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Contents:
Introduction ........................................................................................................................ 3
Chapter 1: Introduction to the idea of the capital market......................................................... 6
1.1. Introduction.......................................................................................................... 6
1.2. The classification of financial markets.................................................................... 6
1.3. The role of the capital market and the purpose which it serves ................................12
1.4. The functions of the Capital Market......................................................................15
1.5. Types of financial investment ...............................................................................19
1.5.1. Equities........................................................................................................20
1.5.2. Fixed-income securities ................................................................................21
1.5.3. Derivatives...................................................................................................22
1.5.4. Money and foreign exchange.........................................................................23
1.6. The economy and the markets...............................................................................24
Chapter 2: The idea of index shares .....................................................................................27
2.1. Introduction.........................................................................................................27
2.2. FTSE indices.......................................................................................................28
Chapter 3: The changes of indices........................................................................................38
3.1. Introduction.........................................................................................................38
3.2. FTSE 100............................................................................................................38
3.2.1. January – December 2007 .............................................................................38
3.2.4. January 2007 – December 2009.....................................................................42
3.3. FTSE 250............................................................................................................44
3.4. FTSE All-Share ...................................................................................................49
3.5. Annual analysis ...................................................................................................55

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3.5.1. January – December 2007 ............................................................................ 55
Chapter 4: The changes of indices and the economic indicators............................................. 59
4.1. Introduction........................................................................................................ 59
4.2. Gross Domestic Product...................................................................................... 59
4.2.1. The idea of GDP and its changes in 2007-2009 .............................................. 59
4.2.2. FTSE 100 and GDP ..................................................................................... 61
4.2.3. FTSE 250 and GDP ..................................................................................... 63
4.2.4. FTSE All-Share and GDP............................................................................. 63
4.3. Pound Sterling Exchange Rate............................................................................. 65
4.3.1. GBP/EUR exchange rate and its changes in 2007-2009 .................................. 65
4.3.2. GBP/EUR and FTSE 100 ............................................................................. 68
4.3.3. GBP/EUR and FTSE 250 ............................................................................. 69
4.3.4. GBP/EUR and FTSE All-Share..................................................................... 70
4.4. Unemployment Rate............................................................................................ 71
4.4.1. The idea of unemployment rate and its changes in 2007-2009......................... 71
4.4.2. Unemployment rate and FTSE 100................................................................ 75
4.4.3. Unemployment rate and FTSE 250................................................................ 76
4.4.4. Unemployment rate and FTSE All-Share....................................................... 77
4.5. Interest Rate ....................................................................................................... 78
4.5.1. The idea of interest rate and its changes in 2007-2009 .................................... 78
4.5.2. Interest rate and FTSE 100 ........................................................................... 82
4.5.3. Interest rate and FTSE 250 ........................................................................... 83
4.5.4. Interest rate and FTSE All-Share................................................................... 84
Summary........................................................................................................................... 85
Bibliography...................................................................................................................... 87
Literature....................................................................................................................... 87
Press ............................................................................................................................. 88
The Internet................................................................................................................... 88
Appendix 1: FTSE 100 constituents (December 2009):......................................................... 89
Appendix 2: FTSE 250 constituents (December 2009):......................................................... 90
Appendix 3: FTSE All-Share constituents (December 2009):................................................ 93

Introduction
The stock market is meant to be the reflection of the state of the economy in a
given country. By observing the situation in the market one should be able to judge
whether the economy is expanding, in recession or experiencing a boom. The decision
to explore the British stock market was based on my residency in the United Kingdom
as well as the phenomenon of Britain being one of the western countries that seemed to
have suffered most from the consequences of the American Credit Crunch.
FTSE indices have been chosen as a subject of the study, in view of the fact that
they stand for the biggest companies present on the British market. FTSE All-Share
covers 98% of total market capitalisation. FTSE 100 stands for the 100 most valuable
companies and FTSE 250, correspondingly, for 250. They also cover all the sectors of
the market from retail to steel industry, which gives a full picture.
Moreover, the reason for choosing the three-year period of time- 2007-2009 was
its attractiveness; after a rather steady 2007 one could observe a major change in 2008
and slow recovery of the economy beginning the end of 2009. This period enables a
researcher to show and analyse all stages of the business cycle: expansion, contraction,
recession and boom.
Furthermore, the aim of this thesis is to observe and describe how indices
changed in 2007-2009, to explore the similarities and differences in their behaviour as
well as check the rank of correlation between indices and four chosen economic
indicators: Gross Domestic Product, Great Britain Pound exchange rate, unemployment
rate and interest rate. In order to show how strong the relationship between the four
chosen variables is, Pearson’s correlation coefficient has been used.
What is more, in order to conduct the study, literary resources as well as
newspapers and the Internet have been used. To explore the very idea of financial
market, including capital market, one focused on work by Blake, Chamber, Clarke, Fell,
McInish, and Midgley. These authors describe the nature, significance, function as well
as the division of financial market which id the field of my research. In order to present
the division of FTSE indices and their role and significance, Vaitilingam’s [2001] work
has been reviewed and updated according to the information provided by the Financial

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Times Stock Exchange website. Barry’s work, as well as another book by Vaitilingam
[2004], was very helpful to analyse the data and relate the indices to the chosen
economic indicators. What I also did find helpful in understanding the data was
Financial Times itself. It describes the economical issues on daily basis and is edited by
specialists, i.e. Bank of England governor, Mervyn King.
Worth mentioning is also a short description of what information is covered by
each of the four chapters. Chapter 1 describes the very idea of financial market,
including capital market. First, it focuses on the division of financial markets presented
briefly according to Blake’s [1990] classification. Moreover, it also explains the idea of
equilibrium and the phenomenon of bid-offer spread present in the market. Furthermore,
it focuses on the role of the capital market- explains who the participants are and how
the cost of capital can be influenced. Later, one can explore the functions of the capital
market, such as creating liquidity, allocating and rationing funds, pricing of shares, as
well as providing a barometer of a company’s success. Besides, types of financial
investment, like equities, fixed-income securities, derivatives and foreign exchange are
enumerated and briefly described. Finally, it presents the idea of how the economy of a
given country is related to the situation of the market; main economical crises are also
briefly described.
The second chapter focuses on the idea of index shares, especially FTSE indices,
presenting their division and significance to the British economy. After presenting the
FTSE UK Index Series family tree, it describes the following components briefly: FTSE
100, FTSE 250, FTSE 350, FTSE SmallCap, FTSE All-Share, FTSE Fledging, FTSE
All-Small as well as FTSE AIM. Moreover, it shows how the daily changed of indices
enumerated above are presented in Financial Times. Lastly, this chapter described the
way of classifying categories of businesses into certain sectors.
The next chapter shows the changes in value of the three chosen FTSE indices:
FTSE 100, FTSE 250 and FTSE All-Share. What is taken into consideration is the price
they had at the beginning and in the end of a given year, as well as their highest and
lowest values they reached over the analysed period. The rate of average monthly
change has also been measured for the whole period as well as for each year separately.
Next, the dynamics of change for each index is calculated and presented by separate
charts.

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Finally, the last chapter discusses the correlation between indices and four major
economic indicators. First, it described the idea of GDP and how it changed in the
United Kingdom over the three years. It is also mentioned that the dynamics of its
changes can be used to identify the phase of business cycle that the economy is
currently in. The relationship between GDP and FTSE indices is also examined.
Similarly, GBP/EUR exchange rate and its change is also introduced and analysed. This
part of the chapter also explains how the value of currency is influenced by the state of
economy. The relationship between the exchange rate and chosen indices is also
measured. Moreover, the focus is moved onto unemployment rate which also says a lot
about the economy of a given country. It is explained why unemployment rises when
the market is facing problems as well as why it does not fall immediately after the
market starts recovering. The level of correlation between the number of people seeking
for work and the value of FTSE indices is also calculated. Finally, the chapter finishes
its analysis by concentrating on interest rate and its significance in reading the state of
the economy in the UK. It is explained how the government reacts to the situation in the
market by fulfilling its monetary policy.

