Macroeconomics Policies and Principles

Effect of Currency Fluctuation on FII

Project Report

Group 9, Section-F
Dishank Jain 11FN-036 Rakhi Palsania -11FN-133 Shikhar Mishra -11DM-148 Vaqar Merchant -11IT-032 Vidhan Biyani -11DM-175

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Table of Contents
Scope and Purpose of the Study ............................................................................................................... 2 Currency Fluctuations ............................................................................................................................... 2 FDIs and FIIs .............................................................................................................................................. 2 Foreign Institutional Investors .................................................................................................................. 3 Currency Fluctuations and FII Mutual Effects ........................................................................................ 4 Effect of FII on Indian Stock Market.......................................................................................................... 7 Conclusion ................................................................................................................................................. 7 References ................................................................................................................................................ 7

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Scope and Purpose of the Study

The scope of the study is very broad study of currency fluctuation and study of its effects is narrowed down to FIIs only. The purpose of the study is to understand the currency fluctuation and its effect on foreign institutional investors. Various articles from reputed newspapers and e-news sites on the internet were followed for the understanding and the effect of currency fluctuation on FIIs was studied.

Currency Fluctuations
Currency fluctuation includes currency appreciation and depreciation. Any change in the value of a countrys currency in the international market has far flung effects on its stock market, imports and exports, net value, FDIs and FIIs. Currency value in India is very volatile and there are many factors which participate in the improvisation or devaluation of money.

FDIs and FIIs

Both FDI and FII are related to investment in a foreign country. FDI or Foreign Direct Investment is an investment that a parent company makes in a foreign country. On the contrary, FII or Foreign Institutional Investor is an investment made by an investor in the markets of a foreign nation. In FII, the companies only need to get registered in the stock exchange to make investments. But FDI is quite different from it as they invest in a foreign nation. The Foreign Institutional Investor is also known as hot money as the investors have the liberty to sell it and take it back. But in Foreign Direct Investment, this is not possible. In simple words, FII can enter the stock market easily and also withdraw from it easily. But FDI cannot enter and exit that easily. This difference is what makes nations to choose FDIs more than then FIIs. FDI is more preferred to the FII as they are considered to be the most beneficial kind of foreign investment for the whole economy. Foreign Direct Investment only targets a specific enterprise. It aims to increase the enterprises capacity or productivity or change its management control. In an FDI, the capital inflow is translated into additional production. The FII investment flows only into the secondary market. It helps in increasing capital availability in general rather than enhancing the capital of a specific enterprise. The Foreign Direct Investment is considered to be more stable than Foreign Institutional Investor. FDI not only brings in capital but also helps in good governance practices and better management skills and even technology transfer. Though the Foreign Institutional Investor helps in promoting good governance and improving accounting, it does not come out with any other benefits of the FDI.

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While the FDI flows into the primary market, the FII flows into secondary market. While FIIs are shortterm investments, the FDIs are long term. In short 1. FDI is an investment that a parent company makes in a foreign country. On the contrary, FII is an investment made by an investor in the markets of a foreign nation. 2. FII can enter the stock market easily and also withdraw from it easily. But FDI cannot enter and exit that easily. 3. Foreign Direct Investment targets a specific enterprise. The FII increases capital availability in general. 4. The Foreign Direct Investment is considered to be more stable than Foreign Institutional Investor.

Foreign Institutional Investors

FII means an entity established or incorporated outside India which proposes to make investment in India. For this purpose, sub-accounts are to be maintained. Sub-account includes those foreign corporations, foreign individuals, and institutions, funds or portfolios established or incorporated outside India on whose behalf investments are proposed to be made in India by a FII. Following entities / funds are eligible to get registered as FII: Pension Funds Mutual Funds Insurance Companies Investment Trusts Banks University Funds Endowments Foundations Charitable Trusts / Charitable Societies

Further, following entities proposing to invest on behalf of broad based funds, are also eligible to be registered as FIIs: Asset Management Companies Institutional Portfolio Managers Trustees Power of Attorney Holders

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Broad Based Fund means a fund established or incorporated outside India, which has at least twenty investors with no single individual investor holding more than 10% shares or units of the fund. Provided that if the fund has institutional investor(s) it shall not be necessary for the fund to have twenty investors. Provided further that if the fund has an institutional investor holding more than 10% of shares or units in the fund, then the institutional investor must itself be broad based fund.

Parameters on which SEBI decides an FII applicants eligibility Applicants track record, professional competence, financial soundness, experience, general reputation of fairness and integrity. (The applicant should have been in existence for at least one year). Whether the applicant is registered with and regulated by an appropriate Foreign Regulatory Authority in the same capacity in which the application is filed with SEBI. Whether the applicant is a fit & proper person.

