A CRITICAL EVALIATION OF FOREIGN INSTITUTIONAL INVESTMENT

IN THE INDIAN STOCK MARKET AND ITS IMPACT ON VOLATITLITY

OF MARKET INDEX

PROJECT REPORT

Prepared and submitted in partial fulfilment of the requirements

For the award of the degree of

Master of Business Administration

Submitted by

SAJEEV.C.M.
(Enrolment No.091378767)

Under the Guidance of

Smt.K.S.SUJATHA

INDIRA GNADHI NATIONAL OPEN UNIVERSITY

MAIDAN GARHI, NEWDELHI-110068

JUNE - 2011

CERTIFICATE OF ORIGINALITY

This is to certify that the project titled A CRITICAL EVALIATION OF

FOREIGN INSTITUTIONAL INVESTMENT IN THE INDIAN STOCK MARKET
AND ITS IMPACT ON VOLATITLITY OF MARKET INDEX is an original work
of the Student and is being submitted in partial fulfilment for the award of the
Masters Degree in Business Administration of Indira Gandhi National Open
University. This report has not been submitted earliest either to this University or to
any other University/Institution for the fulfilment of the requirements of a course of
study.

SMT.K.S.SUJATHA

SAJEEV.C.M.

(091378767)
Project Guide

Chovvarakkaran House,
Chittilappilly.P.O.,
Puranattukara Road,
Vyasapeedam,
District,
Kerala - 680551

Thrissur

ACKNOWLEDGEMENT

A study of this involves a lot of people whose guidance, help and knowledge cannot
be left unnoticed or unexpressed.

With great respect, I place on record my heartfelt gratitude and thanks to this
remarkable personality Associate Professor. K.M.SUJATHA, Assistant Co-Ordinator,
Indira Gandhi National Open University, Thrissur Centre for her invaluable and
wholehearted support in completing this project work. I am grateful to Dr. K.Ravi,
Co-ordinator, IGNOU study centre, Thrissur, and all staff members for their
wholehearted support rendered to me throughout the course of study.

I express my sincere gratitude to Mr.S.Sarath Chandran, Finance Manager and other

Executives of The Kerala State Financial Enterprises Ltd., for all help and guidance
extended to me during the work.

Lastly, but definitely not the least, I would like to thank my family and friends for
their constant encouragement and graceful blessings showered upon me.

Thrissur

CONTENTS
I. List of Tables
II. List of Graphs

Chapter

Title

1.

INTRODUCTION

2.

LITERATURE REVIEW

3.

RESEARCH METHODOLOGY

4.

INDUSTRY PROFILE

5.

DATA ANALYSIS

6.

FINDINGS AND CONCLUSION

BIBLIOGRAPHY
ANNEXURE

LIST OF TABLES

Table
No.

Name of The Table

Page No.

LIST OF GRAPHS

Chart No.

Name of the Graph

Page No.

1. INTRODUCTION
Until the 1980s, there was a general reluctance towards foreign investment or private
commercial flows as Indias development strategy was focused on self-reliance and
import substitution and current account deficits were financed largely through debt flows
and official development assistance. A major development in our country, post 1991 has
been liberalization of the financial sector, especially that of capital markets. After the
launch of the reforms, foreign institutional investors (FIIs) from September 14, 1992,
with suitable restrictions, were permitted to invest in all securities traded on the primary
and secondary markets, including shares, debentures and warrants issued by companies
which were listed or were to be listed on the Stock Exchanges in India and in schemes
floated by domestic mutual funds. A positive contribution of the FIIs has been their role in
improving the stock market infrastructure and the SEBI assured its contribution towards
its development.

Hence, in this age of transnational capitalism, a significant amount of capital is flowing

from developed world to emerging economies. Positive fundamentals combined with fast
growing markets have made India an attractive destination for foreign institutional
investors (FIIs). Although the Foreign institutional investors (FIIs), whose investments
are often called 'hot money' because they can be pulled out at anytime, have been blamed
for large and concerted withdrawals of capital from the country at the time of recent
financial crisis, they have emerged as important players in the Indian capital market.
With over 20 million shareholders, India has the third largest investor base in the world
after the USA and Japan. Over 9,000 companies are listed on the stock exchanges, which
are serviced by approximately 7,500 stockbrokers. The Indian capital market is significant
in terms of the degree of development, volume of trading and its tremendous growth
potential, as stated by (Mehra Saniya 2007).
So basically, one can compute the correlation coefficient between the BSE Sensex and FII
flows. I found it to be a strong correlation between BSE SENSEX and FII activity in
Indian Capital Markets. This strong positive correlation always grabs the headlines. It is
because of the volatile nature of investor s sentiments that FIIs are tracked so closely. It

