CHAPTER TWO MARKET INDEX
To understand the use and Function of the Index derivatives Markets, it is necessary to understand the underlying index. In the following Section, we take a look at index related issues. Traditionally, indexes have been used as information sources. By looking at an index, we know how the market is faring. In recent years, indexes have come to the forefront owing to direct applications in finance in the form of index funds and index derivatives. Index derivatives allow people to cheaply alter their risk exposure to an index (hedging) and to implement forecasts about index movements (Speculation). Hedging using index derivatives has become a central part of risk management in the Modern economy.
UNDERSTANDING THE INDEX NUMBER
An index is a number which measures the change in a set of values over a period of time. A stock index represents the change in value of a set of stocks which constitute the index. More specifically, a stock index number is the current relative value of a weighted average of the prices of a pre/defined group of equities. It is a relative value because it is expressed relative to the weighted average of prices at some arbitrarily chosen starting date or base period. The starting value or base of the index is usually set to a number such as 100 or 1000. For example, the base value of the Nifty was set to 1000 on the start date of November 3,1995.
A good stock market index is one which captures the behavior of the overall equity market. It should represent the market, it should be well diversified and yet highly liquid. Movements of the index should represent the returns obtained by “typical” portfolios in the country.
A MARKET INDEX IS VERY IMPORTANT FOR ITS USE
- As a barometer for market behavior.
- As a benchmark portfolio performance.
- As an underlying in derivative instruments like index Futures, and
- In passive management by index Funds.