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Passing the CFA® Exam Level III Constructed Response: Video Tutorial

By: Kaplan Schweser
January 8, 2021


Level III of the CFA® exam is quite different from the Level I and Level II exams. Learn from Kaplan Schweser about the Constructed Response (CR) portion of Level III and how to pass in this video.



Video Transcription

Welcome everybody. We’ve got some interesting information for you in these next two sessions. I am going to presume that you’ve already watched the predecessor video on how to pass Level III. Please don’t take that lightly. The Level III exam is quite different in a number of critical issues from Level I and II. Unfortunately, that’s the reason the pass rate is so low at Level III. It’s really tempting to sort of go on autopilot. You’ve got some good ideas. They worked well at Level I and II, and you just keep charging straight ahead. And they’re about to make a turn, and you’re going to charge right ahead, and you’re not going to pass the exam. We want to try to get you reoriented into what’s going on at Level III.

From the previous video on how to pass, you should know that this is essentially 100% portfolio management—a topic that didn’t really count for much of anything at Level I and II. Now it’s the focus. That ties directly into the use of constructed response. If you’re not familiar with the term CR, we mean the constructed response half of the exam, sometimes called essay, but essay is a very broad term. CR is much more specific than the broad statement essay, and you’ll find out that CR is very widely used. So, we need to hone in on what does it mean in the context of the CFA exam. You don’t care what it means in an English major’s exam. You care about what does it mean on the CFA exam, so you can get this done. The change to CR, the application of portfolio management, and essentially this requires more judgment is a big reason the pass rate is so abysmally low at Level III. We’d like to put you on the right side of that.

With a constructed response, you’ve got to provide the answer. You can’t just look and select. That requires, again, more judgment on your part of where should you go, what are the important issues. Level III requires a deeper level of knowledge than Level I and II. Now, that’s a very odd kind of a statement. I’ve worked with a lot of people over the course of my career, and every once in awhile you find those people who really…if you have a problem, that’s who you want to help you, because they’re so good at what they do. What they do is, they know the basics. They don’t go off on tangents. They’re not trying to think of some exotic issue. They have a rock solid understanding of the basics. They do know all the side issues and, if necessary, they can go into them, but almost never should you be doing that. You’re going to find the Level III exam questions test the basics. When you head off into tangents, you may think you’re doing the right thing, and then you’re so confused when you get back this “you did not pass” letter. We’re going to try to start to deal with those kinds of things in these sessions. We do want to focus particularly on the issue of the question style and how to deal with it, but of course we can’t completely separate that from the content. You’ll see us referring to both as we go through this.


In terms of our objectives in this particular session…what is constructed response, why is it being used…because if you don’t understand that, you’re going to be headed off in the wrong direction. We’re going to start doing some actual questions, and we’re going to show you a bad answer. It’s a lot more fun to look at what someone else did and point out what’s wrong with it, but it can also be a learning experience of how do you construct good answers. Then, we’ll start to talk about the appropriate way to approach constructed response, and we’ll show you a good answer to that question. We’ll talk about some do’s and don’ts. Again, it’s kind of fun to look at what doesn’t work, because a lot of them seem very seductively appealing, but they in fact do not work. We’re going to emphasize what will work for you. Then, we’ll move into another question where we have two parts, because you’ll find it’s very, very rare, almost never will a CR question on a CFA exam have only one part. Many have two, three, four, five, six, seven parts to them, so they can be quite lengthy. We’ll begin to look at what that’s going to be like.

Passing Level III

Now I want to give you some compliments in terms of at least you made it to Level III. If you started out with say 1,000 candidates who signed up for the Level I exam, about 25% of them don’t even complete the Level I exam. They either don’t show up on exam day or they show up in the morning, and they don’t even come back for the afternoon session. Those are counted as “do not finish.” And when the CFA Institute talks about pass rates, they are only talking about the people who actually took the entire test, so they don’t even count those 250 people who just dropped out.

