Information content of stock market, gold & exchange rate: An Indian market perspective

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  • 1. A Dissertation On:INFORMATION CONTENT OF STOCK MARKET, GOLD & EXCHANGE RATE: AN INDIAN MARKET PERSPECTIVE Submitted To: Dr. Brajesh Kumar By: Sukant Arora JGU ID: 20100040 Jindal Global Business School Contact Number: +91-9999991334 Email ID: 10jgbs-sarora@jgu.edu.in Page 1
  • 2. ACKNOWLEDGEMENTOn completion of my dissertation, I would like to express my sincere thanks to Dr.Brajesh Kumar who guided, advised, inspired and supported me during myproject.I am also indebted to Jindal Global Business School for giving me the opportunityto work on this dissertation. I also take the opportunity to thank all the faculty ofthe Jindal Global Business School who were directly or indirectly concerned withthe completion of my dissertation.I would like to give full acknowledgement to the outstanding help by the librarystaff of O.P Jindal Global University. I hope that this dissertation will helpful to thereaders.Sukant AroraJindal Global Business School Page 2
  • 3. Introduction:In the past and as well as in present, there is a lot of discussion on the macroeconomic variableson the stock market movement. Several literatures are available establishing the linkagebetween stock prices and macroeconomic variables indicating short term and the long termrelationship.Over the period of time there have been numerous studies on different stock indices. Forexample (Mayasami and Koh, 2000) investigated the dynamic relationship between Singaporestock market and the empirical results of the study shows that the Singapore stock market issensitive to exchange rates.The relationship between exchange rate and stock prices has always been in the mind ofeconomists since both the exchange rate and stock price play an important role in influencingthe development of an economy.Traditional approach (at microeconomic level) states that exchange rates lead the stock prices(Dornbusch and Fischer 1980), (Ajayi and Mongoue 1996), (Yau and Nieh 2006). While themacroeconomics (portfolio balance) approach states that market mechanism determines theexchange rates. It the round words, it is said that changes in stock price might have impact onthe exchange rate movements. (Granger et al. 2000), (Caporale et al. 2002), (Pan et al. 2007)Casual relations between the stock prices and exchange rates are suggested in above statedtheories. However on the micro level, we have mixed results. Jorion (1991), Bartov and Bodnar(1994), Choi and Prasad (1995) and Griffin and Stulz’s (2001) suggest that exchange ratesdoesn’t influence the stock prices.The results which presented in previous studies on relationship between the exchange ratesand stock price are best mixed. There are different results in the different economies and thereasons behind this could be the difference in the trade volumes or there could be a differencein the degree of capital mobility.(Ma and Kao 1990) It states that currency appreciation has both a positive and negative effecton the domestic stock market for a country which is export dominant and import-dominated.Several empirical studies states the stock market becomes very sensitive to the domestic andexternal factors (gold is one of such factors) once there is a financial deregulation in theeconomy.There are many examples from the history which shows that when there is a stock marketslump in an economy, the gold always tends to be higher. Page 3
  • 4. Adding to this, when we talk about the macro economy including variables such as the equitymarket up and down, recession and economic prosperity, and either higher or lower consumerprice index, a layman always thinks of investing in something safe, something which has aphysical value and as well as which can be good hedge against inflation such as Gold. During theperiod of stock market slump, historical data shows that gold prices tend to increase andpeople show more interest to invest in gold.International trades are generally affected by changes in the exchange rates and thus it affectsthe stock market as well. When an economy’s currency is appreciating, the importers of thedomestic currency who require exchanging the same amount of any foreign currency have topay less which further reduces the importing costs. When the imported commodity is sold inthe economy for the same price, the profit for