Stock Market Index

Table Of Contents 1.0 INTRODUCTION.....................................................................................................................1 2.0 History of Security Market Indices............................................................................................2 3.0 Characteristics of a good Stock Market Index.........................................................................12 4.0 Classification of Stock Market Indices....................................................................................14 5.0 Purpose of Stock Market Index...............................................................................................17 6.0 Types of Stock Indices.............................................................................................................20 7.0 Construction of a Stock Market Index.....................................................................................21 8.0 Computation of Stock Market Indices.....................................................................................26 9.0 How is the NSE 20 Share Index Derived?...............................................................................40 10.0 Stock Market Robustness......................................................................................................45 11.0 Usefulness and Application of Stock Indices.........................................................................47 12.0 Stock Market Crash and Stock Indices..................................................................................52 13.0 Developments in Stock Indices.............................................................................................59 14.0 How Stock Market Indices have changed investing..............................................................60 15.0 References..............................................................................................................................62

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1.0 INTRODUCTION 1.1 What is an Index? According to the financial dictionary, an index is a Statistical composite that measures changes in the economy or in financial markets, often expressed in percentage changes from a base year or from the previous month. Indexes measure the ups and downs of stock, bond, and some commodities markets, in terms of market prices and weighting of companies in the index. An index's value may be weighted; for example, securities with higher prices or greater market capitalization may affect the index's value more than others. One of the most prominent examples of an index is the Dow Jones Industrial Average, which is weighted for price and tracks 30 stocks important in American markets. Construction of an index is very important for an investor as it helps an investor in the following ways; It shows the performance of a basket of equities instead of just a single equity, i.e. is shows the level of diversification. This helps an investor in making decisions that shall diversify risk by investing negatively correlated securities. It can also show the performance of a meticulous class of assets. For example, in the Nairobi Securities exchange, the performance of the banking sector compared to the telecommunications sector. This helps in investor decision making when it comes to selection of the securities to invest in. This is because percentage change of the index assists investor in predicting the direction in which the market trend will move. An index can also be used to provide a generic securities category for passive management and derivatives (passive investing). A security market index represents a given security market, market segment, or asset class. 1.2 Stock Market Indices A stock index or stock market index is a method of measuring the value of a section of the stock market (Amihud, Hauser and Kirsh, 2003). It is computed from the prices of selected stocks. As per Benic and Franic (2008), it is a tool used by investors and financial managers to describe the market, and to compare the return on specific investments. A stock market index is a bunch of stocks grouped together to measure a certain sector (utilities, banks, tech stocks, etc.) of the stock 2

market (Brealey and Myers, 2003). As explained by (Martinez, 2010) as the stocks in the group change, the index will also change its value. If an index goes up by 4% it means the total value of the stock which makes up the index also goes up by 4% in value. 2.0 History of Security Market Indices Security market indices were first introduced as a simple measure to reflect the performance of the U.S. stock market. Since then, security market indices have evolved into important multipurpose tools that help investors track the performance of various security markets, estimate risk, and evaluate the performance of investment managers. They also form the basis for new investment products. To give readers a sense of how the U.S. stock market in general performed on a given day, publishers Charles H. Dow and Edward D. Jones introduced the Dow Jones Average, the world’s first security market index, in 1884. The index, which appeared in The Customers’ Afternoon Letter, consisted of the stocks of nine railroads and two industrial companies. It eventually became the Dow Jones Transportation Average. Convinced that industrial companies, rather than railroads, would be “the great speculative market” of the future, Dow and Jones introduced a second index in May 1896, the Dow Jones Industrial Average (DJIA). It had an initial value of 40.94 and consisted of 12 stocks from major U.S. industries. Chapple, Kousis and Lewis (2007) argue that, Stock market indices are the barometers of the stock market. They added that stock indices mirror the stock market behavior. For Instance, with some 7000 companies listed on the Bombay stock exchange, it is not possible to look at the prices of every stock to find out whether the market movement is upwards or downwards. The indices represent the market. Kakiya (2010) defines stock index as an aggregate value produced by combining several stocks or other investment vehicles together and expressing their total values against a base value from a specific date. Market indexes are intended to represent an entire stock market and thus track the market's changes over time (Gajewski and Gresse, 2006).

2.1 How Index Changed Investing 3

The impact of indexes on investing was, and continues to be, huge. On the most basic level, indexes brought transparency and a better understanding of market forces. Dow theory, pioneered by Charles Dow and elaborated upon by his predecessor, was one of the first attempts at technical analysis. Indexes have also been invaluable to contrarians, traders and momentum investors, by giving them a measure of overall market sentiment. Most of all, indexes created a benchmark for investors and money managers to measure up against. The creation of this benchmark also encouraged a segment of the investing population to choose a less active route and settle for more modest returns, thus marking the first time in investing history where it became possible for people with little financial knowledge to control their own portfolios. There are now indexes for technology stocks, pharmaceuticals and any subset within the financial world that an investor would care to know. The challenge for investors is no longer how to get reliable market information, but what to do with it. Some of the oldest indices were the Dow Jones Industrial average, NASDAQ and S&P 500. 2.1.1 Dow Jones Industrial Average Charles H. Dow, a finance journalist, unveiled the first stock index in 1896. His Dow Jones Industrial Average was an average of the top 12 stocks in the market. As this was just at the tail end of the industrial revolution, the majority of these companies were in the industrial sector (steel mills, railroads, mining, etc.). He calculated the DJIA by taking all of the stock prices, adding them together and then dividing them by the number of stocks. The number that came out of this equation on May 26, 1896, was 40.94. The range of the Dow has since been expanded. Stock market indices are an important part of modern stock markets. The Dow Jones Industrial Average is arguably the most important index in the world. The index was one of several indices first created by Wall Street Journal editor Charles Dow, who also co-founded Dow Jones & Company (the other co-founder was notable investor Edward Jones). Examples of companies listed in the Dow Jones; American Express, 3M, Goldman Sachs, General Electric, DuPont, Coca-Cola, IBM to name a few.

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The DJIA is a list of some of the wealthiest and most powerful companies in America. General Electric is the longest-running company on the index, having last been added in 1907. General Electric is also the only company on the DJIA that was also on the original DJIA. To calculate the DJIA, the sum of the prices of all 30 stocks is divided by a divisor, the Dow Divisor. The divisor is adjusted in case of stock splits, spinoffs or similar structural changes, to ensure that such events do not in themselves alter the numerical value of the DJIA. Early on, the initial divisor was composed of the original number of component companies; which made the DJIA at first, a simple arithmetic average. The present divisor, after many adjustments, is less than one (meaning the index is larger than the sum of the prices of the components). That is:

Where p is the prices of the component stocks and d is the Dow Divisor. Events like stock splits or changes in the list of the companies composing the index alter the sum of the component prices. In these cases, in order to avoid discontinuity in the index, the Dow Divisor is updated so that the quotations right before and after the events coincide:

2.1.2 NASDAQ Composite Index In 1985, the NASDAQ introduced its own index to compete with the S&P. The NASDAQ 100 was designed as a market-weighted index that contained more companies from the technology sector - largely unmapped territory at the time. The NASDAQ itself was designed to market these stocks and it had been steadily growing in power as both the computer and the internet brought technology into people's homes.

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The term NASDAQ first originated as an acronym for the National Association of Securities Dealers Automated Quotation systems, commencing in 1971. It was the first electronic exchange where investors could buy and sell stock as mentioned earlier in this text. Today, when people mention the NASDAQ, they are generally referring to the NASDAQ Composite Index, which like the Dow, tracks a large number of company stock values. However, instead of tracking large-cap companies as the Dow does, the NASDAQ Composite Index is heavily weighted in approximately 3,000 technology, biotech, and Internet companies that are considered to have high growth potential and are therefore typically more volatile than the average market. It includes both US and non-US companies, and unlike the Dow, the NASDAQ is market cap weighted. The dot-com boom in the late nineties, the Internet then became a mainstream and thousands of tech companies appeared out of nowhere. As the early adopter companies began soaking up the online market share, investors were salivating as well. They wanted to capitalize on the growing online market and began buying shares of the new tech companies. This increase in demand boosted share prices, which attracted even more investors until the stocks became wildly overvalued and the tech bubble popped. Since the NASDAQ Composite Index is largely made up of Internet and tech companies, it followed the wild ride of the tech bubble as well. In the year 2000, the NASDAQ Index reached an amazing peak of 5,132.52 but was soon devastated as many of the tech companies lost a tremendous amount of value and went bankrupt. Today, the NASDAQ Index is still often more volatile than the Dow. Examples of companies listed in NASDAQ; Adobe, Apple, Amazon, Facebook, Intel, Mercantile Bank Corp to name a few. 2.1.3The S&P 500 Composite Index Standard & Poor's 500 trace its roots to 1860, when Henry Varnum Poor published "History of the Railroads and Canals of the United States." Rather than being a literal history of the railroad, it was the first financial history of all the companies laying track or digging canals in the United States. Poor hoped that his book would help get information to investors outside the banking district. Its success led him to publish the Manual of the Railroads of the United States on an annual basis.

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The S&P 500 Composite Index was launched on a small scale in 1923 and was originally named the Composite Index prior to the merger between Poor’s Publishing and Standard Statistics. The Index started off tracking just a few companies, climbed to 90 in 1926, and by 1957 was made up of 500 different companies and renamed the Standard and Poor’s 500 Composite Index. It still tracks 500 companies today that are selected by an S&B Board. The S&P 500 is designed to be a leading indicator of US equities and reflects the rewards and risks of the large cap universe. While somewhat similar to the Dow, many people argue that the S&P 500 is a better representation of the US large cap market because of the large volume of companies it tracks in comparison to the Dow’s 30. As a result, it includes more sectors as well. Like the NASDAQ, each stock is given a weighting based on its market value not the actual stock price. A few examples of the current companies in this index are; 3M, AIG, AMZN, Coca Cola, Delta Airlines to name a few. 2.1.4 The Wilshire 5000 The Wilshire 5000 is sometimes called the "total stock market index" or "total market index" because almost all publicly-traded companies with headquarters in the U.S. that have readily available price data are included in the Wilshire 5000. Finalized in 1974, this index is extremely diverse, including stocks from every industry. Although it's a near-perfect measure of the entire U.S. market, the Wilshire 5000 is referred to less often than the less comprehensive S&P 500 when people talk about the entire market. 2.1.5 The Russell 2000 The Russell 2000 is a market-capitalization-weighted index of the 2,000 smallest stocks in the Russell 3000, an index of the 3,000 largest publicly-traded companies, based on market cap, in the U.S. stock market. The Russell 2000 index gained popularity during the 1990s, when smallcap stocks soared and investors moved more money to the sector. The Russell 2000 is the bestknown indicator of the daily performance of small companies in the market; it is not dominated by a single industry. 2.2 Other Indices around the world

