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SECURITY MARKET INDEXES

 SECURITY MARKET INDEX
STRUCTURE 1

Chapter
INDEX WEIGHTING
METHODS 2
Two 2 INDEX REBALANCING &
RECONSTITUTION 3
SECURITY MARKET
INDEXES
USES OF SECURITIES
INDEXES 4
CHAPTER TWO: SECURITY MARKET INDEXES
2.1: SECURITY MARKET INDEX STRUCTURE
q A security market index is used to represent the performance of an asset class, security market, or segment of
a market. They are usually created as portfolios of individual securities (constituents securities).
q An index has a numerical value (points) that is calculated from the market prices of its constituent securities at
a point in time. An index return is the percentage change in the index’s value over a period of time.
q An index return may be calculated using a price index or a return index.
q Price index uses only the prices of the constituent securities in the return calculation.
q Return index includes both prices and income (capital gain & dividends) from the constituent securities. A
rate of return that is calculated based on a return index is called a total return.
q The total return will equal to price return unless the constituents securities paid any cash dividends, in this case,
the total return index will be greater than the price return.
q Once returns are calculated for each period, they then can be compounded together to arrive at the return
for the measurement period:
q RP = (1 + RS1)(1 + RS2)(1 + RS3)(1 + RS4)...(1 + RSk) − 1
where:
RP = portfolio return during the measurement period
k = total number of sub-periods
RSk = portfolio return during the subperiod k

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CHAPTER TWO: SECURITY MARKET INDEXES
2.1: SECURITY MARKET INDEX STRUCTURE
EXMAPLE: Index Return
q The returns for an index during the first two months were 0.50% and 1.04%, what would be the index return for
the whole period.

Answer:
q RP = (1 + RS1)(1 + RS2) − 1 = (1.005)(1.0104) − 1 = 0.0155 or 1.55%
q If the starting index value is 100, its value after two periods would be 100 × 1.0155 = 101.55.

q Index providers must make several decisions when establish any index:
1. Select the target market where the index will used to measure.
2. Select the constituents securities from the target market to be included in the index.
3. Choose the weighting method for the index.
4. Select the frequency of index rebalancing.
5. Determine when to re-exam the selection and weighting of constituents securities.
q The target market may be defined very broadly (e.g., stocks in the Egyptian Market) or narrowly (e.g.,
Banking sector of the Egyptian Market). It may also be defined by geographic region or by economic sector
(e.g., MSCI Emerging Markets Index).
q The constituent stocks in the index could be all the stocks in that market or just a representative sample (e.g.,
EGX30). The selection process may be determined by an objective rule or subjectively by a committee.

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CHAPTER TWO: SECURITY MARKET INDEXES
2.2: INDEX WEIGHTING METHODS
q The most common weighting methods for the constituents securities of any index are price weighting, equal
weighting, market capitalization weighting.

2.2.1: Price-Weighted Index

q Price-weighted index is simply the arithmetic mean (average) of the prices of the constituents securities.
q The divisor of a price-weighted index is adjusted for any corporate actions to reflect any changes in the
composition of the index when securities (stock split, added or deleted securities), such that the index value is
unaffected by such changes.
q The advantage of a price-weighted index is that its computation is simple.
q One disadvantage is that the higher stocks will drive the performance of the index toward its performance
(biased), this means a given percentage change in the price of a higher priced stock has a greater impact on
the index’s value than the same percentage change in the price of a lower priced stock.
q This bias toward the higher priced stock is due to more weight for higher priced stocks in the calculation of a
price-weighted index.
q Another drawback for the price-weighted index, a stock’s weight in the index going forward changes if the
firm splits its stock, repurchases stock, or issues stock dividends, as all of these actions will affect the price of the
stock and therefore its weight in the index.
q Two major price-weighted indexes are the Dow Jones Industrial Average (DJIA) and the Nikkei Dow Jones
Stock Average. The DJIA is a price-weighted index based on 30 U.S. stocks. The Nikkei Dow is constructed from
the prices of 225 stocks that trade in the first section of the Tokyo Stock Exchange.

