6

Impact of FIIs on
Stock Market Instability
One of the prime objectives of the present study is the measure the impact of
foreign investors’ portfolio investments on volatility of Indian stock market. Accordingly,
an attempt is made to assess the impact of FII flows on volatility of Bombay Stock
Exchange Limited. This chapter encompasses brief introduction of methodology and
empirical findings of the study. The chapter has been divided into three sections as
follows: (i) Backdrop (ii) Impact of FIIs on volatility and (iii) Structure of volatility in
India in pre and post FIIs period.

6.1 Background

Investment of FIIs are motivated not only by the domestic and external economic
conditions but also by short run expectations shaped primarily by what is known as
market sentiment. The element of speculation and high mobility in FII investment can
increase the volatility of stock return in emerging markets. In fact, a widely held
perception among academicians and practitioners about the emerging equity markets is
that price or return indices in these markets are frequently subject to extended deviations
from fundamental values with subsequent reversals and that these swings are in large part
due to the influence of highly mobile foreign capital.

Volatility is an unattractive feature that has adverse implications for decisions

pertaining to the effective allocation of resources and therefore investment. Volatility
makes investors averse to holding stock due to increased uncertainty. Investors in turn
demand higher risk premium so as to ensure against increased uncertainty. A greater risk
premium implies higher cost of capital and consequently lowers physical investment. In

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addition, great volatility may increase the “option to wait” thereby delaying investment.
Also weak regulatory system in emerging market economies (EMEs) reduce the
efficiency of market signals and the processing of information, which further magnifies
the problem of volatility. But some researchers have the opposite assumption of non-
disestablishing hypothesis that says FIIs have no adverse impact on the market volatility.

The conclusion about the impact of FIIs activities on the volatility of India’s stock
market are rather divided: some studies like Karmakar, Madhusudan (2006); Porwal and
Gupta (2006); Upadhyay, Saroj(2006); Bhattacharya and Jaydeep (2005); Biswas,
Joydeep (2005); Pal, Parthapratim (2005); Rai and Bhunumurthy (2004); Singh, Sharwan
Kumar (2004) and Batra (2003) find evidences of higher volatility in the market due to
the arrivals of FIIs. On the other hand, Banerjee and Sarkar(2006), Biswas,
Jaydeep(2006), Mohan, T.T.Ram (2006), and Kim and Singal (1993) do not find any
destabilizing impact on stock prices. Even some researchers such as S.S.S.Kumar (2000)
have the view that the FIIs reduce stock market volatility.

Trading by FIIs happens on a continuous basis and therefore has a lasting impact
on the local stock market. There is, however, surprisingly little empirical evidence on the
impact of FIIs trading on the host country’s stock return volatility, thereby making it
imperative that this aspect of local equity markets, which is important for both risk
analysis and portfolio construction, be examined. This chapter attempts to fill the gap.
Beside the introduction, this chapter is classified into two parts. Part I presents the impact
of foreign institutional investors on the Indian stock market volatility. Part II shows the
structure of the volatility before and after introduction of the foreign institutional
investors in Indian stock market.

The scope of the study is limited to the India which has become an attraction for
FIIs in recent years, infact the emerging markets of many developing countries have been
attracting large inflows of private capital in recent years. The surge in capital flows
occurred first in Latin America, then South East Asia and is now clearly visible in South
Asia. A significant feature of these capital flows is the increasing importance of foreign
portfolio investment (FPI), whose buying and selling of stocks on a daily basis
determines the magnitude of such capital flows. A significant improvement has also

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taken place in India relating to the flow of foreign capital during the period of post
economic reforms. The major change in the capital flows particularly in Foreign
Institutional Investors (FIIs) investments has taken place following the changes in trade
and industrial policy. Over the past 15 years or so India has gradually emerged an
important destination of global investors’ investments in emerging equity markets. In
2006, India had a share of about 0.55 percent of global investment which is quite high in
comparison to year 2001 in which India’s share was only 0.12 percent. On the other hand
some of the developed countries have shown a downward trend.

