Investments
Domain 9 tests investment principles: asset classes, risk and return, asset-liability management and portfolio construction.
Core ideas
- Asset classes: cash, government and corporate bonds, index-linked bonds, equities, property, alternatives and derivatives. Compare return, risk, liquidity, income, inflation linkage, term and credit quality.
- Return may arrive as income or capital growth; the liability's inflation linkage and term should drive asset choice.
- ALM: cash-flow matching, duration and convexity matching, immunization; mismatches create reinvestment and price risk.
- Diversification, benchmarks, active versus passive management, ESG factors and derivative hedging all shape the risk-return profile.
Worked example
Liabilities have present value £200m and duration 14 years. Assets are also £200m but duration 6 years. To immunize, invest a proportion w in a 25-year bond with duration 18 and the rest in cash (duration 0), so 18w = 14 and w = 77.8%, with 22.2% in cash. Reasoning: matching duration reduces sensitivity to small parallel yield shifts, but not to convexity, credit spread changes or non-parallel shifts, and the position must be rebalanced as durations drift.
Traps
Matching duration but not present value or cash-flow timing; confusing Macaulay and modified duration; ignoring credit default and spread risk; assuming property is liquid; using derivatives without understanding leverage and counterparty risk.