Dow Jones Industrial Average
Stock Market Indexes
“… everybody talks about them but
few people understand them…”
Chapter 2 Importance/Uses
People often use them to measure
the “health” of stock market
Asset Classes and Financial Instruments They provide the basis for some of
the most popular mutual funds
They provide the basis for some of
(Part 2)
the most popular exchange-traded S&P 500 Index
funds (‘ETFs’) --- examples, SPY
and QQQ
They’re benchmarks for measuring
portfolio manager’s performance
They are used as the “underlying”
(basis) for some of the most widely
used derivatives such as futures
and options
They provide the basis for ongoing
arbitrage opportunities
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Stock Market Indexes (continued) Stock Market Index Calculation Methods
Domestic indexes within a country may track all stocks, a
representative sample, or an industry.
Price-weighted index
Global indexes include stocks from many countries to help Just add up the prices and adjust the total by a divisor
overcome differences. Biased towards high price stocks (i.e., higher priced stocks
influence the index number more than lower priced stocks)
Question: How are the indexes calculated?
Answer: There are 3 different weighting methods: Market-value weighted index
Use the market capitalizations of the companies
Biased toward large market value companies
Price-weighted average (Dow Jones Industrial Average
‘DJIA’)
Market-value weighted index (S&P 500, Nasdaq 100, An equal weighted (unweighted)
Wilshire 5000) Just use equal weighted average returns
Equally weighted index (Value Line Index) The more numerous smaller companies are more important
than with the other methods
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Price Weighted Example DJIA Companies:
3M ·
American Express ·
Market Value Weighted
AT&T ·
Boeing Co ·
Dow Jones Industrial Average (DJIA): Caterpillar ·
Chevron ·
Cisco Systems ·
The Coca-Cola Company ·
Most stock market indices are calculated this way.
Thirty large cap stocks. DuPont ·
ExxonMobil ·
General Electric ·
Uses market value weights:
High price stocks carry more weight than low Goldman Sachs Group Inc –
The Home Depot · Price per share × Number of Shares Outstanding for each
price stocks. Intel ·
company (some use float instead of outstanding, publicly
IBM ·
Johnson & Johnson ·
JPMorgan Chase ·
available shares).
High growth companies with stock splits lose McDonald's ·
relative importance, thus downward bias. Merck ·
Microsoft ·
Nike Inc
Changes in large cap stocks (high market value) are relatively
Pfizer · more important.
For stock splits, they adjust divisor downwards Procter & Gamble ·
to compensate. (instead of 30, divisor is The Travelers Companies ·
United Technologies
currently about 0.125 to adjust for past stock UnitedHealth Group Automatically adjusts for stock splits and stock dividends by
splits and composition changes.) Verizon Communications ·
Visa Inc adjusting number of shares.
Wal-Mart ·
The Walt Disney Company
CFALA/USC CFA Review Level 1, SS-13 5 6
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Unweighted / Equal Weighted
Index computation examples
Cumulatives of the arithmetic average of the percentage changes in
price for all stocks in index.
Equivalent to investing the same $ amount in each stock, then Assume
rebalancing each period.
Stock Shares Price 0 Price 1
An equal weighted (unweighted) index is biased towards the returns A 100 $50 $55
of smaller companies relative to a value weighted index because
small companies are quite numerous. B 200 $30 $30
C 400 $20 $18
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Value Weighted
Price Weighted Stock Shares MV 0 MV 1 % change
Stock Price 0 Price 1 % change A 100 $5,000 $5,500
A $50 $55 B 200 $6,000 $6,000
B $30 $30 C 400 $8,000 $7,200
C $20 $18 $19,000 $18,700 -1.6%
total $100 $103 3.0% Assume Index = 100 on day 0.
