CFA Level 1 - Equity Investments Session 13 - Reading 48

CFA Level 1 - Equity Investments Session 13 - Reading 48 (Notes, Practice Questions, Sample Questions) 1. When using a security market index to represent a market’s performance, the performance of that market over a period of time is best represented by: A)the percent change in the index value. B)the index value. C)the change in the index value Explanation — Percentage changes in the value of a security market index over time represent the performance of the market, segment, or asset class from which the securities are chosen 2. A security market index is best described as a: A)value used to adjust nominal security prices for the effects of inflation. B)directory of ticker symbols for the securities listed on a given market. C)group of securities selected to represent the performance of a security market Explanation — A security market index is a group of securities (the constituent securities) designed to represent the performance of an asset class, security market, or market segment 3. In one year, a security market index has the following quarterly price returns: First quarter 3% Second quarter 4% Third quarter -2% Fourth quarter 5% The price return for the year is closest to: A)10.2%. B)9.9%. C)10.0% Explanation — Return for the year = (1.03)(1.04)(0.98)(1.05) − 1 = 10.23% 4. The measure of return on a security market index that includes any dividends or interest paid by the securities in the index is known as the: A)price return. B)total return. C)cash flow return Explanation — The total return on a security market index includes cash flows from the securities (dividends and interest) as well as price changes 5. The value of a total return index: A)may increase at either a faster or slower rate than the value of a price return index with the same constituent securities and weights. B)can be calculated by multiplying the beginning value by the geometrically linked series of periodic total returns. C)is determined by the price changes of the securities that constitute the index Explanation — The value of a total return index can be calculated by multiplying the beginning value by the geometrically linked series of index total returns. The value of a total return index includes both the price changes of the securities that constitute the index and any cash flows from the securities (dividends, interest, and other distributions). A total return index cannot increase at a slower rate (or decrease at a faster rate) than an otherwise identical price return index because cash flows from the securities cannot be negative 6. An index provider maintains a price index and a total return index for the same 40 stocks. Assuming both indexes begin the year with the same value, the total return index at the end of the year will be: A)greater than the price index. B)less than the price index if the price index increases and greater than the price index if the price index decreases. C)equal to the price index if the constituent stocks do not pay dividends Explanation — A price index only includes the prices of the constituent securities in the calculation of the index value. A total return index includes the prices and the dividends paid in the calculation of the index value. If all of the constituents are non-dividend paying stocks, then the total return index will be the same as the price index at the end of the year. Otherwise the total return index will be greater than the price index 7. The value of a security market index at the end of December is 1,200. The index returns for the next six months are: Month January February March April May June Return 3.89% 8.76% −4.74% 6.88% −5.39% −8.12% The index value at the end of June is closest to: A) 1200 B) 1186 C) 1214 Explanation — The index value at the end of June is 1,200(1.0389)(1.0876)(0.9526)(1.0688)(0.9461)(0.9188) = 1,200. Note that the compound rate of return is (1.0389)(1.0876)(0.9526)(1.0688)(0.9461)(0.9188)−1 = 0 8. The first step in developing a security market index is choosing the index’s: A)target market. B)constituent securities. C)weighting method. Explanation — The first decision that must be made is choosing the target market the index will represent. Only then can the index provider determine which constituent securities should be included and which weighting scheme is most appropriate to measure the target market’s returns 9. The target market for a security market index is best described as the: A)consumers who will purchase the licensing rights for the index. B)securities that are included in the index. C)market or segment the index is designed to measure. Explanation — The target market of an index is the securities market or portion of a securities market that the index will be designed to represent. The securities from the target market that are included in the index are called its constituent securities 10. Assume a stock index consists of many firms who have recently split their stock. Which of the following weighting schemes will see a bias due to the impact of stock splits? A)Unweighted price series. B)Market value-weighted series. C)Price-weighted series Explanation — Firms that split their stock price will have the identical weight before and after the split in both the unweighted and the market value-weighted series. However, in the price-weighted series, large successful firms will lose weight within the index due to simply splitting their stock. This creates a downward bias in a price-weighted series. Standard and Poor’s 500 Index is a market value-weighted index 11. Which of the following weighting schemes will produce a downward bias on the index due to the occurrence of stock splits by firms in the index? A)Price-weighted series. B)Market-cap weighted series. C)Equal weighted price indicator