Cointegration Of

8/3/2019 Cointegration Of

http://slidepdf.com/reader/full/cointegration-of 1/8

Cointegration of Indian stockmarkets with other leading

stock marketsN. Rajiv Menon

IMT Department, Yanbu Industrial College, Yanbu, Saudi Arabia

M.V. Subha Anna University, Coimbatore, India, and

S. SagaranYanbu Industrial College, Yanbu, Saudi Arabia

AbstractPurpose – One of the anxieties of stock market investors is whether the markets operate efficiently,independently and with sound fundamentals. This concern is also held by academics and practitionersfor quite some time. However, real market situation tends to exhibit a link as is evident from recentmarket movements across the world. The purpose of this paper is to examine whether the stockmarkets in the Indian subcontinent have any link with the major stock markets from China, Singapore,America, and Hong Kong.

Design/methodology/approach – The paper uses Engle Granger test of cointegration.

Findings – The paper finds that the Indian markets are relatedto some of the markets aroundthe world.

Originality/value – The paper offers insight into the cointegration of Indian stock markets withother leading stock markets.

Keywords Stock markets, India

Paper type Research paper

IntroductionThe revolution in Information Technology coupled with the permeation of high-speedInternet connectivity have created a fast track information superhighway with globalreach. The technology permeation is taking place at incredible speeds and is highlydemocratized so that information is available to any one at any place at any time at lowcost. Capital markets thrive on information, and the information revolution hastransformed these markets world over. Investors can now keep track of the movementsof the capital market on real-time basis and they react to the flow of information fromaround the world. These dealings sometimes surge into huge waves of panic actionsand reactions affecting global markets one by one. National economies are no longer

insulated and the repercussions of international events influence the movement of shares and other investments. With globalization taking roots; investors, governmentsand institutions are concerned about the visible linking of geographically separatedmarkets, though a perfect link is far beyond reality.

Due to the time difference, the financial centers and markets do not close at the sametime. When one market closes, another market on another part of the globe opens. Theopening markets are aware of the closing prices in the closed markets. The Shanghaiand Bombay markets open with the index information from Dow Jones and

The current issue and full text archive of this journal is available at

www.emeraldinsight.com/1086-7376.htm

Cointegrationof Indian

stock markets

87

Studies in Economics and FinanceVol. 26 No. 2, 2009

pp. 87-94q Emerald Group Publishing Limited

1086-7376DOI 10.1108/10867370910963028



the NASDAQ. The efficient market hypothesis suggests that these processes shouldresemble random walks with uncorrelated increments. Latest global events of lateseems to point in this direction such as the events of 27th February 2007 where theSSE’s (Shangai Market) worst day of trading in 10 years where the SSE Composite

Index fell nearly 9 percent on fears of capital controls, dragging other markets alongthroughout the world. Every move by the Federal Reserve cascades throughoutfinancial markets across the world.

Many researches have been conducted and currently been undertaken to study thevarious behavioral aspects of capital market in India and beyond. Many studies werecarried out to test the cointegration and interdependencies among various CapitalMarkets (Bala and Mukund, 2001; Wong et al., 2004; David, 1994; Chan et al., 1997;Kanas, 1998; Masih and Masih, 2001). Various researchers have attempted to test theefficiency and co integration of the Indian Capital Market from time to time. This studylooks at the co integration characteristics of the Indian Capital Market with globalmarkets using the Engle Granger test of co integration, in the post-liberalization period.Due to the number of markets and the volume of trade, any number of researchesundertaken is not sufficient to explain the behavior. This study examines the possiblelink; the Indian capital market has with other capital markets of the world.

Objective of the studyThe main objective of the present paper is to test whether the Indian capital market iscointegrated with other leading stock markets of the world using the Engle GranglerTest of cointegration.

