Investment Analysis and Portfolio Management: Lecture Presentation Software

Lecture Presentation Software
to accompany
Investment Analysis and

Portfolio Management
Eighth Edition
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
United States and globally and what are their
characteristics?
Chapter 5
Security-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)?
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
Differentiating Factors in
Constructing Market Indexes
The sample
size
breadth
source
Weighting of sample members
price-weighted series
value-weighted series
unweighted (equally weighted) series
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
Stock-Market Indexes
Price Weighted Index
Dow Jones Industrial Average (DJIA)
Nikkei-Dow Jones Average
Value-Weighted Index
NYSE Composite
S&P 500 Index
Unweighted Index
Value Line Averages
Financial Times Ordinary Share 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)
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)
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
Nikkei-Dow Jones Average
Arithmetic average of prices for 225 stocks
on the First Section of the Tokyo Stock
Exchange (TSE)
Best-known series in Japan
Price-weighted series formulated by Dow
Jones and Company
The 225 stocks represent 15 percent of all
stocks on the First Section
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
Value-Weighted Series
Index t
PQ
t
Beginning
t
Index Value
P Q
h h
where:
Indext = index value on day t
Pt = ending prices for stocks on day t
Qt = number of outstanding shares on day t
Ph = ending price for stocks on base day
Qh = number of outstanding shares on base day
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
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
Stock-Market Indexes
Style Categories
Small-cap growth
Midcap Growth
Large-cap growth
Small-cap value
Midcap value
Large-cap value
Socially responsible investment (SRI) indexes
By country
Global ethical stock index
Global Equity Indexes
There are stock-market indexes available
for most individual foreign markets
These are closely followed within each
country
These are difficult to compare due to
differences in sample selection, weighting,
or computational procedure
Groups have computed country indexes
FT/S&P-Actuaries World Indexes
Jointly compiled by The Financial Times
Limited, Goldman Sachs & Company, and
Standard & Poors in conjunction with the
Institute of Actuaries and the Faculty of
Actuaries
Measures 2,271 securities in 30 countries
Covers 70% of the total value of all listed
companies in each country
FT/S&P-Actuaries World
Indexes
Includes actively traded medium and small
corporations along with major international
equities
Securities included must allow direct
holdings of shares by foreign nationals
Index is market-value weighted with a base
date of December 31, 1986 = 100
FT/S&P-Actuaries World Indexes
Index results are reported in U.S. dollars,
U.K. pound sterling, Japanese yen, German
mark, and the local currency of the country
included
Results are calculated daily after the New
York markets close and published the
following day in the Financial Times
Geographic subgroups are also published
Morgan Stanley Capital
International (MSCI) Indexes
Three international, nineteen national, and
thirty-eight international industry indexes
Include 1,375 companies listed on stock
exchanges in 19 countries with a combined
capitalization representing approximately 60
percent of the aggregate market value of the
stock exchanges of these countries
All the indexes are market-value weighted
Reporting is in U.S. dollars and the countrys
local currency
Also provides
price to book value (P/BV) ratio
price to cash earnings (earnings plus depreciation)
(P/CE) ratio
price to earnings (P/E) ratio
dividend yield (YLD)
The Morgan Stanley group index for
Europe, Australia, and the Far East (EAFE)
is used as the basis for futures and options
contracts on the Chicago Mercantile
Exchange and the Chicago Board Options
Exchange
Dow Jones World Stock Index
Introduced in January 1993
2,200 companies worldwide
Organized into 120 industry groups
Includes 33 countries representing more than 80
percent of the combined capitalization of these
countries
Countries are grouped into three major
regions:Asia/Pacific, Europe/Africa, and the
Americas
Each countrys index is calculated in its own
currency as well as in the U.S. dollar
Comparison of World Stock Indexes
Correlations between the three series since
December 31, 1991 to December 31, 2003,
indicates an average correlation coefficient
among them in excess of 0.99
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
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
Investment-Grade Bond Indexes
Four investment firms maintain indexes for

Treasury bonds and other investment grade
(rated BBB or higher) bonds
Relationship among these bonds is strong
(correlations average 0.95)
Returns for all these bonds are driven by
aggregate interest rates - shifts in the
government yield curve
High-Yield Bond Indexes
Non investment-grade bonds
rated BB, B, CCC, CC, C
Four investment firms and two
academicians created indexes
Relationship among alternative high-yield
bond indexes is weaker than among
investment grade indexes
Merrill Lynch Convertible Securities
Indexes
Global Government Bond Market
Indexes
Global bond market dominated by government
issues
Several indexes created by major investment
firms
Measure total rates of return
Use market-value weighting
Use trader pricing
But sample sizes differ as do numbers of countries
included
Global Government Bond
Market Indexes
Differences affect long-term risk-return
performance
Low correlation among several countries is
similar to stocks
Significant exchange rate effect on volatility
and correlations
Composite Stock-Bond Indexes
Beyond separate stock indexes and bond indexes
for individual countries, a natural step is a
composite series that measures the performance of
all securities in a given country
This allows examination of benefits of
diversification with a combination of asset classes
such as stocks and bonds in addition to
diversifying within the asset classes of stocks or
bonds
Merrill Lynch-Wilshire U.S. Capital
Markets Index (ML-WCMI)
Market-value weighted index measures total
return performance of the combined U.S.
taxable fixed income and equity markets
Combination of Merrill-Lynch fixed-income
indexes and the Wilshire 5000 common-
stock index
Tracks over 10,000 stocks and bonds
Brinson Partners Global
Security Market Index (GSMI)
Includes:
U.S. stocks and bonds
Non-U.S. equities
Non-dollar bonds
Allocation to cash
Matches a typical U.S. pension fund allocation policy
Close to the theoretical market portfolio of risky
assets referred to in the CAPM literature
Comparison of Indexes Over Time
Correlations among monthly equity price
changes
Most differences are attributable to sample
differences
Different segments of U.S. stock market or
from different countries
Lower correlations between NYSE series and
AMEX series or NASDAQ index than between
NYSE alternative series (S&P 500 and NYSE
composite)
Comparison of Indexes Over Time
Correlations among monthly bond indexes
Among investment-grade bonds correlations
range from 0.90 to 0.99
Interest rates differ by risk premiums
Rates of return are determined by systematic
interest rate variables
Low correlation in global returns to U.S.
returns support global diversification
Mean Annual Security Risk-
Returns and Correlations
There are clear differences among the
series due to different asset classes (e.g.,
stocks versus bonds) and when there are
different samples within asset classes
There is a positive relationship between the
average rate of return on an asset and its
measure of risk
Mean Annual Security Risk-
Returns and Correlations
The security market indexes can be used
1. to measure the historical performance of
an asset class
2. as benchmarks to evaluate the
performance of a money manager for a
mutual fund, a personal trust, or a pension
plan
The Internet
Investments Online
http://www.bloomberg.com
http://barra.com
http://msci.com
https://ecommerce.barcap.com/indices/
http://www.barcap.com
http://datastream.com/product/investor/index.html
http://www.dir.co.jp/InfoManage/dbi/menu.html
Future topics
Chapter 6
Sources of Information on Global
Investments
Aggregate Economic Analysis
Aggregate Security-Market Analysis
Industry Analysis
Individual Stock and Bond Analysis
Mutual Funds

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Period T Case A Case B

Four investment firms maintain indexes for

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