Can anyone explain me the following boldened Acted Material of Chapter 14 pg 4: Right issues, for example, will increase both the number of shares and the total market capitalisation. However, this does not mean that the index should be increased. After all, the value of a protfolio of shares would not jump upwards. For a portfolio to remain fully representative of the whole market, some of the holdings would have to be sold in order to take up an appropriate proportion of right issues. Fixed weight indices are rebalanced in a similar way. Part of the portfolio can be notionally sold so that the new issue can be notionally bought. I am unable to grasp how holdings would be sold in order to take up an appropriate proportion of right issues. For instance, if there is an 100 stock index and one company, top company, issues right shares then the lowest 100th market capitalisation would be taken out to include the additional shares of that specific top company. Can anyone please clear me? Falak
Why would the smallest of the 100 largest companies have to leave the index? It's not being replaced by the 101st company moving into its place. You're trying to keep the index continuous. Say the company that had the rights issue had market cap of 100, in a market (of top 100 shares) of total cap of 1000. It's 10% of market and index. If it increases its market cap by 10 to 110, then the total market cap increases to 1010, and it now should be 110/1010 = 10.9% of market and index. Since you want to keep the index continuous, the index stays at 1000, but the share should still be made to be 10.9% of the index. The remaining 99 stocks would have their proportions decreased by a factor of (900/1010)/(900/1000) = 0.99. To track this index, you would sell 1% of each of the holdings of the 99 stocks that did not have the rights issue, and use the money to purchase shares from the rights issue.
