CISI CWM FM — CISI Chartered Wealth Manager — Financial Markets Cheat Sheet
Cheat sheet: exam-prep reference for the Chartered Institute for Securities & Investment CISI Chartered Wealth Manager — Financial Markets (CISI CWM FM), covering markets, instruments, formulas, and decision points.
Use the tables for a quick pre-exam check. Expand a topic’s notes for explanations, examples, and additional distinctions.
Scope and study context
Focus on three exam skills:
- Classify the instrument: equity, debt, derivative, fund, FX, money market, alternative.
- Identify the risk/return driver: rates, credit, inflation, currency, volatility, liquidity, market beta, leverage.
- Apply the client or portfolio context: income, growth, preservation, liquidity, hedge, diversification, time horizon.
| Exam identity | Detail |
|---|---|
| Provider | Chartered Institute for Securities & Investment |
| Official exam title | CISI Chartered Wealth Manager — Financial Markets |
| Official exam code | CISI CWM FM |
| Best use of this page | Fast concept review, error checking, and final-stage practice planning |
| Practice link | Use alongside independent companion practice, original practice questions, topic drills, and detailed explanations |
This page is independent review support. It does not replace the provider’s current syllabus, workbook, or exam guidance.
Use this as a three-pass review:
Scan the concepts Identify topics where the rule, calculation, or instrument feature is not instantly clear.
Practise by topic Use question bank topic drills immediately after each section. Do not wait until you feel “fully ready”; exam readiness comes from applying the concepts.
Build an error log For every missed question, record:
- topic;
- why the wrong answer was tempting;
- the rule that decides the question;
- whether the issue was knowledge, calculation, wording, or timing.
High-yield market map
| Area | What to know | Exam trap |
|---|---|---|
| Money markets | Short-term borrowing/lending, cash equivalents, liquidity management | Low risk is not no risk: credit, reinvestment, liquidity, and rate risk still matter |
| Bonds | Price/yield inverse relationship, duration, credit spread, clean vs dirty price | A higher coupon usually lowers duration versus an otherwise similar low-coupon bond |
| Equities | Ownership, residual claim, dividends, voting, valuation ratios | P/E is not automatically “cheap” or “expensive” without growth, risk, and accounting context |
| FX | Spot, forward, direct/indirect quotes, bid/offer, interest-rate parity logic | The client buys at the dealer’s offer and sells at the dealer’s bid |
| Derivatives | Futures, forwards, options, swaps; hedge/speculation/arbitrage | Futures create symmetric exposure; options create asymmetric exposure |
| Funds | Open-ended vs closed-ended, active vs passive, NAV, premiums/discounts | ETF price and NAV can diverge intraday; closed-ended funds can trade at discounts/premiums |
| Alternatives | Property, commodities, hedge funds, private equity, infrastructure | Diversification benefit may disappear in market stress; liquidity terms matter |
| Market structure | Primary/secondary markets, exchange/OTC, order-driven/quote-driven | Clearing reduces counterparty risk but does not eliminate market risk |
| Portfolio risk | Volatility, beta, correlation, tracking error, VaR, drawdown | Correlation is not constant and is not causation |
Economic and market cycle reference
| Indicator/concept | Rising usually suggests | Falling usually suggests | Wealth-management relevance |
|---|---|---|---|
| GDP growth | Economic expansion, stronger earnings expectations | Slowdown or recession risk | Equity cyclicals, credit spreads, default expectations |
| Inflation | Higher input costs, possible rate rises | Disinflation or weak demand | Real returns, index-linked bonds, cash drag |
| Policy rates | Tighter monetary policy | Easier monetary policy | Bond prices, mortgage costs, discount rates, FX |
| Yield curve steepness | Growth/inflation expectations or term premium | Flattening may signal tightening or slower growth | Duration positioning and bank profitability |
| Credit spreads | Higher perceived default/liquidity risk | Better risk appetite or credit conditions | Corporate bond allocation and credit quality |
| Unemployment | Weak labour market if rising | Tight labour market if falling | Consumer demand, wage inflation, policy response |
| Currency strength | Capital inflows, higher relative rates, better sentiment | Weak external position or lower relative rates | Imported inflation, overseas holdings, hedging |
| Commodity prices | Cost pressure; sector winners/losers | Lower inflation pressure or weak demand | Inflation hedges, resource equities, emerging markets |
Notes and examples
Monetary and fiscal policy distinctions
| Policy tool | Mechanism | Likely market effect | Common trap |
|---|---|---|---|
| Policy rate increase | Raises short-term risk-free rates | Bond prices down, currency may strengthen, equity discount rates up | Effect depends on expectations already priced in |
| Policy rate cut | Lowers discount rates and borrowing costs | Bond prices up, risk assets may rally, currency may weaken | Cuts during crisis may signal economic stress |
| Quantitative easing | Central bank buys assets, injects liquidity | Lower yields, tighter spreads, higher asset prices | QE affects long rates and liquidity, not just overnight rates |
| Quantitative tightening | Central bank balance sheet reduction | Higher yields/liquidity pressure possible | Impact may be gradual and market-dependent |
| Fiscal stimulus | Government spending/tax support | Growth boost, possible inflation/deficit pressure | Bond yields can rise if borrowing concerns dominate |
| Fiscal tightening | Spending cuts/tax increases | Demand restraint | Can improve fiscal credibility but hurt growth |
Economic cycle and asset classes
| Economic environment | Typical market implications, all else equal | Watch the caveat |
|---|---|---|
| Strong growth | Supports equities and credit-sensitive assets | May raise inflation and rate expectations |
| Weak growth | Pressures earnings and credit quality | May support high-quality government bonds if rates fall |
| Rising inflation | Hurts fixed nominal cash flows | Inflation-linked assets may behave differently |
| Falling inflation | May support bonds if rate expectations decline | Deflation can damage growth and profits |
| Tightening monetary policy | Higher short-term rates, pressure on duration assets | Currency may strengthen if rates rise relative to others |
| Easing monetary policy | Lower discount rates, possible support for risk assets | Easing may signal economic weakness |
| Steep yield curve | Market may expect future rate rises/growth/inflation | Interpretation depends on starting conditions |
| Inverted yield curve | Market may expect future rate cuts or slowdown | Not a precise timing tool |
Inflation, nominal returns, and real returns
Nominal return is the return before adjusting for inflation. Real return reflects purchasing power.
\[ r_{\text{real}} = \frac{1+r_{\text{nominal}}}{1+i} - 1 \]Where \(i\) is inflation.
For quick estimation, real return is approximately:
\[ r_{\text{real}} \approx r_{\text{nominal}} - i \]Trap: a positive nominal return can still be a negative real return if inflation is higher.
Interest rates and bond markets
Interest rates affect:
- cash and money market yields;
- bond prices and yields;
- equity valuation through discount rates;
- mortgage and borrowing costs;
- currency values;
- derivative pricing;
- investor preference between income, growth, and defensive assets.
Exam decision rule: when market yields rise, prices of existing fixed-rate bonds fall; when yields fall, prices rise.
Yield curve interpretation
| Curve shape | Possible interpretation | Candidate trap |
|---|---|---|
| Upward sloping | Longer maturities yield more than shorter maturities | Assuming this always means “good for all bonds” |
| Flat | Similar yields across maturities | Ignoring reinvestment and duration risk |
| Inverted | Short yields exceed long yields | Treating inversion as a guaranteed recession signal |
| Steepening | Long yields rise vs short yields, or short yields fall vs long yields | Not identifying which part of the curve moved |
| Flattening | Long and short yields converge | Missing the difference between bear flattening and bull flattening |
Core formula sheet
Use formulas with consistent units: annual with annual, period with period, percentage with percentage.