TABLE 6.1: FOREIGN INVESTMENT IN VARIOUS COUNTRIES IN TERMS

OF THE PERCENTAGE OF GLOBAL INVESTMENTS IN US $

Year India USA UK Japan Singapore Switzerland

2006 0.55 19.31 9.81 4.43 0.39 1.81
2005 0.45 20.54 9.43 4.95 0.33 1.73
2004 0.31 20.81 9.64 4.07 0.29 1.54
2003 0.25 21.83 9.58 0.38 0.28 1.62
2002 0.14 23.26 9.69 3.61 0.29 1.81
2001 0.12 24.39 10.15 4.27 0.39 1.71
Source: Various Issues of Money and Finance

The foreign financial inflows, beside other factors, helped the Indian stock market
to rise at a great height according to financial analysts. Sensex crossed a new high. It
crossed 20000- mark in December 2007, which was 13786.91 in December 2006 and
9397.93 in December 2005. This historical movement is also due to the other parameters
of the economy, which are favorable for the investment. The returns on investment are
also much favorable. The profit performance of the firms may explain the reasons for
high return on investment. There are other factors such as favorable tax laws and
relaxation on the caps of various kinds of investments. The policy measures and
economic factors are also the reasons for the investor’s confidence.

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 6.2 Impact of FIIs on Stock Market instability

For understanding this section appropriately, let us recall the chapter third of this
thesis wherein we have discussed in detail the research methodology used to assess
instability of the stock returns. Traditionally, volatility of returns is measured either with
squared returns or standard deviation of returns or high and low prices. Due to the
limitation of traditional measures of volatility the conditional volatility models such as
ARCH and GARCH are becoming more popular among the researchers. These models
take into account the time varying nature of the volatility. In the present study both
traditional as well as conditional instability models have been used. Table 6.2 presents the
results obtained by the application of traditional model of volatility. The standard
deviation of daily return is used for the same.

TABLE 6.2: VOLATILITY OF STOCK MARKET RETURNS

AS PER TRADITIONAL MEASURES (DAILY DATA)

Time Period Return (%) Volatility

(S.D.%)
Pre- liberalization Period 1961-80 .01564 .051981
Real Sector Reforms 1981-90 .06674 1.00239
Financial Sector Reforms 1991-00 .07432 1.92584
Second Generation Reforms 2001-07 .10566 1.42734
Study Period:
Pre-liberalization 1/1986- 9/1992 .1539 2.1598
Post Liberalization 10/1992-12/2007 .0634 1.6013
Overall Study Period 1986- 07 .09105 1.7704
1986 .04978 2.19485
1987 -0.06499 1.54614
1988 0.20930 1.70077
1989 0.07512 1.48617
1990 0.18249 2.54950
1991 0.31618 1.03258

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 1992 0.21029 3.33207
1993 0.15392 1.81815
1994 0.06242 1.45488
1995 -0.08993 1.26341
1996 0.00987 1.52449
1997 0.07870 1.61367
1998 -0.04623 1.89752
1999 0.18326 1.80060
2000 -0.06698 2.19800
2001 -0.07051 1.70528
2002 0.02933 1.11411
2003 0.22310 1.17293
2004 0.06082 1.60963
2005 0.15000 1.10654
2006 0.17828 1.59114
2007 0.16887 1.54359

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

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

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analysis raised a question whether this reduction in volatility in post reform period is
statistically significant. To answer this question the test of significance of difference in
variance before and after the arrival of FIIs was used. F-test given by the Fisher was used
for the same. The formula for F-test is as under:

F = S12/S22
S1 = Adjusted sample standard deviation before arrival of the FIIs in India
S2 = Adjusted sample standard deviation after arrival of the FIIs in India
Adjusted sample standard deviation can be calculated as under:
S = nS2/n-1

Table 6.3 indicates that variance of daily stock market returns have worked out at
2.5642 level during post FIIs period as against 4.6647 before the arrival of them. It means
the variance has remained just half in FIIs era. Table 6.3 further indicates that the
calculated value of F statistic is 1.8192, which is more than the tabulated value one at a
degree of freedom v1 = 1394 and v2 = 3660. Hence, the null hypothesis stands rejected.
It refers that the variation in Indian stock market returns reduced considerably after
introduction of foreign institutional investors.

TABLE 6.3: RESULT OF FISHER F- TEST

Series Mean Std. Variance(S2) No.of Obs.

Pre – liberalization
.1539 2.1598 4.6647 1395
01 : 1986 – 08 : 1992
Post – liberalization
.0634 1.6013 2.5642 3661
09 : 1992 – 12 : 2007
F-Value (1394, 3660) 1.8192
Table Value (1394, 3660) 1

After examining the volatility of stock market with the use of traditional
measures, we applied econometric model named as GARCH. More, specifically we used
the GARCH (1,1) model. The dummy variable was introduced in the GARCH equation
in order to measure the impact of FIIs. To specify the GARCH model two equations have
to be specified. One is the mean equation and the second is the variance equation. The
mean equation is as follows:

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BSEt = a + b1 R_BSE + b2 S&P + b3 R_S&P + b4 EXCHAGE RATE + b5 FBIR + b6 IIP
+ B7 TBR_IND + et-------------------(6.1)

