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CHAPTER: 1

INTRODUCTION

Portfolio investment flows from industrial countries have become increasingly important for

developing countries in recent years. The Indian situation has been no different. In the year

2000-01 portfolio investments in India accounted for over 37% of total foreign investment in the

country and 47% of the current account deficit. The corresponding figures in the previous year

were 59% and 64% respectively. A significant part of these portfolio flows to India comes in the

form of Foreign Institutional Investors (FIIs) investments, mostly in equities. Ever since the

opening of the Indian equity markets to foreigners, FII investments have steadily grown and they

are highly volatile in nature net FII flow in 1995-96 was $2009 million, $20,328 million in 2007-

08, -$15,017 million in 2008-09 and $23,611 million up to January 2010.1 The nature of the

foreign investors decision-making process that lies at the heart of the portfolio flows.

International portfolio flows, as opposed to foreign direct investment (FDI) flows, refer to capital

flows made by individuals or investors seeking to create an internationally diversified portfolio

rather than to acquire management control over foreign companies. Diversifying internationally

has long been known as a way to reduce the overall portfolio risk and even earn higher returns.

Investors in developed countries can effectively enhance their portfolio performance by adding

foreign stocks particularly those from emerging market countries where stock markets have

relatively low correlations with those in developed countries. The portfolio investors problem

may be thought of as deciding upon appropriate country weights in the portfolio so as to

maximize portfolio returns subject to a risk constraint, or in the absence of a pre-specified risk

1 Foreign Investment Flow in India, RBI Bulletin, January (2010), pp. 1827-1832.

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level, to reach the optimum portfolio since the variability of the portfolio return depends on the

correlation matrix of the country level returns, emerging markets with their lower correlation

with developed markets help to reduce the overall risk of the investor. Thus, emerging markets

like India are naturally attractive to international portfolio investors as investment destinations.

Beginning in the mid-80s several of these markets that were previously closed to foreign

investors, began to liberalize making portfolio investments possible and portfolio investments

poured into them in the 90s till the Asian crisis. While it is generally held that portfolio flows

benefit the economies of recipient countries, policy-makers worldwide have been more than a

little uneasy about such investments. Portfolio flows often referred to as hot money are

notoriously volatile compared to other forms of capital flows. Investors are known to pull back

portfolio investments at the slightest hint of trouble in the host country often leading to

disastrous consequences to its economy. They have been blamed for exacerbating small

economic problems in a country by making large and concerted withdrawals at the first sign of

economic weakness. They have also been held responsible for spreading financial crises

causing contagion in international financial markets. International capital flows and capital

controls have emerged as an important policy issues in the Indian context as well. The danger of

Mexico-style abrupt and sudden outflows inherent with FII flows and their destabilizing effects

on equity and foreign exchange markets have been stressed.

FOREIGN INSTITUTIONAL INVESTMENT IN INDIA: AN OVERVIEW

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FII flows to India formally began in September 1992 under the foreign portfolio investment

(FPI) scheme, when the Guidelines for Foreign Institutional Investment were issued by the

Government of India. In November 1995, the Securities and Exchange Board of India (SEBI)2

enforced the Securities and Exchange Board of India (Foreign Institutional Investors)

Regulations, 1995 (henceforth, referred to as SEBI FII Regulations) to regulate matters relating

to FII investment flows. At present, investment by FIIs is jointly regulated by this and

Regulation 5(2) of the Foreign Exchange Management Act(FEMA), 1999. The SEBI regulations

require FIIs to register with the SEBI and also obtain approval from the Reserve Bank of India

(RBI) under the FEMA for securities trading, operating foreign currency and rupee bank

accounts and remitting and repatriating funds. In the entire process of FII registration and

regulation, the SEBI acts as the nodal authority and once SEBI registration has been obtained, an

FII does not require any further permission for trading securities or for transferring funds into or

Out of India. The SEBI FII Regulations and RBI policies are amended and modified from time to

time in response to the gradual maturing of the Indian financial market and changes taking place

in the global economic scenario. Such modification, needless to mention, is required to be done

to ensure quantitative as well as qualitative improvements in the portfolio flows through the FII

route, as India has to compete with other Asian nations and other emerging markets of the world

for global capital inflows. In India, FII investment (in shares and debentures) started in January

1993. After that number of FII registered with SEBI and investment in India both has increased.

[FIGURE: 1.1]

2Empowered by the Securities and Exchange Board of India Act, 1992.

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SOURCES: SEBI web site .www.sebi.gov.in

The sources of these FII flows are varied. The FIIs registered with SEBI come from as many as

28 countries (including money management companies operating in India on behalf of foreign

investors). US-based institutions accounted for slightly over 41%, those from the UK constitute

about 20% with other Western European countries hosting another 17% of the FIIs (see Figure

1.1). It is, however, instructive to bear in mind that these national affiliations do not necessarily

mean that the actual investor funds come from these particular countries. Given the significant

financial flows among the industrial countries, national affiliations are very rough indicators of

the home of the FII investments. In particular institutions operating from Luxembourg, Cayman

Islands or Channel Islands, or even those based at Singapore or Hong Kong are likely to be

investing funds largely on behalf of residents in other countries. Nevertheless, the regional

breakdown of the FIIs does provide an idea of the relative importance of different regions of the

world in the FII flows.

