What is Security Market Index?

security market index is a means to measure the growth of value of a set of securities.

Stock market index is an average of changes in price movements of returns of a group of security selected on some rational basis.

It is a tool used by investors and financial managers to describe the market, and to compare the return on specific investments.

Names of Security Market Indexes

Some famous international indexes include the DAX (Germany), Hang Seng (Hong Kong), FTSE (U.K.), Nikkei (Japan), and TSX (Canada). Morgan Stanley Capital International(MSCI) constructs many of the leading international indexes.The index of Dhaka Stock Exchange is DSE 20 Index.

Uses 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.

A money manager is a person or financial firm   that manages the securities portfolio of an   individual or institutional investor.

Factors in Constructing Market Indexes

Various factors need to be considered while creating a stock market index.

(1)  Selection of the base year: Selection of base year is one of the most important factors in creating a stock market index. Because, if the year when stock price was higher, taken to be base year, downward tendency of the stock index will be seen. On the other hand, if the year when stock price is lower, taken to be base year, boom in share index will be seen in stock market.

So base year is supposed to be such a year as when there was no flood, earthquake, drought, war or economic disaster.

(2) Sample Size: Amount of different shares is collected during the determination of stock index. The sample size should be representative, otherwise, its size will be meaningless.

During determination of stock index representative of securities from different industry groups must be kept. Otherwise share index determination will not be accurate.

(3)Determination of weight: After determining base year shares of some companies are listed for determining stock index, those companies must have participated in transaction of one of the five main stock markets all through the year.

(4)Computational Procedure: The final consideration is the computational procedure used. One alternative is to take a simple arithmetic mean of the various members in the index. Another is to compute an index using a geometric mean of the components rather than an arithmetic mean.

Calculation of Stock Market Index

There are 3 types of the stock market index:

(1) Price-Weighted Index

(2) Value-Weighted Index

(3) Un-weighted / equally weighted Index

Price-Weighted Stock Market Index

A price-weighted index is a stock market index in which the constituent securities are weighted in proportion to their stock price per share. Price movement of companies with higher stock price have greater influence on the overall movement of the index.

Dow Jones Industrial Average is a prominent example of price-weighted indices.

One of the most popular price-weighted stocks is the Dow Jones Industrial Average (DIJA), which consists of 30 different stocks, or components. In this index, the higher price stocks move the index more than those with lower prices, thus the price-weighted designation.

For example, In a price-weighted index, a stock that increases from $110 to $120 will have a greater effect on the index than a stock that increases from $10 to $20

Price-Weighted Index

The index can be created by summing the stock prices of the constituent securities at some time t and then dividing it by a arbitrary number, called divisor.

Index = P1 + P2+ P3 + P4 +…………+ Pn / D

Here, P1, P2, —- Pn indicates stock prices, and D denotes the divisor

Once a divisor is set, it can’t be changed arbitrarily. However, in the event of a stock-split, it must be changes such that the index value before and after the split remains the same. This is important for the sake of continuity of the index.

Stock Split

All publicly traded companies have a set number of shares that are outstanding. A stock split is a decision by a company’s board of directors to increase the number of shares that are outstanding by issuing more shares to current shareholders.

For example, in a 2-for-1 stock split, an additional share is given for each share held by a shareholder. So, if a company had 10 million shares outstanding before the split, it will have 20 million shares outstanding after a 2-for-1 split.

Effect of Stock Split on Price

A stock’s price is affected by a stock split. After a split, the stock price will be reduced since the number of shares outstanding has increased.

In the example of a 2-for-1 split, the share price will be halved. Thus, although the number of outstanding shares and the price change, the market capitalization remains constant.

Reverse Stock Split

Another version of a stock split is the reverse split. This procedure is typically used by companies with low share prices that would like to increase these prices to either gain more respectability in the market or to prevent the company from being delisted (many stock exchanges will delist stocks if they fall below a certain price per share).

For example, in a reverse 1-for-5 split, 10 million outstanding shares at 50 cents each would now become 2 million shares outstanding at $2.50 per share. In both cases, the company is still worth $5 million.

Effect of Reverse Stock Split on Price

The reverse stock split increases the stock price.

