Contents: Foreign exchange marketing

Currency Exchange Rate Appreciation/depreciation of currency Exchange rate regime Foreign Exchange Market participants Foreign exchange transactions Global foreign exchange market turnover Trading Hours INDIAN FX MARKET Stock markrting

Classification of financial marketing

BSE-SENSEX NSE-NIFTY TEST AND RESULTS FINDINGS CONCLUSION

Introduction
Globalization and financial liberalization in India have brought about battery of changes in the financial functioning of the economy, as a result of which, the resultant gain of the global integration of domestic and foreign financial markets has thrown open new opportunities but at the same time exposed the financial system to significant risks. Consequently, it is important to understand the mutual relationship between the financial markets from the standpoint of financial stability. Though the inception of the financial sector reforms has taken place initiated in the beginning of the 1990s, particularly since 1997, there has been a dramatic change in the functioning of the financial sector of the economy. The recent emergence of new capital markets, the relaxation of foreign capital controls and the adoption of more flexible exchange rate regimes have increased the interest of academics and practitioners in studying the interactions between the stock and foreign exchange markets. The gradual abolition of foreign exchange controls in emerging economies like India has opened the possibility of international investment and portfolio diversification. At the same time, the adoption of more flexible exchange rate regimes by these countries in the late 1980s and early 1990s has increased the volatility of foreign exchange markets and the risk associated with such investments. The advent of floating exchange rates, opening up of current account, Liberalization of capital account, reduction of customs duties, the development of 24-hour screen based global trading, the increased use of national currencies outside the country of issue and innovations in internationally traded financial products have led to the cross Country linkages of capital markets and international integration of domestic economy. Altogether, the whole gamut of institutional reforms, introduction of new instruments, change in procedures, widening of network of participants, call for a reexamination of the relationship between the stock market and the foreign sector of India.

The process of economic liberalization and thrust on reforms in the financial sector and the foreign exchange market in particular that was initiated in India in early nineties has resulted into increasing integration of the Indian FX market with that of the global markets. With a large number of foreign funds and foreign institutional investors now actively participating in the Indian financial markets (foreign exchange reserves standing at about USD118 bn), the style of functioning of the market itself has undergone a lot of change and result of microstructure changes are visible. Today the Indian FX market, which was insulated from outside impacts, has been getting integrated with the world markets. An exchange rate has two effects on stock prices, a direct effect through Multi National Firms and an indirect effect through domestic firms. In case of Multi National Firms involved in exports, a change in rate will change the demand of its product in the international market, which ultimately reflects in its B/S as profit or loss. Once the profit or loss is declared, the stock price will also change for a domestic firm.

On the other hand, currency devaluation could either raise or decrease a firms stock prices. This depends on the nature of the firms operations. A domestic firm that exports part of its output will benefit directly from devaluation due to an increase in demand for its output. As higher sales result in higher profits, local currency devaluation will cause firm stock price to rise in general. On the other hand, if the firm is a user of imported inputs, currency devaluation will raise cost and lower profits. Thus, it will decrease the firms stock price.

Scope of the study

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The study includes only one currency pair i.e. INR/USD for the representation of the forex market while the two major stock markets of India are covered. Thus the relation and effects of other currencies is out of the preview of the research. The data set comprises of daily closing price of Sensex, Nifty and INR/USD exchange rates obtained from the respective Stock Exchange and Reserve Bank of India websites. The sample population of the study comprises of daily closing price, for of BSE Sensex, CNX Nifty and exchange rates of Rupee/Dollar are considered for analyzing.

Benefits
The determination of relationship between the foreign exchange market and stock market would help the students to increase their understanding about these markets. It would also provide a platform for participants to enhance their views about the relationship between the two markets.

Limitations
Unavailability of intra-day minute to minute data of both the markets. The study is limited to period of eight years. Only one pair of USD/INR is used.

3.) Foreign Exchange Market:

The foreign exchange market exists wherever one currency is traded for another. It is by far the largest market in the world, in terms of cash value traded, and includes trading between large banks, central banks, currency speculators, multinational corporations, governments, and other financial markets and institutions. The trade happening in the forex markets across the globe currently exceeds US$1.9 trillion/day (on average). Retail traders (individuals) are currently a very small part of this market and may only participate indirectly through brokers or banks.

The foreign exchange market provides the physical and institutional structure through which the money of one country is exchanged for that of another country, the rate of exchange between currencies is determined, and foreign exchange transactions are physically completed. The retail market for foreign exchange deals with transactions involving travelers and tourists exchanging one currency for another in the form of currency notes or travelers cheques. The wholesale market often referred to as the interbank market is entirely different and the participants in this market are commercial banks, corporations and central banks.

Currency Exchange Rate:

The Exchange rate or FX rate is the rate between two currencies specifies how much one currency is worth in terms of the other. For example an exchange rate of 33 Indian Rupees (IND, Rs.) to the United States Dollar (USD, $) means that IND 33 is worth the same as USD 1. The foreign exchange market is one of the largest markets in the world. By some estimates, about 2 trillion USD worth of currency changes hands every day. The Spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date.

Quotations An exchange rate quotation is given by stating the number of units of a price currency that can be bought in terms of 1 unit currency (also called base currency). In a quotation that says the JPN/USD exchange rate is 120 (USD per JPN), the price currency is USD and the unit currency is JPN.

Quotes
Direct quote is a quote using a countrys home currency as the price currency (e.g.,Rs.33 = $ 1 in India) and is used by most countries. Indirect quote is a quote using a countrys home currency as the unit currency (e.g, $ 0.03 = Rs. 1 in India) and is used in British newspapers and are also common in Australia, New Zealand and Canada.

Appreciation/depreciation of currency:
While using direct quotation, if the home currency is strengthening (i.e., appreciating, or becoming more valuable) then the exchange rate number decreases. Conversely if the foreign currency is strengthening, the exchange rate number increases and the home currency is depreciating.

Exchange rate regime:

The exchange rate regime is the way a country manages its currency in respect to foreign currencies and the foreign exchange market. It is closely related to monetary policy and the two are generally dependent. A floating exchange rate or a flexible exchange rate is a type of exchange rate regime wherein a currencys value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency. A pegged float is pegged to some band or value, either fixed or periodically adjusted. Pegged floats are Crawling bands, Crawling pegs and Pegged with horizontal bands. A fixed rate is that rate that has direct convertibility towards another currency. Here, the currency is backed one to one by foreign reserves.

Functions of foreign exchange market:

The foreign exchange market is the mechanism by which participants Transfer purchasing power between countries, Obtain or provide credit for international trade transactions, and Minimize exposure to the risks of exchange rate changes

Foreign Exchange Market participants:

The foreign exchange market consists of two tiers: the interbank or wholesale market and The client or retail market.

Five broad categories of participants operate within these two tiers: Bank and nonblank foreign exchange dealers:

Banks and a few nonblank foreign exchange dealers operate in both the interbank and client markets. They profit from buying foreign exchange at a bid price and reselling it at a slightly higher ask price. Dealers in the foreign exchange departments of large international banks often function as market makers. Currency trading is quite profitable for commercial and investment banks. Small to medium sized banks are likely to participate but not as market makers in the interbank market. Instead of maintaining significant inventory positions, they buy from and sell to large banks to offset retail transactions with their own customers.

Individuals and firms conducting commercial or investment Transactions:

Importers and exporters, international portfolio investors, Multi National Enterprises, tourists, and others use the foreign exchange market to facilitate execution of commercial or investment transactions. Some of these participants use the market to hedge foreign exchange risk. Speculators and arbitragers:

Speculators and arbitragers seek to profit from trading in the market itself. They operate in their own interest, without a need or obligation to serve clients or to ensure a continuous market. A large proportion of speculation and arbitrage is conducted on behalf of major banks by traders employed by those banks. Thus banks act both as exchange dealers and as speculators and arbitrages. Central banks and treasuries:

Central bank and treasuries use the market to acquire or spend their countrys foreign exchange reserves as well as to influence the price at which their own currency is traded. They may act to support the value of their own currency because of policies adopted at the national level or because of commitments entered into through membership in joint float agreements. Foreign exchange brokers:

Foreign exchange brokers are agents who facilitate trading between dealers. Brokers charge small commission for the service provided to dealers. They maintain instant access to hundreds of dealers world wide via open telephone lines.

Foreign exchange transactions

Transactions within the foreign exchange market are executed either on a spot basis, requiring settlement two days after the transaction, or on a forward or swap basis, which requires settlement at some designated future date. To be successful in the foreign exchange markets, one has to anticipate price changes by keeping a close eye on world events and currency fluctuations.
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Global foreign exchange market turnover:

According to the Bank for International Settlements, average daily turnover in global foreign exchange markets is estimated at $3.98 trillion as of April 2007. Trading in the worlds main financial markets accounted for $3.21 trillion of this. This approximately $3.21 trillion in main foreign exchange market turnover was broken down as follows: Components are: $621 billion in spot $1.26 trillion in derivatives $208 billion in outright forwards $944 billion in forex swaps $107 billion in FX options

Of the $3.98 trillion daily global turnover, trading in London accounted for around $1.36 trillion, or 34.1% of the total, making London by far the global center for foreign exchange. In second and third places respectively, trading in New York accounted for 16.6%, and Tokyo accounted for 6.0%.[4] In addition to traditional turnover, $2.1 trillion was traded in derivatives. Exchange-traded FX futures contracts were introduced in 1972 at the Chicago Mercantile Exchange and are actively traded relative to most other futures contracts. Several other developed countries also permit the trading of FX derivative products (like currency futures and options on currency futures) on their exchanges. All these developed countries already have fully convertible capital accounts. Most emerging countries do not permit FX derivative products on their exchanges in view of prevalent controls on the capital accounts. However, a few select emerging countries (e.g., Korea, South Africa, and India) have already successfully experimented with the currency futures exchanges, despite having some controls on the capital account.