the firm goes up and as a result the stock price ofthe firm increases. But on the other side when the economy’s currency depreciates, theexporters of the domestic currency will receive lesser amount when they exchange thecurrencies. The profit of the firm goes down as they sell at the same price and further leads todecrease in the stock price of that firm.The relationship of USD and Gold is perhaps the most well known in the Global Currencymarkets and the USD and gold have an inverse relationship. The reason for this inverserelationship is typically because the commodity (Gold) is used as a hedging tool against inflationin the economy through its intrinsic metal value. When the exchange value of Dollar decreases,it always takes more currency (Dollar) to Gold, causing increase of value of Gold against Dollar.When the value of Dollar is at risk of fluctuation due to changes in the Monetary Policy, thevalue of Gold is mostly determined by the demand and supply, and there is no interferencefrom changes in the corporate and monetary policies.There were also instances of decoupling of Dollar and Gold in the past between April andDecember 2005. This happened when China revalued its currency and U.S raised the interestrates, and it facilitated them by giving opportunity to buy the commodities such as Gold. Duringthat period the correlation between Dollar and Gold was approximately .6579.When there is more output from a company, its stock price tends to increase, and so as thestock index. Indian stock market and USD shows a negative correlation. So whenever the Niftygoes up, USD-INR goes down and vice versa. In India we see that when the stock market isgoing down, people tend to invest in something which is comparatively safe or in somethingwhich has a physical value so people tend to invest in Gold. Therefore when in there is decliningstock market, the Gold Value tends to increase so as the USD-INR. It shows that whenever the Page 4
  • 5. USD-INR increases or the value of Dollar against Indian Rupee increases, Gold also tends toincrease. Page 5
  • 6. Literature Review:Abdalla and Murinde (1997) investigate stock prices-exchange rate relationships in theemerging financial markets of India, Korea, Pakistan and the Philippines using monthly datafrom 1985 to 1994. The empirical results show unidirectional causality from exchange rates tostock prices in India, Korea and Pakistan. On the contrary, the reverse causation was found forthe Philippines.Aggarwal (1981) examines the influence of exchange rate changes on U.S. stock prices usingmonthly data for the floating rate period from 1974 to 1978. He finds that exchange rates andstock prices and are positively correlated.Ajayi and Mougoue (1996) examine the relationship between stock indices and the exchangerates using the daily data from 1985 to 1991 for the eight advanced economies. According tothe results of the study, there are significant short as well as short run feedback relationsamong the two financial markets. Currency depreciation has a negative both short-run andlong-run effect on the stock market. An increase in stock price has a positive long-run effect aswell as a negative short-run effect on domestic currency value.Doong et al. (2005) examines the dynamic relationship between the exchange rates and stocksfor the six Asian countries (South Korea, Taiwan, Thailand, Philippines, Malaysia and Indonesia)for more than 14 year from 1989 to 2003. Results show that the financial variables areintegrated with each other. Except for Thailand, all the countries show that there is asignificantly negative relation between the stock returns and the contemporaneous change inthe exchange rates. Bidirectional causality can be detected in Thailand, Indonesia, Malaysiaand Korea in the results of the Granger causality test.Nieh and Lee (2001) investigate the relationship between exchange rates and stock prices forthe G-7 countries and from the period October 1st 1993 to February 15th 1996 take the dailyclosing exchange rates and stock market indices. Result of the study was that there is long runequilibrium relationship between exchange rates and stock prices for each G-7 countries.There is no correlation in the United States of America but a significant short run relationshiphas been found in certain G-7 countries. The results might be explained by country’sdifferences in government policy, economic stage etc.Tsoukalas (2003) investigates the relationship between macroeconomic factors and stock pricesin Cyprus. The result of study shows strong relationship between exchange rates and stockprices. The reason of this is that Cypriot economy depends on services (import sector) such astourism etc.Pan et al. (2007) take the data over the period of 1988 to 1998 of the seven Asian countries toexamine the dynamic relationship between the stock prices and exchange rates. The results of Page 6
