Part-04: Stock Market Indices

1
Introduction
 Standard question asked on a daily basis by:
 Investors
 Traders
 Market Analysts

“What Happened to the Market Today?”

2
Introduction (cont…)
 The term “market” refers to the Stock Market.

3
Introduction
 Why focus on the market as a whole?
 The market consists of a multitude of
assets.
 The performance of each asset cannot be
realistically tracked at the same time to draw
meaningful conclusions.
 Thus there is a tendency to focus on a
summary measure of the market’s
performance.
4
Types of Indices

5
Stock Indices

 An Index Number is a summary

measure or a representative measure of

the market’s performance.

 Its value is a barometer of changes in

the overall performance of the market.

6
 Types of Indices

 There are 3 Types

of
different ways of Indices

computing stock
market indices.
Price Value Equally
Weighted Weighted Weighted
Indices Indices Indices

7
Price Weighted Indices

1. Specify the number of stocks

constituting the index
2. Add up all the latest prices of all the
component stocks
3. Divide the price aggregate by a
number known as the Divisor

8
 Formula
 A price weighted index consists of N
stocks
 The day of computation = t
 The value of the index = It

 Price of stock i on day t = Pit

 Value of the Divisor on day t = Divt

9
Hypothetical Example
 Take an index consisting of 5 stocks
 Assume that we are standing on the
base date.
 The Base Date is the date on which the
index is being computed for the first time.
 On the Base Date, the Divisor can be set
equal to any value.
 A logical value for the Divisor is the number
of stocks in the index.
10
Prices of Constituent Stocks
STOCK PRICE
ACC 907
Bombay Dyeing 81
Colgate Palmolive 211
Escorts 68
Hindustan Lever 732
TOTAL 1999

11
Initial Index Value

1999
It = ______ = 399.80
5

12
The Following Day

 Assume that at the end of the next day

the stock prices are:
STOCK PRICE
ACC 925
Bombay Dyeing 90
Colgate Palmolive 225
Escorts 75
Hindustan Lever 750
TOTAL 2065
13
New Index Level

2065
It+1 = ______ = 413
5

14
Conclusion

 The market has moved up since the

index level has risen.
 Conclusion is valid
 Every component stock has moved up in
value.

15
Changing the Divisor

16
Stock Split - A Different Scenario

 Assume that at the end of the first day,

ACC announces a 3:1 split.
 An investor will receive 3 new shares for
every share that he is holding.

17
Second Day’s Prices - Post Split
STOCK PRICE
ACC 308
Bombay Dyeing 90
Colgate Palmolive 225
Escorts 75
Hindustan Lever 750
TOTAL 1448

18
Comparison of Prices -
With & Without the Split
STOCK PRICE - If no PRICE - With
split split
ACC 925 308
Bombay Dyeing 90 90

Colgate 225 225

Palmolive
Escorts 75 75
Hindustan Lever 750 750

TOTAL 2065 1448 19

Comparison of Prices (Cont…)

 If we compare the two sets of prices

we see that:
 All the stocks have the same value
except for ACC

20
Calculation of Index After the Split
using the Existing Divisor

1448
It+1 = ______ = 289.60
5

21
Erroneous Conclusion

 Since the index value on the base date

was 399.80, the index has fallen.

 This is an erroneous conclusion since:

Every Stock Has Risen In Value As
Compared To The Base Date

22
Reason For Wrong Deduction

 The decline is purely due to the stock split

 due to which ACC has only 1/3rd of its value

 How de we account for the split?

 Obviously we have to change the divisor

23
Adjusting the Divisor

 At the end of the day on which ACC

undergoes a 3:1 split
 Only ACC’s price will be impacted.
 It will come down to 1/3rd of the existing value.

 There will be no change in the prices of the other

stocks.

24
Theoretical Post-Split Prices
STOCK PRICE
ACC 302.33
Bombay Dyeing 81
Colgate Palmolive 211
Escorts 68
Hindustan Lever 732
TOTAL 1394.33

25
The New Divisor

 The new divisor X should be such that the

pre- & post-split index value is the same.
 If we denote the adjusted divisor by X:

(1394.33 / X) = 399.80
 The new divisor is 3.4876

26
The New Divisor (Cont…)

 The validity of the new divisor can be

checked by recomputing the index level
on the next day.
1448
It+1 = ______ = 415.1852
3.4876

27
The New Divisor - Conclusion

 After making the necessary adjustments

to the divisor, we would conclude that
the market has risen in value
 Which is the correct conclusion in this case

28
Situations Warranting Re-calculation
of Divisor

 We need to adjust a divisor under the

following situations:
 A stock undergoes a split
 A stock undergoes a reverse split
 A company declares a stock dividend
 A company is deleted from the index and
replaced with another.

