Quantitative Methods

Security Market Indexes

Reading - 53

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Learning Objective Statements (LOS)

a. Use of Security Market Indices b. Important factor in considering an index c. Price-Weighted Index

d. Value-Weighted Index e. Unweighted Index f. Global Equity Indexes

g. Bond Market Indexes

h. Composite Stock-Bond Indexes

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Use of Security Market Indexes

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Used as a benchmark for portfolio performance on a risk adjusted basis.

Index funds and Exchange traded funds (ETFs) are created based on indexes to emulate this market portfolio. Aggregate market movements can be measured by indexes.

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Movements of indexes can aid the technicians to predict and forecast future market movement. Indexes can be used as a proxy for market portfolio to calculate the systematic risk associated with the risky assets.
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Important factors in considering an Index

Sample
Size, breadth and the source of sample are all important. Sample must represent the total population. Sample should be taken from each segment of population.

Weighting Sample Members

Price Weighted Index Market Value Weighted Index Unweighted Index

Computational Procedures
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Simple arithmetic mean of the various members in the index. Compute an index and have all the changes in terms of basic index. Geometric mean of the component rather than arithmetic mean.

Price Weighted Index

It is the arithmetic mean of the current prices
Implies Index movements are influenced by the differential prices of the components.

Dow Jones Industrial Average (DJIA)

30 DJIAt =

i =1

Pat Dadj

DJIAt = Value of Dow Jones Industrial Average on day t Pit = Closing price of stock i on day t Dadj = Adjusted divisor on day t.
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Price Weighted Index

Facts about DJIA:
o It is the price weighted average of 30 blue chip companies. o The divisor is adjusted to take care of the stock splits and changes in sample over time. o The weight of each firm in the index is proportional to the share price rather than the total outstanding market value of the shares.

Limitations of DJIA:
o The size of the sample is limited to 30 blue chip stocks only. o In case of stock split in a company, the price of company declines which results in decline in its weight in DJIA irrespective of its size and importance which causes downward bias.
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Price Weighted Index

Change in DJIA divisor when there is a stock split:

Impact of Differently Priced Shares on a Price-Weighted Index:

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Price Weighted Index

Nikkei Dow Jones Average: It is an arithmetic mean of prices for 225 stocks on the First section of the Tokyo Stock Exchange (TSE).

Limitations: 225 stocks comprise of only 15% of the total stocks in First section.

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Value-Weighted Index
Where, Value Weighted Indext = Index value on day t Pt = ending price for stocks on day t Qt = number of outstanding or freely floating shares on day t Pb = ending price for stocks on base day Qb = number of outstanding or freely floating shares on base day Free Floating Shares = All outstanding shares Shares held by insiders

Market Value = Free Floating Shares x Current Market Price

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Value-Weighted Index

Note: In Value-Weighted Index, change in price for large market value stocks will dominate the changes in the index value over time.
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Unweighted Index
Facts: o All stocks carry equal weight irrespective of their price or market value. o This type of index can be used by individuals to invest in randomly selected stocks for their portfolio and invest equal amount in each stock.

o Actual movements of index are typically based on the arithmetic mean of the percent changes in price or market value of stocks in the index.

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Global Equity Indexes

It is a set of consistent country stock indexes which can be used as a bench mark for various indexes across different nations to create various regional indexes. Major sets of global equity indexes: o FT/S&P-Actuaries World Indexes: Approximately 2500 equity shares in 30 countries which covers at least 70% of the total value of all listed companies in each country, are measured. o Morgan Stanley Capital International (MSCI) Indexes: Approximately 1673 companies listed in stock exchanges in19 countries are considered. o Dow Jones World Stock Index: It is composed of more than 2200 companies organized into 120 industry groups from 28 countries
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Bond-Market Indexes
Reasons for difficulty to create and compute a bond market index in contrast to stock market: 1) The universe of bonds is broader than stocks. 2) Constant changes in the universe of bonds due to new issues, bond maturities, calls and bonds sinking funds.

2) The volatility of prices for individual bonds and bond portfolio changes because of effect of duration.

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Bond-Market Indexes
Bond Indexes: o U.S. Investment-Grade Bond Indexes: Relationship among the returns for these investment grade bonds is strong i.e. correlation average of about 0.95, regardless of the segment of the market. o High-Yield Bond Indexes: These includes bond that are not investment grade i.e. they are rated Bb, B, Ccc, Cc and C. o Global Government Bond Indexes: This type of bond indexes are completely dominated by government bonds .

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Composite Stock-Bond Indexes

It is used to measure the performance of all the securities in a given country. With this, the investors can examine the positive side of diversifying with a combination of different types of asset. Merrill Lynch-Wilshire Capital Markets Index: It measures the total return performance of the combined U.S. taxable fixed income and equity markets. Brinson Partner Global Security Markets Index: It consists of U.S. Stocks and bonds as well as non-U.S. equities and non dollar bonds along with an allocation to cash.
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Thank You

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