Capital Markets and Investments
What the domain tests
Capital markets and investments tests money market instruments, bond pricing and yield, duration and credit spread, investment policy limits, and counterparty and liquidity risk. Expect calculations of price, yield, and price sensitivity, plus questions on eligible instruments and diversification.
Core rules and concepts
- Price and yield. Bond prices move inversely with yields. Price is the present value of coupons and principal at the required yield.
- Clean versus dirty price. The clean price excludes accrued interest; the dirty price includes it. Settlement uses the dirty price.
- Money market day count. Discount yields and add-on yields differ, and ACT/360 versus ACT/365 changes the effective return. Compare instruments on a consistent basis.
- Duration. Modified duration approximates the percentage price change for a small yield change: ΔP/P ≈ -D × Δy. Convexity improves the estimate for larger moves.
- Credit spread. The spread over the benchmark compensates for credit and liquidity risk. Widening spreads reduce price.
- Investment policy. Set eligible instruments, minimum ratings, maximum maturity, issuer and sector limits, and diversification rules. Liquidity and principal preservation may outrank yield.
Worked example
A two-year annual 5% coupon bond is priced at a 6% yield. Price = 5/1.06 + 105/1.06² = 4.717 + 93.450 = 98.17. If the yield falls to 5%, the price rises to par, 100. Modified duration is about 1.86, so the approximate price change for a 1% yield fall is +1.86%, from 98.17 to about 100.0. The calculation confirms the inverse price-yield relationship and shows why duration is a first-order risk measure.
Traps that cost marks
Confusing coupon with yield; quoting clean price at settlement; mixing ACT/360 and ACT/365; using duration for large yield moves; ignoring accrued interest; and treating a higher yield as higher safety when it may reflect wider credit spread.