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Security Analysis

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indication of the aggregate market changes or market movements. More

specifically, the indicator series are used to derive market returns for a

period of interest and then used as a benchmark for evaluating the

performance of alternative portfolios. A second use is in examining the

factors that influence aggregate stock price movements by forming

relationships between market (series) movements and changes in the

relevant variables in order to illustrate how these variables influence market

movements. A further use is by technicians who use past aggregate market

movements to predict future price patterns. Finally, a very important use is in

portfolio theory, where the systematic risk of an individual security is

determined by the relationship of the rates of return for the individual

security to rates of return for a market portfolio of risky assets. Here, a

representative market indicator series is used as a proxy for the market

portfolio of risky assets.

market index? Put another way, what characteristics differentiate

indexes?

sample - the size of the sample (how representative of the total market it is)

and the source (whether securities are of a particular type or a given

segment of the population (NYSE, TSX). The weight given to each member

plays a discriminatory role - with diverse members in a sample, it would

make a difference whether the index is price-weighted, value-weighted, or

unweighted. Finally, the computational procedure used for calculating return

- i.e., whether arithmetic mean, geometric mean, etc.

a case, would you expect a $100 stock to be more important than a

$25 stock? Give an example.

prices of the securities included in the sample - i.e., closing prices of all

securities are summed and divided by the number of securities in the

sample.

A $100 security will have a greater influence on the series than a $25

security because a 10 percent increase in the former increases the

numerator by $10 while it takes a 40 percent increase in the price of the

latter to have the same effect.

A value-weighted index begins by deriving the initial total market value

of all stocks used in the series (market value equals number of shares

outstanding times current market price). The initial value is typically

established as the base value and assigned an index value of 100.

Subsequently, a new market value is computed for all securities in the

sample and this new value is compared to the initial value to derive the

percent change which is then applied to the beginning index value of 100.

Given a four security series and a 2-for-1 split for security A and a 3-

for-1 split for security B, the divisor would change from 4 to 2.8 for a price-

weighted series.

Stock before Split Price After Split Prices

A $20 $10

B 30 10

C 20 20

D 30 30

Total 100/4 = 25 70/x = 25

x = 2.8

The price-weighted series adjusts for a stock split by deriving a new

divisor that will ensure that the new value for the series is the same as

it would have been without the split. The adjustment for a value-

weighted series due to a stock split is automatic. The decrease in stock

price is offset by an increase in the number of shares outstanding.

Before Split

Stock Price/Share # of Shares Market Value

A $20 1,000,000 $20,000,000

B 30 500,000 15,000,000

C 20 2,000,000

40,000,000

D 30 3,500,000

105,000,000

Total $180,000,000

After Split

Stock Price/Share # of Shares Market Value

A $10 2,000,000 $20,000,000

B 10 1,500,000 15,000,000

C 20 2,000,000

40,000,000

D 30 3,500,000

105,000,000

Total

$180,000,000

This is precisely what one would expect since there has been no change in

prices other than the split.

construct such an index. Assume a 20% price change in GM

($40/share; 50 million shares outstanding) and Coors Brewing

($25/share and 15 million shares outstanding). Explain which stocks

change will have the greater impact on this index.

irrespective of their price and/or their value. One way to visualize an

unweighted series is to assume that equal dollar amounts are invested in

each stock in the portfolio, for example, an equal amount of $1,000 is

assumed to be invested in each stock. Therefore, the investor would own 25

shares of GM ($40/share) and 40 shares of Coors Brewing ($25/share). An

unweighted price index that consists of the above three stocks would be

constructed as follows:

Stock Price/Share # of Shares Market Value

GM $ 40 25 $1,000

Coors 25 40 1,000

Total $2,000

GM $ 48 25 $1,200

Coors 25 40 1,000

Total $2,200

A 20% price increase in Coors:

GM $ 40 25 $1,000

Coors 30 40 1,200

Total $2,200

Therefore, a 20% increase in either stock would have the same impact on the

total value of the index (i.e., in all cases the index increases by 10%. An

alternative treatment is to compute percentage changes for each stock and

derive the average of these percentage changes. In this case, the average

would be 10% (20% - 10%)). So in the case of an unweighted price-indicator

series, a 20% price increase in GM would have the same impact on the index

as a 20% price increase of Coors Brewing.

stock market index with percentage changes in the NYSE indexes.

