Investment Instruments
This domain tests the main asset classes and their defining features: equity ownership rights, fixed-income cash flows and price-yield behavior, derivative payoffs, and the structure of pooled and alternative investments. Questions often compare instruments or compute a return or payoff.
Major asset classes
Equities represent ownership: common shares carry a residual claim, voting rights, and dividends; preferred shares rank ahead of common for dividends and liquidation but typically lack voting rights and behave more like debt. Fixed income is a contractual loan: the issuer pays coupons and principal; key features are maturity, coupon, credit quality, and embedded options; price moves inversely to yield, and duration measures sensitivity. Derivatives derive value from an underlying: forwards are customized and settled at maturity; futures are standardized and marked to market daily; options give the right, not the obligation, to buy (call) or sell (put); swaps exchange cash flows. Pooled investments include mutual funds priced at net asset value at end of day, ETFs traded intraday, and hedge funds with lighter regulation, performance fees, and lockups. Alternatives include real estate, private equity, commodities, and infrastructure; they may be illiquid and hard to value.
Worked example
A call option has strike 50, premium 3, and expires when the stock is 58. Payoff = max(0, 58 - 50) = 8. Profit = 8 - 3 = 5 per share. If the stock ends at 48, payoff = 0 and the loss = 3. The premium is the maximum loss for the buyer; the writer's loss is potentially unlimited. Breakeven = strike + premium = 53.
Traps
- Calling preferred stock debt; it is equity with debt-like features.
- Using maturity as a risk measure instead of duration.
- Mixing forwards and futures: futures are standardized, exchange-traded, and daily settled.
- Assuming ETF prices always equal NAV; premiums and discounts occur.
- Ignoring hedge fund lockups and illiquidity when comparing returns.