1.

) RESEARCH METHODOLOGY
Problem Statement
In the last two decades, globalization, interlinkages of the capital markets, gradual eradication of capital inflow barriers and the implementation of more flexible exchange rate mechanism in developed as well as transition economies, created a systematic interdependency between and within the stock and foreign exchange markets. The individual have very vague idea about such relationship between two markets. Thus, investigating the relationship between stock prices and exchange rates has received unprecedented attention in the literature. A number of studies have empirically examined the relationship between the stock and foreign exchange markets. This study explores the evidence of relationship between exchange rates and stock prices and also lead lag relationship between exchange rates and stock prices. We use a three step framework for examining dynamic relationships between exchange rates and stock index.

Literature Review
Apte !"##$% investigated the relationship between the volatility of the stock market and the nominal exchange rate of India by using the &'A()* specifications on the daily closing +,-.I/( exchange rate, 0,& 1# !,ensex% and /I2T3 4# over the period $55$ to "###. The study suggests that there appears to be a spillover from the foreign exchange market to the stock market but not the reverse. 0hattacharya and 6ukhar7ee !"##"% studied the nature of causal relation between the stock market, exchange rate, foreign exchange reserves and value of trade balance in India from $55# to "##$ by applying the co integration and long run 'ranger /on causality tests. The study suggests that there is no causal linkage between stock prices and the three variables under consideration.

To examine the dynamic linkages between the foreign exchange and stock markets for India, /ath and ,amanta !"##1% employed the 'ranger causality test on daily data during the period 6arch $551 to -ecember "##". The empirical findings of the study suggest that these two markets did not have any causal relationship. When the study extended its analysis to verify if liberalization in both the markets brought them together, it found no significant causal relationship between the exchange rate and stock price movements, except for the years $551, "##$ and "##" during when a unidirectional causal influence from stock index return to return in forex market is detected and a very mild causal influence in the reverse direction is found in some years such as $558 and "##". 3amini 9armarkar and ' 9awadia tried to investigate the relationship between (,.: exchange rate and Indian stock markets. 2ive composite indices and five sectoral indices were studied over the period of one year; "###. the results indicated that exchange rate has high correlation with the movement of stock markets.

Re ear!" Ob#e!tive
The present study is being contemplated with the following specific ob7ectives; i% Investigating the relationship between the foreign exchange market and stock market in India. To see that weather there is a significant relationship or dynamic linkage between the two markets. ii% To find out which variable is leading and which variable is lagging. The lead lag relationship illustrates how well the two markets are linked, and how fast one market reflects new information from the other. If relation between foreign exchange market and stock market exist, then it is possible that investor may use this information to predict the exchange rate movement or indices movement.

H$%ot"e i
*#; There is no significant relation between stock prices and exchange rates *$; There is significant relation between stock prices and exchange rates

Re ear!" De i&n
The study type is -escriptive because this research helps to find out the meaning out of the secondary data, but not the cause and effect !causal% linkages among its different elements.

T"e Sam%le
The sample population of the study comprises of daily closing price, for of 0,& ,ensex, )/< /ifty and exchange rates of (upee.-ollar are considered for analyzing.

Sour!e o' Data

=rimary -ata nil ,econdary sources The study is based on the secondary data collected from the official website of 0,&, /,& and &xchange (ate data from exchangeate.com.

Perio( o' t"e Stu($

-aily closing values of 0,& ,ensex, )/< /ifty and exchange rates of (upee.-ollar are considered from $ $ "##$ to 1$ 1 "##5.

Stati ti!al Tool u e( in t"e tu($

Augmented -ickey 2uller test !+nit (oot Test for stationarity of data% >ohnson co integration test !Test for long run relationship% )ross )orrelation !Test for short run relationship%

S!o%e o' t"e tu($

The study includes only one currency pair i.e. I/(.+,- for the representation of the forex market while the two ma7or stock markets of India are covered. Thus the relation and effects of other currencies is out of the preview of the research.

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

Limitation
+navailability of intra day minute to minute data of both the markets. The study is limited to period of eight years. ?nly one pair of +,-.I/( is used.

Data an( Met"o(olo&$

The data set comprises of daily closing price of ,ensex, /ifty and I/(.+,- exchange rates obtained from the respective ,tock &xchange and (eserve 0ank of India websites. The series span the period from $st >anuary "##$ to 1$st 6arch "##5. The daily stock index and I/(.+,- returns are continuously compounded rate of return, computed as the first difference of the natural logarithm of the daily stock index and I/(.+,exchange rate value. The stationary status of series should be tested when investigating the relationship between exchange rate and stock market price. In order to test the unit roots i.e. stationarity in the ,ensex, /ifty and I/(.+,- exchange rates, the study employ augmented -ickey and 2uller !A-2% test. If the findings of A-2 test suggests that the series are integrated of order one, >ohansen co integration tests methodologies would be used to determine whether any co integration between stock and exchange market variables exists or not. 2urther )ross )orrelation method would be used on fragmented data, each of size six months, from "##@ to "##5 to determine any lead or lag relation. The analysis has been performed using 6, &xcel and & view.

*.) +ntro(u!tion
'lobalization and financial liberalization in India have brought about battery of changes in the financial functioning of the economy, as a result of which, the resultant gain of the global integration of domestic and foreign financial markets has thrown open new opportunities but at the same time exposed the financial system to significant risks. )onseAuently, it is important to understand the mutual relationship between the financial markets from the standpoint of financial stability. Though the inception of the financial sector reforms has taken place initiated in the beginning of the $55#s, particularly since $558, there has been a dramatic change in the functioning of the financial sector of the economy. The recent emergence of new capital markets, the relaxation of foreign capital controls and the adoption of more flexible exchange rate regimes have increased the interest of academics and practitioners in studying the interactions between the stock and foreign exchange markets. The gradual abolition of foreign exchange controls in emerging economies like India has opened the possibility of international investment and portfolio diversification. At the same time, the adoption of more flexible exchange rate regimes by these countries in the late $5B#Cs and early $55#Cs has increased the volatility of foreign exchange markets and the risk associated with such investments. The advent of floating exchange rates, opening up of current account, Diberalization of capital account, reduction of customs duties, the development of "@ hour screen based global trading, the increased use of national currencies outside the country of issue and innovations in internationally traded financial products have led to the cross )ountry linkages of capital markets and international integration of domestic economy.

Altogether, the whole gamut of institutional reforms, introduction of new instruments, change in procedures, widening of network of participants, call for a reexamination of the relationship between the stock market and the foreign sector of India. The process of economic liberalization and thrust on reforms in the financial sector and the foreign exchange market in particular that was initiated in India in early nineties has resulted into increasing integration of the Indian 2< market with that of the global markets. With a large number of foreign funds and foreign institutional investors now actively participating in the Indian financial markets !foreign exchange reserves standing at about +,-$$B bn%, the style of functioning of the market itself has undergone a lot of change and result of microstructure changes are visible. Today the Indian 2< market, which was insulated from outside impacts, has been getting integrated with the world markets. In the present scenario, interesting results are emerging particularly for the developing countries where the markets are experiencing new relationships between money markets, forex markets, capital markets, international events, oil prices, WT? agreements etc which were not perceived earlier. The analysis on stock markets is important as it is considered as the most sensitive segment of the economy and through this segment the countryCs exposure to the outer world is most readily felt. The impact of fluctuation in exchange rate on domestic companies, companies importing or exporting and on multi national corporations with the degree of exposure is increasing in each case respectively. The movements in exchange rate indirectly affect the value and hence the stock prices of these companies. The value of the company is affected due to the forex exposures namely Transaction exposures, translation exposure and economic exposure. An exchange rate has two effects on stock prices, a direct effect through 6ulti /ational 2irms and an indirect effect through domestic firms. In case of 6ulti /ational 2irms involved in exports, a change in rate will change the demand of itCs product in the international market, which ultimately reflects in its 0., as profit or loss. ?nce the profit or loss is declared, the stock price will also change for a domestic firm.

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

,.) -orei&n E.!"an&e Mar/et0

The foreign exchange market exists wherever one currency is traded for another. It is by far the largest market in the world, in terms of cash value traded, and includes trading between large banks, central banks, currency speculators, multinational corporations, governments, and other financial markets and institutions. The trade happening in the forex markets across the globe currently exceeds +,:$.5 trillion.day !on average%. (etail traders !individuals% are currently a very small part of this market and may only participate indirectly through brokers or banks. The foreign exchange market provides the physical and institutional structure through which the money of one country is exchanged for that of another country, the rate of exchange between currencies is determined, and foreign exchange transactions are physically completed. The retail market for foreign exchange deals with transactions involving travelers and tourists exchanging one currency for another in the form of currency notes or travelersC cheAues. The wholesale market often referred to as the interbank market is entirely different and the participants in this market are commercial banks, corporations and central banks.

Curren!$ E.!"an&e Rate0

The &xchange rate or 2< rate is the rate between two currencies specifies how much one currency is worth in terms of the other. 2or example an exchange rate of 11 Indian (upees !I/-, (s.% to the +nited ,tates -ollar !+,-, :% means that I/- 11 is worth the same as +,- $. The foreign exchange market is one of the largest markets in the world. 0y some estimates, about " trillion +,- worth of currency changes hands every day. The S%ot exchange rate refers to the current exchange rate. The 'orwar( exchange rate refers to an exchange rate that is Auoted and traded today but for delivery and payment on a specific future date.
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1uotation An exchange rate Auotation is given by stating the number of units of a %ri!e !urren!$ that can be bought in terms of $ unit !urren!$ !also called base currency%. In a Auotation that says the >=/.+,- exchange rate is $"# !+,- per >=/%, the price currency is +,and the unit currency is >=/.

1uote
Direct quote is a Auote using a countryCs home currency as the price currency !e.g.,(s.11 E : $ in India% and is used by most countries. Indirect quote is a Auote using a countryCs home currency as the unit currency !e.g, : #.#1 E (s. $ in India% and is used in 0ritish newspapers and are also common in Australia, /ew Fealand and )anada.

A%%re!iation2(e%re!iation o' !urren!$0

While using direct Auotation, if the home currency is strengthening !i.e., appreciating, or becoming more valuable% then the exchange rate number decreases. )onversely if the foreign currency is strengthening, the exchange rate number increases and the home currency is depreciating.

E.!"an&e rate re&ime0

The exchange rate regime is the way a country manages its currency in respect to foreign currencies and the foreign exchange market. It is closely related to monetary policy and the two are generally dependent. A floating exchange rate or a flexible exchange rate is a type of exchange rate regime wherein a currencyCs value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency.

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A pegged float is pegged to some band or value, either fixed or periodically ad7usted. =egged floats are )rawling bands, )rawling pegs and =egged with horizontal bands. A fixed rate is that rate that has direct convertibility towards another currency. *ere, the currency is backed one to one by foreign reserves.

