trading opportunities. Depending
on the orders permitted by an exchange, traders have the option of submitting hidden limit orders,
discretionary limit orders, or a midspread order. (A limit order pegged to the midpoint of the quoted bid-ask
spread)
Ÿ To find hidden liquidity in an exchange, an electronic trading system may submit an immediate or cancel
order to the exchange where hidden liquidity is suspected to exist.
Ÿ Another trading tactic involves placing a limit order at some price and hoping it will fill at that price.
Examples of How Electronic Trading Changed Trading Strategies

Growth in electronic trading systems changed how traders interact with the market.
1 Hidden Orders
Ÿ Hidden orders work better at electronic exchanges than at floor-based exchanges because
computers never intentionally display the orders improperly.
Ÿ In electronic markets the most common type of order is the immediate or cancel limit order. Traders use
these orders to discover hidden orders which may stand in the spread between a market’s quoted bid
and ask prices.
Ÿ Electronic traders also attempt to discover hidden orders by pinging the market which involves
submitting a small IOC limit order for a few shares at the price at which they are looking for hidden
orders.
2 Leapfrog
Ÿ Involves the dealer quoting a wide bid-ask spread for the sole purpose of trading at more favourable
prices
3 Flickering Quotes
These represent exposed limit orders that electronic traders submit and then cancel shortly so that
Ÿ
other traders know they are willing to trade at the displayed price
Ÿ Traders can place a hidden limit order at the place where the quote is flickering if they want to trade
Ÿ Taking liquidity on both sides: The costliest and least risky arbitrage trading involves using marketable
orders to fill both legs or positions (buying an undervalued position and selling an overvalued position).
Very fast trading systems must be used to lock in the arbitrage spread before prices in one or both markets
change.
Ÿ Offer liquidity on one side. Riskier but less costs than the first strategy involving the arbitrageur offering
liquidity in one or both markets in which they trade.
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Fast Communication
Ÿ Electronic traders and brokers may minimize communication times by minimizing communication
distances and maximizing line speeds.
Ÿ Communication distance = Distance A + Distance of B = Total of two distances that signals must travel
Distance A: Distance between event report site to the computer which will process the information
Distance B: Distance from the computer to the exchange trading system where trader will want to deliver
the order instruction
Electronic Traders and brokers locate their computers as close as possible to exchanges at which they
want to trade to minimize latencies
Following are the steps to minimize latency
Ÿ Calculation: Practice of traders placing servers in the same room in which exchange servers
operate
Ÿ Electronic traders and brokers use fastest communication technologies to collect and transmit
information when distance separates the place where information events occur from the places
where traders act on those events.
Ÿ Electronic traders and brokers subscribe to high speed data feeds directly from exchanges and
other data vendors paying at a premium price
Fast Computations
Electronic traders minimize decision making latencies by using several strategies
Ÿ They use very fast computers, run them at fast processing speeds, and store information in fast
memories
Ÿ They use simple and specialized operating systems to maximize efficiency
Ÿ They optimize their computer code for speed

Ÿ Use high-level languages for electronic trading problems which change very frequently
Ÿ Create contingency tables that contain prearranged action plans which include responses for most-
likely events.
Algorithms
These represent programmed strategies for filling orders. Algorithms may use simple order, advanced
order or multiple orders to achieve objectives.
Brokers use algorithms to trade small orders or break large order into smaller pieces to reduce price impact.
eg. The volume-weighted average price (VWAP) algorithms aim to achieve a volume-weighted average fill
price that is close to (or better than) the volume-weighted average price of all trades within a period. Buy-
side traders rely on the VWAP algorithm when spreading their orders over time and when obtaining the
average market price within an interval that is acceptable to them or their portfolio managers.
Characteristics of good algorithms

ª Obtain low-cost executions by knowing when and where to offer liquidity and keeping the market
uninformed about their efforts.
ª Reduce the price impact of large trades and reduce the cost of managing small trades
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Ÿ Offer liquidity on both sides. This strategy involves offering liquidity in both markets. This strategy is
the riskiest strategy because arbitrageurs are exposed to substantial price risk when one leg is filled
and the other is not as they wait to complete the second trade
Machine Learning
Involves the use of advanced statistical methods to characterize data structures, particularly relations
among variables. These methods are based on observed empirical regularities rather than on theoretical
principles identified by analysts.
Machine learning is useful when trading problems repeat regularly and often as well as in active financial
markets where stable processes generate vast amounts of data.
Machine learning is not useful when trading becomes extraordinary such as when volatility is extreme.
In such cases data volume is low and so there is little from which machines can learn.
LOS i The risks associated with electronic trading and how regulators mitigate
them
HFT Arms Race: Competition among high-frequency traders (HFTs) has created an arms race in
which each trader tries to be faster than the other. This has increased high-frequency trading
technology costs leading to high entry barriers, natural monopolies and HFTs quitting the market.
Ÿ These costs are ultimately incurred by traders who need to pay these costs.
Ÿ It has been observed that technologies used by HFTs do little to promote market liquidity
Systematic Risks of Electronic Trading

