CHAPTER 1

INTRODUCTION
Foreign portfolio investment typically involves short-term positions in financial assets of international markets, and is similar to investing in domestic securities. FPI allows investors to take part in the profitability of firms operating abroad without having to directly manage their operations. This is a similar concept to trading domestically: most investors do not have the capital or expertise required to personally run the firms that they invest in. Foreign portfolio investment differs from foreign direct investment (FDI), in which a domestic company runs a foreign firm. While FDI allows a company to maintain better control over the firm held abroad, it might make it more difficult to later sell the firm at a premium price. This is due to information asymmetry: the company that owns the firm has intimate knowledge of what might be wrong with the firm, while potential investors (especially foreign investors) do not. The share of FDI in foreign equity flows is greater than FPI in developing countries compared to developed countries, but net FDI inflows tend to be more volatile in developing countries because it is more difficult to sell a directlyowned firm than a passively owned security. For example, Ford Motor Company may invest in a manufacturing plant in Mexico, yet not be in direct control of its affairs. Foreign Portfolio Investment (FPI): passive holdings of securities and other financial assets, which do NOT entail active management or control of the securities issuer. FPI is positively influenced by high rates of return and reduction of risk through geographic diversification. The return on FPI is normally in the form of interest payments or non-voting dividends.

DEFINITION
Securities and other financial assets passively held by foreign investors.

Foreign portfolio investment (FPI) does not provide the investor with direct ownership of financial assets, and thus no direct management of a company. This type of investment is relatively liquid, depending on the volatility of the market invested in. It is most commonly used by investors who do not want to manage a firm abroad. A hands-off or passive investment of securities in a portfolio. A portfolio

investment is made with the expectation of earning a return on it. This expected return is directly correlated with the investment's expected risk. Portfolio investment is distinct from direct investment, which involves taking a sizeable stake in a target company and possibly being involved with its day-to-day management. Portfolio investments can span a wide range of asset classes stocks, government bonds, corporate bonds, Treasury bills, real estate investment trusts, exchange-traded funds, mutual funds, certificates of deposit and so on. Portfolio investments can also include options, warrants and other derivatives such as futures, and physical investments like commodities, real estate, land and timber. The composition of investments in a portfolio depends on a number of factors, among the most important being the investors risk tolerance, investment horizon and amount invested. For a young investor with limited funds, mutual funds or exchange-traded funds may be appropriate portfolio investments. For a high net worth (HNW) individual, portfolio investments may include stocks, bonds, commodities and rental properties. Portfolio investments for the largest institutional investors such as pension funds and sovereign funds include a significant proportion of infrastructure assets like bridges and toll roads. This is because their portfolio investments need to have very long lives, so the duration of their assets and liabilities match.
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CHAPTER 2

