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Practice Problems 225

PRACTICE PROBLEMS
1 A security market index represents the:
A risk of a security market.
B security market as a whole.
C security market, market segment, or asset class.
2 Security market indexes are:
A constructed and managed like a portfolio of securities.
B simple interchangeable tools for measuring the returns of different asset
classes.
C valued on a regular basis using the actual market prices of the constituent
securities.
3 When creating a security market index, an index provider must first determine
the:
A target market.
B appropriate weighting method.
C number of constituent securities.
4 One month after inception, the price return version and total return version of
a single index (consisting of identical securities and weights) will be equal if:
A market prices have not changed.
B capital gains are offset by capital losses.
C the securities do not pay dividends or interest.
5 The values of a price return index and a total return index consisting of identi-
cal equal-weighted dividend-paying equities will be equal:
A only at inception.
B at inception and on rebalancing dates.
C at inception and on reconstitution dates.
6 An analyst gathers the following information for an equal-weighted index com-
prised of assets Able, Baker, and Charlie:
Beginning of End of Period Total
Security Period Price (€) Price (€) Dividends (€)

Able 10.00 12.00 0.75

Baker 20.00 19.00 1.00
Charlie 30.00 30.00 2.00

The price return of the index is:

A 1.7%.
B 5.0%.
C 11.4%.
7 An analyst gathers the following information for an equal-weighted index com-
prised of assets Able, Baker, and Charlie:

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226 Reading 34 ■ Security Market Indexes

Beginning of End of Period Total

Security Period Price (€) Price (€) Dividends (€)

Able 10.00 12.00 0.75

Baker 20.00 19.00 1.00
Charlie 30.00 30.00 2.00

The total return of the index is:

A 5.0%.
B 7.9%.
C 11.4%.
8 An analyst gathers the following information for a price-weighted index com-
prised of securities ABC, DEF, and GHI:
Beginning of End of Period Total
Security Period Price (£) Price (£) Dividends (£)

ABC 25.00 27.00 1.00

DEF 35.00 25.00 1.50
GHI 15.00 16.00 1.00

The price return of the index is:

A –4.6%.
B –9.3%.
C –13.9%.
9 An analyst gathers the following information for a market-capitalization-
weighted index comprised of securities MNO, QRS, and XYZ:
Beginning of End of Period Dividends Shares
Security Period Price (¥) Price (¥) per Share (¥) Outstanding

MNO 2,500 2,700 100 5,000

QRS 3,500 2,500 150 7,500
XYZ 1,500 1,600 100 10,000

The price return of the index is:

A –9.33%.
B –10.23%.
C –13.90%.
10 An analyst gathers the following information for a market-capitalization-
weighted index comprised of securities MNO, QRS, and XYZ:
Beginning of End of Period Dividends Shares
Security Period Price (¥) Price (¥) Per Share (¥) Outstanding

MNO 2,500 2,700 100 5,000

QRS 3,500 2,500 150 7,500
XYZ 1,500 1,600 100 10,000

The total return of the index is:

A 1.04%.
B –5.35%.
C –10.23%.
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Practice Problems 227

11 When creating a security market index, the target market:

A determines the investment universe.
B is usually a broadly defined asset class.
C determines the number of securities to be included in the index.
12 An analyst gathers the following data for a price-weighted index:

Beginning of Period End of Period

Shares Shares
Security Price (€) Outstanding Price (€) Outstanding

A 20.00 300 22.00 300

B 50.00 300 48.00 300
C 26.00 2,000 30.00 2,000

The price return of the index over the period is:

A 4.2%.
B 7.1%.
C 21.4%.
13 An analyst gathers the following data for a value-weighted index:

Beginning of Period End of Period

Shares Shares
Security Price (£) Outstanding Price (£) Outstanding

A 20.00 300 22.00 300

B 50.00 300 48.00 300
C 26.00 2,000 30.00 2,000

The return on the value-weighted index over the period is:

A 7.1%.
B 11.0%.
C 21.4%.
14 An analyst gathers the following data for an equally-weighted index:

Beginning of Period End of Period

Shares Shares
Security Price (¥) Outstanding Price (¥) Outstanding

A 20.00 300 22.00 300

B 50.00 300 48.00 300
C 26.00 2,000 30.00 2,000

The return on the index over the period is:

A 4.2%.
B 6.8%.
C 7.1%.
15 Which of the following index weighting methods requires an adjustment to the
divisor after a stock split?
A Price weighting.
B Fundamental weighting.
C Market-capitalization weighting.
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228 Reading 34 ■ Security Market Indexes

