SECURITY MARKET OPERATIONS

Topic: Credit rating & Price indices

Group No. = I (10) Group member:-

Ranjna
Manish rai
Vivek sharma
Bhupendra Yadav
Rajesh Babu Katiyaar
 CREDIT RATING

Many a times, it has happened that investors in debentures or fixed deposits were
shown rosy pictures of companies and offered very high rates of interests by bogus
companies and in the end the investor neither got his money back nor the promised
interest. Actually, it is very difficult for an individual investor to gather details
about creditworthiness of a company, neither he has the time nor the skills to
undertake risk evaluation.
Every investor wants to ensure safety of his investment. Credit rating agencies
investigate the financial position of the company issuing various kinds of
instruments and assess risks involved in investing money in them. In the system of
credit rating, the credit rating agency rate the risks involved in investment in
instruments of a particular company, they may rank it from very safe to very risky.
At present credit rating is done only for debt-instruments and rarely for preference
or equity shares.
DEFINITION
Credit rating system can be defined as an act of assigning values to credit
instruments by assessing the solvency i.e., the ability of the borrower to repay debt,
and expressing them through predetermined symbols.
Credit Rating as “An assessment of the creditworthiness of a borrower in general
terms or with respect to a particular debt or financial obligation”. A credit rating
can be assigned to any entity that seeks to borrow money – an individual,
corporation, state or provincial authority, or sovereign government.
CHARACTERISTICS OF CREDIT RATING
1. Assessment of issuer's capacity to repay. It assesses issuer's capacity to meet
its financial obligations i.e., its capacity to pay interest and repay the principal
amount borrowed.
2. Based on data. A credit rating agency assesses financial strength of the
borrower on the financial data.
3. Expressed in symbols. Ratings are expressed in symbols e.g. AAA, BBB which
can be understood by a layman too.
4. Done by expert. Credit rating is done by expert of reputed, accredited
institutions.
5. Guidance about investment-not recommendation. Credit rating is only a
guidance to investors and not recommendation to invest in any particular
instrument.
WHAT CREDIT RATING IS NOT
1. Not for company as a whole. Credit rating is done for a particular instrument
i.e., for a particular class of debentures and not for the company as a whole, it is
quite possible that two instruments issued by the same company may carry
different rating.
2. Does not create a fiduciary relationship. Credit rating does not create a
fiduciary relationship (relationship of trust) between the credit rating agency and
the investor.
3. Not attestation of truthfulness of information provided by rated. company.
Rating does not imply that the credit rating agency attests the truthfulness of
information provided by the rated company.
4. Rating not forever. Credit rating is not a one-time evaluation of risk. which
remains valid for the entire life of a security. It can change from time to time.
COMPULSORY CREDIT RATING
Obtaining credit rating is compulsory in the following cases
1. For debt securities. The Reserve Bank of India and SEBI have made credit
rating compulsory in respect of all non-government debt securities where the
maturities exceed 18 months 2. Public deposits. Rating of deposits in companies
has also been made compulsory.
3. For commercial papers (CPs). Credit rating has also been made compulsory
for commercial papers. As per Reserve Bank of India guidelines rating of P2 by
CRISIL or A2 by ICRA or PP2 by CARE is necessary for commercial papers.
4. For fixed deposits with non-banking financial institutions (NBFCs). Under
the Companies Act, credit rating has been made compulsory for fixed deposits with
NBFs.
FACTORS CONSIDERED IN CREDIT RATING
1. Issuers ability to service its debt. For this credit rating agencies calculate
a) Issuer company's past and future cash flows.
b) Assess how much money the company will have to pay as interest on borrowed
funds and how much will be its earnings.
c) How much are the outstanding debts?
d) Company's short term solvency through calculation of current ratio.
e) Value of assets pledged as collateral security by the company.
f) availability and quality of raw material used, favorable location, cost advantage.
g) Track record of promoters, directors and expertise of the staff.
2. Market positon of the company. What is the market share of various products
of the company, whether it will be stable, does the company possess competitive
advantage due to distribution network, customer base research and development
facilities etc.
3. Quality of management. Credit rating agency will also take into consideration
track record, strategies, competency and philosophy of senior management.
