## Ethical and Professional Standards: CFA Level I Overview

The "Ethical and Professional Standards" topic is foundational for the CFA Level I exam, emphasizing the importance of ethical conduct in the investment profession. It underpins all other areas of the curriculum, ensuring that investment professionals act with integrity and prioritize client interests. The CFA Institute's Code of Ethics and Standards of Professional Conduct are the cornerstone of this topic.

## The Code of Ethics

The Code of Ethics outlines the overarching principles that guide the professional conduct of CFA Institute members and candidates. There are six core components:

• Act with integrity, competence, diligence, and respect, and in an ethical manner.
• Place the integrity of the investment profession and the interests of clients above their own personal interests.
• Use reasonable care and exercise independent professional judgment.
• Practice and encourage others to practice in a professional and ethical manner that will reflect credit on themselves and the profession.
• Promote the integrity of, and foster confidence in, the global capital markets.
• Maintain and improve their professional competence and strive to maintain and improve the competence of other investment professionals.

## The Standards of Professional Conduct

The Standards provide specific guidance for applying the Code of Ethics in practical situations. They are divided into seven main categories, each with sub-sections:

• I. Professionalism: Covers Knowledge of the Law, Independence and Objectivity, Misrepresentation, and Misconduct. Members must adhere to the stricter of applicable law or the Standards.
• II. Integrity of Capital Markets: Addresses Material Nonpublic Information and Market Manipulation, prohibiting actions that undermine market fairness.
• III. Duties to Clients: Focuses on Loyalty, Prudence, and Care; Fair Dealing; Suitability; Performance Presentation; and Preservation of Confidentiality. Client interests are paramount.
• IV. Duties to Employers: Includes Loyalty; Additional Compensation Arrangements; and Responsibilities of Supervisors.
• V. Investment Analysis, Recommendations, and Actions: Covers Diligence and Reasonable Basis; Communication with Clients and Prospective Clients; and Record Retention.
• VI. Conflicts of Interest: Requires Disclosure of Conflicts; Priority of Transactions (client transactions take precedence); and disclosure of Referral Fees.
• VII. Responsibilities as a CFA Institute Member or Candidate: Pertains to Conduct as Members and Candidates in the CFA Program and proper Reference to CFA Institute, the CFA Designation, and the CFA Program.

## Ethical Decision-Making Framework

When faced with an ethical dilemma, a structured approach is crucial. This typically involves: identifying the relevant facts, stakeholders, and ethical principles; considering alternative actions; making a decision; and monitoring the outcome. This framework helps ensure a consistent and defensible ethical response.

## Time Value of Money (TVM)

TVM is fundamental, stating a dollar today is worth more than a dollar tomorrow. Future Value (FV) is the value of an asset or cash at a specified date in the future, calculated as `FV = PV * (1 + I/N)^(N*T)`. Present Value (PV) is the current value of a future sum of money or stream of cash flows given a specified rate of return, `PV = FV / (1 + I/N)^(N*T)`. An annuity is a series of equal payments at fixed intervals. A perpetuity is an annuity that pays forever. The Effective Annual Rate (EAR) accounts for compounding frequency, `EAR = (1 + Periodic Rate)^m - 1`, where `m` is the number of compounding periods per year.

## Descriptive Statistics

Measures of Central Tendency describe the center of a data set. The arithmetic mean is the sum of observations divided by count. The median is the middle value when data is ordered. The mode is the most frequent value. The geometric mean is used for compounding rates of return, `GM = [(1+R1)*(1+R2)*...*(1+Rn)]^(1/n) - 1`.

Measures of Dispersion describe the spread. Variance is the average of squared deviations from the mean. Standard deviation is the square root of variance. Range is max minus min. Skewness indicates asymmetry of distribution. Kurtosis describes the "tailedness" or peakedness of a distribution.

