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An Empirical Study of Macroeconomic Factors and Stock Market: An Indian Perspective

Saurabh Yadav EDHEC Business School Masters in Risk and Investment Management saurabh.yadav@edhec.com June 26, 2012

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Abstract This thesis is an empirical study of relationship between Indian stock markets and macro economy. There is a huge literature about such kind of empirical studies but mostly on US/UK stock markets and macroeconomic indicators. This study is similar to many of the earlier studies in some aspects, so it uses econometric tools used in earlier studies but at the same time this study dierentiates itself from other studies in the sense it uses Indian markets and macroeconomic data for analysing the relationship and it also tries to analyse the impact of global economy on the Indian markets. The period that will be used for the study will be from 1990 to 2011. We have chosen this period as it represents big regulatory and structural changes in Indian economy. So, an analysis of this period can provide us with insights to how some regulatory and structural changes impact the economy and asset prices in that country. In this study we will use Unit root tests, cointegration, Ljung-Box Q test and multivariate VAR analysis for analysing each macro economic and asset prices time series individually and to build a model that can analyse the impact of one over the other. Also, we will conduct Grangers Causality test and Impulse response analysis between Stock market and macro economic indicators to analyze the impact of macro economic news/shocks on India Stock index (BSE).

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Acknowledgment
I am thankful to Professor Robert Kimmel for his comments and guidance on the subject. He has been a constant source of inspiration and a good mentor, from whom I learned a lot. I am also grateful to Stoyan Stoyanov, Marc Rakotomalala, Aishwarya Iyer, Wen lei, Lixia Loh for some great insights into the subject. Their timely comments and suggestions on empirical tests helped me improve the statistical signicance of my tests. I thank EDHEC Risk Institute for allowing me to use their resources to get the data from various data providers. In the end ill like to thank my parents and my sister for constant support and motivation without which it would have been impossible to climb this arduous path. Regards, Saurabh YADAV

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CONTENTS

Contents
1 Introduction 2 Literature Review 7 9

3 Data 13 3.1 Description of Macroeconomic Indicators . . . . . . . . . . . . . 13 3.2 Description of Stock Market Indices . . . . . . . . . . . . . . . . 14 4 Methodology 15 4.1 Construction of Time Series . . . . . . . . . . . . . . . . . . . . 15 4.2 Unit Root Test and Stationarity . . . . . . . . . . . . . . . . . . . 15 4.2.1 Mathematical representation of Stationary series and unit root test . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 4.2.2 Augmented Dickey Fuller Unit Root Test . . . . . . . . . 17 4.3 Testing Long Term Relationships . . . . . . . . . . . . . . . . . . 18 4.3.1 Johansen test for Cointegration . . . . . . . . . . . . . . . 18 4.4 Impulse Response . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 5 Results 6 Conclusions 7 Graphs and Tables 7.1 Graphs of Time series . . . . . . . . . . . . . . . . . . . . 7.2 Graphs of Time Series - Dierenced . . . . . . . . . . . . 7.3 Correlograms of Time series . . . . . . . . . . . . . . . . . 7.4 Tables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.4.1 Table for Unit root test of Time series . . . . . . . 7.4.2 Tables for Unit root test of Dierenced time series 7.4.3 Tables for Residual based test of cointegration . . . 7.4.4 Johansen cointegration test . . . . . . . . . . . . . 7.4.5 Impulse response tests . . . . . . . . . . . . . . . . 7.4.6 Granger causality test between IP and BSE . . . . 8 Bibliography 21 24 25 25 29 33 40 40 40 40 43 46 49 50

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INTRODUCTION

Introduction

In the past few decades there has been a growing interest among academicians and practitioners about the relationship between macroeconomic variables and asset prices, mainly stocks and house prices. In a good and expanding economy, prices of stocks are supposed to increase as there is an increase in expectation of large future cash ows/ prots for the companies and various role players in the economy. Similarly, during a bad or downward spiralling economy the expectation of large future cash ows and prots decrease and consequently the price of stocks decrease. Stock markets are representative of economy of a country and investors belief. They are able to capture macro economic movements in the economy as well as idiosyncratic factors related to each company or industry. As Stock prices are real time and are more frequent than macroeconomic releases they are better reector of changes in domestic and global economy and can predict the movement of macroeconomic indicators. In other words stock markets are a leading indicator of the economy. Markets respond to dierent macroeconomic indicators in dierent ways. The response of Stock markets to any macroeconomic news is dependent on how the news will eect the prots and interest rates. The price of the stock according to the Discounted Cash Flow formula is: Div2 Divt Div1 + + ... + (1 + r1 )1 (1 + r2 )2 (1 + rt )t

Pt =

(1)

As both dividends and interest rates enter into the formula for value of a stock the reaction of stock price to a macro news will depend on how the news eect the discounting factor ( Interest rates ) and future prots of the companies. Macro economic factors that project brighter times and more prots for the companies like, increasing Industrial production, Increasing M1 money supply, good consumer condence levels will have a positive eect on the stock prices. Whereas, macro news that point to economic recession or slow growth like, decreasing Industrial production coupled with Rising interest rates, Rise in ination, rise in unemployment, etc. will have a downward eect on stock prices. First people to do an empirical study on this subject were Eugene Fama and Kenneth French. In their 1981 paper Stock returns, Real activity, Ination and money they analysed the relationship between stock returns, real activity ination and money supply using macro economic data. After that study there has been a barrage of studies on relationship between stock returns and macro economic factors based on US and UK data. Another important paper published on this research was by Chen,Roll and Ross (1986) who analysed whether innovations in the macroeconomic variables are risks that are awarded in the stock markets. They found that macroeconomic variables like, spread between long and short interest rates, expected and unexpected ination, Industrial production are some of the factors that are awarded by the markets. Further, the Arbitrage pricing theory (APT) of Ross (1976) posits relation between stock prices and certain macro-economic variables. In the last decade or so the focus for these kind of studies have started to shift from developed world economies to developing world economies. As developing world economies have shown signs EDHEC Business School 7

