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China's Stock Index, Index-Linked Products

Since its inception in 1990, China's stock market has grown to list more than 1,300 stocks.

Since its inception in 1990, China's stock market has grown to list more than 1,300 stocks. The Shanghai Shenzhen 300 index issued by the Shanghai Stock Exchange and Shenzhen Stock Exchange in April 2005, however, is the first stock index in China that tracks the broader stock market on both exchanges.



Before the Shanghai Shenzhen 300 index, the two bourses each had a series of indices to track their listed stocks. Although a number of financial institutions developed own-brand indices that tracked stocks on both exchanges, these were not widely used. Investors mostly considered the Shanghai Composite Index, which tracks all A-shares and B-shares listed on the Shanghai Stock Exchange, to be the national benchmark for the stock market.

The new index is the first to be jointly released by the Shanghai and Shenzhen Stock Exchanges. It selects 300 yuan-denominated A-shares from the Shanghai and Shenzhen Stock Exchanges as constituent stocks. At the end of March 2005, the index had a total market capitalization of RMB2.18 trillion (USD263 billion) and accounted for about 65% of the total market capitalization of the two exchanges.


Constituent Stocks Selection, Replacement

To be eligible for the Shanghai Shenzhen 300 index, a stock must be:

* Listed on the Shanghai or Shenzhen Exchange for more than a quarter;

* Not ST ("special treatment") or *ST stocks, or subject to suspended trading;

* Issued by a company that operates well, has no material violation of laws or regulations, and has no material issues with its financial reporting; and,

* Not apparently subject to uncommon fluctuations or market manipulations.

The group of eligible stocks is called a sample space in statistical terms. The Shanghai Shenzhen 300 index then selects from the sample space 300 large-cap, liquid names as index components. This scale and liquidity approach is reflected in a weighted average scoring system that takes into account the following factors in daily average terms:

* Total market capitalization;

* Market value of floating shares;

* Number of floating shares;

* Market value of trading volume; and,

* Trading volume.

The above factors are 12-month averages, or IPO-to-date averages for newly-listed stocks, and the exchanges assign 20%: 20%: 20%: 10%: 10% weights to the factors. All the stocks in the sample space are then ranked by such weighted and averaged calculation results, with the highest 300 scores becoming the index component.

The index will be revised semi-annually, typically each January and July, and no more than 30 stocks (10%) will be changed. The exchanges adopted a so-called sampling buffer mechanism to select new stocks to replace those removed from the index. The buffer gives preference to the top 240 stocks in the new sample space and the top 360 in the old sample space, which aims to reduce the index turnover rate hence reducing index investors' tracking costs.


Chinese Characteristics In Index Computation

Many widely-used indices such as the familiar Standard & Poor's 500 index are weighted by market capitalization. Such an approach, however, faces challenges in China because of the unique share-class structure of the listed companies. The shares of locally listed companies, known as A-shares, are sub-classified into three categories, which are state shares, legal person shares, and public individual shares. Only the public individual shares are freely floating in the open markets. As a result, about two-thirds of the shares of the listed companies are currently not freely tradable.

Such a substantial overhang of non-tradable shares suggests that comparing to market capitalization, the free float of China stocks should reflect their liquidity and suitability for investment more accurately. Using free float directly as weights creates problems, however. As China continues its effort to reduce government ownership in listed companies, the free float of the companies is steadily increasing. Thus simply applying free float as index weights will lead to frequent index adjustments, which will increase index maintenance costs as well as index investors' tracking costs.

In balance, the Shanghai Shenzhen 300 index adopts a float-adjusted capitalization methodology. Based on a stock's float­ to outstanding share ratio, the exchanges assign a weight factor. The weight factor is then applied to the stock's total outstanding shares to determine the appropriate weight for the stock in the index calculation.


Prospect For Index Products

The exchanges and securities firms are expected to offer a series of new investment products linked to the Shanghai Shenzhen 300 index in the near future. In addition to regular index mutual funds, the new index may also be applied to innovative fund products such as exchange-traded funds and listed open-ended funds (DW, Learning Curve 4/25).

Furthermore, with China's stock market trading around multiple-year lows, investors are in desperate need for stock market hedging tools. But a stock borrowing and short selling mechanism is not currently available. Thus a futures contract linked to a broad market index could become an important hedging tool for stock investors. Investors are eagerly waiting to see whether the exchanges will offer index futures following the introduction of the new Shanghai Shenzhen 300 index, which will provide a new alternative for investors to manage the broad stock market risk.



The Shanghai Shenzhen 300 Index is the first stock index jointly issued by the Shanghai and Shenzhen Stock Exchanges in China, providing a truly nationwide benchmark for China's Stock Market. Considering the Chinese characteristics of the stock market, the exchanges adopted a sampling buffer and a float-adjusted capitalization methodology to facilitate the index maintenance process, which should help index investors reduce tracking costs. The Shanghai Shenzhen 300 Index may lead to a new series of index products in China in the near future, including the long-awaited index futures products.


This week's Learning Curve was written by Winston W. Ma, CFA, marketing specialist and products structurer in the equity capital and derivatives markets at JPMorgan Securitiesin New York, and head of the corporate products steering committee of the Structured Products Association.

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