The significance of an index are as follows:
- An index serves as an indicator of overall market performance or even a particular sector.
- it behaves as a benchmark for portfolio performance
- it is used as an underlying for financial application of derivatives
The types of stock market indices are:
1. Market capitalization weighted index
Here each stock in the index is given weight according to its market cap.
Market cap is the market value of a company, calculated by multiplying total number of outstanding shares to its market price.
Lets take an example. Base value of the index is set to 100 on the start date of Jan 1, 1995 and it consists of 5 stocks. We wish to calculate the current value of the index.
Following are the calculations:
Popular Indian market indices like Nifty and Sensex were earlier designed on Market Cap weighing method.
2. Free-Float Market Cap Index
In a business, equity holding is divided differently among various stake holders -
promoters, institutions, corporates, individials etc. The market segregates this on the basis of what is readily available for trading and what is not.
Free float is the category assigned to the shares available immediately for trading.
And when the index is computed based on the free float market cap weights of each security, it becomes a free float market cap index.
Nifty and Sensex have moved to being free float market cap indices.
3. Price-weighted Index
Here, a stock influences the index in proportion to its size. Stocks with a higher price have a greater influence on the performance of the index.
Lets see the following calculation:
4. Equal Weighted Index
This index does not distinguish between small cap and large cap companies. All companies are given equal weighting.
The value of the index is arrived at by adding the prices of each stock in the index divided by the total number of stocks.
Lets see the following calculation:
Cheers!