Do Domestic Institutional Investors (DIIs) Neutralize the Impact of Large Reversal by Foreign

Institutional Investors (FIIs)? Recent Evidence from Indian Stock Market

Authors

Dhananjaya K
Associate Professor
Post-graduate Department of Business Administration
St. Aloysius Institute of Management and Information Technology
St. Aloysius College (Autoonomus), Mangaluru-575022.
E-mail-dhananjaya@staloysius.ac.in

Rowena Wright
Professor
Post-graduate Department of Business Administration
St. Aloysius Institute of Management and Information Technology
St. Aloysius College (Autoonomus), Mangaluru-575022.
E-mail: rowena@staloysius.ac.in

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 Do Domestic Institutional Investors (DIIs) Neutralize the Impact of Large Reversal By Foreign
Institutional Investors (FIIs)? Recent Evidence from Indian Stock Market

Dhananjaya K
dhananjaya@staloysius.ac.in
St. Aloysius Institute of Management and Information Technology, St. Aloysius College (Autoonomus),
Mangaluru-575022.
.
Rowena Wright
Rowena@staloysius.ac.in
St. Aloysius Institute of Management and Information Technology, St. Aloysius College (Autoonomus),
Mangaluru-575022.

Abstract
FIIs and DIIs are the two dominant investment categories in the Indian stock market with enough clout
to move the market. Inflow of FIIs is crucial for an emerging economy like India. At the outset, it
attracts foreign capital to finance economic growth. Inflow of Foreign capital through FIIs is also
expected to enhance liquidity in the stock market by widening the investor base and thereby improves
the functioning of the secondary market. Hence, the flow of FIIs is expected to indirectly contribute to
the economic growth (Lee, 2007). However, on the flip side, they are considered to be voracious, erratic
investors that often profit from destabilizing financial markets of host countries. Batra (2003) observes
that FPIs are considered to be driven by animal spirits rather than rational investment decisions. Hence,
they have often been blamed for large reversal of capital from countries in times of crisis leading to
herding behavior in other investors, particularly, domestic institutional investors (DIIs). As a result,
these flows tend to make financial markets vulnerable and may end up landing the country in a crisis
(Rakshit, 2006). To neuralisze the destabilizing nature of FII trading, it is critical to have powerful DIIs
that would provide a cushion against this adverse effect of FIIs. However, this function of DIIs depends
on the relationship between FIIs and DIIs. Therefore, the present paper attempts to understand the
relationship between foreign institutional investments (FIIs) and domestic institutional investors (DIIs)
in India, using the most recent high frequency data. The study finds that FIIs and DIIs follow a different
trading strategy in the market. Importantly, the study shows that DIIs negatively affect the FII flows,
whereas they are not affected by the FII flows. This suggests that DIIs indeed act as a cushion against
the significant withdrawal by FIIs, thereby maintaining stability in the stock market.

Keywords: FIIs, DIIs, and stock market.

