Competition among firms for investment funds and customers
Even without direct control of their corporation, stockholders (and the investment advisers, pension fund managers, and others hired to help them) have an incentive to monitor the corporation’s management in order to anticipate problems and search for constructive changes. Investors who are the first to spot a profitable new management strategy can buy stock early, before others realize the opportunity, and bid the price up. A rising stock price is both a signal of approval to good managers and an incentive to manage the corporation well. Conversely, when managers’ decisions are contrary to the interests of stockholders, the opposite occurs: the stock price will fall. Knowing that stock prices can plummet motivates stockholders (along with professional managers of stock holdings) to be the first to spot a problem with the company. This way they can dump their stock before everyone else does, and thus prior to the share price falling. Some investment firms even specialize in selling shares “short” (writing contracts to deliver shares of the stock later, when they expect the stock price to be lower than its current level) if they believe a company is overvalued on the market. So managers get constant feedback via stock price changes, which can be just as important as current profits to stockholders and boards of directors.
Similarly, consumers have an incentive to monitor the quality and price of the firm’s output. No one forces them to buy the corporation’s product, so if other firms supply superior products or offer lower prices, consumers can take their business elsewhere. Because investors are free to buy and sell the company’s shares and customers to buy its products or those of other firms, the ability of managers to benefit personally at the expense of either customers or stockholders is limited. While some managers are still able to enrich themselves at stockholders’ expense, at least temporarily, the recent cases of corporations like Tyco and Enron show that their actions tend to catch up with them.
U.S. Dollar Index
A practical example of a weighted index is the U.S. Dollar Index, traded on the New York Futures Exchange. In order of greatest weighting, the 10 currency components are the Deutschemark 20.8%, Japanese yen 13.6%, French franc 13.1%, British pound 11.9%, Canadian dollar 9.1%, Italian lira 9.0%, Netherlands guilder 8.3%, Belgian franc 6.4%, Swedish kroner 4.2%, and the Swiss franc 3.6%. This puts a total weight of 75.5% in European currencies with only the Japanese yen representing Asia, not a practical mix for a world economy that has become dependent on Far Eastern trade. Within Europe, however, allocations seem to be proportional to the relative size of the economies.
The Dollar Index rises when the U.S. dollar rises. Quotes are in foreign exchange notation, where there are 1.25 Swiss francs per U.S. dollar, instead of .80 dollars per franc as quoted on the Chicago Mercantile Exchange’s IMM. For example, when the Swiss franc moves from 1.25 to 1.30 per dollar, there are more Swiss francs per dollar; therefore, each Swiss franc is worth less.
In the daily calculation of the Dollar Index, each price change is represented as a percent. If, in our previous example, the Swiss franc rises .05 points, the change is 5/12 5 04; this is multiplied by its weighting factor .208 and contributes +. 00832 to the Index.