Investment environment, asset classes and financial markets
This domain tests whether you can characterise each asset class by the shape of its cash flows, its risk and return drivers, and the mechanics of the market in which it trades - then judge which characteristics matter for a given investor.
Asset class cash-flow signatures
- Cash and money market instruments: near-zero duration; the real risks are reinvestment and inflation.
- Nominal government bonds (gilts): fix cash flows in money terms, so they hedge nominal liabilities but not inflation.
- Index-linked gilts: coupons and principal uplifted by RPI, with roughly an eight-month indexation lag. They hedge realised inflation, not expected inflation.
- Corporate bonds: a government curve plus a credit spread; investment grade versus high yield, recovery rates, covenants and callability.
- Equities: a residual claim, growth from earnings and dividends, and an equity risk premium that is volatile and regime-dependent.
- Property: illiquid, appraisal-based valuations, lease structures with fixed or RPI-linked reviews.
- Alternatives: infrastructure (long, often inflation-linked revenues), private equity (J-curve, illiquidity), hedge funds, commodities (roll yield), forestry.
Market structure and efficiency
Primary versus secondary markets, exchange-traded versus OTC, market makers, clearing and settlement. Weak, semi-strong and strong-form efficiency: the stronger the efficiency, the harder it is to earn alpha in a liquid, well-researched market, which pushes active managers towards less efficient segments.
Worked example: breakeven inflation
A 10-year nominal gilt yields 4.5%; a 10-year index-linked gilt yields 1.2% real. The implied breakeven inflation rate is approximately 4.5 − 1.2 = 3.3% a year. A scheme with RPI-linked liabilities comparing the two should prefer the linker only if it expects realised RPI above 3.3%, adjusted for the inflation-risk and liquidity premia embedded in the breakeven. Because of the indexation lag, a sudden inflation spike is hedged with a delay, not immediately.
Traps
Treating breakeven inflation as a forecast - it also contains risk and liquidity premia. Forgetting the indexation lag. Treating appraisal-based property valuations as transaction prices, which understates volatility and autocorrelates reported returns.