LOS 37.a: Describe a security market index.
Question 37.1: A security market index represents the:
B) security market as a whole.
C) security market, market segment, or asset class.
A security market index represents the value of a given security market, market segment, or asset class.
Los 37.b : Calculate and interpret the value, price return, and total return of an index.
Question 37.2 : 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:
Return for the year = (1.03)(1.04)(0.98)(1.05) − 1 = 10.23%
RP = (1 + RS1)(1 + RS2)(1 + RS3)(1 + RS4)...(1 + RSk) − 1
Question 37.3 : Martin Gomez holds 100 shares of each of the stocks in a price- weighted index and reinvests cash dividends in additional shares.Assuming there are no stock splits, stock dividends, or changes in the makeup of the index, how will Gomez's portfolio return compare with the price return of the index if the low-priced index stocks outperform the high-priced index stocks?
A. Gomez’s portfolio return will be higher.
B. The price return of the index will be higher.
C. Gomez’s portfolio return will be equal to the price return of the index.
A is correct. The price return on the index does not include cash dividends. Since the reinvested dividends will add to the number of shares of those stocks that pay dividends, Gomez's portfolio return (total return) will be higher than the price return on the index. The relative performance of high-priced and low-priced stocks does not affect this result.
LOS 37.c: Describe the choices and issues in index construction and management.
Question 37.4 : When creating a security market index, an index provider must first determine the:
B) appropriate weighting method.
C) number of constituent securities.
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.
Los 37e: Calculate and analyze the value and return of an index given its weighting method.
Question 37.5 : Which of the following index weighting methods requires the most frequent rebalancing?
B) Equal weighting.
C) Market-capitalization weighting.
B is correct. Changing market prices will cause weights that were initially equal to become unequal, thus requiring rebalancing.
Equal-weighted indices also preferred because of their simplicity. However, they have a
• Assigning an equal weight to all securities underrepresents (overrepresents) those
securities that constitute a relatively large (small) fraction of the target market.
• The index does not remain equally weighted once the prices of the constituent
securities change. Frequent adjustments must be made to maintain equal weighting.
Los 37.d: Compare the different weighting methods used in index constructionQuestion Question 37.6: Which type of stock index must be adjusted for stock splits?
A. Equal weighted index.
B. Price weighted index.
C. Market capitalization weighted index.
B is correct. When computing any price-weighted index, the denominator must be adjusted to take stock splits into account.
A price-weighted index is simply an arithmetic average of the prices of the securities
included in the index. The divisor of a price-weighted index is adjusted for stock splits and changes in the composition of the index when securities are added or deleted, such that the index value is unaffected by such changes
Question 37.7 :
A is correct.
LOS 37.j: Describe indexes representing alternative investments.
Question 37.8 : 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.
A is correct. Commodity indices consist of futures contracts on one or more commodities
Commodity indexes represent futures contracts on commodities such as grains, livestock, metals, and energy
Question 37.9 : The returns of hedge fund indexes are most likely:
A) biased upward.
B) biased downward.
C) similar across different index providers.
A is correct. Voluntary performance reporting may lead to survivorship bias, and poorer performing hedge funds will be less likely to report their performance.
It is often the case that those funds that report are the funds that have been
successful, as the poorly performing funds do not want to publicize their performance
LOS 37.i: Describe types of fixed-income indexes.
Question 37.10 : Creating a bond market index is more difficult than constructing a stock market index due to:
A. lack of continuous trade data for bonds.
B. lower price volatility of bonds versus stocks.
C. a narrower universe of bonds versus stocks.
A is correct.It is difficult to price individual bond issues in an index because continuous trade data may not exist for some bonds. In addition, it is challenging to create a bond market index because the bond universe is much broader, and the price volatility of a bond (i.e., its duration) changes over time as the bond approaches maturity.
READING 39: OVERVIEW OF EQUITY SECURITIES
Los 39.a: Describe characteristics of types of equity securities.
Question 39.1: Dividends on non-participating preference shares are typically:
A) a fixed percentage of par value.
B) lower than the dividends on common shares.
C) a contractual obligation of the company
Non-participating preference shares have a claim equal to par value in the event of liquidation and do not share in firm profits.
LOS 39.b: Describe differences in voting rights and other ownership characteristics
among different equity classes.
Question 39.2: The type of share voting most likely to result in significant minority shareholders having an approximately proportional representation on the board of directors is:
A) statutory voting.
B) weighted voting.
C) cumulative voting
C is correct. Under cumulative voting, shareholders receive one vote per share for each board position election but can vote them for any board candidate or spread them over multiple candidates. This allows, for example, a holder of 20% of the shares to elect one of five board.
