Вы находитесь на странице: 1из 83

A Research Project on

An Empirical Analysis of Relationship between Stock Index


Returns and Inflation.

Submitted in partial fulfillment of the requirement of the MBA degree


Bangalore University

Submitted by
MEGHA.N.BAIS

Register number
04XQCM6054

Under the guidance of


Dr. Nagesh Malavalli
M.P.Birla Institute of Management,
Bangalore.

M.P.Birla Institute of Management,


Associate Bharatiya Vidya Bhavan,
Bangalore 560001
DECLARATION

I hereby declare that the research work embodied in the dissertation

entitled “An Empirical Analysis of Relationship between Stock Index Returns and
Inflation”” is the result of research work carried out by me, under the
guidance and supervision of Dr. Nagesh Malavalli, Principal, M. P. Birla
Institute of Management, Associate Bharatiya Vidya Bhavan, Bangalore.
I also declare that the dissertation has not been submitted to any
University/Institution for the award of any Degree/Diploma.

Place: Bangalore MEGHA N.BAIS

Date: Regd. No. 04XQCM6054.


GUIDE’S CERTIFICATE

This is to certify that the Project titled “An empirical Analysis of


Relationship between stock Index Returns and Inflation” has been prepared by Ms.
MEGHA N.BAIS bearing registration number 04XQCM6054, under the
guidance of Dr. Nagesh Malavalli, M.P.Birla Institute of Management,
Bangalore. This has not formed a basis for the award of any degree/diploma
for any university.

Place: Bangalore

Date: Dr. Nagesh Malavalli


PRINCIPAL’S CERTIFICATE

This is to certify that the Project titled “An Empirical Analysis of


Relationship between Stock Index Return and Inflation” has been prepared by Ms.
MEGHA N.BAIS bearing registration number 04XQCM6054, under the
guidance of Dr. Nagesh Malavalli, M.P.Birla Institute of Management,
Associate Bharatiya Vidya Bhavan, Bangalore.

Place: Bangalore

Date: Dr. Nagesh Malavalli


ACKNOWLEDGEMENT

“Blessed are those who give without remembering and


Blessed are those who take without forgetting”.

The completion of the research would have been impossible without the valuable
contributions of people from the academics, family and friends.
I hereby wish to express my sincere gratitude to all those who supported me
throughout the study.

I am thankful to Dr. NAGESH MALAVALLI, Principal, M.P.Birla Institute of


Management, Bangalore, for his valuable guidance, academic and moral support which
made this report a reality.

I am greatly thankful to Prof. T.V. Narasimha Rao (Finance), Prof. Santhanam


(Statistics) Prof. Bislaiah (Economics) for their support in completion of this report.

A special thanks to my friend Lakshmi S.N. who made this report reality.

Last but certainly not the least, my family and friends who tolerated me and
cooperated when I was not so very best.

Place: Bangalore MEGHA N.BAIS


Date: Reg No: 04XQCM6054
ABSTRACT
Stock market and Inflation are the barometers of the economy and both are the
sensitive segments of the economy. Any changes in the policies of the country are
quickly reflected in the stock market and inflation. There are different factors, which
affect the stock markets like interest rates, company performance, future growth
prospects, political stability, exchange rates etc. There are different factors, which affect
the Inflation like the money supply, interest rates, faith in government's ability to protect
the value of currency, monetary and fiscal policy, budgetary deficits etc. This study
attempts to analyze the interlinkages between inflation and stock prices.

The study is conducted by considering inflation and various indices for various
periods. This is analyzed by using statistical tools like Augmented Dickey Fuller Unit
root Test, Grangers Co-integration test and Grangers causality test.

From the results it is clear that there is negative relationship between stock returns
and inflation, and suggests that investors cannot use common stock investments as a
hedge against rising prices or inflation. It is evident from the overall results that the
causality runs from inflation to stock returns and also in the reverse order.
CONTENTS

Chapter Particulars Page


No. No.
Abstract

1 Introduction 1-13
- Background
- Theoretical Framework
2 Literature Review 14 -18

3 Research Methodology 19 – 31
- Problem Statement
- Objectives of the study
- Purpose of the study
- Hypothesis
- Sample Design
- statistical Methods
- Limitations of the study

4 Empirical Results 32 – 48

5 Conclusions 49 – 51

Bibliography 52 – 53

Annexure 54 - 67
LIST OF TABLES

Table Particulars Page


No. No.
1 List of S&P CNX Nifty Companies 22

2 List of CNX Bank Index Companies 24

3 List of BSE Sensex Companies 24

4 Results of Wholesale Price Index ADF Unit Root Test 32

5 Results of S&P CNX Nifty ADF Unit Root Test 34

6 Results of CNX Bank Index ADF Unit Root Test 36

7 Results of BSE sensex ADF Unit Root Test 38

8 Results of S&P CNX Nifty and WPI Regression 40

9 Results of S&P CNX Nifty and WPI Granger Co-integration Test 40

10 Results of CNX Bank Index and WPI Regression 42

11 Results of CNX Bank Index and WPI Granger Co-integration Test 42

12 Results of BSE Sensex and WPI Regression 44

13 Results of BSE sensex and WPI Granger Co-integration Test 44

14 Results of S&P CNX Nifty and WPI Grangers Causality Test 46

15 Results of CNX Bank Index and WPI Grangers Causality Test 47

16 Results of BSE Sensex and WPI Grangers Causality Test 48


LIST OF GRAPHS

Graph Particulars Page


No. No.
1 S&P CNX Nifty Stationarity Graph 33

2 CNX Bank Index Stationarity Graph 35

3 BSE Sensex Stationarity Graph 37


Introduction
Background
Globalization and financial sector reforms in India have ushered in a sea change
in the financial architecture of the economy. In the contemporary scenario, the activities
in the financial markets and their relationships with the real sector have assumed
significant importance. Since the inception of the financial sector reforms in the
beginning of 1990’s, the implementation of various reform measures including a number
of structural and institutional changes in the different segments of the financial markets,
particularly since 1997, have brought about a dramatic change in the financial
architecture of the economy. Altogether, the whole gamut of institutional reforms,
introduction of new instruments, change in procedures, widening of network of
participants call for a reexamination of the relationship between the financial sector and
the real sector in India. Correspondingly, researches are also being conducted to
understand the current working of the economic and the financial system in the new
scenario. Interesting results are emerging particularly for the developing countries where
the markets are experiencing new relationships which are not perceived earlier. The
analysis on stock markets has come to the fore since this is the most sensitive segment of
the economy. It analyses the relationship between stock prices and macroeconomic
variable inflation with implications on efficiency of stock prices.

Relationship between stock returns and inflation


There are several empirical explanations for 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 an increasingly complex scenario of the financial world, it is of paramount
importance for the researchers, practitioners, market players and policy makers to
understand the working of the economic and financial system and assimilate the mutual
interlink ages between the stock and economic variables in forming their expectations
about the future policy and financial variables
The informational efficiency of major stock markets has been extensively
examined through the study of causal relations between stock price indices and inflation.
The findings of these studies are important since informational inefficiency in stock
market implies on the one hand, that market participants are able to develop profitable
trading rules and thereby can consistently earn more than average market returns, and on
the other hand, that the stock market is not likely to play an effective role in channeling
financial resources to the most productive sectors of the economy.

The Efficient Markets Hypothesis (EMH) assumes that everyone has perfect
knowledge of all information available in the market. Therefore, the current price of an
individual stock (and the market as a whole) portrays all information available at time t.
accordingly, if real economic activity affects stock prices, then an efficient stock market
instantaneously digests and incorporates all available information about economic
variables. The rational behavior of market participants ensures that past and current
information is fully reflected in current stock prices. As such, investors are not able to
develop trading rules and, thus may not consistently earn higher than normal returns.
Therefore, it can be concluded that, in an information ally efficient market, past (current)
levels of economic activity are not useful in predicting current (future) stock prices.

While finding causality from lagged values of stock prices to an economic


aggregate does not violate informational efficiency, this finding is equivalent to the
existence of causality from current values of stock prices to future levels of the economic
variable. This would suggest that stock prices lead the economic variable and that the
stock market makes rational forecasts of the real sector.

If, however, lagged changes in some economic variables cause variations in stock
prices and past fluctuations in stock prices cause variations in the economic variable, then
bi-directional causality is implied between the two series. This behavior indicates stock
market inefficiency. In contrast, if changes in the economic variable neither influence nor
are influenced by stock price fluctuations, then the two series are independent of each
other and the market is information ally efficient.
The inflation rate is an important element in determining stock returns due to the
fact that during the times of high inflation, people recognize that the market is in a state
of economic difficulty. People are laid off work, which could cause production to
decrease. When people are laid off, they tend to buy only the essential items. Thus
production is cut even further. This eats into corporate profits, which in turn makes
dividends diminish. When dividends decrease, the expected return of stocks decrease,
causing stocks to depreciate in value.

Inflation clearly affects different companies in different ways. Inflation is


essentially a disequilibrium phenomenon involving continuing distortions among relative
prices. These distortions result partly from time lags. A given impulse of money and
credit inflation pushes up different prices and wages at different rates and by varying
magnitudes. Moreover, when countries inflate at different rates, relative exchange rates
are distorted, and this in turn feeds back into the domestic price structure, altering relative
prices even further. 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 and the real earnings of the corporate sector.
The overall level of the 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.
Theoretical Framework
The Indian Financial System
The Indian financial system consists of many institutions, instruments and
markets. Financial instruments range from the common coins, currency notes and
cheques, to the more exotic futures swaps of high finance.

Financial Markets
Generally speaking, there is no specific place or location to indicate financial
markets. Wherever a financial transaction takes place, it is deemed to have taken place in
the financial market. Hence financial markets are pervasive in nature since financial
transactions are themselves very pervasive throughout the economic system.

However, financial markets can be referred to as those centers and arrangements


which facilitate buying and selling of financial assets, claims and services. Sometimes,
we do find the existence of a specific place or location for a financial market as in the
case of stock exchange.

Classification of financial markets


Financial markets can be classified as

i) Unorganized Markets
In these markets there a number of money lenders, indigenous bankers, traders
etc. who lend money to the public.

ii) Organized Market


In organized markets, there are standardized rules and regulations governing their
financial dealings. There is also a high degree of institutionalization and
instrumentalization. These markets are subject to strict supervision and control by the
RBI or other regulatory bodies.
Organized markets can be further divided into capital market and Money market.
Capital market
Capital market is a market for financial assets which have a long or definite
maturity. Which can be further divided into:
• Industrial Securities Market
• Government Securities Market
• Long Term Loans Market

Industrial Securities Market


It is a market where industrial concerns raise their capital or debt by issuing
appropriate Instruments. It can be subdivided into two. They are:

• Primary Market or New Issues Market


Primary market is a market for new issues or new financial claims. Hence, it is
also called as New Issues Market. The primary market deals with those securities which
are issued to the public for the first time.

• Secondary Market or Stock Exchange


Secondary market is a market for secondary sale of securities. In other words,
securities which have already passed through the new issues market are traded in this
market. Such securities are listed in stock exchange and it provides a continuous and
regular market for buying and selling of securities. This market consists of all stock
exchanges recognized by the government of India.

