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FAQs
Component illiquidity contaminates index What is wrong with the price information for illiquid stocks? There are three problems: `stale prices', `bid-ask bounce' and vulnerability to manipulation. Through these problems, an index is actually worsened when illiquid stocks are put into it. Top A stock may be liquid on one exchange and illiquid on another -- what price do you take when calculating the index? Illiquid stocks yield bad price data; so the best quality data will come from the most liquid exchange. In India, that is NSE. The S&P CNX Nifty uses price data from NSE for calculations. Top What is `stale prices'? Suppose we look at the closing price of an index. It is supposed to reflect the state of the stock market at 3:30 PM on NSE. Suppose an illiquid stock is in the index. The last traded price (LTP) of the stock might be an hour, or a day, or a week old! The index is supposed to show how the stock market perceives the future of the corporate sector at 3:30 PM. When an illiquid stock injects these `stale prices' into the calculation of an index, it makes the index more stale. It reduces the accuracy with which the index reflects information. Top What is `bid-ask bounce'? Suppose a stock trades at bid 1440 ask 1490. Suppose no news appears for ten minutes. But, over this period, suppose that a buy order first comes in (at Rs.1490) followed by a sell order (at Rs. 1440). This sequence of events makes it seem that the stock price has dropped by Rs.50. This is a totally spurious price movement! Even when no news is breaking, when a stock price is not changing, the `bid-ask bounce' is about prices bouncing up and down between bid and ask. These changes are spurious. This problem is the greatest with illiquid stocks where the bid-ask spread is wide. When an index component shows such price changes it contaminates the index. Top What about market manipulation - how would manipulation of an index take place, and how would an index be made less vulnerable to manipulation? The index is a large entity and is intrinsically harder to manipulate when compared to individual stocks. Obviously, larger indices are harder to manipulate than smaller indices. The weak links in an index are the large, illiquid stocks. These are the achilles heel where a manipulator obtains maximum impact upon the index at minimum cost. Optimal index manipulation consists of attacking these stocks. This 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.
Top Last updated on March 10, 2008. |
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