Chapter 3: Information and Indices Flashcards
What is an index?
An average
What does an index measure?
How average prices change over time.
What is important to remember when it comes to indices?
An important idea is that the index number itself is arbitrary. What matters is how the index number changes, so if it moves up by 10% it means the constituents of the index have moved by 10%.
What does a weighted index do?
It gives some constituents of the index greater importance than others. Common weighting techniques include market weighted where the shares in companies with the biggest total value are most important, or by price (unweighted) where the shares with the highest price are the most important.
Define an index.
An index is a number that gives the value of something (e.g. shares in a stock market) relative to its value at some other point in time.
What happens when an index starts?
It is assigned a base value e.g. 100
What does a movement in an index do?
Any movement in the index measures the change in value of the constituents of the index. If, in our example, the index rises to 1,100, then we know that the constituents of the index have risen in value by 10%.
What do all major stock exchanges calculate indices based on?
The shares traded on that exchange.
What is a tracker fund?
A fund set up to match the movements of a chosen benchmark index.
Explain a passive management style.
Many unit trusts and other collective investment vehicles managing portfolios of securities are established as tracker funds by matching the constituents of a specific index. This style of management is called passive, and its aim is to do at least as well as the market as a whole.
Explain active management.
It attempts to beat a particular index using market timing and stock selection.
Explain how indices are used for derivative products.
Some of the largest traded futures and option products around the world are based on stock market indices, such as the FTSE 100 index future. These allow investors to speculate on the movement of the market in general rather than on the price of an individual security.
How are most indices weighted?
Towards the market capitalisation of their constituent companies.
How is market capitalisation calculated?
Market capitalisation takes the share price for the company and multiplies it by the number of shares in issue.
In market indices are all constituent companies treated equally?
No! For example, in the FTSE 100 index; Royal Dutch Shell is one of the largest companies by market capitalisation currently listed on the LSE. The FTSE 100 index is weighted to market capitalisation. Therefore, a 1% movement in the share price of Royal Dutch Shell will have a greater impact on the FTSE 100 index than a 1% movement in the share price of another FTSE 100 constituent, e.g. Marks and Spencer Group.
How is the Dow Jones Industrial Average used by the New York Stock Exchange calculated?
It is weighted towards the price of a share in a company rather than the full market capitalisation.
What is a benchmark index?
An Index used to assess the performance of a fund manager.
What 3 qualities must a valid benchmark have to effectively evaluate performance?
- Specified in advance.
- Known to both the investment manager and the investor.
- Appropriate to the portfolio that it is compared against.
What are the 7 characteristics of an appropriate benchmark?
- The benchmark should be consistent with the manager’s investment approach and style
- The benchmark should be measurable
- The benchmark should be unambiguous
- The securities and their respective weights should be clearly defined
- The benchmark should be reflective of the manager’s current investment opinions
- The manager should know about the securities of the benchmark
- The benchmark should be investable
What does the EU Benchmark Regulation do?
It introduces a common framework and consistent approach to benchmark regulation across the EU. It aims to ensure benchmarks are robust and reliable and to minimise conflicts of interest in benchmark-setting processes.
When does an index become a benchmark within the scope of the EU Benchmarks Regulation?
- When it is used to determine the amount payable under a financial instrument or financial contract, or the value of a financial instrument
- When it is used to measure the performance of an investment fund for the purpose of:
- Tracking the return
- Defining the asset allocation or a portfolio, or
- Computing the performance fees
- Recent amendments to this regulation provide for standardised provisions to deal with a statutory replacement of a benchmark rate – something we are currently seeing with the LIBOR rate
Explain free float shares.
One of the requirements of a valid benchmark is that it is investable. Most indices are calculated on a ‘free-float’ basis to meet this requirement. Free-float shares are the shares that are theoretically available to be purchased by the general public. For instance, shares held by directors would not be considered free-float shares as directors are unlikely to sell their shares in the short-term. Companies with a low level of free-float shares will have a more volatile share price that may distort an index.
The index weighting will reflect the amount of free-float shares available. For instance, if a company has 40% free-float shares, its index weighting will be 40% rather than 100%. This will ensure that those companies with a low free-float level of shares do not distort the index.
What do stock or share indices normally measure?
The increase in share prices in certain markets such as the London Stock Exchange.
What do stock or share indices normally NOT include?
The indices do not normally include dividends, instead focusing on the increase in the capital value of the shares.
How are bond indices normally calculated?
Bond indices, however, are normally calculated as total return indices including both movements in bond prices and the coupon income received. The index chosen as a benchmark will normally reflect the characteristics of the portfolio being managed i.e. by sector, duration etc.
What steps must be taken to create an index?
To create an index number, a base year and a base value must be chosen:
- The base year is the point in time you wish to monitor the constituents of the index from.
- The base value is the numerical starting point of the index (usually something simple like 100).
What unit is used to refer to changes in an index?
Percentage points.
When is re-basing necessary?
When the index moves too far away from its base value.
Write down the formula for a simple arithmetic index.
Refer to image.
What is the price relative of a share worth £1.52 on the base date, but now worth £1.87?
£1.87/£1.52 = 1.23
1.23 times or 123% of its base price.
Write out the formula used to calculate a market weighted index.
Refer to the attached image.