Importance of Capital Market


Absence of capital market serves as a deterrent factor to capital formation and
economic growth. Resources would remain idle if finances are not funneled through
capital market.
• It serves as an important source for the productive use of the economy’s savings.
• It provides incentives to saving and facilitates capital formation by offering
suitable rates of interest as the price of the capital
• It provides avenue for investors to invest in financial assets.
• It facilitates increase in production and productivity in the economy and thus
enhances the economic welfare of the society.
• A healthy market consisting of expert intermediaries promotes stability in the
value of securities representing capital funds.
• It serves as an important source for technological up gradation in the industrial
sector by utilizing the funds invested by the public.
Inflation
Definition

Inflation is an increase in the amount of currency in circulation, resulting in a


relatively sharp and sudden fall in its value and rise in prices: it may be caused by an
increase in the volume of paper money issued or of gold mined, or a relative increase in
expenditures as when the supply of goods fails to meet the demand.

This definition includes some of the basic economics of inflation and would seem
to indicate that inflation is not defined as the increase in prices but as the increase in the
supply of money that causes the increase in prices i.e. inflation is a cause rather than an
effect.

On the other hand in this definition, inflation would appear to be the consequence
or result (rising prices) rather than the cause -- A persistent increase in the level of
consumer prices or a persistent decline in the purchasing power of money, caused by an
increase in available currency and credit beyond the proportion of available goods and
services.

High and Low inflation


It would seem obvious that low inflation is good for consumers, because costs are
not rising faster than their paychecks.

During the high inflation it is believed that "High Inflation introduces


uncertainty". This is not quite true either. The truth is that steady inflation, if it can be
relied upon to remain steady, does not introduce uncertainty. Changing (fluctuating)
inflation rates is what introduces uncertainty. The best stock market performance takes
place in years of price stability when nothing is happening on the inflation & deflation
front.
Causes
There may be difference of opinion on the causes and consequences of inflation
and the measures to be taken to deal with the problem. What needs to be done is not so
much a general statement of anti inflationary policies as the formulation, in great detail,
of remedial measures, short term as well as long term.

It is the result of economic forces at work, rather than the conspiracy of merchants
and manufacturers, or the faulty functioning of the market mechanism, these can only be
short period.

Inflation represents an imbalance between the flow of incomes to people and the
spending power available with them on the one hand and the availability of goods and
services on the other.

Inflation can occur with unchanged availability of goods and a marked increase in
incomes in the hands of the people and desire to spend from past savings. There are also
situations were production remains sluggish and even declines while incomes in the
hands of the public rises on account of high levels of government and non government,
financed by borrowing from the banking system in a big way.

If inflation continues for a long period, it causes a lot of disturbance to the


economy which gets distorted. The price rise in the country is on account of factors
operating both on the demand & supply sides:

• Expenditure by government larger than its receipts from revenue and loans from the
public, which is known as deficit financing.
Where the deficit financing is of large dimensions, naturally the flow of
incomes is proceeding at a much faster pace than the capacity of the economy to
generate a corresponding larger supply of goods and services.
• Larger credit given by banks to the commercial sector not supported by productive
activities.
The RBI regulates the latter by imposing restrictions on credit in order to
bring about some equilibrium. The former can be controlled by government
imposing greater self discipline and keeping its expenditure within the limits of its
resources.
• Demand generated by unaccounted money.
• Delay in monsoon
• Increase in the purchasing power of the house holds.
• Liberal govt. policies on taxation, excise, customs etc.
• Expansion of currency.

Inflation can be avoided


Price stability can be accomplished, provided there is a will on the part of the
govt. and public in this direction. The fight against inflation calls for a proper formulation
of economic plans and determined implementation of the plans. Fiscal & monetary action
constitutes important elements of the anti inflationary strategy. Various types of action
should be taken to raise the standards of productivity in the farm, factory & the office.
The immediate action should be to arrest forthwith any further rise in commodity prices,
by drastic action on the fiscal & monetary fronts. Measures may be:

• Role of fiscal policy


Reduction of budgetary deficits: Control over expenditure & maximizing tax
income and rise in the rates of interest rates. Ceiling should be put on purchase of
govt securities by the RBI and the commercial banks & the extension of ways &
advances to govt by the Reserve Bank.

• Role of monetary policy


The primary task of monetary policy is to restrain money circulation in the
economy. The RBI has a variety of instruments of credit control. It si the
responsibility of individual commercial banks to ensure that credit allocation to
the various sectors of the economy is done in a manner that fulfills broadly the
official objective of larger credit flows to the neglected & priority sectors while at
the same time keeping down the aggregate extension of credit to the limits
dictated by the overall economic situation. This can be done through selective
credit control; cash reserve ratio, statutory ratios & open market operations.

• Role of the corporate sector


Corporate sector can curb inflation by substantial increase in productivity,
decreasing inventory building.

Types of Inflation
Open inflation: when prices rise substantially and continuously, the phenomenon is
called open inflation.

Latent inflation: for a relatively short period there may be no increase in pieces but there
will be a substantial buildup of what is known as latent inflation. The
community is building up its liquid resources – cash, bank deposits
and short term investments.

Demand pull: it arises when prices are rising as a result of growing demand for goods
and services in relation to their supplies. Generally, it is caused by rising
current & capital expenditure on the part of the govt and the public.
Y0 is the level of real national income. An aggregate demand function D0
intersecting aggregate supply function S at point A. the price level remains at P0. an
upward shift in aggregate demand function will simply raise the price level. It can be seen
in the diagram that a rise in aggregate demand indicated by the aggregate demand
function D1 merely raises the price level to P1 without any impact on real national
income. This is a clear case of what is known as excess demand inflation.

Cost push inflation: it arises when there is a substantial increase in cost, on account of
wage & salary increase much in excess of productivity increases &
increase in the prices of important goods & services.

In an imperfectly competitive economy the aggregate supply function cannot be


assumed to be stable. Consequently, the aggregate supply curve move upward as from S0
to S1 & S2 regardless of the behavior of aggregate demand. The intersection of original
aggregate supply curve S0 & the aggregate demand curve D0 had ensured real income at
point level P0. When the aggregate supply function moves upward from S0 to S1 due to
rising costs, level of real income can be maintained only if the price level is raised to
OP1. An effort to hold prices closer to p0 will result in a decline in employment &
corresponding fall in the level of income. This is a case of what economists call cost push
inflation.
Measures of Inflation
Two most widely used price indices are ‘consumer price index ‘and ‘wholesale
price index’.
Consumer price index:
It is the annual percentage change in the cost of acquiring a fixed basket of goods
and services. There are four different types of consumer price index released for different
levels of working class in the country viz. consumer price index for urban non manual
employee, consumer price inflation for agriculture laborers, consumer price index for
industrial workers, and consumer price inflation for rural laborers. Different
governmental and monitoring agencies use these indices for their purpose. These indices
also form the basis of decisions regarding the dearness allowance for the government
employees.

Wholesale price index:


This is the index that is used to measure the change in the average price level of
goods traded in wholesale market. A total of 435 commodities data on price level is
tracked. The Wholesale Price Index (WPI) is the most widely used price index in India. It
is the only general index capturing price movements in a comprehensive way. It is an
indicator of movement in prices of commodities in all trade and transactions. It is also the
price index which is available on a weekly basis with the shortest possible time lag only
two weeks. It is due to these attributes that it is widely used in business and industry
circles and in Government, and is generally taken as an indicator of the rate of inflation in
the economy. It is imperative that the index is put on as sound a footing as possible.

Calculation of inflation rate:


Rate for Inflation for year t = PIN t – PIN t-1
* 100
PIN t-1
Where, PIN t is index for year t
PIN t-1 is index for previous year.
Literature Review
A significant amount of literature exists that examines the relationship between
stock market returns and a range of macro economic and financial variables over a
number of different stock markets and time periods. Now a day financial economics
provide a number of models that helps to examine the relationship. Some of the
literatures on this topic are:

Fama and Schwert *1 (1977) in their study estimated the extent to which common
stocks are hedge against expected and unexpected components of inflation rate during
1953-71 periods. They found that the common stock returns are negatively related to the
expected components of the inflation and also to the unexpected components.

Their objectives was to find out the relationship between stock return and
expected inflation, whether stocks can be used as hedge against inflation and whether the
market is efficient in impounding available information about future inflation into stock
prices.
The data taken for their study was inflation rates from Jan.1953 to July 1971. The
common stocks taken are the continuously compounded stock of NYSE. They estimated
the relationship using the first twelve autocorrelation of the inflation rate and the nominal
returns for the monthly, quarterly and semiannual data. The returns to the NYSE are
approximately -5.5, with standard error of about 2.0, which implies that common stocks
are not a hedge against the expected inflation rates.

Thus, they concluded that common stock returns are negatively related to the
expected inflation rate during the period 1953-71, it cannot be used as hedge against
inflation. Possibility for negative relationship between common stock returns & the
expected inflation rate could be that the market might be inefficient in impounding
available information about future inflation into stock prices.

*1 indicates reference article no.1 Fama and Schwert. – see bibliography


Jacob Boudoukh and Mathew Richardson*2 (1993) are behind the two main
empirical facts regarding the statistical relation between stock returns & inflation. The
first is the ex post nominal stock returns and inflation are negatively correlated. The
second empirical result documents a negative relation between ex ante nominal stock
returns & ex ante inflation.

The main objective of their study was to find out the long term relationship
between stock returns and inflation. The data for the study is two centuries, 1802-1990
stock returns, short term & long term bonds, & inflation in both United States & United
Kingdom. The ex ante long term inflation has been arrived at by using an instrumental
variables approach. The instruments used are past inflation rates & short and long term
interest rates that have theoretical support as measures of ex ante inflation. Using ex post
inflation as proxy for ex ante inflation rates.

Jacob and Richardson took the help of regression to estimation the relationship.
For ex post relation, they regressed one year stock returns on one year inflation & five
year stock returns on five year inflation:
R t+1 = α 1+ β1 π t+1 +έt

Σ R t+i = α 5 + β5 Σ π t+i +έt

Hypothesis β5 = β1 versus the alternative β5 > β1. The results showed that the
regression coefficient of five year stock returns on the contemporaneous five year
inflation rate is significantly positive, β5 = 0.52, with a standard error of 0.17. Therefore,
nominal stock returns & inflation tend to move together over the sample, thus supporting
the view that stocks provide some compensation for movements in inflation. On the other
hand, they found that the estimate of β1 = 0.07 close to zero, indicating that the stocks
seems to compensate for inflation in the long run.

*2 indicate reference article no.2 Jacob Boudoukh and Matthew Richardson- see bibliography.
For the ex ante relation various instruments have been used by them. The
instrumental variable estimation is generated from the following system of equations:

[ ]
E (Σ R t+I – α j – β j Σ π t+I) Zjt = 0

Where, Rt denotes stock returns, πt denoted inflation rates & Zjt is a set of
instruments associated with particular horizon j.The first set of instruments includes the
one year interest rate & the long tern interest rates. To capture the movements in one year
& five year expected inflation, respectively. The second set of instruments includes the
past one year & five year inflation rates. The results support a positive relation between
stock returns & ex ante inflation. Thus Jacob and Richardson provide strong support for a
positive relation between nominal stock returns & inflation at long horizon.