INTRODUCTION

of huge growth potential and leading the economies globally out of recessions, this motivates us to research on developing markets, like India. Such a study will help us to nd the relation between stock market and macroeconomic indicators and give a new insight to foreign investors, academicians,policy makers, traders and domestic investors. This study is important in a sense it provides an insight to how are Indian stock markets are related to its macroeconomic variables and global macro/micro economic factors. This study will also help us in analysing whether the Indian stock markets have become coupled to global factors or are they still dominated by domestic economic factors. The focus of this study is on relation between Indian stock market, represented by BSE Sensex, and domestic macroeconomic factors and global factors represented by Standard and Poors 500 Index. This study builds on earlier studies done in this area but also open some new doors for further research. It is similar to some earlier studies in a respect that it uses data, macro and micro factors and econometrics tools used in previous studies but at the same time it dierentiates itself from earlier studies in a sense that it is done on a market that is still developing. Also, the time period used in the analysis is a period where Indian market has undergone lot of regulatory changes that has created a structural change in the market. Further, in this study Ill analyse whether the Indian markets are driven mainly by Domestic factors or do global factors have more inuence on Indian markets. To analyse the impact of international factors Ill use Standard and Poors 500 Index and USDINR exchange rate as a substitute of global factors and to model domestic demand Ill use macro factors like Industrial production, M1 money supply, Consumer Price Index and Producer price Index. The outline of the thesis is as followings: Section 2 provides a literature review of the studies done earlier in this area, Section 3 provides a detailed description of the data used in the study Section 4 provides a detailed description of the methodology and various econometric tools that will be used in the study, Section 5 provides the results of the study and Section 6 provides the conclusion of the study.

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LITERATURE REVIEW

Literature Review

Many studies and researchers have tried to nd factors that can explain stock returns. The most famous and earliest model is the Capital Asset Pricing Model (CAPM), developed by Sharpe (1964), Lintner (1965), Mossin (1967) and Black (1972). The concept of this single factor model is developed from diversication introduced by Markowitz (1952). In CAPM model the expected stock returns can be explained with the help of Risk free rate and one risk factor, Market. CAPM says that the systematic risk can be captured by sensitiveness of each stock to change in overall market, which is measured by Beta. According to CAPM, the market factor is the only factor determining the stock returns. CAPM was a revolutionary model. It changed the way people looked at the stock returns as something that is vary arbitrary. As it is very easy to understand and use, CAPM is very popular as the model used to determine the stock return in most of nance textbooks and used by many practitioners in stock market. However, the numerous set of assumptions made in deriving CAPM made it inconsistent with the real world and led to criticism of CAPM. To overcome the limitations and assumptions made in CAPM many scholars came up with multi- factor models like Fama-French three factor model, APT model, etc. In Fama-French model they try to explain stock returns with help of three factors, market,small minus big and value minus growth. the model was able to explain the returns based on these risk factors for some time before it failed. There have been many studies on failure of Fama-French model and markets where it is not applicable. The macroeconomic models of explaining stock returns started with APT (Arbitrage Pricing Theory) by Ross (1976), which was later rened by Roll and Ross (1980). APT is a multi-factor model and claims that the stock return can be explained by unexpected changes or shocks in multiple factors. Chen,Roll and Ross (1986) perform the empirical study for APT model and identify that surprise or shock in macroeconomic variables can explain the stock return signicantly. The variables used in their study are Industrial production index, default risk premium that can measure the condence of investors, and change in yield curve that can be measured by term premium. The study of macroeconomic factors in explaining stock returns have been popular since then. Stock price is present value of all discounted future cash ows. If a rm is performing well then the expectation of large future cash ows rises and consequently the stock price rises. On the other hand if a rm is performing bad for couple of years then the expectation of big future cash ows decrease and in turn the stock price fall. This is a micro and idiosyncratic explanation of stock prices and returns. But, the future cash ows of a stock does not depend solely on the companys performance or prots/loss. The systematic factor can have a huge impact on the cash ows of not only one but many companies. The systematic factor here refers to macro economic variables. The state of Macro economic conditions lead to changes in Monetary and regulatory policies by the government and which in turn aects the stock prices. For example a country with good economic conditions, represented by its Industrial production index, GDP, CPI, Interest rates will create an environment that is conducive for the growth of companies by lowering borrowing rates and other open market operations. So, all macroeconomic factors that can inuence future cash ows or the EDHEC Business School 9