Method of computation of stock market indicesThe CNX Indices are computed using market capitalization weighted method whereinthe level of Index reflects the total market value of all the stocks in the index relative to a

particular base period. The method also takes into account constituent changes in theindex and the corporate actions. Different indices are computed and compiled for use bythe investors. While some indices employ an equal weighting approach (equal amountsassumed to be invested in each component), the others are either price weighted or valueweighted. Both these methods are employed in the compilation of stock indices.

Bombay stock exchange sensitive index of equity prices SENSEX The Bombay stock exchange (BSE) started compiling and publishing a sensitive indexnumber of equity prices from January 2, 1986 with base year 1978-1979 ¼ 100. It iscalled “The Bombay Stock Exchange Sensitive Index of Equity Prices”. The BSE Indexis based on the prices and trading volume of 30 selected shares from the specified andnon-specified list. To provide a broad-based index on a national scale, The Mumbai

Stock Exchange has, compiled a new series called “BSE National Index” with the year1983-1984 as the base year. This index includes 30 scrips of the BSE Sensitive Indexand has 70 scrips selected on an all-India basis depending on their market activity.

NSE – 50 index (NIFTY)The S&P CNX Nifty is one of the popularly watched Indices in India. This Index isbuilt by India Index Services Product Ltd (IISL) and Credit Rating Information Servicesof India Ltd (CRISIL). The CRISIL has a strategic alliance with Standard and Poor

SEF26,2

88



Rating Services. It is named as S&P CNX Nifty or NSE-50 Index and introduced onApril 22, 1996. The selection criteria are the market capitalization and liquidity. Theselection criterion for the index was applied to the entire universe of securities admittedon NSE. The market capitalization of the companies should be Rs. 5 billion (US$ 120

million) or more. The selected securities are given weights in proportion to their marketcapitalization. The base period for the S&P CNX Nifty index is the closing prices onNovember 3, 1995. The base period is selected to commensurate the completion of oneyear operation of NSE in the stock market. The base value is fixed at 1,000 with thebase capital of Rs 2.06 trillion.

Review of empirical evidenceDavid (1994) in his working paper studied the market linkages using Cointegration Ranktest with special application to the US Natural Gas Industry. Likelihood based tests forcointegration was applied to data from natural gas spot markets. The Johansen methodwas used to study the spatial market linkages. The results indicated that the natural gas

spot markets at dispersed locations in the pipeline network are strongly connected. Outof 19 market pairs examined, most of the market pairs (13) satisfied a more stringentcondition for perfect market integration. Chan et al. (1997) conducted a study onintegration of stock markets by including 18 nations covering a 32 year period. Thesemarkets were analyzed both separately and collectively in regions to test for the weakform market efficiency. The cross country market efficiency is tested by using

Johansen’s cointegration test. The results showed that only small number of stockmarkets shown evidence of cointegration with others. Kanas (1998) used themultivariate trace statistic ^P2, the Johansen method, and the Bierens non-parametricapproach to test for pairwise cointegration between the USA and each of the six largestEuropean equity markets for a period of 13 years. The results from the tests are robustand consistent in suggesting that the US market is not pairwise cointegrated with any of

the European markets. Bala and Mukund (2001) in their study examined the nature andextent of linkage between the USAand the Indian stock markets. They used the theory of cointegration to study the interdependence between the BSE, the NYSE and NASDAQ.The data consisted of daily closing prices for the three indices from January 1991through December 1999. The results supported that the Indian stock market was notaffected by the movements in US markets for the entire sample period. Masih and Masih(2001) in their work examined the patterns of dynamic linkages among national stockprices of Australia and four Asian NIC stock markets namely Taiwan, South Korea,Singapore and Hong Kong by employing a multivariate, dynamic framework allowingfor both short and long-run relationships. The results showed that the Hong Kongmarket played a leading role in driving fluctuations in Australia and other NIC stockmarkets. Wong et al. (2004) have empirically investigated the long-run equilibrium

relationship and short-run dynamic linkage between the Indian stock market and thestock markets in major developed countries by examining the Granger causalityrelationship and the pair-wise,multiple and fractional cointegrations between the Indianstock market and the developed stock markets such as the USA, the UK and Japan. Thefindings of the study revealed that the Indian stock market is statistically, significantlyco-integrated with stock markets of the USA, the UK and Japan. There is existence of aunidirectional granger causality running from the USA, the UK and Japanese stockmarkets to the Indian stock markets. Indian stock index and the mature stock indices


stock markets

89



form fractionally cointegrated relationship in the long run with a common fractional,nonstationary component and revealed the cointegration relationship using the

Johansen method. The study confirmed that the financial liberalization in India since1991 has opened up Indian stock markets vis-a -vis the world markets and therefore

influenced by other markets.

