A PROJECT REPORT ON VOLATILITY IN INDIAN STOCK MARKET

AND FOREIGN INSTITUTIONAL INVESTOR

SUBMITTED BYPRANJAL COHPDA

THIRD YEAR BACHELOR OF COMMERCE(FINANCIAL MARKETS)

SEMESTER-V2012-13

MODEL COLLEGE, DOMBIVALIUNIVERSITY OF MUMBAI

OCTOBER-2012

SUBMITTED TOTHE UNIVERSITY OF MUMBAI

IN PRTIAL FULLFILLMENT FOR THE AWARD OF

THE DEGREE OF BACHELOR OF COMMERCE

FINANCIAL MARKETSSEMESTER V

BYPRANJAL CHOPDA

MODEL COLLEGE, DOMBIVALIUNIVERSITY OF MUMBAI

OCTOBER 2012

DECLARATION

I, PRANJAL CHOPDA STUDENT OF BACHELOR OF COMMERCE, FINANCIAL MARKETS, SEMESTER V OF KERALEEYA SAMJAM DOMBIVALI’S MODEL COLLEGE,

HEREBY DECLARE THAT I HAVE COMPLETED PROJECT REPORT ON

“VOLATILITY IN INDIAN STOCK MARKET AND FOREIGN

INSTITUTIONAL INVESTOR” FOR THE ACADEMIC YEAR 2012-13.

THE INFORMATION SUBMITTED IS TRUE AND ORIGINAL TO THE BEST OF MY KNOWLEDGE.

PRANJAL CHOPDABACHELOR OF COMMERCE

FINANCIAL MARKETS

TABLE OF CONTENTS

SR NO. TITLE PAGE NO.

1. CERTIFICATE

2. DECLARATION

3. ACKNOWLEDGEMENT

4. LIST OF ABBREVATIONS

Chapter 1.

Volatility in Indian Stock Markets and Foreign Institutional Investors

CHAPTER 1.AN INTRODUCTION

Indian financial market has seen an extraordinary volatility in the last few

years. Since year 2002, Indian market has grown from a much volatile

conditions to growth phenomena, from a SENSEX point of 5500 in

December 2003 to 13,787 in December 2006 and crossed the mark of

20,000 in the year 2007. Due to various reasons the stock market has also

experienced drastic decline to even less than 8,000 points in 2008. It is not

because of only the domestic market but also the international investors.

There are many other variables which contribute to the positive growth of the

stock market. FIIs investment is considered to be one of the biggest push

after the economic fundamentals. There is no doubt that the liberalization of

the FII flows into the Indian Capital Market since 1993 has had a

considerable impact on Indian stock market. The present paper is an attempt

to explore the FIIs investment behavior and its relationship with SENSEX

movement.

The Indian financial market has experienced tremendous growth in terms of

primary issues and trades on secondary market. The liberalization policies

initiated in India in the early 1990s brought about radical changes in the

behavior of stock market. Rising globalization, deregulation, and foreign

institutional investments made the Indian stock market more competitive and

efficient. The economic benefit from the developed economies particularly

from capital markets comes out as catalyst. With the rise of equity culture

throughout the world, India which has a long history of stock exchanges, has

witnessed a noticeable shift in the proportion of investor’s participation in

stock markets. The role of investors is very vital in the success of market

guided economic systems. As part of economic reforms, India opened its

stock market to foreign investors in September 1992 and has received

portfolio investment from foreigners in the form of foreign 2institutional

investment in equities and other markets including derivatives. It has

emerged as one of the most influential groups to play a critical role in the

overall performance of the stock market. The liberalization of FII flows into

the Indian capital market since 1993 has had a significant impact on market

practices. Many of the moves to modernize the equity markets in the past

decade may be attributed to pressure or behavioral changes from foreign

investors such as SEBI‟s amendment in 2006 about reducing the Validity

Period of Registration Certificate from five years to three years and increase

in the registration and renewal fees. The demat trading system introduced to

increase the confidence of FIIs and others. The demat form of trading could

able to avoid the problems of fake shares and fake transfers etc. The new

industrial policy of the government has initiated many measures to attract

foreign capital. The foreign Exchange Regulation Act has been replaced with

Foreign Exchange Management Act. This resulted in huge movements of

inflow and outflow of capital resources.

