Investment &

Portfolio
Management
Assignment
 Methods Of Calculating Stock Index
 How firms get listed to the stock exchange
 Capital Asset Pricing Model

Submitted to Ma’am Maria Shaikh

By
Sadia Muneer
BBA-2K18-168
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Methods of calculating stock index

What is a stock index?

“Stock index is a statistical indicator used in
measurement and reporting of changes in the market
value of a group of stocks/shares.”

A stock index is a measure of a stock market, or a

smaller subset of the market, that helps investors
compare current price levels with past prices to
calculate market performance. Investors use the
calculated values of stock market indexes as an
indicator of the current value of their component
stocks, and they can determine returns over time by
comparing current and past index levels.

How are stock indexes calculated?

There are various methods for calculating the stock market index. In this post, we will discuss
some of the major methods to calculate stock market index:

1. Full Market Capitalization method: 

In this method, to determine the scripts weighted in the index, the number of shares
outstanding is multiplied by the market price of companies shares. The share with the highest
market capitalization would have a higher weighted in the index and would be most influential
in the index.  In the end, Market capitalization of all companies will be added and it will be the
final value of that index.

The number of shares outstanding means the total number of shares currently held by all its
shareholders, including shares held by institutional investors and restricted shares owned by
the company’s officers and insiders. S&P 500 index in the USA uses this method.

Formula
Full Market Capitalization No. of shares outstanding * Market Price of one share

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2. Free Float Market Capitalization method: 

Free Float is the percentage of shares available in the market for trading. It excludes restricted
shares held by the government in the form of strategic investment, shares held by companies’
officers and insiders, shares locked under employee stock option plan etc. Companies in the
index are provided with the free float factors based on its percentage of shares in free float.
Free float ranges from 0.05 to 1.0.

Steps to calculate:
Add Market capitalization of all the companies in the index calculated through formula 1.

Free float market Capitalization = Total number of free float shares * Market price of each share * Free float
factor

Calculate the index value with the help of formula 2.

Index Value =  (Current Free Float Market Capitalization of index / Base Free Float Market Capitalization of
index) * Base Index Value

free float market capitalization method is used by Pakistan stock exchange.

3. Modified Capitalization Weighted: This method seeks to reduce the effect of largest stock in
the index which would otherwise dominate the value of the index. This method sets a limit on
percentage weight of the largest stock in the group of stocks.

4. Price weighted Index:  In price-weighted index calculation method,   each stock influences
the index in proportion to its price per share. The value of the index is calculated by adding the
prices of each stock in the index and dividing them by the total number of stocks. Stocks with a
higher price is given more weight which has a greater influence on the performance of the
index.

5. Equal Weighing: In this method, percentage weight of every stock in the index is equal. so,
all the stocks have equal influence on the index value.

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How firms are listed on stock

exchange?

What is stock exchange?

The Stock Exchange is a place where shares of listed companies are bought and sold.
Companies list themselves on the stock exchange to raise capital. Shares of companies are
traded, after they are listed, through a process of Initial Public Offering (IPO) or Secondary
Public Offering (SPO). The share purchase represents ownership of the shareholder in a
company to the extent of amount contributed by the investor to the capital of that company.

Listing procedures:
A company can become public and thereby get listed in any of the trading exchanges, by an
Initial Public Offer (IPO). The following is the IPO process:
1. Hiring a Bank: The first step in the IPO process is hiring an underwriter, or an investment
bank that will help guide the company through its IPO. The company and the underwriter will
figure out the “Company’s Financial Needs”.

2. Submitting documents to the SECP: To go public, a company needs to register its IPO
with the Securities & Exchange commission Pakistan. The SECP looks over the registration
statement to determine if the company has provided enough information for potential
investors.

3. Handing out the Red herring Prospectus: Next, those involved in the IPO can hand out
the Red Herring prospectus to seek interest (i.e., potential investors) in the IPO.

4. Going on a Road Show: Management will make live presentations to potential investors,
usually large institutional investors

5. Finalizing the IPO: At the end of the road show and right before IPO pricing, the company
asks SECP to declare the registration statement effective so that purchases can be made. After
getting an idea of demand for the IPO, the company and underwriters determine the share
price of the company’s stock

6. Distributing IPO Shares: After the IPO price is finalized, the underwriters and others involved
in the IPO decide how many shares each investor will receive. This last step in the IPO typically
occurs just before the stock begins trading on the stock market.

Also,

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Analysis on Capital via Global

Research Limited Investment
(2019-present)
Procedure for Listing Requirements are
Public Company has to submit the following documents to Shares Listing in stock
exchange:

 Certified copy of Memorandum & Article of Association

 Prospectus & agreement with underwriters
 Details of Capital Structure
 Copies of an advertisement offering securities during the last 5 years
 Copies of financial statement & auditor’s report for the last 5 years
 Copy of shares & debentures, letter of allotment and letter of regret
 Details of the company since incorporation including changes in the capital structure,
borrowings, etc.
 Details of shares or debentures issued for consideration other than cash

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How companies get listed on Pakistan

Stock Exchange
Following are the two boards on PSX for a company will list on:
1. Main Board
Requirements
Post issue Paid Up Capital PKR 200 Million Rupees and above. In business for at least
three years and profitable for at least two preceding years before getting listed (New
greenfield projects are exempted)Have a working website containing basic business
information and quarterly reports. Must prepare periodic Financial statements audited
by QCR rated chartered accountants and published on the website.

