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Part-04: Stock Market Indices

1
Introduction

 Standard question asked on a daily


basis by:
 Investors
 Traders
 Market Analysts

“What Happened to the Market


Today?” 2
Introduction (cont…)
 The term “market” refers to the Stock
Market.

3
Introduction
 Why focus on the market as a whole?
 The market consists of a multitude of
assets.
 The performance of each asset cannot be
realistically tracked at the same time to
draw meaningful conclusions.
 Thus there is a tendency to focus on a
summary measure of the market’s
performance. 4
Types of Indices

5
Stock Indices

 An Index Number is a summary

measure or a representative measure of

the market’s performance.

 Its value is a barometer of changes in

the overall performance of the market.

6
Types of Indices

 There are 3 Types


of
different ways of Indices

computing stock
market indices.
Price Value Equally
Weighted Weighted Weighted
Indices Indices Indices

7
Price Weighted Indices

 Specify the number of stocks


constituting the index
 Add up all the latest prices of all the
component stocks
 Divide the price aggregate by a
number known as the Divisor

8
Formula
 A price weighted index
consists of N stocks
 The day of computation
=t
 The value of the index =
It
 Price of stock i on day t =
Pit
9
Hypothetical Example
 Take an index consisting of 5 stocks
 Assume that we are standing on the
base date.
 The Base Date is the date on which the
index is being computed for the first time.
 On the Base Date, the Divisor can be set
equal to any value.
 A logical value for the Divisor is the number
of stocks in the index.
10
Prices of Constituent Stocks
STOCK PRICE
ACC 907
Bombay Dyeing 81
Colgate Palmolive 211
Escorts 68
Hindustan Lever 732
TOTAL 1999

11
Initial Index Value

1999
It = ______ = 399.80
5

12
The Following Day

 Assume that at the end of the next day


the stock prices are:
STOCK PRICE
ACC 925
Bombay Dyeing 90
Colgate Palmolive 225
Escorts 75
Hindustan Lever 750
TOTAL 2065
13
New Index Level

2065
It+1 = ______ = 413
5

14
Conclusion

 The market has moved up since the


index level has risen.
 Conclusion is valid
 Every component stock has moved up in
value.

15
Changing the Divisor

16
Stock Split - A Different Scenario

 Assume that at the end of the first day,


ACC announces a 3:1 split.
 An investor will receive 3 new shares for
every share that he is holding.

17
Second Day’s Prices - Post Split
STOCK PRICE
ACC 308
Bombay Dyeing 90
Colgate Palmolive 225
Escorts 75
Hindustan Lever 750
TOTAL 1448

18
Comparison of Prices -
With & Without the Split
STOCK PRICE - If no PRICE - With
split split
ACC 925 308
Bombay 90 90
Dyeing
Colgate 225 225
Palmolive
Escorts 75 75
Hindustan 750 750
Lever
TOTAL 2065 1448
19
Comparison of Prices (Cont…)

 If we compare the two sets of prices


we see that:
 All the stocks have the same value
except for ACC

20
Calculation of Index After the Split
using the Existing Divisor

1448
It+1 = ______ = 289.60
5

21
Erroneous Conclusion

 Since the index value on the base date


was 399.80, the index has fallen.

 This is an erroneous conclusion since:


Every Stock Has Risen In Value As
Compared To The Base Date

22
Reason For Wrong Deduction

 The decline is purely due to the stock

split

 due to which ACC has only 1/3rd of its value

 How de we account for the split?

 Obviously we have to change the divisor


23
Adjusting the Divisor

 At the end of the day on which ACC


undergoes a 3:1 split
 Only ACC’s price will be impacted.
 It will come down to 1/3rd of the existing
value.

 There will be no change in the prices of the


other stocks.
24
Theoretical Post-Split Prices
STOCK PRICE
ACC 302.33
Bombay Dyeing 81
Colgate Palmolive 211
Escorts 68
Hindustan Lever 732
TOTAL 1394.33

25
The New Divisor

 The new divisor X should be such that


the pre- & post-split index value is the
same.
 If we denote the adjusted divisor by X:

(1394.33 / X) = 399.80
 The new divisor is 3.4876
26
The New Divisor (Cont…)

 The validity of the new divisor can be


checked by recomputing the index level
on the next day.
1448
It+1 = ______ = 415.1852
3.4876

27
The New Divisor - Conclusion

 After making the necessary adjustments


to the divisor, we would conclude that
the market has risen in value
 Which is the correct conclusion in this case

28
Situations Warranting Re-calculation
of Divisor

 We need to adjust a divisor under the


following situations:
 A stock undergoes a split
 A stock undergoes a reverse split
 A company declares a stock dividend
 A company is deleted from the index and
replaced with another.