Section 2. Movement of Sensex and Volatility in the Stock Market

To recapitulate the events, the general election was held in four phases-the

dates of polls being 20th April, 26th April, 5th May and 10thMay. The counting

started on 13th May and because of use of electronic voting machines, most

results were declared on that day. However, the exit polls conducted by the

media started to give an indication of a non-NDA government from the

second phase of polling. If one looks closely at the behavior of the Sensex

during this period, it shows that the downward movement of the Sensex

started around 23rd April, that is between the first and second phase of

polling and kept declining till the middle of May. The behavior of the foreign

portfolio investors matched the behavior of Sensex during this period. Net FII

investment in the Indian capital markets started fluctuating sharply from 23

April and from 30th April it turned negative. Net FII investment in the Indian

stock market continued to be negative till the middle of May. During this

period, the Sensex and net FII investment showed very high degree of

correlation. For the period 23rd April to 17th May, the correlation between

daily net FII equity investment and the Sensex was as high as 0.70. Fig u re

1 shows daily movements of Sensex and Net FII investment in India during

the months of April, May and June. A somewhat different trend is observed

from 18th May to the end of that month. The Sensex started a recovery from

18th May and the declining trend of net F II investment also reversed from

that day.

Indian financial market has seen an extraordinary volatility in the last few

years. Since year 2002, Indian market has grown from a much volatile

conditions to growth phenomena, from a SENSEX point of 5500 in

December 2003 to 13,787 in December 2006 and crossed the mark of

20,000 in the year 2007. Due to various reasons the stock market has also

experienced drastic decline to even less than 8,000 points in 2008. It is not

because of only the domestic market but also the international investors.

There are many other variables which contribute to the positive growth of the

stock market. FIIs investment is considered to be one of the biggest push

after the economic fundamentals. There is no doubt that the liberalization of

the FII flows into the Indian Capital Market since 1993 has had a

considerable impact on Indian stock market. The present paper is an attempt

to explore the FIIs investment behavior and its relationship with SENSEX

movement.

ABOUT THE REPORT

Title of the study

The present study is titled as A PROJECT REPORT ON “Volatility in

Stock Markets in India and Foreign Institutional

Investors”. The study made with special reference to commodity

market-Energy segment.

Objectives of Study

• To study in depth.

• To know the changing scenario of Indian stock market after fii

investment.

Data And Methodology

For the purpose of the present study Secondary data were used. The data

is collected from Books & websites.

Limitations of the Study

The study has got all the limitations of using Secondary data and

Inferences were made based on that.

Chapter Layout

The Present study is arranged as follows.

Chapter 1 – An Introduction

Chapter 2 – Deals with the Theoretical view of INDIAN STOCK MARKET

Chapter 3 – Deals with the IMPACT OF FIIs ON STOCK MARKET

INSTABILITY

Chapter 4 –Deals with a.

Chapter 5 – Summarizes the result of the Report.

CHAPTER 2.

- A THEORETICAL VIEW.

Diversifying globally i.e., holding a well diversified portfolio of securities

from around the globe in proportion to market capitalizations, irrespective

of investor’s country of residence, has long been advocated as means to

reduce overall portfolio risk and maximize risk-adjusted returns by the

traditional capital asset pricing model (CAPM). Foreign investment inflow

depends on returns in the stock market, rates of inflation (both home and

foreign), and exante risk. In terms of magnitude, the impact of stock

market returns and the ex-ante risk turned out to be the key determinants

of FII inflows. An investment will always carry the consideration of risk

factor in its risk-return behaviour. In an investment friendly environment

the bullish behaviour dominates the trends and at a given huge volume of

investments, foreign investors may play a role of market makers and book

their profits, i.e., they can buy financial assets when the prices are

declining thereby jacking-up the asset prices and sell when the asset

prices are increasing (Gordon & Gupta, 2003). Hence, there is a

possibility of bi-directional relationship between FII and the equity returns.

Although FII flows help supplement the domestic surplus resources and

augment domestic investments without rising the foreign debt of the

recipient countries, helps to maintain stabilized balance of payments

particularly current account segment. Entry of FII may also leads to

decrease the required rate of return for equity, and improve stock prices

of the host economies / nations. However, there are uncertainties about

the defencelessness of recipient country’s capital markets to such flows.

FII flows, often referred to as 'hot money' (i.e., short-term and overly

tentative), are extremely unstable in character compared to other forms

of capital flows. Foreign portfolio investors are regarded as 'fair weather

friends' who come in when there is money to be made and leave at the

first sign of impending trouble in the host country thereby destabilizing the

domestic economy of the recipient country. Often, they have been blamed

for exacerbating small economic problems in the host nation by making

large and concerted withdrawals at the slightest hint of economic

weakness. It is also alleged that as they make frequent marginal

adjustments to their portfolios on the basis of a change in their

perceptions of a country's solvency rather than variations in underlying

asset value, they tend to spread crisis even to countries with strong

fundamentals thereby causing 'contagion' in international financial

markets.

