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WHAT ARE STOCK MARKET INDICES?

Market Index Traditionally, indices have been used as benchmarks to monitor markets and judge
performance. Modern indices were first proposed by two 19th century mathematicians: Etienne
Laspeyres and Hermann Paasche. The grandfather of all equity indices is the Dow Jones
Industrial Average which was first published in 1896; since then indices have come a long way -
not only in their sophistication - but also in the variety. There are three main types of indices,
namely price index, quantity index and value index. The price index is most widely used. It
measures changes in the levels of prices of products in the financial, commodities or any other
markets from one period to another. The indices in financial markets measure changes in prices
of securities like equities, debentures, government securities, etc. The most popular index in
financial market is the stock (equity) index which uses a set of stocks that are representative of
the whole market, or a specified sector, to measure the change in overall behaviour of the
markets or sector over a period of time.

A stock index is important for its use:

1. as the lead indicator of the performance of the overall economy or a sector of the economy: A
good index tells us how much richer or poorer investors have become.
2. as a barometer for market behaviour: It is used to monitor and measure market movements,
whether in real time, daily, or over decades, helping us to understand economic conditions and
prospects.
3. as a benchmark for portfolio performance: A managed fund can communicate its objectives
and target universe by stating which index or indices serve as the standard against which its
performance should be judged.
4. as an underlying for derivatives like index futures and option. It also underpins products such
as, exchange-traded funds, index funds etc. These index-related products form a several trillion
dollar business and are used widely in investment, hedging and risk management.
5. as it supports research (for example, as benchmarks for evaluating trading rules, technical
analysis systems and analysts’ forecasts); risk measurement and management; and asset
allocation.
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In addition to the above functional use, a stock index reflects changing expectations of the
market about future of the corporate sector. The index rises if the market expects the future to be
better than previously expected and drops if the expectation about future becomes pessimistic.
Price of a stock moves for two reasons, namely, company specific development (product launch,
closure of a factory, arrest of chief executive) and development affecting the general
environment (nuclear bombs, election result, budget announcement), which affects the stock
market as a whole. The stock index captures the second part, that is, impact of environmental
change on the stock market as a whole. This is achieved by averaging which cancels out changes
in prices of individual stocks.
Understanding the index number
An index is a summary measure that indicates changes in value(s) of a variable or a set of
variables over a time or space. It is usually computed by finding the ratio of current values(s) to a
reference (base) value(s) and multiplying the resulting number by 100 or 1000.
For instance, a stock market index is a number that indicates the relative level of prices or value
of securities in a market on a particular day compared with a base-day price or value figure,
which is usually 100 or 1000.

Attributes of an index
A good stock market index should have the following attributes:
1. Capturing behaviour of portfolios: A good market index should accurately reflect the
behaviour of the overall market as well as of different portfolios. This is achieved by
diversification in such a manner that a portfolio is not vulnerable to any individual stock
or industry risk. A well-diversified index is more representative of the market. However
there are diminishing returns from diversification. There is very little gain by diversifying
beyond a point. Including illiquid stocks, actually worsens the index since an illiquid
stock does not reflect the current price behaviour of the market, its inclusion in index
results in an index, which reflects, delayed or stale price behaviour rather than current
price behaviour of the market. Thus a good index should include the stocks which best
represent the universe.
2. Including liquid stocks: Liquidity is much more than reflected by trading frequency. It is
about ability to transact at a price, which is very close to the current market price. For
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example, when the market price of a stock is at Rs.320, it will be considered liquid if one
can buy some shares at around Rs.320.05 and sell at around Rs.319.95. A liquid 119
stock has very tight bid-ask spread. Impact cost is the most practical and operational
definition of liquidity.
3. Maintaining professionally: An index is not a constant. It reflects he market dynamics
and hence changes are essential to maintain its representative character. This necessarily
means that the same set of stocks would not satisfy index criteria at all times. A good
index methodology must therefore incorporate a steady pace of change in the index set. It
is crucial that such changes are made at a steady pace. Therefore the index set should be
reviewed on a regular basis and, if required, changes should be made to ensure that it
continues to reflect the current state of market

WHAT ARE STOCK INDICES?

From among the stocks listed on the exchange, some similar stocks are selected and grouped
together to form an index. This classification may be on the basis of the industry the companies
belong to, the size of the company, market capitalization or some other basis. For example, the
BSE Sensex is an index consisting of 30 stocks. Similarly, the BSE 500 is an index consisting of
500 stocks.

The values of the grouped stocks are used to calculate the value of the index. Any change in the
price of the stocks leads to a change in the index value. An index is thus indicative of the
changes in the market.

Some of the important indices in India are:

 Benchmark indices – BSE Sensex and NSE Nifty

 Sectoral indices like BSE Bankex and CNX IT

 Market capitalization-based indices like the BSE Smallcap and BSE Midcap

 Broad-market indices like BSE 100 and BSE 500

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WHY DO WE NEED INDICES?