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CHAPTER TWO: SECURITY MARKET INDEXES
2.2: INDEX WEIGHTING METHODS
EXMAPLE: Price-Weighted Index
q Given the below data concerning the constituent stock for a price return price-weighted index during the last
period. Calculate the value & return of the index at the end of the period assuming the value of the index was
1000 points at the beginning of the period.

Stock Outstanding Shares Beginning Price Ending Price Dividends per Share
A 3,000 50.00 55.00 0.75
B 10,000 25.00 22.00 0.10
C 8,000 10.00 14.00 0.05

Answer:
(50 + 25 + 10) 85
§ Index Beginning Value = = = 28.33
3 3
(55 + 22 + 14) 91
§ Index Ending Value = = = 30.33
3 3
(30.33 − 28.33)
§ Change in the index = = 7.07%
28.33
§ Value of Index at the end of the period = (1 + 0.0707) * 1000 = 1070.7 point.

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CHAPTER TWO: SECURITY MARKET INDEXES
2.2: INDEX WEIGHTING METHODS

2.2.2: Equal-Weighted Index

q An equal-weighted index is the arithmetic mean return (average return) of the constituents securities.
q As with a price-weighted index, an advantage of an equal-weighted index is its simplicity.
q The main disadvantage of the equal-weighted index is that the weights placed on the returns of the securities
of smaller capitalization firms are greater than their proportions of the overall market value of the index stocks.
q Conversely, the weights on the returns of large capitalization firms in the index are smaller than their
proportions of the overall market value of the index stocks.
q EGX50 EWI, EGX70 EWI, & EGX100 EWI are an examples for equal-weighted indexes.

EXMAPLE: Equal-Weighted Index

q Given the below data concerning the constituent stock for an equal-weighted index during the last period.
Calculate the value & return of the index if it is a price return & total return index at the end of the period
assuming the value of the index was 1000 points at the beginning of the period.

Stock Outstanding Shares Beginning Price Ending Price Dividends per Share
A 3,000 50.00 55.00 0.75
B 10,000 25.00 22.00 0.10
C 8,000 10.00 14.00 0.05

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CHAPTER TWO: SECURITY MARKET INDEXES
2.2: INDEX WEIGHTING METHODS
EXMAPLE: Equal-Weighted Index
q Given the below data concerning the constituent stock for an equal-weighted index during the last period.
Calculate the value & return of the index if it is a price return & total return index at the end of the period
assuming the value of the index was 1000 points at the beginning of the period.

Outstanding Beginning Ending Dividends per Price Return Total Return

Stock
Shares Price Price Share (%) (%)
A 3,000 50.00 55.00 0.75 10.00 11.50
B 10,000 25.00 22.00 0.10 -12.00 -11.60
C 8,000 10.00 14.00 0.05 40.00 40.50

Answer:
(0.10 − 0.12 + 0.40) 0.38
§ Index Price Return = = = 0.1267 or 12.67%
3 3
§ Value of index at the end of the period = (1 + 0.1267) * 1000 = 1126.7 point
(0.115 − 0.116 + 0.405) 0.404
§ Index Total Return = = = 0.1347 or 13.47%
3 3
§ Value of index at the end of the period = (1 + 0.1347) * 1000 = 1134.7 point

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CHAPTER TWO: SECURITY MARKET INDEXES
2.2: INDEX WEIGHTING METHODS

2.2.3: Market Capitalization-Weighted Index

q A market capitalization-weighted index, also known as value-weighted index, has weights based on the
market capitalization of each index stock as a proportion of the total market capitalization of all the stocks in
the index.
q The market capitalization is equal to current stock price multiplied by the number of outstanding shares.
q This weighting method more closely represents changes in aggregate investor wealth than price weighting.
Because it is based on the market capitalization, a market capitalization weighted index does not need to be
adjusted for corporate actions (stock splits or stock dividend).
q The main advantage of market capitalization-weighted indexes of either type is that index security weights
represent proportions of total market value.
q The primary disadvantage of value weighted indexes is that the relative impact of a stock’s return on the index
increases as its price rises and decreases as its price falls (biased toward large market cap.). This means that
stocks that are possibly overvalued are given disproportionately high weights in the index and stocks that are
possibly undervalued are given disproportionately low weights.
q The Standard and Poor’s 500 (S&P 500) Index Composite is an example of a market capitalization-weighted
index.
q EGX30 & EGX30 TR are a good example for market capitalization-weighted indexes.

