Security-Market Indicator Series

Chapter 5

Uses of Security-Market Indexes

Although portfolios are obviously composed of many

different individual stocks, investors typically ask, What
happened to the market today?
The reason for this question is that if an investor owns
more than a few stocks or bonds, it is difficult to follow
each stock or bond individually to determine the
composite performance of the portfolio.
Therefore, if the overall market rose, an individuals
portfolio probably also increased in value.
To supply investors with a composite report on market
performance, some financial publications or investment
firms have developed stock market and bond market
indexes.

Uses of Security-Market Indexes

As benchmarks to evaluate the performance of professional
money managers. a superior portfolio manager should
consistently do better than the market.
To create and monitor an index fund
To measure market rates of return in economic studies
For predicting future market movements by technicians
As a substitute for the market portfolio of risky assets when
calculating the systematic risk of an asset

Differentiating Factors in
Constructing Market Indexes

The sample
size
breadth
source

Differentiating Factors in
Constructing Market Indexes

Weighting of sample members

price-weighted series
value-weighted series
unweighted (equally weighted) series
Fundamental weighted index

Differentiating Factors in
Constructing Market Indexes

Computational procedure
arithmetic average
compute an index and have all changes,
whether in price or value, reported in
terms of the basic index
geometric average

Stock-Market Indexes
Price Weighted Index
Dow Jones Industrial Average (DJIA)
Nikkei-Dow Jones Average
Value-Weighted Index
NYSE Composite
S&P 500 Index
Unweighted Index
Value Line Averages
Financial Times Ordinary Share Index

Dow Jones Industrial Average

(DJIA)
Best-known, oldest, most popular series
Price-weighted average of thirty large wellknown industrial stocks, leaders in their
industry, and listed on NYSE
Total the current price of the 30 stocks and
divide by a divisor (adjusted for

stock

splits and changes in the sample)

Stock Dividends and

Stock Splits
Stock Dividend -- A payment of additional shares
of stock to shareholders. Often used in place of
or in addition to a cash dividend.
Small-percentage stock dividends
Typically less than 25% of previously outstanding
common stock.
Assume a company with 400,000 shares of $5 par
common stock outstanding pays a 5% stock dividend.
The pre-dividend market value is $40. How does this
impact the shareholders equity accounts?

B/S Changes for the Small-% Stock Dividend

Present
NS o/s

400000

Par value /share

MPS

40

Equity
CS

2,000,000

APiC

1,000,000

R/E

7,000,000

Total

Stock Dividend

10,000,000

0.05

New Shares

20,000

Market Value

800,000

subtracted from R/E

Par Value

100,000

Added to CS

Share premium

700,000

Added to APiC

Small-Percentage Stock
Dividends
Before 5% Stock Dividend

Common stock
($5 par; 400,000 shares)
$ 2,000,000
Additional paid-in capital
1,000,000
Retained earnings
7,000,000
Total shareholders equity
$10,000,000
After 5% Stock Dividend
Common stock
($5 par; 420,000 shares)
$ 2,100,000
Additional paid-in capital
1,700,000
Retained earnings
6,200,000
Total shareholders equity
$10,000,000

Stock Dividends,
EPS, and Total Earnings
After a small-percentage stock dividend, what
happens to EPS and total earnings of individual
investors?
Assume that investor SP owns 10,000 shares and the firm earned
$2.50 per share.
Total earnings = $2.50 x 10,000 = $25,000.
After the 5% dividend, investor SP owns 10,500 shares and the
same proportionate earnings of $25,000.
EPS is then reduced to $2.38 per share because of the stock
dividend ($25,000 / 10,500 shares = $2.38 EPS).

Stock Dividends and

Stock Splits
Large-percentage stock dividends
Typically 25% or greater of previously outstanding common stock.
The material effect on the market price per share causes the
transaction to be accounted for differently. Reclassification is
limited to the par value of additional shares rather than pre-stockdividend value of additional shares.
Assume a company with 400,000 shares of $5 par common stock
outstanding pays a 100% stock dividend. The pre-stock-dividend
market value per share is $40. How does this impact the
shareholders equity accounts?

B/S Changes for the LargePercentage Stock Dividend

$2 million ($5 x 400,000 new shares)
transferred (on paper) out of retained
earnings.
$2 million transferred into common stock
account.