Return and compounding
\[ \text{Holding period return}= \frac{\text{ending value}-\text{beginning value}+\text{income}}{\text{beginning value}} \]\[ \text{Arithmetic mean}=\frac{r_1+r_2+\cdots+r_n}{n} \]\[ \text{Geometric mean}= \left[(1+r_1)(1+r_2)\cdots(1+r_n)\right]^{1/n}-1 \]\[ \text{Real return approximation}\approx \text{nominal return}-\text{inflation} \]\[ 1+\text{real return}= \frac{1+\text{nominal return}}{1+\text{inflation}} \]Portfolio risk and return
\[ E(R_p)=\sum_{i=1}^{n} w_iE(R_i) \]\[ \sigma_p^2= w_A^2\sigma_A^2+w_B^2\sigma_B^2+2w_Aw_B\rho_{A,B}\sigma_A\sigma_B \]\[ \beta_i= \frac{\operatorname{Cov}(R_i,R_m)}{\operatorname{Var}(R_m)} \]\[ E(R_i)=R_f+\beta_i\left[E(R_m)-R_f\right] \]\[ \text{Sharpe ratio}= \frac{R_p-R_f}{\sigma_p} \]\[ \text{Information ratio}= \frac{R_p-R_b}{\text{tracking error}} \]Bond price and yield
\[ \text{Dirty price}=\text{clean price}+\text{accrued interest} \]\[ \text{Current yield}= \frac{\text{annual coupon}}{\text{bond price}} \]\[ \text{Approximate YTM}= \frac{\text{annual coupon}+\frac{\text{face value}-\text{price}}{\text{years to maturity}}} {\frac{\text{face value}+\text{price}}{2}} \]\[ \text{Modified duration}= \frac{\text{Macaulay duration}}{1+\frac{y}{m}} \]\[ \%\Delta P\approx -\text{modified duration}\times \Delta y \]Equity and corporate actions
\[ \text{Earnings per share}= \frac{\text{earnings available to ordinary shareholders}}{\text{weighted average ordinary shares}} \]\[ \text{P/E ratio}= \frac{\text{share price}}{\text{earnings per share}} \]\[ \text{Dividend yield}= \frac{\text{annual dividend per share}}{\text{share price}} \]\[ P_0= \frac{D_1}{r-g} \]\[ \text{TERP}= \frac{N(\text{old price})+M(\text{subscription price})}{N+M} \]Options and FX
\[ \text{Call payoff at expiry}=\max(S_T-K,0) \]\[ \text{Put payoff at expiry}=\max(K-S_T,0) \]\[ C+PV(K)=P+S \]\[ F=S\times\frac{1+r_{\text{domestic}}}{1+r_{\text{foreign}}} \]Notes and examples
Main risk types
| Risk | Meaning | Example |
|---|---|---|
| Market risk | Loss from market price movements | Equity market fall |
| Interest-rate risk | Loss from changing rates/yields | Long bond price falls when yields rise |
| Credit risk | Issuer/counterparty fails or deteriorates | Corporate bond downgrade |
| Liquidity risk | Cannot trade quickly at fair price | Thinly traded bond or property fund |
| Inflation risk | Purchasing power erodes | Cash return below inflation |
| Currency risk | FX movement affects return | Foreign equity loses value in home currency |
| Reinvestment risk | Future cash flows reinvested at lower rates | Callable bond redeemed after rates fall |
| Concentration risk | Too much exposure to one issuer/sector/asset | Single-stock portfolio |
| Operational risk | Process, system, people, or external failure | Settlement error |
| Model risk | Valuation or risk model is wrong | Complex derivative mispricing |
Diversification
Diversification depends on correlation, not just number of holdings.
| Correlation | Diversification effect |
|---|---|
| +1.0 | No diversification benefit |
| Between 0 and +1 | Some diversification benefit |
| 0 | Material diversification potential |
| Negative | Stronger diversification potential |
| -1.0 | Potential perfect offset in simplified theory |
Trap: holding many securities in the same sector, currency, or factor may leave the portfolio highly concentrated.
Beta and systematic risk
Beta measures sensitivity to market movements.
| Beta | Interpretation |
|---|---|
| 1.0 | Moves broadly with the market |
| Greater than 1.0 | More sensitive than market |
| Less than 1.0 | Less sensitive than market |
| Negative | Moves inversely to market in theory |
CAPM-style expected return relationship:
\[ E(R_i) = R_f + \beta_i \left(E(R_m)-R_f\right) \]Use this conceptually: investors require compensation for systematic risk, not diversifiable unsystematic risk.
Risk-adjusted return
A common risk-adjusted return measure is the Sharpe ratio:
\[ \text{Sharpe ratio} = \frac{R_p - R_f}{\sigma_p} \]Higher Sharpe ratio indicates more excess return per unit of volatility, assuming the inputs are appropriate.
Trap: a high historical Sharpe ratio does not guarantee future performance and may hide tail risk, illiquidity, or smoothing.
Money markets and cash instruments
| Instrument | Typical issuer/user | Main purpose | Key risk points |
|---|---|---|---|
| Treasury bill | Government | Short-term government funding | Low credit risk, but price varies with rates |
| Certificate of deposit | Bank | Tradable bank deposit | Bank credit risk, liquidity varies |
| Commercial paper | Corporates/financial issuers | Short-term unsecured funding | Credit risk; rollover risk |
| Repo | Securities holder borrowing cash | Secured financing using collateral | Collateral value, haircut, counterparty risk |
| Reverse repo | Cash lender receiving securities | Secured cash investment | Collateral and counterparty risk |
| Interbank deposit | Banks | Short-term bank funding | Bank credit and liquidity risk |
| Money market fund | Fund vehicle | Cash management/diversification | Not identical to a bank deposit; NAV/liquidity rules matter |
Notes and examples
Discount and yield conventions
| Concept | Meaning | Exam reminder |
|---|---|---|
| Discount instrument | Issued below face value, matures at face value | Return is embedded in price appreciation |
| Yield instrument | Pays explicit interest/coupon | Compare on same annualization and day-count basis |
| Bid/offer spread | Dealer buys at bid, sells at offer | Client selling receives bid; client buying pays offer |
| Basis point | 0.01 percentage point | 100 bps = 1.00% |
| Annualization | Converts period return to annual equivalent | Simple and compound annualization are different |
Money markets and cash instruments
Money markets deal with short-term borrowing, lending, and liquidity management.
| Instrument | Main use | Key risk or exam point |
|---|---|---|
| Bank deposits | Cash holding and liquidity | Credit exposure to bank; inflation risk |
| Treasury bills | Short-term government borrowing | Usually discounted instruments; low credit risk in domestic government context |
| Certificates of deposit | Negotiable bank deposits | Bank credit risk and market liquidity |
| Commercial paper | Short-term corporate borrowing | Issuer credit risk |
| Repos | Secured short-term borrowing/lending | Collateral quality and counterparty risk matter |
| Money market funds | Diversified cash-like exposure | Not the same as a guaranteed bank deposit |
Repo basics
A repo is economically similar to a secured loan:
- one party sells securities and agrees to repurchase them later;
- the difference between sale and repurchase price reflects financing cost;
- collateral reduces, but does not eliminate, risk.
Trap: assuming collateral removes all risk. Collateral can fall in value, be illiquid, or be difficult to realise.
