Financial market indices: price or value weighted, partial or whole or sectoral

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Dow Jones, Nikkei, FTSE MIB, Dax 30 and many others, the market indices represent the performance of the stock exchanges.

Financial market indices

The stock market indices can be considered the most significant parameter, being immediately understandable, to represent the performance of a stock market over a time interval; let’s see the calculation methodologies and their possible uses.

What a stock index represents

A stock market index represents the “price” or, better, the value of a specific market, or of a specific basket made up of the most representative securities, and highlights its situation through a synthetic but exhaustive measurement of the market trend itself.

The starting value is conventionally set at a precise reference level in a base year. In itself, the value of the index is not very significant, while what is taken into account is its percentage change, being the return that would be obtained by investing in the securities included in the index and in the same proportion.

Analyzing the possible uses of the market indices, we find that they can act as a reference parameter for the management policies of mutual fund managers or other institutional investors, or as parameters to which the performance of some financial instruments can be indexed (for example structured bonds), or from an underlying instrument of some derivative instruments (for example futures and index options).

What are the stock market indices

The indices are obtained from weighted averages of the prices of the securities traded on the stock exchange, the construction of which can take place in different ways, based on different weighting mechanisms of the individual securities. Therefore, using this criterion, we can divide the stock indices into:

  • price weighted indices, where the weight of a stock depends on its price. This type of index has a big limitation linked to the non-consideration of the size, in terms of capitalization, of the company. In fact, the higher priced securities affect the value of the index to a greater extent than the lower priced securities, but the fact that one share is higher than another does not in any way imply that the relative issuing companies respect the same dimensional order. Illustrious examples of this category are the Dow Jones Industrial Average (New York Stock Exchange) and the Nikkei 225 (Tokyo Stock Exchange)
  • value weighted indices, in which the weighting of the individual securities depends on their capitalization in terms related to the market (ratio between the capitalization of the security and the value of the stock exchange as a whole). Compared to the previous ones, therefore, these indices mainly reflect the performance of the equity securities of the largest companies. Examples are the S&P 500 (New York Stock Exchange), the FTSE MIB (Milan Stock Exchange), the FTSE 100 (London Stock Exchange), the CAC40 (Paris Stock Exchange), the DAX30 (Frankfurt Stock Exchange) and the HANG SENG (Hong Kong Stock Exchange)

All the indices mentioned so far are partial indices, that is indexes that include only a sample of all the securities listed on a certain market; these are contrasted by the general indices, which, on the other hand, include all the securities. The method of choosing the sample can follow different criteria, one of the most important is to group together the titles of the companies operating in the same production sector. Thus there are sectoral indices, which have the function of indicating the health of a certain economic sector.

It is no coincidence that among the cited indexes the most numerous are partial value weighted indices. In fact, the indices thus constructed perform their functions better as they allow, at the same time, to give an overall representation of the evolution of the market and to be easily replicable by operators.

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