Let’s say 750 people actually take the Level I exam…the pass rate is actually quite a bit less than 50%. We use just under 50 to make the numbers kind of nice and round to work with. Let’s say 370 make it through Level I. Again, if just for simplicity we apply about a 50% pass rate, then 180 of them will make it to Level III. So you’re part of a very small group. Now the sobering issue is the pass rate at Level III is only about 50%. So what is it, if you’ve gone through that much, that is making it so difficult to complete the process and actually receive your charter? And I will admit this is probably a little bit pessimistic—it doesn’t consider the repeat, the candidates who take the exam several times and eventually pass.

By the way, from my own personal experience, the record I know of is a Level III candidate who was on their 10th try at the Level III exam. That’s 10 years they’ve been taking the same test. I’m really not encouraging that. I think you’d probably prefer to go ahead and get this done this year. So let’s make that a goal. This is going to be the last year you need to take a CFA exam in order to receive your charter. That’s going to require some work on your part.

Why Three Exams?

I want to emphasize, the exams are not the same. Level I is essentially trivial pursuit for financial analysts. It doesn’t mean it’s easy—there are a tremendous number of factoids and terms you need to become familiar with. But if a Level I question requires you to think of more than two things at once, it’s not really a good question. The questions in hindsight are actually quite simple compared to the things you had to do at Level II.

Level II involved these along deterministic multi-step processes. It’s commonly described by charterholders as the toughest of the three exams. That doesn’t mean Level III is easy, because now they’re going to switch gears. You’re seeing things like…you have to be able to demonstrate, explain, support, extend ideas you were given, write a response to open-ended questions, things you never had to do at Level I and II. And that’s really the heart of why people have so much difficulty with this test. Realize that a 50% pass rate means passing one level has zero correlation with passing the next level. So do not take this lightly. And you really have to change the way you think about things if it’s going to make sense to you.

A Little History

Now, just for fun, we threw in a little bit of a history of how the exam has evolved over time, no question. The best year to have taken the exam and received your charter was 1963. There was only one test. You pass it, you get your charter. It was only four and a half hours long, and the pass rate, by the way, was way over 90%. Unfortunately, there were only a couple hundred people who were invited to take the test, so it was a special sort of a deal.

In the next year, 1964, they began to move to the format you now face. They moved to the three levels— one, two, and three—but it was 100% essay. In 1968, the exam got a little bit longer, and they began to selectively experiment with putting some multiple-choice questions on the exam. Not every year, but occasionally, they throw a few in just to see what happened.

In 1981, they went to the six hours per exam level. In 1986, they went to 50% multiple-choice at Level I. Then they moved to 100% multiple-choice at Level I. Then they evolved to where the Level II became 50% item set. And finally we reached, in 2005, the type of exam you’re familiar with, where Level I was 100% multiple-choice, Level II was 100% item set, and Level III was 50% item set and 50% remained “essay.” But along the way, essay became constructed response, something much more specific that we’re going to be discussing.

You’ll notice, by the way, that all of this comes from CFA Institute material. It’s out there, but it would be very hard for you to find all of this on your own, so we’re trying to help to make this a little bit easier. So let’s see if we can just jump right in and see if you’re beginning to get the idea. The Level III exam is 50% what? Now, by the way, every one of these statements is true. So I want you to identify the three most correct answers out of this list. I’ll give you just a second to do that.

Now, the three best answers are C, D, and A. It is true that it’s half multiple-choice. But multiple-choice is a very generic term. Item set is much more specific, so it’s a better answer. It’s also true that occasionally the institute or I will say essay, but more often they will say constructed response because essay can mean a lot of things. We mean something more specific, constructed response. And, the CR has been evolving over the last through years to typically much shorter answer questions. The institute has explicitly stated…they understand that in many professional educations now, are released not in a so much professional education, but in your undergraduate or even graduate education, writing may not have been emphasized. You may have only been taught keyboarding skills. They realized that the requirement to write is not familiar to many candidates. They also know that many of the candidates, if not a majority, use English as a second language, so they’re making the questions shorter and more specific. That’s why the last three are the better answers.

What Is Constructed Response?