Fixed income reference
Bond terminology
| Term | Meaning | Why it matters |
|---|---|---|
| Par/face value | Amount repaid at maturity | Coupon is usually calculated on par |
| Coupon | Contractual interest payment | Higher coupon increases cash flow and often lowers duration |
| Maturity | Final repayment date | Longer maturity usually means higher interest-rate risk |
| Clean price | Quoted price excluding accrued interest | Common bond quote convention |
| Dirty price | Settlement price including accrued interest | Cash paid at settlement |
| Accrued interest | Interest earned since last coupon date | Paid by buyer to seller at settlement |
| Yield to maturity | Discount rate equating price to promised cash flows | Assumes holding to maturity and reinvestment assumptions |
| Current yield | Coupon divided by price | Ignores capital gain/loss to maturity |
| Credit spread | Extra yield over reference government/swap curve | Compensation for credit, liquidity, and risk premia |
| Duration | Weighted average timing/sensitivity of cash flows | First-order price sensitivity to yield changes |
| Convexity | Curvature of price/yield relationship | Improves approximation for larger yield moves |
Notes and examples
Bond types and decision rules
| Bond type | Main feature | Best fit | Key risk |
|---|---|---|---|
| Government bond | Sovereign issuer | Core defensive allocation, rate exposure | Inflation and rate risk; sovereign risk varies |
| Corporate bond | Company issuer | Income and credit spread exposure | Default/downgrade risk |
| Investment-grade bond | Higher credit quality | Lower credit risk income | Still exposed to rates and spread widening |
| High-yield bond | Lower credit quality | Higher income/risk appetite | Equity-like downside in stress |
| Zero-coupon bond | No periodic coupon; issued at discount | Known future liability matching | High duration for maturity |
| Floating-rate note | Coupon resets to reference rate plus margin | Lower interest-rate sensitivity | Credit spread and reset risk |
| Index-linked bond | Principal/coupon linked to inflation measure | Inflation protection | Real yield changes; index methodology |
| Callable bond | Issuer can redeem early | Higher coupon potential | Reinvestment risk when rates fall |
| Putable bond | Investor can sell back to issuer | Downside/rate protection | Lower yield versus comparable non-putable |
| Convertible bond | Bond plus equity conversion option | Hybrid income/growth exposure | Credit, equity, dilution, option valuation |
| Asset-backed security | Cash flows backed by asset pool | Diversified credit exposure | Prepayment, structure, collateral quality |
Price/yield and duration traps
| If this changes | Bond price effect | Duration effect/comment |
|---|---|---|
| Yield rises | Price falls | Longer duration = larger fall |
| Yield falls | Price rises | Longer duration = larger rise |
| Coupon rises | Price may be higher; duration lower | More cash flow received earlier |
| Maturity lengthens | Usually more sensitive | Especially for low-coupon bonds |
| Credit spread widens | Price falls | Credit deterioration or risk aversion |
| Inflation expectations rise | Nominal yields may rise | Nominal bond prices may fall |
| Bond approaches maturity | Price pulls toward redemption value | Pull-to-par assumes no default |
Bond terminology
| Term | Meaning | Common trap |
|---|---|---|
| Nominal / par / face value | Amount on which coupon is usually calculated and repaid at maturity | Confusing par value with market price |
| Coupon | Stated interest payment | Coupon is not the same as yield |
| Clean price | Price excluding accrued interest | Quoted bond prices are often clean |
| Dirty price | Clean price plus accrued interest | Settlement amount normally reflects accrued interest |
| Maturity | Date principal is repaid | Longer maturity often means more interest-rate risk, but coupon also matters |
| Yield to maturity | Discount rate equating price to future cash flows | Assumes holding to maturity and reinvestment assumptions |
| Current yield | Annual coupon divided by market price | Ignores capital gain/loss to maturity |
Bond price-yield relationship
For fixed-rate bonds:
- yield up → price down;
- yield down → price up;
- longer duration → greater sensitivity to yield changes;
- lower coupon bonds generally have higher duration than higher coupon bonds with the same maturity;
- convexity means the price-yield relationship is curved, not linear.
Approximate price sensitivity:
\[ \frac{\Delta P}{P} \approx -D_{\text{mod}} \times \Delta y \]Where \(D_{\text{mod}}\) is modified duration and \(\Delta y\) is the yield change expressed in decimal form.
Bond types
| Bond type | Main feature | Exam focus |
|---|---|---|
| Government bond | Issued by sovereign government | Interest-rate risk, inflation risk, currency risk if foreign |
| Corporate bond | Issued by company | Credit spread and default risk |
| Floating-rate note | Coupon resets periodically | Lower duration than fixed-rate bond, but not risk-free |
| Index-linked bond | Payments linked to inflation measure | Real return and indexation mechanics |
| Callable bond | Issuer can redeem early | Investor faces reinvestment risk; issuer benefits if rates fall |
| Puttable bond | Investor can require early redemption | Investor has protection; issuer pays for this feature |
| Convertible bond | Can convert into equity | Hybrid exposure: bond floor plus equity option |
| Zero-coupon bond | No periodic coupon; issued at discount | High duration for maturity; return from accretion |
Credit risk and spreads
Credit spread compensates investors for:
- expected default losses;
- downgrade risk;
- liquidity risk;
- uncertainty and risk aversion;
- seniority and recovery assumptions.
| Credit issue | Meaning |
|---|---|
| Default risk | Issuer fails to pay interest or principal |
| Downgrade risk | Credit rating deteriorates |
| Recovery rate | Amount recovered after default |
| Seniority | Priority of claim in insolvency |
| Covenant | Contractual protection for lenders |
Trap: a high yield may indicate high credit risk, not simply an attractive investment.
Duration vs maturity
| Concept | Measures | Why it matters |
|---|---|---|
| Maturity | Final repayment date | Basic time horizon |
| Macaulay duration | Weighted average timing of cash flows | Useful duration concept |
| Modified duration | Price sensitivity to yield changes | More directly used for interest-rate risk |
| Effective duration | Sensitivity allowing for embedded options | Important for callable/putable bonds |
Common mistake: assuming two bonds with the same maturity have the same interest-rate risk.