Chapter 1: Introductionto the idea of the capital
market
1.1. Introduction
The nature of this section is purely introductory to the topic of financial markets
yet essential for understanding how the capital market works and what its significance
is. This chapter presents the very idea of financial markets and the possible way of
classifying them as well as focuses on the role and functions of the capital market itself.
Later, the types of financial investment are also presented and briefly described. It also
introduces essential terms used in discussing the capital market.
1.2. The classificationof financial markets
An organised financial market is a place where, or a system through which,
securities are created and transferred.
Financial markets can be classified in a number of ways. The division made by
Blake [1990, p. 16-35], which is crucial to understanding the functions and subjects of
financial market, is presented below:
- physical v. over-the-counter
- continuous v. call markets
- money v. capital markets
- primary v. secondary markets
- stock v. flow markets
A financial market does not have a physical location. Shares, bonds and money
market instruments are traded over-the-counter using a system of computer screens and

7
telephones together with the Internet. Only financial futures and financial options are
still traded in a physical market, the former, at LIFFE (the London International
Financial Futures Exchange) and the latter, at LTOM (the London Traded Options
Market), on the floor of the ISE (the International Stock Exchange).
Most markets operate on a continuous basis during opening hours, implying that
trading can take place at any time that the markets ape open. Examples here are the
markets for shares, bonds and money market instruments. However, as Blake [1990, p.
17] points out, some markets trade at specific times during opening hours. Such markets
are known as call markets because the securities are ‘called’ for trading. There has to be
sufficient time between calls to allow offers to buy and sell securities to accumulate and
so make trading worthwhile. Examples here are the pit trading of financial futures and
financial options.
Markets can also be classified according to their maturity of the securities traded
in them. A major distinction is usually drawn between money markets and capital
markets which are the subject of this dissertation. Money markets deal in securities
with less than one year to maturity, whereas capital markets deal in securities with
more than one year to maturity. Examples of money market instruments are Treasury
bills, commercial bills, commercial paper, bankers’ acceptances and negotiable
certificates of deposits. Examples of capital market instruments are bonds with more
than one year to maturity and shares.
An important distinction can also be drawn between primary and secondary
markets. Blake [1990, p. 19] reminds that the primary market is the new issues
market. When an investment bank brings a new company to flotation, its shares are
issued on the primary market (as an initial public offer). If this company subsequently
decides to gear up by issuing bonds, these are also floated on the primary market.
Similarly, if a company decides to expand using either equity finance or bond finance,
the additional shares or bonds are floated on the primary market (known as a secondary
public offer). As Chamber [2004, p.72] claims, the most difficult problem facing an
investment bank involved in a new issue is deciding on the offer price of the issue. If
the offer price is too low and there is an excess demand for the new shares or bonds,
then the issuing company will not be satisfied because it could have raised additional
revenue from the issue. But if the offer price is too high and there is insufficient demand

8
for the new shares of bonds, then the investment bank as underwriter will be involved in
often considerable losses. The important point about the primary market is that the
initial price of the security is set rather than determined by the market, unless the
security is issued through a tender offer or by auction.
The secondary market, according to Blake [1990, p. 21], is the market in which
existing securities are subsequently traded. There are two main reasons why individuals
transact in the secondary market: information-motivated reasons and liquidity-
motivated reasons. Information-motivated investors believe that they have superior
information about a particular security than other market participants. This information
leads them to believe that the security is not being correctly priced by the market. If the
information leads them to believe that the security is currently underpriced, and
investors with access to such information will want to buy the security. On the other
hand, if the information is incorrect, the security will be currently overpriced, and such
investors will want to sell their holdings of the security. Liquidity- motivated investors,
on the other hand, transact in the secondary market because they are currently in a
position of either excess or insufficient liquidity. Investors with surplus cash holdings
(e.g. as a result of an inheritance) will buy securities, whereas investors with insufficient
cash (e.g. to purchase a car) will sell securities.
The prices of securities in the secondary market are determined by the market-
makers in those securities. Precisely how those prices are determined can be seen once
we have discussed the final way in which securities markets can be classified, namely as
stock or flow markets. This classification leads us directly to the concept of
equilibrium. Once a security has been issued, it exists in the market-place until it
matures and is redeemed. Although a security can be sold, it can be sold only to
someone who is willing to buy it. Clearly, it is impossible for everyone to sell their
holdings of a particular security. Therefore there is a market for the entire stock of a
particular security, and there is also a market for the flow purchases and sales of that
security over time. These are shown in Fig. 1.1 the left-hand diagram, which shows the
stock market, indicates a fixed stock supply and a downward-sloping stock demand.
The lower the price of the security, the higher the stock demand. The right-hand
diagram shows the flow market per unit of time. If the time period is a day, for example,
the diagram indicates a downward-sloping daily demand curve and an upward-sloping
daily supply curve for the security. Equilibrium in the stock market is defined as the

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situation in which the entire stock supply of the security is voluntarily held. This occurs
when the stock market price of the security is Pe. Equilibrium in the flow market is
defined as the situation in which the flow supply of the security on the market equals
the flow demand. This occurs when the flow market price of the security is Pe. Overall
equilibrium occurs when both the stock and flow markets are simultaneously in
equilibrium. This occurs when the stock and flow market equilibrium prices are
identical. Out of equilibrium, prices will adjust to clear both markers.
Source: Blake [1990, p. 23]
Figure 1.1. The stock and flow markets for a security
Figure 1.2 shows the equilibrium price, but this is never actually observed in the
market-place. What is observed are transaction prices, and these take into account the
bid-offer spread of the market-makers. The transaction price at which a market-maker
buys securities is the bid price and the transaction price at which he sells securities is
the offer price. The difference between the two is the bid-offer spread. If there is more
than one market-maker, then the difference between the highest bid price and the lowest
offer price is known as the market bid-offer spread or the touch. The equilibrium price
lies within the touch, as Fig. 1.2 shows for the flow market.

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Figure 1.2. The bid-offer spread
What determines the bid-offer spread? This can be answered when one examines
the role of a market-maker. In an organised financial market, the role of a recognised
market-maker is to provide continuous and effective two-way prices (i.e. both bid and
offer prices) in all market conditions. In short, the market-maker has the responsibility
of keeping an orderly market. To do this effectively, he or she must hold an inventory of
securities to smooth out price fluctuations. The market-maker must be compensated for
holding these inventories, and the bid-offer spread is the way in which the market-
maker receives his compensation. The bid-offer spread will be determined to
compensate the market-maker for the cost of and risk to the capital that he or she has
tied up in the inventory of securities. The total compensation to the market-makers is
given by the shaded area in Fig 1.2, i.e. (PS –PB)Q.
The costs and risks of market-making depend on such characteristics of the
market as its breadth, depth and resilience. They also depend on the ratio of
information-motivated investors to liquidity-motivated investors.
A market for a particular security is said to have breadth if it has a substantial
volume of both buy and sell orders at the equilibrium price, i.e. if it has a good two-way
flow of orders. Markets with few buyers and sellers are called thin markets. A security
will be regarded as highly liquid if the market for than security has substantial breadth.
Market-makers in a broad market will operate with lower bid-offer spreads than those in

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a thin market, because broad markets provide a bigger volume of business and are also
less risky.
Figure 1.3. A broad, deep market
A market for a security is said to have depth if it has a continuous flow of buy
and sell orders at prices above and below the equilibrium price. This means that both
the flow demand curve and the flow supply curve must be continuous at prices above
and below the equilibrium price. It also means that both the demand curve and the
supply curve must be highly elastic, (e.g. quite flat), at prices around the equilibrium
price. If these conditions hold, then only small changes in the price of the security will
be required to restore equilibrium should a sudden imbalance between buy and sell
orders arise. In short, price changes will be continuous in deep markets. In shallow
markets, on the other hand, the flow demand and supply curves are either discontinuous
or highly inelastic (steep). In such markets price changes will be both highly variable
and discontinuous (i.e. they will jump a great deal). Price changes will be smaller in
deep markets than in shallow markets. Therefore there is less risk of market-makers
incurring losses on their inventories as a result of sudden large adverse price movements
in deep markets compared with shallow markets. As a result, market-makers’ spreads
will be lower in deep markets than in shallow markets. A security will be regarded as

12
highly reversible if the market for that security has substantial depth. Figure 1.3 shows a
broad, deep market, while Fig. 1.4 shows a thin, shallow market.
Figure 1.4. A thin, shallow market
A market is said to be resilient if the flow of buy and sell orders does not dry up
whenever the price changes. If price changes do not reduce the flow of orders, then the
market-makers will not be faced with an inventory of unsaleable securities, and as a
result they will be willing to charge lower spreads.
Summarising, one can see that bid-offer spread will be lower the broader the
market, the deeper the market, and the more resilient the market.
1.3. The role of the capital market and the purpose whichit serves
A market provides a focus on activities of buyers and sellers of a particular
commodity or service. In the course of the dealings the price or series of prices is
settled. The participants in the United Kingdom capital market include businessmen,
central and local government, financial intermediaries such as insurance companies and

13
pension funds, and private investors. According to Midgley [1977, p. 1], the capital
market has no confined location: it is in progress all over the land, wherever suppliers
and users of capital get together to do business. Much business is transacted over the
telephone or the Internet, so that there need be no geographical site at all for certain
activities. However, parts of the market are concentrated in certain well-known centres,
the most renowned of these being the Stock Exchange at 33 Throgmorton Street in
London which deals in company securities and those issued by governments and local
authorities.
The capital market deals in funds, but as securities, for example bonds or share
certificates, are given in exchange for funds, one can equally treat it as a market dealing
in securities. The market conforms to the laws of supply and demand in the ordinary
way. Thus in demand for funds increases and the supply remains constant the price of
funds raisers (that is, the price of securities rises).
Within the capital market one can speak of the price of funds in a general way.
Midgley [1977, p.1] compares capital market to fish market to illustrate the mechanism:
in the fish market one can speak of the price of fish. But of course nobody buys just
fish; one does not ask for a pound of fish, but rather a pound of haddock or cod.
Similarly, in the capital market the buyers of funds are in practice specific about their
requirements. They may wish to raise £1 million of risk capital, or £500,000 of capital
on long-term loan, or £200,000 on bank overdraft, and so on.
The price paid for access to funds may be in the form of a fixed payment per
annum (though it may be paid in instalments, for example, twice a year) or it may be in
the form of an agreement to share profits. An example of the former circumstance is
where interest is paid to providers of loan capital; and the latter circumstance is
exemplified where dividends are paid out to shareholders. However, as Midgley [1977,
p. 26] stresses, one must hasten to add that shareholders are not rewarded only by
dividend payments: if that were the case some companies would appear to be giving a
meagre return to risk capital. Part of the return to shareholders is in the form of retained
earnings is a factor taken into consideration by the market, and if it is regarded as
sufficiently attractive the share price will rise so as to reflect this expected future
growth.