Systematic risk: The risk of an entity failure affecting more than the responsible
entity
Sources of systematic risk:
Ÿ Failure of electronic exchange trading system:
ª Programmers make mistakes
ª Exchange servers do not have capacity to handle traffic
ª Computer hardware/communication lines fail
Ÿ Excessive orders submitted by electronic traders such as:
Ÿ Runaway algorithms
Ÿ Fat finger errors
Ÿ Overlarge orders
Ÿ Malevolent order streams
Measures to Control Systematic Risk
Ÿ 2.1
TestThe Creation/Redemption
software Process
thoroughly before using in live trading.
Ÿ Rigorous market access controls so that trades from approved sources enter the electronic order-
matching system
Ÿ Rigorous access controls on software developers so that authorized developers can change software
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Ÿ Electronic traders generating orders and electronic exchanges receiving orders must monitor their
order flow to ensure it meets preset parameter. Brokers must monitor all client orders introduced
into electronic trading systems and avoid practice of clients submitting orders directly into exchange
trading systems or sponsored naked access
Ÿ Exchanges adopt price limits and trade halts to stop trading when prices move too quickly. These
rules halt trading when there is excess demand for liquidity and prevents extreme price movements
when available market liquidity does not match demand.
LOS j Describe abusive trading practices that real-time surveillance of markets may
detect
While the use of real-time surveillance technologies is not consistent across all markets, real-time
surveillance can detect the following behaviours
Front Running
Involves buying in front of anticipated purchases and selling in front of anticipated sales. Front running is
illegal if information concerning a trade is acquired illegally.
Some traders use electronic artificial intelligence systems to identify when traders are filling large orders
by breaking them into small pieces. These traders will trade ahead on the same side with the hope that
they will benefit from a movement in prices caused by large traders filling their orders.
This strategy is legal if information obtained concerning the trade is properly acquired.
Front running increases transaction costs for traders whose orders are front run.
Market manipulation
The practice of producing misleading or false market prices, quotes or fundamental information to
profit from distorting normal market operations.
Market manipulation strategies are generally illegal in most jurisdictions but enforcement is often
difficult because exact infractions can be hard to define.
Market manipulation strategies involve the following improper market activities:
Ÿ Trading for market impact: Involves a market manipulator incurring substantial trading costs to
raise or lower security prices to influence traders’ perception of value
Ÿ Rumormongering: Disseminating false information about fundamental values or other traders’

trading intentions. This practice is illegal in most jurisdictions but reporting on one side of an
issue is not illegal
Ÿ Wash trading: The practice of arranging trades among commonly controlled accounts to create
the impression of market activity at a particular price which may include false reporting of trades.
The purpose being to increase investor’s confidence both in their assessment of security values
and their ability to exit positions without incurring substantial costs
Ÿ Spoofing/layering: A practice in which traders place exposed standing limit orders to convey to
other traders that the market is more liquid that it actually is or suggest a security is under or
overvalued.
ª Risk of spoofing: Spoofing orders may execute before intended orders execute
Ÿ How to manage risk: Keep track of orders in the limit order book ahead of their spoofing orders. If
spoofing orders fill before intended orders, spoofers will cancel the former to prevent them from
executing.
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Market Manipulation strategies include:

Bluffing
Ÿ Bluffing involves submitting orders and arranging trades to influence other traders’ perceptions of
value.
ª Bluffers prey on momentum traders.
ª Example of trading strategy:
§ “Pump and dump schemes” Buy stocks to raise prices and encourage momentum traders to
buy. This may be accompanied by rumormongering or wash trading. Bluffers then sell the
stock to momentum traders at higher prices.
§ Short and distorts: Manipulator takes short positions and repurchases shares at lower prices
ª To avoid bluffing financial analysts must base analyses on independent assessments of value
and have a reasonable and adequate basis as required by CFA Institute Standards of
Professional Conduct
Gunning the market
Used by manipulators to force disadvantageous trades. A manipulator guns the market by selling quickly
to push down prices with the aim of triggering stop-loss sell orders.
Squeezing and cornering

Used by traders to force traders to do disadvantageous trades. In a squeeze or corner, manipulator
obtains control over resources necessary to settle trading contracts and then withdraws resources from
the market causing traders to default on their contracts. Manipulators profit by providing resources at
high prices or by closing contracts at high prices.
ª Examples of trading strategies:
§ In short squeezes, manipulator obtains controls of a significant portion of available lendable stock
shares or bonds
§ To avoid short squeezes, short sellers should ensure lending market has multiple participants
§ Commodity market corners involve manipulators buying many futures contracts and
simultaneously buying deliverable supply of commodities in the spot market and later demands
delivery from shorts who either buy the commodity or repurchase contracts from the manipulator at
high prices.
Ÿ Corners are illegal in most jurisdictions
Ÿ To avoid being caught in an intentional corner, short sellers who do not intend to make delivery should
close their positions early
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Ethical and Professional