Several research studies on FII flows to emerging market economies

(EMEs) over the world have found that financial market infrastructure like

market size, market liquidity, trading cost, extent of informational

dissemination etc., legal mechanisms relating property rights,

harmonization of corporate governance, accounting, listing and other

rules with those followed in developed economies etc., are some of the

important determinants of foreign portfolio investments into emerging

markets. The Securities and Exchange Board of India (SEBI) and Reserve

Bank of India (RBI) have initiated several measures such as allowing

overseas pension funds, mutual funds, investment trusts and asset

management companies, banks, institutional portfolio managers,

universal funds, endowments, easing the norms for registration of FIIs,

reducing procedural delays, lowering the fees of registration, mandating

strict disclosure norms, improved regulatory mechanisms etc. all these

are supported by strong fundamentals, have made India as one of the

attractive destinations for FIIs. The following table highlights the

registered FIIs in India during the period from 2006 to 2010.

From the above table it is clear that there is constant growth in the

number of registered FIIs in India. In the year 2006(January, 2006), the

number of registered FIIs were 833 only. The same number has been

increased to 1697 by the year 2010 (January 2010). The number has

been increased by more than 100 per cent. In spite of the global financial

crisis the number of registered FIIs has shown a significant increase.

Irrespective of the situation in Indian stock markets these FIIs has

earmarked their presence. But the investment made by FIIs has

experienced drastic decline in the recent past. This is mainly because of

the global economic meltdown. Though the number of registered FIIs

increased the net investments were not increased proportionately. The

important reasons for growth in number of registered FIIs are easing of

registration norms, lowering the registration fees, reducing the procedural

delays. The most important is strong economical foundation of Indian

economy. Though the entire globe affected with the global financial

meltdown, India could face the global financial meltdown effectively.

Compared to many other markets Indian markets are offering attractive

returns on the investments. The growth rates of Gross Domestic Product

(GDP) even during the financial crisis was attractive than many other

economies. This resulted in increased number of registered FIIs in the

last half decade. The following table (Table 2) provides a cross section of

data on the FIIs inflow and stock market movement from the year 2000 to

2011(31stMay). The FIIs and hedge funds had pulled out money mainly

due to higher interest rates in U.S. after Federal Reserve increased

7interest rates to 4.5% under their new governor. Similar changes took

place many times in the history since opening and few times in the study.

Additional indicators and data reflect that movements in the

SENSEX during the two years have clearly been driven by the

behaviour of foreign institutional investors (FIIs), who were responsible for

net equity purchases of as much as $6.6 and $8.5 billion respectively in

2003 and 2004. The Pearson correlation values indicate positive

correlation between the foreign institutional investments and the

movement of Sensex. (The value of Pearson correlation is 0.570894)

The above table (Table:3) shows the proportion of investment made

by the FIIs in Sensex scrip’s. It is observed that almost half of the

companies are equipped with FII investment to the tune of 10% to

20%. Nearly 25% of the companies (Sensex 30 scrip’s) are having the FII

investment between 30% and 40%. Another important thing is all the

thirty scrip’s are showing the presence of foreign institutional investment.

The pattern of change is also very minimal in respect of these

companies regard to FIIs are concerned. It can be understood that the

FIIs may enter and exit frequently form the other scrip’s but not

the Sensex scrip’s. The above table depicts the consistency of FIIs over

a period of time.

From the above table (Table:3) it can be understood that fifty percent of

the companies which are included in BSE SENSEX are having fifteen

to twenty percent of capital from the overseas. This indicates the level

of influence by the foreign institutional investment on those companies

particularly and on the stock market in general. Any withdrawal of

foreign institutional investment may result in huge volatility in the

market as well as share price movements. Similarly, any increase in

the shareholding pattern by the foreign institutional investors may

result huge rally in the market. The psychology of domestic investors

is also affected by the decisions of foreign institutional investors.

Being an agricultural based economy India has faced large number

of problems while establishing industries. After independence, to

establish core industries such as Iron & Steel, Cement, Electrical and

construction of Roads, buildings etc. it took decades. Indian economy

has experienced the problem of capital in many instances.

Particularly, to start large scale industries where capital requirement

was more . While planning to start the steel companies under

government control, due to shortage of resources it has taken the

aid of foreign countries. Likewise we have received aid from Russia,

Britain and Germany for establishing Bhiloy, Rourkela and Durgapur

steel plants. The foreign institutional investment was increased

during the years 2006 and 2007. Later on, due to global financial

crisis the investments by FIIs were reduced.

