Most of the commonly followed stock market indexes are of the following two types: Market capitalization weighted index or price weighted index. In a market capitalization weighted index, each stock in the index affects the index value in proportion to the market value of all shares outstanding. A price weighted index is one that gives a weight to each stock that is proportional to its stock price. Indexes can also be equally weighted. Recently, major indices in the world like the S&P 500 and the FTSE-100 have shifted to a new method of index calculation called the “free float” method. We take a look at a vew methods of index calculation.
- 1. PRICE WEIGHTED INDEX: In a price weighted index each stock is given a weight proportional to its stock price.
- 2. MARKET CAPITALIZATION WEIGHTED INDEX: In
this type of index, the equity price is weighted by the market capitalization of the company (share price * number of outstanding shares). Hence each constituent stock in the index affects the index value in proportion to the market value of all the outstanding shares. This index forms the underlying for a lot of
index based products like index funds and index futures
DESIRABLE ATTRIBUTES OF AN INDEX
A good market index should hav e three attributes:
1.It should capture the behavior of a large variety of different portfolios in the Market.
- The stocks included in the index should be highly liquid.
- It should be professionally Maintained.
CAPTURING BEHAVIOR OF PORTFOLIOS
A good market index should accurately reflect the behavior of the overall market as well as of different portfolios. This is achieved by diversification in such a manner that a portfolio is not vulnerable to any individual stock or industry risk. A well diversified index is more representative of the market. Howrever there are diminishing returns from diversification. There is very little gain by diversifying beyond a point. The more serious problem lies in the stocks that are included in the index when it is diversified. We end up including illiquid stocks, which actually worsens the Index.
Since an illiquid’stock does not reflect the current price behavior of the market, its inclusion in index results in an index, which reflects, delayed or stale price behavior rather than current price behavior of the market.
INCLUDING ILLIQUID STOCKS
Liquidity is much more than trading frequency. It is about ability to transact at a price, which is very close to the current market price. For example, a stock is considered liquid if one can buy some shares at around Rs.320.05 and sell at around Rs.319.95, when the market price is ruling at Rs.320. A liquid stock has very tight bid-ask spread.
MAINTAINING PROFESSIONALLY
It is now clear that an index should contain as many stocks with as little cost as possible. This necessarily means that the same set of stocks would not satisfy’ these criteria at all times. A good index methodology must therefore incorporate a steady pace of change in the index set. It is crucial that such changes are made at a steady pace. It is very healthy to make a few changes every year, each of which is small and does not dramatically alter the character of the index. On a regular basis, the index set should be reviewed, and brought in line with the current state of market. To meet the application needs of users, a time series of the index should be available.
Besides other factors a good stock market index should have the following three factors:
- Diversification.
- Liquidity of the Index,
- Good Operational issues.
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