Determinant of Indian Stock Market Essay

Introduction of stock market Stock markets refer to a market place where investors can buy and sell stocks. The price at which each buying and selling transaction takes is determined by the market forces (i. e. demand and supply for a particular stock). Let us take an example for a better understanding of how market forces determine stock prices. ABC Co. Ltd. enjoys high investor confidence and there is an anticipation of an upward movement in its stock price. More and more people would want to buy this stock (i. e. high demand) and very few people will want to sell this stock at current market price (i. . less supply). Therefore, buyers will have to bid a higher price for this stock to match the ask price from the seller which will increase the stock price of ABC Co. Ltd. On the contrary, if there are more sellers than buyers (i. e. high supply and low demand) for the stock of ABC Co. Ltd. in the market, its price will fall down. In earlier times, buyers and sellers used to assemble at stock exchanges to make a transaction but now with the dawn of IT, most of the operations are done electronically and the stock markets have become almost paperless.

Now investor’s don’t have to gather at the Exchanges, and can trade freely from their home or office over the phone or through Internet. A STOCK EXCHANGE is a platform where buyers and sellers of securities issued by governments, finance institutions, corporate houses etc. , meet and where trading of these corporate securities take place. MUTUAL FUNDS: – A Mutual fund is a trust that pools the saving of a number of investors who share a common financial goal. FOREIGN DIRECT MARKET (FDI): – This category refers to international investment in which the investor obtains a lasting interest in an enterprise in another country.

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Most concretely, it may take the form of buying or constructing a factory in a foreign country or adding improvements to such a facility, in the form of property, plants or equipment. FOREIGN INSTITUTIONAL INVESTOR (FII):- An investor or investment fund that is from of or registered in a country outside of the one in which it is currently investing. Foreign institutional investors have made a sizable investment in Indian financial markets. There are currently about 1324 FIIs registered in India. FOREIGN PORTFOLIO INVESTMENT (FPI):-

FPI is a category of investment instruments that are more easily traded, may be less permanent, and do not represent a controlling stake in an enterprise. These include investments via equity instruments (stocks) or debt (bonds) of a foreign enterprise that does not necessarily represent a long-term interest. BULL MARKET: – A Bull market is a market that is consistently going up. It is a market where there is optimism of further rise batter, business results and other positive factors. Bull Market can sometimes continue for years, for investors this is the preferred market trend.

However no bull market can continue for very long. BEAR MARKET: – Bear Market is a market that is showing a persistent downtrend. A 15-20% downward movement of the market generally termed as a bear market. DIVERSIFICATION: – Diversification is the technique of investing in unrelated business sectors simultaneous so that risk that affects a particular sector does not affect your overall investment. For example your portfolio of share includes sectors like Information Technology, Real estate capital Goods, Autos etc. Exchange rate of a nation’s currency- Currency like other commodities rises or falls in “price” with demand.

When investors leave, they sell their holdings in a country’s currency and as demand falls, the “price” of that currency will also fall. ECONOMIES OF SCALE: – Produces are often able to enjoy considerable production cost savings by buying inputs in bulk, mass-producing or retailing their end product. These lower costs achieved through expanded production are called Economies of Scale. DEBT/EQUITY RATIO:- The debt/equity ratio measures the extent to which a firm’s capital is provided by lenders (through debt instruments such as fixed-return bonds) or owners (through variable-return stocks).