BENEFITS OF FOREIGN PORTFOLIO INVESTMENT

Foreign portfolio investment increases the liquidity of domestic capital markets, and can help develop market efficiency as well. As markets become more liquid, as they become deeper and broader, a wider range of investments can be financed. New enterprises, for example, have a greater chance of receiving start-up financing. Savers have more opportunity to invest with the assurance that they will be able to manage their portfolio, or sell their financial securities quickly if they need access to their savings. In this way, liquid markets can also make longer-term investment more attractive. Foreign portfolio investment can also bring discipline and know-how into the domestic capital markets. In a deeper, broader market, investors will have greater incentives to expend resources in researching new or emerging investment opportunities. As enterprises compete for financing, they will face demands for better information, both in terms of quantity and quality. This press for fuller disclosure will promote transparency, which can have positive spillover into other economic sectors. Foreign portfolio investors, without the advantage of an insiders knowledge of the investment opportunities, are especially likely to demand a higher level of information disclosure and accounting standards, and bring with them experience utilizing these standards and a knowledge of how they function. Foreign portfolio investment can also help to promote development of equity markets and the shareholders voice in corporate governance. As companies compete for finance the market will reward better performance, better prospects for future performance, and better corporate governance. As the markets liquidity and functionality improves, equity prices will increasingly reflect the underlying values of the firms, enhancing the more efficient allocation
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of capital flows. Well functioning equity markets will also facilitate takeovers, a point where portfolio and direct investment overlap. Takeovers can turn a poorly functioning firm into an efficient and more profitable firm, strengthening the firm, the financial return to its investors, and the domestic economy. Foreign portfolio investors may also help the domestic capital markets by introducing more sophisticated instruments and technology for managing portfolios. For instance, they may bring with them a facility in using futures, options, swaps and other hedging instruments to manage portfolio risk. Increased demand for these instruments would be conducive to developing this function in domestic markets, improving risk management opportunities for both foreign and domestic investors. In the various ways outlined above, foreign portfolio investment can help to strengthen domestic capital markets and improve their functioning. This will lead to a better allocation of capital and resources in the domestic economy, and thus a healthier economy. Open capital markets also contribute to worldwide economic development by improving the worldwide allocation of savings and resources. Open markets give foreign investors the opportunity to diversify their portfolios, improving risk management and possibly fostering a higher level of savings and investment.

FPI FLOW CAN HELP AN ECONOMY

FPI benefit to the real sector of an economy in three broad ways Inflow of FPI can provide a developing non debt creating source of foreign investment. FPI can induce financial resources to flow from capital- abundant countries, where expected returns are low, to capital scarce countries where expected returns are high. FPI affects the economy through its various linkage effects via the domestic capital market.

CHAPTER 3

FOREIGN DIRECT INVESTMENT VS. FOREIGN PORTFOLIO INVESTMENT

FDI- Foreign Direct Investment refers to international investment in which the investor obtains a lasting interest in an enterprise in another country. Most concretely, it may take the form of buying or constructing a factory in a foreign country or adding improvements to such a facility, in the form of property, plants, or equipment. FDI is calculated to include all kinds of capital contributions, such as the purchases of stocks, as well as the reinvestment of earnings by a wholly owned company incorporated abroad (subsidiary), and the lending of funds to a foreign subsidiary or branch. The reinvestment of earnings and transfer of assets between a parent company and its subsidiary often constitutes a significant part of FDI calculations. FDI is more difficult to pull out or sell off. Consequently, direct investors may be more committed to managing their international investments, and less likely to pull out at the first sign of trouble. On the other hand, FPI (Foreign Portfolio Investment) represents passive holdings of securities such as foreign stocks, bonds, or other financial assets, none of which entails active management or control of the securities' issuer by the investor. Unlike FDI, it is very easy to sell off the securities and pull out the foreign portfolio investment. Hence, FPI can be much more volatile than FDI. For a country on the rise, FPI can bring about rapid development, helping an emerging economy move quickly to take advantage of economic opportunity, creating many new jobs and significant wealth. However, when a country's economic situation takes a downturn, sometimes just by failing to meet the expectations of

international investors, the large flow of money into a country can turn into a stampede away from it.

Comparison chart

FDI
Involvement - direct or indirect

FPI
No active involvement in management. Investment instruments that are more easily traded, less permanent and do not represent a controlling stake in an enterprise. It is fairly easy to sell securities and pull out because they are liquid.

Involved in management and ownership control; long-term interest

Sell off

It is more difficult to sell off or pull out.

Comes from

Tends to be undertaken by Multinational organizations

Comes from more diverse sources e.g.a small company's pension fund or through mutual funds held by individuals; investment via equity instruments (stocks) or debt (bonds) of a foreign enterprise.

What is invested

Involves the transfer of non-financial assets e.g. technology and intellectual capital, in addition to financial assets. Foreign Direct Investment Having smaller in net inflows Projects are efficiently managed

Only investment of financial assets.