LITERATURE REVIEW

discount rate by which the cash ows are discounted should have an inuence on the stock price. Many researcher have studies the relationship between stock prices and macro economic variables and tried to explain the aect of one over the other. Fama (1981) tries to establish a relationship between stock returns, real activity, ination and money. In his paper he nds that Stock returns have positive relation with real output and money supply but a negative relation with ination. He explains that negative relation between stock returns and ination is induced by negative relation between real output, approximated by Industrial production, and ination. This negative relationship between ination and real activity is explained by money demand theory and quantity theory of money. Fama (1990) explains that measuring the total return variation explained by shocks to expected cash ows, time-varying expected returns, and shocks to expected returns is one way to judge the rationality of stock prices. In his paper he nds that growth rates of production, used to proxy for shocks to expected cash ows, explain 45% of return variance. Chen,Roll and Ross (1986) explored the relationship between a set of economic variables and their systematic inuence on stock market returns. They found that Industrial production, changes in risk premium, twists in yield curve had strong relationship and impact on stock returns. A somewhat weaker eect was found for measures of unanticipated ination and changes in expected ination during periods when these variables were highly volatile. They concluded that stock returns were exposed to systematic economic news, that they are priced in accordance to their exposures, and that the news can be measured as innovation in state variables. Chen (1991) found that state variables that are priced are those that can forecast changes in the investment and consumption opportunity set. According to his research, default spread, the term spread, the one-month T-Bill rate, the lagged industrial production growth rate, and the dividend-price ration are important determinants of future stock market returns. Bulmash and Trivoli (1991) show the eect of business cycle movements on the relationship between stock returns and money growth. An interesting paper in this eld of research is by Fama (1990) and Schwert (1990). In the paper they claim that there are three explanations for the strong link between stock prices and real economic activity:
First, information about the future real activity may be reected in stock prices well before it occurs this is essentially the notion that stock prices are a leading indicator for the well-being of the economy. Second, changes in discount rates may aect stock prices and real investment similarly, but the output from real investment doesnt appear for some time after it is made. Third, changes in stock prices are changes in wealth, and this can aect the demand for consumption and investment goods [Schwert (1990),p.1237]

Campbell and Ammer (1993) use a VAR approach to model the simultaneous interactions between the stock and bond markets, since most previous works do not address the channels through which the macroeconomic activity inuences the stock prices. One example could be that industrial production could be linked to changing expectations of future cash ows (Balvers at al. 1990). On the other hand, interest rate innovations could be the driving factor EDHEC Business School 10

LITERATURE REVIEW

in determining both industrial production (due to change in investment) and stock prices (due to change in the discounted present value of future cash ows). A VAR analysis can distinguish these possibilities. Mukherjee and Naka (1995) show a long-term relationship between the Japanese stock price and real macroeconomic variables. Dr. Nishat (2004) studies the long term association among macroeconomic variables like money supply, CPI,IPI, and foreign exchange rate and stock markets in Pakistan. The results show that there are causal relationship among the stock price and macroeconomic variables. He uses data from 1974 to 2004 in his study. As most of the nancial time series are non stationary in levels he uses unit root technique to make data stationary. Fazal Hussian and Tariq Massod (2001) used variables like investment, GDP and consumption employing Grangers causality test to nd relationship between macro factors and stock markets. They show that at two lags all macroeconomic variables have highly signicant eect on stock prices. James et al. (1985) use a VARMA analysis for investigating relationship between macro economy and stock market. Using VARMA analysis for nding causal relationship between factors is a better technique as the procedure does not preclude any causal structure a priori since it allows feedback among variables. Thus, the VARMA approach allow whatever causal relationship exist to emerge from the data. They nd linkages between real activity and stock returns and real activity and ination. Also, they nd that stock returns signal changes in the monetary base. Since stock returns also signal changes in expected real activity, this suggests a link between the money supply and expected real activity that is consistent with the money supply explanation oered by Geske and Roll. In recent years the focus of these kind of studies have shifted from developed economies to developing economies. As developing economies are the economies that see a lot of structural and monetary policy changes an analysis of relationship between macro and micro can provide new insights. Also, one can analyse the eects of monetary policies on the asset prices especially on stock prices. Tangjitprom (2012) study of macroeconomic factors like unemployment rate, interest rate, ination rate and exchange rate and stock market of Thailand concludes that macroeconomic factors signicantly explain stock returns. He also nds that for Thailand unemployment rate and ination rate are insignicant to determine the stock returns. The reason he provides is that the unemployment rate and ination rate are not timely and there could be some lags before the data becomes available. Also, Grangers test to examine lead-lag relationship among the factors reveal that only few macroeconomic variables could predict the future stock returns whereas the stock returns can predict most of future macro economic variables. This implies that performance of stock markets can be a leading indicator for future macroeconomic conditions. Ali (2011) study of impact of macro and micro factors on stock returns reveals that ination and foreign remittance have negative inuence and industrial production index have positive impact on stock markets. Also he didnt found any Grangers Causality between stock markets and any of the explanatory variables. This lack of Grangers causality reveals the evidence of informationally inecient markets. Ali uses a multivariate regression analysis on standard OLD formula for estimating the relationship. Hosseini et al. (2011) tested the relationship between stock markets and four macro economic variables namely crude oil prices, Money supply, Industrial production and ination rate in China and India. They used a period of 1999 to 2009 for analysis. As most of the economic time series have unit EDHEC Business School 11

