3

RESEARCH METHODOLOGY
3.1 Problem Statement
A common problem plaguing the low and slow growth of small developing economies is the swallow financial sector. Financial markets play an important role in the process of economic growth and development by facilitating savings and channeling funds from savers to investors. While there have been numerous attempts to develop the financial sector, small island economies are also facing the problem of high volatility in numerous fronts including volatility of its financial sector. Volatility may impair the smooth functioning of the financial system and adversely affect economic performance. Similarly, stock market volatility also has a number of negative implications. One of the ways in which it affects the economy is through its effect on consumer spending (Campbell, 1996; Starr-McCluer, 1998; Ludvigson and Steindel 1999 and Poterba 2000). The impact of stock market volatility on consumer spending is related via the wealth effect. Increased wealth will drive up consumer spending.
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However, a fall in stock market will weaken consumer confidence and thus drive down consumer spending. Stock market volatility may also affect business investment (Zuliu, 1995) and economic growth directly (Levine and Zervos, 1996 and Arestis et al 2001). A rise in stock market volatility can be interpreted as a rise in risk of equity investment and thus a shift of funds to less risky assets. This move could lead to a rise in cost of funds to firms and thus new firms might bear this effect as investors will turn to purchase of stock in larger, well known firms. While there is a general consensus on what macroeconomic variable affects the functioning of stock market and its voalatility. In developing countries stock markets are sensitive to change in the macroeconomic variable. It is assumed that domestic economic fundamentals affect performance of the stock market but in today globalization era where the world economy is integrated; domestic variables are also subject to change due to change in the global environment. The degree of stock market volatility can help forecasters predict the path of an economys growth and the structure of volatility can imply that investors now need to hold more stocks in their portfolio to achieve diversification(Krainer, J, 2002:1). Stock market volatility has always remained the most important issue of the debate and discussion world over. Developing economies are not exception to this controversy and the issue has become more important among the economist, regulators, researchers and academicians due to the rapid change in the world envirnment. The questions which are generally raised about the stock market volatility include: I) How to measure the stock market volatility II) what is the relationship between stock market and economic indicators. As stock market volatility is the inevitable issue so it is important to reexamine the topic stock market volatility in developing countries.

3.2 Objective of the Study

The broad objective of the study is to analyze the stock market volatility in developing countries. The specific objectives of the study are as follows: To measure the extent of stock market volatility in selected developing countries.
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To examine the presence of the day of the week effect on stock return and their volatility. To examine the effect of portfolio size on stock return and their volatility. To examine the impact of macroeconomic variable on stock return and their volatility To compare the volatility of Indian stock market with other developing countries stock market.

3.3 Scope of the Study

The study pertains to selected developing countries BRICM (Brazil, Russia, India, China, Mexico) which are the fastest growing countries among the developing countries. These countries are selected on the basis of list of developing countries given by MSCI, Standard & Poor, and Dow Jones. There are only 5 developing countries (Brazil, Russia, India, China, and Mexico) which are always appearing in every list. Scope of the study restricted to BRICM is an appropriate case for conducting such a study, as geographic diversification would eventually generate superior risk-adjusted returns for long-term global investors by reducing overall portfolio risk while capturing some of the higher rates of return offered by the developing countries. Even before the 2003 landmark report by Goldman Sachs economists Dreaming with BRICs: Path to 2050, the rapidly developing economies of Brazil, Russia, India, and China (BRIC) had become a force to reckon with in the world economy. The report helped academics, as well as policy-makers, focus more on these four gigantic countries. The BRIC countries are expected to grow at a phenomenal rate of 8 percent in the next several years. Experts predict that in the next decade or two many of the current G7 countries comprising of USA, Japan, Germany, U.K., France, Italy, and Canada will be replaced by some of the BRIC countries as the worlds biggest economies. It is also predicted that China will overtake all of the G7 countries including the U.S. by 2045 and become the worlds biggest economy, while India will overtake all of the G7 countries except the U.S. in the same period. To achieve the above mentioned objective, SENSEX has been taken as a proxy to its market. Actually, SENSEX is a representative index of Indian stock market, which comprises thirty most liquid individual stocks at Bombay Stock Exchange Ltd. (BSE). It is also considered as an indicator of the performance of whole economy. RTSI has been used as a proxy of the Russian
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Trading System Stock exchange for Russia. Shanghai Stock Exchange (SSE) for China, Brazil BOVESPA Index for Brazil, IPC of Mexican Stock Exchange (BMV:BOLSA) for Mexico. To evaluate the impact of portfolio size on stock return and volatility apart from sensex , three more indices of BSE has also been taken BSE 100, BSE 200, BSE 500.

