Chapter 2 Flashcards
What is price weighting?
In a price weighting scheme a stock with a higher price will have a greater influence on the average.
The Dow Jones Industrial Average (DJIA) is an example of a price weighted index.
The Dow Jones Industrial Average (DJIA) is the oldest and most widely known index representing the 30 largest and most significant stocks in the US economy. Originally, the Index was computed by dividing the sum of the 30 stock prices by 30. However, over time, the weights have been altered to reflect stock splits, stock dividends, and new stocks replacing older ones. The implied weight for this index is determined by the share price and it is therefore a price weighted index.
What is value weighting?
In a value weighted scheme the stock of a company with a larger value (measured by market capitalization = price per share times the number of shares outstanding) will have a greater influence on the average.
The S&P500 index in the US and the TASI (Tadawul All Shares Index) in Saudi Arabia are examples of value weighted indices.
The S&P 500 Index is composed of the 500 largest stocks traded on the US exchanges. The S&P 500 uses market capitalizations as weights - it is a value weighted index. The index’s base value was set in the early 1940s, with the base value arbitrarily set as 10.
What is equal weighting?
An equal weighting scheme as the name implies assigns the same importance to every stock comprising the average.
What is the role of the financial market in the economy?
Financial markets play a number of roles in the economy.
Primary market provides an intermediary function by channeling funds from investors (with savings) to firms and businesses that are seeking funds for investments.
Secondary markets reinforce the primary market by providing the flexibility for investors to liquidate their holdings when desired.
Financial markets also perform an allocative function, by directing investor savings to business and investments with the highest returns.
Firms and businesses that are efficiently operated and are able to identify superior investment opportunities will command higher prices for their securities and will attract the needed capital.
Resources thus will flow to the best uses in the economy. However, this depends on whether the market is efficient, in the sense that whether stock prices accurately reflect the expectations about companies’ performance.
Weak Form of market efficiency is…
The weak form suggests that today’s stock prices reflect all the data of past prices and that no form of technical analysis can be effectively utilized to aid investors in making trading decisions.
In the weak form efficient market, stock prices are assumed to reflect all past information including price and volume information which means that abnormal profits cannot be mode of trading based on historical information.
Semi-Strong Form of market efficiency is…
The semi-strong form efficiency theory follows the belief that because all information that is public is used in the calculation of a stock’s current price, investors cannot utilize either technical or fundamental analysis to gain higher returns in the market.
Strong Form of market efficiency…
The strong form version of the efficient market hypothesis states that all information—both the information available to the public and any information not publicly known—is completely accounted for in current stock prices, and there is no type of information that can give an investor an advantage on the market.
What is market depth?
The market for a security is said to have depth, if there are plenty of buy orders and sell orders within a narrow range around the current market price.
In a deep market, the existence of many orders means that the price of the security is quickly brought to equilibrium as the demand and supply for that security changes.
In contrast, shallow markets are characterized by shortages or oversupply resulting in discontinuity of buy and sell orders and large price jumps.
If supply exceeds demand the price of the security declines by a large amount that may cause material losses to holders of the security, which may force them to postpone selling the security. On the other hand, if demand exceeds supply, prices rise to such a degree that potential buyers may postpone the purchase of the security.
What is market width?
Large transaction volumes characterize wide or broad markets.
In such markets, not only are prices able to change continuously because of the existence of lots of orders (as in a deep market), but the order sizes above and below the current market price are also large.
As a result, there is no incentive for buyers or sellers to postpone their decisions. Market makers are willing to accept smaller margins (spread) as the high turnover volume compensates for the small margins.
What is wash sales?
An undesirable activity…
A wash sale is a means to create an illusion of trading activity for a given stock.
One form of wash sale is when a person sells a security to his son or a family member and then buys back the security on the same day at a higher price or lower price, depending on the illusion that the person is intending to create. The primary motive of such actions is to mislead the market in order to make unethical profits.
What are examples of wash sales?
A deceptive investor could use this method to artificially raise the price of a security by selling the stock at a high price and buying it back at a lower price on the same day.
Encouraged by this false impression of false trading activity other investors enter the market as buyers resulting in a further rise in the security’s market price.
This allows the deceptive investor to sell his holdings at these artificially higher prices.
What is cornering the market?
When a person buys all or most of the available quantities of a certain security, to create a form of monopoly that may later enable him to sell the security at a higher price, he is said to be cornering the market.
In the past there have been some instances where traders have tried to cover the market for precious metals such as gold and silver. Market regulation generally prohibits such activity.
What is churning?
Churning is said to take place when a broker engages in frequent and unnecessary trading on behalf of the client.
This is done by some unscrupulous brokers to generate increased income from trading commissions. It is considered unethical and is an illegal activity.
1 - In calculating the S&P 500 index (which is a value-weighted index), stock splits should be:
(a) Ignored because they occur so infrequently
(b) adjusted for in the numerator of the index
(c) adjusted for in the denominator of the index
(d) Ignored because they do not affect the value of the index
(d) Ignored because they do not affect the value of the index
2 - Value-weighted index calculation:
(a) Is not affected by stock splits but affected by stock dividends
(b) Is not affected by stock dividends but affected by stock splits
(c) Is not affected by both stock splits and stock dividends
(d) Is affected by both stock splits and stock dividends
(c) Is not affected by both stock splits and stock dividends
