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Index Methodology

What is stock market index and how does it construct?


A stock market index is a number that indicates the relative level of prices or value of securities in a market
on a particular day compared with a base-day figure, which are usually 100 or 1000. There are many
different ways of constructing an index. One of the most common methods is illustrated by the following
simple example. The values of a market portfolio at the close of trading on Day 1 and Day 2 are recorded
below:
Trading days

Value of portfolio

Index

DAY 1 (base day)

Tk 20,000

1000

DAY 2

Tk 21,000

1050

We take Day 1 as the base day. The index on that day will be taken as a standard. The value assigned to the
base day index is 1000 in this example. On Day 2 the value of the portfolio has changed from Tk 20,000 to Tk
21,000, a 5% increase. Therefore, the value of the index on Day 2 will change to indicate a corresponding 5%
increase in market value. The computation follows the procedure below:
2's portfolio value
Day 2's index = ------------------------------------------------- * Base Day's (Day 1) index
Base Day's (Day 1) portfolio value
Tk 21,000
= ---------------- * 1000
Tk 20,000
= 1050
Day 2's index is 1050 as compared to the 1000 of day 1. The above illustration only serves as an introduction
to how a particular index is constructed. The daily computation of an index is more involved especially when
there are changes in market capitalization of constituent stocks, e.g., rights offers, stock dividend etc. The
primary objective of constructing market indices is to measure the performance of the market. The indices
provide vital information about the current and historical behavior of the market. Stock market indices differ
from one to another basically in their sampling and/or weighting methods.
Sampling Method
There are some market indices that are composed of all stocks listed in a market, e.g., the American Stock
Market
Index
and
the
Hong
Kong
Stock
Exchange
All-Ordinaries
Index
etc.
In general, an index based on a larger percentage of the total number of listed stocks will be more
representative than that one based on a smaller percentage. Although an index that consists of all listed
stocks can be considered as more representative, a number of stocks may have very few transactions, the
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quoted price of these stocks may not reflect their true market value. An index may still be highly
representative even if it consists of only a relatively small percentage of the total number of stocks. Here,
the sample selection process plays an important role.

Most of well-known stock market indices of the major stock markets in developed countries are still
considered as highly representative since their constituent stocks comprise a high percentage of total value
of the market. For example, the Hang Seng Index (Hong Kong) is composed of 33 constituent stocks
comprising approximately 70% of total value. FOX index (Finland) is composed of 25 most traded shares
which is correspond to roughly 80% of the total market value and ATX 50 (Australia) comprises 84% of the
capitalization and 97% of the turnover of all Australian stocks.
Weighting Method
There are, in general, three different weighting methods, namely, value-weighted, equally-weighted (or unweighted), and price-weighted.
Value-weighted method may be considered as a most appropriate method than others for both the bourses
of the country (DSE & CSE) since the existing indices of the bourses have been calculating under valueweighted method. For a value-weighted index, the weight of each constituent stock is proportional to its
market share in terms of capitalization. We can assume that the amount of money invested in each of the
constituent stocks is proportional to its percentage of the total value of all constituent stocks. Examples
include all major stock market indices of Hong Kong, London and many others.
Computation of Value Weighted Indices and Adjustments for Changes in Market Capitalization
The computation of a value-weighted index is useful to think in terms of evaluating the performance of a
portfolio of securities. Some adjustments need to be made due to changes in market capitalization of the
portfolio's constituent stocks. The adjustment procedures are discussed in detail below.
To make our computation simple, we need to keep the number of constituent stocks small. Let us assume
that the index is composed of only three stocks: A, B and C.
Day 1 (base day)
Market Data of Constituent Stocks on Day 1
Stock

Shares Outstanding

Closing Price

Market Value

20

10

200

40

10

50
2

Aggregate Market Value (AMV) = 290

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The market value of each stock at closing is given by the product of the number of shares outstanding and
the closing price. For stock A, for instance, it is 20 shares times Tk.10 which yields Tk.200. The aggregate
market value (AMV) of all constituent stocks is the sum of the market value of each stock. The AMV of day 1
is Tk.290. Day 1 will be taken as the base day on which the index is set at 1000
Day 2
Market Data of Constituent Stocks on Day 2
Stock

Shares Outstanding

Closing Price

Market Value

20

10

200

45

10

5.5

55

Aggregate Market Value (AMV) = 300


As there is no change in capitalization, no adjustment is needed on Day 2. The AMV is equal to Tk.300. The
computation of the index on Day 2 follows the procedure below:

Day 2's AMV


Day 2's index = -------------------- * Day 1's index
Day 1's AMV
300
= ------- * 1000
290
= 1034.4828
It should be clear that the change in the index value shows the relative change in the aggregate market
value of the constituent stocks. There is a 3.45% increase in AMV (also in index) on Day 2 relative to Day 1
(the base day).
Adjustment to Changes in Capitalization
Adjustments need to be made from time to time as a result of changes in capitalization of the constituent
stocks. They are discussed in detail below:
Day 3 (Ex-Bonus)

Company A issues 50% bonus shares. Its shares are to be traded ex-bonus at the ratio of "1 for 2", i.e., one
share will be given as bonus for every 2 shares held. This issue of shares is going to change the total number
of shares outstanding on Day 3. The adjustment is shown below:
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20(1+2)
New Total No. of Shares Outstanding of Company A = -----------2
= 30
Market Data of Constituent Stocks on Day 3
Stock

