c


  c


|
A PROJECT REPORT ON
³STOCK MARKET INDEX FORECASTING MODEL ON THE
BASIS OF MACROECONOMIC VARIABLES USING
MULTIVARIATE STATISTICAL AND ECONOMETRIC TOOLS´
|
|
Submitted in partial fulfillment of the requirement for the award of degree in

Master of Business Administration

By,

HARISH HOSMANI
REGISTER NUMBER: 0921212
Under the guidance of:
PROF T.S.RAMACHANDRAN
Senior professor-MBA-Finance
CUIM-Bengaluru

HOSUR ROAD, BENGALURU

|

ñ
 
     
 

|
 c

  c

|
¦ Introduction:

¦ ¦: Genesis of the problem:

Due to liberalization privatization and globalization Indian capital markets has witnessed far
reaching changes in ¦

s and 2¦s The corporate sectors were also churning out good results
Stock market is highly volatile and is high risk and high return investment The profitability of
investing and trading in the stock market to a large extent depends on the predictability If any
system be developed which can consistently predict the trends of the dynamic stock market, would
make the owner of the system wealthy More over the predicted trends of the market will help the
regulators of the market in making corrective measures

Another motivation for research in this field is that it possesses many theoretical and experimental
challenges The most important of these is the Efficient Market Hypothesis (EMH); ³Efficient
Capital Markets´ The hypothesis says that in an efficient market, stock market prices fully reflect
available information about the market and its constituents and thus any opportunity of earning
excess profit ceases to exist So it is ascertain that no system is expected to outperform the market
predictably and consistently Hence, modeling any market under the assumption of EMH is only
possible on the speculative, stochastic component not on the changes on the changes in value or
other fundamental factors
Moreover, many researchers claim that the stock market is a chaos system Chaos is a non linear
deterministic system which only appears random because of its irregular fluctuations These systems
are highly sensitive to the initial conditions of the systems The Indian capital market performance is
function of various macro economic variables The behavior of capital market is related to macro
economic variables

ñ
 
     
 

|
 c

  c

|
1.2 Major concepts involved:

The asset returns and macroeconomic events are connected as the marginal value of wealth that
derives the asset market is also important for macroeconomic analysis In dynamic macroeconomics
theory the most important relationships are the equality of saving and investment, the equality of
marginal rate of substitution with marginal rate of transformation and the factors that determine the
allocation of consumption and investment across time and states of nature The asset markets
provide mechanism that performs all these equilibrating processes Asset returns underlie the price
line that draws together marginal rates of substitution and marginal rates of transformation The asset
market gives the marginal value of wealth, and measurement of important variables depends on
modern and dynamic macroeconomics

Many researchers find the evidence of time varying behavior of risks and risk premiums associated
with the economic variables The conditional model provides the specification of information
environment that investors use to form their expectations Therefore, the model is extended to
include conditional information set consist of business-cycle variables, which generate time-varying
risks and premiums associated with these risks

The research on linking macroeconomic variables to asset returns are extensively done for developed
markets It is relatively new area for developing markets Although it is commonly believed that
macroeconomic factors affect stock returns, the nature and direction of influence on stock prices is
not so clear in case of Indian market The linkage of asset prices and macro-economy is investigated
for Indian market in statistic and dynamic settings

Multiple regression concepts were primitively used in major areas of finance to design the normal
forecasting model of any system which is dependent on various variables In later days had
evolved to arbitrage pricing theory to predict the market behavior on various risks co-efficient
Other various concepts are also used to study the market behavior

ñ
 
     
  

|
 c

  c

|
1.3 Need for the study:

The macroeconomic variables influence the asset returns in developed markets There is a surge of
interest to uncover the relationship of macroeconomic variables with stock prices among financial
economist in India Since, economists have started taking interest in this issue only recently, many
areas on research are still not covered In this perspective the present study aims to make a
contribution to the literature by investigating the firm level multifactor price behavior with reference
to NATIONAL STOCK EXCHANGE

As in NSE the derivatives trading is done on the high volumes In the derivative trading section the
index options has got LION¶s share The model designed for studying the stock market behavior
can help the various investors to take decisions on taking call on the various strike prices to have
better returns on the index options The movement of stock market which is predicted on the basis of
the model design can be helpful for both regulators and investors to take the decision
1.4. overview of the study:
The study is mainly involved to provide the blue print how the movement of stock market can be
observed for the given macro economic variables which are considered as important to decide the
movement of the stock market As the finance is considered as ³HARD NUT TO CRACK´, the
study can contribute to nullify the difficulty of understanding the concepts of finance The
understanding of macroeconomic variables can provide the insight about the movement of economic
status in India The macroeconomic variables have some significant effects on asset pricing Overall,
the results suggest that time variation in economic risks and their rewards provide some explanation
of variation in expected returns across assets
The plan of this study is as follows Section ¦ briefly reviews the previous empirical findings The
macroeconomic risk factors which are expected to be priced in the stock market and their data
sources are discussed in section 3 In section 4, the empirical methodology is outlined The analytical
framework of unconditional multifactor model is presented using observed economic variables Then
the multifactor model is extended by including conditional moments and, finally, the behavior of
time varying risks and risk premiums associated with economic variables are incorporated into the
model Section 5 discusses the results and last section concludes the study

ñ
 
     
 !

|
 c

  c

|

CHAPTER 2

Literature review

ñ
 
     
 "

|
 c

  c

|
2.1-Mode of review done:

The methodology applied to review the literature is going through various articles available in
websites like JSTOR, EBSCHO, NSE, SSRN, IIM AHMEDABAD, MADRAS SCHOOL OF
ECONOMICS, ICFAI JOURNAL OF APLLIED ECONOMICS«etc Both offline and online
research is done to find the preliminary study on the research done on the modeling of the stock
market index

2.2 studies conducted abroad:

| Attiya Y. Javid and Eatzaz Ahmad.(2009)Testing multifactor capital asset pricing

model in case of Pakistani market by This article provides how the macro economic
variables influence the capital market of Pakistan.