ADVANTAGES

OF FII IN INDAIN MARKET

• Enhanced flows of equity capital

• FIIs have a greater appetite for equity than debt in their asset

structure. The opening up the economy to FIIs has been in line with the

accepted preference for non-debt creating foreign inflows over foreign

debt. Enhanced flow of equity capital helps improve capital structures and

contributes towards building the investment gap.

• Managing uncertainty and controlling risks.

• FII inflows help in financial innovation and development of hedging

instruments. Also, it not only enhances competition in financial markets,

but also improves the alignment of asset prices to fundamentals.

• Improving capital markets.

• FIIs as professional bodies of asset managers and financial analysts

enhance competition and efficiency of financial markets.

• Equity market development aids economic development.

• By increasing the availability of riskier long term capital for projects,

and increasing firms’ incentives to provide more information about their

operations, FIIs can help in the process of economic development.

• Improved corporate governance.

• FIIs constitute professional bodies of asset managers and financial

analysts, who, by contributing to better understanding of firms’ operations,

improve corporate governance. Bad corporate governance makes equity

finance a costly option. Also, institutionalization increases dividend

payouts, and enhances productivity growth.

DISADVANTAGES

OF FII IN INDAIN MARKET

• Problems of Inflation: Huge amounts of FII fund inflow into the

country creates a lot of demand for rupee, and the RBI pumps the amount

of Rupee in the market as a result of demand created.

• Problems for small investor: The FIIs profit from investing in

emerging financial stock markets. If the cap on FII is high then they can

bring in huge amounts of funds in the country’s stock markets and thus

have great influence on the way the stock markets behaves, going up or

down. The FII buying pushes the stocks up and their selling shows the

stock market the downward path. This creates problems for the small

retail investor, whose fortunes get driven by the actions of the large FIIs.

• Adverse impact on Exports: FII flows leading to appreciation of the

currency may lead to the exports industry becoming uncompetitive due to

the appreciation of the rupee.

• Hot Money: “Hot money” refers to funds that are controlled by

investors who actively seek short-term returns. These investors scan the

market for short-term, high interest rate investment opportunities. “Hot

money” can have economic and financial repercussions on countries and

banks. When money is injected into a country, the exchange rate for the

country gaining the money strengthens, while the exchange rate for the

country losing the money weakens. If money is withdrawn on short notice,

the banking institution will experience a shortage of funds.

CHAPTER 2

Impact of FIIs on

Stock Market Instability

Impact of FIIs on

Stock Market Instability

Investment of FIIs are motivated not only by the domestic and external economic conditions but also by short run expectations shaped primarily by what is known as market sentiment. The element of speculation and high mobility in FII investment can increase the volatility of stock return in emerging markets. In fact, a widely held perception among academicians and practitioners about the emerging equity markets is that price or return indices in these markets are frequently subject to extended deviations from fundamental values with subsequent reversals and that these swings are in large part due to the influence of highly mobile foreign capital. Volatility is an unattractive feature that has adverse implications for decisions pertaining to the effective allocation of resources and therefore investment. Volatility makes investors averse to holding stock due to increased uncertainty. Investors in turn demand higher risk premium so as to ensure against increased uncertainty. A greater risk premium implies higher cost of capital and consequently lowers physical investment. In addition, great volatility may increase the “option to wait” thereby delaying investment. Also weak regulatory system in emerging market economies (EMEs) reduce the efficiency of market signals and the processing of information, which further magnifies the problem of volatility. But some researchers have the opposite assumption of non-disestablishing hypothesis that says FIIs have no adverse impact

Trading by FIIs happens on a continuous basis and therefore has a lasting impact on the local stock market. There is, however, surprisingly little empirical evidence on the impact of FIIs trading on the host country’s stock return volatility, thereby making it imperative that this aspect of local equity markets, which is important for both risk analysis and portfolio

construction, be examined. This chapter attempts to fill the gap. Beside the introduction, this chapter is classified into two parts.

• Part I presents the impact of foreign institutional investors on the Indian stock market volatility.

• Part II shows the structure of the volatility before and after introduction of the foreign institutional investors in Indian stock market.

The scope of the study is limited to the India which has become an attraction for FIIs in recent years, in fact the emerging markets of many developing countries have been attracting large inflows of private capital in recent years. The surge in capital flows occurred first in Latin America, then South East Asia and is now clearly visible in South Asia. A significant feature of these capital flows is the increasing importance of foreign portfolio investment (FPI), whose buying and selling of stocks on a daily basis determines the magnitude of such capital flows. A significant improvement has also taken place in India relating to the flow of foreign capital during the period of post economic reforms. The major change in the capital flows particularly in Foreign Institutional Investors (FIIs) investments has taken place following the changes in trade and industrial policy. Over the past 15 years or so India has gradually emerged an important destination of global investors’ investments in emerging equity markets. In 2006, India had a share of about 0.55% of global investment which is quite high in comparison to year 2001 in which India’s share was only 0.12% . On the other hand some of the developed countries have shown a downward trend.

