Information content of stock market, gold & exchange rate: An Indian market perspective

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A Dissertation On:

INFORMATION CONTENT OF STOCK MARKET, GOLD & EXCHANGE RATE:

AN INDIAN MARKET PERSPECTIVE

Submitted To: Dr. Brajesh Kumar

By:

Sukant Arora

JGU ID: 20100040

Jindal Global Business School

Contact Number: +91-9999991334

Email ID: [email protected]

mailto:[email protected]

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ACKNOWLEDGEMENT

On completion of my dissertation, I would like to express my sincere thanks to Dr.

Brajesh Kumar who guided, advised, inspired and supported me during my

project.

I am also indebted to Jindal Global Business School for giving me the opportunity

to work on this dissertation. I also take the opportunity to thank all the faculty of

the Jindal Global Business School who were directly or indirectly concerned with

the completion of my dissertation.

I would like to give full acknowledgement to the outstanding help by the library

staff of O.P Jindal Global University. I hope that this dissertation will helpful to the

readers.

Sukant Arora

Jindal Global Business School

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Introduction:

In the past and as well as in present, there is a lot of discussion on the macroeconomic variables

on the stock market movement. Several literatures are available establishing the linkage

between stock prices and macroeconomic variables indicating short term and the long term

relationship.

Over the period of time there have been numerous studies on different stock indices. For

example (Mayasami and Koh, 2000) investigated the dynamic relationship between Singapore

stock market and the empirical results of the study shows that the Singapore stock market is

sensitive to exchange rates.

The relationship between exchange rate and stock prices has always been in the mind of

economists since both the exchange rate and stock price play an important role in influencing

the development of an economy.

Traditional approach (at microeconomic level) states that exchange rates lead the stock prices

(Dornbusch and Fischer 1980), (Ajayi and Mongoue 1996), (Yau and Nieh 2006). While the

macroeconomics (portfolio balance) approach states that market mechanism determines the

exchange rates. It the round words, it is said that changes in stock price might have impact on

the exchange rate movements. (Granger et al. 2000), (Caporale et al. 2002), (Pan et al. 2007)

Casual relations between the stock prices and exchange rates are suggested in above stated

theories. However on the micro level, we have mixed results. Jorion (1991), Bartov and Bodnar

(1994), Choi and Prasad (1995) and Griffin and Stulz’s (2001) suggest that exchange rates

doesn’t influence the stock prices.

The results which presented in previous studies on relationship between the exchange rates

and stock price are best mixed. There are different results in the different economies and the

reasons behind this could be the difference in the trade volumes or there could be a difference

in the degree of capital mobility.

(Ma and Kao 1990) It states that currency appreciation has both a positive and negative effect

on the domestic stock market for a country which is export dominant and import-dominated.

Several empirical studies states the stock market becomes very sensitive to the domestic and

external factors (gold is one of such factors) once there is a financial deregulation in the

economy.

There are many examples from the history which shows that when there is a stock market

slump in an economy, the gold always tends to be higher.

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Adding to this, when we talk about the macro economy including variables such as the equity

market up and down, recession and economic prosperity, and either higher or lower consumer

price index, a layman always thinks of investing in something safe, something which has a

physical value and as well as which can be good hedge against inflation such as Gold. During the

period of stock market slump, historical data shows that gold prices tend to increase and

people show more interest to invest in gold.

International trades are generally affected by changes in the exchange rates and thus it affects

the stock market as well. When an economy’s currency is appreciating, the importers of the

domestic currency who require exchanging the same amount of any foreign currency have to

pay less which further reduces the importing costs. When the imported commodity is sold in

the economy for the same price, the profit for the firm goes up and as a result the stock price of

the firm increases. But on the other side when the economy’s currency depreciates, the

exporters of the domestic currency will receive lesser amount when they exchange the

currencies. The profit of the firm goes down as they sell at the same price and further leads to

decrease in the stock price of that firm.

The relationship of USD and Gold is perhaps the most well known in the Global Currency

markets and the USD and gold have an inverse relationship. The reason for this inverse

relationship is typically because the commodity (Gold) is used as a hedging tool against inflation

in the economy through its intrinsic metal value. When the exchange value of Dollar decreases,

it always takes more currency (Dollar) to Gold, causing increase of value of Gold against Dollar.

