In a capitalization-weighted index, each component stock contributes its market value to determine the overall index value and, therefore, stocks with greater market value are given more weight in this type of index.
The market value of each stock can be calculated by multiplying the stock price with the total number of shares outstanding. The sum of the market value of all the component stocks is then divided by a divisor to obtain the final index value. This divisor is an arbitrary number that is first defined when the index is first published.
A capitalization-weighted index, ABC, is first published comprising the following public companies A, B and C.
|Company||Stock Price||Shares Outstanding||Market Cap||Weightage|
As can be seen from the table above, although company B's stock price is two times that of company A's, their weightage in a capitalization-weighted index are the same as their market values are equal.
The total value of the index is: 30m + 30m + 60m = 150m. A divisor of 150,000 is selected to start the index off with an even number of 1000.
Initial Index Value = 150m / 150k = 1000
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