Introduction to investment environment.pptx

An investment is the current
commitment of money or other
resources in the expectation of
reaping future benefits.

Real Assets Versus Financial
Assets
• Material wealth of an economy is determined by production capacity of goods and services, which in turn is
determined by the real assets of the economy, such as land, building, machines and knowledge.
• In comparison to real assets, financial assets such as stock and bonds are no more than sheets of paper (or many
a times mere computer entries) and do not directly contribute to the productive capacity.
• Financial assets are the means by which individuals in well-developed economies hold their claim on real assets.
• Investors are always confronted with two situations, i.e. current consumption or save for later use. If they choose
to save, they may place their wealth in financial assets by purchasing various securities.
• The firms or government at large use this saved money by selling financial securities to investors to buy real
assets.
• Financial assets can be broadly divided into three categories – fixed income, equity and derivatives.

Functions of
Financial Markets
a. Saving
b. Borrowing
c. Raising equity capital
d. Managing risks
e. Exchanging assets for
immediate delivery
f. Information-motivated trading

Structure of Financial Markets
Financial
Markets
Capital Markets
Equity
Primary Secondary
Derivative
Debt
Primary Secondary
Money Markets
Investment
Markets
Traditional
Investment
markets
Alternative
Investment
Markets

Money Markets
• Money market consists of very short-term debt
securities that usually are highly marketable.
Major components of Money Market are:
a) Treasury Bills
b) Certificate of Deposits
c) Commercial Paper
d) Eurodollar
e) Repos & Reverse Repos
f) Interbank lending/borrowing market

Debt or Bond Market
Instruments (Capital
Market)
• Th bond market is composed of longer term borrowing or debt
instruments than those that trade in the money market.
• This market includes
a) Treasury Notes & Bonds
b) Corporate Bonds
c) Municipal Bonds
d) Mortgage securities
e) Inflation Protected Securities
f) International Bonds
g) Government Agency Debt(i.e. issued by government agencies
such as Fannie Mae, Ginnie Mae and Freddie Mac)

Equity Market Instruments (Capital Markets)
Common stock or
Equities
Preferred Stock
Depository
Receipts
Warrants
Pooled Investment
Vehicles

Equity Market Instruments (Capital Markets)
Common Stock is a residual claim on
firm’s assets. Common stock
dividends are paid only after interest
is paid to debtholders and dividends
are paid to preferred stockholders.
Preferred Stock is an equity security
with scheduled dividends that
typically do not change over the
security’s life and must be paid
before any dividends on common
stock may be paid.
Warrants are similar to options in
that they give the holder the right to
buy a firm’s equity shares at a fixed
exercise price prior to the warrant’s
expiration.
A Depository Receipt is a type of
negotiable (transferable) financial
security traded on a local stock
exchange but represents a security,
usually in the form of equity, issued
by a foreign, publicly-listed
company.
Pooled Investment Vehicle include
mutual funds, exchange traded
funds and hedge funds. It refers to
structures that combine the funds of
many investors in a portfolio of
investments.

Traditional v/s Alternative Investment Markets
Traditional Markets - include all
publicly traded debts and equities
and share sin pooled investment
vehicles.
Alternative Investments include
hedge funds, private equities,
commodities, real estate,
securitized debt, operating leases,
collectibles and precious gems.

Financial Intermediaries
• Financial intermediaries stand between buyers
and sellers, facilitating the exchange of assets,
capital and risk.
• Their services allow for greater efficiency and
are vital to a well-functioning economy.
• Financial intermediaries include brokers and
exchanges, dealers, securitizers, depository
institutions, insurance companies, arbitrageurs
and clearing house.

Investor Positions in an asset
• Long Position – an investor who owns an asset or has the right or
obligation under a contract to purchase an asset is said to have a long
position.
• Short Position – the party to a contract who must sell or deliver an
asset in the future is also said to have a short position.
• Short selling/sales – the short seller (1) simultaneously borrows and
sells securities through a broker, (2) must return the securities at the
request of the lender or when the short sale is closed out and (3)
must keep a portion of the proceeds of the short sale on deposit with
the broker.
• Leveraged Positions – the use of borrowed funds to purchase an
asset results in a leveraged position. Investors who use leverage to
buy securities by borrowing from their brokers are said to buy on
margin and the borrowed funds are referred to as ‘margin loan’.

