Chapter-5: Security Market Indexes

 Market Index
 Uses of Security Market Index
 Differentiating Factors in Constituting Market Indexes
 Types of Security Market Index
 Practice Problems

Market Index:


Market index is a market indicator series that provide a general indication of the aggregate market
changes or market movements. To supply investors with a composite report on market performance,
some financial publications or investment firms have developed Stock Market and Bond Market
Indexes. These indexes reflect overall movements of a group of securities. The ever-increasing role of
trade and investments has made indexes part of the general news.

Uses of Security Market Index:



Security market index have several uses:

1. An aggregate stock or bond market index can be used as a benchmark to evaluate the
performance of professional money managers.
2. A second use is in examining the factors that influence aggregate stock price movements by
forming relationships between market (series) movements and changes in the relevant variables.
3. Market index is used to create and monitor an index fund (a portfolio that emulates the market
portfolio).
4. Market index is used to measure market rates of return in economic studies.
5. Market index is used by technicians who use past aggregate market movements to predict future
price patterns.
6. Market indicator series is used as a proxy for the market portfolio of risky assets when
calculating the systematic risk of an asset.

Differentiating Factors in Constituting Market Indexes:



Because the indexes are intended to reflect the overall movements of a group of securities, we need to
consider three factors that are important when constructing an index intended to represent a total
population.
1. The Sample:
The first factor is the sample used to construct an index. The size, the extent, and the source of the
sample are all important.
A small percentage of the total population will provide valid indications of the behavior of the total
population if the sample is properly selected. The sample should be representative of the total
population; otherwise, its size will be meaningless. The sample can be generated by completely random
selection or by a nonrandom selection technique designed to incorporate the important characteristics
of the desired population. Finally, the source of the sample is important if there are any differences
between segments of the population, in which case samples from each segment are required.
2. Weighting Sample Members:
The second factor is the weight given to each member in the sample. Four principal weighting schemes
are used for security-market indexes:
a) A price-weighted index
b) A market-value weighted index
c) An un-weighted index, or an equal-weighted index
d) A fundamental weighted index based on some operating variable like sales, earnings, or return
on equity.
3. Computational Procedure:
The final consideration is the computational procedure used.
a) One alternative is to take a simple arithmetic mean of the various members in the index.
b) Another is to compute an index and have all changes, whether in price or value, reported in
terms of the basic index.
c) Finally, some prefer using a geometric mean of the components rather than an arithmetic mean.

Types of Security Market Index:



Security Market index can be of two types includes the following:

1) Stock- Market Index

2) Bond Market Index
1) Stock- Market Index : In finance, a stock index, or stock market index, is an index that
measures a stock market, or a subset of the stock market, that helps investors compare
current price levels with past prices to calculate market performance.
 Stock Market Index can be of Six types include the following:
a) Price-Weighted Index
b) Value-Weighted Index
c) Un-Weighted Index
d) Fundamental Weighted Index
e) Style Indexes
f) Global Equity Indexes
a) Price-Weighted Index: A price-weighted Index is an un-weighted arithmetic average of current
prices of the securities included in the sample – that is., closing prices of all securities are summed
and divided by the number of securities in the sample.
Following are the name of some popular Price-Weighted Indexes over the world.
 The Dow Jones Industrial Average (DJIA) Index
 The S&P 500 index
 The NASDAQ composite
 The Nikkei Average of Japanese stocks.

Σ Pi Where, Pi = Current price of each security

Formula: Price-Weighted Index = ------------ n = Number of security in the index
n

Note the following features:

1. Price-Weighted Index give higher price shares more weight in determining performance of the
index.
2. Usually sample used is limited to a certain number that cannot be representative of the whole
market.
3. Stock splits require their weight to be reduced.

Example: You are given the following information regarding prices for a sample of stock.

Name No. of Price per share Price per share

of Shares (Tk.) at Period T (Tk.) at Period T+1
Share
A 10 50 55
B 20 20 25
C 30 30 35
D 5 100 80
E 6 50 60
Solution:

Price-Weighted Index:
Σ Pi Tk. (50 + 20 + 30 + 100 + 50) Tk.250
Index T = --------- = --------------------------------------- = ------------ = 50
n 5 5

Σ Pi Tk. (55 + 25 + 35 + 80 + 60) Tk.255

Index T+1 = --------- = --------------------------------------- = ------------ = 51
n 5 5

Index T+1 - Index T 51-50

Percentage Change in Index from T to T+1 = ----------------------------- = --------------- = 2%
Index T 50

Impact of Stock Split and Stock Dividend on Price –Weighted Index:

Stock Split:
A stock split is a method commonly used to lower the market price of a firm’s stock by increasing the
number of shares belonging to each shareholder. Stock Split technique is used in order to avoid
unfriendly or hostile takeover. In a 2 for 1 split, for example, two new shares are exchanged for each
old share, with each new share worth half the value of each old share. A stock split has no effect on the
firm’s capital structure
Stock Dividend:

Stock dividend is referred to as paid out of shares of stock in the form of dividend rather than cash. It is
the direct payment made by the corporation to the shareholders in the form of stock. It is not a true
dividend, because no cash leaves the firm. Rather, a stock dividend increases the number of shares
outstanding, thereby, reducing the value of each share. Corporation can intentionally provide stock
dividend in order to avoid unfriendly or hostile takeover.
Example: You are given the following information regarding prices for a sample of stocks.
Construct a price-weighted index for these five stocks, and compute the percentage change in the index
for the period from T to T + 1.
Name No. of Price per share Price per share
of Shares (Tk.) at Period T (Tk.) at Period T+1
Share
A 10 $50 $55
B 20 $20 $25
C 30 $30 $35
D 5 $100 $80
E 6 $50 $60
  a
Stock split two-for-one during the year
 b
Company paid a 10% stock dividend during the year
 d
Stock split 30% of one during the year
 e
Company paid a 25% stock dividend during the year
Solution:

Stock No. of Price at T Period Price after split & No. of Price at T+1
share stock dividend share
a
A 10 $50 $50 ÷ 2 = $25 20 $55
b
B 20 $20 $20÷1.1= $18.18 22 $25
C 30 $30 $30 30 $35
d
D 5 $100 $100÷1.3= $76.92 6.5 or 7 $80
e
E 6 $50 $50÷1.25 = $40 7.5 or 8 $60

Price-Weighted Index:
Σ Pi $ (50 + 20 + 30 + 100 + 50) $250
Index T = --------- = -------------------------------------------- = ------------ = 50
n 5 5

In case of stock split:

$ (25 + 18.18 + 30 + 76.92 + 40)
Index T = -------------------------------------------- Where, X = Divisor
X

$ 190.10
= > 50 = ------------------ = > X = 3.803
X

Thus, Σ Pi $ (55 + 25 + 35+ 80 + 60) $255

Index T+1 = --------- = ------------------------------------- = ------------ = 67.05
n 3.803 3.803

Percentage Change in Index:

Index T+1 - Index T 67.05 – 50

Percentage Change in Index from T to T+1 = ----------------------------- = ------------------- = 34.10%
Index T 50

Review Problem: You are given the following information regarding prices for a sample of stocks.
Construct a price-weighted index for these four stocks, and compute the percentage change in the index
for the period from T to T + 1.
 Stock Number of Shares Price
T T+1
A 10,000,000 $35 $55
B1 150,000,000 $27 $19
C2 200,000,000 $20 $16
D3 300,000,000 $20 $18
 1
Stock split three-for-one during the year
 2
Company paid a 25% stock dividend during the year
 3
Stock split 50% of one during the year
b) Value Weighted Index: A value-weighted index begins by deriving the initial total market value of
all stocks used in the series (market value equals number of shares outstanding times current market
price). The initial value is typically established as the base value and assigned an index value of
100. Subsequently, a new market value is computed for all securities in the sample and this new
value is compared to the initial value to derive the percent change which is then applied to the
beginning index value of 100.

Σ P t Qt
Formula: Market Value Index t = --------------- x Base Index Value
Σ P b Qb
Where,
Index t = Index value on day t
Pt = Ending price on day t
Qt = No. of outstanding securities on day t
Pb = Ending price on base day
Qb = No. of outstanding securities on base day

Note: Price changes for the large market value stocks will dominate changes in the index value.
Example: You are given the following information regarding prices for a sample of stocks.
Construct a value-weighted index for these five stocks, and compute the percentage change in the index
for the period from T to T + 1.
Name No. of Price per share Price per share
of Shares (Tk.) at Period T (Tk.) at Period T+1
Share
A 10 $50 $55
B 20 $20 $25
C 30 $30 $35
D 5 $100 $80
E 6 $50 $60
  a
Stock split two-for-one during the year
 b
Company paid a 10% stock dividend during the year
 d
Stock split 30% of one during the year
 e
Company paid a 25% stock dividend during the year
Solution:
Before Split:
Stock No. of Price at T Period Market Value
share
a
A 10 $50 $500
b
B 20 $20 $400
C 30 $30 $900
d
D 5 $100 $500
e
E 6 $50 $300
Total=$2600
The $2600 base value is set equal to an index value of 100.

