Understanding the Index

1What an index is

An index is a statistical measure of change in a market or part of it. In financial markets it is a portfolio of securities representing a market or segment, usually expressed relative to a base value. The percentage change matters more than the number itself. A broad stock index should capture the overall behaviour of the equity market and the returns of a typical portfolio.

Remember

• Index level is relative to a base; watch the percentage change.

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2Why stock indices matter

A stock index:

• shows how the market or a sector is performing;
• is a benchmark for portfolios and mutual funds;
• is an underlying for derivatives, both OTC and exchange-traded.

Remember

• Indicator, benchmark, underlying.

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3Ways to build an index

Market capitalisation weighted: each stock's weight = its market cap (shares × price) ÷ total market cap. Bigger companies count more.

Example Five stocks with a total market cap of ₹18,800 lakh on the base date (index = 100). Prices rise and total market cap becomes ₹42,500 lakh. New index = 42,500 ÷ 18,800 × 100 = 226.06, a rise of 126.06%.

Free-float market capitalisation: uses only shares readily available for trading (excluding promoter and other locked holdings). Most global indices have moved to this, including Sensex, Nifty and SX40.

Price weighted: each stock counts in proportion to its price; index = sum of prices ÷ number of stocks. Examples: Dow Jones Industrial Average and Nikkei 225.

Example Base prices 150, 300, 450, 100 and 250 → index = 1,250 ÷ 5 = 250. Current prices 650, 450, 600, 350 and 500 → 2,550 ÷ 5 = 510. Rise = (510 − 250) ÷ 250 = 104%.

Equal weighted: every stock has the same weight at the start. As prices move, weights drift, so the manager sells the winners and buys the losers to restore equal weights.

Example Four stocks with ₹30,000 each (₹1,20,000 total) grow to ₹1,46,000. Index = 146,000 ÷ 120,000 × 100 = 121.67 (up 21.67%).

Remember

• Sensex and Nifty: free-float market cap weighted.
• Dow Jones and Nikkei: price weighted.

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4What makes a good index, and impact cost

A good index reflects market behaviour, is computed by an independent third party free of any market participant's influence, and is professionally maintained.

Liquidity means large orders can be executed without moving the price. The bid-ask spread shows the cost of a small trade; larger orders "walk the book" and get worse prices.

Impact cost is the percentage by which the actual buying or selling price is worse than the ideal price (the average of the best bid and best offer). It varies with order size and differs for buying and selling. Lower impact cost means higher liquidity.

Example Best bid ₹9.80, best offer ₹9.90, so ideal price = ₹9.85. Buying 1,500 shares takes 1,000 at ₹9.90 and 500 at ₹10.00: average ₹9.9333. Impact cost = (9.9333 − 9.85) ÷ 9.85 × 100 = 0.84%.

Exam trap Impact cost is high when liquidity is poor. It is not a fee anyone charges; it arises from lack of liquidity.

Remember

• Ideal price = (best bid + best offer) ÷ 2.

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5Building, maintaining and revising an index

Specialist agencies manage indices: Asia Index Pvt Ltd for BSE indices and NSE Indices Ltd for NSE indices.

• Construction: choosing stocks and the method. A good index balances diversification and liquidity. Going from 10 to 20 stocks cuts risk sharply; going from 50 to 100 barely helps; beyond 100, almost nothing. An index committee makes final decisions on inclusion and exclusion.
• Maintenance: adjusting for corporate actions (bonus, rights, split, consolidation, merger) so the index stays comparable over time.
• Revision: changing constituents to keep the index representative.

SEBI (October 2025) set prudential norms for derivatives on non-benchmark indices (such as Bank Nifty, Fin Nifty and Bankex): at least 14 constituents, top constituent weight ≤ 20%, top three combined ≤ 45%, and a descending weight structure. Bankex and Fin Nifty had to comply by 31 December 2025 in one go; Bank Nifty by 31 March 2026 in four monthly tranches, each tranche reducing the excess weight by the remaining excess divided by the tranches left.

Example Top stock at 28% with a 20% cap: the excess of 8% is cut by 8 ÷ 4 = 2% in the first month (to 26%). If it drifts to 25.5%, the next cut is (25.5 − 20) ÷ 3 = 1.83%, and so on.

Remember

• Non-benchmark index derivatives: 14 stocks minimum, top ≤ 20%, top three ≤ 45%.

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6Major Indian indices and how indices are used

Popular indices: Sensex, Nifty 50, SX40, Sensex Next 50, Nifty Next 50, BSE 100/200/500 and Nifty 100/200/500.

Uses:

• Index funds hold the index stocks in index proportions to match the index return, apart from a small tracking error (from expenses and cash held for redemptions). A Nifty fund holds the 50 Nifty stocks; a Sensex fund the 30 Sensex stocks.
• Index derivatives: index futures and options, the most popular derivatives worldwide, used to hedge market risk.
• Exchange-traded funds (ETFs): baskets that trade like shares on an exchange, allowing intraday trading in small denominations at low cost.

Remember

• Tracking error comes from expenses and cash holdings.

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