Stock market indices are ubiquitous. People come across these indices almost every day. However, many are not aware about their existence.

For instance everyone knows about NYSE, NASDAQ, FTSE, NIFTY etc. However, few are aware that they are referring to stock market indices when they talk about the markets going up or down. The New Stock Exchange is just an exchange. It does not rise or fall in value.

The indices calculated based on the data aggregated by New York Stock Exchange are what everyone seems to be referring to all the time.

In this article, we will provide a basic introduction of market indices. This will equip the reader to understand what these indices are and why they are important.

What are Market Indices ?

Market indices are merely statistical indicators. In financial markets, they are designed to let the people compare the performance of a portfolio of securities. This portfolio could represent an entire market or a particular segment of the market like banking, oil and gas etc.

The index can be easily created because the Pareto principle applies to financial markets. This means that only 20% of the companies that are listed account for more than 80% of the value on the stock exchange.

Hence, these indices only track the movements of a handful of companies in the market. Since these companies broadly represent the market the performance of the entire market can be gauged from their performance.

Index values only make sense when compared to a base value. The base value could be a previous day’s value or it could be the value from many years ago. Usually the base value of an index is 100. The base value, along with the base year, need to be known in order to determine the compounded annual growth rate at which the securities have been growing.

What are Indices Used For

Indices can be used for many purposes. Some of them have been mentioned below.

• Monitoring: The most obvious use of an index is to monitor the movements in stock market. Since all the movements are anchored to the same base year and base value, drawing comparisons amongst them becomes relatively easy. Indices are the most common way to track the movement of stock prices worldwide. That being said the movement in one index cannot be compared to the movement in another index. These indices therefore do not allow from inter-index comparisons.

• Benchmarking: Indices tell investors how a stock behaved in comparison to the market in general. This makes it easier to benchmark stock.

  To know whether a stock outperformed the others, it is essential that the growth of the stock be known and the growth in the relative index be known.

  A stock cannot said to have outperformed even if it grew by 20%. If the index grew by 25% during the same period, a 20% growth would instead be considered a lackluster performance.

• Measure of Riskiness: The value derived from the indices is a critical component when the riskiness of a stock needs to be determined. Just like the returns are relative so is risk.

  A stock is said to be more or less risky in comparison to other stocks in the market. Data is collected which compares the risk of the stock vis-a-vis the indices. This data is then converted into a statistical measure called “beta” which is the universal measure of riskiness.

• Derivatives: Indices are also used as the basis on which derivative contracts are drawn. Since index movements cannot be manipulated, derivatives traders base their contracts on these indices. For instance, a contract may state that a 1% movement in the index will cause party A to pay 2% to party B. Another measure that is used for this purpose is called the LIBOR. However, there are speculations that the LIBOR may have been rigged. Therefore now-a-days traders prefer to use indices.

Characteristics of an Index

Market indices must have certain characteristics. The important ones have been listed below:

• Transparent: Market indices must be transparent. The methodology used for calculations must be revealed to the common public. This builds confidence in the market index and helps in its adaptation. The more people trust a market index, the more they will base their decisions on it.

• Unbiased: Market indices must be unbiased. This is to say that a party that has conflicting interests must not be part of the index calculation process. This is because if they get the information before the rest of the market, then they will be at an advantage. Also, they are likely to manipulate the information to their advantage. To avoid this conflict of interest situation, indices must be transparent.

• Current: Indices must be dynamic. The market situation is dynamic. This means it keeps changing from time to time. Therefore if an index that represents the situation is static, soon the index will no longer be relevant. Indices must therefore be updated from time to time.

Indices can be created based on multiple methodologies. In the next article, we will study some of the methodologies that are used to construct these indices and how they affect the outcomes of those indices.