Indices mindbending poser......

[hjk]

I really feel as if I should know the answer to this (seemingly?) simple question but no-one else has ever been able to give me a satisfactory answer......

In this theoretical scenario lets say the FTSE100 index is at 5000.
The technology stocks are all the rage and at the next re-shuffling of the FTSE100 constituents 10 booming new technology stocks replace 10 boring old-economy stocks.
The FTSE100 index is still at 5000.

However the following week the technolgy bubble bursts and the share prices of those 10 recent FTSE100 entrants plummet causing the index to go down to say 4700. (the share prices of the other 90 constituents stay the same).

So at the next quarterly FTSE100 re-shuffle those 10 technology stocks are expelled to be replaced by those same 10 boring old-economy stocks from before. (their share prices have not moved in the interim).
The FTSE100 index is at 4700.

Now the constituents of the index and the price of the individual shares are the same as three months ago but 300 points have been lost from the value of the FTSE100 !

IS this Correct?
Is this, to a lesser degree, what happened in reality when Kingston Communications/Thus/etc joined and left the FTSE100 within the space of a few months?

Hope someone can put me out of my misery!

Many thanks

 

[TheBramble]

The index was (in your example) 5000 BEFORE the 10 old-economy stocks were replaced.

If they were brought back in, and all the 90 untouched stock values had remained the same AND the 10 old-economy stocks stayed the same (as you state) - the index would be 5000 again - not 4700.

 

[hjk]

If that is right then the index would go from 4700 to 5000 literally overnight, on the day the old stocks are reintroduced.

Is that correct? Still doesn't seem right......

 

[TheBramble]

hjk - as you say, it's your hypothetical situation. It wouldn't occur in reality. But the numbers, as you give them, would give you that exact position.

 

[hjk]

Thanks for the answer Bramble.

 

[theknifemac]

Don't think you are correct TheBramble, the divisor of the FTSE is always set so that the index stays the same when new stocks are added and old ones are removed. In the example given the weightings of all the stocks in the index would change as it is cap weighted.

Stew

 

[TheBramble]

HJK has stated, there has been no change (in his example) to either the share price or the market cap "Now the constituents of the index and the price of the individual shares are the same as three months ago" so the index would be exactly as it was 3 months prior.

If market cap and share price of the 100 companies is now exactly as it was 3 months ago, the index would be exactly as it was 3 months ago.

 

[theknifemac]

HJK has stated, there has been no change (in his example) to either the share price or the market cap "Now the constituents of the index and the price of the individual shares are the same as three months ago" so the index would be exactly as it was 3 months prior.

If market cap and share price of the 100 companies is now exactly as it was 3 months ago, the index would be exactly as it was 3 months ago.

Fraid not as the divisor would be adjusted to make the index level the same as the previous day i.e. 4700. Whenever the index constituents change the divisor is adjusted accordingly. Many years ago I wrote a tool which calculated the index in real time from the constituent prices, weightings and divisor. We were pretty good at getting hold of, or calculating the weightings but the divisor would often cause trouble.

Stew

 

[TheBramble]

I'm blown away by that one Stew!

So, (for argument's sake) - say the least best performer of the FTSE is thrown out next review when the FTSE stands at 6000.

The new boy on the block is another BP and weighs in at 25% the total market cap of the rest of the 99 FTSE constituents (I know, really hypothetical).

So the combined market cap of the FTSE100 is 125% of the previous day (Friday) - yet the divisor is adjusted to make Monday morning kick-off - at 6000?

The FTSE index reflects the activity +/- of the whole bunch.

What if we take this to its extreme and say the new stock represents 99.99% of the market cap of the FTSE100?

Does the index value stay the same? If so, what precisely is it measuring?

Not doubting your knowledge Stew, just my understanding of what the index represents.

 

[SOCRATES]

This is just so funny, what an entertaining thread !

It's quite simple really, why don't you address this poser to the Index Comittee of The London Stock Exchange, who sit regularly on the 18th floor of the tower, to decide what goes in and what comes out, and what weighting they will in their whizzdom, give it ?

 

[theknifemac]

TheBramble

You've got to remember the index tracks the value of its constituents, but when its constituents change the index will not change value overnight. Strangely enough, you could make a profitable trading strategy by buying the shares expected to come out of the index and selling the adds as the removed stocks tend to out perform and the adds tend to under perform (as they have already performed well to get into the index). The theory is that institutional investors cannot buy the adds and sell the removes until the index changes are announced, thus you can get in front of them by attempting to work out the index changes in advance. The rules are fairly simple, but sudden price movements around the time the decision is made can change things.

