behavioyr of stock market in india

8/8/2019 Behavioyr of stock market in india

1/37

1 | P a g e

AProject report

On

Behaviour of Stock Market in India

Being Submitted in Partial Fulfilment of the Degree of

M.B.A. FINANCE for the Course

Financial Market and Regulatory systems

Submitted by: Submitted to:

Mahendra Singh Garva-245&

Harish choudhary-243

Mr.P.K.Jain and

Mr. Sharad KothariFaculty in charge

FMRS.M.B.A- Finance

Semester- III

FACULTY OF MANAGEMENT STUDIES

NATIONAL LAW UNIVERSITY, JODHPUR

AUGUST- 2010


2/37

2 | P a g e

INDEX

Serial no. Chapter Index

Executive Summary 4

1. History and development of stock broking industry 6

2. Major stock exchanges in India 8

3. Stock exchange index 13

4. The behaviour of stock market 18

5. Factors affecting stock market behaviour 26

Conclusion 36

Bibliography 37


3/37

3 | P a g e

Acknowledgement

As anyone who has written a project work, or research work, it is quite impossible to

acknowledge by name every individual who has played some part in this work. We feel it difficult to

express in words my profound sense of gratitude to most respected persons who helped us to make this

work possible.

We acknowledge our gratitude to respected faculty Mr. P.K. Jain & Mr. Sharad Kothari for

having laid the foundation of the work by providing the skeleton upon which this skinny body of project

is wrapped up and who have been kind enough to suggest improvement of this work and make it broad,

based.

An ample use of various reference readings has been very frequently made while compiling data

for this project. Such rich reading has been made available at hand by the treasure-like well maintained

library of the National Law University, Jodhpur. We are very much grateful to the library staff of the

university for their unfailing co-operation.

We are very much under obligation to mention here, the contributions of our batch mates who

have, knowingly or unknowingly, provided us the competitive edge which is the driving force of the

whole labour and extra labour put into the project.

Finally, we feel very much gratified to the administration of the National Law University,

Jodhpur for providing comfortable environment, rich infrastructure and the accessibility to internet

without which it is not possible to imagine the completion of this project work.

Above all, mention has to be made of the Almighty God for continuously blessing us and our

whole family and friends to whom we owe our very existence.

Mahendra Singh Garva

&

Harish Choudhary


4/37

4 | P a g e

EXECUTIVE SUMMARY

A stock exchange, securities exchange or (in Europe) bourse is a corporation or mutual

organization which provides "trading" facilities for stock brokers and traders, to trade stocks and

other securities. Stock exchanges also provide facilities for the issue and redemption of securities

as well as other financial instruments and capital events including the payment of income and

dividends. The securities traded on a stock exchange include: shares issued by companies, unit

trusts and other pooled investment products and bonds. To be able to trade a security on a certain

stock exchange, it has to be listed there. Usually there is a central location at least for

recordkeeping, but trade is less and less linked to such a physical place, as modern markets are

electronic networks, which gives them advantages of speed and cost of transactions. Trade on an

exchange is by members only. The initial offering of stocks and bonds to investors is by

definition done in the primary market and subsequent trading is done in the secondary market. A

stock exchange is often the most important component of a stock market. Supply and demand in

stock markets are driven by various factors which, as in all free markets, affect the price of

stocks (see stock valuation).

There is usually no compulsion to issue stock via the stock exchange itself, nor must

stock be subsequently traded on the exchange. Such trading is said to be off exchange or over-

the-counter. This is the usual way that bonds are traded. Increasingly, stock exchanges are part of

a global market for securities. Stock exchanges to some extent play an important role as

indicators, reflecting the performance of the countrys economic state of health. Stock market is

a place where securities are bought and sold. It is exposed to a high degree of volatility; prices

fluctuate within minutes and are determined by the demand and supply of stocks at a given time.


5/37

5 | P a g e

Stock brokers are the ones who buy and sell securities on behalf of individuals and institutions

for some commission.

The Securities and Exchange Board of India (SEBI) is the authorized body, which

regulates the operations of stock exchanges, banks and other financial institutions. The past

performances in the capital markets especially the securities scam by Hasrshad Mehta has led

to tightening of the operations by SEBI. In addition the international trading and investment

exposure has made it imperative to better operational efficiency. With the view to improve,

discipline and bring greater transparency in this sector, constant efforts are being made and to a

certain extent improvements have been made.


6/37

6 | P a g e

CHAPTER-1

HISTORYOF THESTOCK BROKINGINDUSTRY

Indian Stock Markets are one of the oldest in Asia. Its history dates back to nearly 200

years ago. The earliest records of security dealings in India are meager and obscure. By 1830's

business on corporate stocks and shares in Bank and Cotton presses took place in Bombay.

Though the trading list was broader in 1839, there were only half a dozen brokers recognized by

banks and merchants during 1840 and 1850. The 1850's witnessed a rapid development of

commercial enterprise and brokerage business attracted many men into the field and by 1860 the

number of brokers increased into 60.

In 1860-61 the American Civil War broke out and cotton supply from United States of

Europe was stopped; thus, the 'Share Mania' in India begun. The number of brokers increased to

about 200 to 250. However, at the end of the American Civil War, in 1865, a disastrous slump

began (for example, Bank ofBombay Share which had touched Rs 2850 could only be sold at

Rs. 87). At the end of the American Civil War, the brokers who thrived out of Civil War in 1874,

found a place in a street (now appropriately called as Dalal Street) where they would

conveniently assemble and transact business. In 1887, they formally established in Bombay, the

"Native Share and Stock Brokers' Association" (which is alternatively known as "The Stock

Exchange"). In 1895, the Stock Exchange acquired a premise in the same street and it was

inaugurated in 1899. Thus, the Stock Exchange at Bombay was consolidated. Thus in the same

way, gradually with the passage of time number of exchanges were increased and at currently it

reached to the figure of 24 stock exchanges.


7/37

7 | P a g e

DEVELOPMENT

An important early event in the development of the stock market in India was the

formation of the Native Share and Stock Brokers Association at Bombay in 1875, the

precursor of the present-day Bombay Stock Exchange. This was followed by the formation of

associations /exchanges in Ahmadabad (1894), Calcutta (1908), and Madras (1937). IN addition,

a large number of ephemeral exchanges emerged mainly in buoyant periods to recede into

oblivion during depressing times subsequently.

