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Dissertation Report

on

A STUDY OF FOREIGN EXCHANGE MOVEMENT


AND ITS IMPACT ON FOREIGN INSTITUTIONAL
INVESTMENT AND INDIAN EQUITY MARKET

By

Sonam Mahajan

A0101909157

Under the supervision of


Dr. Anubha Srivastava
Senior Lecturer
Department of Finance

In the Partial fulfillment of Award of Master of Business


Administration

AMITY BUSINESS SCHOOL


AMITY UNIVERSITY, UTTAR PRADESH
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AMITY UNIVERSITY, UTTAR PRADESH

AMITY BUSINESS SCHOOL

DECLARATION

I do hereby declare that the project report titled ―STUDY OF FOREIGN EXCHANGE
MOVEMENT AND IT’S MPACT ON FOREIGN INSTITUTIONAL INVESTMENT
AND INDIAN STOCK MARKET‖ submitted by me in the partial fulfillment of the
requirement of MASTERS OF BUSINESS ADMINISTRATION of AMITY BUSINESS
SCHOOL, AMITY UNIVERSITY is exclusively prepared and conceptualized by me. It
is the original work of mine and has not been obtained from any other part.

DATE: Sonam Mahajan


Enrollment No:A0101909157
PLACE: Noida Program: MBA class of 2011
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AMITY UNIVERSITY, UTTAR PRADESH

AMITY BUSINESS SCHOOL

CERTIFICATE

I hereby certify that Sonam Mahajan, student of Masters of Business Administration at


Amity Business School, Amity University, Uttar Pradesh has completed dissertation on
―STUDY OF FOREIGN EXCHANGE MOVEMENT AND IT‘S MPACT ON
FOREIGN INSTITUTIONAL INVESTMENT AND INDIAN STOCK MARKET‖
under my guidance.

Dr. ANUBHA SRIVASTAVA

Senior Lecturer

Department of Finance
4

ACKNOWLEDGEMENT

On completing this project as I look back on the whole experience from its very
inception, I feel humbled.

At the onset, I want to express my deep gratitude to my faculty guide Dr. Anubha
Srivastava for her timely guidance and untiring efforts in helping me complete this study.
I am indebted to my guide who rendered her valuable advice, precious time, knowledge
and relevant information regarding the collection of material and whose suggestions and
guidance have made it a great experience working under her supervision.

I would also like to give the credit of successful completion of my project to Mr. Santosh
Kumar, who inspired me by discussions and showed me the right course to pursue. The
successful completion of the project would not have been possible without his constant
support.

Lastly thanks to all those whose names are not mentioned here but were directly or
indirectly involved in the project work, for their unrelenting encouragement.
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ABSTRACT

This project is a study of the Indian stock market, with reference to the foreign exchange
rate movement and Foreign Institutional Investment. The project lays emphasis on the
effect of FII on Indian stock market. It investigates the effect of macroeconomic and
micro economic events on foreign investment. A major portion of the study is devoted
towards investigating the volatility in the Indian equity market with respect to the Foreign
Institutional Investment triggers. This is studied through ARCH, GARCH, TARCH and
EGRACH models. Analyzing the data drives us to the conclusion that no ARCH,
GARCH, TARCH, and EGARCH effect exists in Indian stock market. Also, no strong
effect of exchange rate movement is seen on Foreign Institutional Investment.
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CONTENTS

Acknowledgement 4

Abstract 5

CHAPTERS

Chapter 1: Introduction 7
Chapter 2: Literature Support 24
Chapter 3: Methodology 30
Chapter 4: Data Analysis 33
Chapter 5: Conclusions and 40
Recommendations

Reference’s 43
7

CHAPTER 1

INTRODUCTION
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OVERVIEW OF INDIAN FINANCIAL MARKET

India Financial market is one of the oldest across the globe and is definitely the fastest
growing and best among all the financial markets of the emerging economies. The history
of Indian capital markets spans back 200 years, around the end of the 18th century. It was
at this time that India was under the rule of the East India Company. The capital market
of India initially developed around Mumbai; with around 200 to 250 securities brokers
participating in active trade during the second half of the 19th century.

The financial market in India at present is more advanced than many other sectors as it
became organized as early as the 19th century with the securities exchanges in Mumbai,
Ahmedabad and Kolkata. In the early 1960s, the number of securities exchanges in India
became eight - including Mumbai, Ahmedabad and Kolkata. Apart from these three
exchanges, there was the Madras, Kanpur, Delhi, Bangalore and Pune exchanges as well.
Today there are 23 regional securities exchanges in India.

The Indian stock markets till date have remained stagnant due to the rigid economic
controls. It was only in 1991, after the liberalization process that the India securities
market witnessed a flurry of IPOs serially. The market saw many new companies
spanning across different industry segments and business began to flourish.

The launch of the NSE (National Stock Exchange) and the OTCEI (Over the Counter
Exchange of India) in the mid 1990s helped in regulating a smooth and transparent form
of trading securities.

Indian financial market can be classified into two major segments:

 Money market
 Capital market

While the money market deals in short term credit, the capital market handles the
medium to long term credit.
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MONEY MARKET

The money market is a market for short-term funds, which deals in financial assets whose
period of maturity is upto one year. It should be noted that money market does not deal in
cash or money as such but simply provides a market for credit instruments such as bills of
exchange, promissory notes, commercial paper, treasury bills, etc. These financial
instruments are close substitute of money. These instruments help the business units,
other organizations and the Government to borrow the funds to meet their short-term
requirement.

