Sunday , 25 June 2017

Stock Exchanges How They Work

In order to understand what stocks are and how stock markets work, we need to dive into history–specifically, the history of what has come to be known as the corporation, or sometimes the limited liability company (LLC). Corporations in one form or another have been around ever since one guy convinced a few others to pool their resources for mutual benefit.

The first corporate charters were created in Britain as early as the sixteenth century, but these were generally what we might think of today as a public corporation owned by the government, like the postal service.

Privately owned corporations came into being gradually during the early 19th century in the United States , United Kingdom and western Europe as the governments of those countries started allowing anyone to create corporations.

In order for a corporation to do business, it needs to get money from somewhere. Typically, one or more people contribute an initial investment to get the company off the ground. These entrepreneurs may commit some of their own money, but if they don’t have enough, they will need to persuade other people, such as venture capital , investors or banks, to invest in their business.

They can do this in two ways: by issuing bonds, which are basically a way of selling debt (or taking out a loan, depending on your perspective), or by issuing stock, that is, shares in the ownership of the company.

Long ago stock owners realized that it would be convenient if there were a central place they could go to trade stock with one another, and the public stock exchange was born. Eventually, today’s stock markets grew out of these public places.


A corporation is generally entitled to create as many shares as it pleases. Each share is a small piece of ownership. The moreshares you own, the more of the company you own, and the more control you have over the company’s operations. Companies sometimes issue different classes of shares, which have different privileges associated with them.

So a corporation creates some shares, and sells them to an investor for an agreed upon price, the corporation now has money. In return, the investor has a degree of ownership in the corporation, and can exercise some control over it. The corporation can continue to issue new shares, as long as it can persuade people to buy them. If the company makes a profit, it may decide to plow the money back into the business or use some of it to pay dividends on the shares.

Public Markets

How each stock market works is dependent on its internal organization and government regulation. The NYSE (New York Stock Exchange) is a non-profit corporation, while the NASDAQ (National Association of Securities Dealers Automated Quotation) and the TSE (Toronto Stock Exchange) are for-profit businesses, earning money by providing trading services.

Most companies that go public have been around for at least a little while. Going public gives the company an opportunity for a potentially huge capital infusion, since millions of investors can now easily purchase shares. It also exposes the corporation to stricter regulatory control by government regulators.

When a corporation decides to go public, after filing the necessary paperwork with the government and with the exchange it has chosen, it makes an initial public offering (IPO). The company will decide how many shares to issue on the public market and the price it wants to sell them for. When all the shares in the IPO are sold, the company can use the proceeds to invest in the business.

History of NIFTY -NSE

S&P CNX Nifty is a well diversified 50 stock index accounting for 21 sectors of the economy. It is used for a variety of purposes such as benchmarking fund portfolios, index based derivatives and index funds.

S&P CNX Nifty is owned and managed by India Index Services and Products Ltd. (IISL), which is a joint venture between NSE and CRISIL. IISL is India’s first specialised company focused upon the index as a core product. IISL has a Marketing and licensing agreement with Standard & Poor’s (S&P), who are world leaders in index services.

  • ·  The traded value for the last six months of all Nifty stocks is approximately 44.89% of the traded value of all stocks on the NSE
  • ·  Nifty stocks represent about 58.64% of the total market capitalization as on March 31, 2008.
  • ·  Impact cost of the S&P CNX Nifty for a portfolio size of Rs.2 crore is 0.15%
  • ·  S&P CNX Nifty is professionally maintained and is ideal for derivatives trading

Scrip selection criteria

The constituents and the criteria for the selection judge the effectiveness of the index. Selection of the index set is based on the following criteria:

Liquidity (Impact Cost)

For inclusion in the index, the security should have traded at an average impact cost of 0.50% or less during the last six months for 90% of the observations for a basket size of Rs. 2 Crores.