4. Legal position of the instrument. It means whether the issued instrument is
legally valid, what are the terms and conditions of issue and redemption; how
much the instrument is protected from frauds, what are the terms of debenture trust
deed etc.
5. Industry risks. Industry risks are studied in relation to position of demand and
supply for the products of that industry (e.g. cars or electronics) how much is the
international competition, what are the future prospects of that industry, is it going
to die or expand?
6. Regulatory environment. Whether that industry is being regulated by
government (like liquor industry), Whether there is a price control on it, whether
there is government support for it, can it take advantage of tax concessions etc.
7. Other factors. In addition to the above, the other factors to be noted for credit
rating of a company are its cost structure, insurance cover undertaken, accounting
quality, market reputation, working capital management, human resource quality,
funding policy, leverage, flexibility, exchange rate risks etc.
CREDIT RATING PROCESS
In India credit rating is done mostly at the request of the borrowers or issuer
companies. The borrower or issuer company requests the credit rating agency for
assigning a ranking to the proposed instrument. The process followed by most of
the credit rating agencies is as follows:
1. Agreement. An agreement is entered into between the rating agency and the
issuer company. It covers details about terms and conditions for doing the rating.
2. Appointment of analytical team. The rating agency assigns the job to a team of
experts. The team usually comprises of two analysts who have expert knowledge in
the relevant business area and is responsible for carrying out rating.
3. Obtaining information. The analytical team obtains the required information
from the client company and studies company's financial position, cash flows,
nature and basis of competition, market share, operating efficiency arrangements,
managements track cost structure, selling and distribution record, power
(electricity) and labour situation etc.
4. Meeting the officials. To obtain clarifications and understanding the client's
business the analytical team visits and interacts with the executives of the client.
5. Discussion about findings. After completion of study of facts and their analysis
by the analytical team the matter is placed before the internal committee (which
comprises of senior analysts) an opinion about the rating is taken.
6. Meeting of the rating committee. The findings of internal committee are
referred to the “rating committee" which generally comprises of a few directors
and is the final authority for assigning ratings.
7. Communication of decision. The rating decided by the rating committee is
communicated to the requesting company.
8. Information to the public. The rating company publishes the rating through
reports and the press.
9. Revision of the rating. Once the issuer company has accepted the rating, the
rating agency is under an obligation to monitor the assigned rating. The rating
agency monitors all ratings during the life of the instrument.
TYPES OF CREDIT RATING
1. Rating of bonds and debentures. Rating is popular in certain cases for bonds
and debentures. Practically, all credit rating agencies are doing rating for
debentures and bonds.
2. Rating of equity shares. Rating of equity shares is not mandatory in India but
credit rating agency ICRA has formulated a system for equity rating. Even SEBI
has no immediate plans for compulsory credit rating of initial public offerings
(IPOs).
3. Rating of preference shares. In India preference shares are not being rated,
however Moody's Investor Service has been rating preference shares since 1973
and ICRA has provision for it.
4. Rating of medium term loans (Public deposits, CDs etc.). Fixed deposits
taken by companies are rated on regular scale in India.
5. Rating of short-term instruments [Commercial Papers (CPs). Credit rating
of short term instruments like commercial papers has been started from 1990.
Credit rating for CPs is mandatory which is being done by CRISIL, ICRA and
CARE.
6. Rating of borrowers. Rating of borrowers, may be an individual or a company
is known as borrower’s rating.
7. Rating of real estate builders and developers. A lot of private colonisers and
flat builders are operating in big cities. Rating about them is done to ensure that
they will properly develop a colony or build flats. CRISIL has started rating of
builders and developers.
8. Rating of chit funds. Chit funds collect monthly contributions from savers and
give loans to those participants who offer highest rate of interest. Chit funds are
rated on the basis of their ability to make timely payment of prize money to
subscribers. CRISIL does credit rating of chit funds.
