Final report

“A Study on Impact of Macro –Economic Variables on stock Market in India”
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ABSTRACT
Stock market performance is considered as the reflector of financial and economic conditions of a country.
The dynamic linkage between macroeconomic variables and stock prices has fetched increasing amount of
attention from economists, financial analysts, investors and policy makers, since 1980s. There are number of
domestic and international macroeconomic factors that potentially can affect the stock returns of the
companies (Fama, 1981, Chen et al., 1986). According to Fama (1981), there is a comprehensive group of
macroeconomic variables that influences the stock prices in the share market of any country. It is believed
that, if a country’s economy is performing well and expected to grow at a vigorous pace, the market is
frequently anticipated to reflect the same.
The relationship between macroeconomic variables and stock prices has been the focus of an immense body
of theoretical and empirical research since the 19th century. The debate over the decades has been whether
the movement in stock prices leads to the change in economic activity or it is one of the causes of change.
However, the literature suggests some contradictory findings regarding which precise events or economic
factors are likely to influence the stock prices and the degree of influencing power of the economic factors.
Having generated strong controversy, the debate concerning the relationship between stock market
development and macroeconomic variables is still difficult to solve and causality hard to pin down.
Arguments both theoretical and empirical have been diverse. Some group of studies advocates that the stock
prices do respond to the changes in macroeconomic fundamentals, but the sign and causal relationship might
not hold equal for all the studies, given different set for similar macroeconomic variables and also the
methodologies used for the study in this area are different (Fama (1981, 1990), Geske and Roll (1983), and
Chen, Roll, and Ross (1986)). Further, existing Financial and Economic literature advocates the relationship
between the stock market and macroeconomic variables, but, they do not specify the type or the number of
macroeconomic factors that should be included. Besides this, the main key conclusion drawn from literature
review is, that, so far, no study has been done on the relationship between sectoral stock indices and
respective sectoral GDP, which provides the investors a new insight to track the changes in a particular
sector of the stock market by analyzing the movement of sectoral GDP of that particular sector. Thus, this
study is the initiative taken in this area.

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Introduction
Indian capital market has undergone tremendous changes since 1991, when the government has adopted
liberalization and globalization polices. As a result, there is a growing importance of the stock market from
aggregate economy point of view. Nowadays stock market have become a key driver of modern market
based economy and is one of the major sources of raising resources for Indian corporate, thereby enabling
financial development and economic growth. In fact, Indian stock market is one the emerging market in the
world.
The smoothing development process in Indian stock markets continues to be breath taking. Form 3,739.69
points on March 31st 1999, with in nine years; Bombay Stock Exchange (BSE) Sensitivity Index (SENSEX)
had reached to 21,000 level points in January, 2008. But this impact doesn’t last long as it was affected by
the recent global financial crisis of 2008-09 and emerging euro-crisis. Now SENSEX is around 18,000
points. In the context of this effect in Indian Stock Market, the critical question is whether the decades old
development or recent degradation in the markets are in any way influenced by the domestic and
international macroeconomic fundamentals. Agrawalla (2006) stated that rising indices in the stock markets
cannot be taken to be a leading indicator of the revival of the economy in India and vice-versa. However,
Shah and Thomas (1997) supported the idea that stock prices are a minor which reflect the real economy.
Similarly results were found in Kanakaraj et al. (2008). There are several other studies regarding the
interaction of share market returns and the macroeconomic variables and all studies provide different
conclusion related to their test and methodology. Result of this study help in exploring whether the
movement of Bombay Stock Exchanges indices is the result of some selected macroeconomic variables or it
is one of the causes of movement in those variables of the Indian economy. The study consider
macroeconomic variables as Index of Industrial production (IIP), Consumer price Index (CPI), Call Money
Rate (CMR), Dollar Price (DP), Foreign Institutional Investment (FII), Crude Oil Prices (CO), Gold Price
(GP) and Bombay Stock Exchanges indices in the form of SENSEX, BSE- Metals, Auto, Capital Goods,
Fast Moving Consumer Goods and Consumer Durables by using monthly data that span from April, 2005 to
March, 2012. More specifically, in the study we use ADF test, Correlation and Regression analysis and
Granger Casually test to see the effect of macroeconomic variables on Bombay Stock Exchange Indices and
vice versa (by using granger causality test). The results would be very useful for the policy markers, traders,
investors, and other concerned along with the future researchers.
The rest of the study is organized as follow. Module 1 is a survey of the existing literature including
empirical results on the nature of casual relationship between macroeconomic variables and stock prices is
conducted. Module 2 is presents the data descriptions and variables undertaken for the study. Module 3
presents research methodology to be employed for investigation and analysis purposes. Module 4 reports the

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empirical results and discussions of descriptive statistics, ADF test, Correlation and Regression analysis and
Granger Casually test which are followed by conclusion.
The history has shown that the price of shares and other financial assets are an important aspect of the
dynamics of economic activity, performing a crucial role in the economy of any nation. Further, many
researchers have proved that the stock market plays an important role in economic prosperity, fostering
capital formation and sustaining the economic growth of the economy (Charles and Adjasi, 2008; Essaied,
Hamrita et al., 2009; Pilinkus, 2015; Quayes, 2010). The stock market is one of the most vital components of
a free-market economy, as it helps to arrange capital for the companies from shareholders in exchange for
shares in ownership to the investors. Stock exchange provides businesses with the facility to raise capital by
selling shares to the investor (Black and Gilson, 1998). Stock prices can be considered as an indicator of a
country’s economic status and social mood and are seen as a leading indicator of the real economic activity.
Share prices also affect the wealth of households and their consumption; savings and investment decisions.
Thus, it can be said that, the stock market is an integral part of the financial system of any economy, as it
plays a significant role in channelizing funds, connecting savers and investors, which led to economic
growth of the economy. Further, it is believed that there exist many factors to which the stock market reacts,
factors like the economic, political and socio-cultural behavior of any country. Hence, investors carefully
watch the performance of the stock markets by observing the composite market index, before investing
funds. The market index acts as the yardstick to compare the performance of individual portfolios and also
provides investors for forecasting future trends in the market. Especially the stock markets of emerging
economies are likely to be sensitive to fundamental changes in macroeconomic structure and policies, which
plays an important role in achieving financial stability. Being one of the most important pillars of the
country's economy, the stock market is carefully observed by governmental bodies, companies and investors
(Nazir et al., 2010). Therefore, economic policy makers and researchers keep an eye on the behavior of the
stock market, as it’s smooth and risk free operation is essential for economic and financial stability.
The dynamic linkage between macroeconomic variables and stock prices has fetched increasing amount of
attention from economists, financial analysts, investors, practitioners and policy makers (Kwon and Shin,
1999). The claim that macroeconomic variables affect stock market is a well-established theory in the
literature and has been an area of intense interest among academics, investors and stock market regulators
since 1980s. In the past three decades, there has been growing efforts made by researchers to estimate this
relationship since the attempt made by Fama (1981). Following his study, a number of empirical studies
explored this topic to understand the fundamentals of this association in one country or in a selected group of
countries. (Chen et al. (1986), Poon and Taylor (1992), Fama (1991), Pearce & Roley (1988)) modeled the
relation between asset prices and real economic activities in terms of production rates, productivity, and

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growth rate of gross national product, unemployment, yield spread, interest rates, inflation, dividend yields,
and so forth. In the last two decades, because of the globalization trend, a number of researchers – such as
Fama (1990), Geske and Roll (1983), Chen, Roll, and Ross (1986), Canova and de Nicolo (1995) and
Nasseh and Strauss (2000) also investigated the international effects of macroeconomic indicators on stock
prices. Theoretical work shows the significant positive effect of stock market development on economic
growth of specific economies (Levine and Zervos (1998); Modigliani (1971) and Kunt and Levine (1996)).
At the same time, the development of the stock market is the outcome of many macroeconomic variables
like foreign direct investment, foreign institutional investment, exchange rate and economic reforms (Gay
(2008)), whereas, economic growth also plays an important role in the stock market development in
developing or developed economies. Duca (2007) argues that countries doing well in terms of economic
growth have better stock market performance. These studies are different in terms of their hypotheses and
the methodologies used. Other previous studies have examined the short and the long run relationship
between stock prices or returns and some macroeconomic and financial variables such as inflation, interest
rate, output, etc. Within this group of studies, some studies seek to examine local and international economic
factors that affect stock prices or returns, while others examine factors that determine stock return volatility
(Semmler, 2006). Some other explores the role of monetary policy in responding to or altering the stock
market (Sellin, 2001). More recently, an increasing amount of empirical studies has been focusing attention
to relate the stock prices and macroeconomic factors for both developed and emerging economies
(Mukherjee and Naka (1995), Maysami et al. (2004), Ratanapakorn and Sharma (2007), Rahman et al.
(2009)). These studies concluded that stock prices do respond to the changes in macroeconomic
fundamentals, but the sign and causal relationship might not hold equal for all the studies. Based on the
existing literature, it has been concluded that extensive research has been conducted for developed
economies. However, research on the relationship between real economic activity and the stock market in
developing countries, such as Latin American, Eastern Europe, Middle Eastern, and South Asian countries,
is still ongoing. Further, in respect to the Indian economy, few studies have been conducted on the dynamic
relationships between the stock market and macroeconomic variables.
Indian capital market has undergone tremendous changes since 1991, when the government has adopted
liberalization and globalization polices. As a result, there is a growing importance of the stock market from
aggregate economy point of view. Nowadays stock market have become a key driver of modern market
based economy and is one of the major sources of raising resources for Indian corporate, thereby enabling
financial development and economic growth. In fact, Indian stock market is one the emerging market in the
world.