Bulent Gultekin*3(1983) investigates the relation between common stock &


inflation in 26 countries for the postwar period. The study found that there is a consistent
lack of positive relation between stock returns and inflation in most of the countries.

The data taken are monthly compounded inflation rates for individual countries
from January 1947 to December 1979. Stock market returns are obtained from IFS & CIP
indices of about 26 countries. He estimated the first four autocorrelation for inflation
rates & stock market returns for both IFS & CIP. Monthly inflation rates in almost all
countries have positive autocorrelations. IFS stock returns also have positive
autocorrelation.

In order to investigate the relation between nominal stock returns & inflation, the
regression model is estimated by using three different estimates of the expected inflation
rates, contemporaneous inflation rates as proxies for expected inflation, decomposition of
inflation into expected & unexpected components by ARIMA models and short term
interest rates are used as predictors of inflation.

*3 indicate article no 3 Bulent Gultekin – see bibliography


The regression result says that all regression coefficients for the expected inflation
rate are negative. Thus, these results indicate a stronger negative relation between stock
returns & expected inflation.

Bharat kolluri *4 (2005) has made an attempt to identify the casual influence of
inflation on stock returns and a reverse causality from stock return to inflation. The
results indicate bidirectional causality between these two variables.Many of the previous
studies focused on the interpretation of the puzzling negative relationship ignoring the
basic issue of causality. This study corrects this deficiency by examining the basic issue
of causality between stock returns and inflation.

The main objectives of the study was to find out the relationship between stock
returns and inflation using Grangers Co-integration test, the direction of causality
between stock returns and inflation and to find out whether common stock are hedge
against inflation or that they compensate investors for rising prices.

The data used are the continuously compounded monthly returns covering the
period from 1960:1 to 2004:12, of the US. The data on nominal stock returns (RE),
inflation (INF), and Real Treasury bill rate (RTB) are obtained from Ibbotson Associates
(2004). the common stock return measure is based on the Standard and Poor’s (S&P)
composite index. Methodology used is the unit root test called Augmented Dickey Fuller
test. This test is done to find out the stationarity of the time series data. The second used
here is the Grangers co integartion test. To examine if the nominal stock returns and
expected inflation are co-integrated, that is, if they move together for a long period of
time. This is done regressing the two variables on each other.Residuals generated from
such a regression should be stationary. The third test used is the Grangers Causality test.
This is done to find out the direction of causality.

*4 indicate article no 4 Bharat Kolluri – see bibliography.


The overall results support bidirectional causality between stock returns and
expected inflation including the negative sign in both directions. And that the stock
returns and inflation are negatively related as the coefficients of the regression equation
are negative.

Basabi Bhattacharya & Jaydeep Mukherjee*5 (2005) investigates the nature of the
causal relationship between stock prices and inflation in India. And it has been found that
there exists two way causation between stock prices and rate of inflation.

The purpose of the study was to analyze the relationship between stock prices and
inflation with implications on efficiency of stock markets and to determine whether stock
returns are a leading indicator for future real economic activity.

The data for the study is the monthly stock prices of BSE. Methodology used is
the Unit root test such as ADF to determine the stationarity of the data, Grangers co-
integration test to determine the co-integration between stock returns and inflation and
Toda and Yamamoto version Grangers non causality test to test lead and lag variable.
And for the selection of the Hsiao’s optimum lag length was used which has given
optimum lag length to be 2.
The study concluded that there is a bidirectional causality between stock price and
the rate of inflation, thus implying that the market informational efficiency hypothesis
can be rejected for BSE sensitive index.

*5 indicate article no 5 Basabi Bhattacharya and Jaydeep Mukherjee – see bibliography


Research Methodology

Problem statement
There are various studies, which have been done to examine the relationship
between inflation and stock returns by taking various statistical models and various
indices. This study explores the evidence of relationship between inflation rates and stock
returns and also lead lag relationship between the two. And to find out whether the
market is efficient in impounding available information about future inflation into stock
prices.

Objectives of the study

• To analyze the relationship between stock return and inflation rate


• To find out whether the relationship changes with the different indices
• To find out which variable is leading and which variable is lagging.
• To find out whether common stock are hedge against inflation.

Purpose of the Study


The existence of a significant positive one to one relationship between the
nominal rate of interest and the rate of inflation, known as the Fisher effect has been very
well established and accepted for a long time in the economic literature. Fisher asserted
that the nominal interest rate consists of a real rate plus expected inflation rate.
1 + Nominal Rate = (1 + Real Rate) (1 + Expected Inflation Rate)
1 + r = (1 + a) (1 + i )
r = a + i +ai
r=a+i
Fisher hypothesis states that real rates of return on common stock and expected
inflation rates are independent and that nominal stock returns vary in one to one
correspondence with expected inflation. He believed that the real and monetary sectors
of the economy are largely unrelated. According to him expected real rate is determined
by real factors such as the productivity of capital and time preference of savers and is
independent of the expected inflation rate.
The expected nominal returns contain market assessments of expected inflation
rates. Thus, if the market is an efficient or rational processor of the information available
at time t-1, it will set the price of an asset j so that the expected nominal return on the
asset from t-1 to t is the sum of the expected real return and the best possible assessment
of expected inflation rate from t-1 to t.

Likewise one would expect a positive relationship between stock returns and the
rate of inflation. But numerous studies have showed that common stock returns are
negatively correlated with inflation, the value of stocks decreases as inflation rises.

The study would be helpful to all investors, speculators, arbitragers, brokers,


dealers etc as the inflation can also be considered as one of the factors, which affect the
stock prices and in the same way stock prices as a factor affecting inflation rates.

Hypothesis of the study

Hypothesis 1
H0: There is no significant relation between stock returns and inflation rates
H1: There is significant relation between stock returns and inflation rates

Hypothesis 2
H0: There is no significant lead and lag relationship between stock returns and
Inflation
H1: There is significant lead and lag relationship between stock returns and Inflation

Study Design
a) Study Type: The study type is analytical, quantitative and historical.
Analytical because facts and existing information is used for the analysis,
Quantitative as relationship is examined by expressing variables in
measurable terms
Historical as the historical information is used for analysis and
interpretation.

b) Study population: population is the indices of national stock exchange & 30 stocks of
Bombay stock exchange and wholesale 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, CNX Nifty, Bank Index, and the wholesale price index.

e) Sampling technique: Deliberate sampling is used because only particular units are
selected from the sampling frame. Such a selection is undertaken
as these units represent the population in a better way and reflect
better relationship with the other variable.

f) Period of the study: the period is different for different indices. CNX nifty is taken for
ten years from April, 1995 to March, 2005, Bank Index for five
years from January, 2000 to March, 2005 and BSE Sensex from
July, 1996 to March, 2005.

Data gathering procedures and instruments:


Data: Historical continuously compounded monthly share prices BSE Sensex, CNX nifty,
Bank Index. Monthly closing values of wholesale price index.

Data Source: Historical share prices of the NSE sample are taken from
www.nseindia.com and BSE from www.financeyahoo.com and wholesale
price index are taken from www.rbi.org.in

Software packages: various softwares packages like SSPS, Eview and Spreedsheet have
been used to run the statistical models. SSPS and spreadsheet is used
for regression and Eview for calculating ADF Test, Grangers Co-
integration Test and Grangers causality Test.

Statistical Models
• Augmented Dicky Fuller test to test the stationary of the series.
• Granger’s cointegration approach to test for co integration between the series.
• Granger’s Causality test

Samples

S&P CNX Nifty


S&P CNX Nifty is a well diversified 50 stock index accounting for 25 sectors of
the economy. It is used for a variety of purposes such as benchmarking fund portfolios,
index based derivatives and index funds.

Table No.1 S & P CNX Nifty Companies

Company name Industry Symbol


Abb ltd. Electrical equipment Abb
Associated cement companies ltd. Cement and cement products Acc
Bajaj auto ltd. Automobiles - 2 and 3 wheelers Bajajauto
Bharti tele-ventures ltd. Telecommunication - services Bharti
Bharat heavy electricals ltd. Electrical equipment Bhel
Bharat petroleum corporation ltd. Refineries Bpcl
Cipla ltd. Pharmaceuticals Cipla
Dabur india ltd. Personal care Dabur
Dr. Reddy's laboratories ltd. Pharmaceuticals Drreddy
Gail (india) ltd. Gas Gail
Glaxosmithkline pharmaceuticals ltd. Pharmaceuticals Glaxo
Grasim industries ltd. Cement and cement products Grasim
Gujarat ambuja cements ltd. Cement and cement products Gujambcem
Hcl technologies ltd. Computers - software Hcltech
Housing development finance corporation
ltd. Finance - housing Hdfc
Hdfc bank ltd. Banks Hdfcbank
Hero honda motors ltd. Automobiles - 2 and 3 wheelers Herohonda
Hindalco industries ltd. Aluminium Hindalc0
Hindustan lever ltd. Diversified Hindlever
Hindustan petroleum corporation ltd. Refineries Hindpetro
Icici bank ltd. Banks Icicibank
Infosys technologies ltd. Computers - software Infosystch
Indian petrochemicals corporation ltd. Petrochemicals Ipcl
I t c ltd. Cigarettes Itc
Jet airways (india) ltd. Travel & transport Jetairways
Larsen & toubro ltd. Engineering Lt
Mahindra & mahindra ltd. Automobiles - 4 wheelers M&m
Maruti udyog ltd. Automobiles - 4 wheelers Maruti
Mahanagar telephone nigam ltd. Telecommunication - services Mtnl
National aluminium co. Ltd. Aluminium Nationalum
Oil & natural gas corporation ltd. Oil exploration/production Ongc
Oriental bank of commerce Banks Orientbank
Punjab national bank Banks Pnb
Ranbaxy laboratories ltd. Pharmaceuticals Ranbaxy
Reliance energy ltd. Power Rel
Reliance industries ltd. Refineries Reliance
Steel authority of india ltd. Steel and steel products Sail
Satyam computer services ltd. Computers - software Satyamcomp
State bank of india Banks Sbin
Shipping corporation of india ltd. Shipping Sci
Sun pharmaceutical industries ltd. Pharmaceuticals Sunpharma
Tata chemicals ltd. Chemicals - inorganic Tatachem
Tata motors ltd. Automobiles - 4 wheelers Tatamotors
Tata power co. Ltd. Power Tatapower
Tata steel ltd. Steel and steel products Tatasteel
Tata tea ltd. Tea and coffee Tatatea
Tata consultancy services ltd. Computers - software Tcs
Videsh sanchar nigam ltd. Telecommunication - services Vsnl
Wipro ltd. Computers - software Wipro
Zee telefilms ltd. Media & entertainment Zeetele

CNX Bank Index


The Indian banking Industry has been undergoing major changes, reflecting a
number of underlying developments. Advancement in communication and information
technology has facilitated growth in internet-banking, ATM Network, Electronic transfer
of funds and quick dissemination of information. In order to have a good benchmark of
the Indian banking sector, India Index Service and Product Limited (IISL) has developed
the CNX Bank Index.

CNX Bank Index is an index comprised of the most liquid and large capitalized
Indian Banking stocks. It provides investors and market intermediaries with a benchmark
that captures the capital market performance of Indian Banks. The index will have 12
stocks from the banking sector which trade on the National Stock Exchange.