In order to check such aberrations and promote a more orderly development of the stock

market, the central government introduced a legislation called the Securities Contracts

(Regulation) Act, 1956. Under this legislation, it is mandatory on the part of stock exchanges to

seek government recognition. As of January 2002 there were 23 stock exchanges recognized by

the central Government. They are located at Ahmadabad, Bangalore, Baroda, Bhubaneswar,

Calcutta, Chennai,(the Madras stock Exchanges ), Cochin, Coimbatore, Delhi, Guwahati,

Hyderabad, Indore, Jaipur, Kanpur, Ludhiana, Mangalore, Mumbai(the National Stock Exchange

or NSE), Mumbai (The Stock Exchange), popularly called the Bombay Stock Exchange,

Mumbai (OTC Exchange of India), Mumbai (The Inter-connected Stock Exchange of India),

Patna, Pune, and Rajkot. Of course, the principle bourses are the National Stock Exchange and

The Bombay Stock Exchange, accounting for the bulk of the business done on the Indian stock

market. While the recognized stock exchanges have been accorded a privileged position, they are

subject to governmental supervision and control. The rules of a recognized stock exchanges

relating to the managerial powers of the governing body, admission, suspension, expulsion, and

re-admission of its members, appointment of authorized representatives and clerks, so on and so

forth have to be approved by the government. These rules can be amended, varied or rescinded

only with the prior approval of the government.


8/37

8 | P a g e

CHAPTER-2

MAJORSTOCKEXCHANGESININDIA

BSE (BOMBAY STOCKEXCHANGE)

The Stock Exchange, Mumbai, popularly known as "BSE"was established in 1875 as

"The Native Share and Stock Brokers Association".It is the oldest one in Asia, even older

than the Tokyo Stock Exchange, which was established in 1878. It is a voluntary non-profit

making Association of Persons (AOP) and is currently engaged in the process of converting itself

into demutualised and corporate entity. It has evolved over the years into its present status as the

premier Stock Exchange in the country. It is the first Stock Exchange in the Country to have

obtained permanent recognition in 1956 from the Govt. of India under the Securities Contracts

(Regulation) Act, 1956.

The Exchange, while providing an efficient and transparent market for trading in

securities, debt and derivatives upholds the interests of the investors and ensures redressal of

their grievances whether against the companies or its own member brokers. It also strives to

educate and enlighten the investors by conducting investor education program and making

available to them necessary informative inputs. A Governing Board having 20 directors is the

apex body, which decides the policies and regulates the affairs of the Exchange. The Governing

Board consists of 9 elected directors, who are from the broking community (one third of them

retire ever year by rotation), three SEBI nominees, six public representatives and an Executive

Director & Chief Executive Officer and a Chief Operating Officer.


9/37

9 | P a g e

NSE (NATIONAL STOCKEXCHANGE)

NSE was incorporated in 1992 and was given recognition as a stock exchange in April

1993. It started operations in June 1994, with trading on the Wholesale Debt Market Segment.

Subsequently it launched the Capital Market Segment in November 1994 as a trading platform

for equities and the Futures and Options Segment in June 2000 for various derivative

instruments. NSE has been able to take the stock market to the doorsteps of the investors. The

technology has been harnessed to deliver the services to the investors across the country at the

cheapest possible cost. It provides a nation-wide, screen-based, automated trading system, with a

high degree of transparency and equal access to investors irrespective of geographical location.

The high level of information dissemination through on-line system has helped in integrating

retail investors on a nation-wide basis. The standards set by the exchange in terms of market

practices, Products, technology and service standards have become industry benchmarks and are

being replicated by other market participants. Within a very short span of time, NSE has been

able to achieve all the objectives for which it was set up. It has been playing a leading role as a

change agent in transforming the Indian Capital Markets to its present form. The Indian Capital

Markets are a far cry from what they used to be a decade ago in terms of market practices,

infrastructure, technology, risk management, clearing and settlement and investor service.


10/37


11/37

11 | P a g e

FACILITIES PROVIDED BY NCDEX

y NCDEX has developed facility for checking of commodity and also provides a ware

house facility

y By collaborating with industrial partners, industrial companies, news agencies, banks and

developers of kiosk network NCDEX is able to provide current rates and contracts rate.

y To prepare guidelines related to special products of securitization NCDEX works with

bank.

y To avail farmers from risk of fluctuation in prices NCDEX provides special services for

agricultural.

y NCDEX is working with tax officer to make clear different types of sales and service

taxes.

y NCDEX is providing attractive products like weather derivatives.


12/37

12 | P a g e

A person holding assets (Securities/Funds), either to meet his liquidity needs or to reshuffle

his holdings in response to changes in his perception about risk and return of the assets, decides

to buy or sell the securities. He selects a broker and instructs him to place buy/sell order on an

exchange. The order is converted to a trade as soon as it finds a matching sell/buy order. At the

end of the trade cycle, the trades are netted to determine the obligations of the trading members

securities/funds as per settlement cycle. Buyer/seller delivers funds/ securities and receives

securities/funds and acquires ownership of the securities.

A securities transaction cycle is presented above. Just because of this Transaction cycle, the

whole business of Securities and StockB

roking has emerged. And as an extension of stock

broking, the business of Online Stock broking/ Online Trading/ E-Broking has emerged.


13/37

13 | P a g e

CHAPTER-3

STOCK MARKETINDEX

Its ironical that something as huge as a stock market which should be stable as it represents

the economy of a nation, is actually extremely volatile since it is driven more by the sentiments of

the people.

Stock Market is a place where the stocks of a listed company are traded. A single figure

that sums up the overall performance of the market on a daily basis is the Stock Index. A good

Stock Index captures the movement of the well diversified and highly liquid stocks. For a lay

man it is the pulse rate of the economy. Index movements reflect the changing expectations of

the stock market about future dividends of the corporate sector. The index is calculated by

finding the weighted average of the prices of the most actively traded companies in the market,

where the weights are generally in proportion to the market capitalization of the company.

