Traditionally, indices have been used as benchmarks to monitor markets and judge performance.There are three main types of indices, namely price index, quantity index and value index. The price index is most widely used. It measures changes in the levels of prices of products in the financial, commodities or any other markets from one period to another. The indices in financial markets measure changes in prices of securities like equities, debentures, government securities, etc. The most popular index in financial market is the stock (equity) index which uses a set of stocks that are representative of the whole market, or a specified sector, to measure the change in overall behavior of the markets or sector over a period of time.
A stock index is important for its use:
- As the lead indicator of the performance of the overall economy or a sector of the economy: A good index tells us how much richer or poorer investors have become.
- As a barometer for market behavior: It is used to monitor and measure market movements, whether in real time, daily, or over decades, helping us to understand economic conditions and prospects.
- As a benchmark for portfolio performance: A managed fund can communicate its objectives and target universe by stating which index or indices serve as the standard against which its performance should be judged.
- As an underlying for derivatives like index futures and option. It also underpins products such as, exchange-traded funds, index funds etc. These index-related products form a several trillion dollar business and are used widely in investment, hedging and risk management.
- As it supports research (for example, as benchmarks for evaluating trading rules, technical analysis systems and analyst's forecasts); risk measurement and management; and asset allocation.