So what is it you need to do you need to do? You need to able to think more broadly. When you’re approaching the Level III exam, every single question, what exactly did they ask you? We’re going to see some of the questions, and we’re going to see they’re very specific in what they ask for. Then you’ve got to look at the case facts, the information that was given to you. Because they don’t care about the question if you don’t tie it directly to the case facts that were brought up. They don’t want a generic answer—they want an answer that fits this set of case facts. And you can’t just create your own approach. They’re testing taught material.

So this might look a little like the old Venn diagrams from Level I, and that’s exactly what it is. Where is the overlap? It’s pretty small. You’ve got to do all three things in order to give the answer that they will accept. Usually, there’s not just one exact way it could have been said, but you do need to find the intersection. And if you don’t think about all three aspects of this, you’re not going to come up with an answer they will accept. They’ll invite you back to take it again, because they will not give you credit for what you’re writing down.

Now, the most basic definition of constructed response is it’s not multiple-choice. A little more helpful is open response. You’ve got to decide what was important, and what are you going to write down. And that means you’ve got to think about the question, the case facts, and the material you will sign to learn to base your answer on. There will be an intersection. What you can count on is the institute has designed the question to have an answer. The question is, do you know the process you should have gone through to come up with that answer?

This is much harder. When you can look at A, B, or C, and pick the best answer, you have a lot of prompts about what to do. When you’re given a blank piece of paper, it’s tougher to figure out. What are the things I might do, and what is the right thing to do to answer this question? Hence, we’ve got a couple of videos to help you do that.

CR Question 1

So we’re going to jump right into an example of a question. Now, if you’ve started reading this, you’ve got one of those problems—you like to jump ahead and do it your own way. I’m going to suggest with every constructed response question, you want to go through essentially a mantra. What are the minutes? What’s this question worth? How much time am I supposed to be spending on it? Because that’s part of the instruction, that’s part of directing you…how much detail you are to provide in your answer. So the first thing you want to know is the minutes—they will always be provided—every question is different in constructed response.

Then you want to find the actual question. That’s typically at the very end of all the stuff. There’s almost always some bolded command words in the question part, you want to go find that. You want to read it so you know what the topic is, what’s the issue. Then you come back and read the case information, that’s what you see up in front of you, because now you know what you are looking for. Then you want to read the question again, because in the process of reading the case, you can start to go off track. You’ve got to rein yourself back into what exactly are they asking you to do. Then you begin to solve the question.

If you were to Google constructed response on Bing, or whatever search engine you like, you’re going to find hundreds of thousands of entries related to constructed response. I’ve actually gone through quite a few of them to find ones that are relevant to the CFA exam, because it’s a very broad topic. So we’re trying to distill down for you the things that work, and what you’ll find is a common theme. To answer a constructed response is not like multiple-choice—you have to slow down. You first have to read the question, you have to read the case information, you should reread the question to re-verify where you’re trying to go with the information. Then you should check the information for what is in fact relevant, and then you start writing. The tendency is to just grab a pen and start to write. It doesn’t work. You will not do very well following that process. There is a way to do this.

So let’s try to apply. We jump ahead and see this is a six-minute question. You see some bolded command words, so you know you’re in the area of where the actual question is. They say to assume both managers consistently outperform their benchmarks. State whether Bean, Hill, or both, so apparently there are some people involved in this, have violated the efficient market hypothesis. Explain which forms of market efficiency are violated. This by the way was taught at Level I, it is a part of the Level III curriculum, it’s a perfectly plausible question. But everything you need to know to answer this question has already been taught at Level I. It was reviewed at Level II, it is reviewed at Level III, so the philosophy is there are no excuses when you mess this thing up. You have no mercy, no credit. Hey, try again next year. It’s a very basic question, make sure you can do it and can articulate correctly what they’re looking for. And notice you need to support your answer with specifics related to the manager’s techniques. Who are the managers? What did they do? How does it relate to the efficient market hypothesis? And what has been violated in the efficient market hypothesis?

