International Journal of Economics and Financial

Issues
ISSN: 2146-4138

available at http: www.econjournals.com

International Journal of Economics and Financial Issues, 2016, 6(3), 1081-1091.

Macroeconomic Factors and the Indian Stock Market: Exploring

Long and Short Run Relationships

Kiran Kumar Kotha1*, Bhawna Sahu2

1
Indian Institute of Management Indore, India, 2Indian Institute of Management Indore, India. *Email: kirankumar@iimidr.ac.in

ABSTRACT
The rapid growth of Indian economy during the last two decades raises empirical questions regarding the fundamental connection between stock
price and key macroeconomic indicators. This paper aims to examine long and short run relations between selected macroeconomic indicators and
stock market returns with reference to India. This study employs monthly data from July 2001 to July 2015 since major stock market reforms viz.,
ban of Badla system, introduction of rolling settlement and introduction of stock derivatives, were all implemented in July 2001. With the help of
co- integration and error correction model (ECM), the study reveals the presence of long run relation between the BSE Sensex and select
macroeconomic indicators viz., Exchange Rate, wholesale price index, T-bill rates and M3.
Keywords: Macroeconomic Indicators, Stock Returns, Co-integration
JEL Classification: G15

1. INTRODUCTION premium, default spread and term structure, as additional

factors in the market model. There exists a huge volume of
There may be a strong intuitive appeal attached to the belief literature on how stock returns get influenced. Much of the
that relationships exist between macroeconomic fundamentals investigation between stock returns and economic forces is
and equity returns, but we lack correspondingly strong based on the presumption that macroeconomic indicators are
empirical support that goes with it. Macroeconomic variables highly influential in predicting stock returns and asset prices.
can be understood as: Variables reflecting general economic
conditions, variables related to interest rate and monetary One popular area of financial research is studies on the factors
policy, variables concerning price level and variables that affect stock returns. As per the basic standard stock
involving international activities. General economic conditions
valuation model, determinants of stock price are “expected cash
include variables like industrial production index or
flows” from the stock and “required rate of return” as per the
unemployment rate. The variables concerning interest rate and
riskiness of the stock. Macroeconomic indicators affect a firm’s
monetary policy include interest rate, term spread, default
cash flows and also influences risk-adjusted discount rate. The
spread, money supply, etc., Variables focussing on price level
required rate of return comprises of risk free rate along with the
may be general price level index or inflation rate. Variables
measure of asset’s risk. This nominal risk free rate depends
involving international activities are exchange rate or foreign
upon real interest rate as well as expected inflation. Risk free
direct investments (FDI), etc., Studies have used different
rate has an inverse relationship with stock prices. Similar is the
macroeconomic variables to examine which factors have the
most critical impact upon stock returns. One of the notable case with inflation. Inflation depresses stock market (DeTina,
multi factor models, as proposed by Chen et al., (1986) used 1991). Relationship of equity returns with money supply might
empirical evidence to extend other risk factors besides the be an empirical question. We know money supply is positively
notion of equity market risk premium as propagated by capital related with inflation rate, hence it might adversely affect stock
asset pricing model (CAPM). They used various returns. Money supply may also lead to increasing cash flows
macroeconomic shocks including, industrial production by building economic stimulus leading to increasing stock
index, inflation, risk prices.

International Journal of Economics and Financial Issues | Vol 6 • Issue 3 • 2016 1

 Kotha and Sahu: Macroeconomic Factors and the Indian Stock Market: Exploring Long and Short Run Relationships

Expectations also play a very important role in determining market is efficient then we cannot forecast stock returns leaving
stock returns and these expectations, whether adaptive or no arbitrage opportunities to make profit. If the market is
rational, get influenced by economic fundamentals. Changes in efficient, it means that all the relevant information is captured
macroeconomic conditions affect current and future investment and is getting reflected in the prices. We can say that if these
decisions i.e., an inflation shock may result in a change in the macroeconomic variables are insignificant in explaining stock
expected return of an asset. returns and stock returns are also insignificant in explaining
macroeconomic variables, then the market is efficient.
Most popular models to determine stock returns in finance
textbooks are CAPM and arbitrage pricing theory (APT). Interpretation of co-integration with respect to market efficiency
CAPM is derived from Markowitz’s concept of diversification depends upon how efficiency is defined Mukherjee and Naka
and it was further developed by Sharpe (1964), Lintner (1965), (1995). If we see market efficiency as lack of arbitrage
Mossin (1966). CAPM is generally considered a single factor opportunities, then the presence of co-integration (long run
model because it states that only market factor is to be equilibrium relationships) among variables is a sign of market
considered for determining stock returns. Investors need to be inefficiency.
compensated in two ways, time value of money and risk. Time
value of money is represented by risk free rate that Prominent macroeconomic variables generally considered are:
compensates for placing money in any investment over a Inflation rate, exchange rate, money supply, level of economic
period of time. Investors, after diversifying their portfolios, activity and interest rates. There cannot be a finite list. Other
are concerned only with systematic risk or market risk (beta) macroeconomic variables can be unemployment rate, savings,
which is inherent to the market. Sources of systematic risk exports, FDI, fiscal policy (budget deficits), oil prices, and gold
could be interest rate changes, inflation or even recession as prices. Even the spread between short and long interest rates,
they affect the entire market. APT (Ross, 1976; Roll and Ross, expected and unexpected inflation, high and low grade bonds
1980) is a form of multi-factor model which claims that shocks (Chen et al., 1986) can be analysed while observing stock
or surprises of possible multiple factors can be used to explain returns.
stock returns. An asset’s return can be predicted using the
relationship between the asset and many common risk factors. Relationship between stock returns and macroeconomic
variables can be viewed in two ways. One view is to see the
APT predicts a relationship between the returns of a portfolio
stock market as the leading indicator of economic activity the
and the returns of a single asset through a linear combination
macroeconomic variables based on the findings that stock
of many independent macroeconomic variables. A multi
market rationally signals changes in real activity. Another view
factor model can also be thought of as the one in which
is that macroeconomic variables influence and predict stock
macroeconomic variables are used to explain stock returns.
returns. We find that current economic activities can explain
stock market returns since the stock market reflects
Since information technology (IT) revolution, information or
macroeconomic variables on stock price indices. Knowledge
news is readily accessible. Access to information is easy and of sensitivity of stock markets to key macroeconomic
universal. This changing dynamics of the environment has variables and vice versa is important in areas of investment,
indeed made financial markets more efficient. Stock markets finance and business environment.
react promptly to any news, good or bad, whether political
tensions, war situations, regulatory changes in business The present study improves the earlier studies in the Indian
environment or movements in global markets. context and offers a value addition to the existing literature.
This paper is organised as follows: Section 2 reviews previous
Efficient market hypothesis (EMH) is an idea partly developed literature followed by Section 3 giving data related issues.
in the 1960s by Eugene Fama. It states that it is impossible to Section 4 details the methodology employed and Section 5
beat the market because prices already incorporate and reflect presents the results.
all relevant information. One cannot outperform the overall
market through expert stock selection or market timing, and
the only way an investor can possibly obtain higher returns is 2. LITERATURE REVIEW
by purchasing riskier investments. Stocks always trade at their
fair value, making it impossible for investors to either purchase There exists vast literature on the association between
undervalued stocks or sell stocks for inflated prices. Asset macroeconomic variables and stock returns. Although results
are mixed, most studies have shown evidence that there are
prices fully reflect all available information. There are three
significant relationships between macroeconomic variables and
variants of the hypothesis: “Weak,” “semi-strong,” and “strong”
stock returns. An early paper that opened up avenues for
forms. The weak form of the EMH claims that prices on traded
research in this regard was by Chen et al. (1986). ‘Simple and
assets (e.g., stocks, bonds or property) already reflect all past
intuitive financial theory’, as they put it, is a well-known phrase
publicly available information. The semi-strong form of the
in literature. Economic news can be measured as innovations in
EMH claims both that prices reflect all publicly available
variables. They tried to explore the set of economic variables
information and that prices instantly change to reflect new
that systematically influence stock returns and also asset
public information. The strong form of the EMH additionally pricing. These variables were, priori, sources of systematic risk.
claims that prices instantly reflect even hidden “insider” Economic variables which were significant in explaining stock
information. EMH states that if the
 Kotha and Sahu: Macroeconomic Factors and the Indian Stock Market: Exploring Long and Short Run Relationships

