1

A

REPORT

ON

ANALYSING THE EFFECT OF EXCHANGE RATE ON THE STOCKS OF IT & ITES SECTOR IN INDIA

BY

VISHAL UGLE 2004S3P3563

Submitted in partial fulfillment of the course

ECON GC 491

SPECIAL PROJECTS

Under the guidance of

Dr.G.V.KUMARI

BITS- PILANI, GOA CAMPUS

April,2008

2

BIRLA INSTITUTE OF TECHNOLOGY AND SCIENCE

Special Projects: ECON GC 491

Station: BITS Pilani, Goa Campus

Duration: 120 Days

Date of Submission: 25 April 2008

Title of the Report: ANALYSING THE EFFECT OF EXCHANGE RATE ON

THE STOCKS OF IT & ITES SECTOR IN INDIA

Name of Faculty: Dr.G.V.Kumari

Faculty-In-Charge: Dr.Joy Anuradha

Signature:

3

Acknowledgement

I am deeply indebted to the BITS administration for giving such an opportunity to get exposed to

the practical application of the things learnt in the disciplinary courses, through this Special

Projects course.

I express my sincere thanks and profound sense of gratitude to my instructor Dr.G.V.Kumari for

rendering her full support and cooperation to this project, the Instructor-in-charge Dr.Joy

Anuradha for giving us an opportunity to do this project .

4

Abstract:

This report is divided in to two parts ,part1 gives a brief overview of the performance of the Indian IT

sector in the recent past ,its growth and its contribution to the GDP and exports.

In part2 relationship between CNXIT Index and exchange rates in India has been examined by using

monthly data form January 1997 to February 2008. The time series data of exchange rates and the Index

were tested for non stationary by running Dickey Fuller test, ACF and PACF. Exchange rates were found

to be non stationary while the IT Index was stationary, the logarithm of exchange rates and CNXIT were

non stationary. Hence, the two can be tested for co integration. The residuals of the regression of the

logCNXIT and logER were found to be stationary hence they are not co integrated.

5

TABLE OF CONTENTS

PART 1: PERFORMANCE OF IT AND ITES SECTOR IN INDIA

1.1 Introduction 7

PART 2: TESTING FOR COINTEGRATION BETWEEN CNXIT INDEX AND

EXCHANGE RATES FOR THE YEARS 1997-2008

2.1 Literature review of articles referred 12

2.2 Methodology 13

2.3 CNXIT index 13

2.4 Exchange rate 14

2.5 Basic concepts 14

2.6 Testing for non stationarity 16

2.7 Tools used for the test 16

2.8 Source of data 16

2.9 Results for unit root tests 17

2.10 Results for cointegration 20

References 24

6

PART1 PERFORMANCE OF THE IT & ITES SECTOR IN

INDIA

7

1.1 Introduction:

The vision of Information Technology(IT) policy is to use IT as a tool for raising the living

standards of the common man and enriching their lives. Though, urban India has a high internet

density, the government also wants PC and Internet penetration in the rural India. In Information

technology (IT), India has built up valuable brand equity in the global markets. In IT-enabled

services (ITES), India has emerged as the most preferred destination for business process

outsourcing (BPO), a key driver of growth for the software industry and services sector.

India's most prized resource in today's knowledge economy is its readily available technical work

force. India has the second largest English-speaking scientific professionals in the world, second

only to the U.S.

According the data from ministry of communication and information technology, the ITES-BPO

industry has grown by about 54 per cent with export earnings of US$ 3.6 billion during 2003-04.

Output of the Indian electronics and IT industry is estimated to have grown by 18.2 per cent to

Rs. 1,14,650 crore in 2003-04.

The share of hardware and non-software services in the IT sector has declined consistently every

year in the recent past. The share of software services in electronics and IT sector has gone up

from 38.7 per cent in 1998-99 to 61.8 percent in 2003-04. However, there has been some

welcome acceleration in the hardware sector with a sharp deceleration in the rate of decline of

hardware's share in electronics and IT industry. Output of computers in value terms, for example,

increased by 36.0, 19.7 and 57.6 per cent in 2000-01,2002-03,and2003-04,respectively.

All the sub-sectors of the non-software component of electronic and IT industry grew at over 8

per cent in 2003-04, but this was far below the rate of growth of software services. Overall, after

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declining precipitously from 61.4 per cent in 1998-99 to 40.9 percent in 2001-02, the share of

hardware in this important industry declined only marginally to 38.2 percent in the two

subsequent years.

Export markets continue to dominate the domestic segment. The size of the domestic market in

software relative to the export markets for Indian software, which was 45.2 percent in 1998- 99,

after declining rapidly to 29.8 percent in 2001-02, fell only to 29.1 percent and 27.7 per cent in

the two subsequent years.

