DISSERTATION

ON

“AN ANALYSIS TO STUDY THE IMPACT OF FII

ON SENSEX : 2000-2006

Submitted in partial fulfillment of the requirement for MBA

Degree of Bangalore University
BY

R V RAVI KUMAR
Register Number
04XQCM6067
Under the guidance of
Prof. SANTHANAM

M.P.Birla Institute of Management

Associate Bharatiya Vidya Bhavan
Bangalore-560001
2004-2006
 DECLARATION

I hereby declare that the report titled “AN ANALYSIS TO STUDY THE

IMPACT OF FII ON SENSEX: 2000-2006” prepared under the guidance of Prof.

SANTHANAM in partial fulfillment of MBA degree of Bangalore University, and is my

original work.

This project does not form a part of any report submitted for degree or

diploma of Bangalore University or any other university.

Place: Bangalore
Date: R V RAVI KUMAR
 PRINCIPAL’S CERTIFICATE

This is to certify that Mr. R V RAVI KUMAR, bearing registration No:

04XQCM6067 has done a project and has prepared a report “AN ANALYSIS TO

STUDY THE IMPACT OF FII ON SENSEX: 2000-2006” under the guidance of

Prof. SANTHANAM, M P Birla Institute of Management, Bangalore. This has not

formed a basis for the award of any degree/diploma for any other university.

Place: Bangalore Dr.NAGESH.S.MALLAVALLI

Date: PRINCIPAL

MPBIM, Bangalore
 GUIDE’S CERTIFICATE

I hereby declare that the research work embodied in this dissertation

entitled “AN ANALYSIS TO STUDY THE IMPACT OF FII ON SENSEX: 2000-

2006” has been undertaken and completed by Mr. R V RAVI KUMAR under My

guidance and supervision.

I also certify that he has fulfilled all the requirements under the covenant

governing the submission of dissertation to the Bangalore University for the award of

MBA Degree.

Place: Bangalore Prof. SANTHANAM

Date: Internal guide

MPBIM, Bangalore
 ACKNOWLEDGEMENT

The successful accomplishment of any task is incomplete without

acknowledging the contributing personalities who both assisted, inspired and lead us to

visualize the things that turn them into successful stories for our successors.

First, I thank the Almighty God for his grace bestowed on us throughout

this project. I thank Dr. N. MALAVALLI SIR for sufficient guidance and all the

facilities for the completion of this project.

My special thanks to my project guide Prof SANTHANAM, who guided

us with the timely advice and expertise and helped us complete the project early.

Last, but not the least, I would like to thank my parents and all my

friends for their wholehearted support and encouragement.

RAVI KUMAR
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CHAPTER: 1
ABSTRACT
ABSTRACT:

This paper investigates the nature of the causal relationship between stock returns, net
foreign institutional investment (FII) in India. By applying the techniques of unit–root
tests, co integration and the long–run Granger non–causality test, we test the causal
relationships using monthly data for the period January 1993 to March 2006.

Since the beginning of liberalization FII flows to India have steadily grown in
importance. In this paper we analyze these flows and their relationship with other
economic variables and arrive at the following major conclusions:
While the flows are highly correlated with equity returns in India, they are more likely to
be the effect than the cause of these returns;
 CHAPTER 2
INTRODUCTION

INTRODUCTION
May 2004 and May 2006, has some common thing to say to the history of Indian Stock
Market, On may 2006, Global concerns over rising interest rates in the US and sustained
FII outflows continued to take its toll on the market, dragging down the sensex to a three-
and-a-half month low. Despite strong GDP growth and early onset of the monsoon, the
mood remained extremely bearish as FIIs remained major sellers amid hints of a further
rise in interest rates in the wake of inflationary trend in the US.

The foreign investors had made net investments of over $4bn during January-April ‘06.
The FII-led recovery in the sensex may help ease down concerns about heavy FII selling
that caused a crash in the market in the past few weeks. FIIs pulled out funds to the tune
of $1.6bn in May, after pumping in over $4bn in January-April ’06.

The ongoing transition in the international financial architecture is exhibiting several

features of which capital inflows are perhaps the most important. Emerging economies
have experienced massive capital inflows, which in some cases have proved to be
traumatic later. Whether such traumatic situations occurred due to incompatible macro
economic and exchange rate policies or imprudent banking policy or lack of liquidity in
the market is a matter of debate at the theoretical plane and an issue of future policy
concern under country specific conditions. Whatever be the reason, the issue boils down
to the fact whether such flows are properly paced and properly sequenced such that the
inflow of capital is not excessive relative to the maturity of the system in which it must
be absorbed; only then the capital flows can be sustained and systemic stability ensured.

