Return Correlation Between Stock Markets and Real Estates - Essay Example

?Volatility Modelling Study on China’s return correlation between Stock Markets and Real E s IntroductionChina is one of the countries that have experienced a tremendous growth and has achieved spectacular success over the last few decades. These changes have influenced china’s key investment markets, stock markets, and real estate to undergo a series of transformation and development. These changes have taken place since the first initiation of economic reforms, a time when open policy was adopted in 1978. Close follow up shows that China’s economy has slightly outdone Japan’s, in terms of the GDP. This achievement suggests that in a few years to come China will only be a step behind the United States in terms of the largest economy. According to Lai and Yang’s (2009) report, after the two main stock exchanges Shenzhen Stock Exchange and Shanghai Stock Exchange that were launched in 1990, the state owned enterprises have been developed and supported by this two markets financially to a great extent. Taking a closer look at China’s stock markets and real estate it is not clear whether this two components are correlated or not. In this paper, we use volatility models to compare results between the two markets and finally establish whether the two are correlated as we further establish their potential variation effects. In this case we monthly data sets ranging from the year 2005 to 2010. From the data, several statistical test is applied to measure the rate of return on the correlation between the two markets, stock markets, and real estate. Stock Investment In general, investors purchase common stock from the stock market in terms of stock investments, which generate dividends that earn those profits or capital gain because of positive shift in the stocks’, selling price. In a typical stock market, an investor will either receive a return on their investment or make a loss this is when the price remains constant or fluctuates (Kewon, 2010). The two key types of company shares are preferred stock and common stock. There are several reasons for investing in stock markets. The first main reason can be put as, the average returns an investor gets from common stock is usually very high considering other investment options that may be present. The second advantage is that it is possible to minimize the risk on a portfolio greatly by having diversification where several types of stocks are held (Bodie, et al., 2009). The third important advantage is that it is now very possible to sell common stock on secondary markets with minimum transaction costs. This is possible due to the high liquidity of stocks. The other important advantage is that, when compared to other investments, the pricing of common stock is not only affected by shifts in interest rates but is also affected by performance of the firm and earning prospects. Stock Market Stock markets are also referred to as equity markets. They normally provide a platform where shares can be issued, and many investors can come and trade their shares and securities. The markets are divided into two depending on how they carry out transactions. The first is exchange market, and it is usually physical where investors can come and freely trade with their securities. The second one is referred to as over the counter market. In this case, transactions are normally carried out over the phone or through the internet on the computer. The markets are also divided into two main parts, and these are primary and secondary. The primary market issues new securities such as initial public offering (IPO) while secondary markets offer securities that were previously offered and are being presented subsequently for trade. Returns and Risks of Stock Investment The first thing we need to understand is as an investor, there are two ways in which one can gain from their investment, and this is through dividends and capital gains. A capital gain is achieved because of an increase in the value of a capital asset such as stocks that an investor has taken part. This gain is usually realized immediately a capital asset is traded. On the other hand, the investor can also earn from dividends. Dividends are generated from the company’s earnings, which are shared among the shareholders. In this case, the rate of return for an investment can be computed as follows (Kewon, 2010): Rate of Return = ((ending Value-Beginning Value)+Dividend Income)/(Beginning Value) When it comes to the Chinese Stock Markets, majority of the listed companies are taking into account capital raised other than paying out dividends to investors. This has translated to a very low level of dividend payout amongst the listed companies on the Chinese stock markets. This trend has led to change on the return on investment formula where the calculation only involves the capital gains and leaves out the dividends. The risk presented by an investment can be divided into two key parts; these are systematic and unsystematic risks. A systematic risk refers to the market risk that affects the entire market’s or all the assets and cannot be removed through the use of diversification methods such as economic recession, earthquake and interest rates. In reality, a well-diversified portfolio is always at risk of a systematic risk. On the other hand, un-systematic, unique, specific, or diversifiable risk is a type of risk that only affects an individual asset, an industry, or a company. The good part about this risk is that it can be diversified (Howell & Bain, 2008). The unsystematic risk presented by a portfolio can be measured using Beta. In this case, Beta refers to the degree in which a stock is able to respond in relation to shifts in the market portfolio, for example, the S&P 500 Index (Kewon, 2010). The primary value for Beta is 1.0 an increase in this value means the stock price is increasing at a higher rate than the market, and a value below 1.0 means the stock price is moving at a slower rate than that provided by the market. Real Estate Investment The appropriate definition of real estates is something that is taken as immovable such as land, sheds, trees, buildings, and roads. However, in business this is term is usually used to specify the ownership of real estate that can be leased bought or sold. This happens mostly so as to gain monetary value from price appreciation and rent income