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Contents:Introduction....................................................................................................................................3

Chapter 1: Introduction to the idea of the capital market...............................................................6

1.1. Introduction....................................................................................................................6

1.2. The classification of financial markets...........................................................................6

1.3. The role of the capital market and the purpose which it serves...................................12

1.4. The functions of the Capital Market............................................................................15

1.5. Types of financial investment......................................................................................19

1.5.1. Equities.................................................................................................................20

1.5.2. Fixed-income securities........................................................................................21

1.5.3. Derivatives...........................................................................................................22

1.5.4. Money and foreign exchange...............................................................................23

1.6. The economy and the markets......................................................................................25

Chapter 2: The idea of index shares.............................................................................................27

2.1. Introduction..................................................................................................................27

2.2. FTSE indices................................................................................................................28

Chapter 3: The changes of indices...............................................................................................38

3.1. Introduction..................................................................................................................38

3.2. FTSE 100......................................................................................................................38

3.2.1. January – December 2007....................................................................................38



3.2.4. January 2007 – December 2009...........................................................................42

3.3. FTSE 250......................................................................................................................44





3.4. FTSE All-Share............................................................................................................49





3.5. Annual analysis............................................................................................................55




Chapter 4: The changes of indices and the economic indicators.................................................59

4.1. Introduction..................................................................................................................59

4.2. Gross Domestic Product...............................................................................................59

4.2.1. The idea of GDP and its changes in 2007-2009...................................................59

4.2.2. FTSE 100 and GDP..............................................................................................61

4.2.3. FTSE 250 and GDP..............................................................................................63

4.2.4. FTSE All-Share and GDP....................................................................................63

4.3. Pound Sterling Exchange Rate.....................................................................................65

4.3.1. GBP/EUR exchange rate and its changes in 2007-2009......................................65

4.3.2. GBP/EUR and FTSE 100.....................................................................................68

4.3.3. GBP/EUR and FTSE 250.....................................................................................69

4.3.4. GBP/EUR and FTSE All-Share...........................................................................70

4.4. Unemployment Rate.....................................................................................................71

4.4.1. The idea of unemployment rate and its changes in 2007-2009............................71

4.4.2. Unemployment rate and FTSE 100......................................................................75

4.4.3. Unemployment rate and FTSE 250......................................................................76

4.4.4. Unemployment rate and FTSE All-Share............................................................77

4.5. Interest Rate..................................................................................................................78

4.5.1. The idea of interest rate and its changes in 2007-2009........................................78

4.5.2. Interest rate and FTSE 100...................................................................................82

4.5.3. Interest rate and FTSE 250...................................................................................83

4.5.4. Interest rate and FTSE All-Share.........................................................................84

Summary......................................................................................................................................85

Bibliography.................................................................................................................................87

Literature..................................................................................................................................87

Press.........................................................................................................................................88

The Internet..............................................................................................................................88

Appendix 1: FTSE 100 constituents (December 2009):..............................................................89

Appendix 2: FTSE 250 constituents (December 2009):..............................................................90

Appendix 3: FTSE All-Share constituents (December 2009):.....................................................93

2

Introduction

The stock market is meant to be the reflection of the state of the economy in a

given country. By observing the situation in the market one should be able to judge

whether the economy is expanding, in recession or experiencing a boom. The decision

to explore the British stock market was based on my residency in the United Kingdom

as well as the phenomenon of Britain being one of the western countries that seemed to

have suffered most from the consequences of the American Credit Crunch.

FTSE indices have been chosen as a subject of the study, in view of the fact that

they stand for the biggest companies present on the British market. FTSE All-Share

covers 98% of total market capitalisation. FTSE 100 stands for the 100 most valuable

companies and FTSE 250, correspondingly, for 250. They also cover all the sectors of

the market from retail to steel industry, which gives a full picture.

Moreover, the reason for choosing the three-year period of time- 2007-2009 was

its attractiveness; after a rather steady 2007 one could observe a major change in 2008

and slow recovery of the economy beginning the end of 2009. This period enables a

researcher to show and analyse all stages of the business cycle: expansion, contraction,

recession and boom.

Furthermore, the aim of this thesis is to observe and describe how indices

changed in 2007-2009, to explore the similarities and differences in their behaviour as

well as check the rank of correlation between indices and four chosen economic

indicators: Gross Domestic Product, Great Britain Pound exchange rate, unemployment

rate and interest rate. In order to show how strong the relationship between the four

chosen variables is, Pearson’s correlation coefficient has been used.

What is more, in order to conduct the study, literary resources as well as

newspapers and the Internet have been used. To explore the very idea of financial

market, including capital market, one focused on work by Blake, Chamber, Clarke, Fell,

McInish, and Midgley. These authors describe the nature, significance, function as well

as the division of financial market which id the field of my research. In order to present

the division of FTSE indices and their role and significance, Vaitilingam’s [2001] work

has been reviewed and updated according to the information provided by the Financial

Times Stock Exchange website. Barry’s work, as well as another book by Vaitilingam

[2004], was very helpful to analyse the data and relate the indices to the chosen

economic indicators. What I also did find helpful in understanding the data was

Financial Times itself. It describes the economical issues on daily basis and is edited by

specialists, i.e. Bank of England governor, Mervyn King.

Worth mentioning is also a short description of what information is covered by

each of the four chapters. Chapter 1 describes the very idea of financial market,

including capital market. First, it focuses on the division of financial markets presented

briefly according to Blake’s [1990] classification. Moreover, it also explains the idea of

equilibrium and the phenomenon of bid-offer spread present in the market. Furthermore,

it focuses on the role of the capital market- explains who the participants are and how

the cost of capital can be influenced. Later, one can explore the functions of the capital

market, such as creating liquidity, allocating and rationing funds, pricing of shares, as

well as providing a barometer of a company’s success. Besides, types of financial

investment, like equities, fixed-income securities, derivatives and foreign exchange are

enumerated and briefly described. Finally, it presents the idea of how the economy of a

given country is related to the situation of the market; main economical crises are also

briefly described.

The second chapter focuses on the idea of index shares, especially FTSE indices,

presenting their division and significance to the British economy. After presenting the

FTSE UK Index Series family tree, it describes the following components briefly: FTSE

100, FTSE 250, FTSE 350, FTSE SmallCap, FTSE All-Share, FTSE Fledging, FTSE

All-Small as well as FTSE AIM. Moreover, it shows how the daily changed of indices

enumerated above are presented in Financial Times. Lastly, this chapter described the

way of classifying categories of businesses into certain sectors.

The next chapter shows the changes in value of the three chosen FTSE indices:

FTSE 100, FTSE 250 and FTSE All-Share. What is taken into consideration is the price

they had at the beginning and in the end of a given year, as well as their highest and

lowest values they reached over the analysed period. The rate of average monthly

change has also been measured for the whole period as well as for each year separately.

4

Next, the dynamics of change for each index is calculated and presented by separate

charts.

Finally, the last chapter discusses the correlation between indices and four major

economic indicators. First, it described the idea of GDP and how it changed in the

United Kingdom over the three years. It is also mentioned that the dynamics of its

changes can be used to identify the phase of business cycle that the economy is

currently in. The relationship between GDP and FTSE indices is also examined.

Similarly, GBP/EUR exchange rate and its change is also introduced and analysed. This

part of the chapter also explains how the value of currency is influenced by the state of

economy. The relationship between the exchange rate and chosen indices is also

measured. Moreover, the focus is moved onto unemployment rate which also says a lot

about the economy of a given country. It is explained why unemployment rises when

the market is facing problems as well as why it does not fall immediately after the

market starts recovering. The level of correlation between the number of people seeking

for work and the value of FTSE indices is also calculated. Finally, the chapter finishes

its analysis by concentrating on interest rate and its significance in reading the state of

the economy in the UK. It is explained how the government reacts to the situation in the

market by fulfilling its monetary policy.

5

Chapter 1: Introduction to the idea of the capital market

1.1. Introduction

The nature of this section is purely introductory to the topic of financial markets

yet essential for understanding how the capital market works and what its significance

is. This chapter presents the very idea of financial markets and the possible way of

classifying them as well as focuses on the role and functions of the capital market itself.

Later, the types of financial investment are also presented and briefly described. It also

introduces essential terms used in discussing the capital market.

1.2. The classification of financial markets

An organised financial market is a place where, or a system through which,

securities are created and transferred.

Financial markets can be classified in a number of ways. The division made by

Blake [1990, p. 16-35], which is crucial to understanding the functions and subjects of

financial market, is presented below:

- physical v. over-the-counter

- continuous v. call markets

- money v. capital markets

- primary v. secondary markets

- stock v. flow markets

A financial market does not have a physical location. Shares, bonds and money

market instruments are traded over-the-counter using a system of computer screens and

telephones together with the Internet. Only financial futures and financial options are

still traded in a physical market, the former, at LIFFE (the London International

Financial Futures Exchange) and the latter, at LTOM (the London Traded Options

Market), on the floor of the ISE (the International Stock Exchange).

Most markets operate on a continuous basis during opening hours, implying that

trading can take place at any time that the markets ape open. Examples here are the

markets for shares, bonds and money market instruments. However, as Blake [1990, p.

17] points out, some markets trade at specific times during opening hours. Such markets

are known as call markets because the securities are ‘called’ for trading. There has to be

sufficient time between calls to allow offers to buy and sell securities to accumulate and

so make trading worthwhile. Examples here are the pit trading of financial futures and

financial options.

Markets can also be classified according to their maturity of the securities traded

in them. A major distinction is usually drawn between money markets and capital

markets which are the subject of this dissertation. Money markets deal in securities

with less than one year to maturity, whereas capital markets deal in securities with

more than one year to maturity. Examples of money market instruments are Treasury

bills, commercial bills, commercial paper, bankers’ acceptances and negotiable

certificates of deposits. Examples of capital market instruments are bonds with more

than one year to maturity and shares.

An important distinction can also be drawn between primary and secondary

markets. Blake [1990, p. 19] reminds that the primary market is the new issues

market. When an investment bank brings a new company to flotation, its shares are

issued on the primary market (as an initial public offer). If this company subsequently

decides to gear up by issuing bonds, these are also floated on the primary market.

Similarly, if a company decides to expand using either equity finance or bond finance,

the additional shares or bonds are floated on the primary market (known as a secondary

public offer). As Chamber [2004, p.72] claims, the most difficult problem facing an

investment bank involved in a new issue is deciding on the offer price of the issue. If

the offer price is too low and there is an excess demand for the new shares or bonds,

then the issuing company will not be satisfied because it could have raised additional

revenue from the issue. But if the offer price is too high and there is insufficient demand

7

for the new shares of bonds, then the investment bank as underwriter will be involved in

often considerable losses. The important point about the primary market is that the

initial price of the security is set rather than determined by the market, unless the

security is issued through a tender offer or by auction.

The secondary market, according to Blake [1990, p. 21], is the market in which

existing securities are subsequently traded. There are two main reasons why individuals

transact in the secondary market: information-motivated reasons and liquidity-

motivated reasons. Information-motivated investors believe that they have superior

information about a particular security than other market participants. This information

leads them to believe that the security is not being correctly priced by the market. If the

information leads them to believe that the security is currently underpriced, and

investors with access to such information will want to buy the security. On the other

hand, if the information is incorrect, the security will be currently overpriced, and such

investors will want to sell their holdings of the security. Liquidity- motivated investors,

on the other hand, transact in the secondary market because they are currently in a

position of either excess or insufficient liquidity. Investors with surplus cash holdings

(e.g. as a result of an inheritance) will buy securities, whereas investors with insufficient

cash (e.g. to purchase a car) will sell securities.

The prices of securities in the secondary market are determined by the market-

makers in those securities. Precisely how those prices are determined can be seen once

we have discussed the final way in which securities markets can be classified, namely as

stock or flow markets. This classification leads us directly to the concept of

equilibrium. Once a security has been issued, it exists in the market-place until it

matures and is redeemed. Although a security can be sold, it can be sold only to

someone who is willing to buy it. Clearly, it is impossible for everyone to sell their

holdings of a particular security. Therefore there is a market for the entire stock of a

particular security, and there is also a market for the flow purchases and sales of that

security over time. These are shown in Fig. 1.1 the left-hand diagram, which shows the

stock market, indicates a fixed stock supply and a downward-sloping stock demand.

The lower the price of the security, the higher the stock demand. The right-hand

diagram shows the flow market per unit of time. If the time period is a day, for example,

the diagram indicates a downward-sloping daily demand curve and an upward-sloping

daily supply curve for the security. Equilibrium in the stock market is defined as the

8

situation in which the entire stock supply of the security is voluntarily held. This occurs

when the stock market price of the security is Pe. Equilibrium in the flow market is

defined as the situation in which the flow supply of the security on the market equals

the flow demand. This occurs when the flow market price of the security is Pe. Overall

equilibrium occurs when both the stock and flow markets are simultaneously in

equilibrium. This occurs when the stock and flow market equilibrium prices are

identical. Out of equilibrium, prices will adjust to clear both markers.

Source: Blake [1990, p. 23]

Figure 1.1. The stock and flow markets for a security

Figure 1.2 shows the equilibrium price, but this is never actually observed in the

market-place. What is observed are transaction prices, and these take into account the

bid-offer spread of the market-makers. The transaction price at which a market-maker

buys securities is the bid price and the transaction price at which he sells securities is

the offer price. The difference between the two is the bid-offer spread. If there is more

than one market-maker, then the difference between the highest bid price and the lowest

offer price is known as the market bid-offer spread or the touch. The equilibrium price

lies within the touch, as Fig. 1.2 shows for the flow market.

9


Figure 1.2. The bid-offer spread

What determines the bid-offer spread? This can be answered when one examines

the role of a market-maker. In an organised financial market, the role of a recognised

market-maker is to provide continuous and effective two-way prices (i.e. both bid and

offer prices) in all market conditions. In short, the market-maker has the responsibility

of keeping an orderly market. To do this effectively, he or she must hold an inventory of

securities to smooth out price fluctuations. The market-maker must be compensated for

holding these inventories, and the bid-offer spread is the way in which the market-

maker receives his compensation. The bid-offer spread will be determined to

compensate the market-maker for the cost of and risk to the capital that he or she has

tied up in the inventory of securities. The total compensation to the market-makers is

given by the shaded area in Fig 1.2, i.e. (PS –PB)Q.

The costs and risks of market-making depend on such characteristics of the

market as its breadth, depth and resilience. They also depend on the ratio of

information-motivated investors to liquidity-motivated investors.

A market for a particular security is said to have breadth if it has a substantial

volume of both buy and sell orders at the equilibrium price, i.e. if it has a good two-way

flow of orders. Markets with few buyers and sellers are called thin markets. A security

will be regarded as highly liquid if the market for than security has substantial breadth.

Market-makers in a broad market will operate with lower bid-offer spreads than those in

10

a thin market, because broad markets provide a bigger volume of business and are also

less risky.


Figure 1.3. A broad, deep market

A market for a security is said to have depth if it has a continuous flow of buy

and sell orders at prices above and below the equilibrium price. This means that both

the flow demand curve and the flow supply curve must be continuous at prices above

and below the equilibrium price. It also means that both the demand curve and the

supply curve must be highly elastic, (e.g. quite flat), at prices around the equilibrium

price. If these conditions hold, then only small changes in the price of the security will

be required to restore equilibrium should a sudden imbalance between buy and sell

orders arise. In short, price changes will be continuous in deep markets. In shallow

markets, on the other hand, the flow demand and supply curves are either discontinuous

or highly inelastic (steep). In such markets price changes will be both highly variable

and discontinuous (i.e. they will jump a great deal). Price changes will be smaller in

deep markets than in shallow markets. Therefore there is less risk of market-makers

incurring losses on their inventories as a result of sudden large adverse price movements

in deep markets compared with shallow markets. As a result, market-makers’ spreads

will be lower in deep markets than in shallow markets. A security will be regarded as

11

highly reversible if the market for that security has substantial depth. Figure 1.3 shows a

broad, deep market, while Fig. 1.4 shows a thin, shallow market.