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There are many other indices beyond the major three. These are some of the major and very import stock indices around the globe which even in tend to appear in the Nairobi Capital market news as the operations of all of them intend to affect the operations on the Kenyan economy as well due to the effects of Globalization. Below are a few examples of the many indices available across the world: 2.2.1 FTSE 100 Index The Financial Times Stock Exchange 100 Index, also called the FTSE 100 Index, FTSE 100, FTSE is a share index of the 100 companies listed on the London Stock Exchange with the highest market capitalization. It is seen as a gauge of prosperity for businesses regulated by UK company law. The index is maintained by the FTSE Group, a subsidiary of the London Stock Exchange Group. The index began in 1984 with a base level of 1000 and it rises and falls according to the share price performance of the 100 companies within it. The highest value ever reached by the FTSE 100 was 6950.6 in December 1999. The components of the index are assessed every three months. If a company’s shares have underperformed, it may fall out of the index to be replaced by another company, whose shares have performed relatively better. Generally, two or three companies drop out of the FTSE 100 every quarter. In the UK, the FTSE 100 is frequently used by large investors, stock brokers, financial experts and the media as a guide to stock market performance. The index is updated continuously throughout the working day and a closing price is calculated at 16.30 each trading day. It is possible to buy funds that invest in all the companies within a particular index. These are known as index funds. Continuous trading on the London Stock Exchange starts at 08:00 and ends at 16:30 (when the closing auction starts), and closing values are taken at 16:35. Examples of some of the companies listed in the FTSE 100 are: Barclays, British American Tobacco, Kingfisher plc, Pearson plc, Rolls-Royce group, Standard Chartered, Tesco and many more.

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In the FTSE indices, share prices are weighted by market capitalization, so that the larger companies make more of a difference to the index than smaller companies. The basic formula for these indices is:

The Free float Adjustment factor represents the percentage of all issued shares that are readily available for trading. The factor is then rounded up to the nearest multiple of 5%. To find the free-float capitalization of a company, first find its market cap (number of shares x share price) then multiply by its free-float factor. Free-float capitalization, therefore, does not include restricted stocks, such as those held by company insiders.

2.2.2 HANG SENG Index (HIS) The Hang Seng Index (HIS) is a free float-adjusted market capitalization-weighted stock market index in Hong Kong. It is used to record and monitor daily changes of the largest companies of the Hong Kong stock market and is the main indicator of the overall market performance in Hong Kong. These 50 constituent companies represent about 58% of the capitalization of the Hong Kong Stock Exchange. HSI was started on November 24, 1969, by Hong Kong banker Stanley Kwan and is currently compiled and maintained by Hang Seng Index Company Limited, which is a wholly owned subsidiary of Hang Seng Bank, one of the largest banks registered and listed in Hong Kong in terms of market capitalisation. Hang Seng in turn, despite being a public company, is held in majority by British financial firm HSBC. Hang Seng is made up of various sub index such as: finance, utilities, properties, commerce & industry. The current Hang Seng Index is calculated from this formula: 9

Where: P (t)：Current Price at Day t P(t-1)：Closing Price at Day (t-1) IS: Issued Shares (Only H-share (are regulated by chinese law and are freely tradable) portion is taken into calculation in case of H-share constituents) FAF：Free float-adjusted Factor, which is between 0 and 1, adjusted quarterly CF：Cap Factor, which is between 0 and 1, adjusted quarterly 2.2.3 NIKKEI Index The Nikkei index or the Nikkei Stock Average is a stock market index for the Tokyo Stock Exchange (TSE). It has been calculated daily by the Nihon Keizai Shimbun (Nikkei) newspaper since 1950. It is a price-weighted index , and the components are reviewed once a year. Currently, the Nikkei is the most widely quoted average of Japanese equities, similar to the Dow Jones Industrial Average. In fact, it was known as the "Nikkei Dow Jones Stock Average" from 1975 to 1985. The Nikkei 225 began to be calculated on September 7, 1950, retroactively calculated back to May 16, 1949. Since January 2010 the index is updated every 15 seconds during trading sessions. Nikkei 225 index is a price weighted index where the sum of the constituent stock prices adjusted by the presumed par value is divided by the divisor. Adjusted stock price = stock price x 50(yen) / presumed par value (yen) Nikkei Stock Average = sum of Adjusted stock price / Divisor

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Examples of some of major companies listed in Nikkei are: Honda motor, mazda motor, Isuzu motors, Mitsubishi Motors, Nissan motors, Suzuki motors, Toyota Motors, Konica Minolta holdings, Nikon Corp, Yamaha corp and many others.

2.2.4 SENSEX Index The S&P BSE SENSEX (S&P Bombay Stock Exchange Sensitive Index), also-called the BSE 30 or simply the SENSEX, is a free-float market-weighted stock market index of 30 wellestablished and financially sound companies listed on Bombay Stock Exchange. The 30 component companies which are some of the largest and most actively traded stocks, are representative of various industrial sectors of the Indian economy. Published since 1 January 1986, SENSEX is regarded as the pulse of the domestic stock markets in India. The base value of SENSEX is taken as 100 on 1 April 1979, and its base year as 1978–79. As of 21 April 2011, the market capitalisation of SENSEX was about ₹29733 billion (US$440 billion) (47.68% of market capitalisation

of

BSE),

while

its

free-float

market

capitalisation

was ₹15690

billion (US$232 billion). The formula is used to calculate the SENSEX index: (Sum of Free Float Market Capital / Base Market Capital ) x 100 Examples of some of the companies listed in the SENSEX indice are: Tata motors, Reliance industries ltd, Maruti Suzuki, State Bank of India, HDFC bank, ICICI Bank, Bajaj Auto ltd and many more. 2.2.5 The FTSE/ JSE All Share Index The FTSE/JSE All Share Index is a major stock market index which tracks the performance of all companies listed on the Johannesburg Stock Exchange in South Africa. It is a free-float, market capitalization weighted index. The FTSE/JSE All Share Index has a base value of 10815.08 as of June 21, 2002. The FTSE/JSE Africa Index Series are arithmetic weighted indices where the weights are the free float market capitalization of each company. The price index is the summation of the market 11

values (or capitalizations) of all companies within the index and each constituent company is weighted by its market value (shares-in-issue multiplied by share price multiplied by investibility weighting). The investibility weighting is also called the free float factor. The price movement of a larger company (say, representing five per cent of the value of the index) will, therefore, have a larger effect on the index than a smaller company (say, representing one per cent of the value of the index). The formula used for calculating the indices is straightforward. However, determining the capitalization of each constituent company and calculating the capitalization adjustments to the index are more complex. T The index value itself is simply a number that represents the total market value of all companies within the index at a particular point in time compared to a comparable calculation at a starting point. The daily index value is calculated by dividing the total market value of all constituent companies by a number called the divisor. The divisor is an arbitrary number chosen at the starting point of the index to fix the index starting value (say, at 100.0). The divisor is then adjusted when capitalization amendments are made to the constituents of the index allowing the index value to remain comparable over time. Index Value =Total market value of all companies / Latest index divisor 2.2.6 NSE 20 Share Index The NSE 20-Share Index was introduced in 1964; The NSE 20-Share Index (NSE 20) is the long-standing benchmark index used for equities traded on Kenya's Nairobi Securities Exchange (NSE) and represents the geometric mean of share prices of the NSE's 20 top stocks. Examples of the Components of NSE 20 are; Athi River Mining, Bamburi Cement, Barclays Kenya, British American Tobacco Kenya, Centum Investments, EABL, Nation Media Group to name a few. 2.2.7 NSE All Share Index (NASI) In 2008, the NSE All Share Index (NASI) was introduced as an alternative index at the Nairobi Securities Exchange. Its measure is an overall indicator of market performance. The Index 12

incorporates all the traded shares of the day. Its attention is therefore on the overall market capitalisation rather than the price movements of select counters. 3.0 Characteristics of a good Stock Market Index According to Shilling (1996) indices should be calculated, maintaned and constructed according to a set of published objectives including rules and guide lines. This is because rules and guide lines provide investors an opportunity to properly evaluate a benchmark in regard to how it measures the relevant market and its significance to a particular scenerio. Shilling defined the following attributes that are associated with a well constructed indices (1996, pp. 27-28); The index should be relevant and appropriate. It should track the relevant markets, market segments, instruments, individual securities and investment style. The index should be comprehensive or broad based, incorporating to the extent appropriate, the markets, security types and individual securities that reflect the investment opportunities available to investors. The index should be investable and market participants should be able to replicate it. A useful index consists of securities that can be purchased by investors, local and foreign, retail and institutional investors. The index should be maintained accurately and reliably, with a stated corrections policy regarding prices, capital changes, dividends, exchange rates to reflect the actual changes in the value of the portfolio instead of the influence of other factors. The index should be transparent. In addition to information regarding security selection and maintenance policies involving the addition and deletion of companies, calculation methodologies and related practices should be disclosed by the index publisher. The index should be constructed so that each security’s return is weighted according to its market value at the beginning of the period the return is measured. The index should be published frequently , disseminated on a timely basis and be readily available to investors. In addition to price only returns, the index should also measure total rates of return. The latter includes cash dividends recorded in the period received and reinvested at the earliest date in the market. While with bonds, total rates of return should include the reinvestment of interest income received or accrued, as may be appropriate and principal payments, where applicable. Thomas (2005) furthermore, gave a more detailed explanation on each of the. A good stock market index possesses several characteristics. 13

3.1 Representation Any good index must develop methods that provide more representative samples over time. The sample must, in other words, act as a micro-version of the larger market in nearly all respects. This means that within the parameters of an index, including small companies, technology companies, or utilities, the companies selected should be the most representative within that field. This requires the index to list a diverse and controlled group of companies. If, for example, the field is pharmaceuticals, the index must list its large firms, smaller specialty firms and laboratories. Other factors held constant, a larger number of stocks in the index, the better it reflects the overall market performance. According to (Thomas, 2005) It quickly conveys information to a large number of investors about how their stocks are generally performing. The stocks included in the index and the weights given to the stocks represent the stocks and weights applicable to a significant group of investors. 3.2 Weights As the prices of individual stocks change over time, each stocks relative importance in a representative investors portfolio changes. If the price of the shares of Microsoft rose over the years while K-Mart stock dipped, then a larger percentage of your total portfolio is invested in Microsoft today than in the past. The weight accorded to Microsoft in the stock index should have increased relative to that of K-Mart for the index to reflect the overall change in the typical investors’ financial standing. Basically an accurate index relies upon weighting – the concept of compensating for differences in size and numbers of outstanding shares that equalize the very different price changes. A 2 percent change in a stock worth $50 is very different from a 2 percent change in a stock worth $5. Therefore, when coming up with an average, the index must compensate for these differences. Often, indexes such as the Dow Jones Industrial Average focus on market return rates, including capital gains and dividends. If the return figures are not weighted, the index may not be representative of the market as a whole. Therefore, a good stock market index changes the weights given to individual stocks frequently in response to the changing market capitalization- the market value of the aggregate shares of stock outstanding for each company in the index (Thomas, 2005). 3.3 Expertise 14