Now you’re ready to go look at the case information and begin to make some decisions. So we see that we have two individuals, they are Bean and Hill. They are charterholders, and there’s that word, they’re portfolio managers, so we’re tying this into the topic of interest at Level III. They’re discussing efficiency. Bean uses technical analysis, so right now we’ve got a fact. What is Bean doing? Technical analysis, past price in volume. They didn’t even make you remember that…that’s up to you to know. It happens to be in the currency market, but that’s irrelevant.

Hill uses fundamental analysis, financial statements. And by the way, Bean states that his past success using tactical analysis in the currency markets is a violation of all forms—that happens to be true. Hill adds her success is also a violation of the hypothesis. Hey, remember there’s three forms of market efficiency. What exactly is being violated in these situations? So the important issue is who is doing what? Then you want to check the question again because the last thing you want to do is start wandering off in generalities that don’t actually answer the question. Which forms of efficiency are being violated by each of these individuals? Support that, which means refer directly to what they’re doing that’s creating a violation.

Answer 1-1

So let’s take a look then at a potential answer. Now, this looks extremely long for three minutes, and of course it actually keeps going, and it keeps going. So what I want to do is, I’m going to pause the recording for just a moment, and I want you to do the same thing. I want you to read over that answer, and I want you to decide what score you would give it. I’m going to give you a hint. Go back and read the question…what did they ask for and how much of that was actually done in the answer? Because that’s how you’re going to be graded on exam day. So I’m going to hit the pause button, and you give that a try.

Okay, well, I hope everybody did read through that, saw what there is there and took an opinion of what you would give as an answer. Now, here’s what’s interesting. Basically, everything in these couple of pages is correct. This person obviously knows a great deal about the efficient market hypothesis. Everything here should be familiar from other levels of the exam, but unfortunately the score is zero because it never gets around to answering the question. When you’re a grader, you will see answers like this, and you’ll basically be like, "Oh no, not another one.”

Why don’t the candidates understand they’re supposed to answer the question they’ve been asked? And, this doesn’t do the job. You can’t simply expound on things. You’ve got to bring it home to what was asked. That’s what they mean by construct a response directly applicable to the question that was asked. So you look back, you need to state whether they have violated, you need to state which forms of efficiency. You need to point out what exactly they did that committed those violations, and they never got around to that. In addition, you can’t do what was done in six minutes. You’re wasting a lot of time when you do it.

So, it’s not just the bolded command words but what goes with those bold command words. What you’re being asked specifically to find and identify? So, good display of general knowledge, and they have been very clear you receive no credit for that on the exam. You must tie it into what’s being asked. Zero points.

How to Approach a CR Question

So you want to train yourself to actively read the question. It’s a six minute question so you shouldn’t be writing a whole lot. What was done, and how do those actions relate to the three forms of efficiency? If you don’t know the efficient market hypothesis, obviously that’s going to be a problem with this question.

Then you read the case facts. Bean is doing technical analysis. If you know the three forms, that’s a violation of the weak form. Because the semi-strong and strong form incorporate the weak form, it also violates those as well. Hill uses fundamental analysis. Fundamental analysis is not part of weak form, so there’s no violation. Weak form only references the use of public price and volume data, essentially charting type information. Fundamental data is not covered by that, but it is covered by the semi-strong form, so there’s a violation. And again, the strong form incorporates the semi-strong form, so it’s also a violation of strong form. That’s the content issue.

So identify what’s being asked, understand the case facts, relate it to the taught material. Now practice writing that down so you can collect some point value, because so far you have zero credit.

So again, the issues are that you violated all three forms with technical analysis. With fundamental analysis, you’ve only violated two of the forms. And the institute, again, has been fairly generous. If you’re able to wade through the websites, it’s not easy to find all of this stuff, they continually stress, number one, you have to write to answer the question. So if you write a very short answer that doesn’t actually address what was asked for, you’re not going to get full credit.