Figure 1.4. A thin, shallow market

A market is said to be resilient if the flow of buy and sell orders does not dry up

whenever the price changes. If price changes do not reduce the flow of orders, then the

market-makers will not be faced with an inventory of unsaleable securities, and as a

result they will be willing to charge lower spreads.

Summarising, one can see that bid-offer spread will be lower the broader the

market, the deeper the market, and the more resilient the market.

1.3. The role of the capital market and the purpose which it serves

A market provides a focus on activities of buyers and sellers of a particular

commodity or service. In the course of the dealings the price or series of prices is

settled. The participants in the United Kingdom capital market include businessmen,

central and local government, financial intermediaries such as insurance companies and

12

pension funds, and private investors. According to Midgley [1977, p. 1], the capital

market has no confined location: it is in progress all over the land, wherever suppliers

and users of capital get together to do business. Much business is transacted over the

telephone or the Internet, so that there need be no geographical site at all for certain

activities. However, parts of the market are concentrated in certain well-known centres,

the most renowned of these being the Stock Exchange at 33 Throgmorton Street in

London which deals in company securities and those issued by governments and local

authorities.

The capital market deals in funds, but as securities, for example bonds or share

certificates, are given in exchange for funds, one can equally treat it as a market dealing

in securities. The market conforms to the laws of supply and demand in the ordinary

way. Thus in demand for funds increases and the supply remains constant the price of

funds raisers (that is, the price of securities rises).

Within the capital market one can speak of the price of funds in a general way.

Midgley [1977, p.1] compares capital market to fish market to illustrate the mechanism:

in the fish market one can speak of the price of fish. But of course nobody buys just

fish; one does not ask for a pound of fish, but rather a pound of haddock or cod.

Similarly, in the capital market the buyers of funds are in practice specific about their

requirements. They may wish to raise £1 million of risk capital, or £500,000 of capital

on long-term loan, or £200,000 on bank overdraft, and so on.

The price paid for access to funds may be in the form of a fixed payment per

annum (though it may be paid in instalments, for example, twice a year) or it may be in

the form of an agreement to share profits. An example of the former circumstance is

where interest is paid to providers of loan capital; and the latter circumstance is

exemplified where dividends are paid out to shareholders. However, as Midgley [1977,

p. 26] stresses, one must hasten to add that shareholders are not rewarded only by

dividend payments: if that were the case some companies would appear to be giving a

meagre return to risk capital. Part of the return to shareholders is in the form of retained

earnings is a factor taken into consideration by the market, and if it is regarded as

sufficiently attractive the share price will rise so as to reflect this expected future

growth.

13

Moreover, the factors which could influence the cost of capital funds, or, the

reciprocal, the price of securities, must be generally reviewed. As Briston [1995, p. 34]

presents it, perhaps one of the first influences which will come to mind is the extent of

funds available from public savings. Another fairly obvious influence is the level of

demand for funds arising from plans for new forms of industrial and commercial

investment. These will provide a starting point, but in practice there are many complex

factors which exert their influence on the market. On the supply side there is of course

the flow of funds stemming from the banking system. An easy credit policy which leads

to the criterion of new bank money will lead, ceteris paribus, to a reduction in the cost

of funds. Bank credit policy, however, will not be unrelated to governmental fiscal

policy; for example, a budget deficit financed by issue of short-term securities may

encourage expansion of bank credit and thus lower the cost of funds.

In its turn governmental fiscal policy will not be immune to the behaviour of the

balance of payments and capital movements in and out of the country. A serious run-

down of a country’s reserves of foreign currencies will almost certainly be countered by

fiscal stringency and credit restrictions leading to an increase in the cost of capital.

One of the most cogent influences on the cost of funds is the attitude to liquidity

on the part of investors, that is people, institutions, etc. who purchase securities, as a

whole. If investors decide that the return to funds which they provide is too low, or in

other words the price of securities is too high, there may be a sudden and overwhelming

desire to hold cash or near-cash for the time being. This may result in a fairly rapid

slump in security prices, or, the same thing, an increase in the return to funds, that is in

the cost of capital. Conversely, investors may decide that they are too liquid and that

returns to funds are too attractive to ignore. For example, Gilbert [1999, p. 75-76]

illustrates this situation by describing what happened 25 years before; it was known that

the institutional investors (insurance companies, pension funds, investment trusts and

unit trusts) were holding large liquid balances towards the end 1974. Once security

prices began to rise in January 1975, and investors began to appreciate that the return to

funds provided was falling, they flooded the market for securities with buying orders to

such a degree that the Financial Times Actuaries All Share Index rose by over 100 per

cent within a few weeks. Looking at this dramatic change from the point of view of the

return to funds, the earnings yield on industrial ordinary shares fell from over 30 per

cent to 20 per cent within a month. The flat yield on Consols (that is a general

14

indication of the return on long-term gilt-edged securities) also fell during this short

period, though by no means so spectacularly, from 16 per cent to less than 15 per cent.

In fact, as Midgley [1977, p. 13] states, different sectors of the market for

securities are subject to different influences. The return to funds in different sectors may

move more of less rapidly over time, as noted above. It is possible too that the returns in

one sector may be rising when the returns to other sectors are falling. Thus long-term

fixed interest rates may be rising when short-term rates are falling; or the earnings yield

on industrial shares generally may be falling when that on, say, engineering shares is

rising. Generally though, apart from occasional exceptional moves against the trend, the

returns in different broad sectors of the market move together in the same direction,

though not at the same pace.

1.4. The functions of the Capital Market

The fact that the capital market, or at least that part of it represented by the Stock

Exchange, is sometimes regarded as providing a service not unlike that of a casino does

not mean that it has no important, sober and useful functions. Like any other market, the

capital market provides a means whereby suppliers and buyers can exchange a

commodity at mutually satisfactory prices. Here lies perhaps the most obvious, and

certainly the most important, of the market’s functions, according to Midgley [1997,

p.14]: that of creating liquidity. Were it not for the market most of the longer-term

securities issued by companies would be far more permanent investments in the hands

of their holders. Without an organised market, the owner of a block of ordinary shares

in a particular company who wished to dispose of his holding would have to make a

personal search for a potential buyer. He may have to advertise and/pr employ an agent;

he may have to suffer the inconvenience of a considerable delay before finally finding a

buyer, and the price agreed upon would almost certainly be much less satisfactory than

that settled in an organised market where many buyers and sellers confront each other.

As Midgley stresses [1997, p.15], without the market- endowed quality of liquidity,

company shares and debentures would be far less attractive to investors, and companies

would have difficulty in raising all the funds they needed for expansion. It is of course

15

true that a comparatively small part of company funds are raised externally from

investors at present, but this part may nevertheless be of vital importance.

Consequently, the liquidity provided by the stock market (in particular) serves the very

useful purpose of ensuring that external investors are willing to make new funds

available to business as required.

Moreover, the market not only creates liquidity through its pricing mechanism, it

also allocates and rations funds, and it operates a system of incentives and

penalties. As Briston [1995, p. 74] suggests, the market prices funds for borrowers and

suppliers according to their different requirements. For large, efficient companies,

which can offer sound securities subject to the minimum or risk, the rate for borrowing

will be comparatively low. For smaller companies, which cannot give the same

assurance of safety, the rate will be higher. Furthermore, the shares of a successful

company with good growth prospects will be priced much higher in the market than

those of a similar-sized company with a poor record and uncertain growth prospects.

One effect of this is that potential growth companies in expanding industries tend to

have much lower earnings and dividend yields than companies, with uninspired

management in declining industries. In short, the ‘super-companies’, as Briston [1995,

p. 78] calls them, can raise funds by equity share issues with the minimum immediate

obligation in terms of cash outflow to the providers of capital; while the companies

which lack investor confidence will issue securities subject to the maximum obligation

in terms of annual cash returns to investors. The market is thus conferring a

considerable advantage on the more efficient companies.

The market pricing of shares has further repercussion on companies other than

its effect on the allocation of funds. Share-price movements operate so as to provide

both sticks and carrots for those who manage quoted companies. The mechanisms are

various. One fairly obvious form of discipline to management is that exercised by

shareholders who are dissatisfied with the trend in the share price. For some, usually

small quoted companies, the holdings of certain individual shareholders are sufficiently

large for them to take direct action, such as removing directors from the board. In the

case of lager companies, the holdings are often so widely spread that no individual, or

group of individuals, holds sufficient shares to exercise power, and the directors, in such

circumstances, although themselves holding only a small fraction of total voting shares,

can retain full control in the absence of any concerted opposition. This situation is not

16

all-pervasive among large companies. Sometimes ginger groups are set up to act on

behalf of the mass of individual shareholders. Moreover, in most large companies

institutional shareholders now hold between one-third and one-half of the equity shares

via their separate investment protection committees or their combined institutional

shareholders committee ma act as a disciplining force. However, as Midgley points out

[1997, p.16], it has to be said that in spite of some notable successes, such forms of

direct action tend to have been brought to bear too late to avoid the damage which they

sought to avert. This does not mean, incidentally, that shareholders must remain

powerless in terms of direct influence; rather, it may be argued that more effective and

permanent methods of representation must be forged.

Share price movements frequently provide incentives and penalties on a

personal basis for top managers of large companies. Many directors have large

shareholdings, and thus have a personal incentive to work to promote the efficiency of

the company and hence upgrade the value of their own stake. Nowadays, even if

managers have not the wealth to acquire a large holding of shares by direct personal

investment, they may profit from share-incentive or stock-option schemes. Such scheme

may vary in detail according to the circumstances operative at the time of their

introduction and are prone to the taxation policy of the government of the day.

Fundamentally, the idea is that chosen directors and executives, who can influence the

profitability of the company, are given the right to subscribe at some time in the future

to the shares of their company, but at the current day’s price. In this way they have a

strong incentive to work for increased profits, which, if sufficiently meritorious in

relation to results of other companies, will lead to a higher share price. Participants to

the scheme can then exercise their options and sell their shares, thus enjoying a capital

gain – the reward for their efforts. The scheme will be subject to various restrictions to

avoid undue dilution of capital. For example, participants may be prevented from

selling their shares within a stipulated period from allotment; there will be limitations to

the total amount of shares issued under a scheme, and also to the shares issued to any

individual; or a profit target may be built into the scheme, with the effect that

participants can only gain if the target is achieved and other shareholders get some

benefit from company growth.

As Briston presents it [1998, p.81], share-incentive schemes involved a

consideration of which managers should be entitled to benefit and to what extent.

17

Inevitably, the right will tend to be made available in relation to the degree of

importance in the management hierarchy. This may mean that a particular executive

who has made a substantial entrepreneurial contribution, but who is fairly low down in

the hierarchy, is not adequately compensated by a share-incentive scheme. However,

one means of compensation may be open to them, although it is a means which is

generally frowned upon, that is, profiting from dealing in shares on the basis of inside

knowledge. The arguments against this are fairly well known, although the practice, in a

variety of forms, is probably less uncommon than some London apologists would care

to admit. Broadly, insider trading is said to put outsiders at a disadvantage, to allow

insiders to profit at the expense of share-holders who are unaware of the inside

information, and to undermine confidence on the part of the investing public.

Nevertheless, the case for insider trading as a means of rewarding the modern

company entrepreneur has been cogently made. It has been argued that because insider

trading in company stocks does not suppress long-term trends, it does little harm to

long-term outside investors. As for short-term outside speculators, such losses as they

might make as a result of selling (or buying) before inside information becomes

generally known would probably have been made anyway. More importantly, it is

argued that the possibility of dealing in the company’s own shares provides incentives

for anyone who makes an entrepreneurial contribution: that it can reward company

entrepreneurs in a more precise manner than bonus or incentive schemes; that it rewards

regardless of status, and yet ensures that all investors gain as well as entrepreneurs.

Whether or not such arguments are given serious weight, they do at least illustrate

theoretically how company executives might be motivated to work harder and more

imaginatively for the company in response to the possibility of making gains from share

price movements stemming from their own efforts.

There are two more reasons for thinking that share price movements exert an

influence on company management. One is that the share price barometer provides a

rough and ready indicator of the success of company management. A share price which

is falling more than those of rival companies (or not rising as fast) may be thought to

cast a reflection on management efficiency, and managers are unlikely to be insensitive

to the view that share price movements have a bearing on their competence.

18

If some thick-skinned managers are immune to the aspersions or their efficiency

implicit in a falling share price, they may be more open to influence by a pressure more

germane to their pockets and power positions than to their public image. Again, the

pressure derives from share price movements, but here we refer to the view that the

depressed share price of a company which has had a poor profits record will make it

vulnerable to a takeover bid, and that the possibility of dismissal or reduced status and

prospects may act as a spur to management to do better. However, it must be said that

empirical evidence provides only meagre support for the proposition that a company

which is relatively cheap in terms of the relationship between its equity stock market

price and the book value of its equity assets is in practice much more vulnerable to a

takeover bid than a company which has a high valuation ratio of this sort. Even if the

spur provided by falling share prices, and the possibility of takeover depends more on

fear than fact for many companies, the stock market may still be exerting a useful

influence favouring company efficiency.

To sum up, the capital market supports the whole basis of business undertaken

by joint-stock limited companies. By providing a means of converting long-term

investments into liquid funds, it gives a foundation of confidence to the process of

saving an investment. The pricing process for securities not only leads to the allocation

of funds to those companies which can make best use of them, it also provides penalties

and inventiveness to managers, both directly and indirectly, and even threatens to

operate through the takeover mechanism to put the management of inefficient

companies into more competent hands.

1.5. Types of financial investment

In this section the types of financial investments are being presented according

to the division made by McInish [2000]. First the focus is directed onto equities, than

fixed-income securities, derivatives, money, and foreign exchange. All of those

instruments are briefly described.

19

1.5.1. Equities

Equities are securities representing capital contributed to the firm for which

there is no legal obligation to repay. Once they have fully paid the purchase price for

their shares, investors can lose only the amount of their investment and cannot be called

upon to put up additional funds. This limited liability is a major advance in modern

finance that has resulted in a significant increase in the ability of firms to raise capital.

As McInish [2000, p. 11] points out, the advantage of this system from the point of view

of investors can be seen in the case of the insurance firm Lloyds of London, which is

organised as a series of partnerships. Major losses due to the hurricanes and other

insured risks resulted in calls on the partners, called ‘names’, for millions of British

pounds in additional capital, resulting in the bankruptcy of many names. Many of the

names in the USA sought court protection from the requirement to contribute additional

capital.

Equities include all types of stock issued by the firm. Shares of common stock

represent ownership interests in a firm. The owners of stock are called ‘stockholders’ or

‘shareholders’. Common stock represents ownership of the residual claim on the

earnings and assets of the firm after the firm has paid its other commitments. The

shareholders are the owners of the firm. They run the firm through an elected board of

directors. Of course, the shareholders are not the only investors in the firm, as McInish

[2000, p. 14] stresses. Many firms borrow money, becoming debtors, and those lending

the money become creditors of the firm. But the creditors make their decisions on how

much to lend the firm and what rate of interest to charge with full knowledge that

operating decisions are in the hands of the board of directors and the firm’s officers and

managers.