An index must have a staff that is expert in a specific specialty area. An index such as the Calvert Social Index, which specializes in clean energy and environmentally friendly firms, must maintain a staff that is knowledgeable and fluent in these important areas. In order to be included within the Calvert Social Index, the staff must inspect and research various firms dealing in energy and manufacturing to ensure their compliance with strict clean air and other environmental standards. This takes time and subject-area expertise that would mark indexes like these from the ordinary index model. 3.4 Independence and Transparency Independence is a major mark of any reputable stock index. The index is a powerful tool. Seasoned investors make some of their investing decisions based on the broader implications of an indexed market trend. Therefore, if the index itself is financially involved with one of the stocks in the sector or with the sector as a whole, that is a conflict of interest. The purpose of a good index is accuracy, not special interests. One way that this has been achieved is by the public posting of methodologies and selection criteria by indexes such as the S&P 100 or the TSE 300. 3.5 Frequency The index considers the trading frequency of stocks included in the index. An index that includes a large number of infrequently traded stocks fails to accurately reflect market performance, especially over short time intervals, because the price of a non traded stock remains constant while the price of a stock being traded changes continuously (Thomas, 2005). 3.6 Investible The index should be investable and market participants should be able to replicate it. A useful index consists in securities that can be purchased by investors, local and foreign, retail and institutional investors. To ensure it is investible, an appropriate benchmark should qualify based on float capitalization, liquidity, and the absence of ownership restrictions. 3.7 Accuracy

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The index should be maintained accurately and reliably, with a stated corrections policy regarding prices, capital changes, dividends, exchange rates, etc., to reflect the actual changes in the value of the portfolio instead of the influence of other factors. 4.0 Classification of Stock Market Indices A good way to analyze an index is to understand the composition of the stocks it represents. 4.1 Index Scope There are indices that cover a worldwide representation of stocks, such as the Morgan Stanley Capital International index. Other indices are made up of stocks from a single nation or single exchange, for example, the S&P 500 tracks the prices of the 500 largest corporations in the U.S. The Wilshire 5000 is an extremely broad index that follows all publicly traded U.S. stocks. At the other extreme, the Dow Jones Industrial index is made up of 30 large U.S. stocks. Although it has been criticized as being unrepresentative of market trends, the DJI remains one of the mostfollowed and -quoted market indices in the world (Bank, n.d). The most regularly quoted market indices are broad-base indices comprised of the stocks of large companies listed on a nation's largest stock exchanges, such as the British FTSE 100, the French CAC 40, the German DAX, the Japanese Nikkei 225, the Indian Sensex, the Australian All Ordinaries and the Hong Kong Hang Seng Index. In Kenya, the All Share Index captures the overall market and is calculated using all shares traded on a single day. 4.2 Index Calculation The DJI is the numerical average of 30 stock prices -- it is said to be “price-weighted” -- divided by a historical adjustment factor. The factor is modified whenever a replacement in the stock list occurs so that the index doesn’t change value simply due to the replacement components. In the S&P; indices, each stock price is weighted by the value of the publicly traded shares, a scheme called “float weighting." Thus, in the S&P; 500, the stock price of a company with a $100 million market float will be weighted 10 times heavier than one with a $10 million market float (Bank, n.d). 4.3 Index-Linked Contracts

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Some indices form the bases for the trading of options and futures contracts. For instance, an investor who wants to hedge against a stock market crash could buy put options on the S&P; 500 that gain in value as stock prices fall. Alternatively, you could sell S&P; 500 futures contracts, which provide the same benefit. Index-linked contracts support many types of hedging techniques, because they provide instant exposure to a broad range of stocks without having to trade the individual stocks within an index (Bank, n.d). 4.4 Index Funds Most mutual fund companies offer at least one stock index fund, tied to indices like the S&P; 500 or the Wilshire 5,000. These funds are pooled investments in which the investment manager purchases all the stocks in an index, weighted as required, to match an index’s price action. Mutual fund shares are issued and redeemed by the fund company at the end of a trading day. An index ETF is a basket of stocks that reflects the index components, once again managed to match index performance. ETFs are traded as shares just like stocks and thus can be traded at any time throughout the trading day, making ETFs well-suited for day-trading and hedging strategies (Bank, n.d). 4.5 Specialized Index We can either have Industry or Sector specific Index for any particular sector of the economy which then serves as the benchmark for that particular industry or we can have an index for the highly liquid stocks. Taking an example for an industry specific index we have the S&P. Banking Index which is a capitalization-weighted index of 26 domestic equities traded on the New York Stock Exchange and NASDAQ, The stocks in the Index are high-capitalization stocks representing a sector of the S&P 500. Similarly, The S&P CNX Nifty is a relevant example for an index composed of highly liquid stocks. More specialized indices exist tracking the performance of specific sectors of the market. The Morgan Stanley Biotech Index, for example, consists of 36 American firms in the biotechnology industry. Other indices may track companies of a certain size, a certain type of management, or even more specialized criteria — one index published by Linux Weekly News tracks stocks of companies that sell products and services based on the Linux operating environment.

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4.6 Return Based Index Return based index is also known as performance based index. Return based index includes all dividends and other cash events paid out to shareholders. When measuring the return over a given time period. Return based index will add in any dividend amounts to the net share price before calculating the index return (Essvale Corporation Limited, 2008). Some indices, such as the S&P 500 have multiple versions. These versions can differ based on how the index components are weighted and on how dividends are accounted for. For example, there are three versions of the S&P 500 index: price return, which only considers the price of the components, total return, which accounts for dividend reinvestment, and net total return, which accounts for dividend reinvestment after the deduction of a withholding tax. Another example is the Wilshire 4500 and Wilshire 5000 indices have five versions each: full capitalization total return, full capitalization price, float-adjusted total return, float-adjusted price, and equal weight. The difference between the full capitalization, float-adjusted and equal weight versions is in how index components are weighted (Wilshire: Index Calculator Result, Dow Jones Wilshire). 5.0 Purpose of Stock Market Index Mr. Charles Dow created the first and, consequently, most widely known as the Dow Jonesindex back in May of 1896. At that time, it contained 12 of the largest public companies in the U.S. Today, the Dow Jones Industrial Average (DJIA) contains 30 of the largest and most influential companies in the U.S. Like Dow Jones, the Nasdaq, S&P 500, Nikkei, and Sensex, are widely known market indices in the world. In the Sri Lankancontext, the well-known indices would be the ASPI, MPI and MBSL Midcap index. For investors, indices give the direction of the entire market. They use indices to track the performance of the stock market. Ideally, a change in the price of an index represents an exactly proportional change in the stocks included in the index. The ASPI is one of the principal stock indices of the CSE and it measures the movement of share prices of all listed companies based on market capitalization. The most basic purpose is to provide a measure to understand the direction or the movements of the market as a whole. An increase in the index indicates a rising market and decrease indicates a 18

falling market. Market indices enable us to calculate market return. It represents the rate of return earned by investing in a portfolio that impersonates the market portfolio. Market return and risk are typically used as primary benchmarks to judge investment performance of a portfolio. Technical analysts try to predict future price movements by looking at the behavior of past price trends. Market indices also enable us to examine factors that influence aggregate security price movements. Security analysts, portfolio managers, and academics investigate the factors that affect the performance of the market. 5.1 The purpose of The NSE 20-Share Index The NSE 20-Share Index (NSE 20) is the long-standing benchmark index used for equities traded on Kenya's Nairobi Stock Exchange (NSE) and represents the geometric mean of share prices of the NSE's 20 top stocks. It has recently been joined by the more broad-based NSE All Share Index (NASI), aimed at capturing the market capitalization of all the NSE's listed equities traded in a day. The NSE 20-Share Index was introduced in 1964, one year after African natives were first allowed to trade on the NSE. It was joined in February 2006 by the NSE All Share Index (NASI), aimed at reflecting the total market value of all stocks traded on the NSE in one day rather than just the price changes of the 20 best performers captured by the NSE 20.The Nairobi Securities Exchange Ltd 20 Share Index is a price weight index. The members are selected based on a weighted market performance for a 12-month period as follows: Market Capitalization 40%, Shares Traded 30%, Number of deals 20%, and Turnover 10%. Index is updated end of day only. Nairobi Securities Exchange was constituted in 1954 as a voluntary association of stockbrokers registered under the Societies Act. Dealing in shares and stocks started in Kenya in the 1920s. At that time, Kenya was a British colony. Stock broking was conducted solely by Europeans in areas of specialization such as accountants, auctioneers, estate agents and lawyers who met to exchange prices over a cup of coffee. Trading took place on gentleman‟s agreement in which standard commitments such as making good delivery and settling relevant cost. There was no formal market, rules or regulations to govern stock broking (Munga, 1974). By 1966, the NSE had begun measuring daily trading activity by computing the NSE Index. The index measured daily average price change in 17 companies that were considered the most active 19

stocks in the market. It was computed as a weighted average of price changes in the selected stocks and 1966 was used as the base year and set at 100 points (NSE, 2011). Economic growth is promoted through improved efficiency in mobilization of savings as capital is allocated to investments that bring the most value to the economy capital (Kibuthu, 2005).Currently, the NSE has two market indices; the NSE 20 Share Index which is price weighted and an all-inclusive NSE All Share Index (NASI) which is market capitalization weighted. Price weighted indices are based on a geometric mean of average prices of the constituent companies which are equally weighted. The market indices are reviewed periodically to ensure that they reflect an accurate picture of market performance. 5.2 Relationship between NSE 20 Share Index and Overall Market Performance Stock market index movement is used to judge the performance of the stock market and an indication of the economic activities in the country. Broby (2007) asserts that when the stock market index moves upwards on a continuous basis the market is referred to as bullish and when the index moves downwards the market is referred to as bearish. According to Berger and Patti (2002), at times the markets move within a very narrow range and it is neither bullish nor bearish. The stock market index reflects the market performance through the direction of share price movement. Market performance is measured by the stock market index which indicated the direction of share price movement (Hsu, 2006). It measures quickly the overall direction of the market and is considered to be an accurate indicator of changes in the stocks. This implies that a stock market index ought to neither understate nor overstate the market position and should be not only precise, but also exact. The market index entails all listed companies which represent a significant portion of market capitalization and trade actively. According to Kibuthu (2005), there are three main indices in the Nairobi Security Exchange namely; Nairobi Stock Exchange 5.3 (NSE) 20 Index, NSE All Share Index (NASI) and The American International Group (AIG) Index The average performance of 20 large cap stocks drawn from different industries is measured by the NSE 20 Share index. Experiences however, indicate that most large cap stocks do not record 20

a high performance as compared to low cap stocks. There are times small cap counters record growth averaging at 50% while is unlikely for large cap stocks. From this perspective the 20 share index tend to be biased towards a large cap counters and thus fails to transmit the right signals on the entire market performance. This impact negatively on the total market performance of the NSE traded shares. 6.0 Types of Stock Indices There are two types of stock indices based on their methods of computation. A stock market index may either be a price-weighted index or market value-weighted index. 6.1 Price-weighted Index In this type of index, only the prices of individual securities are considered and each security has equal weight in the index. This means that the index is calculated using a stock price instead of the company value. This index gives an idea about the general price movement of the constituents that reflects the entire market. One major undoing with this type of index is that, a company that has a stock price of Kes. 100 will count twice as much as a company with a stock price of Kes. 50. The Dow Jones Industrial Average is the most famous example of a priceweighted index. There are two types of price indices (Owen & Jones, 1994). 6.1.1 Laspeyre’s Index It shows what the cost of goods in the nth year would be, assuming the we brought the same quantities as in the base year, and assuming that we call the base year price 100.