16 If the price return of an equal-weighted index exceeds that of a market-

capitalization-weighted index comprised of the same securities, the most likely
explanation is:
A stock splits.
B dividend distributions.
C outperformance of small-market-capitalization stocks.
17 A float-adjusted market-capitalization-weighted index weights each of its con-
stituent securities by its price and:
A its trading volume.
B the number of its shares outstanding.
C the number of its shares available to the investing public.
18 Which of the following index weighting methods is most likely subject to a
value tilt?
A Equal weighting.
B Fundamental weighting.
C Market-capitalization weighting.
19 Rebalancing an index is the process of periodically adjusting the constituent:
A securities’ weights to optimize investment performance.
B securities to maintain consistency with the target market.
C securities’ weights to maintain consistency with the index’s weighting
method.
20 Which of the following index weighting methods requires the most frequent
rebalancing?
A Price weighting.
B Equal weighting.
C Market-capitalization weighting.
21 Reconstitution of a security market index reduces:
A portfolio turnover.
B the need for rebalancing.
C the likelihood that the index includes securities that are not representative
of the target market.
22 Security market indexes are used as:
A measures of investment returns.
B proxies to measure unsystematic risk.
C proxies for specific asset classes in asset allocation models.
23 Uses of market indexes do not include serving as a:
A measure of systemic risk.
B basis for new investment products.
C benchmark for evaluating portfolio performance.
24 Which of the following statements regarding sector indexes is most accurate?
Sector indexes:
A track different economic sectors and cannot be aggregated to represent the
equivalent of a broad market index.
B provide a means to determine whether an active investment manager is
more successful at stock selection or sector allocation.
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Practice Problems 229

C apply a universally agreed upon sector classification system to identify the

constituent securities of specific economic sectors, such as consumer goods,
energy, finance, health care.
25 Which of the following is an example of a style index? An index based on:
A geography.
B economic sector.
C market capitalization.
26 Which of the following statements regarding fixed-income indexes is most
accurate?
A Liquidity issues make it difficult for investors to easily replicate fixed-
income indexes.
B Rebalancing and reconstitution are the only sources of turnover in fixed-
income indexes.
C Fixed-income indexes representing the same target market hold similar
numbers of bonds.
27 An aggregate fixed-income index:
A comprises corporate and asset-backed securities.
B represents the market of government-issued securities.
C can be subdivided by market or economic sector to create more narrowly
defined indexes.
28 Fixed-income indexes are least likely constructed on the basis of:
A maturity.
B type of issuer.
C coupon frequency.
29 Commodity index values are based on:
A futures contract prices.
B the market price of the specific commodity.
C the average market price of a basket of similar commodities.
30 Which of the following statements is most accurate?
A Commodity indexes all share similar weighting methods.
B Commodity indexes containing the same underlying commodities offer sim-
ilar returns.
C The performance of commodity indexes can be quite different from that of
the underlying commodities.
31 Which of the following is not a real estate index category?
A Appraisal index.
B Initial sales index.
C Repeat sales index.
32 A unique feature of hedge fund indexes is that they:
A are frequently equal weighted.
B are determined by the constituents of the index.
C reflect the value of private rather than public investments.
33 The returns of hedge fund indexes are most likely:
A biased upward.
B biased downward.
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230 Reading 34 ■ Security Market Indexes

C similar across different index providers.

34 In comparison to equity indexes, the constituent securities of fixed-income
indexes are:
A more liquid.
B easier to price.
C drawn from a larger investment universe.
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Solutions 231

SOLUTIONS
1 C is correct. A security market index represents the value of a given security
market, market segment, or asset class.
2 A is correct. Security market indexes are constructed and managed like a port-
folio of securities.
3 A is correct. The first decision is identifying the target market that the index
is intended to represent because the target market determines the investment
universe and the securities available for inclusion in the index.
4 C is correct. The difference between a price return index and a total return
index consisting of identical securities and weights is the income generated over
time by the underlying securities. If the securities in the index do not generate
income, both indexes will be identical in value.
5 A is correct. At inception, the values of the price return and total return ver-
sions of an index are equal.
6 B is correct. The price return is the sum of the weighted returns of each secu-
rity. The return of Able is 20 percent [(12 – 10)/10]; of Baker is –5 percent [(19
– 20)/20]; and of Charlie is 0 percent [(30 – 30)/30]. The price return index
assigns a weight of 1/3 to each asset; therefore, the price return is 1/3 × [20% +
(–5%) + 0%] = 5%.
7 C is correct. The total return of an index is calculated on the basis of the change
in price of the underlying securities plus the sum of income received or the
sum of the weighted total returns of each security. The total return of Able is
27.5 percent; of Baker is 0 percent; and of Charlie is 6.7 percent:
Able: (12 – 10 + 0.75)/10 = 27.5%
Baker: (19 – 20 + 1)/20 = 0%
Charlie: (30 – 30 + 2)/30 = 6.7%
An equal-weighted index applies the same weight (1/3) to each security’s return;
therefore, the total return = 1/3 × (27.5% + 0% + 6.7%) = 11.4%.
8 B is correct. The price return of the price-weighted index is the percentage
change in price of the index: (68 – 75)/75 = –9.33%.
Beginning of Period End of Period
Security Price (£) Price (£)

ABC 25.00 27.00

DEF 35.00 25.00
GHI 15.00 16.00
TOTAL 75.00 68.00

9 B is correct. The price return of the index is (48,250,000 –

53,750,000)/53,750,000 = –10.23%.
Beginning Beginning End of
of Period Shares of Period Period End of Period
Security Price (¥) Outstanding Value (¥) Price (¥) Value (¥)

