2.

1 Introduction to an Index
An index is a statistical indicator that measures changes in the economy in general or
specific areas. In case of financial markets, an index is a portfolio of securities that
represent a particular market or a portion of a market. Each index has its own calculation
methodology and usually is expressed in terms of a change from a base value. The base
value might be as recent as the previous day or many years in the past. Thus, the
percentage change is more important than the actual numeric value. Financial indices are
created to measure price movement of stocks, bonds, T-bills and other type of financial
securities. More specifically, a stock index is created to provide market participants with
the information regarding the average share price movement in the market. Broad indices
are expected to capture the overall behaviour of equity market and need to represent the
return obtained by typical portfolios in the country.

2.2 Significance of the stock index

· A stock index is an indicator of the performance of the overall market or a
particular sector.
· It serves as a benchmark for portfolio performance - Managed portfolios,
belonging either to individuals or mutual funds, use the stock index as a measure
for evaluation of their performance.
· It is used as an underlying for financial application of derivatives – Various
products in OTC and exchange traded markets are based on indices as the
underlying asset.

2.3 Types of Stock Market Indices

Indices can be designed and constructed in various ways. Depending upon their
methodology, they can be classified as under:
Market capitalization weighted index
In this method of calculation, each stock is given a weight according to its market
capitalization. So higher the market capitalization of a constituent, higher is its weight in
the index. Market capitalization is the market value of a company, calculated by
multiplying the total number of shares outstanding to its current market price. For

example, ABC company with 5,00,00,000 shares outstanding and a share price of Rs 120
per share will have market capitalization of 5,00,00,000 x 120 = Rs 6,00,00,00,000 i.e.,
600 Crores.
Let us understand the concept with the help of an example: There are five stocks in an
index. Base value of the index is set to 100 on the start date which is January 1, 1995.
Calculate the current value of index based on following information:
The market capitalization of the index on January 1, 1995 is Rs. 18,800 which is the sum of
the market price multiplied by the quantity of shares for each stock in the index. With the
change in market prices, the market capitalization of these stocks increases from Rs.18,800
lakhs to Rs.42,500 lakhs. The market capitalization on January 1, 1995 is equated to 100.
Hence, the new value of the index is calculated as (42500 lakhs / 18800 lakhs) * 100, which
works out to 226.06. Since the index has risen from a base of 100 to a new value of 226.06,
the change in the index value is 126.06 per cent.

O No. Old Ol N New Ne

St ld of [Link]. d e [Link]. w
oc Pr Sha (in Rs Weig w (in Rs Weig
ic res lakhs) hts Pr lakhs) hts
k
e ic
Na (in e
(Rs lakhs)
me
) (Rs)

AZ 150 20 3000 0.16 650 13000 0.31

BY 300 12 3600 0.19 450 5400 0.13

CX 450 16 7200 0.38 600 9600 0.23
DW 100 30 3000 0.16 350 10500 0.25
EU 250 8 2000 0.11 500 4000 0.09
18800 1.00 42500 1.00

Popular indices in India, Sensex and Nifty, were earlier designed on market capitalization
weighted method.

Free-Float Market Capitalization Index

In various businesses, equity holding is divided differently among various stakeholders –

promoters, institutions, corporates, individuals, etc. The market has started to segregate

this on the basis of what is readily available for trading and what is not. The one available
for immediate trading is categorized as free float. And, if we compute the index based on
weights of each security based on free float market cap, it is called free float market
 capitalization index. A majority of the stock indices globally, over a period of time, have
moved to free float basis, including the Indian equity indices - Sensex, Nifty and SX40.
Price-Weighted Index
This is a stock index in which each stock influences the index in proportion to its price.
Stocks with a higher price will be given more weight and therefore, will have a greater
influence over the performance of the Index.
Let us take the same data as above for calculation of price-weighted index:

N To
Stock Stock u da
Sr. price m y’s
Name
as on b sto
No.
Januar e ck
y 1, r
pri
1995
o ce
(in
Rs.) f
(in

s Rs.
h )
a
r
e
s

i
n

l
a
k
h
s

AZ 20 65
1 150 0
BY 12 45
2 300 0
 CX 16 60
3 450 0
30 35
4 DW 100 0
8 50
5 EU 250 0

The formula for calculating the value of a price-weighted index is as follows:

Price index = (Sum of the prices of all stocks included in Index) / (No. of stocks in
Index) Hence, the price index on January 1, 1995 = (150+300+450+100+250)/5 = 250.
The current value of the index is the sum of the current prices of all stocks included in the
index divided by the number of stocks. The current value of the index =
(650+450+600+350+500) / 5 = 510. Thus, the increase in the value of the index is (510 -
250) / 250, i.e. 104%. This can be verified as follows:

Weigh C Percent
S Pric ts Perce change in
t e on nt price *
o Jan Change weight
c 1, in price
k 1995

N
a
m
e

150 650
A 0.12 333.33% 40.00%
Z

300 0.24 450

B 50.00% 12.00%
Y

450 0.36 600

C 33.33% 12.00%
X
 100 0.08 350
D 250.00% 20.00%
W

250 0.20 500

E 100.00% 20.00%
U

1250 1.00 2550 104.00%

Dow Jones Industrial Average and Nikkei 225 are popular price-weighted indices.

