The application of indices are as follows:
Other than reflecting the overall direction of the stock market, few applications of index have emerged in the investment field.
1. Index Funds:
These funds invest in a specific index to generate returns equivalent to return on index. This is achieved by investing in Index stocks in the same proportions in which the stocks exist in the index.
For ex, Nifty Index funds would get similar returns as that of Nifty index. Since Nifty has 50 shares, the fund will also invest in these 50 companies in the proportion in which they exist in Nifty.
2. Index derivatives:
These derivative contracts use the index as the underlying asset. Index derivatives are the most useful tools to hedge against market risk. Index futures and options are the most popularly traded derivative contracts worldwide.
3. Exchange Traded Funds(ETF's):
ETF's is a basket of securities that trade like individual stocks on an exchange. Their advantage over Mutual Funds is that they can be bought and sold on the exchange which makes it feasible for regular trading. ETF's can also be traded for intraday as it routes through the exchange. Further, ETF's can be used as basket trading in terms of the smaller denomination and low transaction cost.
The first ETF in the Indian Securities Market was Nifty BeES, introduced in December 2001. The ETF named SPIcE was the first ETF on Sensex, intraduced in Jan 2003.