Security Market Indices PDF

Preview

Summary

financial markets...

Description

LOS: Describe a security market index. A security market index represents a given security market, market segment, or asset class. Indices are constructed as portfolios of marketable securities known as constituent securities. The value of an index is calculated on a regular basis using either the actual or estimated market prices of the individual securities within the index. A price return index, also known as a price index, reflects only the prices of the constituent securities within the index. A total return index, in contrast, reflects not only the prices of the constituent securities but also the reinvestment of all income received since inception.

1

LOS: Calculate and interpret the value, price return, and total return of an index. The divisor is a number initially chosen at inception. It is frequently chosen so that the price index has a convenient initial value, such as 1,000. The index provider then adjusts the value of the divisor as necessary to avoid changes in the index value that are unrelated to changes in the prices of its constituent securities. For example, when changing index constituents (replacing old constituents by new ones), the divisor is adjusted so that the value of the index with the new constituents equals the value of the index prior to the changes.

2

LOS: Calculate and interpret the value, price return, and total return of an index.

LOS: Calculate and interpret the value, price return, and total return of an index. This is an example of a single-period price return calculation. It is not a measure of total return as total return measures the change in the value of the price return index plus the effects of income (dividends, interest, and/or other distributions).

3

A second method is as follow: c alculate price return for each security: LMN: (€12 - €10) ÷ €10 = 20% OPQ: (€24 - €25) ÷ €25 = - 4% RST: (€18 - €15) ÷ €15 = 20% Next, determine the weight of each security in the initial portfolio: The size of the initial portfolio is (€10 × 200) + (€25 × 100) + (€15 × 400) = €10,500. Thus, the weights of the three securities in the portfolio are: LMN: (€10 × 200) ÷ €10,500 ≈ 0.1905 OPQ: (€25 × 100) ÷ €10,500 ≈ 0.2381 RST: (€15 × 400) ÷ €10,500 ≈ 0.5714 Then calculate the single-period price return: PRI = (0.1905 × 20%) + (0.2381 × -4%) + (0.5714 × 20%) ≈ 14.29%

LOS: Calculate and interpret the value, price return, and total return of an index. Price return measures only price appreciation or percentage change in price. Total return measures price appreciation plus interest, dividends, and other distributions.

4

LOS: Calculate and interpret the value, price return, and total return of an index. This is a continuation of the example in slide 5. The total return for the index could also be determined by weighting out the total return for each individual security: First calculate the return for each security including individual incomes: LMN: (€12.00 - €10.00 + €0.50) ÷ €10.00 = 25% OPQ: (€24.00 - €25.00 + €1.00) ÷ €25.00 = 0% RST: (€18.00 - €15.00 + €0.25) ÷ €15.00 ≈ 21.67% Same as last example, the weights of the three securities in the initial portfolio are: LMN: (€10 × 200) ÷ €10,500 ≈ 0.1905 OPQ: (€25 × 100) ÷ €10,500 ≈ 0.2381 RST: (€15 × 400) ÷ €10,500 ≈ 0.5714 Therefore: TRI = (0.1905 × 25%) + (0.2381 × 0%) + (0.5714 × 21.67%) ≈ 17.14%

5

LOS: Calculate and interpret the value, price return, and total return of an index.

LOS: Calculate and interpret the value, price return, and total return of an index.

6

LOS: Discuss the choices and issues in index construction and management. Which market? – Which securities? – Which weight? – When to rebalance? – When to examine?

LOS: Discuss the choices and issues in index construction and management. Other characteristics that could be considered in the target market selection include the economic sector, company size, investment style (value, growth or blend of both), duration, or credit quality.

7

Some equity indices, such as the S&P 500 Index and the FTSE 100, fix the number of constituent securities included in the index and indicate this number in the name of the index.

LOS: Compare and contrast the different weighting methods used in index construction.

LOS: Compare and contrast the different weighting methods used in index construction.

