2012

IMPACT OF FOREIGN INSTITUTIONAL INVESTORS (FIIs) AND MACRO ECONOMIC FACTORS ON STOCK MARKETS
This report provides summary regarding the sectors that are most influenced by FII investment and macro economic factors and tries to identify the risks an investor faces in these sectors.

By: Ravindra Singh 10BSPHH011012 Kumar Shreyas 10BSPHH011075

IBS Hyderabad 1/31/2012

ACKNOWLEDGEMENT
With great pleasure we take the privilege to acknowledge the people who have been involved in completion of our project till this date.

We would like to thank Prof. Kaushik Bhattacharjee, our faculty IBS Hyderabad who inspired us by his discussions and showed me the right course to pursue. The success of this project would not have been possible and reached this stage without his constant support.

In the end, we express our thanks to all those who were directly or indirectly involved in this project.

TABLE OF CONTENTS
Contents
Contents .................................................................................................................................................... 3 1. 2. 2.1. 2.2. 2.3. 3. 3.1. 3.2. 4. 4.1. ABSTRACT ..................................................................................................................................... 4 INTRODUCTION........................................................................................................................... 5 Objectives of the Project........................................................................................................... 10 Scope of the Project................................................................................................................... 10 Limitations ................................................................................................................................. 11 DATA SOURCES & METHODOLOGY ................................................................................... 12 Data Sources .............................................................................................................................. 12 Methodology .............................................................................................................................. 13 ANALYSIS & FINDINGS............................................................................................................ 15 Regression Analysis of SENSEX and Sector Specific Indexes .............................................. 15

Findings.................................................................................................................................................. 23 5. Analysis of Automobile Sector: The auto companies analyzed are: ............................................ 24

Findings ................................................................................................................................................... 27 6.1 Conclusion ............................................................................................................................................. 28 During Bull Phase: .................................................................................................................................. 28 During Bear Phase: ................................................................................................................................. 28 During Stagnation Phase: ........................................................................................................................ 28

1. ABSTRACT
Foreign Institutional Investors (FIIs) are investor or investment fund that is from or registered in a country outside of the one in which it is currently investing1.

FIIs can impact the factor productivity of the host country and can also affect the balance of payments. Foreign investments provide a channel through which host country may gain access to foreign capital. In this age of transnational capitalism, significant amounts of capital are flowing from developed world to emerging economies. Positive fundamentals combined with fast

growing markets have made India an attractive destination for FIIs. Portfolio investments brought in by FIIs have been the most dynamic source of capital after the opening up of Indian economy.

FIIs, given their short-term nature, can have bidirectional causation with the returns of other domestic financial markets such as money markets, stock markets, and foreign exchange markets. Hence, understanding the determinants of FII is very important for any emerging economy as FII exerts a huge impact on the domestic financial markets in the short run and a real impact in the long run. India, being a capital scarce country, has taken many measures to attract foreign investment since the beginning of reforms in 1991 when it opened its gates for FIIs.

A rational investor always tries to maximize his/her gains and minimize the risk while investing in stock markets. Given the volatility in Indian stock markets due to its high growth rate it is imperative to asses the risk involved in investing.

This report tries to identify the sectors which have been most impacted by the FII investment and macro economic factors. Then this report will try to formulate a framework using which an investor might asses the risks involved due to investment in those sectors. The report shall prove beneficial to the investors who are trying to maximize their returns in stock markets and minimize their risk.
1

http://www.investopedia.com/terms/f/fii.asp 4

2. INTRODUCTION
FIIs attracted by the fast growing economy of India and strong performance of Indian companies have been attracted towards India to an extent that India has gone on to become the preferred investment destination.

The primary reasons for India being a preferred destination for FIIs are: Global liquidity into the equity markets. Improved performance and competitiveness of Indian firms. Opening up of Indian economy. Cheap labor and other factors of production. Highly developed stock market and high degree of vigilance over it. Tax Incentives.

