Digital Assignment 2

Capital Market and Financial Services

Q. 1 What do you understand by Index Management? What is the need of index

computation? Discuss the methods and significance of stock market Indies and index
computation. Explain the Stock market indices in India.

Indexing is broadly referred to as an indicator or measure of something. In the financial markets,

indexing can be used as a statistical measure for tracking economic data, a methodology for grouping a
specific market segment or as an investment management strategy for passive investments.

 Indexing is the practice of compiling economic data into a single metric.

 There are many indices in finance that reflect on economic activity or summarize market
activity - these become performance benchmarks against which portfolios and fund managers
are measured against.
 Indexing is also used to refer to passively investing in market indices to replicate broad market
returns rather than actively selecting individual stocks.

Market Index

A market index is a hypothetical portfolio of investment holdings which represents a segment of the
financial market. The calculation of the index value comes from the prices of the underlying holdings.
Some indices have values based on market-cap weighting, revenue-weighting, float-weighting, and
fundamental-weighting. Weighting is a method of adjusting the individual impact of items in an index.

A wide variety of investors use market indices for following the financial markets and managing their
investment portfolios. Indexes are deeply entrenched in the investment management business with
funds using them as benchmarks for performance comparisons and managers using them as the basis
for creating investable index funds.

 Market indexes provide a broad representative portfolio of investment holdings.

 Methodologies for constructing individual indexes vary but nearly all calculations are based on
weighted average mathematics.
 Indexes are used as benchmarks to gauge the movement and performance of market segments.
 Investors use indexes as a basis for portfolio or passive index investing
Stock Indices

A stock market index is a statistical measure which shows changes taking place in the stock market. To
create an index, a few similar kinds of stocks are chosen from amongst the securities already listed on
the exchange and grouped together.

The criteria of stock selection could be the type of industry, market capitalisation or the size of the
company. The value of the stock market index is computed using values of the underlying stocks. Any
change taking place in the underlying stock prices impact the overall value of the index. If the prices of
most of the underlying securities rise, then the index will rise and vice-versa.

In this way, a stock index reflects overall market sentiment and direction of price movements of
products in the financial, commodities or any other markets.

 Some of the notable indices in India are as follows:

 Benchmark indices like NSE Nifty and BSE Sensex
 Broad-based indices like Nifty 50 and BSE 100
 Indices based on market capitalization like the BSE Small cap and BSE Midcap
 Sectoral indices like Nifty FMCG Index and CNX IT

The following lists the importance of stock market index:

a. Aids in Stock-Picking

In a share market, you would thousands of companies listed on the exchange. Broadly, picking the
appropriate stock for investment may seem like a nightmare. Without a benchmark, you may not be
able to differentiate between the stocks. Simultaneously sorting the stocks becomes a challenge. In this
situation, a stock market acts like an instant differentiator. It classifies the companies and their shares
based on key characteristics like the size of company, sector, industry type and so on.

b. Acts as a Representative

Investing in equities involves risk and you need to take an informed decision. Studying about stocks
individually may seem very impractical. Indices help to fill the knowledge gaps that exist among the
investors. They represent the trend of the whole market or a certain sector of the market. In India, the
NSE Nifty the BSE Sensex act as the benchmark indices. They are believed to indicate the performance
of the entire stock market. In the same manner, an index which is made up of pharma stocks is assumed
to portray the average price of stocks of companies operating in the pharmaceutical industry.

c. The Parameter for Peer Comparison

Before including a stock in your portfolio, you have to assess whether it’s worth the money. By
comparing with the underlying index, you can easily judge the performance of a stock. If the stock gives
higher returns than the index, it’s said to have outperformed the index. If it gives lower returns than the
index, it’s said to have underperformed the index.

You would definitely want to invest in a multibagger so as to justify the risk assumed. Else you can be
better off investing in low-cost professionally managed index funds. You may also compare the index
with a set of stocks like the Information technology sector. As an investor, you can know market trends
easily.

d. Reflects Investor Sentiment

When you are participating in equity markets, amongst other things, knowing investor sentiment
becomes an important aspect. It is because the sentiment affects the demand for a stock which in turn
impacts the overall price. In order to invest in the right stock, you should know the reason behind the
rise/fall in its prices. At this juncture, indices help to gauge the mood of investors. You may even
recognize investor sentiment for a particular sector and across market capitalizations.

e. Helps in Passive Investment

Passive investment refers to investing in a portfolio of securities which replicates the stocks of an index.
Investors who want to cut down on the cost of research and stock selection prefer to invest in index
portfolio. Consequently, the returns of the portfolio will resemble that of the index. If an investor’s
portfolio resembles the Sensex, then his portfolio is going to deliver returns of around 8% when the
Sensex earns 8% returns.

Some of the market’s leading indexes include:

 S&P 500
 Dow Jones Industrial Average
 Nasdaq Composite
 S&P 100
 Russell 1000
 S&P 400
 Global Aggregate Bond Market

How are stock market indices developed

An index is made up of similar stocks based on market capitalization, industry or company size. Upon
selection of stocks, the index value is computed. Each stock will have a different price and price change
in one stock would not be proportionately equal to the price change in another. So, the value of the
index value cannot be arrived at as a simple sum of the prices of all the stocks.
Here is when the importance of assigning weights to stocks comes into play. Each stock in the index is
assigned a particular weightage based on its market capitalization or price. The weight represents the
extent of the impact that the stock’s price change has on the value of the index.

