Equity Investments. 13 question(s) in this unit's pool
(2 above the exam). Free up to ten a day; the coach picks which ones based on what you have
already answered and when each is next due.
Pick an answer, say how sure you are, then reveal. Every wrong choice gets its own
explanation. Questions you have already answered correctly and confidently stay out of the way until they
are due for review again.
Question 1Exam level
A price-weighted index contains three stocks: Stock A at $20, Stock B at $60, and Stock C at $120. Over the period, Stock A rises 50%, Stock B rises 10%, and Stock C falls 5%. Which stock most likely has the greatest impact on the price-weighted index return?
How sure are you?
Correct: B. In a price-weighted index, the contribution of each stock to index movement is proportional to its absolute price. Not its percentage change or market capitalization. Stock C at $120 represents 120/(20+60+120) = 60% of the index weight. A 5% decline in Stock C = -$6.00 price change. Stock A's 50% gain = +$10.00. Stock B's 10% gain = +$6.00. Net change: -6 + 6 + 10 = +$10. Stock C's decline offset Stock B's gain entirely. The exam tests whether you know that price, not market cap, drives weight in a price-weighted index.
A. You might be tempted to think that the middle-priced stock has a balanced influence, but in a price-weighted index, the stock with the highest price, not the middle price, carries the most weight, making Stock B's position irrelevant to its impact on the index.
C. Choosing C might tempt you if you assume equal weighting in an index, but in a price-weighted index, stocks with higher prices have greater impact, directly contradicting the idea that all stocks have equal influence.
Unit: security-market-indexes
Question 2Exam level
An equal-weighted index is constructed with three stocks, each initially priced at $50. After one year: Stock 1 is at $75, Stock 2 is at $50, Stock 3 is at $25. The return of the equal-weighted index is closest to:
How sure are you?
Correct: A. In an equal-weighted index, each stock receives an equal weight at inception. Return = (1/3)(50%) + (1/3)(0%) + (1/3)(-50%) = (50 + 0 - 50)/3 = 0/3 = 0.0%. Each stock starts with equal weighting, so returns are averaged equally regardless of price level. But a value-weighted index would return 0% only if shares outstanding are also equal. The exam tests whether candidates can distinguish the equal-weight averaging formula from price-weighted averaging.
B. You might be tempted to choose +16.7% if you incorrectly averaged the price changes instead of the percentage returns, but in an equal-weighted index, you must average the percentage returns of each stock, which in this case results in 0.0%.
C. You might be tempted to choose +8.3% if you incorrectly averaged the price changes directly rather than the percentage returns, but in an equal-weighted index, you must average the percentage returns of each stock, not their price changes, leading to a return of 0.0%.
Unit: security-market-indexes
Question 3Exam level
Which of the following is most accurate regarding the rebalancing requirements of an equal-weighted index compared to a market-capitalization-weighted index?
How sure are you?
Correct: B. An equal-weighted index starts with equal dollar investment in each constituent. As prices move at different rates, weights drift away from equal. To restore equal weighting, the index must sell recent outperformers and buy underperformers. A form of systematic contrarian trading. A market-cap-weighted index is self-rebalancing: as prices rise, market caps rise, and weights automatically adjust. No rebalancing is needed between reconstitution dates for a cap-weighted index.
A. You might be tempted to think that frequent rebalancing is necessary to maintain equal weights in a market-cap-weighted index, but this confuses the nature of market-cap-weighting, which naturally adjusts weights as stock prices change, thus requiring less frequent rebalancing compared to an equal-weighted index that needs intervention to maintain equal weights.
C. Choosing C might seem logical if you assume that both index types naturally maintain their weights without intervention, but this overlooks the fundamental difference in how equal-weighted and market-cap-weighted indexes manage their compositions, where an equal-weighted index specifically needs frequent adjustments to keep the weights equal as prices fluctuate.
Unit: security-market-indexes
Question 4Exam level
The Dow Jones Industrial Average (DJIA) currently contains 30 stocks. When a constituent stock undergoes a stock split, the DJIA divisor is adjusted. Which of the following most likely explains WHY the divisor is adjusted?
How sure are you?
Correct: A. A stock split mechanically reduces a stock's price (e.g., 2-for-1 halves the price). If the divisor were unchanged, the DJIA would drop as if there were a real economic loss. But no economic value has changed. The divisor is reduced so that the pre-split and post-split index values are identical. This preserves the continuity of the index as a time series. The divisor has been adjusted hundreds of times since the DJIA's creation in 1896. It is currently approximately 0.152 (not 30) because of accumulated splits and changes.
B. You might think that adjusting the divisor balances the influence of lower-priced stocks, but the divisor adjustment actually aims to maintain the index value, not to equalize stock influence, which means choice B confuses the purpose of the adjustment with an unrelated concept of stock pricing influence.
C. You might be thinking that a stock split involves fractional shares, but the DJIA adjusts the divisor to maintain the index value, not to account for dividends or fractional shares, thus choice C confuses the purpose of the divisor adjustment with unrelated corporate actions.
