AI For Trading: How an Index is Constructed (34)
How to construct
Let's see how an index is constructed and updated to see where the index number comes from.
Hang Seng Index
Suppose the Hang Seng Index started at 100 points on its very first day of creation. Let’s also pretend that the total market cap of all fifty companies in the index sums to 100 billion hong kong dollars.
On day 2, let’s say the market cap changed to 102 billion. The percent change is HK$ 102b / HK$ 100b = 1.02 or a 2% increase.
Multiply day one’s index value of 100 points by this 2% increase: 100 points \times× 1.02 = 102 points So day two’s index value is 102 points
A market cap weighted index has only two stocks, A and B. On day 1, the index has a value of 100. Stock A has a market cap of 100 million, while stock B has a market cap of $200 million. One month later, stock A has a market cap of $105 million, while stock B has a market cap of $210 million. What is the value of the index?
On day 1, the total market cap is $100 + $200 = $300 million.
One month later, the total market cap is $105 + $210 = $315 million.
The percent change in market cap over a month is 315/300 -1, or 5%.
Adding 5% to the index of 100 points is 105 points.
Hang Seng Index Construction
Free float shares refers to the number of shares that are liquid and tradable on the stock exchange.
Free float shares may be considered a better measure when calculating market cap because only free float shares can be bought or sold, which means only the trade of free float shares affects the market movement of the stock.
Now let’s define a capped index. First of all, the English is a bit funny in that the word “cap” that we’re using here has a different meaning from market cap. The “cap” in this context is similar to the concept of putting a cap on a cookie jar, or putting a cap on your daily spending on cookies. It refers to setting a maximum limit.
Tencent holding has a market capitalization of 4 trillion hong kong dollars, while the market capitalization of all companies in the Hang Seng Index, including Tencent, is about 20 trillion.
So Tencent actually accounts for about 4 divided by 20, or 20% of the value of these 50 companies. An index that tries to keep large companies from dominating the index is called a capped index, because it sets a maximum weight that can be assigned to a single company. In the case of the Hang Seng Index, the largest allowed weight assigned to any single company is 15% so Tencent is assigned a weight of 15% and not 20%.