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Investor Sentiment, Stock Market Returns and Volatility: Evidence from

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Article  in  International Journal of Management Practice · December 2015

DOI: 10.1504/IJMP.2016.077816

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Int. J. Management Practice, Vol. 9, No. 3, 2016 213

Investor sentiment, stock market returns

and volatility: evidence from National Stock
Exchange of India

Pramod Kumar Naik*

Department of Economics,
Central University of Rajasthan,
Bandarsindri 305817, Ajmer, Rajasthan, India
Email: kpramodnaik@gmail.com
*Corresponding author

Puja Padhi
Department of Humanities and Social Sciences,
Indian Institute of Technology Bombay,
Mumbai 400076, India
Email: pujapadhi@iitb.ac.in

Abstract: This study explores the relationship between investor sentiment and
stock return volatility using monthly data from National Stock Exchange
(NSE) of India over July 2001 to December 2013 period. Using seven market-
related implicit indicators a sentiment index has been constructed with the
help of principal component analysis. Then the analysis has been done by
employing ordinary least squares methods, vector autoregression, Granger
causality and EGARCH-M models. Findings show that sentiment index
significantly influences market excess returns. At the first glance it was found
that sentiment has negative influence on the conditional volatility. However,
when the sentiment index is decomposed into positive sentiment and negative
sentiment changes, the study reveals that positive and negative sentiments have
asymmetric impacts on excess return volatility. The Granger causality results
suggest a bi-directional causality between excess return and investor sentiment
at the third lags.

Keywords: investor sentiment; stock market volatility; principal component

analysis; VAR; EGARCH-M.

Reference to this paper should be made as follows: Naik, P.K. and Padhi, P.
(2016) ‘Investor sentiment, stock market returns and volatility: evidence from
National Stock Exchange of India’, Int. J. Management Practice, Vol. 9,
No. 3, pp.213–237.

Biographical notes: Pramod Kumar Naik is an Assistant Professor in the

Department of Economics in Central University of Rajasthan. He obtained his
MPhil and PhD from Indian Institute of Technology Bombay. He has published
several articles in both international as well as national journals such as,
Review of Accounting and Finance, Global Business Review, Indian Journal of
Finance etc. His research interest includes financial economics, stock market
volatility, corporate finance, applied econometrics time-series and panel data,
industrial economics, money and banking.

Copyright © 2016 Inderscience Enterprises Ltd.

214 P.K. Naik and P. Padhi

Puja Padhi is an Associate Professor of Economics in the Department of

Humanities and Social Sciences in Indian Institute of Technology Bombay. She
has published a number of journal articles in international as well as national
journals, such as, Journal of Multinational Financial Management, Journal of
Business Economics and Management, Journal of Empirical Finance,
Transition Studies Review, Review of Accounting and Finance, Journal of
Quantitative Economics etc. Her research area includes financial economics,
stock market volatility, applied econometrics, money and banking.

This paper is a revised and expanded version of a paper entitled ‘Investor

sentiment, stock market returns and volatility: evidence from National Stock
Exchange India’ presented at the ‘International Conference on Evidence Based
Management (ICEBM2015)’, BITS Pilani, India, 20–21 March 2015.

1 Introduction

The relationship between investor sentiment1 and stock returns has long been a
considerable debate in the field of empirical and behavioural finance. Literature provides
contradicting view on the sentiment-based traders’ impact on stock prices. The Efficient
Market Hypothesis (EMH) introduced by Fama (1965) believes that financial markets are
information efficient. Further, the Capital Asset Pricing Model (CAPM) holds that, in an
efficient financial market, the prices of traded assets reflect all available information
about market fundamentals. The argument is that investors in such markets are rational
who always force the market prices to equal the present value of expected future cash
flow; even if some investors are irrational their demands are offset by the arbitrageurs.2
Thus, according to this theory, investor sentiment has no role in determining stock prices
volatility. The EMH was popular and dominant in the academic circles during the 1970s
(Shiller, 2003). However, this classical finance theory failed to explain various market
anomalies, such as the 1987 crash, the Dot.com bubble of 1990s, etc.
The belief of rationality in EMH has been challenged by modern empirical and
behavioural finance literature. Under the behavioural finance theory, it is argued that
investors are not necessarily rational, and they may prone to exogenous sentiment waves.
Their overly optimism and pessimism about the market lead them to bias of irrationalities
in investment decision. Thus, investor sentiment can induce systematic risk and affect
asset price in equilibrium. Amongst many, Shiller (1981) argues that investors are not
fully rational and thus stock prices may be affected by factors other than fundamentals.
Similarly, Black (1986) and De Long et al. (1990) believe some of the market anomalies
can be caused by the traders who trade based on noise or sentiment. According to Black
(1986) such investors are known as noise traders since they do not have access to inside
information and act irrationally on noise. If the uninformed noise traders make their
trading decision on the basis of sentiment then measure of it may have predictive power
for stock price behaviour (Wang et al., 2006). De Long et al. (1990) and Shefrin and
Statman (1994) theoretically show that investor sentiment is an intrinsic factor that
affects the asset prices in equilibrium. In literature it is termed as the ‘noise traders’
theory which suggests that if some investors trade on a noisy signals, that are unrelated to
fundamentals, then asset prices would deviate from their intrinsic value. Thus, investor
sentiment should influence the stock returns as well as the market volatility.
 Investor sentiment, stock market returns and volatility 215

Supporting the ‘noise traders’ theory of De Long et al. (1990), Lee et al. (2002)
empirically show that sentiment is a systematic risk that is priced. They document a
positive relationship between excess returns and change in sentiment, and a negative
relationship between the shifts in sentiment and the conditional volatility. Fisher and
Statman (2000) analyse the relationship between level as well as change in sentiment and
future stock returns considering three groups of investors such as the Wall Street
strategists (large), the writers of investment newsletters (medium), and individual
investors (small). They document a negative relationship between future returns and
sentiment of both small and large groups. They also document that returns generate
sentiment of small and medium groups of investors. Brown and Cliff (2004) find that
investor sentiment (both in level and changes) are significantly correlated with the
contemporaneous returns. They conclude that past returns are the important determinants
of investor sentiment. Brown and Cliff (2005) indicate that investor sentiment predicts
market returns over one to three years. Kumar and Lee (2006) examine whether the retail
investor sentiment can explain the return co-movement and find that it has a significant
ability to explain the return co-movements. Wang et al. (2006) investigate the causal
relationship between sentiment, returns and volatility, and find that investor sentiments
caused by market returns and volatility rather than vice versa.
The most influential study of Baker and Wurgler (2006, 2007) find that when the
sentiment is low the returns are relatively high, whereas when sentiment is high the
subsequent returns are low. Following their study and their sentiment index construction,
several subsequent studies investigate the relationship between sentiment index and stock
returns in various ways. For example, Yu and Yuan (2011) examine the impact of
investor sentiment on market returns and volatility using a similar index of investor
sentiment and find that the expected returns are positively related to volatility in the low
sentiment periods but not significantly related in high sentiment periods. Dergiades
(2012) also uses the similar index and report that investor sentiment has a significant
influence on stock returns. Qiang and Shu-e (2009) find that the impacts due to positive
and negative changes in sentiments are different in affecting stock price fluctuations.
Chuang et al. (2010) conclude that the volatility that generated from investor sentiment
gives rise to idiosyncratic risk rather than systematic risk.
Other studies, such as, Verma and Verma (2007) indicate that investor sentiment has
a positive effect on stock returns but has a negative effect on market volatility for both
individual and institutional investors. Verma and Soydemir (2009) find that individual
and institutional investor sentiments are driven by both rational and irrational factors.
Their findings indicate that when the noise traders are bullish the rational investors are
bearish and when the noise traders are bearish the rational investors are bullish. Lux
(2011) finds a feedback relationship between the stock returns and sentiment. Zhu (2012)
shows a strong correlation between sentiment index and Shanghai stock market index.
Changsheng and Yongfeng (2012) also show that investor sentiment has incremental
power to explain return co-movement indicating that when investors are bullish the stock
return is high and it is low when the investors are bearish. Li (2014) shows that the
sentiment index has a good predictive power of Chinese stock market return. Huang et al.
(2014) find that sentiment has positively related to current periods stock returns, whereas
negatively related with lagged stock returns. Perez-Liston et al. (2014) estimate GARCH-
in-mean model and VAR model to find that changes in investor sentiment have a positive
influence on excess returns. Their analysis also shows that the bullish shift in investor
sentiment has negative effect on conditional volatility. Yang and Copeland (2014) find
216 P.K. Naik and P. Padhi

