3 - relationship between indian stock markets with forex rates since liberalisation

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Relationship betweenIndian Stock markets

with Forex rates since

liberalisation

Submitted by:

Jay Parekh – 138

Rohan Raut – 141

Vivek Rawat – 142

Vaibhav Shah – 152

Group No - 3

Financial Markets and Institutions

2014



Relationship between Indian Stock markets with Forex rates since liberalisation

Roll no – 138, 141, 142, 152 Page 1

Introduction:

Indian Stock Markets:

The Indian stock exchanges are of great importance not only in Asia but also the world. The

Bombay Stock Exchange (BSE) is one of the oldest exchanges in the world, whereas the

National Stock Exchange (NSE) is amongst the best in terms of sophistication and technological

advancement. The Indian stock markets boomed post the liberalization of the economy in the

early 90’s. The whole of those years were used to experiment and refine the markets into an

efficient and effective system. Corporate governance rules were gradually put into effect which

began the process of bringing listed companies at a uniform level. On the global scale, the

economic environment began taking paradigm shift with the ‘Dot-com bubble burst’, 9/11

attacks, and rising crude prices. The slowdown in the US economy and interest rate tightening

made the equation more complex. However after 2000, owing to robust growth and a maturing

economy having relaxed regulations, outside investors, both institutional and others, got more

range to operate. The opening up of the economy led to increased integration with increased

cross-border flow of capital, and India emerged as a favourable investment destination leading to

our stock exchanges being impacted by global events that never happened earlier.

Indian Forex Markets:

The foreign exchange market in India started less than three decades ago in 1978 when the

government allowed banks to trade foreign exchange with each other. Today, over 70% of the

forex trading take place in the inter-bank market. The market comprises of above 90 authorized

dealers, chiefly banks, that trade in currency amongst themselves and end up without exposure at

day end. Trading is regulated by the Foreign Exchange Dealers Association of India (FEDAI),

which is a self-regulatory dealers association. Since 2001, clearing and settlement functions in

the foreign exchange market are mainly carried out by the Clearing Corporation of India Limited

(CCIL) which manages transactions of approx $3.5 billion daily, which makes about 80% of the

total transactions.

From a foreign-exchange-starved, control-ridden economy, India has progressed to a position of

more than $150 billion in forex reserves, with a steadily progressing rupee and largely reduced

forex control. As foreign trade and cross-border capital flows continue growing, and the country




Roll no – 138, 141, 142, 152 Page 2

moves towards capital account convertibility, the forex market is set to have a more larger role in

the economy, but is unlikely to be completely free of RBI interventions.

Impact of 1991 economic reforms on the stock & forex markets:

The 1991 liberalization policies led the Indian economy into a new phase of growth and freed it

from its slowed pace of progress. The major impacts of the reforms pertinent to the stock market

and forex market are discussed as follows:

Bringing in the Security Regulations (Modified) and the SEBI Act of 1992 which rendered

the legitimate power to the Securities Exchange Board of India to record and control all the

mediators in the capital market.

The Controller of Capital matters was abolished in 1992, which used to determine the rates

and number of stocks that companies were supposed to issue in the market.

The National Stock Exchange (NSE) was launched in 1994 in the form of a computerized

share buying and selling system, which also influenced the restructuring of the other stock

exchanges in the country.

In 1992, overseas corporate investors were allowed to invest into the equity markets of the

country. The companies were allowed to raise funds from overseas markets by issuance of

GDRs.

The rigid, old fixed exchange rate system was replaced with a new less regulated market-

driven exchange rate system.

The Sodhani Committee of 1994 suggested increased freedom to participating banks,

allowing them to fix their own trading limits & interest rates on FCNR deposits and using

derivatives products.




Roll no – 138, 141, 142, 152 Page 3

Objectives

In the light of above discussion, our study tries to identify relation between stock market

movements & forex rate movements. Our study tries to determine whether there is any

correlation between the two indicators. We have taken data points after liberalization in our

study. We have also tried to examine relation between stocks of certain sectors with currency

movements. As Oil & gas is biggest importing sector, we have tried to determine relationship

between currency movements & stock price movements of companies in Oil & sector space

using S&P BSE Oil & Gas index. Similarly, IT & Pharma are India’s biggest exporters. So we

have tried to determine relationship between currency movements & stock price movements of

companies in IT & pharma space using S&P BSE IT index & S&P BSE healthcare index. We

have also done hypothesis testing to find if SENSEX movements & FOREX movements are

dependent or not.

