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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?
5 Uses of Security-Market
Indexes
1. For calculating benchmark returns to judge
portfolio performance
2. For development of an index portfolio
3. For examining factors that influence
aggregate security price movements
4. For technical analysis, to predict future
price movements
5. 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
(“unweighted”)?
• 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
Wilshire 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; about .1249 in March
2006)
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 (most indexes use this)
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 (Equal-Weighted)
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 (can
use a 6-category matrix)
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 (especially MSCI EAFE Index)
– 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 require an index to emulate
– Many managers have not matched aggregate
bond market return, so think about passive rather
than actively-managed bond portfolios
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 (0.98-0.99)
– 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
(different interest rate movements sometimes, but
exchange-rate changes may be key driver for the
U.S. investor)