However, the more common problem is, people write too much. They just start wandering around and saying a lot of things, and even if they’re true, if they’re not on point, they do no good, and they actually sort of indicate you don’t know how to answer the question. You should be spending more than half the time reading, thinking, and deciding, and you should be spending less than half the assigned time in actually writing out the answers. One without the other won’t do it, so you want to begin to get a sense of proportion and begin to practice. And remember, the clock is ticking, the clock is running, so it’s going to take some practice to do this. We’ll continue this, by the way, all the way through our class presentations. We’ll give you the opportunity to practice. So think first, then write, is the message.

Answer 1-2

How about this as an answer. Bean uses past price and volume data to outperform, so we’ve got to be factual with what is being done. It’s correct, that’s a violation of the weak form. Why? We give a brief explanation of what the weak form encompasses, and then we point out that since the semi-strong and strong form incorporate that, it becomes a violation of all three. We go on to state what Hill has done using fundamental data, which was not covered by the weak form. So there’s no violation there, but it does violate the semi-strong and the strong form. Good answer. This answer would almost certainly get full credit. By the way, you’re never going to know the exact wording to use. It’s the content of your answers that’s going to be graded.

So you want to begin to calibrate…to what does a good answer, in this case a six minute question, look like? And the reason it’s a good answer, because it answers the question that was asked. You’re supposed to state, you have to be specific to what’s happening. You have to relate it back to the three forms of market efficiency. We did all those things. That makes it a good answer. If you could do it in less, that’d be fine. If you want to write a whole lot more, and you still get it done, that’s okay, but you’re almost certainly going to run out of time on the exam when you start to give run-on on answers.

So, the answer key will spell out for the grader how to award the point value. Probably something like stating whether they have or haven’t violated is going to get you two points. Explaining, getting into what they’ve done and what the efficiency assumes, gets you two points. And supporting that with direct references to the case facts might get the other two points. The answer keys have never been released, you never get to see one of these, which is why we talk about them. The Institute does release the last three years of the morning exam, and they provide a sample answer, but they…when we cover this in the previous video on Level III…those sample answers they have clearly stated do not reflect what you’re supposed to write. They’re typically much longer, they run on into a lot of other issues. They’re a nice opportunity for them to expound, but they’re not actually showing you how to write an answer to the exam question. Hence we’re going to address head on, how do you write an effective answer to the exam?

What Others Say

Now, curiously, you’re going to find that many charterholders say this is the easiest of the three exams. So I want you to sort of think about this graphic, and you see over to the left and the right, all those people just fading away and disappearing…those are the candidates who signed up but never make it to Level III. You’re in a very small group here in the center. But once again, you see in sharp focus in the front and then sort of fading away into the background into a lot of people—that’s the 50% pass rate.

Let’s assume in the front row are the charterholders. They regularly say the Level III exam is the easiest of the three exams. But you may be in the back row. What is it that candidates are saying about Level III? Essentially, they express confusion. “I don’t know what they want me to write.” They don’t want you to write anything. They want you to answer the question. It’s the wrong question that you’re posing. When you say, “What do I write?” you’re actually looking at it the wrong way. It’s never going to get any better as long as you do that. You’ve got to know the material, you’ve got to read the question, you’ve got to read the case facts, and remember, they wrote it so there will be a fairly small intersection that will provide the answer. You can’t look at other answers to other questions and copy them because the facts and the case specifics will be different. Every question is unique. But if you get in the habit of doing this, it’s actually not that tough a test.

Other people will say, “I just don’t even know why I failed.” Well, they didn’t listen, they didn’t change direction. They’re still trying to think like Level I and II. Unfortunately, that can be terminal in this exam process. You don’t want to do that.

Passing Level III Required for Better Jobs

So if you want to pass…and by the way prospective employers are going to look for the same thing. I’ve been told this a number of times by senior professionals. What they value in the CFA Program is it requires people learn the ability to think, to find the big picture, the main points. It is not an exam of technical expertise. If you’re going to be a technical expert in any one aspect of the CFA Program curriculum, you’re going to be spending years on one area. This is a test of general knowledge and broader thinking. That’s why it is so valuable.

