“Spread between E/P Ratio and Interest Rate and its effects on

Indian Stock Market”

Submitted in partial fulfillment of the requirements of

the M.B.A Degree Course of Bangalore University
By
VIVEK GUPTA
(REGD.NO:05XQCM 6117)

Under the Guidance

Of
Prof. S. SANTHANAM
Faculty
MPBIM

M.P.BIRLA INSTITUTE OF MANAGEMENT

Associate Bharatiya Vidya Bhavan
43, Race Course Road, Bangalore-560001
2005-2007
 DECLARATION

I hereby declare that the dissertation entitled “Spread between E/P Ratio and Interest
Rate and its effects on Indian Stock Market” is the result of work undertaken by me,
under the guidance of Prof. S. SANTHANAM, permanent faculty, M.P. Birla Institute of
Management, Bangalore.

I also declare that this dissertation has not been submitted to any other
University/Institution for the award of any Degree or Diploma.

Place: Bangalore VIVEK GUPTA

Date : 16th May 2007 (REGD.NO:05XQCM 6117)
 PRINCIPAL’S CERTIFICATE

This is to certify that the Research Report entitled “Spread between E/P Ratio and
Interest Rate and its effects on Indian Stock Market” done by Mr. VIVEK GUPTA
bearing Registration No. 05XQCM 6117 under the guidance of Prof. S. SANTHANAM.

Place: Bangalore (Dr.N.S.Malavalli)

Date: 16th May 2007 Principal MPBIM, Bangalore
 GUIDE’S CERTIFICATE

This is to certify that the Research Report entitled “Spread between E/P Ratio and
Interest Rate and its effects on Indian Stock Market” done by Mr. VIVEK GUPTA
bearing Registration No. 05XQCM6117 is a bonafide work carried under my guidance
during the academic year 2006-07 in a partial fulfillment of the requirement for the
award of MBA degree by Bangalore University. To the best of my knowledge, this report
has not formed the basis for the award of any other degree.

Place: Bangalore Prof.S. SANTHANAM

Date : 16th May 2007
 ACKNOWLEDGEMENT

As students collect accolades in the form of grades for the success in his/her endeavors
and his/her success depends on adequate preparation and in domination and most
important of all the support received from his/her guide. So the accolades I earn of this
project, I would like to share with all those who have played a notable part in its making.

I take this opportunity to sincerely thank Dr.T.V.N Rao who guided me through out the
project through his Valuable suggestions, without which the project would not have
been successful.

I also thank PROF. S. SANTHANAM for giving me the opportunity to explore my areas
of interest by consistently lending support in terms of his expertise and also supplying
valuable inputs in terms of resources every step of the way.

It would be improper if I do not acknowledge the help and encouragement by my family,

friends and well-wishers who always helped me directly or indirectly.

Vivek Gupta
 ABSTRACT

In recent years, spreads between the earning/price ratios of some stock market indices
and interest rates have been widely used as indicators for future equity market
movements by market practitioners. For example, a number of investment banks have
used the spreads in the past few years to justify their bullish outlook for the stock
market. Various business publications use the spreads in their discussions of the overall
market conditions and outlooks as well.

E/P ratios and interest rates appear to be unlikely candidates since they contain only
widely publicly available information. E/P ratios of individual stocks or portfolios are
regularly used to explain the stock or portfolio returns. In this study, we find that though
spread seems to have reasonably strong causal influence on E/P ratio and Call money
rate but there is no influence on Market Return as such. Further we also find that there
is low relationship exist between Call money rate and Market Return.
 CHAPTER 1

INTRODUCTION
Introduction:

The earnings-price ratio (E/P ratio) of a stock market index is used to forecast the
overall stock market outlook. The spreads between the E/P ratio and interest rates are
other indicators used to monitor the stock market. These spreads are used for “market
timing” such that, based on the signals generated from the spreads, a decision is made
to invest in the stock market index or in bonds. The reason behind such use is that
theoretically the E/P ratio and interest rates should have an equilibrium relationship, as
investors will arbitrage between stocks and bonds [Gram, Dodd and Cottle (1962)].
Whenever there is a deviation from the equilibrium, stock prices will move the E/P ratio
and interest rates to the direction of the equilibrium. It is also noted that some central
banks’ financial stability reports include measures of whether stock markets are
overvalued by looking at E/P ratios. Few people consider the spread between the E/P
ratio and interest rate the most important variable in forecasting returns.

