LOS a, (Part 1): Compare and contrast the characteristics of, and discuss the source and direction of bias exhibited by, each of the three predominant weighting schemes used in constructing stock market indexes.

Q1. 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.

Q2. 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)   Market value-weighted series.

B)   Unweighted price indicator series.

C)   Price-weighted series.

Q3. Which of the following statements best describes the investment assumption used to calculate an unweighted price indicator series?

A)   An equal number of shares of each stock are used in the index.

B)   A proportionate market value investment is made for each stock in the index.

C)   An equal dollar investment is made in each stock in the index.

Q4. In a value-weighted index firms with:

A)   higher stock prices have greater impacts on the index.

B)   larger market caps have lesser impacts on the index.

C)   greater market caps have greater impacts on the index.

LOS a, (Part 1): Compare and contrast the characteristics of, and discuss the source and direction of bias exhibited by, each of the three predominant weighting schemes used in constructing stock market indexes. fficeffice" />

Q1. 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.

Correct answer is C)

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.

Q2. 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)   Market value-weighted series.

B)   Unweighted price indicator series.

C)   Price-weighted series.

Correct answer is C)

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.

Q3. Which of the following statements best describes the investment assumption used to calculate an unweighted price indicator series?

A)   An equal number of shares of each stock are used in the index.

B)   A proportionate market value investment is made for each stock in the index.

C)   An equal dollar investment is made in each stock in the index.

Correct answer is C)

The unweighted 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.

Q4. In a value-weighted index firms with:

A)   higher stock prices have greater impacts on the index.

B)   larger market caps have lesser impacts on the index.

C)   greater market caps have greater impacts on the index.

Correct answer is C)

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.

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