Financial Markets and Products
Financial Markets and Products
This domain tests valuation and risk of bonds, equities, derivatives and structured products, and how markets transmit risk to insurers and pension schemes.
Core rules and concepts
- Bond prices move inversely to yields. Modified duration estimates percentage price change for a small yield change; convexity corrects for larger moves.
- Forwards and futures lock in a price; options give a right, not an obligation; swaps exchange cash flows.
- No-arbitrage pricing links spot, forward, carry and risk-free rates. Credit spreads reflect default and liquidity risk.
- Derivatives create leverage and counterparty exposure, so collateral and margining matter.
Worked example
A bond has modified duration 5.0 and convexity 60. Yields rise by 0.50% (0.005). Duration effect = -5.0 x 0.005 = -2.5%. Convexity effect = 0.5 x 60 x (0.005)^2 = +0.075%. Estimated price change = -2.425%. The duration-only estimate overstates the fall because convexity is positive.
Traps
Confusing coupon with yield, ignoring convexity for large yield moves, treating futures as zero-risk, and forgetting that option value depends on volatility and time. Also ignoring counterparty credit risk in over-the-counter derivatives.