Money market does not imply to any specific market place. Rather it refers to the whole
networks of financial institutions dealing in short-term funds, which provides an outlet to
lenders and a source of supply for such funds to borrowers. Most of the money market
transactions are taken place on telephone, fax or Internet. The Indian money market
consists of Reserve Bank of India, Commercial banks, Co-operative banks, and other
specialized financial institutions. The Reserve Bank of India is the leader of the money
market in India. Some Non-Banking Financial Companies (NBFCs) and financial
institutions like LIC, GIC, UTI, etc. also operate in the Indian money market.

CAPITAL MARKET

Capital Market may be defined as a market dealing in medium and long-term funds. It is
an institutional arrangement for borrowing medium and long-term funds and which
provides facilities for marketing and trading of securities. So it constitutes all long-term
borrowings from banks and financial institutions, borrowings from foreign markets and
raising of capital by issue various securities such as shares debentures, bonds, etc.

The market where securities are traded known as Securities market. It consists of two
different segments namely primary and secondary market. The primary market deals with
new or fresh issue of securities and is, therefore, also known as new issue market;
whereas the secondary market provides a place for purchase and sale of existing
securities and is often termed as stock market or stock exchange.
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INDIAN STOCK MARKET

Stock exchange is the term commonly used for a secondary market, which provide a
place where different types of existing securities such as shares, debentures and bonds,
government securities can be bought and sold on a regular basis. A stock exchange is
generally organised as an association, a society or a company with a limited number of
members. It is open only to these members who act as brokers for the buyers and sellers.
The Securities Contract (Regulation) Act has defined stock exchange as an ― association,
organisation or body of individuals, whether incorporated or not, established for the
purpose of assisting, regulating and controlling business of buying, selling and dealing in
securities‖.

The first organised stock exchange in India was started in Mumbai known as Bombay
Stock Exchange (BSE). It was followed by Ahmedabad Stock Exchange in 1894 and
Kolkata Stock Exchange in 1908. The number of stock exchanges in India went upto 7 by
1939 and it increased to 21 by 1945 on account of heavy speculation activity during
Second World War. A number of unorganised stock exchanges also functioned in the
country without any formal set-up and were known as kerb market. The Security
Contracts (Regulation) Act was passed in 1956 for recognition and regulation of Stock
Exchanges in India. At present we have 23 stock exchanges in the country. Of these, the
most prominent stock exchange that came up is National Stock Exchange (NSE). It is
also based in Mumbai and was promoted by the leading financial institutions in India. It
was incorporated in 1992 and commenced operations in 1994. This stock exchange has a
corporate structure, fully automated screen-based trading and nation-wide coverage.

Another stock exchange that needs special mention is Over The Counter Exchange of
India (OTCEI). It was also promoted by the financial institutions like UTI, ICICI, IDBI,
IFCI, LIC etc. in September 1992 specially to cater to small and medium sized companies
with equity capital of more than Rs.30 lakh and less than Rs.25 crore. It helps
entrepreneurs in raising finances for their new projects in a cost effective manner. It
provides for nationwide online ringless trading with 20 plus representative offices in all
major cities of the country.
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BOMBAY STOCK EXCHANGE

Bombay Stock Exchange is the oldest stock exchange in Asia What is now popularly
known as the BSE was established as "The Native Share and Stock Brokers' Association"
in 1875. Over the past 135 years, BSE has facilitated the growth of the Indian corporate
sector by providing it with an efficient capital raising platform.

The equity market capitalization of the companies listed on the BSE


was US$1.63 trillion as of December 2010, making it the 4th largest stock exchange in
Asia and the 8th largest in the world. The BSE has the largest number of listed companies
in the world. It has also been cited as one of the world's best performing stock market. As
of December 2010, there are over 5,034 listed Indian companies and over 7700 scrips on
the stock exchange, the Bombay Stock Exchange has a significant trading volume.

NATIONAL STOCK EXCHANGE

The National Stock Exchange (NSE) is India's leading stock exchange covering various
cities and towns across the country. NSE was set up by leading institutions to provide a
modern, fully automated screen-based trading system with national reach. The Exchange
has brought about unparalleled transparency, speed and efficiency, safety and market
integrity. It has set up facilities that serve as a model for the securities industry in terms
of systems, practices and procedures.

NSE is mutually-owned by a set of leading financial institutions, banks, insurance


companies and other financial intermediaries in India but its ownership and management
operate as separate entities. There are at least 2 foreign investors NYSE Euronext and
Goldman Sachs who have taken a stake in the NSE. As of 2006, the
NSE VSAT terminals, 2799 in total, cover more than 1500 cities across India. NSE is the
third largest Stock Exchange in the world in terms of the number of trades in equities. It
is the second fastest growing stock exchange in the world with a recorded growth of
16.6%.
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FOREIGN INSTITUTIONAL INVESTMENT

Foreign Institutional Investor (FII), defined by SEBI Regulation Act 1995, means an
institution established or incorporated outside India which proposes to make investment
in India in securities.

