Valuation and pricing of fixed-income, equity and derivative instruments
This domain tests whether you can value instruments from first principles and explain the assumptions behind the number. Expect discounted cashflow, yield measures, duration and convexity, equity valuation and basic derivative pricing.
Fixed income
A bond's price is the present value of coupons and redemption at the appropriate spot or yield curve. Yield to maturity assumes reinvestment at that yield and a single flat curve. Duration measures first-order price sensitivity; convexity captures curvature. Credit spreads are added to the government curve, but the spread is not a default probability by itself.
Equity and derivatives
Equity valuation uses dividend discount models, free cashflow or multiples. Derivatives are priced by no-arbitrage: a forward is the spot price compounded at the funding rate less income; an option value depends on volatility, time and the forward, not on the expected return of the underlying. Put-call parity links European options.
Worked example
A 5-year bond pays a 4% annual coupon and yields 3%. Its price is 4/1.03 + 4/1.03^2 + 4/1.03^3 + 4/1.03^4 + 104/1.03^5 = 104.58 per 100 nominal. If the yield rises by 1 basis point, the price falls by roughly duration x price x 0.0001. The calculation shows why a lower yield creates a higher price and why long-duration bonds are more sensitive.
Traps
- Mixing yield to maturity with spot rates.
- Ignoring convexity for large yield moves.
- Using a risk-free rate to discount risky cashflows.
- Forgetting that option prices use risk-neutral, not real-world, expected returns.