3.4 Data Base and Source

This study is descriptive and experimental or empirical in nature as the effect of certain events or actions have been observed in it objectively and by distinguishing the effect of extraneous variables. Therefore experimental research design is appropriate for this study. This study is based on secondary data which have been collected from various websites such as www.bseindia.com, www.moneycontrol.com, www.allstocks.com,
www.rbi.org.in,

www.allstat.com. Besides the above mentioned sources various publication of reserve bank of india and Bombay stock exchange have also been the source of study. To analyze the extent of stock market volatility and day of the week effect in selected developing countries daily closing price from the period January 1999 to May 2010 has been collected, however to determine the relationship between stock price and macroeconomic variable in India and relationship between volatility of stock market and macroeconomic variable volatility in India monthly data have been used from the period January 2000 to May 2010. Daily data regarding the macroeconomic variable is not available for the above mentioned period so study is restricted to the monthly data. Due to non availability of sufficient data of Macroeconomic variable for Mexico, China, Brazil and Russia analysis of relationship between stock price and macroeconomic variable is restricted to India only. A detail presentation of the data series and sources of all dependent and independent variables considered for the study is given in Table 3.1

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TABLE 3.1: THE DATA SERIES AND SOURCES Notation BSE( Sensex) Variable Data Series and Source Daily return on the Bombay Stock Exchange Sources: www.bseindia.com RTS exchange (RTSI) Daily return on the Russian Trading system exchange Sources: www.rts.ru BM&FBOVESPA (Ibovespa) Daily return on the BM&FBOVESPA Exchange
Sources: www.allstocks.com

SSE(SSE Composite Index)

Daily return on Shanghai Stock Exchange Sources: www.allstocks.com

BMV (IPC)

Daily return on Bolsa Mexicana de Valores Sources: www.allstocks.com

REER

Real effective exchange Rate Source: www.rbi.org.in

BOT

Balance of Trade Source: www.indiastat.com

ACMMR

Average call money market rate Source: www.indiastat.com

WPI

Wholesale price index

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Source: www.rbi.org.in IIPM sector Source: www.indiastat.com 3MTBYTM 3 months treasury bill rate(Indian interest rate) Source: www.rbi.org.in NM Net Money supply Source: www.indiastat.com Gold rate Gold rate per 10g Source: www.rbi.org.in MSCI Morgan Stanley composite index of developed countries. Source: www.msci.com 3MTBUS 3 months treasury bill rate(Federal bank interest rate) www.stls.frb.org MTBSE Market turnover or volume of BSE Sources: www.bseindia.com FII Foreign institutional investment Sources: www.moneycontrol.com MF Mutual Fund Sources: www.moneycontrol.com Index of industrial production of manufacturing

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3.5 Analysis of Data

The research methods or tools used in this study are objective specific. The methods of analysis used to accomplish the different objectives are mentioned below.

3.5.1 Method of Analysis for Measuring the Extent of Stock Market Volatility
To measure the extent of stock market volatility in selected developing countries is one of the primary objectives of the study. Measuring Extent of stock market volatility comprises two parts 1) measuring historical stock market volatility 2) Modeling stock market volatility. For analyzing the volatility various volatility measures can be used. Many econometrics models assume that the variance as a measure of uncertainty is constant. Financial time series such as stock returns or exchange rates exhibits volatility clustering. This means that large changes in time series tend to be followed by large changes and small changes by small changes. The technical term given to the behaviour is called autoregressive conditional heteroscedasticity (ARCH). It was Engle (1982) who first introduced the time varying conditional variance model with ARCH process that uses past disturbances to model the variances of the series and allows the variances of error term to vary overtime. Bollerslev (1986) generalized the ARCH process by allowing the conditional variance to be a function of past observations as well as of recent news named as GARCH model. Following the introduction of ARCH and GARCH, there have been numerous refinements of the approach to model volatility to better capture the stylize characteristics of the data. All these possible approaches to measures can be segregated into three parts: Traditional Volatility Estimators: These estimators assume that true volatility is unconditional and constant. The estimation is based on either squared returns or standard deviation of return over a period of time. Extreme Value Volatility Estimators: These estimators are similar to traditional estimators except that these also incorporate high and low prices observed unlike traditional estimators, which are based on opening and closing price of asset.
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Conditional Volatility Model: These models (ARCH/GARCH Class of Model) take into account the time varying nature of volatility. There have been a quite few extensions of the basic conditional volatility models to incorporate observed or known characteristics of the return.