This may be attained through structural and operational realignment of the domestic and
financial sector variables of the economies exposed to global financial network. It is in
this context that the inter linkage among the stock market, the most sensitive sector of the
economy, exchange rate, the barometer of external interaction and the FII flows, indicator
of capital surge needs to be addressed
To what extent the stock market can internalize or in other words, can capture the
information on these is a case in point. For otherwise there may arise the possibility of
capital flow reversals. The present study focuses on this issue in the Indian context. In
fact, from among the whole gamut of institutional reforms undertaken in India since the
1990’s, gradual abolishment of capital inflow barriers and foreign exchange restrictions,
adoption of more flexible exchange rate arrangements deserve a special attention at this
juncture to reexamine whether India is approaching towards achieving the twin goals of
stability and efficiency of the financial system .
 CHAPTER 3

PAST RESEARCHES ON FII IMPACT

PAST RESEARCHES ON FII IMPACT

There is a general perception that FIIs play a major role in the movements of stock
indices. This is because the swings in institutional demand for a particular stock or in a
particular group of stocks have a larger effect on its prices than swings in individual
demand. Foreign investors largely held responsible for the collapse of East Asian stock
markets.

Radelet and Sachs (1998) attributed the East Asian economic crisis to financial panic due
to sudden reversal of portfolio investment. Academicians often argue that foreign
investors destabilize stock prices due to various reasons. More often, according to
Dornbusch and Park (1995) foreign investors pursue positive feedback strategies, which
makes stocks to overreact to change in fundamentals.

Very few studies have been carried out in India empirically to see the impact of FIIs
investments on Indian stock market. Early studies by Samal (1997) and Pal (1998) found
co movement between FIIs flows and Bombay Stock Exchange (BSE) index to be high
Chalapati Rao and et al. (1999) analyzed the investment exposure of five US-based India
specific funds, which suggested a close resemblance between FIIs investment profile and
trading pattern at the BSE. However, they did not study the causality between FIIs flows
and BSE. Batra (2003), using both daily and monthly data attempted to understand the
trading behavior of FIIs and returns in Indian equity market. He found the strong
evidence of FIIs chasing trends and adopting positive feedback and herding trading
strategies.

However, Batra did not find FIIs having any destabilizing impact on the equity market.
Chakrabarti (2002), made an empirical investigation to see the interrelationship between
FIIs flows and equity returns in India using monthly data. He came with the evidence that
the FIIs flows are highly correlated with equity returns in India. He also found that FIIs
flows are more likely to be the effect than the cause of these returns, which contradicted
the view that the FIIs determine market returns in general.
 CHAPTER 4
PRESENT STATE OF ART
THE PRESENT STATE OF ART

India embarked on a programme of economic reforms in the early 1990s to tie over its
balance of payment crisis and also as a step towards globalization. An important
milestone in the history of Indian economic reforms happened on September 14, 1992,
when the FIIs (Foreign Institutional Investors) were allowed to invest in all the securities
traded on the primary and secondary markets, including shares, debentures and warrants
issued by companies which were listed or were to be listed on the stock exchanges in
India and in the schemes floated by domestic mutual funds. Initially, the holding of a
single FII and of all FIIs, NRIs (Non-Resident Indians) and OCBs (Overseas Corporate
Bodies) in any company were subject to a limit of 5% and 24% of the company’s total
issued capital respectively. In order to broad base the FII investment and to ensure that
such an investment would not become a camouflage for individual investment in the
nature of FDI, a condition was laid down that the funds invested by FIIs had to have at
least 50 participants with no one holding more than 5%. Ever since this day, the
regulations on FII investment have gone through enormous changes and have become
more liberal over time.

There have been attempts to explain FII in India. All the existing studies found that the
equity return has a significant and positive impact on the FII (Agarwal, 1997;
Chakrabarti, 2001; and Trivedi & Nair, 2003). But given the huge volume of investments,
foreign investors could 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. Ahmad et al
(2005) make a firm level analysis of FII’s role in the Indian equity market. At the
aggregate level FII investments and NSE Nifty seem to have a strong bi-directional
causality. At the firm level FIIs are influencing equity returns especially in the
government owned companies. On the issue of market stability Mazumdar (2004) finds
that FII flows have enhanced liquidity in the Indian stock market but not much evidence
is there to support the hypothesis that FII flows have generated volatility in the returns.
Ahmed et al (2005) also confirms that there has been very little destabilizing effect of FII
flows on individual equity returns of the firms during their period of study. Kumar (2001)
inferred that FII flows do not respond to short-term changes or technical position of the
market and they are more driven by fundamentals. The study finds that there is causality
from FII to Sensex. This is in contradiction to Rai and Bhanumurthy (2003) results using
similar data but for a larger period. A study by Panda (2005) also shows FII investments
do not affect BSE Sensex. No clear causality is found between FII and NSE Nifty. FIIs
are found to follow positive feedback strategy and to have return clustering tendency.

Following the Asian crisis and the bust of info-tech bubble internationally in 1998-99 the
net FII has declined by US$ 61 million. But there was not much effect on the equity
returns. Chakrabarti (2001) has marked a regime shift in the determinants of FII after
Asian crisis. The study found that in the pre-Asian crisis period any change in FII found
to have a positive impact on the equity returns. But in the post-Asian crisis period a
reverse relation was found, i.e. a change in FII was mainly due to change in equity
returns.

