Research Proposal

Class project# 01
Submitted to:

Sir Mazhar Manzoor

Submitted by: Mohammad Irfan Malik

MBA (Finance) Sec. A Roll No# 51

Federal Urdu University for Arts Science and Technology Karachi (Gulshan campus)

Problem statement:
How the stock exchange index increases and decreases what are the factors responsible for it.

Introduction
Many kinds of factors affect the stock market. Social unrest can cause the market to drop, while a company discovering a new source of renewable energy can cause stock market prices to soar. Several economic factors affect the stock market that every investor should be aware of before getting involved in market investing.

Variables to study
Inflation and Deflation Inflation can have an adverse affect on the stock market, according to the article titled "Forces that Move Stock Prices" as published on the financial website Investopedia. Inflation is the rate at which the price of goods and services increases. It is the result of several factors, including a rise in the cost of manufacturing, transporting and selling goods. When inflation is at a low rate, the stock market responds with a surge in selling. High inflation causes investors to think that companies may hold back on spending; this causes an across the board decrease in revenue and the higher cost of goods coupled with the drop in revenue causes the stock market to drop. Deflation is when the cost of goods drops. While deflation sounds like it should be welcomed by investors, it actually causes a drop in the stock market because investors perceive deflation as the result of a weak economy. Interest Rates Interest rates as established by the Federal Reserve Board and individual banks can have an affect on the stock market, according to an informational pamphlet titled "What Drives Stock Prices" published by the New York Stock Exchange. Higher interest rates mean that money becomes more expensive to borrow. To compensate for the higher interest costs, companies may have to cut back spending or lay off workers. Higher interest rates also mean that a company's money cannot borrow as much as it used to, and this has an adverse affect on company earnings. All of this adds up to a drop in the stock market. Foreign Markets Economic trends in foreign markets can have an effect on the stock market in the United States, according to the article titled "Riding the Economic Roller Coaster" published in "Inc." magazine. When the economies in foreign countries are down, American companies cannot sell as many goods overseas as they used to. This causes a drop in revenue, and that

can show up as a drop in the stock market. Foreign stock exchanges also have an effect on the American stock market. If foreign exchanges start to fail or experience sharp drops, then that kind of activity can cause American investors to anticipate a ripple effect, resulting in a drop in the United States stock exchange. References & Resources "Inc." Magazine: Riding the Economic Roller Coaster New York Stock Exchange: What Drives Stock Prices Investopedia: Forces the Move Stock Prices PBS Online News hour: Economic Downturn

Research objective:
To understand the stock exchange practices To provide knowledge to new investors about the market How the company performance increase its share worth on the stock exchange index

Importance of the study:

The study has importance for the students doing their specialization in the field of finance as well as for the new investors who are willing to invest in the stock exchange. The study is important to know the market forces and factors responsible for the change in stock index so that the investor may be aware of the forces which can bring the share price up or down

Literature review:
Inflation or recession - which do stock investors fear the most? Since most well-allocated stock investors are also bond investors, the question becomes even more important. Bonds, which can be a relatively safe haven during the market turmoil associated with a recession, take a beating when inflation becomes a problem. There are Treasury Inflation Protection bonds that offer some protection against inflation, but they can be expensive when demand exceeds supply as is often the case. Think of TIPs as insurance policies that investors rush to buy when the river begins spilling out of its banks. The better time to buy them was when the sky was clear and there was no threat of flooding. Rising Interest Rates The most common treatment for inflation is for the Fed to raise interest rates. Rising interest rates play havoc with bonds since new bonds pay more interest than older bonds. To compensate for the difference in interest rates, bond prices fall.

Rising energy (oil) prices can fuel inflation by making just about everything more expensive to produce and transport. Along with food prices, the price of energy can seem to distort the inflation rate. However, economists also calculate the rate of inflation (Consumer Price Index) without food and energy. When this core inflation rate begins moving up, it means that higher prices are spreading throughout the economy. Dont Abandon Bonds Investors shouldnt abandon their investment plan at the first sign of rising inflation rates; however, they should be aware that balancing their portfolio is the best long-term strategy. Bonds should remain a portion of almost every portfolio. Safer bonds may not pay as much, but conservative investors will sleep better. To avoid the pain of inflation, consider a well-diversified bond mutual fund or highly rated corporate bonds. Youll still take a hit if you want to sell the bonds during a period of rising interest rates, but you will reduce the probability of default. It is often easier to deal with a slowing economy than inflation, because there are more choices when it comes to equities. Stocks of well-managed companies may slip, but longterm investors shouldnt worry about short-term price changes. However, that is no reason to abandon bonds every time inflation rears its ugly head. The overall defense against almost all market and economic ills is a well-balanced portfolio of quality stocks and bonds. Norges Bank surprised most experts by cutting the interest rate by as much as 1.75 percentage points during the final interest rate meeting in 2008. Surprise interest rate changes like this, so-called interest rate shocks, can cause major changes in stock prices. Professors Hilde C. Bjorn land and Kai Leitemo of BI Norwegian School of Management have conducted an extensive study of the interaction between U.S interest rate decisions and the stock market (S&P 500) over a 20-year period from 1983 to 2002. The results of the study are now being published in the venerable international science periodical Journal of Monetary Economics. Interest rate increase slows down stock exchange A surprise interest rate cut of one percentage point can send stock prices up by seven to nine percent, says Bjorn land, professor of economics at BI Norwegian School of Management. This is a stronger link than in other similar analyses of data from the US. Similarly, a surprise interest rate increase will be not be well received by the stock market, and can trigger a stock price fall of seven to nine percent.