returns were industrial production, changes in risk

premium, twists in yield curve and also measures of explains about 8% of variance in real stock returns whereas
unanticipated inflation and changes in expected inflation during innovations in real stock returns account for only 1% of
periods of high volatility. Real per capita consumption and
index of oil price get insignificant.

Starting with the developed countries, Morelli (2002) has taken

monthly UK data from January 1967 to December 1995 and
tried to analyse “conditional stock market volatility” and
“conditional macroeconomic volatility.” To estimate
conditional volatility GARCH, ARCH models are used.
Macroeconomic variables incorporated in the study are
industrial production, real retail sales, money supply, inflation
and exchange rate (German Deutsche mark/pound). A vector
autoregressive (VAR) model of order 12 is constructed which
indicates that only exchange rate (DM/pound) can explain some
significance in predicting stock market volatility while no
significance was observed in terms of ability of stock market’s
volatility to predict macroeconomic volatility. Results of
regression analysis done on conditional stock market volatility
estimated from ARCH model on all macroeconomic volatilities
reveals that none of the macroeconomic volatilities can explain
stock market volatility. In fact, only 4.4% of variation in stock
market volatility is explained by macroeconomic volatility.
They estimated a best-fit model for conditional stock market
volatility where measures of conditional volatility of
macroeconomic variables are included as weighted variables.
Based on a significant change in log-likelihood value, best
model is one in which “conditional volatility of inflation” is
included. Overall they have concluded that volatility in
macroeconomic variables selected in the study do not explain
volatility in the stock market.

Flannery and Protopapadakis (2002) have estimated a GARCH

model of daily equity returns in which realized returns and their
conditional volatility depend upon 17 macro series
announcements over the period 1980-1996. Out of these, three
nominal factors, consumer price index (CPI), PPI and a
monetary aggregate, are taken; three real factors, balance of
trade, employment report and housing starts, are also
considered. Popular overall measures of economic activity like
industrial production or GNP are not taken into consideration as
real GNP was not significantly affecting conditional return
volatility nor was it affecting the trade volume. As per the
results, out of the 17 macro indicators, six are strong risk factor
variables. Two inflation measures, CPI and PPI, affect only
level of market returns. Real variables like, balance of trade,
employment/unemployment and housing, affect only
conditional volatility of returns.

