Security Market Indicator Series

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What is a market index?

It is an indicator
that answers the
question: What
happened in the
market today?
Uses of Security-Market Indexes

 To compute a security’s systematic risk by

examining how its return responds to
changes in the market index
 For calculating benchmark returns to judge
portfolio performance
 For development of an index portfolio
 For examining factors that influence
aggregate security price movements
 For technical analysis, to predict future price
movements

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Stock-Market Indexes
 Price-Weighted Indexes
 Dow Jones Industrial Average (DJIA)

 Value-Weighted Indexes
 GSE Indexes
 NYSE Composite
 S&P 500 Index
 Russell Indexes
 Willshire 5000 Index

 Equal-Weighted Indexes
 Value Line Averages
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Price Weighted Series
 A price weighted series is an arithmetic average of
current prices, which means that index movements
are influenced by the differential prices of the
components.

 Dow Jones Industrial Average (DJIA)

 Best-known, oldest, most popular index
 First computed in 1896

 Price-weighted average of thirty large well-

known industrial stocks, leaders in their
industry, and listed on NYSE
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Price Weighted Series – Investment in One Share

 The procedure in computing returns means that

the percentage change in the DJIA measures the
return (excluding dividends) on a portfolio that
invests in one share in each of the 30 stocks in
the index.

 Portfolio
 Initial value = (1*25) + (1*100) = 125
 Final value = (1*30)+ (1*90) = 120
 % change = (120-125)/125 = -4%
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Price Weighted Series – Investment in
One Share

 Index

 Initial index value = (25+100)/2 = 62.5

 Final index value = (30+90)/2 = 60

 % Change = (60-62.5)/62.5 = -4%

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Demonstration of the Impact of Differently
Priced Shares
Stock Initial Final % Change Price Shares Initial Final
Price Price Gain (millions) Value(mil Value
lions) (millions)

ABC 25 30 20% 5 20 500 600

XYZ 100 90 -10% -10 1 100 90

Total 600 690

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Demonstration of the Impact of Differently
Priced Shares
 Although ABC increased by 20% and XYZ fell by
10%, the index dropped in value
 This is because the 20% increase in ABC represented
a small price gain ($5) than the 10% decrease in XYZ
($10)
 The portfolio has four times as much invested in
XYZ ($100) as in ABC ($25)

 Notice that the overall value of the portfolio

increased from $600m to $690m!
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Demonstration of the Impact of Differently Priced
Shares
Period T+1
Stock Period T Case A Case B
A (10%) 100 110 100
B 50 50 50
C (10%) 30 30 33
Sum 180 190 183
Divisor 3 3 3
Average 60 63.3 61
Percentage change 5.5% 1.7%

 A 10% change in a $100 stock causes a larger percentage

change in the index (5.5%) compared to a 10% change in a $30
stock (1.7%)

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Price Weighted Series – Stock Split

 The divisor is adjusted so the index value will

be the same before and after the split.

𝑝𝑖𝑡
 𝐷𝐽𝐼𝐴𝑡 = σ30
𝑖=1 𝐷𝑎𝑑𝑗
 𝐷𝐽𝐼𝐴𝑡 = value of DJIA on day t
 𝑝𝑖𝑡 = closing price of stock i on day t
 𝐷𝑎𝑑𝑗 = adjusted divisor on day t

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Example 1 - Stock Split

Stock Initial Final Shares Initial Final Value

Price Price (millions) Value(millions) (millions)

ABC 25 30 20 500 600

XYZ 100 90 1 100 90
Index 62.5 60

 Suppose XYZ were to split two for one so that its price fell to $50.
 We would not want the average to fall, as that would incorrectly
indicate a fall in the general level of market prices.
 Following a split, the divisor must be reduced to a value that leaves
the average unaffected.

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Example 1 - Stock Split

Stock Initial Final Shares Initial Final

Price Price (millions) Value(mill Value
ions) (millions)

ABC 25 30 20 500 600

XYZ 50 45 2 100 90
Index 62.5
Total 600 690

 Index value before the split is 62.5

 The number of shares of doubled after the split leaving the market
value unchanged
 We must find a new divisor, d, that leaves the index unchanged
after XYZ splits and its price falls to $50.