Where BSEt = Return at Bombay Stock Exchange

a = Intercept
b1, b2, b3…… b8 = Coefficients
R_BSE = Risk at Bombay Stock Exchange
S&P = Return of Standard and Poor 500
R_S&P = Risk at Standard and Poor 500
EXCHAGE RATE = Exchange Rate US $ v/s Indian Rupee
FBIR = Federal Bank Three Months Treasury Bills Rate
IIP = Index of Industrial Production
TBR_IND = Interest Rate of Indian 3 Months Treasury Bills in India
et = Error Term

Second equation used is the variance equation of the following form:

ht = w + ai e2t-1 + bi ht-j + DFII------------------------------------------(6.2)

Where ht is the conditional variance at period t. In equation (6.2) first term after
the intercept w is the ARCH term, which shows the affect of recent news on the volatility
of the underlying stock market by putting the square of previous error term. And second
term is the GARCH term, which shows the affect of previous volatility on the current
volatility. And DFII is showing the impact of the dummy variable on the volatility in the
return of underlying stock market, which is BSE in case of the present study. The
empirical results in this regard are reported in table 6.4.

TABLE 6.4: IMPACT OF INTRODUCTION OF FOREIGN INSTITUTIONAL

INVESTORS ON VOLATILITY OF BSE (ANALYSIS OF DAILY DATA)

Variable Coefficient Standard Error Prob.

Constant 0.0000166 0.00000163 0.0000
ARCH (1) 0.121213 0.007309 0.0000
GARCH (1) 0.845663 .008074 0.0000

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 FIIs Dummy -.00000752 .00000118 0.0000

It is obvious from the table that the coefficient of ARCH (1) term is significant at
1 percent level. The above clearly indicates that the recent past information is creating a
positive and significant impact on the volatility of the return of the stock market.
Similarly, the coefficient of GARCH (1) term also shows a positive and significant
impact on the share market volatility, the GARCH term impact is higher in comparison to
ARCH term which implies that the past volatility affect is more on the future volatility.
The impact of the dummy variable, which is net investment by foreign institutional
investors is negative. The coefficient is very small but it is statistically significant.
Similar to the S.S.S. (2000), it implies that due to the introduction of foreign institutional
investors the volatility in our stock market has reduced.

The total of the ARCH and GARCH term is less than 1, which implies that the
model is perfectly structured. It must be noted that the time period under this study was a
period of policy initiation in Indian stock market. So many developments like
compulsory rolling settlement, dematerialization of securities, emphasis on free trading
practices and strict corporate governance practices adopted by the SEBI etc. took place in
the market during the study period under reference. The above has helped bringing
efficiency and reduction in the volatility in the market. Therefore, the extent to which the
reduction in the volatility of the market is linked to introduction of FIIs is really
ambiguous. To eliminate this ambiguity monthly data analysis is conducted for time
period from January 1993 to December 2007. So in place of the dummy variable we have
taken the original value of the FIIs monthly net investment in Indian market. The
equation used for the analysis was the same to the equation 6.2 with the only difference
that now the data is monthly in place of daily basis and in the place of the dummy
variable the original value of monthly investment of the foreign institutional investors in
Indian stock market has been taken:

ht = w + ai e2t-1 + bi ht-j + FIIN--------------------------(6.3)

In the equation (6.3) first term after the intercept w is the ARCH term, which
shows the affect of recent news on the volatility of the underlying stock market by
putting the square of previous error term. Second term is the GARCH term, which shows

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the affect of previous volatility on the current volatility and FIIN shows the impact of
FII investments on the volatility of stock market. The results of the analysis are shown in
the Table 6.5. The results show that in the case of monthly data ARCH(1) coefficient is
not found significant while the GARCH (1) coefficient is still positively significant

TABLE 6.5: IMPACT OF INTRODUCTION OF FOREIGN INSTITUTIONAL

INVESTORS ON VOLATILITY OF BSE (ANALYSIS OF MONTHLY DATA)

Variable Coefficient Standard Error Prob.

Constant 0.001563 0.008000 0.0508
ARCH (1) 0.150000 0.143734 0.2967
GARCH (1) 0.600000 .0.219675 0.0063
FII Investments -.000000239 .000000128 0.0629

which implies that the past volatility affect present volatility. So there is a tendency of
volatility clustering. The impact of the foreign institutional investor investments it is still
negative but this time it is significant at a significance level of 10 percent. Thus if
volatility is tested at 10 percent, it has declined, but the impact is found statistically
insignificant. In alignment of Ananthanarayanan, Krishnamurthi and Sen (2003), Batra
(2003), Mazumdar (2004), Banerjee and Sarkar(2006) Biswas, Jaydeep(2006) Mohan,
T.T.Ram (2006) Rakshit, Mihir (2006) the results of the study conclude that there is no
significant impact on volatility of the FII investments. Hence, volatility remains equal in
both the periods.

