Understanding the Stock Market: Why it's worth becoming familiar with Footsie

"The top 100 shares quoted on the London stock market, whose changes in price are measured constantly to see how the market generally is moving," is the neat way that Gill Nott, the chief executive of ProShare, describes the Financial Times/Stock Exchange 100 index. The FTSE 100 is mentioned in most news bulletins and its progress is always featured whenever there is a crisis on one of the world's stock exchanges.

Affectionately known as the Footsie, it may be viewed as one of the market's barometers. It can be used as a yardstick against which to measure the performance of individual shares or a portfolio. It was launched on 3 January 1984 with a base of 1,000. When it broke through the 5,000 level on 6 August 1997, it meant the shares it represents had risen by a multiple of five in 13 years and 215 days.

One of the main reasons for the birth of the Footsie was Chicago's then newly established Traded Options and Financial Futures market. So that London could match the services provided in Chicago, the City wanted a constantly up-dated index so that products could be developed to allow investors to hedge, or take a view on future market trends, with a single transaction.

Before the introduction of the Footsie there were only two stock market indices. The FT Ordinary Share Index, established in 1935, only comprises 30 constituents and was considered unrepresentative of the market generally. Also, it is an unweighted geometric index which, while curbing the effect of dramatic price movements, has a bias to downward turns over time. Furthermore it was only calculated each hour.

A completely fresh start was called for. An index with 100 constituents was chosen because more than this number would not have resulted in speedy calculations, while less would not be an accurate way of measuring the market's performance. The companies are selected by their market capitalisation, which is simply the total number of shares they have issued multiplied by their price in the market. The Footsie is therefore an index of Britain's 100 largest companies.

Those selected account for just over 70 per cent of the total market value of UK shares. However, for various reasons, some companies are excluded. This may be because the company is considered to be resident overseas for tax purposes, or it is a subsidiary of a company already in the index or because it has a large, static shareholding.

Technically, the Footsie is a weighted arithmetic index, which means that a change in price is weighted by the issued share capital of the company. Consequently, a 10 per cent movement in the shares of the smallest company in the index has less "weight" than a 10 per cent movement in the price of shares of the company which has the largest market capitalisation.

Naturally, values of companies are changing constantly. Nevertheless, alterations to the constituent list of members of the Footsie are kept to a minimum. Normally a company will only be removed if it has fallen below 110 in its market value ranking. None the less, by the time the index celebrated its 10th birthday, 42 companies had been removed from the original list. Of these, 23 had failed to keep pace with the market and shrank in comparison with their peers; 17 were taken over or merged, while Ferranti and British & Commonwealth had failed.

The first change took place on 19 January 1984 when J Rothschild replaced Eagle Star. Usually changes are made each quarter following the meaning of the FTSE Actuaries UK Indices Committee.

On 10 December this year, the Committee approved the inclusion of Mercury Asset Management (MAM), British Energy and Amvescap. RMC Group, Blue Circle lndustries and TI Group were excluded. The changes became effective on 22 December.

However, on 23 December Merrill Lynch's bid for MAM became unconditional. As a result, the Committee's rules concerning takeovers came into play and Blue Circle, excluded just 24-hours previously, was reinstated.

The same rules were used on 16 December following the merger of Guinness and Grand Metropolitan to create Diageo. On that occasion, Nycomed Amersham was admitted to the index. To ensure that natural occurrences, such as mergers and takeovers, are dealt with efficiently, the Committee has a reserve list of companies on which they may draw.

Responsibility for the design, management and calculation of London's stock market indices rests with the FTSE UK Indices Committee, an autonomous body sponsored jointly by the London Stock Exchange, the Financial Times and the Institute of Actuaries.