JEL Classification: G1

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1. INTRODUCTION

One of the significant developments in the Indian stock market is the increased presence of institutional
investors. The dominance of institutional investors, particularly, Foreign Institutional Investors (FIIs) in
the stock market has increased the volatility in the stock market during the crisis. Foreign Portfolio
Investors (FPIs) which mainly consist of Foreign Institutional Investors (FIIs) and Domestic Institutional
Investors (DIIs) which prominently includes domestic mutual funds, banks and financial institutions,
insurance and pension funds are the two important categories of institutional investors in Indian stock
market. Inflow of FIIs is considered as crucial for emerging economies like India. On the one hand, it
channelizes foreign capital to fund economic growth and on the other hand, inflow of foreign capital
through FIIs is also expected to enhance liquidity in the security market by widening the investor base
thereby improves the functioning of the secondary market. This would lead to lower cost of capital,
which in turn would enhance the level of investment. Inflow of FPIs also helps the country to build up
foreign exchange reserves to meet the current account deficit. Hence the flow of FPIs is expected to
indirectly contribute to the economic growth (Lee, 2007). However, on the flip side, they are considered
voracious, erratic type of investors that often profit from destabilizing financial markets of host
countries. Batra (2003) observes that FPIs are considered to be driven by “animal spirits” rather than
rational investment decisions. Hence, they have often been blamed for large reversal of capital from
countries in times of crisis leading to herding behavior among the investors. As a result, FII flows tend
to make financial markets vulnerable and may end up landing the country in a crisis (Rakshit, 2006). In
this context, the presence of strong domestic institutional investors (DIIs) is important for ensuring
stability in the stock market. DIIs, on the other hand, play an important role in mobilizing the savings
from small investors. Mutual funds, for instance, have a great role to play in India as the majority of the
investors are not comfortable to directly participate in the stock market (NSE, 2014). On the other hand,
strong DIIs also act as a cushion against the adverse effect caused by sudden withdrawal of FIIs in times
of economic shocks (Bose, 2012). However, this role of DIIs depends on their relative ability as market
movers. With this backdrop, the present study attempts to understand the dynamic relationship between
these two classes of investors and their impact on the market return in Indian stock market.
The following is the layout of the paper. Section 2 briefly discusses the theoretical relationship between
institutional investors and market return. Section 3 includes a review of literature. Section 4 presents the
trading activities of FIIs and DIIs in Indian stock market. Section 5 briefly describes the data and

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methodology. Section 6 deals with the empirical results and discussion, and Section 7 holds the
concluding remarks.
2. TRADING STRATEGIES OF INSTITUTIONAL INVESTORS AND THE IMPACT ON THE
STOCK MARKET- THEORETICAL UNDERPINNINGS
There are divergent views on the trading strategies of institutional investors and the impact of it on the
stock market. One premise propounds that institutional investors do not trade on fundamentals, but on
the short term and potentially destabilizing feedback trading. This may be due to the agency problem in
money management. Managers would be interested in short term performance of the stock. Long term or
fundamental strategies like negative feedback investment strategies would take long time to perform and
may actually do very badly in the short run. This puts managers at significant risk as their performance
is continuously monitored. Hence, they may be pursuing trend chasing or positive feedback strategy
with the belief that trends are likely to continue. This strategy is destabilizing, if institutions buy
overpriced stocks and sell underpriced stocks, which results in the price deviations away from
fundamentals. However, the positive feedback strategy can also stabilize the market by bringing prices
closer to the fundamentals, if stocks under react to the news (Lakonishok, Shleifer, and Vshny, 1992).
Foreign Institutional investors are also said to be pursuing contagion trading, thereby act as a channel of
crisis transmission. FIIs have often been blamed for large and sudden reversal of capital from countries
in times of crisis, thereby destabilizing the stock market which they exit. Hence, FII investment is highly
sensitive to any shocks in the host country or favorable environment in other countries. For example,
quantitative easing (QE) in the USA has kept interest rates at very low levels. Consequently, there has
been a flow of investment into emerging markets such as India. As the US economy is recovering, the
Federal Reserve of USA has initiated reversal of easy monetary policy. IMF (2014) warns that this
reversal will have implications for global financial stability through the contagion trading by FIIs. The
large FII reversal from the Indian stock market in the recent months shows that FIIs actually engage in
contagion trading. The effect of contagion trading is multiplied, if DIIs follow FIIs in the stock market.
Both feedback as well as the contrarian trading strategy by FIIs may result in market wide herding.
Wang (2008) defines herding as the behavior of an investor to imitate the observed actions of others or
the movements of the market instead following his own beliefs and information. Hence, an investor is
said to herd when he trades against his own private information (Ionescu, 2012). Specifically, herding is
defined as a group of investors following each other in or out of the same securities over some period of
time (Chen, Wang and Lin, 2008). Herding implies that investors follow the market rather than take the
time and expense to make their own assessment of each country’s fundamentals (Calvo and Mendoza,

