A Study of FII Investment Flow and SENSEX Movement

Dr. Rahul Singh

Assistant Professor Birla Institute of Management Technology, Greater Noida, India rahul.singh@bimtech.ac.in (Contact Author and copyright)

Sumit Agrawal
Project Coordinator TFS Business Advisors India Pvt. Ltd., New Delhi

Nitin Sehgal
Management Trainee Reliance Life Insurance Limited, Mumbai.

Abstract
Indian stock market has seen an unprecedented growth in the last few years. Since year 2002, Indian market has grown from a much volatile conditions to growth phenomena, from a SENSEX point of 5500 in December 2003 to 13,600 in December 2006. this has been due to not only the domestic market but also the international investors. Since January 2004 which reached to close to 6000, SENSEX has seen many new heights for the period of study (year 2007) and touched close to 19800 in December 2007. There have been doubts raised on the fundamental strengths of the economy for such height of the SENSEX. There are many other variables which contribute to the positive growth of the stock market. FIIs investment is considered to be one of the biggest push after the economic fundamentals. The liberalisation of the FII flows into the Indian Capital Market since 1993 has had a considerable impact on Indian stock market. This paper is exploring the FIIs investment behaviour and its relationship with (if there is any) SENSEX movement.

Keywords: Foreign Institutional Investor (FII), SENSEX, Volatility

Introduction
The financial market has experienced tremendous growth in terms of primary issues and trades on secondary market. The liberalization policies initiated in India in

the early 1990s brought about radical changes in the conduct of stock market. Rising globalization, deregulation, and foreign portfolio investments made the Indian stock exchanges competitive and efficient in its functioning. The economic benefit from the
developed financial markets comes out as catalyst by a) augmenting the real saving and formation of capital from any given level of national income, b) Increasing the net capital inflow from abroad, c) raising the productivity of investment by improving allocation of funds, and d) reducing the cost of capital.

With the rise of equity culture across the globe, India which has a long history of stock exchanges, has witnessed a perceptible shift in the proportion of investors participation in equity markets. The role of investors is the key to success of market guided economic systems and since it is they who pump their savings into the markets, their investments need to be channelized to the most rewarding sectors of the economy. India opened its stock market to foreign investors in September 1992 and has received portfolio investment from foreigners in the form of foreign institutional investment in equities and other markets including derivatives. It has emerged as one of the most influential groups to play a critical role in the overall performance of the stock market. The liberalization of FII flows into the Indian capital market since 1993 has had a considerable impact on market practices. Many of the moves to modernize the equity markets in the past decade may be attributed to pressure or behavioural changes from foreign investors such as SEBIs amendment in 2006 about reducing the Validity Period of Registration Certificate from 5 years to 3 years and increase in the registration and renewal fees. And also some of the changes in the earlier stages such as FII investment in the Indian market only took off after paperless trading was introduced in the late 1990s. Earlier, most funds were scared to punt in the market because of fake shares and transfer. To make the process of share transfer and delivery easier and quicker, the regulator, SEBI introduced dematerialization of shares where the shareholders were compulsorily asked to trade shares in the demat form.