-un!tion o' 'orei&n e.!"an&e mar/et0

The foreign exchange market is the mechanism by which participants Transfer purchasing power between countries, ?btain or provide credit for international trade transactions, and 6inimize exposure to the risks of exchange rate changes

-orei&n E.!"an&e Mar/et %arti!i%ant 0

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

-ive broa( !ate&orie o' %arti!i%ant o%erate wit"in t"e e two tier 0 0ank and nonblank foreign exchange dealers;

0anks and a few nonblank foreign exchange dealers operate in both the interbank and client markets. They profit from buying foreign exchange at a GbidC price and reselling it at a slightly higher GaskC price. -ealers in the foreign exchange departments of large international banks often function as market makers. )urrency trading is Auite profitable for commercial and investment banks. ,mall to medium sized banks are likely to participate but not as market makers in the interbank

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market. Instead of maintaining significant inventory positions, they buy from and sell to large banks to offset retail transactions with their own customers.

Individuals and firms conducting commercial or investment Transactions;

Importers and exporters, international portfolio investors, 6ulti /ational &nterprises, tourists, and others use the foreign exchange market to facilitate execution of commercial or investment transactions. ,ome of these participants use the market to GhedgeC foreign exchange risk. ,peculators and arbitragers;

,peculators and arbitragers seek to profit from trading in the market itself. They operate in their own interest, without a need or obligation to serve clients or to ensure a continuous market. A large proportion of speculation and arbitrage is conducted on behalf of ma7or banks by traders employed by those banks. Thus banks act both as exchange dealers and as speculators and arbitrages. )entral banks and treasuries;

)entral bank and treasuries use the market to acAuire or spend their countryCs foreign exchange reserves as well as to influence the price at which their own currency is traded. They may act to support the value of their own currency because of policies adopted at the national level or because of commitments entered into through membership in 7oint float agreements. 2oreign exchange brokers;

2oreign exchange brokers are agents who facilitate trading between dealers. 0rokers charge small commission for the service provided to dealers. They maintain instant access to hundreds of dealers world wide via open telephone lines.

-orei&n e.!"an&e tran a!tion

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

Global 'orei&n e.!"an&e mar/et turnover0

According to the 0ank for International ,ettlements, average daily turnover in global foreign exchange markets is estimated at :1.5B trillion as of April "##8. Trading in the worldCs main financial markets accounted for :1."$ trillion of this. This approximately :1."$ trillion in main foreign exchange market turnover was broken down as follows; Components are: :H"$ billion in spot :$."H trillion in derivatives :"#B billion in outright forwards :5@@ billion in forex swaps :$#8 billion in 2< options

?f the :1.5B trillion daily global turnover, trading in Dondon accounted for around :$.1H trillion, or 1@.$I of the total, making Dondon by far the global center for foreign exchange. In second and third places respectively, trading in /ew 3ork accounted for $H.HI, and Tokyo accounted for H.#I.J@K In addition to LtraditionalM turnover, :".$ trillion was traded in derivatives. &xchange traded 2< futures contracts were introduced in $58" at the )hicago 6ercantile &xchange and are actively traded relative to most other futures contracts.

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,everal other developed countries also permit the trading of 2< derivative products !like currency futures and options on currency futures% on their exchanges. All these developed countries already have fully convertible capital accounts. 6ost emerging countries do not permit 2< derivative products on their exchanges in view of prevalent controls on the capital accounts. *owever, a few select emerging countries !e.g., 9orea, ,outh Africa, and India% have already successfully experimented with the currency futures exchanges, despite having some controls on the capital account.

14

,ource; 0I, Triennial ,urvey "##8

15

,ource; 0I, Triennial ,urvey "##8

Stru!ture

-ecentralized GinterbankC market 6ain participants; )entral 0anks, commercial and investment banks, hedge funds, corporations N private speculators

The free floating currency system arose from the collapse of the 0retton Woods agreement in $58$

?nline trading began in the mid to late $55#Cs

Tra(in& Hour

"@ hour market ,unday 4pm &,T through 2riday @pm &,T. Trading begins in the Asia =acific region followed by the 6iddle &ast, &urope, and America

Si3e

?ne of the largest financial markets in the world :1." trillion average daily turnover, eAuivalent to;

o o o o

6ore than $# times the average daily turnover of global eAuity markets$ 6ore than 14 times the average daily turnover of the /3,&" /early :4## a day for every man, woman, and child on earth1 An annual turnover more than $# times world '-=@

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The spot market accounts for 7ust under one third of daily turnover World 2ederation of &xchanges aggregate "##H World of 2ederation H.H billion of &xchanges +, )ensus "##H 0ureau population

$. About :"B# billion ". 1. About 0ased :B8 on billion world

@. About :@B trillion World 0ank "##H.

Ma#or Mar/et

The +, N +9 markets account for 7ust over 4#I of turnover 6a7or markets; Dondon, /ew 3ork, Tokyo Trading activity is heaviest when ma7or markets overlap /early two thirds of /3 activity occurs in the morning hours while &uropean markets are open

Avera&e Dail$ Turnover b$ Geo&ra%"i! Lo!ation

,ource; 0I, Triennial ,urvey "##8

Con!entration in t"e )an/in& +n(u tr$

$" banks account for 84I of turnover in the +.9.

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$# banks account for 84I of turnover in the +.,. 1 banks account for 84I of turnover in ,witzerland 5 banks account for 84I of turnover in >apan

,ource; 0I, Triennial ,urvey "##8

Curren!ie

The +, dollar is involved in over B#I of all foreign exchange transactions, eAuivalent to over +,:".8 trillion per day

Curren!$ Co(e

+,- E +, -ollar &+( E &uro >=3 E >apanese 3en '0= E 0ritish =ound )A- E )anadian -ollar A+- E Australian -ollar /F- E /ew Fealand -ollar

Avera&e Dail$ Turnover b$ Curren!$

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/.0. 0ecause two currencies are involved in each transaction, the sum of the percentage shares of individual currencies totals "##I instead of $##I. ,ource; 0I, Triennial ,urvey "##8

Curren!$ Pair

6a7ors; &+(.+,- !&uro -ollar%, +,-.>=3, '0=.+,- !commonly referred to as the L)ableM%, +,-.)*2

-ollar bloc; +,-.)A-, A+-.+,-, /F-.+,6a7or crosses; &+(.>=3, &+(.'0=, &+(.)*2

Avera&e Dail$ Turnover b$ Curren!$ Pair

19

,ource; 0I, Triennial ,urvey "##8

-a!tor a''e!tin& E.!"an&e rate 0

The prime factor that affects currency prices are supply and demand forces. The three factors include; E!onomi! 'a!tor 0 'overnment budget deficits or surpluses 0alance of trade levels and trends Inflation levels and trends &conomic growth and health

Politi!al !on(ition 0 =olitical upheaval and political instability (elation between two countries

Mar/et % $!"olo&$0 2lights to Auality &conomic numbers Dong term trends

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4.) +n(ian -5 Mar/et

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India foreign exchange reserve is at : "8B.8 0illion +,- !2eb 4, "#$#% /,& has witnessed healthy growth in the turnover and open interest positions during its first completed month of currency futures trading in India. /,& commenced currency futures trading in India on "5th August. )-< !)urrency -erivative &xchange%, currency derivative segment of 0,& !0ombay ,tock &xchange% commenced currency futures trading from $st ?ctober. 0,& on its very
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first day of trading in currency futures clocked a turn over of about H4,### contracts, which is approximately (s. 1## )rores. With ever growing global financial crisis, exchange rates are fluctuating widely. I/( exchange rate has touched @8 against +,-. )urrency futures trading in India has generated huge interest among Indian retail investors and traders. There is a strong demand for information gathering about the intricacies of currency futures from small investors and enterprises. After over a year of introduction of exchange traded currency futures in the +,- I/( pair on the stock exchanges in the country, the market regulators have now permitted trading of &uro I/(, >apanese 3en I/( and =ound ,terling I/( on the exchange platform. This is a move that the market had been demanding for a long time. This is an apt time to review how the exchange traded currency market has fared so far and what lies ahead as it ventures further into new currency pairs. The currency derivatives segment on the /,& and 6)< has witnessed consistent growth both in traded value and open interest since its inception. The total turnover in the segment has increased incredibly from :1.@bn in ?ctober "##B to :B@bn in -ecember "##5. The average daily turnover reached :@bn in -ecember "##5. ?pen interest in the segment on the /,& and 6)< stood at around @ lakh contracts till end -ecember "##5. India already has an active over the counter !?T)% market in currency derivatives where the average daily turnover was :"5bn in "##B and :"$bn in "##5 !till ,eptember "##5%. This market is being driven by its ability to meet the respective needs of participants. 2or example, it is used by importers.exporters to hedge their payables.receivablesO foreign institutional investors !2IIs% and /(Is use it to hedge their investments in IndiaO borrowers find it an effective way to hedge their foreign currency loans and resident Indians find it an effective tool to hedge their investments offshore. 2urther, for arbitrageurs it presents an opportunity to arbitrage between onshore and non deliverable forward !/-2% markets.

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The exchange traded currency futures market is an extension of this already available ?T) market, but with added benefits of greater accessibility to potential participantsO high price transparencyO high liAuidityO standardised contractsO counterparty risk management through clearing corporation and no reAuirement of underlying exposure in the currency. As the market participants are realising these benefits of exchange traded market in currency, they are choosing this market over ?T). *owever, it is too early to see a ma7or shift in activity from ?T) to exchange traded market as it has created a niche for itself and it would perhaps take some time for the currency futures market to create one for itself. 'lobally, too, the foreign exchange market is largely ?T) in character. While the notional amount outstanding of ?T) derivatives was as high as :H1trn in >une "##B, the exchange traded market is rather non existent with notional amount outstanding as end >une "##5 being only #.4I of that in the ?T) segment. *owever, there is a renewed debate on the level of transparency and counterparty risk in the ?T) market kindled by the sub prime mortgage crisis in the +, and the need to regulate ?T) transactions effectively. This throws up certain important issues which, at best, may need to be handled separately.