8

• In price weighting, the weight on each constituent security is determined by dividing its price by the sum of all the prices of the constituent securities. • Unlike a price-weighted index, where the weights are arbitrarily determined by the market prices, the weights in an equal-weighted index are assigned by the index provider. • In market-capitalization weighting, the weight on each constituent security is determined by dividing its market capitalization by the total market capitalization of all the securities in the index. Market-capitalization weighting is sometimes called value weighting. Market capitalization or value is calculated by multiplying the number of shares outstanding by the market price per share.

LOS: Calculate and interpret the value and return of an index on the basis of its weighting method. Exhibit 1 illustrates the values, weights, and single-period returns following inception of a priceweighted equity index with five constituent securities. The value of the price-weighted index is determined by dividing the sum of the security values (101.50) by the divisor, which is typically set at inception to equal the initial number of securities in the index. Thus, in our example, the divisor is 5 and the initial value of the index is calculated as 101.50 ÷ 5 = 20.30. As illustrated in this exhibit, Security A, which has the highest price, also has the highest weighting and thus will have the greatest impact on the return of the index. Note how both the price return and the total return of the index are calculated on the basis of the corresponding returns on the constituent securities.

9

LOS: Calculate and interpret the value and return of an index on the basis of its weighting method. Exhibit 2 illustrates the values, weights, and single-period returns following inception of an equalweighted index with the same constituent securities as those in Exhibit 1. This example assumes a beginning index portfolio value of 10,000 (an investment of 2,000 in each security). To set the initial value of the index to 1,000, the divisor is set to 10 (10,000 ÷ 10 = 1,000). Exhibits 1 and 2 demonstrate how different weighting methods result in different returns. The 10.4 percent price return of the equal-weighted index shown in Exhibit 2 differs significantly from the 3.45 percent price return of the price-weighted index in Exhibit 1.

10

LOS: Calculate and interpret the value and return of an index on the basis of its weighting method. Exhibit 3 illustrates the values, weights, and single-period returns following inception of a marketcapitalization-weighted index for the same five-security market. Security A, with 3,000 shares outstanding and a price of 50 per share, has a market capitalization of 150,000 or 26.29 percent (150,000/570,500) of the entire index portfolio. The resulting index weights in the exhibit reflect the relative value of each security as measured by its market capitalization. As shown in Exhibits 1, 2, and 3, the weighting method affects the index’s returns. The price and total returns of the market-capitalization index in Exhibit 3 (1.49 percent and 2.13 percent, respectively) differ significantly from those of the price-weighted (3.45 percent and 4.33 percent, respectively) and equal-weighted (10.40 percent and 10.88 percent respectively) indices. To understand the source and magnitude of the difference, compare the weights and returns of each security under each of the weighting methods. The weight of Security A, for example, ranges from 49.26 percent in the price-weighted index to 20 percent in the equal-weighted index. With a price return of 10 percent, Security A contributes 4.93 percent to the price return of the price-weighted index, 2.00 percent to the price return of the equal-weighted index, and 2.63 percent to the price return of the market- capitalization-weighted index. With a total return of 11.50 percent, Security A contributes 5.66 percent to the total return of the price-weighted index, 2.30 percent to the total return of the equal-weighted index, and 3.02 percent to the total return of the market-capitalization-weighted index.

11

LOS: Discuss the choices and issues in index construction and management. The earnings weight of Stock A is 50 percent (20/40) which is higher than its marketcapitalization weight of 20 percent (200/1,000). The earnings weight of Stock B is 50 percent (20/40), which is less than its market-capitalization weight of 80 percent (800/1,000).

LOS: Compare and contrast the different weighting methods used in index construction.