Another equity security is preferred stock, which has a claim to earnings and,

typically, also assets that is superior to or ahead of that of the common stock, but that

comes after all other obligations of the firm. Many issues of preferred stock have a fixed

dividend payment that is specified in the form’s documents such as the corporate charter

or by-laws. This specified dividend payment does not generally represent a legally

enforceable claim against the firm, but firms are often required to give certain privileges

to preferred stockholders if the specified dividends are not met. As McInish [2000, p.

20

16] enumerates, these privileges may include the right to receive any back dividends

owed before the common stockholders can receive any dividends and the right to elect

some or all of the members of the board of directors. Because many preferred stock

issues have the right to receive fixed dividend payments and no more, preferred stock is

often regarded as being a fixed-income security.

A warrant is a security issued by a firm that gives the holder the right to acquire

stock in the issuing firm, or sometimes in another firm, at a stated price for a specified

period of time. Warrants are often issued in combination with other securities such as

common stock or bonds which will be discussed later in this chapter. Traditionally, as

McInish [2000, p. 17] mentions, warrants have been considered as equities, and the

funds raised from the sale of warrants are part of the firm’s capital.

A right is a short-term warrant that is distributed to the holders of a firm’s

common stock as a dividend. Each right entitles the owner to purchase an asset,

typically the common stock of the firm distributing the right, at a price that is less than

the current market price of the firm’s common stock. The goal is to have the

stockholders exercise the right so that the firm can increase its equity. Rights offerings

are a popular way of rising equity in many countries, including the United Kingdom,

which is the subject of my dissertation, and Japan. As McInish [2000, p. 21] points out,

they were also popular in the USA at one time, but their use has declined sustainability

in the end of 1990s.

1.5.2. Fixed-income securities

Fixed-income securities are securities that promise to make payments of

specified amounts to investors at specified dates. As it was mentioned before preferred

stock is often a fixed-income security. But most fixed-income securities are debt

instruments. A bond is a security which is evidence of debt issued by firms and

governmental bodies, including nations and their subdivisions and international

organizations such as the World Bank (the International Bank for Reconstruction and

Development), that requires that the issuer make one or more payments to the owner. A

money market instrument is a debt obligation with an initial maturity date of less than

21

one year. Capital market instruments have lives of one year and more. Money market

instruments are traded in the money market, in contrast to the market for bonds,

equities, and warrants, which are traded in the capital market.

1.5.3. Derivatives

A derivative, according to McInish [2000, p. 25] is a contract that specifies the

conditions under which each party transfers assets, including cash, to the other during

the life of the contract. While the derivative contract specifies how the amounts to be

transferred are to be determined, at least some of the amounts are intended to be

uncertain. The contract may involve cash payments or the transfer of real or financial

assets. The types of items that may be transferred or that may be the basis for

calculating cash payments are highly varied and include:

- commodities such as precious metals (silver, gold, platinum), agricultural

products (corn, soybeans, live cattle, pork bellies), and industrial commodities

(gasoline, heating oil, lumber);

- equities and equity indexes;

- currencies;

- debt instruments;

- other derivatives;

- price indexes or other type of pricing arrangements such as the movement over

time of the US Consumer Price Index, freight rates, or insurance claims.

This definition encompasses the six types of derivatives examined in this chapter:

options, futures, forwards, swaps, warrants, and rights. While warrants are considered

equities, they also have the characteristics of derivatives.

An option is a contract with a stated life in which one party acquires, in return for a

fee, the right to receive something if it is advantageous to do so. Some option contracts

provide for the payment of the cash value of the difference between an assets’s price

and a stated price. Other options allow the purchase of a real asset such as corn at s

22

predetermined price, the purchase of a financial asset such as common stock at a

predetermined price, the sale of a real asset at a predetermined price.

Futures are standardised contracts in which on party acquires the right to receive

and the other the obligation to deliver a specified amount and type of an asset at a

specified future date at a price stated in the contract. Some futures contracts call for one

party to pay the liquidating value of the contract to the other party rather than for the

delivery of an asset in exchange for cash. Non-standardised contracts similar to futures

contracts, except that the terms are individually negotiated on a bilateral basis, are

called forward contracts.

A swap is a contract evidenced by a single document in which two parties agree to

exchange one or more periodic payments based on the value of change in value of

something specified in the contract. The payments that are exchanged can be based on

any number of items, including interest rated and exchange rates. Depending on the

terms of the swap, one party’s payments can be fixed while the other’s fluctuate, or both

parties’ payments may fluctuate. The terms for many types of swaps have become

standard so that the market price can be determined from usual information vendors.

Warrants were defined previously. A warrant is equity because the funds received

from the sale of a warrant do not have a definite repayment obligation. But because the

value of which is uncertain, a warrant is also a derivative as defined here.

1.5.4. Money and foreign exchange

Money is anything used as a medium of exchange. In modern economies there

are three principal types of money: coins, currency and deposits which are liabilities of

financial institutions that are generally accepted as a medium of exchange and therefore

classified as money. The trading of money of one country for that of another is called

the foreign exchange market, and the money itself is foreign exchange.

23

Governments and firms issue equities and fixed-income securities at specific

times in large quantities to raise funds. The parties to the derivative contract create

derivatives (excluding warrants) as the need to transfer risk arises. Money is created by

governments through the minting of coins and the printing of paper currency and by the

banking system through the creation of deposits that can serve as a medium of

exchange.

The most basic goals of individuals, according to McInish [2000, p. 23], is to

maximise their utility – i.e. their satisfaction. The maximisation of utility translates into

the financial goal of maximising wealth. For a firm this means maximising the wealth of

the owners. Production is the way that wealth is created in the economy. Individuals can

directly consume the production for a given year, or they can divert some of the

production for use in producing other goods and services. This diversion of production

from immediate consumption to use in facilitating additional production is called saving

or direct investment.

Direct investment is the use of resources to produce other goods and services.

But not everyone who wishes to defer consumption wants to invest directly. Instead,

some prefer to give their funds to others to invest. Financial markets are institutional

arrangements designed to facilitate the transfer of resources from those who have more

to those who have less than they wish to consume.

Financial markets and instruments contribute to the enhancement of wealth.

They increase the use of capital in the economy, and they lower the cost of transferring

capital from those with a surplus to those with a shortage.

1.6. The economy and the markets

According to Vaitilingam [2000, p.248] the economy is one of the most

important drivers of the stock market. The central economic force of interest rates, plus

the assorted effects of exchange rates, inflation, public spending and taxation, will

eventually have a say in overall valuations, whatever the temporary investment craze.

At the same time, the stock market has a major impact on the economy, both as a

forward indicator and determinant of consumer sentiment, and as a vital mechanism in

24

the management of risk encouraging the innovation and entrepreneurship that drive

economic growth.

Shares and bonds provide the essential capital that enables companies to take the

risks inherent in business. From their origins in medieval Italy, through increasing size

and sophistication in 17th- and 18th- century Amsterdam, 19th- century London and 20th-

century New York, the stock markets in which these assets traded have meant that the

business risks of new projects can be shared – from building the rail, road and aviation

infrastructure of the 19th-and 20th-century economies to building the electronic

infrastructure of the 21st-century economy. Such risk-sharing has transformed the

potential for economic growth and, in the latter part of the last century, as more and

more people have got involved in the investment process, changed fundamentally our

understanding of the relationship between risk and return.

For most of financial market history, debt finance was dominant. Until as late as

the 1950s, shares were largely in the hands of wealthy individuals. Buying and owning

shares was considered far too risky by the less well off and even by the institutions that

now dominate the investment scene; instead, they held portfolios of high-grade, long-

term bonds. But this arrangement has been swept aside in the last few decades, as

investors of all kinds have sought better returns, companies have seen the hugely

increased financing opportunities of the equity markets, and economic growth has made

enormous improvements in living standards in the developed world.

Of course, there have been bad times in the past sixty years and the stock market

has been a good leading indicator of future economic gloom. For example, the of the

period 1950-73 – often described in literature as the ‘golden age’ of economic growth in

western Europe and the United States [Vitilingam, 2000, p.249] – was clearly foretold

in the disastrous crash of 1973-4, when markets fell by over 50 per cent. The bear

market of the early 1970s clearly reflected the ominous economic events of that

unfortunate decade: sky-rocketing oil prices, the breakdown of the Bretton Woods

agreements for managing international monetary affairs, and the emergence of

persistent inflationary forces.

Many feared that these collapsing share valuations would lead to economic

disaster, just as the Great Crash of 1929 was thought to have led to the Great Depression

of the 1930s. Certainly, as Chamber [2004, p.38] states, speculative manias or ‘bubbles’

25

that culminate in self-feeding panics and eventual crashes can have widespread and

undesirable consequences in the real economy. Clearly, too, a booming market boosts

consumer sentiment, encouraging spending, reducing saving and increasing debt, and

adding further fuel to a raging economy.

But economic policy itself has a major impact on the interaction between share

values and the economy. In the 1990s, for example, cheap and easily available money

sustained the market’s upward trend. And in both the United States and the United

Kingdom, the crashes of 1987 had marginal effects on economic performance since the

monetary policy authorities in both countries were quick to cut interest rates to increase

liquidity. Similarly, the US Federal Reserve’s rate-cutting response to the global crisis

of 1997-8 seemed to be successful in restoring the good times.

This situation didn’t last for much longer than a decade though. The increasing

rates and decreasing availability of loans in the United States in 2008, widely known as

the Credit Crunch, made economies of many countries collapse, especially the US itself

and Western, Central and Eastern Europe. Some, like Hayek [2009], would call it a

natural end of the prolonged boom and others, like Minford [2010], would name

western societies victims of easy-money policy. Minford also states that for the credit

crunch shock it was 20% of borrowers that were marginal and not able to get loans on

normal basis, which meant that they had to pay interest they could not afford. The

situation led to great panic spread by the media as well, many people lost their jobs,

especially in the City. Credit Crunch forced the British government to cut their

spending, more than ever in the social sector, and raise taxes. Anxiety, panic and

terrifying statistics dominated the period of over a year, starting in the middle of 2008.

26

Chapter 2: The idea of index shares

2.1. Introduction

To begin discussing indices one has to know what they are. According to

Vaitilingam [2001, p. XV] an index is a number used to represent the changes in a set of

values between a base year and the present. Index numbers blend many different

ingredients into a single index, and measure changes in it by changes in its parts. This

involves giving appropriate weighting to the components according to their importance

in what is being measured. A weighted average is usually calculated as an arithmetic

mean, either using the same weights throughout (a base-weighted index) or adjusting

the weights as the relative importance of different components changes (a current-

weighted index). Vaitilingam also adds that base-weighted indices may have the base

shifted periodically.

Moreover, Fell [2000, p.74] adds that as well as providing information on

individual share prices, financial information sources often also report on the movement

of the value of shares as a whole by recording and commenting on share indices. A

share index records the change in the aggregate value of a particular group of shares

from a base period. For instance, the Financial Times – Stock Exchange 100 index,

otherwise known as ‘Footsie’, was started in 1984 and records the total value of the

hundred largest UK firms by market capitalisation. The index started at a value of 1000

and stands at 5,996.45 at the time of writing (January 2010). What this means is that the

top hundred firms in the UK are worth 5,996.45 times more/less than they were in 1984.

Worth mentioning is the fact that the FTSE 100 is one of the most important

share indices the UK, though there are other broader indices too, notably FTSE All

Share index, which includes around 850 UK quoted companies. Indices of European

shares are also produced by the Financial Times in conjunction with the Stock

Exchange. The FTSE Eurotop 100 index records the value of the hundred most actively

traded shares in Europe, while the Eurotop 300 is more similar to the Footsie in being

based on the 300 largest European companies by market capitalisation. Other important

indices from around the world are the Dow-Jones 30 share index and Standard and

Poor’s 500 index, which are based on American shares, and the Nikkei 225 index,

which reports movement in the Japanese market.

2.2. FTSE indices

Most widely based indices have been developed by the Financial Times, the

Stock Exchange and the Institute and Faculty of Actuaries. As of November 1995, these

have been managed by a joint company, FTSE International. These indices are

arithmetically weighted by the market capitalisation rather than being based on crude

price movements. In other words, the larger a company, the bigger the effect its price

movements will have on the index.

Source: FTSE 100 Index Factsheet

Figure 2.1 FTSE UK Index Series family tree

As Vaitilingam [2001, p. 93] states, the FTSE Actuaries share indices, and notably

the All-Share index, are the professional investor’s yardstick for the whole UK equity

28

market, for use in analysing investment strategies and as a measure of portfolio

performance. There are 39 component indices in the All-Share index relating to

different industrial sectors of the market, and nine component indices relating to

different levels of capitalisation (including the well-known Footsie). Beyond the All-

Share are the new fledgling indices, incorporating companies with a market

capitalisation below £35 million. Figure 2.1 represents the whole FTSE UK Index

Series family tree.

Furthermore, it is important to know what each index represents. The indices are

presented below according to Vaitilingam [2001, p. 95-97] description and updated

according to the official FTSE International website <http://www.ftse.com/

Indices/UK_Indices/ index.jsp> [consulted on 05.01.2011]:

Source: London Stock Exchange Prices

Figure 2.2. FTSE UK 100 5-year performance

- FTSE 100: the Footsie index was started with a base of 1,000 in January 1984 to

fill a gap in the market. At that time, the FT 30 index was calculated only

hourly, and there was demand for a constantly updated – or real-time – index in

view of both the competition from overseas and the needs of the new traded

29

options and financial futures markets. For most purposes, the Footsie has

replaced the FT 30. The index, amended quarterly, includes the 100 largest UK

companies in terms of market capitalisation – the blue chips – and represents

over 81% per cent of total UK market capitalisation. Figure 2.2. represents it’s

performance over the last 5 years.



- FTSE 250: an index of the next 250 companies by the market capitalisation,

those directly beneath the FTSE 100. These are companies capitalised between

£350 million and £3 billion, in total around 15 per cent of overall market

capitalisation. It is calculated two ways, one that includes and one that excludes

investment companies. Figure 2.3. represents the performance of the index

during the last 5 years.

- FTSE 350: the combination of the FTSE 100 and the FTSE 250, again

calculated both including and excluding investment companies. Figure 2.4.

shows how the index changed over the last 5 years.

30



- FTSE 350 Higher and Lower Yield: these two indices, introduced at the

beginning of 1995, are calculated by a quarterly descending ranking of the 350

companies by the size of their annual dividend yield, and then their division into

two equal halves as measured by total capitalisation of the 350 companies.


31

Figure 2.5. FTSE UK 350 Lower Yield 5-year performance


Figure 2.6. FTSE UK 350 Higher Yield 5-year performance

- FTSE SmallCap: the 450-plus companies capitalised at up to £350 million,

which when added to the 350 make up the All-Share index. Like 250 and 350,

this index is calculated two ways.


32

Figure 2.7. FTSE UK SmallCap 5-year performance

- FTSE Fledgling: another index launched at the beginning of 1995, this was

introduced to indicate the Stock Exchange’s concern for smaller companies. It

includes the over 700 companies that fail to qualify for the All-Share index

(including shares quoted on the AIM), representing 1-2 per cent of total market

capitalisation. It is calculated two ways as well. The figure below represents

how the index changed over the last 5 years.


Figure 2.9. FTSE UK Fledging 3-year performance

- FTSE All-Small and FTSE AIM: the former combines the SmallCap and

Fledgling indices; the latter is an index of all AIM-listed companies, around 460

in late 2009, with a total market capitalisation of £15 billion.

