1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Investments and Portfolio Analysis
Lecture 1: Introduction to Financial Market
Dr. Maxime Couvert
University of Hong Kong
Fall, 2022
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Fall, 2022
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Today’s agenda
1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
3.1 Fixed-income securities
3.1.1 The money market
3.1.2 The bond market
3.2 Equity securities
3.3 Derivatives
4. Stock and Bond Market Indices
4.1 Weighting Schemes
4.1.1 Price-weighted indices
4.1.2 Value-weighted indices
4.1.3 Equally-weighted indices
4.2 Stock splits, dividends, composition changes
4.3 Indices for non-listed assets
Part 1. Introduction to the course
1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 1. About me
Contact Details:
Dr. Maxime Couvert
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email: mcouvert@hku.hk
phone: 3917 2192
office: KKL 1006
My Research Interests:
Mutual Funds
Shareholder Activism
ESG Investments
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 1. Teaching Assistants
Contact Details:
Mr. Jason Tse
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email: jasontch@hku.hk
phone: 2857 8308
office: KKL 1026
Ms. Stephanie Ting
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email: scwting@hku.hk
phone: 2857 8308
office: KKL 1026
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 1. Assessment Methods
4 types of assessment:
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Assignment(s)/Project(s): 25%
Midterm Exam: 20%
Class/Tutorial Participation: 5%
Final Exam: 50%
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 1. Exams
Midterm:
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Date: October 22, 2022
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Review session: a session will take place on the last lecture before the
midterm
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Formula sheet: a formula sheet will be provided
Final:
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Date: TBA
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Review session: a session will take place on the last lecture before the
final
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Formula sheet: a formula sheet will be provided
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 1. Assignments
There will be 2 group assignments
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The assignments will be posted on Moodle two weeks before the due
dates
The first assignment due date is Oct. 10, 2022
The second assignment due date is Nov. 21, 2022
Please form groups of 4-5 students (you are allowed to team up with
students from subclasses A, B, C, and D)
Fill the group members in the ”Investment Competition” Excel sheet
by Tuesday, September 20
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 1. FINA2320 - Investment Competition
This year we will organize our first investment competition!
Source: https://www.wealthandfinance-news.com/7-things-people-get-terribly-wrong-about-stocks-and-the-stock-market/
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 1. FINA2320 - Investment Competition
Imagine that your team (same as for the assignments) is working in a
private bank. You are meeting with a potential new client, Kevin. He is a
25-year-old soccer player who knows that soccer careers tend to be
short. Therefore, he has decided to hire a private bank to help him prepare
for his retirement. However, there are many good private banks and he
does not know which one to choose. His soccer coach suggested that he
organizes an investment competition between the different private banks
to help him choose the best one.
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 1. FINA2320 - Investment Competition
Rules of the investment competition:
1
Report the names, UID, email of your team members in the Excel
sheet
2
Choose a name for your bank and report it in the Excel sheet.
3
Your team must construct a (approximately) USD1,000,000 portfolio
composed of 2 stocks.
4
Choose the weights that you assign to each stock in the portfolio.
5
Provide a short rationale for your decision to invest in each stock.
(max 50 words)
6
Submit your Excel on Moodle by September 20, 2022
7
On November 9, Kevin will analyze the performance of your portfolio
and declare the winner.
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 1. Other administrative matters
Office hours:
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Thursdays from 4:20pm, Office KK1006 (+Zoom)
Emails:
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Regarding exercise sessions and administrative matters: please contact
the teaching assistants
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For other questions: I will answer the questions in class such that
everyone benefits from answers
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 1. Textbook
Investments, 12th Edition, Zvi Bodie, Alex Kane, and Alan J.
Marcus, McGraw-Hill. 2021.