Stands for

Foreign Portfolio Investment Having larger net inflows Projects are less efficiently managed

Volatility

Management

CHAPTER 4

POSITIVE EFFECT OF FOREIGN PORTFOLIO INVESTMENT

Capital Inflows Over the past several decades, the hundreds of billions of dollars of foreign capital that has been invested in the United States have been of tremendous benefit to the U.S. economy, strengthening the dollar, and helping to bring down interest rates by increasing the supply of capital for loans to business and individuals. The decreased investment flows due to the Financial Crisis and the Sovereign Debt Crisis certainly negatively impacted the flow of capital to the U.S. and Europe. In recent history the worlds largest recipient of foreign investment has been the United States. In the first half of 2012 though, China surpassed the United States and became the worlds largest recipient of foreign direct investment, though by the end of 2012, the U.S. regained its number one spot. In 2003, China did beat out the United States for the number one position. One reason might be the fact that the China is growing faster than the U.S. and most developed countries, even though the growth rate in Asia is slowly down. Another reason may be that China no longer seems to be a risky investment. According to a 2012 IMF Working Paper, for developing countries: Reductions in the global price of risk and in domestic borrowing costs were the main contributors to the increase over time in net capital inflows and domestic credit. However, the large cross-country differences in domestic and international finance are best explained by fundamentals such as institutional quality, access to international export markets, and an appropriate macroeconomic policy. Both private capital inflows and domestic credit exert a
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positive effect on investment; they also mediate most of the investment impact of the global price of risk and domestic borrowing costs. Surprisingly, neither greater domestic credit nor greater institutional quality increase the extent to which capital inflows translate into domestic investment. ( Luca, Spatfora, 2012) This means that developing countries can strengthen their institutions and better attract foreign investment though improved institutions do not always translate into better domestic investment (domestic companies investing locally).

Employment Stated very simply, when a company builds a factory in a foreign country, it generally creates new jobs. Foreign investment in the United States contributes significantly to domestic employment. In 2010, roughly four percent of the U.S.
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labor force (six million Americans) was employed by foreign-owned enterprises (Jackson, 2012). (Note: Because most foreign investment into the United States is portfolio investment, rather than direct, as discussed above, one might assume that foreign investment would account for more than four percent of the jobs in the United States. Portfolio investment undoubtedly accounts for a large number of jobs in the U.S., but is harder to quantify because it often involves ownership of a portion of a company, making the numbers harder to disaggregate.) Opponents of globalization often express concerns about jobs lost in the domestic economy when a factory moves abroad, and about downward pressure on wages at home due to the availability of cheaper labor abroad. Job losses can mean that displaced domestic workers, though unlikely to remain unemployed permanently, may be forced to take lower-paying jobs. But any downward pressure on wages in general (for those in trade and non-trade related industries) may be offset by lower prices for domestic consumers as a whole due to the movement of the factory. Consider the following process: a company moves its factory to a less developed country to take advantage of lower labor costs and increase its profits. The poorer country may be said to have a comparative advantagein the production of low-skill, labor-intensive goods, such as textiles and apparel. Other companies follow to gain the benefits of lower costs of labor, and are likely to cut their prices to compete with the company already established in the poor country. As competition increases, consumers in the home market as well as those in the poor market will benefit from lower prices, while the less developed country has all the benefits of new know-how, jobs, and related consumer demand. Globalization has raised numerous issues of concern about labor markets. Foreign investment, trade, technology, and immigration, to name a few issues,
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are all disruptive to traditional means of productions. While most economists believe that the changes brought about by these factors tend to work to promote economic efficiency, and have great potential to improve the living standards of people all over the world, a host of concerns remain. Numerous proposals have been put forth to help mitigate the disruptions caused by globalization. Bringing down the prices of goods and services has the same effect as giving a pay raise to every worker who has access to these cheaper goods: their paycheck can now buy more.