Research methodology Data and sources of dataThe share index data is obtained from the NSE NIFTY index along with other majorstock indices from China, Singapore, America, and Hong Kong. The study covers atime span of ten years; from April 1997 to May 2007.

The two important equity share prices indices in India are:

(1) The BSE Index.

(2) The NSE Index.

These index values are quoted and published on a daily basis at the end of each tradingday. The broad based NSE-NIFTY index values are used for the study. To compareIndian stock market movements with other global markets, stock index values of popular markets such as the SEC (China), NASDAQ (America), Hang Seng (HSI, HongKong), STI (Singapore) are used.

Period of studyThe period of study is ten years, from April 1, 1997 to May 10, 2007. Similarly theclosing index values of various international stock markets are also collected for thesame period (April 1, 1997-May 10, 2007). The daily Index values from the variousmarkets are used. No adjustments are made for non-trading days and when the stockexchange is closed for holidays.

Analysis of dataThe theory of cointegration is used to study the interdependence between the NationalStock Exchange (NSE), SEC (China), NASDAQ (America), HSI (Hong Kong) and STI(Singapore). The Engle Granger test is used to test the cointegration among these indices.

Test of cointegrationThe Engle Granger test of cointegration is used to test the cointegration betweenNSE-NASDAQ, NSE-HSI, NSE-STI and NSE-SSE. The idea of cointegratedmultivariate time series was introduced by Granger (1981) and developed by Engleand Granger (1987). Two variables are said to be cointegrated when a linearcombination of the two variables is stationary implying that there is a long term

relationship existing between them. Lack of cointegration suggests that no suchrelationship exists. Non stationary univariate time series can be made stationary byapplying the differencing operator delta, repeatedly to the series. In order to test thecointegration between the NSE and other global stock indices the following hypothesis( H 0 – Null Hypothesis; H 1 – Alternate Hypothesis) are formulated:

H 0 . There is no linear dependence between the indices of the NSE-NASDAQ stockexchanges.

SEF26,2

90



H 1. There is linear dependence between the indices of the NSE-NASDAQ stockexchanges.

H 0 . There is no linear dependence between the indices of the NSE-HSI stock

exchanges H 1. There is linear dependence between the indices of the NSE-HSI Stock

Exchanges.

H 0 . There is no linear dependence between the indices of the NSE-SSE StockExchanges.

H 1. There is linear dependence between the indices of the NSE-SSE StockExchanges.

H 0 . There is no linear dependence between the indices of the NSE-STI StockExchanges.

H 1. There is linear dependence between the indices of the NSE-STI StockExchanges.

Testing for co integration involves testing the residuals (the difference between actualvalue of the dependent value and the predicted value from the estimated equation) froman Ordinary Least Square regression for the time series and the residuals are obtained:

Y t ¼ b 0 þ b 1 xt þ b 2 zt þ 1 ð1Þ

Regress y on x and z. The residuals are obtained from the Ordinary least square and aDicky Fuller unit root test2 is carried out to check for unit root. If a unit root is notpresent, the residuals are stationary and the variables are cointegrated.

The first difference of the residuals DY t is regressed against the first lag of theresidual Y t 21 and sufficient lags of Y t :

DY t ¼ ðY t 2 Y t 21Þ ¼ ut ð2Þ

The results of the unit root test, t-statistics have to be compared with speciallycalculated critical values. If the estimated jtj exceeds any of these critical values thenull hypothesis that there is no cointegration among the variables can be rejected.Otherwise, the null hypothesis is to be accepted.

