Introduction to Index
Index is a statistical indicator that measures changes in the economy in general or in particular areas. In case of financial markets, an index is a portfolio of securities that represent a particular market or a portion of a market. Each Index has its own calculation methodology and usually is expressed in terms of a change from a base value. The base value might be as recent as the previous day or many years in the past. Thus, the percentage change is more important than the actual numeric value.
Financial indices are created to measure price movement of stocks, bonds, T‐bills and other type of financial securities. More specifically, a stock index is created to provide market participants with the information regarding average share price movement in the market. Broad indices are expected to capture the overall behaviour of equity market and need to represent the return obtained by typical portfolios in the country.
* A stock index is an indicator of the performance of overall market or a particular sector.
* It serves as a benchmark for portfolio performance ‐ Managed portfolios, belonging either to individuals or mutual funds; use the stock index as a measure for evaluation of their performance.
* It is used as an underlying for financial application of derivatives – Various products in OTC and exchange traded markets are based on indices as underlying asset.
Types of Stock Market Indices
Indices can be designed and constructed in various ways. Depending upon their methodology, they can be classified as under:
Market capitalization weighted index
In this method of calculation, each stock is given weight according to its market capitalization. So higher the market capitalization of a constituent, higher is its weight in the index. Market capitalization is the market value of a company, calculated by multiplying the total number of shares outstanding to its current market price. For example, ABC company with 5,00,00,000 shares outstanding and a share price of Rs 120 per share will have market capitalization of 5,00,00,000 x 120 = Rs 6,00,00,00,000 i.e. 600 Crores.
LEARNING OBJECTIVES: After studying this chapter, you should know about: Meaning of Index and its significance Different types of stock market indices Index management and maintenance Application of indices
18
Let us understand the concept with the help of an example: There are five stocks in an index. Base value of the index is set to 100 on the start date which is January 1, 1995. Calculate the present value of index based on following information.
Free‐Float Market Capitalization Index
In various businesses, equity holding is divided differently among various stake holders – promoters, institutions, corporates, individuals etc. Market has started to segregate this on the basis of what is readily available for trading or what is not. The one available for immediate trading is categorized as free float. And, if we compute the index based on weights of each security based on free float market cap, it is called free float market capitalization index. Indeed, both Sensex and Nifty, over a period of time, have moved to free float basis. SX40, index of MSEI is also a free float market capitalization index.
Price‐Weighted Index
A stock index in which each stock influences the index in proportion to its price. Stocks with a higher price will be given more weight and therefore, will have a greater influence over the performance of the Index.
Equal Weighted Index
An equally‐weighted index makes no distinction between large and small companies, both of which are given equal weighting. The value of the index is generated by adding the prices of each stock in the index and dividing that by the total number of stocks. Let us take the same example for calculation of equal weighted index.
- Application of Indices
Traditionally, indices were used as a measure to understand the overall direction of stock market. However, few applications on index have emerged in the investment field. Few of the applications are explained below.
Index Funds
These types of funds invest in a specific index with an objective to generate returns equivalent to the return on index. These funds invest in index stocks in the proportions in which these stocks exist in the index. For instance, Sensex index fund would get the similar returns as that of Sensex index. Since Sensex has 30 shares, the fund will also invest in these 30 companies in the proportion in which they exist in the Sensex.
Index Derivatives
Index Derivatives are derivative contracts which have the index as the underlying asset. Index Options and Index Futures are the most popular derivative contracts worldwide. Index derivatives are useful as a tool to hedge against the market risk.
Exchange Traded Funds
Exchange Traded Funds (ETFs) is basket of securities that trade like individual stock, on an exchange. They have number of advantages over other mutual funds as they can be bought and sold on the exchange. Since, ETFs are traded on exchanges intraday transaction is possible. Further, ETFs can be used as basket trading in terms of the smaller denomination and low transaction cost. The first ETF in Indian Securities Market was the Nifty BeES, introduced by the Benchmark Mutual Fund in December 2001. Prudential ICICI Mutual Fund introduced SPIcE in January 2003, which was the first ETF on Sensex.
- Index management
Index construction, maintenance and revision process is generally done by specialized agencies. For instance, NSE indices are managed by a separate company called “India Index Services and Products Ltd.” (IISL). Index construction is all about choosing the index stocks and deciding on the index calculation methodology. Maintenance means adjusting the index for corporate actions like bonus issue, rights issue, stock split, consolidation, mergers etc. Revision of index deals with change in the composition of index as such i.e. replacing some existing stocks by the new ones because of change in the trading paradigm of the stocks / interest of market participants.
Index Construction A good index is a trade‐off between diversification and liquidity. A well diversified index reflects the behaviour of the overall market/ economy. While diversification helps in reducing risk, beyond a point it may not help in the context. Going from 10 stocks to 20 stocks gives a sharp reduction in risk. Going from 50 stocks to 100 stocks gives very little reduction in risk. Going beyond 100 stocks gives almost zero reduction in risk. Hence, there is little to gain by diversifying beyond a point.
Stocks in the index are chosen based on certain pre‐determined qualitative and quantitative parameters, laid down by the Index Construction Managers. Once a stock satisfies the eligibility criterion, it is entitled for inclusion in the index. Generally, final decision of inclusion or removal of a security from the index is taken by a specialized committee known as Index Committee.
***********
That’s it for this post. Do check out my other posts to gain more knowledge about finance.
Please do let me know if there is any other concept in finance you want me to write an article on, I will try my best to explain it in simpler terms.
Also, feel free to ask questions in the comment section. Will be happy to help you out :)
PS: The analogy I have used might not be 100% correct but it’s easy to understand things with a simpler analogy.
Feel free to connect me on LinkedIn : https://www.linkedin.com/in/
Comments
Post a Comment