Standards
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violation comes to your notice, get in touch with us at [email protected]
We have concealed a user specific code within this material to identify the original user. In case of
violation of copyright laws, duplication or mass circulation of this material, the original user to whom
this material was issued will be identified and pursued under appropriate laws. Further, the user
indetification will also be reported to CFA Institute.
Ethics and Trust In The

Investment Profession
Ÿ Ethics can be defined as a set of moral principles or rules of conduct that provide
guidance for our behavior when it affects others. Ethical principles include
honesty, fairness, diligence, and care and respect for others.
Ÿ Unethical behavior by individuals have serious personal consequences—ranging

from job loss and reputational damage to fines and even jail—but unethical
conduct from market participants, investment professionals, and those who
service investors can damage investor trust and thereby impair the sustainability
of the global capital markets as a whole
Ethics, Society, and the Capital Markets

Ÿ Efficient capital market system is dependent on trust of the participants.
Ÿ If investors believe that the capital markets are unfair such that only insiders can
be successful, they will be unlikely to invest & will require a higher risk premium.
Ÿ Decreased investment capital can reduce innovation and job creation and hurt the
economy and society as a whole
Capital Market Sustainability and the Actions of The Relationship between Ethics and
One Regulations
Ÿ In an interconnected global economy and Ÿ Ethical behavior is often distinguished from

marketplace, each participant should be legal conduct by describing legal behavior as
aware of how his or her actions may have an what is required and ethical behavior as
impact on capital market participants in conduct that is morally correct.
other regions or countries. Ÿ Therefore, reliance on compliance with laws
Ÿ Corporate compensation strategies should and regulation alone is insufficient to ensure
not encourage otherwise ethically sound ethical behavior of investment professionals
individuals to engage in unethical or or to create a truly ethical culture in the
questionable conduct for financial gain industry
Applying an Ethical ª Establishing an ethical framework for an internal thought process prior
Framework - to deciding to act is a crucial step in engaging in ethical conduct.
ª Utilizing a framework for ethical decision making will help investment
professionals effectively examine their conduct in the context of
conflicting interests
Commitment to ª Development, maintenance, and demonstration of a strong culture of

Ethics by Firms - integrity within the firm by senior management may be the single
most important factor in promoting ethical behavior among the firm's
employees
Ethical Commitment ª CFA Institute's goal is to ensure that the organization and its members
of CFA Institute - and candidates develop, promote, and follow the highest ethical
standards in the investment industry
ª There are set of principles that define the overarching conduct CFA
Institute expects from its members and CFA Program candidates
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Code of Ethics
Members and Candidates of CFA Institute must:
Act with integrity, competence, diligence, respect and in an ethical manner
with the public, clients, prospective clients, employers, employees, colleagues
in the investment profession and other participants in the global capital
markets.
Place the integrity of the investment profession and the interests of the clients
above their own personal interests.
Use reasonable care and exercise independent professional judgement when

conducting investment actions and engaging in other professional activities.
Practice and encourage others to practice in a professional and ethical manner

that will reflect credit on themselves and the profession.
Promote the integrity and viability of the global capital markets for the
ultimate benefit of the society.
Maintain and improve their professional competence and strive to maintain

and improve the competence of other investment professionals.
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Standard I: Professionalism
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Standard II: Integrity Of Capital Markets
Guidance
è Material information - Disclosure would impact the price of security
è If reasonable investor would want the information before making an investment decision
è Nonpublic information - It is not available to the marketplace
è Analyst’s conference call is not public disclosure
è Selective disclosure causes insider trading
è Prohibition against acting on material nonpublic information extends to securities, swaps, option
contracts and matual funds
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Standard III: Duties To Clients
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Standard IV: Duties To Employers
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Ÿ Members and Candidates must make reasonable efforts to ensure that anyone subject
to their supervision or authority complies with applicable laws, rules, regulations, and
the Code and Standards
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Standard V: Investment Analysis,

Recommendation & Actions
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Ÿ Disclose to clients and prospective clients significant limitations and risks associated
with the investment process
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Standard VI: Conflict Of Interest
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Standard VII: Responsibilities as CFAI

Member or CFA Candidate
Ÿ 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
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Required Vs Recommended Standard I to VII