The analysis of this study explores a set of macroeconomic variables along with market return as the
systematic sources of risks explaining variations in expected stock returns for 4
stocks traded at
Karachi Stock Exchange for the period ¦

3-24 Some of these economic variables are found to
be significant in explaining expected stock returns The test of conditional multifactor CAPM is
carried out by specifying conditional variance as a GARCH (¦,¦)-M process The results of the
conditional multifactor CAPM-with- GARCH-M model reveal that conditional model shows very
marginal improvement in explaining risk-return relationship in Pakistani Market during the sample
period As regards the risk premium for variance risk, the results are not so supportive, only for a
few stocks significant compensation for variance risk to investors is observed The model is then
extended to allow variability in economic risk variables and conditioning information is taken as
lagged macroeconomic variables that influence business conditions in Pakistan The results show
evidence in support of conditional multifactor CAPM The economic variables that are observed to
perform relatively well in explaining variations in assets¶ returns include consumption growth,
inflation risk, call money rate, term structure However, the market return, foreign exchange risk and
oil price risk, which explain a significant portion of the time series variability of stock returns, have

ñ
 
     
 #

|
 c

  c

|
limited influence on the asset pricing Therefore we can conclude that expected returns variation
could be explained by macroeconomic variations and this variability has some business cycle
correlations
The result of the model reveal that conditional CAPM performs relatively well in explaining risk-
return relationship in Pakistan during ¦

3-24 As regards the risk premium for variance risk, the
results are not so convincing, only for a few stocks significant compensation for this risk by
investors is observed The model is then extended to allow variability in economic risk variables and
their rewards The empirical results show evidence in support of conditional multifactor CAPM The
conditioning information is taken as lagged macroeconomic variables that influence business
conditions in Pakistan

The economic variables that are observed to perform relatively well in explaining variations in
assets¶ returns include consumption growth, inflation risk, call money rate and term structure
However, the market return, exchange risk and oil prices risk, which explain a significant portion of
the time series variability of stock returns, have limited influence on the asset pricing

| Ahmad Eatzaz and Badar-u-Zaman (1999) Volatility and Stock Return at Karachi Stock
Exchange. x
  
   37:1, 25±37.

Which provides study empirically investigates the Fama-French three-factor model and
consumption CAPM model in unconditional and conditional setting with individual stocks
traded at Karachi Stock Exchange (KSE), the main equity market in Pakistan for the period
¦

3-24 This study empirically investigates the Fama-French three-factor model an
consumption CAPM model in unconditional and conditional setting with individual stocks
traded at Karachi Stock Exchange (KSE), the main equity market in Pakistan for the period
¦

3-24 These extensions are in response of the empirical findings that do not support
standard CAPM as a model to explain assets pricing in Pakistani equity market The observation
is that the dynamic size and book-to-market value coefficients explain the cross-section of
expected returns in some sub-periods In the second stage, the consumption risk is incorporated
in standard CAPM in static and dynamic context The findings reveal that the market rewards

ñ
 
     
 $

|
 c

  c

|
systematic risk for higher return, but the relevant measure for systematic risk appears to be
conditional consumption beta rather than market beta This evidence leads to investigate
macroeconomic risks that can describe the variation in expected return in a more complete and
meaningful way
The standard CAPM is extended with Fama-French (¦

2) variables, size and book-to-
market value, in unconditional and conditional setting The observation is that the dynamic size
and style coefficient explain the cross-section of expected returns in some sub-periods The
consumption risk is incorporated in standard CAPM in static and dynamic way The findings
reveal that the market rewards systematic risk for higher returns, but the relevant measure for
systematic risk appears to be conditional consumption beta rather than market beta This
evidence leads to investigate macroeconomic risks that can describe the variation in expected
return in a more complete and meaningful way

| Antoniou, A., I. Garrett and Priestley, R. (1998) Macroeconomic Variables as Common

Pervasive risk factors and the Empirical Content of Arbitrage Pricing Theory Ô

 
  5, 22¦24 This paper models UK fixed income security returns of
various bond types and maturities with Ross's (¦
) Arbitrage Pricing Theory

In this paper authors investigated the performance of the APT for securities traded on the
London Stock Exchange We analyze performance in terms of the presence of common
pervasive factors across two different samples allowing for the fact that returns exhibit an
approximate factor structure Unlike most previous studies, we find that for two subsamples
of assets it is possible to arrive at a unique return generating process in the sense that three
factors relating to the money supply, inflation and excess returns on the stock market are
priced and carry the same prices of risk in both samples

ñ
 
     
 %

|
 c

  c

|

The Arbitrage Pricing Theory (APT) of Ross [¦
 is one of the most important building
blocks of modern asset pricing theory, and the prime alternative to the celebrated Capital
Asset Pricing Model (CAPM) of Sharpe [¦
4, Lintner [¦
5, and others This paper
briefly reviews the theoretical underpinnings underlying the APT and highlights the
econometric techniques used to test the APT with pre-specified macroeconomic factors
Besides this, the prime objective of this study is to perform an empirical test of the APT
in the Pakistani stock market by using pre-specified macroeconomic factors and
employing Iterative Non-Linear Seemingly Unrelated Regressions (ITNLSUR) These
empirical results will be, hopefully, helpful for corporate managers undertaking cost of
capital calculations, for domestic and international fund managers making investment
decisions and, amongst others, for individual investors who wish to assess the
performance of managed funds

In this paper, we have examined the risk-return relationship of the Pakistani stock market
The purpose of the study was to examine whether the APT has any empirical validity for the
Pakistani stock market Our results suggest that domestic macroeconomic factors -
unexpected inflation, exchange rate, trade balance, and oil prices - are a source of systematic
risk in the Pakistani stock market, and the APT pricing restrictions hold These results can
help corporate managers undertaking cost of capital calculations, domestic and international
fund managers making investment decisions and, amongst others, individual investors who
wish to assess the performance of managed funds These results, however, do not suggest
that the macroeconomic variables that are found to have significant risk premia in this paper
are the only factors that carry systematic risk, but these results could be used as a benchmark
to help the key market players in the Pakistani stock market upgrade their knowledge about
the phenomenon of risk and return