Currency Fluctuations and FII Mutual Effects

Firstly, it is important to understand the effects of any sort of currency fluctuation on the Indian economy, which affects its different industries and how that finally affects Foreign Investment. India has a managed floating exchange rate system. This implies that the exchange rates are decided by international trade of currency but the government does intervene when it deems necessary. It intervenes by controlling the money supply in the economy and as per the demands of the situation. An example: Say the Rupee is currently trading at 50 Rs. = $1 Two scenarios are now possible: Scenario 1: 40 Rs. = $1 This essentially implies that the Rupee has now appreciated, or that the Rupee had become stronger. This also implies that Indian goods have gotten more expensive and will lead to an increase in imports. Scenario 2: 50 Rs. = $1 This implies that the Rupee has now become weaker or depreciated and also implies that Indian goods have now become cheaper as compared to foreign goods resulting in an increase in exports.

MEPP These effects may be result of:

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Interest rates: Increasing interest rates mean higher returns on investments in the home country which result in higher investments, this in turn results in a greater demand for the Rupee which eventually causes it to appreciate. The direct affects of this appreciation on the FIIs can be explained with the help of the following example: An FII invests at an exchange rate of $1 = Rs. 50 and invests an amount of Rs. 10 lakhs which is equivalent to $20000. Now, say, after a year the Rupee appreciates to $1 = Rs. 40. Excluding the returns on the investment it can now be seen that it can be seen that the investment is now worth $25000(100000/40). Thus, the appreciation of the Rupee is a positive sign and encourages Foreign Institutional Investment. The impact of Rupee fluctuation on the industry Considering the previous example, the appreciation of the Rupee has now led to making imports cheaper which spells good news for companies who rely on imports.

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Rupee movement has a very high correlation with stock price movement in India. This is explained by the fact that foreign institutional investors (FIIs) are the largest group of investors in the Indian stock market and their buying and selling has a big influence on domestic stock prices. FIIs tend to track rupee movement closely as the returns they make on their Indian holdings can be affected significantly by currency movements. For example, if the Nifty returned 0.51 per cent in one month, the domestic investors would have broken even on their Nifty investment. FIIs investing in Nifty would, on the other hand, have lost 6 per cent in the same period largely due to currency movement if they were from the US. FIIs from other countries too would have made losses but to a lower extent as the rupee has been depreciating against most major currencies, including the yen, euro, pound and Australian dollar over the past month. It is, therefore, not surprising those FIIs would track rupee closely and their outflows would accelerate in a scenario of rapid currency depreciation. The stance of FIIs has an equally strong impact on the movement on the Indian currency. On days when Indian stocks witness a sell-off, the rupee too depreciates on fears that FIIs could be moving out of Indian stocks. The situation is the reverse on days when Indian stocks rally. The fact that our current account deficit is financed mainly through foreign portfolio flows and India's forex reserves of $316 billion is largely built through FII inflows, could explain the influence that these flows have on the rupee's direction. The following table shows year-wise FII investments in India in

Year
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

FII (INR Cr.)

8574.5 5957.2 -1584 10122.1 9933.4 8762.6 45764.7 45881.3 41466.7 30840.4 66179.1 -45811 142658.3 146438.1 8503.7

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Effect of change in FII on Indian Stock Market

1) Impact of FIIs on Sensex: The relationship between these two variables is more in the period when there is bearish trend. The correlation is although very subtle and hence the relationship is not very significantly effective on each other. 2) Impact of FIIs on Nifty: Nifty shows a strong decline with withdrawal of FIIs. 3) Impact of FIIs on Industrial Sectorial Indices: In different Industrial sectorial indices of BSE (BSE Auto, BSE Banking, BSE CD, BSE FMCG, BSE Realty) the correlation is always less. FII doesnt have much impact on the sectorial indices. The withdrawal by FIIs is resulting in a fall in the indices and so FIIs are playing a good role in the industrial sectorial indices. 4) FIIs have less impact on other stock indices and other unexplained variables are also influencing the Indices. 5) In bearish trend the volatility in Indian Stock indices due to FIIs is more than in bullish trend. No doubt FII inflow is more in bearish times. The domestic investors also play an important role. FIIs influence market more when domestic investors are not in the market.

Conclusion
The above graph shows an almost linear pattern. It can be attributed to the fact that the correlation coefficient among the selected companies in the portfolio is quite high. According to the Table 5, all the pair of companies has this value above 0. This means that this portfolio does not provide hedging i.e. reduces the risk in the portfolio. As one stock increase, the others would also increase and vice-versa. Hence, it is not advisable for any investor to participate in such a portfolio of investment which does provide any protection on risk.

References
1. 2. 3. 4. 5.

http://www.sebi.gov.in/sebiweb/investment/statistics.jsp?s=fii# http://stockshastra.moneyworks4me.com/learn/exchange-rate-fluctuation-rupee-appreciationimpact-on-stock-markets/ http://www.mydigitalfc.com/stock-market/currency-fluctuations-will-not-trigger-fii-exit-onlyhot-money-may-flow-out-640 http://www.business-standard.com/india/news/fii-inflows-steady-despite-se-asian-crisissebi/63647/ http://www.indistock.com/currency-derivatives/default.asp