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 1. Course Objectives
1
Gain a fundamental knowledge of investment strategies
2
Understand equity portfolio management techniques
3
Understand different asset pricing models and equity valuation
techniques
4
Understand the concepts and applications of capital market
equilibrium and market efficiency
5
Understand portfolio performance evaluation and current issues
about investments and portfolio management
6
Introduction to financial modeling using Excel
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 1. Course Content
Objective 1: Fundamental knowledge of investment strategies
Basic Knowledge in Financial Markets (Ref.: Chapters 1 and 2)
How to Trade Securities? (Ref.: Chapter 3)
Mutual Funds and Other Investment Companies (Ref.: Chapter 4)
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 1. Course Content
Objective 2: Understand equity portfolio management techniques
Portfolio Statistics (Ref.: Chapter 5)
Markowitz Portfolio Selection Model (Ref.: Chapters 6 and 7)
Index Models (Ref.: Chapter 8)
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 1. Course Content
Objective 3: Understand different asset pricing models and equity
valuation techniques
CAPM (Ref.: Chapter 9)
Arbitrage Pricing Theory (Ref.: Chapter 10)
Equity Valuation Model (Ref.: Chapter 18.3)
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 1. Course Content
Objective 4: Understand the concepts and applications of capital market
equilibrium and market efficiency
Market Efficiency (Ref.: Chapter 11)
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 1. Course Content
Objective 5a: Understand portfolio performance evaluation
Portfolio Performance Evaluation (Ref.: Chapter 24)
Objective 5b: Current issues about investments and portfolio
management
Introduction to Sustainable Finance
Objective 6: Introduction to financial modelling using Excel
Assignment 2
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 1. Questions?
Any question?
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Part 2. Basic Knowledge in Financial Markets
(Ref. Chapter 1)
1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 2. What is an investment?
Definition
An investment is the current commitment of money or other resources in
the expectation of future benefits.
Investing therefore implies that
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You are willing to sacrifice resources today...
in the hope that...
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your sacrifice will be rewarded with benefits in the future.
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 2. The investment decision
Investing therefore implies decision making on:
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How much to invest vs. consume?
How to invest?
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Which assets?
Which proportion?
How long are you willing to sacrifice your resources for?
Which amount of risk are you willing to take?
What benefits can you expect?
All these questions are part of the investment decision.
This class will provide you with tools to make such investments
decisions.
Question: Is saving an investment?
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 2. Financial vs. Real Assets
Definition
Real assets are assets that you can directly use for the production of goods
or services.
For example: Land, machines, or knowledge.
Definition
Financial assets are means by which an individual holds claims on real
assets.
For example: Stocks, bonds, or options.
Question: Are $100 notes financial or real assets? What about your
bachelor education?
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 2. Financial Assets
We generally classify financial assets in three large categories:
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Fixed-income securities: they are securities that promise a stream of
income that is either fixed or determined by a fixed formula. E.g.
bonds
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Equity securities: they are corporation ownership titles. E.g. stocks
▶
Derivative securities: they are more complex financial assets. E.g.
options or forwards
We will study these securities in more details later in the course.
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 2. Financial markets are very competitive
Financial markets competitiveness implies a risk-return trade-off
Financial markets competitiveness implies markets efficiency
In other words, ”there is no free lunch”
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 2. Financial markets’ main players
Three main players:
1
Firms: net demanders of capital
2
Households: net suppliers of capital
3
Governments: can borrow or lend
Other important players:
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Financial intermediaries: bring suppliers and demanders of capital
together (banks, investment companies, insurance companies, etc.)
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Investment banks: provide services that help firms raise capital
(economies of scale and expertise)
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Venture Capital and Private Equity: provide capital to non-listed firms
(e.g. start-ups)
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Fintech: firms that apply technological innovation to provide finance
related products and services.
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Reading
Read Chapter 1 of the reference book.
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Part 3. Financial asset categories
Ref. Chapter 2
1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 3. Financial asset categories
Three main financial asset categories:
1
Fixed-income
2
Equity
3
Derivatives
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3.1. Fixed-income securities
1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 3.1. Fixed-income securities
Definition
Fixed-income securities are securities that promise a stream of income that
is either fixed or determined by a fixed formula.
Why do fixed-income securities pay a rate of return?
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 3.1. Fixed-income securities
Definition
Fixed-income securities are securities that promise a stream of income that
is either fixed or determined by a fixed formula.