The purpose of this paper is to study the usefulness of the E/P ratio of the NSE CNX
Nifty and the spreads between the E/P ratio and interest rates & its effects on the return
of the Nifty.

Campbell and Shiller (1998) investigate the relationship between the E/P ratio of the
S&P 500 index and the general stock market outlook. They find that the E/P ratio at the
beginning of a 10-year period is positively correlated with the return of the S&P 500
index over that 10-year period using data from 1872 to 1997. Rolph and Shen (1999)
find that the historical extreme values of the spreads between the E/P ratio of the CRSP
index in the US and the long-term and short-term interest rates contain information on
the direction of the stock market.

As the information on both E/P ratio and the prevailing market rate of interest are
publicly available, apparently the spread between two variables as defined above could
not be an important indicator of market movements in an efficient market. Along with
different indicators, market practitioners often use different measures of spread to
analyze and predict market movements. Number of research papers attempted to
explain/predict future stock return by considering some of the regressors among E/P
ratio, yields, interest rate, etc.

In this paper, an attempt is made to assess the usefulness of spread between E/P ratio
and interest rate in the context of Indian stock market. For analyzing the relationship
between spread and return, a number of analytical tools, viz., correlation analysis,
regression analysis and Granger.s causality test have been employed.
 CHAPTER 2

REVIEW OF LITERATURE
Rolph, Douglas and Pu Shen (1999), “Do The Spreads Between the E/P Ratio and
Interest Rates Contain Information on Future Equity Market Movements?”
Research Working Paper, Federal Reserve Bank of Kansas City, RWP 99-03 (March).

Introduction

In recent years, spreads between the earning/price ratios of some stock market indices
(e.g. S&P 500 index) and interest rates have been widely used as indicators for future
equity market movements by market practitioners. For example, a number of investment
banks have used the spreads in the past few years to justify their bullish outlook for the
stock market. Various business publications (Wall Street Journal, Barrons, Business
Week are a few examples) use the spreads in their discussions of the overall market
conditions and outlooks as well. Value Line Investment Survey in its market monitor
section regularly publishes the current spread, its changes since last week, last quarter,
last year, and the level of the spread at last market top, last market bottom, etc.

Academics, on the other hand, tend to be suspicious to any claim that a model can
consistently predict future market movements beyond a long-term trend because they
generally believe stock prices are on average efficient. E/P ratios and interest rates also
appear to be unlikely candidates since they contain only widely publicly available
information. While e/p ratios of individual stocks or portfolios are regularly used to
explain the stock or portfolio returns, there are only a few papers using e/p ratios or
interest rates to forecast the overall market performance. Campbell and Shiller (1998)
show that the e/p ratio at the beginning of a 10-year period is negatively correlated to
the stock returns for the 10-year period. Lander, Orphanides, and Douvogiannis (1997)
use linear combinations of e/p ratio and bond yields to predict returns on the S&P 500
index in a regression framework.2 Finally, both interest rates and e/p ratios are among
the possible explanatory variables in Pesaran and Timmermann's attempt to explain
stock market movements (1995). None of these papers, however, have used spreads
between the e/p ratio and interest rates or directly evaluated the usefulness of the
spreads as indicators for the overall market outlook.

OBJECTIVE OF STUDY

To examine directly the usefulness of the spreads between the e/p ratio and interest
rates as indicators for overall stock market conditions.

To compare the predictive power of the spreads when different interest rates are used.

METHODOLOGY

Examine the predictive power of the spread variable in the in-sample regression
analysis and out-of-sample forecast comparisons.

Sample covers the time period from January 1962 to December 1997. The dependent
variable of the regression is the monthly total returns of the CRSP value-weighted
index. Two interest rates are used: one is the short rate, which is the yield on 3-month
Treasury bills; and the other is the long rate, which is the yield on 10-year Treasury
notes.