Table No.2 CNX Bank Index Companies

Company name Symbol


Andhra bank Andhrabank
Bank of baroda Bankbaroda
Bank of india Bankindia
Canara bank Canbk
Corporation bank Corpbank
Hdfc bank ltd. Hdfcbank
Icici bank ltd. Icicibank
Oriental bank of
commerce Orientbank
Punjab national bank ltd. Pnb
State bank of india Sbin
Syndicate bank Syndibank
Union bank of india Unionbank

BSE Sensex
Of the 23 stock exchanges in the India, Mumbai's (earlier known as Bombay),
Bombay Stock Exchange is the largest, with over 6,000 stocks listed. The BSE accounts
for over two thirds of the total trading volume in the country. Established in 1875, the
exchange is also the oldest in Asia. Among the twenty-two Stock Exchanges recognized
by the Government of India under the Securities Contracts (Regulation) Act, 1956, it was
the first one to be recognized.

SENSEX is a basket of 30 constituent stocks representing a sample of large,


liquid and representative companies. The base year of SENSEX is 1978-79 and the base
value is 100. The index is widely reported in both domestic and international markets
through print as well as electronic media.
Table No.3 BSE Sensex Companies
Company name Industry
Reliance industries ltd. Refineries
Infosys technologies ltd. Computer software
Icici bank ltd. bank
Itc ltd. Cigarettes
Housing development finan Finance housing
Larsen & toubro ltd. Engineering
Hindustan lever ltd. Diversified
Bharti tele-ventures ltd. Telecommunication - services
Oil & natural gas corpora Oil exploration/production
Tata steel ltd. Steel and steel products
State bank of india bank
Satyam computer services Computer software
Hdfc bank ltd. bank
Bajaj auto ltd. Automobiles - 2 and 3 wheelers
Tata motors ltd. Automobiles - 4 wheelers
Tata consultancy services Computer software
Bharat heavy electricals Electrical equipment
Hindalco industries ltd. Aluminium
Ntpc ltd
Grasim industries ltd. Cement and cement products
Wipro ltd. Computer software
Gujarat ambuja cements lt Cement and cement products
Associated cement compani Cement and cement products
Ranbaxy laboratories ltd. Pharmaceuticals
Cipla ltd. Pharmaceuticals
Maruti udyog ltd. Automobiles - 4 wheelers
Hero honda motors ltd. Automobiles - 2 and 3 wheelers
Dr. Reddy's laboratories Pharmaceuticals
Tata power company ltd. Power
Reliance energy ltd. Power

Limitations of the study

• The results may not give accurate picture as there could be many other macro
factors other than inflation which affects the stock returns at the same period.
• The study is limited to only three indices.
Statistical Models
In this study, a co-integration approach using the Engle-Granger methodology is
applied to capture both the long run and the short run dynamics of stock returns and
inflation rates. Before doing co-integration analysis, it is necessary to test whether the
time series are stationary at levels by running Augmented Dickey fuller (ADF) test on the
series. Because most time series are non stationary in levels, and the original data need to
be transformed to obtain stationary series. And then the granger causality test is done to
test the causal relationship between stock returns and inflation.

Stationarity
According to Engle and Granger, a time series is said to be stationary if
displacement over time does not alter the characteristics of a series in a sense that
probability distribution remains constant over time. In other words, the mean, variance
and co-variance of the series should be constant over time. A nonstatioanry time series
will have a time varying mean or a time varying variance or both or are
autocorrelated.The degree of co-integration is closely related with stationary.

It is evident from the time-series literature that the standard estimation and
statistical test procedures are highly inappropriate, and even invalid, when the variables
involved are nonstationary.

The empirical works based on time series data assumes that the underlying time
series is stationary. In regressing a time series variable on another time series variables,
one often obtains a very high R2 (residuals) even though there is no meaningful
relationship between the two variables. This situation exemplifies the problem of
spurious or nonsense regression, which arises when data is non stationary.

A series is said to be integrated of order one [I (1)] if it has to be differentiated


once before becoming stationary. Similarly, a series is of order two [I(2)] if it has to be
differentiated twice before becoming stationary.
Theory of Stationarity
Following are different ways of examining about whether a time series variable Xt is
stationary or has a unit root
• In the AR(1) model, if Φ=1, then X has a unit root. If |Φ| <1 then X is stationary.
• If X has a unit root then the series will exhibit trend behavior.
• If X has a unit root, then ΔX will be stationary. For this reason, series with unit root
are often referred to as difference stationary series
• Series is stationary if durbin Watson values lies between 1.5 to 2.5, which indicates
that there is no autocorrelation

Testing Stationarity
In general, the procedure start with whether the variables Y in its level form is
stationary. If the hypothesis is rejected, then the series is transformed into first difference
of the variable and tested for stationarity. If first difference series is stationary, this
implies that Y is I(1).
H0: Series has Unit root : Non Stationary
H1: Series does not have Unit root : Stationary

Unit Root Test [Dickey Fuller Test]:


Dickey Fuller test involve estimating regression equation and carrying out the
hypothesis test. The AR (1) process is….
Yt = C + ρYt-1+ εt

Where c and ρ are parameters and is to be white noise. If -1 < ρ < 1, then Y is
stationary series . While ρ if = 1, y is non stationary series. Therefore, why not simply
regress Yt on its lagged value yt-1 and find out if the estimated ρ is statistically equal to 1
? If it is, then Yt is nonstationary this is the general idea behind the unit root test of
stationarity. The test is carried out by estimating an equation with Yt-1 subtracted from
both sides of the equation.
Δyt = C + γt-1 + εt
Where δ = (ρ-1), and the null and alternative hypotheses are

Ho: δ = 0 …..Non Stationary


H1: δ < 0 …..Stationary

Dickey and fuller simulated the critical values for selected sample sizes. More
recently, Mackinnon (19991) has implemented a much larger set of simulations than
those tabulated by Dickey and Fuller.

Unit root test [Augmented dickey fuller test]


The simple Unit root test is valid only if the series is an AR (1) Process. If the
series is correlated at high order lags, the assumption of white noise disturbances is
violated. [In other words, in DF test,it was assumed that the error term εt was
uncorrelated. But in case the error ter mis correlated, Dickey and Fuller have developed a
test, knoen as Augmented Dickey Fuller test]. The ADF controls for higher - order
correlation by adding lagged difference terms of the dependent variable to the right-hand
side of the regression
ΔYt = C + γt-1 + δ1Δ yt-1 + δ2Δ y t-2 + …..+ δpΔ y t-p + εt

This augmented specification is then tested


H0: δ = 0 Non Stationary
H1: δ < 0 Stationary

The unit root test is based on the following three regression forms:
1. Without intercept and trend (random walk) ΔYt = δYt-1 + εt
2. with intercept (random walk with drift) ΔYt = α + δYt-1 +εt

3. with intercept and trend (with drift around a stochactic trend) ΔYt = α βT + δYt-1 +εt
Where, α is the intercept/constant, T is trend, β is the slope i.e level of
dependency and integration, δ is drift parameter i.e. Change from Yt to Yt-1 and εt is the
error term.
In general, the procedure start with whether the variables X and Y in its level
form under none, intercept and trend and intercept is stationary. If the hypothesis is
rejected, then the series is transformed into first difference of the variable and tested for
stationarity. If first difference series is stationary, this implies that X and Y are I(1).

Grangers co-integration Test


The fundamental aim of co integration analysis is to detect any common
stochastic trends in the price data and to use these common trends for a dynamic analysis
of correlation in returns. Correlation is based only on return data, but full co integration
analysis is based on the raw prices, rate or yield as well as return data.

According to co integration theory, two variables that are stationary in changes


are co integration if a linear combination of them in levels is stationary. Thus, changes in
the prices are taken for running the test.

Granger introduced the concept of co-integration when he wrote that two


variables may move together though individually they are non stationary. Co-integration
is based on the long run relationship between variables. The idea arises from considering
equilibrium relationships, where equilibrium is a stationary point characterized by forces
that tend to push the variables back toward equilibrium.

In general, if Yt and Xt are both integrated of order I (d), then any linear
combination of the two series will also be I (d)... That is, the residuals obtained on
regressing Yt on Xt are I (d).

If two or more series are co integrated then even though the series themselves
may be non stationary, they will move closely together over time and their difference will
be stationary. Their long run relationship is the equilibrium to which the system
converges overtime and the disturbance term Et can be construed as the disequilibrium
error or the distance that the system is away from equilibrium at time t.
The Engle granger test is a two step process:
• First estimating an ordinary least square (OLS) regression on the data. A
regression of one integrated variable on the other integrated variables (x on y and
y on x).
Yt = a + bx t + e t
X & y will be co-integrated if and only if e is stationary.
• Then test the residuals from regression for stationarity using a unit root test such
as ADF.

Grangers Causality Test


The relationship between co integration and causality arises from the fact that, if
two variables are co-integrated, then causality must exist in at least one direction and
possibly in both directions.

Although regression analysis deals with the dependence of one variable on other
variables, it does not necessarily imply causation. In other words, the existence of a
relationship between variables does not prove causality or direction of influence. More
generally, since the future cannot predict the past, if variable X causes variable Y, then
changes in X should precede changes in Y.

Granger causality is a technique for determining whether one time series is useful
in forecasting another. Ordinarily, regressions reflect "mere" correlations, but Clive
Granger causality test shows about the causality between two series.

It measures the significance of past values of variable X in explaining variable Y,


taking into account the effect of past values of variable Y itself. Usually causal relations
are tested both ways, from X to Y and from Y to X.

A time series X is said to Granger-cause Y if it can be shown, usually through a


series of F-tests on lagged values of X (and with lagged values of Y also known), that
those X values provide statistically significant information on future values of Y.
The test works by first doing a regression of ΔY on lagged values of ΔY. Once
the appropriate lag interval for Y is proved significant (t-stat or p-value), subsequent
regressions for lagged levels of ΔX are performed and added to the regression provided
that they 1) are significant in of themselves and 2) add explanatory power to the model.
This can be repeated for multiple ΔX's (with each ΔX being tested independently of other
ΔX's, but in conjunction with the proven lag level of ΔY). More than 1 lag level of a
variable can be included in the final regression model, provided it is statistically
significant and provides explanatory power.