So it is not surprising that interest rate decisions by Norges Bank are followed with great interest, not only by journalists and people with large mortgages, but also players in the finance markets. However, not all interest rate changes have this effect on stock prices. This is valid only for unexpected interest rate changes. An expected increase in interest rates will already be taken into account in stock prices, and as such, not affect them. Our analysis of the U.S. data indicates that 40 percent of the interest rate changes over this 20-year period came as a surprise to the market. This indicates that changes to the interest rate significantly affect stock prices, Bjorn land says. However, she stresses that these are only temporary effects. In the long term, stock prices are mainly influenced by the companys productivity. Stock prices can affect interest rates But it is not only surprise changes to interest rates which can have an impact on the stock market. In a similar manner, surprise changes in the stock market can affect the interest rate market. A surprise stock price drop of ten percent could result in an immediate interest rate cut of 0.40 percent, according to the study. Over the course of six months, a drop in stock prices could cause interest rates to be cut by a full percentage point. The Bjorn land/Leitemo study differs from previous studies in that it to a greater degree looks at the interdependence between interest rate decisions by the central bank and movements in the stock market. Source: BI Norwegian School of Management Does Foreign Trading Destabilize Local Stock Markets? Tomas Dvorak Department of Economics Williams College tdvorak@williams.edu tel: (413) 597 3143 Fax: (413) 597 4045 http://lanles.williams.edu/ tdvorak June, 2001

This paper investigates the impact of foreign trading on short term volatility and the correlation of local with world returns. I nd that trading in general is associated with higher volatility, whether it is trading by foreign or domestic investors. However, controlling for total trading volume, foreign trading has no impact on volatility in developed countries, and only a marginally signicant impact in developing countries. Thus, in developed markets, foreigners generate as much volatility as domestic investors, while foreigners are able to destabilize emerging markets. (JEL: F36, G15) Key words: volatility, emerging markets, foreign trading volume1 Introduction The share of foreign trading activity in total stock market volume increased tremendously during the last decade. Today, the amount of gross cross border ows in stocks and bonds is spectacular, exceeding 7 times the GDP (IMF (1998) p.186). The internationalization of capital markets is reected not only in the addition of foreign securities to otherwise domestic portfolios, but also in active trading in foreign markets. There is surprisingly little evidence, however, on the impact of foreign trading activity on local equity markets. The purpose of this paper is to establish the empirical relationship between foreign trading the volatility of returns and the correlation of local and world returns. The motivation for this exercise is straightforward. Despite the benets of free capital mobility, there are growing concerns that international capital ows are destabilizing. The perception is that by opening capital markets, countries expose themselves to the ckle sentiment of foreign investors. In addition, this sentiment is not only volatile but is also highly dependent on returns in other countries. The required rate of return, which is the cost of capital, depends on the variance of returns and the correlation with world returns. If the impact of liberalization is that the variance and the correlation increase, expected Returns must increase. When returns increase, the cost of capital also increases. A higher cost of capital reduces investment and growth, and in this case the opening of the capital account may not be a good idea. The eects of capital account liberalization have been the subject of much recent research. However, the existing literature focuses primarily on the eects of the lifting of restrictions, the introduction of country funds, ADRs, and structural breaks in net capital ows. The impact of foreign trading activity on return volatility and co-movement has not been previously studied. This paper tries to ll in the gap.

There are a number of hypotheses which hold that foreigners often pursue noisy or irrational trading strategies such as herding, quick changes in sentiment (Calvo and Mendoza(1999)), positive feedback trading, overreaction to changes in fundamentals(Dornbush and Park(1995)), and nancial crisis and contagion (Kodres and Pritskert(1999)). These hypotheses are related to various market imperfections that occur across national borders, The chief being incomplete or asymmetric information some of these theoretical models are supported by empirical work. Kim and Wei(2000) and Choe et al(1999) nd evidence that foreign investors in the Korean stock market pursued herding and positive feedback trading strategies. In addition to theoretical reasons and the empirical evidence that foreigners are a noisy kind of investor, there is an overwhelming perception in the popular press that this is the case. For two examples, see Stieglitzs (1998) article in the Financial Times and Krugmans(1997) in Fortune. It is important to point out that even when foreigners are noisy and irrational, their activity does not necessarily have a destabilizing impact. Domestic investors may be powerful enough and the market as a whole suciently liquid to accommodate selling or buying pressures from noisy foreigners. As long as domestic investors are not subject to the same imperfections that give rise to noisy trading strategies, foreigners should have no impact on volatility. In a detailed paper, Choe et al (1999) nd strong evidence of positive feedback trading and herding by foreign investors in Korea. However, they nd no permanent eects of net foreign order imbalances on prices and volatility. Large sales or purchases by foreigners are quickly accommodated by domestic investors. It can be concluded from this that foreign investors do not destabilize the Korean stock market. Thus, noisy or irrational trading strategies are necessary but not sucient conditions for foreigners to destabilize local stock markets. The data I have does not allow me to directly measure herding or positive feedback trading by foreign investors. I consider these strategies on the part of foreign investors to be a possibility, and investigate whether foreign trading has a disproportionate impact on volatility and correlations. I proceed in three steps: First, I look at the relationship between volatility and total trading volume. This relationship has been the subject of much research using U.S. data. I use data for 20 developed and developing countries and compare the results to those for the U.S. Second, I look at the relationship between volatility and the foreign component