LITERATURE REVIEW

root, they rst used the Augmented Dickey Fuller unit root test and found the underlying series to be non-stationary at levels but stationary after in dierence. Also, the use of Jhonson-Juselius (1990) Multivariate cointegration and Vector Error Correction model technique, indicate that there are both long and short run linkages between macroeconomic variable and stock market index in each of the two countries. Their analysis shows that in long run the impact of increase in prices of crude oil for China is positive but for India is negative. In terms of money supply, the impact on Indian stock market is negative, but for China, there is a positive impact. The eect of Industrial production is negative only in China. In addition the eect of increases in ination on these stock markets is positive in both countries. Wickremasinghe (2006) analysed the relationship between stock prices and macroeconomic variables in Sri Lanka. He used the Unit root tests, Jhonsons test, Error-correction model, variance decomposition and impulse response to analyse the relationships. His ndings indicate that there is both long term and short term causal relationship between stock prices and macroeconomic variables in Sri Lanka. The result indicate that the stock prices can be predicted from certain macroeconomic variables and hence violate the validity of the semi-strong version of ecient market hypothesis. Ahmed (2008) investigates the causal relationship between Indian macroeconomic factors like Industrial Production, Exports, Foreign direct investment, Money supply, exchange rate, interest rate and stock market indices NSE Nifty Index and BSE Sensex. For nding the long term relationship he applies Johansens cointegration and Toda and Yamamoto Granger Causality tests. For analysing the Impulse response and variance decomposition he uses bivariate VAR. His ndings reveal that stock prices in India lead macroeconomic activity except movement in interest rate. Interest rate seem to lead the stock price. The study also reveals that 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 dimensions in the economy. An important paper by Bilson et al. (2001) argues that emerging markets local factors are more important than global factors. They nd that for emerging markets are at least partially segmented from global capital markets. The global factors are proxied by world market returns and local factors by set of macro economic variables like money supply, prices, real activity and exchange rate. Some evidence is found that local factors are signicant in their association with emerging equity market returns above than that explained by the world factor. When they use a larger set of variables the explanatory power of the model improves substantially such that they are able to explain a large amount of return variation for most emerging markets.

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12

DATA

3
3.1

Data
Description of Macroeconomic Indicators

One of the biggest problems when conducting a research with macroeconomic data is the frequency of the data. Most of the macroeconomic indicator time series are yearly,quarterly or monthly time series. This low frequency of the macroeconomic indicators results in very few data points for conducting a analysis that is robust. A possible cure for the problem is to use longer time periods to incorporate more data points for macroeconomic variables. But, another problem that we face when we look at the macroeconomic indicators for Asian countries is reporting of the data. For most of the Asian countries the macroeconomic data doesnt have a long history and same can be said about history of Indian macroeconomic variables. So, in this research we have used a time period for which we can nd data for most of the macroeconomic indicators. In this paper we use a time period of 20 years starting from 1990 to 2011. This time period in Indian economy is representative of many structural and monetary policy changes like liberalization of India markets. Also as the time period is long it gives us enough data point for each macroeconomic factors to do a robust empirical analysis. When one starts to build a model of interaction between macro and micro economic factors one dominant and important question one faces is, among the myriad of macro indicators available for an economy which factors to choose to incorporate in the model. If one chooses macroeconomic factors that are highly correlated among themselves then the power of test results decrease as it may result in a model where the macro indicators are able to explain most of the movement of micro factors but the macro factors may not be relevant. To circumvent this problem we use variables that have been tested in earlier researches and that have been proven to have eect on stock markets. I also test a few macro factors that have some nancial theory behind them that connect them to stock markets. Ali (2011), Wickremasinghe (2006), Bilson et.al (2001) and Bailey (1996) nd that Industrial production, CPI, exchange rate, M1 money supply, GDP are few of the macro economic factors that can signicantly explain stock returns. Sahu(2011), Ahmed(2008), Tripathy(2011) study on Indian markets specically show that Industrial Production, Exchange rate, Ination index are macro economic indicators that have a strong positive or negative relationship with the stock markets. So, in our study we test 5 macro economic variables namely M1 money supply, Consumer and Producer price Index, Industrial production, Exchange rate. The time period for these indicators is from 1990-2011. The data for Ination indices, Industrial production and exchange rate has been pulled from Bloomberg c and Datastream c . The data has been processed for errors and missing values. Data for M1 money supply has been pulled from RBI website. For most of the indices like ination and Industrial production index, the base year has been changed to 1990. Also, as some of the indices are in levels and some in actual gures (M1 money supply), we convert all of the indicators to level form (starting at 100 in 1990).

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DATA

3.2

Description of Stock Market Indices

Compared to Macro Indicators, stock market data is relatively easy to nd and has considerably long history. Also, the stock market data is a real time data so it has a very high frequency of seconds. Here, in our analysis we will make use of BSE (Bombay Stock Exchange) as representation of Indian markets and SP500 (Standard and Poors 500 Index) as representation of global factors. BSE is a market cap-weighted of 30 stocks. It is the oldest Index in the Asian markets (established in 1875) and have had a long history. We choose this index as it is the Index that represent the most liquid and traded stocks of the Indian stock market. Also, the index is most traded index in India and a good representation of trade prices of the stocks. Even in terms of an orderly growth, much before the actual legislations were enacted, BSE Limited had formulated a comprehensive set of Rules and Regulations for the securities market. It had also laid down best practices which were adopted subsequently by 23 stock exchanges which were set up after India gained its independence. Our choice of SP500 is based on the fact that it has a long history and many researchers have used this index as a good proxy representation of global markets and economic conditions. We will take the monthly returns of each of the indices from 1990-2011 in accordance with data frequency of macro economic variables. Also, as the indices have dierent levels at beginning of 1990 we rebase both the indices to base year of 1990 starting at a level of 100.

