SYNOPSIS

Volatility & Factors Affecting Indian Stock Market

Students Name: Arpit Chawla Faculty Guide: Ms.Navleen Kaur

Introduction:
An investor with a heavy concentration of stocks in an investment portfolio might be feeling some unease these days. The market is behaving a lot different now then over recent years.

Stock market volatility is all about uncertainty.

How macroeconomic events and trends

will affect the future profitability (dividends, cash flows) of listed companies and hence their market valuations? Typical examples of such variables in the current environment are: geo-political tensions, energy prices, inflation expectations, interest rate policies, instability of exchange rates, p-notes, RBI and Government policies, subprime crises, investors sentiment etc. These uncertainties in some form or another are always present and sometimes it is much higher than in other periods. Furthermore, volatility increases with the financial leverage (debt) of companies. In addition, volatility is correlated with interest rate movements and increases during economic recessions.

Stock markets in general have treated investors well over the past few years with no major setbacks. In general markets followed one direction only, namely upwards (in the long

run). However, during this year (FY 2007-2008) volatility once again has come to the fore as more investors and traders were piling into the markets.

The main objective of this study is to analyze the causes of stock market volatility. This report approaches to study: the various causes that results in volatility in stock market the 1

reactions of stock market to these causes using the above information to manage the future volatility in the stock market

This study makes a detailed analysis of various issues causing volatility in stock market there by reflecting it on the market movements i.e., response and behavior of market.

During the past years, Indian Capital Market has undergone metamorphic reforms. Every segment of Indian Capital Market viz primary and secondary markets, derivatives, institutional investment and market intermediation has experienced impact of these changes. Our market, today, is being recognized as one of the most transparent, efficient and clean markets. Several techniques /instruments are used by academicians, policy

makers, practitioners and investors to test the extent of efficiency of the market. An attempt has been made to analyze characteristics of stock indices in India and compare them with some of the mature as well as emerging capital markets around the globe.

In the recent past there have been perceptions that volatility in the market has gone up; Inter and Intra-day volatility. News items and some clinical research papers also provided figures to evidence this argument. SEBI undertook a comprehensive and deep analysis of volatility by using several statistical techniques to measure and analyze it. 18 countries covering almost all continents- developed as well as emerging markets and young and old markets- have been analyzed. The results show that the volatility has gone up in the recent past as it has been perceived.

Indian stock market provides a very high rate of return and comparatively high volatility. Efficiency of Indian market appear to have improved in the past few years

owing to contraction in settlement cycles, introduction of derivative products, improvement in corporate governance practices etc.

Financial markets play an important role in the process of economic growth and development by facilitating savings and channeling funds from savers to investors. While there have been numerous attempts to develop the financial sector, growing economies are also facing the problem of high volatility in numerous fronts including volatility of its financial sector. 2

Volatility may impair the smooth functioning of the financial system and adversely affect economic performance. Similarly, stock market volatility also has a number of negative implications. One of the ways in which it affects the economy is through its effect on consumer spending. The impact of stock market volatility on consumer spending is related via the wealth effect. Increased wealth will drive up consumer spendi ng. However, a f a l l i n s t o c k market will w e a k e n consumer confidence and thus drive down consumer spending. Stock market volatility may also affect business investment and economic growth directly. A rise in stock market volatility can be interpreted as a rise in risk of equity investment and thus a shift of funds to less risky assets. This move could lead to a rise in cost of funds to firms and thus new firms might bear this effect as investors will turn to purchase of stock in larger, well known firms.

While there is a general consensus on what constitutes stock market volatility and, to a lesser extent, on how to measure it, there is far less agreement on the causes of changes in stock market volatility. Some economists see the causes of volatility in the arrival of new, unanticipated information that alters expected returns on a stock. Thus, changes in market volatility would merely reflect changes in the local or global economic environment. Others claim that volatility is caused mainly by changes in trading volume, practices or patterns, which in turn are driven by factors such as modifications in macroeconomic policies, shifts in investor tolerance of risk and increased uncertainty.

The causes and the degree of stock market volatility can help forecasters predict the path of an economys growth and the structure of volatility can imply that investors now need to hold more stocks in their portfolio to achieve diversification thereby minimizing risk with maximum returns.

Scope of the study:

The existence of volatility is not surprising: stock market volatility depends on the overall health of the economy, and real economic variables themselves tend to display existence of volatility. The persistence of stock market return volatility has two interesting implications. First, volatility is a proxy for investment risk. Persistence in volatility

implies that the risk and return tradeoff changes in a predictable way over the business cycle. Second, the persistence in volatility can be used to predict future economic variables.

Objectives of the study:

To know the causes of volatility in Indian Stock Market. To make a detailed study of each and every cause of volatility. To know the Market reaction to various causes of volatility. To put the investors and traders at ease to play in the Indian Stock market. To increase the return and reduce the risk of the investors and traders. To help investors and traders in managing future volatility. To suggest the steps to be taken by investors and traders during volatility.

