SECURITY MARKET INDICES

Prof. Mohamed Amine ISSAMI

Lecture 4
February 21st, 2024
 CONTENTS
• 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

2
DESCRIPTION OF A SECURITY MARKET
INDEX

Constituent Security market

securities index

Price return index Total return index

3
 VALUE OF A PRICE RETURN INDEX
N

ån P i i
VPR I = 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

4
CALCULATION OF SINGLE-PERIOD PRICE
RETURN
VPRI 1 - VPRI 0 N N
æ Pi1 - Pi 0 ö
PR I = = å w i PR i = å w i çç ÷÷
VPRI 0 i =1 i =1 è Pi 0 ø
PRI = the price return of index portfolio I
PRi = the price return of constituent security i
wi = the weight of security i
Pi1= the price of constituent security i at the end of the
period
Pi0= the price of constituent security i at the beginning
of the period

5
 EXAMPLE: CALCULATION OF SINGLE-PERIOD
PRICE RETURN
Beginning Ending of Dividends
of Period Period Price per share Shares
Security Price (€) (€) (€) Outstanding
LMN 10.00 12.00 0.50 200
OPQ 25.00 24.00 1.00 100
RST 15.00 18.00 0.25 400
Divisor = 100
( 200 ´ 10 ) + (100 ´ 25) + ( 400 ´ 15)
VPR I 0 = = 105.00
100
( 200 ´ 12 ) + (100 ´ 24 ) + ( 400 ´ 18)
VPR I 1 = = 120.00
100
120.00 - 105.00
PR I = » .1429 » 14 .29 %
105.00
6
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).

Note 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

The price return for each security is:

LMN: (€12 - €10) ÷ €10 = 20%
OPQ: (€24 - €25) ÷ €25 = - 4%
RST: (€18 - €15) ÷ €15 = 20%

An alternative approach to calculate the single-period price return

PRI = (0.1905 × 20%) + (0.2381 × -4%) + (0.5714 × 20%) ≈ 14.29%
7
CALCULATION OF SINGLE-PERIOD TOTAL
RETURNS
VPR I 1 - VPRI 0 + Inc I
TR I =
VPR I 0
N
æ P1i - P0i + Inci
N
ö
TR I = å w i TR i = å w i çç ÷÷
i =1 i =1 è P0i ø

TRI = the total return of the index portfolio

IncI = the total income from all securities in the index
TRi = the total return of the constituent security i
Inci = the total income from security i

8
 EXAMPLE: CALCULATION OF SINGLE-PERIOD
TOTAL RETURN
Beginning Ending of Dividends
of Period Period per share Shares
Security Price (€) Price (€) (€) Outstanding
LMN 10.00 12.00 0.50 200
OPQ 25.00 24.00 1.00 100
RST 15.00 18.00 0.25 400
Divisor = 100

IncI = [(200 ´ 0.50) + (100 ´1.00) + (400 ´ 0.25)] ÷100 = 3.00

120.00 - 105.00 + 3.00
TR I = » .1714 » 17.14%
105.00
9
• The total return for the index could also be determined by weighting
out the total return for each individual security:

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%

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

Therefore:
TRI = (0.1905 × 25%) + (0.2381 × 0%) + (0.5714 × 21.67%) ≈ 17.14%

10
 CALCULATION OF INDEX VALUES OVER
MULTIPLE TIME PERIODS

The calculation of index values over multiple time

periods requires geometrically linking the series of
index returns.

VPRIT = VPRI 0 (1 + PR I 1 )(1 + PR I 2 ) (1 + PR IT )

VTRIT = VTRI 0 (1 + TR I 1 )(1 + TR I 2 ) (1 + TR IT )

11
 EXAMPLE: CALCULATION OF INDEX VALUES
OVER MULTIPLE TIME PERIODS
For an index with an inception value set to 1,000 and
price returns of 5 percent and 3 percent for Periods 1
and 2 respectively, the values of the price return index
would be calculated as follows:

Period Return (%) Calculation Ending Value

0 1,000(1.00) 1,000.00

1 5.00 1,000(1.05) 1,050.00

2 3.00 1,000(1.05)(1.03) 1,081.50

12
EXAMPLE: PRICE RETURN AND TOTAL
RETURN INDICES

13
Price return index

Value at the end of 2008: 1,000 * 1.075 = 1,075

Value at the end of 2009: 1,000 * 1.075 * 1.083 = 1,164.225

Total return index

Value at the end of 2008: 1,000 * 1.126 = 1,126

Value at the end of 2009: 1,000 * 1.126 * 1.134 = 1,276.884

14
CHOICES IN INDEX CONSTRUCTION AND
MANAGEMENT
Which target market should the index represent?

Which securities should be selected from that target market?

