The reforms were undertaken to widen and deepen the secondary to turn it in to a vibrant market. A vibrant secondary market is a prerequisite for the development of an active primary market. Whether reforms have made any positive impact on the volatility, liquidity, size, and transaction cost is a matter of analysis.
Volatility: Volatility of a stock measures the frequency with which changes in its market price take place over a period of time. If a stock is highly volatile, that is, if there are large fluctuations in its market prices, there is a risk and investors avoid these shares. Hence, volatility is a factor, which is taken into consideration when assessing the risk return trade offs. Moreover volatility has macroeconomic implications in the sense that the quantum of the external flow of funds is influenced by the volatility of stocks.
Volatility is caused by a number of factors such as speculation, trading and settlement system, government budget, inflation, interest rates, announcement of corporate results, extent of integration with international markets, regulatory framework governing the stock market, and so on. All these factors directly or indirectly influence the movements in share prices.
Indian stocks are found to be highly volatile. The volatility of the Indian stocks can be measured in terms of the coefficient of variation (CV) in the BSE Sensex and S&P CNX Nifty.
The coefficient of variation in both BSE Sensex and S&P CNX Nifty was high in the years 1998-99 and 1999-2000. This indicates a high volatility of Indian stocks. The factors responsible for high volatility were as follows:
(1) Inclusion of the new economy stocks, most of which were over-valued in the BSE Sensex
(2) Increased influence of international stock indices, especially NASDAQ. The repercussions of the crash in technology stocks on NASDAQ were witnessed on Indian IT stock also.
(3) High speculation when the badla system was prevalent led to large fluctuations in prices.
(4) Day trading increased which led to wild fluctuations in intra-day prices.
(5) Investment by foreign institutional investors: FIIs exit the markets at the slightest whiff of trouble. This increase volatility in the stock markets. Domestic investors follow FIIs and emulate their investment pattern. If FIIs buy, everyone buys and if FIIs sell, everyone sells.
(6) Indian markets have high volume but they lack depth as the volumes are contributed by few institutional participants. Indian markets lack hedge funds and pension funds, which can take a long term view of the markets. Moreover, domestic financial institutions like UTI, which used to act as a counter force in the time of crisis, have stopped being a force to reckon with. This lack of depth increases volatility in the stock market.
The volatility in share prices was contained in 2000-01 and 2001-02 due the introduction of rolling settlement which restricts speculation.
Liquidity is one of the most important indicators that greatly influence stock market development and efficiency. It is also one of the factors affecting the price discovery mechanism. A market is considered to be liquid when large volume of trades can take place without any significant effects on price. When an investor is able to transact at a price close to the current market price in the stock market, the market is liquid.
Liquidity is an important parameter taken into consideration by foreign institutional investors for investing in a market. A highly market implies higher FII inflows and reduced liquidity implies lower FII inflows, reduced market capitalization, poor sentiments, and inability of market participants to transact easily. Moreover, corprorates are also unable to raise money from the markets for investment.
There are two methods for measuring stock market liquidity – turnover ratio and value traded ratio.
a) Turnover ratio: It equals the total value of domestic shares traded divided by market capitalization. This ratio measures the trading of domestic equities on domestic exchanges relative to the size of the market. High turnover is often used as an indicator of low transaction costs. The turnover also compliments the measure of stock market size since markets may be large but inactive. A large but inactive market will have a large market capitalization ratio but a small turnover ratio.
b) Value traded ratio: It equals the total value of domestic shares traded on the major stock exchanges divided by gross domestic product (GDP). It measures organized trading of firm equity as a share of national output and, therefore, reflects liquidity on an economy wide basis.
The value traded ratio captures trading relative to the size of the economy, while the turnover ratio measures trading relative to the size of the market. Thus, a small liquid market will have a high turnover ratio but a small value ratio. Such a stock market would not provide significant liquidity to the economy as a whole.