SECURITYMARKET

1
Chapter 7

• SECURITY-MARKET
• INDEXES

2
Chapter 7 Questions

• What are some major uses of security-market
  indexes?
• What are the major characteristics that cause
  various indexes to differ?
• What are the major stock-market indexes in the
  United States and globally, and what are their
  characteristics?
• What are the major bond-market indexes for the
  United States and the world?

3
Chapter 7 Questions

• Why are bond indexes more difficult to create and
  maintain than stock indexes?
• What are some of the composite stock-bond market
  indexes?
• Where can you get historical and current data for
  all these indexes?
• What is the relationship among many of these
  indexes in the short-run (monthly)?

4
What is a market index?

• It is an indicator that answers the question
  What happened in the market today?

5
5 Uses of Security-Market Indexes

• For calculating benchmark returns to judge
  portfolio performance
• For development of an index portfolio
• For examining factors that influence aggregate
  security price movements
• For technical analysis, to predict future price
  movements
• To compute a securitys systematic risk by
  examining how its return responds to changes in
  the market index

6
Factors in Constructing Market Indexes

• The sample of firms to include
• What is the intended population that the sample
  is to represent? How large a sample is needed
  for the index to be representative?
• Weighting system for sample members
• Should the weighting system be based on price,
  total firm value, or equally weighted
  (unweighted)?
• Computational procedure
• How should the values of the index be reported
  and tracked (arithmetic or geometric mean)?

7
Stock-Market Indexes

• Price-Weighted Indexes
• Dow Jones Industrial Average (DJIA)
• Value-Weighted Indexes
• NYSE Composite
• SP 500 Index
• Russell Indexes
• Wilshire 5000 Index
• Equal-Weighted Indexes
• Value Line Averages

8
Dow Jones Industrial Average (DJIA)

• Best-known, oldest, most popular index
• Price-weighted average of thirty large well-known
  industrial stocks, leaders in their industry, and
  listed on NYSE
• Total the current price of the 30 stocks and
  divide by a divisor
• Original divisor was 30
• Divisor now adjusted for stock splits and changes
  in the sample, so now much smaller (about 0.1356
  in October 2004 about .1249 in March 2006)

9
Criticism of the DJIA

• Sample used is limited
• 30 non-randomly selected blue-chip stocks are not
  representative of the 1800 NYSE listed stocks
• Price-weighted series
• Similar to assuming an investment of one share
  per stock
• Places more weight on higher-priced stocks rather
  than those with higher market values
• Introduces a downward bias in DJIA by reducing
  weight of growing companies whose stock splits

10
Value-Weighted Indexes

• Although the DJIA is the most popular index, the
  most popular type (most indexes use this) is
  value-weighted.
• Derive the initial total market value of all
  stocks used in the series
• Market Value Number of Shares Outstanding
• x Current Market Price
• Beginning index value is usually 100, new market
  values change the value of the index
• Automatic adjustment for splits
• Weighting depends on market value

11
Value-Weighted Indexes

• where
• Indext index value on day t
• Pt ending prices for stocks on day t
• Qt number of outstanding shares on day t
• Pb ending price for stocks on base day
• Qb number of outstanding shares on base
  day

12
Value-Weighted Indexes

• Construction similar to assuming investment in
  proportion to total market value
• Take into account that large market value stocks
  make up more of the market than do smaller market
  value stocks
• Large market value stocks dominate the impact on
  index values over time
• Also these series tend to be more broad than the
  DJIA

13
Unweighted (Equal-Weighted) Price Indexes

• All stocks carry equal weight regardless of price
  or market value
• Constructed in a parallel fashion to individuals
  who select stocks and invest the same dollar
  amount in each stock
• Changes in the index can be reported either in
  terms of arithmetic or geometric means

14
Style Indexes

• Additional indexes have been created that seek to
  measure the performance of various investment
  styles or sectors
• Size indexes track the performance of large-cap,
  mid-cap, and small cap stocks
• Other indexes track the relative performance of
  growth and value stocks, perhaps also broken down
  into sizes (can use a 6-category matrix)

15
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 computation
• In response, some standardized indexes have been
  developed
• FT/SP Actuaries World Indexes
• Morgan Stanley Capital International (MSCI) World
  Indexes (especially MSCI EAFE Index)
• Dow Jones World Stock Index

16
FT/SP-Actuaries World Indexes

• Track over 2,400 securities in 30 countries
• Covers 70 of the total value of all listed
  companies in each country
• 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
• Results are calculated daily and published the
  following day in the Financial Times
• Geographic subgroups are also published

17
MSCI Indexes

• Three international, nineteen national, and
  thirty-eight international industry indexes
• Include 1,673 companies listed on stock exchanges
  in 19 countries with a combined capitalization
  representing 60 percent of the aggregate market
  value of the stock exchanges of these countries
• All the indexes are market-value weighted

18
Dow Jones World Stock Index

• Introduced in January 1993
• Includes 28 countries with a total of 2,200
  companies worldwide, organized into 120 industry
  groups
• Countries are grouped into 3 regions
• Represents over 80 of the combined
  capitalization of these countries

19
Comparison of World Stock Indexes

• Correlations between all of the pairs of broad
  world indexes are nearly 1.00, indicating that
  the results with the alternative world stock
  indexes are quite comparable

20
Bond-Market Indexes

• Relatively new and not widely published
• Growth in fixed-income mutual funds increase need
  for reliable benchmarks for evaluating
  performance
• Increasing interest in bond index funds, which
  require an index to emulate
• Many managers have not matched aggregate bond
  market return, so think about passive rather than
  actively-managed bond portfolios

21
Difficulties in Creating a Bond-Market Index

• 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 differently by changing
  interest rates dependent on maturity, coupon, and
  market yield
• Correctly pricing individual bond issues can be a
  challenge without current and continuous
  transaction prices available

22
Bond Market Indexes

• Investment-Grade Bond Indexes
• Four investment firms maintain indexes for
  Treasury bonds and other investment grade bonds
  (rated BBB or higher)
• Relationship among these bonds is strong
  (correlations average 0.95)
• High-Yield Bond Indexes
• Non investment-grade bonds (rated BB or below)
• Several indexes have been created
• Relationship among alternative high-yield indexes
  is weaker than among investment grade indexes

23
Bond Market Indexes

• Global Government Bond Market Indexes
• Global bond market dominated by government issues
• Several indexes created by major investment firms
• Indexes have similar characteristics

24
Composite Stock-Bond Indexes

• Considers the benefits of diversification with
  asset allocation across stocks and 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
• Brinson Partners Global Security Market Index
  (GSMI)
• Matches a typical U.S. pension fund allocation
  policy
• Close to the theoretical market portfolio of
  risky assets referred to in CAPM

25
Comparison of Indexes Over Time

• Correlations among monthly equity price changes
• Most differences are attributable to sample
  differences
• High correlations between SP 500 and several
  broad stock market indexes (0.98-0.99)
• Lower correlations between style indexes and
  other broader indexes
• Correlations between U.S. series and other
  countries confirm the wisdom of global investing
  since values are often much lower

26
Comparison of Indexes Over Time

• Correlations among monthly bond indexes
• Among investment-grade bonds correlations range
  from 0.94 to 0.98
• Significantly lower correlation between
  investment grade and high-yield indexes (about
  0.49)
• Low correlation in global returns to U.S. returns
  (about 0.35) support global diversification
  (different interest rate movements sometimes, but
  exchange-rate changes may be key driver for the
  U.S. investor)