that sentiment index has an asymmetric effect on both short-run and long-run volatility.
They conclude that the bearish sentiment leads to a lower excess returns and the bullish
sentiment leads to higher market returns; the bullish sentiment has a positive influence on
short-run volatility, whereas it has a negative impact on long-run volatility.
Owing to these diverse explanations several studies tried to explore the impact of
investor sentiment on stock returns, using several different proxies since the sentiment is
not directly observable and quantifiable. Most studies discussed the positive and negative
impacts of investor sentiments on the current and expected future stock returns.
However, as Wang et al. (2006) note, if the investors are sensitive to the changes in
sentiment, then, it would affect both return and volatility. Alternatively, if trading of
noise traders is on the basis of extreme sentiment, i.e. they only trade when the sentiment
is extremely high or low relative to previous levels, then the sentiment level is expected
to affect returns and volatility. Moreover, one can also argue that investor sentiments,
generally, generated through the market behaviour, and therefore returns should
influence the investor sentiment change. Despite the well-documented literature of
investor irrationality, only a handful of studies have been devoted to investigate how
different states of sentiment are related to stock return and its volatility (see, e.g.,
Lee et al., 2002; Qiang and Shu-e, 2009; Chuang et al., 2010; Yu and Yuan, 2011; Huang
et al., 2014; Yang and Copeland, 2014) and also the dynamic interaction as well as the
direction of causality between them (e.g. Wang et al., 2006; Lux, 2011; Verma and
Soydemir, 2009; Perez-Liston et al., 2014).
In the present study, we explore the role of investor irrational sentiment in
influencing market excess returns and volatility considering an Indian equity market
NSE. The basic objective is to investigate whether Indian equity market is driven by the
investor sentiment or the market excess returns influence investor sentiment. In order to
accomplish the objective we closely follow the approaches similar with Lee et al. (2002),
Qiang and Shu-e (2009), Chuang et al. (2010), and Perez-Liston et al. (2014). More
specifically, we examine the impact of positive and negative sentiment that has on
market excess returns by following similar approach with Qiang and Shu-e (2009). The
effects of different states of sentiment (i.e. positive and negative changes in sentiment) on
market excess return are examined by augmenting the sentiment change in the
conditional volatility model, similar with Lee et al. (2002), Qiang and Shu-e (2009),
Chuang et al. (2010), and Perez-Liston et al. (2014). The dynamic interaction between
investor sentiment and excess return has been examined by adopting approaches similar
with Verma and Soydemir (2009), Lux (2011) and Perez-Liston et al. (2014). From the
best of our knowledge this type of analysis has not yet been conducted using Indian data.
Recently, Bennet et al. (2012), Dash and Mahakud (2012, 2013a, 2013b), and Chandra
and Thenmozhi (2013) examined the impact of investor sentiment using Indian data.
However, these studies primarily dealt with one part of the analysis, i.e. the overall
impact of investor sentiment on stock returns, and the role of different states of investor
sentiment, if any, in generating market volatility has been neglected.
It is expected that investigation of our kind would extend the growing literature in
the context of emerging market economy by providing more ideas about the market
behaviour, and discussing how a set of investors, i.e. the noise traders with their different
states of sentiment, affect market excess return. As Fisher and Statman (2000) note,
analysis in this kind would enable us to know about the biases in stock market forecast of
investors; and it teaches us about the opportunities to earn extra returns by exploiting
those biases.
 Investor sentiment, stock market returns and volatility 217

The present work has been organised as follows. Section 2 deals with the data and
empirical methodology, in which the construction of investor sentiment index, the data
sources and the empirical framework have been described. The empirical findings are
discussed in Section 3 and finally Section 4 concludes the study.

2 Empirical methodology and data

2.1 Construction of investor sentiment index

As there is no definitive indicator available, many previous studies adopted different
proxies for investor sentiment. This is due to the fact that investor sentiment is not
directly and physically observable. Existing literature establishes several different
measures to represent the unobservable sentiment index, which can broadly be classified,
at least, as follows. The first is the direct survey from the individual and institutional
investors for their anticipated movement of stock market and aggregate economy
(e.g. Fisher and Statman, 2000; Brown and Cliff, 2005; Verma and Soydemir, 2009;
Schmeling, 2009; Lux, 2011). Studies also use investors’ intelligence sentiment index as
a proxy variable (e.g. Lee et al., 2002; Perez-Liston et al., 2014). The second is the
market-related implicit sentiment proxies (e.g. Baker and Wurgler, 2006; Baker and
Wurgler, 2007; Wang et al., 2006; Brown and Cliff, 2004; Baker et al., 2012; Li, 2014).
Since the direct survey measure of investor sentiment has several limitations, such as
likelihood of errors in the stage of data collection and processing, its limited scope of
generalisation, unscalability, etc., many recent studies used the market-related implicit
proxies as the indicators of investor sentiment. Unlike the direct survey, the market-
related proxies have advantages of representing the mood of the economy, easily
generalised and often available from the most authentic sources. However, there are no
specific numbers of factors to represent these market-related implicit proxies. Different
studies use different proxies according to the nature of the analysis. For example, the
behavioural finance literature in the 1990s considered closed-end fund discounts to be the
appropriate variable to represent the investment sentiment indicator (e.g. Lee et al., 1991;
Swaminathan, 1996; Neal and Wheatley, 1998). Some studies also considered the trend
in trade variables, such as trading volume and turnover ratios (e.g. Jackson, 2003; Kumar
and Lee, 2006; Chuang et al., 2010). The contemporary studies modify the approach and
construct a conglomerate sentiment index by combining several market-related implicit
proxies. The most influential study in this regard is Baker and Wurgler (2006, 2007).
They use six variables, namely closed-end fund discounts, number of IPO (NIPO), IPOs
first day returns, turnover ratio, equity-debt ratios, and dividend premium to construct a
composite sentiment index employing Principal Component Analysis (PCA). Following
Baker and Wurgler (2006, 2007) many subsequent studies use several numbers of proxies
and their composite sentiment index. Table 1 represents some of the previous studies in
this regard.
Based on the literature and the availability of the data we select Advance Declining
Ratios (ADRs), Put-Call Ratios (PCR), NIPO, PE ratios (PER), turnover rates (TURN),
trading volumes (TV), and Mutual Funds Net Flow (MFNF) to construct a composite
investor sentiment index. ADR represents the ratio of the number of advancing and
declining stock prices. It helps to know the recent trend of the stock market performance.
A rising values of ADR means the upward trend of the market; and a lower value shows
218 P.K. Naik and P. Padhi

