security market indicator series.st

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Chapter 5

Innovative Financial Instruments

Dr. A. DeMaskey

Security-Market Indicator

Series


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Uses ofSecurity-Market IndexesAs benchmarks to judge portfolio

performance

To develop an index portfolioTo examine factors that influence

aggregate security price movement

To predict future price movementTo compute systematic risk of an asset


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Differentiating Factors inConstructing Market Indexes

The samplesize

breadth

sourceWeighting sample

membersprice-weighted series

value-weighted series

unweighted (equallyweighted) series

Computationalprocedurearithmetic average

indexedgeometric average


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Stock-Market Indicator

SeriesPrice-Weighted SeriesDow Jones Industrial Average (DJIA)

Nikkei Average

Value-Weighted SeriesNYSE Composite

S&P 500 Index

AMEX Index

and more.

Unweighted IndexValue Line

Financial Times Ordinary Share Index


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Dow Jones Industrial

Average (DJIA)

Best-known, oldest, most popular series

Price-weighted average of thirty largewell-known industrial stocks, leaders intheir industry, and listed on NYSE

Total the current price of the 30 stocksand divide by a divisor (adjusted forstock splits and changes in the sample)


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Example of Change in DJIA Divisor

When a Sample Stock Splits

After Three-for OneBefore Split Split by Stock A

Prices Prices

A 10 10

B 15 15

C 20 1045 3 = 15 35 X = 15

X = 2.33 (New Divisor)


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Demonstration of the Impact ofDifferently Priced Shares on a Price-Weighted Indicator Series

PERIOD T+ 1 .

Period T Case A Case B

A 100 110 100B 50 50 50

C 30 30 33

Sum 180 190 183Divisor 3 3 3

Average 60 63.3 61

Percentage Change 5.5% 1.7%


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Criticism of the DJIA

Sample used is limited

30 non-randomly selected blue-chip stocksare not representative of the 1800 NYSE

listed stocksPrice-weighted series

Stock split results in less weighting for

sample stockIntroduces a downward bias in DJIA by

reducing weighting of fastest growingcompanies whose stock splits


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Nikkei-Dow Jones Average

Arithmetic average of prices for 225stocks on the First Section of the Tokyo

Stock Exchange (TSE)Best-known series in Japan

Price-weighted series formulated by

Dow Jones and CompanyThe 225 stocks represent 15 percent of

all stocks on the First Section


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Value-Weighted Series

Derive the initial total market value of allstocks used in the seriesMarket 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


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Value-Weighted Series:Illustration

Consider the following three stocks:

Stock Price No. of Shares Value(Million) ($Million)

June 30, 2000:

A 20 2.0 40

B 40 2.5 100

C 60 1.0 60

200

Let this $200 million have an index value of 100.


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Value-Weighted Series:Illustration Continued

Stock Price No. of Shares Value(Million) ($Million)

June 30, 2001:

A 24 2.0 48

B 30 5.0 150

C 60 1.0 60

258

(Note: Stock B split 2-for-1 during the year.)


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Global Equity Indexes

There are stock-market indexesavailable for most individual foreignmarkets.

These are closely followed within eachcountry.

These are difficult to compare due todifferences in sample selection,weighting, or computational procedure.

Groups have computed countryindexes.


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FT/S&P-Actuaries WorldIndexes

Jointly compiled by The Financial TimesLimited, Goldman Sachs & Company, and

Standard & Poors in conjunction with theInstitute 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.


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Includes actively traded medium andsmall corporations along with major

international equities.Securities included must allow direct

holdings of shares by foreign nationals.

Index is market-value weighted with abase date of December 31, 1986 = 100.


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Index results are reported in U.S. dollars,U.K. pound sterling, Japanese yen,

German mark, and the local currency ofthe country included.

Results are calculated daily after the New

York markets close and published thefollowing day in the Financial Times.

Geographic subgroups are also published.


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Morgan Stanley CapitalInternational (MSCI) Indexes

Three international, nineteen national, andthirty-eight international industry indexes

1,375 companies listed on stock exchanges in

19 countries with a combined capitalizationrepresenting

60% of the aggregate market value of the stockexchanges of these countries

All the indexes are market-value weighted

Reporting is in U.S. dollars and the countryslocal currency


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Morgan Stanley CapitalInternational (MSCI) Indexes

Also provides:price to book value (P/BV) ratio

price to cash earnings (earnings plus depreciation)

(P/CE) ratioprice to earnings (P/E) ratio

dividend yield (YLD)

The Morgan Stanley group index for Europe,

Australia, and the Far East (EAFE) is used asthe basis for futures and options contracts


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Dow Jones World Stock

Index

Introduced in January 1993

2,200 companies worldwide

Organized into 120 industry groups

Includes 33 countriesCountries are grouped into 3 regions

Represents over 80% of the combinedcapitalization of these countries

Country indexes are computed in localcurrency, U.S. dollars, British pound, Germanmark, and Japanese yen


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Comparison ofWorld Stock Indexes

Correlations between the three seriessince December 31, 1991, indicate the

results with the alternative world stockindexes are quite comparable.

