The Nifty Financial Services Index: The Backbone Of Modern Economy

By: Tavaga Research

The Nifty Financial Services Index captured the eyeballs of market participants this week, as the National Stock Exchange (NSE) launched F&O (Futures & Options) contracts on the Nifty Financial Services Index (FINNIFTY) on 11th January 2021.

There were 1.4 lakh contracts traded on the first day itself worth Rs. 511 Crores. The exchange transaction charges on these contracts have been waived-off by the NSE for 6 months, in order to promote the financial instrument.

What is the Nifty Financial Services Index (FINNIFTY)?

FINNIFTY comprises 20 stocks with a majority composition of bank stocks of both Private and Public Sector banks, followed by housing finance companies, insurance companies, financial institutions, and other financial services companies. This is a strong composition given that the financial services industry accounts for around 33.5 percent of the Nifty 500 Index.

The FINNIFTY was launched by the NSE on 7th September 2007, to track the performance of the above-mentioned companies. It gives the investors a wider exposure to financial sector companies compared to Nifty Bank that comprises the 12 largest private and public banks listed on the exchange. FINNIFTY follows a similar free-float methodology to calculate its market capitalization.

The three largest contributors to the Nifty Financial Services Index are HDFC Bank Ltd., Housing Development Finance Corporation, and ICICI Bank Ltd which sum up to 59.1% of FINNIFTY weightage.

Below is a graph of how the Nifty Financial Services Index and the share prices of the three banks move:

The FINNIFTY does not have a share price but has its value determined based on the performance of the stocks that the index comprises. Hence it is updated in real-time, just like the movements in share prices of the banks and other financial institutions that make up the index.

Typically, investors use derivatives to hedge their positions and reduce their investment risk. The derivatives newly launched on the Nifty Financial Services Index would provide investors with a benefit from such movements in share prices, the diversification that the index offers, and thus work as a “risk management tool” for those having exposures to the financial services sector.

Derivatives Traded on the Nifty Financial Services Index

Futures and options were launched for trading by the National Stock Exchange (NSE) on the FINNIFTY index from 11th January 2021 on a weekly basis for the first time.  According to the exchange, futures and options would be offered in seven serial weekly contracts and three serial monthly contracts except for the monthly expiry.

The lot size for the F&Os traded on the FINNIFTY index would be 40.

The expiry for the F&Os traded on the Nifty Financial Services Index

The expiry for the F&O contracts:
Monthly contracts – Last Thursday of the month of the expiry

Weekly contracts – Thursday of the week of expiry except for the above i.e. last Thursday of the month of expiry.

If there is a trading holiday on Thursday, the expiry for the monthly and weekly contracts would be the previous trading day. For the settlement of stock F&O contracts physical settlement has been mandated by the SEBI after October 2019.

FINNIFTY Option Chain (Equity Derivatives):

Just like the Bank Nifty and Nifty50 have an option chain with all the information related to the option contracts that are being traded in the market, there is a similar Nifty Financial Futures and Options chain published by the NSE for information regarding various index Options’ contracts along with their expiry dates.

For options, the strike prices, indicating the price at which options contracts are available in the market are also available.

Banking News’ impact on Nifty Financial Services Index

FINNIFTY is affected by the news revolving around banks and other financial institutions including notable cases like:

• IL&FS Crisis: Infrastructure Leasing & Financial Services (IL&FS), a leading infrastructure lending company with over 150 subsidiaries, defaulted on interest payments to its bondholders in June 2018. These payments amounted to around Rs. 450 crore and led to a downgrade in IL&FS’ long-term ratings in the 2-3 months to follow. Rs. 4,475 crores of debt securities were downgraded from AAA to AA+ rating.

Furthermore, the company defaulted on an Rs. 1000 crore loan from SIDBI and its subsidiary defaulted on an Rs. 500 crore loan as well which was taken from the Development Finance Company. This downgrade in their ratings affected mutual funds to whom IL&FS had issued bonds worth more than Rs. 11 lakh crores. The debt on the books of IL&FS had reached over Rs. 91000 crores in 2018, of which Rs. 57,000 crores were owed to public sector banks.

The Serious Fraud Investigation Office (SFIO) later found that the books were window-dressed by former management and the Employee Welfare Trust was used for personal gain.

• DHFL Crisis: Dewan Housing Finance Ltd aka DHFL, is a non-banking financial intermediary (NBFC), the first NBFC to go in for bankruptcy resolution. The company had been facing a liquidity crisis since 2018, concerns over which gained more attention when DSP Mutual fund sold DHFL debt papers worth Rs. 300 Crore at a yield of 11%.

In 2018, reports about the siphoning off of Rs. 31,000 crores by the promoters of DHFL started floating in the market. These allegations, however, were denied by the promoters. In June 2019, DHFL missed out on interest payments of Rs. 960 crores on their commercial papers. This also led to a downgrade of their commercial papers to D, signaling default and which led to a sharp fall in the stock price of DHFL.

