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Cointegration of Indian stock markets with other leading stock markets

N. Rajiv Menon
IMT Department, Yanbu Industrial College, Yanbu, Saudi Arabia

Cointegration of Indian stock markets 87

M.V. Subha
Anna University, Coimbatore, India, and

S. Sagaran
Yanbu Industrial College, Yanbu, Saudi Arabia
Abstract
Purpose One of the anxieties of stock market investors is whether the markets operate efciently, independently and with sound fundamentals. This concern is also held by academics and practitioners for quite some time. However, real market situation tends to exhibit a link as is evident from recent market movements across the world. The purpose of this paper is to examine whether the stock markets in the Indian subcontinent have any link with the major stock markets from China, Singapore, America, and Hong Kong. Design/methodology/approach The paper uses Engle Granger test of cointegration. Findings The paper nds that the Indian markets are related to some of the markets around the world. Originality/value The paper offers insight into the cointegration of Indian stock markets with other leading stock markets. Keywords Stock markets, India Paper type Research paper

Introduction The revolution in Information Technology coupled with the permeation of high-speed Internet connectivity have created a fast track information superhighway with global reach. The technology permeation is taking place at incredible speeds and is highly democratized so that information is available to any one at any place at any time at low cost. Capital markets thrive on information, and the information revolution has transformed these markets world over. Investors can now keep track of the movements of the capital market on real-time basis and they react to the ow of information from around the world. These dealings sometimes surge into huge waves of panic actions and reactions affecting global markets one by one. National economies are no longer insulated and the repercussions of international events inuence the movement of shares and other investments. With globalization taking roots; investors, governments and institutions are concerned about the visible linking of geographically separated markets, though a perfect link is far beyond reality. Due to the time difference, the nancial centers and markets do not close at the same time. When one market closes, another market on another part of the globe opens. The opening markets are aware of the closing prices in the closed markets. The Shanghai and Bombay markets open with the index information from Dow Jones and

Studies in Economics and Finance Vol. 26 No. 2, 2009 pp. 87-94 q Emerald Group Publishing Limited 1086-7376 DOI 10.1108/10867370910963028

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the NASDAQ. The efcient market hypothesis suggests that these processes should resemble random walks with uncorrelated increments. Latest global events of late seems to point in this direction such as the events of 27th February 2007 where the SSEs (Shangai Market) worst day of trading in 10 years where the SSE Composite Index fell nearly 9 percent on fears of capital controls, dragging other markets along throughout the world. Every move by the Federal Reserve cascades throughout nancial markets across the world. Many researches have been conducted and currently been undertaken to study the various behavioral aspects of capital market in India and beyond. Many studies were carried out to test the cointegration and interdependencies among various Capital Markets (Bala and Mukund, 2001; Wong et al., 2004; David, 1994; Chan et al., 1997; Kanas, 1998; Masih and Masih, 2001). Various researchers have attempted to test the efciency and co integration of the Indian Capital Market from time to time. This study looks at the co integration characteristics of the Indian Capital Market with global markets using the Engle Granger test of co integration, in the post-liberalization period. Due to the number of markets and the volume of trade, any number of researches undertaken is not sufcient to explain the behavior. This study examines the possible link; the Indian capital market has with other capital markets of the world. Objective of the study The main objective of the present paper is to test whether the Indian capital market is cointegrated with other leading stock markets of the world using the Engle Grangler Test of cointegration. Method of computation of stock market indices The CNX Indices are computed using market capitalization weighted method wherein the level of Index reects the total market value of all the stocks in the index relative to a particular base period. The method also takes into account constituent changes in the index and the corporate actions. Different indices are computed and compiled for use by the investors. While some indices employ an equal weighting approach (equal amounts assumed to be invested in each component), the others are either price weighted or value weighted. Both these methods are employed in the compilation of stock indices. Bombay stock exchange sensitive index of equity prices SENSEX The Bombay stock exchange (BSE) started compiling and publishing a sensitive index number of equity prices from January 2, 1986 with base year 1978-1979 100. It is called The Bombay Stock Exchange Sensitive Index of Equity Prices. The BSE Index is based on the prices and trading volume of 30 selected shares from the specied and non-specied list. To provide a broad-based index on a national scale, The Mumbai Stock Exchange has, compiled a new series called BSE National Index with the year 1983-1984 as the base year. This index includes 30 scrips of the BSE Sensitive Index and has 70 scrips selected on an all-India basis depending on their market activity. NSE 50 index (NIFTY) The S&P CNX Nifty is one of the popularly watched Indices in India. This Index is built by India Index Services Product Ltd (IISL) and Credit Rating Information Services of India Ltd (CRISIL). The CRISIL has a strategic alliance with Standard and Poor