Example 1: Short Selling
You short-sell 200 shares of Tuckerton Trading Co.,
now selling for $50 per share. What is your
maximum possible loss?
A. $50
B. $150
C. $10,000
D. Unlimited

Example 1: Short
Selling
You short-sell 200 shares of Tuckerton Trading Co., now
selling for $50 per share. What is your maximum possible
loss?
A. $50
B. $150
C. $10,000
D. Unlimited
Solution: There is no upper limit to the price of a share of
stock and, therefore, no upper limit to the price you will
have to pay to replace the 200 shares of Tuckerton.

You short-sell 200 shares of Tuckerton Trading Co., now
selling for $50 per share. What is your maximum possible
gain, ignoring transactions cost?
A. $50
B. $150
C. $10,000
D. Unlimited

You short-sell 200 shares of Tuckerton Trading Co., now selling for $50 per share. What
is your maximum possible gain, ignoring transactions cost?
A. $50
B. $150
C. $10,000
D. Unlimited
Solution: Tuckerton could go bankrupt, with a share price of $0. You could keep the
entire proceeds from the short sale.
Maximum gain = Proceeds – Minimum Possible replacement cost
=200*$50 – 200*$0
=$10,000

Type of
orders
Market
Order
A market order instructs the broker to execute the trade immediately at the best
possible price.
This order is often appropriate when the trader wants to execute quickly, as when the
trader has information he/she believes is not reflected in market prices.
Limit
Order
A limit order places a minimum execution price on sell orders and a maximum
execution price on buy orders.
To avoid price execution uncertainty, a trader can place a limit order instead of market
order.
The disadvantage of the limit order is that it might not be filled.
For example, a buy order with a limit of $6 will be executed immediately as long as
the shares can be purchased for $6 or less.
Stop
Loss
Orders
Stop loss orders are those that are not executed unless the stop price has been met
and are often used to prevent losses or protect profits
For example, if the current price of an asset is 1.2567, a trader might place a buy stop
order with a price of 1.2572. If the market trades at 1.2572 or above, the trader's stop
order will be processed as a market order, and will then get filled at the current best
price.

Example 3: Bid-Ask Spread
You find that the bid and ask prices for a stock are
$10.25 and $10.30, respectively. If you purchase or sell
the stock, you must pay a flat commission of $25. If you
buy 100 shares of the stock and immediately sell them,
what is your total implied and actual transaction cost in
dollars?
A. $50
B. $25
C. $30
D. $55

Example: Bid-Ask Spread
You find that the bid and ask prices for a stock are $10.25 and $10.30, respectively.
If you purchase or sell the stock, you must pay a flat commission of $25. If you buy
100 shares of the stock and immediately sell them, what is your total implied and
actual transaction cost in dollars?
A. $50
B. $25
C. $30
D. $55
Solution: 100(10.30 - 10.25) + 2(25) = $55
Note: Impact Cost:
https://www1.nseindia.com/products/content/equities/indices/impact_cost.htm

Example: Bid-Ask
Spread
• On a given day a stock dealer maintains a bid price
of $1,000.50 for a bond and an ask price of
$1003.25. The dealer made 10 trades that totaled
500 bonds traded that day. What was the dealer's
gross trading profit/loss for this security?
A. $1375
B. $500
C. $275
D. $1450

Example: Bid-Ask Spread
The dealers’ gross trading profit for the given security is calculated as:
(1,003.25 - 1,000.50)500 = $1,375

Example: Limit/Stop-
Loss Order
You purchased XYZ stock at $50 per share. The stock
is currently selling at $65. Your gains could be
protected by placing a _________.
A. Limit buy order
B. Limit sell order
C. Market order
D. Stop-loss order

Example: Limit/Stop-Loss Order
You purchased XYZ stock at $50 per share. The stock is currently selling
at $65. Your gains could be protected by placing a Stop-loss order .
A. Limit buy order
B. Limit sell order
C. Market order
D. Stop-loss order

Consider the following limit order book of a specialist. The last trade in the stock occurred at a price
of $40. If a market buy order for 100 shares comes in, at what price will it be filled?
A. $ 39.75
B. $40.25
C. $40.375
D. $40.25 or less
Limit Buy Orders Limit Sell Orders
Price Shares Price Shares
$39.75 100 $40.25 100
$39.50 100 $40.50 100

In this case the specialist would have the option of matching the buy
order with the lowest limit sell order ($40.25) or setting an ask price
lower than $40.25 ($40 for example) and trading the order from her
own stock.

