2 Asset Classes and Financial Instruments Bodie, Kane and Marcus

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2 Asset Classes and Financial Instruments Bodie, Kane and Marcus Essentials of Investments 9th Global Edition

2.4 Stock and Bond Market Indexes Uses Track average returns Compare performance of managers Base of derivatives Factors in constructing/using index Representative? Broad/narrow? How is it constructed?

2.4 Stock and Bond Market Indexes Construction of Indexes How are stocks weighted? Price weighted (DJIA) Market value weighted (S&P 500, NASDAQ) Equally weighted (Value Line Index) How much money do you put in each stock in the index?

2.4 Stock and Bond Market Indexes Constructing Market Indexes Weighting schemes Price-weighted average: Computed by adding prices of stocks and dividing by “divisor” Market value-weighted index: Return equals weighted average of returns of each component security, with weights proportional to outstanding market value Equally weighted index: Computed from simple average of returns

2.4 Stock and Bond Market Indexes PriceB QuantityB P1 Q1 A $10 40 $15 B 50 80 25 160 C 140 150 Price-Weighted Series Time 0 index value: (10 + 50 + 140)/3 = 200/3 = 66.7 Time 1 index value: (10 + 25 + 140)/Denom = 66.67 Denominator = 2.624869 Time 1 index value: (15 + 25 + 150)/2.624869 = 72.38 Other problems: Similar % change movements in higher-price stocks cause proportionally larger changes in the index Splits arbitrarily reduce weights of stocks that split in index

2.4 Stock and Bond Market Indexes PriceB QuantityB P1 Q1 A $10 40 $15 B 50 80 25 160 C 140 150 Value-Weighted Series IndexV = Equal-Weighted Series wlog invest $300 in each IndexE =

2.4 Stock and Bond Market Indexes Case 1 Case 2 Stock PB QB P1 Q1 A $10 40 $12 B 100 80 C 50 200 60 Why do the two differ? Case 1: 20% change in price of small-cap firm IndexV = wlog invest $100 in each stock IndexE =

2.4 Stock and Bond Market Indexes Case 1 Case 2 Stock PB QB P1 Q1 A $10 40 $12 B 100 80 C 50 200 60 Case 1 VW = 100.43 Case 1 EW = 106.67 Why do the two differ? Case 2: 20% change in price of large-cap firm IndexV = Assume $100 investment in each stock IndexE =