29
Handling Stock Dividends
 From a mathematical standpoint, a stock
split and a stock dividend are identical
 20% stock dividend  1 new share will be issued
for every 5 existing shares
 This is exactly analogous to a 6:5 split.

 Procedure for adjusting the divisor will be

identical to that for a stock split

30
 Changing the Composition of the
Index
 Assume that
Escorts, which has a price of 75, is deleted
at the end of the 2nd day
 It is replaced with Ranbaxy which has a

price of 120.
STOCK PRICE
ACC 308
Bombay Dyeing 90
Colgate Palmolive 225
Ranbaxy 120
Hindustan Lever 750
TOTAL 1493 31
Changes in Composition and Divisor
Adjustment

 The new divisor X, should be such that:

1493
It+1 = ______ = 415.1852
X

 The value of X turns out to be 3.5960

32
Price weighted indices

33
Examples of Price Weighted Indices

 The Dow Jones Industrial Average

commonly known as the DOW and
abbreviated as DJIA
 It consists of 30 Blue Chip companies
 The Nikkei Index in Japan is also a price
weighted index
 It consists of 225 stocks

34
The Importance of Price
 High priced stocks carry more weight
in the case of price weighted indices
than low priced stocks.

35
Illustration of Relative
Importance

 Case A: Consider a 20% increase in the

price of ACC

 Case B: Consider a 20% increase in the

price of Colgate, which is priced lower

36
 Illustration of Relative
Importance
STOCK Day 1 Day 2: Day 2:
Case A Case B
ACC 900 1080 900
Bombay Dyeing 90 90 90

Colgate 200 200 240

Palmolive
Escorts 80 80 80
Hindustan Lever 700 700 700
37
Illustration (Cont…)

 Assume that the divisor is 5

 Index value on Day 1 = 394
 Case A: Index value on Day 2 = 430
 Increase of 9.14%

 Case B: Index value on Day 2 = 430


Increase of 2.03%

38
Value weighted indices

39
Value Weighted Indices

 Unlike price weighted indices, these

indices use Market capitalization, not
just price

 Market capitalization is defined as:

price * no. of shares outstanding

40
Formula

41
Explanation of Symbols
 Pib ≡ Price of stock i on the base date
 Qib ≡ Number of shares outstanding of stock i on the
base date
 Pit ≡ Price of stock i on date t
 Qit ≡ No. of shares outstanding of stock i on day t
 M ≡ No. of companies constituting the index on the
base date
 N ≡ No. of companies constituting the index on day t

Note: M need not equal N

i.e. no. of stocks present in the index can change over
a period of time.

42
Starting Index Value

 We have assigned the index a value of

100 on the base date.
 This is common but is arbitrary
 In practice, one can assign any value.

43
The Divisor

 Once again a Divisor has been used

 The treatment of the divisor in this case
is slightly different
 On the base date, the divisor is always
assigned a value of 1.0

44
Hypothetical Example

 Take the same 5 stocks

 We will focus on their market

capitalizations, not just their prices.

45
 Market Capitalizations on the
Base Date
STOCK Price No. of Market Cap.
(P) Shares (Q)

ACC 907 1,000,000 907,000,000

Bombay Dyeing 81 500,000 40,500,000
Colgate 211 700,000 147,700,000
Palmolive
Escorts 68 200,000 13,600,000
Hindustan Lever 732 1,500,000 1,098,000,000

46
Total Market Capitalization

 ΣPiQi = 2,206,800,000

47
 Market Capitalizations on the Next
Day
STOCK Price No. of Market Cap.
(P) Shares (Q)
ACC 925 1,000,000 925,000,000
Bombay Dyeing 90 500,000 45,000,000

Colgate 225 700,000 157,500,000

Palmolive
Escorts 75 200,000 15,000,000
Hindustan 750 1,500,000 1,125,000,000
Lever
48
Total Market Capitalization & New
Index Level

