IMPACT OF FII ON STOCK MARKET

A PROJECT REPORT ON

IMPACT OF FII ON STOCK MARKET A PROJECT REPORT Submitted by ASHOK AMIPARA (09003) VIMAL BODA (09018) BATCH – 2009-2011 To Director (PGDM) In partial fulfillment of the requirements of Tolani Institute of Management Studies, Adipur For the award of the degree of Post Graduate Diploma in Management

Tolani Institute of Management Studies Adipur – 370 205 FEBRUARY 2011 Tolani Institute of Management Studies

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DECLARATION

We hereby declare that the project work entitled “IMPACT OF FII ON STOCK MARKET” Submitted to Tolani Institute of Management Studies, Adipur is a record of an original work done by me under the guidance of Prof. Hitendra Lachhwani and this project work is not submitted for the award of any other degree/diploma/associate ship/fellowship or seminar award.

Ashok Amipara Vimal boda 14-02-2011 ADIPUR

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Executive Summery Title

:

Objectives

“IMPACT OF FII ON STOCK MARKET” :

Primary Objective: To study the impact of FII on Indian stock market. To understand the concept of BSE sensitive index.

Secondary Objective: To understand the concept of FIIs. To understand the relationship between the Sensex and FII. To know the sector which get affected more by activities of FIIs.

Research Methodology: • Research problem • Research design • Sampling design • Data collection method

ResearchProblem: The project deals with the “Impact of Foreign Institutional Investors on Indian Stock Market”. This research project studies the relationship between FIIs investment and stock indices. For this purpose India’s two major indices i.e. Sensex and S&P CNX Nifty are selected. These two indices, in a way, represent the picture of India’s stock markets. Five indices of BSE i.e. BSE Auto, BSE Bankex, BSE IT, BSE FMCG, BSE Oil and Gas are also selected so as to further observe the effect of FII in particular industry . So this project reveals the impact of FII on the Tolani Institute of Management Studies

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Indian

capital

market.

There may be many other factors on which a stock index may depend i.e. Government policies, budgets, bullion market, inflation, economic and political condition of the country, FDI, Re./Dollar exchange rate etc. But for this study I have selected only one independent variable i.e. FII. This study uses the concept of correlation, regression and hypothesis to study the relationship between FII and stock index. The FII started investing in Indian capital market from September 1992when the Indian economy was opened up in the same year. Their investments include equity only. The sample data of FIIs investments consists of daily basis from January 2001

to

February

2011.

RESEARCHDESIGN: Null Hypothesis (Ho): The various BSE indices and S&P CNX Nifty index does not rise with the increase

in

FIIs

investment.

Alternate Hypothesis (Ha): The various BSE indices and S&P CNX Nifty index rises with the increase

in

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FIIs

investment.

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Exploratory Research: As an exploratory study is conducted with an objective to gain familiarity with the phenomenon or to achieve new insight into it, this study aims to find the new insights in terms of finding the relationship between FII’S and Indian Stock Indices. SAMPLING DESIGN: • Universe In this study the universe is finite and will take into the consideration related news and events that have happened in last few year. • Sampling Unit: As this study revolves around the foreign institutional investment and Indian stock market. So for the sampling unit is confined to only the Indian stock market.

Data collection Method: Secondary data: For the secondary data various literatures, books, journals, magazines, web links are used. As there are not possibilities of collecting data personally so no questionnaire is made.

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RESEARCH ANALYSIS TOOLS: Regression analysis and Correlation analysis: Regression Analysis: We can analyze how a single dependent variable is affected by the values of one or more independent variables — for example, how an athlete's performance is affected by such factors as age, height, and weight. Correlation: This analysis tool and its formulas measure the relationship between two data sets that are scaled to be independent of the unit of measurement. We can use the Correlation tool to determine whether two ranges of data move together — that is, whether large values of one set are associated with large values of the other (positive correlation), whether small values of one set are associated with large values of the other (negative correlation), or whether values in both sets

are

unrelated

(correlation

near

zero).

Finding & Analysis: According to findings and results, we can conclude that FII have positive correlation with NIFTY & SENSEX as well as other sectorial indices but did not have any significant impact on the Indian capital market. Recommendations: After the analysis of the project study, following recommendations can be made: 1) Simplifying procedures and relaxing entry barriers for business activities and providing investor friendly laws and tax system for foreign investors. 2) Allowing foreign investment in more areas. In different industries indices the FIIs should be encouraged through different patterns. 3) Somewhere, a restriction related to the track record of Sub- Accounts is also to be made on the investors who withdraw money out of the Indian stock market who have invested with the help of participatory notes. 4) We have to modernize and also have to save our culture. Similarly the laws should be such that it protect domestic investors and also promote trade in country through FIIs. 5) Encourage industries to grow to make FIIs an attractive junction to invest.