Where: Pn = cost of goods in the nth year

21

P0 = cost of goods in the base year Q0 = quantity of goods in the base year 3 6.1.2 Paasche’s Index The Lasperye index tends to overstate increases in prices, and to overcome these problems statisticians have suggested that current-year quantities should be used as weights and hence the Paasche‘s index. This index is not a pure price index as it takes into account changes in quantities bought. The equation Paasche‘s Index is then calculated as:

Where: Pn = cost of goods in the nth year P0 = cost of goods in the base year Qn = quantity of goods in the nth year 6.2 Market value-weighted Index In value-weighted index, a company with higher capitalization will have greater impact on the index than a company with smaller capitalization. This means is that the index measures the total value of all the outstanding stock issued by the various companies in the index. One of the drawbacks of a market-weighted index is that sometimes one company or one type of industry can make up a very large portion of the index. An example is the S&P 500. 7.0 Construction of a Stock Market Index Choosing the number and type of stocks to factor into an index is one of the most critical aspects of constructing it. 22

In critiquing the NSE 20 Share Index, Wahome (2008) argued that it was not reflective of market performance. Wahome argued that it was because it was equally weighted where stocks with very varying market capitalization were given the same weight for example KenGen, which had a market capitalization of about Sh57billion carried the same weight as Express Kenya, under market capitalization which is only SH814 million or a seventieth of its size as at February 2008. Additionally low priced stocks have ‘higher’ performance in terms of share price movement since investors have been seen to prefer them for their ‘room for growth’ as opposed to those with larger prices. Several factors are therefore considered when constructing an index as below: 7.1 Liquidity Liquidity of stocks as measured by the ―impact cost‖ criterion which determines the cost faced when actually trading the index. For example if the current market price of a stock is $ 200 and a trader purchases it at $ 202 (due to involved transaction costs) then the market impact cost is 1% and the stock is considered highly liquid for lower impact cost. Shah and Thomas (1998) propose an approach to index construction which is aimed at creating a highly liquid index. High liquidity would result in reduced noise in the index time series and help produce financial products based on the index. The approach described relies on measures of liquidity derived from ―snapshots‖ of the limit order book. This approach was developed in the course of the creation of the NSE-50 index on India‘s National Stock Exchange (NSE), an open electronic limit order book market. The NSE- 50 index has proved to be the most liquid of the indices which aim to represent the Indian equity market. Likewise, according to Huang (2005) and Bagneris and Topscalian (1997), the most important point to focus on when building an index is liquidity. 7.2 Free-float adjustment According to Sauter (2002), an index must rely on objective, not subjective rules. It must adjust weighting for cross-holdings/float. In the mid- 1980s, the Toronto Stock Exchange in Canada and Salomon Smith Barney (later Citigroup, then S&P) introduced the concept of free float- adjusted

23

weightings. Similar to market capitalization weighting, free float is defined as the percentage of each company‘s shares that is freely available for trading on the market. It reflects the effective trading opportunities for investors more closely and thereby improves the representation of the indices. The idea is to account for shares that are rarely available for trading, such as those controlled by the founding family of a company. The float-adjusted weighting methodology removes these strategically held shares from market capitalization calculations; stocks are weighted based only on their ―liquid‖ share counts. Russell 2000 first announced the move to the free float model in the year 1984. Since then, almost all major index providers, including MSCI, FTSE, S&P and STOXX, have adopted the free-float methodology in constructing their indices. 7.3 Diversification By incorporating a large number of sectors in the economy, the index is more representative of the happenings in the larger market. In their study ‘Investors Perceptive on the NASI AND THE NSE 20 Share Index as Performance Measurement Indicators at the Nairobi Securities Exchange in Kenya’ Osoro, Jagongo (2013) also recommend the construction of sector specific indices which narrow down to each sector/segment of the market/economy. 7.4 Optimum size Osoro and Jagongo (2013) also posit that ‘in the shorter run NSE should construct a new price weighted index that compliments the NSE 20 Share and NASI indices. The new index should be constructed in such a way that more counter are included. In determining the counters to be included in the new index liquidity of the counters should be considered to avoid the inclusion of illiquid counters that may not have an impact in the movement of the index. This will ensure that the current price bias is eliminated.’ Increasing the number of stocks leads to greater diversification but up to some point. Increasing number of stocks in an index from 10 to say 30 give a sharp reduction in risk, but increasing the number beyond a point does very little in risk reduction.

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7.5 Market Capitalization The index should include primarily the stocks of companies that have significant market capitalization with respect to the index such that any major change in the price of the stock is reflected in the index. For example in Bombay Stock Exchange (BSE) 30 Index, the scrip must have a minimum of 0.5% of the market capitalization of the Index. An interesting observation is that while almost all global indices are float adjusted, there are a handful of U.S. indices (Standard and Poor‘s, Dow Jones Wilshire ) that still use market capitalization weighting to construct their indices. According to Strongin, Petsch and Sharenow (2000), because of the heavy weighting of the large capitalization stocks, the S&P 500 index actually consists of 86 stocks and the Russell 2000 of 118. Consequently, index performance is often dictated by the few biggest companies of the index and these indices do not provide investors with the risk reduction through diversification they think they are achieving. Schoenfeld (2002) suggests that market capitalization weighting is a prerequisite of a good index. He also defines seven key criteria that are useful in identifying a good broad capitalization equity benchmark, via; a) Completeness- reflection of the overall investment opportunity set, both in terms of market cap-range/country coverage and company inclusion. b) Invest ability- the inclusion of only those securities that can be effectively purchased by investors. c) Transparency- clear publication of the rules that govern the benchmark, especially during index reconstitution periods and during major corporate actions. d) Accurate and complete data readily available to investors, including price/total/net dividend returns, consistent sub-indices, quality and timely release of data, transparent release of index changes and historical returns. e) Acceptance by investors- an index that is well known and widely used. f) Availability of tradable products, as widely used indices offers potential cost savings. g) Relatively low turnover and related transaction costs. 25

7.6 Weights The choice of an appropriate weighting system makes it possible to produce acute and investable benchmarks in line with investing management. 6.6.1 Equal Weighted They give the same importance to the price movements of all the stocks they are made up of, so the price change of every company in the index has the same impact on the changing value of the index. Each stock has an equal influence on index performance, regardless of its market capitalization or share price. 7.6.2 Value-Weighted Market-capitalization weighting (or value weighting) is used by many index providers. Two major reasons can be offered for this. The capitalization-weighted index is easier to implement as a tradable portfolio, because price changes do not necessitate portfolio rebalancing. Sharpe‘s CAPM is constructed. The Standard & Poor‘s and Russell indices use this methodology, as well as the CAC 40 in France and the FTSE 100 in the U.K. 7.7 Factor Analysis Factor analysis techniques have been extensively used in finance, both in the context of term structure analysis (a classic reference is Litterman and Sheinkman , 1991) as well as in the timeseries analysis of equity portfolios (Chan, Karceski and Lakonishok , 1998). In the context of empirical testing of the Arbitrage Pricing Theory (Ross, 1976), replicating portfolios are extracted in an attempt to track the performance of unobserved implicit factors that drive asset returns (Huberman, Kandel and Stambaugh ,1987). At the intuitive level, the aim of the methodology is to use a small sample of stocks to design a replicating portfolio for the return of the total stock market. To this end, the selection criterion is the loading of individual stocks on the first principal component. The higher the loading of a stock on the first principal component, the higher its contribution will be to the common trend in hedge stock returns following a given strategy.

26

Alexander and Dimitriu (2003) propose to obtain portfolio weights from a principal component analysis of stock returns. Their model filters out the noise by focusing on replicating the common trend in stock returns, as described by the first principal component. This allows them to achieve significant out performance of capitalization weighted benchmarks while maintaining high correlation with the latter. They attribute this out performance to exposure to the value and to the volatility premium. Troskie and Money (2002) note that the trouble with the use of principal components in the construction of stock market indices is that it often results in the allocation of negative weights to some of the securities. The authors show that, by a simple restatement of the problem, this disadvantage can be easily overcome. In addition, extra constraints can be imposed on the weights assigned to the different securities if so desired. The foundations of the construction of stock market indices based on a principal component analysis are to be found in Feeney and Hester (1964). The intuition is that if an index is designed to measure movement on the market, then it will be most sensitive (and hence most informative) if the weights are assigned in such a way that the index has a maximum variance over all linear combinations of the stocks to be included in the index. Such a combination is simply the largest principal component. The problem of getting positive weightings can be solved using any of the methods for solving either general non-linear programming problems (such as, the Flexible Tolerance method) or quadratic programming problems subject to quadratic constraints. 8.0 Computation of Stock Market Indices Most indices are constructed as portfolios of marketable securities. The value of an index is calculated on a regular basis using either the actual or estimated market prices of the individual securities, known as constituent securities, within the index. For each security market index, investors may encounter two versions of the same index (i.e., an index with identical constituent securities and weights): one version based on price return and one version based on total return. Price return index, also known as a price index, reflects only the prices of the constituent securities within the index. A total return index, in contrast, reflects not only the prices of the constituent securities but also the reinvestment of all income received since inception. 27

At inception, the values of the price and total return versions of an index are equal. As time passes, however, the value of the total return index, which includes the reinvestment of all dividends and/or interest received, will exceed the value of the price return index by an increasing amount. As per Aggarwal, Bhagat, and Rangan, (2009) a stock market index may either be a price index or a weighted index. They added that the unweighted price index is a simple arithmetical average of share price with base day figure, which are usually 100 or 1000. This index gives an idea about the general price movement of the constituents that reflects the entire market. In a weighted index, prices are weighted by market capitalization. In such an index, the base period values are adjusted for subsequent rights and bonus offers (Bergstrom, Nilsson, and Wahlberg, 2006). This gives an idea about real wealth created for shareholder over a period of time 8.1 Price Weighted Price-weighted indices are computed by arithmetically averaging the prices of the assets that make up the indices. The drawback of this method is the fact that assets with low unitary value have less weight in the index than assets with high unitary value. Moreover, it does not take asset capitalisation and trade volume into account. The advantages are that computation and interpretation are simple. This type of index is evaluated in the following way:

Where: n = the number of assets in the index and Pit = the price of asset i at the time the index is computed.

