PROPOSAL

Significance of Macro Economic Variables in a Stock Market: Evidence from Indian Stock Market

Significance of Macro Economic Variables in a Stock Market: Evidence from Indian Stock

CHAPTER 1: INTRODUCTION

Introduction

The stock market plays a vital role in the modern economy since it acts as a mediator between lenders and borrowers. That is, a well-functioning stock market may assist the development process in an economy through two important channels: boosting savings and allowing for a more efficient allocation of resources. Savings are presumed to increase as the stock market provides households with assets that may satisfy their risk preferences and liquidity needs (Leigh, 1997). Also, based upon the idea of the price mechanism, a well-functioning stock market values profitable company's shares more than those of unsuccessful companies. That is, relative share prices in a well-functioning stock market may fundamentally reflect the status of a company compared to the other companies listed in the stock market, i.e., the expected dividend growth and discount rates.

Therefore, the price mechanism ensures the efficiency of utilizing current and future economic resources available to the economy in the sense that the cost of capital to the profitable company will be lower compared to the cost that the unsuccessful companies would face (Lamin, 1997). It is, also, well established that volatility characterizes the behavior of the stock market (Mandelbrot, 1963; Black, 1976). The most direct definition of volatility is the relative rate at which the price of a security moves up and down within a very short period of time (Taylor, 2007). Typically volatility is calculated by variance or the standard deviation of the price of stock market returns. A highly volatile market means that prices or stock returns have enormous swings over a specific time; i.e., day, week, month or year. In light of this definition, volatility can be considered as a measurement of the uncertainty or the risk that is associated with stock market investment decisions (Alexander, 2007 and Taylor, 2007).

Excessive volatility may prevent the smooth functioning of financial markets and adversely affect the performance of the economy. The Wall Street Crash of 1929, Black Monday on October 19, 1987, The Asian Crisis of 1997, and recently the Global Financial Crisis of 2008 are examples of the stock market's effects on the domestic and global economies1. Thus, understanding the dynamic behavior of the stock market is crucial for financial analysts, macroeconomists, and policymakers. Financial analysts and investors are interested in understanding the nature of volatility patterns of financial assets, and what events can alter and determine the persistence of volatility over time (Malik, 2004). This type of information is significant to build an accurate volatility model which may help to analyze the risk of holding an asset, and provide indicators for investors to diversify their portfolios. Also, volatility plays a central role in determining investment spending. That is, excessive volatility may cause investors in financial markets to shift their funds towards risk-free assets rather than investing in new, riskier ...