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1997). Therefore, large reversal by FIIs may cause herding by DIIs resulting in market wide herding,
thereby destabilizing the market. Finance literature discuses four possible explanations to the
institutional herding in the stock market. Firstly, institutional investors may engage in reputational
herding, wherein they trade with the crowd in order to overcome the reputational risk of acting
differently from other managers and in the process, they may disregard their private information
(Scharfstein and Stein, 1990). As eminent economist Paul Krugman says “To be wrong when everyone
else is wrong is not such a terrible thing: You may lose a bonus, but probably not your job. On the other
hand, to be wrong when everyone else is right... So everyone focuses on the same short-term numbers,
tries to ride the trends….” (Krugman, 1997). This is non-informational herding as this view centers on
investor psychology and investors forego rational analysis and follow one another blindly. This kind of
herding can result in systematic erroneous and can lead subsequent return reversal destabilizing the
market (Ionescu, 2012). Park and Sgroi (2008) argue that this kind of herding can lead to painful
financial crisis as a few early wrong movements by investors induce price jumps in one direction or
other driving away the prices from the fundamentals. Secondly, institutional investors may engage in
investigative herding in which managers may follow each other into or out of the same securities just
because they receive same private information (Froot, Scharfstein, and Stein, 1992; Devenow and
Welch, 1996). Hence, in the case of investigative herding all the investors receive correlated information
and interpret it similarly. This form of herding is not irrational as they trade based on the information
about the stock. According to Kim and Wei (2002) this kind of herding helps to speed up the
information incorporated into the stock prices and improves market efficiency. Thirdly, herding may
also occur due informational cascades in which, managers infer private information from prior trades of
better-informed managers and trade in the same direction (Bikchandani, Hershleifer and Welch, 1992).
According to Park and Sgroi (2008) institutional investors observe the actions of others, derive
information from them and then follow the majority action. According to Bikchandani, Hershleifer and
Welch (1992) an informational cascade occurs when individuals find it optimal to follow the behavior of
the past individual without regard to his own information after observing their actions. They show that at
some stage a decision maker will ignore his private information and act only on the information obtained
from previous decisions. Nevertheless, this form of herding is not completely irrational because they try
to derive the information from other better informed traders before following the majority. The impact
of this form of herding on the stock market depends on the veracity of the information received and
interpreted by the managers. Lastly, herding may also occur in the stock market simply because

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institutional investors may prefer certain type of stocks, such as stocks with high liquidity, lower
transaction costs or stocks which more risky as documented by Falkenstein (1996).

As opposed to the above arguments, it is also contended that institutional investors are rational investors
who offset changes in the sentiment of individual investors. Unlike individual investors, they have
access to various information sources like news reports and analyses and the guidance of professional
money managers and hence they are in a better position to understand the fundamentals of the stocks
which they trade. Hence, institutional investors prefer not to engage in irrational herding. They will herd
only when all the investors receive the same information and interpret similarly. Since they trade based
on the fundamental, they are likely to engage in negative feedback or contrarian trading strategies which
means buying stocks that have fallen too far (past losers) and selling stocks that have risen too far (past
winners) (Lakonishok, Shleifer, and Vishny, 1992).
The more neutral view of institutional investors, says that institutions are neither rational negative
feedback investors nor pursue destabilizing strategies of herding and positive feedback strategies in their
trading. This premise argues that institutional investors are heterogeneous in nature and hence, the
trading strategy is also heterogeneous. Accordingly, some class of institutional investors may be
pursuing positive feedback and/or herding strategy, while others may pursue a negative feedback
strategy. Therefore, their trading strategy does not destabilize asset prices as the heterogeneity of trading
strategies is fair enough that the aggregate excess demand is approximately zero, which indicates that
there are enough negative feedback traders to offset the positive feedback traders. For instance, the
positive feedback trading strategy of FIIs would be offset by negative feedback trading strategy followed
by DIIs. Hence trading strategies followed by various classes of institutional investors would have a
neutral impact on the equity market despite generating a substantial trading volume in the market
(Lakonishok, Shleifer, and Vishny, 1992).
Based on these premises one can infer that, institutional investors may be pursuing positive feedback
and herding trade strategies or negative feedback trading strategy or both positive feedback and negative
feedback strategies and herding, or contagion trading in the case of FIIs. Accordingly, the impact on the
stock market is also divergent. Figure 1 summarizes the possible trading behaviors of FIIs and the
potential impact of these behaviors on the stock market and domestic institutional investors. It shows
that FIIs may engage in feedback trading, herding and negative feedback trading. Positive feedback
trading may destabilize the market, if investors buy overreacted stocks, thereby taking the prices away
from the fundamentals. Positive feedback trading may also lead to stabilization in the equity market if
investors buy under reacted stocks. Contrarian trading, on the other hand, is expected to stabilize the