You will find many of the things in the Level III curriculum, as we go through them, that you’ve already had at Level I and II. In many cases, we’ll tell you a little bit more or what you thought you learned you didn’t quite get it right…you’ve actually got some fundamental mistakes to correct. We’re going to come across a number of those kinds of things. You want to always hone in on what is the most basic issue that is being taught, and then how do I apply that to a very case-specific situation? When you think it’s hard, it’s because you’re not actually paying attention to what they wanted you to focus on. So sometimes Kurt Schuldes and I, we’re going to be your primary contacts, as well as a local instructor if you’re taking our live classes. Sometime we’re going to tell you, “You know, you’re looking at the wrong stuff. Stop looking at that. Let’s go over this way, and you’ll be able to understand what’s going on.” If you keep heading off in the wrong direction, it’s not going to work. So we’ve got to head where you should be going.

You can think about this exam in a sense as a big puzzle. You’ve got the case situation, the specifics. You’ve got to be able to articulate and support what you’re trying to say. You’ve got to be able to prioritize. You can’t spend unlimited amounts of time just wandering wherever seems interesting to you. Time management is much more difficult at Level III when you have the open response type question, than it is at Level I and I. We, again, can work on those as we move along.

Remember the very first thing you should check on every CR question is how many minutes go with this question. That, by the way, is another thing you would have been taught if you were to go study—what is constructed response, and how are you supposed to answer them? You always start by understanding the minutes assigned to that question and allocated to it. And of course you do have that issue…you’ve got to be able to display, and that means write, an answer. So there’s quite a puzzle we’re going to be walking through. It’s not going to happen in one video, but it certainly will happen over the course of the study program. At some point you want to learn to self-edit. It’s one of the most valuable things I learned in my entire college career. I could pick out a handful of times when a professor actually did something particularly useful.

I remember I had a course, I had a paper, I got an A-minus on the paper. Got a nice grade, but the professor was kind enough to sit down with me and show me how you could edit it and make it so much better. Take out the superfluous stuff. What is your main point? Support and make that point. That’s essentially the same type of thing that you have to do on this exam. That’s why we sometimes show you bad answers before we show you good answers. Begin to hone in on what is going to work. And you can’t, of course, skip the content knowledge. That’s why you’re going to need to go through the classes and the study process. You should allocate about four, five months for that, and then about a month for intense review and sample exam practice.

This is going to take practice. It is not in an innate skill. Maybe there’s a one tenth of one percent who are innately born able to do it. That’s not going to help most of us, you’re going to have to begin to learn to do this. You need the knowledge and you need some writing and thinking skills to pass Level III.

Do’s and Don’ts

Now, CR in general is thought of as anything that’s not item set. However, we need to hone this down to what does it mean in the CFA Program curriculum? It means some very specific kinds of things. You can well have been taught things in other parts of your education about essay that in fact do not apply here and can actually be detrimental. So if you were to look over there on the left-hand column, I’m not going to read through that, those are probably things at some point or another that you have heard. However, they do not apply to the CFA exam. Restate the question, write in full paragraphs and full sentences, start with an intro paragraph, then a content paragraph, then a conclusion paragraph. You’re going to be graded on your spelling, on your grammar. No, you’re not. In many exams, that’s true. It is not true on the CFA exam.

Again, the institute is not shy about making this available…it’s just kind of hard to find. They are looking for content, and they are only grading the content. Argue answering using what you were taught relevant to the case facts, the question that was asked. They do require coherent statements, but they actually prefer you write in statements, or some people call this bullet points, and not bother to use full sentences. They are grading you on content, so you may have to let go of some things that you thought were important elsewhere.

And the problem with all the stuff on the left is it gets in the way of focusing on what matters. So the stuff on the left isn’t inherently wrong, except it takes too long. It’s consuming your clock, and you’re not getting around to doing what you’ll be graded on. So I don’t want to harp on this or maybe I do, but it’s pretty important to get this straight and begin to do this correctly.