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Need for the study and Research Questions
The last two decades have witnessed a dramatic change in world financial markets, particularly the stock
markets, and the fundamental causes of these changes were probably the end of fixed exchange rates in the
early 1970s and the progressive removal of international financial flows. These changes resulted in a
significant increase in the volatility of prices and trade volumes and also lead to noticeable contradictions
between market sentiments and economic growth, due to irrational behavior of investors. The practical
consequences of these changes sometimes have discouraging and humiliating challenges for policy makers
and forecasters, and the investors have to bear greater risk and uncertainty regarding their investment
decisions. Therefore, to predict the possible changes in the stock market those fundamental factors should be
studied, who works as the triggers of changes and drives the market. According to Fama (1981), there is a
comprehensive group of macroeconomic variables that influences the stock prices in the share market of any
country. If a country’s economy is performing well and expected to grow at a vigorous pace, the market is
frequently anticipated to reflect the same.
Indian stock market has developed in terms of number of stock exchanges and other intermediaries, the
number of listed stocks, market capitalization, trading volumes, turnover of the stock exchanges, investor
population and the price indices. The process of reforms has led to a pace of growth almost unparalleled in
the history of any country. The shape and structure of the market have undergone remarkable changes in the
recent past. The stock market of emerging economics like India carries huge expectations of the investors.
The Indian stock market has also undergone tremendous changes since 1991, when the government has
adopted liberalization and globalization policies. As a result, there is a growing importance of the stock
market from the aggregate economic point of view. Nowadays, the stock market has become a key driver of
the modern market based economy and is one of the major sources of raising resources for Indian corporate,
thereby enabling financial development and economic growth. In fact, Indian stock market is one of the
emerging markets in the world. The smoothing development process in Indian stock markets continues to be
breathtaking. From 3,739.69 points on March 31st, 1999, within nine years Bombay Stock Exchange (BSE)
Sensitivity Index (SENSEX) had reached to 21,000 level points in January, 2008. But this impact doesn’t
last long as it was affected by the recent global financial crisis of 2008-09; emerging euro-crisis; and the
recent slowdown of the Chinese economy. Now SENSEX is hovering around 25,500 points after breaching
30,000 points in march 2015, its all time high (BSE India); and similarly after the establishment of nifty in
1994, it goes to its all time high breaching 9,000 points (NSE India). In the context of this effect in Indian
Stock Market, the critical question is whether the decades old development or recent degradation in the
markets are in any way influenced by the domestic and international macroeconomic fundamentals. There
are several studies concluding contradictory results, based on different methodologies, regarding the

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interaction of share market returns and the macroeconomic variables, viz-a-viz, Agrawalla (2006) stated that
rising indices in the stock markets cannot be taken to be a leading indicator of the revival of the economy in
India and vice-versa. However, Shah and Thomas (1997) supported the idea that stock prices are a minor
which reflect the real economy. Similarly, Kanakaraj et al. (2008) examined the trend of stock prices and
various macroeconomic variables between the time periods 1997-2007 and tried to explore upon if the rise in
the stock market can be explained in the terms of macroeconomic fundamentals and concluded by
recommending a strong relationship between the two. Despite the growth of Indian stock market, it is
suffering from various typical weaknesses of an emerging market. First, speculation practices cause high
market volatility, which makes the market highly unpredictable. Second, it is widely known that one of the
biggest problems facing by investors is the lack of transparency. Reporting requirements for listed
companies are not well defined, and significantly less comprehensive than those in the developed stock
markets. Third, information disclosed to the public is not clear and transparent, thus, not reliable. Due to all
these problems, investors become irrational and may base their actions on the decisions of others who are
well informed about market developments, by following the market consensus. In other words, the herding
behavior may exist in the Indian stock market. Therefore, from the point of view of policy makers, investors
and research practitioners, it is important to study the effect of both domestic and international
macroeconomic variables on the performance of the stock market because both investors and policy makers
mostly concern if the current market prices reflect all publicly available information, such as information on
inflation, economic growth, money supply, exchange rates, interest rates, foreign inflows, gold prices, etc.
Hence, this study tries to investigate whether or not it is possible for market participants to make consistently
superior returns just by analyzing the movement in fundamental macroeconomic factors of the country. In
other words, the focus of this study is to find out the relationship between stock prices and macroeconomic
variables in India.
Objectives of the study
The present work is designed to address the linkage between macroeconomic variables and stock market
development in the present context for Indian economy. Accordingly the objectives of the present study are
set as follows:
1. The first objective is to examine the role of macroeconomic variables on the stock market development in
the context of financial innovation, liberalization, globalization and asset market changes in India.
2. The second objective is to examine the dynamic relationship between fiscal policy variables and the stock
market development in India.
3. The third objective is to explore the relationship between sectoral stock market indices and sectoral
macroeconomic parameters.

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4. The fourth objective is to evaluate the implications of evidence for framing appropriate economic policies
for improving stock market efficiency.
Significance of the study
The present study is expected to add several primary contributions to the existing literature. First, it will add
to the present literature by examining the relationship of the stock market with a set of macroeconomic
variables in emerging markets like India, in the present context. Second, the study will apply different
modern econometric methods like Auto regressive Distributed Lag (ARDL), Vector Error Correction Model
(VECM), Variance Decomposition (VDC) and Impulse Response function (IRF), which may provide insight
for the existing literature if the analysis is sensitive to the methods employed. To the best of my knowledge,
this will be the first study to estimate sectoral contribution of GDP and its impact on respective sectoral
indices of stock market using data on the Indian economy. The importance of the sectoral analysis is that, if
any sector performs extremely well than it will help policy makers and investors especially, to predict the
changes in the prices of the stocks of that particular sector. This study is expected to offer some insights for
Indian policymakers, investors, researchers and portfolio managers. Investors may be able to make informed
decisions based on macroeconomic dynamics and it is possible for them to decide the ideal time to buy and
sell the stocks. The study will be advantageous to know the relationship of prices and economic activity; the
direction of the outcome of the relationship may enhance the predictive ability of policy makers; thus, both
contractions and expansion of the Indian economy may be forecasted and predicted with some degree of
certainty. Policymakers are mainly interested in exploring the determinants of the stock market, and how
stock market reflects the changes in domestic and international macroeconomic variables of the economy,
thus, the study will provide them a background to determine the variables, which are expected to influence
the stock market. Moreover, economic theory suggests that stock prices should reflect expectations about
future corporate performance, and the corporate profits generally reflect the level of economic activities. If
stock prices accurately reflect the underlying fundamentals, then the stock prices should be considered as the
leading indicators of future economic activities, and not the other way around. Therefore, the study of the
causal relations and dynamic interactions between macroeconomic variables and stock prices will help in the
formulation of the nation’s macroeconomic policy.
Organization of the study
The rest of the study is organized in seven chapters; Chapter 2 focuses on the overview of Indian stock
market, which aims to present a historical review of the development stages of the Indian stock market since

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its establishment in 1875. The chapter has been organized as follows. Section 2.1 presents an introduction to
the chapter; Section 2.2 provides highlights the historical development of the Indian stock market; section
2.3 discusses the case for India as an emerging market economy. In Section 2.4, some of the major changes
in the financial sector of the Indian economy are briefly described; the section 2.5 consists of the description
of the trends of the Indian Stock Market; and the last section 2.6 outlines the summary of the chapter.
Scope of study
The current study unravels the linkage between stock market & macroeconomic variables in the Indian
context using techniques like regression, Granger causality test, ADF test & Unit root test using SPSS. A
time span of 7 years has been chosen for this study from April, 2005 to March, 2012 uses monthly data to
portray a larger view of the relationship.
The study also attempts to analyze the impact of macroeconomic variables on stock market sector wise. Five
sectors have been taken for this analysis namely Auto, metals, Capital goods, FMCG and Consumer
Durables sectors of BSE. Not only the domestic economic variables have been considered but the linkage
with the external world through the exchange rate movement has also been included in the analysis.
The study does not assume any a prior relationship between these variables and the stock market and is open
to the possible two-way relationship between them which has been tested through Granger causality test.
Limitations of study
There are four limitations that need to be acknowledged and addressed regarding the present study.
And these limitations are as follows:
 Reliability
This study is based on the analysis of the secondary data that has been collected. Secondary data is the data
that is already available & has been used for analysis & thus might not be reliable.
 Accuracy
The result & conclusion of this study might not be accurate due to reliability of the secondary data
& limitation on the variables selected & the time span considered.
 Time period
A time span of only 7 years has been considered for examining the relation between macroeconomic
variables and Indian stock market.
 Limited variables
This study mainly focuses on selected seven independent variables which may not completely represent the
macroeconomic variables.