29
Handling Stock Dividends

 From a mathematical standpoint, a


stock split and a stock dividend are
identical
 20% stock dividend  1 new share will be
issued for every 5 existing shares
 This is exactly analogous to a 6:5 split.
 Procedure for adjusting the divisor will
be identical to that for a stock split
30
Changing the Composition of the
Index
 Assume that
Escorts, which has a price of 75, is deleted
at the end of the 2nd day
 It is replaced with Ranbaxy which has a

price of 120.
STOCK PRICE
ACC 308
Bombay Dyeing 90
Colgate Palmolive 225
Ranbaxy 120
Hindustan Lever 750
TOTAL 1493 31
Changes in Composition and Divisor
Adjustment

 The new divisor X, should be such that:


1493
It+1 = ______ = 415.1852
X

 The value of X turns out to be


3.5960
32
Price weighted indices

33
Examples of Price Weighted Indices

 The Dow Jones Industrial Average


commonly known as the DOW and
abbreviated as DJIA
 It consists of 30 Blue Chip companies
 The Nikkei Index in Japan is also a price
weighted index
 It consists of 225 stocks
34
The Importance of Price
 High priced stocks carry more weight
in the case of price weighted indices
than low priced stocks.

35
Illustration of Relative
Importance

 Case A: Consider a 20% increase in the

price of ACC

 Case B: Consider a 20% increase in the

price of Colgate, which is priced lower

36
Illustration of Relative
Importance

STOCK Day 1 Day 2: Day 2:


Case A Case B
ACC 900 1080 900
Bombay 90 90 90
Dyeing
Colgate 200 200 240
Palmolive
Escorts 80 80 80
Hindustan 700 700 700
Lever
TOTAL 1970 2150 2010
37
Illustration (Cont…)

 Assume that the divisor is 5


 Index value on Day 1 = 394
 Case A: Index value on Day 2 = 430
 Increase of 9.14%

 Case B: Index value on Day 2 = 430


 Increase of 2.03%

38
Value weighted indices

39
Value Weighted Indices

 Unlike price weighted indices, these


indices use Market capitalization, not
just price

 Market capitalization is defined as:


price * no. of shares outstanding

40
Formula

41
Explanation of Symbols
 Pib ≡ Price of stock i on the base date
 Qib ≡ Number of shares outstanding of stock i
on the base date
 Pit ≡ Price of stock i on date t
 Qit ≡ No. of shares outstanding of stock i on
day t
 M ≡ No. of companies constituting the index
on the base date
 N ≡ No. of companies constituting the index
on day t

Note: M need not equal N 42


Starting Index Value

 We have assigned the index a value of


100 on the base date.
 This is common but is arbitrary
 In practice, one can assign any value.

43
The Divisor

 Once again a Divisor has been used


 The treatment of the divisor in this case
is slightly different
 On the base date, the divisor is always
assigned a value of 1.0

44
Hypothetical Example

 Take the same 5 stocks

 We will focus on their market

capitalizations, not just their prices.

45
Market Capitalizations on the
Base Date
STOCK Price No. of Market Cap.
(P) Shares
ACC 907 (Q)
1,000,000 907,000,000

Bombay Dyeing 81 500,000 40,500,000

Colgate 211 700,000 147,700,000


Palmolive
Escorts 68 200,000 13,600,000

Hindustan 732 1,500,000 1,098,000,00


Lever 0 46
Total Market Capitalization

 ΣPiQi = 2,206,800,000

47
Market Capitalizations on the Next
Day
STOCK Price No. of Market Cap.
(P) Shares (Q)
ACC 925 1,000,000 925,000,000

Bombay 90 500,000 45,000,000


Dyeing
Colgate 225 700,000 157,500,000
Palmolive
Escorts 75 200,000 15,000,000

Hindustan 750 1,500,000 1,125,000,00


Lever 0
48
Total Market Capitalization & New
Index Level

 ΣPiQi = 2,267,500,000

 New Index Level is:


2,267,500,000
It+1 = ___________ x 100 = 102.7506
2,206,800,000

49
Conclusion

 We will conclude that the market has


risen in value
 This is a valid inference because
every component stock has gone up
in value as compared to the base
date.
50
The Divisor

 The Divisor need not be adjusted for


 Stock Splits

 Reverse Splits

 Stock Dividends

51
Rationale – a theoretical
standpoint
 The below will not have any impact on
the market capitalization of the stock
 Stock splits
 Reverse splits
 Stock dividends
 The decrease/increase in the stock price
will be exactly offset by an
increase/decrease in the no. of shares
outstanding 52
Example

HLL HLL post a


3:1 split
Market price 750 250

No. of shares 1,500,000 4,500,000


outstanding

Market 1,125,000,000 1,125,000,00


capitalization 0

53
Change in Composition and
the Divisor
 The divisor will have to be adjusted if
there is a change in the composition.
 Assume that Escorts is replaced by
Ranbaxy.
Escorts Ranbaxy
Price 75 120
No. of shares 200,000 100,000
outstanding
54
Post-Change Market Cap.
STOCK Price No. of Market
(P) Shares Cap.
ACC 925 (Q)
1,000,000 925,000,000

Bombay 90 500,000 45,000,000


Dyeing
Colgate 225 700,000 157,500,000
Palmolive
Ranbaxy 120 100,000 12,000,000

Hindustan 750 1,500,000 1,125,000,0


Lever 00 55
New Divisor
 The new market capitalization is
2,264,500,000

 The new divisor should be such that:


1 2,264,500,000
_ x ___________ x 100 = 102.7506
X 2,206,800,000

 X is therefore equal to 0.9987


56
Relative Importance of Stocks

 In a value weighted index, the


importance of a stock would depend on
its market value
 A given percentage change in the value
of a large cap firm, will have a greater
impact on the index, than a similar
percentage change in the value of a
57
Examples of Value Weighted
Indices

 Standard & Poor’s S&P 500


 It consists of 500 stocks.
 Nasdaq 100 index
 In India - the Sensex and the Nifty
 The Sensex consists of 30 stocks.
 The Nifty is based on 50 stocks.

58
Equally weighted indices

59
Equally Weighted Indices

 The value of an equally weighted index


consisting of N stocks is given by

60
Prices & Returns

is equal to (1 + rit) where rit is the rate of


return on stock i between day t-1 and day
t

61
The Formula in Terms of Returns

 It =

62
Explanation of Formula

is the arithmetic average of the returns on all


the component stocks

Thus
Value of the index =
(Index level on the previous day) * (average
return on all the stocks)

63
Tracking portfolois

64
Mimicking Portfolios

 A mimicking portfolio also known as a


Tracking Portfolio is formed to replicate
the behaviour of the index
 “Passive investors” are sometimes quite
content to acquire portfolios of stocks
that mirror the movements in an index

65
Replication Techniques

 The method for forming a tracking

portfolio depends on the nature of the

index

66
To track…
Price Equally Value weighted
weighted weighted index
index
The investor index
The investor The investor needs to
needs to needs to invest invest a fraction of
purchase an an equal his wealth in each
equal number amount in every component stock,
of shares of stock that that is equal to the
every stock constitutes the ratio of its market
that index capitalization divided
constitutes the by the total market
index capitalization of all
the assets in the 67
index
Portfolio Rebalancing

68
Portfolio Rebalancing
 Once a tracking portfolio is formed it
will not continue to track the index
automatically forever
 There are circumstances under which the
index ought to be rebalanced if it is to
maintain its property of being a tracking
portfolio.
 The circumstances under which the portfolio
has to be rebalanced depend on the nature
69
of the index.
Events that Warrant Rebalancing
Price weighted Equally weighted index Value
index weighted
index
One of the Has to be rebalanced every If there is
constituent stocks day, unless none of the a change
in the index: component stocks changes in the
Undergoes a split
in price - because a price compositio
Undergoes a
change in even 1 stock is n of the
reverse split adequate to ensure that the index
Or pays a stock
portfolio is no longer
dividend
If there is a change equally weighted.
in the composition
of the index 70
Equally Weighted Tracking
Portfolio

71
An Equally Weighted Tracking
Portfolio
 Assume that
 We have Rs. 500,000

 We wish to form an equally weighted

portfolio consisting of 4 four stocks.