The foreign corporate or individuals who propose to invest their funds in India, can
belong to any of the following categories:

a. Pension funds

b. Mutual Funds

c. Investment Trusts

d. Insurance or reinsurance companies

e. Endowment Funds

f. University Funds

g. Foundations or Charitable Trusts or Charitable Societies who propose to invest


on their own behalf, and

h. Asset Management Companies

i. Nominee Companies

j. Institutional Portfolio Managers

k. Trustees

According to the SEBI Regulation Act, 1995, a Foreign Institutional Investor may invest
only in the following:-

(a) Securities in the primary and secondary markets including shares, debentures and
warrants of companies [unlisted], listed or to be listed on a recognised stock exchange in
India; and
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(b) Units of schemes floated by domestic mutual funds including Unit Trust of India,
whether listed on a recognised stock exchange or not,

(c) Dated Government Securities;

(d) Derivatives traded on a recognised stock exchange;

(e) Commercial paper;

(f) Security receipts;

The total investments in equity and equity related instruments (including fully convertible
debentures, convertible portion of partially convertible debentures and tradable warrants)
made by a Foreign Institutional Investor in India, whether on his own account or on
account of his sub-accounts, shall not be less than seventy per cent of the aggregate of all
the investments of the Foreign Institutional Investor in India, made on his own account
and on account of his sub-accounts.
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INDIA’S GOBALIZATION & FII

With the trade liberalization, came the process of liberalization of capital flows
management regulations. The FII framework was setup in the early 1990s, and further
rationalized by the late 1990s. The home bias of global equity portfolios against India
started getting alleviated by the early 2000s, a decade after the first opening to foreign
investors. Debt inflows and outward flows began in the late 1990s. FDI inflows began in
the early 1990s and have gathered momentum, particularly after India became important
to global private equity funds. In the year 2000-01 portfolio investments in India
accounted for over 37% of total foreign investment in the country and 47% of the current
account deficit. A significant part of these portfolio flows to India comes in the form of
Foreign Institutional Investors‘ (FIIs‘) investments, mostly in equities.

Ever since the opening of the Indian equity markets to foreigners, FII investments have
steadily grown from about Rs. 2600 crores in 1993 to over Rs. 1,40,059 crores in
November 2010. Their share in total portfolio flows to India grew to 32, 797 million $ in
2010.1 In tandem with the boom in stock markets and sound global scenario, investments
by FIIs into India were quite high in last few years, particularly since 2003-04. FIIs made
a record investment in the Indian equity market in 2009, surpassing the 2007 inflows.

While it is generally held that portfolio flows benefit the economies of recipient
countries, policy-makers worldwide have been more than a little uneasy about such
investments. Portfolio flows – often referred to as ―hot money‖ – are notoriously volatile
compared to other forms of capital flows. Investors are known to pull back portfolio
investments at the slightest hint of trouble in the host country often leading to disastrous
consequences to its economy.

India‘s foreign investment framework has been influenced by perceptions that foreign
investment is volatile and could respond sharply to adverse domestic events, thus
aggravating a domestic crisis. They have been blamed for making large and concerted

1
RBI Bulletin 2010
15

withdrawals thus giving early signs of weakness. They have been held responsible for
spreading financial crises- causing ‗contagion‘ in international financial markets.

There have been concerns regarding ‗abrupt and sudden outflows‘ regarding FII and their
destabilizing effects on financial market and Indian economy. A proper understanding of
the nature and determinants of these flows and the effect of domestic events on these
flows is essential. In an attempt to address the issue, the paper undertakes the analysis of
various events to understand FII investment flows to India.
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FII TRENDS OVER THE PAST 10 YEARS

Since the time FIIs were allowed to invest in Indian markets, their participation has
increased except in 1998-99 and 2008-09.
The gross purchases of debt and equity by FIIs increased by 37.7 percent Rs.8,46,438
crore in 2009-10 from Rs.6,14,579 crores in 2008-09. The combined gross sales by FIIs
increased by 6.6 percent Rs7,03,780 crores from Rs .6,60,389 crores during the same
period in previous year. The total net inflow of FII was Rs.1,42,658 crore in 2009-10 as
against an outflow of FII was Rs.45,811 crore in 2008-09. This was the highest net
inflow for any financial year so far.2 The following table gives details about the Foreign
Institutional Investments in India.

YEAR GROSS GROSS SALES NET


PURCHASES (crores) INVESTMENT
(crores) (crores)
1992-93 18 4 13
1993-94 5,593 467 5127
1994-95 7,631 2835 4796
1995-96 9,694 2752 6942
1996-97 15,554 6980 8575
1997-98 18,695 12,737 5958
1998-99 16,116 17,699 -1,584
1999-00 56,857 46,735 10,122
2000-01 74,051 64,118 9,933
2001-02 50,071 41,368 8,763
2002-03 47,062 44,372 2,689
2003-04 1,44,855 99,091 45,764
2004-05 2,16,951 1,71,071 45,880
2005-06 3,46,976 3,05,509 41,467
2006-07 5,20,506 4,89,665 30,841

2
SEBI Annual Report 2010
17

2007-08 9,48,018 8,81,839 66,179


2008-09 6,14,576 6,60,386 -45,811
2009-10 8,46,438 7,03,780 1,42,658
SOURCE: SEBI Annual Report 2010

Trends in Foreign Institutional Investment


80000

60000
FII Net Investment (crore)

40000

20000

-20000

-40000

-60000

FIIs withdrew huge amounts in times of Global financial crisis from Indian capital
market. From being net investors in 2007-08, investing a sum of Rs. 62,584 core, they
became net sellers in 2008-09. The table below details the investments by FIIs pre and
post global crisis.