the downward trend of the market. Brown and Cliff (2004), Wang et al. (2006), and Dash
and Mahakud (2013a) use this variable as the indicator of market sentiment. The variable
PCR represents the derivative trading activities. PCR is the ratio of trading volumes of
put-call options. This measure is widely accepted as a bearish indicator, i.e. in a bear
market period the PCR is high and in a bull market period it is low (Brown and Cliff,
2004). NIPO is the commonly used variable in the recent studies (e.g. Brown and Cliff,
2004; Baker and Wurgler, 2006; Baker and Wurgler, 2007; Kurov, 2010; Yu and Yuan,
2011; Changsheng and Yongfeng, 2012; Baker et al., 2012; Corredar et al., 2013; Dash
and Mahakud, 2013a; Li, 2014). It is argued that NIPO can be considered as the
sentiment indicator since demand for IPO is often sensitive towards the market condition.
Table 1 List of investor sentiment proxies used in related studies

Studies Measure of sentiment

Lee et al. (2002) Investor intelligent index
Advance and declining ratio, high and low ratio, margin
borrowings, short interest, short sales, odd lot sales to purchase,
put-call ratio, SPX future (institutional sentiment, activity of
Brown and Cliff (2004) small traders), monthly forecast of commodity market returns,
expected volatility relative to current volatility, closed-end fund
discounts, mutual fund flows, fund cash, first-day IPO returns
and number of IPO
Brown and Cliff (2005) Survey data of American Association of Individual investors
Kumar and Lee (2006) Buy–Sell imbalance ratio
Put-call trading volume ratio, put-call open interest ratio,
Wang et al. (2006) ARMS index (advance decline ratio), survey data of American
Association of Individual investors, investor intelligence index
Baker and Wurgler closed-end fund discounts, number of IPO, IPOs first-day
(2006, 2007) returns, turnover ratio, equity-debt ratios, and dividend premium
Baker and Wurgler (2006, 2007) measures, investor intelligence
Kurov (2010)
survey
Turnover, closed-end fund discounts, growth rate of investors
Qiang and Shu-e (2009)
account
Schmeling (2009) Consumer confidence index
Verma and Soydemir Survey data of individual and institutional sentiment similar
(2009) with Brown and Cliff (2005)
Chuang et al. (2010) Trading volume
Yu and Yuan (2011) Baker and Wurgler (2006, 2007) measures
Lux (2011) Survey data
Dergiades (2012) Baker and Wurgler (2006, 2007) measures
PE ratio, trading volume, turnover, closed-end fund discount,
Zhu (2012)
new account amounts, VIX index
Changsheng and IPO, closed-end fund discounts, turnover, number of new stock
Yongfeng (2012) accounts
 Investor sentiment, stock market returns and volatility 219

Table 1 List of investor sentiment proxies used in related studies (continued)

Studies Measure of sentiment

Rehman (2013) Baker and Wurgler (2006, 2007) measures
Turnover volatility ratio, share turnover velocity, advance
declining ratio, margin borrowings, buy–sell imbalance ratio,
Dash and Mahakud
put-call ratio, number of IPO, equity issue in total issue,
(2013a)
dividend premium, mutual fund flow, cash to total asset in
mutual fund market, price-to-earnings high–low ratio difference
Perez-Liston et al. (2014) Investor intelligence
Closed-end fund discounts, turnover, number of IPO, first-day
Li (2014) return of IPO, number of Chinese A shares net-added accounts,
relative degree of active trading in equity market

We also use the Price to Earnings Ratio (PER) as it reflects both the price of the stock
market and the financial situation of the listed companies in the macroeconomic
environment. The PER is often positively correlated with the market index and thus a
higher value of PER represents higher market sentiments (see also Sehgal et al., 2009;
Zhu, 2012). TURN and TV represent the market liquidity. In a highly liquid market the
irresistible investors cause the frequent trading so that the trading volume is high so as
the turnover rates. Thus, previous studies such as Qiang and Shu-e (2009), Zhu (2012)
and Li (2014) use turnover rate as a sentiment indicator. Chuang et al. (2010) uses
trading volume as the investor sentiment index. Following Brown and Cliff (2004),
Chi et al. (2012) and Dash and Mahakud (2013a) we use the mutual fund net flow as
another sentiment proxy since fund flow suggests the importance of a preferred asset
class, and as an economic substitute by the market participants. The mutual fund
investors are well known to chase investment in high returns.
It should be noted that the aforementioned sentiment indicators may partially contain
the rational expectation-based risk factors and hence likely to be contained fundamental
(rational) and non-fundamental (irrational) components (see Shleifer and Summers,
1990; Brown and Cliff, 2004; Brown and Cliff, 2005; Baker and Wurgler, 2006; Baker
and Wurgler, 2007; Verma and Soydemir, 2009; Dash and Mahakud, 2012). In the
present study, our goal is to test the impact of investor irrational sentiment on stock
market return and volatility. Thus, we follow Baker and Wurgler (2006), Verma and
Soydemir (2009) and Dash and Mahakud (2012) approaches to obtain the irrational
sentiment component. For this purpose, each of the underlying market-related implicit
proxies have been regressed on the six important macroeconomic fundamentals, namely
the growth rate of industrial production index (IIP), the rate of inflation (INF), exchange
rate (EXRT), short-term interest rate (INT), term spread (TS),3 and net investment of
foreign institutional investors (FINI). This process removes the business cycle variation
from each of the seven sentiment proxies prior to the construction of final composite
sentiment index (Baker and Wurgler, 2006). We estimate the following equation:
k
Yt = 0 + k  Funda kt + t (1)
k 1

where Yt represents each of the market-related implicit sentiment proxies undertaken in

the study, α0 is the constant, βk is the parameter to be estimated, Funda represents
the aforementioned macroeconomic fundamentals, K represents the number of
220 P.K. Naik and P. Padhi

macroeconomic fundamentals, and εt is the error term. The fitted values of equation (1)
would provide the rational components, whereas the residuals capture the irrational
component of sentiment (see Verma and Soydemir, 2009). We then obtain the residual
from equation (1) to have the orthogonal implicit sentiment proxies and used them in the
subsequent analysis. After obtaining each of the orthogonal sentiment proxy from
equation (1) we then construct a conglomerate market sentiment index to represent the
aggregate investor sentiment employing the PCA. The PCA transforms the original set of
variables into a smaller set of linear combinations that account for the most of the
variance of the original set. The benefit of PCA is that it filters out idiosyncratic noise in
the orthogonal sentiment measures and captures their common components. The aim here
is to extract the factors loadings for our original sentiment proxy indicators. After
obtaining the factor loadings for each orthogonal sentiment indicators a composite
sentiment index has been constructed using the following formula.
k
Yt
SentIndex t   a (2)
j 1 j
 Yt

