Part 2: Understanding Index, Types of Stock Market Indices & Their Applications

NISM Series VIII – Part 2: Understanding Index, Types of Stock Market Indices & Their Applications

Welcome to Part 2 of our NISM Series VIII Equity Derivatives short notes series. In this post, we cover one of the most important foundational topics — understanding market indices, how they are constructed, and how they are applied in the derivatives market. This is essential reading for anyone preparing for the NISM equity derivatives certification exam.

Quick Answer (Featured Snippet): A stock market index is a portfolio of securities representing a particular market or segment. It is used as a performance benchmark and as the underlying asset for index derivatives like Nifty futures and Nifty options.

What is a Stock Market Index?

An index is a collection of securities that represents a particular market or a portion of a market. Key points:

• Every index has its own calculation methodology
• It is expressed as a change from a base value
• It reflects the overall performance of the market or a specific sector
• It serves as a benchmark for portfolio performance
• It is used as the underlying asset for index derivatives such as index futures and index options

Types of Stock Market Indices 1. Market Capitalisation Weighted Index

In this method, each stock is weighted according to its total market capitalisation. Stocks with higher market cap have a greater influence on the index value. India's Sensex and Nifty were originally built on this method.

Formula logic: Higher market cap = Higher weight in index

2. Free-Float Market Capitalisation Index

Not all shares of a company are freely available for trading at any given time. Promoter holdings, government stakes, and strategic holdings are not available for open-market trading. The free float refers to shares that are readily available for trading.

In a free-float market cap index, each stock's weight is calculated based on only its free-float market cap. Today, both Sensex and Nifty 50 are free-float market cap weighted indices.

3. Price Weighted Index

Here, each stock's influence on the index is proportional to its share price. A stock trading at a higher price gets more weight in the index, regardless of its total market capitalisation.

Example: The Dow Jones Industrial Average (DJIA) in the USA is a price-weighted index.

4. Equal Weighted Index

In an equal-weighted index, every stock — whether large-cap or small-cap — is given exactly the same weight. The index value is calculated by adding all stock prices and dividing by the total number of stocks.

This method treats every company in the index equally, regardless of size.

Attributes of a Good Market Index

Featured Snippet: A good stock market index should reflect actual market behaviour, be computed by an independent third party free from any market participant's influence, and be professionally maintained and updated.

• It must accurately reflect overall market or sectoral behaviour
• It must be computed by an independent third-party organisation, free from influence by any market participant
• It must be professionally maintained with transparent revision processes

What is Impact Cost?

In the context of stock markets, liquidity means the ability to execute large orders without significantly moving the price of the security. Impact cost is the practical measure of market liquidity.

A market with low impact cost is a liquid market where you can buy or sell large quantities without causing major price disruption. Impact cost is an important criterion when selecting stocks for inclusion in an index.

Index Management – Construction, Maintenance & Revision

The process of managing a market index involves three key activities:

• Index Construction: Selecting the methodology and the initial set of stocks that will form the index
• Index Maintenance: Ongoing monitoring to ensure the index continues to reflect the market accurately
• Index Revision: Periodic review to add or remove stocks based on eligibility criteria such as market cap, liquidity, and trading volumes

This work is generally done by specialised index management agencies like NSE Indices Limited (for Nifty) and Asia Index Pvt. Ltd. (for Sensex).

Applications of Indices in Financial Markets 1. Index Funds

Index funds are mutual funds designed to replicate the performance of a specific index. They invest in the same stocks that form the index, in the same proportions. The goal is not to outperform the market but to match index returns.

Index funds are known for their low cost and passive management style.

2. Index Derivatives

Index derivatives are contracts where the underlying asset is a market index such as Nifty 50 or Sensex. Index futures and index options are the most widely used derivative instruments worldwide.

Key uses of index derivatives:

• Hedging a portfolio against broad market risk (systematic risk)
• Taking directional bets on market movements
• Earning income through options writing strategies

3. Exchange Traded Funds (ETFs)

ETFs are index-tracking funds that trade on stock exchanges just like individual shares. Unlike regular mutual funds that are priced at the end of the day, ETFs can be bought and sold throughout the trading session.

Advantages of ETFs:

• Available for intraday trading on the exchange
• Lower transaction costs compared to actively managed funds
• Can be used for basket trading with small denomination investments

Comparison Table – Index Funds vs ETFs vs Index Derivatives

Key Semantic Terms to Know for the NISM Series 8 Exam

• Underlying asset – The security or index on which a derivative contract is based
• Free float – Shares available for open-market trading, excluding promoter and locked-in holdings
• Benchmark index – A standard index used to evaluate portfolio performance (e.g., Nifty 50)
• Impact cost – A measure of market liquidity; lower impact cost means higher liquidity
• Passive investing – Strategy of replicating index returns rather than actively selecting stocks
• Systematic risk – Market-wide risk that cannot be diversified away; managed using index derivatives

Quick Revision – What to Remember

• Sensex and Nifty are now free-float market capitalisation weighted indices
• The Dow Jones follows a price-weighted methodology
• Index derivatives are the primary tool for hedging systematic (market) risk
• ETFs combine features of both index funds and exchange-traded stocks
• A good index must be independent, professionally maintained, and market-reflective

Internal Links

• Part 1 – Basics of Derivatives & Indian Market
• Part 3 – Introduction to Forwards and Futures
• Practice NISM Series 8 Mock Test
• Register for NISM Certification Exam

This is Part 2 of the NISM Series VIII Short Notes series on PassNISM.in. Continue to Part 3 – Introduction to Forwards and Futures.