Last few years have been significant in terms of portfolio flow and thus playing a key role in the development of the Indian capital market. The number of Foreign Institutional Investors registered with the SEBI has also gone up to 1157 at the end of November 2007. The FIIs net investments increased from Rs. 9,584.20 Crore by March 2001 to Rs. 247,015.60 Crore by August 2007. Grand total of FII investments in equity till January, 2004 was Rs. 89,601 Crore. As a consequence of the swelled optimism of FIIs in the Indian Economy, the SENSEX breached 15,318 marks and jumped further by 4,364 points on November 15, 2007. There are possibilities of direct and indirect impacts on the stock market due to strong movements of the FIIs. One, they have potential to influence the policy making as the inflow or outflow are significant sometimes, which has capacity to direct volatility sometimes. Two, the increased capital gains which when translated into consumption and further investment, have a probabilistic model between the investment and physical markets. Total Market Capitalization reached to Rs. 5,202,955 Crore from Rs. 1,206,854 Crore in January 2004. The investors wealth also grew nearly four times and the average trading turnover grew nearly 1.5 times. Few particular days in May 2006 have been in strong reverse direction which caused the FIIs interest getting down by close to $1.2 billion (FIIs contribution to the market happened to be 18,472 Crore in April and 11,122 Crore in May 20061). Table 1 provides a cross section of data on the FIIs inflow and stock market movement, not necessarily at cause and effect relationship however this is not been tested by us anyway. The FIIs and hedge funds had pulled out money mainly due to higher interest rates in U.S. after Federal Reserve increased interest rates to 4.5% under their new governor. Similar changes and took place many times in the history since opening and few times in the study.
Table 1: FIIs inflow and SENSEX movement in year 2006
Date 31-Jan 28-Feb 31-Mar 30-Apr 31-May 30-Jun 31-Jul 21-Aug
1

FIIs Inflow in Crores 3677.8 11265.5 17654.1 18476.2 11122.1 11601.8 12746.7 16524.1

SENSEX 9919.89 10370.24 11279.96 12042.56 10398.64 10609.25 10743.88 11511.68

SEBI Bulletin, November 2006. Data used at other places at this page have reference from SEBI bulletin and CMIE database.

Source: SEBI Bulletin

Additional indicators and data reflect that movements in the SENSEX during the two years have clearly been driven by the behaviour of foreign institutional investors (FIIs), who were responsible for net equity purchases of as much as $6.6 and $8.5 billion respectively in 2003 and 2004. An analysis estimated that at the end of June 2004, FIIs controlled on average 21.6 per cent of shares in SENSEX companies 2. As it appears from the data given in Table 2, there are many companies for changing positions which given the limited floating shares in the market in the short period is a significant change. Table 2: Frequency Distribution of FII Holdings in SENSEX Companies
Holding Size March 2004 < 10 per cent 3 10-20 per cent 13 20-30 per cent 9 30-40 per cent 1 > 40 per cent 4 Source: SEBI Bulleting June 2004 5 12 8 2 3 September 2004 2 14 9 2 3

Theoretical Framework
FII inflow depends on stock market returns, inflation rates (both domestic and foreign), and ex-ante risk. In terms of magnitude, the impact of stock market returns and the ex-ante risk turned out to be the major determinants of FII inflow (Agarwal, 1997). An investment will always carry the consideration of risk factor in its risk-return behaviour. Therefore it is important and necessary to chart the complete profile of FIIs including risk variables. If realized risk is decomposed into ex-ante and unexpected risk. Ex ante risk is an observed component and is negatively related to FII, but the relationship between unexpected risk and FII is obscure; therefore one needs to separate the unobserved component from the realized risk while examining the impact of risk on FII (Trivedi & Nair, 2003). In an investment friendly environment the bullish behaviour dominates the trends and at a given huge volume of investments, foreign investors may play a role of market makers and book their profits, i.e., they can buy financial assets when the prices are declining thereby jacking-up the asset prices and sell when the asset prices are increasing (Gordon & Gupta, 2003). Hence, there is a possibility of bi-directional relationship between FII and the equity returns.

Chandrasekhar, C. P. and Jayati Ghosh, The FII Fest in India's Stock Markets, extracted on 20th April 2008 from http://www.macroscan.org/the/trade/feb05/trd040205Stock_Markets.htm

Following the Asian crisis and the bust of info-tech bubble internationally in 1998-99 the net FII has declined by US$ 61 million. But there was not much effect on the equity returns. This negative investment would possibly disturb the long-term relationship between FII and the other variables like equity returns, inflation, etc. Chakrabarti (2001) has marked a regime shift in the determinants of FII after Asian crisis. The study found that in the pre-Asian crisis period any change in FII found to have a positive impact on the equity returns. But in the post-Asian crisis period it was found the reverse relation that change in FII is mainly due to change in equity returns. Hence, any empirical exercise on FII has to take care of this fact. The paper is an attempt to measure the linear association with the help of Spearmans coefficient of correlation3 in different samples collected from the historical data of Net FII flows and BSE sensitivity Index.