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Importance of study
Stock market is an important part of the economy of a country. The stock market plays a pivotalrole in the
growth of the industry and commerce of the country that eventually affects the economy of the country to a
great extent. Stock market is seen as a very significant component of the financial sector of any economy.
Furthermore it plays a vital role in the mobilization of capital in many of the emerging economies.
The importance of this study stems from the vital role of the Indian stock Market in the economy for the
following reasons:
Indian stock market plays an important role in collecting money and encouraging investments, so study was
designed to explore the influences of some factors on stock market prices in BSE.
This study will be useful for the investors who might be able to identify some basic economic variables that
they should focus on while investing in stock market and will have an advantage to make their own suitable
investment decisions.
Many different kinds of investors would find this study as an assistant, especially, individual investors,
portfolio managers, institutional investors and foreign investors.
CHAPTER-1
LITERATURE REVIEW

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Literature related to this study is divided into the following two parts.
1.1 Macroeconomic Factors Affecting Foreign Stock Markets
Shanken and Weinstein (2006) concluded that only Index of Industrial Production is a significant factor for
stock markets. Yang and Wang (2007) concluded that in the short run, although bivariate causality exists
between RMB exchange rate and A-share stock index, bivariate causality does not exist between RMB
exchange rate and B-share stock index. Frimpong (2009) concluded that with the e x c e p t i o n o f e x c h a
n g e r a t e , a l l o t h e r macroeconomic variables impact stock prices negatively. Aydemir and Demirhan
(2009) reported bidirectional causal relationship between exchange rate and all stock market indices.
Adebiyi et al. (2009) established a causal relationship from oil price shocks to stock returns, and from stock
returns to real exchange rate. Ali et al. (2010) found that co-integration exists between industrial production
index and stock prices. However, no causal relationship was found between other macro-economic
indicators and stock prices in Pakistan. Cagli et al. (2010) found out that the stock market is co-integrated
with gross domestic product, U.S. crude oil price, and industrial production. Hosseini and Ahmad (2011)
found both long and short run linkages between stock market indices and macroeconomic variables like
crude oil price (COP), money supply (M2), industrial production (IP) and inflation rate (IR) in India and
China. Buyuksalvarci (2010) concluded that interest rate, industrial production index, oil price, foreign
exchange rate have a negative effect, while money supply has a positive influence on Turkish Index return.
On the other hand, inflation rate and gold price do not appear to have any significant effect. Daly and Fayyad
(2011), after studying seven countries (Kuwait, Oman, UAE, Bahrain, Qatar, UK and USA), found that oil
price can predict stock return better after a latest rise in oil prices. Liu and Shrestha (2008) found that a co-
integrating relationship exists between stock prices and the macro-economic variables like money supply,
industrial production, inflation, exchange rate and interest rates. Azizan and Sulong (2011) found that the
Malaysian stock market is more integrated with other Asian countries' economic variables. It also found that
stock prices and exchange rates of other Asian countries have the most impact on Malaysian stock markets.
1.2 Macroeconomic Factors Affecting the Indian Stock Market
Ahmed (2008), by applying Toda and Yamamoto Granger causality test, variance decomposition and
impulse response functions, concluded that stock prices in India lead economic activity except movement in
interest rate. Interest rate seems to lead the stock prices. Debasish (2009a) concluded that spot price
volatility and trading efficiency was reduced due to introduction of future trading. Debasish (2009b) found
that the futures market clearly leads the cash market. It also found that the index call options lead the index
futures more strongly than futures lead calls, while the futures lead puts more strongly than the reverse.
Debasish (2009c), by using GARCH analysis, confirmed no structural change after the introduction of

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futures trading on Nifty. Besides Bansal and Pasricha (2009) found volatility is significantly reduced after
the permission of foreign investment in the equity sector. Goudarzi and Ramanarayanan (2011) established
that BSE500 stock index and FII series are co-integrated and bilateral causality exists between them. Gupta
(2011) concluded that foreign institutional investment affects stock prices significantly.
Ghosh et al. (2010) found that dollar price, oil price, gold price and CRR have a significant impact on stock
market returns. However, food price inflation and call money rate do not affect stock market return. Agrawal
and Srivastava (2011) found bidirectional causality between exchange rate and stock market; and positive
significant relationship between volatility in stock returns and exchange rates through the GARCH model.
Agrawalla and Tuteja (2007) provided evidence of a stable long run equilibrium relationship between stock
market developments and economic growth in India. Srivastava (2010) concluded that in the long term,
stock market was more affected by domestic macroeconomic factors like industrial production, wholesale
price index and interest rate than global factors. Agrawalla and Tuteja (2008) reported causality running
from economic growth proxies by industrial production to share price index. In support to this, Padhan
(2007), by applying Toda- Yamamota non-causality tests, found that both the stock price (BSE Sensex) and
economic activity (IIP) are integrated of order one, i.e. I (1) and bidirectional causality exists.
1.3 Review of Literature
For this study, it is not viable to survey all the literature in every dimension. However, the present study
focuses on the causal relationship between macroeconomic factors and stock prices. Therefore, in this
section, we will discuss the studies showing the relationship between macroeconomic variables and stock
prices. The first section will discuss the relevant studies from overall economies, the studies related to Indian
economy will be provided in the second section.
1.3.1. Studies conducted in Rest of the World
Asprem (1989) investigated the relationship between stock indices, asset portfolios and macroeconomic
variables in ten European countries. The study uses quarterly data from 1968 to 1984. Correlation and
regression techniques were adopted for estimation. Variables used for the study were changes in industrial
production, real gross national product, gross capital formation, employment, exports, exchange rate,
consumption, interest rate, inflation and money supply. Results showed that employment, imports, inflation
and interest rates, are negatively correlated with stock prices. Changes in imports may be viewed as an
indicator for changes in consumption. Thus, the relation between imports and stock prices is evidence in
support of the consumption capital asset pricing model.

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Campbell and Hamao (1992) studied the predictability of monthly excess returns on equity portfolios over
the domestic short-term interest rate in the U.S. and Japan during the period January 1971 to March 1989. A
highly restricted model was estimated and tested for the study, in which expected excess returns in Japan and
the U.S. are driven by a common unobserved variable, so that they are perfectly correlated. The paper found
that similar variables, including the dividend-price ratio and interest rate variables help to forecast excess
returns in each country. In addition, in the 1980's U.S. variables help to forecast excess Japanese stock
returns.
Pesaran and Timmermann (1995) examined the robustness of the evidence on the predictability of U.S. stock
returns, using recursive modeling approach. Monthly time series data from January 1954 to December 1992.
Variables used for the study include S&P 500 index, one month T-bill rate, producer price index (inflation),
twelve month discount bond rate, rate of change in industrial production index. It is found from the study
that the predictive power of various economic factors over the stock returns changes through time and tends
to vary with the volatility of returns.
Canova and Nicolo (1995) analyzed the relationship between stock returns and real activity from the point of
view of a general equilibrium, multi country model of the business cycle, using correlation and regression
techniques. The data set consists of quarterly data on real stock returns, dividend yields and real GNP,
consumption and investment for the US, the UK, France, Germany and Italy for the period 1970-1991. We
found from the study that when government expenditure shocks drive the international cycle the association
between real GNP growth and stock returns is primarily due to the strong positive effect these disturbances
have on dividend payments. And, when technology shocks drive the cycle, the association is weaker because
dividend yields are less correlated with GNP.
Mookerjee and Yu (1997) explored the nexus between Singapore stock returns and macroeconomic
variables, using co integration and causality techniques. Monthly time series data from October 1984
through April 1993 was used. Macroeconomic variables used for the study were money supply, nominal
exchange rates and aggregate foreign currency reserves and all-share price index for the Singapore stock
market. The results indicated that three of the four macro variables are co integrated with stock prices,
suggesting potential inefficiencies in the long run. The causality tests and forecasting equations provide
conflicting evidence on the informational efficiency of the stock market in the short run.
Cheung and Ng (1998) studied the empirical evidence of long run co-movements between five national stock
market indexes and measures of aggregate real activity, including the real oil price, real consumption, real
money supply and real output (GNP), using co integration and error correction mechanism (ECM). The
quarterly stock index and macroeconomic data from 1957:Q1 to 1992:Q2 for Canada, Germany, Italy, Japan,

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and the U.S. was considered for the study. The findings showed that the real stock market indexes are
typically co integrated with measures of the countries’ aggregate real activity such as the real oil price, real
consumption, real money stock, and real output. Based on the ECM, it was also found that the real returns on
stock indexes are generally related to deviations from the empirical long run relationship and to changes in
macro variables.
Garcia and Liu (1999) examined the macroeconomic determinants of stock market development, particularly
market capitalization for fifteen industrial and developing countries from 1980 to 1995, using correlation and
regression techniques. The study focused on the determinants of stock market capitalization as a proxy for
stock market development. Macroeconomic variables considered were real income and income growth rate,
the savings and investment and the financial intermediary development. The paper found that the variables
like real income, saving rates, financial intermediary development, and stock market liquidity are important
determinants of stock market capitalization; and stock market development and financial intermediary
development are complements instead of substitutes.
Kwon and Shin (1999) investigated that whether current economic activities in Korea can explain stock
market returns by using a co integration test and a Granger causality test from a vector error correction
model by using monthly data from January 1980 to December 1992. The macroeconomic variables used for
the study include the production index, exchange rate, trade balance, money supply, Korea Composite Stock
Price Index (KOSPI) and Small-size Stock Price Index (SMLS). The results showed that stock market index
and macroeconomic variables are co integrated. The study also found that the stock price indices are not a
leading indicator for economic variables.
Gjerde and Saettem (1999) investigated to what extent important results on relations among stock returns
and macroeconomic factors from major markets are valid in a small, open economy by utilizing the
multivariate vector autoregressive (VAR) approach on Norwegian data. Monthly time series data from 1974
to 1994 was used for the study. Variables used include stock returns, interest rates, inflation, industrial
production, consumption, OECD industrial production index, and foreign exchange rate NOK/USD, and oil
prices. The results suggested that real interest rate changes affect both stock returns and inflation, and the
stock market responds accurately to oil price changes. On the other hand, the stock market shows a delayed
response to changes in domestic real activity.
Nasseh and Strauss (2000) explored the existence of a significant, long-run relationship between stock prices
and domestic and international economic activity in six European economies, namely, France, Germany,
Italy, Netherlands, Switzerland and the U.K, using a vector error correction model (VECM). The data set
consists of quarterly data from 1962:Q1 to 1995:Q4 for real industrial production indices and business

