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Chapter 7


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Chapter 7

  2. 2. Chapter 7 Questions <ul><li>What are some major uses of security-market indicator series (indexes)? </li></ul><ul><li>What are the major characteristics that cause alternative indexes to differ? </li></ul><ul><li>What are the major stock-market indexes in the United States and globally, and what are their characteristics? </li></ul><ul><li>What are the major bond-market indexes for the United States and the world? </li></ul>
  3. 3. Chapter 7 Questions <ul><li>Why are bond indexes more difficult to create and maintain than stock indexes? </li></ul><ul><li>What are some of the composite stock-bond market indexes? </li></ul><ul><li>Where can you get historical and current data for all these indexes? </li></ul><ul><li>What is the relationship among many of these indexes in the short-run (monthly)? </li></ul>
  4. 4. What is an indicator series? <ul><li>It is an index that answers the question: What happened in the market today? </li></ul>
  5. 5. Uses of Security-Market Indexes <ul><li>For calculating benchmark returns to judge portfolio performance </li></ul><ul><li>For development of an index portfolio </li></ul><ul><li>For examining factors that influence aggregate security price movements </li></ul><ul><li>For technical analysis, to predict future price movements </li></ul><ul><li>To compute a security’s systematic risk by examining how its return responds to changes in the market index </li></ul>
  6. 6. Factors in Constructing Market Indexes <ul><li>The sample of firms to include </li></ul><ul><ul><li>What is the intended population that the sample is to represent? How large a sample is needed for the index to be representative? </li></ul></ul><ul><li>Weighting system for sample members </li></ul><ul><ul><li>Should the weighting system be based on price, total firm value, or equally weighted? </li></ul></ul><ul><li>Computational procedure </li></ul><ul><ul><li>How should the values of the index be reported and tracked (arithmetic or geometric mean)? </li></ul></ul>
  7. 7. Stock-Market Indicator Series <ul><li>Price-Weighted Series </li></ul><ul><ul><li>Dow Jones Industrial Average (DJIA) </li></ul></ul><ul><li>Value-Weighted Series </li></ul><ul><ul><li>NYSE Composite </li></ul></ul><ul><ul><li>S&P 500 Index </li></ul></ul><ul><ul><li>Russell Indexes </li></ul></ul><ul><ul><li>Willshire 5000 Index </li></ul></ul><ul><li>Equal-Weighted Series </li></ul><ul><ul><li>Value Line Averages </li></ul></ul>
  8. 8. Dow Jones Industrial Average (DJIA) <ul><li>Best-known, oldest, most popular index </li></ul><ul><li>Price-weighted average of thirty large well-known industrial stocks, leaders in their industry, and listed on NYSE </li></ul><ul><li>Total the current price of the 30 stocks and divide by a divisor </li></ul><ul><ul><li>Original divisor was 30 </li></ul></ul><ul><ul><li>Divisor now adjusted for stock splits and changes in the sample, so now much smaller (about 0.1445 in March 2002) </li></ul></ul>
  9. 9. Criticism of the DJIA <ul><li>Sample used is limited </li></ul><ul><ul><li>30 non-randomly selected blue-chip stocks are not representative of the 1800 NYSE listed stocks </li></ul></ul><ul><li>Price-weighted series </li></ul><ul><ul><li>Similar to assuming an investment of one share per stock </li></ul></ul><ul><ul><li>Places more weight on higher-priced stocks rather than those with higher market values </li></ul></ul><ul><ul><li>Introduces a downward bias in DJIA by reducing weight of growing companies whose stock splits </li></ul></ul>
  10. 10. Value-Weighted Series <ul><li>Although the DJIA is the most popular index, the most popular type is value-weighted. </li></ul><ul><li>Derive the initial total market value of all stocks used in the series </li></ul><ul><ul><li>Market Value = Number of Shares Outstanding </li></ul></ul><ul><ul><li>x Current Market Price </li></ul></ul><ul><li>Beginning index value is usually 100, new market values change the value of the index </li></ul><ul><li>Automatic adjustment for splits </li></ul><ul><li>Weighting depends on market value </li></ul>
  11. 11. Value-Weighted Series <ul><li>where: </li></ul><ul><li>Index t = index value on day t </li></ul><ul><li>P t = ending prices for stocks on day t </li></ul><ul><li> Q t = number of outstanding shares on day t </li></ul><ul><li>P b = ending price for stocks on base day </li></ul><ul><li>Q b = number of outstanding shares on base day </li></ul>
  12. 12. Value-Weighted Series <ul><li>Construction similar to assuming investment in proportion to total market value </li></ul><ul><li>Take into account that large market value stocks make up more of the market than do smaller market value stocks </li></ul><ul><ul><li>Large market value stocks dominate the impact on index values over time </li></ul></ul><ul><li>Also these series tend to be more broad than the DJIA </li></ul>
  13. 13. Unweighted Price Indicator Series <ul><li>All stocks carry equal weight regardless of price or market value </li></ul><ul><li>Constructed in a parallel fashion to individuals who select stocks and invest the same dollar amount in each stock </li></ul><ul><li>Changes in the index can be reported either in terms of arithmetic or geometric means </li></ul>
  14. 14. Style Indexes <ul><li>Additional indexes have been created that seek to measure the performance of various investment styles or sectors </li></ul><ul><ul><li>Size indexes track the performance of large-cap, mid-cap, and small cap stocks </li></ul></ul><ul><ul><li>Other indexes track the relative performance of growth and value stocks, perhaps also broken down into sizes </li></ul></ul>