Required :
● Understand & comply with all applicable laws, rules & regulations pertaining to any govt, regulatory
organization, licensing agency or professional association governing their professional activities
● Comply with more strict law, rule or regulation in case of conflict
● Must not knowingly participate or assist & must dissociate from any violation of laws, rules or regulations
Recommended :
● Know laws & regulations related to their professional activity in all countries where they work/ conduct
business
● Never violate code & standards even if activity is otherwise legal
● Dissociate or separate from any ongoing client or employee activity if it’s illegal or unethical - in extreme case
they may have to leave the employer
● Confront the individual involved. Approach the supervisor or compliance department
● Inaction with continued association may be construed as knowing participation
● Have procedures to keep up with changes in laws
● Compliance procedures- review on ongoing basis
● Maintain current reference material for employees
● In doubt seek advice of counsel or compliance department
● Document any violation when disassociating
● Report other members’ violations also
● No requirement to report violations to governmental authorities except when required by law
● Encourage their firms to develop and/or adopt a code of ethics, provide information to employees which
highlights applicable laws and regulations, establish written procedures for reporting suspected violation of
laws, regulations or company policies
● In charge of supervision/ investment services- comply with regulations and laws in their country of origin and
where products/services will be sold
I B : Independence & Objectivity
Required :
● Use reasonable care & judgement to achieve & maintain independence & objectivity in professional
activities
● Not to offer, solicit or accept any gift, benefit, compensation or any type of consideration that compromises
their own or another’s independence & objectivity
Recommended :
● Investment process must not be influenced by any external sources
● Modest gifts are permitted

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● Allocation of shares in oversubscribed IPO to personal accounts not permitted
● Distinguish gifts from clients & entities seeking influence to the detriment of the client
● Gifts must be disclosed to the member’s employer in any case either prior to acceptance or subsequently
● Don’t get pressurized from sell-side analyst to issue favourable research on current or prospective
investment-banking client in “road shows”
● Effective “firewalls” between research/ investment management & investment banking activities
● Analyst should not be pressured to issue favourable research by the companies they follow
● Do not limit research to discussions with company management. Use sources like suppliers, customers,
competitors
● Portfolio managers should not pressure sell side analysts may have large positions in particular securities
rating downgrade may adversely affect portfolio performance. Their responsibility to respect and foster
intellectual honesty of sell side research
● Members responsible for selecting outside managers should not accept gifts, entertainment or travel that
might be perceived as impairing independence and/or objectivity
● Members employed by credit rating agencies should make sure they prevent undue influence by security
issuing firms, be aware of potential conflict of interest & consider whether independent analysis is
warranted
● Create a restricted list
● Analyst’s compensation for such research should be limited preference is a flat fee without regard to
conclusions or the report’s recommendation
● Best practice analysts pay their own commercial travel while attending informative events or tours
sponsored by the firm being analyzed
● Protect the integrity of opinions & design proper compensation systems
● Restrict special cost arrangements. Pay for commercial transportation & hotel charges
● Limit the acceptance of gratuities and/or gifts to token items
● Develop formal policies related to employee purchases of equity, IPOs & private placements
● Effective supervisory & review procedures
● Formal written policies on independence and objectivity
● Appoint a compliance officer, have clear procedures for employee for reporting the unethical behaviour and
violation of regulations
I C : Misrepresentation
Required :
● Must not knowingly make any misrepresentations relating to investment analysis, recommendation, actions
or other professional activities compromises their own or another’s independence & objectivity
Recommended :
● Do not give false impressions in writing, oral or electronic communication
● Misrepresentation includes guaranteeing investment performance and plagiarism
● Plagiarism using someone else’s work without giving him credit