LOS 39.c: Distinguish between public and private equity securities.
Question 39.3: In a transaction referred to as a management buyout (MBO):
A) management sells its shares to an investor group attempting to gain control of a company.
B) management buys a controlling interest in a public company to gain control of the board of directors.
C) an investor group that includes management buys all the shares of a company and they no longer trade on an exchange.
C is correct. Management buyout refers to a situation where an investor group that includes the firm's key management purchases all the outstanding shares (not just a controlling interest) of a public company in order to take it private. Once this is done, the shares are no longer registered for public trading and, as a result, are no longer traded on exchanges or in other public markets.
In a leveraged buyout (LBO), investors buy all of a firm’s equity using debt financing (leverage). If the buyers are the firm’s current management, the LBO is referred to as a management buyout (MBO). Firms in LBOs usually have cash flow that is adequate to service the issued debt or have undervalued assets that can be sold to pay down the debt over time.
Los 39.d : Describe methods for investing in non-domestic equity securities.
Question 39.4: The type of equity depository receipt that gives its owners the right to vote and receive dividends from a company's shares is best described as:
A) a global depository receipt.
B) a sponsored depository receipt.
C) a fully-owned depository receipt.
B is correct. The owner of a sponsored DR share has the same voting rights and receives the same dividends as the owner of a common share of the firm. With an unsponsored DR, the depository bank retains the voting rights. A global depository receipt may be sponsored or unsponsored.
Depository receipts (DRs) represent ownership in a foreign firm and are traded in the markets of other countries in local market currencies. A bank deposits shares of the foreign firm and then issues receipts representing ownership of a specific number of the foreign shares. If the firm is involved with the issue, the depository receipt is a sponsored DR; otherwise, it is an unsponsored DR
Question 39.5: Global depository receipts are most likely issued:
A) in the United States and denominated in U.S. dollars.
B) outside the issuer’s home country and denominated in U.S. dollars.
C) outside the issuer’s home country and denominated in the exchange’s home currency.
B is correct. Global depository receipts are issued outside the U.S. and the issuer's home country and are most often denominated in U.S. dollars. Depository receipts issued in the United States and denominated in U.S. dollars are called American depository receipts. Global registered shares are denominated in the home currencies of the exchanges on which they trade.
LOS 39.e: Compare the risk and return characteristics of different types of equity
Question 39.6: From an investor’s point of view, which of the following equity securities is the least risky?
A) Puttable preference shares.
B) Callable preference shares.
C) Non-callable preference shares.
A is correct. Puttable shares, whether common or preference, give the investor the option to sell the shares back to the issuer at a pre-determined price. This pre-determined price creates a floor for the share’s price that reduces the uncertainty of future cash flows for the investor
LOS 39.g: Distinguish between the market value and book value of equity securities
Question 36.7: The most likely reason that a company's book value of equity and the market value of its equity securities may be different is that:
A) market value of equity securities includes preferred stock, but the book value of equity does not.
B) the issuance of new equity will increase the book value of equity, but will not affect the share price.
C) the market value of equity securities reflects investor expectations about future performance, but book value of equity does not.
C is correct. The market value of equity securities is affected by investor expectations about future firm performance, while the book value of equity is based on the firm's past performance. The book value of equity includes both common and preferred equity. The issuance of new equity will increase the market value of equity, even if the share price is unaffected.
The market value and book value of equity are seldom equal. Although management may be maximizing the book value of equity, this may not be reflected in the market value of equity because book value does not reflect investor expectations about future firm performance.
Question 39.8: Pearl River Heavy Industries shows the following information in its financial statements:
Total Assets HK$146,000,000
Total Liabilities HK$87,000,000
Net Income HK$27,000,000
Price per Share HK$312
Shares Outstanding 200,000
The equity securities of Pearl River have a:
A) book value of HK$62,400,000.
B) book value of HK$59,000,000.
C) market value of HK$146,000,000.
B is correct. Book value = Total assets – total liabilities = 146,000,000 – 87,000,000 = HK$59,000,000
Market value of equity = Market price per share × shares outstanding = HK$312 × 200,000 = HK$62,400,000
LOS 39.h: Compare a company’s cost of equity, its (accounting) return on equity, and
investors’ required rates of return.
Question 39.9: Holding all other factors constant, which of the following situations will most likely lead to an increase in a company’s return on equity?
A) The market price of the company’s shares increases.
B) Net income increases at a slower rate than shareholders’ equity.
C) The company issues debt to repurchase outstanding shares of equity.
C is correct. A company’s ROE will increase if it issues debt to repurchase outstanding shares of equity.