9. Ratings of insurance companies. With the entry of private sector insurance
companies, credit rating of insurance companies is also gaining ground. Insurance
companies are rated on the basis of their claim paying ability (whether it has high,
adequate, moderate or weak claim-paying capacity). ICRA is doing the work of
rating insurance companies.
10. Rating of collective investment schemes. When funds of a large number of
investors are collectively invested in schemes, these are called collective
investment schemes. Credit rating about them means (assessing) whether the
scheme will be successful or not. ICRA is doing credit rating of such schemes.
11. Rating of banks. Private and cooperative banks have been failing quite
regularly in India. People like to deposit money in banks which are financially
sound and capable of repaying back the deposits. CRISIL and ICRA are now doing
rating of banks.
12. Rating of states. States in India are now being also rated whether they are fit
for investment or not. States with good credit ratings are able to attract investors
from within the country and from abroad.
13. Rating of countries. Foreign investors and lenders are interested in knowing
the repaying capacity and willingness of the country to repay loans taken by it.
They want to make sure that investment in that country is profitable or not. While
rating a country the factors considered are its industrial and agricultural
production, gross domestic product, government policies, rate of inflation, extent
of deficit financing etc. Moody’s, and Morgan Stanley are doing rating of
countries.
FUNCTIONS/IMPORTANCE OF CREDIT RATING
1. It provides unbiased opinion to investors. Opinion of good credit rating
agency is unbiased because it has no vested interest in the rated company.
2. Provide quality and dependable information. Credit rating agencies employ
highly qualified, trained and experienced staff to assess risks and they have access
to vital and important information and therefore can provide accurate information
about creditworthiness of the borrowing company.
3. Provide information in easy to understand language. Credit rating agencies
gather information, analyse and interpret it and present their findings in easy to
understand language that is in symbols like AAA, BB, C and not in technical
language or in the form of lengthy reports.
4. Provide information free of cost or at nominal cost. Credit ratings of
instruments are published in financial newspapers and advertisements of the rated
companies. The public has not to pay for them. Even otherwise, anybody can get
them from credit rating agency on payment of nominal fee. It is beyond the
capacity of individual investors to gather such information at their own cost.
5. Helps investors in taking investment decisions. Credit ratings help investors in
assessing risks and taking investment decision.
6. Disciplines corporate borrowers. When a borrower gets higher credit rating, it
increases its goodwill and other companies also do not want to lag behind in
ratings and inculcate financial discipline in their working and follow ethical
practice to become eligible for good ratings, this tendency promotes healthy
discipline among companies.
7. Formation of public policy on investment. When the debt instruments have
been rated by credit rating agencies, policies can be laid down by regulatory
authorities (SEBI, RBI) about eligibility of securities in which funds can be
invested by various institutions like mutual funds, provident funds trust etc.
For example, it can be prescribed that a mutual fund cannot invest in debentures of
a company unless it has got the rating of AAA.
BENEFITS OF CREDIT RATING
Credit rating offers many advantages which can be classified into
A. Benefits to investors.
B. Benefits to the rated company.
C. Benefits to intermediaries.
D. Benefits to the business world.
BENEFITS TO INVESTORS
1. Assessment of risk. The investor through credit rating can assess risk involved
in an investment. A small individual investor does not have the skills, time and
resources to undertake detailed risk evaluation himself. Credit rating agencies who
have expert knowledge, skills and manpower to study these matters can do this job
for him. Moreover, the ratings which are expressed in symbols like AAA, BB etc.
can be understood easily by investors.
2. Information at low cost. Credit ratings are published in financial newspapers
and are available from rating agencies at nominal fees. This way the investors get
credit information about borrowers at no or little cost.
3. Advantage of continuous monitoring. Credit rating agencies do not normally
undertake rating of securities only once. They continuously monitor them and
upgrade and downgrade the ratings depending upon changed circumstances.
4. Provides the investors a choice of Investment. Credit ratings agencies help the