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● To avoid plagiarism firm should keep record of all sources and cite them
● Deliberately omitting information that could affect investment decision
● Models and analysis developed by others at firm property of firm can be used with attribution
● A report written by another analyst employed by the firm cannot be released as another analyst’s work
● Provide employees a written list of firm’s available services and description of the firm’s qualifications
● Employees’ qualification should be accurately presented
● Information from recognized financial and statistical reporting services need not be cited (Eg Fred, S&P)
● Establish procedures for verifying marketing claims of third parties whose information the firm provides to
clients
I D : Misconduct
Required :
● Must not involve in any professional misconduct, dishonesty, fraud, deceit or commit any act that reflects
adversely on their professional reputations, integrity or competence
Recommended :
● Unethical behaviour in all aspects of M&C’s lives is discouraged
● Do not abuse CFA Institute’s Professional Conduct Program by seeking enforcement of this Standard to
settle personal, political, or other disputes that are not related to professional ethics
● Develop and adopt a code of ethics and make clear that unethical behaviour will not be tolerated
● Give employees a list of potential violations and sanctions including dismissal
● Check references of potential employees (Background check)
II A : Material Non-Public Information
Required :
● Members and Candidates who possess material nonpublic information that could affect the value of an
investment must not act or cause others to act on the information
Recommended :
● Material information if disclosure would impact price of security or if reasonable investor would want the
information before making an investment decision
● Nonpublic information not available to the marketplace
● Analysts’ conference call is not public disclosure
● Selective disclosure causes insider trading
● Prohibition against acting on material nonpublic information extends to securities, swaps, option contracts
and mutual funds
● Material nonpublic information received while being involved in transactions like investment banking, can
be used for its intended purpose, but must not use the information for any other purpose unless it becomes
public information
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● Mosaic Theory No prohibition on reaching an investment decision through public and non-material
nonpublic information
● Information from internet or social media sources not all of it is considered public information confirm if it is
also available from public sources, such as company press releases or regulatory filings.
● Seeking insight from individuals who have specialized expertise in an industry not act or cause others to act
on any material nonpublic information obtained from these experts until that information has been publicly
● Make reasonable efforts to achieve public dissemination of information
● Encourage firms to adopt procedures to prevent misuse of material nonpublic information
● Use a “firewall” within the firm
● Substantial control of relevant interdepartmental communication through a clearance area like compliance/
legal department
● Review employee trades maintain watch, rumor, and restricted lists
● Monitor & prohibit proprietary trading if a firm possesses material non-public information
● Prohibiting all proprietary trading may send a signal to the market firm should take the contra side of
unsolicited customer trades
II B : Market Manipulations
Required :
● Members and Candidates must not engage in practices that distort prices or artificially inflate trading
volume with the intent to mislead market participants
Recommended :
● Spreading false rumors is prohibited
● Standard applies to transactions that :
- deceive the market by distorting the price setting mechanism of financial instruments or
- by securing a controlling position to manipulate the price of a related derivative and/or the asset itself
III A : Loyalty, Prudence, and Care
Required :
● Duty of loyalty to clients & must act with reasonable care & exercise prudent judgment.
● Must act for the benefits of clients & place their client’s interests before their employer’s & their own
interests
Recommended :
● Client interest comes first (but no imposition of fiduciary duty)
● Exercise same level of prudence, judgment & care as in management & disposition of their own interests in
similar circumstances
● Manage pool of assets in accordance with the terms of governing documents (e.g. trust documents)
● Determine the identity of “client’” to whom duty of loyalty is owed (may be individual or beneficiaries in
67
case of pension plan or trust)
● Follow any guidelines set by their clients for the management of their assets
● Investment decisions are judged in context of total portfolio rather individual investments
● Conflict arises when client brokerage, “soft dollars” or “soft commissions” are not used for benefits of clients
● Cost-benefit analysis may show that voting all proxies may not be a beneficial strategy for clients
● Submit to each client, at least quarterly, a statement showing funds & securities
● Follow applicable rules and laws
● Establish investment objectives of client
● Consider suitability of portfolio relative to client’s needs and circumstances, the investment’s basic
characteristics, or the basic characteristics of the total portfolio
● Diversify
● Deal fairly with all clients in regards to investment actions
● Disclose conflicts
● Disclose compensation arrangements
● Vote proxies in the best interest of clients and ultimate beneficiaries
● Maintain confidentiality
● Seek best execution
● Place client interests first
III B : Fair Dealing
Required :
● Deal fairly and objectively with all clients when providing investment analysis, making investment
recommendations, taking investment action, or engaging in other professional activities
Recommended :
● No discrimination among clients while disseminating recommendations or taking investment action (growth
funds over other funds, discretionary over non discretionary accounts)
● Fairly does not mean equally difference in timings of emails & fax received by clients are normal course of
business
● Different services levels are okay as far as these do not adversely affect any client
● Disclose different levels of services to all clients and prospects
● Premium services should be available to all those who are willing to pay for them
● All clients must be given fair opportunity to act upon every recommendation
● Clients unaware of change in recommendation should be advised before the order is accepted
● Clients must be treated fairly in the light of their investment objectives and circumstances
● Both institutional and individual clients must be treated in a fair & impartial manner
● M&C should not take advantage of their position to disadvantage clients (e.g. in IPOs)
68
● Firms are encouraged to establish compliance procedures to treat customers & clients fairly
● Communicate recommendations simultaneously within the firm & to customers
● Limit the no. of people who are aware that a recommendation is going to be disseminated
● Shorten the time frame b/w decision & dissemination
● Publish guidelines for pre-dissemination behaviour
● Simultaneous dissemination treat all clients fairly
● Maintain a list of clients & their holdings
● Develop & document trade allocation procedures
● Disclose trade allocation procedures fair & equitable
● Establish systematic account review no preferential treatment to any client or customer
● Disclose level of services different levels of services are possible for same or different fees
III C : Suitability
Required :
● In an advisory relationship with a client-
● Make a reasonable inquiry into a client’s or prospective clients’ investment experience, risk and return
objectives, and financial constraints prior to making any investment recommendation or taking investment
action and must reassess and update this information regularly
● Determine that an investment is suitable to the client’s financial situation and consistent with the client’s
written objectives, mandates, and constraints before making an investment recommendation or taking
investment action
● Judge the suitability of investments in the context of the client’s total portfolio
● Managing a portfolio to a specific mandate, strategy, or style, they must make only investment
recommendations or take only investment actions that are consistent with the stated objectives and
constraints of the portfolio
Recommended :
● Develop IPS at beginning of the relationship
● Consider client’s needs, circumstances & risk tolerance
● Consider whether the use of leverage is suitable for the client or not
● Make sure to abide by the stated mandate
● Develop written IPS of each client considering client identification, investor objectives, investor constraints,
performance measurement benchmark (Update IPS at least annually)
● Objectives & constraints should be maintained & reviewed periodically to reflect any changes in clients’
circumstances
● Suitability test policies
● Unsolicited Trade Requests request to purchase a security that is unsuitable which may or may not have a
material effect on the risk characteristics of the client’s total portfolio discussed with the client that it’s
unsuitable
69
● If it has minimal impact after discussing with the client about unsuitability follow his firm’s policy with
regard to unsuitable trades
● Material impact on the risk/return profile
● Update the IPS
● Trade to be made in a separate client-directed account
● In the absence of other options discontinue relationship
III D : Performance Presentation
Required :
● When communicating investment performance information > make reasonable efforts to ensure that it is
fair, accurate, and complete
Recommended :
● Avoid misstating performance or misleading clients about investment performance of themselves or their
firms
● Not misrepresent past performance or reasonably expected performance
● Not state or imply the ability to achieve a rate of return similar to that achieved in the past
● Provide reference to limited information provided on brief presentations
● For brief presentations make detailed information available on request
● Apply Global Investment Performance Standards (GIPS)
● Consider the knowledge of audience to whom performance presentation is addressed
● Performance of weighted composite of similar portfolios rather a single account
● Include performance history of terminated accounts
● Disclosures that fully explain the performance results being reported
● Maintain data & records used to calculate the performance being presented
III E : Preservation of Confidentiality
Required :
● Keep information about current, former, and prospective clients confidential unless:
● The information concerns illegal activities on the part of the client or prospective client
● Disclosure is required by law
● The client or prospective client permits disclosure of the information.
Recommended :
● If a client is involved in illegal activities members may have an obligation to report to the authorities
● Extends to former clients as well
● Not prevent members from cooperating with a CFA PCP investigation

