Chapter 9 in Best of Wilmott, Vol. 2, pp.99-132 (Oct. 2005)

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The Relative Valuation of an Equity Price Index

 

Ruben D. Cohen (e-mail)

 

Abstract

 

A new approach for the relative valuation of an equity price index is presented.  The method is based on a coordinate transformation or mapping, which enables one to weigh the index against the aggregated earnings and GDP.  This, therefore, gives rise to the notion of relative valuation between the index, the earnings and the GDP.  A practical demonstration of this is then provided for the US, UK and Japan economies and some of their major equity indices, namely the S&P500, FTSE100 and TOPIX, respectively.

Another potential application of the above is also discussed, which relates to forecasting the GDP.  This stems from the assumption that the expected GDP, one year ahead from today, is readily priced in today’s interest rates.  The method is further applied to computing duration.  This is shown to circumvent the difficulties that are generally associated with calculating the parameter.