AN ANALYSIS TO STUDY THE IMPACT OF GOLD PRICE ON SENSEX

Submitted in partial fulfillment of the requirements for MBA Degree of Bangalore University

Submitted By

Sreekanta.M
Registration Number: 04XQCM6095 Under the Guidance Of: Professor S. Santhanam. M.P.BIRLA INSTITUTE OF MANAGEMENT Associate Bharatiya Vidya Bhavan Race Course Road, Bangalore-560001

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DECLARATION

I hereby declare that the Project report on ‘An analysis to study the impact of gold prices on SENSEX’ is a record of independent work carried out by me, towards partial fulfillment of the requirements for MBA course of Bangalore University at M.P.Birla Institute of Management. This has not been submitted in part or full towards any other degree or Diploma of Bangalore University or any other University

Date: 12/06/2006 Place: Bangalore

SREEKANTA.M 04XQCM6095

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PRINCIPAL’S CERTIFICATE

This is to certify that this report titled ‘An analysis to study the impact of gold prices on SENSEX’ is the result of project work undergone by Sreekanta.M, bearing the Register Number 04XQCM6095, under the guidance of Prof. S.Santhanam. This has not formed a basis for the award of any Degree/Diploma for any other University.

Place : Bangalore Date : 12-06-2006

Dr. Nagesh.S.Malavalli

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GUIDE’S CERTIFICATE

This is to certify that the dissertation entitled “An analysis to study the impact of gold prices on SENSEX” is an original study conducted by Sreekanta.M, bearing register number 04XQCM6095, of M. P. Birla Institute of Management, Associate Bharatiya Vidya Bhavan, under my guidance.

This has not formed the basis for the award of any Degree/Diploma by Bangalore University or any other University.

I also certify that he has fulfilled all the requirements under the covenant governing the submission of dissertation to the Bangalore University for the award of MBA Degree.

Date : 12-06-2006 Place : Bangalore

Professor S. Santhanam

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ACKNOWLEDGEMENT

A teacher is a perennial source of inspiration and guidance in all the academic activities of his students throughout. I whole-heartedly extend my deep and sincere gratitude to Dr.Nagesh.S.Malavalli, principal of MPBIM, for his continuous guidance and help provided for completing this research study.

I am also thankful to Prof. S.S. Santhanam, M.P Birla Institute of Management for sharing his expertise in the field of Statistics with me whenever I approached him.

I also express my gratitude to all friends and family members for extending their helping hand whenever I approached them. Without their help this research could not have been presented in a proper manner.

Sreekanta.M

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INDEX CHAPTER 1 INTRODUCTION CHAPTER 2 LITERATURE REVIEW CHAPTER 3 RESEARCH DESIGN CHAPTER 4 RESEARCH METHODOLOGY CHAPTER 5 EXAMINATION OF STOCK MARKET CHAPTER 6 ANALYSIS & FINDINGS CHAPTER 7 CONCLUSIONS 01 07 13 31 28 37 46 6 .

CHAPTER 1 INTRODUCTION 7 .

Introduction: 8 . The future of the gold and Gold price movements are determined by the perception of gold as a `store of value' rather than its fundamentals as a commodity. gold prices for 2005 using daily time series data. Since gold is an important saving instrument in India and is very often used as a hedge against inflation. interest rates and the presence of lucrative alternative investment avenues in the economy. Gold price is included in the model as an additional variable.e. The study looks after the rise of gold market in India.Abstract This paper reexamines the relationship between stock prices and one of best investment considered in India i. to examine whether gold price contain any additional significant information about price movements. for speculative purposes. With the ADF UNIT ROOT TEST and JOHANSENS COINTEGRATION TEST We find that the trend lines are deterministic and on applying GRANGERS CAUSALITY TEST We find that gold prices have no relation with the Sensex returns. The precious metal's value is also determined by such factors as inflation. it is expected that gold may be looked upon as alternative asset for those holding idle money. The study uses Granger non causality test procedure developed by Toda and Yamamoto(1995). The causal relationship tested between the BSE index and gold prices.

S. in which case the outcome is the best possible under the circumstances . The latter in turn is influenced by the fundamentals which may be based on either rational or adaptive expectation models. Many empirical studies have been conducted to examine the relationship between stock price and macro economic variables and findings are generally mixed. Empirical studies indicate that once the financial deregulation takes place. in principles. The Famma Theory of efficient market hypothesis suggests that stock markets are efficient because they reflect the fundamental macro economic behavior. Famma and French (1989) and Poterba and Summers (1988) have shown that the U. 9 . The external factors influencing the stock return would be stock prices in global economy. the stock market becomes more sensitive to both domestic and external factors.A significant amount of literature now exists that examines the relationship between stock market returns and a range of macro economic and financial variables over a number of different stock markets and time periods. as well as by many subjective factors which are unpredictable and also non quantifiable. The return on stocks is highly sensitive to both fundamentals and expectations. However there may be a lot of divergence between the overall state of the economy and individual stock return. The term efficiency implies that a financial market incorporates all relevant information (including macro economic fundamentals) in the market. The early survey on the behaviour of stock return was done by Famma(1970). are related to domestic macro economic conditions. stock returns have a mean reverting tendency and can be predictable to some extent . The domestic fundamentals. Now a days financial economics provide a number of models that helps to examine the relationship. the interest rate and the exchange rate.