If FIIs use positive feedback trading strategies, causality may run from stock prices to
foreign investment. The portfolio balancing efforts of foreign investors would also put
pressure on demand for (or supply) of currency, which may affect its exchange rate. On
the other hand, the payoff of foreign investors depends on exchange rate movements as
well as on stock price movements, and they may rebalance their portfolio in response to
an (an anticipated) change in exchange rate. The relationship of FII investment with stock
prices on the one hand, and with exchange rate on the other hand may produce indirect
relation between exchange rate and stock prices

In the contemporary Indian scenario, study on interlinkage of stock prices, net FII
investment and exchange rate is scarce. Using monthly data from April 1993 to March
2004, Badhani (2005) observed (i) bi-directional long-term causality between FII
investment Flow and stock prices, but no short-term causality could be traced between
the variables, (ii) no long-term relationship between exchange rate and stock prices, but
short-term causality runs from change in exchange rate to stock returns, not vice versa,
and (iii) exchange rate long term granger causes FII investment flow, not vice versa. The
issue of the above interlinkage among stock price, FII and exchange rate gains
importance from its own course of happenings.

The current pattern of concomitant advancement of FII flows and the Sensex does pose
concern for the market analyst and the researchers. These may have multifaceted
ramifications in terms of economic and financial stability of the economy in which
exchange rate does have a role to play as discussed above.

Apart from exhibiting some concern, the market analysts do not currently observe any
destabilizing motion in the current scenario nor do they apprehend it for the future;
however, we feel that the time is perhaps ripe for analyzing the interlinkage in the stock
price –FII- exchange rate nexus and examine to what extent the stock price can capture
the publicly available information on the other two. This is true for the other two
variables as well.

The concern lies in the fact that if such information is not captured, then there is scope
for profitable trading as discussed above which at faster pace of occurrence may trigger
off higher volatility and generate systemic risk. Some studies do reveal volatility
clustering at the firm level equity returns but till now these are not transferred to other
firms. It may be feared that at a higher pitch such transfer may occur endangering
systemic risk in the entire equity market. Attempts are also being currently made by the
authorities to check intra-day volatility through ‘Block Deals’. Although destabilizing
motion is not presently apprehended, some concern are expressed on the sustainability of
FII flows since new traders are setting in the market posing edgy character and selling at
the slightest concern.

There also prevails optimistic outlook which puts forward that FIIs are not ‘villains’. In
most of the market crashes the FIIs were net buyers (e.g.stock market crash of 2001,
market collapse of 1998). Even in the 17 May 2004 Black Monday episode FIIs were not
the culprits. Though there was a net outgo there was also a come back in the next month
June as a net inflow. Further, improved risk management system was also seen to
withstand volatility of ‘8’ sigma against the normal built in capacity of ‘3-6’ sigma
variations internationally.

It is further argued that FIIs tend to support stock market purely to ensure stability and
safety of their own investments. All these reflect much concern on issue of FII, Stock
prices and exchange rate interlinkage and this itself justifies our study done in terms of
Efficient Market Hypothesis (EMH).
 CHAPTER 5
FOREIGN INSTITUTIONAL INVESTORS
Foreign Institutional Investment in India: An Overview

India opened its stock markets to foreign investors in September 1992 and has, since
1993, received considerable amount of portfolio investment from foreigners in the form
of Foreign Institutional Investor’s (FII) investment in equities. This has become one of
the main channels of international portfolio investment in India for foreigners13. In order
to trade in Indian equity markets, foreign corporations need to register with the SEBI as
Foreign Institutional Investors (FII)14. SEBI’s definition of FIIs presently includes
foreign pension funds, mutual funds, charitable/endowment/university funds etc. as well
as asset management companies and other money managers operating on their behalf.

AVERAGE MONTHLY FII FLOWS

The trickle of FII flows to India that began in January 1993 has gradually expanded to an
average monthly inflow of close to Rs. 1900 crores during the first six months of 2001.
By June 2001, over 500 FIIs were registered with SEBI. The total amount of FII
investment in India had accumulated to a formidable sum of over Rs. 50,000 crores. In
terms of market capitalization too, the share of FIIs has steadily climbed to about 9% of
the total market capitalization of BSE (which, in turn, accounts for over 90% of the total
market capitalization in India).

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 Fig. 2). 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.

[Fig. 2 about here]

 CHAPTER 6
FINANCIAL MARKET OVERVIEW

FINANCIAL MARKET OVERVIEW

 In the new financial year (2006-07), there has been overall buoyancy across the markets,
with the equity stock indices ruling at unprecedented levels, gilt-edged markets sloshing in surfeit
of liquidity and improved volumes in commodities market. This bullishness has been backed by
the healthy state of the macro-economy at a sustained growth rate of 8 per cent and RBI’s
positive outlook on growth and price stability and sound corporate earnings–particularly the
impressive performance by the top three IT companies. The market has been pleasantly
surprised by the RBI governor’s decision to keep short-term rates unchanged. The international
rating agency Standard and Poor’s decision to upgrade the sovereign rating by a notch has
further propelled market sentiments. In the equity market, the bourses has displayed immense
volatility, nevertheless have retained their bullishness as BSE sensex has crossed yet another
milestone of 12,000 mark amidst a highly volatile market. A notable feature during the month has
been the countervailing role played by mutual funds supporting the bourses to sustain the FIIs
selling spree, which in turn has been induced by the relatively expensive domestic equity market
in comparison to other emerging markets on account of a higher P/E ratio of more than 21.
Meanwhile, following NSE’s hike in margins in both cash and derivative segments, the derivative
market has registered a marginal increase in its turnover as compared to the previous month. In
the debt market, the prevailing surplus liquidity has boosted market sentiments, reinforced by the
surprisingly neutral interest rate stance in the Annual Credit Policy announced on April 19. The
secondary market for gilt-edged securities has remained buoyant. However, the corporate bond
market has turned subdued and the total resources mobilised through it have nose-dived on
account of the on–going slack season and uncertainty prevailing over the hardening of interest
rates. In the foreign exchange market the rupee has depreciated against the dollar following the
spiralling international crude oil prices as well as RBI intervention in the market. Meanwhile, in the
commodity futures market, the Forward Market Commission (FMC) has, on April 25, classified
real time trading in commodity by opening the terminals of foreign commodity exchanges without
prior approval of the Centre or FMC as illegal and punishable.

