Security Market Indicator Series

(Stock market indexes,

their construction
and use)

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 Stock Markets
• Most everyone ‘follows’ the stock markets
• Daily news media commonly report the daily value and the
change in U.S. market indicator series such as the Dow
Jones Industrial Average and the Down Jones
Transportation Average and the NASDAQ Composite.
• In Canada we commonly hear about the TSE (Toronto
Stock Exchange) 300 Composite Index and the CDNX
(Canadian Venture Exchange)
• But what are these measures? How are they conceived?
What do they measure? How can we use them?

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 Security-market Indicator Series
• The term “security-market indicator series” is a more
correct term to use when describing the whole range of
stock market ‘indices’ and ‘averages’
– this is because not all indicator series is constructed as an index
• For example the DJIA (Dow Jones Industrial Average) is
an average of 30 large ‘blue-chip’ stocks traded on the
NYSE (New York Stock Exchange)
• The TSE (Toronto Stock Exchange) 300 is a composite
index made of the the 300 largest ‘value-weighted’ stocks
publicly traded on the Toronto Stock Exchange

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 What is a ‘Blue Chip’ Stock?
• Blue chip stocks is a general term that is loosely applied to
companies that are generally considered to be leaders in their
industry, are typically very large in terms of market
capitalization (the number of shares outstanding multiplied by
their current market price), are considered to be ‘mature’ (ie.
they are not necessarily rapidly growing in terms of sales or
stock price) and often pay a substantial and consistent cash
dividend.
• Examples include IBM, American Express, etc.
• Why not do an internet search and find out what 30 stocks are
included in the DJIA?
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 DJIA
• Companies included in the average are those selected by
Dow Jones & Company, publisher of the Wall Street Journal
• The composition of the average changes over time as
companies are dropped because of a merger or bankruptcy
has occurred, because a company’s trading activity is low, or
because a company not in the average becomes very
prominent.
• When a company is replaced by another company, the
average is readjusted in such a way as to provide
comparability with earlier values.

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 Use 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 proxy for the market portfolio of risky assets when
calculating the systematic risk of an asset

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 Differentiating Factors in the
Construction of Market Indexes
• Because the indicator series are intended to reflect overall
market price changes of a group of securities, it is
necessary to consider which factors are important in
computing an index that is intended to represent a total
population.
• Each indicator series will be built upon conscious choices
on the following issues:
– SAMPLE
– WEIGHTING SAMPLE MEMBERS
– COMPUTATIONAL PROCEDURE

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 Differentiating Factors in the
Construction of Market Indexes
• SAMPLE - the size of the sample, the breadth of the sample, and the
source of the sample used to construct a series are all important
• WEIGHTING SAMPLE MEMBERS - three principal weighting
systems are (1) price-weighted (2) value-weighted (3) unweighted (equally
weighted)
• COMPUTATIONAL PROCEDURE - one alternative is to take a
simple arithmetic average of the various member in the series. Another is to
compute an index and have all changes, whether in price or value, reported in
terms of the basic index. Finally, some prefer a geometric average of the
components rather than an arithmetic average.

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 Price-Weighted Series
• A price-weighted series is an arithmetic average of
current prices, which means that index movements
are influenced by the differential prices of the
components. 30

• DJIA
DJIA  
pit / Dadj
i 1
– the Dow Jones Industrial Average is the best-known
price-weighted series and is also the oldest and most
popular stock-market indicator series.
– It is computed by totaling the current prices of the 30
stocks and dividing the sum by a divisor that has been
adjusted to take account of stock splits and changes in the
sample over time.
Price-weighted series
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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
• when a stock splits, the divisor becomes smaller as shown.
• The cumulative effect of splits can be derived from the DJIA…it was originally
30…but as of July 1999 it was 0.197405

Price-weighted series
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 Example of the Impact of Differently
Priced Shares on a Price-Weighted Series
Period T + 1
Period T Case A Case B
A 100 110 100.7
B 50 50 50
C 30 30 33
Sum 180 190 183
Divisor 3 3 3
Average 60 63.3 61
Percent Change 5.5 1.7

• because the series is price-weighted, a high-priced stock carries more weight

than a low-priced stock.