Indices are an important part of the stock market. Here’s why we need stock indices:

1. Sorting: In a share market, there are thousands of companies listed. How do you
differentiate between all of those and pick one or two to buy? How do you sort them out?
It is a classic case of a pin in a stack of hay. This is where indices come into the picture.
Companies and their shares are classified into indices based on key characteristics like
size of company, sector or industry they belong to, and so on.

2. Representation: Indices act as a representative of the entire market or a certain segment

of the market. In India, the BSE Sensex and the NSE Nifty are considered the benchmark
indices. They are considered to represent the overall market performance. Similarly, an
index formed of IT stocks is supposed to represent all stocks of companies from the
industry.

3. Comparison An index makes it easy for an investor to compare performance. An index

can be used as a benchmark to compare against. For example, in India the Sensex is often
used as a benchmark. So, to find if a stock has outperformed the market, you simply
compare the price trends of the index and the stock. On the other hand, an index can also
be used to compare a set of stocks against a benchmark or another index. For example, on
a given day, the benchmark index like Sensex may jump 200 points, but this rally may
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not extend to a certain segment of stocks like IT. Then, the fall in the value of index
representing IT stocks could be used for comparison rather than each individual stocks.
This also helps investors identify market trends easily.

4. Reflection Investor sentiment is a very important aspect of stock market movements.

This is because, if sentiment is positive, there will be demand for a stock. This will
subsequently lead to a rise in prices. It is very difficult to gauge investor sentiment
correctly. Indices help reflect investor’s mood – not just for the overall market, but even
sector-wise and across company sizes. You can simply compare an index with a
benchmark to see if has underperformed or outperformed. This will, in turn, reflect
investor sentiment.

5. Passive investment Many investors prefer to invest in a portfolio of securities that

closely resembles an index. This is called passive investment. An index portfolio helps
investors cut down cost of research and stock selection. They rely on the index for stock
selection. As a result, portfolio returns will match that of the index. For example, if
Sensex gave 8% returns in one month, an investor’s portfolio that resembles the Sensex is
also likely to give the same amount of returns. Indices are also used to construct mutual
funds and exchange-traded funds (ETFs).

HOW ARE STOCK INDICES FORMED?

An index consists of similar stocks. This could be on the basis of industry, company size, market
capitalization or another parameter. Once the stocks are selected, the index value is calculated.
This could be a simple average of the prices of the components. In India, the free-float market
capitalization is commonly used instead of prices to calculate the value of an index.

The two most common kinds of indices are – Price-weighted and market capitalization-weighted
index.

What is stock weightage?

Every stock has a different price. So, a 1% change in one stock may not equal a similar change in
another stock’s price. So, the index value cannot be a simple total of the prices of all the stocks.
Here is where the concept of stock weightage comes into play. Each stock in an index has a
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particular weightage depending on its price or market capitalization. This is the amount of
impact a change in the stock’s price has on index value.

 Market-cap weightage

Market capitalization is the total market value of a company’s stock. This is calculated by
multiplying the share price of a stock with the total number of stocks floated by the company. It
thus takes into consideration both the size and the price of the stock. In an index using market-
cap weightage, stocks are given weightage on the basis of their market capitalization in
comparison with the total market-capitalization of the index. For example, if stock A has a
market capitalization of Rs. 10,000 while the index it is part of has a total m-cap of Rs. 1,00,000,
then its weightage will be 10%. Similarly, another stock with a market-cap of Rs. 50,000, will
have a weightage of 50%.

The point to remember is that market capitalization changes every day as the stock price
fluctuates. For this reason, a stock’s weightage too changes every day. However, it is usually a
marginal change. Also, the market capitalization-weightage method gives more importance to
companies with higher m-caps.

In India, most indices use free-float market capitalization. In this method, instead of using the
total shares listed by a company to calculate market capitalization, only the amount of shares
publicly available for trading are used. As a result, free-float market capitalization is a smaller
figure than market capitalization.

 Price weightage

In this method, an index value is calculated on the basis of the company’s stock price, and not
market capitalization. Stocks with higher prices have greater weightages in the index than stocks
with lower prices. The Dow Jones Industrial Average in the US and the Nikkei 225 in Japan are
examples of price-weighted indices.

There are also other kinds of weightages like equal-value weightage or fundamental weightage.
However, they are rarely used by public indices.
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HOW IS INDEX VALUE CALCULATED?

An index’s value depends on whether it is a price-weighted index or market cap-weighted. Let us

take the example of the BSE Sensex to understand how an index is calculated.
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Sensex Calculation Methodology:

Sensex is calculated using the "Free-float Market Capitalization" methodology. As per this
methodology, the level of index at any point of time reflects the Free-float market value of 30
component stocks relative to a base period. The market capitalization of a company is
determined by multiplying the price of its stock by the number of shares issued by the
company. This market capitalization is further multiplied by the free-float factor to determine
the free-float market capitalization.

