CFA Level 3 - Equity Investments Session 12 - Reading 29

CFA Level 3 – Equity Investments, Session 12 – Reading 29

(Notes, Practice Questions, Sample Questions)

1.1 A small, developing country has just developed an organized stock exchange where several dozen firms of all sizes trade. Craig Aversa has gathered data for the companies on the exchange and plans to construct an index using a sample of the firms that he feels are representative of the stocks that trade on the exchange and the country’s economy. He meets with Jamie Weir who has experience in creating country indexes.

As they begin, Aversa says that he will develop a strict set of guidelines for determining which firms to include in the index. Weir says that the guidelines should be published so that the index may be used more effectively and efficiently as a trading tool.As Aversa does his research, he uncovers some issues that may lead to potential problems. Many of the firms that are traded on the exchange and would be good candidates for inclusion in the index have large positions that are owned by a controlling family and will probably not be actively traded for the foreseeable future.

Several of the firms own positions, ranging from 5 to 20%, of another company on the exchange. When Weir proposes the creation of a value-weighted index based upon capitalization, Aversa says that such an index may have weights that are not representative of the actual value of the shares in the companies that are available for trading. Weir acknowledges Aversa’s concerns and computes a float adjustment that will increase the value of shares trading for each company to better reflect their tradable value.

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Aversa decides to construct the index using 10 firms. For the index, Aversa decides to use the firm with the largest capitalization from each of the four major industries in the country. He will then rank the remaining firms by size and choose the six firms with the largest capitalization from that list. In so doing, he feels that he is striking an appropriate balance. One advantage of this method is that it turns out the gap, in terms of capitalization, between the sixth firm on the second list and the seventh firm, is fairly large. Thus, Aversa feels the criteria for selection will minimize the likelihood that the component firms in the index will have to change in the near future.Weir says that Aversa may still need to monitor the amount of the float adjustment. Aversa says he plans to employ a precise float adjustment. Weir says it may be more practical to create acceptable ranges for the stocks that approximate the true free float. As long as the free float is within the band, they will not adjust the index. With respect to their approach to creating the guidelines:

A)Aversa is proposing objectivity and Weir is proposing transparency.

B)Weir is proposing objectivity and Aversa is proposing transparency.

C)Weir is proposing judgment and Aversa is proposing transparency

<Explanation> Aversa’s plan to set up strict guidelines imposes objectivity. It removes subjective judgment from the process of maintaining the index. Weir is proposing transparency in that she wants those who use the index to be informed as to the criteria for the index and under what conditions it might change.

1.2 Among the potential problems that Aversa discovered is:

A)cross hedging.

B)cross holding.

C)crossing.

<Explanation> The fact that many of the firms on the exchange own shares of the other firms presents a problem in measuring the free float. Such ownership is called cross holding.

1.3 With respect to Aversa’s concern about problems of using a value-weighted index and Weir’s solution:

A)Aversa’s concern is unjustified, and Weir’s solution is unwarranted.

B)Aversa’s concern is justified, but Weir’s solution is wrong.

C)Aversa’s concern is justified, and Weir’s solution is appropriate

<Explanation> Aversa is correct in his assertion that there could be problems in assigning correct weights to the stocks in the index. This is because the cross ownership and the large amount of closely held stock will mean the free float for any given issue is less than the reported capitalization. Float adjustments should be applied to each stock to get a better idea of the free float for each issue, and they should use those measures for the portfolio weights. Weir’s solution is wrong, however, in that a float adjustment should decrease the value of the float of each issue where cross holding is a problem and not increase it.

1.4 In determining his criteria for the number of firms to select based upon size, Aversa is striking a balance between:

A)objectivity and judgment.

B)liquidity and crossing opportunities.

C)breadth and investability.

<Explanation> Including only the largest firms increases investability. It avoids including small, closely held firms for which obtaining stock to replicate the index may be difficult. However, using only a few large firms will reduce the breadth of the index and make it less representative of the stocks that trade in the country and on the exchange. This is classic choice that the creator of an index must consider.

1.5 If Aversa’s assessment that the component firms in his index will probably not change in the near future is CORRECT:

A)there will be lower index reconstitution effects.

B)there will be lower float adjustment effects.

C)there will be more breadth.

<Explanation> This is true by definition. If the makeup of the index remains constant, then the users of the index will have lower costs in using the index as a benchmark. These costs are part of the “reconstitution effects.”

1.6 With respect to Aversa’s proposal for rebalancing and Weir’s suggestion, Aversa’s proposal will lead to:

A)high transactions costs, and Weir’s suggestion is a practical solution.

B)high transactions costs, but Weir’s suggestion is not a practical solution.

C)low transactions costs, so Weir’s suggestion is not relevant

<Explanation> In creating and managing an index, there is a tradeoff between how precisely to adjust the float. “Precise float adjustment” results in frequent rebalancing with the accompanying high transaction costs for portfolios tracking the index. Instead of making precise float adjustments, an index may use a band adjustment. In this case, the managers will create ranges that they feel capture the true percentage of the firm’s market cap that is free floating (e.g. 65% to 85%). As long as the firm’s estimated free float stays within that band, they do not adjust the firm’s weight in the index.

2. Market cap weighted indices as compared to float adjusted indices give:

A)higher weight to lower float companies with large cross-holdings of shares.

