Dividend policies of indian

companies & volatility in its

share prices
ANALYSIS 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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