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 market. Both positive feedback and negative feedback trading strategy may result in market wide
herding and would impact the sentiments of domestic institutional investors. Contagion trading by FIIs
may also cause destabilization in the equity market through sudden withdrawal of funds.

Figure 1-Trading behavior of FIIs and its impact

Foreign Institutional Investors (FIIs)

Feedback Trading Herding Contagion Trading

Negative Positive
feedback Trading feedbackTrading

Impact on Domestic Institutional

Investors’ Sentiments

Stabilizing Effect on Stock Destabilizing Effect on

Market Stock Market

Source: Authors’ Construction

3. RELATED LITERATURE
The dominance of institutional investors, particularly, FIIs, is increasing in the Indian equity market.
According to Mohan (2005) FIIs have displaced domestic mutual funds in importance in the Indian
equity market. Their shareholding in the Sensex companies is large enough for them to be able to move
the market. Thiripalraju and Acharya (2009) empirically show that FIIs have increased their capacity to
influence the market, whereas mutual funds are losing their ability as market movers. Bikhchandani and
Sharma (2001) argue that more empirical research is required in emerging markets where, according to
them, there is a greater tendency to herd by institutional investors. Further, they observe that
informational cascades and reputational herding are more likely to occur in emerging markets due to the
uncertain environment characterized by weak reporting requirements, lower accounting standards, lax
enforcement of regulations, and costly information acquisition. They also contend that in emerging

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markets due to the prevalence of imperfect information, momentum investment strategies may be more
profitable for the investors.

In India, few studies attempted to understand the behavior of FIIs. For instance, using data on FII equity
purchases and sales on daily and monthly basis over the period from January 2000 to December 2002,
Batra (2003) studies the behavior of FIIs in India. He finds that the FIIs have been positive feedback
investors. He also shows that foreign investors have a tendency to herd in the Indian equity market. Bose
(2012) examines the dynamic interaction between FII investment and mutual fund investment covering
the recent post-crisis period from April 1, 2008 to March 31, 2012. Using daily data on net investment
flows of FIIs and mutual funds to Indian stock markets, he reports that that the past FII flows have
significant explanatory power for mutual fund net inflows. He also studies the relationship between
Bombay Stock Exchange (BSE) returns and the flow of FIIs and mutual funds and finds that the
contemporaneous BSE return is significant in determining mutual fund flows, while BSE returns with a
lag are significant in explaining FII flows to the Indian stock market. He also documents some evidence
that during global uncertainties domestic mutual fund flows positively influenced FII inflows. Similarly,
Mukherje et al (2002) analyzes the factors determining the flow of FIIs in India. Using daily flows of
FIIs during January 1999-May 2002, they find that the market return is an important factor that
influences FII flows into the country. This finding, according to them, is suggestive of the return-chasing
behavior of FIIs in Indian equity market. But their evidence does not support that the market return is
influenced by the flow of FIIs. Contrary to Mukherje et al (2002), Patnaik and Shaha (2008) report that
both foreign and domestic institutional do not chase returns. They examine the preferences of foreign
and domestic institutional investors in Indian stock markets. Their evidence shows that both foreign and
domestic institutional investors prefer larger, more widely held firms. But foreign investors prefer to buy
stocks of more liquid, younger, private sector firms with global visibility while domestic investors prefer
older firms, with a large share of fixed assets and high leverage. They also find that unlike foreign
investors, domestic investors do not have a bias against public sector enterprises. Gordon and Gupta
(2003) also study the determinants of FII flows into India using the data on monthly FII flows. They find
that a combination of global, regional and domestic factors influence the flow of FIIs. Their result shows
that the performance of the emerging market equities positively influences FII flows into India. This
shows that there could be risk of outflows if the market return declines across the emerging markets.
This finding also reflects the extent of integration of equity markets. They also find that the lagged
domestic equity market returns, exchange rate depreciation and rating downgrades negatively affect FII
flows. The negative influence of market returns is contrary to the findings of Mukherje et al (2002)