How much weight should be allocated to each security in the index?

When should the index be rebalanced?

When should the security selection and weighting decision be re-

examined?

15
TARGET MARKET SELECTION

Defined
broadly or
narrowly?

Other
Based on an
characteristics
asset class?
?
Target
market

Based on
Based on an
geographic
exchange?
region?

16
 DIFFERENT WEIGHTING METHODS USED IN
INDEX CONSTRUCTION

Market
Equal
capitalization
weighted
weighted

Fundamentally
Price weighted
weighted
Index
weighting

17
 WEIGHTING SCHEMES
Price weighted: Market capitalization weighted:

Pi Q i Pi
w =
P w M
i = N
i
åQ P
N

å Pi
i =1
j =1
j j

Equal weighted: Factor weighted:

Fi
1 w = F

w E
= i N
i
N åF j =1
j

18
EXAMPLE : PRICE-WEIGHTED INDEX

19
1. Value of the index at the beginning of 2009:
= [(30 ×1)+(22×1)+(35×1)+(50 ×1)+(48×1)]/5 = 37
2. Weight of security A = 30/185 = 16.22%
Weight of security B = 22/185 = 11.89%
Weight of security C = 35/185 = 18.92%
Weight of security D = 50/185 = 27.03%
Weight of security E = 48/185 = 25.95%
3. Value of the index at the end of 2009:
((34*1) +(28*1)+(31*1)+(54*1)+(44*1))/5 = 38.2
Price return of the index for 2009 = (38.2 – 37) / 37 = 3.24%

20
EXAMPLE : EQUAL-WEIGHTED INDEX

21
Since the index consists of five securities, each security will be assigned a weight of 20% in
the index. As the total value of the index is 10,000, the value assigned to each security will
be 2,000.
1. Number of shares of Stock A = 2,000/30 = 66
Number of shares of Stock B = 2,000/22 = 90
Number of shares of Stock C = 2,000/35 = 57
Number of shares of Stock D = 2,000/50 = 40
Number of shares of Stock E = 2,000/48 = 41
2. The value of the index position in each security at the end of 2009 is calculated as:
Security A: 66*34 = 2,244
Security B: 90*28 = 2,520
Security C: 57*31 = 1,767
Security D: 40*54 = 2,160
Security E: 41*44 = 1,804
Therefore, the total value of the index at the end of 2009 is calculated as:
2,244 + 2,520 +1,767 + 2,160 +1,804 = 10,495
3. The price return of the index for 2009 = (10,495 / 10,000) – 1 = 4.95%

22
EXAMPLE : MARKET CAPITALIZATION-
WEIGHTED INDEX

23
1. Total market capitalization at the beginning of 2009:

(30*4,000)+(22*6,000)+(35*2,000)+(50*2,500)+(48*3,000) = 591,000

The weights of each of the 5 securities are calculated below:

Security A = (30*4,000) / 591,000 = 20.30%

Security B = (22*6,000) / 591,000 = 22.34%

Security C = (35*2,000) / 591,000 = 11.84%

Security D = (50*2,500) / 591,000 = 21.15%

Security E = (48*3,000) / 591,000 = 24.37%

2. Value of the divisor = 591,000 / 1,000 = 591

3. Total market capitalization at the end of 2009:

(34*4,000)+(28*6,000)+(31*2,000)+(54*2,500)+(44*3,000) = 633,000

Price return of the index for 2009 = (633,000/591) / 1,000 – 1 = 7.11%

24
25
26
EXAMPLE : FLOAT-ADJUSTED MARKET-
CAPITALIZATION WEIGHTED INDICES

27
1. The number of shares of each security to be included in the index is
calculated as:
Security A = 4,000*40% = 1,600
Security B = 6,000*70% = 4,200
Security C = 2,000*80% = 1,600
Security D = 2,500*50% = 1,250
Security E = 3,000*60% = 1,800
2. The total float-adjusted market-capitalization at the beginning of
2009 is calculated as:
(30*1,600) + (22*4,200) + (35*1,600) + (50*1,250) + (48*1,800) =
345,300
3. The total float-adjusted market-capitalization at the end of 2009 is
calculated as:
(34*1,600) + (28*4,200) + (31*1,600) + (54*1,250) + (44*1,800) =
368,300
Price return of the index for 2009 = (368,300 / 345,300) – 1 = 6.66%
28
EXAMPLE : FUNDAMENTAL WEIGHTING