When the value of Dollar is at risk of fluctuation due to changes in the Monetary Policy, the

value of Gold is mostly determined by the demand and supply, and there is no interference

from changes in the corporate and monetary policies.

There were also instances of decoupling of Dollar and Gold in the past between April and

December 2005. This happened when China revalued its currency and U.S raised the interest

rates, and it facilitated them by giving opportunity to buy the commodities such as Gold. During

that period the correlation between Dollar and Gold was approximately .6579.

When there is more output from a company, its stock price tends to increase, and so as the

stock index. Indian stock market and USD shows a negative correlation. So whenever the Nifty

goes up, USD-INR goes down and vice versa. In India we see that when the stock market is

going down, people tend to invest in something which is comparatively safe or in something

which has a physical value so people tend to invest in Gold. Therefore when in there is declining

stock market, the Gold Value tends to increase so as the USD-INR. It shows that whenever the

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USD-INR increases or the value of Dollar against Indian Rupee increases, Gold also tends to

increase.

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Literature Review:

Abdalla and Murinde (1997) investigate stock prices-exchange rate relationships in the

emerging financial markets of India, Korea, Pakistan and the Philippines using monthly data

from 1985 to 1994. The empirical results show unidirectional causality from exchange rates to

stock prices in India, Korea and Pakistan. On the contrary, the reverse causation was found for

the Philippines.

Aggarwal (1981) examines the influence of exchange rate changes on U.S. stock prices using

monthly data for the floating rate period from 1974 to 1978. He finds that exchange rates and

stock prices and are positively correlated.

Ajayi and Mougoue (1996) examine the relationship between stock indices and the exchange rates using the daily data from 1985 to 1991 for the eight advanced economies. According to the results of the study, there are significant short as well as short run feedback relations among the two financial markets. Currency depreciation has a negative both short-run and long-run effect on the stock market. An increase in stock price has a positive long-run effect as well as a negative short-run effect on domestic currency value. Doong et al. (2005) examines the dynamic relationship between the exchange rates and stocks for the six Asian countries (South Korea, Taiwan, Thailand, Philippines, Malaysia and Indonesia) for more than 14 year from 1989 to 2003. Results show that the financial variables are integrated with each other. Except for Thailand, all the countries show that there is a significantly negative relation between the stock returns and the contemporaneous change in the exchange rates. Bidirectional causality can be detected in Thailand, Indonesia, Malaysia and Korea in the results of the Granger causality test. Nieh and Lee (2001) investigate the relationship between exchange rates and stock prices for the G-7 countries and from the period October 1st 1993 to February 15th 1996 take the daily closing exchange rates and stock market indices. Result of the study was that there is long run equilibrium relationship between exchange rates and stock prices for each G-7 countries. There is no correlation in the United States of America but a significant short run relationship has been found in certain G-7 countries. The results might be explained by country’s differences in government policy, economic stage etc. Tsoukalas (2003) investigates the relationship between macroeconomic factors and stock prices in Cyprus. The result of study shows strong relationship between exchange rates and stock prices. The reason of this is that Cypriot economy depends on services (import sector) such as tourism etc. Pan et al. (2007) take the data over the period of 1988 to 1998 of the seven Asian countries to examine the dynamic relationship between the stock prices and exchange rates. The results of

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the study reveal that in Hong Kong before the 1997 Asian crises there is a bidirectional causal relation. There is a unidirectional causal relation from stock prices and exchange rates for Thailand, Malaysia and Japan and stock prices to exchange rate for Singapore and Korea. In 1997 during the Asian crises, except Malaysia there is only a causal relation from exchange rates to stock prices for all the countries. Hatemi-J and Irandoust (2002) studied a causal relation between the stock prices and exchange rates in Sweden. Over the period of 1993-98 they used the stock prices and the monthly nominal effective exchange rates. A result of the study was that Granger causality is unidirectional from stock prices to exchange rates.

Kim (2003) over the period 1974-1998 uses monthly data in the United States of America and

the empirical results of the study reveal that Standards & Poor’s common stock price is

negatively related to the exchange rate.