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surveys of manufacturing orders (real domestic macroeconomic activity), money market or call interest rates
(short-term interest rates) and long-term government bond rates (long-term interest rates); and the industrial
(INSEE) share price index represents stock prices (SP) for France, the all share price index is used for
Germany, Netherlands and Switzerland, the MSE share price index for Italy, and the FT 500 share price
index for the U.K. The results showed that the stock price levels are significantly related to industrial
production, business surveys of manufacturing orders, short- and long-term interest rates as well as foreign
stock prices, short-term interest rates and production.
Canova and Nicolo (2000) analyzed the empirical interdependencies among asset returns, real activity, and
inflation from multicounty and international points of view, using the VAR model. Monthly data from
1973:1 to 1995:12 was used for the study. Variables used were - measure of nominal stock returns (SR),
slope of the nominal term structure (TERM), real activity growth (IP), and inflation (INF). The findings of
the study suggested that innovations in nominal stock returns are not significantly related to inflation or real
activity, that the U.S. term structure of interest rates predicts both domestic and foreign inflation rates and
domestic future real activity.
Maysami and Koh (2000) examined the long-term equilibrium relationships between the Singapore stock
index and selected macroeconomic variables, as well as among stock indices of Singapore, Japan, and the
United States by using month-end data for the period from January 1988 to January 1995. Variables used for
the study were weighted average closing prices for all shares listed on the Stock Exchange of Singapore,
exchange rate of the Singapore SDRs (Special Drawing Rights), Money Supply (M2), Consumer Price
Index, Industrial Production Index, 3-month Interbank Offer Rate, yield on 5-year government securities,
stock-price index of the United States, stock price index of Japan, Total Domestic Export from Singapore.
The methodology adopted was Vector Error-Correction Models (VECM) to examine the dynamic relations.
The study concluded that changes in Singapore’s stock market levels do form a co-integrating relationship
with changes in price levels, money supply, short- and long-term interest rates, and exchange rates. While
changes in interest and exchange rates contribute significantly to the co-integrating relationship, those in
price levels and money supply do not. This suggests that the Singapore stock market is interest and
exchanges rate sensitive. Additionally, the article also concluded that the Singapore stock market is
significantly and positively co-integrated with stock markets of Japan and the United States.
Ibrahim and Yusoff (2001) analyzed dynamic interactions among macroeconomic variables such as real
output, price level, and money supply, exchange rate, and equity prices for the Malaysia (Kuala Lumpur
Composite Index (KLCI)), using co integration and vector auto regression techniques. Monthly time series
data from January 1977 to August 1998 was considered for the study. The findings showed that the money

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supply exerts a positive effect on the stock prices in the short run. However, money supply and stock prices
are negatively associated in the long run.
David E. Rapach (2001) examined the effects of money supply, aggregate spending, and aggregate supply
shocks on real US stock prices in a structural vector auto regression framework. Macroeconomic variables
used for the study include S&P 500 index deflated by the implicit GDP deflator, 3 month T-bills rate and
GDP. Quarterly time series data from the period 1959: Q3–1999: Q1 was used for the study The empirical
results indicated that each macro shock has important effects on real stock prices.. The real stock price
impulse responses to the various macro shocks follow to the standard present-value equity valuation model,
and they shed considerable light on the well-known negative correlation between real stock returns and
inflation.
Wongbangpo and Sharma (2002) investigated the role of selected macroeconomic variables, i.e., GNP,
consumer price index, money supply, interest rate and the exchange rate on the stock prices in five ASEAN
countries, namely, Indonesia, Malaysia, Philippines, Singapore and Thailand, using cointegration and
Granger causality. The data set consists of monthly data from 1985 to 1996 for Jakarta composite stock price
index (JCSPI) for Indonesia, Kuala Lumpur Stock Exchange Composite Index (KLSE) for Malaysia,
Philippine Stock Exchange Composite Index (PSE) for Philippine, Stock Exchange of Singapore Index
(SES) for Singapore and the Stock Exchange of Thailand Index (SET) for Thailand. The study observed long
and short term relationships between stock prices and the macroeconomic variables; and the macroeconomic
variables in these countries cause and are caused by stock prices in the granger sense.
Ewing (2002) studied the response of the NASDAQ Financial 100 index to macroeconomic news, by using
generalized impulse response analysis. Monthly time series data from January 1988 to September 2000 was
used for the study. Macroeconomic variables used for the study were the coincident index (real output),
changes in the fed funds rate (stance of monetary policy), spread between Baa and Aaa corporate bond rates
(interest rate spread), consumer price index. The results indicated that a monetary policy shock reduces
financial sector returns, having a significant initial impact effect that continues to affect returns for around 2
months. Unexpected changes in economic growth have a positive initial impact effect, but exhibit no
persistence. An inflation shock is associated with a negative and statistically significant initial impact effect
which lasts for up to 1 month after the time of shock.
1.3.2. Studies related to Indian economy
Fama (1981, 1982) and many other research studies like Fama and Schwert (1977), Gallagher and Taylor
(2002), Geske and Roll (1983) empirically find that stock returns are negatively affected by both expected

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and unexpected inflation. Marshall (1992) also finds that negative effect of inflation on stock return is
generated by real economic fluctuations, by monetary fluctuations or changes in both real and monetary
variables.
Darat and Mukherjee (1987) applied a Vector Auto Regression (VAR) model and found that a significant
causal relationship exists between stock returns and selected macroeconomic variables of China, India,
Brazil and Russia which are emerging economies of the world using oil price, exchange rate, and moving
average lags values as explanatory variables employed MA (Moving Average) method with OLS (Ordinary
Least Square) and found insignificant results which postulate inefficiency in market. Finally they concluded
that in emerging economies the domestic factors influence more than external factors, i.e., exchange rate and
oil prices.
Bahmani and Sohrabian (1992) studied the causal relationship between U.S. stock market (S&P 500 index)
and effective exchange rate of dollar in the short period of time. Their theory established bidirectional
causality between the two for the time period taken. However, co integration analysis failed to identify any
long run relationship between the two variables.
Mukherjee and Naka (1995) applied Johansen’s (1998) VECM to analyze the relationship between the
Japanese Stock Market and exchange rate, inflation rate, money supply, real economic activity, long-term
government bond rate, and call money rate. They concluded that a co integrating relation indeed existed and
that stock prices contributed to this relation.
Abdalla and Murinde (1997) investigated the intersections between exchange rates and stock prices in the
emerging financial markets of India, Korea, Pakistan and the Philippines. They found that results show
unidirectional granger causality from exchange rates to stock prices in all the sample countries, except the
Philippines, where they found that the stock price lead the exchange rate.
Shah and Thomas (1997) argue that because of the enabling government policies stock market in India is
more efficient than the Indian banking system, both in terms of quality of information processing and
imposition of transaction cost. Their research supports the idea that stock prices are a mirror which reflect
the real economy, and are relatively insensitive to factors internal to the financial system such as market
mechanisms. However the arguments require more explanation.

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Naka, Mukherjee and Tufte (1998) analyzed relationships among selected macroeconomic variables and the
Indian stock market, using a vector error correction model. Quarterly time series data from 1960:Q1 to
1995:Q4 was used. Macroeconomic variables used for the study were real output (IPI), inflation (CPI),
money stock (M1) and interest rate (money market rate in the Bombay inter-bank market) and Sensex. The
results suggested that three long-term equilibrium relationships exist among the variables. It was also found
that domestic inflation is the most severe deterrent to Indian stock market performance, and domestic output
growth is its predominant driving force.
Pethe and Karnik (2000), using Indian data for April 1992 to December 1997, attempts to find the way in
which stock price indices are affected by and affect other crucial macroeconomic variables in India. But this
study runs causality tests in an error correction framework on non co integrated variables, which is
inappropriate and not econometrically sound and correct. The study, of course avers that in the absence of co
integration it is not legitimate to test for causality between a pair of variables and it does so in view of the
importance attached to the relation between the state of the economy and stock markets. The study reports
weak causality running from IIP to share price index (Sensex and Nifty) but not the other way round. In
other words, it holds the view that the state of the economy affects stock prices.
Muradoglu, Taskin And Bigan (2000) investigated the relationship between stock returns and
macroeconomic variables in emerging markets like Argentina, Brazil, Columbia, and Mexico from South
America; Portugal and Greece from Europe; Korea from the Pacific rim; Jordan, Pakistan, and India from
Asia; and Nigeria and Zimbabwe from Africa., using co integration and granger causality test. Monthly time
series data from 1976 through 1997. Variables used were, stock returns, exchange rates, and interest rates
were assumed to be linear in a set of local and global information variables, whereas inflation and industrial
production were assumed to be linear in a set of local information variables only. The global information
variable was the return on the S&P 500 index, which represents the world market portfolio, and controls for
the degree of market liberalization. Local informational variables were, return on country indices, exchange
rates, interest rates, inflation, and industrial production index, which is a measure of general economic
activity and proxies for GDP. The results of the study explored that the two-way interaction between stock
returns and macroeconomic variables is mainly due to the size of the stock markets, and their integration
with the world markets, through various measures of financial liberalization.
Mohtadi and Agarwal (2001) examined the relationship between stock market development and economic
growth for 21 emerging markets, using a dynamic panel method. Annual data from 1977 to 1997 was used
for the study. Stock Market Variables used were, market capitalization ratio, total value of shares traded