Value of software and services export is estimated to have increased by 30 percent to US$12.5

billion in 2003-04. The Software Technology Parks of India have reported software exports of

Rs. 31,578 crore (US$ 6,947 million) during April - December 2004- 05 as against Rs. 22,678

crore (US$ 4,913) during the corresponding period lastyear.

The annual growth rate of India's software exports has been consistently over 50 percent since

1991. No other Indian industry has performed so well against the global competition. According

to a NASSCOM-McKinsey report, annual revenue projections for India’s IT industry in 2008 are

US $ 87 billion and market openings are emerging across four broad sectors, IT services,

software products, IT enabled services, and e-businesses thus creating a number of opportunities

for Indian companies. In addition to the export market, all of these segments have a domestic

market component as well.

The IT-enabled service industry in India began to evolve in the early nineties when companies

such as American Express, British Airways, GE and Swissair set up their offshore operations in

India.

The Indian software and services export is estimated at Rs 103200 crore (US$ 23.4 billion) in

2005-06, as compared to Rs 80180 crore (US$ 17.7 billion) in 2004-05, an increase of 32 per

9

cent in dollar terms.. The production of the Indian electronics and IT industry is estimated at Rs

185660 crore during 2005-06, as compared to Rs 152420 crore during the year 2004-05, a

growth of 21.8 per cent. The Industry’s contribution to the national GDP has risen from 1.2 per

cent during the year 1999-2000 to a 4.8 per cent during 2003-04.

Latest data (2006-07) of export of Services for India available mainly by broad categories shows

the high growth of miscellaneous services (including software services and business services)

which grew by 70.5% in 2004-05 and further by 47.6% in 2005-06 and 35.9% in 2006-07 . The

major category of export of services of India is the miscellaneous services category with a share

of 76.7% in total services exports in 2006-07. While software services is the major item under

miscellaneous services exports, since 2003-04, non-software miscellaneous services exports have

grown rapidly almost equaling the value of software services exports. The major contributors

among non-software miscellaneous services are business services (75.5% share and 82.4%

growth) and financial services (10.3% share and 88.6% growth).

10

Some more details are available for computer services exports of India as a result of the RBI’s

‘Survey on Software and IT services exports, 2002-03’ which shows that almost 50 per cent of

the companies reported ‘Development, production, supply and documentation of customized

software, including operating systems made on order for specific users’ as one of their activities

while the activity of ‘Analysis, design and programming of systems ready to use (including web

page development and design), and technical consultancy related to software’ occupied second

position with a share of 42 per cent as one of the activities of the companies. Majority of the

computer services exports were made to USA, Canada and Europe accounting for around 87 per

cent of total computer services exports. Exports toAsian countries were only around 9 per cent

of the total computer services exports. About 53 per cent of the computer services exports were

offshore exports, while the rest were onsite exports.

Today a large number of foreign affiliates operate IT-enabled services in India. The different

service lines of It enabled services off shored to India include customer care, finance, human

resources, billing and payment services, administration and content development.

11

PART2 TESTING FOR COINTEGRATION BETWEEN CNXIT

INDEX AND EXCHANGE RATES FOR THE YEARS

1997-2008

12

2.1 Literature review of the articles referred

We had referred the following research papers for conducting the above mentioned tests for co

integration

Relationship Between Exchange Rates and Stock Prices Empirical Evidence from Bahrain’s

Financial Markets by Rizwan Tahir, Ahmed Abdul Ghani

The Relationship Between Exchange Rates and Stock Prices, A causality analysis by Saadet

Kasman

Volatility Spillover between the Stock Market and the Foreign Market in Pakistan by Abdul

Qayyum and A. R. Kemal

The above mentioned papers had followed the methodology of checking the relevant time

series data for non stationarity using the Dickey Fuller and Advanced Dickey Fuller tests,if

the tests were positive for non stationarity then they were tested for co integration by

regressing the variables and testing the residuals of the regression for non stationarity.If the

residuals were stationary ,the two series are co integrated and those are tested for causality

relationship using Engle Granger tests and EGARCH models.

13

2.2 Methodology:

The basic steps for testing co integration for time series data involves first checking it for non

stationary, before describing the method in detail , we have mentioned few basic concepts and

the details regarding the variables exchange rate and CNXIT Index.

2.3 CNX IT Index Information Technology (IT) industry has played a major role in the Indian economy during the

last few years. A number of large, profitable Indian companies today belong to the IT sector and

a great deal of investment interest is now focused on the IT sector. In order to have a good

benchmark of the Indian IT sector, IISL has developed the CNX IT sector Index. CNX IT

provides investors and market intermediaries with an appropriate benchmark that captures the

performance of the IT segment of the market .