would not be prudent to drive away foreign investors from investing in our country. I had
mentioned the importance of foreign capital in the context of a developing economy and
that is precisely why the government has been so keen on liberalizing the external
financial sector since 1991. If one foreign investor has had a good experience investing in
our country, it builds up our reputation in the international community and encourages
more foreign investors to invest in our economy. However, a crisis of any kind will create
panic among foreign investors as well, and regaining their trust and confidence in our
economy will entail another mammoth task !
In India, FII has a positive impact on the stock market, corporate transparency and
governance norms. Equity Research, in particular, has significantly benefitted and
compelled investment banks to invest in a previously neglected resource. FII is a short
term flow and though it may appear as a regular flow, it has to be segregated from FDI
and constantly monitored.
We know that our country needs more than $150 billion over the next ten years. FII
inflows lower the cost of capital and benefit the economy as a whole. We have seen the
benefit of this to Indian Companies as they raise money cheaply to finance their capital
expenditure programmes. Besides FII inflows, raising the level of transparency/
disclosure and improved corporate governance standards in the system. In the end what
really matters is that capital is made available to the businesses and that purpose is served
equally by FII capital.

1.1 STOCK EXCHANGE

A STOCK EXCHANGE is a platform where buyers and sellers of securities issued
by governments, finance institutions, corporate houses etc., meet and where trading of
these corporate securities take place. This is a market of speculation. If speculation of
investors become wrong than the investors loss. Nobody knows what will happen
even after a second.
A Stock Exchange refers to the segments of the capital market where the securities
issued by corporate are trade. It is open auction market where buyers and sellers meet
and involve competitive prices of the securities. It reflects hopes aspiration fair of
people regarding the performance of the economy. I t provides necessary mobility to
capital and direct flow of the capital into possible and successful enterprise.
Since buying and selling of the different of securities take place ion stock exchange.
The prices of particularly securities reflect their demand and supply. In fact, stock
exchange is said to be a barometer of economy and financial health.
The stock exchange is the nerve center of capital market. The stock exchange
9

discharges three essential functions in the process of capital formation not in raising
resources for the corporate sector.
It provides places for sale and purchase of securities i.e. share, bonds etc. . . .
It [provides linkage between the saving of household sector and investment in
corporate sector of economy.
It provides market quotation for shares debenture and bonds and serves as a role of
barometer, not only of the state of health of individual companies but also of the
economy as a whole.
Therefore, by providing market place quotation of the prices of shares and bonds or
sort of collective judgment. Simultaneously reached

by many buyers and sellers in

the market stock exchange serve the role of barometer, not only of the state of health
of individual companies but also of the nations economy as a whole.

1.2 FEATURES OF STOCK EXCHANGE

It is the place where listed securities are bought and sold.

It is an association of persons known as members.

Trading in securities is allowed under rules and regulations of stock exchange.

Membership is must for transacting business.

Investors and speculators, who want to buy and sell securities, can do so
through members of stock exchange i.e. brokers

10

1.3 OPERATIONAL DEFINITIONS

STOCK MARKET:A STOCK EXCHANGE is a platform where buyers and sellers of securities issued by
governments, finance institutions, corporate houses etc., meet and where trading of
these corporate securities take place.
MUTUAL FUNDS: - A Mutual fund is a trust that pools the saving of a number of
investors who share a common financial goal.
FOREIGN DIRECT MARKET (FDI): - This category 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.
FOREIGN INSTITUTIONAL INVESTOR (FII):- An investor or investment fund that
is from of or registered in a country outside of the one in which it is currently
investing. Foreign institutional investors have made a sizable investment in Indian
financial markets. There are currently about 1324 FIIs registered in India.
FOREIGN PORTFOLIO INVESTMENT (FPI):- FPI is a category of investment
instruments that are more easily traded, may be less permanent, and do not represent a
controlling stake in an enterprise. These include investments via equity instruments
(stocks) or debt (bonds) of a foreign enterprise that does not necessarily represent a
long-term interest.
BULL MARKET: - A Bull market is a market that is consistently going up. It is a
market where there is optimism of further rise batter, business results and other
positive factors. Bull Market can sometimes continue for years, for investors this is
the preferred market trend. However no bull market can continue for very long.
11

BEAR MARKET: - Bear Market is a market that is showing a persistent downtrend. A

15-20% downward movement of the market generally termed as a bear market.
DIVERSIFICATION: - diversification is the technique of investing in unrelated
business sectors simultaneous so that risk that affects a particular sector does not
affect your overall investment. For example your portfolio of share includes sectors
like Information Technology, Real estate capital Goods, Autos etc.
Exchange rate of a nation's currency- Currency like other commodities rises or falls in
"price" with demand. When investors leave, they sell their holdings in a country's
currency and as demand falls, the "price" of that currency will also fall
ECONOMIES OF SCALE: - Produces are often able to enjoy considerable
production cost savings by buying inputs in bulk, mass-producing or retailing their
end product. These lower costs achieved through expanded production are called
Economies of Scale.
DEBT/EQUITY RATIO-The debt/equity ratio measures the extent to which a firm's
capital is provided by lenders (through debt instruments such as fixed-return bonds) or
owners (through variable-return stocks). A greater reliance on financing through debt
can mean greater profitability for shareholders, but also greater risk in the event things
go sour.
INTERNATIONAL MONETARY FUND-The IMF is an international organization of
186 member countries, established in 1947 to promote international monetary
cooperation, exchange stability, and orderly exchange arrangements; to foster
economic growth and high levels of employment; and to provide temporary financial
assistance to countries to help ease balance of payments adjustment.
INSTITUTIONAL INVESTOR An organization whose primary purpose is to invest
its own assets or those held in trust by it for others. Includes pension funds,
investment companies, insurance companies, universities and banks.
12