investors to gather information about creditworthiness of different companies. So,
investors have a choice to invest in one company or the other.
5. Ratings by credit rating agencies is dependable. A rating agency has no
vested interest in a security to be rated and has no business links with the
management of the issuer company. Hence ratings by them are unbiased and
credible.
BENEFITS TO THE RATED COMPANY
1. Ease in borrowings. If a company gets high credit rating for its securities, it can
raise funds with more ease in the capital market.
2. Borrowing at cheaper rates. A favourably rated company enjoys the
confidence of investors and therefore, could borrow at lower rate of interest.
3. Facilitates growth. Encouraged by favourable rating, promoters are motivated
to go in for plans of expansion, diversification and growth. Moreover, highly rated
companies find it easy to raise funds from public through issue of ownership or
credit securities in future. They find it easy to borrow from banks.
4. Recognition of lesser known companies. Favourable credit rating of
instruments of lesser known or unknown companies provides them credibility and
recognition in the eyes of the investing public.
5. Adds to the goodwill of the rated company. If a company is rated high by
rating agencies it will automatically increase its goodwill in the market.
6. Imposes financial discipline on borrowers. Borrowing companies know that
they will get high credit rating only when they manage their finances in a
disciplined manner i.e., they maintain good operating efficiency, appropriate
liquidity, good quality assets etc. This develops a sense of financial discipline
among companies who want to borrow.
7. Greater information disclosure. To get credit rating from an accredited
agency, companies have to disclose a lot of information about their operations to
them. It encourages greater information disclosures, better accounting standards
and improved financial information which in turn help in the protection of the
investors.
BENEFITS TO INTERMEDIARIES
1. Merchant bankers' and brokers' job made easy. In the absence of credit rating,
merchant bankers or brokers have to convince the investors about financial
position of the borrowing company. If a borrowing company's credit rating is done
by a reputed credit agency, the task of merchant bankers and brokers becomes
much easy.
BENEFITS TO THE BUSINESS WORLD
1. Increase in investor population. If investors get good guidance about investing
the money in debt instruments through credit ratings, more and more people are
encouraged to invest their savings in corporate debts.
2. Guidance to foreign investors. Foreign collaborators or foreign financial
institutions will invest in those companies only whose credit rating is high. Credit
rating will enable them to instantly identify the position of the company.
CREDIT RATING AGENCIES IN INDIA
There are 6 credit rating agencies which are registered with SEBI. These are
CRISIL, ICRA, CARE, Fitch India, Brickwork Ratings, and SMERA.
1. Credit Rating and Information Services of India Limited (CRISIL) It is
India’s first credit rating agency which was incorporated and promoted by the
 Erstwhile ICICI Ltd, along with UTI and other financial institutions in 1987.
After 1 year, i.e. in 1988 it commenced its operations
 It has its head office in Mumbai.
 It is India’s foremost provider of ratings, data and research, analytics and
solutions,
 With a strong track record of growth and innovation. It delivers independent
opinions and efficient solutions.
 CRISIL’s businesses operate from 8 countries including USA, Argentina,
Poland,
 UK, India, China, Hong Kong and Singapore. CRISIL’s majority shareholder is
Standard
 Poor’s. It also works with governments and policy-makers in India and other
emerging
 Markets in the infrastructure domain.
2. Investment Information and Credit rating agency (ICRA) The second credit
rating agency incorporated in India was ICRA in 1991.
 It was set up by leading financial/investment institutions, commercial banks and
 Financial services companies as an independent and professional investment
Information and Credit Rating Agency. It is a public limited company.
 It has its head office in New Delhi.
 ICRA’s majority shareholder is Moody’s.
3. Credit Analysis & Research Ltd. (CARE) The next credit rating agency to be
set up was CARE in 1993.
 It is the second-largest credit rating agency in India.
 It has its head office in Mumbai.
 CARE Ratings is one of the
5. Partners of an international rating agency called ARC
 Ratings.
6. ONICRA it is a private sector agency set up by Onida Finance.
 It has its head office in Gurgaon.
 It provides ratings, risk assessment and analytical solutions to Individuals,
MSMEs
 Corporates. It is one of only 7 agencies licensed by NSIC (National Small
Industries
 Corporation) to rate SMEs. They have Pan India Presence with offices over 125
locations.