YEAR NET INVESTMENT


(CRORES)
2006-07 23,755

2007-08 62,584
18

2008-09 -43,338

2009-10 1,14,901

SOURCE: RBI Statistics

2009-10 saw FIIs becoming net investors, investing a total of Rs 1,10,220 crores in
Indian equity market. Month-wise the net FII was highest in equity segment in May 2009
(Rs 20,017 crore) followed by March 2010 (Rs.19,928 crore) and September
2009(Rs.18,344 crore). Indian capital market saw FIIs becoming net sellers only in one
month, i.e., January, 2010.

MONTH NET INVESTMENT BY FIIs IN


EQUITY (crores)
April-09 6,508
May-09 20,177
June-09 3,830
July-09 11,066
Aug-09 4,903
Sep-09 18,344
Oct-09 9,077
Nov-09 5,497
Dec-09 10,233
Jan-10 -500
Feb-10 1,217
March-10 19,928
SOURCE: SEBI Annual Report 2010

These inflows can be attributed to the quick recovery, post Lehman, in the capital
markets in India. Significantly, by December 31, 2009, FIIs' net investment in the
domestic bourses had touched a record Rs 80,500 crore, the highest ever inflow in rupee
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terms in a single year. This reflects the confidence that the investors had in the India‘s
growth. The total investment made by FIIs in the domestic equity market in the April-
December period of 2009 stood at Rs 89,576 crore. These fund houses had pulled out a
net Rs 41,555 crore from Indian stocks in April-December period of 2008-09.
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INDIAN ECONOMY AND BEHAVIOR OF FIIs

FIIs are believed to cause volatility in Indian Stock Market. One of the major impulse
behind India‘s reluctant capital account liberalisation is a fear of an en masse exit by
foreign investors from the Indian economy. We would now address these issues with the
empirical data available for investigation.

Most important issue to examine is if FIIs exit en masse at times of domestic stress. The
following table shows information about net FII flow during the recent times of domestic
stress.

Net FII Flows (Rs. Crores) Percent to market


EVENTS capitalization
T-1 T T+1 T-1 T T+1
Parliament -91.0 78.8 -90.4 -0.015 0.012 -0.015
Attack
12-12-2001
Gujrat Riots 141.8 178.8 -2.9 0.020 -0.025 -0.001
27-02-2002
UPA -295.1 -604.4 -504.4 -0.029 -0.060 -0.050
Government
13-05-2004
Mumbai -436.0 Holiday 419.4 -0.015 NA 0.015
Attacks
26-11-2008
SOURCE:FII WORKING GROUP REPORT, MINISTRY OF FINANCE

In each of the above cited events of domestic stress, relatively small values are seen for
the net sales by FIIs. Formation of UPA government saw largest values involving net
sales of 0.11 percent of market capitalization on the event date (‗T‘) and the following
day (‗T+1‘) associated with the formation of the UPA government in 2004. We can thus
21

say that the scenario of massive sales by foreigners when India is experiencing
difficulties does not fit the evidence we examined.

Another major event from which the insights into the en masse exit by FII can be
obtained is the disclosure of the corporate governance fraud by Satyam Computer
Services in December 2008. The investors did not appear to generalize from these events
to India at large. There was no large scale exit. However, reallocation to other software
companies was seen while maintaining the industry weights of the overall portfolio.3

While investigating about the events that could have led to the en masse exit of FIIs, one
can not forget to mention the Lehman Crisis. The table below displays the data for FII
activity during the crisis. The biggest exit in this data was in October 2008, of Rs.16,296
crores of equity capital. However, in October 2008 FIIs (as a whole) purchased Rs.52,104
crores of shares and sold Rs.68,310 crores.

MONTH GROSS BUY GROSS SELL NET BUY


(Rs. Crores) (Rs. Crores) (Rs. Crores)

July 2008 70,592 68,010 2,582

August 2008 48,914 49,792 -877

September 2008 75,214 80,061 -4,846

October 2008 52,014 68,310 -1,62,96

November 2008 37,746 36,383 1,363

December 2008 38,925 36,979 1,945

SOURCE: SEBI

3
Working group Report on FII, Ministry of Finance
22

FII Acitivity during Lehman Crisis


2,582 1,945
1,363

Jul-08 Aug-08 Sep-08 Oct-08 Nov-08 Dec-08


-877
-4,846

-16296.00

Taking into consideration the macroeconomic issues, we begin by talking about the
currency exposures of the firms. Different theories on currency exposures of the firms
exist. One view involves thinking that India is mostly closed and that firms are relatively
unsophisticated about addressing exchange rate risk. An alternative view involves
thinking that India is substantially open, and that the firms are quite concerned about
exchange rate risk. The table below shows the analysis of how currency exposure of large
Indian firms varied across changes in exchange rate regime.4

PERIOD INR/USD AVERAGE


VOLATILITY CURRENCY RISK OF
THE FIRM
1 April 1993 – 17 Feb 1995 0.16 5.889

17 Feb 1995 – 21 Aug 1998 0.93 0.540

21 Aug 1998- 19 March 0.29 3.753


2004
19 March 2004- 31 March 0.64 2.066
2008

4
Working Group Report on FII, Ministry of Finance
23

The table suggests that when the central bank has an exchange rate regime with reduced
exchange rate flexibility, and a country‘s capital account is sufficiently open, firms are
alert and able to modify their currency risk to exploit opportunities presented to these
firms. Indian multinationals handling of currency risk patterns then suggest relative
agility in managing changes in the exchange rate.
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CHAPTER 2

LITERATURE SUPPORT
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Rajput Ajaysingh and Thaker Keyur (2007)1 measured the relationship between
exchange rate, FII and stock index. The period used for the analysis is from January 2000
to December, 2005. Simple correlation and regression analysis were used and it was
found that no long run positive correlation exists between exchange rate and Stock Index
except for year 2002 and 2005. FII and Stock Index show positive correlation, but fail to
predict the future value.

