Reasearch Paper

Globally leading stock exchange: New York and London, movement of Indices due to GDP of US and UK.

Research Paper Submitted To: Prof C.P Joshi

Submitted By Nidhi Agarwal PGDM-(IB)-02

Table of Contents Hypothesis..................................................................................................................4 Need...........................................................................................................................4 Summary of Methodology used..................................................................................4 Executive summary....................................................................................................5 Introduction................................................................................................................7 International Environment..........................................................................................7 European Integration...............................................................................................7 Stock Market Integration.........................................................................................8 Global Equity Market...............................................................................................8 Key areas of hypothesis.............................................................................................9 Modern Portfolio Theory..........................................................................................9 The Impact of Macroeconomic and Financial Variables on Equity Market...............9 Imports and exports...........................................................................................10 Inflation..............................................................................................................10 Government surplus to GDP ratio.......................................................................11 Credit rating.......................................................................................................11 Taxes to GDP ratio.............................................................................................11 Benefits of Diversification and Integration for International Equity.......................11 Stock Market Integration reducing diversification benefits...................................12 Equity Market Benchmarks....................................................................................13

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Leading Stock Exchange and Indices....................................................................13 Result and Conclusion..............................................................................................14 Correlation............................................................................................................14 Return Analysis.....................................................................................................18 Recommendation.....................................................................................................20 Bibliography.............................................................................................................21 Bibliography

List of tables Table 1 : Leading Exchange and Indices.................................................................13 Table 2 : Correlation coefficient between GDP and Indices of US and UK.................14 Table 3 : Correlation between Indices under study..................................................14 Table 4 : Stock Exchange and Indices......................................................................16 Table 5: Correlation of Returns of Stock Indices.......................................................16 Table 6: Return Analysis for Developed and Developing Economies for the period of June 2006 to June

2009........................................................................................18

Table 6: Return Analysis for Developed and Developing Economies for the period of June 2006 to June 2009

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List of Figures Fig 1 : Trend in correlation between NYSE Composite Index and FTSE 100............15 Fig 2 : Return of Stock Indices for countries.............................................................19

Hypothesis H1: There exist a positive correlation between the Indices and the GDP of the country (US and UK). H2: There exist a positive correlation between the US and the UK Stock Exchange.

Need Market reacts differently to various factors ranging from economic political, and sociocultural. The indices of are affected either positivity or negatively by a number of factors occurring within or without the economic system. Relation between the indices and the GDP would give the investors and MNE’s idea about impact of GDP on the stock prices. Companies in the world are facing daunting times. Each day seems to bring fresh news of yet higher energy

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prices, inflationary forecasts, etc which impacts the GDP and indices of the country. MNE’s need to adjust to this new reality and steer their businesses amid the roiling waters of an increasingly connected global economy. A strong positive correlation approaching 1 indicates more and more integration of US and UK Stock Exchange because of which there will be less diversification benefits for these developed economy as a result MNE’s and investors needs to focus on other developing economies.

Summary of Methodology used US and UK Stock exchange and the indices is analysed closely. Time series analysis and Return analysis is used. The secondary research in terms of various articles is reviewed. In order to determine the impact of GDP on equity index and to prove correlation between them, correlation between US GDP and data of NYSE composite index is found. Similarly correlation between UK GDP and data on FTSE 100 is found. Quarterly data on equity indexes and GDP from June 2006 to June 2009 is used.. This provides an econometric relation which allows us to explain the correlation between the GDP (macroeconomic and financial Variables) and equity Indices of the country.

To determine the relation between US stock exchange (New York Stock Exchange) and UK stock Exchange (London stock Exchange), correlation between data of NYSE Composite index and data of FTSE 100 is found. Daily data on equity index from June 2006 to June 2009 is used. The equation for the correlation coefficient is,

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where x and y are the sample means AVERAGE(array1) and AVERAGE(array2). Array1 is a range of values for x. Array2 is a range of values for y.