Methodology of Credit Rating

The process of credit rating begins with the prospective issuer approaching the
rating agency for evaluation. The experts in analyzing banks should be given a free
hand and they will collect data and informant and will investigate the business
strength and weaknesses in detail. The entire process of rating stands on the for of
confidentiality and hence even the most confidential business strategies, marketing
plans, future outlook etc., are revealed to the steam of analysis.
The rating is based on the investigation analysis, study and interpretation of
various factors. The world of investment is exposed to the continuous onslaught of
political, economic, social and other forces which does not permit any one to
understand sufficiently certainty. Hence a logical approach to systematic
evaluation is compulsory and within the framework of certain common features the
agencies employ different methodologies. The key factors generally considered are
listed below:
1. Business Analysis or Company Analysis
This includes an analysis of industry risk, market position of the company,
operating efficiency of the company and legal position of the company.
Industry risk: Nature and basis of competition, key success factors; demand
supply position; structure of industry; government policies, etc.
Market position of the company within the Industry: Market share; competitive
advantages, distribution arrangements; product and customer diversity etc.
Operating efficiency of the company: Locational advantages; labor relationships;
cost structure and manufacturing as compared to those of competition.
Legal Position: Terms of prospectus; trustees and then responsibilities; system for
timely payment and for protection against forgery/fraud, etc.
2. Economic Analysis
In order to evaluate an instrument an analyst must spend a considerable time in
investigating the various economic activities and also analyze the characteristics
peculiar to the industry, whose issue the analyst is concerned with. It will be an
error to ignore these factors as the individual companies are always exposed to
changing environment and the economic activates affect corporate profits, attitudes
and expectation of investors and the price of the instrument. Hence the relevance
of the economic variables such as growth rate, national income and expenditure
cannot be ignored. The analysis, while doing the economic forecasting use surveys,
various economic indicators and indices.
3. Financial Analysis
This includes an analysis of accounting, quality, earnings, protection adequacy of
cash flows and financial flexibility.
Accounting Quality: Overstatement/under statement of profits; auditors
qualification; methods of income recognition’s inventory valuation and
depreciation policies, off balance sheet liabilities etc.
Earnings Protection: Sources of future earnings growth; profitability ratios;
earnings in relation to fixed income changes.
Adequacy of cash flows: In relation to dept and fixed and working capital needs;
variability of future cash flows; capital spending flexibility working capital
management etc.
Financial Flexibility: Alternative financing plans in ties of stress; ability to raise
funds asset redeployment.
4. Management Evaluation
 Track record of the management planning and control system, depth of
managerial talent, succession plans.
 Evaluation of capacity to overcome adverse situations
 Goals, philosophy and strategies.
5. Geographical Analysis

 Location advantages and disadvantages

 Backward area benefit to the company/division/unit
6. Fundamental Analysis
Fundamental analysis is essential for the assessment of finance companies. This
includes an analysis of liquidity management, profitability and financial position
and interest and tax sensitivity of the company.
 Liquidity Management: Capital structure; term matching of assets and
liabilities policy and liquid assets in relation to financing commitments and
maturing deposits.
 Asset Quality: Quality of the company’s credit-risk management; system
for monitoring credit; sector risk; exposure to individual
borrower; management of problem credits etc.
 Profitability and financial position: Historic profits, spread on fund
deployment revenue on non-fund based services accretion to reserves etc.
 Interest and Tax sensitivity: Exposure to interest rate changes, hedge
against interest rate and tax low changes, etc.

SHARE PRICE INDICES

You may often hear people speaking that the ‘market’ fell one day, or that the
‘market’ jumped. However, if you read the stock table, you will realize that not all
stocks rose or fell. There were some which moved in the opposite direction. Then,
what does the ‘market’ mean?
It means an index.
WHAT ARE STOCK INDICES?
From among the stocks listed on the exchange, some similar stocks are selected
and grouped together to form an index. This classification may be on the basis of
the industry the companies belong to, the size of the company, market
capitalization or some other basis. For example, the BSE Sensex is an index
consisting of 30 stocks. Similarly, the BSE 500 is an index consisting of 500
stocks.
The values of the grouped stocks are used to calculate the value of the index. Any
change in the price of the stocks leads to a change in the index value. An index is
thus indicative of the changes in the market.
Some of the important indices in India are:
Benchmark indices – BSE Sensex and NSE Nifty
Sectoral indices like BSE Bankex and CNX IT
Market capitalization-based indices like the BSE Smallcap and BSE Midcap
Broad-market indices like BSE 100 and BSE 500
WHY DO WE NEED INDICES?
Indices are an important part of the stock market. Here’s why we need stock
indices:

Sorting:
In a share market, there are thousands of companies listed. How do you
differentiate between all of those and pick one or two to buy? How do you sort
them out? It is a classic case of a pin in a stack of hay. This is where indices come
into the picture. Companies and their shares are classified into indices based on
key characteristics like size of company, sector or industry they belong to, and so
on.
Representation:
Indices act as a representative of the entire market or a certain segment of the
market. In India, the BSE Sensex and the NSE Nifty are considered the benchmark
indices. They are considered to represent the overall market performance.
Similarly, an index formed of IT stocks is supposed to represent all stocks of
companies from the industry.
Comparison:
An index makes it easy for an investor to compare performance. An index can be
used as a benchmark to compare against. For example, in India the Sensex is often
used as a benchmark. So, to find if a stock has outperformed the market, you
simply compare the price trends of the index and the stock. On the other hand, an
index can also be used to compare a set of stocks against a benchmark or another
index. For example, on a given day, the benchmark index like Sensex may jump
200 points, but this rally may not extend to a certain segment of stocks like IT.
Then, the fall in the value of index representing IT stocks could be used for
comparison rather than each individual stocks. This also helps investors identify
market trends easily.
Reflection:
Investor sentiment is a very important aspect of stock market movements. This is
because, if sentiment is positive, there will be demand for a stock. This will
subsequently lead to a rise in prices. It is very difficult to gauge investor sentiment
correctly. Indices help reflect investor’s mood – not just for the overall market, but
even sector-wise and across company sizes. You can simply compare an index
with a benchmark to see if has underperformed or outperformed. This will, in turn,
reflect investor sentiment.
Passive investment:
Many investors prefer to invest in a portfolio of securities that closely resembles an
index. This is called passive investment. An index portfolio helps investors cut
down cost of research and stock selection. They rely on the index for stock
selection. As a result, portfolio returns will match that of the index. For example, if
Sensex gave 8% returns in one month, an investor’s portfolio that resembles the
Sensex is also likely to give the same amount of returns. Indices are also used to
construct mutual funds and exchange-traded funds (ETFs).
HOW ARE STOCK INDICES FORMED?
An index consists of similar stocks. This could be on the basis of industry,
company size, market capitalization or another parameter. Once the stocks are
selected, the index value is calculated. This could be a simple average of the prices
of the components. In India, the free-float market capitalization is commonly used
instead of prices to calculate the value of an index.
The two most common kinds of indices are – Price-weighted and market
capitalization-weighted index.
What is stock weightage?
Every stock has a different price. So, a 1% change in one stock may not equal a
similar change in another stock’s price. So, the index value cannot be a simple total
of the prices of all the stocks. Here is where the concept of stock weightage comes
into play. Each stock in an index has a particular weightage depending on its price
or market capitalization. This is the amount of impact a change in the stock’s price
has on index value.
Market-cap weightage
Market capitalization is the total market value of a company’s stock. This is
calculated by multiplying the share price of a stock with the total number of stocks
floated by the company. It thus takes into consideration both the size and the price
of the stock. In an index using market-cap weightage, stocks are given weightage
on the basis of their market capitalization in comparison with the total market-
capitalization of the index. For example, if stock A has a market capitalization of
Rs. 10,000 while the index it is part of has a total m-cap of Rs. 1, 00,000, then its
weightage will be 10%. Similarly, another stock with a market-cap of Rs. 50,000
will have a weightage of 50%.
The point to remember is that market capitalization changes every day as the stock
price fluctuates. For this reason, a stock’s weightage too changes every day.
However, it is usually a marginal change. Also, the market capitalization-
weightage method gives more importance to companies with higher m-caps.
In India, most indices use free-float market capitalization. In this method, instead
of using the total shares listed by a company to calculate market capitalization,
only the amount of shares publicly available for trading are used. As a result, free-
float market capitalization is a smaller figure than market capitalization.
Price weightage
In this method, an index value is calculated on the basis of the company’s stock
price, and not market capitalization. Stocks with higher prices have greater
weightages in the index than stocks with lower prices. The Dow Jones Industrial
Average in the US and the Nikkei 225 in Japan are examples of price-weighted
indices.
There are also other kinds of weightages like equal-value weightage or
fundamental weightage. However, they are rarely used by public indices.

