Dividend policies of indian companies & volatility in its share pricesANALYSIS AND CONTRAST OF DIVIDEND POLICIES OF INDIAN COMPANIES AND VOLATILITY IN ITS SHARE PRICES

CHAPTER1

Introduction

1.1 Dividends polices and share volatility: An Overview

In this section we take an overview of the dividend policy and volatility of the stock market. When we think about stock market, we think about its volatile nature. Fickleness is the necessary part of the market. Volatility in stock market is the relative rate at which the price of a security moves up and down. In financial terms, volatility is the degree to which the price of a security, commodity, or market rises or falls within a short-term period (Mullins, 2000). According to researchers, volatility is a polite way of referring to investor`s anxiety Charest (1978) and Titman (1984). Many analysts like Fama, Fischer believe that increased volatility can indicate a rebound. In simple terms, if the price of a stock moves up and down rapidly over short time periods, it has high volatility. If the price almost never changes, it has low volatility. Many Investors feel that when volatility is high, it's time to buy but when it is low you should not step into market. On the contrary, a number of studies have also shown that when volatility increases, there is a better chance that the stock market is suffering losses. Basically, when the stock market is rising, volatility tends to decay. On the other hand when the stock market falls, volatility tends to rise. However, volatility can be good in that if we buy on the lows, you can make money. Short term market players hope to make money through volatility. Now if we take an overview of dividend policy, dividend refers to that portion of the profits of a company which is owed to the holders of shares by a formal

statement in the yearly general meeting of the firm. In other words, it refers to the profit on shares held by a stockholder. Every firm enjoys and characteristic power to state and allocate dividend. Such a power need not expressly be authorised by the memorandum or the articles of the company though the articles may regulate the manner in which dividends are to be distributed. Paying large dividends decreases risk and thus affect stock price (Gordon, 1963) and is a substitution for the future incomes (Baskin, 1989). A quantity of theoretical mechanisms has been instructed that root dividend yield and pay-out ratios to vary inversely with common stock volatility.

1.2 Problem statement - Require a methodical examination of Volatility and Dividend Policy

Different schemes that cause dividend yield and pay-out ratios to differ inversely with joint stock volatility are duration effect, rate of return effect, arbitrage pricing effect and information effect. Duration effect suggests that high dividend profit brings extra near term cash flow. If dividend policy is continuously high, dividend stocks will have a smaller duration. (Gordon Growth Model) can be used to forecast that high-dividend will be fewer delicate to fluctuations in reduction rates and thus must show lower price volatility. Model as settled by Jensen and Meckling (1976) suggested that dividend payments decrease costs and increase cash flow, that is payment of dividends motivates administrators to pour out cash rather than capitalising at below the cost of capital or wasting it on basic inefficiencies .Some authors have stressed the reputation of information content of dividend (Asquith and Mullin, 1983; Born, Moser and officer 1983).

1.3 Behaviour of Dividend Policies and Volatility in Indian Stock Market and Details to Discuss:

The behaviour of dividend policy is one of the very important issues for the Indian stock market. It is the most debatable issue and still keeps its prominent place. Many researches have been conducted by the well known researchers. Lintner, Brealey and Myers provided the theories regarding the determinants of dividend policy. But the issue is still unresolved. As it will be discussed that many researchers try to cover the issues regarding the dividend behaviour of volatility and dividend policy but we still don't have an acceptable explanation for the observed dividend behaviour of firms. It will be discussed to cover the complete factors that derive the dividend policy decision and the way these

factors interact. One of the renowned dividend behaviours is the smoothing of firm's dividends vis-�-vis earnings and growth. Lintner (1956) in his research found that firms in India adjust their dividends smoothly to maintain a target long run pay-out ratio and Lintner(1956) findings regarding the dividend smoothing have also been confirmed by numerous studies. The smoothing of the dividend is the well known empirical fact but the empirical evidence is based on Indian market. The dividend policy of the companies varies from country to country due to various institutions and stock market differences. The Brealey and Myers (2005) list dividends as one of the top ten important unresolved issues. The today's picture regarding the dividend is the same as the Black (1976) says that dividend is the primary puzzle in the Stock market and especially in case of India. There is no doubt that in stock market of India dividend policy is totally different from the developed countries. Dividends can be divided into following categories.

1.Cash Dividends: Cash has to be paid in this dividend, usually quarterly. These are also termed as regular dividends.

2.3.Extra dividends: These are unlikely repeated dividends "extraordinary"

or "special". Both regular and "extra" dividends declared by companies.

4.5.Stock dividend: Shareholders receive new stock in the corporation as

a form of a dividend. A stock dividend is commonly expressed as a proportion; with a 2 % stock divided a shareholder receives one new share for every 50 currently owned. Like a "stock split", the quantity of shares rises, but no cash changes hands. The entire value of the firm does not change. Value per share is reduced by both cash dividends and stock dividends.

According to Lintner (1965) and Fama (2001) Firms have long-run target dividend outgoing ratios. Developed firms with steady earnings generally have a higher dividend pay-out ratio than advance companies. Why do firms pay dividends? If stockholders have to pay greater taxes on dividends than in investment gains, then firms that pay dividends should have a greater cost of equity than firms that do not pay dividends. Cash dividends are cash in hand, while investment gains are not. Investment gains to be expected in the future should be riskier than the dividends expected today. The several reasons to make up the study on dividend policies and volatility in Indian stock exchange are as follows.

1.Perceptions vary about the spreading of Indian stock prices.2.3.There is a necessity for a study on volatility and dividend policies in

Indian stock markets after 2000 to see whether changes in stock

market structure have bring about in changes in volatility pattern and smoothing international comparison of volatility and dividend policies of Indian stock market.

4.5.Comparison of time series volatility of Indian equity market with other

emerging and established markets, volatility under different market conditions may shed stimulating light on the developing characteristics of Indian Stock market. The increased participation of institutional investors, global economic crisis and its aftermath on world stock markets in general and India in particular calls for a comparative study on volatility in emerging and developed stock markets.

6.7.At the level of investor, frequent and wide stock market variations

cause hesitation about the value of an asset and affect the sureness of the investor. Risk adverse investors may shy away from market with frequent and sharp price movements. An understanding of volatility over a period of time is significant from the point of view of individual investors.

1.4 Research Aims and Objectives:

The primary aim of this research is to develop an elaborate discussion on how the volatility is prevailed in the Indian stock market and the dividend policies of different firms. The objectives of the study are to investigate how Indian firms set their dividend policies in there individual institutional environment than that of developed markets in contrast to stock market of United Kingdom. Particularly this study examined whether Indian firms follow stable dividend policies as in developed markets where dividend smoothing is stylised fact in long run. The research also identifies the areas of firm level factors that influence the degree of dividend smoothing and study of volatility in Indian stock market.

1.5 Methodology

The research methodology illustrates the processes that take place in the development of a thesis, the manner the researcher should progress; the way of measuring its success, and the factors contributing to the effectiveness of the study. This chapter is dedicated to elaborating the various research approaches for the study. This is critical since research methodologies are the foundation upon which the research will be developed. The way we have decided the methodology will depend on two objectives one is to elucidate on how the data were collected and the second is to explicate the manner upon which the

data are analysed. Further, this section will explain the means by which the researcher came about the data since there are several methods of data collection. Through an explanation of the research methodologies, the reader would be able to assess the reliability or credibility of the research. However, these methods will not be employed by the research for the reason that the qualitative analysis will be used which will come in the manner of reviewing documents pertinent to the topic. A quantitative approach necessitates a more in-depth investigation of information while a qualitative approach entails a more profound load of evidence. The methodology is the fusion, created as the mixed or combined method. The mixed method employed the attributes of both the qualitative and quantitative design. It also utilises the data gathering and analysis in a way parallel with both methods. As trading is believed to be more flourishing in the Indian stock market so transparency of trading system is lacked in the stock market. Earlier there is no law against the volatility. After SEBI was formed investigations about trading are carry out in specific cases. Greater transparency in transactions will make insider trading more difficult to hide we use The agency theory of dividend, The signalling theory, The model used in this study is a cost minimisation model, Parkinson Model and Garman and Klass model where an attempt is made to capture the factors that are likely to be important in influencing the dividend policy of firms operating in the Indian environment.