Thus, our major objectives from the study are –

1. To determine relation between stock market movements & forex rate movements using

correlation & hypothesis testing from the data points after liberalization

2. To find impact of forex movements on stock prices of specific sectors which have high

currency exposure

Literature Review

Financial markets are very complex & thus it is very important for investors, market players,

researchers & policy makers to understand the relationship between stock market & foreign

exchange market as both these indicators are barometers for any economy. Stock market & forex

market are most sensitive indicators of financial system.

There are various explanations given with respect to our study by different researchers. The first

one was undertaken by Franck and Young (1972) to determine forex market & stock market

dynamics. Their study showed that there are no notable interactions between stock market &

forex market. The second one is flow oriented model approach by Fischer & Dornbusch (1980)

which says that forex movements have direct relation with global competitiveness & currency




Roll no – 138, 141, 142, 152 Page 4

movements have direct relation with balance of payment of any Country. Thus, stock prices of

various companies are affected by currency movements. Slonik (1987) undertook study to find

impact of various economic parameters including currency rates on stock market movements. He

found that currency movements do not have notable impact on stock prices. Roll (1992) carried

out research on movements of US stock market & forex market & he concluded that there exists

a positive relationship between the two variables. Abdalla and Murinde (1997) undertook co-

integration test to find the relation between Stock market movement & forex movement for

Asian Countries viz. India, Pakistan, South Korea and Philippines. The study used data points

from 1985 to 1994. They found causation runs from forex rates to stock market movements for

India, South Korea and Pakistan and found reverse causation runs for Philippines. Chow et al.

(1997) conducted research on stock market & forex markets & found no relation between both

the variables. They conducted the research again with a longer time zone and found that two

variables had positive relation.

Nieh and Lee (2001) also concluded that there is no notable long-run relationship between stock

market movements and forex movements in G-7 Countries (Canada, France, Italy, US, UK,

Japan, France). Bhattacharya and Mukherjee (2003) in their research concluded that no notable

relationship exists between stock market movement & forex movements. Apte (2001) conducted

the same research on Indian stock market & USD-INR movements from 1991 to 2000 &

concluded that spillover from forex market to stock market exists (but not the reverse). Yamini

Karmarkar and G Kawadia undertook research to find relationship between rupee & dollar rate

movements & Indian stock market movements. Five composite indices and spectral indices were

also examined for the year 2000. They concluded that forex rate movements have high

correlation with the stock prices.




Roll no – 138, 141, 142, 152 Page 5

Quantitative Analysis:

Dataset for Analysis:

In order to find relationship between Indian stock market and Forex rate we have considered

monthly closing price of BSE Sensex and USD-INR exchange rate. The dataset is from October

1993 to August 2014. We have collected historical data from www.bseindia.com and

www.onada.com. We have also done analysis of Forex with respect to some major BSE indices

like S&P BSE IT, S&P BSE HEALTHCARE and S&P BSE OIL & GAS. Monthly historical

dataset for these indices were available from February 1999 on www.bseindia.com

Since oil and gas is amongst major import in India and IT services and pharmaceuticals are

among major export, we have consider above three indices.

Methodology:

1. Descriptive statistics of monthly returns of Forex, BSE Sensex, S&P BSE IT, S&P BSE

HEALTHCARE and S&P BSE OIL & GAS

2. Graphical Representation of BSE Sensex, Forex and BSE indices

3. The monthly returns on the basis of closing values of the stock indices were calculated as below:

R t = (Pt - Pt-1) / Pt-1 *100

Where R represents returns, P is the closing value of the stock index and t is the time

Simple average of monthly returns were taken and multiplied by 12 to get yearly returns

4. Find the correlation between the following

a. Forex and BSE Sensex

b. Forex and S&P BSE IT

c. Forex and S&P BSE HEALTHCARE

d. Forex and S&P BSE OIL & GAS

5. Perform hypothesis testing to test if there is correlation between stock market and forex

rates.




