# Understanding Price-Weighted Index and Its Mechanics

## Mechanics of Price-Weighted Index

### Selection of Component Stocks

The first step in constructing a price-weighted index is selecting the component stocks. Typically, the index provider chooses a set of stocks that are representative of a specific market or sector. The selection process may involve various criteria, such as market capitalization, liquidity, and industry classification.

### Calculation of the Index

Once the component stocks are selected, the next step is to calculate the index value. In a price-weighted index, the index value is determined by summing the prices of all the component stocks and dividing the total by a divisor. The divisor is a constant that is used to maintain continuity in the index value over time.

For example, let’s consider a price-weighted index with three component stocks: Stock A, Stock B, and Stock C. If the prices of these stocks are \$50, \$100, and \$200, respectively, the index value would be calculated as follows:

1. Add the prices of all the component stocks: \$50 + \$100 + \$200 = \$350.
2. Divide the total by the divisor: \$350 / Divisor.

The divisor is adjusted periodically to account for stock splits, stock dividends, and other corporate actions that may affect the index value. This ensures that the index value remains representative of the underlying stocks’ performance.

### Weighting of Component Stocks

In a price-weighted index, the component stocks are weighted based on their prices. This means that stocks with higher prices have a greater influence on the index’s value. For example, in the above example, Stock C with a price of \$200 would have a higher weightage compared to Stock A with a price of \$50.