  • 7. the study reveal that in Hong Kong before the 1997 Asian crises there is a bidirectional causalrelation. There is a unidirectional causal relation from stock prices and exchange rates forThailand, Malaysia and Japan and stock prices to exchange rate for Singapore and Korea. In1997 during the Asian crises, except Malaysia there is only a causal relation from exchangerates to stock prices for all the countries.Hatemi-J and Irandoust (2002) studied a causal relation between the stock prices and exchangerates in Sweden. Over the period of 1993-98 they used the stock prices and the monthlynominal effective exchange rates. A result of the study was that Granger causality isunidirectional from stock prices to exchange rates.Kim (2003) over the period 1974-1998 uses monthly data in the United States of America andthe empirical results of the study reveal that Standards & Poor’s common stock price isnegatively related to the exchange rate.Ozair (2006) investigates the causal relationship between exchange rates and stock prices in theUnited States of America by using the quarterly data over the period 1964-2000. Results of thestudy showed that there is no integration and no causal relationship between stock prices andexchange rates.Muhammad and Rasheed (2002) investigates the relationship between exchange rates andstock prices for the countries like India, Sri Lanka, Bangladesh and Pakistan using the monthlydata from 1994 to 2000. The empirical results of the study show that for Bangladesh and SriLanka there is bi-directional long run causality between exchange rates and stock prices. Norelationship found between exchange rates and stock prices for Pakistan and India.Smyth and Nandha (2003) examine the association between stock prices and exchange rates forthe countries like Bangladesh, Pakistan, Sri Lanka and India over the period 1995-2001. Resultsof the study made it clear that there is no long run relationship between exchange rates andstock prices. Also, there is unidirectional causality running from exchange rates to stock pricesfor only Sri Lanka and India. Stock Prices got influenced by change in exchange rates throughinfluencing firm’s export in Sri Lanka and India.Ajayi et al. (1998) examines causal relationship between changes in exchanges rates and stockreturns for the eight Asian emerging markets from 1987 to 1991 and for seven advancedmarkets from 1985 to 1991, by taking the daily exchange rates and market indexes. Theempirical results of the study show that there is unidirectional causality between the exchangerates and the stock price in all the advance economies, while there is no consistent causalrelationship between exchange rates and stock prices in emerging markets. They differentiated Page 7
  • 8. advanced and emerging economies by drawing our differences in the characteristics andstructure of financial markets between these groups.Erbaykal and Okuyan (2007) for the 13 developing economies investigate relationship betweenstock price and exchange rates using different time periods for each economy. Empirical resultsof the study clearly show that there is a causality relation for eight economies. There isunidirectional causality from stock prices to exchange rates in five economies and bidirectionalcausality relation is there for three economies.Wang et al. (2001) explored the impact of fluctuations in gold price and exchange rates of U.SDollar vs. various currencies on the stock prices indices of the United States, Germany, Taiwan,Japan and China as well as the short and long term correlations between these variables.Empirical results of the study show that there is existence of co-integration among fluctuationsin gold price and the exchange rate of the dollar vs. various currencies indicating there is longterm stable relationship between these variables.Ibrahim and Aziz (2003) used monthly data over the period 1977-1998 to analyze the dynamiclinkages between the four macroeconomic