Investment Analysis and Portfolio Management: Frank K. Reilly & Keith C. Brown

Investment Analysis and

Portfolio Management
by
Frank K. Reilly & Keith C. Brown

Chapter 5
Chapter 5
Security-Market Indicator Series
Questions to be answered:
• What are some major uses of security-market
indicator series (indexes)?
• What are the major characteristics that cause
alternative indexes to differ?
• What are the major stock-market indexes in the
United States and globally and what are their
characteristics?
Chapter 5
Security-Market Indicator Series
• What are the major bond-market indexes for the
United States and the world?
• What are some of the composite stock-bond
market indexes?
• Where can you get historical and current data for
all these indexes?
• What is the short-run relationship among many of
these indexes in the short run (monthly)?
What is an Index?
 Index is just an average
 when we want to study the behavior of a group, we
use index.
For example;
• Sock Market Index
• CPI: consumer price index
• WPI: wholesale price index
• AEI: Average earning index
• IIP: Index of industrial production
• LSMI: large scale manufacturing index
• CGI: Corporate governance index
Stock Market Index
 Stock market index is a mathematical average that
quickly tells you how the stock market is doing.

 So anything that’s a calculated average of many

different components can be considered an index.
E.g. S&P 500:

 which is the most widely used stock market index and is the
average of the 500 largest US companies all rolled up into
one easy to read average price.
 The levels of the index is expressed as points (the S&P is up
10 points, it’s down 10 points)
Stock Market Index
 If you want to know how the economy of a particular
country is doing, you can just look at the stock market
index for that country.
9 major Indices/Indexes:
1. S&P 500 (500 largest companies)
2. Dow Jones Industrial Average (30 largest companies)
3. Nasdaq (3000 stocks)
4. MSCI World (major stocks across 23 developed

countries)
Stock Market Index
5. MSCI Emerging Markets Index (major stocks across 24
emerging market countries)
6. S&P GSCI Commodity Index (tracks commodities like

oil, gold, cotton etc.)
7. Dow Jones Real Estate Index (Real Estate)
8. The Dollar Index (strength of US dollar relative to other

major currencies)
9. VIX (Fear 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 substitute for the market portfolio of risky assets
when calculating the systematic risk of an asset
Stock Market Indexes in Pakistan
o KSE 100 Index (Uses free float capital)
o KSE 30 Index (Blue chip companies)
o KSE All share Index
o KMI 30 Index (30 most liquid Islamic

and Sharia compliant securities)
o BRIndex 30 (uses outstanding shares)

Factors considered in Index construction
1. The sample
• Size : Sample should be representative of the
population
• Selection
• Random sampling
– Is better b/c each company has equal probability of
selection
• Non random sampling
– In Pakistan (the market is very diversified in sense of
composition)
» Industry consideration
» Size consideration
Measures of Size
Market capitalization
Number of shares * Market Price of Share
Total Assets (not comparable)
Some companies may be established in 1960, some in
1980, some in 2010
So there historical cost of asset will differ which are
not comparable
Total Sale (not comparable)
Not used because it does not truly represent the
market share
Factors considered in Index
construction
2. Weighting of sample
members
• price-weighted series
• value-weighted series
• unweighted (equally weighted) series
Factors considered in Index
construction
3. Computational procedure
• arithmetic average
• geometric average
Stock-Market Indicator Series
Price Weighted Series
• Dow Jones Industrial Average (DJIA)
• Nikkei-Dow Jones Average
Value-Weighted Series
• NYSE Composite
• S&P 500 Index and more…
Unweighted Price Indicator Series
• Value Line Averages
• Financial Times Ordinary Share Index
Price-Weighted Index
In this method we shall use only “price-
related” information.
Index = Pn /Po * 1000
Pn : Average price at time t

Po : Base value
KSE 100 index : 1000 base point
• It means the starting index will be your assumption
• for example, if you assumed 1000 base point so it
would be 1000. similarly 10, 50, and 100.
• Fixed base method is used.
Example 1 Excel
Average
Date NRL PRL ARL Byco Total Price Index
1-Jan 200 80 120 40 440 110 1000
2-Jan 210 80 160 30 480 120 1090.9
3-Jan 230 100 170 40 540 135 1227.3
4-Jan 220 120 180 60 580 145 1318.2
5-Jan 230 110 190 70 600 150 1363.6