70
● Avoid disclosing information received from client except to authorized coworkers working for the client
● Follow firm’s procedures for storing electronic data
● Recommend development of such procedures if they are not in place
IV A : Loyalty
Required :
● In matters related to their employment 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 employer
Recommended :
● Applicable to employees. Independent contractors abide by agreement
● Place client interests above interests of their employer but consider the effects of their actions on firm
integrity and sustainability
● No requirement that the employee put employer interests ahead of family and other personal obligations
balance these obligations with work obligations
● Not have incentive and compensation systems that encourage unethical behaviour
● Independent practice for compensation prior consent of employer describe all aspects of the services,
including compensation, duration and the nature of the activities
● Leaving an Employer continue to act in their employer’s best interests until resignation is effective Activities
which may constitute a violation include:
- Misappropriation of trade secrets
- Misuse of confidential information
- Soliciting employer’s clients prior to leaving
- Self-dealing
- Misappropriation of client lists
● Employer records on any medium (e.g. home computer, PDA, cell phone) are the property of the firm
● Simple knowledge of names and existence of former clients is generally not confidential
● Give employer a copy of the Code and Standard
● No prohibition on the use of experience or knowledge gained while with a former employer
● If an agreement exists among employers permitting brokers to take certain client information when leaving
a firm act within the terms of the agreement without violating the Standard
● Adhere to their employers’ policies concerning social media when planning to leave an employer - notifying
clients about employee separations
● Best practice separate social media accounts for personal and professional communication
● Whistleblowing duty to employer violated to protect clients or the integrity of the market and not for
personal gain
71
IV B : Additional Compensation Arrangements
Required :
● 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
Recommended :
● Compensation includes both direct & indirect form
● Additional benefits are also included
● Written consent from employer includes email communication
● Hired to work part time discuss any arrangements that may compete with their employer’s interest and
abide by any limitations their employer identifies
● Immediately report to employer in written format detailing any proposed compensation and services
● Performance incentives should be verified by the offering party
● Bonus depending on ’future’ performance – addn comp.
● Reward for ‘past’ performance – gift
IV C : Responsibility of Supervisors
Required :
● Make reasonable efforts to ensure that anyone subject to their supervision or authority complies with
applicable laws, rules, regulations, and the Code and Standards
Recommended :
● Make reasonable efforts to prevent as well as detect violations of laws, rules, regulations or code &
standards by employees
● Adequate compliance system must meet industry standards, regulatory requirements, and the requirements
of the Code and Standards
● Inadequate compliance system bring to attention of firm’s management and recommend corrective action
● If violation respond promptly conduct investigation limit the suspected employee’s activities
● No compliance procedures or inadequate procedures decline supervisory responsibility in writing until