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Moreover, the factors which could influence the cost of capital funds, or, the
reciprocal, the price of securities, must be generally reviewed. As Briston [1995, p. 34]
presents it, perhaps one of the first influences which will come to mind is the extent of
funds available from public savings. Another fairly obvious influence is the level of
demand for funds arising from plans for new forms of industrial and commercial
investment. These will provide a starting point, but in practice there are many complex
factors which exert their influence on the market. On the supply side there is of course
the flow of funds stemming from the banking system. An easy credit policy which leads
to the criterion of new bank money will lead, ceteris paribus, to a reduction in the cost
of funds. Bank credit policy, however, will not be unrelated to governmental fiscal
policy; for example, a budget deficit financed by issue of short-term securities may
encourage expansion of bank credit and thus lower the cost of funds.
In its turn governmental fiscal policy will not be immune to the behaviour of the
balance of payments and capital movements in and out of the country. A serious run-
down of a country’s reserves of foreign currencies will almost certainly be countered by
fiscal stringency and credit restrictions leading to an increase in the cost of capital.
One of the most cogent influences on the cost of funds is the attitude to liquidity
on the part of investors, that is people, institutions, etc. who purchase securities, as a
whole. If investors decide that the return to funds which they provide is too low, or in
other words the price of securities is too high, there may be a sudden and overwhelming
desire to hold cash or near-cash for the time being. This may result in a fairly rapid
slump in security prices, or, the same thing, an increase in the return to funds, that is in
the cost of capital. Conversely, investors may decide that they are too liquid and that
returns to funds are too attractive to ignore. For example, Gilbert [1999, p. 75-76]
illustrates this situation by describing what happened 25 years before; it was known that
the institutional investors (insurance companies, pension funds, investment trusts and
unit trusts) were holding large liquid balances towards the end 1974. Once security
prices began to rise in January 1975, and investors began to appreciate that the return to
funds provided was falling, they flooded the market for securities with buying orders to
such a degree that the Financial Times Actuaries All Share Index rose by over 100 per
cent within a few weeks. Looking at this dramatic change from the point of view of the
return to funds, the earnings yield on industrial ordinary shares fell from over 30 per
cent to 20 per cent within a month. The flat yield on Consols (that is a general

15
indication of the return on long-term gilt-edged securities) also fell during this short
period, though by no means so spectacularly, from 16 per cent to less than 15 per cent.
In fact, as Midgley [1977, p. 13] states, different sectors of the market for
securities are subject to different influences. The return to funds in different sectors may
move more of less rapidly over time, as noted above. It is possible too that the returns in
one sector may be rising when the returns to other sectors are falling. Thus long-term
fixed interest rates may be rising when short-term rates are falling; or the earnings yield
on industrial shares generally may be falling when that on, say, engineering shares is
rising. Generally though, apart from occasional exceptional moves against the trend, the
returns in different broad sectors of the market move together in the same direction,
though not at the same pace.
1.4. The functions of the Capital Market
The fact that the capital market, or at least that part of it represented by the Stock
Exchange, is sometimes regarded as providing a service not unlike that of a casino does
not mean that it has no important, sober and useful functions. Like any other market, the
capital market provides a means whereby suppliers and buyers can exchange a
commodity at mutually satisfactory prices. Here lies perhaps the most obvious, and
certainly the most important, of the market’s functions, according to Midgley [1997,
p.14]: that of creating liquidity. Were it not for the market most of the longer-term
securities issued by companies would be far more permanent investments in the hands
of their holders. Without an organised market, the owner of a block of ordinary shares
in a particular company who wished to dispose of his holding would have to make a
personal search for a potential buyer. He may have to advertise and/pr employ an agent;
he may have to suffer the inconvenience of a considerable delay before finally finding a
buyer, and the price agreed upon would almost certainly be much less satisfactory than
that settled in an organised market where many buyers and sellers confront each other.
As Midgley stresses [1997, p.15], without the market- endowed quality of liquidity,
company shares and debentures would be far less attractive to investors, and companies
would have difficulty in raising all the funds they needed for expansion. It is of course

16
true that a comparatively small part of company funds are raised externally from
investors at present, but this part may nevertheless be of vital importance.
Consequently, the liquidity provided by the stock market (in particular) serves the very
useful purpose of ensuring that external investors are willing to make new funds
available to business as required.
Moreover, the market not only creates liquidity through its pricing mechanism, it
also allocates and rations funds, and it operates a system of incentives and
penalties. As Briston [1995, p. 74] suggests, the market prices funds for borrowers and
suppliers according to their different requirements. For large, efficient companies,
which can offer sound securities subject to the minimum or risk, the rate for borrowing
will be comparatively low. For smaller companies, which cannot give the same
assurance of safety, the rate will be higher. Furthermore, the shares of a successful
company with good growth prospects will be priced much higher in the market than
those of a similar-sized company with a poor record and uncertain growth prospects.
One effect of this is that potential growth companies in expanding industries tend to
have much lower earnings and dividend yields than companies, with uninspired
management in declining industries. In short, the ‘super-companies’, as Briston [1995,
p. 78] calls them, can raise funds by equity share issues with the minimum immediate
obligation in terms of cash outflow to the providers of capital; while the companies
which lack investor confidence will issue securities subject to the maximum obligation
in terms of annual cash returns to investors. The market is thus conferring a
considerable advantage on the more efficient companies.
The market pricing of shares has further repercussion on companies other than
its effect on the allocation of funds. Share-price movements operate so as to provide
both sticks and carrots for those who manage quoted companies. The mechanisms are
various. One fairly obvious form of discipline to management is that exercised by
shareholders who are dissatisfied with the trend in the share price. For some, usually
small quoted companies, the holdings of certain individual shareholders are sufficiently
large for them to take direct action, such as removing directors from the board. In the
case of lager companies, the holdings are often so widely spread that no individual, or
group of individuals, holds sufficient shares to exercise power, and the directors, in such
circumstances, although themselves holding only a small fraction of total voting shares,
can retain full control in the absence of any concerted opposition. This situation is not

17
all-pervasive among large companies. Sometimes ginger groups are set up to act on
behalf of the mass of individual shareholders. Moreover, in most large companies
institutional shareholders now hold between one-third and one-half of the equity shares
via their separate investment protection committees or their combined institutional
shareholders committee ma act as a disciplining force. However, as Midgley points out
[1997, p.16], it has to be said that in spite of some notable successes, such forms of
direct action tend to have been brought to bear too late to avoid the damage which they
sought to avert. This does not mean, incidentally, that shareholders must remain
powerless in terms of direct influence; rather, it may be argued that more effective and
permanent methods of representation must be forged.
Share price movements frequently provide incentives and penalties on a
personal basis for top managers of large companies. Many directors have large
shareholdings, and thus have a personal incentive to work to promote the efficiency of
the company and hence upgrade the value of their own stake. Nowadays, even if
managers have not the wealth to acquire a large holding of shares by direct personal
investment, they may profit from share-incentive or stock-option schemes. Such scheme
may vary in detail according to the circumstances operative at the time of their
introduction and are prone to the taxation policy of the government of the day.
Fundamentally, the idea is that chosen directors and executives, who can influence the
profitability of the company, are given the right to subscribe at some time in the future
to the shares of their company, but at the current day’s price. In this way they have a
strong incentive to work for increased profits, which, if sufficiently meritorious in
relation to results of other companies, will lead to a higher share price. Participants to
the scheme can then exercise their options and sell their shares, thus enjoying a capital
gain – the reward for their efforts. The scheme will be subject to various restrictions to
avoid undue dilution of capital. For example, participants may be prevented from
selling their shares within a stipulated period from allotment; there will be limitations to
the total amount of shares issued under a scheme, and also to the shares issued to any
individual; or a profit target may be built into the scheme, with the effect that
participants can only gain if the target is achieved and other shareholders get some
benefit from company growth.
As Briston presents it [1998, p.81], share-incentive schemes involved a
consideration of which managers should be entitled to benefit and to what extent.

18
Inevitably, the right will tend to be made available in relation to the degree of
importance in the management hierarchy. This may mean that a particular executive
who has made a substantial entrepreneurial contribution, but who is fairly low down in
the hierarchy, is not adequately compensated by a share-incentive scheme. However,
one means of compensation may be open to them, although it is a means which is
generally frowned upon, that is, profiting from dealing in shares on the basis of inside
knowledge. The arguments against this are fairly well known, although the practice, in a
variety of forms, is probably less uncommon than some London apologists would care
to admit. Broadly, insider trading is said to put outsiders at a disadvantage, to allow
insiders to profit at the expense of share-holders who are unaware of the inside
information, and to undermine confidence on the part of the investing public.
Nevertheless, the case for insider trading as a means of rewarding the modern
company entrepreneur has been cogently made. It has been argued that because insider
trading in company stocks does not suppress long-term trends, it does little harm to
long-term outside investors. As for short-term outside speculators, such losses as they
might make as a result of selling (or buying) before inside information becomes
generally known would probably have been made anyway. More importantly, it is
argued that the possibility of dealing in the company’s own shares provides incentives
for anyone who makes an entrepreneurial contribution: that it can reward company
entrepreneurs in a more precise manner than bonus or incentive schemes; that it rewards
regardless of status, and yet ensures that all investors gain as well as entrepreneurs.
Whether or not such arguments are given serious weight, they do at least illustrate
theoretically how company executives might be motivated to work harder and more
imaginatively for the company in response to the possibility of making gains from share
price movements stemming from their own efforts.
There are two more reasons for thinking that share price movements exert an
influence on company management. One is that the share price barometer provides a
rough and ready indicator of the success of company management. A share price which
is falling more than those of rival companies (or not rising as fast) may be thought to
cast a reflection on management efficiency, and managers are unlikely to be insensitive
to the view that share price movements have a bearing on their competence.