A greater reliance on financing through debt can mean greater profitability for shareholders, but also greater risk in the event things go sour. INTERNATIONAL MONETARY FUND:- The IMF is an international organization of 186 member countries, established in 1947 to promote international monetary cooperation, exchange stability, and orderly exchange arrangements; to foster economic growth and high levels of employment; and to provide temporary financial assistance to countries to help ease balance of payments adjustment. INSTITUTIONAL INVESTOR:-

An organization whose primary purpose is to invest its own assets or those held in trust by it for others. Includes pension funds, investment companies, insurance companies, universities and banks. INTEREST RATES:- Interest rates have a powerful effect on the volume of a nation’s money supply. By raising interest rates, i. e. , making the cost of borrowing money more expensive, governments or banks can decrease the money supply. A decrease in the money supply tends to be counter-inflationary, which makes a currency more valuable compared to other currencies. MOST FAVORED NATION TREATMENT:-

The phrase “most favored nation” refers to the obligation of the country receiving the investment to give that investment the same treatment as it gives to investments from its “most favored” trading partner. BALANCE OF PAYMENT:- The Balance of Payments (BOP) is a statistical statement that summarizes, for a specific period (typically a year or quarter), the economic transactions of an economy with the rest of the world. It covers: All the goods, services, factor income and current transfers an economy receives from or provides to the rest of the world Capital transfers and changes in an economy’s external financial claims and liabilities.

PORTFOLIO INVESTMENT:- Covers the acquisition and disposal of equity and debt securities that cannot be classified under direct investment or reserve asset transactions. These securities are tradable in organized financial markets. FDI FLOWS AND STOCKS: – Through direct investment flows the investors builds up a direct investment stock (position), making part of the investor’s balance sheet. The FDI stock (position) normally differs from accumulated flows because of revaluation (changes in prices or exchange rates) and other adjustments like rescheduling or cancellation of loans, debt forgiveness or debt-equity swaps with different values.

MULTINATIONAL COMPANIES (MNCs):- Do incorporated or unincorporated enterprises comprise parent enterprises and their foreign affiliates? FOREIGN DIRECT INVESTOR: – A foreign direct investor is an individual, an incorporated or unincorporated public or private enterprise, a government, a group of related individuals, or a group of related incorporated and/or unincorporated enterprises which have a direct investment enterprise that is a subsidiary, associate or branch – operating in a country other than the country or countries of residence of the direct investor or investors.

HOST ECONOMY:- Is the country that receives FDI or FPI from the foreign investor(s)? HOME ECONOMY:- Is the country of origin/residence of the company that invests in the foreign economy/host economy? SUBSIDIARY:- Is an incorporated enterprise in the host country in which the foreign investor owns more than 50 per cent of the shareholder’s voting power or has the right to appoint or remove a majority of the members of this enterprise’s administrative, management or supervisory body. EQUITY CAPITAL:- Comprises of equity in branches and ordinary shares in subsidiaries and associates.

Reinvested earnings – consist of the direct investor’s share of earnings not distributed as dividends by subsidiaries or associates and earnings of branches not remitted to the direct investor. OTHER CAPITAL:- Covers inter-company debt (including short-term loans such as trade credits) between direct investors and subsidiaries, branches and associates. WTO – World Trade Organization. Trading Pattern of the Indian Stock Market Indian Stock Exchanges allow trading of securities of only those public limited companies that are listed on the Exchange(s). They are divided into two categories: [pic]

Indian stock exchange allows a member broker to perform following activities: • Act as an agent, • Buy and sell securities for his clients and charge commission for the same, • Act as a trader or dealer as a principal, • Buy and sell securities on his own account and risk Over The Counter Exchange of India (OTCEI) Traditionally, trading in Stock Exchanges in India followed a conventional style where people used to gather at the Exchange and bids and offers were made by open outcry. This age-old trading mechanism in the Indian stock markets used to create many functional in efficiencies.

Lack of liquidity and transparency, long settlement periods and benami transactions are a few examples that adversely affected investors. In order to overcome these inefficiencies, OTCEI was incorporated in 1990 under the Companies Act 1956. OTCEI is the first screen based nationwide stock exchange in India created by Unit Trust of India, Industrial Credit and Investment Corporation of India, Industrial Development Bank of India, SBI Capital Markets, Industrial Finance Corporation of India, General Insurance Corporation and its subsidiaries and Can Bank Financial Services. pic] Advantages of OTCEI • Greater liquidity and lesser risk of intermediary charges due to widely spread trading mechanism across India • The screen-based scrip less trading ensures transparency and accuracy of prices • Faster settlement and transfer process as compared to other exchanges • Shorter allotment procedure (in case of a new issue) than other exchanges National Stock Exchange

In order to lift the Indian stock market trading system on par with the international standards. On the basis of the recommendations of high powered Pherwani Committee, the National Stock Exchange was incorporated in 1992 by Industrial Development Bank of India, Industrial Credit and Investment Corporation of India, Industrial Finance Corporation of India, all Insurance Corporations, selected commercial banks and others.

