What are the Nifty and Sensex and how are the indices calculated?

Stock Market | Published on 3rd March 2018 | 418

A common question that is asked in the stock markets very colloquially is “Market kya lagta hai”. While this question does not have a very specific answer, what the person is referring to is the likely levels of the Nifty or the Sensex. The Nifty and the Sensex are two popular indices which capture the gist of the market movement. When the Nifty and the Sensex are consistently moving upwards for a longer period of time, it is referred to as a bull market. On the other hand, if the Nifty and the Sensex are consistently moving downwards then it is generally referred to as a bear market.

But what exactly are the Nifty and the Sensex levels and what do they indicate? How to trade the markets when the Sensex is going up and how to trade the market when the Sensex is going down? What is the essential difference between the Nifty and the Sensex. Firstly, the Nifty is the benchmark index of the NSE while the Sensex is the benchmark index of the BSE. Secondly, the Nifty is a collection of just 30 stocks while the Nifty is a collection of 50 stocks. Thirdly, all indices are calculated based on the base year concept. For the Nifty the base value is taken as 1000 for the year 1995. In the case of the Sensex, the base value is taken as 100 for the year 1979.

Let us know more about the Nifty and the Sensex…

As we have seen earlier, both the Nifty and the Sensex represent benchmark indices for the two principal stock exchanges. Here are 3 commonalities between the Sensex and the Nifty…

  • The wealth creation of the indices is calculated with reference to their base years. Nifty was at a level of 1000 in 1995 and is at 10,400 in 2018. That means, the Nifty has appreciated 10.4 times in the last 22 years. The Sensex was at 100 in 1979 and is at 33,800 today. That means in the last 39 years the Sensex has multiplied 338 times. Intuitively, one can conclude that a lot more wealth got created in the equity markets prior to 1995 compared to the post-1995 period.
  • Both the Nifty and the Sensex are denominated in Indian Rupees. That means the foreign currency fluctuations in the value of the INR/$ are not captured by the Nifty or the Sensex. The Nifty also trades currently on the Singapore Exchange under the nomenclature of SGX Nifty which is denominated in US Dollars.
  • One can use these indices to take a trading view on the overall market direction by buying or selling futures and options on the Nifty and the Sensex. Futures and options on both the indices are available for trading in the respective exchange platforms.

How are the Nifty and the Sensex constructed and maintained?

The methodology of the construction and maintenance of both the indices are broadly the same. We know the concept of the base year but how are the components of the Nifty and the Sensex selected and monitored? Here is how…

  • The idea of an index is that the index should be broadly reflective of the overall Indian economy. 20 years back IT companies hardly had any presence in India and hence were not part of the indices. Today, their importance has increased and they constitute over 12% of the indices. For the Sensex and the Nifty, Banking and Financials dominate with over 30% exposure overall.
  • The Nifty places a lot of accent on the liquidity. Stocks must be extremely liquid to be included in the Nifty index. Liquidity is normally measured in terms of impact cost (it implies the impact that a large order has on the price). The impact on price should be less than 0.5% when a buy/sell order worth Rs.10 crore is placed. This criterion must be met consistently.
  • Both the Nifty and the Sensex are based on the free-float methodology; that means only shares that are freely traded will be included in the calculation of the index values. The total free float of the index must represent at least 65% of the free float of the market as a whole.
  • The Nifty index is weighted based on market capitalization. The market cap is the product of the price of the stock and the number of shares of free float available. Greater the market cap, greater is the impact of the stock price movement on the Nifty. That is why stocks like Reliance and ICICI Bank have such a profound impact on the market movements since they have a very high proportion of free float weight in the index.
  • The indices are corporate action neutral. What are corporate actions? We are referring to bonuses, stock splits, rights etc. These corporate actions get automatically adjusted in the index calculations so that the net impact is neutral on the stock price.
  • Both the Nifty and the Sensex is periodically monitored by an Index Committee which consists of eminent professionals from the stock markets, macroeconomics, statisticians, industry experts etc. It is the job of this committee to constantly evaluate the components of the indices and suggest and approve changes to the same to reflect the macroeconomic reality of India.

Globally, the performance of stock markets is judged by the performance of the indices. Dow Jones in the US, Footsie in the UK, DAX in Germany, Nikkei in Japan and Hang Seng in Hong Kong are the equity benchmark indices. For India, it is the Sensex and the Nifty!