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India has, in this light, embarked upon an experiment by attempting to make the exchange traded currency market popular and a first choice for investors. Though the market has not been able to evince the kind of activity that the ?T) market has witnessed as yet, the recent phenomenal growth is a pointer towards better days ahead for this market. ,ome of the issues plaguing the market at present include the fact that many corporates using currency derivatives for hedging their foreign currency exposure find the reAuirement of margin and settlement of daily mark to market differences cumbersome, especially since there is no such reAuirement for ?T) trades. It would conceivably take some time for them to realise the concomitant benefits of these risk containment measures. Also, there is a perceived resistance to change and switchover from ?T) to exchange traded framework following a level of comfortability reached by market players with the ?T) market framework. 2urther, the market has been restricted in a number of ways. Till recently only +,- I/( futures contracts were permitted. ?ne hopes to see more activity in the segment with more currency pairs being added. Also to start with, 2IIs have not been permitted to participate in this market. This has in effect restricted the liAuidity that 2IIs could have otherwise created. 2IIs are already active in -ubai 'old and )ommodity &xchange !-')<%. There is an opportunity for business for domestic exchanges and intermediaries to be created in bringing this market onshore. According to the latest release from -')<, Indian rupee futures volume rose 41#I in "##5 to HH,1@H contracts on the exchange. Polume in -ecember "##5 was 1@HI higher compared with the same period last year. Though small in comparison to volumes being traded on Indian exchanges, there is still merit in getting this market onshore. Additionally, the offshore /-2 market in Indian rupee has also been witnessing increasing volumes. The average daily volumes on the /-2 rupee market have increased from :1Bmn in "##1 Q$ to :B##mn during "##B #5 !Asian )apital 6arkets 6onitor of A-0, April, "##5%. 6ost of the ma7or foreign banks offer /-2s, but Indian banks are barred from doing so. These markets have evolved for the Indian rupee following foreign exchange convertibility restrictions. It is serving as an avenue for non domestic players, private companies and investors in India to hedge foreign currency exposure. It also derives liAuidity from non

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residents wishing to speculate in the Indian rupee without exposure to the currency and from arbitrageurs who try to exploit the differentials in the prices in the onshore and offshore markets. Though foreign investors can now transact in the onshore Indian forward markets with greater flexibility following various measures taken by (0I in recent years, allowing them access to the exchange traded currency futures platform would further help in getting the volumes in the /-2 market onshore and enhance liAuidity on domestic exchanges. India has witnessed enhanced foreign investment inflows and trade flows in recent years. The Indian currency is now becoming an important international currency. Though India accounts for a very small proportion of the total foreign exchange market turnover in the world as compared to other countries, its share has been slowly but continuously increasing. According to 0I, estimates, the percentage share of Indian rupee in total daily average foreign exchange turnover has increased from #.$I in $55B to #."I in "##$ to #.1I in "##@ and to #.5I in April "##8 !updated data will be available in April "#$#%. All of this implies greater need for hedging currency risk in Indian rupee, particularly given that the exchange rate has been Auite volatile during the last few years and hence increased importance of exchange traded currency market.

-lu!tuation in 6SD2+7R over t"e $ear

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Table o' $ear on $ear (ata o' -++8 an( -orei&n e.!"an&e Re erve o' +n(ia09

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Parti!ular

-++ +nve tment !(s. )r%

SE7SE5 !Annual increase or decrease%

-orei&n E.!"an&e Re erve !billion :%

"##@ "##4 "##H "##8 "##B "##5

""8B5.1 @4118.5 "B#5".H H##48." 414H".H "@48@.1

81#."$ ",88$.@@ @,1H@.@" H,@45."" $#,H88.5H @,881."5

$"4 $"8 $H# "H# "@4 "H4

,ource; ,&0I Website "#$#

:.) Sto!/ Mar/et0

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

-un!tion o' to!/ e.!"an&e 0

6ost important source for companies to raise money =rovides liAuidity to the investors Acts as clearing house for transactions =rovides realistic value of companies

India has "" stock exchanges and the important stock exchanges are 0ombay ,tock &xchange and /ational ,tock exchange at 6umbai. &stablished in $B84 0,& is one of the oldest stock exchanges in Asia and has seen significant development ever since. The regulatory agency which oversees the functioning of stock markets is the ,ecurities and &xchange 0oard of India !,&0I%, which is also located in 0ombay.

Cla i'i!ation o' 'inan!ial mar/et

i) 6nor&ani3e( Mar/et

In these markets there a number of money lenders, indigenous bankers, traders etc. who lend money to the public. ii) Or&ani3e( Mar/et

In organized markets, there are standardized rules and regulations governing their financial dealings. There is also a high degree of institutionalization and instrumentalization. These markets are sub7ect to strict supervision and control by the (0I or other regulatory bodies. Organized markets can be further divided into capital market and 6oney market.

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Ca%ital mar/et
)apital market is a market for financial assets which have a long or definite maturity. ;"i!" !an be 'urt"er (ivi(e( into Industrial ,ecurities 6arket 'overnment ,ecurities 6arket RDong Term Doans 6arket

+n(u trial Se!uritie Mar/et It is a market where industrial concerns raise their capital or debt by issuing appropriate Instruments. It can be subdivided into two. They are; S Primary Market or New Issues Market =rimary market is a market for new issues or new financial claims. *ence, it is also called as /ew Issues 6arket. The primary market deals with those securities which are issued to the public for the first time.

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

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

+m%ortan!e o' Ca%ital Mar/et

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Absence of capital market serves as a deterrent factor to capital formation and economic growth. (esources would remain idle if finances are not funneled through capital market. It provides incentives to saving and facilitates capital formation by offering suitable rates of interest as the price of the capital It serves as an important source for the productive use of the economyCs savings. It provides avenue for investors to invest in financial assets. It facilitates increase in production and productivity in the economy and thus enhances the economic welfare of the society. A healthy market consisting of expert intermediaries promotes stability in the value of securities representing capital funds. It serves as an important source for technological up gradation in the industrial sector by utilizing the funds invested by the public. The ma7or stock indices also have a correlation with the currency rates. ! ree ma"or forces affect t e indices: $% )orporate earnings, forecast and actualO "% Interest rate expectations and 1% 'lobal considerations.

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

31

about the future policy and financial variables. The analysis of dynamic and strategic interactions between stock and foreign exchange market came to the forefront because these two markets are the most sensitive segments of the financial system and are considered as the barometers of the economic growth through which the countryCs exposure towards the outer world is most readily felt. The present study is an endeavor in this direction. 0efore going to discuss further about the interlink ages between the stock and foreign exchange market, it is better to highlight the evolutions and perspectives that are associated with both the markets since liberalization in the Indian context. In the literature, there is theoretical consensus neither on the existence of relationship between stock prices and exchange rates nor on the direction of relationship. In theory there are two approaches to exchange rate determination. They are Flow oriented # are considered as the traditional approach and assume that the exchange rate is determined largely by countryCs current account or trade balance performance. The model posits that changes in exchange rates affect international competitiveness and trade balance, thereby influencing real economic variables such as real income and output !-ornbusch and 2isher, $5B#%. This model represents a positive relationship between stock prices and exchange rates with direction of causation running from exchange rates to stock prices. Stock-oriented - models put much emphasis on the role of financial !formerly capital% account in the exchange rate determination. These 6odels can be distinguished as portfolio balance models and monetary models !0ranson and 2rankel, $5B1%. They postulate a negative relationship between stock prices and exchange rates and come to the conclusion that stock prices have an impact on exchange rates.

<.) )SE 9 SE7SE5

32

+ntro(u!tion 0ombay ,tock &xchange is the oldest stock exchange in Asia with a rich heritage of over $11 years of existence. What is now popularly known as 0,& was established as LThe /ative ,hare N ,tock 0rokersC AssociationM in $B84.

0,& is the first stock exchange in the country which obtained permanent recognition !in $54H% from the 'overnment of India under the ,ecurities )ontracts !(egulation% Act !,)(A% $54H. 0,&Cs pivotal and pre eminent role in the development of the Indian capital market is widely recognized. It migrated from the open out cry system to an online screen based order driven trading system in $554. &arlier an Association ?f =ersons !A?=%, 0,& is now a corporatised and demutualised entity incorporated under the provisions of the )ompanies Act, $54H, pursuant to the 0,& !)orporatisation and -emutualisation% ,cheme, "##4 notified by the ,ecurities and &xchange 0oard of India !,&0I%. With demutualisation, 0,& has two of worldCs prominent exchanges, -eutsche 0Trse and ,ingapore &xchange, as its strategic partners.

?ver the past $11 years, 0,& has facilitated the growth of the Indian corporate sector by providing it with cost and time efficient access to resources. There is perhaps no ma7or corporate in India which has not sourced 0,&Cs services in raising resources from the capital market.

Today, 0,& is the worldCs number $ exchange in terms of the number of listed companies and the worldCs 4th in handling of transactions through its electronic trading system. The companies listed on 0,& command a total market capitalization of +,-Trillion $.#H as of >uly, "##5. 0,& reaches to over @## cities and town nation wide and has around @,518 listed companies, with over 88@4 scrips being traded as on 1$st >uly #5.

The 0,& Index, ,&/,&<, is IndiaCs first and most popular stock market benchmark
33

index. ,ensex is tracked worldwide. It constitutes 1# stocks representing $" ma7or sectors. The ,&/,&< is constructed on a Gfree floatC methodology, and is sensitive to market movements and market realities. Apart from the ,&/,&<, 0,& offers "1 indices, including $1 sectoral indices. It has entered into an index cooperation agreement with -eutsche 0Trse and ,ingapore ,tock &xchange. These agreements have made ,&/,&< and other 0,& indices available to investors across the globe. 6oreover, 0arclays 'lobal Investors !0'I%, at*ong 9ong, the global leader in &T2s through its i,haresU brand, has created the exchange traded fund !&T2% called Gi,hares U0,& ,&/,&< India TrackerC which tracks the ,&/,&<. The &T2 enables investors in *ong 9ong to take an exposure to the Indian eAuity market.

The exchange traded funds !&T2% on ,&/,&<, called L,=Ic&M and 9otak ,&/,&< &T2 are listed on 0,&. They bring to the investors a trading tool that can be easily used for the purposes of investment, trading, hedging and arbitrage. These &T2s allow small investors to take a long term view of the market.

0,& provides an efficient and transparent market for trading in eAuity, debt instruments and derivatives. It has always been at par with the international standards. The systems and processes are designed to safeguard market integrity and enhance transparency in operations. 0,& is the first exchange in India and the second in the world to obtain an I,? 5##$;"### certification. It is also the first exchange in the country and second in the world to receive Information ,ecurity 6anagement ,ystem ,tandard 0, 8855 " "##" certification for its 0,& ?n line Trading ,ystem !0?DT%.

34

(ecently,0,& launched the 0,& I=? index that will track the value of companies for two years after listing. Also, as an investor friendly gesture, 0ombay ,tock &xchange has commenced a facility of sending trade details to investors. 6oving a step further a new transaction fee structure for cash eAuity segment has also been introduced. 0,& also launched G0,& ,tA( 62C 6utual fund trading platform, would enable exchangeCs members to use its existing infrastructure for transaction in 62 schemes. It is an inclusive model with two depositories and industry wide participation. 0,& also revamped its websiteO the new website presents a wide range of new features like GDive streaming Auotes for ,&/,&< companiesC, GAdvanced ,tock (eachC, G,ensex PiewC, G6arket 'alaxyC, and G6embersC.

SE7SE5 9 T"e )arometer o' +n(ian Ca%ital Mar/et +ntro(u!tion ,&/,&<, first compiled in $5BH, was calculated on a L6arket )apitalization WeightedM methodology of 1# component stocks representing large, well established and financially sound companies across key sectors. The base year of ,&/,&< was taken as $58B 85. ,&/,&< today is widely reported in both domestic and international markets through print as well as electronic media. It is scientifically designed and is based on globally accepted construction and review methodology. ,ince ,eptember $, "##1, ,&/,&< is being calculated on a free float market capitalization methodology. The Lfree float market capitalization weightedM methodology is a widely followed index construction methodology on which ma7ority of global eAuity indices are basedO all ma7or index providers like 6,)I, 2T,&, ,T?<<, ,N= and -ow >ones use the free float methodology. The growth of the eAuity market in India has been phenomenal in the present decade. (ight from early nineties, the stock market witnessed heightened activity in terms of various bull and bear runs. In the late nineties, the Indian market witnessed a huge frenzy in the GT6TC sectors. 6ore recently, real estate caught the fancy of the investors.

