Wednesday, August 20, 2008

Sensitive Index (SENSEX)

Sensitive Index....Are you getting ?
SENSEX....???
I am damn sure you have got it now. Yes, you are right....the heart beat of Indian Stock Exchange. Lets explore some basic facts about SENSEX alias Sensitive Index.
SENSEX is a basket of 30 constituent stocks representing a sample of large, liquid and representative companies. It was first compiled in 1986.The base year of SENSEX is 1978-79 and the base value is 100.

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.


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.

Free-float Methodology
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.


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 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.
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.
Determining Free-float factors of companies
BSE has designed a Free-float format, which is filled and submitted by all index companies on a quarterly basis with the Exchange. The Exchange determines the Free-float factor for each company based on the detailed information submitted by the companies in the prescribed format. Free-float factor is a multiple with which the total market capitalization of a company is adjusted to arrive at the Free-float market capitalization. Once the Free-float of a company is determined, it is rounded-off to the higher multiple of 5 and each company is categorized into one of the 20 bands given below. A Free-float factor of say 0.55 means that only 55% of the market capitalization of the company will be considered for index calculation.


Free-float Bands
>0 – 5%
0.05
>50 – 55%
0.55
>5 – 10%
0.10
>55 – 60%
0.60
>10 – 15%
0.15
>60 – 65%
0.65
>15 – 20%
0.20
>65 – 70%
0.70
>20 – 25%
0.25
>70 – 75%
0.75
>25 – 30%
0.30
>75 – 80%
0.80
>30 – 35%
0.35
>80 – 85%
0.85
>35 – 40%
0.40
>85 – 90%
0.90
>40 – 45%
0.45
>90 – 95%
0.95

Calculation of Index at Closure

The closing SENSEX on any trading day is computed taking the weighted average of all the trades on SENSEX constituents in the last 30 minutes of trading session. If a SENSEX constituent has not traded in the last 30 minutes, the last traded price is taken for computation of the Index closure. If a SENSEX constituent has not traded at all in a day, then its last day's closing price is taken for computation of Index closure. The use of Index Closure Algorithm prevents any intentional manipulation of the closing index value.
Adjustment for Bonus, Rights and Newly issued Capital
The arithmetic calculation involved in calculating SENSEX is simple, but problem arises when one of the component stocks pays a bonus or issues rights shares. If no adjustments were made, a discontinuity would arise between the current value of the index and its previous value despite the non-occurrence of any economic activity of substance. At the Index Cell of the Exchange, the base value is adjusted, which is used to alter market capitalization of the component stocks to arrive at the SENSEX value.
· Adjustments for Rights Issues:
When a company, included in the compilation of the index, issues right shares, the free-float market capitalisation of that company is increased by the number of additional shares issued based on the theoretical (ex-right) price. An offsetting or proportionate adjustment is then made to the Base Market Capitalisation (see 'Base Market Capitalisation Adjustment' below).
· Adjustments for Bonus Issue:
When a company, included in the compilation of the index, issues bonus shares, the market capitalisation of that company does not undergo any change. Therefore, there is no change in the Base Market Capitalisation, only the 'number of shares' in the formula is updated.
· Other Issues:
Base Market Capitalisation Adjustment is required when new shares are issued by way of conversion of debentures, mergers, spin-offs etc. or when equity is reduced by way of buy-back of shares, corporate restructuring etc.
  • Base Market Capitalisation Adjustment:
The formula for adjusting the Base Market Capitalisation is as follows:




New Mkt Cap
New Base Mkt Capitalisation
=
Old Base Mkt Capitalisation
x
--------------------




Old Mkt Cap
To illustrate, suppose a company issues right shares which increases the market capitalisation of the shares of that company by say, Rs.100 crores. The existing Base Market Capitalisation (Old Base Market Capitalisation), say, is Rs.2450 crores and the aggregate market capitalisation of all the shares included in the index before the right issue is made is, say Rs.4781 crores. The "New Base Market Capitalisation " will then be:
2450 x (4781+100)


--------------------------
=
Rs.2501.24 crores
4781


This figure of 2501.24 will be used as the Base Market Capitalisation for calculating the index number from then onwards till the next base change becomes necessary.
SENSEX - Scrip selection criteria
The general guidelines for selection of constituents in SENSEX are as follows:
  1. 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.
  1. 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.
  1. 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.
  1. 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.
  1. Industry Representation:
Scrip selection would generally take into account a balanced representation of the listed companies in the universe of BSE.
  1. Track Record:
In the opinion of the Committee, the company should have an acceptable track record.


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