Shares Outstanding

Closing Price

Market Value

30

210

40

10

60

Aggregate Market Value (AMV) = 310


Therefore,
Day 3's AMV
Day 3's index = ---------------------- * Day 2's index
Day 2's AMV
310
= ----------- * 1034.4828
300
= 1068.9656
Note that the closing price of Company A on day 3 is Tk. 7/- determined by demand and supply factors in the
market against the theoretically adjusted price (to the extent of disclosure) of Tk. 6.67 made on day 2 after
closing market / on day 3 before starting market.
If the company issuing bonus share also recommends / declares cash dividend, then the cash dividend (to
the extent of disclosure) should also be adjusted in the aforesaid theoretical price.
Day 4 (Ex-Rights)
Stock C has declared 40% rights share at the ratio of "2 for 5" at Tk.1.50 each including a premium of Tk. 0.5
each. The offer expires on Day 4 (i.e. ex-rights). As mentioned earlier, it is useful to treat the constituent
stocks as a portfolio held by an investor. In the computation of the index on Day 4, the investor is assumed
to exercise the rights. Therefore, the new number of shares outstanding for stock C is given below:
10(2+5)
New Number of Shares Outstanding for Stock C = ---------5
= 14

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Market Data of Constituent Stocks on Day 4


Stock

Shares Outstanding

Closing Price

Market Value

30

6.5

195

9.2

46

14

4.5

63

Aggregate Market Value (AMV) = 314

Since all rights are exercised, capitalization adjustment needs to be made on day 3 after closing market / on
day 4 before starting market. The number of shares outstanding increases by 4. This will cause an increase in
capitalization by Tk.6 (= 4*1.50). The adjusted AMV on Day 3 after closing market / on day 4 before starting
market in the index computation on Day 4 will be:
310 + 6 = 316
Therefore,
Day 4's AMV
Day 4's index =--------------------------------- * Day 3's index
Adjusted Day 3's AMV
304
= ---------- * 1068.9656
316
= 1028.3720

1028.3720 - 1068.9656
Percentage change = ------------------------------- * 100%
1068.9656
= -3.80%
The index dropped from 1068.9656 to 1028.3720. This can be interpreted as a 3.80% decrease in AMV.

Day 5 (Replacement)
5
Stock B is replaced by stock D, which has a closing price at Tk.11.5 on Day 4 and its number of shares
outstanding is 20. Market Data of Constituent Stocks on Day 5

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Stock

Shares Outstanding

Closing Price

Market Value

30

210

20

11

220

14

70

Aggregate Market Value (AMV) = 500

The adjustment on Day 4's AMV in computing Day 5's Index follows a procedure as if the stock replacement
had taken place on Day 4. The adjusted AMV on Day 4 is given as:
Stock

Shares Outstanding

Closing Price

Market Value

30

6.5

195

20

11.5

230

14

4.5

63

Aggregate Market Value (AMV) = 488

Therefore,
Day 5's AMV
Day 5's index = --------------------------------- * Day 4's index
Adjusted Day 4's AMV
500
= ------ * 1028.3720
488
= 1053.6598
Day 6 (Addition)
Stock E is added to the index as a constituent stock on Day 6. Stock E has a closing price of Tk.4 and the
number of shares outstanding is 40 on Day 5.
Market Data of Constituent Stocks on Day 6
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Stock

Shares Outstanding

Closing Price

Market Value

30

7.2

216

14

4.8

67.2

20

12

240

40

4.5

180

Aggregate Market Value (AMV) = 703.2

Since the number of stocks has changed, we need to compute the adjusted AMV for Day 5 in computing Day
6's index. Day 5's adjusted AMV will be equal to the original AMV plus the market value of stock E on Day 5.
This is equal to Tk.500 + 160 (4*40) = 660.
Day 6's AMV
Day 6's index = ---------------------------------- * Day 5's index
Adjusted Day 5's AMV
703.2
= ------- * 1053.6598
660
= 1122.6266

Any new issue should not be considered in the computation of index for x days from the date of first trade.
X may be a single digit parameter e.g. x = 1, 2, 3...... Days. Here, in DSE and CSE, x is equal to 1.

Shares issued under Repeat Public Offer (RPO), conversion, amalgamation, acquisition etc. should be
treated as new issue (addition) and adjusted to give effect in the index on the following day of crediting/
issuing of those shares as per the guideline of Day 6.

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Day 7 (Deletion)
Stock C is deleted from the index's constituent stocks. The new total number of stocks is reduced to 3.
Market Data of Constituent Stocks on Day 7
Stock

Shares Outstanding

Closing Price

Market Value

30

210

20

12.3

246

40

200

Aggregate Market Value (AMV) = 656

The adjusted AMV on Day 6 will be a reduction by the amount of market value of stock C on Day 6. Day 6's
adjusted AMV will be equal to Tk 703.2 - 67.2 = 636.
Day 7's AMV
Day 7's index = --------------------------------- * Day 6's index
Adjusted Day 6's AMV
656
= ----- * 1122.6266
636
= 1157.9293
Day 8 (Ex-Dividend)
Cash dividends of Tk .50 per share are declared for stock E and Day 8 is to be ex-dividend. Market Data of
Constituent Stocks on Day 7
Stock

Shares Outstanding

Closing Price

Market Value

30

7.2

216

20

12.3

246

40

4.6

184

Aggregate Market Value (AMV) = 646

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No adjustment is needed, as there is no change in capitalization.


646
Day 8's index = ------- * 1157.9293
656
= 1140.2779

Note that the price of stock E drops. This is a normal phenomenon as a stock goes ex-dividend. Day 8s index
records a decrease as well.
Note that the closing price of Company E on day 8 is Tk. 4.6 determined by demand and supply factors in the
market against the theoretically adjusted price (to the extent of corporate disclosure) of Tk. 4.50 made on
day 7 after closing market / on day 8 before starting market.

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