30

A: Advantage D: Disadvantage • Price weighting: The primary advantage of price weighting is its simplicity. Its primary disadvantage is the stocks with the highest price have the greatest impact on index return. Also, stock split (i.e. 2 for 1) results in arbitrary (unintentional) changes in weights of all securities in the index. The divisor needs to change to retrieve back the index value before split. • Equal weighting: Like price weighting, the primary advantage of equal weighting is its simplicity. Equal weighting, however, has a number of disadvantages. First, securities that constitute the largest fraction of the target market value are under-represented, and securities that constitute a small fraction of the target market value are overrepresented. Second, after the index is constructed and the prices of constituent securities change, the index is no longer equally weighted. Therefore, maintaining equal weights requires frequent adjustments (rebalancing) to the index (by adding or removing number of shares for each security to realize equal weights again). • Market capitalization weighting: The primary advantage of market-capitalization weighting is that each constituent security’s market value is reflected (represented) in the index. In addition, a constituent’s stock split does not affect the index value because the market capitalization remains unchanged (half the price * double the shares number). The primary disadvantage is that constituent securities whose prices have risen the most (or fallen the most) have a greater (or lower) weight in the index. This weighting method leads to overweighting stocks that have risen in price (and may be overvalued) and underweighting stocks that have declined in price (and may be undervalued). • Fundamental weighting: The most important property (advantage) of fundamental weighting is that it’s less focused on market capitalization (market value and size), but rather based on fundamental factors such as sales revenue, cashflow, dividends and book value. The proponents of such weighting method believe that these accounting figures lead to better estimation of the stock’s intrinsic value, rather than just trading it based on its market value. This leads to truer constituents’ estimates, thus a more accurate index value. However, this approach requires an extensive data collection and analysis.

31

LOS: Discuss rebalancing and reconstitution. Rebalancing: refers to adjusting or realigning the weight of the constituent securities, for a more accurate target market representation. The constituents weights change due to the change in their respective market prices. Higher (lower) prices lead to higher (lower) representation in the index (as shares numbers do not change between rebalancing dates) Rebalancing is handled on a regular basis (usually quarterly). Index providers would buy and / or sell constituent securities shares to recalibrate their weights in the index consistent with the index weighting method. Equal-weighted indices are frequently rebalanced. They start off with equal capitalization for each constituent security. When the prices changes during a period, the securities capitalizations will change accordingly, so do their respective weights. They end up unequal at the end of the period. Rebalancing bring them back to their original prescribed equal weights. Price-weighted indices are self-rebalanced because the weight of each constituent security is determined by its price. Therefore constituents weights are appropriately reflected. For market-capitalization-weighted indices are also self-rebalanced. When a constituent’s price changes, so does its weight in the index basket. However market-capitalization weights are adjusted to reflect mergers, acquisitions, liquidations, and other corporate actions between rebalancing dates, but this process is called reconstitution. Fundamental-weighted Index is frequently rebalanced when constituents market prices deviate from fundamental intrinsic values. When a constituent market value rises above its intrinsic value, the security is overvalued. Here the rebalance involves selling some of the constituent securities shares. In contrast, when a constituent security’s market value drops below its intrinsic value, The security is undervalued and the rebalance means buying more of the constituent securities shares

32

LOS: Discuss rebalancing and reconstitution. Reconstitution is the process of changing the constituent securities in an index. Initial criteria for index inclusion is applied on the reconstitution date to determine which securities to substitute. Indices are reconstituted to reflect changes in the target market (bankruptcies, de- listings, mergers, acquisitions, etc.) and/or to reflect the judgment of the index selection committee (the people in charge of the index constituents selection)

33

LOS: uses of market indices ETF: Exchanged Traded Funds: Index tracking instrument, that is formed of the same stocks that make up the index. They can be traded in the stock market same as stocks. CAPM: Capital Asset Pricing Model: It determines the expected return an investor should be compensated with when investing in a security: The expected return equals a risk free rate (as a minimum compensation) plus a risk premium for compensating against taking the investment risk. The market index helps in the determination of the risk premium and thus the expected return.