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CONTENT

NO.

Particulars Executive summary Introduction of FII in India Literature review FII and Government policies Role of FII in capital market in India Determinants of FII Portfolio Investment FII:A cost benefit analisis A study of major episodes of volatility Objective of project Methodology Finding Conclusion Recommendations Bibliography

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Page No.

List of Table No.

Particular

1

No. of FII registered with SEBI

2

FII investment in India

3

FII behavior during East Asian crisis

4

FII behavior in the aftermath Pokhran Nuclear Explosion

5

FII behavior during the stock market scam 2001

6

FII behavior around Black Monday, May 17 2004

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Page No.

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INTRODUCTION: Financial markets are the catalysts and engines of growth for any nation. India’s financial market began its transformation path in the early 1990s. The banking sector witnessed sweeping changes, including the elimination of interest rate controls, reductions in reserve and liquidity requirements and an overhaul in priority sector lending. Persistent efforts by the Reserve Bank of India (RBI) to put in place effective supervision and prudential norms since then have lifted the country closer to global standards. Around the same time, India’s capital markets also began to stage extensive changes. The Securities and Exchange Board of India (SEBI) was established in 1992 with a mandate to protect investors and usher improvements into the microstructure of capital markets, while the repeal of the Controller of Capital Issues (CCI) in the same year removed the administrative controls over the pricing of new equity issues. India’s financial markets also began to embrace technology. Competition in the markets increased with the establishment of the National Stock Exchange (NSE) in 1994, leading to a significant rise in the volume of transactions and to the emergence of new important instruments in financial intermediation. Indian investors have been able to invest through mutual funds since 1964, when UTI was established. Indian mutual funds have been organized through the Indian Trust Acts, under which they have enjoyed certain tax benefits. Between 1987 and 1992, public sector banks and insurance companies set up mutual funds. Since 1993, private sector mutual funds have been allowed, which brought competition to the mutual fund industry. This has resulted in the introduction of new products and improvement of services. The notification of the SEBI (Mutual Fund) Regulations of 1993 brought about a restructuring of the mutual fund industry. An arm’s length relationship is required between the fund sponsor, trustees, custodian, and asset Management Company. This is in contrast to the previous practice where all three functions, namely trusteeship, custodianship, and asset management, were often performed by one body, Usually the fund sponsor or its subsidiary. The regulations prescribed disclosure and advertisement norms for mutual funds, and, for the first time, permitted the entry of private sector mutual funds. FIIs registered with SEBI may invest in domestic mutual funds, whether listed or unlisted. The 1993 Regulations have been revised on the basis of the recommendations

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of the Mutual Funds 2000 Report prepared by SEBI. The revised regulations strongly emphasize the governance of mutual funds and increase the responsibility of the trustees in overseeing the functions of the asset management company. Mutual funds are now required to obtain the consent of investors for any change in the “fundamental attributes” of a scheme, on the basis of which unit holders have invested. The revised regulations require disclosures in terms of portfolio composition, transactions by schemes of mutual funds with sponsors or affiliates of sponsors, with the asset Management Company and trustees, and also with respect to personal transactions of key personnel of asset management companies and of trustees. India opened its stock markets to foreign investors in September 1992 and has, since 1993, received considerable amount of portfolio investment from foreigners in the form of Foreign Institutional Investor’s (FII) investment in equities. This has become one of the main channels of portfolio investment in India for foreigners. In order to trade in Indian equity markets, foreign corporations need to register with the SEBI as Foreign Institutional Investor (FII). SEBI’s definition

of

FIIs

presently

includes

foreign

pension

funds,

mutual

funds,

charitable/endowment/university fund’s etc. as well as asset management companies and other money managers operating on their behalf The sources of these FII flows are varied .The FIIs registered with SEBI come from as many as 28 countries(including money management companies operating in India on behalf of foreign investors).US based institutions accounted for slightly over 41% those from the U.K constitute about 20% with other Western European countries hosting another 17% of the FIIs. Portfolio investment flows from industrial countries have become increasingly important for developing countries in recent years. The Indian situation has been no different. A significant part of these portfolio flows to India comes in the form of FII’s investments, mostly in equities. Ever since the opening of the Indian equity markets to foreigners, FII investments have steadily grow from about Rs.2600 crores in 1993 to over Rs.272165 crores till the end of Feb 2008. 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 as “hot money”-are notoriously volatile compared to other types of capital inflows. Investors are known to pull back portfolio investments at the slightest hint of trouble in the host Tolani Institute of Management Studies