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ratio, and turnover ratio; and macroeconomic variables include growth, foreign direct investment, investment
(real investment divided by GDP) and Secondary School Enrolment. The results suggested a positive
relationship between several indicators of the stock market performance and economic growth both directly,
as well as indirectly by boosting private investment behaviour.
Biswal and Kamaiah (2001) addressed the behaviour of stock market development indicators, namely,
market size, liquidity, and volatility and examined whether these indicators have exhibited any trend changes
after India liberalized its financial policies. Variables considered for the study were three stock market
indicators, viz.,size, liquidity and volatility, and two time series trend break techniques of Perron were
applied on monthly data of Bombay Stock Exchange. Data for market capitalization and turnover ratio range
from 1991:1 through 1998:12 while that for the value traded spans from 1989:1 through 1998:12. Required
price data for constructing volatility series has been collected as the average monthly value of the BSE
Sensitive Index for the period 1983:12 through 1998:12. The study suggested that the stock market has
become larger and more liquid, in the post liberalization period. In respect of volatility, however, the market
does not exhibit any significant change.
Bilson, Brailsford & Hooper (2001) addressed the question of whether local macroeconomic variables have
explanatory power over stock returns in emerging markets, incorporating six Latin American countries, eight
Asian countries, three European countries, one Middle Eastern country and two African countries, using
correlation and regression. Monthly data from January 1985 to December 1997 was used for the study.
Macroeconomic variables used were money supply (M1), consumer price index, industrial production index
and exchange rate. The results show that while emerging stock markets are segmented to a degree, there is
significant commonality in return variation across markets. Furthermore, little evidence of common
sensitivities to the extracted factors was found when the markets are considered in aggregate, but common
sensitivity is found at the regional level.
Bhattacharya and Mukherjee (2002) studied the nature of the causal relationship between stock prices and
macroeconomic aggregates in India, by applying the techniques of unit–root tests, co integration and the
long–run Granger non–causality test proposed by Toda and Yamamoto (1995), Variables used for the study
were the BSE Sensitive Index and the five macroeconomic variables, viz., money supply, index of industrial
production, national income, interest rate and rate of inflation using monthly data from 1992-93 to 2000-01.
The study found that there is no causal linkage between stock prices and money supply, stock prices and
national income and stock prices and interest rate; index of industrial production leads the stock price; and
there exists a two-way causation between stock price and rate of inflation.

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Pretorius (2002) estimates cross-section and time-series models to determine the fundamental factors that
influence the correlation and evolvement of the correlation between emerging stock markets, using Ordinary
Least Square (OLS) methodology. Quarterly data from 1995:Q1 to 2000:Q2 was considered for the study.
Ten emerging stock markets (according to the Emerging Market Database definition) with the highest
market capitalization was used in the study. Variables used were, inflation, exchange rate, trade and
industrial production. The results showed that only the extent of bilateral trade and the industrial production
growth differential were significant in explaining the correlation between the two countries on a cross-
sectional basis. In addition, countries in the same region are more correlated than countries in different
regions.
Chancharoenchai, Diboog Lu & Mathur (2005) investigated the relationship between domestic
macroeconomic variables and stock excess returns to evaluate the effects of macroeconomic variables on
excess returns and assess market efficiency in the six Southeast Asian economies prior to the 1997 Asian
crisis. Monthly data from January 1987 to December 1996 was considered for the study. GARCH model was
used for the empirical estimation. Variables used were interest rate (risk-free rate of return), inflation and
excess stock returns. The results showed that some macroeconomic variables evidently had a certain
predictive power for excess returns and their volatility.
Srivyal Vuyyuri (2005) investigated the causal relationship between the financial and the real sectors of the
Indian economy using multivariate co integration and Granger causality tests. Monthly time series data from
July 1992 to December 2002 was used for the study. Financial variables included were interest rates,
inflation rate, exchange rate, stock return, and real sector is proxies by industrial productivity. The results
showed that there exist a long run equilibrium relationship between the financial sector and the real sector
and unidirectional Granger causality was also found between the financial sector and the real sector of the
economy.
Nikkinen, Omran, Sahlström & Äijö (2006) investigated how global stock markets are integrated with
respect to the U.S. macroeconomic news, announcements, using data from the period July 1995 to March
2002. Methodology adopted was GARCH volatilities around ten important scheduled U.S. macroeconomic
news announcements on 35 local stock markets that are divided into six regions. These regions were the G7
countries, the European countries other than G7 countries, developed Asian countries, emerging Asian
countries, Latin American countries and countries from Transition economies. The results showed that
theG7 countries, the European countries other thanG7 countries, developed Asian countries and emerging

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Asian countries are closely integrated with respect to the U.S. macroeconomic news, while Latin America
and Transition economies are not affected by U.S. news.
Yartey (2008) examined the institutional and macroeconomic determinants of stock market development
using a panel data of 42 emerging economies for the period 1990 to 2004. Macroeconomic variables used for
the study were income level, banking sector development, savings and investment, stock market liquidity,
macroeconomic stability, private capital flows and institutional quality. The study found that
macroeconomic factors such as income level, gross domestic investment, banking sector development,
private capital flows, and stock market liquidity are important determinants of stock market development in
emerging market countries.
Agrawalla and Tuteja (2008) examined the interaction between stock prices and a few important
macroeconomic variables for India using co integration analysis and granger causality. Monthly time series
data for the period November 1965 to October 2000 was considered. Macroeconomic variables used were
share price index, industrial production, money supply, credit to the private sector, exchange rate, wholesale
price index, and money market rate. The study reported unidirectional causality running from economic
growth proxied by industrial production to share price index and not the other way round.
Lekshmi R. Nair (2008) examined the macroeconomic determinants of stock market development in India
for monthly data from 1993-94 to 2006-07.Cointegration and error correction modelling were used for the
analysis. Macroeconomic variables used for the study were turnover ratio (As an indicator of stock market
development), inflation rate, real income and its growth rate, financial intermediary development, foreign
institutional investment, exchange rate and SBI Prime lending rate. The results showed that there exists a
long run relationship between all the macroeconomic variables used and stock market development.
Variables like real income and its growth rate, interest rate and financial intermediary development
significantly affect stock market development in the short run.
Gay, Jr. (2008) investigated the time-series relationship between stock market index prices and the
macroeconomic variables used were exchange rate and oil price for Brazil, Russia, India, and China (BRIC)
using the Box-Jenkins ARIMA model. Monthly data from March 1993 to June 2006 was used for the study.
The study found no significant relationship between respective exchange rate and oil price on the stock
market index prices of either BRIC country, this may be due to the influence other domestic and
international macroeconomic factors on stock market returns, warranting further research.

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Shahid Ahmed (2008) investigated the nature of the causal relationships between Indian stock prices, and the
key macroeconomic variables for the period March, 1995 to March, 2007 using quarterly data. Variables
used were index of industrial production, exports, foreign direct investment, money supply, exchange rate,
interest rate, NSE Nifty and BSE Sensex. Johansen`s approach of co-integration and Toda and Yamamoto
Granger causality test were applied to explore the long-run relationships while BVAR modelling for
variance decomposition and impulse response functions was applied to examine short run relationships. The
study revealed that stock prices in India lead economic activity except movement in interest rate as interest
rate seem to lead the stock prices. The study concluded that the movement of stock prices is not only the
outcome of behaviour of key macroeconomic variables, but it is also one of the causes of movement in other
macro dimension in the economy.
Seetanah, Sannassee & Lamport (2008) examined simultaneously banking sector development, stock market
development, and economic growth in a unified framework for 27 developing countries, using rigorous
panel VAR procedures. Annual time series data from 1991 to 2007 was considered for the study. The
variables used were real per capita gross domestic product, investment ratio, openness and secondary
enrolment ratio. Results showed that stock market development is an important ingredient of growth, but
with a relatively lower magnitude as compared to the other determinants of growth, particularly with
banking development. Interestingly, stock market development and banking development are seen to be
complement to each other and moreover there are important indirect effects through ‘investment channel’ to
grow.
1.3.3. Summary of Literature review
The objective of detailed literature review was to point out the contradictory views regarding the effect of
macroeconomic variables on the stock prices with reference to the empirical analysis approach of cross-
sectional and time series data. From this comprehensive literature review, several key conclusions can be
drawn. One of them states that, while the existing theories hypothesize a link between macroeconomic
variables and stock markets, they do not specify the type or the number of macroeconomic factors that
should be included. Thus, the existing empirical studies, reviewed in this chapter, have shown the use of a
vast range of macroeconomic variables to examine their influence on stock prices. A brief summary of the
literature review indicate that the macroeconomic variables that were mainly used by the researchers are
Index of Industrial production, real gross national product, gross capital formation, employment, exports,
exchange rate (Real Effective Exchange Rate, Nominal Effective Exchange Rate), consumption, interest rate
(T-bill rate, call money rate), inflation (Producer Price Index, Consumer Price Index and Wholesale Price
Index), aggregate foreign currency reserves, Crude oil price, real consumption, consumption expenditures,