34

LOS: Discuss types of equity indices. Broad market equity indices typically include securities representing more than 90% of the selected market. In the United States, the Wilshire 5000 Total Market Index is a marketcapitalization-weighted index that includes more than 6,000 equity securities and is designed to represent the entire U.S. equity market. MSCI Barra offers a number of multi-market indices, classified based on 2 dimensions: level of economic development developed, emerging, frontier) and geographic region (Europe, Asia, Pacific, International, Americas etc.). MSCI Emerging Market Index captures 24 securities from 24 emerging market (developing) countries. Sector indices represent and track different economic sectors, such as energy, finance, health care, and technology and con either an consumer goods, on national, regional, or global basis. UTIL is a Dow Jones Utilities Average Index keeps track of the 15 largest utility companies. Style indices represent groups of securities classified according to market capitalization, value, growth, or a combination of these characteristics (combinations: small cap-value, large capgrowth, mid-cap-value etc.) They are intended to reflect the investing styles of certain investors, such as the growth investor (looking for growth oriented companies to benefit from capital appreciation), value investor (wants to invest in mature stable, undervalued business with dividend potential) and small-cap investor. S&P small-Cap Value index represents securities of the 600 US small-cap businesses with value style (combination of size and value)

35

LOS: Discuss types of fixed-income indices. Major types of fixed-income indices can be organized on the basis of various dimensions. • Coupon type • Issuer’s economic sector • Issuer’s geographic region • Economic development of the issuer’s geographic region • Type of issuer • Type of financing • Currency of payments • Maturity • Credit quality • Inflation indexed • Absence or presence of inflation protection • Embedded options (convertible, call, put)

36

LOS: Discuss types of fixed-income indices. Issue 1: There are too many securities with different characteristics issued by governments, government agencies, and corporations. A fixed income market or sector index would have to include thousands of different constituents. Updates will be a “nightmare”! Issue 2: Fixed income markets are primarily dealer markets. They mostly trade in specific securities more frequently than others. As a result, those left out securities become relatively illiquid (with a thin market). Issue 3: Due to the lack of trading in some constituents, these securities would lack market data. Index providers would have to contact dealers directly to obtain current prices on the securities to update the index or they must estimate the prices of constituent securities using the prices of traded fixed-income securities with similar characteristics.

37

LOS: Discuss indices representing alternative investments. Many investors seek to lower the risk (by diversification) or enhance the performance of their portfolios by investing in assets classes other than equities and fixed income. As a result of this new interest in alternative assets and investment strategies, special entities have created indices designed to represent broad classes of alternative investments.

38

LOS: Discuss indices representing alternative investments. Commodity indices are futures contracts of one or more commodities (agricultural products, livestock, precious metals, energy commodities) Commodity indices do not have an obvious weighting mechanism. Each index may use existing or create a suitable weighing. As a result indices with same commodities may show different performance results. The commodity index return is based on: • Risk free interest rate: a theoretical rate of return from a zero risk investment. An investor would expect such a minimum rate just by investing without incurring any risk. In the US, it’s usually based on 3-month T-bill, because it’s the safest (riskless) security in the market.

•

Changes in futures prices: everytime the underlying commodities prices change, they’ll be reflected in the index. • Roll yield: futures contracts must be continually “rolled over” (replacing a contract nearing expiration with a new contract). The roll over process incurs losses (when the old contracts are replaced by more expensive ones) or generates gains (when old contracts are replaced with cheaper ones). Those gains / losses are then accounted for in the index return calculation

LOS: Discuss indices representing alternative investments. They represent real estate securities and market for real estate. The real estate market is illiquid. Appraisal indices: are estimations based on cost, locations, future returns, potentials etc. to generate fair market value. Repeat sale indices: measure changes in real estate prices over periods (when they change hands) to provide info about housing market. It excludes new constructions and family transactions.

39

REITs are public or private corporations organized specifically to invest in real estate: • ownership of properties • investment in mortgages (through MBS) REIT indices are based on publicly traded REITs with continuous market pricing so their value is calculated continuously. Example: The FTSE EPRA/NAREIT Global REIT Index, with FTSE representing UK index, EPRA representin...