For an index
to work as an investment benchmark, it must provide an unbiased model of
the market segment it is intended to represent. The selection criteria
of an index set should aim at fulfilling this objective. As GDRs are bought
and traded mostly by large funds abroad, a GDR index should reflect the
transaction costs (execution cost + impact cost) faced by fund managers
when they trade in them.
Execution
costs arise due to spreads between the bid and offer. If one assumes
a round trip transaction, in which a fund manager buys and then sells the
security at the next instant, he would buy at the best ask price (e.g.
Reliance-$23.25) and sell at the best bid price (Reliance-$22.75), which
is lower. By doing this, a fund manager would suffer a loss, which is his
cost of executing the transaction. A security enjoying sufficient liquidity
would have narrow spreads and thus lower execution cost.
Also, as funds
trade in large sized orders, the possibility of price impacts need
to be considered. Price impacts arise due to the law of supply and demand.
Larger the size of an order, more likely its purchase price will be higher,
which also adds to the fund managers transaction cost. For a security that
enjoys sufficient liquidity, impact cost would be low as large orders can
be executed without distorting the price too much.
The approach
of quantifying liquidity using spreads between the bid and offer ensures
that execution and impact costs are low for securities in the index set.
For inclusion
in the index, all GDRs should fulfill the following criteria
The spreads¹
of the GDRs in the index should be less than or equal to an average 6.00% in the previous four quarters or since existence (if less than four quarters), as the case may be.
Those GDRs
once included in the index set will be removed if the average spread
in the previous four quarters is greater than 9.00% or since existence
(if less than four quarters), as the case may be.
New issues
will only be included in the index set if they fulfill the above criteria
when the index comes up for its quarterly review.
¹
The bid-ask spread of a security is defined as the
percent spread between the best bid and ask over the midway quote, i.e.
best (bid + ask)/2.
