Lectures 1-3: Assets, Asset Classes, and Financial Instruments

Stock and Bond Market Indices

• Price-weighted

• Value-weighted

• Equally-weighted

Price-Weighted Average

computed by adding the prices of the stock and dividing by a “divisor”

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the percentage change in the DJIA measures the return (excl dividends) on a portfolio investing one share in each index stock

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Gives higher-priced shares more weight in determining the performance of the index

Price-Weighted Index

Equivalent to buying one share of each firm on the index and tracking portfolio return

+Easy to calculate

-Needs split adjusting

What kind of index is the DJIA (Dow Jones Industrial Average)?

Price-weighted average of 30 large corporations

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The percentage change in the DJIA measures the return (excl dividends) on a portfolio investing one share in each index stock

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The amount of money invested in each company is proportional to that company’s share price

Consider this hypothetical 2-stock version of the DJIA and compare the changes in the value of the portfolio and price-weighted index.

What is the starting index value?

Ending index value?

Index return?

Stock	P1	P2	Shares	% Change
A	$25	$30	20	20%
B	$100	$90	1	-10%

Starting Index Value (Avg of initial prices)

(25 + 100)/ 2 = 62.5

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Ending Index Value (Avg of final prices)

(30 + 90)/ 2 = 60

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Index Return (% change)

(60 - 62.5) / 62.5 = -0.04 or -4%

Consider this hypothetical 2-stock version of the DJIA and compare the changes in the value of the portfolio and price-weighted index.

What happens in a stock split? What is the index return?

Stock	P1	P2	Shares 1	Shares 2
A	$25	$30	20	20
B	$100	$45	1	2

1) Starting Index Value

(25 + 100) / 2 = 62.5

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2) Adjust the divisor (d) so the index value stays the same as if there were no changes in the stock prices (other than the split)

100 (previous price)/2 (new number of shares) = 50 (new price as if there were no changes)

(25 + 100) / 2 = (25 + 50) / d → d = 75 / 62.5 = 1.2

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3) Calculate the ending index value using d

(30 + 45) / 1.2 = 62.5

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4) Calculate the index return

(62.5 - 62.5) / 62.5 = 0%

*the value of the index doesn’t change, but the return is affected as the relative weights change

Value-Weighted Index

Equivalent to buying stock in firms proportional to their market capitalization

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Computed by calculating a weighted average of the returns of each security in the index (500 firms)

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+Driven by larger, more widely owned firms

+Does not need split-adjusting

-Overweights overpriced firms, underweights underpriced firms

What kind of index is the S&P 500?

Market Value-Weighted Index of 500 firms computed by calculating the total market value of those firms on the previous day of trading

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Percentage increase in the total market value represents the increase in the index

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The rate of return of the index = the rate of return earned by an investor holding a portfolio of all 500 firms in proportion to their market value (excl dividends)

Consider this hypothetical 2-stock version of the S&P 500 and compare the changes in the value of the portfolio and value-weighted index.

Starting index value?

Ending index value?

Index return?

Stock	P1	P2	Shares 1	% Change
A	$25	$30	20	20%
B	$100	$90	1	-10%

Starting index value (beginning market cap)

(Shares 1 × Price 1) + (Shares 2 × Price 2)

(20 × 25) + (1 × 100) = 600

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Ending index value

(20 × 30) +(1 × 90) = 690

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Index return

(690 - 600) / 600 = 0.15 or 15%

Consider this hypothetical 2-stock version of the S&P 500 and compare the changes in the value of the portfolio and value-weighted index.

What happens in a stock split? What is the index return?

Stock	P1	P2	Shares 1	Shares 2
A	$25	$30	20	20
B	$100	$45	1	2

Doesn’t change anything because the # of shares is already considered and market cap is unaffected

Equal-Weighted Index

Equivalent to investing equal dollars in each stock in the index

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Computed from a simple average of returns

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Do not correspond to buy-and-hold portfolio strategies, therefore must reset the portfolio to equal weights or rebalance by purchasing/selling

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+Companies are on an even playing field

-Frequent rebalancing causes high transaction costs

Consider this hypothetical 2-stock version of the S&P 500 Equal and compare the changes in the value of the portfolio and value-weighted index.

Starting index value?

Ending index value?

Index return?

Stock	P1	P2	Shares 1	% Change
A	$25	$30	20	20%
B	$100	$45	1	-10%

Starting index value (sum of all stocks)

The minimum investment value is the lowest common multiple

$100 for each stock, 4 shares of A (100/25=4) and 1 share of B

$100 × 2 = $200

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Ending index value (shares owned with price change)

(4 × 30) + (1 × 90) = $210

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Index return

(210 - 200) / 200 = 0.05 or 5%

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NEEDS REBALANCING, IN THE NEXT PERIOD:

$120 in A, $90 in B so sell $15 worth of A and buy $15 worth of B

Consider this hypothetical 2-stock version of the S&P 500 Equal and compare the changes in the value of the portfolio and value-weighted index.

What happens in a stock split? What is the index return?

Stock	P1	P2	Shares 1	Shares 2
A	$25	$30	20	20
B	$100	$45	1	2

Unaffected since equal dollars are invested

Derivative markets include:

Options and Futures

Option Types:

Call option: right to buy an asset at the exercise/strike price at or before expiration

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Put option: right to sell an asset at the exercise/strike price at or before expiration

Option Premium

Price of the option contract

Futures (Forwards)

Help hedge volatility

• Long = obligation to buy an asset at an agreed-upon price at a specified future date

• Short = obligation to sell an asset at an agreed-upon price at a specified future date

Important features: delivery date and the deliverable item

*Negative oil prices due to futures during the pandemic

Difference between options and futures

Options have writers

A futures contract is an obligation

An options contract is a right

Difference between forwards and futures

Futures trade on organized exchanges

Futures are highly standardized and regulated

Forward are deal-specific agreements written between two parties