Chaudhuri and Koo(2001) investigated the volatility of stock returns in some Asian emerging markets in terms of the volatility of domestic and external factors. industrial production. Fang and Loo (1995) studied the relationship between stock return volatility and international trade for four Asian countries. inflation . Naj and Rahman(1991) studied the relationship between volatility of stock return and of macroeconomic variables in four developed countries and confirmed the relationships Fang and Lee(1990) studied the long term relationships between stock return on the one hand and GNP. real economic activity. Their empirical results suggest the presence of a significant contagion effect and integration of capital market in this region. inflation and unemployment on the other hand. inflation and money supply on the other in Taiwan and concluded that the efficient market hypothesis is not valid for an emerging market. They however. found evidence in favor of the efficient market hypothesis. Their empirical results based on vector autoregressive model(VAR) suggested that the stock return volatility in the four markets respond to information on trade. The results also suggested the role of government in terms of fiscal and monetary policy in smooth functioning of the stock market is crucial in this region 10 . Mukherjee and Naka(1995) explored the relationship between exchange rate. money supply.Similar results have been found by MacDonald and Power (1991) that U. The behavior of stock price (BSE) in relation to some key macro economic variables in India during the scam period 1992 was studied by Bhattacharya and Chakravarty (1994). Their dynamic forecasts indicate that the behavior of stock price is unrelated to key macro variables. GDP. long term government bond rate and call money rate with the Japanese stock market. such as. found that both domestic macroeconomic variables and international variables have significant impact on stock return volatility. stock returns have a mean reverting-tendency and so can be predicted.K. Their empirical result suggested that cointegration relation existed and positive relationship was found between the Japanese industrial production and stock return. Famma and Gibbons(1982) Summers(1986) and Chen(1991) verified that the efficient market hypothesis holds in US market. Subsequent studies like Famma(1981). and there was significant linkage between US stock market on one hand and real economic variables.

Bhattacharya and Mukherjee (2002) studied the nature of the causal relationship between stock prices and macro aggregates in India by using the methodology proposed by Toda and Yamamoto for the period of 1992-93 to 20002001. Mishra (2004) examined the relationship between stock market and foreign exchange markets using Granger causality test and Vector Auto Regression technique . Their results suggested that there is no causal linkage between stock price and the three variables.Their results show that there is no causal relationship between stock price and macro economic variables like money supply. They also added that if these types of results hold for subsequent periods then it can be said that Indian stock market is approaching towards informational efficiency with the three variables. foreign exchange reserves and trade balance. They further investigated the causal linkage between stock prices and macro economic aggregates in the foreign sector in India like exchange rate. The study uses 11 . interest rate and demand for money for the period 1992 to 2002. The BSE sensex is about to cross the five digit points mark and will be major index in the Asian market so it compel us to think whether the market is expected to remain bullish in the long run or not? Is there any macro economic variables which causes this bullish behavior of stock price in India? In reference to the above statements this paper attempts to examine whether the macro economic variables causes the recent bull phase of stock price in India . foreign exchange reserves and value of trade balance by applying the technique of co integration and long run Granger non causality test developed by T&Y(1995). The study found that there exists a unidirectional causality between the exchange rate and interest rate and also between the exchange rate return and demand for money. According to them index of industrial production lead the stock price. The study also suggested that there is no Granger causality between the exchange rate return and stock return . ie exchange rate.In Indian context . national income and interest rate but there exists a two way causation between stock price and rate of inflation.They used monthly data for stock return exchange rate. Thus BSE sensitive index neither leads these three variables nor do they lead the BSE sensitive index.

Since gold is an important saving instrument in India and is very often used as a hedge against inflation.The causal relationship tested between the BSE index and important key macro economic variable such as gold prices. Gold price is included in the model as an additional variable.Granger non causality test by Toda and Yamamoto(1995)( T&Y) for the period of April 1991 to December2005. 12 . it is expected that gold may be looked upon as alternative asset for those holding idle money. for speculative purposes. to examine whether gold price contain any additional significant information about price movements.

CHAPTER 2 LITERATURE REVIEW 13 .

silver. Millions of people all over the world continue to use gold as a hedge against inflation and as a basic form of savings and a reliable store of value during times of economic uncertainty or political upheaval. Australia.Gold market in India. Because of its rarity and its durability. gold has found its principal use as a store of value. Indeed. Eternally attractive to mankind. Gold is mined in more than 76 countries around the world. or economic distress. and Canada. so termed because of their inertness. gold has been almost universally acceptable as money for thousands of years. is widely sought after throughout the world for both its investment qualities and industrial properties. and as a raw material primarily used in jewelry and decorative objects. social. the most famous of all precious metals. and Thailand. or reluctance to enter into chemical reactions. with the majority of use occurring in the United States. and other platinum group metals). gold can provide individual and institutional investors alike with a portfolio safety net against sharp downward spikes in complementary assets such as stocks and bonds. China. Gold. gold traditionally has served three functions: as a monetary instrument. Gold is the most prominent of the noble metals (gold. followed by the United States. Its beauty has made it popular in decoration. with the large number of development projects in these countries expected to keep production growing well into the next century. Currently. As such. Jewelry production has been growing at a robust pace in the developing countries of Southeast Asia and the Middle East since 1988. While investment demand is important. Italy. as a financial asset. Gold also is used in electronic connectors and dental alloys. As an investment. platinum. Gold will not react with common acids. Japan. Gold has also become an increasingly important industrial metal. gold typically is viewed as a financial asset that will maintain its value during times of political. 14 . India. the largest use for gold is in jewelry. South Africa is the largest gold producing country.

These two factors explain the wide divergence in the returns from gold in the domestic and international markets. Between 1997 and 2002. this has never been so. gold now trades at about Rs 625 per gram. though. 15 . There have been price variations. price movements should largely be in line with international prices. Behind the price divergence India imports most of its gold requirements.580 per 10 grams to end the year at Rs 6. The year thus saw a sharp upswing in the price for ten grams. The 5 per cent appreciation in the rupee vis-à-vis the dollar made dollar-denominated gold imported into India cheaper and capped the rise in domestic prices. Hence. which had hovered around the Rs 4.000 mark for the five years between 1996 and 2001. to an extent.175. During this period there was a consistent depreciation in the value of the rupee. the price of standard gold in the Mumbai market rose 11 per cent from Rs 5. The steep cut in import duties over the years has also narrowed the gap between international and domestic prices. Shining performance The year 2003 was a bonanza for those who set much store by the traditional value of gold. gaining 20 per cent in 2003. The quantum of rise in 2003 was. in Mumbai the price rose 16 per cent. Interestingly. caused by the fluctuations in exchange rate and policy changes on the import duty front. Continuing its unabated rally.1035 grams). which reached a low of Rs 49 to a dollar. checked by the appreciation in the value of the rupee and the steep cut in import duties. Import duties on gold were slashed from Rs 400 per 10 gm in 1999 to Rs 100 per 10 gm in 2003. with forex reserves crossing $100 billion. international gold prices edged up just 1 per cent. In contrast. And this in a year when your savings or fixed deposit earned just about five per cent. It now quotes close to $419 per troy ounce (one troy ounce = 31. The international price of gold moved at a much faster pace. The reversal of this trend in 2003 was notable. Equities had a dream year too. But it was the yellow metal that outperformed most fixed-income investment options. gaining about 11 per cent in value.In 2003.