INTEREST RATES-Interest rates have a powerful effect on the volume of a nation's

money supply. By raising interest rates, i.e., making the cost of borrowing money
more expensive, governments or banks can decrease the money supply. A decrease in
the money supply tends to be counter-inflationary, which makes a currency more
valuable compared to other currencies.
MOST FAVORED NATION TREATMENT-The phrase "most favored nation" refers
to the obligation of the country receiving the investment to give that investment the
same treatment as it gives to investments from its "most favored" trading partner.
BALANCE OF PAYMENT-The Balance of Payments (BOP) is a statistical statement
that summarizes, for a specific period (typically a year or quarter), the economic
transactions of an economy with the rest of the world. It covers:
All the goods, services, factor income and current transfers an economy receives from
or provides to the rest of the world
Capital transfers and changes in an economy's external financial claims and liabilities
PORTFOLIO INVESTMENT covers the acquisition and disposal of equity and debt
securities that cannot be classified under direct investment or reserve asset
transactions. These securities are tradable in organized financial markets.
FDI FLOWS AND STOCKS Through direct investment flows the investors builds
up a direct investment stock (position), making part of the investors balance sheet.
The FDI stock (position) normally differs from accumulated flows because of
revaluation (changes in prices or exchange rates) and other adjustments like
rescheduling or cancellation of loans, debt forgiveness or debt-equity swaps with
different values.
MULTINATIONAL COMPANIES (MNCs) are incorporated or unincorporated
enterprises comprising parent enterprises and their foreign affiliates.
FOREIGN DIRECT INVESTOR A foreign direct investor is an individual, an
incorporated or unincorporated public or private enterprise, a government, a group of
13

related individuals, or a group of related incorporated and/or unincorporated

enterprises which have a direct investment enterprise that is a subsidiary, associate or
branch operating in a country other than the country or countries of residence of the
direct investor or investors.
HOST ECONOMY is the country that receives FDI or FPI from the foreign
investor(s).
HOME ECONOMY is the country of origin/residence of the company that invests
in the foreign economy/host economy.
SUBSIDIARY is an incorporated enterprise in the host country in which the foreign
investor owns more than 50 per cent of the shareholders voting power or has the right
to appoint or remove a majority of the members of this enterprises administrative,
management or supervisory body.
EQUITY CAPITAL comprises of equity in branches and ordinary shares in
subsidiaries and associates.
Reinvested earnings consist of the direct investors share of earnings not distributed
as dividends by subsidiaries or associates and earnings of branches not remitted to the
direct investor.
OTHER CAPITAL covers inter-company debt (including short-term loans such as
trade credits) between direct investors and subsidiaries, branches and associates.

14

2. LITERATURE REVIEW
Bruce A. Blonigen
This paper surveys the recent burgeoning literature that empirically examines the
foreign direct investment (FDI) decisions of multinational enterprises (MNEs) and the
resulting aggregate location of FDI across the world. The contribution of the paper is
to evaluate what we can say with relative confidence about FDI as a profession, given
the evidence, and what we cannot have much confidence in at this point. Suggestions
are made for future research directions.
Hugo Rojas-Romagosa
Foreign Direct Investment (FDI) flows have increased substantially in the past two
decades. These developments have motivated the appearance of a large number of
empirical papers that test the expected benefits that FDI inflows are assumed to bring
to the host countries. We survey the recent theoretical and empirical literature, but
restrict our attention to the productivity changes that are induced by increased FDI
inflows. We review both the aggregate productivity effects, as well as the spillover
effects of FDI on local firms.
Giorgio De Saints

15

This paper study the dynamics of expected stock return and volatility in emerging
financial market. We find clustering predict ability and persistence in conditional
volatility and others have documented for mature market. However, emerging market
exhibit higher volatility and conditional probability of large price changes then mature
market exposure to high country specific risk does not appear to be rewarded with
higher expected return. We deduct a risk reward relation in Latin America but not in
Asia.