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country often leading to disastrous consequences to its economy. They have been blamed for exacerbating small economic problems in a country by making large and concerted withdrawals at the first sign of economic weakness. They have also been responsible for spreading financial crisis –causing contagion in international financial markets. International capital flows and capital controls have emerged as an important policy issues in the Indian context as well. The danger of “abrupt and sudden outflows” inherent with FII flows and their destabilizing effect on equity and foreign exchange markets have been stressed. The financial market in India have expanded and deepened rapidly over the last ten years. The Indian capital markets have witnessed a dramatic increase in institutional activity and more specifically that of FII’s. This change in market environment has made the market more innovative and competitive enabling the issuers of securities and intermediaries to grow. In India the institutionalization of the capital markets has increased with FII’s becoming the dominant owner of the free float of most blue chip Indian stocks. Institutions often trade large blocks of shares and institutional order’s can have a major impact on market volatility. In smaller markets, institutional trades can potentially destabilize the markets. Moreover, institutions also have to design and time their trading strategies carefully so that their trades have maximum possible returns and minimum possible impact costs.

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LITERATURE REVIEW

Purendra Verma (2002) has investigated the impact of FII on Capital Market to find the relation between FII and Stock indices. For this he has taken seven indices into consideration, out of them five are Consumer Durables, Capital Goods, Fast Moving Consumer Goods, Health Care, Information Technology and the other two are Sensex and Nifty. He observed these indices during January 1993 to September 2001. If BSE & Nifty increase with rise in FII investment, He has taken hypothesis for this study. To find out the results he used least square method. Finally, after completing his study he concluded that except IT sector on all other indices the impact is very low during January 1993 to September 2001 as the correlation is negative in Consumer Durables, Capital Goods, Fast Moving Consumer Goods, Health Care, Sensex and Nifty. Paramita Mukherjee, Suchismita Bose and Dipankar Coondoo (2002) carried out research on the topic Foreign Institutional Investment in The Indian Equity Market an Analysis of daily flows during Jan 1999 - May 2002. The paper was conducted to understand the relationship of foreign institutional investment (FII) flows to the Indian equity market. FII flows to and from the Indian market tend to be caused by return in the domestic equity market and not the other way round. Returns in the equity market are very important to influence the flows of FIIs in the country. They concluded that in India the prime focus should be on regaining investor’s confidence in the equity market so as to strengthen the domestic investor’s base of the market. S.S.S. Kumar (2005) of IIM-Kozhikode carried out research on the Role of Institutional Investors in Indian Stock Market during 1992 - 2005. The paper was conducted to examining whether the institutional investors, with their war chests of money, set the direction to the market. He concluded with the use of Regression analysis that the combined force of the FIIs and MF are a powerful force and in fact their direction can forecast market direction. It gives it constantly rise in Indian context since all their trades are delivery based and Market become more efficient with the growing presence of institutional investors who primarily go by fundamentals.

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Anand Bansal and J.S. Pasricha (2009) in the paper titled Foreign Institutional Investor’s Impact on Stock Prices in India for the purpose of analyzing Impact of FIIs entry and the stock market behavior. Average return before and after the event day has been calculated for different sub sample days, the change of volatility in the Indian stock prices has been examined by comparing the variance of the returns of sub sample days before and after the event day. They concluded that return declined reasonably after the entry of FIIs, the correlation between FIIs investments and market volatility and market return has been comparatively low. It means volatility in Indian market is not the function of FIIs investment flows. TIMS Batch 2008-10, Leena Kanjani, Sulabh Mehta, Anita Pariyani, Amin Pattani, Mehul Rakholiya & Krishna Vyas conducted a research study on FII in India, they analyzed the monthly movement of stock market from 2006 to 2009. The paper was conducted to understand influence of FII on movement of Indian Stock market and to understand the FII policy in India. They used Correlation and Hypothesis test methodology and concluded that FII did have significant impact on Sensex but there is less co-relation with Benkex and IT. Sandhya Ananthanarayanan from CRISIL, Chandrasekhar Krishnamurti from Department of Finance and Nilanjan Sen from Nanyang Technological University conducted this research of Foreign Institutional Investors and Security Returns: Evidence from Indian Stock Exchanges for understanding the impact of trading of Foreign Institutional Investors on the major stock indices of India. Their contribution to this growing literature pertaining to globalization is twofold. First, they separate the flows into expected and unexpected and found that unexpected flows have a greater impact than expected flows. Second, they identify the specific flows of foreign institutional investors flowing into (or out of) each exchange and examine the impact on the specific stock market indices. Their principal conclusions are as follows. They found strong evidence consistent with the base-broadening hypothesis consistent with prior work. They do not found compelling confirmation regarding momentum or contrarian strategies being employed by foreign institutional investors. Their findings supported the price pressure hypothesis. They do not found any substantiation to the claim that foreigners’ destabilize the market. Tolani Institute of Management Studies