1.6 Overview of the Dissertation

Chapter 1 is a general summary and a brief introduction of the study. It mapped out the research aims, objectives and research questions, and an overview of the dissertation. Chapter 2 will be the Critical review of the related literature that will put the study.. It will proceed with addressing the research objectives, thereby meeting the research aims. Chapter 3 will present a detailed picture of the methodology. Chapter 4 will expound on the discussions of the study and the final chapter shall present the conclusions and recommendations of the study.

CHAPTER 2

Critical Review of Literature

2.1 Introduction

Dividend policy has been the subject of investigation and debate for almost 50 years, most of it conducted in the United Kingdom. Before regression analysis was applied by John Lintner in 1956 to the behaviour of a small group of industrial companies, dividends were good and should be maximised by firms wherever possible. Lintner, who showed that firms adopted and tended to adhere to optimal long-term dividend pay-out ratios which were relatively stable, suggested that managers would only raise a firm's dividend if they were confident that the firm's future earnings could be maintained at a consistently higher level in the future. An implication of this was that the announcement of a dividend increase might convey useful information about future earnings. Lintner's work (and the work of Darling (1957) who confirmed the relationship between dividends and past and current earnings) opened a Pandora's Box of dividend-related phenomena, the validity of which, other researchers have spent years and decades debating closely1. In a series of researches at the beginning of the 1960s, Miller and Modigliani (in particular, Miller and Modigliani, 1961) provided a mathematically consistent theory of capital structure in which dividends were shown to be irrelevant to a firm's value. But this did not appear to coincide with the observed behaviour of dividend policy-setters in a sufficiently watertight fashion. A competing theory, which stated that dividends directly contributed to the value of a firm, was produced by Gordon (1962).Gordon's model2 for the valuation of a firm's share price. Hence, the current dilemma concerning the role of dividends in the stock market was laid bare almost forty years ago. It is best summed up in the words of Black (1976):"The harder we look at the dividend picture, the more it seems like a puzzle, with pieces that just don't fit together."But the debate was, however, broadened by Miller and Modigliani (1961), who added several adjuncts to their assertion of dividend irrelevance to the firm's value. One of these was the existence of tax clienteles. Investors would choose the kind of firm they wanted to invest in with respect to the firm's dividend policy and thereby sort themselves into clientele groups. Investors who wished to accumulate long-term wealth would choose firms with low or zero dividend pay-outs, while those who wished to have a steady dividend income to meet short-term consumption needs would invest in firms with a tradition of high dividend pay-out ratios.3

1 Lintner's findings have been reconfirmed by a large number of studies over the decades. Early confirmations with respect to United Kingdom data were made by Brittain (1964), Brittain (1966), and Fama and Babiak (1968). McDonald, Jacquillat and Nussenbaum (1975) observed dividend policies in France; Chateau (1979) published results with respect to Canadian companies; Shevlin (1982) observed the stability of dividend policies in India. More recently Leithner and Zimmermann (1993) tested the dividend stability of West German (prior to

Unification), British, French and Swiss companies; and Dividend stability in the United Kingdom was further assessed by Lasfer (1996). Dividend policies in Japan were found to be stable by Kato and Loewenstein (1995), and also by Dewenter and Warther (1998), who compared the Japanese market with the market in India. Adaoglu himself however, observing firms on the Indian Stock Exchange, confirmed Glen, Karmokolias, Miller and Shah (1995), who found relatively unstable dividend policies in emerging markets. 2 This has been shown to be based on at least one flawed assumption (Brennan, 1971), but has not been disproved to the satisfaction of all scholars.

The existence and effects of tax clienteles have been analysed by a large number of scholars. Brennan (1971), for instance, argued that the existence of a clientele effect would logically have no impact on the value of the firm, while Long (1978) and Litenberger and Ramaswamy (1982) presented evidence that it did. No clear, irrefutable resolution to this debate has yet emerged. A further kind of clientele has also been discussed by Black and Scholes (1974) and Pettit (1977. The other important adjunct Miller and Modigliani posited was that a firm's choice of dividend might be seen as a signal to investors (actual and potential), which contained hitherto unavailable information concerning the firm's future earnings prospects. This conclusion was to be the starting point of a forty-year record of research into the existence and nature of signals putatively broadcasted in dividend announcements. But dividend research did not develop in isolation from other major developments. The 1950s and 1960s were fertile times in the development of financial economics. It was in this period that Sharpe (1964) and Lintner (1965) developed the Capital Asset Pricing Model (CAPM). This development in particular, provided stimulus for investigation of dividend policy behaviour associated with volatility. 3 The pay-out ratio measures the dividend paid out as a percentage of net profit after tax available for potential distribution to shareholders. In fact, it was not until the tail end of the 1970s that a proper basis for a theory of dividend policy was formulated. During the last fifty years the several theoretical and empirical studies are done leading to the mainly three outcomes: the increase (decrease) in dividend pay-out affect the market value of the firm or the dividend policy of the firm does not affect the firm value. Furthermore there are numerous theories on why and when the firms pay dividends. Miller and Modigliani (1961) suggest that in perfect markets, dividend do not affect firms' value. Shareholders are not concerned to receiving their cash flows as dividend or in shape of capital gain, as far as firm's doesn't change the investment policies. In this type of situation firm's dividend pay-out share effect their residual free cash flows and the result is when the free cash flow is positive firms decide to pay dividend and if negative firm's decide to issue shares. It is concluded that change in dividend may be conveying the information to

the market about firm's future earnings. Gordon and Walter (1963) present the bird in the hand theory which says that investors always prefer cash in hand rather then a future promise of capital gain due to minimising risk. The agency theory of Jensen and Meckling (1976) is based on the conflict between managers and shareholder and the percentage of equity controlled by insider ownership should influence the dividend policy. Easterbrook (1984) gives further explanation regarding agency cost problem and says that there are two forms of agency costs; one is the cost monitoring and other is cost of risk aversion on the part of directors or managers. The explanation regarding the signalling theory given by Bhattacharya (1980) and John Williams (1985) dividends allay information asymmetric between managers and shareholders by delivering inside information of firm future prospects. Miller and Scholes (1978) find that the effect of tax preferences on clientele and conclude different tax rates on dividends and capital gain lead to different clientele. Life Cycle Theory explanation given by the Lease (2000) and Fama and French (2001) is that the firms should follow a life cycle and reflect management's assessment of the importance of market imperfection and factors including taxes to equity holders, agency cost asymmetric information, floating cost and transaction costs Catering theory given by Baker and Wurgler (2004) suggest that the managers in order to give incentives to the investor according to their needs and wants and in this way cater the investors by paying smooth dividends when the investors put stock price premium on payers and by not paying when investors prefer non payers. As regards the empirical literature the roots of the literature on dividend policy is related to Lintner (1956) seminal work after this work the model is extended by the Fama and Babiak (1968). D'Souza (1999) finds negatively relationship between agency cost and market risk with dividends pay-out. However, the result does not support the negative relationship between dividend pay-out policies and investment opportunities. The empirical analysis by Adaoglu (2000) shows that the firms listed on Indian Stock Exchange follow unstable cash dividend policy and the main factor for determining the amount of dividend is earning of the firms. DeAngelo (2004) document highly significant association between the decision to pay dividends and the ratio of earned equity to total equity controlling for size of the firm, profitability, growth, leverage, cash balance and history of dividends. In addition, the dividend payments prevent significant agency problems since the retention of the earnings give the managers' command over an additional access to better investment opportunities and without any monitoring. Eriotis (2005) reports that the western firms distribute dividend each year according to their target pay-out ratio, which is determined by distributed earnings and size of these firms. Stulz (2005) observe significant association between decision to pay dividends and contributed capital mix. In investigating the determinants of dividend

