Investments: Asset Classes, Valuation and Derivative Basics
Asset classes
Equities: dividend discount and Gordon growth models, P/E and EV/EBITDA, growth versus value. Fixed income: the inverse price-yield relationship, Macaulay versus modified duration, convexity, credit spreads, curve strategies (bullet, barbell, ladder) and immunization. Alternatives: hedge funds, private equity, real estate and commodities, characterised by illiquidity, layered fees and smoothed reported volatility. Derivatives: payoff diagrams, option pricing drivers and hedging with futures.
Traps
Duration is usually quoted as modified duration: the approximate percentage price change equals minus modified duration times the change in yield; Macaulay duration is expressed in years. In the Gordon model P0 = D1 / (r minus g), g must be below r, and the denominator makes price hyper-sensitive. Preferred stock is a perpetuity (D / r). Hedge fund performance fees apply only above the high-water mark and often a hurdle. Private valuations are appraisal-based, so reported volatility and correlation understate true risk.
Worked example
D1 = $2.00, r = 9%, g = 4%, so P0 = 2.00 / 0.05 = $40. If expected growth rises to 5%, P0 = 2.00 / 0.04 = $50, a 25% price move from a one-point change in g. This is why DDM fair values swing so widely and why implied growth should always be sanity-checked.
Rule of thumb: for a small parallel shift, bond price change approximately equals minus modified duration times the yield change, plus a convexity adjustment for larger moves.