ims cfa reading 53

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Security Market Indexes

Reading - 53

Quantitative Methods
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Learning Objective Statements (LOS)

a. Use of Security Market Indices

b. Important factor in considering an index

c. Price-Weighted Index

d. Value-Weighted Index

e. Unweighted Index

f. Global Equity Indexes

g. Bond Market Indexes

h. Composite Stock-Bond Indexes


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Use of Security Market Indexes

Used as a benchmark for portfolio performance on a

risk adjusted basis.1 Index funds and Exchange traded funds (ETFs) are

created based on indexes to emulate this market

portfolio.2

Aggregate market movements can be measured byindexes.3

Movements of indexes can aid the technicians topredict and forecast future market movement.4

Indexes can be used as a proxy for market portfolio tocalculate the systematic risk associated with the risky

assets.5


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Important factors in considering an Inde

x

Size, breadth and the source of sample are all important.

Sample must represent the total population.

Sample should be taken from each segment of population.

Sample

Price Weighted Index

Market Value Weighted Index

Unweighted Index

WeightingSample

Members

Simple arithmetic mean of the various members in the index.

Compute an index and have all the changes in terms of basic index.

Geometric mean of the component rather than arithmetic mean.

ComputationalProcedures


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Dow Jones Industrial Average (DJIA)

DJIAt = Value of Dow Jones Industrial Average on day t

Pit = Closing price of stock i on day t

Dadj = Adjusted divisor on day t.

It is the arithmetic mean

of the current prices Implies

Index movements are

influenced by the differential

prices of the components.

30

Pat

Dadj

i = 1

DJIAt =


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Facts about DJIA:o It is the price weighted average of 30 blue chip companies.

o The divisor is adjusted to take care of the stock splits andchanges in sample over time.

o The weight of each firm in the index is proportional to theshare price rather than the total outstanding market value ofthe shares.

Limitations of DJIA:

o The size of the sample is limited to 30 blue chip stocks only.o In case of stock split in a company, the price of company

declines which results in decline in its weight in DJIAirrespective of its size and importance which causesdownward bias.


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Change in DJIA divisor

when there is a stock

split:

Impact of DifferentlyPriced Shares on a

Price-Weighted Index:




Nikkei Dow Jones Average:It is an arithmetic mean of prices for 225 stocks on the First

section of the Tokyo Stock Exchange (TSE).

Limitations:

225 stocks comprise of only 15% of the total stocks in First

section.



Value-Weighted Index

Where,

Value Weighted Indext = Index value on day t

Pt = ending price for stocks on day t

Qt = number of outstanding or freely floating shares on day t

Pb = ending price for stocks on base day

Qb = number of outstanding or freely floating shares on base day

Free Floating Shares = All outstanding shares Shares held byinsiders

Market Value = Free Floating Shares x Current Market Price



Value-Weighted Index

Note:

In Value-Weighted Index,

change in price for large

market value stocks will

dominate the changes in

the index value over time.



Unweighted Index

Facts:o All stocks carry equal weight irrespective of their price or

market value.

o This type of index can be used by individuals to invest in

randomly selected stocks for their portfolio and invest equal

amount in each stock.

o Actual movements of index are typically based on the

arithmetic mean of the percent changes in price or marketvalue of stocks in the index.



Global Equity Indexes

It is a set of consistent country stock indexes which can be usedas a bench mark for various indexes across different nations tocreate various regional indexes.

Major sets of global equity indexes:

o FT/S&P-Actuaries World Indexes: Approximately 2500 equityshares in 30 countries which covers at least 70% of the totalvalue of all listed companies in each country, are measured.

oMorgan Stanley Capital International (MSCI) Indexes:Approximately 1673 companies listed in stock exchanges in19

countries are considered.

o Dow Jones World Stock Index: It is composed of more than2200 companies organized into 120 industry groups from 28countries



Bond-Market Indexes

Reasons for difficulty to create and compute a bond market indexin contrast to stock market:

1) The universe of bonds is broader than stocks.

2) Constant changes in the universe of bonds due to new issues,

bond maturities, calls and bonds sinking funds.

2) The volatility of prices for individual bonds and bond portfolio

changes because of effect of duration.



Bond-Market Indexes

Bond Indexes:o U.S. Investment-Grade Bond Indexes: Relationship among the

returns for these investment grade bonds is strong i.e.

correlation average of about 0.95, regardless of the segment

of the market.

o High-Yield Bond Indexes: These includes bond that are not

investment grade i.e. they are rated Bb, B, Ccc, Cc and C.

o Global Government Bond Indexes: This type of bond indexesare completely dominated by government bonds .



Composite Stock-Bond Indexes

It is used to measure the performance of all the securities in agiven country. With this, the investors can examine the positive

side of diversifying with a combination of different types of

asset.

Merrill Lynch-Wilshire Capital Markets Index: It measures the

total return performance of the combined U.S. taxable fixed

income and equity markets.

Brinson Partner Global Security Markets Index: It consists of U.S.

Stocks and bonds as well as non-U.S. equities and non dollar

bonds along with an allocation to cash.


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ims cfa reading 53

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