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Price-weighted series
 Citicisms of the DJIA
• Limited sample size
– 30 nonrandomly selected blue-chip stocks make up the average
– the stocks selected are the largest and most pretigious companies
in various industries.
– The DJIA, therefore, probably reflects price movements for large,
mature, blue-chip firms rather than the typical company listed on
the NYSE
– Several studies have pointed out that the DJIA has not been a
volatile as other market indexes and that the long-run returns on
the DJIA are not comparable to other NYSE stock indexes.

Price-weighted series
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 Citicisms of the DJIA ...
• Weighting Scheme
– because the DJIA is price weighted, when companies split their
stock, their prices decline, and therefore their weight in the DJIA
is reduced - even though they may be large and important.
– Therefore, the weight scheme casues a downward bias in the
DJIA, because the stocks that have higher growth rates will have
higher prices, and because such stocks tend to split, they will
consistently lose weight within the index.

Price-weighted series
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 Value-Weighted Series
• A value-weighted series is generated by deriving the initial total
market value of all stocks used in the series:
Market Value = Number of Shares Outstanding × Current Market Price
• This initial figure is typically established as the base and assigned an
index value (the most popular beginning index value is 100, but it can
vary - say, 10, 50).
• Subsequently, a new market value is computed for all securities in the
index, and the current market value is compared to the initial “base”
value to determine the percentage change, which in turn is applied to
the beginning index value:

Index t 
 PQ
t t
 Beginning Index Value
PQ
b b

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 Value-Weighted Series
• In a value-weighted series, there is an automatic adjustment for stock
splits and other capital changes (since the decreased price of the share
is offset by an equal and opposite effect of an increase in the number
of shares outstanding).

• In a value-weighted index, the importance of individual stocks in the

sample depends on the market value of the stocks. Therefore, a
specified percentage change in the value of a large company has a
greater impact than a comparable percentage change in a small
company.

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 Example of a Computation of a Value-
weighted index
Stock Share Price Number of Shares Market Value
December 31, 1999
A $10.00 1,000,000 $10,000,000
B 15.00 6,000,000 90,000,000
C 20.00 5,000,000 100,000,000
Total $200,000,000
Base Value Equal to an Index of 100
December 31, 2000
A $12.00 1,000,000 $12,000,000
B (2 for 1 split) 10.00 12,000,000 120,000,000
C (10% stock dividend) 20.00 5,500,000 110,000,000
Total $242,000,000
New Index Value = [Current MV] / [Base Value] × Beginning Index Value
= [$242 M / $200 M] × 100 = 1.21

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 Value-weight Indexes
• Price changes for the large market value stocks in a value-
weighted index will dominate changes in the index over
time.
• This value-weighted effect was prevalent on U.S. stock
markets (NYSE, OTC) in 1998 when the market was being
driven by large growth stocks - that is, almost all of the
gain for the year was attributable to the largest 50 of the
S&P 500 Index.

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 Value-Weighted Series
The TSE 300 Composite

• TSE 300 Composite Index is a value-weighted series:

– 300 stocks (comprised of 14 subindexes)
– weights of the stocks is based on market capitalization adjusted for
major shareholders
– Base year = 1975
– Base value of the index = 1000

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 TSE 300 Composite Index
Date
Dec-97
Jan-98
Recent History
Closing Value
6699.4
6700.2
Feb-98 7092.5
Mar-98 7558.5
Apr-98 7665 6931.4
May-98 7589.8 5530.7 TSE 300 Composite Index
Jun-98 7366.9 5614.1
Jul-98 6931.4 6208.3
Aug-98 5530.7 12000
6344.2
Sep-98 5614.1
6485.9 10000
Oct-98 6208.3
6729.6
Nov-98 6344.2 8000
Dec-98 6485.9 6312.7
Jan-99 6729.6 6597.8 6000
Feb-99 6312.7 7014.7
Mar-99 6597.8 6841.8 4000
Apr-99 7014.7 7010.1
2000
May-99 6841.8 7080.7
Jun-99 7010.1 6970.8 0
Jul-99 7080.7 6957.7
Aug-99 6970.8 7256.2
Sep-99 6957.7
7519.5
Oct-99 7256.2
8413.8
Nov-99 7519.5
Dec-99 8413.8
Jan-00 8481.1
Feb-00 9129
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 TSE 300 Composite Index
The 14 sub-indexes - 04/06/01
1. Metals and Minerals: 11.Communications & Media
2. Gold & Precious Metals 12.Merchandising
3. Oil & Gas 13.Financial Services
4. Paper & Forest Products 14.Conglomerates
5. Consumer Products
6. Industrial Products
7. Real Estate
8. Transportation &
Environmental Services
9. Pipelines
10.Utilities

