In our previous blog “What is Stock Exchange? BSE & NSE?” you must have understood the benefits and purpose of stock exchange. Now as you know in India, there are two prominent exchanges, the Bombay Stock Exchange and the National Stock Exchange. Both of these exchanges maintain their own index which is Sensex & Nifty respectively. So what are these indices and what are they used for? Let us find out.
The Bombay Stock Exchange prepares and maintains an index called The SENSEX (made out of two words Sensitive Index). Sensex or sometimes referred as BSE 30 is a free float market-weighted index (which means the current price of each stock is multiplied by its total number of outstanding shares, that are available for general public and not the promoter holdings) that comprises of top 30 companies that are listed on the exchange. The 30 component companies are some of the largest and most actively traded stocks that are representative of various industrial sectors of the Indian economy. It was published on 1st January 1986. The index has a value that is calculated using the prices and the outstanding shares of the component companies using market capitalization method.
Why only 30 companies?
Now one question must be popping in your mind that why only 30 companies are taken to calculate the value of Sensex out of 5000+ companies that are listed on the exchange. Understand this with an example of our democracy, when we vote then only a few people whom we elect go to the parliament and not the whole population of the country. These people are the representative of our country. Same way out of all the listed companies on the exchange, only the top 30 companies are chosen based on their market strength in the particular sector. These 30 companies represent the current condition and mood of the market.
Sometimes you may see that are more than 30 or less than 30 companies in the index. This is because if a particular company losses its market strength or violates any regulation that is required for listing on the exchange then that company is taken out of the index calculation and you may see less than 30 companies. And if any company gains market strength (market capitalization) then that company is added in the calculation.
This is another popular index that is prepared and maintained by the National Stock Exchange of India Limited. It was launched in 1st April 1996 and comprised of 50 top companies. It is also a free float market-weighted index like the Sensex. The companies that are taken for the calculation of this index are from 12 different sectors. Nifty 50 is the world’s most actively traded contract. Nifty future and options are its derivative products. A similar index to nifty is Nifty Bank. It comprises of bank stocks and the derivative products of this index are also traded.
Use of Market Index
A Barometer for market behavior
A market index is mainly calculated to represent the current market behavior and condition. It even reflects the situation of an economy and how slow or fast the economy is growing.
As a Benchmark Portfolio performance
A market index is also used by investors to judge the performance of their portfolio or their portfolio manager. For example, if Nifty is giving a return of 15% p.a. but your portfolio or your portfolio manager has given only 10% p.a. return then this shows they have underperformed.
In Passive Fund Management by Index Funds
Many mutual fund companies have index funds where they invest the money of the investors only in the stocks of a particular index like Nifty 50. Then the index is again used to assess the performance of the fund and such funds are good for those people who do not want the risk of direct investing the shares of the index.
As an underlying in Derivative Instruments like Index Futures and Options
Various exchanges have derivatives that have their index as an underlying (based on). In India, NSE has Nifty futures and options that are actively traded. The underlying is Nifty 50.