Terms related to FIIs2: Sub Account: Sub-account includes those foreign corporate, 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.

Designated Bank: Designated Bank means any bank in India which has been authorized by the Reserve Bank of India to act as a banker to FII.

Domestic Custodian: Domestic Custodian means any entity registered with SEBI to carry on the activity of providing custodial services in respect of securities.

Broad Based Funds: 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.

http://investor.sebi.gov.in/faq/foreign%20institutional%20investor.html

Entities that can register as FIIs in India are3: As FII: Pension Funds Mutual Funds Insurance Companies Investment Trusts Banks University Funds Endowments Foundations Charitable Trusts / Charitable Societies

Entities proposing to invest on behalf of broad based funds, are also eligible to be registered as FIIs6:

Asset Management Companies (AMC) Institutional Portfolio Managers Trustees Power of Attorney Holders

As Sub Accounts7: Partnership Firms Private Companies Public Companies Pension Funds Investment Trusts Individuals

Major regulations by Securities and Exchange Board of India (SEBI)4:

3 4

http://investor.sebi.gov.in/faq/foreign%20institutional%20investor.html http://investor.sebi.gov.in/faq/foreign%20institutional%20investor.html

The SEBI is the nodal agency for dealing with FIIs, and they have to obtain initial registration with SEBI.

The SEBI's initial registration is valid for five years. The Reserve Bank of India's general permission to FIIs will also hold good for five years. Both will be renewable. FIIs can invest in all securities traded on the primary and secondary markets. FIIs can repatriate capital gains, dividends, incomes received by way of interest and any compensation received towards sale/renouncement of rights offering of shares.

The total investments in equity and equity related instruments should be at least 70% of the aggregate of all the investments of the Foreign Institutional Investor in India.

The cumulative debt investment limit for FII investments in Corporate Debt is USD 15 billion. The debt investment limit for FIIs in government debt in G-secs currently capped at $5 billion and cumulative investments under 2% of the outstanding stock of G-secs. The Foreign Institutional Investor is allowed to transact business only on the basis of taking and giving deliveries of securities bought and sold. A Foreign institutional Investor or a sub-account having an aggregate of securities worth INR 10 crore or more, as on the latest balance sheet date, can settle their only through dematerialised securities.

Investment by individual FIIs cannot exceed 10% of paid up capital. Investment by foreign registered as sub accounts of FII cannot exceed 5% of paid up capital.

Role of FIIs: The Indian stock market has come of age and has substantially aligned itself with the international order. Market has also witnessed a growing trend of 'institutionalization' that may be considered as a consequence of globalization. It is influence of the FIIs which changed the face of the Indian stock markets. Screen based trading and depository are realities today largely because of FIIs.

FII which based the pressure on the rupee from the balance of payments position and lowered the cost of capital to Indian business. FIIs are the trendsetters in any market. They were the first ones to identify the potential of Indian technology stocks. When the rest of the investors invested in these scrips, they exited the scrips and booked profits.

Rolling settlement was introduced at the insistence of FIIs as they were uncomfortable with the badla system.

The FIIs are playing an important role in bringing in funds needed by the equity market. The increase in the volume of activity on stock exchanges with the advent of on screen trading coupled with operational inefficiencies of the former settlement and clearing system led to the emergence of a new system called the depository System.

Flow of money into Indian economy via FIIs has been increasing at a rapid rate. This has forced economist and policy makers to consider impacts of this inflow on the macro economic factors as well. This has resulted in deeper analysis of factors like Interest Rate, Inflation Rate, GDP and Exchange Rate etc. both in short term as well as long term.