Furthermore, DHFL stopped taking any fresh deposits from their customers in addition to putting a freeze on the withdrawal of existing deposits that their customers had with DHFL.

Even though IL&FS and DHFL do not form a part of the Nifty Financial Services Index, such defaults do have an impact on the banks and other financial institutions who are affected as a result of these wrongdoings.

Top components of the FINNIFTY Index

• HDFC Bank Ltd:
  With a weightage of 25.42% in the 20 of the Nifty Financial Services Index, HDFC Bank Ltd. stands at the top of the index’s constituents. HDFC Bank Ltd has been a consistent performer with a reported net profit after tax of Rs. 7,711 Crore in quarter ended September 2020 vs Rs. 6,648 Crore in the quarter ended in September 2019.
  
  Similarly, net profit after tax for HDFC Bank stood at Rs. 27,296 crores in March 2020 vs Rs. 22,446 Crore in March 2019, with an Earning Per Share (EPS) of Rs. 49.84 in March 2020. The return on equity (ROE) for the year ended March 2020 stood at 15.45%.

The bank has also increased its Capital Adequacy Ratio over the years which as of March 2020 stands at 19%, making the bank stand stronger against the impact of the Covid-19 pandemic.

• Housing Development Finance Corporation Ltd:
  HDFC has a weightage of 18.66% in the 20 constituents of the Nifty Financial Services Index. The net profit after tax for HDFC at the end of March 2020 stood at Rs. 17,080 crore vs Rs. 10,190 Crore in March 2019, growing at a rate of roughly 6% YoY. The net profit after tax for the quarter ended September 2020 stood at Rs. 3,392 Crore.
  The earnings per share for March 2020 stood Rs. 124.14, with a return on equity (ROE) of 16.94%.
  
• ICICI Bank Ltd: ICICI Bank has a weightage of 15.02% in the 20 constituents of the FINNIFTY index. The net profit after tax for March 2020 stood at Rs. 11,050 crore vs Rs. 5,689 crores in March 2019. For the quarter ended September 2020, the net profit after tax stood at Rs. 5,426 crores.
  The earnings per share stood at Rs. 14.81 while the return on equity for ICICI bank is 7.98%. The capital adequacy ratio stands at 16% for the bank. In addition, the above-mentioned constituents of the FINNIFTY index are not just good performers in isolation, but also contribute majorly towards the growth of the index. Strong performing banks are often well equipped to brace for unexpected storms.

Similarly, when we look at SBI Life Insurance Company Ltd, which has the lowest weightage of 1.44% in the Nifty Financial Services Index, the company has delivered a net profit after tax of Rs. 1,422 crores vs Rs. 1,326 crores in March 2019.

The earnings per share for SBI Life Insurance Corporation Ltd has risen as well standing at Rs. 14.22 for the year ended March 2020 and return on equity of 16.26%. The 3-year CAGR sales stood at 35.51% with a 3-year CAGR net profit of 22.05%, growing steadily over the years.

Is the Nifty Financial Services Index relevant?

With the help of the analysis of the above-mentioned companies, it has become easier to justify their inclusion in the FINNIFTY index. Furthermore, the recent inflow of New Foreign Portfolio Investors (FPIs) recorded, including 48% of such inflows in the financial services sector.

In addition to the contribution of banks to the Nifty Bank, other financial institutions including housing finance companies, NBFCs, and insurance companies have also been strong performers in recent years. The FINNIFTY index thus, helps investors track the performance of the combination of financial institutions and gauge where the sector is headed. F&Os traded on the FINNIFTY index thus, gives investors a way to hedge their risks.

Bank Nifty vs Nifty Financial Services Index

The Bank Nifty index comprises of the 12 largest banking stocks by market capitalization. Bank Nifty has offered a return of 13.06% over the past 5 years as of 31st December 2020.

In comparison, the FINNIFTY consists of the 20 largest stocks, not exclusively of banking stocks but also of NBFCs, HFCs, Insurance companies, etc. The index has offered a return of 16.59% over the past 5 years as of 31st December 2020. This signifies the contribution of the FINNIFTY index’s constituents.

As seen in the chart above, the Nifty Financial Services Index has been a better performer in the past five years, although growing neck-to-neck with Bank Nifty in the initial years of comparison.

To conclude, the FINNIFTY index would be useful in the months to come, as there would be a much clearer picture of the current asset quality i.e., of the loans given out by banks, NBFCs, HFCs, etc. combined with the performance of the insurance industry given the impact of the Covid-19 pandemic.

However, this financial instrument (Dervivate Contracts) should only be used by full-time traders participating actively in the stock market, and not by passive investors.

As the passive instruments have started gaining traction in India, hopefully, the investors will also get a chance to invest in the Nifty Financial Services Index via ETFs or index funds.

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