NSE provides exposure to investors in two types of markets, namely: 1. Wholesale debt market 2. Capital market Wholesale Debt Market – Similar to money market operations, debt market operations involve institutional investors and corporate bodies entering into transactions of high value in financial instruments like treasury bills, government securities, commercial papers etc. Trading at NSE • Fully automated screen-based trading mechanism Strictly follows the principle of an order-driven market • Trading members are linked through a communication network • This network allows them to execute trade from their offices • The prices at which the buyer and seller are willing to transact will appear on the screen • When the prices match the transaction will be completed • A confirmation slip will be printed at the office of the trading member Advantages of trading at NSE Integrated network for trading in stock market of India • Fully automated screen based system that provides higher degree of transparency • Investors can transact from any part of the country at uniform prices • Greater functional efficiency supported by totally computerized network Literature review: This gap in the literature and examine the effects of exposure to foreign markets on volume, volatility, liquidity of stocks in the domestic markets. Yet they are not clear how the volume affects the Indian stock market. There are so many evidences e. . Aamihud (2002), Datar (1998) etc. , in the literature that there exist a positive relationship between return and liquidity. If return & risk are positively related then risk and liquidity is expected to have a positive association. Admati and Pfleiderer (1988), Foster & Viswanathan (1990) also predict positive relation between illiquidity and volatility. So a negative relation between liquidity and risk is expected. We are describing about the supply and demand in the market that affects the Indian stock market. As they move towards the fluctuation.

As it is common the more the purchasing in the market the more the price of the share goes up as less the price the price of the share goes down. Our research shows that the improvement in the volume the stock prices goes up the more the foreign capital the improvements in the liquidity of their equity traded on the Indian stock market. We will see that the firm raising its capital by the improvements of the liquidity in the stock market. Raising capital allow the people to invest in a firms shares could result in positive changes. This provides a verification affect that increase the value of the firm equity.

Moel (2000) analyzes the effect of ADR listings from emerging markets on three aspects of development. Openness, liquidity and growth- in the home market. Accounting disclosure standards are used to proxy for openness of the market while liquidity is measured using the share turnover of the firms. He uses a sample of firms from 28 emerging markets and uses annual data to measure changes in openness, liquidity and growth. Moel that suggest the firms that raises capital do not see significant improvement to the liquidity of their equity traded securities.

They particular found of more of the foreign investment securities invested in local market. We found of that the firms raising capital the foreign capital-raising event. Lower volatility of underlying assets returns implies lower inventory reduced possibility of informed trading. Declining spreads and volatility of spreads therefore imply better liquidity in the market. Pagano , Chowdhry and Nanda and Domowitz, Glen and Madhavan show that the effect of cross-listing a firm’s shares is not unequivocally value improving.

In Domowitz, Glen and Madhavan (1998), cross-listing of shares on the domestic and a foreign market increases total number of trades and results in improved liquidity and firm value, only if markets are linked. If information is not freely available, volume will flow to the country. Nanda and chowdary that one of the markets will emerge as the dominant market, which will attract the informed and liquidity traders. Hence, the volume of trade in the domestic market could decline. For these reasons, it is not clear that firms are unconditionally better off subsequent to foreign capital-raising.