35

,&/,&< has captured all these happenings in the most 7udicious manner. ?ne can identify the booms and busts of the Indian eAuity market through ,&/,&<. As the oldest index in the country, it provides the time series data over a fairly long period of time !from $585 onwards%. ,mall wonder, the ,&/,&< has become one of the most prominent brands in the country. +n(e. S%e!i'i!ation0 0ase 3ear $58B 85

0ase Index Palue $## -ate of Daunch 6ethod calculation #$ #$ $5BH of Daunched on full market capitalization method and effective ,eptember #$, "##1, calculation method shifted to free float market capitalization. /umber of scripts 1# Index calculation (eal Time freAuency

36

SE7SE5 Cal!ulation Met"o(olo&$ ,&/,&< is calculated using the L2ree float 6arket )apitalizationM methodology, wherein, the level of index at any point of time reflects the free float market value of 1# component stocks relative to a base period. The market capitalization of a company is determined by multiplying the price of its stock by the number of shares issued by the company. This market capitalization is further multiplied by the free float factor to determine the free float market capitalization. The base period of ,&/,&< is $58B 85 and the base value is $## index points. This is often indicated by the notation $58B 85E$##. The calculation of ,&/,&< involves dividing the free float market capitalization of 1# companies in the Index by a number called the Index -ivisor. The -ivisor is the only link to the original base period value of the ,&/,&<. It keeps the Index comparable over time and is the ad7ustment point for all Index ad7ustments arising out of corporate actions, replacement of scrips etc. -uring

37

market hours, prices of the index scrips, at which latest trades are executed, are used by the trading system to calculate ,&/,&< on a continuous basis. SE7SE5 9 S!ri% Sele!tion Criteria The general guidelines for selection of constituents in ,&/,&< are as follows; Li te( Hi tor$0 The scrip should have a listing history of at least 1 months at 0,&. &xception may be considered if full market capitalization of a newly listed company ranks among top $# in the list of 0,& universe. In case, a company is listed on account of merger. demerger. amalgamation, minimum listing history would not be reAuired.

Tra(in& -re=uen!$0 The scrip should have been traded on each and every trading day in the last three months at 0,&. &xceptions can be made for extreme reasons like scrip suspension etc.

-inal Ran/0 The scrip should figure in the top $## companies listed by final rank. The final rank is arrived at by assigning 84I weight age to the rank on the basis of three month average full market capitalization and "4I weight age to the liAuidity rank based on three month average daily turnover N three month average impact cost.

Mar/et Ca%itali3ation ;ei&"ta&e0 The weight age of each scrip in ,&/,&< based on three month average free float market capitalization should be at least #.4I of the Index.

+n(u tr$2Se!tor Re%re entation0 ,crip selection would generally take into account a balanced representation of the listed companies in the universe of 0,&.

38

Tra!/ Re!or(0 In the opinion of the 0,& Index )ommittee, the company should have an acceptable track record.

0,& has designed a 2ree float format, which is filled and submitted by all index companies on a Auarterly basis. 0,& determines the 2ree float factor for each company based on the detailed information submitted by the companies in the prescribed format. 2ree float factor is a multiple with which the total market capitalization of a company is ad7usted to arrive at the 2ree float market capitalization. ?nce the 2ree float of a company is determined, it is rounded off to the higher multiple of 4 and each company is categorized into one of the "# bands given below. A 2ree float factor of say #.44 means that only 44I of the market capitalization of the company will be considered for index calculation. +n(e. Clo ure Al&orit"m The closing ,&/,&< on any trading day is computed taking the weighted average of all the trades on ,&/,&< constituents in the last 1# minutes of trading session. If a ,&/,&< constituent has not traded in the last 1# minutes, the last traded price is taken for computation of the Index closure. If a ,&/,&< constituent has not traded at all in a day, then its last dayCs closing price is taken for computation of Index closure. The use of Index )losure Algorithm prevents any intentional manipulation of the closing index value. Maintenan!e o' SE7SE5 ?ne of the important aspects of maintaining continuity with the past is to update the base year average. The base year value ad7ustment ensures that replacement of stocks in Index, additional issue of capital and other corporate announcements like Grights issueC etc. do not destroy the historical value of the index. The beauty of maintenance lies in the fact that ad7ustments for corporate actions in the Index should not per se affect the index values.

39

The 0,& Index )ell does the day to day maintenance of the index within the broad index policy framework set by the 0,& Index )ommittee. The 0,& Index )ell ensures that ,&/,&< and all the other 0,& indices maintain their benchmark properties by striking a delicate balance between freAuent replacements in index and maintaining its historical continuity. The 0,& Index )ommittee comprises of capital market expert, fund managers, market participants and members of the 0,& 'overning 0oard. On9Line Com%utation o' t"e +n(e. -uring trading hours, value of the Index is calculated and disseminated on real time basis. This is done automatically on the basis of prices at which trades in Index constituents are executed. +n(e. Review -re=uen!$ The 0,& Index )ommittee meets every Auarter to discuss index related issues. In case of a revision in the Index constituents, the announcement of the incoming and outgoing scrips is made six weeks in advance of the actual implementation of the revision of the Index. Con tituent o' )SE en e.9 $ $ (eliance Industries H $ " ?/') 8 $ 1 0harti Airtel B $ @ Tata )onsultancy 5 " 4 Infosys tech # Tata steel Tata motors -r (eddys *ero *onda -D2

40

" H (eliance )ommunication $ " 8 Wipro " " B I)I)I 0ank 1 " 5 $ # $ $ $ " $ 1 $ @ $ 4 *-2) DNT *DD *indalco ,0I 0*&D A)) @ " 4 " H " 8 " B " 5 1 # /T=) (anbaxy ,iemens )ipla 'u7arat Ambu7a 'rasim industries ,un pharma 6aruti udyog 'AID 0a7a7 auto

41

>.) 7SE 9 7+-TY

T"e Or&ani3ation The /ational ,tock &xchange of India Dimited has genesis in the report of the *igh =owered ,tudy 'roup on &stablishment of /ew ,tock &xchanges. It recommended promotion of a /ational ,tock &xchange by financial institutions !2Is% to provide access to investors from all across the country on an eAual footing. 0ased on the recommendations, /,& was promoted by leading 2inancial Institutions at the behest of the 'overnment of India and was incorporated in /ovember $55" as a tax paying company unlike other stock exchanges in the country. The following years witnessed rapid development of Indian capital market with introduction of internet trading, &xchange traded funds !&T2%, stock derivatives and the first volatility index IndiaPI< in April "##B, by /,&. August "##B saw introduction of )urrency derivatives in India with the launch of )urrency 2utures in +,- I/( by /,&. Interest (ate 2utures was introduced for the first

42

time in India by /,& on 1$st August "##5, exactly after one year of the launch of )urrency 2utures. With this, now both the retail and institutional investors can participate in eAuities, eAuity derivatives, currency and interest rate derivatives, giving them wide range of products to take care of their evolving needs. /,&Cs mission is setting the agenda for change in the securities markets in India. The /,& was set up with the main ob7ectives of; V establishing a nation wide trading facility for eAuities, debt instruments and

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

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

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

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

7SE Mile tone

/ovember $55" April $551 Incorporation (ecognition as a stock exchange

43

April $55H >une $55H

Daunch of ,N= )/< /ifty &stablishment of ,ettlement 'uarantee 2und ,etting up of /ational ,ecurities -epository Dimited, first depository in India, co promoted by /,& )ommencement of Internet Trading )ommencement of -erivatives Trading !Index 2utures% )ommencement of trading in Index ?ptions )ommencement of trading in ?ptions on Individual ,ecurities )ommencement of trading in 2utures on Individual ,ecurities Daunch of )urrency -erivatives Daunch of Interest (ate 2utures Daunch of 6utual 2und ,ervice ,ystem

/ovember $55H

2ebruary "### >une "### >une "##$ >uly "##$ /ovember "##$ August "##B August "##5 /ovember "##5

S?P C75 7i't$

,N= )/< /ifty is a well diversified 4# stock index accounting for "" sectors of the economy. It is used for a variety of purposes such as benchmarking fund portfolios, index based derivatives and index funds.

,N= )/< /ifty is owned and managed by India Index ,ervices and =roducts Dtd. !II,D%, which is a 7oint venture between /,& and )(I,ID. II,D is IndiaCs first specialized company focused upon the index as a core product. II,D has a 6arketing and licensing agreement with ,tandard N =oorCs !,N=%, who are world leaders in index services.

44

The total traded value for the last six months of all /ifty stocks is approximately 4"I of the traded value of all stocks on the /,& /ifty stocks represent about H1I of the 2ree 2loat 6arket )apitalization as on -ec 1$, "##5. Impact cost of the ,N= )/< /ifty for a portfolio size of (s." crore is #.$#I ,N= )/< /ifty is professionally maintained and is ideal for derivatives trading 2rom >une "H, "##5, ,N= )/< /ifty is computed based on free float methodology.

Con tituent o' 7i't$9 " $ " (eliance Industries ?/') H " 'u7arat Ambu7a )ipla

45

8 " 1 0harti Airtel B " @ Tata )onsultancy 5 1 4 Infosys tech # 1 H (eliance )ommunication $ 1 8 Wipro " 1 B I)I)I 0ank 1 1 5 $ # $ $ $ " $ 1 $ @ $ 4 *-2) DNT *DD *indalco ,0I 0*&D A)) @ 1 4 1 H 1 8 1 B 1 5 @ # 'laxo ,mith ?riental 0ank >et Airways I=)D -abur *=)D 6T/D Fee &ntertainment P,/D IT) /T=) (anbaxy ,iemens

46

$ H $ 8 $ B $ 5 " # " $ " " " 1 " @ " 4 'rasim industries ,un pharma 6aruti udyog 'AID 0a7a7 auto Tata steel Tata motors -r (eddys *ero *onda ,atyam computers

@ $ @ " @ 1 @ @ @ 4 @ H @ 8 @ B @ 5 4 # *)D tech ,eagrams 6N6 /ational Alu *indalco A00 =un7ab /ational 0ank (eliance energy 0=)D Tata power

