CHAPTER II LITERATURE REVIEW. 2.1 Indonesia Stock Exchange (IDX)

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1 CHAPTER II LITERATURE REVIEW 2.1 Indonesia Stock Exchange (IDX) Indonesia Stock Exchange also as known as Jakarta Stock Exchange and Surabaya Stock Exchange, by the act No.8 of 1995 concerning the Capital Market reaffirmed the role of both the exchange as Self Regulatory Organizations (SROs). Since then, JSX has grown rapidly due to the implementation of technology including Jakarta Automated Trading System (JATS) in 1995, scrip less trading in 2000 and remote trading in In the meantime the SSX successfully developed bond and derivative markets, in the brink of 2007, both of JSX and SSX was consolidated into IDX (Indonesia Stock Exchange) this consolidation was expected to increase the role of the Capital Market in Indonesia s economy. IDX uses Indonesian Rupiah (IDR) as its currency, the major index in IDX are Jakarta Composite Index (JKSE), LQ-45 which contains 45 most liquid company stocks, and Jakarta Islamic Index, JKSE or IHSG is the indices that used in this thesis, the formula to calculate index value is as following : Index value = the sum product of regular closing price with number of shares / Base value x 100, where base value is the sum product of base price and number of shares. In December 2009 IDX market capitalization reached IDR 2, trillion or increased by 87.59% from previous year IDR 1, trillion, with 398 listed companies compare to 396 companies in 2008, with share turnover value of IDR 944 trillion or 46.75% of its market capitalization. 14

2 2.2 Tokyo Stock Exchange (TSE) Other than USD/IDR Exchange rate the movement of regional indices might affect investor behavior towards their investment activity in Indonesia Stock Exchange that would affect the trend of Indonesia Stock Index as known as IHSG. The first stock indices used in this thesis is Nikkei 225, which is one of the Japan Stock Market Index for the Tokyo Stock Exchange, that have been calculated by the Nihon Keisai Shimbun or Nikkei newspaper since 1950 that consist of 225 top-rated Japanese companies listed in the First Section of the Tokyo Stock Exchange. Currently Nikkei is used as the major indicator for the Japanese economy. The method they use in calculating the index is equal weighted index a method that calculate market capitalization for each stock is redefined so that each index constituent has an equal weighting in the index, it is designed to reflect the overall market, there is no specific weighting of industries, Nikkei prices is denominated in Japanese Yen. In 2008 and 2009 Nikkei 225 indices stock average was Yen and Yen respectively. Tokyo Stock Exchange first section market Capitalization on December 2009 was 302,712,168 million Yen (equivalent to IDR 30,271 trillion, with 1 Yen = 100 IDR, which consist of 1684 listed companies, with USD 3,990.9 billion (equivalent to IDR 39,909 trillion, with 1 USD = 10,000 IDR) of share turnover value, which is % of its market capitalization. 15

3 2.3 Hong Kong Stock Exchange (HSI) The Second stock indices used in this thesis is Hang Seng, the most widely use indices in the Hong Kong Stock Market, it includes the largest and most liquid stocks listed on the main board of the Stock Exchange of Hong Kong. HKSE allows derivatives to be traded. Hang Seng Indexes Company Limited is a wholly-owned subsidiary of Hang Seng bank, and is Hong Kong s leading index compiler covering Hong Kong and mainland China markets, and has been use since 1969 as the barometer of the Hong Kong stock market, the indexes are grouped into four categories: Flagship Indexes, Benchmark Indexes, Thematic Indexes and Strategy Indexes, then classified as Hong Kong-listed, Cross-market or mainland-listed according to where their constituents are listed, the currency used in Hang Seng index or HSI, is Hong Kong Dollar (HKD), most of listed constituent in HSI is financial sector (11 constituents), and followed by properties & Construction (7 Constituents), largest market capitalization in HSI is HSBC Holdings (15% of total market capitalization), and followed by China Mobile (8% of total market capitalization). Hangseng Index covered 65% of the total market capitalization, to be included in Hangseng index a constituent is selected by rigorous process of detailed analysis, supported by extensive external consultation, top 90% of the total market value of all eligible shares listed on the HIS, the index is calculated using weighting and free float adjustment. Fuelled by abundant capital inflow Hong Kong Securities market capitalization in 2009 reached HKD 17.9 trillion (equivalent to IDR 21,480 trillion with 1 HKD = 1,200 IDR) grow by 74% from 2008, the share turnover in 2009 reached USD 1,