We are mainly focused on the domestic market so we will see how the bullish and bearish factors that play a dominant role in the stock market. As we also focused on the technical analysis and charts and volume liquidity that affects the Indian stock markets and more of the local investors that traded in these securities as they are the biggest investors and FII has the only 28% of investment in the market. And we will focused on FII also how they technical analysis say about them. Various Aspects that determine the efficiency of the Indian stock market Nature of the government.

The Annual Budget The financial policy of RBI Investor psychology Inflation GDP of a country Economic cycle (Recession and Boom) Demand and Supply Purchasing Power of people Climate condition Natural calamites Mergers and acquisition Change in organization structure Effect of Terror Attacks on Stock market Various studies have been done before to measure the impact of unanticipated event on the financial market. (1) Impact of September 11 attacks on US and Indian Stock market which concluded that – a) There was huge Impact of Terror attack on WTE on various Industries. ) There has been an Initial downslide in both American and Indian markets after the event. (2) Terrorism and stock market which concluded that- a) Human Capital loss such as kidnappings of Co. Executives has larger impact on Stock Prices rather than Bombings on buildings. b) There is need of Terrorism Risk Insurance. The study has been done to look upon that whether volatility in the stock prices is due to the terror attacks on Mumbai. Effect Of Climatic Conditions On Stock Market There are several researches on weather effect on stock returns. Goetzmann and Zhu (2002; pp. -29) have investigated weather effects on traders for five major U. S. cities by Using individual investors account information. They have virtually reported no difference in individual’s propensity to buy or sell equities on cloudy days as opposed to sunny days. However, the behavior of market makers may be responsible for the relation between returns and weather. In respect of humidity, sunny, cloudy, and snowy and rainy days, weather effect has been tested on stock returns and liquidity in literature. For example, Hirshleifer and Shum way(2001; pp. -29) have followed the same ways for 26 stock exchanges and reported that sunshine is highly significantly correlated with daily stock returns after controlling the sunshine and other weather conditions such as rain and snow, which are unrelated to returns. Effect of RBI Policies on Stock Market The response of asset prices to RBI policy is a key component for analyzing the impact of monetary policy on the economy. As Blinder (1998) notes, “Monetary policy has important macroeconomic effects only to the extent that it moves financial market prices that really matter—like long-term interest rates, stock market values, and exchange rates. The RBI’s decision to announce changes in the target funds rate affects, the volatility of the stock price response to RBI actions is more than ten times greater than in the remaining periods in the sample. Further, unexpected changes to the target funds rate in this high-volatility state have no statistically significant effect on the level of the S 500 index in the thirty-minute window bracketing the policy announcement. In the low-volatility state, the market response to unexpected changes in the target federal funds rate is significantly negative and reflects the recent body of work documenting this effect,

A recent example using the event-study framework to assess the effects of monetary policy on the stock market is Bernanke and Kuttner (2005), who use daily CRSP value-weighted returns and a measure of unexpected changes to the target federal funds rate computed from federal funds futures contract prices the day prior to a change to the target rate. They find that an unexpected 25-basis-point cut in the target federal funds rate is associated with a 1 percent increase in equity prices.

A similar approach is used by Gurkaynak, Sack, and Swanson (2005), who use high-frequency data to overcome the potential endogeneity and omitted-variables problems associated with using data covering a broad time window around policy announcements. By focusing on a narrow window around policy changes, they isolate the impact of unexpected moves in the target federal funds rate on equity prices, finding that the S 500 increases slightly more than 1 percent in response to a surprise 25-basis-point cut. Related literature measuring the response of equity returns to monetary policy using the event-study ramework also includes Patelis (1997), Thorbecke (1997), D’Amico and Farka (2002), Bomfin (2003), Craine and Martin (2003), and Bentzen et al. (2004) Effect of economy on Stock market The interaction between the stock market and aggregate economic activity has been the subject of considerable interest in the past decade. The relationship has traditionally been one in which the economy affects the stock market, usually based on the common text-book model of share prices as the discounted present value of expected future dividends.