HOW IS INDEX VALUE CALCULATED?

An index’s value depends on whether it is a price-weighted index or market cap-
weighted. Let us take the example of the BSE Sensex to understand how an index
is calculated.
Price Index
Meaning:
Changes in the levels of prices are measured using a scale called a price index.
This is the most useful device for measuring change in the price level.
In most countries price indexes are used to measure inflation, each focusing on the
prices of a collection of goods and services important to a particular segment of the
economy.
The consumer price index focuses on goods and services typically purchased by
households; the producer price index focuses on goods purchased by business; and
a GDP chain-type index measures price changes in the economy as a whole. To
able to the index numbers we most know what a price index is, how it is
constructed, and how it is interpreted.
A price index is a measure of price changes using a percentage scale. A price index
can be based on the prices of a single item or a selected group of items, called a
market basket. For example, several hundred goods and services—such as rent,
electricity, and automobiles—are used in calculating the consumer price index.
Because a market basket includes a range of goods and services, it provides a more
comprehensive measure of inflationary pressure than a single item would.
Compilation and Uses of Price Indices:
We know that goods and services are valued in terms of money. Their prices
indicate their relative value. When prices go up, the amount which can be bought
with a fixed amount of money goes down; when prices fall, the amount which can
be bought increases. In other words, when prices fall, the value of money rises; and
when prices rise, the value of money falls.
An index number is a statistical device used to express price changes as a
percentage of prices in a base year (or at a base date). (This base date is indicated
by a phrase such as ‘1980= 100’.) In this case, movement in prices is expressed as
percentage changes over the average level prevailing in 1980.
In India there are various price indices such as index of retail prices, index of
wholesale prices, cost of living index of industrial workers, export prices, and so
on. A separate index number can be calculated to measure changes in each price
level. However, the method of construction is the same in each case.
An index number is simply compiled by selecting a group of commodities, noting
their prices in a given year (the base year) and putting the number 100 to the total.
If the prices of the selected commodities rise by, for example, 3% during the next
year, the index number at the end of the year is 103. A fall in price of 1% would be
shown by an index number of 99.
Two related points may be noted in this context:
1. The value of money:
Firstly, commodity prices, wholesale and retail, not only differ but also may be
moving in different directions at different rates at any one time. So, there is no
such things as ‘the value of money’. We have to think of the value of money in
particular uses or in different sectors of the economy.
2. Retail price movements:
Even within any specific sector, e.g., the retail sector, each commodity will have
different prices in different places and even in different shops in the same town.
Moreover, different people buy different things and even when they buy the same
things they buy them in different quantities.
Thus, it is not proper to treat a fall in the average retail value of money as ‘a rise in
the cost of living’. In only means that the cost to a certain section of society living
in its normal manner has risen. A family in a different section of society may have
experienced a greater or lesser rise—or even a fall in its cost of living.
Three Steps:
Three steps are involved in compiling a retail price index. Firstly, one has to decide
which section of the population is to be covered by the index. Thereafter, one has
to find out how the families concerned spend their money. Finally, one has to
choose a base year for the index.
1. Which section of the population?
This depends on the purchase for which the index is to be used. If it is going to be
used for regulating old age pensions the basis of the calculations must be the
pattern of expenditure of old people. If the index is going to be used to assess the
welfare and economic progress of the community as a whole, information has to be
collected from a cross- section of people (i.e., all classes of people). It would be in
the lightness of things to eliminate the very rich and the very poor because their
patterns of expenditure differ so much from the rest of the society that they, if
included, would unduly distort the average picture.
2. What is the average pattern of expenditure of the selected group?
This is found out by taking a survey of the expenditure of the families in the group.
A random sample of families must declare every detail of expenditure in a random
selection of weeks throughout the year. On the basis of this information an average
pattern of expenditure is calculated.
3. What should be the base date (year)?
In determining the base date of index—which should be as mean to the period of
the survey as possible — it is important to consider normal year(s). Any
exceptional year(s) —such as the year(s) of war or emergency or revolution — has
(have) to be avoided. This is because certain factors affecting prices during
wartime are unlikely to be repeated in future (peace time).