Equal Weighted Index

An equal-weighted index is one in which all stocks included in the index have the same
weightage. The number of shares of each stock is adjusted in such a way that the weight
of each stock in the index is the same. Subsequently, if there is any change in the market
price of each stock, the weight of each stock will change. To maintain the same equal
weights as earlier, the fund manager needs to sell those stocks that have increased in price
and buy the stocks that have fallen in price.
The following is an example of the computation of an equal weighted index:

S P Qua V W C Cu P P
t r ntit a ei u rre ri ri
o i y as l g r nt ce ce
c c on u ht r val c ch
k e Jan e o e ue h a
o 1, a n n (= a n
n n 199 s Ja t Qt n ge
a J 5 o n p y* g *
m a n 1, r Pri e O
e n J 19 i ce) ld
1 a 95 c w
, n e ei
1 1 g
9 , ht
9 1
5 9
9
 5
10 300 0.25 150 45000 12.5
P 0 3 50.0 0%
0 0%
0
0
0

Q 15 200 0.25 130 26000 - -

0 3 13. 3.33
0 33 %
0 %
0
0

R 12 240 3 0.25 200 48000 60.0 15.0

5 0 0% 0%
0
0
0
S 20 150 0.25 180 27000 - -
0 3 10. 2.50
0 00 %
0 %
0
0

1.00 14600 21.6

1 0 7%
2
0
0
0
0

Consider an index constructed on January 1, 1995 with 4 stocks. The number of shares of
each stock is adjusted in such a manner that the value of all stocks in the index is equal.
Thus, each stock has the same weight in the index. With a change in the stock prices, the
current value of the stocks in the index has changed from 120,000 to 146,000. If the old
index value is equated to 100, the new index value will be 146000/120000*100, i.e.
 121.67. As can be seen from the last column in the above table, this is simply the
percentage change in the stock price multiplied by the original weight of each stock,
which equals to a rise of 21.67%.
With the changed prices, stock P and stock R have a weight greater than 25% while stock
Q and stock S have a weight lower than 25%. The fund manager will then have to
rebalance the index to restore equal weights. This can be done by selling appropriate
quantities of stocks P and R and buying required quantities of stocks Q and S.

2.4 Attributes of an Index

A good market index should have following attributes:

· It should reflect the market behaviour.

· It should be computed by independent third party and be free from

influence of any market participant.

· It should be professionally maintained.

Impact Cost
Liquidity in the context of stock market means a market where large orders are executed without
moving the prices.

Let us understand this with help of an example. The order book of a stock at a point in
time is as follows:
Sell
Buy

Q Price Price Q
S u (in (in u S
r. a Rs.) Rs.) a r
N .
o nt nt N
. it it o
y y .

1 4.00 4.50 2 5
1 0
0 0
0
0 0

2 3.90 4.55 1 6
1 0
0 0
0
 0
0

3 3.80 4.70 7
2 5
0 0
0 0
0

4 1 3.70 4.75 1 8
0 0
0 0
0
In the order book given above, there are four buy orders and four sell orders. The
difference between the best buy and the best sell orders is 0.50 - called bid-ask spread. If
a person places a market buy order for 100 shares, it would be matched against the best
available sell order at Rs. 4.50. He would buy 100 shares for Rs. 4.50. Similarly, if he
places a market sell order for 100 shares, it would be matched against the best available
buy order at Rs. 4 i.e. the shares would be sold at Rs. 4. Hence, if a person buys 100
shares and sells them immediately, he is poorer by the bid-ask spread i.e., a loss of Rs 50.
This spread is regarded as the transaction cost which the market charges for the privilege
of trading (for a transaction size of 100 shares).
Now, suppose a person wants to buy and then sell 3000 shares. The sell order will hit the
following buy orders:

Sr. No. Q Price

u (in Rs.)
a
nt
it
y

1 4.00
1
0
0
0

2 3.90
1
0
 0
0

3 3.80
1
0
0
0

While the buy order will hit the following sell orders:
Q Price Sr. No.
u (in Rs.)
a
nt
it
y
4.50 5
2
0
0
0

4.55 6
1
0
0
0

There is increase in the transaction cost for an order size of 3000 shares in comparison to
the transaction cost for order for 100 shares. The “bid-ask spread” therefore conveys the
transaction cost for a small trade.