Equity markets reference
Equity security types
| Security | Holder position | Typical rights | Risk/return profile |
|---|---|---|---|
| Ordinary share/common stock | Ownership residual claim | Voting, dividends if declared, capital growth | Highest corporate claim risk among standard securities |
| Preference share/preferred stock | Hybrid-like equity claim | Priority dividend vs ordinary; terms vary | Rate-sensitive, issuer-specific terms matter |
| Depositary receipt | Claim on foreign shares via receipt structure | Economic exposure to overseas issuer | Currency, country, custody, liquidity risk |
| Rights | Temporary entitlement to buy new shares | Allows participation in new issue | Value depends on share price and subscription price |
| Warrant | Longer-dated right to buy shares | Often issued by company or institution | Option-like leverage; expiry risk |
Notes and examples
Valuation ratios
| Ratio | Calculation | Interpretation | Trap |
|---|---|---|---|
| P/E | price / EPS | Price paid per unit of earnings | Low P/E may reflect low quality or declining earnings |
| Forward P/E | price / forecast EPS | Market valuation using expected earnings | Forecast risk |
| Dividend yield | dividend / price | Income return from dividends | High yield may signal dividend risk |
| Price/book | price / book value per share | Useful for banks, asset-heavy firms | Book value may not reflect economic value |
| EV/EBITDA | enterprise value / EBITDA | Capital-structure-neutral operating multiple | Ignores capex, tax, working capital |
| ROE | net income / equity | Profitability relative to equity capital | Leverage can inflate ROE |
| Payout ratio | dividends / earnings | Share of earnings paid out | Very high payout may be unsustainable |
Corporate actions
| Action | What happens | Investor wealth effect before market movement | Exam reminder |
|---|---|---|---|
| Cash dividend | Cash paid to shareholders | Share price often adjusts down on ex-dividend | Total value includes cash plus share value |
| Scrip dividend | Shares issued instead of cash | More shares, lower price per share mechanically | Check tax/accounting assumptions in question |
| Stock split | More shares at lower price per share | No automatic wealth creation | Liquidity/psychological effects possible |
| Consolidation/reverse split | Fewer shares at higher price per share | No automatic wealth creation | Per-share figures change |
| Bonus/capitalisation issue | Free additional shares from reserves | No automatic wealth creation | EPS and price per share adjust |
| Rights issue | Existing holders offered new shares | Value depends on discount and participation | TERP and right value are common calculations |
| Share buyback | Company repurchases shares | Can raise EPS if shares reduced | Value depends on price paid and capital allocation |
Rights issue quick method
For a “1 for n” rights issue:
| Step | Action |
|---|---|
| 1 | Identify old share price before rights, subscription price, and ratio |
| 2 | Calculate total value: n old shares at old price plus 1 new share at subscription price |
| 3 | Divide by n + 1 to get TERP |
| 4 | Value per right is old price minus TERP, assuming one right attaches to one old share |
| 5 | Check whether the investor subscribes, sells rights, or lets them lapse |
Equity ownership
Ordinary shares usually represent:
- ownership interest;
- voting rights;
- residual claim on assets and profits;
- variable dividends;
- participation in capital growth and losses.
Preference shares may offer a fixed dividend priority over ordinary shares but often have limited voting rights and less participation in upside.
Equity valuation measures
| Measure | Calculation idea | Interpretation trap |
|---|---|---|
| Earnings per share | Profit attributable to ordinary shareholders divided by shares | Can be affected by buybacks, dilution, and accounting policy |
| P/E ratio | Price divided by EPS | High P/E may mean growth expectations or overvaluation |
| Dividend yield | Dividend per share divided by price | High yield may signal risk of dividend cut |
| Price/book | Price compared with accounting net assets | Less useful for asset-light businesses |
| EV/EBITDA | Enterprise value compared with operating cash-flow proxy | Ignores capex, debt structure nuances, and accounting differences |
| Free cash flow yield | Free cash flow relative to value | Quality of cash flow matters |
Corporate actions
| Corporate action | What happens | Candidate trap |
|---|---|---|
| Dividend | Cash distribution to shareholders | Price may adjust on ex-dividend date |
| Scrip dividend | Shares instead of cash | Ownership percentage and tax/accounting treatment may matter |
| Rights issue | Existing shareholders offered new shares, often at discount | Ignoring dilution if rights are not taken up or sold |
| Bonus issue | Additional shares issued without new capital | Value per share adjusts; total value not automatically higher |
| Share split | More shares at lower price per share | Economic value unchanged before market reaction |
| Buyback | Company repurchases shares | Can increase EPS but may not improve business value |
| Takeover | Control transaction | Consider cash vs share offer and execution risk |
Equity indices
Index construction can be:
- price-weighted;
- market-cap weighted;
- free-float adjusted;
- equal-weighted;
- total return or price return.
Trap: price index performance excludes dividends; total return index includes reinvested income.
Foreign exchange reference
Quote logic
| Quote type | Meaning | Example logic |
|---|---|---|
| Direct quote | Domestic currency per 1 foreign currency | If GBP investor sees GBP/USD in domestic terms, define the quote carefully before calculating |
| Indirect quote | Foreign currency per 1 domestic currency | Reciprocal of direct quote |
| Base currency | First currency in common market notation | In EUR/USD, EUR is base |
| Terms/quote currency | Second currency in common market notation | In EUR/USD, USD is quote |
| Bid | Dealer buys base currency | Client sells base at bid |
| Offer/ask | Dealer sells base currency | Client buys base at offer |
| Spread | Offer minus bid | Cost and liquidity indicator |
Notes and examples
FX forward and hedge rules
| Situation | Typical hedge | Directional logic |
|---|---|---|
| Investor will receive foreign currency | Sell foreign currency forward | Locks domestic value of future receipt |
| Investor will pay foreign currency | Buy foreign currency forward | Locks domestic cost |
| Overseas asset held by domestic investor | Sell foreign currency forward or use FX overlay | Reduces currency translation risk |
| Overseas liability | Buy foreign currency forward | Matches future outflow |
| Expected currency volatility but uncertain timing | Options may suit | Premium buys flexibility |
| Currency with higher interest rate | Trades at forward discount under interest parity logic | Depends on quote convention |
FX traps
| Trap | Correct approach |
|---|---|
| Confusing base and quote currency | Write “1 base = quote amount” before calculating |
| Using mid-price when bid/offer is given | Use bid or offer based on client action |
| Adding forward points incorrectly | Follow the quote convention; positive points normally add to spot in that convention |
| Ignoring hedge ratio | Hedge notional should match exposure unless partial hedge intended |
| Treating forward hedge as free | Forward price embeds interest-rate differential and opportunity cost |
FX quote logic
An FX quote expresses one currency in terms of another.
- In GBP/USD, GBP is the base currency and USD is the terms currency.
- If GBP/USD rises, GBP has strengthened against USD.
- If GBP/USD falls, GBP has weakened against USD.
Candidate trap: reversing the meaning of the quote.