where aj is the factor loadings for j-th item derived by the PCA, K is the number of
sentiment proxies used, and Yt and σYt are the sentiment proxies and their standard
deviation, respectively.
It is argued in literature that some proxies take longer time to reveal the sentiment.
For this reason we follow the approach similar with Baker and Wurgler (2006) and
estimate the PCA for our essential variables with levels as well as with their lags. For
example, we have seven sentiment proxies and with their lags leaving us to have 14
loadings. In the spirit of Baker and Wurgler (2006) the final sentiment index has been
identified by adopting the following steps. First, a raw sentiment index has been
calculated using the seven orthogonal sentiment proxies and their lags that provide us 14
factor loadings. Second, compute the correlation coefficient between this first stage raw
sentiment index and the seven orthogonal proxies and their lags. Third, we select the
variables with or without lags (whichever has higher correlation with the first stage raw
sentiment index) and then construct the final sentiment index. The first principal
component having 28% sample variance gives the following measure of sentiment index.
SentIndex t  0.003 ADRt  0.575 PCRt 1  0.536 NIPOt  0.530 PERt
0.112TURN t  0.120TVt 1  0.286MFNI t 1

The correlation coefficient between the 14-terms first stage sentiment index and the
seven-terms final sentiment index is 0.955, suggesting that the risk of losing substantial
information by dropping the seven implicit sentiment proxies is very less. Figure 1
depicts the trend and the relationship between the first stage raw sentiment index and the
final sentiment index. A close correlation between these two stages sentiment index is
clearly visible. Figure 2 depicts the trend of sentiment index and the Nifty closing index
for the period from July 2001 to December 2013. It can be observed from the figure that
these two indices show a similar trend. It seems that investor sentiment gradually
increased with the increase in Nifty index, but SentIndex fluctuates more than the Nifty
index. It also seems that during the US sub-prime crisis both the indices fall together and
then recovered gradually. Figure 3 shows the trend of sentiment index and the trend of
change in sentiment index, comparing them with the trend of market excess return. It
 Investor sentiment, stock market returns and volatility 221

seems from the figure that all the three lines on an average are approaching each other. It
can be observed that when the stock market index, as well as excess market return, goes
upward the sentiment index also goes up, but when the market index and excess return
approach to a downward trend the investor tends to become more bearish. However, the
figures only tell about the trend and not the cause and effect relationship between these
two. Statistical test therefore is necessary.

Figure 1 Trend of investor sentiment index (final) and sentiment index (first stage) from
July 2001 to December 2013 (see online version for colours)

Figure 2 Trend of investor sentiment index and Nifty index from July 2001 to December 2013
(see online version for colours)

Figure 3 Trend of investor sentiment index, change in investor sentiment index and Nifty excess
returns from July 2001 to December 2013 (see online version for colours)
 222

Table 2

Variables Mean Max Min Std. Dev. Skewness Kurtosis Jarque–Bera Prob.
Market-related implicit proxies for sentiment
ADR 0.933 1.800 0.550 0.219 0.738 4.006 19.937 0.000
PCR 0.884 1.462 0.330 0.204 –0.445 2.943 4.972 0.083
NIPO 3 18 0 3.357 1.535 5.973 114.107 0.000
P.K. Naik and P. Padhi

PER 18.024 27.600 11.700 3.300 0.218 2.550 2.453 0.293

macroeconomic variables

TURN 188410.7 496589.0 28572.0 103118.5 0.423 2.697 5.056 0.080

TV 815.067 1819.000 97.000 446.151 –0.090 1.617 12.155 0.002
MFNI –116.920 7893.000 –7236.000 2021.826 0.278 6.489 78.023 0.000
Macroeconomic factors
IIPGrowth 0.789 14.940 –14.264 5.536 –0.194 3.697 3.975 0.137
WPIGrowth 0.468 2.579 –2.500 0.693 –0.467 5.760 53.066 0.000
EXRT 47.313 63.752 39.374 4.802 1.277 5.085 67.952 0.000
TBILL91 6.395 11.510 3.227 1.683 0.185 2.681 1.488 0.475
TS 0.185 2.592 –1.840 0.498 0.419 8.429 188.610 0.000
FIINI 4913.647 35228.000 –44162.000 10360.260 –0.005 6.360 70.554 0.000
Stock market index
NIFTY 3616.850 6246.900 949.400 1792.174 –0.181 1.507 14.747 0.001
LnRt 0.012 0.181 –0.270 0.062 –0.777 5.595 57.164 0.000
Descriptive statistics of market-related implicit sentiment proxies and other
 Investor sentiment, stock market returns and volatility 223

2.2 Data set and summary statistics

National Stock Exchange (NSE) of India has been considered to represent the Indian
stock market4 and an aggregate investor sentiment index has been constructed based on
the market-related implicit proxies. We choose seven market-related implicit sentiment
indicators based on their use in the literature and relevance with the Indian stock market
behaviour. The details of these variables are already discussed in the above subsection.
This study utilised monthly data for the period from July 2001 to December 2013. The
sample period is based on the availability of data for all the variables used in this study.
All the stock market-related data are extracted from a single source, i.e. Handbook of
Statistics on Indian Security Market 2012 and 2013 provided by SEBI year books.
Monthly closing prices of S&P CNX Nifty are converted into compounded log return as
 P 
rt  ln  t  where rt is the compounded return at time t and Pt and Pt–1 are the monthly
 Pt 1 
stock index at the two successive months t and t – 1, respectively. Then the risk-free
interest rate has been subtracted to obtain the excess return. Monthly data of
macroeconomic variables are obtained from Handbook of Statistics on Indian Economy
provided by Reserve Bank of India.
Table 2 reports the descriptive statistics of all the variables used in the first stage
analysis. From Table 2 it can be observed that during the period of investigation the
mean values of all the sentiment indicators except the net investment of mutual funds are
positive. The negative mean value of mutual fund net flow indicates that on an average
the mutual fund investor sells more than they purchase stocks. While the positive value
of put-call option ratio shows the market as bearish sentimental the mean values of ADR,
price-to-earnings ratio and the market liquidity measures indicate the market has been
performing well. This is also evident from the mean value of Nifty index and returns. The
average number of IPO issues in the study period 3 per month with a minimum of 0 and
maximum of 18.
Table 3 Correlation matrix of market-related orthogonal sentiment proxies

ADR PCR NIPO PER TURN TV MFNI

ADR 1
PCR 0.011 1
NIPO –0.055 0.533 1
PER 0.124 0.486 0.376 1
TURN 0.139 0.077 0.059 0.018 1
TV 0.125 –0.045 –0.041 –0.072 0.868 1
MFNI –0.012 –0.144 –0.096 –0.249 0.026 0.076 1

Table 3 reports the cross-correlation among the investors irrational sentiment indicators,
i.e. the orthogonal sentiment proxies. It can be seen from this table that on an average all
the sentiment proxies are positively correlated with each other but the magnitudes are
lesser. Table 4 reports the descriptive statistics of the final variables of interest. The mean
value of the irrational sentiment is positive but very less in magnitude which is not
sufficient to justify a bullish sentiment. It may be noted that during the study period the
average monthly return is 0.012 (see Table 2), while that of the excess return is –0.052.
224 P.K. Naik and P. Padhi

The correlation between the sentiment index and the excess returns, however, is positive.
This suggests that Indian investors became more conservative when the market shows
downward trend and the market sentiment decreases. It can therefore be hypothesised
that when sentiment changes to positive the excess return will be higher and when the
sentiment turns to negative the excess return will be lower.