Results and discussionsThe daily closing prices of NSE (India) and SEC (China), NASDAQ (America), HSI(Hong Kong), STI (Singapore) are taken to see whether there is any relationshipbetween the Indian stock market and the US markets. The Engle Granger test of cointegration is applied and t values are estimated. The critical value forEngle-Granger statistics at 1 percent, 5 percent and 10 percent are 22.5899,21.9439, and 21.6177, respectively.

For the NSE-NASDAG stock indices the estimated EG DF (Engle-Grange,Dicky-Fuller) test statistic is 1.1547. Since, the EG DF statistic is found to be less thanthe critical value specified by Engle andGranger statistics at all levels, the NullHypothesisthat there is no dependency is accepted for all these levels.We recognize theview that thereis no dependence between the USA stock markets and the Indian stock markets.


stock markets

91



For NSE-Hang Seng stock indices, the estimated EG DF test statistic is 20.9310.Since, the EG DF statistic is found to be less than the critical value specified by Engleand Granger statistics at all levels, the Null Hypothesis that there is no dependency isaccepted at all the given levels. We accept the view that there is no dependence

between Hang Seng and the Indian stock markets.For the NSE-Shangai the estimated EG DF test statistic is 22.0389. Since, the EG

DF statistic is found to be more than the critical value specified by Engle and Grangerstatistics at the 5 percent and 10 percent levels, the Null Hypothesis that there is nodependency is rejected at these levels. We do not accept the view that there is nodependence between the Shangai stock market and the Indian stock markets at thesetwo levels. But at 1 percent level, the null hypothesis cannot be rejected that there is nodependency between Shangai and the Indian Stock market.

For the NSE-Singapore stock indices the estimated EG DF test statistic is 23.1749.Since, the EG DF test statistic falls in the critical region for all three levels of criticalvalue specified by Engle and Granger statistics, the Null Hypothesis that there is nodependency is rejected at all the three levels. We accept the view that there isdependence between the Singapore stock market and the Indian stock markets.

The study uses the theory of cointegration to understand the interdependencebetween the NSE and the NASDAQ, HangSeng, Shangai and Singapore stock marketsTable 1. The results support the hypothesis that the Indian stock market is notexhibiting long term relationship with the US markets for the entire sample period.Therefore, the findings show that the Indian markets are operating independently andare not exhibiting any inter relationship with the US stock markets.

The result also supports the hypothesis that the Indian stock market is notinterrelated to the HangSeng Index for the same period. The finding shows that theIndian markets operate independently of Hong Kong based Hang Seng stock market.However, the results are mixed when tested for the Indian and Shangai markets.

The finding shows at 5 percent and 10 percent, the markets are independent of eachother but at 1 percent level the markets are dependent. This shows that the Indian andthe Singapore markets operate in dependence of each other. These two markets arecointegrated, implying that there is a long-term relationship between these markets.

ConclusionThe study examined the extent of cointegration between the Indian stock market andother leading stock markets using the NSE Nifty index along with other major stockindices of US, China, Singapore and Hong Kong. The study covers a period of ten years;

1% 5% 10%

Index X

variableStandard

errorTest t -statistic

CR DFEG critical

valueEG critical

valueEG critical

value

22.5899 21.9439 21.6177NSE – NASDAQ 20.000831 0.000719 1.1547 Accept ( H 0 ) Accept ( H 0 ) Accept ( H 0 )NSE – Hang Seng 20.0017 0.001821 20.9310 Accept ( H 0 ) Accept ( H 0 ) Accept ( H 0 )NSE – Shangai 20.00448 0.002197 22.0389 Accept ( H 0 ) Reject ( H 0 ) Reject ( H 0 )NSE – S’pore 20.00622 0.001959 23.1749 Reject ( H 0 ) Reject ( H 0 ) Reject ( H 0 )Table 1.