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which may be indicative of contrarian trading by FIIs. Chakrabarti (2001) also examines the nature and
determinants of FIIs during the period May 1993 to December 1999. He documents a strong correlation
between contemporaneous market return and FII flows into India. Specifically, their evidence shows that
BSE index explains a third of the total variation in FII flows during the study period. However, they
report that FII flows do not influence the market return which shows that FII flows do not lead herding
and subsequent destabilizing impact on the equity market. Their results also show that other domestic
and international factors like US and world returns, country risk ratings do not significantly influence
the FII flows. Further, they provide some evidence of positive feedback trading by FIIs, which they fear
would exacerbate the occurrence of equity market bubbles if not cause it. Dua and Garg (2013) also find
that the domestic stock market performance is an important determinant of FII flow along with other
factors like exchange rate and domestic output growth. Contrary to Chakrabarti (2001), Thiripalraju and
Acharya (2009) document some evidence of herding and momentum strategies by FIIs. Their analysis
shows that there is a significant relationship between index return and lagged FIIs investment showing
that FII trading activity influence the market return. Most recently, Prosad et al (2012) examine the
presence of herd behavior in the Indian equity market using the daily return of Nifty50 stocks. Using
Cross Sectional Standard Deviation (CSSD) method of herding developed by Christie and Huang
(1995), they find no evidence of herding on average. However, they document the presence of herding
when the market was advancing and no herding when the market was declining.
It is evident from the above discussion that most of the studies did not examine the dynamic interaction
between FIIs and DIIs. Studies, that attempt to understand the relationship between FIIs, DIIs used
mutual fund as representative of DIIs. However, Badrinath and Wahal (2002) argue that focusing on
particular subsets of institutional investors provides an incomplete view of the trading landscape of
institutional investors. Therefore, the present study overcomes this limitation by including the trading
activities of all DIIs while analyzing the dynamic relationship between DIIs and FIIs and market return.
Secondly, the study employs the most recent data involving large reversal by FIIs from the stock market.

4. SOURCE OF DATA AND METHODOLOGY

The study relies on secondary data to examine the relationship between FPIs and DIIs and market return.
The data on the daily net investment of FII has been obtained from the Securities and Exchange Board
of India (SEBI). The data on the daily net investment of DIIs has been sourced from moneycontrol.com
which compiles the data from National Stock Exchange (NSE) Ltd. 1 The study uses S&P Sensex to

1
Though NSE reports the data on daily DII trading activities, it does not provide historical data. The data provided by
moneycontrol.com was verified with the daily trading date reported by NSE.
8

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compute the market return. 2 The daily data on S&P Sensex has been procured from Bombay Stock
Exchange. The data span from 1st January 2018 to 31st July 2018. The study employs correlation, VAR
Granger causality and multivariate VAR technique to understand the dynamic interaction between DIIs,
FIIs, and market return in the Indian stock market.

5. INSTITUTIONAL TRADING ACTIVITY IN INDIAN STOCK MARKET

DIIs and FIIs are the two important categories of institutional investors in Indian stock market. DIIs in
India prominently consist of domestic mutual funds, insurance companies, pension funds, banks and
financial institutions. Powerful DIIs potentially counteract the destabilizing nature of FII trading,
thereby providing a cushion against the adverse effect of FIIs, especially in times of major shocks or

Table 1: DII Investment in Indian Stock Market (Rs. crore)

Net Net
Year Purchases Sales 2018 Purchases Sales
Investment Investment
2007-08 311483 263758 47697 Jan-18 93030 92631 399
2008-09 247396 187356 60040 Feb-18 82217 64404 17813
2009-10 342875 318815 24060 Mar-18 79303 72609 6694
2010-11 319687 336082 -16395 Apr-18 70706 62042 8664
2011-12 271016 274802 -3786 May-18 87103 72049 15054
2012-13 234020 300957 -66936 Jun-18 78930 64784 14146
2013-14 271989 326061 -54072 Jul-18 66201 62113 4088
2014-15 398916 418180 -19264
2015-16 467179 388492 78687
2016-17 566182 536250 29932
Source: Compiled from moneycontrol.com

