Understanding the index

Most of the derivatives volume in India is on the index, not on single stocks, so the exam asks how an index is built before it asks how to trade it. A distributor who can explain why Nifty moved 1% when a client's favourite stock moved 5% has understood weights, free float and impact cost, and that is this chapter.

What an index measures

A stock market index is a single number that summarises the price movement of a chosen basket of shares. It is expressed relative to a base period and a base value. The Nifty 50, maintained by NSE Indices, has a base date of 3 November 1995 and a base value of 1,000. The S&P BSE Sensex has 30 stocks, a base year of 1978-79 and a base value of 100. Both are broad, large-cap benchmarks and both serve as the underlying for the most liquid derivative contracts in the country.

An index serves four purposes that the exam names: it is a barometer of the market, a benchmark against which fund performance is judged, the underlying for index funds and ETFs, and the underlying for index futures and options. Because an index is a number and not a deliverable asset, every index derivative is settled in cash.

Construction: free-float market capitalisation

Early indices were price-weighted (a ₹5,000 share counted fifty times a ₹100 share) or full market cap weighted. Indian benchmarks today use free-float market capitalisation. Free float is the part of a company's shares that is actually available for trading in the market: total shares less promoter holdings, government holdings, strategic stakes and locked-in shares. The index provider publishes an investible weight factor (IWF) for each stock that captures this.

Notice that Stock A has the largest full market cap (₹50,000 crore) but Stock B carries the largest weight because more of it is free to trade. If Stock B rises 10% with the others flat, free-float market cap rises by ₹6,000 crore and the index rises 6.67%, to 10,667. The base market cap is adjusted whenever constituents change or corporate actions alter share counts, so that the index does not jump for reasons unrelated to prices.

Constituents are reviewed periodically (semi-annually for Nifty 50) against rules on listing history, trading frequency, free-float size and impact cost. Changes are announced in advance so that index funds and arbitrageurs can rebalance.

Impact cost: the liquidity test

Liquidity is not just volume. The exam measures it as impact cost: the percentage by which the price you actually pay for an order of a given size differs from the ideal mid-price. A stock with a tight order book has low impact cost; a stock where a ₹10 lakh order moves the price has high impact cost.

For inclusion in Nifty 50 a stock must have traded at an average impact cost of 0.50% or less for a reference order size (₹10 crore at present) in at least 90% of observations over the previous six months, as specified by the index provider. The impact cost of the index itself is published and is a key input to the eligibility of an index for derivatives trading.

Index as an underlying

An index derivative treats the index level as a price in rupees. Nifty at 24,000 with a lot of 75 gives a contract value of ₹18,00,000. On expiry the contract settles at the closing value of the index in the cash market, computed as the weighted average of the last 30 minutes of trading, and the difference from your trade price is paid in cash. Because the underlying is diversified, index derivatives are less volatile than single-stock derivatives, need lower margins per rupee of exposure, and are the natural tool for hedging a portfolio. SEBI permits derivatives only on indices that meet eligibility conditions on constituent count, weight concentration and the derivative eligibility of the constituents themselves.

Index funds and ETFs versus index derivatives

• An index fund or ETF actually buys the constituent shares in index weights. There is no expiry, no leverage, no margin, and the investor pays the full amount. Performance lags the index by the expense ratio and tracking error.
• An index future gives the same exposure for a margin of roughly a tenth of the contract value. It expires, so a long-term holder must roll each month and pay the cost of carry embedded in the futures price. Gains and losses are settled daily in cash.
• An index option gives one-sided exposure for a premium. The buyer can lose only the premium; the writer earns it but carries the risk.

For a retail investor who wants to own the market for years, the fund is the right product. For a fund manager who wants to cut exposure for a month without selling 50 stocks, the future is. The exam often frames this as a "which product suits this need" question, and the answer turns on horizon, leverage and the willingness to post margin.