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By WM in the Classroom
July 14, 2018 | Dubai
Just like a thermometer is used to determine the temperature or a weighing scale the weight of an individual, the index becomes a barometer for the performance of a particular market. For example, the Bombay Stock Exchange, India has over 5500 listed securities – however, its performance gets represented by only 30, which make up the BSE Sensex (Sensitivity Index). Stocks selected within the index act as representatives presenting a diversified view of the market as a whole. See more on the DFM General Index and BSE Sensex composition here.
So what makes a company eligible to act as a representative to its sector and form part of the index? While there’s no standard rule to the same, the criteria listed in regards to the DFM General Index does present an idea
(Source: DFM General Index “DFMGI” Rules – January 2016)
From the above, it is evident that some of the qualities essential for inclusion with the index are
How is the index calculated? Let’s assume we want to create a Healthcare index and we have decided to set a base value for the same at 1000.
Step 1: Identify stocks: Based on the parameters listed above, we have identified 3 stocks within this sector from the overall base of 14 companies: ABC Hospitals, DEF Pharmacy and XYZ Medical Equipment. What we have used as parameters are market capitalization and diversification.
Step 2: Use the free float shares & market price as shown in the table below
Step 3: Using our assumed base value of 1000, we determine the current level of the index today = (850,000/ 830,000) x 1,000 = 1024 points, implying that there has been a 2.4% jump in the Healthcare index today.
Thus, while the price of a security is said to be representative of the fundamentals of the company, emerging from the demand-supply dynamics, the index translates all of the complex happenings across the market in a numerical value, acting as an indicator. It enables comparison including performance measurement and benchmarking.