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CH2 Security Market Indices 2020
CH2 Security Market Indices 2020
CH2 Security Market Indices 2020
Security market indices have evolved into important multi-purpose tools that help:
investors track the performance of various security markets,
estimate risk,
evaluate the performance of investment managers, and
form the basis for new investment products
n P i i
VPRI i 1
D
VPRI = the value of the price return index
ni = the number of units of constituent securities in the
index
N = the number of constituent securities in the index
Pi = the unit price of constituent security i
D = the value of the divisor
• (set for convenience, change when changes in index
unrelated to change in prices)
LOS: Calculate and interpret the value, price return, and total return of an index.
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The divisor is a number initially chosen at inception. It is frequently chosen so that the price index has
a convenient initial value, such as 1,000. 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.
For example, when changing index constituents (replacing old constituents by new ones), the divisor
is adjusted so that the value of the index with the new constituents equals the value of the index prior
to the changes.
LOS: Calculate and interpret the value, price return, and total return of an index.
LOS: Calculate and interpret the value, price return, and total return of an index.
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This is an example of a single-period price return calculation. It is not a measure of total return as total
return measures the change in the value of the price return index plus the effects of income (dividends,
interest, and/or other distributions).
A second method is as follow: Calculate price return for each security:
LMN: (€12 - €10) ÷ €10 = 20%
OPQ: (€24 - €25) ÷ €25 = - 4%
RST: (€18 - €15) ÷ €15 = 20%
Next, determine the weight of each security in the initial portfolio:
The size of the initial portfolio is (€10 × 200) + (€25 × 100) + (€15 × 400) = €10,500.
Thus, the weights of the three securities in the portfolio are:
LMN: (€10 × 200) ÷ €10,500 ≈ 0.1905
OPQ: (€25 × 100) ÷ €10,500 ≈ 0.2381
RST: (€15 × 400) ÷ €10,500 ≈ 0.5714
Then calculate the single-period price return:
PRI = (0.1905 × 20%) + (0.2381 × -4%) + (0.5714 × 20%) ≈ 14.29%
LOS: Calculate and interpret the value, price return, and total return of an index.
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LOS: Calculate and interpret the value, price return, and total return of an index.
This is a continuation of the example above. The total return for the index could also be determined
by weighting out the total return for each individual security:
First, calculate the return for each security including individual incomes:
LMN: (€12.00 - €10.00 + €0.50) ÷ €10.00 = 25%
OPQ: (€24.00 - €25.00 + €1.00) ÷ €25.00 = 0%
RST: (€18.00 - €15.00 + €0.25) ÷ €15.00 ≈ 21.67%
Same as last example, the weights of the three securities in the initial portfolio are:
LMN: (€10 × 200) ÷ €10,500 ≈ 0.1905
OPQ: (€25 × 100) ÷ €10,500 ≈ 0.2381
RST: (€15 × 400) ÷ €10,500 ≈ 0.5714
Therefore: TRI = (0.1905 × 25%) + (0.2381 × 0%) + (0.5714 × 21.67%) ≈ 17.14%
LOS: Calculate and interpret the value, price return, and total return of an index.
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3 4% 1,000(1.05)(1.03)(1.04) 1,124.76
LOS: Calculate and interpret the value, price return, and total return of an index.
LOS: Discuss the choices and issues in index construction and management.
Which market? – Which securities? – Which weight? – When to rebalance? – When to examine?
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Based on
Based on an
geographic
exchange
region
Stock market
Domestic
OTC
International
Alternative market
Emerging
LOS: Discuss the choices and issues in index construction and management.
Other characteristics that could be considered in the target market selection include the economic
sector, company size, investment style (value, growth or blend of both), duration, or credit quality.
Some equity indices, such as the S&P 500 Index and the FTSE 100, fix the number of constituent
securities included in the index and indicate this number in the name of the index.
Market
Equal
capitalization
weighted
weighted
Fundamentally
Price weighted
weighted
Index
weighting
LOS: Compare and contrast the different weighting methods used in index construction.
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WEIGHTING SCHEMES
Price weighted: Market capitalization weighted:
Pi Q i Pi
w iP w iM N
Q
N
P
i 1
i
j 1
j Pj
LOS: Compare and contrast the different weighting methods used in index construction.