4 billion (equivalent to IDR 15,016 trillion, with 1 USD = 10,000 IDR) or 69.91% of its market capitalization. 2.4 Shanghai Stock Exchange (SSE) Shanghai Stock Exchange (SSE) is directly governed by the China Securities Regulatory Commission (CSRC), it has 14 indexes, the one that calculated in this thesis is SSE composite that consist of A Shares and B shares, which is launched on 15 July 1991, the A shares are denominated in CNY, and B shares are denominated in USD, with A shares are restricted to domestic investor only, and B shares are allowed for both domestic and foreign. SSE is the second largest market capitalization in Asia, behind Tokyo Stock Exchange, the currency used in trading is denominated in Chinese Renminbi (CNY), the indices are calculated using a Paasche weighted composite price index formula, the index is calculated on its base period for its calculation, the formula in calculating is Current index = Current total market cap of constituents x Base value/base Period. Some of the largest stocks by market capitalization in SSE are Petro China, Industrial and Commercial Bank of China, Sinopec, Bank of China, and China Life. SSE market capitalization in 2009 was USD billion (equivalent to IDR 27,047 trillion with 1 USD = 10,000 IDR) with 870 listed companies, Shanghai Stock Exchange share turnover in 2009 was USD billion (equivalent to IDR 50,615 trillion IDR, with 1 USD = 10,000 IDR), it is the highest share turnover in this thesis indices variable, with % share turnover ratio. 17

5 2.5 Singapore Stock Exchange (SGX) Singapore Stock Exchange, is the company that came from the merger of two established and well-respected financial institution Stock Exchange of Singapore and Singapore International Monetary Exchange, in SGX derivatives is allowed to be traded, the trading session starts from 9 AM until PM and 2 PM until 5 PM, 2 major indices are use in SGX, the first one is MSCI Singapore Free Index and Strait Times Index (STI) that used in this thesis. The Currency used in SGX is Singapore Dollar (SGD). STI uses market value weighted stock market index based on 30 representative companies stocks that listed on SGX, it represented about 61.2% of the total market capitalization. Industrial transportation is the biggest sector in STI (30%), followed by General Industrial (18%), and Fixed Line Telecom (15%). The formula in calculating the index is Index level = total market capitalization x free float factor/index divisor, where free float factor represent the proportion of shares that is free floated as a percentage of issued shares. SGX market capitalization in 2009 was USD billion (equivalent to IDR 4,812 trillion with 1 USD = 10,000 IDR), with 773 listed companies in 2009, with share turnover ratio of 51%, with total value USD billion (equivalent to IDR 2,454 trillion with 1 USD = 10,000 IDR) 18

6 2.6 Foreign Exchange Rate Foreign Exchange rate is a term that specify how much one currency is worth in terms of the other home nation s currency, spot exchange rate refers to the current exchange rate, and the forward exchange rate is a rate that quoted and traded today but its delivery and payment is at specific future date. Foreign exchange rate that being observed in this thesis is USD against IDR, in the international market by spot rate that provided by bloomberg, data taken from 1 January 2008 until 31 December 2009, with average value in 2008 equal to /USD, in 2009 the average value increased by 7.24%, IDR depreciated against USD happen in the brink of 2008, as Indonesia foreign reserve depletes on that time, but as Indonesia foreign reserves increases, the exchange value became more and more stabilize. 2.7 Risk Free Rate The rate that used as risk free rate in this thesis is BI rate, which is an interest rate that reflect monetary policy stance that the government announce to the public. BI rate is announce by BI board of governor meeting each month and be implemented in BI monetary operation to conduct liquidity management on the money market to achieve monetary operational target. The monetary policy operational target is reflected in movement in the interbank overnight rate (O/N rate). BI will normally raise the BI rate if the future inflation is forecasted more than established inflation target, and the other way around. 19

