Transcript Lecture Presentation to accompany Investment Analysis

Security-Market Indicator
Series
Innovative Financial Instruments
Dr. A. DeMaskey
Chapter 5
Uses of
Security-Market Indexes
As benchmarks to judge portfolio
performance
To develop an index portfolio
To examine factors that influence
aggregate security price movement
To predict future price movement
To compute systematic risk of an asset
Differentiating Factors in
Constructing Market Indexes
The sample
size
breadth
source
Weighting sample
members
price-weighted series
value-weighted series
unweighted (equally
weighted) series
Computational
procedure
arithmetic average
indexed
geometric average
Stock-Market Indicator
Series
Price-Weighted Series
Dow Jones Industrial Average (DJIA)
Nikkei Average
Value-Weighted Series
NYSE Composite
S&P 500 Index
AMEX Index
and more….
Unweighted Index
Value Line
Financial Times Ordinary Share Index
Dow Jones Industrial
Average (DJIA)
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)
Example of Change in DJIA Divisor
When a Sample Stock Splits
A
B
C
After Three-for One
Before Split
Split by Stock A
Prices
Prices
10
10
15
15
20
10
45 3 = 15
35 X = 15
X = 2.33 (New Divisor)
Demonstration of the Impact of
Differently Priced Shares on a PriceWeighted Indicator Series
Period T
A
100
B
50
C
30
Sum
180
Divisor
3
Average
60
Percentage Change
PERIOD T+ 1
Case A
Case B
110
100
50
50
30
33
190
183
3
3
63.3
61
5.5%
1.7%
.
Criticism of the DJIA
Sample used is limited
30 non-randomly selected blue-chip stocks
are not representative of the 1800 NYSE
listed stocks
Price-weighted series
Stock split results in less weighting for
sample stock
Introduces a downward bias in DJIA by
reducing weighting of fastest growing
companies whose stock splits
Nikkei-Dow Jones Average
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 Series
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)
New market values are compared to the
base index
Automatic adjustment for splits
Weighting depends on market value
Value-Weighted Series:
Illustration
Consider the following three stocks:
Stock
Price
June 30, 2000:
A
20
B
40
C
60
No. of Shares
Value
(Million)
($Million)
2.0
2.5
1.0
40
100
60
200
Let this $200 million have an index value of 100.
Value-Weighted Series:
Illustration Continued
Stock
Price
June 30, 2001:
A
24
B
30
C
60
No. of Shares
(Million)
2.0
5.0
1.0
(Note: Stock B split 2-for-1 during the year.)
Value
($Million)
48
150
60
258
Unweighted Price Indicator
Series
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 and derive the
holding period yield from this calculation.
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.
FT/S&P-Actuaries World
Indexes
Jointly compiled by The Financial Times
Limited, Goldman Sachs & Company, and
Standard & Poor’s in conjunction with the
Institute of Actuaries and the Faculty of
Actuaries.
Measures 2,461 securities in 30 countries.
Covers 70% of the total value of all listed
companies in each country.
FT/S&P-Actuaries World
Indexes
Includes actively traded medium and
small corporations along with major
international equities.
Securities included must allow direct
holdings of shares by foreign nationals.
Index is market-value weighted with a
base date of December 31, 1986 = 100.
FT/S&P-Actuaries World
Indexes
Index results are reported in U.S. dollars,
U.K. pound sterling, Japanese yen,
German mark, and the local currency of
the country included.
Results are calculated daily after the New
York markets close and published the
following day in the Financial Times.
Geographic subgroups are also published.
Morgan Stanley Capital
International (MSCI) Indexes
Three international, nineteen national, and
thirty-eight international industry indexes
1,375 companies listed on stock exchanges in
19 countries with a combined capitalization
representing
60% of the aggregate market value of the stock
exchanges of these countries
All the indexes are market-value weighted
Reporting is in U.S. dollars and the country’s
local currency
Morgan Stanley Capital
International (MSCI) Indexes
Also provides:
price to book value (P/BV) ratio
price to cash earnings (earnings plus depreciation)
(P/CE) ratio
price to earnings (P/E) ratio
dividend yield (YLD)
The Morgan Stanley group index for Europe,
Australia, and the Far East (EAFE) is used as
the basis for futures and options contracts
Dow Jones World Stock
Index
Introduced in January 1993
2,200 companies worldwide
Organized into 120 industry groups
Includes 33 countries
Countries are grouped into 3 regions
Represents over 80% of the combined
capitalization of these countries
Country indexes are computed in local
currency, U.S. dollars, British pound, German
mark, and Japanese yen
Comparison of
World Stock Indexes
Correlations between the three series
since December 31, 1991, indicate the
results with the alternative world stock
indexes are quite comparable.