SEF26,2

92



from 1 April 1997 to 10 May 2007. The Engle Granger test of cointegration is used tocheck the level of dependence between the various capital markets. The results of thetest showed absence of cointegration between the two variables suggesting nointerdependence between the Indian stock markets and the American Stock markets.

This is also the case with Indian stock markets and Hong Kong stock market. TheIndian stock markets and Hong Kong markets operate independently of each other.There is some amount of cointegration between the Indian stock markets and theShanghai stock market. The markets in India and Shangai are dependent to someextent. However, the results show the presence of strong cointegration between Indianand Singapore stock markets suggesting a strong inter-dependency. The test of cointegration reveals the absence of interdependence and long term relationshipbetween the Indian, Amercian Stock Markets and Indian and Hong Kong stockmarkets. When studied with the SSE (China) index, and STI (Singapore) the resultsshow that there is some amount relationship between the Indian and Shanghai stockmarkets and a strong relationship between Indian and Singapore stock markets.

References

Bala, A. and Mukund, K.S. (2001), “Interrelationship between Indian and US stock markets”, Journal of Management Research, Vol. 1 No. 3, pp. 141-8.

Chan, C.K., Benton, G.E. and Min, S.P. (1997), “International stock market efficiency andintegration: a study of eighteen nations”, Journal of Business Finance & Accounting , Vol. 24No. 6, pp. 803-13.

David, W. (1994), “A cointegration rank test of market linkages with an application to the USnatural gas industry”, Review of Industrial Organisation, Vol. 9, pp. 181-91.

Engle, R.F. and Granger, C.W.J. (1987), “Cointegration and error correction: representation,estimation and testing”, Econometrica, Vol. 55, pp. 251-76.

Granger, C.W.J. (1981), “Some properties of time series data and their use in econometric modelspecification”, Journal of Econometrics, Vol. 16, pp. 121-30.

Kanas, A. (1998), “Linkages between the US and European equity markets: Further evidencefrom cointegration test”, Applied Finance Economics, Vol. 8, pp. 607-14.

Masih, A.M.M. and Masih, R. (2001), “Dynamic modeling of stock market interdependencies:an empirical investigation of Australia and the Asian NIC’s”, Review of Pacific Basin

Financial Markets and Policies, Vol. 4 No. 2, pp. 235-64.

Wong, W.K., Agarwal, A. and Du, J. (2004), “Financial integration for Indian stock market:a fractional co-integration approach”, Finance India, Vol. XVIII No. 4, pp. 1581-604.

Further reading

Azizjon, A.A., Chakroborty, D., Raymond, A.K.C. and Jain, A.K. (2004), “The random walkhypothesis on the Bombay Stock Exchange”, Finance India, Vol. XVIII No. 3, pp. 1251-8.

Dickey, A.D. and Fuller, A.W. (1981), “Likelihood ratio statistics for autoregressive time serieswith a unit root”, Econometrica, Vol. 49 No. 4, pp. 1057-72.

Engle, R.F. and Yoo, B.S. (1987), “Forecasting and testing in co-integrated systems”, Journal of Econometrics, Vol. 35, pp. 143-59.

Monder, C. (2002), “Asymmetry in the EMS: new results from a cointegration analysis”, Finance India, Vol. XVI No. 2, pp. 573-84.


stock markets

93



Samanta, G.P. and Sanjib, B. (2005), “Predicting stock market – ‘an application of artificialneural network technique through genetic algorithm’”, Finance India, Vol. XIX No. 1,pp. 173-88.

Schleifer, A. (2000), Inefficient Markets: An Introduction to Behavioral Finance, Oxford

University Press, Oxford.Sharma, J.L. and Robert, E.K. (1977), “A comparative analysis of stock price behaviour on the

Bombay, London and New York stock exchanges”, Journal of Financial and Quantitative Analysis, September, pp. 391-413.

SEF26,2

94

To purchase reprints of this article please e-mail: [email protected] visit our web site for further details: www.emeraldinsight.com/reprints

Documents

Cointegration Of