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It
is our endeavour to furnish you with the most exhaustive information. This section seeks
to answer most of the questions you may have. Click on the relevant links down below :
What is an index?
What is a stock index?
Are there different
methodologies in calculating the index?
What are the uses of stock indexes?
Are there different kinds of market
indexes?
Companies announce dividends.
Does the index capture this information?
Is there a financial theory
behind the market Index being a good barometer for the overall market?
How does one achieve a good index?
What are index funds?
What are derivative instruments?
Next Page
What is an index?
An
Index is a number used to represent the changes in a set of values between a base time
period and another time period.
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What is a stock index?
Stock
Index represents change in the value of a set of stocks, which constitute the index, over
a base year.
Any
Index is an average of its constituents. For example, the BSE Sensex is a weighted average
of prices of 30 select stocks and S&P CNX Nifty of 50 select stocks, where the weight
is the market capitalization of individual stocks.
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Are there different
methodologies in calculating the index?
Market
Capital Index
Most
indexes are capitalization-weighted. Number of shares issued to outstanding multiplied by
the market price of company’s share determines its weightage in the index. The total
of market capital of all shares in the index is linked to an index number. The shares with
highest market capitalization are most influential in this type of index.
Examples
: S&P 500 Index in USA , BSE Sensex & S&P CNX Nifty in India.
Modification –
1 : The number used as outstanding shares is adjusted to reflect only those shares that
are freely available for trade (floating stock) ignoring those shares which are not
expected to be traded in the market (like promoters holding).
Example
– RUSSEL 1000
Modification
– 2: It seeks to limit the influence of the largest stocks in the index, which
otherwise would dominate the entire index. This is done by setting a limit on the
percentage weight of the largest stock or a group of stocks.
Example
– NASDAQ 100
Price
Weighted Index
This
type of index sums up the price of each stock in the index, which is then equated to an
index starting value. The shares with the highest price are not influential in this type
of index. If a stock splits, its market price falls resulting in less weight in the index.
Examples
: NIKKIE 225 average of Japanese Stocks, DJIA and PSE Technology indexes in US.
Equal
Weighting :
Each
Stock’s percentage weight in the index is equal and therefore all stocks have equal
influence on the index movement.
Examples
: Value line Index at KCBT ( Kansas City Board of Trade)
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What are the uses of stock indexes?
A
market Index is very important because of the following reasons:
It
acts as a barometer for market behavior
It
is used to benchmark portfolio performance
It
is used in derivative instruments like Index futures
It
can be used for passive fund management as in case of Index Funds.
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Are there different kinds of market
indexes?
Broad
based index is geared to provide overall picture of stock market movements. Examples
of these indexes are S&P 500, Value line Index and NYSE Composite.
In
addition, specialized Indexes, like sector specific ones, track the performance of
individual sectors. Similarly different types of Indexes can be created depending on the
companies included in the set.
For
example S&P Midcap 400 represents companies in USA whose value is in the middle
range of all firms and does not include any stock which is part of S&P 500.
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Companies
announce dividends. Does the Index capture this information?
In
general, the popular Indexes ignore the dividend pay-out. To calculate the total returns
of any Index, we have to factor in the dividends announced by the companies comprising the
Index. The Total Return Index is the correct Index for benchmarking mutual fund
performance as they earn dividends.
DAX,
Germany’s blue-chip index of 30 leading stocks is an example of total return index.
Income from dividends and rights issues are reinvested in the index portfolio and are
reflected in the index value.
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Is there a financial theory
behind the market Index being a good barometer for the overall market?
Stock
prices get impacted by two separate factors, which includes
Company
specific events like results, bonus announcements, product launches, accidents, tie-ups,
etc.
Events
that impact overall economy or sector like diesel price hike, tax rates, etc.
For
example, suppose the government announces a corporate tax hike, we expect the index to be
negatively impacted. On the same day, if Company A announces financial results much better
than expected, its stock price should increase. In reality, the price movement in stock
price of Company A is a combination of good news from Company A and bad news about the
economy. The role of a good Index is to reflect only that component which affects the
state of the overall market.
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How does one achieve a good index?
This
is achieved by diversification. As is explained in portfolio theory, one can reduce risk
by adding stocks in a portfolio. If the rates of return of individual securities are not
perfectly positively correlated, diversification results in risk reduction. Empirical
studies have shown that high benefits of diversification are obtained by forming a
portfolio of 10-15 securities, thereafter gains of diversification are negligible.
As
explained earlier, each individual stock price movement is a combination of stock related
events and events affecting overall economy, or market. With diversification, events
relating to individual stocks tend to cancel each other and one is left with only events
common to the entire economy. Hence the risk captured in the Index is systematic risk or
market risk.
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What are index funds?
Index
funds are funds that passively invest in a basket of securities that exactly imitate the
market Index.
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What are derivative instruments?
A
derivative is an instrument whose value is derived from the value of one or more
underlying, which can be commodities, precious metals, currency, bonds, stocks, stocks
indices, etc. Four most common examples of derivative instruments are Forwards, Futures,
Options and Swaps.
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