Out of these three models, two models assume that the volatility is unconditional and constant and this assumption does not follow in time series data. The conditional volatility model uses only low frequency daily data explicitly recognized time varying volatility of returns and hence can be used to measure the volatility in the proposed study. The forecast by these conditional volatility models are based on the parameters of the model itself as well as they are on the return characteristics during the relevant period Methodology for measuring historical stock market volatility: The simplest model for volatility is the historical estimate. Historical volatility simply involves calculating the variance (or standard deviation) of returns in the usual way over some historical period, and this then becomes the volatility forecast for all future periods. The historical average variance (or standard deviation) was traditionally used as the volatility input to options pricing models, although there is a growing body of evidence suggesting that the use of volatility predicted from more sophisticated time series models will lead to more accurate option valuations. Historical volatility is still useful as a benchmark for comparing the forecasting ability of more complex time models. Volatility is the standard deviation or varience of stock prices or rate of return. In the current study volatility has been measured as the standard deviation of the rate of return. The rate of return is calculated as follows:
Rt = (In Pt - In Pt-1)* 100 Where Rt is the return in the period t, Pt is the daily closing share price index of the BSE at a particular time t; Pt-1 is the closing share price index for the preceding period and In is natural logarithm.

Calculating the average return (or arithmetic mean) of the return of a security over a given period will generate the expected return of the asset. For each period, subtracting the expected return
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from the actual return results in the difference from the mean. Squaring the difference in each period and taking the average gives the overall variance of the return of the asset. The larger the variance, the greater risk the security carries. Finding the square root of this variance will give the standard deviation of the investment tool in question. Thus standard deviation was calculated as follows:

Volatility is a measurement of how much a market moves over a period. Most measures of volatility are based on an annualized measure of daily movements of the market. These concepts measure a period of daily movements and multiply this number by the square root of time to annualize the number The annualized volatility is the standard deviation of the instrument's yearly logarithmic returns. The annualized volatility T for time horizon T in years is expressed as:

Methodology for modeling stock market volatility: Daily stock prices have been converted to daily returns. This objective uses the logarithmic difference of prices of two successive periods for the calculation of rate of return. Symbolically,
Rt = ln(Pt /Pt-1)* 100 Where Rt is the return in the period t, Pt is the daily closing share price index at a particular time t; P t-1 is the closing share price index for the preceding period and In is natural logarithm.

Time series data are often assumed to be non-stationary. It is thus necessary to perform a pre-test
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to ensure that a stationary relationship existed among the variables. This would avoid problems of spurious regressions. To test for the presence of unit roots, the standard Augmented DickeyFuller (ADF) and Philips-Perron (PP) tests are employed in the study. Augmented Dickey Fuller Test: It is a test for unit root in a time series sample developed by Dickey and Fuller (1981). The augmented Dickey-Fuller (ADF) statistics, used in the test, is a negative number. The more negative it is, the stronger the rejection of the hypothesis that there is a unit roots at some level of 5 percent confidence. ADF test follows the below stated model: Yt= + t + Yt-1 + t Yt-1 + + pYt-p + t----------------------- (3.1) Where is a constant, the coefficient on a time trend and p the lag order of the autoregressive process. Imposing the constraints = 0 and = 0 corresponds to modeling a random walk and using the constraint = 0 corresponds to modeling a random walk with a drift. By including lags of the order p the ADF formulation allows for higher-order autoregressive processes. This means that the lag length p has to be determined when applying the test. For the purpose of our analysis, the study have considered a lag of 1 variable. Phillips-Perron (PP) Test: Phillips and Perron (1988) suggest an alternative (nonparametric) method of controlling for serial correlation when testing for a unit root. The PP method estimates the non-augmented DF test equation and modifies the -ratio of the coefficient so that serial correlation does not affect the asymptotic distribution of the test statistic. The advantage of Phillips and Perron test is that it is free from parametric errors. PP test allows the disturbances to be weakly dependent and heterogeneously distributed. The PP test is based on the following statistic:

---------------------- (3.2) Where is the estimate, and the -ratio of ,t ( ), is coefficient standard error, and is the , is a consistent estimate of the error variance?

standard error of the test regression. In addition The remaining term

, is an estimator of the residual spectrum at frequency zero. The

asymptotic distribution of the PP modified -ratio is the same as that of the ADF statistic
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Autoregressive Conditional Heteroscedasticity model is first model designed to model and forecast conditional variances. In this model, the variance of the dependent variable is modeled as a function of past value of dependent variable and independent or exogenous variables while measuring volatility of returns. While developing an ARCH model, two distinct specifications have to be considered one for the conditional mean equation that may be structured regression equation and the other for conditional variance equation. Here, the simplest mean return is:
yt = axt + et ----------------------------------------(3.3a)

Where Yt is the mean return, xt is the independent variable and et is error term . and variance for the ARCH (q) Model is :
q

ht = w + ai e2t-1----------------------------------------(3.3b)
i=1

Where ht is conditional variance at period t, q is the numbers of lags included in the model and w, a1, a2 . aq parameters to be estimated. Here the inclusion of et in the variance equation denotes the effect of news about the volatility from the past period on the current variance. Therefore, in ARCH (q) model, the volatility at time t is a function of q past square terms. For the ARCH model to be well defined, parameter should be stratified that are w 0 and a1, a2 aq > 0. Since empirical application of ARCH (q) model require long lag length and a large no of parameters to be estimated, Bollerstev (1986) generalized this process by arguing that volatility at time t is not affected only by squared zero mean variables but also by p lags of past estimated volatility. In this way, starting with the pioneering work of Engle (1982), numerous refinements have been made in the variance models to capture the time varying volatility. Out of these models, the most important are:
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Generalized Autoregressive Conditional Heteroscedasticity GARCH (p,q) Exponential GARCH EGARCH Threshold GARCH TGARCH Multivariate GARCH MGARCH GARCH in mean GARCH - M

This objective is based on four model specification-Standard GARCH model, GARCH-M model, EGARCH model and TGARCH model. . Econometrics analysis package EView has been used to test the return and volatility data for various statistical properties and to estimate GARCH/GARCH-M/EGARCH/TGARCH models. Model Specification: GARCH Model: In order to determine the nature of conditional volatility GARCH model developed by Bollerslev (1986)& Taylor (1986)has been used. The model can be specified as follows: --------------------------------(3.4a) --------------------------------(3.4b)

---------------------------------(3.4c) Where, in return equation is the stock market return in time period t and pure white noise error term. In variance equation is the conditional variance and , 1, 2 .. q ,1 . p are

parameters to be estimated. q is the number of squared error term lags in the model and p is the number of past volatility lags included in the model.The study has used the GARCH(1,1) Model that assume > 0, and 0. The stationary condition for GARCH (1,1) is +< 1. If this condition is fulfilled, it means the conditional variance is finite. A straightforward interpretation of the estimated coefficient in above equation is that the constant is long term average volatility where i and j represent how the volatility is affected by current news and past information regarding volatility, respectively. GARCH-M Model:

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To determine the impact of conditional volatility on the return GARCH in mean or GARCH M model has been used. The model has been developed by Engle, Lilien and Robins (1987). The GARCH-M specifies conditional mean return as a linear function of conditional variance, while conditional variance may follow any of GARCH specification. This study used the following GARCH-M (1,1) model which can be specified as follows: ---------------- (3.5a) ---------------- (3.5b) ---------------- (3.5c) Where, in return equation c, and are the parameters to be estimated. R tis the stock market return, ht is the conditional variance and tstand error for a Gaussian innovation with zero mean. Among all the parameters is the most significant one as itdescribes the nature of relationship between stock market return and volatility. More precisely a positive and significant implies that increased risk given by an increase in conditional variance represented by h t leads a hike in the mean return or vice versa. EGARCH Model:This model was proposed by Nelson (1991). EGARCH Model is based on log transformation of conditional variance [log ( )] then even if the parameters are negative, will be positive.. Thus there is no need to artificially impose non negativity constraints on model parameters. Models. This study uses the following EGARCH (1, 1) model: -------------------- (3.6a) ---------------------- (3.6b) ----------------- (3.6c) Here, value of is the standard residual. The term ) measures the size measures the sign effect. A negative Therefore this Exponential GARCH Model is most popular among the asymmetric GARCH

