Security Market Indexes

Chapter 5
Course Outline

 Uses of Security Market Indexes

 Differentiating Factors in Constructing Market Indexes
 Stock-Market Indexes
 Bond-Market Indexes
 Composite Stock-Bond Indexes
Uses of Security Market Indexes

 Gauges of market sentiment

 Proxies for measuring and modeling returns, systematic risk, and risk-
adjusted performance
 Benchmarks for actively managed portfolios
 Model portfolios for such investment products as index funds and exchange
traded funds (ETFs)
 Proxies for asset classes in asset allocation models
Differentiating Factors

 The Sample
 Weighting of Sample Members
 Price-weighted series
 Value-weighted series
 Unweighted (equally weighted) series
 Computational Procedure
 Price return, Total return
 Arithmetic average, Geometric average
Stock Market Indexes

 Price Weighted Index

 Simplest method to weight an index
 Arithmetic mean of current stock prices
𝑆𝑢𝑚 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒𝑠
 𝑃𝑟𝑖𝑐𝑒 𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑖𝑛𝑑𝑒𝑥 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘𝑠 𝑖𝑛 𝑖𝑛𝑑𝑒𝑥

 Examples:
 Dow Jones Industrial Average (DJIA)
 Nikkei-Dow Jones Average
Stock Market Indexes

 Example: Compute for the price return and total return of the price-
weighted index with five constituent securities.

Security Shares Beginning of Period End of Period Dividends

Price Price
A 1 50.00 55.00 0.75
B 1 25.00 22.00 0.10
C 1 12.50 8.00 0.00
D 1 10.00 14.00 0.05
E 1 4.00 6.00 0.00
Stock Market Indexes

 Price Weighted Index

 Divisor is adjusted for stock splits to avoid changing the value of the index
 Stock split on one constituent security changes the weight on all the securities in
the index
 Example: Given a 2-for-1 split in Security A, what is the new divisor for the index so
that the index value is maintained before the split?

Security Price before Split

A 55.00
B 22.00
C 8.00
D 14.00
E 6.00
Stock Market Indexes

 Price Weighted Index

 Advantage: Simplicity
 Disadvantages:
 Results in arbitrary weights for each security
 Higher priced stocks have more weight in the calculation of index
Stock Market Indexes

 Equal Weighted Index

 Assigns an equal weight to each constituent security at inception
 Weights are arbitrarily assigned by the index provider
 Actual movements in the index are typically based on the arithmetic mean of
the percent changes in price or value for the constituent securities
 Examples: Value Line Averages, Financial Times Ordinary Share Index
 Advantage: simplicity
 Disadvantages:
 Frequent adjustments or rebalancing to the index
 Weights placed on the returns of the securities are either underrepresented
or overrepresented
Stock Market Indexes

 Example: Compute for the price return and total return of the equal-
weighted index with five constituent securities. Assume beginning index
value of 10,000.

Security Beginning of Period End of Period Dividends

Price Price
A 50.00 55.00 0.75
B 25.00 22.00 0.10
C 12.50 8.00 0.00
D 10.00 14.00 0.05
E 4.00 6.00 0.00
Stock Market Indexes

 Value Weighted Index

 Weight on each constituent security is determined by dividing its market
capitalization by the total market capitalization
 Market capitalization = number of shares outstanding (freely floating shares) x
market price per share
 Advantage: Index security weights represent proportions of total market value
 Disadvantage: Constituent securities whose prices have risen the most (or fallen
the most) have a greater (or lower) weight in the index
Stock Market Indexes

 Example: Compute for the price return and total return of the value-
weighted index with five constituent securities. Assume beginning index
value of 1,000

Security Shares Beginning of Period End of Period Dividends

Price Price
A 3,000 50.00 55.00 0.75
B 10,000 25.00 22.00 0.10
C 5,000 12.50 8.00 0.00
D 8,000 10.00 14.00 0.05
E 7,000 4.00 6.00 0.00
Stock Market Indexes

 Example: You are given the following information regarding prices for a
sample of stocks.
Stock Number of Shares Price at T Price at T+1
A 1,000,000 60 80
B 10,000,000 20 35
C 30,000,000 18 25
 (1) Construct a price weighted index for these three stocks, and compute the
percentage change in the index for the period from T to T+1.
 (2) Construct a value weighted index for these three stocks, and compute the
percentage change in the index for the period from T to T+1.
 (3) Construct an equal weighted index by assuming 1,000 is invested in each stock,
and compute the percentage change in the index for the period from T to T+1.
Stock Market Indexes

 Index Management:
 Rebalancing: adjusting the weights of the constituent securities in the
index
 Issue primarily for equal-weighted index
 Reconstitution: process of changing the constituent securities (adding
or deleting constituent securities) in an index
Stock Market Indexes

 Classifications of stock market indexes:

 Broad market index
 Multi-market index
 Sector index
 Style index
 6 Major Style Categories:
 Small-cap growth
 Midcap growth
 Large-cap growth
 Small-cap value
 Midcap value
 Large-cap value
Bond Market Indexes

 Relatively new and not widely published

 Universe of bonds is much broader than stocks
 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
Bond Market Indexes

 Classifications of bond market indexes:

 Broad market index
 Market/Economic sector index
 Style index
 Specialized Index
 Investment grade bond index
 High yield bond index
 Global government bond index
Composite Stock-Bond Market Indexes

 Beyond separate stock indexes and bond indexes for individual countries, a
natural step is composite series
 measures the performance of all securities in a given country
 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