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Source: BIS Triennial Survey 2007

Source: BIS Triennial Survey 2007

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Structure

Decentralized interbank market Main participants: Central Banks, commercial and investment banks, hedge funds, corporations & private speculators

The free-floating currency system arose from the collapse of the Bretton Woods agreement in 1971

Online trading began in the mid to late 1990s

Trading Hours

24 hour market Sunday 5pm EST through Friday 4pm EST. Trading begins in the Asia-Pacific region followed by the Middle East, Europe, and America

Size

One of the largest financial markets in the world $3.2 trillion average daily turnover, equivalent to:

o o o o

More than 10 times the average daily turnover of global equity markets1 More than 35 times the average daily turnover of the NYSE2 Nearly $500 a day for every man, woman, and child on earth3 An annual turnover more than 10 times world GDP4

The spot market accounts for just under one-third of daily turnover

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1. About $280 billion - World Federation of Exchanges aggregate 2006 2. 3. About Based $87 on billion World of Federation 6.6 billion of Exchanges US Census 2006 Bureau world population

4. About $48 trillion - World Bank 2006.

Major Markets

The US & UK markets account for just over 50% of turnover Major markets: London, New York, Tokyo Trading activity is heaviest when major markets overlap Nearly two-thirds of NY activity occurs in the morning hours while European markets are open

Average Daily Turnover by Geographic Location

Source: BIS Triennial Survey 2007

Concentration in the Banking Industry

12 banks account for 75% of turnover in the U.K. 10 banks account for 75% of turnover in the U.S.
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3 banks account for 75% of turnover in Switzerland 9 banks account for 75% of turnover in Japan

Source: BIS Triennial Survey 2007

Currencies

The US dollar is involved in over 80% of all foreign exchange transactions, equivalent to over US$2.7 trillion per day

Currency Codes

USD = US Dollar EUR = Euro JPY = Japanese Yen GBP = British Pound CAD = Canadian Dollar AUD = Australian Dollar NZD = New Zealand Dollar

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Average Daily Turnover by Currency

N.B. Because two currencies are involved in each transaction, the sum of the percentage shares of individual currencies totals 200% instead of 100%. Source: BIS Triennial Survey 2007

Currency Pairs

Majors: EUR/USD (Euro-Dollar), USD/JPY, GBP/USD - (commonly referred to as the Cable), USD/CHF

Dollar bloc: USD/CAD, AUD/USD, NZD/USD Major crosses: EUR/JPY, EUR/GBP, EUR/CHF

Average Daily Turnover by Currency Pair

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Source: BIS Triennial Survey 2007

Factors affecting Exchange rates:

The prime factor that affects currency prices are supply and demand forces. The three factors include: Economic factors: Government budget deficits or surpluses Balance of trade levels and trends Inflation levels and trends Economic growth and health

Political conditions: Political upheaval and political instability Relation between two countries

Market psychology:
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Flights to quality Economic numbers Long-term trends

Indian FX Market

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India foreign exchange reserve is at $ 278.7 Billion USD (Feb 5, 2010) NSE has witnessed healthy growth in the turnover and open interest positions during its first completed month of currency futures trading in India. NSE commenced currency futures trading in India on 29th August. CDX (Currency Derivative Exchange), currency derivative segment of BSE (Bombay Stock Exchange) commenced currency futures trading from 1st October. BSE on its very first day of trading in currency futures clocked a turn over of about 65,000 contracts, which is approximately Rs. 300 Crores. With ever-growing global financial crisis, exchange rates are fluctuating widely. INR exchange rate has touched 47 against USD. Currency futures trading in India has generated huge interest among Indian retail investors and traders. There is a strong demand for information gathering about the intricacies of currency futures from small investors and enterprises. After over a year of introduction of exchange-traded currency futures in the USD-INR pair on the stock exchanges in the country, the market regulators have now permitted trading of Euro-INR, Japanese Yen-INR and Pound Sterling-INR on the exchange platform. This is a move that the market had been demanding for a long time. This is an apt time to review how the exchange-traded currency market has fared so far and what lies ahead as it ventures further into new currency pairs. The currency derivatives segment on the NSE and MCX has witnessed consistent growth both in traded value and open interest since its inception. The total turnover in the segment has increased incredibly from $3.4bn in October 2008 to $84bn in December 2009. The average daily turnover reached $4bn in December 2009. Open interest in the segment on the NSE and MCX stood at around 4 lakh contracts till end-December 2009. India already has an active over-the-counter (OTC) market in currency derivatives where the average daily turnover was $29bn in 2008 and $21bn in 2009 (till September 2009). This market is being driven by its ability to meet the respective needs of participants. For example, it is used by importers/exporters to hedge their payables/receivables; foreign
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institutional investors (FIIs) and NRIs use it to hedge their investments in India; borrowers find it an effective way to hedge their foreign currency loans and resident Indians find it an effective tool to hedge their investments offshore. Further, for arbitrageurs it presents an opportunity to arbitrage between onshore and non-deliverable forward (NDF) markets.

The exchange-traded currency futures market is an extension of this already available OTC market, but with added benefits of greater accessibility to potential participants; high price transparency; high liquidity; standardised contracts; counterparty risk management through clearing corporation and no requirement of underlying exposure in the currency. As the market participants are realising these benefits of exchange-traded market in currency, they are choosing this market over OTC. However, it is too early to see a major shift in activity from OTC to exchange-traded market as it has created a niche for itself and it would perhaps take some time for the currency futures market to create one for itself. Globally, too, the foreign exchange market is largely OTC in character. While the notional amount outstanding of OTC derivatives was as high as $63trn in June 2008, the exchange-traded market is rather non-existent with notional amount outstanding as end-June 2009 being only 0.5% of that in the OTC segment.

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However, there is a renewed debate on the level of transparency and counterparty risk in the OTC market kindled by the sub-prime mortgage crisis in the US and the need to regulate OTC transactions effectively. This throws up certain important issues which, at best, may need to be handled separately. India has, in this light, embarked upon an experiment by attempting to make the exchangetraded currency market popular and a first choice for investors. Though the market has not been able to evince the kind of activity that the OTC market has witnessed as yet, the recent phenomenal growth is a pointer towards better days ahead for this market. Some of the issues plaguing the market at present include the fact that many corporates using currency derivatives for hedging their foreign currency exposure find the requirement of margin and settlement of daily mark-to-market differences cumbersome, especially since there is no such requirement for OTC trades. It would conceivably take some time for them to realise the concomitant benefits of these risk containment measures. Also, there is a perceived resistance to change and switchover from OTC to exchange-traded framework following a level of comfortability reached by market players with the OTC market framework. Further, the market has been restricted in a number of ways. Till recently only USD-INR futures contracts were permitted. One hopes to see more activity in the segment with more currency pairs being added. Also to start with, FIIs have not been permitted to participate in this market. This has in effect restricted the liquidity that FIIs could have otherwise created. FIIs are already active in Dubai Gold and Commodity Exchange (DGCX). There is an opportunity for business for domestic exchanges and intermediaries to be created in bringing this market onshore. According to the latest release from DGCX, Indian rupee futures volume rose 530% in 2009 to 66,346 contracts on the exchange. Volume in December 2009 was 346% higher compared with the same period last year. Though small in comparison to volumes being traded on Indian exchanges, there is still merit in getting this market onshore. Additionally, the offshore NDF market in Indian rupee has also been witnessing increasing volumes. The average daily volumes on the NDF rupee market have increased from $38mn in 2003 Q1 to $800mn during 2008-09 (Asian Capital Markets Monitor of ADB, April, 2009). Most of the major foreign banks offer NDFs, but Indian banks are barred from doing so. These markets have evolved for the Indian rupee following

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foreign exchange convertibility restrictions. It is serving as an avenue for non-domestic players, private companies and investors in India to hedge foreign currency exposure. It also derives liquidity from non-residents wishing to speculate in the Indian rupee without exposure to the currency and from arbitrageurs who try to exploit the differentials in the prices in the onshore and offshore markets. Though foreign investors can now transact in the onshore Indian forward markets with greater flexibility following various measures taken by RBI in recent years, allowing them access to the exchange-traded currency futures platform would further help in getting the volumes in the NDF market onshore and enhance liquidity on domestic exchanges. India has witnessed enhanced foreign investment inflows and trade flows in recent years. The Indian currency is now becoming an important international currency. Though India accounts for a very small proportion of the total foreign exchange market turnover in the world as compared to other countries, its share has been slowly but continuously increasing. According to BIS estimates, the percentage share of Indian rupee in total daily average foreign exchange turnover has increased from 0.1% in 1998 to 0.2% in 2001 to 0.3% in 2004 and to 0.9% in April 2007 (updated data will be available in April 2010). All of this implies greater need for hedging currency risk in Indian rupee, particularly given that the exchange rate has been quite volatile during the last few years and hence increased importance of exchange-traded currency market.

