NISM-Series-VIII: Equity Derivatives

Chapter 2: Understanding the Index

2.1 What is an Index?

An Index is a statistical indicator that tracks the performance of a basket of securities.

In stock markets, it represents the movement of selected stocks to reflect the overall market or a specific sector. Examples include Nifty 50 (top 50 stocks) and Sensex (top 30 stocks).

👉 Think of an index like a “thermometer” of the market. If the index rises, overall market sentiment is positive.

2.2 Significance of a Stock Index

Market Performance Indicator: Shows how the overall market or a sector is doing.
Benchmark for Portfolios: Mutual funds and other investment vehicles compare their returns against indices to measure performance.
Underlying for Derivatives: Index futures and options are based on indices, allowing for broad market hedging and speculation.

2.3 Types of Stock Market Indices

Indices are primarily categorized by how their constituent stocks are weighted:

Market Capitalization Weighted Index: The weight of a stock is determined by its market capitalization ($$ \text{Market cap} \div \text{Total market cap of index} $$). Larger companies have a greater influence on the index's movement. Examples include earlier versions of Sensex and Nifty.
Free-Float Market Cap Index: This is a more modern approach that only considers the shares available for public trading (excludes promoter holdings, government shares, etc.). This method more accurately reflects the supply and demand dynamics of the market. The current Nifty 50 and Sensex are based on this method.
Price-Weighted Index: The weight of a stock is determined by its share price. High-priced stocks have a disproportionate influence. A well-known example is the Dow Jones Industrial Average (DJIA) in the U.S.
Equal-Weighted Index: All stocks within the index are given an equal weight, regardless of their price or size. This approach requires frequent rebalancing to maintain the equal weighting.

2.4 Attributes of a Good Index

A well-designed index should have the following attributes:

It should be a true representative of the market behavior it intends to measure.
Its calculation should be independent and free from manipulation.
It must be professionally maintained.
It should have a low Impact Cost.

Impact Cost:

Impact cost measures the liquidity of the market.
It is the difference between the actual traded price and the ideal price (the average of the best bid and ask prices).
A lower impact cost indicates a more liquid market.

2.5 Index Management

Indices are managed by specialized agencies such as NSE Indices Ltd. (for Nifty) and Asia Index Pvt. Ltd. (for Sensex). Their key functions include:

Construction: Selecting stocks based on established criteria (e.g., size, liquidity, sector representation).
Maintenance: Adjusting the index for corporate actions like bonus issues, stock splits, and dividends.
Revision: Periodically replacing stocks to ensure the index remains representative of the market.

2.6 Major Indices in India

Some of the most prominent indices in the Indian market include:

S&P BSE Sensex (30 stocks)
Nifty 50
Nifty Next 50
Nifty 100, 200, 500
S&P BSE 100, 200, 500
SX40

2.7 Applications of Indices

Index Funds: These are mutual funds that passively replicate the portfolio of a specific index. For example, a Nifty 50 index fund holds all 50 stocks in the same proportion as the index.
Index Derivatives: Futures and Options contracts based on indices are used for hedging against overall market risk or for speculating on the direction of the market.
Exchange-Traded Funds (ETFs): Similar to index funds, ETFs are a basket of securities that track an index, but they are traded on a stock exchange like individual shares. They are known for their low cost and high liquidity.

✅ Key Takeaways:

An index is a market indicator.
Calculated in different ways: Market cap weighted, Free-float, Price-weighted, Equal-weighted.
A good index is representative, independently calculated, and liquid.
Impact Cost measures liquidity; a low impact cost indicates a highly liquid market.
Indices are used as benchmarks, underlying for derivatives, and for investment products like ETFs and Index Funds.