CHAPTER-1

INTRODUCTION

1. Introduction
The movement of stock indices is highly sensitive to the changes in fundamentals of the economy and to the changes in expectations about future prospects. Expectations are influenced by the micro and macro fundamentals which may be formed either rationally or adaptively on economic fundamentals, as well as by many subjective factors which are unpredictable and also non quantifiable. It is assumed that domestic economic fundamentals play determining role in the performance of stock market. However, in the globally integrated economy, domestic economic variables are also subject to change due to the policies adopted and expected to be adopted by other countries or some global events. The common external factors influencing the stock return would be stock prices in global economy, the interest rate and the exchange rate. For instance, capital inflows and outflows are not determined by domestic interest rate only but also by changes in the interest rate by major economies in the world. Burning example in India is the appreciation of currency due to higher inflow of foreign exchange. Rupee appreciation has declined stock prices of major export oriented companies. Information technology and textile sector are the example of falling stock prices due to rupee appreciation. From the beginning of the 1990s in India, a number of measures have been taken for economic liberalization. At the same time, large number of steps has been taken to strengthen the stock market such as opening of the stock markets to international investors, regulatory power of SEBI, trading in derivatives, etc. These measures have resulted in significant improvements in the size and depth of stock markets in India and they are beginning to play their due role. Presently, the movement in stock market in India is viewed and analyzed carefully by large number of global players. Understanding macro dynamics of Indian stock market may be useful for policy makers, traders and investors. Results may reveal whether the movement of stock prices is the outcome of something else or it is one of the causes of movement in other macro dimension in the economy. The study also expects to explore whether the movement of stock market are associated with real sector of the economy or financial sector or both

1.1 Macroeconomics
Macroeconomics examines the economy as a whole to explain broad aggregates and their interactions "top down," that is, using a simplified form of general-equilibrium theory.[45] Such aggregates include national income and output, the unemployment rate, and price inflation and sub aggregates like total consumption and investment spending and their components..

Macroeconomics variables
The important variables of macroeconomics such as ; Gross domestic product The monetary value of all the finished goods and services produced within a country's borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory. Gross national product (GNP), in economics, a quantitative measure of a nation's total economic activity, generally assessed yearly or quarterly. G.N.P. Is defined both in terms of factor consumption (goods and services purchased by private citizens and government, gross private investment, and the net foreign tradeinvestment balance) and in terms of factor earnings (wages, taxes, rents, interest and profits, and depreciation Unemployment rates Unemployed Persons 16 years and over who had no employment during the reference week, were available for work, except for temporary illness, and had made specific efforts to find employment sometime during the 4-week period ending with the reference week. Persons who were waiting to be recalled to a job from which they had been laid off need not have been looking for work to be classified as unemployed. The unemployment rate is defined as the number of unemployed persons divided by the labor force, where the labor force is the number of unemployed persons plus the number of employed persons

Price indices is a normalized average (typically a weighted average) of prices for a given class of goods or services in a given region, during a given interval of time. It is a statistic designed to help to compare how these prices, taken as a whole, differ between time periods or geographical locations. Price indices have several potential uses. For particularly broad indices, the index can be said to measure the economy's price level or a cost of living. More narrow price indices can help producers with business plans and pricing. Sometimes, they can be useful in helping to guide investment.

National income A measure of the health of the economy; the in the country and income earned by residents abroad.

money

value of the

total flow of goods and services produced within the country, including what is spent

Consumption According to some economists, only the final purchase of goods and services constitutes consumption, and every other commercial activity is some form of production. Other economists define consumption much more broadly, as the aggregate of all economic activity that does not entail the design, production and marketing of goods and services (e.g. "the selection, adoption, use, disposal and recycling of goods and services").

Exchange rate between two currencies specifies how much one currency is worth in terms of the other. It is the value of a foreign nations currency in terms of the home nations currency. For example an exchange rate of 102 Japanese yen (JPY, ) to the United States dollar (USD, $) means that JPY 102 is worth the same as USD 1.

Inflation The overall general upward price movement of goods and services in an economy, usually as measured by the Consumer Price Index and the Producer Price Index. Over time, as the cost of goods and services increase, the value of a dollar is going to fall because a person won't be able to purchase as much with that dollar as he/she previously could

International trade is exchange of capital, goods, and services across international borders or territories 4

With special reference to my study I have taken four major variables in my study and I am going in detail about them as below

1.1.1 Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. A chief measure of price inflation is the inflation rate, which is the percentage change in a price index over time. The overall general upward price movement of goods and services in an economy, usually as measured by the Consumer Price Index and the Producer Price Index. Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply. Views on which factors determine low to moderate rates of inflation are more varied. Low or moderate inflation may be attributed to fluctuations in real demand for goods and services, or changes in available supplies such as during scarcities, as well as to growth in the money supply. However, the consensus view is that a long sustained period of inflation is caused when money supply increases faster than the rate of economic growth.

Type of inflation
(i) Cost push inflation (ii) Demand pull inflation

Cost-Push Inflation
Aggregate supply is the total volume of goods and services produced by an economy at a given price level. When there is a decrease in the aggregate supply of goods and services stemming from an increase in the cost of production, we have cost-push inflation. Costpush inflation basically means that prices have been pushed up by increases in costs of any of the four factors of production (labor, capital, land or entrepreneurship) when 5

companies are already running at full production capacity. With higher production costs and productivity maximized, companies cannot maintain profit margins by producing the same amounts of goods and services. As a result, the increased costs are passed on to consumers, causing a rise in the general price level (inflation).

The graph

shows the level of output that can be achieved at each price level. As

production costs increase, aggregate supply decreases from AS1 to AS2 (given production is at full capacity), causing an increase in the price level from P1 to P2. The rationale behind this increase is that, for companies to maintain (or increase) profit margins, they will need to raise the retail price paid by consumers, thereby causing inflation.

Demand-Pull Inflation
Demand-pull inflation occurs when there is an increase in aggregate demand, categorized by the four sections of the macroeconomy: households, businesses, governments and foreign buyers. When these four sectors concurrently want to purchase more output than the economy can produce, they compete to purchase limited amounts of goods and services. Buyers in essence bid prices up, again, causing inflation. This excessive demand, also referred to as too much money chasing too few goods, usually occurs in an expanding economy.

Factors Pulling Prices Up

The increase in aggregate demand that causes demand-pull inflation can be the result of various economic dynamics. For example, an increase in government purchases can increase aggregate demand, thus pulling up prices. Another factor can be the depreciation of local exchange rates, which raises the price of imports and, for foreigners, reduces the price of exports. As a result, the purchasing of imports decreases while the buying of exports by foreigners increases, thereby raising the overall level of aggregate demand (we are assuming aggregate supply cannot keep up with aggregate demand as a result of full employment in the economy). Rapid overseas growth can also ignite an increase in demand as more exports are consumed by foreigners. Finally, if government reduces taxes, households are left with more disposable income in their pockets. This in turn leads to increased consumer spending, thus increasing aggregate demand and eventually causing demand-pull inflation. The results of reduced taxes can lead also to growing consumer confidence in the local economy, which further increases aggregate demand.

Looking at the price-quantity graph, we can see relationship between aggregate supply and demand. If aggregate demand increases from AD1 to AD2, in the short run, this will not change (shift) aggregate supply, but cause a change in the quantity supplied as represented by a movement along the AS curve. The rationale behind this lack of shift in aggregate supply is that aggregate demand tends to react faster to changes in economic the

conditions than aggregate supply. As companies increase production due to increased demand, the cost to produce each additional output increases, as represented by the change from P1 to P2. The rationale behind this change is that companies would need to pay workers more money (e.g. overtime) and/or invest in additional equipment to keep up with demand, thereby increasing the cost of production. .

Measures of inflation
Inflation is usually measured by calculating the inflation rate of a price index, usually the The Consumer Price Index measures prices of a selection of goods and services purchased by a "typical consumer" The inflation rate is the percentage rate of change of a price index over time. For example, in January 2007, the U.S. Consumer Price Index was 202.416, and in January 2008 it was 211.080. The formula for calculating the annual percentage rate inflation in the CPI over the course of 2007 is High or unpredictable inflation rates are regarded as harmful to an overall economy. They add inefficiencies in the market, and make it difficult for companies to budget or plan long-term.

The resulting inflation rate for the CPI in this one year period is 4.28%, meaning the general level of prices for typical U.S. consumers rose by approximately four percent in 2007.