Ozair (2006) investigates the causal relationship between exchange rates and stock prices in the

United States of America by using the quarterly data over the period 1964-2000. Results of the

study showed that there is no integration and no causal relationship between stock prices and

exchange rates.

Muhammad and Rasheed (2002) investigates the relationship between exchange rates and

stock prices for the countries like India, Sri Lanka, Bangladesh and Pakistan using the monthly

data from 1994 to 2000. The empirical results of the study show that for Bangladesh and Sri

Lanka there is bi-directional long run causality between exchange rates and stock prices. No

relationship found between exchange rates and stock prices for Pakistan and India.

Smyth and Nandha (2003) examine the association between stock prices and exchange rates for

the countries like Bangladesh, Pakistan, Sri Lanka and India over the period 1995-2001. Results

of the study made it clear that there is no long run relationship between exchange rates and

stock prices. Also, there is unidirectional causality running from exchange rates to stock prices

for only Sri Lanka and India. Stock Prices got influenced by change in exchange rates through

influencing firm’s export in Sri Lanka and India.

Ajayi et al. (1998) examines causal relationship between changes in exchanges rates and stock

returns for the eight Asian emerging markets from 1987 to 1991 and for seven advanced

markets from 1985 to 1991, by taking the daily exchange rates and market indexes. The

empirical results of the study show that there is unidirectional causality between the exchange

rates and the stock price in all the advance economies, while there is no consistent causal

relationship between exchange rates and stock prices in emerging markets. They differentiated

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advanced and emerging economies by drawing our differences in the characteristics and

structure of financial markets between these groups.

Erbaykal and Okuyan (2007) for the 13 developing economies investigate relationship between

stock price and exchange rates using different time periods for each economy. Empirical results

of the study clearly show that there is a causality relation for eight economies. There is

unidirectional causality from stock prices to exchange rates in five economies and bidirectional

causality relation is there for three economies.

Wang et al. (2001) explored the impact of fluctuations in gold price and exchange rates of U.S

Dollar vs. various currencies on the stock prices indices of the United States, Germany, Taiwan,

Japan and China as well as the short and long term correlations between these variables.

Empirical results of the study show that there is existence of co-integration among fluctuations

in gold price and the exchange rate of the dollar vs. various currencies indicating there is long

term stable relationship between these variables.

Ibrahim and Aziz (2003) used monthly data over the period 1977-1998 to analyze the dynamic linkages between the four macroeconomic variables and stock prices for Malaysia. The empirical results show that stock prices are negatively associated with the exchange rates. Kurihara (2006) investigates the relationship between daily stock prices and macroeconomic variables in Japan from March 2001 to September 2005. He takes exchange rate (Yen/U.S Dollar), the Japanese interest rate, U.S stock prices and Japanese stock prices for the study. The empirical results show that Japanese stock prices are not influenced by domestic interest rate. However the Japanese stock prices are affected by the U.S stock prices and exchange rate i.e. Yen/U.S Dollar. Japanese stock prices were influenced by the quantitative easing policy which was implemented in 2001.

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Objective of the Study:

To determine the relationship between the Indian Stock Market; Gold prices and the

exchange rate i.e. USD- INR (U.S Dollar and Indian Rupee) during the pre and post crisis

period.

The study will help in creating a hedging strategy so that an efficient portfolio can be

created.

The study will analyze the data from January 2005 to December 2007 and January 2009 to

July 2011.

Data and Methodology:

Daily closing price of S&P CNX Nifty, Gold and USD/INR exchange rate obtained from the

National Stock Exchange, Gold.org and Reserve Bank of India constitutes the data set from

January 2005 to December 2007 and January 2009 to July 2011. The gold prices, stock index

and the USD/INR are continuously rate of returns, computed as the first difference of the

natural logarithm of the daily gold price, USD/INR exchange rate value and stock index.

Basic statistical analysis of the data which will include time series analysis will be done with the

help of Ms. Excel.

