CH5 Flashcards
Uses of Security-Market Indexes
As benchmarks to evaluate the performance of
money managers
To create and monitor an index fund
To measure market rates of return
For predicting future market movements
As a substitute for the market portfolio of risky
assets when calculating the systematic risk of
an asset
Factors/ Characteristics
Affecting Market Indexes
1) The Sample
-Size
-Breadth
-Source
2) The Weighting of Sample Members
-Price-weighted series
-Value-weighted series
-Unweighted (equally weighted) series
3) Computational Procedure
-Arithmetic average
-Compute an index and have all changes, whether in price or value, reported in terms of the basic
index
-Geometric average
Stock-Market Indexes
Price Weighted Index
1) Dow Jones Industrial Average (DJIA)
2) Nikkei-Dow Jones Average
Value-Weighted Index
1) NYSE Composite
2) S&P 500 Index
Unweighted Index
1) Value Line Averages
2) Financial Times
Ordinary Share Index
Dow Jones Industrial Average (DJIA)
Price Weighted Index
Best-known, oldest, most popular series
Price-weighted average of thirty large
well-known industrial stocks, leaders in their
industry, and listed on NYSE
Total the current price of the 30 stocks and
divide by a divisor (adjusted for stock splits
and changes in the sample)
Criticism of the DJIA
Limited to 30 non-randomly selected blue-chip
stocks (BIGGEST)
Does not represent a vast majority of stocks
The divisor needs to be adjusted every time
one of the companies in the index has a stock
split
Introduces a downward bias by reducing
the weighting of fastest growing companies whose
stock splits
Nikkei-Dow Jones Average
Price Weighted Index
Arithmetic average of prices for 225 stocks on
the First Section of the Tokyo Stock Exchange
(TSE)
Best-known series in Japan
Price-weighted series formulated by Dow
Jones and Company
The 225 stocks represent 15 percent of all
stocks on the First Section
Value-Weighted Index Derive
Derive the initial total market value of all
stocks used in the series
Market Value =
Number of Shares Outstanding
X Current Market Price
Assign a beginning index value (100) and
new market values are compared to the base
index
Automatic adjustment for splits
Weighting depends on market value
Unweighted Index
All stocks carry equal weight regardless of
price or market value
May be used by individuals who randomly
select stocks and invest the same dollar
amount in each stock
Some use arithmetic average of the percent
price changes for the stocks in the index
Value Line and the Financial Times Ordinary
Share Index compute a geometric mean of the
holding period returns
Global Equity Indexes
There are stock-market indexes available for
most individual foreign markets
These are closely followed within each country
These are difficult to compare due to
differences in sample selection, weighting, or
computational procedure
Groups have computed country indexes
Difficulties in Creating the Bond Index
(Why are bond indexes more difficult to create and maintain than stock indexes?)
Universe of bonds is much broader than that of
stocks
(BIG VARIATION) Range of bond quality varies from U.S. Treasury
securities to bonds in default
Bond market changes constantly with new issues,
maturities, calls, and sinking funds
Bond prices are affected by duration, which is
dependent on maturity, coupon, and market yield
PROBLEMS IN Correctly pricing individual bond issues without current and continuous transaction prices available
Bond-Market Indexes
U.S. Investment-Grade Bond Indexes
High-Yield Bond Indexes
Global Government Bond Indexes
U.S. Investment-Grade Bond Indexes
Four investment firms maintain indexes for
Treasury bonds and other investment grade (rated
BBB or higher) bonds
Relationship among these bonds is strong
(correlations average 0.95)
Returns for all these bonds are driven by
aggregate interest rates - shifts in the government
yield curve
High-Yield Bond Indexes
Non-investment-grade bonds
Rated BB, B, CCC, CC, C
Four investment firms and two academicians
created indexes
Relationship among alternative high-yield bond
indexes is weaker than among investment grade
indexes
Merrill Lynch Convertible Securities Indexes
Global Government Bond Indexes
Global bond market dominated by government
issues
Several indexes created by major investment firms
-Measure total rates of return
-Use market-value weighting
-Use trader pricing
-But sample sizes and numbers of countries differ
Differences affect long-term risk-return performance
Low correlation among several countries
Significant exchange rate effect on volatility and
correlations
what are Composite Stock-Bond Indexes
composite series that measures the
performance of all securities in a given country
This allows examination of benefits of
diversification with a combination of asset
classes such as stocks and bonds in addition to
diversifying within the asset classes of stocks or
bonds