But when and where did it all start? Stock Exchanges as a centre for trading were

established as early as the 16th century. In Antwerp, a major financial hub in Belgium, traders

gathered together in 1531 to speculate in shares and commodities. This was the world's first

Stock Exchange. London and Paris set up Exchanges sometime near the end of the 17th century.

Close to hundred years later, in 1792, the New York Stock Exchange (NYSE) was established,

which is still one of the worlds most powerful exchanges today.

The reason for establishment was primarily the need for financing businesses and for

providing returns for the finances. In India, the Stock Exchange, Mumbai, was established in

1875 as "The Native Share and Stockbrokers Association" (a voluntary non-profit making

association) and is now popularly known as the Bombay Stock Exchange (BSE). The other

major exchange is the National Stock Exchange of India Limited (NSE) and was incorporated in

November 1992. Combined the two trading zones are responsible for 99.9% of the trading done

in India.


14/37

14 | P a g e

Types of Indexes available:-

Broad-Market Index: This consists of all the large, liquid stocks of the country and becomes

the benchmark for the entire capital market of the country. An example for this is the S&P CNX

500.

Specialized Index: We can either have Industry or Sector specific Index for any particular

sector of the economy which then serves as the benchmark for that particular industry or we can

have an index for the highly liquid stocks. Taking an example for an industry specific index we

have the S&P Banking Index which is a capitalization-weighted index of 26 domestic equities

traded on the New York Stock Exchange and NASDAQ, The stocks in the Index are high-

capitalization stocks representing a sector of the S&P 500. Similarly, The S&P CNX Nifty is a

relevant example for an index composed of highly liquid stocks

Determinants of a Stock Index

Following parameters should be taken into picture before one constructs a stock index:

Liquidity Liquidity of stocks as measured by the impact cost criterion which determines

the cost faced when actually trading the index. For example if the current market price of a stock

is Rs 200 and a trader purchases it at Rs 202 (due to involved transaction costs) then the market

impact cost is 1% and the stock is considered highly liquid for lower impact cost. EG.

Diversification Diversification, by putting stocks of various sectors that reflect the economy,

is used to cancel out stock noise which is essentially the individual stock fluctuations and to

reduce investors risks. An index must thus have a balanced representation of all sectors.

Optimum size - More stocks lead to greater diversification but the limiting factor is the size of

the index. Increasing number of stocks in an index from 10 to say 30 gives a sharp reduction in

risks but increasing the number beyond a point does very little in risk reduction. Further it might

lead to addition of illiquid stocks. For example, the optimal size forBSE Sensex is 30.

Market Capitalization: The index should include primarily the stocks of companies that have

significant market capitalization with respect to the index such that any major change in the price


15/37

15 | P a g e

of the stock is reflected in the index. For example in BSE 30 Index, the scrip must have a

minimum of 0.5% of the market capitalization of the Index.

Averaging - Every stock primarily moves for two reasons: The news about the company and

the news about the country. An ideal index is affected only by the latter, that is the news of the

economy and the effect of the former is knocked out by proper averaging. The various methods

of averaging employed are:-

y PriceWeighted: The weights assigned are proportional to the stock prices.

y Market Capitalization Weighted: The equity price is weighted by the market

capitalization of the company. Hence each constituent stock in the index affects the

index value in proportion to the market value of all outstanding shares.

(Current market capitalization)Index = ---------------------------------------- x Base Value

(Base Market Capitalization)

Where:

CMS = Sum of (current market price * outstanding shares) of all securities in the index

BMS = Sum of (market price * issue size) of all securities as on base date.

y Equal Weighted: The weights are equal and assigned irrespective of both market

capitalization or price

Index revision is done periodically taking into consideration the factors mentioned above.

The relevant index body makes clear, researched and publicly documented rules for this purpose.

These rules are applied regularly, to obtain changes to the index set. However, it is ensured that

the value of the index does not change significantly after the revision of the index set.

Sensex (BSE 30)

The index includes 30 companies which figure in top 100 in terms of market

capitalization and are also among the leaders in their industry groups. Presently the following are

the constituent companies: ACC, Infosys, ICICI Bank, Dr. Reddys Lab, SBI, CIPLA, Zee


16/37

16 | P a g e

Telefilms, Nestle India, RPL, RIL, HCL Tech., Bajaj Auto, BHEL, Castrol, BSES, Colgate

Palmolive, Hindalco, Grasim, Glaxo, Hero Honda, Gujrat Ambuja Cements, HLL, HPCL, ITC,

L&T, MTNL, Ranbaxy, TISCO, TELCO and Satyam.

Standard and Poors CRISILNSEExchange NIFTY

S&P CNX NIFTY is an S&P endorsed Stock Index owned by the India Index Services

Ltd. (IISL). It is a highly diversified index, accurately reflecting the overall market conditions

and is composed of 50 liquid stocks. It is backed by solid economic research and three extremely

respected organizations (NSE, CRISIL and S&P).

Signals from the Stock Index

The Index finds uses in various fields starting from economic research to helping

investors choose appropriate portfolio for investment. For example the index funds are funds that

passively invest in the market i.e. the portfolio returns of the index funds is same as that of the

Index. Since the Index is an indicator of the overall mood of the investors in the secondary

market, it helps a company answer questions like is it the right time to take out an IPO, how to

price the issue, etc.

It acts as a signal to the government of the feel good factor prevailing in the economy.

As much as the finance ministry may want to ignore it, the performance of the stock market right

after the introduction of the budget gives an immediate feedback to the Finance Minister about

the acceptability of the budget. However, the market index is a double edged sword. Because the

index is influenced by expectations of the future performance of the stocks, it leads to a self

fulfilling prophecy. Suppose an investor thinks that the stock of the company is going to go

down and this feeling prevails across the market then everyone would want to get out of the

companys stock. This will automatically lead to the stock prices crashing. The Stock Index can

often also act as a trigger to herd mentality. Any downturn in the market would be reinforced bythe collective action of the investors to hedge against any losses and get out of the market. This

would further depress the market. This herd mentality is often used to the advantage of

speculators. The speculator buys long thus creating waves in the market that the stock he is

investing in is hot. Thus everyone would follow suit giving the speculator a good short term

profit margin.


