Q&A with CMMB Securities

Q. What is the composite index and how is it arrived at?

Cheryl, D’Abadie

A: A Composite Index is a statistical measure of the stock market or a segment of the stock market performance. It is a good measure of the direction or strength of the market or the particular segment. A Composite Index measures all the equities listed on a Stock Exchange, for example, the Trinidad and Tobago Composite Index (TTCI) measures all the stocks listed on the Trinidad and Tobago Stock Exchange (TTSE). The index tracks the change in market value of all listed equities and is adjusted to eliminate the effects of new listings (for example, Capital and Credit Merchant Bank) and de-listings.

There are three methods that are used to construct indexes:
1. Market Value or Market Capitalisation Weighted (Standard and Poor’s 500 Index or the TTCI)
2. Price Value Weighted (The Dow Jones Industrial Average), and
3. The Equal Weighted Method

The market value-weighted method is the most popular method used. Under this method, each stock is given a weighting proportional to its market capitalisation value. Market capitalisation value is calculated by multiplying its price per share by the number of shares listed. For example, RBTT market capitalisation value as at November 14, 2003 was $11.154 billion and the value of all stocks that form the Composite Index was $61.634 billion, thus RBTT would be worth 18 percent of the index. By giving larger companies higher weighting, this method reflects the fact that large companies have larger revenues and profits and that any change will have a larger effect on economic activity than change in smaller companies. A base year is chosen for the index and the prices prevailing at that point in time form the base value of the index.
Under the Price Weighted Method each stock is given a weighting proportional to its market price. The performance of companies with higher listed stock prices is over-weighted in a price-weighted index. Using an Equally Weighted Method, each stock is equally weighted in the index; therefore there is no distinction between companies with large or small market values. Consequently, the positive performance by a large market value stock may be eroded by the poor performance of smaller-cap stocks in this index.

Q. I can see the benefit of investing in a Money Market Fund, but there are so many of them out there, is there any difference and if there is, how do I go about choosing one that’s right for me?

Sita, Couva

A: A Money Market Fund (MMF) invests in short-term securities available on the money market with maturities of less than one year. The money market is simply a market where large institutions and government manage their short-term cash needs by issuing securities such as Treasury bills and repurchase agreements. The spread on the pool of money market instruments on the local market is very small so Money Market Rates tend to be highly competitive. These rates can be fixed on a monthly basis. When deciding to invest in a MMF, one should consider the management fees and other fees, such as front-load or back-load fees, charged by these funds. The expense ratio gives an indication of these charges. Though MMFs are considered to be very liquid, some institutions make withdrawals or deposits more convenient than others, for example, having widespread locations or providing ATMs. Safety is another consideration and risk adjusted returns, which was discussed in last week’s column, is a good measure of comparing the risks of MMFs.

Q. In stock market terms what is a derivative?

Vishnu, Port-of-Spain

A: A derivative, in terms of financial assets, refers to an asset that derives its value from another asset. In stock market terms, there are derivatives on common stocks, of which the most popular are options on common stock. Options give the buyer the right, not the obligation, to buy (a call option) or sell (a put option) a stock at a specified price (called the strike or exercise price) on a specific day (for European style options).

A premium or cash consideration is paid for the right to own the option and is based on many factors including the strike price, and the difference between it and the current market price or what is called the intrinsic value of the option. Other major factors affecting the premium would be the time to expiration and the volatility of the underlying asset’s price. There are also options and future contracts on stock indices. However, there is a wide variety of derivatives which can increase in complexity including future contracts, swaps and swaptions which are options on interest rate swaps and can be used as a risk management tool or for speculative purposes.