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four-for-four switch. Home Depot has been grouped as replacing Sears

Bodie’Kane’Marcus: I. Elements of Investments 2. Global Financial © The McGraw’Hill
Essentials of Investments, Instruments Companies, 2003
Fifth Edition

2 Global Financial Instruments

the average unchanged by the substitution. By now, the divisor for the Dow Jones Industrial
Average has fallen to a value of about .145.

4. Suppose XYZ™s final price in Table 2.4 increases in price to $110, while ABC falls Concept
to $20. Find the percentage change in the price-weighted average of these two
stocks. Compare that to the percentage return of a portfolio that holds one share
in each company.
Dow Jones & Company also computes a Transportation Average of 20 airline, trucking,
and railroad stocks; a Public Utility Average of 15 electric and natural gas utilities; and a Com-
posite Average combining the 65 firms of the three separate averages. Each is a price-weighted
average and thus overweights the performance of high-priced stocks.

Standard & Poor™s Indexes
The Standard & Poor™s Composite 500 (S&P 500) stock index represents an improvement
over the Dow Jones averages in two ways. First, it is a more broadly based index of 500 firms.
market value-
Second, it is a market value-weighted index. In the case of the firms XYZ and ABC in Ex-
weighted index
ample 2.2, the S&P 500 would give ABC five times the weight given to XYZ because the
market value of its outstanding equity is five times larger, $500 million versus $100 million. Computed by
The S&P 500 is computed by calculating the total market value of the 500 firms in the in- calculating a
dex and the total market value of those firms on the previous day of trading. The percentage weighted average
of the returns of
increase in the total market value from one day to the next represents the increase in the index.
each security in
The rate of return of the index equals the rate of return that would be earned by an investor
the index, with
holding a portfolio of all 500 firms in the index in proportion to their market value, except that weights proportional
the index does not reflect cash dividends paid by those firms. to outstanding
market value.

To illustrate how value-weighted indexes are computed, look again at Table 2.4. The final
value of all outstanding stock in our two-stock universe is $690 million. The initial value was
$600 million. Therefore, if the initial level of a market value-weighted index of stocks ABC
and XYZ were set equal to an arbitrarily chosen starting value such as 100, the index value Value-Weighted
at year-end would be 100 (690/600) 115. The increase in the index would reflect the Indexes
15% return earned on a portfolio consisting of those two stocks held in proportion to out-
standing market values.
Unlike the price-weighted index, the value-weighted index gives more weight to ABC.
Whereas the price-weighted index fell because it was dominated by higher-price XYZ, the
value-weighted index rose because it gave more weight to ABC, the stock with the higher to-
tal market value.
Note also from Tables 2.4 and 2.5 that market value-weighted indexes are unaffected by
stock splits. The total market value of the outstanding XYZ stock increases from $100 million
to $110 million regardless of the stock split, thereby rendering the split irrelevant to the per-
formance of the index.

A nice feature of both market value-weighted and price-weighted indexes is that they re-
flect the returns to straightforward portfolio strategies. If one were to buy each share in the in-
dex in proportion to its outstanding market value, the value-weighted index would perfectly
track capital gains on the underlying portfolio. Similarly, a price-weighted index tracks the re-
turns on a portfolio comprised of equal shares of each firm.
Bodie’Kane’Marcus: I. Elements of Investments 2. Global Financial © The McGraw’Hill
Essentials of Investments, Instruments Companies, 2003
Fifth Edition

46 Part ONE Elements of Investments

Investors today can purchase shares in mutual funds that hold shares in proportion to their
representation in the S&P 500 as well as other stock indexes. These index funds yield a return
equal to that of the particular index and so provide a low-cost passive investment strategy for
equity investors.
Standard & Poor™s also publishes a 400-stock Industrial Index, a 20-stock Transportation
Index, a 40-stock Utility Index, and a 40-stock Financial Index.

5. Reconsider companies XYZ and ABC from Concept Check Question 4. Calculate
the percentage change in the market value-weighted index. Compare that to the
CHECK rate of return of a portfolio that holds $500 of ABC stock for every $100 of XYZ
stock (i.e., an index portfolio).

Other U.S. Market Value Indexes
The New York Stock Exchange publishes a market value-weighted composite index of all
NYSE-listed stocks, in addition to subindexes for industrial, utility, transportation, and finan-
cial stocks. These indexes are even more broadly based than the S&P 500. The National As-
sociation of Securities Dealers publishes an index of 4,000 over-the-counter firms using the
National Association of Securities Dealers Automatic Quotations (Nasdaq) service.
The ultimate U.S. equity index so far computed is the Wilshire 5000 Index of the market
value of all NYSE and American Stock Exchange (Amex) stocks plus actively traded Nasdaq
stocks. Despite its name, the index actually includes about 7,000 stocks. Figure 2.10 reproduces
a listing of stock index performance that appears daily in The Wall Street Journal. Vanguard of-
fers mutual funds to small investors, which enables them to match the performance of the
Wilshire 5000 Index, the S&P 500, or the Russell 2000 index of small firms.

