Los 40.c

Question 1

What do index providers have to decide?

Answer 1

• Target market
• Which Securities
• How should they be weighted
• How often should the index be rebalanced
• How often should the selection and weighting of securities change

Question 2

What are the different weighting schemes used in index construction?

Answer 2

• Price-weighted
• equal-weighed
• Market Capitalization weighted
• Float Adjusted Weighted
• Fundamental Weifhted

Question 3

How to calculate price weighted index and advantage/disadvantage of usage?

Answer 3

sum of the price of securities / number of securities
Advantage = computation is simple
Disadvantage = higher priced stocks have more weight in the calculation

Question 4

How to work out an equal weighed index?
What’s their disadvantage?

Answer 4

average return of securities / number of securities
Disadvantage:
* Larger capitalized stocks are have smaller proportions and vice versa
* Also requires periodic rebalancing

Question 5

What is a market capitalization weighted index? and their advantage/disadantage

Answer 5

Market Capitalization of each stock / all stocks in the index
Advantage:
* Represents market realistically: Bigger companies have bigger impact.
Disadvantages:
* Favours potentially overvalued stocks: Gives too much weight to stocks whose prices have risen a lot, even if they might be overpriced.
* Creates momentum: Rising prices lead to higher weighting, pushing the index up further, and vice-versa for falling prices, increasing market swings

Question 6

What is a market float and a free float?

Answer 6

Market float = the total value of all the shares - ones held by controlling stockholders (or corps/governments)
Free float = Market float - shares not available to foreign buyers

Question 7

What is fundamental weighting?

Answer 7

Based on firm fundamentals - an advantage is that it looks at the fundamentals and so firms with high value based metrics would have a higher weight.