Understanding the Index — the whole chapter in plain English

What an index is

An index is a statistical indicator that measures changes in the economy in general or in specific areas.

In financial markets it means something more concrete: an index is a portfolio of securities that represent a particular market or a portion of a market.

Every index has its own calculation methodology and is usually expressed as a change from a base value. That base might be as recent as the previous day or many years in the past.

Now the sentence that decides several exam questions:

The percentage change is more important than the actual numeric value.

That is worth sitting with. An index reading of 226.06 tells you almost nothing on its own. Read against a base of 100, it tells you the market has risen 126.06 per cent. The number is only a marker; the movement is the information.

Financial indices are created to measure the price movement of stocks, bonds, T-bills and other types of financial securities. A stock index specifically exists to give market participants information regarding the average share price movement in the market. And broad indices are expected to capture the overall behaviour of the equity market and need to represent the return obtained by typical portfolios in the country.

Why the index matters — three uses

The workbook gives exactly three, and they are worth memorising as a set:

• An indicator of the performance of the overall market or a particular sector.
• A benchmark for portfolio performance. Managed portfolios — whether an individual's or a mutual fund's — use the stock index as a measure for evaluation of their performance.
• An underlying for financial application of derivatives. Various products in OTC and exchange traded markets are based on indices as the underlying asset.

That third one is why this chapter sits inside an equity derivatives syllabus at all. Every Nifty future and every Sensex option in Chapters 3 and 4 rests on something built by the rules in this chapter.

The four ways to build an index

Indices can be designed and constructed in various ways. The methodology decides which stocks push the index around.

1. Market capitalization weighted index

Each stock is given a weight according to its market capitalization. Higher the market capitalization of a constituent, higher is its weight in the index.

Market capitalization is the market value of a company — the total number of shares outstanding multiplied by its current market price. The workbook's example: a company with 5,00,00,000 shares at ₹120 per share has a market capitalization of 5,00,00,000 × 120 = ₹6,00,00,00,000, that is ₹600 crore.

Here is the full worked index. Five stocks, base value 100 set on 1 January 1995:

The market capitalization on 1 January 1995 was ₹18,800 lakh, and that figure is equated to 100. Prices moved and the market capitalization rose to ₹42,500 lakh.

New index value = (42,500 ÷ 18,800) × 100 = 226.06

Since the index rose from a base of 100 to 226.06, the change is 126.06 per cent.

Notice what happened to the weights. CX started as the heaviest stock at 0.38 and ended at 0.23. Nobody traded anything. The weights moved by themselves, because prices moved. That is the defining property of a market-cap index — it rebalances itself.

Sensex and Nifty were earlier designed on the market capitalization weighted method.

2. Free-float market capitalization index

Here is the problem the market noticed. In various businesses, equity holding is divided differently among various stakeholders — promoters, institutions, corporates, individuals. Not all of it is actually available to buy.

So the market started to segregate holdings on the basis of what is readily available for trading and what is not. The portion available for immediate trading is categorized as free float. Compute the index using weights based on free float market cap and you have a free float market capitalization index.

A majority of the stock indices globally have, over a period of time, moved to a free float basis — including the Indian equity indices Sensex, Nifty and SX40.

Read that carefully, because it is a favourite question. Sensex and Nifty were earlier market-capitalization weighted. They are now free float market capitalization weighted. Both statements are in the workbook, and an exam option will offer you the wrong one.

3. Price-weighted index

A stock index in which each stock influences the index in proportion to its price. Stocks with a higher price will be given more weight and therefore will have a greater influence over the performance of the index.

The formula is startlingly simple:

Price index = (Sum of the prices of all stocks included in the index) ÷ (Number of stocks in the index)

Take the same five stocks:

Base, 1 January 1995 = (150 + 300 + 450 + 100 + 250) ÷ 5 = 250 Current = (650 + 450 + 600 + 350 + 500) ÷ 5 = 510 Increase = (510 − 250) ÷ 250 = 104%

And it can be verified the long way round, which is how the workbook proves that price is doing the weighting:

Look at CX. It has the highest price, so it gets the highest weight of 0.36 — even though it has fewer shares than DW and a smaller market capitalization than DW ends up with. Number of shares is completely irrelevant in a price-weighted index. That is the whole idea, and it is why the method is now uncommon.

Dow Jones Industrial Average and Nikkei 225 are popular price-weighted indices.

4. Equal weighted index

An equal-weighted index is one in which all stocks included in the index have the same weightage. The number of shares of each stock is adjusted in such a way that the weight of each stock in the index is the same.

Four stocks, constructed on 1 January 1995, quantities chosen so every stock is worth ₹30,000:

New index value = (1,46,000 ÷ 1,20,000) × 100 = 121.67, a rise of 21.67% — which is exactly the sum of the last column.

Now the part that makes this method different from every other one. Subsequently, if there is any change in the market price of each stock, the weight of each stock will change. With the new prices, P and R have a weight greater than 25% while Q and S have a weight lower than 25%.

To maintain equal weights, the fund manager needs to sell those stocks that have increased in price and buy the stocks that have fallen in price. Here: sell appropriate quantities of P and R, buy required quantities of Q and S.

An equal-weighted index therefore requires continuous human intervention. A market-cap index requires none. That contrast is examinable.

What makes a good index

Three attributes, and the middle one is the one people forget:

• It should reflect the market behaviour.
• It should be computed by an independent third party and be free from the influence of any market participant.
• It should be professionally maintained.

Impact cost — the cost nobody actually pays

Liquidity, in the context of the stock market, means a market where large orders are executed without moving the prices.

Start with an order book:

The difference between the best buy and the best sell order is 0.50 — this is called the bid-ask spread.