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investment expenditure, federal funds rate, Foreign Direct Investment, Foreign Institutional Investment,
foreign portfolio investment, GDP deflator, trade balance, school enrolment, trade openness, money supply
(M1, M2, M3), unemployment rate, gold prices, foreign exchange reserves, macroeconomic prosperity
index, consumer confidence index, corporate goods price index and gross fixed capital formation. And to
study the impact of these macroeconomic variables the dependent variables used for the study are, stock
market capitalization, stock market index, market liquidity and stock market turnover ratio. All the
researches are conducted by applying different methodologies, namely, correlation analysis, regression
analysis under Ordinary Least Square (OLS) method, generalized autoregressive conditional
heteroskedasticity (GARCH) model, cointegration tests using Vector Auto Regression (VAR) framework,
causality tests by employing Vector Error Correction Model (VECM), and Auto Regressive Distributed Lag
(ARDL) approach. These researches are conducted using different sets of data periods starting with the
frequency of daily data, weekly data, monthly data, quarterly and annual data, further, all the studies use
time series data and the studies with multi country data uses the cross-sectional approach.
The other key conclusion drawn by the study indicates that, while previous studies have significantly
improved our understanding of the relationships between macroeconomic variables and stock prices, the
findings from the literature are mixed given that they were sensitive to the choice of countries, variable
selection, and the time period studied. It is difficult to generalize the results because each market is unique in
terms of its own rules, regulations, and type of investors. Additionally, the VAR framework, co integration
tests, Granger causality tests, and GARCH models were commonly used to examine the relationships
between stock prices and macroeconomic variables. However, there is no definitive guideline for choosing
an appropriate model. Further, the review of literature clearly indicates that there exists a large pool of
studies for developed economies regarding the investigation of the relationship between macroeconomic
variables and stock prices, but there is a shortage of literature concerning emerging stock markets.
1.4 STATEMENT OF HYPOTHESIS
The hypothesis for this study has been stated below:

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NULL HYPOTHESIS
H0: There is no significant relation between Index of industrial production and SENSEX
H0: There is no significant relation between Consumer Price Index and SENSEX
H0: There is no significant relation between Call Rate and SENSEX
H0: There is no significant relation between Dollar price and SENSEX
H0: There is no significant relation between Gold price and SENSEX
H0: There is no significant relation between Crude oil and SENSEX
H0: There is no significant relation between Foreign Institutional Investment and SENSEX
H0: There is no significant relation between all these macroeconomic variables and Stock market sector
wise.
NULL HYPOTHESIS
Ha: There is a significant relation between Index of industrial production and SENSEX
Ha: There is a significant relation between Consumer Price Index and SENSEX
Ha: There is a significant relation between Call Rate and SENSEX
Ha: There is a significant relation between Dollar price and SENSEX
Ha: There is a significant relation between Gold price and SENSEX
Ha: There is a significant relation between Crude oil and SENSEX
Ha: There is a significant relation between Foreign Institutional Investment and SENSEX
Ha: There is a significant relation between all these macroeconomic variables and Stock market sector wise
CHAPTER-2
DATA DESCRIPTION

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2.1 An overview of the developments in Indian stock market
During the last two decades, Indian stock market faced various ups and downs. Moreover, it is forced to
severe corrections which were initiated by the SEBI and the government of India. The important events,
news and views which were published in National dailies and various Magazines were considered to provide
an idea about the trends in the Indian Capital Market. Well-developed securities markets are the backbone of
any financial system. Apart from providing the medium for channelizing funds for investment purposes,
securities markets aid in pricing of assets and serve as a barometer of the financial health of the economy.
The Indian securities markets have witnessed extensive reforms in the post-liberalization era in terms of
market design, technological developments, settlement practices and the introduction of new instruments.
The markets have achieved tremendous stability and as a result, have attracted huge investments by foreign
investors. There still is tremendous scope for improvement in both the equity market and the government
securities market. Prior to the early 1990s, most of the financial markets in India faced controls of pricing,
entry barriers, transaction restrictions, high transaction costs and low liquidity. A series of reforms were
undertaken since the early 1990s, so as to develop the various segments of financial markets by phasing out
administered pricing system, removing barrier restrictions, introducing new instruments, establishing an
institutional framework, upgrading technological infrastructure and evolving efficient, safer and more
transparent market practices, which ultimately leads to the economic development of the nation. Since the
study is concerned with studying predictability in the Indian stock market, it is necessary as well as logical to
present the origin, any relevant details about the Indian stock market and its important stock indices. To this
end, we first present the history and origin of the Indian stock market. Followed by historical overview, we
will state some recent facts on the performance of the Indian economy to get the knowledge of India’s
current status as one of the most important emerging market economies with huge growth potential and the
role other variables in its sustainability. Since we are concerned with the behavior of the stock market, we
then cite a few major structural, operational and regulatory reforms which were carried out in the Indian
stock market during the last one and-a-half decades since its reform process started in the early nineties of
the last century.
2.2 Historical Development of the Indian Stock Market
The history of Indian stock market is about 200 years old. Prior to this the hundis and bills of exchange were
in use, especially in the medieval period, which can be considered as a form of virtual stock trading but it
was certainly not an organized stock trading. The recorded stock trading can be traced only after the arrival
of the East India Company. The first organized stock market that was governed by the rules and regulations
came into the existence in the form of The Native Share and Stock Broker’s Association in 1875. After
passing through numerous changes this association is today better as Bombay Stock Exchange, which

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remains the premier stock exchange since its inception. The formation of the native share and the stock
broker’s Association at Bombay in 1875 was an important early event in the development of the stock
market. This was followed by the formation of association/exchanges in Ahmedabad (1894), Calcutta
(1908), and Madras (1937). In addition, a large number of short-lived exchanges emerged mainly in rising
periods to go back into darkness during depressing times subsequently. Indian stock market marks to be one
of the oldest stock market in Asia. It dates back to the close of the 18th century when the East India
Company used to transact loan securities. In the 1830s, trading on corporate stocks and shares in the Bank
and Cotton presses took place in Bombay. However, the items in which the trading took place increased
tremendously by the end of 1839. Thereafter, the concept of broker business was started which show
momentum in the mid-18th century. Though the trading was broad but the brokers were hardly a half dozen
during 1840 and 1850. An informal group of 22 stockbrokers began trading under a banyan tree opposite the
Town Hall of Bombay from the mid-1850s, each investing a (then) princely amount of Rupee one. This
banyan tree still stands in the Horniman Circle Park, Mumbai. In 1860, the exchange flourished and the
number of brokers who are dealing in the trading of items goes up to 60. Around 1860-61, there is no supply
of cotton from America as the civil war took place in America. Due to this, there is a concept of “Share
Mania” that took place in India. Further, the number of brokers increased from 60 to 250 in around 1862-
1863. The informal group of stockbrokers organized themselves as The Native Share and the Stock Brokers
Association, which, in 1875, was formally organized as the Bombay Stock Exchange (BSE). In 1930, BSE
was shifted to an old building near the Town Hall in Bombay. On 31 August 1957, the BSE became the first
stock exchange to be recognized by the Indian Government under the Securities Contracts Regulation Act.
And finally in 1986, it developed the BSE SENSEX index, giving the BSE a means to measure overall
performance of the exchange.
Early 1960s was starting of bearish phase in the stock exchange as the Indo China war took place. After the
ban in forward trading and badla in 1969, the bearish trend became worse. Badla in share trading means
something in return. It is a system to carry-forward. Badla is the charge, which the investor pays to carry
forward his position. Using the Badla tool or system, an investor can take a position in the scrip without
actually taking delivery of the stock. He can carry-forward his position on the payment of small margin.
Financial institutes helped to boost the sentiment by injecting liquidity in the market. In 1964, the first Indian
mutual fund came into market, named the Unit Trust of India.
The badla trading was resumed again in 1970s, under another form of hand delivery contracts. But in 1974,
6th of July capital market had to face a bad news. The government introduced the Dividend Restriction
Ordinance (DRO); this rule restricting the companies for the payment of dividend up to 12 per cent of the
face value or one-third of the profits of the companies can be distributed (Whichever was lower). With the

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news, the stock market crashed again. Stocks went down by 20% and the market was closed for nearly a
fortnight. The stock market remained in a bearish trend until the optimism came to market with the MNCs
who forced to dilute majority stocks in their company in favor of Indian public. It was the first time Indian
public had the opportunity to invest in some of the finest MNCs. In 1977, Mr. Dhirubhai Ambani entered in
Indian stock exchange.
The period of 1980s, proved to be the growth period for Indian stock exchange. Indian public discovered
profitable opportunities in the stock exchange. It was the time when people became aware of the stock
exchange and started to get attracted and invest in the same. It was the time when convertible debentures and
public sector bonds were popular in the market. New stock market entries like Reliance and LNT re-defined
Indian stock market scenario. Such factors enlarged volume in the stock exchange. 1980s can be
characterized by the huge increase in the number of listed companies in the stock market and increase in
market capitalization.
The 1990s can be described as the most decisive decade in the history of Indian stock market. Everyone was
talking about liberalization and globalization. The Capital Issue Act of 1947 was replaced in 1992. SEBI was
emerging as a new regulator of the market. FII is coming to India and re-rating India as one of the most
attractive market in the world. Number of new stock exchanges was rising in the county. Private sector
mutual funds were welcome in the market. Some very big scams of Indian scam history took place in 1990s.
A major scandal with market manipulation by a BSE member named Harshad Mehta took place in 1992.
The impact of such incidence was very deep. Indian investors drove their money out of the market for some
years. With this BSE responded to calls for reform with intransigence. The slow actions by the BSE helped
radicalize the position of the government and opened Indian government eyes, which encouraged the
creation of the National Stock Exchange (NSE), which created an electronic marketplace. New technology
new systems were introduced in Indian stock exchange. The Bombay stock exchange had two new
competitors in the market, the OTC (Over the Counter Exchange of India) and NSE established in 1992. The
national securities clearing corporation (NSCC) and National securities depository Limited (NSDL) were
established in 1995 and 1996 respectively. Option trading service was started in 1995—1996. Rolling
settlement was introduced in India in early 1998. 1990s are known as era of Indian IT companies too. Wipro,
Infosys, Satyam were some of the preferred stocks. Telecom and Media sector also rising during the same
time.
2.3 India as an emerging market economy
The Indian economy has shown a remarkable performance over the last two decades. From the year 1985
onwards, the problem of balance of payments was getting started in India. In the middle of 1991, exchange
rate of India was subjected to a severe correction. The corrections were started with the decline in the value