The foreign financial inflows, beside other factors, helped the Indian stock

market to rise at a great height according to financial analysts. Sensex

crossed a new high. It crossed 20000- mark in December 2007, which

was 13786.91 in December 2006 and

9397.93 in December 2005. This historical movement is also due to the

other parameters of the economy, which are favorable for the investment.

The returns on investment are also much favorable. The profit

performance of the firms may explain the reasons for

high return on investment. There are other factors such as favorable

tax laws and relaxation on the caps of various kinds of investments.

The policy measures and economic factors are also the reasons for the

investor’s confidence.

Table 6.2 clearly indicates that both daily return and volatility during 1981-90, period of real sector reforms, were significantly higher than those found pre-liberalization period (i.e.1961-80). Interestingly, return and volatility increase further to 0.074 and 1.92 respectively. In era of first generation reforms financial sector reforms (i.e. 1991-2000).It is appreciable to see from the table that the second generation reforms have brought in more cheers for the capital market as the risk (i.e. Standard Deviation of return) decreased but the stock return went up in the period. Clearly the volatility has declined in Indian stock market after year 2000.

Table 6.2 further reveals that the stock return has remained around half (0.06%) after the arrival of FIIs as compared to that obtained (0.15%) during 1986 to 1992 period. Simultaneously, the standard deviation which measures the volatility has declined from 2.1598 percent during 1986-92 to 1.59 percent during 1992-2007. Thus, both volatility and return have declined after the opening up of domestic stock market for FIIs. Time period 1994 to 2001 gave a serious set back to stock market performance.

FII and FDI connection

The relationship between FII and FDI (Foreign Direct Investment) is intertwined. In 1998 – 1999 a number of reforms were initiated, that were designed specifically for attracting FDI. In India FDI is allowed through FII’s. This is done through private equity, preferential allotment, joint ventures and capital market operations. The only industries in which FDI isn’t allowed are arms, railways, coal, nuclear and mining. 100% financing by FDI is allowed in infrastructural projects such as construction of the bridges and the tunnels. In the financial sector, insurance and banking operations can have foreign investors.

Differences between FII & FDI

FDI and FIIs are two important sources of foreign financial flows into a country. FDI (Foreign Direct Investment) the acquisition abroad of physical assets such as plant and equipment, with operating control residing in the parent corporation. It is an investment made to acquire a lasting management interest (usually 10 percent of voting stock) in an enterprise operating in a country other than that of the investor, the investor’s purpose being an effective voice in the management of the enterprise. It includes equity capital, reinvestment of earnings, other long-term capital, and short-term capital. Usually countries regulate such investments through their periodic policies. In India such regulation is usually done by the Finance Ministry at the Centre through the Foreign Investment Promotion Board).

Types of Investments

FDI typically brings along with the financial investment, access to modern technologies and export market. The impact of the FDI in India is far more than that of FII largely because the former would generally involve setting up of production base - factories, power plant, telecom networks, etc. that enables direct generation of employment. There is also multiplier effect on the back of the FDI because of further domestic investment in related

downstream and upstream projects and a host of other services. Korean Steel maker Posco’s USD 8 billion steel plant in Orissa would be the largest FDI in India once it commences. Maruti Suzuki has been an exemplary case in the India's experience. However, the issue is that it puts an impact on local entrepreneur as he may not be able to always successfully compete in the face of superior technology and financial power of the foreign investor. Therefore, it is often regulated that Foreign Direct Investments should ensure minimum level of local content, have export commitment from the investor and ensure foreign technology transfer to India.FII investments into a country are usually not associated with the direct benefits in terms of creating real investments. However, they provide large amounts of capital through the markets. The indirect benefits of the market include alignment of local practices to international standards in trading, risk management, new instruments and equities research. These enable markets to become more deep, liquid, feeding in more information into prices resulting in a better allocation of capital to globally competitive sectors of the economy. Foreign Institutional Investors Since, these portfolio flows can technically reverse at any time, the need for adequate and appropriate economic regulations are imperative.