Norway is a small open economy with not so mature financial

markets. Gjerde and Saettem (1999) have done a study on
Norway using multivariate VAR framework. Apart from stock
returns, they have taken macroeconomic variables like, interest
rate, inflation, industrial production, consumption variable, oil
prices, exchange rate (NOK/USD) and OECD industrial
production index, taking monthly observations from 1974 to
1994. Consumption variable checks whether assets will be
priced as per their co-variances with aggregate consumption
(consumption based asset pricing model). Innovation
accounting results reveal that domestic industrial production
International Journal of Economics and Financial Issues | Vol 6 • Issue 3 • 2016 108
variance in industrial production. Stock returns show a delayed forecasts, they have used three different criteria - statistical
but positive response towards industrial production. Stock criteria, utility-
return’s response is immediate and negative to changes in based criterion and an length for each explanatory
interest rate. Real interest rate changes affect both stock returns options-based criterion. variable is determined. Lag
and inflation. Stock returns explain little variation in inflation. Results prove that the that minimizes autoregressive
Norway is an oil-dependent country and hence stock returns forecasts of stock market FPE is selected. Bivariate
respond actively to oil prices. Both oil prices and real activity volatility based on real time regression is estimated in
affects stock returns here unlike the European markets. macroeconomic data can be which stock prices are
compared with the forecasts regressed against own lagged
Mukherjee and Naka (1995) have taken six macroeconomic based on revised values and on lagged values
variables, exchange rate, inflation, money-supply, real macroeconomic data. of other variables, taken one
economic activity, long term government bond rate and call at a time. Specific gravity
money rate in Japan. Monthly data was taken from January Another important paper is by criterion is used to estimate
1971 to December 1990. Vector error correction mechanism Darrat (1990) who used trivariate regressions. Finally
(VECM) is applied for analysis; they also apply likelihood multivariate Granger causality likelihood test is performed.
ratio to check if linear trend exists. Results of trace test and λmax to check if economic Their results imply that in
test indicate that there is more than one co-integrating relation. variables (including base Canada budget deficits exert a
They have based their analysis on the co-integrating vector that money and fiscal deficit) significant lagged impact
is represented by the largest Eigen-value. They found that a co- affect stock returns in upon stock prices even when
integrating relation exists and stock prices contribute to this. Canada. Monthly data is other variables are excluded.
Results indicate that the relation between Tokyo stock exchange taken from January 1972 to Monetary policy has
(TSE) and exchange rate is positive since TSE increases as Yen February 1987. Darrat insignificant lagged
depreciates against US Dollar. Relation between TSE and focussed on the role of fiscal relationship with stock prices.
Inflation is negative. Relationships between TSE and money- policy (budget deficit) in In Canada stock prices fully
supply, and TSE and industrial production are positive. In determining stock prices. reflect all available
Japan, money-supply’s positive effect on stock prices through Toronto stock exchange 300 information on monetary
augmented corporate earnings overpowers the negative effect index is taken as a proxy for policy, as revealed by the
because of inflation. There is a negative relation between TSE stock returns. Multivariate study.
and long term government bond rates but a positive relation Granger causality test along
between TSE and call money rates. They argue that in Japan it with Akaike’s final prediction For Singapore, Mookerjee and
is possible that the nominal risk free component of discount error (FPE) and specific Yu (1997) have tested for
rate in valuation model is better served by long term gravity criterion are applied. degree of informational
government bond rate rather than short term rate. They believe Percentage change in efficiency in stock market
that VECM consistently outperforms VAR; with VECM one monetary base (average for with respect to a subset of
can avoid the potential misspecification bias inherent in VAR. the month) is taken as a proxy macroeconomic variables.
According to them VAR is incapable of exploring long term as for monetary policy. Change Sample period spans from
well as short term relations in the presence of co-integration. in cyclically-adjusted October 1984 to April 1993.
With the help of root mean square test and Theil’s Inequality (structural) budget deficit is Four macroeconomic
coefficient they show that forecasting errors are less with taken as a proxy for fiscal variables are used: Two
VECM as compared to VAR. policy. Monthly data on measures of money supply
cyclically adjusted deficits (narrow and broad), nominal
are unavailable in Canada. exchange rate and aggregate
Considering Korea, a well cited paper is by Kwon and Shin
Series is obtained by foreign currency reserves. The
(1999) who use co-integration test and granger causality test
residuals from regressing all share price index was
from a vector ECM (VECM) to check whether stock price
actual total budget deficits on chosen to trace the stock
indices are co-integrated with a set of macroeconomic
current and lagged values of market in Singapore. Engle
variables namely, production index, exchange rate, trade
industrial production index and Granger co-integration
balance and money supply. For stock returns they have taken
since monthly real GNP data test gives the result that stock
value-weighted Korea composite stock price index and Small-
is also not available. Other prices are co-integrated with
size stock price index. Monthly data is studied from January
variables included in the both money supply measures
1980 to December 1992. Results indicate that there is no co-
study are: Industrial and aggregate foreign
integrating relation between stock price indices and any single
production index, long term exchange measures, but not
macro variable. In fact, stock indices are co-integrated with a
interest rates, short term with exchange rate. They have
combination of four macroeconomic variables. They claim that
interest rates, exchange rate made conclusions on
macroeconomic variables are significant in predicting changes
movements, inflation rate and efficiency by linking co-
in stock prices.
volatility of interest rates. integration to market
Common lag length for all efficiency. Finding of co-
Pierdzioch et al. (2008) have opted for a recursive modelling
variables may give biased integration is interpreted as
approach to forecast stock market volatility in real time. They
results. Hence, with Akaike’s potential market inefficiency.
have used monthly real time macroeconomic variables for
FPE criterion, appropriate lag Three of the four macro
Germany from 1994 to 2005. To evaluate accuracy of these