You short-sell 200 shares of Rock Creek Fly Fishing Co., now selling for
$50 per share. If you want to limit your loss to $2,500, you should place
a stop-buy order at ____.
A. $37.50
B. $62.50
C. $56.25
D. $59.75

You short-sell 200 shares of Rock Creek Fly Fishing Co., now selling for
$50 per share. If you want to limit your loss to $2,500, you should place
a stop-buy order at ____.
A. $37.50
B. $62.50
C. $56.25
D. $59.75
Solution: Amount received from short sale = 200 × $50 = $10,000
Loss = $2,500 = 200P - 10,000
$12,500 = 200P, so P = $62.50

Buying on margin
• When purchasing securities, investors have easy access to a source of debt
financing called ‘broker’s call loans’. The act of taking advantage of broker’s call
loans is called buying on margin.
• The ‘margin’ in the account is the portion of the purchase price contributed by
the investor; the remainder is borrowed from the broker.
• The brokers in turn borrow money from banks at the call money rate to finance
these purchases.
• To guard against fall in value of equity (or fall in value of the collateral) the broker
sets a maintenance margin.
• If the percentage margin falls below the maintenance level, the broker will issue a
margin call, which requires the investor to add new cash or securities to the
margin account.
• If the investor does not act, the broker may sell securities from the account to pay
off enough of the loan to restore the percentage margin to an acceptable level.

Example: Margin Trading
• Suppose an investor initially pays $6000 toward the purchase of
$10,000 worth of stock (100 shares at $100 per share), borrowing the
remaining $4000 from a broker. The initial balance sheet looks like
this:
• The initial percentage margin is:
𝑀𝑎𝑟𝑔𝑖𝑛 =
𝐸𝑞𝑢𝑖𝑡𝑦 𝑖𝑛 𝑎𝑐𝑐𝑜𝑢𝑛𝑡
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘
=
$6000
$10,000
= 0.60 𝑜𝑟 60%
ASSETS LIABILITIES & OWNERS’ EQUITY
Value of Stock $10,000 Loan from broker $4000
Equity $6000

• If the price declines to $70 per share, the account balance becomes:
• The asset in the account fall by the full decrease in the stock value, as
does the equity. The percentage margin is calculated as:
𝑀𝑎𝑟𝑔𝑖𝑛 =
𝐸𝑞𝑢𝑖𝑡𝑦 𝑖𝑛 𝑎𝑐𝑐𝑜𝑢𝑛𝑡
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘
=
$3000
$7000
= 0.43 𝑜𝑟 43%
ASSETS LIABILITIES & OWNERS’ EQUITY
Value of Stock $7000 Loan from broker $4000
Equity $3000

• In the previous example, if the stock value were to fall below $4000,
owners’ equity would become negative, meaning the value of the
stock is longer sufficient collateral to cover the loan from the broker.
• To guard against this possibility, the broker sets a ‘maintenance
margin’. If the percentage margin falls below the maintenance level,
the broker will issue a ‘margin call’, which requires the investor to add
new cash or securities to the margin account.
• If the investor does not act, the broker may sell securities from the
account to pay off enough of the loan to restore the percentage
margin to an acceptable level.

Continuing with the previous example, suppose the
maintenance margin is 30%. How far could the stock price fall
before the investor would get a margin call?

Let P be the price of the stock. The value of the investor’s 100 shares is
then 100P, and the equity in the account is 100P-$4000.
The percentage margin is (100P-$4000)/100P.
Now, the price at which the percentage margin equals the maintenance
margin of 0.3 is found by solving the following equation:
100𝑃 − 4000
100𝑃
= 0.3
Which implies that P=$57.14. If the price of the stock were to fall below
$57.14 per share, the investor would get a margin call.

Buying on margin – Key ratios
• Percentage Margin = equity in account/value of asset
• Leverage ratio = value of asset/value of equity position
• Margin Call Price =
(1−𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑚𝑎𝑟𝑔𝑖𝑛)
(1−𝑚𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 𝑚𝑎𝑟𝑔𝑖𝑛)
* 𝑃0
(Margin call price is the stock price which results in a margin call)

Example: Margin Call Price
• If an investor purchases a stock for $40 per share with an
initial margin requirement of 50% and the maintenance
margin requirement is 25%, at what price will the investor
get a margin call ?