Inflation in India
Inflation in India is based on Wholesale Price Index.A set of 435 commodities are used for the WPI based inflation calculation The base year for WPI calculation is 1993-94 WPI is available at the end of every week (generally Saturday), for a period of 1 year ended that day As on today, India uses a basket of 435 commodities and a base year of 1993-94 for its Wholesale Price Index (WPI) based inflation rate calculation. The 435 commodities used for finding WPI range from food items like rice, wheat to petroleum products to

medicines and are given weightages depending upon their importance and impact on the economy The 435 commodities are divided to various groups and subgroups. Individual commodities, and as a result, groups and subgroups have weightages. On a broader level, the 435 commodities are grouped into, Primary Articles Fuel, Power, Light & Lubricants Manufactured Products

Primary Articles consist of food grains, fruits and vegetables, milk, eggs, meats and fishes, condiments and spices, fibers, oil seeds and minerals.fuel, Power, Light & Lubricants consist of coal and petroleum related products, lubricants, electricity etc. Manufactured Products consist of dairy products, atta, biscuits, edible oils, liquors, cloth, toothpaste, batteries, automobiles etc. The group weightages are 22.02525%, 14.22624% and 63.74851% for Primary Articles, Fuel, Power, Light & Lubricants and Manufactured Products respectively.

1.2.3 Calculation of WPI (Wholesale Price Index)

In this method, a set of 435 commodities and their price changes are used for the calculation. The selected commodities are supposed to represent various strata of the economy and are supposed to give a comprehensive WPI value for the economy. WPI is calculated on a base year and WPI for the base year is assumed to be 100. To show the calculation, lets assume the base year to be 1970. The data of wholesale prices of all the 435 commodities in the base year and the time for which WPI is to be calculated is gathered. Let's calculate WPI for the year 1980 for a particular commodity, say wheat. Assume that the price of a kilogram of wheat in 1970 = Rs 5.75 and in 1980 = Rs 6.10 The WPI of wheat for the year 1980 is, (Price of Wheat in 1980 Price of Wheat in 1970)/ Price of Wheat in 1970 x 100 i.e. (6.10 5.75)/5.75 x 100 = 6.09 Since WPI for the base year is assumed as 100, WPI for 1980 will become 100 + 6.09 = 106.09. 9

Effect of inflation
Decrease in the purchasing power of currency An increase in the general level of prices implies a decrease in the purchasing power of the currency. That is, when the general level of prices rises, each monetary unit buys fewer goods and services. Individuals or institutions with cash assets will experience a decline in the purchasing power of their holdings. Increases in payments to workers and pensioners often lag behind inflation, especially for those with fixed payments. Inefficiencies in the market High or unpredictable inflation rates are regarded as harmful to an overall economy. They add inefficiencies in the market, and make it difficult for companies to budget or plan long-term. Inflation can act as a drag on productivity as companies are forced to shift resources away from products and services in order to focus on profit and losses from currency inflation. Effect on investor Investors are two types ; (1) those who invest their capital in government securities ,debentures, bonds (2) Those who hold shares of joint stock companies whose profits fluctuate .of these the former are looser Effect on producer and entrepreneurs This class gain by inflation because they produce more to meet rising demand and they gain on the stock of raw material bought at pre inflation prices Balance of Payments Because of rising price export falls and import rise.This leads to unfavorable balance of payment problem Public Debts: Cost of government projects under completion rise unexpectedly because of rising prices. This upsets government as

Measures to control inflation

Monetary policy The primary tool for controlling inflation is monetary policy. Most central banks are tasked with keeping the federal funds lending rate at a low level, normally to a target rate around 2% to 3% per annum, and within a targeted low inflation range, somewhere from about 2% to 6% per annum.

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There are a number of methods that have been suggested to control inflation. Central banks such as the U.S. Federal Reserve can affect inflation to a significant extent through setting interest rates and through other operations. High interest rates and slow growth of the money supply are the traditional ways through which central banks fight or prevent inflation, though they have different approaches. For instance, some follow a symmetrical inflation target while others only control inflation when it rises above a target, whether express or implied. Fixed exchange rates Under a fixed exchange rate currency regime, a country's currency is tied in value to another single currency or to a basket of other currencies (or sometimes to another measure of value, such as gold). A fixed exchange rate is usually used to stabilize the value of a currency, vis--vis the currency it is pegged to. It can also be used as a means to control inflation. However, as the value of the reference currency rises and falls, so does the currency pegged to it.

Wage and price controls In general wage and price controls are regarded as a
temporary and exceptional measure, only effective when coupled with policies designed to reduce the underlying causes of inflation during the wage and price control regime, for example, winning the war being fought. They often have perverse effects, due to the distorted signals they send to the market. Artificially low prices often cause rationing and shortages and discourage future investment, resulting in yet further shortages. The usual economic analysis is that any product or service that is under-priced is over consumed. For example, if the official price of bread is too low, there will be too little bread at official prices, and too little

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investment in bread making by the market to satisfy future needs, thereby exacerbating the problem in the long term

1.1.2 Exchange Rate

In finance, the exchange rates (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies specifies how much one currency is worth in terms of the other. It is the value of a foreign nations currency in terms of the home nations currency.[1] For example an exchange rate of 102 Japanese yen (JPY, ) to the United States dollar (USD, $) means that JPY 102 is worth the same as USD 1. The foreign exchange market is one of the largest markets in the world. By some estimates, about 3.2 trillion USD worth of currency changes hands every day.

Foreign Exchange market

The foreign exchange market (currency, forex, or FX) market is where currency trading takes place. It is where banks and other official institutions facilitate the buying and selling of foreign currencies.
[1]

FX transactions typically involve one party purchasing a

quantity of one currency in exchange for paying a quantity of another. The foreign exchange market that we see today started evolving during the 1970s when worldover countries gradually switched to floating exchange rate from their erstwhile exchange rate regime, which remained fixed as per the Bretton Woods system till 1971. Now, the FX market is one of the largest and most liquid financial markets in the world, and includes trading between large banks, central banks, currency speculators, corporations, governments, and other institutions.

Functions of foreign exchange market

Transfer function; It implies transfer of purchasing power in terms of foreign exchange across different countries of the world.

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Credit function It implies provision of credit in terms of foreign exchange for the export and import of goods and services across different countries of the world

Hedging function It implies protection against the risk related to variation in foreign exchange rate. Demand for and supply of foreign exchange is committed at some commonly agreed rate of exchange even when the commitments are to be honoured on some future date

Operation of foreign exchange market

Spot Market
A spot transaction is a two-day delivery transaction (except in the case of the Canadian dollar and the Mexican Nuevo Peso, which settle the next day), as opposed to the futures contracts, which are usually three months. This trade represents a direct exchange between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed-upon transaction.. Forward Market One way to deal with the foreign exchange risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be a one day, a few days, months or years.

Type of exchange rate

Fixed exchange rate system

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fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime wherein a currency's value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold. A fixed exchange rate is usually used to stabilize the value of a currency, vis-a-vis the currency it is pegged to. This facilitates trade and investments between the two countries, and is especially useful for small economies where external trade forms a large part of their GDP. It is also used as a means to control inflation. However, as the reference value rises and falls, so does the currency pegged to it. In addition, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability. Flexible exchange rate system A floating exchange rate or a flexible exchange rate is a type of exchange rate regime wherein a currency's value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency. The opposite of a floating exchange rate is a fixed exchange rate. There are economists who think that, in most circumstances, floating exchange rates are preferable to fixed exchange rates. As floating exchange rates automatically adjust, they enable a country to: dampen the impact of shocks & foreign business cycles; and preempt the possibility of having a balance of payments crisis. However, in certain situations, fixed exchange rates may be preferable for their greater stability and certainty. This may not necessarily be true, considering the results of countries that attempt to keep the prices of their currency "strong" or "high" relative to others, such as the UK or the Southeast Asia countries before the Asian currency crisis. The debate of making a choice between fixed and floating exchange rate regimes is set forth by Mundell-Fleming model, which argues that an economy cannot simultaneously maintain a fixed

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exchange rate, free capital movement, and an independent monetary policy. It can choose any two for control, and leave third to the market forces.

Reason for volatility in exchange rate

Growth of international financial markets: There has been a stupendous growth of international financial markets. Consequently, there has been a significant rise in the international transfer of money and capital, causing a huge pressure on supply and demand parameters of international currencies. Consequently, exchange rates have become volatile. Growth of information technology : with the growth and spread of information technology , funds can be transferred across different parts of the world just with a click of the mouse .This has raised levels of supply and demand for international currencies and change therein .volatility in exchange rate is obvious consequences Growing speculative activities: flexible exchange rate system has promoted speculation in international money market. People hold international currencies with a view to making speculative gains. Exchange rate are bound to be volatile in response to speculative mentality of investors in the international money market Rapid change in domestic interest rates : Developing economies tend to adopt this policy with a view to insulating themselves from impact of trade cycle. But change in interest rates significantly affect supply of foreign exchange.

Determinants of foreign exchange rate

The following theories explain the fluctuations in FX rates in a floating exchange rate regime (In a fixed exchange rate regime, FX rates are decided by its government):

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International parity conditions viz; purchasing power parity, interest rate parity, Domestic Fisher effect, International Fisher effect. Though to some extent the above theories provide logical explanation for the fluctuations in exchange rates, yet these theories falter as they are based on challengeable assumptions [e.g., free flow of goods, services and capital] which seldom hold true in the real world.

