The S&P CNX Nifty is an market capitalisation index based upon solid economic research. It was designed not only as a barometer of market movement but also to be a foundation of the new world of financial products based on the index like index futures, index options and index funds. A Trillion calculations were expended to evolve the rules inside the S&P CNX Nifty.
The results of this work are remarkably simple:
The correct size to use is 50.
Stocks considered for the S&P CNX Nifty must be liquid by the impact cost criterion,.
The largest 50 stocks that meet the criterion go into the index. .
S&P CNX Nifty is a contrast to the adhoc methods that have gone into index construction in the preceding years, where indexes were made out of intuition and lacked a scientific basis. The research that led up to S&P CNX Nifty is well respected internationally as a pioneering effort in better understanding how to make a stock market index.
The Nifty is uniquely equipped as an index for the index derivatives market owing to its LOW MARKET IMPACT COST and HIGH HEDGING EFFECTIVENESS. The good diversification of Nifty generates low initial margin requirement. Finally. Nifty is calculated using NSE prices, the most liquid exchange in India, thus making it easier to do arbitrage for index derivatives.
What makes a good stock market index for use in an index futures and index options market? Several issues play a role in terms of the choice of Index.
We will discuss how the S&P CNX Nifty addresses .some of these issues:
DIVERSIFICATION: As mentioned earlier, a stock market index should be well diversified, thus ensuring that hedgers or speculators are not vulnerable to individual-company or industry risk. .
LIQUIDITY OF THE INDEX: The index should be easy to trade on the cash market. This is partly related to the choice of stocks in the index. High liquidity of index components implies that the information in the index is less noisy.
OPERATIONAL ISSUES: The index should be professionally maintained, with a steady evolution of securities in the index to keep pace with changes in the economy. The calculations involved in the index should be accurate and reliable. When a stock trades at multiple venues, index computation should be done using prices from the most liquid market.
Market impact cost is a measure of the liquidity of the market. It reflects the costs faced when actually trading an index. For a stock to qualify for possible inclusion into the Nifty, it has to have market impact cost of below 0.75% when doing Nifty trades of half a crore rupees.
The Market impact cost on a trade of Rs.3 Million of the full Nifty works out to be about 0.05%. This means that if Nifty is at 2000. A buy order goes through at 2001, i.e.. 2000+(2000 *0.0005) and a sell order gets 1999. i.e.. 2000-(2000*0.0005).
Hedging effectiveness is a measure of the extent to which an index correlates with a portfolio, whatever the portfolio may be. Nifty correlates better with all kinds of portfolios in India as compared to other indexes. This holds good for all kinds of portfolios, not just those that contain index stocks. Similarly, the CNX IT and Bank Nifty contracts which NSE trades in. correlate well with information technology and banking sector portfolios.
Nifty. CNX IT and CNX Bank (Underlying index for Bank Nifty) indices are owned, computed and Maintained by India Index Services & Products Limited (IISL). a company setup by NSE and CRISIL with technical assistance from Standard & Poor’s.