Trends in the Equity Market

i) Primary Issues

According to Ernst & Young’s third annual global IPO report –‘Accelerating Growth’, 29
countries, including India, Brazil, Eygpt, Greece, Isreal, Kazakhstan, Malaysia, Poland, Saudi
Arabia, South Korea and the UAE have, each floated more than $1 billion worth of IPO in 2005, a
trend which is expected to continue in 2006. As per the report, India has evoked lively investor
interest. While the amounts raise have fallen from $2.9 billion in 2004 to $2.3 billion in 2005,
reflecting fewer privatisation, the number of transactions (issues) have surged from 21 to 53,
placing India in the fourth position in Asia, following China, Japan, and South Korea. While the
financial sector dominated the overall funds mobilised, IPO activity in India has been fairly spread
across sectors with companies from energy and power, airlines, engineering, industrial,
healthcare, consumer goods, technology and media segments accessing the capital market.

ii) Secondary Market

In April, the stock markets have remained volatile, yet bullish with both the bourses
touching yet newer all time highs reflecting strong macroeconomic fundamentals, excellent
corporate results and sound business outlook, further reaffirmed by, the global rating agency,
Standard and Poor’s decision to revise its outlook on India’s sovereign credit rating and confirm
its ‘BB+/B’ ratings for the sovereign after hinting a scope of upgradation to investment grade if the
country’s public finances improve. Moreover, the RBI’s decision to keep the reverse repo and
repo rate unchanged in its Annual Credit Policy has further fuelled the market sentiments.

Notably, what has stood out is the extreme volatility that has gripped the market in the
latter half of the month. Amidst the above stated positive developments, coupled with the
overwhelming response to the Reliance Petroleum initial public offer and the surprise bonus
share announcement by Infosys, the BSE sensex has surged to cross yet another milestone of
12,000 points on April 20 as it closed at 12,039.55 points, within just 16 trading sessions.
However, it could not sustain the 12,000 level as the surge in international crude oil prices,
worries over reports regarding below-normal monsoon as well as NSE’s hike in margins in both
cash and derivative segments led to a massive fall of around 383.52 points in just two days as the
sensex closed at 11646.78 points on April 25. But, irrespective of FIIs being net sellers to the
tune of Rs 508.8 crore, sensex has seen a rise by 292 points on the very next day supported by
encouraging corporate results and a dip in the international crude oil prices. Then again following
a dip of 104 points on April 27, it has risen by around 208 points to close the month at 12042.56
points, making a gain of 6.76 per cent over its previous month’s close. Meanwhile, BSE Mid-Cap
and BSE Small-Cap have registered gains of 9.28 per cent and 12.22 per cent, respectively, both
above that recorded by sensex

Monthly Percentage Change in the Stock Indices of BSE

 Change
Base March April
Index April over month
Year Closing Closing
(per cent)
High Low
SENSEX 1978-79 11279.96 12042.56 12102 11008.43 6.76
BSE 100 1983-84 5904.17 6251.39 6265.23 5745.18 5.88
BSE 200 1989-90 1412.62 1500.48 1502.34 1376.42 6.22
BSE 500 1998-99 4516.73 4829.73 4835.21 4413.61 6.93
BSE Mid-Cap 2002-03 5348.62 5843.29 5848.73 5277.7 9.25
BSE Small-Cap 2002-03 6591.66 7397.48 7462.51 6613.15 12.22
BSE TECk Apr 02,2001 2713.12 2745.43 2903.03 2588.8 1.19
BSE PSU 1998-99 6114.88 6147.31 6329.82 5837.85 0.53
BSE AUTO Feb 01,1999 5322.73 5548.91 5586.3 5088.67 4.25
BANKEX Jan 01,2003 5265.24 5245.79 5558.02 4853.39 -0.37
BSE CG Feb 01,1999 8170.56 8811.05 8932.69 8092.27 7.84
BSE CD Feb 01,1999 3212.33 3458.62 3515.51 3129.9 7.67
BSE FMC Feb 01,1999 2211.45 2312.19 2358.27 2129.34 4.56
BSE HC Feb 01,1999 3858.10 3894.84 4119.57 3656.16 0.95
BSE IT Feb 01,1999 4030.29 4034.92 4343.63 3828.7 0.11
BSE METAL Feb 01,1999 8869.91 10762.23 10870.22 8929.83 21.33
BSE OIL&GAS Feb 01,1999 4918.98 5687.90 5745.45 4953.69 15.63
Source: BSE (www.bseindia.com)

Foreign Institutional Investments (FIIs)

During the month, FIIs investments in the equit y market have dipped to Rs 522 crore
with purchases worth Rs 44,645 crore and sales of Rs 44,123 crore as against Rs 6,689 crore in
March, irrespective of the rise in the number of FIIs registered with Sebi to 906 from 882 in the
previous month. During the first four months of the calendar year 2006, FIIs have invested US $
4.03 billion as against US $ 3.5 billion in the corresponding period last year. Meanwhile, the share
of FIIs in the total cash turnover of both the bourses has stood at 33.68 per cent during the
month.

