changes to any of the constituent companies is captured by either modifying the divisor, which in the case of such indices is always assigned a value of 1.0 on the base date, or by changing the base period market capitalisation subsequently.
The beauty of such indices is that, in theory, the market capitalisation of a company is invariant to stock splits and reverse splits, and bonus issues. Consequently, the only actions that mandate a change in the divisor (or the base period market capitalisation) are rights issues, at a discount or otherwise, and changes in index composition.
In addition to the Dow, the Nikkei 225 index based on the Japanese stock market is also a well-known price weighted index. However, other global indices, such as the S&P 500 and the Nasdaq 100, are value weighted. In India, both the Sensex and the Nifty are value weighted.
An equally weighted index is very simple to compute in practice. We need to calculate one plus the arithmetic average return of all the constituent stocks from one day till the next. The number is multiplied by the previous day’s index value to compute the latest index value. Once again, the index value on the base date can be any arbitrary number.
The writer has authored ‘Fundamentals of Financial Instruments’, published by Wiley, India
In a nutshell
* A stock index number is a summary measure of the performance of the stock market as a whole
* The methods to compute a stock index number include: the price-weighted technique, the value-weighted technique and the equally weighted method.
* Irrespective of the computational method, the first step in constructing a stock market index is to decide how many companies ought to be represented, and which ones in particular.
* A price-weighted index is computed by adding up the latest prices of all the component stocks and dividing the price aggregate by a number known as the ‘divisor’
* In the value-weighted technique, the aggregate market capitalisation on the day of computation is divided by the aggregate market capitalisation on the base date, and the ratio is multiplied by the base