Research Methodology:
Data collection method: 1. Primary 2. Secondary Research Design: 1. Survey: Questionnaire 2. Observation: Personal Observation of Secondary data. 4

Limitation of the Study:

The study is limited to Bombay Stock exchange. What is true in case of BSE may not be the same for other stock exchanges. The period of the study is limited to the year 20012-13. The study does not include other small factors which indirectly results in volatility.

Contribution from the Study:

To learn the practical aspects of equity market. To help the investors and traders to take right decisions at different circumstances. To help the investors and traders to make maximum profits at minimum risk. To help in analyzing and ascertaining the future movements in the market. To help investors in analyzing stop loss, support and resistance levels To help the investors and traders with the tricks of playing in volatile markets.

Literature Review:

Chatrath, Ramchander and Song (1996) examined the relationship between the Indian stock market and the stock markets of the U.S. and other developed countries using daily data for the period 1984 to 1992. They used the Bombay Stock Exchange National Index (BSENI) and the Dow Jones Industrial Average (DJIA) as representative indexes for the Indian and U.S. Markets, respectively. The authors identify two major concerns in portfolio

diversification studies. First, return comparisons between countries are exposed to currency risk. Second, correlations between stock returns for various countries must be stable over time in order to be able to employ past correlations as a proxy in creating optimal portfolios. They find that the Indian stock market had low correlations with the markets of the developed countries. Therefore, the Indian market offered diversification benefits for

investors in the developed countries for the period 1984 to 1992.

Barry, Peavy III and Rodriguez (1998) examined the return characteristics of emerging stock markets along with returns to several U.S. market indexes. They conclude that

investments in emerging markets increased in importance because many investors from developed nations believe that markets in the developing countries have the potential for high returns along with increased diversification benefits. emerging markets do not consistently generate high returns. The authors find that the However, these markets

continue to provide diversification benefits for investors from the developed countries. The authors find that the relative ranking of returns between developed and emerging stock markets largely depends on the time period. Therefore, optimal asset allocation between developed and emerging markets changes over time.

Arshanapalli and Kulkarni (2001) examined the relationship between the U.S. and the Indian stock markets. They explain that this relationship is important because of the transformation of the Indian economy to a more open economy over the decade of the nineties. The authors state that increased integration with developed nations is beneficial to Indias economic prosperity, but greater integration with the world economy also makes the Indian economy more vulnerable to outside risk. The authors collected daily data for one Indian index (the BSE 30 Index) and two U.S. indexes (the NASDAQ composite and the NYSE composite) for the period January 1991 to December 1999. They expected the 6

Indian stock index to be more integrated with NASDAQ than with the NYSE composite because the majority of the Indian companies listed in the U.S. over that time period were in the NASDAQ index. Most of these companies became listed by NASDAQ during 1998 and 1999. In order to test the hypothesis, the authors divided their data into two sub-

periods, pre-1998 and 1998-99. They found that the NASDAQ index was more highly correlated with the Indian stock market than was the NYSE index. Furthermore, the correlation increased from the first sub-period (pre-1998) of their study to the second subperiod (1998-99).

Patel (2003) examined the relationship between the U.S. stock market and ten emerging markets of Asia. He utilized Morgan Stanley Country Indexes as representative stock market indexes during the period January 1993 to December 2001. Patel analyzed two sub-periods defined by the 1997 Asian financial crisis: January 1991 to June 1997, and July 1997 to December 2001. The second sub-period generated generally lower returns in comparison to the first for stock markets of almost all countries, including the U.S. The correlation coefficients of stock market returns for the ten Asian emerging markets increased with those of the U.S. market during the second sub -period. Patel concluded that, in recent years, the emerging markets have become more integrated with the U.S. stock market. He also found that the correlations of returns between the U.S. market and the South Asian stock markets of India, Pakistan and Sri Lanka continued to remain low during the second sub-period in comparison with the correlations for the other emerging markets of Asia. The Indian stock market is considerably larger than the other two South Asian markets. Patel suggests the need for researchers to further examine the Indian stock market to determine whether it continues to provide investment opportunities and diversification benefits to U.S. investors.

The volatility of stock futures market has been studied by a number of researchers from different angles. Despite a disagreement of the researchers regarding the kind of influence that the market of derivatives has on the underlying market, most of them agree that it is beneficial even if the volatility is derivatives market acts as a catalyst increased for or decreased because the

the dissemination of information.

Particularly, Danthine (1978) concluded that the derivatives market increases the depth of a market and consequently reduces its volatility.