HISTOGRAM AND DESCRIPTIVE STATISTICS OF FII FLOW

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FIGURE: 1.2 (Values are in Rs.) Crore

SOURCES: SEBI web site .www.sebi.gov.in

FII flow which started in the year of 1992-93 was not able to bring huge amount of money in the

initial years up to 2003 FII flows were less than 10,000 crore But in the year of 2003-04 there

was huge surge in FII flow in the year it touched the level of 44,000 crore in 2007-08 went to

62,583.56 crore but in 2008-09 due to bad economic condition FII flow became negative and it

touched the level of -43,337.75 crore.

FII regulations by the SEBI were first introduced on November 14, 1995 in the form of the SEBI

FII Regulations. Over the years, the SEBI and the RBI together, through a variety of measures,

are trying to improve the scope, coverage and quality of FII investment. These measures include

(a) widening the array of instruments in which FIIs are allowed to trade, (b) expanding the list of

the types of funds that can be registered as FIIs in India and the entities on behalf of whom they

can invest, (c) raising the caps for FII investment in different sectors and companies, (d) easing

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the norms for FII registration, reducing procedural delays, lowering fees, etc., and (e) mandating

stricter disclosure norms, etc. A summary of the major regulatory changes relating to FIIs along

with their reference dates is as follows:

Chronology of important regulations related to FIIs3

Nov-95 SEBI empowered by the Securities and Exchange Board of India Act, 1992

institutionalized the FII regulations, known as the Securities and Exchange Board of India

(Foreign Institutional Investors) Regulations, November 14, 1995, allowing Pension Funds,

Mutual Funds or Investment Trusts, incorporated outside India; any Asset Management

Company or Nominee Company, Bank or Institutional Portfolio Manager, established or

incorporated outside India and proposing to make investments in India on behalf of broad based

funds any Trustee or Power of Attorney holder, incorporated or established outside India, and

proposing to make investments in India on behalf of broad based funds to apply for FII status to

carry out trading in equities and debentures listed on the Indian stock exchanges.

Oct-96 University fund, endowments, foundations or charitable trusts or charitable societies

were considered eligible for being registered as FIIs; FIIs were allowed to invest in unlisted

companies; Equity share investment on own account and on behalf of subaccounts increases to

10 from 5 per cent, of total capital issue of a company. Custodians asked to become members of

the clearing houses/ clearing corporations of the stock exchange(s) and participate in the clearing

and settlement process through the clearing house/clearing corporation for all securities.

Feb-97 Proprietary funds were included as eligible FIIs (for FII and subaccount).

3www.sebi.gov.in; www.rbi.org.in & www.finmin.nic.in

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Nov-97 SEBI allowed institutional investors, FIIs, stock brokers, stock exchanges etc. to make

use of the facility of warehousing of trades.

Apr-98 The gilts market was opened up to FII investment. Investments in Treasury bills and

dated Government Securities were allowed within the overall approved debt ceilings. Stock

lending permitted through an approved intermediary in accordance with stock lending scheme

Jun-98 FIIs allowed to invest in unlisted companies through the 100 per cent debt route FIIs

asked to tender their securities directly in response to an open offer made in terms of the SEBI

(Substantial Acquisition of Shares and Takeovers) Regulations, 1997; FIIs allowed to buy and

sell derivative (index futures) contracts traded on a stock exchange; FIIs permitted to trade in

derivatives without requiring to take or give delivery; Transactions among FIIs with respect to

Indian stocks would no longer require the post facto confirmation from RBI; Process of approval

of sub-accounts of registered FIIs simplified. Trigger point limit for investments in Indian

companies by FIIs/ NRIs/OCBs under the portfolio scheme was raised by 2 percentage points;

ADs were to be permitted to provide forward cover to FIIs in respect of their fresh investments

in India, in equity, effective June 12, 1998. ADs were to be allowed to extend forward cover

facility to FIIs to cover the appreciation in the market value of their existing investments in

India.

16-Apr-99 In respect of investments in the secondary market, FIIs were allowed to participate in

open offers in accordance with take-over codes; in case of an open offer by a company to buy-

back its securities, the FIIs may sell the securities held by it to such company in accordance with

the SEBI (Buy-Back of securities) Regulations, 1998.

29-Feb-00 A domestic portfolio manager or domestic asset management company were made

eligible to be registered as a foreign institutional investor to manage the funds of sub-accounts,

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provided the applicant is an approved asset management company or a registered portfolio

manager and that the approval or registration is valid and no disciplinary proceeding is pending

before the Board against such applicant. In case of foreign corporate or individuals, investing in

equity, each of such sub-account (substituted forall sub accounts together) shall not invest more

than 5% of the total issued capital, within the aggregate limit of 24%, of the company in which

such investment is made. Non-resident Indians (NRIs) and overseas corporate bodies (OCBs)

registered with RBI shall not be eligible to invest as sub-account or as foreign institutional

investor.

24-Apr-00 Indian companies (other than banking companies) including those which have

already enhanced the aggregate ceiling from the normal level of 24% to 30% were permitted to

enhance the aggregate ceiling on FII investment up to 40% of the issued and paid-up capital.

20-Sep-01 In consultation with the Government, RBI permitted Indian companies to increase the

FII investment limit up to the sectoral cap/statutory ceiling, as applicable.

27-Feb-02 FIIs permitted to trade in all exchange traded derivative contracts; FII portfolio

investments will not be subject to the sectoral limits applicable for FDI except in specified

sectors.