Spot, forward, and hedging
| Term | Meaning | Exam point |
|---|---|---|
| Spot rate | Exchange rate for near-term settlement | Current market exchange rate |
| Forward rate | Agreed exchange rate for future settlement | Reflects spot and interest-rate differential, not a forecast guarantee |
| Forward points | Adjustment from spot to forward | Premium/discount depends on relative interest rates |
| Currency option | Right but not obligation to exchange | Protects downside while preserving upside, at premium cost |
Currency risks
| Risk | Meaning |
|---|---|
| Transaction risk | Known foreign currency cash flow changes value before settlement |
| Translation risk | Foreign assets/liabilities affect reported accounts when translated |
| Economic risk | Long-term competitive or cash-flow impact from exchange rates |
| Political/convertibility risk | Restrictions or instability affect currency movement and repatriation |
Common exam traps
| Trap | Better rule |
|---|---|
| Coupon equals yield | Coupon is fixed by bond terms; yield depends on price and expected cash flows |
| Long maturity always means highest risk | Duration depends on maturity, coupon, yield, and embedded options |
| Floating-rate notes have no risk | They still have credit, liquidity, spread, and reset-period risk |
| Higher yield means better investment | Higher yield may compensate for higher credit or liquidity risk |
| All government bonds are risk-free | Consider currency, inflation, interest-rate, and sovereign risk |
| Bid is the buying price for the investor | Investor usually buys at offer and sells at bid |
| Diversification means many holdings | True diversification requires imperfect correlation |
| Options are always speculative | Options can hedge, insure, or create structured payoffs |
| Selling options is low risk because premium is received | Short options can create large or unlimited losses |
| Forward rate is a market forecast | It is primarily derived from spot and interest-rate differentials |
| NAV discount always means bargain | Discount may reflect risk, fees, gearing, illiquidity, or poor prospects |
| Price index equals investor return | Dividends/distributions matter; total return is different |
| Nominal return equals real return | Inflation changes purchasing power |
| Correlation is stable | Correlations can rise in stressed markets |
| Margin is a cost like premium | Futures margin is collateral, not the same as an option premium |
| Structured product capital protection is absolute | Issuer credit and terms matter |
Derivatives reference
Forwards, futures, options, swaps
| Instrument | Exchange/OTC tendency | Obligation? | Main uses | Key risks |
|---|---|---|---|---|
| Forward | OTC | Both parties obligated | Tailored hedge of price, rate, FX exposure | Counterparty, liquidity, settlement |
| Future | Exchange-traded | Both parties obligated | Standardised hedge/speculation | Margin calls, basis risk |
| Call option | Exchange or OTC | Buyer has right, seller has obligation | Upside exposure or hedge short exposure | Premium loss for buyer; potentially large seller loss |
| Put option | Exchange or OTC | Buyer has right, seller has obligation | Downside protection | Premium cost; seller downside |
| Interest-rate swap | OTC | Exchange fixed/floating cash flows | Manage rate exposure | Counterparty, valuation, basis |
| Currency swap | OTC | Exchange currency cash flows/principal terms | Long-term FX funding/hedging | FX, counterparty, liquidity |
| Credit derivative | OTC | Transfers credit risk | Hedge/speculate on credit events | Documentation, counterparty, jump risk |
Notes and examples
Option positions
| Position | Market view | Maximum loss | Maximum gain | Common use |
|---|---|---|---|---|
| Long call | Bullish, wants upside | Premium | Theoretically unlimited | Leveraged upside |
| Short call | Neutral/bearish or income | Potentially unlimited if uncovered | Premium | Covered call income if stock held |
| Long put | Bearish or protective | Premium | Large, limited by asset price falling to zero | Portfolio insurance |
| Short put | Neutral/bullish income | Large, limited by asset price falling to zero | Premium | Income with obligation to buy |
| Covered call | Hold asset, sell call | Downside on asset less premium | Upside capped | Income enhancement |
| Protective put | Hold asset, buy put | Limited below strike net of premium | Upside retained less premium | Downside hedge |
Option Greeks
| Greek | Measures | Long call sign | Long put sign | Interpretation |
|---|---|---|---|---|
| Delta | Price sensitivity to underlying | Positive | Negative | Hedge ratio; directional exposure |
| Gamma | Delta sensitivity to underlying | Positive | Positive | Convexity; large near at-the-money expiry |
| Theta | Time decay | Usually negative | Usually negative | Options lose time value as expiry approaches |
| Vega | Sensitivity to implied volatility | Positive | Positive | Higher volatility increases option value |
| Rho | Sensitivity to interest rates | Usually positive | Usually negative | Often less important than delta/vega for short-dated equity options |
Hedging decision table
| Risk to hedge | Possible instrument | Choose when | Watch for |
|---|---|---|---|
| Equity market fall | Index futures short | Liquid, low-cost beta hedge | Basis risk, margin calls |
| Equity market fall with upside retained | Protective put | Need floor and can pay premium | Strike, expiry, implied volatility |
| Known FX receipt | FX forward sale | Amount/date reasonably certain | Opportunity cost if FX moves favourably |
| Uncertain FX exposure | FX option | Need flexibility | Premium cost |
| Rising interest rates for borrower | Pay-fixed receive-floating swap | Wants fixed funding cost | Counterparty and termination value |
| Falling interest rates for investor | Receive-fixed swap or longer duration | Wants lock-in of fixed income | Rate forecast risk |
| Commodity input cost | Commodity future/forward | Need price certainty | Basis and delivery/roll issues |
Derivatives review
Derivatives derive value from an underlying asset, rate, index, currency, or credit event. They are used for hedging, speculation, arbitrage, income generation, and structured product construction.
Main derivative types
| Derivative | Obligation or right? | Typical use | Main risk |
|---|---|---|---|
| Forward | Bilateral obligation | Custom hedge | Counterparty risk and liquidity |
| Future | Exchange-traded obligation | Standardised hedge/speculation | Margin calls and basis risk |
| Option | Buyer has right, seller has obligation | Asymmetric exposure | Premium loss for buyer; potentially large loss for seller |
| Swap | Exchange of cash flows | Interest-rate/currency management | Counterparty, valuation, collateral risk |
| Warrant | Long-dated option-like security | Leveraged exposure | Time decay and issuer risk |
| Structured product | Packaged combination of bond/derivative | Defined payoff profile | Issuer credit, complexity, liquidity |
Options: calls and puts
| Position | Market view | Right or obligation | Maximum loss concept |
|---|---|---|---|
| Long call | Bullish | Right to buy | Premium paid |
| Short call | Neutral/bearish or income strategy | Obligation to sell if exercised | Potentially unlimited if uncovered |
| Long put | Bearish or protective | Right to sell | Premium paid |
| Short put | Neutral/bullish or income strategy | Obligation to buy if exercised | Large loss if underlying falls significantly |
Option value drivers
| Driver rises | Call value | Put value | Reason |
|---|---|---|---|
| Underlying price | Usually rises | Usually falls | Calls benefit from upside; puts from downside |
| Exercise price | Usually falls | Usually rises | Higher strike makes call less attractive, put more attractive |
| Volatility | Usually rises | Usually rises | Optionality becomes more valuable |
| Time to expiry | Usually rises | Usually rises | More time for favourable movement |
| Interest rates | Usually supports calls | Usually pressures puts | Present value and forward pricing effects |
| Dividends | Usually pressures calls | Usually supports puts | Expected price adjustment for dividends |
Hedging direction rules
| Exposure or concern | Typical hedge |
|---|---|
| Own equity and fear downside | Buy put or sell equity futures |
| Need future equity exposure and fear prices rising | Buy futures or buy calls |
| Borrower fears interest rates rising | Use instruments that benefit from rising rates or fix borrowing cost |
| Investor fears currency depreciation of foreign asset currency | Hedge FX exposure using forward/future/option |
| Bond portfolio manager fears yield rises | Reduce duration or sell bond futures |
Trap: hedging reduces one risk but may introduce basis risk, liquidity risk, counterparty risk, or opportunity cost.
Futures and margin
Futures are marked to market. Gains and losses are settled through margin accounts.
Key points:
- initial margin is posted to open a position;
- variation margin reflects daily gains/losses;
- leverage magnifies both gains and losses;
- futures prices may not move perfectly with the exposure being hedged.
Swaps
| Swap type | Basic idea | Common use |
|---|---|---|
| Interest-rate swap | Exchange fixed and floating interest cash flows | Manage rate exposure |
| Currency swap | Exchange cash flows in different currencies | Manage currency and funding exposure |
| Equity swap | Exchange equity return for another cash flow | Gain or hedge equity exposure |
| Credit default swap | Transfers credit risk | Protection buyer pays premium; protection seller assumes credit event exposure |
Trap: the notional amount is used to calculate cash flows; it is not usually exchanged in a plain interest-rate swap.
