Chapter 7Chapter 7

SECURITY-MARKET SECURITY-MARKET

INDEXESINDEXES

Chapter 7 QuestionsChapter 7 Questions

• What are some major uses of security-market What are some major uses of security-market indexes?indexes?

• What are the major characteristics that cause What are the major characteristics that cause various indexes to differ?various indexes to differ?

• What are the major stock-market indexes in What are the major stock-market indexes in the United States and globally, and what are the United States and globally, and what are their characteristics?their characteristics?

• What are the major bond-market indexes for What are the major bond-market indexes for the United States and the world?the United States and the world?

Chapter 7 QuestionsChapter 7 Questions

• Why are bond indexes more difficult to create Why are bond indexes more difficult to create and maintain than stock indexes?and maintain than stock indexes?

• What are some of the composite stock-bond What are some of the composite stock-bond market indexes?market indexes?

• Where can you get historical and current data Where can you get historical and current data for all these indexes?for all these indexes?

• What is the relationship among many of What is the relationship among many of these indexes in the short-run (monthly)?these indexes in the short-run (monthly)?

What is a market index?What is a market index?

It is an indicator that It is an indicator that answers the answers the question: What question: What happened in the happened in the market today?market today?

5 Uses of Security-Market 5 Uses of Security-Market IndexesIndexes

1.1. For calculating benchmark returns to judge For calculating benchmark returns to judge portfolio performanceportfolio performance

2.2. For development of an index portfolioFor development of an index portfolio3.3. For examining factors that influence For examining factors that influence

aggregate security price movementsaggregate security price movements4.4. For technical analysis, to predict future For technical analysis, to predict future

price movementsprice movements5.5. To compute a security’s systematic risk by To compute a security’s systematic risk by

examining how its return responds to examining how its return responds to changes in the market indexchanges in the market index

Factors in Constructing Factors in Constructing Market IndexesMarket Indexes

• The sample of firms to include The sample of firms to include – What is the intended population that the sample is What is the intended population that the sample is

to represent? How large a sample is needed for to represent? How large a sample is needed for the index to be representative? the index to be representative?

• Weighting system for sample membersWeighting system for sample members– Should the weighting system be based on price, Should the weighting system be based on price,

total firm value, or equally weighted total firm value, or equally weighted (“unweighted”)?(“unweighted”)?

• Computational procedureComputational procedure– How should the values of the index be reported How should the values of the index be reported

and tracked (arithmetic or geometric mean)?and tracked (arithmetic or geometric mean)?

Stock-Market IndexesStock-Market Indexes

• Price-Weighted IndexesPrice-Weighted Indexes– Dow Jones Industrial Average (DJIA)Dow Jones Industrial Average (DJIA)

• Value-Weighted IndexesValue-Weighted Indexes– NYSE CompositeNYSE Composite– S&P 500 IndexS&P 500 Index– Russell IndexesRussell Indexes– Wilshire 5000 IndexWilshire 5000 Index

• Equal-Weighted IndexesEqual-Weighted Indexes– Value Line AveragesValue Line Averages

Dow Jones Industrial Dow Jones Industrial Average (DJIA)Average (DJIA)

• Best-known, oldest, most popular indexBest-known, oldest, most popular index• Price-weighted average of thirty large well-Price-weighted average of thirty large well-

known industrial stocks, leaders in their known industrial stocks, leaders in their industry, and listed on NYSEindustry, and listed on NYSE

• Total the current price of the 30 stocks and Total the current price of the 30 stocks and divide by a divisor divide by a divisor – Original divisor was 30Original divisor was 30– Divisor now adjusted for stock splits and changes Divisor now adjusted for stock splits and changes

in the sample, so now much smaller (about in the sample, so now much smaller (about 0.1356 in October 2004; about .1249 in March 0.1356 in October 2004; about .1249 in March 2006)2006)

Criticism of the DJIACriticism of the DJIA

• Sample used is limitedSample used is limited– 30 non-randomly selected blue-chip stocks are 30 non-randomly selected blue-chip stocks are

not representative of the 1800 NYSE listed stocksnot representative of the 1800 NYSE listed stocks

• Price-weighted seriesPrice-weighted series– Similar to assuming an investment of one share Similar to assuming an investment of one share

per stockper stock– Places more weight on higher-priced stocks Places more weight on higher-priced stocks

rather than those with higher market valuesrather than those with higher market values– Introduces a downward bias in DJIA by reducing Introduces a downward bias in DJIA by reducing

weight of growing companies whose stock splitsweight of growing companies whose stock splits

Value-Weighted IndexesValue-Weighted Indexes

• Although the DJIA is the most popular index, the Although the DJIA is the most popular index, the most popular type (most indexes use this) is most popular type (most indexes use this) is value-weighted.value-weighted.