In price weighting, the weight on each constituent security is determined by dividing its price
by the sum of all the prices of the constituent securities.
Unlike a price-weighted index, where the weights are arbitrarily determined by the market
prices, the weights in an equal-weighted index are assigned by the index provider.
In market-capitalization weighting, the weight on each constituent security is determined by
dividing its market capitalization by the total market capitalization of all the securities in the
index. Market-capitalization weighting is sometimes called value weighting. Market
capitalization or value is calculated by multiplying the number of shares outstanding by the
market price per share.
Fundamental weighting uses other measures of a company, that are independent of its
security price, to determine weights. These measures include book value, cash flow, revenues,
earnings, dividends, and number of employees.
Divisor = 5
BOP = Beginning of period
EOP = End of period
LOS: Calculate and interpret the value and return of an index on the basis of its weighting method.
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Exhibit 1 illustrates the values, weights, and single-period returns following inception of a price-
weighted equity index with five constituent securities. The value of the price-weighted index is
determined by dividing the sum of the security values (101.50) by the divisor, which is typically set at
inception to equal the initial number of securities in the index. Thus, in our example, the divisor is 5
and the initial value of the index is calculated as 101.50 ÷ 5 = 20.30.
As illustrated in this exhibit, Security A, which has the highest price, also has the highest weighting and
thus will have the greatest impact on the return of the index. Note how both the price return and the
total return of the index are calculated based on the corresponding returns on the constituent
securities.
Divisor = 10
BOP = Beginning of period
EOP = End of period
LOS: Calculate and interpret the value and return of an index on the basis of its weighting method.
Exhibit 2 illustrates the values, weights, and single-period returns following inception of an equal-
weighted index with the same constituent securities as those in Exhibit 1. This example assumes a
beginning index portfolio value of 10,000 (an investment of 2,000 in each security). To set the initial
value of the index to 1,000, the divisor is set to 10 (10,000 ÷ 10 = 1,000).
Exhibits 1 and 2 demonstrate how different weighting methods result in different returns. The 10.4
percent price return of the equal-weighted index shown in Exhibit 2 differs significantly from the 3.45
percent price return of the price-weighted index in Exhibit 1.
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Divisor = 570.50
BOP = Beginning of period
EOP = End of period
LOS: Calculate and interpret the value and return of an index on the basis of its weighting method.
Exhibit 3 illustrates the values, weights, and single-period returns following inception of a market-
capitalization-weighted index for the same five-security market. Security A, with 3,000 shares
outstanding and a price of 50 per share, has a market capitalization of 150,000 or 26.29 percent
(150,000/570,500) of the entire index portfolio. The resulting index weights in the exhibit reflect the
relative value of each security as measured by its market capitalization.
As shown in Exhibits 1, 2, and 3, the weighting method affects the index’s returns. The price and total
returns of the market-capitalization index in Exhibit 3 (1.49 percent and 2.13 percent, respectively)
differ significantly from those of the price-weighted (3.45 percent and 4.33 percent, respectively) and
equal-weighted (10.40 percent and 10.88 percent respectively) indices.
To understand the source and magnitude of the difference, compare the weights and returns of each
security under each of the weighting methods. The weight of Security A, for example, ranges from
49.26 percent in the price-weighted index to 20 percent in the equal-weighted index. With a price
return of 10 percent, Security A contributes 4.93 percent to the price return of the price-weighted
index, 2.00 percent to the price return of the equal-weighted index, and 2.63 percent to the price
return of the market-capitalization-weighted index. With a total return of 11.50 percent, Security A
contributes 5.66 percent to the total return of the price-weighted index, 2.30 percent to the total
return of the equal-weighted index, and 3.02 percent to the total return of the market-capitalization-
weighted index.
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Stock A Stock B
Earnings = €20 Earnings = €20
Market cap = €200 Market cap = €800
Market cap weight = 20% Market cap weight = 80%
Fundamental weight = 50% Fundamental weight = 50%
LOS: Discuss the choices and issues in index construction and management.
