USING INDEXES
The use of indexes is a method of expressing the value of a group of like products. However, to appreciate the index value, the observer must know exactly what the index’s purpose is. A stock index made up of the common stock of the one thousand largest corporations by capitalization would have some different components and a different value from an index of the one thousand largest corporations by common shares price weighting. Similarly, an index of growth stocks would have different components from an index of high dividend payers, even though they may have the same index manager and the same primary names.
Some indexes that we use, such as the Dow Jones Industrial Average, are price weighted, which means that each component corporation’s contribution to the index is the same set share quantity for all component shares multiplied by its price, divided by a preset denominator known as the base. Some other stock indexes are capitalization-weighted indexes or are market value weighted, which involves a formula of the shares outstanding times price divided by some preset denominator. The NASDAQ Composite index is this type of index. In the second method, the larger capitalized companies have sway.
A variation of the capitalization-weighted index is the floating adjusted weighting index. The purpose of the adjustment is to account for the shares that are closely held and not readily available for trading. Shares that were issued and outstanding, but are reacquired by a company for use in some corporate strategy and are temporarily held as treasury stock, are examples of this concept. If the amount held totals 10 percent, the weighting would be multiplied by 90 percent.
The most well-known stock indexes are the general market indexes. The index is composed of selected common shares traded on a country’s financial markets. Listed below are some of the more popular ones:
NORTH AMERICA
CANADA
S&P TSX Composite = Based on the common shares of the largest companies traded on the Toronto Stock Exchange. It also includes income trust units.
MEXICO
IPC = Índice de Precios y Cotizaciones (Index of Prices and Quotations), a market-weighted selection of shares trading on the Mexican Bolsa representing all sectors of Mexico’s economy.
UNITED STATES
Dow Jones Industrial Average = Comprises thirty major industrial companies and is price weighted.
Standard & Poor’s 500 index = A free-floating index capitalization weighted index.
Standard & Poor’s 100 index = Known as the OEX, this is a capitalization-weighted index best known for the options that trade on it.
NASDAQ Index = A capitalization weighted index of approximately five thousand companies.
UNITED KINGDOM
FTSE 100 (aka “Footsie”) = Financial Times London Stock Exchange, a capitalization float weighted index comprising the one hundred largest market-capitalized stocks traded on the London Stock Exchange.
FRANCE
CAC 40 = Cotation Assistée en Continu (Continuous Assisted Quotation) = A free-floating market-capitalized index. The common shares selected from forty of the top one hundred companies traded on the Euronext exchange.
GERMANY
DAX = Deutscher Aktienindex (German Shares Index) = Thirty blue-chip stocks traded on the Frankfurt Stock Exchange and market capitalization weighted.
SPAIN
IBEX 35 = A capitalization-weighted index containing the thirty-five most liquid stocks traded on the Madrid Stock Exchange’s continuous market.
ASIA AND PACIFIC
AUSTRALIA
All Ordinaries = The equities of more than three hundred companies traded on the Australian Stock Exchange make up this market-weighted index.
CHINA
SSE = Shanghai Stock Exchange Composite Index = Contains shares of all the stocks, both A and B shares, traded on the Shanghai Stock Exchange. It is a market capitalization index.
HONG KONG
Hang Seng = Capitalization-weighted forty-stock index of companies traded on the Hong Kong Stock Exchange.
INDIA
Nifty = Known as the Nifty Fifty, this is a free-floating capitalization index of stocks traded on the National Exchange of India.
Topix = A capitalization-weighted index of all the stocks traded on the First Section of the Tokyo Stock Exchange.
Nikkei 225 = A price-weighted index of shares of the 225 largest companies traded on the Tokyo Stock Exchange.
KOREA
KOSPI Composite Index = A market capitalization index based on all the stocks traded on the South Korean Stock Exchange (Korea Stock Exchange).
SINGAPORE
Straits Times = Capitalization-weighted index of thirty companies traded on the Singapore Stock Exchange.
TURKEY
ISE = Istanbul Stock Exchange = 100 = stock index is a price-weighted index.
SOUTH AMERICA
ARGENTINA
MerVal = Mercado de Valores is a price-weighted index. The weighting is based on the stocks’ share of the overall trading done on the Argentina Stock Exchange.
BRAZIL
Bovespa (Bolsa de Valores do Estado de São Paulo) = A total return price-weighted index of fifty stocks. Its value represents the current worth of an investment made in the then fifty stocks on January 2, 1968, and includes all distributions, such as dividends (a total return index).
CHILE
IPSA = Índice de Precios Selectivo de Acciones comprises the forty most heavily traded stocks, revised quarterly.
GLOBAL
BBC Global 30 = Comprises the thirty largest companies by stock market value in the Americas, Asia, and Europe.
S&P Global 1200 = Covering thirty countries and about 70 percent of the global capitalization.
Many of the indexes above are accompanied by subindexes. The DAX index, for example, has a DAX subsector All Airlines index, and a DAX subsector Auto Parts and Equipment index to name just two. There are many indexes that are not listed here, such as the Russell and the Wilshire indexes, which are umbrella names for many subindexes. Russell indexes cover eighty-three markets worldwide and capture 98 percent of investible global equity.
