What are stock indices or stock indexes?

Stock indexes are used to compare the price fluctuations of a group of stocks of similar companies, which are combined based on a similar industry or a particular market capitalization limit or type of market. The price comparison is based on a pre-determined standard method or indicators. These stock indexes are usually considered a base for comparison of a particular stock, and the performance of that particular company can be easily determined.

Uses of stock indices

• Primary stakeholders in the financial market
• Service providers in the financial market
• Regulators in the financial market
• Administrators to facilitate the financial market

Some major global stock indices

Following are the few major global stock indices:

1. NASDAQ

NASDAQ is the largest U.S. electronic stock market in terms of shares traded and is the home of leading companies across all industry sectors, such as Microsoft, Intel, Google, etc. NASDAQ also considers its listing cost structure to be a competitive advantage. It has actively pursued the opportunities created by the globalization of equity capital markets. Over the past decade, it has listed far more companies than any other exchange. NASDAQ has steadily outpaced the other major markets to become the fastest-growing stock index in the U.S.

2. FTSE (London stock index)

London is considered one of the most leading international financial hubs globally. London stock exchange provides a range of services to companies and investors, such as company services, trading services, and information services. Supporting these activities, the exchange regulates the market to protect the investors. FTSE is the name of the London stock index.

3. Dow Jones industrial average

Dow Jones industrial average is a U.S. stock index that tracks blue-chip companies trading on NYSE and NASDAQ. Dow Jones industrial average is a cap-weighted index that is widely watched index not only in the U.S. but across the world. The word Dow Jones is derived from the founder of the index, Charles Dow and Edward Jones.

4. DAX stock index

The DAX (Deutscher Aktien Index) is a German stock index representing the forty largest German companies listed on the Frankfurt exchange. The companies listed on DAX influence the domestic economy and the global economy as well. The DAX is known for the outstanding gauge for German and European stocks.

5. BSE- SENSEX

BSE-SENSEX is India's first stock index to obtain permanent recognition from the Government of India. It has a pre-eminent and pivotal role in the Indian capital market at the global level. SENSEX is the index that is tracked worldwide.

6. NSE- NIFTY

NSE can handle up to 9 million daily trades in the capital market segment. NIFTY lists more than 1600 companies. Out of these, 50 companies are selected for NIFTY composition. Companies are chosen by SEBI and NSE selection committee based on their performance. Any company which is not performing well can be excluded from listing. As per SEBI's direction, there is no time limit or restriction of inclusion and exclusion.

Basics of stock market indices

Indices are representative of the entire stock market. Movements of the index represent the average returns obtained by the investors in the stock market.

• A base year is set along with a basket of base shares.
• The market index includes those shares that are traded in high volume regularly.
• Every stock exchange has a flagship index like in India, Sensex in BSE, and outside India is Dow Jones, FTSE, etc.

The concept behind the fluctuation of an index

Stock indices reflect the expected prices based on the expected future performance of the companies listed in the stock market by discounting the company's future cash flows based on the industrial sector's performance. When the index goes up, the stock market thinks that the future returns will be higher than they are at present, and when the index goes down, the stock market believes that the future returns will be lower than they are at present. Stock prices are majorly dependent on the company and country-specific news.

Computation of index

The following steps are involved in the calculation of the index on a particular date:

Step 1: Calculate the market capitalization of each company comprising the index.

Step 2: Calculate total market capitalization by adding the individual market capitalization of all companies in the index.

Step 3: Computing the index of the next day requires the index value and the total market capitalization of the previous day and is computed by dividing today's market capitalization by yesterday's market capitalization and multiplying by yesterday's index point.

It should be noted that indices may also be calculated using the price-weighted method. Almost all equity indices are calculated using the market capitalization-weighted method.

Why do we need indices?

Stock indices are required to understand the flow and behavior of the stock market. An investor needs to analyze the flow of the market index before investing. The investor who plays in the stock market is taking a high risk on his investment, so it becomes crucial to check the pattern of the total market index to decide which investment can prove to be a winning bet.

Apart from helping in the investment decision, the market index also helps know the economy's condition. A continuously declining stock indices represent a terrible condition of the economy whereas, an upward movement in stock indices represents a growing economy.

Functions of stock indices

Functions of stock indices can be summarized as follows:

1. Liquidity and marketability of securities

Stock indices help investors to switch their portfolios as per the movement in the market index. Enabling investors to be liquidated means their securities can be converted into cash anytime.

2. Fair price determination

Due to almost accurate information, active bidding is performed from both ends, ensuring fair price determination by demand and supply forces.

3. Helps in capital formation

Stock indices render services by arranging primary industry and country-based news. Members of the stock exchange assist in the flotation of the new issues. It enables a new class of investors to take part in the market and renounce their position by money considerations.

4. Reflects a general state of the economy

The stock indices are a barometer of boom and depression in the economy. To all those concerned, the stock index is an indicator of the general state of the economy.

Circuit breakers to curb excess volatility

The circuit breaker causes temporary termination of trading in any particular stock or index for a specific time. The two methods of practicing circuit breakers are suspension of trade-in-index for a certain period or suspension of trade-in index for an entire trading day.

Circuit breakers help participants to reassess the situation by collecting new information. Circuit helps in controlling panic among the investors while trading. It is crucial and complex to make a rational approach towards the market when trading is suspended during trading.

On the other side, it also prevents a true picture of the price when the circuit is imposed. Sometimes, a circuit breaker proves to be unfair to small traders because the well-informed and big trading players make a wise move before the circuit. It ultimately leads to chaos and confusion among other players.

Context and Applications

This topic is significant in the professional exams for both undergraduate courses & postgraduate courses and competitive exams, especially for:

• Bachelor of Business Administration (Banking and Finance)
• Masters of Business Administration (Banking and Finance)
• Certified Public Accountants
• Chartered Financial Analyst

Practice Problems

Common Mistakes

The most common mistake done by students is that they get confused between the stock exchange and the stock market. It is important to learn about the importance of stock indices. Further, students should also learn about the background of every stock index.

Related Concepts

While studying this topic, it is important to read the following topics to get a better knowledge:

• Stock Market
• Financial Intermediaries
• Risk Management
• Margin Trading
• Trading and Settlement