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Role of FII in Capital Market

Submitted in the partial fulfillment of the requirements for the award of degree of BACHELOR OF BUSINESS ADMINISTRATION 2010-2013

Submitted to: MR AMAR JOHRI Asst Professor of BBA GEU

Submitted by: DEEPANSHU PARGAIN BBA - 6Th Sem Roll no-2400648

Department of BBA Graphic Era University Dehradun (Uttarakhand)







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This is to certify that the Dissertation title ROLE OF FII IN CAPITAL

MARKET submitted by DEEPANSHU PARGAIN, during semester VI of BBA

program (batch 2010-13) embodies original work done by him.

Signature of faculty guideName- MR.AMAR JOHRI Designation-ASSISTANT PROFESSOR CenterDate-


This project is a bonafide record of the research work done by me in the partial fulfillment of the curriculum of BACHELOR OF BUSINESS ADMINISTRATION. I would like to convey my special thanks to MR.AMAR JOHRI (Management Department of GEU) for giving me an opportunity to undergo this project. Above all I would like to thank God as the project would not have been completed without the shadow of his dignity



I DEEPANSHU PARGAIN, student of BBA VI sem of GEU, Dehradun, declared that the project report of ROLE OF FII IN CAPITAL MARKET is prepared and analyzed under the guidance of MR.AMAR JOHRI (faculty of BBA Dept. GEU, Dehradun)

This project report is a bonafide record of Research work done by me in the partial fulfillment of the requirement of the course of BBA of GEU, Dehradun. DEEPANSHU PARGAIN BBA VI SEM. GEU, DEHRADUN


The financial architecture of India has witnessed a massive change as a result of globalization and reforms in the financial sector. In the present scenario, significant importance is given to the financial markets and its relationship with the real world. Since the payment crisis in 1991 and the subsequent introduction of the New Economic Policy, there has been a remarkable improvement in the working of the financial sector. One of the main liberalization was the opening of Indian markets for foreign investment. The market access to the foreign investors was made easy resulting in large inflow of capital. This was mainly done by the foreign financial institutions in the form of indirect investments. A re-evaluation of the correlation between the foreign investment and its affect on the stock market has to be done before making any institutional modifications or alterations in the existing procedures and programs or introducing any new mechanism etc. The examination of the stock market is very important as it is a very sensitive part of the financial system and it interprets the effects of world economy on the country. The stock markets of the developing countries are building new relations with the foreign

investments. Hence, it is necessary to understand the financial system of the economy in the present state. In the developing world, India has emerged as one of the most affluent economies with constant growth and a few setbacks. In terms of Gross Domestic Product (GDP), India ranks fourth with an estimated GDP (PPP) of $2.989 trillion and a growth rate of 9.2%. The rapid growth and positive report of the Indian economy, makes it an attractive place for the foreign investment.


Since liberalization in 1991, Indian economy has roofed an extended ground. In spite of the surfeit profitable opportunities for investment all around the world, the Foreign Institutional Investors are attracted towards India as a favoured destination after UK and China. Despite the fact that there are many other developing countries which are giving improved earnings ,positive reports about the Indian economy along with the fast pace of growth of the stockmarket and intrinsic intensity of the economic operation fundamentals has made India an eye-catching place for the FIIs. In the recent times, China has experienced tremendous growth due to opening up of the stock market to the foreign investors through the QFII scheme .Whereas,


the growth and development in India is natural based on domestic demand and not solely on the international markets. There has been an exemplary change in India and an Indian since independence. The government policies, economy, outlook of the people of India and position of Business and Industry has changed elementarily and overwhelmingly. At a point of time, there was a shortage food and foreign exchange in the economy but now it has a surplus. India, which was primarily an economy based on agriculture has now developed as an economy with service sector orientation.

According to the Goldman Sachs report, Dreaming with BRICs: The path to 2050 dated October 2003, the future of Indian Economy would be: Indias GDP will reach $1 trillion by 2011, $2 trillion by 2020, $3 trillion by 2025, $6 trillion by 2032, $ 10 trillion by 2038, and $ 27 trillion by 2050, becoming the third largest economy after USA and China. In terms of GDP, India economy will overtake Italy by the year 2016, France by 2019, UK by 2022, Germany by 2023, and Japan by 2032. It also states that the Chinese GDP could overtake Germany by 2007, Japan by 2016, and the US by 2041. Among the BRIC group, India alone has the potential to show the highest growth 9%(over 5 percent) over the next 50


years. The Chinese growth rate is likely to reduce to 5% by 2020, 4% by 2029, and 3% by 2046.

India has the second largest labour force in the word and its population consists of 54% of people below 25 years of age and 63.5% of people in the working age of 15-64 years. This makes the country a lively place for strength, energy and youth. India has a vibrant and stirring culture as the young population works hard, earns more, demands more and hence, spends more. India is the fourth largest economy in terms of Purchasing Power Parity (PPP), just behind China, USA and Japan and is expected to go past Japan in the next ten years and become the third major economic power. The emerging retail markets of India are appraised as fifth most alluring market around the world and ranked as the second most attractive by A T Kearney in the Global Development Index of 30 developing countries.

There is ample reason for India's viability as a destination for foreign investment. The FMCG sector of India has become the fourth largest sector in the economy and is established to increase from USD 11.6


billion in 2003 to USD 33.4 billion in 2015. The telecommunication industry of India is also growing at a fast pace and is expected to become the second largest telecom market internationally. Other than the aforementioned macroeconomic indicators, emerging middle class, higher disposable incomes, investment friendly policies,

progressive reform process and low cost competitive workforce, all participate towards India being a suitable preference for investors.



Bombay Stock Exchange (BSE) is Asias oldest exchange market. It started off in 1850s when the stock brokers used to gather in front of Mumbais Town Hall under the banyan tree. In 1875, it became an official organisation named The Native Share & Stock Brokers Association. It became the first stock exchange to be recognized by the Indian Government under Securities Contracts Regulation Act in 1956. In 1986, BSE Sensex was developed and BSE used this index to open its derivative market, trading Sensex futures contract in 2000. It is the biggest stock exchange in the world with 4,800 listed companies as on August 2007 and is the tenth largest stock exchange in the world in terms of market capitalization as on December 2007.


