Chapter 6Chapter 6

SECURITY-MARKET

INDEXES

1.2Investments Chapter 6

Chapter 7 Questions

What are some major uses of security-market indexes? What are the major characteristics that cause various

indexes to differ? What are the major stock-market indexes in the United States

and globally, and what are their characteristics? What are the major bond-market indexes for the United

States and the world? Why are bond indexes more difficult to create and maintain

than stock indexes? What are some of the composite stock-bond market indexes? Where can you get historical and current data for all these

indexes? What is the relationship among many of these indexes in the

short-run (monthly)?

1.3Investments Chapter 6

What is a market index?

An index created as a statistical measure of the performance of an entire market or segment of a market based on a sample of securities form the market or segment of a market.

It is an indicator that answers the question: What happened in the market today?

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Uses of Security-Market Indexes

For calculating benchmark returns to judge portfolio performance

For development of an index portfolio For examining factors that influence aggregate security price

movements For technical analysis, to predict future price movements As a proxy for the market portfolio of risky assets when

calculating the systematic risk of an asset

1.5Investments Chapter 6

Factors in Constructing Market Indexes

The sample of firms to include What is the intended population that the sample is to

represent? How large a sample is needed for the index to be representative?

Weighting system for sample membersShould the weighting system be based on price, total firm

value, or equally weighted? Computational procedure

How should the values of the index be reported and tracked (arithmetic or geometric mean)?

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Stock-Market Indexes

Price-Weighted IndexesDow Jones Industrial Average (DJIA)

Value-Weighted IndexesNYSE CompositeS&P 500 IndexRussell IndexesWillshire 5000 Index

Equal-Weighted IndexesValue Line Averages

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Dow Jones Industrial Average (DJIA)

Best-known, oldest, most popular index Price-weighted average of thirty large well-known industrial

stocks, leaders in their industry, and listed on NYSE Total the current price of the 30 stocks and divide by a

divisor Original divisor was 30Divisor now adjusted for stock splits and changes in the

sample, so now much smaller (about 0.1356 in October 2004)

• exampleOne day Next day

The Divisor will change when A SAMPLE STOCK SPLITS

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Criticism of the DJIA

Sample used is limited30 non-randomly selected blue-chip stocks are not

representative of the 1800 NYSE listed stocks Price-weighted series

Places more weight on higher-priced stocks rather than those with higher market values

Introduces a downward bias in DJIA by reducing weight of growing companies whose stock splits

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Value-Weighted Indexes

Although the DJIA is the most popular index, the most popular type is value-weighted.

Derive the initial total market value of all stocks used in the seriesMarket Value = Number of Shares Outstanding x Current Market Price

Beginning index value is usually 100, new market values change the value of the index

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Value-Weighted Indexes

where:

Indext = index value on day t

Pt = ending prices for stocks on day t

Qt = number of outstanding shares on day t

Pb = ending price for stocks on base day

Qb = number of outstanding shares on base day

ValueIndex BeginningIndex t

bb

tt

QP

QP

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Value-Weighted Indexes

Automatic adjustment for splits Weighting depends on market value Construction similar to assuming investment in proportion to

total market value Take into account that large market value stocks make up

more of the market than do smaller market value stocksLarge market value stocks dominate the impact on

index values over time Also these series tend to be more broad than the DJIA

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Unweighted Price Indexes

All stocks carry equal weight regardless of price or market value

Constructed in a parallel fashion to individuals who select stocks and invest the same dollar amount in each stock

Changes in the index can be reported either in terms of arithmetic or geometric means

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Style Indexes

Additional indexes have been created that seek to measure the performance of various investment styles or sectorsSize indexes track the performance of large-cap, mid-

cap, and small cap stocksOther indexes track the relative performance of growth

and value stocks, perhaps also broken down into sizes

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stats hs300 sfz szy snb porfolio

mean .0030804 .0037214 .0045365 .0010742 .0031718

sd .0175665 .0299458 .0309206 .0407499 .0194515

2005.4.8-2007.9.18

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Global Equity Indexes

There are stock-market indexes available for most individual foreign marketsThese are closely followed within each countryThese are difficult to compare due to differences in sample

selection, weighting, or computation In response, some standardized indexes have been

developedFT/S&P Actuaries World IndexesMorgan Stanley Capital International (MSCI) World IndexesDow Jones World Stock Index

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FT/S&P-Actuaries World Indexes

Track over 2,400 securities in 30 countries Covers 70% of the total value of all listed companies in each

country Securities included must allow direct holdings of shares by

foreign nationals Index is market-value weighted with a base date of December

31, 1986 = 100 Results are calculated daily and published the following day

in the Financial Times Geographic subgroups are also published

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MSCI Indexes

Three international, nineteen national, and thirty-eight international industry indexes

Include 1,673 companies listed on stock exchanges in 19 countries with a combined capitalization representing 60 percent of the aggregate market value of the stock exchanges of these countries

All the indexes are market-value weighted

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Dow Jones World Stock Index

Introduced in January 1993 Includes 28 countries with a total of 2,200

companies worldwide, organized into 120 industry groups

Countries are grouped into 3 regions Represents over 80% of the combined

capitalization of these countries

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Comparison of World Stock Indexes

Correlations between all of the pairs of broad world indexes are nearly 1.00, indicating that the results with the alternative world stock indexes are quite comparable

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Bond-Market Indexes

Relatively new and not widely published Growth in fixed-income mutual funds increase need

for reliable benchmarks for evaluating performance Increasing interest in bond index funds, which

requires an index to emulateMany managers have not matched aggregate bond

market return

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Difficulties in Creating a Bond-Market Index

Range of bond quality varies from U.S. Treasury securities to bonds in default

Bond market changes constantly with new issues, maturities, calls, and sinking funds

Bond prices are affected differently by changing interest rates dependent on maturity, coupon, and market yield

Correctly pricing individual bond issues can be a challenge without current and continuous transaction prices available

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Bond Market Indexes

Investment-Grade Bond IndexesFour investment firms maintain indexes for Treasury bonds

and other investment grade bonds (rated BBB or higher)Relationship among these bonds is strong (correlations

average 0.95) High-Yield Bond Indexes

Non investment-grade bonds (rated BB or below)Several indexes have been createdRelationship among alternative high-yield indexes is weaker

than among investment grade indexes

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Bond Market Indexes

Global Government Bond Market IndexesGlobal bond market dominated by government issuesSeveral indexes created by major investment firmsIndexes have similar characteristics

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Composite Stock-Bond Indexes

Considers the benefits of diversification with asset allocation across stocks and bondsMerrill Lynch-Wilshire U.S. Capital Markets Index (ML-WCMI)

Market-value weighted index measures total return performance of the combined U.S. taxable fixed income and equity markets

Brinson Partners Global Security Market Index (GSMI)Matches a typical U.S. pension fund allocation policyClose to the theoretical “market portfolio of risky assets” referred

to in CAPM

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Comparison of Indexes Over Time

Correlations among monthly equity price changesMost differences are attributable to sample differencesHigh correlations between S&P 500 and several broad stock

market indexes (.98-.99)Lower correlations between style indexes and other broader

indexesCorrelations between U.S. series and other countries confirm

the wisdom of global investing since values are often much lower

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Comparison of Indexes Over Time

Correlations among monthly bond indexesAmong investment-grade bonds correlations range from 0.94

to 0.98Significantly lower correlation between investment grade

and high-yield indexes (about 0.49)Low correlation in global returns to U.S. returns (about 0.35)

support global diversification