ñ
 
     
 &

|
 c

  c

|

| Chen, Nai-Fu, Roll, Richard and Stephen A. Ross. ³Economic Forces and the Stock
Market ´
The Journal of Business 5
, 3 (¦
): pp 33-43 Chen, Roll and Ross (¦
) were among
the earliest researchers to identify and test economics factors that should affect stock returns
either through future cash flows or through the discount rate By analyzing factors such as
inflation, the term structure of interest rates, industrial production etc and discovered them to
be important in explaining stock returns Simply stated, Chen et al strove to discover, the
relation of stock price and macroeconomic variables
This paper tests whether innovations in macroeconomic variables are risks that are rewarded
in the stock market Financial theory suggests that the following macro- economic variables
should systematically affect stock market returns: the spread between long and short interest
rates, expected and unexpected inflation, industrial production, and the spread between high-
and low- grade bonds We find that these sources of risk are significantly
priced Furthermore, neither the market portfolio nor aggregate consumption are priced
separately We also find that oil price risk is not separately re- warded in the stock -market

2.3 STUDIES CONDUCTED IN INDIA:

Manna Majumder, MD Anwar Hussian: FORECASTING OF INDIAN STOCK MARKET

INDEX USING ARTIFICIAL NEURAL NETWORK: (2009).
This paper presents a computational approach for predicting the S&P CNX Nifty 5 Index A neural
network based model has been used in predicting the direction of the movement of the closing value
of the index The model presented in the paper also confirms that it can be used to predict price
index value of the stock market
The uniqueness of the research comes from the fact that this will help to develop neural network as
another forecasting tool for highly volatile Indian market In this paper, we attempted to find an
optimal architecture of the neural network to predict the direction of the CNX S&P Nifty 5 Index
with a high level of accuracy This paper has considered most of the issues and critical factors for
designing the neural network model and has tested the performance of each of the structures at

ñ
 
     
 '

|
 c

  c

|
various historic periods of the trading sessions of the Indices A rigorous trial and error method is
employed in selecting each of the features of the network structure
In a highly volatile market like Indian Stock Market, the performance levels of the neural network
models, reported in the paper will be very useful Especially, the prediction of the direction of the
market with fairly high accuracy will guide the investors and the regulators However, for prediction
at different time in future, the network may be trained periodically and need be there the network
may be revalidated with changes in the some of the features of the model This is recommended as
with time the characteristic of the market changes and the network may miss out on the additional
information We believe that neural network tool gives a promising direction to the study of
prediction of the markets and other economic time series

Desai, V. S., & Bharati, R., (1998). A comparison of linear regression and neural network
methods for predicting excess returns on large stocks. Annals of Operations Research, 78, 127±
163
Recent studies have shown that there is predictable variation in returns of financial assets over time
We investigate whether the predictive power of the economic and financial variables employed in
the above studies can be enhanced if the statistical method of linear regression is replaced by feed
forward neural networks with back propagation of error

A shortcoming of backpropagation networks is that too many free parameters allow the neural
network to fit the training data arbitrarily closely resulting in an "overfitted" network Overfitted
networks have poor generalization capabilities We explore two methods that attempt to overcome
this shortcoming by reducing the complexity of the network The results of our experiments confirm
that an "overfitted" network, while making better predictions for within-sample data, makes poor
predictions for out-of-sample data The methods for reducing the complexity of the network,
explored in this paper, clearly help improve out-of-sample forecasts We show that one cannot say
that the linear regression forecasts are conditionally efficient with respect to the neural networks
forecasts with any degree of confidence However, one can say that the neural networks forecasts are
conditionally efficient with respect to the linear regression forecasts with some confidence

ñ
 
     
 

|
 c

  c

|
T Manjunatha and T Mallikarjunappa: Bivariate Analysis of Capital Asset Pricing Model in
Indian Capital Market(2009):

Explain the variations in security portfolio returns, the other combinations do not explain the
variation in the security/portfolio returns Further analysis in this paper has shown that beta, with
some of the combinations of the independent variables, explains the variation in security/portfolio
returns
Capital Asset Pricing Model (CAPM) establishes the relationship between risks and returns in the
efficient capital markets A review of studies conducted for various markets
in the world reveals that researchers have used a number of methodologies to test the
validity of CAPM While some studies have supported the validity of CAPM, some others have
revealed that beta alone is not a suitable determinant of asset pricing and that a
number of other factors could explain the cross-section of returns This paper has attempted to test
the validity of the combination effect of the two parameter CAPM to
determine the security/portfolio returns The results show that:

‡ Intercept is not significantly different from zero

‡ In case of portfolios, the combination of ȕp and Rm-Rf explains the variation of portfolio returns
when portfolios formed with market value weights under both percentage and log returns and ȕp and
ln(BE/ME)p explain the portfolio percentage returns when market value weights are used It is
observed that while combinations of some of the independent variables, as opposed to the univariate
variable considered in Manjunatha and Mallikarjunappa¶s (2) paper, explain the variations in
security/portfolio returns, the other combinations do not explain the variation in the
security/portfolio returns Further analysis in this paper has shown that beta, with some of the
combinations of the independent variables, explains the variation in security/portfolio returns
However, beta alone, when considered individually in the two parameter regressions, does not
explain the variation in security/portfolio returns This casts doubt on the validity of the standard
form of CAPM

ñ
 
     
 

|
 c

  c

|
2.4 use fullness of review:

The review provided a perfect macro and micro picture of forecasting stock market index Review
also helped in understanding the status of research work done in both in INDIA and ABROAD The
review also showed that the kind of research work on the finance in INDIA is not too much
satisfactory compared to the quality work done in the abroad This also gives an opportunity to
explore in the research work of forecasting the stock market index

ñ
 
     
  

|
 c

  c

|

CHAPTER 3

DESIGN

AND

METHOD OF STUDY

ñ
 
     
 !

|
 c

  c

|

3.1. Variables of the study:

Dependent Variable: SENSEX

INDEPENDENT VARIABLES:
¦ | Manufacturing Output Index (IIP)
2 | FII
3 | Call Money Rate (CR)
4 | GDP
5 | Whole Sale Price Index (WPI)
 | Money Supply (M3)
 | Foreign Exchange rate (E)

SECONDARY DATA COLLECTION:

All the data is secondary data which is collected from www rbi org
DATA HORIZON: ¦

3-2¦
FREQUENCY OF DATA: Monthly
Sample Number of observations of each variable: ¦
2(¦(years) *¦2 (months))

SENSEX:
The 'BSE SENSEX' is a value-weighted index composed of 3 stocks and was started on January ¦,
¦
 The Sensex is regarded as the pulse of the domestic stock markets in India It consists of the
3 largest and most actively traded stocks, representative of various sectors, on the Bombay Stock
Exchange in INDIA These companies account for around fifty per cent of the market capitalization
of the BSE The base value of the sensex is ¦ on April ¦, ¦