The steps involved in implementing the Granger causality are:


• Restricted Residual Sum of squares (RSSR):
Regress X on all lagged X, but do not include the lagged y variables in thie
regression.
• Unrestricted residual sum of squares (RSSUR):
Now run the regression including the lagged Y terms.
• The null hypothesis is, lagged Y terms do not belong in the regression.
• To test this hypothesis, apply F test:
F = (RSSR – RSSUR)/Y
RSSR / (n-k)
Y is equal to the number of lagged Y terms and k is the number of parameters
estimated in the unrestricted regression.
If the computed f value exceeds the critical F values at the chosen level of
significance, we reject the null hypothesis, in which case the lagged y belongs in
the regression. i.e. Y causes X.
The whole procedure should be repeated to test whether X causes Y.
Empirical Results

Unit Root Test [Augmented Dickey Fuller Test]


Wholesale Price Index:
The wholesale price index for this test is taken from April 1995 to March 2005.
The data taken are raw prices. The unit root result is as under:

Table No 4: WPI ADF Test


Constraints ADF values Mackinnon
( log 0 ) Critical values
None 7.763608** 1% (-2.5830)
( level) 5% (-1.9426)
10% (-1.6171)
Intercept 0.893221** 1% (-3.4861)
(level) 5% (-2.8857)
10% (-2.5795)
Trend & intercept -2.101586** 1% (-4.0373)
(level) 5% (-3.4478)
10% (-3.1488)
None -6.321485* 1% (-2.5831)
( 1st difference) 5% (-1.9427)
105 (-1.6171)
** indicates acceptance of null hypothesis
* indicates rejection of null hypothesis
( * reference no.1,2,3 & 4)

Hypothesis:
H0 = ADF > critical values -- not reject hull hypothesis i.e., unit root exists.
H1 = ADF < critical values – reject null hypothesis i.e. unit root does not exist.

* for reference no 1,2,3 & 4 – see annexure)


Interpretation
The above table tells that WPI series has a unit root problem, so they are non
stationary in their level at various constraints i.e ADF is greater than critical values at
none intercept and trend & intercept. The null hypothesis is accepted at 1%, 5% and 10%
level of significance.

However, the series at 1st difference level is stationary as ADF is greater than
critical value the 1st difference level is nothing but the log natural returns of the raw
prices. Log natural returns are to make series mean and variance constant. Thus WPI
series is stationary at I (1) and null hypothesis is rejected at 1%, 5% and 10% level of
significance.

Graph no. 1

WPI Movements from April,1995 to March,2005

200

150
WPI prices

100

50

0
1 11 21 31 41 51 61 71 81 91 101 111
No.of observation

Interpretation
The stationarity of a series can also be presented graphically. The graph above
indicates the rough idea on whether a time series is stationary or not. The series seems as
a non stationary data since it is increaseing upward as time changes.
S & P CNX Nifty:
The CNX Nifty prices are taken from April, 1995 to March, 2005. The data taken
are raw closing prices. The unit root result is as under:

Table No. 5 Nifty ADF Test


Constraints ADF values Mackinnon
( log 0) Critical values
None 0.985726** 1% (-2.5830)
( level) 5% (-1.9426)
10% (-1.6171)
Intercept -0.497179** 1% (-3.4861)
(level) 5% (-2.8857)
10% (-2.5795)
Trend & intercept -1.480579** 1% (-4.0373)
(level) 5% (-3.4478)
10% (-3.1488)
None -10.60268* 1% (-2.5831)
st
( 1 difference) 5% (-1.9427)
105 (-1.6171)
(** indicates acceptance of null hypothesis)
(* indicates rejection of null hypothesis)
(*reference no.5,6,7 & 8)

Hypothesis:
H0 = ADF > critical values -- not reject hull hypothesis i.e., unit root exists.
H1 = ADF < critical values – reject null hypothesis i.e. unit root does not exist.

(* for reference no.5,6,7 & 8 – see annexure)


Interpretation
The CNX Nifty results from the table shows unit root problem, so they are non
stationary at their at none, intercept and trend & intercept i.e. ADF is greater than
Mackinnon critical values of 1%,5% and 10% level of significance. However, their 1st
difference is stationary as ADF is greater than critical value. The null hypothesis is
rejected for (-10.60268) at 1%,5% and 10% level of significance.

Graph no 2

NIFTY Movements from April,1995 to March,2005

2500

2000
Nifty prices

1500

1000

500

0
1 12 23 34 45 56 67 78 89 100 111
No of observation

Interpretation
The graph above speaks about the stationarity of the eries. It indicates whether a
time series is stationary or not. Nifty movements from April, 1995 to March, 2005
showing upward trend. Thus the series seems as a non stationary data since it is
increaseing upward as time changes.
Bank Index:
The Bank index is for the period January 2000 to march, 2005. The Data taken are
raw closing prices. The unit root result is as under:

Table No.6 Bank Index ADF Test:


Constraints ADF values Mackinnon
( log 0) Critical values
None 1.909361** 1% (-2.6000)
( level) 5% (-1.9457)
10% (-1.6185)
Intercept 0.807602** 1% (-3.5380)
(level) 5% (-2.9084)
10% (-2.5915)
Trend & intercept -1.526356** 1% (-4.1109)
(level) 5% (-3.4824)
10% (-3.1689)
None -7.624449* 1% (-2.6006)
st
( 1 difference) 5% (-1.9458)
105 (-1.6186)
(** indicates acceptance of hypothesis)
(* indicates rejection of hypothesis)
(*reference 9,10,11 & 12)

Hypothesis:
H0 = ADF > critical values -- not reject hull hypothesis i.e., unit root exists.
H1 = ADF < critical values – reject null hypothesis i.e. unit root does not exist.

(* for reference no.9,10,11 & 12– see annexure)


Interpretation
The table above shows that the Bank index is non stationary and their exists the
unit root problem as ADF is greater than Mackinnon critical values. Thus the null
hypothesis is rejected at 1%,5% and 10% level of significance.
However, they are stationary at I (1) where null hypothesis is rejected at various
level of significance 1%,5% and 10%.

Graph No 3

BANK INDEX Movements from January,2000 to


March,2005.

4000
bank Index prices

3000

2000

1000

0
1 6 11 16 21 26 31 36 41 46 51 56 61
No of observations

Interpretation
The bank index movements are moving upward as time changes, indicating the
non stationarity nature of the series. Thus it can be concluded from the graph that the
bank index time series are non stationary.
BSE Sensex:
The BSE sensex is taken from January 1996 to March, 2005. The data taken for
ADF are the raw closing prices. The unit root result is as under:

Table no.7 BSE Sensex ADF Test


Constraints ADF values Mackinnon
( log 0) Critical values
None 0.847576** 1% (-2.5856)
( level) 5% (-1.9431)
10% (-1.6173)
Intercept -0.340429** 1% (-3.4940)
(level) 5% (-2.8892)
10% (-2.5813)
Trend & intercept -1.086908** 1% (-4.0485)
(level) 5% (-3.4531)
10% (-3.1519)
None -9.896049* 1% (-2.5858)
st
( 1 difference) 5% (-1.9432)
10% (-1.6174)
(** indicates acceptance of null hypothesis)
(* indicates rejection of null hypothesis)
(* Reference no.13,14,15 & 16)

Hypothesis:
H0 = ADF > critical values -- not reject hull hypothesis i.e., unit root exists.
H1 = ADF < critical values – reject null hypothesis i.e. unit root does not exist.

(* for reference no.13,14,15 & 16 – see annexure)


Interpretation
The ADF in none, intercept and trend are greater than Mackinnon critical value
indicating that the BSE sensex series are non stationary at their levels. Thus the null
hypothesis is accepted at 1%,5% and 10% level of significance. However the series are
stationary at I(1) at 1%,5% and 10% level of significance.

Graph No.4

BSE Sensex Movements from July,1996 to


March,2005
8000.00
BSE Sensex Prices

7000.00
6000.00
5000.00
4000.00
3000.00
2000.00
1000.00
0.00
1 12 23 34 45 56 67 78 89 100
No of observations

Interpretation
The above graph of BSE Sensex is moving upward from January 1996 to march,
2005, indicating the non stationarity of the series.
Grangers Co integration Test:
Co integration between CNX Nifty and Whole sale price index

• An ordinary least square (OLS) regression is done on the data. First x is regressed
on y then y on x.
X on Y -- Dependent variable(X) is CNX Nifty and Independent variable(Y) is WPI.
Y on X -- Dependent variable(X) is WPI and Independent variable(Y) is CNX Nifty.

NIFTYt = a + bWPI t + e t ………………………………….. (1)


WPIt = a + bNIFTY t + e t ………………………………….. (2)

Table No.8 Nifty and WPI Regression Result


Parameter (1) (2)
Coefficient -3.027 -0.0174
(* Reference table 17)

• Residuals e=y-y^ Results


The residuals of both the regression equations are stationary.
Table No.9 Nifty and WPI Co-integration Test:
Constraints ADF values Mackinnon
(log 0) Critical values
None ( level) 1% (-2.530)
-12.08444*
[X on Y] 5% (-1.9426)
10% (-1.6171)
None ( level) 1% (-2.530)
-11.13941*
[Y on X] 5% (-1.9426)
10% (-1.6171)
(* indicates rejection of null hypothesis)
(* Reference no.18 & 19)

(*for reference 17,18 & 19 -see annexure)


Interpretation:
Unit root test for stationarity of residuals from the co integration equation shows
that the null hypothesis is rejected at 1%,5% and 10% level of significance implying
CNX Nifty and WPI are co integrated, but as the coefficients are statistically significant
with a negative sign. This indicates the negative relationship between CNX Nifty and
WPI.
Co integration between Bank Index and Whole sale price index

• An ordinary least square (OLS) regression is done on the data. First x is regressed on
y then y on x.
X on Y -- Dependent variable(X) is Bank Index and Independent variable(Y) is WPI.
Y on X -- Dependent variable(X) is WPI and Independent variable(Y) is bank Index.

BANKt = a + bWPI t + e t ………………………………….. (1)


WPIt = a + bBANK t + e t ………………………………….. (2)

Table No.10 Bank Index and WPI Regression Results


Parameter (1) (2)
Coefficient -3.643 -0.0151
(* Reference 20)

• Residuals e=y-y^ Results


The residuals of both the regression equations are stationary.
Table No.11 Bank Index and WPI co-integration Test
Constraints ADF values Mackinnon
( log 0) Critical values
None ( level) 1% (-2.6000)
-8.611257*
[X on Y] 5% (-1.9457)
10% (-1.6185)
None ( level) 1% (-2.6000)
-7.523411*
[Y on X] 5% (-1.9457)
10% (-1.6185)
(* indicates rejection of null hypothesis)
(* Reference no.21 & 22)

(* for reference no.20,21 & 22 – see annexure)


Interpretation:
The Bank Index and WPI are correlated as Unit root test for stationarity of
residuals from the co integration equation shows that the null hypothesis is rejected at
1%,5% and 10% level of significance, implying Bank Index and WPI are co integrated,
but as the coefficients are statistically significant with a negative sign. This indicates the
negative relationship between CNX Nifty and WPI.
Co integration between BSE Sensex and Whole sale price index

• An ordinary least square (OLS) regression is done on the data. First x is regressed on
y then y on x.
X on Y -- Dependent variable(X) is BSE Sensex and Independent variable(Y) is WPI.
Y on X -- Dependent variable(X) is WPI and Independent variable(Y) is BSE Sensex.

BSEt = a + bWPI t + e t ………………………………….. (1)


WPIt = a + bBSE t + e t ………………………………….. (2)

Table No.12 BSE Sensex and WPI Regression Results


Parameter (1) (2)
Coefficient -3.146 -0.0169
(* Reference no.23)

• Residuals e=y-y^ Results


The residuals of both the regression equations are stationary.