The weakening dollar and the prevailing low interest rates at the global level have left investors with limited alternative investment avenues. even if just as a bulwark against the dollar. which has been on a relentless decline. This has forced investors to look for a relatively risk-free investment option. dollar-denominated instruments were considered the favourite assets for central banks and institutional investors. an 8. speculative activity and the US economy's strength. tendency to shift in and out of gold depending upon currency. fuelled by the spurt in commodity prices. at best. such as central bank sales. 16 . The spectre of even a moderate increase in inflation levels. In the past two years. But. Weak dollar drives gold Gold price movements are determined by the perception of gold as a `store of value' rather than its fundamentals as a commodity. In these circumstances. For long. The US' mounting current account deficit has been eroding the value of the dollar. Gold prices are seldom governed by fundamentals.Even small saving schemes or bonds earned. The direction of its movement is governed by various external factors. of late. The precious metal's value is also determined by such factors as inflation. there has been a rush towards gold as it is an eternal asset with an intrinsic value. the consistent depreciation in the value of the dollar vis-à-vis currencies such as the euro and the yen has forced a shift in the investment strategy. gold regained fancy. gold has regained popularity as a `store of value'.5 per cent return. would further squeeze the real rate of return on debt investments. At the global level. too. interest rates and the presence of lucrative alternative investment avenues in the economy. The euro appreciated 20 per cent against the dollar during the year.

especially China and Japan. 17 . The US Fed rates are at a 45-year low of 1 per cent. a distinction it has gained in the past two years. interest rates have fallen sharply. gold has regained its position as a `store of value. To overcome this problem.' Investment demand picks up The gold price rally could also be attributed to the lack of alternative investment options. A similar situation in most other parts of the world has led to an increased investment demand for gold. in the current circumstances. The Federal Reserve has not indicated that it will raise interest rates as it would hamper the economic growth that is now picking up after a prolonged slowdown. much to the discomfiture of the US. Asian countries. China is now one of the top ten countries holding a large quantum of gold in its reserves. the deficit. Hence. at $435. A mounting current account deficit means its debt obligation to foreign countries has been increasing. Its gold reserves increased from 391 tonnes in December 2001 to 600 tonnes in December 2003. weakening the purchasing power of the dollar.500 years. was over 5 per cent of the US' GDP. China has been investing a larger part of its reserves in gold. even over about 2. has also played a significant role in the firm trend in gold prices.As of 2002. A weakness in the value of the dollar would dent the returns on the dollar-denominated reserve assets held by them.2 billion. hold over 30 per cent of the US' external debt. China's unwillingness to let the Yuan appreciate. Empirical research proves that the value of gold measured in terms of its purchasing power parity has remained unchanged in the long run. Globally.

a sharp spike from the current levels. the precious metal would still be competitive. Gold in a portfolio can be used for diversification purposes to lend stability but it also tends to drag returns.Outlook In the near term. The trend of a rapidly widening US current account deficit may get accentuated as its economy is now on a recovery path and needs more capital from the rest of the world. Europe and Japan. not be repeated. however. For retail investors. at least for the short term. If it remains weak vis-à-vis other currencies and if interest rates remain stable. gold prices may get a boost. This looming risk may ensure that the dollar continues to remain weak in the near future. as the yield on debt is unlikely to be vastly superior. however. Interest rates appear to be stabilizing after the relentless rate-cutting over the past three years. it may be better not to divert much of the portfolio into gold. though. appear unlikely as central bankers may not want to disturb the trends of economic revival in the US. The price performance of gold over the past two years may. But even if returns move into single-digit territory. Their direction would hinge largely on how the dollar moves. 18 . gold prices are likely to show a firm undertone.

CHAPTER 3 RESEARCH DESIGN 19 .

OBJECTIVE: To study if there is any dynamic relationship between the volatility in the stock market with the fluctuations in the gold prices. people have often trusted gold as a better investment than bonds and stocks. They have also been both a cause of war and a medium of exchange. Analyzing the causal relation of the gold prices with Sensex returns JUSTIFICATION AND RELEVANCE: Is gold a golden investment? Gold and silver have been sought and prized since prehistoric times. According to the World Gold Council Report. In that sense these metals have been more attractive than bank deposits or gilt-edged securities. Gold is the standard by which the value of anything is assessed. Gold and silver have been popular in India because historically these acted as a good hedge against inflation. an Egyptian ruler of 3100 BC. Silver was actually more widely employed as the standard of value until the nineteenth century. it is universally accepted. In developing countries. Silver does not lag behind in global trade markets and as an investment. India stands today as the world’s largest single market for gold consumption. In the code of Menes. it is declared that ‘one unit of gold is equal to twoand-a-half units of silver in value’. 20 .

Shakespeare called it ‘the saint-seducing gold’. besides being the basic form of saving.000 tonnes estimated to have been mined through history could be transported by one single modern super tanker. Its beauty recommends it for ornament making above all other metals. So far. gold is an important and popular investment for many reasons:  In many countries gold remains an integral part of social and religious customs. there have been no Mundra-type or Mehta-type scams in gold. 50 lakh underneath his shirt. to conclude that ‘gold is the most useless thing in the world’.  Gold is so dense that all the 90. a microscopic circuit of liquid gold ‘printed’ on a ceramic strip saves miles of wiring in a computer.  Superstition about the healing powers of gold persists. it is interesting to note that apart from its aesthetic appeal gold has no intrinsic value.  Finally.  Gold is so highly valued that a single smuggler can carry gold worth Rs. or even smell it. It does not tarnish and is also not corroded by acid – except by a mixture of nitric and hydrochloric acids.  Gold is so ductile that one ounce of it can be drawn into fifty miles of thin gold wire. You cannot eat it. the founder of Ford Motors.  Gold is so malleable that one ounce of the metal can be beaten into a sheet covering nearly a hundred square feet. This aspect of gold compelled Henry Ford. 21 .  Gold is indestructible. On the other hand.  Gold is an excellent conductor of electricity.Despite recent hiccups. Thus.  Gold has aesthetic appeal. the lure of this yellow metal continues. gold is scam-free. Ayurvedic medicine in India recommends gold powder and pills for many ailments. drink it.

