Lesson Corporate Finance: Stock Market Index

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A <A HREF="stock_merket_index.wikipedia">stock market index</A> is made from a hypothetical basket of securities which are statistically combined to track the market performance. The index reflects the combined value of the components of the index and can be utilized effectively to gauge if the market on whole is performing well or not. The average return on the market is also indicated by the return on the index, i.e. by the increase/decrease in the index value.

Indices can be differentiated in many ways. One type of index is a broad based index which is based on the performance of the whole <A HREF="Stock_exchange.lesson">stock market</A>, i.e. based on the combined value of the securities of large companies trading on major exchanges of the economy. This thus gives the picture of the economy as a whole. On other hand, there are specialized indices which deal with particular sectors of society like auto sector, real estate and pharmaceuticals etc.

Other indices can be based on selection of a few companies which are representative of the performance of the stock market or the economy. For example, the <A HREF="Dow_Jones_Industrial_Average.wikipedia">Dow Jones Industrial Average</A> (DJIA) is an index made of stocks of 30 companies of US.

The calculation of the combined value of the components of the index can be done by several methods. One of the commonly used method is the <A HREF="Weighted_average.wikipedia">weighted average</A> method. Here the index value is calculated by taking a weighted average of the market value of the underlying components. The weights assigned to different components are based on different criteria like equally weighted, price weighted, capitalization weighted and market share weighted.

Equally weighted index is calculated by assigning equal weights to the components. The index thus does not take into account the price of share or the size of the company.

<A HREF="Price-weighted.wikipedia">Price weighted </A>index is calculated by assigning weights equal to price of the underlying stocks. The index thus does not take in account the size of the company and even a small price movement in stocks of higher price effects the index promptly.

<A HREF="capitalization-weighted.wikipedia">Capitalization based</A> index takes into account the size of the companies of underlying stocks which are weighted using the market value of the corresponding companies. Thus a small movement in the value of stock of a large company effects the index more than a smaller company.

<A HREF="Market_share.wikipedia">Market share</A> weighted index is based on the market share of the constituent companies (i.e. the number of stocks listed) and thus the company with more number of stocks in market effects the market more.