NIKKEI 225 RECONSTITUTION

1) As a portfolio manager for the HEC-UNIL Advisors Nikkei 225 Index Fund, which has ¥100 billion of assets linked to Nikkei 225 index, what would you do when you hear the news of index reconstitution?

The Nikkei 225 is a price-weighted average of the stocks it incorporates. It simply adds the prices of the 225 stocks and divides this sum by a divisor. When the announcement about index change takes place, the index is calculated as the above-mentioned method until the new composition of stocks becomes effective. The announcement date and the date of “effectiveness” are different – there is a time period between them. After the effectiveness date the shares of new member companies are added and divided by the new divisor. The price sequence has to be maintained by the index. Therefore, the new divisor is calculated to guarantee the sequence before and after the effectiveness date. The equation below must be satisfied:

Σ 225 stocks before changeDivisor before change= Σ 225 stocks after changeNew divisor

From the point of view of one who does not like a lot of risk and wants to minimize it. So, I would like to sell stocks that will be deleted and then will be stocks that will be added one day before the effectiveness date. In this case, if I would be able to swap the deletions and additions at the date, I would bear no risk.

2) What would you do if, instead, you were at the proprietary trading desk of Goldman Sachs?

There are two possible trading strategies.
1st: used by arbitrageurs who anticipate a continuous price rise in the period after the announcement. But simply irrational bull traders may cause the price rise. Arbitrageur shorts deletions (buy additions) on announcement and holds the position until one day prior to the change date and settles it as close as possible to this day market close. Also, he can wait