Chapter 2: Understanding Index Flashcards
2.1 Introduction to Index
Index is a statistical indicator that measures changes in the economy in general or in
particular 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 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 Index
A stock index is an indicator of the performance of 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 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
Free-Float Market Capitalization Index
Price-Weighted Index
Equal Weighted Index
Market capitalization weighted index
1
In this method of calculation, each stock is given 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 present value of index based on following information.
Market capitalization (Mcap) = Number of Shares * Market Price
Old value of portfolio is equated to 100. Therefore, on that scale new value of portfolio
would be (525.05/ 296.27)*100 = 177.22
Thus, the present value of Index under market capitalization weighted method is
177.22.
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 stake holders –
promoters, institutions, corporates, individuals etc. Market has started to segregate this
on the basis of what is readily available for trading or 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. Indeed, both Sensex and Nifty, over a period of time, have moved
to free float basis. SX40, index of MSEI is also a free float market capitalization index.
Price-Weighted Index
2
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 example for calculation of price-weighted index.
We equate 310 to 100 to find the current value, which would be (532/310)*100 =
171.7268
Dow Jones Industrial Average and Nikkei 225 are popular price-weighted indices.
Equal Weighted Index
3
An equally-weighted index makes no distinction between large and small companies,
both of which are given equal weighting. The value of the index is generated by adding
the prices of each stock in the index and dividing that by the total number of stocks.
Let us take the same example for calculation of equal weighted index.
Base level of this index would be (150+300+450+100+250)/5 = 250. We equate this to
100.
Current level of this index would be (650+450+600+350+500)/5 = 510. It means current
level of index on the base of 100 would be (510/250)*100 = 204.
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
4
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:
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:
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
transaction cost for small trade.
Now, we come across the term called impact cost. We have to 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 actually 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. 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.
To buy 1500 shares, Ideal price = (9.8+9.9)/ 2 = Rs.9.85
Actual buy price = [(10009.9)+(50010.00)]/1500 = Rs.9.93
Impact cost for (1500 shares) = {(9.93 - 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, NSE indices are managed by a separate company called 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 index
deals with change in the composition of index as such i.e. replacing some existing stocks
by the new ones because of change in the trading paradigm of the stocks / 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, beyond a point it may not help in the context. Going from 10 stocks to 20
stocks gives a sharp reduction in risk. Going from 50 stocks to 100 stocks gives very little
reduction in risk. Going beyond 100 stocks gives almost zero reduction 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 criterion, it is entitled for inclusion in the index. Generally, final
decision of inclusion or removal of a security from the index is taken by a specialized
committee known as 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 an unabated phenomenon to ensure that 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 few popular indices in India:
S&P BSE Sensex
S&P BSE Midcap
S&P BSE 100
S&P BSE 200
S&P BSE 500
Nifty
Nifty Next 50
Nifty 100
Nifty 200
Nifty 500
SX 40
2.7 Application of Indices
Traditionally, indices were used as a measure to understand the overall direction of
stock market. However, few applications on index have emerged in the investment field. Few of the applications 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). Since 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 a small “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 stock, on an exchange. They have 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. The first ETF in Indian Securities Market was the Nifty BeES, introduced by the Benchmark Mutual Fund in December 2001.
Prudential ICICI Mutual Fund introduced SPIcE in January 2003, which was the first ETF on Sensex.