Chakraborty Tanupa (2007)2 investigated whether FII flows affect or are affected by
domestic stock market returns. With the application of various stochastic tools such as
granger causality test she found that FII flows are more an effect than a cause of the stock
market returns in India.

Pal Parthapratim (2006)3 examined the impact of Foreign Portfolio Investment on


India‘s economy and industry. The findings of this paper show that the perceived benefits
of foreign portfolio investment have not been realized in India. The study found that the
entry of foreign portfolio investors will boost a country's stock market and consequently
the economy, does not seem be working in India. The influx of FIIs has indeed
influenced the secondary market segment of the Indian stock market. But the supposed
linkage effects with the real economy have not worked in the way the mainstream model
predicts. Instead there has been an increased uncertainty and skepticism about the stock
market in this country.
On the other hand, the surge in foreign portfolio investment in the Indian economy has
introduced some serious problems of macroeconomic management for the policymakers.
Uncertainty and volatility associated with FPI have not only reduced the degrees of
maneuverability available to the policymakers but have also forced them to take some
measures which impose significant fiscal cost on the economy.

Chakrabarti Rajesh4 analyzed these flows and their relationship with other economic
variables and found that while the flows are highly correlated with equity returns in India,
they are more likely to be the effect than the cause of these returns; the FIIs do not seem
to be at an informational disadvantage in India compared to the local investors; the Asian
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Crisis marked a regime shift in the determinants of FII flows to India with the domestic
equity returns becoming the sole driver of these flows since the crisis.

Bhattacharya Basabi5 examined the cause and effect relationship between the stock
prices and macroeconomic aggregates in the foreign sector in India. The causal
relationship between BSE sensitive index and other three variables, viz., exchange rate,
foreign exchange reserves and value of trade balance using monthly data for the period
1990-91 to 2000-01 was established by applying the techniques of unit–root tests,
cointegration and the long–run Granger non–causality test proposed by Toda and
Yamamoto (1995). They concluded that no causal relationship exists between stock
prices and three variables considered.

Nath Golaka and Samanta G. (2003)6 examined causal relationship between the returns
in the stock market and Forex market in India, using daily data from March 1993 to
January 2002. They concluded that a weak causal link exists between the two, though, in
recent years, there has been a strong causal influence from stock market return to forex
market return. The authors, while giving explanations for the existence of relationship,
cited portfolio balance approach as alternative explanation. They said that blooming stock
market attracts capital flows from foreign investors, which may cause an increase in the
demand for a country‘s currency leading to appreciation of local currency. The reverse
happens in case of falling stock prices where the investors try to sell their stocks to avoid
further losses and convert their money into foreign currency to move out of the country
leading to increasing demand for foreign currency resulting in depreciation of local
currency.
Moreover, foreign investment in domestic equities could increase over time due to
benefits of international diversification that foreign investors would gain. Furthermore,
movements in stock prices may influence exchange rates and money demand because
investors‘ wealth and liquidity demand could depend on the performance of the stock
market.

Kumar Manish (2009)7 examined dynamic relation between stock index and exchange
rate by using the daily data for India. The long run relationship between the two variables
27

is tested with the help of unit root and cointegration tests. To examine the dynamic
relationship between the variables, the study also uses linear and nonlinear granger
causality tests after removing the volatility dependence from the series. The nonlinear
granger causality between stock index and exchange rate was investigated by using
bivariate noisy Mackey Glass model. The empirical evidence suggested that there is no
long-run relationship; however, there is bidirectional linear and nonlinear granger
causality between stock index and exchange rates. The findings of the study strongly
support the micro and macroeconomic approach on the relationship between exchange
rates and stock prices.

Reddy Y. and Sebastin A. (2008)8, made an attempt to study the interaction between the
stock and the forex markets in India by computing transfer entropy between daily data
series of the 5- stock index of NSE, viz., Nifty and the exchange rate of Indian Rupee vis-
à-vis US Dollar, viz., Reserve Bank of India reference rate. They divided the entire
period—November 1995 to March 2007—selected for the study, into three sub-periods
for the purpose of analysis, considering the developments that took place during these
sub-periods. They found that only low levels of interactions between the stock market
and the forex market of India exist. Also, they found that the flow from the stock market
to the forex market is more pronounced than the flow in the reverse direction.

Mishra Alok, Swain Niranjan, and Malhotra D. (2007)9 provided useful insights into
how information is transmitted from stock market to foreign exchange market and vice
versa. This paper explored volatility spillovers between the Indian stock and foreign
exchange markets. The results indicate that there exists a bidirectional volatility spillover
between the Indian stock market and the foreign exchange market with the exception of
S&P CNX NIFTY and S&P CNX 500. The findings of the study also suggest that both
the markets move in tandem with each other and there is a long run relationship between
these two markets. The results of significant bidirectional volatility spillover suggest that
there is an information flow (transmission) between these two markets and both these
markets are integrated with each other.
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Muhammad Naeem and Rasheed Abdul10 examined whether stock prices and
exchange rates are related to each other or not. Both the long-run and the short-run
association between these variables are explored by the authors. The study uses monthly
data on four South Asian countries, including Pakistan, India, Bangladesh and Sri- Lanka,
for the period January 1994 to December 2000. Tools such as cointegration, vector error
correction modeling technique and standard Granger causality tests were employed to
examine the long-run and short-run association between stock prices and exchange rates.
The results of this study show no short-run association between the said variables for all
four countries. There is no long-run relationship between stock prices and exchange rates
for Pakistan and India as well. However, for Bangladesh and Sri Lanka there appear to be
a bi-directional causality between these two financial variables.