19
If some thick-skinned managers are immune to the aspersions or their efficiency
implicit in a falling share price, they may be more open to influence by a pressure more
germane to their pockets and power positions than to their public image. Again, the
pressure derives from share price movements, but here we refer to the view that the
depressed share price of a company which has had a poor profits record will make it
vulnerable to a takeover bid, and that the possibility of dismissal or reduced status and
prospects may act as a spur to management to do better. However, it must be said that
empirical evidence provides only meagre support for the proposition that a company
which is relatively cheap in terms of the relationship between its equity stock market
price and the book value of its equity assets is in practice much more vulnerable to a
takeover bid than a company which has a high valuation ratio of this sort. Even if the
spur provided by falling share prices, and the possibility of takeover depends more on
fear than fact for many companies, the stock market may still be exerting a useful
influence favouring company efficiency.
To sum up, the capital market supports the whole basis of business undertaken
by joint-stock limited companies. By providing a means of converting long-term
investments into liquid funds, it gives a foundation of confidence to the process of
saving an investment. The pricing process for securities not only leads to the allocation
of funds to those companies which can make best use of them, it also provides penalties
and inventiveness to managers, both directly and indirectly, and even threatens to
operate through the takeover mechanism to put the management of inefficient
companies into more competent hands.
1.5. Types of financial investment
In this section the types of financial investments are being presented according
to the division made by McInish [2000]. First the focus is directed onto equities, than
fixed-income securities, derivatives, money, and foreign exchange. All of those
instruments are briefly described.

20
1.5.1. Equities
Equities are securities representing capital contributed to the firm for which
there is no legal obligation to repay. Once they have fully paid the purchase price for
their shares, investors can lose only the amount of their investment and cannot be called
upon to put up additional funds. This limited liability is a major advance in modern
finance that has resulted in a significant increase in the ability of firms to raise capital.
As McInish [2000, p. 11] points out, the advantage of this system from the point of view
of investors can be seen in the case of the insurance firm Lloyds of London, which is
organised as a series of partnerships. Major losses due to the hurricanes and other
insured risks resulted in calls on the partners, called ‘names’, for millions of British
pounds in additional capital, resulting in the bankruptcy of many names. Many of the
names in the USA sought court protection from the requirement to contribute additional
capital.
Equities include all types of stock issued by the firm. Shares of common stock
represent ownership interests in a firm. The owners of stock are called ‘stockholders’ or
‘shareholders’. Common stock represents ownership of the residual claim on the
earnings and assets of the firm after the firm has paid its other commitments. The
shareholders are the owners of the firm. They run the firm through an elected board of
directors. Of course, the shareholders are not the only investors in the firm, as McInish
[2000, p. 14] stresses. Many firms borrow money, becoming debtors, and those lending
the money become creditors of the firm. But the creditors make their decisions on how
much to lend the firm and what rate of interest to charge with full knowledge that
operating decisions are in the hands of the board of directors and the firm’s officers and
managers.
Another equity security is preferred stock, which has a claim to earnings and,
typically, also assets that is superior to or ahead of that of the common stock, but that
comes after all other obligations of the firm. Many issues of preferred stock have a fixed
dividend payment that is specified in the form’s documents such as the corporate charter
or by-laws. This specified dividend payment does not generally represent a legally
enforceable claim against the firm, but firms are often required to give certain privileges
to preferred stockholders if the specified dividends are not met. As McInish [2000, p.

21
16] enumerates, these privileges may include the right to receive any back dividends
owed before the common stockholders can receive any dividends and the right to elect
some or all of the members of the board of directors. Because many preferred stock
issues have the right to receive fixed dividend payments and no more, preferred stock is
often regarded as being a fixed-income security.
A warrant is a security issued by a firm that gives the holder the right to acquire
stock in the issuing firm, or sometimes in another firm, at a stated price for a specified
period of time. Warrants are often issued in combination with other securities such as
common stock or bonds which will be discussed later in this chapter. Traditionally, as
McInish [2000, p. 17] mentions, warrants have been considered as equities, and the
funds raised from the sale of warrants are part of the firm’s capital.
A right is a short-term warrant that is distributed to the holders of a firm’s
common stock as a dividend. Each right entitles the owner to purchase an asset,
typically the common stock of the firm distributing the right, at a price that is less than
the current market price of the firm’s common stock. The goal is to have the
stockholders exercise the right so that the firm can increase its equity. Rights offerings
are a popular way of rising equity in many countries, including the United Kingdom,
which is the subject of my dissertation, and Japan. As McInish [2000, p. 21] points out,
they were also popular in the USA at one time, but their use has declined sustainability
in the end of 1990s.
1.5.2. Fixed-income securities
Fixed-income securities are securities that promise to make payments of
specified amounts to investors at specified dates. As it was mentioned before preferred
stock is often a fixed-income security. But most fixed-income securities are debt
instruments. A bond is a security which is evidence of debt issued by firms and
governmental bodies, including nations and their subdivisions and international
organizations such as the World Bank (the International Bank for Reconstruction and
Development), that requires that the issuer make one or more payments to the owner. A

22
money market instrument is a debt obligation with an initial maturity date of less than
one year. Capital market instruments have lives of one year and more. Money market
instruments are traded in the money market, in contrast to the market for bonds,
equities, and warrants, which are traded in the capital market.
1.5.3. Derivatives
A derivative, according to McInish [2000, p. 25] is a contract that specifies the
conditions under which each party transfers assets, including cash, to the other during
the life of the contract. While the derivative contract specifies how the amounts to be
transferred are to be determined, at least some of the amounts are intended to be
uncertain. The contract may involve cash payments or the transfer of real or financial
assets. The types of items that may be transferred or that may be the basis for
calculating cash payments are highly varied and include:
- commodities such as precious metals (silver, gold, platinum), agricultural
products (corn, soybeans, live cattle, pork bellies), and industrial commodities
(gasoline, heating oil, lumber);
- equities and equity indexes;
- currencies;
- debt instruments;
- other derivatives;
- price indexes or other type of pricing arrangements such as the movement over
time of the US Consumer Price Index, freight rates, or insurance claims.
This definition encompasses the six types of derivatives examined in this chapter:
options, futures, forwards, swaps, warrants, and rights. While warrants are considered
equities, they also have the characteristics of derivatives.
An option is a contract with a stated life in which one party acquires, in return for a
fee, the right to receive something if it is advantageous to do so. Some option contracts

23
provide for the payment of the cash value of the difference between an assets’s price
and a stated price. Other options allow the purchase of a real asset such as corn at s
predetermined price, the purchase of a financial asset such as common stock at a
predetermined price, the sale of a real asset at a predetermined price.
Futures are standardised contracts in which on party acquires the right to receive
and the other the obligation to deliver a specified amount and type of an asset at a
specified future date at a price stated in the contract. Some futures contracts call for one
party to pay the liquidating value of the contract to the other party rather than for the
delivery of an asset in exchange for cash. Non-standardised contracts similar to futures
contracts, except that the terms are individually negotiated on a bilateral basis, are
called forward contracts.
A swap is a contract evidenced by a single document in which two parties agree to
exchange one or more periodic payments based on the value of change in value of
something specified in the contract. The payments that are exchanged can be based on
any number of items, including interest rated and exchange rates. Depending on the
terms of the swap, one party’s payments can be fixed while the other’s fluctuate, or both
parties’ payments may fluctuate. The terms for many types of swaps have become
standard so that the market price can be determined from usual information vendors.
Warrants were defined previously. A warrant is equity because the funds received
from the sale of a warrant do not have a definite repayment obligation. But because the
value of which is uncertain, a warrant is also a derivative as defined here.
1.5.4. Money and foreign exchange
Money is anything used as a medium of exchange. In modern economies there
are three principal types of money: coins, currency and deposits which are liabilities of
financial institutions that are generally accepted as a medium of exchange and therefore
classified as money. The trading of money of one country for that of another is called
the foreign exchange market, and the money itself is foreign exchange.

