<ul><li>Financial Instruments and Market Indexes </li></ul><ul><ul><li>Chapter 2 </li></ul></ul>
Major Types of Securities <ul><li>Debt </li></ul><ul><ul><li>Money market instruments </li></ul></ul><ul><ul><li>Bonds </l...
Markets and Instruments <ul><li>Money Market </li></ul><ul><ul><li>Debt Instruments </li></ul></ul><ul><ul><li>Derivatives...
Stock Market Indexes <ul><li>Uses </li></ul><ul><ul><li>To track average returns </li></ul></ul><ul><ul><li>To measure the...
Construction of Indexes <ul><li>How are stocks weighted? </li></ul><ul><ul><li>Price weighted (DJIA) </li></ul></ul><ul><u...
Indexes <ul><li>The effectiveness of an index depends on: </li></ul><ul><ul><li>Which securities are included in the index...
Indexes <ul><li>Indexes are generally constructed as: </li></ul><ul><ul><ul><li>I t =  (Q it  P it ) </li></ul></ul></ul...
Price-Weighted Index <ul><li>The quantity of each security is the same for all component securities.  </li></ul><ul><li>Th...
Price-Weighted Index <ul><li>Example: </li></ul><ul><ul><li>Adjustment of divisor for stock splits:  Suppose there is a pr...
Price-Weighted Index <ul><li>In-class exercise: </li></ul><ul><ul><li>Can we figure out how large the divisor for DJIA is ...
Price-Weighted Index <ul><li>In-class exercise: </li></ul><ul><ul><li>What is the effect of $1 change in a component stock...
Value-Weighted Index <ul><li>Based on the total market value of each component security rather than just the price of each...
Equally Weighted Index <ul><li>Calculated by giving each security the same weight regardless of its price or market capita...
An Example <ul><li>Assume that we are interested in constructing a portfolio with two stocks: ABC and XYZ.  The informatio...
An Example <ul><li>Initial wealth allocation: </li></ul><ul><ul><li>Price weight </li></ul></ul><ul><ul><li>Value weight <...
An Example <ul><li>Wealth allocation at time 1: </li></ul><ul><ul><li>Price weight </li></ul></ul><ul><ul><li>Value weight...
An Example <ul><li>Work out allocation at time 2  </li></ul><ul><ul><li>Price weight </li></ul></ul><ul><ul><li>Value weig...
Examples of Indexes <ul><li>Dow Jones Industrial Average (30 Stocks) </li></ul><ul><li>Standard & Poor’s 500 Composite </l...
Bond Indexes <ul><li>Lehman Brothers </li></ul><ul><li>Merrill Lynch </li></ul><ul><li>Salomon Brothers </li></ul><ul><li>...
Homework Assignment <ul><li>Chapter 2: </li></ul><ul><ul><li>Problems 2, 3, 10, 11 </li></ul></ul>
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Sidkias

  1. 1. <ul><li>Financial Instruments and Market Indexes </li></ul><ul><ul><li>Chapter 2 </li></ul></ul>
  2. 2. Major Types of Securities <ul><li>Debt </li></ul><ul><ul><li>Money market instruments </li></ul></ul><ul><ul><li>Bonds </li></ul></ul><ul><li>Common stock </li></ul><ul><li>Preferred stock </li></ul><ul><li>Derivative securities </li></ul>
  3. 3. Markets and Instruments <ul><li>Money Market </li></ul><ul><ul><li>Debt Instruments </li></ul></ul><ul><ul><li>Derivatives </li></ul></ul><ul><li>Capital Market </li></ul><ul><ul><li>Bonds </li></ul></ul><ul><ul><li>Equity </li></ul></ul><ul><ul><li>Derivatives </li></ul></ul>
  4. 4. Stock Market Indexes <ul><li>Uses </li></ul><ul><ul><li>To track average returns </li></ul></ul><ul><ul><li>To measure the general performance of an economy </li></ul></ul><ul><ul><li>To compare performance of managers </li></ul></ul><ul><ul><li>To serve as base of derivatives </li></ul></ul><ul><ul><li>To serve as guide for passively managed mutual funds </li></ul></ul><ul><ul><li>To serve as proxies for the market portfolio when estimating the risk measures such as beta </li></ul></ul><ul><li>Factors in constructing or using an Index </li></ul><ul><ul><li>Representative? </li></ul></ul><ul><ul><li>Broad or narrow? </li></ul></ul><ul><ul><li>How is it constructed? </li></ul></ul>
  5. 5. Construction of Indexes <ul><li>How are stocks weighted? </li></ul><ul><ul><li>Price weighted (DJIA) </li></ul></ul><ul><ul><li>Market-value weighted (S&P500, NASDAQ) </li></ul></ul><ul><ul><li>Equally weighted (Value Line Index) </li></ul></ul><ul><li>How returns are averaged? </li></ul><ul><ul><li>Arithmetic (DJIA and S&P500) </li></ul></ul><ul><ul><li>Geometric (Value Line Index) </li></ul></ul>
  6. 6. Indexes <ul><li>The effectiveness of an index depends on: </li></ul><ul><ul><li>Which securities are included in the index and how many </li></ul></ul><ul><ul><li>How the index decides the changes to its components </li></ul></ul><ul><ul><li>How the index is adjusted for changes in the securities </li></ul></ul><ul><ul><li>Which method is used to calculate the index </li></ul></ul>