Equally Weighted Indexes
Market performance is sometimes measured by an equally weighted average of the returns of
each stock in an index. Such an averaging technique, by placing equal weight on each return,
corresponds to a portfolio strategy that places equal dollar values in each stock. This is in con-
trast to both price weighting, which requires equal numbers of shares of each stock, and mar-
ket value weighting, which requires investments in proportion to outstanding value.
Unlike price- or market value-weighted indexes, equally weighted indexes do not corre-
equally weighted
spond to buy-and-hold portfolio strategies. Suppose you start with equal dollar investments in
the two stocks of Table 2.4, ABC and XYZ. Because ABC increases in value by 20% over the
An index computed
year, while XYZ decreases by 10%, your portfolio is no longer equally weighted but is now
from a simple average
more heavily invested in ABC. To reset the portfolio to equal weights, you would need to re-
of returns.
balance: Either sell some ABC stock and/or purchase more XYZ stock. Such rebalancing would
be necessary to align the return on your portfolio with that on the equally weighted index.

Foreign and International Stock Market Indexes
Development in financial markets worldwide includes the construction of indexes for these
markets. The most important are the Nikkei, FTSE (pronounced “footsie”), and DAX. The
Nikkei 225 is a price-weighted average of the largest Tokyo Stock Exchange (TSE) stocks.
The Nikkei 300 is a value-weighted index. FTSE is published by the Financial Times of Lon-
don and is a value-weighted index of 100 of the largest London Stock Exchange corporations.
The DAX index is the premier German stock index.
More recently, market value-weighted indexes of other non-U.S. stock markets have pro-
liferated. A leader in this field has been MSCI (Morgan Stanley Capital International), which
Bodie’Kane’Marcus: I. Elements of Investments 2. Global Financial © The McGraw’Hill
Essentials of Investments, Instruments Companies, 2003
Fifth Edition

2 Global Financial Instruments

F I G U R E 2.10
Listing of stock index
Source: From The Wall
Street Journal, October 19,
2001. Reprinted by
permission of Dow Jones &
Company, Inc. via
Copyright Clearance Center,
Inc. © 2001 Dow Jones &
Company, Inc. All Rights
Reserved Worldwide.

computes over 50 country indexes and several regional indexes. Table 2.6 presents many of
the indexes computed by MCSI.

Bond Market Indicators
Just as stock market indexes provide guidance concerning the performance of the overall stock
market, several bond market indicators measure the performance of various categories of
bonds. The three most well-known groups of indexes are those of Merrill Lynch, Lehman
Brothers, and Salomon Smith Barney.
Table 2.7, Panel A, lists the components of the bond market in mid-2001. Panel B presents
a profile of the characteristics of the three major bond indexes.
The major problem with these indexes is that true rates of return on many bonds are diffi-
cult to compute because bonds trade infrequently, which makes it hard to get reliable, up-to-
date prices. In practice, some prices must be estimated from bond valuation models. These
so-called matrix prices may differ from true market values.

A significant development in financial markets in recent years has been the growth of futures
and options markets. Futures and options provide payoffs that depend on the values of other as-
sets, such as commodity prices, bond and stock prices, or market index values. For this reason,
Bodie’Kane’Marcus: I. Elements of Investments 2. Global Financial © The McGraw’Hill
Essentials of Investments, Instruments Companies, 2003
Fifth Edition

48 Part ONE Elements of Investments

TA B L E 2.6
Sample of MSCI stock indexes

Regional Indexes Countries

Developed Markets Emerging Markets Developed Markets Emerging Markets

EAFE (Europe, Australia, Far East) Emerging Markets (EM) Australia Argentina
EASEA (EAFE ex Japan) EM Asia Austria Brazil
Europe EM Far East Belgium Chile
EMU EM Latin America Canada China
Far East Emerging Markets Free (EMF) Denmark Colombia
Kokusai (World ex Japan) EMF Asia Finland Czech Republic
Nordic Countries EMF Eastern Europe France Egypt
North America EMF Europe Germany Greece
Pacific EMF Europe & Middle East Hong Kong Hungary
The World Index EMF Far East Ireland India
EMF Latin America Italy Indonesia
Japan Israel
Netherlands Jordan
New Zealand Korea
Norway Malaysia
Portugal Mexico
Singapore Morocco
Spain Pakistan
Sweden Peru
Switzerland Philippines
UK Poland
US Russia
South Africa
Sri Lanka

Source: www.msci.com.

derivative asset these instruments sometimes are called derivative assets or contingent claims. Their values
or contingent derive from or are contingent on the values of other assets. We discuss derivative assets in de-
claim tail in Part Five, but the nearby box serves as a brief primer.
A security with a
payoff that depends
on the prices of other
A call option gives its holder the right to purchase an asset for a specified price, called the
exercise or strike price, on or before some specified expiration date. An October call option
call option on IBM stock with exercise price $100, for example, entitles its owner to purchase
IBM stock for a price of $100 at any time up to and including the option™s expiration date
The right to buy an
in October. Each option contract is for the purchase of 100 shares, with quotations made on
asset at a specified
a per share basis. The holder of the call need not exercise the option; it will make sense to
price on or before a
specified expiration exercise only if the market value of the asset that may be purchased exceeds the exercise
Bodie’Kane’Marcus: I. Elements of Investments 2. Global Financial © The McGraw’Hill
Essentials of Investments, Instruments Companies, 2003
Fifth Edition


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