Security-Market Indexes

USES OF SECURITY-MARKET INDEXES

 Everybody talks about security market indexes but few people understand
them.
 A primary application is to use the index values to compute total returns
and risk measures for an aggregate market or some component of a market
over a specified time period. In turn, many investors use the computed
return-risk results as a benchmark to judge the performance of individual
portfolios.
 An aggregate stock or bond-market index can be used as a benchmark to
judge the performance of professional money managers.
 USES OF SECURITY-MARKET INDEXES

 Securities analysts, portfolio managers, and academicians doing research use

security market indexes to examine the factors that influence aggregate
security price movements.
 Like how inflation, interest rate and exchange rate impact stock prices
 Another group interested in an aggregate market index is composed of
“technicians,” who believe past price changes can be used to predict future
price movements.
 DIFFERENTIATING FACTORS IN CONSTRUCTING
MARKET INDEXES
 Because the indexes are intended to reflect the overall movements of a group of
securities, we need to consider three factors that are important when constructing an
index intended to represent a total population.
1- The Sample
2- Weighting Sample Members
3- Computational Procedure
 DIFFERENTIATING FACTORS IN CONSTRUCTING
MARKET INDEXES
1- The Sample
 A small percentage of the total population will provide valid indications of the behavior of
the total population if the sample is properly selected.
 For example, if we are taking sample of finance managers of Pakistan, than such sample
should be from all provinces and all business sectors.
 Assuming you are not including the total population, the sample should be representative of
the total population; otherwise, its size will be meaningless.
 The sample can be generated by completely random selection or by a nonrandom
selection technique designed to incorporate the important characteristics of the desired
population.
Random Sampling: Select any 10 companies from Pakistan Stock Exchange (PSX)
Non-Random Sampling: Select top 10 companies from textile sector of Pakistan Stock
Exchange (PSX)
 DIFFERENTIATING FACTORS IN CONSTRUCTING
MARKET INDEXES
1- The Sample
 Finally, the source of the sample is important
If you want to collect share prices data it is better to take from PSX website instead of
any other less reputable website
 DIFFERENTIATING FACTORS IN CONSTRUCTING
MARKET INDEXES

2- Weighting Sample Members

I. A price-weighted index
II. A market-value weighted index
III. An unweighted index or equal-weighted index
3- Computational Procedure
IV. One option can be to take simple arithmetic or geometric mean
V. Another option can be to consider different value changes
 STOCK SPLIT