 ΣPiQi = 2,267,500,000

 New Index Level is:

2,267,500,000
It+1 = ___________ x 100 = 102.7506
2,206,800,000

49
Conclusion

 We will conclude that the market has

risen in value
 This is a valid inference because
every component stock has gone up
in value as compared to the base
date.
50
The Divisor

 The Divisor need not be adjusted for

 Stock Splits

 Reverse Splits

 Stock Dividends

51
Rationale – a theoretical
standpoint
 The below will not have any impact on the
market capitalization of the stock
 Stock splits
 Reverse splits
 Stock dividends
 The decrease/increase in the stock price
will be exactly offset by an
increase/decrease in the no. of shares
outstanding 52
Example

HLL HLL post a

3:1 split
Market price 750 250

No. of shares 1,500,000 4,500,000

outstanding

Market 1,125,000,000 1,125,000,000

capitalization

53
 Change in Composition and
the Divisor
 The divisor will have to be adjusted if
there is a change in the composition.
 Assume that Escorts is replaced by
Ranbaxy.
Escorts Ranbaxy
Price 75 120
No. of shares 200,000 100,000
outstanding
54
 Post-Change Market Cap.
STOCK Price (P) No. of Market Cap.
Shares (Q)

ACC 925 1,000,000 925,000,000

Bombay Dyeing 90 500,000 45,000,000

Colgate 225 700,000 157,500,000

Palmolive
Ranbaxy 120 100,000 12,000,000
Hindustan Lever 750 1,500,000 1,125,000,00
0
55
New Divisor
 The new market capitalization is
2,264,500,000

 The new divisor should be such that:

1 2,264,500,000
_ x ___________ x 100 = 102.7506
X 2,206,800,000

 X is therefore equal to 0.9987

56
Relative Importance of Stocks
 In a value weighted index, the importance of a
stock would depend on its market value
 A given percentage change in the value of a
large cap firm, will have a greater impact on the
index, than a similar percentage change in the
value of a small cap firm.

57
Examples of Value Weighted
Indices

 Standard & Poor’s S&P 500

 It consists of 500 stocks.
 Nasdaq 100 index
 In India - the Sensex and the Nifty
 The Sensex consists of 30 stocks.
 The Nifty is based on 50 stocks.

58
Equally weighted indices

59
 Equally Weighted Indices
 The value of an equally weighted index consisting of N stocks is given
by

60
Prices & Returns

is equal to (1 + rit ) where rit is the rate of

return on stock i between day t-1 and day
t

61
The Formula in Terms of Returns

 It =

62
Explanation of Formula

is the arithmetic average of the returns on all

the component stocks

Thus
Value of the index =
(Index level on the previous day) * (average
return on all the stocks)

63
Tracking portfolois

64
Mimicking Portfolios

 A mimicking portfolio also known as a

Tracking Portfolio is formed to replicate
the behaviour of the index
 “Passive investors” are sometimes quite
content to acquire portfolios of stocks
that mirror the movements in an index

65
Replication Techniques

 The method for forming a tracking

portfolio depends on the nature of the

index

66
 To track…
Price weighted Equally Value weighted
index weighted index index

The investor The investor The investor needs to

needs to needs to invest invest a fraction of his
purchase an an equal amount wealth in each
equal number of in every stock component stock, that
shares of every that constitutes is equal to the ratio of
stock that the index its market
constitutes the capitalization divided
index by the total market
capitalization of all the
assets in the index 67
Portfolio Rebalancing

68
Portfolio Rebalancing
 Once a tracking portfolio is formed it will
not continue to track the index
automatically forever
 There are circumstances under which the index
ought to be rebalanced if it is to maintain its
property of being a tracking portfolio.
 The circumstances under which the portfolio
has to be rebalanced depend on the nature of
the index.

69
 Events that Warrant Rebalancing
Price weighted Equally weighted index Value
index weighted
index
One of the Has to be rebalanced every If there is a
constituent stocks in day, unless none of the change in
the index: component stocks changes the
Undergoes a split in price - because a price composition
Undergoes a change in even 1 stock is of the index
reverse split adequate to ensure that the
Or pays a stock portfolio is no longer equally
dividend weighted.
If there is a change
in the composition of 70
Equally Weighted Tracking
Portfolio

71
 An Equally Weighted Tracking
Portfolio
 Assume that
 We have Rs. 500,000

 We wish to form an equally weighted

portfolio consisting of 4 four stocks.