CR Question 2

So let’s take a look at another question, and I’ll make sure we do that in each of the videos. You already know the issue. What are the minutes? Typically they will tell you upfront how many parts and how many minutes in total. It’s eleven minutes. Then you want to find the question. That means you’ve got to advance through the material, and you see two parts. In Part A, we want to assume Cassidy wants to retain all upside potential if his forecast is correct. So what the heck is his forecast? How are you going to answer the question if you don’t know what the facts are? What does Cassidy think? He wants to retain upside. Upside on what? We need the case facts. Recommend what he would do and explain how it would work using only put options or only call options.

Now I’ll give you another hint. There’s another part of the question. Until you see intervening additional information, it’s helpful to know what the other questions are going to be asking about. Assuming he wants to eliminate any initial cost and become highly confident in his forecast, don’t continue. Because now we’re making new assumptions. Those assumptions do not apply to Part A. So you read anything up until you start seeing new information, and then you stop. We’re going to focus only on one Part A and once we solve Part A, then come back and work on Part B.

What does he believe? He wants to keep the upside. How can he do something with put options or call options? Not and…or, either/or, what can he do? Now you’re prepared that you’ve actively read the question, you’re ready to read the case facts. So we have John Cassidy, as a CFA manager of bond portfolios, US-based. He manages duration in anticipation of interest rate changes. Interest rates may increase.

All right, there’s his view. His view is that interest rates are going to go up. He wants to retain upside in his bond portfolio if the rates go up. He wants to change portfolio in duration and anticipation, sure. If you lower duration when rates go up, value goes down, but it goes down magnified by duration. Remember the old formula: percentage change in value is minus duration, Delta R, rates go up times minus duration, value goes down. With a lower duration number, value would go down less. That was taught at Level I. Here is the heart of things you will be working on in Level III as a portfolio manager.

Now, what does he have available? Some derivative instruments. He has available calls and puts on bond prices. That’s one category of derivatives. He has calls and puts on interest rates. You studied all these at previous levels. And he has futures contracts on Treasury bonds. He wants to minimize the number of transactions, don’t do a lot of transaction when you can use a smaller number, and he doesn’t want to have to do subsequent re-balancing. The view is that rates will go up. You have available calls and puts on bond prices. I want put options on bond prices. If rates go up, prices go down. Those puts will become more valuable, that will provide some buffering.

Second, I have call options on interest rates, a call option on interest rates. When interest rates go up, you receive the difference as the rate goes above the strike rate. Material that was taught at Level I, Level II, and will be extensively reviewed at Level III, now apply it to a portfolio management situation and directly answer the question. The question, remember, said to use either calls or puts. So we’ve identified what we need to do, we’ve checked the case facts, we’ve selected the relevant body of knowledge that applies to this question. Now you’ve got to go collect your point value.

CR Strategy

Read the question, read the case facts. Reread the question, think about the case facts. What were you taught, how does it intersect, and what would be an appropriate answer to give? Then write it down. The writing process really shouldn’t take 50% of the allotted time.

Now, as a hint, on exam day, this needs to have become automatic. But to get there, you should always, after you’ve done a question, stop and review what you’ve done. Relook at the question, relook at the case facts and ask, have you actually answered the question? Did you use the most prominently taught material to do it, or have you wandered off on a tangent you thought was interesting and didn’t display a mastery of the body of knowledge? That’s all it takes to pass this exam. It’s not a tough test.

Answer 2A

So how about this as an answer? You know it’s a nice beginning. You can purchase options, would give asymmetric risk modification. He can retain all of the upside without downside. He expects interest rates to increase, he mustn’t reduce duration. That’s all true. By the way, it doesn’t answer the question. What kind of options? Because we’ve got options on prices, we’ve got options on interest rates. This is a nice generic statement, but it doesn’t answer the question. It gets zero credit.

Then you jump in and start saying exactly what you’re going to do. Now we’re getting down to something that could be worth something. Buy call options on interest rates. If rates increase, he’ll receive the difference between the rate and the strike rate. Okay, we’ve answered the question. Buy put options on bond prices. We elaborate a little bit. These are good answers.