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of the rupee leading up to mid-1991. The action against this event was taken by the authorities of the
Reserve Bank of India, as they expended international reserves in order to slow down the decline in value of
the rupee. The reserves were near to depletion and the exchange rate was devalued sharply in the first week
of July, against major foreign currencies. By the end of 1990, the country was in a serious economic crisis.
After the occurrence of this major economic crisis, the Government of India had taken some major reforms,
in terms of globalization and liberalization, and thus, the economy started experiencing a rapid economic
growth with the inflow of increasing foreign investment. According to International Monetary Fund, the
Indian Economy is the seventh-largest economy in the world in terms of nominal GDP and the third-largest
by purchasing power parity (PPP). The Central Intelligence Agency (the Fact Book Indian Economy) stated
that, India is also classified as Newly Industrialized Country, one of the G-20 major economies, a member of
BRICS and a developing economy with approximately 7% average growth rate for the last two decades.
India's economy became the world's fastest growing major economy from the last quarter of 2014, replacing
China's and India’s gross domestic product (GDP) grew at 7.5% during the January-March of 2014-15
period, faster than China’s 7% in the same period, mainly on account of improvement in services and
manufacturing sectors. (DNA, Indian economy overtaken china growth rate). As per the report of Economic
Survey 2007-08, show, the Indian economy registered a growth rate of 10.2 percent during the year 2007,
the highest ever and after that, the GDP comes down to 3.7 in 2008-09, due to the Global financial crisis in
that year so-called sub-prime housing mortgage crisis. Because there was fiscal and monetary space, timely
stimulus allowed the economy to recover fairly quickly to a growth of 8.4 percent in 2009-10 and 2010-11.
Since then, however, the fragile global economic recovery and a number of domestic factors have led to a
slowdown once again (as per the Ministry of Finance). Therefore, the GDP in 2011-12 also moderated to 6.5
percent from 9.8 percent in the 2010-11, as per the former finance minister Pranab Mukherjee “the negative
growth in the mining sector along with a slowdown in the construction sector has also contributed to the
decline in GDP growth”. The GDP growth in 2012-13 was worse than expected, according to the Ministry of
Finance, the slowing growth rate in 2012-13 can be explained in terms of both global factors and domestic
factors. The slowdown in growth in advanced economies and near recessionary conditions prevailing in
Europe resulted not only in lower growth of international trade but also lower capital flows. The growth rate
of India’s exports declined. At the same time, however, the international price of crude oil remained high.
Hence, India’s trade and current account deficits widened. Turning to domestic factors, rainfall in the
monsoon season of 2012-13 has been below normal, particularly in the key months of June and July. This
affected sowing and resulted in a lower growth rate of agriculture and allied sectors. The Gross Domestic
Product (GDP) growth rate for 2013-14 has revised upwards to 6.9 percent following adoption of the new
series with base year 2011-12. The GDP growth rate in the year 2014-15 is 7.4 percent as per the statistics of
the Central Statistics Office (CSO). The overall economic situation in the country is looking better and the

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basic parameters of the Indian economy are moving in the right direction, according to Union Finance
Minister Arun Jaitley. As per the Indian Economic Survey 2014-15, the Indian economy in 2014-15 has
emerged as one of the largest economies with a promising economic outlook on the back of controlled
inflation, rise in domestic demand, increase in investments, decline in oil prices and reforms among others.
Apart from India’s success in terms of high growth rates, there exist other important factors necessary for the
sustainability of the growing economy, which came into the picture after the 1991 reforms, i.e., after the
adoption of globalization and liberalization policies, the role of international financial inflows and the degree
of openness to trade has been increased, accelerating the growth of the overall economy. Capital formation is
an important element of any economy. International financial inflows play a complementary role in the
overall capital formation of an economy, by filling the gap between domestic savings and investment.
International Financial inflows can be broadly categorized in two components, the FDI (Foreign Direct
Investment) and the FII (Foreign Institutional Investment). Foreign Direct investment plays an important
role in the growth of an economy. It is a direct investment by the company situated in a country, into the
production or business running in another country, either by buying a company in the target country or by
expanding operations of an existing business in that country. Inflows of FDI have increased substantially
after adopting globalization and liberalization policies relating to FDI in 1991 by the government of India,
increased FDI from US$ 2696 million in 1996 to US$ 4,029 million in 2000-01 and in 2005-06 inflow of
FDI becomes more than doubled to exceed US$ 8,961 million in 2005-06. But after 2005-06, the reported
statistics show a steep increase in inflows: from US$ 22,826 million in 2006 to nearly US$ 37,758 million in
2014-15, as reported by the DIPP (Department of Industrial Policy and Promotion). Thus, the trend analysis
of the FDI data from 1995-96 to 2014-15 shows that there is always a positive average trend of FDI in India
but if we deeply analyze the data, FDI flow in India. Further, the FIIs have emerged as noteworthy players in
the Indian stock market and their growing contribution adds an important feature to the development of
stock markets in India. To facilitate foreign capital flows, developing countries have been advised to
strengthen their stock markets. FII inflows into Indian equities have been steady ever since the markets were
opened up for it in 1993. It owns a dominant 16% of Indian equities (worth US$147bn) and account for 10-
15% of the equity volumes. It injected US$ 23 billion in the Indian equity markets during the third quarter of
2012, which is very negligible when compared to second quarter in the same year due to lack of confidence
among investors and the prevailing economic downturn. But in the year 2014-15 FIIs have invested a net of
US$ 43.5 billion, the highest investment in any fiscal year. This huge investment is because of expectations
of the investors for an economic recovery, falling interest rates and improving earnings outlook. Although
there is some debate over the inherent weaknesses with FII flows and their destabilizing effects on equity
and foreign exchange markets, it cannot be ignored that India is increasingly becoming an attractive
destination for the global investors.

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2.4 Reforms in the financial sector
In 1990s, India was undergoing extremely fragile financial condition arising out of exceptionally severe
balance of payment crisis, sluggish growth, and political instability, therefore, India’s economic reforms
began in 1991 when the newly elected congress government, wanted to get rid of the pertaining economic
and financial problems of the country, thus, major policy changes and reform programs were initiated in
most of the sectors of the economy including, of course, the financial sector, to achieve short term
stabilization combined with a longer term program of comprehensive structural reforms. The reforms
initiated in 1991 were formulated by keeping in view the need for a system change, involving liberalization
of government controls, a larger role for the private sector and greater integration with the world economy.
Consequently, some fundamental changes have taken place in the Indian economy as a whole, and in
particular, in the financial sector. Parallel with the reforms in the banking sector, an action has been taken for
the reforms of the capital market, as it was an important part of the agenda of financial sector reforms. In
1991 India’s capital market did not have any statutory regulatory framework. The process of reform of the
capital market was initiated in 1992 as per the guidelines recommended by the Narasimham Committee. It
aimed at removing direct government control and replacing it by a regulatory framework based on
transparency and disclosure supervised by an independent regulator. Therefore, in the context of Indian
capital market, which is the focus of the study, the first step was taken in 1992 when the Securities and
Exchange Board of India (SEBI), which was originally established as a non-statutory body in 1988, was
formed to a full-fledged capital market regulator with statutory powers in 1992. The requirement of prior
government permission for accessing capital markets and for prior approval of issue pricing was abolished
and companies were allowed to access markets and price issues freely, subject only to disclosure norms laid
down by SEBI. Consequently, the stock exchanges, which were earlier dominated by brokers and lacked
effective supervision, are now much better governed.
Another important policy initiative in 1993 was taken; the economy was opened to portfolio investment in
two ways. The opening of the capital market to foreign institutional investors (FIIs) meeting certain
minimum standards were allowed to invest in Indian equity and later also in debt instruments through
secondary market purchases in the stock market. At present 528 FIIs are registered with the Securities and
Exchange Board of India (SEBI) and around 150 are active investors. A second window for portfolio
investment was provided by allowing Indian companies to issue fresh equity abroad through the mechanism
of Global Depository Receipts (GDRs). This enabled Indian companies to raise resources from passive
investors in world markets instead of seeking active investors as is the case with joint venture partners.
Portfolio investment has expanded rapidly in the post-reform period (Montek S. Ahluwalia, 1999).