Large-Percentage Stock
Dividends
Before 100% Stock Dividend
Common stock
($5 par; 400,000 shares)
$ 2,000,000
Additional paid-in capital
1,000,000
Retained earnings
7,000,000
Total shareholders equity
$10,000,000
After 100% Stock Dividend
Common stock
($5 par; 800,000 shares)
$ 4,000,000
Additional paid-in capital
1,000,000
Retained earnings
5,000,000
Total shareholders equity
$10,000,000

Stock Dividend Example 2

100,000 shares
outstanding; $1 par; $5
5% s toc k dividend
market
B efore
effec t of dividend balanc e after

Com m on s toc k par value

S hares outs tanding
Total par value
A dditional paid-in c apital

$1.00
100,000
$100,000
750,000

Total paid-in c apital

Retained earnings

850,000
1,000,000

Total s toc k holders ' equity

$1,850,000

5%

30%

MPS

NS

5000

30000

Par

Par price

5000

30000

Extra

Extra

20000

MPS

25000

30000

is s ue 5,000 s h
5,000
20,000
(25,000)

$1.00
105,000
$105,000
770,000

30% s toc k dividend

effec t of dividend balanc e after
$1.00
is s ue 30,000 s h
130,000
30,000
$130,000
750,000

875,000
975,000

880,000
970,000

$1,850,000

5% stock dividend on
100,000 shares: issue
5,000 additional
shares recorded at $5
per share

(30,000)

$1,850,000

30% stock dividend

on 100,000 shares:
issue 30,000
additional shares
recorded at $1 per
share

Stock Dividends and

Stock Splits
Stock Split -- An increase in the number of
shares outstanding by reducing the par value of
the stock.
Similar economic consequences as a 100% stock dividend.
Primarily used to move the stock into a more popular trading
range and increase share demand.
Assume a company with 400,000 shares of $5 par common
stock splits 2-for-1. How does this impact the shareholders
equity accounts?

Stock Splits
Before 2-for-1 Stock Split

Common stock
($5 par; 400,000 shares)
$ 2,000,000
Additional paid-in capital
1,000,000
Retained earnings
7,000,000
Total shareholders equity
$10,000,000
After 2-for-1 Stock Split
Common stock
($2.50 par; 800,000 shares)
$ 2,000,000
Additional paid-in capital
1,000,000
Retained earnings
7,000,000
Total shareholders equity
$10,000,000

Value to Investors of Stock

Dividends or Stock Splits

Effect on investor total wealth

Effect on investor psyche
Effect on cash dividends
More popular trading range
Informational content

Stock Dividends and

Stock Splits
Reverse Stock Split -- A stock split in which the
number of shares outstanding is decreased.
Used to move the stock into a more popular trading range and
increase share demand.
Usually signals negative information to the market upon its
announcement (consistent with empirical evidence).
Assume a company with 400,000 shares of $5 par common
stock splits 1-for-4. How does this impact the shareholders
equity accounts?

Reverse Stock Splits

Before 1-for-4 Stock Split

Common stock
($5 par; 400,000 shares)
$ 2,000,000
Additional paid-in capital
1,000,000
Retained earnings
7,000,000
Total shareholders equity
$10,000,000
After 1-for-4 Stock Split
Common stock
($20 par; 100,000 shares)
$ 2,000,000
Additional paid-in capital
1,000,000
Retained earnings
7,000,000
Total shareholders equity
$10,000,000

Example of Change in DJIA Divisor When a Sample Stock Splits

Assume the index price-weighted index consists of three stocks, A, B,
and C. This example illustrates how the index and the new divisor are
computed before and after a 3-for-1 stock split for Stock A.