Rating Services. It is named as S&P CNX Nifty or NSE-50 Index and introduced on April 22, 1996. The selection criteria are the market capitalization and liquidity. The selection criterion for the index was applied to the entire universe of securities admitted on NSE. The market capitalization of the companies should be Rs. 5 billion (US$ 120 million) or more. The selected securities are given weights in proportion to their market capitalization. The base period for the S&P CNX Nifty index is the closing prices on November 3, 1995. The base period is selected to commensurate the completion of one year operation of NSE in the stock market. The base value is xed at 1,000 with the base capital of Rs 2.06 trillion. Review of empirical evidence David (1994) in his working paper studied the market linkages using Cointegration Rank test with special application to the US Natural Gas Industry. Likelihood based tests for cointegration was applied to data from natural gas spot markets. The Johansen method was used to study the spatial market linkages. The results indicated that the natural gas spot markets at dispersed locations in the pipeline network are strongly connected. Out of 19 market pairs examined, most of the market pairs (13) satised a more stringent condition for perfect market integration. Chan et al. (1997) conducted a study on integration of stock markets by including 18 nations covering a 32 year period. These markets were analyzed both separately and collectively in regions to test for the weak form market efciency. The cross country market efciency is tested by using Johansens cointegration test. The results showed that only small number of stock markets shown evidence of cointegration with others. Kanas (1998) used the multivariate trace statistic ^P2, the Johansen method, and the Bierens non-parametric approach to test for pairwise cointegration between the USA and each of the six largest European equity markets for a period of 13 years. The results from the tests are robust and consistent in suggesting that the US market is not pairwise cointegrated with any of the European markets. Bala and Mukund (2001) in their study examined the nature and extent of linkage between the USA and the Indian stock markets. They used the theory of cointegration to study the interdependence between the BSE, the NYSE and NASDAQ. The data consisted of daily closing prices for the three indices from January 1991 through December 1999. The results supported that the Indian stock market was not affected by the movements in US markets for the entire sample period. Masih and Masih (2001) in their work examined the patterns of dynamic linkages among national stock prices of Australia and four Asian NIC stock markets namely Taiwan, South Korea, Singapore and Hong Kong by employing a multivariate, dynamic framework allowing for both short and long-run relationships. The results showed that the Hong Kong market played a leading role in driving uctuations in Australia and other NIC stock markets. Wong et al. (2004) have empirically investigated the long-run equilibrium relationship and short-run dynamic linkage between the Indian stock market and the stock markets in major developed countries by examining the Granger causality relationship and the pair-wise, multiple and fractional cointegrations between the Indian stock market and the developed stock markets such as the USA, the UK and Japan. The ndings of the study revealed that the Indian stock market is statistically, signicantly co-integrated with stock markets of the USA, the UK and Japan. There is existence of a unidirectional granger causality running from the USA, the UK and Japanese stock markets to the Indian stock markets. Indian stock index and the mature stock indices

Cointegration of Indian stock markets 89

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form fractionally cointegrated relationship in the long run with a common fractional, nonstationary component and revealed the cointegration relationship using the Johansen method. The study conrmed that the nancial liberalization in India since ` 1991 has opened up Indian stock markets vis-a-vis the world markets and therefore inuenced by other markets. Research methodology Data and sources of data The share index data is obtained from the NSE NIFTY index along with other major stock indices from China, Singapore, America, and Hong Kong. The study covers a time span of ten years; from April 1997 to May 2007. The two important equity share prices indices in India are: (1) The BSE Index. (2) The NSE Index. These index values are quoted and published on a daily basis at the end of each trading day. The broad based NSE-NIFTY index values are used for the study. To compare Indian stock market movements with other global markets, stock index values of popular markets such as the SEC (China), NASDAQ (America), Hang Seng (HSI, Hong Kong), STI (Singapore) are used. Period of study The period of study is ten years, from April 1, 1997 to May 10, 2007. Similarly the closing index values of various international stock markets are also collected for the same period (April 1, 1997-May 10, 2007). The daily Index values from the various markets are used. No adjustments are made for non-trading days and when the stock exchange is closed for holidays. Analysis of data The theory of cointegration is used to study the interdependence between the National Stock Exchange (NSE), SEC (China), NASDAQ (America), HSI (Hong Kong) and STI (Singapore). The Engle Granger test is used to test the cointegration among these indices. Test of cointegration The Engle Granger test of cointegration is used to test the cointegration between NSE-NASDAQ, NSE-HSI, NSE-STI and NSE-SSE. The idea of cointegrated multivariate time series was introduced by Granger (1981) and developed by Engle and Granger (1987). Two variables are said to be cointegrated when a linear combination of the two variables is stationary implying that there is a long term relationship existing between them. Lack of cointegration suggests that no such relationship exists. Non stationary univariate time series can be made stationary by applying the differencing operator delta, repeatedly to the series. In order to test the cointegration between the NSE and other global stock indices the following hypothesis (H0 Null Hypothesis; H1 Alternate Hypothesis) are formulated: H0. There is no linear dependence between the indices of the NSE-NASDAQ stock exchanges.

