Macroeconomic Variables and Security Prices in India during the Liberalized Period

Kenneth A. Loparo

• Publisher: Palgrave Macmillan
• Year: 2016
• ISBN:
  9781137492012
• Topic: Business
• Subtopic: International Business
• Index: Business

The liberalization and globalization of the Indian economy has made India more vulnerable to macro issues. This book provides a comprehensive analysis of the dynamic relationship between macroeconomic variables and stock prices in India. The research findings and policy implications discussed here may also be relevant for other emerging economies.

Chapter 1

Introduction

1.1. Background of the Study

The stock market is an important part of the economy of a country. It plays a pivotal role to the growth of industry and commerce of a country, which eventually affects the economy of that country to a great extent. That is why the government, industry, investors, and even the central bank of a country are always vigilant about the operation of its stock market and the ups and downs of stock market indices. The stock market plays two crucial roles in the economy. It can promote economic growth by attracting domestic and foreign capital and channeling it to the corporate sector. At the same time, the stock market is a market place for securities, where they can be traded to provide liquidity to investors. Therefore, it provides opportunities for new capital formation and maintains the investment liquidity. Nowadays, the stock market has become a key driver of our modern market-based economy, and is one of the major sources of raising resources for corporates, and thereby enables the financial development and economic growth of a nation. The Indian economy has experienced significant changes in the economic system. The capital market has also undergone tremendous changes since 1991, when the government adopted liberalization and globalization polices. Like in other developing nations, the government of India has taken significant steps towards the development of its capital market, including opening the market to international investors. As a result, the Indian stock market is gaining in importance from an aggregate economic point of view. Despite its growing importance in the world economy, the stock market remains unstable due to its inherent nature. It works in correlation with the sentiments of participants, which makes the stock market a very sensitive segment of the economy. Globalization and financial sector reforms have added to the sensitivity by increasing determinants of the stock market movement manifold. Further, the movement of stock prices is highly sensitive to the changes in fundamentals of the economy and to the change in expectations about future prospects. The expectations are influenced by macro and micro economic fundamentals. The volatility in macroeconomic variables affects the corporate fundamentals and ultimately affects the stock prices. Since the economy and capital market are closely related, information regarding macroeconomic behavior may be very useful to predict stock market behavior.

Most of the empirical studies regarding the determinants of stock market movements have been confined to two contradicting theories: Efficient Market Hypothesis (EMH) and Asset pricing theory. According to Eugene Fama (1965, 1970) the EMH advocates that stock prices fully and rationally incorporate all relevant information. Thus, past information is useless in predicting future asset prices. On the other hand, the asset pricing theories such as the Arbitrage Price Theory (APT), and the Present Value Model (PVM), however, illustrate the dynamic relationship between the stock market and economic activity.

1.1.1. Theory of Efficient Market Hypothesis (EMH)

A market is efficient if prices fully and instantaneously reflect all relevant available information, and no abnormal profit opportunities exist. The world is integrated as one global village today, and hence the accessibility to information has become much easier than ever before. The basic idea underlying the EMH developed by Fama (1965, 1970) is that asset prices promptly reflect all available information, such that abnormal profits cannot be earned regardless of the investment strategies. In an efficient market, past information is of no use in predicting future prices. In other words, the EMH theory hypothesizes that asset prices evolve according to a random walk. Thus, asset prices cannot be predicted, and investors cannot beat the market. However, since this is unpredictable by definition, price changes or returns in an efficient market cannot be predicted.

Fama (1970) distinguishes between three types of market efficiency. From the efficiency point of view, a market is said to the weak form of market efficiency if the history of prices is of no use in predicting future prices changes. The market efficiency is in the semi-strong form if all publicly available information like corporate fundamentals, industry news, and economic factors like interest rate, inflation, exchange rate, money supply, and so on—including the past prices of securities, trading volume, and security dividend—have no predictive power. Finally, market efficiency is strong if all information is reflected in prices, including so called “inside” information. From an investor’s perspective, participants in the stock market should not be able to generate an abnormal profit, regardless of the level of information they may have possessed.

1.1.2. Asset Pricing Theory

The theory of asset pricing, in general, demonstrates how assets are priced, given the associated risks. In finance, APT is a general theory of asset pricing that holds that the expected return of a financial asset can be modeled as a linear function of various macroeconomic factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factor-specific beta coefficient. The theory was proposed by the economist Stephen Ross in 1976. APT does not specify the type or the number of macroeconomic factors for researchers to include in their study. For example, although Ross (1976) examined the effect of four factors including inflation, gross national product, investor confidence, and the shifts in the yield curve, he suggested that the APT should not be limited to these factors. Therefore, there is a large body of empirical studies that have included a large number of macroeconomic factors, depending on the stock market being studied.

An alternative approach is the PVM or the discounted cash flow approach. The model links the stock prices and the future discount rate of expected cash flows. PVM simply states that the price of a stock is the present discounted value of the expected future dividends to be received by the owner. The PVM can be expressed as follows:

This formula indicates that the stock price, P_t, is strongly affected by any possible changes in the expected stream of returns, E_t (R_t+i), and by factors associated with the discount rate of future cash flows, K_t. All essential factors that may directly or indirectly affect expected returns and subsequently affect stock prices should be considered. It means that all macroeconomic variables that influence future expected cash flows and the discount rate by which these cash flows are discounted should have an influence on the stock prices. The price of a share is equal to the discounted sum of the shareholders’ future returns and therefore, the stock market indices in an economy are affected by the macroeconomic movements. The advantage of the PVM model is that it can be used to focus on the long-term relationship between the stock market and macroeconomic variables.