Rai Kulwant and Bhanumurthy N. (2004)11 examined the impact of huge volumes of
FII flow on the domestic markets. They analyzed monthly data and found that FII inflow
depends on stock market returns, inflation rates and ex-ante risk. In terms of magnitude,
the impact of stock market returns and the ex-ante risk turned out to be the major
determinants of FII inflow. However, the study did not find any causative link running
from FII inflow to stock returns. Stabilizing stock market volatility and minimizing the
ex-ante risk would help to attract more FII, an inflow of which has positive impact on the
real economy.

Pandian Punithavathy, Jeyanthi Q (2009)12 examined the volatility of the Indian Stock
Market. They made an attempt to analyze the return and volatility of Indian stock market.
10 year data from 1998-2008 was taken and various parameters of volatility were
assessed.

Mishra P. K. (2010)13 examined the volatility of the Indian capital market in the
aftermath of global market slowdown. The paper investigated the nature and
characteristics of stock return volatility in the capital market of India using GARCH
models. The results provide the evidence of time varying stock return volatility over the
sample period spanning from January 1991 to August 2009. It is further found that the
effect of bad news is relatively greater in causing market volatility in India.
29

Mala Rajni, R. Mahendra (2007)14 used the ARCH models and its extension to find out
the presence of the stock market volatility on Fiji‘s stock market. The analysis was done
using a time series data for the period 2001-2005 on specific firms and it was found out
that seven out of the sixteen firms listed on Fiji‘s stock market is volatile. The volatility
of stock returns were then regressed against the interest rates and the results showed that
the interest rates changes have a significant effect on stock market volatility. Using a
priori theory and knowledge, the impact of factors like government regulations, low
levels of liquidity on volatility were also derived.

P. Puja (2006)15 made an attempt to explain the stock market volatility at the individual
script level and at the aggregate indices level. The empirical analysis has been done by
using Autoregressive conditional heteroscedasticity model (ARCH), Generalised
autoregressive conditional heteroscedasticity (GARCH) model and ARCH in Mean
model and it is based on daily data for the time period from January 1990 to November
2004. The analysis reveals the same trend of volatility in the case of aggregate indices
and five different sectors such as electrical, machinery, mining, non-metalic and power
plant sector.
30

CHAPTER 3

METHODOLOGY
31

PURPOSE OF THE STUDY

The purpose of the project is to study the Indian stock market with respect to foreign
exchange movement and FII in India. The project analyzes the impact of exchange rate
movement on FII in India. A major portion of the study is dedicated towards studying the
volatility of FII in Indian Stock Market. Also, emphasis is laid on understanding of the
behavior of Foreign Institutional Investors in India in terms of various macroeconomic
and microeconomic events.

The project thus aims to develop a relationship between the foreign exchange movement
and Foreign Institutional Investment and study its volatility on Indian Stock Market.

SCOPE OF THE STUDY

The project gives an insight on the relationship between the foreign exchange movement,
FII and hence Indian Stock Market. The use of the causality tools to establish the
relationship between the variables provides econometric support to the relationship
established. The project is highly beneficial to the investors in the sense that it provides
them with the detailed mechanism about the manner in which FII affects Indian Stock
Market and the manner in which it is influenced by exchange rate movement.

METHODOLOGY

Research objectives

The objective of the research is as follows:

 To establish a relationship between exchange rate movement and FII.


 To study the volatility caused by FII on Indian Stock Market.
32

Research Design

The methodology involves a descriptive research design. The study is carried out through
secondary data. 10 year data on Exchange Rate Movement, FII and Stock Index (S&P
CNX) was collected and analyzed to establish relationship and study the volatility effect.

The analysis for the project is divided into two parts. In the first part, impact of foreign
exchange movement is studied on FII by establishing correlation and regression between
the two variables. 10 year monthly data of exchange rate movement and FII was used. In
the second part, volatility of FII on Indian stock market is studied. 10 year daily data is
used to arrive at the results. Emphasis has been laid on studying the volatility in Indian
stock market.

The detailed discussion on the tools used is done in the subsequent chapters.

Source of data

The data has been obtained from the authentic website:

 www.nseindia.com
 www.sebi.gov.in
 www.rbi.org.in

LIMITATIONS OF THE STUDY

The project has the following limitations

 Due to limited time frame an extensive model could not be developed.


 Due the limitations of the software, large amount of data could not be processed.
 There is a requirement of high end programming skills, which can add value to
the existing analysis.
33

CHAPTER 4

DATA ANALYSIS
34

PART I: IMPACT OF FOREIGN EXCHANGE MOVEMENT ON FII


IN INDIA

10-year data of monthly exchange rate movement and monthly FII net purchases was
collected and analysed to check if there exists any correlation and regression between
them. Following results were obtained when the data was processed through SPSS.

CORRELATION

H0= No significant relation exists between net FII purchases and Exchange rate.

H1= Significant correlation between the variables exists.