policy of Indian stock Exchange Naceur (2006) find that the high profitable firms with more stable earnings can manage the larger cash flows and because of this they pay larger dividends. Moreover, the firms with fast growth distribute the larger dividends so as attract to investors. The ownership concentration does not have any impact on dividend payments. The liquidity of the firms has negatively impacted on dividend payments. In Indian case Reddy (2006) show that the dividends paying firms are more profitable, large in size, and growing. The corporate tax or tax preference theory doesn't appear to hold true in Indian context. Amidu and Abor (2006) find dividend pay-out policy decision of listed firms in Indian Stock Exchange is influenced by profitability, cash flow position, and growth scenario and investment opportunities of the firms. Megginson and Eije (2006) observe that the dividend paying tendency of fifteen European firms decline dramatically over this period 1989 to 2003. The increase in the retained earnings to total equity doesn't increase the pay-out ratio, but company age does. They also find that the effect of catering the dividend systematically which is nor conclusive evidence of continent and wide convergence in dividend policy. Baker (2007) reports that Indian dividend paying firms are significantly larger and more profitable, having greater cash flows, ownership structure and some growth opportunities. Daniel (2007) concludes that managers treat expected dividend levels as a vital earning threshold for Indian firms. Jeong (2008) identifies that the Indian firms make dividend payments on the basis of firm's stock face value which is very close to the average interest rate of deposits. The change in dividends is less likely to reflect change in fundamentals of the firms. They find the determinants of dividend smoothing, firm risk, size and growth factors play very important role in explaining the cross section of smoothing the dividend behaviour. One branch of this literature has focused on an agency-related rationale for paying dividends. It is based on the idea that monitoring of the firm and its management is helpful in reducing agency conflicts and in convincing the market that the managers are not in a position to abuse their position. Some shareholders may be monitoring managers, but the problem of collective action results in too little monitoring taking place. Thus Easterbrook (1984) suggests that one way of solving this problem is by increasing the pay-out ratio. When the firm increases its dividend payment, assuming it wishes to proceed with planned investment, it is forced to go to the capital market to raise additional finance. This induces monitoring by potential investors of the firm and its management, thus reducing agency problems. Rozeff (1982) develops a model that underpins this theory, called the cost minimisation model. The model combines the transaction costs that may be controlled by limiting the pay-out ratio, with the agency costs that may be controlled by raising the pay-out ratio. The central idea on which the model rests is that the optimal pay-out ratio is at the level where the sum of these two types of costs is minimised. Thus Rozeff's

cost minimisation model is a regression of the firm target pay-out ratio on five variables that proxy for agency and transaction costs. Transaction costs in the model are represented by three variables that proxy for the firm's historic and predicted growth rates and risk. High growth and high risk imply greater dependency on external finance due to investment needs, and in order to honour financial obligations, respectively. More support and further contribution to the agency theory of dividend debate, is provided by Moh'd, Perry and Rimbey (1995). These authors introduce a number of modifications to the cost minimisation model including industry dummies, institutional holdings and a lagged dependent variable to the RHS of the equation to address possible dynamics. The results of a Weighted Least Squares regression, employing panel data on 341 UK firms over 18 years from 1972 to 1989 support the view that the dividend process is of a dynamic nature. The estimated coefficient on the institutional ownership variable is positive and significant, which is in line with tax explanations but contradicts the idea about the monitoring function of institutions. Holder, Langrehr and Hexter (1998) extend the cost minimisation model further by considering conflicts between the firm and its non-equity stakeholders and by introducing free cash flow as an additional agency variable. The study utilises panel data on 477 UK firms each with 8 years of observations, from 1983 to 1990. The results show a positive relation between the dependent variable and the free cash flow variable, which is consistent with Jensen (1986). Likewise the estimated coefficient on the stakeholder theory variable is shown to be significant and negative as predicted. The estimated coefficients on all the other explanatory variables are also shown to be statistically significant and to bear the hypothesised signs. Hansen, Kumar and Shome (1994) also take a broader view of what constitutes agency costs, and apply a variant of the cost minimisation model to the regulated electric utility industry. The prediction is that the agency rationale for dividend should be particularly applicable in the case of regulated firms because agency costs in these firms extend to conflicts of interests between shareholders and regulators. Results of cross sectional OLSQ regression for a sample of 81 UK utilities and for the period ending 1985 support the cost minimisation model and the contribution of regulation to agency conflicts in the firm. Another innovative approach to Rozeff's cost minimisation model is offered in Rao and White (1994) who applies it to 66 private UK firms. Using a limited dependent variable, Maximum Likelihood (ML) technique, the study shows that an agency rationale for dividends applies even to private firms that do not participate in the capital market. It will be noted that perhaps by paying dividends by private firms can still induce monitoring by bankers, accountants and tax authorities. To summarise, the agency theory of dividend in general, and the cost minimisation model in particular, appear to offer a good description of how dividend policies are determined. The variables in

the original cost minimisation model remain significant with consistently signed estimated coefficients, across the other six models reviewed above. Specifically, the constant is, without exception, positively related to the dividend policy decision, while the agency costs variable, the fraction of insider ownership, is consistently negatively related to the firms' dividend policy. The latter is with exception of the study by Schooley and Barney (1994) where the relationship is found to be of a parabolic nature. Similarly, the agency cost variable, ownership dispersion, is consistently positively related to the firm's dividend policy, while the transaction cost variable, risk, is consistently negatively related to the firm's dividend policy regardless of the precise proxy used. The other transaction cost proxies, the growth variables, are also mainly significant and negatively related to the firm's dividend policy, although past growth appears to be a less stable measure than future growth. However, in spite of the apparent goodness of fit of the cost minimisation model to UK data, its applicability to the Indian case may be challenged. Indeed, Samuel (1996) hypothesises that agency problems are less severe in India compared with the UK. In contrast, it may be argued that some aspects of the Indian economy imply a particular suitability of the agency theory, and of the cost minimisation model, to this economy. Notably, as explained in Haque (1999) many developing countries, including India, established state-centred regimes following their independence. These regimes drew their ideology from socialist and Soviet ideas and were accompanied by highly centralised economic policies, which may increase agency costs in at least three ways as follows. First, such policies may increase managers' agency behaviour. Indeed Joshi and Little (1997) note that when domestic firms enjoy subsidies or a policy of protectionism, the pressure on managers to become more efficient is relaxed. Second, high state intervention means an extension of agency problems to shareholder-administrator conflicts. Indeed, Hansen, Kumar and Shome (1994) show that the degree of industry regulation enters the dividend policy decision. Third, to the extent that management of the economy is based on social philosophies of protecting the weaker sectors such as employees or poorer customers, this may influence managers to consider the interests of non-equity stakeholders. This implies that stakeholder theory should be particularly relevant to the Indian case, and, as shown by Holder, Langrehr and Hexter (1998) this may lead to a downward pressure on dividend levels. However, the relevance of stakeholder theory to the Indian case also implies extension of agency problems to conflicts of interests between equity holders and other stakeholders, increasing the need for shareholders to monitor management behaviour. It is thus the case that on the one hand stands the prediction by Samuel (1996) that agency costs should be lower in the Indian business environment. This implies that the agency rationale for dividends should be less applicable in the case of India. To contrast

this, the agency rationale for dividends is predicted to become particularly applicable to India, due to the extension of agency conflicts on at least three accounts as explained above.