, and the base year of BSE-
SENSEX is ¦


SENSEX is one of the barometer which is used to measure the stock market efficiency of INDIA

ñ
 
     
 "

|
 c

  c

|

Manufacturing output Index(IIP)

(IIP) in simplest terms is an index which details out the growth of various sectors in an economy
E g Indian IIP will focus on sectors like mining, electricity, Manufacturing & General Also base
year needs to be decided on the basis of which all the index figures would be arrived at In case of
India the base year has been fixed at ¦

3-
4 hence the same would be equivalent to ¦ Points but
now it changed its based year to 24-25
Index of Industrial Production (IIP) is an abstract number, the magnitude of which represents the
status of production in the industrial sector for a given period of time as compared to a reference
period of time
Real income and its growth rate are expected to influence stock market development positively This
is because higher volume of intermediation through stock markets promotes real income growth,
which in turn promotes development in the stock market As income increases, its cyclical
component is expected to increase the size of stock market and its price index

FII: (Foreign institutional investment (FII))

Foreign Institutional investors are organizations which pool large sums of money and invest those
sums in securities, real property and other investment assets They can also include operating
companies which decide to invest its profits to some degree in these types of assets

Types of typical investors include banks, insurance companies, retirement or pension funds, hedge
funds, investment advisors and mutual funds Their role in the economy is to act as highly
specialized investors on behalf of others For instance, an ordinary person will have a pension from
his employer The employer gives that person's pension contributions to a fund The fund will buy
shares in a company, or some other financial product Funds are useful because they will hold a
broad portfolio of investments in many companies This spreads risk, so if one company fails, it will
be only a small part of the whole fund's investment

ñ
 
     
 #

|
 c

  c

|
Institutional investors will have a lot of influence in the management of corporations because they
will be entitled to exercise the voting rights in a company They can actively engage incorporate
governance Furthermore, because institutional investors have the freedom to buy and sell shares,
they can play a large part in which companies stay solvent, and which go under Influencing the
conduct of listed companies, and providing them with capital are all part of the job of investment
management

Foreign institutional investment (FII) is expected to influence stock market development positively

Call Money Rate (CR):

| The money market is a market for short-term financial assets that are close substitutes of
money The most important feature of a money market instrument is that it is liquid and can
be turned over quickly at low cost and provides an avenue for equilibrating the short-term
surplus funds of lenders and the requirements of borrowers The call/notice money market
forms an important segment of the Indian money market Under call money market, funds are
transacted on overnight basis and under notice money market; funds are transacted for the
period between 2 days and ¦4 days
Banks borrow in this money market for the following propose
To fill the gaps or temporary mismatches in funds
‡ To meet the CRR & SLR Mandatory requirements as stipulated by the Central bank
‡ To meet sudden demand for funds arising out of large outflows
The call money usually serves the role of equilibrating the short-term liquidity position of
banks
The lower the interest rate in the fixed income segment, the higher the incentive for the investors to
flock to the stock market to get better returns and thus stock market should get a boost Thus interest
rate is expected to have a negative relationship on stock market development

ñ
 
     
 $

|
 c

  c

|

Whole Sale Price Index (WPI):

The Wholesale Price Index (WPI) is the price of a representative basket of wholesale goods Some
countries use WPI changes as a central measure of inflation The Wholesale Price Index or WPI is
the price of a representative basket of wholesale goods Some countries use the changes in this index
to measure inflation in their economies, in particular India  The Indian WPI figure is released
weekly on every thursday and influences stock and fixed price markets The Wholesale Price Index
focuses on the price of goods traded between corporations, rather than goods bought by consumers,
which is measured by the Consumer Price Index The purpose of the WPI is to monitor price
movements that reflect supply and demand in industry, manufacturing and construction This helps
in analyzing both macroeconomic and microeconomic conditions

Inflation rate can be used to proxy macroeconomic instability It is expected that higher the
volatility of the underlying economic situation, the less incentive firms and savers would have to
participate in the market At times of high macroeconomic instability, prices became signals with
large standard deviations which make it very difficult to assert whether price changes were
temporary or permanent and stock markets become more uncertain Hence inflation is expected to
have a negative relationship with stock market development

Money Supply.(M3):

In economics, the money supply or money stock is the total amount of money available in
an economy at a particular point in time There are several ways to define "money," but standard
measures usually include currency in circulation and demand deposits (depositors' easily-accessed
assets on the books of financial institutions)

Money supply data are recorded and published, usually by the government or the central bank of the
country Public and private sector analysts have long monitored changes in money supply because of
its possible effects on the price level, inflation and the business cycle

That relation between money and prices is historically associated with the quantity theory of money
There is strong empirical evidence of a direct relation between long-term price inflation and money-

ñ
 
     
 %

|
 c

  c

|
supply growth, at least for rapid increases in the amount of money in the economy This is one
reason for the reliance on monetary policy as a means of controlling inflation

EXCHANGE RATE:

In finance, the exchange rates (also known as the foreign-exchange rate, forex rate or FX rate)
between two currencies specify how much one currency is worth in terms of the other It is the value
of a foreign nation¶s currency in terms of the home nation¶s currency

A fall in the exchange rate should lead to more exports and more foreign exchange into the
economy, which will increase the money supply and inflation in the economy Hence the impact of
exchange rate on stock market development is ambiguous

3.2: objectives of study:

i| The objective of the study is to have deep insight into the determinants of stock market
index in INDIAN corporate sector
i| To find the importance of the macro economic variables in deciding the return of stock
market in INDIA

3.3: Hypothesis of the study:

H: ȕ1=ȕ2=ȕ3=«ȕn=0(no linear relationship between market index and the explanatory
variables)

H¦: at least ȕi0 ( linear relationship between market index and at least one of the variable)

ñ
 
     
 &

|
 c

  c

|
3.4: Design of study:

Multiple linear regression and GARCH model can used

In linking macroeconomic variables with expected returns, we start our analysis with the
unconditional multifactor linear regression The multifactor linear regression model implies that the
expected returns of assets are related to their sensitivity to change in the state of the economy A set
of economic variables is specified as proxies for economic risks and it is investigated whether or not
these risk factors are rewarded in the stock market For the analysis a modified version two-step
estimation procedure is used The set of macroeconomic variables is included in the test of CAPM
with the perspective to see whether these factors have pricing significance as against the market
index First, the changes in asset returns are linked to the changes in economic variables, therefore,
the step one is time series regression of the excess returns of each asset on the economic variables
and market return
The slope coefficients in these time-series regressions give estimates of assets¶
Sensitivity to economic state variables, called betas The estimated sensitivity or betas are used as
independent variables in cross-sectional regressions with average asset¶s excess returns of a
particular month being the dependent variable The step two is cross-sectional regression estimation
done year by year
Each set of coefficients of cross section for any particular month gives estimate of risk premiums
associated with the economic variables for that month Then these two steps are repeated for each
year and as a result time series of these estimated risk premiums are obtained Then time series
means of these estimates are tested for statistical significance under the null hypotheses that the
means of risk premiums are equal to zero The t-ratio for testing the hypothesis that the average
premium is zero is calculated using the standard deviation of the time series of estimated risk
premiums Since estimated betas are used in second stage regressions, the regression involves error-
in-variables problem

ñ
 
     
 '

|
 c

  c

|
Methodology applied:
i| Raw data of SENSEX, FOREX, IIP, WPI, CALL RATE, MONEYSUPPLY, FII, GDP
is collected from RBI website from ¦

4 to 2¦ with frequency of monthly
i| The same excel file uploaded to SPSS software interface to find the complete descriptive
statistics of all the variables
i| Multiple regression tools is used in the SPSS to find the co-efficient of all the variables
considered for predicted the movement the stock market index
i| Individual regression plots are drawn between the SENSEX and all other variables, so that
one can easily understand the co relation of variable with the SENSEX
i| Complete correlation matrix is drawn among the variables which are used to understand the
correlation among the variables
i| Individual beta coefficients are found that to find the generalized linear multiple regression
equation with sensex as output variable and all other variables which are considered to be as
independent variables
i| Later the same excel file is used as input to software EVIEWS to find the GARCH
Co-efficient, so that generalized multivariate GARCH model is used to find forecasting the
index
i| GARCH CO-EFFICENTS can be used understand the volatatilty of each variables
i| Corellogram is drawn for each variable which is considered for the analysis
i| In the corellogram one can find the autocorelation and partial auto correlation
i| When the auto correlation diminishes from value ¦ to  as time tends infinity it indicates that
the variable is perfectly co related with its past variables
i| In the GARCH analysis FII is not considered as one of the input variable for analysis as FII
has got negative values which means that FII involved only selling the shares in that
particular month where positive value indicates bulk buys of shares in the Indian equity
market
i| In the end of GARCH analysis one can get the generalized model of return on sensex with
the GARCH coefficients of each variable

ñ
 
     
 

|
 c

  c

|
3.5: TOOLS USED IN THE STUDY:
MULTIPLE REGRESSION:
The general purpose of multiple regression (the term was first used by Pearson, ¦
) is to learn
more about the relationship between several independent or predictor variables and a dependent or
criterion variable For example, a real estate agent might record for each listing the size of the house
(in square feet), the number of bedrooms, the average income in the respective neighborhood
according to census data, and a subjective rating of appeal of the house Once this information has
been compiled for various houses it would be interesting to see whether and how these measures
relate to the price for which a house is sold For example, you might learn that the number of
bedrooms is a better predictor of the price for which a house sells in a particular neighborhood than
how "pretty" the house is (subjective rating) You may also detect "outliers," that is, houses that
should really sell for more, given their location and characteristics

Personnel professionals customarily use multiple regression procedures to determine equitable

compensation You can determine a number of factors or dimensions such as "amount of
responsibility" (
) or "number of people to supervise" ( 

) that you believe to contribute
to the value of a job The personnel analyst then usually conducts a salary survey among comparable
companies in the market, recording the salaries and respective characteristics (i e , values on
dimensions) for different positions This information can be used in a multiple regression analysis to
build a regression equation of the form:

Salary = .5*Resp + .8*No_Super.

Once this so-called regression line has been determined, the analyst can now easily construct a graph
of the expected (predicted) salaries and the actual salaries of job incumbents in his or her company
Thus, the analyst is able to determine which position is underpaid (below the regression line) or
overpaid (above the regression line), or paid equitably

ñ
 
     
 

|
 c

  c

|
GARCH : ( Genaralised Autoregressive Conditional Heteroscedasticity)
An econometric term developed in ¦
2 by Robert F Engle, an economist and 23 winner of the
Nobel Prize for Economics to describe an approach to estimate volatility in financial markets There
are several forms of GARCH modeling The GARCH process is often preferred by financial
modeling professionals because it provides a more real-world context than other forms when trying
to predict the prices and rates of financial instruments
The general process for a GARCH model involves three steps The first is to estimate a best-fitting
autoregressive model; secondly, compute autocorrelations of the error term and lastly, test for
significance

GARCH models are used by financial professionals in several arenas including trading, investing,
hedging and dealing Two other widely-used approaches to estimating and predicting financial
volatility are the classic historical volatility (VolSD) method and the exponentially weighted moving
average volatility (VolEWMA) method
ARCH/GARCH Processes
The simplest ARCH model can be written as follows Suppose that 0is the random variable to be
modeled, is a sequence of independent standard normal variables, and ı is a hidden variable The
ARCH(¦) model is written as


This basic model was extended by Bollerslev¦ who proposed the GARCH(
,) model written as

ñ
 
     
  

|
 c

  c

|

Its generalization, the GARCH family of models, applies to processes such as financial time series
that exhibit volatility clustering The GARCH( ) model can be further generalized to multivariate
processes by modeling not only the process¶s volatility but the entire variance-covariance matrix In
this form the model is known as multi variate GARCH Because multivariate GARCH becomes
rapidly unmanageable with the number of assets, simplified forms have been proposed GARCH
models are not necessarily stationary insofar as their stationary depends on the coefficients of the
ARMA process If the ARMA process is not stationary, then the process is called IGARCH While
ARCH and GARCH models model volatility, asset pricing models require that returns depend on
volatility as higher volatility commands a higher return Engle, Lilien, and Robins24 suggested
adding an expected return term to the GARCH equations Equations then become

While ARCH and GARCH models are based on empirical findings of volatility clustering, Markov-
switching models are based on a generalization of the idea that a model¶s parameters cannot be
considered stable for long periods of time If our objective is to retain linear models as the basic
DGP, then we have to accept that parameters will change in time Markov switching models use a
Markov chain to drive the parameters of a basic linear model The Hamilton model, for example,
uses a Markov chain to drive the parameters of a random walk In a more general Markov-switching
VAR, a Markov chain drives the parameters of a VAR model

ñ
 
     
 !

|
 c

  c

|

CHAPTER 4:
ANALYSIS
OF
DATA

ñ
 
     
 "

|
 c

  c

|

Descriptive statistics.