## Probability & Hypothesis Testing

Probability quantifies uncertainty. Unconditional probability (marginal probability) is the probability of an event regardless of other events. Conditional probability is the probability of an event occurring given that another event has already occurred. Expected Value is the weighted average of possible outcomes.

Hypothesis Testing involves making inferences about a population parameter. The null hypothesis (H0) is the statement being tested, often representing no effect or equality. The alternative hypothesis (Ha) is what is concluded if H0 is rejected. A Type I error is rejecting a true H0 (false positive). A Type II error is failing to reject a false H0 (false negative). The p-value is the smallest significance level at which H0 can be rejected.

## Correlation & Regression

Covariance measures the extent to which two variables move together. The correlation coefficient (ρ) standardizes covariance, ranging from -1 (perfect negative) to +1 (perfect positive), indicating strength and direction of linear relationship. Simple linear regression models the relationship between a dependent variable (Y) and one independent variable (X): `Y = b0 + b1*X + ε`. `b0` is the intercept, `b1` is the slope. R-squared (coefficient of determination) represents the proportion of the variance in Y that is explained by X.

## Microeconomics: Demand, Supply, and Market Structures

Demand represents the quantity consumers are willing and able to purchase at various prices. The Law of Demand states that as price increases, quantity demanded decreases (inverse relationship). Factors shifting the demand curve include income, tastes, prices of related goods (substitutes, complements), and expectations. Supply is the quantity producers are willing and able to sell. The Law of Supply states that as price increases, quantity supplied increases (direct relationship). Supply shifters include input prices, technology, and government policies.

Market Equilibrium occurs where quantity demanded equals quantity supplied, determining the equilibrium price and quantity. Elasticity measures the responsiveness of one variable to changes in another. Price Elasticity of Demand (PED) measures how much quantity demanded changes in response to a price change. If PED > 1, demand is elastic; if PED < 1, inelastic. Income Elasticity of Demand indicates if a good is normal (positive) or inferior (negative). Cross-Price Elasticity shows if goods are substitutes (positive) or complements (negative).

Market Structures categorize industries based on competition:

• Perfect Competition: Many small firms, homogeneous product, free entry/exit, price takers.
• Monopolistic Competition: Many firms, differentiated products, some pricing power, low barriers.
• Oligopoly: Few large firms, interdependent decisions, high barriers, potential for collusion.
• Monopoly: Single firm, unique product, significant barriers, price setter.

## Macroeconomics: Aggregate Output, Business Cycles, and Policy

Gross Domestic Product (GDP) measures the total market value of all final goods and services produced within a country's borders in a specific period. It can be calculated via the Expenditure Approach (C + I + G + (X-M)) or the Income Approach (Wages + Rent + Interest + Profits). Nominal GDP uses current prices, while Real GDP uses constant base-year prices, adjusting for inflation. The GDP Deflator is a price index used to convert nominal to real GDP.

The Business Cycle describes the short-term fluctuations in economic activity: Expansion (growth), Peak (highest point), Contraction/Recession (decline), and Trough (lowest point). Indicators include leading, coincident, and lagging.

Monetary Policy (central bank) aims to influence money supply and credit conditions to achieve economic goals (e.g., price stability, full employment). Tools include policy rates (e.g., fed funds rate), open market operations, and reserve requirements. Fiscal Policy (government) uses government spending and taxation to influence aggregate demand. Expansionary policy (increased spending, decreased taxes) stimulates the economy; Contractionary policy (decreased spending, increased taxes) slows it down.

Inflation is a general increase in the price level. It can be Demand-Pull (excess aggregate demand) or Cost-Push (supply shocks). The Consumer Price Index (CPI) is a common measure of inflation.

## Introduction to Financial Statement Analysis (FSA)

Financial Statement Analysis involves using financial reports to evaluate a company's past performance, present condition, and future prospects. The primary goal is to make informed economic decisions. Key tools include ratio analysis, common-size analysis, and trend analysis. Analysts use information from the Income Statement, Balance Sheet, Cash Flow Statement, and Statement of Changes in Equity, along with footnotes and MD&A.