Executive summary In a dynamic economic environment, knowledge of international stock market is important for the investors, portfolio managers, MNC’s, FII’s and policy makers. In recent years, globalization, economic assimilation and integration among countries and their financial markets have increased interdependency among major world stock markets. This increased interdependency among the worldwide stock markets may have impacts on the global investors for their assets allocation decision and on the economic policies of economies for ensuring economic stability. The objective of this paper to investigate whether there exist a relation between GDP and Indices of the country also whether there is positive correlation between the US and UK stock exchange. Both being developed economies it will help in better comparison with developing economies. A strong positive correlation approaching 1 indicates more and more integration of US and UK Stock Exchange because of which there will be less diversification benefits for these

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developed economy as a result MNE’s and investors needs to focus on other developing economies. Macroeconomic and financial variables which affects the stock index return where determine, Also the relation between variable and stock index return is determined using beta. Correlation test was conducted between the GDP of 2 countries (US and UK) and their indices respectively. The result of positive correlation coefficient proved the hypothesis that there exist a positive correlation between the Indices and the GDP of the country (US and UK). Thus, 1st hypothesis is accepted A close analysis of US and UK Stock Exchange indices has been done to find the relation between them. Daily data on return of equity indexes were used to obtain Change in growth percentage. A correlation test was conducted. This provides an econometric relation which allows us to explain positive correlation between the US and the UK Stock. Thus, 2nd hypothesis is accepted. In the last section return analysis is done on data of return for equity index for major leading stock exchange and indices for a period of 3 years. This information provides investors the return they would have received had they diversified their portfolio based on those indices. The returns were relatively higher for developing economies than developed economies. The findings in this paper may have some practical implications. For example, portfolio managers interested in global asset allocation may want to understand how world market risks differ across countries and what explains these differences, and therefore this kind of information may be useful in their portfolio selection decisions. It will also give information about the integration and diversification benefits between world market. In order to design hedging strategies for risk exposures to the world market and in which economy to invest in, MNC’s and FII’s may be interested in predicting future world market risks by employing information about

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the current state of the macroeconomy. The relation between world equity market indexes and the macroeconomy may also provide useful information for government policy makers.

Introduction Various theories in finance suggest that it is the degree and direction of correlation among the returns of securities as well as those of the stock markets which decide whether an investor is going to have any gains of diversification across the securities and the markets. For instance, if the stock markets of different countries move together, then investing in different stock markets would not generate required portfolio diversification gains. Hence, it is important for the investors to know whether diversification across the global stock markets will provide desired diversification gains. For this, it is imperative for them to have an accurate estimate of the degree and nature of correlation among the returns across the global stock markets. In a different vein, there has been work to identify the underlying economic variables which cause stock index movements. This research has uncovered a number of key macroeconomic variables (GDP, output, inflation, import/export, Government surplus to GDP ratio) and financial variables (Taxes to GDP Ratio) as significant determinants of stock market movements. Also, if the policy makers of a particular economy understand fully the way the global markets are integrated and factors impacting the movement of equity market, then suitable economic policies could be designed so as to take care of the economic crisis traveling to domestic market from other international markets. It will also benefits MNC’s, FII’s and Investors.

International Environment European Integration

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Correlations between EMU country indices are rising as the level of economic market integration in the EMU increases over time. The main empirical finding is that correlations among country indices have increased considerably during the period of closer economic cooperation and integration starting from 1979 until 1999. Moreover, as the European stock markets become less distinct from one another, asset managers looking to diversify their stock portfolios might increasingly divert part of their assets from the European market to other regions where cross-market correlations are still at a lower level. This would lead to a gradual withdrawal of investment flows away from the European stock markets, which could potentially have substantial implications for the size and liquidity of the European markets, not to mention the ability of continental companies to raise sufficient money for investment projects in the financial markets.

Stock Market Integration During the last few decades capital markets throughout the world have become increasingly integrated. There are several reasons for this. It has been suggested that the common effect of stock markets in different countries has been boosted due to the deregulation and liberalization of capital markets and an increase in the international activities of multinational companies. Thus, in the course of time, the national separate stock market is first internationalized and then globalized. Part of this integration is due to the impact of international investors on the comovements of national stock prices and part may be due to economic integration.

Global Equity Market

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Development of financial intermediaries and openness to trade are positively associated with the size and activity of equity markets, while government consumption is negatively associated with equity market activity and liquidity. Over the past thirty years, stock markets around the world have experienced phenomenal expansion. The aggregated market capitalization of all national equity markets has grown from less than US$1 trillion in 1974 to over US$16 trillion by the end of 1997. The process of growth in global equity markets is still imperfectly understood. One view points to improved macroeconomic and financial fundamentals as the source of the growth. Others who are more skeptical of efficiently functioning capital markets, suggest that investors in their “exuberance” may have been buying up stocks, disregarding the historical relationship between market fundamentals and equity valuation.

