Index Definition and Calculations of Value and Returns

Understanding Security Market Indexes: Definition and Calculations of Value and Returns | CFA Level I Equity Investments

Welcome to the world of security market indexes! In this lesson, we’ll learn about the definition of a security market index and how to calculate value and returns of market indexes. So, buckle up and let’s dive in!

What is a Security Market Index?

A security market index represents the performance of an asset class, security market, or a segment of a market. It’s created by selecting a number of representative securities in the market it seeks to represent. These selected securities are known as the constituent securities of the index.

The market prices of the constituent securities are used to compute the numerical value of the index at that particular moment. We’ll learn various methods to calculate this value in the next lesson, but for now, let’s use a simple average of four prices. This works out to be 303.25.

How Index Value and Index Return Change Over Time

As the prices of the securities change through time, the index value changes accordingly. An index return is the percentage change in the index’s value over a period of time. For example, when an index increases from 303.25 to 310.25, we get an increase of 2.39% for this period.

The type of index value here is known as a price index, as only the prices of the constituent securities are used in the calculation. The index return here is known as the price return.

Return Index and Total Return

Another type of index takes into account the interim cash flows such as dividends or interest payments issued by the securities. This is known as a return index, and the index return is known as total return. Both the return index and total return will be higher than the price index counterparts, as taking into account the income portion increases the return.

Calculating Aggregate Return for Multiple Periods

If there are multiple periods, the aggregate return for the entire period can be calculated by compounding the returns for each period. Simply multiply the return factors, and subtract 1 from the result. (For negative returns, the return factor should be less than 1).

Calculate the aggregate return for multiple periods:

And there you have it! That’s our quick introduction to the topic of market indexes. In our next lesson, we’ll dive into the various methods to calculate index values. Stay tuned!

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