series Explanation — The price-weighting scheme sums the market price of each of the stocks contained in the index and then divides this sum by the number of stocks in the index. Thus if a firm executes a stock split thereby reducing its share price, this will cause a downward bias in the index 12. Which of the following statements best describes the investment assumption used to calculate an equal weighted price indicator series? A)An equal number of shares of each stock are used in the index. B)An equal dollar investment is made in each stock in the index. C)A proportionate market value investment is made for each stock in the index Explanation — An equal weighted price indicator series assumes that an equal dollar investment is made in each stock in the index. All stocks carry equal weight regardless of their price or market value 13. In a market-capitalization weighted index firms with: A)greater market caps have greater impacts on the index. B)higher stock prices have greater impacts on the index. C)larger market caps have lesser impacts on the index. Explanation — In a value weighted index, firms with greater market caps have a greater impact on the index than firms with lower market caps. A higher stock price does not necessarily mean a higher market cap 14. Which of the following statements about indexes is CORRECT? A)A market weighted series must adjust the denominator to reflect stock splits in the sample over time. B)An equal weighted index assumes a proportionate market value investment in each company in the index. C)A price-weighted index assumes an equal number of shares (one of each stock) represented in the index. Explanation — The descriptions of value weighted and unweighted indexes are switched. The denominator of a price-weighted index must be adjusted to reflect stock splits and changes in the sample over time. A market value-weighted series assumes you make a proportionate market value investment in each company in the index 15. With regard to stock market indexes, it is least likely that: A)a market-cap weighted index must be adjusted for stock splits but not for dividends. B)the use of price weighting versus market value weighting produces a downward bias on the index. C)buying 100 shares of each stock in a price-weighted index will result in a portfolio that tracks the index quite well. Explanation — A price-weighted index needs to be adjusted for stock splits, but a market-cap weighted index does not. Neither type of index considers dividend income unless it is designed as a total return index. Price weighting produces a downward bias compared to market weighting because firms that split their stocks (which tend to be the more successful firms) decrease in weight within a price-weighted index. The returns on a price-weighted index can be matched by purchasing a portfolio with an equal number of shares of each stock in the index 16. An index was recently begun with the following two stocks: ● Company A – 50 shares valued at $2 each. ● Company B – 10 shares valued at $10 each. Given that the value-weighted index was originally set at 100 and Company A's stock is currently selling for $4 per share while Company B’s stock is still at $10 per share, what is the current value of the price-weighted index and the market-cap-weighted index? Price-weighted Market-cap-weighted A) 7 150 B) 8 150 C) 7 300 Explanation — Price weight = [(4) + (10)] / 2 = 7 Market-cap weight = [(4)(50) + (10)(10)] / [(2)(50) + (10)(10)](100) = 150 17. Reconstitution of an index refers to: A)removing some securities from the index and adding others. B)adjusting the weights of the securities that constitute the index. C)changing the methodology used to calculate the value of the index. Explanation — Reconstitution begins with evaluating the securities in an index against the index’s criteria. Securities that are no longer representative of the index are removed and replaced with different securities that do meet the criteria. Adjusting the weights of the securities that constitute an index is termed rebalancing 18. The providers of the Smith 30 Stock Index remove Jones Company from the index because it has been acquired by another firm, and replace it with Johnson Company. This change in the index is best described as an example of: A)rebalancing. B)redefinition. C)reconstitution Explanation — Reconstitution refers to changing the securities that make up an index. Reconstitution of an index is required if one of its constituent securities goes out of existence (for example, a maturing bond or an expiring futures contract) or no longer meets the requirements to be included in the index 19. When a security is added to a widely followed market index, the security’s price is most likely to: A)increase. B)decrease. C)be unaffected Explanation — Adding a security to a market index typically causes an increase in that security’s price as portfolio managers who track the index purchase the security 20. The most appropriate benchmark for measuring the relative performance of an investment manager is: A)a broad market index. B)an index that closely matches the manager’s investment approach. C)the risk-adjusted return on the market portfolio Explanation — An index chosen as a benchmark for an investment manager’s performance should include securities in the manager’s investment universe. For example, the performance of an emerging market bond fund manager should be measured relative to the performance of an emerging market bond index 21. Contreras Fund is a mutual fund that invests in value stocks. The most appropriate type of equity index to use as a benchmark of manager performance for Contreras Fund is a: A)sector index. B)style index. C)broad market index Explanation — The index selected as a benchmark for manager performance should