Equity and Fixed Income Investments
What the domain tests
This domain tests equity valuation models, market efficiency, bond pricing, yield measures, and interest-rate risk.
Core rules
- DDM: P0 = D1/(r − g); g = retention ratio × ROE. The model requires r > g and a stable dividend policy.
- FCFE and FCFF models value firms that do not pay dividends or have changing payout policies.
- Multiples such as P/E, P/B, and EV/EBITDA must be compared across similar firms and accounting policies.
- Bond price = PV of coupons plus PV of par, discounted at the yield per period.
- Clean price = dirty price − accrued interest.
- Macaulay duration is the weighted average time to cash flows; modified duration = Macaulay/(1 + y/m). Price change ≈ −modified duration × Δy + 0.5 × convexity × Δy².
Worked example
A 3-year, 5% annual-coupon bond with par 100 and YTM 6% prices at 5/1.06 + 5/1.06² + 105/1.06³ = 4.717 + 4.450 + 88.165 = 97.33. Modified duration is approximately 2.86. A 50 bp yield rise implies a price change of about −2.86 × 0.005 × 97.33 ≈ −1.39 before the convexity adjustment. The negative sign shows price and yield move inversely.
Traps
Clean vs dirty price; annual vs semiannual compounding; Macaulay vs modified duration; YTM vs spot rates; applying DDM to non-dividend payers; ignoring credit spread and liquidity risk.