24
Governments and firms issue equities and fixed-income securities at specific
times in large quantities to raise funds. The parties to the derivative contract create
derivatives (excluding warrants) as the need to transfer risk arises. Money is created by
governments through the minting of coins and the printing of paper currency and by the
banking system through the creation of deposits that can serve as a medium of
exchange.
The most basic goals of individuals, according to McInish [2000, p. 23], is to
maximise their utility – i.e. their satisfaction. The maximisation of utility translates into
the financial goal of maximising wealth. For a firm this means maximising the wealth of
the owners. Production is the way that wealth is created in the economy. Individuals can
directly consume the production for a given year, or they can divert some of the
production for use in producing other goods and services. This diversion of production
from immediate consumption to use in facilitating additional production is called saving
or direct investment.
Direct investment is the use of resources to produce other goods and services.
But not everyone who wishes to defer consumption wants to invest directly. Instead,
some prefer to give their funds to others to invest. Financial markets are institutional
arrangements designed to facilitate the transfer of resources from those who have more
to those who have less than they wish to consume.
Financial markets and instruments contribute to the enhancement of wealth.
They increase the use of capital in the economy, and they lower the cost of transferring
capital from those with a surplus to those with a shortage.
1.6. The economy and the markets
According to Vaitilingam [2000, p.248] the economy is one of the most
important drivers of the stock market. The central economic force of interest rates, plus
the assorted effects of exchange rates, inflation, public spending and taxation, will
eventually have a say in overall valuations, whatever the temporary investment craze.

25
At the same time, the stock market has a major impact on the economy, both as a
forward indicator and determinant of consumer sentiment, and as a vital mechanism in
the management of risk encouraging the innovation and entrepreneurship that drive
economic growth.
Shares and bonds provide the essential capital that enables companies to take the
risks inherent in business. From their origins in medieval Italy, through increasing size
and sophistication in 17th- and 18th- century Amsterdam, 19th- century London and 20th-
century New York, the stock markets in which these assets traded have meant that the
business risks of new projects can be shared – from building the rail, road and aviation
infrastructure of the 19th-and 20th-century economies to building the electronic
infrastructure of the 21st-century economy. Such risk-sharing has transformed the
potential for economic growth and, in the latter part of the last century, as more and
more people have got involved in the investment process, changed fundamentally our
understanding of the relationship between risk and return.
For most of financial market history, debt finance was dominant. Until as late as
the 1950s, shares were largely in the hands of wealthy individuals. Buying and owning
shares was considered far too risky by the less well off and even by the institutions that
now dominate the investment scene; instead, they held portfolios of high-grade, long-
term bonds. But this arrangement has been swept aside in the last few decades, as
investors of all kinds have sought better returns, companies have seen the hugely
increased financing opportunities of the equity markets, and economic growth has made
enormous improvements in living standards in the developed world.
Of course, there have been bad times in the past sixty years and the stock market
has been a good leading indicator of future economic gloom. For example, the of the
period 1950-73 – often described in literature as the ‘golden age’ of economic growth in
western Europe and the United States [Vitilingam, 2000, p.249] – was clearly foretold
in the disastrous crash of 1973-4, when markets fell by over 50 per cent. The bear
market of the early 1970s clearly reflected the ominous economic events of that
unfortunate decade: sky-rocketing oil prices, the breakdown of the Bretton Woods
agreements for managing international monetary affairs, and the emergence of
persistent inflationary forces.

26
Many feared that these collapsing share valuations would lead to economic
disaster, just as the Great Crash of 1929 was thought to have led to the Great Depression
of the 1930s. Certainly, as Chamber [2004, p.38] states, speculative manias or ‘bubbles’
that culminate in self-feeding panics and eventual crashes can have widespread and
undesirable consequences in the real economy. Clearly, too, a booming market boosts
consumer sentiment, encouraging spending, reducing saving and increasing debt, and
adding further fuel to a raging economy.
But economic policy itself has a major impact on the interaction between share
values and the economy. In the 1990s, for example, cheap and easily available money
sustained the market’s upward trend. And in both the United States and the United
Kingdom, the crashes of 1987 had marginal effects on economic performance since the
monetary policy authorities in both countries were quick to cut interest rates to increase
liquidity. Similarly, the US Federal Reserve’s rate-cutting response to the global crisis
of 1997-8 seemed to be successful in restoring the good times.
This situation didn’t last for much longer than a decade though. The increasing
rates and decreasing availability of loans in the United States in 2008, widely known as
the Credit Crunch, made economies of many countries collapse, especially the US itself
and Western, Central and Eastern Europe. Some, like Hayek [2009], would call it a
natural end of the prolonged boom and others, like Minford [2010], would name
western societies victims of easy-money policy. Minford also states that for the credit
crunch shock it was 20% of borrowers that were marginal and not able to get loans on
normal basis, which meant that they had to pay interest they could not afford. The
situation led to great panic spread by the media as well, many people lost their jobs,
especially in the City. Credit Crunch forced the British government to cut their
spending, more than ever in the social sector, and raise taxes. Anxiety, panic and
terrifying statistics dominated the period of over a year, starting in the middle of 2008.

Chapter 2: The idea of index shares
2.1. Introduction
To begin discussing indices one has to know what they are. According to
Vaitilingam [2001, p. XV] an index is a number used to represent the changes in a set of
values between a base year and the present. Index numbers blend many different
ingredients into a single index, and measure changes in it by changes in its parts. This
involves giving appropriate weighting to the components according to their importance
in what is being measured. A weighted average is usually calculated as an arithmetic
mean, either using the same weights throughout (a base-weighted index) or adjusting
the weights as the relative importance of different components changes (a current-
weighted index). Vaitilingam also adds that base-weighted indices may have the base
shifted periodically.
Moreover, Fell [2000, p.74] adds that as well as providing information on
individual share prices, financial information sources often also report on the movement
of the value of shares as a whole by recording and commenting on share indices. A
share index records the change in the aggregate value of a particular group of shares
from a base period. For instance, the Financial Times – Stock Exchange 100 index,
otherwise known as ‘Footsie’, was started in 1984 and records the total value of the
hundred largest UK firms by market capitalisation. The index started at a value of 1000
and stands at 5,996.45 at the time of writing (January 2010). What this means is that the
top hundred firms in the UK are worth 5,996.45 times more/less than they were in 1984.
Worth mentioning is the fact that the FTSE 100 is one of the most important
share indices the UK, though there are other broader indices too, notably FTSE All
Share index, which includes around 850 UK quoted companies. Indices of European
shares are also produced by the Financial Times in conjunction with the Stock
Exchange. The FTSE Eurotop 100 index records the value of the hundred most actively
traded shares in Europe, while the Eurotop 300 is more similar to the Footsie in being
based on the 300 largest European companies by market capitalisation. Other important
indices from around the world are the Dow-Jones 30 share index and Standard and

28
Poor’s 500 index, which are based on American shares, and the Nikkei 225 index,
which reports movement in the Japanese market.
2.2. FTSE indices
Most widely based indices have been developed by the Financial Times, the
Stock Exchange and the Institute and Faculty of Actuaries. As of November 1995, these
have been managed by a joint company, FTSE International. These indices are
arithmetically weighted by the market capitalisation rather than being based on crude
price movements. In other words, the larger a company, the bigger the effect its price
movements will have on the index.
Source: FTSE 100 Index Factsheet
Figure 2.1 FTSE UK Index Series family tree
As Vaitilingam [2001, p. 93] states, the FTSE Actuaries share indices, and notably
the All-Share index, are the professional investor’s yardstick for the whole UK equity

29
market, for use in analysing investment strategies and as a measure of portfolio
performance. There are 39 component indices in the All-Share index relating to
different industrial sectors of the market, and nine component indices relating to
different levels of capitalisation (including the well-known Footsie). Beyond the All-
Share are the new fledgling indices, incorporating companies with a market
capitalisation below £35 million. Figure 2.1 represents the whole FTSE UK Index
Series family tree.
Furthermore, it is important to know what each index represents. The indices are
presented below according to Vaitilingam [2001, p. 95-97] description and updated
according to the official FTSE International website <http://www.ftse.com/
Indices/UK_Indices/ index.jsp> [consulted on 05.01.2011]:
Source: London Stock Exchange Prices
Figure 2.2. FTSE UK 100 5-year performance
- FTSE 100: the Footsie index was started with a base of 1,000 in January 1984 to
fill a gap in the market. At that time, the FT 30 index was calculated only
hourly, and there was demand for a constantly updated – or real-time – index in
view of both the competition from overseas and the needs of the new traded

30
options and financial futures markets. For most purposes, the Footsie has
replaced the FT 30. The index, amended quarterly, includes the 100 largest UK
companies in terms of market capitalisation – the blue chips – and represents
over 81% per cent of total UK market capitalisation. Figure 2.2. represents it’s
performance over the last 5 years.
- FTSE 250: an index of the next 250 companies by the market capitalisation,
those directly beneath the FTSE 100. These are companies capitalised between
£350 million and £3 billion, in total around 15 per cent of overall market
capitalisation. It is calculated two ways, one that includes and one that excludes
investment companies. Figure 2.3. represents the performance of the index
during the last 5 years.
- FTSE 350: the combination of the FTSE 100 and the FTSE 250, again
calculated both including and excluding investment companies. Figure 2.4.
shows how the index changed over the last 5 years.