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FII AND GOVERNMENT POLICIES: Investment by FII was jointly regulated by Securities and Exchange Board of India (SEBI) through the SEBI (Foreign Institutional Investors) Regulations, 1995 and by the Reserve Bank of India through Regulation 5(2) of the Foreign Exchange Management Act (FEMA), 1999. The promulgation of legislation pertaining to foreign investment by SEBI in 1995 market a watershed for FII flows to India; this led to a significant increase in the level of FII equity inflows in the pre-Asian crisis period. The SEBI FII Regulations and RBI policies are amended and modified from time to time in response to the gradual maturing of the Indian financial market and changes taking place in the global economic scenario. In order to trade in India equity market, foreign corporation need to register with SEBI as Foreign Institutional Investors. Without registration they can invest, but cases require the approval from RBI. They are generally concentrated in secondary market. FII are allowed to invest in a) Securities in primary and secondary market including shares, debentures and warrant of companies, unlisted, listed or to be the listed in India. b) Units of mutual funds c) Dated government securities d) Derivative traded in a recognized stock market and e) Commercial papers FII can invest their own funds as well as invest on behalf of their overseas clients registered as such with SEBI. These client accounts that the FII manages are known as ’sub accounts’. FII sub accounts include those foreign corporate, foreign individual, institution funds or portfolio established or incorporated outside India.

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FII may issue deal in or hold off share derivative instrument such as participatory notes (PN). The entities that can subscribe to the PN are a) Any entity incorporated in a jurisdiction that requires filing of constitutional or other documents with a registrar of companies or comparable regulatory agency or body under the applicable companies legislation in that jurisdiction b) Any entity that is regulated authorized or supervised by a central bank, such as the Bank of England, or any other similar body provided that the entity must not only be authorized but also be regulated by the aforesaid regulatory bodies c) Any entity that is regulated, authorized or supervised by a securities or futures commission, such as the Financial Services Authority or other securities or futures authority or commission in any country, state or territory d) Any entity that is a member of securities or futures exchanges such as the New York Stock Exchange or other self-regulatory securities or futures authority or commission within any country, state or territory provided that the aforesaid mentioned organizations which are in the nature of self- regulatory organizations are ultimately accountable to the respective securities financial market regulators.

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Investment limit for FIIs: As per the September 1992 policy permitted foreign institutional investment registered FII could individually invest in a maximum of 5% of a company’s issued capital and all FIIs together up to a maximum of 24%. From November 1996 are allowed to make 10 percentage investment in debt securities subject to the specific approval from SEBI as a separate category of FIIs or sub accounts as 100% debt fund investment such investment were of occurs subjected to the fund specific ceiling prescribed by SEBI and had to be within overall ceiling US 1.5 $. The investment was however, restricted to the debt instrument of companies listed or to be listed on the stock exchanges. In 1997, the aggregate limit on investment by FIIs was allowed to be raised from 24% to 30% by then board of directors of individual companies by passing a resolution in their meeting and by special resolution to that effect in the company’s Board meeting. In June 1998 the 5% individual limit was raised to 10%.In March 2000, the ceiling on aggregate FII portfolio investment increased to 49%.This was subsequently raised to 49%, on March 8 2001, Finance minister announced February 28 2002 that foreign institutional investors can invest in accompany under the portfolio investment rout beyond 24% of the paid up capital of the company with the approval of the general body of the share holders by a special resolution.

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New registration criteria for FIIs in India: With a view to make the P-Note holders eligible for FII registration thereby obviating the need for ODIs, SEBI has made the following relaxations in the FII registration criteria: Broad Based Criteria – Registration criteria for “broad based funds” has been modified to include entities having at least 20 investors with no single investor holding more than 49% of the shares or units of the fund as against the earlier 10% limit. Track Record of the Applicant – Track record of individual fund managers will be considered for the purpose of ascertaining the track record of a newly set up fund, subject to such fund manager providing its disciplinary track record details. Perpetual Registration – FII and sub-account registrations will be perpetual, subject to payment of fees. Under the earlier regime, FIIs and their sub-accounts were registered for a period of three years after which the renewal application was subject to a re-examination by SEBI. Relaxation of the “regulated” requirement –Pension Funds, Foundations, Endowments, University Funds and Charitable trusts or societies have been exempted from the requirement of being “regulated” for registration as FIIs.

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Number of FIIs registered with SEBI: The following table represents the number of FIIs registered with SEBI from 1992 to 2010 yearly. From the below table it’s clear that the number of FIIs increases year by year except for the years 1998- 1999, and 2001- 2002. Number of FIIs registered with SEBI- (1992-1993 to 2009-2010). Year 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10

End of March 0 3 156 353 439 496 450 506 527 490 502 540 685 882 997 1319 1626 1713

End of Decemeber 517 637 823 993 1219 1594 1706

Source- www.sebi.org The number of foreign institutional investors which was 3 in1993 increased to 1713 in the year 2010.