Table 2: FII & Mutual Fund investment in Equity and Debt (Rs. Crores)
FII Mutual Funds
Net Investment in Net Investment in Net Investment Net Investment
Year
Equity Debt in Equity in Debt
2007-08 53404 12775 16306 73790
2008-09 -47706 1895 6983 81803
2009-10 110221 32438 -10512 180588
2010-11 110121 36317 -19975 248854
2011-12 43738 49988 -1358 334820
2012-13 140033 28334 -22749 473460
2013-14 79709 -28060 -21224 543247
2014-15 108673 162822 40714 594457
2015-16 -17579 14382 63889 383464
2016-17 54735 325026
Source: Compiled from SEBI

2
Market return is computed as the first difference of log of Sensex.
9

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crisis in the economy. However, this function of DIIs depends on their trading strategies in the market.
Table 1 presents the trading activities of DIIs in the equity market. As evident from the table 1, DIIs
have shown strong trading activities during the global financial crisis of 2008 with the net investment of
Rs. 60040.47 crores in 2008-09 which was up by 26 per cent of the net investment in 2007-08. On the
other hand, during the same period, FII investment saw a huge outflow from the market whose net
investment stood at Rs. 45811 crores. However, in the post-crisis period DIIs outflow from the market
was more than inflow which continued till 2014-15 as depicted in the table 1. On the other hand, FIIs
increased their equity investment in the post crisis period as shown in the table 2, which indicates that
the trading strategies of FIIs and DIIs highly differ in the market. Table 2 shows the net investment by

Table 3: Recent trends in FII Investment

Equity Debt
2018 Gross Net Gross Gross Net
Gross Sales
Purchase Investment Purchase Sales Investment
Jan-18 131014 117012 14002 36691 28523 8168
Feb-18 108958 121450 -12491 22524 25295 -2771
Mar-18 112107 98735 13372 24493 31791 -7298
Apr-18 109750 116218 -6468 34970 46839 -11868
May-18 132566 137543 -4977 17848 35391 -17543
Jun-18 108775 110675 -1900 15255 25261 -10006
Jul-18 85892 85973 -81 16659 17902 -1242
Source: Compiled from moneycontrol.com

Figure 1: Recent trends in FII and DII Investment

20000

15000
Net FII & DII Investment

10000
(Rs. Crore)

5000 DIIs
0 FIIs
Jan-18 Feb-18 Mar-18 Apr-18 May-18 Jun-18 Jul-18
-5000

-10000

-15000
Source: Authors’ construction

FIIs and mutual funds in equity and debt. It is evident from the table that equity route is the preferred
mode of investment by FIIs. For instance, in 2012-13 83 per cent of the total net investment by FIIs
came from this route. Net FII investment in equity was Rs.8546 crore in 1996-97 which rose to its peak

10

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in 2012-13 with net investment to the tune of Rs. 140,033 crore. On the other hand, net FII investment in
debt has experienced a substantial increase over 2006-12. It has experienced a steep decline after 2012-
13 except for 2014-15. However, in 2015-16 there was a substantial FII outflow from the equity market.
Interestingly, in the same year mutual funds increased their investment in equity. Table 1 and table 3
also present the monthly flow of investment by DIIs and FIIs in 2018. FIIs investment has witnessed
significant exit from the market since February 2018. However, DIIs have maintained the positive net
investment during the same period. Therefore, it is clear that, on an average, FIIs and DIIs follow a
different trading strategy in the market as depicted in figure 1. This has motivated the author to
reexamine the relationship between FPIs, DIIs and stock market returns in India, using recent high
frequency data.