Table 4 Descriptive statistics of final sentiment index and market excess return

SentIndex_Final SentIndex_Raw Excess Return

Mean 0.010 0.004 –0.052
Median 0.050 0.082 –0.046
Max 4.700 5.139 0.142
Min –2.940 –3.597 –0.351
Std. Dev. 1.401 1.888 0.068
Skewness 0.291 0.207 –0.604
Kurtosis 2.847 2.462 5.192
Jarque–Bera 2.243 2.861 38.887
Prob. 0.326 0.239 0.000
Obs. 149 149 149
Correlation matrix
SentIndex_Final 1
SentIndex_RAW 0.955 1
ExcessReturn 0.257 0.175 1
ADF test statistics
–4.209** –2.735* –4.738**
ADF t-stat
(0.000) (0.070) (0.000)
Notes: The probability values for ADF statistics are in parenthesis.
** indicates statistical significant at 1% level and * indicates statistical
significant at 10% level.

2.3 Empirical methodology

The analysis has been done by employing various econometric techniques, such as the
Ordinary Least Squares (OLS), vector autoregression (VAR), Granger Causality, and
the Exponential Generalised Autoregressive Conditional Heteroskedasticity-in-mean
(EGARCH-M) methods. After constructing the aggregate investor sentiment index, its
impact on excess stock market return and volatility has been tested. Before employing
these econometrics techniques, the stationary properties of both the time-series have been
confirmed by the Augmented Dickey–Fuller (ADF) unit root tests.
We start the analysis by employing the OLS method. The regression equation for the
purpose is described as follows.
rt  rt f     SentIndex t  t ; t  t 1   t (3)
 Investor sentiment, stock market returns and volatility 225

where rt stands for monthly log return of market index, rt f represents the risk-free
interest rate, α is the constant, β is the parameter to be estimated, SentIndex represents
the investor sentiment index, and μt is the error term. The first-order autoregressive
residual is added to the equation to control for serial correlation of residuals. It has often
been argued in the literature that different impacts of positive and negative sentiment as
well as the changes in positive and negative sentiment have likely to influence differently
on the excess stock returns. To test this belief, a dummy variable Dt has been added. We
define Dt is equal to 1 when the sentiment index value is positive, and 0 otherwise.
Similar definition has been used to describe the change in sentiment index. Therefore, the
influence of positive and negative sentiment on excess return has been tested by
estimating the following equation.5

 2
t
 
rt  rt f   0  1   SentIndex   Dt   2   SentIndex   1  Dt   t
2
t
 (4)
t  t 1   t
where β1 and β2 represent the coefficient of positive and negative sentiment, respectively,
representing the bullish and bearish shift in investor irrational sentiment. Similarly, the
impacts of positive sentiment changes and negative sentiment changes have been tested
by estimating the following equation. However, in this case the dummy Dt is equal to 1
when the changes in sentiment index are positive, and 0 otherwise. The regression
equation is specified as follows.

rt  rt f   0  1   SentIndex   Dt   2   SentIndex   1  Dt   t
2 2
t t
(5)
t  t 1   t

where ΔSentIndext represents the change in sentiment index, i.e. SentIndext – SentIndext–1.
The OLS analysis will provide us the direct impact of investor sentiment on excess
return. It does not provide sentiment impact on market volatility, i.e. whether the
fluctuation in investor sentiment is a systematic risk and obtains risk premium (Qiang
and Shu-e, 2009). For this purpose previous studies, such as Lee et al. (2002), Verma and
Verma (2007), Qiang and Shu-e (2009), Chuang et al. (2010) and Yang and Copeland
(2014), augmented sentiment index in the volatility models like GARCH-in-mean and
EGARCH-in-mean. Following these literatures and assuming that Indian stock market
exhibits volatility asymmetry, we test the impact of positive and negative investor
sentiment on returns as well as volatility using the EGARCH-M model. Accordingly the
testable EGARCH (1, 1)-M model has been represented as follows.

rt  rt f  a   ln  ht   b1  rt  rt f   c1SentIndex t   t
t 1
(6)

ln  ht     1 ln  ht 1    1  t 1 
ht 1  1  t 1 ht 1  1SentIndex t

where rt  rt f is the excess return, the δht represents the market risk premium for the
expected volatility, and εt is the error term. The trade-off parameter δ can take positive,
negative and a zero value. The log of the conditional variance in the left-hand side
implies that the asymmetric effect is exponential rather than quadratic and that forecast of
226 P.K. Naik and P. Padhi

conditional variance is guaranteed to be non-negative. The terms ω, α1, β1, γ1, and θ1 are
the parameters to be estimated. In order to incorporate the impact of positive change and
negative change of sentiment, equation (6) is modified as follows.

rt  rt f  a   ln  ht   b1  rt  rt f   c1SentIndex t   t
t 1

ln  ht     1 ln  ht 1    1  t 1  
ht 1  1  t 1 
ht 1  1   SentIndex t  Dt
2
 (7)

  2   SentIndex t  1  Dt   1rt
2
 f

In the spirit of Lee et al. (2002), Chuang et al. (2010) and Perez-Liston et al. (2014) we
add the risk-free interest rate in the conditional volatility in equation (7).
Further, some of the previous studies suggest that investor sentiment and stock
market return may act as a system (see Brown and Cliff, 2004; Brown and Cliff, 2005;
Verma and Soydemir, 2009; Perez-Liston et al., 2014). OLS and the conditional volatility
model do not able to control for the endogeneity bias, and they unable to provide the
direction of causality. Thus, a VAR model has also been estimated which is free from
endogeneity problem. The aim here is to test the dynamic interaction of sentiment and
market excess returns and any statistical causality exists between them.
The causality equations are expressed in a VAR framework as follows.
p p
Excessreturn t =1   1i Excessreturn t 1    1i SentIndex t  i   tR (8)
i 1 i 1

p p
SentIndex t = 2    2i SentIndex t 1    2i Excessreturn t 1   tS (9)
i 1 i 1

where α1 and α2 are the intercepts, β and γ are the parameters to be estimated, and  tR and
 tS are the white noise error terms, and p denotes the lag lengths. In equation (8),
sentiment index Granger cause market excess return if either γ1i are jointly significant by
testing null hypothesis of H0: γ11 = γ12 = … = γ1p = 0. Similarly, in equation (9) market
excess return Granger sentiment index if either β1i are jointly significant.