variables and stock prices for Malaysia. Theempirical results show that stock prices are negatively associated with the exchange rates.Kurihara (2006) investigates the relationship between daily stock prices and macroeconomicvariables in Japan from March 2001 to September 2005. He takes exchange rate (Yen/U.SDollar), the Japanese interest rate, U.S stock prices and Japanese stock prices for the study.The empirical results show that Japanese stock prices are not influenced by domestic interestrate. However the Japanese stock prices are affected by the U.S stock prices and exchange ratei.e. Yen/U.S Dollar. Japanese stock prices were influenced by the quantitative easing policywhich was implemented in 2001. Page 8
  • 9. Objective of the Study:  To determine the relationship between the Indian Stock Market; Gold prices and the exchange rate i.e. USD- INR (U.S Dollar and Indian Rupee) during the pre and post crisis period.  The study will help in creating a hedging strategy so that an efficient portfolio can be created. The study will analyze the data from January 2005 to December 2007 and January 2009 to July 2011.Data and Methodology:Daily closing price of S&P CNX Nifty, Gold and USD/INR exchange rate obtained from theNational Stock Exchange, Gold.org and Reserve Bank of India constitutes the data set fromJanuary 2005 to December 2007 and January 2009 to July 2011. The gold prices, stock indexand the USD/INR are continuously rate of returns, computed as the first difference of thenatural logarithm of the daily gold price, USD/INR exchange rate value and stock index.Basic statistical analysis of the data which will include time series analysis will be done with thehelp of Ms. Excel. Page 9
  • 10. Basic Characteristics of the DATA SET: Standard Maximum Minimum Deviation Value Value USD-INR 2.6897 52.0600 39.27 NIFTY 1221.3870 6312.4500 1902.5 GOLD 4628.4092 23032.5988 5771.936698 USD-INR & Correlation USD-INR & NIFTY NIFTY & GOLD GOLD 2005 -0.1131 -0.1333 0.1712 2006 -0.0986 -0.0202 0.1402 2007 -0.1944 0.0234 0.1405 2008 -0.1747 -0.0143 -0.0872 2009 -0.1045 -0.0284 0.0993 2010 0.0964 0.0021 0.0034 2011 -0.2863 -0.0113 -0.1000 USD-INR & Correlation USD-INR & NIFTY NIFTY & GOLD GOLD Before Crisis -0.1382 -0.0172 0.1380 Crisis Period -0.1747 -0.0143 -0.0872 After Crisis -0.0796 -0.0256 0.0571 USD-INR & NIFTY NIFTY & GOLD USD-INR & GOLD Correlation -0.1074 -0.0210 0.0515 Page 10
  • 11. 0.20000.15000.10000.05000.0000 Correlation USD-INR & NIFTY 2005 2006 2007 2008 2009 2010 2011-0.0500 Correlation NIFTY & GOLD-0.1000 Correlation USD-INR & GOLD-0.1500-0.2000-0.2500-0.3000 Correlation 2005 0.2000 0.1500 0.1000 0.0500 Correlation 2005 0.0000 USD-INR & NIFTY NIFTY & GOLD USD-INR & GOLD -0.0500 -0.1000 -0.1500 Page 11
  • 12. Correlation 20060.20000.15000.10000.0500 Correlation 20060.0000 USD-INR & NIFTY NIFTY & GOLD USD-INR & GOLD-0.0500-0.1000-0.1500 Correlation 20070.20000.15000.10000.05000.0000 USD-INR & NIFTY NIFTY & GOLD USD-INR & GOLD Correlation 2007-0.0500-0.1000-0.1500-0.2000-0.2500 Page 12
  • 13. Correlation 20080.0000 USD-INR & NIFTY NIFTY & GOLD USD-INR & GOLD-0.0200-0.0400-0.0600-0.0800-0.1000 Correlation 2008-0.1200-0.1400-0.1600-0.1800-0.2000 Correlation 20090.15000.10000.05000.0000 Correlation 2009 USD-INR & NIFTY NIFTY & GOLD USD-INR & GOLD-0.0500-0.1000-0.1500 Page 13
  • 14. Correlation 20100.12000.10000.08000.0600 Correlation 20100.04000.02000.0000 USD-INR & NIFTY NIFTY & GOLD USD-INR & GOLD Correlation 20110.0000 USD-INR & NIFTY NIFTY & GOLD USD-INR & GOLD-0.0500-0.1000-0.1500 Correlation 2011-0.2000-0.2500-0.3000-0.3500 Page 14
  • 15. Correlation Before Crisis0.20000.15000.10000.05000.0000 Correlation Before Crisis-0.0500 USD-INR & NIFTY NIFTY & GOLD USD-INR & GOLD-0.1000-0.1500-0.2000 Correlation Crisis Period0.0000 USD-INR & NIFTY NIFTY & GOLD USD-INR & GOLD-0.0500-0.1000 Correlation Crisis Period-0.1500-0.2000 Correlation After Crisis0.08000.06000.04000.02000.0000 USD-INR & NIFTY NIFTY & GOLD USD-INR & GOLD Correlation After Crisis-0.0200-0.0400-0.0600-0.0800-0.1000 Page 15
