Security Market Indices

Dr. Himanshu Joshi

 Indian and Foreign Stock Market
Indices
S&P BSE Sensex: The S&P Bombay Stock
Exchange Sensitivity Index, also called the BSE
30 or simply the SENSEX, is a free-float market
weighted stock market index of 30 well
established and financially sound companies
listed on Bombay Stock Exchange.
 Indian and Foreign Stock Market
Indices
NIFTY: The NSE S&P CNX Nifty 50 or NIFTY, as
it is commonly known, is the prime index of
the National Stock Exchange. CNX Nifty is a
well diversified 50 stock index accounting for
22 sectors of the economy. It is used for a
variety of purposes such as benchmarking
fund portfolios, index based derivatives and
index funds.
 Foreign Stock Indices..
Dow Jones Industrial Average (DJIA) An Index of
the 30 largest publicly traded corporations in the
US maintained by the Dow Jones Corporation.
S&P 500: An index of 500 of the largest
companies traded in US maintained by Standard
& Poors.
Nasdaq Composite: An index for all the stocks
that trade on the Nasdaq stock market, where
most of the technology stocks in the US are
traded.
 Foreign Stock Indices..
FTSE 100: An Index of the 100 most highly
capitalized UK companies listed on the London
Stock Exchange.
DAX: An index of 30 largest German companies
trading on the Frankfurt Stock Exchange.
CAC 40: An index of the largest 40 French
Companies traded on Euronext Paris.
Hang Seng: An Index of the largest companies
traded on the Hong Kong stock markets.
Strait Times: An index of the largest 30
companies traded on the Singapore exchange.
 Index Definition
A Security Market Index represents a given
security market, market segment, or asset
class. Most indices are constructed as
portfolios of marketable securities.
 Value of Index
The value of an index is calculated on a regular basis
using either the actual or estimated market prices of
the individual securities, known as constituent
securities, within the index.
For each security index, investors may encounter two
versions of the same index.
1. One version based on price return.
2. Another version based on total return.
Total Return Index, reflects not only the prices of the
constituent securities but also the reinvestment of all
income received since inception.
 Value of Index
At inception, the values of the price and total
return versions of an index are equal.
As time passes, however, the value of the total
return index, which includes the reinvestment
of all dividends and/or interest received, will
exceed the value of the price return index by
an increasing amount.
Description of a Security Market Index

Constituent Security market

securities index

Price return index Total return index

 Value of a Price Return Index
N

n P i i
VP RI i 1
D
VPRI = the value of the price return index
ni = the number of units of constituent securities in the
index
N = the number of constituent securities in the index
Pi = the unit price of constituent security i
D = the value of the divisor
 Calculation of Single-Period Price Return

VPRI 1 VPRI 0 N N
Pi1 Pi 0
PR I w i PR i w i
VPRI 0 i 1 i 1 Pi 0
PRI = the price return of index portfolio I
PRi = the price return of constituent security i
wi = the weight of security i
Pi1= the price of constituent security i at the end of the
period
Pi0= the price of constituent security i at the beginning
of the period
 Example: Calculation of Single-Period
Price Return
Beginning Ending of Dividends
of Period Period Price per share Shares
Security Price () () () Outstanding
LMN 10.00 12.00 0.50 200
OPQ 25.00 24.00 1.00 100
RST 15.00 18.00 0.25 400
Divisor = 100
( 200 10) (100 25) ( 400 15)
VP RI 0 105.00
100
( 200 12) (100 24) ( 400 18)
VP RI 1 120.00
100
120.00 105.00
PR I .1429 14.29%
105.00
 Calculation of Single-Period Total Returns

VPRI 1 VPRI 0 Inc I

TR I
VPRI 0
N
P1i P0i Inc i
N

TR I w i TR i w i
i 1 i 1 P0i

TRI = the total return of the index portfolio

IncI = the total income from all securities in the index
TRi = the total return of the constituent security i
Inci = the total income from security i
 Example: Calculation of Single-Period
Total Return
Beginning Ending of Dividends
of Period Period per share Shares
Security Price () Price () () Outstanding
LMN 10.00 12.00 0.50 200
OPQ 25.00 24.00 1.00 100
RST 15.00 18.00 0.25 400
Divisor = 100

Inc I [(200 0.50) (100 1.00) (400 0.25)] 100 3.00

120.00 105.00 3.00
TR I .1714 17.14%
105.00
Calculation of Index Values over Multiple Time Periods

The calculation of index values over multiple time

periods requires geometrically linking the series of
index returns.