FT - MS:
FT - DJ:
MS - DJ:
U.S. Dollars
.998
.997
.996
Bond-Market Indicator
Series
Relatively new and not widely published
Growth in fixed-income mutual funds
increase need for reliable benchmarks
for evaluating performance
Many managers have not matched
aggregate bond market return
increasing interest in bond index funds
requires an index to emulate
Difficulties in Creating and Computing
Bond-Market Indicator Series
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
Correctly pricing individual bond issues without
current and continuous transaction prices
available
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
Four investment firms and two
academicians created indexes
Relationship among alternative highyield bond indexes is weaker than
among investment grade indexes.
Merrill Lynch Convertible Securities
Indexes
Global Government Bond
Market 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 differ as do numbers of
countries included
Global Government Bond Market
Indexes: Analysis of Performance
Differences affect long-term risk-return
performance
Low correlation among several countries
is similar to stocks
Significant exchange rate effect on
volatility and correlations
Composite Stock-Bond
Indexes
A composite series measures the
performance of all securities in a given
country.
Allows examination of benefits of
diversification with a combination of asset
classes such as stocks and bonds
Merrill Lynch-Wilshire U.S.
Capital Markets Index (ML-WCMI)
Market-value weighted index
Measures total return performance of
the combined U.S. taxable fixed income
and equity markets
Combination of Merrill-Lynch fixedincome indexes and the Wilshire 5000
common-stock index
Tracks over 10,000 stocks and bonds
Brinson Partners Global
Security Market Index (GSMI)
Includes:
U.S. stocks and bonds
Non-U.S. equities
Non-dollar bonds
Allocation to cash
Matches a typical U.S. pension fund
allocation policy
Close to the theoretical “market portfolio
of risky assets” referred to in CAPM
Comparison of Indexes Over
Time
Correlations Among Monthly Equity
Price Changes
Most differences are attributable to sample
differences
Different segments of U.S. stock market or
from different countries
Lower correlations between NYSE series
and AMEX series or NASDAQ index than
between NYSE alternative series (S&P 500
and NYSE composite)
Comparison of Indexes Over
Time
Correlations Among Monthly Bond
Indexes
Among investment-grade bonds correlations
range from 0.90 to 0.99
Interest rates differ by risk premiums
Rates of return are determined by systematic
interest rate variables
Low correlation in global returns to U.S.
returns support global diversification
Comparison of Indexes Over
Time
Mean Annual Stock Price Changes
Expect differences among price changes
and measures of risk for various series due
to the different samples.
NYSE series have lower rates of return and risk
measure than AMEX and OTC series, as
expected.
Canadian results had higher average returns
than NYSE and lower risk than NASDAQ.
Japanese markets had lower returns and
slightly lower volatility than U.S. market.
Comparison of Indexes Over
Time
Mean Annual Stock Price Changes
(continued)
United Kingdom (FT All-Share) had higher returns
than NYSE indexes, but much larger variability
Japanese markets experienced lower returns and
slightly lower volatility than the U.S. markets
Low correlation between Japanese market
with alternative U.S. stock-market indexes.
Japan could be a prime source of diversification
Comparison of Indexes Over
Time
Annual Bond Rates of Return
Total rates of return for bond-market indexes
cannot be directly compared to stock
percentage price change results
Expect difference in level of return due to
differential risk premiums
Results confirm expectations
The Internet:
Investments Online
www.bloomberg.com
www.stockmaster.com
www.asx.com.au
www.bolsamadrid.es
www.tse.com
www.nikko.co.jp:80/SEC/index_e.html
www.exchange.de/realtime/dax_d.html