After Three-for One

Exhibit 5.1
Before Split
Split by Stock A
Prices
Prices
A
30
10
B
20
20
C
10
10
60 3 = 20
40 X = 20
X = 2 (New Divisor)

Demonstration of the Impact of Differently Priced Shares on a

Price-Weighted Indicator Series
The example demonstrates the impact of differently priced
shares on a price-weighted index. It shows that higher
Exhibit 5.2
priced stock will affect the index more (Case A) than
lower priced stock (Case B).
Period T
A
100
B
50
C
30
Sum
180
Divisor
3
Average 60
Percentage Change

PERIOD T+ 1
Case A
Case B
110
100
50
50
30
33
190
183
3
3
63.3
61
5.5%
1.7%
(180-190)/180)

Criticism of the DJIA

Limited to 30 non-randomly selected blue-chip
stocks
Does not represent a vast majority of stocks
The divisor needs to be adjusted every time one
of the companies in the index has a stock split
Introduces a downward bias by reducing
weighting of fastest growing companies whose
stock splits

Criticism of the DJIA

Because the DJIA is price weighted, when
companies have a stock split, their prices decline,
and therefore their weight in the DJIA is reduced
even though they may be large and important.
Therefore, the weighting scheme causes a
downward bias in the DJIA, because high-growth
stocks will have higher prices; and, because such
stocks tend to split, they will consistently lose
weight within the index

Nikkei-Dow Jones Average

Arithmetic average of prices for 225 stocks on the
First Section of the Tokyo Stock Exchange (TSE)
Best-known series in Japan
Price-weighted series formulated by Dow Jones
and Company, it is a price-weighted series
It is also criticized because the 225 stocks that are
included comprise only about 15 percent of all
stocks on the First Section.

Problem 1

a. Construct a price-weighted index for these three

stocks, and compute the percentage change in the
series for the period from T to T + 1.
b. Construct a market-value-weighted index for these
three stocks, and compute the percentage change in
the series for the period from T to T + 1.
c. Briefly discuss the difference in the results for the
two stock indexes.

 a price change from period t to t+1, the percentage

change in the series would be 42.85 percent

Value-Weighted Series
Derive the initial total market value of all stocks
used in the series
Market Value = Number of Shares Outstanding
X Current Market Price

In mid 2004, S&P consider only free floating

shares. Excluding shares held by insider
Assign an beginning index value (100) and new
market values are compared to the base index
Automatic adjustment for splits
Weighting depends on market value

Value-Weighted Series
Index t

PQ

Beginning
P Q
t

Index Value

where:
Indext = index value on day t
Pt = ending prices for stocks on day t
Qt = number of outstanding shares on day t
Ph = ending price for stocks on base day
Qh = number of outstanding shares on base day

 a Stock split twofor-one during the

year.
bCompany paid a
10 percent stock
dividend during the
year

 In a market-value-weighted index, the

importance of individual stocks in the sample
depends on the market value of the stocks.
Therefore, a specified percentage change in the
value of a large company has a greater impact
than a comparable percentage change for a small
company.
As shown in previous slide, price changes for the
large market value stocks in a market-valueweighted index will dominate changes in the
index value over time.

Problem 1-b
b. Construct a market-value-weighted index
for these three stocks, and compute the
percentage change in the series for the
period from T to T + 1.

Problem 1(b)

Unweighted Price Indicator Series

All stocks carry equal weight regardless of price
or market value. A $20 stock is as important as a
$40 stock.
May be used by individuals who randomly select
stocks and invest the same dollar amount in each
stock. (for example, an equal $1,000 investment
in each stock would work out to 50 shares of a
$20 stock, 100 shares of a $10 stock, and 10
shares of a $100 stock).
Some use arithmetic average of the percent
price changes for the stocks in the index

Unweighted Price Indicator Series

Value Line and the Financial Times
Ordinary Share Index compute a geometric
mean of the holding period returns and
derive the holding period yield from this
calculation

 This demonstrates the downward bias of the

geometric calculation.
Specifically, the geometric mean of holding period
yields (HPY) shows an average change of only 5.3
percent versus the actual change in wealth of 6%.

Equal weighted v/s market

weighted index: exmple

Problem 2

a. Given the data in Problem 1, construct an equalweighted index by assuming $1,000 is invested in
each stock. What is the percentage change in wealth
for this equal-weighted portfolio?
b. Compute the percentage of price change for each of
the stocks in Problem 1. Compute the arithmetic
average of these percentage changes. Discuss how
this answer compares to the answer in 2a.
c. Compute the geometric average of the three
percentage changes in 2b. Discuss how this result
compares to the answer
in 2b.

