Stock Index

• An index is a number which measures the change in a set of values over a period of time. A
stock index represents the change in value of a set of stocks which constitute the index. Stock
market indexes are meant to capture the overall behavior 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.
 Advantages of Stock index

Stock market indices are useful for a variety of reasons

• They provide a historical comparison of returns on money invested in the stock market
against other forms of investments such as gold or debt.
• They can be used as a standard against which to compare the performance of an equity fund.
• It is a lead indicator of the performance of the overall economy or a sector of the economy
• Stock indexes reflect highly up to date information
• Financial products like exchange traded fund , Index fund , Index future are created based
stock index.
 Economic Significance of Index Movements

• Index movements reflect the changing expectations of the stock market about future dividends
of the corporate sector. The index goes up if the stock market perceives that the prospective
dividends in the future will be better than previously thought. When the prospects of
dividends in the future become pessimistic, the index drops. The ideal index gives us instant
picture about how the stock market perceives the future of corporate sector.
Every stock price moves for two possible reasons:
1. News about the company- micro economic factors (e.g. a product launch, or the closure of a
factory, other factors specific to a company)
2. News about the economy – macro economic factors (e.g. budget announcements, changes in
tax structure and rates, political news such as change of national government, other factors
common to all companies in a country)
The index captures the second part, the movements of the stock market as a whole (i.e. news about
the macroeconomic factors related to entire economy)
 Attributes of a good index

A good market index should have three attributes:

 It should capture the behavior of a large variety of different portfolios in the market.
 The stocks included in the index should be highly liquid.
 It should be professionally maintained.
 Index construction method

A good index is a trade-off between diversification and liquidity. A well diversified index is more
representative of the market/economy
There are three methods for index creation:

 Free Float Market Capitalization Weighted Index

 Market Capitalization Weighted index
 Price Weighted Index
 Free Float Market Capitalization Weighted Index

 The free float factor (Investible Weight Factor), for each company in the index is determined
based on the public shareholding of the companies as disclosed in the shareholding pattern
submitted to the stock exchange by these companies
 The Free float market capitalization is calculated in the following manner:
Free Float Market Capitalization = Issue Size * Price * Investible Weight Factor
The Index in this case is calculated as per the formulae given below:

Index=( Free float current market capitalization/Free float base market capitalization)*base value

The India Index Services Limited (IISL), a joint venture between the NSE and CRISIL,
introduced the free float market capitalization methodology for its main four indices, viz., S&P
CNX Nifty, S&P CNX Defty, CNX Nifty Junior and CNX 100. With effect from May 4, 2009
CNX Nifty Junior and with effect from June 26, 2009, S&P CNX Nifty, CNX 100 and S&P CNX
Defty are being calculated using free float market capitalization.
 Market Capitalization Weighted Index

• In this type of index calculation, each stock in the index affects the index value in proportion
to the market value of all shares outstanding. In this the index would be calculated as per the
formulae below:
Index= ( Current market capitalization/Base market capitalization)*base value

Where, Current market capitalization = Sum of (current market price * Issue size) of all securities
in the index.
Base market capitalization = Sum of (market price * issue size) of all securities as on base date
 Price Weighted Index

In a price weighted index each stock influences the index in proportion to its price per share. The
value of the index is generated by adding the prices of each of the stocks in the index and dividing
then by the total number of stocks.

Stocks with a higher price will be given more weight and therefore, will have a greater influence

over the performance of the index .

The Dow Jones Industrial Average (DJIA) is a price-weighted index
 Impact costs

• Liquidity in the context of stock markets means a market where large orders can be executed
without incurring a high transaction cost. The transaction cost referred here is not the fixed
costs typically incurred like brokerage, transaction charges, depository charges etc. but is the
cost attributable to lack of market liquidity as explained subsequently. Liquidity comes from
the buyers and sellers in the market, who are constantly on the look out for buying and selling
opportunities. Lack of liquidity translates into a high cost for buyers and sellers.
• The electronic limit order book (ELOB) as available on NSE is an ideal provider of market
liquidity. This style of market dispenses with market makers, and allows anyone in the market
to execute orders against the best available counter orders. The market may thus be thought of
as possessing liquidity in terms of outstanding orders lying on the buy and sell side of the
order book, which represent the intention to buy or sell.

• When a buyer or seller approaches the market with an intention to buy a particular stock, he
can execute his buy order in the stock against such sell orders, which are already lying in the
order book, and vice versa.
 An example of an order book for a stock at a point in time is detailed below:

Buy Sell

Sr.No. Quantity Price Quantity Price Sr. No.

