Stock Prices
Stock market indices are the barometers of the stock market. They mirror the stock market behavior. With some 7,000 companies listed on the Bombay Stock Exchange, it is not possible to look at the prices of every stock to find out whether the market movement is upward or downward. The indices give a broad outline of the market movement and represent the market. Some of the stock market indices are BSE Sensex, BSE-2000, Dollex, NSE-50, CRISIL-500, Business Line 250 and RBI Indices of Ordinary Shares.
Usefulness of indices
1. Indices help to recognize the broad trends in the market.
2. Index can be used as a bench mark for evaluating the investors portfolio.
3. Indices function as a status report on the general economy. Impacts of the various economic policies are reflected on the stock market.
4. The investor can use the indices to allocate funds rationally among stocks. To earn returns on par with the market returns, he can choose the stocks that reflect the market movement.
5. Index funds and futures are formulated with the help of the indices. Usually fund managers construct portfolios to emulate any one of the major stock market index. ICICI has floated ICICI index bonds. The return of the bond is linked with the index movement.
6. Technical analysts studying the historical performance of the indices predict the future movement of the stock market. The relationship between the individual stock and index predicts the individual share price movement.
Differences between the indices
The indices are different from each other to a certain extent. Some times the Sensex may move up by 100 points but NSE Nifty may move up only 40 points. The main factors that differentiate one index from the other are given below: The number of the component stocks The composition of the stocks The weights Base year
The number of the component stocks
The number of stocks in an index influences the behavior of the index. If the number of component stocks were larger, it would be a representative sample capable of reflecting the market movement. The sensex has 30 scrips like the Dow Jones Industrial Average in the US. At the same time BSE-100 (National), BSE-200, the Dollex, the RBI index (338 stocks) and Nifty (50 stocks) are also widely used. Private organizations like CRISIL has constructed its own index and named it as CRISIL-500. From the above examples, it is clear that the number of scrips differs from one index to another and hence their movements vary. BSE National Index is considered more representative than Sensex because it has 100 stocks. Out of 100, 22 are quoted on the BSE and the rest are listed on the BSE and other exchanges.
The composition of the stocks
The composition of the stocks in the index should reflect the market movement as well as the macro economic changes. The Center for Monitoring Indian Economy maintains an index. It often changes the composition of the index to reflect the market movements in a better manner. Some of the scrip’s traded volume may fall down and at the same time some other stock may attract the market interest. In such a case the scrip that has lost the market, interest should be dropped and others must be added. Only then, the index would become more representative. In 1993, sensex dropped one company and added another. In August 1996, sensex was thoroughly revamped. Half of the scrips were changed. The composition of the Nifty was changed in April 1996 and 1998. In October 1998, the Nifty Junior Index composition has been changed. Recognizing the importance of the information technology scrips, they are included in the index.
The weights
The weight assigned to each company’s scrip also influences the movement of the index. The indices may be weighted with the price or value. The Dow Jones Industrial Average and Nikkei Stock Average of 225 scrips of Tokyo stock exchange are weighted with the price. A price-weighted index is computed by adding the current prices of the stocks in the stock exchange and dividing the sum by the total number of stocks. The stocks with high price influence the index more than the low priced stock in the sample. The number of stocks is usually adjusted for any stock splits, bonus and right issues.
In the value-weighted index, the total market value of the share is the weight. Most of the indices all over the world and in India except Economic Times Ordinary Share Index are weighted with the value. The scrip influences the index in proportion to its importance in the market. The price changes that occur in scrip with heavy market capitalization dominate the changes that occur in the index. The price changes caused by bonus issue or right of particular scrip are reflected in the index. With the bonus issue or right issue, the number of outstanding shares and their values used to change.
In an unweighted index, all stocks carry equal weights. The price or market volume of the scrip does not affect the index. The movement of the price is based on the percentage change in the average price of the stocks in the particular index. Here it assumes that equal amount of money is invested in each of the stocks in the index, Value Line Average in the US is calculated without weights but geometric mean is used in the computation instead of arithmetic mean.
Base Year
The choice of base year also leads to variations in the index. The base year differs from each other in the various indices. The base year should be free from any unnatural fluctuations in the market. If the base year is close to the current year, the index would be more effective in reflecting the changes in the market movement. At the same time if it is too close, the investor cannot make historical comparison.
Revision of sensex scrips
In 1998, the index committee of the BSE decided to give a wide representation to the four market favorites at its meeting. The need to have a broad-based and liquid index was felt with index futures on its way. The revised index has a representation of 15 industries. It has assigned the food and beverages sector a weight of 12. 75 percent with the market cap at Rs. 21,113 crores. Health care industry has been given a weight of 4. 70 percent, Consumer non-durables: 21. 74 percent, petrochemicals: 7. 92 percent, telecom: 7. 71 percent, power: 1. 98 percent, and hotel: 1. 10 percent.
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