Divided by 3 33.33 34.33 3.0% Day 0: 100 = 100 x (19,000 / 19,000)
Index at Index at Day 1: 98.4 = 100 x (18,700 / 19,000), a 1.6% drop.
time 0 time 1
9 CFALA/USC CFA Review Level 1, SS-13 10
Summary
UnWeighted (Equal Weighted)
Stock Price 0 Price 1 % change
A $50 $55 10.0% Method Return Explanation
B $30 $30 0.0% Price Weighted +3.0% Highest price stock went up
Value Weighted -1.6% Largest Mkt value stock went down
C $20 $18 -10.0%
Unweighted 0.0% Average return was zero
Sum: 0.0%
Divided by 3 - - 0.0%
If Index was 100 on day 0,
it would also be 100 on day 1
I0 (1+%D) = I1
CFALA/USC CFA Review Level 1, SS-13 11 CFALA/USC CFA Review Level 1, SS-13 12
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Another Example: Data to Construct Stock Indexes Stock Price Indices (continued)
Company Stock Price Shares Outstanding Market Value ($ Billions) Company Stock Price Shares Outstanding Market Value ($ Billions)
($/share) (in Billions) = Stock Price x Shares Out. ($/share) (in Billions) = Stock Price x Shares Out.
Citigroup (C) $ 20 5.0 $20 x 5 = $100 Citigroup (C) $ 20 5.0 $20 x 5 = $100
Google (GOOG) $ 450 0.1 $450 x 0.1 = $45 Google (GOOG) $ 450 0.1 $450 x 0.1 = $45
1) Construct each of the 3 types of indices. 1) Construct each of the 3 types of indices.
Price-weighted average: index is one share of each company divided by divisor.
2) Examine how each index changes if C’s stock price increases 10% and Index value = (20 + 450) / 2 = 235. (Initially, let divisor = # of companies.)
GOOG’s price drops by 20%. Market-value weighted index: companies are weighted by their market value.
Index value = we can use any number initially. Let’s let index initially = 100.
3) Examine the impact of a 2:1 stock split by GOOG. When we calculate the index, we’ll add the current market caps of C and
GOOG, multiply by 100 and then divide that total by $145 billion.
4) Examine the implications of index type on mutual fund managers whose Initially: ($100B+$45B)*(100/$145B)
funds are supposed to replicate each index’s return. Equally weighted index: simply calculate the returns for each company and average.
Index value = any number initially. For simplicity, let’s let index initially = 100.
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Stock Price Indices (continued) Stock Price Indices (continued)
Company Stock Price Shares Outstanding Market Value ($ Billions) Company Stock Price Shares Outstanding Market Value ($ Billions)
($/share) (in Billions) = Stock Price x Shares Out. ($/share) (in Billions) = Stock Price x Shares Out.
Citigroup (C) $ 20 5.0 $20 x 5 = $100 Citigroup (C) $ 20 5.0 $20 x 5 = $100
Google (GOOG) $ 450 0.1 $450 x 0.1 = $45 Google (GOOG) $ 450 0.1 $450 x 0.1 = $45
2) Examine how each index changes if C’s stock price increases 10% and GOOG’s 2) Examine how each index changes if C’s stock price increases 10% and GOOG’s
price drops by 20%. price drops by 20%.
Price-weighted average: --- First, calculate the new stock prices: Market-value weighted index: Calculate the new market values:
C’s new stock price = $20x(1+0.10) = $22. C’s new market value = $20x(1+0.10)x(5.0) = $110 billion.
GOOG’s new stock price = $450x(1-.20) = $360. GOOG’s market value = $450x(1-.20) x(0.1) = $ 36 billion.
Index value now = (22 + 360) / 2 = 191. Index value now = ($110B+$36B)*(100/$145B) = 100.69.
Change in index = (New value – Old value)/ Old value Change in index = (100.69-100)/100 = 0.0069 or 0.69%.
= (191-235)/235 = -0.187 or -18.7%. NOTE --- the company with the higher market value has more impact on the index.
NOTE --- the higher priced stock has more impact on the index.