• Derive the initial total market value of all stocks Derive the initial total market value of all stocks used in the seriesused in the seriesMarket Value = Number of Shares Outstanding Market Value = Number of Shares Outstanding x Current Market Pricex Current Market Price

• Beginning index value is usually 100, new market Beginning index value is usually 100, new market values change the value of the indexvalues change the value of the index

• Automatic adjustment for splitsAutomatic adjustment for splits• Weighting depends on market valueWeighting depends on market value

Value-Weighted IndexesValue-Weighted Indexes

where:where:

IndexIndextt = index value on day = index value on day tt

PPtt = ending prices for stocks on day = ending prices for stocks on day tt

QQtt = number of outstanding shares on day = number of outstanding shares on day t t

PPbb = ending price for stocks on base day = ending price for stocks on base day

QQbb = number of outstanding shares on base day = number of outstanding shares on base day

ValueIndex BeginningIndex t

bb

tt

QP

QP

Value-Weighted IndexesValue-Weighted Indexes

• Construction similar to assuming investment Construction similar to assuming investment in proportion to total market valuein proportion to total market value

• Take into account that large market value Take into account that large market value stocks make up more of the market than do stocks make up more of the market than do smaller market value stockssmaller market value stocks– Large market value stocks dominate the Large market value stocks dominate the

impact on index values over timeimpact on index values over time

• Also these series tend to be more broad than Also these series tend to be more broad than the DJIAthe DJIA

Unweighted (Equal-Unweighted (Equal-Weighted) Price IndexesWeighted) Price Indexes

• All stocks carry equal weight regardless of All stocks carry equal weight regardless of price or market valueprice or market value

• Constructed in a parallel fashion to Constructed in a parallel fashion to individuals who select stocks and individuals who select stocks and invest the invest the same dollar amount in each stocksame dollar amount in each stock

• Changes in the index can be reported either Changes in the index can be reported either in terms of arithmetic or geometric meansin terms of arithmetic or geometric means

Style IndexesStyle Indexes

• Additional indexes have been created Additional indexes have been created that seek to measure the performance that seek to measure the performance of various investment styles or sectorsof various investment styles or sectors– Size indexes track the performance of Size indexes track the performance of

large-cap, mid-cap, and small cap stockslarge-cap, mid-cap, and small cap stocks– Other indexes track the relative Other indexes track the relative

performance of growth and value stocks, performance of growth and value stocks, perhaps also broken down into sizes (can perhaps also broken down into sizes (can use a 6-category matrix)use a 6-category matrix)

Global Equity IndexesGlobal Equity Indexes

• There are stock-market indexes available for There are stock-market indexes available for most individual foreign marketsmost individual foreign markets– These are closely followed within each countryThese are closely followed within each country– These are difficult to compare due to differences in These are difficult to compare due to differences in

sample selection, weighting, or computationsample selection, weighting, or computation

• In response, some standardized indexes have In response, some standardized indexes have been developedbeen developed– FT/S&P Actuaries World IndexesFT/S&P Actuaries World Indexes– Morgan Stanley Capital International (MSCI) World Morgan Stanley Capital International (MSCI) World

Indexes (especially MSCI EAFE Index)Indexes (especially MSCI EAFE Index)– Dow Jones World Stock IndexDow Jones World Stock Index

FT/S&P-Actuaries World FT/S&P-Actuaries World IndexesIndexes

• Track over 2,400 securities in 30 countriesTrack over 2,400 securities in 30 countries• Covers 70% of the total value of all listed Covers 70% of the total value of all listed

companies in each countrycompanies in each country• Securities included must allow direct holdings Securities included must allow direct holdings

of shares by foreign nationalsof shares by foreign nationals• Index is market-value weighted with a base Index is market-value weighted with a base

date of December 31, 1986 = 100date of December 31, 1986 = 100• Results are calculated daily and published the Results are calculated daily and published the

following day in the Financial Timesfollowing day in the Financial Times• Geographic subgroups are also publishedGeographic subgroups are also published

MSCI IndexesMSCI Indexes

• Three international, nineteen national, and Three international, nineteen national, and thirty-eight international industry indexesthirty-eight international industry indexes

• Include 1,673 companies listed on stock Include 1,673 companies listed on stock exchanges in 19 countries with a combined exchanges in 19 countries with a combined capitalization representing 60 percent of the capitalization representing 60 percent of the aggregate market value of the stock aggregate market value of the stock exchanges of these countriesexchanges of these countries

• All the indexes are market-value weightedAll the indexes are market-value weighted

Dow Jones World Stock Dow Jones World Stock IndexIndex

• Introduced in January 1993Introduced in January 1993

• Includes 28 countries with a total of Includes 28 countries with a total of 2,200 companies worldwide, organized 2,200 companies worldwide, organized into 120 industry groupsinto 120 industry groups

• Countries are grouped into 3 regionsCountries are grouped into 3 regions

• Represents over 80% of the combined Represents over 80% of the combined capitalization of these countriescapitalization of these countries