But there’s also a lot of extraneous stuff here. So I want you to look at that answer for a minute, and then I want you to determine how you can quickly, without any great difficulty, mark out about thirty percent of it. And what else do you need to do to actually answer what was asked. Go back and check the question. I’ll give you a second to do that.

That first paragraph is nice, but it’s not actually answering anything. It’s a nice general display of knowledge. You don’t get any credit for that. You have to take the knowledge and hone it in and say things that are directly relevant. And many are in the habit of…you just want to show them all you know all this stuff. It’s not what they’re looking for. You’re wasting your time. But even worse if you don’t consider your time important, you’re wasting the grader’s time. That’s generally a bad idea. It doesn’t really encourage confidence on their part that you know what you’re doing.

And by the way, how many people picked up that the candidate gave the answer backwards? Part II asked about interest rates and calls. Part I was asking about puts and bond prices. So let’s write the answer down in the right order. If you get in the habit of, well I put it down, I’m sure the grader will go find it for me. They really won’t. They’re going to stress you have to put the answer down where you’re supposed to put it. You can’t jumble it together. This is a matter of slow down, be disciplined, and pay attention to details. Exactly the type of skills that a prospective employer has a right to ask for…the inability to do that will get in the way of receiving the charter.

Answer 2B: Homework

So we could have quickly honed this down and made it an easy answer to write within the allotted time. Now, for Part 2B that’s a homework assignment. A good way to do this is to buy yourself a nice big spiral notebook, you know, maybe one of those 300 or 500-pagers, a couple of ballpoint pens, and every time you’re working a question, do it right there so you can look back and see…are you getting better? Are you getting to the point where instead of just rambling discussion, you give short to the point, this is what I was asked, this is the answer to what I was asked. Because that’s what they’re looking for. It’s going to take practice.

And notice I did say ballpoint pens. Over the years, from time to time, the institute has said they will accept pencil. Most years they say they won’t even accept it. If they write in pencil, they warn you that may cause you to fail the exam because the pencils tend to smudge. If they can’t read what’s on the paper, you get no credit. It’s your problem if they can’t read it, so you do want to get in the habit of writing in ink. It trains you to think before you write, and that’s a very good skill for the exam and for your future career.


So for 2B’s homework, we’ll pick it up in the next video. Hint, I will keep saying this. This is well-taught material. How do you learn to do constructed response? You learn, you read the question, you pay attention to the minutes that are assigned to the question, you read the case facts, you reread the question, you reconsider how the case facts fit the question that was asked, and what was prominently taught. What is someone well-familiar with the material going to do to answer this question? Then you start writing.

Somebody, I saw this, I was actually reading a novel over the Christmas break. I had some spare time. There was a great quote in there. Somebody…was going to take some kind of exam and they said, “Read every question twice before you pick up your pen.” It’s good advice. You only have to take it for it to be of any value to get in the habit of doing this.

And before you come back and watch the next video, put your answer away for a day and then go back and self-edit it. That means go back and reread the question, reread the case facts, and just ask yourself, "Is this really a good answer? Is this really to the point exactly what they ask for?” Or are you throwing in a bunch of extra stuff? Or did you miss that they said, “Support with two one, just give one reason.” Pay attention to the command words or you’re going to be in trouble. Improve on your answer. It’s the only way you get better. It’s just like a musical instrument, skiing, riding a bicycle, all kinds of things. Without practice and learning from your own mistakes, you’re not going to be ready on exam day. But it’s easy to get there.

Now, in part two, we’re going to do several things. We are going to go back over Question 2B. We’ll see if you’ve applied what we’ve all been talking about. We’ll show you a calculation-type question because they do include those in constructed response. They’re going to stress showing your work. We’re going to cover what many people call the worst question they get on the exam—an investment policy statement relating to an individual. It’s the one many people have nightmares about because they’re not following a taught process. It’s not even that hard to do. And we’ll talk about some additional next steps that you’re going to want to be following over the next months.

So, time to take a break. Think about what you’ve learned. Work on Question 2B, put it away for a day or two, come back and review it before you watch Part 2. See you then.


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