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Basic Characteristics of the DATA SET:

Standard Deviation

Maximum Value

Minimum Value

USD-INR 2.6897 52.0600 39.27

NIFTY 1221.3870 6312.4500 1902.5

GOLD 4628.4092 23032.5988 5771.936698

Correlation USD-INR & NIFTY NIFTY & GOLD USD-INR & GOLD

2005 -0.1131 -0.1333 0.1712

2006 -0.0986 -0.0202 0.1402

2007 -0.1944 0.0234 0.1405

2008 -0.1747 -0.0143 -0.0872

2009 -0.1045 -0.0284 0.0993

2010 0.0964 0.0021 0.0034

2011 -0.2863 -0.0113 -0.1000

Correlation USD-INR & NIFTY NIFTY & GOLD USD-INR & GOLD

Before Crisis -0.1382 -0.0172 0.1380

Crisis Period -0.1747 -0.0143 -0.0872

After Crisis -0.0796 -0.0256 0.0571

USD-INR & NIFTY NIFTY & GOLD USD-INR & GOLD

Correlation -0.1074 -0.0210 0.0515

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-0.3000

-0.2500

-0.2000

-0.1500

-0.1000

-0.0500

0.0000

0.0500

0.1000

0.1500

0.2000

2005 2006 2007 2008 2009 2010 2011Correlation USD-INR & NIFTY

Correlation NIFTY & GOLD

Correlation USD-INR & GOLD

-0.1500

-0.1000

-0.0500

0.0000

0.0500

0.1000

0.1500

0.2000


Correlation 2005

Correlation 2005

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-0.1500

-0.1000

-0.0500

0.0000

0.0500

0.1000

0.1500

0.2000


Correlation 2006

Correlation 2006

-0.2500

-0.2000

-0.1500

-0.1000

-0.0500

0.0000

0.0500

0.1000

0.1500

0.2000


Correlation 2007

Correlation 2007

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-0.2000

-0.1800

-0.1600

-0.1400

-0.1200

-0.1000

-0.0800

-0.0600

-0.0400

-0.0200

0.0000


Correlation 2008

Correlation 2008

-0.1500

-0.1000

-0.0500

0.0000

0.0500

0.1000

0.1500


Correlation 2009

Correlation 2009

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0.0000

0.0200

0.0400

0.0600

0.0800

0.1000

0.1200


Correlation 2010

Correlation 2010

-0.3500

-0.3000

-0.2500

-0.2000

-0.1500

-0.1000

-0.0500

0.0000


Correlation 2011

Correlation 2011

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-0.2000

-0.1500

-0.1000

-0.0500

0.0000

0.0500

0.1000

0.1500

0.2000


Correlation Before Crisis

Correlation Before Crisis

-0.2000

-0.1500

-0.1000

-0.0500

0.0000


Correlation Crisis Period

Correlation Crisis Period

-0.1000

-0.0800

-0.0600

-0.0400

-0.0200

0.0000

0.0200

0.0400

0.0600

0.0800


Correlation After Crisis

Correlation After Crisis

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USD-INR & NIFTY:

The result of the study carried out shows that during the most of the period, there is a negative

correlation between the USD-INR and the S&P CNX NIFTY. It shows that when the value of the

domestic currency appreciates in comparison to the foreign currency, US Dollar in this case, it

takes less amount of domestic currency in order to exchange for the foreign currency and thus

importers have to pay less and exporters could gain more. As a result output of the firm or a

company increases and further leads to increase in the stock price, ultimately leading to the

upward trend of stock market. On the contrary when an economy’s domestic currency

depreciates, it takes more domestic currency in order to exchange the foreign currency and

thus leading to less profit on exports and more cost of importing the goods. This cause in

reduction of the output and profits as well, thus we can see decline in the stock price of a

company or a firm further leading to downward trend in the stock market. Here we see that

during the global financial crisis period, negative correlation among two goes on increasing,

which clearly indicates the negative relationship in both the variables. But we can also see that

during certain periods the correlation was positive as well, the reasons for this were more

foreign direct investment in our economy, our poor gross domestic production and the global

appreciation of the US Dollar.