Roll no – 138, 141, 142, 152 Page 6

Calculations:

1. Descriptive statistics of monthly returns in the long run

FOREX BSE

SENSEX

S&P BSE

IT

S&P BSE

HEALTHCARE

S&P BSE

OIL & GAS

Mean 0.0028 0.0120 0.0191 0.0159 0.0177

Median 0.0004 0.0114 0.0212 0.0233 0.0177

Std. Deviation 0.0011 0.0744 0.1234 0.0723 0.0895

Sample Variance 0.0003 0.0055 0.0152 0.0052 0.0080

Kurtosis 4.3077 0.5707 3.7783 1.2323 1.9479

Skewness 0.8988 0.0172 0.4388 -0.3949 0.1955

Range 0.1525 0.5215 1.0318 0.4667 0.6188

Minimum -0.0625 -0.2389 -0.4171 -0.2433 -0.3146

Maximum 0.0899 0.2826 0.6147 0.2234 0.3042

2. Graphical representation & interpretation:

Observations:

From Aug-93 to Aug-99, rupee depreciated by 33% but Sensex appreciated by almost

70% showing an indirect relationship.

From Aug-99 to Aug-02, rupee further depreciated and Sensex also depreciated showing

a direct relationship.

0

10

20

30

40

50

60

70

0

5000

10000

15000

20000

25000

30000

- - c - 9 - - - - - - - - - - -

S e n s e x

SENSEX and Forex pattern

SENSEX

Forex




Roll no – 138, 141, 142, 152 Page 7

From Aug-02 onwards till Oct-07, we saw a bull run in Sensex with huge inflow of FII’s

in Indian Equity markets and meanwhile money also appreciated.

When Subprime crisis occurred in 2008, FII sold their holdings from Indian companies &

thus rupee depreciated with outflow of money.

After 2009, markets are recovering and we can see now a bull run being anticipated.

Observations:

From Feb-99 to Feb-02, rupee depreciated and BSE Oil & Gas also dipped showing a

direct relationship between them.

Then till feb-08 money appreciated and so did appreciate BSE Oil & Gas reaching an all-

time peak in Dec-07.

In 2008, due to subprime crisis, rupee depreciated and even BSE Oil & Gas depreciate.

Jan-09 onwards till Jan-11, rupee appreciated and BSE Oil & Gas also appreciated again

showing an direct relationship.

Again from Aug13 till now rupee is appreciating and BSE Oil & Gas is also appreciating.

Thus, overall we can observe that with every rupee depreciation cycle, there is decrease

in prices of Oil & gas shares.

0

10

20

30

40

50

60

70

0

2000

4000

6000

8000

10000

12000

14000

-

J

- 0 - -

J

- - -

J

- 0 - -

J

- -

S & P B S E O i l a n

d G a s

BSE Oil & Gas and Forex

BSE Oil & Gas

Forex




Roll no – 138, 141, 142, 152 Page 10

Interpretations

BSE SENSEX increased at average yearly rate of 14.38% post liberalization while Indian

rupee depreciated against dollar at average yearly rate of 3.37% after liberalization.

In this paper we have found out correlation of SENSEX movements with USD-INRmovements (with post-liberalization data points). We found that there exists moderate

correlation between movements of SENSEX stocks & USD-INR.

We also examined relation of share prices of companies which have high foreign

currency exposure. We found that share price movements of pharma/healthcare sector

were highly correlated with currency movements & share price movements of IT sector

were moderately correlated with currency movements. Although Oil & gas sector shares

didn’t show any significant correlation with foreign exchange movements.

Also, through hypothesis testing we concluded that SENSEX movement & FOREX

movements are correlated but correlation is weak to moderate since co-efficient of

determination (R²) is low.




Roll no – 138, 141, 142, 152 Page 11

References

www.bseindia.com

www.onada.com

http://webcache.googleusercontent.com/search?q=cache:http://www.craig.csufresno.edu/I

JB/Volumes/Volume%252012/V123-5.pdf

Research paper on “Exchange rates & current account” by Rudiger Dombusch & Stanley

Fischer from

http://webcache.googleusercontent.com/search?q=cache:http://www.mit.edu/~14.54/hand

outs/dornbusch80.pdf

http://www.pbr.co.in/Vol-5%20Iss-5/7.pdf

Abdalla, and V. Murinde, (1997) research paper on "Exchange Rate and Stock Price

Interactions in Emerging Financial Markets: Evidence on India, Korea, Pakistan, and

Philippines” from http://www.tandfonline.com/doi/pdf/10.1080/096031097333826

Apte P. (2001) research paper on “The interrelationship between stock markets and the

foreign exchange market” from

http://webcache.googleusercontent.com/search?q=cache:http://iimb.ac.in/research/sites/d

efault/files/wp.iimb_.169.pdf

3 - relationship between indian stock markets with forex rates since liberalisation

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