Table No.13 BSE Sensex and WPI co-integration Test


Constraints ADF values Critical values
None ( level) 1% (-2.5856)
-10.56767*
[X on Y] 5% (-1.9431)
10% (-1.6173)
None ( level) 1% (-2.6000)
-10.34426*
[Y on X] 5% (-1.9431)
10% (-1.6173)
(* indicates rejection of hull hypothesis)
(* Reference no.24 & 25)

(* for reference no.23,24, & 25 – see annexure)


Interpretation:
The BSE Sensex and WPI are co integrated but they have a negative relationship as
coefficients are negative. Unit root test for stationarity of residuals from the co
integration equation shows that the null hypothesis is rejected at 1%,5% and 10% level of
significance.
Grangers Causality Test:

CNX Nifty and Whole sale price index

The causality results for the two variables are:

Table No.14 Nifty and WPI causality Test


No of
Lags Hypothesis observations F statistics Probability
WPI does not causes Nifty 3.33728 0.03910
2 Nifty does not causes WPI 117 3.37426 0.03776
WPI does not causes Nifty 3.64799 0.00797
4 Nifty does not causes WPI 115 2.00270 0.09940
WPI does not causes Nifty 2.81231 0.01461
6 Nifty does not causes WPI 113 1.51338 0.18144
WPI does not causes Nifty 2.70617 0.00400
12 Nifty does not causes WPI 107 1.54497 0.12503
WPI does not causes Nifty 2.18444 0.01131
24 Nifty does not causes WPI 95 1.00842 0.47574
(* Reference no.26)

H0 = NIFTY does not causes WPI


H1 = NIFTY causes WPI

H0 =WPI does not causes NIFTY


H1 = WPI causes NIFTY

Interpretation
The calculated F values from lag 2 to 24 are greater than the F statistics, which
rejects the null hypothesis. And the P value is also close to zero. Thus there is
bidirectional causality at every lag between CNX Nifty and WPI.

( * for reference no.26 see annexure)


Bank Index and Whole sale price index

The causality results for the two variables are:

Table No.15 Bank Index and WPI causality Test


No of
Lags Hypothesis observations F statistics Probability
WPI does not causes Bank 3.22490 0.04739
2 Bank does not causes WPI 60 6.43431 0.00308
WPI does not causes Bank 3.03205 0.02599
4 Bank does not causes WPI 58 3.43213 0.01498
WPI does not causes Bank 2.47260 0.03830
6 Bank does not causes WPI 56 2.37257 0.04554
WPI does not causes Bank 1.82921 0.09817
12 Bank does not causes WPI 50 1.18496 0.34507
(* Reference 27)

H0 = BANK does not causes WPI


H1 = BANK does WPI

H0 =WPI does not causes BANK


H1 =WPI causes BANK

Interpretation
As the P value is close to zero and the calculated F values from lag 2 to 12 are
greater than the F statistics, the null hypothesis is rejected. Thus there is bidirectional
causality between bank indexes to WPI.

(* for reference no.27 – see annexure)


BSE Sensex and Whole sale price index

The causality results for the two variables are:

Table No.16 BSE Sensex and WPI causality Test


No of
Lags Hypothesis observations F statistics Probability
WPI does not causes BSE 5.38766 0.00603
2 BSE does not causes WPI 103 2.93531 0.05780
WPI does not causes BSE 3.11784 0.01874
4 BSE does not causes WPI 101 1.44428 0.22575
WPI does not causes BSE 3.44288 0.00428
6 BSE does not causes WPI 99 1.48854 0.19167
WPI does not causes BSE 3.00089 0.00203
12 BSE does not causes WPI 93 1.19113 0.30734
WPI does not causes BSE 1.75291 0.06878
24 BSE does not causes WPI 81 1.22307 0.29359
(* Reference no.28)

H0 = BSE does not causes WPI


H1 = BSE causes WPI

H0 =WPI does not causes BSE


H1 = WPI causes BSE

Interpretation
The calculated F values from lag 2 to 24 are greater than the F statistics, which
rejects the null hypothesis. The P values are also close to zero. Thus there is bidirectional
causality between bank indexes to WPI.

(* for reference no.28 – see annexure)


Conclusions
The Fisher hypothesis states that the real rates of returns on common stock and
expected inflation rates are independent and the nominal stock returns vary in one to one
correspondence with expected inflation. The expected nominal returns contain market
assessments of expected inflation rates. Thus, if the market is efficient processor of the
information available, it will set the prices so that the expected nominal return is the sum
of the expected real return and the best possible assessment of the expected inflation.

As the index is nothing but weighted average of the share prices of various
companies from different sectors, the sensex has been considered to see the impact of
inflation on it. Sensex, Nifty and Bank index are considered to see where they move in
the same direction or not.
After analyzing the data using the various Grangers test, it has been found that
there is no positive relationship between stock returns and inflation. The results of the
three indices are:
• CNX Nifty:
The nifty is considered for a period of 10 years. The series is stationary at I(1), but
it is negatively related to inflation as the coefficients statistically significant with negative
sign (-3.027) & (-0.01742) And there exists a bidirectional causal relationship between
nifty and inflation.

• Bank Index:
The bank index is considered for 5 years. The series is stationary at I(1). And its
coefficient is also statistically significant with a negative sign (-3.643) & (-0.01515).
Thus showing the negative relation between the two. Its causal relationship is in both
directions.

• BSE Sensex:
The results of BSE are also same as nifty and bank. Study is done for a period of 9
years. It is stationary at I (1) and its coefficients are (-3.146) & (-0.01692) showing the
negative relation. And the causality runs from the both direction.
Thus, the relationship between stock returns and inflation does not change with
indices.
It is evident from the overall results that the causality runs from inflation to stock
returns and also in the reverse order with a negative sign in both directions. The
coefficients are statistically significant with a negative sign.

The negative relationship can be interpreted several ways: for example the
unexpected inflation is generally considered to be positively correlated with inflation
uncertainty and high level of inflation uncertainty discourages investments in risky assets
and results in reduced nominal returns. Another interpreted is that the negative relation is
due to the fact that changes in expected inflation are most likely to be positively
correlated with unexpected inflation.

The market informational efficiency hypothesis can be rejected, as there exists a


bidirectional relationship between stock returns and inflation. The market is
informationally inefficient with respect to the rate of inflation. The market participants
can develop profitable trading rules and thereby can consistently earn more than average
market returns, as future inflation can be predicted.

It can be concluded that the stocks are a perverse inflation hedge. This does not
mean that equities are hazardous to investors’ health. Stocks are priced today to yield
very lucrative returns. The prospective returns have to be good; however, to compensate
stockholders for the risk they bear because equities are a perverse inflation hedge. When
the rate of inflation unexpected increases, real stock prices will fall. Conversely, when the
rate of inflation unexpectedly drops, real stock prices will raise.

So if one does not mind bearing some risk especially the risk that the inflation rate
may be higher than stocks are a good investment. If one seeks an inflation hedge, stocks
are generally poor investments. My conclusion rests on the observation that rising
inflation rates tend to depress corporate earnings and thereby stock prices, which has
been proved by the Grangers co integration test.
Thus, if one wants to cover the stock price risks, he can go for derivative market.
If an investor is having underlying asset and wants to protect himself from unexpected
inflation movements, he can enter the future market by entering into long and short
contracts based on future predictions.
Bibliography
TEXT BOOKS:
• Basic Econometrics
- Damodar N.Gujarati, (fourth edition)
• Macroeconomics
- Mishra and Puri
• Multinational Financial Management
- Alan C. Shapiro ( seventh edition)

REFERENCE BOOKS
• Inflation in India – Indian Institute of Management, Bangalore
• Market Models -- Indian Institute of Management, Bangalore.

WEB SITES:
• www.nseindia.com
• www.financeyahoo.com
• www.inflationdata.com
• www.google.com
• www.investorpedia.com
• www.bseindia.com
• www.rbi.org.in

ARTICLES:
• Stock market and macro economic behaviour in India
-- Sangeeta Chakravarty, Institute of Economic growth, University
Enclave, Delhi.
• An overview of the impact of inflation on the stock market
-- Richard T.Coghlam and J.Anthony Boekh.
• How Inflation Swindles the equity investors
-- Warren E.Buffett
• Stocks are not an Inflation hedge
-- Richard W.Kopcke
• The Mythes of common stocks and Inflation
-- Steven C.Leuthold
• Inflation and the stock market
-- Franco Modigliani and Richard A.Cohn

REFERENCES:
1. Fama and Schwartz (1977), “Asset Returns and Inflation”, Journal of Financial
economics, Vol.5, November, pp. 115-46.

2. Jacob Boudoukh and Matthew Richardson (1993), “Stock returns and Inflation:
A long horizon Perspective”, American Economic review, Vol.83, pp. 1346-
1355.

3. Gultekin, N B (1983), “Stock market Returns and Inflation: evidence from other
countries”, The Journal of Finance, Vol. 38, No.1 (March), pp. 49-65.

4. Bharat Kolluri (2005), “Stock Market returns and Inflation: An Analysis of the
Direction of Causality”. The ICFAI University Press.

5. Basabi Bhattacharya and Jaydeep Mukherjee,(2005) “ the Nature of the causal


Relationship between Stock Market and Macroeconomic Aggregates in India:
An Empirical Analysis”, JEL Classification: GI, E4.
Reference No. 1 -- ADF Unit Root Test on WPI [none]

ADF Test Statistic 7.763608 1% Critical Value* -2.5830


5% Critical Value -1.9426
10% Critical Value -1.6171
*MacKinnon critical values for rejection of hypothesis of a unit root.

Augmented Dickey-Fuller Test Equation


Dependent Variable: D(WPI)
Method: Least Squares
Date: 06/11/06 Time: 20:44
Sample(adjusted): 1995:05 2005:03
Included observations: 119 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic Prob.
WPI(-1) 0.003893 0.000501 7.763608 0.0000
R-squared 0.006599 Mean dependent var 0.589916
Adjusted R-squared 0.006599 S.D. dependent var 0.837105
S.E. of regression 0.834339 Akaike info criterion 2.484013
Sum squared resid 82.14227 Schwarz criterion 2.507367
Log likelihood -146.7988 Durbin-Watson stat 1.530646

Reference No. 2 -- ADF Unit Root Test on WPI [intercept]

ADF Test Statistic 0.893221 1% Critical Value* -3.4861


5% Critical Value -2.8857
10% Critical Value -2.5795
*MacKinnon critical values for rejection of hypothesis of a unit root.

Augmented Dickey-Fuller Test Equation


Dependent Variable: D(WPI)
Method: Least Squares
Date: 06/11/06 Time: 20:46
Sample(adjusted): 1995:05 2005:03
Included observations: 119 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic Prob.
WPI(-1) 0.003359 0.003761 0.893221 0.3736
C 0.082203 0.573573 0.143317 0.8863
R-squared 0.006773 Mean dependent var 0.589916
Adjusted R-squared -0.001716 S.D. dependent var 0.837105
S.E. of regression 0.837823 Akaike info criterion 2.500644
Sum squared resid 82.12786 Schwarz criterion 2.547352
Log likelihood -146.7883 F-statistic 0.797843
Durbin-Watson stat 1.530092 Prob(F-statistic) 0.373573
Reference No. 3-- ADF Unit Root Test on WPI [trend & intercept]

ADF Test Statistic -2.101586 1% Critical Value* -4.0373


5% Critical Value -3.4478
10% Critical Value -3.1488
*MacKinnon critical values for rejection of hypothesis of a unit root.