31
- FTSE 350 Higher and Lower Yield: these two indices, introduced at the
beginning of 1995, are calculated by a quarterly descending ranking of the 350
companies by the size of their annual dividend yield, and then their division into
two equal halves as measured by total capitalisation of the 350 companies.
Figure 2.5. FTSE UK 350 Lower Yield 5-year performance

32
Figure 2.6. FTSE UK 350 Higher Yield 5-year performance
- FTSE SmallCap: the 450-plus companies capitalised at up to £350 million,
which when added to the 350 make up the All-Share index. Like 250 and 350,
this index is calculated two ways.
Figure 2.7. FTSE UK SmallCap 5-year performance

33
- FTSE Fledgling: another index launched at the beginning of 1995, this was
introduced to indicate the Stock Exchange’s concern for smaller companies. It
includes the over 700 companies that fail to qualify for the All-Share index
(including shares quoted on the AIM), representing 1-2 per cent of total market
capitalisation. It is calculated two ways as well. The figure below represents
how the index changed over the last 5 years.
Figure 2.9. FTSE UK Fledging 3-year performance
- FTSE All-Small and FTSE AIM: the former combines the SmallCap and
Fledgling indices; the latter is an index of all AIM-listed companies, around 460
in late 2009, with a total market capitalisation of £15 billion.
- FTSE All-Share index: 800-plus companies with a total market capitalisation
of about £1.733 billion in November 2010, 98-99 per cent of total UK market
capitalisation. Introduced on a daily basis in 1962, it is far more representative
than the FT index. Its mathematical structure makes it a reliable yardstick
against which to measure portfolio performance, and hence it represents an

34
essential tool for professional investment managers. The figure below shows
how the value of the index changed within the last 5 years.
Figure 2.8. FTSE UK All-Share 5-year performance
The Footsie is calculated every 15 seconds from the price movements of the 100
largest UK companies by market capitalisation. Since it incorporates fewer companies
than the All-Share index, it can be calculated more rapidly and frequently. The Footsie
was the first real-time index in the UK and was introduced mainly as a basis for dealing
in equity index options and futures. It rapidly became a key indicator of the stock
market’s mood, not least because it is quoted widely throughout the day. In many
respects, the market thinks in terms of Footsie figures with particular points being seen
as psychological watersheds.
The FTSE 100 constituents are mostly multinationals and companies with strong
overseas interests, while the FTSE 250 are mainly strongly UK orientated companies.
As a result, the former are likely to be more influenced by overseas factors such as

35
exchange rate movements, while the latter may be influenced more by domestic factors
such as interest rate movements. Membership of both indices is reviewed every quarter
as market caps rise and fall. For the FTSE 100, any share that is 90th or higher
automatically joins the index; 111th or lower means automatic relegation.
The FTSE All-Share accurately reflects the whole market, as Vaitilingam [2001,
p. 98] states. With over 800 constituents, it has a very broad coverage, encompassing 98
per cent of the market’s aggregate capitalisation, with each company weighted
according to its market value so that a move in the price of a large company has more
effect than that of a small one. It can be used as a measure of the market’s performance
over long periods. It serves as a reliable yardstick against which to assess portfolio
performance. As a weighted arithmetic index it is designed to behave as an actual
portfolio would behave.
The breakdown into industry groups allows investors to track the performance of
particular sectors. This is of great assistance to specialist sector analysts, as well as
allowing more general investors to improve their understanding of the structure of the
market as a whole. Industrial classification is highly important since it is normally
accepted by the stock market and institutional research departments as the basis for the
analysis of companies. Correctly classifying all companies traded on the London market
is the responsibility of the FTSE Actuaries Industry Classification Committee, made up
of market practitioners, investment managers and actuaries. Figure 2.2 is an example of
how FTSE is presented daily in Financial Times.
Over time, as the structure of the UK industry has shifted, it has been necessary
to amalgamate sectors and create new ones. For example, Radio and TV, Teas and
Diamonds have gone, while Health, Media, Photography, and Electricity have been
formed. When a new group is created, its initial value is set at the level of its immediate
predecessor. In 1999, FTSE International introduced the Global Industry Classification
System, allowing comparison across national boundaries as well as across sectors and
sub-sectors. There are three levels of classification:
- Economic group, for example resources
- Industry sector, for example oil and gas
- Industry sub-sector, for example oil services or oil integrated

36
Source: Financial Times, January 26, 2011
Figure 2.9. An example of FTSE Indices presented daily in Financial Times

37
At the moment FTSE International is using Industry Classification Benchmark
(ICB) that comprises of four categories:
- Industry: basic materials
- Supersector: basic resources
- Sector: industrial materials
- Subsector: steel
Institutional investors attempt to beat the index most relevant to their portfolio.
Increasingly, investors want a set of indices that covers the entire equity capital
structure of the UK market so that they can accurately assess the performance of large,
medium and small companies within the framework of the whole market. There has also
been a growing interest in the performance of medium-sized companies since the
beginning of current century. The newer indices increase the visibility of many medium
and small companies.
The FTSE 350 provides a real-time measure covering around 90 per cent of the
UK equity market by value. The SmallCap and Fledgling indices are higher risk but
likely to boom in a recovery. They are good for the visibility and marketability of
smaller companies. Beyond the markets covered by the All-Share and Fledgling indices
is Ofex, an unregulated off-exchange dealing facility for companies not eligible for the
AIM or the index. It is offered by the broker JP Jenkins Ltd, with daily share
information published in the Financial Times.
The differentiation between Higher Yield and Lower Yield companies in the FT
350 is an interesting reflection of the decreasing importance of dividends as part of the
rewards to investors. Indeed, many of the market’s hottest stocks pay no dividends at
all, as Stowell, D.P. [2010, p.77] points out. Companies normally have relatively high
yields because investors expect their share prices to perform relatively badly. There are
three main types of high yielding stocks:
- Stodgy companies like utilities that chug along but are unlikely to produce
fireworks
- Companies in decline that are overdistributing their earnings
- Recovery shares that may or may not make it back.

Chapter 3: The changes of indices
3.1. Introduction
This section focuses on the changes in value of analysed indices: FTSE 100,
FTSE 250 and FTSE All-Share. The changes are explored annually as well as for the
whole period of three years which this thesis covers. The choice of indices is
determined by their importance and significance to the UK market. They represent the
state of British economy as they stand for all the industries present at London Stock
Exchange, together covering 98 per cent of total UK market capitalisation.
3.2. FTSE 100
3.2.1. January – December 2007
The chart below presents the changes in value of FTSE100 index during 2007:
Figure 3.1. FTSE100 in 2007

39
As one can observe, in January 2007 the value of the index was 6.311 and in the
end of the period – December 2007 it was 6.411. The average monthly change of the
index for the whole year was 0.19%. It reached the highest value in October, 11th –
6.724 and the lowest in August, 16th -5.880. Hence, the spread in 2007 was 0.844.
One can say that 2007 was a good year for FTSE 100. The companies forming it
were using the opportunities the market gave them. The growth in value over the whole
year’s period shows that economy was, generally speaking, expanding in spite of minor
falls and increases.
Worth mentioning is the fact that this index contains the main banking groups
present on the British market: Barclays, Lloyds TSB, Royal Bank of Scotland and
HSBC, according to the data published on the FTSE website. The growth in value of
these banks proves the high level of borrowing to invest in companies present in the
UK. Moreover, one has to bear in mind that financial institutions are the biggest part of
FTSE 100 – over 30% of the whole group. Well prospering estate market, growing
number of vehicles purchased by the British as well as increasing wages, allowing more
pension-related savings, led to increase in value of insurance companies like Aviva and
RSA Insurance Group which also belong to the index. Another important sector which
led to the growth of FTSE 100 value is consumer goods (20%). The amount of money
that the Brits spent on their weekly grocery shopping in Tesco, Marks & Spencer,
Sainsbury’s and Morrison which, according to the data published by The Independent,
are the four most popular general shopping stores in the country and all belong to FTSE
100.
Figure 3.2. presents the changes in value of FTSE100 index during 2008 – the
second year analysed within the contents of this dissertation.
As it can be read, in January 2008 the value of the index was 6.425 and in the
end of the period – December 2008 it was 4.807. The average monthly change of the
index was -4.03%. It reached the highest value in January, 3rd – 6.488 and the lowest in

40
November, 21st -3.761. Hence, the difference in 2008 was more noticeable than a year
before – 2.664.
The sudden decrease in the value of the index was caused by the influence that
American Credit Crunch had on the British economy. It started with the financial sector,
especially banking institutions which had to refuse giving out loans to many existing
and new customers. The lack of money in the circuit reduced spending as well as
saving, hence influencing all the other sectors- nearly 70% of FTSE 100. Surplus in
supply forced the companies to cut their costs by, for example, letting their staff go,
which had a great influence on the situation in the following year.
last year analysed within the contents of this dissertation.

41
As the chart represents it, in January 2009 the value of the index was 4.562 and
in the end of the period – December 2008 it was 5.264. The average monthly change of
the index was 1.28%. It reached the highest point in December, 29th – 5.438 and the
lowest in March, 9th -3.493. Hence, the difference in 2009 was by nearly a third smaller
than a year before yet more than twice as large as in 2007– 1.945.
In the beginning of the year the index was still struggling with decrease of its
value. March turned out to be the lowest as well as the turning point for the market
cycle. After reaching the market bottom, stocks started going up, which means the end
of late contraction and the beginning of expansion phase once again. Moreover, one has
to remember that the market cycle is from 3 to 9 months ahead of economic cycle, as
Artis states [1999, p. 56]. Growing value of FTSE 100 in the second half of 2009 means
that recession is coming to an end.