BSE Sensex (Sensitive Index) is a value-weighted index composed of 30 stocks with the base April 1979 = 100. It consists of the 30 largest and the most actively traded stocks, representative of various sectors on BSE. It is the standard index of India and acts as an indicator of the economy. In past sixteen years, Sensex has risen continuously from 2000 points on January 1992 to 21,000 points on January 2008. The mobility of international Capital flows has increased globally in the past decade and this is more evident as more and more capital is flowing in to the emerging countries. India is an emerging economy and is experiencing excessive inflow of foreign capital due to the rapid economic growth, regulated stock market, positive report etc., and in the recent years has become the most preferred country for foreign institutional investment after China.


FIIs are those institutions or investment funds, which invest by registering in a country outside the country of origin or incorporation. In other words, Foreign Institutional Investor is an entity established or incorporated outside India which invests in the financial markets of India. Foreign investors have to get themselves registered as FII under Securities Exchange Board of India (SEBI) before trading in the Indian stock market. FII includes mutual funds, pension funds, insurance companies, investment trusts, banks, university funds, endowments , charitable trusts / societies, foundations


etc. Some of the active FIIs in India are Citigroup, HSBC, CLSA, Merrill Lynch, Crown Capital, Goldman Sachs, Morgan Stanley, ABN Amro etc. The stock market of India was liberalized in September 1992, but the inflow of foreign capital started from January 1993. The number of FIIs registered with SEBI has increased from 492 in the beginning of 2000 to 1319 on 31st March 2008. The net investment by the foreign investors in debt and equity in India from the beginning till 31st March 2008 is approximately USD 68 billion. The companies involved in construction, banking and information technology are most favoured by the foreign investors for investment.



Globalization has resulted in Institutionalization of the stock market of India. The trend of mutual funds and portfolio investments is rising and large institutions are controlling the stock market owing to enormous funds. As a result of restrictions on full participation of foreign investors; pension funds and mutual funds of India have equal contribution to the development of India stock market. The importance of foreign investors is evident as most of the fluctuations in the stock market are a result of inflow and outflow of foreign capital. This trend is experienced by all the emerging markets. The institutional investors have executed an efficient pricing of the stocks, raised the breadth and depth of the market and expanded the securities business. However, FIIs


are notorious in nature as there is an outflow of funds on the first sign of trouble. This increases the volatility of stock market.




If the cost of equity capital is reduced by liberalization then, with constant expected future cash flows, there must be a rise in the equity price index of the country when the investors get the information about the occurrence of stock market liberalization. Moreover, there should be a rise in the physical investments subsequent to liberalization. Therefore, the objective of this research is to analyze the impact of


liberalization on the stock market by evaluating the movement of stock returns around liberalization and to check the consistency of data with the above implications. The rise in stock returns immediately after liberalization and a subsequent fall is tested. The effect of successive liberalizations and the changes in the level of volatility are also examined. The event study approach is applied in order to evaluate the relationship between stock market liberalization, equity price revaluation and fall in cost of equity capital. The standard models of event study approach like International Asset Pricing Model (IAPM), are used to analyze the data.


Literature review


Literature review
Out of the many liberalization policies implied by the government of India, FII scheme is very important to the stock market as well as the economy of India. This scheme has opened the domestic stock market of India to the rest of the world and has allowed the foreign investors to invest in the shares of the companies listed on the stock exchange. Many empirical studies have been done in the past to analyze the impact of the stock market liberalization on the behaviour of the stock market and the economy as a whole. In this chapter, literature regarding the effects of liberalization on emerging economies is reviewed. In the beginning, the definition of Emerging stock market and Stock market liberalization is stated and the theoretical framework of International Asset Pricing Model is discussed. Then the long and short term effects of liberalization on emerging economies is explained by analyzing the market behavior on liberalization for a sample of countries and its effects on the economic development of these countries. The effects of liberalization on India are also explained.



According to Henry (2000), Stock market liberalization is a specific type of a more general policy reform called capital account liberalization, which is a decision by countrys government to remove restrictions on capital inflows and outflows more generally. A broader definition of the same given by Biem and Calomiris (2001) is that, it is a package of reforms that includes global opening up, creation of governing infrastructure for appropriate trading and sound law and reliable system of accounting information and control. Bekaert (2003) explains that as a result of equity market

liberalizations, foreign investors get the right to invest in the domestic equity market of a country and the domestic investors of the same country get the right to invest in the foreign equity securities. Another definition by Bekaert & Harvey (2000) defines liberalization as regulatory changes, the introduction of depositary receipts and country funds, and structural breaks in equity capital flows to the emerging markets.








objectives of liberalization namely, (i) opening of the country to new and large volumes of international financial flows; (ii) liberalizing the governing terms of outflows of foreign exchange in form of current account investment income payments and capital account transfers; and (iii) Transformation of the financial structure and nature and operations of the financial firms to make it resemble to that of the developed countries. For calculating the effects of liberalization, it is necessary to recognize the actual date of each countrys stock market liberalization.