Augmented Dickey-Fuller Test Equation


Dependent Variable: D(WPI)
Method: Least Squares
Date: 06/11/06 Time: 20:52
Sample(adjusted): 1995:05 2005:03
Included observations: 119 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic Prob.
WPI(-1) -0.071890 0.034208 -2.101586 0.0378
C 8.755472 3.960056 2.210946 0.0290
@TREND(1995:04) 0.045001 0.020337 2.212766 0.0289
R-squared 0.046999 Mean dependent var 0.589916
Adjusted R-squared 0.030568 S.D. dependent var 0.837105
S.E. of regression 0.824212 Akaike info criterion 2.476108
Sum squared resid 78.80166 Schwarz criterion 2.546170
Log likelihood -144.3284 F-statistic 2.860373
Durbin-Watson stat 1.480420 Prob(F-statistic) 0.061294

Reference No4 -- ADF Unit Root Test on WPI [1st difference level]

ADF Test Statistic -6.321485 1% Critical Value* -2.5831


5% Critical Value -1.9427
10% Critical Value -1.6171
*MacKinnon critical values for rejection of hypothesis of a unit root.

Augmented Dickey-Fuller Test Equation


Dependent Variable: D(WPI,2)
Method: Least Squares
Date: 06/11/06 Time: 20:53
Sample(adjusted): 1995:06 2005:03
Included observations: 118 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic Prob.
D(WPI(-1)) -0.507888 0.080343 -6.321485 0.0000
R-squared 0.254591 Mean dependent var -0.001695
Adjusted R-squared 0.254591 S.D. dependent var 1.034613
S.E. of regression 0.893255 Akaike info criterion 2.620549
Sum squared resid 93.35481 Schwarz criterion 2.644029
Log likelihood -153.6124 Durbin-Watson stat 2.123953
Reference No. 5 -- ADF Unit Root Test on Nifty [none]

ADF Test Statistic 0.985726 1% Critical Value* -2.5830


5% Critical Value -1.9426
10% Critical Value -1.6171
*MacKinnon critical values for rejection of hypothesis of a unit root.

Augmented Dickey-Fuller Test Equation


Dependent Variable: D(NIFTY)
Method: Least Squares
Date: 06/11/06 Time: 20:55
Sample(adjusted): 1995:05 2005:03
Included observations: 119 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic Prob.
NIFTY(-1) 0.006447 0.006540 0.985726 0.3263
R-squared -0.002772 Mean dependent var 9.191765
Adjusted R-squared -0.002772 S.D. dependent var 87.89297
S.E. of regression 88.01472 Akaike info criterion 11.80125
Sum squared resid 914097.7 Schwarz criterion 11.82461
Log likelihood -701.1746 Durbin-Watson stat 1.982355

Reference No. 6-- ADF Unit Root Test on Nifty [intercept]

ADF Test Statistic -0.497179 1% Critical Value* -3.4861


5% Critical Value -2.8857
10% Critical Value -2.5795
*MacKinnon critical values for rejection of hypothesis of a unit root.

Augmented Dickey-Fuller Test Equation


Dependent Variable: D(NIFTY)
Method: Least Squares
Date: 06/11/06 Time: 20:56
Sample(adjusted): 1995:05 2005:03
Included observations: 119 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic Prob.
NIFTY(-1) -0.013523 0.027200 -0.497179 0.6200
C 25.38429 33.55681 0.756457 0.4509
R-squared 0.002108 Mean dependent var 9.191765
Adjusted R-squared -0.006421 S.D. dependent var 87.89297
S.E. of regression 88.17469 Akaike info criterion 11.81318
Sum squared resid 909648.8 Schwarz criterion 11.85989
Log likelihood -700.8843 F-statistic 0.247187
Durbin-Watson stat 1.952699 Prob(F-statistic) 0.619995
Reference No. 7 -- ADF Unit Root Test on Nifty [trend & intercept]

ADF Test Statistic -1.480579 1% Critical Value* -4.0373


5% Critical Value -3.4478
10% Critical Value -3.1488
*MacKinnon critical values for rejection of hypothesis of a unit root.

Augmented Dickey-Fuller Test Equation


Dependent Variable: D(NIFTY)
Method: Least Squares
Date: 06/11/06 Time: 20:58
Sample(adjusted): 1995:05 2005:03
Included observations: 119 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic Prob.
NIFTY(-1) -0.051225 0.034598 -1.480579 0.1414
C 39.28946 34.21688 1.148248 0.2532
@TREND(1995:04) 0.520631 0.299301 1.739487 0.0846
R-squared 0.027476 Mean dependent var 9.191765
Adjusted R-squared 0.010709 S.D. dependent var 87.89297
S.E. of regression 87.42111 Akaike info criterion 11.80424
Sum squared resid 886524.2 Schwarz criterion 11.87430
Log likelihood -699.3521 F-statistic 1.638640
Durbin-Watson stat 1.929766 Prob(F-statistic) 0.198708

Reference No. 8 -- ADF Unit Root Test on Nifty [1st difference level]

ADF Test Statistic -10.60268 1% Critical Value* -2.5831


5% Critical Value -1.9427
10% Critical Value -1.6171
*MacKinnon critical values for rejection of hypothesis of a unit root.

Augmented Dickey-Fuller Test Equation


Dependent Variable: D(NIFTY,2)
Method: Least Squares
Date: 06/11/06 Time: 20:59
Sample(adjusted): 1995:06 2005:03
Included observations: 118 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic Prob.
D(NIFTY(-1)) -0.980829 0.092508 -10.60268 0.0000
R-squared 0.489975 Mean dependent var -1.043814
Adjusted R-squared 0.489975 S.D. dependent var 124.0451
S.E. of regression 88.58815 Akaike info criterion 11.81431
Sum squared resid 918199.7 Schwarz criterion 11.83779
Log likelihood -696.0444 Durbin-Watson stat 1.994521
Reference No. 9-- ADF Unit Root Test on Bank Index [none]

ADF Test Statistic 1.909361 1% Critical Value* -2.6000


5% Critical Value -1.9457
10% Critical Value -1.6185
*MacKinnon critical values for rejection of hypothesis of a unit root.

Augmented Dickey-Fuller Test Equation


Dependent Variable: D(BANK)
Method: Least Squares
Date: 06/11/06 Time: 21:01
Sample(adjusted): 2000:02 2005:03
Included observations: 62 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic Prob.
BANK(-1) 0.024430 0.012795 1.909361 0.0609
R-squared 0.010723 Mean dependent var 38.51210
Adjusted R-squared 0.010723 S.D. dependent var 176.4821
S.E. of regression 175.5333 Akaike info criterion 13.18953
Sum squared resid 1879528. Schwarz criterion 13.22384
Log likelihood -407.8755 Durbin-Watson stat 2.131805

Reference No. 10 -- ADF Unit Root Test on Bank Index [intercept]

ADF Test Statistic 0.807602 1% Critical Value* -3.5380


5% Critical Value -2.9084
10% Critical Value -2.5915
*MacKinnon critical values for rejection of hypothesis of a unit root.

Augmented Dickey-Fuller Test Equation


Dependent Variable: D(BANK)
Method: Least Squares
Date: 06/11/06 Time: 21:06
Sample(adjusted): 2000:02 2005:03
Included observations: 62 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic Prob.
BANK(-1) 0.023319 0.028875 0.807602 0.4225
C 2.163314 50.30884 0.043001 0.9658
R-squared 0.010753 Mean dependent var 38.51210
Adjusted R-squared -0.005734 S.D. dependent var 176.4821
S.E. of regression 176.9873 Akaike info criterion 13.22176
Sum squared resid 1879470. Schwarz criterion 13.29038
Log likelihood -407.8745 F-statistic 0.652221
Durbin-Watson stat 2.129512 Prob(F-statistic) 0.422510
Reference No. 11 -- ADF Unit Root Test on Bank Index [trend & intercept]

ADF Test Statistic -1.526356 1% Critical Value* -4.1109


5% Critical Value -3.4824
10% Critical Value -3.1689
*MacKinnon critical values for rejection of hypothesis of a unit root.

Augmented Dickey-Fuller Test Equation


Dependent Variable: D(BANK)
Method: Least Squares
Date: 06/11/06 Time: 21:06
Sample(adjusted): 2000:02 2005:03
Included observations: 62 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic Prob.
BANK(-1) -0.078832 0.051647 -1.526356 0.1323
C -4.805393 48.60710 -0.098862 0.9216
@TREND(2000:01) 5.276050 2.246611 2.348448 0.0222
R-squared 0.095321 Mean dependent var 38.51210
Adjusted R-squared 0.064654 S.D. dependent var 176.4821
S.E. of regression 170.6816 Akaike info criterion 13.16465
Sum squared resid 1718800. Schwarz criterion 13.26758
Log likelihood -405.1043 F-statistic 3.108256
Durbin-Watson stat 2.103689 Prob(F-statistic) 0.052070

Reference No. 12 -- ADF Unit Root Test on Bank Index [1st difference level]

ADF Test Statistic -7.624449 1% Critical Value* -2.6006


5% Critical Value -1.9458
10% Critical Value -1.6186
*MacKinnon critical values for rejection of hypothesis of a unit root.

Augmented Dickey-Fuller Test Equation


Dependent Variable: D(BANK,2)
Method: Least Squares
Date: 06/11/06 Time: 21:02
Sample(adjusted): 2000:03 2005:03
Included observations: 61 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic Prob.
D(BANK(-1)) -0.987757 0.129551 -7.624449 0.0000
R-squared 0.492085 Mean dependent var -1.083934
Adjusted R-squared 0.492085 S.D. dependent var 255.2891
S.E. of regression 181.9398 Akaike info criterion 13.26149
Sum squared resid 1986125. Schwarz criterion 13.29609
Log likelihood -403.4753 Durbin-Watson stat 1.987823
Reference No. 13-- ADF Unit Root Test on BSE Sensex [none]

ADF Test Statistic 0.847576 1% Critical Value* -2.5856


5% Critical Value -1.9431
10% Critical Value -1.6173
*MacKinnon critical values for rejection of hypothesis of a unit root.

Augmented Dickey-Fuller Test Equation


Dependent Variable: D(BSE)
Method: Least Squares
Date: 06/11/06 Time: 21:10
Sample(adjusted): 1996:07 2005:02
Included observations: 104 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic Prob.
BSE(-1) 0.006124 0.007226 0.847576 0.3986
R-squared -0.001734 Mean dependent var 27.89750
Adjusted R-squared -0.001734 S.D. dependent var 300.1898
S.E. of regression 300.4499 Akaike info criterion 14.25801
Sum squared resid 9297827. Schwarz criterion 14.28344
Log likelihood -740.4164 Durbin-Watson stat 1.968782

Reference No. 14-- ADF Unit Root Test on BSE Sensex [intercept]

ADF Test Statistic -0.340429 1% Critical Value* -3.4940


5% Critical Value -2.8892
10% Critical Value -2.5813
*MacKinnon critical values for rejection of hypothesis of a unit root.