For example, in May 2011, Citigroup reverse split its shares 1-for-10 in an effort to reduce its share volatility and discourage speculator trading. The reverse split increased its share price from $4.52 pre-split to $45.12 post-split and every 10 shares held by an investor was replaced with one share. While the split reduced the number of its shares outstanding from 29 billion to 2.9 billion shares, the market cap of the company stayed the same at approximately $131 billion.

Value-Weighted Index

The Value-Weighted Index is also called Capitalization- Weighted Index.

A capitalization-weighted index is a type of market index with individual components that are weighted according to their total market capitalization.

The larger components carry higher percentage weightings, while the smaller components in the index have lower weights.

Value-Weighted Index

The value-weighted index is calculated as follows:

Value-weighted index =∑PtQt/ ∑PbQb

Here, Pt  = ending prices for the stocks on day t

Qt   = number of outstanding or freely   floating shares on day t

Pb    = ending price for stocks on base day

Qb      = number of outstanding or freely   floating shares on base day

Examples of Equal-Weighted

Many of the most widely followed stock market indices are value-weighted. That includes The NASDAQ Composite Index, and the Wiltshire 5000 Total Market Index.

Un-Weighted or Equally-Weighted Index

Equal weight is a type of weighting that gives the same weight, or importance, to each stock in a portfolio or index fund, and the smallest companies are given equal weight to the largest companies in an equal-weight index fund or portfolio.

Equal-weighted index funds tend to have higher stock turnover than market-cap weighted index funds, and as a result, they usually have higher trading costs.

Examples of Equal-Weighted

The following indices follow the equal-weighted index.

S&P 500

Russell 2000

NASDAQ-100

Bond-Market

The bond market – also called the debt market or credit market – is a financial market in which the participants are provided with the issuance and trading of debt securities.

Types of Bond Markets

The general bond market can be classified into corporate bonds, government and agency bonds, municipal bonds, mortgage-backed bonds, asset-backed bonds, and collateralized debt obligations.

Bond-Market Indexes

A bond index or bond market index is a method of measuring the value of a section of the bond market.

It is computed from the prices of selected bonds (typically a weighted average). It is a tool used by investors and financial managers to describe the market, and to compare the return on specific investments.

Just like the S&P 500 Index or Russell Indexes for equities, bond indices manage and measure bond portfolio performance.

Big names include Barclays Capital Aggregate Bond Index, the Merrill Lynch Domestic Master and the Citigroup U.S. Broad Investment-Grade Bond Index. Many bond indices are members of broader indices that may be used to provide and measure the performances of global bond portfolios.

Difficulties to Create and Compute a Bond-Market Index

It is more difficult to create and compute a bond-market index than a stock-market index for several reasons.

First, the universe of bonds is much broader than that of stocks, ranging from U.S. Treasury securities to bonds in default.

Second, the universe of bonds is changing constantly because of new issues, bond maturities, calls, and bond sinking funds.

Third, the volatility of prices for individual bonds and bond portfolios changes because bond price volatility is affected by duration, which is likewise changing constantly because of changes in maturity, coupon, and market yield.

Finally, significant problems can arise in correctly pricing the individual bond issues in an index (especially corporate and mortgage bonds) compared to the current and continuous transactions prices available for most stocks used in stock indexes.

Correlations between Monthly Equity Price Changes

There is a high positive correlation (0.98–0.99) between the Dow Jones Total Stock Market Index and the several comprehensive U.S. equity indexes: the S&P 500, and the Russell 3000 and Russell 1000 large cap index. In contrast, there are lower correlations with various style indexes such as the Russell 2000 Small-Cap index (0.828).

This analysis is based on Exhibit 5-13

Correlations between Monthly Equity Price Changes

The correlations between the Dow Jones Total Stock Market Index and the several non-U.S. indexes are clearly lower ranging from 0.462 (Pacific Basin) to 0.726 (Europe). All of these support the case for global investing.

These results confirm the benefits of global diversification because such low correlations would definitely reduce the variance of a pure U.S. stock portfolio.

Correlations between Monthly Bond Index Returns

The correlations with the U.S. investment-grade bond indexes ranged from about 0.94 to 0.98.

In contrast, the correlations with high-yield bonds indicate a significantly weaker relationship (correlations about 0.51).

Finally, the low and diverse relationships among U.S. investment-grade bonds and all world government bonds (0.57) and world government bonds without the United States (about 0.37).

Again, these results support the benefits of global diversification of bond portfolios alone or with stock portfolios.