The Behaviour of Stock Returns and Volatility around Parliamentary

Elections in India
Abstract

The study examines the behavior of stock returns and volatility of returns around nine
parliamentary elections in India during the period 1984-2014. Four time windows covering 5, 10,
15 and 20 days before and after the election are used. The results show that stock returns are
abnormal during all time-windows except the 5-day window. Stock return volatility is higher
than normal during all time-windows. The increase in stock return volatility gets stronger as we
approach the election date. India Volatility Index data available for elections in year 2009 and
2014 also provide strong evidence of increased volatility during election days. Investors can use
the consistent pattern of abnormal stock returns and volatility during election days in designing
appropriate investment and hedging strategies.

Introduction

Stock market movements have been found to be driven by fundamental factors such as earnings
and dividends. These have also been linked to macroeconomic variables, financial leverage and
trading volume . However these factors are able to explain a small proportion of the fluctuations
in the market volatility (Schewert, 1989). Many studies have identified another important factor
that affects stock market movements , i.e. political events and changes.

Niederhoffer, et al. (1970) study the movement of Dow Jones Industrial Average around the U.S.
presidential election and observe that short-term market movements are intimately related to
presidential elections. Allvine, et al. (1980), Reilly and Lukscitch (1980), Huang (1985) and
Stovall (1992) also find evidence of the existence of the four-year election cycle in stock prices
in the U.S. that helps investors make market timing decisions and forecast stock market
performance. Gartner et al. (1995) demonstrate that for more than three decades, U.S. stock
prices have followed a four-year cycle. Stock prices fall during the first-half of a presidency and
rise during the second. In hindsight, exploitation of this cycle could have resulted in a real rate of
return of 57.52 percent for four years as compared to 21.66 percent produced by a simple buy-
and-hold strategy.

Foerster et al. (1997) examine the effect of the 4-year U.S. election cycle on stock returns of
eighteen countries and demonstrate the international pervasiveness of this effect. Santa Clara and
Volkanov (2003) observe that the presidential cycle variables capture information about returns
that is not correlated with business cycle variables. In more recent studies, Boutchkova et al.
(2012) examine the effect of local and global political risks on industry return volatility in the
U.S. They observe that while systematic volatility is associated with domestic political
uncertainty, global political risks translate into larger idiosyncratic volatility.
Similar studies have also been carried out in markets outside the U.S. Gemmil (1992) examines
the behavior of stock and options market in London during the 1987 election and find an
extremely close relationship between opinion polls and the FTSE 100 index of share prices.
Gwilyn and Buckle (1994) reach similar conclusions based on their study of the 1992 election in
London. Pentzalis, et al. (2000) investigate the behavior of stock market indices across 33
countries around political elections and find a positive abnormal return during the two-week
period prior to the election week. Lin and Wang (2005), however, have a contrary finding. They
observe that the ruling party effect is not a crucial variable to Nikkei 225 return and volatility. In
another multi-country study, Bialkowski et al. (2008) investigate stock market volatility around
election time in 27 OECD countries and find a significant rise in stock return volatility during the
week around election.

The purpose of the present study is to investigate the effect of parliamentary elections in India on
the stock market movement. To the best of my knowledge, no such study has so far been carried
out in India. The study is important as a significant relation between stock prices and
parliamentary elections has important implications for investors. They can diversify
internationally to reduce country-specific political risk. They can time the market to enhance
their portfolio returns. As stock market volatility has a direct relationship with option prices,
investors can adopt suitable option-based strategies to either reduce risk or increase returns.

Data and Methodology

The data consists of closing prices of the Bombay Stock Exchange Sensitive Index (BSE Sensex)
for the period November 1, 1984 to June 30, 2014 covering nine parliamentary elections. The
data was obtained from the website of the BSE. Though elections in India date back to 1951, I
have started with the election held in 1984 due to non-availability of index values corresponding
to earlier elections. Table 1 presents the details of these nine elections.