effect of innovations in returns on volatility, while

is consistent with leverage effect, which explains that when the total value of a

leveraged firm falls due to fall in price, the value of its equity becomes a smaller share of the total value. The total effect of a positive shock in return is equal to one standardized unit is (1+
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, that of a negative shock of one standardizes unit is (1autoregressive term in variance equation. The value of the variance. TGARCH Model:

).

is the coefficient of

must be less than 1 for stationary of

To confirm the results produced by the EGARCH model, Threshold GARCH or TGARCH model has also been used by the study. This model is also named as GJR model after the names of its authors Glosten, Jagannathan and Runkle (1993).The specification of the TGARCH model used in the study is as follows: -------------- (3.7a) -------------- (3.7b) -------------- (3.7c) Where, the dummy variable the variance is represents the bad news, a positive value of signify an asymmetric volatility response. When the innovation in return is positive, the total effect in

; while the return shock is negative the total effect in the variance is . To accept the Null hypothesis of no asymmetric effect in TARCH model, the

coefficient must be negative; otherwise alternative hypothesis will be accepted. In other words, if the coefficient is not negative there is evidence of asymmetric effects in the series.

3.5.2 Method of Analysis for Examining Presence of Day of the Week Effect on Stock Market Return and Stock Market Volatility.
The study has measured stock returns as the continuously compounded daily percentage change in the share price index in order to avoid the influences of extreme index values. Symbolically, Rt = (In Pt - In Pt-1)* 100 Where Rt is the return in the period t, P t is the daily closing share price index of the BSE at a particular time t; Pt-1 is the closing share price index for the preceding period and In is natural logarithm.
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Three types of methodologies are available to analyze the day of the week effect, these are: parametric tests, non-parametric tests and econometric models. In order to analyze the day effect, the return of a particular day was compared with the average return of rest of the days. Firstly, the study used independent sample t test to find weather the return of a particular day is statistically different from average return of rest of the days. The t- test has been applied by using the following formulae.

Where

Where s2 is the unbiased estimator of the variance of the two samples, n = number of observations, 1 = group one, 2 = group two.

To analyze the equality of the return among different working days of the week by applying non-parametric test, H statistic produced by Kruskal Wallis test has been used which was calculated by following formulae.

Where, H is Kurskal Wallis value, n is total no. of observation in all samples and R is rank of the sample. In order to measure the equality of the variance across the week days Levenes test statistic has been used which is calculated by using following formulae:
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Where W is the result of the test, k is the number of different groups to which the samples belong, N is the total number of samples, Ni is the number of samples in the ith group, Yij is the value of the jth sample from the ith group,

There is a general argument that financial time series have almost a persistent trend and are self-explaining in nature. So to avoid the effect of such trend value we also apply the econometric model. We use the auto regressive model with dummy day variable in which the dependent variable is daily return and independent variables are constant, day dummy and AR(5). The dummy variable represents the specific day of the week, as its value is 1 for the specific day and 0 for all other days of the week. The choice of five AR terms is rather arbitrary, but is has been motivated with the objective to make estimation of conditional mean smooth and unbiased for the week days through taking into consideration all the five trading days of the week. More specially, the following regression model is used. Rt = a + b1 D + b2 AR (1) + b3 AR (2) + b4 AR (3) + b5 AR(4) + b6 AR(5)+ et
------------(3.8)

Where, Rt is daily return of market, a is constant, D is dummy variable and e t is the error term. Before using a time series in the regression model it is pre condition that the series must be stationary. So to ensure the stationarity of the time series used in our analysis we apply Augmented Dickey Fuller (ADF) unit root test and Phillip Perron tests. We have applied both test with intercept and with trend & intercept at level by taking 1 lag value in all cases. As one of the prime objectives of the present study is to measure the day of the week effect on the volatility of underlying stock market, for that purpose GARCH (1, 1) model has been used. To specify the GARCH model two equations have to be specified. One is the mean equation (which has been mentioned above) excluding dummy variable. And the second is the variance equation, which is as follows: ht = w + ai e2t-1 + bi ht-j + D ----------------------- (3.9)
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In the equation first term after the intercept w is the ARCH term, which shows the effect of recent news on the volatility of the underlying stock market by putting the square of previous error term. Second term is the GARCH term, which shows the effect of previous volatility on the current volatility and D is showing the impact of the day dummy variable on the volatility in the return of underlying stock market.