@.) Te t an( Re ult

Te t 'or Stationarit$9
A time series is said to be stationary if its mean and variance are constant over time and the value of the covariance between the two time periods depends only on the distance or
47

gap or lag between the two time periods and not the actual time at which the covariance is computed. Tests for stationarity are routinely applied to highly persistent time series. 2ollowing 9wiatkowski, =hillips, ,chmidt and ,hin !$55"%, standard stationarity employs a rescaling by an estimator of the long run variance of the !potentially% stationary series. Test for stationarity is important in case of time series data because a nonstationary time series will have time varying mean or a time varying variance or both. *ence the results cannot be extrapolated for the entire population. The test for stationarity can be done using +nit (oot Test. It is due to the fact that W E $. If however, XWX Y $, that is if the absolute value of W is less than one, then it can be shown that the time series is stationary. 'iven that in most situations only one observation is available at a given time, stationarity ensures that all parts of the series are like the other parts, which allows us to estimate the needed parameters. Therefore, the mean, the variance and the covariance of the series are not functions of time and depend rather on the lag between the observations !the difference between the times at which two observations were recorded%. To summarize, if <t is a discrete time series, its distribution is described by its first two ments, which under stationarity must depend only on the lag; &J<tK E Zt E Z, P ar!<t% E ["t E [", )ov!<t, <t\s% E &J!<t \ Zt%!<t\s \ Zt\s%K E [t,t\s E [XsX, )orr!<t, <t\s% E [t,t\s [" E Wt,t\s. ,ince all time series data sets contain either deterministic or stochastic trends !or both%, unit root tests and stationarity tests are a way of determining which kind of trends are present in the data. If only deterministic trends are present, then the series can be seen as being generated by some non random, pre determined function of time with

48

some random error thrown in. ?n the other hand, if stochastic trends are present, then the generating model of the series combines a starting value and a seAuence of random innovations with zero mean and constant variance, which forms a more dynamic structure. In this case, each observation depends on its history of past random innovations, which greatly impact its current value. Thus, in the case of stochastic trends the value of a future observation depends on the values of present and past observations. Au&mente( Di!/e$ -uller Te t9 An augmented -ickey 2uller test is a test for a unit root in a time series sample. An augmented -ickey 2uller test is a version of the -ickey 2uller test for a larger and more complicated set of time series models. The augmented -ickey 2uller !A-2% statistic, used in the test, is a negative number. The more negative it is, the stronger the re7ections of the hypothesis that there is a unit root at some level of confidence. +nder the -ickey 2uller test the null hypothesis that ] E #, the estimated t value of the coefficient of 3t $ in follows the ^ !tau% statistic. The values are arrived from 6onte )arlo simulation. This test is conducted by LaugmentingM the preceding three eAuations by adding the lagged values of the dependent variable ,o the reAuired regression is; Yt = 1 + 2 t + Yt-1+ ! i " Yt-i + # t Where Z is a constant, _ the coefficient on a time trend and p the lag order of the autoregressive process. Imposing the constraints Z E # and _ E # corresponds to modeling a random walk and using the constraint _ E # corresponds to modeling a random walk with a drift. 0y including lags of the order p the A-2 formulation allows for higher order autoregressive processes. This means that the lag length p has to be determined when applying the test. ?ne possible approach is to test down from high orders and examine 3t.

49

the t values on coefficients. An alternative approach is to examine information criteria such as the Akaike information criterion, 0ayesian information criterion or the *annon Quinn criterion. The unit root test is then carried out under the null hypothesis ` E $ against the alternative hypothesis of ` a $. ?nce a value for the test statistic b

)omputed it can be compared to the relevant critical value for the -ickey 2uller Test. If the test statistic is less than the critical value then the null hypothesis of ` E $ is re7ected and no unit root is present Where c t is a pure white noise error term and the number of lagged difference terms to include is often determined empirically, the idea being to include enough terms so that the error term in is serially uncorrelated. -ickey and 2uller !$585% found that the distributions of the t statistics for the models given above are skewed to the left and have critical values that are Auite large and negative. That means that if the standard t distributions were used during testingO we would tend to over re7ect the null hypothesis. ?ne important element in the A-2 test is the number of lags present in the model. It has been observed that the number of lagged factors has a great impact on the size and power properties of the A-2 test and therefore it is important to precisely determine how many should be included in the model. ,ome advocate starting with a large number of lags, estimating their coefficients and eliminating the ones than are statistically insignificant at the chosen level. This process would continue until no insignificant terms are left in the model. we can include deterministic trends in the models !linear or non linear% and the analysis goes along the same lines as in the case of the -2 variants. The only modification is, once again, the presence of the lagged terms, which has to be determined with relatively high accuracy for the unit root tests to be effective.

50

Then the test statistic Td!b?D, $% has a known, documented distribution. Its value in a particular sample can be compared to that distribution to determine a probability that the original sample came from a unit root autoregressive processO that is, one in which bE$. =roperties and )haracteristics of +nit (oot =rocesses b ,hocks to a unit root process have permanent effects, they do not decay /on stationary processes have no long run means to revert to after a shock Their variance is time dependent and it goes to infinity as it goes to infinity I!$% processes can be rendered stationary and used for ?D, estimation by taking their first differences yt E yt \ y 2irst the stationarity has been checked for the closing values of stock markets and settlement price of exchange market. If they are not stationary, then they are converted in logarithmic values in order to make them in a continuous form. And if yet the time series are not stationary, then daily returns are identified as the difference in the natural logarithm of the closing index value for the two consecutive trading days .It can be presented as; or

Where

is logarithmic daily return at time t.

and

are daily prices of an asset at

two successive days, t $ and t respectively. In order to do time series analysis, transformation of original series is reAuired depending upon the type of series when the data is in the level form. The series of return was transformed by taking natural logarithm. There are two advantages of this kind of transformation of the series. 2irst it eliminates the possible dependence of changes in

51

stock price index on the price level of the index. ,econd, the change in the log of the stock price index yields continuously compounded series. In the sample time series data i.e., 0,& ,ensex, /,& /ifty and &xchange (ate data have been tested for their stationarity and the results are as follows b 7+-TY9 Dags A-2 T ,tatistic $ " 1 @ 4 H 8 # @8.B8#B1 @#.4B45$ 1$.B81$H "B.4"8#4 "4.B451H "@.8@"1@ "@.#1BHB H".@BB1# $I ,ignificance value ".4HH4"$ ".4HH4"$ ".4HH4"$ ".4HH4"$ ".4HH4"$ ".4HH4"$ ".4HH4"$ ".4HH4"$ 4I ,ignificance value $.5@$#18 $.5@$#18 $.5@$#18 $.5@$#18 $.5@$#18 $.5@$#18 $.5@$#18 $.5@$#18 $#I ,ignificance value $.H$H44H $.H$H44H $.H$H44H $.H$H44H $.H$H44H $.H$H44H $.H$H44H $.H$H44H

In the analysis we find that the calculated Tau statistic is significant even at $I significant level

*ence we can conclude that the data set !/,& /ifty% is stationary at first difference.

E.!"an&e Rate9 Dags A-2 T $I ,ignificance 4I ,ignificance $#I ,ignificance

52

,tatistic $ " 1 @ 4 H 8 # 48."B1"4 @8.8"H1$ @$.#$1@4 14.H$8"$ 1#.1BB15 "B.$H"H8 "8.#1"84 B@.B1B58

value ".4HH4"$ ".4HH4"$ ".4HH4"$ ".4HH4"$ ".4HH4"$ ".4HH4"$ ".4HH4"$ ".4HH4"$

value $.5@$#18 $.5@$#18 $.5@$#18 $.5@$#18 $.5@$#18 $.5@$#18 $.5@$#18 $.5@$#18

value $.H$H44H $.H$H44H $.H$H44H $.H$H44H $.H$H44H $.H$H44H $.H$H44H $.H$H44H

The log naturals of &xchange rate is found to be stationary at $I significance level using Augmented -ickey 2uller test

The regression eAuation showed that the variables are stationary at $I critical value.

SE7SE5 A Dags A-2 T ,tatistic $I ,ignificance value 4I ,ignificance value $#I ,ignificance value

53

$ " 1 @ 4 H 8 #

@8.@1B#B @#.8@15@ 1".B1H4$ "B."H#B" "H.#B4#4 "@.B@B"4 "@."184B H#.$$$"4

".4HH4"$ ".4HH4"$ ".4HH4"$ ".4HH4"$ ".4HH4"$ ".4HH4"$ ".4HH4"$ ".4HH4"$

$.5@$#18 $.5@$#18 $.5@$#18 $.5@$#18 $.5@$#18 $.5@$#18 $.5@$#18 $.5@$#18

$.H$H44H $.H$H44H $.H$H44H $.H$H44H $.H$H44H $.H$H44H $.H$H44H $.H$H44H

The data set of 0,& ,ensex is tested for stationarity using Augmented -ickey 2uller test

The Test showed that the data is ,tationary at $st difference The test is stationary at $I critical value.

+nter%retation0 In Table /ifty, &xchange rate and ,ensex, A-2 statistics of the series shows absence of unit root !i.e. eE#% in the series exceeds the .

$. /ifty # lag ! H".@BB1# f ".4HH4"$% and 8 lag ! "@.#1BHB f ".4HH4"$% ". &xchange rate # lag ! B@.B1B58 f ".4HH4"$% and 8 lag ! "8.#1"84 f ".4HH4"$%

54

1. ,ensex # lag ! H#.$$$"4 f ".4HH4"$% and 8 lag ! "@."184B f ".4HH4"$% Thus the series are now stationary. And trend coefficients of both the series are also statistically insignificant, that shows the absence of trend in both the series.

Te tin& 'or t"e (i tribution A

A 're=uen!$ (i tribution is a list of the values that a variable takes in a sample. It is usually a list, ordered by Auantity, showing the number of times each value appears. 2reAuency distribution is said to be skewed when its mean and median are different. The kurtosis of a freAuency distribution is the concentration of scores at the mean, or how peaked the distribution appears if depicted graphicallygfor example, in a histogram. If
55

the distribution is more peaked than the normal distribution it is said to be leptokurticO if less peaked it is said to be platykurtic. 7ormal (i tribution A The importance of the normal distribution as a model of Auantitative phenomena in the natural and behavioral sciences is due to the central limit theorem. 6any psychological measurements and physical phenomena !like photon counts and noise% can be approximated well by the normal distribution. While the mechanisms underlying these phenomena are often unknown, the use of the normal model can be theoretically 7ustified by assuming that many small, independent effects are additively contributing to each observation. The normal distribution also arises in many areas of statistics. 2or example, the sampling distribution of the sample mean is approximately normal, even if the distribution of the population from which the sample is taken is not normal. In addition, the normal distribution maximizes information entropy among all distributions with known mean and variance, which makes it the natural choice of underlying distribution for data summarized in terms of sample mean and variance. The normal distribution is the most widely used family of distributions in statistics and many statistical tests are based on the assumption of normality. In probability theory, normal distributions arise as the limiting distributions of several continuous and discrete families of distributions. While statisticians and mathematicians uniformly use the term Lnormal distributionM for this distribution, physicists sometimes call it a 'aussian distribution and, because of its curved flaring shape, social scientists refer to it as the Lbell curve.M 2eller !$5HB% uses the symbol for in the above eAuation, but then switches to in 2eller !$58$%. -e 6oivre developed the normal distribution as an approximation to the binomial distribution, and it was subseAuently used by Daplace in $8B1 to study measurement errors and by 'auss in $B#5 in the analysis of astronomical data. The normal distribution is implemented in Mat ematica as /ormal -istribution Jmu, sigmaK. The so called Lstandard normal distributionM is given by taking ZE# and ["E$ in
56

a general normal distribution. An arbitrary normal distribution can be converted to a standard normal distribution by changing variables to , yielding

/ormal distributions have many convenient properties, so random variates with unknown distributions are often assumed to be normal, especially in physics and astronomy. Although this can be a dangerous assumption, it is often a good approximation due to a surprising result known as the central limit theorem. This theorem states that the mean of any set of variates with any distribution having a finite mean and variance tends to the normal distribution. 6any common attributes such as test scores, height, etc., follow roughly normal distributions, with few members at the high and low ends and many in the middle. 0ecause they occur so freAuently, there is an unfortunate tendency to invoke normal distributions in situations where they may not be applicable. As Dippmann stated, L&verybody believes in the exponential law of errors; the experimenters, because they think it can be proved by mathematicsO and the mathematicians, because they believe it has been established by observationM !Whittaker and (obinson $5H8, p. $85%. Among the amazing properties of the normal distribution are that the normal sum distribution and normal difference distribution obtained by respectively adding and subtracting variates < and 3 from two independent normal distributions with arbitrary means and variances are also normalh The data is tested for the distribution that it follows and the results are as follows Te tin& (ata 'or (i tribution9 )SE Sen e. Stati ti! / 6ean $5B" #.###B8$8B8
57

6edian ,td. -eviation Pariance ,kewness 9urtosis 6inimum 6aximum ,um

#.##$48@8$4 #.#$15$#B"$ #.###$514$$ #.H588B18#4 4.55#H4H#51 #.#851$#58$ #.$$B#5$88 $."5B5H"8H

Te tin& (ata 'or (i tribution9 E.!"an&e rate Stati ti!