Data and Methodology

The present study is based on the secondary data. The data for the net flows of Foreign Institutional Investors (FIIs) and Sensitivity Index closing points is collected from http://www.5paisa.com and http://in.finance.yahoo.com for the duration of 4 years between January, 2004 and December, 2007 excluding 6 days data set which was not available. A set of 24 samples out of 48 monthly observations from the above mentioned range of historical data were collected to study the distribution of correlation. MINITAB and MS Excel has been used for plotting of graphs and analysis of data and SEBI and Centre for Monitoring Indian Economy (CMIE) Prowess Database has been used for collection of data otherwise. The correlation values for samples are calculated through and tests for normality are performed. The test for normality included JarqueBera Test, Kolmogorov-Smirnov Test and Anderson-Darling Normality Test. Graphical display using Normal probability plots has also been presented for an easy understanding.

Spearmans Coefficient of correlation for the sample is calculated by

( Where x and y are the data variables and n denotes the no. of data sets.

Jarque-Bera Test has an asymptotic chi-square distribution with two degrees of freedom and can be used to test the null hypothesis that the data are from a normal distribution. The null hypothesis is a joint hypothesis of both the skewness4 and excess kurtosis5 being 0, since samples from a normal distribution have an expected skewness of 0 and an expected excess kurtosis of 0. As the definition of JB shows, any deviation from this increases the JB statistic.

Kolmogorov-Smirnov Test (often called the KS test) is a goodness of fit test used to determine whether two underlying one-dimensional probability distributions differ, or whether an underlying probability distribution differs from a hypothesized distribution, in either case based on finite samples. The one-sample KS test compares the empirical distribution function with the cumulative distribution function specified by the null hypothesis. The main applications are testing goodness of fit with the normal and uniform distributions.

Result and Analysis

Another important measure of FIIs impact on SENSEX is the movement and comparison between volatility and return on SENSEX. The movement of returns and volatility suggests an inverse relationship. It can be observed that movement of the returns on SENSEX and volatility is not only cyclical but it is notable that the peak of the former coincides with the
4

Skewness is an asymmetrical property of frequency distribution in which the values are concentrated on one side of the central tendency and trail out on the other side. Defined as:

where is the third central moment, respectively, the variance.

5

is the sample mean, and

is the second central moment,

Kurtosis characterizes the relative peakedness or flatness of a distribution. Positive kurtosis indicates a relatively peaked distribution. Negative kurtosis indicates a relatively flat distribution. Defined as:

where is the fourth central moment, respectively, the variance.

is the sample mean, and

is the second central moment,

trough of the latter and vice-versa. The 48 months data on net FII inflows and volatility shows negative correlation. Despite being significant it suggests a higher net FII inflow would lessen the volatility in the SENSEX. With respect to net FII inflows and Returns on SENSEX, the time series data for 44 months shows a positive and significant correlation and same has been depicted by the Graph shown below. Graph 1: Net FII Flows and BSE Sensitive Index
22000 20000 18000 16000 14000 12000 10000 8000 -5,000.00 6000 4000 2000
Jan-05 Jan-06 Jan-04 Jan-07 Jul-06 Oct-04 Apr-05 Oct-05 Oct-06 Jul-07 Jul-04 Jul-05 Oct-07 Apr-04 Apr-06 Apr-07

55,000.00 45,000.00 35,000.00 25,000.00 15,000.00 5,000.00 Net FII Sensex

-15,000.00 -25,000.00 -35,000.00

Graph 2: Correlation for Different Samples

Correlation

0.700000 0.600000 0.500000 0.400000 0.300000 0.200000 0.100000 0.000000 -0.100000 -0.200000 -0.300000

Minimum 1st Quartile Median 3rd Quartile Maximum

-0.29806 -0.01562 +0.20528 +0.35384 +0.68640

Confidence Intervals [0.06710 0.28059] @ 95% for Mean [0.02317 0.31940]@95% for Median [0.19648 0.35461] @ 95% for StDev