## Financial Statements Overview

• Income Statement: Reports a company's financial performance over a period, showing revenues, expenses, and net income.
• Balance Sheet: Presents a company's financial position at a specific point in time, detailing assets, liabilities, and equity.
• Cash Flow Statement: Summarizes cash inflows and outflows from operating, investing, and financing activities over a period.
• Statement of Changes in Equity: Details changes in owner's equity over a period.

## Financial Analysis Techniques

• Ratio Analysis: Involves calculating and interpreting financial ratios to assess liquidity, solvency, profitability, and efficiency. Ratios are compared over time, to industry averages, or to competitors.
• Liquidity Ratios: Ability to meet short-term obligations (e.g., Current Ratio, Quick Ratio).
• Solvency Ratios: Ability to meet long-term obligations (e.g., Debt-to-Equity, Debt-to-Assets).
• Profitability Ratios: Company's ability to generate earnings (e.g., Net Profit Margin, ROA, ROE).
• Activity/Efficiency Ratios: How efficiently assets are used (e.g., Inventory Turnover, Receivables Turnover).
• Common-Size Analysis: Expresses each line item on a financial statement as a percentage of a base item (e.g., revenues for income statement, total assets for balance sheet). Useful for comparing companies of different sizes or analyzing trends.
• Trend Analysis: Examines financial data over several periods to identify patterns or changes.

## Key Accounting Considerations

• Inventory: FIFO (First-In, First-Out) generally results in higher reported net income and assets during periods of rising costs compared to LIFO (Last-In, First-Out), which is permitted under U.S. GAAP but not IFRS.
• Long-Lived Assets: Depreciation methods (straight-line vs. accelerated) impact reported net income and asset values. Capitalizing expenditures (vs. expensing) increases assets and net income in the short term but leads to higher depreciation expenses later.
• Financial Reporting Quality: Refers to the extent to which financial reports provide useful information, characterized by relevance and faithful representation. Low quality can involve earnings management or aggressive accounting choices.

## Corporate Issuers: An Overview

Corporate issuers are entities that raise capital by issuing securities to finance their operations, investments, and growth. The primary objective of a for-profit company is generally to maximize shareholder wealth, often reflected in the stock price, while considering the interests of other stakeholders.

## Corporate Governance

Corporate governance is the system of principles, policies, and procedures by which a company is directed and controlled. It defines the distribution of rights and responsibilities among different participants in the corporation, such as the board of directors, managers, shareholders, and other stakeholders, and spells out the rules and procedures for making decisions. Effective governance ensures transparency, accountability, and fairness, which can enhance investor confidence and reduce the cost of capital.

• Stakeholders: Include shareholders (owners), management, employees, customers, suppliers, creditors, and the community. The board of directors is crucial in balancing these interests.
• Board of Directors: Oversees management, sets strategy, and ensures compliance. A strong board typically includes a significant number of independent directors (non-executive directors with no material relationship to the company) to provide objective oversight.

## Environmental, Social, and Governance (ESG) Factors

ESG factors are non-financial considerations that are increasingly integrated into investment analysis and corporate strategy.

• Environmental: Climate change, resource depletion, pollution, biodiversity.
• Social: Labor practices, human rights, product safety, community relations.
• Governance: Board structure, executive compensation, business ethics, shareholder rights.

Integrating ESG can mitigate risks, identify opportunities, and enhance long-term value creation.

## Capital Structure and Sources of Capital

Capital structure refers to the mix of debt and equity used to finance a company's assets.

• Debt Capital:
• Advantages: Lower cost (interest is tax-deductible), no dilution of ownership, may impose financial discipline.
• Disadvantages: Increases financial risk (fixed payments), restrictive covenants, potential for bankruptcy.
• Equity Capital:
• Advantages: No fixed payments, no maturity date, less financial risk.
• Disadvantages: Higher cost (shareholders demand higher returns), dilution of ownership, loss of control.