1 1000 3.50 2000 4.00 5

2 1000 3.40 1000 4.05 6

3 2000 3.40 500 4.20 7

4 1000 3.30 100 4.25 8

• Here are four buy and four sell orders lying in the order book. The difference between the best
buy and the best sell orders (in this case, 0.50) is the bid-ask spread. If a person places an
order to buy 100 shares, it would be matched against the best available sell order at 4 i.e. he
would buy 100 shares for 4. If he places a sell order for 100 shares, it would be matched
against the best available buy order at 3.50 i.e. the shares would be sold at 3.5.

• Hence if a person buys 100 shares and sells them immediately, he is poorer by the bid-ask
spread. This spread may be regarded as the transaction cost which the market charges for the
privilege of trading (for a transaction size of 100 shares).

• Progressing further, it may be observed that the bid-ask spread as specified above is valid for
an order size of 100 shares up to 1000 shares. However for a larger order size the transaction
cost would be quite different from the bid-ask spread.
 Suppose a person wants to buy and then sell 3000 shares. The sell order will hit the
following buy orders:

No. Quantity Price

1 1000 3.50
2 1000 3.40
3 1000 3.40
 while the buy order will hit the following sell orders:

Quantity Price Sr. No.

2000 4.00 5
1000 4.05 6
• This implies an increased transaction cost for an order size of 3000 shares in comparison to
the impact cost for order for 100 shares. The "bid-ask spread" therefore conveys transaction
cost for a small trade.

• This brings us to the concept of impact cost. We start by defining the ideal price as the
average of the best bid and offer price, in the above example it is (3.5+4)/2, i.e. 3.75. In an
infinitely liquid market, it would be possible to execute large transactions on both buy and sell
at prices which are very close to the ideal price of 3.75. In reality, more than 3.75 per share
may be paid while buying and less than 3.75 per share may be received while selling. Such
percentage degradation that is experienced vis-à-vis the ideal price, when shares are bought or
sold, is called impact cost. Impact cost varies with transaction size.
 For example, in the above order book, a sell order for 4000 shares will be
executed as follows:

Sr. No. Quantity Price Value

1 1000 3.50 3500
2 1000 3.40 3400
3 2000 3.40 6800
Total value 13700
Wt. average price 3.43
• The sale price for 4000 shares is 3.43, which is 8.53% worse than the ideal price of 3.75.
Hence we say "The impact cost faced in buying 4000 shares is 8.53%".
• Definition
• Impact cost represents the cost of executing a transaction in a given stock, for a specific
predefined order size, at any given point of time.
• Impact cost is a practical and realistic measure of market liquidity; it is closer to the true cost
of execution faced by a trader in comparison to the bid-ask spread.
• It should however be emphasized that:
• impact cost is separately computed for buy and sell
• impact cost may vary for different transaction sizes
• impact cost is dynamic and depends on the outstanding orders
• where a stock is not sufficiently liquid, a penal impact cost is applied
• In mathematical terms it is the percentage mark up observed while buying / selling the desired
quantity of a stock with reference to its ideal price (best buy + best sell) / 2.
 Example A:
ORDER BOOK SNAPSHOT
Buy Quantity Buy Price Sell Quantity Sell Price
1000 98 1000 99
2000 97 1500 100
1000 96 1000 101
 Stock categorization

The National Stock Exchange classifies stocks broadly under six categories namely A,
B, T, S, TS and Z. The classification stocks are being done on the basis of their size,
liquidity and exchange compliance and, in some cases, also the speculative interest in
them.
 A -Category

 These are the most liquid shares among the whole lot of shares that are listed in the
NSE.
 These are companies which are rated excellent in all aspects; Market capitalization
is one key factor in deciding which scrip should be classified in Group A.
 Volumes are high and trades are settled under the normal rolling settlement (i.e. to
say intraday buy-sell deals are netted out)
 T-category

The "T" Group represents Securities which are settled on a trade-to-trade basis
as a surveillance measure.
Intra day trade is not allowed in this category of stocks. Each share
purchased/sold which are parts of this segment need to be taken delivery by
paying full amount. The settlement of scrips available in this segment is done
on a trade for trade basis and no netting off is allowed for the day.
 Z-category