  • 16. USD-INR & NIFTY: Correlation USD-INR & NIFTY 0.1500 0.1000 0.0500 0.0000 -0.0500 2005 2006 2007 2008 2009 2010 2011 -0.1000 Correlation USD-INR & NIFTY -0.1500 -0.2000 -0.2500 -0.3000 -0.3500The result of the study carried out shows that during the most of the period, there is a negativecorrelation between the USD-INR and the S&P CNX NIFTY. It shows that when the value of thedomestic currency appreciates in comparison to the foreign currency, US Dollar in this case, ittakes less amount of domestic currency in order to exchange for the foreign currency and thusimporters have to pay less and exporters could gain more. As a result output of the firm or acompany increases and further leads to increase in the stock price, ultimately leading to theupward trend of stock market. On the contrary when an economy’s domestic currencydepreciates, it takes more domestic currency in order to exchange the foreign currency andthus leading to less profit on exports and more cost of importing the goods. This cause inreduction of the output and profits as well, thus we can see decline in the stock price of acompany or a firm further leading to downward trend in the stock market. Here we see thatduring the global financial crisis period, negative correlation among two goes on increasing,which clearly indicates the negative relationship in both the variables. But we can also see thatduring certain periods the correlation was positive as well, the reasons for this were moreforeign direct investment in our economy, our poor gross domestic production and the globalappreciation of the US Dollar. Page 16
  • 17. USD-INR & GOLD: Correlation USD-INR & GOLD 0.2000 0.1500 0.1000 0.0500 Correlation USD-INR & GOLD 0.0000 2005 2006 2007 2008 2009 2010 2011 -0.0500 -0.1000 -0.1500The relationship of USD and Gold is perhaps the most well known in the Global Currencymarkets and the USD and gold have an inverse relationship. The reason for this inverserelationship is typically because the commodity (Gold) is used as a hedging tool against inflationin the economy through its intrinsic metal value. When the exchange value of Dollar decreases,it always takes more currency (Dollar) to Gold, causing increase of value of Gold against Dollar.The result of the study carried out shows that during the pre-crisis period there was a positivecorrelation between the two variables and during the post crisis period we see evident negativecorrelation. We observe that whenever the Indian currency depreciates, causing a decline instock market, Gold is always the first and the safest choice to invest.When an economy’s currency is appreciating, the importers of the domestic currency whorequire exchanging the same amount of any foreign currency have to pay less which furtherreduces the importing costs. When the imported commodity is sold in the economy for thesame price, the profit for the firm goes up and as a result the stock price of the firm increases.But on the other side when the economy’s currency depreciates, the exporters of the domesticcurrency will receive lesser amount when they exchange the currencies. The profit of the firmgoes down as they sell at the same price and further leads to decrease in the stock price of thatfirm. Page 17
  • 18. NIFTY & GOLD: Correlation NIFTY & GOLD 0.0400 0.0200 0.0000 2005 2006 2007 2008 2009 2010 2011 -0.0200 -0.0400 -0.0600 Correlation NIFTY & GOLD -0.0800 -0.1000 -0.1200 -0.1400 -0.1600The result of the study carried out shows that during the most of the period, we observed boththe positive and the negative correlation among the two variables. The reason for this is Goldhaving a good physical value. People have a strong tendency to buy Gold in India as it isconsidered as a safe investment because of the physical value and people in India buy Goldbecause of the emotional quotient as well as it is considered the best commodity for auspiciousoccasions.Despite this factor, we see a negative correlation between the two variables because whenpeople we see that a stock is not performing well, so as the stock market and they are notsatisfied with the returns they get from the stock market, they for the safest investment in Goldconsidering it has a good physical value. Therefore more investment in gold (more demand)causes increase in gold prices. So whenever we see a stock market slump, we observe rise inprices of Gold as people see Gold as a safe investment, showing the negative correlationbetween two variables. Page 18
  • 19. ROOT MIN SQAURE ERROR ANALYSIS: USD-INR & NIFTY NIFTY & GOLD USD-INR & GOLD Correlation -0.1074 -0.0210 0.0515 RMSE 150 0.1223 0.0743 0.1129 RMSE 100 0.1679 0.0923 0.1329 RMSE 50 0.1679 0.1313 0.1634 RMSE 25 0.2190 0.1894 0.2116 0.2500 0.2000 0.1500 0.1000 USD-INR & NIFTY 0.0500 NIFTY & GOLD USD-INR & GOLD 0.0000 Correlation RMSE 150 RMSE 100 RMSE 50 RMSE 25 -0.0500 -0.1000 -0.1500As we are increasing the moving correlation from data set of 25 variables to data set of 150variables, we can observe that error is becoming less but on the contrary we are losing thevariables. Page 19