2.a

4,472.60 - 3,000 1,472.60

Percentage change

49.09%
3,000
3,000
80 60 20
Lauren

33.33%
60
60
AM = 49.07%

2.b

The answers are the same since

Kayleigh

Madison

35 20 15
Part A represents the percentage

75.00%
change of an equal-weighted series
20
20
25 - 18 7

38.89%
18
18

and Part B applies an equal weight

to the separate stocks

2.c
Geometric

average

[(1.3333)

(1.75) (1.3889)]

1/3

[ 3 . 2407 ]1 / 3 1
1 . 4798 1
. 4798 or 47.98%

The geometric average is less than the arithmetic

average.
This is because variability of return has a greater
affect on the arithmetic average than the geometric
average.

Problem 4

a. Calculate a Dow Jones Industrial Average for Days

1 through 5.
b. What effects have the splits had in determining the
next days index? (Hint: Think of the relative
weighting of each stock.)

After stock split, the

value of stock B
changes (22 to 44)
at close of day 2

We require new divisor at close of day 2 after stock split

We require new divisor at close of day 3 after stock split

 C. Since the index is a price-weighted average,

the higher priced stocks carry more weight.
But when a split occurs, the new divisor ensures
that the new value for the series is the same as it
would have been without the split.
Hence, the main effect of a split is just a
repositioning of the relative weight that a
particular stock carries in determining the index.
For example, a 10% price change for company B
would carry more weight in determining the
percent change in the index in Day 3 after the
reverse split that increased its price, than its
weight on Day 2.

Problem 5
Utilizing the price and volume data in
Problem 4.
a. Calculate a Standard & Poors Index for
Days 1 through 5 using a beginning index
value of 10.
b. Identify what effects the splits had in
determining the next days index.

1. Find market value at each day, As at day 1, 12*500= 1200

2. Now sum of day 1 will be used as base, in this case 27050
3. Calculate new index value at each day as:

B. The market values are unchanged due to

splits and thus stock splits have no effect.
The index, however, is weighted by the
relative market values.

Stock-Market Indexes

Style Categories

Small-cap growth
Midcap Growth
Large-cap growth
Small-cap value
Midcap value
Large-cap value
Socially responsible investment (SRI) indexes
By country
Global ethical stock index

Global Equity Indexes

There are stock-market indexes available
for most individual foreign markets
These are closely followed within each
country
These are difficult to compare due to
differences in sample selection, weighting,
or computational procedure
Groups have computed country indexes

FT/S&P-Actuaries World
Indexes
Jointly compiled by The Financial Times
Limited, Goldman Sachs & Company, and
Standard & Poors in conjunction with the
Institute of Actuaries and the Faculty of
Actuaries
Measures 2,500 securities in 30 countries
Covers 70% of the total value of all listed
companies in each country

FT/S&P-Actuaries World
Indexes
Includes actively traded medium and small
corporations along with major international
equities
Securities included must allow direct
holdings of shares by foreign nationals
Index is market-value weighted with a base
date of December 31, 1986 = 100

FT/S&P-Actuaries World
Indexes
Index results are reported in U.S. dollars,
U.K. pound sterling, Japanese yen, German
mark, and the local currency of the country
included
Results are calculated daily after the New
York markets close and published the
following day in the Financial Times
Geographic subgroups are also published

Morgan Stanley Capital

International (MSCI) Indexes
Three international, nineteen national, and
thirty-eight international industry indexes
Include 1,673 companies listed on stock
exchanges in 22 countries with a combined
capitalization representing approximately 60
percent of the aggregate market value of the
stock exchanges of these countries

Morgan Stanley Capital

International (MSCI) Indexes

All the indexes are market-value weighted

Reporting is in U.S. dollars and the countrys
local currency
Also provides

price to book value (P/BV) ratio

price to cash earnings (earnings plus depreciation)
(P/CE) ratio
price to earnings (P/E) ratio
dividend yield (YLD)

Morgan Stanley Capital

International (MSCI) Indexes
The Morgan Stanley group index for
Europe, Australia, and the Far East (EAFE)
is used as the basis for futures and options
contracts on the Chicago Mercantile
Exchange and the Chicago Board Options
Exchange