Table 1: Parliamentary Elections in India 1984-2014

Election Year Dates of Election

1984 December 24, 27,28
1989 November 22, 26
1991 May 20, June 12, 15
1996 April 27, May 2,7
1998 February 16, 22, 28
1999 September 5,11, 18, 25, October 3
2004 April 20, 26, May 5, 10
2009 April 16, 22,23,30, May 7, 13
2014 April 7 to May 12
Daily stock returns (Rt) are computed as:

 P 
Rt  ln  t  *100 (1)
 Pt 1 

where Pt is the closing index value on a given day, Pt-1 is the closing index value on the
previous day and ln is the natural logarithm. The returns are tested for stationarity using the
Augmented Dickey-Fuller and Philips-Perron tests and are found to be stationary.
Figure 1 shows the return series over the sample period, the various ‘spikes’ indicating the
possibility of presence of heterodcedasticity. The ARCH-LM test confirms the presence of
autoregressive conditional heteroskedasticity in the data requiring the use of a GARCH type
model for data analysis.

Figure 1: Daily returns on the BSE-Sensex for the period November 1,1984 to June 30,2014

0.2

0.15

0.1
Daily Stock Returns

0.05

-0.05

-0.1

-0.15

-0.2
Time

Table 2 presents the descriptive statistics of the daily stock return data of the BSE-Sensex for
the period November 1, 1984 to June 30, 2014.
 Table 2: Descriptive Statistics of Daily Stock Returns
of BSE-Sensex for the period November 1, 1984
to June 30,2014
Mean 0.0007
Median 0.0008
Maximum 0.1599
Minimum -0.1366
Std. Dev 0.0174
Skewness -0.0246
Kurtosis 8.2159
Jarque-Bera 7873.2
(0.0000)
Augmented Dickey Fuller Statistic -58.1
(0.0000)
Philips-Perron Statistic -76.01
(0.0001)
ARCH-F Statistic 176.57
(0.0000)
Figures in parentheses are the p-values

The following GARCH (1, 1) model is used to assess the impact of parliamentary elections on
stock returns and volatility of returns.
p q
Rt     D  i Rt i   t  i t i ,  t N (0, ht ) (1)
i 1 i 1

ht   0  1 t21  1ht 1   2 D (2)

Equation (1) is the conditional mean equation where Rt is the continuously compounded returns
on the BSE sensitive index in period t. D is a dummy variable equal to 1 for n days before the
first date on which elections are held and for n days after the last day of the elections. In this
study, n has been taken as 5, 10, 15 and 20. εt is the random shock at time t. The mean equation
has been formulated as an auto-regressive moving average (ARMA) model with p auto-
regressive terms and q moving average terms. The order of the model has been identified using
the AIC and SIC criteria. If the value of β is significant, it will indicate abnormal returns during n
days before the start of elections and n days after the end of the elections. No other control
variable has been used in the equation as the purpose of the study is not to forecast stock returns
but to understand the effect of elections on stock returns.

Equation (3) is the conditional variance equation. The conditional variance ht is assumed to be
time-varying and dependent on both squared residuals and variance in the previous time period.
The dummy variable is used in Equation (3) to see whether the conditional variance or volatility
is different from that prevailing outside the event window. The use of dummy variables to pick
up abnormal returns and volatility is motivated by their use by Booth and Booth (2003), Cahan et
al. (2005), Worthington (2006) and Anderson et al.(2008) to pick evidence of any political cycle
in the sample data. Equations (2) and (3) are jointly estimated using the maximum likelihood
method for the entire sample period separately for four different values of n.

