RISK MANAGEMENT

Lecture 13
Stock Indices
Stock Index
 A stock index is a portfolio of stocks which
are used to represent either segments of an
exchange or the whole exchange.
 An index can also be constructed by having
stocks from different exchanges.
 National Index:
 Wilshire 5000
 Trans-national Index:
 MSCI World and S&P Global 100
 Euronext 100 includes stocks from all over the European
Union.
Types of Stock Indices
 Broad- based/ Composite index:
 Is the one which covers almost all stocks on the
exchange (or a certain majority percentage of the
market capitalization on the exchange).
 The main purpose of the broad based index is to
act as a proxy for the performance of the
economic conditions of the entire market, or
reveal investor sentiment towards the market
Types of Stock Indices
 Sectoral Index:
 Is the one which covers stocks of a particular
category:
 Bank NIFTY, CNX INFRA, etc
 Morgan Stanley Biotech Index which consists of 36
American firms in the biotechnology industry.
 The main purpose of the sectoral index is to act
as a proxy for the performance of the economic
conditions of the sector, or reveal investor
sentiment towards the sector.
Construction of Stock Indices
 Careful consideration of following factors:
 Liquidity: as measured by Impact Cost.
 Optimum size
 Diversification: to cancel noise
 Weighting methodology
Calculation of Stock Indices
 Stock indices can also be categorized on the
basis of the way they are calculated:
 Market Capitalization-weighted: NIFTY, NASDAQ
 Price-weighted: DJIA
 Attribute-weighted
 Each method has its own advantages and
disadvantages.
Capitalization-weighted Stock
Indices
 These indices are also called Value-weighted
indices.
 They involve the total market capitalization of
the companies weighted by their effect on the
index.
 The larger stocks would make more of a
difference to the index as compared to a smaller
market cap company.
 Full-weighting:
 Index level= Σ(Price of stock* Number of shares)/
Index Divisor.
 Capitalization-weighted Stock
Indices
 Another type is Free Float Method:
 Index level= Σ(Price of stock* Number of
shares)*FFAF
 The Free Float Adjustment Factor represents the
proportion of shares that is free floated as a
percentage of issued shares.
 Capitalization-weighted Stock
Indices
 Continuity in index values is maintained by
adjusting the divisor for all changes in the
constituents’ share capital after the base date.
 This includes additions and deletions to the index, rights
issues, share buybacks and issuance's, and spin-offs.
 The divisor’s time series is, in effect, a chronological
summary of all changes affecting the base capital of the
index.
 The divisor is adjusted such that the index value at an
instant just prior to a change in base capital equals the
index value at an instant immediately following that
change.
Price-weighted Stock Indices
 Also called Equal-weighted stock index.
 A stock index in which each stock influences
the index in proportion to its price per share.
 The value of the index is generated by adding
the prices of each of the stocks in the index
and dividing them by the total number of
stocks.
 Stocks with a higher price will be given more
weight and, therefore, will have a greater
influence over the performance of the index.
Price-weighted Stock Indices
 For example, assume that an index contains
only two stocks, one priced at $1 and one priced
at $10.
 The $10 stock is weighted nine times higher
than the $1 stock. Overall, this means that this
index is composed of 90% of the $10 stocks and
10% of $1 stock.
 In this case, a change in the value of the $1
stock will not affect the index's value by a large
amount, because it makes up such a small
percentage of the index.
 Capitalization-weighted Stock
Indices
 Modified capitalization-weighted index:
 Is a hybrid between capitalization weighting and
equal weighting.
 It is similar to a capitalization weighting with one
main difference: the largest stocks are capped to a
percent of the weight of the total stock index and
the excess weight will be redistributed equally
amongst the stocks under that cap.
 Attribute-weighted Stock
Indices
 Assigns weight to the stock in the index
depending on the score it gets relative to the
value attributes that define the criteria of a
specific index.
 S&P Pure Growth Style Index:
 Growth factors include sales growth, earnings change to
price and momentum.
 S&P Pure Value Style Index:
 Value factors include book value to price ratio, sales to
price ratio and dividend yield.
 Other Types of Stock Indices
 Ethical Indices: include only those companies
which satisfy ecological or social criteria.
 FTSE4 Good Index
 Dow Jones Sustainability Index
 Environmental Indices.
 These main criticism of such indices is due to
subjectivity.
 Stock Index & Passive
Investment Strategy
 Index Funds: Mutual Fund schemes which
track the index.
 Many studies suggest that index funds
routinely beat a large majority of actively
managed mutual funds.
 Reason:
 Lower fund management costs.