The Indian market was opened for the FIIs in September 1992 when the government announced that the foreign investors will be allowed to invest in the listed Indian companies directly but IFC considers the market to be fully opened from November 1992when SEBI was permitted to register the FIIs to invest in the primary and secondary markets by the Ministry of Finance. The actual inflow of foreign capital in the Indian stock markets started from January 1993 i.e. the


implementation date of FIIs. The date of liberalization for this research is taken as 1st January 1993 and not the announcement date, as the effects of inflow of foreign capital has to be analyzed. The restrictions on foreign investments were reduced later and the settlement and clearance procedures were improved in order to build the confidence of the investors and to stimulate the markets

Chandrasekhar (2000), after examining the trends of the market describes that there was an extreme volatility in Sensex during the years of liberalization but also documents that the structure of financial markets of India is also a cause of volatility. Further he suggests that the markets of developing countries like India are thin or shallow in three senses namely; (i) Stocks of only a few countries are traded actively in the market. Even though there are more than 5000 companies listed on the stock exchange, BSE Sensex assimilates only 30 companies, trading in whose shares is perceived as a symbol of market activity,


(ii) A large proportion of shares is held by promoters, financial institutions and others interested in corporate control or influence leading to the availability of a small proportion of shares for routine trading, and (iii) The number of players trading in these stocks is also small.

Mukherjee (2002) also confirm this return chasing behaviour of the FIIs by analyzing the daily data from 1999 to 2002 and discover that the sale of Indian stocks by foreign investors is a consequence of returns and not purchases. On the contrary, Gordon and Gupta (2003) perform an analysis on the monthly data for the time period 1993-2000 and determine that there is a negative relationship between foreign inflows and lagged stock market returns which suggests negative feedback trading. Hence, there is a need for analyzing more recent data to understand the relationship between FIIs and stock market returns.

According to the Finance Ministry of Indias report (2005), the main concerns regarding vulnerability of Indias capital market to FII inflows can be classified into three parts: about the outflow of hot


money and creation of chaos in both securities and foreign exchange markets, about too much inflow, and leading of upward pressure on either the exchange rate of the domestic currency or prices or both, and about foreigners capturing a large part of the markets in securities. Two precise worries about chaos caused by FIIs centre around the problems of herding where many FIIs may trade in similar ways and positive feedback trading where FIIs buy after positive returns and sell after negative returns, thus aggravating market volatility. the risks and ill effects related to it.





The Foreign Institutional Investors were allowed to invest in India since 1992. The decision of opening up of the Indian stock markets for the foreign portfolio investors was taken by the policy makers due to a number of reasons. In 1991, Indias external finances and capital market were in complete disorder. The country was suffering from an extreme balance of payment crisis. So in order to discipline the emerging capital market and guarantee the inflow of non-debt creating capital, foreign investments were allowed in the country. The major inflows from FIIs started from January 1993 and it is supposed to be the foremost driver of the stock market of India.

This chapter discusses an overview of Foreign Institutional Investment in India, qualifications and procedure to become FII and the rules and regulations guarding FIIs. Anybody or everybody cannot be registered as FII. It is guarded by the Securities and Exchange Board of India (SEBI) and proper procedures have to be followed for registering as FII. The benefits and costs of FII scheme are also discussed.



The stock markets of India were opened in September 1992 to foreign investors and has, Since 1993, received substantial amount of portfolio investment from foreigners in the form of Foreign Institutional Investors (FII) investment in equities. This has turn out to be one of the foremost channels of international portfolio investment in India for the foreigner institutions. To facilitate trade in Indian stock markets, foreign corporations need to register themselves with SEBI as Foreign Institutional Investors (FII). SEBIs definition of FIIs presently includes charitable/endowment/university funds, mutual funds, foreign pension funds etc. as well as asset management companies and other money managers functioning on their behalf. The most significant means of foreign investments in India is Foreign Institutional Investment (FII) and there are a total of 1456 FIIs registered with SEBI till August 2008. In the recent years, FIIs have played the most important role in emerging and established market economies as a class of institutional investors. Since 2003-04, the FIIs are growing gradually in the Indian equity markets. According to SEBI, there is a 50 percent rise in the gross purchases of equity and debt together by FIIs to INR 5,205,080 million in 2006-07 from INR 3,469,780 million in 2005-06. Furthermore, the gross sales by FIIs have also increased by 60.3 percent, from INR 3,055,120 million to INR 4,866,670 million during the same period.


In spite of this, in 2006-07 there is a fall in the net investments of FIIs by 25.6 percent from INR 414,670 million in 2005-06 to INR 308,400 million primarily due to huge net outflows from the equity segment. But since 1993, the collective net investment by FIIs in Indian stock market went across USD 60 billion till the end of March 2008. As on March 31, 2008, the collective net investment by FIIs was USD 63.5 billion. The collective net investment by FIIs at acquisition cost had increased to USD 45.3 billion till the end of March 2006, which was USD 15.8 billion at the end of March 2003. Indicating the amiable investment atmosphere, total number of FIIs registered with SEBI rose to 1319 as on March 31, 2008 compared to 997 a year ago. A discrete characteristic of the newly registered FIIs was the increase in registration from the exceptional countries like Brussels, Slovenia, Guernsey, Oman, Cyprus, Japan and Sweden, etc. other than the conventional investors from United Kingdom, USA, Singapore, Hong Kong, Malaysia, Luxembourg and others. Permission was given to the FII to invest in the derivative markets since February 2002. The collective investment by FIIs in derivatives market was INR 2,252,780 million as on March 31, 2007


Year 2003 2004 2005 2006 2007 2008 (10/08/08)

Net Investment 30458.7 38965.1 47181.2 36539.7 71486.5 -29169


Gross Purchases

Gross Sales


2003 2004 2005 2006 2007 2008 (10/08/08)

94410.5 185671.5 286020.5 475622.5 814877 560480.9

63951.8 146706.4 238839.4 439082.8 743390.7 589650

Year 2003

Gross Purchases Gross Sales Net Investment % Change 94410.5 63951.8 30458.7 0


2004 2005 2006 2007

185671.5 286020.5 475622.5 814877

146706.4 238839.4 439082.8 743390.7

38965.1 27.92765 47181.2 54.90221 36539.7 19.96474 71486.5 134.6998

2008 (10/08/08)







There are varied sources for the inflow of foreign investment. SEBI has registered FIIs from 28 countries together with the money management corporations working on behalf


of foreign investors in India. Most of the FIIs registered belong to US, UK and Western European countries. This nationwide association does not essentially indicate that the real investor funds come from these countries. Nationwide association cannot be taken as an instrument to measure the home of FII investments as it proves to be a rough indicator. The major amount of funds may be flowing from institutions operating on behalf of other country residents from Cayman Islands, Hong Kong, Luxembourg or even Singapore. However, breaking the FIIs on the basis of region does give an idea of comparative significance of different regions of the world in FII flows.