Unit: security-market-indexes
Question 5Harder
An analyst is comparing the performance of a price-weighted index to an equal-weighted index using the same three constituents. During a bull market where small-cap stocks outperform large-cap stocks, which index is most likely to show higher returns?
How sure are you?
Correct: A. An equal-weighted index assigns the same dollar weight to each constituent regardless of company size. This gives proportionally more weight to smaller-cap stocks than a cap-weighted index would. In periods when small-cap stocks outperform (value/small-cap rotation), the equal-weighted index captures more of this outperformance. Historically, equal-weighted versions of indexes like the S&P 500 have outperformed the cap-weighted version during small-cap rally periods. The price-weighted index is biased toward high-priced stocks. Which may or may not correlate with large-cap stocks.
B. You might think that since both indexes include the same stocks, their returns would be identical, but this overlooks how different weighting methods allocate capital, with an equal-weighted index giving more exposure to smaller stocks that outperform in this scenario.
C. You might be thinking that less frequent rebalancing allows the price-weighted index to hold onto winners longer, but this overlooks that price-weighted indices weight stocks by price, not market cap, giving disproportionate weight to large-cap stocks, which do not outperform in this scenario as much as small-cap stocks in an equal-weighted index.
Unit: security-market-indexes
Question 6Exam level
A float-adjusted market-capitalization-weighted index most likely differs from a full market-capitalization-weighted index primarily because:
How sure are you?
Correct: A. Float adjustment reduces a stock's weight to reflect only the shares freely available for trading. The 'free float.' Shares held by governments (e.g., Saudi Aramco with ~98% government ownership post-IPO), company founders, controlling families, or strategic corporate investors are excluded because these shares are not available to market participants. The S&P 500 uses float-adjusted market cap weighting precisely because it wants to reflect only investable market capitalization. MSCI also uses free float adjustment for its global indexes.
B. You might be misled by the idea that trading volume influences weight, but float-adjusted indexes still use market capitalization for weighting, just based on the free float rather than total shares outstanding. Weighting by trading volume would focus on liquidity rather than the economic size of the company, which is the core principle of market-capitalization-weighted indexes.
C. You might be misled into thinking rebalancing frequency is the key difference, but float-adjusted indexes focus on the proportion of shares available to the public, not on rebalancing schedules, which can vary regardless of the adjustment method used.
Unit: security-market-indexes
Question 7Exam level
In the context of maintaining a market index over time, index reconstitution is most likely defined as:
How sure are you?
Correct: A. Reconstitution is the periodic process of changing the composition of an index. Adding stocks that now meet inclusion criteria and removing those that no longer do. This is distinct from rebalancing, which adjusts weights of existing constituents. For example, the Russell 2000 reconstitutes annually every June. Stocks newly added to the Russell 2000 experience buying pressure because index funds tracking the index must purchase them. A well-documented 'Russell reconstitution effect.' Rebalancing adjusts weights; reconstitution changes membership.
B. You might be thinking that recalculating the divisor after a stock split is related to maintaining the index value, but this action is part of the index maintenance for continuity and does not involve changing the index composition, which is what reconstitution actually entails.
C. You might be tempted by choice C if you think index reconstitution involves changing the method of index calculation, but converting a price-weighted index to a value-weighted index pertains to the weighting methodology, not the process of adding or removing securities from the index.
Unit: security-market-indexes
Question 8Exam level
An index contains Stock A ($30, 2M shares) and Stock B ($10, 10M shares). The index is value-weighted. What percentage weight does Stock B represent? The value is closest to:
How sure are you?
Correct: B. Market cap of Stock A = $30 x 2,000,000 = $60,000,000. Market cap of Stock B = $10 x 10,000,000 = $100,000,000. Total market cap = $160,000,000. Weight of Stock B = $100M / $160M = 62.5%. Despite Stock B having a lower price per share, it has a far larger market cap due to more shares outstanding. In a value-weighted index, market cap, not price, determines weight. This is the fundamental difference from a price-weighted index where Stock A ($30) would receive 75% weight vs Stock B ($10) at 25%.
A. Choosing 33.3% might tempt you if you incorrectly assume that the percentage weight is based on the number of shares outstanding, but in a value-weighted index, the weight is determined by market capitalization, not just the number of shares, which is why Stock B's larger market cap results in a 62.5% weight.
C. Choosing 50.0% might tempt you if you incorrectly assume equal market caps for both stocks due to their share numbers, but in a value-weighted index, the weight is based on market capitalization, not just the number of shares, making Stock B's weight 62.5% due to its larger market cap.
Unit: security-market-indexes
Question 9Exam level
A security market index that uses fundamental factors such as earnings, dividends, and book value as weighting criteria is most likely described as:
How sure are you?
Correct: B. Fundamental weighting assigns index weights based on accounting or economic metrics, revenue, earnings, dividends, book value, or combinations, rather than share price or market capitalization. Proponents argue this breaks the link between overvaluation and overweighting that exists in cap-weighted indexes (overvalued stocks have inflated market caps and thus inflated index weights). The RAFI (Research Affiliates Fundamental Index) is the most cited example. The CFA curriculum introduces fundamental weighting as one of the alternative weighting schemes beyond the three primary methods.
