Market Indexes— Definition and Calculation

An index represents a given security market, a segment of the security market, or ascertain asset
class. The main purpose of an index is to reflect the performance of the market that it represents,
estimate its risk, and measure the performance offend managers. The stocks included in an index
are a sample of the stocks in the equity market in most cases. The value of the index changes
with the change in the price of underlying stocks and is calculated on an ongoing basis. An index
could be a Price Return Index which only reflects the prices of the stocks constituting the index,
or another form of index could be a Total Return Index, which not only reflects the prices of the
securities but also the reinvestment of all the income received since the start. The income from
the stock could be in the shape of cash dividends, stock dividends, or any other kind of
distribution.
Uses of Market Indexes
Market Indexes are used to understand the market sentiment. They are also used as a proxy for
measuring return, systematic risk, risk-adjusted performance, and benchmark for comparing a
fund manager's performance. An index also provides a historical perspective of stock market
performance, giving investors greater insight into their investment decisions. Investors who do
not know which individual stocks to invest in can use indexing as a method of choosing their
stock investments. Indexes are also often used as a forecasting tool. By studying the historical
performance of the Indexes, investment managers try to forecast trends in the market, however,
there is insufficient evidence to conclude whether such trends are present in the market or not.
For an index to be viable, it must be possible to buy all the components of the index in the same
proportions of the index without incurring very high transaction costs or having a market impact.
1. Broad Market Indexes
Broad market Indexes generally refer to the broader market and include stocks with
characteristics such as an actively traded stock with large market capitalization and representing
at least one particular sector, etc. In Pakistan, the broadest market index is KSE-100, which
comprises 100 stocks from the total market based on various categories.
2. Sector Indexes
Sector Indexes represent and track different economic sectors such as the KMI-30Index in
Pakistan Stock Exchange tracks Shariah-compliant stocks. They can also represent various
sectors such as fertilizer, energy, finance, etc. Indexes also represent certain asset classes or
regions e.g., Morgan Stanley
3. Style Indexes
Style Indexes represent groups of securities, which are classified according to certain
characteristics they may have. There could be growth stocks, value stocks, small-cap stocks, or a
combination of stocks. The two most popular and commonly tracked Indexes in PSX are KSE-
100 and KMI-30.
4. KSE-100 Index
The primary objective of the KSE-100 index is to have a benchmark by which the stock price
performance can be compared over a period. In particular, the KSE-100 index is designed to
provide investors with a sense of how the Pakistan equity market is performing. The KSE 100
index is similar to other indicators that track various sectors of Pakistan’s economic activity such
as the gross national product, consumer price index, etc. The KSE-100 index was introduced in
November 1991 with a base value of 1,000 points. The index comprises 100 companies selected
based on sector representation and the highest free-float capitalization. This captures about 80%
of the free-float capitalization of companies listed on the Pakistan Stock Exchange. Thirty-four
companies are selected i.e., one company from each sector based on the highest free-float
capitalization, and the remaining 66 companies are selected based on the largest free-float
capitalization in descending order. KSE-100 is a total returns index that is adjusted for dividends,
bonuses, and rights as and when announced.
Free-float methodology
Free-float means the proportion of total shares issued by a company that is readily available for
trading on the stock exchange. It generally excludes shares held by controlling directors,
sponsors, promoters, government, and other locked-in shares not available for trading in the
normal course.
Objective and description
- Free-float calculation methodology is used to construct stock indexes for better market
representation than those constructed using total free-float market capitalization.
- It gives weight to constituent companies as per their actual liquidity in the market and is not
influenced by tightly help large-cap companies.
- Free-float can be used by the exchange for regulatory purposes such as risk management and
market surveillance.
Market capitalization
Market capitalization refers to the total market value of a company’s outstanding shares.
Commonly referred to as “market cap”, it is calculated by multiplying a company's outstanding
shares by the current market price of one share. The investment community uses this figure to
determine a company’s size, as opposed to using total sales or assets.
5. KMI-30 Index
The objective of the KSE-Meezan index (KMI) is to serve as a gauge for measuring the
performance of Shariah-compliant equity investments. Besides tracking the performance of
Shariah-compliant equity investments, it may also act as a research tool for the strategic asset
allocation process. Besides tracking the performance of Shariah-compliant equities, its
construction helps increase investor trust and participation.
Eligibility Criteria
• The core business of the company should not violate any principle of Shariah.
• Interest Bearing Debt to Total Assets, <37%
• Non-Compliant Investments to Total Assets, <33%
• Non-Compliant Income to Total revenue, <5%
• Liquid Assets to Total Assets, >25%
• Net Liquid Assets/Share vs Market Price/Share

Further Explanation of Indices

1. Price-Weighted Series:

 In a price-weighted index, each stock in the index is weighted according to its price.
 Stocks with higher prices have more influence on the index.
 Example: The Dow Jones Industrial Average (DJIA) is a price-weighted index.
 How it works: Imagine two stocks: Stock A is priced at $100, and Stock B is priced at
$20. If Stock A rises by 5% (i.e., $5), and Stock B rises by 5% (i.e., $1), Stock A will
impact the index more because of its higher price.