02-Dec-04 Limit for investment by FIIs in Corporate Debt will be US $1.75 billion applicable to

FII investment in dated Government securities and T-bills only, both under 100% debt route and

general 70:30 route.

21-Jul-2008 All FIIs have to submit their monthly report to their custodians.

13-Mar-09 The Government of India reviewed the External Commercial Borrowing policy and

increased the cumulative debt investment limit by USD 9 billion (from USD 6 billion to USD 15

billion) for FII investments in Corporate Debt.

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SIGNIFICANCE OF FOREIGN INSTITUTIONAL INVESTORS

A survey of literature on portfolio investments revealed the importance of such investments for a

developing economy like Indias. Foremost, FII investments are non-debt creating flows, also a

reason why Indian policy makers sought to liberalize such flows in the wake of the BoP crisis in

1990-91. Theoretically, FII investments bring in global liquidity into the equity markets and raise

the price-earnings ratio and thereby reduce the cost of capital domestically. FII inflows help

supplement domestic savings and smoothen inter-temporal consumption. Studies indicate a

positive relationship between portfolio flows and the growth performance of an economy, though

such specific studies for India were not found. India, in the recent past few years seems to have

received a disproportionately large part of its foreign investment flows via the FII investments in

the equity markets and FII inflows had significantly contributed to the sharp increase in the

foreign exchange reserves of the economy. Without immediately implicating any significant

withdrawal of funds out of India of crisis precipitating proportions, it needs to be noted that

outflows of FII capital from the market could adversely impact the value of the Indian currency,

as FII inflows form the most significant part of foreign inflows into the economy. There are

likely to be repercussions on the growth momentum of the Indian economy if FII inflows

significantly slow down. This is because a large extent of buoyancy in consumption was possible

due to the positive wealth effects of a booming stock market and a decline in the interest rates

due to a large overhang of rupee liquidity in the system. Therefore, if FII inflows were to slow

down, it will reduce the wealth generated by the stock market, the Indian currency will

depreciate and RBI will have to draw down on the foreign exchange reserves or hike interest

rates to prevent wild swings in the exchange rate.

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CHAPTER: 2

LITERATURE REVIEW

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International portfolio flows are, as opposed to foreign direct investment, liquid in nature and are

motivated by international portfolio diversification benefits for individual and institutional

investors in industrial countries. They are usually undertaken by institutional investors like

pension funds and mutual funds. Such flows are, therefore, largely determined by the

performance of the stock markets of the host countries relative to world markets. With the

opening of stock markets in various emerging economies to foreign investors, investors in

industrial countries have increasingly sought to realize the potential for portfolio diversification

that these markets present. While the Mexican crisis of 1994, the subsequent Tequila effect,

and the widespread Asian crisis have had temporary dampening effects on international

portfolio flows, they have failed to counter the long-term momentum of these flows. Indeed,

several researchers4have found evidence of persistent home bias in the portfolios of investors

in industrial countries in the 90s. This home bias the tendency to hold disproportionate

amounts of stock from the home country suggests substantial potential for further portfolio

flows as global market integration increases over time.5

It is important to note that global financial integration, however, can have two distinct and in

some ways conflicting effects on this home bias. As more and more countries particularly the

emerging markets open up their markets for foreign investment, investors in developed

countries will have a greater opportunity to hold foreign assets. However, these flow themselves,

4French, Kenneth R & Poterba, James M, (1991), Why is there a Home Bias? An Analysis ofForeign Portfolio Equity Ownership in Japan, American Economic Association vol. 81(2),pages 222-26, May.5 Tesar, Linda L. & Werner, Ingrid M., (1995), Home bias and high turnover, Journal of

International Money and Finance, vol. 14(4), pages 467-492, August.

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along with greater trade flows will tend to cause different national markets to increasingly

become parts of a more unified global market, reducing their diversification benefits. Which of

these two effects will dominate is, of course, an empirical issue, but given the extent of the

home bias it is likely that for quite a few years to come, FII flows would increase with global

integration.

In recent years, international portfolio flows to developing countries have received the attention

of scholars in the areas of finance and international economics alike. In the 90s several papers

have explored the causes and effects of cross-border portfolio investment. Previous research has

also attempted to identify the factors behind these capital flows. The main question is whether

capital flew in to these countries primarily as a result of changes in global (largely US) factors or

in response to events and indicators in the recipient countries like its credit rating and domestic

stock market return. The question is particularly important for policy makers in order to get a

better understanding of the reliability and stability of such flows. The answer is mixed both

global and country-specific factors seem to matter, with the latter being particularly important in

the case of Asian countries and for debt flows rather than equity flows.

As for the motivation of US equity investment in foreign markets, recent research3

suggest that US portfolio managers investing abroad seem to be chasing returns in foreign

markets rather than simply diversifying to reduce overall portfolio risk. The findings include the

well-documented home bias in OECD investments, high turnover in foreign market

3 Bohn, Henning & Tesar, Linda L, (1996), US equity investment in foreign market,American Economic Association, vol. 86(2), pages 77-81, May.