Funds and pooled investments
Vehicle comparison
| Vehicle | Structure | Pricing | Key point |
|---|---|---|---|
| Open-ended fund | Issues/redeems units with investor flows | Usually NAV-based | Fund size expands/contracts with demand |
| Closed-ended investment company/trust | Fixed capital listed vehicle | Market price may differ from NAV | Can trade at premium or discount |
| ETF | Listed fund, often index-tracking | Exchange price plus NAV mechanism | Intraday trading; spread and tracking error matter |
| Index fund | Passive exposure to benchmark | NAV-based or ETF form | Low active risk, not no risk |
| Active fund | Manager selects securities | NAV or market price by structure | Performance depends on skill, costs, style |
| Fund of funds | Invests in other funds | NAV-based | Diversification but layered fees possible |
| Hedge fund | Flexible strategies | Periodic valuation/liquidity terms | Leverage, shorting, derivatives, liquidity gates possible |
| Private equity fund | Invests in private companies | Infrequent valuation | Illiquidity, capital calls, J-curve |
Notes and examples
Fund metrics
| Metric | Meaning | Exam use |
|---|---|---|
| NAV per unit | assets less liabilities divided by units | Base valuation for open-ended funds |
| Premium to NAV | market price above NAV | Closed-ended/ETF market demand indicator |
| Discount to NAV | market price below NAV | May reflect sentiment, liquidity, fees, leverage |
| Ongoing charges | Recurring fund costs | Reduce investor return |
| Tracking error | Variability of active return vs benchmark | Passive implementation or active risk measure |
| Active share | Difference from benchmark holdings | High active share means more benchmark deviation |
| Turnover | Trading activity | Costs and style clue |
| Distribution yield | Income distributed relative to price | Not the same as total return |
Funds and pooled investments
Wealth management candidates should be comfortable comparing direct securities with pooled structures.
| Structure | Key feature | Main exam considerations |
|---|---|---|
| Open-ended fund | Units/shares created and cancelled based on demand | Priced around NAV; liquidity depends on underlying assets |
| Unit trust / OEIC-style vehicle | Collective investment structure | Charges, dealing frequency, valuation basis |
| Investment trust | Closed-ended listed company | Can trade at premium/discount to NAV; may use gearing |
| ETF | Exchange-traded fund | Intraday trading, tracking error, bid-offer spread |
| Index fund | Passive exposure to an index | Tracking difference and methodology |
| Hedge fund | Flexible strategy set | Leverage, shorting, derivatives, liquidity restrictions |
| Private equity fund | Invests in unlisted companies | Illiquidity, valuation uncertainty, long horizon |
| REIT / property fund | Property exposure | Rental income, valuation lag, liquidity mismatch |
NAV, premium, and discount
- NAV = value of assets minus liabilities.
- A closed-ended fund may trade:
- above NAV = premium;
- below NAV = discount.
- Open-ended funds usually create/redeem units around NAV, subject to pricing and dealing rules.
Trap: assuming a discount always means “cheap.” It may reflect poor performance, illiquidity, high fees, gearing risk, or weak sentiment.
Alternatives and real assets
| Asset class | Return drivers | Diversification role | Key risks |
|---|---|---|---|
| Direct property | Rent, occupancy, capital values | Income and inflation linkage potential | Illiquidity, valuation lag, concentration |
| REIT/property securities | Listed property exposure | Easier trading than direct property | Equity market correlation, rate sensitivity |
| Commodities | Spot prices, roll yield, collateral return | Inflation/geopolitical hedge potential | No inherent income; futures curve effects |
| Gold/precious metals | Real rates, currency confidence, risk aversion | Crisis hedge potential | No cash flow; sentiment-driven |
| Infrastructure | Contracted cash flows, economic usage | Long-duration income potential | Political, regulatory, leverage, liquidity |
| Hedge funds | Strategy alpha, market dislocations | Alternative return streams | Fees, leverage, opacity, liquidity |
| Private equity | Operational improvement, leverage, multiple expansion | Long-term growth | Illiquidity, valuation uncertainty, vintage risk |
| Structured products | Embedded derivative payoff | Tailored payoff profile | Issuer credit, complexity, liquidity |
Notes and examples
Alternative and real assets
| Asset class | Potential benefit | Key risks |
|---|---|---|
| Property | Income, inflation linkage, diversification | Illiquidity, valuation lag, leverage, tenant risk |
| Commodities | Inflation/geopolitical sensitivity, diversification | No income, storage/roll yield issues, volatility |
| Infrastructure | Long-term cash flows, inflation-linked revenues in some cases | Political, regulatory, construction, liquidity risk |
| Private equity | Long-term growth and operational improvement | Illiquidity, valuation uncertainty, leverage, manager selection |
| Hedge funds | Strategy diversification and risk targeting | Leverage, opacity, liquidity gates, fee structure |
| Gold/precious metals | Crisis hedge narrative and store-of-value role | No yield, sentiment-driven pricing |
Trap: alternative assets are not automatically low risk. Many reduce correlation to traditional markets but add liquidity, valuation, leverage, and complexity risks.
Market structure and trading
Primary vs secondary markets
| Market | Function | Participants | Exam distinction |
|---|---|---|---|
| Primary market | New securities issued | Issuer, underwriters, investors | Raises capital for issuer |
| Secondary market | Existing securities traded | Investors, brokers, dealers, market makers | Provides liquidity and price discovery |
| Public offer | Securities offered broadly | Issuer, advisers, public investors | Disclosure and process requirements depend on jurisdiction |
| Private placement | Securities sold to selected investors | Issuer and eligible/sophisticated investors | Less liquid; terms negotiated |
| Rights issue | New shares offered to existing shareholders | Company and shareholders | Protects pre-emption/economic position if taken up or sold |
Notes and examples
Trading venues and price formation
| Structure | How prices form | Strength | Weakness |
|---|---|---|---|
| Order-driven market | Buy/sell orders interact in order book | Transparency and competition | Liquidity can disappear in stress |
| Quote-driven market | Market makers quote bid/offer | Continuous liquidity provision | Wider spreads in difficult markets |
| Auction | Orders matched at clearing price | Efficient for opens/closes/illiquid securities | Timing concentration |
| OTC market | Bilateral trading | Customisation | Counterparty and transparency issues |
| Exchange-traded market | Standardised venue rules | Transparency, clearing, liquidity | Less customisation |
Order types
| Order | Meaning | Use | Trap |
|---|---|---|---|
| Market order | Execute immediately at best available price | Speed | Execution price uncertain |
| Limit order | Execute at specified price or better | Price control | May not execute |
| Stop order | Triggered when stop price reached | Risk control or breakout entry | Trigger price not guaranteed execution price |
| Stop-limit order | Stop trigger plus limit price | More control than stop | May fail to execute in fast market |
| Good-for-day | Valid for trading day | Short-lived instruction | Expires if not filled |
| Good-till-cancelled | Remains until cancelled/expiry rules | Persistent instruction | Must be monitored |
Core functions of financial markets
Financial markets exist to:
- allocate capital from savers to borrowers and issuers;
- provide liquidity and price discovery;
- transfer risk between participants;
- enable investment, hedging, speculation, and arbitrage;
- support monetary policy transmission through money and bond markets.
Primary vs secondary markets
| Market | What happens | Example | Exam point |
|---|---|---|---|
| Primary market | New securities are issued and capital is raised | IPO, bond issue, rights issue | Proceeds usually go to the issuer |
| Secondary market | Existing securities are traded between investors | Stock exchange trading, bond trading | Provides liquidity and price discovery |
Trap: buying shares on an exchange normally does not provide new capital to the company; buying in a new issue does.
Exchange-traded vs OTC markets
| Feature | Exchange-traded | OTC |
|---|---|---|
| Trading venue | Centralised exchange | Bilateral or dealer network |
| Standardisation | Usually standardised contracts | Often customised |
| Transparency | Generally higher | Can be lower |
| Counterparty risk | Often reduced by central clearing | Depends on counterparty and collateral arrangements |
| Examples | Listed equities, listed futures, listed options | Many bonds, swaps, bespoke forwards |
Brokers, dealers, market makers, and custodians
| Participant | Main role | Key distinction |
|---|---|---|
| Broker | Acts as agent for a client | Earns commission/fees; does not usually take principal risk |
| Dealer | Trades as principal | Buys/sells for own account |
| Market maker | Quotes bid and offer prices | Provides liquidity and earns spread |
| Custodian | Safeguards assets | Handles settlement, custody, income collection, corporate actions |
| Clearing house / CCP | Reduces settlement and counterparty risk | Interposes itself between counterparties in cleared markets |
Bid-offer spread
- Bid = price at which the dealer/market maker buys.
