Chapter 15: Indices

Question 1

Explain what is meant by:

• Chain linking
• Free float

Answer 1

Chain linking

• Process used to maintain continuity in index value when number of shares issused by constituent company changes
• Many arise due to rights issues/share buybacks, shares entering/leaving index

Free float

• Percentage of shares freely available for purchase on open market
• Excludes strategic holding

Question 2

State the formula for a weighted arithetic average capital value index

Answer 2

I(t) = (ΣN_i,t P_i,t)/B(t)

• N - is the number of shares issued for i - ith constituent at time t
• P_i,t is price of i-th constituent at time t
• B(t) is based value, or divisor at time t
• B(t) is obtained from B(t - 1) through chain - linking process

Question 3

Explain with the aid of a formula what the ex dividend adjustment represents

Answer 3

Ex dividend adjustment

Represents accumulated total of dividends paid by constituent companies in index from start of calendar year to current date

XD_t = ΣΣxd_i,t = ΣΣ (Ni,tD_i,t)/B(t - 1)

• D_i,t dividend per share declared by the i-th constituent at time t (net, gross as required)
• B(t - 1) is divisor at close of business on previous day after allowing for any capital changes

Question 4

Eight factors to consider when constructing an index

Answer 4

• Purpose of index
• Constituents and basis for inclusion/exclusion
• type of index
• Price data used
• frequency of calculation
• base date and value
• how to deal with capital changes
• how to deal with income

Question 5

List the eight main uses of indices

Answer 5

• Benchmark against to asess investment performance of portfolios
• Valuing notional portfolio
• Basis for derivatives relating to market or sub-section of market
• basis for index tracker funds
• charting long term histroy of market movements and levels
• estimating future market movements and levels
• Measuring of short term market movements
• analysing sub-sectors of the market

Question 6

List 4 further usees of government bond indices

Answer 6

• Yield indices
  
  • Provided standard against which yields on other fixed interest investments can be assessed
  • summarise yield curve
  • indicate size of the yield gap between bonds and equities
• Price indices
  
  • Can be used for approximate valuation of fised interest portfolio

Question 7

Describe how the FTSE equitiy indices are calculated and list 6 figures, in addition to the capital value index, which are provided in respect of each FTSE index

Answer 7

• Calculated on weighted arithmetic average basis with market capitalisations as weights
• weightings based on free floats

In addition to capital value index indicates also give

1. Total return index
2. Average dividend cover
3. average dividend yield
4. price earnings ratio
5. ex dividend adjustment
6. euro value index

Question 8

Outline the following indicies

• FTSE 100
• FTSE 250
• FTSE 350 Supersectors

Answer 8

FTSE 100

Consists of 100 largest quoted companies by market capitlisation accounting for about 80 per cent of total UK equity market capitalisation

FTSE 250

Covers next 250 companies ranking below top 100 companies by market capitalisation

FTSE 350 Supersectos

Combines 100 and 250 indicies and accounts for over 90 percent of total UK equity market. Sub - indices also calculated for high yielding and low yielding stocks

Question 9

Outline the coverage of the following indicies

• FTSE SmallCap
• FTSE All share
• FTSE Fledging
• FTSE AIM

Answer 9

FTSE SmallCap

Covers all companies below top 350 with market capitalisation greater than certain limit and whose shares are actively traded

FTSE All share

Comprises 350 and SmallCap indicies, and accounts for around 98 - 99 per cent of total overall market capitalisation

FTSE Fledging

Consists of remaining, sufficiently marketable, quoted companies that are too small to be included in SmallCap index

FTSE AIM

Covers some 1000 companies traded in Alterative Investment Market

These are companies too small or too new to apply for full listing

Question 10

Describe the FTSE gilts index series

Answer 10

• Cover coventional and index linked gits
• Both price and yield indices published, with price indicies being subdivided according to term and yield indicies subdivided according to term and coupon
• Index number calculated using dirty prices ie inclusive of accured interest
• Accrued interest and XD adjustment published for price index series

Question 11

Describe the coverage and construction of the FTSE global equity iindicies

Answer 11

• Cover 8000 securities in 48 markets
• Capture around 98% of world’s equit markets by investible market capitalisation
• Indicies divided into 3 segments: Developed, advanced emerging and secondary emerging
• Stocks not available to foreign investors excluded from indicies, making them suitable for performance measurement
• indicies calculated in US dollar and local currency
• weighted arithmetic capital value indices, baed on free floats

Question 12

Describe briefly the two main US equity indicies

Answer 12

• Dow Jones Industrial Average
  
  • Unweighted arithmetic index based on only 30 industrial shares
  • Unsuitable for performance measurement
• Standard & Poor’s Composite Index (S&P 500)
  
  • Weight arithmetic index
  • Consitituents are 500 leading commpanies in USA representing broad cross - section of all sectors of market
  • Often suitable for performance measurement of portfolio of US equities

Question 13

Describe briefly the 2 main Japanese indicies

Answer 13

Nikkei Stock Average 225

• Unweighted arithmetic index
• Consistuents reviewed annually, but unrepresentative of Japanese Equity market
• Not suitable for performance measurement

Tokyo Stock Exchange First Section Index (Topix)

• Comprises about 1700 shares
• Market capitalisation weighted arithmetic index
• Constituents represent leading copanies in market
• Much more comprehensive than Nikkei
• Suitable for performance measurement

Question 14

State the two key problems when constructing property indicies and list the 6 problems in obtaining market values for constituents of property indicies

Answer 14

Two key problems when constructing property indices

• Lack of reliable and up to data on property prices
• Heterogeneity of properties

Six problems obtaining

• Each property is unique
• Market value of property only known for certain at sale
• Estimation of vlaue is subjective and expensive process
• Valuations carried out at different points in time
• Sales of certain types of investment property relatively infrequent
• Sale prices treated with degree of confidentiallity

Question 15

Distinguish between the 2 main types of property index

Answer 15

Property Indices

• measures rental values, capital values or total returns of actual portfolio of rented properities
• responds slowly to movemennts in rental values
• behaves like actual property portfolio
• Sometimes calculated on money weighted basis

Barometer index

• Based on estimates of hypothetical rack rents
• responds quickly to market conditions
• useful indicator of short term movements in rents and yields
• unsuitable for performance measurement

Question 16

Explain what an equity volatility index is and list the two main ways they may be calculated

Answer 16

Rather than recording market movements in equity prices or total returns these measure the volatility of equities

As such volatility indicies are typically used as an indicaton of the market perception of risk

They may be calculated in two ways

1. By using historical equity price movements
2. by using the volatility implied by option prices based on the equity being considered

Question 17

Explain what is meant by a credit derivative index and give an example

Answer 17

Whereas corporate bond indicies blend interest and credit risk, credit derivative indicies can be used to monitor prices of credit derivatives can be used to monitor prices of credit derivatives and hence more directly the price of credit risk

Examples include the markit iTraxx Europe index in Europe and the CDX family in the US