Why do fixed-income securities pay a rate of return?
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Inflation risk:
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Assume that a 10-year bond with a face value of $1M that pays a 2%
fixed annual coupon
If inflation goes up, the value of the coupons will decrease in real terms
Investors care about real terms!
So the higher risk of inflation, the higher the interest rate on the bond
needs to be
Default risk:
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Will the borrower pay back the borrowed amount and the interest on
time?
The hire the default risk, the higher the interest rate on the bond needs
to be
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 3.1. Fixed-income securities
Two main markets for fixed-income securities:
1
The Money Market
2
The Bond Market
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 3.1.1. The money market
Key features of the money market:
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Debt securities
Very short-term
Highly liquid (almost equivalent to cash)
Very low risk
Large denominations
Main money market securities (we focus on those):
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U.S. Treasury Bills
Commercial Paper
Repos and Reverse Repos
Other important money market securities (please read Chapter 2)
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Certificates of deposit
Bankers’ Acceptances
Eurodollars
Brokers’ Calls
Federal Funds
LIBOR (London Interbank Offer Rate)
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 3.1.1. Treasury Bills
Often referred to as T-bills
Concept:
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The US government borrows money from the public
Investors buy the bill at a discount and the government pays the face
value of the bill at maturity
Example for a $10,000 bill: US government borrows $9,900 today and
pays back $10,000 in one year
Key features:
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Short-term: common maturities are 4, 13, 26, or 52 weeks
Most marketable and most liquid of all money market instruments
Very safe: currently, the risk that the US government defaults over the
forthcoming year is almost zero
Small denomination: $100 denominations exist but $10,000 are much
more common
Regularly issued: every week for short maturities, every month for
52-week maturity
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 3.1.1. Remark: risk-free assets
Definition
The risk free rate is the rate of interest on a theoretically risk-free asset.
In practice, no such asset exists
Because of its core features, the one-month T-bill is often used as a
risk-free asset (e.g. for CAPM)
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Almost no risk
Very liquid
A common alternative for risk-free rate proxy is the rate on
short-term German government bills
Over the past few years, we have started to observe negative interest
rates on German government bills
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 3.1.1. Remark: risk-free assets
Historical risk-free rate
Remarks:
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The risk-free rate fluctuates over time
These fluctuations are due to:
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Changes in the Federal Reserve monetary policy (interest rate)
Changes in inflation
Changes in investors’ demand for safe assets
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 3.1.1. Commercial Paper
Concept:
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Large, well-known companies issue debt notes
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Allows companies to borrow directly from financial markets rather than
from banks
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They are short-term
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They are generally unsecured (but can be backed by bank credit lines
or other financial assets)
Key features:
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Rather safe (although less than a government bill)
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Maturities: generally 1 or 2 months
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Denominations: generally multiples of $100,000
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 3.1.1. Repos and Reverse Repos
Repo is the short name for Repurchase Agreement
Concept:
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A borrower sells a very safe security to a buyer with at a slightly higher
price
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The borrower commits to buy back the security at a slightly higher
price after a specified short period
Key features:
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Very short-term: usually overnight
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Very safe: backed by a very safe security (often a government bond)
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Repo rate: interest rate paid by the borrower to the lender on the
amount borrowed
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Haircut: It is common that the lender delivers less cash than the
market value of the collateral. The spread is called the haircut.
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 3.1.1. Repos and Reverse Repos
Other remarks:
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Reverse Repo:It is a Repo but from the perspective of the lender
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The Repo rate can be used as a proxy for the overnight risk-free rate
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Useful to borrow to buy new securities (i.e. leverage a position)
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During the 2007-2008 crisis, there was a so-called ”Run on Repos”
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The value of collateral decreased because of increasing counterparty
risk and concerns about liquidity of the bond market
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In consequence, haircuts increased
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The US banking system became effectively insolvent for the first time
since the Great Depression of the 1920’s. (Gorton, Metrick; 2012)
Source: Gorton, G., & Metrick, A. (2012). Securitized banking and the run on repo. Journal of Financial Economics, 104(3),
425-451.
