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Chapter 5

Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Reilly & Keith C. Brown. Chapter 5. Chapter 5 Security-Market Indicator Series. Questions to be answered:

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Chapter 5

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  1. Lecture Presentation Softwareto accompanyInvestment Analysis and Portfolio ManagementSeventh Editionby Frank K. Reilly & Keith C. Brown Chapter 5

  2. Chapter 5Security-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?

  3. Chapter 5Security-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)?

  4. 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

  5. Differentiating Factors in Constructing Market Indexes The sample • size • breadth • source

  6. Differentiating Factors in Constructing Market Indexes Weighting of sample members • price-weighted series • value-weighted series • unweighted (equally weighted) series

  7. Differentiating Factors in Constructing Market Indexes Computational procedure • arithmetic average • compute an index and have all changes, whether in price or value, reported in terms of the basic index • geometric average

  8. 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

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

  10. 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) Exhibit 5.1

  11. 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%

  12. Value-Weighted Series • Derive the initial total market value of all stocks used in the series Market Value = Number of Shares Outstanding X Current Market Price • Assign an beginning index value (100) and new market values are compared to the base index • Automatic adjustment for splits • Weighting depends on market value

  13. Value-Weighted Series 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

  14. Unweighted Price Indicator Series • 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

  15. Unweighted Price Indicator Series • 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

  16. Bond-Market Indicator Series • Relatively new and not widely published • Growth in fixed-income mutual funds increase need for reliable benchmarks for evaluating performance • Many managers have not matched aggregate bond market return • increasing interest in bond index funds • requires an index to emulate

  17. Difficulties in Creating and Computing Bond-Market Indicator Series • Universe of bonds is much broader than that of stocks • Range of bond quality varies from U.S. Treasury securities to bonds in default • Bond market changes constantly with new issues, maturities, calls, and sinking funds • Bond prices are affected by duration, which is dependent on maturity, coupon, and market yield • Correctly pricing individual bond issues without current and continuous transaction prices available poses significant problems

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