VPRIT VPRI 0 1 PR I 1 1 PR I 2 1 PR IT
VTR IT VTR I 0 1 TR I 1 1 TR I 2 1 TR IT
 Example: Calculation of Index Values
over Multiple Time Periods
For an index with an inception value set to 1,000 and price
returns of 5 percent and 3 percent for Periods 1 and 2
respectively, the values of the price return index would be
calculated as follows:

Period Return (%) Calculation Ending Value

0 1,000(1.00) 1,000.00

1 5.00 1,000(1.05) 1,050.00

2 3.00 1,000(1.05)(1.03) 1,081.50

Choices in Index Construction and Management

Which target market should the index represent?

Which securities should be selected from that target market?

How much weight should be allocated to each security in the index?

When should the index be rebalanced?

When should the security selection and weighting decision be re-examined?

 Target Market Selection

Defined broadly
or narrowly?

Other Based on an
characteristics? asset class?
Target
market

Based on
Based on an
geographic
exchange?
region?
 Different Weighting Methods Used in
Index Construction
Market
Equal weighted capitalization
weighted

Fundamentally
Price weighted
weighted
Index
weighting
 Weighting Schemes
Price weighted: Market capitalization weighted:

Pi Q i Pi
w
P w M
i N

Q
i N

Pi
i 1
j 1
j Pj

Equal weighted: Factor weighted:

Fi
1 w F

w E
i N
i
N F j 1
j
 EXHIBIT 2-1 Example of a Price-Weighted Index
BOP BOP
Value Value Weight Weight
Shares (Shares BOP (Shares Price Total x Price x Total EOP
in BOP x BOP Weight EOP Dividends x EOP Total Return Return Return Return Weight
Security Index Price Price) % Price Per Share Price) Dividends % % % % %
A 1 50.00 50.00 49.26 55.00 0.75 55.00 0.75 10.00 11.50 4.93 5.66 52.38
B 1 25.00 25.00 24.63 22.00 0.10 22.00 0.10 12.00 11.60 2.96 2.86 20.95
C 1 12.50 12.50 12.32 8.00 0.00 8.00 0.00 36.00 36.00 4.43 4.43 7.62
D 1 10.00 10.00 9.85 14.00 0.05 14.00 0.05 40.00 40.50 3.94 3.99 13.33
E 1 4.00 4.00 3.94 6.00 0.00 6.00 0.00 50.00 50.00 1.97 1.97 5.72
Total 101.50 100 105.00 0.90 3.45 4.33 100.00
Index
Value 20.30 21.00 0.18 3.45 4.33