The earnings weight of Stock A is 50 percent (20/40) which is higher than its market-capitalization
weight of 20 percent (200/1,000). The earnings weight of Stock B is 50 percent (20/40), which is less
than its market-capitalization weight of 80 percent (800/1,000).
Market
Price Equal Fundamental
capitalization
weighted weighted weighted
weighted
A-Securities market Based on more
A-Simple A-Simple
values are reflected accurate accounting
in the index values rather than
D-Increase Appropriate market market trading value
(decrease) in price D-Under representation Leads to more
leads to over (under) representation of
accurate index
weighting large securities
A-Stock split is
Over-representation absorbed
of small securities
D-Stock splits result D-Increase D-Requires intensive
in arbitrary changes (decrease) in price data research
in weights D-Frequent leads to over (under)
rebalancing weighting
LOS: Compare and contrast the different weighting methods used in index construction.
A: Advantage D: Disadvantage
Price weighting: The primary advantage of price weighting is its simplicity. Its primary disadvantage
is the stocks with the highest price have the greatest impact on index return. In addition, stock split
(i.e. 2 for 1) results in arbitrary (unintentional) changes in weights of all securities in the index. The
divisor needs to change to retrieve back the index value before split.
Equal weighting: Like price weighting, the primary advantage of equal weighting is its simplicity. Equal
weighting, however, has a number of disadvantages. First, securities that constitute the largest
fraction of the target market value are under-represented, and securities that constitute a small
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fraction of the target market value are over-represented. Second, after the index is constructed and
the prices of constituent securities change, the index is no longer equally weighted. Therefore,
maintaining equal weights requires frequent adjustments (rebalancing) to the index (by adding or
removing number of shares for each security to realize equal weights again).
Market capitalization weighting: The primary advantage of market-capitalization weighting is that
each constituent security’s market value is reflected (represented) in the index. In addition, a
constituent’s stock split does not affect the index value because the market capitalization remains
unchanged (half the price * double the shares number). The primary disadvantage is that constituent
securities whose prices have risen the most (or fallen the most) have a greater (or lower) weight in
the index. This weighting method leads to overweighting stocks that have risen in price (and may be
overvalued) and underweighting stocks that have declined in price (and may be undervalued).
Fundamental weighting: The most important property (advantage) of fundamental weighting is that
it’s less focused on market capitalization (market value and size), but rather based on fundamental
factors such as sales revenue, cashflow, dividends and book value. The proponents of such weighting
method believe that these accounting figures lead to better estimation of the stock’s intrinsic value,
rather than just trading it based on its market value. This leads to truer constituents’ estimates, thus a
more accurate index value. However, this approach requires an extensive data collection and analysis.
REBALANCING
May become
necessary as
market prices
change
Rebalancing: refers to adjusting or realigning the weight of the constituent securities, for a more
accurate target market representation. The constituents weights change due to the change in their
respective market prices. Higher (lower) prices lead to higher (lower) representation in the index (as
shares numbers do not change between rebalancing dates)
Rebalancing is handled on a regular basis (usually quarterly). Index providers would buy and / or sell
constituent securities shares to recalibrate their weights in the index consistent with the index
weighting method.
Equal-weighted indices are frequently rebalanced. They start-off with equal capitalization for each
constituent security. When the prices changes during a period, the securities capitalizations will change
accordingly, so do their respective weights. They end up unequal at the end of the period. Rebalancing
bring them back to their original prescribed equal weights.
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Price-weighted indices are self-rebalanced because the weight of each constituent security is
determined by its price. Therefore constituents weights are appropriately reflected.
Market-capitalization-weighted indices are also self-rebalanced. When a constituent’s price changes,
so does its weight in the index basket. However, market-capitalization weights are adjusted to reflect
mergers, acquisitions, liquidations, and other corporate actions between rebalancing dates, but this
process is called reconstitution.
Fundamental-weighted Index is frequently rebalanced when constituents’ market prices deviate from
fundamental intrinsic values. When a constituent market value rises above its intrinsic value, the
security is overvalued. Here the rebalance involves selling some of the constituent securities shares. In
contrast, when a constituent security’s market value drops below its intrinsic value, the security is
undervalued and the rebalance means buying more of the constituent securities shares
RECONSTITUTION
Change constituent
securities?