Now, we come across a term called impact cost. We must start by defining the ideal price
as the average of the best bid and offer price. In our example it is (4+4.50)/2, i.e., Rs.
4.25. In an infinitely liquid market, it would be possible to execute large transactions on
both buy and sell at prices that are very close to the ideal price of Rs.4.25. However,
while trading, you will pay more than Rs.4.25 per share while buying and will receive
less than Rs.4.25 per share while selling. The percentage degradation, which is
experienced vis-à- vis the ideal price, when shares are bought or sold, is called impact
cost. Impact cost varies with transaction size. Also, it would be different for buy side and
sell side.
 Buy Price Sell Price Sell
Buy (in Rs.) (in Rs.) Quan
Quan tity
tity

9.90
1000 9.80 1000

2000 9.70 10.00 1500

3000 9.60 10.10 1000

To buy 1500 shares, Ideal price = (9.8+9.9)/ 2 = Rs.9.85

Actual buy price = [(1000*9.9)+(500*10.00)]/1500 = Rs.9.9333

Impact cost for (1500 shares) = {(9.9333 - 9.85)/9.85}*100 = 0.84
%

2.5 Index management

Index construction, maintenance and revision process is generally done by specialized
agencies. For instance, BSE indices are managed by Asia Index Pvt Ltd and NSE indices
are managed by NSE Indices Limited.
Index construction is all about choosing the index stocks and deciding on the index
calculation methodology. Maintenance means adjusting the index for corporate actions
like bonus issue, rights issue, stock split, consolidation, mergers etc. Revision of an index
deals with change in the composition of index as such i.e., replacing some existing stocks
by the new ones because of a change in the trading paradigm of the stocks, or a shift in
the interest of market participants.
Index Construction
A good index is a trade-off between diversification and liquidity. A well-diversified
index reflects the behaviour of the overall market/economy. While diversification helps
in reducing risk, it may not help beyond a point. Going from 10 stocks to 20 stocks leads
to a sharp reduction in risk. Going from 50 stocks to 100 stocks enables very little
reduction in risk. Going beyond 100 stocks causes almost zero decline in risk. Hence,
there is little to gain by diversifying beyond a point.
Stocks in the index are chosen based on certain pre-determined qualitative and
quantitative parameters, laid down by the Index Construction Managers. Once a stock
satisfies the eligibility criteria, it is entitled for inclusion in the index. Generally, the final
decision of inclusion or removal of a security from the index is taken by a specialized
committee known as the Index Committee.
Index Maintenance and Index Revision

Maintenance and revision of the indices is done with the help of various mathematical
formulae. In order to keep the index comparable across time, the index needs to take into
account corporate actions such as stock splits, share issuance, dividends and restructuring
events. While index maintenance issue gets triggered by a corporate action, index
revision is a continuous exercise to ensure that the index captures the most vibrant lot of
securities in the market and continues to correctly reflect the market.

2.6 Major Indices in India

These are some of the popular equity indices in India:

· S&P BSE Sensex · Nifty 50 · SX 40

· S&P BSE Sensex · Nifty Next 50

Next 50 · Nifty 100
· S&P BSE 100 · Nifty 200
· S&P BSE 200 · Nifty 500
· S&P BSE 500

2.7 Application of Indices

Traditionally, indices were used as a measure to understand the overall direction of the
stock market. However, a few applications have emerged in the investment field which
are explained below:
Index Funds
These types of funds invest in a specific index with an objective to generate returns
equivalent to the return on index. These funds invest in index stocks in the proportions in
which these stocks exist in the index. For instance, Sensex index fund would get similar
returns as that of Sensex index (except for a small “tracking error” which occurs due to
fund management related expenses and cash holdings maintained to take care of
redemptions). Since the Sensex has 30 shares, the fund will also invest in these 30
companies in the proportion in which they exist in the Sensex. Similarly, a Nifty index
fund would invest in the 50 component companies of Nifty index in the same proportion
in which they exist in the Nifty index and therefore generates similar returns as that of
Nifty index (adjusted for tracking error).

Index Derivatives
Index Derivatives are derivative contracts which have the index as the underlying asset.
Index Options and Index Futures are the most popular derivative contracts worldwide.
Index derivatives are useful as a tool to hedge against the market risk.
Exchange Traded Funds

Exchange Traded Funds (ETFs) is basket of securities that trade like individual stocks, on
an exchange. They have a number of advantages over other mutual funds as they can be
bought and sold on the exchange. Since, ETFs are traded on exchanges, intraday
transaction is possible. Further, ETFs can be used as basket trading in terms of the
smaller denomination and low transaction cost.