FII investment in India: There may be many other factors on which a stock index may depend i.e. Government policies, budgets, bullion market, inflation, economic and political condition of the country, FDI, Re./Dollar exchange rate etc. The following table revels the pattern of gross sales, gross purchase, and net investment during the period 1993- 1994 to 2009- 2010.

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Year 1993-1994 1994-1995 1995-1996 1996-1997 1997-1998 1998-1999 1999-2000 2000-2001 2001-2002 2002-2003 2003-2004 2004-2005 2005-2006 2006-2007 2007-2008 2008-2009 2009-2010

Gross purchase

Gross sales

Net investment

Rs. In crores 5593 7631 9694 15458 16679 16507.5 57430.4 73269.3 50184.4 148514.3 148514.3 214524.1 347850.6 522417.8 947770.5 612406.5

Rs. In crores 466 2835 2752 6974 11804 17935.9 46846.3 64179.1 41453.7 44186 99547.1 171604.6 106697.7 489770.2 882699 658791.9

Rs. In crores 5126 4796 2752 8484 4876 -1428.5 10582.5 9511.5 8648 2822 48968.3 42920.3 41153.3 32647.8 65073.2 -46385.7 111053

The net investment made by FII in Indian market is volatile. Based on the performance of the Indian market the net investment changes. During the year of 2007- 2008, the net investment was very high which reaches to RS. 65073.2 crores. But on the consequent year i.e., 2008- 2009, and on 1997- 1998, the net investment goes to negative (RS. -46385.7 crores). The gross purchase is lower than the gross sales because of the economic crisis. FII crossed 65 thousand crores in the Indian history of capital market in 2008 is the highest investment made by FII. ROLE OF FOREIGN INSTITUTIONAL INVESTORS IN CAPITAL MARKET IN INDIA: Volatility: Foreign institutional investment is certainly volatile in nature and its volatility has certainly posed some threats to the Indian stock market considering its influence on the market. Given the presence of foreign institutional investors in Sensex companies and their active trading behavior, small and periodic shifts in their behavior lead to market volatility. Such volatility is an inevitable result of the structure of India’s financial markets as well. Markets in developing countries like India are thin or shallow in at least three senses. First, only stocks of a few companies are actively traded in the market. Thus, although there are more than 8,000 companies Tolani Institute of Management Studies

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listed on the stock exchange, the BSE Sensex incorporates just 30 companies, trading in whose shares is seen as indicative of market activity. Second, of these stocks there is only a small proportion that is routinely available for trading, with the rest being held by promoters, the financial institutions and others interested in corporate control or influence. And, third the number of players trading these stocks is also small. In such a scenario investment by the foreign institutional investors leads to a sharp price increase this provides incentives to FII investment and enhances investment and when the correction in the stock prices begins it would have to be a pull out by the FII and can result in sharp decline in the prices. The other reason for volatility is that the foreign institutional investors are attracted to a market by the expectation of price increase that tend to be automatically realized, the inflow of foreign capital can result in an appreciation of the rupee vis-à-vis the dollar This increases the return earned in foreign exchange, when rupee assets are sold and the revenue converted into dollars. As a result, the investments turn even more attractive triggering an investment spiral that would imply a sharper fall when any correction begins. Apart from that the growing realization by the FIIs of the power they wield in what are shallow markets, encourages speculative investment aimed at pushing the market up and choosing an appropriate moment to exit. This manipulation of the market would certainly enhance the volatility and in volatile markets even the domestic investors try to manipulate the market when the prices are really high. Overall the foreign institutional investors have been Bullish on the Indian stocks but the problem is that this bullish nature might be a result of the activities outside the Indian market it might be due to the performance of their equity market or their non equity returns. Therefore they seek out for best returns and diversified geographical portfolio in order to hedge their risk and when they make some adjustments in their portfolio and make shifts in favor or against a country it borings about sharp changes.

Price building mechanism: With the increasing participation of the institutional investors in the capital market, it has also helped the different companies to raise funds for their use through the capital market in India. Earlier the companies use to go for debt financing which a cost has attached to it and also in Tolani Institute of Management Studies

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those days the cost of issuing an IPO was higher as compared to the funds that were being generated by the companies. With the help of FII the market has become more competitive fair value of their.

