A good index is a trade-off between diversification and liquidity. A well divers ified index is more representative of the market/economy.

There are however, diminishing return s to diversification. Going from 10 stocks to 20 stocks gives a sharp reduction in ri sk. Going from 50 stocks to 100 stocks gives very little reduction in risk. Going beyond 100 st ocks gives almost zero reduction in risk. Hence, there is little to gain by diversifying be yond a point. The more serious problem lies in the stocks which are included into an index when it is broadened. If the stock is illiquid, the observed prices yield contaminated information and actually worsen an index. The computational methodology followed for construction of stock market indices are (a) Free Float Market Capitalization Weighted Index, (b) Market Capitalization Weighted i ndex and the (c) Price Weighted Index. Free Float Market Capitalisation Weighted Index: The free float factor (Investib le Weight Factor), for each company in the index is determined based on the public shareho lding of the15 companies as disclosed in the shareholding pattern submitted to the stock exchan ge by these companies1 . The Free float market capitalization is calculated in the following manner: Free Float Market Capitalisation = Issue Size * Price * Investible Weight Factor The Index in this case is calculated as per the formulae given below: The India Index Services Limited (IISL), a joint venture between the NSE and CRI SIL, introduced the free float market capitalization methodology for its main four indices, viz. , S&P CNX Nifty, S&P CNX Defty, CNX Nifty Junior and CNX 100. With effect from May 4, 2009 CNX Ni fty Junior and with effect from June 26, 2009, S&P CNX Nifty, CNX 100 and S&P CNX Defty are being calculated using free float market capitalisation. Market Capitalisation Weighted Index: In this type of index calculation, each st ock in the index affects the index value in proportion to the market value of all shares ou tstanding. In this the index would be calculated as per the formulae below: Where, Current market capitalization = Sum of (current market price * Issue size) of al l securities in the index. Base market capitalization = Sum of (market price * issue size) of all securitie s as on base date. Similarly, in a price weighted index each stock influences the index in proporti on to its price per share. The value of the index is generated by adding the prices of each of t he stocks in the index and dividing then by the total number of stocks. Stocks with a higher pric e will be given more weight and, therefore, will have a greater influence over the performance o f the index.

2.5 Desirable Attributes of an Index A good market index should have three attributes: It should capture the behaviour of a large variety of different portfolios in the market. The stocks included in the index should be highly liquid. It should be professionally maintained. It should ensure that the index is not vulnerable to speculation. Stocks with lo w trading volume or with very tight bid ask spreads are illiquid and should not be a part of inde x. The index should be managed smoothly without any dramatic changes in its composition. Box 2.1 describes how S&P CNX Nifty addresses these issues. Box 2.1: The S&P CNX Nifty The S&P CNX Nifty is a float-adjusted market capitalization weighted index deriv ed from economic research. It was designed not only as a barometer of market movement bu t also to be a foundation of the new world of financial products based on the index lik e index futures, index options and index funds. A trillion calculations were expended to evolve the rules inside the S&P CNX Nifty index. The results of this work are remarkably si mple: (a) the correct size to use is 50, (b) stocks considered for the S&P CNX Nifty m ust be liquid by the impact cost criterion, (c) the largest 50 stocks that meet the criterion go int o the index. 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 S&P CNX Nif ty covers 21 sectors of the Indian economy and offers investment managers exposure to the Indian market in one efficient portfolio. It is used for a variety of purposes, such as benchmarking fund portfolios, index based derivatives and index funds. The Nifty is uniquely equipped as an index for the index derivatives market owin g to its (a) low market impact cost and (b) high hedging effectiveness. The good diversif ication of Nifty generates low initial margin requirement. Market impact cost is a measure of the liquidity of the market. It reflects the costs faced when actually trading an index. Suppose a stock trades at bid 99 and ask 101. We say the ideal price is Rs. 100. Now, suppose a buy order for 1000 shares goes through at Rs.10 2. Then we say the market impact cost at 1000 shares is 2%. If a buy order for 2000 shares goes through at Rs.104, we say the market impact cost at 2000 shares is 4%. For a stock to qu alify for possible inclusion into the S&P CNX Nifty, it has to have market impact cost of below 0.50% when doing S&P CNX Nifty trades of two crore rupees. This means that if S&P CNX 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).