1. Chapter 5 Innovative Financial Instruments Dr. A. DeMaskey Security-Market Indicator Series

2. Uses of Security-Market Indexes zAs benchmarks to judge portfolio performance zTo develop an index portfolio zTo examine factors that influence aggregate security price movement zTo predict future price movement zTo compute systematic risk of an asset

3. Differentiating Factors in Constructing Market Indexes zThe sample ysize ybreadth ysource zWeighting sample members yprice-weighted series yvalue-weighted series yunweighted (equally weighted) series zComputational procedure yarithmetic average yindexed ygeometric average

4. Stock-Market Indicator Series zPrice-Weighted Series yDow Jones Industrial Average (DJIA) yNikkei Average zValue-Weighted Series yNYSE Composite yS&P 500 Index yAMEX Index yand more…. zUnweighted Index yValue Line yFinancial Times Ordinary Share Index

5. Dow Jones Industrial Average (DJIA) zBest-known, oldest, most popular series zPrice-weighted average of thirty large well-known industrial stocks, leaders in their industry, and listed on NYSE zTotal the current price of the 30 stocks and divide by a divisor (adjusted for stock splits and changes in the sample)

6. Example of Change in DJIA Divisor When a Sample Stock Splits After Three-for One Before Split Split by Stock A Prices Prices A 10 10 B 15 15 C 20 10 45 3 = 15 35 X = 15 X = 2.33 (New Divisor)

7. Demonstration of the Impact of Differently Priced Shares on a Price- Weighted Indicator Series PERIOD T+ 1. Period T Case A Case B A 100 110 100 B 50 50 50 C 30 30 33 Sum 180 190 183 Divisor 3 3 3 Average 60 63.3 61 Percentage Change 5.5% 1.7%

8. Criticism of the DJIA zSample used is limited y30 non-randomly selected blue-chip stocks are not representative of the 1800 NYSE listed stocks zPrice-weighted series yStock split results in less weighting for sample stock yIntroduces a downward bias in DJIA by reducing weighting of fastest growing companies whose stock splits

9. Nikkei-Dow Jones Average zArithmetic average of prices for 225 stocks on the First Section of the Tokyo Stock Exchange (TSE) zBest-known series in Japan zPrice-weighted series formulated by Dow Jones and Company zThe 225 stocks represent 15 percent of all stocks on the First Section

10. Value-Weighted Series zDerive the initial total market value of all stocks used in the series Market Value = Number of Shares Outstanding x Current Market Price yAssign a beginning index value (100) yNew market values are compared to the base index yAutomatic adjustment for splits yWeighting depends on market value

11. Value-Weighted Series: Illustration Consider the following three stocks: Stock Price No. of Shares Value (Million) ($Million) June 30, 2000: A 20 2.0 40 B 40 2.5 100 C 60 1.0 60 200 Let this $200 million have an index value of 100.

12. Value-Weighted Series: Illustration Continued Stock Price No. of Shares Value (Million) ($Million) June 30, 2001: A 24 2.0 48 B 30 5.0 150 C 60 1.0 60 258 (Note: Stock B split 2-for-1 during the year.)

13. Unweighted Price Indicator Series zAll stocks carry equal weight regardless of price or market value. zMay be used by individuals who randomly select stocks and invest the same dollar amount in each stock. zSome use arithmetic average of the percent price changes for the stocks in the index. zValue 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.

14. Global Equity Indexes zThere are stock-market indexes available for most individual foreign markets. zThese are closely followed within each country. zThese are difficult to compare due to differences in sample selection, weighting, or computational procedure. zGroups have computed country indexes.

15. FT/S&P-Actuaries World Indexes zJointly compiled by The Financial Times Limited, Goldman Sachs & Company, and Standard & Poor’s in conjunction with the Institute of Actuaries and the Faculty of Actuaries. zMeasures 2,461 securities in 30 countries. zCovers 70% of the total value of all listed companies in each country.

16. FT/S&P-Actuaries World Indexes zIncludes actively traded medium and small corporations along with major international equities. zSecurities included must allow direct holdings of shares by foreign nationals. zIndex is market-value weighted with a base date of December 31, 1986 = 100.

17. FT/S&P-Actuaries World Indexes zIndex results are reported in U.S. dollars, U.K. pound sterling, Japanese yen, German mark, and the local currency of the country included. zResults are calculated daily after the New York markets close and published the following day in the Financial Times. zGeographic subgroups are also published.