The Basic Equation:

The equation for calculating an index number for a given year is

Rupee outlay for a given year/rupee outlay for the base year x 100
= price index number for a given year.
For example, in year 4, Rs. 600 are needed to buy what Rs. 500 bought in the base
year. Putting these numbers into the equation yields.
Rs. 600/Rs. 500 x 100 = 120.0.
To determine an annual percentage change in prices between two consecutive
years, 1 and 2, in a price index, use the following equation:
year 2 index number – year 1 index number/year 1 index number x 100
= annual percentage change.
For example if P1, = 105 and P0 = 100 of then annual price charge will be:
105 – 100 / 100 x 100%
= 5%

Method of Calculation:
The method of calculation is illustrated in Table 19.1. We use imaginary figures
and include only three commodities in the consumption basket for the sake of
simplicity.
The method can be simply explained by assuming that the index covers only two
items —say bread and butter. It would, of course, be easy to take a simple average
of their price changes over any period, but this would not give a true indication of
the change in their combined cost to consumers unless household expenditure on
each commodity happened to be the same.
For instance, if the price of bread rose by 70% and butter by 10% the average
increase would be 40%. But their combined cost would not rise by exactly that
average if consumers spend more on, say, bread than on butter.
To take account of the different significance of items in the index, a system of
weights is adopted. In a retail price index each item is weighed according to its
relative importance in the average family budget.
Thus, if out of every rupee spent each day on bread and butter 80P goes on bread
and 20P on butter, the ratio of 80 to 20 reflects their relative importance and these
figures represent their respective weights out of a total of 100. By using the
weights, our index takes account of the fact that consumers spend four times as
much on bread as on butter.
Let us now calculate the weighted index on the original assumption that the price
of bread rose by 70% and butter by 10%. First, it is customary to express
percentage price changes in an index by calling all prices 100, on the starting (or
base) date.
The percentage increases for bread and butter are thus represented by the numbers
170 and 110 respectively. (If a price fell by, say, 10%, the number would become
90.) The index number for each item is then multiplied by its weight. The resulting
products are next added together and the total finally divided by the sum of the
weights as illustrated in Table 19.2.
Table 19.2: Index Number Calculation:
The weighted index figure of 158 shows a combined price increase of 58% instead
of a 40% increase using an un-weighted average. The difference arises because the
larger price increase was for bread on which our consumers spend more.
Importance of Indexes:
The consumer price index and other measures of inflation are not studied by
academics, business people, and government officials out of idle curiosity. Rather,
the indexes have an important impact on policymakers’ decisions and on the
operation of the economy. They directly affect wages of union workers who
receive cost-of-living adjustments based on the consumer price index, and they
influence the size of many non-union income payments as well.
Employers and employees often look to these indexes in determining “fair” salary
increases. Some government programmes, such as social security, base changes in
monthly checks on a variation of one of these indexes. Private business contracts
may provide for price adjustments based on the producer price index and, in some
instances, other payments such as child support and rent have been tied to one of
these indexes.
Index numbers can be used for a variety of purposes. By comparing the index
numbers of several years in succession we can find out whether the price level is
rising or falling and the degree of change. Appropriate measures can then be taken
by the government to counteract the bad effects of price changes in either
direction.
Cost of living index numbers can be used to judge the conditions of the working
class. In some countries, wages are varied in proportion to the changes in the cost
of learning index number so that the workers may not suffer distress when prices
rise.
Index numbers are useful for comparing the price situation of one year with that of
another. For example, the index numbers of the years 1939 to 1945 show how the
price level and the value of money changed during these years. But long range
comparisons should not be made. It is useless to compare the index number of
1939 with that of 1999.
The reason is that in 1999 many new commodities have come into existence and
most of the commodities of 1939, which are still in use in 1999, have considerably
changed in quality. When the time interval is much too long, there is no common
base for comparison. This is also true for index numbers of different countries.

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