adequate procedures are adopted by the firm
● Adopt a code of ethics. Don’t commingle compliance procedures with the firm’s code of ethics
● Adequate compliance procedures should:
● Be clearly written
● Be easy to understand
● Designate a compliance officer with authority clearly defined
● Have a system of checks and balances
● Outline the scope of procedures
72
● Outline what conduct is permitted
● Contain procedures for reporting violations and sanctions
● Structure incentives so that unethical behaviour is not rewarded
● Once the compliance program is instituted, the supervisor should:
- Distribute it to the proper personnel
- Update it as needed
- Continually educate staff regarding procedures
- Issue reminders as necessary
- Require professional conduct evaluations
- Review employee actions to monitor compliance and identify violations
- Enforce procedures once a violation occurs
- Review procedures and identify any changes needed to prevent violations in the future
V A : Diligence and Reasonable Basis
Required :
● Exercise diligence, independence, and thoroughness in analyzing investments, making investment
recommendations, and taking investment actions
● Have a reasonable and adequate basis, supported by appropriate research and investigation, for any
investment analysis, recommendation or action
Recommended :
● Level of research for due diligence depends on product/service offered
● Prior to making recommendation or investment action consider:
- Global and national economic conditions
- Firm’s financial and operating history & business cycle stage
- Mutual fund’s fee & management history
- Limitation of any quantitative methods used
- Appropriateness of peer group comparisons
● Quantitative Research consider positive & negative results, scenarios which are not typically used to assess
downside risk explain the importance of research and how results were used in decision making process
● Secondary or Third-Party Research review it’s quality consider following :
- Review assumptions
- How rigorous is the analysis
- How timely the research is
- Evaluate objectivity & independence of recommendations
73
● Review External Advisers :
- Have adequate compliance and internal controls
- Review the quality of the published return information
- Do not deviate from stated strategies
● Don’t agree with the independent and objective view of the group need not decline to be identified with the
report, as long as there is a reasonable and adequate basis
● Policy requiring that research reports, credit ratings & investment recommendations have a reasonable &
adequate basis
● Develop written guidance for analysts, supervisory analysts & review committees
● Develop measurable criteria for research report quality assessment
● Written guidance for computer-based models used in developing, rating & evaluating financial instruments
● Develop measurable criteria for assessing outside providers
● Standardized set of criteria for evaluating the adequacy of external advisers
V B : Communication with Clients and Prospective Clients
Required :
● 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
● Disclose to clients and prospective clients significant limitations and risks associated with the investment
process
● Use reasonable judgment in identifying which factors are important to their investment analyses,
recommendations, or actions and include those factors in communications with clients and prospective
clients
● Distinguish between fact and opinion in the presentation of investment analysis and recommendations
Recommended :
● Always include basic characteristics of security identified
● Illustrate investment decision making process used
● The standard does not confine communication to a research report
● Communicate any specific risk factors associated with securities
● Clearly communicate potential gains & losses in terms of total return
● Communicate significant changes in the risk characteristics of an investment/ strategy
● Update clients regularly about changes in the investment process, risks and limitations newly identified
● Projections from quantitative models and analysis explain the limitations of the model and the assumptions
it uses this judging the uncertainty regarding the estimated investment result
● Inform clients about limitations inherent to an investment liquidity & capacity
● Ability to supply additional information if requested hence maintain relevant information
74
V C : Record Retention
Required :
● Develop and maintain appropriate records to support their investment analysis, recommendations, actions,
and other investment-related communications with clients and prospective clients
Recommended :
● Maintain records that support conclusion or any investment action
● Such records are property of the firm
● If regulatory requirements do not recommend, maintain records for at least 7 years
● All communications with clients through any medium, including emails and text messages, are records that
must be retained
● Members who change firms must recreate analysis documentation > not rely on memory or material created
in previous firms
● Record-keeping is generally firm’s responsibility
VI A : Disclosure of Conflict
Required :
● 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
● Ensure that such disclosures are prominent, are delivered in plain language, and communicate the relevant
information effectively
Recommended :
● Fully disclose to clients, prospects, employers all actual and potential conflicts of interest in order to protect
investors and employers let them judge any potential bias
● Disclosure of :
● Servicing as a board member
● Broker/dealer market making activities
● Holdings in companies that member recommends or clients hold
● Fee arrangements including those in which the firm benefits from investment recommendations
● Special compensation arrangements, bonus programs, commissions, and incentives
● Give employer enough information to judge the impact of conflict take reasonable steps to avoid conflict
report promptly if conflict occurs
VI B : Priority of Transaction
Required :
● Investment transactions for clients and employers must have priority over investment transactions in which
a Member or Candidate is the beneficial owner
Recommended :
● Prioritize client’s transactions over personal transactions & transactions made on behalf of the member’s
firm
75
● Personal transactions may be undertaken after clients and employer have given adequate opportunity and
time to act upon an investment recommendation
● Personal transactions include situations where the member is a “beneficial owner”
● Regular fee-paying family member accounts should not be disadvantaged to client accounts
● Information about pending trades should not be acted on for personal gains
● Limited participation in equity IPOs by investment personnel
● Restrictions on private placements for investment personnel
● Establish blackout/ restricted periods for investment personnel, no front running
● Reporting requirements for investment personnel:
● Disclosure of holdings in which the employee has a beneficial interest
● Provide duplicate confirmations of transactions
● Preclearance procedures
● Disclosure of policies regarding personal investing
VI C : Referral Fees
Required :
● Disclose to their employer, clients, and prospective clients, as appropriate, any compensation, consideration,
or benefit received from, or paid to, others for the recommendation of products or services
Recommended :
● Inform employers, clients and prospects of benefits received for referrals of customers and clients >
allowing them to evaluate the full cost of the service as well as any potential partiality
● All types of consideration must be disclosed
● Encourage firms to adopt procedures regarding compensation for referrals
● Update firm at least quarterly regarding nature and value of referral compensation received if firms do not
have clear procedures for approval
VII A : Conduct as Participants in CFA Institute Programs
Required :
● 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
Recommended :
● Must not engage in any activity that undermines the integrity of CFA charter
● Standard applies to:
● Cheating in CFA or any CFAI exam
● Revealing anything about the contents & topics of exam
● Not following the rules & polices for CFA program