B)higher weight to lower float companies with small cross-holdings of shares.

C)lower weight to higher float companies with large cross-holdings of shares.

<Explanation> Market cap weighted indices weigh companies based on market cap and not float. Those companies that have lower float would then get higher weight when the index is market cap weighted and not adjusted for float. Lower float is caused by large cross-holdings of shares (among other things)

3. Float adjustment is needed for international equity benchmarks because the international equity indices are:

A)market cap weighted and the float is higher due to cross-holdings.

B)float weighted and the float is lower due to cross-holdings.

C)market cap weighted and the float is lower due to cross-holdings.

<Explanation> International equity benchmarks (and most US benchmarks) are market-cap weighted, however, the proportion of the float for international equity benchmarks is lower, meaning less shares are available for trading. One of the key reasons for the lack of float is a large amount of cross-holding of shares among companies. For example, if one firm holds a controlling interest in another, those shares held are not available for trading

4. Which of the following is a valid reason for the need for float adjustment in the construction of international equity benchmarks as compared to US equity benchmarks?

A)The proportion of free float of market capitalization is higher for international equity benchmarks as compared to US equity benchmarks.

B)The crossholding of the benchmark in the US is lower than the crossholding in international markets.

C)The proportion of free float of market capitalization is lower for international equity benchmarks as compared to US equity benchmarks

<Explanation> The proportion of free float (amount of shares actually available for trading) is lower for international equity markets necessitating float adjustment. Crossholdings of company shares (not the benchmark) is one factor contributing to lower float in international markets

5. Portfolio managers tracking international equity indices have a tradeoff between breadth and investability because:

A)lower breadth results in higher investability and higher transaction costs.

B)higher breadth results in higher investability and lower transaction costs.

C)higher breadth results in lower investability and higher transaction costs

<Explanation> Index breadth refers to the number of companies covered by an index. Higher breadth means that a larger number of companies are covered, however, that results in lower investability (liquidity issues for smaller companies in the index) and higher transaction costs

6. The effect of index reconstitution is more severe for:

A)more popular indices because of higher price pressure.

B)less popular indices because of lower price pressure.

C)less popular indices because of higher price pressure

<Explanation> Index reconstitution results in added demand for a stock when it is added to the index (due to index replicators trying to buy) and added supply for a stock when it is deleted from the index. (due to index replicators trying to sell). The result is that managers are forced to buy added stocks at high prices and sell deleted stocks at low prices. This price pressure is more severe for more popular indices (more replicators)

7. Transaction costs in general are higher for:

A)precise float adjustment and less popular indices.

B)precise float adjustment and more popular indices.

C)float adjustment bands and less popular indices

<Explanation> Precise float adjustment results in frequent rebalancing and higher transaction costs. More popular indices have higher liquidity and lower transaction costs

8. ANZ Asia equity index is a new entry into Asian market indices. The index has better coverage especially in the South Asian markets as compared to its more popular rivals. The index has coverage of 90% of all stocks listed in the constituent markets. Which of the following statements best describes the index?

A)Breadth is high, liquidity is low, and crossing opportunities are high.

B)Breadth is high, liquidity is low, and crossing opportunities are low.

C)Breadth is high, liquidity is high, and crossing opportunities are low

<Explanation> Since the index is fairly comprehensive (90% coverage), breadth of the index is high. However due to the high breadth and being fairly new in the market, the index is not very liquid. Also lower popularity (new index) translates into lower crossing opportunities

9. Ireland recently moved from being classified as an emerging market to a developed market. Ireland will now represent a:

A)smaller proportion of the index and will raise capital more easily.

B)larger proportion of the index and will raise capital more easily.

C)smaller proportion of the index and will find raising capital more difficult

<Explanation> When a country moves from being classified as an emerging market to a developed market, the country’s stock will represent a smaller proportion of a developed world index where other countries in the index will be larger in size than in the emerging index. The country should have an easier time raising capital because developed countries’ stocks have more liquidity

10. When a country moves from being classified as an emerging market to a developed market which of the following statements is least accurate?

A)The country will have a more difficult time raising capital due to the higher returns of emerging stocks.

B)The country’s returns will represent a smaller proportion of the stock index.

C)The country’s stock will increase in liquidity

<Explanation> When a country moves from being classified as an emerging market to a developed market, the country should have an easier time raising capital because developed countries’ stocks have more liquidity. The country and its stock will represent a smaller proportion of a developed world index where other countries in the index will be larger in size than in the emerging index

11. The country of Galdavia recently moved from being classified as an emerging market to a developed market. Its return over the last year was 40% in local currency terms and 30% in dollar terms. The country of Tinia is still classified as an emerging market. Its return over the last year was 42% in local currency terms and 28% in dollar terms. Which of the following statements regarding Galdavia and Tinia is CORRECT?

A)Galdavia will more easily raise capital due to its higher returns in U.S. dollars.

B)Galdavia will more easily raise capital due to its classification as a developed market.

C)Tinia will more easily raise capital due to its higher returns in local currency

<Explanation> When a country moves from being classified as an emerging market to a developed market, the country should raise capital more easily because developed countries’ stocks have more liquidity. With more capital access, Galdavia’s growth should increase