Karimullah:
The article examines the impact of foreign institutional investor s FII equity
investment behavior in the Indian stock market. It attempts to find out the two-way
causality between foreign institutional investors (FIIs) behavior and performance of
Indian stock market for the period of January 1997 to June 2007.this article seeks to
examine the idea that financial liberalization induces increased efficiency in the
financial market as permission of FIIs equity investment is an important example of
financial liberalization. Return in the stock market is used as proxy for the efficiency
of the stock market in India .granger causality test has been applied to test the
bidirectional causality. Apart from net investment of FIIs, the purchase and sales
behavior of FIIs are analyzed separately. The results indicate that stock market
performance is a major determinant of both the FIIs purchase and sales behavior. But
we did not find strong evidence that the variations in the stock market indices are
determined by FIIs investment behavior.
Blockholder, Market efficiency and managerial myopia:
This paper shows holders can add value even if they cannot interview in a firms
operations. Blockholders have strong incentive to monitor the firms fundamental
value, since they can sell their stakes upon bad news. By trading on their private
information (following the Wall Street rule) they cause prices to reflect fundamental
value rather than current earnings. This in turn encourages managers to invest for long
16

term growth rather than short term profits. Contrary to the view that the U.S.s liquid
markets and transient shareholders exacerbate myopia, this paper shows that they can
encourage investment.
Robert Lensink and Oliver Morrissey
This paper contributes to the literature on FDI and economic growth. We deviate from
previous studies by introducing measures of the volatility of FDI Inflows. As
introduced into the model, these are predicted to have a negative effect on growth. We
estimate the standard model using cross-section, panel data and instrumental variable
techniques. Whilst all results are not entirely robust, there is a consistent finding that
FDI has a positive effect on growth whereas volatility of FDI has a negative impact.
The evidence for a positive effect of FDI is not sensitive to which other explanatory
variables are included. In particular, it is not conditional on the level of human capital
(as found in some previous studies). There is a suggestion that it is not the volatility of
FDI per se that retards growth but that such volatility captures the growth-retarding
effects of unobserved variables.

3. RESEARCH METHODOLOGY
3.1 Objectives of the Study
The objectives of the study as follows
1. To analyze whether the volatility in the Indian stock market is exclusively
dependent on the purchase and sales activities done by FIIs
2. To study whether the market is efficient that results in immediate stock price
adjustment

17

3.2 Hypothesis
H0: The volatility in the Indian stock market is not fully dependent on the FII activity
(r=0)
H1: The volatility in the Indian stock market is fully dependent on the FII activity
(r=1)

3.3 Research Design:

Research Methodology has many dimensions, it include not only research methods
but also considers the logic behind the methods used in the context of the study and
explains why only a particular method of technique had been used so that research
lend themselves to proper evaluations. Thus in a way it is a written game plan for
concluding research therefore in order to solve research problem it is necessary to
design a research methodology for the problem as the same differ from problem to
problem.
The research design is a pattern or an outline of a research project . It is a statement
only the essential of a study those provide the basic guidelines for the detail of the
project. The present study being conducted follows a descriptive research design has
the data would be responses from a simple containing g a large numbers of sources .It
is a cross section of the situation design of the descriptive studies including the nature
and the analytical method.
Data Collection
After the research problem has been defied and the research design has been chalked
out, the task of date collection begins. Data can be collected from other primary or
secondary sources.

18

The main source of obtaining necessary data for the study was Secondary Data. This
study is empirical in nature and hence secondary data is used to conduct the research.
The data was collected from the Internet by exploring the Secondary sources available
on websites. Secondary Data: The secondary data constitutes of daily FII flows data
which was collected from Money Control and Equity Master, the daily returns of
SENSEX and NIFTY from BSE and NSE websites respectively. The trends in FII
flow from the RBI website and information on FII from SEBI.
SAMPLING PLANNING

Sampling is an effective step in collection of primary and secondary data and has a
great influence on the quality of the results. The sampling plan includes population,
sample size and sample design.
DATA ANALYSIS:-

The data gathered from various sources were primarily studied and necessary data
was sorted out sequentially keeping in mind the procedure of the study. The analysis
has been made by, correlating the FII purchases, sales and net investment with equity
market returns to identify whether a relation exists between them. Findings are
included which transmits the important points, which were gathered from the study.
The data has been analyzed with the help of various graphs like bar graph etc.

3.4 LIMITATIONS OF THE STUDY

As the time available is limited and the subject is very vast.

The study is general.

