In this case, we use the monthly returns of the two indexes for the seven-year period between 6th May, 2009 and 5th May, 2016. The monthly return are determined by comparing the current price with the previous month’s price. The monthly returns are then used to determine the average monthly return and the monthly standard deviation.
S&P MID CAP 400 INDEX
Average monthly return = 1.2047% or 0.012047
Monthly standard deviation = 4.4024% or 0.044024
Annual return = (1 + monthly return)12 – 1
= 1.01204712 – 1
= 1.1545 - 1
= 15.45%
Annualised standard deviation = Monthly standard deviation × √12
= 0.044024 × √12
= 0.044024 × 3.4641
= 0.1525
= 15.25%
NASDAQ 100 INDEX
Average monthly return = 1.4196% or 0.014196
Monthly standard deviation = 4.425% or 0.04425
Annual return = (1 + monthly return)12 – 1
= 1. 01419612 – 1
= 1.1843 – 1
= 18.43%
Annualised standard deviation = Monthly standard deviation × √12
= 0.04425 × √12
= 0.04425 × 3.4641
= 0.1533
= 15.33%
The average annual return on the S&P Mid-Cap 400 Index for the last seven years was 15.45% while that of NASDAQ 100 was 18.43%. The annualized standard deviation for S&P Mid-Cap 400 was 15.25% while that of NASDAQ 100 15.33%. This implies that the investors of S&P Mid-Cap 400 companies earned a lower return compared to the return earned by investors of the largest companies included in the NASDAQ 100 index. The standard deviation of NASDAQ 100 index was slightly higher than that of S&P Mid-Cap 400 Index. This indicates that the S&P Mid-Cap 400 had a lower risk than that of NASDAQ 100.
Correlation
The correlation coefficient between the two indices was 0.8587 indicating that there was a strong positive correlation between the two indices. This further shows that an investor willing to create a well-diversified portfolio should not invest in stocks included in both indices (Lee, Lee, & Lee, 2013).
Causes of changes in stock market indices
Stock market indices are affected by factors influencing the demand and supply in the market. These include interest rates, inflation, and economic growth rate, among other factors.
Interest rates
When the interest rate is high, the cost of borrowing increases hence fewer investors can afford loans. This reduces the purchasing power thereby reducing the demand for stocks in the stock exchange (Brigham & Ehrhardt, 2013). A reduction in demand will cause a fall in stock prices hence the stock index falls. If the interest rate is lowered, there will be an increase in money supply since the cost of borrowing will fall. The rise in the demand for stocks will cause an increase in stock prices hence the stock market index will increase.
Inflation rate
When the inflation rate is high, stock prices also increase as the prices of other commodities. The value of money declines when the rate if inflation is too high hence investors will be less willing to buy stocks. This reduces the demand for shares thereby causing a fall in the stock market index (Brigham & Ehrhardt, 2013). The inflation rate is affected by the rate of interest in the economy. In the US, the Fed manipulates its fund's rate to influence inflation.
The state of the economy affects the stock market index. It impacts the earnings of companies including those whose shares are listed. When the economy is growing, there is a rise in aggregate demand. This further increases the revenues and profits of companies. Stock market prices are influenced by the earnings of the respective firms. If a firm’s earnings increases, it can pay dividends hence this increases the return on shareholders’ investments. If firms are doing well, there will be an increase in the demand for their stocks thus causing an increase in the stock market index (Brigham & Ehrhardt, 2013). During the financial crisis of 2008/2009, there was a decline in the demand for securities. The Dow Jones Industrial Average shed value. Besides, the fall in Chinese stock market was also attributed to the slowdown in the country’s economy. However, the free fall was due to a bubble created by expansionary monetary policies that led to an increase in the demand for stocks even though individual stocks were not doing well.
Exchange rates
The exchange rate also affects the stock market as it influences the earnings of firms operating in international markets. Favorable movements in the exchange rates cause a rise in the stock market index while unfavorable movements cause a fall in the index (Reilly & Brown, 2011).
Other government policies
Government policies to encourage participation in the stock markets can increase the stock market index. For instance, fiscal and monetary policies that increase money supply will increase the demand for stocks thereby increasing the stock market index (Reilly & Brown, 2011). Some government policies are meant to encourage small investors and low-income earners to buy stocks in the exchange market. For instance, in the run-up to the Chinese stock market crash, the government encouraged small investors to buy stocks. This was done through quantitative easing, allowing short selling and margin trading, among other measures. The Chinese stock market index fell since the measures to increase participation in the market were not controlled. The measures increased the demand for stocks while the economy was slowing down and firms were making losses. Excessive demand created a bubble which later busted thereby causing a free fall in the stock market index.
References
Brigham, E. & Ehrhardt, M. (2013). Financial Management: Theory & Practice (14th ed.).
New York: Cengage Learning.
Lee, C., Lee, J., & Lee, A. (2013). Statistics for business and financial economics. New York,
NY: Springer.
Reilly, F. & Brown, K. (2011). Investment analysis and portfolio management (4th ed.). Fort
Worth, Tex.: Dryden Press.