Role of speculation: The effect of foreign speculative activity in emerging markets can be particularly beneficial if in the emerging market, liquidity is poor first, the potential of market manipulation is acute in small emerging markets and liquidity is often poor. Although there are many policy initiatives that could increase liquidity and reduce the degree of collusion among large traders, there may not be a sufficient mass of domestic speculators to ensure market liquidity and efficiency. Second, opening the market to foreign speculators may increase the valuation of local companies, thereby reducing the cost of equity capital

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DETERMINANTS OF FOREIGN INSTITUTIONAL INVESTMENT After the initiation of economic reforms in the early 1990s, the movement of foreign capital flow increased very substantially. There are a lot of factors that determine the nature and cause of foreign institutional investment in a country a few of them being inflation exchange rate equity returns, government policies, price earring ratio and risk. Now if we try to analyze the relation of each of these factors with the level of foreign inflow in the country, we might have a better understanding. let us broadly classify the factors into inflation, risk and stock market returns and understand the basic principle behind the inflows. a) Equity returns- An increase in the return in the foreign market will induce investors to

withdraw from the Indian (domestic) stock market to invest in the foreign market. Investors are believed to follow a higher return, hence when the return in the domestic market increases, FII flows to the domestic market. 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. . It is assumed that the equity returns have a positive impact on the FII inflow but foreign investors can also get involved in profit booking. They can buy financial assets when the prices are declining, thereby jacking-up the asset prices and sell when the asset prices are increasing and hence be the cause of such returns so making it more of a bi-directional relationship. b) Risk- Investors are considered to be risk averse, hence when risk in the domestic market increases they will withdraw from the domestic market, when risk in the foreign market increases, investors will withdraw from the foreign market and invest in the Indian (domestic) market. Investments, either domestic or foreign, depend heavily on risk factors. Hence, while studying the behavior of FII, it is important to consider the risk variable. Risk can be divided into ex-ante and unexpected risk. While the ex-ante risk certainly has an inverse relation with the foreign investment nothing can be clearly said about the unexpected risk. c) Inflation- The inflation no doubt has an inverse relation with the foreign investment inflow as the investor would keep in mind the purchasing power of the funds invested and as inflation Tolani Institute of Management Studies

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increase i.e. the purchasing power declines the investor is most likely to withdraw his money. When inflation in the domestic country increases, the purchasing power of the funds invested declines, hence investors will withdraw from the domestic market. Similarly, when inflation in the foreign country increases, the purchasing power of funds invested in the foreign country declines, causing institutional investors to withdraw from the foreign market and make investment in the domestic (Indian) market. d) Exchange rate –When the value of the home currency is stronger the FII investments will also increase as the percentage of returns the FII get automatically increases and visa versa So it can be said that the inflation and risk in the domestic country and return in the foreign country adversely affect the FII flowing to the domestic country, whereas inflation and risk in the foreign country and return in the domestic country have a favorable effect on the flow of FII.

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Portfolio Investment: Portfolio investment represents passive holdings of securities such as foreign stocks, bonds, or other financial assets, none of which entails active management or control of the securities’ issuer by the investor; where such control exists, it is known as foreign direct investment. The liberalization of the policy regime was extended to portfolio investment in September1992. To begin with, foreign institutional investors such as pension funds or mutual funds were allowed to invest in the domestic capital market subject simply to registration with the Securities and Exchange Board of India. Guidelines issued by the Reserve Bank of India permitted such foreign institutional investors to invest in the secondary market for equity subject to a ceiling of 5per cent (subsequently raised to 10 per cent) for individual foreign institutional investors in a single Indian firm with an overall limit at 24 per cent of equity (later relaxed to 30 per cent of equity at the option of the firm) for total foreign institutional investment in a single Indian firm. Foreign portfolio investment further classified into 1. ADR/GDR, 2. Offshore funds. Global Depositary Receipt: A negotiable certificate held in the bank of one country representing a specific number of shares of a stock traded on an exchange of another country. American Depositary Receipts make it easier for individuals to invest in foreign companies, due to the widespread availability of price information, lower transaction costs, and timely dividend distributions. Also called European Depositary Receipt. The option of portfolio investment was also made available to domestic corporate entities from September 1992. Indian firms were allowed access to international capital markets through global depository receipts or Euro convertible bonds which converted debt into equity after stipulated period. This access, however, was not automatic. Individual applications, drawn up

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inconformity with the general guidelines of the government, were subject to approval. This process remains unchanged.

Offshore Funds An offshore fund is a collective investment scheme domiciled in an Offshore Financial Centre, for example British Virgin Islands, Luxembourg, Cayman Islands or Dublin. Similar facilities for portfolio investment were subsequently extended to Offshore funds, nonresident Indians (as individuals) and overseas corporate bodies, only for investment in shares or debentures through stock exchanges, on the same terms as foreign institutional investors, but subject to a ceiling of 5 per cent for individual non-resident Indians or overseas corporate bodies in a single Indian firm.