After Split:
Stock Price after split No. of Market Value
share
a
A $50 ÷ 2 = $25 20 $500
b
B $20÷1.1= $18.18 22 $400
C $30 30 $900
d
D $100÷1.3= $76.92 6.5 or 7 $500
e
E $50÷1.25 = $40 7.5 or 8 $300
Total=$2600

Value Weighted Index:

Current Market Value
New Index Value = -------------------------------- x Beginning Index Value
Base Market Value

$2600
= ---------- x 100 = 100
$2600

This is precisely what one would expect since there has been no change in prices other than the split.

Percentage Change in Index:

Index T+1 - Index T 100 – 100

Percentage Change in Index from T to T+1 = --------------------------- = ------------------- = 0%
Index T 100
Review Problem: (Note: Base value equal to an index of 100)

December 31, 2015

Stock Share Price No. of shares Market Value (Tk.)
(Tk.)
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 Tk. 200,000,000
December 31, 2016
A 12.00 1,000,000 12,000,000
B 10.00 12,000,000 120,000,000
C 20.00 5,500,000 110,000,000
Total Tk. 242,000,000
Solution:
Value Weighted Index:

Current Market Value

New Index Value 2016 = -------------------------------- x Beginning Index Value
Base Market Value

Tk. 242,000,000
= ----------------------- x 100
Tk. 200,000,000

= (1.21 x 100) = 121

Percentage Change in Index:

Index 2016 - Index 2015 121 – 100

Percentage Change in Index from 2015 to 2016 = --------------------------- = ------------------- = 21%
Index 2015 100

c) Un-weighted Index: In an un-weighted 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. Such an index can be used by individuals who randomly select stock for
their portfolio or invest the same amount in each stock.

Formula of Un-Weighted Index

 AM of HPY: One way to calculate an un-weighted index by using the average of the percent
changes for each of the stocks.
Σ HPY
Formula: AM of HPY = --------------
n
Un-Weighted Index T+1 = {(AM of HPY) + 1} x Index Value T
  GM of HPY: Another way to calculate an un-weighted index by using a geometric mean of the
holding period returns and derive the holding period yield from this calculation.

Formula: GM of HPY = (∏ HPR) 1/n – 1

Un-Weighted Index T+1 = {(GM of HPY) + 1} x Index Value T

Example: You are given the following information regarding prices for a sample of stocks.
Construct a price-weighted index for these five stocks, and compute the percentage change in the index
for the period from T to T + 1.
Name No. of Price per share Price per share
of Shares (Tk.) at Period T (Tk.) at Period T+1
Share
A 10 $50 $55
B 20 $20 $25
C 30 $30 $35
D 5 $100 $80
E 6 $50 $60

 a
Stock split two-for-one during the year
 b
Company paid a 10% stock dividend during the year
 d
Stock split 30% of one during the year
 e
Company paid a 25% stock dividend during the year

Stock No. of Price at Price after split Beginning No. of Price Market HPR HPY
share T Period Value share at T+1 Value at
T+1 Period

a
A 10 $50 $50 ÷ 2 = $25 500 20 $55 1100 2.20 1.20
b
B 20 $20 $20÷1.1= $18.18 400 22 $25 550 1.38 0.38
C 30 $30 $30 900 30 $35 1050 1.67 0.67
d
D 5 $100 $100÷1.3= 500 7 $80 560 1.12 0.12
$76.92
e
E 6 $50 $50÷1.25 = $40 300 8 $60 480 1.60 0.60
Total = 2600 Total = 3740 Σ 2.97
Un-weighted Index:
Σ HPY 2.97
AM of HPY = -------------- = ---------- = 0.594
n 5

Un-Weighted Index T+1 = {(AM of HPY) + 1} x Index Value T

= (0.594 +1) x 100 = 159.40
 Index T+1 - Index T 159.40 – 100
Percentage Change in Index from T to T+1 = ----------------------------- = ------------------------ = 59.40%
Index T 100
GM of HPY = (∏ HPR)1/n – 1
= (2.20 x 1.38 x 1.67 x 1.12 x 1.60) 1/5 - 1 = 0.5548

Un-Weighted Index T+1 = {(GM of HPY) + 1} x Index Value T

= (0.5548 + 1) x 100 = 155.48

Index T+1 - Index T 155.48– 100

Percentage Change in Index from T to T+1 = ----------------------------- = ------------------------ = 55.48%
Index T 100
Problem: Price-Weighted Index, Value – Weighted Index and Un-Weighted Index Together

Example: You are given the following information regarding prices for a sample of stock.