Therefore, the EMH and the asset pricing theories are not consistent with each other. The EMH is based on the assumption that the players in the stock market are informed of all changes in the macroeconomic variables well in advance and accordingly, the stock prices absorb the effect of changes in the macroeconomic variables—both internal and external. Thus, in an efficient market, the changes in macroeconomic variables are fully reflected in current stock prices, so that investors will not be able to earn abnormal profit through prediction of the future stock market movements. But several evidences from the financial literatures like Chen, Roll, and Ross (1986), Kwon and Shin (1999), Ibrahim and Yusoff (2001), Bhattacharya and Mukherjee (2002), Chandran and Rahman (2004), Gan et al. (2006), Chen (2007), Rajput and Thaker (2008), Miller and Ratti (2009), Sohail and Hussain (2009), Filis (2010), Sahu, Bandyopadhyay, and Bandopadhyay (2011), Sahu and Gupta (2011), Basher, Haug, and Sadorsky (2012), Sahu, Mondal, and Bandopadhyay (2012), and Naik (2013) support the asset pricing theories and indicate that macroeconomic factors have a strong influence on stock market return. The earlier studies (Mukherjee and Mishra, 2007; Hoque, 2007; Meric, Pati, and Meric, 2011, etc.) also show that the Indian stock market is very much influenced by the stock markets of other developed and developing countries like the United States, Japan, Australia, Germany, South Africa, Spain, Canada, and so on. Therefore, the stock prices are generally believed to be determined by some fundamental macroeconomic factors and the movements in stock markets of other developed countries.

The analysis of the stock market has come to the fore because it is the most sensitive segment of the economy and is considered the barometer through which the country’s exposure to the outer world is immediately felt. Thus, understanding the determinants of stock market movement is an essential goal, not only for economists or financial analysts, but also for academicians and researchers. Stock market movements are difficult to understand, and forecasting them is even more difficult. This creates a need for empirical structural analysis, which can assist in understanding the functioning of the stock market and help in forecasting the stock market. The present study is an endeavor to investigate the impact of macroeconomic variables on the Indian stock market in the short and the long run, using a series of econometric analyses.

1.2. Research Problem

Given the background as presented above, it is understood that according to EMH, the stock market prices incorporate all relevant information. Thus, past information may be useless in predicting future asset prices. At the same time the asset pricing theories such as the APT, and the PVM, however, illustrate the dynamic relationship between the stock market and economic activity by admitting that the information regarding the movement of macroeconomic variables are important to predict the future prices of securities, and the players of the stock market are able to earn abnormal profits by using such macroeconomic information. These theories demonstrate the stock market’s sensitivity by incorporating the information of macroeconomic variables. Thus, there arises a contradiction between EMH and asset pricing theories. Furthermore, these theories raise the following fundamental questions, which motivate this research work.

Could the time series analyses of stock market indices be explained by underlying aggregate macroeconomic variables? If so, then how significant are the relationships, and how can they be described?

1.3. Objectives of the Study

Given the background previously provided, the principal objective of the present study is to investigate the effect of macroeconomic variables on stock prices in India and to explain the dynamic relationship between the stock prices and each of the macroeconomic variables selected in this study. The principal objectives can be decomposed into the following specific objectives:

(i)	to enquire whether the key macroeconomic variables included in this study have long-run equilibrium relationships with the stock prices in India, represented by the stock price index of the Bombay Stock Exchange (Sensex) and that of the National Stock Exchange of India (S&P CNX Nifty);
(ii)	to explore the short-run dynamics in the relationships between macroeconomic variables and the security prices in India;
(iii)	to enquire whether the individual macroeconomic variables considered in this study have a causal relationship with stock price movement during the sample time period;
(iv)	to measure the effects of country-specific internal macroeconomic variables and external economic variables on stock price movements in India separately and jointly, and assess their relative importance in this regard; and
(v)	to examine how the stock prices respond to sudden changes (i.e., shocks) or innovations to the macroeconomic variables considered in the study.

1.4. Hypotheses of the Study

Keeping in mind the above-mentioned objectives of the study, we have formulated the following hypotheses, which will be tested by applying appropriate statistical and econometric tests.

Hypothesis—I:

Null Hypothesis (H₀): There is no long-run association among the selected macroeconomic variables and the stock prices in India during the period under study.

Alternative Hypothesis (H₁): H₀ is not true.

Hypothesis—II:

Null Hypothesis (H₀): There is no short-run dynamic in the relationships between macroeconomic variables ...

Table of contents

• Cover
• Title
• 1 Introduction
• 2 The Indian Stock Market and the Macroeconomic Environment—an Overview
• 3 Review of Related Literature
• 4 Research Design and Methodology
• 5 Analysis and Findings of the Study
• 6 Summary and Conclusion
• Bibliography
• Index