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Investments and that, in general, the patterns of foreign equity investment were far from what an

international portfolio diversification model would recommend. The share of investments going

to emerging markets has been roughly proportional to the share of these markets in global market

capitalization but the volatility of US transactions were even higher in emerging markets than in

other OECD countries. Furthermore there was no relation between the volume of US transactions

in these markets and their stock market volatility. The Mexican and Asian crises and the

widespread outcry against international portfolio investors in both cases have prompted analyses

of short-term movements in international portfolio investment flows.

The question of feedback trading has received considerable attention. This refers to investors

reaction to recent changes in equity prices. If a gain in equity values tends to bring in more

portfolio inflows, it is an instance of positive feedback trading while a decline in flows

following a rise in equity values is termed negative feedback trading. Between 1989 and 1996

unexpected equity flows from abroad raised stock prices in Mexico with at the rate of 13

percentage points for every 1% rise in the flows.4 There has been, however, no evidence of

feedback trading among foreign investors in Mexico. In the period leading to the Asian crisis,

on the other hand, Korea witnessed positive feedback trading and significant herding among

foreign investors. Nevertheless, contrary to the belief in some segments, these tendencies

actually diminished markedly in the crisis period and there has been no evidence of any

4 Clark and Berko (1997), Emerging market finance, Journal of Empirical Finance, Volume10, Issues 1-2, February 2003, Pages 3-56

Crisis countries dropped sharply in 1997 and 1998 from their pre-crisis levels; it is generally held

that the flows reacted to the crisis (possibly exacerbating it) rather than causing it.

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More recent studies5 find that the effect of regional factors as determinants of portfolio flows

have been increasing in importance over time. In other words portfolio flows to different

countries in a region tend to be highly correlated. Also the flows are more persistent than returns

in the domestic markets. Feedback trading or return-chasing behavior is also more pronounced.

The flows appear to affect contemporaneous and future stock returns positively, particularly in

the case of emerging markets. Finally stock prices seem to behave on the assumption of

persistent portfolio inflows.

It is commonly argued that local investors possess greater knowledge about a countrys financial

markets than foreign investors and that this asymmetry lies at the heart of the observed home

bias among investors in industrialized countries. A key implication of recent theoretical work in

this area is that in the presence of such information asymmetry, portfolio flows to a country

would be related to returns in both recipient and source countries. In the absence of such

asymmetry, only the recipient countrys returns should affect these flows.

Examine the impact of uncertain capital flows on the growth of 60 developing countries during

the 1990s. They distinguished between total capital flows, official capital flows and private

capital flows. For the three types of capital flows, they derived a yearly uncertainty measure.

They have used the yearly uncertainty measures in Ordinary Least Square (OLS) as we as

Generalized Method of Moments (GMM) estimates, to explain the impact of uncertain capital

5 Froot, Kenneth A. & O'Connell, Paul G. J. & Seasholes, Mark S., (2001) "The portfolio flowsof international investors", Journal of Financial Economics, Elsevier, vol. 59(2), pages 151-193, February.flows on growth. They conclude that both types of estimates suggest that uncertain capital flows

have a negative effect on financial market and growth in developing countries.

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capital flows and its impact on the capital formation and economic growth taking into the

variable as net private capital flows, net direct investment, net official flows, net portfolio

investment and other net investments in 22 countries during 1992 to 2000. 6 If capital Inflows

were volatile or temporary, the country would have to go through an adjustment process in both

the real and financial market. Inflows, which take the form of direct foreign investment, are

generally considered more permanent in character. Capital flows can be promoted purely by

external factors which may tend to be less sustainable than those induced by domestic factors.

Both capital inflows and outflows when they are large and sudden have important implication for

economies. When capital inflows are large, they can lead to an appreciation of real exchange

rate. He concludes that the capital account liberalization is not a discrete event.

Examines the macro economic impact on Indian capital market7 as well as the corporate sector

and what is the macro economic effects on inflows of capital to Indian and micro economic

effects on the capital market during 1989 to 2002. He took the macro variable as FDI, FPI, NRI

deposits, external assistance and GDP/GDS/GNP. He tells that entry of international capital

flows helps to provide greater depth to the domestic capital market and reduce the systematic

risk of the economy. He argues that advanced for liberalizing capital market for liberalizing

capital market and opening them to foreign investor are to increase the availability of capital

6 Rangarajan, C (2000), Capital Flows: Another Look, Economic Political Weekly, Dec.9,PP-4421-27.7Khanna, Sushil (2002), Has India Gained from Capital Account Liberalization? Private

Capital Flows and Indian Economy in the 1990s, Paper Presented at the IDEAS Conference,International Money and Developing Countries, Dec.16-19.

with domestic industries and 9 commercial firms. On the other hand, the Indian stock market is

today largely dominated by a small group of FIIs, are able to move the market by large

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intervened. He concludes that in case of India, the microanalysis of stock market also fails to

provide any evidence that the entry of FII has reduced the cost of Indian corporate sector.

How capital flows affect a range of economic variables such as exchange rates, interest rates of

foreign exchange reserves, domestic monetary condition and financial system in India during the

period 1986 to 2001.8 She has examines how capital inflows induce real exchange rate

appreciation, stock market and real estate boom, real accumulation and monetary expansion as

well as effects on production and consumption. She investigates the impact on capital flows upon

the domestic financial sector in India. Inflows of foreign capital have a significant impact on

domestic money supply and stock market growth, liquidity and volatility. At the conclusion, the

domestic financial sector that is the banking sector and capital market in the event of a heavy

inflow of foreign capital in India. Correlation between domestic and foreign financial market

highlights Indias vulnerability to external financial shocks. For India on the relationship

between portfolio flows and some stock market indicators suggest that market price are not

unaffected by capital inflows. So far the difference between net capital inflows and current

account deficit has been positive in India.