28

Divisor = an adjustment term that makes it possible to express the index as a percentage with regard to a reference date. This formulation allows us to adjust the index by recalculating the divisor, in case of events occurring on firm capital. The most well-known price-weighted index, and the first one, is the Dow Jones Index Average. The Nikkei index in Japan is another example of this type of index. Because of the way they are calculated, these indices are not suited to an evaluation of the performance of a stock exchange. Indeed, these indices are more affected by price variation among assets with high unitary value than among assets with low unitary value. Moreover, as they are made up of a restricted number of assets, they are also unsuited to an evaluation of the performance of diversified portfolios. According to Brav (2009), there are many different ways of calculating an index. One of the most common methods is illustrated by the following simple example. The values of a market portfolio at the close of trading on Day 1 and Day 2 are recorded below: Training Days

Value of Portfolio

Index

Day 1 (Base Day)

KSHS. 20,000

1000

Day 2

KSHS. 21,000

Assuming Day 1 as the base day. This shall be taken as a standard. The value assigned to the base day index is 1000 in this example. On Day 2 the value of the portfolio has changed from Ksh 20,000 to Ksh 21,000, a 5% increase. Therefore, the value of the index on Day 2 will change to indicate a corresponding 5% increase in market value. The computation follows the procedure below:

29

Day 2's index is 1050 as compared to the 1000 of day 1. The above illustration only serves as an introduction to how a particular index is constructed. The daily computation of an index is more involved especially when there are changes in market capitalization of constituent stocks, e.g., rights offers, stock dividend etc. The primary objective of constructing market indices is to measure the performance of the market. The indices provide vital information about the current and historical behavior of the market. Stock market indices differ from one to another basically in their sampling and/or weighting methods. 8.2 Weighting method There are, in general, three different weighting methods, namely, value-weighted, equallyweighted (or un- weighted), and price-weighted (Cao, 2008). Value weighted method may be considered as a most appropriate method since the existing indices have been calculating under value weighted method (Coakley and Wood, 2006). They added that, for a value weighted index, the weight of each constituent stock is proportional to its market share in terms of capitalization. Assuming that the amount of money invested in each of the constituent stocks is proportional to its percentage of the total value of all constituent stocks. Examples include all major stock market indices of Hong Kong, London and many others. 8.2.1 Computation of Value Weighted Indices & Adjustments for Changes in Market Capitalization Most of Standard & Poor's indices, indeed most widely quoted stock indices, are capitalizationweighted indices. Sometimes these are called value-weighted or market cap weighted instead of capitalization weighted. Examples include the S&P 500, the S&P Global 1200, the NASI and the S&P/Citigroup indices. Examples from other index providers (where some of the details may vary slightly from those described here) include MSCI‘s indices, FTSE‘s indices and Russell‘s indices. While Dow Jones does offer market cap weighted indices, the well-known Dow Jones Industrial Average is not cap-weighted. The formula to calculate the S&P 500 is:

30

Where: Pi= price of each stock in the index Qi = number of shares used in the index calculation Divisor = an adjustment term that makes it possible to express the index as a percentage with regard to a reference date The numerator on the right hand side is the price of each stock in the index multiplied by the number of shares used in the index calculation. This is summed across all the stocks in the index. The denominator is the divisor. If the sum in the numerator is $11.8 trillion and the divisor is $9.4 billion, the index level would be 1250, close to the current levels of the S&P 500. This index formula is sometimes called a ―base-weighted aggregative‖ method. The formula is created by a modification of a Laspeyre’s index, which uses base period quantities (share counts) to calculate the price change. The computation of a value weighted index is useful to think in terms of evaluating the performance of a portfolio of securities Dimitrov and Jain, 2008). Some adjustments need to be made due to changes in market capitalization of the portfolio's adjustment

procedures

are

discussed

in

detail

constituent

stocks.

The

below. To make the computation

simple it is required that the number of constituent stocks to be kept small. Assuming that the index is composed of only three stocks: A, B and C. Day 1(base day) Market Data of Constituent Stocks on Day 1

The market value of each stock at closing is given by the product of the number of shares outstanding and the closing price. For stock A, for instance, it is 20 shares times Ksh.10 which yields Ksh.200. The aggregate market value (AMV) of all constituent stocks is the sum of the 31

market value of each stock. The AMV of day 1 is Ksh.290. Day 1 will be taken as the base day on which the index is set at 1000. Day 2 Market Data of constituent stocks Day 2

As there is no change in capitalization, no adjustment is needed on Day 2. The AMV is equal to Ksh.300. The computation of the index on Day 2 follows the procedure below:

It should be clear that the change in the index value shows the relative change in the aggregate market value of the constituent stocks. There is a 3.45% increase in AMV (also in index) on Day 2 relative to Day 1 (the base day). Day 3 Market Data of Constituent Stocks on Day 3

32

Therefore,

Note that the closing price of Company A on day 3 is Ksh 7/- determined by demand and supply factors in the market against the theoretically adjusted price (to the extent of disclosure) of Ksh 6.67 made on day 2 after closing market or on day 3 before starting market. Day 4 Ex-rights Stock C has declared 40% rights share at the ratio of "2 for 5" at Ksh .1.50 each including a premium of Ksh. 0.5 each. The offer expires on Day 4 (i.e. ex-rights). As mentioned earlier, it is useful to treat the constituent stocks as a portfolio held by an investor. In the computation of the index on Day 4, the investor is assumed to exercise the rights. Therefore, the new number of shares outstanding for stock C is given below: New Number of Shares Outstanding for Stock C = 10(2+5)/5 = 14 r stock C is given below: Day 5 (Replacement) Stock B is replaced by stock D, which has a closing price at Ksh.11.5 on Day 4 and its number of shares outstanding is 20. Market Data of Constituent Stocks on Day 5

33

The adjustment on Day 4's AMV in computing Day 5's Index follows a procedure as if the stock replacement had taken place on Day 4. The adjusted AMV on Day 4 is given as:

Therefore,

Day 6 (Addition) Stock E is added to the index as a constituent stock on Day 6. Stock E has a closing price of Ksh.4 and the number of shares outstanding is 40 on Day 5. Market Data of Constituent Stocks on Day 6

Since the number of stocks has changed, there is need to compute the adjusted AMV for Day 5 in computing Day 6's index. Day 5's adjusted AMV will be equal to the original AMV plus the market value of stock E on Day 5. This is equal to Ksh.500 + 160 (4*40) = 660.

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Shares issued under Repeat Public Offer (RPO), conversion, amalgamation, acquisition etc. should be treated as new issue (addition) and adjusted to give effect in the index on the following day of crediting/ issuing of those shares as per the guideline of “Day 6”. Day 7 (Deletion) Stock C is deleted from the index's constituent stocks. The new total number of stocks is reduced to 3. Market Data of Constituent Stocks on Day 7

The adjusted AMV on Day 6 will be a reduction by the amount of market value of stock C on Day 6.

Day 8 (Ex-Dividend) 35

Cash dividends of Ksh .50 per share are declared for stock E and Day 8 is to be ex-dividend. Market Data of Constituent Stocks on Day 7

No adjustment is needed, as there is no change in capitalization.

If the company issuing bonus share also recommends or declares cash dividend, then the cash dividend (to the extent of disclosure) should also be adjusted in the aforesaid theoretical price. Note that the price of stock E drops. This is a normal phenomenon as a stock goes ex-dividend. Day 8’s index records a decrease as well. Note that the closing price of Company E on day 8 is Ksh. 4.6 determined by demand and supply factors in the market against the theoretically adjusted price (to the extent of corporate disclosure) of Ksh. 4.50 made day 7 after closing market / on day 8 before starting market. 8.3 Geometric mean The standard procedure for calculating an index is multiplication of prices by weights, summed over the stock population of the index and divided by the number of stocks included to produce an arithmetic mean. An alternative exists with geometric mean indices. These indices are related to the group of equally weighted indices, as they do not take asset capitalization into account. Price relatives of the stocks included are multiplied over all stocks and the n-th root is taken from the product thus obtained. 36

It = It-1 √II (Pit / Pit-1 ) An example of a geometric mean index is the Value Line Index and the NSE 20 share index. The Nairobi Stock Exchange uses the following formula in computing the NSE 20 share index. The index is an equi-weighed geometric mean of 20 large ordinary stocks traded on the Nairobi Stock Exchange. The geometric mean is much easier to compute than may appear to be the case at first sight especially with the availability of simple electronic calculators. According to Cootner (1966), a geometric mean index is a downward biased index of price changes compared to an arithmetic mean index. On the other hand, other authors underline that while arithmetic mean indices are sensitive to the selection of the time interval (monthly, quarterly, semi-annual, or annual) in the model, geometric indices will produce the same calculation of returns regardless of the time interval. 8.4 Equal Weighted Indices An equal weighted index is one where every stock has the same weight in the index, and a portfolio that tracks the index will invest an equal dollar amount in each security. As stock prices move, the weights will shift and exact equality will be lost. Therefore, an equal weighted index must be rebalanced from time to time to re-establish the proper weighting. (In contrast, a capweighted index requires no rebalancing as long as there aren‘t any changes to share counts, IWFs, returns of capital, or stocks added or deleted.) The overall approach to calculate equal weighted indices is the same as in the cap weighted indices; however, the constituents‘market values are re-defined to be values that will achieve equal weighting at each rebalancing. The two basic formulae are as follows:

or

Where 37

Pi = price of each stock in the index Sharesi = shares used in the index calculation IWFi = the stock‘s float factor Divisor = an adjustment term that makes it possible to express the index as a percentage with regard to a reference date To calculate an equal weighted index, the market capitalization for each stock used in the calculation of the index is redefined so that each index constituent has an equal weight in the index at each rebalancing date. In addition to being the product of the stock price, the stock‘s shares outstanding, and the stock‘s float factor (IWF), as written above – and the exchange rate when applicable – a new adjustment factor is also introduced in the market capitalization calculation to establish equal weighting.