Stock Number of Shares Price

T T+1
A 10,000,000 $35 $55
B1 150,000,000 $27 $19
C2 200,000,000 $20 $16
D3 300,000,000 $20 $18

 1
Stock split three-for-one during the year
 2
Company paid a 25% stock dividend during the year
 3
Stock split 50% of one during the year
Solution:

Stock No. of share Price at T Price after Beginning No. of share Price at Market Value HP HPY
Period split Value T+1 at T+1 Period R
Thousand Thousand
A 10,000,000 $35 $35 350 10,000,000 $55 550 1.57 0.57
B1 150,000,000 $27 27÷3= $9 4050 450,000,000 $19 8550 2.11 1.11
C2 200,000,000 $20 20÷1.25=$16 4000 250,000,000 $16 4000 1.00 0
D3 300,000,000 $20 20÷1.5= $13 6000 450,000,000 $18 8100 1.35 0.35
Total = Σ14400 Total =Σ21200 Σ2.03
1. Price-Weighted Index:
Σ Pi $ (35 + 27 + 20 + 20) $102
Index T = --------- = --------------------------- = ------------ = 25.5
n 4 4
In case of stock split:
$ (35 + 9 + 16 + 13) Where, X = Divisor
Index T = ------------------------------
X
 $ 73.33
= > 25.5 = -------------- = > X = 2.88
X

Thus, Σ Pi $ (55 + 19 + 16+ 18) $108

Index T+1 = --------- = ----------------------------- = ------------ = 37.5
n 2.88 2.88

Index T+1 - Index T 37.5 – 25.5

Percentage Change in Index from T to T+1 = ----------------------------- = ------------------- = 47.06%
Index T 25.5
2. Value Weighted Index:
Ending Market Value
Value Weighted Index T+1 = -------------------------------------- X Base Index Value
Beginning Market Value

21200
= ------------- X 100 = 147.22
14400

Index T+1 - Index T 147.22 – 100

Percentage Change in Index from T to T+1 = ----------------------------- = ------------------------- = 47.22%
Index T 100
3. Un-weighted Index:
Σ HPY 2.03
AM of HPY = -------------- = ---------- = 0.5075
n 4
Un-Weighted Index T+1 = {(AM of HPY) + 1} x Index Value T
= (0.5075 +1) x 100 = 150.75

Index T+1 - Index T 150.75 – 100

Percentage Change in Index from T to T+1 = ----------------------------- = ------------------------ = 50.75%
Index T 100

GM of HPY = (∏ HPR)1/n – 1
= (1.57 x 2.11 x 1 x 1.35) ¼ - 1 = 0.4542

Un-Weighted Index T+1 = {(GM of HPY) + 1} x Index Value T

= (0.4542 + 1) x 100 = 145.42
Index T+1 - Index T 145.42– 100
Percentage Change in Index from T to T+1 = ----------------------------- = ------------------------ = 45.42%
Index T 100
 Practice Problem :( Assignment Part)
Problem-1: You are given the following information regarding prices for a sample of stocks.
Price
Stock Number of Shares T T+1
A 1,000,000 60 80
B 10,000,000 20 35
C 30,000,000 18 25

a) Construct a price-weighted index for these three stocks, and compute the percentage change in
the index for the period from T to T + 1.
b) Construct a value-weighted index for these three stocks, and compute the percentage change in
the index for the period from T to T + 1.
Problem-2:
a) Given the data in Problem 1, construct an equal-weighted index by assuming $1,000 is invested
in each stock. What is the percentage change in wealth for this portfolio?
b) Compute the percentage of price change for each of the stocks in Problem 1. Compute the
arithmetic mean of these percentage changes.
c) Compute the geometric mean of the percentage changes in Part b.

Problem-3: Based on the following stock price and shares outstanding information, compute the
beginning and ending values for a price-weighted index and a market-value-weighted index.
Stocks DECEMBER 31, 2019 DECEMBER 31, 2020
Price Share Outstanding Price Share Outstanding
Stock K 20 100,000,000 32 100,000,000
Stock M 80 2,000,000 45 4,000,000a
Stock R 40 25,000,000 42 25,000,000
a
Stock split two-for-one during the year.
a) Construct a price-weighted index for these three stocks, and compute the percentage change in
the index for the period from 2019 to 2020.
b) Construct a value-weighted index for these three stocks, and compute the percentage change in
the index for the period from 2019 to 2020.
c) Construct an equal-weighted index by assuming $1,000 is invested in each stock. What is the the
percentage change for an un-weighted index.

****Thank You****