According to the act a foreign individual is a foreign resident other than NRI and Overseas Corporate Body. Hence, one can be registered as an FII if he intends to invest his proprietary funds or on behalf of "broad based" funds or of foreign corporate and individuals and belong to any of the under given categories.
Pension Funds

Investment Trust Endowment Funds University Funds Asset Management Companies Nominee Companies


Institutional Portfolio Managers Trustees Bank Mutual Funds Insurance or reinsurance companies Foundations or Charitable Trusts or Charitable Societies who propose to invest on their own behalf, and Institutional Portfolio Managers Power of Attorney Holders

The format of the application is provided by SEBI in the SEBI (FII) Regulations Act, 1995 as Form A. The application form must be filled by the applicant and submitted along with the other required documents to SEBI and Reserve Bank of India (RBI) as well.


According to Regulation 6 of SEBI (FII) Regulations, 1995, the Board looks into all the issues that are significant for award of the certificate and it is essential for the Foreign


Institutional Investors to accomplish the following conditions in order to qualify for grant of registration: Applicant should be professionally competent, financially sound, experienced, have a track record, general reputation of fairness and integrity; The regulation of the applicant must be done by a suitable foreign regulatory authority in equal aptitude/group where registration is required from SEBI. It is inadequate to qualify as a Foreign Institutional Investor by registering with authorities that are in charge for incorporation. A formal permission under the provisions of the Foreign Exchange Management Act, 1999 from the Reserve Bank of India is required to be taken by the applicant. The applicant must have legal permission for investing in securities outside the country of its in-corporation / establishment. The applicant must be a "fit and proper" person. A local custodian has to be assigned by the applicant and he/she has to enter into an agreement with the custodian. The appointment of a designated bank for routing the transactions is also necessary. The applicant has to make a payment of registration fee of US $ 5,000.



The application process for registration of FII under the 100% debt route is parallel to that of normal funds besides a clear declaration by the applicant that it wants to be registered as FII below 100% debt route. However, the overall annual investment limit for 100% debt funds is allocated by the Government of India. The allocation of the individual 100% debt funds investment limit is within this overall limit. The debt funds have to ask for any further investment limit in case the limit granted to them is finished and they wish to invest more.

Names of 100% debt FIIs 1 ABN AMRO Asia Pacific Pte Ltd 2 Bank of America Singapore Ltd. 3 Citicorp Investment Bank (Singapore) Limited 4 DB International (Asia) Limited 5 Dresdner Bank AG 6 UBS AG 7 DBS Bank Ltd Debt 8 BNP Paribas 9 The Bank of Nova Scotia Asia Limited 10 Standard Chartered Bank (Mauritius) Limited


11 Merrill Lynch Mortgage Lending, Inc. 12 Standard Bank Asia Ltd 13 Rabo Bank Ireland plc 14 RBC Dexia Truat Services Singapore Limited as Trustee of DBS Asia Bond Fund 15 Shenton Income Fund


In the primary or secondary markets, under the Portfolio Investment Scheme, the investment limit of all the registered FIIs or sub accounts is subject to a ceiling of 24% of issued share capital of a company. This limit can be increased up to 49% per sectoral cap if it is approved by the general body of the company.



There are other investment restrictions on FIIs besides registering with SEBI. According to the SEBI FII Regulation Act 1995, the following are the highlights of the restrictions applied on the FII investment: FIIs can invest in securities in the primary and secondary markets including shares, warrants and debentures of unlisted or listed or to be listed companies on a standard stock exchange in India. FIIs can also invest in units of schemes floated by domestic mutual funds including Unit Trust of India, whether listed or unlisted on a recognized stock exchange, commercial paper, derivatives traded on a recognized stock exchange and dated government securities,. Short selling of securities is not permitted to FIIs. They can only trade on a delivery basis, however short selling in derivatives is allowable. There are additional investment restrictions levied on FII including ownership limitations etc.


The benefits of the foreign investments to India (report by Foreign Ministry of India, 2005) are listed below: 1. Reduced cost of equity capital: There is a reduction in the cost of equity capital as risk gets divided between the foreign and domestic investors. The investments by FIIs raise the stock prices, decrease the required rate of return on equity, and promote investments by Indian firms in the country. 2. Stability in Balance of Payment of India: For increasing the growth of India, there is a need of increasing the domestic investments beyond domestic savings into the country by capital inflows. Excessive investments over savings lead to current account deficit which are financed by capital flows in balance of payment. The capital inflows in the equity market by FIIs are safer and more justifiable for funding the current account deficits as opposed to debt creating flows. 3. Knowledge Flows: The actions of foreign portfolio investors help in reinforcing Indian finance. FIIs encourage innovation, support modern ideas in market design, promote the growth of sophisticated products such as financial derivatives, result in overflow of human capital by revealing modern financial techniques, foreign best systems and practices to the Indian investors and augment competition in financial intermediation. 4. Corporate governance strengthening: The domestic investors (institutional as well as individual), mostly accept the corporate policies followed in India even when they do


not match the international standards, but the FIIs do not tolerate the malpractices of the owners and managers as they have enormous experience with the corporate governance practices. Hence, the operation of FIIs into the market leads to higher efficiency, better shareholder value and sound corporate governance practices. 5. Enhancement of market efficiency: The presence of FIIs in the market can improve the market efficiency in two ways. Firstly, the unfavourable macroeconomic news which affects the domestic investors does not particularly effect the investments by foreign investors leading to stability in the market. Secondly, FIIs prove to be a channel through which information and awareness regarding valuation of an industry or a firm rapidly circulates in India.



