Contemporary issues in the Indian stock market

Abstract

EXECUTIVE SUMMARY The Indian equity has displayed tumultuous growth over the last 4 years, generating returns of around 300%. This study first does a trend analysis of this period and finds that the Indian equity market is highly liquidity sensitive, with the correlation between Nifty returns and turnover being 0.8. The authors also divide the equity market growth into key phases and present an analysis of the same. In the second section of preliminary analysis, the authors identify reasons for growth in the Indian equity market. The primary reasons for the same are enumerated below: 1. 8% growth in the real GDP for the last 3 years 2. Increase in FII investment by a factor of 10 3. Growth in retail investor participation both through individual accounts and MFs 4. Prudent SEBI regulations and cutting edge market infrastructure 5. Growth of derivative market offering opportunity to both hedge and speculate After establishing the drivers of the market and analyzing past trends, the paper presents two key research initiatives of the authors – comparison of India with other emerging markets as an avenue for foreign investment, and pricing of options on the dollar denominated Nifty, which might soon be introduced by NSE.

The authors propose a model for evaluating attractiveness of emerging markets to portfolio investment. As per the results obtained, India has been an extremely attractive investment destination owing to strong equity returns to compensate for market risk, positive interest rate differential, and a low covariance with US market. The variation in the net returns to the US investor is on account of fluctuations in the value of the Rupee. Brazil, Russia and Korea are identified as key competitors for foreign capital, but do not score above India in all parameters. With the broadening of definition of FII and prevalence of the drivers of growth of Indian market, the authors predict that foreign investment would continue to flow in atleast over the next 5 years even though the market returns stabilize gradually and correlation with global markets increases.The second research topic first involves modeling of price and volatility processes of Defty. Since Defty is essentially a cross-currency index, and both stock price and exchange rate can be assumed to follow a lognormal distribution, the Defty can be modeled as a lognormal function itself. Since Defty is a lognormal function, Black Scholes model can be used to determine its price. For modeling volatility, the authors considered both historical and GARCH based models. GARCH (1, 1) was found to have the highest forecasting power and hence was used for pricing options on Defty. This option pricing model can be put to practice once NSE introduces options on Defty and its efficacy can then be evaluated by comparing modeled option price with market price.