Mergers, bankruptcies, de-listings,
acquisitions etc.
Reconstitution
date
Beginning
New index
index
Reconstitution is the process of changing the constituent securities in an index. Initial criteria for index
inclusion is applied on the reconstitution date to determine which securities to substitute. Indices are
reconstituted to reflect changes in the target market (bankruptcies, de-listings, mergers, acquisitions,
etc.) and/or to reflect the judgment of the index selection committee (the people in charge of the
index constituents’ selection)
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ETF: Exchanged Traded Funds: Index tracking instrument that is formed of the same stocks that make
up the index. They can be traded in the stock market same as stocks.
CAPM: Capital Asset Pricing Model: It determines the expected return an investor should be
compensated with when investing in a security. The expected return equals a risk free rate (as a
minimum compensation) plus a risk premium for compensating against taking the investment risk. The
market index helps in the determination of the risk premium and thus the expected return.
EQUITY INDICES
Broad market equity indices typically include securities representing more than 90% of the selected
market. In the United States, the Wilshire 5000 Total Market Index is a market-capitalization-weighted
index that includes more than 6,000 equity securities and is designed to represent the entire U.S.
equity market.
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Multimarket equity indices usually comprise indices from different countries and are designed to
represent multiple security markets. MSCI Barra offers a number of multi-market indices, classified
based on 2 dimensions: level of economic development developed, emerging, frontier) and geographic
region (Europe, Asia, Pacific, International, Americas etc.). MSCI Emerging Market Index captures 24
securities from 24 emerging market (developing) countries.
Sector indices represent and track different economic sectors, such as energy, finance, health care,
and technology, on national, regional, or global basis. UTIL is a Dow Jones Utilities Average Index keeps
track of the 15 largest utility companies.
Style indices represent groups of securities classified according to market capitalization, value, growth,
or a combination of these characteristics (combinations: small cap-value, large cap-growth, mid-cap-
value etc.) They are intended to reflect the investing styles of certain investors, such as the growth
investor (looking for growth-oriented companies to benefit from capital appreciation), value investor
(wants to invest in mature stable, undervalued business with dividend potential) and small-cap
investor. S&P small-Cap Value index represents securities of the 600 US small-cap businesses with
value style (combination of size and value)
FIXED-INCOME INDICES
DIMENSIONS
Global
Market Regional
Country or currency zone
Collateralized
Securitized Government
Type Corporate Government
Mortgage- agency
backed
Major types of fixed-income indices can be organized based on various dimensions. The dimensions
fixed-income securities can be classified along include:
Coupon type
Issuer’s economic sector
Issuer’s geographic region
Economic development of the issuer’s geographic region
Type of issuer
Type of financing
Currency of payments
Maturity
Credit quality
Inflation indexed
Absence or presence of inflation protection
Embedded options (convertible, call, put)
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1-High Number
of different 2-Illiquid
securities securities
A market index would Dealer market,
have to include
Dealers may trade
thousands 3-Lack of them less than others
pricing data
From lack of trading
Index has to contact
dealer or estimate by
comparison
Issue 1: There are too many securities with different characteristics issued by governments,
government agencies, and corporations. A fixed income market or sector index would have to include
thousands of different constituents. Updates will be a “nightmare”!
Issue 2: Fixed income markets are primarily dealer markets. They mostly trade in specific securities
more frequently than others. As a result, those left out securities become relatively illiquid (with a thin
market).
Issue 3: Due to the lack of trading in some constituents, these securities would lack market data. Index
providers would have to contact dealers directly to obtain current prices on the securities to update
the index or they must estimate the prices of constituent securities using the prices of traded fixed-
income securities with similar characteristics.
Commodities
Indices
for
Real estate alternative
investments
Hedge funds
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Many investors seek to lower the risk (by diversification) or enhance the performance of their
portfolios by investing in assets classes other than equities and fixed income.
As a result of this new interest in alternative assets and investment strategies, special entities have
created indices designed to represent broad classes of alternative investments.
COMMODITY INDICES
Risk-free rate
Futures contracts of one or more
Theoretical
commodities
Based on 3 month T-bill rate
Commodity indices are futures contracts of one or more commodities (agricultural products,
livestock, precious metals, energy commodities).