- FTSE All-Share index: 800-plus companies with a total market capitalisation

of about £1.733 billion in November 2010, 98-99 per cent of total UK market

capitalisation. Introduced on a daily basis in 1962, it is far more representative

than the FT index. Its mathematical structure makes it a reliable yardstick

33

against which to measure portfolio performance, and hence it represents an

essential tool for professional investment managers. The figure below shows

how the value of the index changed within the last 5 years.


Figure 2.8. FTSE UK All-Share 5-year performance

The Footsie is calculated every 15 seconds from the price movements of the 100

largest UK companies by market capitalisation. Since it incorporates fewer companies

than the All-Share index, it can be calculated more rapidly and frequently. The Footsie

was the first real-time index in the UK and was introduced mainly as a basis for dealing

in equity index options and futures. It rapidly became a key indicator of the stock

market’s mood, not least because it is quoted widely throughout the day. In many

respects, the market thinks in terms of Footsie figures with particular points being seen

as psychological watersheds.

The FTSE 100 constituents are mostly multinationals and companies with strong

overseas interests, while the FTSE 250 are mainly strongly UK orientated companies.

As a result, the former are likely to be more influenced by overseas factors such as

34

exchange rate movements, while the latter may be influenced more by domestic factors

such as interest rate movements. Membership of both indices is reviewed every quarter

as market caps rise and fall. For the FTSE 100, any share that is 90th or higher

automatically joins the index; 111th or lower means automatic relegation.

The FTSE All-Share accurately reflects the whole market, as Vaitilingam [2001,

p. 98] states. With over 800 constituents, it has a very broad coverage, encompassing 98

per cent of the market’s aggregate capitalisation, with each company weighted

according to its market value so that a move in the price of a large company has more

effect than that of a small one. It can be used as a measure of the market’s performance

over long periods. It serves as a reliable yardstick against which to assess portfolio

performance. As a weighted arithmetic index it is designed to behave as an actual

portfolio would behave.

The breakdown into industry groups allows investors to track the performance of

particular sectors. This is of great assistance to specialist sector analysts, as well as

allowing more general investors to improve their understanding of the structure of the

market as a whole. Industrial classification is highly important since it is normally

accepted by the stock market and institutional research departments as the basis for the

analysis of companies. Correctly classifying all companies traded on the London market

is the responsibility of the FTSE Actuaries Industry Classification Committee, made up

of market practitioners, investment managers and actuaries. Figure 2.2 is an example of

how FTSE is presented daily in Financial Times.

Over time, as the structure of the UK industry has shifted, it has been necessary

to amalgamate sectors and create new ones. For example, Radio and TV, Teas and

Diamonds have gone, while Health, Media, Photography, and Electricity have been

formed. When a new group is created, its initial value is set at the level of its immediate

predecessor. In 1999, FTSE International introduced the Global Industry Classification

System, allowing comparison across national boundaries as well as across sectors and

sub-sectors. There are three levels of classification:

- Economic group, for example resources

- Industry sector, for example oil and gas

- Industry sub-sector, for example oil services or oil integrated

35

Source: Financial Times, January 26, 2011

Figure 2.9. An example of FTSE Indices presented daily in Financial Times

36

At the moment FTSE International is using Industry Classification Benchmark

(ICB) that comprises of four categories:

- Industry: basic materials

- Supersector: basic resources

- Sector: industrial materials

- Subsector: steel

Institutional investors attempt to beat the index most relevant to their portfolio.

Increasingly, investors want a set of indices that covers the entire equity capital

structure of the UK market so that they can accurately assess the performance of large,

medium and small companies within the framework of the whole market. There has also

been a growing interest in the performance of medium-sized companies since the

beginning of current century. The newer indices increase the visibility of many medium

and small companies.

The FTSE 350 provides a real-time measure covering around 90 per cent of the

UK equity market by value. The SmallCap and Fledgling indices are higher risk but

likely to boom in a recovery. They are good for the visibility and marketability of

smaller companies. Beyond the markets covered by the All-Share and Fledgling indices

is Ofex, an unregulated off-exchange dealing facility for companies not eligible for the

AIM or the index. It is offered by the broker JP Jenkins Ltd, with daily share

information published in the Financial Times.

The differentiation between Higher Yield and Lower Yield companies in the FT

350 is an interesting reflection of the decreasing importance of dividends as part of the

rewards to investors. Indeed, many of the market’s hottest stocks pay no dividends at

all, as Stowell, D.P. [2010, p.77] points out. Companies normally have relatively high

yields because investors expect their share prices to perform relatively badly. There are

three main types of high yielding stocks:

- Stodgy companies like utilities that chug along but are unlikely to produce

fireworks

- Companies in decline that are overdistributing their earnings

- Recovery shares that may or may not make it back.

37

Chapter 3: The changes of indices

3.1. Introduction

This section focuses on the changes in value of analysed indices: FTSE 100,

FTSE 250 and FTSE All-Share. The changes are explored annually as well as for the

whole period of three years which this thesis covers. The choice of indices is

determined by their importance and significance to the UK market. They represent the

state of British economy as they stand for all the industries present at London Stock

Exchange, together covering 98 per cent of total UK market capitalisation.

3.2. FTSE 100

3.2.1. January – December 2007

The chart below presents the changes in value of FTSE100 index during 2007:


Figure 3.1. FTSE100 in 2007

As one can observe, in January 2007 the value of the index was 6.311 and in the

end of the period – December 2007 it was 6.411. The average monthly change of the

index for the whole year was 0.19%. It reached the highest value in October, 11 th –

6.724 and the lowest in August, 16th -5.880. Hence, the spread in 2007 was 0.844.

One can say that 2007 was a good year for FTSE 100. The companies forming it

were using the opportunities the market gave them. The growth in value over the whole

year’s period shows that economy was, generally speaking, expanding in spite of minor

falls and increases.

Worth mentioning is the fact that this index contains the main banking groups

present on the British market: Barclays, Lloyds TSB, Royal Bank of Scotland and

HSBC, according to the data published on the FTSE website. The growth in value of

these banks proves the high level of borrowing to invest in companies present in the

UK. Moreover, one has to bear in mind that financial institutions are the biggest part of

FTSE 100 – over 30% of the whole group. Well prospering estate market, growing

number of vehicles purchased by the British as well as increasing wages, allowing more

pension-related savings, led to increase in value of insurance companies like Aviva and

RSA Insurance Group which also belong to the index. Another important sector which

led to the growth of FTSE 100 value is consumer goods (20%). The amount of money

that the Brits spent on their weekly grocery shopping in Tesco, Marks & Spencer,

Sainsbury’s and Morrison which, according to the data published by The Independent,

are the four most popular general shopping stores in the country and all belong to FTSE

100.


Figure 3.2. presents the changes in value of FTSE100 index during 2008 – the

second year analysed within the contents of this dissertation.

As it can be read, in January 2008 the value of the index was 6.425 and in the

end of the period – December 2008 it was 4.807. The average monthly change of the

index was -4.03%. It reached the highest value in January, 3rd – 6.488 and the lowest in

39

November, 21st -3.761. Hence, the difference in 2008 was more noticeable than a year

before – 2.664.



The sudden decrease in the value of the index was caused by the influence that

American Credit Crunch had on the British economy. It started with the financial sector,

especially banking institutions which had to refuse giving out loans to many existing

and new customers. The lack of money in the circuit reduced spending as well as

saving, hence influencing all the other sectors- nearly 70% of FTSE 100. Surplus in

supply forced the companies to cut their costs by, for example, letting their staff go,

which had a great influence on the situation in the following year.



last year analysed within the contents of this dissertation.

40



As the chart represents it, in January 2009 the value of the index was 4.562 and

in the end of the period – December 2008 it was 5.264. The average monthly change of

the index was 1.28%. It reached the highest point in December, 29 th – 5.438 and the

lowest in March, 9th -3.493. Hence, the difference in 2009 was by nearly a third smaller

than a year before yet more than twice as large as in 2007– 1.945.

In the beginning of the year the index was still struggling with decrease of its

value. March turned out to be the lowest as well as the turning point for the market

cycle. After reaching the market bottom, stocks started going up, which means the end

of late contraction and the beginning of expansion phase once again. Moreover, one has

to remember that the market cycle is from 3 to 9 months ahead of economic cycle, as

Artis states [1999, p. 56]. Growing value of FTSE 100 in the second half of 2009 means

that recession is coming to an end.

41

3.2.4. January 2007 – December 2009

The chart below presents the changes in value of FTSE100 index during 2007-

2009.


Figure 3.4. FTSE 100 in 2007-2009

During the three years of observations FTSE 100 reached its highest value in

October, 11th, 2007– 6.724 and the lowest in March, 9th, 2009- 3.493. The difference

between those two points is 3.231, which means a 48% decrease during the three-year

period. The average monthly change for this index over the analysed period is -0.53%.

The index kept its value on a relatively even level throughout 2007. In 2008,

however, the value suddenly dropped towards the end of the year. From June 2008 up

until March 2009, for three quarters of a year the index’s price was decreasing rapidly.

It slowly started to build back up form April 2009 reaching the value of 5.438 in the end

of December 2009.

42

The chart below represents the dynamics of changes of the FTSE100 index

during 2007-2009:

2007

-1

2007

-3

2007

-5

2007

-7

2007

-9

2007

-11

2008

-1

2008

-3

2008

-5

2008

-7

2008

-9

2008

-11

2009

-1

2009

-3

2009

-5

2009

-7

2009

-9

2009

-11

-0.2

-0.15

-0.1

-0.05

0

0.05

0.1

0.15

0.2

-14.22%

13.39%

FTSE100 dynamics[Q1 2007=100] in %

FTSE100


Figure 3.5. FTSE 100 dynamics in 2007-2009

As far as 2007 is concerned, the changes did not reach higher than 5%.

However, the situation changed in 2008: towards the end of the year the changes were

more drastic reaching nearly 15% in November. The situation of the index was still

unstable in 2009, especially during the first quarter of the year and reaching nearly 14%

in April. From May until the end of the year the value of the index was generally

speaking increasing gradually with minor downfalls by up to 4%.

Summing up the analysis of changes of FTSE 100, one can generally state that it

pictured the economic situation happening in the country. The further analysis of the

relationship between the index and four major economic indicators proves that it can be

treated as a barometer for the state of a given country’s economy.

43

3.3. FTSE 250


The chart below presents the changes in value of FTSE 250 index during 2007 –

the first year analysed within the contents of this dissertation.


Figure 3.6. FTSE 250 in 2007

As one can observe, in January 2007 the value of the index was 11.313 and in

the end of the period – December 2007 it was 10.745. The average monthly change of

the index was -0.47%. It reached the highest point in May, 23 rd – 12.222 and the lowest

one in December, 17th -10.160. Hence, the spread in 2007 was 2.062- a downfall by 16

per cent to the highest value.

Over the year the value of the index was rather steady. The well-prospering

economy gave all the businesses the opportunity to develop, invest and gain new

customers. According to the data published on the official FTSE website, financial

44

institutions constituted 23% of FTSE 250 in 2007, so even though its role is less

influential than in case of FTSE 100, it still is significant. At the time it included nearly

30 investment trusts. As mentioned in the previous part of this chapter, since this sector

was expanding, it influenced other sectors as well, guaranteeing prosperity. The stability

of FTSE 250 basically meant the stability of the economy since as much as 35% of

companies belong to a group called cyclical industry which is specifically sensitive to

the business cycle.


The chart below presents the changes in value of FTSE250 index during 2008 –

the second year analysed within the contents of this dissertation.



As one can observe, in January 2008 the value of the index was 10.650 and in

the end of the period – December 2008 it was 5.830. The average monthly change of the

45

index was -5.33%. It reached the highest point in January, 2nd – 10.650 and the lowest in

November, 21st – 5.543. Hence, the difference in 2008 was 5.107, which means a nearly

48% decrease between those two points.

This year brought a significant fall in the value of FTSE 250 due to the influence

of the crash in American economy on the British one. Since, as mentioned before, 35%

of the index belongs to cyclical industry, their sensitivity to what happened in the

banking sector cause a lot of companies struggle for survival. Additionally, consumer

goods and services constitute 25% of the index. Since banks were not able to provide as

many loans as requested, companies had to lower their costs, which led to higher

unemployment. Furthermore, disposable income of the citizens has been reduced as

well. This chain of events led to major loses in the consumer goods and services sector

which, obviously, is strongly connected to general industrials. Hence, value of FTSE

250 decreased significantly.



last year analysed within the contents of this dissertation.


end of the period – December 2009 it was 9.135. The average monthly change if the

index was 3.18%. It reached the highest point in October, 19 th – 9.547 and the lowest in

March, 9th – 5.772. Hence, the difference in 2009 was 3.775 which is higher than in

2007 but also significantly lower than in 2008.

Similarly to the previous index analysed, FTSE 250 changed its direction in

March 2009. From then on the index would gradually regain its value from before

depression. The sudden fall of interest rates in the beginning of 2009 helped all business

get back on their feet. Worth mentioning is also the fact that GDP started rising as well,

which means that the whole economic activity of the country was improving. All these

reasons led to a rise in the value of FTSE 250.

46




Figure 3.9. presents the changes in value of FTSE250 index during 2007-2009. It

covers the whole analysed period of three years.

During the three years of observations FTSE 250 reached its highest value in

May, 23rd, 2007– 12.222 and the lowest in November, 21st, 2008– 5.543. The difference

between those two points is 6.679, which means a 54% decrease over three years. The

average monthly change for this index over the analysed period is -0.61%.

The index did not change its value that much during 2007 as it did in 2008. It

was not earlier than the in third quarter of 2008 when it started decreasing rapidly by up

to 20% per month. It started growing back in the beginning of the second quarter of

2009 after nearly 10 months of losing value constantly.

47


Figure 3.9. FTSE 250 in 2007-2009

The dynamics of changes is presented in the chart below:

2007

-1

2007

-3

2007

-5

2007

-7

2007

-9

2007

-11

2008

-1

2008

-3

2008

-5

2008

-7

2008

-9

2008

-11

2009

-1

2009

-3

2009

-5

2009

-7

2009

-9

2009

-11

-25.00%

-20.00%

-15.00%

-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

-20.48%

15.75%

FTSE250 dynamics[Q1 2007=100] in%

FTSE250


Figure 3.10. FTSE 250 dynamics in 2007-2009

48

Similarly to the situation of the index analysed previously, FTSE 250 stayed

relatively stable throughout 2007 and up until the third quarter of 2008. The rapid

changes by up to 20% continued until May 2009 where the increase to April the same

year was over 15%. Throughout the rest of the year the index was not changing by more

than 8%.

The chart presents how the economy was behaving throughout the covered

period of time. The instability of the market can be noticed by relatively high changes in

price of FTSE 250. The changes were cause by a number of reasons describes before in

this section, like change of interest rates, lack of ability to obtain loans, limited

investment opportunities, cutting down on costs in general.

3.4. FTSE All-Share


Figure 3.11. presents the changes in value of FTSE All-Share index during 2007

– the first year analysed within the contents of this thesis.



index was 0.04%. It reached the highest point in June, 15th – 3.479 and the lowest in

August, 16th – 3.042. Hence, the difference in 2007 was 0.437.

The low yet indicating growth rate of average monthly change of the index states

for its stability. This indicates that 98% of British economy could be described as

prospering despite the minor rises and falls. It is important to mention that 23% of

FTSE All-Share was financial institutions in 2007. Moreover, the biggest constituent of

the whole index was HSBC itself which stands for over 6% of the index itself. Since, as

mentioned before, banks and other financial institutions were doing very well and

interest rates were the highest for 6 years [Turner, 2008, p. 76] this sector was booming.

