Chapter 6Chapter 6
SECURITY-MARKET
INDEXES
1.2Investments Chapter 6
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? 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)?
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What is a market index?
An index created as a statistical measure of the performance of an entire market or segment of a market based on a sample of securities form the market or segment of a market.
It is an indicator that answers the question: What happened in the market today?
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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 As a proxy for the market portfolio of risky assets when
calculating the systematic risk of an asset
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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 membersShould the weighting system be based on price, total firm
value, or equally weighted? Computational procedure
How should the values of the index be reported and tracked (arithmetic or geometric mean)?
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Stock-Market Indexes
Price-Weighted IndexesDow Jones Industrial Average (DJIA)
Value-Weighted IndexesNYSE CompositeS&P 500 IndexRussell IndexesWillshire 5000 Index
Equal-Weighted IndexesValue Line Averages
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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 30Divisor now adjusted for stock splits and changes in the
sample, so now much smaller (about 0.1356 in October 2004)
• exampleOne day Next day
The Divisor will change when A SAMPLE STOCK SPLITS
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Criticism of the DJIA
Sample used is limited30 non-randomly selected blue-chip stocks are not
representative of the 1800 NYSE listed stocks Price-weighted series
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
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Value-Weighted Indexes
Although the DJIA is the most popular index, the most popular type is value-weighted.
Derive the initial total market value of all stocks used in the seriesMarket Value = Number of Shares Outstanding x Current Market Price
Beginning index value is usually 100, new market values change the value of the index
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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
ValueIndex BeginningIndex t
bb
tt
QP
QP
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Value-Weighted Indexes
Automatic adjustment for splits Weighting depends on market value 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 stocksLarge market value stocks dominate the impact on
index values over time Also these series tend to be more broad than the DJIA
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Unweighted 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
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Style Indexes
Additional indexes have been created that seek to measure the performance of various investment styles or sectorsSize indexes track the performance of large-cap, mid-
cap, and small cap stocksOther indexes track the relative performance of growth
and value stocks, perhaps also broken down into sizes
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stats hs300 sfz szy snb porfolio
mean .0030804 .0037214 .0045365 .0010742 .0031718
sd .0175665 .0299458 .0309206 .0407499 .0194515
2005.4.8-2007.9.18
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Global Equity Indexes
There are stock-market indexes available for most individual foreign marketsThese are closely followed within each countryThese are difficult to compare due to differences in sample
selection, weighting, or computation In response, some standardized indexes have been
developedFT/S&P Actuaries World IndexesMorgan Stanley Capital International (MSCI) World IndexesDow Jones World Stock Index
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FT/S&P-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
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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
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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
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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
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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
requires an index to emulateMany managers have not matched aggregate bond
market return
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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
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Bond Market Indexes
Investment-Grade Bond IndexesFour 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 createdRelationship among alternative high-yield indexes is weaker
than among investment grade indexes
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Bond Market Indexes
Global Government Bond Market IndexesGlobal bond market dominated by government issuesSeveral indexes created by major investment firmsIndexes have similar characteristics
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Composite Stock-Bond Indexes
Considers the benefits of diversification with asset allocation across stocks and bondsMerrill 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 policyClose to the theoretical “market portfolio of risky assets” referred
to in CAPM
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Comparison of Indexes Over Time
Correlations among monthly equity price changesMost differences are attributable to sample differencesHigh correlations between S&P 500 and several broad stock
market indexes (.98-.99)Lower correlations between style indexes and other broader
indexesCorrelations between U.S. series and other countries confirm
the wisdom of global investing since values are often much lower
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Comparison of Indexes Over Time
Correlations among monthly bond indexesAmong investment-grade bonds correlations range from 0.94
to 0.98Significantly 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