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METHODOLOGY

4
4.1

Methodology
Construction of Time Series

The rst step in constructing an econometric model is constructing time series all of which are in same units. Most of the time series used in our analysis are in dierent formats. For example CPI, PPI, BSE Index, SP500 are in levels. M1 money supply, USDINR exchange rate is in absolute current format. Industrial production is in absolute production levels. So, rst we convert all of the given time series to level. The way we construct time series in levels is rstly taking the initial data point of each time series as 100. We then nd the percentage change from one period to the next one for each time series using a continuous compounding assumption (taking a natural log of change in values). In mathematical terms it can be stated as: Assume the original Index value at time t to be It and at time t+1 to be It + 1. Then we can compute the new rebased index by formula: RIt+1 = RIt (1 + ln(It+1 /It )) where, RIt = Rebased Index at time t RIt+1 =Rebased Index at time t+1 We can use these rebased indices in building and testing our econometric model.

4.2

Unit Root Test and Stationarity

Unit root test is to nd whether the series is stationary or non-stationary. A strictly stationary process is one where, for any t1 , t2 ,...., tt Z, any k Z and T=1,2,... Fyt1 ,yt2 ,yt3 ,....,ytT (y1 , ...., yT ) = Fyt1+k ,yt2+k ,yt3+k ,....,ytT +k (y1 , ...., yT ) where F represents joint distribution function of the set of random variables. It can also be stated that the probability measure of sequence of yt is same as yt+k for all k. In other words a series is stationary if the distribution of its value remain the same as time progresses. Similar to the concept of strict stationary is weakly stationary process. A weakly stationary process is one which has a constant mean, variance and autocovariance structure. Stationary is a necessary condition for a time series to be tested in regression. A non-stationary series can have several problems like: 1. The shocks given to the series would not die of gradually, resulting in increase of variance as time passes. 2. If the series is non stationary then it can lead to spurious regressions. If two series are generated independent of each other then if one is regressed on other it will result in very low R2 values. But if two series are trending over time then a regression of one over the other will give high R2 even though the series may be unrelated to each other. So, if normal regressions tools EDHEC Business School 15

METHODOLOGY

are used on non stationary data then it may result in good but valueless results. 3. If the variables employed in a regression model are not stationary, then it can be proved that the standard assumptions for asymptotic analysis will not be valid. In other words, the usual t-ratios will not follow a t-distribution, and the F-statistic will not follow an F-distribution, and so on. Stationarity is a desirable condition for any time series so that it can be used in regressions and give meaningful result that have some value. to test for stationarity a quick and dirty way is looking at the autocorrelation and partial correlation function of the series. If the series is stationary then the autocorrelation function should die o gradually after few lags and the partial correlation function will me non zero for some lags and zero thereafter. Also we can use the Ljung-Box test for testing that all m of k autocorrelation coecients are zero using Q-statistic given by formula: k 2 2 T k

Q = T (T + 2)m k=1

where, T = Sample size and m = Maximum lag length The lag length selection can be based on dierent Information Criteria like Akaikes Information criteria (AIC), Schwarzs Bayesian information criteria (SBIC), Hannan-Quinn criterion (HQIC). Mathematically dierent criteria are represented as: AIC = ln( 2 ) +
2k T k T lnT 2k T ln(ln(T ))

SBIC = ln( 2 ) + HQIC = ln( 2 ) +

For a better test for stationarity we use augmented Dickey fuller Unit root test on each time series separately. Augmented Dickey Fuller test is test of null hypothesis that the time series contains a unit roots against a alternative hypothesis that the series is stationary.

4.2.1

Mathematical representation of Stationary series and unit root test

Assume a variable Y whose structure can be given by AR process with no drift equation: yt = 1 yt1 + 2 yt2 + 3 yt3 + ... + n ytn + ut (2) where, ut is the residual at time t. Using a Lag operator L we can write eq.(1) as: yt = 1 L1 yt + 2 L2 yt + 3 L3 yt + ... + n Ln yt + ut (3)

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METHODOLOGY

Rearranging eqn. (2) we get, yt 1 L1 yt 2 L2 yt 3 L3 yt + ... n Ln yt = ut yt (1 1 L 2 L 3 L + ... n L ) = ut or, (L)yt = ut The time series is stationary if we can write eqn.(5) in form, yt = (L)1 ut (7) (6)
1 2 3 n

(4) (5)

with (L)1 converging to zero. It means the autocorrelation function would decline as lag length is increased. If eqn. (6) is expanded to a MA() process the coecients of residuals should decrease such that the the residuals that the eect of residuals decrease with increase in lags. SO, if the process is stationary the coecients of residuals will converge to zero and for non-stationary series they will and converge to zero and will have long term eect. The condition for testing of unit root for an AR process is that the roots of eqn.(6) or Characteristic equation should lie outside unit circle.

4.2.2

Augmented Dickey Fuller Unit Root Test

Consider an AR(1) process of variable Y yt = yt1 + ut Subtracting yt1 from both sides of eqn.(7) we get, y = ( 1)yt1 + ut (9) (8)

Eqn.(8) is the test equation for Dickey Fuller test. For Dickey-Fuller Unit root test, Null Hypothesis: The value of is equal to 1 or value of 1 is equal to 0 v/s, Alternate Hypothesis: The value of is less than one or value of 1 is less than zero Augmented Dickey-Fuller test is similar to normal Dickey-Fuller tests except, it takes the lag structure of more than one into account.
p

y = yt1 +
i=1

i yti + ut

(10)

If the series has one or more unit root it is said to be integrated of order n, where n is the number of unit roots of the characteristic equation. To make these time series stationary they needs to be dierenced. Mathematically, if yt I (n) then (d) yt I (0) (12) (11)

To make our time-series stationary we will use the natural log returns of these series in the analysis.

