Chapter 4: Stock Indices

4.1 Stock exchanges and stock indices

Primarily, the stock exchange provides a trading platform for investors to purchase securities. There are two major stock exchanges in India: NSE (National Stock Exchange) and BSE (Bombay Stock Exchange). A stock index measures the price changes of a specified group of stocks or stocks of a specified sector.

The primary index of BSE is the Sensex, comprising of 30 stocks. NSE has the Nifty Index consisting of 50 stocks. The BSE Sensex is older and most widely followed. Both these indices are calculated based on free-float market capitalization and contain heavily traded shares with largest market capitalization from key sectors.

4.2 Importance of stock index

The two main purposes of the stock index are to provide representation and benchmarking. Indexes are most often used as benchmarks against which investors and portfolio managers can measure their investment performance. The stock index represents the trend of the broad market or a certain sector of the market.

Nifty and Sensex are broad benchmark indices that are used to represent the Indian stock market across the world. Similarly, an index which consists of bank stocks will represent the price of banking stocks. I Investors can benchmark their portfolio performance with a suitable index consisting of securities similar to their portfolio. There are many popular indices worldwide such as Dow Jones, NASDAQ, Hang Seng, Nikkei etc.

4.3 Value of stock indices

We can compute stock market index value through changes in prices of selected stocks. Each stock in the index is assigned a particular weightage based on its market capitalization or price. The weight represents the extent of impact the stock’s price change has on the value of the index.

The following method is used for calculating the value of the index in India:

Step 1: The market capitalization of each of the companies comprising the index is first determined by multiplying the price of their stocks with the number of shares issued by that company.

Step 2: Market capitalization is multiplied by free-float factor to calculate free-float market capitalization. Free-float market capitalization means the market value of the holding which is available for trade in the market.  It excludes holdings available with promoters and institutions.

Step 3: The sum of the free-float market capitalization of all stocks in the index is divided by a similar sum calculated during the base period. The ratio is then multiplied by the index’s base value (typically 100 or 1000).  For example, the base year for Sensex is 1978-79 and the index value was 100.

Current Index Value = (Current total market value of index stocks* base year index value)/ (base year total market value of index stocks)

Let’s understand this with an example:

Assuming that there are three stocks, ABC, XYZ and PQR that form an index with the following values:

 Stock name No. of shares (A) Free-float factor (B) Market price as on base date (C) Free float market capitalization on base date (A*B*C) Market price on next day (D) Free float market capitalization on next day (A*B*D) ABC 1000000 0.45 80 36000000 75 33750000 XYZ 2000000 0.55 50 55000000 55 60500000 PQR 5000000 0.7 100 350000000 105 367500000 Total 441000000 461750000 Index Value 100 100*461750000/441000000 =104.71