What are Stock Market indices? How do they work?

What are Stock Market indices How do they work
What are Stock Market indices How do they work

Benchmarks are essential for comparison. Relative comparison helps give an overall picture of the performance. The performance of a portfolio gets measured when compared to another portfolio or a general market.

Benchmarks are yardsticks or reference points for comparison. The Equity Market has many listed companies, and they get added periodically. A broad market index is constructed by selecting Equity stocks that represent the entire market, sector, or segment. Besides the broad market indices, there are sectoral indices, thematic indices, etc.,

Broad utility indices are used for:

  • Historical comparison of the Stock Market with other asset classes like gold, bonds, etc.,
  • Benchmark for comparing the performance of Equity Funds or portfolios.
  • It reflects the overall economic health of the country.
  • It reflects investor sentiment. Positive sentiment leads to indices going up and vice versa.
  • Derivative instruments like Futures & Optionsdepends on indices to help hedge the portfolio.

Construction of index

Indexes are modelled based on the index weights method. Three models followed here are:

  • Price weighted: Companies with larger current market prices enjoy higher weights. This ignores how big or small the company is.
  • Equal weighted: Here, all companies are given equal weights ignoring the company’s size again.
  • Market-cap weighted: This is the most preferred model. The market-cap-based model uses the total market capitalisation, and weights are assigned while the index gets calculated.

Indian indexes get calculated based on market-cap weights

In India, a float-adjusted market cap gets used by both the National Stock Exchange and Bombay Stock Exchange. The free-float market cap gets used more than the total float. Free float means those shares in a company held by the public are available for trading. Promoter holding, government holdings, associate and group companies, employee welfare trusts, shares in lock-in period, etc., are excluded from the total outstanding shares.

Example: For XYZ Ltd  
 Full floatShares%
Total equityShares (A)1,00,00,000100
 Free floatShares%
Shareholding of promoter and promoter group19,75,00019.75
Government holding based on strategic investor50,0000.50
Promoters hold shares through ADR/GDRs.2,50,0002.50
Equity held by associate/group companies (cross-holdings)12,5750.13
Employee Welfare Trusts1,45,9871.46
Shares under the lock-in category14,78,50014.79
Total (B)39,12,062 
Investible Weight Factors (IWFs) (A)-(B)60,87,93860.88

In the above example, if the current market price is Rs.200 then the market capitalisation will be:

Market capitalisation = Total shares X Current market price

                                          = 1,00,00,000 X 200

                                          = Rs.2,00,00,00,000

Free-float market capitalisation = Market capitalisation X IWF(%)

                                                             = Rs.2,00,00,00,000 X 60.88%

                                                             = Rs. 1,21,76,00,000

Nifty 50 is an index including 50 companies’ float-adjusted market capitalisation weighted index and covers significant sectors of the Indian economy. At the same time, the Sensex is a basket of 30 companies indexed similarly.

The base year and value for Nifty 50 share price are November 3, 1995, and 1,000. Meanwhile, the Sensex is September 1, 2003, and 100. There are other entry criteria like liquidity, listing history, trading frequency, liquidity, etc., that go into selecting stocks in the index.

An example of driving home

CompanyMarket Cap (a)IWF % (b)Free float (c)= (a)x(b)Weightage (d)= (c)/(total (c)Weighted free float market cap (c) x (d)
A Ltd2000000.611220000.4756809.16
B Ltd1500000.5750000.2921469.47
C Ltd1000000.65650000.2516125.95
Total450000 262000 94404.58
Current market cap94404.58    
CompanyMarket Cap (a)IWF % (b)Free float (c)= (a)x(b)Weightage (d)= (c)/(total (c)Weighted free float market cap (c) x (d)
A Ltd1000000.51510000.199927.48
B Ltd750000.45337500.134347.57
C Ltd500000.6300000.113435.11
Total225000 114750 17710.16
Base year market cap17710.16    
Base year index Value1000
Current index value5330.53    ((Current market cap/base year market cap) X Base year index value)

Keywords: Nifty 50, Nifty 50 share price Disclaimer – ICICI Securities Ltd. ( I-Sec). Registered office of I-Sec is at ICICI Securities Ltd. – ICICI Venture House, AppasahebMarathe Marg, Prabhadevi, Mumbai – 400 025, India, Tel No: 022 – 6807 7100. The contents herein above shall not be considered as an invitation or persuasion to trade or invest.  I-Sec and affiliates accept no liabilities for any loss or damage of any kind arising out of any actions taken in reliance thereon. The contents herein above are solely for informational purpose and may not be used or considered as an offer document or solicitation of offer to buy or sell or subscribe for securities or other financial instruments or any other product. Investments in securities market are subject to market risks, read all the related documents carefully before investing. The contents herein mentioned are solely for informational and educational purpose.