108 International Journal of Economics and Financial Issues | Vol 6 • Issue 3 • 2016
indicators are co-integrated inflation and Singapore (GDP) data unemployment
with stock prices, suggesting stock returns. Short term rate, that represents general A well cited paper on India is
potential inefficiencies in interest rates showed business condition and that of Ahmed (2008).
long run. For short run, we positive relationship with business cycle factor, is Analysis has been done
get conflicting evidence on Singapore’s equity market taken. To trace stock market taking quarterly data
informational efficiency of whereas long term interest movement SET50 index, spanning from March 1995
the equity market in rate showed negative MAI index and average to March 2007, using
Singapore. Maysami et al. relationship. Positive stock return of top ten variables like, index of
(2004) have examined the correlation is observed securities are taken. industrial production (IIP),
co-integration between between money supply Regression analysis with money supply, interest rate,
macroeconomic variables changes and stock returns. macroeconomic variables as exchange rate, FDI inflows,
and sector indices, mainly Similarly positive explanatory variables and and export earnings. For
finance index, property index relationship is observed stock returns as dependent analysing stock returns, BSE
and hotel index. Monthly between exchange rate and variables shows that interest Sensex and NSE Nifty have
data is obtained from January Singapore stock market. As rate and exchange rate are been taken. Toda and
1989 to December 2001. per the finance index, significantly negative. Both Yamamoto Granger causality
Their findings include finance sector is inflation and unemployment test and Johansen’s co-
significant positive significantly affected by rate get insignificant in integration test were applied
relationship between changes in inflation rate, explaining stock market to check for long run
exchange rate, and both performance. Using short direction of causality. Short
short term and long term term interest rate instead of run causal links were
interest rates. Short and long long term, or using real explored using variance
term interest rates, and variables instead of nominal decomposition and impulse
money supply do not have does not alter the result. response functions. Sims’s
significant effect on Variance decomposition VAR is applied. Co-
Singapore hotel index but reveals that interest rate is integration regressions
significant negative relation the most important economic indicates the presence of long
is observed between the variable in explaining stock run relationship between
hotel sector and exchange returns. Few lagged stock prices-FDI, stock
rates. macroeconomic variables prices-money supply, stock
can explain stock returns, prices-IIP. Movement in BSE
It is interesting to see how whereas lagged stock returns Sensex influences exchange
developing markets respond can significantly explain rate and IIP, but NSE Nifty
to the economic most of the macroeconomic does not influence them.
fundamentals as compared to variables except Results reveal that NSE Nifty
well developed and more unemployment rate. Hence influences exchange rate,
organized markets. Talking stock market performance is exports, IIP and money
about emerging economies, a a good indicator of the future supply, while interest rate
study on Thailand by macroeconomic scenario. and FDI are causing
Tangjitprom (2011) uses NSE Nifty returns. Broadly, also concludes that even
four macroeconomic same is observed for BSE monetary policy measures that
variables namely, Sensex. Results reveal that affect interest rates are
unemployment rate, interest stock price movement is influential in determining
rate, inflation and exchange causing movement in IIP, stock returns.
rate. Lead-lag relationship is implying stock prices lead
analysed through VAR real economic activity. FDI Pal and Mittal (2011)
model and Granger causality causes movement in stock observed Indian capital
test. Variance decomposition prices but stock price markets and macroeconomic
is used to examine sensitivity movement does not affect variables like, inflation rate,
of stock returns to each FDI. Stock price movement interest rate, exchange rate and
macroeconomic factor. affects export flows through gross domestic savings
Sectorial analysis is done its effect on exchange rate. In (GDS). Quarterly data has
using sectorial indices as short run, Sensex and Nifty been taken from the first
each industry is sensitive to influence exchange rate. On quarter of 1995 to the last
macroeconomic indicators the other side, exchange rate quarter of 2008. Co-
differently. Monthly data does not affect BSE Sensex integration test is applied to
spans from January 2001 to and NSE Nifty. Study reveals check for long run
December 2010. Due to that money supply does not relationship and ECM is
unavailability of monthly affect stock returns but applied to check for short run
gross domestic product interest rate does. The paper patterns. They started with the
International Journal of Economics and Financial Issues | Vol 6 • Issue 3 • 2016 108
null hypothesis that Bidirectional causality exists in Bombay interbank rate that lagged values of
macroeconomic variables do between IIP and stock prices. (proxy for interest rate) and macroeconomic variables
not have any significant Unidirectional causality is period of study ranges from like, CPI, money supply and
impact upon stock prices. observed from money supply the first quarter of 1960 to interest rate, significantly
S&P CNX Nifty and BSE to stock prices, stock return to the fourth quarter of 1995. influence the stock market.
Sensex serving as a proxy for inflation and interest rate to Their investigation implies Interest rate serves as the
stock returns have been taken stock indices. that inflation and output strongest determinant
as dependent variables. growth are the main compared to other variables
Partial elasticity analysis is Naka et al. (1998) tried to see determinants of BSE and in the study. It influences
done on logarithms of the impact of economic performance of BSE has stock returns and also gets
models. ECM shows that reforms of 1991 on Indian improved as compared to influenced by stock returns.
inflation rate affects both capital markets. For equity pre-1991 period. Except for interest rates (T-
BSE Sensex and S and P market BSE data is taken. bill rates) stock indices are
CNX Nifty significantly. VECM is employed to check Another study on India by unable to explain any
Interest rate impacts for co-integration (long run Singh (2010) attempted to movement in other
movements in S and P CNX equilibrium relationship) explore causal relations macroeconomic indicators.
Nifty. Exchange rate among the factors. Through between stock market and Both variance decomposition
significantly affects BSE impulse response and macroeconomic variables and impulse response
Sensex. GDS shows no variance decomposition they by applying Granger function suggest that
association with BSE Sensex have demonstrated effects of causality test. Monthly data economic indicators can