Balance of payments model . This model, however, focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. It failed to provide any explanation for continuous appreciation of dollar during 1980s and most part of 1990s in face of soaring US current account deficit.

Asset market model views currencies as an important asset class for constructing investment portfolios. Assets prices are influenced mostly by peoples willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of these assets. The asset market model of exchange rate determination states that the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies.

None of the models developed so far succeed to explain FX rates levels and volatility in the longer time frames. Large and small institutions and professional individual traders have made consistent profits from it. It is understood from above models that many macroeconomic factors affect the exchange rates and in the end currency prices are a result of dual forces of demand and supply. The world's currency markets can be viewed as a huge melting pot: in a large and ever-changing mix of current events, supply and demand factors are constantly shifting, and the price of one currency in relation to another shifts accordingly. No other market encompasses (and distills) as much of what is going on in the world at any given time as foreign exchange. Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several. These elements generally fall into three categories: economic factors, political conditions and market psychology.

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Economic factors
.Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government's central bank influences the supply and "cost" of money, which is reflected by the level of interest rates).

Economic conditions include: Government budget deficits or surpluses

The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's currency. Balance of trade levels and trends

The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country's currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's economy. For example, trade deficits may have a negative impact on a nation's currency. Inflation levels and trends

Typically a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising [. This is because inflation erodes purchasing power, thus demand, for that particular currency. However, a currency may sometimes strengthen when inflation rises because of expectations that the central bank will raise short-term interest rates to combat rising inflation. Economic growth and health

Reports such as GDP, employment levels, retail sales, capacity utilization and others, detail the levels of a country's economic growth and health. Generally, the

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more healthy and robust a country's economy, the better its currency will perform, and the more demand for it there will be. Productivity of an economy

Increasing productivity in an economy should positively influence the value of its currency. It affects are more prominent if the increase is in the traded sector

Market psychology
Market psychology and trader perceptions influence the foreign exchange market in a variety of ways: Flights to quality

Unsettling international events can lead to a "flight to quality," with investors seeking a "safe haven". There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts. The Swiss franc has been a traditional safe haven during times of political or economic uncertainty. Long-term trends

Currency markets often move in visible long-term trends. Although currencies do not have an annual growing season like physical commodities, business cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may rise from economic or political trends. "Buy the rumor, sell the fact"

This market truism can apply to many currency situations. It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction. This may also be referred to as a market being "oversold" or "overbought".[12] To buy the rumor or sell the fact can also be an example of the

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cognitive bias known as anchoring, when investors focus too much on the relevance of outside events to currency prices. Economic numbers

While economic numbers can certainly reflect economic policy, some reports and numbers take on a talisman-like effect: the number itself becomes important to market psychology and may have an immediate impact on short-term market moves. "What to watch" can change over time. In recent years, for example, money supply, employment, trade balance figures and inflation numbers have all taken turns in the spotlight.

Political conditions
Internal, regional, and international political conditions and events can have a profound effect on currency markets. All exchange rates are susceptible to political instability and anticipations about the new ruling party. Political upheaval and instability can have a negative impact on a nation's economy. For example, destabilization of coalition governments in India, Pakistan and Thailand can negatively affect the value of their currencies. Similarly, in a country experiencing financial difficulties, the rise of a political faction that is perceived to be fiscally responsible can have the opposite effect. Also, events in one country in a region may spur positive or negative interest in a neighboring country and, in the process, affect its currency.

1.1.4 Foreign Exchange Reserves

Foreign exchange reserves (also called Forex reserves) in a strict sense are only the foreign currency deposits and bonds held by central banks and monetary authorities. However, the term in popular usage commonly includes foreign exchange and gold, SDRs and IMF reserve positions. This broader figure is more readily available, but it is more accurately termed official international reserves or international reserves. These are assets of the central bank held in different reserve currencies, such as the dollar, euro and yen, and used to back its 19

liabilities, e.g. the local currency issued, and the various bank reserves deposited with the central bank, by the government or financial institutions

Products of foreign exchange reserve

Currency

A currency is a unit of exchange, facilitating the transfer of goods and/or services. It is coins and paper bills used as money. It is one form of money, where money is anything that serves as a medium of exchange, a store of value, and a standard of value. Currencies are the dominant medium of exchange. Coins and paper money are both forms of currenc currency swap

A currency swap (or cross currency swap) is a foreign exchange agreement between two parties to exchange principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal (regarding net present value) loan in another currency. currency future A currency future, also FX future or foreign exchange future, is a futures contract to exchange one currency for another at a specified date in the future at a price (exchange rate) that is fixed on the purchase date. Typically, one of the currencies is the US dollar. The price of a future is then in terms of US dollars per unit of other currency. This can be different from the standard way of quoting in the spot foreign exchange markets. The trade unit of each contract is then a certain amount of other currency, for instance 125,000. Most contracts have physical delivery, so for those held at the end of the last trading day, actual payments are made in each currency Forex swap

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In finance, a forex swap (or FX swap) is a simultaneous purchase and sale, or vice versa, of identical amounts of one currency for another with two different value dates Foreign exchange option

In finance, a foreign exchange option (commonly shortened to just FX option or currency option) is a derivative financial instrument where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date

Function of foreign exchange reserve

In a flexible exchange rate system, official international reserve assets allow a central bank to purchase the domestic currency, which is considered a liability for the central bank. This action can stabilise the value of the domestic currency. Central banks throughout the world have sometimes cooperated in buying and selling official international reserves to attempt to influence exchange rates.

Benefits and Criticism of foreign exchange reserve

Large reserves of foreign currency allow a government to manipulate exchange rates usually to stabilize the foreign exchange rates to provide a more favorable economic environment. In theory the manipulation of foreign currency exchange rates can provide the stability that a gold standard provides, but in practice this has not been the case. . Fluctuations in exchange markets result in gains and losses in the purchasing power of reserves. Even in the absence of a currency crisis, fluctuations can result in huge losses. For example, China holds huge U.S. dollar-denominated assets, but the U.S. dollar has been weakening on the exchange markets, resulting in a relative loss of wealth. In addition to fluctuations in exchange rates, the purchasing power of fiat money decreases constantly due to devaluation through inflation. Therefore, a central bank must 21

continually increase the amount of its reserves to maintain the same power to manipulate exchange rates. Reserves of foreign currency provide a small return in interest. However, this may be less than the reduction in purchasing power of that currency over the same period of time due to inflation, effectively resulting in a negative return known as the "quasi-fiscal cost". In addition, large currency reserves could have been invested in higher yielding assets.

1.1.5 Gold Price

A soft, yellow, corrosion-resistant element, the most malleable and ductile metal, occurring in veins and alluvial deposits and recovered by mining or by panning or sluicing. A good thermal and electrical conductor, gold is generally alloyed to increase its strength, and it is used as an international monetary standard, in jewelry, for decoration, and as a plated coating on a wide variety of electrical and mechanical components. Atomic number 79; atomic weight 196.967; melting point 1,063.0C; boiling point 2,966.0C; specific gravity 19.32 Gold (pronounced /old/) is a chemical element with the symbol Au (from its Latin name aurum). It is a highly sought-after precious metal, having been used as money, as a store of value, in jewelry, in sculpture, and for ornamentation since the beginning of recorded history. The metal occurs as nuggets or grains in rocks, underground "veins" and in alluvial deposits. It is one of the coinage metals. Gold is dense, soft, shiny and the most malleable and ductile substance known. Pure gold has a bright yellow color traditionally considered attractive. Gold formed the basis for the gold standard used before the collapse of the Bretton Woods system in 1971. The ISO currency code of gold bullion is XAU.

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General Characteristics Name, Symbol, Number gold, Au, 79 Element category Group, Period, Block transition metals 11, 6, d metallic yellow

Appearance

Standard atomic weight 196.966569(4) gmol1 Electron configuration Electrons per shell [Xe] 4f14 5d10 6s1

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Physical characteristics of gold

Gold, whose chemical symbol is Au, is capable of being shaped Malleable Capable of being shaped or formed, as by hammering or pressure Sectile cut by a knife, with a shaving curling away, like cerargyrite (horn silver) and some of the softer metals. Oxidation and its high thermal and electrical conductivity as well as its resistance to the combination of a substance with oxygen. Reactions in which the atoms in an element lose electrons and the valence of the element is correspondingly increased make its uses innumerable. Malleability The ability of gold and other metals to be pressed or hammered into thin sheets, 10 times as thin as a sheet of paper. These sheets are sometimes evaporated onto glass for infrared reflectivity, molded as fillings for teeth, or used as a coating or plating for parts. Ductility Gold's ability to be drawn into thin wire enables it to be deposited onto circuits such as transistors and to be used as an industrial solder and brazing alloy. For example, gold wire is often used for integrated circuit electrical connections, for orthodontic and prosthetic appliances, and in jet engine fabrication.