Example: Margin Call Price
• Answer:
• Margin Call Price =
* 𝑃0
(Margin call price is the stock price which results in a margin call)
•
$40(1−0.50)
(1−0.25)
= $26.67
• A margin call is triggered at a price below $26.67

Example: Margins in Short Selling
• Suppose you are bearish on Dot Bomb stock and its market price is
$100 per share. You tell your broker to short sell 1000 shares and the
broker borrows 1000 shares either from another customer’s account
or form another broker. The $100,000 cash proceeds are credited to
your account and the broker requires you to maintain an initial
margin of 50% and maintenance margin of 30% on short sales. How
much can the price of Dot Bomb stock rise before you get a margin
call ?

Example: Margins in Short Selling
Method 1: Percentage margin = Equity/Value of Stock Owned
0.30 = $150,000 – 1000P/1000P
P= $115.38 per share
Method 2: Margin Call Price =
(1+𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑚𝑎𝑟𝑔𝑖𝑛)
(1+𝑚𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 𝑚𝑎𝑟𝑔𝑖𝑛)
* 𝑃0
Margin Call Price = (1+ 0.50)/(1+ 0.30)*100 = $115.38 per share

Example: Calculating Return on Margin Trading
• Suppose an investor is bullish on IBM stock, which is selling for $100
per share. An investor with $10,000 to invest expects IBM to go up in
price by 30% during the next year. Ignoring any dividends, the
expected rate of return would be 30% if the investor invested $10,000
to buy 100 shares. Further assume, that the investor borrows another
$10,000 from the broker and invests it in IBM too. The total
investment in IBM would be $20,000 (for 200 shares). Assuming an
interest rate on the margin loan of 9% per year, what will be the
investor’s rate of return if the IBM stock goes up 30% by year’s end?
• Also, calculate the expected rate of return if stock goes down by 30%.

• The 200 shares will be worth $26000.Paying off $10,900 of principal and interest
on the margin loan leaves $15,100 (i.e. $26000-$10,900).The rate of return in this
case will be:
$15,100 − $10,000
$10,000
= 51%
The investor has parlayed a 30% rise in the stock’s price into a 51% rate of return on
the $10,000 investment.
• If the stock goes down by 30%, then the IBM stock is worth $70 per share. Thus,
the value of 200 shares will be $14000 and the investor is left with $3100 after
paying off the $10,900 of principal and interest on the loan. The rate of return in
this case will be:
$3100 − $10,000
$10,000
= −69%

Pay-off Matrix for Buying IBM Stock on Margin
Change in stock price End-of-Year Value of
Shares
Repayment of
Principal & Interest
Investor’s Rate of
Return
30% increase $26,000 $10,900 51%
No Change $20,000 $10,900 -9%
30% decrease $14,000 $10,900 -69%

Practice Questions
Q1. You sold short 300 shares of common stock at $30 per share. The initial
margin is 50%. You must put up _________as initial margin.
Q2. You purchased 250 shares of common stock on margin for $25 per share. The
initial margin is 65%, and the stock pays no dividend. Your rate of return would
be __________ if you sell the stock at $32 per share. Ignore interest on margin.
Q3. An investor puts up $5,000 but borrows an equal amount of money from his
broker to double the amount invested to $10,000. The broker charges 7% on the
loan. The stock was originally purchased at $25 per share, and in 1 year the
investor sells the stock for $28. The investor's rate of return was ____.

Practice Questions
Q4. You are bullish on Telecom stock. The current market price is
$50per share and you have $5000 of your own to invest. You borrow an
additional $5000 from your broker at an interest rate of 8% per year
and invest $10,000 in the stock.
a) What will be your rate of return if the price of Telecom stock goes
up by 10% during the next year? The stock currently pays no
dividend.
b) How far does the price of Telecom stock have to fall for you to get a
margin call if the maintenance margin is 30%? Assume the price fall
happens immediately.