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METHODOLOGY

4.3

Testing Long Term Relationships

Engle and Granger (1987) in their seminal paper described cointegration which forms the basis for testing for long term relationship between variables. According to Engle and Granger two variables are cointegrated if they are integrated process in their natural form (of the same order), but a weighted combination of the variables can be found such that the combined new variable is integrated of order less than the order of individual time series. Mathematically, assume yt to be a k X 1 vector of variables, then the components are cointegrated or integrated of order (d,b) if: 1. All components of yt are I(d) 2. There is at least one vector of coecients such that yt I (d b)

(13)

As most of the nancial time series are integrated of order one we will restrict ourselves to case d=b=1. Two or more variables are said to be cointegrated if there exist a linear combination of these variables that is stationary. Many of the series are non-stationary but move together over time which implies two series are bound by some common force or factor in long run. We will test for cointegration by a residual-based approach and Johansens VAR method. Residual Based approach Consider a model, yt = 1 + 2 x2t + 3 x3t + ... + ut (14)

where yt , x2t , x3t , ... are all integrated of order N. Now if the residual of this regression, ut is stationary then we can say that the variables are cointegrated else there exist no long term relationship between the variables. To test the residual for stationarity we will run Augmented Dickey-Fuller tests on the residuals. Under the Null hypothesis the residual are integrated of order one or more and under alternate hypothesis the residuals are I(0).

4.3.1

Johansen test for Cointegration

Johansen test for cointegration presents a better model for testing multiple cointegration among multiple variables. The Residual based approach can only nd atmost one cointegration and can be tested for a model with two variables. Even if more than two variables are present in the equation that are cointegrated, the Residual based approach will give only one cointegration. SO we will use Jhoansen VAR based cointegration for testing more than one cointegration. Suppose that a set of g variables are under consideration that are I(1) and which are thought to be cointegrated. A VAR with k lags containing these variables could be set up. yt = 1 yt1 + 2 yt2 + + k ytk + ut g1 gg g1 gg 18 g1 gg g1 g1 (15)

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METHODOLOGY

In order to use the Johansen test, the VAR above should be turned into a vector error correction model of form, yt = ytk + 1 yt1 + 2 yt2 + + k1 yt(k1) + ut where, = (k i ) Ig and i = (i j ) Ig j=1 i=1 The Johansens test centers around testing the matrix which is the matrix that represents the long term cointegration between the variables. The test for number of cointegration is calculated by looking at the rank of the matrix through its eigenvalues. The rank of the matrix is equal to number of roots (eigenvalues) i of the matrix that are dierent from zero. The roots should be less than 1 in absolute value and positive. If the variables are not cointegrated the rank of the matrix will not be signicantly dierent from zero i.e. i 0. There are two test statistics for Johansen test trace r and max
g trace (r) = T i=r+1 ln(1 i ) and, max (r, r + 1) = T ln(1 r+1 )

(16)

trace is a test statistic for joint test where the null hypothesis is that the number of cointegration vector is less than or equal to r against an alternative that there are more than r. max conducts another separate test on eigenvalues and has null hypothesis that the number of cointegrating vector is r against r+1.

4.4

Impulse Response

Once we have determined whether the variables have long term relationship or not we can form a multivariate VAR model for the variables. A multivariate VAR model between g variables is a model where the current value of a variable depend on diernt combinations of the previous k values of all the variables and error terms. A general representation of the model can be: yBSEt = + BSE yBSE + IP yIP + CP I yCP I + M 1 yM 1 + SP 500 ySP 500 + u1t (17) where all the coecients except are g k matrices and all variables y are k 1 matrices. Once we have formed a model like this we can use the model for Impulse response. A VAR(p) model can be written as a linear fuction of the past innovations, that is, rt = + at + 1 at1 + 2 at2 + . . . (18)

where = [(1)]1 0 provided that the inverse exists, and the coecient matrices i can be obtained by equating the coecients of B i in the equation (I 1 B . . . P B P )(I + 1 B + 2 B 2 + . . .) = I EDHEC Business School 19 (19)

METHODOLOGY

where I is the Identity martix. This is a moving average representation of rt with the coecient matrix i being the impact of the past innovation ati on rt . Equivalently, i is the eect of at on the future observation rt+i . Therefore, i is often referred to as the Impulse Response Function of rt . For our impulse response we will use equation of variables in rst diernce form like,
k k

BSEt = t +
i=0

11 (i)BSEti +
j=1

12 (j)M Itj +

BSEt

(20)

M It = t +
i=0

21 (i)M Iti +
j=1

22 (j)BSEtj +

M It

(21)

Grangers causality and Blocks F test of a VAR model will suggest which of the variables have statistically signicant impacts on the future values of other variables in the system. But F-test results cannot explain the sign of the relationship nor how long these eects require to take place. Such information will, however, be given by an examination of the VARs impulse responses and variance decompositions. Impulse response is a technique that trace out the responsiveness of the dependent variable in the VAR to shocks of each of the other variables. So for each variable from each equation separately we will apply a unit shock to the error and trace the eects upon the VAR system over time. By using the impulse response technique we can determine how responsive is the BSE stock index to Indian macro indicators and SP500. This will help us determine whether the BSE index is more reactive to domestic news or global news.

