Investments and Finance
Investments and Finance tests whether you can build and monitor an asset portfolio that meets liabilities, quantify its risks, and explain the governance around it. Questions mix portfolio theory with practical UK constraints: matching adjustment portfolios, liquidity, credit spreads and derivative hedging.
Core toolkit
- Asset classes and risks: gilts (interest-rate, inflation), corporate bonds (spread, default, downgrade), equities (volatility, dividend cuts), property (illiquidity, valuation lag), alternatives.
- Duration and convexity: modified duration measures price sensitivity to small yield moves; convexity matters for large ones.
- Immunisation (Redington): match present value and duration, and use convexity so the position is protected whichever way rates move.
- Portfolio theory: diversification, efficient frontier, CAPM, Sharpe ratio - and recognition that inputs are estimated with error.
- Derivatives: swaps, futures and options to hedge interest rate, inflation and currency risk; collateral and basis risk are part of the cost.
Worked example
Liabilities are GBP 50m with modified duration 12; assets are GBP 50m of bonds with duration 6. Yields rise 25bp. Liabilities: -50m x 12 x 0.0025 = -GBP 1.5m. Assets: -50m x 6 x 0.0025 = -GBP 0.75m. Surplus improves by GBP 0.75m because the fund is short duration relative to its liabilities. Extending asset duration to 12 immunises the position and removes both the gain and the loss.
Traps
- Quoting Macaulay duration as if it were modified duration.
- Assuming matched nominal cash flows remove inflation risk.
- Ignoring credit spread widening when government yields rise.
- Overlooking liquidity and collateral calls, as in the 2022 LDI episode.
- Treating diversification as removing systemic and correlated risk.