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Sem 5 Prep
← Money & BankingThe secondary market, indices and efficiency

Formulas for this chapter

Price-weighted index

Index = SUM(prices) / divisor New divisor after a corporate action = new price sum / index level to be preserved

When the question gives only prices. The divisor starts as the number of stocks and must be re-solved after any split or constituent change.

prices
Market price of each constituent
divisor
Initially the number of stocks; adjusted to keep the index continuous

Value-weighted index

Index = (SUM(price x shares) / base market cap) x base index value Shortcut: New index = Old index x (new aggregate cap / old aggregate cap)

The method the Sensex and Nifty use. Needs share counts as well as prices, and requires no adjustment for splits.

price x shares
Market capitalisation of each constituent
base market cap
Aggregate capitalisation on the base date
base index value
Index level assigned to the base date, e.g. 100 or 1,000

Equal-weighted index return

Return = (SUM of individual percentage returns) / number of stocks

When every constituent is to count the same. It over-weights small companies relative to the market and needs periodic rebalancing.

individual return
(new price - old price) / old price, per stock
Step 3 of 23
The real wordsTheory

Price dynamics

The slide's account of why anything trades at all. Investors buy when the market price is below their own valuation and sell when it is above it.

So every trade is a disagreement about value, settled at a price. That is what price discovery means in practice.

Follow the logic and you get a testable claim: if everyone had the same information and the same model, no one would trade at all. Which is why the market efficiency question at the end of this chapter is not academic.

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