Financial markets are traditionally classified into Money markets and Capital markets.
Money market instruments include short-term, marketable, liquid, low-risk debt securities. Capital markets, in contrast, include longer term and riskier securities.
Capital markets are sub divided into the following categories: Longer-term bond markets, Equity markets, and the derivative markets for future and options.
Stock market indices: We can divide the stock market index into 2 categories Price-weighted index and value-weighted index.
We will start our discussion of stock market indices by discussing about Dow Jones Industrial Average (DJIA) for 2 reasons. It is probably the oldest known index in the world. And secondly, it is a price weighted index.
Dow Jones Averages: DJIA of 30 large, blue-chip corporations has been computed since 1896.
Originally, the DJIA was calculated as the simple average of the stocks included in the index.
To illustrate this, consider the table for the hypothetical two-stock version of the DJIA like this.
Here the divisor “d” will be 2 since it includes 2 stocks.
Initial value of AB is 25 and XY is 100 so the initial index value will be (100+25)/d= (100+25)/2=62.5
The final price of AB is 30 and that of XY is 90, so the final index value will be (30+90)/2=60
So the 2.5 point drop in the index is a 4% decrease.
Similarly a portfolio holding of each stock would also have an identical 4% decrease in the asset.
Consider another situation in which XY were split two for one so that its share price fell to $50.
Consider the table like this.
Following a split, the divisor “d” must be changed to a value that leaves the average unaffected.
Initial price of XY fall to $50 from $100 because of stock split. So the number of shares just doubled to 2 million from 1 million.
For calculating “d” we can use the formula sum of the post split stock price/d=average presplit price
That is equal to 75/d=62.5 so d=75/62.5=1.20
So calculating the index by using the new value of d we will get like this (30+45)/1.20=62.5.
That is the index is unchanged.
Very interesting information: Because the DJIA are based on small number of firms, care must be taken to ensure that they are representative of the broad market. As a result, the composition of the average is changed every so often to reflect changes in the economy. The last change took place on November 1, 1999, when Microsoft, Intel, Home Depot, and SBC communications were added to the index and Chevron, Goodyear Tire & Rubber, Sears Roebuck, and Union Carbide were dropped.
Both Sensex and Nifty are Value-weighted indices. The details about value-weighted indices will be discussed tomorrow.
Regards Hari " लोका समस्ता सुखिनो भवन्तु "
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