EXCHANG
RETURN E IIP WPI MONEY CALL GDP
Mean  
325 3 4¦
5 ¦
44
5 25
42 ¦4 23¦  3544 ¦4 5

Median ¦ 5
4
3 3¦ 5 ¦45 5 5¦4 ¦4 2343¦  5 ¦4 3¦5
Maximum 25 33 3
33 5 533  3555 ¦5 5442 34 3 ¦5 55
Minimum -2 ¦3 3 445
3 4 4¦ 4 5¦ ¦3 

4  3 ¦3 3¦
Std Dev  2  ¦33¦¦  344
 ¦23  255 5 
  5¦
Skewness - 25 -
542
 ¦3¦4¦ ¦ 543  2
5 2 

¦  4545
Kurtosis 4 ¦4

4 2 34 2 52 5 5¦3 ¦ 
3234 ¦3 ¦3434 2 45
2

Jarque-Bera ¦3 2453 2
435¦ 
¦ ¦5 ¦¦

224
¦ 2
 355

Probability  ¦33    ¦42    

¦    24
2

Sum ¦53 4 2¦ 52 ¦2
¦5 ¦¦4

5 233 ¦4 ¦55 4 23 53
Sum Sq
Dev ¦
 ¦ 3 3
3¦ ¦ 3 2 ¦¦54 ¦ 25
4

¦ 544 4 2
¦

Observations ¦
2 ¦
3 ¦
3 ¦
3 ¦
2 ¦
3 ¦
3

TABLE 1: Descriptive statistics Output of EVIEWS SOFTWARE

ñ
 
     
 #

|
 c

  c

|

INTREPRETATION:

Only FII variable is missing in the output as the software does not accept negative values of FII

i| After return of sensex the variable call rate has got the maximum standard deviation which
indicates that both call rate and sensex returns are more volatile in nature as a part
fundamental statistical analysis
i| Call rate and WPI have higher kurtosis which means that more of the variance is the result of
infrequent extreme deviations, as opposed to frequent modestly sized deviations

TABLE 2: SPSS OUTPUT OF CO-EFFICIENTS OF REGRESSION

Generalized Multiple regression model;

SENSEX=10018.277-342.274*(EXCHG)+0.002*FII+34.451*IIP-
5.407*WPI+0.003*M3+0*GDP

ñ
 
     
 $

|
 c

  c

|
RESULT OF HYPOTHESIS:
NULL HYPOTHESEIS is rejected as various coefficients are having NON zero values

Residuals Statistics

Std
Minimum Maximum Mean Deviation N

Predicted Value 235 2 ¦3
 ¦ 
5 
¦ 453
5
 ¦
2
Residual -44 
3 333 4  ¦32 333 ¦
2
Std Predicted -¦ ¦3 2 3¦¦  ¦  ¦
2
Value
Std Residual -3 3 2 33 
2 ¦
2

a | Dependent Variable: SENSEX

TABLE 3: SPSS OUTPUT OF RESIDUALS STATISTICS.

INTREPRETATION: GDP value has less got lesser value coefficient where as IIP has got the
higher positive co-efficient when compared to high negative coefficient for EXCHANGE RATE,
which indicates that the variables has got both negative and positive influence on the movement of
stock market index From residual statistics one can easily find out that there more deviation among
forecasting of sensex based on the variables

ñ
 
     
 %

|
 c

  c

|

TABLE 4: SPSS OUTPUT OF CORRELATION COEFFICIENTS AMONG VARIABLES.

INTREPREATION:

i| Sensex has got the more correlation with GDP, M3, and IIP, when compared to lower
correlation with call rate
i| Exchange rate has got more correlation with GDP, IIP numbers which indicates that
exchange rates are more decided on the movement on GDP and IIP
i| M3 has negative correlation with call rate but high correlation with IIP
i| FII move with IIP and GDP which means that growth in the economy and production in
INDIA makes more investment from overseas investors
i| Call rate has got negative co-relation with all the variables which indicates that rise in the call
rates always has negative impact on the economy
i| WPI has got more correlation with M3 when compared to other variables which always says
that more the money supply more the impact on WPI

ñ
 
     
 &

|
 c

  c

|

GRAPH 1: Partial regression plot between sensex and ex-rate

INTREPRETATION:

Sensex is negatively correlated with the exchange rate, which indicates that sensex will move
opposite direction of exchange rate The exchange rate increase will make a negative impact on the
equity market index A fall in the exchange rate should lead to more exports and more foreign
exchange into the economy, which will increase the money supply and inflation in the economy
Hence the impact of exchange rate on stock market development is negative |

ñ
 
     
  '

|
 c

  c

|
|

GRAPH 2: Partial regression plot between SENSEX and FII

INTREPRETATION:

The regression plot shows that sensex movement with FII flows is quiet ambiguous , not able to
predict the movement of sensex on the basis of direction of FII The FII has very less importance
on the prediction of sensex in the future It also indicates that FII and sensex had clustered on one
particular time horizon, which also means that FII has invested in the equity market for lesser
number of years

ñ
 
     
  

|
 c

  c

|

GRAPH 3: Partial regression plot between SENSEX and IIP

INTREPRETATION:

The regression plot shows that sensex movement with IIP flows is predictable, i e able to predict the
movement of sensex on the basis of direction of IIP The IIP data has very high importance on the
prediction of sensex in the future The plot also shows that sensex is moving with IIP for more
extent The sensex has got the better correlation with the IIP data, which indicates that
manufacturing activity has got more positive impact on the equity market index