17/37

17 | P a g e

The stock index is often more a representation of investors perceptions (noise element)

rather than real news. The dot com bubble of 2000 is a case in point. There was a rush of

investment in anything even remotely connected with information-technology driving up the

stock prices way above what they should have been according to their P/E ratios. Thus it can be

seen that though the index is a popular investors guide, it is riddled with imperfections which

can often confuse rather than help. The index popularly used in India is the NSE CNX Nifty.

There are processes afoot to reduce the pure noise element and speculative margin of the

index. The basic problem arises due to imperfect information reflected by the inclusion of

illiquid stocks in the calculation of the index. Illiquid stock is one which is not actively traded in

the market or has been lying dormant for a long time. Inclusion of such stocks leads to problems

of stale prices, bid-ask bounce and ease in manipulation.

Bid-ask bounce: Illiquid stocks have a wide bid-ask spread. Thus even when no news is

breaking, when a stock price is not changing, the `bid-ask bounce' is about prices bouncing up

and down between bid and ask. Such changes are spurious in nature.

Stale prices: A stock index is supposed to represent the state of the stock market at the closing

time (3:30 pm in NSE) on a particular day. However the last traded price of an illiquid stock (if

included in the index) may be even a week old thus distorting the index.

Hence to make an index useful, there has to be continuous evaluation of the stocks listed

and any stock which remains inactive for a period of time should be de-listed or removed from

the index. A prudent investor is one who exercises caution while interpreting the market index,

taking into account all its inconsistencies.1

1http://www.iimcal.ac.in/community/finclub/dhan/dhan1/art17-smi.pdf


18/37

18 | P a g e

CHAPTER-4

THEBEHAVIOROFSTOCK MARKE

From experience we know that investors may temporarily pull financial prices away from

their long term trend level. Over-reactions may occurso that excessive optimism (euphoria)

may drive prices unduly high or excessive pessimism may drive prices unduly low According to

the efficient market hypothesis (EMH), only changes in fundamental factors, such as profits or

dividends, ought to affect share prices. (But this largely theoretic academic viewpoint also

predicts that little or no trading should take placecontrary to factsince prices are already at

or near equilibrium, having priced in all public knowledge.) But the efficient-market hypothesis

is sorely tested by such events as the stock market crash in 1987, when the Dow Jones index

plummeted 22.6 percentthe largest-ever one-day fall in the United States. This event

demonstrated that share prices can fall dramatically even though, to this day, it is impossible to

fix a definite cause: a thorough search failed to detect any specific or unexpected development

that might account for the crash.

It also seems to be the case more generally that many price movements are not

occasioned by new information; a study of the fifty largest one-day share price movements in the

United States in the post-war period confirms this. Moreover, while the EMH predicts that all

price movement (in the absence of change in fundamental information) is random (i.e., non-

trending), many studies have shown a marked tendency for the stock market to trend over time

periods of weeks or longer. Various explanations for large price movements have been

promulgated.

For instance, some research has shown that changes in estimated risk, and the use of

certain strategies, such as stop-loss limits and Value at Risk limits, theoretically could cause

financial markets to overreact. Other research has shown that psychological factors may result in

exaggerated stock price movements. Psychological research has demonstrated that people arepredisposed to 'seeing' patterns, and often will perceive a pattern in what is, in fact, just noise.

(Something like seeing familiar shapes in clouds or ink blots.) In the present context this means

that a succession of good news items about a company may lead investors to overreact positively

(unjustifiably driving the price up).


19/37

19 | P a g e

A period of good returns also boosts the investor's self-confidence, reducing his

(psychological) risk threshold. The stock market, as any other business, is quite unforgiving of

amateurs. Inexperienced investors rarely get the assistance and support they need. In the period

running up to the recent Nasdaq crash, less than 1 percent of the analyst's recommendations had

been to sell (and even during the 2000 - 2002 crash, the average did not rise above 5%). The

media amplified the general euphoria, with reports of rapidly rising share prices and the notion

that large sums of money could be quickly earned in the so-called new economy stock market.

Irrational behavior

Sometimes the market tends to react irrationally to economic news, even if that news has

no real affect on the technical value of securities itself. Therefore, the stock market can be

swayed tremendously in either direction by press releases, rumors, euphoria and mass panic.

Over the short-term, stocks and other securities can be battered or buoyed by any number of fast

market-changing events, making the stock market difficult to predict. Emotions can drive prices

up and down. People may not be as rational as they think. Behaviorists argue that investors often

behave irrationally when making investment decisions thereby incorrectly pricing securities,

which causes market inefficiencies, which, in turn, are opportunities to make money

Crashes

A stock market crash is often defined as a sharp dip in share prices of equities listed on

the stock exchanges. In parallel with various economic factors, a reason for stock market crashes

is also due to panic. Often, stock market crashes end speculative economic bubbles.

There have been famous stock market crashes that have ended in the loss of billions of dollars

and wealth destruction on a massive scale. An increasing number of people are involved in the

stock market, especially since the social security and retirement plans are being increasingly

privatized and linked to stocks and bonds and other elements of the market. There have been a

number of famous stock market crashes like the Wall Street Crash of 1929, the stock market

crash of 19734, the Black Monday of 1987, the Dot-com bubble of 2000.

One of the most famous stock market crashes started October 24, 1929 on Black

Thursday. The Dow Jones Industrial lost 50% during this stock market crash. It was the

beginning of the Great Depression.


20/37

20 | P a g e

Another famous crash took place on October 19, 1987 Black Monday. On Black

Monday itself, the Dow Jones fell by 22.6% after completing a 5 year continuous rise in share

prices. This event not only shook the USA, but quickly spread across the world. Thus, by the end

of October, stock exchanges in Australia lost 41.8%, in Canada lost 22.5%, in Hong Kong lost

45.8%, and in Great Britain lost 26.4%. The names Black Monday and Black Tuesday are

also used for October 28-29, 1929, which followed Terrible Thursday--the starting day of the

stock market crash in 1929. The crash in 1987 raised some puzzles- main news and events did

not predict the catastrophe and visible reasons for the collapse were not identified. This event

raised questions about many important assumptions of modern economics, namely, the theory of

rational human conduct, the theory of market equilibrium and the hypothesis of market

efficiency. For some time after the crash, trading in stock exchanges worldwide was halted, since

the exchange computers did not perform well owing to enormous quantity of trades being

received at one time. This halt in trading allowed the Federal Reserve System and central banks

of other countries to take measures to control the spreading of worldwide financial crisis.