Companies raise capital internally (retained earnings) or externally (issuing debt or equity).

## Working Capital Management

Working capital management involves managing current assets (cash, accounts receivable, inventory) and current liabilities (accounts payable, short-term debt) to optimize liquidity and profitability.

• Objective: Ensure the company has sufficient cash flow to meet short-term obligations while maximizing returns on assets.
• Key Ratios:
• Current Ratio: Current Assets / Current Liabilities (liquidity)
• Quick Ratio (Acid-Test Ratio): (Current Assets - Inventory) / Current Liabilities (more stringent liquidity)

## Equity Market Structure and Organization

Equity markets facilitate the issuance and trading of company shares. The primary market is where new securities are issued by firms to raise capital (e.g., through Initial Public Offerings - IPOs). The secondary market is where existing securities are traded among investors, providing liquidity.

Orders can be market orders (executed immediately at the best available price) or limit orders (executed only at a specified price or better). Other order types include stop orders and stop-limit orders, which become market or limit orders once a trigger price is reached. Markets can be dealer markets (brokers trade with dealers), auction markets (buyers and sellers meet at a central location), brokered markets (brokers find counterparties for clients), or direct markets (investors deal directly).

## Equity Valuation Approaches

Valuing equity involves estimating the intrinsic worth of a company's shares.

• Dividend Discount Model (DDM): Values equity based on the present value of expected future dividends. The Gordon Growth Model (GGM) is a single-stage DDM assuming dividends grow at a constant rate (g) indefinitely: `V0 = D1 / (r - g)`, where `D1` is next year's dividend and `r` is the required rate of return. A key assumption is `r > g`.
• Free Cash Flow (FCF) Models: Value the firm or equity based on cash flows available to investors. Free Cash Flow to Equity (FCFE) is cash flow available to equity holders after all expenses and debt obligations. Free Cash Flow to Firm (FCFF) is cash flow available to all capital providers (debt and equity).
• Multiples Valuation (Relative Valuation): Compares a company's valuation metrics (e.g., Price-to-Earnings (P/E), Price-to-Book (P/B), Enterprise Value-to-EBITDA (EV/EBITDA)) to those of comparable companies or industry averages. This approach assumes similar assets should trade at similar prices.
• Residual Income Model: Values equity based on the present value of expected future residual income (earnings minus a charge for the use of equity capital).

## Market Efficiency

Market efficiency refers to how quickly and fully information is reflected in security prices.

• Weak-form efficiency: Prices reflect all past market data (e.g., historical prices, trading volumes). Technical analysis would not consistently generate abnormal returns.
• Semi-strong form efficiency: Prices reflect all publicly available information. Neither technical nor fundamental analysis would consistently generate abnormal returns.
• Strong-form efficiency: Prices reflect all public and private information. No investor, not even insiders, could consistently earn abnormal returns.

Most evidence suggests markets are at least semi-strong form efficient, implying that active management strategies struggle to consistently outperform passive strategies after accounting for costs.

## Introduction to Fixed Income Securities

Fixed income securities represent a loan made by an investor to a borrower (typically corporate or government). They are characterized by a promise to make specified payments over a specified period. Key features include the issuer (sovereign, agency, corporate, municipal), maturity date (when principal is repaid), par value (face value, typically $1,000), and coupon rate (annual interest payment as a percentage of par). Bonds can have fixed-rate, floating-rate, or zero-coupon structures. Some bonds also include embedded options, such as call provisions (issuer can repurchase) or put provisions (investor can sell back).

## Bond Valuation and Yield Measures

The value of a bond is the present value of its expected future cash flows (coupon payments and principal repayment), discounted at the market discount rate (or required yield).

