Derivatives & Risk Management - 2 - Market Index

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2. Market Index

V. Shankar



Index gives an idea on how the market isfaring

Product of innovation – creation of indexfunds and index derivatives

Facilitates hedging of a portfolio of underlying assets

Enables forecasting of future throughspeculation

V. Shankar/20.07.08



Measures change in a set of values over aperiod of time

A good stock market index should capture the

overall market behavior Index should be well diversified, yet highly

liquidUses of market index

• Barometer for market behavior • Benchmark for portfolio performance

• Underlying for index options and futures• Allows passive fund management by index funds

V. Shankar/20.07.08



Reflect the changing expectations of thestock market about future dividends of thecorporate sector

Stock price movement influenced by:• News about the company (acquisition/takeover, new

product launch, new client/order acquisition ,modernization program, etc.)

• News about the country (budget announcements, etc.)Function of index is to capture news about

the country accurately – after eliminatingstock-specific variations

V. Shankar/20.07.08



A good index is a trade-off betweendiversification and liquidity

Going from 10 stocks to 20 - sharpreduction in risk. Going from 50 stocks to100 - very little reduction. Going beyond100 – almost zero reduction.

Critical issue is choice of stock for inclusion in the index – illiquid stockactually contaminates the index

V. Shankar/20.07.08



Price-weighted index• Each stock in the index is assigned a weight in

proportion to its stock price

• E.g. Dow Jones Industrial AverageMarket capitalization-weighted index

• Each stock in the index affects the index value inproportion to the market value of all itsoutstanding shares

• “Free float” method is a refinement

E.g. S&P500, FTSE100, S&P CNX Nifty, Sensex

V. Shankar/20.07.08



Index = Current MC--------------- x Base valueBase MC

Where

Current MC = Sum of (current MP xoutstanding shares) of all index securities

Base MC = Sum of (MP x issue size) of allindex securities in base year

V. Shankar/20.07.08



Should capture behavior of portfolios• Should reflect behavior of overall market as well as of

diverse portfolios• Diversification of index basket to minimize individual

stock/industry risk Should include liquid stocks

• Trading frequency, trading volume and impact cost areattributes of liquidity

Should be managed professionally• Periodic review to determine need for change in index

basket• Small changes in composition so as not to alter the

fundamental characteristic of the index• Time series date should be available

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Barometer of the economy / market Index derivatives

• Derivative contracts having index as the underlying (e.g. index futures andindex options)

Index funds• A fund that attempts to replicate index returns

• Investment in index stocks in same proportion as in the index Exchange Traded Funds

• Introduced in USA in 1993• Over US$ 500 billion invested in more than 500 ETFs• About 60% of trading on Amex is from ETFs – Spiders based on S&P500,

Cubes based on Nasdaq100, iSHARES based on MSCI and Tracks basedon Hang Seng

• Provide exposure to index/basket of securities by trading as a single stock• Can be bought and sold at prices usually close to intraday NAV of the

scheme• Nifty BeEs based on S&P CNX Nifty launched in December 2001 by

Benchmark Mutual Fund

V. Shankar/20.07.08



V. Shankar/20.07.08

Derivatives & Risk Management - 2 - Market Index

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