Sebi has, on April 05, allocated new limits for FIIs to invest in the debt market in line with
the announcement made in this regard in the budget 2006-07, wherein the government had
increased the limit on FII investment in government securities from $1.75 billion to $2 billion and
in corporate debt from $0.5 billion to $1.5 billion. Under the revised limits, the $2 billion
investment in government securities by FIIs will be divided into a proportion of $1.75 billion for
100 per cent debt FIIs and $250 million for 70:30 FII/sub-accounts. Similarly, the corporate debt
limit of $1.50 billion will be shared as $ 1.35 billion for 100 per cent debt FIIs and $150 million for
70:30 FIIs. Further, it has also been clarified that FII investments will be restricted to listed debt
securities of companies.

Mutual Funds

In the financial year 2005-06 there has been a huge surge in the mobilisations by the
private sector mutual funds through new fund offers (NFOs). The total amount mobilised via
NFOs has risen by almost 173 per cent to Rs 70,583 crore from Rs 25,811 crore in the previous
financial year. Likewise, the assets under management (AUM) of the mutual funds have
increased by almost 27 per cent to Rs 23,25,841 crore from 18,33,602 crore in the last financial
year. In April, the total amount mobilised via NFOs has registered a decline by almost 87 per cent
to Rs 2,918 crore from Rs 22,868 crore in the previous month, while the AUM have increased to
Rs 2,57,499 crore from Rs 2,31,862 crore in March. Meanwhile, the share of mutual funds in the
total cash turnover of both the bourses has stood at 8.49 per cent.

Foreign Exchange Market

The rupee–dollar exchange rate in April has sharply depreciated against the dollar by
around 36 paise from Rs 44.61 to Rs 44.97 as on April 28. During the month, a variety of factors
such as escalation in international crude oil prices and the resultant heavy dollar demand by oil
companies have adversely affected the rupee–dollar exchange rate. In April, the RBI continued to
intervene in the market to modulate the rupee movement, which has further aggravated the
currency’s weakness against the dollar. The month began with the rupee trading at Rs 44.61 per
dollar amid robust FIIs inflows into the surging domestic equity market. But, subsequently the
rupee movement has been adversely affected by the increased volatility in the domestic stock
market due to a selling spree of the FIIs coupled with the RBI’s intervention in the market as it
breached the psychologically important Rs 45 mark and has traded above the Rs 45 level for
most part of the month. However, in the latter part of the month with the Chinese Central Bank
raising its basic lending rates by 27 basis points to 5.85 per cent and the Fed’s Chief signalling
that it may pause its interest rate–tightening policy has resulted in the rupee recovering smartly to
end the month at Rs 44.97 per dollar. Meanwhile, in the forward premia market, all three tenures,
viz., one-month, three-month and twelve –month, have converged in the initial part of the month;
though the one-month annualised premia have ruled above the other two tenures in the later part
of the month .
 CHAPTER 8
METHODOLOGY
METHODOLOGY

A plethora of researches are being conducted to understand the current working of the
economic and the financial system. Interesting results are emerging particularly for the
developing countries where the markets are experiencing new relationships which are not
perceived earlier. One of the most important changes that Indian capital market witnessed
with the reforms is the entry of foreign institutional investors. Since then the country has
been receiving increasing amounts of portfolio investment. The analysis of the
interrelationship between stock prices, net foreign institutional investment (FII) and
exchange rate in the present study runs in terms of efficiency of Indian stock markets.

The Efficient Market Hypothesis (semi-strong form), states that in a semi strong efficient
market, everyone has perfect knowledge of all publicly available information in the
market. The idea is, whether in a mutually interactive framework, stock market can
effectively digest and incorporate all available information about economic variables.

This is important because, if it does so, then the rational behavior of market participants
ensures that past and current information is fully reflected in stock prices. Otherwise, (a)
the market participants are able to develop profitable trading rules and thereby can
consistently earn more than average market returns, and (b) the stock market is not likely
to play an effective role in channeling financial resources to the most productive sector of
the economy. The use of Granger Causality Test in examining market informational
efficiency has been there for quite some time. This is based on the hypothesis that
informational efficiency exists if a uni-directional lagged causal relationship from an
economic variable to stock prices or bi-directional lagged causal relationship from an
economic variable to stock price or from the latter to the former, could not be detected. It
implicates that the economic variable neither influences nor is influenced by stock price
fluctuations, and the two series are independent of each other and the market is
informationally efficient.
This paper makes use of the Granger Causality test. The study investigates the empirical
relationship between stock prices, net FII investment and using monthly data from
January 2000 to May 2006.