18. Morgan Stanley Capital International (MSCI) Indexes zThree international, nineteen national, and thirty-eight international industry indexes y1,375 companies listed on stock exchanges in y19 countries with a combined capitalization representing y60% of the aggregate market value of the stock exchanges of these countries zAll the indexes are market-value weighted zReporting is in U.S. dollars and the country’s local currency

19. Morgan Stanley Capital International (MSCI) Indexes zAlso provides: yprice to book value (P/BV) ratio yprice to cash earnings (earnings plus depreciation) (P/CE) ratio yprice to earnings (P/E) ratio ydividend yield (YLD) zThe Morgan Stanley group index for Europe, Australia, and the Far East (EAFE) is used as the basis for futures and options contracts

20. Dow Jones World Stock Index zIntroduced in January 1993 z2,200 companies worldwide zOrganized into 120 industry groups zIncludes 33 countries zCountries are grouped into 3 regions zRepresents over 80% of the combined capitalization of these countries zCountry indexes are computed in local currency, U.S. dollars, British pound, German mark, and Japanese yen

21. Comparison of World Stock Indexes Correlations between the three series since December 31, 1991, indicate the results with the alternative world stock indexes are quite comparable. U.S. Dollars FT - MS:.998 FT - DJ:.997 MS - DJ:.996

22. Bond-Market Indicator Series zRelatively new and not widely published zGrowth in fixed-income mutual funds increase need for reliable benchmarks for evaluating performance zMany managers have not matched aggregate bond market return yincreasing interest in bond index funds yrequires an index to emulate

23. Difficulties in Creating and Computing Bond-Market Indicator Series zRange of bond quality varies from U.S. Treasury securities to bonds in default zBond market changes constantly with new issues, maturities, calls, and sinking funds zBond prices are affected by duration, which is dependent on maturity, coupon, and market yield zCorrectly pricing individual bond issues without current and continuous transaction prices available

24. Investment-Grade Bond Indexes zFour investment firms maintain indexes for Treasury bonds and other investment grade (rated BBB or higher) bonds. zRelationship among these bonds is strong (correlations average 0.95). zReturns for all these bonds are driven by aggregate interest rates - shifts in the government yield curve.

25. High-Yield Bond Indexes zNon investment-grade bonds zFour investment firms and two academicians created indexes zRelationship among alternative high- yield bond indexes is weaker than among investment grade indexes. zMerrill Lynch Convertible Securities Indexes

26. Global Government Bond Market Indexes zGlobal bond market dominated by government issues zSeveral indexes created by major investment firms: yMeasure total rates of return yUse market-value weighting yUse trader pricing yBut sample sizes differ as do numbers of countries included

27. Global Government Bond Market Indexes: Analysis of Performance zDifferences affect long-term risk-return performance zLow correlation among several countries is similar to stocks zSignificant exchange rate effect on volatility and correlations

28. Composite Stock-Bond Indexes zA composite series measures the performance of all securities in a given country. zAllows examination of benefits of diversification with a combination of asset classes such as stocks and bonds

29. Merrill Lynch-Wilshire U.S. Capital Markets Index (ML-WCMI) zMarket-value weighted index zMeasures total return performance of the combined U.S. taxable fixed income and equity markets zCombination of Merrill-Lynch fixed- income indexes and the Wilshire 5000 common-stock index zTracks over 10,000 stocks and bonds

30. Brinson Partners Global Security Market Index (GSMI) zIncludes: yU.S. stocks and bonds yNon-U.S. equities yNon-dollar bonds yAllocation to cash zMatches a typical U.S. pension fund allocation policy zClose to the theoretical “market portfolio of risky assets” referred to in CAPM

31. Comparison of Indexes Over Time zCorrelations Among Monthly Equity Price Changes yMost differences are attributable to sample differences xDifferent segments of U.S. stock market or from different countries yLower correlations between NYSE series and AMEX series or NASDAQ index than between NYSE alternative series (S&P 500 and NYSE composite)

32. zCorrelations Among Monthly Bond Indexes yAmong investment-grade bonds correlations range from 0.90 to 0.99 yInterest rates differ by risk premiums yRates of return are determined by systematic interest rate variables yLow correlation in global returns to U.S. returns support global diversification Comparison of Indexes Over Time

33. zMean Annual Stock Price Changes yExpect differences among price changes and measures of risk for various series due to the different samples. xNYSE series have lower rates of return and risk measure than AMEX and OTC series, as expected. xCanadian results had higher average returns than NYSE and lower risk than NASDAQ. xJapanese markets had lower returns and slightly lower volatility than U.S. market. Comparison of Indexes Over Time

34. zMean Annual Stock Price Changes (continued) xUnited Kingdom (FT All-Share) had higher returns than NYSE indexes, but much larger variability xJapanese markets experienced lower returns and slightly lower volatility than the U.S. markets yLow correlation between Japanese market with alternative U.S. stock-market indexes. xJapan could be a prime source of diversification Comparison of Indexes Over Time

35. zAnnual Bond Rates of Return yTotal rates of return for bond-market indexes cannot be directly compared to stock percentage price change results yExpect difference in level of return due to differential risk premiums yResults confirm expectations Comparison of Indexes Over Time

36. The Internet: Investments Online www.bloomberg.com www.stockmaster.com www.asx.com.au www.bolsamadrid.es www.tse.com www.nikko.co.jp:80/SEC/index_e.html www.exchange.de/realtime/dax_d.html