-0.3500

-0.3000

-0.2500

-0.2000

-0.1500

-0.1000

-0.0500

0.0000

0.0500

0.1000

0.1500

2005 2006 2007 2008 2009 2010 2011

Correlation USD-INR & NIFTY

Correlation USD-INR & NIFTY

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USD-INR & GOLD:

The relationship of USD and Gold is perhaps the most well known in the Global Currency

markets and the USD and gold have an inverse relationship. The reason for this inverse

relationship is typically because the commodity (Gold) is used as a hedging tool against inflation

in the economy through its intrinsic metal value. When the exchange value of Dollar decreases,

it always takes more currency (Dollar) to Gold, causing increase of value of Gold against Dollar.

The result of the study carried out shows that during the pre-crisis period there was a positive

correlation between the two variables and during the post crisis period we see evident negative

correlation. We observe that whenever the Indian currency depreciates, causing a decline in

stock market, Gold is always the first and the safest choice to invest.

When an economy’s currency is appreciating, the importers of the domestic currency who

require exchanging the same amount of any foreign currency have to pay less which further

reduces the importing costs. When the imported commodity is sold in the economy for the

same price, the profit for the firm goes up and as a result the stock price of the firm increases.

But on the other side when the economy’s currency depreciates, the exporters of the domestic

currency will receive lesser amount when they exchange the currencies. The profit of the firm

goes down as they sell at the same price and further leads to decrease in the stock price of that

firm.

-0.1500

-0.1000

-0.0500

0.0000

0.0500

0.1000

0.1500

0.2000

2005 2006 2007 2008 2009 2010 2011



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NIFTY & GOLD:

The result of the study carried out shows that during the most of the period, we observed both

the positive and the negative correlation among the two variables. The reason for this is Gold

having a good physical value. People have a strong tendency to buy Gold in India as it is

considered as a safe investment because of the physical value and people in India buy Gold

because of the emotional quotient as well as it is considered the best commodity for auspicious

occasions.

Despite this factor, we see a negative correlation between the two variables because when

people we see that a stock is not performing well, so as the stock market and they are not

satisfied with the returns they get from the stock market, they for the safest investment in Gold

considering it has a good physical value. Therefore more investment in gold (more demand)

causes increase in gold prices. So whenever we see a stock market slump, we observe rise in

prices of Gold as people see Gold as a safe investment, showing the negative correlation

between two variables.

-0.1600

-0.1400

-0.1200

-0.1000

-0.0800

-0.0600

-0.0400

-0.0200

0.0000

0.0200

0.0400

2005 2006 2007 2008 2009 2010 2011



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ROOT MIN SQAURE ERROR ANALYSIS:


Correlation -0.1074 -0.0210 0.0515

RMSE 150 0.1223 0.0743 0.1129

RMSE 100 0.1679 0.0923 0.1329

RMSE 50 0.1679 0.1313 0.1634

RMSE 25 0.2190 0.1894 0.2116

As we are increasing the moving correlation from data set of 25 variables to data set of 150

variables, we can observe that error is becoming less but on the contrary we are losing the

variables.

-0.1500

-0.1000

-0.0500

0.0000

0.0500

0.1000

0.1500

0.2000

0.2500

Correlation RMSE 150 RMSE 100 RMSE 50 RMSE 25

USD-INR & NIFTY

NIFTY & GOLD

USD-INR & GOLD

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0.0000

0.0500

0.1000

0.1500

0.2000

0.2500

RMSE 150 RMSE 100 RMSE 50 RMSE 25

USD-INR & NIFTY

USD-INR & NIFTY

0.0000

0.0500

0.1000

0.1500

0.2000


NIFTY & GOLD

NIFTY & GOLD

0.0000

0.0500

0.1000

0.1500

0.2000

0.2500


USD-INR & GOLD

USD-INR & GOLD

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Hedging Strategies:

Long investment in the stock market can be hedged by a long investment of the equal

amount of the currency pair i.e. USD-INR or equivalent long investment in Gold. In

currency segment currency options are the best hedging tools.

Long investment in the currency market can be hedged by a long investment of the

equal amount in stock market or equivalent long investment in Gold.

Long investment in the gold can be hedged by a long investment of the equal amount of

the currency pair i.e. USD-INR. In currency segment currency options are the best

hedging tools

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