19

It is mainly based on the data available in various websites &other secondary

sources

The inferences made is purely from the past years performance;

There is no particular format for the study;

Sufficient time is not available to conduct an in-depth study;

4. INDUSTRY PROFILE
20

INVESTMENT IN INDIAN MARKET

India is believed to be a good investment despite political uncertainty, bureaucratic
hassles, shortages of power and infrastructure deficiencies. India presents a vast
potential for overseas investment and is actively encouraging the entrance of foreign
players into the market. No company, of any size, aspiring to be a global player can,
for long ignore this country, which is expected to become one of the top three
emerging economies.
Success in India
Success in India will depend on the correct estimation of the country's potential;
underestimation of its complexity or overestimation of its possibilities can lead to
failure. While calculating, due consideration should be given to the factor of the
inherent difficulties and uncertainties of functioning in the Indian system. Entering
India's marketplace requires a well-designed plan backed by serious thought and
careful research. For those who take the time and look to India as an opportunity for
long-term growth, not short-term profit- the trip will be well worth the effort.
Market potential
India is the fifth largest economy in the world (ranking above France, Italy, the United
Kingdom, and Russia) and has the third largest GDP in the entire continent of Asia. It
is also the second largest among emerging nations. (These indicators are based on
purchasing power parity). India is also one of the few markets in the world, which
offers high prospects for growth and earning potential in practically all areas of
business. Despite the practically unlimited possibilities in India for overseas
businesses, the world's most populous democracy has, until fairly recently, failed to
get the kind of enthusiastic attention generated by other emerging economies such as
China.

21

Lack of enthusiasm among investors

The reason being, after independence from Britain 50 years ago, India developed a
highly protected, semi-socialist autarkic economy. Structural and bureaucratic
impediments were vigorously fostered, along with a distrust of foreign business. Even
as today the climate in India has seen a sea change, smashing barriers and actively
seeking foreign investment, many companies still see it as a difficult market. India is
rightfully quoted to be an incomparable country and is both frustrating and
challenging at the same time. Foreign investors should be prepared to take India as it
is with all of its difficulties, contradictions and challenges.

Developing a basic understanding or potential of the Indian market

Envisaging and developing a Market Entry Strategy and implementing these strategies
when actually entering the market are three basic steps to make a successful entry into
India. The Indian middle class is large and growing; wages are low; many workers are
well educated and speak English; investors are optimistic and local stocks are up;
despite political turmoil, the country presses on with economic reforms. But there is
still cause for worries- Infrastructure hassles.
The rapid economic growth of the last few years has put heavy stress on India's
infrastructure facilities. The projections of further expansion in key areas could snap
the already strained lines of transportation unless massive programs of expansion and
modernization are put in place. Problems include power demand shortfall, port traffic
capacity mismatch, poor road conditions (only half of the country's roads are
surfaced) and low telephone penetration.
Indian Bureaucracy
Although the Indian government is well aware of the need for reform and is pushing
ahead in this area, business still has to deal with an inefficient and sometimes still
slow-moving bureaucracy.
22

Diverse Market
The Indian market is widely diverse. The country has 17 official languages, 6 major
religions, and ethnic diversity as wide as all of Europe. Thus, tastes and preferences
differ greatly among sections of consumers. Therefore, it is advisable to develop a
good understanding of the Indian market and overall economy before taking the
plunge.
INTERNATIONAL PORTFOLIO FLOWS:
International portfolio flows, as opposed to foreign direct investment (FDI) flows,
refer to capital flows made by individuals or investors seeking to create an
internationally diversified portfolio rather than to acquire management control over
foreign companies. Diversifying internationally has long been known as a way to
reduce the overall portfolio risk and even earn higher returns. Investors in developed
countries can effectively enhance their portfolio performance by adding foreign stocks
particularly those from emerging market countries where stock markets have
relatively low correlations with those in developed countries.
International portfolio flows are largely determined by the performance of the stock
markets of the host countries relative to world markets. With the opening of stock
markets in various emerging economies to foreign investors, investors in industrial
countries have increasingly sought to realize the potential for portfolio diversification
that these markets present.
It is likely that for quite a few years to come, FII flows would increase with global
integration. The main question is whether capital flew in to these countries primarily
as a result of changes in global (largely US) factors or in response to events and
indicators in the recipient countries like its credit rating and domestic stock market
23

return. The answer is mixed both global and country-specific factors seem to matter,
with the latter being particularly important in the case of Asian countries and for debt
flows rather than equity flows.

4.1 FOREIGN INSTITUTIONAL INVESTMENT IN INDIA:

MILESTONES

India embarked on a programme of economic reforms in the early 1990s to tie

over its balance of payment crisis and also as a step towards globalisation.

An important milestone in the history of Indian economic reforms happened

on September 14, 1992, when the FIIs (Foreign Institutional Investors) were
allowed to invest in all the securities traded on the primary and secondary
markets, including shares, debentures and warrants issued by companies
which were listed or were to be listed the stock exchanges in India and in the
schemes floated by domestic mutual funds.

Initially, the holding of a single FII and of all FIIs, NRIs (Non-Resident
Indians) and OCBs (Overseas Corporate Bodies) in any company were subject
to a limit of 5% and 24% of the company's total issued capital respectively.

( In order to broad base the FII investment and to ensure that such an
investment would not become a camouflage for individual investment in the
nature of FDI (Foreign Direct Investment), a condition was laid down that the
funds invested by FIIs had to have at least 50 participants with no one holding
more than 5%. Ever since this day, the regulations on FII investment have
gone through enormous changes and have become more liberal over time.