Practice Questions
Solution to Q1:
Investment = 300(30)(.50) = 4,500
Solution to Q2:
Rate of Return =
32−25
25(0.65)
0.43 𝑜𝑟 43%
Solution to Q3:
Rate of Return =
28∗400−(0.07∗5000+5000) −5000
5000
= 0.17 𝑜𝑟 17%

Practice Questions
Solution to Q4:
a. Shares bought: 200
Value change: $1000
Interest Payment: $400
Rate of Return: $1000-$400/$5000 = 0.12 or 12%
b. Margin Call Price =
* 𝑃0
Margin Call Price = (1- 0.50)/(1- 0.30)*50 = $35.71 per share

Concept of Stock Market Index & Its
Construction
• A security market index is used to represent the performance of an asset class,
security market or segment of a market.
• They are usually created as portfolios of individual securities, which are referred
to as the ‘constituent securities’ of the index.
• An index has a numerical value that is calculated from the market prices of its
constituent securities at a point in time.
• An index return may be calculated using a ‘price index’ or a ‘return index’.
• A ‘price index’ uses only the prices of the constituent securities in the return
calculation.
• A ‘return index’ includes both price and income from the constituent securities.
• For indices available on National Stock Exchange
https://www1.nseindia.com/products/content/equities/indices/indices.htm

Key Considerations Involved in Index Construction
A. What is the target market the index is intended to measure ?
B. Which securities from the target market should be included ?
C. How should the securities be weighted in the index ?
D. How often should the index be rebalanced ?
E. When should the selection and weighting of securities be re-
examined ?

Calculation of Price Index
• Price return index only reflects the prices of the constituent securities within the index.
• Value of price return index is calculated as:
𝑉
𝑃𝑅𝐼= 𝐼=1
𝑛
𝑛𝑖𝑃𝑖
𝐷
𝑉𝑃𝑅𝐼 𝑖𝑠 𝑡ℎ𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 𝑖𝑛𝑑𝑒𝑥
𝑛𝑖 the number of units of constituent security held in the index portfolio
N= the number of constituent securities in the index
𝑃𝑖 𝑡ℎ𝑒 𝑢𝑛𝑖𝑡 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑐𝑜𝑛𝑠𝑡𝑖𝑡𝑢𝑒𝑛𝑡 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦 𝑖
D= the value of the divisor
• The divisor is a number initially chosen at inception. It is frequently chosen to that the price index has a
convenient initial value such as 1000.
• The index provider then adjusts the value of the divisor as necessary to avoid changes in the index value that
are unrelated to changes in the prices of its constituent securities.

Calculation of Price Return
• For a security market index, price return can be calculated in two ways:
either the percentage change in value of the price return index or weighted
average of price returns of the constituent securities. The price return of an
index can be expressed as:
𝑃𝑅𝐼 =
𝑉𝑃𝑅𝐼1 − 𝑉𝑃𝑅𝐼0
𝑉𝑃𝑅𝐼0
Where, 𝑃𝑅𝐼 𝑖𝑠 𝑡ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑡ℎ𝑒 𝑖𝑛𝑑𝑒𝑥 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜.
𝑉𝑃𝑅𝐼1 = 𝑡ℎ𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 𝑖𝑛𝑑𝑒𝑥 𝑎𝑡 𝑡ℎ𝑒 𝑒𝑛𝑑 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑
𝑉𝑃𝑅𝐼0
= 𝑡ℎ𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 𝑖𝑛𝑑𝑒𝑥 𝑎𝑡 𝑡ℎ𝑒 𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑

Calculation of Price Return
• Price return can also be calculated as the weighted average Of price
returns of individual securities:
𝑃𝑅𝐼 = 𝑤1𝑃𝑅2 + 𝑤2𝑃𝑅2 + ⋯ … … + 𝑤𝑁𝑃𝑅𝑁
𝑃𝑅𝐼 = the price return of index portfolio𝑃𝑅𝑖 =
𝑡ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑐𝑜𝑛𝑠𝑡𝑖𝑡𝑢𝑒𝑛𝑡 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦 𝑖
𝑤𝑖= the weight of the security I
N= the number of securities in the index