The Index was initially calculated based on the ‘Fullmarket capitalization’ methodology but was shifted to the ‘Free-float methodology’ with effect from September 1. was set up in 1993 to encourage stock exchange reform through system modernization and competition. Most other studies on Indian market use the BSE Sensex index to compute market returns. NSE has emerged to be superior by providing improved market quality and high standards of investor protection . We look at the relationship between VOLUME and market returns using both. The index is widely reported in both domestic and international markets through print as well as electronic media. BSE Sensex is a basket of 30 constituent stocks representing a sample of large. The base year of SENSEX is 1978-79 and the base value is 100. With lower execution cost. NSE being demutualized provides a better market quality. 22 . Established in 1875. lower price volatility and higher liquidity compared to BSE. located in Bombay. With NSE being an equally prominent stock exchange in India. we also use the S&P CNX Nifty index to compute returns. It opened for trading in mid-1994. liquid and representative companies. It accounts for over one-third of the total trading volume in the country.DATA DESCRIPTION We obtain the aggregate daily gold prices AND RETURNS OF SENSEX. The National Stock Exchange (NSE). The Reserve Bank of India and the Securities Exchange Board of India also provide the data on FII SENSEX. but is also the oldest in Asia. The return for market i for month t would be given by. from January 2005 to Dec 2006 from India Infoline and Equity Master. Between the two exchanges. BSE is not only the oldest stock exchange in India. The data on market index is obtained from the respective stock exchanges. 2003. that is. the returns on the Bombay stock exchange (BSE). Since then the NSE has made major strides and is now the dominant stock exchange in the country..

Due to is wide acceptance amongst the Indian investors. Small wonder. SENSEX is regarded to be the pulse of the Indian stock market. SENSEX is a basket of 30 constituent stocks representing a sample of large. The "Free-float Market Capitalization" methodology of index construction is regarded as an industry best practice globally. FTSE. it provides the time series data over a fairly long period of time (From 1979 onwards).Since then. SENSEX is not only scientifically designed but also based on globally accepted construction and review methodology. The journey in the 20th century has not been an easy one. All major index providers like MSCI. The Stock Exchange. A lot has changed since 1875 when 318 persons became members of what today is called "The Stock Exchange. STOXX. The index is widely reported in both domestic and international markets through print as well as electronic media. 23 . The base year of SENSEX is 1978-79 and the base value is 100. liquid and representative companies. Mumbai (BSE) in 1986 came out with a stock index that subsequently became the barometer of the Indian stock market. 128 years of experience seems to be a proud milestone. Mumbai" by paying a princely amount of Re1. As the oldest index in the country. 2003. S&P and Dow Jones use the Free-float methodology. First compiled in 1986. The Index was initially calculated based on the "Full Market Capitalization" methodology but was shifted to the free-float methodology with effect from September 1. the country's capital markets have passed through both good and bad periods. the SENSEX has over the years become one of the most prominent brands in the country. Till the decade of eighties.SENSEX: THE BAROMETER OF INDIAN ECONOMY For the premier Stock Exchange that pioneered the stock broking activity in India. there was no scale to measure the ups and downs in the Indian stock market.

prices of the index scrips. are used by the trading system to calculate SENSEX every 15 seconds and disseminated in real time. The calculation of SENSEX involves dividing the Free-float market capitalization of 30 companies in the Index by a number called the Index Divisor. The market capitalization of a company is determined by multiplying the price of its stock by the number of shares issued by the company. SENSEX Calculation Methodology SENSEX is calculated using the "Free-float Market Capitalization" methodology. The Divisor is the only link to the original base period value of the SENSEX. Right from early nineties the stock market witnessed heightened activity in terms of various bull and bear runs.The growth of equity markets in India has been phenomenal in the decade gone by. 24 . It keeps the Index comparable over time and is the adjustment point for all Index adjustments arising out of corporate actions. This market capitalization is further multiplied by the free-float factor to determine the free-float market capitalization. the level of index at any point of time reflects the Free-float market value of 30 component stocks relative to a base period. at which latest trades are executed. The base period of SENSEX is 1978-79 and the base value is 100 index points. One can identify the booms and busts of the Indian stock market through SENSEX. This is often indicated by the notation 1978-79=100. Dollex-30 BSE also calculates a dollar-linked version of SENSEX and historical values of this index are available since its inception. replacement of scrips etc. During market hours. The SENSEX captured all these events in the most judicial manner. As per this methodology.

the concentration of top five companies in SENSEX has fallen under the free-float scenario thereby making the SENSEX more diversified and broad-based. strategic holding and other locked-in shares that will not come to the market for trading in the normal course. This enables an apple-to-apple comparison thereby facilitating better evaluation of performance of active managers. In India. Free-float market capitalization is defined as that proportion of total shares issued by the company that are readily available for trading in the market. In other words. BSE pioneered the concept of Free-float by launching BSE TECk in July 2001 and BANKEX in June 2003. SENSEX becomes the third index in India to be based on the globally accepted Free-float Methodology. Major advantages of Free-float Methodology: A Free-float index reflects the market trends more rationally as it takes into  consideration only those shares that are available for trading in the market. BANKEX is positioned as a benchmark for the banking sector stocks. Being a perfectly replicable portfolio of stocks. government holding. While BSE TECk Index is a TMT benchmark. It aids active  managers by enabling them to benchmark their fund returns vis-à-vis an investable index. For example. the market capitalization of each company in a Free-float index is reduced to the extent of its readily available shares in the market. a Free-float adjusted index is best suited for the passive managers as it enables them to track the index with the least tracking error. Free-float Methodology makes the index more broad-based by reducing the  concentration of top few companies in Index.Understanding Free-float Methodology Concept: Free-float Methodology refers to an index construction methodology that takes into consideration only the free-float market capitalization of a company for the purpose of index calculation and assigning weight to stocks in Index. 25 . It generally excludes promoters' holding. A Free-float index aids both active and passive investing styles.