Government Preference

FDI is preferred over FII investments since it is considered to be the most beneficial form of foreign investment for the economy as a whole. Direct investment targets a specific enterprise, with the aim of enhancing capacity and productivity or changing its management control. Direct investment to create or augment capacity ensures that the capital inflow translates into additional production. In the case of FII investment that flows into the secondary market, the effect is to increase capital availability in general, rather than availability of capital to a particular enterprise. Translating an FII inflow into additional production depends on production decisions by someone other than the foreign investor — some local investor has to draw upon the additional capital made available via FII inflows to augment production. In the case of FDI that flows in for acquiring an existing asset, no addition to production capacity takes place as a direct result of the FDI inflow. Just like in the case of FII inflows, in this case too, addition to production capacity does not result from the action of the foreign investor – the domestic seller has to invest the

proceeds of the sale in a manner that augments capacity or productivity for the foreign capital inflow to boost domestic production. There is a widespread notion that FII inflows are hot money — that it comes and goes, creating volatility in the stock market and exchange rates. While this might be true of individual funds, cumulatively, FII inflows have only provided net inflows of capital

Stability

FDI tends to be much more stable than FII inflows. Moreover, FDI brings not just capital but also better management and governance practices and, often, technology transfer. The know-how thus transferred along with FDI is often more crucial than the capital per se. No such benefit accrues in the case of FII inflows, although the search by FIIs for credible investment options has tended to improve accounting and governance practices among listed Indian companies.

Types of FIIs

FII investments in India can be of the two types:

1. Normal FIIs: FII allocation of its total investment between equity and non-equity instruments (including dated government securities and treasury bills in the Indian capital market) should not exceed the ratio of 70:30. Equity related instruments would include fully convertible debentures, convertible portion of partially convertible debentures and tradable warrants.

2. 100% Debt FIIs: FII that can invest the entire corpus in dated government securities including treasury bills, non-convertible debentures/bonds issued by an Indian company subject to limits, if any. A FII needs to submit a clear statement that it wishes to be registered as FII/sub-account under 100% debt route.

Entities which can register as FIIs:

Entities who propose to invest their proprietary funds or on behalf of "broad based" funds (fund having more than twenty investors with no single investor holding more than 10 per cent of the shares or units of the fund) or of foreign corporate and individuals and belong to any of the under given categories can be registered for FII.

Pension Funds

Mutual Fund

Investment Trust

Insurance or reinsurance companies

Endowment Funds

University Funds

Foundations or Charitable Trusts

Charitable Societies who propose to in

on their own behalf, and

Asset Management Companies

Nominee Companies

Institutional Portfolio Managers

Trustees

Power of Attorney Holders

Banks

Foreign Government Agency

Foreign Central Bank

International or Multilateral Organization or an Agency there of

Trends in FIIs

In 1993, when investments in FII s were introduced, Pictet Umbrella Trust Emerging Markets’ Fund, an institutional investor from Switzerland, Indian market. While in 1994, no new registrations were reported, between 1995 and 2003, an average of 51 new FIIs began operations in the country each year. The graph below clearly indicates the steep increase in number of FII to the number of registered FII’s at the end of

each calendar year). Currently, there are 1,695 registered FIIs and 5,264 registered sub accounts (As on 11th September, 2009).

Since 1993 when FII’s were first allowed to enter the India, there has always been a preference towards investing in equity than debt. The following graph shows the debt and equity FII flows from

FII investments through QIPs

QIPs are private placements or issuances of certain specified securities by Indian listed companies to qualified institutional buyers in accordance with the provisions of SEBI guidelines. Qualified Institutional placements or QIPs were introduced in mid-2006.

Indian companies that are listed on stock exchanges having nationwide terminals — the BSE and NSE have been raising capital through the QIP route. Quarterly Institutional buyers are preferred primarily because these entities have a large risk appetite, possess the general expertise and have the experience to make an informed decision.

In August 2008, SEBI liberalized the pricing conditions for QIPs by reducing the period of reckoning to an average of two weeks’ stock price, prior to the relevant date, against the earlier requirement of taking the higher of the previous six months’ or 15 days’ average price. The pre-existing slowdown in the markets led to attractive valuations for the investors.

Companies have taken advantage of this revision in pricing guidelines .Unitech, raised Rs 1,621 cores in April 2009 at Rs 38.50 per share, and again raised Rs. 2,760 crores in July 2009 at Rs 81 per share. Other companies which successfully raised capital through QIPs were HDIL, Shobha Developers, Network 18, Dewan Housing and Bajaj Hindustan. Most of the companies which came out with QIPs were in the real-estate/infrastructure sector. However, some companies like GMR Infrastructure were not so successful and had to withdraw their issue and GVK Power and Infrastructure had to scale down by nearly 60% due to problems in the valuations. Domestic institutional investors, especially life insurers kept away from the QIPs on valuation concerns. However, FIIs which were net sellers had purchased Rs 9,500 crores in the same period.