Divisor = 5
BOP = Beginning of period
EOP = End of period

Type of Index BOP Value Return % EOP Value

Price Return 20.30 3.45 21.00
Total Return 20.30 4.33 21.18
 Price Weighting
Security A, which has the highest price, also
the highest weighting and thus highest impact
on the return of the index.
Also note that securities having positive
returns, have also attained the higher weight
after the price change.
 Disadvantages of Price Weighting
It results in arbitrary weights for each security.
In particular stock split in one security causes
arbitrary changes in the weights of all the
constituents.
 Equal Weighted
To construct an equal weighted index from the
five securities in the previous example of price
weighted index, the index provider allocates
one fifth (20%) of the value of index (at the
beginning of the period) to each security.
Dividing value allocated to each security by
each securitys individual share price
determines the number of shares of each
security to include in the index.
 Equal Weighted
One can observe that how different weighting
methods results in different returns.
The 10.4% price return of the equal weighted
index differs significantly from the 3.45% price
return of the price-weighted index.
 Disadvantages of Equal Weighted
Index
1. Securities that constitute the largest fraction of
the target market value are underrepresented,
and securities that constitute a small fraction of
the market value are overrepresented.
2. After the index is constructed and the prices of
constituent securities change, the index is no
longer equally weighted.
3. Maintaining equal weights requires frequent
index rebalancing.
 EXHIBIT 2-3 Example of an Equal-Weighted
Equity Index
Value Value Weight Weight
Shares (Shares (Shares Price Total x Price x Total EOP
in BOP x BOP Weight EOP Dividends x EOP Total Return Return Return Return Weight
Security Index Price Price) % Price Per Share Price) Dividends % % % % %
A 40 50.00 2,000 20.00 55.00 0.75 2,200 30 10.00 11.50 2.00 2.30 19.93
B 80 25.00 2,000 20.00 22.00 0.10 1,760 8 12.00 11.60 2.40 2.32 15.94
C 160 12.50 2,000 20.00 8.00 0.00 1,280 0 36.00 36.00 7.20 7.20 11.60
D 200 10.00 2,000 20.00 14.00 0.05 2,800 10 40.00 40.50 8.00 8.10 25.36
E 500 4.00 2,000 20.00 6.00 0.00 3,000 0 50.00 50.00 10.00 10.00 27.17
Total 10,000 100.00 11,040 48 10.40 10.88 100.00

Index 1,000 1,104 4.80 10.40 10.88

Value

Divisor = 10
BOP = Beginning of period
EOP = End of period

Type of Index BOP Value Return % EOP Value

Price Return 1,000.00 10.40 1,104.00
Total Return 1,000.00 10.88 1,108.80
 Market Capitalization Weighting
In market capitalization weighting, or value
weighting, the weight on each constituent
security is determined by dividing its market
capitalization by the total market
capitalization of all securities in the index.
Market capitalization or value is calculated by
multiplying the number of shares outstanding
by the market price per share.
 Market Capitalization Weighting
The market capitalization weight of security i is:

WiM =
=
Where,
Wi = fraction of the portfolio that is allocated to
security i or weight of security i,
Qj = number of shares outstanding of security j,
Pi = price of security I
N = number of securities in the index
 Comparative Weights
The weighting method affects the indexs returns.
The price and total returns of market
capitalization index (1.49% and 2.13%,
respectively) differ significantly from those of the
price weighted (3.45% and 4.33%) and equal
weighted (10.40% and 10.88%) indices.
To understand the source and magnitude of the
difference, compare the weights and returns on
each security under each of the weighting
methods.
 EXHIBIT 2-4 Example of a Market-Capitalization-
Weighted Equity Index
BOP BOP
Weight Weight
Shares BOP BOP EOP Price Total x Price x Total EOP
Out- BOP Market Weight EOP Dividends Market Total Return Return Return Return Weight
Stock standing Price cap % Price Per Share cap Dividends % % % % %
A 3,000 50.00 150,000 26.29 55.00 0.75 165,000 2,250 10.00 11.50 2.63 3.02 28.50
B 10,000 25.00 250,000 43.82 22.00 0.10 220,000 1,000 12.00 11.60 5.26 5.08 38.00
C 5,000 12.50 62,500 10.96 8.00 0.00 40,000 0 36.00 36.00 3.95 3.95 6.91
D 8,000 10.00 80,000 14.02 14.00 0.05 112,000 400 40.00 40.50 5.61 5.68 19.34
E 7,000 4.00 28,000 4.91 6.00 0.00 42,000 0 50.00 50.00 2.46 2.46 7.25
Total 570,500 100.00 579,000 3,650 1.49 2.13 100.00
Index
1,000 1,014.90 6.40 1.49 2.13
Value

Divisor = 570.50
BOP = Beginning of period
EOP = End of period

Type of Index BOP Value Return % EOP Value

Price Return 1,000.00 1.49 1,014.90
Total Return 1,000.00 2.13 1,021.30
 Comparison of Fundamental
Weighting with Market-Capitalization
Weighting
Assume a 2-stock Index, consisting of Stock A and
Stock B:

Stock A Stock B
Earnings = 20 Earnings = 20
Market cap = 200 Market cap = 800
Market cap weight = 20% Market cap weight = 80%
Fundamental weight = 50% Fundamental weight = 50%
4. Float Adjusted Market Capitalization
Weighting
Market float is the number of shares of the
constituent security that are available to the
investing public.
For companies that are closely held, only a
portion of the shares outstanding are available
to the investing public. Rest are held by small
group of controlling investors.
 Float Adjusted Market Capitalization
Weighting
In float adjusted market capitalization weighting the weight
on each constituent security is determined by adjusting its
market capitalization for its market float.
In addition to excluding shares held by the controlling
shareholders, most float adjusted market capitalization-
weighted indices also exclude shares held by other
corporations and governments.
Some providers of indices that are designed to represent
the investment opportunities for global investors further
reduce the number of shares included in the index by
excluding shares that are not available for foreign investors.
These are known as Free-Float Adjusted Market
Capitalization Weighted Indices.
 Advantages/Disadvantages
The primary advantage of market capitalization
weighting (including float adjusted) is that
constituent securities are held in proportions of
their value in the target market.
The primary disadvantage is that constituent
securities whose prices have risen the most (or
fallen the most) have greater (or lower) weight in
the index.
Thus if a securitys price rises relative to other
securities in the index, its weight increases and
vice versa.
 Advantages/Disadvantages
This weighting method leads to over
weighting stocks that have risen in price (and
may be overvalued) and underweighting of
the stocks that have declined in price (and
may be undervalued).
 Advantages and Disadvantages
Market
Fundamental
Price weighted Equal weighted capitalization
weighted
weighted

Simple Simple Securities held Ensures a

in proportion value or
to their value contrarian tilt
High price stocks Under- and
have greater over-
impact representation
Stock splits Similar to a
result in Frequent momentum Data intensive
arbitrary rebalancing strategy
changes
 Rebalancing
May become
necessary as
market prices
change

Creates
turnover

Rebalancing
 Reconstitution
Change constituent
securities?

Reconstitution
date

Beginning
New index
index
 Uses of Market Indices

Gauges of market sentiment

Proxies for measuring and modeling returns, systematic risk,

and risk-adjusted performance

Proxies for asset classes in asset allocation models

Benchmarks for actively managed portfolios

Model portfolios for such investment products as index funds

and exchange-traded funds (ETFs)
 Equity Indices
Wilshire 5000
Broad market Total Market
Index

MSCI Emerging
Multimarket
Markets
Equity indices
GSTI
Sector Semiconductor
Index

Dow Jones U.S.

Style Small-Cap Value
Index
Challenges Facing Fixed Income Index
Construction
Illiquid
Number securities
of
securities

Lack of
pricing
data
 EXHIBIT 2-9 Dimensions of Fixed-
Global
Income Indices
Market Regional
Country or currency zone
Collateralized
Securitized Government
Type Corporate
Mortgage- agency
Government
backed

Maturity For example, 13, 35, 57, 710, 10+ years; short-
term, medium-term, or long-term
For example, AAA, AA, A, BBB, etc.; Aaa, Aa, A, Baa,
Credit quality
etc.; investment grade, high yield
 Indices for Alternative Investments

Commodities

Indices
for
Real estate alternative
investments

Hedge funds
Commodity Indices
Risk-free
interest rate

Changes in Commodity
futures index
prices return

Roll yield
 Real Estate Indices

Real estate
Repeat sales
Appraisal indices investment trust
indices
(REIT) indices

Ownership of Investment in
properties mortgages
EXHIBIT 2-12 The FTSE EPRA/NAREIT
Global REIT Index Family

Source: FTSE International, FTSE EPRA/NAREIT Global & Global Ex US Indices (Factsheet 2009).
 Hedge Fund Indices
Hedge funds are private investment vehicles that
typically use leverage and long and short
investment strategies.

Research organizations maintain databases of

hedge fund returns and summarize these
returns into indices.

Most indices reflect performance on a broad

global level or on a strategy level.

Most indices are equal weighted.

Problems Caused by Voluntary Investment
Reporting

Indices reflect
Voluntary different
investment Survivorship bias performances for
performance the same time
period
 Summary
Price return index
Total return index
Choices in index construction and management
Advantages and disadvantages of different
weighting schemes
Rebalancing and reconstitution
Uses of market indices
Equity, fixed income, and alternative investment
indices