The costs of liberalization (report by Foreign Ministry of India, 2005) to India are listed below: 1. Positive feedback trading and herding behaviour of FIIs: The tendency of large number of FIIs to buy and sell together (herding) and buying and selling after positive and negative returns respectively (positive feedback trading) can intensify volatility and push the prices away from true values. This behaviour of FIIs is not noticed in India but according to a research done by Gordon and Gupta (2003), there is evidence of positive feedback trading by the FIIs.

2. Exposure of Balance of Payment: There are major concerns that on the occurrence of a severe incident, there could be a major outflow of foreign capital from India leading to difficulties in Balance of Payment. There has been no evidence of a major outflow of foreign capital out of the country till now but it poses a threat for the future.

3. Possibility of takeover of the companies: The FIIs can try to enforce control over the companies in which they have considerable shareholding. But to take control of this, SEBI has applied a takeover code according to which all the investors will benefit equally in the event of takeover.


4. Monetary management complexities: Indias greater openness to FIIs has made the capital account of the country convertible for the foreign investors and institutions. The major complexity of monetary management is preserving a logical interest rate, rigid exchange rate system and balanced inflation at the same time. This problem has come forward in recent times and the government has introduced Market Stabilization Scheme (MSS) for maintaining stable macroeconomic conditions.

It can be concluded that India is acquiring the attention of more and more foreign investors. The aggregate of total investments by the foreign institutions in debt and equity is rising. But there are strict regulations governing the Foreign Institutional Investments. SEBI makes sure that the costs of liberalization are minimized and the country reaps the benefits of liberalization to the maximum.





5.1 Problem Statement:

The FII investment has increased many folds leading to new levels reached by the market. The investments of areas of FIIs have impacted the relevant shares. So, the study is being conducted to study the investment of FIIs in Indian Capital Market.

5.2 Research Objectives:

A. B. To study the investment of FIIs. To find out the impact of FIIs in Stock Exchange in India.

5.3 Research Design:

The present investigation is descriptive type of study undertaken to estimate the scenario which helps to improve the confidence of investors in Stock Exchange.

5.4Methods of Data Collection:

Only secondary data was used to conduct the study. The data was collected from the official websites of SEBI and RBI. The final data were analyzed systematically to achieve the desired reserve from magazines, journals, various websites etc.


The standard methodology employed in order to estimate the reaction of stock prices to the introduction of guidelines is event study, which was employed by Dolley in 1933. The procedure of event study has been applied in many researches over the past seven decades and its complexity has been improved enormously by authors like Fama et al.


(1969) and Brown and Warner (1980, 1985). The determination of the event, estimation window, event window, investigation window and estimation model is necessary to construct an event study. The event is the report that hypothetically influences the share prices and in this case opening of the stock market for the foreign investors is the event. The time in which the event takes 40 place is the event window. The effect of the event must be studied from the period when its occurrence is publicly announced. Liberalization in India was officially announced in September 1992 however, the investments by the FIIs were first made in January 1993 (Source: RBI), so this has been taken as the event window and the volatility of stock returns is analyzed around this period. The estimation window is the phase of data used in the valuation of boundaries. The daily data is analyzed from April 1988 to March 2008 namely four years before and sixteen years after the liberalization. The abnormal returns arising both, throughout the time of event window and the period near the event window should be inspected. The investigation of occurrence of abnormal returns before the event window shows if the investors have predicted the information restricted in the event or if they have been trading on any inside report. On the other hand, investigation of abnormal returns after the event window can describe if the market under-reacts or over-reacts to the declaration of event. The extension of event window is investigation window (Bamesa and Ma, 2002). Event study is used to analyse the effect of liberalization in different phases of time by applying IAPM


5.6 IAPM
As event study is one of the highly suitable methods qualified to observe the market reactions to the occurrence of events, it is applied to the index prices of BSE to analyze the excess returns due to the announcement of FII policy and stock market liberalization. The analysis is done in order to examine whether the abnormal returns resulted in the pre event, post event, after event or later event period.

The research period is of 20 years from 1st April 1988 to 31st March 2008 and the daily returns of BSE Sensex are analyzed (as it constitutes the thirty major companies of the country which carry out the maximum trade). This consists of four years before the opening of the stock market and sixteen years after it. Since the previous papers do not capture such a big research period using daily data, this research would prove to be significant in capturing the movement of the stock market in the preceding years. The event window i.e. day 0 is assumed to be 1st January 1993 instead of 1st September 1992 which is the date of announcement of the policy. India is an emerging economy and its capital market is neither efficient nor liquid, so the actual investment by the FIIs in India first took place after four months of liberalization. This contradicts the definition of event window as it states that the announcement date should be the event window rather than implementation date. The purpose of the research is to examine the


effect of FII investment on stock market, therefore using the implementation date as the event window would be perfect for the research. Before-event period is denoted as the event window which ranges from day -742 today. There are four investigation windows namely, pre-event period (-66, -1), post-event period (1, 71), after event period (72, 1213) and later event period (1214, 3700). The results from before-event period are used to compare with the results of the other study periods. In order to examine the abnormal returns from time of announcement of FII scheme to the time of actual investment, pre-event period is used whereas post-event period measures the market reactions in the 71 trading days after the implementation of FII. After event period evaluates the market reactions till 31st March 1998 when India was facing a depression. The later event periods analyze the market perceptions of FII in the long run till March 2008 after further liberalizations made by the policy makers. Consequently, the evaluation model is constructed as follows: Let RBSE,t be the return of Bombay Stock Exchange share Index (SENSEX) on day t. Therefore, RBSE,t has to be calculated by using continuous compounding method:

RBSE, t2 = ln PBSE,t - ln PBSE,t - 1 Where, PBSE, t = market index level i on the dat t.


