Lesson 14.1: Decoding Command Words
Introduction
In this lesson, we will focus on one of the most crucial skills needed to succeed in the CFA Level III exam: decoding command words in constructed response (essay) questions. These command words dictate how you should approach your response, and understanding their nuances is essential for earning full credit. You will learn the meaning behind several common command words, what is required in your answers to meet these expectations, and how these elements are mapped to the scoring rubric.
Learning Objectives
- Identify the command words: determine, calculate, justify, explain, discuss, recommend, and contrast.
- Understand what each command word requires from your response.
- Map command words to the rubric's scoring points.
- Define what each common command word entails.
- Translate a command word into the elements that a graded answer must include.
Understanding Command Words
Command words serve as a guide for your response, directing the reader on how to evaluate the content. Here, we will explore the meaning and expectations of specific command words commonly encountered in the CFA Level III exam.
Determine
When a question asks you to "determine," it requires a clear answer based on given data. You should arrive at a specific conclusion, often requiring a calculation or the application of a formula.
Example
Question: Determine the future value of an investment of $10,000 at an interest rate of 5% over 10 years.
Response:
To determine the future value (FV), we use the formula:
$$FV = PV \times (1 + r)^n$$
where:
- $PV$ = present value ($10,000$)
- $r$ = interest rate ($0.05$)
- $n$ = number of years ($10$)
Plugging in the numbers:
$$FV = 10,000 \times (1 + 0.05)^{10}$$
$$FV = 10,000 \times 1.62889 \approx 16,288.95$$
Thus, the future value of the investment is approximately $16,288.95.
Calculate
The command word "calculate" indicates that you should perform a numerical computation, often using provided data or formulas to achieve a result. This response should include the detailed workings of your calculations.
Example
Question: Calculate the standard deviation of the following data set: 5, 7, 8, 10, 12.
Response:
To calculate the standard deviation ($\sigma$), first find the mean ($\mu$):
$$\mu = \frac{5 + 7 + 8 + 10 + 12}{5} = 8.4$$
Next, compute each deviation from the mean, square it, and then average these squared deviations:
$$\sigma^2 = \frac{(5 - 8.4)^2 + (7 - 8.4)^2 + (8 - 8.4)^2 + (10 - 8.4)^2 + (12 - 8.4)^2}{5}$$
$$\sigma^2 = \frac{(11.56 + 1.96 + 0.16 + 2.56 + 12.96)}{5}$$
$$\sigma^2 = \frac{29.20}{5} = 5.84$$
So, the standard deviation is $\sigma = \sqrt{5.84} \approx 2.42$.
Justify
When a command asks you to "justify," it signals that you need to provide reasons or evidence to support a conclusion. Justifying often involves critical thinking and logical argumentation.
Example
Question: Justify the recommendation to invest in asset A over asset B given their risk profiles.
Response:
To justify the recommendation for asset A, we can observe the following:
- Asset A has a lower standard deviation (risk) of 5% compared to asset B’s 10%.
- Given the return projections, asset A offers a better risk-adjusted return as measured by the Sharpe ratio:
$$Sharpe\ Ratio = \frac{Expected\ Return - Risk\ Free\ Rate}{Standard\ Deviation}$$
Calculating the Sharpe Ratio for both assets shows that Asset A provides a greater return for each unit of risk taken. This comparison justifies choosing asset A over asset B.
Explain
The command "explain" requires a detailed account or description of a concept, process, or relationship. It should be comprehensive and convey sufficient details to ensure understanding.
Example
Question: Explain why diversification reduces risk in a portfolio.
Response:
Diversification reduces risk by allocating investments across various financial instruments or asset classes. The core principle of diversification is that different assets will perform differently under various market conditions. By combining assets that are not perfectly correlated, the overall risk of the portfolio decreases because the poor performance of some assets can be offset by the better performance of others. This reduces the volatility and potential for loss of the overall portfolio, enabling more stable returns.
Discuss
When prompted with "discuss," you are expected to explore and examine various perspectives on a topic. This may involve comparing and contrasting different viewpoints and providing a balanced answer.
Example
Question: Discuss the implications of low interest rates on consumer spending.
Response:
Low interest rates tend to encourage consumer spending by lowering the cost of borrowing. Consumers are more likely to finance large purchases such as homes and vehicles when loan costs are minimal. However, the implications may vary: Some consumers may use the lower rates to manage existing debt rather than spend, potentially limiting the positive effects on economic output. Furthermore, while low rates generally stimulate spending, they can also lead to inflated asset prices, potentially creating negative long-term economic impacts.
Recommend
A command to "recommend" requires actionable advice based on an analysis of the situation. This entails integrating information from various sources to guide decision-making.
Example
Question: Recommend a strategy for improving a company’s cash flow situation.
Response:
To improve the company’s cash flow, I recommend several strategies:
- Tightening credit policies to ensure that customers pay their invoices on time.
- Offering discounts for early payments to incentivize quicker cash inflows.
- Reviewing and renegotiating supplier contracts to extend payment terms without affecting relationships.
By implementing these strategies, the company can enhance its cash flow position effectively.
Contrast
The command word "contrast" directs you to highlight differences between two or more subjects. An effective answer should distinctly outline these differences, providing context and rationale.
Example
Question: Contrast qualitative and quantitative analysis in investment decisions.
Response:
Qualitative analysis involves assessing non-numerical factors, such as company management, industry conditions, and market trends. This approach provides insights into the overall business environment but can be subjective. On the other hand, quantitative analysis relies on numerical data and statistical metrics to assess investment opportunities, offering a more objective and often less biased approach. While both analyses are valuable, their contrast lies in their methodologies and types of insight provided.
Conclusion
Understanding command words is fundamental for constructing effective responses on the CFA Level III exam. By recognizing the requirements associated with each command word, you can tailor your answers to meet the specific expectations of the graders, optimizing your chances of earning full credit. Practice is essential; therefore, continually reference these command words when preparing for your constructed response questions.
Study Notes
- Command words dictate the expectations and style of your response.
- “Determine” and “calculate” require explicit numerical answers.
- “Justify” and “recommend” involve supportive reasoning and actionable advice.
- “Explain” calls for detailed observations and comprehensive detail on concepts.
- “Discuss” requires exploration of multiple perspectives.
- “Contrast” focuses on identifying differences between subjects.