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RESULTS

Results

Before we use the time series for VAR analysis or cointegration tests we need to determine whether the series are Stationary or not. If the series are stationary in levels, we can use them directly else we need to use the dierenced time series. One way to look for autocorrelation or integrated process is to see the graphs of the various time series used. Section 7.1 shows the graphs of variables we use for our analysis. As we can see from the graphs all of the time series have a trend in long run which points to an integrated process. As a second step we plot the graphs of dierenced time series in Section 5.2. We can see that the dierenced graphs in Section 7.2 dont show a long term trend and cross the X-axis frequently. This is usually a property of I(1) processes. So we check the series for autocorrelations at dierent lag lengths. Section 7.3 shows correlograms graph, autocorrelation coecient, partial autocorrelation coecient, Q-Stat and p-value for various time series up to 36 lags. As can be seen in the tables the Q-stat for all lags is zero and we can reject the joint null hypothesis that all the autocorrelations up to 36 lags are zero. Table 7.4.1 shows that if we conduct a Unit root test on levels of the series we nd that all the 7 series are integrated as we cannot reject the t-stat for unit root at 1% level. But if we conduct the same test on dierenced values of the series we nd that we can reject the null hypothesis of unit root at 1% signicance level for all the series except CPI. This tells us that all the series are I(1) as there rst dierence series are I(0). As our series are I(1) we will work with index levels of time series to determine if there exist one or more cointegrating relationships between the series. Tables in subsection 7.4.3 are based on residual approach where we run a regression of BSE and various macroeconomic indicators and test the residuals for unit root using Augmented Dickey-Fuller test. As we assume the two series are cointegrated we conduct the test with no trend and intercept. If the two series are cointegrated then the errors should not have any trend or intercept. We see that we can reject the null hypothesis of unit root at 1% signicance for CPI,IP, M1. We can reject the null of unit root for PPI at 5 % and for SP500 and USDINR we cant reject the null hypothesis of unit root at even 5% level. This points to the fact that BSE has a strong long term relationship with IP, M1 money supply, CPI at 1% level with IP, M1, CPI, PPI at 5% signicance level. Also, BSE has no long term relationship with SP500 and USD INR exchange rate. To test for multiple cointegrating relationship we now employ a Johansen VAR based cointegration test. The results of the test are displayed in subsection 7.4.4. The rst panel of the test results displays the value of t race andm ax of Johansen test with dierent assumptions about intercept and trend. We can see from this panel that when we consider a functional form of intercept and no Trend we have atleast and atmost three cointegrating relationships. The second panel of the results display the value of information criteria for lag lengths. For most of the models we see that Akalike criteria points to a lag of three and Schwarz criteria points to a lag of one. To estimate the cointegrating model we choose the model with intercept and no trend and run a cointegration test.Test results are shown in Table 2 of subsection 7.4.4. At 5% signicance level we can reject the null of atmost two cointegrating factors for t race and same for m ax. Now to test which all variables have a long tern relationship we perform a Restricted cointegration with vector error correction model. As we had already EDHEC Business School 21

RESULTS

seen in our residual based test of cointegration that BSE has no cointegrating relationship with SP500 and USDINR we create a restricted cointegration model where we set coecients of SP500 and USDINR as zero. The test results are displayed in Table 3 of subsection 7.4.4. In this case as there are two restrictions, the test statistic follow 2 with two degrees of freedom. We can see that the p-value for the test is 13.33 % which tells us that the restrictions are supported by data at 10% level of signicance. So we can conclude that the BSE has a long term relationship with CPI,IP,PPI,M1 money supply but has no long term relationship with SP500 and USDINR exchange rate. One interpretation of this result can be that the Indian stock market, represented here by BSE Sensex, moves more in accordance with domestic factors like Industrial production, M1 money supply, Consumer price index and Producer Price index than with global factors or in other words, as BSE is representation of largest market cap Indian companies we can say that the biggest companies in India are ones that are more dependent on domestic demand rather than exports. This result presents an opportunity for international investors to diversify their portfolio by investing in BSE Sensex as it is decoupled with global markets and macroeconomic factors. We use A bivariate Vector Autoregression (BVAR) technique to analyze the dynamic interaction between real asset prices and macro economy. VAR is preferred method to study Macroeconomy and asset prices where variables endogenously eect each other. We begin with a bivariate VAR with no restriction. Asset prices and instruments are allowed to respond to each other freely. For paired variables with cointegration relationship, VAR is performed at levels whilst for those that are not cointegrated VAR is performed at rst dierence. Constant term is ignored with loss of generality. We use the Bivariate Autoregression analysis for both impulse response and Grangers causality tests. Impulse response results are displayed in subsection 7.4.5. From rst graph of impulse response of BSE to USDINR we can see that USDINR has a negative impact on BSE. As impulse response is response of BSE to shocks given to USDINR we can see that a positive shock or unexpected appreciation INR value w.r.t USD, will have a negative eect on BSE for few lags and will disappear after few lags. If we look at the constituents of BSE Index over time we see that most of the time, some of its constituent are companies that thrive on exports. Some of the biggest Market-Cap in India are companies in service sector like Infosys, TCS, etc that are hugely dependent on services provided to clients from Europe and U.S.. So, an appreciation of INR compared to USD makes these rms costlier for the global clients and in turn reduces the income of these companies. As the rms revenue/ prot decreases the value of the stock also decreases that in turn aects the returns of BSE Sensex. Second graph (betwen BSE and SP500) shows that increase in SP500 has a positive eect on BSE as higher returns of SP500 indicate strong global economy which in turn results in higher trade between countries. The positive response of BSE to one unit shock to SP500 indicates a spillover eect of global factors on Indian economy but the response is weak as can be seen from the graph. Moving forward, response of BSE to shocks in M1 money supply, CPI, PPI make economic sense. As for M1 money supply one unit shock means increase in M1 money supply. This increase in money supply allows companies to borrow more money from banks at lower rates, which they can use for investing EDHEC Business School 22