Discuss the reason for this similarity: is it size of sample, source of

sample, or method of computation?

Based upon the sample from which it is derived and the fact that is a

value-weighted index, the Wilshire 5000 Equity Index is a weighted

composite of the NYSE composite index, the AMEX market value series, and

the NASDAQ composite index. We would expect it to have the highest

correlation with the NYSE Composite Index because the NYSE has the highest

market value.

price changes for the alternative NYSE indexes. Discuss the reason

for this similarity: is it size of sample, source of sample, or method

of computation?

The high correlations between returns for alternative NYSE price index

series can be attributed to the source of the sample (i.e. stock traded on the

NYSE). The four series differ in sample size, that is, the DJIA has 30

securities, the S&P 400 has 400 securities, the S&P 500 has 500 securities

and the NYSE Composite over 2,800 stocks. The DJIA differs in computation

from the other series, that is, the DJIA is a price-weighted series where the

other three series are value-weighted. Even so, there is strong correlation

between the series because of similarity of types of companies.

composite index. Examine the correlation between the MSCI Pacific

basin index and the DJTSM in Exhibit 5.13. Explain why these

relationships differ?

The two price indices (Tokyo SE and Nikkei) for the Tokyo Stock

Exchange show a high positive correlation even though the two indices

represent substantially different sample sizes and weighting schemes. The

Nikkei-Dow Jones Average consists of 225 companies and is a price-weighted

series. Alternatively, the Tokyo SE encompasses a much larger set of 1,800

companies and is a value-weighted series.

10. You learn that the Dow Jones total stock market value- weighted

index increased by 16 percent during a specified period, where as a

Dow Jones total stock market equal-weighted increased by 23%

during the same period. Discuss what this difference in result

implies.

Since the equal-weighted series implies that all stocks carry the same

weight, irrespective of price or value, the results indicate that on average all

stocks in the index increased by 23%. On the other hand, the percentage

change in the value of a large company has a greater impact than the same

percentage change for a small company in the value weighted index.

Therefore, the difference in results indicates that for this given period, the

smaller companies in the index outperformed the larger companies.

11. Why is it contended that bond market indexes are more difficult

to construct and maintained than stock market indexes?

The bond-market series are more difficult to construct due to the wide

diversity of bonds available. Also bonds are hard to standardize because

their maturities and market yields are constantly changing. In order to better

segment the market, you could construct five possible subindices based on

coupon, quality, industry, maturity, and special features (such as call

features, warrants, convertibility, etc.).

5%, whereas the Merill Lynch-Dow Jones capital market index

increased by 15% during the same period. What does this difference

in results imply?

distribution of bonds as well as stocks, the fact that this index increased by

15%, compared to a 5% gain in the Wilshire 5000 Index indicates that bonds

outperformed stocks over this period of time.

13. Suppose the Russell 1000 increased by 8% during the past year,

whereas the Russell 2000 increased by 15%. Discuss the implication

of these results

Russell 2000 outperformed the Russell 1000 during the past year.

14. Based on what you know about the financial times world index,

the Morgan Stanley capital international world index. And the Dow

jones world stock index, what level of correlation would you expect

between monthly rates of return? Discuss the reasons for your

answer based on the factors that affect indexes.

One would expect that the level of correlation between the various

world indices should be relatively high. These indices tend to include the

same countries and the largest capitalization stocks within each country.

15. How would you explain that the ML High-Yield bond index was

more highly correlated with the NYSE composite index than the ML

aggregate bond index?

High yield bonds (ML High Yield Bond Index) have definite equity

characteristics. Consequently, they are more highly correlated with the NYSE

composite stock index than with the ML Aggregate Bond Index.

in a broadly diversified portfolio of U.S. stocks, which two or three

indexes should be considered as an appropriate benchmark? Why?

Wilshire 5000, the NYSE Composite, and possibly the NASDAQ composite.

These indices would be appropriate benchmarks for portfolio managers

wishing to construct a broadly diversified portfolio.

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