In the United States the SEC introduced several new measures of control into the stock

market in an attempt to prevent a re-occurrence of the events of Black Monday. Computer

systems were upgraded in the stock exchanges to handle larger trading volumes in a more

accurate and controlled manner. The SEC modified the margin requirements in an attempt to

lower the volatility of common stocks, stock options and the futures market. The New York

Stock Exchange and the Chicago Mercantile Exchange introduced the concept of a circuit

breaker.

Stock market index

The movements of the prices in a market or section of a market are captured in price

indices called stock market indices, of which there are many, e.g., the S&P, the FTSE and the

Euro next indices. Such indices are usually market capitalization weighted, with the weights

reflecting the contribution of the stock to the index. The constituents of the index are reviewed

frequently to include/exclude stocks in order to reflect the changing business environment.


21/37

21 | P a g e

Investment strategies

One of the many things people always want to know about the stock market is, "How do I

make money investing?" There are many different approaches; two basic methods are classified

as either fundamental analysis or technical analysis. Fundamental analysis refers to analyzing

companies by their financial statements found in SEC Filings, business trends, general economic

conditions, etc. Technical analysis studies price actions in markets through the use of charts and

quantitative techniques to attempt to forecast price trends regardless of the company's financial

prospects. One example of a technical strategy is the Trend following method, used by John W.

Henry and Ed Seykota, which uses price patterns, utilizes strict money management and is also

rooted in risk control and diversification.

Additionally, many choose to invest via the index method. In this method, one holds a

weighted or unweighted portfolio consisting of the entire stock market or some segment of the

stock market (such as the S&P 500 or Wilshire 5000). The principal aim of this strategy is to

maximize diversification, minimize taxes from too frequent trading, and ride the general trend of

the stock market (which, in the U.S., has averaged nearly 10%/year, compounded annually, since

World War II).

Taxation

According to much national or state legislation, a large array of fiscal obligations is taxed

for capital gains. Taxes are charged by the state over the transactions, dividends and capital gains

on the stock market, in particular in the stock exchanges. However, these fiscal obligations may

vary from jurisdiction to jurisdiction because, among other reasons, it could be assumed that

taxation is already incorporated into the stock price through the different taxes companies pay to

the state, or that tax free stock market operations are useful to boost economic growth.

The role of stock exchanges

Stock exchanges have multiple roles in the economy, this may include the following:-

y Raising capital for businesses

The Stock Exchange provides companies with the facility to raise capital for expansion

through selling shares to the investing public.


22/37


23/37

23 | P a g e

(2001), One.Tel (2001), Sunbeam (2001), Webvan (2001), Adelphia (2002), MCI WorldCom

(2002), Parmalat (2003), Fannie Mae (2008), Freddie Mac (2008), Lehman Brothers (2008),

were among the most widely scrutinized by the media.

y Creating investment opportunities for small investors

As opposed to other businesses that require huge capital outlay, investing in shares is open to

both the large and small stock investors because a person buys the number of shares they can

afford. Therefore the Stock Exchange provides the opportunity for small investors to own shares

of the same companies as large investors.

y Government capital-raising for development projects

Governments at various levels may decide to borrow money in order to finance infrastructure

projects such as sewage and water treatment works or housing estates by selling another category

of securities known as bonds. These bonds can be raised through the Stock Exchange whereby

members of the public buy them, thus loaning money to the government. The issuance of such

bonds can obviate the need to directly tax the citizens in order to finance development, although

by securing such bonds with the full faith and credit of the government instead of with collateral,

the result is that the government must tax the citizens or otherwise raise additional funds to make

any regular coupon payments and refund the principal when the bonds mature.

y Barometer of the economy

At the stock exchange, share prices rise and fall depending, largely, on market forces. Share

prices tend to rise or remain stable when companies and the economy in general show signs of

stability and growth. An economic recession, depression, or financial crisis could eventually lead

to a stock market crash. Therefore the movement of share prices and in general of the stock

indexes can be an indicator of the general trend in the economy.


24/37

24 | P a g e

Understanding Stock Market Behaviour

Earnings, we are told, are what drive the price of a stock. But real (inflation-adjusted)

earnings growth for the period 1965-1982 was roughly the same as for 1982-1999. Yet we all

know that the S&P 500 had significantly different results. The first period was one of no stock

price growth, and the latter saw growth of over 1000%.

What was the difference? Clearly, it was how investors perceived the relative value of the

earnings. In a period of high inflation, earnings growth of 6-7% is not all that impressive. In

today's low inflation environment it is.

"Since the Civil War cycle there have been two effects of inflation. First, inflation reduces the

value the market places on earnings, resulting in a flat trend, rather than a rising trend in the

index. Secondly, the effect of the cheapening dollar makes the real value of the index fall even

further. As a result, P/R falls to extremely low levels during inflationary bear markets."

When inflation ends, you get the benefit of the old earnings growth and new growth,

giving the market a double boost. Investors become very optimistic about earnings growth and

adjust their future value of stocks accordingly. But as I have often asserted, trees cannot grow to

the sky. For 200 years, the overall market has not grown much faster than the growth in GDP.

Now we enter a period where the expectations of earnings growth cannot match reality.

The stock market must come back to trend, which can be a painful adjustment for some

investors. The effect of both the monetary conditions and a very optimistic assessment of theearnings growth still to come are priced into the index. This is shown by the extraordinary high

level of P/R. We should expect the current monetary cycle to be followed by a "real" cycle. It

should start with a secular bear market in which lower earnings growth will be the problem, not

inflation.

Growing Pains

The goal of every business is to grow its income and to grow its income at a faster rate

over time. The income you get for the money you invested, or the profit you generate from a

given level of resources, is called the Rate of Return or ROR.

However, there appear to be very real upper limits on both the absolute value of and the

growth of the ROR that can be achieved for a given level of resources. This ROR fluctuates over


25/37

25 | P a g e

time, just as P/E and P/R do. Why wouldn't ROR be constant, as many firms try to do? Why can't

ROR just grow every year, as market cheerleaders on TV constantly predict?