and S&P CNX Nifty. They macroeconomic factors on from April 1995 to March explain only a small margin
conclude that Indian stock markets. 2009 has been used. Macro of error variance of equity
macroeconomic variables do Macroeconomic variables indicators like WPI, IIP and returns.
have a significant impact considered in the study are: exchange rate are observed.
upon stock returns in the Industrial production index BSE Sensex is taken as a Sohail and Hussain (2009)
Indian context. (proxy for output), CPI proxy for Indian equity have examined short run and
(proxy for inflation), M1 market. Strong correlation is long run relationships
BSE Sensex and NSE Nifty (narrow money; proxy for observed between BSE between macro indicators
show high correlation with money supply) and money Sensex-IIP and BSE and stock returns in
each other because of similar market rate Sensex-WPI, but not for Pakistan. Macroeconomic
composition. Results which exchange rate-BSE Sensex. variable like, CPI as a
indicate that these indices are Granger causality test measure of inflation, IIP, real
reacting differently in the indicated that IIP is the only effective exchange rate,
context of the same variable having bilateral money supply and 3 month
macroeconomic variable are causal relationship with BSE Treasury bill rate, are
questionable. Naik and Puja Sensex. observed. For tracing Lahore
(2012) investigated Indian stock exchange LSE25 index
equity market through BSE Considering the lower is taken. Monthly data
Sensex and macroeconomic middle income countries, spanning from December
variables like, IIP, wholesale Gunasekarage et al. (2004) 2002 to June 2008 is taken.
price index (WPI) as a have done a study on Sri Co-integration test was
measure of inflation, money Lanka, examining applied to check for long run
supply, T-bill rates as a macroeconomic influence relationship. ECM checks for
measure of interest rates and on stock market. They have short run dynamics. Variance
exchange rate. Monthly data used Colombo all share price decomposition gives further
is studied from April 1994 to index to represent the stock evidence of interactions
June 2011. To check for long market. Macroeconomic among variables. In long run,
run equilibrium relationship, variables like, money supply, inflation is negatively
Johansen’s co-integration and T-bill (measure of interest impacting stock prices while
VECM are applied. Stock rate), CPI (proxy for IIP, real effective exchange
prices are positively related inflation rate) and exchange rate and money supply are
to money supply and IIP, and rate, are taken. Monthly data having a positive effect on
negatively related to is analysed from January stock returns. 3 month T-bill
inflation. Exchange rate and 1985 to December 2001. rate is insignificant in
short term interest rate are VECM, impulse response explaining stock returns in
found to be insignificant in function and variance long run. Among macro
explaining stock returns. decomposition are employed indicators taken in the study
Granger causality suggests to check for long run and inflation explained maximum
that macro variables may be short run relationships. variance.
causing stock prices in long Results from VECM suggest
run but not in short run.
108 International Journal of Economics and Financial Issues | Vol 6 • Issue 3 • 2016
After a thorough review of exchange rate, as rate, interest rate, money problem in VAR model
literature, we found that the macroeconomic indicators. supply and exchange rate. We because of lack of
following variables are Based on the underlying have taken WPI as a proxy observation points, we
extensively used in literature economic theory and for inflation. For interest employ monthly data. IIP
viz., money supply, interest literature, we frame the rates, we use 365 days shows the amount of
rate, inflation rate and following hypotheses. Government of India T-bill industrial production or level
When we talk of inflation as borrowing, serving as an rates. For money supply, we of manufacturing in an
per the money demand incentive for firms and have taken broad money economy and is available at
theory, economic activity is increasing their stock prices. (M3). Exchange rate is a monthly frequency, but
negatively related to Hence, interest rates and obtained through US over the years contribution of
inflation, therefore stock stock returns must show Dollar/Indian Rupee FX Spot IIP is declining since the
returns are also negatively negative relation with each Rate. For tracking stock major contribution in GDP
influenced by inflation Fama other. Gjerde and Saettem returns in India, we have comes from the service
(1981). An increase in (1999) also show interest rate taken S and P BSE Sensex, sector and not from the
inflation may also lead to an to be negatively related to the benchmark stock index manufacturing sector. As per
increase in nominal risk free stock prices. Impact of for the Indian equity market. Planning Commission report,
rate, and also the discount exchange rate on an economy in 2014 contribution from
rate, leading to declining depends upon its level of Level of economic activity is Industry is around 24.2%
stock prices as stock prices international trade and also one of the crucial whereas Service sector
are the discounted value of trade balance. Depreciation of determinants of stock returns. contributes as much as
expected cash flows. Thereby currency leads to an increase GDP is the most 57.9%. Hence, we have
inflation and stock returns in demand for exports, comprehensive measure of excluded IIP from the study.
must show negative relation thereby increasing cash flows real economic activity in an
with each other. Geske and in the country under the economy. In India, GDP data Data for exchange rate (US
Roll (1983), Mukherjee and assumption that demand for is available only on a Dollar/Indian Rupee), S and
Naka (1995), Naka et al exports is elastic. In such a quarterly basis. To avoid P BSE Sensex and S and P
(1998), Sohail and Hussain case, the impact of exchange potential degrees of freedom BSE 500 is collected from
(2009), Pal and Mittal (2011) rate depends upon whether Thomson Reuters. For
show significant negative the firm is an exporting firm interest rates, 365 days
relation between inflation or import dominant. Government of India T-bill
and equity returns. Depreciation of domestic rate that is implicit yield at
currency induces investors to cut-off price (in Per cent) and
Relationship between money shift funds from domestic M3 (broad money supply) is
supply and stock prices lies assets to foreign currency taken from EPWRF time
in ambiguity. If increase in assets, depressing stock series data base. The study
money supply leads to prices. Hence we hypothesize covers the period from July
economic stimulus resulting a positive relation between 2001 to July 2015. The
in corporate earnings, it will exchange rate and equity reason we have taken 2001
increase stock prices. market. Mukherjee and Naka as the starting year is because
However when increase in (1995) conclude that Indian stock markets are at a
money supply leads to exchange rate is positively nascent level and are more
increase in inflation, it would related with stock returns prone to manipulation