3.5.3 Method of Analysis for Examining the Impact of Portfolio Size on Stock Return and Volatility.
The first step in examining the impact of portfolio size on stock return and volatility is to calculate the logarithmic difference of prices of two successive periods for the calculation of rate of return. In order to check whether there is any difference in the return of four indices which are of different size, T test and Kruskal Wallis test has been used. Levenes test has been used to check equality of volatility among the four indices of different size. The detail formula of these tests has already been mentioned under 3.5.2 method of analysis for day of the week effect.

3.5.4 Method of Analysis for Examining Impact of Macroeconomic Variable on Stock Market Return and Its Volatility
The first step in examining the relationship between macroeconomic variable and stock prices is to calculate the return of all the variables selected for the study. Stock Return and macroeconomic variables return are calculated as follows: Rt = (pt - pt-1)/ pt-1*100 Where Rt is the rate of return for the period t, pt and pt-1 are the prices of the two successive periods t-1 and t. The next step in the analysis is to subject the macroeconomic series to unit root tests or tests the series for stationarity. After testing the series for stationarity, the next step is the testing for cointegration. This helps check whether the series are co-integrated i.e. whether there is any long-run relationship among the variables chosen. The present study uses Johansen Cointegration Tests for the purpose. Then the causality tests among the cointegrated variables are undertaken.
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After that VAR test is applied for the ananlysis. Finally that multiple regression and GARCH model is being applied. Unit Root Test:Prior to the formation of a regression model it is necessary to perform a pretest to ensure that a stationary relationship exist among the variables. This would avoid the problem of spurious regression.Augmented Dickey-Fuller (ADF), Philips-Perron(PP) test are used in this study to test the presence of unit root problem in the time series data. If the time series data is non-stationary in levels, it should be stationary in first difference with the same level of lags. Formula for the ADF and PP test has already been given in the first part of method of analysis of this chapter. To study the long term relationship and the short term relationship between stock market and macroeconomic various tools has been used. For the long term relationship co-integration test is used and for the short term relationship VAR Granger Causality test, Variance Decomposition and impulse response have been used. The detail description of these test are mentioned below. Co integration Test: Engle and Granger (1987) pointed out that a linear combination of two or more non-stationary series may be stationary. If such a stationary linear combination exists, the non-stationary time series are said to be co integrated. The stationary linear combination is called the co integrating equation and may be interpreted as a long-run equilibrium relationship among the variables. The purpose of the co integration test is to determine whether a group of non-stationary series is co integrated or not. The presence of a co integrating relation forms the basis of the VEC specification. After identifying the order of integration, we then use the Johansen (1991, 1995a) to determine whether there is a long-run relationships (co integrating) between the various series. If there is co integration between two variables, there, exists a long-run effect that prevents the two series from drifting away from each other and this will force the series to converge into long-run equilibrium. The Johansens technique for estimating co integration is superior because it is based on well-established maximum likelihood procedure that provides test statistics to determine number of co integration vectors as well as their estimates. The existence of more than one co integrating vector implies higher stability in the system.

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The co integration testing procedure suggested by Johansen (1991, 1995a) to test the restrictions imposed by co integration on the unrestricted VAR involving the series. Considering a VAR of order:

----------------------- (3.10a) Where Yt is a K-vector of non-stationary 1(1) variables, Xt is a d vector of deterministic variables and t is a vector of innovations. It can rewrite the VAR as

----------------------- (3.10b)

---------------------- (3.10c) Grangers representations theorem asserts that if the coefficient matrix has reduced rank r<k, then there exist Kr matrixes and & each with rank r such that = is stationary r is the number of co integrating relations and each column of is the co integrating rector. The elements of are known as the adjustment parameters in the vector error the matrix in an unrestricted form. Johansens (1995) test the following possibilities: Series Y have no deterministic trends and the co integration equations do not have intercepts. -------------------- (3.10d) The likelihood Ratio Test Statistic:

----------------------- (3.10e) For r=0, 1------------ K 1 where I is the i-th largest Eigen value. Qr is the so called trace statistics and is the test of H1 (r) against H1 (k).

