Equity Investments

Correct Answer: It does not adjust for corporate actions like stock splits, which can distort the index value

The correct answer is that a limitation of using the divisor in the calculation of a price-weighted security market index is that it does not adjust for corporate actions like stock splits, which can distort the index value. A price-weighted index is calculated by adding the prices of each constituent security and dividing by a divisor. The divisor is adjusted to maintain continuity in the index value when there are changes to the constituent securities, such as additions or deletions. However, the divisor does not account for corporate actions like stock splits or dividends, which can affect the price of individual securities without reflecting a change in the overall market value. The other two answers are incorrect because: - A price-weighted index does not account for the market capitalization of the constituent securities. It only considers the price of each security, regardless of the company's size or the number of shares outstanding. - The divisor adjustments in a price-weighted index are not intended to keep the index value constant over time. Rather, they are made to maintain continuity in the index value when there are changes to the constituent securities. The index value can still change due to price movements of the underlying securities.

Correct Answer: The total return index accounts for the reinvestment of dividends, while the price return index does not.

The total return index accounts for the reinvestment of dividends, while the price return index does not. The price return index only tracks the movement of the security prices, capital gains or losses. It excludes any income generated from dividend payments. On the other hand, the total return index assumes that any cash distributions, such as dividends, are reinvested back into the index. This reinvestment increases the total return index value over time compared to the price return index. The other two statements are incorrect: - The price return index is not always higher than the total return index. In fact, over the long term, the total return index will likely be higher due to the reinvested dividends. - The total return index and price return index will not always have the same value, as the total return index factors in reinvested dividends while the price return index does not.

Correct Answer: Price-weighted indices can be overly influenced by a few high-priced stocks, regardless of their economic significance.

The best answer is that price-weighted indices can be overly influenced by a few high-priced stocks, regardless of their economic significance. In a price-weighted index, the stocks with higher prices have a greater impact on the index value, even if those stocks have a smaller market capitalization or are less economically significant compared to other stocks in the index. The other two answers are incorrect: - Price-weighted indices do not necessarily have lower turnover compared to market-cap weighted indices. The turnover depends on the specific stocks included and their price movements, not the weighting scheme itself. - Price-weighted indices are actually more susceptible to the impact of corporate actions like stock splits or dividends. These actions directly affect stock prices, which in turn affect the index value in a price-weighted scheme. In contrast, market-cap weighted indices are less affected by these actions, as they adjust for changes in the number of shares outstanding.