  15. 15. Global Equity Indexes <ul><li>There are stock-market indexes available for most individual foreign markets </li></ul><ul><ul><li>These are closely followed within each country </li></ul></ul><ul><ul><li>These are difficult to compare due to differences in sample selection, weighting, or computation </li></ul></ul><ul><li>In response, some standardized indexes have been developed </li></ul><ul><ul><li>FT/S&P Actuaries World Indexes </li></ul></ul><ul><ul><li>Morgan Stanley Capital International (MSCI) World Indexes </li></ul></ul><ul><ul><li>Dow Jones World Stock Index </li></ul></ul>
  16. 16. FT/S&P-Actuaries World Indexes <ul><li>Track over 2,400 securities in 30 countries </li></ul><ul><li>Covers 70% of the total value of all listed companies in each country </li></ul><ul><li>Securities included must allow direct holdings of shares by foreign nationals </li></ul><ul><li>Index is market-value weighted with a base date of December 31, 1986 = 100 </li></ul><ul><li>Results are calculated daily and published the following day in the Financial Times </li></ul><ul><li>Geographic subgroups are also published </li></ul>
  17. 17. MSCI Indexes <ul><li>Three international, nineteen national, and thirty-eight international industry indexes </li></ul><ul><li>Include 1,375 companies listed on stock exchanges in 19 countries with a combined capitalization representing 60 percent of the aggregate market value of the stock exchanges of these countries </li></ul><ul><li>All the indexes are market-value weighted </li></ul>
  18. 18. Dow Jones World Stock Index <ul><li>Introduced in January 1993 </li></ul><ul><li>Includes 28 countries with a total of 2,200 companies worldwide, organized into 120 industry groups </li></ul><ul><li>Countries are grouped into 3 regions </li></ul><ul><li>Represents over 80% of the combined capitalization of these countries </li></ul>
  19. 19. Comparison of World Stock Indexes <ul><li>Correlations between all of the pairs of broad world indexes are nearly 1.00, indicating that the results with the alternative world stock indexes are quite comparable </li></ul>
  20. 20. Bond-Market Indicator Series <ul><li>Relatively new and not widely published </li></ul><ul><li>Growth in fixed-income mutual funds increase need for reliable benchmarks for evaluating performance </li></ul><ul><li>Increasing interest in bond index funds, which requires an index to emulate </li></ul><ul><ul><li>Many managers have not matched aggregate bond market return </li></ul></ul>
  21. 21. Difficulties in Creating a Bond-Market Index <ul><li>Range of bond quality varies from U.S. Treasury securities to bonds in default </li></ul><ul><li>Bond market changes constantly with new issues, maturities, calls, and sinking funds </li></ul><ul><li>Bond prices are affected differently by changing interest rates dependent on maturity, coupon, and market yield </li></ul><ul><li>Correctly pricing individual bond issues can be a challenge without current and continuous transaction prices available </li></ul>
  22. 22. Bond Market Index Series <ul><li>Investment-Grade Bond Indexes </li></ul><ul><ul><li>Four investment firms maintain indexes for Treasury bonds and other investment grade bonds (rated BBB or higher) </li></ul></ul><ul><ul><li>Relationship among these bonds is strong (correlations average 0.95) </li></ul></ul><ul><li>High-Yield Bond Indexes </li></ul><ul><ul><li>Non investment-grade bonds (rated BB or below) </li></ul></ul><ul><ul><li>Several indexes have been created </li></ul></ul><ul><ul><li>Relationship among alternative high-yield indexes is weaker than among investment grade indexes </li></ul></ul>
  23. 23. Bond Market Index Series <ul><li>Global Government Bond Market Indexes </li></ul><ul><ul><li>Global bond market dominated by government issues </li></ul></ul><ul><ul><li>Several indexes created by major investment firms </li></ul></ul><ul><ul><li>Indexes have similar characteristics </li></ul></ul>
  24. 24. Composite Stock-Bond Indexes <ul><li>Considers the benefits of diversification with asset allocation across stocks and bonds </li></ul><ul><ul><li>Merrill Lynch-Wilshire U.S. Capital Markets Index (ML-WCMI) </li></ul></ul><ul><ul><ul><li>Market-value weighted index measures total return performance of the combined U.S. taxable fixed income and equity markets </li></ul></ul></ul><ul><ul><li>Brinson Partners Global Security Market Index (GSMI) </li></ul></ul><ul><ul><ul><li>Matches a typical U.S. pension fund allocation policy </li></ul></ul></ul><ul><ul><ul><li>Close to the theoretical “market portfolio of risky assets” referred to in CAPM </li></ul></ul></ul>
  25. 25. Comparison of Indexes Over Time <ul><li>Correlations among monthly equity price changes </li></ul><ul><ul><li>Most differences are attributable to sample differences </li></ul></ul><ul><ul><li>High correlations between series based on NYSE firms (about .993) </li></ul></ul><ul><ul><li>Lower correlations between NYSE series and AMEX or Nasdaq series (about .903) </li></ul></ul><ul><ul><li>Correlations between U.S. series and other countries confirm the wisdom of global investing since values are much lower (averaging .627) </li></ul></ul>
  26. 26. Comparison of Indexes Over Time <ul><li>Correlations among monthly bond indexes </li></ul><ul><ul><li>Among investment-grade bonds correlations range from 0.90 to 0.99 </li></ul></ul><ul><ul><li>Low correlation in global returns to U.S. returns (.07 to .29) support global diversification </li></ul></ul>