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Stock Price Indices (continued) Stock Price Indices (continued)
Company Stock Price Shares Outstanding Market Value ($ Billions) Company Stock Price Shares Outstanding Market Value ($ Billions)
($/share) (in Billions) = Stock Price x Shares Out. ($/share) (in Billions) = Stock Price x Shares Out.
Citigroup (C) $ 20 5.0 $20 x 5 = $100 Citigroup (C) $ 20 5.0 $20 x 5 = $100
Google (GOOG) $ 450 0.1 $450 x 0.1 = $45 Google (GOOG) $ 450 0.1 $450 x 0.1 = $45
2) Examine how each index changes if C’s stock price increases 10% and GOOG’s 3) Examine the impact of a 2:1 stock split by GOOG.
price drops by 20%. Price-weighted average: In step 1, we calculated an index of 235.
--- Calculate the new stock price for GOOG when it splits:
Equally weighted index: GOOG’s new stock price = $450 / 2 = $225.
--- Calculate the new divisor needed to keep index unchanged at 235:
Change in index = [(10% + (-20%)]/2 = -5%. Index = 235 = (20 + 225) / (new divisor).
A little algebra: new divisor = (20 + 225) / 235 = 1.042553
NOTE --- the companies have equal impact on index. NOTE --- because we’ve had a stock split, we have to calculate new divisor that we
will use from now on ---- until the next unusual event that makes us change it.
Examples of events: stock splits, dividends>10%, and changes of companies.
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Stock Price Indices (continued) Stock Price Indices (continued)
Company Stock Price Shares Outstanding Market Value ($ Billions) 4) Now examine the implications of index type on mutual fund managers whose
($/share) (in Billions) = Stock Price x Shares Out. funds are supposed to replicate each index’s return.
Citigroup (C) $ 20 5.0 $20 x 5 = $100 Suppose the fund manager is managing $145,000.
Google (GOOG) $ 450 0.1 $450 x 0.1 = $45
Price-weighted average:
3) Examine the impact of a 2:1 stock split by GOOG.
- The manager initially has to invest in equal number of shares of each stock.
- Let n = number of shares we want to solve for:
Market-value weighted index:
(n)($20) +(n)($450) = $145,000
No changes necessary – stock split has no impact on index.
(n)($20 + $450) = $145,000
n = $145,000/ ($20 + $450)
Equally weighted index:
= 308.51 shares in each stock.
No changes necessary – stock split has no impact on index.
We will not have to rebalance our holdings of each stock when prices change.
Exception --- when stocks pay dividends --- we will have to reinvest in equal shares.
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Stock Price Indices (continued) Stock Price Indices (continued)
4) Now examine the implications of index type on mutual fund managers whose 4) Now examine the implications of index type on mutual fund managers whose
funds are supposed to replicate each index’s return. funds are supposed to replicate each index’s return.
Suppose the fund manager is managing $145,000. Suppose the fund manager is managing $145,000.
Market –value weighted average: Equally weighted average:
- The manager initially has to invest in proportion to market value. - The manager initially has to invest equal $ amounts in each stock.
-- $ to invest in C = ($145,000)(100/145) = $100,000. -- $ to invest in C = ($145,000/2) = $72,500.
So shares of C = $100,000/($20 per share) = 5,000 shares. So shares of C = $72,500 /($20 per share) = 3,625 shares.
-- $ to invest in GOOG = ($145,000)(45/145) = $45,000. -- $ to invest in GOOG = ($145,000/2) = $72,500.
So shares of GOOG = $45,000/($450 per share) = 100 shares. So shares of GOOG = $45,000/($450 per share) = 161.11 shares.
We will not have to rebalance our holdings of each stock when prices change. We WILL have to rebalance our holdings of each stock when prices change.
Exception --- when stocks pay dividends --- we will have to reinvest them in To convince yourself, look at the case where C increases by 10% and GOOG
proportion to market values at that time. drops by 20%.
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