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 3.1.1. Repo - Example
In t, a borrower (e.g. a hedge fund) sells $10M in treasuries to a
lender (e.g. an asset manager)
In t + 1, a borrower buys back the treasuries at a pre-determined
price $10.01M from the lender
Haircut = 10%
Repo rate = 1%
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 3.1.1. Remarks on other money market instruments
The LIBOR:
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LIBOR is the short name for the London Interbank Offer Rate
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Concept:
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Overnight rate at which banks can borrow from one another
Key features:
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Very short term
It is part of the European money market
It is at the base of many financial contracts (e.g. mortgages)
A major scandal occurred in 2012 (the so-called ”LIBOR scandal”)
As a consequence of the scandal, it was decided to put an end to the
LIBOR, effective as of the end of 2021 (for some specific cases 2023).
Money Market Funds:
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Money market funds are mutual funds that invest in the money market
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 3.1.2. The bond market
Key features of the bond market
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Debt securities
Longer-term than money market
Liquidity depends on the bond (can be highly illiquid)
Tends to be riskier than money market securities
Main bond securities (we focus on those):
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Treasury Notes and Bonds
Corporate Bonds
Other important bond securities (please read Chapter 2)
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Municipal Bonds
Mortgage Securities
Federal Agency Debt
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 3.1.2. Treasury Notes and Bonds
Concept:
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They represent a large portion of the US government borrowing
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T-notes have maturities ranging up to 1 year
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T-bonds have maturities ranging from 10 to 30 years
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Denomination: $1,000 is the most common but $100 also exists for
both
Coupons: both deliver semiannual interest payments called coupons
Key features:
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They are both very liquid
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They are both very safe (as the US government is unlikely to default)
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 3.1.2. Remarks on other types of bonds
Corporate Bonds
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Concept:
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Corporations use these bonds to borrow from public markets
They generally deliver semiannual coupons
Face-value is generally paid back at maturity
Key Features:
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They are riskier than government bonds (default risk)
Municipal bonds:
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Concept:
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Debt securities issued by state and local governments
Similar to corporate bonds but no federal income tax on their interest
payments
Key features:
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Wide variety of maturities
Although these are securities that are issued by governmental
authorities, they can be quite risky
Defaults are not uncommon among local US public entities
Examples of large municipal bonds’ defaults: The City of Detroit in
2013 ($US20B), the government of Puerto Rico in 2015 ($72B)
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 3.1.2. Example of government default - Vulture funds
Definition
Vulture Funds are investment (hedge) funds that specialize in acquiring
fixed-income securities (generally bonds) of near-default entities and that
try to recover the borrowed money
Argentina vs. Elliott Capital Management (Elliott)
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In 2001, Argentina defaulted on its $100B sovereign debt and
restructured it, cutting payouts down to 30 cents per dollar of debt
Elliott had acquired an estimated $117M of deprecated Argentinian
bonds
Elliott refused the restructuring plan and decided to sue Argentina
US courts rules in favor of Elliott
In 2012, Elliott requested and obtained the seizure of the Argentinian
military vessel, the Liberdad, with 250 crew members onboard
Elliott even attempted to seize satellite contracts between Argentina
and SpaceX
In 2016, Elliott and Argentina reached an agreement with Argentina
accepting to pay $2.4B to Elliott
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 3.1.2. Rating agencies
How do you assess the riskiness of fixed-income securities?
Rating agencies provide riskiness ratings
They rate fixed-income securities based on their default risk
Which are the three main credit agencies?
How does their rating system work?
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 3.1.2. Rating agencies
Source: https://prepnuggets.com/glossary/credit-ratings-agency/
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 3.1.2. Problems with rating agencies
They performed very poorly during the 2007-2008 crisis
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Default probabilities were estimated with historical data that did not
take into account systemic risk
▶
They entities that pay for the services are the ones being rated
(conflicts of interest)
Their ratings can be used to compute bank capital ratios
Are these issues gone?
What about ESG ratings?