49


Figure 3.11. FTSE All-Share in 2007

Furthermore, so was oil & gas sector, constituting over 17% of FTSE All-Share.

With prospering businesses this segment could not be better. It also influenced the

consumer goods, services as well as basic materials sectors, each of which stands for

10-11% of FTSE All-Share market capitalisation value. New investments caused the

fall in unemployment and rise in consumption and savings. All in all the economy was

prospering, which changed the following year.


Figure 3.12. on the next page of this thesis presents the changes in value of

FTSE All-Share index during 2008 – the second year analysed within the contents of

this dissertation.

50





index was -4.24%. It reached the highest point in January, 3rd – 3.295 and the lowest in

November, 21st – 1.884. Hence, the difference in 2008 was 1.411.

Moreover, the 43% downfall of the value of the index represents the situation

that involved 98% of the businesses present on the British market. In 2008 it was 630

companies, according to the data published on the official FTSE website. The economy

was strongly influenced the Credit Crunch is the United States, as Brummer states

[2008, p.39]. As mentioned in chapter 1, the banks were not able to give away as many

loans as previously, which caused all sectors to suffer the consequences. Since demand

dropped suddenly, unemployment increased and, consequently, GDP was lower,

businesses had to cut their costs, which even caused the damage to be deeper.

November 2008 illustrates how low the index could get and it is known that the

following year the index got even lower.

51


The chart below present the changes in value of FTSE All-Share index during

2009 – the last year analysed within the contents of this study.



As the chart says, in January 2009 the value of the index was 2.269 and in the


index was 1.63%. It reached the highest point in December, 29th – 2.772 and the lowest

in March, 9th – 1.770. Hence, the difference in 2009 was 1.002.

The value of the index started rising in March 2009. Similarly to FTSE 100 and

FTSE 250, the improvement of the economical state of the country let the constituents

of FTSE All-Share slowly build their way up to the point from before the Credit

Crunch. Worth mentioning is the fact that the lowered interest rates encouraged

business owners to invest and develop. When they started making more profits, they

could share them with employees who started spending more. This string of events

leads to prosperity, as Artis states [1999, p. 17].

52


The chart below present the changes in value of FTSE All-Share index during

2007-2009.


Figure 3.14. FTSE All-Share in 2007-2009

During the three years of observations FTSE All-Share reached its highest value

in June, 15th, 2007– 3.479 and the lowest in March, 9th, 2009– 1.770. The difference

between those two points is 1.709, which means a 49% decrease over three years. The

average monthly change for this index over the analysed period is -0.53%.

Moreover, throughout 2007 the index was not changing much. It was slowly

decreasing during the first quarter of 2008 and faced a rapid downfall after that up until

the beginning of the third quarter of 2009 when it slowly started building its value up.

Naturally, its behaviour was similar to the one of FTSE 100 and FTSE 250 since they

both are parts of FTSE All-Share.

53

The dynamics of FTSE All-Share are represented by the chart below:

2007

-1

2007

-3

2007

-5

2007

-7

2007

-9

2007

-11

2008

-1

2008

-3

2008

-5

2008

-7

2008

-9

2008

-11

2009

-1

2009

-3

2009

-5

2009

-7

2009

-9

2009

-11

-15.00%

-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

-13.45%

11.77%

FTSE All-Share dynamics[Q1 2007=100] in%

FTSE All-Share


Figure 3.15. FTSE All-Share dynamics in 2007-2009

During 2007 the value of the index was not changing by more than 5%.

Similarly to FTSE 100 and FTSE 250 the index faced the biggest changes beginning

from the middle on the third quarter in 2008 until the end the second quarter in 2009,

changing by up to 14%. From June 2009 the value of the index was increasing.

Furthermore, all the reasons for the changes in the value of FTSE All-Share,

which were mentioned throughout this chapter, have their illustration in the chart above.

The bottom of the market value of the index caused by lack of demand of goods and

services and lack of supply for cheap loans is clearly marked by the downfall by over

13% in the end of 2008.

54

On the other hand, the sudden increase in value visible towards the middle of

2009 is a response of the market to the changing situation in the country, like lower

interest rates, as well as a natural way the economy reacts to recession. As Leitch [2006]

describes it, the economy has the ability of bringing itself back to prosperity.

3.5. Annual analysis


During the first year of analysis all three indices changed in a similar way as it

can be seen in the chart below:

2007-1

2007-2

2007-3

2007-4

2007-5

2007-6

2007-7

2007-8

2007-9

2007-10

2007-11

2007-12

0.000

2.000

4.000

6.000

8.000

10.000

12.000

14.000

6.311 6.441

11.31310.745

3.266 3.281

FTSE 100

FTSE 250

FTSE AllShare


Figure 3.16. FTSE 100, 250 and All-Share in 2007

During 2007 all indices behaved in a similar yet not exactly the same way. They

all reached a downfall towards the end of the first quarter, an increase towards the end

55

of the second one, a slight decrease towards the end of the third one as well as a raise in

November followed by a fall in December. However, one can notice that FTSE 250 was

slightly more sensitive to the change than the other two indices. The spread for FTSE

100 between the highest and the lowest point was 13%, for FTSE All-Share 12% and

for FTSE 250 it was slightly more – 16%, which leads to a conclusion that the sector of

15 per cent of overall market capitalisation in Britain was influenced in a rather stronger

manner by the changes in economy during this year than the other analysed indices. The

reason for that is the difference in the structure of these indices. In other words, the

sector breakdown matters here. FTSE 250, according to the official data published on

FTSE website, has a relatively larger group of companies that belong to cyclical

industry.


2008-1

2008-2

2008-3

2008-4

2008-5

2008-6

2008-7

2008-8

2008-9

2008-10

2008-11

2008-12

0.000

2.000

4.000

6.000

8.000

10.000

12.000

6.425

4.087

10.650

5.830

3.269

2.030

FTSE 100

FTSE 250

FTSE AllShare



56

In 2008 all three indices faced, again, similar changes. They all reached their

highest value in January and the lowest one in the end of the year. Moreover, all indices

began to decrease in the most drastic pace in the end on the third quarter of the year.

Similarly to the previous year, FTSE 250 has changed the most throughout the year- the

average monthly change for that index was -5.33%, whereas for FTSE 100 it was -

4.03% and for FTSE All-Share -4.24%. Furthermore, the difference between the highest

and the lowest value of indices was also the biggest for FTSE 250 – 48% to the highest

value. FTSE 100 changed by 41% over the year and FTSE All-Share by 42%. The

reason for that has been explained on the previous page- FTSE 250 has a larger share of

businesses sensitive to the current market situation.


2009-1

2009-2

2009-3

2009-4

2009-5

2009-6

2009-7

2009-8

2009-9

2009-10

2009-11

2009-12

0.000

1.000

2.000

3.000

4.000

5.000

6.000

7.000

8.000

9.000

10.000

4.562

5.246

6.627

9.135

2.2692.710

FTSE 100

FTSE 250

FTSE AllShare



57

Throughout 2009, likewise, the indices behaved in a similar way. They all

reached their lowest value in March and the highest one towards the end of the year.

March seems to be the breakthrough point for the rapid decrease in value of analysed

indices. Beginning in the second quarter of 2009, as mentioned before in this chapter,

indices started increasing rather gradually - slowly but surely with only minor

downfalls. Yet again, FTSE 250 turned out to be more sensitive than FTSE 100 and

FTSE All-Share. The average monthly change of the index value for FTSE 250 was

more than twice as high as for FTSE 100: 3.18% to 1.28%; it was also nearly twice as

high as for FTSE All-Share: 3.18% to 1.63%. Since in 2009 the structure of indices did

not change a lot in comparison to the previous two years, the difference in behaviour of

FTSE 100 and FTSE All-Share, and FTSE 250 is due the fact that the latter contains,

proportionally, more companies belonging to cyclical industries.

58

Chapter 4: The changes of indices and the economic indicators

4.1. Introduction

In this chapter the relationship between FTSE indices and the most significant

economic indicators is analysed. It is Gross Domestic Product, the British Pound

exchange rate to Euro, unemployment rate and rate of interest that are taken into

consideration. The analysis focuses on the three years which this dissertation takes into

consideration – 2007-2009. Since the stock market is said to be the reflection of the

economy, the aim so to check what is the level of correlation between two series of

data, i.e. GDP and FTSE All-Share in 2008.

4.2. Gross Domestic Product

4.2.1. The idea of GDP and its changes in 2007-2009

First, it is worth mentioning that Gross Domestic Product (GDP), as Vaitilingam

(2004, p. 22) states, is the most comprehensive measure of economic activity, as

reflected in the circular flow of income. It is calculated by adding together the total

value of the annual outputs of goods and services (with quarterly figures annualised)

and expressed, here, in billions of pounds. The figure is gross because it does not

incorporate a deduction for the depreciation of capital goods.

Second, the data representing GDP can be used to assess the economy’s position

on the business cycle, and its likely future trends. As Barry (2002, p. 25) states, the

business cycle can be characterised by four phases: expansion or recovery when output

and employment are rising; boom when both are at high levels; recession when both are

falling; and slump or depression when both are at low levels.

The figure below presents the value of GDP in the United Kingdom of Great

Britain in 2007-2009 presented quarterly:

2007

Q1

2007

Q2

2007

Q3

2007

Q4

2008

Q1

2008

Q2

2008

Q3

2008

Q4

2009

Q1

2009

Q2

2009

Q3

2009

Q4335.000

340.000

345.000

350.000

355.000

360.000

365.000

345.283

363.264

344.583

351.353

GDP value [in billions of GBP]

GDP

Source: GDP in UK since 1984

Figure 4.1. GDP in the United Kingdom in 2007-2009 in billions of pounds

As one can read from the chart, the value of GDP was rising until the second

quarter of 2008. For the next two quarters it was falling in a slower manner then in the

following two, until the second quarter 2009. After reaching its lowest point- the value

of 344.583- it started slowly growing towards the end of the year. On the other hand,

GDP reached its highest value in the second quarter 2008: 363.264. Hence, the

difference between these two points is nearly £20 billion.

Moreover, as stated by Sharp [1999, p. 13], when analysing the changes in value

of GDP one has to keep in mind that its value is calculated on a quarterly basis. It

involves a certain delay factor in looking at the overall state of a given country’s

economy.

To understand the situation of the economy one also has to take into

consideration the dynamics of quarterly change. It shows the change of the value of a

certain quarter to the value in the previous one, in per cents and is presented in table 4.2.

60

2007

Q1

2007

Q2

2007

Q3

2007

Q4

2008

Q1

2008

Q2

2008

Q3

2008

Q4

2009

Q1

2009

Q2

2009

Q3

2009

Q4

-3.00%

-2.50%

-2.00%

-1.50%

-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%

2.00%

1.34%

-2.65%

GDP dynamics[Q1 2007=100] in%

GDP

Source: GDP in UK since 1984

Figure 4.2. GDP dynamics in the United Kingdom in 2007-2009

As it can be read from the chart, until the second quarter of 2008 the economy

was expanding since GDP was rising quarter to quarter. The fall in the third quarter of

2008 could be described as contraction and because GDP continued on falling, the

changes until the third quarter 2009 will be described as recession. Towards the end of

the year the economy started its recovery.

4.2.2. FTSE 100 and GDP

The value of the first index analysed, FTSE 100, and the GDP for the three-year

period of 2007-2009 are presented quarterly in table 4.1. on the next page.

61

Table 4.1.

FTSE 100 and GDP in 2007-2009

FTSE 100

GDP

2007Q1

6.116 345.283

2007Q2

6.666 349.523

2007Q3

6.315 352.830

2007Q4

6.441 357.209

2008Q1

5.816 362.002

2008Q2

6.012 363.264

2008Q3

5.503 361.466

2008Q4

4.087 358.848

2009Q1

3.638 349.356

2009Q2

4.477 344.583

2009Q3

4.820 347.413

2009Q4

5.246 351.353

Source: GDP in UK since 1984 and London Stock Exchange Prices

As calculated on the basis of the data above, the rank correlation coefficient is

0.206762739, which means that the correlation is rather vague. Both of the variables

reached their highest and lowest values at different points in time. FTSE 100 was most

valuable in the second quarter of 2007, whereas GDP was the highest just before the

Credit Crunch – in the second quarter of 2008. On the other hand, the lowest values

were close to each other yet there was a three-month difference between them. The

index hit its lowest rate in the first quarter of 2009 and GDP a quarter later, yet both

were the lowest during the recession.

The delay between the lowest and highest points might be caused by the fact that

market cycle is always ahead of economic cycle, as Artis states [1999]. Another reason

62

may be the fact that FTSE indices are updated on daily basis and GDP is calculated

quarterly, as Sharp states [1999, p. 13].

4.2.3. FTSE 250 and GDP

The value of the second index analysed, FTSE 250, and the GDP for the three-

year period of 2007-2009 are presented quarterly in the table below:

Table 4.2.

FTSE 250 and GDP in 2007-2009

FTSE 250

GDP

2007Q1

10.984 345.283

2007Q2

12.197 349.523

2007Q3

11.309 352.830

2007Q4

10.745 357.209

2008Q1

10.009 362.002

2008Q2

10.049 363.264

2008Q3

9.410 361.466

2008Q4

5.830 358.848

2009Q1

5.869 349.356

2009Q2

7.759 344.583

2009Q3

8.620 347.413

2009Q4

9.135 351.353


63


0.045072, which means that the correlation basically does not exist. The two variables

behaved in a different way throughout the three-year period. The index reached its

highest point in the second quarter of 2007 and GDP exactly a year later. There was also

a half-a-year difference between the lowest points – for FTSE 250 it was the last quarter

of 2008 and for GDP the second one in 2009.

4.2.4. FTSE All-Share and GDP

The value of the third index analysed, FTSE All-Share, and the GDP for the

three-year period of 2007-2009 are presented quarterly in table 4.3. on the next page.

Table 4.3.

FTSE All-Share and GDP in 2007-2009

FTSE All-Share

GDP

2007Q1

3.170 345.283

2007Q2

3.467 349.523

2007Q3

3.260 352.830

2007Q4

3.281 357.209

2008Q1

3.009 362.002

2008Q2

3.061 363.264

2008Q3

2.855 361.466

2008Q4

2.030 358.848

2009Q1

1.855 349.356

2009Q2

2.198 344.583

2009Q3

2.474 347.413

64

2009Q4

2.710 351.353



0.201946, which means that the correlation is not strong. It’s similar to the value of

correlation of FTSE 100 and GDP. Yet again, the highest and lowest points did not meet

for those two variables. The index reached its highest value in the second quarter of

2007 and GDP just before the crisis – in the second quarter of 2008. FTSE All-Share

faced its lowest value in the first quarter of 2009 and GDP- three months later.

Summarising, if one was to base the assumption that the relationship between

GDP and the index prices is basically nonexistent, it would not be entirely true. They

both react to the state of the economy, and as Theil [1996, p. 12] stated, illustrate the

state of it. The lack of correlation is due to the difference in time of reaction to what is

happening. Calculating a given value on the daily basis makes indices more sensitive to

any ups and downs on the market whereas calculating GDP quarterly gives a totally

different point of view on the changes.

4.3. Pound Sterling Exchange Rate

4.3.1. GBP/EUR exchange rate and its changes in 2007-2009

Foremost, it is important to explain what the relationship between the value of

currencies and the state of the economy is. As Barry [2002, p. 78-80] explains, as in all

markets, the value of currencies in the international market is determined by supply and

demand. The main players are the foreign exchange dealers of commercial banks and

foreign exchange brokers. However, the market is often significantly affected by the

intervention of central banks on behalf of governments. In this marketplace, there is

considerable interaction between the authorities and market professionals. But despite

this intervention, swings in currency values can be vast, and often not very attached to

65

‘fundamentals’, the state of the real economy. Such swings can be particularly

damaging for companies that rely heavily on exports or imported raw materials.