What appears to happen over time is that firms, in a moment of optimism, either build too

much capacity or resource (R) and the ROR drops as capacity utilization drops; or, firms invest

too little and thus the growth of ROR is self-limiting.

Managers simply cannot know the exact amount of future resource needed. They can do

their best to make very intelligent guesses, but in the end there is usually either too much or too

little resources.

It is a difficult job. Too much resource and you don't get a reasonable return. You use

resources which cannot be easily re-allocated to some more productive use. Too little and you

invite competition or give up market share. Further, that nasty thing called competition makes it

possible for a lot of businesses to build capacity for the same market, all hoping to increase their

business and market share. Then you end up with too much capacity and no ability to raise

prices. Computers, oil, soybeans, ships, etc., are all examples. The list is endless. Supply and

demand works. The business cycle is real.

In the telecommunications industry, management decided the world needed large

amounts of fiber optics cable. We now use less than 5% of the capacity of that new cable.

Clearly, the industry overbuilt. But all the firms which supplied equipment for that expansion

also assumed that the future would look like the past and built large factories capable of building

massive amounts of fiber optic cable equipment. The over-capacity went right down the food

chain.

The 90's were characterized by the growth of capacity in almost every industry,

including "mature" industries like agriculture, shipping, mining, retailing, etc. We now have a

new level of total "R" or resources available to US businesses and the world. But since economic

growth and profits do not grow faster than GDP, whatever growth we do have will be spread

over a larger amount of Resources. This means the rate of return of "R" will be smaller than it

has been for the last ten years. It follows that the growth of earnings will be smaller as well.


26/37

26 | P a g e

Expansions and Expectations

One of the great charts in StockCycles shows the relationship between the length of

economic expansions and the expectations investors have for the stock market. The longer we

think economic expansions will last, the more we are willing to pay for earnings which will

compound at 15% forever. Every time we come to a period like the one we are in toady, we are

told that this time it is different.

If earnings truly could compound at 15% forever, a P/E ratio of 25 would not be illogical.

But earnings cannot grow faster than GDP. Period. Earnings will come back to trend.

This is because we build (or invest in) too much resource for a given market or technology. The

potential profit is spread over a greater amount of resource, and earnings growth suffers.


27/37

27 | P a g e

CHAPTER-5

FACTORS AFFECTINGSTOCK MARKET BEHAVIOR

These include news about new technology, patent approval, war, natural disaster, product recalls

and lawsuits that shall have positive and negative impact to the relevant company stocks. The

health or mishap of a key leader in a company may also affect the stock price of the company.

1. UNCERTAINTY ABOUTGOVERNMENTPOLICY AND STOCKPRICES

Governments shape the environment in which the private sector operates. They affect firms

in many ways: they levy taxes, provide subsidies, enforce laws, regulate competition, define

environmental policies, etc. In short, governments set the rules of the game. Governments

change these rules from time to time, eliciting price reactions in financial markets. These

reactions are weak if the change is anticipated, but they can be strong if the markets are caught

by surprise. For example, the U.S. governments decision to allow Lehman Brothers to go

bankrupt, which was perceived by many as signaling a shift in the governments implicit too-big-

to-fail policy, was followed by a 4.7% drop in the S&P 500 index on September 15, 2008. This

paper analyzes the effects of changes in government policy on stock prices.A key role in our analysis belongs to uncertainty about government policy, which is an

inevitable by-product of policymaking. We consider two types of uncertainty. The first type,

which we call policy uncertainty, relates to the uncertain impact of a given government policy on

the profitability of the private sector. The second type, which we call political uncertainty,

captures the private sectors uncertainty whether the current government policy will change. In

other words, there is uncertainty about what the government is going to do, as well as what the

effect of its action is going to be. We find that both types of uncertainty affect stock prices in

important ways.

Prior studies have analyzed the effects of uncertainty, broadly defined, on various aspects of

economic activity. For example, it is well known that uncertainty generally reduces firm

investment when this investment is at least partially irreversible. The impact of uncertainty about

government policy on investment has been analyzed both theoretically and empirically. The


28/37

28 | P a g e

literature has also analyzed the effects of uncertainty about government policy on capital flows

and welfare. However, the literature seems silent on how this uncertainty affects asset prices.

We find that, on average, stock prices fall at the announcement of a policy change. Positive

announcement returns are typically small because they tend to occur in states of the world in

which the policy change is largely anticipated by investors. Given the governments economic

motive, any policy change that lifts stock prices is mostly expected, so that much of its effect is

priced in before the announcement. In contrast, negative announcement returns tend to be larger

because they occur when the announcement of a policy change contains a bigger element of

surprise. The probability distribution of the announcement returns is left-skewed and, most

interesting; its mean is below zero. We prove analytically that the expected value of the stock

return at the announcement of a policy change is negative.

We also show numerically that this expected announcement return is more negative when

there is more uncertainty about government policy. When policy uncertainty is larger, so is the

risk associated with a new policy, and so is the discount rate effect that pushes stock prices down

when the new policy is announced. When political uncertainty is larger, so is the element of

surprise in the announcement of a policy change.

We relate the stock return at the announcement of a policy change to the length and depth of

the preceding downturn. We find that the announcement returns are negative especially after

downturns that are short or shallow. The announcement returns can also be positive, mostly after

downturns that are long or deep. However, such positive returns tend to be small because after

long or deep downturns, policy changes are largely anticipated.

Before the announcement of a policy decision, investors are uncertain whether the policy will

change. If it does change, stock prices tend to jump down; if it does not change, prices tend to

jump up. The expected jump in stock prices at the announcement of a policy decision is

generally nonzero. This expected jump captures the risk premium demanded by investors for

facing an uncertain jump in the stochastic discount factor when the policy decision is announced.

The conditional jump risk premium can be positive or negative, depending on the posterior mean

of the policy impact. The unconditional premium is positive and increasing in both policy

uncertainty and political uncertainty.

The volatilities and correlations of stock returns are also affected by changes in government

policy. By introducing new policies whose impact is more uncertain, policy changes increase the


29/37

29 | P a g e

volatility of the stochastic discount factor. As a result, risk premium go up and stock returns

become more volatile and more highly correlated across firms. All of these effects are stronger

when policy uncertainty is larger. Before a policy change, stock returns are affected by

fluctuations in the investors beliefs about the current policy as well as in the investors

assessment of the probability of a policy change. The latter fluctuations stop after the

government makes its policy decision, typically resulting in lower volatilities and correlations if

the decision does not change the prevailing policy.