58

/ 6ean 6edian ,td. -eviation Pariance ,kewness 9urtosis 6inimum 6aximum ,um

$5B" @.BH1B1& #4 @.1"H@$& #4 #.##84H11HB 4.8"#@4& #4 #.#$"8$B#4@ "@.@5B81"1@ #.#81@51$@ #.#H@BHHB#5 #.#8"@8$#B5

Te tin& (ata 'or (i tribution9 7SE 7i't$

59

Stati ti! / 6ean 6edian ,td. -eviation Pariance ,kewness 9urtosis 6inimum 6aximum ,um $5B" #.###B$"54 #.###8@8B41 #.#$@@5#14$ #.###"#558 #.541B8$81B 5.5$H@$55H1 #.$#"@81@5 #.$1#41BH" $."$$"54B5@

60

+nter%retation As can be seen from the above results the data sets of 0,& ,ensex, /,& /ifty and &xchange (ate follows normal distribution. *ence the data is capable for further testing. The variances of the data sets are ## which confirms the data as to its stationarity.

Te t 'or Co9inte&ration A Bo"n on8 Co9inte&ration te t

Co inte&ration is an econometric techniAue for testing the correlation between stationary time series variables. If two or more series are themselves stationary, and a linear combination of them is stationary, then the series are said to be co integrated. 2or instance, a stock market index and the price of its associated futures contract move through time, each roughly following a random walk. Testing the hypothesis that there is a statistically significant connection between the futures price and the spot price could now be done by finding a co integrating vector. !If such a vector has a low order of integration it can signify an eAuilibrium relationship between the original series, which are said to be !o inte&rate( of an order below one%. It is often said that co integration is a means for correctly testing hypotheses concerning the relationship between two variables having unit roots !i.e. integrated of order one%. ,eries is said to be Lintegrated of order dM if one can obtain a stationary series by LdifferencingM the term d times. ,uch that; C $ % & d' ()* is stationary, where the parameter d is the co integrating parameter that links the two time series together. 2urther, the relationship 3 E d< is considered to be a long run, or GeAuilibriumC, relationship suggested by economic theory. +nder such circumstances these markets are said to be co integrated. In contrast, lack of co integration implies that the aforementioned variables have no link in the long run. If two, or more series, are co integrated, then there exist common factors that affect both and their permanent or secular trends, and so the series will eventually ad7ust to eAuilibrium. The implications
61

for diversification are that even if, in the short term the covariance between two series indicates portfolio benefits, in the long run such benefits are spurious as the two series will eventually ad7ust to an eAuilibrium relationship. *ence, the existence of an eAuilibrium relationship between two or more variables, assuming that they all are integrated individually to the same degree, reAuires that the co integration between them is of a lower degree. That is if both < and 3 are stationary I!$% the co integration vector must be stationary I!#%. *owever, if < and 3 are integrated to different degrees, there will not be any parameter d that satisfies &Auation !$%. Thus a long run relationship implies the reAuirement that the two variables should be !i% integrated to the same degree and !ii% a linear combination of the two variables should exist which is integrated to a lower degree than the individual variables. Testing for co integration involves two steps. $. -etermine the degree of integration in each of the series, a unit root analysis. ". &stimate the co integration regression and test for integration. Assuming that each series has the same number of unit roots, the co integration test can commence. &ngle and 'ranger !$5B8% proposed seven tests for examining the hypothesis that two time series are not co integrated. In co integration tests, the null hypothesis is non co integration. ?nly two are used here both based on the using an ?D, regression in the following form; 3 E a i b< i m !1% where b is the estimator for the eAuilibrium parameter, dO a is the interceptO and m is the disturbance term. The first of the two tests of co integration is based on the )o integrating (egression -urbin Watson !)(-W% statistic. As a simple Grule of thumbC for a Auick evaluation of the co integration hypothesis 0aner7ee et al !$5BH% proposed that; if the )(-W statistic is smaller than the coefficient of determination !("% the co

62

integration hypothesis is likely to be falseO otherwise, when )(-Wf (", co integration may occur. Alternatively the )(-W statistic can be evaluated against critical values developed by &ngle and 'ranger !$5B8%, if the )(-W statistic exceeds the critical value, the null hypothesis of non co integration is re7ected. ,uggesting that the series are not co integrated. The test for co integration involves the significance of the estimated l$ coefficient. Again the null hypothesis is that the error terms are nonstationary and acceptance of this hypothesis indicates that the series under investigation are not integrated. If the t statistic on the l$ coefficient exceeds the critical value, the m residuals from the co integration regression eAuation !1% are stationary and the variables < and 3 are co integrated. )ritical values for this t statistic are given in 6ackinnon !$55$%. Te t0 Bo"n on8 Co9inte&ration te t ,ample; $ $5B" Included observations; $5B" ,eries; $. &xchange rate and /,& ". &xchange rate and 0,& Dags interval; $ to @ &igenvalue Dikelihood ratio #.$H5B""B4@1"5 #.$4#@@4B1#"H4 4@#.$4#$"HH4 "4".""B@#8BB 4I Palue $5.5H 5."@ )ritical $I Palue "@.H#dd $".58dd )ritical *ypothesized /o. of )&!s% /one At most $

CC in(i!ate t"e re#e!tion o' inte&ration between erie at 1D an( :D i&ni'i!an!e level +nter%retation9

63

As per >ohnsonCs )o integration Test there exists no relationship between the two series i.e., &xchange rate and /,& /ifty and &xchange rate and 0,& ,ensex

Through this test we can conclude that there is no long term relationship between exchange rate and stock indices.

Te t 'or Cro

!orrelation

)ross correlation is a standard method of estimating the degree to which two series are correlated. )onsider two series x!i% and y!i% where iE#,$,".../ $. The cross correlation r at delay d is defined as

Where mx and my are the means of the corresponding series. If the above is computed for all delays dE#, $, ", / $ then it results in a cross correlation series of twice the length as the original series.

There is the issue of what to do when the index into the series is less than # or greater than or eAual to the number of points. !i d a # or i d fE /% The most common approaches are to either ignore these points or assuming the series x and y are zero for i a # and i fE /. In many signal processing applications the series is assumed to be circular in which case the out of range indexes are LwrappedM back within range, ie; x! $% E x!/ $%, x!/i4% E x!4% etc.

64

The period for cross correlation has been decreased to $st >anuary "##@ to 1#th >une "##5. This time period has been further segmented into duration of six months i.e. two eAual halfCs of a year to find out if there is any short run relation or spillover from one variable to another in this time period. $" days lag is considered to see the lead.lag relation between the two variables.

Abbreviation &(; &xchange rate 0,& ,ensex

,ensex;

/ifty; )/< /ifty

/&'ATIP& DA' &( b I/-&< I/-&< b &( D&A-I/' DA''I/'

=?,ITIP& DA' DA''I/' D&A-I/'

St(. Error 'or ea!" "al' at E la& II I half of "##@ )orrelation

0.0909

half

of I half of "##4 )orrelation

0.0910

II "##4

half

of I half of "##H )orrelation

0.0899

"##@ )orrelation
0.0890

)orrelation
0.0940

65

II "##H

half

I "##8

half

II "##8

half

I "##B

half

II "##B

half

I "##5

half

)orrelati on
0.0910

)orrelati on
0.0920

)orrelati on
0.0889

)orrelati on
0.0910

)orrelati on
0.0910

)orrelati on
0.1034

Correlation an( T value o' ER an( SE7SE5 'or t"e %erio( *EE4 to *EEF I half of "##@ )orrelati Dag on #.#@" $" !#.@1B% #.#11 $$ !#.1@@% #.#B4 $# !#.B54% #.##1 5 !#.#1"% #.#1B B 8 !#.@#@% #.#5" II half of I half of II half of I half of

"##@ )orrelation #.#$$ !#.$$8% #.#B8 !#.514% #.#55 !$.#H4% #.$@B !$.H#5% #.#B$ !#.BB#% #.$$H

"##4 )orrelation #.$"H !$.1"H% #.#51 !#.585% #.#$8 !#.$B$% #."14 !".4##%d #.$"$ !$."B8% #.$#$

"##4 )orrelation #.#$$ !#.$$#% #.$"1 !$."@"% #.$#B !$.#5$% #.#4$ !#.4"#% #.#"" !#.""@% #.$#1

"##H )orrelation #.#1B !#.@##% #.##$ !#.#$$% #.#$" !#.$"B% #.$$ !$.$8#% #.#H1 !#.H88% #.$4@

66

!#.585% #.#H@ H !#.HB$% #.$B" 4 !$.548% #.#H4 @ !#.H55% #.$$5 1 !$."51% #.#$$ " !#.$"#% #.#44 $ !#.45B% #.##" # !#.#""% #.#8$ $ !#.88"% #.#5H " !$.#@1% #.$1H 1 !$.@8B%

!$."H$% #.#HH !#.8"4% #.$#" !$.$"$% #."#4 !"."41%d #.#18 !#.@$$% #." !"."""%d #.##" !#.#""% #.$H" !$.B"#% #.#44 !#.H$B% #.$"1 !$.1H8% #.#5$ !$.#$$%

!$.#BH% #.#8" !#.88@% #.#H5 !#.84#% #.#"1 !#."4#% #."#5 !"."8"%d #.$$$ !$.""#% #."#4 !"."41%d #.#8H !#.B14% #.$H5 !$.B48% #.#$" !#.$1"% #.##@ !#.#@1%

!$.#H"% #.#15 !#.@#"% #.$4B !$.H@H% #.$8H !$.B11% #.##5 !#.#54% #.$"$ !$."8@% #.@#5 !@.14$%d #.1"B !1.@B5%d #.1#8 !1."HH%d #.#85 !#.B1"% #.$H5 !$.885%

