How are Nifty and Sensex created and what do they indicate?

March 23, 2019 9:30 AM

The Nifty and the Sensex have become synonymous with the performance of the market. But, have you ever wondered, what are these indices and what exactly do they represent?

stock market, stock market in india, Nifty, Sensex, what is nifty, what is Sensex, stock market investment, share marketThe Nifty and the Sensex use a sample of stocks to represent the market as a whole.

In a way, the Nifty and the Sensex have become synonymous with the performance of the market. If you are at a gathering and if others realize that you are a stock market analyst, the first question would be “Market kya lagta hai”? It may sound generic, but they are basically asking for your view on the index. Old timers still prefer the Sensex whereas the post-derivative traders are more comfortable with the Nifty. The Sensex went from 100 in 1981 to 38,000 in 2018. Similarly the Nifty moved from 1000 in 1995 to 11,000 in 2018. The one thing you can safely concluded that equity investing appears to be a good idea in the long run. But, have you ever wondered, what are these indices and what exactly do they represent?

What exactly do the Nifty and the Sensex represent?

Like any index, the Nifty and the Sensex are also based on a representative sample of companies. Here are 5 key things you need to know about these indices…

# Both the Nifty and the Sensex are calculated with reference to a base year value. While the Nifty assigns a base value of 1000 and uses 1995 as the base year, the Sensex assigns a base value of 100 and uses 1979 as the base year. The Nifty at 11,000 means the value creation is 11 times since 1995.

# The Nifty and the Sensex use a sample of stocks to represent the market as a whole. The Nifty has 50 stocks in the index while the Sensex has 30 stocks. These components of the Nifty and the Sensex are subject to change over time and the index is regularly reconstituted to reflect the current market situation. For example, banks and IT were not part of the index 25 years ago, but today they constitute more than 50% of the index.

# The currency used for the calculation of the Nifty and the Sensex is INR. All changes in the Nifty and the Sensex are necessarily denominated in INR only and the impact of foreign currency value shifts are not captured by these indices. That means a 50% return on the Nifty with 10% currency depreciation will imply 40% dollar returns.

# Indices like the Nifty and the Sensex are not only an index of the market but also can be traded in the futures and the options segment. That means they are also an underlying asset for stock futures and stock options. The Nifty is also traded on the Singapore Exchange (SGX) and the SGX Nifty is denominated in US dollars.

# The Nifty and the Sensex are weighted on free float market cap. That means if there are two companies with the same market capitalization but one company has a much higher free float, then that company will have a higher impact on the index.

Focus on the Nifty creation and monitoring methodology

An index is not just a random number that is generated through a high end algorithm. The Nifty and the Sensex have an Index Committee that regularly reviews the methodology of the index and regularly takes a view on inclusion and exclusion of stocks so as to make the index as representative as possible. Indices like the Nifty are based on the base year concept and the Nifty is calculated with reference to a base value of 1000 for the year 1995. Here are 6 things you need to understand about the Nifty construction methodology…

1. Nifty only considers those companies that are domiciled in India and listed on the NSE for the purpose of calculation of the Nifty index. Hence foreign companies or companies domiciled in other countries cannot be included in the Nifty Index. This is the basic condition for Nifty creation and maintenance.

2. Stocks in the Nifty index, as a portfolio, are representative of the key sectors driving economic growth of India. That explains why banking, IT, oil and auto have a high weightage in the Nifty. Nifty is calculated based on free-float market cap (excluding promoter holdings) and broadly intends to represent 65% of the total free float market cap of the market overall.

3. Only highly liquid stocks are included in the Nifty Index. Liquidity is measured by the Impact Cost. When the stock is traded the impact (price impact of the trade) should be less than 0.50% for a trade worth Rs 10 crore. The stock should be traded on all the trading days. The idea is to reduce the price impact of large trades.

4. Since the index insists on profitable existence and track record, what about the IPOs. When large and systemically important IPOs list on the NSE, they become eligible for inclusion in the Nifty within 3 months subject to their meeting the criteria with respect to free-float market cap and liquidity.

5. The Nifty index is neutral to any corporate actions. That means if the company announces a bonus issue, rights issue or a stock split then the index will also be proportionately adjusted to the extent of the corporate action to make the impact neutral. This is important to avoid any disruption in index futures and index options.

6. The Nifty Index constituents derive their weight on the basis of Free Float Market Cap. It means that companies with a higher Free Float market cap will have a much bigger impact on the index as compared to companies with lesser Free Float market cap. For example, RIL will have a bigger impact on Nifty than Sun Pharma. While ITC and HUL are both of similar size and business; the impact of ITC on the index is much larger due to its higher free float Market cap.

The additions and deletions of companies from the index are backed by a dedicated Index Committee which deliberates and then takes a decision on reconstitution of the index. For analysts, the index is a market representation. For traders, the index becomes a tool for executing a market view and also for hedging portfolio.

(By Amar Singh, Head Advisory, Angel Broking Ltd)

(Disclaimer: The above opinion is of the author and not of Angel Broking and is for reference only)

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