In specific. which is followed by Foreign Institutional Investors (FIIs) to track Indian equities. NASDAQ-100. the following categories of holding are generally excluded from the definition of Free-float: Holdings by founders/directors/ acquirers which has control element  Holdings by persons/ bodies with "Controlling Interest"  Government holding as promoter/acquirer  Holdings through the FDI Route  Strategic stakes by private corporate bodies/ individuals  Equity held by associate/group companies (cross-holdings)  Equity held by Employee Welfare Trusts  26 . The MSCI India Standard Index. companies with large market capitalization and low free-float cannot generally be included in the Index because they tend to distort the index by having an undue influence on the index movement. under the Free-float Methodology. This improves market coverage and sector coverage of the index. Globally. the Free-float Methodology of index construction is considered to be an  industry best practice and all major index providers like MSCI. a leading global index provider. since only the free-float market capitalization of each company is considered for index calculation. is also based on the Free-float Methodology. shifted all its indices to the Free-float Methodology in 2002. For example. in the normal course come into the open market for trading are treated as 'Controlling/ Strategic Holdings' and hence not included in free-float.Free-float Methodology improves index flexibility in terms of including any stock  from the universe of listed stocks. However. MSCI.QQQ is based on the Free-float Methodology. under a Full-market capitalization methodology. Definition of Free-float: Share holdings held by investors that would not. the underlying index to the famous Exchange Traded Fund (ETF) . FTSE. it becomes possible to include such closely held companies in the index while at the same time preventing their undue influence on the index movement. S&P and STOXX have adopted the same.

The Exchange determines the Freefloat factor for each company based on the detailed information submitted by the companies in the prescribed format. Maintenance of SENSEX One of the important aspects of maintaining continuity with the past is to update the base year average. If a SENSEX constituent has not traded at all in a day. the last traded price is taken for computation of the Index closure. Free-float factor is a multiple with which the total market capitalization of a company is adjusted to arrive at the Free-float market capitalization. The remaining shareholders would fall under the Free-float category. If a SENSEX constituent has not traded in the last 30 minutes. Once the Free-float of a company is determined.Locked-in shares and shares which would not be sold in the open market in  normal course.55 means that only 55% of the market capitalization of the company will be considered for index calculation Index Closure Algorithm The closing SENSEX on any trading day is computed taking the weighted average of all the trades on SENSEX constituents in the last 30 minutes of trading session. Determining Free-float factors of companies: BSE has designed a Free-float format. The use of Index Closure Algorithm prevents any intentional manipulation of the closing index value. The base year value adjustment ensures that replacement of stocks in Index. which is filled and submitted by all index companies on a quarterly basis with the Exchange. it is rounded-off to the higher multiple of 5 and each company is categorized into one of the 20 bands given below. A Free-float factor of say 0. then its last day's closing price is taken for computation of Index closure. 27 .

Finance-Journalists. The Index Cell ensures that SENSEX and all the other BSE indices maintain their benchmark properties by striking a delicate balance between frequent replacements in index and maintaining its historical continuity. Independent Governing Board members. 28 . a discontinuity would arise between the current value of the index and its previous value despite the non-occurrence of any economic activity of substance. They include Academicians. are automatically used by the trading computer to calculate the SENSEX every 15 seconds and continuously updated on all trading workstations connected to the BSE trading computer in real time. do not destroy the historical value of the index. If no adjustments were made. On-Line Computation of the Index: During market hours. Rights and Newly issued Capital: The arithmetic calculation involved in calculating SENSEX is simple. The Index Cell of the Exchange keeps a close watch on the events that might affect the index on a regular basis and carries out daily maintenance of all the 14 Indices. and Exchange administration. Adjustment for Bonus. but problem arises when one of the component stocks pays a bonus or issues rights shares. the base value is adjusted. At the Index Cell of the Exchange. at which trades are executed. prices of the index scrips. Fund-managers from leading Mutual Funds.additional issue of capital and other corporate announcements like 'rights issue' etc. The Index Committee of the Exchange comprises of experts on capital markets from all major market segments. which is used to alter market capitalization of the component stocks to arrive at the SENSEX value. Market Participants. The Index Cell of the exchange does the day-to-day maintenance of the index within the broad index policy framework set by the Index Committee. The beauty of maintenance lies in the fact that adjustments for corporate actions in the Index should not per se affect the index values.

issues right shares. the freefloat market capitalisation of that company is increased by the number of additional shares issued based on the theoretical (ex-right) price. mergers. spin-offs etc. Adjustments for Bonus Issue:  When a company. or when equity is reduced by way of buy-back of shares. Other Issues:  Base Market Capitalisation Adjustment is required when new shares are issued by way of conversion of debentures. the market capitalisation of that company does not undergo any change. Base Market Capitalisation Adjustment:  The formula for adjusting the Base Market Capitalisation is as follows: New Base Market = Old Base Market X New Market Capitalisation / Old Base capitalisation 29 . An offsetting or proportionate adjustment is then made to the Base Market Capitalisation (see 'Base Market Capitalisation Adjustment' below). only the 'number of shares' in the formula is updated. included in the compilation of the index.Adjustments for Rights Issues:  When a company. Therefore. included in the compilation of the index. issues bonus shares. corporate restructuring etc. there is no change in the Base Market Capitalisation.

4781 crores.24 crores Criteria for Selection and Review of SENSEX Constituents The scrip selection and review policy for BSE Indices is based on the objective of: Improvement  Transparency  Simplicity  Qualification Criteria: The general guidelines for selection of constituent scrips in SENSEX are as follows: A. The "New Base Market Capitalisation " will then be: This figure of 2501. say Rs.To illustrate.24 will be used as the Base Market Capitalisation for calculating the index number from then onwards till the next base change becomes necessary. say.100 crores. The existing Base Market Capitalisation (Old Base Market Capitalisation). suppose a company issues right shares which increases the market capitalisation of the shares of that company by say. 2450 X (100+4781) 4781 = 2501. Final Rank: The scrip should figure in the top 100 companies listed by Final Rank. Rs. 30 . is Rs. Quantitative Criteria: 1. The final rank is arrived at by assigning 75% weightage to the rank on the basis of six-month average full market capitalisation and 25% weightage to the liquidity rank based on six-month average daily turnover & six-month average impact cost.2450 crores and the aggregate market capitalisation of all the shares included in the index before the right issue is made is.