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 TSE 300 Composite Index
Sub-indexes and components - 04/06/01
1. Metals and Minerals: Distilleries
integrated mines breweries & Beverages
mining Household Goods
Biotechnology/Pharmaceuticals
2. Gold & Precious Metals
6. Industrial Products
3. Oil & Gas
steel
integrated oils
fabricating & engineering
oil & gas producers
transportation equipment
oil & gas services
technology-hardware
4. Paper & Forest Products building materials
5. Consumer Products chemicals & fertilizers
food processing technology -software
tobacco autos & parts

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 TSE 300 Composite Index
Sub-indexes - 04/06/01 ...

7. Real Estate 12.Merchandising

8. Transportation & wholesale distributors
Environmental Services food stores
9. Pipelines department stores
10.Utilities specialty stores
telephone utilities hospitality
gas/electrical utilities 13.Financial Services
11.Communications & Media banks & trusts
broadcasting investment companies & funds
cable & entertainment insurance
publishing & printing financial management companies
14.Conglomerates
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 TSE 300 Composite Index
Sub-indexes - 04/06/01 … examples

7. Real Estate 12.Merchandising

– ACK - Acktion Corp wholesale distributors
– BEI - Boardwalk Equities – FTT - Finning International Inc.
– TZH - Trizec Hahn Corp – RCH - Richelieu Hardware Ltd.
– UNS - Uni-select Inc.

14.Conglomerates
– BNN.A - Brascan Corp
– CP - Canadian Pacific Ltd
– OCX - Onex Corporation SV
– POW - Power Corporation of
Canada SV

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 TSE
• For further information on the Toronto Stock Exchange go
to:

http://www.tse.com

• go to the periodicals in the Chancellor Patterson Library

and go to Toronto Stock Exchange Review

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 Value-Weighted Series
A TSE Problem - when a company’s market capitalization gets too
great

• This became a serious problem for the TSE 300 Composite in 2000
since BCE (Bell Canada Enterprises) has a large number of shares
outstanding and their the individual share price rose to a point where
the firm and its subsidiaries represented more than 20% of the TSE
300

• The reason this is a problem is that professionally-managed portfolios

are not allowed to invest more than 10% of their value in any one
stock (for proper diversification of risk…and the need as a
professional fiduciary to ensure proper diversification)…hence, the
usefulness of the TSE 300 as a benchmark of comparison has
diminished considerably.
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 Unweighted Price Indicator Series

• In an unweighted index, all stocks carry equal weight

regardless of their price or market value.
• A $20 stock is as important as a $40 stock, and the total
market value of the company is unimportant.
• USE:
– such an index can be used by individuals who randomly select
stock for their portfolio and invest the same dollar amount in each
stock.

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 Unweighted Price Indicator
Series ...
• The actual movements in the index are typically based on
the arithmetic average of the percent changes in price or
value for the stocks in the index.
• The use of the percent price changes means that the price
level or the market value of the stock does not make a
difference - each percentage change has equal weight.
• The arithmetic average of percent changes procedure is
used in academic studies when the authors specify equal
weighting.