Stew

 

[TheBramble]

TKM - this is the same theory as "Dogs of the DOW" I believe.

 

[theknifemac]

TKM - this is the same theory as "Dogs of the DOW" I believe.

A bit similar yes. The last time I saw clients doing this when working for an IB, it was getting the case where people were wanting to put on the trade very early before anyone else, but obviously the earlier the trade is done the more risk there is that the constituents changes will change due to adverse price movements. Not something I have traded or likely to do, but interesting none the less.

I know in the US the Russell rebalance generates some huge portfolio trades, so I guess it is worthwhile knowing when the indices are about to change just in case you get caught up.

Stew

 

[hjk]

I knew it wasn't THAT simple !

The 'divisor' is the spanner in the works.
So my original theoretical situation IS possible (?) where the constituents of the index and their individual share prices are the same as several months ago but the index is a different figure.........yes?

Another way of saying it is that the index is NOT a direct indicator of total market capitalisation of the 100 constituents.......correct? .................or not?

academic maybe but interesting never-the-less.................

 

[TheBramble]

I'm still not so sure.

I've attached the rules for calculating the index which I pulled off the FTSE site.

If you look at rule 3.2 it mentions the divisor saying "the divisor is [then] adjusted when capitalisation amendments are made to the constituents of the index...".

Which is exactly (in your example) you were saying HADN'T occurred - no changes to cap.

So my original position still stands. If the divisor is only adjusted to "...allow the index to remain comparable over time" and no change to constituent market cap has occurred - it should be the same in the examples used above.

 

[theknifemac]

I'm still not so sure.

I've attached the rules for calculating the index which I pulled off the FTSE site.

If you look at rule 3.2 it mentions the divisor saying "the divisor is [then] adjusted when capitalisation amendments are made to the constituents of the index...".

Which is exactly (in your example) you were saying HADN'T occurred - no changes to cap.

So my original position still stands. If the divisor is only adjusted to "...allow the index to remain comparable over time" and no change to constituent market cap has occurred - it should be the same in the examples used above.

The Bramble

I've not looked at the document yet, but I think it is talking about the situation when a company in the index has a stock split or share issue. The FTSE Index is designed to track the value of companies in the index, and the divisor is used to adjust the index with the new constituents so it gives off the previous days closing prices the same index value as the old constituents had.

Sections 6.3.1 covers this (though on the subject of shares issues, where the index level should be unchanged due to changes in shares in issue.

In fact read 6.4.1 and that pretty much covers it
"When a company is added to or deleted from the index, the market capitalisation of that company is added to or deleted from the index and the total marker capitalisation will rise or fall accordingly. The index divisor is adjusted to maintain a constant index value."

It goes on to give an example.

You have to remember that the index shows the performance of the top 100 or so companies ranked by market capitalisation with rules in place for when stocks enter and leave the index. By definition higher market capitalisation stocks will replace lower cap stocks, but the index level is unchanged when the additions occur.

Stew

 

[theknifemac]

I knew it wasn't THAT simple !


Another way of saying it is that the index is NOT a direct indicator of total market capitalisation of the 100 constituents.......correct? .................or not?

academic maybe but interesting never-the-less.................

It IS a direct indicator of the total market cap of stocks WHEN they are in the index. You are confusing changes that occur when the stocks are outside the index....

Stew

 

[Rognvald]

Tony
Have you thought of trying apply the laws of thermodynamics to this little problem?

"Energy exists in many forms, such as heat, light, chemical energy, and electrical energy. Energy is the ability to bring about change or to do work. Thermodynamics is the study of energy.

First Law of Thermodynamics: Energy can be changed from one form to another, but it cannot be created or destroyed. The total amount of energy and matter in the Universe remains constant, merely changing from one form to another. The First Law of Thermodynamics (Conservation) states that energy is always conserved, it cannot be created or destroyed. In essence, energy can be converted from one form into another.

The Second Law of Thermodynamics states that "in all energy exchanges, if no energy enters or leaves the system, the potential energy of the state will always be less than that of the initial state." This is also commonly referred to as entropy. A watchspring-driven watch will run until the potential energy in the spring is converted, and not again until energy is reapplied to the spring to rewind it. A car that has run out of gas will not run again until you walk 10 miles to a gas station and refuel the car. Once the potential energy locked in carbohydrates is converted into kinetic energy (energy in use or motion), the organism will get no more until energy is input again. In the process of energy transfer, some energy will dissipate as heat. Entropy is a measure of disorder: cells are NOT disordered and so have low entropy. The flow of energy maintains order and life. Entropy wins when organisms cease to take in energy and die."