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CHAPTER TWO: SECURITY MARKET INDEXES
2.2: INDEX WEIGHTING METHODS
EXMAPLE: Market Capitalization-Weighted Index
q Given the below data concerning the constituent stock for an value-weighted index during the last period.
Calculate the value & return of the index if it is a price return & total return index at the end of the period
assuming the value of the index was 1000 points at the beginning of the period.

Stock Outstanding Shares Beginning Price Ending Price Dividends per Share
A 3,000 50.00 55.00 0.75
B 10,000 25.00 22.00 0.10
C 8,000 10.00 14.00 0.05
Answer:
§ Index beginning value = (50*3,000) + (25*10,000) + (10*8,000) = 480,000.
§ Index ending value (Price Return) = (55*3,000) + (22*10,000) + (14*8,000) = 497,000.
497,000 − 480,000
§ Index Price Return = = 0.0354 or 3.54%.
480,000
§ Index Value at the ending of the period = (1 + 0.0354) * 1000 = 1035.4 points.
§ Index ending value (Total Return) = 497,000 + (0.75*3,000) + (0.10*10,000) + (0.05*8,000) = 500,650.
500,650 − 480,000
§ Index Price Return = = 0.043 or 4.3%.
480,000
§ Index Value at the ending of the period = (1 + 0.043) * 1000 = 1043 points.
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CHAPTER TWO: SECURITY MARKET INDEXES
2.3: INDEX REBALANCING & RECONSTITUTION

2.1.1: Index Rebalancing

q Rebalancing refers to adjusting the weights of securities in a portfolio to their target weights after price
changes have affected the weights.
q For index calculations, rebalancing to target weights on the index securities is done on a periodic basis, usually
quarterly.

2.1.2: Index Reconstitution

q Index reconstitution refers to periodically adding & deleting securities to the index.
q Securities are deleted if they no longer meet the index criteria & are replaced by other securities that do.
q Indexes are reconstituted to reflect corporate events such as bankruptcy or delisting of index firms and are at
the subjective judgment of a committee.
q When a security is added to an index, its price tends to rise as portfolio managers seeking to track that index in
a portfolio buy the security. The prices of deleted securities tend to fall as portfolio managers sell them.

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CHAPTER TWO: SECURITY MARKET INDEXES
2.4: USES OF SECURITIES INDEXES
q Security market indexes have several uses:
1. Reflection of market sentiment: Indexes provide a representative market return & thus reflect investor
confidence. Although the EGX30 is the most popular index for Egyptian market, it reflects the performance of
only 30 stocks and thus may not be a good measure of sentiment with regard to the broader market.
2. Benchmark of manager performance: An index can be used to evaluate the performance of an active
manager. Because portfolio performance depends to a large degree on its chosen style, the benchmark
should be consistent with the manager’s investment approach and style to assess the manager’s skill
accurately.
3. Measure of market return & risk: In asset allocation, estimates of the expected return & standard deviation of
returns for various asset classes are based on historical returns for an index of securities representing that asset
class.
4. Measure of beta & risk-adjusted return: The use of the capital asset pricing model (CAPM) to determine a
stock’s expected return requires an estimate of its beta and the return on the market. Index portfolio returns
are used as a proxy for the returns on the market portfolio, both in estimating a stock’s beta, and then again
in calculating its expected return based on its systematic (beta) risk. Expected returns can then be compared
to actual stock returns to determine systematic risk-adjusted returns.
5. Model portfolio for index funds: Investors who wish to invest passively can invest in an index fund, which seeks
to replicate the performance of a market index. There are index mutual funds and index exchange-traded
funds (ETFs), as well as private portfolios that are structured to match the return of an index.

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