( From November 1996, FIIs were allowed to make 100% investment in debt
securities subject to specific approval from SEBI as a separate category of FIIs
or sub-accounts as 100% debt funds. Such investments were, of course,
subjected to the fund-specific ceiling prescribed by SEBI and had to be within

24

an overall ceiling of US $ 1.5 billion. The investments were, however,

restricted to the debt instruments of companies listed or to be listed on the
stock exchanges.

In 1997, the aggregate limit on investment by all FIIs was allowed to be raised
from 24% to 30% by the Board of Directors of individual companies by
passing a resolution in their meeting and by a special resolution to that effect
in the company's General Body meeting.

( From the year 1998, the FII investments were also allowed in the dated
government securities, treasury bills and money market instruments.

( In 2000, the foreign corporates and high net worth individuals were also
allowed to invest as sub-accounts of SEBI-registered FIIs. FIIs were also
permitted to seek SEBI registration in respect of sub-accounts. This was made
more liberal to include the domestic portfolio managers or domestic asset
management companies.

( 40% became the ceiling on aggregate FII portfolio investment in March

2000.

( This was subsequently raised to 49% on March 8, 2001 and to the specific
sectoral cap in September 2001.

( As a move towards further liberalization a committee was set up on March

13, 2002 to identify the sectors in which FIIs portfolio investments will not be
subject to the sectoral limits for FDI.

( Later, on December 27, 2002 the committee was reconstituted and came out
with recommendations in June 2004. The committee had proposed that, 'In
general, FII investment ceilings, if any, may be reckoned over and above
prescribed FDI sectoral caps. The 24 per cent limit on FII investment imposed
in 1992 when allowing FII inflows was exclusive of the FDI limit. The
suggested measure will be in conformity with this original stipulation.' The
committee also has recommended that the special procedure for raising FII
investments beyond 24 per cent up to the FDI limit in a company may be
dispensed with by amending the relevant regulations.

( Meanwhile, the increase in investment ceiling for FIIs in debt funds from US
$ 1 billion to US $ 1.75 billion has been notified in 2004. The SEBI also has

25

reduced the turnaround time for processing of FII applications for registrations
from 13 working days to 7 working days except in the case of banks and
subsidiaries.

All these are indications for the country's continuous efforts to mobilize more
foreign investment through portfolio investment by FIIs. The FII portfolio
flows have also been on the rise since September 1992. Their investments
have always been net positive, but for 1998-99, when their sales were more
than their purchase

ACTS AND RULES

FII registration and investment are mainly governed by SEBI (FII) Regulations, 1995.
ELIGIBILITY FOR REGISTRATION AS FII: Following entities / funds are eligible
to get registered as FII:
1. Pension Funds
2. Mutual Funds
3. Insurance Companies
4. Investment Trusts
5. Banks
6. University Fund s
7. Endowments
8. Foundations
9. Charitable Trusts / Charitable Societies
Further, following entities proposing to invest on behalf of broad based funds(a fund
established or incorporated outside India, which has at least twenty investors with no
26

single individual investor holding more than 10% shares or units of the fund) , are
also eligible to be registered as FIIs:
1. Asset Management Companies
2. Institutional Portfolio Managers
3. Trustees
4. Power of Attorney Holders

4.2 INVESTMENT OPPORTUNITIES FOR FIIs

The following financial instruments are available for FII investments
a) Securities in primary and secondary markets including shares, debentures and
warrants of companies, unlisted, listed or to be listed on a recognized stock exchange
in India;
b) Units of mutual funds;
c) Dated Government Securities;
d) Derivatives traded on a recognized stock exchange;
e) Commercial papers.
Investment limits on equity investments
a) FII, on its own behalf, shall not invest in equity more than 10% of total issued
capital of an Indian company.
b) Investment on behalf of each sub-account shall not exceed 10% of total issued
capital of an India company.
c) For the sub-account registered under Foreign Companies/Individual category, the
27

investment limit is fixed at 5% of issued capital.

These limits are within overall limit of 24% / 49 % / or the sectoral caps a prescribed
by Government of India / Reserve Bank of India.
Investment limits on debt investments
The FII investments in debt securities are governed by the policy if the Government
of India. Currently following limits are in effect:
For FII investments in Government debt, currently following limits are applicable:
For corporate debt the investment limit is fixed at US $ 500 million.
TAXATION
The taxation norms available to a FII is shown in the table below.
Nature of Income

Tax Rate

Long-term capital gains

10%

Short-term capital gains

30%

Dividend Income

Nil

Interest Income

20%

Long term capital gain: Capital gain on sale of securities held for a period of more
than one year.
Short term capital gain: Capital gain on sale of securities held for a period of less than
one year.