ñ
 
     
  

|
 c

  c

|

GRAPH 4: Partial regression plot between SENSEX and GDP

The regression plot shows that sensex movement with GDP flows is less predictable, i e not able to
predict the movement of sensex on the basis of direction of GDP The data has very high
importance on the prediction of sensex in the future The plot also shows that sensex is moving with
GDP for more extent The sensex has got the better correlation with the GDP data, which indicates
that income level has got more positive impact on the equity market index

ñ
 
     
  

|
 c

  c

|

GRAPH 5 : Partial regression plot between SENSEX and WPI

INTREPRETATION:

The regression plot shows that sensex movement with WPI flows is predictable, i e able to predict
the movement of sensex on the basis of direction of WPI The WPI data has very high importance on
the prediction of sensex in the future The plot also shows that sensex is moving opposite with WPI
for more extent The sensex has got the better correlation with the WPI data, which indicates that
inflationary activity has got more negative impact on the equity market index

ñ
 
     
  !

|
 c

  c

|

GRAPH 6: Partial regression plot between sensex andM3

The regression plot shows that sensex movement with M3 flows is un predictable, i e not able to
predict the movement of sensex on the basis of direction of M3 The M3 data has very high
importance on the prediction of sensex in the future The plot also shows that sensex is moving with
M3 for more extent The sensex has got the lesser correlation with the M3 data, which indicates that
manufacturing activity has got more diversified impact on the equity market index

ñ
 
     
  "

|
 c

  c

|

GRAPH 7: Partial regression plot between SENSEX and CALL RATE

INTREPRETATION:

The regression plot shows that sensex movement with CALL RATE flows is un predictable, i e not
able to predict the movement of sensex on the basis of direction of CALL RATE The CALL RATE
data has very high importance on the prediction of sensex in the future The plot also shows that
sensex is moving with CALL RATE for more extent The sensex has got the better correlation with
the CALL RATE data, which indicates that manufacturing activity has got more positive impact on
the equity market index

ñ
 
     
  #

|
 c

  c

|

CALL RATE:


|

|||






                 
3


3



|
|


|||








                  

3


3


3


3


GRAPH :CORRELOGRAM for CALL RATE:

INTREPRETATION:
The auto correlation and partial auto correlation graph shows call rate is completely alternating
series which does have both positive and negative correlation with various lags This means that the
predictability of call rate in the future values based on the past values is more difficult

ñ
 
     
  $

|
 c

  c

|

EXCHANGE RATE:


|

|| 
|










3
                  
3

3

3

3



|
|


|| 
|







3
                  

3


GRAPH
:CORRELOGRAM for EXCHANGE RATE

The auto correlation and partial auto correlation graph shows call rate is completely alternating
series which does have both positive correlation with some set of lags and negative correlation with
some set of This means that the predictability of exchange rate in the future values based on the
past values is lesser difficult as it has got fixed correlation with for some set of lags

ñ
 
     
  %

|
 c

  c

|
GDP:


|
|


||











 



3
                  
3

3



|

||















                 

GRAPH ¦:CORRELOGRAM for GDP

The auto correlation and partial auto correlation graph shows GDP is not alternating series which
have only positive correlation with almost all lags This means that the predictability of GDP in the
future values based on the past values is quiet easy The graphs show that GDP data is stationary
series
It is more stationery series without cyclicity

ñ
 
     
  &

|
 c

  c

|

IIP: ( INDEX OF INDUSTRIAL PRODUCTION)


|

||










3
                  
3

3



|
|


||





                 
3


3

GRAPH ¦¦ :CORRELOGRAM for IIP

The auto correlation and partial auto correlation graph shows IIP is completely alternating series
which does have both positive and negative correlation with various lags This means that the
predictability of call rate in the future values based on the past values is more difficult
The extent of cyclicity in the IIP is less

ñ
 
     
 !'

|
 c

  c

|
MONEY SUPPLY:


|

||
| 












3
                  
3

3

3



|
|


||
|
 









3
                  
3

3

3


GRAPH ¦2:CORRELOGRAM for MONEY SUPPLY

The auto correlation and partial auto correlation graph shows call rate is completely alternating
series which does have both positive and negative correlation with various lags The M3 data has got
the alternating variation which means that money supply is completely depend on the economic
cycle It has got the cyclic variation on the whole time horizon which is considered

There is cyclicity in the money supply over the period

ñ
 
     
 !

|
 c

  c

|

WPI ( WHOLE SALE PRICE INDEX)


|

||





                                  


|

||

















3
                                   
3


GRAPH ¦3:CORRELOGRAM for WPI

The auto correlation and partial auto correlation graph shows WPI is not alternating series which
have only positive correlation with almost all lags This means that the predictability of WPI in the
future values based on the past values is quiet easy The graphs show that WPI data is stationary
series No cyclicity in the WPI data

ñ
 
     
 !

|
 c

  c

|

SENSEX:


|

|||

||






3
                  

3
 

3

3


3


3



|
|


||

||

|



                 
3


3


3


GRAPH ¦4:CORRELOGRAM for RETURN ON SENSEX

The auto correlation and partial auto correlation graph shows RETURN ON SENSEX is not
alternating series which have only positive correlation and negative correlation with various lags
This means that the predictability of RETURN ON SENSEX in the future values based on the past
values is not easy The graphs show that RETURN data is NOT stationary series
That means sensex is not correlated with its past data so always there are some drivers to move the
sensex in particular

ñ
 
     
 ! 

|
 c

  c

|
GARCH: (TABLE 5)
Dependent Variable: RETURN
Method: ML - ARCH (Marquardt) - Normal distribution
Date: ¦/3¦/¦¦ Time: :

Sample (adjusted): 2 ¦
2
Included observations: ¦
¦ after adjustments
Convergence achieved after 45 iterations
Variance backcast: ON
GARCH = C(3) + C(4)*RESID(-¦)^2 + C(5)*GARCH(-¦) + C()*CALL +
C()*EXCHANGE + C()*GDP + C(
)*IIP + C(¦)*MONEY +
C(¦¦)*WPI