The base period of Sensex is 1978-79 and the base value is 100 index points. This is often
indicated by the notation 1978-79=100. The calculation of Sensex involves dividing the Free-
float market capitalization of 30 companies in the Index by a number called the Index
Divisor.

The Divisor is the only link to the original base period value of the Sensex. It keeps the Index
comparable over time and is the adjustment point for all Index adjustments arising out of
corporate actions, replacement of scrips etc. During market hours, prices of the index scrips,
at which latest trades are executed, are used by the trading system to calculate Sensex every
15 seconds and disseminated in real time

Dollex-30
BSE also calculates a dollar-linked version of Sensex and historical values of this index are
available since its inception.

Understanding Free-float Methodology :

Free-float Methodology refers to an index construction methodology that takes into

consideration only the free-float market capitalisation of a company for the purpose of index
calculation and assigning weight to stocks in Index. Free-float market capitalization is
defined as that proportion of total shares issued by the company that are readily available for
trading in the market.

It generally excludes promoters' holding, government holding, strategic holding and other
locked-in shares that will not come to the market for trading in the normal course. In other
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words, the market capitalization of each company in a Free-float index is reduced to the
extent of its readily available shares in the market.

In India, BSE pioneered the concept of Free-float by launching BSE TECk in July 2001 and
Bankex in June 2003. While BSE TECk Index is a TMT benchmark, Bankex is positioned as
a benchmark for the banking sector stocks. Sensex becomes the third index in India to be
based on the globally accepted Free-float Methodology

Example:

Suppose the Index consists of only 2 stocks: Stock A and Stock B.

Suppose company A has 1,000 shares in total, of which 200 are held by the promoters, so that
only 800 shares are available for trading to the general public. These 800 shares are the so-called
'free-floating' shares.

Similarly, company B has 2,000 shares in total, of which 1,000 are held by the promoters and the
rest 1,000 are free-floating.

Now suppose the current market price of stock A is Rs 120. Thus, the 'total' market capitalisation
of company A is Rs 120,000 (1,000 x 120), but its free-float market capitalisation is Rs 96,000
(800 x 120).

Similarly, suppose the current market price of stock B is Rs 200. The total market capitalisation
of company B will thus be Rs 400,000 (2,000 x 200), but its free-float market cap is only Rs
200,000 (1,000 x 200).

So as of today the market capitalisation of the index (i.e. stocks A and B) is Rs 520,000 (Rs
120,000 + Rs 400,000); while the free-float market capitalisation of the index is Rs 296,000. (Rs
96,000 + Rs 200,000).

The year 1978-79 is considered the base year of the index with a value set to 100. What this
means is that suppose at that time the market capitalisation of the stocks that comprised the index
then was, say, 60,000 (remember at that time there may have been some other stocks in the
index, not A and B, but that does not matter), then we assume that an index market cap of 60,000
is equal to an index-value of 100.
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Thus the value of the index today is = 296,000 x 100/60,000 = 493.33

This is how the Sensex is calculated.

The factor 100/60000 is called index divisor.

NSE calculating methodology

Methodology for index construction

WEIGHTING METHOD: In a value-weighted index, the weight of each constituent stock is

proportional to its market share in terms of market capitalization. In an index portfolio, we can
assume that the amount of money invested in each constituent stock is proportional to its
percentage of the total value of all constituent stocks. Examples include all major stock market
indices like S&P CNX Nifty.

There are three commonly used methods for constructing indices:

• Price weighted method

• Equally weighted method

• Market capitalisation weighted method

A price-weighted index is computed by summing up the prices, of the various securities included
in the index, at time 1, and dividing it by the sum of prices of the securities at time 0 multiplied
by base index value. Each stock is assigned a weight proportional to its price.

Example: Assuming base index = 1000, price weighted index consisting of 5 stocks tabulated
below would be:

COMPANY Share Price at Time- 0 Share Price at Time- 1

Reliance 351.75 340.50
AB & U 329.10 350.30
INFOSYS 274.60 280.40 274.60 280.40
HLL 1335.25 1428.75
Tata Tea 539.25 570.25
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Total 2829.95 2970.20

Index = 2829.95/ 2970.20 *1000 = 1049.56

Market capitalisation weighted index: The most commonly used weight is market capitalization
(MC), that is, the number of outstanding shares multiplied by the share price at some specified
time.

In this method,

Index = Current Market Capitalization / Base Market Capitalization* Base Value

Where, Current MC = Sum of (number of outstanding shares*Current Market Price) all stocks in
the index

Base MC = Sum of (number of outstanding shares*Market Price) all stocks in index as on base
date

Base value = 100 or 1000

Difficulties in index construction:

1. The major difficulties encountered in constructing an appropriate index are:

2. deciding the number of stocks to be included in the index,
3. selecting stocks to be included in the index,
4. selecting appropriate weights, and
5. selecting the base period and base value.