This led several FIIs to pick up the target stocks via QIP before the July 6thBudget and offload the same after the budget session. As per a CRISIL study, 10 out of 13 QIPs are currently quoting below the offer price. Since most of QIPs were in the reality and infrastructure sectors, one explanation is that FIIs came in expecting some quick gains from significant sops to the infrastructure and housing sectors in the Budget. It is also possible that the rush for QIPs was driven largely by short-term

considerations, where the FIIs hedged their bets by taking short positions in the issuers’ stock even as they bought into the offers.

New sources of FII funds

The Securities and Exchange Board of India is in talks with the Cayman Islands Monetary Authority (Cima), over allowing funds based in the Caribbean into the country. Cayman Islands is one of the world’s largest tax havens and a lot of global hedge funds are based out of Cayman Islands Sebi has received numerous applications from Cayman-based funds since June when Cima was admitted as a full member of the international body of securities market regulators, the International Organization of Securities Commissions (Iosco).

Iosco's constituents regulate more than ninety percent of the world's securities markets. Funds from Cayman Islands were usually not favoured by SEBI owning to lack of transparency and difficulty in establishing the owner base. Consequently, these investments were viewed unfavorably and any Cayman fund seeking to invest in India had to be carefully examined.

Post Cayman’s admission to Iosco, Sebi is now determining which grades of investment funds can be admitted expeditiously and which should be examined more carefully. Presently, there are 19 registered foreign institutional investors from Cayman Islands, taking the total to 19. The two recent additions have been Fir Tree Capital Opportunity Master Fund and Fir Tree Value Master Fund. The fund base of Cayman Islands is huge. There are about 9870 funds based there. Indian markets can expect more inflow from Cayman Island if SEBI agrees to let them come in.

Recommendations

Increase cap on G-Sec Bond Markets:

Currently, the cap on FII investments in the bond market is USD 6 Billion. As per the new budget, proposes to borrow Rs.4.5 lakh crore in 2009-10 to support its infrastructure and other developmental projects. This could be opened up to the FIIs so that they can take part in India’s hitherto almost

closed debt market. The Indian debt markets are not fully developed and see low volumes. The lifting of the cap on FIIs will increase the traded volumes and it will also help in preventing the ‘crowding out’ of investment for private enterprises.

Allow dollar settlements in India:

The suggestion by SEBI to permit dollar settlements for FIIs would revolutionize the way in which they invest in the country. This will help mitigate risks of currency fluctuations for FIIs, and help in improve the volume and liquidity of the derivatives market. With dollar settlements, many participants, who want to take exposure to Indian markets through index buying, will be able to participate freely. This, in turn, will give stability to Indian markets as there will be buying of underlying stocks by the sellers of these contracts to FIIs.

At present, settlements in India are done in rupee denominations. As a result, a number of FIIs, who intend to trade in Nifty futures, take the Singapore route where CNX Nifty index futures are traded on SGX.

About 50 per cent of the total open interest (OI) build-up in Nifty futures takes place on the SGX, which allows settlements in US dollar. This enables different types of FIIs to operate there. Also, low transaction costs due to the absence of securities transaction tax, stamp duty and P-note complications have resulted in a gradual shift of FIIs into offshore markets. Settlements in dollar would also help in reducing the volatility in dollar-rupee conversion value caused due to FII flows. Each time a settlement is done, a seller of futures contracts to an FII would buy an equivalent amount of underlying stocks to hedge his/her exposure due to the sale. This would increase the trading volume and liquidity of Indian markets, once dollar settlement is allowed.

Stricter implementation of regulation to curb p-notes etc.

To prevent the misuse of the participatory notes, there should be stricter implementation of the regulations. Tough implementation of KYC norms should be done. In the long run, the group is of the opinion that registration procedures for FIIs should be made simpler after which P-Notes should be done away with.

LIMITATIONS OF THE STUDY

As the time available is limited and the subject is very vast the study is mainly focused on identifying whether there does exist a relationship between FIIs and Indian Equity Stock Market.

•The study is general.

•It is mainly based on the data available in various websites;

•The inferences made is purely from the past year’s performance;

•There is no particular format for the study;

•Sufficient time is not available to conduct an in-depth study

Conclusion

It is clear that the FIIs are influencing the Sensex movement to a greater extent. Further it is evident that the Sensex has increased when there are positive inflows of FIIs and there were decrease in Sensex when there were negative FII inflows. It has been perceived in some quarters that FII flows are major drivers of stock markets in India and hence a sudden reversal of flows may harm the stability of its markets. The nature of relationship between FII flows and Indian stock market returns can be explained in terms of “cumulative informational disadvantage” of foreign portfolio investors vis-a-vis domestic investors. The theory says that domestic investors posses better knowledge about Indian financial markets than foreign investors and this information asymmetry leads to „positive feedback trading‟ by the foreign portfolio investors. There is no doubt FIIs are influencing the movement of Sensex to a greater extent.