Linear regression approach is applied to the data in order to find out the market reactions to the implementation of the FIIs. The equation for linear regression model for the stock market is as follows:

RBSE,t = BSE,i + BSE,1 PREBSE,t + BSE,2 POSTBSE,t + BSE,3 AFTERBSE,t + BSE,4 LATERBSE,t+ BSE,t Here, RBSE,t is the dependent variable and BSE,i is the market specific dummy variable.PREBSE,t, POSTBSE,t, AFTERBSE,t and LATERBSE,t are the independent dummy variables. The dummy variable PREBSE,t is 1 in the pre-event period (-66, -1) and 0 in the other event periods, POSTBSE,t is 1 in the post-event period (1, 71) and 0 in the other event periods, AFTERBSE,t is 1 in the after event period (72, 1213) and 0 in the other event periods whereas LATERBSE,t is 1 in the later event period (1214, 3700) and 0 in the other event periods. The daily average abnormal return is measured by BSE,1 BSE,2, BSE,3 and BSE,4 in the pre, post, after and later-event periods respectively. According to Henry (2000), the preliminary opening of the stock market does not establish the final liberalization for the foreign investors. It is an ongoing process and subsequent liberalizations are done after the initial one. Same is the case with Indian stock market. In such a case, future liberalizations are probably predicted at the time of


initial liberalization of the stock market and there will be two cases to consider here, namely:

Case 1: Future liberalizations are expected when the initial stock market liberalizations take place and it is acknowledged that they will occur with a probability of 1. Case 2: Future liberalizations are expected when the initial stock market liberalizations take place but there is certain probability that all of the succeeding liberalizations will not take place. If Case 1 is true then the announcement of the first stock market liberalization will be the only time when the revaluation will take place but the prices will appreciate gradually till the whole liberalization process is complete. Whereas, if Case 2 is true then further revaluations will take place in addition to the initial price jump whenever the scheduled date of liberalization approaches and the members of the market receive news confirming the occurrence of liberalizations according to the scheduled dates. In this condition two additional dummy variables need to be introduced. The first dummy variable i.e. LIBERALIZE1 will take the value 1 in course of the event window when the first stock market liberalization takes place whereas the second dummy variable, LIBERALIZE2 will take the value 1 in all the subsequent liberalizations (listed in Appendix 1) after the


first one. Hence, another equation for linear regression model to analyze the effect of subsequent liberalizations on the stock market would be: RBSE,t = BSE,i + BSE,1 LIBERALIZE1BSE,t + BSE,2 LIBERALIZE2BSE,t + BSE,t

Further, there are other factors with effect the behaviour of the FIIs. Exchange rate is one of them. The movement of exchange rates in favor of foreign investors leads to a higher inflow of capital and vice-versa. Hence, the effect of fluctuations in exchange rates is analyzed after the liberalization. Linear regression model is applied on the stock returns and exchange rates from 1st April 1991. The equation for this would be:

RBSE,t = BSE,i + BSE,1 Exchange rate BSE,t + BSE,t The daily data of stock returns and exchange rates is used to this purpose. In event studies, researches conducted in the past provide with the evidence of use of daily aswell as monthly stock return data. Daily stock return data is used by Frankfurter and Schneider (1995), Corrado (1989) and Scholes (1972) in their research however, Brown and Warner (1980) and Fama et al. used monthly data.

According to Brown and Warner (1985),daily and monthly data differ in potentially important aspects. Fama (1976) explain that daily returns depart more from normality


than monthly returns. Moreover, due to non synchronous trading, it is complicated to estimate parameters from the daily data and there can be a severe bias in the results (Scholes and Williams 1977). Lastly, Brown and Warner (1985) prove that the standard deviation of daily data is lesser than that of monthly data. Conversely, Brown and Warner (1985) supported the use of daily data and described that it can be sometimes advantageous, like in cases involving variance increases or unusually high autocorrelation, as characteristics of daily data generally presents few difficulties in context of event study methodologies. The use of daily data is straightforward. They also highlighted that there is no obvious impact of non-normality of daily returns on the event study methodologies. They argued that even though daily excess returns are highly non-normal but there is a proof that mean excess returns in a cross-section of securities, converges to normality as the number of samples increases. According to their study, there are well specified standard parametric tests for checking the importance of mean excess return. These excess returns are calculated in many ways including OLS market model and Market adjusted returns. These methodologies have higher power in case of daily data than the monthly data. Moreover, usage of daily data other than monthly data is more advantageous as it allows the investigator to take the benefit of specific information concerning the exact date of month on which the event had taken place.


The daily price index of the Bombay Stock exchange is derived from DataStream and BSE. The data regarding the opening of the stock market and the subsequent liberalizations thereafter is acquired from Reserve Bank of India and the Finance Ministry of India and the information about the SEBI regulations for the investment by FIIs is retrieved from Securities and Exchange Board of India.




ANALYSIS AND FINDING 6.1- EXPLANATORY ANALYSISThe summary of results of Mean and Standard deviation for the BSE stock indices daily returns in the five periods is presented in Table 1 below:

Description of Stock indices daily returns for four event periods



STANDARD DEVIATION 12.57172% 2.20495% 2.23993% 1.51216% 1.65625%

1. Before event period 0.21218% 2. Pre event period 3. Post event period 4. After event period 5. Later event period -0.22378% -0.25286% 0.05312% 0.05593%