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Fluctuations in USD/INR over the years

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Table of year on year data of FIIs and Foreign exchange Reserve of India:-

Particulars

FII Investment (Rs. Cr)

SENSEX (Annual increase or decrease)

Foreign Exchange Reserve (billion $)

2004 2005 2006 2007 2008 2009

22789.3 45337.9 28092.6 60057.2 -53562.6 24574.3

730.21 2,771.44 4,364.42 6,459.22 -10,677.96 4,773.29

125 127 160 260 245 265

Source: SEBI Website 2010

5.) Stock Market:

A stock market is a market for the trading of company stock and derivatives of same; both of these are securities listed on a stock exchange as well as those only traded privately.

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Functions of stock exchanges:

Most important source for companies to raise money Provides liquidity to the investors Acts as clearing house for transactions Provides realistic value of companies

India has 22 stock exchanges and the important stock exchanges are Bombay Stock Exchange and National Stock exchange at Mumbai. Established in 1875 BSE is one of the oldest stock exchanges in Asia and has seen significant development ever since. The regulatory agency which oversees the functioning of stock markets is the Securities and Exchange Board of India (SEBI), which is also located in Bombay.

Classification of financial markets

i) Unorganized Markets

In these markets there a number of money lenders, indigenous bankers, traders etc. who lend money to the public. ii) Organized Market

In organized markets, there are standardized rules and regulations governing their financial dealings. There is also a high degree of institutionalization and instrumentalization. These markets are subject to strict supervision and control by the RBI or other regulatory bodies. Organized markets can be further divided into capital market and Money market.

Capital market
Capital market is a market for financial assets which have a long or definite maturity.
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Which can be further divided into Industrial Securities Market Government Securities Market Long Term Loans Market

Industrial Securities Market It is a market where industrial concerns raise their capital or debt by issuing appropriate Instruments. It can be subdivided into two. They are: Primary Market or New Issues Market Primary market is a market for new issues or new financial claims. Hence, it is also called as New Issues Market. The primary market deals with those securities which are issued to the public for the first time.

Secondary Market or Stock Exchange Secondary market is a market for secondary sale of securities. In other words, securities which have already passed through the new issues market are traded in this market.

Such securities are listed in stock exchange and it provides a continuous and regular market for buying and selling of securities. This market consists of all stock exchanges recognized by the government of India.

Importance of Capital Market

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Absence of capital market serves as a deterrent factor to capital formation and economic growth. Resources would remain idle if finances are not funneled through capital market. It provides incentives to saving and facilitates capital formation by offering suitable rates of interest as the price of the capital It serves as an important source for the productive use of the economys savings. It provides avenue for investors to invest in financial assets. It facilitates increase in production and productivity in the economy and thus enhances the economic welfare of the society. A healthy market consisting of expert intermediaries promotes stability in the value of securities representing capital funds. It serves as an important source for technological up gradation in the industrial sector by utilizing the funds invested by the public. The major stock indices also have a correlation with the currency rates. Three major forces affect the indices: 1) Corporate earnings, forecast and actual; 2) Interest rate expectations and 3) Global considerations.

Consequently, these factors channel their way through the local currency. In an increasingly complex scenario of the financial world, it is of paramount importance for the researchers, practitioners, market players and policy makers to understand the working of the economic and the financial system and assimilate the mutual interlink ages between the stock and foreign exchange markets in forming their expectations about the

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future policy and financial variables. The analysis of dynamic and strategic interactions between stock and foreign exchange market came to the forefront because these two markets are the most sensitive segments of the financial system and are considered as the barometers of the economic growth through which the countrys exposure towards the outer world is most readily felt. The present study is an endeavor in this direction. Before going to discuss further about the interlink ages between the stock and foreign exchange market, it is better to highlight the evolutions and perspectives that are associated with both the markets since liberalization in the Indian context. In the literature, there is theoretical consensus neither on the existence of relationship between stock prices and exchange rates nor on the direction of relationship. In theory there are two approaches to exchange rate determination. They areFlow oriented - are considered as the traditional approach and assume that the exchange rate is determined largely by countrys current account or trade balance performance. The model posits that changes in exchange rates affect international competitiveness and trade balance, thereby influencing real economic variables such as real income and output (Dornbusch and Fisher, 1980). This model represents a positive relationship between stock prices and exchange rates with direction of causation running from exchange rates to stock prices. Stock-oriented - models put much emphasis on the role of financial (formerly capital) account in the exchange rate determination. These Models can be distinguished as portfolio balance models and monetary models (Branson and Frankel, 1983). They postulate a negative relationship between stock prices and exchange rates and come to the conclusion that stock prices have an impact on exchange rates.

BSE - SENSEX

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Introduction Bombay Stock Exchange is the oldest stock exchange in Asia with a rich heritage of over 133 years of existence. What is now popularly known as BSE was established as The Native Share & Stock Brokers Association in 1875.

BSE is the first stock exchange in the country which obtained permanent recognition (in 1956) from the Government of India under the Securities Contracts (Regulation) Act (SCRA) 1956. BSEs pivotal and pre-eminent role in the development of the Indian capital market is widely recognized. It migrated from the open out-cry system to an online screenbased order driven trading system in 1995. Earlier an Association Of Persons (AOP), BSE is now a corporatised and demutualised entity incorporated under the provisions of the Companies Act, 1956, pursuant to the BSE (Corporatisation and Demutualisation) Scheme, 2005 notified by the Securities and Exchange Board of India (SEBI). With demutualisation, BSE has two of worlds prominent exchanges, Deutsche Brse and Singapore Exchange, as its strategic partners.

Over the past 133 years, BSE has facilitated the growth of the Indian corporate sector by providing it with cost and time efficient access to resources. There is perhaps no major corporate in India which has not sourced BSEs services in raising resources from the capital market.

Today, BSE is the worlds number 1 exchange in terms of the number of listed companies and the worlds 5th in handling of transactions through its electronic trading system. The companies listed on BSE command a total market capitalization of USDTrillion 1.06 as of July, 2009. BSE reaches to over 400 cities and town nation-wide and has around 4,937 listed companies, with over 7745 scrips being traded as on 31st July 09.

The BSE Index, SENSEX, is Indias first and most popular stock market benchmark index. Sensex is tracked worldwide. It constitutes 30 stocks representing 12 major sectors. The

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SENSEX is constructed on a free-float methodology, and is sensitive to market movements and market realities. Apart from the SENSEX, BSE offers 23 indices, including 13 sectoral indices. It has entered into an index cooperation agreement with Deutsche Brse and Singapore Stock Exchange. These agreements have made SENSEX and other BSE indices available to investors across the globe. Moreover, Barclays Global Investors (BGI), atHong Kong, the global leader in ETFs through its iShares brand, has created the exchange traded fund (ETF) called iSharesBSE SENSEX India Tracker which tracks the SENSEX. The ETF enables investors in Hong Kong to take an exposure to the Indian equity market.

The exchange traded funds (ETF) on SENSEX, called SPIcE and Kotak SENSEX ETF are listed on BSE. They bring to the investors a trading tool that can be easily used for the purposes of investment, trading, hedging and arbitrage. These ETFs allow small investors to take a long-term view of the market.

BSE provides an efficient and transparent market for trading in equity, debt instruments and derivatives. It has always been at par with the international standards. The systems and processes are designed to safeguard market integrity and enhance transparency in operations. BSE is the first exchange in India and the second in the world to obtain an ISO 9001:2000 certification. It is also the first exchange in the country and second in the world to receive Information Security Management System Standard BS 7799-2-2002 certification for its BSE On-line Trading System (BOLT).

Recently,BSE launched the BSE IPO index that will track the value of companies for two years after listing. Also, as an investor friendly gesture, Bombay Stock Exchange has commenced a facility of sending trade details to investors. Moving a step further a new transaction fee structure for cash equity segment has also been introduced. BSE also launched BSE StAR MF Mutual fund trading platform, would enable exchanges members to use its existing infrastructure for transaction in MF schemes. It is an inclusive

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model with two depositories and industry wide participation. BSE also revamped its website; the new website presents a wide range of new features like Live streaming quotes for SENSEX companies, Advanced Stock Reach, Sensex View, Market Galaxy, and Members.

SENSEX - The Barometer of Indian Capital Markets Introduction SENSEX, first compiled in 1986, was calculated on a Market Capitalization-Weighted methodology of 30 component stocks representing large, well-established and financially sound companies across key sectors. The base year of SENSEX was taken as 1978-79. SENSEX today is widely reported in both domestic and international markets through print as well as electronic media. It is scientifically designed and is based on globally accepted construction and review methodology. Since September 1, 2003, SENSEX is being calculated on a free-float market capitalization methodology. The free-float market capitalization-weighted methodology is a widely followed index construction methodology on which majority of global equity indices are based; all major index providers like MSCI, FTSE, STOXX, S&P and Dow Jones use the free-float methodology. The growth of the equity market in India has been phenomenal in the present decade. Right from early nineties, the stock market witnessed heightened activity in terms of various bull and bear runs. In the late nineties, the Indian market witnessed a huge frenzy in the TMT sectors. More recently, real estate caught the fancy of the investors. SENSEX has captured all these happenings in the most judicious manner. One can identify the booms and busts of the Indian equity market through SENSEX. As the oldest index in the country, it provides the time series data over a fairly long period of time (from 1979 onwards). Small wonder, the SENSEX has become one of the most prominent brands in the country. Index Specification: Base Year 1978-79

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Base Index Value 100 Date of Launch Method calculation 01-01-1986 of Launched on full market capitalization method and effective September 01, 2003, calculation method shifted to free-float market capitalization.