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An important reform measure had been taken place in the form of modernization of technology of trading
with the formation of a new stock exchange, called the National Stock Exchange (NSE). The NSE was set
up in 1994 as an automated electronic exchange as a competitor to the oldest stock exchange of India viz.,
the Bombay Stock Exchange (BSE). It enabled brokers in 220 cities all over the country to link up with the
NSE computers via VSATs and trade in a unified exchange with automatic matching of buy and sell orders
with price time priority, thus ensuring maximum transparency for investors. The introduction of electronic
trading by the NSE generated competitive pressure which forced the BSE to also introduce electronic trading
in 1995. This was the first step towards paperless trading, which allowed dematerialization of share
certificates with settlement by electronic transfer of ownership from one account to another within a
depository and dematerialization of shares. Another major development concerning the secondary segment
of the Indian capital market was the introduction of Futures trading in 1999. A well-functioning market in
index futures would help in risk management and provide greater liquidity to the market.
Another measure was taken by the government of India in July 1991, by devaluing the rupee by 24% as part
of the initial stabilization program, and a dual exchange rate was introduced in March 1992. Shortly after
March 1993, the dual exchange rate was unified and the unified rate was allowed to float. The cumulative
effect of these changes was that between June 1991 and March 1993 the exchange rate depreciated from $1=
Rs. 20 to $1=Rs. 31, a depreciation of 35% in the dollar value of the rupee and a real depreciation (adjusting
for price changes) of around 27% viz.-a-viz., India’s major trading partners. This adjustment in the exchange
rate clearly helped the Indian industry to meet the import competition resulting from trade liberalization.
Exchange rate management has avoided the danger of excessive rigidity and also the opposite dangers of
overshooting with associated loss of confidence (Montek S. Ahluwalia, 1999). As part of the process of
transiting to an open economy, the rupee was made convertible on the current account in 1993. The Indian
currency is set to be made fully convertible in phases over the five years ending 2010-2011.In June 2008, the
rupee appreciated to a ten-year high of US$ 39.29. The stability of the Indian economy attracted substantial
foreign direct investment, while high interest rates in the country led the companies to borrow funds from
abroad. The global financial crisis of 2007-08, exerted pressure on crude oil prices, which gradually plunged
to below $50 a barrel. Due to this, inflow of dollar declined, with oil companies and investors purchasing
more and more dollars. Persistent outflow of foreign funds increased the pressure on the rupee, causing it to
decline. On March 5, 2009, the Indian currency depreciated to a record low of US$ 52.06 (Economy Watch,
2010).
2.5 Trends of the Indian Stock Market
The Indian stock exchanges hold a place of prominence not only in Asia but also at the global stage. As
mentioned above, the Bombay Stock Exchange (BSE) is one of the oldest exchanges across the world, while

[Type text] Page 31
the National Stock Exchange (NSE) is among the best in terms of sophistication and advancement of
technology. The Indian stock market scene really picked up after the opening up of the economy in the early
nineties. The whole of nineties were used to experiment and fine tune an efficient and effective system, and
right from the era of globalization, the stock market started to work efficiently and showed its new heights,
at different phases of its development. There are times when the Indian stock market achieves new heights,
breaching its previous records and there is time also when stock market plunges up to its extreme. Theses
ups and downs of the stock market were definitely due to some unavoidable circumstances created in the
economy, because the stock market index is also an important part of the economic cycle. The present
section of the chapter gives a brief overview of the development of the Indian stock market.
Table 2.1: Key indicators of Indian stock market activity
The table 2.1 represents the growth statistics for the key indicators of Indian stock market activity. The
Sensex has increased by over twenty five times from June 1990 to the present. Using information from April
1979 onwards, the long-run rate of return on the S&P BSE SENSEX works out to be 18.6% per annum (BSE
indie). In the mid of 1990, the SENSEX touched the four-digit figure for the first time and closed at 1,001
due to good monsoon in the country and excellent corporate results. The Sensex crossed the 2,000 points
with the start of the year 1992, i.e. January, because of the liberal economic policy initiatives undertaken by

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the then finance minister and Former Prime Minister of India Dr Manmohan Singh. And right in the next
month of the year 1992, with the announcement of the market friendly budget, the index surged to 3000
points. Further, in the consecutive month of 1992, the sensex crossed the 4,000 points due to the
expectations of a liberal export-import policy. The development process of stock market was give a jerk in
October 1992 when the Sensex registered a fall of 570 points (12.77 per cent) to close at 3,870, following
the Harshad Mehta securities scam. In the year 1999, the Sensex crossed the 5,000 mark, because of the
political factors, as the Bharatiya Janata Party-led association won the majority in the 13th LokSabha
election. In February 2000, the information technology boom helped the Sensex to cross the 6,000 points.
This record would stand for nearly four years, until May 2004, when the Sensex faced another fall of 565
points, due to the political instability in the country.
Figure 2.1: Indian Stock Market Trends
The gradual development process of Indian stock market continued in the subsequent years, due to the affect
of various economic and political, domestic and international circumstances of the nation. On 22 May 2006,
the Sensex plunged by 1,100 points during intra-day trading, leading to the suspension of trading for the first
time since 17 May 2004. The volatility of the SENSEX had caused investors to lose Rs 6 trillion (US$131
billion) within seven trading sessions. When trading resumed after the reassurances of the Reserve Bank of
India and the Securities and Exchange Board of India (SEBI), the Sensex managed to move up 700 points,
but still finished the session 457 points in the red. The Sensex eventually recovered from the volatility, and

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on 16 October 2006, the Sensex closed at an all-time high of 12,928.18. This was a result of increased
confidence in the economy and also because India's manufacturing sector grew by 11.1% in August 2006.
On 29 October 2007, the Sensex crossed the 20,000 mark for the first time with a massive 734.5-point gain.
The journey of the last 10,000 points was covered in just 483 sessions, compared to 7,297 sessions taken to
touch the 10,000 mark from its base value of 100 points. After a long spell of growth, the Indian economy
were experiencing a downturn, because the Industrial growth has been faltering, inflation remains at double-
digit levels, the current account deficit is widening, foreign exchange reserves are depleting and the rupee is
depreciating. Furthermore, the breathtaking development process continued till the effects of the subprime
crisis in the U.S., started to spread on Indian economy, and the investors panicked following weak global
cues accompanied by the fears of a recession in the US and consequently, in the third week of January 2008,
the Sensex experienced huge falls along with other markets around the world. On 21 January 2008, the
Sensex saw its highest ever loss of 1,408 points at the end of the session. The most immediate effect of that
crisis on India has been an outflow of foreign institutional investment from the equity market. Foreign
institutional investors, who need to retrench assets in order to cover losses in their home countries and were
seeking havens of safety in an uncertain environment, have become major sellers in Indian markets. In 2007-
08, net FII inflows into India amounted to $20.3 billion. As compared with this, they pulled out $11.1 billion
during the first nine-and-a-half months of calendar year 2008, of which $8.3 billion occurred over the first
six-and-a-half months of financial year 2008-09 (April 1 to October 16). In addition, this withdrawal by the
FIIs led to a sharp depreciation of the rupee. Between January 1 and October 16, 2008, the RBI reference
rate for the rupee fell by nearly 25 per cent, even relative to a weak currency like the dollar, from Rs 39.20 to
the dollar to Rs 48.86 (Chart 2). This was despite the sale of dollars by the RBI, which was reflected in a
decline of $25.8 billion in its foreign currency assets between the end of March 2008 and October 3, 2008.
In March 2008, the Sensex dropped by 951.03 points on the global credit crisis and distress, and the
volatility in market continued till the mid of 2009. The Sensex plunged by 869.65 points in July 2009, the
day of Union Budget presentation in Parliament on concerns over high fiscal deficit. Further, the Sensex
closed at more than 21,000 points for the first time, in November 2010. The Sensex crossed the historical
mark of 30,000 after repo rate cut announcement by RBI. But the volatility in the market still continues, due
to the euro crisis, Greece debt crisis and the emerging crisis of slow down of Chinese economy.
Thus, it can be concluded that the stock market movements are the effect of changes in the various economic
and political conditions of an economy. Furthermore, it is also observed that various domestic and
international macroeconomic factors work as the driving forces of the Indian stock market.
Variable selection and data source

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This empirical analysis has used particular software like Gretl and SPSS and depends on both availability of
data and established statistical criteria that are frequently used in the selection of variables.
The Bombay Stock Exchange- Sensitive Index (SENSEX) has been considered as a proxy of the Indian
Stock Market and used to obtain a measure of market price movement of Indian securities since this index is
comprehensive. To address the objective of this research 7 variables and 5 sectors namely Auto, Metals,
Capital goods, Consumer goods, FMCG have been considered.
Consumer price index has been used as a proxy to inflation in Indian economy, Call rate as a proxy of
domestic interest rate affecting stock market, dollar price to show the effect of external world on Indian
stock market. To test the common perception that Foreign Institutional Investment has been a driver to stock
market in India we have included FII as another crucial variable. Also any slight fluctuation in crude oil and
gold prices can have both indirect & direct influence on the economy of the country. Thus these 2 variables
have also been included to analyze their effect on stock market. Even after being a very important variable
GDP growth rate was not included in the analysis because of unavailability of monthly data series of GDP
growth rate (only quarterly series was available). Industrial Production Index of all commodities is
considered as a proxy to GDP growth rate.
The empirical investigation is carried out using monthly data from April, 2005 to March, 2012 which covers
84 monthly observations. The data of BSE SENSEX (including sector wise data) has been extracted from
BSE website. Database of Industrial Production Index (including sector wise data) & Consumer price index
has been extracted from DULS website. RBI website has been referred for FII, gold price, and call rate and
dollar price data. Lastly Index Mundi has been referred for database of crude oil (Shown in table 2.2).
Table 2.2: Description of Variables

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