A market proxy is an abstract representation of the movement of a financial market and is usually represented in investment calculations by standard market indexes such as the S&P 500 or Dow-Jones Industrial Average (DJIA) in the US, or the Sensex index on the Bombay Stock Exchange in India. The purpose of any proxy is to serve as a variable in statistical calculations for a section of a market, often to gauge the performance of an individual stock against market movement overall. The limitation of any market proxy 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 to determine the risk of certain assets in terms of general trends in the marketplace.
When choosing an appropriate market proxy for investment hypothesis, investors attempt to find proxies that reflect the fragment of the market in which they are interested in getting involved. This means that each proxy can be unique because each investment portfolio and strategy itself is unique. The more narrow an investment range is, the narrower the proxy itself has to be. This would mean that anyone investing in an arena like commodities such as gold would want to use a market proxy that represents the broader movement of this market segment such as a commodity exchange traded fund (ETF).
One of the main roles that a market proxy plays is to reveal what is known as an alpha generator. Any stock, bond, commodity, or overall portfolio of investments 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 is focused on how risk and rate of return directly affect each other where the market proxy is a benchmark that CAPM calculations must exceed in order for a security to be worth investing in.
Determining whether an asset warrants investment using CAPM is done by comparing the beta, or risk of an asset, to its expected rate of return in the CAPM formula and seeing if it beats overall proxy trends. A time factor is also input into such calculations known as the risk-free rate of return, which represents the amount of time that money must be tied up in an investment before it can show a reasonable profit. All of these factors can point to excessive returns in the form of an alpha that beat the predictions of a market proxy, or they can under-perform trends and serve as a cautionary analysis for interested investors.
The use of a market proxy, however, can be misleading in calculations. This is because it may represent a very small segment of a market such as the DJIA, which is only comprised of 30 very large US stocks. The DJIA is often quoted as a proxy for the New York Stock Exchange, which trades in over 2,300 stocks as of September 2011.
The effective use of market proxies can also be employed in international finance. An example of this as of 2011 is the financial turmoil taking place in the European Union due to debt problems with certain member states. Italy has been portrayed in financial circles as an effective market proxy for the entire European Union. This is because Italy's investment sector is very large and sophisticated, representing a bond market alone of $2,600,000,000,000 US Dollars (USD), which is equal to €1,900,000,000,000 Euros as of November 2011. This makes Italy's bond market the third largest globally, trailing that of only the United States and Japan in trading volume and size.