Number of scripts 30 Index calculation Real Time frequency

SENSEX Calculation Methodology

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SENSEX is calculated using the Free-float Market Capitalization methodology, wherein, the level of index at any point of time reflects the free-float market value of 30 component stocks relative to a base period. The market capitalization of a company is determined by multiplying the price of its stock by the number of shares issued by the company. This market capitalization is further multiplied by the free-float factor to determine the free-float market capitalization. The base period of SENSEX is 1978-79 and the base value is 100 index points. This is often indicated by the notation 1978-79=100. The calculation of SENSEX involves dividing the free-float market capitalization of 30 companies in the Index by a number called the Index Divisor. The Divisor is the only link to the original base period value of the SENSEX. It keeps the Index comparable over time and is the adjustment point for all Index adjustments arising out of corporate actions, replacement of scrips etc. During market hours, prices of the index scrips, at which latest trades are executed, are used by the trading system to calculate SENSEX on a continuous basis. SENSEX - Scrip Selection Criteria The general guidelines for selection of constituents in SENSEX are as follows: Listed History: The scrip should have a listing history of at least 3 months at BSE. Exception may be considered if full market capitalization of a newly listed company ranks among top 10 in the list of BSE universe. In case, a company is listed on account of merger/ demerger/ amalgamation, minimum listing history would not be required.

Trading Frequency: The scrip should have been traded on each and every trading day in the last three months at BSE. Exceptions can be made for extreme reasons like scrip suspension etc.

Final Rank: The scrip should figure in the top 100 companies listed by final rank. The final rank is arrived at by assigning 75% weight age to the rank on the basis of three-month average full market capitalization and 25% weight age to the liquidity rank based on three32

month

average

daily

turnover

&

three-month

average

impact

cost.

Market Capitalization Weightage: The weight age of each scrip in SENSEX based on three-month average free-float market capitalization should be at least 0.5% of the Index.

Industry/Sector Representation: Scrip selection would generally take into account a balanced representation of the listed companies in the universe of BSE.

Track Record: In the opinion of the BSE Index Committee, the company should have an acceptable track record.

BSE has designed a Free-float format, which is filled and submitted by all index companies on a quarterly basis. BSE determines the Free-float factor for each company based on the detailed information submitted by the companies in the prescribed format. Free-float factor is a multiple with which the total market capitalization of a company is adjusted to arrive at the Free-float market capitalization. Once the Free-float of a company is determined, it is rounded-off to the higher multiple of 5 and each company is categorized into one of the 20 bands given below. A Free-float factor of say 0.55 means that only 55% of the market capitalization of the company will be considered for index calculation. Index Closure Algorithm The closing SENSEX on any trading day is computed taking the weighted average of all the trades on SENSEX constituents in the last 30 minutes of trading session. If a SENSEX constituent has not traded in the last 30 minutes, the last traded price is taken for computation of the Index closure. If a SENSEX constituent has not traded at all in a day, then its last days closing price is taken for computation of Index closure. The use of Index Closure Algorithm prevents any intentional manipulation of the closing index value. Maintenance of SENSEX

33

One of the important aspects of maintaining continuity with the past is to update the base year average. The base year value adjustment ensures that replacement of stocks in Index, additional issue of capital and other corporate announcements like rights issue etc. do not destroy the historical value of the index. The beauty of maintenance lies in the fact that adjustments for corporate actions in the Index should not per se affect the index values. The BSE Index Cell does the day-to-day maintenance of the index within the broad index policy framework set by the BSE Index Committee. The BSE Index Cell ensures that SENSEX and all the other BSE indices maintain their benchmark properties by striking a delicate balance between frequent replacements in index and maintaining its historical continuity. The BSE Index Committee comprises of capital market expert, fund managers, market participants and members of the BSE Governing Board. On-Line Computation of the Index During trading hours, value of the Index is calculated and disseminated on real time basis. This is done automatically on the basis of prices at which trades in Index constituents are executed. Index Review Frequency The BSE Index Committee meets every quarter to discuss index related issues. In case of a revision in the Index constituents, the announcement of the incoming and outgoing scrips is made six weeks in advance of the actual implementation of the revision of the Index. Constituents of BSE sensex1 Reliance Industries 2 ONGC 3 Bharti Airtel 4 Tata Consultancy 5 Infosys tech 6 Reliance Communication 16 DLF 17 Hero Honda 18 Dr Reddys 19 Tata motors 20 Tata steel 21 Bajaj auto
34

7 Wipro 8 ICICI Bank 9 ACC

22 GAIL 23 Maruti udyog 24 Sun pharma

NSE - NIFTY
The Organization The National Stock Exchange of India Limited has genesis in the report of the High Powered Study Group on Establishment of New Stock Exchanges. It recommended promotion of a National Stock Exchange by financial institutions (FIs) to provide access to investors from all across the country on an equal footing. Based on the recommendations, NSE was promoted by leading Financial Institutions at the behest of the Government of India and was incorporated in November 1992 as a tax-paying company unlike other stock exchanges in the country. The following years witnessed rapid development of Indian capital market with introduction of internet trading, Exchange traded funds (ETF), stock derivatives and the first volatility index - IndiaVIX in April 2008, by NSE. August 2008 saw introduction of Currency derivatives in India with the launch of Currency Futures in USD INR by NSE. Interest Rate Futures was introduced for the first time in India by NSE on 31st August 2009, exactly after one year of the launch of Currency Futures. With this, now both the retail and institutional investors can participate in equities, equity derivatives, currency and interest rate derivatives, giving them wide range of products to take care of their evolving needs. NSEs mission is setting the agenda for change in the securities markets in India. The NSE was set-up with the main objectives of:

35

establishing a nation-wide trading facility for equities, debt instruments and

hybrids, ensuring equal access to investors all over the country through an appropriate

communication network, providing a fair, efficient and transparent securities market to investors using

electronic trading systems, enabling shorter settlement cycles and book entry settlements systems, and meeting the current international standards of securities markets.

The standards set by NSE in terms of market practices and technology have become industry benchmarks and are being emulated by other market participants. NSE is more than a mere market facilitator. Its that force which is guiding the industry towards new horizons and greater opportunities.

NSE Milestones
November 1992 April 1993 April 1996 June 1996 Incorporation Recognition as a stock exchange Launch of S&P CNX Nifty Establishment of Settlement Guarantee Fund Setting up of National Securities Depository Limited, first depository in India, co-promoted by NSE Commencement of Internet Trading Commencement of Derivatives Trading (Index Futures)

November 1996

February 2000 June 2000

36

June 2001 July 2001 November 2001 August 2008 August 2009 November 2009

Commencement of trading in Index Options Commencement of trading in Options on Individual Securities Commencement of trading in Futures on Individual Securities Launch of Currency Derivatives Launch of Interest Rate Futures Launch of Mutual Fund Service System

S&P CNX Nifty

S&P CNX Nifty is a well diversified 50 stock index accounting for 22 sectors of the economy. It is used for a variety of purposes such as benchmarking fund portfolios, index based derivatives and index funds.

S&P CNX Nifty is owned and managed by India Index Services and Products Ltd. (IISL), which is a joint venture between NSE and CRISIL. IISL is Indias first specialized company focused upon the index as a core product. IISL has a Marketing and licensing agreement with Standard & Poors (S&P), who are world leaders in index services. The total traded value for the last six months of all Nifty stocks is approximately 52% of the traded value of all stocks on the NSE Nifty stocks represent about 63% of the Free Float Market Capitalization as on Dec 31, 2009. Impact cost of the S&P CNX Nifty for a portfolio size of Rs.2 crore is 0.10% S&P CNX Nifty is professionally maintained and is ideal for derivatives trading From June 26, 2009, S&P CNX Nifty is computed based on free float methodology.

