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Stock Market Indexes: " Everybody Talks About Them But Few People Understand Them "
Stock Market Indexes: " Everybody Talks About Them But Few People Understand Them "
Stock Market Indexes: " Everybody Talks About Them But Few People Understand Them "
Importance/Uses
People often use them to measure
the “health” of stock market
They provide the basis for some of
the most popular mutual funds
They provide the basis for some of
the most popular exchange-traded S&P 500 Index
funds (‘ETFs’) --- examples, SPY
and QQQ
They’re benchmarks for measuring
portfolio manager’s performance
They are used as the “underlying”
(basis) for some of the most widely
used derivatives such as futures
and options
They provide the basis for ongoing
arbitrage opportunities
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Stock Market Indexes (continued)
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Stock Market Index Calculation Methods
Price-weighted index
Just add up the prices and adjust the total by a divisor
Biased towards high price stocks (i.e., higher priced stocks
influence the index number more than lower priced stocks)
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Assume
Stock Shares Price 0 Price 1
A 100 $50 $55
B 200 $30 $30
C 400 $20 $18
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Price Weighted
Stock Price 0 Price 1 % change
A $50 $55
B $30 $30
C $20 $18
total $100 $103 3.0%
Divided by 3 33.33 34.33 3.0%
Index at Index at
time 0 time 1
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Value Weighted
Stock Shares MV 0 MV 1 % change
A 100 $5,000 $5,500
B 200 $6,000 $6,000
C 400 $8,000 $7,200
$19,000 $18,700 -1.6%
Assume Index = 100 on day 0.
Day 0: 100 = 100 x (19,000 / 19,000)
Day 1: 98.4 = 100 x (18,700 / 19,000), a 1.6% drop.
Summary
2) Examine how each index changes if C’s stock price increases 10% and GOOG’s
price drops by 20%.
4) Examine the implications of index type on mutual fund managers whose funds are
supposed to replicate each index’s return.
2-12
Stock Price Indices (continued)
Company Stock Price Shares Outstanding Market Value ($ Billions)
($/share) (in Billions) = Stock Price x Shares Out.
Citigroup (C) $ 20 5.0 $20 x 5 = $100
Google (GOOG) $ 450 0.1 $450 x 0.1 = $45
2-13
Stock Price Indices (continued)
Company Stock Price Shares Outstanding Market Value ($ Billions)
($/share) (in Billions) = Stock Price x Shares Out.
Citigroup (C) $ 20 5.0 $20 x 5 = $100
Google (GOOG) $ 450 0.1 $450 x 0.1 = $45
2) Examine how each index changes if C’s stock price increases 10% and GOOG’s
price drops by 20%.
Price-weighted average: --- First, calculate the new stock prices:
C’s new stock price = $20x(1+0.10) = $22.
GOOG’s new stock price = $450x(1-.20) = $360.
2-14
Stock Price Indices (continued)
Company Stock Price Shares Outstanding Market Value ($ Billions)
($/share) (in Billions) = Stock Price x Shares Out.
Citigroup (C) $ 20 5.0 $20 x 5 = $100
Google (GOOG) $ 450 0.1 $450 x 0.1 = $45
2) Examine how each index changes if C’s stock price increases 10% and GOOG’s
price drops by 20%.
Market-value weighted index: Calculate the new market values:
C’s new market value = $20x(1+0.10)x(5.0) = $110 billion.
GOOG’s market value = $450x(1-.20) x(0.1) = $ 36 billion.
2-15
Stock Price Indices (continued)
Company Stock Price Shares Outstanding Market Value ($ Billions)
($/share) (in Billions) = Stock Price x Shares Out.
Citigroup (C) $ 20 5.0 $20 x 5 = $100
Google (GOOG) $ 450 0.1 $450 x 0.1 = $45
2) Examine how each index changes if C’s stock price increases 10% and GOOG’s
price drops by 20%.
2-16
Stock Price Indices (continued)
Company Stock Price Shares Outstanding Market Value ($ Billions)
($/share) (in Billions) = Stock Price x Shares Out.
Citigroup (C) $ 20 5.0 $20 x 5 = $100
Google (GOOG) $ 450 0.1 $450 x 0.1 = $45
2-17
Stock Price Indices (continued)
Company Stock Price Shares Outstanding Market Value ($ Billions)
($/share) (in Billions) = Stock Price x Shares Out.
Citigroup (C) $ 20 5.0 $20 x 5 = $100
Google (GOOG) $ 450 0.1 $450 x 0.1 = $45
2-18
Stock Price Indices (continued)
4) Now examine the implications of index type on mutual fund managers whose
funds are supposed to replicate each index’s return.
Suppose the fund manager is managing $145,000.
Price-weighted average:
- The manager initially has to invest in equal number of shares of each stock.
- Let n = number of shares we want to solve for:
(n)($20) +(n)($450) = $145,000
(n)($20 + $450) = $145,000
n = $145,000/ ($20 + $450)
= 308.51 shares in each stock.
We will not have to rebalance our holdings of each stock when prices change.
Exception --- when stocks pay dividends --- we will have to reinvest in equal shares.
2-19
Stock Price Indices (continued)
4) Now examine the implications of index type on mutual fund managers whose
funds are supposed to replicate each index’s return.
Suppose the fund manager is managing $145,000.
We will not have to rebalance our holdings of each stock when prices change.
Exception --- when stocks pay dividends --- we will have to reinvest them in
proportion to market values at that time.
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Stock Price Indices (continued)
4) Now examine the implications of index type on mutual fund managers whose
funds are supposed to replicate each index’s return.
Suppose the fund manager is managing $145,000.
We WILL have to rebalance our holdings of each stock when prices change.
To convince yourself, look at the case where C increases by 10% and GOOG
drops by 20%.
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