Conclusion

Examine the usefulness of the spreads between the e/p ratio of the stock market index
and the interest rates of 3-month and 10-year Treasury securities. Findings are that
while spreads do not appear to be particularly useful in a regression framework, the
extreme values of the spreads, relative to their historical ranges, do contain useful
information on future overall equity market movements. In particular, for the time period
of 1967 to 1997, when the spreads were below their historical 10th percentile levels,
roughly 50% of the time they were followed by a market downturn. Further, switching
strategies based on the signals of the spreads outperformed the benchmark buy-and-
hold strategy. Finally, even though many practitioners and the business press have
focused on the spreads calculated with longterm interest rates, spreads calculated with
short-term interest rates actually perform marginally better, though the differences
between the two are not significant statistically

G. P. Samanta and Kaushik Bhattacharya “Is the Spread between E/P Ratio and
Interest Rate Informative for Future Movement of Indian Stock Market?” NSE
RESEARCH INITIATIVE PAPER NO.: 9

Introduction

Empirical evidence for the developed economies suggests that the information on the
spread between E/P ratio at the stock market and a measure of interest rate is
sometimes useful in predicting stock market movements. The paper employs several
statistical and econometric tools (viz., correlation analysis, regression analysis,
Granger’s causality test and measures of out-of-sample forecast performance) for
rigorously assessing the usefulness of spread in explaining stock market return in India.
Also, examine the possibility of formulating profitable business/trading strategy using
spread for varying degrees of transaction cost. Empirical results reveal that though
spread seems to have reasonably strong causal influence on return and the causal
model helps achieving forecasts slightly better than the random walk model, the
usefulness of spread in formulating a profitable business strategy is not clear. The
paper finds that the performances of different strategies vis-à-vis a simple buy-and-hold
strategy would crucially depend on several factors like the choice of interest rate, choice
of trading period and choice of threshold for determining extreme values of spread. The
paper also reveals that the profitability of a spread based trading strategy would
crucially depend on the extent of transaction cost. In this context, however, it is
interesting to note that a spread based strategy in many occasions yielded higher
returns than that of the buy-and-hold strategy, especially when transaction cost was
low.

OBJECTIVE OF STUDY

In this paper, an attempt is made to assess the usefulness of spread between E/P ratio
and interest rate in the context of Indian stock market.

To explore the possibility of formulating profitable business/trading strategy using

spread.

METHODOLOGY

For assessing the information content of spread about future stock market return,
following analytical tools and methodologies are employed in the study-
• Correlation/Cross-Correlation Analysis
• Regression Analysis

• Granger’s Causality Test

Database

In study, both weekly and monthly data are used. The basic variable covered in weekly
database pertain to weekly average stock price index, E/P ratio of the index portfolio
and a representative interest rate from the week ended January 6, 1996 to the week
ended December 30, 2000. The monthly database also covers these basic variables for
the months from January 1996 to December 2000. The data on return and spread are
derived from these basic variables.
Closing value of BSE National index (i.e. BSE-100 index) is considered for calculating
stock market return
The study has used the call money rate and the Bank Rate as indicators of short-term
interest rate.

Conclusion

Empirical results shows spread seems to have reasonably strong causal influence on
return and the causal model helps achieving forecasts better than the random walk
model, the usefulness of spread in formulating a profitable business strategy is not
clear. Empirical work in the paper reveals that the performances of different strategies
vis-à-vis a simple buy-and-hold strategy, crucially depend on several factors like the
choice of interest rate, choice of trading period and choice of threshold for determining
extreme values of spread. Study also reveals that the profitability of a spread based
trading strategy would crucially depend on the extent of transaction cost. In this context,
however, it is interesting to note that spread based strategies in many occasions yielded
higher returns that of the buy-and-hold strategy, especially when transaction cost was
low.
 CHAPTER 3

RESEARCH METHODOLOGY
Statement of Problem

The issue of whether the spread between Earning/Price (E/P) ratio and interest rate
contains useful information about the movement of stock market is a matter of empirical
investigation in recent years. Therefore, in this paper, an attempt is made to assess the
effects of spread between E/P ratio and interest rate on Indian stock market.

