Traditional Investments
The building blocks
Traditional investments cover public equity and fixed income. Know equity valuation (discounted cash flow, dividend discount, multiples), the risk–return framework (CAPM, beta, the security market line), portfolio theory (efficient frontier, diversification), market efficiency, and performance measurement (Sharpe ratio, information ratio, tracking error, attribution).
Fixed income is where most candidates surrender easy points: the inverse price–yield relationship, duration as price sensitivity, modified versus Macaulay duration, convexity, and the level, slope, and curvature of the yield curve. Recall that total return combines coupon income, price change, and reinvestment, and that credit spreads widen in stress.
Traps
- Confusing maturity with duration. A zero-coupon bond's duration equals its maturity, but a coupon bond's duration is shorter.
- Forgetting convexity's sign. For plain vanilla bonds, positive convexity means price rises more than duration predicts and falls less.
- Mixing real and nominal returns, or using the Fisher approximation when the exact relationship is requested.
- Using arithmetic mean returns to project long-horizon compounding.
Worked example
A bond has modified duration 5.0 and convexity 60. If yields rise 100 bp (0.01), the duration effect is -5.0 x 0.01 = -5.0%. The convexity adjustment is +0.5 x 60 x (0.01)^2 = +0.30%. Estimated price change is about -4.70%. Rule of thumb: duration is the first-order estimate; convexity always works in the holder's favor for plain vanilla bonds, so duration-only estimates overstate losses on selloffs and understate gains on rallies.