Introduction to an Index :
- Definition of an Index: A statistical indicator measuring changes in the economy or specific sectors.
- Financial Market Index: Represents a portfolio of securities for a market or market segment.
- Calculation Methodology: Each index uses unique methods and reflects changes from a base value, which can vary from recent days to years ago.
- Key Focus: Percentage change is more significant than the numeric value.
- Purpose of Financial Indices: Tracks price movements of stocks, bonds, T-bills, and other financial securities.
- Stock Index Function: Provides market participants with insights into average share price movements.
- Broad Indices Role: Captures overall equity market behavior and reflects typical portfolio returns.
Significance of the stock index:
- A stock index reflects market or sector performance.
- It benchmarks portfolio performance for evaluation.
- It serves as the basis for derivatives in OTC and exchange-traded markets.
Types of Stock Market Indices :
- Stock Market Indices Types:
- Market Capitalization Weighted Index: Stocks weighted by market capitalization. Example: Sensex, Nifty.
- Free-Float Market Capitalization Index: Based on shares available for trading, e.g., Sensex, Nifty, SX40.
- Price-Weighted Index: Weights determined by stock prices, e.g., Dow Jones, Nikkei 225.
- Equal Weighted Index: All stocks carry the same weight; adjustments required for price changes.
- Market Capitalization Calculation:
- Example calculation: Market cap = Outstanding shares × Current price.
- Index value formula: New Index Value=(Current Market Cap/Base Market Cap)×100\text{New Index Value} = (\text{Current Market Cap} / \text{Base Market Cap}) \times 100New Index Value=(Current Market Cap/Base Market Cap)×100.
- Price-Weighted Index:
- Index based on stock price averages. Example: Price Index=Sum of PricesNo. of Stocks\text{Price Index} = \frac{\text{Sum of Prices}}{\text{No. of Stocks}}Price Index=No. of StocksSum of Prices .
- Equal Weighted Index Example:
- Stocks weighted equally.
- Changes require rebalancing to maintain weights.
- Significance of Indices:
- They measure market performance, guide investors, and benchmark portfolios.
Attributes of an Index :
- Attributes of a Good Market Index:
- Reflects market behavior.
- Computed by an independent third party, free from market participant influence.
- Professionally maintained.
- Liquidity in Stock Markets:
- Liquidity allows large orders to be executed without significantly moving prices.
- Bid-Ask Spread:
- The difference between the best buy price and the best sell price.
- Acts as a transaction cost for small trades.
- Impact of Order Size on Transaction Cost:
- Larger orders increase transaction costs compared to smaller orders due to hitting multiple price levels.
- Impact Cost:
- Defined as the percentage deviation from the ideal price when trading.
- Calculated based on the degradation in price relative to the ideal price, varying with transaction size and buy/sell sides.
Index management :
- Index Management Agencies
- BSE indices: Managed by Asia Index Pvt Ltd.
- NSE indices: Managed by NSE Indices Limited.
- Index Construction
- Involves selecting index stocks and determining the calculation methodology.
- Balances diversification and liquidity to reflect market/economy behavior.
- Risk reduction is significant up to 50 stocks but minimal beyond 100 stocks.
- Stocks are chosen based on pre-determined criteria by the Index Committee.
- Index Maintenance
- Adjusts for corporate actions like stock splits, bonuses, mergers, etc., to ensure comparability over time.
- Index Revision
- Involves replacing stocks to capture the most active and relevant securities, ensuring the index reflects market dynamics.
- Utilizes mathematical formulas for consistent updates.
Major Indices in India :
| S&P BSE Indices | Nifty Indices | SX 40 |
| S&P BSE Sensex | Nifty 50 | |
| S&P BSE Sensex Next 50 | Nifty Next 50 | |
| S&P BSE 100 | Nifty 100 | |
| S&P BSE 200 | Nifty 200 | |
| S&P BSE 500 | Nifty 500 |
Application of Indices :
- Traditional Use of Indices: Initially used to gauge the overall stock market direction.
- Index Funds:
- Invest in specific indices to mirror their returns.
- Proportions of investments align with index components.
- Examples: Sensex Index Fund and Nifty Index Fund.
- Returns are adjusted for tracking errors from fund management costs and redemptions.
- Index Derivatives:
- Include Index Options and Index Futures.
- Serve as tools to hedge market risk.
- Exchange-Traded Funds (ETFs):
- A basket of securities traded like individual stocks on exchanges.
- Allow intraday transactions and cost-effective trading.