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Foreign Institutional Investors in India: India opened her doors to foreign institutional investors in September, 1992. This event represents a landmark event since it resulted in effectively globalizing its financial services industry. Initially, pension funds, mutual funds, investment trusts, Asset Management Companies, nominee companies and incorporated/institutional portfolio managers were permitted to invest directly in the Indian stock markets. Beginning 1996-97, the group was expanded to include registered university funds, endowment, foundations, charitable trusts and charitable. Since then, FII flows which form a part of foreign portfolio investments have been steadily growing in importance in India. In the year 1998, the net flows have been positive. The nuclear tests and East Asian crisis did slow down the flows but as stated by Gordan and Gupta (2003), their effects were short lived. In percentage of total net turnover of BSE, the share of average of FII sales and purchases increased from 2.6 percent in 1998 to 5.5 percent in 2002. The cumulative net FII investment in India as on August 2003 is approximately $17400 million. As of August 2003 net FII investment was 9 percent of the BSE market capitalization which is small compared to the size of the market. However, in the words of Banaji (2002), it is not the market capitalization that matters but what is important is the level of the free float, that is, the shares that are actually publicly available for trading. With floating stock in the Indian market being less than 25 percent, about 35 percent of the 3 free float available has been bagged by FIIs - despite the fact that they invest in just a few highly liquid stocks.

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Though India receives hardly 1 percent of the FII investments in emerging markets, the portfolio flows to India have been less volatile when compared with that of many other emerging markets (Gordan and Gupta, 2003). FIIs by adopting a bottom-up approach seem to invest in top-quality, high growth, large cap stocks (Gordan and Gupta, 2003). Sytse et al. (2003) provide empirical evidence that foreign institutional investors in India, invest in large, liquid companies which enable them to exit their positions quickly at relatively lower cost and also that the foreign institutional owners have a larger impact than foreign corporate owners when performance is measured using stock market valuation criterion. Given that India is one of the fastest growing economies in South Asia, promising a growth of over 6 percent, second only to China, it would not be a surprise to see increased FII flows to India in the future. FIIs are now looking at the economy as a whole, with the macro-economic factors also playing their role in attracting foreign investors. Factors like a strong currency, key reforms in the banking, power and telecommunications sector, increased consumer spending and stable policies are expected to play a major role in attracting FIIs to India. The Securities Exchange Board of India (SEBI) along with the Institute of Chartered Accountants of India (ICAI) jointly monitor the markets and announces the regulatory measures thus making the Indian companies more transparent and more disciplined. According to the April 2001 report on corporate governance by CLSA Emerging Markets, India ranks fourth with a score of 55.6 percent. Banaji (2000) emphasizes that the capital market reforms like improved market transparency, automation, dematerialization and regulations on reporting and disclosure standards were initiated because of the presence of the FIIs. But FII flows can be considered both as the cause and the effect of capital market reforms. The market reforms were initiated because of the presence of FIIs and this in turn has lead to increased flows. The Government of India gave preferential treatment to FIIs till 1999-2000 by subjecting their long term capital gains to lower tax rate of 10 percent while the domestic investors had to pay higher long-term capital gains tax. The Indo-Mauritius Double Taxation Avoidance Convention 2000 (DTAC), exempts Mauritius-based entities from paying capital gains tax in India including tax on income arising from the sale of shares. This gives an incentive for foreign Tolani Institute of Management Studies

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investors to invest in Indian markets taking the Mauritius route. Consequently, we now see investments coming from Mauritius while there were none before 2000.

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FII: A COST BENEFIT ANALYSIS

BENEFITS a) Reduced cost of equity:

FII inflows augment the sources of funds in the Indian capital markets. FII investment reduces the required rate of return for equity, enhances stock prices, and fosters investment by Indian firms in the country. The impact of FIIs upon the cost of equity capital may be visualized by asking what stock prices would be if there were no FIIs operating in India. b) Stability in the balance of payment: For promoting growth in a developing country such as India, there is need to augment domestic investment, over and beyond domestic saving, through capital flows. The excess of domestic investment over domestic savings result in a current account deficit and this deficit is financed by capital flows in the balance of payments. Prior to 1991, debt flows and official development assistance dominated these capital flows. This mechanism of funding the current account deficit is widely believed to have played a role in the emergence of balance of payments difficulties in 1981 and 1991. Portfolio flows in the equity markets, and FDI, as opposed to debt-creating flows, are important as safer and more sustainable mechanisms for funding the current account deficit. c) Knowledge flows: The activities of international institutional investors help strengthen Indian finance. FIIs advocate modern ideas in market design, promote innovation, development of sophisticated products such as financial derivatives, enhance competition in financial intermediation, and lead to spillovers of human capital by exposing Indian participants to modern financial techniques, and international best practices and systems.