RESULTS

in protable projects and generating larger cash ows. For Ination indicators one unit shock means increase in ination. This increase in ination results in higher costs for the companies that in turn reduces their prot margins and as a result value of stocks. By looking at the graphs we can also see that shocks to Indian macroeconomic indicators creates stronger response by BSE as compared to global factors like SP500 or USDINR. This indicates that BSE Index is driven by companies that depend hugely on domestic demand rather than exports. Response of BSE to shocks to Industrial Production are contradictory to theory. In theory an increase in industrial production should result in positive response from BSE but our analysis shows the other way. A possible reason for this response could be that industrial production time series is seasonal as can be seen from the graph. So, there is a possibility of a lead/lag relationship between the two variables. To test for possibility of lead/lag relationship we run a Grangers causality test between BSE and IP. The result in section 6.4.6 shows that at a lag length of 4 we can reject the Null hypothesis of BSE does not Granger cause IP at 1% signicance level. This proves that BSE is a leading indicator of industrial production and there exist a lead/lag relationship between the two indicators.

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CONCLUSIONS

Conclusions

In this paper I tested the relations between Indian stock market, represented by BSE, and domestic and global macro economic factors. The research concludes that the India stock markets are mainly driven by domestic demand and the inuence of global macro factors on the stock market is weak. I also tested for Granger causality between BSE and IP and found that BSE is a leading indicator of Industrial production and can help in predicting the industrial climate in India. The research is insightful for investors and professionals who are looking for investment opportunities to diversify their risks. As Indian stock markets are more dependent on domestic factors one can invest in Indian indices and stocks to diversify their risks gained through investing in U.S. and European stocks. The paper opens new doors for research in this eld. One can use variance decomposition technique to see how much variance of BSE can be explained my various domestic and global macro factors. Also one can use dierent global factors like sovereign CDS spreads, T-Bill rates, a composite indicator of global economy for further research on interaction between Indian stock market and global economy.One can also research on how various global macroeconomic news aects India stock markets and for how long the eects persists.

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GRAPHS AND TABLES

7
7.1

Graphs and Tables

Graphs of Time series

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GRAPHS AND TABLES

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GRAPHS AND TABLES

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7.2

Graphs of Time Series - Dierenced

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GRAPHS AND TABLES

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GRAPHS AND TABLES

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GRAPHS AND TABLES

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GRAPHS AND TABLES

7.3
BSE

Correlograms of Time series

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GRAPHS AND TABLES

IP

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SP500

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GRAPHS AND TABLES

USDINR

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GRAPHS AND TABLES

CPI

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GRAPHS AND TABLES

PPI

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GRAPHS AND TABLES

M1

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7.4
7.4.1

Tables
Table for Unit root test of Time series T-Stat -2.671 -1.315 -1.909 -1.669 -2.420 -3.353 -2.955 p-value 24.95 % 88.18 % 64.66 % 8.99 % 36.79 % 6.01 % 14.69 %

Variables BSE SP500 CPI IP M1 PPI USDINR 7.4.2

Tables for Unit root test of Dierenced time series T-Stat -13.848 -14.832 -3.344 -3.865 -3.867 -9.656 -13.701 p-value 0.00 % 0.00 % 1.40 % 0.27 % 0.26 % 0.00 % 0.00 %

Variables BSE SP500 CPI IP M1 PPI USDINR 7.4.3

Tables for Residual based test of cointegration

Table 1: BSE - CPI ADF test statistic Test critical values: t-Statistic -2.622676 -2.573818 -1.94204 -1.615891 Prob.* 0.87%

1% level 5% level 10% level

Table 2: BSE - IP ADF test statistic Test critical values: t-Statistic -3.738802 -2.574513 -1.942136 -1.615828 Prob.* 0.02%

1% level 5% level 10% level

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GRAPHS AND TABLES

Table 3: BSE - M1 ADF test statistic Test critical values: t-Statistic -2.875518 -2.573784 -1.942035 -1.615894 Prob.* 0.41%

1% level 5% level 10% level

Table 4: BSE - PPI ADF test statistic Test critical values: t-Statistic -2.399055 -2.573784 -1.942035 -1.615894 Prob.* 1.62%

1% level 5% level 10% level

Table 5: BSE - SP500 ADF test statistic Test critical values: t-Statistic -1.427184 -2.573784 -1.942035 -1.615894 Prob.* 14.30%

1% level 5% level 10% level

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GRAPHS AND TABLES

Table 6: BSE - USDINR ADF test statistic Test critical values: t-Statistic -1.659522 -2.573818 -1.94204 -1.615891 Prob.* 9.17%

1% level 5% level 10% level

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GRAPHS AND TABLES

7.4.4

Johansen cointegration test

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Table 2

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Table 3

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7.4.5

Impulse response tests

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GRAPHS AND TABLES

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GRAPHS AND TABLES

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7.4.6

Granger causality test between IP and BSE

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BIBLIOGRAPHY

Bibliography

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BIBLIOGRAPHY

Yao, Juo and Loh, On Chinas Monetary Policy and Asset Prices, University of Nottingham- China policy Institute, 2011 Bilson et. al, Selecting macroeconomic variables as explanatory factors of emerging stock market returns, Pacic-Basin Finance Journal, 2001 CHen, Roll and Ross, Economic forces and the Stock Markets, The Journal of Business, 1986 William H. Greene, Econometric Analysis, 6th Edition, Pearson International Edition Ruey Tsay, Analysis of Financial Time series Chris Brooks, Introductory Econometrics for Finance, Cambridge Publications

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