The destabilization theory argues that the introduction of futures trading increases spot volatility. For example, Harris (1989) documents marginal increases in the variances of S&P 500 stocks after trading in S&P 500 index futures began. Lockwood and Linn (1990) report similar variance increases when index futures began trading in 1982. Brorsen (1991) finds that futures trading tend to reduce autocorrelations and increase the volatility of index stock returns. Lee and Ohk (1992) document that the volatility of stock returns in Australia, Hong Kong, Japan, the U.K., and the U.S. rose significantly, following the introduction of index futures. On the other hand, Antoniou and Holmes (1995), and Antoniou, Holmes, and Priestly (1997) also document increases in spot volatilities after the introduction of index futures, however this increase is attributed to an increase in the rate of flow of information to spot markets. On the other side Edwards (1988a, b), Grossman (1988), and Bechetti and Roberts (1990) find that S&P 500 index futures have an insignificant impact on cash market volatility. Schwert (1990) maintains that the growth in stock index futures and options trading has not caused increases in volatility. Similar conclusions are reached by Becketti and Roberts (1990), Kamara, Miller and Siegel (1992), Pericli and Koutmos (1997), Galloway and Miller (1997), and Darat, Rahman and Zhong (2002), who document that introduction of stock index futures has either decreased or not significantly increased the

volatility in spot markets, confirming the stabilization theory. Min and Najand (1999) investigated lead and lag relationship in returns and volatilities between cash market and KOSPI 200 futures interactions. This study depended on some ten-minute's price data belonging to the periods of 3 May 1996 and 16 October 1996 when futures transactions were introduced over KOSPI 200. Granger causality analysis was used in the study. As for the analysis results; futures market leads the cash market by as long as 30 minutes. The trading volume has significant explanatory power for volatility changes in both spot and futures markets. Futures transactions have stronger influence than cash transactions and the futures transactions have stronger influence over cash market volatility. Gulen and Mayhew (2000) find that spot volatility is independent of changes in futures trading in eighteen countries and that informationless futures volume has a negative impact on spot volatility in Austria and the UK. Thenmozhi (2002) showed that the inception of futures trading has reduced the volatility of 8

spot index returns due to i n c r e a s e d information flow. According t o Shenbagaraman (2003) the introduction of derivative products did not have any significant impact on market volatility in India. Raju and Karande (2003) also reported a decline in volatility of S&P CNX Nifty after the introduction of index futures. Nath (2003) studied the behavior of stock market volatility after derivatives and arrived at the conclusion that the volatility of the market as measured by benchmark indices like S&P CNX Nifty and S&P CNX Nifty Junior has fallen during the post-derivatives period. The finding is in-line with the earlier findings of Thenmozhi (2002), and Raju and Karande (2003). Bandivadekar and Ghosh (2003), and Sah and Omkarnath (2005) also investigated the behaviour of volatility in cash market in futures trading era. They also found that futures trading have led to reduction in volatility in the underlying asset market but they attributed the degree of decline in volatility in the underlying market to the trading volume in futures market. They inferred that as the trade volume in the F&O segment of BSE is very low, the volatility in BSE has not significantly declined; whereas in the case of NSE (where the trade volume is at the peak), the volatility in NIFTY has reduced significantly Mallikarjunappa and Afsal (2007) studied the volatility implications of the introduction of derivatives on the stock market in India using S&P CNX IT index and found that clustering and persistence of volatility in different degrees before and after derivatives and the listing in futures has increased the market volatility. Kanas (2009), using a time-varying regime-switching vector error correction approach, finds that the NIKKEI stock index cash and futures prices are jointly characterized by regime switching, which is time-varying and dependent upon the basis, the interest rate, the volatility of the cash index, and the US futures market. Gannon (2010) develops simultaneous volatility models that allow for simultaneous and unidirectional volatility and volume of trade effects. Intraday data from the Australian cash index and index futures markets are used to test these effects. Overnight volatility spillover effects are tested with the data from the S and P 500 index using alternative estimates of the United States volatility. It is found that the simultaneous volatility model is robust to alternative specifications of returns equations and to misspecification of the direction of volatility causality. 9

Most recent studies on financial market volatility are placed in the context of transmission of volatility across economies and the contagion effects of a financial crisis. These include studies by Forbes and Rigobon (2002), Bekaert, Harvey and Lumsdaine (2002a,b), Edwards (2000) and others. Rogobon (2003) has focussed on alternative measures of volatility in the equity and bond markets in the period surrounding the financial crises. Bekaert and Harvey (2000) analyzed equity returns in a group of emerging markets before and after financial reforms. The empirical studies investigating the volatility of returns have yielded mixed conclusions. Aggarwal, Inclan and Leal (1999) analyze volatility in emerging stock markets during 1985-95. Using an ICSS algorithm to identify the points of sudden changes in the variance of returns they examine the nature of events that cause large shifts in stock return volatility in these economies. Aggarwal et al find that mostly local events cause jumps in the stock market volatility of the emerging markets. Kim and Singal (1997) and De Santis and Imorohoroglu (1994) study the behavior of stock prices following the opening of a stock market to foreigners or large foreign inflows. They find that there is no systematic effect of liberalization on stock market volatility. These findings corroborate Bekaerts findings that volatility in emerging markets is unrelated to his measure of market integration. Richards (1996) used three different methodologies and two sets of data to estimate volatility of emerging markets. A common claim of all these studies is that, the proposition that liberalization increases volatility is not supported by empirical evidence. However, Levine and Zervos (1995) suggest that volatility may increase after liberalization.

