Tuesday, February 26, 2013

Excellent Trading School - 13 - Understanding the Stock Index

Understanding the Stock Index

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. A stock market index is created by selecting a group of stocks that are representative of the entire market or a specified sector or segment of the market. It is calculated with reference to a base period and a base index value. The beginning value or base of the index is usually set to a number such as 100 or 1000. For example, the base value of the Nifty was set to 1000 on the start date of November 3, 1995.

Stock market indices are meant to capture the overall behavior of equity markets. Stock
market indices are useful for a variety of reasons. Some uses of them are:
1. As a barometer for market behaviour,
2. As a benchmark for portfolio performance,
3. As an underlying in derivative instruments like Index futures, Index options, and
4. In passive fund management by index funds/ETFs

Economic Significance of Index Movements
Index movements reflect the changing expectations of the stock market about future dividends of the corporate sector. The index goes up if the stock market perceives that the prospective dividends in the future will be better than previously thought. When the prospects of dividends in the future become pessimistic, the index drops. The ideal index gives us instant picture about how the stock market perceives the future of corporate sector. Every stock price moves for two possible reasons:
1. News about the company- micro economic factors (e.g. a product launch, or the closure of a factory, other factors specific to a company)
2. News about the economy – macro economic factors (e.g. budget announcements,
changes in tax structure and rates, political news such as change of national government,
other factors common to all companies in a country)

The index captures the second part, the movements of the stock market as a whole (i.e. news about the macroeconomic factors related to entire economy). 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. The correct method of averaging is that of taking a weighted average, giving each stock a weight proportional to its market capitalization.

Example: Suppose an index contains two stocks, A and B. A has a market capitalization of Rs.1000 crore and B has a market capitalization of Rs.3000 crore. Then we attach a weight of 1/4 to movements in A and 3/4 to movements in B.

Index Construction Issues
A good index is a trade-off between diversification and liquidity. A well diversified index is more representative of the market/economy. There are however, diminishing returns to
diversification. 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. The more serious problem lies in the stocks which are included into an index when it is broadened. If the stock is illiquid, the observed prices yield contaminated information and actually worsen an index.

The computational methodology followed for construction of stock market indices are (a) Free Float Market Capitalization Weighted Index, (b) Market Capitalization Weighted index and the (c) Price Weighted Index.

Free Float Market Capitalization Weighted Index: The free float factor (Investible Weight Factor), for each company in the index is determined based on the public shareholding of the companies as disclosed in the shareholding pattern submitted to the stock exchange by these companies1 . The Free float market capitalization is calculated in the following manner:
Free Float Market Capitalization = Issue Size * Price * Investible Weight Factor
The Index in this case is calculated as per the formulae given below:
 Index = (Free float current market capitalization / free float base market capitalization ) * Base value

The India Index Services Limited (IISL), a joint venture between the NSE and CRISIL, introduced the free float market capitalization methodology for its main four indices, viz., S&P CNX Nifty, S&P CNX Defty, CNX Nifty Junior and CNX 100. With effect from May 4, 2009 CNX Nifty Junior and with effect from June 26, 2009, S&P CNX Nifty, CNX 100 and S&P CNX Defty are being calculated using free float market capitalisation.

Market Capitalisation Weighted Index: In this type of index calculation, each stock in the index affects the index value in proportion to the market value of all shares outstanding. In this the index would be calculated as per the formulae below:
Where, Current market capitalization = Sum of (current market price * Issue size) of all securities in the index.

Base market capitalization = Sum of (market price * issue size) of all securities as on base date.

Similarly, in a price weighted index each stock influences the index in proportion to its price per share. The value of the index is generated by adding the prices of each of the stocks in the index and dividing then by the total number of stocks. Stocks with a higher price will be given more weight and, therefore, will have a greater influence over the performance of the index.

Desirable Attributes of an good Index:
A good market index should have three attributes:
• It should capture the behaviour of a large variety of different portfolios in the market.
• The stocks included in the index should be highly liquid.
• It should be professionally maintained.

The level of diversification of a stock index should be monitored on a continuous basis. It should ensure that the index is not vulnerable to speculation. Stocks with low trading volume or with very tight bid ask spreads are illiquid and should not be a part of index. The index should be managed smoothly without any dramatic changes in its composition.
Impact cost
Market impact cost is a measure of the liquidity of the market. It reflects the costs faced when Actually trading an index. Suppose a stock trades at bid 99 and ask 101. We say the “ideal” price is Rs. 100. Now, suppose a buy order for 1000 shares goes through at Rs102 Then we say the market impact cost at 1000 shares is 2%. If a buy order for 2000 shares goes through at Rs.104, we say the market impact cost at 2000 shares is 4%. For a stock to qualify for possible inclusion into the S&P CNX Nifty, it has to have market impact cost of below 0.50% when doing S&P CNX Nifty trades of two crore rupees. This means that if S&P CNX Nifty is at 2000, a buy order goes through at 2001,
 i.e. 2000+(2000*0.0005) and a sell order gets 1999, i.e. 2000-(2000*0.0005).

Applications of Index
Besides serving as a barometer of the economy/market, the index also has other applications in finance. Various products have been designed based on the indices such as the index derivatives, index funds and the exchange traded funds .

Index derivatives: Index derivatives are derivative contracts which have the index as the underlying. The most popular index derivative contracts the world over are index futures and index options. NSE’s market index, the S&P CNX Nifty was scientifically designed to enable the launch of index based products like index derivatives and index funds.
Following are the reasons of popularity of index derivatives:
• Institutional and large equity-holders need portfolio-hedging facility. Index-derivatives
are more suited to them and more cost-effective than derivatives based on individual
stocks. Pension funds in the US are known to use stock index futures for risk hedging
• Index derivatives offer ease of use for hedging any portfolio irrespective of its
• Stock index is difficult to manipulate as compared to individual stock prices, more so
in India, and the possibility of cornering is reduced. This is partly because an individual
stock has a limited supply, which can be cornered.
• Stock index, being an average, is much less volatile than individual stock prices. This
implies much lower capital adequacy and margin requirements.
• Index derivatives are cash settled, and hence do not suffer from settlement delays and
problems related to bad delivery, forged/fake certificates.

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