Nevertheless, as Vaitilingam [2004, p. 47] states, the core determining factor of

a currency’s value in still the health of the real national economy, especially the balance

of payments current account. The process is best demonstrated with an example: if there

is a surplus on the current account, that is, a county sells more goods than it buys, and

then buyers have to acquire its currency to purchase goods. This adds to the selling

country’s reserves of foreign currencies, and bids up the price of the currency. As the

price rises, exports rise in price: if there is a fall in the quantity sold, the currency woo

will fall.

Moreover, the currency’s value is also affected by the level of domestic inflation

and the domestic interest rates. High rates of interest and low rates of inflation make a

currency attractive to borrowers. As a result, a central bank may use interest rates to try

to raise or lower the value of its currency. This will have a limited effect though if the

fundamentals are wrong, that is, if there is a persistent deficit on the current account.

One further significant factor determining short-term currency values is market

sentiment. There is often a self-fuelling process in which enthusiasm for a currency, or

the lack of it, drives the rate. Speculators may decide, as they did with the GBP on

Black Wednesday, that a currency is overvalued or simply that there are speculative

gains to be made. Short selling will then cause it to fall, often in spite of government

intervention.

The figure below represents the exchange rate of pound sterling to Euro in 2007-

2009:

66

2007

-1

2007

-3

2007

-5

2007

-7

2007

-9

2007

-11

2008

-1

2008

-3

2008

-5

2008

-7

2008

-9

2008

-11

2009

-1

2009

-3

2009

-5

2009

-7

2009

-9

2009

-11

0.00000

0.20000

0.40000

0.60000

0.80000

1.00000

1.20000

1.40000

1.600001.50687

1.08962 1.11153

GBP/EUR

GBP/EUR

Source: Bank of England’s Exchange Rates

Figure 4.3. GBP/EUR in 2007-2009

As the figure above stands, the exchange rate was highest in January 2007:

1.50687 and lowest in March 2009 – 1.08962. The situation picked up a little towards

the end of the analysed period- the exchange rate in December 2009 was 1.11153. A

sudden fall can be noticed during the last quarter of 2008 – the exchange rate

experienced a nearly 10% decrease within those three months. The average monthly rate

of change for the whole period is -0.87%. As one can see, the value of GBP/EUR in the

end of the analysed period is still closer to the lowest than the highest value.

Worth mentioning is the fact that when analysing the value of currency

exchange one has to keep in mind the reaction of the currency to the general ‘feeling’ of

the economy, as Fane [2000, p. 34-36] calls it. The idea is that even certain economic

indicators do have crucial influence of the value of a given currency, the mood around it

is as important. It may encourage or discourage foreign investors as well as have an

influence on the currency market in general.

In order to understand the process of changes that pound sterling underwent, one

should be able to analyse the dynamics of it which is presented by figure 4.4.

67

2007

-1

2007

-3

2007

-5

2007

-7

2007

-9

2007

-11

2008

-1

2008

-3

2008

-5

2008

-7

2008

-9

2008

-11

2009

-1

2009

-3

2009

-5

2009

-7

2009

-9

2009

-11

-0.1

-0.08

-0.06

-0.04

-0.02

0

0.02

0.04

0.06

-8.62%

3.49%

GBP/EUR dynamics

GBP

Source: Bank of England’s Exchange Rates

Figure 4.4. GBP/EUR dynamics in 2007-2009

As the figure above represents it, pound sterling faced the biggest decrease in its

value to Euro in November 2008. Up until that point the currency was decreasing in a

relatively proportional manner. After this point the situation of GBP became much less

stable- it experienced its highest downfall as well increases to the previous month.

Summarising, the British currency was not indifferent to the changes in the economy.

That was the reaction to the crisis in the economical situation of the country caused

mainly by the financial sector. The less steady the economy of the country is, the less

valuable its currency [Leibscher, 2008, p. 56].

4.3.2. GBP/EUR and FTSE 100

The value of the first index analysed, FTSE 100, and the GBP/EUR exchange

rate for the three-year period of 2007-2009 are presented quarterly in the chart below:

68

2007

Q1

2007

Q2

2007

Q3

2007

Q4

2008

Q1

2008

Q2

2008

Q3

2008

Q4

2009

Q1

2009

Q2

2009

Q3

2009

Q4

0.000

1.000

2.000

3.000

4.000

5.000

6.000

7.000 6.666

3.638

1.480361.08771

FTSE100

GBP/EUR

Source: Bank of England’s Exchange Rates and London Stock Exchange Prices

Figure 4.5. FTSE 100 and GBP/EUR in 2007-2009

Using the data in the chart above one can calculate the rank correlation

coefficient which for those two variables is very high: 0.888009. Both FTSE 100 and

GBP/EUR reached their highest value in the second quarter of 2007 and the lowest one

in the first quarter of 2009. They behaved in a similar way until the second half of 2009

when FTSE 100 grew faster than GBP/EUR.

One can say that the exchange rate reacts immediately to the situation of a given

country’s economy. There is no coincidence in this phenomenon. Interest rates, the

general mood of the economy as well as the market situation – it all has its influence on

the value of British currency, as explained before in this chapter. The strong relationship

is also expressed by the calculated correlation.

4.3.3. GBP/EUR and FTSE 250

The value of the second index analysed, FTSE 250, and the GBP/EUR exchange

rate for the three-year period of 2007-2009 are presented quarterly by figure 4.7.

69

2007

Q1

2007

Q2

2007

Q3

2007

Q4

2008

Q1

2008

Q2

2008

Q3

2008

Q4

2009

Q1

2009

Q2

2009

Q3

2009

Q4

0.000

2.000

4.000

6.000

8.000

10.000

12.000

14.000

12.197

5.830

1.480361.08771

FTSE250

GBP/EUR


Figure 4.6. FTSE 250 and GBP/EUR in 2007-2009

The rank correlation coefficient is 0.888788 for those two variables. It is even

higher than for FTSE 100 and GBP exchange rate. Both FTSE 250 and pound sterling

exchange rate reached their highest value in the second quarter of 2007. However, the

index was the lowest in the last quarter in 2008 and GBP/EUR was the lowest in the

first quarter of 2009. Similarly to the situation with the first analysed index, FTSE250

grew faster towards the end of the year than GBP/EUR exchange rate.

Furthermore, the exchange rate reacted to the situation in the market

immediately, similarly to the situation of FTSE 100. Also, lowering interest rates made

the currency less attractive to borrowers [Moser, 2001, p. 112], hence less demand for

GBP.

4.3.4. GBP/EUR and FTSE All-Share

70

The value of the last index analysed, FTSE All-Share, and the GBP/EUR

exchange rate for the three-year period of 2007-2009 are presented quarterly in the chart

below:

2007

Q1

2007

Q2

2007

Q3

2007

Q4

2008

Q1

2008

Q2

2008

Q3

2008

Q4

2009

Q1

2009

Q2

2009

Q3

2009

Q4

0.000

0.500

1.000

1.500

2.000

2.500

3.000

3.500

4.000

3.467

1.855

1.48036

1.08771

FTSEAllShare

GBP/EUR


Figure 4.7. FTSE All-Share and GBP/EUR in 2007-2009

Similarly to the first analysed index, FTSE All-Share reached its highest level in

the same quarters as GBP/EUR exchange rate. Again, the difference is seen most in the

last two quarters of 2009 when FTSE All-Share grew faster. The rank correlation

coefficient is 0.886557, which is the lower than in the case of the two previous indices

analysed but still very high proving that the exchange rate depends on the state of the

economy of a given country.

The strong relationship between the two variables is easily seen in the chart

above. Moreover, the value of the British currency is strongly sensitive to the situation

on the market. Sudden falls of the values of 98% of British companies, according to the

market capitalisation, caused a sudden fall of GBP. Again, the economic mood in the

whole Europe was rather pessimistic [Johnston, 2009, p. 9] during late 2008 and early

2009, which also influenced the price of the currency. Moreover, Johnston pointed out

that the fact that a country is not an attractive investment target does not help the value

71

of its currency. And, as described before, the situation in Britain did not look very

encouraging after 2007.

4.4. Unemployment Rate

4.4.1. The idea of unemployment rate and its changes in 2007-2009

The levels of employment and unemployment are some of the most contentious

and widely reported economic indicators. Not only are they good indicators for

investors and managers of the state of the business cycle, but they are also of wide

interest to all participants in the labour market. In addition to covering jobs,

employment data are an essential guide to personal incomes, wages and unit labour

costs, as well as being the basis for measuring GDP by income, and for assessing

inflationary pressures. Furthermore, unlike data on industrial production and retail sales,

they provide a broad picture of the economy, going beyond manufacturing and retail to

encompass the service and agricultural sectors. Two important indicators of the state of

the market are:

- Registered unemployment: the total number of people (excluding school

leavers) that were out of work and claiming unemployment benefit in the

previous period. The figure is seasonally adjusted to take account of annual

fluctuations in the labour market, such as at the end of the academic year

when school leavers flood the jobs market.

- Unfilled vacancies: vacancies notified to Department of Employment Job

Centres, about one-third of the total vacancies in the economy. The change

in the number of vacancies is seen as an important indicator of future

employment trends.

Figures for unemployment and vacancies in the UK, as well as for average

earnings and unit wage costs, are provided by the Department of Employment. The

standard measure of unemployment, known as the claimant count, is often criticised for

excluding large numbers of people who cannot find jobs, but who are not eligible for

unemployment benefit. For example, women seeking to return to work, the self-

employed and 16-and 17-year-old school leavers do not show up in the official count.

72

Department of Employment statistics cover very detailed aspects of the labour

market, for example, the breakdown of unemployment by region of the country, which

can be useful for potential investors. For example, a multinational considering opening

a new plant might consider basing it in an area of relatively high unemployment in order

to take advantage of the substantial pool of workers available for hire. They may also

benefit from a local wage level that is lower than in low unemployment regions.

Managers in such company will want to focus on critical microeconomic and supply

side issues, such as whether a regional labour force contains workers with the right

skills, or whether the workforce will need to be trained.

Mismatch between the skills demanded and the skills available in the local

workforce is a frequent problem for companies. It is the reason why managers often find

a trade-off between the rates of unemployment and inflation. If unemployment falls, the

individuals who have found work may often be the ones that are the most attractive to

employers in terms of the skills they possess. The resulting skills shortages mean that

managers have to raise the wage and salary levels they are willing to pay in order to

attract the talent they need away from other companies. This can put pressure on

inflation.

On the other hand, a decline in the unemployment rate is frequently good news

for business. It gives a boost to personal disposable incomes, and invariably has a

positive effect on the consumer confidence, potentially increasing aggregate demand. At

an individual level, fear of unemployment might be eased by a fall in unemployment

throughout the economy. It could be the foundation for re-emergence of the ‘feel good’

factor, that intangible indicator of recovery and imminent boom.

Indicators of this kind are based on a standard view of the business cycle. For

example, in the first stages of a recovery, demand increases, company stocks are run

down, and output rises as inventories and rebuilt. Next, firms hire unemployed workers

who spend their incomes on consumer goods, creating more demand and employment

through the multiplier. Finally, capacity constraints lead to new investment and even

more demand. Eventually though, output hits a ceiling as a result of bottleneck and

supply constraints, higher interest rates, and full employment. At this point, advancing

inflation rates throw everything into reverse.

73

Figure 4.8 represents the monthly value in per cent of the unemployed in the UK

from January 2007 until December 2009:

2007

-1

2007

-3

2007

-5

2007

-7

2007

-9

2007

-11

2008

-1

2008

-3

2008

-5

2008

-7

2008

-9

2008

-11

2009

-1

2009

-3

2009

-5

2009

-7

2009

-9

2009

-11

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

4.70%

7.90%

Unemployment rate[in %]

Source: UK Office for National Statistics

Figure 4.8. Unemployment rate in 2007-2009

As the figure above stands, the unemployment rate was the lowest in January

2007 – right at the beginning of the analysed period. It reached its highest point in

August 2009 and continued to be on the same level until the end of 2009. A sudden

increase in its value started in the middle of 2008. It was caused by the sudden fall in

total spending due to the reaction to the Credit Crunch. Since businesses had to produce

a lower volume of goods they needed less labour to fulfil their sales targets.

The situation was dramatic for the British labour market. Cuts in vacancies were

caused not only by the real loss of business but also by panic and the common need to

restructure the companies, as Riley states [1999, p. 54]. During the analysed period

unemployment grew by 68% leaving a lot of professionals with 20 years of experience

without jobs. This led to the biggest in history unemployment amongst graduates. Since

there were people with experience willing to work for less than before, graduates were

forced to take on jobs for which they were far too overqualified or stay unemployed.

74

Moreover, figure 4.9. represents the dynamic of change in unemployment rate

for the analysed period.

2007

-1

2007

-3

2007

-5

2007

-7

2007

-9

2007

-11

2008

-1

2008

-3

2008

-5

2008

-7

2008

-9

2008

-11

2009

-1

2009

-3

2009

-5

2009

-7

2009

-9

2009

-11

-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%17.02%

-1.82% -1.89%

4.41%

Unemployment rate dynamics[Q1 2007=100] in %

Source: UK Office for National Statistics

Figure 4.9. Unemployment rate dynamics in 2007-2009

As one can read from the chart above, apart from a major increase in February

2007, unemployment was slowly falling until June 2008 when it started gradually

increasing. This is directly connected to the state of the economy in the UK. Since it

faced a contraction in the second quarter of 2008, followed by recession in 2009,

unemployment was gradually growing.

The relationship between unemployment rate and all three indices analysed in

this dissertation is presented next.

4.4.2. Unemployment rate and FTSE 100

75

Figure 4.10. represents the value of FTSE 100 and unemployment rate for the

analysed period of 2007-2009:

2007

Q1

2007

Q2

2007

Q3

2007

Q4

2008

Q1

2008

Q2

2008

Q3

2008

Q4

2009

Q1

2009

Q2

2009

Q3

2009

Q4

0.000

1.000

2.000

3.000

4.000

5.000

6.000

7.000

8.000

9.000

6.666

3.638

5.200

7.900

FTSE100

Unemployment

Source: UK Office for National Statistics, London Stock Exchange Prices

Figure 4.10. Unemployment rate and FTSE 100 in 2007-2009

As calculated on the basis of the data above, the rank correlation coefficient for

these two variables is -0.68061, which means that the correlation is quite strong. It can

be read from the chart above as well: when FTSE 100 started to fall in value,

unemployment began to rise. This basically pictures how lack of business for the

hundred of biggest businesses in the UK caused vacancy cuts in all sectors. As one can

observe, FTSE 100 started to regain its value towards the end of 2009, yet

unemployment was still highest ever. The reason for that is the fact that companies still

want to keep their costs as low as possible so they try to use the potential of their staff to

the maximum before they start recruiting again, as Wei states [2002, p. 94].

4.4.3. Unemployment rate and FTSE 250

76

Figure 4.11. represents the value of FTSE 250 and unemployment rate for the


2007

Q1

2007

Q2

2007

Q3

2007

Q4

2008

Q1

2008

Q2

2008

Q3

2008

Q4

2009

Q1

2009

Q2

2009

Q3

2009

Q4

0.000

2.000

4.000

6.000

8.000

10.000

12.000

14.000

12.197

5.8305.200

7.900

FTSE250

Unemployment


Figure 4.11. Unemployment rate and FTSE 250 in 2007-2009


these two variables is -0.57306, which means that the correlation is quite strong yet

lower than for FTSE 100. It can be read from the chart above as well: when FTSE 250

started to fall in value in the second quarter of 2008, unemployment began to rise.