 A stock split is a way for a company to reduce or increase the number of shares
outstanding and make them more appealing to new investors.
 Splitting stock doesn't change a company's total value, it simply changes the number
of outstanding shares.
 By reducing or increasing the number of outstanding shares, the company can in
turn increase or decrease the share price to achieve the outcome it seeks.
 There are 2 types of stock splits
 Forward split
 Reverse split
 FORWARD SPLIT (Increase in Shares)
 A forward split is when a company increases the number of outstanding shares held by current
shareholders. Let's say you're a shareholder in Company X. You own 100 shares and each
share is worth $50, for a total market capitalization of $5,000 (100 x 50 = 5000). Company X
decides to do a 2-for-1 forward stock split; this means you will now have 2 shares for every 1
that you own, or 200 shares, with each share now being worth $25 (50/2 = 25). Although you
now own twice as many shares, your investment in the company remains the same at $5,000
 Summary Before Any Split
o Shareholder having 100 share or total shares of shareholders = 100.
o The price of each share is $50.
o Total market capitalization (market value) will be
o Number of shares x price per share = 100 x 50 = $5000
 In case of announcement of forward split “2 for 1”
o Now the shares of shareholder will become 100 x 2 = 200
o The price of each share will become half 50/2 = 25
o Overall market capitalization (market value will remain same) = 200 x 25= $5000
 REVERSE SPLIT
(Decrease in Shares)
 A reverse split is when a company decreases the number of outstanding shares held
by current shareholders. For example, a 1-for-2 reverse stock split means that you'll
receive one share for every 2 shares that you currently own.
 Summary Before Any Split
o Shareholder having 100 share or total shares of shareholders = 100.
o The price of each share is $50.
o Total market capitalization (market value) will be
o Number of shares x price per share = 100 x 50 = $5000
 In case of announcement of reverse split “1 for 2”
o Now shareholder share will be half: 100/2 =50
o The price of each share will become double: 50 x 2=100
o Overall market capitalization (market value will remain same) = 50 x 100= 5000
 Why would a company want to split its
stock?
 As the price per share of a company's outstanding stock rises, the pool of
investors that are willing to invest becomes potentially smaller. In order to
make the stock more affordable for investors (and increase liquidity), the
company can perform a forward stock split, essentially lowering the price
per share
 For example, if a company’s share reach at the price of $1000, than the
investor who have $500, cannot purchase the share. However, in case of
forward split, the $1000 shares can become $500. So now this share can
come into reach of small investors
 Why would a company want to split its
stock?
 On the other hand, if a company's share price is too low, investors may take
it as a warning sign. A company may want to perform a reverse stock split
to increase its price per share to reassure investors of a company's value.
This is often done out of necessity to meet a share price requirement and
avoid being delisted from a stock exchange.
 Forexample, if there is requirement that if a company share in the stock
market comes below $1 than the company will be delisted. So the company
whose share is at $1 can adopt reverse split and make the price 2 $
 STOCK-MARKET INDEXES
1- Price-Weighted Index
 A price-weighted index is an arithmetic mean of current stock prices, which means that
index movements are influenced by the differential prices of the components.
 Example 1
 The best-known price-weighted index is also the oldest and certainly the most
popular stock-market index, the Dow Jones Industrial Average (DJIA).
 The DJIA is a price-weighted average of 30 large, well-known industrial stocks that
are generally the leaders in their industry (blue chips).
 Example 2
 Nikkei-Dow Jones Average
 Also referred to as the Nikkei Stock Average Index, it is an arithmetic mean of prices
for 225 stocks of the Tokyo Stock Exchange (TSE)
 STOCK-MARKET INDEXES
2- Value-Weighted Index
 A value-weighted index is generated by deriving the initial total market value of all
stocks used in the index (Market Value = Number of Shares Outstanding (or freely
floating shares) × Current Market Price).
 Example KSE 100 Index
3- Unweighted Index or Equally Weighted Index
 In an unweighted index, all stocks carry equal weight regardless of their price or
market value.
 Example
 The most prominent of the unweighted stock indexes is the S&P 500 Equal
Weight Index (EWI)
 STOCK-MARKET INDEXES
4- Fundamental Weighted Index
 A fundamentally weighted index, or fundamental index, is one in which the
equity components were chosen based on criteria other than market
capitalization. For example, a fundamentally weighted index can be based
on revenue, dividend yields, earnings, or other fundamental factors
 STOCK-MARKET INDEXES
5- Global Equity Indexes
 The Morgan Stanley Capital International Indexes.
 The indexes consider some 1,673 companies listed on stock exchanges in 22
countries, with a combined market capitalization that represents approximately 60
percent of the aggregate market value of the stock exchanges of these countries. All
the indexes are market value weighted.
 The following relative valuation information is available: (1) price-to-book value
(P/BV) ratio, (2) price-to-cash earnings (earnings plus depreciation) (P/CE) ratio,
(3) price-to-earnings (P/E) ratio, and (4) dividend yield (YLD).
 Dow Jones Wilshire Global Indexes
 TheDow Jones Wilshire Global Indexes is composed of more than 2,200
companies worldwide
 BOND-MARKET INDEXES
1- U.S. Investment-Grade Bond Indexes
1. Maturity of over 1 year
2- High-Yield Bond Indexes
2. Bonds of mixed maturity
3- Global Government Bond Indexes
3. Bonds have maturity of over 1 year
4. Combination of different countries bonds
 COMPOSITE STOCK-BOND INDEXES

 Beyond separate stock indexes and bond indexes for individual

countries, a natural step is the development of a composite index that
measures the performance of all securities in a given country.
First,a market-value-weighted index called Merrill Lynch-Wilshire
Capital Markets Index (ML-WCMI) measures the total return
performance of the combined U.S. taxable fixed income and equity
markets.
 COMPARISON OF INDEXES OVER TIME
1- Correlations between Monthly Equity Price Changes or correlation between
indexes
 The correlation differences are mainly attributable to the different sample of firms
listed on the various stock exchanges.
 Because index are calculated based on the sample of whole market
 Correlation difference may be due to different sectors/segments
 There is a high positive correlation (0.98–0.99) between the Dow Jones Total Stock
Market Index and the several other U.S. equity indexes such as the S&P 500
 COMPARISON OF INDEXES OVER TIME
2- Correlations between Monthly Bond Index Returns
1. Correlation among bond types differ according to different types of bonds
indexes
 MEAN ANNUAL SECURITY RETURNS AND
RISK
 The security indexes are also used to measure returns and risk. This risk and return
provide the securities aggregate risk and return