2.2 The cost and agency theory of dividend

The literature on dividend policy is mainly concerned with explaining observations on the dividend practices of firms. For example Lintner (1956) observes that dividend policy is important to managers and that the market reacts positively to dividend increase announcements and negatively to decreases. Two important theories to explain these observations include the signalling and agency theories of dividend. The signalling theory of dividend emphasises the role of dividend in conveying information about the prospects of the firm. The agency theory of dividend emphasises the role of dividend in controlling agency behaviour. In both cases dividend reduce information or agency problems but the limitation of using dividend for these purposes is the firm dependency. In the signalling models of Bhattacharya (1979) and Miller and Rock (1985) it is assumed that there is preference for internal finance and that dependency on external finance partly explains firm's dividend policies. What distinguishes between good and bad quality firms is that in the case of the former the gain from high dividend more than offset the associated cost. In Bhattacharya (1979) frictionless access to extra external financing is assumed to be unavailable, and the cost of paying high dividend is the issue cost of having to resort to outside financing to meet the dividend commitment which implies that firms that face lower issue costs are able to use more signalling, In Miller and Rock (1985) the cost of paying high dividend is the need to cut planned investment. And thus the firm's dividend policy is partly determined by the need for funds for expansion. Moreover, dependency on external finance explicitly enters the dividend model in a number of studies. For example, in the cost minimisation model of Rozeff (1982), the optimal pay-out ratio is at the level that minimises the sum of agency costs and the cost of raising external finance. Similarly in Higgins (1972) the optimal pay-out ratio is at the level that minimises the sum of the cost of holding idle resources and the cost of issuing external finance. Hence as is implied in the signalling theories of Bhattacharya (1979) and Miller and Rock (1985), the optimal dividend policy in Rozeff (1982) and in Higgins (1972) is explicitly modelled as an inverse function of dependency on external finance. This inverse relationship between dependency on external finance and the firm's dividend policy is referred to as the transaction cost theory of dividend. In Rozeff (1982), dependency on external finance is measured in terms of growth prospects and firm's risk. Other possible proxies for dependency on external finance include issue costs, ease of access to

capital markets and the availability of surplus cash. However, regardless of how dependency on external finance is measured, the transaction cost theory of dividend is partly based on pecking order theory, information asymmetry and other market imperfections. This is the reason that the transaction cost theory should explain particularly well the dividend policies of firms that rely on capital markets that are characterised by distortions and imperfections. Indeed, these are the characteristics of many capital markets in emerging economies. Capital markets in emerging economies are often differentiated from their Counter parts in developed economies partly in terms of their effectiveness in fulfilling their intended functions. Failure in the case of the former is often attributed to high risk due to political and social instability, high transaction costs, lack of liquidity, and asymmetric information and agency problems. These problems are typically caused by lack of adequate disclosure, inappropriate trading systems, weak and erratic regulations and under-developed financial intermediaries that in efficient markets provide monitoring and market for corporate control. Indeed, Kumar and Tsetsekos (1999) argue that the institutional infrastructure of emerging markets tend to be inferior to that in developed markets in terms of the legal, technological and regulatory framework. A comparative analysis finds the financial and corporate sectors in emerging markets to be substantially less developed compared with those in developed markets. It is suggested that this can be partly explained by their more recent origins. Similarly, Glen, Karmokolias, Miller and Shah (1995), note that the dividend levels in developing countries are substantially lower compared with developed countries. It is suggested that the lower dividend level could be a reflection of less efficient markets, leading to greater reliance on internal finance. The study also finds evidence in a group of developing countries of a positive relationship between pay-out rates and the fraction of total investment that is financed by retained earnings. This is taken as another indication of a relationship in developing countries between dividend policy and the gap between external and internal finance. Consistent with the above discussion and particularly with Glen, Karmokolias, Miller and Shah (1995) the dividend policies of firms in emerging markets should be particularly sensitive to dependency on external finance. The implementation of cost model of dividend should have a good fit when applied to firms from an emerging market. A company's performance is to a large extent influenced by the risks that result from its operating and financial activities. Performance volatility is attributable to the inherent uncertainty of fluctuations in revenue and operating costs. It also results from the financial costs of the interest on debt financing, Many studies show that performance volatility conveys information about a company's level of risk to the market (Howatt, 2009) and that higher degrees of volatility have a negative effect on firm value (Allayannis and Weston, 2003; Barnes, 2001). Other studies are

concerned about the impact of performance volatility on forecasts of future performance (Minton, 1999; Dichev and Tang, 2009; Petrovic, 2009; Brennan and Hughes, 1991; Schipper, 1991). Financial analysts and institutional investors are generally reluctant to make predictions about the performance of enterprises with higher levels of volatility because doing so may increase their forecast error and result in negative surprises (Badrinath, 1989). Enterprises that exhibit extreme performance volatility may reverse faster (Freeman, Ohlson and Penman, 1982), while high volatility may be due to the inclusion of temporary items, the sustainability of which is unlikely. Performance volatility may also have an impact on a company's future financing costs (Trueman and Titman, 1988), as it signals a higher likelihood of failure. Another line of research has examined the impact of cash flow volatility on firm performance. For example, Minton and Schrand (1999) reported that cash flow volatility is positively correlated with average levels of capital expenditure, research and advertising costs, and significantly and negatively correlated with the cost of external financing. Allayannis and Weston (2003) reported that cash flow volatility has a significantly negative correlation with firm value. Moreover, the negative impact on firm value from fluctuations in accounting profits is of greater statistical and economic significance. These findings are entrenched in the financial and accounting literature (Petrovic 2009). As performance volatility conveys information to the market about firm value, future performance and future financing costs, it will be interesting to determine whether management is aware of the inherent informational value of earnings volatility and quality and that it subsequently takes action to control risks. In the next chapter methodological considerations and the data collected for the calculations will be discussed.

CHAPTER 3

Methodological Consideration

3.1 Methodological Consideration and Data:

The methodology of the study consists of following steps namely: construction of theory or model; data collection and testing to generate conclusions and relate them to the literature and theory. In this chapter different theories and the models are defined to achieve our target and give a brief view of the cost and agency theory which were previously described in chapter 2. The Indian emerging market has been

undergoing economic reforms since 1991, prior to which it was characterised by high controls and extensive public ownership. The foreign trade regime prior to reforms was characterised by high protectionism from import competition and restrictions on foreign ownership of Indian companies. Likewise the government was heavily involved with the workings of the financial systems. High reserve requirements were stipulated, interest rates were imposed, and credit was directed to priority sectors giving rise to manipulation and inefficiencies. Furthermore, supervision and financial discipline were slack, and equity markets suffered from lack of transparency and poor investor protection, while the large public sector was similarly inefficient. In 1991 India suffered a financial crisis which was followed by the initiation of economic reforms. For example, capital market reforms included the establishment of the Securities and Exchange Board of India (SEBI) in 1988, which was given statutory powers in 1992. SEBI was charged with improving disclosure rules in the primary market for equity as well as the transparency of trading practices in the secondary market. Similarly the office of the Controller of Capital Issues, which controlled the issue and pricing of new equity, was abolished in 1992, encouraging firms to sell shares. Other reforms were also launched including relaxing restrictions on foreign ownership, lowering import controls and tariffs, restructuring of the domestic tax system, and phasing out of government subsidies. In the early 1990s it was opened to foreign investors, in spite of which it is still characterised by poor liquidity, low standards of corporate disclosures, and high domination, by a few large companies.