generated from tenants. It should be noted that real estate involves ownership, administration, and leasing of real estates (Brueggman & Fisher, 2008). The key benefits for indulging into real estate include; a source of income that are generated by the rent paid by users of that real estate. Second advantage is that real estate is prone to appreciation; therefore, the investor can take advantage of this and benefit from the shift in value of the real estate. The third advantage an investor can make use of is that it can be used as a financial leverage. The fourth advantage that an investor may have for investing in real estate is that it may act as an inflation hedge system, which means that the investor is able to secure his or her wealth. Fifth attribute for investing in real estate is very secure investment keeping the fact that land situated in major locations tends to retain its value over years. Lastly, real estate can act as a portfolio asset, which offers investors an opportunity to spread their investment opportunities (Jaffe & Sirmans, 1995). Real estates are divided into three major parts, and these are commercial properties, vacant land, and residential properties. However, in China urbanized areas categorize houses sold into two groups that are non-residential and residential buildings. Residential consists of high quality apartments, apartments, economically affordable houses, and villas. On the other hand, non-residential buildings consist of commercial buildings such as industrial buildings, warehouses, and offices. According to a report by Hou (2009), in 2007 about 90.7 percent for the buildings sold were residential. Risks and Returns of Investing Real Estate Unlike in Stock Investment, Real Estate investment has several risks that an investor has to face. These risks may include liquidity risk, interest rate risk, financial risk, inflation risk, and business risk. In China, these risks can be divided into two key stages, the developmental and ownership stage. I developmental stage the risks are mainly related to political, permits, financing, and construction costs. The ownership stage is usually associated with risks such as interest rate, taxation, technical, and price risks (Hou, 2009). Empirical study and analysis Data description In this experimental study, the main variables used are stock composite index and the housing price index. The housing pricing index figures are from a national level (HP), Shenhen (SZHP), Beijing (GJHP), Guangzhou (GZHP), and Shanghai (SHHP). This data is outsourced from the China’s Bureau of National Statistics (NBSC) ranging from the year 2005 to 2010. For the Monthly composite index, the data is sourced from Shenzhen stock exchange (SZI) and Shanghai stock exchange (SHI). Hypothesis statement The study question states “Is there a correlation between China’s Stock Market and Real Estate returns.” In this case, the null hypothesis (H0) can be ‘there is no correlation between changes brought about by stock indexes and real estate indexes’. The alternative hypothesis (H1) is ‘there is a correlation between changes created by changes in monthly returns for stock indexes and real estate returns. An experimental study to reveal whether there is a synchronous change in monthly index returns for Chinese stock market and real estate are as below: Before carrying out the test, the following criterion is set: If probability (p-value) is higher than 0.05 we accept the null hypothesis. If p-value is below 0.05, we accept the alternative hypothesis. Pearson Correlation Coefficient is used due to the state of the data, which is numerical (Saunders, et al., 2009) Results and analysis Table 1 Monthly Changes in Returns between Stock Indexes and Real Estate using Pearson Correlation Coefficients . pwcorr dHP dBJHP dSHHP dGZHP dSZHP dSHI dSZI, sig star(.05) dHP dBJHP dSHHP dGZHP dSZHP dSHI dSZI dHP 1.0000 dBJHP 0.6650* 1.0000 0.0000 dSHHP 0.5837* 0.3736* 1.0000 0.0000 0.0033 dGZHP 0.2870* 0.0957 -0.0380 1.0000 0.0262 0.4672 0.7731 dSZHP 0.3328* 0.2515 0.2717* 0.0890 0.0094 0.0526 0.0357 0.4989 1.0000 dSHI 0.0453 -0.1284 0.0720 -0.0305 0.0617 1.0000 0.7309 0.3281 0.5844 0.8171 0.6396 dSZI -0.0199 -0.1491 0.0457 -0.1608 -0.0074 0.9240* 1.0000 0.8798 0.2555 0.7287 0.2196 0.9550 0.0000 Source: Statistical data output from STATA From the results, the following assumptions are made Correlation between national housing price dHP and Shenzhen composite index dSZI There was a weak correlation of -0.0199 and a p-value of 0.8798. In this case, the value is above 0.05 therefore, there is no correlation. Correlation between national housing price dHP and Shanghai composite dSHI The result is a weak positive of 0.0453. Using a two-tailed test with a significance level of 0.05 the result is a p-value of 0.7309, which is above 0.05. This means there is no correlation. Conclusion Using the results generated by the experiment, we can gather the following information. The changes from monthly returns on China’s stock composite indexes (dSZI & dSHI) and the selected local housing price indexes (dBJHP, dSZHP, dSHHP, & dGZHP) all have pearson correlation coefficient that is not exactly zero. Their p-values are also greater than 0.05. We can therefore conclude that the two markets are not correlated. In general, the best advice from this experiment is that when investing in China’s Capital Markets, investors can take advantage of diversification benefits by ensuring that they have a balanced portfolio that has both stock and real estate assets. References Bodie, Z., Kane, A. & Marcus, A. J., 2009. Investments. 8th ed. Boston: McGraw Hill. Brueggman, W. B. & Fisher, J. D., 2008. Real estate finance and investments. 13th ed. New York: McGraw-Hill. Hou, Y., 2009. Urban Housing Markets in China. Stockholm: Royal Institute of Technology. Howell, P. & Bain, K., 2008. The economics of money, banking and finance: A European text. 4th ed. Harlow: Prentice Hall. Jaffe, A. J. & Sirmans, C. F., 1995. Real estate investment. 3rd ed. New Jersey: Prentice Hall. Kewon, A. J., 2010. Personal Finance: Turning money into wealth. 5th ed. New Jersey: Prentice Hall. Lai, S. M. & Yang, Y., 2009. From scorned to loved? The political economy of the development of the stock market in China. Global Economic Review, IV(38), pp. 409-429. Saunders, M., Lewis, P. & Thornhill, A., 2009. Research methods for business students. 5th ed. Harlow: Prentice Hall. Read More