Financial Products and Their Valuation
What CB1 tests in financial products and valuation
This domain tests whether you can value cash-flow claims using consistent discounting and no-arbitrage. Expect bond and equity valuation, derivative payoffs, and the assumptions behind pricing models.
Core rules and concepts
- Present value discounts each cash flow at a rate matching its timing and risk; compounding convention must match the quotation.
- A straight bond’s value is the present value of coupons plus redemption. Yield to maturity is the single rate that equates price to cash flows; it is not the coupon rate.
- Duration measures price sensitivity to yield; modified duration approximates percentage price change for small yield moves.
- Equities can be valued with dividend discount models; growth must be below the discount rate in the Gordon model.
- Forwards and futures lock in a future price; options give rights, not obligations. Put-call parity links European calls and puts with the same strike and expiry.
Worked example
Value a three-year bond, face 100, annual coupon 5%, flat discount rate 4%. Price = 5/1.04 + 5/1.04² + 105/1.04³ = 4.808 + 4.623 + 93.345 = 102.78. Because the coupon exceeds the discount rate, the bond trades above par. The 2.78 premium is the present value of the excess coupon.
Traps that cost marks
Do not mix a coupon rate with a market yield. Use clean versus dirty bond prices consistently. In options, remember the right but not the obligation, and do not apply put-call parity to American options without adjustment. Check whether rates are annual, semi-annual or continuous.