The two most commonly used stock market indices are as follows:

a. Market-cap weightage

Market capitalization refers to the total market value of the stock of a company. It is calculated by
multiplying the total number of outstanding stocks floated by the company with the share price of a
stock. It, therefore, considers both the price as well as the size of the stock. In an index which uses
market-cap weightage, the stocks are assigned weightage based on their market capitalization as
compared to the total market capitalization of the index.

b. Price weightage

In this method, the value of an index value is computed based on the stock price of a company rather
than the market capitalization. Thus, the stocks which have higher prices receive greater weightages in
the index as compared to the stocks which have lower prices. This method has been used in The Dow
Jones Industrial Average in the US and the Nikkei 225 in Japan.

A sound risk management system is integral to an efficient clearing and settlement system. NSE
introduced for the first time in India, risk containment measures that were common internationally but
were absent from the Indian securities markets.

Q.2 Discuss the Risk Management system in BSE & NSE. Explain with real examples.

NSE RISK MANAGEMENT

Risk containment measures include capital adequacy requirements of members, monitoring of member
performance and track record, stringent margin requirements, position limits based on capital, online
monitoring of member positions and automatic disablement from trading when limits are breached, etc.

Risk Management for Derivative products is managed with Standard Portfolio Analysis of Risk
(SPAN)® is a highly sophisticated, value-at-risk methodology that calculates performance bond/margin
requirements by analyzing the "what-if's" of virtually any market scenario.

SPAN ® is a registered trademark of the Chicago Mercantile Exchange, used herein under License. The
Chicago Mercantile Exchange assumes no liability in connection with the use of SPAN by any person
or entity.
BSE RISK MANAGEMENT

Nature of Risks:

The Exchange has been exposed to a large number of risks, which have been inherently borne by the
member brokers for all times. Since the introduction of the screen based trading the nature of risks to
which the members of the Exchange are exposed to has undergone radical transformation. At the same
time the inherent risk involved with the trading of paper based securities still remains. Though the
process of dematerialisation has already begun, till such that it is made compulsory in all Securities, the
risk of trading in fake/forged shares and instances of loss of shares etc. will continue to exist. The safe
custody of these shares in physical form in the Exchange as well as in the member brokers offices is of
prime importance.

The Risks can be classified as under:

1 . Risks associated with Paper Based Trading

 Lost/misplaced securities
 Damage to securities
 Loss of securities in transit

2. Client Risk

 Client default
 Client absconding
 Fake/ forged/stolen securities introduced by the clients

Reduction and Control of Risks:

As a measure of the pro-active risk control several measures have been initiated by the Exchange to
reduce the risks to which the Exchange and the member brokers are exposed. In this regard the
Exchange has initiated the following measures:

BSE RISK MANAGEMENT

1.Know Your Client Scheme :

Under the procedure the member brokers of the Exchange are compulsory required to obtain detailed
information of clients prior to commencement of any transactions for new clients. A similar procedure
is also to be followed for existing clients. This information is to be made available to the Exchange
authorities whenever called for. In case the member brokers fails to furnish the same it is viewed
seriously.

2. Database of lost , Stolen , Misplaced Securities :

The Exchange maintains a database on all the shares that have been reported as lost, stolen, duplicate
etc. by the Companies / registrars. The information available through the database is time relevant thus
the database is modified on a regular basis and is downloaded by the members through BOLT on a
weekly basis. This database is also provided to the Clearing House. The member brokers can thus reduce
the instances of delivery of shares that have been reported by the Company as bad delivery by checking
all the deliveries in their office with the database provided. The Exchange has designed and developed
a software module for the above for the benefit of the members.

The Clearing House also uses the database. At the time of pay-in the members of the Exchange are
required to submit the details of the shares being deposited in the pay-in in a softcopy in a prescribed
format.. These details are checked against the database and a report is generated in case a match is
found. Such shares are then reported as bad delivery in the Exchange. Further follow-up is done with
the delivering broker and they are directed to lodge a police complaint against the client introducing the
stolen shares.

3. Client Caution Database :

The Risk Management department in conjunction with the Bad Delivery Cell of the Exchange, the
Exchange has designed and developed a client database. All member brokers whose clients / sub-
brokers have introduced fake / forged shares are required to lodge a FIR / Police complaint against their
clients and also report the same to the Exchange. The information of such clients is called for in a
prescribed format. As per the scheme the members have to collect detailed information about the clients.
These details are incorporated in the database, which is downloaded to the members, as a precautionary
measure. The member brokers at the time of admitting new clients can refer to the client caution
database for further verification.

4. Verification of shares at members office :

The Risk Management Committee has outlined a process for minimising the risks arising out of Fake/
forged /stolen shares introduced by the clients of the member brokers.

As per the procedure outlined issued by the Exchange, in case the transaction in a Security with one
particular client in a settlement exceeds Rs. 10 lakhs then the member brokers are required to send the
photocopies of the transfer - deeds and the share certificates to the Company / Registrar for verification
of the material particulars. The members can select a random sample for the same from the lot. A similar
procedure should also be followed in case the shares worth more than Rs. 10 lakhs are received from
the Clearing House during pay-out in one Security.

The basic idea behind the introduction of this procedure is to prevent Fake/ forged/stolen shares from
being introduced in the market. The Exchange issued a notice outlining the procedure to be followed.
The above procedure is an important Risk Management Tool especially where there exists a large
volume of deliveries. The Risk Management Department acts as a facilitator in this regard and has
written to all "A" group and B1 group companies in this regard seeking their co-operation.

5. Inspection :

The department is carrying out inspection of the member brokers records as regards compliance of the
risk management procedures.