Production Advantages Increased outward orientation: Foreign based affiliates tend to be more

outward oriented. As multi-nationally based operations themselves, they are often more aware of the opportunities of foreign markets and therefore more likely to seek to export. This also helps improve a nations balance of payments. In turn, this outward orientation often helps domestic firms become more aware of international opportunities. Technology transfers: When companies build plants in foreign countries,

they tend to bring the same production techniques and technologies with them that they use in domestic production. This helps raise the skill level of the workers employed in the new plants. The economist Raymond Vernon has observed that direct investment possesses a life cycle, starting with innovation in a firms home market, successful application of that new knowledge or technology, and ending with the replication of that innovation in foreign affiliates.

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Productivity spillovers: Productivity spillovers can spur growth and raise

productivity in industrialized countries as well as developing economies. For example just in time manufacturing allows firms to minimize their needs for inventory by receiving necessary inputs immediately before they are needed. This reduces the need for warehousing and inventory costs. This innovation was brought to the United States from Japanese firms. It was adopted by many domestic firms and helped improve the productivity of many American businesses. Improved production processes: Companies can enjoy significant

improvements in productivity from economies of scale, which can be augmented by participating in global operations. Foreign investment need not mean duplicating production and distribution networks in new markets. Rather, foreign investment can make production more efficient by purchasing elements of a final product in the country with a comparative advantage in making that product. Globalization has produced an integration of production and marketing of goods across national borders. Increased competitiveness in domestic industry: Competition from foreign

corporations often encourages domestic companies to become more efficient and globally competitive. These improvements can result from the effect known as backward linkages. Backward linkages are the long-term relationships that develop between a foreign investor and other firms in the host country. For example, when a firm decides to build a plant that assembles electrical appliances in a foreign country, the firm not only provides a certain number of people with new jobs, but the location of the plant is also likely to encourage the development of new local industries that can supply it with electric motors, fans, and other parts for its production.

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CHAPTER 5

POLICIES FOR FOREIGN PORTFOLIO INVESTMENT

For foreign portfolio investment, strong and well-regulated financial markets are necessary to deal with the inherent volatility. The financial system must have the capacity to assess and manage risks if it is to prudently and productively invest capital flows, foreign or domestic. Its central role of financial intermediation and credit allocation is a key element of economic growth and development. As has been shown above, foreign portfolio investment can be an important player in this function, and bring additional strengths and benefits, but those benefits will be most effective when working within a healthy financial system. For a financial system to maintain its health, the institutions within it must be able to identify, monitor and manage business risks efficiently. The payments system, through financial institutions and clearing houses, must be efficient and reliable. The financial system must also have the ability to withstand economic shocks, such as a substantial shift in the exchange or interest rates, or a sudden capital withdrawal. It must, as well, be able to withstand systemic shocks, such as financial distress or bank failure. Systemic risk, from economic or systemic shocks, is a central, and perhaps unique, element of capital markets. It demands adequate capitalization and risk management capabilities. Adequate and sound prudential supervision is necessary for a healthy financial system. Financial institutions face a myriad of risks: from credit risk to exchange rate risk, from liquidity risk to exposure concentration risk, from various risks stemming from the institutions internal operations to risks inherent in the payments system. Supervisors need to have a sound understanding of all these types of risk and how they can be managed. They also need to understand the environment in which the banks operate, and the various ways these risks can be transmitted. Adequate capital is a necessary element of
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prudential regulation, providing a safeguard against losses and a cushion in the face of institutional or systemic problems. Financial institutions should also limit their exposure to individual or associated counterparties, to related parties, to market risk, to short-term debt or mismatches in liquidity. The IMF and World Bank have developed effective banking supervision frameworks through financial sector surveillance and assessment, carried out, at least in part, through the Financial Sector Assessment Programme and through Reports on Observance of Standards and Codes. Although supervisors need to be able to verify that a financial institutions exposure is balanced and capital is adequate, the extent of specificity in the regulations should be a function of the overall soundness and structure of the financial system. Regulation and regulators will be most effective when they create incentives for sound behavior and when their application and practices are able to evolve with the needs of the market. Supervisors need to be aware of the risks and costs of excessive prudential regulation. The costs will be seen in the time and resources required to comply with the regulations, which should be balanced against the need for regulation, but they will also be seen in the effect on innovation and evolution in the markets, which can bring benefits to both the financial markets and the broader domestic economy. Excessive regulation and supervision can put the onus for effective management of financial institutions on the supervisory authorities, rather than the directors and managers of the institutions. This will reduce the effectiveness of management and of market disciplines, potentially the most practical and efficient regulators. The right balance is essential. Market discipline can provide the greatest incentives for effective risk management. Therefore, it is important not to subvert it by excessive regulation, but there are other factors to watch to ensure that market discipline is effective. Market discipline depends on clear signals from the market. Government
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guarantees of financial institutions, or implicit government support, can keep the market from signaling a growing problem, as can government ownership. Financial safety nets and market failure response arrangements need to be able to effectively resolve market distress situations, without creating unnecessary moral hazard. If financial safety nets and market failure responses are not appropriately designed, they can take away, or at least reduce, the financial institutions incentive to manage its risks adequately, the first and best line of defense against risks. Competition in the financial sector will also strengthen market disciplines, and a financial sector open to foreign investment, which can bring with it new and different outlooks and approaches to these problems, will help attain the benefits of competition. A sound financial system is best sustained when the broader legal, political and economic environment is also marked by sound policies. As these boost the benefits of both portfolio and direct investment, we will return to them below. NON RESIDENT INDIANS PORTFOLIO INVESTMENT SCHEME (PNB BANK) NRIs can approach, PNBs any of the following branches RBI had allotted specific code to the banks dealing in PIS.

