Stock Indices Presentation
Understanding Stock Markets: Functions and Their Role as Economic
Indicators
1. Stock Markets: Functions
The stock market serves several crucial roles in an economy, acting as a catalyst for
economic growth,
providing liquidity, facilitating capital formation, enabling price discovery, and offering
instruments for risk management.
A. Capital Formation
Stock markets enable companies to raise funds for expansion by issuing shares to the
public.
This capital is crucial for business growth, innovation, and job creation, which ultimately
stimulates economic development.
Example in Kenya: The Nairobi Securities Exchange (NSE) is a key player in Kenya’s
financial system.
Through initial public offerings (IPOs), Kenyan companies can raise funds to expand their
operations. For instance, Safaricom,
one of Kenya's largest companies, used funds raised from its NSE listing to expand its
mobile services, particularly M-Pesa,
which has become a major component of the Kenyan economy.
Comparison with Developed Markets: In developed markets like the United States,
companies have multiple
avenues for capital, but stock markets remain vital. For example, Apple Inc. routinely issues
shares and bonds to fund growth
initiatives. The depth and liquidity of the U.S. stock market allow companies like Apple to
raise billions, highlighting the
mature and efficient nature of these markets.
B. Liquidity Provision
The stock market enables investors to buy and sell shares easily, ensuring that stocks are
relatively
liquid assets. This liquidity is essential for investor confidence as it allows easy entry and
exit from investments.
Example in Kenya: Although the NSE provides liquidity, it is relatively lower compared to
more developed
markets. Liquidity at the NSE is concentrated in a few large-cap stocks, such as Equity Bank
and KCB Group, where daily trading
volumes are higher, enabling easier buying and selling. Smaller stocks, however, may see
lower liquidity, which can be
challenging for investors seeking to trade in those assets.
C. Price Discovery
Price discovery is the process by which the market determines the price of an asset through
supply and
demand interactions. Stock prices fluctuate based on investors' perceptions of a company’s
future prospects.
Example in Kenya: The NSE plays an essential role in price discovery. When Safaricom
launched its M-Pesa
services, its share price reacted positively due to increased investor confidence. Similarly,
the price of Kenya Airways shares
reflects investor sentiment about the company's financial health and prospects amid
operational challenges.
D. Risk Management
Stock markets offer derivative instruments, such as futures and options, allowing investors
to hedge
against risks in their portfolios.
Example in Kenya: The NSE introduced equity derivatives in 2019, which allows investors
to hedge against
the price fluctuations of shares like Safaricom and KCB Group. Although the uptake of these
instruments is still growing, it
marks a significant development in Kenya’s financial markets.
2. Is the Stock Market the Barometer of the Economy?
A. Stock Market as an Economic Indicator
Stock indices are often viewed as economic barometers because they reflect investor
sentiment, which can
be influenced by economic conditions. Rising stock prices generally signal economic growth,
while declines may indicate economic
downturns.
Example in Kenya: The NSE 20 Share Index and the NASI (NSE All Share Index) are closely
watched as indicators
of economic performance in Kenya. For instance, during periods of political instability, such
as the 2017 elections, the NSE 20
Index declined due to investor concerns over economic uncertainty.
B. Limitations of Stock Markets as Economic Indicators
The stock market can sometimes misrepresent economic conditions due to various factors,
such as speculative
trading, government intervention, and the concentration of large-cap stocks.
Example in Kenya: In Kenya, the NSE’s performance can be heavily influenced by a few large
companies, like
Safaricom, which represents a significant portion of the NSE’s total market capitalization.
This concentration can skew the
perception of economic health.
C. Factors That Influence Stock Market and Economic Correlation
Economic policies, such as interest rate changes and fiscal stimulus, have a direct impact on
stock market
performance. In Kenya, Central Bank policies to stabilize the currency or control inflation
can affect investor confidence,
impacting the NSE’s performance.