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H1. H0. H1. H0. H1. H0. H1.

There is linear dependence between the indices of the NSE-NASDAQ stock exchanges. There is no linear dependence between the indices of the NSE-HSI stock exchanges There is linear dependence between the indices of the NSE-HSI Stock Exchanges. There is no linear dependence between the indices of the NSE-SSE Stock Exchanges. There is linear dependence between the indices of the NSE-SSE Stock Exchanges. There is no linear dependence between the indices of the NSE-STI Stock Exchanges. There is linear dependence between the indices of the NSE-STI Stock Exchanges.

Cointegration of Indian stock markets 91

Testing for co integration involves testing the residuals (the difference between actual value of the dependent value and the predicted value from the estimated equation) from an Ordinary Least Square regression for the time series and the residuals are obtained: Y t b0 b1 xt b2 zt 1 1

Regress y on x and z. The residuals are obtained from the Ordinary least square and a Dicky Fuller unit root test2 is carried out to check for unit root. If a unit root is not present, the residuals are stationary and the variables are cointegrated. The rst difference of the residuals DYt is regressed against the rst lag of the residual Yt2 1 and sufcient lags of Yt: DY t Y t 2 Y t21 ut 2

The results of the unit root test, t-statistics have to be compared with specially calculated critical values. If the estimated jtj exceeds any of these critical values the null hypothesis that there is no cointegration among the variables can be rejected. Otherwise, the null hypothesis is to be accepted. Results and discussions The daily closing prices of NSE (India) and SEC (China), NASDAQ (America), HSI (Hong Kong), STI (Singapore) are taken to see whether there is any relationship between the Indian stock market and the US markets. The Engle Granger test of cointegration is applied and t values are estimated. The critical value for Engle-Granger statistics at 1 percent, 5 percent and 10 percent are 2 2.5899, 2 1.9439, and 2 1.6177, respectively. For the NSE-NASDAG stock indices the estimated EG DF (Engle-Grange, Dicky-Fuller) test statistic is 1.1547. Since, the EG DF statistic is found to be less than the critical value specied by Engle and Granger statistics at all levels, the Null Hypothesis that there is no dependency is accepted for all these levels. We recognize the view that there is no dependence between the USA stock markets and the Indian stock markets.

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For NSE-Hang Seng stock indices, the estimated EG DF test statistic is 2 0.9310. Since, the EG DF statistic is found to be less than the critical value specied by Engle and Granger statistics at all levels, the Null Hypothesis that there is no dependency is accepted at all the given levels. We accept the view that there is no dependence between Hang Seng and the Indian stock markets. For the NSE-Shangai the estimated EG DF test statistic is 2 2.0389. Since, the EG DF statistic is found to be more than the critical value specied by Engle and Granger statistics at the 5 percent and 10 percent levels, the Null Hypothesis that there is no dependency is rejected at these levels. We do not accept the view that there is no dependence between the Shangai stock market and the Indian stock markets at these two levels. But at 1 percent level, the null hypothesis cannot be rejected that there is no dependency between Shangai and the Indian Stock market. For the NSE-Singapore stock indices the estimated EG DF test statistic is 2 3.1749. Since, the EG DF test statistic falls in the critical region for all three levels of critical value specied by Engle and Granger statistics, the Null Hypothesis that there is no dependency is rejected at all the three levels. We accept the view that there is dependence between the Singapore stock market and the Indian stock markets. The study uses the theory of cointegration to understand the interdependence between the NSE and the NASDAQ, HangSeng, Shangai and Singapore stock markets Table 1. The results support the hypothesis that the Indian stock market is not exhibiting long term relationship with the US markets for the entire sample period. Therefore, the ndings show that the Indian markets are operating independently and are not exhibiting any inter relationship with the US stock markets. The result also supports the hypothesis that the Indian stock market is not interrelated to the HangSeng Index for the same period. The nding shows that the Indian markets operate independently of Hong Kong based Hang Seng stock market. However, the results are mixed when tested for the Indian and Shangai markets. The nding shows at 5 percent and 10 percent, the markets are independent of each other but at 1 percent level the markets are dependent. This shows that the Indian and the Singapore markets operate in dependence of each other. These two markets are cointegrated, implying that there is a long-term relationship between these markets. Conclusion The study examined the extent of cointegration between the Indian stock market and other leading stock markets using the NSE Nifty index along with other major stock indices of US, China, Singapore and Hong Kong. The study covers a period of ten years;

