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How are indices like Nifty and Sensex constructed and what they indicate..?

12 Sep 2023

If you are even remotely interested in the stock market, a standard question you would have come across is "Market kya lagta hai"? This is an extremely generic question but it broadly refers to a view on the indices like the Nifty and the Sensex. Since no single stock can really tell you the story of the entire stock market, indices like the Nifty and the Sensex give a broad representation of the market. Indices, by default, cover the most active and liquid stocks in the market and therefore give you an indication of the direction of the stock market as a whole. For example, between Feb 2016 and Jan 2018, the Nifty was up by nearly 23% in each of the years. That is broadly reflective of a bullish market with positive trading sentiments.
What exactly are these indices like Nifty and Sensex? What does a number like 11,000 on the Nifty and 36,000 on the Sensex actually represent? For that we need to understand how stock market indices are calculated. Let us also understand what is Nifty and Sensex, the two principal market indices in India. Let us also focus in detail on how the Nifty is calculated as an index value and how to read the number as a case study!

5 things you need to know about indices like the Nifty and the Sensex..
Before getting into the index methodology, here are 5 key things you need to know about the concept of stock market indices..

Like other macroeconomic indices, the Nifty and Sensex are also calculated with reference to a base year. While Nifty assigns a base value of 1000 and uses 1995 as the base year, Sensex assigns a base value of 100 and uses 1979 as the base year.

The current index value is with reference to the base year value. A Sensex value of 36,000 indicates that wealth has multiplied 360 times in the 39 years since 1979. The Nifty value of 11,000 indicates that wealth has multiplied 11 times in 23 years since 1995.

The Nifty has 50 components while the Sensex has 30 components. These components of the Nifty and Sensex are subject to change over time and the index is regularly reconstituted to reflect the current market situation.

The currency used for the calculation of the Nifty and the Sensex is INR. All changes in the Nifty and Sensex are necessarily denominated in INR only and the impact of foreign currency value shifts are not captured by these indices.

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. Indices like Nifty are also traded on the Singapore Exchange (SGX) and the SGX Nifty is denominated in US dollars.

Understanding the Nifty Construction methodology..
We saw earlier that indices like the Nifty are based on the base year concept and 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..

Only those companies that are domiciled in India and listed on the NSE can be included in the Nifty index. Hence foreign companies or companies domiciled in other countries cannot be included in the Nifty Index.

How are stocks selected in the index? Firstly, the stocks as a portfolio should be representative of the key sectors driving economic growth of India. Nifty is calculated based on free-float market cap and broadly represents 65% of the total free float market cap of the market.

Only highly liquid stocks are included in the Nifty Index. Liquidity is measured by the Impact Cost. That means when the stock is bought 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.

When large and systemically important IPOs list on the NSE, they will be eligible for inclusion in the Nifty within 3 months subject to their meeting the criteria with respect to free-float market cap and liquidity.

Nifty index is corporate-action neutral. 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.

The Nifty index is market capitalization weighted. What it means is that large companies with a large market cap will have a much bigger impact on the index than companies with smaller market cap. For example, RIL will have a bigger impact on Nifty than Sun Pharma.

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. To sum it up, these indices continue to be the singular number that represents the undertone of the stock market!

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