represent the investment universe from which the manager actually selects stocks. If the manager only invests in value stocks, then the most appropriate index is a style index that seeks to represent the returns from a value strategy. A sector index is appropriate for managers who invest in specific sectors (e.g., technology stocks, emerging market bonds) 22. An equity index comprised of value stocks, identified by their price-to-earnings ratios, is best described as a: A)style index. B)sector index. C)fundamental weighted index. Explanation — An index of value stocks is an example of a style index. Sector indexes measure the performance of securities in specific industries or industry sectors. Fundamental weighting is used to weight indexes by a factor such as the size of the firms or economies represented in the index 23. Which type of security market index provides a measure of a market’s overall performance and usually contains a significant portion of the market’s total value? A)Broad market indexes. B)Sector indexes. C)Style indexes Explanation — A broad market index typically consists of securities that represent 90% or more of the total market capitalization for a given market. The object of a broad market index is to provide a measure for the performance of the total market. A sector index measures the returns for an industry sector such as financials. Style indexes measure the returns to strategies that are differentiated by market capitalization and by value or growth 24. The Top Banking Index contains stocks in the finance industry that represent more than 90% of the total market capitalization for the finance industry. The index is best described as a: A)broad market index. B)sector index. C)style index Explanation — A sector index measures the returns for an industry sector such as financials. Style indexes measure the returns to strategies that are differentiated by market capitalization and by value or growth. A broad market index typically consists of constituent securities that represent 90% or more of the total market capitalization for a given market 25. Which of the following regarding bond market indexes is least accurate? A)Unlike stocks, bonds lack continuous price trading data. B)The bond universe is more stable than the stock universe. C)There are more bond issues than stocks Explanation — One reason why the creation of a bond index is more difficult than a stock index is due to the fact that the universe of bonds is constantly changing because of numerous new issues, bond maturities, calls, and bond sinking funds 26. Which of the following is NOT a reason bond market indexes are more difficult to create than stock market indexes? A)The universe of bonds is much broader than that of stocks. B)Bond deviations tend to be relatively constant. C)There is a lack of continuous trade data available for bonds. Explanation — Bond prices are quite volatile as measured by the bond’s duration 27. Commodity price indexes are based on the prices of: A)futures contracts. B)real assets such as grains, oil, and precious metals. C)commodities. Explanation — The constituent securities of commodity price indexes are commodity futures contracts. As a result, the return on a commodity index can be different than the returns from holding the constituent commodities themselves 28. Which of the following statements is most accurate regarding commodity indexes? A)Weighting methodology varies among index providers and leads to differences in index risk and returns. B)Commodity indexes are based on spot prices, while most investors purchase futures contracts. C)The return to commodity indexes consists of two major components: the risk-free rate of return and the roll yield Explanation — Weighting methodology is a major issue for commodity indexes. Several different methodologies are used, including equal weighting and global production values. Differences in weighting cause differing exposures for the indexes and lead to different risk and return profiles. Commodity indexes represent futures contracts on commodities, not the actual spot prices of commodities. Commodity index returns come from three sources: the risk-free rate of return, changes in futures prices, and the roll yield 29. Voluntary reporting of performance by hedge fund managers leads to: A)an upward bias in hedge fund index returns. B)a downward bias in hedge fund index returns. C)no appreciable bias in hedge fund index returns Explanation — Empirical studies have shown that since hedge fund managers have the option to report performance results only funds with good results will report. Since funds with poor performance do not report their results, the results of hedge fund indexes will be biased upwards 30. Which of the following indexes is a price weighted index? A)The New York Stock Exchange Index. B)The Nikkei Dow Index. C)The Standard and Poor's Index. Explanation — The Nikkei Dow Index is a price-weighted index. The other two are market value-weighted indexes 31. Which of the following sets of indexes are price-weighted? A)Dow Jones World Stock Index and Russell Index. B)Dow Jones Industrial Average and Nikkei Dow Jones Stock Market Average. C)S&P 500 Index and Dow Jones Industrial Average. Explanation — The Dow Jones World Stock Index, the Russell Index, the S&P 500 Index, and Morgan Stanley Capital International Index are all market-value weighted. Only the Dow Jones Industrial Average and the Nikkei Dow Jones Stock Market Averages are price-weighted 32. Equal weighting is the most common weighting methodology for indexes of which of the following types of assets? A)Hedge funds. B)Equities. C)Fixed income securities. Explanation — Most hedge fund indexes are equal-weighted. Equity and fixed income indexes are predominately market capitalization weighted