Registration Process for FIIs5

5

http://investor.sebi.gov.in/faq/foreign%20institutional%20investor.html

Advantages of FII Investment: Enhanced flows of equity capital. FIIs have a greater appetite for equity than debt in their asset structure. The opening up the economy to FIIs has been in line with the accepted preference for non-debt creating foreign inflows over foreign debt. Enhanced flow of equity capital helps improve capital structures and contributes towards building the investment gap. FII inflows help in financial innovation and development of hedging instruments. Also, it not only enhances competition in financial markets, but also improves the alignment of asset prices to fundamentals. Improving capital markets. FIIs as professional bodies of asset managers and financial analysts enhance competition and efficiency of financial markets. Equity market development aids economic development. By increasing the availability of riskier long term capital for projects, and increasing firms incentives to provide more information about their operations, FIIs can help in the process of economic development. Improved corporate governance.

Disadvantages of FII Investments: Huge amounts of FII fund inflow into the country creates a lot of demand for rupee, and the RBI pumps the amount of Rupee in the market as a result of demand created. This leads to Inflation. The FIIs profit from investing in emerging financial stock markets. If the cap on FII is high then they can bring in huge amounts of funds in the countrys stock markets and thus have great influence on the way the stock markets behaves, going up or down. This creates problem for Small Investors. FII flows leading to appreciation of the currency may lead to the exports industry becoming uncompetitive due to the appreciation of the rupee. This can have adverse impact on Exports. It may lead to circulation of Hot Money.

2.1.

Objectives of the Project

Following are the purpose of the project: To find the impact of investments made by FIIs and Macro Economic Factors on the various indexes mentioned below. To analyze impact of FIIs and macro economic factors on five companies of the two sectors that are found to be most impacted by above analysis.

Stock Indexes considered for the purpose of study are: BSE SENSEX BSE REALITY Index BSEIT Index BSE BANKEX Index BSE Power Index BSE Oil & Gas Index BSE Metal Index BSE FMCG Index BSE Auto Index Macro Economic Factors considered for the purpose of study: GDP Growth Rate Inflation Rate Interest Rate Exchange Rate

2.2.

Scope of the Project

Following is the scope of the project: The project shall try to identify two sectors that have been most impacted by FII investment and macro economic factors. Thereafter the project will identify five major companies of each sector to see the impact of FIIs investment and macro economic factors in past over them.

10

The project will then try to classify different types of risks in each sector. Finally the project will try to develop a framework depending upon which investors can create investment strategies in future.

Academic Benefits: The project will help: To foster strong analytical skills and decision making power. To apply functional knowledge to real life problems To gain experience of corporate world and to acquire social skills by coming into contact with real professionals. To get acquainted with risks involved in stock markets and ways to analyze a company.

2.3.

Limitations

Following are the limitations of the study: Movement of stocks might be governed by multiple factors. This study only focuses upon the impact of FIIs and macro economic factors mentioned above on stock movement, considering other factors to be constant. The growth rate of GDP and Lending Rate are taken to be constant, for the purpose of making the study convenient, for the entire year which in reality is not the case. Exchange rate is only considered for USD against INR. A company might be getting cash inflows in multiple currencies.

11

3. DATA SOURCES & METHODOLOGY

3.1. Data Sources

Secondary Data has been collected using the following web sources: http://www.moneycontrol.com/ http://www.bseindia.com/ http://www.rbi.org.in/ http://www.sebi.gov.in/ http://www.tradingeconomics.com/Economics/ http://www.gocurrency.com/ http://eaindustry.nic.in/wpi_data_display/display_data.asp

Following data has been collected till now for the purpose of analysis: Net investment by FIIs in India on monthly basis for the period of January 2006 to December 2010 in INR Crores (5 years). SENSEX monthly average closing value for the period of January 2006 to December 2010 (5 years). BSE REALITY monthly average closing value for the period of January 2006 to December 2010 (5 years). BSE IT monthly average closing value for the period of January 2006 to December 2010 (5 years). BSE BANKEX monthly average closing value for the period of January 2006 to December 2010 (5 years). BSE POWER monthly average closing value for the period of January 2006 to December 2010 (5 years). BSE OIL & GAS monthly average closing value for the period of January 2006 to December 2010 (5 years). BSE METAL monthly average closing value for the period of January 2006 to December 2010 (5 years).
12