STOCK PRICE
Alfa Laval 50
Atlas Copco 100
Sandvik 40
Sulzer 125
72
Equally Weighted…(Cont…)
 We have Rs. 500,000
 We need to invest Rs. 125,000 in each
stock
 We will have to buy:
 2,500 shares of Alfa Laval
 1,250 shares of Atlas Copco
 3,125 shares of Sandvik
 1000 shares of Sulzer
73
Equally Weighted …(Cont…)
 If we assume that the index level is 100  our
portfolio will be worth 5000 times the index
 Assume that the prices on the next day are as
follows.

STOCK PRICE
Alfa Laval 40
Atlas Copco 125
Sandvik 50
Sulzer 100
74
Equally Weighted …(Cont…)

 The total portfolio value is Rs. 512,500


of which:
 100,000 is in Alfa Laval
 156,250 is in Atlas Copco
 156,250 is in Sandvik
 100,000 is in Sulzer

75
Equally Weighted …(Cont…)
 The percentage of each stock in the
portfolio
STOCK PERCENTAGE

Alfa Laval 19.51%

Atlas Copco 30.49%

Sandvik 30.49%

Sulzer 19.51%

76
Equally Weighted… (Cont…)
 The portfolio is no longer equally weighted.
 The total portfolio value is 512,500
 We need to invest 128,125 in each stock
To reset the weights to 0.25 each, we will have
to:
Sell part of our Sell 225 shares of Atlas

holdings in Atlas Copco


Copco & Sandvik Sell 562.5 shares of

Sandvik
Invest the proceeds in Buy 703.125 shares of
Alfa Laval & Sulzer Alfa Laval
Buy 281.25 shares of

Sulzer 77
Rebalancing at Zero Cost
 If we assume that there are no
transactions costs, we can rebalance at
no cost.

 Inflow from rebalancing is:


(225 x 125) + (562.50 x 50) = $56,250

 Outflow from rebalancing is:


(703.125 x 125) + (281.25 x 100) =
78
$56,250
The New Index Level

 It+1 = It x (1 + )
= 100 x (1 + )

 = (-0.20 + 0.25 + 0.25 - 0.20)


_____________________
4
= 0.025

 It+1 = 102.50
79
Mimicking Property

 The portfolio value is:

512,500 = (102.50 x 5,000)


 Thus the portfolio continues to mimic
the index

80
Price Weighted Tracking
Portfolio

81
A Price Weighted Tracking
Portfolio
 Assume that we wish to form a price
weighted tracking portfolio by buying
1000 shares
STOCK PRICE
Alfa Laval 50
Atlas Copco 100
Sandvik 40
Sulzer 125
82
Price Weighted…(Cont…)
 Assume that the divisor is 4.0, the index
level will be:

50 + 100 + 40 + 125
It = ________________ = 78.75
4.0

83
Price Weighted…(Cont…)
 The value of our tracking portfolio will
be:
{1000 x (50 + 100 + 40 + 125)} =
315,000
= 4000 x
78.75

 Thus the portfolio will be worth 4000 84


Stock Split
 Assume that Atlas Copco undergoes a
2:1 split
 The post split theoretical value of the
stock will be 50

 The new divisor should be such that:


50 + 50 + 40 + 125
_______________ = 78.75 ⇒ X = 3.3651
X
85
Rebalancing
 In order to ensure that our portfolio
continues to mimic the index, we
need to rebalance in such a way that
the portfolio value remains
unchanged.

86
Rebalancing (Cont…)
 The portfolio value = 4000 x 78.75
= 1000 X 4 x 78.75

 If the portfolio value is to remain


unchanged:
1000 x 4 x 78.75 = N x 3.3651 x 78.75
N = no. of shares of each stock that is
to be held after rebalancing

87
Rebalancing (Cont…)
 Therefore:
1000 x 4
N = ______ = 1188.672
3.3651

88
Rebalancing (Cont…)
 Assume that fractional shares can be
bought & sold
 We need to buy
 188.672 shares of Alfa Laval, Sandvik, and
Sulzer,
 We need to sell
 811.328 shares of Atlas Copco
 Because we would have 2000 shares after
the split and we need only 1188.672 shares89
Rebalancing (Cont…)
 Inflow:
811.328 x 50 = 40,566.40

