SYNOPSIS

STUDY TOPIC: AN EMPIRICAL ANALYSIS ON RELATIONSHIP BETWEEN STOCK INDEX

RETUEN AND INFLATION.

Introduction:

Stock market performs a very important function in the Indian economy where this measures a growth
and development of the country. Even though there are many other tools to identify the growth level, it
is a vital barometer of the economy. It helps the public in savings and investment which leads to
employment of funds rather than ideal money with the public. A small savings of public money are
collected and employed in several companies to diversify the risk of loss, theft, fire etc. Since this
market is more liquid, where it can be easily converts the money from public to financial instruments
and from financial instruments to liquid cash whenever it requires.

Since the stock market is very sensitive to the macroeconomic variables like interest rates, inflation,
exchange rates, FII's etc. This study is focused on changes in inflation rates and its effect on stock
prices. It is very common for equities to hedge against inflation because the returns from equities
should not be affected by variations from inflation.

Relation between stock index returns & inflation:

There are several empirical explanations that say the negative correlation between stock returns &
inflation. Some attribute this inconsistency between the theory & empirical findings to market
inefficiency. Others attribute it to the negative correlation between real economic activity (fiscal &
monetary) and inflation known as proxy effect hypothesis. In the current changing situation of financial
system, it is supreme for market players, researchers, policy maker and practitioners to know the in
depth knowledge of economic and financial structure and learn the close movements of stock prices
and economic variables while preparing the financial policies and procedures.
The informational effectiveness of some foremost stock markets is widely examined from the research
report of causal relationship between stock price index and inflation. The result from the studies are
significant because informational ineffectiveness in stock market shown in one side, market players
capable of increase profit by trading rules and by this means can constantly receive in excess of
aggregate market returns and on the another side, stock marketplace is not expected to show successful
role in channeling financial wealth to the mainly productive sectors of economy.
The Efficient Markets Hypothesis (EMH) assumes everybody have complete awareness of each and
every information accessible in market. As a result, present value of an individual stock ( market as
complete) depict all information available at time t. consequently, if real economic activities affect
stock prices, then well-organized stock market immediately digest and involves every existing
information regarding economic factors. The rational performance of market players ensure historical
and present information is wholly showed on present stock prices. So the impact is, investor are unable
to build up trading rules so, hence they need not always earn more than usual returns. For that reason, it
can be concluded that, in an information ally well-organized market, historical (present) stage of
economic movement are not helpful in predicting present (future) stock prices.

During the study to identify the lagged values of stock index to economic variables do not cause
informational effectiveness; this proves that almost the presence of effect from present values of index
prices to future stage of economic factors. This provides an advice that the index prices lead the
macroeconomic factors and market makes logical forecasts of real sector.

Likewise some of the lagging factors in the economy affects the index prices and historical volatility in
index prices affects the volatility of economic factors, after that bi-directional causality is understood
among these two variables (stock index return and inflation) . This activity shows that stock market is
ineffective. In other words, if variations in the economic factors neither influence nor are influenced by
stock price fluctuation, so the two variables are not dependent on each other hence we can say that the
market is effective.

Inflation rate is a significant factor in identifying stock index return because of the reality that at the
time when the inflation is very high, investor thinks that the market is in the position of high
complexity. People are terminated from the job, which in turn leads to reduction in the production
activity. Public do not want spend unnecessarily hence they purchase only the necessaries for daily
requirements. Therefore the production level is brought below the average level. The affect of these
activities in the economy affects the profits of the business, which further more affects the dividend
payout ratios of the company. When the dividend paid by the company decreases, the stocks return also
diminishes leads to depreciation in the value of stocks.

Inflation directly has impact on all the companies in different ways. This is basically an imbalance
involving a continuous twist in the return prices. These twists may be because of the happening of
events. A compulsion of money and credit inflation increases the price and wage rates at different
volume. Furthermore, when the different countries inflation rates differ that affects the exchange rates
of those countries which in turn have impact on prices of domestic products, changes relative price
even more. There are also institutional factors which affect relative prices, for example import
controls, unions, and regulation and deregulation of such things as oil and transport. Thus relative
prices will shift during a period of fluctuating inflation rates, affecting the growth and stability of
earnings.

Common stock represents an ownership claim on the prospective after-tax earnings of the company.
Thus, an unexpected increase in the inflation rate would tend to depress the after tax earnings on
capital, thereby depressing the value of corporate assets to potential owners. Accordingly, real stock
prices tend to fall.

It has only been in periods of accelerating inflation and tight monetary policy that the market has
really been poor. The depressing effect of accelerating inflation on the stock market resulted from the
perceived risk by investors that the monetary authorities would tighten policy in order to control
inflation, and that this would work by depressing the economy as well as real earnings of the corporate
segment.

The entire level of stock market will be affected by cyclical movements of the economy. Prices will
rise at times of easy money and low interest rates, which provide a stimulus to economic growth. As
interest rates and money tightens, so the business environment will worsen, costs will rise, demand
will fall, profits will be squeezed from both sides, and stock prices will become depressed.
1.1 STATEMENT OF PROBLEM:

There are various studies conducted to find the relationship between inflation and stock return by using
different statistical tools and various indices. This study shows the evidence of relationship between
inflation rates and stock returns and also lead lag relationship between the two. And also find out
whether the market is efficient in impounding available information about future inflation into stock.