Index NSE NSE NSE NSE NASDAQ Hang Seng Shangai Spore

X variable 2 0.000831 2 0.0017 2 0.00448 2 0.00622

Standard Test t-statistic error CR DF 0.000719 0.001821 0.002197 0.001959 1.1547 20.9310 22.0389 23.1749

1% EG critical value 22.5899 Accept (H0) Accept (H0) Accept (H0) Reject (H0)

5% EG critical value 2 1.9439 Accept (H0) Accept (H0) Reject (H0) Reject (H0)

10% EG critical value 21.6177 Accept (H0) Accept (H0) Reject (H0) Reject (H0)

Table 1.

from 1 April 1997 to 10 May 2007. The Engle Granger test of cointegration is used to check the level of dependence between the various capital markets. The results of the test showed absence of cointegration between the two variables suggesting no interdependence between the Indian stock markets and the American Stock markets. This is also the case with Indian stock markets and Hong Kong stock market. The Indian stock markets and Hong Kong markets operate independently of each other. There is some amount of cointegration between the Indian stock markets and the Shanghai stock market. The markets in India and Shangai are dependent to some extent. However, the results show the presence of strong cointegration between Indian and Singapore stock markets suggesting a strong inter-dependency. The test of cointegration reveals the absence of interdependence and long term relationship between the Indian, Amercian Stock Markets and Indian and Hong Kong stock markets. When studied with the SSE (China) index, and STI (Singapore) the results show that there is some amount relationship between the Indian and Shanghai stock markets and a strong relationship between Indian and Singapore stock markets.
References Bala, A. and Mukund, K.S. (2001), Interrelationship between Indian and US stock markets, Journal of Management Research, Vol. 1 No. 3, pp. 141-8. Chan, C.K., Benton, G.E. and Min, S.P. (1997), International stock market efciency and integration: a study of eighteen nations, Journal of Business Finance & Accounting, Vol. 24 No. 6, pp. 803-13. David, W. (1994), A cointegration rank test of market linkages with an application to the US natural gas industry, Review of Industrial Organisation, Vol. 9, pp. 181-91. Engle, R.F. and Granger, C.W.J. (1987), Cointegration and error correction: representation, estimation and testing, Econometrica, Vol. 55, pp. 251-76. Granger, C.W.J. (1981), Some properties of time series data and their use in econometric model specication, Journal of Econometrics, Vol. 16, pp. 121-30. Kanas, A. (1998), Linkages between the US and European equity markets: Further evidence from cointegration test, Applied Finance Economics, Vol. 8, pp. 607-14. Masih, A.M.M. and Masih, R. (2001), Dynamic modeling of stock market interdependencies: an empirical investigation of Australia and the Asian NICs, Review of Pacic Basin Financial Markets and Policies, Vol. 4 No. 2, pp. 235-64. Wong, W.K., Agarwal, A. and Du, J. (2004), Financial integration for Indian stock market: a fractional co-integration approach, Finance India, Vol. XVIII No. 4, pp. 1581-604.

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Further reading Azizjon, A.A., Chakroborty, D., Raymond, A.K.C. and Jain, A.K. (2004), The random walk hypothesis on the Bombay Stock Exchange, Finance India, Vol. XVIII No. 3, pp. 1251-8. Dickey, A.D. and Fuller, A.W. (1981), Likelihood ratio statistics for autoregressive time series with a unit root, Econometrica, Vol. 49 No. 4, pp. 1057-72. Engle, R.F. and Yoo, B.S. (1987), Forecasting and testing in co-integrated systems, Journal of Econometrics, Vol. 35, pp. 143-59. Monder, C. (2002), Asymmetry in the EMS: new results from a cointegration analysis, Finance India, Vol. XVI No. 2, pp. 573-84.

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Samanta, G.P. and Sanjib, B. (2005), Predicting stock market an application of articial neural network technique through genetic algorithm, Finance India, Vol. XIX No. 1, pp. 173-88. Schleifer, A. (2000), Inefcient Markets: An Introduction to Behavioral Finance, Oxford University Press, Oxford. Sharma, J.L. and Robert, E.K. (1977), A comparative analysis of stock price behaviour on the Bombay, London and New York stock exchanges, Journal of Financial and Quantitative Analysis, September, pp. 391-413.

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