A Comparative study of Risk – Return profile of Indian and Developed Economies

Equity Markets.

Recently Indian equity market has been in the news, scaling new heights and
attracting massive international inflows in the form of investment by foreign
institutional investors. This raises the issue of how attractive is Indian equity market in
comparison with that of developed economies equity markets. The present paper is a
comparative study of return and risk of Indian equity and that of selected developed
economies markets from the perspective of an investor in the respective developed
country. In this exercise conversion from Indian currency to the currency of the foreign
country becomes relevant. Hence the above risk and return have to be adjusted for
currency conversion. The author has selected Japan, USA and UK for this study. Using
selected stock indices and exchange rate data for the last one year, the study compares
the risk-return measures of Indian equity with those of Japan, USA and UK.
Suggestions are made for foreign institutional investors.

A Comparative study of Risk – Return profile of Indian and Developed Economies

Equity Markets.
Introduction:
Indian equity market has been in the news in the recent past scaling new heights
and receiving foreign portfolio investments from not only the west and also the eastern
economies. This draws one’s attention to the position of Indian equity market in the
global scenario.

The twentieth century has seen international flows of capital. However till
eighties it was predominantly debt capital in the form of bank loans and bond issues.
The international new issues market with globally syndicated offerings emerged during
eighties.

The initial thrust came from desire on the part of institutional investors to
diversify their portfolio’s globally in search of higher return and risk reduction.
Financial deregulation and elimination of exchange controls in a number of countries
permitted large institutional investors to increase their exposure to foreign equities.

The trend has seen some hiccups like the stock market crash of October 1987
While some markets remained bullish despite the crash of October 1987, institutional
investors reduced their exposure to equities in general during 1988-89. The trend has
turned upward again.

Data on international equity flows bringout the substantial increase in net equity
flows, from 1986 onwards. It is interesting to note that there is substantial increase in
equity flows to markets other than US, Japan, UK and Europe – like South Korea,
Taiwan, Indonesia.

Equity capital flow may be in the form of

direct equity flows
in the form of GDRs
through mutual funds which may be country specific or multi country regional
funds

Whatever may be the form of investment, the underlying equity market databases
become relevant.

An attempt is made in this study to critically compare the risk return profile of
Indian equity market with that of selected developed countries from the point of view of
an investor in the developed economy.

International investing:
 Investors go in for international investing for it offers opportunities for higher
return and at a lower overall risk. International Investing offers good diversifying
opportunities, which lowers risk in the portfolio for an investor. Recent surge in the
equity capital inflow to India illustrates the opportunities for developing economies for
investing in India.
But international investing brings in new set of threats in the form of new risks
like political, economic, legal, exchange rate related risks.

International equity investing is similar to domestic equity investing in many

ways. But the major difference comes from the fact that in the process of international
investing two currencies are involved i.e.,

 home country currency of the investing fund

 foreign currency of the equity investing economy
and the exchange rate risk becomes relevant

For ex. when a Japanese fund invests in Japanese equity market, it is domestic
equity investing.

When a Japanese invests in Indian equity market it is international investing.

Here the Japanese yen and Indian rupee are involved.

We analyse the risk – return profile of the equity market from the point of view of
the Japanese investing fund. Two market returns become relevant for the Japanese
institution

 Japanese stock market returns denominated in Japanese Yen

 Indian (Foreign) equity market returns converted to Japanese yen

Here we analyse the risk-return profile from the developed economies view.
Hence India is considered on foreign economy.

For an investor in a developed economy we consider two stock returns

 Indian (Foreign) equity market returns in terms of home country currency

 Home country stock market returns denominated in home country currency

Measurement of Stock return and risk –

return = (p1-p0) + dividend / po
po – buying price of equity
p1 – selling price of equity

Risk – standard deviation of return

Data:
In this paper we consider three developed economies
 Japan
 USA
 UK

For each of the countries we collect data on one popular stock index, as follows

Country Stock Index

Japan Nikkie
USA S&P
UK FTSE – 100
India BSE - 30

Relevant data on weekly stock prices is collected for the year 2005 and the weekly
mean return and standard deviation are computed using MS Excel. Later they are
converted to annual returns and risks.

Relevant weekly exchange rates are also collected.

Return – Risk measurement:

As noted already, we will compute home – currency risk return and Indian equity
foreign currency risk-return for the selected developed economies.

If a Japanese investor invests in Japanese stock market the return earned is

referred to as home country return. If that investor invests in Indian stock market earns
a return and converts it to yen, it will be referred to as Indian stock – Japanese currency
return for the Japanese investor.

Indian stock market risk-return profile:

In the period under study, Indian stock market gave an annual return of 41% with
a standard deviation of 25.5%

Currency behaviour:
In the period under study,
 Yen depreciated against rupee by 8%
 Dollar depreciated against rupee by 5%
 Pound appreciated against rupee by 4.5%

We have the following data for the developed countries studied.

