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FINANCIAL DERIVATIVE AND RISK MANAGEMENT

ASSIGNMENT-1: STOCK MARKET I NDI CES

WHAT IS A STOCK MARKET INDEX?

A stock market index is a statistical  measure of the relative value of a group of stocks

in numerical terms. It shows how  specified portfolios of share prices are moving inorder to give an indication of market trends. It is a basket of securities and the average

 price movement  (typically a weighted average) of the basket of securities indicates the

index movement, whether upwards or downwards. It is a tool used by investors and

financial managers to describe the market, and to compare the return on

specific investments. Each index has its own calculation methodology and is usually

expressed in terms of a change from a base value. Thus, the percentage change is

more important than the actual numeric value. Thus, we can say an index is animaginary portfolio of securities representing a particular market or a portion of it.

Stock market indexes are meant to capture the overall behaviour of equity markets.

A stock market index is created by selecting a group of stocks that are representative

of the whole market or a specified sector or segment of the market. An Index is

calculated with reference to a base period and a base index value. An Index is used to

give information about the price movements of products in the financial, commodities

or any other markets.

ARE THERE ANY DIFFERENCES BETWEEN THE INDICES?

The indices are different from each other to a certain extent. Like some times, the

Sensex may move up by 100 points but Nifty may move up by only 40 points. Themain factors that differentiates one from the other are-

1.  The number of component stocks: the number of stocks in an index influences

the behaviour of the index. If the number of component stocks is larger, it

would be a representative sample capable of reflecting the market movement.

Sensex has 30 stocks whereas Nifty has 50 stocks.

2. 

The composition of the stocks:  it would reflect market movement as well asmacroeconomic changes. In order to show the market movement in batter

manner, scrip whose market interest has dropped would be replaced by others.Sensex stocks represent large, well-established and financially sound

companies across key sectors. Nifty accounts for stocks from 23 sectors of the

Indian economy. The criteria for selection of both the indices differ from each

other.

3.  The weights:  the weight assigned to each company’s scrip also influences the

movement of index. Both Nifty and Sensex is calculated using the "Free-float

Market Capitalization" methodology, which takes into consideration only those

shares issued by the company that are readily available for trading in the

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market. It generally excludes promoters' holding, government holding, strategic

holding and other locked-in shares that will not come to the market for tradingin the normal course.

4.   Base year: the choice of the base year also leads to variation among the indices.

Base year closer to the current year would reflect market movement effectively.The base period of Sensex is 1978-79 and the base value is 100 index points

whereas, the base period of Nifty is 1995 and the base value is 1000 index points.

Except for the above discussed points there is not much difference between Sensexand Nifty calculation methodology.

The formula for calculating the Index = (Sum of free flow market capitalization

of X benchmark stocks) * Index Factor

Where, X= number of component stocks,

Index Factor = 100/Index value,Index value is the market capitalization value during base year of the stock exchange.

WHAT ARE THE ATTRIBUTES OF A STOCK MARKET INDEX?

A stock index is a way of expressing the overall performance of a set of different

stocks in the form of a single figure. It serves two main purposes for investors. The

first is informational, providing an easy-to-understand way of tracking overall marketmovements. The second is as the basis of financial products, where either the price of

the product or the return it offers investors is linked to a specific index.

1.   Representative Selection: The representative sample of stocks acts as a micro-

version of the larger market in nearly all respects. It means that within the

 parameters of an index, including small companies, the companies selected

should be the most representative within that field. The more diverse the

sample, the more representative the overall average becomes.

2.   Basis and Weighting: An accurate index relies upon weighting –  the concept of

compensating for differences in size and numbers of outstanding shares that

equalize the very different price changes. If the return figures are not weighted,

the index may not be representative of the market as a whole. Thus, it clearly

explains the basis on which the index operates and how it reflects the market.3.   Easily Tradable: The stocks included in an index are the ones that usually have

high levels of both demand and supply. It means that somebody wanting to buy

or sell each stock should usually be able to find a trading partner without too

much delay. Stocks that aren't easily tradable don't necessarily reflect the

overall performance of a market and can thus distort an index.