What is the meaning of indeces like Dow Jones and how are they constructed/calculated?
professor asked:
For example we read every day in financial newspapers that Dow Jones is 8750 points,what does that mean and how is this number calculted,how can we compare different stockmarkets by using that number,is it possible,are they comparable?
For example we read every day in financial newspapers that Dow Jones is 8750 points,what does that mean and how is this number calculted,how can we compare different stockmarkets by using that number,is it possible,are they comparable?
Thanks
Tags: Dow Jones, Financial Newspapers, Indeces, Stockmarkets
By Sweet Rosalyn, March 1, 2009 @ 7:39 am
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By NC, March 1, 2009 @ 8:46 pm
There are two ways of computing an index. Some indexes are equal-weighted (each company is given an equal weight), others, capitalization-weighted.
To compute an equal-weighted index, you only need to know stock prices. Let’s say we decided to compute an index of 10 stocks. We can do it by putting together a fantasy portfolio consisting of $10,000 invested in each of 10 stocks. So on the first day of index computation (or, as index compilers say, on the base date), the value of our portfolio is $100,000. For convenience, we can drop the thousands and say that our index on its base date has a base value of 100.
Next day, the value of our fantasy portfolio dropped to $98,600, so we report the index value of 98.60. The day after next, it rose to $101,250, so we report the index value of 101.25.
Capitalization-weighted indexes work in a similar way, but instead of prices, market capitalizations are used. Say, today is the base date, and the total market capitalization of companies in our index is $100 billion. We’ll take it as a base value and report it as 100. Next day, the value rises to $102 billion, so we report the index as 102.
In practice, the numbers are not round, of course…
As to comparing different indexes, comparing raw indexes is meaningless. You can, however, make informative comparisons of index returns and volatilities.