2. How sensitive are markets to armed conflict

The second war that the coalition of the willing lunched against the Iraqi regime of

Saddam Hussein in March 2003 has heightened the public debate on the social and economic

consequences of war. The empirical problem of this debate is that almost no reliable figures exist

on key economic activities in war-torn societies. This makes it easy for the proponents and the

opponents of a war alike to downplay or exaggerate the human and, in the context of this paper,

economic costs of combat.

Unfortunately, major theories in International Relations are no great help in solving this

dispute either. While Marxist theories expect in the tradition of Rudolf Hilferding, Rosa

Luxemburg and Lenin that the capitalist world economy profits from a major war (Schneider and

Trger 2004), both realism and liberalism have speculated more over the causal arrow going

from trade to conflict rather than the one pointing in the opposite direction. As Barbieri and Levy

note, the two leadings paradigms in international relations research only cursorily mention the

alleged causal path going from war to economic activities and especially trade. The two

contending approaches converge, however, at least in the conjecture that economic exchange will

suffer from warfare. Yet, this interpretation does not hold for all realist work. Some theoretical

work, which draws on the concept of relative gains, also lets us expect that increasing tensions

between belligerents might not affect their trade ties severely. As Morrow (1997) shows, even

trade with military goods can constitute an equilibrium in a situation of mutual distrust. This

prediction receives some support in the comparative case studies ofBarbieri and Levy (1999,

2001, 2003). They show for some dyads that war did not lead to a significant drop in the trade

going on between the warring parties.


30/37

30 | P a g e

The sceptic work on the influence of conflict on economic activities is in considerable

contrast to the liberal worldview. Generations of economists reiterated the claim originally

advocated by Montesquieu and Kant that war will disrupt trade. Commenting upon the situation

before World War I, Keynes described how insane delusion and reckless self-regard let

Germany destroy the nearly complete internationalization of social and economic life that was

present in Europe around 1914. This hypothesis is the reverse side of commercial liberalism, a

school of thought that mainly advocates the peace-through-trade conjecture. Although it is not

completely obvious why the opposite relationship should automatically hold, no firm theoretical

and empirical work in support of the disruption thesis exist. The articles by Anderton and Carter

are a partial exception. They reject the claim by Barbieri and Levy that war does often not affect

trade between war parties in a significant fashion The studies by Anderton and Carter have,

however, not yet completely settled the controversy over the economic consequences of war. The

two liberalists followed the lead ofBarbieri and Levy and did not examine their claims on a

random sample of dyads. Furthermore, trade, which is just one indicator of economic activities,

might not be ideal to account for the market responses to international political events. Trade

relationship can for instance not be reversed as easily as capital investments. The stickiness of

trade consequently biases examinations that use this indicator for the test of the disruption thesis

in favour of the null hypothesis.

It is therefore not surprising that further evidence renders the liberal case quite

compelling that war generally affects markets negatively. Distinguishing between two periods of

British stock market reactions to World War II, Chappell and Eldridge employ a time series

framework to demonstrate the considerable inefficiency that hampers a war economy. Their

results tentatively suggest a psychological foundation for this divergence and possibly reflect

the despair caused by the loss of much of Europe and Scandinavia in the early subperiod,

followed by a renewed hope later on. The negative reactions of some particularly sensitive

sectors to political violence are well-known. Fleischer and Buccola (2002) show that the demand

of foreign tourists for Israeli hotels significantly reacts to terrorist attacks. Neumayer (2004)

reports that terrorism, war and human rights violations harm tourism. This negative impact is

especially pronounced in destinations for which substitutes can be found easily. Similarly,

Rigobon and Sack (2003) demonstrate that the increased risk of the second US-led war against


31/37

31 | P a g e

Iraq has negatively affected key financial variables. While the dollar, equity prices and Treasury

yields declined and the spread of corporate yields widened, oil prices soared.

Yet, the impact was not uniformly negative since the escalation that finally resulted in a

military campaign did not affect the price of gold or the liquidity premium on the on-the-run ten-

year Treasury note. The analysis of a future traded on an online betting exchange, dubbed

Saddam Securities, additionally demonstrates that an increasing probability of war has lowered

the stock markets around the world in the wake of the 2nd war of the US-led forces against Iraq

(Leigh, Wolfers and Zitzewitz 2003). These negative effects are more pronounced for countries

that are highly integrated into the world economy and that depend heavily on oil imports.

Although we expect the liberal argument to be at the average right, there are ample reasons to

suspect that the effect of war on economic activities is not always negative. A first source for our

scepticism is the obvious distributive effect of war. While both the export and import sectors

suffer under increasing hostilities, a tax financed military sector can profit from them especially

in a situation of growing global integration (Schneider and Schulze 2003, 2004). Stocks of arms

manufacturers will thus typically experience a boost in times of growing tensions, as Brandes

(1997) and many others have shown. Similarly, the prospect of an impending war affects the

gold and energy sectors negatively.

The second objection against the standard version of commercial liberalism is the

occurrence of stock market rallies during the course of combat. We will focus in this article on

this seemingly cynical behavior while we analyse the distributional consequences of

international crises in a companion paper (Schneider and Trger 2004). A war-induced stock

market rally typically implies that the use of military force propels international traders to buy

stocks instead of gold or government bonds. We will investigate whether such positive reactions

to an escalation are the exception rather than the norm. Although such rallies appear cynical at

first sight, they make perfect sense from an informational point of view.

Standard finance theory can account for positive market reactions to war through a

rational learning model. In this view, the prospect of a major diplomatic or armed contest creates

uncertainty over the economic costs that can be attributed to the different war and peace

scenarios. If the market expects a long war, traders will sell stocks and escape into less risky

alternatives. A negative collective belief about the possible course of action will thus typically

reduce the aggregate value of the stock market, while the expectation of a positive development


32/37

32 | P a g e

increases the attractiveness of stocks. On many occasions, market reactions will, however, be

minimal. Obstfeld and Rogoff (1996:25-27) show that the reactions of the global financial

markets to the Russo- Japanese war were limited. According to them, traders were able to predict

the winner of the conflict fairly easily. We believe therefore that stock market rallies will only

happen if an economy is greatly affected by the political developments of the region in which the

war takes place.

