6.6 Reading the nancial press

The basic principles behind the construction of a share price index are set out

in Box 6.12. Obviously, keeping an index up to date involves frequent recalculation,

though the effort involved has diminished with computerisation. The FTSE-100

index was established in 1984 because traders wanted a ‘real-time’ index which

could be used for pricing equity-related contracts in futures and options markets.

A real-time index is one which is recalculated (and published) every timethe price

of one of its component shares changes. This means, obviously, that the index may

change many times during a trading session (even though it may nish at exactly

the same level at which it started). Basing the index upon 100 shares was thought

to be a reasonable compromise between the demands for the widest coverage and

the desire for speed in continuous recalculation. While the FTSE-100 is recalculated

every minute of the day, the FT-Actuaries All Share Index (of more than 750 shares)

is recalculated only once a day.

Box 6.12

Calculating a share price index

We have rstly to decide whether our index is to be based upon the populationof all

listed rms (as with the FT-Actuaries All Share Index) or upon a sampleof rms. The

latter, being smaller, is quicker to calculate and thus easier to keep up to date. If we

decide upon a sample, we have to select a subset whose behaviour we think is likely

to be representative of the larger population of rms we are interested in. This might

be the 100 largest (as with the FTSE-100).

The next step is to decide upon a base dateand a base valueto which all subsequent

values of the index can be related. For the FTSE-100 the base date is February 1984

(when the index began) and its base value is 1,000 (chosen in preference to 100 to reduce

the need for fractions).

The third step involves calculating the value of shares in the index at the base date

and converting that value to 1,000. If we denote each of our 100 rms by i, and let P

and Nstand for the number and market price of its shares respectively, then we can

nd the market capitalisation of each rm, at any time, simply as (PN). Letting 0 stand

ii

for the values in the base year and remembering that ∑stands for ‘sum of’, the value

of the index in the base year, I, will be:

0

∑(PN)

i0i0

I1,000



⁰∑(PN)

i0i0

At any future time, 1,2,3..., the value of our companies can be compared with their

value in the base period simply by expressing their new value in a ratio to the base value

and multiplying by 1,000. If we want a value for the index in period 3, for example, we

recalculate as follows:

∑(PN)

i3i0

I1,000



³∑(PN)

i0i0

As we explain in the text, our sample may have to change over time, and we shall also

have to make further adjustments if rms in the sample make new share issues after

they join the index.

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Chapter 6 • The capital markets

The advantage of an index is that it enables us to make reasonably precise

statements about movements in the whole market over a period of time. We need,

however, to be careful in the way we interpret movements in an index number. As

we have said several times, we would expect share prices to increase over time, and

this will be reected in any index of share prices. During May 2003, for example, the

FTSE-100 varied around the 4,000 level. In April 2006 it had risen to over 6,000.

Movements in the index are often reported as absolute numbers. In Box 6.9, for

example, the market report says that the FTSE-100 fell sharply on 17 May 2006, by

over 170 points. But it also converts this to a percentage rate of decline (2.9 per cent)

so that we can put the size of the fall into context. This is a reminder that we should

always be careful in our interpretation of absolutemovements in the value of the

index. It is not so much the number of points that matters but the number of points

as a percentage of the starting level. In June 1989 the FTSE-100 stood at 2,147. The

same fall of 170 points would then have been equivalent to 8 per cent. Beware of

newspaper headlines that scream ‘FTSE rises (or falls) by 300 points – largest move-

ment since it began’ – 300 on 4,000 is very different from 300 on 10,000.