The history also supports our findings as in most of the market crashes the FIIs
were net buyers (e.g. stock market crash of 2001, market collapse of 1998). Evening 1,7
May 2004 Black Monday episode does not conclude that FII were the culprits. The
investment behavior of the FIIs vis-a vis the movements of the stock market indices
during these episode are given in Tables 6.6 to 6.9.

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 TABLE 6.6: FIIs BEHAVIOUR DURING EAST ASIAN CRISIS

Month BSE Index for the Month FII Investments (Rs. Crore)
July 1997 4256.11 1002.8
August 1997 4276.31 493.66
September 1997 3944.78 598.59
October 1997 3991.75 641.59
November 1997 3611.83 -289.87
December 1997 3515.54 -182.38
January 1998 3472.87 -374.97
February 1998 3402.96 629.05
March 1998 3816.89 472.22

TABLE 6.7: FIIs BHAVIOUR IN THE AFTERMATH OF POKHRAN NUCLEAR

EXPLOSION
Month BSE Index for the Month FII Investments (Rs. Crore)
May 1998 3911.95 -557.45
June 1998 3317.49 -896.30
July 1998 3271.73 104.68
August 1998 2988.40 -390.82
September 1998 3089.88 111.09
October 1998 2866.55 -552.46

TABLE 6.8: FIIs BEHAVIOUR DURING THE STOCK MARKET SCAM 2001
Month BSE Index for the Month FII Investments (Rs. Crore)
November 2000 3928.10 1090.11
December 2000 4081.42 -461.78
January 2001 4152.39 3971.58
February 2001 4310.13 1574.14
March 2001 3807.64 2204.80

TABLE 6.9: FIIs BEHAVIOUR AROUND BLACK MONDAY, MAY 17, 2004
Month BSE Index for the Month FII Investments

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 (Rs. Crore)
May 2004 5204.65 -3151.29
June 2004 4823.87 511.00
July 2004 4972.88 1292.83
Source: Report of the Expert Group on Encouraging FII Flows and Checking the Vulnerability of
Capital Market to Speculative Flows

FII investment behavior during four events indicates that these events did affect the
investments of foreign institutional investors but for a short time period. For example, in
case of East Asian crisis FIIs were net seller in only three months after that they again
became the net buyer and during their selling period BSE Sensex declined but not so
much. The same thing can be seen in case of Pokhran nuclear explosion. In another two
cases: (i) stock market scam 2001 and (ii) Black Monday 2004 although, FIIs were net
sellers but still BSE Sensex saw a small decline. All the facts show that though there was
a net outgo but there was also a come back in the next very month as a net positive
inflow. On the basis of above analysis, we can It is further argue that FIIs tend to support
stock market purely to ensure stability and safety of their own investments and supports
the broad base hypotheses, which suggest that FIIs add liquidity to the local market and
reduce volatility.

6.3 Structure of instability Before and After influx of FIIs

After an investigation into the impact of FII flows on stock market return
instability an attempt is made to analyze changes in the structure of the instability. To
determine the structure of the volatility into Indian stock market we classified the data
into four parts (i) before the announcement of permission granted to the foreign
institutional investors [from January 1986 to August 1992] (ii) after announcement of
permission granted to the foreign institutional investors [i.e. September 1992 to
December 2007] (iii) before the arrival of the foreign institutional investors [from
January 1986 to September 1992] and (iv) after the arrival of the foreign institutional
investors[i.e. October 1992 to December 2007]. The structure of the Volatility is searched
by using the GARCH (1,1) model, the equation for the same is as follows:

ht = w + ai e2t-1 + bi ht-j--------------------------------------(6.4)

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where the first term after intercept is the ARCH term and second term is the GARCH
term and the results of the same are given in Table 6.10. The table reveals that the
coefficients of ARCH and GARCH for the entire period of the study are 0.1655 and
0.7794 respectively. Note worthy is that both of these coefficients are significant at 1
percent level. It means recent past news about the volatility have a significant bearing on
the stock market volatility. The magnitude of the GARCH (1) is comparatively higher
and statistically significant which indicates the tendency of volatility clustering. It means
past volatility affects current volatility in a significant manner. By this we can conclude
that the historical information affect the stock market in a significant way and shock to
conditional variance take a long time to die out in Indian market.