Place a market buy order for 100 shares and it is matched against the best available sell order at ₹4.50. Place a market sell order for 100 shares and it is matched against the best available buy order at ₹4.00.

So buy 100 shares and sell them immediately and you are poorer by the bid-ask spread — a loss of ₹50. This spread is regarded as the transaction cost which the market charges for the privilege of trading, for a transaction size of 100 shares.

Now try 3,000 shares. The sell order eats down through 1,000 at ₹4.00, 1,000 at ₹3.90 and 1,000 at ₹3.80. The buy order eats up through 2,000 at ₹4.50 and 1,000 at ₹4.55.

There is an increase in the transaction cost for an order size of 3,000 shares compared with an order for 100 shares. Hence: the bid-ask spread conveys the transaction cost for a small trade — and only for a small trade.

For anything bigger you need impact cost.

Start by defining the ideal price as the average of the best bid and offer price. Here that is (4.00 + 4.50) ÷ 2 = ₹4.25.

In an infinitely liquid market it would be possible to execute large transactions on both buy and sell at prices very close to the ideal price. In reality you will pay more than ₹4.25 per share while buying and receive less than ₹4.25 per share while selling.

The percentage degradation experienced vis-à-vis the ideal price, when shares are bought or sold, is called impact cost.

Two properties follow directly, and both get tested:

• Impact cost varies with transaction size.
• It would be different for the buy side and the sell side.

The workbook's calculation, on a second order book:

To buy 1,500 shares:

Ideal price = (9.80 + 9.90) ÷ 2 = ₹9.85 Actual buy price = [(1,000 × 9.90) + (500 × 10.00)] ÷ 1,500 = ₹9.9333 Impact cost = {(9.9333 − 9.85) ÷ 9.85} × 100 = 0.84%

And the relationship you must not get backwards: poor liquidity means a HIGH impact cost. A liquid market absorbs your order near the ideal price; an illiquid one makes you climb the order book. The workbook asks this as a true-or-false and the answer to "impact cost is low when liquidity is poor" is False.

The other examinable point: impact cost is not a fee. Nobody invoices you for it. Brokerage, Securities Transaction Tax and SEBI charges are actually paid. Impact cost is not paid to anybody — it arises purely from a lack of liquidity.

Index management

Index construction, maintenance and revision is generally done by specialized agencies. In India:

• BSE indices are managed by Asia Index Pvt Ltd.
• NSE indices are managed by NSE Indices Limited.

Three separate activities, and the exam likes to swap them:

• Construction is choosing the index stocks and deciding on the index calculation methodology.
• Maintenance means adjusting the index for corporate actions like bonus issue, rights issue, stock split, consolidation and mergers.
• Revision deals with change in the composition of the index — replacing some existing stocks by new ones because of a change in the trading paradigm of the stocks, or a shift in the interest of market participants.

Said another way: index maintenance gets triggered by a corporate action, while index revision is a continuous exercise to ensure the index captures the most vibrant lot of securities and continues to correctly reflect the market. Maintenance and revision keep the index comparable across time, taking account of stock splits, share issuance, dividends and restructuring events.

How many stocks? The diversification–liquidity trade-off

A good index is a trade-off between diversification and liquidity. A well-diversified index reflects the behaviour of the overall market. But diversification may not help beyond a point:

• 10 stocks to 20 stocks — a sharp reduction in risk
• 50 stocks to 100 stocks — very little reduction in risk
• Beyond 100 stocks — almost zero decline in risk

Hence there is little to gain by diversifying beyond a point.

Stocks are chosen on pre-determined qualitative and quantitative parameters laid down by the Index Construction Managers. Once a stock satisfies the eligibility criteria it is entitled for inclusion — but the final decision of inclusion or removal is taken by a specialized committee known as the Index Committee.

Eligibility criteria for derivatives on existing non-benchmark indices

Per the SEBI circular dated 30 October 2025, stock exchanges must follow these prudential norms for derivatives on existing non-benchmark indices:

• Minimum of 14 constituents
• Top constituent weight not more than 20%
• Combined weight of the top 3 constituents not more than 45%
• Descending weight structure

The four-tranche method works by dividing the remaining gap by the number of tranches left, not by four every time:

Read the mechanism, not just the numbers. A constituent at Rank 1 by weight sits at 28% against a target of 20% — an adjustment of 8%. The first tranche moves it by 8 ÷ 4 = 2%, to 26%. Then, at the beginning of the next tranche, weights of all the constituents are re-evaluated, and because of inter-tranche price movement the weight has drifted to 25.5%. The remaining gap of 5.5% is now divided by 3, giving 1.83%.

In months 3 and 4 the target itself changes — from 20% to 19.5% and then 18.5% — because relative price movement of the constituents, and hence their free float market cap, changed the target weight of that constituent.

Major indices in India

What indices are used for

Traditionally, indices were used as a measure to understand the overall direction of the stock market. Three applications have since emerged.

Index funds invest in a specific index with the objective of generating returns equivalent to the return on the index. They invest in index stocks in the proportions in which those stocks exist in the index. Since the Sensex has 30 shares, a Sensex index fund invests in those 30 companies in Sensex proportions; a Nifty index fund invests in the 50 component companies in Nifty proportions.

They do not match the index exactly. The gap is tracking error, and the workbook names its two causes precisely: fund management related expenses and cash holdings maintained to take care of redemptions.

Index derivatives are derivative contracts which have the index as the underlying asset. Index options and index futures are the most popular derivative contracts worldwide, and index derivatives are useful as a tool to hedge against market risk.

Exchange Traded Funds (ETFs) are a basket of securities that trade like individual stocks, on an exchange. Their advantages over other mutual funds follow from that one fact: they can be bought and sold on the exchange, so intraday transaction is possible, and they can be used as basket trading in terms of smaller denomination and low transaction cost.