Companies in this Index are those that have more than 50% of their turnover from IT related

activities like software development, hardware manufacture, vending, support and maintenance.

The Index is a market capitalization weighted Index with its base period being December 1995

and the base date and base value being January 1, 1996 and 1,000 respectively.

The Base Value of the Index is being revised from 1000 to 100 w.e.f. 28 May 2004.

Selection of the Index set is based on the following criteria:

1. Company's market capitalization rank in the universe should be less than 500

2. Company's turnover rank in the universe should be less than 500

3. Company's trading frequency should be at least 90% in the last six months

4. Company should have a positive net worth.

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5. A company which comes out with an IPO will be eligible for inclusion in the Index, if it

fulfills the normal eligibility criteria for the Index for a 3 month period instead of a 6

month period.

2.4 Exchange rate:

The exchange rate is considered to be the ratio of US dollar to Indian Rupee. The monthly

average for each month from Jan 1997 to Feb 2008 is calculated and used. The logarithm of

exchange rate is used for checking for unit root

2.5 Basic concepts:

Co-integration and error correction modeling technique involves three main steps. Testing the

relevant time series for stationarity (unit roots), testing for co-integration, and finally error-

correction modeling. We shall use standard textbook notation to explain briefly the steps

involved.

A non-stationary time series Yt is said to be integrated of order d, [Yt ~ I(d)], if it achieves

stationarity after being differenced d times. To determine the order of integration, unit root tests

have been developed. The most common test is known as Dickey-Fuller (DF) or Augmented

Dickey-Fuller (ADF). To discuss the DF test, consider the model

Yt = β0 + β1t + ut

ut = αut-1 + εt

where εt is a covariance stationary process with zero mean. The reduced form for this model is

Yt = γ + δt + β1t + αYt-1 + εt -------------------------------------------------------------- (1)

15

Where γ = β0 (1 – α) + β1α and δ = β1 (1 – α). This equation is said to have a unit root if α = 1. The DF

test is based on testing the hypothesis α = 1 in (1) under the assumption that εt are white noise errors. The

test statistics are:

k(1) = T(ά – 1) t(1) = (ά – 1)/SE(ά)

Since these statistics do not have a standard t distribution, the critical values for k(1) and t(1) are tabulated

in Fuller (1976).

Suppose that Yt ~ I(d) and Xt ~ I(d). Then Yt and Xt are said to be co-integrated if there exists a β such

that Yt - β Xt is I(d-b) and b > 0. Thus testing for co-integration one must make sure that both series are

integrated of the same order in first step. Second step then involves estimating the following co-

integration equation by Ordinary Least Squares (OLS):

Yt = a0 + bo Xt + μt ---------------------------------------------------------------------------(2)

X t = a0 + bo Yt + μ′t --------------------------------------------------------------------------- (3)

And testing for the stationarity of the residuals from Equations 2 & 3 to make sure that μt and μ′t

are I(d-b), b > 0.

If two variables are co-integrated, then the third step involves formulating the error-correction

model (ECM) as follows:

tit

n

i

oiit

n

i

oitt XLfYLedCYL )1()1()1(11

100 (4)

tit

n

i

it

n

i

itt YLfXLedCXLi

)1()1()1(11

1111 1

(5)

where L is the lag operator and the error correction terms (ECTs) μt and μ′t are the stationary

residuals from co-integration Equations 2 and 3, respectively. According to the standard Granger

16

causality test, X is said to Granger cause Y if foi’s are jointly significant. The inclusion of ECTs,

however, provide additional channel through which the Granger causality could be detected.

Thus, X is said to Granger cause Y, as long as the ECT carries a significant coefficient even if

foi’s are not jointly significant.

2.6 Testing for non stationarity:

We had conducted the following tests on the data to check for non stationarity.

1. Philips -Perron test which incorporates both Dickey Fuller and Advanced Dickey fuller

test

2. We have generated the autocorrelation and partial autocorrelation function for the data to

check for non stationarity.