TABLE 6.10: PATTERN OF STOCK MARKET VOLATILITY IN INDIA

Variable Statistics Constant ARCH (1) GARCH (1)

Pre – liberalization Coefficient .0000169 .116949 .846768
01 : 1986 – 08 : 1992 Probability .0000 .0000 .0000
Post – liberalization Coefficient .0000485 .167302 .612751
09 : 1992 – 12 : 2007 Probability .0000 .0000 .0000
Pre – liberalization Coefficient .0000138 .098115 .870536
01 : 1986 – 10 : 1992 Probability .0000 .0000 .0000
Post – liberalization Coefficient .0000129 .155620 .800390
11 : 1992 – 12 : 2007 Probability .0000 .0000 .0000
Whole Period Coefficient .0000178 .165501 .779462
01 : 1986 – 12:2007 Probability .0000 .0000 .0000

Table 6.10 also shows the ARCH (1) and GARCH (1) estimates before and after the
announcement and entry of the foreign institutional investors in Indian stock market. In
case of pre announcement ARCH (1) and GARCH (1) values are 0.1169 and 0.8467
respectively while in post announcement period the former coefficient has increased to
0.1673 and later component has declined to 0.6128. It indicates that impact of recent
news about the volatility has increased after the introduction of foreign institutional

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investors in Indian stock market. The phenomenon is the same in case of the real entry of
the foreign institutional investors in the Indian stock market. ARCH (1) value has
increased from 0.0981 to 0.1556 and GARCH (1) value decreased from 0.8705 to 0.8004.
Simply speaking, the information is quickly disseminated and quality of information has
improved in the market in the post liberalization period.

6.4 References:
Ananthanarayanan, Sandhya, Krishnamurti, Chandrasekher and Sen, Nilanjan
(2003), “Foreign Institutional Investors and Security Returns: Evidence from
Indian Stock Exchanges”.
Banerjee, Ashok & Sarkar, Sahadeb (2006), “Modelling Daily Volatility of the
Indian Stock Market using Intra-day Data”, IIM Calcutta, WPS No. 588/March.
Batra, A. (2003), “The Dynamic of Foreign Portfolio Inflows and Equity Returns
in India”, Working Paper, ICRIER, New Delhi, October
Battacharya, Basabi and Mukherjee, Jaydeep (2005), “An Analysis of Stock
Market Efficiency in the Light of Capital Inflows and Exchange Rate Movements:
The Indian Context”,
http://www.igidr.ac.in/money/An%20Analysis%20of%20Sock%20Market%20Efficiency...
Basabi%20&%20Jaydeep.pdf, Date:11/12/06.

Biswas, Joydeep (2005), “ Foreign Portfolios Investment and Stock Market

Behavior in a Liberalized Economy: An Indian Experience”, Asian Economic
Review, August, Vol. 47, No.2, pp. 221-232.
Karmakar, Madhusudanv (2006), “Stock Market Volatility in the Long Run 1965-
2005”, Economic and Political Weekly, May, pp. 1796-1802.
Kim, E. H., and Singal, V. (1993), “Opening up of Stock Markets by
Emerging economies: Effects on Portfolio Flows and Volatility of Stock Prices,
in Portfolio Investment in Developing Countries”, World Bank Discussion Paper
No.228 Ed. By Stijn Claessens and Sudarshan gooptu (Washington: World Bank,
1993), pp.383-403.

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Mohan, T.T.Ram (2006), “Neither Dread Nor Encourage Them”, Economic and
Political Weekly, January, pp. 95-98.
Pal, Pathapratim (2005), “Recent Volatility in Stock Market in iNdia and Foreign
Instituttional Investirs”, Economic and political Weekly, March.
Porwal, Ajay, Kumar, Hamender and Gupta, Rohit (2005), “The Stock Market
Volatility”, The Journal Accounting and Finance, Vol. 20, No.1, October, pp. 31-
44.
Rai, K. and Bhanumurthy, N.R. (2003), “Determinants of Foreign Institutional
Investments in India: The Role of Return, Risk and Inflation”, JEL Classification:
E44, G15, G11.
Rakshit, Mihir (2006), “On Liberalizing Foreign Institutional Investment”,
Economic and Political Weekly, 18 March, pp. 991-998.
Kumar, S.S.S. (2000), “Foreign Institutional Investment: Stabilizing or
Destabilizing?”, Abhigyan, pp. 23-27.
Singh, Sharwan Kumar (2004), “Foreign Portfolio Investment”, The Indian
Journal of Commerce, Vol.57, No.4, October-December, pp. 120-137.
Upadhyay, Saroj (2006), “FIIs in the Stock Market and the Question of
Volatility”, Portfolio Organizer, May, pp. 22-30.

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