raise discount rate, reducing whereas Pal and Mittal coupled with physical
stock prices. Hence relation (2011) show significant exchange of shares and
between money supply and negative relation between incomplete markets, with no
stock returns is still an exchange rate and stock efficient hedging instruments
empirical question. market returns. for investors and the presence
Mukherjee and Naka (1995) of fixed period of settlement
Sohail and Hussain (2009) 3. D system. Indian financial
show that money supply and markets have gone through
A
stock prices positively relate several reforms during this
to each other. T
period. Derivative
A instruments (index and stock)
Interest rate is another were introduced in India
fundamental macroeconomic In this paper, we investigate during 2000 and 2001. IPO
variable having significant the case for India using relaxation for information
impact upon stock returns. monthly frequency of data technology, media and
Reduction in interest rate and taking macro-economic telecommunication
reduces the cost of variables namely, inflation companies, i.e., permission to
International Journal of Economics and Financial Issues | Vol 6 • Issue 3 • 2016 108
issue a minimum of 10% directional causality between observations, r = Number of vectors is less than or equal
shares, came into existence most macro-economic co-integrating vectors. The to r against the alternative of
on 15th October 1999. variables and the stock trace test statistics test the r + 1 co-integrating vectors.
Venture Capital guidelines market. null hypothesis that the Again, if the estimated value
came into existence on number of distinct co- of the characteristic root is
September 15, 2000. 4. EMPIRICAL integrating vectors is less close to zero, λmax will be
Collective Investment than or equal to r against the small.
METHODOL
Scheme Regulations came alternative hypothesis of
into existence on July 15,
OGY more than r co-integrating To examine the short run
1999. Flexible face value relationships. It is clear that causality, Granger causality
In line with the literature, we
concept came into existence λtrace = 0 when λj = 0. The test is employed. Since the
examine long run
on October 11, 1999. farther the estimated future cannot predict the
relationships among macro
Negotiated deals were not characteristic roots are from past, if variable X granger
variables and stock index
permitted from September zero, the more negative is ln causes variable Y, then
returns by employing Co-
14, 1999. Internet Trading (1-λj) and larger would be changes in X should precede
integration analysis. A brief
was permitted by SEBI the λtrace. The maximum changes in Y. Therefore, a
methodology on multivariate
Board on January 25, 2000. eigenvalue statistics test the regression of Granger’s
Co-integration is presented
Corporate Governance came null hypothesis that the concept of causality states
below. that any time series X
into existence on January 1, number of co-integrating
2000, to be adhered by all A Granger-causes another
Co-integration analysis is =t- t + time series Yt, if
group S&P CNX Nifty designed to find linear (1) -1 series Yt can be
index companies by March combination of variables that AX predicted with
31, 2001. All deferral better accuracy
also removes unit root. For
products namely, example, if Yt and Xt are both = П Xt-1 + εt by using past values of Xt
ALBM/BLESS/MCFS/CNS I(1), then there may be a rather than by not doing so,
Where Xt denotes a vector of n keeping other information
, ceased to be available for unique value of β for which
Yt - βXt is I(0), that is no unit variables; Xt and εt are n × 1 identical, obtained by
all scrips from July 2,
vectors excluding all information on
2001.With these root in the relation linking Xt
infrastructure and regulatory and Yt. Co-integration is a Xt from Yt. Toda and
improvements, Indian stock testable restriction on a Yamamoto (1995), propose
markets are in a far better dynamic model. Co- an applicable
integration vectors, if exist, and At is an n × n matrix of the number of characteristic
position to absorb and react parameters. If rank of П is 0,
determine I(0) relations that each roots that differ from zero. We
at a much faster pace to any
hold between variables element of П equals 0. Then can obtain estimates of П and
information arrival. Most of
which are individually non- ΔXt = εt. Thus the first also the characteristic roots.
the existing studies focussed stationary. Such relations are difference of each Xt is I(0)
a period of infancy level in We need to test for number of
often referred to as “long run since all the {Xi,t} sequences
Indian stock market and equilibrium” relationships characteristic roots that are
are unit root processes and insignificantly different from
hence reported a bi- since they prove as there is no linear combination 0. Johansen test comprises of
attractors towards which
of the variable that is Trace test and Max-Eigen test.
convergence occurs. cointegrating relation unlike stationary. At the other λi denotes estimated values of
Conclusion on Co-integration Engle Granger test. The test extreme, suppose П is of full characteristic roots obtained
cannot be made by a mere for co-integration between the rank, then long run solution is from estimated П. Trace
visual inspection of graphical Xs is calculated by looking at given by n independent statistic tests whether number
plotting of variables that the rank of the matrix Π. equations. Each of these n of distinct cointegrating
might look or do not look Rank of a matrix is equal to equations is an independent vectors is less than or equal to
cointegrated. The only way the number of its restriction on the long run r. The farther the estimated
to find is through a careful characteristic roots solution of the variables. The characteristic roots are from 0,
statistical analysis. Co- (eigenvalues) that are n variables in the system face the greater is λ trace. Max-
integration analysis is different from zero. n long run constraints, each Eigen statistic tests whether
inherently multivariate, it of the n variables contained number of co-integrating
considers a set of integrated Xt = AtXt-1 + εt in vector Xt must be stationary vectors is r, against the
variables as a single time with long run values. In
ΔXt = AtXt-1 – Xt-1 + εt alternative of r+1.
series that cannot be general, if the rank of П is r,
cointegrated. then there are “r” co- Meanwhile, co-integration as
integrating vectors. Number such does not speak anything
Johansen (1991) test is a of distinct cointegrating about the direction of
preferable multivariate co- vectors can be found by causality. Hence, estimation of
integration test that accounts characteristic roots of П. ECM is important. The
for more than one Rank of a matrix is equal to concept of error correction
108 International Journal of Economics and Financial Issues | Vol 6 • Issue 3 • 2016
basically refers to the methodology independent of disturbance term with E(uit)=0,
adjustment process between the integration or co- (i = 1, 2),
short-run disequilibrium and integration properties of the E(u1t, u2t)=0.
+ α21 Y1t−1 + α2k Y1t−k + u2t
a desired long run position. model. In this method a 2t−k