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Example of an Arithmetic and Geometric
Mean of Percentage Changes
Share Price
Stock T T+1 HPR HPY
X 10 12 1.20 0.20
Y 22 20 0.91 -0.09
Z 44 47 1.07 0.07
II = 1.20 × 0.91 × 1.07 sum = 0.18
= 1.168 0.18/3 = 0.06
1.1681/3 = 1.0531 = 6%

Index Value (T) × 1.0531 = Index Value (T + 1)

Index Value (T) × 1.06 = Index Value (T + 1)
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 Unweighted Series ...
• Both 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.

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 Summary of Stock Market
Indexes
Number of
Name of Index Weighting Stocks Source
Dow Jones Industrial Average Price 30 NYSE
Nikkei-Dow Jones Average Price 225 Tokyo
S&P 400 Industrial Market Value 400 NYSE, OTC
S&P Composite Market Value 500 NYSE, OTC
NASDAQ Composite Market Value 4,879 OTC
Wilshire 5000 Equity Value Market Value 5,000 NYSE, AMEX, OTC
Russell 3,000 Market Value 3,000 NYSE, AMEX, OTC
Value Line Industrial Average Equal (geo) 1,499 NYSE, AMEX, OTC
TSE 300 Composite Market Value 300 TSE

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 Bond-Market Indicator Series

• Investors know little about the several bond-market series

because these bond series are relatively new and not
widely published.
• Knowledge regarding these bond series is becoming more
important because of the growth of fixed-income mutual
funds and the consequent need to have a reliable set of
benchmarks to use in evaluating performance.

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 Bond-Market Indicator Series
Challenges

• The creation and computation of bond-market indexes is more

difficult than stock-market series for several reasons:
– the universe of bonds is much broader than that of stocks, ranging from
Federal Government bonds to bonds in default.
– The universe of bonds is constantly changing because numerous new
issues, bonds maturing, calling of outstanding bonds, and bond sinking
funds.
– The volatility of prices for individual bonds and bond portfolios change
because bond price volatility is affected by duration, which is likewise
constantly changing because of changes in maturity, coupon, and market
yield.
– Pricing of bonds correctly especially in the case of corporates.

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 Composite Stock-Bond Indexes
• A composite series is intended to measure the performance of
all securities in a given country.
• Use of a composite series of stocks and bonds makes it possible
to examine the benefits of diversifying with a combination of
asset classes such as stocks and bonds in addition to
diversifying within the asset classes of bonds or stocks.
• Examples:
– Merrill Lynch - Wilshire U.S. Capital Markets Index
– Brinson Partners Global Security Market Index (GSMI) - this index
contains both U.S. stocks and bonds, but also includes non-U.S. equities
and nondollar bonds as well as an allocation to cash.

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Mean and Standard Deviation of Annual Percentage
Price Change for Stock Price Series 1972 - 1997

Geometric Arithmetic Standard Coefficient

Mean Mean Deviation of Variation
DJIA 8.79 10.09 16.70 1.66
S&P 500 9.06 10.35 16.49 1.59
NASDAQ 11.89 13.94 20.81 1.49
Wilshire 5000 9.29 10.69 17.07 1.60
TSE 300 11.32 12.54 16.52 1.32
FT All-share 10.37 14.36 31.94 2.22
Nikkei 6.97 9.74 25.77 2.65

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 Mean and Standard Deviation of Annual Rates of
Return for Lehman Brothers Bond Indexes 1972 - 1997

Geometric Arithmetic Standard Coefficient

Mean Mean Deviation of Variation
Government/Corporate 9.68 9.95 8.04 0.81
Government 9.65 9.77 7.15 0.73
Corporate 10.17 10.60 10.25 0.97
Mortgage-Backed9.94 10.35 10.07 0.97

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Correlation Coefficients Among Monthly Percentage
Price Changes In Alternative Equity Indices 1972 - 1997

S&P NASDAQ Wilshire TSE

500 NYSE Composite 5000 300
S&P 500 -
NYSE 0.919 -
NASDAQ 0.783 0.881 -
Wilshire 5000 0.906 0.987 0.906 -
TSE 300 0.687 0.761 0.740 0.870 -
Nikkei 0.358 0.350 0.308 0.335 0.293
FT All-Share 0.615 0.712 0.620 0.693 0.627

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