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FAQ's on Stock Indexes

1.1    What is an Index ?

1.2    What is a Stock Index ?

1.3    Are there different methodologies in calculating the index ?

1.3.1 Market Capital Index

1.3.2 Price Weighted Index

1.3.3 Equal Weighting

1.4    What are the uses of stock indexes ?

1.5    Are there different kinds of market indexes ?

1.6    Companies announce dividends. Does the index capture this information

1.7    Is there a financial theory behind the market Index being a good barometer for the overall market?

1.8    What is the impact of diversification ?

1.9    What are Index funds ?

 

1.1 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.

 

1.2 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 CSE 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.

 

1.3 Are there different methodologies in calculating the index ?

1.3.1 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

 

1.3.2 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.

1.3.3 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)

1.4 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.
 

1.5 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.

1.6 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.

1.7 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.

1.8 What is the impact of diversification ?

Diversification reduces the unsystematic risk. 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.

1.9 What are Index funds ?

Index funds are funds that passively invest in a basket of securities that exactly imitate the market Index

Cochin Stock Exchange, Kochi, India