Unit Root Test and Co integration:

Empirical studies (for example, Engle and Granger, 1987) have shown that many time
series variables are non-stationary or not integrated of order zero. The time series
variables considered in this paper are the stock prices and fii flows. In order to avoid a
spurious regression situation the variables in a regression model must be stationary or
cointegrated. Therefore, in the first step, we perform unit root tests to investigate whether
they are stationary or not.
The Augmented Dickey-Fuller (ADF) unit root test is used for this purpose. The
ADF regression equations are:

where åô is white noise. The additional lagged terms are included to ensure that the
errors are uncorrelated.
HYPOTHESIS

ADF UNIT ROOTS TEST

The tests are based on the

null hypothesis (H0): Yt is not I (0). If the calculated ADF statistics are less than their
critical values from Fuller’s table

then the null hypothesis (H0) is rejected and the series are stationary or not integrated of
order zero.

COINTEGRATION

In the second step we estimate cointegration regression using variables having the same
order of integration. The cointegration equation estimated by the OLS method is
given as:

In the third step residuals (Zt) from the cointegration regression are subject to the
stationarity test based on the following equations:
Toda and Yamamoto Version of Granger Causality:

Toda and Yamamoto (1995) proposed a simple procedure requiring the estimation of an
‘augmented’ VAR, even when there is cointegration, which guarantees the asymptotic
distribution of the statistic. Therefore, the Toda-Yamamoto causality procedure has been
labelled as the long-run causality tests. All one needs to do is to determine the maximal
order of integration dmax, which we expect to occur in the model and construct a VAR in
their levels with a total of (k + dmax) lags. Toda and Yamamoto point out that, for d=1,
the lag selection procedure is always valid, at least asymptotically, since k 1 . =d. If d=2,
then the procedure is valid unless k=1. Moreover, according to Toda and Yamamoto, the
statistic is valid regardless whether a series is I (0), I (1) or I (2), non-cointegrated or
cointegrated of an arbitrary order.

In order to clarify the principle, let us consider the simple example of a bivariate model,
with one lag (k=1). That is,
The statistic will be asymptotically distributed as a Chi Square, with degrees of freedom
equal to the number of "zero restrictions", irrespective of whether x1t and x2t are I (0), I
(1) or I (2), non-cointegrated or cointegrated of an arbitrary order. In this study, we used
monthly data series for three variables for the period January 1993 to March 2005
forming around 147 observations. The monthly return on stock prices (RBSE) is
calculated by taking a percentage change in the BSE Sensitive Index (base: 1978-
79=100).

The other two variables included in our study are net investments by FIIs (in equities) in
the Indian capital market and the indices (36-country bilateral weight with base
1985=100). Incidentally, it may be noted that FIIs were allowed to invest in the Indian
capital market securities from September 1992. However, investments made by them
were first made in January 1993. The data has been compiled from Handbook of
Statistics on Indian Economy published by Reserve Bank of India and various issues of
RBI Bulletin.
 CHAPTER 9
DATA DESCRIPTION
DATA DESCRIPTION

We obtain the aggregate monthly FII flow data from the time India opened her doors to
FIIs, that is, from January 2000 to June 2006 from India Infoline and Equity Master. We
also have data on each of the three components of the flows, that is, the purchases, sales
and the net flows (purchases less sales) with the markets returns. The Reserve Bank of
India and the Securities Exchange Board of India also provide the data on FII flows. We
look at the relationship between flows and market returns using both, the returns on the
Bombay stock exchange (BSE) and National stock exchange (NSE). The data on market
index is obtained from the respective stock exchanges. The return for market i for month t
would be given by;

Established in 1875, BSE is not only the oldest stock exchange in India, but is also the
oldest in Asia. It accounts for over one-third of the total trading volume in the country.
The National Stock Exchange (NSE), located in Bombay, was set up in 1993 to
encourage stock exchange reform through system modernization and competition. It
opened for trading in mid-1994. Since then the NSE has made major strides and is now
the dominant stock exchange in the country. Most other studies on Indian market use the
BSE Sensex index to compute market returns. With NSE being an equally prominent
stock exchange in India, we also use the S&P CNX Nifty index to compute returns.
Between the two exchanges, NSE being demutualized provides a better market quality.
With lower execution cost, lower price volatility and higher liquidity compared to BSE,
NSE has emerged to be superior by providing improved market quality and high
standards of investor protection .

BSE Sensex is a basket of 30 constituent stocks representing a sample of large, liquid

and representative companies. The base year of SENSEX is 1978-79 and the base value
is 100. The index is widely reported in both domestic and international markets through
print as well as electronic media. The Index was initially calculated based on the ‘Full-
market capitalization’ methodology but was shifted to the ‘Free-float methodology’ with
effect from September 1, 2003.

