Stock Market Indexes in India - Functioning and Construction
SPR Vittal

Does the movement of Sensex or Nifty really mean any thing to the investors, fund managers, investment advisors, and last but not the least to the regulators? Do these numbers have any significance? Do they have any scientific basis? How does a lay man understand these numbers? What exactly that goes into these numbers? This three part write up tries to address these questions.

This first part explains the basics of the Index.

Introduction

In recent years, indexes have come to the forefront owing to direct applications in finance in the form of index funds and index derivatives. Index derivatives allow people to cheaply alter their risk exposure to an index (hedging) and to implement forecasts about index movements (speculation). Hedging using index derivatives has become a central part of risk management in the modern economy. Securities market indexes have been constructed to give a quick answer to the question: What is the market doing?

What the Index Means

An index is a number, which measures the change in a set of values over a period of time. A stock index represents the change in value of a set of stocks which constitute the index. More specifically, a stock index number is the current relative value of a weighted average of the prices of a pre-defined group of equities. It is a relative value because it is expressed relative to the weighted average of prices at some arbitrarily chosen starting date or base period. The starting value or base of the index is usually set to a number such as 100 or 1000.

Characteristics of a good Index

A good stock market index is one which captures the behavior of the overall equity market. It should represent the market, it should be well diversified and yet highly liquid. Movements of the index should represent the returns obtained by “typical” portfolios in the country. A market index is very important for its use

• as a barometer for market behavior,

• as a benchmark portfolio performance,

• as an underlying in derivative instruments like index futures, and

• in passive fund management by index funds

Construction of an Index

A well constructed market index will give an unbiased indication of the prices of the population under consideration. The factors that go into designing an index are

Sample Size: The sample should be statistically significant fraction of the population studied. If the sample is too large and diverse it would be uneconomical to complile and would be uninteresting to specialised investors. The sample size may be as small as 30 (BSE-30, and Dow Jones Industrial Average) to as large as 500 (S&P 500, ).
Representativeness: A good index should represent every industry of the economy. There should not be too many stocks from the same industry . For example the BSE 30 represnts all the major industries of the Indian economy.
Weighting: The various securities of an Index should be assigned weights which are proportional to the securitys’ market capitalization.
Conveninet Units: An Index should be stated in convenient units that are easy to understand.

Economic significance of index movements

How do we interpret index movements? What do these movements mean? They reflect the
changing expectations of the stock market about future dividends of the corporate sector. The
index goes up if the stock market thinks that the prospective dividends in the future will be better than previously thought. When the prospects of dividends in the future becomes pessimistic, the index drops. The ideal index gives us instant readings about how the stock market perceives the future of corporate sector.

Every stock price moves for two possible reasons:
1. News about the company (e.g. a product launch, or the closure of a factory)
2. News about the country (e.g. nuclear bombs, or a budget announcement)

The job of an index is to purely capture the second part, the movements of the stock market
as a whole (i.e. news about the country). This is achieved by averaging. Each stock contains a
mixture of two elements - stock news and index news. When we take an average of returns on
many stocks, the individual stock news tends to cancel out and the only thing left is news that is common to all stocks. The news that is common to all stocks is news about the economy. That is what a good index captures. The correct method of averaging is that of taking a weighted average, giving each stock a weight proportional to its market capitalization.

Types of Indexes

Most of the commonly followed stock market indexes are of the following two types: Market
capitalization weighted index or price weighted index. In a market capitalization weighted index, each stock in the index affects the index value in proportion to the market value of all shares outstanding. In India both S&P CNX Nifty of National Stock Exchange and BSE – 30 of Bombay Stock Exchange use the Market Capitalization weighted method.

A price weighted index is one that gives a weight to each stock that is proportional to its stock price. Indexes can also be equally weighted.

Recently, major indices in the world like the S&P 500 and the FTSE-100 have shifted to a new method of index calculation called the “Free float” method.

(The second part, to be continued, deals with the S&P CNX Nifty, its functioning and construction.)

SPR Vittal
Faculty – Finance Area
Aurora’s PG College, Chikkadpally
Hyderabad-20
sprv_@rediffmail.com

Back