The Role of Market Sentiment in Stock Price Movements: An Indian Experience

The Role of Market Sentiment in Stock Price Movements: An Indian Experience

Kiranjit Sett (West Bengal State University, India) and Debabrata Mukhopadhyay (West Bengal State University, India)
DOI: 10.4018/978-1-4666-8274-0.ch002
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Abstract

In an efficient capital market, the prices of securities always fully reflect all available information implying that prices always reflect the fundamental values. When there is under reaction or over reaction to new information, competition among the arbitrageurs quickly brings the price of an asset back to its fair value. But, if the asymmetry of information about a stock is high and there is a ‘limit to arbitrage', sentiment of the noise traders is likely to influence the price of that stock. This chapter aims at studying the role of market sentiment, during the period which starts with June 2003 and ends with July 2011, in influencing the return from investment in small capitalization stocks listed on Indian stock exchanges. We have found the presence of ARCH (1) in the time series on returns. Market sentiment, rate of interest and inflation are found to have significant influence on return from investment in small capitalization stocks. The presence of month effects in returns from such stocks has also been detected.
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Introduction

In a perfect and frictionless capital market, the competition among profit-seeking arbitrageurs makes the prices of securities equal to their fair values (Modigliani & Miller, 1958; Horne, 2006). In reality, capital markets are far from perfect due to the existence of a number of imperfections and frictions like taxes, floatation costs, cost of information, cost of trading etc. But capital markets can be efficient in which the prices of securities fully reflect all available information (Fama, 1965a; Fama, 1965b). The efficient market hypothesis (hereinafter called EMH) holds that when a new piece of information (which has the potential of affecting the price of a security) arrives the market, it gets incorporated in the price instantaneously and accurately resulting into an immediate reaction to the price and rate of return, but in the absence of any new information, the rate of return is likely to be commensurate with the risk associated with the investment and tenure of such investment (Fama, 1965a; Fama, 1965b; Fama, 1991). Since the expected values of the variables affecting the stock price are likely to have already incorporated in the price at a given point of time, only the shocks (i.e., unpredicted elements) contributing to the changes in the expectations can make abnormal changes in the prices of securities. Since unpredictable shocks occur randomly, abnormal movements in the prices of securities or rates of return on investment in such securities are also likely to be random. So, the abnormal movements in prices or rates of return are likely to be independently and identically distributed (Fama, 1965a; Fama, 1965b; Fama, 1970). Thus, in an efficient capital market, returns will be commensurate with risks (Malkiel, 2003) and time. The uninformed investors who invest in well diversified portfolios are likely to generate returns which would not be significantly different from the rate of returns which smart investors can generate (Malkiel, 2003).

Economic reforms and particularly the financial sector reforms introduced in India since 1991 have aimed at unshackling the Indian economy from bureaucratic controls. The financial sector reforms have aimed at making Indian financial system efficient and vibrant and integrating Indian financial markets with other financial markets of the world. Several measures have been taken in order to increase the efficiency of the Indian financial markets with respect to their operations, allocation of resources and incorporation of available information into prices.

In an efficient market dominated by rational traders, the role of market sentiment is likely to be less and financial markets are likely to play an important role in mobilizing funds from ultimate savers and allocating funds to ultimate users at market determined rates efficiently whatever may be the size of savings, investment and firm. But, in reality, the prices of shares of small and new companies which are characterized by high asymmetry of information are influenced by market sentiment. As a result, these small and new companies face greater hurdles in raising capital from the market than the large and diversified companies. Hence, this empirical investigation about the role of market sentiment in influencing the prices of stocks listed on Indian stock exchanges has been undertaken.

We have detected the presence of ARCH (1) in returns. We have found that market sentiment has significant influence on returns from investment in small capitalization stocks. Interest rate and inflation also have significant influences on the returns from such stocks. We have also detected the presence of month effects on the returns from such stocks.

This paper has nine sections viz., introduction, review of literature, motivation for the study, objective of the study, identification of dependent and independent variables, methodology and model, findings, analysis and interpretations and concluding remarks. The rest of the sections have been laid down hereunder.

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