of trading volume. It is possible that the eect of foreign trading on volatility is dierent than that of domestic trading. Finally, I look at the eect of foreign trading on volatility controlling for total trading volume. It is a well established result that in the U.S. data, trading volume is associated with volatility (Schwert(1989), Jones et al(1994), Gallant et al(1992)). There are two possible sources of this relationship. One is that the relationship between volume and volatility is driven by changes in fundamentals. If investors interpret information dierently, new information will cause both price changes and trading. This gives rise to a contemporaneous relationship between volatility and trading as in Wang (1994). Trading is the process through which private information is incorporated into prices. In this case the causality runs from volatility to volume and markets are ecient. The other possibility is that trading itself generates volatility in prices. There are now many papers that show how destabilizing noise traders can be sustained in equilibrium. Noise trading can take many dierent forms. In Delong et al (1990a) noise traders have misperceptions about expected prices. In Delong et al (1990b) they are positive feedback traders. Traders are over-condent in Odeon (1998). In all of the above papers noise trading generates excessive volatility. Furthermore, French and Roll (1987) provide striking evidence that trading generates volatility. Foreign trading is part of the total trading volume. Given the positive relationship between total volume and volatility, one would expect that foreign trading is also associated with volatility. This relationship can mean two things. First, it can reect the heterogeneity within the group of foreign investors. This heterogeneity causes information ow about fundamentals to be associated with trading. Second, it can mean that foreigners pursue noisy trading strategies and that their activity is not arbitraged away by domestic investors. If the degree of heterogeneity within groups of foreign and domestic investors is the same, They compare volatility when markets are closed versus when markets are open. In 1968, the NYSE was closed on Wednesdays due to paper overow. French and Roll found that the volatility of returns from Tuesdays to Thursdays was roughly halved when the markets were closed on Wednesdays. If price volatility is driven by shocks to fundamentals, then the closing of the market on Wednesdays should have had no eect on volatility between

Tuesday and Thursday. The implication of French and Rolls nding is that Wednesdays trading itself generated price volatility. 3then the two groups should exhibit proportional amounts of trading based on heterogeneity and fundamentals. Hence, controlling for total trading volume, foreign trading should have no impact on volatility if foreign investors are as noisy as domestic. However, if foreign investors are especially noisy and irrational, then even controlling for total trading volume their activity may have an impact on volatility. The relationship between trading volume and volatility is of some importance. For example, transaction taxes are often proposed as a mechanism for reducing the eects of speculation on asset prices (Summers and Summers(1989), Niehans(1994)). Such proposals are even more frequent in an international context (Tobin(1984), Eichengreen and Wyplosz(1996)). Daily turnover on foreign exchange markets is in spectacular excess of the needs of international trade in goods and assets. Similarly, the tremendous amount of trading in bonds and equities that takes place across borders is far greater than what is necessary for net redistribution of savings across countries (see Tsar and Werner (1995)). Taxes on cross border transactions are supposed to reduce speculative trading and dampen exchange rate and asset price volatility. In light of these proposals, it is important to understand the relationship between total trading, foreign trading and volatility. The following section briey summarizes existing work on the eects of capital account liberalization on asset price volatility. Sections 3 and 4 describe the data and empirical results and the last section concludes.

Research methodology
Secondary data will be analyzed to understand the history of stock exchange. Investment books and internet material will be analyzed. The focus of study will be to analyze the stock market of Pakistan specially Karachi Stock Exchange KSE100 index as benchmark. This research is partly qualitative and partly quantitative. The data of different industries companies will be analyzed in accordance with their share values and the factors responsible for it and the effect of those factors on the performance of stock exchange. The history of the companies will also be taken into consideration. It will also be analyzed that how the companies business practices effect their share value and their share to the stock market.

Contents of the research:

Introduction of the stock exchange Research methodology Literature review Findings Conclusion and recommendations

Schedule of the work

As it is mention in the research methodology the data will be collected through secondary sources (books, internet, and research articles literature review) initially I will emphasize on the current mechanism of the stock exchange and analyze its current performance and position. I will review the literature available about stock exchange Then I will analyze the finding and on the basis of findings conclusion and recommendation will be made. It is estimated that it will take five to six weeks to complete this project