1.2 NEED OF THE STUDY:

The study is conducted for the purpose to know the relationship among inflation rate & stock return.
This study clearly shows whether the stock returns are influenced by inflation rates or not this also
helps in finding out whether stocks can be hedge against inflation by the investor.

1.3 OBJECTIVES:

1. To know the relationship between stock return and inflation.

2. To find out whether the common stocks can hedge against inflation.

3. To analyze whether the relationship varies with the different stock indices.

4. To find out which variable is lagging and which variable is leading.

1.4 SCOPE OF STUDY:

The study is conducted for a period of 10weeks and collected the data available relating to nifty price,
bank nifty, Sensex, and inflation rates on websites. The data is limited only for a period of 3years.
1.5 RESEARCH METHODOLOGY:

a. Data collection: Data which are used for this analysis is secondary data collected from website
i.e. money control. Data used from this website are financial statement, stock prices etc.

b. Study population: population is the indices of national stock exchange & 30 stocks of Bombay
stock exchange and consumer price index.

c. Sampling frame: Sampling Frame is the Indian stock market.

d. Sample: Sample chosen is continuously compounded monthly closing values of BSE Sensex,
Nifty, Bank Index, and the consumer price index for 3 years only.

e. Period of the study: Nifty is taken forthree years from January 2013 to Dec 2015, Bank Index
for threeyears from January, 2013 to March, 2015 and BSE Sensex from January 2013 to Dec
2015.

1.6 LITERATURE REVIEW

Fama and schwert (1997) and Fama (1981) say there was negative relation among stock market
prices & inflation. But Hardouvelis (1988) found not much relation among stock price and inflation.
From the study of Fisher (1930) tells the expected rate of inflation is composed return and expected
inflation rate. The study indicates, there was no major relation among return and monetary sector. It
shows clear picture of inverse or negative relation among stock index return & rates of inflation. Fama
(1981) says from the proof in his study that increase in the real economic activity leads to increase the
stock price but decrease value of money and inflation due to the demand for money. This shows the
opposite way of his previous study that there is negative relation among stock price and inflation rates
and he suggesting that the income from real assets must be hedge against inflation.
Jiranyakul (2009) has done a study on stock market index and macro-economic variables. He used
few technique such as unit root test, granger co-integration test and co-integration test by using two-
step Engle method to do the study by taking into account multivariate time series regression analysis.
From this analysis they wanted to know the long and short term relation between macro variables and
stock index. Result from the research shows there is long term relation among these two variables.

Robert (2008) conducted a study of relationship of macro variables and stock return of four different
economies such as Russia, India, China and. This study clearly explained that there is no relationship
between such past and present market return and macro-economic variables. Also, no relationship
between these variables, oil price and exchange rates.

Pearce and Roley (1985) while conducting study on variation of stock prices to the inflation rates
considered some more factors i.e., real economic activity, inflation rate and monitory policy. The result
showed a significant relation between monitory policy and stock price and very little amount of affect
by inflation on the stock price but no significant relation of real economic activity to variation in the
stock prices.

The industrial production moves in opposite direction with stock price but stock prices are moving
along with inflation rates, money supply and interest rates.

Naik and padhi (2012) in his study on relation among Indian stock index prices and macro-economic
factors such as wholesale price index, interest rates, money supply, industrial productions treasury bills
etc. for the data related from the year 1994 to 2011 reflected that the Indian stock index as well as
economic factors are inter related and also there is long term balanced relation exist.

The study explains that stock index market and macro variables such as industrial production and
money supply are optimistically connected except the rate of inflation which is negatively related. The
interest rates and exchange rates are insignificant with the relation between stock price and macro
variables.
Sireesha (2013) says about movements of stock market index like nifty, silver and gold withmacro-
economic variables by using linear regression equation. Gold and silver are taken into consideration as
a sample for the analysis. The internal variable shows interdependence of gold, silver and stock with
these variables. The stock prices or returns are significantly influenced by inflation and GDP but
money supplies have an impact on the gold returns.

Durai and Bhaduri (2009) tested the relation among inflation, stock index price in India by using
wavelet methodology. The hypothesis is test by using the data from 1995 to 2006. The study of wavelet
method for expected and unexpected inflation showed equal result. In short run, expected inflation
shows insignificant relation on stock price but in long run, expected inflation has pessimistic relation
on stock index price and unexpected inflation showed insignificant relationship with stock.

Shanmugam and Misra (2008) conducted a study on emerging economy like India for the period of
1980 to 2004 about the relation among Indian stock market index and rates of inflation during the pre-
and post-reform phase. This study used ordinary least square method was used and also the study
showed whether Indian stock market be able to hedge against inflation or not. The single equation
treatment gives improper result so they used two step OLS method. The result from the study showed a
pessimistic relation among stock index price and rates of inflation in India. This study also agrees to
Fama's hypothesis but it is valid only for pre-reform phase and not for post-reform phase.

This study concluded that stock index returns are not dependent on inflation in post-reform period.

1.7 LIMITATIONS:

1. The time period of the study is limited.

2. The results are limited only to inflation than many other macroeconomics factors.