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3.2. Equity securities
1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 3.2. Equity securities
Definition
Common stocks represent ownership shares in corporations
Commons stocks are also often referred to as equity securities or
equities
Concept:
▶
▶
▶
▶
▶
▶
The term Common refers to the fact that each share entitles its owner
to one vote
In contrast, non-common stocks may entitle their owner to more than
one vote
Limited Liability: shareholders’ liability is limited to the money they
invested (no need to sell their house to pay back the companies’ debts)
Infinite maturity: as long as the corporation exists
Residual claim on benefits: shareholders have a claim on any remaining
benefits after all other claimants have been paid.
Dividends: firms’ benefits can be reinvested or paid as cash dividends
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 3.2. Corporate Governance and Voting
Corporations resemble democracies
▶
▶
▶
In democracies:
⋆
Citizens elect representatives, Parliament Members
⋆
These Parliament Members select the executive body, the Government
In corporations:
⋆
Shareholders elect representatives, Board Members
⋆
These Board Members select the executive body, the Management
Direct democracies:
⋆
Corporations even resemble direct democracies as shareholders have the
right to submit proposals requesting the implementation of some sort
of reforms
Shareholder voting:
▶
In consequence, shareholders vote at corporation’s meetings to elect
board members and to approve a lot of matters related to auditing,
dividends, executive compensation, shareholder proposals, etc.
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 3.2. Preferred Stocks
Preferred Stocks:
▶
Inbetween bond and equity
▶
Like a bond, it provides a specific fixed income every year
▶
Like equity, there is no obligation to pay dividends, instead dividends
cumulate and must be paid before common stockholders receive
dividends
▶
Preferred stocks do not convey voting rights
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3. Derivatives
1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 3.3. Derivatives
Their value depends on the value of another asset, the underlying
asset
Common derivatives include:
▶
▶
▶
▶
Options
Futures
Forwards
Swaps
Read Chapter 2.5
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Part 4. Stock and Bond Market Indices
(Ref. Chapter 2.4)
1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 4. Market indices
Definition
A Market Index is a basket of securities used to measure the evolution of a
specific subset of the market
Key feature:
▶
The ”price” of an index reflects the average changes of its constituents
Key roles:
▶
▶
▶
Market barometer: allows to track the performance of a specific
(sub-)market
Market benchmark: allows to compare performances
Underlying index: provides a basis for securities (derivatives) or funds
(e.g. index trackers)
Examples:
▶
▶
▶
▶
Dow Jones Industrial Average
S&P500
HSI (Hang Seng Index)
CSI 300
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 4. Example: the S&P500 and the HSI
S&P500 in blue and HSI in red
Informational role of financial markets regarding the global macro
economy
We can easily observe the covid-related crashes as well as the recovery
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 4. How to construct an index?
Are the assets listed on public markets?
▶
▶
Yes:
⋆
Examples: listed stocks, bonds, or listed derivatives
⋆
Computation base: public prices
No:
⋆
Examples: real estate, art, or some private equity funds
⋆
Computation base: much more difficult as transaction prices may not
be public
Which weighting scheme?
1
Price weighted
2
Value weighted
3
Equally weighted
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Part 4.1. Weighting Schemes
1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 4.1.1. Price-weighted indices
Numerical example price-weighted index:
Stock
Price in t
Price in t + 1
Return
Firm A
Firm B
100
20
110
18
+10%
-10%
Index
60
64
+6.67%
Index Price in t: PI ,t = PA,t + PB,t
Index Price in t + 1: PI ,t+1 = PA,t+1 + PB,t+1
Return of the index between t and t + 1: RI ;t,t+1 =
PI ;t+1
PI ;t
−1
Price-weighted indices give more weights to larger prices
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 4.1.1. Price-weighted indices
Price-weighted indices deliver the same returns as equally-weighted
portfolio:
Stock
Price in t
Price in t + 1
Return
Firm A
Firm B
100
20
110
18
+10%
-10%
Portfolio
120
128
+6.67%
Example of price-weighted index:
▶
Dow Jones Industrial Average (Dow Jones)
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 4.1.1. Price-weighted indices
Generalization to N securities:
Definition
PN
PI ,t =
i=1 Pi,t
N
PI ,t is the price of the index in t
Pi,t is the price of security i in t
N is the total number of securities in the index
Remark: the denominator N can be replaced by another value to take
into account stock splits or when firms are dropped or added to the
index
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 4.1.2. Value-weighted indices
Numerical example value-weighted index:
Stock
Shares
Price
in t
Mkt.cap.