The situation here is similar to the behaviour of unemployment and FTSE 100-

when the index started recovering, the rate of people seeking for jobs did not fall

automatically. It takes time for companies to start hiring more staff; in order to keep

costs low managers will delay recruiting until the present staff cannot cope with new

volume of goods or services required.

4.4.4. Unemployment rate and FTSE All-Share

77

Figure 4.12. represents the value of FTSE All-Share and unemployment rate for

the analysed period of 2007-2009:

2007

Q1

2007

Q2

2007

Q3

2007

Q4

2008

Q1

2008

Q2

2008

Q3

2008

Q4

2009

Q1

2009

Q2

2009

Q3

2009

Q4

0.000

1.000

2.000

3.000

4.000

5.000

6.000

7.000

8.000

9.000

3.467

1.855

5.200

7.900

FTSEAllShare

Unemployment


Figure 4.12. Unemployment rate and FTSE All-Share in 2007-2009


these two variables is -0.676993, which means that the correlation here is stronger than

for FSTE 250 and lower than for FTSE 100. It can also be read from the chart above:

when FTSE All-Share started to fall in value in the second quarter of 2008,

unemployment began to rise.

Similarly, unemployment rate increased drastically when the price of FTSE All-

Share fell in value. This represents the overall state of 98% of the British economy.

Companies in all sectors had to cut vacancies and try to maximise profits by, amongst

others, minimising the cost of labour.

4.5. Interest Rate

78

4.5.1. The idea of interest rate and its changes in 2007-2009

Finally, linking financial markets together with the state of the economy are

interest rates. These are prices for use the use of money, comparable to prices in the

product markets and wages and salaries in the labour markets, as Vaitilingam states

[2004, p.19]. That generally speaking is the idea of interest rates; an individual holding

cash rather than depositing it in an interest-bearing bank account is paying a price, the

foregone interest. Once the money is deposited, it is the bank that pays the price for the

funds it can now use, again the interest payable on that account. Moreover, when the

bank lends the money to a company, the company is paying a price for being able to

borrow: the interest the bank charges for loans, normally higher than the rate it pays the

original depositor so it can make a profit. Lastly, interest rates are stated at different

levels according to i.e. the length of a deposit; the greater the risk, the higher the price.

All of these rates are intimately related: if one changes, they all do. This works

by the same process as the changing prices of products or assets, that is, the rebalancing

of demand and supply. If, for example, the rate of interest payable on short-term

deposits were to rise, money in long-term deposits would flow into short-term deposits,

as Cairns represents it [2004, p. 124]. The sellers or suppliers of long-term deposits

would decline, and to attract them back, the price, the interest rate would need to rise in

line with the short-term rate.

A rise in interest rates has beneficial effect on investors with cash deposits in

interest-bearing accounts. On the other side of the market though, the buyers of money

or the borrowers face increased costs since the price has gone up. This would be the

experience companies borrowing to finance new investments. Furthermore, lack of

investment does not help economic growth; hence the market is ‘slowing down’ as

James calls it [2000, p. 9]. But a change in interest rates also has effects on the prices of

other assets, as well as on many other key variables in the wider economy, i.e. equity

markets.

The effects of changed interest rates could conceivably come before the change

is actually implemented, as Vaitilingam stresses it [2004, p.19]. This is because of the

expectations of investors: for example, if a rate rise is anticipated, bond owners (whose

assets prices have an inverse relationship with interest rates) will probably sell in

79

expectation of being able to buy the bonds back at new lower price. This will cause

prices to fall automatically because of surplus supply. Financial markets often discount

the future in this way, building into the prices of the assets traded on them all past,

present and prospective information on their future values. For example, expectations of

company profits can influence the current price of a share just as much as actual

announced profits, and sometimes more so.

Interest rates tend to rise and fall in line with the level of economic activity. In a

recession and the early stages of a recovery, they will generally be low and falling to

encourage borrowing; while in the subsequent boom, they will rise as the demand for

money exceeds the supply. Vogl [1996, p. 56] explains that for companies, the rising

interest rates of a boom might be disadvantageous, but the growing economy itself

should offer numerous opportunities for enhanced profitability. This should benefit

investors in equities.

Even forms without substantial existing or planned debts need to monitor rates,

for example, those in sectors where business is highly sensitive to changes in interest

rates, such as banks and life assurance companies. In these industries, revenues and a

substantial proportion of costs are directly affected by rate changes. Firms in industries

dependent on household expenditure, such as retail sector and breweries, will be less

directly affected but still experience important changes in demand, as consumers shift

their spending in responses to accessibility and cost of credit.

News about particular companies can have a powerful impact on the market, as

well as causing individual equity price movements. This is especially the case with the

blue chip companies, the most highly regarded companies in the market and usually

ones with substantial assets, a strong record of growth, and a well-known name. Moves

in response to blue chip news are typically short-term, affected by such intangibles as

sentiment, investor psychology, and how the market is ‘feeling’, as Fane describes it

[2000, p. 34-36]. Medium term moves seem to be influenced by supply and demand

factors, such as the weight of money moving into or out of stocks: for example, the

market tends to expect a certain level of growth in overall corporate earnings. If it does

not materialise, money might leave the market.

It is probable that long-term moves depend on fundamental economic and

political factors. The market often follows the broad patterns of economic activity, and

80

certainly news about inflation, productivity, growth and the government’s fiscal and

monetary stance can have major effects on the level of the market. Hence the

importance of understanding what the economic indicators mean and how they relate to

the markets.

Furthermore, the value of the UK’s interest rates for the analysed period is

presented by the chart below:

2007

-1

2007

-3

2007

-5

2007

-7

2007

-9

2007

-11

2008

-1

2008

-3

2008

-5

2008

-7

2008

-9

2008

-11

2009

-1

2009

-3

2009

-5

2009

-7

2009

-9

2009

-11

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

5.75%

0.50%

Interest rate[in %]

Source: Bank of England Statistics Database

Figure 4.13. Interest rate in 2007-2009

As figure 4.13. represents it, the rate of interest reached its highest value of

5.75% in July 2007 and fell by over 90% to the value of 0.5% in April 2009. The

decision to lower interest rates was made by Bank of England due to their duty of

handling monetary policy. As Brenner states [2006, p.72], lowering interest rates in

times of recession and early recovery is meant to encourage economic development by

making borrowing cheaper. Hence, drastic fall in interest rate value in November 2008

when Britain’s businesses started to struggle financially.

81

The drastic fall in the rate of interest is represented by figure 4.14. which

pictures the dynamics of change in interest rated for the analysed period.

2007

-1

2007

-3

2007

-5

2007

-7

2007

-9

2007

-11

2008

-1

2008

-3

2008

-5

2008

-7

2008

-9

2008

-11

2009

-1

2009

-3

2009

-5

2009

-7

2009

-9

2009

-11

-60.00%

-50.00%

-40.00%

-30.00%

-20.00%

-10.00%

0.00%

10.00%

Interest rate dynamics[Q1 2007=100] in %

Source: Bank of England Statistics Database

Figure 4.14. Interest rate dynamics in 2007-2009

As the figure above represents it, the value of interest rates in the UK suddenly

dropped in November 2008. It continued on falling until May 2009 since the situation of

the economy was not getting a lot better. The change stopped when the interest rate

reached 0.5%, which was the lowest in 22 years, according to the data published on the

official website of Bank of England. Vaitilingam [2004, p. 19] also states that indices

reflect the overall market as all sectors are taken into consideration here. Hence, one

should analyse how interest rates changed in comparison to the value of analysed

indices.

4.5.2. Interest rate and FTSE 100

82

Figure 4.15. represents the value of FTSE 100 and interest rate for the analysed

period of 2007-2009:

2007

Q1

2007

Q2

2007

Q3

2007

Q4

2008

Q1

2008

Q2

2008

Q3

2008

Q4

2009

Q1

2009

Q2

2009

Q3

2009

Q4

0.000

1.000

2.000

3.000

4.000

5.000

6.000

7.000 6.666

3.638

5.750

0.500

FTSE100

interest rate

Source: Bank of England Statistics Database, London Stock Exchange Prices

Figure 4.15. Interest rate and FTSE 100 in 2007-2009

After analysing the data above, one can calculate the rank correlation coefficient

for those two variables for the period of 2007-2009. For interest rates and FTSE 100

here is rather strong: 0.804112. In response to the boom in the beginning of 2007 when

FTSE 100 reached its highest value, Bank of England increased the rate of interest to

5.75%. When situation changed and the value of the index fell drastically in the third

quarter of 2008, the value of interest rates started decreasing as well. The government in

response to recession lowered the interest rate to 0.5% since supply exceeded demand

and business owners should be encouraged to invest in their companies in order to lift

the economy off the ground.

4.5.3. Interest rate and FTSE 250

83

Figure 4.16. represents the value of FTSE 250 and interest rate for the analysed

period of 2007-2009:

2007

Q1

2007

Q2

2007

Q3

2007

Q4

2008

Q1

2008

Q2

2008

Q3

2008

Q4

2009

Q1

2009

Q2

2009

Q3

2009

Q4

0.000

2.000

4.000

6.000

8.000

10.000

12.000

14.000

12.197

5.8305.750

0.500

FTSE250

interest rate


Figure 4.16. Interest rate and FTSE 250 in 2007-2009


these two variables is 0.712384 which is rather high but lower than for FTSE 100.

Similarly though, when the state of the economy reflected by FTSE 250 started looking

more like recession, interest rates fell as well. Even though the index started gaining its

value back towards the end of 2009 interest rate remained on the 0.5% level. Bank of

England still encouraged companies to develop by offering them discounted supply of

money to increase the demand for it again.

4.5.4. Interest rate and FTSE All-Share

84

Figure 4.17. represents the value of FTSE All-Share and interest rate for the


2007

Q1

2007

Q2

2007

Q3

2007

Q4

2008

Q1

2008

Q2

2008

Q3

2008

Q4

2009

Q1

2009

Q2

2009

Q3

2009

Q4

0.000

1.000

2.000

3.000

4.000

5.000

6.000

7.000

3.467

1.855

5.750

0.500

FTSEAllShare

interest rate


Figure 4.17. Interest rate and FTSE All-Share in 2007-2009

As it can be calculated, the rank correlation coefficient for these two variables is

0.801511 which is very high. It was slightly higher for FTSE 100 and lower for FTSE

250. As it happened with two other indices, the value of interest rate started dropping

together with the decreasing value of FTSE All-Share and stayed on the same level

from the second quarter of 2009 even though the index started slowly recovering. The

lasting recession forced Bank of England to keep interest rates as low as possible to

encourage further investment and to create new work places in order to reduce

unemployment and increase disposable incomes of residents of the British Isles.

85

Summary

Whilst reading English press as well as observing the everyday situation in the

United Kingdom I have come across opinions on how American Credit Crunch ruined

the British economy. To fulfil the aim of my thesis I have analysed how the

representatives of 98% of total market capitalisation, the most popular FTSE indices,

changed over the period of three years: 2007-2009. To check whether one can call the

market a reflection of the state of the economy I have also correlated the indices with

GDP and GBP/EUR exchange rate. On the basis of results of the analysis the following

conclusions can be drawn:

- FTSE 100, FTSE 250 and FTSE All-Share behaved in a similar way when

reacting to the 2008 sudden crash of the economy;

- All three indices faced the biggest change in 2008 when they all reached

their highest values in January and the lowest ones in November;

- After a sudden downfall in the second half of 2008 all three indices began to

raise in the third quarter of 2009;

- FTSE 250 was more sensitive to the changes than the two other indices

analysed;

- The difference in structure of FTSE indices has an influence on their

sensitivity;

- Stock market reflects the state of the economy in the United Kingdom;

- Stock market prices are strongly influenced by the situation in the financial

sector of the economy;

- Market cycle is ahead of economic cycle, hence it can be treated as the

barometer of the economy in a given country;

- There is a very strong correlation (0.88; 0,89) between FTSE indices value

and the GBP/EUR exchange rate;

- There is a very weak correlation (0,05; 0,21) between FTSE indices and

Gross Domestic Product;

- There is a fairly strong correlation (-0.68; -0.57) between FTSE indices and

unemployment rate;

- There is a strong correlation (0.71 – 0.80) between FTSE indices and interest

rate;

- The British currency value is influenced by the health of the United

Kingdom’s economy;

- The British currency value is influenced by the ‘feeling’ of the economy;

- The British currency value reacts to the changing market situation

immediately;

- Low interest rates encourage borrowing as a part of Monetary Policy;

- When the value of FTSE indices falls, the rate of unemployment rises;

- Economic indicators described in this dissertation are strongly related and

influence one another;

By conducting this study one could come to understanding of how the state of

the economy of the United Kingdom of Great Britain changed over as short period of

time as three years. The value of the main FTSE indices dropped by nearly 50% over a

few months, yet they managed to slowly start regaining their value. This phenomenon

illustrates how the economy behaves in a natural way, how it bounces back to shape

after recession.

Moreover, one by one analysis of economic indicator makes the way the markets

work even clearer. There is a visible relationship between unemployment, demand,

consumption and interest rates. It has also been shown how the Bank of England uses

the latter to help the economy recover and encourage creating new job opportunities,

which will eventually lead to higher consumption, investment and saving. The

phenomenon of the market cycle is simply inevitable.

Summarising, the analysis of FTSE index prices has let one prove that the

capital market is the reflection of the British economy. They are highly sensitive to all

changes and provide valuable information for local as well as foreign investors and

market analysts.