Objective

• To find out the relationship between spread between E/P ratio and interest rate
and S&P CNX Nifty returns.
• To find out weather change in interest rate effects S&P CNX Nifty returns.

Study Design

a) Study Type:

The study type is analytical, quantitative and historical. Analytical because facts and
existing information is used for the analysis, Quantitative as relationship is examined by
expressing variables in measurable terms and also Historical as the historical
information is used for analysis and interpretation.

b) Study population:

Population is the daily closing prices of S&P CNX NIFTY Index.

c) Sample:

• Daily closing values of S&P CNX NIFTY Index from 08-08-2000 to 30-4-2007.
• Interest rate- Call money rate (maximum) from 08-08-2000 to 30-4-2007.
 e) Sampling technique:

Deliberate sampling is used because only particular units are selected from the
sampling frame. Such a selection is undertaken as these units represent the population
in a better way and reflect better relationship with the other variable.

SAMPLE SIZE AND DATA SOURCES

In this study S&P CNX Nifty index has been considered as a proxy for the stock market
and accordingly the closing index values were collected from Aug. 08, 2000 till April 30,
2007.

In a study, Balasubramanian and Narasimhan (1999) made an attempt to assess to

what extent various indices reflect the market performance. Their empirical results
suggest that the similarity in behavior of various indices e.g. BSE National index,
Economic 100 index, Financial Express 100 Index, NSE-50 etc.

For Interest rate Call money rate (maximum) from Aug 08, 2000 to April 30, 2007 has
been taken.

As per some studies, possible proxies for short-term interest rate would be, call money
rate, yields on certain Treasury Bills, Deposit Rate, Bank Rate., etc.

LIMITATIONS OF THE RESEARCH

• Data considered for the period from Aug 08, 2000 to April 30, 2007 only.
• Sample is restricted to S&P CNX Nifty index
• For few dates in between complete data is not available, so in order to not getting
any misrepresenting figures we excluded those dates as a whole.
• For simplicity calculation is been made on a daily basis.
• There is change in methodology for calculation of P/E ratio for S&P CNX Nifty
w.e.f. Dec 20, 2004, which is not taken into consideration in this study.
 CHAPTER 4

DATA ANALYSIS
Analysis and Interpretation

Steps followed in the analysis

• The data is collected from

1. S&P CNX NIFTY Index.

2. Call money rate(maximum)

• Closing index values were collected from Aug. 08, 2000 to April 30, 2007.
• Return were calculated by-

Where, Rt = Return at time point t

Pt = Price at time point t
Pt-1 = Price of previous day

• E/P ratio is been calculated by inversing P/E ratio

• Spread is been calculated between interest rate and E/P ratio on daily basis.

Sp = E/P - Call

Where, Sp = Spread between E/P ratio and Call money rate

E/P = 1/ [P/E ratio]
Call = Call money rate
 • Results on Investigating Relationship Between Spread and Return

Correlation between Return and spread

Correlations

Return spread
return Pearson Correlation 1 -.016
Sig. (2-tailed) .524
N 1573 1573
spread Pearson Correlation -.016 1
Sig. (2-tailed) .524
N 1573 1574

Interpretation

As it is clear that Pearson Correlation between return and spread is low (-.016),
therefore it is clear that there is near to no correlation between return and spread.
 • Results on Investigation of Granger’s causality test

Pairwise Granger Causality Tests

Sample: 1 1578
Lags: 2
Null Hypothesis: Obs F-Statistic Probability
Return does not Granger Cause Close 1571 2.71003 0.06685
Close does not Granger Cause Return 0.33482 0.71552
Spread does not Granger Cause Close 1571 0.91782 0.39960
Close does not Granger Cause Spread 0.90055 0.40656
E/P does not Granger Cause Close 1571 3.43454 0.03248
Close does not Granger Cause E/P 1.90963 0.14848
Call does not Granger Cause Close 1571 0.92347 0.39736
Close does not Granger Cause Call 0.87471 0.41719
Spread does not Granger Cause Return 1571 0.14009 0.86929
Return does not Granger Cause Spread 0.93688 0.39207
E/P does not Granger Cause Return 1571 5.04567 0.00654
Return does not Granger Cause E/P 6.10514 0.00228
Call does not Granger Cause Return 1571 0.14188 0.86774
Return does not Granger Cause Call 0.93636 0.39227
E/P does not Granger Cause Spread 1571 8.68787 0.00018
Spread does not Granger Cause E/P 2.12754 0.11947
Call does not Granger Cause Spread 1571 8.68787 0.00018
Spread does not Granger Cause Call 8.51210 0.00021
Call does not Granger Cause E/P 1571 2.12754 0.11947
E/P does not Granger Cause Call 8.51210 0.00021