2.7 Tools used for the tests:

The following software tools were used for performing tests

1. R- programming ,a statistical software for conducting PP test

2. Minitab14.0 for generating ACF and PACF

3. Microsoft Excel for storing data

2.8 Source of data:

The primary source of data was internet, the following links were used

1. www.nse.org.in for CNX IT Index

2. http://www.oanda.com/convert/fxhistory for exchange rates

17

2.9 Results for the Unit Root tests

For CNX IT Index

1. Philips-Perron test

Data: logCNXITIndex_ts

Dickey-Fuller = -3.1783, Truncation lag parameter = 4, p-value =0.09471

2. Autocorrelation function and partial autocorrelation function

Lag

Au

toco

rre

lati

on

302520151051

1.0

0.8

0.6

0.4

0.2

0.0

-0.2

-0.4

-0.6

-0.8

-1.0

Autocorrelation Function for LOG NORMALIZEDCNXIT(with 5% significance limits for the autocorrelations)

18

Lag

Pa

rtia

l A

uto

co

rre

lati

on

302520151051

1.0

0.8

0.6

0.4

0.2

0.0

-0.2

-0.4

-0.6

-0.8

-1.0

Partial Autocorrelation Function for LOG NORMALIZEDCNXIT(with 5% significance limits for the partial autocorrelations)

For Exchange rate:

1. Philips-Perron test

Data: logEr_ts

Dickey-Fuller = -2.2296, Truncation lag parameter = 4, p-value = 0.4811

2. Autocorrelation function and partial autocorrelation function

19

Lag

Au

toco

rre

lati

on

302520151051

1.0

0.8

0.6

0.4

0.2

0.0

-0.2

-0.4

-0.6

-0.8

-1.0

Autocorrelation Function for log ER(with 5% significance limits for the autocorrelations)

Lag

Pa

rtia

l A

uto

co

rre

lati

on

302520151051

1.0

0.8

0.6

0.4

0.2

0.0

-0.2

-0.4

-0.6

-0.8

-1.0

Partial Autocorrelation Function for log ER(with 5% significance limits for the partial autocorrelations)

20

Conclusions:

The following conclusions can be drawn

Series p-value conclusion

logCNXIT 0.09471 Non stationary

logEr 0.4811 Non stationary

Hence it can be concluded that both the series are non stationary and can be tested for co

integration

2.10 Testing for co integration

To test for cointegration the two series i.e logCNXIT and logER have to be regressed on each

other and the residuals have to be tested for stationarity. The regression equations are as follows

LOG NORMALIZEDCNXIT = - 7.54 + 7.18 log ER ---------------------------------- (1)

log ER = 1.45 + 0.0452 LOG NORMALIZEDCNXIT-----------------------------------(2)

now the residuals of the above regressions have to be tested for stationarity,Philips Perron

test,the ACF and PACF for the residuals of equation (1),(2) are as follows

Phillips-Perron Unit Root Test

data: res_ts

Dickey-Fuller = -2.831, Truncation lag parameter = 4, p-value = 0.2308

21

Lag

Au

toco

rre

lati

on

302520151051

1.0

0.8

0.6

0.4

0.2

0.0

-0.2

-0.4

-0.6

-0.8

-1.0

Autocorrelation Function for residuals of equation 1(with 5% significance limits for the autocorrelations)

Lag

Pa

rtia

l A

uto

co

rre

lati

on

302520151051

1.0

0.8

0.6

0.4

0.2

0.0

-0.2

-0.4

-0.6

-0.8

-1.0

Partial Autocorrelation Function for RESIDUALS OF EQUATION 1(with 5% significance limits for the partial autocorrelations)

22

Lag

Au

toco

rre

lati

on

302520151051

1.0

0.8

0.6

0.4

0.2

0.0

-0.2

-0.4

-0.6

-0.8

-1.0

Autocorrelation Function for RESIDUALS OF EQUATION 2(with 5% significance limits for the autocorrelations)

Lag

Pa

rtia

l A

uto

co

rre

lati

on

302520151051

1.0

0.8

0.6

0.4

0.2

0.0

-0.2

-0.4

-0.6

-0.8

-1.0

Partial Autocorrelation Function for RESIDUALS OF EQUATION2(with 5% significance limits for the partial autocorrelations)

23

Conclusions:

Series p-value conclusion

Residuals of regression

of equation 1,2

0.2308 Non stationary

It can be seen from the PP test results and the above graphs that the residuals are non stationary.

Hence, we conclude that both the series are not co integrated ,therefore we cannot perform the

Error correction Modeling to know the causality relationship.

24

References:

Relationship Between Exchange Rates and Stock Prices Empirical Evidence from Bahrain’s

Financial Markets by Rizwan Tahir, Ahmed Abdul Ghani

The Relationship Between Exchange Rates and Stock Prices, A causality analysis by Saadet

Kasman

Volatility Spillover between the Stock Market and the Foreign Market in Pakistan by Abdul

Qayyum and A. R. Kemal

Gujrati ,Basic econometrics 4th

edition

Chandan sen gupta ,Financial Modeling using Excel

www.nse.org.in

http://www.oanda.com/convert/fxhistory

http://india.gov.in/sectors/communication/index.php

www.eximbank.in

Stock Prices and Exchange Rates: Are they Related? Evidence from South Asian Countries

By Naeem Muhammad and Abdul Rasheed

25