 Outflow:
188.672 x (50 + 40 + 125) = 40,564.48

 Once again if we ignore transactions


costs we can rebalance at zero net cost
90
Value Weighted Tracking
Portfolio

91
A Value Weighted Tracking Portfolio
 Consider a value weighted portfolio
consisting of the following 4 stocks.
STOCK Price No. of Market
(P) Shares Cap.
(Q)
MRF 20 100,000 2,000,00
J.K. Tyres 40 50,000 0
2,000,00
Apollo 50 100,000 0
5,000,00
Tyres
Vikrant 10 100,000 0
1,000,00
92
Tyres 0
Value Weighted…(Cont…)

 The total market capitalization is


10,000,000
 Assume:
 Base period market capitalization =
16,000,000
 Divisor = 1

 Index level = 62.50 93


Value Weighted… (Cont…)
 Consider a person with a capital of
200,000

 In order for his portfolio to mimic the


index, it must have:

 2,000,000
________ x 200,000 = 40,000 in MRF
10,000,000
94
Value Weighted…(Cont…)
 2,000,000
_________ x 200,000 = 40,000 in J.K. Tyres
10,000,000

 5,000,000
_________ x 200,000 = 100,000 in Apollo
Tyres
10,000,000

 1,000,000
________ x 200,000 = 20,000 in Vikrant Tyres
95
Value Weighted… (Cont…)

 Thus he needs to buy


 2000 shares of MRF
 1000 shares of JK Tyres
 2000 shares of Apollo Tyres
 2000 shares of Vikrant Tyres
 The total value of the portfolio is 3200
times the index level of 62.50
96
Value Weighted…(Cont…)

 Assume that Vikrant Tyres is replaced


by CEAT
 Price = 35
 No. of shares outstanding = 100,000
 The total market capitalization of the
four companies after the change will be
12,500,000
97
The Divisor
 The divisor must be changed in such a
way that the index level remains
unchanged.

1 x 12,500,000 x 100
__ _________ = 62.50
X 16,000,000

⇒ X = 1.25
98
Value Weighted…(Cont…)
 For the portfolio to remain value
weighted, the investor must have:

 2,000,000
_________ x 200,000 = 32,000 in MRF
12,500,000

 2,000,000 x 200,000 = 32,000 in J.K. Tyres


________
12,500,000
99
Value Weighted…(Cont…)
 5,000,000 x 200,000 = 80,000 in Apollo
Tyres ________
12,500,000

 3,500,000 x 200,000 = 56,000 in CEAT


________
12,500,000

100
Value Weighted…(Cont…)

The investor requires The investor needs to

1600 shares of MRF Sell 400 shares of MRF

800 shares of J.K. Tyres Sell 200 shares of J.K. Tyres

1600 shares of Apollo Sell 400 shares of Apollo


Tyres Tyres
Sell 2000 shares of Vikrant
Tyres

1600 shares of CEAT Buy 1600 shares of CEAT


101
Value Weighted…(Cont…)
 Inflow = 400x20 + 200x40 + 400x50 +
2000x10 = 56,000

 Outflow = 1600x35 = 56,000

 Once again, if we ignore transactions


costs, we can rebalance at zero cost.

102
Base period capitalization

103
Changing the Base Period
Capitalization

 We have just seen one way of handling


a change in the composition of a “value
weighted index”
 Adjust the Divisor

104
Base Period…(Cont…)
Adjust the Divisor Keep the Divisor fixed
at 1.0
This is the approach In India we follow this
used for the S&P500 procedure for the
Sensex and the Nifty

The base period The base period


capitalization remains capitalization is changed
fixed in such cases and
is never changed

105
Base Period…(Cont…)
 In our illustration when the market
capitalization changed from 10,000,000
to 12,500,000 we changed the divisor to
1.25 to keep the index level fixed at
62.50.
 In India we would have changed the
base period capitalization instead.
 12,500,000
_________ x 100 = 62.50 ⇒ X = 20,000,000
106
X
Base Period…(Cont…)

 For subsequent computations of the

index we would use the changed base

period capitalization, unless there were

to be another change in the index

composition.

107