Drawback of gold
Gold's one for use in industry is that it is a relatively soft metal (sectile). To combat this weakness, gold is usually alloyed with another member of the metal family such as silver, copper, platinum, or nickel. Gold alloys are measured by karats (carats). A karat is a unit equal to 1/24 part of pure gold in an alloy. Thus, 24 karat (24K) gold is pure gold, while 18 karat gold is 18 parts pure gold to 6 parts other metal.

Extraction and Refining

Gold is usually found in a pure state; however, it can also be extracted from silver, copper, lead and zinc. Seawater can also contain gold, but in insufficient quantities to be

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profitably extractedup to one-fortieth (1/40) of a grain of gold per ton of water. Gold is generally found in two types of deposits: lode (vein) or placer deposits; the mining technique used to extract the gold depends upon the type of deposit. Once extracted, the gold is refined with one of four main processes: floatation, amalgamation, cyanidation, or carbon-in-pulp. Each process relies on the initial grinding of the gold ore, and more than one process may be used on the same batch of gold ore.

Price of gold
Like other precious metals, gold is measured by troy weight and by grams. When it is alloyed with other metals the term carat or karat is used to indicate the amount of gold present, with 24 karats being pure gold and lower ratings proportionally less. The purity of a gold bar can also be expressed as a decimal figure ranging from 0 to 1, known as the millesimal fineness, such as 0.995 being very pure. The price of gold is determined on the open market, but a procedure known as the Gold Fixing in London, originating in September 1919, provides a daily benchmark figure to the industry. The afternoon fixing appeared in 1968 to fix a price when US markets are open.

1.2 Indian Stock Market

During the past few years Indian Capital Market has undergone metaphoric 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. 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 under took a comprehensive and deep analysis of volatility by using several statistical techniques to measure and analyze it. 18 countries

25

covering almost all continents- developed as well as emerging markets and young and old markets- have been analyzed. The results show that volatility has not gone up much in the recent past as it has been perceived. Indian stock market provides a very high rate of return and comparatively moderate 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, stock market return exhibit informational efficiency and approximates to normal distribution.

Bombay Stock Exchange:

The BSE is the oldest stock exchange in Asia. It is situated in Dalal Street in Mumbai. It is the third largest stock exchange in south Asia and the tenth largest in the world. BSE has over 5000 companies that are listed in it. The objectives of the BSE are similar to that of the NSE. BSE also uses the latest technologies in the IT field to provide a single place where traders from across the world can buy/sell shares in the Indian share market.

Sensex
The BSE Sensex or Bombay Stock Exchange Sensitive Index or BSE 30 is a valueweighted index composed of 30 stocks with the base April 1979 = 100. It consists of the 30 largest and most actively traded stocks, representative of various sectors, on the Bombay Stock Exchange. These companies account for around one-fifth of the market

capitalization of the BSE.

The base value of the Sensex is 100 on April 1, 1979, and the base year of BSE-SENSEX is 1978-79.At irregular intervals, the Bombay Stock Exchange (BSE) authorities review and modify its composition to make sure it reflects current market conditions. The index has increased by over ten times from June 1990 to today. Using information paying a princely amount of Re1. from April 1979 onwards, the long-run rate of return on the BSE Sensex works out to be 18.6% per annum, which translates to roughly 9% per annum after compensating for inflation. 26

For the premier Stock Exchange that pioneered the stock broking activity in India, 128 years of experience seems to be a proud milestone. A lot has changed since 1875 when 318 persons became members of what today is called "The Stock Exchange, Mumbai" by Since then, the country's capital markets have passed through both good and bad periods. The journey in the 20th century has not been an easy one. Till the decade of eighties, there was no scale to measure the ups and downs in the Indian stock market. The Stock Exchange, Mumbai (BSE) in 1986 came out with a stock index that subsequently became the barometer of the Indian stock market. SENSEX is not only scientifically designed but also based on globally accepted construction and review methodology. First compiled in 1986, SENSEX is a basket of 30 constituent stocks representing a sample of large, liquid and representative companies. The base year of SENSEX is 1978-79.The Index was initially calculated based on the "Full Market Capitalization" methodology but was shifted to the free-float methodology with effect from September 1, 2003. The "Free-float Market Capitalization" methodology of index construction is regarded as an industry best practice globally. All major index providers like MSCI, FTSE, STOXX, S&P and Dow Jones use the Free-float methodology. Due to is wide acceptance amongst the Indian investors; SENSEX is regarded to be the pulse of the Indian stock market. As the oldest index in the country, it provides the time series data over a fairly long period of time (From 1979 onwards). Small wonder, the SENSEX has over the years become one of the most prominent brands in the country. The growth of equity markets in India has been phenomenal in the decade gone by. Right from early nineties the stock market witnessed heightened activity in terms of various bull and bear runs. The SENSEX captured all these events in the most judicial manner. One can identify the booms and busts of the Indian stock market through SENSEX.

Sensex calculation methodology

SENSEX is calculated using the "Free-float Market Capitalization" methodology. As per this methodology, the level of index at any point of time reflects the Free-float market value of 30 component stocks relative to a base period. The market capitalization of a company is determined by multiplying the price of its stock by the number of shares

27

issued by the company. This market capitalization is further multiplied by the free-float factor to determine the free-float market capitalization. The base period of SENSEX is 1978-79 and the base value is 100 index points. This is often indicated by the notation 1978-79=100. The calculation of SENSEX involves dividing the Free-float market capitalization of 30 companies in the Index by a number called the Index Divisor. The Divisor is the only link to the original base period value of the SENSEX. It keeps the Index comparable over time and is the adjustment point for all Index adjustments arising out of corporate actions, replacement of scrips etc. During market hours, prices of the index scrips, at which latest trades are executed, are used by the trading system to calculate SENSEX every 15 seconds and disseminated in real time.

Objectives of sensex
The BSE Sensex is the benchmark Index of the Indian Stock Market with wide acceptance among individual investors, institutional investors and fund managers. The objectives of the index are: To measure Markey movement Given its long history and wide acceptance, no other index matches the BSE Sensex in reflecting market movements and sentiments. Sensex is widely used to describe the mood in the Indian Stock Market. Benchmark for fund performance The inclusion of the Blue chip companies and the wide and balanced industry representation in the Sensex makes it the ideal benchmark for fund managers to compare the performance of their funds

Security market indices

Security market indices represent security market prices. Stock price index is a way of measuring the performance of a market over time. Indices are regarded as an important indicator by the finance industry and the investing public at large. An index can be used as a benchmark by which an investor or fund manager compares the returns of their own portfolio. As the share market index represents the return of the market as a whole, one

28

can easily evaluate market or industry performance using this index. The market index can also be used to define the universe from which investors or fund managers pick their stocks. BSE-100 Index BSE-200 Index BSE-500 Index Dollex Series of BSE Indices. Sectoral indices BSE TECk Index BSE PSU Index BSE Mid-Cap and BSE Small-Cap Index

Current Scenario
The Indian capital market attained further depth and width in business transacted during 2007. The Bombay Stock Exchange (BSE) Sensex, which had been witnessing an upswing since the latter part of 2003, scaled a high of 20,000 mark at the close of calendar year 2007.The National Stock Exchange (NSE) Index rose in tandem to close above the 6,100 mark at the end of 2007. Both the indices more than tripled between 2003 and 2007, giving handsome yearly returns. Alongside the growth of business in the Indian capital market, the regulatory and oversight norms have improved over the years, ensuring a sound and stable market. While the climb of BSE Sensex during 2007-08 so far was the fastest ever, the journey of BSE Sensex from 18,000 to 19,000 mark was achieved in just four trading sessions during October 2007. It further crossed the 20,000 mark in December 2007 and 21,000 in an intra-day trading in January 2008. However, BSE and NSE indices declined subsequently reflecting concerns on global developments. BSE Sensex yielded a compounded return of 36.5 per cent per year between 2003 and 2007. In terms of simple average, BSE Sensex has given an annual return of more than 40 per cent during the last three years. BSE 500 recorded compounded annual return of 38 per cent between 2003

29

and 2007. In the secondary market segment, the market activity expanded further during 2007-08 with BSE and NSE indices scaling new peaks of 21,000 and 6,300, respectively, in January 2008. Although the indices showed some intermittent fluctuations, reflecting change in the market sentiments, the indices maintained their north-bound trend during the year. This could be attributed to the larger inflows from Foreign Institutional Investors (FIIs) and wider participation of domestic investors particularly the institutional investors. During 2007, on a point-to-point basis, Sensex and Nifty Indices rose by 47.1 and 54.8 per cent, respectively. The buoyant conditions in the Indian bourses were aided by, among other things, India posting a relatively higher GDP growth amongst the emerging economies, continued uptrend in the profitability of Indian corporates, persistence of difference in domestic and international levels of interest rates, impressive returns on equities and a strong Indian rupee on the back of larger capital inflows.

