Lecture Presentation Software

to accompany

Investment Analysis and

Portfolio Management
by
Frank K. Reilly & Keith C. Brown

Chapter 5
 Chapter 5
Security-Market Indicator Series
Questions to be answered:
• 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 Pakistan and what are their
characteristics?
Uses of Security-Market Indexes
1. As benchmarks to evaluate the performance of
professional money managers
2. To create and monitor an index fund
3. To examine the factors that influence aggregate
security price movements
4. For predicting future market movements by
technicians
5. As a substitute for the market portfolio of risky assets
when calculating the systematic risk of an asset
 Differentiating Factors in
Constructing Market Indexes
1. The sample
2. Weighting Sample Members
3. Computational Procedure
 Differentiating Factors in
Constructing Market Indexes
The sample
1. Size-the sample should be representative of the total
population; otherwise, its size will be meaningless.
• A large biased sample is no better than a small biased
sample.
2. Source-of the sample is important if there are any
differences between segments of the population, in which
case samples from each segment are required.
 Differentiating Factors in
Constructing Market Indexes
Weighting of sample members
• Four principal weighting schemes are used for security-
market indexes:
(1) a price-weighted index
(2) a market-value weighted index
(3) an un-weighted index, or an equal-weighted index,
(4) a fundamental weighted index based on some
operating variable like sales, earnings, or return on
equity.
 Differentiating Factors in
Constructing Market Indexes
Computational procedure
1. arithmetic average
2. compute an index and have all changes,
whether in price or value, reported in
terms of the basic index
3. geometric average
 Stock-Market Indicator Series
Price Weighted Series
• Dow Jones Industrial Average (DJIA)(30 stocks
NYSE,USA)
• Nikkei-Dow Jones Average (224 stocks, TSE, Japan)
Value-Weighted Series
• NYSE Composite
• S&P 500 Index and more…
Unweighted Price Indicator Series
• Value Line Averages
• Financial Times Ordinary Share Index
 Stock-Market Indicator Series
• KSE 100 Index
• KSE all shares Index
• KSE 30 Index
• KMI 30 Index
• PSX-KMI all shares Index
• Group assignment-prepare detail report
on the above indexes(what are they,how
are they calculated etc)-submission date
02-05-2025.marks 10
• Calculations of various indexies
 Price-Weighted Index
• A price-weighted index is an arithmetic
mean of current stock prices,
Price-Weighted Index -Dow Jones
Industrial Average (DJIA)

• Best-known, oldest, most popular series

• 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 (adjusted for stock splits
and changes in the sample)
Price-Weighted Index -Dow Jones
Industrial Average (DJIA)
• A stock split is a corporate action in which a
company divides its existing shares into multiple
shares to boost the liquidity of the shares, decrease
share price, renew investor interest.
• number of shares outstanding increases by a specific
multiple, the total dollar value of the shares remains
the same compared to pre-split amounts.
• The most common split ratios are 2-for-1 or 3-for-1,
which means that the stockholder will have two or
three shares, respectively, for every share held
earlier.
 Example-stock split
• assume that XYZ Corp. has 20 million shares
outstanding and the shares are trading at $100.
• Its market cap will be 20 million shares x $100 = $2
billion.
• Let's say the company’s board of directors decides to
split the stock 2-for-1.
• Right after the split takes effect, the number of
shares outstanding would double to 40 million,
while the share price would be halved to $50,
leaving the market cap unchanged at 40 million
shares x $50 = $2 billion.
 1-Price-Weighted Index -Dow
Jones Industrial Average (DJIA)
Example of Change in DJIA Divisor
When a Sample Stock Splits
After Three-for One
Exhibit 5.1
Before Split Split by Stock A
Prices Prices
A 30 10
B 20 20
C 10 10
60 3 = 20 40 X = 20
X = 2 (New Divisor)
 Points to remember
• Because the index is price weighted, a high-
priced stock carries more weight than a low
priced stock.
• 10 percent change in a $100 stock ($10)
will cause a larger change in the index than
a 10 percent change in a $30 stock ($3).
• See example in next slide
Demonstration of the Impact of Differently
Priced Shares on a Price-Weighted
Indicator Series Exhibit 5.2
PERIOD T+ 1 .

