Investment environment, asset classes and financial markets
This domain tests whether you can place an asset in its economic context and explain the return drivers, market structure and practical constraints that matter to an insurer or pension scheme. The exam favours reasoning about why an asset behaves as it does over simple lists.
Asset class map
- Cash and money market instruments: low volatility, liquidity, but exposed to inflation and reinvestment risk.
- Government bonds: nominal and index-linked; the latter hedge real liabilities but carry real-yield and inflation-basis risk.
- Credit: spread over government curves compensates for default, downgrade and illiquidity; spread duration matters as well as interest-rate duration.
- Equities: residual claim, growth and inflation exposure, high volatility and drawdown risk.
- Property: income plus capital growth, valuation smoothing, high transaction costs and illiquidity.
- Alternatives: private equity, infrastructure, hedge funds; return drivers include illiquidity premium, leverage and manager skill.
Return drivers
Separate income from capital growth, and nominal from real return. A liquidity premium is not free: it is compensation for being unable to sell quickly or at a fair price. Currency exposure changes the risk of overseas assets even when local-currency returns are stable.
Worked example
A scheme needs a real return of 1.5% a year. A 10-year index-linked gilt yields 0.8% real; a corporate bond yields 5.2% nominal and expected inflation is 3.0%. The corporate bond's approximate real yield is (1.052 / 1.03) - 1 = 2.14%, which exceeds the target, but only before credit losses, liquidity cost and default risk. The index-linked gilt gives a certain real yield below target. The correct conclusion is not simply 'buy corporate bonds'; you must state the extra risks and whether the scheme can bear them.
Traps
- Quoting a nominal return when the question asks for real.
- Treating historical correlations as stable in a crisis.
- Ignoring market impact and transaction costs when recommending a large allocation.