Chapter 5
Q3. Explain how a market index is price-weighted. In such a case, would you expect a $100
stock to be more important than a $25 stock? Give an example.
Answer: A price-weighted series is an unweighted arithmetic average of current prices of the securities
included in the sample - i.e., closing prices of all securities are summed and divided by the
number of securities in the sample.
A $100 security will have a greater influence on the series than a $25 security because a 10
percent increase in the former increases the numerator by $10 while it takes a 40 percent
increase in the price of the latter to have the same effect.
Q4. Explain how to compute a value-weighted index.
Answer: A value-weighted index begins by deriving the initial total market value of all stocks used in the
series (market value equals the number of shares outstanding times the current market price).
The initial value is typically established as the base value and assigned an index value of 100.
Subsequently, a new market value is computed for all securities in the sample and this new
value is compared to the initial value to derive the percent change which is then applied to the
beginning index value of 100.
Q5. Explain how a price-weighted index and a value-weighted index adjust for stock splits.
Answer: Given a four-security series and a 2-for-1 split for security A and a 3-for-1 split for security B,
the divisor would change from 4 to 2.8 for a price-weighted series.
Stock Before Split Price After Split Prices
A $20 $10
B 30 10
C 20 20
D 30 30
Total 100/4 = 25 70/x = 25
x = 2.8
The price-weighted series adjusts for a stock split by deriving a new divisor that will ensure that
the new value for the series is the same as it would have been without the split. The adjustment
for a value-weighted series due to a stock split is automatic. The decrease in stock price is offset
by an increase in the number of shares outstanding.
Before Split
Stock Price/Share # of Shares Market Value
A $20 1,000,000 $20,000,000
B 30 500,000 15,000,000
C 20 2,000,000 40,000,000
D 30 3,500,000 105,000,000
Total $180,000,000
The $180,000,000 base value is set equal to an index value of 100.
After Split
Stock Price/Share # of Shares Market Value
A $10 2,000,000 $20,000,000
B 10 1,500,000 15,000,000
C 20 2,000,000 40,000,000
D 30 3,500,000 105,000,000
Total $180,000,000
Current Market Value
New Index Value = x Beginning Index Value
Base Value
180,000,000
= x 100
180,000,000
= 100
which is precisely what one would expect since there has been no change in prices other than the split
Q 6. Describe an unweighted price index and describe how you would construct such an index. Assume a
20 percent price change in GM ($40/share; 50 million shares outstanding) and Coors Brewing
($25/share and 15 million shares outstanding). Explain which stock’s change will have the greater impact
on this index.
Answer: In an unweighted price indicator series, all stocks carry equal weight irrespective of their price
and/or their value. One way to visualize an unweighted series is to assume that equal dollar
amounts are invested in each stock in the portfolio, for example, an equal amount of $1,000 is
assumed to be invested in each stock. Therefore, the investor would own 25 shares of GM
($40/share) and 40 shares of Coors Brewing ($25/share). An unweighted price index that
consists of the above three stocks would be constructed as follows:
Stock Price/Share # of Shares Market Value
GM $ 40 25 $1,000
Coors 25 40 1,000
Total $2,000
A 20% price increase in GM:
Stock Price/Share # of Shares Market Value
GM $ 48 25 $1,200
Coors 25 40 1,000
Total $2,200
A 20% price increase in Coors:
Stock Price/Share # of Shares Market Value
GM $ 40 25 $1,000
Coors 30 40 1,200
Total $2,200
Therefore, a 20% increase in either stock would have the same impact on the total value of the
index (i.e., in all cases the index increases by 10%. An alternative treatment is to compute
percentage changes for each stock and derive the average of these percentage changes. In this
case, the average would be 10% (20% - 10%)). So in the case of an unweighted price-indicator
series, a 20% price increase in GM would have the same impact on the index as a 20% price
increase in Coors Brewing.
Q 8. There are high correlations between the monthly percentage price changes for the alternative NYSE
indexes. Discuss the reason for this similarity: is it the size of the sample, source of the sample, or
method of computation?