Listing Fees

Procedure to get listed

 Your Company appoints a “Consultant” and completes submission of all documents.
 The consultant completes an initial review and necessary due diligence of your Company to
ensure adequate disclosures in the prospectus.
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 On behalf of the Exchange, the PSX Listing Committee allows approval of your listing
application.
 After PSX listing committee’s approval, SECP gives its approval on the prospectus.
 An Initial Public Offering is held through a Public offer by either a fixed price method or
book building method.
 Your Company is formally listed on the Stock Exchange.

2. GEM listing
Business requirements
 Minimum post issue Paid Up Capital of PKR 25 Million.
 Have a working website containing basic business information, information memorandum
and quarterly reports
 Must prepare periodic Financial statements audited by QCR rated chartered accountants
and published on the website

Procedure to get listed

 GEM appoints “Advisor and Consultant”.
 Consultant submits listing application to the Listing Department at PSX.
 The listing department reviews documents and performs due diligence.
 Your listing application is submitted to the PSX Listing Committee.
 PSX Listing Committee approves the listing application.
 The issuer offers its shares to eligible investors and gets listed after they subscribe to its
shares.

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Capital Asset Pricing Model (CAPM)

Definition:
Capital Asset Pricing Model (CAPM) is a measure of the relationship between the expected
return and the risk of investing in security. This model is used to analyze securities and
pricing them given the expected rate of return and cost of capital involved.

CAPM Formula and Calculation

CAPM is calculated according to the following formula:

Where:

Ra = Expected return on a security

Rrf = Risk-free rate
Ba = Beta of the security
Rm = Expected return of the market

Note: “Risk Premium” = (Rm – Rrf)

The CAPM formula is used for calculating the expected returns of an asset.  It is based on
the idea of systematic risk (otherwise known as non-diversifiable risk) that investors need to
be compensated for in the form of a risk premium. A risk premium is a rate of return greater
than the risk-free rate. When investing, investors desire a higher risk premium when taking
on more risky investments.

Expected Return CAPM

The “Ra” notation above represents the expected return of a capital asset over time, given
all of the other variables in the equation. “Expected return” is a long-term assumption
about how an investment will play out over its entire life.

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Risk-Free Rate CAPM

The “Rrf” notation is for the risk-free rate, which is typically equal to the yield on a 10-year
US government bond. The risk-free rate should correspond to the country where the
investment is being made, and the maturity of the bond should match the time horizon of
the investment. Professional convention, however, is to typically use the 10-year rate no
matter what, because it’s the most heavily quoted and most liquid bond.

Beta CAPM
The beta (denoted as “Ba” in the CAPM formula) is a measure of a stock’s risk (volatility of
returns) reflected by measuring the fluctuation of its price changes relative to the overall
market. In other words, it is the stock’s sensitivity to market risk. For instance, if a
company’s beta is equal to 1.5 the security has 150% of the volatility of the market average.
However, if the beta is equal to 1, the expected return on a security is equal to the average
market return. A beta of -1 means security has a perfect negative correlation with the
market.

Market Risk Premium

From the above components of CAPM, we can simplify the formula to reduce “expected
return of the market minus the risk-free rate” to be simply the “market risk premium”. The
market risk premium represents the additional return over and above the risk-free rate,
which is required to compensate investors for investing in a riskier asset class. Put another
way, the more volatile a market or an asset class is, the higher the market risk premium will
be.

Why CAPM is Important

The CAPM formula is widely used in the finance industry. It is vital in calculating the
weighted average cost of capital (WACC), as CAPM computes the cost of equity.WACC is
used extensively in financial modeling. It can be used to find the net present value (NPV) of
the future cash flows of an investment and to further calculate its enterprise value and
finally its equity value.

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CAPM Example – Calculation of Expected Return

Calculating the expected return on a stock, using the Capital Asset Pricing Model (CAPM)
formula. Suppose the following information about a stock is known:

It trades on the NYSE and its operations are based in the United States

Current yield on a U.S. 10-year treasury is 2.5%

The average excess historical annual return for U.S. stocks is 7.5%

The beta of the stock is 1.25 (meaning its average return is 1.25x as volatile as the S&P500 over the last 2 years)

What is the expected return of the security using the CAPM formula?

Let’s break down the answer using the formula from above in the article:

Expected return = Risk Free Rate + [Beta x Market Return Premium]

Expected return = 2.5% + [1.25 x 7.5%]

Expected return = 11.9%

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Representation of CAPM

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