!$.H4H% #.$1@ !$.@48% #.#"B !#.1#@% #.$#B !$.$8@% #.#1" !#.14"% #.$8" !$.5$$% #.#$ !#.$$#% #.#HB !#.84H% #.##" !#.#""% #.#"1 !#."41% #.#5@ !$.#11%

67

#.#"5 @ 4 !#.1$"% #.#8$ !#.8H1% H #.#BH !#.5$4% #.#@5 8 !#.4"$% #.$@8 B !$.4H@% #.#$ 5 !#.$#4% #.#H8 $# !#.8#4% #.$$H $$ !$."#B% #.$8@ $" !$.B$1%

#.#@@ !#.@B@% #.#1 !#.11#% #.#H5 !#.84B% #."84 !".5B5%d #.#"$ !#.""B% #.$@5 !$.H"#% #.#8@ !#.85H% #.$H1 !$.841% #.#1@ !#.1H"%

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#.#48 !#.45@% #.$15 !$.@@B% #.#4" !#.41H% #.#$@ !#.$@@% #.#4$ !#.4"#% #.#"B !#."BH% #.$1H !$.18@% #.#4@ !#.4@4% #.#1@ !#.1@#%

#.#B@ !#.5$1% #.#1 !#.1"H% #.#B8 !#.5@H% #.#B@ !#.5#1% #.#1$ !#.111% #.#15 !#.@$4% #.#4 !#.41"% #.#@" !#.@@8% #.#@ !#.@"$%

68

Dag

II half "##H )orrela tion

half

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half

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$"

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!".@#5% d #.$@1

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69

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!$.@#5% #.#$@ !#.$4$%

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70

!#."5#% 8 #.#"8 !#."5#% B #.#81 !#.888% 5 #.$"8 !$.14$% $# #.#BH !#.5$4% $$ #.#H4 !#.HB@% $" #.$8@ !$.B1"%

!#.5$4% #.#55 !$.#41%

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!#.H55% #.#4$ !#.4@B% #.""4

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#.##B !#.#B4% #.#$ !#.$#H% #.#4B !#.H$$% #.$B1 !$.5"H% #.#$4 !#.$4H%

!".15@% d #.#$@ !#.$@5% #.#54 !$.#$$% #.#"8 !#."B@% #.#"B !#."54%

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/umbers with in brackets indicate T values E correlation. standard error d indicates t values greater than ", j 4I significance level

+nter%retation0

71

2rom the above table, it is clear that in first half of "##@, T value for all the leads and lags is not statistically significant. ,o there is no impact of &( on sensex and vice versa. In the second half of "##@ T value at " lag and at @ lag is significant. This shows that &( at zero date has an inverse effect on second and fourth dayCs share prices and T value at i 8 lag is also significant. ,o ,&/,&< inversely affects the &(. In the first half of "##4 ,&/,&< is affected by &( on first, third and ninth day. In the second half of "##4 on the same day and next day there was an inverse affect on Index due to fluctuations in &(. And there was cyclical relationship between the variables during this period. In the year "##H and in first half of "##8, &( and ,&/,&< are not affected by each other. In the second half "##8 &( affects ,&/,&< on the second day. In the first half of "##B &( leads ,&/,&< at five day lag and ,&/,&< leads &( at five day lag. In the second half of "##B ,&/,&< leads &( at the same day and at i" and iB days lag. In the first half of "##5 fluctuations in &( are reflected in ,&/,&< on the next day. ,o finally we can find that there is no systematic pattern of lead or lag between the variables in this period.

72

Correlation an( T value o' ER an( 7+-TY 'or t"e %erio( *EE4 to *EEF Dag I of "##@ )orrela tion $" #.#15 !#.@#H% $$ #.#@1 !#.@@B% $# #.$ !$.#41% 5 #.#"8 !#."B@% B #.#$ !#.$#H% 8 #.#H8 !#.8$1% H #.#5H !$.#"$% 4 #.$8 half II half of "##@ )orrelation #.#$$ !#.$$8% #.$$5 !$."B#% #.#5B !$.#4@% #.$14 !$.@H8% #.#8B !#.B@B% #.$#B !$.$8@% #.#84 !#.B"@% #.#H4 I half of "##4 )orrelation #.$#$ !$.#H1% #.#8$ !#.8@8% #.#1" !#.1@#% #."1" !".@HB%d #.#5H !$.#"$% #.$#@ !$.$$B% #.#@5 !#.4"8% #.#8$ II half of "##4 )orrelation #.##@ !#.#@#% #.$$1 !$.$@$% #.$$" !$.$1$% #.#@$ !#.@$B% #.#$" !#.$""% #.$$8 !$."#H% #.#"@ !#."@8% #.$H I half of "##H )orrelation #.#@8 !#.@54% #.#$1 !#.$1B% #.##1 !#.#1"% #.#5@ !$.###% #.#8" !#.88@% #.$8$ !$.B15% #.$@B !$.H#5% #.#1$

73

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74

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half

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75

!$.$@8% $# #.#H5 !#.81@% 5 #.#85 !#.B@#% B #.#48 !#.H#H% 8 #.##@ !#.#@1% H #.#"8 !#."5#% 4 #.#81 !#.851% @ #.#H8 !#.8"B% 1 #.$#" !$.$#5% " #.#BB !#.5H8% $ #.#51

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76

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!#.B$4% #.$#1 !$.$"#% #.##@ !#.#@1% #.#B" !#.B5$% #.#15 !#.@$5% #.$@$ !$.4$H% #.#55 !$.#41% #.#H1 !#.H8#% #.#51 !#.5B5% #.#BH !#.5#4% #.#"4 !#."H1% #.#"B

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77

!#.H$8% $$ #.#@5 !#.4$H% $" #.$84 !$.B@"%

!#."5"% #.#$B !#.$BB%

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#.$$H !$.#44%

/umbers with in brackets indicate T values E correlation. standard error d indicates t values greater than ", j 4I significance level.

Interpretation$ 2rom the above tables, it is clear that in the year "##@, there is no relationship between the variables. In the year "##4 there was cyclical relation between the variables. In the year "##H and first half "##8 there was no significant relationship between the variables. In the second half "##8 &( affects /I2T3 on the second day. In the first half of "##B &( leads /I2T3 at five day length and /I2T3 leads &( at five day length. In the first half of "##5 fluctuations in &( are reflected in /I2T3 on the next day. ,o finally we can find that there is no systematic pattern of lead or lag between the variables in this period. This also shows that ,&/,&< and /I2T3 are moving in the same direction.

78

F.) -in(in& 9
Theory says that exchange rates should have a direct impact on the companies with heavy import or export activities and thus affecting the profitability and hence the stock prices. An exchange rate has two effects on stock prices, a direct effect through 6ulti /ational 2irms and an indirect effect through domestic firms. As the index is nothing but weighted average of the share prices of various companies from different sectors, the sensex has been considered to see the impact of &( on it. 0oth ,ensex and /ifty are considered to see where they move in the same direction or not. $.% After analyzing the data by using >ohnson )o integration, we found that in the long run &xchange (ate does not affect the share prices. The results show that there was no significant relationship between the &xchange (ate and any index. The possible reasons for such behavior could be as follows;
79

It can be said that because of using only a single variable, namely exchange rate, the impact on stock prices was not felt. If more of independent variables like interest rates, money supply etc. could be added, then possibly a very good relation could have been established.

In reality, stock prices and exchange rate are affected by a myriad of factors such as fiscal and monetary policy, interest rates, inflation, money supply, political factors, international events, fundamental performance, forex reserves, 0?=, exchange control, etc.

The non existence of relationship may also be because of Indian markets not yet being highly integrated or sensitive to the new information. Also the Indian companies comparatively may not be exposed to a lot of forex exposure, like companies in developed countries.

Alternatively Indian managers are highly cautious and hedge to a good extent of their forex exposure.

*igh volatility introduced in the exchange market due to floating rate regime nurtures the speculative activities, makes it difficult to pinpoint the precise effect of exchange rates on stock prices.

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

".% An attempt has been made to investigate lead lag relationship, by using cross correlation. The results for the both index and for exchange rate are as follow; In the second half of "##4, there was very significant relationship between the exchange rates and all the indices. -uring this period, all the indices have also influenced the exchange rates at one day lag. There was also a very good cyclical relationship of lead and lag between the variables.
80

The lead lag relationship occurred between the variables during different periods is because in India, though stock market investment does not constitute a very significant portion of total household savings compared to other form of financial assets, it may have a significant impact of exchange rate movement as 2II investment has played a dominant role. The control measures of (0I have shown its influence from time to time and disrupted the relation between the two variables.

2or the market efficiency, it can be inferred from the analysis that for the given time period a spillover effect or influence from foreign exchange market is seen on the stock market, so it is not efficient in processing the information.

1E.) Con!lu ion 9

0y using daily data, we have examined the long run and short run dynamics between stock prices and exchange rates in India. ?ur main concerns were to examine whether these links were affected by the existence of foreign exchange controls, floating rates and raising value of (upee and raising indices in India. The following conclusions have been derived from our analysis; There is no significant cause and effect relationship between the two variables. As the relationship occurred between the variables during different periods is because of chance factor and not because of cause factor. Thus the results provide the evidence for the presence goods market or portfolio approach. *ence, we can re7ect the hypothesis that there is relationship between the exchange rate and stock indices and the two are affected by various factors in spite of the increasing integration between the two markets.

81

The outcome of the study is consistent with the findings of Apte !"##$% and it also in agreement with /ath and ,amanta !"##1%. In conclusion, in the era of increasing integration in financial markets one should take sufficient care while implementing exchange rate policies. 2urthermore, indications are that the existence of foreign exchange restrictions does not isolate the domestic capital markets. The general increase in international trade and the resultant increase in economic integration have also increased financial integration and reduced the benefit of international diversification.

1E.) )+)LOGRAPHY 9
Te.t )oo/
S %a&ic 'cono(etric&) -amodar /. 'u7arati and , ,angeetha, !2ourth &dition%

S *e&earch +ethodolog, -onald )ooper and =amela ,chindler , !&ighth &dition%

S Financial (arket& and &er-ice& 'ordon and /atra7an, !,econd &dition%

82

;eb ite
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Re'eren!e0

LIntegration between 2oreign &xchange and )apital 6arkets in India; An empirical explorationk by 'olka ) /ath and ' = ,amanta, the I)2AI >ournal of Applied 2inance vol. 5 /o. H, =g. "5 to @#

L,tock =rices and &xchange (ates interlinkages in emerging financial markets; the Indian perspectiveM by Alok 9umar 6ishra the I)2AI >ournal of Applied 2inance vol.$$ /o.@,=g. 1$ to @B

-ickey, -.A., and 2uller, W.A. !$5B$%. Dikelihood ratio statistics for autoregressive time series with a unit root. &conometrica @5, $#48 $#8".

83

>ohansen, ,. and 9. >uselius, $55#, L6aximum Dikelihood &stimation and Inference on )o integration With Application to the -emand for 6oney,M ?xford 0ulletin of &conomics and ,tatistics 4", $H5 "$#.