In this framework share prices are influenced both by output (via profits and dividends) and interest rates (via the rate at which future dividends are discounted). More recently, attention has also been focused on effects in the opposite direction, which is from the stock market to the economy, no doubt influenced by the strong stock market performance in the 1990s and the sharp “corrections” in 2001 following the long bull market.

The extant literature has identified two principal channels of influence, the first from stock prices to consumption via a wealth effect and the second from stock prices to investment via cost of capital and other influences. Effect of Inflation on stock Market: Inflation can have a big impact; Emerging markets tend to have higher inflation than developed ones. Our country tends to have high inflation, and suffered about of hyperinflation after the Asia crisis. Since equities are more-or-less real assets (i. e. nes that should reflect the effects of inflation over time) this will push up the level of the stock market without translating into real gains for investors. In fact, the effects of inflation are among the most striking things when we look at long-term stock market returns. Another is how variable returns have been. The chart below shows long-term real and nominal returns from 17 developed stock markets over the last 110 years. Note that this is on a total return basis (i. e. including the effects of receiving and reinvesting dividends). pic] Equities beat inflation over the very long run in every market. They also invariably beat local bonds, although only just in some cases. But you can also see that inflation took a sizeable chunk out of returns in many countries. Overall, the average real return has been about 5% a year. Unfortunately, there isn’t anything comparable for emerging markets. Many markets aren’t very old. And for those that are, historical data is sketchy. Note that the time frames involved are much shorter. And this is price return data (i. e. ust based on the change in the index, rather than dividends). Also, these numbers cover just the benchmark index for each market, which in some cases might not be a perfect reflection of the whole market. And the inflation data could be sketchy. However on the plus side, as overseas investors, we should also benefit from rising currencies. We can also try to structure our portfolios to avoid companies and sectors that are likely to destroy value. That will mean higher returns for us – something that I’ll be discussing in the future. Effect of GDP on Stock Market

GDP is measured by the BEA quarterly. The BEA revises estimates as it receives better data throughout the next quarter. To compute economic growth, it compares each quarter to the previous one. For a summary of all GDP growth reports since Q4 2006, see GDP Current Statistics The stock market and gross domestic product (GDP) measure two separate values. The stock market is a measure of how investors value individual companies based on supply and demand while GDP gauges economic growth and contraction. Nonetheless, investors should care about both.

GDP is the broadest measure of economic activity and represents all sectors of the economy, according to Barron’s. GDP affects stock market performance in that investors rely on the indicator as a barometer for upcoming corporate profits. Stock market trading represents multiple sectors across corporate of country & globally, including technology, finance, media and health care. The major components of GDP are personal consumption and spending, investments, exports and the government, according to “Barron’s. ” GDP is considered the most comprehensive economic scorecard, according to “Barron’s. The stock market affects national economies. If economic perception is negative, investors may cut back on personal spending and buying stocks, which can interfere with a company’s growth plans. The stock market trades Monday through Friday between 9:30 a. m. ET and 4 p. m. ET. GDP is reported on a quarterly basis and is released by the Bureau of Economic Analysis and the U. S. Department of Commerce. After four straight quarters of declines in GDP, economic contraction was reversed when GDP began rising again in the third quarter of 2009, according to “The Wall Street Journal. The reversal indicated the end of a recession in the U. S. economy. Oil price: Oil prices extended a terrible influence on his stock market in the 1970s and 1980s and we are experiencing the same thing now. Some have speculated that crude oil prices could hit $ 100/ barrel in one to two years if events fall into place just right. A couple of factors are driving oil prices, like continuing increase in worldwide demand for oil. Any massive increase or decrease in crude oil has its impact on the condition of stock markets in through out the world.

The stock exchanges of every country keep a close eye on any up and downward movement of the crude oil price. There exist an inverse relationship between oil prices and equity markets. An increase in the oil prices leads to nose dive in the stock market and vise-a-versa. Market commentators and journalist like to draw direct lines between the behavior or crude oil prices and market behavior on crude oil prices and market behavior on a given day, with such headlines as “Oil Spike Pummels Stock Market ” (Wall street Journal) or “U. S. Stocks Rally as oil Prices Fall” (Finance Times).