Where; Pi = price of each stock in the index AWFi= the adjustment factor of stock i assigned at each index rebalancing date, t ExRate = the exchange rate IWFi = the stock‘s float factor The AWFi makes all index constituents modified market capitalization equal (and, therefore, equal weight), while maintaining the total market value of the overall index. The AWF for each index constituent, i, at rebalancing date, t, is calculated by:

38

Where; N = the number of stocks in the index Z= an index specific constant set for the purpose of deriving the AWF Therefore, each stock‘s share count used in the index calculation (often referred to as modified index shares).The index divisor is defined based on the index level and market value from equation The index level is not altered by index rebalancing. However, since prices and outstanding shares will have changed since the last rebalancing, the divisor will change at the rebalancing. So,

Where,

8.5 Modified Market Capitalization Weighted Indices A modified market cap weighted index is one where index constituents have a user-defined weight in the index. This methodology is typically used for indices where some constituents are confined to a maximum weight (sometimes called capped indices), and the excess weight is distributed proportionately among the remaining index constituents. As stock prices move, the weights will shift and the modified weights will change. Therefore, as in the case of an equalweighted index, a modified market cap weighted index must be rebalanced from time to time to re-establish the proper weighting.

39

The overall approach to calculate modified market cap weighted indices is the same as in the cap-weighted indices; however, the constituents‘ market values are re-defined to be values that will achieve the user-defined weighting at each rebalancing. Recall two basic formulae:

And

In addition to being the product of the stock price, the stock‘s shares outstanding, and the stock‘s float factor (IWF), as written above – and the exchange rate when applicable – a new adjustment factor is also introduced in the market capitalization calculation to establish the appropriate weighting.

Where AWFi is the adjustment factor of stock i assigned at each index rebalancing date, t, which adjusts the market capitalization for all index constituents to achieve the user-defined weight, while maintaining the total market value of the overall index. The AWF for each index constituent, i, on rebalancing date, t, is calculated by:

Where; 40

Z = an index specific constant set for the purpose of deriving the AWF and, therefore, each stock‘s share count used in the index calculation (often referred to as modified index shares). Wi,t= the user-defined weight of stock i on rebalancing date t. The index divisor is defined based on the index level and market value from equation. The index level is not altered by index rebalancing. However, since prices and outstanding shares will have changed since the last rebalancing, the divisor will change at the rebalancing. So:

Where:

9.0 How is the NSE 20 Share Index Derived? An index as explained in our earlier article is a sample or portfolio of stocks representing the entire stock market. Investors use indexes to track the performance of the stock market. The NSE currently has two market indices namely; The NSE 20-Share Index which is price weighted, An all-inclusive NSE All Share Index (NASI), which is market capitalization, weighted. Currently, the NSE has two markets: 

Equities market - where shares are traded 41



Bond market - where bonds (papers issued by the government and companies as a means of borrowing money) are traded.

The NSE (Nairobi Securities Exchange) 20-share index is used to track the performance of the NSE equities (shares) market. The NSE 20 Share Index is a price weight index calculated as a geometric mean of the shares of 20 public, listed companies. These companies are selected based on a weighted market performance during the period under review based the following criteria; 9.1 The Criteria Based On Which Companies Are Selected i.

ii.

Trading activity measures weighed in the ratio of 4:3:2:1.comprising as follows Market Capitalization 40% Shares traded 30% Deals/liquidity 20% Turnover 10%. A company must have a free float of at least 20%, and must have a minimum market

iii.

capitalization of Kshs. 20 million. A company should ideally be a blue chip with superior profitability and dividend record.

   

Currently the following companies make up the NSE 20 share index. The list includes the sector in which the companies are found. Agricultural Sector Sasini Limited Commercial & Services Sector Kenya Airways Limited Nation Media Group Scangroup Limited Investment Sector Centum Investment Company Ltd 42

Banking Sector Kenya Commercial Bank Limited The Cooperative Bank of Kenya Limited Standard Chatered Bank Limited Barclays Bank Limited Equity Bank Limited CfC Stanbic Holdings Limited Manufacturing & Allied Sector East African Breweries Limited British American Tobacco Kenya Limited Construction & Allied Sector Athi River Mining Limited Bamburi Cement Limited Energy & Petroleum Sector KenolKobil Limited Kenya Power Limited Kenya Electricity Generating Company Limited Insurance Sector British-American Investments Company (Kenya) Limited Telecommunications & Technology Sector Safaricom Limited

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The NSE reviews the constituent companies of the NSE 20 share index from time to time. Some companies are dropped and others added to the list. 9.2 Formula for deriving NSE 20 share Index As suggested above, the NSE 20 share index an equal-weighed geometric mean of 20 large ordinary stocks traded on the Nairobi Securities Exchange. The formula is as follows:

Where: It = Index at time t It-1 = Index at time t-1 Pjt = Price of stock j ( j=1, 2...19,20) at time t. Pjt-1 = Price of stock j at time t-1

Multiplying operator (Product)

=Operator for taking the 20th root of the value inside the bracket 9.2.1 The procedure to be used

44

i.

At the close of each trading period (day), tabulate the prices of all the stocks in the index. (The ideal price is the volume weighted average price of the day but if no trade occurred,

ii. iii. iv.

then the last traded price is used. Tabulate alongside these, the previous day's prices computed in the same manner. Multiply all the prices for the day. (Numerator). Multiply all the prices for the day (Denominator). (Do not round off the products in 4 and

v. vi. vii.

5) Divide the Numerator in 3 by the Denominator in 4 (Value). Take the 20th root of the value computed in step 5. (Do not round off). Multiply the result in 6 by the Index computed for the previous day (This will give the

viii.

new index for the day). Double check for errors, it is absolutely essential to avoid rounding off. This can be achieved by using a floating decimal calculator. Even a small rounding off can cause a substantial error in the final index. (If there has been no change in the price of a given stock from one day to the next, both prices can be ignored from the computation. But the 20th root must still be taken nevertheless).

9.3 Eligibility criteria In order for a company to qualify for inclusion in the Index, the issuer shall fulfill the following conditions: i. ii. iii. iv. v.

Shares must have their primary listing on the Nairobi Securities Exchange. Must have a least 20% of its shares quoted on the NSE. Must have been continuously quoted for a least 1 year. Must have a minimum market capitalization of Kshs 20 million. Should ideally be a ―blue chip‖ superior profitability and dividend record.

9.4 Periodic review of constituent companies The Advisory Committee meets semi-annually to review the constituents of the index. The constituent reviews are based on data collected. Details of the outcome of the review will be published as soon as possible after the Index Management Committee meeting has concluded. The periodic review of constituents will be conducted using the following steps: i. ii.

Create database of all securities listed on the Nairobi Stock Exchange; Apply all liquidity tests set out in Ground Rules;

45

iii.

Weighting all the activity measures as set out in Ground Rules as follows; Market

iv. v. vi.

capitalization (40%), shares traded (30%) Number of Deals (20%) Turnover (10%) Exclude securities which do not fulfil criteria set out in Ground Rules; Rank all eligible securities by market capitalization, largest first and smallest last; Existing constituents which have fallen to position 21 or below will qualify to be

vii.

removed from the index at the periodic review; Where a greater number of securities qualify to be included in the index than those qualifying to be removed, the lowest ranking securities presently included in the index will be removed to ensure that the number of securities remains constant. Likewise, where a greater number of securities qualify to be removed from the index than those qualifying for inclusion, the highest ranking securities which are presently not in the index will be included to match.

9.5 Reserve List The Nairobi Securities Exchange is responsible for publishing the five highest ranking nonconstituent securities of the NSE 20 share Index following each semi-annual review. This Reserve List will be used in the event that one or more constituent securities is deleted from the NSE 20 share Index during the period up to the next semi-annual review of the Index. Where a security is removed from the Index after the Index management Committee has met and approved semi-annual changes to the Index but before the semi-annual changes have been implemented, the highest ranking security by full market capitalization from the new Reserve List (excluding current Index constituents) will replace the deleted security. 10.0 Stock Market Robustness According to Wimsatt (1987), Robustness is the ability of a financial trading system to remain effective under different markets and different market conditions, or the ability of an economic model to remain valid under different assumptions, parameters and initial conditions. 10.1 Index compositional changes 10.1.1 Price Changes In France, decisions on list changes are taken and announced by ‘the Conseil scientifique des Indices‘, usually four weeks before the effective change. The FTSE Committee meets quarterly 46

to review the composition of the FTSE100 and changes are implemented in about ten days. The results improve on recent evidence from the S&P500 index. The evidence for the FTSE100 additions shows, in particular, that markets learn about an imminent inclusion and incorporate this information into prices, even before the announcement date. All things being equal, analysts regard a company‘s inclusion in an index (especially a company with a high weighting in that index) as being beneficial to its share price. That is because it prompts fund managers who track indices to buy up shares in the companies being added, while selling those that have been removed. Lynch and Mendenhall (L-M, 1997) provided new evidence on stock price effects associated with changes in the S&P 500 index‘, by taking advantage of a modification in the S&P procedure. Namely, since October 1989 S&P has been announcing compositional changes one week before an effective change. For the additions‘, they found a significant positive cumulative abnormal return from the day after the announcement ‘until the day before the effective‘ change; while prices partly reverted on and after the effective‘ date of the inclusion. The effect around the announcement date is consistent with both heavy index fund trading and the Price Pressure Hypothesis (PPH), which states that the price is temporarily affected and gradually reverts. 10.1.2 Volume Effects With regard to volume effects, the largest volume of trade is observed one day before the effective ‘index change, consistent with an index fund attempting to minimize a tracking error by trading before the effective index modification, even if around the announcement‘ date a positive volume effect is also observed. According to a survey by the Bank of France, institutional investors hold one-quarter of all French securities quoted on the Bourse and this share remained relatively steady from 1998 to September 2000. London is host to the world‘s largest pool of investment funds. In a recent survey on asset management, The Economist concluded that actively managed funds under perform index funds after accounting for expenses, and that ever more investors are adopting indexing . Institutional investors, in particular, are putting more money into passive funds and less into active fund management than other investors

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10.1.3 Foreign Asset Holding Co-movement of stock indices returns with Country Crises stock market crises are spread globally through asset holdings of international investors. By separating emerging market stocks into two categories, namely, those that are eligible for purchase by foreigners (accessible) and those that are not (inaccessible), we estimate and compare the degree to which accessible and inaccessible stock index returns co-move with crisis country index returns. Our results show greater co-movement during high volatility periods, especially for accessible stock index returns, suggesting that crises spread through the asset holdings of international investors rather than through changes in fundamentals. 10.1.4 Contagion The past decade was marked by several stock market crises in developing economies; in particular, the Mexican peso collapse in 1994, the Asian crisis in 1997, and the Russian default in 1998. One striking feature common to these crises is how an initially country-specific event seemed to transmit rapidly to markets around the globe. In the empirical literature, Karolyi and Stulz (1996) and Connolly and Wang (2002) find that macroeconomic announcements and other public information do not affect co-movements of Japanese and American stock markets. King, Sentana, and Wadhani (1994) find that observable economic variables explain only a small fraction of international stock market co-movements. Forbes (2002) finds evidence that international trade linkages allow country-specific crises to spread to stock markets elsewhere in the world. However, these trade linkages only partially explain the reaction of stock markets to crises that originate in other countries. In addition, correlations among market returns computed by Longin and Solnik (2001), Connolly and Wang (1998), Ang and Bekaert (2002), and Ang and Chen (2002) are especially large during market downturns, suggesting that contagion may be ―asymmetric,‖ that is, stronger during market downturns.