87

Bibliography

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Press

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The Internet

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6. London Stock Exchange Prices <http://www.londonstockexchange.com/exchange/ prices- and-markets/stocks/indices/summary/summary-indices-constituents.html? index=UKX> [consulted on 27.01.2011]

7. UK Office for National Statistics < http://www.statistics.gov.uk/hub/index.html> [consulted on 10.03.2011]

89

Appendix 1: FTSE 100 constituents (December 2009):

3i Admiral Group African Barrick

Gold Aggreko Alliance Trust AMEC Anglo American Antofagasta ARM Holdings Associated British

Foods AstraZeneca Autonomy

Corporation Aviva BAE Systems BG Group BHP Billiton BP BT Group Barclays British American

Tobacco British Land

Company British Sky

Broadcasting Group Bunzl Burberry Group Cairn Energy Capita Group Capital Shopping

Centres Group Carnival Centrica Compass Group Diageo Essar Energy Eurasian Natural

Resources Corporation

Experian Fresnillo G4S GKN GlaxoSmithKline HSBC

Hammerson ICAP IMI Imperial Tobacco Inmarsat International

Airlines Group InterContinental

Hotels Group International Power Intertek Group Invensys Investec Johnson Matthey Kazakhmys Kingfisher Land Securities

Group Legal & General Lloyds Banking

Group Lonmin Man Group Marks & Spencer Wm Morrison

Supermarkets National Grid Next Old Mutual Pearson Petrofac Prudential RSA Insurance

Group Randgold Resources Reckitt Benckiser Reed Elsevier Resolution Rexam Rio Tinto Group Rolls-Royce Group Royal Bank of

Scotland Group Royal Dutch Shell SABMiller Sage Group J Sainsbury Schroders

Scottish and Southern Energy

Serco Group Severn Trent Shire Smith & Nephew Smiths Group Standard Chartered

Bank Standard Life Tesco TUI Travel Tullow Oil Unilever United Utilities Vedanta Resources Vodafone WPP Group Weir Group Whitbread Wolseley Xstrat

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Appendix 2: FTSE 250 constituents (December 2009):

3i Infrastructure AZ Electronic

Materials Aberdeen Asset

Management Aberforth Smaller

Companies Trust Aegis Group Afren Amlin Aquarius Platinum Ashmore Group Ashtead Group WS Atkins Aveva Avis Europe BBA Aviation BH Global BH Macro BTG Babcock

International Group Bankers Investment

Trust A.G. Barr Balfour Beatty Barratt

Developments Beazley Group Bellway Berkeley Group

Holdings Betfair Group Big Yellow Group BlackRock World

Mining Trust Bluecrest Allblue

Fund Bodycote

International Booker Group Bovis Homes Group Brewin Dolphin

Holdings Brit Insurance

Holdings British Assets Trust

British Empire Securities and General Trust

Britvic N Brown Group CPP Group CSR Cable & Wireless

Communications Cable & Wireless

Worldwide Caledonia

Investments Capital & Counties

Properties Carillion Carpetright Catlin Group Centamin Egypt Charter

International Chemring Group City of London

Investment Trust Close Brothers

Group Cobham COLT Group Computacenter Cookson Group Cranswick Croda International Daejan Holdings Daily Mail and

General Trust Dairy Crest Group Davis Service

Group De La Rue Debenhams Derwent London Devro Dexion Absolute Dignity Domino Printing

Sciences

Domino's Pizza UK & IRL

Drax Group DSG International Dunelm Group EasyJet Edinburgh Dragon

Trust The Edinburgh

Investment Trust Electra Private

Equity Electrocomponents Elementis Enterprise Inns EnQuest Euromoney

Institutional Investor

Exillon Energy F&C Asset

Management F&C Commercial

Property Trust Fenner Ferrexpo Fidelity China

Special Situations Fidelity European

Values Fidelity Special

Values Fidessa Group Filtrona FirstGroup Foreign & Colonial

Investment Trust Forth Ports Galiform Gartmore Group Genesis Emerging

Markets Fund Genus Go-Ahead Group Grainger Great Portland

Estates

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Greene King Greggs HSBC

Infrastructure Company

Halfords Group Halma Hansen

Transmissions Hargreaves

Lansdown Hays Helical Bar Henderson Group Herald Investment

Trust Heritage Oil Hikma

Pharmaceuticals Hiscox Hochschild Mining Home Retail Group Homeserve Hunting IG Group Holdings ITE Group ITV Imagination

Technologies Group

Impax Environmental Markets

Inchcape Informa Intermediate Capital

Group International

Personal Finance International Public

Partnerships JD Sports Fashion JKX Oil & Gas JPMorgan

American Investment Trust

JPMorgan Asian Investment Trust

JPMorgan Emerging Markets Investment Trust

JPMorgan European Fledgling Investment Trust

JPMorgan Fleming Mercantile Investment Trust

JPMorgan Indian Investment Trust

Jardine Lloyd Thompson Group

Jupiter Fund Management

Keller Group Kenmare Resources Kesa Electricals Kier Group Ladbrokes Laird Lamprell Lancashire

Holdings Law Debenture Logica London & Stamford

Property London Stock

Exchange Group MITIE Group Marston's McBride Meggitt Melrose Merchants Trust Michael Page

International Micro Focus

International Millennium &

Copthorne Hotels Misys Mitchells & Butlers Mondi Moneysupermarket.

com Group Monks Investment

Trust Morgan Crucible

Co Mothercare Murray Income

Trust

Murray International Trust

National Express Group

Northumbrian Water Group

Ocado Group PZ Cussons Pace Paragon Group of

Companies PartyGaming Pennon Group Perpetual Income &

Growth Investment Trust

Persimmon Petropavlovsk plc Phoenix Group

Holdings Polar Capital

Technology Trust Premier Farnell Premier Foods Premier Oil Provident Financial Punch Taverns QinetiQ RIT Capital

Partners RPS Group Rank Group Rathbone Brothers Redrow Regus Renishaw Rentokil Initial Restaurant Group Rightmove Rotork SDL International SIG plc SSL International SVG Capital Salamander Energy Savills Schroder

AsiaPacific Fund Scottish Investment

Trust

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Scottish Mortgage Investment Trust

Segro Senior Shaftesbury Shanks Group Smith (DS) SOCO International Spectris Spirax-Sarco

Engineering Spirent Sportingbet Sports Direct St. James's Place St. Modwen

Properties Stagecoach Group SThree Stobart Group SuperGroup Synergy Health TalkTalk Telecom

Group Talvivaara Mining

Company Tate & Lyle Taylor Wimpey Telecity Group Temple Bar

Investment Trust Templeton

Emerging Markets Investment Trust

Thomas Cook Group

Travis Perkins TR Property

Investment Trust (two listings, both ordinary and sigma shares)

Tullett Prebon UK Commercial

Property Trust Ultra Electronics

Holdings Unite Group United Business

Media Victrex

W H Smith Wellstream Wetherspoon (J D) William Hill Witan Investment

Trust Wood Group Yule Catto

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Appendix 3: FTSE All-Share constituents (December 2009):

3i Grp. 3i Inf. Ord 888 Hldgs A.b.food Abdn.asian Sml Abdn.asn Inc Abdn.asset.man. Abdn.nw.dwn Aberfth.smll.co Absolute Rtn S Acencia Admiral Grp Adv.dev.mkt Tst Aegis Grp. Afren African Barr Aga Rangemaster Aggreko Alliance Trust Alt.inv.strat Alterian Amec Amlin Anglo & O'seas Anglo American Anglo Pacific Anglo-eastern Anite Antofagasta Aquarius Plat. Arena Leisure Arm Hldgs. Artemis Alpha Ashley(laura) Ashmore Ashtead Grp. Assura Grp Astrazeneca Atkins(ws) Autonomy Aveva Grp Avis Europe Aviva Axis-shield Az Electro. Babcock Intl Bae Sys.

Baillie G.jap. Balfour B. Bankers Inv.tst Barclays Baring Emerging Barr (A.g.) Barratt Devel. Batm Advanced Bba Aviation Beazley Bellway Berendsen Berkeley Gp.hld Betfair Grp Bg Grp. Bh Global Bh Global $ Bh Macro Eur Bh Macro Gbp Bh Macro Usd Bhp Billiton Big Yellow Grp Biotech Gwth Blackrock Com Blackrock Great Blackrock Lat A Blackrock New E Blackrock Sml Blackrock Wld Bloomsbury Pub. Bluecrest Gbp Bodycote Booker Bovis Homes Bp Br.amer.tob. Br.assets Trust Br.empire Sec. Br.land Br.polythene Braemar Ship Brammer Brewin Dolphin Brit Ins Hldgs Britvic Brown(n.) Grp. Brunner Inv.tst

Bskyb Bt Group Btg Bunzl Burberry Grp Cable&wire Com Cable&ww Cairn Energy Caledonia Inv. Camellia Candover Inv. Cap & Count Cap.&reg. Capita Group Capital Shop Carclo Carillion Carnival Carpetright Catlin Grp Cazenove Ab. Centamin Egypt Centaur Centrica Charles Taylor Charter Intl Chaucer Hldgs Chemring Grp. Chesnara Chime Comms. Cineworld City Lon Inv City Lon. City Merch. City Nat Clarke T. Clarkson Clinton Card Close Br.grp. Cls Hdgs Cobham Collins Stewart Colt Grp S.a. Compass Group Computacenter Consort Med. Cookson Grp.

Costain Grp. Cppgroup Cranswick Croda Intl. Csr Daejan Hldgs Daily Mail'a' Dairy Crest De La Rue Debenhams Dechra Pharm Derwent London Dev.secs. Devro Dexion Abs Dexion Eq.alt Dexion Trading Diageo Dialight Dignity Diploma Dixons Retail Domino Print. Domino's Pizza Drax Dtz Hldgs Dunedin Ent.it. Dunedin Inc. Dunelm E2v Tech Eaga East.euro Tst Easyjet Ecofin Wtr.ord Edin.drgn.tst. Edin.inv.tst. Edin.uk Tracker Edin.us Tracker Edin.wwide Inv Elec.& Gen.it Electra Private Electrocomps. Elementis Emblaze Ld Enquest Ent.inns Essar Energy Eurasian Euromoney Inst. Evolution Grp. Exillon Energy Experian F&c Asset Man F&c Cap&inc F&c Comm Prp

F&c Global F&c Priv. Ord F&c Us Smaller Fenner Ferrexpo Fiberweb Fid.euro.val. Fid.sp.val. Fidelity Asian Fidelity China Fidessa Group Filtrona Findel Finsbury Gth. Firstgroup Fisher(j)& Sons For.&col.iv.tst Forth Ports Fortune Oil Fresnillo Fuller,smith'a' G4s Galliford Try Game Group Gart.eur.it Gart.fledge.tst Gart.glbl.tst Gart.irish Gartmore Grp

Gem Diaonds Di Genesis E.m.f. Genus (GNS) Gkn Glaxosmithkline Gleeson (Mj) Go-ahead Group Goldenport Goldman D Gbp Goodwin Gr.portland Grainger Graphite Ent Greene King Greggs Halfords Halma Hammerson Hampson Ind. Hansa Tst 'A' Hansa Tst Plc Hansard Hansen Tran. Hansteen Hldgs Hardy Oil

Hardy Under. Bm Hargreaves Lans Hays Headlam Group Helical Bar Helphire Grp Hend.euro. Hend.far East Hend.high Inc Hend.small Cos. Hend.tr Pac.it Henderson Grp Herald Inv. Heritage Oil Hg Capital Hikma Hill & Smith Hilton Food Hiscox Hmv Grp Hochschild Hogg Rob. Holidaybreak Home Retail Homeserve Hornby Howden Joinery Hsbc Hldgs.uk Hsbc Inf. Co Ld Hunting Huntsworth Hyder Cons Icap Ig Group Imagintn.tech Imi Imp.tobacco Grp Impax Asian Impax Env.mkt Inchcape Informa Ing Global Ing Uk Inmarsat Innovation Grp Int Ferro Int.cap.grp Inter. Pers. Intercon. Hotel Interserve Intertek Group Intl Consol Air Intl Power Intl Public Invensys

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Invesco Asia Invesco Inc Gth Invesco Perp Uk Investec Invista Euro. Invista Fnd Tst Ip Group Irp Prop Inv Isis Property Ite Grp. Itv Jardine Lloyd Jd Sports Jjb Sports Jkx Oil & Gas Johnson,matth Johnston Press Jp Morg.as Jp Morg.chin Jpmor Indian Jpmor. Jap.sml Jpmor.amer. Jpmorg.eur Jpmorg.oseas It Jpmorg.smaller Jpmorgan Clav Jpmorgan Emerg Jpmorgan G Jpmorgan Glob Jpmorgan Japan. Jpmorgan Mid Jpmorgan Rus Jupiter Euro. Jupiter Fnd Jz Capital Kazakhmys Kcom Grp Keller Grp. Kenmare Res. Kesa Elect. Kewill Keystone It Kier Group Kingfisher Kofax Ladbrokes Laird Lamprell Lancashire Land Secs. Lavendon Group Law.deb.corp Legal&gen. Lloyds Grp. Lms Capital

Logica Lon.stk.exch London & Stam. Lonmin Lookers Low & Bonar Lowland Inv. Lsl Prop M.c.pacific Majedie Inv. Man Group Manchester&lon. Mangmnt.cons.gp Marks & Sp. Marshalls

Marston's Martin C.port. Mcbride Mckay Secs. Mears Group Mecom Grp Medicx Fund Meggitt Melrose Melrose Res. Menzies(j) Mercantile Merchants Tst Metric Prop Michael Page Micro Focus Millennium &Cop Minerva Misys Mitchells & But Mitie Grp. Mondi Moneysup. Monks Inv.tst. Montanaro Uk Morgan Cr. Morgn Sindl Grp Morrison (Wm) Mothercare Mouchel Group Mucklow (A&j) Murray Inc.tst. Murray Intl.tst Mwb Group Namakwa Di. Nat.express National Grid Ncc Grp New India New Star Inv

Next North Atl.smlr Northgate Northumbn.wtr Novae Grp Nthn.foods Ocado Old Mutual Optos Oxford Biomed. Oxford Instrmnt Pace Pacific Assets Pacific Horizon Pantheon Int. Paragon Grp. Partygaming Paypoint Pearson Pendragon Pennon Group Perptl.i&g.inv. Persimmon Personal Assets Petrofac Petropavlovsk Phoenix Grp(di) Phoenix It Photo-me Intl. Polar Cap Glbl Polar Cap. Prem Foods Premier Farnell Premier Oil Primary Health Promethean Prostrakan Provident Fin. Prudential Psion Punch Tvns Pv Crystalox Pz Cussons Qinetiq Quintain Est. R.e.a.hldgs. Randgold Res. Rank Grp. Rathbone Bros Raven Russia Rds 'A' Rds 'B' Reckitt Ben. Gp Redrow Reed Elsevier

96

Regus Renishaw Renold Renovo Grp Rentokil Initl. Resolution Restaurant Gp Rexam Ricardo Rightmove Rio Tinto Rit Capital Rm Robert Walt. Robert Wiseman Rolls-royce Rotork Royal Bank Scot Rpc Grp. Rps Grp. Rsa Ins. Rsm Tenon Ruffer Inv. Co. Sabmiller Safestore Sage Grp. Sainsbury(j) Salamander Savills Schroder Asia Schroder Inc. Schroder Japan Schroder Orient Schroder Uk Schroder Uk Mc Schroders Schroders Nv Scot.&sth.enrgy Scot.amer.inv. Scot.inv.tst. Scot.orntl.smll Scottish Mort Sdl Secs.scotland Segro Senior Sepura Serco Grp. Severfield Severn Trent Shaftesbury Shanks Grp.

Shire Shires Inc. Sig Sinclair Pharma Smith&nephew Smith(ds) Smiths Group Smiths News Soco Intl. Southern Cross Spectris Speedy Hire Spirax-sarco Spirent Sportech Sportingbet Sportsdirect St.ives St.james's Plac St.modwen Prop. Stagecoach Stand Life Uk Stand.chart. Standard Life Std Lfe In Pty Std Life Std Life Euro Sthree Stobart Supergroup Svg Cap. Svm Global Svm Uk Synergy Hlth. Talktalk Talvivaara Tarsus Grp. Tate & Lyle Taylor Wimpey Ted Baker Telecity Telecom Plus Temple Bar Templeton Emrg. Tesco Thames Riv. The Euro Inv The Vitec Grp. Thomas Cook Thorntons Throg.trust Topps Tiles

Town Centre Tr Euro.growth Tr Prop.inv.sig Tr Prop.inv.tst Travis Perkins Tribal Grp. Trinity Mirror Troy Income Tt Electronics Tui Travel Tullett Prebon Tullow Oil Uk Coal Uk Comm Prop Uk Mail Group Ultra Elec. Umeco Unilever Unite Group Utd. Utilities Utd.bus.media Utv Media Value And Inc Vectura Vedanta Victrex Vodafone Grp. Volex Grp. Vp Weir Grp. Wellstream Wetherspoon(jd) Wh Smith Whitbread Wichford William Hill Wilmington Grp. Wincanton Witan Inv Tst Witan Pac Wolfson Mic Wolseley Wood Grp Workspace Grp Worldwide Hc Wpp Wsp Grp. Xchanging Xp Power Xstrata Yell Grp Yule Catto

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