3 Empirical results

The stationary properties of the variables SentIdex and ExcessReturn have been tested
through the ADF test and are reported in Table 4. The results clearly show that both
SentIndex and ExcessReturns are stationary at level. The analysis has been started with
estimating the OLS regression. The OLS regression has been conducted in three different
specifications. The results are reported in Table 5. Specification1, specification2 and
specification3 represent the results of regression equations (3), (4) and (5), respectively.
It can be observed from Table 5 that sentiment index positively influences market excess
returns. When the sentiment index is decomposed into positive sentiment and negative
sentiment, an asymmetric relationship has been observed. It is evident that while the
positive sentiment index has a positive impact on market excess return the negative
sentiment index has negative impact. Similar findings are obtained when considered the
 Investor sentiment, stock market returns and volatility 227

changes in sentiment index. The results indicate that during the period of investigation,
when the change in investor sentiment turns to positive (negative) the market excess
return also moves positive (negative) as well. The magnitude of negative changes in
sentiment is more dominant than the changes in positive sentiment. The adjusted R-
squared values for the regression specifications1, specification2 and specification3 are
22%, 23% and 27%, respectively, indicating that around 27% of the excess returns have
been explained by the sentiment index. The explanatory power of the equations has been
increased when the sentiment index decomposed to positive and negative sentiment
changes. The regression results free from heteroskedasticity and serial correlations.
From the OLS regression results, it can be said that investor irrational sentiment or
the impact of noise traders and the excess returns in Indian market are positively related,
but the impact of negative sentiment seems higher impact on marker excess return than
the positive sentiment. It implies that when investor irrational sentiment is positive the
investors are more optimistic about the market, earning more excess return and their
speculative motive are stronger, tempting them to invest more. Eventually, they tend to
lose when the sentiment goes bearish. In short, when investors are more optimistic or
bullish about the market they earn higher excess return and when they are more
pessimistic or bearish they earn lower excess return.
Table 5 Results of OLS regressions (robust)

Variable Specification1 Specification2 Specification3

Coeff. t-stat Coeff. t-stat Coeff. t-stat
SentIndex 0.015 2.99***
Positive SentIndex 0.003 1.94*
Negative SentIndex –0.011 –2.356***
+ve changes in SentIndex 0.009 1.998**
–ve changes in SentIndex –0.012 –3.542***
AR(1) 0.431 5.749*** 0.429 5.508*** 0.434 5.658***
Constant –0.052 –6.039*** –0.045 –4.815*** –0.049 –5.802***
Adj-R2 0.223 0.236 0.271
F-stat 22.328*** 16.309*** 19.276***
D-W stat 1.96 1.97 1.95
Notes: Specifications1, 2 and 3 represent the OLS regression in equations (3), (4) and
(5), respectively. AR(1) is the first-order autocorrelation in the residuals. D-W
stat is the Durbin–Watson d-statistics.
*** implies statistical significance at 1% level; ** implies statistical
significance at 5% level; and * implies statistical significance at 10% level.
We also estimated the sentiment augmented EGARCH-in-mean model in order to
investigate if the investor irrational sentiment impacts the market excess return and
volatility. Table 6 reports the results of the relationship between the investor sentiment,
market excess returns and conditional volatility based on the EGARCH(1, 1)-M model.
Again, the analysis has been conducted in two different specifications. In specification1
we consider the aggregate sentiment index described in equation (6), and in specification2
we consider the changes in investor sentiment described in equation (7).
228 P.K. Naik and P. Padhi

The risk-return trade-off parameter δ from the mean equation of Table 6 is found to
be positive and statistically significant at 1% level which supports the argument of
CAPM. The conventional CAPM states that investor should reward by taking the
systematic risk. Our results imply that the noise trader’s risks are systematic. The
parameter b1 representing the coefficient for lagged excess returns is positive and highly
significant. The coefficient of investor irrational sentiment, c1, is positive and statistically
significant at 10% in specification1 and 1% level in specification2 implying that when
investor sentiment is bullish investors are optimistic about the market and they earn
higher excess return. This result is consistent with findings in Table 5. Similar results
have also been documented in the previous studies, such as Lee et al. (2002), Chuang
et al. (2010) and Perez-Liston et al. (2014).
The variance equation of specification1 in Table 6 indicates that all the GARCH
terms α1 and β1 have the expected sign. The asymmetric parameter γ1 has a negative sign
but statistically insignificant. The coefficient of investor irrational sentiment θ1 appears
with a negative sign and statistically significant at 10% level. This result indicates that in
aggregate the investor sentiment has negative effect on the conditional volatility. The
positive and negative shift in investor sentiment has been augmented in specification2.
Results show that the asymmetric parameter γ1 has now statistically significant at 1%
level with the expected negative sign. This implies that the market exhibits volatility
asymmetry.
The positive change in investor sentiment or the bullish shift and the negative change
in investor sentiment or the bearish shift has been measured by the coefficient θ1 and θ2.
It is evident from Table 6 that, while θ1 appears with a negative sign and significant at
1% level, θ2 appears with a positive sign and significant at 10% level. These results
imply that when the change in investor sentiment is positive or bullish, the return
volatility is lower; on the other hand, when the change in investor sentiment is negative
volatility is higher. This finding is consistent with Lee et al. (2002) and Perez-Liston
et al. (2014). However, it contradicts with the findings of Chuang et al. (2010) which
reported that bullish shift is insignificant. Our findings confirm that the bullish and
bearish shifts in investor sentiment have an asymmetric impact on conditional volatility
in Indian equity market.
In line with Lee et al. (2002), Chuang et al. (2010) and Perez-Liston et al. (2014) we
add the risk-free rate as an exogenous variable in the conditional volatility equation. The
parameter Φ1 represents the coefficient of risk-free interest rate. We find a negative and
statistically significant coefficient for Φ1 which is in contradict with Lee et al. (2002) but
consistent with Chuang et al. (2010) and Perez-Liston et al. (2014).
Table 6 Investor sentiment, excess returns, and conditional volatility: EGARCH(1, 1)-M
model

Parameters Specification1 Specification2

Mean equation
Coeff. z-stat Coeff. z-stat
a 6.510 14.828** 0.521 9.043**
δ 1.107 15.158** 0.090 9.487**
b1 0.577 3.864** 0.738 12.343**
c1 0.166 1.968* 0.041 5.771**
AR(1)
 Investor sentiment, stock market returns and volatility 229

Table 6 Investor sentiment, excess returns, and conditional volatility: EGARCH(1, 1)-M
model (continued)

Parameters Specification1 Specification2

Variance equation
ω –5.215 –12.153** –3.615 –34.988**
α1 0.010 1.716* 0.0009 0.029
β1 0.116 1.645* 0.342 390.289**
γ1 –0.012 –1.302 –0.382 –22.956**
θ1 –0.130 –1.716* –0.112 –2.656**
θ2 0.063 1.925*
Φ1 –0.038 –4.723**
Log likelihood 218.256 233.037
AIC –2.808 –2.980
SBC –2.627 –2.758
Q(12) 19.09 17.56
Q2(12) 17.47 28.84**
Notes: Specification1 and 2 represent equations (6) and (7), respectively.
*** indicate statistical significance at 1% level and * indicate statistical
significance at 10% level.
Since it has also been argued in the literature that the market excess return and the
investor sentiment may act as a system, and due to the fact that the OLS and the
EGARCH model do not able to control for the problem of endogeneity, we also estimate
a bi-variate vector autocorrelation (VAR) model. This will provide us the robustness
check. However, in this section we have only consider the aggregate sentiment index and
not decomposed into positive and negative changes. The aim here is to test the dynamic
interaction between sentiment index and excess market returns, and identify the direction
of causality, if any. Since the VAR model is likely to be sensitive towards different lags,
we first checked for the optimum lags through the VAR lag selection criteria. Table 7
reports results of VAR lag selection criteria. While the SBC test suggests one lag for the
VAR estimation, the HQ test suggests a lag order of three and the AIC test suggests a lag
order of five. As it is almost impossible to judge which model would have to be preferred
we proceed with all three criteria. Accordingly, we estimate the VAR model of the form
of equations (8) and (9) with one, three, and five lags. The results are reported in Table 8.
Table 8 shows that both excess returns and investor sentiment have the powerful
predictor of themselves. The VAR estimation results with one lag indicate that investor
sentiment has insignificant in influencing the market excess return. However, the excess
return has a positive and significant impact on investor sentiment. The lagged level of
investor sentiments and market excess return explain about 62% of variation in
sentiment. This is evident from the adjusted R-squared value of 0.629. In fact, in all the
three specifications (i.e. VAR model with one lag, three lags, and five lags) the lagged
levels of investor sentiment and market excess returns explain a substantial variation in
sentiment. The adjusted R-squared is more than 60%.
When considered a VAR model with three lags, sentiment index turns significant and
negative in influencing the market excess returns at lag three. The excess returns
230 P.K. Naik and P. Padhi

