Nikkei 225

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1) Suppose you are a portfolio manager for the MBA Advisor Nikkei 225 index fund, which has Y100 billion in assets linked to the Nikkei 225 index. What should you do when you hear news of the index redefinition? In your preparation, you should consider: a) The construction of the Nikkei index and the portfolio weights it gives rise to. In order to minimize risk, they would like to sell stocks to be deleted and buy stocks to be added to rebalance the portfolios and swap the deletions and additions at the closing price. Upon announcement of the composite change, they can go long the stocks newly adopted and short sell deletions. For short sales, they go the securities lending market and borrow the stocks. They have to act fast since borrowing demand in the securities lending market shoots up upon announcements. This long position in additions and short position in deletions will be held until one day prior to the change date. And then unwind the position as close as possible to the closing of the change date. For the price-weight average, since the index substituted 30 large capitalization stocks for 30 small capitalization stocks, down weighting the 195 stocks that remained in the index and most of the additions were technology companies which experienced high returns, the index divisor would be adjusted for this redefinition. The additions would drive the price up and have a higher weight in the portfolio.

b) The effect of your trading on the prices of the index constituents. When additions face a large number of temporary bidders, the increase in demand will lead to higher stock price. The stocks remain expensive because the lack of substitutes makes it prohibitively difficult for arbitrageurs to short them. 2) You have heard that many portfolio managers submitted "market on close" orders for Friday, April 21. They reason that this allows them to lock in the new index value, achieving zero tracking error. Do you think this is sensible? If you could...
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