Why Do Companies Invest Overseas? Companies choose to invest in fo re ign markets fo r a number o f reasons, o f ten thes a m e   r e a s o n s   f o r   e x p a n d i n g   t h e i r   o p e r a t i o n s   w i t h i n  t h e i r   h o m e   c o u n t r y .   T h e economist John Dunning has identified four primary reasons for corporate foreigninvestments:Market seeking -Firms may go overseas to find new buyers for goods and services.Market-seeking may happen when producers have saturated sales in their homemarket, or when they believe investments overseas will bring higher returns thanadditional investments at home. This is often the case with high technology goods.Resource seeking -Put simply, a company may find it cheaper to produce its productin a foreign subsidiary- for the purpose of selling it either at home or in foreignmarkets. The foreign facility may be able to obtain superior or less costly access to theinputs of production (land, labor, capital and natural resources) than at home.Strategic asset seeking -Firms may seek to invest in other companies abroad to help bu i ld s t ra teg ic assets , such as d is t r ibu t ion networks or new techno logy. Th is may invo lve   the  es tab l ishment  o f  par tnersh ips w i th  o ther  ex is t ing   fo re ign   f i rms  tha tspecialize in certain aspects of production.Efficiency seeking -Mul t ina t iona l  companies  may a lso  seek   to   reorgan ize   the i r  overseas holdings in response to broader economic changes. Fluctuations in exchangerates may also change the profit calculations of a firm, leading the firm to shift theallocation of its resources.

Introduction

Many developing countries, including India, restricted the flow of foreign capital till the early 1990s and depended on external aid and official development assistance. Later, most of the developing countries opened up their economies by dismantling capital controls with a view to attracting foreign capital, supplementing it with domestic capital to stimulate domestic growth and output.

Since then, portfolio flows from foreign institutional investors (FII) have emerged as a major source of capital for emerging market economies (EMEs) such as Brazil, Russia, India, China and South Africa. Besides, the surge in foreign portfolio flows since 1990s can be attributed to greater integration among international financial markets, advancement in information technology and growing interest in EMEs among FIIs such as private equity funds and hedge funds so as to achieve international diversification and reduce the risk in their portfolios.

Economic growth is a function of, among other things, capital formation. As FII flows are a source of non-debt creating capital for the economy, many EMEs have been competing with each other to attract such flows throughflexible investment norms/regulations or by offering fiscal sops. Further, FIIshave been assured decent returns on their investments, enabling continuous and sustainable investment flows.

FII flows into India registered substantial growth from a meagre US$4 million in 1992–93 to over US$ 32 billion in 2010–11 (SEBI, 2011: 76). FII inflows underwent a sea-saw movement in India during the last decade. They registered spectacular growth especially since the middle of 2003 due to the higher growth rate in Indian GDP, robust corporate performance and an investment-friendly environment. Portfolio investment flows into India turned negative (outflow of US$ 12 billion) during 2008–09 (ibid.) mainly due to the heightened risk aversion of foreign investors, emanating from the global financial meltdown.

Ever since foreign portfolio investors were allowed to invest in Indian financial markets in September 1992, there have been extensive deliberations on the impact of such flows. It is said that portfolio flows from

FIIs inject global liquidity into the capital markets, raise the price-to-earnings ratios, thereby reducing the cost of capital. This, in turn, leads to further issues of equity capital and stimulates investment growth in the host economy, apart from bringing in best international corporate governance practices. Yet, FIIs have been targets of criticism due to characteristics such as return chasing behaviour, herd mentality, hot money flows, short-term speculative gains and their influence on domestic policy-making.

Though numerous research studies have been conducted in respect of FII flows into India, most of them have been confined to assessing the impact of such flows on stock markets. Very few studies have focused on the overall impact of FII flows on all segments of the Indian financial markets, viz., the capital market, the foreign exchange market, the money market and other macro-economic variables, such as inflation, money supply and Index of Industrial Production (IIP). Given this background, it is all the more relevant to undertake a causeand-effect study of FII flows into Indian financial markets in a holistic manner, by considering various macro-economic parameters, such as IIP, interest rates, inflation, exchange rates, apart from the BSE Sensex, so as to enable policymakers to take informed decisions in this regard. The present study examines the causes and effects of FII net flows into Indian financial markets with the support of empirical data for the period April 2003–March 2011, i.e., a time span of eight years, covering the period before, during and after the eruption of the global financial crisis.