Question

How are stock market indices constructed? Discuss the reasons why their coverage and construction vary.

Answer 1

A stock market index refers to a measuring a section of the stock market. While constructing a market index, certain factors need to be considered are the weighting sample members, representativeness of the sample, and procedures of computations. It is a tool applied by financial managers and investors to describe the market, and making a comparison on the return on specific investments. The index is usually calculated with weighted average capitalization; and the market capitalization is computed with multiplication of the stock price and the shares outstanding

An index can be classified according to the method it applies to determine its price. In the price-weighted index, the price of each component stock would be the only main factor while determining the index value; and as a result movement of price of even a single security can have heavy impact on the index value even though the dollar shift is less important in a relatively highly valued issuance, and also ignoring the relative size of the organisation as a whole. On contrary the capitalization-weighted index consideration is the factors in the size of the company. Therefore, a relatively small shift in the price of a big organisation wills impact heavily on the value of the index. Thus their coverage and construction may vary.