Explaining the effects of inflows of private foreign capital on some major macroeconomic

variables in India using quarterly data for the period 1993-99.9 She analyses of trends in private

foreign capital inflows and some other variables indicate instability. She has taken the net

8Kohli, Renu (2003), Capital Flows and Domestic Financial Sector in India, Economic

Political Weekly, Feb. 22. PP-761-68.9Chakrabarti, Rajesh (2001), FII Flows to India: Nature and Causes, Money and Finance,

VOL.2, Issue 7. Oct-Dec.inflows of private foreign capital as well as macro-economic variables foreign currency assets,

wholesale price index, money supply, real and nominal effective exchange rates and exports. The

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Co integration test confirms the presence of long-run equilibrium relationships between a few

pairs of variables. But the dependence of each variable on private capital flows invalidates such

co integration except in two cases: co integration exists between foreign currency assets and

money supply and between nominal effective exchange rate and exports, even after controlling

for private capital flows. The Granger Causality Test shows unidirectional causality from 10

private capital flows to nominal effective exchange rates- both trade-based and export

based-,which raises concern about the RBI strategy in the foreign exchange market. Finally,

instability in the trend of foreign currency assets could be partially explained by the instability in

private capital flows with some lagged effect. The characteristic of international capital flows

since 1970 and summarizes some of the findings of the research conducted in the 1990s on the

effects of globalization.10 Even if international capital flows do not trigger excess volatility in

domestic financial market; it is still true that large capital flows can spark off inflation in the

presence of fixed exchange rate. He said globalization allows capital to more to its more

attractive destination, fueling higher growth. He suggests that in the short run, globalization

triggers bankruptcy of the financial system and protracted recession. The exploration of capital

flows to emerging markets in the early and mid-1990s and the recent reversal following the

crisiss around the globe have ignited once again a heated debate on how to manage international

capital flows. He indicates capital outflows worry policy makers, but so do capital inflows as

they may trigger bubbles in asset market and foster an appreciation of the domestic currency and

a loss of competitiveness.

10 Kaminsky, Graciela (2005), International Capital Flows, Financial Stability and Growth,DESA Working Paper, No.10, December.

CHAPTER: 3

RESEARCH METHODOLOGY

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A research methodology defines what the activity of research is, how to proceed, how to measure

progress, and what constitutes success.

NEED OF THE STUDY

Foreign Institutional Investors (FIIs) in Indian capital market playing an important role. FIIs in

India include Assets Management Companies, Pension Funds, Mutual Funds, Incorporated

Portfolio Managers, Charitable Trusts and charitable societies etc. SEBI acts as the nodal point in

the entire process of FIIs regulations. It frames legal framework for FIIs. Investment in India is

regulated under SEBI (FII) regulations 1995.FIIs are required to allocate their investment

between equity and debt instruments in the ratio of 70:30. (however, it is also possible for an FII

to declare itself a 100 percent FII in which case it can make its entire investment in debt

instrument).FIIs can buy or sell securities on stock exchange. They can also invest in listed and

unlisted securities outside stock exchange, where the price has been approved by RBI. FII

investment is frequently referred to as hot money for the reason that it can leave the country at

the same speed at which it comes in. In any country stock market (and its return) is considered as

symbol of countrys growth and FII would like to invest in those countries that provide better

return. Same is the case with India, so study will explore the impact of selected variable on

Foreign Institutional Investor flow in the Indian stock market.

OBJECTIVES OF THE STUDY

To study the relationship between FIIs flows and Bombay Stock Exchange returns.

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To find out the impact of macroeconomic variable (such as Industrial Production) on FIIs

flow to Indian stock market.

To find out the relationship between exchange rate and net FIIs flows to Indian Stock

Market.

SCOPE OF THE STUDY

The study will explore the relationship of net FIIs flow to Indian stock market with its possible

co-variants based on the monthly data set for period January 2009 to January 2010.

RESEARCH DESIGN

A research design specifies the methods and procedures for conducting a particular study. It is an

exploratory research because secondary data is used for purpose of research and in this research

following research methods has been used.

DATA COLLECTION METHODS

Secondary Data

All the data has been collected data from the available sources like internet, journals, newspaper,

published data etc.

Research Instrument

Correlation, Regression has been used as a research instrument.

DATA PROCESSING

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Data has been analyzed with the help of MS-EXCEL and is presented with the help of graphical

and tabulation techniques.

LIMITATIONS OF THE STUDY

(1) Sampling period is very small (one year) so it may or may not be the true representative of

the rest of the years.

(2) Data have been collected from secondary sources so I have to rely on that.

(3) The conclusion given regarding FII flow and other variables are based on present economic

conditions.

CHAPTER: 4

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DATA ANALYSIS AND INTERPRETATION

FII FLOW AND BOMBAY STOCK EXCHANGE RETURNS

Some descriptive statistics about returns of Bombay Stock Exchange which has been used in the

analysis of the paper are given in the Table 1 of Appendix I. while all the returns of BSE has

been diagrammatically presented in Figure 4.1 Returns of Bombay Stock Exchange remained

highly volatile during sample period. Result shows that in the month of January 2009 returns

were in negative (-3.46%). Whereas in the month of March it has touched the level of 16.63%.