World’s Equity Market Capitalization at year-end 2006: $52 trillion

Key areas of hypothesis Modern Portfolio Theory In the portfolio management industry, financial investment and security firms base their optimal asset allocation strategies on the diversification benefits as suggested by the Modern Portfolio Theory. First introduced by Markowitz (1952), Modern Portfolio Theory shows that the risk of a portfolio of assets is not equal to the sum of the weighted average of the variances of individual securities, but also depends on the correlations between the assets. The weaker the correlations between assets are, the greater is the reduction in portfolio risk. Therefore, a welldiversified portfolio (among low correlated stocks) can bring the same return for an investor at a

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lower risk level for investors. The rationale of international diversification in portfolio management thus highly depends on low correlations between international equity markets.

The Impact of Macroeconomic and Financial Variables on Equity Market There is a general consensus among researchers that macroeconomic news affects security prices. Ultimately, returns on stocks and bonds reflect real economic activity, and therefore in the long run we expect to see a relationship between macroeconomic activity and equity returns. Beginning with the early work of Fama (1981), researchers have examined the relation between stock markets and economic variables. Chen et al. (1986) extend this idea and find that industrial production, changes in risk premiums, term premiums and inflation affect stock returns in the US. The idea that macroeconomic and financial variables can explain time-varying risk exposures (betas) of stocks and their risk-adjusted excess returns (alphas) has also been extended to the study of international equity markets (see, for instance, Ferson and Harvey, 1998). Dilip K. Patro, John K. Wald and Yangru Wu empirical work was grounded on the international asset-pricing models of Stulz (1981) and Adler and Dumas (1983). The models specify that an asset’s expected return is based on the covariance of the asset’s return with the returns on the world market portfolio and on the covariance of the asset’s return with the returns on foreign exchange rates. This additional exchange risk factor results from deviations from purchasing power parity (PPP), which cause investors in different countries to have different real returns for the same asset. The macroeconomic variables examined were a country’s imports, exports, tax revenues, government surplus, and equity market capitalisation all as fractions of GDP, as well as inflation, money supply growth, and credit ratings. The financial variables we

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use are market capitalisation as a fraction of world capitalisation, dividend yields, term spreads, price-to-book ratios, and earnings-to-price ratios.

Impact of macroeconomic variables Imports and exports. A country with high exports as a fraction of GDP will be more sensitive to the world economy as a whole than a country with relatively low exports. Similarly, a country with high imports may face higher import and factor costs if the world economy is strong, and thus it may have a less positive correlation with the world market index. That is, when countries have higher exports (imports), their stock markets will reflect a more positive (negative) exposure to world market risk.

Inflation According to the Fisher theory, if stocks provide a hedge against inflation, the relation between stock returns and inflation should be positive. However, Fama’s proxy hypothesis (1981) asserts than an increase in inflation is expected to be followed by a decline in real economic activity and corporate profits, thus stocks will react negatively to a rise in inflation. Fama (1981) and Geske and Roll (1983) find support for this hypothesis for the USA. However, Solnik and Solnik (1997) test the Fisher hypothesis for eight developed countries and find a positive relationship between stock returns and inflation. In contrast, Wasserfallen (1989) finds

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little evidence of such a correspondence using international data. Government surplus to GDP ratio.

If a country’s government is running a surplus, the likelihood of an increase in taxes or borrowing by the government in the future will be lower than for a government running a deficit. If higher tax rates lead to higher betas, a higher government surplus may have the same impact on beta as lower taxes. Thus, we expect that a higher government surplus will lead to a lower beta. Credit rating. Country with a better credit rating may be associated with a lower world market risk. The result from articles implies that countries with a high credit rating appear to be more sensitive to world market risk and thus equity return. Possibly the goods and services provided by highcredit countries are somehow more sensitive to overall world market activity. Taxes to GDP ratio. If investors care about returns on an after-tax basis, then a higher tax rate may impact required before-tax returns. If investors demand a constant, or nearly constant, after-tax rate of return and return premium, then higher taxes may imply a higher discount rate or a higher beta. Therefore, we expect the parameter on the tax variable to be positive.

Benefits of Diversification and Integration for International Equity

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It is well known from portfolio theory that pure domestically invested asset portfolios are usually sub-optimal. If for example a private household in Europe invests only in Europe equities she will have a lower return-to-risk ratio than compared to a world-wide investment. As this is true in general for all types of investors, countries and assets, a better diversification should improve the performance of investments. Capital market integration and diversification are connected in several ways. In a fully integrated capital market all risk factors trade at the same price. This means, for example, if the European capital markets were fully integrated then the business cycle risk or the inflation risk would have the same price in all European capital markets. Capital market integration means in other words that the law of one price is fully applicable to all traded assets. This per se should have a positive effect on the functioning of financial markets and indirectly on the performance of investments. But integration of capital markets has also a more basic meaning: free access to foreign financial markets.