- Offer/ask = price at which the dealer/market maker sells.
- The investor usually sells at bid and buys at offer.
- Wider spreads usually indicate lower liquidity, higher volatility, larger transaction costs, or more dealer risk.
Common mistake: reading the bid price as the investor’s purchase price.
Clearing, settlement, custody, and operational risk
| Term | Meaning | Candidate focus |
|---|---|---|
| Trade date | Date transaction is agreed | Market exposure begins economically |
| Settlement date | Date cash and securities exchange | Settlement cycles vary by market/instrument |
| Delivery versus payment | Securities delivered only if payment made | Reduces principal risk |
| Central counterparty | Interposes between buyer and seller | Reduces bilateral counterparty risk; concentrates risk |
| Margin | Collateral for derivative/financing exposure | Initial vs variation margin |
| Custodian | Safekeeps assets and administers events | Asset servicing, income, corporate actions |
| Nominee | Registered holder on behalf of beneficial owner | Operational convenience; ownership records matter |
| Failed trade | Settlement does not complete on time | Liquidity, operational, and reputational risk |
| Reconciliation | Matching records across systems/parties | Key control against operational errors |
Risk and performance measures
Risk types
| Risk | Definition | Example |
|---|---|---|
| Market risk | Loss from price movements | Equity index falls |
| Interest-rate risk | Loss from yield curve movement | Bond price falls when yields rise |
| Credit/default risk | Issuer/counterparty fails to pay | Corporate bond default |
| Spread risk | Credit/liquidity spread widens | Investment-grade bond falls despite stable government yields |
| Liquidity risk | Cannot trade quickly at fair price | Property fund redemption stress |
| Currency risk | FX movement affects value | Overseas equity falls in domestic terms |
| Inflation risk | Purchasing power erodes | Cash earns below inflation |
| Reinvestment risk | Cash flows reinvested at lower rates | Callable bond redeemed after rates fall |
| Concentration risk | Too much exposure to one issuer/sector | Employer stock concentration |
| Operational risk | Process, system, people failure | Incorrect settlement instruction |
| Model risk | Valuation/risk model is wrong | Mispriced structured product |
| Political/regulatory risk | Policy or rule change affects value | Sector affected by government decision |
Notes and examples
Performance attribution and ratios
| Measure | Plain calculation | Use | Trap |
|---|---|---|---|
| Absolute return | portfolio return | Did the portfolio gain or lose? | Ignores benchmark and risk |
| Relative return | portfolio return minus benchmark return | Active performance | Benchmark must be appropriate |
| Alpha | return above CAPM-expected return | Manager skill estimate | Can reflect omitted risk factors |
| Beta | sensitivity to market | Systematic risk | Beta changes over time |
| Sharpe ratio | excess return / total volatility | Risk-adjusted return for total risk | Penalises upside and downside volatility equally |
| Treynor ratio | excess return / beta | Reward per unit of systematic risk | Requires diversified portfolio assumption |
| Information ratio | active return / tracking error | Active manager consistency | High ratio may not persist |
| Tracking error | volatility of active return | Benchmark-relative risk | Low tracking error can still underperform |
| Maximum drawdown | peak-to-trough loss | Downside experience | Backward-looking |
| VaR | loss threshold at confidence over horizon | Tail risk summary | Not worst-case loss |
| Expected shortfall | average loss beyond VaR threshold | Tail severity | Model-dependent |
Time-weighted vs money-weighted returns
| Return measure | Cash flow treatment | Best use | Exam trap |
|---|---|---|---|
| Time-weighted return | Removes effect of external cash flow timing | Assess manager performance | Requires sub-period linking |
| Money-weighted return | Internal rate of return including cash flow timing | Assess investor’s actual experience | Heavily affected by when client adds/withdraws money |
Suitability-style decision rules for wealth management
| Client objective or constraint | Instruments/approaches often considered | Avoid assuming |
|---|---|---|
| Capital preservation | Cash, money market, high-quality short-duration bonds | That nominal capital preservation protects real purchasing power |
| Income | Bonds, dividend equities, property, income funds | That high yield is sustainable or low risk |
| Long-term growth | Equities, diversified multi-asset, selected alternatives | That volatility equals permanent loss for long horizons |
| Inflation protection | Index-linked bonds, equities, property, commodities | That every “real asset” hedges inflation in every period |
| Liquidity need | Cash, liquid funds, listed securities | That listed always means liquid at fair value |
| Liability matching | Bonds/cash flows matched to timing and currency | That return maximisation is the main goal |
| Currency exposure | FX forwards/options, natural hedges | That hedging always improves returns |
| Downside protection | Puts, structured payoffs, lower-risk allocation | That protection is free |
| Tax-sensitive investing | Asset location, turnover awareness, after-tax return focus | That pre-tax return is client outcome |
| Ethical/ESG preference | Screened funds, thematic funds, stewardship approaches | That labels alone define risk or impact |
Notes and examples
Suitability-style decision rules
Even in technical Financial Markets questions, the best answer often depends on matching instrument features to investor objectives.
