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Security Market Indexes

A security market index measures stock market performance by comparing current stock prices to past prices, aiding investors in assessing returns and risks. Different types of indexes, such as price-weighted, value-weighted, and unweighted indexes, have distinct methods of calculation and implications for investment strategies. Fundamental weighted indexes use economic measures like sales and profits to determine weightings, offering advantages in stability and reduced influence from market price fluctuations.

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11 views20 pages

Security Market Indexes

A security market index measures stock market performance by comparing current stock prices to past prices, aiding investors in assessing returns and risks. Different types of indexes, such as price-weighted, value-weighted, and unweighted indexes, have distinct methods of calculation and implications for investment strategies. Fundamental weighted indexes use economic measures like sales and profits to determine weightings, offering advantages in stability and reduced influence from market price fluctuations.

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10meh.meh10
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Security Market

Indexes
What is Security Index
Stock market index, is an index that measures a stock market, or a subset of the
stock market, that helps investors compare current stock price levels with past
prices to calculate market performance.

Stock Market Index refers to a portfolio of securities that represent a particular


section of the security. Securities that are a part of a particular index often come
with a certain characteristics.
Uses of security index
 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.

Many investors use the computed return risk results as a benchmark to judge
the performance of a individual portfolios

Use of indexes to develop an index portfolio. It is difficult for most money


managers to consistently outperform specified market indexes on a risk adjusted
basis over time. If this is true an obvious alternative is to invest in a portfolio that
will emulate this market portfolio.
 Security analysts, portfolio managers and academicians doing research use
security market indexes to examine the factors that influence the aggregate
security price movements and to compare the risk-adjusted performances of
alternative asset classes.

Another group interested is technicians , who believe past price changes can be
used to predict future price performance.
Differentiating Factors in
constructing market indexes
Weighting Sample Members:
Price weighted index
A market value weighted index
An unsighted index/equal weighted index.
A fundamental weighted index. [ based on some operating variable
like sales, earnings or ROE]
The sample : The first factor is the sample. The size , the breadth and the
source of the sample are all important. A small percentage of the total
population will provide valid indications of the behavior of the total
population if the sample is properly selected
Computational Procedures: A simple arithmetic mean or geometric mean
of the various members in the index.
Price Weighted Index: Is an arithmetic mean of current stock price , which
means that index movements are influenced by the differential prices of the
component.
Dow Jones Industrial Index (DJIA)
Where

DJIAt = The value of DJIA on day t


Pit = the closing price on stock i on day t
Dadj = the adjusted divisor on day t.
Period T+1

Stock Period T Case A Case B


A 100 110 100
B 50 50
50
C 30 30 33
Sum 180 190 183
Divisor 3 3 3
Percentag 60 63.3 61
e change
5.5 1.7
Example of change in DJIA
Divisor when a sample stock
splits
Stock A Before Split After three for one split by stock
A
A 30 10
B 20 20
C 10 10
60/3=20 40/X=20 X=2 (new Divisor)
Value Weighted Index
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]
Prior to 2004 , the tradition was to consider all outstanding shares. In mid
2004 Standard and Poor’s began only considering “ Freely Floating Shares” that
exclude shares held by insiders. This initial figure is typically established as base
and assigned an index value .

 Indext= Σ PtQt/Σ PbQb * Beginning Value Index


Index t = Index value on day t
Pt = Ending Prices for stock on day t.
Qt = Number of outstanding or freely floating shares on day t
P b = Ending Prices for stock on base day.
Q b= Number of outstanding or freely floating shares on base day.
Stock Stock Price Number of shares Market Value
December 31 , 2011
A $10 1,000,000 $10,000,000

B 15 6,000,000 90,000,000

C 20 5,000,000 100,000,000 *Stock Split Two for One split


** Company paid a 10% stock
2,00,000,000 dividend during the year

December 31, 2012


A 12 1,000,000 12,000,000
B 10 12,000,000* 120,000,000
C 20 5,500,000** 110,000,000
$242,000,000
New Index value =Current Market Value/ Base value * Beginning Index Value
=242,000,000/200,000,000* 100
=????

There is an automatic adjustment for stock splits and other capital changes with a value
weighted index because the decrease in the stock price is offset by a an increase in the
number of shares outstanding.
In an MVWI, the stock with a larger (smaller) market capitalization will have a greater (smaller)
impact on the changes or movements of such an index, even if its absolute price is lower.
Therefore the largest companies in S&P 500 (based on market capitalization) will have the
greatest influence on this index’s price performance.
Un weighted Index
In an un weighted index all stocks carry equal weights regardless of their price or
market value . A $20 stock and $40 stock is equally important, and the total
market value is unimportant.
The actual movement in index is typically based on the arithmetic mean of the
percentage change in price or value for the stocks in the market.

There are some advantages of EWI’s. First, they are perceived to carry less risk,
when compared to MVWIs as they are considered more diversified.
Computation of Index value
assuming Un weighted Index
Dec 31 , 2021 Dec 31 , 2022

Stocks Price*weight Price Price Percentage Change

A 100 *.25 25 150 50


B 95*.25 23.75 126.35 33
C 115.8*.25 28.75 127.3 10
D 50*.25 12.50 55 10.0
90 103

103/4=25.75
New Index = Old equal Weighted Index +[1- Percentage change in index]
= 90+[1-25.75]=90-24.75=65.25
Fundamental Weighted Index
 Market value of a firm is a measure of its economic importance.

Some Observers contend that this weighting scheme resulting in overweighting


overvalued stocks and underweighting undervalued stocks.

In response to this implicit problem with market value weighting some
observers have suggested other measures of company’s economic foot print.
They proposed four broad fundamental measures of size: i) sales ii) profits (cash
flow). (iii) net assets (book value) (iv) dividends.
How to calculate
Assume that the stock market has three companies
Market Last years earnings
capitalization
Company A 6 billion 100 million
Company B 3 billion 300 million
Company C 1 billion 200 million
10 billion 600 million
Fundamentally Weighted Index
Company A 100 m/600m 16.7% weight in index
Company B 300/600 50% weight in index
Company C 200/600 33.3% weight in index
Advantage and disadvantage of
fundamental weighted index
Advantages
Since the index is not influenced by price, it is not influenced by short term emotions. Unlike
market cap weighted indexes, pricing errors are random.

Since fundamental rankings between companies are based upon sales, book value and other
measures of economic size that change relatively slowly, the index can be managed on efficient
basis.

Notice that market capitalization (and therefore market price) is not considered for this
fundamental index.

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