Stock Market Integration reducing diversification benefits One of the key issues in international equity investment is the measurement of diversification gain. Is there a positive diversification value as a result of international investment? A simple understanding of a positive diversification value is that an international equity investment will lead to higher return via the construction of a lower risk of portfolio of funds (assuming stable currency). However, the significance of benefits from international portfolio diversification has been questioned recently in view of the increasing integration among equity markets throughout the world. The issue above has prompted many investigations being made to provide evidence of

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changing correlation coefficient over time across countries. The reason for the significance of this is valid. If the correlation coefficient is shifting haphazardly over time or shifting towards perfect correlation across any two markets, then gains from international diversification will be difficult to predict. The study also shows that the average correlation coefficients of domestic-based portfolios are generally lower than those of internationally diversified portfolios. Thus, domestic-based portfolios may sometimes be superior to internationally diversified portfolios. The main determinants for the superiority of a domestic-based portfolio over an internationally diversified portfolio are the correlation coefficients among stocks in the domestic-based portfolio and the stock market or economic condition of the investment period. If the global stock markets are moving towards higher positive correlation over time, it would mean that the world’s equity markets are becoming more integrated. The implication would be that the benefits for international portfolio diversification will be reduced.

Equity Market Benchmarks ➢ An index of stocks from a particular country (or region) is used to measure or gauge the activity and performance of that country’s (or region’s) equity market(s). ➢ Low cost, convenient way for investors to hold diversified investments in several different countries.

Leading Stock Exchange and Indices Table 1 : Leading Exchange and Indices Country

Major Exchange

Index

Ticker

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NYSE

US

New York Stock Exchange

UK

London Stock Exchange

FTSE100

Japan

Tokyo Stock Exchange

Nikkei 225

NYA INDEX

Composite Index UKX INDEX NKY INDEX

Australia

Australian Securities Exchange

S&P/ASX 200

AS51 INDEX

Canada

Toronto Stock Exchange

S&P/TSX

SPTSX INDEX

Germany

Frankfurt Stock Exchange

DAX

DAX INDEX

China

Shanghai Stock Exchange

Shanghai

SHCOMP

Composite

INDEX

National Stock Exchange of

S&P CNX

India

NIFTY

Brazil

Sao Paulo Stock Exchange

Bovespa

Mexico

Bolsa Mexicana de Valores

Bolsa

MEXBOL INDEX

JALSH

JALSH INDEX

KOSPI

KOSPI INDEX

India

NIFTY INDEX IBOV INDEX

South Africa

Korea

Johannesburg Securities Exchange Korea Exchange

Result and Conclusion Correlation 1st Hypothesis Table 2 : Correlation coefficient between GDP and Indices of US and UK

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Correlation between US GDP and NYSE Composite

0.69

Index Correlation Coefficient between UK GDP and FTSE

0.40

100 index

It can be clearly seen from the above table that there exist a strong positive correlations between US GDP and its indices and moderate correlation between UK GDP and its indices. Hence proved, there exists a positive correlation between GDP and indices of US and UK.

2nd Hypothesis Table 3 : Correlation between Indices under study

Index NYSE composite Index (US) and FTSE 100 (UK)

Correlation Coefficient 0.6219763

NYSE composite Index (US) and S&P CNX NIFTY (India)

0.374295

S&P CNX NIFTY (India) and FTSE 100 (UK)

0.445515

NYSE composite Index (US) and Shanghai Composite (China)

0.101923

FTSE 100(UK) and Shanghai Composite (China)

0.167655

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S&P CNX NIFTY (India) and Shanghai Composite (China)

0.284448

It can be clearly seen from the table above that correlation among the returns of the countries vary across countries, but there exist a positive correlation between them. It may be seen as first indication for the existence of interdependency among them. The highest of correlations is among NYA index (US) and UKX Index (UK) both of which are developed country. It must also be pointed out that NYA index (US) shows low correlations with all other Asian markets specially SHCOMP Index (China) as compared to developed countries.

Fig 1 : Trend in correlation between NYSE Composite Index and FTSE 100.

Trend analysis also shows that there exist a strong positive correlation between NYSE Composite index and FTSE 100 for each quarter in the last 3 years. Hence, proved there exist a strong positive correlation between the US and UK stock Exchange. In line with the general belief, results from the study show that there is indeed a positive trend in correlation coefficients between equity markets throughout the world. This is especially true for the developed countries. It is more notable during non-crisis periods. Table 4 : Stock Exchange and Indices

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Table 5: Correlation of Returns of Stock Indices

Referring to above table 4 and table 5 which used data over the period from 19/10/1999 to 25/04/2008, it can be clearly seen that correlations among the returns of the countries under study are high. It may be seen as first indication for the existence of interdependency among them.