| Client or portfolio objective | Instruments/features that may fit | Watch for |
|---|---|---|
| Capital preservation | Cash, high-quality short-duration bonds | Inflation risk and reinvestment risk |
| Income | Bonds, dividend equities, property/infrastructure income | Credit risk, dividend sustainability, concentration |
| Growth | Equities, diversified growth funds, private assets | Volatility and time horizon |
| Inflation protection | Index-linked bonds, real assets, equities with pricing power | Valuation and liquidity |
| Liquidity | Cash, money market instruments, liquid listed securities | Yield sacrifice |
| Liability matching | Bonds/cash flows aligned to liabilities | Duration, currency, inflation linkage |
| Currency hedging | Forwards, futures, options, share class hedging | Hedge cost and imperfect hedge |
| Downside protection | Puts, structured protection, lower-risk allocation | Premium cost, issuer risk, caps on upside |
| Tactical market exposure | ETFs, futures, liquid funds | Leverage, tracking error, timing risk |
Instrument selection matrix
| Need | More suitable | Less suitable | Reason |
|---|---|---|---|
| Known cash need in months | Cash/money market | Long-duration bonds/equities | Liquidity and capital certainty matter |
| Lock fixed income for a known future date | High-quality bond maturing near liability date | Perpetual or long equity exposure | Cash-flow matching |
| Hedge equity beta temporarily | Index futures | Selling every holding | Fast, cost-efficient overlay |
| Keep equity upside but limit downside | Protective put | Short futures hedge | Put preserves upside after premium |
| Generate extra income from held shares | Covered call | Naked short call | Covered call caps upside but avoids uncovered call exposure |
| Hedge known foreign currency receipt | Sell FX forward | Speculative FX option only | Forward locks future conversion rate |
| Reduce interest-rate sensitivity | Shorter duration or floating-rate exposure | Long zero-coupon bonds | Lower duration |
| Seek credit income | Diversified corporate bond fund | Single low-quality issuer | Diversification reduces idiosyncratic default exposure |
| Access illiquidity premium | Private markets allocation | Daily-liquidity cash reserve | Time horizon must support lock-up |
| Track broad market cheaply | Index fund/ETF | High-cost closet tracker | Lower active and fee drag |
Common calculation traps
| Trap | Correct habit |
|---|---|
| Confusing percent and decimal | 5% = 0.05; 50 bps = 0.50% |
| Treating basis points as percentages | 1 bp = 0.01 percentage point |
| Ignoring accrued interest | Bond settlement uses dirty price |
| Using current yield as YTM | Current yield ignores redemption gain/loss |
| Forgetting price/yield inverse relation | Yield up means bond price down |
| Applying duration to large yield moves without caution | Add convexity intuition for large moves |
| Ignoring sign of short positions | Short gains when price falls, loses when price rises |
| Using wrong FX side | Client buys at offer, sells at bid |
| Annualising incorrectly | Use same compounding convention as question |
| Comparing nominal and real returns | Adjust for inflation when purchasing power matters |
| Mixing arithmetic and geometric returns | Geometric is better for compounded multi-period performance |
| Ignoring dividends/coupons in total return | Include income unless question says price return only |
| Assuming diversification eliminates all risk | It reduces unsystematic risk, not systematic market risk |
| Treating correlation as stable | Correlations can rise in market stress |
Common conceptual traps
| Statement | Why it is incomplete or wrong |
|---|---|
| “Government bonds are risk-free.” | They may have low default risk but still have rate, inflation, currency, and liquidity risk |
| “A high dividend yield is attractive.” | It may signal falling price or expected dividend cut |
| “A low P/E means undervalued.” | It may reflect weak growth, cyclicality, accounting issues, or high risk |
| “Hedging removes risk.” | Hedging exchanges one risk for another: basis risk, cost, liquidity, opportunity cost |
| “Options are always riskier than futures.” | Long options have limited loss; futures have symmetric exposure and margin calls |
| “Closed-ended fund discount means bargain.” | Discount can persist or widen due to fees, leverage, performance, or sentiment |
| “Cash has no risk.” | Cash has inflation, reinvestment, currency, and institution risk |
| “Higher yield means better bond.” | Higher yield often compensates for higher credit, liquidity, or structural risk |
| “Passive funds cannot underperform.” | Fees, tracking error, sampling, taxes, and cash drag can cause underperformance |
| “VaR is maximum loss.” | VaR is a threshold estimate, not the worst possible loss |
Final review checklist
Before exam day, make sure you can quickly:
- Explain price/yield inverse movement and identify which bond has higher duration.
- Calculate holding period return, real return, current yield, approximate YTM, and TERP.
- Distinguish clean price, dirty price, and accrued interest.
- Use bid/offer correctly in FX and securities dealing questions.
- Select between forward, future, option, and swap for a hedge scenario.
- Compare open-ended funds, closed-ended funds, ETFs, and investment trusts/companies.
- Interpret Sharpe ratio, information ratio, tracking error, beta, alpha, VaR, and drawdown.
- Recognise when liquidity, currency, tax, inflation, and time horizon dominate instrument choice.
- Avoid treating labels such as “income,” “defensive,” “guaranteed,” or “alternative” as substitutes for risk analysis.
Notes and examples
Final review checklist before practice
Before starting a mock exam or mixed question-bank session, make sure you can answer these without notes:
- What is the difference between primary and secondary markets?
- Who buys at bid and who buys at offer?
- How do bond prices respond to yield changes?
- Why is duration not the same as maturity?
- What is the difference between clean and dirty bond price?
- What risks remain in a high-quality bond?
- How do callable bonds affect investor reinvestment risk?
- What does an inverted yield curve suggest, and what does it not prove?
- How do dividends affect equity return and option pricing?
- How does a rights issue affect existing shareholders?
- What is the difference between open-ended and closed-ended funds?
- Why can an investment trust trade at a premium or discount?
- What is the payoff logic of long call, short call, long put, and short put?
- What is the difference between forwards and futures?
- What does margin mean in futures trading?
- How do spot and forward FX rates relate to interest-rate differentials?
- What is the difference between transaction, translation, and economic FX risk?
- What does beta measure?
- Why does correlation drive diversification?
- What conduct or suitability issue could change the “best” answer?
High-yield mental model
Financial Markets questions often test whether you can connect economic conditions, instruments, risks, market structure, and client objectives.
| If the question is asking about… | Think first about… | Common trap |
|---|---|---|
| Which instrument is suitable? | Objective, time horizon, risk, liquidity, income/capital growth | Choosing the highest return without considering risk or liquidity |
| What happens when interest rates rise? | Bond prices, duration, yield curve, currency expectations | Confusing coupon rate with market yield |
| Which risk is present? | Market, credit, liquidity, inflation, currency, reinvestment, operational | Calling every risk “market risk” |
| How a derivative position works | Directional exposure, obligation/right, margin, payoff | Mixing up long call, short call, long put, short put |
| Fund structure comparison | Open-ended vs closed-ended, NAV, liquidity, pricing | Treating ETFs, investment trusts, and open-ended funds as identical |
| FX question | Base currency, terms currency, spot/forward, interest-rate differential | Reversing the quote |
| Portfolio question | Diversification, correlation, beta, volatility, client constraints | Assuming more holdings automatically means lower risk |
Core calculation refresher
Holding period return
\[ \text{Holding period return} = \frac{\text{Ending value} - \text{Beginning value} + \text{Income received}} {\text{Beginning value}} \]Income includes dividends, coupons, distributions, or other cash flows during the holding period.
Basis points
| Movement | Equivalent |
|---|---|
| 1 basis point | 0.01% |
| 10 basis points | 0.10% |
| 25 basis points | 0.25% |
| 100 basis points | 1.00% |
Trap: confusing percentage points with percentage changes. A move from 4% to 5% is a 1 percentage point move, or 100 basis points, but a 25% relative increase.
Annualisation
| Situation | Care point |
|---|---|
| Simple annualisation | Appropriate for short periods when compounding is ignored |
| Compound annual growth rate | Needed when returns compound over multiple periods |
| Money-weighted return | Affected by timing and size of cash flows |
| Time-weighted return | Better for manager performance comparison because it neutralises external cash flows |
Market conduct and professional judgement
Candidates should be alert to conduct themes even when the question appears product-focused.
High-level principles include:
- act with integrity and professionalism;
- avoid misleading communications;
- manage conflicts of interest;
- protect confidential and price-sensitive information;
- avoid abusive trading behaviour;
- understand client objectives and constraints before recommending instruments;
- ensure risks, costs, and limitations are not hidden by product complexity;
- maintain accurate records and clear rationale for decisions.
Trap: selecting a technically correct instrument that is unsuitable for the client’s risk capacity, liquidity need, or knowledge level.
Practice plan using a question bank
Use this Cheat Sheet as a bridge into active practice:
Start with topic drills Work through original practice questions by topic: market structure, economics, fixed income, equities, funds, derivatives, FX, alternatives, and risk.
Review detailed explanations carefully Do not only read why the correct answer is right. Identify why each distractor is wrong.
Convert mistakes into rules Example: “If yields rise, fixed-rate bond prices fall; longer modified duration means larger price move.”
Move to mixed sets Once individual areas are stable, use mixed question bank sessions to practise switching topics quickly.
Finish with mock exams Simulate timing and review every missed or guessed question. Your final score improvement usually comes from fixing repeated traps, not rereading entire chapters.
For the next step, choose one weak topic from this Cheat Sheet and complete a focused set of original practice questions with detailed explanations before moving on to a full mock exam.