6. RESULTS AND DISCUSSION

The correlation matrix in table 4 shows important patterns in the relationship between FII, DII and
return. The table depicts significant negative contemporaneous correlation between FIIs and DIIs which
indicates that positive net inflows by FIIs in a given day would tend to be accompanied by net outflows
by DIIs and vice versa, which is contrary to the findings of Sehgal and Tripathi, (2009) who conclude
that FIIs propelled the investment by DIIs (mutual funds). This negative relationship is more
Table 4: Correlation of FII Investments with DII Investments and Market Return
Panel A: Daily (net) flows
FII FII (-1) DII DII (-1) RETURN RETURN (-1)
FII 1.00
FII (-1) 0.24** 1.00
DII -0.44* -0.21* 1.00
DII (-1) -0.29* -0.45* 0.22* 1.00
RETURN 0.01 0.07 0.20** -0.06 1.00
RETURN (-1) 0.33* -0.00 -0.10 0.21** 0.12 1.00
Panel B: 5-day moving average of daily (net) flows
FII FII (-1) DII DII (-1) RETURN RETURN (-1)
FII 1.00
FII (-1) 0.90* 1.00
DII -0.73* -0.66* 1.00
DII (-1) -0.71* -0.73* 0.89* 1.00
RETURN 0.21** 0.12 -0.06 0.01 1.00
RETURN (-1) 0.30* 0.20** -0.18** -0.05 0.85** 1.00
Source: Authors’ Computation. *significant at 1%, ** significant at 5%
pronounced when the weekly (moving average) data are considered. This may infer that the investment
strategies of these investors differ in the market. There is also a significant negative correlation between
FII and one day lagged DIIs which becomes stronger when the weekly data is considered. Further, a
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 significant positive auto correlation is found in the case FIIs when one day lagged net flow is
considered. DIIs showed significant positive auto correlation indicating that their net inflow on a given
period is influenced by their inflow in the previous day. As far as the relationship between stock returns
and daily institutional flow is concerned, a significant positive correlation is found between one day
lagged returns and FII flows, indicating that FII may pursue positive feedback trading in the market. On
the other hand, significant negative correlation is found between DII flows and one day lagged returns in
the weekly data indicating the contrarian trading strategy being followed by DIIs which is consistent
with Thiripalraju and Acharya (2011) who found a significant negative relationship between lagged
market return and mutual fund investment. The table also indicates that both FIIs and DIIs do not
significantly influence the market return.

Table 5: Phillips-Perrron Test Statistic for Stationarity of Variables

Null Hypothesis: FII has a unit root Null Hypothesis: DII has a unit root Null Hypothesis: Return has a unit root
T Stat Prob* T Stat Prob* T Stat Prob*
Phillips-Perron test statistic -9.53 0.000 Phillips-Perron test statistic -9.64 0.000 Phillips-Perron test statistic -10.35 0.000
Test critical values 1% -3.47 Test critical values 1% -3.47 Test critical values 1% -3.43
5% -2.88 5% -2.88 5% -2.86
10% -2.57 10% -2.57 10% -2.57
Source: Authors’ computation. ADF test also shows that variables are stationary.

Table 6: Results of VAR Estimation

Endogenous Variables FII DII Return
0.03 0.016 0.000
FII (-1)
(0.31) (0.24) (0.19)
0.09 -0.051 -0.000
FII (-2)
(1.13) (-0.82) (-0.46)
-0.42* 0.159 -0.000
DII (-1)
(-3.39) (1.71) (-0.90)
-0.29* 0.223 * 0.000
DII (-2)
(-2.11) (2.15) (0.64)
61567* -0.111 0.13
Return (-1)
(5.01) (-1.21) (1.48)
5788 26743* 0.114
Return (-2)
(0.42) (-2.64) (1.16)
t values in the bracket.
In order to understand the dynamic interaction between FIIs, DIIs and market return we ran the
multivariate VAR analysis. Table 5 shows that all the variables are stationary at levels, which allows us
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to run the VAR regression. The result of the VAR analysis is presented in Table 6. Two important
findings are revealed from the VAR estimation. First, FII investment is negatively influenced by past
DII flows. This shows that higher investment by DIIs is followed by withdrawal by FIIs. However, DIIs
are not influenced by the past FIIs flows. This suggests that DIIs follow an independent trading strategy
in the market, and hence they are not affected by the movement of FIIs. This is an important finding
from the point of view of the stability of the stock market. Secondly, the findings show that DIIs and
FIIs respond differently to the market return. As shown in the table 5, FIIs flows are positively
influenced by past return. This suggests that FIIs follow a positive feedback trading strategy which can
cause destabilizing impact on the stock market in times of economic shocks. However, DIIs are
negatively influenced by the market return, which indicates that they follow a negative feedback trading
strategy in the market. Interestingly, market return is not influenced by the either DIIs or FIIs flows.