37

Constituents of Nifty1 2 3 4 5 6 7 8 9 Reliance Industries ONGC Bharti Airtel Tata Consultancy Infosys tech Reliance Communication Wipro ICICI Bank ACC 26 Gujarat Ambuja 27 Cipla 28 Siemens 29 Ranbaxy 30 NTPC 31 ITC 32 VSNL 33 Zee Entertainment 34 MTNL 35 HPCL 36 Dabur
38

10 BHEL 11 SBI

12 Hindalco 13 HLL 14 L&T 15 HDFC 16 Satyam computers 17 Hero Honda 18 Dr Reddys 19 Tata motors 20 Tata steel 21 Bajaj auto 22 GAIL 23 Maruti udyog 24 Sun pharma 25 Grasim industries

37 IPCL 38 Jet Airways 39 Oriental Bank 40 Glaxo Smith 41 Tata power 42 BPCL 43 Reliance energy 44 Punjab National Bank 45 ABB 46 Hindalco 47 National Alu 48 M&M 49 Seagrams 50 HCL tech

Tests and Results

Test for StationarityA time series is said to be stationary if its mean and variance are constant over time and the value of the covariance between the two time periods depends only on the distance or gap or lag between the two time periods and not the actual time at which the covariance is computed. Tests for stationarity are routinely applied to highly persistent time series. Following Kwiatkowski, Phillips, Schmidt and Shin (1992), standard stationarity employs a rescaling by an estimator of the long-run variance of the (potentially) stationary series. Test
39

for stationarity is important in case of time series data because a nonstationary time series will have time varying mean or a time-varying variance or both. Hence the results cannot be extrapolated for the entire population. The test for stationarity can be done using Unit Root Test. It is due to the fact that = 1. If however, || 1, that is if the absolute value of is less than one, then it can be shown that the time series is stationary. Given that in most situations only one observation is available at a given time, stationarity ensures that all parts of the series are like the other parts, which allows us to estimate the needed parameters. Therefore, the mean, the variance and the covariance of the series are not functions of time and depend rather on the lag between the observations (the difference between the times at which two observations were recorded). To summarize, if Xt is a discrete time series, its distribution is described by its first two ments, which under stationarity must depend only on the lag:

Since all time series data sets contain either deterministic or stochastic trends (or both), unit root tests and stationarity tests are a way of determining which kind of trends are present in the data. If only deterministic trends are present, then the series can be seen as being generated by some non-random, pre-determined function of time with some random error thrown in. On the other hand, if stochastic trends are present, then the generating model of the series combines a starting value and a sequence of random innovations with zero mean and constant variance, which forms a more dynamic structure. In this case, each observation depends on its history of past random innovations, which greatly impact its current value. Thus, in the case of stochastic trends the value of a future observation depends on the values of present and past observations. Augmented Dickey Fuller Test-

40

An augmented Dickey-Fuller test is a test for a unit root in a time series sample. An augmented Dickey-Fuller test is a version of the Dickey-Fuller test for a larger and more complicated set of time series models. The augmented Dickey-Fuller (ADF) statistic, used in the test, is a negative number. The more negative it is, the stronger the rejections of the hypothesis that there is a unit root at some level of confidence. Under the Dickey-Fuller test the null hypothesis that = 0, the estimated t value of the coefficient of Yt-1 in follows the (tau) statistic. The values are arrived from Monte Carlo simulation. This test is conducted by augmenting the preceding three equations by adding the lagged values of the dependent variable Yt. So the required regression is: Yt = 1 + 2 t + Yt-1+ i Yt-i + t Where is a constant, the coefficient on a time trend and p the lag order of the autoregressive process. Imposing the constraints = 0 and = 0 corresponds to modeling a random walk and using the constraint = 0 corresponds to modeling a random walk with a drift. By including lags of the order p the ADF formulation allows for higher-order autoregressive processes. This means that the lag length p has to be determined when applying the test. One possible approach is to test down from high orders and examine the t-values on coefficients. An alternative approach is to examine information criteria such as the Akaike information criterion, Bayesian information criterion or the Hannon Quinn criterion. The unit root test is then carried out under the null hypothesis = 1 against the alternative hypothesis of < 1. Once a value for the test statistic

41

Computed it can be compared to the relevant critical value for the Dickey-Fuller Test. If the test statistic is less than the critical value then the null hypothesis of = 1 is rejected and no unit root is present Where t is a pure white noise error term and the number of lagged difference terms to include is often determined empirically, the idea being to include enough terms so that the error term in is serially uncorrelated. Dickey and Fuller (1979) found that the distributions of the t-statistics for the models given above are skewed to the left and have critical values that are quite large and negative. That means that if the standard t-distributions were used during testing; we would tend to over-reject the null hypothesis. One important element in the ADF test is the number of lags present in the model. It has been observed that the number of lagged factors has a great impact on the size and power properties of the ADF test and therefore it is important to precisely determine how many should be included in the model. Some advocate starting with a large number of lags, estimating their coefficients and eliminating the ones than are statistically insignificant at the chosen level. This process would continue until no insignificant terms are left in the model. we can include deterministic trends in the models (linear or non-linear) and the analysis goes along the same lines as in the case of the DF variants. The only modification is, once again, the presence of the lagged terms, which has to be determined with relatively high accuracy for the unit root tests to be effective. Then the test statistic T*(bOLS -1) has a known, documented distribution. Its value in a particular sample can be compared to that distribution to determine a probability that the original sample came from a unit root autoregressive process; that is, one in which b=1. Properties and Characteristics of Unit Root Processes Shocks to a unit root process have permanent effects, they do not decay Non-stationary processes have no long-run means to revert to after a shock

42

Their variance is time dependent and it goes to infinity as it goes to infinity I(1) processes can be rendered stationary and used for OLS estimation by taking their first differences yt = yt y

First the stationarity has been checked for the closing values of stock markets and settlement price of exchange market. If they are not stationary, then they are converted in logarithmic values in order to make them in a continuous form. And if yet the time series are not stationary, then daily returns are identified as the difference in the natural logarithm of the closing index value for the two consecutive trading days .It can be presented as: or

Where

is logarithmic daily return at time t.

and

are daily prices of an asset at

two successive days, t-1 and t respectively. In order to do time series analysis, transformation of original series is required depending upon the type of series when the data is in the level form. The series of return was transformed by taking natural logarithm. There are two advantages of this kind of transformation of the series. First it eliminates the possible dependence of changes in stock price index on the price level of the index. Second, the change in the log of the stock price index yields continuously compounded series. In the sample time series data i.e., BSE Sensex, NSE Nifty and Exchange Rate data have been tested for their stationarity and the results are as follows NIFTYLags ADF T Statistic 1 -47.87083 10% 1% Significance 5% Significance Significance value -2.566521 value -1.941037 value -1.616556

43

2 3 4 5 6 7 0

-40.58591 -31.87316 -28.52705 -25.85936 -24.74234 -24.03868 -62.48830

-2.566521 -2.566521 -2.566521 -2.566521 -2.566521 -2.566521 -2.566521

-1.941037 -1.941037 -1.941037 -1.941037 -1.941037 -1.941037 -1.941037

-1.616556 -1.616556 -1.616556 -1.616556 -1.616556 -1.616556 -1.616556

In the analysis we find that the calculated Tau statistic is significant even at 1% significant level

Hence we can conclude that the data set (NSE Nifty) is stationary at first difference.

Exchange RateLags ADF T Statistic 1 2 3 4 -57.28325 -47.72631 -41.01345 -35.61721 10% 1% Significance 5% Significance Significance value -2.566521 -2.566521 -2.566521 -2.566521 value -1.941037 -1.941037 -1.941037 -1.941037 value -1.616556 -1.616556 -1.616556 -1.616556

44

5 6 7 0

-30.38839 -28.16267 -27.03275 -84.83897

-2.566521 -2.566521 -2.566521 -2.566521

-1.941037 -1.941037 -1.941037 -1.941037

-1.616556 -1.616556 -1.616556 -1.616556

The log naturals of Exchange rate is found to be stationary at 1% significance level using Augmented Dickey Fuller test

The regression equation showed that the variables are stationary at 1% critical value.

SENSEX Lags ADF T Statistic 1 2 3 4 5 -47.43808 -40.74394 -32.83651 -28.26082 -26.08505 10% 1% Significance 5% Significance Significance value -2.566521 -2.566521 -2.566521 -2.566521 -2.566521 value -1.941037 -1.941037 -1.941037 -1.941037 -1.941037 value -1.616556 -1.616556 -1.616556 -1.616556 -1.616556

45

6 7 0

-24.84825 -24.23758 -60.11125

-2.566521 -2.566521 -2.566521

-1.941037 -1.941037 -1.941037

-1.616556 -1.616556 -1.616556

The data set of BSE Sensex is tested for stationarity using Augmented Dickey Fuller test

The Test showed that the data is Stationary at 1st difference The test is stationary at 1% critical value.

Testing for the distribution

A frequency distribution is a list of the values that a variable takes in a sample. It is usually a list, ordered by quantity, showing the number of times each value appears. Frequency distribution is said to be skewed when its mean and median are different. The kurtosis of a frequency distribution is the concentration of scores at the mean, or how peaked the distribution appears if depicted graphicallyfor example, in a histogram. If the distribution is more peaked than the normal distribution it is said to be leptokurtic; if less peaked it is said to be platykurtic. Normal distribution The importance of the normal distribution as a model of quantitative phenomena in the natural and behavioral sciences is due to the central limit theorem. Many psychological measurements and physical phenomena (like photon counts and noise) can be approximated well by the normal distribution. While the mechanisms underlying these phenomena are

46

often unknown, the use of the normal model can be theoretically justified by assuming that many small, independent effects are additively contributing to each observation. The normal distribution also arises in many areas of statistics. For example, the sampling distribution of the sample mean is approximately normal, even if the distribution of the population from which the sample is taken is not normal. In addition, the normal distribution maximizes information entropy among all distributions with known mean and variance, which makes it the natural choice of underlying distribution for data summarized in terms of sample mean and variance. The normal distribution is the most widely used family of distributions in statistics and many statistical tests are based on the assumption of normality. In probability theory, normal distributions arise as the limiting distributions of several continuous and discrete families of distributions. While statisticians and mathematicians uniformly use the term normal distribution for this distribution, physicists sometimes call it a Gaussian distribution and, because of its curved flaring shape, social scientists refer to it as the bell curve. Feller (1968) uses the symbol for in the above equation, but then switches to in Feller (1971). De Moivre developed the normal distribution as an approximation to the binomial distribution, and it was subsequently used by Laplace in 1783 to study measurement errors and by Gauss in 1809 in the analysis of astronomical data. The normal distribution is implemented in Mathematica as Normal Distribution [mu, sigma]. The so-called standard normal distribution is given by taking =0 and 2=1 in a general normal distribution. An arbitrary normal distribution can be converted to a standard normal distribution by changing variables to , yielding