BSE FMCG monthly average closing value for the period of January 2006 to December 2010 (5 years). BSE AUTO monthly average closing value for the period of January 2006 to December 2010 (5 years). Inflation Rate monthly average value for the period of January 2006 to December 2010 in terms of % increase over previous year (5 years). Exchange Rate monthly average value for the period of January 2006 to December 2010 in terms of INR/USD (5 years). Prime Lending Rate annual average value for the period of January 2006 to December 2010 in terms of % (5 years). GDP Growth Rate annual average value for the period of January 2006 to December 2010 in terms of % growth over previous year (5 years). WPI of automotive sector annual value for a period of January 2006 to December 2010.

3.2.

Methodology

Research Methodology is the study of research methods and rules for doing research work. Research is defined as Diligent and systematic inquiry or investigation into a subject in order to discover or revise facts, theories, and applications6. Following research methodologies shall be used for the purpose of analysis: Regression Analysis: A statistical measure that attempts to determine the strength of the relationship between one dependent variable (usually denoted by Y) and a series of other changing variables (known as independent variables)7.

For the purpose of analysis various stock indexes shall be taken as the dependent variable and Investment by FIIs and the macro economic factors will be considered as the independent variables. A multiple regression analysis will be carried out with individual stock indexes.

6 7

http://dictionary.reference.com/browse/research http://www.investopedia.com/terms/r/regression.asp

13

We shall be focus upon the model significance, correlations and multi-co linearity among various independent variables. Finally we shall focus on the coefficients of the various variables, their significance as well as their magnitude. Index = ( Net FII Investment) + ( Inflation Rate) + ( Exchange Rate) + ( Lending Rate) + ( GDP Growth Rate) +

Where: , , , , = Coefficients. = Error Term

14

4. ANALYSIS & FINDINGS

4.1. Regression Analysis of SENSEX and Sector Specific Indexes
4.1.1. SENSEX with FIIs and Macro Economic Factors: The monthly average closing value of SENSEX was taken as the dependent variable and Net FII Investment, Inflation Rate, GDP Growth Rate, Exchange Rate, Lending Rate (BPLR) were taken as the independent variables and a regression analysis was run on it. The model is clearly significant and explains 60.44% of the movement of the BSE SENSEX Index due to above independent variables.

Final Regression Equation would be: SENSEX = (0.13633 Net FII Investment) + (483.38020 Inflation Rate) (591.77365 Exchange Rate) + 32920

4.1.2. BSE AUTO with FIIs and Macro Economic Factors: The monthly average closing value of BSE AUTO was taken as the dependent variable and Net FII Investment, Inflation Rate, GDP Growth Rate, Exchange Rate, Lending Rate (BPLR) were taken as the independent variables and a regression analysis was run on it.
15

The model is clearly significant and explains 57.19% of the movement of the BSE AUTO Index. Final Regression Equation is: BSE AUTO = (0.07759 Net FII Investment) + (321.1961 Inflation Rate) (143.61065 Exchange Rate) - (897.71247 GDP Growth Rate)

4.1.3. BSE BANKEX with FIIs and Macro Economic Factors: The monthly average closing value of BSE BANKEX was taken as the dependent variable and Net FII Investment, Inflation Rate, GDP Growth Rate, Exchange Rate, Lending Rate (BPLR) were taken as the independent variables and a regression analysis was run on it.

16

The model is clearly significant and explains 50.72% of the movement of the BSE BANKEX Index. Final Regression Equation is: BSE BANKEX = (0.12402 Net FII Investment) + (390.11250 Inflation Rate) (294.94732 Exchange Rate)

4.1.4. BSE FMCG with FIIs and Macro Economic Factors: The monthly average closing value of BSE FMCG was taken as the dependent variable and Net FII

Investment, Inflation Rate, GDP Growth Rate, Exchange Rate, Lending Rate (BPLR) were taken as the independent variables and a regression analysis was run on it.

