UNDERSTANDING THE INDEX

1. Introduction to an Index

• Definition: An index is a statistical indicator that measures changes in the economy or specific areas, representing a portfolio of securities in a particular market.
• Details: Each index has its own calculation methodology, expressed in terms of a change from a base value, which can be recent or from the past. The percentage change is more important than the actual numeric value.
• Purpose: Financial indices, including stock indices, are created to measure price movement of various financial securities, providing market participants with information on average share price movement.
• Types:
  • Broad indices aim to capture the overall behavior of the equity market.
  • Specific indices represent the return obtained by typical portfolios in a country, offering insights into market trends and performance.

Significance of the stock index

• Market Performance Indicator: A stock index is an indicator of the performance of the overall market or a particular sector.
• Benchmark for Portfolio Performance: It serves as a benchmark for portfolio performance, allowing managed portfolios (belonging to individuals or mutual funds) to evaluate their performance.
• Underlying for Derivatives: It is used as an underlying for financial applications of derivatives, with various products in OTC and exchange-traded markets based on indices as the underlying asset.

Types of Stock Market Indices

• Market Capitalization Weighted Index: This method of calculation gives each stock a weight according to its market capitalization. The market capitalization is calculated by multiplying the total number of shares outstanding by its current market price.
• Free-Float Market Capitalization Index: This index is computed based on the free float market capitalization of each security, which is the market capitalization based on the shares that are readily available for trading.
• Price-Weighted Index: In this type of index, each stock influences the index in proportion to its price. Stocks with a higher price will have more weight and a greater influence over the performance of the index.
• Equal Weighted Index: This is an index in which all stocks included have the same weightage. The number of shares of each stock is adjusted so that the weight of each stock in the index is the same.

Key Characteristics of Each Index Type

• Market Capitalization Weighted Index:
  • Weights stocks based on their market capitalization.
  • Examples: Sensex and Nifty (initially designed on this method).
• Free-Float Market Capitalization Index:
  • Weights stocks based on their free float market capitalization.
  • Examples: Sensex, Nifty, and SX40 (currently designed on this method).
• Price-Weighted Index:
  • Weights stocks based on their price.
  • Examples: Dow Jones Industrial Average and Nikkei 225.
• Equal Weighted Index:
  • Gives equal weight to all stocks in the index.
  • Requires periodic rebalancing to maintain equal weights.

Calculation Examples

• For Market Capitalization Weighted Index: Calculate the market capitalization of each stock and then find the total market capitalization of the index. The new value of the index is calculated as (New Total Market Capitalization / Base Total Market Capitalization) * Base Index Value.
• For Price-Weighted Index: Calculate the sum of the prices of all stocks and divide by the number of stocks to get the index value.
• For Equal Weighted Index: Adjust the quantity of each stock so that each stock has the same value, and thus the same weight. The new index value is calculated based on the percentage change in the price of each stock multiplied by its original weight.

Attributes of an Index

• Definition: A good market index should have the following attributes:
  • It should reflect the market behaviour.
  • It should be computed by an independent third party and be free from influence of any market participant.
  • It should be professionally maintained.
• Importance of Liquidity: Liquidity in the context of the stock market means a market where large orders are executed without moving the prices.

Impact Cost

• Definition: The percentage degradation, which is experienced vis-à-vis the ideal price, when shares are bought or sold, is called impact cost.
• Calculation: Impact cost varies with transaction size and is different for the buy side and sell side. It is calculated as the difference between the actual transaction price and the ideal price, expressed as a percentage of the ideal price.
• Example:
  • Ideal price = (9.8+9.9)/2 = Rs.9.85
  • Actual buy price = [(10009.9)+(50010.00)]/1500 = Rs.9.9333
  • Impact cost for (1500 shares) = {(9.9333 - 9.85)/9.85}*100 = 0.84 %
• Key Points:
  • Bid-ask spread is the difference between the best buy and the best sell orders.
  • Transaction cost is the cost associated with buying and selling securities, which includes the bid-ask spread.
  • Impact cost is a measure of the market's liquidity and efficiency.

Major Indices in India

• Equity Indices: These are stock market indices that measure the performance of a group of stocks. In India, some popular equity indices include:
  • S&P BSE Sensex
  • Nifty 50
  • SX 40
  • S&P BSE Sensex Next 50
  • Nifty Next 50
• Broad Market Indices: These indices represent a broader segment of the market, including:
  • S&P BSE 100: Covers the top 100 stocks by market capitalization
  • Nifty 100: Represents the top 100 stocks by market capitalization
  • S&P BSE 200: Covers the top 200 stocks by market capitalization
  • Nifty 200: Represents the top 200 stocks by market capitalization
  • S&P BSE 500: Covers the top 500 stocks by market capitalization
  • Nifty 500: Represents the top 500 stocks by market capitalization

Application of Indices

• Index Funds: These funds invest in a specific index to generate returns equivalent to the return on the index. They invest in index stocks in the same proportions as they exist in the index, with the goal of tracking the index's performance, except for a small tracking error due to fund management expenses and cash holdings.
• Index Derivatives: Derivative contracts with an index as the underlying asset, including Index Options and Index Futures. These are useful for hedging against market risk.
• Exchange Traded Funds (ETFs): A basket of securities that trade like individual stocks on an exchange, offering advantages such as intraday transactions and low transaction costs. ETFs can be used for basket trading in smaller denominations.

Key points to remember:

• Index funds aim to replicate the performance of a specific index.
• Index derivatives are used for hedging against market risk.
• ETFs offer flexibility and cost-effectiveness in trading.

Note: Sample questions provided are for practice and not part of the summary.