29
EXAMPLE : CALCULATION OF INDEX DIVISOR
AFTER A STOCK SPLIT

30
EXAMPLE : ADJUSTING A PRICE-WEIGHTED
INDEX FOR STOCK SPLITS

31
 A PRICE-WEIGHTED INDEX SERIES IS COMPOSED OF THE
FOLLOWING THREE STOCKS:

If stock Z completes a three-for-one stock split at the end of Day 1, the value of the index
after the split (at the end of Day 3) is closest to:
A. 29.9
B. 31.7
C. 32.3

32
 THE DATA FOR FOUR STOCKS IN AN INDEX ARE AS FOLLOWS:

Assuming the beginning value of the float-adjusted market capitalization-

weighted equity index is 100, the ending value is closest to:
A. 109.1
B. 110.9
C. 111.3
 ADVANTAGES AND DISADVANTAGES

Market
Price Equal Fundamental
capitalization
weighted weighted weighted weighted

Simple Securities
Simple Ensures a
held in
value or
proportion to
contrarian tilt
High price their value
Under- and
stocks have over-
greater impact representation
Stock splits Similar to a
Data
result in momentum
Frequent intensive
arbitrary strategy
rebalancing
changes

34
 EXHIBIT 2-1 EXAMPLE OF A PRICE-
WEIGHTED INDEX
BOP BOP
Value Value Weight Weight
Shares (Shares BOP (Shares Price Total x Price x Total EOP
in BOP x BOP Weight EOP Dividends x EOP Total Return Return Return Return Weight
Security Index Price Price) % Price Per Share Price) Dividends % % % % %
A 1 50.00 50.00 49.26 55.00 0.75 55.00 0.75 10.00 11.50 4.93 5.66 52.38
B 1 25.00 25.00 24.63 22.00 0.10 22.00 0.10 –12.00 –11.60 –2.96 –2.86 20.95
C 1 12.50 12.50 12.32 8.00 0.00 8.00 0.00 –36.00 –36.00 –4.43 –4.43 7.62
D 1 10.00 10.00 9.85 14.00 0.05 14.00 0.05 40.00 40.50 3.94 3.99 13.33
E 1 4.00 4.00 3.94 6.00 0.00 6.00 0.00 50.00 50.00 1.97 1.97 5.72
Total 101.50 100 105.00 0.90 3.45 4.33 100.00
Index
Value 20.30 21.00 0.18 3.45 4.33

Divisor = 5
BOP = Beginning of period
EOP = End of period

Type of Index BOP Value Return % EOP Value

Price Return 20.30 3.45 21.00
Total Return 20.30 4.33 21.18

35
 EXHIBIT 2-3 EXAMPLE OF AN EQUAL-
WEIGHTED EQUITY INDEX
Value Value Weight Weight
Shares (Shares (Shares Price Total x Price x Total EOP
in BOP x BOP Weight EOP Dividends x EOP Total Return Return Return Return Weight
Security Index Price Price) % Price Per Share Price) Dividends % % % % %
A 40 50.00 2,000 20.00 55.00 0.75 2,200 30 10.00 11.50 2.00 2.30 19.93
B 80 25.00 2,000 20.00 22.00 0.10 1,760 8 –12.00 –11.60 –2.40 –2.32 15.94
C 160 12.50 2,000 20.00 8.00 0.00 1,280 0 –36.00 –36.00 –7.20 –7.20 11.60
D 200 10.00 2,000 20.00 14.00 0.05 2,800 10 40.00 40.50 8.00 8.10 25.36
E 500 4.00 2,000 20.00 6.00 0.00 3,000 0 50.00 50.00 10.00 10.00 27.17
Total 10,000 100.00 11,040 48 10.40 10.88 100.00