17

Although the model is significant but is able to explain only 47.13% of the movement of BSE FMCG. Thus we wont consider it as a satisfactory model.

4.1.5. BSE IT with FIIs and Macro Economic Factors: The monthly average closing value of BSE IT was taken as the dependent variable and Net FII Investment, Inflation Rate, GDP Growth Rate, Exchange Rate, Lending Rate (BPLR) were taken as the independent variables and a regression analysis was run on it.

18

The model is clearly significant and explains 55.22% of the movement of the BSE IT Index. Final Regression Equation is: BSE IT = (0.033 Net FII Investment) + (142.281 Inflation Rate) (111.461 Exchange Rate) (744.705 GDP Growth Rate) + (625.763 Lending Rate)

4.1.6. BSE METAL with FIIs and Macro Economic Factors: The monthly average closing value of BSE METAL was taken as the dependent variable and Net FII

Investment, Inflation Rate, GDP Growth Rate, Exchange Rate, Lending Rate (BPLR) were taken as the independent variables and a regression analysis was run on it.

19

The model is significant and explains 63.2% of the movement of the BSE METAL index. Final Regression Equation is: BSE METAL = (0.12 Net FII Investment) + (892.232 Inflation Rate) - (998.062 Exchange Rate) + 57208.759

4.1.7. BSE OIL & GAS with FIIs and Macro Economic Factors: The monthly average closing value of BSE OIL & GAS was taken as the dependent variable and Net FII Investment, Inflation Rate, GDP Growth Rate, Exchange Rate, Lending Rate (BPLR) were taken as the independent variables and a regression analysis was run on it.

20

The model is significant and explains 58.3% of the movement of the BSE OIL & GAS index. Final Regression Equation is: BSE OIL & GAS = (0.066 Net FII Investment) + (368.386 Inflation Rate) - (379.978 Exchange Rate) + (941.238 GDP Growth Rate) + 18759.532

4.1.8. BSE POWER with FIIs and Macro Economic Factors: The monthly average closing value of BSE POWER was taken as the dependent variable and Net FII

Investment, Inflation Rate, GDP Growth Rate, Exchange Rate, Lending Rate (BPLR) were taken as the independent variables and a regression analysis was run on it.

21

The model is significant and explains 54.1% of the movement of the BSE POWER index. Final Regression Equation is: BSE POWER = (0.024 Net FII Investment) + (92.186 Inflation Rate) (153.503 Exchange Rate) + (271.511 GDP Growth Rate) + 9213.176 4.1.9. BSE REALITY with FIIs and Macro Economic Factors: The monthly average closing value of BSE REALITY was taken as the dependent variable and Net FII Investment, Inflation Rate, GDP Growth Rate, Exchange Rate, Lending Rate (BPLR) were taken as the independent variables and a regression analysis was run on it.

22

The model is significant and explains 63.1% of the movement of the BSE REALITY index. Final Regression Equation is: BSE REALITY = 29638.513 - (541.961 Exchange Rate)

Findings
Except for FMCG sector, movement of all the sectors can be explained to a great extent by the factors considered in the project. A table representing various sectors, the overall extent of impact explained by the factors considered and the individual factors impacting each sector is represented by the table below: Index Sensex Auto Banks FMCG IT Metal Oil & Gas Power Reality FII Inflation Exchange GDP BPLR Explanation 57.6% 57.2% 50.7% 47.1% 55.2% 63.2% 58.3% 54.1% 63.1%