Listed History: The scrip should have a listing history of at least 3 months on BSE. Trading Frequency: The scrip should have been traded on each and every trading day for the last six months.2. However. every review meeting need not necessarily result in a change in the index constituents. Market Capitalization Weightage: The weight of each scrip in SENSEX based on six-month average Free-Float market capitalisation should be at least 0.5% of the Index. The index companies should be leaders in their industry group. In case of a revision in the Index constituents. However. Industry Representation: Scrip selection would take into account a balanced representation of the listed companies in the universe of BSE. 4. Index Review Frequency: The Index Committee meets every quarter to review all BSE indices. B. the Committee may relax the criteria under exceptional circumstances. the announcement of the incoming and outgoing scrips is made six weeks in advance of the actual implementation of the revision of the Index. 31 . Exceptions can be made for extreme reasons like scrip suspension etc. 3. Qualitative Criteria: Track Record In the opinion of the Committee. 5. the company should have an acceptable track record.

78.2% loss for the day.7bn on Indian shares in 2005. Unsubstantiated fears that the government's Left Front allies would insist on higher taxes on foreign investors also caused market jitters. and so far this year they have spent a net US$3. However. made possible by economic liberalisation. With a rebound after this hiatus.3% to close at 10. brought a slightly larger correction than had been expected. Uncertainty about the global economy and US monetary policy. 32 . reportedly led by state-run mutual funds and institutions.600—up around a third in year-to-date terms. with a sell-off on May 22nd causing the 30-share Bombay Sensitive Index (Sensex) to lose as much as 10% of its value—triggering an automatic suspension of trading for one hour. the Sensex recovered to record a 4. India's stock market lacks depth and liquidity—market capitalisation as a percentage of GDP remains low. But a correction had long been expected. Foreign investors spent a record US$10.BSE India Today India's stockmarket has been among the most volatile in the region. as well as foreign institutional investors' desire to exploit these opportunities. On May 23rd it rose 3. coupled with concerns over the sustainability of India's economic boom. and only a relatively small number of companies are actively traded—so that new capital inflows tend to trigger price increases. More fundamental problems belie the confidence investors had placed in Indian equities until recently. the increasingly common assertion that the ongoing Indian boom is "different" and "warranted by fundamentals" sounded naïve. The Sensex had doubled in value in 2005 and hit a record on May 10th of around 12. and has been tempered by the recent volatility. The trend also reflects the high returns that investments in highly profitable Indian companies offer. breaking a losing streak which had seen the index lose around 14% of its value since May 17th.8bn.822.

The trouble is the instruments the FM has at his disposal to influence the stock markets are deeply flawed. if we look at the stock markets not in isolation. the FM had no option but to intervene. but in the context of capital flows in and out of the economy. They could keep buying shares and book profits at higher prices. And yet. FIIs may be less willing to rush in.VOLATILITY OF BSE SENSEX As the potential for spectacular profit declines. 33 . But in this effectiveness lie the seeds of an even bigger crisis. if he is to be faulted it is not because he intervened to prevent a crisis but because the government refuses to see that such crises are inherent in allowing foreign institutional investors to bloat the size of the stock markets. had a dampening effect on growth by raising the costs of imports including oil. it distorts the market values of shares. Sooner rather than later this would have encouraged flight of FII capital out of the country. panic could easily have resulted in an even more dramatic drop the next day. a fair amount of flak for intervening against the bears in the stock markets. The reason the FII outflow was halted is because these investors realised they were now in a no-loss situation. With the sensex having lost over 800 points in a day. Indeed. this would have had an impact on the rupee. Since FII investments are currently much greater than foreign direct investment (FDI). The popular argument about protecting investors too does not hold as those who have benefited from a spectacular boom must know that they stand the risk of an equally spectacular bust. the pressure on the rupee was beginning to show. In fact. Even if the rupee did not collapse dramatically this would have. Getting state-controlled institutions to buy shares may appear very effective in the short run as the market slide was halted. There is little doubt that when the government lines up on the side of the bulls. But that may not be as bad a thing to happen as it’s sometimes made out to be. in turn. the way they have done over the past few years.

The way out of this potentially dangerous situation is to ensure that the markets become inherently less volatile. They will see an opportunity when speculators drop prices well below the intrinsic value of the share. The flight of FIIs in the stock markets will then be accompanied by the outflow of foreign direct investment in the rest of the economy. Conversely when speculators take prices to unrealistically high levels. In practice. the government may in fact be moving to remove the brakes that already exist. long-term investors too have to recognise that prices may not remain all that sensitive to earnings. though things don’t always work out that way. especially pension funds. If the FII pressure in the stock markets did not affect foreign direct investment it was because of the absence of full convertibility. The collapse then would result in a full-blown currency crisis. In theory this should happen if there are more long-term investors in the market.The risk of their profit-taking leading to a collapse in the markets was now minimised since the government could be relied upon to step in and prevent a dramatic fall in prices. into the market. the costs of stepping in to provide stability will also increase. Instead long-term expectations of the 34 . And a point could well be reached where the investments required to prevent a collapse are well beyond the capabilities of government-controlled institutions. To make matters worse. A case can then be made to bring in more long-term investors. But with the prime minister revealing an ideological passion to push towards full convertibility this critical safeguard will be removed. When price-earning ratios remain at extraordinarily high levels. far from offering the FM more and better instruments to stabilise capital flows. thereby limiting the fall in prices. But as the FII investment keeps growing. the long-term investors will bring sanity into the market by booking profits.