Table 7: VAR Granger Causality Tests

Dependent variable: FII
Excluded Chi-sq. df Prob.
DII 17.48 2 0.000
RETURN 26.54 2 0.000
All 37.44 4 0.000
Dependent variable: DII
Excluded Chi-sq. df Prob.
FII 0.71 2 0.699
RETURN 9.55 2 0.008
All 11.79 4 0.018
Dependent variable: RETURN
Excluded Chi-sq. df Prob.
FII 0.24 2 0.885
DII 1.12 2 0.568
All 1.56 4 0.814

Table 8: VAR Stability Check

Root Modulus
0.562988 - 0.091616i 0.570394
0.562988 + 0.091616i 0.570394
-0.394699 - 0.077348i 0.402207
-0.394699 + 0.077348i 0.402207
-0.088212 0.088212
0.072169 0.072169
No root lies outside the unit circle. VAR satisfies the
stability condition.

This shows that though FIIs and DIIs are the dominant investors in the market, they do not have the
independent ability to influence the market. This is an intriguing finding. The reason for this would be

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that they follow different trading strategies. Thus, when the market is down, FIIs sell, whereas DIIs buy
more. Therefore, the net effect on the market is neutral. Our results are contrary to the findings reported
by Bose (2012) that show that the past FII flows have significant explanatory power for mutual fund net
inflows. This shows that DIIs, particularly, mutual funds, acquired prominence in the stock market in the
recent years. Further, the negative influence of DIIs on FIIs shows that DIIs counteract the investment
reversal by FIIs, thereby act as a cushion against the destabilizing nature of FIIs, particularly, in times of
economic shocks. VAR Granger Causality test results presented in table 7 further confirm the results of
VAR estimation. As shown in the table, FIIs are caused by both DIIs and the market return. DIIs are
caused by market return, and the market return is not caused by either FIIs or DIIs. Table 8 shows that
VAR satisfies the stability condition.

7. CONCLUSION
The paper examines the behavior of FIIs and DIIs using the most recent high frequency trading data.
The study finds negative correlation between the flow of FIIs and DII, indicating that there exists
contrarian opinion among the FIIs and DIIs which is very critical for maintaining stability in the stock
market. The study shows that the trading strategies of FIIs and DIIs differ. While FIIs follow positive
feedback trading strategy, DIIs pursue the negative feedback trading strategy. Further, FIIs are
negatively caused by DII investment, which clearly suggests that DIIs counteract the withdrawal
pressure on the market caused by FIIs. Since they follow different trading strategies in the market, their
net trading activity would bring stability in the equity market, which is indicated by the fact that the
market return is not significantly affected by either FIIs or DIIs. These findings are significant from the
perspective of developing strong DIIs to act as a guard against the destabilizing nature FIIs flows.

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Appendix 1: Impulse Response Function

Response to Cholesky One S.D. Innovations ± 2 S.E.

Response of FII to FII Response of FII to DII Response of FII to SEN
1,200 1,200 1,200

800 800 800

400 400 400

0 0 0

-400 -400 -400

-800 -800 -800

1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

Response of DII to FII Response of DII to DII Response of DII to SEN

800 800 800

600 600 600

400 400 400

200 200 200

0 0 0

-200 -200 -200

-400 -400 -400

1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

Response of SEN to FII Response of SEN to DII Response of SEN to SEN

.008 .008 .008

.006 .006 .006

.004 .004 .004

.002 .002 .002

.000 .000 .000

-.002 -.002 -.002

1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

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