Hamao and Mei (2001) examined the impact of foreign and domestic trading on market volatility for Japan and find no systematic evidence that foreign trading tends to increase market volatility more than trading by domestic groups. The study however relates to the time period during which the foreign portfolio investment in Japan was rather small. Folkerts Landau and Ito (1995) computed volatility of emerging markets in periods that differ in their intensity of portfolio flows. Their evidence is rather mixed with Mexican stock prices being least volatile when flows are most volatile and vice versa for Hong Kong. Nilsson (2002) has explored that stock market liberalization can lead to excess volatility possibly on account of noise trading for Nordic stock markets using the Markov regime-switching model. He finds evidence of higher expected return, higher volatility and stronger links with international stock markets characteristic of the 10

deregulated period in all Nordic stock markets.

Studies analyzing the behavior of stock prices over financial cycles have been undertaken in the recent years. They show that stock markets when liberalized tend to become more stable. Kaminsky and Schumkler (2001,2002) examine the time varying patterns of financial cycles before and after financial liberalization in 28 countries. Their results indicate that while financial liberalization may trigger financial excesses in the short-run it also triggers changes in institutions supporting a better functioning of financial markets. They observe a temporary volatility increase in the years immediately following liberalization in these countries. Edwards et al (2003) analyze the behavior of stock prices in six emerging countries. They find that after financial liberalization Latin American markets are less unstable while the Asian economies, especially Korea, are in the process of recovering their stability.

De Long et al. (1990) studied the possible effects of positive feedback trading in a theoretical model. According to the researchers, in the presence of feedback trading, even rational speculators might jump on the bandwagon, and therefore prices may go further away from fundamentals. According to Dornbusch and Park (1995), foreign investors pursue a positive feedback strategy, which makes stocks to overreact to change in fundamentals. An attempt by Clark and Berko (1996) using Wa rther (1995) approach to evaluate price pressure by foreign investors in the Mexican stock market, emphasized the beneficial effects of allowing foreigners to trade in stock markets. The study concluded that FPIs are considered as positive feedback trader means they buy when the market increases and sell when the market falls. A research by Bohn and Tesar (1996) and Brennan and Cao (1997) based on quarterly data of US investments on foreign equity markets found a positive correlation of these flows and local returns on majority of the sample countries.

In order to investigate te whether

FDI

announcements provide information to

investors, Ding & Sun (1997) studied whether shareholder benefits were a product of their firms FDI decisions, and whether abnormal returns were attainable by trading shares. Their results showed that an average 2.73% additional return could be

observed by investors buying and holding the stock of an announcing firm 21 days 11

around the announcement date. On the same lines, Wang and Shen (1999) put forth that large and sudden inflows may stimulate stock prices while the outflow of FI may reduce equity value, thus, ultimately, increasing the volatility of stock markets. In another related study by Bekaert and Harvey (2000), it was found that insignificant increase in the volatility of stock returns follow capital market liberalizations.

Henry (2000), Bekaert and Harvey (2002), and Kim and Singal (2000) tested the abnormal returns after liberalization. These studies argued that, with more foreign investors, start-up companies as well as existing companies can raise capital easier. Contrary to the foreign direct investment, foreign portfolio investors ask for faster returns of their investment. And this may lead these investors to suddenly enter or leave a country. Therefore, many countries are worried about the destructive effects of foreign equity outflow during a crisis. For instance, some countries imposed rules to prevent the outflow (Kim and Singal, 2000). Consistent with these studies, Stiglitz (1998)

argued that in developing countries, there is more need for capital flow controls since these countries are more vulnerable to changes in international flows. An attempt by Chakrabarti (2001) reflected that the FPI net inflows were more likely the effect rather than the cause of equity market returns, with the FPIs not having informational disadvantages compared to domestic investors. On the same lines,

Mukherjee et al. (2002) found that the FPI activities had a strong demonstration effect and was driving the domestic market indicating that the flow of foreign flows is dependent on return in the domestic market. A study by Rai & Bhanumurthy (2001) examined the determinants of Foreign Portfolio Investments in India by using monthly data. They found that FPI inflow depends on stock market returns, inflation rate and exante risk. This study did not find any causation running from FPI inflow to stock returns as it was found by some studies.

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