Commodity indices do not have an obvious weighting mechanism. Each index may use existing or
create a suitable weighing. As a result, indices with same commodities may show different
performance results.
The commodity index return is based on:
Risk free interest rate: a theoretical rate of return from a zero risk investment. An investor
would expect such a minimum rate just by investing without incurring any risk. In the US, it’s
usually based on 3-month T-bill, because it’s the safest (riskless) security in the market.
Changes in futures prices: every time the underlying commodities prices change, they’ll be
reflected in the index.
Roll yield: futures contracts must be continually “rolled over” (replacing a contract nearing
expiration with a new contract). The roll over process incurs losses (when the old contracts are
replaced by more expensive ones) or generates gains (when old contracts are replaced with
cheaper ones). Those gains / losses are then accounted for in the index return calculation
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Repeat sales
Appraisal indices Real estate
indices Measure changes in prices investment trust
Based on cost, location,
over periods (REIT) indices
future returns, potentials Provide info about housing
market Specifically for REITs
Exclude new constructions
Investment in
Ownership of mortgages
properties
MBS
They represent real estate securities and market for real estate. The real estate market is illiquid:
Appraisal indices: are estimations based on cost, locations, future returns, and potentials etc.
to generate fair market value.
Repeat sale indices: measure changes in real estate prices over periods (when they change
hands) to provide info about housing market. It excludes new constructions and family
transactions
REITs are public or private corporations organized specifically to invest in real estate:
o ownership of properties
o investment in mortgages (through MBS)
REIT indices are based on publicly traded REITs with continuous market pricing so their value is
calculated continuously. Example: The FTSE EPRA/NAREIT Global REIT Index, with FTSE representing
UK index, EPRA representing Brussels and NAREIT representing US
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Research organizations rely on the voluntary cooperation of hedge funds to compile performance
data. As unregulated entities, hedge funds are not required to report their performance to any party
other than their investors. Therefore, each hedge fund decides to which database(s) it will report its
performance. As a result, rather than index providers determining (choosing) the constituents, the
constituents determine (chose) the index.
Another consequence of the voluntary performance reporting is the potential for survivorship bias
and, therefore, inaccurate performance representation. This means that hedge funds with poor
performance tend to avoid to report their bad performance to the database, or even stop reporting to
the database.
Therefore, their returns may be excluded when measuring the return of the index. As a result, the
index may not accurately reflect actual hedge fund performance. It only reflects good performances.
Usually, a hedge fund reports its performance to only one database. As a result, each index will have
different constituents and will most likely show different result during the same period.
SUMMARY
• Price return index
• Total return index
• Choices in index construction and
management
• Advantages and disadvantages of different
weighting schemes
• Rebalancing and reconstitution
• Uses of market indices
• Equity, fixed income, and alternative
investment indices
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Practice questions:
A. More liquid
B. Easy to price
C. Drawn from a larger investment pool
D. Cost higher
Divisor = 20.
A. 2.44%
B. 3.44%
C. 4.44%
D. 5.44%
A. 10.11%
B. 11.11%
C. 12.11%
D. 13.11%
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A. 5.25%
B. 5.75%
C. 6.25%
D. 6.75%
A. 12.11%
B. 12.31%
C. 12.51%
D. 12.81%
8-The price return based on dividend distribution weight factor (fundamental weight) is:
A. 2.78%
B. 3.78%
C. 4.78%
D. 5.78%
9-The DJIA (Dow Jones Industrial Average) index showed a 5% return in 2014, 7% return in 2015,
however it dropped by 6% in 2017. What is the overall period return for the DJIA? (Not the geometric
mean)
A. 5.61%
B. 6.61%
C. 7.61%
D. 8.61%
11-If a merger is related to a constituent in an index, the index provider should therefore consider
making some changes in the index. The changing process is called:
A. Reinstitution
B. Reconstitution
C. Rebalancing
D. Recalibrating
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A. involuntary reporting
B. Mandatory reporting
C. Regulatory reporting
D. Voluntary reporting
15- The primary uses for market indices are all, but:
19-A survivorship bias in a hedge fund voluntary reporting means that the fund
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