Anne.ure
Sen e. !lo in& value 'or t"e %erio( *EE:
Log Normal of P1/P0 0.0077 0.0066 0.0055 0.0110 0.0049 0.0039 0.0062 0.0032 0.0049 0.0029 0.0095 0.011! 0.000! 0.001! 0.0015 0.0041 0.0144 0.0045 0.0111 0.0116 0.0035

DATE 31/5/2005 30/5/2005 27/5/2005 26/5/2005 25/5/2005 24/5/2005 23/5/2005 20/5/2005 19/5/2005 1!/5/2005 17/5/2005 16/5/2005 13/5/2005 12/5/05 11/5/05 10/5/05 9/5/05 6/5/05 5/5/05 4/5/05 3/5/05

CLOSING 6715.11 6663.55 6707.72 6670.7! 6597.6 6565.37 6539.!3 6499.5 647!.94 6447 6466 652!.03 6451.54 6456.!2 6445.13 6454.71 64!1.35 63!!.4! 6359.65 62!9.55 6216.77

P1/P0 1.0077 0.9934 1.0055 1.0111 1.0049 1.0039 1.0062 1.0032 1.0050 0.9971 0.9905 1.0119 0.9992 1.001! 0.99!5 0.9959 1.0145 1.0045 1.0111 1.0117 1.0035

84

2/5/05 29/4/2005 2!/4/2005 27/4/2005 26/4/2005 25/4/2005 22/4/2005 21/4/2005 20/4/2005 19/4/2005 1!/4/2005 15/4/2005 13/4/2005 12/4/05 11/4/05 !/4/05 7/4/05 6/4/05 5/4/05 4/4/05 31/3/2005 30/3/2005 29/3/2005 2!/3/2005 24/3/2005 23/3/2005 22/3/2005 21/3/2005 1!/3/2005 17/3/2005 16/3/2005 15/3/2005 14/3/2005 11/3/05 10/3/05 9/3/05 !/3/05 7/3/05 4/3/05 3/3/05 2/3/05 1/3/05 2!/2/2005 25/2/2005 24/2/2005 23/2/2005 22/2/2005 21/2/2005 1!/2/2005 17/2/2005 16/2/2005 15/2/2005 14/2/2005 11/2/05 10/2/05 9/2/05

6195.15 6154.44 62!4.2 627!.5 6339.9! 6377.!5 6346.57 6299.2 6243.74 6134.!6 6156.7! 624!.34 6467.92 6464.61 6397.52 6479.54 6545.64 6606.41 6550.29 6604.42 6492.!2 63!1.4 6367.!6 6510.74 6442.!7 6454.46 6535.45 6656.69 6700.34 6669.52 6746.!! 6752.45 6!10.04 6!53.73 6907.65 6!92.!2 6915.09 6!7!.9! 6!49.4! 67!4.72 66!6.!9 6651.0! 6713.!6 6569.72 6574.21 65!2.5 65!9.41 6534.6! 65!4.32 65!9.29 6607.7! 6670.06 6679.33 6633.76 6577.!3 6593.53

1.0066 0.9794 1.0009 0.9903 0.9941 1.0049 1.0075 1.00!9 1.0177 0.9964 0.9!53 0.9661 1.0005 1.0105 0.9!73 0.9!99 0.990! 1.00!6 0.991! 1.0172 1.0175 1.0021 0.97!1 1.0105 0.99!2 0.9!76 0.9!1! 0.9935 1.0046 0.9885 0.9992 0.9915 0.9936 0.9922 1.0022 0.9968 1.0052 1.0043 1.0095 1.0146 1.0054 0.9906 1.0219 0.9993 0.9987 0.9990 1.0084 0.9925 0.9992 0.9972 0.9907 0.9986 1.0069 1.0085 0.9976 1.0075

0.0066 0.0209 0.0009 0.0097 0.0060 0.0049 0.0075 0.00!! 0.0176 0.0036 0.014! 0.0345 0.0005 0.0104 0.0127 0.0101 0.0092 0.00!5 0.00!2 0.0170 0.0173 0.0021 0.0222 0.0105 0.001! 0.0125 0.01!4 0.0065 0.0046 0.0115 0.000! 0.00!5 0.0064 0.007! 0.0021 0.0032 0.0052 0.0043 0.0095 0.0145 0.0054 0.0094 0.0217 0.0007 0.0013 0.0010 0.00!3 0.0076 0.000! 0.002! 0.0094 0.0014 0.006! 0.00!5 0.0024 0.0074

85

!/2/05 7/2/05 4/2/05 3/2/05 2/2/05 1/2/05 31/1/2005 2!/1/2005 27/1/2005 25/1/2005 24/1/2005 20/1/2005 19/1/2005 1!/1/2005 17/1/2005 14/1/2005 13/1/2005 12/1/05 11/1/05 10/1/05 7/1/05 6/1/05 5/1/05

6544.77 6535.17 661!.23 6619.97 6530.06 6552.47 6555.94 6419.09 6239.43 6162.9! 6106.43 61!3.24 6173.32 6192.35 6194.07 6173.!2 6221.06 6102.74 6222.!7 630!.54 6420.46 6367.39 645!.!4

1.0015 0.9874 0.9997 1.0138 0.9966 0.9995 1.0213 1.0288 1.0124 1.0093 0.9876 1.0016 0.9969 0.9997 1.0033 0.9924 1.0194 0.9807 0.9864 0.9826 1.0083 0.9858 0.9711

0.0015 0.0126 0.0003 0.0137 0.0034 0.0005 0.0211 0.02!4 0.0123 0.0092 0.0125 0.0016 0.0031 0.0003 0.0033 0.0076 0.0192 0.0195 0.0137 0.0176 0.00!3 0.0143 0.0293

E"#$a%g& 'a(&) for ($& *&ar 2005 DATE 4 -a% 5 -a% 6 -a% 7 -a% 10 -a% 11 -a% 12 -a% 13 -a% 14 -a% 1! -a% 20 -a% 24 -a% 25 -a% 26 -a% 27 -a% 2! -a% 1 .&/ 2 .&/ 3 .&/ 7 .&/ ! .&/ 9 .&/ 10 .&/ ')/+S, 43.49364 43.63293 43.7!201 43.65672 43.!4261 43.72259 43.561!! 43.53!63 43.5!271 43.5!263 43.75279 43.70195 43.72211 43.669!4 43.67276 43.66156 43.71259 43.33247 43.32255 43.44269 43.651!5 43.651!9 43.71111 P1/P0 1.0032 1.0034 0.9971 1.0043 0.9973 0.9963 0.9995 1.0010 1.0000 1.0039 0.99!! 1.0005 0.99!! 1.0001 0.9997 1.0012 0.9913 0.999! 1.002! 1.004! 1.0000 1.0014 Log Normal of P1/P0 0.0032 0.0034 0.0029 0.0042 0.0027 0.0037 0.0005 0.0010 0.0000 0.0039 0.0012 0.0005 0.0012 0.0001 0.0003 0.0012 0.00!7 0.0002 0.002! 0.004! 0.0000 0.0014

86

11 .&/ 14 .&/ 15 .&/ 16 .&/ 17 .&/ 1! .&/ 22 .&/ 23 .&/ 24 .&/ 25 .&/ 2! .&/ 1 0ar 2 0ar 3 0ar 4 0ar 7 0ar ! 0ar 9 0ar 10 0ar 11 0ar 14 0ar 15 0ar 16 0ar 17 0ar 1! 0ar 21 0ar 22 0ar 23 0ar 24 0ar 25 0ar 2! 0ar 29 0ar 30 0ar 31 0ar 1 A1r 4 A1r 5 A1r 6 A1r 7 A1r ! A1r 11 A1r 12 A1r 13 A1r 14 A1r 15 A1r 1! A1r 19 A1r 20 A1r 21 A1r 22 A1r 25 A1r 26 A1r 27 A1r 2! A1r 29 A1r 2-May

43.74456 43.70121 43.73176 43.70216 43.71217 43.74031 43.67757 43.6201! 43.6291 43.63162 43.60753 43.6746! 43.65224 43.667!6 43.64942 43.6569 43.60364 43.60555 43.52!17 43.4!405 43.4960! 43.5262! 43.563!7 43.6074 43.59!46 43.66779 43.67592 43.7356 43.70206 43.7043 43.733!6 43.7519 43.7454! 43.67049 43.6!055 43.6933! 43.76521 43.7037! 43.72772 43.67612 43.667!1 43.7005 43.70595 43.69394 43.77!05 43.7030! 43.73003 43.65527 43.72473 43.69043 43.66!69 43.65923 43.6503! 43.70642 43.52396 43.50566

1.000! 0.9990 1.0007 0.9993 1.0002 1.0006 0.99!6 0.99!7 1.0002 1.0001 0.9994 1.0015 0.9995 1.0004 0.9996 1.0002 0.99!! 1.0000 0.99!2 0.9990 1.0003 1.0007 1.0009 1.0010 0.999! 1.0016 1.0002 1.0014 0.9992 1.0001 1.0007 1.0004 0.9999 0.9983 1.0002 1.0003 1.0016 0.9986 1.0005 0.9988 0.9998 1.0007 1.0001 0.9997 1.0019 0.9983 1.0006 0.9983 1.0016 0.9992 0.9995 0.9998 0.9998 1.0013 0.9958 0.9996

0.000! 0.0010 0.0007 0.0007 0.0002 0.0006 0.0014 0.0013 0.0002 0.0001 0.0006 0.0015 0.0005 0.0004 0.0004 0.0002 0.0012 0.0000 0.001! 0.0010 0.0003 0.0007 0.0009 0.0010 0.0002 0.0016 0.0002 0.0014 0.000! 0.0001 0.0007 0.0004 0.0001 0.0017 0.0002 0.0003 0.0016 0.0014 0.0005 0.0012 0.0002 0.0007 0.0001 0.0003 0.0019 0.0017 0.0006 0.0017 0.0016 0.000! 0.0005 0.0002 0.0002 0.0013 0.0042 0.0004

87

3-May 4-May 5-May 6-May 9-May 10 0a* 11 0a* 12 0a* 13 0a* 16 0a* 17 0a* 1! 0a* 19 0a* 20 0a* 23 0a* 24 0a* 26 0a* 27 0a* 31 0a*

43.5!325 43.4557! 43.37!45 43.39546 43.47917 43.3979 43.2430! 43.35403 43.39!35 43.43531 43.4499 43.4!2!7 43.4!53! 43.392!1 43.39335 43.39922 43.4905! 43.49993 43.6672

1.0018 0.9971 0.9982 1.0004 1.0019 0.9981 0.9964 1.0026 1.0010 1.0009 1.0003 1.0008 1.0001 0.9979 1.0000 1.0001 1.0021 1.0002 1.0038

0.001! 0.0029 0.001! 0.0004 0.0019 0.0019 0.0036 0.0026 0.0010 0.0009 0.0003 0.000! 0.0001 0.0021 0.0000 0.0001 0.0021 0.0002 0.003!

88