liquid and representative companies. S&P and Dow Jones use the Free-float methodology. Some companies may have to be groomed to play this role. This has happened to several mutual funds. This could happen by introducing an effective. The "Free-float Market Capitalization" methodology of index construction is regarded as an industry best practice globally. separate Small Cap market. The long-term investors are then also forced to be guided by speculators. 2003. All major index providers like MSCI.price of a share too may be determined by what speculators do to a share. And when these shares come in their own they can be graduated into the big league. The base year of SENSEX is 1978-79 and the base value is 100. 35 . Analysis of Indian stock market BSE Sensex Index The BSE SENSEX is not only scientifically designed but also based on globally accepted construction and review methodology. This market would be designed in such a way that it attracts minimal attention from global speculators. Such a market would allow new companies to be traded in the initial years without having to cope with the volatility that global speculators bring. and there is no guarantee that pension funds will be immune to this lure. This would happen if there are more shares that attract the attention of all investors. if that. STOXX. SENSEX is a basket of 30 constituent stocks representing a sample of large. FTSE. The critical task then is to bring price-earning ratios closer to a level where actual earnings play a more important role in the decision making of longterm investors. The index is widely reported in both domestic and international markets through print as well as electronic media. The Index was initially calculated based on the "Full Market Capitalization" methodology but was shifted to the free-float methodology with effect from September 1. First compiled in 1986.

As the oldest index in the country.Due to is wide acceptance amongst the Indian investors. 36 . the SENSEX has over the years become one of the most prominent brands in the country. Small wonder. SENSEX is regarded to be the pulse of the Indian stock market. it provides the time series data over a fairly long period of time (From 1979 onwards).

CHAPTER 4 RESEARCH METHODOLOGY 37 .

we perform unit root tests to investigate whether they are stationary or not. in the first step. The Augmented Dickey-Fuller (ADF) unit root test is used for this purpose. The ADF regression equations are: where åô is white noise. The additional lagged terms are included to ensure that the errors are uncorrelated. In order to avoid a spurious regression situation the variables in a regression model must be stationary or cointegrated. 38 . Engle and Granger. The time series variables considered in this paper are the stock prices and fii flows. Therefore.Unit Root Test and Co integration: Empirical studies (for example. 1987) have shown that many time series variables are non-stationary or not integrated of order zero.

The cointegration equation estimated by the OLS method is given as: In the third step residuals (Zt) from the cointegration regression are subject to the stationarity test based on the following equations: 39 .ADF UNIT ROOTS TEST The tests are based on the null hypothesis (H0): Yt is not I (0). If the calculated ADF statistics are less than their critical values from Fuller’s table then the null hypothesis (H0) is rejected and the series are stationary or not integrated of order zero. COINTEGRATION In the second step we estimate cointegration regression using variables having the same order of integration.

Therefore. according to Toda and Yamamoto. In order to clarify the principle. at least asymptotically. the Toda-Yamamoto causality procedure has been labelled as the long-run causality tests. non-cointegrated or cointegrated of an arbitrary order. If d=2. then the procedure is valid unless k=1. 40 .Toda and Yamamoto Version of Granger Causality: Toda and Yamamoto (1995) proposed a simple procedure requiring the estimation of an ‘augmented’ VAR. the statistic is valid regardless whether a series is I (0). which we expect to occur in the model and construct a VAR in their levels with a total of (k + dmax) lags. I (1) or I (2). let us consider the simple example of a bivariate model. for d=1. with one lag (k=1). the lag selection procedure is always valid. Moreover. which guarantees the asymptotic distribution of the statistic. Toda and Yamamoto point out that. All one needs to do is to determine the maximal order of integration dmax. That is. =d. since k 1 . even when there is cointegration.

with degrees of freedom equal to the number of "zero restrictions". The monthly return on stock prices (RBSE) is calculated by taking a percentage change in the BSE Sensitive Index (base: 197879=100). In this study. irrespective of whether x1t and x2t are I (0). 41 . we used monthly data series for three variables for the period January 1993 to March 2005 forming around 147 observations. non-cointegrated or cointegrated of an arbitrary order.The statistic will be asymptotically distributed as a Chi Square. I (1) or I (2).

usually through a series of F-tests on lagged values of X (and with lagged values of Y also known). that those X values provide statistically significant information on future values of Y. A time series X is said to Granger-cause Y if it can be shown. This can be repeated for multiple ÄX's (with each ÄX being tested independently of other ÄX's. Once the appropriate lag interval for Y is proved significant (t-stat or p-value). The test works by first doing a regression of ÄY on lagged values of ÄY. regressions reflect "mere" correlations. More than 1 lag level of a variable can be included in the final regression model.GRANGER CAUSALITY TEST Granger causality is a technique for determining whether one time series is useful in forecasting another. but in conjunction with the proven lag level of ÄY). provided it is statistically significant and provides explanatory power. Ordinarily. subsequent regressions for lagged levels of ÄX are performed and added to the regression provided that they 1) are significant in of themselves and 2) add explanatory power to the model. 42 .

CHAPTER 5 ANALYSIS & FINDINGS 43 .

of regression Sum squared resid Log likelihood Coefficient -0. -2.806367 0.D.011877 -6.5388 Std. dependent var Akaike info criterion Schwarz criterion Durbin-Watson stat t-Statistic -12.402169 0.999033 44 . Error 0.524568 1. 0.5739 -1.0000 3.020747 808.9409 -1.538776 -6.062682 Mean dependent var S. To check the values are stationary we conduct the unit root test and thus the result indicates the following information ADF Test Statistic -12. The augmented dickey fuller test for the time series values of trading volumes of sensex.402169 0.86430 Prob.E.86430 1% Critical Value* 5% Critical Value 10% Critical Value *MacKinnon critical values for rejection of hypothesis of a unit root.009184 0.6163 Augmented Dickey-Fuller Test Equation Dependent Variable: D(SENSEX) Method: Least Squares Date: 06/12/06 Time: 17:47 Sample(adjusted): 2 248 Included observations: 247 after adjusting endpoints Variable SENSEX(-1) R-squared Adjusted R-squared S.EMPIRICAL RESULTS: AUGMENTED DICKEY FULLER TEST: THE FOLLOWING TESTS ARE CONDUCTED TO TEST THE STATIONARITY OF THE RETURNS OF THE SENSEX.11E-05 0.