3.2 The Structure and Scope of the Study:

Before turning to the analysis of how the dividend policy in the Indian firms works, the starting point for the debate on how dividend affects firm value, which is often referred to as the dividend puzzle, it is typically marked by Miller and Modigliani's (1961) irrelevancy theory. Thus the chapter begins by describing the irrelevancy theory, and then outlines some of the leading theories that have evolved once the assumptions underlying the irrelevancy theory are relaxed. These include the transaction costs theory, the bird in the hand argument, and the signalling and agency theories. The transaction cost theory of dividends is based on transaction costs, control and other considerations that are associated with paying dividends and then resorting to external finance to fund investments. The bird in the hand argument is based on the idea that dividends reduce risk, while the signalling theory is based on the information content of dividends. Finally the agency theory of dividends deals with the role of dividends in resolving agency conflicts. After reviewing some of the relevant experimental methodologies and

evidence, here an extended agency theoretic rationale for the dividend decision is investigated. The extended theory considers conflicts and associated costs that broaden beyond the pure owner-manager relations. To this end, a variant of the cost minimisation model is utilised, relaxing the assumption of linearity and using data on Indian firms. As previously hinted, management of the Indian economy has traditionally been based on socialist ideology and a high degree of state-intervention. The observed method is the general to specific approach, starting with an unrestricted model that includes non-linear terms, and carrying out a simplification process based on Wald and t-tests. In particular, the degree of government holdings appears to be significant in explaining the target pay-out ratios of firms in the Private Sector in India. To test whether the dividend policies of group-affiliated firms are substantially different to that of independent firms, a number of techniques are applied to data on Indian firms. The experimental procedure begins with a comparative analysis, followed by multivariate analysis that utilises qualitative and limited dependent variable methodologies. Results support the notion that the decision of whether to pay dividend is sensitive.

3.3 Dividend Theories

3.3.1 The transaction cost theory Firms may incur costs in distributing dividends while investors may incur costs in collecting and reinvesting these payments. Moreover, both firms and investors may incur costs when, due to paying dividends, the firm has to raise external finance in order to meet investment needs. Indeed, the transaction costs incurred in having to resort to external financing is the cost of dividend in Bhattacharya's (1979) model. In contrast, however, it may be argued that dividend are beneficial as they save the transaction costs associated with selling stocks for consumption purposes1. Either way, if there are Additional transaction costs that are associated with paying or not paying dividends, then dividend policy should impact earnings expectations and hence share price and firm value. Alternatively dividends may influence value if dividend policy has an impact on management's investment decisions. For example, managers may decide to forgo positive net present value investments because dividend payments exhausted internal finance and raising external funds involves transaction or other costs. Indeed in Miller And Rock's (1985) model the cost of dividends arises from cutting or distorting the investment decision. However, more typically, the transaction cost theory of dividend Retains the assumption of a given level of investment, and focuses on the costs of raising external funds when the firm increases its dividend payment. Transaction costs include flotation costs to the firm of raising additional external finance such as underwriter fees,

administration costs, management time, and legal expenses. Further, when the firm pays dividend and then has to raise additional external finance, existing shareholders suffer dilution of control. Thus to maintain control or for other reasons, existing shareholders may subscribe to the new issue, incurring trading costs such as stamp duty and stockbroker`s commissions. Thus Rozeff (1982) suggests that firms that have greater dependency on external finance would maximise shareholder wealth by adopting lower pay-out policies. Leverage, growth potential and volatility are all factors that can increase dependency on costly external funds. High levels of leverage imply high fixed costs that the firm has to ensure it can meet. Growth potential means the firm is faced with good investment opportunities for which it requires funds. Similarly earnings volatility suggests that dependency on external finance is higher because there is less certainty regarding earnings to be generated. This implies that highly leveraged, risky or growth firms should be associated with conservative pay-out policies. Another important factor that has implications for control consideration and for the transaction costs of raising external finance and thus for firm`s dividend policies, is size.

1. Having to sell stock for consumption purposes is the assumption in John and Williams (1985). Indeed, Fama and French (2001) note that one possible explanation for the decline over time in the benefits of dividends may be the increased tendency to hold stocks via mutual funds. Holding via these funds reduces the transaction costs associated with selling stock to meet liquidity needs. Particularly, the ownership structure of small companies is likely to be less dispersed than that of larger firms. The more dispersed is ownership the less control is exercised by each shareholder and hence the problem of loosing control is more critical for smaller firms. Further, the cost of external finance is likely to be higher for smaller firms compared with larger, well-established firms with easier access to the capital markets. Add to this the observation that growth firms are usually smaller.

3.3.2 The bird in the hand argument The traditional argument for dividend is the idea that dividends reduce risk because they bring shareholder`s cash inflows forward. Although shareholders can create their own dividends by selling part of their holdings, this entails trading costs, which are saved when the firm pays dividends. The risk reduction or bird in the hand argument is associated with Graham and Dodd (1951) and with Gordon (1959) and it is often defended as follows. By paying dividends the firm brings forward cash inflows to shareholders, thereby reducing the uncertainty associated with future cash flows. In terms of the discounted dividend equation of firm value, the idea is that required rate of return demanded by investors (the discount rate) increases with the plough-back ratio. Although the increased earnings retention brings about higher expected future dividend, this additional

dividend stream is more than offset by the increase in the discount rate. This argument overlooks the fact that the risk of the firm is determined by its investment decisions and not by how these are financed. The required rate of return is influenced by the risk of the investments and should not change if these are financed from retained earnings rather than from the proceeds of new equity issues. As noted by Easterbrook (1984), in spite of paying dividends the firm does not withdraw from risky investments, thus the risk is merely transferred to new investors.

3.3.3 The signalling theory A more convincing argument for dividends is the signalling theory, which is associated with propositions put forward in Bhattacharya (1979), Miller and Rock (1985), John and Williams (1985). It is based on the idea of information asymmetries between the different participants in the market and in particular between managers and investors. Under such conditions, the costly payment of dividend is used by managers, to signal information about the firm's prospects to the market. For example, in John and Williams' (1985) model the firm may be temporarily under-valued when investors have to meet their liquidity needs. If investors sell their holdings when the firm is undervalued, then there is a wealth transfer from old to new shareholders. However, the firm can save losses to existing shareholders by paying dividends. Although investors pay taxes on the dividends, the benefits from holding on to the undervalued firm more than offset these extra tax costs. A poor quality firm would not mimic the dividend behaviour of an undervalued firm because holding-on to over-valued shares does not increase wealth. The signalling theory can explain the preference for dividends over stock repurchases in spite of the tax advantage of the latter. Particularly, as suggested in Jagannathan, Stephens and Weisbach (2000), Guay and Harford (2000) and DeAngelo, and Skinner (2000), the regular dividend signal an on going commitment to pay out cash. This signal is consistent with Lintner (1956) observation that managers are typically reluctant to decrease dividend levels. However, unlike regular dividends, repurchases and special dividends can be used to signal prospects without long-term commitment to higher pay-outs. Therefore announcements of increases in regular dividends signal permanent improvements in performance, and should be interpreted as confidence in the firm on behalf of managers thus triggering a price rise. Conversely, announcements of dividend decreases should be interpreted as signalling poor performance and lack of managerial confidence and should therefore trigger drops in prices. If changes in the levels of dividend release information to the market, then firms can reduce price volatility and influence share prices by paying dividends. However, it is only unexpected changes which have an informative value and which can thus impact prices. Therefore, the value of the signal depends on the level of information asymmetries in the market.