Index 1,000 1,104 4.80 10.40 10.88

Value

Divisor = 10
BOP = Beginning of period
EOP = End of period

Type of Index BOP Value Return % EOP Value

Price Return 1,000.00 10.40 1,104.00
Total Return 1,000.00 10.88 1,108.80

36
 EXHIBIT 2-4 EXAMPLE OF A MARKET-
CAPITALIZATION-WEIGHTED EQUITY INDEX
BOP BOP
Weight Weight
Shares BOP BOP EOP Price Total x Price x Total EOP
Out- BOP Market Weight EOP Dividends Market Total Return Return Return Return Weight
Stock standing Price cap % Price Per Share cap Dividends % % % % %
A 3,000 50.00 150,000 26.29 55.00 0.75 165,000 2,250 10.00 11.50 2.63 3.02 28.50
B 10,000 25.00 250,000 43.82 22.00 0.10 220,000 1,000 –12.00 –11.60 –5.26 –5.08 38.00
C 5,000 12.50 62,500 10.96 8.00 0.00 40,000 0 –36.00 –36.00 –3.95 –3.95 6.91
D 8,000 10.00 80,000 14.02 14.00 0.05 112,000 400 40.00 40.50 5.61 5.68 19.34
E 7,000 4.00 28,000 4.91 6.00 0.00 42,000 0 50.00 50.00 2.46 2.46 7.25
Total 570,500 100.00 579,000 3,650 1.49 2.13 100.00
Index
1,000 1,014.90 6.40 1.49 2.13
Value

Divisor = 570.50
BOP = Beginning of period
EOP = End of period

Type of Index BOP Value Return % EOP Value

Price Return 1,000.00 1.49 1,014.90
Total Return 1,000.00 2.13 1,021.30

37
 COMPARISON OF FUNDAMENTAL WEIGHTING WITH
MARKET-CAPITALIZATION WEIGHTING

Assume a 2-stock Index, consisting of Stock A and

Stock B:

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%

38
 REBALANCING
May become
necessary as
market prices
change

Creates
turnover

Rebalancing

39
 RECONSTITUTION
Change
constituent
securities?

Reconstitution
date

Beginning
index New index

40
 USES OF MARKET INDICES

Gauges of market sentiment

Proxies for measuring and modeling returns,

systematic risk, and risk-adjusted performance

Proxies for asset classes in asset allocation models

Benchmarks for actively managed portfolios

Model portfolios for such investment products as

index funds and exchange-traded funds (ETFs)

41
 EQUITY INDICES
Wilshire 5000
Broad market Total Market
Index

MSCI Emerging
Multimarket
Markets
Equity indices
GSTI
Sector Semiconductor
Index

Dow Jones
Style U.S. Small-Cap
Value Index

42
CHALLENGES FACING FIXED INCOME INDEX
CONSTRUCTION

Illiquid
Number securities
of
securities

Lack of
pricing
data

43
 EXHIBIT 2-9 DIMENSIONS OF FIXED-INCOME
INDICES
Global
Market Regional
Country or currency zone
Collateralized
Securitized Government
Type Corporate
Mortgage- agency
Government
backed

Maturity For example, 1–3, 3–5, 5–7, 7–10, 10+ years;

short-term, medium-term, or long-term
Credit For example, AAA, AA, A, BBB, etc.; Aaa, Aa, A,
quality Baa, etc.; investment grade, high yield

44
 INDICES FOR ALTERNATIVE
INVESTMENTS

Commodities

Indices
for
Real estate alternative
investments

Hedge funds

45
 COMMODITY INDICES

Risk-free
interest rate

Changes in Commodity
futures index
prices return

Roll yield

46
 REAL ESTATE INDICES

Real estate
Appraisal Repeat sales
investment trust
indices indices (REIT) indices

Ownership of Investment in
properties mortgages

47
EXHIBIT 2-12 THE FTSE EPRA/NAREIT GLOBAL
REIT INDEX FAMILY

Source: FTSE International, “FTSE EPRA/NAREIT Global & Global Ex US Indices”

(Factsheet 2009).
48
 HEDGE FUND INDICES
Hedge funds are private investment
vehicles that typically use leverage and
long and short investment strategies.

Research organizations maintain

databases of hedge fund returns and
summarize these returns into indices.

Most indices reflect performance on a

broad global level or on a strategy level.

Most indices are equal weighted.

49
PROBLEMS CAUSED BY VOLUNTARY
INVESTMENT REPORTING

Indices reflect
Voluntary different
Survivorship performances
investment
performance bias for the same
time period

50