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
Average 60 63.3 61
Percentage Change 5.5% 1.7%
 Criticism of the DJIA
• Limited to 30 non-randomly selected blue-chip
stocks
• Does not represent a vast majority of stocks
• The divisor needs to be adjusted every time one
of the companies in the index has a stock split
• Introduces a downward bias by reducing
weighting of fastest growing companies whose
stock splits
 2-Value-Weighted Series
• 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
X Current Market Price
• Assign an beginning index value (100) and new market
values are computed & compared to the base index to
determine the percentage change, which in turn is
applied to the beginning index value
• Automatic adjustment for splits
• Weighting depends on market value
 Value-Weighted Series

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
 points to remember
• In a value-weighted index, the importance of
individual stocks in the sample depends on the
market value of the stocks.
• Therefore, a specified percentage change in the
value of a large company has a greater impact than
a comparable percentage change for a small
company
• price changes for large market value stocks in a
value-weighted index will dominate changes in the
index value over time. Therefore, it is important to
be aware of the large-value stocks in the index.
• See example in next slide
3-Unweighted Price Indicator Series
• All stocks carry equal weight regardless of
price or market value
• May be used by individuals who randomly
select stocks and invest the same dollar
amount in each stock
• Some use arithmetic average of the
percent price changes for the stocks in the
index
 Measures of
Historical Rates of Return
1.4

Arithmetic Mean
 Measures of
Historical Rates of Return
1.5

Geometric Mean
Unweighted Price Indicator Series
• Value Line and the Financial Times
Ordinary Share Index compute a geometric
mean of the holding period returns and
derive the holding period yield from this
calculation
 Problem 2
• Given the data in Problem 1, construct an equal-
weighted index by assuming $1,000 is invested in each
stock.
a) What is the percentage change in wealth for this
portfolio?
b) Compute the percentage of price change for each of the
stocks in Problem 1. Compute the arithmetic mean of
these percentage changes. Discuss how this answer
compares to the answer in Part a.
c) Compute the geometric mean of the percentage changes
in Part b. Discuss how this result compares to the
answer in Part b.
 Style Indexes
• Financial service firms such as Dow Jones,
Moody’s, Standard & Poor’s, Russell, and
Wilshire Associates are generally very fast in
responding to changes in investment practices.
• One example is the growth in popularity of
small-cap stocks following academi research in
the 1980s that suggested that over long-term
periods, small-cap stocks outperformed large-cap
stocks on a risk-adjusted basis.
• This led to sets of size indexes, including
large-cap, mid-cap, small-cap, and micro-cap.
• The next innovation was for money managers
to concentrate in types of stocks—that is,
growth stocks or value stocks.
• Eventually, these two factors (size and type)
were combined into six major style categories:
1.Small-cap growth 2. Small-cap value
3.Mid-cap growth 4.Mid-cap value
5.Large-cap growth 6. Large-cap value
Market Cap / Style Growth Value

Small-cap Growth 🔹
Small-cap Value 🔹 Small
Small companies with
companies considered
high growth potential.
undervalued. Potential for
Small-cap Often innovative or
turnaround or stable
emerging businesses, but
performance with
may have higher risk and
attractive pricing.
volatility.

Mid-cap Value 🔹 Mid-

Mid-cap Growth 🔹 Mid-
sized firms undervalued
sized firms growing faster
by the market. Often
than average. Offer
Mid-cap more stable than small-
balance between growth
caps but with more
potential and moderate
growth potential than
risk.
large-caps.

Large-cap Growth 🔹 Large-cap Value 🔹

Large, established firms Large, mature firms seen
with strong earnings as undervalued. Typically
Large-cap
growth (e.g., tech giants). stable with consistent
Usually less risky but dividends and lower
offer slower growth. volatility.
• The most recent style indexes are those
created to track ethical funds referred to as
socially responsible investment (SRI) funds.
• These SRI indexes are further broken down
by country and include a global ethical
stock index.
An ESG index is a benchmark that reflects
the performance of companies with strong
Environmental, Social, and Governance
(ESG) practices. It helps investors identify
and assess companies that prioritize
sustainability, aligning investments with
ethical and long-term values.

Companies are rated on their ESG performance,

and those with higher scores are included in the
index. The index then tracks the performance of
these companies, providing investors with a
benchmark for how sustainable investments are
doing.