42
3.2.4. January 2007 – December 2009
The chart below presents the changes in value of FTSE100 index during 2007-
2009.
Figure 3.4. FTSE 100 in 2007-2009
During the three years of observations FTSE 100 reached its highest value in
October, 11th, 2007– 6.724 and the lowest in March, 9th, 2009- 3.493. The difference
between those two points is 3.231, which means a 48% decrease during the three-year
period. The average monthly change for this index over the analysed period is -0.53%.
The index kept its value on a relatively even level throughout 2007. In 2008,
however, the value suddenly dropped towards the end of the year. From June 2008 up
until March 2009, for three quarters of a year the index’s price was decreasing rapidly.
It slowly started to build back up form April 2009 reaching the value of 5.438 in the end
of December 2009.

43
The chart below represents the dynamics of changes of the FTSE100 index
during 2007-2009:
Figure 3.5. FTSE 100 dynamics in 2007-2009
As far as 2007 is concerned, the changes did not reach higher than 5%.
However, the situation changed in 2008: towards the end of the year the changes were
more drastic reaching nearly 15% in November. The situation of the index was still
unstable in 2009, especially during the first quarter of the year and reaching nearly 14%
in April. From May until the end of the year the value of the index was generally
speaking increasing gradually with minor downfalls by up to 4%.
Summing up the analysis of changes of FTSE 100, one can generally state that it
pictured the economic situation happening in the country. The further analysis of the
relationship between the index and four major economic indicators proves that it can be
treated as a barometer for the state of a given country’s economy.
-14.22%
13.39%
-20.00%
-15.00%
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
2007-1
2007-3
2007-5
2007-7
2007-9
2007-11
2008-1
2008-3
2008-5
2008-7
2008-9
2008-11
2009-1
2009-3
2009-5
2009-7
2009-9
2009-11
FTSE100 dynamics
[Q1 2007=100]in %
FTSE100

44
3.3. FTSE 250
The chart below presents the changes in value of FTSE 250 index during 2007 –
the first year analysed within the contents of this dissertation.
Figure 3.6. FTSE 250 in 2007
As one can observe, in January 2007 the value of the index was 11.313 and in
the end of the period – December 2007 it was 10.745. The average monthly change of
the index was -0.47%. It reached the highest point in May, 23rd – 12.222 and the lowest
one in December, 17th -10.160. Hence, the spread in 2007 was 2.062- a downfall by 16
per cent to the highest value.
Over the year the value of the index was rather steady. The well-prospering
economy gave all the businesses the opportunity to develop, invest and gain new
customers. According to the data published on the official FTSE website, financial

45
institutions constituted 23% of FTSE 250 in 2007, so even though its role is less
influential than in case of FTSE 100, it still is significant. At the time it included nearly
30 investment trusts. As mentioned in the previous part of this chapter, since this sector
was expanding, it influenced other sectors as well, guaranteeing prosperity. The stability
of FTSE 250 basically meant the stability of the economy since as much as 35% of
companies belong to a group called cyclical industry which is specifically sensitive to
the business cycle.
The chart below presents the changes in value of FTSE250 index during 2008 –
the second year analysed within the contents of this dissertation.
As one can observe, in January 2008 the value of the index was 10.650 and in
the end of the period – December 2008 it was 5.830. The average monthly change of the

46
index was -5.33%. It reached the highest point in January, 2nd – 10.650 and the lowest
in November, 21st – 5.543. Hence, the difference in 2008 was 5.107, which means a
nearly 48% decrease between those two points.
This year brought a significant fall in the value of FTSE 250 due to the influence
of the crash in American economy on the British one. Since, as mentioned before, 35%
of the index belongs to cyclical industry, their sensitivity to what happened in the
banking sector cause a lot of companies struggle for survival. Additionally, consumer
goods and services constitute 25% of the index. Since banks were not able to provide as
many loans as requested, companies had to lower their costs, which led to higher
unemployment. Furthermore, disposable income of the citizens has been reduced as
well. This chain of events led to major loses in the consumer goods and services sector
which, obviously, is strongly connected to general industrials. Hence, value of FTSE
250 decreased significantly.
last year analysed within the contents of this dissertation.
end of the period – December 2009 it was 9.135. The average monthly change if the
index was 3.18%. It reached the highest point in October, 19th – 9.547 and the lowest in
March, 9th – 5.772. Hence, the difference in 2009 was 3.775 which is higher than in
2007 but also significantly lower than in 2008.
Similarly to the previous index analysed, FTSE 250 changed its direction in
March 2009. From then on the index would gradually regain its value from before
depression. The sudden fall of interest rates in the beginning of 2009 helped all business
get back on their feet. Worth mentioning is also the fact that GDP started rising as well,
which means that the whole economic activity of the country was improving. All these
reasons led to a rise in the value of FTSE 250.

47
Figure 3.9. presents the changes in value of FTSE250 index during 2007-2009. It
covers the whole analysed period of three years.
During the three years of observations FTSE 250 reached its highest value in
May, 23rd, 2007– 12.222 and the lowest in November, 21st, 2008– 5.543. The difference
between those two points is 6.679, which means a 54% decrease over three years. The
average monthly change for this index over the analysed period is -0.61%.
The index did not change its value that much during 2007 as it did in 2008. It
was not earlier than the in third quarter of 2008 when it started decreasing rapidly by up
to 20% per month. It started growing back in the beginning of the second quarter of
2009 after nearly 10 months of losing value constantly.

48
Figure 3.9. FTSE 250 in 2007-2009
The dynamics of changes is presented in the chart below:
Figure 3.10. FTSE 250 dynamics in 2007-2009
-20.48%
15.75%
-25.00%
-20.00%
-15.00%
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
20.00%
FTSE250 dynamics
[Q1 2007=100]in%
FTSE250

49
Similarly to the situation of the index analysed previously, FTSE 250 stayed
relatively stable throughout 2007 and up until the third quarter of 2008. The rapid
changes by up to 20% continued until May 2009 where the increase to April the same
year was over 15%. Throughout the rest of the year the index was not changing by more
than 8%.
The chart presents how the economy was behaving throughout the covered
period of time. The instability of the market can be noticed by relatively high changes in
price of FTSE 250. The changes were cause by a number of reasons describes before in
this section, like change of interest rates, lack of ability to obtain loans, limited
investment opportunities, cutting down on costs in general.
3.4. FTSE All-Share
Figure 3.11. presents the changes in value of FTSE All-Share index during 2007
– the first year analysed within the contents of this thesis.
index was 0.04%. It reached the highest point in June, 15th – 3.479 and the lowest in
August, 16th – 3.042. Hence, the difference in 2007 was 0.437.
The low yet indicating growth rate of average monthly change of the index states
for its stability. This indicates that 98% of British economy could be described as
prospering despite the minor rises and falls. It is important to mention that 23% of
FTSE All-Share was financial institutions in 2007. Moreover, the biggest constituent of
the whole index was HSBC itself which stands for over 6% of the index itself. Since, as
mentioned before, banks and other financial institutions were doing very well and
interest rates were the highest for 6 years [Turner, 2008, p. 76] this sector was booming.

50
Figure 3.11. FTSE All-Share in 2007
Furthermore, so was oil & gas sector, constituting over 17% of FTSE All-Share.
With prospering businesses this segment could not be better. It also influenced the
consumer goods, services as well as basic materials sectors, each of which stands for
10-11% of FTSE All-Share market capitalisation value. New investments caused the
fall in unemployment and rise in consumption and savings. All in all the economy was
prospering, which changed the following year.
Figure 3.12. on the next page of this thesis presents the changes in value of
FTSE All-Share index during 2008 – the second year analysed within the contents of
this dissertation.

51
index was -4.24%. It reached the highest point in January, 3rd – 3.295 and the lowest in
November, 21st – 1.884. Hence, the difference in 2008 was 1.411.
Moreover, the 43% downfall of the value of the index represents the situation
that involved 98% of the businesses present on the British market. In 2008 it was 630
companies, according to the data published on the official FTSE website. The economy
was strongly influenced the Credit Crunch is the United States, as Brummer states
[2008, p.39]. As mentioned in chapter 1, the banks were not able to give away as many
loans as previously, which caused all sectors to suffer the consequences. Since demand
dropped suddenly, unemployment increased and, consequently, GDP was lower,
businesses had to cut their costs, which even caused the damage to be deeper.
November 2008 illustrates how low the index could get and it is known that the
following year the index got even lower.

52
The chart below present the changes in value of FTSE All-Share index during
2009 – the last year analysed within the contents of this study.
As the chart says, in January 2009 the value of the index was 2.269 and in the
index was 1.63%. It reached the highest point in December, 29th – 2.772 and the lowest
in March, 9th – 1.770. Hence, the difference in 2009 was 1.002.
The value of the index started rising in March 2009. Similarly to FTSE 100 and
FTSE 250, the improvement of the economical state of the country let the constituents
of FTSE All-Share slowly build their way up to the point from before the Credit
Crunch. Worth mentioning is the fact that the lowered interest rates encouraged
business owners to invest and develop. When they started making more profits, they
could share them with employees who started spending more. This string of events
leads to prosperity, as Artis states [1999, p. 17].

53
The chart below present the changes in value of FTSE All-Share index during
2007-2009.
Figure 3.14. FTSE All-Share in 2007-2009
During the three years of observations FTSE All-Share reached its highest value
in June, 15th, 2007– 3.479 and the lowest in March, 9th, 2009– 1.770. The difference
between those two points is 1.709, which means a 49% decrease over three years. The
average monthly change for this index over the analysed period is -0.53%.
Moreover, throughout 2007 the index was not changing much. It was slowly
decreasing during the first quarter of 2008 and faced a rapid downfall after that up until
the beginning of the third quarter of 2009 when it slowly started building its value up.
Naturally, its behaviour was similar to the one of FTSE 100 and FTSE 250 since they
both are parts of FTSE All-Share.