Total Return Index
• Total Return of an index is the price appreciation or change in the value of the price
return index plus income over the period, expressed as a percentage of the beginning
value of the price return index.
𝑇𝑅𝐼 =
𝑉𝑃𝑅𝐼1−𝑉𝑃𝑅𝐼0+𝐼𝑛𝑐𝑜𝑚𝑒𝐼
𝑉𝑃𝑅𝐼0
𝑇𝑅𝐼 𝑖𝑠 𝑡ℎ𝑒 𝑡𝑜𝑡𝑎𝑙 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑡ℎ𝑒 𝑖𝑛𝑑𝑒𝑥 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
𝑉𝑃𝑅𝐼1 𝑖𝑠 𝑡ℎ𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 𝑟𝑒𝑡𝑢𝑛 𝑖𝑛𝑑𝑒𝑥 𝑎𝑡 𝑡𝑒ℎ 𝑒𝑛𝑑 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑
𝑉𝑃𝑅𝐼0 𝑖𝑠 𝑡ℎ𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 𝑖𝑛𝑑𝑒𝑥 𝑎𝑡 𝑡ℎ𝑒 𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑
𝐼𝑛𝑐𝐼 𝑖𝑠 𝑡ℎ𝑒 𝑡𝑜𝑡𝑎𝑙 𝑖𝑛𝑐𝑜𝑚𝑒 𝑓𝑟𝑜𝑚 𝑎𝑙𝑙 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠 𝑖𝑛 𝑡𝑒ℎ 𝑖𝑛𝑑𝑒𝑥 ℎ𝑒𝑙𝑑 𝑜𝑣𝑒𝑟 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑.

Types of Security Index
SECURITY
INDEX
Price Weighted
Index
Price Return Total Return
Equal Weighted
Index
Market
Capitalization
Weighted Index
Fundamental
Weighted Index
Steps to Calculate:
1. Calculate the average of prices
2. Calculate the percentage
increase/decrease in average
prices
Steps to Calculate:
1. Calculate the percentage return
on each stock
2. Calculate the average of
percentage return
Steps to Calculate:
1. Calculate the market capitalization*
at the beginning and end of the
period
2. Determine the percentage
increase/decrease

Concept of Market Capitalization & Free Float
Market Capitalization
• Market capitalization is the total dollar value of all outstanding shares of a
company.
• It is computed by multiplying current market price of a share by the total
number of outstanding shares.
• It is commonly referred to as "market cap," where “cap” represents
capitalization - a financial term used for indicating the size of the company.
• Market cap is used to size up corporations and understand their aggregate
market value.
• Companies may be categorized as large-, mid-, or small-cap.
• Blue chip companies are large-cap or mega-cap stocks, while the very
smallest are mico-caps.

Concept of Market Capitalization & Free Float
Market Capitalization
• Free-float market capitalization takes into consideration only those equity shares issued by the
company that are readily available for trading in the market.
• The goal to calculate Free Float is to distinguish between strategic (control) shareholders, and those
holders whose investments depend on the stock's price and their evaluation of a company's future
prospects.
• Free float market capitalization is used for the computation of indices.
• While calculating free-float market capitalization the following categories of shareholdings are generally excluded:
• Shares held by founders/directors/acquirers which have control element
• Shares held by persons/ bodies with "Controlling Interest"
• Shares held by the Government(s) as promoters/acquirers
• Holdings through the FDI route
• Strategic stakes by private corporate bodies/ individuals
• Equity held by associate/group companies (cross-holdings)
• Equity held by Employee Welfare Trusts
• Locked-in shares and shares which would not be sold in the open market in normal course

Concept of Market Capitalization & Free Float Market
Capitalization
• Free-float factor is a multiple with which the total market capitalization of a company is adjusted to
arrive at the Free-float market capitalization.
• A Free-float factor of say 0.55 means that only 55% of the market capitalization of the company will
be considered for calculation.
No. of Shares %
Total Equity Shares 2,50,00,000 100
For example:
Category No. of Shares %
Promoter and Promoter Group 1,20,00,000 48.00
Promoter Depository Receipts
(DR)
10,000 0.04
Public Shareholders Locked in 75,000 0.30
Strategic holding 25,000 0.10
Total 48.44
Free Float Factor in the above case is (100-48.44)/100 = 0.51