Results

The results from running Equations (2) and (3) are presented in Table 3

Table 3: Estimation Results

Parameter 5-day Window 10-day Window 15-day Window 20-day Window

β 0.0013 0.0017 0.0017 0.0014
(0.31) (0.08) (0.04) (0.05)
α0 4.17E-06 4.11E-06 4.38E-06 4.43E-06
(0.00) (0.00) (0.00) (0.00)
α1 0.100 0.101 0.104 0.104
(0.00) (0.00) (0.00) (0.00)
β1 0.887 0.889 0.884 0.884
(0.00) (0.00) (0.00) (0.00)
β2 9.42E-06 5.63E-06 3.08E-06 1.84E-06
(0.00) (0.00) (0.03) (0.10)
Q(10) 10.14 10.20 9.87 9.52
Q2(10) 12.41 12.76 9.50 9.62
This table reports estimates of the select parameters in the regression equations (2) and (3). Equation (2) is the
conditional mean equation where Rt is the continuously compounded returns on the BSE sensitive index in period t.
β in equation (2) is the coefficient of dummy variable equal to 1 for n days before the first date on which elections
are held and for n days after the last day of the elections ((n=5,10,15 and 20). α0, α1, β1 and β2 are the parameters
of the conditional variance equation (3). Figures in parentheses are the p-values of the estimates. Q(10) and Q2(10)
are the Ljung-Box Q statistics for the residuals and squared residuals at 10 lags, respectively. All values of the Q
statistic are less than their critical values indicating lack of autocorrelation in residuals.

The values of β are statistically significant for all time windows except the 5-day window
indicating abnormality in stock returns during election days. Positive values of β imply that
returns are higher than the normal. Values of β2 in the conditional variance equation, though
small, are positive and statistically significant in all the time windows indicating an increase in
the stock return volatility during election days. The volatility is higher as we approach the
election day as the value of β2 increases successively as we move from the 20-day window to the
5-day window.

The presence of higher volatility during parliamentary elections is also corroborated by the
movement in the India VIX. India VIX is a volatility index based on the index option prices of
NIFTY. India. VIX is computed using the best bid and ask quotes of the out-of-the-money near
and mid-month NIFTY option contracts which are traded on the F&O segment of NSE. India
VIX indicates the investor’s perception of the market’s volatility in the near term. The index
depicts the expected market volatility over the next 30 calendar days, i.e., higher the India VIX
values, higher the expected volatility and vice-versa.

The VIX data is available since 2009. For the two elections held in 2009 and 2014, the graphs of
VIX are displayed in Figure 2 and Figure 3, respectively.

Elections in the year 2009 were held during the period April 16-May 13. The level of the index
was 37.37 on April 2. It ruled at a level of around 50 during election days, reached a high of
56.07 on May 19 and then declined to 39.38 on May 25.

Figure 2: Movement of VIX during 2009 Parliamentary Election in India

60

50

40
VIX

30

20

10

0
28-Mar-09 7-Apr-09 17-Apr-09 27-Apr-09 7-May-09 17-May-09 27-May-09 6-Jun-09
Date

The figure shows the movement of VIX during parliamentary elections in India held during April 16-May 13, 2009

Elections in the year 2014 were held during the period April 7-May 12. The index started rising
from a level of 20.69 on April 1. It reached a peak of 37.71 on May 9 before declining to a level
of 19.23 on May 20.

Figure 3: Movement of VIX during 2014 Parliamentary Election in India

40
35
30
25
VIX

20
15
10
5
0
22-Mar-14 1-Apr-14 11-Apr-14 21-Apr-14 1-May-14 11-May-14 21-May-14 31-May-14
Date
The figure shows the movement of VIX during parliamentary elections in India held during April 7-May 12, 2014

Conclusion

The study examines the behavior of stock returns and volatility of returns around nine
parliamentary elections in India during the period 1984-2014. Four time windows covering 5, 10,
15 and 20 days before and after the election are used. The results show that stock returns are
abnormal during all time-windows except the 5-day window. Stock return volatility is higher
than normal during all time-windows. The increase in stock return volatility gets stronger as we
approach the election date. India VIX data available for elections in year 2009 and 2014 also
provide strong evidence of increased volatility during election days. The consistent pattern of
abnormal stock returns and volatility during election days has important implications for
investors. They can bet on volatility movements by designing appropriate option trading
strategies or create positions in variance swaps and volatility futures. Banks and financial
institutions, whose capital requirement is linked to the level of volatility, can also adopt suitable
strategies with respect to their investment portfolios.

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