For example, in developing countries where capital markets are typically less efficient and where information is not as reliable as in more sophisticated markets, the signalling function of dividend may be more important. Moreover, it can be argued that information will eventually be revealed whether or not the dividend signal is sent; hence the dividend impact on prices is only temporary.

3.3.4 The agency theory of dividend Another argument in for dividend payments is that this shifts the reinvestment decision back to the owners which may not necessarily always act as on maximise shareholders wealth. The problem here is the separation of ownership and control which gives rise to agency conflicts as defined in Jensen and Meckling (1976). Accordingly when the levels of retained earnings are high managers are expected to channel funds into bad projects either in order to advance their own interests or due to incompetency. Hence dividend policy enhances the firm's value because it can be used to reduce the amount of free cash flows in the discretion of management and thus controls the over investment problem (Jensen, 1986). Another agency theory based explanation of how dividends increase value is described in Easterbrook (1984). While the transaction cost theory of dividend proposes that dividend payments reduce value because they lead to the raising of costly external finance, Easterbrook (1984) argues that it is this process which reduces agency problems. The idea is that the payment of dividends is one possible solution to the problem of collective action that tends to lead to under-monitoring of the firm and its management. Thus the payment of dividends and the subsequent raising of external finance induce investigation of the firm by financial intermediaries such as investment banks, regulators of the securities exchange where the firm's stock is traded and potential investors. This capital market monitoring reduces agency costs and lead to appreciation in the market value of the firm. Moreover, total agency cost, as defined by Jensen and Meckling (1976), is the sum of the agency cost of equity and the agency cost of debt. The latter is partly due to potential wealth transfer from bond to equity holders through assets substitutions. Thus Easterbrook (1984) note that by paying out dividends and then raising debt, new debt contracts can be negotiated to reduce the potential for wealth transfer. We start our analysis by testing the partial adjustment model of Lintner (1956) According to the Lintner each firm has target dividend pay-out ratio (ri). By using the target pay-out ratio Lintner calculated the target dividend at time (Dit*) as percentage of net earning of the firms i at the time t, the relationship is given below: D it * = ri Eit (Eit)                                      (1) In reality the dividend which firms finally pay at time t (Dit) is different from the target one (Dit*). Therefore, it is more reasonable to model the change between the real dividends at time t-1, instead of the real dividend at time t only. By taking the change in real dividend into

account it is realistic and consistent with the long run target pay-out ratio, it is assume that the real change in dividend at time t (Dit- Dit-1) equal to the constant portion (ai) plus the speed of adjustment to the target dividend at time t (Dit*- Dit-1). Since the target dividend at time t is a proportion of the net earnings at the time t, the final model become as follow: Dit- Dit-1= a +ci ri Eit ci Dit-1                                       (2) Where Dit is the actual dividend paid by the firms during period t, Eit is the net earnings of the firms during the period t; ci is the adjustment factor which shows the speed of adjustment of dividends, at the time t-1, to optimum target pay-out ratio of dividends at time t and rt is the target pay-out ratio. This theoretical model can be estimated using the following econometric model: ?Dit =a + �1 Eit + �2 Dt-1 +eit           (3) Where ?Dit is the change in dividend form time t-1 for the firm i, �1 represents the ci times rt of the theoretical model �2 is represent the variable ci of the theoretical model with negative sign (�2 = -ci) and eit represent the error term. Fama and Babiak (1968) extend Lintner (1956) model by incorporating one more explanatory variable that is the difference between the current earnings and previous earnings of earnings without constant term: Dit=a + �1 ?Eit + �2 Dt-1 +eit           (4) Where Dit is the dividend of the firm i at the time t, ?Eit the change in income to the stockholders, at the time t and the time t-1 and eit is the error term. We estimate the above model by taking the ?DPSit is the change in dividend per share of the firm i at the time t as dependent variable and ?EPSit , is change in earning per share at the time t as explanatory variable and the model becomes as follow: ?DPSit = a +�1 EPSit +�2 ?DPSt-1                                                          (5)

Table1 reports the parameter estimates obtained for the dividend model in Indian firms. The coefficient on the lagged dependent variable (dividend) a varies from 0.22 obtained from GMM estimations to 0.58 when ordinary least square level is used by pool, fixed effect random effect. Though the speed of adjustment (1-a) lies within the range of 41to 77.73%. This suggests that there are some unobserved individual firm's effects on the dividend smoothing behaviour which are not captured by this model and cause a large variation in the speed of adjustment. The coefficient of dividend declines from 0.58 to 0.27 in fixed effect method estimation which suggest the firm-specific factors effects in the dividend pay-out policy of Bombay stock exchange and the endogeneity is also an issue to deal with. Furthermore the coefficients of the dividends are significant with the fixed effect method. The other useful statistics is the implicit target pay-out ratio which is shown in the above table of partial adjustment model. The target pay-out ratio (�/1-a) varies from 18 to 55 % and the significantly lower then the target pay-out ratio observed from the data. The coefficient of the determination R2 is also varies from 0.39 to 0.65. Table 1: Dividend Policy table which report the results of extended dividend model of

Lintner (1956) by applying GMM, pooled time series cross section data with common effect model (POOL), fixed effect model (FEM) and random effect model (REM). ?Dit =a + �1 Eit + �2 Dt-1 +eit Where, ?Dit is the change in dividend form time t-1 for the firm i Eit is the net earnings of the firms during the period t

Table 2: Dividend Stability Model The table reports the results of extended dividend model of Lintner (1956) modified by using dividend per share and earning per share. The GMM, pooled time series cross section data with common effect model (POOL), fixed effect model (FEM) and random effect model (REM) are used as estimation technique ?DPSit = a +�1 EPSit +�2 ?DPSt-1 Where, ?DPSit is the change in dividend per share of the firm i at the time t. ?EPSit is the change in earning per share of the firm i at the time t.

