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  • 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 security’s 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
      • S&P 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:
    • Index t = index value on day t
    • P t = ending prices for stocks on day t
    • Q t = number of outstanding shares on day t
    • P b = ending price for stocks on base day
    • Q b = 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/S&P Actuaries World Indexes
      • Morgan Stanley Capital International (MSCI) World Indexes (especially MSCI EAFE Index)
      • Dow Jones World Stock Index
  • 16. 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
  • 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 S&P 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)