Chapter 7

SECURITY-MARKET INDICATOR
SERIES
 Chapter 7 Questions
What are some major uses of security-market
indicator series (indexes)?
What are the major characteristics that cause
alternative 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 an indicator
series?
It is an index 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 Indicator
Series
Price-Weighted Series
 Dow Jones Industrial Average (DJIA)
Value-Weighted Series
 NYSE Composite
 S&P 500 Index
 Russell Indexes
 Willshire 5000 Index
Equal-Weighted Series
 Value Line Averages
 Dow Jones Industrial
Average (DJIA)
Best-known, oldest, most popular index
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
 Original divisor was 30
 Divisor now adjusted for stock splits and changes
in the sample, so now much smaller (about 0.1445
in March 2002)
 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 Series
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 Series

Index t 
 PQ
t t
 Beginning Index Value
P Q
b b

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 Series
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
Indicator Series
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 1,375 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 Indicator
Series
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 Index
Series
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 Index
Series
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 series based on NYSE
firms (about .993)
 Lower correlations between NYSE series and
AMEX or Nasdaq series (about .903)
 Correlations between U.S. series and other
countries confirm the wisdom of global investing
since values are much lower (averaging .627)
Comparison of Indexes
Over Time
Correlations among monthly bond
indexes
 Among investment-grade bonds
correlations range from 0.90 to 0.99
 Low correlation in global returns to U.S.
returns (.07 to .29) support global
diversification