30

1.3 Objectives of the study

The present study was conducted with the main objective of analyzing the impact of macroeconomic variables on stock price. However, the specific objectives are as follows: To study the concept of macro economic variables To study the effect of macro economic variables on stock price To study is their any correlation between stock price and macro economic variables

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CHAPTER-2

REVIEW OF LITERATURE

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Atsuyuki Naka; Tarun Mukherjee; David Tufte after (1990) studied Macro economic variables and the performance of Indian stock market. They analyzed the longterm relationship between the BSE and certain relevant macroeconomic factors. They employed a vector error correction model (VECM) (Johansen (1991)) in a system of five equations to investigate the presence of cointegration (and, by implication, long-term equilibrium relations) among these factors. The complete system of long-run and shortrun effects indicates that domestic inflation and domestic output growth are the primary determinants of prices of the BSE. They found that countrys stock index is affected by factors that influence its economic growth or bring about changes in its real rate of interest, expected rate of inflation, and risk premium. They analyzed a negative relationship between interest rates or inflation and stock prices, and a positive relation between output growth and stock prices. Basabi Bhattacharya, Jaydeep Mukherjee (2001) investigates the nature of the causal relationship between stock prices and macroeconomic aggregates in India. By applying the techniques of unitroot tests, cointegration and the longrun Granger noncausality test recently proposed by Toda and Yamamoto (1995).They test the causal relationships between the BSE Sensitive Index and the five macroeconomic variables, viz., money supply, index of industrial production, national income, interest rate and rate of inflation using monthly data for the period 1992-93 to 2000-01. They found that (i) there is no causal linkage between stock prices and money supply, stock prices and national income and stock prices and interest rate, (ii)index of industrial production lead the stock price, and (iii) there exists a two way causation between stock price and rate of inflation. Mishra (2004) examined the relationship between stock market and foreign exchange markets using Granger causality test and Vector Auto Regression technique. He used monthly data for stock return exchange rate, interest rate and demand for money for the period 1992 to 2002. The study found that there exists a unidirectional causality between the exchange rate and interest rate and also between the exchange rate return and demand for money. The study also suggested that there is no Granger causality between the exchange rate return and stock return .

33

Ray, Prantik and Vani, Vina (1993) attempt to unravel the relationship between the real

economic variables and the capital market in Indian context. The paper considers the monthly data of several economic variables like the national output, fiscal deficit, interest rate, inflation, exchange rate, money supply, foreign institutional investment in Indian markets between 1994 and 2003, and tries to reveal the relative influence of these variables on the sensitive index of the Bombay stock exchange. Compared to the earlier similar attempts, this paper applies the modern non-linear technique like VAR and Artificial Neural Network and compares the results. The finding shows that certain variables like the interest rate, output, money supply, inflation rate and the exchange rate has considerable influence in the stock market movement in the considered period, while the other variables have very negligible impact on the stock market. Partha Ray and Somnath Chatterjee (2001) made an attempt to analyse the impact of stock prices on commodity price inflation in India in the recent period (1994-2000).They constructed a vector autoregression (VAR) model comprising the call money rate, broad money growth, output gap, stock price inflation and commodity price inflation. They found that while stock price inflation did not Granger cause an output gap, it seemed to have Granger caused commodity price inflation. The results remained unaltered even if the output gap was replaced by output growth in the model. They analyze that while stock prices may not have much significance for the growth of output; they contain important information about commodity prices and may thus serve as a leading indicator of inflation. They also considered gold as an alternative asset in the household portfolio. Gold price inflation, however, failed to emerge as a leading indicator of inflation. Abdalla and Murinde (1996) investigate interactions between exchange rates and stock prices in the emerging financial markets of India, Korea, Pakistan and the Philippines. The results of the granger causality tests results show uni-directional causality from exchange rates to stock prices in all the sample countries, except the Philippines.

34

Dornbusch and Fischer(1980) study that changes in exchange rates affect the competitiveness of a firm as fluctuations in exchange rate affects the value of the earnings and cost of its funds as many companies borrow in foreign currencies to fund their operations and hence its stock price. An alternative explanation for the relation between exchange rates and stock prices can be provided through portfolio balance approaches that stress the role of capital account transaction He found that rising (declining) stock prices would lead to an appreciation (depreciation) in exchange rates. Chen, Roll and Ross (1986) have argued that stock returns should be affected by any factor that influences future cash flows or the discount rate of those cash flows. In an empirical investigation they found that the yield spread between long and short term government bonds, expected inflation, unexpected inflation, nominal industrial production growth and the yield spread between corporate high and low grade bonds significantly explain stock market returns. An alternative way of linking macroeconomic variables and stock prices is the discounted cash flow or present value model (PVM). This model relates the stock price to future expected cash flows and the future discount rate of the cash flows. Again, all macroeconomic factors that influence future expected cash flows or the discount rate by which the cash flows are discounted should have an influence on stock price.(check) Sangeeta Chakravarty reexamines the relationship between stock price and some key macro economic variables in India for the period 1991-2005 using monthly time series data. The study uses Granger non causality test procedure developed by Toda and Yamamoto(1995).The results of the study indicate that index of industrial production and inflation Granger cause stock price but stock price does not cause either of the two so the causation is unidirectional. The causal relation between stock price and money supply is unidirectional as stock price Granger cause money supply but money supply does not. On the other hand there is no causal relation between stock price and exchange rate. Similarly there is no causal linkage between gold price and stock price.

35

Sahid Ahmed (2008) the key macro economic variables representing real and financial sector of the Indian economy for the period March, 1995 to March, 2007 using quarterly data. These variables are the index of industrial production, exports, foreign direct investment, money supply, exchange rate, interest rate, NSE Nifty and BSE Sensex in India. Johansen`s approach of cointegration and Toda and Yamamoto Granger causality test have been applied to explore the long-run relationships while BVAR modeling for variance decomposition and impulse response functions has been applied to examine short run relationships. The results of the study reveal differential causal links between aggregate macro economic variables and stock indices in the long run. However, the revealed causal pattern is similar in both markets in the short run. The study indicates that stock prices in India lead economic activity except movement in interest rate. Interest rate seems to lead the stock prices. The study indicates that Indian stock market seems to be driven not only by actual performance but also by expected potential performances. The study reveals that the movement of stock prices is not only the outcome of behaviour of key macro economic variables but it is also one of the causes of movement in other macro dimension in the economy. Mukherjee and Naka (1995) argue that a change in the money supply provides information on money demand, which is caused by future output expectations. If the money supply increases, it means that money demand is increasing, which, in effect, signals an increase in economic activity. Higher economic activity implies higher cash flows, which causes stock prices to rise. Bernanke and Kuttner (2005) argue that the price of a stock is a function of its monetary value and the perceived risk in holding the stock. A stock is attractive if the monetary value it bears is high. On the other hand, a stock is unattractive if the perceived risk is high. The authors argue that the money supply affects the stock market through its effect on both the monetary value and the perceived risk. Money supply affects the monetary value of a stock through its effect on the interest rate. The authors believe that tightening the money supply raises the real interest rate. An increase in the interest rate would in turn raise the discount rate, which would decrease the value of the stock.

36

Raman K. Agrawalla (2005) to examine for India the causal relationships between the share price index and industrial production in a multivariate vector error correction model which involved certain other crucial macroeconomic variables namely money supply, credit to the private sector, exchange rate, wholesale price index, and money market rate for the reason of right and robust model specification. The result of the estimated multivariate VECM (vector error correction model) is that the share price index and the macroeconomic variables are cointegrated. That is, there is a long run equilibrium relationship between the share price index and the select macroeconomic variables. Hondroyiannis and Papapetrou (2001) investigate whether movements in the indicators of economic activity affect the performance of the stock market for Greece. The study performs a VAR analysis to analyse the dynamic interactions among indicators of economic activity. It uses the monthly data for the period 1984:1 to 1999:9 for Greece. The following variables are taken as the indicator of economic activity, viz., industrial production as a measure of output, real oil prices (Consumer price index (CPI) for fuels deflated by CPI), interest rate, exchange rate, the performance of the foreign stock market (difference between the continuously compounded return on S & P 500 index and the USA inflation rate) and domestic real stock returns (difference between the continuously compounded return on the Athens general stock market index and Greek inflation rate).The major findings of the study is that the domestic market economic activity affects the performance of domestic stock market. Impulse response analysis carried out in the study shows that all the macroeconomic variables are important in explaining stock price movements. Growth in industrial production responds negatively to a real stock return shock, implying that an increase in real stock returns does not necessarily lead to a higher level of industrial production. The empirical results suggest that the Greek stock market returns do not rationally signal changes in the overall macroeconomic activity. Real stock returns respond negatively to interest rate shocks, while a depreciation of the currency leads to higher real stock market returns. Habibullah et al (2000) determines the lead and lag relationships between Malaysian stock market and five key macroeconomic variables. It employs the methodology of