It can be analyzed from the above table that before liberalization, the stock market had positive returns because of less number of stock holders investing in the market. The decision of liberalization was taken by the policy makers due to the fact that the country was


facing balance of payment crisis in 1990-91. As a result of this India was subject to the IMF style adjustment program which acted like a representative in the transition of the economy through the process of liberalization in 1991. The only reason for liberalization of the economy was its dependence on debt caused by the liberalization in 1980s which was adopted with support from an IMF loan in 1981. The performance of the stock market in the pre-event period is not up to the mark as compared to the before event period and the indices have negative returns of -0.22378%. The changes are quite

significant and prove that the investors of the BSE stock exchange are not indifferent towards the announcement of the opening of the stock market to the foreign investors and they have reacted to the market liberalization reform considerably. After the implementation of the FII scheme i.e. with the inflow of foreign capital, there were fluctuations in the stock prices. The mean index returns in the post event period (first 71 days) are even worse. It is lesser than the mean index return of pre-event period. This shows that the investors are doubtful about the market reactions to the launch of new scheme and have withdrawn their investments from the market. In the after and later event period, the


investors respond optimistically to the further liberalizations initiated by the government. The stock returns are more stabilized with positive average stock returns of 0.05312% and 0.05593% in the after and later event period respectively. This can also be illustrated by analyzing the results of Standard deviation of returns in the five time periods which is an indicative of unconditional variance in returns. The standard deviation of the before event period is quite high which shows that the stock markets were volatile in that period. With the liberalization of stock market, the standard deviation fell significantly from 12.6% to 2.2%. There was a minor increase in value in post event period pointing the reluctance of investment by both, the foreign and domestic investors. The standard deviation of after and later event period is less than the pre-event period demonstrating the decline in volatility of the stock market in later period and a positive impact of liberalization on returns in the long run. The difference between the minimum and maximum value of stock market returns is also high in the before event period as compared to all the other event periods. This also proves that the introduction of FIIs in the Indian stock market has reduced the volatility and brought


stability to the market returns in the long run. The volatility of stock returns in the pre-event period is lower than the post event period as it was the first time the foreign investors invested in the stock markets of India and both foreign and domestic investors were hesitant in investing in the market. There were many disturbances in the market around liberalization period and actual inflow of foreign capital into the market. The stability of the market in long term goes along with the derivation of long run effect of emerging stock market liberalization from IAPM partly as average index daily return of other periods for Bombay Stock Exchange is lower than the before event period which signals the realization of lower risk premium in long period.


Firstly, linear regression is applied to the data to further analyze the impact of FIIs on the stock indices in the five event periods. The empirical results of the analysis are summarized below:


TABLE 2 Results for Linear Regression 1. Intercept

0.20752% -0.4313% -0.46039% -0.1544% -0.15159% 0.0002 4442

2. Pre 3. Post 4. After 5. Later 6. R2 7. No. of observations

First of all, according to IAPM, there could be certain leakages of information prior to the announcement of the FII policy. But the objective of this research is to discover the market reactions to the implementation of FIIs rather than announcement of the policy. Hence, insider trading and information leakage is not the core of this research. The pre-event period is the time period between the announcement and implementation of the FII policy and its coefficient 1 is negative (-0.4313%) and statistically insignificant indicating the unenthusiastic response of the investors towards the announcement of opening of the stock markets to the foreign investors. In the beginning, there was a rise in stock prices in anticipation of foreign


capital inflows, but due to the non-investment of FIIs into the stock market, the stock prices subsequently fell. This gave an impression that the investors were uncertain about the efficacy of the application of FII in escalating growth and efficiency of the market. This finding is consistent with the one in explanatory analysis. Furthermore, IAPM depicts that 2 should be positive signifying readjustment of the market and 3 must be negative indicating the reduction in cost of equity capital. From the above table, the value of 2 (-0.46039%) is statistically insignificant as it does not abide by IAPM. The reaction of the Indian market contradicts IAPM and shows that the investments of domestic investors moved in the reverse direction on the implementation of FII. It appears that the investors are not confident and there is not major reaction of the foreign investors just after liberalization. The attitude of bulk of market investors on the introduction of foreign investors is to just wait and watch. Moreover, in 1993 Pictet Umbrella Trust Emerging Markets Fund, an institutional investor from

Switzerland, was the only FII to enter the Indian market and in 1994, there were no new registrations. The market became active later with the entry of FIIs after 1995.


Also, the values of 3 and 4 (coefficient of AFTER and LATER) are -0.1544% and -0.15159% respectively and are not consistent with IAPM and statistically insignificant. It is a sign of reduction of cost of capital. On comparing these values with the coefficient of before event period (0.16862%) it can be seen that before liberalization the cost of capital was high and it can be concluded that FIIs are beneficial for the stock markets and lead to reduction in cost of capital in long run. Secondly, the effect of the initial and subsequent liberalizations is analyzed by applying linear regression model to the data and the observed results are summarized below: TABLE 3 Results for Linear Regression 1. Intercept 2. Liberalize1 3. Liberalize2 4. R2 5. No. of observations 0.07069% 3.00784% 0.14761% 0.0001 4442

The above table shows that the effect of first liberalization on the stock market returns is the maximum. The value of 1 (Liberalize1) is


-3.00784% and is statistically insignificant. This shows that there is inverse effect of liberalization on stock returns. The investors are indefinite about investing in the market so there are greater fluctuations in the market. There is an immense rise in stock returns as soon as the announcement of liberalization is made by the government but fall gradually till the implementation of FIIs. Once the market opens, the investors get used to liberalization and do not react in the same manner as they did on the first liberalization. The response of the stock market returns to subsequent

liberalizations is lesser than that of the first liberalization. This again shows that in long run the investors and the market becomes mature with liberalization, and the volatility of the market reduces and the stock market becomes more stable. Finally, regression analysis is applied on the stock market returns and the exchange rate to evaluate the relationship between the exchange rate fluctuations and its effect on amount of investment by FIIs. The summary of the analysis is given below:


TABLE 4 Results for Linear Regression 1. Intercept 2. Exchange Rate 3. R2 4. No. of observations 3.69948% -0.08561% 0.0019 4049

The above table shows that this analysis is significant and the changes in exchange rate have impact on the stock returns. The value of 1 (Exchange rate) is -0.08561% and is significant which describes that there is an inverse relationship between the stock returns and exchange rate. If the exchange rate increases by 1% then the stock returns decrease by 0.08561%. This basically means that when the exchange rate moves against the foreign investors, they pull 55 back their investments from the market or do not invest further which leads to a fall in the stock index prices and vice-versa. Hence, fluctuations in the stock returns are also affected by changes in the exchange rates.