After the analysis of the above models, partial adjustment model and the model of Fama and Babiak (1968) we modify the model which by using the change in dividend per share as dependent variable and regress it on change in earning per share of current period and lagged term of change in dividend per share. The parameter estimates obtained from our dividend stability models are reported in above Table 2. The coefficient of the lagged term dividends a varies from 40 % by GMM estimation to 57 % by OLS when it's used in levels. The balanced panels have been used to estimate the above mentioned model. The results of the model show that the speed of adjustment (1-a) lies within the range of 42.5 %to 59.01 % by GMM method which suggest that the estimate techniques use in the model are appropriate. The random effect estimation shows that the extensive firm specific effects in the dividend policy in India. The endogeneity of the explanatory variables coefficient of dividends is taken account of when GMM is used as estimation technique against OLS but the significant level is reduced when the GMM is used to however, the variation in the significance is very small. On the other side the target pay-out ratio (�/1-a) which is also shown in the above table1. The target pay-out ratio vary from 25 % to 38.49 % which is significantly equal to the observed target pay-out ratio which amounts to 30 % in full sample and 35.7 % in dividend paying firms sample. The coefficient of determination does not have the variation. The firms listed on Bombay stock exchange are continuously improving their target pay-out ratio by applying this model and we can say that the India's listed firms non financial are not smooth to pay their dividends. The results of the adjustment of the speed and the target pay-out ratio when compared with the findings in the experimental studies, the Fama and Babiak (1968) find that for non-financial UK firms the average speed of adjustment approximately 0.37 slightly higher than Lintner (1956) findings of 0.30 and target pay-out ratio of 50% almost

equal to the Lintner (1956). The Behm and Zimmerman (1993) for German listed firms find a speed of adjustment ranging from 0.13 to 0.58 and the target pay-out ratio lies between 25 to 58 %. Glen (1995) fined the speed of adjustment between 40 % in Zimbabwe and 90 % in Turkey and the target pay-out ratio between 30 % and 40 %. Belanes (2007) find the speed of adjustment in Tunisian listed firms which is 23.66 to 96.59 % and the target dividend pay-out ratio lies between 14 to 52.96 %. Our results regarding the speed of adjustment and target pay-out ratio are closer to findings of other developing markets for example Turkey and Tunisia however, less then the speed of adjustment and target pay-out ratio of Germany and United Kingdom. To sum up the test of the Lintner partial adjustment model and the modified model on the sample of Bombay Stock Exchange Listed non financial firms reject that dividend decision are not based on the long term target dividend pay-out ratio. However, there is an indication that the firms give the higher importance on stable dividend pay-out to signal their future profitability to minimize the agency cost.

3.4.1 Data Collected and Calculations of Stock Price Volatility Data were collected from BSE Sensex and NSE Nifty for calculating return and volatility. Sensex is a basket of 30 constituent stocks representing a sample of large, liquid and representative companies. Due to its wide acceptance amongst the Indian investors, Sensex is regarded the pulse of the Indian stock market. Nifty is a well diversified 50 stock index accounting for 24 sectors of the economy. Hence these two indices were taken for the study. Data were taken from 1998 to 2008. Return is calculated using logarithmic method as follows. rt = (log pt-log pt-1)*100 Where, rt= Market return at the period t Pt= Price index at day t Pt-1= Price index at day t-1 and log = Natural log

3.4.2 Inter-day Volatility The variation in share price return between the two trading days is called inter-day volatility. Inter-day volatility is computed by close to close and open to open value of any index level on a daily basis. Standard deviation is used to calculate inter-day volatility. The inter-day volatility is calculated by close to close and open to open volatility method.

3.4.3 Close to close volatility For computing close to close volatility, the closing values of the Nifty and Sensex are taken. Close to close volatility (standard estimation volatility) is measured with the following formula s=v[(1/ n -1)? (rt - r`)2] Where n = The number of trading days rt = Close to close return (in natural log) r`= Average of the close to close return

3.4.4 Open to open volatility Open to open volatility is considered necessary for many market participants because opening prices of

shares and the index value reflect any positive or negative information that arrives after the close of the market and before the start of the next day's trading the following formula is used to calculate open-to-open volatility: s=v[(1/ n -1)? (rt - r`)2] Where n = the number of trading days rt = Open to open return (in natural log) r`= Average of the open to open return Inter-day volatility takes into account only close to close and open to open index value and it is measured by standard deviation of returns.

3.4.5 Intra-day Volatility The variation in share price return within the trading day is called intra-day volatility. It indicates how the indices and shares behave in a particular day. Intra-day volatility is calculated with the help of Parkinson Model and Garman and Klass model.

3.5 Parkinson Model

High-low volatility is calculated with the following formula: s=kv[1/ n ?log (Ht /Lt)2] Where s = High-Low volatility k = 0.601 Ht = High price on the day Lt = Low price on the day n = Number of trading days

3.6 Garman and Klass Model

The Garman and Klass model is used to calculate the open-close volatility. The formula for Garman and Klass model (1980) takes the following form. s=v[1/ n ?(1/2{log (Ht /Lt)}2 -[2log(2)-1] [log (Ct /Ot) ] ]2 Where Ht = High price on the day Lt = Low price on the day Ct = Closing price on the day Ot = Opening price on the day n = Number of trading days s = Intra-day volatility for the period

TABLE 1 Year-wise Descriptive Statistics for Nifty And Sensex (1998-2008)

The daily average return of the Nifty and the Sensex in the year 1998-99 was 0.00294 %and -0.02482 %respectively. The Nifty had positive return whereas the Sensex had negative return. The pressure of economic sanctions following detonation of nuclear service, woes of East Asian financial markets, volatility of Indian currency and the redemption pressures faced by the Unit Trust of India (UTI) in respect of its US-64 Scheme made the Nifty decline from 1212.75 in April, 1998 to 808.7 in October, 1998 and the Senses from 4280.96 to 2764.16. In the year 1999-2000, the Nifty and the Sensex return increased from 0.00294 % to 0.15606 %and -0.02482 % to 0.14112 % respectively. The union budget of 1999, strength of the Government and also its commitment towards second generation reforms improved macro economic parameters and better corporate results raised the return. In

this year the growth rate of GDP and industrial sector was 6.4% and 6.6% respectively and within industrial sector, the growth rate of manufacturing sector was 7.3 %The trend got reversed during 2000-2001.The Indian economy decelerated and the Nifty and the Sensex yielded negative return of -0.09435% and -0.13788% respectively. There was a large sell off in new economy stocks in global markets. This brought down the Nifty from the height of 1636.95 in April, 2000 to the lower level of 1108.20 in October, 2000 and the Sensex from 5426.82 in April, 2000 to 3689.43 in October, 2000, the growth rate of GDP and the industrial sector declined from 6.4% to 6% and from 6.6% to 4.9% respectively. Within the industrial sector, the growth rate of manufacturing sector declined to 5% and the infrastructure sector also registered a lower growth as compared to that of the previous year. Scams have over and again proved the vulnerability of the regulatory network and system of the finance and capital markets in this year. Ketan Parek scam in the stock market resulted in a big default in Calcutta Stock Exchange, the BSE and the NSE. Several stockbrokers grossly misused the badla finance given to them by investors. FIIs investment was very low in that year. The above cited reasons were the major reasons for the negative returns. The year 2001-02 recorded positive return of 0.00317% but Sensex had negative return of - 0.01129%. The introduction of rolling settlement and derivatives encouraged FIIs and domestic investment even though markets were affected by riots in Gujarat, cyclone in Orisa, suspension of repurchase facility under UTI's US 64 scheme and the attack of World trade Centre, Indian Parliament and Jammu and Kashmir Assembly. The year 2002-03 recorded negative return of -0.05239% and -0.05568% in the Nifty and Sensex respectively. Morgan and Stanley Capital International Index value for India declined to 3.9 %. Failure of the monsoon, bomb blast in Ghatkopar area of Mumbai, the war between Indo-Pak border and tussle between US and Iraq had negative impact on the stock market. There was a subdued trend in both public and rights issue. The divestment programme of the public sector units was deferred and PSU stock price declined by 50%. In June and October 2002, the FIIs turned as net sellers, and their investments were -Rs.8660 mn and -Rs.8757 mn respectively. In this year a total of Rs.4070 crore was mobilised as against Rs.7543 crore in 2001-02. Banks and financial institutions were the main mobilisers during the year. All these factors led to the negative return in the Nifty and Sensex. The daily average return in the Nifty and the Sensex was the highest in the year 2003-04. Strong economic fundamentals exhibited in the fall in interest rates, strong GDP growth rate, increase in foreign exchange reserves and exports of Indian companies doubled the Nifty and the Sensex in the first three quarters. Further, the large expenditure by the Government on infrastructure sector and the reform process enhanced the morale and motivation levels of Corporate India which in turn boosted the stock market returns.

