Chp.

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Security Market Indices

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What is an index?
•An index is a group of securities chosen to track a particular investment

theme such as a market, sector, or industry.

• Generally the goal is to accurately represent the risk/return profile of that

theme without necessarily holding every security that might qualify.

•The exact collection of securities in an index is known as its basket, while the

proportion of the index each individual security comprises is its weighting.

• An index’s value is a single number that, when referenced to a starting value,

describes how the index has performed over time.

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Uses of Security-Market Indexes

•For calculating benchmark returns to judge portfolio performance

•For development of an index portfolio

•For examining factors that influence aggregate security price

movements

•For technical analysis, to predict future price movements

•To compute a security’s systematic risk by examining how its

return responds to changes in the market index

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Factors in Constructing Market Indexes
•The sample of firms to include
What is the proposed population that the sample is to represent? How large a
sample is needed for the index to be representative?
•Weighting system for sample members
Should the weighting system be based on price, total firm value, or equally
weighted?
•Computational procedure
How should the values of the index be reported and tracked (arithmetic or
geometric mean)?

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Price-weighted index
•A price-weighted index is an arithmetic mean of current stock prices, which
means that index movements are influenced by the differential prices of the
components.
•Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 large,
well-known industrial stocks that are generally the leaders in their industry (blue
chips).
The DJIA is computed by totaling the current prices of the 30 stocks and dividing
the sum by a divisor that has been adjusted to take account of stock splits and
changes in the sample over time. The divisor is adjusted so the index value will be
the same before and after the split.
30



DJIA t 


  Pit / Dadj
i 1

where:
DJIAt = the value of the DJIA on day t
Pit = the closing price of stock i on day t
Dadj = the adjusted divisor on day t
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Adjusted Devisor
Stock Before Split After Three-for-One Split by Stock A
Prices
A 30 10
B 20 20
C 10 10
60/3=20 40/X=20
New Divisor is 2.
•The adjusted divisor ensures that the new value for the index is the same as it
would have been without the split.
•Due to stocks split, the divisor becomes smaller and the cumulative effect of
splits can be derived from the fact that the divisor was originally 3.0, but as of
April 8, 2011 it was 0.132129493.

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 Example:
Period T+1
Stock Period T Case A Case B
A 100 110 100
B 50 50 50
C 30 30 33
Sum 180 190 183
Divisor 3 3 3
Average 60 63.3 61
Percentage change 5.5 1.7
•As the index is price weighted, a high-priced stock carries more weight than a
low priced stock.
•A 10 percent change in a $100 stock ($10) will cause a larger change in the
index than a 10 percent change in a $30 stock ($3).
•For Case A, when the $100 stock increases by 10 percent, the average rises by
5.5 percent; for Case B, when the $30 stock increases by 10 percent, the average
rises by only 1.7 percent.
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Criticism:
1.The sample used for the index is limited to 30 non randomly selected large,
mature blue-chip stocks that cannot be representative of the thousands of U.S.
stocks. As a result, the DJIA has not been as volatile as other market indexes.
2.Because the DJIA is price weighted, when companies have a stock split, their
prices decline and therefore their weight in the DJIA is reduced—even though
they may be large and growing.
•The weighting scheme causes a downward bias in the DJIA because high-growth
stocks will have higher prices and because such stocks tend to split, these stocks
of growing companies will consistently lose weight within the index.

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Nikkei-Dow Jones Average
•Nikkei-Dow Jones Average also referred to as the Nikkei Stock Average Index

•It is an arithmetic mean of prices for 225 stocks on the First Section of the Tokyo

Stock Exchange (TSE) and shows stock price trends since the reopening of the

TSE.

•Similar to the DJIA, it is a price-weighted index and is also criticized because the

225 stocks only comprise about 15 percent of all stocks on the First Section.

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Value-Weighted Index
•A value-weighted index is generated by deriving the initial total market value of
all stocks used in the index (Market Value = Number of Shares Outstanding (or
freely floating shares) × Current Market Price).
• Prior to 2004, the tradition was to consider all outstanding shares. In mid-2004,
Standard & Poor’s began only considering “freely floating shares” that exclude
shares held by insiders.
•The initial figure is typically considered as the base and assigned an index value
(typically the beginning index value is 100, but it can vary—say, 10, 50).
• Subsequently, a new market value is computed for all securities in the index,
and the current market value is compared to the initial “base” market value to
determine the percentage change.
•Index(t) =∑Pt.Qt/Pb.Qb
where:
Indext = index value on day t
Pt = ending prices 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
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Example:
Stock Share Price Number of Shares Market Value
December 31, 2011
A $10.00 1,000,000 \ $10,000,000
B 15.00 6,000,000 90,000,000
C 20.00 5,000,000 100,000,000
Total $200,000,000
Base Value Equal to an Index of 100
December 31, 2012
A $12.00 1,000,000 $12,000,000
B 10.00 12,000,000a 120,000,000
C 20.00 5,500,000b 110,000,000
Total $242,000,000
New Index Value =Current Market Value/Base Value× Beginning Index Value
=$242,000,000/$200,000,000 × 100
= 1:21 × 100
= 121
Where
a Stock split two-for-one during the year. b company paid a 10 percent stock dividend
during the year.
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•Value Weighted Index(Cont.)
•There is an automatic adjustment for stock splits and other capital changes with a

value-weighted index because the decrease in the stock price is offset by an

increase in the number of shares outstanding.

•The importance of individual stocks in the sample depends on the market value

of the stocks.

•Therefore, a specified percentage change in the value of a large company has a

greater impact than a comparable percentage change for a small company.

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Value Weighted Index(Cont.)
•If we assume that the only change is a 20 percent increase in the value of stock A,
which has a beginning value of $10 million, the ending index value would be $202
million, or an index value of 101.
•In contrast, if only stock C increases by 20 percent from $100 million, the ending
value will be $220 million or an index value of 110.
• The point is, price changes for large market value stocks in a value-weighted index
will dominate changes in the index value over time.
•It is important to be alert of the large-value stocks in the index.

DECEMBER 31, 2011 DECEMBER 31, 2012

Case A Case B
Stock No. of Shares Price Value Price Value Price Value
A 1,000,000 $10.00 $ 10,000,000 $12.00 $12,000,000 $10.00 $1 0,000,000
B 6,000,000 15.00 90,000,000 15.00 90,000,000 15.00 90,000,000
C 5,000,000 20.00 100,000,000 20.00 100,000,000 24.00 120,000,000
$200,000,000 $202,000,000 $220,000,000
Index Value 100.00 101.00 110.00

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Unweighted Index (Equally weighted Index)
•In an unweighted index, all stocks carry equal weight regardless of their price
or market value.
•A $20 stock is as important as a $40 stock, and the total market value of the
company is unimportant.
•Such an index can be used by individuals who randomly select stock for their
portfolio or invest the same dollar amount in each stock.
DECEMBER 31, 2011 DECEMBER 31, 2012

Stock No. of Shares Price Value Price Value % change

A 200,000 $20.00 $40,000,000 $30 $60,000,000 50
B 8,000,000 15.00 120,000,000 20 160,000,000 33.3
C 10,000,000 30.00 300,000,000 33 330,000,000 10
$460,000,000 $550,000,000 93.3/3=31.1
Equal Weighted Index= 100 x 1.311 = 131.100
Market Value Weighted Index:=100 x550,000,000/460,000,000= 119.565

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