Net FII Exchange Rate


Purchases

Net_purchases Pearson’s correlation 1 -0.068


Sig. (2 tailed) 0.442
N 132 132

Ex_Rate Pearson’s correlation -0.068 1


Sig. (2 tailed) 0.442
N 132 132

The Pearson‘s correlation between Net FII Purchases and Exchange Rate movement
comes out to be -0.068. The figure indicates that a weak –ve linear association exists
between the variables. The correlation coefficient found is insignificant (since p=0.442).
Thus we would accept the null hypothesis and say that no correlation exists between the
variables.
35

REGRESSION

H0 = No significant dependency of FII on foreign exchange movement exits.

H1 = FII is dependent on foreign exchange rate movement.

R R square Adjusted R Std. Error of


Square the Estimate

0.068 0.005 -0.003 6726.67149

ANNOVAb
Model Sum of Degrees of Mean F Sig.
squares freedom square

Regression 2.693E7 1 2.693E7 0.595 0.442a


Residual 5.882E9 130 4.525E7
total 5.909E9 131
a: predictors: (constant), ex_rate
b: Dependent variable: net_purchases_or_sales

We need to find whether the regression is significant or not. This is found with the help
of ANNOVA table under Sig. This comes out to be 0.442, which implies that the
regression is insignificant. Thus we can say that significant proportion of variability in
FII cannot be accounted by variability in exchange rate movement. Hence the amount
that foreign investors invest in India is not governed by exchange rate movement.
36

PART II: STUDY OF VOLATILITY OF FII ON INDIAN STOCK


MARKET

The volatility of FII on Indian stock market is studied with the help of GARCH, TARCH
and EGARCH models. We study the volatility of the Indian equity market with respect to
trigger NFIIPT.

An equation for RT is formed as

RT= C + NFIIPT

where,

RT is the return on equity, given by , C is a constant (intercept on x-axis),

NFIIPT is the net FII purchases (NFIIPT= FII purchases- FII sales).

We would now apply the simple GARCH model.

We examine the GARCH and the ARCH effect. Hence, we have the following hypothesis

H0 = There is no ARCH effect (lagged value dependence)

H1 = Significant ARCH effect exists.

H0 = There is no GARCH effect (forecasting error)

H1 = GARCH effect exists.

Coefficient Standard z-statistics Probability


error
C 0.007985 0.011877 0.672298 0.5014

NFIIPT 3.419401 0.177246 19.29185 0.0000

VARIANCE EQUATION
C 0.015512 0.001828 8.484566 0.0000
37

ARCH(1) 0.145291 0.010129 14.34440 0.0000

GARCH(1) 0.833452 0.010032 83.07877 0.0000

R-squared 0.051259 Mean dependent 0.019355


variance
Adjusted R-squared 0.049632 S.D. dependent 0.784076
variance
S.E. of regression 0.764371 Akaike info criterion 1.992821
Sum squared residual 1363.085 Schwarz criterion 2.005133
Log likelihood -2324.608 F-statistic 31.51182
Durbin-Watson stat 1.929166 Prob(F-statistic) 0.000000

The value of ARCH(1) comes out to be 0.1453 and p=0.0000. For p<0.05, we would
reject the null hypothesis and accept the alternate. Thus, we can conclude that lagged
value dependency exists. In other words, we can say that present values are dependent on
the past values.

The value of GARCH(1) comes out to be 0.833 and p=0.0000. We would again reject the
null hypothesis and accept the alternate. Thus, forecasting error exists. Hence we can
conclude that the actual return on equity deviates significantly from the forecasted value.

The total value of ARCH(1) and GARCH(1) comes out to be around 0.98 (≈1), thus we
can say that volatility shocks are persistent in the market i.e; such shocks keep coming in
the market.
38

EGARCH Model

The hypothesis for the model is as follows:

H0 = Long term memory effect does not exist in the market.

H1 = There is significant long term memory effect in the market.

Coefficient Standard z-statistics Probability


error
C -0.017388 0.011410 -1.523924 0.1275

NFIIPT 3.653460 0.177901 20.53648 0.0000

VARIANCE EQUATION

C -0.236422 0.015250 -15.50267 0.0000

|RES|/SQR[GARCH](1) 0.250987 0.016558 15.15779 0.0000

RES/SQR[GARCH](1) -0.129276 0.012114 -10.67206 0.0000

EGARCH(1) 0.949672 0.004953 191.7219 0.0000

R-squared 0.053942 Mean dependent 0.019355


variance
Adjusted R-squared 0.051914 S.D. dependent 0.784076
variance
S.E. of regression 0.763453 Akaike info criterion 1.966013

Sum squared resid 1359.229 Schwarz criterion 1.980787

Log likelihood -2292.269 F-statistic 26.59318


Durbin-Watson stat 1.936632 Prob(F-statistic) 0.000000

The EGARCH coefficient is RES/SQR, which is 0.2509 and p=0.000, thus we reject the
null hypothesis. Accepting the alternate hypothesis implies that long term memory exits
in the market. In other words we can say that history repeats itself.
39

TARCH model

The hypothesis for the TARCH model is:

H0 = There is symmetry in the performance of the market in times of good news and bad
news.

H1 = No symmetry in market exists.