Returns remained positive for next consecutive two months where it has touched the highest

level of return 31.978% (in the month of May). Following the trends of January and February

2009 returns once again became negative in the month of June. On an average BSE has provided

DIAGRAMATIC REPRESTENTATION OF BSE RETURNS FROM JANURAY 2009 TO

JANUARY 2010

FIGURE: 4.1

7% return between July and September 2009. Fifth time during sample period BSE returns went

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negative (-6.4%) in the month of January 2010. Average return during sample period was around

5.5%. While analyzing the returns company wise we come to know that highest return was

provided by Tata Motor 14.76% followed by Infosyss who gave13.71% return during sample

period whereas lowest return provided by Bharti Airtel -5.32% and 0.1695% by HUL.

FII flow has been used as a dependent variable to find out relation with BSE return.

Diagrammatically representation of FII flow from January 2009 to January 2010 has been shown

in Figure 4.2. FII flow for the first three months was negative (January, $ -614 million, February,

$-1058, March $-909 million). In the month of April it became positive for the first time during

sample period where it reached up to $2245 million after that it touched $ 5639 million mark

FIGURE: 4.2

highest during sample period followed by ups and downs but in the month of August once again

FII flow became negative ($-29 million). In the month of September institutional investor once

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again shown positive attitude and net FII investment reached up to $4999 million and same trend

of positive investment remained till January 2010 when FII flow was $ 3093 million.

After analysis we come to know that FII flows and stock returns are strongly correlated in India.

The correlation coefficient between FII flows and market returns on the Bombay Stock

Exchange during sample periods is shown in table 3 and table 4 of Appendix 1 Diagrammatically

representation of correlation between two variables has been shown in Figure 4.3. While the

correlation remained moderate throughout the sample period. These positive correlations have

often been held as evidence of FII actions determining Indian equity market returns

RETURNS AND FII FLOW BETWEEN JANUARY 2009 AND JANUARY 2010

FIGURE 4.3

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Further statistical tool regression has been used to find out impact of BSE return on FII flow.

Here BSE return has been used as independent variable while FII flows are dependent variables.

After statistical analysis (see table 5 of Appendix I) we have following equation

Y = 1145.46 + 83.37 X

This equation has been used to estimate the FII flow to India (see table 6 of Appendix I). The

estimates show that moment BSE return increases FII will increase. Suppose X which shows

BSE RETURN and its expected returns in the month of February is 16% then ultimately

expected FII flow goes to $2477.96 million which is more than the average FII flow during

sample period. It shows the moment BSE return increases, FII flow increases further it proves

that there is strong positive correlation between these two variables.

However, correlation itself does not imply causality. A positive relationship between portfolio

inflows and stock returns is consistent with at least four distinct theories: 1) the omitted

variables hypothesis; 2) the downward sloping demand curve view; 3) the base-broadening

theory; and 4) the positive feedback strategy view. The omitted variables view is the classic

case of spurious correlation that the correlated variables, in fact, have no causal relationship

between them but are both affected by one or more other variables missed out in the analysis.

The downward sloping demand curve view contends that foreign investment creates a buying

pressure for stocks in the emerging market in question and causes stock prices to rise much in the

same way as suddenly higher demand for a commodity would cause its price to rise. The base-

broadening argument contends that once foreigners begin to invest in a country, the financial

markets in that country are now no longer moved by national economic factors alone but rather

begin to be affected by foreign market movements as well. As the market itself is now affected

by more factors than before, its exposure to domestic shocks decline. Consequently the risk of

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IIP, the acceleration in growth has been skewed. The top five of the 17 manufacturing industries,

with a combined weight of 24.1 per cent in IIP, grew by 12.7 per cent and contributed 60.3 per

cent of the IIP growth during April-November 2009. This suggests that there is scope for further

acceleration as the recovery becomes broader based. In terms of use-based classification, there

was sharp acceleration in the growth of basic goods, intermediate goods and consumer durables

during April-November 2009. The recovery began with a steady acceleration in growth of the

intermediate goods sector during the current financial year. This was followed by the recovery in

capital goods sector, to a growth of 11.4 percent during August-November 2009, from the

decline in output during March-May 2009, indicating an improvement in investment sentiments.

Consumer nondurables output witnessed growth since July 2009, despite being weighed down by

the decline in food products, beverages and tobacco products and jute and other vegetable fibre

FIGURE: 4.4* GROWTH IN INDEX OF INDUSTRIAL PRODUCTION (Y-O-Y)

*Source: Central Statistical Organization

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textiles (except cotton). The overall growth in the consumer goods during April-November 2009-

10 has been driven by a sharp double digit growth in the durable segment, with significant

contribution coming from automobiles production.

There is positive correlation between Industrial Production and FII flow to Indian equity market.