Sr. No.

Name of the Branch

Code allotted by RBI

1 2 3

PNB House Fort, Mumbai 400 001. ECE House, K.G.Marg, New Delhi 110 001. Brabourne Road, Kolkata

4401 4402 4403

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CHAPTER 6

FOREIGN PORTFOLIO INVESTMENT FLOWS TO INDIA

The international flow of capital is expected to benefit both the source as well as the host country. However, the historical and recent financial crises have also brought into focus the fact that these flows can expose the countries to new risks. Hence it is important to understand the risks associated with these flows and the factors that drive flows into India, so that policy reactions can be formulated in advance to avoid any imbalances arising out of extremely high capital inflows or sudden reversal of capital flows in future, whatever the case may be. The recent volatility in capital flows, especially when periods of high capital inflows were followed by periods of huge reversal in these flows, has posed macroeconomic challenges to countries across the world. India has not remained untouched by the developments in the global financial markets due to greater linkages of the Indian markets with the international markets. The recent volatility in capital flows to India can mainly be attributed to volatility in foreign portfolio investment flows and especially the foreign institutional investment flows. Hence it is important to analyse the determinants of portfolio flows in this uncertain global scenario. Foreign portfolio investment (FPI) flows have been the most volatile component of capital flows in India and play an important role in determining the overall balance of payments. During the Asian crisis as well as during the recent sub-prime crisis, it was the huge reversal of FPI flows that led to deterioration in the overall balance of payments. This is because by their very nature FPI flows do not involve a long lasting interest in the economy. The ultimate aim of FPIs is to ensure profits and risk diversification.

