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A price-weighted index is a stock market index where each constituent makes up a fraction of the index that is proportional to its price. For a stock market index this implies that stocks are included in proportions based on their quoted prices. A stock trading at $100 will thus be making up 10 times more of the total index compared to a stock trading at $10. This is different from a market weighted index where stocks are included based on the equity market values of the underlying companies, i.e. the quoted stock price multiplied by the number of shares outstanding.
The development of a price-weighted index will not accurately reflect the evolution of the underlying market values. This is so because the $100 stock above might be that of a small company and the $10 stock that of a large company. A change in the price quote of the small company will thus drive the price-weighted index (as it makes up a large part of the index) while the combined market values will remain relatively unaffected without changes in the price quote of the large company. Moreover, constant rebalancing needs to take place. The quoted price for each stock used in the calculation of the index is redefined so that each index constituent has an appropriate weight in the index at each rebalancing date. An Adjustment factor is introduced to a stock, that is assigned to the stock at each rebalancing date, which allows for price weighting. For index component, the value would be:
- Adjustment Factor= Index specific constant "Z"/(Number of shares of the stock*Adjusted stock market value before rebalancing)
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