Index Construction Methods
•It is simply the arithmetic average of the prices of the securities included in the index.
•The divisor of a price-weighted index is adjusted for stock splits and changes in the composition of the index when securities are added or
deleted.
•Advantage : Simple computation ; Disadvantage: higher priced stocks have more weight in the calculation of index.
Price-Weighted Index
•Weights are based on the market capitalization of each index stock as a proportion of the total market capitalization of all the stocks in the
index.
•The index does not need to be adjusted when a stock splits or pays a stock dividend.
•Float-adjusted market capitalization index uses only those shares that are actually available to the investing public and excludes the value od
shares held by promoters, government, or any other controlling stockholder.
Market-Capitalization
Weighted Index
•Equal-weighted index is calculated as the arithmetic average return of the index stocks and, for a given time period would be matched by the
returns on a portfolio that has equal dollar amounts invested in each index stock.
Equal-weighted Index
•A fundamentally weighted index is constructed by calculating the economic size of each company within the index's universe, based on such
factors as: revenues; cash flow; book value; and dividends.
•The index is then weighted to reflect the relative economic size of each stock to the overall universe.
•Since fundamental rankings between companies are based upon sales, book value and other measures of economic size that change relatively
slowly, the index can be managed through ETFs or mutual funds on a relatively tax efficient basis.
•The index does not use relative or absolute value to determine company weights in the index.
Fundamental
Weighted Index

Market Capitalization Weighted Index

Example: Calculation of Price Return
Securities in the Index Opening Price Closing Price Number of Shares
A 100 130 100
B 500 600 100
C 1000 800 200
You are required to calculate the price return assuming the weights in the index are calculated according to:
a. Price weighted index
b. Equal weighted index
c. Market capitalization index

A 100 130 100
B 500 600 100
C 1000 800 200
1. Price Weighted Index
Step 1: Calculate the average of opening &
closing prices:
100 + 500 + 1000
3
=
1600
3
= 533.33
130 + 600 + 800
3
=
1530
3
= 510
Step 2: Calculate the % increase/decrease
return
510 − 533.33
533.33
= −4.37%
2. Equal Weighted Index
Step 1: Calculate the % increase or decrease in
prices between two periods
A =
130−100
100
=
30
100
= +30%
B =
600−500
500
=
100
500
= +20%
C =
800−1000
1000
=
−200
1000
= −20%
Step 2: Take the average of %
increase/decrease in return calculated in step
1
30% + 20% − 20%
3
= 10%

A 100 130 100
B 500 600 100
C 1000 800 200
3. Market Capitalization Index
Step 1: Calculate the Market Capitalization of the beginning and closing price
Step 2: Calculate the % change in market cap
% change =
2,33,000 −2,60,000
2,60,000
= −10.30%
Securities in the Index Market Cap @ Opening Market Cap @ Closing
A 10,000 13,000
B 50,000 60,000
C 2,00,000 1,60,000
Total 2,60,000 2,33,000

Example: Calculation of Total Return
• Suppose an index comprises of three securities – A,B and C. Their prices at the beginning and
closing and number of traded shares are presented below
Securities Opening Price Closing Price Dividends at the
end of the period
No. of shares
traded
A 100 120 5 100
B 200 250 10 100
C 1000 750 50 10
You are required to calculate price return and total return using:
i. Price weighted index
ii. Equal weighted index
iii. Market Capitalization weighted index

end of the period
No. of shares
traded
A 100 120 5 100
B 200 250 10 100
C 1000 750 50 10
Calculation of Price Return using Price
Weighted Index:
Step 1: Take average of opening & closing
prices
100 + 200 + 1000
3
=
1300
3
= 433.33
120 + 250 + 750
3
=
1120
3
= 373.33
Step 2: Calculate the % increase/decrease in
average prices
373.33 − 433.33
433.33
= −13.82%
Calculation of Total Return using Price
Weighted Index:
Step 1: Take average of opening & closing
prices
100 + 200 + 1000
3
=
1300
3
= 433.33
125+260+800
3
=
1185
3
= 395
Step 2: Calculate the % increase/decrease in
average prices
395 − 433.33
433.33
= −8.845%

end of the period
No. of shares
traded
A 100 120 5 100
B 200 250 10 100
C 1000 750 50 10
Calculation of Price Return using Equal
Weighted Index:
Step 1: Calculate % increase/decrease in
prices
A =
120−100
100
=
20
100
= +20%
B =
250−200
200
=
50
200
= +25%
C =
750−1000
1000
=
−250
1000
= −25%
Step 2: Calculate the average of %
increase/decrease as calculated in Step 1
20% + 25% − 25%
3
= 6.67%
Calculation of Total Return using Equal
Weighted Index:
Step 1: Calculate % increase/decrease in
prices
A =
125−100
100
=
25
100
= +25%
B =
260−200
200
=
60
200
= +30%
C =
800−1000
1000
=
−200
1000
= −20%
Step 2: Calculate the average of %
increase/decrease as calculated in Step 1
25% + 30% − 20%
3
= 11.67%

