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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 companys 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.
DJIA
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.

30
1
/
i
adj it
D p DJIA
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 DJIAit was
originally 30but 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.
Price-weighted series
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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:
Value Index Beginning Index
t

b b
t t
Q P
Q P
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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
Recent History
Date Closing Value
Dec-97 6699.4
Jan-98 6700.2
Feb-98 7092.5
Mar-98 7558.5
Apr-98 7665
May-98 7589.8
Jun-98 7366.9
Jul-98 6931.4
Aug-98 5530.7
Sep-98 5614.1
Oct-98 6208.3
Nov-98 6344.2
Dec-98 6485.9
Jan-99 6729.6
Feb-99 6312.7
Mar-99 6597.8
Apr-99 7014.7
May-99 6841.8
Jun-99 7010.1
Jul-99 7080.7
Aug-99 6970.8
Sep-99 6957.7
Oct-99 7256.2
Nov-99 7519.5
Dec-99 8413.8
Jan-00 8481.1
Feb-00 9129
6931.4
5530.7
5614.1
6208.3
6344.2
6485.9
6729.6
6312.7
6597.8
7014.7
6841.8
7010.1
7080.7
6970.8
6957.7
7256.2
7519.5
8413.8
TSE 300 Composite Index
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TSE 300 Composite Index
The 14 sub-indexes - 04/06/01
1. Metals and Minerals:
2. Gold & Precious Metals
3. Oil & Gas
4. Paper & Forest Products
5. Consumer Products
6. Industrial Products
7. Real Estate
8. Transportation &
Environmental Services
9. Pipelines
10. Utilities
11. Communications & Media
12. Merchandising
13.Financial Services
14. Conglomerates
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TSE 300 Composite Index
Sub-indexes and components - 04/06/01
1. Metals and Minerals:
integrated mines
mining
2. Gold & Precious Metals
3. Oil & Gas
integrated oils
oil & gas producers
oil & gas services
4. Paper & Forest Products
5. Consumer Products
food processing
tobacco
Distilleries
breweries & Beverages
Household Goods
Biotechnology/Pharmaceuticals
6. Industrial Products
steel
fabricating & engineering
transportation equipment
technology-hardware
building materials
chemicals & fertilizers
technology -software
autos & parts
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TSE 300 Composite Index
Sub-indexes - 04/06/01 ...
7. Real Estate
8. Transportation &
Environmental Services
9. Pipelines
10. Utilities
telephone utilities
gas/electrical utilities
11. Communications & Media
broadcasting
cable & entertainment
publishing & printing

12. Merchandising
wholesale distributors
food stores
department stores
specialty stores
hospitality
13. Financial Services
banks & trusts
investment companies & funds
insurance
financial management companies
14. Conglomerates
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TSE 300 Composite Index
Sub-indexes - 04/06/01 examples
7. Real Estate
ACK - Acktion Corp
BEI - Boardwalk Equities
TZH - Trizec Hahn Corp

12. Merchandising
wholesale distributors
FTT - Finning International Inc.
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 companys 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 riskand 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
1.168
1/3
= 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
This gives you an idea of the mean return and volatility of returns for
the universe of securities measured by the respective index.
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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-Backed 9.94 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