Interpretation

From the above Granger’s Causality Test we can easily find that there is strong
relationship (F test) between E/P ratio and Spread (8.68787), Call money rate and
Spread (8.68787), Spread and Call money rate (8.51210) & E/P ratio and Call money rate
(8.51210). Though there is relationship exist between E/P ratio and Return (5.04567) &
Return and E/P ratio (6.10514) but it is not that strong.
From this, we can interpret that –
- Spread is causing E/P ratio
- Spread is causing Call money rate
- Call money rate is causing Spread
- Call money rate is causing E/P ratio

It is also established that there is no direct relationship between Spread and Market
return.
• Results on Regression Analysis

- Regression between Call money rate and Market return

Variables Entered/Removedb

Variables Variables
Model Entered Removed Method
1 returna . Enter
a. All requested variables entered.
b. Dependent Variable: call

Model Summary

Adjusted Std. Error of

Model R R Square R Square the Estimate
1 .016a .000 .000 3.69246
a. Predictors: (Constant), return

ANOVAb

Sum of
Model Squares df Mean Square F Sig.
1 Regression 5.482 1 5.482 .402 .526a
Residual 21419.372 1571 13.634
Total 21424.854 1572
a. Predictors: (Constant), return
b. Dependent Variable: call

Coefficientsa

Unstandardized Standardized
Coefficients Coefficients
Model B Std. Error Beta t Sig.
1 (Constant) 6.847 .093 73.435 .000
return 3.930 6.198 .016 .634 .526
a. Dependent Variable: call
Interpretation

As it can be seen from ANOVA table that value of “F” is low (.402) but “t” in coefficients
is comparatively high (73.435) which shows that there is some significant relationship
between these two.
CHAPTER 5

CONCLUSION
Market practitioners frequently use spread to get higher returns. Moreover, evidence
from the developed economies suggests that the information on spread could be useful.
In this study, we have employed various statistical and econometric tools for rigorously
assessing the usefulness of spread in explaining stock market return. Results, at this
stage, however, are not conclusive. In this study, we find that though spread seems to
have reasonably strong causal influence on E/P ratio and Call money rate but there is
no influence on Market Return as such. Further after running regression analysis
between Call money rate and Market Return where Call money rate is taken as
Dependent variable and Market return is taken as Independent variable we find that
there is low relationship exist.
ANNEXTURE
Bibliography

BOOKS
1. Basic Econometrics: By Damodar N. Gujrati
2. Introductory Econometrics: By Ramu Ramanathan

ECONOMETRICS SOFTWARE PACKAGES

1. Eviews
2. SPSS

REFERENCES

• G. P. Samanta and Kaushik Bhattacharya “Is the Spread between E/P Ratio
and Interest Rate Informative for Future Movement of Indian Stock
Market?” NSE RESEARCH INITIATIVE PAPER NO.: 9

• Rolph, Douglas and Pu Shen (1999), “Do The Spreads Between the E/P Ratio
and Interest Rates Contain Information on Future Equity Market
Movements?” Research Working Paper, Federal Reserve Bank of Kansas City,
RWP 99-03 (March).

• Market-Timing Strategies That Worked - Pu Shen, MAY 2002, RWP 02-01

Research Division, Federal Reserve Bank of Kansas City

• Can the Forecasts Generated from E/P Ratio and Bond Yield be Used to
Beat Stock Markets?, Wing-Keung Wong, Department of Economics Working
Paper No. 0201.

• Macroeconomic Variables and the E/P Ratio By Prem C. Jain, Joshua G.

Rosett