• Yield to Maturity (YTM): The discount rate that equates the present value of a bond's future cash flows to its current market price. It assumes the bond is held to maturity and all coupons are reinvested at the YTM.
• Current Yield: Annual coupon payment divided by the bond's current market price.
• Spot Rates: Yields on zero-coupon bonds. The spot rate curve (or zero-coupon yield curve) is fundamental for valuing coupon bonds by discounting each cash flow at its corresponding spot rate.
• Forward Rates: Interest rates for a future period that are implied by current spot rates.

## Interest Rate Risk and Duration

Interest rate risk is the risk that a bond's price will change due to changes in market interest rates. Bonds with longer maturities and lower coupon rates generally have higher interest rate risk.

• Duration: A measure of a bond's interest rate sensitivity. It approximates the percentage change in a bond's price for a 1% change in yield.
• Macaulay Duration: The weighted average time until a bond's cash flows are received.
• Modified Duration: Macaulay Duration / (1 + YTM/frequency). It's the more practical measure for estimating price changes.
• Effective Duration: Used for bonds with embedded options, as it considers how the option affects cash flows when rates change.
• Convexity: A measure of the curvature of the bond's price-yield relationship. Duration is a linear approximation; convexity accounts for the non-linear relationship. Positive convexity is generally desirable as it means prices rise more when yields fall than they fall when yields rise.

## Credit Risk

Credit risk is the risk that a bond issuer will fail to make timely principal and/or interest payments. It has two main components:

• Default risk: The probability of default.
• Loss severity: The percentage of a bond's value lost if a default occurs.
• Credit ratings: Issued by agencies like Moody's, S&P, and Fitch, providing an opinion on an issuer's creditworthiness. Investment-grade bonds have higher ratings (e.g., AAA to BBB-), while speculative-grade (high-yield or junk) bonds have lower ratings (e.g., BB+ and below).

## Introduction to Portfolio Management

Portfolio management is the process of constructing and managing a collection of investments to achieve specific financial goals. The foundational document for this process is the Investment Policy Statement (IPS). The IPS is a written document that clearly defines an investor's objectives (both return and risk tolerance) and constraints (such as liquidity needs, time horizon, tax considerations, legal/regulatory factors, and unique circumstances). It acts as a guide for all investment decisions and performance evaluations.

## Risk and Return

Investors are generally concerned with maximizing return for a given level of risk, or minimizing risk for a desired return. Return is typically measured by concepts like holding period return or expected return. Risk is commonly quantified by the standard deviation of returns, which measures the total variability of an asset's or portfolio's returns. Most investors exhibit risk aversion, meaning they require a higher expected return to compensate for taking on higher levels of risk.

## Diversification and Modern Portfolio Theory (MPT)

Diversification is a key strategy to reduce portfolio risk by combining assets that are not perfectly positively correlated. It is particularly effective in reducing unsystematic risk (also known as firm-specific or diversifiable risk), which is unique to a particular company or industry. However, systematic risk (market risk or non-diversifiable risk) affects all investments and cannot be eliminated through diversification.

Modern Portfolio Theory (MPT), pioneered by Harry Markowitz, emphasizes optimizing portfolios based on expected return and risk. MPT introduces the efficient frontier, which represents the set of portfolios offering the highest expected return for each level of risk, or the lowest risk for each level of expected return. The Capital Asset Pricing Model (CAPM) is a central MPT concept that describes the relationship between systematic risk and expected return. It uses beta as the measure of systematic risk. The Security Market Line (SML) graphically depicts the CAPM, showing the required rate of return for any asset based on its beta.

## Portfolio Performance Evaluation

Evaluating how well a portfolio has performed is critical. Key metrics include:

• Sharpe Ratio: Measures excess return (portfolio return minus risk-free rate) per unit of total risk (standard deviation). A higher Sharpe ratio indicates better risk-adjusted performance.
• Treynor Ratio: Measures excess return per unit of systematic risk (beta). Useful for well-diversified portfolios.
• Jensen's Alpha: Measures the portfolio's actual return minus the return predicted by the CAPM. A positive alpha indicates the portfolio outperformed its benchmark after adjusting for systematic risk.