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Example 1 - Stock Split
 We solve for d in the following equation

𝑷𝒓𝒊𝒄𝒆 𝒐𝒇 𝑨𝑩𝑪 + 𝑵𝒆𝒘 𝑷𝒓𝒊𝒄𝒆 𝒐𝒇 𝑿𝒀𝒁 𝟐𝟓 + 𝟓𝟎

= = 𝟔𝟐. 𝟓
𝒅 𝒅
d = 1.20
 Thus d falls from 2 to 1.20
 The split reduces the relative weight of XYZ because of the
reduction in its price

Stock Before Split After Three-for-

One Split by Stock
A

Prices Prices
ABC 25 25
XYZ 100 50
125/2 = 62.5 75/x = 62.5 X=1.20
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Example 2 - Stock Split

Stock Before Split After Three-for-One

Split by Stock A

Prices Prices
A 30 10
B 20 20
C 10 10
60/3 = 20 40/x = 20 X=2

 The index is adjusted to take into account stock

splits and changes in the sample over time
 New divisor is 2 instead of 3.

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Criticisms of Price Weighted Series
 Similar to assuming an investment of one share
per stock

 Places more weight on higher-priced stocks rather

than those with higher market values

 Introduces a downward bias by reducing weight of

growing companies whose stock splits

 Divisor changes frequently to account for stock

splits and firms being replaced (divisor in 2010 has
reduced to 0.132 for the DJIA)

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Value Weighted Series
 A value weighted series is generated by deriving the initial
total market value of all stocks used in the series.

 Market value/capitalization = Number of shares

outstanding * current market price

 The initial figure is typically established as the base and

assigned an index value (the most popular beginning index
is 100).

 Subsequently a new market value is computed for all

securities in the index, and the current market value is
compared to the initial ‘base’ value to determine the
percentage change, which in turn is applied to the
beginning value.

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Value Weighted Series
 The rate of return of the index equals the rate of return that
would be earned by an investor holding a portfolio of all
firms in the index in proportion to their market values.

 The index does not reflect cash dividends paid by the firms

 Most indexes today use a modified version of market-value

weights.

 Rather than weighting by total market value, they weight by

the market value of free float, that is, by the value of shares
that are freely tradable among investors.

 For example, this procedure does not count shares held by

founding families or governments.

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Value Weighted Series

σ 𝑃𝑡 𝑄𝑡
𝐼𝑛𝑑𝑒𝑥𝑡 = ∗ 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝐼𝑛𝑑𝑒𝑥 𝑉𝑎𝑙𝑢𝑒
σ 𝑃𝑏 𝑄𝑏

 𝐼𝑛𝑑𝑒𝑥𝑡 = index value on day t

 𝑃𝑡 = ending prices of stock on day t

 𝑄𝑡 = number of outstanding shares on day t

 𝑃𝑏 = ending price for stocks on the base day

 𝑄𝑏 = number of outstanding shares on base day

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Value Weighted Series - Example
Stock Share Price Number of Shares Market Value

Time T
A $10 1,000,000 $10,000,000
B 15 6,000,000 90,000,000
C 20 5,000,000 100,000,000
Total $200,000,000
Base value of 100
index
Time T+1
A $12 1,000,000 12,000,000
B 10 12,000,000 – 2-for- 120,000,000
1 stock split

C 20 5,500,000 – 110,000,000
company paid 10%
stock dividend

Total 242,000,000
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Value Weighted Series

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒

 𝑁𝑒𝑤 𝐼𝑛𝑑𝑒𝑥 𝑉𝑎𝑙𝑢𝑒 = ∗ 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝐼𝑛𝑑𝑒𝑥 𝑉𝑎𝑙𝑢𝑒
𝐵𝑎𝑠𝑒 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒

242,000,000
 𝑁𝑒𝑤 𝐼𝑛𝑑𝑒𝑥 𝑉𝑎𝑙𝑢𝑒 = ∗ 100 = 121
200,000,000

 There is an automatic adjustment for stock splits and other

capital changes with a value-weighted index.

 This is because the decrease in the stock price is offset by an

increase in the number of shares outstanding.

