Explained: What is an index; its construction, types, and applications
There are thousands of listed companies in India. It is not possible for any investor to track every single stock. Amidst such a scenario comes the importance of ‘index’ in the picture.
An index is an indicator or a measure of something. Similarly, in finance, the index is a statistical indicator that measures changes in the economy or securities market in general or in particular areas e.g. Sensex (Sensitive Index) is the combined value of 30 blue-chip stocks listed on Bombay Stock Exchange (BSE). If Sensex goes up, investors are interested in buying stocks as they believe that economy is going to grow and will help them in order to earn profits. However, if Sensex goes down, people tend to stop investing in the market and liquidate their securities to avoid future risks.
Indices are constructed by using various methods. A good index is a trade-off between diversification and liquidity. The process starts by identifying stocks to include in the index. These are chosen based on certain qualitative and quantitative parameters, laid down by the index construction managers or entity. (Like NSE indices are managed by a separate company called NSE Indices Ltd) Also, in order to keep the index comparable across time, the maintenance is done, in which, various corporate actions like stock splits, mergers, bonuses, and right issues are taken into consideration. The process is known as index maintenance and revision.
Depending upon the method of calculation, indices are divided into several categories:
1) Market capitalisation weighted index (each stock is given weight according to its market capitalisation).
2) Price weighted index (stock with a higher price will be given more weight and hence, will have a larger influence over the performance of the index).
3) Equal weighted index (equal weight is assigned to each stock in the index).
The index serves as a benchmark for portfolio performance. It is also used as an underlying asset for various financial applications of derivatives. Some of the applications are:
1) Index funds - These types of funds invest in a specific index. The objective behind this is to generate equivalent returns to the returns on the index. These funds invest in index stocks in the proportion in which these stocks exist in the index.
2) Index derivatives - These are derivative contracts that use the index as the underlying asset. Index Options and Index Futures are the most popular derivative contracts.