Impact cost is cost of executing a transaction in a security in proportion to the weightage of its market capitalisation as against the index market capitalisation at any point of time. This is the percentage mark up suffered while buying / selling the desired quantity of a security compared to its ideal price (best buy + best sell) / 2

Floating Stock 

Companies eligible for inclusion in S&P CNX Nifty should have atleast 10% floating stock. For this purpose, floating stock shall mean stocks which are not held by the promoters and associated entities (where identifiable) of such companies.


a) A company which comes out with a IPO will be eligible for inclusion in the index, if it fulfills the normal eligiblity criteria for the index like impact cost, market capitalisation and floating stock, for a 3 month period instead of a 6 month period.

b) Replacement of Stock from the Index:

A stock may be replaced from an index for the following reasons:

  1. Compulsory changes like corporate actions, delisting etc. In such a scenario, the stock having largest market capitalization and satisfying other requirements related to liquidity, turnover and free float will be considered for inclusion.
  2. When a better candidate is available in the replacement pool, which can replace the index stock i.e. the stock with the highest market capitalization in the replacement pool has at least twice the market capitalization of the index stock with the lowest market capitalization.

With respect to (2) above, a maximum of 10% of the index size (number of stocks in the index) may be changed in a calendar year. Changes carried out for (2) above are irrespective of changes, if any, carried out for (1) above.

Calculation Methodology

S&P CNX Nifty is computed using market capitalization weighted method, wherein the level of the index reflects the total market value of all the stocks in the index relative to a particular base period. The method also takes into account constituent changes in the index and importantly corporate actions such as stock splits, rights, etc without affecting the index value.

History of SENSEX- BSE

For the premier Stock Exchange that pioneered the stock broking activity in India, 128 years of experience seems to be a proud milestone. A lot has changed since 1875 when 318 persons became members of what today is called ‘The Stock Exchange, Mumbai’ by paying a princely amount of Re.1/-.

Since then, the country’s capital markets have passed through both good and bad periods. The journey in the 20th century has not been an easy one. Till the decade of eighties, there was no scale to measure the ups and downs in the Indian stock market. The Stock Exchange, Mumbai (BSE) in 1986 came out with a stock index that subsequently became the barometer of the Indian stock market.

SENSEX is not only scientifically designed but also based on globally accepted construction and review methodology. First compiled in 1986, SENSEX is a basket of 30 constituent stocks representing a sample of large, liquid and representative companies. The base year of SENSEX is 1978-79 and the base value is 100. The index is widely reported in both domestic and international markets through print as well as electronic media.

The Index was initially calculated based on the ‘Full Market Capitalization’ methodology but was shifted to the free-float methodology with effect from September 1, 2003. The ‘Free-float Market Capitalization’ methodology of index construction is regarded as an industry best practice globally. All major index providers like MSCI, FTSE, STOXX, S&P and Dow Jones use the Free-float methodology.

Due to is wide acceptance amongst the Indian investors; SENSEX is regarded to be the pulse of the Indian stock market. As the oldest index in the country, it provides the time series data over a fairly long period of time (From 1979 onwards). Small wonder, the SENSEX has over the years become one of the most prominent brands in the country.

The growth of equity markets in India has been phenomenal in the decade gone by. Right from early nineties the stock market witnessed heightened activity in terms of various bull and bear runs. The SENSEX captured all these events in the most judicial manner. One can identify the booms and busts of the Indian stock market through SENSEX.

Calculation Methodology

SENSEX is calculated using the ‘Free-float Market Capitalization’ methodology. As per this methodology, the level of index at any point of time reflects the Free-float market value of 30 component stocks relative to a base period. The market capitalization of a company is determined by multiplying the price of its stock by the number of shares issued by the company. This market capitalization is further multiplied by the free-float factor to determine the free-float market capitalization.

The base period of SENSEX is 1978-79 and the base value is 100 index points. This is often indicated by the notation 1978-79=100. The calculation of SENSEX involves dividing the Free-float market capitalization of 30 companies in the Index by a number called the Index Divisor. The Divisor is the only link to the original base period value of the SENSEX. It keeps the Index comparable over time and is the adjustment point for all Index adjustments arising out of corporate actions, replacement of scrips etc. During market hours, prices of the index scrips, at which latest trades are executed, are used by the trading system to calculate SENSEX every 15 seconds and disseminated in real time

Scrip selection criteria

The general guidelines for selection of constituents in SENSEX are as follows:

Listed History: The scrip should have a listing history of at least 3 months at BSE. Exception may be considered if full market capitalisation of a newly listed company ranks among top 10 in the list of BSE universe. In case, a company is listed on account of merger/ demerger/ amalgamation, minimum listing history would not be required.

