Description

Indices-big_big

 

Indices are a benchmark used to measure a group of securities performance listed in a Stock Exchange (e.g. New York Stock Exchange, Euronext, Bolsa de Madrid ,...), allowing investors to easily assess the evolution of the most representative Corporate Shares listed on a given Stock Exchange.

The steps to build an index are:

  • Set the number of corporations that are part of the index (ie. 35 companies in the case of Ibex-35, 100 companies in the case of Nasdaq 100 ...)
  • Sort corporations in descending order that are part of the index, using as criterium their market capitalization
  • Add up the market capitalization of corporations that are part of the index
  • Assign a certain number of points to that sum (1000 points, 100 points, ...)

 

The market capitalization of a corporation is the result of multiplying its share price (e.g. Telefonica trades at 15 euros per share) by the number of it's shares outstanding that represent the corporation capital stock (e.g. if Telefonica has 1 000 million shares, its market capitalization would be 15 000 million Euros).

To illustrate the concepts outlined above let's see the following example:

  • Assume we want to build an Index from 3 corporations: Google, Amazon and Microsoft
  • Assume the price of each Corporate Share and the number of shares representing each corporation's capital stock is as follows
    • Price of each Corporate Share (Unit: USD)
      • Google: 400
      • Amazon: 40
      • Microsoft: 20
    • Number of shares representing the capital stock of each corporation (Unit: millions of shares):
      • Google: 100
      • Amazon: 1.000
      • Microsoft: 1.000
    • Consequently,  the market capitalization for each corporation (Unit: Millions of dollars):
      • Google: 40.000
      • Amazon: 40.000
      • Microsoft: 20.000
  • You can see that each corporation is sorted in descendent order by it's market capitalization. The total market capitalization is 100.000 millions.
  • The weight that each corporation in the Index would be the following:
    • Google: 40%
    • Amazon: 40%
    • Microsoft: 20%
  • For this reason, buying the index is a cheap way to diversify the investment. Otherwise, we should buy each of the Corporate Shares of each corporation which is cumbersome and is more expensive (because it involves higher trading costs).
  • Finally, it is necessary to define the number of index points for day 1: 1 000 points
  • Suppose now that on day 2, the price of each Corporate Share is as follows (Unit: USD):
    • Google: 440 (+10% up; day 2 vs. day 1)
    • Amazon: 42 (+5%; up; day 2 vs. day 1)
    • Microsoft: 21 (+5 %; up; day 2 vs. day 1)
  • With these prices we obtain that the total market capitalization of the Index on day 2 is (Unit: Millions of USD):
    • Google: 44 000 (41%; weigh in the index by market cap)
    • Amazon: 42 000 (39%; weigh in the index by market cap)
    • Microsoft: 21 000 (20 %; weigh in the index by market cap)
    • Total: 107 000 (100%; weigh in the index by market cap)
  • To obtain the new Index value, we proceed as follows:
    • 100.000 millons USD -------- 1.000 points
    • 107.000 millons USD --------  X points
    • X = 1. 070 points, the Index rose 70 points, representing an increase of 7% (1,070 ÷ 1,000 -1)
  • Indexes should be rebalanced if firms pay dividends or a company leaves the Index and is replaced by another.
Demo
Real