STOCK PRICE
Alfa Laval 50
Atlas Copco 100
Sandvik 40
Sulzer 125
72
Equally Weighted…(Cont…)
 We have Rs. 500,000
 We need to invest Rs. 125,000 in each
stock
 We will have to buy:
 2,500 shares of Alfa Laval
 1,250 shares of Atlas Copco
 3,125 shares of Sandvik
 1000 shares of Sulzer

73
 Equally Weighted …(Cont…)
 If we assume that the index level is 100  our
portfolio will be worth 5000 times the index
 Assume that the prices on the next day are as
follows.

STOCK PRICE
Alfa Laval 40
Atlas Copco 125
Sandvik 50
Sulzer 100
74
Equally Weighted …(Cont…)

 The total portfolio value is Rs. 512,500

of which:
 100,000 is in Alfa Laval
 156,250 is in Atlas Copco
 156,250 is in Sandvik
 100,000 is in Sulzer

75
 Equally Weighted …(Cont…)
 The percentage of each stock in the portfolio

STOCK PERCENTAGE

Alfa Laval 19.51%

Atlas Copco 30.49%

Sandvik 30.49%

Sulzer 19.51%

76
 Equally Weighted… (Cont…)
 The portfolio is no longer equally weighted.
 The total portfolio value is 512,500
 We need to invest 128,125 in each stock

To reset the weights to 0.25 each, we will have to:

Sell part of our Sell 225 shares of Atlas

holdings in Atlas Copco Copco

& Sandvik Sell 562.5 shares of

Sandvik
Invest the proceeds in Buy 703.125 shares of
Alfa Laval & Sulzer Alfa Laval
77
Buy 281.25 shares of
Rebalancing at Zero Cost
 If we assume that there are no transactions
costs, we can rebalance at no cost.

 Inflow from rebalancing is:

(225 x 125) + (562.50 x 50) = $56,250

 Outflow from rebalancing is:

(703.125 x 125) + (281.25 x 100) = $56,250

78
The New Index Level

 It+1 = It x (1 + )
= 100 x (1 + )

 = (-0.20 + 0.25 + 0.25 - 0.20)

_____________________
4
= 0.025

 It+1 = 102.50
79
Mimicking Property

 The portfolio value is:

512,500 = (102.50 x 5,000)

 Thus the portfolio continues to mimic
the index

80
Price Weighted Tracking
Portfolio

81
 A Price Weighted Tracking
Portfolio
 Assume that we wish to form a price weighted
tracking portfolio by buying 1000 shares

STOCK PRICE
Alfa Laval 50
Atlas Copco 100
Sandvik 40
Sulzer 125
82
Price Weighted…(Cont…)
 Assume that the divisor is 4.0, the index
level will be:

50 + 100 + 40 + 125
It =________________ = 78.75
4.0

83
Price Weighted…(Cont…)
 The value of our tracking portfolio will be:
{1000 x (50 + 100 + 40 + 125)} = 315,000
= 4000 x 78.75

 Thus the portfolio will be worth 4000 times the

index

84
Stock Split
 Assume that Atlas Copco undergoes a 2:1 split
 The post split theoretical value of the stock will be 50

 The new divisor should be such that:

50 + 50 + 40 + 125
_______________ = 78.75 ⇒ X = 3.3651
X

85
Rebalancing
 In order to ensure that our portfolio continues to
mimic the index, we need to rebalance in such a
way that the portfolio value remains unchanged.