The correlation coefficient between FII flow and industrial production during sample period has

shown in table 7 of Appendix I. While the level of correlation between growth of industrial

production and FII flow to Indian Market was low throughout the sample period. (See table 7

and 8 of Appendix I). Diagrammatically presentation of relationship between FII and growth of

IP shown in Figure 4.5

FIGURE 4.5: IIP AND FII FLOW BETWEEN JANUARY 2009 AND JANUARY 2010

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Further statistical tool regression has been used to find out impact of Industrial Production on FII

flow. Here Industrial Production has been used as independent variable while FII flows are

dependent variables. After statistical analysis (see table 9 of Appendix I) we have following

equation

Y = 819.61 + 127.96 X

With the help of this equation we can estimate the future value FII flow to Indian market. Study

shows that whenever there is increase in industrial production it has resulted increase in FII Flow

(see table10 of appendix I). Suppose X which shows INDUSTRIAL PRODUCTION increases to

12% then ultimately FII flow goes to $2356.08. Similarly when industrial production growth was

2.1 % FII flow was $ 1088.32 million. It shows whenever there is increase in Industrial

Production, FII flow would like to increases. So we can say that industrial production is a strong

microeconomic variable which determine the FII flow to India and can be used to find out the

expected FII flows to Indian Market.

EXCHANGE RATE

An exchange rate has been defined as a relative price of two national currencies. More

specifically, it can be stated that the exchange rate is "the ratio between a unit of one currency

and the amount of another currency for which that unit can be exchanged at a particular time."

(FASB 1975) As such, it can be seen that exchange rates are designed to facilitate the actual

exchange of one currency for another. It would appear that exchange rates are relatively

straightforward. However, this is unfortunately not the case.

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Exchange rates are normally quoted in terms of a buying rate, a flat rate, and a selling rate. The

buying rate is that which a bank will pay for a foreign currency, the selling rate is the rate a bank

will charge for the currency, and the flat rate is an average of the buying and selling rates. In

addition, the exchange rate which is quoted will often depend on various factors such as the

market sector and type of foreign-exchange instrument involved. The foreign-exchange market

can be divided into four main sectors: (I) retail--dealings with the general public; (2) wholesale--

trading among banking institutions and, where permitted, between large firms and brokers; (3)

foreign--dealings between domestic and foreign banks; and (4) supranational--dealings among

large multinational corporations and large private banks. The basic types of foreign-exchange

instruments include foreign currencies, bank transfers, bills of exchange, letters of credit, and

forward exchange contracts.2

These varied circumstances call for different exchange rates, 3 which can usually be classified

into three main categories: spot rates, forward rates, and differential rates. Spot rates are the rates

quoted for immediate delivery of a currency (usually two days). Forward rates are those quoted

for delivery of a currency at a specified future date (usually within one year, but after the period

for the spot rate). Differential rates may be either preferential or penalty rates which are limited

to special markets or customers. They are normally found in economies where the government

controls foreign exchange and differ from the spot and forward rates. In such cases, the

government will often establish exchange rates based on the status of the transaction involved. If

the government considers a transaction to be economically favorable, the exchange rates attached

2 Desai, Meghnad, The Anarchy of Exchange Rates, The Financial Express 13 April, (2010)3 Bhagwati, Jaimini, Is appreciation of rupee inevitable? Business Standard 15 April, (2010)

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to it will often reflect that fact. That is, the government will often establish more favorable

exchange rates for those transactions that it wishes to encourage. On the other hand, the

government will also establish less favorable exchange rates for those transactions that it wishes

to discourage. "Where controlled rates differ widely from the free-market rate for a currency,

black-market rates usually appear as an equalizing mechanism. Consequently, the mere existence

of a black-market rate is evidence of an overvalued currency." Exchange rate is also an important

aspect for Foreign Institutional Investor they may use exchange rate for the purpose of

FIGURE: 4.6 EXCHANGE RATE BETWEEN JANURAY 2009 TO JANUARY2010

diversification of resources. So here we try to find out is there any relationship between foreign

investment flow and exchange rate. There were lots of fluctuations in the exchange rate during

sample period. In January it stands at Rs 49.71 where as in March it has touched the level of Rs

52.61. From May to September it remained at the level of Rs 48 from September onwards it has

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started gaining value against dollar and in the month of January 2010 it has touched the level of

46.17. Diagrammatical representation of exchange rate has shown in Figure 4.6

There is negative lower level correlation between exchange rate and FII flow during sample

period (See table 11 and table 12 of Appendix I). It states that the moment rupee will appreciate

flow of FII will decrease and when the value of rupee will decrease FII flow will increase. But

the rate increase and decrease on FII flow is low. Diagrammatical presentation of two variables

(FII flow and Exchange rate) has shown in Figure 4.7 Correlation level between these two

variable (FII Flow and Exchange Rate) is very low. Further statistical tool regression has been

used to find out impact of Exchange rate on FII flow or the expected values of FII flow with the

help of exchange rate.

EXCHANGE RATE AND FII FLOW BETWEEN JAN.2009 TO JAN.2010

FIGURE: 4.7

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Here exchange rate has been used as independent variable while FII flows has been used as a

dependent variable. After statistical analysis (see table 13 and 14 of Appendix I) we have

following equation.

Y = 1452.87 + 3.25 X

With the help of this equation we can make estimates regarding FII flows. Suppose X which

shows Exchange Rate goes to Rs 50 it ultimately increases FII Flow to $ 1615.37 million.

Similarly if rupee value goes to 46 it will ultimately decrease the FII flow to $ 1602.48 million

and when rupee will be 40 FII flow would be $ 1582.87 million. It shows whenever there is

increase in rupee value FII flow would like to decrease and vice versa. But the rate of increase

and decrease is slow in comparison to rupee value appreciation or depreciation. It is because the

is lower level correlation between these two variables.