  7. 7. Indexes <ul><li>Indexes are generally constructed as: </li></ul><ul><ul><ul><li>I t =  (Q it  P it ) </li></ul></ul></ul><ul><ul><li>Where Q it is the quantity of security i used to construct the index at time t, P it is the price of the security at time t. </li></ul></ul><ul><ul><li>There are three types of indices: price-weighted, value-weighted and equally weighted indices. </li></ul></ul>
  8. 8. Price-Weighted Index <ul><li>The quantity of each security is the same for all component securities. </li></ul><ul><li>The value of a price-weighted index is found by adding the prices of each security and dividing by a divisor. </li></ul><ul><li>The divisor is the number that is adjusted periodically for stock dividends, stock splits, and other changes. </li></ul><ul><li>Higher priced stocks have greater impacts on the index. Why? </li></ul><ul><li>After a stock split, what happens to its impact on a price weighted index? </li></ul><ul><li>Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 U.S. industrial stocks </li></ul>
  9. 9. Price-Weighted Index <ul><li>Example: </li></ul><ul><ul><li>Adjustment of divisor for stock splits: Suppose there is a price-weighted index composed of three stocks: </li></ul></ul>40/Divisor=20 60/3=20 Index Value 40 60 SUM 10 10 C 20 20 B 10 30 A After Split Before Split Stocks Prices
  10. 10. Price-Weighted Index <ul><li>In-class exercise: </li></ul><ul><ul><li>Can we figure out how large the divisor for DJIA is now? </li></ul></ul>
  11. 11. Price-Weighted Index <ul><li>In-class exercise: </li></ul><ul><ul><li>What is the effect of $1 change in a component stock on the level of DJIA? </li></ul></ul><ul><ul><li>What about a 1% change in a component stock? </li></ul></ul>
  12. 12. Value-Weighted Index <ul><li>Based on the total market value of each component security rather than just the price of each share. </li></ul><ul><li>Stock splits do not affect the value of the index, or the impact of a stock on the index. </li></ul><ul><li>The greater the market capitalization of a stock, the larger its influence. </li></ul><ul><li>Examples of value-weighted index: </li></ul><ul><ul><li>S&P 500 index, NASDAQ Composite Index, NASDAQ 100. </li></ul></ul>
  13. 13. Equally Weighted Index <ul><li>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. </li></ul><ul><li>At the time t, the equally weighted index is computed as: </li></ul>
  14. 14. An Example <ul><li>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, let’s assume fractional shares are allowed. </li></ul>2,000,000 1,000,000 Total Shares Outstanding 18 16 15 XYZ 14 12 10 ABC 2 1 0 Assets Prices at Different Time
  15. 15. An Example <ul><li>Initial wealth allocation: </li></ul><ul><ul><li>Price weight </li></ul></ul><ul><ul><li>Value weight </li></ul></ul><ul><ul><li>Equal Weight </li></ul></ul>2,000,000 1,000,000 Total Shares Outstanding 18 16 15 XYZ 14 12 10 ABC 2 1 0 Assets Prices at Different Time
  16. 16. An Example <ul><li>Wealth allocation at time 1: </li></ul><ul><ul><li>Price weight </li></ul></ul><ul><ul><li>Value weight </li></ul></ul><ul><ul><li>Equal Weight </li></ul></ul><ul><li>Do we need to adjust our portfolio holdings under each case? </li></ul>2,000,000 1,000,000 Total Shares Outstanding 18 16 15 XYZ 14 12 10 ABC 2 1 0 Assets Prices at Different Time
  17. 17. An Example <ul><li>Work out allocation at time 2 </li></ul><ul><ul><li>Price weight </li></ul></ul><ul><ul><li>Value weight </li></ul></ul><ul><ul><li>Equal Weight </li></ul></ul><ul><li>Do we need to adjust our portfolio holdings under each case? </li></ul>2,000,000 1,000,000 Total Shares Outstanding 18 16 15 XYZ 14 12 10 ABC 2 1 0 Assets Prices at Different Time
  18. 18. Examples of Indexes <ul><li>Dow Jones Industrial Average (30 Stocks) </li></ul><ul><li>Standard & Poor’s 500 Composite </li></ul><ul><li>NASDAQ Composite </li></ul><ul><li>NYSE Composite </li></ul><ul><li>Wilshire 5000 </li></ul>
  19. 19. Bond Indexes <ul><li>Lehman Brothers </li></ul><ul><li>Merrill Lynch </li></ul><ul><li>Salomon Brothers </li></ul><ul><li>Specialized Indexes </li></ul><ul><ul><li>Merrill Lynch Mortgage </li></ul></ul>
  20. 20. Homework Assignment <ul><li>Chapter 2: </li></ul><ul><ul><li>Problems 2, 3, 10, 11 </li></ul></ul>
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