37

Granger noncausality proposed by Toda and Yamamoto (1995) for the sample period 1981:1 to 1994:4 to test whether the Malaysia stock market can act as a barometer for the Malaysian economy. The study includes five macroeconomic variables namely broad divisia money supply aggregate, nominal income (Gross National Product), price level (Consumer Price Index), interest rate (3-month Treasury bill rate) and the exchange rate (Real Effective Exchange Rate). The study used Gandolfos (1981) technique to interpolate quarterly data series from annual observations of GNP. The results reported in the study indicate that stock prices lead nominal income, the price level and the exchange rate, but money supply and interest rate lead the stock price. Naka, Mukherjee and Tufte (2001), analyses long-term equilibrium relationship among selected macroeconomic variables and the Bombay Stock Exchange index. The study uses data for the period 1960:1 to 1995:4 for India on the following macroeconomic variables; namely, the Industrial production index, the consumer price index, a narrow measure of money supply, and the money market rate in the Bombay inter bank market. It employs a vector error correction model to avoid potential misspecification biases that might result from the use of a more conventional VAR modeling technique. The study finds that the five variables are cointegrated and there exists three long-term equilibrium relationships among these variables. One is long-run monetary neutrality, the second relates interest rates to output (i.e., an IS function), and the third relates nominal stock prices to nominal GDP and a downward trend. The signs on these relations are consistent with macroeconomic theory. The results of the study suggest that domestic inflation is the most severe deterrent to Indian stock market performance, and domestic output growth as its predominant driving force. After accounting for macroeconomic factors the Indian stock markets still appear to be drawn downward by residual negative trend. Pethe and Karnik (2000) using Indian data for April 1992 to December 1997, attempts to find the way in which stock price indices are affected by and affect other crucial macroeconomic variables in India. But this study runs causality tests in an error correction framework on non-cointegrated variables, which is inappropriate and not econometrically sound and correct. The study of course avers that in the absence of

38

cointegration it is not legitimate to test for causality between a pair of variables and it does so in view of the importance attached to the relation between the state of economy and stock markets. The study reports weak causality running from IIP to share price index (Sensex and Nifty) but not the other way round. In other words, it holds the view that the state of economy affects stock prices. Basabi Bhattacharya, Jaydeep Mukherjee (2002) This paper investigates the nature of the causal relationship between stock prices and macroeconomic aggregates in the foreign sector in India. By applying the techniques of unitroot tests, cointegration and the longrun Granger noncausality test recently proposed by Toda and Yamamoto (1995), They test the causal relationships between the BSE Sensitive Index and the three macroeconomic variables, viz., exchange rate, foreign exchange reserves and value of trade balance using monthly data for the period 1990-91 to 2000-01. The results suggest that there is no causal linkage between stock prices and the three variables. Basabi Bhattacharya, Jaydeep Mukherjee (2006) investigates the nature of the causal relationship between stock returns, net foreign institutional investment (FII) and exchange rate in India. By applying the techniques of unitroot tests, cointegration and the longrun Granger noncausality test recently proposed by Toda and Yamamoto (1995), we test the causal relationships using monthly data for the period January 1993 to March 2005. The major findings are that (a) a bi-directional causality exists between stock return and the FII, (b) unidirectional causality runs from change in exchange rate to stock returns (at 10% level of significance), not vice versa, and (c) no causal relationship exist between exchange rate and net investment by FIIs. Chatrath , Ramchander ,Song (1997) study a negative relationship between stock market returns and inflationary trends has been widely documented for developed economies in Europe and North America. This study provides similar evidence for India. This relationship is investigated in light of Fama's explanation that centres around linkages between inflation and real activity, and between stock returns and real activity. Specifically, the study tests whether the negative stock return-inflation relationship is

39

explained by a negative relationship between inflation and real economic activity, and a positive relationship between real activity and stock returns. The results from the heteroscedasticity and autocorrelation corrected models provide only partial support for Fama's hypothesis. The relationship between real activity and inflation does not account for the negative relationship between real stock returns and the unexpected component of inflation. Horobet , Alexandra and Ilie, Livia (2007) explore the interactions between exchange rates and stock market prices applied to Romania, one of the emerging economies in Central and Eastern Europe and a new member of European Union since January 2007. The study uses standard bivariate cointegration tests, using both the Engle-Granger and the Johansen-Juselius methodology, as well as standard and modified Granger causality tests. In the analysis, three types of exchange rates of the Romanian currency are used: bilateral rates against the euro and the US dollar, effective nominal rates and real effective rates. The two indices of the Bucharest stock exchange were capturing the evolution of stock prices. The analysis involved the January 1999 June 2007 period, but also two sub-periods (January 1999 - October 2004 and November 2004 June 2007) to take into account the alteration of the Romanian foreign exchange market occurring after the end of 2004.The results indicate indicates no cointegration between the exchange rates and the stock prices, the use of the Johansen-Juselius procedure suggests the presence of cointegration between the two stock market indices and the exchange rates, either nominal bilateral, nominal effective or real effective rates. When standard Granger causality test were performed on non-cointegrated variables, they identified unilateral causality relations from the stock prices to exchange rates for the entire period and the second sub-period, and one bilateral causality relation between the stock prices and the bilateral exchange rate against the US dollar for the first sub-period. Mazharul H. Kazi (2008) reviewed the recent trends of analyzing the relationship between the security market movement and a priori variables, while retaining the basic attributes of asset pricing theory .He used the cointegration approach one can efficiently analyze the long-run relationship between a priori variables (macroeconomic variables) that are considered as proxy for systematic risk factors and security market prices. This

40

paper recognizes that although an empirical study in asset pricing imposes no limits within the boundaries of its traditional methods or models, the cointegration method or an autoregressive model based on the stock market prices are more suitable for empirical analysis of asset pricing under the globalised market place. Mookerjee and Yu (1997) study the Singapore stock market pricing mechanism by investigating whether there are long-term relationships between macroeconomic variables and stock market pricing. Macro economic variables include the narrow money supply, the broad money supply, nominal exchange rates, and foreign currency reserves to ascertain whether these variables were related to Singapore stock market prices in both the long- and short-runs They have chosen the all-share price index to broadly represent Singapore stock market prices. They find that three out of four macroeconomic variables are cointegrated with stock market prices. To test for informational efficiency they employ cointegration and causality techniques because these techniques allow them for any potential linkages between variables in the long-run as well as in the short-run. Nasseh and Strauss (2000) study the longrun relationships between stock market prices (represented by relevant share price indices) and domestic and international economic activity in six countries that included France, Germany, Italy, Netherlands, Switzerland and the UK. In their study Johansens cointegration tests demonstrate that stock price levels are significantly related to industrial production, business surveys of manufacturing orders, short- and long-term interest rates as well as foreign stock prices, shortterm interest rates, and production. Nasseh and Strauss (2000) also use variance decomposition methods that support the strong explanatory power of macroeconomic variables in contributing to the forecast variance of stock market prices. They recognize the usefulness of Johansens framework for analyzing stock market and macroeconomic activity it incorporates dynamic comovements or simultaneous interactions, allowing the researchers to study the channels through which macroeconomic variables affected asset pricing, as well as their relative importance. Their variance decomposition methods, based on a vector autoregression with orthogonal residuals, show that macroeconomic factors.They find that although stock prices are explained by economic fundamentals in

41

the medium and short-run, the underlying volatility inherent in stock prices is related to macroeconomic movements in the long-run. Mohiuddin (2008) investigated the explanatory power of various macro-factors such as inflation rate, exchange rate, interest rate, money supply and production index on the variability of the stock price in Bangladesh. Multiple regression analysis has been conducted to asses the relationship between the stated macro economic factors with stock price. All share price index of the Dhaka Stock Exchange has been used as a proxy for stock price, the dependent variable of the study. No significant relationship has been found between the stock price and any of the macroeconomic factors. The study bodes well for advanced empirical models with additional macroeconomic variables. Cheah Lee Hen 1 , Zainudin Arsad 2 , Husna Hasan 3 (2006) makes use of Kalman filter and variety of ARCH type models to investigate the feedback causal relationship between stock prices with each of currency exchange and derivative product. Since the development by Kalman and Bucy in 1960s, Kalman filter technique has been the subject of extensive research and application. It is a set of equations which allows an estimator to be updated once a new observation becomes available. Three series used are monthly Kuala Lumpur Composite Index (KLCI), Pound Sterling (STL) and Kuala Lumpur Composite Index Futures (FKLI). All data covered from January 1997 to February 2005. In general, the results show that dynamic linkages between stock market and derivative are relatively weak. For the asymmetry GARCH models, there is a bi-directional causality runs between KLCI and FKLI. On the other hand, the symmetry GARCH models fail to reveal any recognizable pattern between the two variables. For the dynamic between KLCI and STL, the results suggest that many of the relationships or effects between the two series are significant. However, only KF-GARCH-M model has a bidirectional feedback effect between KLCI and STL. In addition, the result proves the existence of leverage effect in the stock market. However, the there is no evidence of risk-return tradeoff in the Malaysian stock market.

