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McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Asset Classes and Financial Instruments Bodie, Kane and Marcus.

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Presentation on theme: "McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Asset Classes and Financial Instruments Bodie, Kane and Marcus."— Presentation transcript:

1 McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Asset Classes and Financial Instruments Bodie, Kane and Marcus Essentials of Investments 9 th Global Edition 2

2 2.4 S TOCK AND B OND M ARKET I NDEXES Uses Track average returns Compare performance of managers Base of derivatives Factors in constructing/using index Representative? Broad/narrow? How is it constructed?

3 2.4 S TOCK AND B OND M ARKET I NDEXES Construction of Indexes How are stocks weighted? Price weighted (DJIA) Market value weighted (S&P 500, NASDAQ) Equally weighted (Value Line Index) How much money do you put in each stock in the index?

4 2.4 S TOCK AND B OND M ARKET I NDEXES Constructing Market Indexes Weighting schemes Price-weighted average: Computed by adding prices of stocks and dividing by “divisor” Market value-weighted index: Return equals weighted average of returns of each component security, with weights proportional to outstanding market value Equally weighted index: Computed from simple average of returns

5 2.4 S TOCK AND B OND M ARKET I NDEXES Time 0 index value: ( )/3 = 200/3 = 66.7 Time 1 index value: ( )/Denom = Denominator = Time 1 index value: ( )/ = Other problems: Similar % change movements in higher-price stocks cause proportionally larger changes in the index Splits arbitrarily reduce weights of stocks that split in index Stoc k Price B Quantity B P1P1 Q1Q1 A$1040$1540 B C Price-Weighted Series

6 2.4 S TOCK AND B OND M ARKET I NDEXES Value-Weighted Series Index V = Equal-Weighted Series wlog invest $300 in each Index E = Stoc k Price B Quantity B P1P1 Q1Q1 A$1040$1540 B C

7 2.4 S TOCK AND B OND M ARKET I NDEXES Why do the two differ? Case 1: 20% change in price of small-cap firm Index V = wlog invest $100 in each stock Index E = Case 1Case 2 Stock PBPB QBQB P1P1 Q1Q1 P1P1 Q1Q1 A$1040$1240$1040 B C

8 2.4 S TOCK AND B OND M ARKET I NDEXES Why do the two differ? Case 2: 20% change in price of large-cap firm Index V = Assume $100 investment in each stock Index E = Case 1 VW = Case 1 EW = Case 1Case 2 Stock PBPB QBQB P1P1 Q1Q1 P1P1 Q1Q1 A$1040$1240$1040 B C


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