Chapter 7
SECURITY-MARKET
INDEXES
Chapter 7 Questions
• What are some major uses of security-market
indexes?
• What are the major characteristics that cause
various indexes to differ?
• What are the major stock-market indexes in
the United States and globally, and what are
their characteristics?
• What are the major bond-market indexes for
the United States and the world?
Chapter 7 Questions
• Why are bond indexes more difficult to create
and maintain than stock indexes?
• What are some of the composite stock-bond
market indexes?
• Where can you get historical and current data
for all these indexes?
• What is the relationship among many of
these indexes in the short-run (monthly)?
What is a market index?
It is an indicator that
answers the
question: What
happened in the
market today?
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
Factors in Constructing
Market Indexes
• The sample of firms to include
– What is the intended 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)?
Stock-Market Indexes
• Price-Weighted Indexes
– Dow Jones Industrial Average (DJIA)
• Value-Weighted Indexes
–
–
–
–
NYSE Composite
S&P 500 Index
Russell Indexes
Willshire 5000 Index
• Equal-Weighted Indexes
– Value Line Averages
Dow Jones Industrial Average
(DJIA)
• Best-known, oldest, most popular index
• Price-weighted average of thirty large wellknown industrial stocks, leaders in their
industry, and listed on NYSE
• Total the current price of the 30 stocks and
divide by a divisor
– Original divisor was 30
– Divisor now adjusted for stock splits and changes
in the sample, so now much smaller (about
0.1356 in October 2004)
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
– Similar to assuming an investment of one share
per stock
– Places more weight on higher-priced stocks rather
than those with higher market values
– Introduces a downward bias in DJIA by reducing
weight of growing companies whose stock splits
Value-Weighted Indexes
• Although the DJIA is the most popular index,
the most popular type is value-weighted.
• Derive the initial total market value of all
stocks used in the series
Market Value = Number of Shares Outstanding
x Current Market Price
• Beginning index value is usually 100, new
market values change the value of the index
• Automatic adjustment for splits
• Weighting depends on market value
Value-Weighted Indexes
Index t
PQ


P Q
t
t
b
b
 Beginning Index Value
where:
Indext = index value on day t
Pt = ending prices for stocks on day t
Qt = number of outstanding shares on day t
Pb = ending price for stocks on base day
Qb = number of outstanding shares on base day
Value-Weighted Indexes
• Construction similar to assuming investment
in proportion to total market value
• Take into account that large market value
stocks make up more of the market than do
smaller market value stocks
– Large market value stocks dominate the impact
on index values over time
• Also these series tend to be more broad than
the DJIA
Unweighted Price Indexes
• All stocks carry equal weight regardless
of price or market value
• Constructed in a parallel fashion to
individuals who select stocks and invest
the same dollar amount in each stock
• Changes in the index can be reported
either in terms of arithmetic or
geometric means
Style Indexes
• Additional indexes have been created
that seek to measure the performance
of various investment styles or sectors
– Size indexes track the performance of
large-cap, mid-cap, and small cap stocks
– Other indexes track the relative
performance of growth and value stocks,
perhaps also broken down into sizes
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 computation
• In response, some standardized indexes
have been developed
– FT/S&P Actuaries World Indexes
– Morgan Stanley Capital International (MSCI)
World Indexes
– Dow Jones World Stock Index
FT/S&P-Actuaries World
Indexes
• Track over 2,400 securities in 30 countries
• Covers 70% of the total value of all listed
companies in each country
• 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
• Results are calculated daily and published
the following day in the Financial Times
• Geographic subgroups are also published
MSCI Indexes
• Three international, nineteen national, and
thirty-eight international industry indexes
• Include 1,673 companies listed on stock
exchanges in 19 countries with a combined
capitalization representing 60 percent of the
aggregate market value of the stock
exchanges of these countries
• All the indexes are market-value weighted
Dow Jones World Stock Index
• Introduced in January 1993
• Includes 28 countries with a total of
2,200 companies worldwide, organized
into 120 industry groups
• Countries are grouped into 3 regions
• Represents over 80% of the combined
capitalization of these countries
Comparison of World Stock
Indexes
• Correlations
between all of the
pairs of broad world
indexes are nearly
1.00, indicating that
the results with the
alternative world
stock indexes are
quite comparable
Bond-Market Indexes
• Relatively new and not widely published
• Growth in fixed-income mutual funds
increase need for reliable benchmarks
for evaluating performance
• Increasing interest in bond index funds,
which requires an index to emulate
– Many managers have not matched
aggregate bond market return
Difficulties in Creating a
Bond-Market Index
• 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 differently by
changing interest rates dependent on
maturity, coupon, and market yield
• Correctly pricing individual bond issues can
be a challenge without current and
continuous transaction prices available
Bond Market Indexes
• Investment-Grade Bond Indexes
– Four investment firms maintain indexes for
Treasury bonds and other investment grade
bonds (rated BBB or higher)
– Relationship among these bonds is strong
(correlations average 0.95)
• High-Yield Bond Indexes
– Non investment-grade bonds (rated BB or below)
– Several indexes have been created
– Relationship among alternative high-yield indexes
is weaker than among investment grade indexes
Bond Market Indexes
• Global Government Bond Market
Indexes
– Global bond market dominated by
government issues
– Several indexes created by major
investment firms
– Indexes have similar characteristics
Composite Stock-Bond
Indexes
Considers the benefits of diversification with
asset allocation across 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
– Brinson Partners Global Security Market Index
(GSMI)
• 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
– High correlations between S&P 500 and several
broad stock market indexes (.98-.99)
– Lower correlations between style indexes and
other broader indexes
– Correlations between U.S. series and other
countries confirm the wisdom of global investing
since values are often much lower
Comparison of Indexes Over
Time
• Correlations among monthly bond indexes
– Among investment-grade bonds correlations
range from 0.94 to 0.98
– Significantly lower correlation between investment
grade and high-yield indexes (about 0.49)
– Low correlation in global returns to U.S. returns
(about 0.35) support global diversification