But does a change in oil prices affect the overall stock market in any predictable meaningful way? Any movement in the oil prices results in uncertainty in the stock market. Higher the oil prices, higher the transportation, production and heating costs. There will be great combination of crude & stock market since major world economy are based on crude and US dollar. If you look at past Indian stock market has started shooting up around May 2003 to Dec 2007. As per statistics around 550% gains has been registered on monthly closing levels which has come down to 270% if we take 52 weeks levels.

Now look at crude oil statistics crude oil has started its upward journey from US $ 25 in April 2003, in December 2007 it was below $ 100 and gone up its all time highest levels $ 146 in July 2008 still Indian Stock market was keep shooting up like rocket till December. Political Factor Political instability is always bad for the stock market. Political instability in any country affects the markets. The current year we have experience ups and down because of the news/rumors of the instability of the present Dr. Manmohan government. The survival of the government was under the question due to nuclear deals.

Markets reacted very strong and looking to the volatility in the stock market the finance minister has to come in front of the media to retain the confidence of the investor. Effect of FII On Stock market In this age of transnational capitalism, significant amounts of capital are flowing from Developed world to emerging economies. Positive fundamentals combined with fast growing markets have made India an attractive destination for foreign institutional investors (FIIs). Portfolio investments brought in by FIIs have been the most dynamic source of capital to emerging markets.

At the same time there is unease over the volatility in foreign institutional investment flows and its impact on the stock market. The stock markets in India had to put up the burden in terms of being the second largest loser of foreign money in Asia accounting for 22% of the total net sales -April-May 2006. One of the reasons for the attack of Black Monday is claimed to be FIIs. Statistical records provided by Securities and Exchange Board of India (SEBI) indicated that both FIIs and domestic institutional investors together influenced market sentiment.

As per the information provided in BSE India. com during the fortnight from May 16th to May 31st 2006, the withdrawals by FIIs were to the extent of US$2. 061 billion. This explains the fact that sales of FIIs had a major impact on the market and this impact led to the crash. Apart from the impact they create on the market, their holdings will influence firm performance. For instance, when foreign institutional investors reduced their holdings in Dr. Reddy’s Lab by 7% to less than 18%, the company dropped from a high of around US$30 to the current level of below US$15.

This 50% drop is apparently because of concerns about shrinking profit margins and financial performance. These instances made analysts to generally claim that foreign portfolio investment has a short term investment horizon. Growth is the only inclination for their investment. Their strategy is –‘Why take risk when you are not in profit-exit’. According to the industry experts, hedge funds played a very active role in Indian stock market since 2003 by entering both Indian cash and derivative market. The upward trend in the domestic market is due to hedge funds and not due to regular long-term FIIs.

Thus the foreign portfolio investments are found to be very volatile in nature. Despite these observations, countries and firms are interested in attracting foreign capital because it helps to create liquidity for both the firms stock and the stock market in general. This leads to lower cost of capital for the firm and allows firm to compete more effectively in the global market place. This directly benefits the economy and the country. Availability of foreign capital depends on many firm specific factors other than economic development of the country.

Contemporary research has investigated only the portfolio preferences of FIIs from the viewpoint of fund management companies. This paper attempts to examine the specific characteristics of the firms included in sensitivity index (Sensex) of Bombay Stock Exchange and their influence in attracting more foreign institutional investment. Effect of FDI on Stock Market FDI has been touted as the magic wand that will transform “under-developed” India into an advanced nation with a “modern” infrastructure. Every government that has followed has dutifully talked of taking steps to encourage and expand FDI.

