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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 do something different, what would it be?
Submitting the market on close orders on the closing date is sensible since it involved with a large numbers of trading and the price would change very fast and the uncertainty associated with the index is minimize due to the close of the market. Also buying Nikkei 225 average future can be another way to hedge the uncertainty since the bid ask spread for the future, which as 10 basis point, lower than the index.
3) Taka Haneda is expecting several billion dollars of customer orders in the coming week. What should he do? Is this a risky strategy? How will you know when to exit the trade?
The front running strategy seems to be more reasonable for Haneda. This strategy can build up the inventory in the additions as quickly as possible but the problem is that the price of additions stocks would be driven to high when Haneda buy in and he would face price risk if he was unable to unwind the position by the closing bell. The other strategy is to go long on the deletions at the closing price on one day prior to the change date but the problem is that it is difficult to detect any reversion of the price in the long run. And for strategy one, the time to exit the trade is that when the trading volume reached a pretty high peak.

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