Security Market Indices (Reading 47)

Exercise Problems:

1.      Which of the following is least likely to be directly reflected in the returns on a commodity index?

A. Roll yield

B. Changes in the spot prices of underlying commodities

C. Changes in the futures prices of commodities in the index

B is correct. Commodity index returns reflect the changes in future prices and the roll yield. Changes in the underlying commodity spot prices are not reflected in a commodity index.

2.      Compared to its market-value-weighted counterpart, a fundamentally weighted index will least likely have a:

A. value tilt.

B. contrarian “effect.”

C. momentum “effect.”

C is correct. Momentum “effect” is a characteristic of a market-value-weighted index, not a fundamentally weighted index.

3.      The index weighting that results in portfolio weights shifting away from securities that have increased in relative value (e.g., decrease in book-to-market) toward securities that have fallen in relative value whenever the portfolio is rebalanced is most accurately described as:

A. equal weighting.

B. fundamental weighting.

C. float-adjusted market-capitalization weighting.

B is correct. Fundamentally weighted indices generally will have a contrarian “effect” in that the portfolio weights will shift away from securities that have increased in relative value and toward securities that have fallen in relative value whenever the portfolio is rebalanced.

4.      An analyst uses a stock screener and selects the following metrics: a global equity index, P/E ratio lower than the median P/E ratio, and a price-book value ratio lower than the median price-book value ratio. The stocks so selected would be most appropriate for portfolios of which type of investors?

A. Value investors.

B. Growth investors.

C. Market-oriented investors.

Metrics such as low P/E and low price-book are aimed at selecting value companies; therefore the portfolio is most appropriate for value investors.

5.      An equity fund manager is considering a market index as benchmark for his portfolio and he has the following preferences:

•  the index should have a contrarian “effect”;
•  shares held by controlling shareholders should not be excluded;
•  dividends should be included in the weighting of constituent securities; and
•  the weights of constituent securities should not be arbitrarily determined by the index provider.

Which of the following weightings of indices best meets the fund manager’s preferences?

A. Equal.

B. Fundamental.

C. Float-adjusted market-capitalization.

Fundamental weighting satisfies the fund manager’s preferences. Fundamental indices use a single measure, such as total dividends, to weight the constituent securities. Fundamentally weighted indices generally will have a contrarian “effect” in that the portfolio weights will shift away from securities that have increased in relative value and toward securities that have fallen in relative value whenever the portfolio is rebalanced. All shares are included in a fundamental weighted index.

6.      Which of the following statements is most accurate with respect to rebalancing and reconstitution of security market indices?

A. Equal weighted indices require frequent rebalancing.

B. Turnover within an index results from a reconstitution but not from rebalancing.

C. A price-weighted index requires rebalancing more than a market-capitalization-weighted index.

After an equal weighted index is constructed and the prices of constituent securities change, the index is no longer equally weighted. Therefore, maintaining equal weights requires frequent adjustments (rebalancing) to the index.

7.      The data for four stocks in an index are as follows:

Assuming the beginning value of the float-adjusted market-capitalization-weighted equity index is 100, the ending value is closest to:

A. 109.1.

B. 110.9.

C. 111.3.

In float-adjusted market-capitalization weighting, the weight on each constituent security is determined by adjusting its market capitalization for its market float. Per computations shown below, the ending value of the index so computed equals 109.1. (654,900 ÷ 600,000)

8.      A price-weighted index series is composed of the following three stocks:

If stock Z completes a three-for-one stock split at the end of Day 1, the value of the index after the split (at the end of Day 3) is closest to:

A. 29.9.

B. 31.7.

C. 32.3.

The price-weighted index is computed by totaling the current prices of the stocks in the index and dividing the sum by a divisor that has been adjusted for stock splits and changes in the sample over time.

Index before the split = (10 + 20 + 60) / 3 = 30; New divisor: [(10 + 20 + 20) / X] = 30; X = 1.67

Index after the split = (12 + 19 + 22) / 1.67 = 31.7

9.      Which of the following most accurately describes the computation of nearly all bond market indices, U.S. and global?

A. Model priced

B. Trader priced

C. Market priced

11 out of the 12 major bond indexes are trader priced and only one index (Ryan Treasury) is market priced. Two other indices, Lehman Brothers and Merrill Lynch, are both trader priced and model priced.

10.  An analyst is creating a new stock market index that is not affected by stock splits. The index the analyst is least likely to develop is:

A. unweighted.

B. price-weighted.

C. value-weighted.

A price-weighted index, such as the Dow Jones Industrial Average, requires adjustment for stock splits. It is computed by summing the prices of individual stocks and dividing by a divisor that is adjusted for stock splits such that the index value is the same before and after the split.

11.  Value Line Index, an unweighted index, uses which of the following methods in the computation of the holding period returns of underlying stocks?

A. Geometric mean.

B. Arithmetic mean.

C. Value-weighted mean.

The Value Line Index, an un-weighted index, uses the geometric mean return approach.