2. Value-Weighted Series (Market-Cap Weighted):

 In a value-weighted index, each stock is weighted according to its market value (or
market capitalization), which is the price of the stock multiplied by the number of shares.
 Bigger companies have a greater impact on the index.
 Example: The S&P 500 is a value-weighted index.
 How it works: If Company A has a market value of $500 billion and Company B has a
market value of $100 billion, Company A will have more influence on the index’s
movement because it’s worth more.

3. Unweighted (Equally Weighted) Series:

 In an equally weighted index, all stocks are given the same weight regardless of their
price or market value.
  This means smaller companies have the same influence as larger companies.
 How it works: If you have 10 stocks in the index, each stock will make up 10% of the
index, no matter if one stock is worth more or less than the others.
 This can result in more volatility because smaller stocks, which can be more volatile,
have a bigger effect.

4. Bond-Market Indicator Series:

 A bond-market indicator tracks the performance of bonds rather than stocks. Bonds are
different because they represent loans to governments or companies, rather than
ownership in companies.
 The index might measure things like interest rates or bond prices.
 Example: The Bloomberg Barclays U.S. Aggregate Bond Index is a popular bond-
market index.
 How it works: Bonds in the index are often weighted by their market value, but they also
take into account the length of time until the bond matures and the interest payments.

Summary:

 Price-weighted: Stocks with higher prices matter more.

Each type of index gives a different perspective on how the market is performing, based on how
it’s constructed.
Let’s walk through some examples for each type of market index to help you understand the
calculations. We’ll look at how changes in stock prices affect the index in each case.

1. Price-Weighted Index Calculation Example

Assume we have three companies:

Stock Price (initial) Price (after change)

A $50 $60

B $100 $90

C $150 $160

Calculation:

 Step 1: Calculate the initial index value by averaging the prices of the stocks.

Initial Index=(50+100+150)/3= 300/3 =100

 Step 2: Calculate the new index value after the price changes.

 New Index= (60+90+160)/3 = 310/3 =103.33

 Index Change: The index has increased from 100 to 103.33, which reflects a 3.33%
increase.

2. Value-Weighted (Market-Cap Weighted) Index Calculation Example

Assume we have three companies with different market capitalizations:

Price Shares Market Cap Price (after Market Cap (after

A $50 1,000 $50,000 $60 $60,000

B $100 500 $50,000 $90 $45,000

C $150 300 $45,000 $160 $48,000

Calculation:

 Step 1: Calculate the total market capitalization before the price changes.
 Total Market Cap (initial) =50,000+50,000+45,000= 145,000

 Step 2: Calculate the total market capitalization after the price changes.

Total Market Cap (after change) = 60,000+45,000+48,000=153,000

 Step 3: Calculate the index based on the change in total market capitalization.

Index (initial)= 145,000/145,000×100 = 100

Index (after change) =153,000/145,000×100=105.52

 Index Change: The index has increased by 5.52%.

3. Equally Weighted Index Calculation Example

We give each stock equal weight, regardless of price or market cap.

Stock Price (initial) Price (after change)

A $50 $60

B $100 $90

C $150 $160

Calculation:

 Step 1: Calculate the percentage change for each stock.

o Stock B: (90−100)/100 ×100 =(−10%)

o Stock C: (160−150)/150 ×100 =6.67%

 Step 2: Average the percentage changes to calculate the overall change in the index.

Average Change= (20+(−10)+6.67)/3=5.56%

Index Change: The index has increased by 5.56%.

Assume we have three bonds with different face values, prices, and interest rates:

Bond Face Value Price (initial) Yield (initial) Price (after change) Yield (after change)

A $1,000 $950 5.26% $960 5.21%

B $2,000 $1,900 5.26% $1,880 5.32%

C $1,500 $1,400 7.14% $1,430 6.99%

Calculation:

 Step 1: Calculate the initial total bond prices and yields.

 Initial total yield: (950×5.26%)+(1,900×5.26%)+(1,400×7.14%)=50+100+100=250

 Step 2: Calculate the total bond prices and yields after the price changes.
o New total bond prices: 960+1,880+1,430=4,270

 New total yield: (960×5.21%)+(1,880×5.32%)+(1,430×6.99%)=50+100+100 =250

 Step 3: Compare the bond prices and yields to determine how the index has changed.

While the prices have slightly increased, the yields remain roughly constant, suggesting a
stable bond market with a small price increase.