A market proxy is an artificial representation of a financial market, often represented by standard market indices, used to measure the performance of an individual stock against overall market movement. Investors choose proxies that reflect the market segment they are interested in, and the effective use of market proxies can also be used in international finance. However, the use of a market proxy can be misleading in calculations, as it can represent a small segment of the market.
A market proxy is an abstract representation of the movement of a financial market and is typically represented in investment calculations by standard market indices such as the S&P 500 or the Dow-Jones Industrial Average (DJIA) in the US, or the Sensex index on the Bombay Stock Exchange of India. The purpose of any proxy is to serve as a variable in statistical calculations for a section of a market, often to measure the performance of an individual stock against overall market movement. The limitation of any market power is that it is an artificial representation of the entire market. As a sample of a wide range of investment options, it is designed to help determine the risk of certain assets in terms of general trends in the market.
When choosing an appropriate market proxy for the investment scenario, investors try to find proxies that reflect the fragment of the market they are interested in getting involved with. This means that each proxy can be unique because each investment portfolio and strategy itself is unique. The narrower an investment range is, the narrower the proxy has to be. This would mean that anyone investing in an arena like commodities like gold would want to use a market proxy that represents the broader movement of this market segment, such as an exchange-traded fund (ETF).
One of the main functions that a market proxy performs is to reveal what is known as an alpha generator. Any stock, bond, commodity, or general investment portfolio that adds value to an investment group without increasing risk or volatility is known as an alpha generator. These increased returns are based on what is known as the capital asset pricing model (CAPM). The CAPM model focuses on how risk and rate of return are directly affected when market power is a benchmark that CAPM calculations must exceed for a security to be worth investing in.
Determining whether an asset is worth investing using the CAPM is done by comparing an asset’s beta or risk to its expected rate of return in the CAPM formula and seeing if it exceeds general power trends. A time factor is also entered into such calculations known as the risk-free rate of return, which represents the amount of time money must be tied up in an investment before it can show a reasonable return. All of these factors can indicate excessive returns in the form of alpha that exceed the predictions of a market proxy, or can underperform trends and serve as a cautionary tale for interested investors.
However, the use of a market proxy can be misleading in the calculations. This is because it can represent a very small segment of a market like the DJIA, which is only made up of 30 very large US stocks. The DJIA is often cited as representing the New York Stock Exchange, which trades in more than 2,300 shares as of September 2011.
The effective use of market powers can also be used in international finance. An example of this from 2011 is the financial crisis taking place in the European Union due to debt problems with certain member states. Italy has been portrayed in financial circles as an effective representative of the market for the entire European Union. This is because Italy’s investment sector is very large and sophisticated, representing a bond market of only $2,600,000,000,000 United States Dollars (USD), which is equivalent to €1,900,000,000,000 Euros as of November 2011. This makes the market Italian bond trading is the third largest globally, behind only the United States and Japan in volume and size of trading.
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