Coefficient Standard z-statistics Probability


error
C -0.015104 0.012506 -1.207656 0.2272

NFIIPT 3.567475 0.182215 19.57840 0.0000

VARIANCE EQUATION
C 0.018789 0.002012 9.336561 0.0000
ARCH(1) 0.040435 0.010480 3.858291 0.0001

(RESID<0)*ARCH(1) 0.184950 0.020413 9.060273 0.0000


GARCH(1) 0.833956 0.010767 77.45784 0.0000

R-squared 0.053392 Mean dependent 0.019355


variance
Adjusted R-squared 0.051362 S.D. dependent 0.784076
variance
S.E. of regression 0.763675 Akaike info criterion 1.971190
Sum squared residual 1360.020 Schwarz criterion 1.985964

Log likelihood -2298.321 F-statistic 26.30652

Durbin-Watson stat 1.934728 Prob(F-statistic) 0.000000

We check the value of residual, it is 0.1849 with p= 0.0000. For p< 0.05, we would reject
the null hypothesis and accept the alternate. Thus asymmetry in market exists , i.e; the
market behaves differently in response to the good news and bad news. Impact of bad
news is higher than the impact of good news, or the speed with which the market
dwindles is higher than the speed with which the market retraces.
40

CHAPTER 5

CONCLUSIONS AND
RECOMMENDATIONS
41

CONCLUSIONS

Indian equity market saw huge inflows from Foreign Institutional Investors over the
recent times. The SENSEX touched the 20,000 level and NIFTY crossed 6150 level in
October 2010 due to huge foreign inflow. FIIs invested more than Rs 27500 crores in
Indian equity market since 6th September, 2010 till 30th September 2010. However
recently, they withdrew a lot of amount from the market. The total number of FIIs
registered with the Securities and Exchange Board of India (SEBI) dropped in past four
months to 1,702 as on March 1, 2011 against 1,741 FIIs as on October 29, 2010. The
number is lower even when compared with 1,713 FIIs registered as on March 31, 2010.
Such fluctuations in FII investment saw the Indian stock market touching the benchmark
levels at one point of time and dwindling down to the lows, the other point of time. Such
variations in the performance of the equity market lead me to investigate the volatility of
FII on Indian Equity market.

We found that

 The current returns of the equity market are dependent on the lagged values of
FII.
 The return on equity forecasted taking into consideration FII trigger differs vastly
from the actual returns of the market.
 The past events leave a long lasting impression on the market. The market
performance is governed by the belief that the historical events can repeat
themselves.
 The market performs differently to the good news and the bad news. Bad news
has a higher impact on the market. With any bad news in the market, FIIs are seen
withdrawing their money from the market which in turn affects the performance
of the market.

Also, I investigated the impact of foreign exchange movement on FII in India. The results
obtained for the relationship were negative thereby implying that FII is not governed by
foreign exchange movement.
42

RECOMMENDATIONS

The investigation revealed that FII flows have the ability to affect the sources of funds in
Indian capital market, strengthen the liquidity system, improve the efficiency of the
company, and motivate the Indian companies to adopt modern financial techniques and
international best practices. Thus, the role of FII on developing Indian market can not be
ignored.

India, being a capital scarce country needs huge foreign investments for the development
of the country. However, the easy exit route brings an element of uncertainty in these
types of inflows. Thus, Indian policy makers should adopt policies that should, on the one
hand, attract more Foreign Institutional Investments in India with being more cautious on
the other hand. They can liberalize the FII policy by bringing built-in-cushion within the
system that would weaken the destabilizing effect of sudden reversals.
43

REFRENCES

JOURNALS

1. Exchange rate, FII and stock index relationship in India, XIMB Journal, March
2008.
2. Foreign Institutional Investors Flows and Indian Stock Market returns- A cause
and effect relationship study; Indian Accounting Review, Vol. 11, No. 1, June
2007, pp 35-48.
3. Foreign Portfolio Investment, Stock market and Economic Development: a case
study of India; Annual conference on Development and Change Mission:
Promoting Development in a Globalized world, Brazil, November 2006.
4. FII Flows to India: Nature and Causes; Money and Finance2, No. 7.
5. Causal Relationship between Stock market and Exchange rate, Foreign Exchange
Reserves and value of Trade Balance: A case study of India.
6. Relationship between Exchange rate and Stock prices in India- An empirical
Analysis, January 2003.
7. A Bivariate Linear and Non-linear Causality between Stock prices and Exchange
Rates; Economics Bulletin, Vol. 29, No. 4, pp 2884-2895.
8. Interaction between Forex and Stock market in India: An Entropy Approach.
9. Volatility Spillover between Stock and Foreign exchange market: Indian
Evidence; International Journal of Economics, 2007.
10. Stock prices and Exchange Rate: Are they related? Evidence from South Asian
Countries.
11. Determinants of FII in India: The role of Return, Risk and Inflation; The
Developing Economies, XLII-4, December 2004, pp 479-93.
12. Stock Market Volatility in Indian stock exchanges, indiastat.com, May- June
2009.
13. A GARCH model approach to capital, market volatility: A case study for India;
Indian Journal of Economics & Business, September 2010, Vol. 9, Issue 3.
44

14. Measuring Stock market volatility in an Emerging economy; International


Research Journal of Finance & Economy, 2007, Issue 8.
15. Stock market volatility in India: A case of select scripts, 2007

REPORTS
16. Working Group report on FII, Ministry of Finance, Government of India.
17. Annual Report, 2009-10, SEBI
18. Monetary Policy Review, February 2011, Reserve Bank of India.

WEBSITES
19. www.nseindia.com
20. www.rbi.org
21. www.sebi.gov.in
22. www.moneycontrol.com

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