Normal distributions have many convenient properties, so random variates with unknown distributions are often assumed to be normal, especially in physics and astronomy. Although this can be a dangerous assumption, it is often a good approximation due to a

47

surprising result known as the central limit theorem. This theorem states that the mean of any set of variates with any distribution having a finite mean and variance tends to the normal distribution. Many common attributes such as test scores, height, etc., follow roughly normal distributions, with few members at the high and low ends and many in the middle. Because they occur so frequently, there is an unfortunate tendency to invoke normal distributions in situations where they may not be applicable. As Lippmann stated, Everybody believes in the exponential law of errors: the experimenters, because they think it can be proved by mathematics; and the mathematicians, because they believe it has been established by observation (Whittaker and Robinson 1967, p. 179). Among the amazing properties of the normal distribution are that the normal sum distribution and normal difference distribution obtained by respectively adding and subtracting variates X and Y from two independent normal distributions with arbitrary means and variances are also normal! The data is tested for the distribution that it follows and the results are as follows Testing data for distribution- BSE Sensex Statistics N Mean Median Std. Deviation Variance Skewness Kurtosis Minimum 1982 -0.000871787 -0.001574715 0.013910821 0.000193511 0.697783705 5.990656093 -0.079310971

48

Maximum Sum

0.11809177 -1.29896276

Testing data for distribution- Exchange rate Statistics N Mean Median Std. Deviation Variance Skewness Kurtosis 1982 4.86383E-05 4.32641E-05 0.007563368 5.72045E-05 0.012718054 24.49873234

49

Minimum Maximum Sum

-0.07349314 0.064866809 0.072471089

Testing data for distribution- NSE Nifty Statistics N Mean Median Std. Deviation Variance Skewness 1982 -0.00081295 -0.000747853 0.014490351 0.00020997 0.953871738

50

Kurtosis Minimum Maximum Sum

9.916419963 -0.10247349 0.13053862 -1.211295894

Interpretation As can be seen from the above results the data sets of BSE Sensex, NSE Nifty and Exchange Rate follows normal distribution. Hence the data is capable for further testing. The variances of the data sets are 00 which confirms the data as to its stationarity.

Test for Co-integration Johnsons Co-integration test

51

Co integration is an econometric technique for testing the correlation between stationary time series variables. If two or more series are themselves stationary, and a linear combination of them is stationary, then the series are said to be co integrated. For instance, a stock market index and the price of its associated futures contract move through time, each roughly following a random walk. Testing the hypothesis that there is a statistically significant connection between the futures price and the spot price could now be done by finding a co integrating vector. (If such a vector has a low order of integration it can signify an equilibrium relationship between the original series, which are said to be co integrated of an order below one). It is often said that co integration is a means for correctly testing hypotheses concerning the relationship between two variables having unit roots (i.e. integrated of order one). Series is said to be integrated of order d if one can obtain a stationary series by differencing the term d times. Such that: C = Y dX (1) is stationary, where the parameter d is the co integrating parameter that links the two time series together. Further, the relationship Y = dX is considered to be a long-run, or equilibrium, relationship suggested by economic theory. Under such circumstances these markets are said to be co integrated. In contrast, lack of co integration implies that the aforementioned variables have no link in the long-run. If two, or more series, are co integrated, then there exist common factors that affect both and their permanent or secular trends, and so the series will eventually adjust to equilibrium. The implications for diversification are that even if, in the short-term the covariance between two series indicates portfolio benefits, in the long-run such benefits are spurious as the two series will eventually adjust to an equilibrium relationship. Hence, the existence of an equilibrium relationship between two or more variables, assuming that they all are integrated individually to the same degree, requires that the co integration between them is of a lower degree. That is if both X and Y are stationary I(1)

52

the co integration vector must be stationary I(0). However, if X and Y are integrated to different degrees, there will not be any parameter d that satisfies Equation (1). Thus a longrun relationship implies the requirement that the two variables should be (i) integrated to the same degree and (ii) a linear combination of the two variables should exist which is integrated to a lower degree than the individual variables. Testing for co integration involves two steps. 1. Determine the degree of integration in each of the series, a unit root analysis. 2. Estimate the co integration regression and test for integration. Assuming that each series has the same number of unit roots, the co integration test can commence. Engle and Granger (1987) proposed seven tests for examining the hypothesis that two time series are not co integrated. In co integration tests, the null hypothesis is nonco integration. Only two are used here both based on the using an OLS regression in the following form: Y = a + bX + m (3) where b is the estimator for the equilibrium parameter, d; a is the intercept; and m is the disturbance term. The first of the two tests of co integration is based on the Co integrating Regression Durbin-Watson (CRDW) statistic. As a simple rule of thumb for a quick evaluation of the co integration hypothesis Banerjee et al (1986) proposed that: if the CRDW statistic is smaller than the coefficient of determination (R2) the co integration hypothesis is likely to be false; otherwise, when CRDW> R2, co integration may occur. Alternatively the CRDW statistic can be evaluated against critical values developed by Engle and Granger (1987), if the CRDW statistic exceeds the critical value, the null hypothesis of non-co integration is rejected. Suggesting that the series are not co integrated. The test for co integration involves the significance of the estimated l1 coefficient. Again the null hypothesis is that the error terms are nonstationary and acceptance of this hypothesis indicates that the series under investigation are not integrated. If the t-statistic on the l1 coefficient exceeds the critical value, the m residuals from the co integration

53

regression equation (3) are stationary and the variables X and Y are co integrated. Critical values for this t statistic are given in Mackinnon (1991). Test: Johnsons Co-integration test Sample: 1 1982 Included observations: 1982 Series: 1. Exchange rate and NSE 2. Exchange rate and BSE Lags interval: 1 to 4 Eigenvalue 5% Likelihood ratio Value 0.169822854329 0.150445830265 540.15012665 252.22840788 19.96 9.24 Critical 1% Value 24.60** 12.97** Critical Hypothesized No. of CE(s) None At most 1

** indicates the rejection of integration between series at 1% and 5% significance level Interpretation As per Johnsons Co integration Test there exists no relationship between the two series i.e., Exchange rate and NSE Nifty and Exchange rate and BSE Sensex Through this test we can conclude that there is no long term relationship between exchange rate and stock indices.

Test for Cross correlation

54

Cross correlation is a standard method of estimating the degree to which two series are correlated. Consider two series x(i) and y(i) where i=0,1,2...N-1. The cross correlation r at delay d is defined as

Where mx and my are the means of the corresponding series. If the above is computed for all delays d=0, 1, 2, N-1 then it results in a cross correlation series of twice the length as the original series.

There is the issue of what to do when the index into the series is less than 0 or greater than or equal to the number of points. (i-d < 0 or i-d >= N) The most common approaches are to either ignore these points or assuming the series x and y are zero for i < 0 and i >= N. In many signal processing applications the series is assumed to be circular in which case the out of range indexes are wrapped back within range, ie: x(-1) = x(N-1), x(N+5) = x(5) etc. The period for cross correlation has been decreased to 1st January 2004 to 30th June 2009. This time period has been further segmented into duration of six months i.e. two equal halfs of a year to find out if there is any short run relation or spillover from one variable to another in this time period. 12 days lag is considered to see the lead/lag relation between the two variables.

Abbreviations

55

ER:

Exchange rate BSE Sensex

Sensex:

Nifty: CNX Nifty

NEGATIVE LAG ER INDEX INDEX ER LEADING LAGGING

POSITIVE LAG LAGGING LEADING

0.0910

0.0920

0.0889

0.0910

0.0910

0.1034

Correlation and T values of ER and SENSEX for the period 2004 to 2009 II half of I half of II half of I half of

I half of 2004 Lag Correlation 0.042 -12 (0.438) 0.033 -11 (0.344) 0.085 -10 (0.895)

2004 Correlation -0.011 (0.117) 0.087 (0.935) 0.099 (1.065)

2005 Correlation 0.126 (1.326) -0.093 (0.979) -0.017 (0.181)

2005 Correlation -0.011 (0.110) 0.123 (1.242) 0.108 (1.091)

2006 Correlation 0.038 (0.400) -0.001 (0.011) 0.012 (0.128)

56

0.003 -9 (0.032) -0.038 -8 (0.404) 0.092 -7 (0.979) 0.064 -6 (0.681) 0.182 -5 (1.957) 0.065 -4 (0.699) 0.119 -3 (1.293) 0.011 -2 (0.120) 0.055 -1 (0.598) 0.002 0 1 (0.022) 0.071

0.148 (1.609) -0.081 (0.880) 0.116 (1.261) 0.066 (0.725) 0.102 (1.121) -0.205 (2.253)* 0.037 (0.411) -0.2 (2.222)* -0.002 (0.022) -0.162 (1.820) -0.055

-0.235 (2.500)* -0.121 (1.287) 0.101 (1.086) 0.072 (0.774) 0.069 (0.750) 0.023 (0.250) 0.209 (2.272)* 0.111 (1.220) -0.205 (2.253)* -0.076 (0.835) -0.169

0.051 (0.520) -0.022 (0.224) 0.103 (1.062) -0.039 (0.402) -0.158 (1.646) -0.176 (1.833) -0.009 (0.095) -0.121 (1.274) -0.409 (4.351)* -0.328 (3.489)* -0.307