Stock Returns:
 Home country Indian stock-foreign currency return
Japan 34.02% 32.34%
US 4.5 35.73%
UK 20.44% 46.10%

Risk measured as standard Deviation

Home country Indian stock-market foreign currency risk

Japan 1.9% 19.6%
US 1.3% 19.25%
UK 1.3% 20.33%

In the period under study investors from USA and UK are benefited by investing
in India. They are getting higher return but the risk is also high.

In the case of Japan, that country’s stock market itself is doing very well. Further
in the period studied the yen depreciated against rupee by 8% annually. It fell from .4
to .38 per rupee. The decline has off set the gain made in stock returns in India.

In case of all the developed countries studied the risk in respective countries
market is lower than risk in India. This is understandable as India is an emerging
economy still to be developed.

Correlation:
Japan Nikkie vs Indian stock market index converted using yen = .92
US S & P vs Indian stock market index converted into dollar = .73
UK FTSE – 100 vs Indian stock market index converted into pound = .98

Stock indices of different countries show the following correlations.

I USA UK
J 1
USA .67 1
UK .86 .78 1
.91 .73 .9698 1

Correlation study shows that major equity markets are integrated.

It means effects are contageous.

Interpretation:
 Indian market offers superior returns compared to selected developed equity
markets. Hence foreign institutional investors are pouring money into India.

 But Indian market is riskier than the developed markets

 Indian market is integrated with the developed economy markets i.e. whenever
stock markets rise elsewhere, Indian market also rises and vice-versa.
 Due to the above behaviour any stock market crash in the developed market, may
have ill – effect on the Indian market as well.

Limitations:
 The study analyses historical price movements. But investors’ decisions are
based on future expectations. Hence research should focus on future forecasts
 The study for simplicity assumes that the investing fund in the developed foreign
country converts the returns into foreign country on a real time basis. But the
fund may convert if anytime in future when we take this possibility into account
the study takes dimension which needs to be addressed taking into account
advanced techniques beyond the scope of this study.

References:
1. Apte P.G – International Financial Management, Tata McGraw Hill Pub. Co.
2. Shapiro Allen – Multinational Financial Management, Prentice Hall of India
3. Business World – Jan 2006
Editorial

Business Education adapting itself to the challenges posed by the dynamic

business environment has been an ongoing process. The transition from regulated
environment to a liberalized one, from protection to integration with international
markets, from planned to market economy the coming to age of Information and
Communication technology and Internet have forced repositioning of business
education in terms of content, structure, orientation focus and pedagogy. Business
Education has been successfully facing the challenges posed by turbulent environment.
 The everchanging business environment has been directing the business
education. It is not without purpose that Business Education is being discussed in
various academic gatherings at different levels in our country. Hence we decided to
have ‘Repositioning Business Education in the present environment of WTO, service
sector challenge globalised financial markets as main theme of the national seminar.
There are three major sub themes spanning issues in Accounting and Taxation to
Banking and Finance and bringing out a glimpse of the service sector.

Our teacher friends have responded to our ‘call for paper’ for this seminar and
contributed papers on the major theme and the various sub themes. We bring out their
views in the form of abstracts.

We are living in an age of and information – communication technology and

electronics.

Which has dramatically changed the way we live the way we function. Thanks to
the electronics age, we are able to bring out a CD containing full papers of all
contributors.

Instrument of investment – equity:

In this paper we consider only equity as investment avenue.

Portfolio is a set of securities so formed as to not to keep all eggs in the same
basket. Investor while selecting equity in the portfolio, will consider

i) return earned by a security

ii) risk of a security measured by standard deviation
iii) covariance of return along with other securities in the portfolio
Return earned by a security = Dividend + Capital appreciations / Purchase price

Risk of a security = Std. Deviation of return earned by a sec

International investing is similar to domestic investing, in several ways.
However a new dimension namely exchange rate becomes relevant in international
investing. An investing entity – an individual or an institution investing in a foreign
country will repatriate the funds to domestic country at a prevailing interest rate. Hence
exchange rate is an important variable affecting international investment decisions,
which will not be relevant in domestic investing. Hence in international investing, we
consider exchange rate adjusted return and risk of a security.

Since we consider different countries, and different regions we consider an

important index for each region and measure return and risk based on that index.

Data:
In this paper, we attempt a comparison of Indian Equity Prices with developed
economy’s equity prices. The developed economies markets we consider are
i) US equity market represented by S & P index
ii) UK and European market represented by FTSE index
iii) Japan represented by Nikkie index

The data on index levels and the corresponding exchange rates was collected
from the magazine The Economist different issues for 1st January to 31st December 2005

Analysis of Data:
Following table describes the return and risk for the selected markets studies

Annual Return Risk

Japan
US
UK
India

We find that in the year 2005 Indian Equity market has given the highest return
on investment but the risk also is highest.

Another parameter which investors are interested while making international

investment decisions is covariance of exchange rate adjusted security return.

Following matrix describes the covariance of security return

Japan US UK India
Japan
US
UK
India