The highest of correlations was among BSE and JC (over 98%) and the lowest between NIKKEI and TA (about 42%). It must also be pointed out that the NIKKEI shows low correlations with all other Asian markets (but Taiwan); it is relatively highly correlated with the US markets. The BSE is found to be highly correlated, with other Asian markets with the exception of NIKKEI and Taiwan, which is not as connected as other Asian markets.

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BSE is more related with Dow Jones than S&P. TA is found to correlated also, but this relation is relatively lesser with NIKKEI and Taiwan, where as NIKKEI and Taiwan are related to an extent of 80%. TA is also relatively lesser related with S&P and DJIA .In fact, among both the US markets, only DJIA is highly related, above 90%, with ST. Very high degree of correlations among few stock markets may indicate the way their financial markets are integrated and also, help in studying the flows of money from one country to another.

This study shows that as long as the correlation coefficients between countries are less than +1.0, there is still some gain to be made from international portfolio diversification: however, from an academic as well as practical points, any unpredictable shift is likely to make investment practice that much less reliable, while a predictable upwardshift towards unity makes the diversification gain marginally smaller over each time period of the upward shift. That latter will also make diversification benefits unmanageable. However, shifts in the structure need to be identified to estimate the extend of the uniform movement of the market towards lessened diversification benefits.

Return Analysis Table 6: Return Analysis for Developed and Developing Economies for the period of June 2006 to June 2009

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Country

Major Exchange

Index

3 Years

2 years

1 year

6 month

3 month

1 month

Developed Economies US

New York Stock Exchange

UK

London Stock Exchange

Japan

Tokyo Stock Exchange

Australia

Composite Index

-25.0%

-39.5%

-33.3%

7.7%

15.3%

2.1%

FTSE100

-24.8%

-35.2%

-24.9%

0.9%

9.0%

-2.6%

Nikkei 225

-35.4%

-45.8%

-29.2%

15.0%

15.5%

4.8%

S&P/ASX 200

-22.9%

-38.9%

-26.4%

7.6%

6.8%

3.2%

-8.3%

-24.2%

-28.3%

24.6%

17.7%

2.8%

-12.1%

-38.9%

-27.5%

3.7%

13.7%

-2.4%

Australian Securities Exchange

Canada

NYSE

Toronto Stock Exchange S&P/TSX

Germany

Frankfurt Stock Exchange

DAX

Developing Economies China

Shanghai Stock Exchange

Shanghai Composite

India

Brazil

-26.4%

0.7%

56.9%

27.6%

12.1%

National Stock Exchange of

S&P CNX

India

NIFTY

42.2%

-1.0%

-0.3%

45.4%

42.1%

0.1%

Bovespa

49.9%

-4.3%

-21.8%

41.2%

23.2%

1.4%

Bolsa

34.5%

-21.1%

-18.0%

8.5%

19.6%

0.2%

JALSH

9.5%

-22.9%

-26.1%

5.5%

4.2%

-1.1%

KOSPI

11.6%

-20.4%

-18.9%

23.4%

13.3%

-0.6%

Sao Paulo Stock Exchange

Mexico

Bolsa Mexicana de Valores

South Africa

Johannesburg Securities Exchange

Korea

78.4%

Korea Exchange

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Fig 2 : Return of Stock Indices for countries

The above diagram and table clearly shows that return for developing country in the last 3 years has been positive and relatively greater than the developed economies. It has been highest for China followed by Brazil and India which are the BRIC country. Thus MNC’s, portfolio managers, investors, FII’s should all shift their investment to developing economies to reap the benefit of these booming economies.

Recommendation A strong positive correlation approaching 1 indicates more and more integration of US and UK Stock Exchange because of which there will be less diversification benefits for these developed

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economy as a result MNE’s and investors needs to focus on other developing economies like China, Brazil and India. A positive correlation between GDP and Indices of the country indicate that movement of indices is affected by GDP. For US it is strong. For UK it is moderate. Thus, a forecast of positive (negative) GDP growth can lead to positive sentiments in the market and can give positive (negative) return. Thus GDP can give some indication to investors about the movement of the Indices. Using return analysis we found out that the return for equity indices is relatively higher for developing economies than developed economies. So, MNC’s, FII’s, investors, policy makers and Portfolio manager should focus on developing economies to reap the benefit of higher return.

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