7 2.8 Relation of Stock Index, Forex and Interest Rate The relation of stock index, foreign exchange rate and BI rate, could be explain seen through 2 approaches, there are portfolio approach and traditional approach. According to portfolio approach, the changes in stock market lead to changes in exchange rate due to portfolio adjustment made by foreign investor, portfolio adjustment refers to the process of inflow and outflow of capital from home country to host country or vice versa. Traditional approach see the exchange rate changes affect the balance sheet of a firms by changing their asset and liabilities, that denominated in foreign currency, thus changing its profitability and affect its competitiveness, which its performance will ultimately reflected in the stock market (Abbas and Javed, 2010). 2.9 Previous Studies the first examination of the relation of stock prices with exchange rates, were done in 1972, where concluded that there were no relationship existed between stock return and exchange rates on the basis of empirical analysis of six different exchange rates (Frank and Young, 1972), but using different econometric technique; regression of the stock price indices and dollar exchange rate over a period of 1974 to 1978 were found there were a positive correlation between both of them, and the relationship were found stronger in the short run than in the long run using traditional approach (Aggarwal et al, 1981). Using portfolio approach, that examines the association between exchange rate and U.S stock market indices, were concluded that decrease in value of currency leads to rise in stock 20

8 market returns and vice versa (Ong, 1999) the method used was non-linear least square method. Most studies in the 1990s applied cointegration technique. The result of Granger causality test that done in a established market in a advanced country; Japan and Hong Kong, shows that the relationship between stock prices and exchange rates displayed a strong long-run relationship, and there were a bidirectional Granger causality found in Tokyo Stock Market and unidirectional Granger causality for Hong Kong (Yu, 1997). But it is evident that there is no consensus from both the theoretical and empirical literature on the direction of causality between stock price and exchange rates, was found to be so in both the advanced Asian and emerging countries, since the countries and the regions were so diverse and the result were so mixed, however there were more evidences suggesting that changes in exchange rate would lead stock prices to fluctuate, most cases with a negative sign, means that an appreciation in foreign exchange rate would cause stock price to fall (Alexandra and Livia, 2007). In Nigeria the test of foreign exchange relation with its stock market was also done using data from 2001 to 2008 and with Augmented Dickey Fuller (ADF) and the Philips and Perron (PP), in addition the Engle and Granger two-step and the Johansen and Juselius Cointegration procedures were applied, the result from shows that stock prices and exchange rate are bound together in the form of bidirectional relationship in the long-run, means that if Naira exchange rate appreciate, it would bring a rise in stock price in Nigeria; or an increase in stock price has a positive effect on the appreciation on its exchange rate (Aliyu, 2009). Another study observe in Pakistan, India, Korea, Srilanka and Indonesia, using Johansen Cointegration technique and Granger Causality test, Granger-causality 21

9 test was done to explore the short run linear relationship. While the long-run relationship were tested using Johansen cointegration test to see stock market return relate to exchange rate return, the result negates the existence of any long run linkage between stock market and currency markets in all the sample economies, but in short run though at different level, has been found running from exchange rate to stock market in Pakistan, India and Indonesia. (Abbas and Javed, 2010) analysis period starts form July 1997 to October Investor sentiment has the potential to affect stocks return, and it is already considered self-evident by most practitioners (Byrne, Brooks, 2008), it is also said that information in the form of suggestion in pricing securities would affect investor behavior in taking investment activity for short-term (up to 12 months) period. Investor suffer conservatism bias, means that they are slow to change their beliefs in the something new, they tend to use what they are already know, believe in what other investor believe, and they also follows other investor behaviors (Hong, Kubik, and Stein, 2005). 22