U.S. Dollars

FT - MS: .998FT - DJ: .997

MS - DJ: .996


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Bond-Market Indicator

Series

Relatively new and not widely published

Growth in fixed-income mutual funds

increase need for reliable benchmarksfor evaluating performance

Many managers have not matched

aggregate bond market returnincreasing interest in bond index funds

requires an index to emulate


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Difficulties in Creating and Computing

Bond-Market Indicator Series

Range of bond quality varies from U.S. Treasurysecurities to bonds in default

Bond market changes constantly with new issues,maturities, calls, and sinking funds

Bond prices are affected by duration, which isdependent on maturity, coupon, and market yield

Correctly pricing individual bond issues withoutcurrent and continuous transaction pricesavailable


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Investment-Grade BondIndexes

Four investment firms maintain indexesfor 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 byaggregate interest rates - shifts in thegovernment yield curve.


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High-Yield Bond Indexes

Non investment-grade bonds

Four investment firms and two

academicians created indexesRelationship among alternative high-

yield bond indexes is weaker than

among investment grade indexes.Merrill Lynch Convertible Securities

Indexes


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Global Government BondMarket Indexes

Global bond market dominated bygovernment issues

Several indexes created by majorinvestment firms:Measure total rates of return

Use market-value weighting

Use trader pricing

But sample sizes differ as do numbers ofcountries included


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Global Government Bond Market

Indexes: Analysis of Performance

Differences affect long-term risk-returnperformance

Low correlation among several countriesis similar to stocks

Significant exchange rate effect on

volatility and correlations


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Composite Stock-BondIndexes

A composite series measures theperformance of all securities in a given

country.Allows examination of benefits of

diversification with a combination of asset

classes such as stocks and bonds


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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 incomeand equity markets

Combination of Merrill-Lynch fixed-

income indexes and the Wilshire 5000common-stock index

Tracks over 10,000 stocks and bonds


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Brinson Partners GlobalSecurity 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 policyClose to the theoretical market portfolio

of risky assets referred to in CAPM


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Comparison of Indexes Over

Time

Correlations Among Monthly EquityPrice Changes

Most differences are attributable to sampledifferences

Different segments of U.S. stock market orfrom different countries

Lower correlations between NYSE seriesand AMEX series or NASDAQ index thanbetween NYSE alternative series (S&P 500and NYSE composite)


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Correlations Among Monthly BondIndexes

Among investment-grade bonds correlationsrange 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


Time


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Mean Annual Stock Price Changes

Expect differences among price changesand measures of risk for various series dueto the different samples.

NYSE series have lower rates of return and riskmeasure than AMEX and OTC series, asexpected.

Canadian results had higher average returnsthan NYSE and lower risk than NASDAQ.

Japanese markets had lower returns andslightly lower volatility than U.S. market.


Time


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Mean Annual Stock Price Changes(continued)

United Kingdom (FT All-Share) had higher returnsthan NYSE indexes, but much larger variability

Japanese markets experienced lower returns andslightly lower volatility than the U.S. markets

Low correlation between Japanese marketwith alternative U.S. stock-market indexes.

Japan could be a prime source of diversification


Time


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Annual Bond Rates of Return

Total rates of return for bond-market indexes

cannot be directly compared to stockpercentage price change results

Expect difference in level of return due todifferential risk premiums

Results confirm expectations


Time


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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
http://www.bloomberg.com/http://www.stockmaster.com/http://www.asx.com.au/http://www.bolsamadrid.es/http://www.tse.com/http://www.nikko.co.jp/SEC/index_e.htmlhttp://www.exchange.de/realtime/dax_d.htmlhttp://www.exchange.de/realtime/dax_d.htmlhttp://www.nikko.co.jp/SEC/index_e.htmlhttp://www.tse.com/http://www.bolsamadrid.es/http://www.asx.com.au/http://www.stockmaster.com/http://www.bloomberg.com/

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