Under the 'Full-market capitalization' methodology, the total market capitalization of a

company, irrespective of who is holding the shares, is taken into consideration for
computation of an index. Recognizing the limitation with this methodology, BSE now
uses the Free-float market capitalization of a company for index calculation, like MSCI,
FTSE, S&P and Dow Jones. Using ‘Free-float methodology’, generally excludes
promoters' holding, government holding, strategic holding and other locked-in shares,
which are not tradable in the normal course. Thus, the market capitalization of each
company in a Free-float index is reduced to the extent of its Free-float available in the
market.

S&P CNX Nifty is a well diversified 50 stock index accounting for 23 sectors of the
economy. S&P CNX Nifty is computed using market capitalization weighted method,
wherein the level of the index reflects the total market value of all the stocks in the index
relative to a particular base period. The method also takes into account constituent
changes in the index and importantly corporate actions such as stock splits, rights, etc
without affecting the index value. The base period selected for S&P CNX Nifty index is
the close of prices on November 3, 1995, which marks the completion of one year of
operations of NSE's Capital Market Segment. The base value of the index has been set at
1000 and a base capital of Rs.2.06 trillion. The stocks in these indices, both BSE Sensex
and S&P CNX Nifty, are the ones in which the FIIs are most likely to invest in. Figure 4
shows the movement of BSE Sensex with FII flows starting January 1993. Figure 5
shows the same relation between S&P CNX Nifty and flows.

The purchases and sales seem to be more correlated with the indices from late 90’s.We
scale the flows for the month by market capitalization at the beginning of the month, that
is, market capitalization as at the end of previous month. Regressions looking at
relationship between BSE returns and flows have flows normalized by BSE market
capitalization. For analyzing the relationship between NSE returns and flows, we scale
the flows by NSE market capitalization. With the monthly BSE market capitalization data
available from April 1993; we have the scaled flows starting May 1993 to June 2006
giving us scaled flow data for 122 months. The monthly market capitalization data for
NSE is available from November 1994, giving the scaled flows from December 1994 to
June 2006.

Therefore, with the scaled flow data for 103 months the sample size becomes smaller for
the analysis using NSE returns. The data on market capitalization has been taken from the
respective stock exchange. The seasonal pattern in the average monthly FII flows
(scaled) to India. Consistent with Rao et al. (1999) the graph shows that the month of
January witnesses the highest inflow and the flow (especially purchases) decreases as the
year progresses. The fund managers might be investing most of the funds allocated to a
market, at the beginning of the year and the investment reduces subsequently with the
reduction in availability of funds. Rao et al. (1999) make an interesting observation that
BSE Sensex and FII investments decline in the fourth quarter and this may be because the
local market players might be looking toward FIIs for leads.
 CHAPTER 10
EMPIRICAL RESULTS
EMPIRICAL RESULTS:

UNIT ROOT TEST OF NET FII INVESTMENTS

ADF Test Statistic -4.584336 1% Critical Value* -2.5945

5% Critical Value -1.9448
10% Critical Value -1.6181
*MacKinnon critical values for rejection of hypothesis of a unit root.

Augmented Dickey-Fuller Test Equation

Dependent Variable: D(FII)
Method: Least Squares
Date: 06/11/06 Time: 22:13
Sample(adjusted): 2000:02 2006:02
Included observations: 73 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic Prob.
FII(-1) -0.454260 0.099090 -4.584336 0.0000
R-squared 0.225923 Mean dependent var 0.000201
Adjusted R-squared 0.225923 S.D. dependent var 0.041759
S.E. of regression 0.036740 Akaike info criterion -3.756306
Sum squared resid 0.097187 Schwarz criterion -3.724930
Log likelihood 138.1052 Durbin-Watson stat 2.227419
The ADF t-test has value t = -4.584336 which is smaller than the 5% critical value of -
1.9448 and also at 1 % critical value i.e -2.5945
Therefore the ADF t-test rejects the null hypothesis of a trend (at the 5% significance
level, and also at the 1% significance level).

Since, the null hypothesis of a trend is rejected by the ADF F-test. Thus the trend
indicates the trend is deterministic.
 0.15

0.10

0.05

0.00

-0.05
00 01 02 03 04 05 06

FII

SENSEX
 Similarly, the ADF UNIT ROOT TEST for the sensex returns of the year 2000-06, states
that

AT LEVEL

ADF Test Statistic -7.889 1% Critical Value* -3.52001

5% Critical Value -2.9007

10% Critical Value -2.58736

*MacKinnon critical values for rejection of hypothesis of a unit root.

Augmented Dickey-Fuller Test Equation

Dependent Variable: D(SENSEX)
Method: Least Squares
Date: 06/09/06 Time: 12:59
Sample(adjusted): 2000:02 2006:03
Included observations: 74 after adjusting endpoints

Variable Coefficient Std. Error t-Statistic Prob.

SENSEX(-1) -0.933779 0.118357 -7.8896 2.46445e-5

C 0.009799 0.008302 1.1804 0.2418

R-squared 0.4636679 Mean dependent var 0.000609

Adjusted R-squared 0.456218918 S.D. dependent var 0.0958866410

032
S.E. of regression 0.07070827 Akaike info criterion -2.4339

Sum squared resid 0.35997539 Schwarz criterion -2.37159

Log likelihood 92.052584 F-statistic 62.24519

Durbin-Watson stat 2.00089 Prob(F-statistic) 2.464469e-11

We see, the Augmented Dickey-Fuller Test Equation, for which the t-statistics value of -
7.889 is less than the critical value of -1.94467 at 5 % significance level . hence the null
hypothesis is rejected for the above values.