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CHAPTER: 5

FINDINGS

Foreign Institutional Investors (FIIs) in Indian capital market playing an important role. FIIs in

India include Assets Management Companies, Pension Funds, Mutual Funds, Incorporated

Portfolio Managers, Charitable Trusts and charitable societies etc. SEBI acts as the nodal point in

the entire process of FIIs regulations. It frames legal framework for FIIs. Investment in India is

regulated under SEBI (FII) regulations 1995.FIIs are required to allocate their investment

between equity and debt instruments in the ratio of 70:30. (however, it is also possible for an FII

to declare itself a 100 percent FII in which case it can make its entire investment in debt

instrument).FIIs can buy or sell securities on stock exchange. They can also invest in listed and

unlisted securities outside stock exchange, where the price has been approved by RBI. FII

investment is frequently referred to as hot money for the reason that it can leave the country at

the same speed at which it comes in.

OBJECTIVES OF THE STUDY

To study the relationship between FIIs flows and Bombay Stock Exchange returns.

To find out the impact of macroeconomic variable (such as Industrial Production) on FIIs

flow to Indian stock market.

To find out the relationship between exchange rate and net FIIs flows to Indian Stock

Market.

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The empirical investigation of FII flows to India has elicited the following stylized facts about

such flows:

a) There is positive moderate level correlation between FII flow and return in the Indian markets

during sample period. Further statistical tool (regression) shows that BSE returns has strong

impact over FII flow. Expected values shows that wherever there is increase in BSE return the

FII flow has increased and vice-versa.

b) Study shows that there is correlation between Industrial Production and FII flow to Indian

market. Although correlation was low during sample period. Statistical tool (such as regression)

shows the impact of industrial production on FII flow. Calculated expected values (in regression)

shows that when there is increase the value of Industrial Production the amount of FII flow has

increased. It shows that industrial production has strong impact on FII flow to Indian market.

c) To find out whether foreign institutional investors use the exchange rate for purpose of

diversification. Correlation between Exchange Rate and FII flow has been studied. Study shows

that there is negative low level correlation between exchange rate and FII flow. It shows the

moment the value of rupee decrease FII flow increases , but the correlation between two variable

is very low it shows that foreign institutional investor dont use exchange for the purpose of

diversification of their funds.

The stylized facts listed above lead to a better understanding of FII flows to India. This study

provides a preliminary analysis of FII flows to India and their relationship with several relevant

variables especially returns in the Indian stock market. FII flows which now account for a

significant part of the capital account balance in our balance of payments. The extent to which

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FII participation in Indian markets has helped lower cost of capital to Indian industries is also an

important issue to investigate. A more detailed study by using daily data can be useful in

understanding of the nature and determinants of FII flows to India.

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Tesar, Linda L. & Werner, Ingrid M., (1995), Home bias and high turnover Journal ofInternational Money and Finance, vol. 14(4), pages 467-492, August.

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http://www.bseindia.com/stockinfo/stockprc.aspxhttp://www.sebi.gov.in/Index.jsp?contentDisp=Department&dep_id=10http://mospi.nic.in/mospi_iip.htmhttp://www.rbi.org.in/scripts/BS_ViewBulletin.aspxhttp://www.bseindia.com/stockinfo/stockprc.aspxhttp://www.sebi.gov.in/Index.jsp?contentDisp=Department&dep_id=10http://mospi.nic.in/mospi_iip.htmhttp://www.rbi.org.in/scripts/BS_ViewBulletin.aspx


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APPENDIX I

TABLE: 1

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TABLE: 2

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TABLE: 3

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TABLE: 4

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TABLE: 5

REGRESSION EQUATION OF BSE RETURNS (X) AND FII FLOW (Y)

REGRESSION EQUATION OF Y ON X

Y = a + b x

The two normal equations are:

Y = Na + b X .. (i)

XY = a X + b X2 (ii)

Putting the value in equations

20943 = 13a + b 72.59 (i)

253085.2 = 72.59 a + b 2038.97 . (ii)

Multiply (i) by 5.58

253085.2 = 72.59 a + b 2038.97 . (ii)

116861.94 = 72.59 a + b 405.052 (iii)

Subtracting (iii) from (ii)

136223.26 = 1633.91 b

b = 83.37

Putting the value of b in equation (i)

20943 = 13a + (83.37) 72.59

a = 1145.46

Y = a + b X

Y = 1145.46 + 83.37 X

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TABLE: 7

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TABLE: 8

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TABLE: 9

REGRESSION EQUATION OF INDUSTRIAL PRODUCTION (X) AND FII FLOW (Y)

REGRESSION EQUATION OF Y ON X

Y = a + b x

The two normal equations are:

Y = Na + b X .. (i)

XY = a X + b X2 (ii)

Putting the value in equations

20943 = 13a + b 80.4 (i)

160243.1 = 80.4 a + b 737.7 . (ii)

Multiply (i) by 6.18

160243.1 = 80.4 a + b 737.7 . (ii)

129427.74 = 80.4 a + b 496.87 (iii)

Subtracting (iii) from (ii)

30815.36 = 240.82 b

b = 127.96

Putting the value of b in equation (i)

20943 = 13a + (127.96) 80.4

a = 819.61

Y = a + b X

Y = 819.61 + 127.96 X

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TABLE: 10

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TABLE: 11

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TABLE: 14

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