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 Value Weighted Series - Larger companies carry more
weight

Time T Time T+1

20% Increase in 20% Increase in Stock
Stock A C
Stock No. of Price Value Pric Value Price Value
Shares e
A 1,000,000 $10 $10,000,00 12 12,000,000 10 $10,000,000
0
B 6,000,000 15 90,000,000 15 90,000,000 15 90,000,000

C 5,000,000 20 100,000,00 20 100,000,000 24 120,000,000

0
Total 200,000,00 202,000,000 220,000,000
0
Index 100 101 110
value

 The importance of individual stocks in the sample depends on

the market value of the stocks
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Value Weighted Series - Larger companies carry
more weight
Stock Initial Price Final Price Shares Initial Final Value
(millions) Value(milli (millions)
ons)
ABC 25 30 20 500 600
XYZ 100 90 1 100 90
Total 600 690

 Assuming initial index value of 100 then,

690,000,000
 𝑁𝑒𝑤 𝐼𝑛𝑑𝑒𝑥 𝑉𝑎𝑙𝑢𝑒 = ∗ 100 = 115
600,000,000

 Unlike the price-weighted index, the value weighted

index gives more weight to ABC.
 The value weighted index gives ABC (500m) five times the
weight of given to XYZ (100m)
 Whereas the price-weighed index fell because it was
dominated by XYZ, the value weighted index rises
because it gives more weight to ABC.
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Equally Weighted Series

 All stocks carry equal weight, regardless of their price or

market value

 A $20 stock is as important as a $40 stock, and the total

market value of the company is unimportant.

 Such an index is used by individuals who randomly select

stocks for their portfolio and invest the same dollar amount
in each stock.

 An equal $1000 investment in each stock would work out to

50 shares of a $20 stock, 100 shares of a $10 stock, and 10
shares of a $100 stock.

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Equally Weighted Series

 The actual movements in the index are based on the

arithmetic average of the percentage changes in price or
value for the stocks in the index.

 The use of percentage price changes means that the price

level or the market value of the stock does not make a
difference – each percentage change has equal weight.

 The geometric average can also be used to compute the

returns.

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Equally Weighted Series

Stock Time T Time HPR HPY

T+1
X 10 12 1.20 0.20
Y 22 20 0.91 -0.09
Z 44 47 1.07 0.07

0.20−0.09+0.07
 𝐴𝑟𝑖𝑡ℎ𝑚𝑒𝑡𝑖𝑐 𝑟𝑒𝑡𝑢𝑟𝑛 = = 0.06/6%
3
1
 𝐺𝑒𝑜𝑚𝑒𝑡𝑟𝑖𝑐 𝑟𝑒𝑡𝑢𝑟𝑛 = 1.20 ∗ 0.91 ∗ 1.07 3 −1=
0.0531/5.31%

 Index value (T+1) = Index Value(T) * 1.06 – Arithmetic

 Index value (T+1) = Index Value(T) * 1.0531 – Geometric

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 Equally Weighted Series
Stock Initial Price
ABC 25
XYZ 100
Total

 Suppose you begun with equal dollar investments in ABC

and XYZ.
 If stock ABC increases in value by 20% while XYZ
decreases in value by 10%, your portfolio is no longer
equally weighted.
 To reset the portfolio to equal weights, you would need to
rebalance:
 Sell off some ABC stock and or
 Purchase more XYZ stock
 Such rebalancing will be necessary to align the return on
your portfolio with that on the equally weighted index.

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Index Funds and ETFs
 Investors today can easily buy market indexes for their
portfolios.

 One way is to purchase shares in mutual funds that hold

shares in proportion to their representation in the market
portfolio (e.g GSE or S&P 500)

 These index funds yield a return equal to that of the index

and so provide a low-cost passive investment for equity
investors

 Another approach is to purchase an exchange traded fund

(ETF)

 An ETF is a portfolio of shares that can be bought or sold as

a unit, just as one can buy or sell a single share or stock.
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Summary

 If one were to buy shares in each component firm in the

index in proportion to the outstanding market value, the
value weighted index would perfectly track capital gains on
the underlying portfolio.

 Similarly, a price weighted index tracks the returns on a

portfolio comprised of an equal number of shares of each
firm.

 Unlike price- or market-value weighted indexes, equally

weighted indexes do not correspond to buy-and-hold
portfolio strategies.

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