One of the primary formulas used to calculate indexes are:
The Laspeyres index is calculated from the value of a basket of fixed assets, which is set as the base. The base is assigned the number 1. A calculation is then made on the value of the same basket of assets at a later time. The index value is equal to the ratio of the value of the basket at the end of the second period divided by the value of the first period.
Here’s an example:
On day 1 = Market value of 100 stocks set as Base 1.
On day X = Market value of same 100 stocks on day X divided by value determined in Base 1. The difference is the index.
While not directly involved with common stocks, many economic indexes are studied as they have an impact on the stock market. Among these are the Consumer Confidence Index (CCI) and the Consumer Price Index (CPI).
The Consumer Confidence Index measures the attitude of a sample of the public toward their current financial condition and what they see coming in the near term. Their collective attitude is thought to affect their spending habits, which in turn affects what and how much they will purchase.
The Consumer Price Index is the primary index that measures inflation. A variation of the CPI is the chain-weighted CPI, which not only tracks prices but tracks changes in the choices people are making. If product A and product B are in both indexes and the public begins to buy more of product B and less of product A, the chain-weighted CPI will reflect this; the CPI will not.
Here’s an example:
Last year the cost of an apple pie was $7.00 and a chocolate cake was $5.00. Your bakery sold twice as many chocolate cakes as apple pies. This year, apple pie was $6.00 and the chocolate cake was $9.00. Your bakery sold twice as many apple pies as it did chocolate cakes.
Your base year is (1 pie × $7.00 + 2 cakes × $5.00)
The CPI calculation would be:
(1 pie × $6.00 + 2 cakes × $9.00) / (1 pie × $7.00 + 2 cakes × $5.00)
$6.00 + $18.00 = $24.00 / $7.00 + $10.00 = $17.00
$24.00 / $17.00 = 1.411764 or an inflation level of 41.17%
The chained CPI calculation would be:
(2 pies × $6.00 + 1 cake × $9.00) / (1 pie × $7.00 + 2 cakes × $5.00)
$12.00 + $9.00 = $21.00 / $7.00 + $10.00 = $17.00
$21.00 / $17.00 = 1.235294 or an inflation level of 23.53% (rounded upward)
There are many other aspects related to working with stock indexes. Among the more important is the application of corporate actions such as stock splits, dividends, and mergers. Another key element is the criteria required to make changes to the indexes’ components. Let’s take a look at how they relate to derivative products.
Throughout this book, the mention of indexes has been as prevalent as the underlying product for derivative issues. The OEX options, which are listed for trading on the Chicago Board Options Exchange, have the Standard & Poor’s (S&P) 100 index as their underlying issue. There is an exchange-traded fund that uses the NASDAQ 100 index for a base. Companies such as Vanguard offer many products that are index based. Portfolio managers will “index” a portfolio—meaning they will structure a portfolio to replicate the performance of a particular index.
With the success of ETFs, the proliferation of indexes has grown geometrically. Indexes can be designed to cover debt instruments as well as equities. There are indexes that measure the volatility of financial products, or the activity of sectors, or the relationships between different industries. There is a volatility index (VIX) that measures the volatility in the prices and volume relation of put and call options on the S&P 500 index. The world of commodities has its own indexes, such as the Commodity Price Index and the Commodity Research Board (CRB) indexes.
The CRB Index, known as the CRB Futures Price Index, calculated by Thomson Reuters/Jefferies, measures the price movements of commodity sectors. The CRB BLS (Bureau of Labor Statistics) produces spot market indexes. Included in the group are the CRB BLS Spot Index, CRB BLS Metals Sub-Index, CRB BLS Textiles Sub-Index, CRB BLS Raw Industrials Sub-Index, CRB BLS Food Stuff Sub-Index, CRB BLS Fats and Oils Sub-Index, and CRB BLS Livestock Sub-Index.
Goldman Sachs has developed its own commodity index, now known as the S&P GSCI.
During different periods certain indexes have outperformed those of managed portfolios. In other words we have a tortoise and hare situation, with the index being the tortoise and the managers’ researched information and recommended strategies being the hare. Investors may request that the money manager “index” their portfolio to replicate a particular index. The money manager will then focus on altering the portfolio so that the securities contained therein will have a high correlation to the index.
The wide world of indexes and their uses can fill a book by itself. This section was merely intended to show their relevance to the derivatives market.
New derivative products will be introduced as the need arises, and those that become redundant or unnecessary will cease to exist. The industry is and always has been in transition. It has always been interesting to see how nonfinancial events affect different segments of the financial markets. For example, a drought or a flood in a particular region can affect prices of certain futures contracts, or a change in the tax law, such as the creation of individual retirement accounts, can have effects on the mutual fund industry segment. The increase in asset gathering by financial institutions, when combined with advancements in technology, allowed for the introduction of exchange-traded fund products.
The evolution of products, processes, and regulations will continue to move forward and events will raise new problems; resolution of those problems will be accomplished via new solutions. The Dodd-Frank Act, in its blending with other markets’ efforts, such as EMIR, will lead to global standards that we will all adhere to. In short order, the “mysterious” products discussed in this book will become commonplace and the next batch of “exotic” products will come along. It is all part of this dynamic and exciting industry. Those who look at their employment in the financial industry as just a “job” are missing out on participating in this interesting and ever-changing market. I trust this book answered some of your questions and that your time spent with it was worthwhile.