Tuesday, March 13, 2007

Impact of global volatility on Indian markets

With the recent volatility in Indian stock markets attributed more to global events, again popped the question about whether we can escape global volatility. We take note of the opinions expressed by three experts.

The global downswings in the markets across the board (across asset classes and currencies) were attributed to the sub-prime mortgage problems in the US and fears of a sharp unwinding of the yen carry-trade (borrowing an asset at the yen interest rate, selling the asset, then investing those funds into a different asset that generates a higher interest rate yield).

There has been a rise in the correlation between various markets and asset classes, and risk averseness will result in an in-sync movement. Over the past 5 years, the correlation between Nifty returns and the S&P 500 returns has risen from around 0.25 to 0.38. Thus whenever the world markets move, the valuation of Indian stocks is affected.

The influence of the global markets in Indian markets can be accounted for in three ways:

  1. Some large firms in India being entirely engaged in export driven performance. Example: the IT sector. As global volatility affects their customers, their future earnings are affected, which in turn affects their stock’s performance on Indian bourses.
  2. Equalization of product prices through import parity. Eg. Prices of locally produced steel are determined by the international market prices. This phenomenon makes companies’ bottom lines vulnerable to global market swings.
  3. The arrival of the Indian MNC on the scene. Their profits and future growth would depend on world markets and world economy. Hence their share prices are naturally affected by the global swings in markets.

So, the answer to the question whether India can stay insulated from global swings, is in the negative. As on one hand we are seeking a more tighter integration with the world economy, we cannot with the other keep looking at the possibility of insulating our economy from the effects of globalization and integration. They go hand in hand. We should be prepared for the volatility. This will be a tough learning process; but one which we cannot do without.

By the way, do you know that volatility on market is also measured? The ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index (VIX) shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking and is calculated from both calls and puts. The VIX is a widely used measure of market risk and is often referred to as the "investor fear gauge".

There are three variations of volatility indexes: the VIX tracks the S&P 500, the VXN tracks the Nasdaq 100 and the VXD tracks the Dow Jones Industrial Average. I think we don’t have any Indian equivalent as yet for our markets.