As per Engle and Granger, if modified Wald test is used to The most fundamental
two variables are contrast the parameters of Where uit is a white noise advantage with VAR is that
cointegrated, then there the VAR. An extended VAR p there is no need for th
researcher
ˆ toorspecify which variables are
endogenous
exists an error correction data model is used, whose order ˆ
generating mechanism, and is determined by the number trace (r)  max (r, r 1)  exogenous - all are
vice versa. Two variables that of optimal lag lengths in the T In(1 r1) endogenous.
are cointegrated would not system (k) and the maximum T  (2)
drift apart over time; this number of times one must
In(1  j )
concept provides insight into differentiate the variables j
the long-run relationship (dmax). When a VAR max 

between the two variables (k+dmax) is predicted (where
and testing for the co- max d is the maximum order Where λj are the estimated Impulse responses trace out
integration between two of integration to occur in the values of characteristic the responsiveness of the
variables. system), this test displays roots dependent variables in the
asymptotic chi-square (eigenvalues) obtained VAR to shocks to each of the
distribution, it is also shown from Π` matrix. T = variables. So, for each
Number of
that if variables are
integrated of order d, the variable from each equation The descriptive statistics for
usual selection procedure is separately, a unit shock is all five variables is shown in
valid whenever k ≥ d. Toda applied to the error, and the Table 1. These variables are
and Yamamoto test has been effects upon the VAR system BSE Sensex, M3 (broad
used to capture long-run over time are noted. Thus, if money supply), WPI, and
causality pattern. there are g variables in a exchange rate and T-bill rates.
system, a total of (g*g) For a standard normal
In the Granger test we deal impulse responses could be distribution, skewness should
with bilateral causality but generated. Variance be zero and kurtosis should be
many times we come across decompositions offer a at three. It can be observed
multivariable causality slightly different method for that frequency distribution of
which can be resolved examining VAR system the above mentioned variables
through vector auto dynamics. They give the are not normal. The
regression. Models (VARs) proportion of the movements JarqueBera statistics also
in the dependent variables confirm the same. As is
were popularised by Sims
that are due to their ‘own’ obvious, standard deviation
(1980) as a natural
shocks versus shocks to the indicates that stock returns are
generalisation of univariate
other variables. A shock to more volatile as compared to
autoregressive models.
the ith variable will, of course, macroeconomic indicators.
According to Sims, if there
directly affect that variable, Since the time series analysis
is true simultaneity among a
but it will also be transmitted can only be done with a
set of variables, they should
to all of the other variables in stationary data series so as to
all be treated on an equal
the system through the avoid spurious results,
footing. There should not be dynamic structure of the Augmented Dickey Fuller
any priori distinction VAR. Variance (ADF) test is employed to
between endogenous and decompositions determine check for stationarity. As
exogenous variables. In VAR how much of the s-step- shown in Table 1, all the
framework each of the ahead forecast error variance series are found to be at non-
current values depends on of a given variable is stationary at levels. However,
different combinations of the explained by innovations to after first differencing, we get
previous k values of both each explanatory variable for stationary series for all the
variables and error terms s = 1,2. variables even at 1% level.
where k refers to the lag Thus all the variables are
term. integrated of the order I(1).
5. EMPIRI
Y1t = β10 + β11 Y1t−1 + β1k CAL This table reports descriptive
RESULT statistics of the variables used
Y1t−k+α11 Y2t−1 + α1k Y2t−k + u1t S in the study for the period July
2001 to July 2015. Log (M3)
International Journal of Economics and Financial Issues | Vol 6 • Issue 3 • 2016 108
stands for natural logarithm of co-integrating Gjerde and Saettem (1999)
of month end broad money relationships among the For money supply, the also show interest rate to be
supply. Log (WPI) stands for underlying variables. We positive relation indicates negatively related to stock
natural logarithm of monthly observe trace statistic and that an increase in money prices. Exchange rate and
average WPI. Log (exchange supply leads to economic stock returns show positive
max-Eigen statistic to
rate) stands for natural stimulus resulting in relation with each other.
identify the number of co-
logarithm of monthly corporate earnings, hence Depreciation of currency
integrating vectors. Results
average of USD/INR. T-bill leading to an increase in leads to an increase in
indicate presence of one long
rate stands for monthly stock prices. Mukherjee and demand for exports, thereby
run relationship between
average of 365 days Naka (1995), Sohail and increasing cash flows in the
macro indicators and stock
Government of India treasury Hussain (2009) show that country under the assumption
market returns.
bills. Last column reports money supply and stock that demand for exports is
daily percentage change in prices positively relate to elastic. In such a case, impact
Sensex values. ADF test is This table reports test
statistics of Trace and λmax each other. As proposed, of exchange rate depends
employed to check the interest rate shows negative upon whether the firm is an
presence of unit root in the are based without a linear
trend (µ = 0). The critical relationship with stock exporting firm or import
series at the levels and first returns. Reduction in dominant. Depreciation of
differences. values at 5% level are
obtained from Osterwald- interest rate reduces the cost domestic currency induces
Lenum (1992). The null of borrowing, serving as an investors to shift funds from
Table 2 represents incentive for firms and domestic assets to
unrestricted co-integration hypothesis implies at most r
cointegrating vectors, where increasing their stock prices.
rank test. Johansen’s
multivariate Co-integration r is the order of co-
test is employed to check for integration. Table 1: Descriptive statistics
number Statistic Log (M3) Log (WPI) Log (ex
Normalized co-integrating Mean 12.99 4.95
coefficients are displayed as Median 14.09 5.02
follows:- Maximum 15.21 5.23
Minimum 10.61 4.58
Standard deviation 1.75 0.20
Xt = (Sensext, Tbillt, WPIt, Skewness −0.17 −0.37
XRatet, M3t) Kurtosis 1.15 1.65
Jarque-Bera 24.86 16.52
Bt = (1.00, 5.1464, −1.5666, Probability 0.00 0.00
ADF test-levels −2.24 −1.83
−4.1392, −0.4907)
ADF test-first differences −13.22 −12.72
ADF test table values at 1%, 5% and 10% level are 4.01, 3.43 and 3.14 respectively
The co-integrating
relationship can be expressed foreign currency assets explained by the
as - depressing stock prices. macroeconomic variables viz.,
Mukherjee and Naka (1995) interest rate (T-bill rates),
Sensext = also conclude that exchange money supply (M3), inflation
1.5666WPIt+4.139 rate is positively related with (WPI) and exchange rate
2XRATEt+0.4907 stock returns. A contrasting (USD/INR). Similarly, for
M3t–5.1464Tbillt result is obtained for inflation interest rates, it is 6%, for
(1.06) as it is showing a positive money supply it stands at 6%
relation with stock returns. and for exchange rate and
(1.64) Maysami et al. (2004) and inflation it is 4% and 4%
Ratanapakorn and Sharma respectively. It clearly
(3.14) (- (2007) show positive relation suggests that only 11% of
5.14)
between inflation and stock movements in stock returns
returns. Indian economy as are getting influenced by
The t-statistics are reported
well as Indian capital markets these macroeconomic
in parentheses. The
are evolving at a rapid growth variables at monthly
coefficients for WPI and
pace and hence equities are frequency.
money supply are positive
serving as a hedge against
and statistically significant.
inflation. Table 2: Multivariate Co-integration
Interest rate shows negative
Johansen’s method
and statistically significant
Results of the VECM are Null: Number Trace Critical
relation with stock returns. presented in Table 3. As can of cointegrated statistic value at
Exchange rate shows be seen from the reported vectors 5% level
positive but insignificant adjusted R2, 11% of the r=0 80.04 77.74
relation with stock returns. variation in BSE Sensex is r≤1 36.39 54.64
109 International Journal of Economics and Financial Issues | Vol 6 • Issue 3 • 2016
r≤2 16 34.55 months in Exchange rate by result that the direction of
r≤3 5.13 Panel A of this table reports
18.17
long run relation 18.74% and about 8.74% causality runs from Sensex to
r≤4 2.01 variation in T-bills. This exchange rate.
(normalized cointegrating
relation) coefficients further supports the earlier
between logged values of
Sensex and logged values of Table 3: Vector error correction estimates
macroeconomic indicators. Panel A: Normalized cointegrating coefficients
Panel B reports the Variable LN_Sensex(−1) LN_T-bill(−1) LN_WPI
coefficients of VECM. The Coefficient 1.0000 −5.1464 1.566
numbers in parentheses Standard error (−1.0004) (−1.476
t-statistic [−5.14439]*** [1.0610
estimated coefficients are
Panel B: Error correction coefficients
standard errors and the
numbers in square brackets Error correction D (LN_Sensex) D (LN_T-bill) D (LN_W
CointEq1 0.0116 0.0050 −0.008
are t-statistics. (−0.0050) (−0.0072) (−0.003
[2.3112]** [0.6903] [−2.2425
Co-integration results are D (LN_Sensex[−1]) −0.0181 0.2498 0.129
reported in Table 3 which (−0.0893) (−0.1278) (−0.064
suggests that there exists [−0.2025] [1.9544]* [2.0053
long run relationships among D (LN_T-bill[−1]) 0.0553 −0.2435 −0.028
(−0.0567) (−0.0812) (−0.040
variables, but says nothing
[0.9747] [−2.9988]*** [−0.704
about the direction of D (LN_WPI[-1]) 0.2976 0.0191 0.008
causality. Engle and Granger (−0.1069) (−0.1530) (−0.077
suggest that, if variables are [2.7829]*** [0.1250] [0.108
co-integrated in long run D (LN_XRate[−1]) −0.2327 0.0807 0.517
then there must exist (−0.2681) (−0.3836) (−0.193
[−0.8682] [0.2103] [2.6792]
unidirectional or
D (LN_M3[−1]) −0.0455 0.0177 −0.002
bidirectional relationship (−0.0146) (−0.0209) (−0.010
between variables. To shed [−3.1179]*** [0.8466] [−0.192
more light into the findings C 0.0127 −0.0029 −0.002
of VECM model, the results (−0.0053) (−0.0076) (−0.003
of variance decomposition [2.4083]** [−0.3850] [−0.536
analysis are reported in Adjusted R2 0.11 0.06 0.04
F-statistic 4.42 2.72 2.11
Table 4. The reported figures
*,**,***Denote statistical significance at the 10%, 5% and 1% levels respectively
indicate the percentage of
movement in each variable
that can be attributed to its
own shock and the shocks to
the other variables in the
system. These are provided
for five difference lagged
time horizons: 1 month, 5
months, 10 months (short
run), 15 months and 20
months (long run). The
results support the argument
that the movements in the
Sensex can be explained by
some of the macroeconomic
indicators analysed. In the 1st
month, 100% of the
variability in the Sensex is
explained by its own shocks
while after 10 months,
84.73% of variability is
explained by its own
innovations; 7.37% by the
shocks from T-bills; 6.27%
by the shocks of WPI.
Similarly, Sensex accounts
for the variation after 10