03 0. the values are stationary and the trend is deterministic. which is less than the critical values hence at 5% and 1% significance level.86. 0.02 0.01 -0.01 0.Here the null hypothesis is rejected since the t-statistics value is -12.02 -0.03 50 100 150 SENSEX 200 45 . Thus we can conclude that.00 -0.

508725 0.035646 Prob.E.003987 -8. 0. of regression Sum squared resid Log likelihood Coefficient -1. The augmented dickey fuller test for the time series values of gold prices. To check the values are stationary we conduct the unit root test and thus the result indicates the following information ADF Test Statistic -14.001759 0.003194 1829.002798 0.016117 0.45353 0.TEST FOR THE STATIONARITY OF THE GOLD THE FOLLOWING TESTS ARE CONDUCTED TO TEST THE STATIONARITY OF THE GOLD PRICES. dependent var Akaike info criterion Schwarz criterion Durbin-Watson stat t-Statistic -14.998592 46 .0000 0.D.564 Std.914947 -8. Error 0.895356 1.9716 1.09E-05 0.070302 0.049354 Mean dependent var S.5706 -1.45353 1% Critical Value* 5% Critical Value 10% Critical Value *MacKinnon critical values for rejection of hypothesis of a unit root.507521 0.6160 Augmented Dickey-Fuller Test Equation Dependent Variable: D(GOLD) Method: Least Squares Date: 06/12/06 Time: 17:50 Sample(adjusted): 3 412 Included observations: 410 after adjusting endpoints Variable GOLD(-1) D(GOLD(-1)) R-squared Adjusted R-squared S. -2.9403 -1.

015 -0.005 -0. which is less than the critical values hence at 5% and 1% significance level.010 0.000 -0.Here the null hypothesis is rejected since the t-statistics value is -14. Thus we can conclude that. the values are stationary and the trend is deterministic 0.020 50 100 150 200 250 300 350 400 GOLD 47 .453.010 -0.005 0.015 0.

3265 131.R.365 C 8. suggests the likelihood of the existence of the other model due to the initial model.65 Hypothesized No.000000 SENSEX -0.4982 5 Percent Critical Value 15.52E-05 SENSEX -0.JOHANSEN COINTEGRATION TEST The cointegration test.838642 Likelihood Ratio 320. of CE(s) None ** At most 1 ** Log likelihood 48 . Date: 06/12/06 Time: 17:54 Sample: 1 414 Included observations: 247 Test assumption: Linear deterministic trend in the data Series: GOLD SENSEX Lags interval: No lags Eigenvalue 0.201458 Normalized Cointegrating Coefficients: 1 Cointegrating Equation(s) GOLD 1.534427 0.41 3. test indicates 2 cointegrating equation(s) at 5% significance level Unnormalized Cointegrating Coefficients: GOLD 20. Thus calculating the likelihood ratio will show the probability of the regression of other equation with initial equation.01982) 1827.78813 2.931143 6.76 1 Percent Critical Value 20.04 6.412795 *(**) denotes rejection of the hypothesis at 5%(1%) significance level L.044792 (0.

0.01 -0.03 0.Here. the likelihood ratio is 320.326 which is greater than critical values at 5 % significance value.00 -0.01 0.03 50 100 GOLD 150 SENSEX 200 49 . Hence by looking at the table we can say that rejection of the hypothesis at 5%(1%) significance level.02 -0.02 0.

21037 50 . FINDINGS AND CONCLUSIONS Pairwise Granger Causality Tests Date: 06/12/06 Time: 17:57 Sample: 1 414 Lags: 2 Null Hypothesis: SENSEX does not Granger Cause GOLD GOLD does not Granger Cause SENSEX Obs 246 F-Statistic 1.35191 0.GRANGER CAUSALITY TEST FROM THE TABLE BELOW.04892 1. WE INTERPRETE THE FOLLOWING .56900 Probability 0.

Now following is the finding for grangers causality test.04892 which is less than the critical value of 1.7 and 1. Thus we again reject the null hypothesis and can say gold has cause on sensex returns. f-statistic value is 1. that sensex doesn’t granger cause gold and vice versa.7 and 1. 51 .: There is no relation between gold and sensex returns. In case 1: Sensex on granger cause to gold Here.58 at 5 % and 1 % significance level respectively.56900 which is less than the critical value of 1.HYPOTHESIS: We took the null hypothesis .58 at 5 % and 1 % significance level respectively. Thus we reject the null hypothesis and can say sensex causes the gold On the other hand analyzing the impact of gold on sensex for monthly basis we see that F-statistic value is 1.

CHAPTER 6 CONCLUSION 52 .

for speculative purposes. Gold price is included in the model as an additional variable. 53 . it is expected that gold may be looked upon as alternative asset for those holding idle money. The causality test proved that null hypothesis exits and thus proved there is no relation between the gold prices and stock returns. we found the times series for the year 2005 for gold prices and stock returns. which shows both the trends are deterministic. to examine whether gold price contain any additional significant information about price movements. Since gold is an important saving instrument in India and is very often used as a hedge against inflation. After looking at the following testing . and the values are stationary. these trends were tested for cointigration.Conclusion The causal relationship was tested between the BSE index and gold . We find investors tendency to switch to gold investment when they find the market to be too risky. and were found that the multicollinearity exits as the likelihood ratio was high . Even though gold is considered to be the best alternative source of investment.

Institute of Economic Growth Discussion paper series. S. Share price behaviour in India: An Econometric Analysis.YAHOOFINANCE.BIBLOGRAPHY:  Bhattacharya.BSEINDIA.  Bhattacharya.COM  WWW.igidr. paper presented in Econometric Conference.B. 1994. Pune.www.COM 54 .B.MONEYCONTROL.S.  WWW.(2002).ac. and Chakravarty.foreign exchange reserves and value of trade balance :A case study for India .COM  WWW. B.in  Bhattacharya B and Mukherjee J(2001) The nature of the causal relationship between stock market and macroeconomic aggregates in India: An empirical analysis .COM  WWW.NCDEX.B.55/2002  Bhattacharya B and Mukherjee J(2002) Causal relationship between stock market and exchange rate. (1994). and Chakravarty.Stock Volatility in India.

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