0.11 (1.170) 0.063 (0.677) 0.154 (1.656) 0.134 (1.457) 0.028 (0.304) -0.108 (1.174) 0.032 (0.352) -0.172 (1.911) 0.01 (0.110) -0.068 (0.756) -0.002

57

-0.096 2 (1.043) 0.136 3 (1.478) -0.029 4 (0.312) -0.071 5 (0.763) -0.086 6 (0.915) -0.049 7 (0.521) -0.147 8 (1.564) 0.01 9 (0.105) -0.067 10 (0.705) -0.116 11 12 (1.208) -0.174

0.123 (1.367) -0.091 (1.011) 0.044 (0.484) -0.03 (0.330) 0.069 (0.758) -0.275 (2.989)* 0.021 (0.228) -0.149 (1.620) 0.074 (0.796) -0.163 (1.753) -0.034

0.012 (0.132) -0.004 (0.043) 0.019 (0.207) -0.024 (0.261) -0.067 (0.720) 0.008 (0.086) -0.035 (0.372) -0.075 (0.798) 0.009 (0.096) 0.033 (0.347) -0.044

-0.079 (0.832) -0.169 (1.779) -0.057 (0.594) -0.139 (1.448) -0.052 (0.536) -0.014 (0.144) -0.051 (0.520) -0.028 (0.286) -0.136 (1.374) -0.054 (0.545) 0.034

0.023 (0.253) 0.094 (1.033) -0.084 (0.913) -0.03 (0.326) -0.087 (0.946) -0.084 (0.903) -0.031 (0.333) -0.039 (0.415) -0.05 (0.532) -0.042 (0.447) 0.04
58

(1.813)

(0.362)

(0.463)

(0.340)

(0.421)

L a g

II

half

half

II

half

half

II

half

half

2006 Correla tion

2007 Correla tion 0.024 (0.247) 0.085 (0.885) -0.111 (1.156) 0.003 (0.032) -0.056 (0.589) -0.081 (0.862) -0.066

2007 Correla tion -0.024 (0.255) 0.085 (0.914) -0.158 (1.699) 0.066 (0.717) 0.049 (0.533) -0.025 (0.272) 0.033

2008 Correla tion -0.006 (0.063) -0.09 (0.947) -0.039 (0.411) 0.054 (0.574) -0.049 (0.521) 0.044 (0.468) 0.023

2008 Correla tion -0.031 (0.326) -0.013 (0.137) 0.076 (0.809) -0.001 (0.011) 0.068 (0.723) 0.036 (0.387) -0.147

2009 Correlat ion 0.14 (1.273) -0.063 (0.573) 0.006 (0.055) 0.001 (0.009) -0.107 (0.991) -0.068 (0.636) -0.106

1 2 1 1 1 0 -9 0.109 (1.147) -0.07 (0.745) -0.081 (0.862) -8 -0.073 (0.777) -7 -0.007 (0.075) -6 0.006 -0.047 (0.495)

59

(0.065) -5 0.06 (0.652) -4 -0.024 (0.261) -3 -0.082 (0.891) -2 -0.04 (0.440) -1 0.137 (1.505) 0 -0.123 (1.352) 1 -0.065 (0.714) 2 -0.011 (0.121)

(0.702)

(0.363)

(0.247) -0.224

(1.581)

(0.991)

0.114 (1.213) -0.131 (1.409) -0.014 (0.151)

-0.034 (0.374) 0.168 (1.846) -0.042 (0.467) -0.198

(2.409) * -0.143 (1.554) 0.021 (0.228)

0.053 (0.576) 0.151 (1.641) -0.103 (1.120)

0.14 (1.321) -0.113 (1.076) -0.012 (0.114)

-0.092 (1.000)

(2.176) *

-0.183 (1.989)

-0.009 (0.099)

-0.05 (0.481) -0.251

-0.076 (0.826)

-0.123 (1.382)

-0.165 (1.813)

0.032 (0.352) -0.188

(2.413) *

0.12 (1.304) -0.017 (0.185)

-0.012 (0.135) -0.09 (1.011)

-0.111 (1.220) 0.121 (1.330)

(2.066) * -0.004 (0.044) -0.192

-0.009 (0.087) 0.022 (0.212)

-0.106 (1.152)

-0.062 (0.689)

-0.023 (0.250)

(2.110) *

-0.107 (1.029)

60

0.126 (1.370)

0.049 (0.527) -0.151 (1.624) -0.079 (0.840) 0.086 (0.915) -0.099 (1.053)

-0.16 (1.778) 0.049 (0.538) -0.048 (0.527) 0.032 (0.352) -0.09 (0.978)

0.02 (0.217) 0.03 (0.326) 0.036 (0.387) 0.068 (0.731) -0.006 (0.064)

0.08 (0.870) -0.003 (0.033) 0.014 (0.152) 0.065 (0.699) -0.051 (0.548) 0.225

-0.05 (0.476) 0.081 (0.771) 0.138 (1.302) 0.063 (0.589) -0.004 (0.037)

-0.01 (0.109)

0.063 (0.685)

0.027 (0.290)

-0.027 (0.290)

8 0.073 (0.777) 9 -0.127 (1.351) 1 0 1 1 1 2 -0.086 (0.915) -0.065 (0.684) 0.174 (1.832) -0.089 (0.937) 0.009 (0.095) -0.009 (0.094) 0.04 (0.094) -0.002 (0.021) 0.006 (0.065) 0.101 (1.098) 0.025 (0.269) 0.122 (1.312) 0.171 (1.819) 0.008 (0.085) 0.01 (0.106) -0.058 (0.611) 0.183 (1.926) -0.015 (0.156)

(2.394) * -0.014 (0.149) -0.095 (1.011) -0.027 (0.284) 0.028 (0.295)

0.046 (0.426) -0.139 (1.287) 0.194 (1.780) 0.054 (0.491) 0.083 (0.755)

61

Numbers with in brackets indicate T values = correlation/ standard error * indicates t values greater than 2, @ 5% significance level

Interpretation: From the above table, it is clear that in first half of 2004, T value for all the leads and lags is not statistically significant. So there is no impact of ER on sensex and vice versa. In the second half of 2004 T value at -2 lag and at -4 lag is significant. This shows that ER at zero date has an inverse effect on second and fourth days share prices and T value at + 7 lag is also significant. So SENSEX inversely affects the ER. In the first half of 2005 SENSEX is affected by ER on first, third and ninth day. In the second half of 2005 on the same day and next day there was an inverse affect on Index due to fluctuations in ER. And there was cyclical relationship between the variables during this period. In the year 2006 and in first half of 2007, ER and SENSEX are not affected by each other. In the second half 2007 ER affects SENSEX on the second day. In the first half of 2008 ER leads SENSEX at five day lag and SENSEX leads ER at five day lag. In the second half of 2008 SENSEX leads ER at the same day and at +2 and +8 days lag. In the first half of 2009 fluctuations in ER are reflected in SENSEX on the next day. So finally we can find that there is no systematic pattern of lead or lag between the variables in this period.

62

Correlation and T values of ER and NIFTY for the period 2004 to 2009 La g II half of 2004 Correlatio n -0.011 (0.117) 0.119 (1.280) 0.098 (1.054) 0.135 (1.467) -0.078 (0.848) 0.108 I half of 2005 Correlatio n 0.101 (1.063) -0.071 (0.747) -0.032 (0.340) -0.232 (2.468)* -0.096 (1.021) 0.104 II half of 2005 Correlatio n 0.004 (0.040) 0.113 (1.141) 0.112 (1.131) 0.041 (0.418) -0.012 (0.122) 0.117 I half of 2006 Correlatio n 0.047 (0.495) 0.013 (0.138) -0.003 (0.032) 0.094 (1.000) 0.072 (0.774) 0.171

I half of 2004 Correlatio n

-12

0.039 (0.406)

-11

0.043 (0.448)

-10

0.1 (1.053)

-9

-0.027 (0.284)

-8

-0.01 (0.106)

-7

0.067

63

(0.713) -6 0.096 (1.021) -5 0.17 (1.828) -4 0.055 (0.591) -3 0.146 (1.587) -2 0.042 (0.457) -1 0.033 (0.359) 0 0.036 (0.396) 1 0.04 (0.435) 2 -0.053 (0.576) 3 0.132

(1.174) 0.075 (0.824) 0.065 (0.714) -0.181 (1.989) 0.02 (0.222) -0.155 (1.722) -0.03 (0.337) -0.17 (1.910) -0.068 (0.764) 0.129 (1.433) -0.112

(1.118) 0.049 (0.527) 0.071 (0.772) 0.028 (0.304) 0.203 (2.207)* 0.105 (1.154) -0.165 (1.813) -0.099 (1.088) -0.152 (1.670) 0.018 (0.198) -0.009

(1.206) -0.024 (0.247) -0.16 (1.667) -0.179 (1.865) 0.004 (0.042) -0.146 (1.537) -0.42 (4.468)* -0.365 (3.883)* -0.335 (3.564)* -0.105 (1.105) -0.17

(1.839) 0.148 (1.609) 0.031 (0.337) -0.112 (1.217) 0.013 (0.143) -0.189 (2.100)* 0.012 (0.132) -0.072 (0.800) -0.002 (0.022) 0.027 (0.297) 0.079