  • 20. USD-INR & NIFTY0.25000.20000.15000.1000 USD-INR & NIFTY0.05000.0000 RMSE 150 RMSE 100 RMSE 50 RMSE 25 NIFTY & GOLD0.20000.15000.1000 NIFTY & GOLD0.05000.0000 RMSE 150 RMSE 100 RMSE 50 RMSE 25 USD-INR & GOLD0.25000.20000.1500 USD-INR & GOLD0.10000.05000.0000 RMSE 150 RMSE 100 RMSE 50 RMSE 25 Page 20
  • 21. Hedging Strategies:  Long investment in the stock market can be hedged by a long investment of the equal amount of the currency pair i.e. USD-INR or equivalent long investment in Gold. In currency segment currency options are the best hedging tools.  Long investment in the currency market can be hedged by a long investment of the equal amount in stock market or equivalent long investment in Gold.  Long investment in the gold can be hedged by a long investment of the equal amount of the currency pair i.e. USD-INR. In currency segment currency options are the best hedging tools Page 21
  • 22. References:1. Abdalla, I.S.A. and V. Murinde, 1997, “Exchange Rate and Stock Price Interactions in Emerging Financial Markets: Evidence on India, Korea, Pakistan, and Philippines,” Applied Financial Economics 7, 25-352. Aggarwal, R., 1981. “Exchange rates and stock prices: A study of the United States capital markets under floating exchange rates”, Akron Business and Economic Review 12 (fall), pp. 7-12.3. Ajayi, R.A., Friedman, J., and Mehdian, S. M., 1998. “On the relationship between stock returns and exchange rates: Test of granger causality”, Global Finance Journal 9 (2), pp. 241–251.4. Ajayi, R. A. and Mougoue, 1996, “On the Dynamic Relation between Stock Price and Exchange Rates, “Journal of Financial Research 19, 193-207. Dornbusch, R. and S. Fischer, 1980, “Exchange Rates and Current Account,” American Economic Review 70, 960-715. Caporale, G.M., Pittis, N., and Spagnolo, N., 2002. “Testing for causality-in-variance: an application to the East Asian markets”, International Journal of Finance & Economics 7 (3), pp. 235-245.6. Chung S. Kwon and Tai S. Shin (1999), “Co integration and Causality between Macroeconomic Variables and Stock Market Returns”, Global Finance Journal, 10(1), 71-81.7. Cumhur Erdem and Cem Kaan Arslan and Meziyet Sema Erdem (2005), “Effects of Macroeconomic Variables on Istanbul Stock Exchange Indexes”, Applied Financial Economics, 15(14), 987-9948. Engle, R. F. and C. W. J. Granger, 1987, “Co-integration and Error Correction: Representation, Estimation, and Testing,” Econometrica 55, 251-769. George Hondroyiannis and Evangelia Papapetrou (2001), “Macroeconomic Influences on the Stock Market”, Journal of Economics and Finance, 25(1), 33-49.10. Granger, C. W. J., 1986, “Developments in the Study of Co-integrated Economic Variables,” Oxford Bulletin of Economics and Statistics, 48:3 213-2811. Granger, C. W. J., 1988, “Some Recent Developments in a Concept of Causality,” Journal of Monetary Economics, 39, 199-106 Page 22
  • 23. 12. Ibrahim, H and Aziz, H., 2003. “Macroeconomic variables and the Malaysian equity market: A view through rolling subsamples”, Journal of Economic Studies 30(1), pp. 6-2713. Kurihara, Yutaka, 2006. “The Relationship between Exchange Rate and Stock Prices during the14. Quantitative Easing Policy in Japan”, International Journal of Business 11(4), pp.375-386.15. Muhammad, Naeem and Rasheed, Abdul, 2002. “Stock Prices and Exchange Rates: Are They16. Related? Evidence from South Asian Countries”, the Pakistan Development Review 41(4), pp.535-55017. Ramasamy, B. and M. Yeung, 2001, “The Causality between Stock Returns and Exchange Rates: Revisited,” Research Paper Series, 11, Division of Business and Management, the University of Nottingham in Malaysia18. Smyth, R. and Nandha, M., 2003. “Bivariate causality between exchange rates and stock prices in South Asia”, Applied Economics Letters 10, pp. 699–70419. Tsoukalas, Dimitrios, 2003. “Macroeconomic factors and stock prices in the emerging Cypriot equity market”, Managerial Finance 29(4), pp. 87-92.20. Vaihekoski, M., & Patari, E. (2007). “Gold Investments and Short- and Long-Run Price Determinants of the Price of Gold”. Lappeenranta University of Technology, School of Business Finance, 1-77. Page 23