42

Serkan Yilmaz Kandir (2008) investigates the role of macroeconomic factors in explaining Turkish stock returns. A macroeconomic factor model is employed for the period that spans from July 1997 to June 2005. Macroeconomic variables used in this study are, growth rate of industrial production index, change in consumer price index, growth rate of narrowly defined money supply, change in exchange rate, interest rate, growth rate of international crude oil price and return on the MSCI World Equity Index. This study uses data for all non-financial firms listed on the ISE. The analysis is based on stock portfolios rather than single stocks. In portfolio construction, four criteria are used: market equity, the book-tomarket equity, the earnings-to-price equity and the leverage ratio. A multiple regression model is designed to test the relationship between the stock portfolio returns and seven macroeconomic factors. Empirical findings reveal that exchange rate, interest rate and world market return seem to affect all of the portfolio returns, while inflation rate is significant for only three of the twelve portfolios. On the other hand, industrial production, money supply and oil prices do not appear to have any significant affect on stock returns. Erman Erbaykal Sr.,H.Aydin okuyan (2008) investigate the relationship between reel macroeconomic variables and stock prices in Turkey under "Proxy hypothesis" developed by Fama (1981). According to Proxy hypothesis of Fama, real macroeconomic variables such as consumption expenditures, economic growth, employment, fixed investment affect stock prices via inflation. In the study, consumption expenditures, industrial production index, employment level and fixed investments are used as indicators of real economic activity and consumption price index as indicator of inflation. The long-run relationship between the variables is tested by Bound testing approach developed by Paseran et al (2001). Our findings support the validity of the Proxy Hypothesis of Fama (1981) for Turkey

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CHAPTER-3

RESEARCH METHODOLOGY

44

Research Methodology

3.1 Nature of study

The Whole study is based on descriptive in nature. Descriptive research is conducted for examine the effect of macroeconomic factors on the stock portfolio returns. In this study, a multiple regression model is employed to test for the effects of macroeconomic factors on stock price for the period Jan 2008 to Jan 2009. Macroeconomic variables used in this study are, change in exchange rate, foreign exchange reserve , inflation rate and gold price. In the regression models, stock price are used as dependent variables, while the macroeconomic variables are used as independent variables.

3.2 Data Collection

In this study, the analysis is conducted by using weekly data for the period spans from Jan 2008 to Jan 2009. The data used in the study is divided into two sub-groups. First data set consist of stock data (BSE Sensex). Second data set consist of macroeconomic factors such as inflation rate, foreign exchange reserve, exchange rate and gold price In this study only Secondary data is used. Exchange rate data is collected from the the federal reserve statistical release. Inflation data and foreign exchange reserve data are obtained from Reserve Bank of India. Gold price is obtained from NASDAQ. BSE. Stock returns are obtained from Bombay Stock Exchange and The Money Control

3.3 Research Methodology of the study

For the purpose of analysis, Statistical techniques multiple regression model is designed to test the effect of four macroeconomic factors on the stock portfolio returns. A stastical technique that simultaneously develop a mathematical relationship between a single dependent variable and two or more independent variables.

45

With four independent variables the prediction of Y is expressed by the following equation:

Y'i = b0 + b1X1i + b2X2i + b3X3i + b4X4i

The "b" values are called regression weights and are computed in a way that minimizes the sum of squared deviations

Y'i = is the return on the stock portfolio i, X1i = is the change in whole sale price X2i = is the change in exchange rate, X3i = is the change in foreign exchange reserve X4i = is the change in gold price.

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CHAPTER-4

ANALYSIS & INTERPRETATIONS

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Analysis &Interpretation
Macro economic variables has effect on the stock price. There is a relationship between Inflation rate , exchange rate ,foreign exchange reserve and gold price. So this study An Empirical Study on the Relationship between Macroeconomic Variables and Stock Price is based on regression analysis . Regression analysis is a statistical tool for the

investigation of relationships between variables in terms of the original units of the data. Regression analysis attempts to establish the nature of the relationship between variablesthat is to study the functional relationship between the variables and there by provide a mechanism for prediction. . The description of the nature of the relationship between two or more variables; it is concerned with the problem of describing or estimating the value of the dependent variable on the basis of one or more independent variables. Regression analysis is applied for examine is there is any effect of macro economic variables on stock price? Regression creates temporary variables containing predicted values, residuals, measures of fit and influence, and several statistics based on these measures. These temporary variables can be analyzed within regression in Casewise Diagnostics tables , scatterplots Histograms and normal probability plots , and partial regression plots Regression calculates multiple regression equations and associated statistics and plots.

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Weekly wise multi regression analysis

Table no 4. 1: Descriptive Statistics
Descriptive Statistics Mean Stock Price Inflation Rate Exchange Rate Foriegnexchange Reserve Gold Price 13892.4336 8.4338 43.9260 285817.25 870.3231 Std. Deviation 3428.08609 2.99887 3.72590 24888.775 65.84736 N 55 55 55 55 55

Interpretation; Table no 1 shows the Descriptive statistics. Display mean, standard deviation, and for each variable on the Variables list in the Descriptive Statistics table. Above table shows that stock price mean is 13892.46 and std.deviation is 3428.08609. This means that stock price standard deviation is verh high. It reflect lot of variability in stock price. Inflation rate mean is 8.4338 and std.deviation is 2.99887 so there is moderate variability in inflation rate .Exchange rate mean is 43.9260 and std.deviation is 3.72590. So there is very less variability in exchange rate. Foreign exchange reserve mean is 285817.25 and Standard deviation is 248888.775 . It shows that there is moderate variability in foreign exchange reserve .Gold price mean and std. Deviation is 870.3231 and 65.84736.There is high moderate variability in gold price.

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Table no 4. 2 : Correlations Matrix

Correlations

Exchange Stock Price Pearson Correlation Inflation Rate Exchange Rate Foreign exchange Reserve Gold Price Sig. (1-tailed) Stock Price Inflation Rate Exchange Rate ForiegnexchangeR eserve Gold Price N Stock Price Inflation Rate Exchange Rate ForiegnexchangeR eserve Gold Price 55 55 55 .000 55 55 55 55 .050 55 55 55 55 .000 55 55 55 55 .555 . .083 .000 .000 -.224 .083 . .094 .015 -.677 .000 .094 . .000 -.189 -.943 .754 1.000 .180 .294 .180 1.000 -.817 Stock Price 1.000 Inflation Rate -.189 Rate -.943

Foriegnexchan geReserve .754 .294 -.817 1.000 Gold Price .555 -.224 -.677 .653

.653 .000 .015 .000 .

1.000 .000 .050 .000 .000

.000 55 55 55 55

. 55 55 55 55

55

55

Interpretation ; Table no 2 shows the correlation among the Inflation rate, foreign exchange reserve and gold price with stock price. Stock price Pearson correlation extended to 1. Exchange rate correlation is -.943. It shows that exchange rate has high negative correlation with stock price. Inflation rate correlation is -.189.this reflect that

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inflation very low negative correlation with stock price. This variable doesnt influence the stock price .foreign exchange reserve correlation is.754.this has a positive correlation with stock price. Gold price correlation with stock price is .555 so gold price has a moderate correlation with stock price The relation between inflation rate and exchange rate is highly positive to the extent of . 094 but it is less than 1.There is very low positive relation between foreign exchange reserve and inflation rate to the extent of .015. There is moderate positive relation between inflation rate with gold price to the extent of .05. There is no relation between exchange rate and foreign exchange reserve. There is .0 relation between exchange rate and foreign exchange reserve .Similarly there is not any relationship between exchange rate and gold price. There is .000 relation between foeiegn exchange reserve and gold price Table no 3: Variables entered
Variables Entered/Removed Variables Model 1 2 Entered Exchange Rate Gold Price Variables Removed Method . Forward (Criterion: Probability-of-F-to-enter <= .050) . Forward (Criterion: Probability-of-F-to-enter <= .050)

a. Dependent Variable: Stock Price

Interrpretation

In table 3 Multiple regression analysis accepts two variables i.e.

Exchange rate and gold price which has effect on sock price.