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This study examines the determinants of portfolio flows to India in the light of increasing volatility in FPI flows which is due to uncertainty in the global scenario in recent times. This is done by using the determinants suggested by a theoretical model, initially proposed by Fernandez- Arias (1996) and FernandezArias and Montiel (1995), where portfolio flows have been modeled using a zero arbitrage condition. According to the model expected return from investing in the host country, adjusted for credit worthiness of the country should be equal to the opportunity cost i.e. returns from investing in home country. The model therefore suggests that capital flows are a function of economic factors in the host and the source country and also of the factors that influence creditworthiness of host country. These factors include domestic stock market performance, exchange rate, foreign exchange reserves to imports ratio, volatility in exchange rate, interest rate differential and domestic and foreign output growth. In addition to the factors suggested by the theoretical model, other factors that are considered important are also included in the empirical model. This includes the effect of the stock market performance of emerging markets in general, on portfolio flows received by India is captured by emerging market MSCI index. The disaggregated components of FPI flows i.e. determinants of Foreign Institutional Investment flows (FIIs) and American/Global Depository Receipts (ADRs/ GDRs) which have been the major components of FPI flows to India are also analyzed. It is important to do so in order to assess whether different components of portfolio flows are driven by the same or different factors. The results indicate that a well performing domestic stock market, an appreciating exchange rate and strong domestic economic growth attracts portfolio flows. Greater volatility in the exchange rate discourages these flows. If the overall stock market performance of emerging markets in general is good
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then the flows received by India decline indicating that India competes with other emerging economies in terms of receiving portfolio flows. A higher interest rate differential between domestic and foreign interest rates attracts FPI flows. The results relating to FII flows are same as that of aggregate FPI flows. For ADR/GDRs, domestic stock market performance, exchange rate, domestic as well as foreign output growth, are observed to be the most significant determinants. It is observed that reserves to import ratio, which measures creditworthiness of India, does not influence any component of portfolio flows, in time series framework. It makes an important contribution to the literature related to FPI flows to India. Most of the literature that analyses the determinants of portfolio flows (FPI) to India has concentrated on the FII component only. ADR/ GDR flows have not received much attention despite the fact that the Indian corporate sector has increasingly used ADR/GDR mechanism to raise foreign capital. This study thus examines the macroeconomic determinants of not only FII but also ADR/GDR flows to India in order to fill the existing gap in the literature. Furthermore, this study examines a wider set of potential determinants of FII flows to India compared to other studies pertaining to the Indian economy such as Chakrabarti (2001), Kaur and Dhillon (2010), Rai and Bhanumurthy (2004), Srinivasan and Kalaivani (2013). While the study by Gordon and Gupta (2003) includes a wide range of determinants of portfolio flows, it uses the OLS methodology that may yield biased and inconsistent estimates if the regressors are endogenous. This study follows the ARDL approach to cointegration for estimating the long-run coefficients which overcomes such problems. The longrun coefficients are unbiased and the t-tests are also valid, even if the regressors included in the specification are endogenous (Harris and Sollis 2003).

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CHAPTER 7

BIBLIOGRAPHY

http://www.investopedia.com/ www.google.com

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CHAPTER 8

CONCLUSION
To characterize portfolio investment as bad and direct investment as good oversimplifies a much more complex situation. Both bring risks, and both require their own policy approaches. There seems to be a certain fear attached to foreign portfolio investment, due perhaps to its complexity and the central economic role of the financial system. (At one time there was a fear of foreign direct investment.) Does foreign portfolio investment engender greater concern? Certainly, financial disturbances have not been confined to foreign investors. If you take foreign out of foreign portfolio or direct investment, most policy makers would acknowledge that domestic portfolio and direct investment are both necessary for healthy economic growth and development. Portfolio investment and the financial system it is part of are central to any healthy economy. Put foreign back in and you have effectively increased the quantity and diversity of investment to even greater effect. As shown above, both portfolio and direct investment can bring powerful benefits to the economy, and together the benefits are increased. The best answer is not to shut either type of investment out not to label one bad and the other good. Instead, both should be welcomed within the proper regulatory structure to maximize the benefits, and to manage the drawbacks and potential negatives. Both portfolio and direct investment bring value for economic growth. They are not intrinsically good or bad, but they are different. Liberalize both with respect for their differences. Beneficial if well functioning stock markets support the economic development of the country. Impose significant fiscal cost on economy as has to maintain the value of rupee in a very narrow band. Have to ensure the attractiveness for the Investors
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