It has also been analysed that FIIs are not the only driving force for the rise of the BSE Sensex . This can be proved by examining the diagram below:


It can be interpreted from the above figure that a fall in the foreign investments does not always lead to a subsequent fall in the Sensex. There are other factors that result in fluctuations in the market. Moreover, the inflow of foreign capital also depends on many reasons. It is believed that the FIIs are the major drivers of the stock returns whereas; the inflow of foreign capital is based on the performance of the stock market. It has been observed that the reactions of stock market returns and FIIs are interdependent on each other. The financial press portrays that the flow of foreign capital is the foremost driver of the Indian stock market returns. On the other hand, it has been noticed that the foreign capital inflows are the effect and not the cause of performance of the stock market. There were four incidents of susceptibility in India, which were harmful shocks disturbing the economy and stimulating the behaviour of the FIIs. They were: East-


Asian crisis in 1997, Pokhran Nuclear explosion in May 1998 and attendant sanctions, stock market scam in early 2001, and Black Monday of May 17, 2004. The tables of data for stock returns of BSE and net FII investments during these incidents are given below:








millions) MAY 1998 JUNE 1998 JULY 1998 AUGUST 1998 SEPTEMBER 1998 OCTOBER 1998 3,686.39 3,250.69 3,211.31 2,933.85 3,102.29 2,812.49 -5574.5 -8963.0 1046.8 -3908.2 1110.9 -5524.6





millions) NOVEMBER 2000 DECEMBER 2000 JANUARY 2001 FEBRUARY 2001 3,997.99 3,972.12 4,326.72 4,247.04 10901.1 -4617.8 39715.8 15741.4


MARCH 2001



FII BEHAVIOUR AROUND BLACK MONDAY MONTH BSE SENSEX NET FII INVESTMENTS (in millions) MAY 2004 JUNE 2004 JULY 2004 4,759.62 4,795.46 5,170.32 -31512.9 5110.0 12928.3

In all these four incidents, it is observed that the behaviour of foreign portfolio investors is influenced by these events. On 17th May 2004, the Sensex fell by 562 points with net sales of roughly INR 5000 million by FIIs which is just a small proportion of the total trading volume of BSE spot and derivatives. In 2004, the gross turnover of the equities market was INR 880 million out of which the gross turnover by FIIs was just INR 50 million. This shows that FIIs are not the only drivers of stock market returns and there are other factors (domestic individual and institutional investors) which affect the returns.



It can be concluded from the above research that there are many factors that affect the inflow of foreign capital into the country like exchange rate, balance of payment, interest rate etc. Moreover, liberalization of stock markets is beneficial for the development of the market as well as the economy as a whole in long run. Volatility is a part and parcel of liberalization and does not have a major effect of the fluctuations of stock return. Further, there is an interrelationship between the FII inflow and stock returns and foreign capital is not the only driving force for the rise or fall in the stock returns. Overall, liberalization has proved to be beneficial for India and the economy has more scope for further development.







The main findings of this research are as follows: a) FII inflows are correlated with simultaneous returns in the Indian markets. b) Changes in interest rate, balance of payments and exchange rate affect the inflows of foreign capital. c) The stock markets of India have always been volatile and introduction of foreign investors does not have any major affect of the volatility of the market. d) There is a minor rise in volatility on liberalization but in long run, opening of stock markets is beneficial as it reduces volatility, cost of capital and enhances the market efficiency.


e) Market capitalization is directly related to GDP, and FII inflow helps in financing the development of economy. f) FIIs are not the major drivers of stock returns and other factors like domestic institutional and individual investors etc. also affect the stock returns. g) First liberalization had the most important impact on the stock returns as compared to subsequent liberalizations as the investors got used to policy changes. The stylized findings listed above lead to a better understanding of affects of liberalization on the stock market returns of India. The results of this research contradicts the view that FIIs determine the market returns in general, though there could be a herding behaviour of domestic speculators imitating the moves of FIIs. This study provides an analysis of the fluctuations in stock returns due to liberalization and the after effects in long run. The stability of the market in long run goes along with the derivation of long run effect of emerging stock market liberalization from IAPM partly, as average index daily return of other periods for Bombay Stock Exchange is lower than the before event period which signals the realization of lower risk premium in long period.


The insignificant impact of the FII policy on the stock market may be a result of the current investment restrictions on the foreign investors, rigid application procedures and the hypothetical problems in the Indian stock market. Further, steps must be taken by the government of India to encourage the inflow of capital by the FIIs as these flows increase the domestic investments without any rise in the foreign debt.

The FIIs can also raise the stock prices; reduce the cost of equity capital, encourage investments by Indian firms and initiate further improvements in the securities market design and corporate

governance. The expert groups have suggested that in order to encourage the FII flows, sufficiently high limits of investment must be set, there must be a rise in supply of good quality equities by disinvesting in the public sector, FII investment caps must be established etc.

8.1-LIMITATIONS OF RESEARCHBroader and long term issues involving foreign portfolio investment in India and their nationwide implications have not been discussed in


this research. Moreover, the analysis is done on the daily stock indices of Bombay stock exchanges Sensitive Index (Sensex) alone which only constitutes thirty major companies of India rather than NIFTY (National stock exchange) which contains hundred major companies of the country. A detailed understanding of FII inflows can help address the questions in a more informed manner allowing a better evaluation of risks and benefits related to the permission of FIIs in the country.


This research provides an overview to the opening up of the Indian stock market to the foreign investors and the effects of liberalization on the stock market returns. It also examines the investment behaviour of FIIs and the long term effect of foreign inflow on the development of the stock market and the economy as a whole. But a more detailed study using the daily data of stock returns as well as the transactions of FIIs at stock market levels (for both Bombay stock exchange and National stock exchange) can help in tackling the questions related to the herding and positive feedback trading behaviour of the FIIs. The extent to which the participation of FIIs in


Indian markets has helped in reducing the cost of equity capital to the industries of India is also an important matter to investigate.


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