4.3 BRIEF PROFILE OF IMPORTANT INSTITUTIONS:

A brief profile of important institutions included in the study is given below.
RESERVE BANK OF INDIA
India's Central Bank - the RBI - was established on 1 April 1935 and was nationalized
28

on 1 January 1949. Some of its main objectives are regulating the issue of bank notes,
managing India's foreign exchange reserves, operating India's currency and credit
system with a view to securing monetary stability and developing India's financial
structure in line with national socio-economic objectives and policies.
The RBI acts as a banker to Central/State governments, commercial banks, state
cooperative banks and some financial institutions. It formulates and administers
monetary policy with a view to promoting stability of prices while encouraging higher
production through appropriate deployment of credit. The RBI plays an important role
in maintaining the exchange value of the Rupee and acts as an agent of the
government in respect of India's membership of IMF. The RBI also performs a variety
of developmental and promotional functions.
The first concern of a central bank is the maintenance of a soundly based commercial
banking structure. While this concern has grown to comprehend the operations of all
financial institutions, including the several groups of non-bank financial
intermediaries, the commercial banks remain the core of the banking system. A central
bank must also cooperate closely with the national government. Indeed, most
governments and central banks have become intimately associated in the formulation
of policy.
They are often responsible for formulating and implementing monetary and credit
policies, usually in cooperation with the government. they have been established
specifically to lead or regulate the banking system.
SECURITUIES AND EXCHANGE BOARD OF INDIA
In 1988 the Securities and Exchange Board of India (SEBI) was established by the
Government of India through an executive resolution, and was subsequently upgraded
as a fully autonomous body (a statutory Board) in the year 1992 with the passing of
the Securities and Exchange Board of India Act (SEBI Act) on 30th January 1992. In
place of Government Control, a statutory and autonomous regulatory board with
defined responsibilities, to cover both development & regulation of the market, and
29

independent powers has been set up.

The basic objectives of the Board were identified as:
To protect the interests of investors in securities;
To promote the development of Securities Market;
To regulate the securities market and
For matters connected therewith or incidental thereto.
Since its inception SEBI has been working targeting the securities and is attending to
the fulfillment of its objectives with commendable zeal and dexterity. The
improvements in the securities markets like capitalization requirements, margining,
establishment of clearing corporations etc. reduced the risk of credit and also reduced
the market.
SEBI has introduced the comprehensive regulatory measures, prescribed registration
norms, the eligibility criteria, the code of obligations and the code of conduct for
different intermediaries like, bankers to issue, merchant bankers, brokers and subbrokers, registrars, portfolio managers, credit rating agencies, underwriters and others.
It has framed bye-laws, risk identification and risk management systems for Clearing
houses of stock exchanges, surveillance system etc. which has made dealing in
securities both safe and transparent to the end investor.

Another significant event is the approval of trading in stock indices (like S&P CNX
Nifty & Sensex) in 2000. A market Index is a convenient and effective product
because of the following reasons:
It acts as a barometer for market behavior;
It is used to benchmark portfolio performance;
It is used in derivative instruments like index futures and index options;
It can be used for passive fund management as in case of Index Funds.

30

Two broad approaches of SEBI is to integrate the securities market at the national
level, and also to diversify the trading products, so that there is an increase in number
of traders including banks, financial institutions, insurance companies, mutual funds,
primary dealers etc. to transact through the Exchanges. In this context the introduction
of derivatives trading through Indian Stock Exchanges permitted by SEBI in 2000 AD
is a real landmark.
BOMBAY STOCK EXCHANGE:
Of the 22 stock exchanges in the country, Mumbai's (earlier known as Bombay),
Bombay Stock Exchange is the largest, with over 6,000 stocks listed. The BSE
accounts for over two thirds of the total trading volume in the country. Established in
1875, the exchange is also the oldest in Asia. Among the twenty-two Stock Exchanges
recognized by the Government of India under the Securities Contracts (Regulation)
Act, 1956, it was the first one to be recognized and it is the only one that had the
privilege of getting permanent recognition ab-initio.
Approximately 70,000 deals are executed on a daily basis, giving it one of the highest
per hour rates of trading in the world. There are around 3,500 companies in the
country which are listed and have a serious trading volume. The market capitalization
of the BSE is Rs.5 trillion. The BSE `Sensex' is a widely used market index for the
BSE.
The main aims and objectives of the BSE are to provide a market place for the
purchase and sale of security evidencing the ownership of business property or of a
public or business debt. It aims to promote, develop and maintain a well-regulated
market for dealing in securities and to safeguard the interest of members and the
investing public having dealings on the Exchange. It helps industrial development of
the country through efficient resource mobilization. To establish and promote
honorable and just practices in securities transactions
BSE Sensex

