CFAI Practice: M02 — Security Market Indexes
Source: CFAI Official Practice Problems 2026
Questions
1. A security market index represents:
- A. The return on a specific security
- B. The value of a given security market or segment ✓
- C. The most actively traded securities in a market
A security market index measures the value (or performance) of a specific market, market segment, or asset class. It is calculated from the prices of selected constituent securities.
2. The difference between a price return index and a total return index is that a total return index:
- A. Uses only price changes
- B. Includes income (dividends/interest) in addition to price changes ✓
- C. Adjusts for stock splits
Total return index: . It captures both price appreciation and income (dividends, interest), while a price return index only tracks price changes.
3. In a price-weighted index, a stock split by one of the constituents will most likely:
- A. Increase the index value
- B. Not affect the index value
- C. Require an adjustment to the divisor to keep the index value unchanged ✓
Stock splits reduce the price of the split stock. To prevent this from artificially lowering the index value, the divisor is adjusted downward. The DJIA uses this approach.
4. A market-capitalization-weighted index is most likely biased toward:
- A. Small-cap stocks
- B. Low-priced stocks
- C. Large-cap stocks with recent price increases (momentum bias) ✓
Market-cap weighting gives more weight to larger companies. As a stock price rises, its market cap and weight increase — creating a momentum bias toward recent winners.
5. Which weighting method requires the most frequent rebalancing?
- A. Market-capitalization weighted
- B. Price weighted
- C. Equal weighted ✓
Equal-weighted indexes must be rebalanced frequently because price changes cause weights to deviate from equal. Market-cap-weighted indexes are self-adjusting and need minimal rebalancing.
6. The process of changing the constituent securities in an index is called:
- A. Rebalancing
- B. Reconstitution ✓
- C. Re-weighting
Reconstitution is the process of adding or removing securities from an index based on selection criteria. Rebalancing adjusts weights back to target without changing constituents.
7. An index in which each constituent has the same weight at inception is best described as:
- A. Price weighted
- B. Equal weighted ✓
- C. Fundamental weighted
An equal-weighted index assigns the same weight () to each constituent at inception (and after each rebalancing).
8. A float-adjusted market-capitalization-weighted index differs from a full market-cap-weighted index in that it:
- A. Uses fundamental factors
- B. Excludes shares not available for public trading ✓
- C. Weights by share price only
Float-adjusted weighting uses only the publicly available (free-float) shares, excluding shares held by insiders, governments, and strategic investors. This better represents the investable opportunity set.
9. Which of the following is least likely a use of security market indexes?
- A. Benchmark for evaluating portfolio performance
- B. Basis for creating index funds and ETFs
- C. Determining the creditworthiness of a bond issuer ✓
Security market indexes are used for benchmarking, asset allocation proxies, sentiment gauging, research, and passive investing. Credit analysis of individual bond issuers requires fundamental analysis, not market indexes.
10. An index constructed using measures such as book value, cash flow, and dividends to determine weights is best described as:
- A. Market-capitalization weighted
- B. Equal weighted
- C. Fundamental weighted ✓
Fundamental weighting uses accounting/economic measures (book value, earnings, dividends, cash flow, revenue) rather than market prices to determine weights. This creates a value tilt.
11. Consider a price-weighted index of three stocks with prices: A = 60, C = $100. Which stock has the largest weight?
- A. Stock A
- B. Stock B
- C. Stock C ✓
In a price-weighted index, weight is proportional to price. Stock C at $100 has the highest price and therefore the largest weight: .
12. The reconstitution of an index most likely causes:
- A. A decrease in index value
- B. Upward price pressure on added stocks and downward pressure on removed stocks ✓
- C. An increase in the index divisor
When stocks are added to a popular index, index funds must buy them (demand increases, price rises). When stocks are removed, index funds sell them (supply increases, price falls). This is the reconstitution effect.
13. A fundamental-weighted index will most likely have a:
- A. Growth bias
- B. Momentum bias
- C. Value/contrarian bias ✓
Fundamental weighting overweights stocks with high fundamentals relative to price (value stocks). Rebalancing sells winners and buys losers (contrarian). Market-cap weighting has momentum bias; fundamental weighting is the opposite.
14. Which index weighting method most closely reflects the market portfolio?
- A. Price weighted
- B. Equal weighted
- C. Market-capitalization weighted ✓
Market-cap weighting reflects the aggregate portfolio held by all investors (the “market portfolio”). This aligns with the CAPM concept of the market portfolio.
15. An investor replicating an equal-weighted index must:
- A. Periodically sell outperformers and buy underperformers to restore equal weights ✓
- B. Do nothing after initial investment
- C. Adjust the divisor for stock splits
Equal-weighted indexes drift from equal weights as prices change. Rebalancing requires selling stocks that have risen (reduced weight is too high) and buying stocks that have fallen — a contrarian strategy.