Table no 4. 4: Model summary

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Model Summaryc

Change Statistics R Model 1 2 R .943a .950b Square .889 .902 Adjusted R Std. Error of the Square .887 .898 Estimate 1153.91790 1095.47475 R Square Change .889 .013 F Change df1 df2 Sig. F Change 423.593 6.806 1 1 53 52 .000 .012 DurbinWatson

.488
.

a. Predictors: (Constant), Exchange Rate b. Predictors: (Constant), Exchange Rate, Gold Price c. Dependent Variable: Stock Price

Interpretation R2 is a statistic that will give some information about the goodness of fit of a model. In regression, the R2 coefficient of determination is a statistical measure of how well the regression line approximates the real data points. An R2 of 1.0 indicates that the regression line perfectly fits the data. It is important to see that values of R2 outside the range 0 to 1 can occur where it is used to measure the agreement between dependent and independent variables R2 is computed to indicate the direction of the relationship. The range of r2 is from 0to1. In model 1 exchange rate coefficient of correlation is .943. it shows the very high positive correlation between stock price and exchange rate .r2 indicate the 88.9% exchange rate has relation with stock price. The impact of exchange rate on stock price is significant . In model 2 coefficient of correlation (R) is .950. it indicate that very high positive correlation between stock price and gold price . r2 is 90.2% .The results shows in model

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2 gold price has 90.2% impact on stock price .there is a significant relation between stock price and exchange rate and gold price Adjusted R2 (sometimes written as ) is a modification of R2 that adjusts for the number of explanatory terms in a model. Unlike R2, the adjusted R2 increases only if the new term improves the model more than would be expected by chance. The adjusted R2 can be negative, and will always be less than or equal to R2. Adjusted R square in model first is . 887 which is less than R square .In model 2 Adjusted R square is .902 which is less than R square Table no 5; ANOVA

ANOVAc Model 1 Regression Residual Total 2 Regression Residual Total Sum of Squares 5.640E8 7.057E7 6.346E8 5.722E8 6.240E7 6.346E8 df 1 53 54 2 52 54 2.861E8 1200064.938 238.401 .000b Mean Square 5.640E8 1331526.522 F 423.593 Sig. .000a

a. Predictors: (Constant), Exchange Rate b. Predictors: (Constant), Exchange Rate, Gold Price c. Dependent Variable: Stock Price

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Interpretation ANOVA table no 5 displayed a regression and residual sums of squares, mean square, F, and probability of F. ANOVA table examine the difference in the mean value of the dependent variable i.e. stock price associated with the effect of the controlled independent variables. Results show that there is a significant relation between exchange rate and stock price. Because F calculated value is greater than the table value. In model 2 shows there is a significant relation between dependent variable and independent variable. Exchange rate and gold price effect is significant on gold price.

Table no 6: Coefficients

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Coefficientsa Standardized Unstandardized Coefficients Model 1 (Constant) 51994.040 Exchange Rate -867.404 2 (Constant) 63197.024 Exchange Rate -963.434 Gold Price -8.026 3.076 -.154 -2.609 .012 54.367 -1.047 -17.721 .000 4642.361 13.613 .000 42.145 -.943 -20.581 .000 1857.794 27.987 .000 B Std. Error Coefficients Beta t Sig.

a. Dependent Variable: Stock Price Interpretation In Above table beta shows the coefficient which measures the degree to which two variables are linearly related. Results shows that there is a perfect linear relationship with negative slope between the two variables, a correlation coefficient of -1. In model 1 exchange rate is contant. Alternative hypothesis is accepted. there is a significant relation between exchange rate and stock market. In table 2 there is a significant relation between exchange rate and gold price. Beta shows about the god fitness of the model. t-test is used to determine whether there is a significant difference between the average values of the same measurement made under two different conditions. Both measurements are made on each unit in a sample, and the test is based on the paired differences between these two values.

Table no 7: Excluded variables

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Excluded Variablesc Collinearity Partial Model 1 InflationRate ForiegnexchangeReserve GoldPrice 2 InflationRate ForiegnexchangeReserve Beta In -.020a -.047a -.154a -.037b .000b t -.433 -.590 -2.609 -.833 -.012 Sig. .667 .558 .012 .409 .991 Correlation -.060 -.082 -.340 -.116 -.002 Statistics Tolerance .968 .333 .542 .948 .315

a. Predictors in the Model: (Constant), ExchangeRate b. Predictors in the Model: (Constant), ExchangeRate, GoldPrice c. Dependent Variable: StockPrice Interpretation Multi regression model doesnt accept the inflation rate and foreign exchange reserve have relation with stock market. Above table shows the inflation rate and foreign exchange reserve are excluded from the computation of the correlation matrix on which all analyses are based. Because these variable are above their tolerance

Table no 8 Residual statistics

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Residuals Statisticsa

Minimum Predicted Value 8773.0830 Residual -2423.01270 Std. Predicted Value -1.573 Std. Residual -2.212

Maximum

Mean

Std. Deviation

18366.2773

13892.4336

3255.17375

55

2514.84814

.00000

1074.99679

55

1.374

.000

1.000

55

2.296

.000

.981

55

a. Dependent Variable: StockPrice

Interpretation

Residual (or error) represents unexplained (or residual) variation after

fitting a regression model. It is the difference (or left over) between the observed value of the variable and the value suggested by the regression model Results shows the minimum predicted value is 8773.0830 and maximum predicted value is18366.2773 .The mean of predicted value is 13892.433 and standard deviation is 3255.17375 . The minimum residual value is-2423.01270 and maximum residual value is 2514.84814. Mean of residual .00000 and standard deviation is 3255.17375 .The minimum std. predict value is-1.573 and maximum value is 1.374 mean is .000 ,std. deviation is 1.000 .Minimum value of std. residual is -2.212 ,maximum value is 2.296 ,mean is .000 .std deviation is . 981.

Figure no 1 Satterplot

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Interpretation The scatter plot identify relationships between the stock price and regression standardized predicted value. Regression standardized predicted values are exchange rate and gold price. Results shows that points follow a linear pattern. It is clear from the scatter plot that there is a high linear correlation between stock price and regression standardized predicted value.

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CHAPTER-5

FINDINGS &CONCLUSION

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Findings
Macroeconomic variables play a central role to influence the stock market The major findings are there is a significant relation between exchange rate and stock price Study fond that the 88.9 % correlation exist between exchange rate and stock price. It reveals that the exchange rate play a key role to affect the stock price There is a significant difference between gold price and stock price Results found that 90.2% correlation between gold price and stock price Multi regression model doesnt accept the inflation rate and foreign exchange reserve have relation with stock market. Above table shows the inflation rate and foreign exchange reserve are excluded from the computation of the correlation matrix on which all analyses are based. No causal linkage between inflation rate and stock price Foreign exchange reserve doesnt influence the stock price The relation between inflation rate and exchange rate is highly positive to the extent of .094 but it is less than 1 There is very low positive relation between foreign exchange reserve and inflation rate to the extent of .015. Study revealed that moderate positive relation between inflation rate with gold price to the extent of .05.

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No relation between exchange rate and foreign exchange reserve. There is .0 relation between exchange rate and foreign exchange reserve

There is not any relationship between exchange rate and gold price. There is .000 relation between foeiegn exchange reserve and gold price

Inflation rate mean is 8.4338 and std.deviation is 2.99887 so there is moderate variability in inflation rate

Foreign exchange reserve mean is 285817.25 mn. and Standard deviation is 248888.775 mn. . It shows that there is moderate variability in foreign exchange reserve

Gold price mean and std. Deviation is 870.3231 and 65.84736.There is high moderate variability in gold price

In ANOVA table it is found that significant relation between exchange rate and stock price. Because F calculated value is greater than the table value.

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Conclusion
The main objective of the study is to determine the lead and lag interrelationships between the stock price and macroeconomic variables A number of studies have found that a relationship exists between macroeconomic variables and equity market returns. The relationship between stock returns and macroeconomic factors is well documented for developed (Chen, Roll and Ross (1986), Chen (1991), Clare and Thomas (1994), Mukherjee and Naka (1995), Gjerde and Saettem (1999), Flannery and Protopapadakis (2002)) and East-Asian (Bailey and Chung (1996), Mookerjee and Yu (1997), Kwon and Shin (1999), Ibrahim and Aziz (2003)) countries. There are also cross-country studies (Cheung and Ng (1998), Wongbangpo and Sharma (2002)). These studies have provided different results. The results of the previous studies have changed according to the macroeconomic factors used . This study extends the literature by considering the effects of macroeconomic variables on the stock price. In this study, a multiple regression model is employed to test for the effects of macroeconomic factors on stock price for the period Jan 2008 to Jan 2009. foreign Macroeconomic variables used in this study are, change in exchange rate,

exchange reserve , inflation rate and gold price. In the regression models, stock price are used as dependent variables, while the macroeconomic variables are used as independent variables. Empirical result reveals that exchange rate, and gild price to affect all of the BSE. Stock price. There is 88.9% correlation of exchange rate with stock price and gold price has 90.2% correlation with stock price. Independent variables except inflation rate and foreign exchange reserve have a significant relation with stock price. Null hypothesis is rejected. Exchange rate and gold price seem to affect all of the stock price while inflation rate is significant for only three of the twelve portfolios

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On the other hand, inflation rate and gold price do not appear to have any significant affect on stock returns. Null hypothesis is accepted. It means that inflation rate and foreign exchange reserve dont influence the stock price.

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