Augmented Dickey-Fuller Test Equation


Dependent Variable: D(BSE)
Method: Least Squares
Date: 06/11/06 Time: 21:12
Sample(adjusted): 1996:07 2005:02
Included observations: 104 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic Prob.
BSE(-1) -0.011130 0.032693 -0.340429 0.7342
C 72.14834 133.3051 0.541227 0.5895
R-squared 0.001135 Mean dependent var 27.89750
Adjusted R-squared -0.008658 S.D. dependent var 300.1898
S.E. of regression 301.4865 Akaike info criterion 14.27437
Sum squared resid 9271202. Schwarz criterion 14.32522
Log likelihood -740.2673 F-statistic 0.115892
Durbin-Watson stat 1.940570 Prob(F-statistic) 0.734234
Reference No. 15 -- ADF Unit Root Test on BSE Sensex [trend & intercept]

ADF Test Statistic -1.086908 1% Critical Value* -4.0485


5% Critical Value -3.4531
10% Critical Value -3.1519
*MacKinnon critical values for rejection of hypothesis of a unit root.

Augmented Dickey-Fuller Test Equation


Dependent Variable: D(BSE)
Method: Least Squares
Date: 06/11/06 Time: 21:15
Sample(adjusted): 1996:07 2005:02
Included observations: 104 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic Prob.
BSE(-1) -0.039094 0.035968 -1.086908 0.2797
C 82.13961 132.0319 0.622120 0.5353
@TREND(1996:06) 1.927460 1.083393 1.779097 0.0782
R-squared 0.031487 Mean dependent var 27.89750
Adjusted R-squared 0.012308 S.D. dependent var 300.1898
S.E. of regression 298.3367 Akaike info criterion 14.26274
Sum squared resid 8989485. Schwarz criterion 14.33903
Log likelihood -738.6627 F-statistic 1.641768
Durbin-Watson stat 1.945900 Prob(F-statistic) 0.198762

Reference No. 16-- ADF Unit Root Test on BSE Sensex [1st difference level]

ADF Test Statistic -9.896049 1% Critical Value* -2.5858


5% Critical Value -1.9432
10% Critical Value -1.6174
*MacKinnon critical values for rejection of hypothesis of a unit root.

Augmented Dickey-Fuller Test Equation


Dependent Variable: D(BSE,2)
Method: Least Squares
Date: 06/11/06 Time: 21:16
Sample(adjusted): 1996:08 2005:02
Included observations: 103 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic Prob.
D(BSE(-1)) -0.976913 0.098717 -9.896049 0.0000
R-squared 0.489775 Mean dependent var 4.208738
Adjusted R-squared 0.489775 S.D. dependent var 422.3126
S.E. of regression 301.6581 Akaike info criterion 14.26613
Sum squared resid 9281755. Schwarz criterion 14.29171
Log likelihood -733.7055 Durbin-Watson stat 2.005614
Reference no.17 Regression of X on Y and Y on X [NIFTY AND WPI]

Coefficients
Unstandardized Standardized t Sig.
Coefficients Coefficients
Model B Std. Error Beta
1 (Constant) 4.048 1.186 3.414 .001
WPI -3.027 1.181 -.230 -2.563 .012
Dependent Variable: NIFTY

Coefficients
Unstandardize Standardized t Sig.
d Coefficients Coefficients
Model B Std. Error Beta
1 (Constant) 1.022 .007 148.650 .000
NIFTY -1.742E-02 .007 -.230 -2.563 .012
Dependent Variable: WPI

Reference no.18Residual based Co-integration Test on X on Y


[Nifty & WPI]

ADF Test Statistic -12.08444 1% Critical Value* -2.5830


5% Critical Value -1.9426
10% Critical Value -1.6171
*MacKinnon critical values for rejection of hypothesis of a unit root.

Augmented Dickey-Fuller Test Equation


Dependent Variable: D(E)
Method: Least Squares
Date: 06/11/06 Time: 21:48
Sample(adjusted): 1995:05 2005:03
Included observations: 119 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic Prob.
E(-1) -1.105416 0.091474 -12.08444 0.0000
R-squared 0.553050 Mean dependent var -0.000955
Adjusted R-squared 0.553050 S.D. dependent var 0.105286
S.E. of regression 0.070388 Akaike info criterion -2.461212
Sum squared resid 0.584632 Schwarz criterion -2.437858
Log likelihood 147.4421 Durbin-Watson stat 1.940615
Reference no.19 Residual based Co-integration Test on Y on X
[WPI & Nifty]

ADF Test Statistic -11.13941 1% Critical Value* -2.5830


5% Critical Value -1.9426
10% Critical Value -1.6171
*MacKinnon critical values for rejection of hypothesis of a unit root.

Augmented Dickey-Fuller Test Equation


Dependent Variable: D(E)
Method: Least Squares
Date: 06/11/06 Time: 21:51
Sample(adjusted): 1995:05 2005:03
Included observations: 119 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic Prob.
E(-1) -1.026674 0.092166 -11.13941 0.0000
R-squared 0.512522 Mean dependent var -0.001063
Adjusted R-squared 0.512522 S.D. dependent var 0.106185
S.E. of regression 0.074138 Akaike info criterion -2.357417
Sum squared resid 0.648575 Schwarz criterion -2.334063
Log likelihood 141.2663 Durbin-Watson stat 1.973553

Reference no.20Regression of X on Y and Y on X [BANK AND WPI]

Coefficients
Unstandardized Standardized t Sig.
Coefficients Coefficients
Model B Std. Beta
Error
1 (Constant) 4.679 1.938 2.414 .019
WPI -3.643 1.930 -.235 - .064
1.888
Dependent Variable: BANK

Coefficients
Unstandardized Standardized t Sig.
Coefficients Coefficients
Model B Std. Beta
Error
1 (Constant) 1.020 .008 124.13 .000
9
BANK -1.515E-02 .008 -.235 -1.888 .064
Dependent Variable: WPI
Reference no.21 Residual based Co-integration Test on X on Y
[BANK & WPI]

ADF Test Statistic -8.611257 1% Critical Value* -2.6000


5% Critical Value -1.9457
10% Critical Value -1.6185
*MacKinnon critical values for rejection of hypothesis of a unit root.

Augmented Dickey-Fuller Test Equation


Dependent Variable: D(E)
Method: Least Squares
Date: 06/11/06 Time: 22:00
Sample(adjusted): 2000:02 2005:03
Included observations: 62 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic Prob.
E(-1) -1.100340 0.127779 -8.611257 0.0000
R-squared 0.548661 Mean dependent var -0.000223
Adjusted R-squared 0.548661 S.D. dependent var 0.124962
S.E. of regression 0.083952 Akaike info criterion -2.101146
Sum squared resid 0.429924 Schwarz criterion -2.066837
Log likelihood 66.13552 Durbin-Watson stat 1.951314

Reference no.22 Residual based Co-integration Test on Y on X


[WPI & Bank]

ADF Test Statistic -7.523411 1% Critical Value* -2.6000


5% Critical Value -1.9457
10% Critical Value -1.6185
*MacKinnon critical values for rejection of hypothesis of a unit root.

Augmented Dickey-Fuller Test Equation


Dependent Variable: D(E)
Method: Least Squares
Date: 06/11/06 Time: 22:04
Sample(adjusted): 2000:02 2005:03
Included observations: 62 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic Prob.
E(-1) -0.970509 0.128999 -7.523411 0.0000
R-squared 0.481284 Mean dependent var -0.000683
Adjusted R-squared 0.481284 S.D. dependent var 0.124620
S.E. of regression 0.089753 Akaike info criterion -1.967502
Sum squared resid 0.491397 Schwarz criterion -1.933193
Log likelihood 61.99256 Durbin-Watson stat 1.965120
Reference no.23 Regression of X on Y and Y on X [BSE AND WPI]

Coefficients
Unstandardized Standardized t Sig.
Coefficients Coefficients
Model B Std. Beta
Error
1 (Constant) 4.166 1.312 3.174 .002
WPI -3.146 1.307 -.231 -2.407 .018
Dependent Variable: BSE

Coefficients
Unstandardized Standardized t Sig.
Coefficients Coefficients
Model B Std. Beta
Error
1 (Constant) 1.021 .007 143.720 .000
BSE -1.692E-02 .007 -.231 -2.407 .018
Dependent Variable: WPI

Reference no.24 Residual based Co-integration Test on X on Y


[BSE & WPI]

ADF Test Statistic -10.56767 1% Critical Value* -2.5856


5% Critical Value -1.9431
10% Critical Value -1.6173
*MacKinnon critical values for rejection of hypothesis of a unit root.

Augmented Dickey-Fuller Test Equation


Dependent Variable: D(E)
Method: Least Squares
Date: 06/11/06 Time: 22:10
Sample(adjusted): 1996:07 2005:02
Included observations: 104 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic Prob.
E(-1) -1.039920 0.098406 -10.56767 0.0000
R-squared 0.520206 Mean dependent var 3.79E-05
Adjusted R-squared 0.520206 S.D. dependent var 0.106673
S.E. of regression 0.073889 Akaike info criterion -2.362935
Sum squared resid 0.562338 Schwarz criterion -2.337508
Log likelihood 123.8726 Durbin-Watson stat 1.983658
Reference no.25 Residual based Co-integration Test on Y on X
[BSE & WPI]

ADF Test Statistic -10.34426 1% Critical Value* -2.5856


5% Critical Value -1.9431
10% Critical Value -1.6173
*MacKinnon critical values for rejection of hypothesis of a unit root.

Augmented Dickey-Fuller Test Equation


Dependent Variable: D(E)
Method: Least Squares
Date: 06/11/06 Time: 22:11
Sample(adjusted): 1996:07 2005:02
Included observations: 104 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic Prob.
E(-1) -1.020573 0.098661 -10.34426 0.0000
R-squared 0.509532 Mean dependent var -0.000109
Adjusted R-squared 0.509532 S.D. dependent var 0.110501
S.E. of regression 0.077388 Akaike info criterion -2.270405
Sum squared resid 0.616855 Schwarz criterion -2.244978
Log likelihood 119.0610 Durbin-Watson stat 1.983072
Reference no.26 Granger’s causality Test
[NIFTY AND WPI]

F critical values:
Level of No. of observations for different lags
significance 117 115 113 107 95
(lag 2) (lag 4) (lag 6) (lag 12) (lag 24)
1% 1.23 1.21 1.19 1.12 1.74
5% 1.32 1.29 1.27 1.20 1.07
10% 1.50 1.47 1.44 1.36 1.21

Reference no.27 Granger’s causality Test


[BANK INDEX AND WPI]

F critical values
Level of No. of observations for different lags
significance 60 58 56 50 (lag 24)
(lag 2) (lag 4) (lag 6) (lag 12)
1% 1.40 1.35 1.31 1.17 --
5% 1.53 1.48 1.43 1.28 --
10% 1.84 1.78 1.72 1.53 --

Reference no.28 Granger’s causality Test


[BSE SENSEX AND WPI]

F critical values
Level of No. of observations for different lags
significance 103 101 99 93 81
(lag 2) (lag 4) (lag 6) (lag 12) (lag 24)
1% 1.06 1.04 1.04 0.98 0.85
5% 1.15 1.13 1.11 0.05 0.91
10% 1.31 0.94 1.26 1.19 1.03