The SEBI's ban on the Participatory Notes issued by unregulated entities made the markets more disciplined and investor friendly. Global liquidity had almost been drained off following the rate increases in the US, Europe and in Japan. The RBI had also done its bit in doing the same in India and a further movement in that direction cannot but had an adverse impact on the stock market. FII flows in 2006, at about $8.5 billion (around Rs 38,000 crore), were lower by 20% than in 2005. But this was due to the markets tanking in May and June. Pharma, ferrous metals, FMCG, oil and gas, and auto components did perform wellin that year. The year 2007 saw Indian stock markets scaling new peaks. During 2007-08 the secondary market rose on a point-to-point basis with the Sensex and Nifty rising by 47.1 and 54.8% respectively. Amongst NSE indices, both Nifty and Nifty Junior delivered record annual equity returns of 54.8% and 75.7% respectively during the calendar year. The Indian financial sector is on a roll. It has emerged as the third best performing market in the world with a dollar return of 71.23%. The popular Bombay Stock Exchange (BSE) benchmark index, sensex, also posted its highest ever absolute gain of 6500 points in over two decades. Simultaneously, the National Stock Exchange (NSE) has climbed to the top spot in stock futures contracts and number-two slot in the index futures segment in the world. Spices export from India has reached record levels and exceeded the target set for 2007-08.

3.7 RETURNS IN BULL PHASE AND BEAR PHASE

Ups and downs in the share prices are quite natural in stock market. The bull and the bear markets have certain characteristics and the investors adopt different strategies in the bull and the bear markets. The rise and the fall of shares are linked to a number of conditions such as economic cycle, economic growth, international trends, budget, general business conditions, company profits, product demand etc. In the bull market, buy-hold approach is adopted and in the bear market sell-move out approach is adopted by the investors. Results of return during the bull and the bear phases are presented in the following table 2

TABLE 2 Descriptive Statistics for Various Phases -Nifty and Sensex

Table 2 gives the descriptive statistics for various phases for the Nifty and Sensex. The durations of the bull and the bear phases are more or less similar for the stocks of the Nifty and Sensex. In the bear phase-A, they had negative return of -0.22900% and -0.25564% respectively. Nuclear tests conducted in May, 1998 and imposition of economic sanctions by the US, Japan and other industrialized countries resulted

in uncertainty in the Indian stock market. In the bear phase, the FIIs net investment was negative and they were net sellers except in July and September 1998.The growth in macro economic factors like GDP, industrial sector and manufacturing sector turned out to be positive with good corporate results. FIIs average monthly investment was Rs.52.41 crore in the bull phase. This moved the Nifty and Sensex to newer peaks. There was a hike in the Nifty and the Sensex index level from December, 1998 to February, 2000. The main calculations of the stock market volatility are shown in table 3, 4, 5 and 6. Stock market volatility indicates the degree of price variation between the share prices during a particular period. A certain degree of market volatility is unavoidable, even desirable, as the stock price fluctuation indicates changing values across economic activities and it facilitates better resource allocation. But frequent and wide stock market variations cause uncertainty about the value of an asset and affect the confidence of the investor. The risk averse and the risk neutral investors may withdraw from a market at sharp price movements. Extreme volatility disrupts the smooth functioning of the stock market. The literature on stock market volatility is voluminous, but, some general conclusions on common stock risk have emerged from this research. The overall stock market volatility has fluctuated over the time with no discernible trend and some authors have argued that volatility is higher during the bear markets. In this study, inter-day and intra-day volatility are calculated for each year and for different phases. Inter-day volatility of the Nifty and Sensex are given in table 3

TABLE 3 Year-wise Inter-day Volatility for Nifty and Sensex (1998-2008)

The loss was very high in Sensex compared to Nifty The entire financial year (2000-2001) of the stock market was in the grip of bears. From 1998 - 2003 the Sensex values were consistently higher than the values of the Nifty, in both the volatility. From 2004-2008 the close to close volatility was very high in Nifty. In the Nifty the open to open volatility was high in the year 1999 - 2000. In the Sensex the open to open volatility was high in the year 2000- 2001. The Nifty recorded negative return and a low volatility in the year 2002-2003. The close to close volatility in the Nifty was at their peak in 2007-2008. On 3rd September 2007 the value of Sensex was 15422.05 but on 28th September it was 17291.10. In the first half of October 2007 Sensex climbed from 18K to 19K in just four days. As a result circuit breakers were applied on October 16. Year-wise intra-day volatility for the Nifty and the Sensex are given in the table 4. The close to close volatility and the open to open volatility in the Nifty and the Sensex moved in cycle. In the Nifty and in the Sensex, the close to close volatility ranged from 0.991% to 2.025% and 1.010% to 2.151% respectively. The open to open volatility

in the Nifty and the Sensex ranged from 0.992% to 2.041% and 1.047% to 2.846 %respectively. The close to close and the open to open volatility in the Sensex was very high in the year 2000-2001.

TABLE 4 Year-wise Intra-day Volatility for Nifty and Sensex (1998-2008)

In the Nifty, both open-close and high-low volatility were very high in the year 2007-2008. In 2002-2003 open -close and high -low volatility was very low in Nifty and Sensex. But in the Sensex open-close volatility was high in the year 2000-2001 and high-low volatility was very high in the year 2007-2008. Except 2007-2008 the close to close volatility was low in Sensex compared to Nifty. Open- close volatility was low compared to other volatility and it ensures minimum fluctuation in the share prices within a trading day. High-low and open -close volatility moved alongside in the Nifty and in the Sensex. Open to open volatility was the highest of the four types of volatility; that indicates high flow of information.

3.8 Inter-Day and Intra-Day Volatility in Different Phases

The bear market had a negative return and the bull market had a positive return. To know the volatility during bull and bear phases the inter-day and the intra-day volatility is calculated. Tables 5 give the result of the inter-day volatility for various phases in the Nifty and the Sensex.

TABLE 5 Inter - Day Volatility for Various Phases -Nifty- Sensex

Open to open volatility in the Sensex was higher than that of in the Nifty. Close to close volatility in the Nifty and in the Sensex touched its peak in the bear phase-C. It lasted for a very short period. The rise in gold and silver prices and the election result affected the market sentiments negatively. In the Sensex and in Nifty open to open volatility was high in the Bull phase-I. In general the close to close volatility in the bull phase was low compared to the close to close volatility in the bear phase. Close to close volatility in the bull phase and the bear phase in the Nifty and the Sensex moved in tandem with little difference. The intra-day volatility details are given in Table 6. Open-close volatility is lower than the high-low volatility. In the Nifty and in the Sensex open- close volatility was high in the bear phase and low in the bull phase. The intra-day volatility in the bull phase moved down in all the indices. For Nifty the open-close and high low volatility was very high in the bear phase-B and in the Sensex it was very high in the bear phase-C.

TABLE 6 Intra -Day Volatility for Various Phases -Nifty- Sensex

3.9 Conclusion

The conclusion is that small firms are likely to find the payment of dividends more costly compared with larger firms. This conclusion may explain the positive correlation often observed between firm size and the likelihood that the firm is a dividend payer (Redding, 1997, and Fama and French, 2001). The bull phases earned decent returns and the bear phases incurred loss. In the bull phases volatilities were lower than bear phases.

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