Graph 3: Normal Probability Plot and Anderson - Darling Test

A-Squared P-Value Mean StDev Variance Skewness Excess Kurtosis

0.16 0.933 (>0.05) 0.17384 0.25279 0.06391 0.061510 -0.522605

Jarque Bera test Jarque-Bera test is a goodness-of-fit measure of departure from normality, based on the sample kurtosis and skewness. The test statistic JB is defined as

Where n is the number of observations (or degrees of freedom in general); S is the sample skewness, K is the sample kurtosis. Skewness : 0.061509922

Excess Kurtosis : -0.522605146 Jarque Beta : P- Value : 0.26423 0.87624 ( > 0.05) Insignificant

K-S Test The empirical distribution function Fn for n independent and identically distributed observations Xi is defined as

Where

is the indicator function.

The Kolmogorov-Smirnov statistic for a given function F(x) is

Under null hypothesis that the sample comes from the hypothesized distribution F(x),

in distribution, where B(t) is the Brownian bridge. If F is continuous then converges to the Kolmogorov distribution which does not

depend on F. This result may also be known as the Kolmogorov theorem, see Kolmogorov's theorem for disambiguation. The goodness-of-fit test or the Kolmogorov-Smirnov test is constructed by using the critical values of the Kolmogorov distribution. The null hypothesis is rejected at level if Where K is found from , The asymptotic power of this test is 1.

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Conclusion
Sampling distribution of correlation obtained shows a range of -0.2980 to a maximum of 0.68640 with 25% values lying at -0.01562, 50% of the values lying at 0.2058 and 75% of the values lying at 0.3538. Further analysis of correlation shows that 95% of the times mean value lies between 0.06710 to 0.28059, median value lies in the range of 0.02317 to 0.31940. While testing for normality in correlation it was found that JB test with p value 0.876 (> 0.05) and KS test with p value greater than 0.150. Skewness and kurtosis obtained from the correlation distribution is 0.061510 & 2.477395, which shows that the curve is plutocratic. Though it is a popular belief that FII and SENSEX are positively correlated, our analysis also shows that there have been many instances for a negative correlation between the net FII and SENSEX.

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References

Aggrawal, Reena, L. Klapper and P. Wysocki (2005), Portfolio Preferences of Foreign Institutional Investors, Journal of Banking and Finance, Elsevier, vol. 29(12), pp 2919-2946.

Gordon, James and Poonam Gupta (2003), Portfolio Flows into India: Do Domestic Fundamentals Matter, June, IMF Working Paper No. 03/20. Mohan, T. T. Ram (2005), Taking Stock of Foreign Institutional Investors, Economic and Political Weekly, Vol. 40, No. 24. Pal, Parthapratim, (1998), Foreign Portfolio Investment in Indian Equity Markets: Has the Economy Benefited, Economic and Political Weekly, Vol. 33, No.11. Chakrabarti, R (2001), FII Flows to India: Nature and Causes, Money and Finance, Oct-Dec, Vol.2, Issue 7. Agarwal, R. N. (1997), Foreign Portfolio Investment in Some Developing Countries: A study of Determinants and Macroeconomic Impact, Indian Economic Review, Vol. XXXII, No. 2, pp.217-229.

Samal, C. Kishore (1997), Emerging Equity Market in India: Role of Foreign Institutional Investors, Economic and Political Weekly, Vol. 32, No. 42. Trivedi, Pushpa and N. Abhilash, (2003), Determinants of FII Investment Inflow to India, paper presented in 5th Annual conference on Money & Finance in The Indian Economy, Indira Gandhi Institute of Development Research, unpublished work.

Kumar Saji (2006), FIIs Vs. SENSEX: An Emerging Paradigm, Treasury Management, ICFAI University Press, February. Singh, Rahul and P N Mishra (2005), Information and Stock Market Volatility: A Study of SENSEX, Journal of Insurance and Risk Management, Vol. III, Issue 06, pp 105.

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