11.0 Usefulness and Application of Stock Indices 11.1 Uses of Stock Indices 48

11.1.1 Provide information on market trends Stock indices are used as a tool a short-hand measure of the performance of the stock market and thus provide information on the general trend of the movement of stock prices in the market. Siklos et al (2001) in their study for example use stock indices to study the trends of international markets against regime shifts in Asian markets. Indices are very useful for studying the general trend of how markets move.Boyer (2006) used market indices extensively to follow global trends of spread of stock market crashes. Indices were useful in being able to detect these easily and compare the stock market trend across different countries and financial centers 11.1.2 Evaluation of performance of performance of individual companies Stock indices provide a measure against which investors can evaluate companies. A company whose share price performs better than the market index has a better performance than one that does not. It has higher returns than the market. Generally stock market indices are regarded as a barometer of the economy. By looking at an index one knows how the economy is moving. The impact of various monetary policies will be reflected in the stock market. Many believe that large decreases in stock prices are reflective of a future recession, whereas large increases in stock prices suggest future economic growth. Given that the speed with which stock markets incorporate new information is faster than the speed with which macroeconomic conditions change, stock markets are often used as a forecasting tool in predicting future economic conditions (Bernanke et al, 1999). 11.1.3 Evaluate the performance of individual investor’s portfolio Aman (2008) in his research constructed an index based on good corporate governance of companies in Japan and used this index to compare the performance of these companies against the Nikkei. Investors too can compare the portfolio of companies they have invested in and compare the return on their portfolios against the index to see how well they did. An index is used to compute the total returns and risk measures for the aggregate market or some component of the market over a specified period. Such computed risk and returns are used to judge the performance of individual‘s portfolios by providing benchmarks against which

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investment performances of portfolios is measured. The performance of the portfolio is compared to the performance of market indices, referred to as the ‗benchmark‘. Outperforming the benchmark is regarded as good performance, while underperforming the benchmark is regarded as poor performance. Stock indices therefore allow investors to perform analysis on yields of already performed transactions or on investment opportunities that may arise in the future. Individual investors with professionally managed portfolios can use the indexes to determine how well their managers are doing in managing their money (Sharpe, 1992). 11.1.4 Information to individual investors on investment decisions The investor can use the indices to allocate funds rationally among stocks. First, the market indexes provide an historical perspective of stock market performance, giving investors more insight into their investment decisions. Investors who do not know which individual stocks to invest in can use indexing as a method of choosing their stock investments. By wanting to match the performance of the market, investors can invest in index mutual funds or index exchangetraded funds (ETFs) that track the performance of the indexes with which they are aligned. This form of investing gives investors the opportunity to do as well as the markets and not significantly underperform the markets (Jegadeesh &S. Titman, 1993). 11.1.5 Formulate Index Funds The point follows closely the previous one, where it is possible for funds to be created based on all the stocks of a particular fund, Tang et al (2012) mention the increased preference for commodity index investment or index funds which provide a return similar to the underlying index that the fund is built on. This involves purchase of all the components of the index and only trading in these components. Some of the advantages of this approach is that these funds charge lower fees and lower churn in the portfolio resulting in lower capital gains tax paid. These are formulated with the help of indices. Most index funds work by identifying an already well-known index, then building a fund that either owns every asset in the index or achieves the same end by holding similar securities. Usually the fund managers construct portfolio that 50

emulates any of the major stock market indices. The return of the portfolio is closely linked with the index movement. Index investing refers to the practice of buying all the components of an index, often through a mutual fund set up for that purpose (Tang & Wei, 2012). Advantages of the index funds are that: Usually they have lower management fees They trade much less, so turnover ratio is lower. As a result capital gains taxes can be lower. 11.1.6 Forecasting Technical analysts studying the historical performance of the indices can predict the future movement of the stock market. The relationship between the individual stock and index predicts the individual share price movement. The returns generated in the stock market are based on future expectations. The future streams of expected returns from the companies are discounted to arrive at their present value known as market price (Diler, 2003). 11.2 Benefits of Stock Market Indices According to (Pandian, 2009), Benefits of stock market indices are as follows; a) Indices help to recognize the broad trends in the market. b) Index can be used as a bench mark for evaluating the investor’s portfolio. c) Indices function as a status report on the general economy. Impacts of the various economic policies are reflecting on the stock market. d) The investor can use the indices to allocate funds rationally among stocks. To earn returns on par with the market returns, he can choose the stocks that reflect the market movement. e) Index funds and futures are formulated with the help of the indices. Usually fund managers construct portfolios to emulate any one of the major stock market index. 11.2.1 Stock Market Indices as a Barometer of the Economy There are various ways in which the stock market and the macro economy have been related in literature. According to Chen, Roll and Ross (1986) economic variables have a systematic effect on stock market returns. That is, economic forces affect the discount rates, the ability of firms to generate cash flows and future dividend payments. 51

Some studies explored impact of economic growth on stock prices and found that oscillation in stock prices usually imitate true economic activities (Fama, 1990; Nishat and Shaheen, 2004; Cook, 2007; Ratanapakorn and Sharma, 2007; Shabaz et al. 2008; Humpe and Macmillan, 2009 ) studied the connections of real GDP and stock returns and explored immense association among stock returns and GNP, and stock returns and industrial production. Chen et al. (1986) found a powerful affiliation among the economic activity and the stock market. Nishat &Shaheen (2004) explored that there was a strong positive effect of industrial production on stock returns in Pakistan. The Granger causality test showed stock price affected industrial production. Ratanapakorn & Sharma (2007) investigated the long run association between industrial production and US stock prices. The authors found that stock prices were influenced by change in output level via impact of output on profitability. Humpe & Macmillan (2009) investigated effects of industrial production on stock returns and found in US stock returns were positively affected by the industrial production. An increase in the production levels therefore increases the profitability of the firms which in turn increases their stock prices and this will have an impact on the stock exchange index. This implies a growth in the economy. Aggarwal (2003) found positive association between foreign exchange rate and stock prices in US. Stock prices were positively affected by real effective exchange rate. It interpreted that with the depreciation in domestic currency due to increase in exchange rate , exports become cheaper which resulted in increase in exports and stock prices of exporting firms. The same results were reported by Sohail & Hussain, (2010). Ratanapakorn and Sharma, (2007) investigated that there was positive effects of increase in money supply on stock prices in US. Money supply affects the present value of future returns through its effect on the interest rate. A tightening of the money supply raises the real interest rate. An increase in the interest rate would in turn raise the discount rate, which would decrease the present value of future returns, which in turn decreases the price of a stock. Therefore decreasing prices of the stock prices is an indicator of decreased levels of money supply and high interest rates. Fisher (1930) asserted that inflation leads to high nominal interest rates since investors demand compensation for a loss in the future value of money. Since stock prices are based primarily on 52

the present value of future streams of cash flow, inflation will reduce the future value of cash flows which means that the future cash flows are worth less today. The subsequent high interest rates lead to high costs of borrowing, and thus a rise in inflation induces a decline in the stock index reflecting a decline in the stock market performance. This is explained by the fact that borrowers tend to shy from the stock market to avoid getting into a debt whose cost is very high due to high rate of interest The monetary authority should therefore ensure that they come up with sound fiscal and monetary policies as these policies affect the stock market which not only facilitates the trade of financial assets but is also a major determinant in the growth of the national economy. 12.0 Stock Market Crash and Stock Indices Stock market crash refers to a dramatic decline of stock prices across a significant cross-section of a stock market, resulting in a significant loss of paper wealth. Numerically, it applies to steep double-digit percentage losses in a stock market index over a period of several days. It is driven by panic and underlying economic factors. Selling by some market participants drives more participants to sell. 12.1 The Wall Street crash of 1929 Due to the technological innovations of the time, the U.S economy was growing rapidly and the companies that had pioneered these advances (e. g General Motors) saw their stocks soar, and so did financial corporations and Wall Street bankers. Some innovations included radio, automobiles, aviation and telephone companies. Some investors were so infatuated with the returns from the stock market that they started using leverage through margin debt. On August 24, 1921, the Dow Jones Industrial Average (DJIA) stood at a value of 63.9. By September 3, 1929, it stood to 381.2. By that summer, the economy started to contract as the stock market went through a series unsettling price declines. This increased anxiety among investors leading to the events on October 24, 28, and 29 (known as Black Thursday, Black Monday and Black Tuesday). On Black Monday, the DJIA fell 38 points to 260, a drop of 12.8%. A rush of selling overwhelmed the ticker tape system that normally gave investors the current prices of their 53

prices. The system’s telephone lines and telegraphs were clogged and unable to cope. The following day, Black Tuesday was a day of chaos. Investors flooded the exchange with sell orders because they were forced to liquidate their stocks. The Dow fell 30 points to close at 230 on that day. From Black Tuesday to Black Thursday, the Dow fell by 23%. By the end of the weekend of November 11, the index stood at 228, a drop of 40% from the September high. Although the market tried to recover in the succeeding months, this was a false recovery that caused unsuspecting investors into further losses. The Dow lost 89% of its value before in finally reached its lowest point in July 1932. This was followed by the Great depression, the worst economic crisis that plagued the stock market globally.

12.2 The Crash of 2008-2009 On September16, 2008, failures of massive financial institutions in the USA rapidly developed into a global crisis, resulting in a number of bank failures in Europe and sharp reductions in the value of stocks and commodities worldwide. Beginning October 6 and lasting all week, the DJIA closed lower for all five sessions. Volumes levels were also record breaking. The Dow fell over 1.84 points (18%). The S&P 500 fell more than 20%. On October 8, the Indonesian stock market halted trading, after a 10% drop in one day. After having been suspended for 3 successive trading days, the Iceland stock market reopened with the main index, the OMX Iceland 15, closing at 678.4 indicating fall of 77%. This was due to the fact that the value of the 3 big banks that formed 73.2% of value of the OMX Iceland 15 had been set to zero.

