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Understanding Security-Market Indicator Series in Investment Analysis and Portfolio Management

This chapter provides insights into security-market indicator series, focusing on their key uses, characteristics, and differences among indexes. It discusses major stock and bond market indexes in the U.S. and globally, as well as composite stock-bond market indexes. Important questions address the functionalities of these indexes as benchmarks for professional performance evaluation, their role in index funds, and their significance in economic studies and market predictions. The chapter also covers the construction of market indexes and the challenges faced in creating bond-market indicator series.

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Understanding Security-Market Indicator Series in Investment Analysis and Portfolio Management

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  1. Lecture Presentation Softwareto accompanyInvestment Analysis and Portfolio ManagementSeventh Editionby Frank K. Reilly & Keith C. Brown Chapter 5

  2. Chapter 5Security-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 United States and globally and what are their characteristics?

  3. Chapter 5Security-Market Indicator Series • What are the major bond-market indexes for the United States and the world? • 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 short-run relationship among many of these indexes in the short run (monthly)?

  4. Uses of Security-Market Indexes • As benchmarks to evaluate the performance of professional money managers • To create and monitor an index fund • To measure market rates of return in economic studies • For predicting future market movements by technicians • As a substitute for the market portfolio of risky assets when calculating the systematic risk of an asset

  5. Differentiating Factors in Constructing Market Indexes The sample • size • breadth • source

  6. Differentiating Factors in Constructing Market Indexes Weighting of sample members • price-weighted series • value-weighted series • unweighted (equally weighted) series

  7. Differentiating Factors in Constructing Market Indexes Computational procedure • arithmetic average • compute an index and have all changes, whether in price or value, reported in terms of the basic index • geometric average

  8. Stock-Market Indicator Series Price Weighted Series • Dow Jones Industrial Average (DJIA) • Nikkei-Dow Jones Average Value-Weighted Series • NYSE Composite • S&P 500 Index and more… Unweighted Price Indicator Series • Value Line Averages • Financial Times Ordinary Share Index

  9. 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)

  10. Example of Change in DJIA Divisor When a Sample Stock Splits After Three-for One 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) Exhibit 5.1

  11. 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%

  12. Value-Weighted Series • Derive the initial total market value of all stocks used in the series Market Value = Number of Shares Outstanding X Current Market Price • Assign an beginning index value (100) and new market values are compared to the base index • Automatic adjustment for splits • Weighting depends on market value

  13. 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

  14. 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

  15. 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

  16. Bond-Market Indicator Series • Relatively new and not widely published • Growth in fixed-income mutual funds increase need for reliable benchmarks for evaluating performance • Many managers have not matched aggregate bond market return • increasing interest in bond index funds • requires an index to emulate

  17. Difficulties in Creating and Computing Bond-Market Indicator Series • Universe of bonds is much broader than that of stocks • 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 by duration, which is dependent on maturity, coupon, and market yield • Correctly pricing individual bond issues without current and continuous transaction prices available poses significant problems

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