PWI weekly graph
Example 2 Excel
Average
Date A B C Total Price Index
1-Jan 30 20 10 60 20 1000
2-Jan 35 25 12 72 24 1200
3-Jan 33 25 17 75 25 1250
4-Jan 30 24 16 70 23.3 1166.67
5-Jan 34 30 20 84 28 1400
PWI weekly graph
Basic Problems in PWI
1. Abnormal prices:
•Because the series is price weighted, a high-priced stock carries more
weight than a low-priced stock
•In other words, If the prices behavior is significantly abnormal, then
PWI will be driven by a specific price.
– For example, in Pakistan, Unilever share price is Rs. 9200/share,
PTCL is Rs. 7/share, and OGDCL is Rs. 106/share
– So in this case the result will be dominated by Unilever company.
•Example: A 10 percent change in a $100 stock ($10) will cause a larger
change in the series than a 10 percent change in a $30 stock ($3).
•Consider two cases: In Case A, when the$100 stock increases by 10
percent, the average rises by 5.5 percent; in Case B, when the $30 stock
increases by 10 percent, the average rises by only 1.7 percent.
Demonstration of the Impact of Differently
Priced Shares on a Price-Weighted Indicator
Series
Exhibit 5.2
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%
Example of Abnormal price
Average
Date A B C D Total Price Index
T1 1000 20 40 100 1160 290 1000
T2 1000 40 40 100 1180 295 1017.24
T3 2000 20 40 100 2160 540 1862.06
2. Stock split: new divisor
•A stock split is a corporate action in which a company
divides its existing shares into multiple shares. Basically,
companies choose to split their shares so they can lower the
trading price of their stock to a range deemed comfortable by
most investors and increase liquidity of the shares.
•For example, a stock split may be 2-for-1, 3-for-1, 5-for-1,

10-for-1, 100-for-1, etc. A 3-for-1 stock split means that for
every one share held by an investor, there will now be three.
• In a price weighted index, when companies have a
stock split, their prices decline, and therefore their
weight in the index is reduced—even though they
may be large and important.
• Therefore, the weighting scheme causes a

downward bias in the index, because high-growth
stocks will have higher prices; and, because such
stocks tend to split, they will consistently lose
weight within the index
Example of Change in DJIA Divisor
When a Sample Stock Splits
After Three-for One
Exhibit 5.1
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)
Market-Value-Weighted Series
• Derive the initial total market value of all stocks
used in the index
Market Value = Number of Shares Outstanding
X Current Market Price
• Assign a beginning index value (e.g., 1000 in
case of Pakistan) and new market values are
compared to the base index
• Automatic adjustment for splits
• Weighting depends on market value
Value-Weighted Series
Index t 
 PQ t t
 Beginning Index Value
P Q b b
where:
Indext = index value on day t
Pt = ending prices for stocks on day t
Qt = number of outstanding shares on day t
Pb = ending price for stocks on base day
Qb = number of outstanding shares on base day
OR
Index = Total Market Value/Divisor × 1000

• All stocks carry equal weight regardless of
price or market value
• May be used by individuals who randomly
select stocks and invest the same dollar
amount in each stock
• Some use arithmetic average of the percent
price changes for the stocks in the index
• 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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Investment Analysis and

 So anything that’s a calculated average of many

E.g. S&P 500:

1. S&P 500 (500 largest companies)

2. Dow Jones Industrial Average (30 largest companies)

3. Nasdaq (3000 stocks)

4. MSCI World (major stocks across 23 developed

6. S&P GSCI Commodity Index (tracks commodities like

7. Dow Jones Real Estate Index (Real Estate)

8. The Dollar Index (strength of US dollar relative to other

9. VIX (Fear Index)

o KSE 30 Index (Blue chip companies)

o KSE All share Index

o KMI 30 Index (30 most liquid Islamic

o BRIndex 30 (uses outstanding shares)

Index = Pn /Po * 1000

Pn : Average price at time t

1-Jan 200 80 120 40 440 110 1000

2-Jan 210 80 160 30 480 120 1090.9

3-Jan 230 100 170 40 540 135 1227.3

4-Jan 220 120 180 60 580 145 1318.2

5-Jan 230 110 190 70 600 150 1363.6

4-Jan 30 24 16 70 23.3 1166.67

Period T Case A Case B

•For example, a stock split may be 2-for-1, 3-for-1, 5-for-1,

• Therefore, the weighting scheme causes a

Index = Total Market Value/Divisor × 1000

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