64

(1.435) 4 -0.046 (0.495) 5 -0.051 (0.548) 6 -0.069 (0.734) 7 -0.07 (0.745) 8 -0.113 (1.202) 9 0.001 (0.011) 10 -0.096 (1.011) 11 -0.081 (0.844) 12 -0.161 (1.677)

(1.244) 0.069 (0.758) -0.026 (0.286) 0.029 (0.319) -0.263 (2.859) 0.03 (0.326) -0.151 (1.641) 0.069 (0.742) -0.169 (1.817) -0.053 (0.564)

(0.098) 0.011 (0.120) -0.016 (0.174) -0.063 (0.677) -0.002 (0.022) -0.021 (0.223) -0.084 (0.894) 0.01 (0.106) 0.05 (0.526) -0.055 (0.579)

(1.789) -0.075 (0.781) -0.149 (1.552) -0.048 (0.495) -0.015 (0.155) -0.041 (0.418) -0.032 (0.327) -0.139 (1.404) -0.063 (0.636) 0.038 (0.380)

(0.868) -0.084 (0.913) -0.021 (0.228) -0.074 (0.804) -0.118 (1.269) -0.052 (0.559) -0.03 (0.319) -0.05 (0.532) -0.057 (0.606) 0.035 (0.368)

65

L a g

II

half

half

II

half

half

II

half

half

2006 Correla tion

2007 Correla tion 0.078 (0.813) -0.093 (0.969) -0.002 (0.021) -0.053 (0.558) -0.078 (0.830) -0.074 (0.787)

2007 Correla tion 0.053 (0.570) -0.139 (1.495) 0.109 (1.185) 0.063 (0.685) -0.025 (0.272) 0.008 (0.088)

2008 Correla tion -0.092 (0.968) -0.045 (0.474) 0.056 (0.596) -0.026 (0.277) 0.055 (0.585) 0.018 (0.194) -0.241

2008 Correla tion -0.016 (0.168) 0.091 (0.968) -0.002 (0.021) 0.043 (0.457) 0.039 (0.419) -0.158 (1.699)

2009 Correlat ion 0.008 (0.073) -0.004 (0.037) 0.006 (0.056) -0.113 (1.046) -0.019 (0.178) -0.148 (1.383)

1 1 1 0 -9

0.109 (1.147) -0.069 (0.734) -0.079 (0.840)

-8

-0.057 (0.606)

-7

-0.004 (0.043)

-6

-0.027 (0.290)

-5 0.073 (0.793) -4 -0.067 (0.728) -3 -0.102 0.087 (0.926) -0.088 (0.946) -0.008 -0.009 (0.099) 0.146 (1.604) -0.038

(2.591) * -0.141 (1.533) 0.001

0.081 (0.880) 0.126 (1.370) -0.113

0.159 (1.500) -0.107 (1.019) -0.047

66

(1.109) -2 0.088 (0.967) -1 0.093 (1.022) 0 -0.111 (1.220) 1 -0.112 (1.231) 2 0.035 (0.385) 3 0.095 (1.033) 4 0.029 (0.315) 5 0.045 (0.489) 6 -0.028 (0.301) 7 0.017

(0.086)

(0.422) -0.235

(0.011)

(1.228)

(0.448)

-0.102 (1.109)

(2.582) *

-0.181 (1.967)

0.007 (0.077)

-0.024 (0.231) -0.222

-0.075 (0.815) 0.103 (1.120) 0.004 (0.043) -0.082 (0.891) 0.039 (0.419) -0.141 (1.516) -0.099 (1.053) 0.063 (0.670) -0.093

-0.112 (1.258) -0.014 (0.157) -0.091 (1.022) -0.083 (0.922) -0.145 (1.611) 0.016 (0.176) -0.022 (0.242) 0.018 (0.198) -0.096

-0.172 (1.890) -0.101 (1.110) 0.132 (1.451) -0.003 (0.033) 0.027 (0.293) 0.045 (0.489) 0.034 (0.366) 0.069 (0.742) 0.006

0.043 (0.473) -0.169 (1.857) -0.014 (0.154) -0.154 (1.692) 0.076 (0.826) -0.02 (0.217) 0.019 (0.207) 0.068 (0.731 -0.038

(2.135) * -0.063 (0.612) 0.003 (0.029) -0.035 (0.337) -0.032 (0.305) 0.038 (0.362) 0.179 (1.689) -0.014 (0.131) 0.08
67

(0.183) 8 0.124 (1.319) 9 -0.134 (1.426) 1 0 1 1 1 2 0.175 (1.842) -0.058 (0.617) -0.049 (0.516)

(0.989) -0.086 (0.905) 0.025 (0.263) -0.028 (0.292) 0.018 (0.188)

(1.043) 0.061 (0.663) 0.119 (1.293) 0.035 (0.376) 0.119 (1.280) 0.195

(0.064) -0.009 (0.096) -0.002 (0.021) -0.022 (0.232) 0.163 (1.716)

(0.409) 0.173 (1.840) -0.009 (0.096) -0.093 (0.989) -0.018 (0.189)

(0.748) 0.022 (0.204) -0.128 (1.185) 0.179 (1.642) 0.044 (0.400)

0.012 (0.124)

(2.074) *

-0.008 (0.083)

0.021 (0.221)

0.116 (1.055)

Numbers with in brackets indicate T values = correlation/ standard error * indicates t values greater than 2, @ 5% significance level.

Interpretation:

68

From the above tables, it is clear that in the year 2004, there is no relationship between the variables. In the year 2005 there was cyclical relation between the variables. In the year 2006 and first half 2007 there was no significant relationship between the variables. In the second half 2007 ER affects NIFTY on the second day. In the first half of 2008 ER leads NIFTY at five day length and NIFTY leads ER at five day length. In the first half of 2009 fluctuations in ER are reflected in NIFTY on the next day. So finally we can find that there is no systematic pattern of lead or lag between the variables in this period. This also shows that SENSEX and NIFTY are moving in the same direction.

9.) FindingsTheory says that exchange rates should have a direct impact on the companies with heavy import or export activities and thus affecting the profitability and hence the stock prices. An exchange rate has two effects on stock prices, a direct effect through Multi National Firms and an indirect effect through domestic firms. As the index is nothing but weighted average of the share prices of various companies from different sectors, the sensex has been considered to see the impact of ER on it. Both Sensex and Nifty are considered to see where they move in the same direction or not. 1.) After analyzing the data by using Johnson Co integration, we found that in the long run Exchange Rate does not affect the share prices. The results show that there was no significant relationship between the Exchange Rate and any index. The possible reasons for such behavior could be as follows: It can be said that because of using only a single variable, namely exchange rate, the impact on stock prices was not felt. If more of independent variables like interest

69

rates, money supply etc. could be added, then possibly a very good relation could have been established. In reality, stock prices and exchange rate are affected by a myriad of factors such as fiscal and monetary policy, interest rates, inflation, money supply, political factors, international events, fundamental performance, forex reserves, BOP, exchange control, etc. The non-existence of relationship may also be because of Indian markets not yet being highly integrated or sensitive to the new information. Also the Indian companies comparatively may not be exposed to a lot of forex exposure, like companies in developed countries. Alternatively Indian managers are highly cautious and hedge to a good extent of their forex exposure. High volatility introduced in the exchange market due to floating rate regime nurtures the speculative activities, makes it difficult to pinpoint the precise effect of exchange rates on stock prices.

Another very important reason can be that Indian stocks are highly sentiment driven and stocks of certain companies may start soaring for no reason. There are few qualitative factors that influence stock prices like speculation and investor confidence level.

2.) An attempt has been made to investigate lead-lag relationship, by using cross correlation. The results for the both index and for exchange rate are as follow: In the second half of 2005, there was very significant relationship between the exchange rates and all the indices. During this period, all the indices have also influenced the exchange rates at one day lag. There was also a very good cyclical relationship of lead and lag between the variables.

70

The lead-lag relationship occurred between the variables during different periods is because in India, though stock market investment does not constitute a very significant portion of total household savings compared to other form of financial assets, it may have a significant impact of exchange rate movement as FII investment has played a dominant role. The control measures of RBI have shown its influence from time to time and disrupted the relation between the two variables.

For the market efficiency, it can be inferred from the analysis that for the given time period a spillover effect or influence from foreign exchange market is seen on the stock market, so it is not efficient in processing the information.

10.) ConclusionsBy using daily data, we have examined the long-run and short-run dynamics between stock prices and exchange rates in India. Our main concerns were to examine whether these links were affected by the existence of foreign exchange controls, floating rates and raising value of Rupee and raising indices in India. The following conclusions have been derived from our analysis: There is no significant cause and effect relationship between the two variables. As the relationship occurred between the variables during different periods is because of chance factor and not because of cause factor. Thus the results provide the evidence for the presence goods market or portfolio approach. Hence, we can reject the hypothesis that there is relationship between the exchange rate and stock indices and the two are affected by various factors in spite of the increasing integration between the two markets. The outcome of the study is consistent with the findings of Apte (2001) and it also in agreement with Nath and Samanta (2003).
71

In conclusion, in the era of increasing integration in financial markets one should take sufficient care while implementing exchange rate policies. Furthermore, indications are that the existence of foreign exchange restrictions does not isolate the domestic capital markets. The general increase in international trade and the resultant increase in economic integration have also increased financial integration and reduced the benefit of international diversification.

72