86
Rebalancing (Cont…)
 The portfolio value = 4000 x 78.75
= 1000 X 4 x 78.75

 If the portfolio value is to remain

unchanged:
1000 x 4 x 78.75 = N x 3.3651 x 78.75
N = no. of shares of each stock that is
to be held after rebalancing

87
Rebalancing (Cont…)
 Therefore:
1000 x 4
N = ______ = 1188.672
3.3651

88
Rebalancing (Cont…)
 Assume that fractional shares can be
bought & sold
 We need to buy
 188.672 shares of Alfa Laval, Sandvik, and
Sulzer,
 We need to sell
 811.328 shares of Atlas Copco
 Because we would have 2000 shares after the
split and we need only 1188.672 shares
89
Rebalancing (Cont…)
 Inflow:
811.328 x 50 = 40,566.40

 Outflow:
188.672 x (50 + 40 + 125) = 40,564.48

 Once again if we ignore transactions

costs we can rebalance at zero net cost
90
Value Weighted Tracking
Portfolio

91
 A Value Weighted Tracking Portfolio
 Consider a value weighted portfolio
consisting of the following 4 stocks.
STOCK Price No. of Market
(P) Shares Cap.
(Q)
MRF 20 100,000 2,000,000

J.K. Tyres 40 50,000 2,000,000

Apollo Tyres 50 100,000 5,000,000 92

Value Weighted…(Cont…)

 The total market capitalization is 10,000,000

 Assume:
 Base period market capitalization = 16,000,000
 Divisor = 1

 Index level = 62.50

93
Value Weighted… (Cont…)
 Consider a person with a capital of
200,000

 In order for his portfolio to mimic the

index, it must have:

 2,000,000
________ x 200,000 = 40,000 in MRF
10,000,000
94
Value Weighted…(Cont…)
 2,000,000
_________ x 200,000 = 40,000 in J.K. Tyres
10,000,000

 5,000,000
_________ x 200,000 = 100,000 in Apollo Tyres
10,000,000

 1,000,000
________ x 200,000 = 20,000 in Vikrant Tyres
10,000,000

95
Value Weighted… (Cont…)

 Thus he needs to buy

 2000 shares of MRF
 1000 shares of JK Tyres
 2000 shares of Apollo Tyres
 2000 shares of Vikrant Tyres
 The total value of the portfolio is 3200
times the index level of 62.50
96
Value Weighted…(Cont…)

 Assume that Vikrant Tyres is replaced

by CEAT
 Price = 35
 No. of shares outstanding = 100,000
 The total market capitalization of the
four companies after the change will be
12,500,000
97
The Divisor
 The divisor must be changed in such a way
that the index level remains unchanged.

1 x 12,500,000 x 100
__ _________ = 62.50
X 16,000,000

⇒ X = 1.25

98
Value Weighted…(Cont…)
 For the portfolio to remain value
weighted, the investor must have:

 2,000,000
_________ x 200,000 = 32,000 in MRF
12,500,000

 2,000,000 x 200,000 = 32,000 in J.K. Tyres

________
12,500,000
99
Value Weighted…(Cont…)
 5,000,000 x 200,000 = 80,000 in Apollo
Tyres ________
12,500,000

 3,500,000 x 200,000 = 56,000 in CEAT

________
12,500,000

100
 Value Weighted…(Cont…)
The investor requires The investor needs to

1600 shares of MRF Sell 400 shares of MRF

800 shares of J.K. Tyres Sell 200 shares of J.K. Tyres

1600 shares of Apollo Sell 400 shares of Apollo

Tyres Tyres

Sell 2000 shares of Vikrant

Tyres

1600 shares of CEAT Buy 1600 shares of CEAT 101

Value Weighted…(Cont…)
 Inflow = 400x20 + 200x40 + 400x50 +
2000x10 = 56,000

 Outflow = 1600x35 = 56,000

 Once again, if we ignore transactions

costs, we can rebalance at zero cost.

102
Base period capitalization

103
Changing the Base Period
Capitalization

 We have just seen one way of handling

a change in the composition of a “value
weighted index”
 Adjust the Divisor

104
 Base Period…(Cont…)
Adjust the Divisor Keep the Divisor fixed
at 1.0
This is the approach used In India we follow this
for the S&P500 procedure for the Sensex
and the Nifty

The base period The base period

capitalization remains capitalization is changed
fixed in such cases and is
never changed

105
Base Period…(Cont…)
 In our illustration when the market capitalization
changed from 10,000,000 to 12,500,000 we
changed the divisor to 1.25 to keep the index
level fixed at 62.50.
 In India we would have changed the base period
capitalization instead.
 12,500,000
_________ x 100 = 62.50 ⇒ X = 20,000,000
X

106
Base Period…(Cont…)

 For subsequent computations of the

index we would use the changed base

period capitalization, unless there were

to be another change in the index

composition.

107