Comparison of World Comparison of World Stock IndexesStock Indexes

• Correlations Correlations between all of the between all of the pairs of pairs of broad broad world indexesworld indexes are are nearly 1.00, nearly 1.00, indicating that the indicating that the results with the results with the alternative world alternative world stock indexes are stock indexes are quite comparablequite comparable

Bond-Market IndexesBond-Market Indexes

• Relatively new and not widely publishedRelatively new and not widely published• Growth in fixed-income mutual funds Growth in fixed-income mutual funds

increase need for reliable benchmarks for increase need for reliable benchmarks for evaluating performanceevaluating performance

• Increasing interest in bond index funds, Increasing interest in bond index funds, which require an index to emulatewhich require an index to emulate– Many managers have not matched aggregate Many managers have not matched aggregate

bond market return, so think about passive rather bond market return, so think about passive rather than actively-managed bond portfoliosthan actively-managed bond portfolios

Difficulties in Creating a Difficulties in Creating a Bond-Market IndexBond-Market Index

• Range of bond quality varies from U.S. Range of bond quality varies from U.S. Treasury securities to bonds in defaultTreasury securities to bonds in default

• Bond market changes constantly with new Bond market changes constantly with new issues, maturities, calls, and sinking fundsissues, maturities, calls, and sinking funds

• Bond prices are affected differently by Bond prices are affected differently by changing interest rates dependent on changing interest rates dependent on maturity, coupon, and market yieldmaturity, coupon, and market yield

• Correctly pricing individual bond issues can Correctly pricing individual bond issues can be a challenge without current and be a challenge without current and continuous transaction prices availablecontinuous transaction prices available

Bond Market IndexesBond Market Indexes

• Investment-Grade Bond IndexesInvestment-Grade Bond Indexes– Four investment firms maintain indexes for Four investment firms maintain indexes for

Treasury bonds and other investment grade Treasury bonds and other investment grade bonds (rated BBB or higher)bonds (rated BBB or higher)

– Relationship among these bonds is strong Relationship among these bonds is strong (correlations average 0.95)(correlations average 0.95)

• High-Yield Bond IndexesHigh-Yield Bond Indexes– Non investment-grade bonds (rated BB or below)Non investment-grade bonds (rated BB or below)– Several indexes have been createdSeveral indexes have been created– Relationship among alternative high-yield indexes Relationship among alternative high-yield indexes

is weaker than among investment grade indexesis weaker than among investment grade indexes

Bond Market IndexesBond Market Indexes

• Global Government Bond Market Global Government Bond Market IndexesIndexes– Global bond market dominated by Global bond market dominated by

government issuesgovernment issues– Several indexes created by major Several indexes created by major

investment firmsinvestment firms– Indexes have similar characteristicsIndexes have similar characteristics

Composite Stock-Bond Composite Stock-Bond IndexesIndexes

Considers the benefits of diversification with Considers the benefits of diversification with asset allocation across stocks and bondsasset allocation across stocks and bonds– Merrill Lynch-Wilshire U.S. Capital Markets Index Merrill Lynch-Wilshire U.S. Capital Markets Index

(ML-WCMI)(ML-WCMI)• Market-value weighted index measures total return Market-value weighted index measures total return

performance of the combined U.S. taxable fixed income performance of the combined U.S. taxable fixed income and equity marketsand equity markets

– Brinson Partners Global Security Market Index Brinson Partners Global Security Market Index (GSMI)(GSMI)

• Matches a typical U.S. pension fund allocation policyMatches a typical U.S. pension fund allocation policy• Close to the theoretical “market portfolio of risky assets” Close to the theoretical “market portfolio of risky assets”

referred to in CAPMreferred to in CAPM

Comparison of Indexes Comparison of Indexes Over TimeOver Time

• Correlations among monthly equity price Correlations among monthly equity price changeschanges– Most differences are attributable to sample Most differences are attributable to sample

differencesdifferences– High correlations between S&P 500 and several High correlations between S&P 500 and several

broad stock market indexes (0.98-0.99)broad stock market indexes (0.98-0.99)– Lower correlations between style indexes and Lower correlations between style indexes and

other broader indexesother broader indexes– Correlations between U.S. series and other Correlations between U.S. series and other

countries confirm the wisdom of global investing countries confirm the wisdom of global investing since values are often much lowersince values are often much lower

Comparison of Indexes Comparison of Indexes Over TimeOver Time

• Correlations among monthly bond indexesCorrelations among monthly bond indexes– Among investment-grade bonds correlations Among investment-grade bonds correlations

range from 0.94 to 0.98range from 0.94 to 0.98– Significantly lower correlation between investment Significantly lower correlation between investment

grade and high-yield indexes (about 0.49)grade and high-yield indexes (about 0.49)– Low correlation in global returns to U.S. returns Low correlation in global returns to U.S. returns

(about 0.35) support global diversification (about 0.35) support global diversification (different interest rate movements sometimes, but (different interest rate movements sometimes, but exchange-rate changes may be key driver for the exchange-rate changes may be key driver for the U.S. investor)U.S. investor)