A. You might be tempted by choice A because market-capitalization-weighted indexes are common and familiar, but this type of index weights securities by market capitalization, not by fundamental factors like earnings or book value, which is what the question specifically asks for.
C. Choosing an equal-weighted index might seem plausible if you think all securities are given the same weight, but this approach assigns equal weights regardless of fundamental factors, unlike a fundamentally weighted index which specifically uses metrics like earnings, dividends, and book value to determine weights.
Unit: security-market-indexes
Question 10Exam level
An analyst calculates the total return index for a period during which the price return index gained 8.0%. The dividend yield during the period was 2.5%. The total return index, most likely:
How sure are you?
Correct: A. A total return index assumes dividends are reinvested in the index at the time of payment. The total return approximately equals price return plus dividend yield: 8.0% + 2.5% = 10.5%. This is approximate because of compounding (dividends reinvested earn returns on returns). The price return index only captures capital gains; the total return index captures capital gains PLUS income. The CFA exam tests both versions and expects candidates to know which is higher (total return > price return for dividend-paying indexes) and why.
B. Choosing B might tempt you if you assume that dividends do not affect the index return, but this ignores the fundamental concept that a total return index includes both price appreciation and dividend reinvestment, unlike a price return index which only accounts for capital gains.
C. You might be thinking that dividends detract from price appreciation, but this confuses the concept of total return, which actually includes both price appreciation and dividend income, thus choice C violates the principle that dividends enhance total return when reinvested, not reduce it.
Unit: security-market-indexes
Question 11Exam level
Which of the following statements about a price-weighted index is most accurate?
How sure are you?
Correct: A. In a price-weighted index, the weight of each constituent equals its price divided by the sum of all prices. A $200 stock has twice the influence of a $100 stock on index movement. Regardless of how many shares either company has outstanding. This is the defining characteristic and key limitation of price-weighted indexes: they confuse share price (which is arbitrary and can be changed by splits) with economic importance. Option B is wrong: a stock split reduces the price and would DECREASE the index value if the divisor were not adjusted. Option C is wrong: cap-weighted indexes self-rebalance, not price-weighted.
B. A price-weighted index does not rebalance itself when prices move; each stock's weight is simply its own price divided by the sum of all constituent prices, so a price change just moves that weight mechanically, it is not a rebalancing event. The real adjustment a price-weighted index needs is after a stock split, since a split cuts the price without changing the company's true value; without a divisor adjustment the index level would move for no economic reason. That divisor fix is applied by the index provider, it is not automatic.
C. Option C is wrong: cap-weighted indexes self-rebalance, not price-weighted.
Unit: security-market-indexes
Question 12Above the exam
A price-weighted index contains two stocks: Stock A at $100 and Stock B at $50, divisor 2. Stock A then undergoes a 4-for-1 stock split. Combining the mechanics of divisor adjustment with a stock split's effect on price, the new divisor needed to keep the index value unchanged immediately after the split is closest to:
How sure are you?
Correct: A. Before the split, index value = (100 + 50) / 2 = 75. After a 4-for-1 split, Stock A's price becomes $100 / 4 = $25; the new sum of prices = 25 + 50 = 75. To keep the index value unchanged at 75, the new divisor must satisfy 75 / new divisor = 75, so the new divisor = 75 / 75 = 1.00... Re-deriving precisely: new divisor = new sum / old index value = 75 / 75 = 1.00. (Checking against the offered choices, the closest correctly reasoned value from this method is captured by recomputing new divisor = new sum / old index value.)
B. 2.00 is simply the OLD divisor left unchanged; a stock split changes the sum of prices in the index without changing its economic value, so the divisor must be adjusted (recomputed), not held at its pre-split level.
C. 0.50 would result from a mechanical halving of the old divisor as though the split ratio were applied directly to the divisor itself, rather than working through the actual new sum-of-prices-over-index-value relationship the divisor adjustment requires.
Unit: security-market-indexes
Question 13Above the exam
An analyst compares a price-weighted index and a market-cap-weighted index built from the same two stocks. Stock A: price $200, 1 million shares outstanding. Stock B: price $20, 50 million shares outstanding. Stock A's price then rises 10% while Stock B is unchanged. Combining how each weighting method allocates influence, the analyst should most likely expect:
How sure are you?
Correct: B. A price-weighted index gives influence in proportion to SHARE PRICE, regardless of company size, so Stock A ($200) dominates over Stock B ($20) in that index. A market-cap-weighted index gives influence in proportion to total MARKET CAPITALIZATION: Stock A's cap is $200 x 1M = $200M, while Stock B's cap is $20 x 50M = $1,000M, five times larger, so Stock B actually dominates the cap-weighted index despite its much lower share price. The same 10% move in Stock A therefore moves the two indexes very differently.
A. The two weighting schemes allocate influence on completely different bases (share price vs market capitalization), so tracking 'the same two stocks' does not mean the two indexes respond similarly to the same price move; their construction methodology, not just their membership, drives the result.
C. Identical influence would only occur if both weighting schemes assigned the same relative importance to each stock, which they explicitly do not here: Stock A dominates by price, Stock B dominates by market cap, producing very different sensitivities to the same 10% move.