Calculating index values and performance

What is an index value?

Differences in how index values are calculated can occur depending on the index
weighting scheme. For the sake of simplicity, we will explain the calculation of market
cap-weighted index values.
As prices and market values of the stocks within an index rise and fall, the index
reflects this movement using a series of index values. Index values are calculated and
published daily after the market closes, and in some cases they are calculated in real
time. The change in an index’s value from one point in time to the next represents the
performance of the index (i.e., the performance of the market/segment it is designed to
measure).
Calculating index values
Below is a hypothetical market cap-weighted index that includes five constituents.

STOCK STOCK SHARES MARKET INDEX

NAME PRICE INCLUDED VALUE WEIGHT

A $3 50 $150 15%

B $1 50 $50 5%

C $7 70 $490 51%

D $9 20 $180 19%

E $10 10 $100 10%

TOTAL MARKET
VALUE $970 100%

The market value for each stock is calculated by multiplying its price by the number of
shares included in the index, and each stock’s weight in the index is determined based
on its market value relevant to the total market value of the index.
Stock A, for example, has a share price of $3, and there are 50 shares of this stock in
the index, so its market value is $150 ($3 X 50 shares = $150).
The total market value of every stock in the index is $970, so Stock A’s weight, or
representation within the index is 15% ($150 / $970 = 15%).
When an index is first created, a starting (base) value is chosen. In our example, we will
use 100 as the base value. Now that we have the total market value of our index and our
base value, the next step is to determine the index divisor by dividing the total market
value of the index by the base index value of 100 ($970 / 100 = 9.7).
Each day, as the market values of the stocks in the index fluctuate based on changes to
their prices, the new total market value of the index is divided by the same divisor (9.7)
to produce a new index value:

INDEX TOTAL MARKET INDEX

DAY VALUE DIVISOR VALUE

Day 1 $970 9.7 100.0

Day 2 $1010 9.7 104.1

Day 3 $995 9.7 102.6

Day 4 $1000 9.7 103.1

The divisor remains constant until the index constituency changes. For example, if a
stock is delisted or a stock split occurs, the divisor will be recalculated to be reflective
of the new index membership.
How are index values used to calculate performance?
Index performance between any two dates can be calculated by dividing the ending
index value by the beginning index value as follows. Using our hypothetical index as an
example:
Day 1 index value = 100.0
Day 4 index value = 103.1
((103.1 / 100) -1) x 100 = 3.1%
Why do index values vary so widely across indexes and index providers?
Comparing the values of indexes designed to measure the same market or market
segment can be daunting, and in most cases irrelevant. Indexes can be started, or
“launched” at different points in time and with different base values, so it is important
not to get hung up on the values themselves, but rather the growth (or decline) of those
values over time.
For example, if Index A had a base value of 100 in January of 2015 and that value
increased to 150 as of January 2018, the index value increased by 50% over that 3-year
period.
Index B measures the exact same market, but its starting base value was 1,000 in
January of 2015, and its value grew to 1,500 as of January 2018. This value of this
index also rose 50% over the same 3-year period.
Comparing their January 2018 values of 150 and 1,500 is irrelevant, as they were
started with different base numbers. It’s their performance, not their values, that should
be compared.
What is the difference between a price return and total return index values?
A price return value measures the changes in the stock prices and market values of the
index constituents over time, as shown in the example above.
A total return value measures the changes in stock prices and market values as well,
while also capturing the dividends paid to shareholders by the companies in the index
by reinvesting the dividends. The dividend reinvestment and compounding is done at
the total index level, not at the security level.
CALCULATING THE KSE-100

Step I The Base Period Day 1, TABLE 1

Stock Share Price Number of Market Value (in Pak Rs.) FF Shares (in Rs.)
A. 20.00 x 50,000,000 = 1,000,000,000.00
B. 30.00 x 100,000,000 = 3,000,000,000.00
C. 40.00 x 150,000,000 = 6,000,000,000.00

Total Free-Float Capitalization 10,000,000,000.00

Note: Base Period Value/Base Divisor = Rs. 10,000,000,000.00/10,000,000 = 1000.00

* All figures taken are only hypothetical
Step 2

Index Value as on Day 2, TABLE 2

Stock Share Price Number of Market Value (in Rs.) FF Shares (in Rs.)
A. 22.00 x 50,000,000 = 1,100,000,000.00
B. 33.00 x 100,000,000 = 3,300,000,000.00
C. 44.00 x 150,000,000 = 6,600,000,000.00

Total Free-Float Capitalization 11,000,000,000.00/10,000,000,000 =1.1 x 1000 =1,100

Thus, the formula for calculating the KSE-100 Index is

Sum of free-float free-float Shares x Current Price / Base Period Value Free-Float
Capitalization x 1000 Base Divisor

The KSE100 Index calculation at any time involves the same multiplication of share
price and free-float shares for each of the K5E100 Index component stocks. The
aggregate market value is divided by the base value and multiplied by 1000 to arrive at
the current index number.

Impact Cost

Impact cost is a measure of the stock or security liquidity.

Impact cost occurs when an investor is executing a transaction because of the prevalent liquidity
conditions.

The impact cost of a trade is the cost incurred when the security’s price changes triggered by the
high demand from a bulk order.

Example

If we were to buy a million shares at Rs 50, the size of the order may be large enough for the
share prices to start rising following the excessive demand, and by the time we complete our
purchase, the spot price could have risen to Rs 56, with our purchases paying for the incremental
rise for the units left to buy as we go acquiring.

Impact cost is a measure of the stock or security liquidity. Impact cost refers to the expense of
executing a transaction of a given index or security with a specific order size. Impact cost shows
the impact on a stock price when stocks are bought or sold in large quantities by an investor.
Impact cost is a realistic and pragmatic measure of a market liquidity.

Impact Cost Formula

Ideal Price = (Best Buy Price + Best Sell Price)/2

Impact Cost = (Actual Buy Price – Ideal Price) * 100/ Ideal cost

Example:

Buy Quantity Buy Price Sell Price Sell Quantity

1000 9.80 9.90 1000
2000 9.70 10.00 1500
3000 9.60 10.10 100

Buy Quantity is 1000 and Buy Price is 9.80 and Sell Price 9.90 and Sell Quantity is 1000.

Now to buy 1500 shares, the ideal price would be = ((9.80+9.90))/2 = 9.85 i.e. the best bid plus
best offer divided by 2 or taking average of best bid and best offer.

Actual Buy Price = [(1000*9.9) + (500*10.00)]/1500 = 9.93

Impact cost for 1500 shares [(9.93 – 9.85)/9.85] * 100 = 0.84%