Structure Features of Different Indexes

Domestic Stock Indexes
Made up of domestic stock securities and based on various components such as market capitalization.

Example: S&P500

Global Stock Indexes
Made up of both domestic and international equity securities. For a global investor, this is a nice gauge to measure relative return.

An example: S&P Global 1200 which comprises securities in 29 countries.

Bond market indexes
· Relatively more difficult to construct than equity indexes because:
· the bond universe is too broad
· the bond universe is constantly changing
· price volatility of bonds is affected by duration, which is constantly changing (volatility is due to numerous new issues, maturities, sinking features, volatility is measured by duration which subject to maturity and market yield)
· with the exception of Treasuries, bond prices are not available on a continuous basis.

Example: Lehman Brothers Aggregate Bond Index made up of 5,545 bonds across all segments of fixed income

Composite Stock-Bond Indexes
Contain both stock and bond securities.

Example: The Merrill Lynch –Wilshire U.S. Capital Markets Index

Unweighted, Price-weighted and Value-weighted index

Unweighted index:
· Assigns an equal weight to all constituent securities.
· Equivalent to a portfolio with $1 invested in each security.
· Arithmetic averages or geometric averages can be used.
· Geometric has a downward bias so is always lower than arithmetic.

Arithmetic average = ΣX/ n, Geometric average =(X1…Xn)1/n
where X=(1+HPR)

Price-weighted index:
· Assign a weight proportional to the price of each security.
· Equivalent to a portfolio with one unit of each security.
· Higher priced stocks have a greater influence on the index.
· Price must be adjusted to reflect stock splits, causing a downward bias since successful firms split stocks and lose weight in index.

Price-weighted index value = Sum of Stock prices / Number of stocks after splits

Example of stock splitting:
If the index consists of two securities, A & B,
Initial price A $25 B$100, then
Price weighted index = (25+100)/2 = 62.50

If each security B split into 2 and the price after split price A $25 B$50, then calculate the value of divisor;
(25+50)/divisor= 62.5
=> divisor = 1.2

Then use the determined divisor for computation on the day end price.
Day end price A $30 B60
Price weighted index = (30+60)/divisor = 90/1.2 = 75

Example: DJIA( Dow Jones Industrial Ave) Nikkei

Value-weighted index:
· Assign a weight proportional to the market cap of each security.
· Uses geometric averaging.
· The index ends up controlled by a few large firms.

Value-weighted index value = [Sum of stock prices today x Number of stocks) / (Sum of stock prices in base year x Number of stocks)] x Index value in base year.
= sum of current market values x beginning value / sum of base market values

Example: S&P500, NYSE, NASDAQ, MSCI

Dow Jones (DJIA):
Price-weighted index of 30 stocks traded on NYSE. Criticized for being too limited and representing only large blue chips and downward bias due to price weighting. Studies show that DJIA tracks NSYE well on daily/monthly basis, but not in the long term.

Other Equity indexes:
· S&P 500 - value-weighted index of 500 US stocks
· Nikkei – price-weighted index of the 225 Japanese stocks
· FTSE 100 - value-weighted index of 100 UK stocks
· FT/S&P Actuaries value - weighted indexes of 2,500 international stocks
· MSCI Indexes- value-weighted indexes of over 1,400 stocks

Market Indexes and Factors ot costruct index

Market indexes:
· to represent the behaviour of the market
· to track the market movements,
· to construct market-tracking (index) portfolios,
· to evaluate the performance of actively-managed funds
· to calculate market risk premium and betas

Factors to construct index:
· sample be representative of population
· weighting by price, total value or equal weight
· maths & computation method