Trading Frequency: The scrip should have been traded on each and every trading day in the last three months. Exceptions can be made for extreme reasons like scrip suspension etc.

Final Rank: The scrip should figure in the top 100 companies listed by final rank. The final rank is arrived at by assigning 75% weightage to the rank on the basis of three-month average full market capitalisation and 25% weightage to the liquidity rank based on three-month average daily turnover & three-month average impact cost.

Market Capitalization Weightage :The weightage of each scrip in SENSEX based on three-month average free-float market capitalisation should be at least 0.5% of the Index.

Industry Representation: Scrip selection would generally take into account a balanced representation of the listed companies in the universe of BSE.

Track Record: In the opinion of the Committee, the company should have an acceptable track record.

Concept :

Free-float Methodology refers to an index construction methodology that takes into consideration only the free-float market capitalization of a company for the purpose of index calculation and assigning weight to stocks in Index. Free-float market capitalization is defined as that proportion of total shares issued by the company that are readily available for trading in the market. It generally excludes promoters’ holding, government holding, strategic holding and other locked-in shares that will not come to the market for trading in the normal course. In other words, the market capitalization of each company in a Free-float index is reduced to the extent of its readily available shares in the market.

In India, BSE pioneered the concept of Free-float by launching BSE TECk in July 2001 and BANKEX in June 2003. While BSE TECk Index is a TMT benchmark, BANKEX is positioned as a benchmark for the banking sector stocks. SENSEX becomes the third index in India to be based on the globally accepted Free-float Methodology.

Major advantages of Free-float Methodology

  • A Free-float index reflects the market trends more rationally as it takes into consideration only those shares that are available for trading in the market.
  • Free-float Methodology makes the index more broad-based by reducing the concentration of top few companies in Index. For example, the concentration of top five companies in SENSEX has fallen under the free-float scenario thereby making the SENSEX more diversified and broad-based.
  • A Free-float index aids both active and passive investing styles. It aids active managers by enabling them to benchmark their fund returns vis-a-vis an investable index. This enables an apple-to-apple comparison thereby facilitating better evaluation of performance of active managers. Being a perfectly replicable portfolio of stocks, a Free-float adjusted index is best suited for the passive managers as it enables them to track the index with the least tracking error.
  • Free-float Methodology improves index flexibility in terms of including any stock from the universe of listed stocks. This improves market coverage and sector coverage of the index. For example, under a Full-market capitalization methodology, companies with large market capitalization and low free-float cannot generally be included in the Index because they tend to distort the index by having an undue influence on the index movement. However, under the Free-float Methodology, since only the free-float market capitalization of each company is considered for index calculation, it becomes possible to include such closely held companies in the index while at the same time preventing their undue influence on the index movement.
  • Globally, the Free-float Methodology of index construction is considered to be an industry best practice and all major index providers like MSCI, FTSE, S&P and STOXX have adopted the same. MSCI, a leading global index provider, shifted all its indices to the Free-float Methodology in 2002. The MSCI India Standard Index, which is followed by Foreign Institutional Investors (FIIs) to track Indian equities, is also based on the Free-float Methodology. NASDAQ-100, the underlying index to the famous Exchange Traded Fund (ETF) – QQQ is based on the Free-float Methodology.

Definition of Free-float

Share holdings held by investors that would not, in the normal course come into the open market for trading are treated as ‘Controlling/ Strategic Holdings’ and hence not included in free-float. In specific, the following categories of holding are generally excluded from the definition of Free-float :

  •   Holdings by founders/directors/ acquirers which has control element
  •   Holdings by persons/ bodies with ‘Controlling Interest’
  •   Government holding as promoter/acquirer
  •   Holdings through the FDI Route
  •   Strategic stakes by private corporate bodies/ individuals
  •   Equity held by associate/group companies (cross-holdings)
  •   Equity held by Employee Welfare Trusts
  •   Locked-in shares and shares which would not be sold in the open market in normal course.
  •   The remaining shareholders would fall under the Free-float category.

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