Market Sentiment Dynamics and Return Volatility in the Indian Equity Market

In this study, we constructed a composite index of irrational market sentiment to ascertain the impact of market sentiment upon return volatility in the Indian equity market using monthly data spanning the time period from April 2007 to January 2015 of four major indices of Bombay Stock Exchange such as : BSE Sensex, BSE 500, BSE Mid-cap, BSE Small-cap. The Sentindex significantly portrayed the fluctuations in accordance with the events that took place in the market during the period of analysis, and at the same time, its movements were found to be uncorrelated with that of economic fundamentals. Though the graphical analysis showed indications of higher fluctuations in returns in times of pessimistic sentiments and moderate and calm period of volatility regimes with moderate positive sentiment in the market, from further investigation, we observed that the effect of sentiment was significant only in case of the volatilities in medium and small cap portfolio returns. On examination of temporal dependency, based on ARDL modeling, we noticed significant long-term relationship between return volatility and irrational sentiments in case of such portfolios. An initial shock in the sentiment component was found to create varying magnitude of responses in volatility over the months and was observed to be disappearing after four to five months. These observations necessitate the incorporation of sentiment factors in the pricing models of assets as well as in risk estimation, especially in case of those stocks with the characteristics that are sensitive to market sentiment. Along with this, in order to pinpoint the causes of the persistence of sentiment effects, further investigations on : the nature and trading behavior of investors who participate in such market segments, level of trading and fund flows, sophistication of trading mechanism, and effectiveness of policy level initiatives to eliminate market inefficiency in these segments is recommended.