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: Kumar Shreyas 10BSPHH011075

IBS Hyderabad
1/31/2012
 TABLE OF CONTENTS

Contents
Contents .................................................................................................................................................... 2
1. ABSTRACT ..................................................................................................................................... 3
2. INTRODUCTION........................................................................................................................... 4
2.1. Objectives of the Project............................................................................................................. 9
2.2. Scope of the Project..................................................................................................................... 9
2.3. Limitations ................................................................................................................................. 10
3. DATA SOURCES & METHODOLOGY ................................................................................... 11
3.1. Data Sources .............................................................................................................................. 11
3.2. Methodology .............................................................................................................................. 12
4. ANALYSIS & FINDINGS............................................................................................................ 14
4.1. Regression Analysis of SENSEX and Sector Specific Indexes .............................................. 14
Findings.................................................................................................................................................. 21
5. Analysis of Automobile Sector: The auto companies analyzed are: ............................................ 22
Findings ................................................................................................................................................... 25
6.1 Conclusion ............................................................................................................................................. 26
During Bull Phase: .................................................................................................................................. 26
During Bear Phase: ................................................................................................................................. 26
During Stagnation Phase: ........................................................................................................................ 26

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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

1
http://www.investopedia.com/terms/f/fii.asp

3
beneficial to the investors who are trying to maximize their returns in stock markets and
minimize their risk.

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.

2
http://investor.sebi.gov.in/faq/foreign%20institutional%20investor.html

4
 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.

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
3
http://investor.sebi.gov.in/faq/foreign%20institutional%20investor.html

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

4
http://investor.sebi.gov.in/faq/foreign%20institutional%20investor.html

6
 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.

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 Registration Process for FIIs5

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 country’s stock markets and
thus have great influence on the way the stock markets behaves, going up or down. This
creates problem for Small Investors.

5
http://investor.sebi.gov.in/faq/foreign%20institutional%20investor.html

8
  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:

9
  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.
 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.

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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).

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  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).
 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 applications”6.
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.

6
http://dictionary.reference.com/browse/research
7
http://www.investopedia.com/terms/r/regression.asp

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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.

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 = (α × Net FII Investment) + (β × Inflation Rate) + (γ × Exchange Rate) +

(λ × Lending Rate) + (υ × GDP Growth Rate) + ℮

Where:
α, β, γ, λ, υ = Coefficients.
℮ = Error Term

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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

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 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.

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.

15
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.

16
Although the model is significant but is able to explain only 47.13% of the movement of
BSE FMCG. Thus we won’t 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.

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 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.

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

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 (BPLR) were taken as the independent variables and a regression analysis was run
on it.

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.

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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.

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 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 FII Inflation Exchange GDP BPLR Explanation

Sensex    57.6%
Auto     57.2%
Banks    50.7%
FMCG 47.1%
IT      55.2%
Metal    63.2%
Oil & Gas     58.3%
Power     54.1%
Reality  63.1%

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

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 Index Equation
Sensex (0.136× Net FII Investment) + (483.380 × Inflation Rate) -
(591.77 × Exchange Rate) + 32920
Auto (0.078× Net FII Investment) + (321.196 × Inflation Rate) -
(143.611 × Exchange Rate) - (897.712 × GDP Growth Rate)
Banks (0.124× Net FII Investment) + (390.113 × Inflation Rate) - (294.947 ×
Exchange Rate)
FMCG Model is not significant
IT (0.033× Net FII Investment) + (142.281 × Inflation Rate) - (111.461 ×
Exchange Rate) – (744.705 × GDP Growth Rate) + (625.763 × Lending
Rate)
Metal (0.12× Net FII Investment) + (892.232 × Inflation Rate) - (998.062 ×
Exchange Rate) + 57208.759
Oil & Gas (0.066× Net FII Investment) + (368.386 × Inflation Rate) - (379.978 ×
Exchange Rate) + (941.238 × GDP Growth Rate) + 18759.532
Power (0.024× Net FII Investment) + (92.186 × Inflation Rate) – (153.503 ×
Exchange Rate) + (271.511 × GDP Growth Rate) + 9213.176
Reality 29638.513 - (541.961 × Exchange Rate)

 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:

22
Bajaj Auto:

23
Hero Honda:

Maruti Suzuki:

24
Tata Motors:

Analysis: The Regression analysis of various companies with the selected factors indicates
following result:

Company FII Risk Inflation Risk Exchange Risk Lending Rate Risk
Ashok Leyland Low Medium Medium High
Bajaj Auto High Low High Medium
Hero Honda High High Low Low
Maruti Suzuki Medium Medium Medium Low
Tata Motors Low Medium Medium High

Findings
If we look at the actual risk being faced by these companies; the regression analysis provides
following result:

Company FII Risk Inflation Exchange Risk BPLR

Risk Risk
Ashok Leyland   
Bajaj Auto  

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 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.

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