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Johansen also proposes an alternative LR Test Statistic, known as the maximum Eigen value statistics, which tests (r) against (r+1). The maximum Eigen value statistic can be computed from the trace statistics as ------------------ (3.10f) Vector Auto Regression (VAR) VAR methodology considers several endogenous variables together where each endogenous variable is explained by its lagged values and the lagged values of all other endogenous variables in the model. The pair wise Grangers causality test provides the causal relation between the two variables at a time, whereas the VAR model considers many variables at a time. If one variable Granger causes other variable the coefficients of the lagged values of the former must be significant in VAR. But as a VAR includes many lags of variables, it is difficult to establish which set of variables have significant effect on each dependent variable and which do not. In order to address this issue, VAR Granger Causality or the Block exogeneity Wald test are usually conducted that restrict all of the lags of a particular variable to zero. The VAR Grangers causality or the Block exogeneity Wald test is specified as follows: Variance Decomposition (VDC) and Impulse Response Function (IRF): The vector autoregression (VAR) by Sims (1980) has been estimated to capture short run causality between stock prices and macro economic variables. Variance decomposition and impulse response function has been utilized for drawing inferences.The VDC is an estimate of the proportion of the movement of the n-step ahead forecast error variance of a variable in the VAR system that is attributable to its own shock and that of another variable in the system. Similarly, the IRF shows impulse responses of a variable in the VAR system to the time path of its own shock as well as that of the shock to another variable in the system. While impulse response functions trace the effects of a shock to one endogenous variable on to the other variables in the VAR, variance decomposition separates the variation in an endogenous variable into the component shocks to the VAR. Thus, the variance decomposition provides information about the relative importance of each random innovation in affecting the variables in the VAR. The IRF are responses of all variables in the model to a one unit structural shock to one variable in the model. The impulse responses are plotted on the Y-axis with the periods from the initial

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shock on the X-axis. Formally each is interpreted as the time specific partial derivatives of the VMA Function (Enders, 1995):

This measures the changes in the variable jth in period t resulting from a unit shock to the variable kth in the present period. Regression and GARCH Model Specification In this study following regression model have been used to accomplish our main objective, impact of macroeconomic variable on the Indian stock market return. BSEt=0+1X1t+ 2X2t+ 3X3t+ 4X4t+ 5X5t+ 6X6t+ 7X7t+ 8X8t+ 9X9t+ 10X10t+ 11X11t+ 12X12t+ 13X13t+ 14X14t+t In the above model 0 is the intercept and are coefficient of variables and is the error term. In this model BSE sensex is used as the dependent variable and macro economic variables are used as the independent variable. In the above mentioned model AR and MA term have not been included because no lag was found significant after applying the residual test (Correlogram Squared Residual). As one of our prime objective is to study the impact of macroeconomic variable on volatility of stock market return for that purpose GARCH(1,1) model have been used. To specify the GARCH model two equation need to be specified, one is mean equation and other is variance equation. Mean equation which is used in GARCH model is as follows: BSEt = 0 + t Where 0 is the intercept, t is the error term and BSEt is the stock return at time t. Second is the variance equation that needs to be specified which is as follows: ht = 0 + 1 e2t-1 + 0 ht-j + 1X1t+ 2X2t+ 3X3t+ 4X4t+ 5X5t+ 6X6t+ 7X7t+ 8X8t+ 9X9t+ 10X10t+ 11X11t+ 12X12t+ 13X13t+ 14X14t
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In the equation first term after the intercept 0 is the ARCH term, which shows the affect of recent news on the volatility of the underlying stock market by putting the square of previous error term. And second term is the GARCH term, which shows the affect of previous volatility on the current volatility. And 1X1t to 14X14t are showing the impact of the dummy variables on the volatility in the return of underlying stock market, which is BSE in case of the present study. Variables BSEt X1 X2 X3 X4 X5 X6 X7 X8 X9 X10 X11 X12 X13 X14 Definitions of Variables is the percentage change in BSE return at time t is the percentage in 3 months Treasury bill interest rate of Federal Bank is the percentage change in 3 months Treasury bill rate of India is the percentage change in average call money market rate is the percentage change in Balance of Trade is the percentage change in Foreign Institutional Investment is the percentage change in gold rate is the percentage change in industrial production is the percentage change in mutual fund is the percentage change in morgan Stanley composite index is the percentage change in market turnover of BSE is the percentage change in money supply is the percentage change in exchange rate is the percentage change in volatility of BSE is the percentage change in wholesale price index