A point how the majority of FDI has come in the form of speculative investments in India’s stock market, where select scripts have seen phenomenal jumps in their stock prices, while stocks of some major Indian manufacturing companies have languished at very low valuations. Such speculative investments could leave just as easily as they came, leading to greater instability in India’s financial markets. In the power and telecom sectors, FDI has come at a very heavy price. There are a large number of studies that investigate the dynamic linkages among world equity markets.

Some of them provide evidence for integration, and some of them, against. Those studies that examine multiple countries may even provide evidence for some countries and against some others. Hamao and Masulis (1990), Kasa (1992), and Arshanapalli and Doukas (1993) present evidence for the equity markets of the developed countries being integrated. Chen et al. , (2002) for emerging markets, Gilmore and McManus (2002) between the US and three developing Central European Markets and Manning (2002) for South East Asia, all find co integrating relationships among equity markets.

In addition to those, Tokic (2003) supports the integration results for the USA and five markets; Australia, Japan, Hong Kong, New Zealand and Singapore; Cha and Oh (2000) for the Japanese, the US, Hong Kong, Korea, Singapore and Taiwan; and Ghosh et al. (1999) for the US, Hong Kong, India, Korea and Malaysia. Eun and Shim (1989) finds effects of the US equity markets on world markets, and also argue that the US is the most dominant market in the world, an argument usually supported in other studies that include the US in their sample.

Some of the studies that do not support the integrating relationship are as follows: Yang, Khan and Pointer (2003) for developed markets, DeFusco et al. 1996 for the US market and thirteen emerging capital markets, Pan et al. (1999) for six country’s equity indices. No long-term linkages between the US and European equity markets were found by Byers and Peel (1993) and Kanas (1998). Ghosh et al. (1999) does not find any effect of the USA and Japan on the stock markets of Taiwan and Thailand. A very recent study by Ozdemir et al. 2008) find long term relationship (co integration) for 8 of the 15 emerging markets they examine. For the remaining 7, including Turkey, they do not find evidence of co integration, but they document granger causality from the US, but not vice versa. Another study on Turkey was conducted by Berument and Ince 2005, who assess the effect of S return on the Istanbul Stock Exchange by using daily data. Their estimates suggest that returns on S affect ISE return positively up to four days. Data and methodology Data used in this study is the MSCI Indices for the US and for Turkey, both denominated in US Dollars.

By using indices with a common denominator, and that are constructed with same methodology, I make sure that these indices are comparable, and lead to meaningful results. As the indices represent the level of the equity markets for each country, I take the natural logarithm of both. The method first employed in this study is co integration analysis. Co integration is based on the idea that if two or more non-stationary economic variables are in an equilibrium relationship, then their stochastic trends must be linked.

In other words, co integration represents a stationary linear combination of variables that are non-stationary. That linear combination is generally considered as representing an equilibrium relationship among the factors. When two or more series are co integrated, error correction models (ECMs) can be used to examine the short-term relationships, as stated by Johansen [1988]. Error correction models are based on the idea that co integrated series can only have short-term deviations from equilibrium, and these deviations will be corrected in the long-run, thus the series will drift together.

In ECMs, there is an error correction term for each co integrating vector included in each equation in addition to the lagged values of variables. The first step in co integration analysis is to test for the presence of a unit root in each series in the system. The Augmented Dickey and Fuller [1979] (ADF) methodology is generally used for unit root tests. However, when a series is shown to have a unit root, another round of unit root tests have to be applied to the first differences of the series in order to conclude that the series is not integrated with an order higher than one.

Series with higher levels of integration should not be included in the co integration analysis when the other series are I(1). After showing the existence of unit roots in the data, the next step is testing for the presence of co integration among the series. Johansen’s [1988] maximum likelihood method is an advanced method used in estimating the systems. Johansen develops a method that corrects for the shortcoming of Engle and Granger’s [1987] original methodology. His method can test for multiple co integrating relationships among the series.

This is an important advantage when there are more than two series employed in the study because the number of co integrating relationships can theoretically be up to one less than the number of series employed. Engle and Granger methodology, which is a single equation linear regression that tests for the stationarity of the error term, is more intuitive than Johansen’s methodology, but it can not identify more than one co integrating relationship even when there is multiple co integrating relations.