Hence we conclude the returns of the sensex are stationary, and the trend is deterministic.

0.2

0.1

0.0

-0.1

-0.2
00 01 02 03 04 05 06

SENSEX

COINTEGRATION TEST
The cointegration test, suggests the likelihood of the existence of the other model due to
the initial model.
Thus calculating the likelihood ratio will show the probability of the regression of te
other equation with initial equation.

Date: 06/11/06 Time: 22:50

Sample: 2000:01 2006:12
Included observations: 73
Test assumption:
Linear
deterministic trend
in the data
Series: FII SENSEX
Lags interval: No lags
Likelihood 5 Percent 1 Percent Hypothesized
Eigenvalue Ratio Critical Value Critical Value No. of CE(s)
0.622208 98.23513 15.41 20.04 None **
0.310836 27.17616 3.76 6.65 At most 1 **
*(**) denotes
rejection of the
hypothesis at
5%(1%)
significance level
L.R. test indicates
2 cointegrating
equation(s) at 5%
significance level

Unnormalized Cointegrating Coefficients:

FII SENSEX
-2.519865 1.506949
2.595813 0.854860

Normalized
Cointegrating
Coefficients: 1
Cointegrating
Equation(s)
FII SENSEX C
1.000000 -0.598028 -0.022068
(0.08712)

Log likelihood 232.1339

Here, the likelihood ratio is 84.525 which is greater than critical values at 5 %
significance value. Hence by looking at the table we can say that rejection of the
hypothesis at 5%(1%) significance level.

0.2

0.1

0.0

-0.1

-0.2
00 01 02 03 04 05 06

FII SENSEX

GRANGER’S CAUSALITY TEST

Granger causality is a technique for determining whether one time series is useful in
forecasting another. Ordinarily, regressions reflect "mere" correlations.

A time series X is said to Granger-cause Y if it can be shown, usually through a series of

F-tests on lagged values of X (and with lagged values of Y also known), that those X
values provide statistically significant information on future values of Y.

The test works by first doing a regression of ÄY on lagged values of ÄY. Once the
appropriate lag interval for Y is proved significant (t-stat or p-value), subsequent
regressions for lagged levels of ÄX are performed and added to the regression provided
that they 1) are significant in of themselves and 2) add explanatory power to the model.
This can be repeated for multiple ÄX's (with each ÄX being tested independently of other
ÄX's, but in conjunction with the proven lag level of ÄY). More than 1 lag level of a
variable can be included in the final regression model, provided it is statistically
significant and provides explanatory power.

FROM THE TABLE BELOW, WE INTERPRETE THE FOLLOWING , FINDINGS

AND CONCLUSIONS

Pairwise Granger Causality Tests

Date: 06/11/06 Time: 22:52
Sample: 2000:01 2006:12
Lags: 1
Null Hypothesis: Obs F-Statistic Probability
SENSEX does not Granger Cause FII 73 3.91007 0.05194
FII does not Granger Cause SENSEX 9.85815 0.00248

HYPOTHESIS:
We took the null hypothesis , that sensex doesn’t granger cause netfii and vice versa,

In case 1:
Sensex on granger cause to netfii

Here,
f-statistic value is 3.7002 which is greater than the critical value of 1.53 and 1.40 at 5 %
and 1 % significance level respectively.

Thus we reject the null hypothesis and can say sensex causes the netfii investments

On the other hand analysing the impact of net fii on sensex for monthly basis we see that

F-statistic value is 9.86 which is greater than the critical value of 1.53 and 1.40 at 5 %
and 1 % significance level respectively.

Thus we again reject the null hypothesis and can say net fii has cause on sensex returns.

Now following is the finding for grangers causality test.:

a bi-directional causality between stock price and the net foreign institutional
investment, thus implying that the market informational efficiency hypothesis can be
rejected for BSE Sensitive Index with respect to the FII,
CHAPTER 11
CONCLUSION
CONCLUSIONS:

The main objective of the present paper is to determine impact and relationship between
the Indian stock market, net foreign institutional investment. To test this, we employ the
methodology of Granger non-causality recently proposed by Toda and Yamamoto (1995)
for the sample period January 2000 to

March 2006. In this study, the returns on BSE Sensitive Index are used as a proxy for the
Indian stock market. The result suggests uni-directional causality between stock price and
the net foreign institutional investment, thus implying that the market informational
efficiency hypothesis can be rejected for BSE Sensitive Index with respect to the FII. It
suggests the policy implication that the authorities can focus on domestic economic
policies to stabilize the stock market.

Our results imply that stock prices can capture information on neither the FIIs. Investors
can therefore apply profitable trading rules to earn supernormal profits. Under the
circumstances, the Indian stock market seems to be bearing the underlying strain not
currently visible at the surface. The implementation of profitable trading strategy may at
any point of time generate over-enthused investment and this, if coupled with market
overreaction, may result in a destabilized system. A point also to be noted here is the
current concentration of FII funds in the IT and Banking sector, which in any event of
flow reversals may worsen the situation.
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