end of the period
No. of shares
traded
A 100 120 5 100
B 200 250 10 100
C 1000 750 50 10
Calculation of Price Return using Market Cap Weighted
Index:
Step 1: Calculate opening & closing market capitalization
44,500 − 40,000
40,000
= 11.25%
Calculation of Total Return using Market Cap Weighted
Index:
Step 1: Calculate opening & closing market capitalization
44,500 + 2000 − 40,000
40,000
= 16.25%
Securities Opening Market
Cap
Closing Market
Cap
A 10,000 12,000
B 20,000 25,000
C 10,000 7500
Total 40,000 44,500
Securities Op.Mkt Cap Cl.Mkt Cap Dividends
A 10,000 12,000 500
B 20,000 25,000 1000
C 10,000 7500 500
Total 40,000 44,500 2000

Impact of stock split on price return index
• A property unique to price-weighted indexes is that a stock split on
one constituent security changes the weights on all the securities in
the index.1
• To prevent the stock split and the resulting new weights from
changing the value of the index, the index provider must adjust the
value of the divisor

Impact of stock split
on price return
index
Given a 2-for-1 split in Security A, the divisor is adjusted by
dividing the sum of the constituent prices after the split
(77.50) by the value of the index before the split (21.00). This
adjustment results in changing the divisor from 5 to 3.69 so
that the index value is maintained at 21.00.

Example: Price-weighted Index Model
• Given the information for the three stocks presented in the following
figure, calculate a price-weighted index return over a 1-month period.
Index Firm Data
Share price
December 31, 2016
Share price
January 31, 2017
Stock X $10 $20
Stock Y $20 $15
Stock Z $60 $40

Example: Price-weighted Index Model
• Answer:
The price-weighted index is (10+20+60)/3 = 30 as on December 30,
2016 and (20+15+40)/3 = 25 as on January 31, 2017.
Hence, the price-weighted 1-month percentage return is :
25/30-1 = -16.7%

Example: Adjusting a price weighted index for stock splits
At the market close on day 1, stock A had a price of $10, stock B had a
price of $20 and stock C had a price of $90. The value of a price-
weighted index of these three stocks is (10+20+90)/3 = 40 at the close
of trading ?
If stock C splits 2-for-1, effective on day 2, what is the new
denominator for the index?

Example: Adjusting a price weighted index for stock splits
Answer:
The effect of the split on the price of Stock C, in the absence of any
change form the price at the end of day 1, would be to reduce it to
$90/2= $45.
The index denominator will be adjusted so that the index value would
remain at 40 if there were no changes in the stock prices other than to
adjust for the split.
The new denominator, ‘d’, must satisfy (10+20+45)/d =40 and equals
1.875.

Example – Market Capitalization Index
If the total market value of the index portfolio on December 31 and
January 31 are $80 million and $95 million respectively, the index value
at the end of January is (assuming base year index value is 100):
Current Index Value =
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑡𝑜𝑡𝑎𝑙 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑖𝑛𝑑𝑒𝑥 𝑠𝑡𝑜𝑐𝑘𝑠
𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑡𝑜𝑡𝑎𝑙 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑖𝑛𝑑𝑒𝑥 𝑠𝑡𝑜𝑐𝑘𝑠
*base year index value
Current index value =
$95 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
$80 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
∗ 100 = 118.75

Rebalancing & Reconstitution of Index
• Rebalancing refers to adjusting the weights of securities in a portfolio to
their target weights after price changes have affected the weights.
• For index calculations, rebalancing to target weights on the index securities
is done on a periodic basis, usually quarterly or semi-annually.
• Index reconstitution refers to periodically adding and deleting securities
that make up an index. Securities are deleted if they no longer meet the
index criteria and are replaced by other securities.
• When a security is added to an index, its price tends to rise as portfolio
managers seeking to track that index in a portfolio buy the security.
• The prices of deleted securities tend to fall as portfolio managers sell them.

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