in t
Price
in t + 1
Mkt.cap.
in t + 1
Return
Firm A
Firm B
1
20
100
20
100
400
110
18
110
360
+10%
-10%
100
500
94
470
-6.00%
Index
Index Price in t: PI ,t = 100 (set arbitrarily)
Index Price in t + 1: PI ,t+1 = PI ,t ×
Mkt.cap.t+1
Mkt.cap.t
Return of the index between t and t + 1: RI ;t,t+1 =
PI ;t+1
PI ;t
−1
Price-weighted indices give more weights to larger market
capitalizations
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 4.1.2. Value-weighted indices
Generalization to N securities:
Definition
PN
PI ,t+1 = PI ,t × Pi=1
N
MCi,t+1
i=1 MCi,t
PI ,t is the arbitrarily set price of the index at the initial period t
N is the total number of securities in the index
MCi,t is the market capitalization of firm i in t
Remark: the factor
PN
PI ,t
MCi,t
can be much more complex to take into
i=1
account stock splits or when firms are dropped or added to the index
Price-weighted indices deliver the same returns as equally-weighted
portfolio
Most common weighting scheme. For example: S&P500, HSI, CSI
300
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 4.1.3. Equally-weighted indices
Numerical example equally-weighted index:
Stock
Price in t
Price in t + 1
Return
Firm A
Firm B
100
20
110
18
+10%
-10%
Index
100
100
+0%
Return of the index between t and t + 1:
RI ;t,t+1 =
RA;t,t+1 + RB;t,t+1
10% − 10%
=
2
2
Index Price in t: PI ,t = 100 (set arbitrarily)
Index Price in t + 1:
PI ,t+1 = PI ,t × (1 + RI ;t,t+1 ) = 100 × (1 + 0%)
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 4.1.3. Equally-weighted indices
Generalization to N securities:
Definition
PN
RI ;t,t+1 =
i=1 Ri;t,t+1
N
PI ,t+1 = PI ,0 × (1 + RI ;0,1 ) × (1 + RI ;1,2 ) × ... × (1 + RI ;t,t+1 )
PI ,0 is the arbitrarily set price of the index at the initial period t
N is the total number of securities in the index
Ri;t,t+1 is the return on asset i from time t to t + 1
Equally-weighted indices deliver the same returns as a portfolio
strategy that invests equal dollar value in each security.
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Part 4.2. Stock splits, dividends, composition changes
1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 4.2. Stock splits, dividends, composition changes
How to deal with stock splits or dividends or composition changes?
Composition changes:
▶
You need to adjust!
Stock splits:
▶
You need to adjust!
Dividends:
▶
▶
▶
Some indices take them into account, others don’t!
Example of included dividends: S&P500
Example of excluded dividends: CAC40 (France)
Read Chapter 2.4 of the reference book
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 4.2. Stock splits, dividends, composition changes
Evolution of the CAC40 with and without dividends
CAC 40 GR: includes dividends
CAC 40: excludes dividends
Source: Google Finance
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Part 4.3. Indices for non-listed asset
1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 4.3. Constructing indices for non-listed assets
Examples:
▶
Real estate, art, private equity funds
Much more difficult to compute:
▶
▶
▶
Prices may not be public
Transactions can be very infrequent
Assets may be very different from one another
Solutions:
▶
▶
Hedonic regressions: take into account the characteristics of the assets
Repeated sales: for example the Case-Shiller index
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1. Introduction to the Course
2. Basic Knowledge in Financial Markets
3. Financial Asset Categories
4. Market Indices
Part 4.3. Constructing indices for non-listed assets
The Case-Shiller index
Repeated sales index based on the single-family house prices of 20 US
cities
One can clearly observe the 2007-2008 real estate crash
Source: FRED St.Louis
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