International Journal of Economics and Financial Issues | Vol 6 • Issue 3 • 2016 109
 Table 4: Variance decomposition results
Panel A: Percentage of the Movement in the Sensext explained by shocks
Lags (n) LN_Sensext-n LN_T-billt-n LN_WPIt-n LN_XRATEt-n LN_M3t-n
1 100.00 0.00 0.00 0.00 0.00
5 91.38 1.61 4.93 0.11 1.96
10 84.73 7.37 6.27 0.42 1.20
15 77.50 14.04 6.88 0.78 0.80
20 71.07 19.99 7.19 1.11 0.64
Panel B: Percentage of a shock to Sensext-n explaining movements in
LN_Sensext LN_T-billt LN_WPIt LN_XRATEt LN_M3t
1 100.00 2.49 0.12 25.23 2.05
5 91.38 8.02 1.41 21.59 2.30
10 84.73 8.74 2.71 18.74 1.22
15 77.50 8.93 3.76 16.28 0.86
20 71.07 8.99 4.54 14.34 0.84

This table reports the results of variance decomposition analysis Fama, E.F. (1981), Stock returns, real activity, inflation, and money. The
over five different lagged time horizons. Panel A reports the
percentage movement in Sensex that can be attributed to itself
and other variables. Panel B reports the percentage of
movement in macroeconomic indicators that is attributed to
Sensex.

6. CONCLUSION

This paper explored the nexus between Indian stock market and
selected macro-economic indicators by performing necessary
analysis that addresses long run and short run relations.
Specifically, the study employs monthly data from July 2001
to July 2015 along with Johansen’s co-integration analysis and
granger causality tests are performed. The results are interesting
and useful in understanding the dynamic relations between
stock returns and macro-economic factors. The study finds
support for the presence of one cointegrating vector between
Sensex and macro-economic indicators viz., exchange rate,
money supply, WPI and treasury bill rate.

Further, the study observes that three out of four factors (viz.,
WPI, money supply and T-bill) are relatively more significant
in a long run relation. Turning to short run relations, the study
reports bi-directional causality between Sensex and exchange
rate. Inflation and money supply show positive and significant
relation with stock returns. Interest rate shows negative and
insignificant relation with stock market returns. We can say that
Indian capital markets are showing signs of market inefficiency
because of co-integration between stock returns and
macroeconomic indicators.

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