Furthermore, Johansen’s method employs maximum likelihood estimation method that is more robust to non-normality in the distributions in the series, compared to the two-step process employed by Engle-Granger method. When using Johansen’s method, the system is represented by the following equation: [pic] (I) where [pic] and [pic]. Xt is the vector of the variables, and ( is the first difference operator. p is the maximum number of lags, and (t is a four dimensional identically independently distributed vector with zero mean and variance matrix ((.

The n(n ( matrix, the long run impact matrix, can be represented as the multiplication of two n(r matrices ( and ( as in ( = ((?. r represents the rank of ( matrix, and it is less than or equal to n. The test for co integration is a rank test for ( matrix. Reduced rank of ( implies that under certain conditions the process (Xt is stationary, Xt is nonstationary, but also that (’Xt is stationary. Thus we can interpret the relations (? Xt as the stationary relations among nonstationary variables, i. e. as co integrating relations.

The rank test for ( is the test for the number of characteristic roots of the ( matrix that are significantly different from zero, and it is conducted using the following log-likelihood ratio test statistics. The first test statistic, (max, tests the null that the number of co integrating vectors is r against the alternative of r+1 co integrating vectors. The second statistic, (trace, tests the null hypothesis that the number of co integrating vectors is less than or equal to r against a general alternative. max is preferred as the primary selection criteria to pin down the number of co integrating vectors, as it provides a sharp alternative hypothesis. However, (trace statistic is conventionally reported and used as a supporting test for choosing the number of co integrating vector, as it may provides a more robust test statistic in some cases. The critical values for the two tests are provided in Johansen and Juselius [1990]. After determining the rank of ( matrix as the number of co integrating vectors, coefficients of ( and ( matrices can be examined.

Significant coefficients of the ( matrix are interpreted as an indicator of adjustment of a series towards the equilibrium state represented by the co integrating relationship(s). Another such indicator is the coefficients of the error correction term(s) in the error correction models, and these two indicators can be examined together. As part of the information set provided by the ( matrix, coefficients of the ( matrix identify the linear combinations of the variables that result in a stationary (co integrated) system. When the co integration tests result show no co integrating among variables, e can use the VAR system to examine short-term influences. Instead, in this study, I employ the Toda-Yamamoto (1995) procedure to test for long run Granger causality. The procedure only requires a VAR in level, which does not lead to a loss of information due to differencing. However, the procedure allows for long run Granger causality tests only. Empirical Results The first step is testing for unit roots in the two series, LTR and LUS by using two unit root tests: augmented Dickey and Fuller (1979) (ADF), Phillips and Perron (1988) (PP).

The unit root test results are shown in Table 1. Table 1 Unit root test results | |LEVELS | | | |ADF |PP | |Intercept |LTU |-2022814(0) |-2. 189575 | | |LUS |-1. 716258(0) |-1. 716258 | |Intercept and |LTU |-2. 746078(0) |-3. 037539 | |Trend | | | | | |LUS |-1. 247228(0) |-1. 38562 | | |FIRST DIFFERENCES | | | |ADF |PP | |Intercept |LTU |-14. 71834a(0) |-14. 71655a | | |LUS |-15. 60480a(0) |-15. 60467a | |Intercept and |LTU |-14. 68701a(0) |-14. 68510a | |Trend | | | | | |LUS |-15. 66517a(0) |-15. 66517a | a denotes significance at 1% level LTR is the log of MSCI Turkey series (in US$)

LUS id the log of MSCI US series (in US$) Both unit root tests yield a similar result, which shows that LTR and LUS are both I(1). Hence, the maximum order of integration (d) is determined to be 1. As both variables are integrated of the same order, 1, next Johansen co integration tests are run by employing the two series. Table 2 Co integration test results | |  |Number of co integrating vectors | | | |  | | | |0 |


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