• Stocks marked ‘Z’ grade are companies that have either not complied with the
exchange’s listing requirements or ones that have failed to redress investor
complaints. This grade also includes stocks of companies that have
dematerialisation arrangement with only one of the two depositories, CDSL and
NSDL. These stocks may perhaps be the riskiest in terms of various grades
accorded. For one, not much information would be available in the public domain
on these companies, making it tough to track them. Second, the low media coverage
that keeps them relatively hidden from public scrutiny also makes them more
vulnerable to insider trading. Third, since the companies already have a poor score
in redressing investor complaints, in all likelihood they may not lend their ears to
your grumbles, if any, as well.
 ‘B’ category

• This category comprises stocks that don’t fall in any of the other groups. These
counters see normal volumes and are settled under the rolling system. In all respects
these stocks resemble their counterparts in ‘A’ but for their size. Typically, stocks of
mid- and small market capitalisation come under this grade. Example: ABG
Shipyard, C&C Construction and Eicher Motors.
 Clearing & settlement
• The transactions in secondary market pass through three distinct phases, viz.,
trading, clearing and settlement. While the stock exchanges provide the platform for
trading, the clearing corporation determines the funds and securities obligations of
the trading members and ensures that the trade is settled through exchange of
obligations. The clearing banks and the depositories provide the necessary interface
between the custodians/clearing members for settlement of funds and securities
obligations of trading members.
 Entities involved in Clearing and Settlement

Clearing Member:
Clearing Members are responsible for settling their obligations as determined by the
clearing corporation. They do so by making available funds and/or securities in the
designated accounts with clearing bank/ depositories on the date of settlement
 Custodians

Custodians are clearing members but not trading members. They settle trades on behalf
of trading members, when a particular trade is assigned to them for settlement. The
custodian is required to confirm whether he is going to settle that trade or not. If he
confirms to settle that trade, then clearing corporation assigns that particular obligation
to him.
As on date, there are 13 custodians empanelled with NSCCL.
They are
 Deutsche Bank A.G
 HDFC Bank Ltd.
 Hong Kong Shanghai Banking Corporation Ltd.
 Infrastructure leasing and Financial Services Ltd.
 ICICI Bank Ltd
 Standard Chartered Bank Ltd.
 Stock Holding Corporation of India Ltd.
 Axis Bank Ltd.
 DBS bank Ltd.
 JP Morgan Chase Bank
 Kotak Mahindra Bank Ltd.
 State Bank of India
 Citibank N.A
 Orbis Financial Corporation Ltd.
 Clearing Banks

Clearing banks are a key link between the clearing members and Clearing
Corporation to effect settlement of funds. Every clearing member is required to
open a dedicated clearing account with one of the designated clearing banks.
Based on the clearing member’s obligation as determined through clearing, the
clearing member makes funds available in the clearing account for the pay-in
and receives funds in case of a pay-out.

There are 13 clearing banks of NSE, viz., Axis Bank Ltd, Bank of India Ltd.,
Canara Bank Ltd., Citibank N.A, HSBC Ltd, HDFC Bank Ltd., ICICI Bank
Ltd IDBI Bank Ltd., IndusInd Bank Ltd., Kotak Mahindra Bank, Standard
Chartered Bank, State Bank of India and Union Bank of India
 Depositories

• Depository holds securities in dematerialized form for the investors in their

beneficiary accounts.
• Each clearing member is required to maintain a clearing pool account with
the depositories. He is required to make available the required securities in
the designated account on settlement day. The depository runs an electronic
file to transfer the securities from accounts of the custodians/clearing
member to that of NSCCL and visa-versa as per schedule of allocation of
securities. The two depositories in India are the National Securities
Depository Ltd (NSDL) and Central Depository Services (India) Ltd
(CDSL).
Clearing and Settlement Process at NSE
1. Trade details from Exchange to NSCCL (real-time and end of day trade fi le).
2. NSCCL notifies the consummated trade details to clearing members/custodians
who affirm back. Based on the affirmation, NSCCL applies multilateral netting
and determines obligations.
3. Download of obligation and pay-in advice of funds/securities.
4. Instructions to clearing banks to make funds available by pay-in time.
5. Instructions to depositories to make securities available by pay-in-time.
6. Pay-in of securities (NSCCL advises depository to debit pool account of
custodians/CMs and credit its account and depository does it)
7. Pay-in of funds(NSCCL advises Clearing Banks to debit account of
custodians/CMs and credit its account and clearing bank does it)
8. Pay-out of securities (NSCCL advises depository to credit pool account of
custodians/CMs and debit its account and depository does it)
9. Pay-out of funds (NSCCL advises Clearing Banks to credit account of
custodians/CMs and debit its account and clearing bank does it)
10. Depository informs custodians/CMs through DPs.
11. Clearing Banks inform custodians/CMs.