s is one more reason why illiquid stocks should be excluded from a market index; indeed this aspect requires that the liquidity of a stock in an index should be proportional to its market capitalisation.
The NIFTY 50
NIFTY 50 is based upon solid economic research. A trillion calculations were expended to evolve the rules inside the NIFTY 50 index. The results of this work are remarkably simple: (a) the correct size to use is 50, (b) stocks considered for the NIFTY 50 must be liquid by the 'impact cost' criterion, (c) the largest 50 stocks that meet the criterion go into the index. NIFTY 50 is a contrast to the adhoc methods that have gone into index construction in the preceding years, where indices were made out of intuition and lacked a scientific basis. The research that led up to NIFTY 50 is well-respected internationally as a pioneering effort in better understanding how to make a stock market index. See "Market microstructure considerations in index construction" by Ajay Shah and Susan Thomas, CBOT Research Symposium Proceedings, Summer 1998, page 173-193.
Suppose a stock trades at bid 99 and ask 101. We say the "ideal" price is ₹ 100. Now, suppose a buy order for 1000 shares goes through at ₹ 102. Then we say the market impact cost at 1000 shares is 2%. If a buy order for 2000 shares goes through at ₹ 104, we say the market impact cost at 2000 shares is 4%. Market impact cost is the best measure of the liquidity of a stock. It accurately reflects the costs faced when actually trading an index. For a stock to qualify for possible inclusion into the NIFTY 50, it has to reliably have market impact cost of below 0.50 % when doing NIFTY 50 trades of twp crore rupees.
Earlier, we said that the index assigns weightages to index components, and the weight of a stock is proportional to its market capitalisation. This idea can be applied to buying the NIFTY 50. If you buy all 50 stocks in the NIFTY 50, in correct proportions, that would be called "an index trade".
It is safe to think that the impact cost is 0.1% or so. This means that if NIFTY 50 is at 1000, a buy order goes through at 1001 and a sell order gets 999. NSE's NEAT software has special facilities to enable buying or selling the entire the NIFTY 50 at one shot. The impact cost is not something fixed. It changes, depending upon the liquidity of the market. Indeed, the time-series of the NIFTY 50 impact cost is one of the best measures of changes in market liquidity over the years.
Think of a liquid stock as a good thermometer, one which gives accurate data about the true price of the stock, because it trades actively with a tight spread. The prices observed for an illiquid stock are like readings from a low quality thermometer, which reports noisy data about the phenomenon of interest (the true price of the security). We try to find the fifty best thermometers in the country and average their values to make the NIFTY 50. As time passes, better thermometers become available (in the form of large, liquid stocks that are not in the NIFTY 50). We would like that NIFTY 50 always uses the best thermometers possible. So we remove the weakest thermometer from inside the NIFTY 50 and accept the new stock into it. The world changes, so the index should change. Yet, the change should not be sudden - for that would disrupt the character of the index. NIFTY 50 uses clear, researched and publicly documented rules for index revision. These rules are applied regularly, to obtain changes to the index set. Index reviews are carried out every six months to ensure that each security in the index fulfils all the laid down criteria. IDBI was once not listed; SBI was once illiquid; Infosys was once an obscure software startup. The world changes, and one by one, these stocks have come into the NIFTY 50. Each change in the NIFTY 50 is small, so the continuity of the index is maintained. Yet, at all times, NIFTY 50 represents the 50 large and most liquid stocks in the country, the best thermometers to build an index out of.
No. There are mathematical formulas, which ensure that yesterday'