continued to be positive and significant at its first lag but significantly negative in its
second lag in influencing the sentiment index. Similar results are found when consider
the VAR model with five lags. Excess market returns seem to be influenced by the past
sentiment although with relatively long lag. At its third lag sentiment index negatively
and significantly influences market excess return. Once again, the excess return is
significant and positive in its first lag while significantly negative with its second lag to
influence the investor sentiment index. The VAR Granger causality/block exogeneity test
suggests that with one lag and five lags, the excess return causes the sentiment index; but
with three lags it shows a bidirectional causality between sentiment and excess return.
These results imply that when the market performs well it throws signal of a bullish
sentiment to the investor, but over optimistic tempt the noise traders to buy (sell) most of
the risky stocks and more likely to suffer a capital loss (Friedman’s effect).
The predicted pattern of surprise changes or the innovation has been captured by the
Impulse Response Function (IRF) generated from the VAR model. The results of which
are plotted in Figure 4. This figure depicts the generalised IRF of estimated VAR (5)
model where the response of sentiment index and excess market return to a one time
unitary shocks in shocks of sentiment index and excess market return are captured. In
other words, it let us know by what percentage a series increases or decreases in
response to one unit shock due to some other series in the system. While this is measured
in the y-axis of the IRF in Figure 4, the x-axis measures the time path of the response of a
series to shock. Results clearly indicate that the response of sentiment index to the shocks
excess return is positive and significant (see bottom of column 1 in Figure 4) and the
impact continues for a long period. The response of market excess return to shocks of
sentiment index is negatively insignificant in the first month; it turns to positive and
insignificant in the second month and again turns negative and significant in the third
month. The response of excess return to its own shock is significantly positive in the first
and third month but insignificant afterwards. On the other hand, the response of
sentiment to its own shock is highly significant and positive and also remains for a long
time.
The proportion of forecast error of one variable due to other variables has been
shown through the variance decomposition. Table 10 presents the results of variance
decomposition. It indicates that the share of sentiment index in fluctuation of excess
returns is only 6.5%. In fact, the forecast error variance of excess returns is almost
accounted by its own shocks (95%). Sentiment index explains 5% impact on excess
return. However, excess return explains around 32% on sentiment index, and around 68%
of the forecast error variance of sentiment index is accounted by its own shocks.
Table 7 VAR lag order selection criteria

Endogenous variables: ExcessReturn and SentIndex

Lag LogL LR FPE AIC SC HQ
0 –58.194 – 0.008 0.872 0.914 0.889
1 23.485 159.809 0.0026 –0.253 –0.126* –0.201
2 28.678 10.009 0.0026 –0.270 –0.058 –0.184
3 37.464 16.680 0.0024 –0.340 –0.043 –0.219*
4 38.678 2.269 0.0025 –0.299 0.082 –0.144
5 46.138 13.730 0.0024* –0.349* 0.116 –0.160
 Investor sentiment, stock market returns and volatility 231

Table 7 VAR lag order selection criteria (continued)

Endogenous variables: ExcessReturn and SentIndex

Lag LogL LR FPE AIC SC HQ
6 47.027 1.611 0.0025 –0.304 0.246 –0.080
7 48.644 2.882 0.0026 –0.270 0.366 –0.011
8 49.955 2.297 0.0027 –0.231 0.489 0.061
9 54.151 7.237 0.0027 –0.234 0.571 0.093
10 54.697 0.924 0.0028 –0.184 0.706 0.178
11 61.139 10.737* 0.0027 –0.219 0.756 0.177
12 64.959 6.256 0.0027 –0.216 0.843 0.214
Note: LR: sequential modified LR test statistic (each test at 5% level); FPE: final
prediction error; AIC: Akaike information criterion; SC: Schwarz information
criterion; HQ: Hannan–Quinn information criterion.
* indicates lag order selected by the criterion.

Table 8 Results of VAR models

VAR with one lag VAR with three lags VAR with five Lags
ExcessReturn SentIndex ExcessReturn SentIndex ExcessReturn SentIndex
–0.028 0.125 –0.022 0.116 –0.021 0.182
Intercept
(0.006) (0.089) (0.007) (0.102) (0.008) (0.109)
[–4.435]*** [1.403] [–3.132]*** [1.130] [–2.731]*** [1.672]*
0.449 2.117 0.500 4.137 0.488 4.424
ExcessReturnt–1
(0.077) (1.066) (0.083) (1.196) (0.091) (1.244)
[5.834]*** [1.985]** [5.977]*** [3.456]*** [5.341]*** [3.555]***
–0.265 –3.229 –0.230 –3.229
ExcessReturnt–2
(0.093) (1.372) (0.100) (1.372)
[–
[–2.284]*** [–2.284]** [–2.351]**
2.699]***
0.316 1.219 0.266 1.179
ExcessReturnt–3
(0.082) (1.182) (0.099) (1.354)
[3.823]*** [1.031] [2.673]*** [0.870]
0.092 0.555
ExcessReturnt–4
(0.101) (1.379)
[0.907] [0.402]
–0.041 –0.067
ExcessReturnt–5
(0.089) (1.221)
[–0.460] [–0.055]
–0.004 0.761 –0.003 0.618 –0.003 0.633
SentIndext–1
(0.003) (0.089) (0.006) (0.089) (0.006) (0.087)
[–1.294] [1.403] [–0.582] [6.907]*** [–0.497] [7.286]***
232 P.K. Naik and P. Padhi

Table 8 Results of VAR models (continued)

