Chapter 4 Security Market Indicator Series 1 Uses

Chapter 4 Security Market Indicator Series 1

Uses of Security-Market Indexes 1. 2. 3. 4. 5. As benchmarks to evaluate the performance of professional money managers 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 2

Differentiating Factors in Constructing Market Indexes The sample size breadth (be representative) source 3

Differentiating Factors in Constructing Market Indexes Weighting of sample members 1. price-weighted series 2. market value-weighted series 3. unweighted (equally weighted) series 4

Differentiating Factors in Constructing Market Indexes Computational procedure 1. arithmetic average 2. compute an index and have all changes reported in terms of the basic index. 3. geometric average 5

Stock-Market Indicator Series Price Weighted Series Dow Jones Industrial Average (DJIA) Nikkei-Dow Jones Average (225 stocks on the First Section of Tokyo Stock Exchange) Market-Value-Weighted Series NYSE Composite S&P 500 Index and more… Unweighted Price Indicator Series Value Line Averages Financial Times Ordinary Share Index See Exhibit 4. 5 Summary of Stock Market Indexes 6

Dow Jones Industrial Average (DJIA) 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) 7

Example of Change in DJIA Divisor When a Sample Stock Splits Exhibit 4. 1 After Three-for One Before Split by Stock A Prices A 30 10 B 20 20 C 10 10 60/3 = 20 40/X = 20 X = 2 (New Divisor) 8

The Impact of Differently Priced Shares on a Price. Weighted Indicator Series Exhibit 4. 2 Period T+ 1 Case A Case B 110(+10%) 100 50 50 30 33(+10%) 190 183 3 3 63. 3 61 5. 5% 1. 7%. Period T A 100 B 50 C 30 Sum 180 Divisor 3 Average 60 Percentage Change 9

Criticism of the DJIA Limited to 30 non-randomly selected bluechip stocks (see http: //www. dowjones. com/ for component 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 10

Value-Weighted Series Market Value = Number of Shares Outstanding X Current Market Price Assign an beginning index value (e. g. 100) and new market values are compared to the base index Automatic adjustment for splits 11

Value-Weighted Series 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

Example of a Computation of a Market-Value. Weighted Index Exhibit 4. 3 13

The Impact of Different Values on a Market-Value-Weighted Stock Index Exhibit 4. 4 20% increase in Stock A and C 14

Unweighted Price Indicator Series All stocks carry equal weight regardless of price or market value May be used by individuals who randomly select stocks and invest the same dollar amount in each stock Some use arithmetic average of the percent price changes for the stocks in the index 15

Example of an Arithmetic and Geometric Mean of Percentage Changes Exhibit 4. 8 16

Style Indexes Styles (size and type) Small-cap growth Mid-cap growth Large-cap growth Small-cap value Mid-cap value Large-cap value 17

Bond-Market Indicator Series 18

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 19

Difficulties in Creating and Computing Bond-Market Indicator Series 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. 20

Investment-Grade Bond Indexes rated BBB or higher 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 21

High-Yield Bond Indexes Non investment-grade bonds rated BB, B, CCC, C Relationship among high-yield bond indexes is weaker than among investment grade indexes 22

Exercises Do Problem 1, 2, 6. Good reference: Appendix-Foreign Stock Market Indexes 23