Dow Jones World Stock Index

Introduced in January 1993

2,200 companies worldwide
Organized into 120 industry groups
Includes 33 countries representing more than 80
percent of the combined capitalization of these
countries
Countries are grouped into three major
regions:Asia/Pacific, Europe/Africa, and the
Americas
Each countrys index is calculated in its own
currency as well as in the U.S. dollar

Comparison of World Stock Indexes

Correlations between the three series since

December 31, 1991 to December 31, 2003, indicates
an average correlation coefficient among them in
excess of 0.99

Correlations between the three series since December 31, 1991

to December 31, 2007, indicates an average correlation
coefficient in excess of 0.99

Bond-Market Indicator Series

Relatively new and not widely published
Growth in fixed-income mutual funds
increase need for reliable benchmarks for
evaluating performance
Many managers have not matched
aggregate bond market return
increasing interest in bond index funds
requires an index to emulate

Difficulties in Creating and Computing

Bond-Market Indicator Series
Universe of bonds is much broader than that of stocks
Range of bond quality varies from U.S. Treasury
securities to bonds in default
Bond market changes constantly with new issues,
maturities, calls, and sinking funds
Bond prices are affected by duration, which is
dependent on maturity, coupon, and market yield
Correctly pricing individual bond issues without
current and continuous transaction prices available
poses significant problems

Investment-Grade Bond Indexes

Four investment firms maintain indexes for
Treasury bonds and other investment grade
(rated BBB or higher) bonds
Relationship among these bonds is strong
(correlations average 0.95)
Returns for all these bonds are driven by
aggregate interest rates - shifts in the
government yield curve

High-Yield Bond Indexes

Non investment-grade bonds
rated BB, B, CCC, CC, C

Four investment firms and two

academicians created indexes
Relationship among alternative high-yield
bond indexes is weaker than among
investment grade indexes
Merrill Lynch Convertible Securities
Indexes

Global Government Bond Market

Indexes
Global bond market dominated by government
issues
Several indexes created by major investment
firms

Measure total rates of return

Use market-value weighting
Use trader pricing
But sample sizes differ as do numbers of countries
included

Global Government Bond

Market Indexes
Differences affect long-term risk-return
performance
Low correlation among several countries is
similar to stocks
Significant exchange rate effect on volatility
and correlations

Composite Stock-Bond Indexes

Beyond separate stock indexes and bond indexes
for individual countries, a natural step is a
composite series that measures the performance of
all securities in a given country
This allows examination of benefits of
diversification with a combination of asset classes
such as stocks and bonds in addition to
diversifying within the asset classes of stocks or
bonds

Merrill Lynch-Wilshire U.S. Capital

Markets Index (ML-WCMI)
Market-value weighted index measures total
return performance of the combined U.S.
taxable fixed income and equity markets
Combination of Merrill-Lynch fixedincome indexes and the Wilshire 5000
common-stock index
Tracks over 10,000 stocks and bonds

Brinson Partners Global

Security Market Index (GSMI)
Includes:
U.S. stocks and bonds
Non-U.S. equities
Non-dollar bonds
Allocation to cash
Matches a typical U.S. pension fund allocation policy
Close to the theoretical market portfolio of risky
assets referred to in the CAPM literature

Comparison of Indexes Over Time

Correlations among monthly equity price
changes
Most differences are attributable to sample
differences
Different segments of U.S. stock market or
from different countries
Lower correlations between NYSE series and
AMEX series or NASDAQ index than between
NYSE alternative series (S&P 500 and NYSE
composite)

Comparison of Indexes Over Time

Correlations among monthly bond indexes
Among investment-grade bonds correlations
range from 0.90 to 0.99
Interest rates differ by risk premiums
Rates of return are determined by systematic
interest rate variables
Low correlation in global returns to U.S.
returns support global diversification

Mean Annual Security RiskReturns and Correlations

There are clear differences among the
series due to different asset classes (e.g.,
stocks versus bonds) and when there are
different samples within asset classes
There is a positive relationship between the
average rate of return on an asset and its
measure of risk

Mean Annual Security RiskReturns and Correlations

The security market indexes can be used
1. to measure the historical performance of
an asset class
2. as benchmarks to evaluate the
performance of a money manager for a
mutual fund, a personal trust, or a pension
plan