VAR with one lag VAR with three lags VAR with five Lags
ExcessReturn SentIndex ExcessReturn SentIndex ExcessReturn SentIndex
0.010 0.199 0.011 0.166
SentIndext–2
(0.007) (0.104) (0.007) (0.102)
[1.444] [1.904]* [1.502] [1.614]
–0.014 –0.002 –0.013 0.002
SentIndext–3
(0.006) (0.087) (0.007) (0.104)
[–2.396]** [–0.034] [–1.754]* [0.026]
–0.006 –0.275
SentIndext–4
(0.007) (0.105)
[–0.797] [–2.617]***
0.004 0.326
SentIndext–5
(0.006) (0.086)
[0.680] [3.770]***
2
Adj-R 0.178 0.629 0.258 0.647 0.242 0.667
Log likelihood 205.401 –186.167 213.424 –177.535 210.724 –167.699
LM(12) 2.227 1.977 3.699
Block
Exogeneity 1.67 3.94** 8.31** 14.59*** 8.19 16.70***
Wald test (χ2)
Notes: The standard errors and t-statistics are shown in () and [], respectively.
*** represents statistical significance at 1%; ** represents statistical
significance at 5%; and * represents statistical significance at 10%,
respectively.
In order to get the closer insight of the direction of causality, i.e. whether sentiment cause
excess market return or market return cause sentiment we also apply the Granger
causality test. If the noise trader explanation is expected then causality must run from
investor sentiment to market excess return. However, if asked how the sentiment might
be generated then it is reasonable to expect that the market behaviour will generate
the bullish trend and bearish trend which ultimately influence the investor sentiment
(see Wang et al., 2006). Table 9 reports the results of pair wise Granger causality test
starting from lag one to lag five. In all the cases the null hypothesis ‘ExcessReturn does
not Granger cause SentIndex’ has been rejected at one and 5% level of significance.
Except in lag three, we do not able to reject the null hypothesis that ‘SentIndex does not
Granger cause ExcessReturn’ at the usual 5% level. Thus, it can be concluded from this
result that market excess return Granger cause investor sentiment and not vice versa is
found. This finding is consistent with the previous findings, such as Brown and Cliff
(2004) and Wang et al. (2006) who document the empirical support for return causes
sentiment and not vice versa.
 Investor sentiment, stock market returns and volatility 233

Table 9 Pair wise Granger causality test

H0: SentIndex does not H0: excess return does not

Lags Obs. Granger cause excess return Granger cause SentIndex
F-statistic Prob. F-statistic Prob.
1 149 1.675 0.197 3.943 0.048
2 148 1.287 0.279 7.053 0.001
3 147 2.772 0.043 4.866 0.003
4 146 2.097 0.084 3.334 0.012
5 145 1.638 0.154 3.341 0.007

Table 10 Variance decomposition

Variance decomposition of excess returns:

Period S.E. ExcessReturns SentIndex
1 0.058 100 0.000
2 0.065 99.865 0.134
3 0.065 99.067 0.932
4 0.066 98.936 1.063
5 0.068 96.502 3.497
6 0.068 96.078 3.921
7 0.068 95.530 4.469
8 0.068 95.072 4.927
9 0.068 94.899 5.100
10 0.069 94.588 5.411
Variance decomposition of SentIndex:
Period S.E. ExcessReturns SentIndex
1 0.800 12.023 87.976
2 1.028 25.290 74.709
3 1.138 25.695 74.304
4 1.215 25.706 74.293
5 1.240 27.855 72.144
6 1.267 28.660 71.339
7 1.296 29.719 70.280
8 1.320 30.724 69.275
9 1.351 31.193 68.806
10 1.368 31.931 68.068
234 P.K. Naik and P. Padhi

Figure 4 Impulse response functions (see online version for colours)

Response to Cholesky One S.D. Innovations ± 2 S.E.

Response of Excess Return to Excess Return Response of Excess Return to SentIndex

.08 .08

.06 .06

.04 .04

.02 .02

.00 .00

-.02 -.02

-.04 -.04
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

Response of SentIndex to Excess Return Response of SentIndex to SentIndex

1.0 1.0

0.8 0.8

0.6 0.6

0.4 0.4

0.2 0.2

0.0 0.0

-0.2 -0.2
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

4 Conclusions

The present study investigated whether Indian equity market driven by the irrational
investor sentiment or the excess returns impact investor sentiment, by considering the
NSE of India. The method of PCA has been employed to construct the investor sentiment
index using several market-related implicit sentiment proxies such as trading volume,
turnover ratio, ADR, the ratio of put and call option, NIPOs, price earnings ratio, and
mutual fund net investment. The irrational component of sentiment has been generated
by regressing each of the sentiment indicators on macroeconomic fundamentals such as
growth rate of IIP, rate of inflation, exchange rate, risk-free rate of interest, term spread,
and net flow of foreign institutional investors. After constructing the sentiment index the
study also decomposed it into the positive changes and negative changes in investors’
sentiment to represent the bullish and bearish sentiments, respectively. The analysis has
been done using the regression methods of OLS, the vector autoregression (VAR) and
EGARCH-M models.
The main findings from the study may be summarised as follows. The results from
OLS estimation indicate that sentiment index significantly influences market excess
returns. When the sentiment index decomposed into positive and negative sentiment the
study finds an asymmetric relationship. It is found that, while the positive sentiment
index has a positive impact on market excess return, the negative sentiment index has
negative impact. These results imply that when investors are more optimistic about the
market they earn more excess return, and their excessive optimism leads them to
speculate more which tempt them to invest even more. Subsequently, they tend to lose
when the sentiment goes bearish.
 Investor sentiment, stock market returns and volatility 235

The results of EGARCH-M model suggest that sentiment index positively influences
the market excess returns, whereas it has a negative impact on volatility. When the
sentiment index is decomposed into positive sentiment changes and negative sentiment
changes, the results indicate that the changes in investor sentiment continue to have a
positive impact on contemporaneous returns. However, an asymmetric impact of the
positive and negative sentiment changes on the excess return volatility is found, i.e. while
the positive sentiment change negatively related to market volatility, the negative
sentiment change influences the market volatility positively. Thus, it can be concluded
from these results that when the change in investor sentiment takes a bullish shift excess
return volatility goes down, and when it takes a bearish shift excess return volatility goes
up during the study period.
The results from VAR estimation suggest that excess market returns are negatively
influenced by the lagged sentiment although at its third lag. Secondly, we find that the
lagged excess return starts with a positive influence on investor sentiment in the first lag,
but turns to negatively influence on sentiment in the second lag. Finally, the Granger
causality results suggest a bidirectional causality between excess return and investor
sentiment at the third lag. However, causality runs from excess return to sentiment at the
one and fifth lags. The findings from this study may helpful for the policy makers, retail
investors and other decision makers in the Indian stock market. However, the findings are
limited with seven market-related implicit factors for investor sentiment. Inclusion of
more such factors or using a direct survey data on investor sentiment may extend the
study.

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Notes
1 Investor sentiment represents the expectation of market participants based on the market
behaviour. For example, a bullish investor expects the returns to be above average and a
bearish investor expects it to be below average (Brown and Cliff, 2004). Baker and Wurgler
(2006) define it as a belief about future cash flows and investment risks that is not justified by
the facts at hand. Overall, investor sentiment is the propensity of the investors to believe the
future trend of the market.
2 Irrational investors are met in the market by rational arbitrageurs who trade against them and
in the process drive prices close to fundamental values. In the course of such trading those
whose judgements of asset values are sufficiently mistaken to affect prices lose money to
arbitrageurs and so eventually disappear from the market (De Long et al., 1990).
3 We consider 91 days T. bills rate as risk-free interest rate and the term spread has been
computed as the difference between 364 days T. bills rate and 91 days T. bills rate.
4 These days NSE has gained utmost popularity among the trading members contributing 83%
of total turnover in India as on 2012–2013. S&P CNX Nifty, as a benchmark index of the
Indian equity markets, consists of 50 major stocks of Indian companies and covering 22
sectors of the Indian economy. It represents about 67% of the free float market capitalisation
of the stocks listed in NSE of India.
5 Similar approach for positive and negative changes in sentiment has employed in the previous
studies such as Lee et al. (2002), Qiang and Shu-e (2009), Chuang et al. (2010) and Yang and
Copeland (2014).

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