31

The BSE Sensex is a value-weighted index composed of 30 companies with the base
April 1979 = 100. It has grown by more than four times from January 1990 till date.
The set of companies in the index is essentially fixed. These companies account for
around one-fifth of the market capitalization of the BSE.
NATIONAL STOCK EXCHANGE OF INDIA
The National Stock Exchange of India Limited has genesis in the report of the High
Powered Study Group on Establishment of New Stock Exchanges, which
recommended promotion of a National Stock Exchange by financial institutions (FIs)
to provide access to investors from all across the country on an equal footing. Based
on the recommendations, NSE was promoted by leading Financial Institutions at the
behest of the Government of India and was incorporated in November 1992 as a taxpaying company unlike other stock exchanges in the country.
On its recognition as a stock exchange under the Securities Contracts (Regulation)
Act, 1956 in April 1993, NSE commenced operations in the Wholesale Debt Market
(WDM) segment in June 1994. The Capital Market (Equities) segment commenced
operations in November 1994 and operations in Derivatives segment commenced in
June 2000.
S&P CNX Nifty
S&P CNX Nifty is a well-diversified 50 stock index accounting for 23 sectors of the
economy. It is used for a variety of purposes such as benchmarking fund portfolios,
index based derivatives and index funds.
S&P CNX Nifty is owned and managed by India Index Services and Products Ltd.
(IISL), which is a joint venture between NSE and CRISIL. IISL is India's first
specialized company focused upon the index as a core product. IISL have a consulting
and licensing agreement with Standard & Poor's (S&P), who are world leaders in
index services.
The average total traded value for the last six months of all Nifty stocks is
32

approximately 58% of the traded value of all stocks on the NSE

Nifty stocks represent about 60% of the total market capitalization as on March 31,
2005.
Impact cost of the S&P CNX Nifty for a portfolio size of Rs.5 million is 0.07%
S&P CNX Nifty is professionally maintained and is ideal for derivatives trading.

33

5. DATA ANALYSIS
A. Closing Index of Nifty and FII inflows comparison chart
Year

Closing Index of CNX

NIFTY
1042.59
1182.28
908.53
899.1
1315.46
960.92
911.02
1263.55
1410.98
1580.75
3497.25
2080.5
2836.55
3966.4
6138.6
2959.15
5201.05
6134.5
4624.3
5905.1
6304

1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Standard
Deviation
2040.093

Confidance Level at 95%

of Alpha
28.60549

FII Inflows(in CR)

13.4
5126.2
4796.3
6942
8574.5
5957.4
-1584.4
6370.08
13128.2
3629.6
30459
38965.8
47181.9
36540.2
71486.3
-52987.4
83424.2
133266.8
-2714.2
128360.7
112968.7
Correlati
on
0.75857

34

NIFTY Vs FII
150000
100000
50000
0
-50000
-100000
Closing Index of CNX NIFTY

FII INFLOWS

From the above data in table 1 the correlation between the closing stock index of
every year end of NSE and the corresponding FII of those years was calculated and it
was found that the relation between them is 0.7859 which indicates that there is very
high correlation between the FII inflows and the stock index of the Indian market.

B.
Further analysis was made to find out the correlation between the Indian stock market
and the FII for the year 2013 by taking the closing index of all the months in the year
2013 and the corresponding FII inflow into the Indian market.
Month(2013) of FII
January
February
March
April
May
June
July

Closing CNX inflows(CR)

6034.75
5963.05
5682.55
5930.2
6124.05
5842.2
5755.05

Index NIFTY
22059.2
24439.3
9124.3
5414.1
22168.6
-11026.9
-6253

35

August
September
October
November
December

5471.8
5735.3
6251.7
6176.1
6291.1

-5922.5
13057.8
15706.2
8116.1
16085.8

Closing CNX Vs NIFTY

25000
20000
15000
10000
5000
0
-5000
-10000
-15000
Closing CNX inflows

Index Nifty

From the above data in table 2 for the year 2013 the correlation between the closing
stock index of every month of NSE and the corresponding FII of those years was
calculated and it was found that the relation between them is 0.44811 which indicates
that there is a significant correlation between the FII inflows and the stock index of
the Indian market.
Further analysis was made to find out in depth the correlation between the Indian
stock market and the FII inflow for 13 days in the month of March 2014.

36

C.
March index NIFTY (CR)
3.3.2014
4.3.2014
5.3.2014
6.3.2014
7.3.2014
10.3.2014
11.3.2014
12.3.2014
13.3.2014
14.3.2014
18.3.2014
19.3.2014
20.3.2014

2014 of FII
203.1
193.3
770.9
1299.8
2672.7
-3743.2
1519.3
907.6
636.6
1403.9
1254.8
1120.8
749.7

Closing CNX Inflow

6221.45
6297.95
6328.65
6401.15
6526.65
6537.25
6511.9
6516.9
6493.1
6504.2
6516.65
6524.05
6483.1

2014 FII Vs CNX

8000
6000
4000
2000
0
-2000
-4000

From the above data in table 3 for the month March 2014 the correlation between the
closing stock index of every month of NSE and the corresponding FII of those years
was calculated and it was found that the relation between them is 0.04667 which

37

indicates that there is a poor correlation between the FII inflows and the stock index
of the Indian market.

38