Coefficient Std Error z-Statistic Prob

C ¦ 243  
¦¦5 ¦3 42¦5  

RETURN(-¦)  ¦3

 
 2 35  3¦

Variance Equation

C ¦  524 52
3  335
¦  35

RESID(-¦)^2  
 2¦22 3 
  2
GARCH(-¦) -¦ 243  523¦ -¦
 232  
CALL - 424  32 -¦5 5
4  
EXCHANGE 242 

¦ 4 2 35  3
GDP -53 33¦3 ¦3 434¦ - 3524
 ¦
IIP 4 3223 24 
3 2 2¦4¦  5
MONEY - 5¦
¦2 444 - 32
3  524
WPI ¦ 4
 4 2335 2 24¦¦  23

R-squared  ¦24
3 Mean dependent var  ¦
2

Adjusted R-squared - 423
S D dependent var  232
S E of regression  44¦2 Akaike info criterion  5
Sum squared resid

3
22 Schwarz criterion 
53¦2
Log likelihood -35 ¦4¦4 F-statistic  22¦5
Durbin-Watson stat 2 
Prob(F-statistic) 

3332

ñ
 
     
 !!

|
 c

  c

|

RETURN = 177.0766 + 0.077809*RESID (-1) ^2 + 1.026436*

GARCH (-1) -0.468240*CALL+242.0789*EXCHANGE --
53 33¦3*GDP + 64.38223*IIP -76.76519*MONEY +
107.4097*WPI.
A MULTI VARIATE GARCH MODEL FOR ONE MONTH RETURN OF SENSEX

INTREPRETATION:

i| Exchange rate, IIP, WPI has got positive coefficients which indicate that these variables are
boosting variables to move forward the equity market index
i| Call rate, Money supply, GDP has got negative coefficients which indicate these variables
are demotivating factors for the forward movement of sensex
i| R-SQUARED value is  ¦24 which indicates that the prediction factor has got less
significance
i| Durbin-Watson stat value is 2  which indicate that there is no autocorrelation in the
return of sensex
i| Akaike info criterion has to be between ¦ and 2 which indicates that goodness of fitting of
data with statistics, but its value  5 which indicates that it is difficult to make inferences
on the results got statistically
i| S E of regression is low which indicates low error in estimation

ñ
 
     
 !"

|
 c

  c

|

CHAPTER -5

SUMMARY

AND

CONCLUSIONS |

ñ
 
     
 !#

|
 c

  c

|

5.1 Major findings

i| There is always more volatility in the return of sensex

i| Exchange rate, IIP, WPI are more motivating factors for the forward movement of stock
market index
i| WPI is motivating for the movement of sensex in forward direction though it sounds
paradoxical but it is irony to understand insight into it
i| The GDP factor unfortunately considered as negative factor for the equity market index, but
it is quiet questionable and the arguable
i| The variables selected are having mixed response for the movement of the equity market
index

†
|
  
 |

i| The generalized linear model of multiple regression has shown that GDP has zero
contribution for the movement of sensex
i| As per GARCH based model application one came to know that GDP has negative
contribution for the movement of the sensex
i| It indicates that GARCH based model application has got more efficiency in terms of
estimation of the return of index
i| The movement of equity market index has got the more drivers for its movement in both
forward and backward direction

ñ
 
     
 !$

|
 c

  c

|
† |  

|  

 |

i| Got to know that there are many generalized linear time series models like GARCH, ARIMA etc
i| Volatility can only analyzed by using econometrical models like ARCH, ARIMA
i| Econometrical models are necessary to understand the time series models

5.4 LIMITATIONS OF THE STUDY:

i| |The research on the study of implications of macroeconomic variables on stock market index has got
less significance in INDIA when compared to study done on abroad
i| The multiple regressions has got limitation on forecasting the complex variable like SENSEX return
i| Lot of data transformation needed to give as inputs for the GARCH model
i| Perfection in the forecasting the index is questionable on the basis of multiple regression model
i| Non availability of free software like ³EVIEWS´ on internet
i| Lot of calculations needed to arrive at the output of GARCH MODEL
i| GARCH MODEL output has got the both residuals and LAG Factors which makes quiet difficult to
compare the predicted value and actual value
i| FII variable is not considered in GARCH as it does not accept the negative values

5.5. Suggestions for further study.

i| The further more variables can be taken to understand the movement of sensex
like Corporate earnings of companies which are components of sensex, market
capitalization ratio which means amount of new capitalization raised through stock
offerings as percentage of GDP
i| The same study can be studied to forecast the sensex on ARIMA (AUTO REGRESSIVE
INTEGRATED MOVING AVERAGE) basis
i| The same kind of study can be further studied by using software like ³MATLAB´,
³FINANCIAL TOOL BOX´ by (MATHWORKS), and ³R´.

ñ
 
     
 !%

|
 c

  c

|
¦
 |

WEBSITES:

i| WWW NSE-INDIA COM

i| WWW JSTOR ORG

i| WWW EBSCHO ORG

i| WWW EBSCOHOST COM

i| WWW MSE AC IN ( Madras school of economics)

i| WWW IIMAHD ERNET IN

i| WWW EUROJOURNALS COM

i| WWW EMERALDINSIGHT COM/JOURNALS HTML

i| WWW MENTORMYPROJECT COM

i| WWW MUIC MAHIDOL AC TH

ñ
 
     
 !&

|
 c

  c

|

REFERENCES:

Serial Author Title Edition Pages

no

¦) Attiya Y. Javid and Testing multifactor capital asset 4th ¦-25

Eatzaz Ahmad pricing model in case of Pakistani
market

2) Ahmad Eatzaz and Volatility and Stock Return at 2ND 25-3

Badar-u-Zaman (1999) Karachi Stock Exchange.

3) Antoniou, A., I. Macroeconomic Variables as - 22¦-

Garrett and Priestley, Common Pervasive risk factors 24
R. and the Empirical Content of
Arbitrage Pricing Theory

4) Chen, Nai-Fu, Roll, Economic Forces and the Stock 5
3 33-

Richard and Stephen Market ´ 43
A. Ross

5) Desai, V. S., & A comparison of linear regression - 5-2

Bharati, R., and neural network methods for
predicting excess returns on large
stocks.

) T Manjunatha and T Bivariate Analysis of Capital Asset - ¦-2

Mallikarjunappa Pricing Model in Indian Capital
Market

ñ
 
     
 "'

|
 c

  c

|

 |

! |" |" #|

ñ
 
     
 "

|
 c

  c

|

ñ
 
     
 "

|
 c

  c

|

ñ
 
     
 " 

|
 c

  c

|
|

ñ
 
     
 "!

|