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3.6 Significance of the Study

The present study is an addition to the existing body of knowledge as very scanty work is available in this area of research in case of BRICM (Brazil, Russia, India, China, Mexico) countries. Due to the globalization stock markets have been developed where investors are having lucrative opportunities to invest in diversified portfolios across the world. Global investment decisions are based on several aspects but the knowledge of volatility of market is a vital aspect for making smart decision to get maximum return with minimum risk. As volatility remains high in a single nations portfolio in comparison to that of a international portfolio because the risk level is less in international market than that of a single nations market due to variation in different aspects affecting volatility like political and economic environment, inflationary condition. This study would be useful for the investors and policy makers as this would provide the knowledge of volatility and another related aspects of most emerging market BRICM, thereby investors can frame their global investment decision in developing countries and, policy makers and regulators can develop mechanism by measuring and predicting stock market volatility to avoid the dangers associated with excessive volatility.

3.7 Limitations of the Study

During the completion of this study, we have faced some limitation. Some part of this study is restricted to India only due to non availability of the sufficient data of other developing countries. In case of India high frequency data of macroeconomic variable was not available therefore monthly data have been taken for this study.

3.8 Organization of the Study

This study is organized as follows: Chapter 1 gives an overview of the developing countries and BRICM (Brazil, Russia, China, India and Mexico). It provides a brief introduction of stock market of BRICM and conceptual framework of volatility which include

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Chapter 2 presents the review of existing literature on the topic of the study. This chapter is divided into three sections: I) Studies concerning day of the week effect on stock market return and volatility. II) Studies related to measurement of stock market volatility. III) Studies related to relationship between stock market and macroeconomic variable. Chapter 3 presents the research methodology used in the study. The various aspects herein include problem statement, objectives and hypothesis of the study, scope of the study, database and sources, data analysis tools, rationale and limitation of the study. Chapter 4 elaborate the historical stock market volatility in developing countries using standard deviation as a measure of volatility and presents the results of modeling stock market volatility using family of GARCH models. Chapter 5 describe the day of the week effect on stock market return and their volatility in developing countries. Chapters 6 explain the impact of portfolio size on stock market return and their volatility. Chapter 7 presents the analysis of impact of macroeconomic variable on stock market return and their volatility. Chapter 8 embodies the major findings and conclusions emerged from the present study and suggestion offered to review the policy of government of India and stock exchange regulatory authorities towards stock market volatility..

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References:
Arestis, P., P.O. Demetriades and K.B. Luintel (2001)Financial Development and Economic Growth: The Role of Stock Markets, Journal of Money, Credit and Banking, 33(2):16-41. Campbell, J (1996) Consumption and the Stock Market: Interpreting International Experience, NBER Working Paper, 5610. Krainer, J (2002)Stock Market Volatility, FRBSF Economic Letter, Western Banking, 2002-32, pp1-4. Levine, R and S. Zervos (1996)Stock Market Development and Long-Run Growth, World Bank Economic Review, 10(1):323-339. Ludvigson, S and C. Steindel (1999)How Important is the Stock Market Effect on ConsumptionFederal Reserve Bank of New York Economic Policy Review , 5(1):29-51. Poterba, J. M (2000)Stock Market Wealth and Consumption, Journal of Economic Perspectives, 14(2):99-118. Starr-McCluer, M (1998)Stock Market Wealth and Consumer Spending, Board of Governors of the Federal Reserve System, Finance and Economics Discussion Paper Series, 98/20. Zuliu, H (1995)Stock market Volatility and Corporate Investment, IMF Working Paper, 95/102.

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