Answer: The high correlations between returns for alternative NYSE price indicator series can be
attributed to the source of the sample (i.e. stock traded on the NYSE). The four series differ in
sample size, that is, the DJIA has 30 securities, the S&P 400 has 400 securities, the S&P 500 has
500 securities, and the NYSE Composite has over 2,800 stocks. The DJIA differs in computation
from the other series, that is, the DJIA is a price-weighted series whereas the other three series
are value-weighted. Even so, there is a strong corre lation between the series because of the
similarity of types of companies.
Math Problem:
Q 6. Based on the following stock price and shares outstanding information, compute the beginning and
ending values for a price-weighted index and a market-value-weighted index.
DECEMBER 31, 2011 DECEMBER 31, 2012
Shares Shares
Price Outstanding Price Outstanding
Stock K 20 100,000,000 32 100,000,000
Stock M 80 2,000,000 45 4,000,000a
Stock R 40 25,000,000 42 25,000,000
a
Stock split two-for-one during the year.
a. Compute the percentage change in the value of each index during the year.
b. Explain the difference in results between the two indexes.
c. Compute the percentage change for an unweighted index and discuss why these results
differ from those of the other indexes.
Answer: Price-weighted index (PWI)2002 = (20 + 80+ 40)/3 = 46.67
To account for stock split, a new divisor must be calculated:
(20 + 40 + 40)/X = 46.67
X = 2.143 (new divisor after stock split)
Price-weighted index2003 = (32 + 45 + 42)/2.143 = 55.53
VWI2002 = 20(100,000,000) + 80(2,000,000) + 40(25,000,000)
= 2,000,000,000 + 160,000,000 + 1,000,000,000
= 3,160,000,000
assuming a base value of 100 and 1998 as the base period, then
(3,160,000,000/3,160,000,000) x 100 = 100
VWI2003 = 32(100,000,000) + 45(4,000,000) + 42(25,000,000)
= 3,200,000,000 + 180,000,000 + 1,050,000,000
= 4,430,000,000
assuming a base value of 100 and 2002 as the base period, then
(4,430,000,000/3,160,000,000) x 100 = 1.4019 x 100 = 140.19
6(a). Percentage change in PWI = (55.53 - 46.67)/46.67 = 18.99%
Percentage change in VWI = (140.19 - 100)/100 = 40.19%
6(b). The percentage change in VWI was much greater than the change in the PWI because the
stock with the largest market value (K) had the greater percentage gain in price (60%
increase).
6 (c) December 31, 2002
Stock Price/Share # of Shares Market Value
K $20 50.0 $1,000.00
M 80 12.5 1,000.00
R 40 25.0 1,000.00
Total $3,000.00
December 31, 2003
Stock Price/Share # of Shares Market Value
K $32 50.0 $1,600.00
M 45 25.5* 1,125.00
R 42 25.0 1,050.00
Total $3,775.00
3,775. 00-3,000 775 . 00
Percentage change = = =25 . 83 %
3 ,000 3 ,000
(*Stock-split two-for-one during the year.)
Unweighted averages are not impacted by large changes in stocks prices (i.e. price-weighted
series) or in market values (i.e. value-weighted series
Geometric average =[(1.60)(1 .125 )(1.05 )]1/3 - 1
¿[ 1. 89 ]1/3−1
¿1.2364−1
¿.2364 or 23.64%
6(c). December 31, 2002
Stock Price/Share # of Shares Market Value
K $20 50.0 $1,000.00
M 80 12.5 1,000.00
R 40 25.0 1,000.00
Total $3,000.00
December 31, 2003
Stock Price/Share # of Shares Market Value
K $32 50.0 $1,600.00
M 45 25.5* 1,125.00
R 42 25.0 1,050.00
Total $3,775.00
(*Stock-split two-for-one during the year.)
3,775. 00-3,000 775 . 00
Percentage change = = =25 . 83 %
3 ,000 3 ,000
Geometric average =[(1.60)(1 .125 )(1.05 )]1/3 - 1
¿[ 1. 89 ]1/3−1
¿1.2364−1
¿.2364 or 23.64%
Unweighted averages are not impacted by large changes in stock prices (i.e. price-weighted
series) or in market values (i.e. value-weighted series).