It should also be noted that war rallies are short-term events. The market regains during

them what was probably lost during the uncertainty of the escalation preceding the military

campaign. A case in point is again the Gulf War of 1991 where the main markets lost in value

after Iraq s invasion of Kuwait, but regained some value during the military campaign of the

United States and its allies. We expect that war rallies occur in situations where an intensification

of conflict can be seen as a sign of resolve rather than despair. We have chosen the confrontation

between Iraq and the US-led alliance, the wars in Ex-Yugoslavia and the conflict between Israel

and the Palestinians to assess how an intensification of the hostility level affects the aggregate

value of the stock market.

We have selected here three conflicts because they all continued for more than three

years and engaged the United States, the European Union or some of its member states in a

significant way, be it in the role of the intervening force or as a mediator. These three conflicts,

however, affect the world economy in different ways. We expect that especially the hostilities in

Iraq and to a lesser extent the ones between Israel and the Palestinians or Ex-Yugoslavia, should

be of importance to traders. Another difference between these conflicts is the extent to which the

confrontation is influenced through actions by the Western powers. While the United States and

Britain were the leading members of the multilateral forces engaged against Saddam Hussein and

Slobodan Milosevic, they could at best indirectly affect the hostilities between Israel and the

Palestinians. This means in other words that only an increasing level of hostility in the Gulf

Region and to some extent in Ex-Yugoslavia could be interpreted by the markets as a sign of

resolve. We expect therefore only for those conflicts that war rallies should accompany an

intensification of the conflict.2

2http://www.jrtr.net/jrtr41/pdf/f04_sat.pdf


33/37

33 | P a g e

3. OTHER FACTORS:-

Certain economic indicators, financial news, world events and according to some, the

phases of the moon, affect the stock market's performance. Interest rates, inflation, supply and

demand, human behavior and news contribute to volatility and performance of the stock market.

y Interest Rates

Anyone with a credit card or loan clearly understands how he or she becomes personally affected

by interest rates changes. But when rates change what effect does that have on the stock market?

The market does not immediately become affected by a change in interest rates. The change

happens slowly and trickles down to the market as a whole. The Federal Reserve (the Fed)

charges borrowing banks the U.S. Federal Reserve's federal funds rate (fed funds rate). The Fed

uses this rate to curb inflation---caused when too much money enters the market and not enough

goods and services get purchased. The Fed increased the rate to borrowing banks. Borrowing

banks increase the rate to businesses. When businesses spend more on financing the company's

growth can suffer, in turn driving down the stock price. If enough companies experience these

symptoms it can impact the stock market as a whole.

y

Human BehaviorIn 1942 Sidney Wachtel wrote a paper outlining the abnormal performance the stock market sees

during the month of January. Year-after-year the market enjoys bigger gains in January than

during any other time of the year. He called this the January effect. Numerous studies have tried

to reconcile the January effect with existing economic variables. His results indicate that human

psychological behavior could contribute to the January effect---violating the efficient markets

theory. Wachtel concluded that the higher than normal returns achieved in January possibly arise

from the "general feeling of good fellowship and cheer existing throughout

the Christmas holidays..." In a 2005 research paper conducted by the College of William and

Mary entitled, "Yes, Wall Street, There is a January Effect! Evidence from Laboratory

Auctions", the authors conclude, "Even after controlling for a wide variety of auxiliary effects,

we find the same result. The January effect is present in laboratory auctions, and the most


34/37

34 | P a g e

plausible explanation is a psychological effect that makes people willing to pay higher prices in

January than in December."

y News

Good and bad news both affect the stock market and sometimes bad news has a positive effect.

Corporate layoffs immediately increase company earnings and have a positive effect on a

corporation, but when too many companies experience layoffs at the same time it creates a drop

in the market as a whole. Market scandals such as the Enron scandal have a negative effect on

the market. Positive news from world leaders has a positive effect on the market, but news of

war and decreased supply of goods and services has a negative market effect.

When we get positive news about a company then it can increase the buying interest in the

market. On the other hand, when there is a negative press release, it can ruin the prospect of a

stock. In this case you should remember that news should not matter much but the overall

performance of the company matters more. So, news is another factor affecting stock price.

y Demand and supply

One of the major factors affecting stock price is demand and supply. The trend of the stock

market trading directly affects the price. When people are buying more stocks, then the price of

that particular stock increases. On the other hand if people are selling more stocks, then the price

of that stock falls. So, you should be very careful when you decide to invest in the Indian stockmarket.

y Market Cap

Never try to guess the worth of a company simply by comparing the price of the stock. You

should always keep in mind that it is not the stock but the market capitalization of the company

that determines the worth of the company. So market cap is another factor that affects stock

price.

y Earning/Price Ratio

Another important factor affecting stock price is the earning/price ratio. This gives you a fair

idea of a companys share price when it is compared to its earnings. The stock becomes

undervalued if the price of the share is much lower than the earnings of a company. But if this is


35/37


36/37

36 | P a g e

CONCLUSION

There are so many other reasons behind the fall or rise of the share price. Especially there are

stock specific factors that also play its part in the price of the stock. So, it is always important

that you do your research well and stock trading on the basis of your research and information

that you get from your broker. To get benefit from the effective consultancy service it is

therefore always better from professional stock trading companies rather than getting lured

by discount brokerage advertisements that you must be coming across every day.


37/37

37 | P a g e

BIBLIOGRAPHY

Books referred:

The Indian Institute of Banking, Indian Financial System and Commercial Banking,

Macmillan Publication, New Delhi, 1999. Bharati, V. Pathak, Indian Financial System, Pearson Education, New Delhi, 2004.

Fabozzi & Modiglani, Capital Markets; Institutions and Instruments, Prentice Halls

Indian Ltd. 4th ed., 2008.

Websites:

http://www.bseindia.com/

http://www.nse-india.com/

www.ncdex.com/

http://www.inv.com/6q74.htm http://www.ehow.com/list_5793821_factors-affect-stock-market.html

http://www.jstor.org/stable/246566?seq=1

behavioyr of stock market in india

Documents