54
The dynamics of FTSE All-Share are represented by the chart below:
Figure 3.15. FTSE All-Share dynamics in 2007-2009
During 2007 the value of the index was not changing by more than 5%.
Similarly to FTSE 100 and FTSE 250 the index faced the biggest changes beginning
from the middle on the third quarter in 2008 until the end the second quarter in 2009,
changing by up to 14%. From June 2009 the value of the index was increasing.
Furthermore, all the reasons for the changes in the value of FTSE All-Share,
which were mentioned throughout this chapter, have their illustration in the chart above.
The bottom of the market value of the index caused by lack of demand of goods and
services and lack of supply for cheap loans is clearly marked by the downfall by over
13% in the end of 2008.
-13.45%
11.77%
-15.00%
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
2007-1
2007-3
2007-5
2007-7
2007-9
2007-11
2008-1
2008-3
2008-5
2008-7
2008-9
2008-11
2009-1
2009-3
2009-5
2009-7
2009-9
2009-11
FTSE All-Share dynamics
[Q1 2007=100]in%
FTSE All-Share

55
On the other hand, the sudden increase in value visible towards the middle of
2009 is a response of the market to the changing situation in the country, like lower
interest rates, as well as a natural way the economy reacts to recession. As Leitch [2006]
describes it, the economy has the ability of bringing itself back to prosperity.
3.5. Annual analysis
During the first year of analysis all three indices changed in a similar way as it
can be seen in the chart below:
Figure 3.16. FTSE 100, 250 and All-Share in 2007
During 2007 all indices behaved in a similar yet not exactly the same way. They
all reached a downfall towards the end of the first quarter, an increase towards the end
6.311 6.441
11.313
10.745
3.266 3.281
0.000
2.000
4.000
6.000
8.000
10.000
12.000
14.000
FTSE 100
FTSE 250
FTSE AllShare

56
of the second one, a slight decrease towards the end of the third one as well as a raise in
November followed by a fall in December. However, one can notice that FTSE 250 was
slightly more sensitive to the change than the other two indices. The spread for FTSE
100 between the highest and the lowest point was 13%, for FTSE All-Share 12% and
for FTSE 250 it was slightly more – 16%, which leads to a conclusion that the sector of
15 per cent of overall market capitalisation in Britain was influenced in a rather stronger
manner by the changes in economy during this year than the other analysed indices. The
reason for that is the difference in the structure of these indices. In other words, the
sector breakdown matters here. FTSE 250, according to the official data published on
FTSE website, has a relatively larger group of companies that belong to cyclical
industry.
6.425
4.087
10.650
5.830
3.269
2.030
0.000
2.000
4.000
6.000
8.000
10.000
12.000
FTSE 100
FTSE 250
FTSE AllShare

57
In 2008 all three indices faced, again, similar changes. They all reached their
highest value in January and the lowest one in the end of the year. Moreover, all indices
began to decrease in the most drastic pace in the end on the third quarter of the year.
Similarly to the previous year, FTSE 250 has changed the most throughout the year- the
average monthly change for that index was -5.33%, whereas for FTSE 100 it was -
4.03% and for FTSE All-Share -4.24%. Furthermore, the difference between the highest
and the lowest value of indices was also the biggest for FTSE 250 – 48% to the highest
value. FTSE 100 changed by 41% over the year and FTSE All-Share by 42%. The
reason for that has been explained on the previous page- FTSE 250 has a larger share of
businesses sensitive to the current market situation.
4.562
5.246
6.627
9.135
2.269
2.710
0.000
1.000
2.000
3.000
4.000
5.000
6.000
7.000
8.000
9.000
10.000
FTSE 100
FTSE 250
FTSE AllShare

58
Throughout 2009, likewise, the indices behaved in a similar way. They all
reached their lowest value in March and the highest one towards the end of the year.
March seems to be the breakthrough point for the rapid decrease in value of analysed
indices. Beginning in the second quarter of 2009, as mentioned before in this chapter,
indices started increasing rather gradually - slowly but surely with only minor
downfalls. Yet again, FTSE 250 turned out to be more sensitive than FTSE 100 and
FTSE All-Share. The average monthly change of the index value for FTSE 250 was
more than twice as high as for FTSE 100: 3.18% to 1.28%; it was also nearly twice as
high as for FTSE All-Share: 3.18% to 1.63%. Since in 2009 the structure of indices did
not change a lot in comparison to the previous two years, the difference in behaviour of
FTSE 100 and FTSE All-Share, and FTSE 250 is due the fact that the latter contains,
proportionally, more companies belonging to cyclical industries.

Chapter 4: The changes of indices and the
economicindicators
4.1. Introduction
In this chapter the relationship between FTSE indices and the most significant
economic indicators is analysed. It is Gross Domestic Product, the British Pound
exchange rate to Euro, unemployment rate and rate of interest that are taken into
consideration. The analysis focuses on the three years which this dissertation takes into
consideration – 2007-2009. Since the stock market is said to be the reflection of the
economy, the aim so to check what is the level of correlation between two series of
data, i.e. GDP and FTSE All-Share in 2008.
4.2. Gross Domestic Product
4.2.1. The idea of GDP and its changes in 2007-2009
First, it is worth mentioning that Gross Domestic Product (GDP), as Vaitilingam
(2004, p. 22) states, is the most comprehensive measure of economic activity, as
reflected in the circular flow of income. It is calculated by adding together the total
value of the annual outputs of goods and services (with quarterly figures annualised)
and expressed, here, in billions of pounds. The figure is gross because it does not
incorporate a deduction for the depreciation of capital goods.
Second, the data representing GDP can be used to assess the economy’s position
on the business cycle, and its likely future trends. As Barry (2002, p. 25) states, the
business cycle can be characterised by four phases: expansion or recovery when output
and employment are rising; boom when both are at high levels; recession when both are
falling; and slump or depression when both are at low levels.

60
The figure below presents the value of GDP in the United Kingdom of Great
Britain in 2007-2009 presented quarterly:
Source: GDP in UK since 1984
Figure 4.1. GDP in the United Kingdom in 2007-2009 in billions of pounds
As one can read from the chart, the value of GDP was rising until the second
quarter of 2008. For the next two quarters it was falling in a slower manner then in the
following two, until the second quarter 2009. After reaching its lowest point- the value
of 344.583- it started slowly growing towards the end of the year. On the other hand,
GDP reached its highest value in the second quarter 2008: 363.264. Hence, the
difference between these two points is nearly £20 billion.
Moreover, as stated by Sharp [1999, p. 13], when analysing the changes in value
of GDP one has to keep in mind that its value is calculated on a quarterly basis. It
involves a certain delay factor in looking at the overall state of a given country’s
economy.
To understand the situation of the economy one also has to take into
consideration the dynamics of quarterly change. It shows the change of the value of a
certain quarter to the value in the previous one, in per cents and is presented in table 4.2.
345.283
363.264
344.583
351.353
335.000
340.000
345.000
350.000
355.000
360.000
365.000
GDP value
[in billions of GBP]
GDP

61
Source: GDP in UK since 1984
Figure 4.2. GDP dynamics in the United Kingdom in 2007-2009
As it can be read from the chart, until the second quarter of 2008 the economy
was expanding since GDP was rising quarter to quarter. The fall in the third quarter of
2008 could be described as contraction and because GDP continued on falling, the
changes until the third quarter 2009 will be described as recession. Towards the end of
the year the economy started its recovery.
4.2.2. FTSE 100 and GDP
The value of the first index analysed, FTSE 100, and the GDP for the three-year
period of 2007-2009 are presented quarterly in table 4.1. on the next page.
1.34%
-2.65%
-3.00%
-2.50%
-2.00%
-1.50%
-1.00%
-0.50%
0.00%
0.50%
1.00%
1.50%
2.00%
GDP dynamics
[Q1 2007=100]in%
GDP

62
Table 4.1.
FTSE 100 and GDP in 2007-2009
FTSE 100 GDP
2007Q1 6.116 345.283
2007Q2 6.666 349.523
2007Q3 6.315 352.830
2007Q4 6.441 357.209
2008Q1 5.816 362.002
2008Q2 6.012 363.264
2008Q3 5.503 361.466
2008Q4 4.087 358.848
2009Q1 3.638 349.356
2009Q2 4.477 344.583
2009Q3 4.820 347.413
2009Q4 5.246 351.353
Source: GDP in UK since 1984 and London Stock Exchange Prices
As calculated on the basis of the data above, the rank correlation coefficient is
0.206762739, which means that the correlation is rather vague. Both of the variables
reached their highest and lowest values at different points in time. FTSE 100 was most
valuable in the second quarter of 2007, whereas GDP was the highest just before the
Credit Crunch – in the second quarter of 2008. On the other hand, the lowest values
were close to each other yet there was a three-month difference between them. The
index hit its lowest rate in the first quarter of 2009 and GDP a quarter later, yet both
were the lowest during the recession.
The delay between the lowest and highest points might be caused by the fact that
market cycle is always ahead of economic cycle, as Artis states [1999]. Another reason
may be the fact that FTSE indices are updated on daily basis and GDP is calculated
quarterly, as Sharp states [1999, p. 13].

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