Financial Instruments and Market Indexes

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• Financial Instruments and Market Indexes
• Chapter 2

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Major Types of Securities

• Debt
• Money market instruments
• Bonds
• Common stock
• Preferred stock
• Derivative securities

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Markets and Instruments

• Money Market
• Debt Instruments
• Derivatives
• Capital Market
• Bonds
• Equity
• Derivatives

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Stock Market Indexes

• Uses
• To track average returns
• To measure the general performance of an economy
• To compare performance of managers
• To serve as base of derivatives
• To serve as guide for passively managed mutual
  funds
• To serve as proxies for the market portfolio when
  estimating the risk measures such as beta
• Factors in constructing or using an Index
• Representative?
• Broad or narrow?
• How is it constructed?

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Construction of Indexes

• How are stocks weighted?
• Price weighted (DJIA)
• Market-value weighted (SP500, NASDAQ)
• Equally weighted (Value Line Index)
• How returns are averaged?
• Arithmetic (DJIA and SP500)
• Geometric (Value Line Index)

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Indexes

• The effectiveness of an index depends on
• Which securities are included in the index and
  how many
• How the index decides the changes to its
  components
• How the index is adjusted for changes in the
  securities
• Which method is used to calculate the index

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Indexes

• Indexes are generally constructed as
• It?(Qit?Pit)
• Where Qit is the quantity of security i used to
  construct the index at time t, Pit is the price
  of the security at time t.
• There are three types of indices price-weighted,
  value-weighted and equally weighted indices.

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Price-Weighted Index

• The quantity of each security is the same for all
  component securities.
• The value of a price-weighted index is found by
  adding the prices of each security and dividing
  by a divisor.
• The divisor is the number that is adjusted
  periodically for stock dividends, stock splits,
  and other changes.
• Higher priced stocks have greater impacts on the
  index. Why?
• After a stock split, what happens to its impact
  on a price weighted index?
• Dow Jones Industrial Average (DJIA) is a
  price-weighted average of 30 U.S. industrial
  stocks

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Price-Weighted Index

• Example
• Adjustment of divisor for stock splits Suppose
  there is a price-weighted index composed of three
  stocks

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Price-Weighted Index

• In-class exercise
• Can we figure out how large the divisor for DJIA
  is now?

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Price-Weighted Index

• In-class exercise
• What is the effect of 1 change in a component
  stock on the level of DJIA?
• What about a 1 change in a component stock?

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Value-Weighted Index

• Based on the total market value of each component
  security rather than just the price of each
  share.
• Stock splits do not affect the value of the
  index, or the impact of a stock on the index.
• The greater the market capitalization of a stock,
  the larger its influence.
• Examples of value-weighted index
• SP 500 index, NASDAQ Composite Index, NASDAQ
  100.

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Equally Weighted Index

• Calculated by giving each security the same
  weight regardless of its price or market
  capitalization. An equal dollar amount is
  invested in each security in the index.
• At the time t, the equally weighted index is
  computed as

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An Example

• Assume that we are interested in constructing a
  portfolio with two stocks ABC and XYZ. The
  information is given in the following table. If
  our initial wealth is 1 million, how do we
  construct a portfolio with value weight, price
  weight, and equal weight? How would our wealth
  change in each period? For convenience, lets
  assume fractional shares are allowed.

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An Example

• Initial wealth allocation
• Price weight
• Value weight
• Equal Weight

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An Example

• Wealth allocation at time 1
• Price weight
• Value weight
• Equal Weight
• Do we need to adjust our portfolio holdings under
  each case?

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An Example

• Work out allocation at time 2
• Price weight
• Value weight
• Equal Weight
• Do we need to adjust our portfolio holdings under
  each case?

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Examples of Indexes

• Dow Jones Industrial Average (30 Stocks)
• Standard Poors 500 Composite
• NASDAQ Composite
• NYSE Composite
• Wilshire 5000

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Bond Indexes

• Lehman Brothers
• Merrill Lynch
• Salomon Brothers
• Specialized Indexes
• Merrill Lynch Mortgage

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Homework Assignment

• Chapter 2
• Problems 2, 3, 10, 11