76
● Disclosing confidential information on CFA program to candidates or to public
● Improperly using the designation
● Misrepresenting information on PCS or CFAI PDP
● Members can express their opinion on CFA institute or program
● Members volunteering CFA program must not solicit or reveal information about :
● Exam questions
● Deliberation related to exam process
● Scoring of question
VII B : Reference to CFA Institute, the CFA Designation, and the CFA Program
Required :
● Not misrepresent or exaggerate the meaning or implication of membership in CFA institute, holding the CFA
designation or candidacy in CFA program
Recommended :
● Do not over-promise individual competence
● Do not over promise future investment results
● Sign PCS annually
● Pay CFAI membership dues annually
● Do not misrepresent or exaggerate the meaning of the designation
● No partial designation exists
● Acceptable : candidate has successfully completed the program in 3 years claiming superior ability is not
permitted
● In written/ oral communications : usage as adjectives or after charterholder’s name. Not as nouns
77
FinTree
CFA® Level II JuiceNotes 2022
© 2022 FinTree Education Pvt. Ltd., All rights reserved.
FinTree Education Pvt. Ltd. FinTree Education Pvt. Ltd.

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Lane 16, Bhandarkar Rd, near KHB Colony, 5th Block,
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Portfolio Management| Ethics

Chartered Financial Analyst - Level II

Check out some

Exchange Traded Funds: Mechanics &

The Creation/Redemption Process

ETF Creation Process ETF Redemption Process

Step 1: AP acquires securities Step 1: AP exchanges ETF

Step 2 : Securities basket Step 2: AP sells securities

LOS b Describe how ETFs are traded in secondary markets

Ÿ All trades in US are submitted to NSCC

Ÿ NSCC becomes guarantor of a stock transaction between two parties

Ÿ Trades are settled and cleared centrally within 2 business days.

European trading and settlement:

ª Trading is similar to the US

Describe sources of tracking error for ETFs

LOS c Describe sources of tracking error for ETFs

Expense Ratios Index Tracking/Tracking Error

Types of index tracking for ETF:

LOS d Describe factors aﬀecting FTFs bid-ask spreads

ETF bid-ask spreads are Bid/ask spreads

Ÿ Amount of competition Ÿ +Compensation (to the

Ÿ Costs and risks for the Ÿ +Market maker’s desired

Ÿ -Discount related to the

Factors driving premiums/discounts:

LOS f Describe costs of owning an ETF

Types of costs of ETF ownership (TOTT):

Ÿ Ongoing Costs : Management fees, portfolio turnover, security lending proceeds

Ÿ Tracking error: an implicit cost, can be positive or negative

Total cost = Round-Trip Trading Cost +Management fees

Round-Trip Trading Cost = Round - Trip Commission +Spread

LOS g Describe types of ETF Risk

Counterparty Risk Fund Closures Expectation related risk.

ETFs based on complex

Ÿ Soft closures - do not involve These complex ETFs might

LOS e Identify and describe portfolio uses of ETFs

Primary applications of ETFs include:

Ÿ Asset class exposure management

Ÿ Active and factor Investing

Asset Class Exposure Management

Types of ETF exposures based on asset class

Equity Commodity Fixed Income

Ÿ Domestic small cap

Active and Factor Investing

Forum Link Video Link

An Introduction To Multifactor Models

ª Linear model with factors that capture systematic risk

ª No ﬁxed number of factors

ª Unsystematic risk can be eliminated in a portfolio

ª No arbitrage opportunities exist

Pure factor portfolio:

LOS b Arbitrage opportunity

Take long position on portfolio A and B and short 0.5 0.5

LOS c Calculate factor risk premium

Calculate RFR and factor risk premium

Expected return = RFR + (β × FRP) 17 = 8 + 0.9 × FRP FRP = 10%

Macroeconomic Fundamental Statistical

Factors are ﬁrm-speciﬁc and