MNO 2,500 5,000 12,500,000 2,700 13,500,000

QRS 3,500 7,500 26,250,000 2,500 18,750,000
(continued)
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232 Reading 34 ■ Security Market Indexes

Beginning Beginning End of

of Period Shares of Period Period End of Period
Security Price (¥) Outstanding Value (¥) Price (¥) Value (¥)
XYZ 1,500 10,000 15,000,000 1,600 16,000,000
Total 53,750,000 48,250,000

10 B is correct. The total return of the market-capitalization-weighted index is

calculated below:
Beginning of Total
Period Value End of Period Dividends Total Return
Security (¥) Value (¥) (¥) (%)

MNO 12,500,000 13,500,000 500,000 12.00

QRS 26,250,000 18,750,000 1,125,000 –24.29
XYZ 15,000,000 16,000,000 1,000,000 13.33
Total 53,750,000 48,250,000 2,625,000 –5.35

11 A is correct. The target market determines the investment universe and the
securities available for inclusion in the index.
12 A is correct. The sum of prices at the beginning of the period is 96; the sum at
the end of the period is 100. Regardless of the divisor, the price return is 100/96
– 1 = 0.042 or 4.2 percent.
13 B is correct. It is the percentage change in the market value over the period:
Market value at beginning of period: (20 × 300) + (50 × 300) + (26 × 2,000)
= 73,000
Market value at end of period: (22 × 300) + (48 × 300) + (30 × 2,000) =
81,000
Percentage change is 81,000/73,000 – 1 = 0.1096 or 11.0 percent with
rounding.
14 C is correct. With an equal-weighted index, the same amount is invested in
each security. Assuming $1,000 is invested in each of the three stocks, the index
value is $3,000 at the beginning of the period and the following number of
shares is purchased for each stock:
Security A: 50 shares
Security B: 20 shares
Security C: 38.46 shares.
Using the prices at the beginning of the period for each security, the index value
at the end of the period is $3,213.8: ($22 × 50) + ($48 × 20) + ($30 × 38.46). The
price return is $3,213.8/$3,000 – 1 = 7.1%.
15 A is correct. In the price weighting method, the divisor must be adjusted so the
index value immediately after the split is the same as the index value immedi-
ately prior to the split.
16 C is correct. The main source of return differences arises from outperformance
of small-cap securities or underperformance of large-cap securities. In an
equal-weighted index, securities that constitute the largest fraction of the mar-
ket are underrepresented and securities that constitute only a small fraction of
the market are overrepresented. Thus, higher equal-weighted index returns will
occur if the smaller-cap equities outperform the larger-cap equities.
17 C is correct. “Float” is the number of shares available for public trading.
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Solutions 233

18 B is correct. Fundamental weighting leads to indexes that have a value tilt.

19 C is correct. Rebalancing refers to adjusting the weights of constituent securi-
ties in an index to maintain consistency with the index’s weighting method.
20 B is correct. Changing market prices will cause weights that were initially equal
to become unequal, thus requiring rebalancing.
21 C is correct. Reconstitution is the process by which index providers review the
constituent securities, re-apply the initial criteria for inclusion in the index, and
select which securities to retain, remove, or add. Constituent securities that
no longer meet the criteria are replaced with securities that do. Thus, recon-
stitution reduces the likelihood that the index includes securities that are not
representative of the target market.
22 C is correct. Security market indexes play a critical role as proxies for asset
classes in asset allocation models.
23 A is correct. Security market indexes are used as proxies for measuring market
or systematic risk, not as measures of systemic risk.
24 B is correct. Sector indexes provide a means to determine whether a portfolio
manager is more successful at stock selection or sector allocation.
25 C is correct. Style indexes represent groups of securities classified according to
market capitalization, value, growth, or a combination of these characteristics.
26 A is correct. The large number of fixed-income securities—combined with the
lack of liquidity of some securities—makes it costly and difficult for investors to
replicate fixed-income indexes.
27 C is correct. An aggregate fixed-income index can be subdivided by market sec-
tor (government, government agency, collateralized, corporate), style (maturity,
credit quality), economic sector, or some other characteristic to create more
narrowly defined indexes.
28 C is correct. Coupon frequency is not a dimension on which fixed-income
indexes are based.
29 A is correct. Commodity indexes consist of futures contracts on one or more
commodities.
30 C is correct. The performance of commodity indexes can be quite different
from that of the underlying commodities because the indexes consist of futures
contracts on the commodities rather than the actual commodities.
31 B is correct. It is not a real estate index category.
32 B is correct. Hedge funds are not required to report their performance to any
party other than their investors. Therefore, each hedge fund decides to which
database(s) it will report its performance. Thus, for a hedge fund index, con-
stituents determine the index rather than index providers determining the
constituents.
33 A is correct. Voluntary performance reporting may lead to survivorship
bias, and poorer performing hedge funds will be less likely to report their
performance.
34 C is correct. The fixed-income market has more issuers and securities than the
equity market.