Various sector based indexes and their regression equations are listed below:
23

Index Sensex Auto Banks FMCG IT

Equation (0.136 Net FII Investment) + (483.380 Inflation Rate) (591.77 Exchange Rate) + 32920 (0.078 Net FII Investment) + (321.196 Inflation Rate) (143.611 Exchange Rate) - (897.712 GDP Growth Rate) (0.124 Net FII Investment) + (390.113 Inflation Rate) - (294.947 Exchange Rate) Model is not significant (0.033 Net FII Investment) + (142.281 Inflation Rate) - (111.461 Exchange Rate) (744.705 GDP Growth Rate) + (625.763 Lending Rate) (0.12 Net FII Investment) + (892.232 Inflation Rate) - (998.062 Exchange Rate) + 57208.759 (0.066 Net FII Investment) + (368.386 Inflation Rate) - (379.978 Exchange Rate) + (941.238 GDP Growth Rate) + 18759.532 (0.024 Net FII Investment) + (92.186 Inflation Rate) (153.503 Exchange Rate) + (271.511 GDP Growth Rate) + 9213.176 29638.513 - (541.961 Exchange Rate)

Metal Oil & Gas Power Reality

One of the sectors that are highly impacted by the investment of FIIs and macro economic factors, and which we shall further take up for study are: Automobile Sector Metal Sector

5. Analysis of Automobile Sector: The auto companies analyzed are:

Ashok Leyland Bajaj Auto Hero Honda Maruti Suzuki Tata Motors

Regression Analysis: As per Regression analysis run taking stock prices of different companies as the dependent factor and FII holding in each company, WPI of the specific sector, Interest Rate and Exchange Rate as the independent variables following outputs were found: Ashok Leyland:

24

Bajaj Auto:

25

Hero Honda:

Maruti Suzuki:

26

Tata Motors:

Analysis: The Regression analysis of various companies with the selected factors indicates following result: Company Ashok Leyland Bajaj Auto Hero Honda Maruti Suzuki Tata Motors FII Risk Low High High Medium Low Inflation Risk Medium Low High Medium Medium Exchange Risk Medium High Low Medium Medium Lending Rate Risk High Medium Low Low High

Findings
If we look at the actual risk being faced by these companies; the regression analysis provides following result: Company Ashok Leyland Bajaj Auto FII Risk Inflation Risk Exchange Risk BPLR Risk

27

Hero Honda Maruti Suzuki Tata Motors

Ashok Leyland is the only company which is not affected by FII movements. Increase or decrease in lending rates affects Maruti Suzuki and Ashok Leyland only. Baja Auto and Maruti Suzuki are immune to inflation. Tata Motors and Hero Honda are affected by changes in exchange rates.

6.1 Conclusion
An informed investor would know that in a relatively stable economy changes in macro economic factors would be small and predictable in advance. But the investment/disinvestment by FIIs is not readily predictable. Thus I would predict following investment strategies for any such investor: During Bull Phase: Generally the investment by FIIs tends to be on a continuous rise during this phase. Also the inflation rate tends to be relatively on the higher side. Thus a risk appetite investor should look for those companies for which FII risk and Interest Rate risk are high. If an investor feels that there is over liquidity in the market then the government might look to raise the interest rates to tap extra money from the market. This will cause the interest rate risk to go up and also the value of currency to appreciate. Thus Exchange Rate risk is also bound to increase. An investor depending upon its appetite for risk should invest accordingly.

During Bear Phase: FIIs tend to exit during this phase from the market. Also the inflation rate tends to go down. A risk averse investor should look to invest in companies having high inflation rate risk. If there is not enough liquidity in the market, banks tend to drop interest rate during this period. Also the currency would depreciate as a result of this. Thus an investor should take an informed decision according to its appetite for risk.

During Stagnation Phase: This is rather a difficult phase to design an investment strategy for. I would suggest that an investor should rather stay away from companies that have high risk due FIIs and Exchange Rate as these two are more difficult to predict and are more governed by global factors than local factors. The best strategy would be to hedge the investments by choosing one company having high risk in each class and distribute the investments evenly among them.
28