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Since September 2008, the world’s stock markets’ performance fell substantially as the stock indices dropped to between five-nine year lows (CMA). This led to Banks tightening lending standards and credit terms. As of October 208, stocks in North America, Europe and the Asian Pacific region had all fallen by 30% (Krugman, 2008). Stock markets recorded a 21% fall in Uganda, 24% in South Africa and 27% in Kenya between September 1 and November 30 (Wanjohi, 2011). As at October 2008, the Bank of England reported that the world’s financial firms had lost USD 2.8 trillion as a result of the crisis. This was 133 times Kenya’s current GDP in absolute terms (CMA). Tax payers around the world, Kenya inclusive spent around USD 8 trillion trying to revive the world’s banks. Africa’s liquid financial market suffered from the impact, mainly attributed to the over valuation of stocks and outflow of portfolio investments. African investors especially Egyptians and Nigerians recorded six months on average loss of more than half the wealth invested at the end of July 2008. The cost of external debt for emerging countries on international financial markets started to increase in July 2007. The crisis increased the cost between 45 and 50 points. During an attempt to issue bonds on the international financial markets, Tunisia had to increase its offer by 25 points to attract and entice investors. There were increased currency fluctuations especially against the US dollar and the Euro. The depreciation was attributed to the impact of crisis on commodity prices and the decline in foreign exchange reserves. The 65.8% drop in copper prices led to a fall in Zambia’s foreign reserves. The Kwacha exchange rate to the US dollar depreciated sharply in 2008 by as much as 50%. The global Foreign Direct Investment (FDI) showed a sharp decline of 21% in 2008. The FDI inflow to Africa was steady at a low level of USD 61.9 billion, an increase of 16.8% from 2007. However, there were large discrepancies across countries, as Egypt and Morocco respectively reported a decline of -5.6% and -7%. Tourism suffered a big hit from the crisis as a result of declining incomes in developed and emerging countries, where most tourist flows originated. Kenya announced a 25% to 30% 55

decline in tourist arrivals. Kenya Airways posted a 62.7% drop in profit for the half year at the end of September 2008. Egypt also announced a 40% cancellation of hotel reservations. The Seychelles announced a 10% fall in tourism revenue. Several textile factories were closed in Madagascar and Lesotho. This led to a decline in external textile demands from South Africa and the US, their major trading partners. This led to a decline in economic activity and employment opportunities. A local textile company in the West of South Africa closed, causing the loss of 4000 jobs. The manufacturing sector was affected by both falling global demand and rising cost of imports of intermediate goods caused by the currency depreciation. As a result, factories run at low capacity and employment was seriously threatened. In Uganda, the Uganda Manufacturers’ Association reported that 15 factories closed in 2008. South Africa announced a significant drop in the sale of new cars, reflecting the crisis facing vehicle manufacturers worldwide. Effect of the crash on the Nairobi Securities Exchange (Capital Markets Authority, 2008)

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By mid-July last year, the key NSE 20 Share Index had dipped 10.5% to 4578 points. As a result, local investors became cautious when buying shares so as to avoid the risk of getting locked into higher buying prices at a time the market would be on downward trend. Foreign investors started exiting to curb any further losses on their portfolios due to the weakening shilling. (Business Daily July 23, 2015). By October 8th, 2015, the NSE Equity markets had been in the red zone for seven consecutive trading days. The NSE All Share Index slacked by 0.30 points to end at 142.40 points. The NSE 20 Index sagged by 30.21 points to close at 4041.35 points. The NSE 25 plunged by 0.20% to close at 187.58 and the FSE NSE 25 sagged by 0.19% at 187.58 points. (Capital Markets in Africa, October 8, 2015). As a result, volume of shares traded dropped 77.49% to close at 10.53 million and total turnover also went down to close at KES 276.55 billion. The losers included Bamburi Cement Limited by dropping 5.42%, Mumais Sugar Company Limited sagged by 2.63% and UNGA Group Limited tumbled by 2.11%. 57

By December 19th 2015, all indices were down with NSE 20 Index at 0.16%, NASI at 0.53% and the NSE 25 at 0.90%. As a result most of the participants were foreign investors who were mostly sellers (Standard Chartered market report). As a result, share prices of half of the companies linked to the NSE 20 Share Index fell as some foreign investors sold e.g. Britam, Equity Bank, Kengen and CFC Stanbic. (Business Daily Sunday December 20th 2015). By the end of December, the NSE 20 Index was down 23% from the beginning of 2015. The overall market declined 12% over the same period as captured by the NSE All Share Index. Some of the 14 wealthy stock holders that saw a steep decline in the valuation of their portfolios were Peter Munga and Pradeep Paunrana. (Business Daily Sunday December 29 2015). 11.3 Mitigation strategies to curb the impact of stock market failure on stock index 11.3.1 Trading Curbs A trading curb is a point at which a stock market will stop trading for a period of time in response to substantial drops in value. For example, on the New York Stock Exchange, one type of trading curb is a circuit breaker. This limit was put in place after Black Monday in order to reduce market volatility and massive panic sell-offs, giving traders time to reconsider their transactions. At the start of each quarter, the NYSE sets three circuit breaker level of 7% (level 1 ), 13% (level 2) and 20% (level 3) of average closing price of the S&P 500 for the preceding month, rounded to the nearest 50 point interval. Depending on the point drop that happens and the time of day when it happens, different actions occur automatically. Level 1 and Level 2 declines result in a 15 minute trading halt unless they occur after 3:25pm, when no trading halts apply. A level 3 decline results in trading being suspended for the remainder of the day, in Japan, the stock trading will be halted in cases where the criteria for the Central Bank are met. The trading halt time is 10 minutes. In China, a circuit breaker mechanism began a test run on January 1 st 2016. If the CSI 300 Index rises or falls by 5% before 14:45 (15 minutes before normal closing time), stock trading will halt for 15 minutes. If this happens after 14:45 or the index change reaches further to 7% at any time,

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trading will close immediately for the day (full breaking). However, the use of circuit breaker was suspended in China. 12.4 Mitigation strategies in Kenya The Capital Markets Authority, being the Government Regulator charged with licensing and regulating the capital markets in Kenya listed the following strategies to mitigate the effects of a future global crisis (CMA report 2008); 12.4.1 The right regulation model This is because the deregulated and fragmented model of the US and Europe didn’t foresee the collapse because the institutes which collapsed were considered too big to fail and monitoring was left in the hands of institutions. Memorandum of Understanding was signed between all the financial sector regulators to share information on risk and other cooperation to ensure no gray areas are unregulated. This included the regulations on asset backed securities. Stockholder exposure and presentation on the proposed changes was held in November 2008. 12.4.2 Investor education and public awareness CMA encouraged measures to make the public more knowledgeable on products so that they make informed investment decisions because an informed investor is a protected investor. 12.4.3 Good Corporate Governance This was required to restore market confidence, attract FDI and capital inflows, and investments so as to promote economic growth. This would be achieved by increasing;    

The accountability of directors The transparency of corporate structures Valuation models Transparency of financial transactions

12.4.5 International Surveillance This was mainly encouraged to police the global financial system and warn of potential trouble spots, crisis and define its extent. This would enable Kenya to utilize the surveillance information available and act quickly to prevent any crisis. All financial sector regulators 59

adoption of risk based supervision. Financial institutions have to carry out risk management, with the regulator risk profiling and continuously reviewing the risks independently. More information sharing by the financial sector regulators in Kenya on the risk profiles as well as other pertinent information was encouraged. 13.0 Developments in Stock Indices On September 16, 2014, the Nairobi Securities Exchange was added as a constituent of the FTSE Mondo .Visione Exchanges Index, the first Index in the world to focus on listed exchanges and other trading venues. The FTSE Mondo Visione Exchanges Index compares the performance of individual exchanges and trading platforms and provides a reliable barometer of the health and performance of the exchange sector. “The NSE is elated to be added to the FTSE Mondo Visione Exchange Index. The Index aims to reflect market sentiment and is a key indicator of the exchanges’ performance. This addition is line with our vision ‘To be a leading securities exchange in Africa, with a global reach in Africa,’ benchmarking our Exchange against the most competitive Exchanges in the world and giving the Kenyan market international visibility” (CEO, Peter Mwangi announced). Last year, the NSE launched a new index comprising of 25 companies, with financial sector firms making up more than half the list. The NSE reported that the new index was expected to facilitate smooth operation of upcoming market for derivatives, which are instruments used in hedging against risk present in underlying assets. The new index (NSE 25 Share Index) has nine banks including Barclays, CFC Stanbic, Equity Group, Diamond Trust Bank, KCB Group, NIC, Stanchart and I &M (Business Daily 05.10.2015). In order for a company to qualify for inclusion in the NSE 25 share Index, the issuer shall fulfill the following conditions:     

Shares must have their primary listing on the Nairobi Securities Exchange Must have at least 20% of its shares quoted on NSE Must have been continuously quoted for at least 1 year Must have a minimum market capitalization of KES 1 billion Should ideally be a “blue chip” with super profitability and dividend record

On January 25, 2016, the S&P Dow Jones indices announced the launch of S&P Shift to Retirement Income and DEcumulation (STRIDE) index series to represent a strategy that focuses 60

on reflecting theoretical interest-rate hedged, inflation-adjusted retirement payout. This new retirement plan is intended to measure risks and rewards accruing to a specific strategy of shifting from growth assets to an expected, inflation-adjusted simulated retirement income stream. This was launched in response to the need for income focused benchmarks within defined contribution plans. S&P STRIDE index blends the process of wealth creation with the need to mitigate uncertainty of in-retirement income. (S&P press release). Last year, the S&P 500 launched the S&P 500 Catholic Values index which is designed to include the companies within S&P 500 whose business practices adhere to the Socially Responsible Investment Guidelines as outlined by the United States Conference of Bishops (US CCB) and exclude those that do not. This index is the first Catholic index based on such a prominent benchmark as the S&P 500. Constituents are screened to exclude companies who are involved in activities that are perceived to be inconsistent with Catholic values as set out by the US CCB (e.g biological and chemical weapons, nuclear weapons and conventional military sales (August, 2015 Press Release). 14.0 How Stock Market Indices have changed investing Andrew Beattie (2007) discussed 3 ways in which stock market indices changed investing; 14.1 Indices brought transparency and a better understanding of market forces For example, Dow Theory pioneered by Charles Dow and elaborated upon by his predecessors was one of the first attempts at technical analysis. Indices are also used by traders and investors by giving them a measure of overall market sentiment. 14.2 Indices created a benchmark for investors and money managers to measure up against. The creation of this benchmark also encouraged a segment of the investing population to choose a less active route and settle for more modest returns, thus becoming possible with little financial knowledge to control their own portfolios. 14.3 What to do with reliable market information

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The challenge for investors is no longer how to get reliable market information, but what to do with it. This is because there are indices for technology stocks, pharmaceuticals and any subset within the financial world that an investor would care to know.

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15.0 References

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