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d) Strengthening corporate governance: Domestic institutional and individual investors, used as they are to the ongoing practices of Indian corporate, often accept such practices, even when these do not measure up to the international benchmarks of best practices. FIIs, with their vast experience with modern corporate governance practices, are less tolerant of malpractice by corporate managers and owners (dominant shareholder). FII participation in domestic capital markets often lead to vigorous advocacy of sound corporate governance practices, improved efficiency and better shareholder value. e) Improving market efficiency: A significant presence of FIIs in India can improve market efficiency through two channels. First, when adverse macroeconomic news, such as a bad monsoon, unsettles many domestic investors, it may be easier for a globally diversified portfolio manager to be more dispassionate about India's prospects, and engage in stabilizing trades. Second, at the level of individual stocks and industries, FIIs may act as a channel through which knowledge and ideas about valuation of a firm or an industry can more rapidly propagate into India. For example, foreign investors were rapidly able to assess the potential of firms like Infosys, which are primarily export-oriented, applying valuation principles that prevailed outside India for software services companies.

COSTS

a) Hedging and positive feedback training: There are concerns that foreign investors are chronically ill informed about India, and this lack of sound information may generate herding (a large number of FIIs buying or selling together) and positive feedback (buying after positive returns, selling after negative returns).These Kinds of behavior can exacerbate volatility ,and push prices away from fair values.

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b) Balance of payment vulnerability: There are concerns that in an extreme event, there can be a massive flight of foreign capital out of India, triggering difficulties in the balance of payments front. India's experience with FIIs so far, however, suggests that across episodes like the Pokhran blasts, or the 2001 stock market scandal, no capital flight has taken place. A billion or more of US dollars of portfolio capital has never left India within the period of one month. When juxtaposed with India's enormous current account and capital account flows, this suggests that there is little vulnerability so far.

c) Possibility of takeovers: While FIIs are normally seen as pure portfolio investors, without interest in control, portfolio investors can occasionally behave like FDI investors, and seek control of companies that they have a substantial shareholding in. Such outcomes, however, may not be inconsistent with India's quest for greater FDI. Furthermore, SEBI's takeover code is in place, and has functioned fairly well, ensuring that all investors benefit equally in the event of a takeover.

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A STUDY OF MAJOR EPISODES OF VOLATILITY FII investment in equities had little role to play in the crisis. Fung, Hsieh, and Stsatsaronis (2000) report “At the height of the episode, some Asian government officials accused speculators and hedge funds of attacking the currencies and causing their downfall. A public debate ensued, and the International Monetary Fund (IMF) responded by examining the role of hedge funds in the Asian currency crisis. The resulting study by Eichengreen, Mathieson, Chadha, Jansen, Kodres, and During the stock market scam which shook the capital market in India the FII were also one of the major factors which exacerbates the fall in the Sensex. During the Black Monday episode the FII were also on a heavy selling spree which ultimately leads to some major fall in the Sensex value. There have been four episodes of vulnerability in India, which are negative shocks affecting the economy, and influencing the behavior of investors. These are: the East-Asian crisis in 1997, the Pokhran Nuclear explosion (May 1998) and the attendant sanctions, the stock market scam of early 2001, and the Black Monday of May 17, 2004.10 The investment behavior of the FIIs vis-àvis the movements of the stock market indices during these episodes are given in Table.

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FII Behavior During East Asian Crisis MONTH

July 1997 August 1997 September 1997 October 1997 November 1997 December 1997 January 1998 February 1998 March 1998

BSE INDEX FOR THE

FII INVESTMENTS

MONTH

(Rs. crore)

4256.11 4276.31 3944.78 3991.75 3611.83 3515.54 3472.87 3402.96 3816.89

1002.8 493.66 598.59 641.59 -289.87 -182.38 -374.97 629.05 472.22

FII investment behavior during these four specific events indicates that these events did affect the behavior of the foreign portfolio investors. But, these events did affect domestic investors’ behavior as well. FII Behavior in the aftermath of Pokhran Nuclear Explosion Month May 1998 June 1998 July 1998 August 1998 September1998 October 1998

Bse index for the month 3911.95 3317.49 3271.73 2988.40 3089.88 2866.55

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FII investments (Rs. In crores) -557.45 -896.30 104.68 -390.82 111.09 -552.46

FII Behavior during the Stock Market Scam 2001 Month November 2000 December 2000 January 2001 February 2001 March 2001

BSE index for the month 3928.10 4081.42 4152.39 4310.13 3807.64

FII investment (Rs. In crores) 1090.11 -461.78 3971.58 1574.44 2204.80

FII Behavior around Black Monday, May 17, 2004 Month May 2004 June 2004 July 2004

BSE index for the month 5204.65 4823.87 4972.88

FII investments -3151.29 511.00 1292.83

These experiences show that FII outflow of as much as a billion dollars in a month –which corresponds to an average of $40 million or Rs.170 crore per day – has never been observed. These values – Rs.170 crore per day – are small when compared with equity turnover in India. In calendar 2004, gross turnover on the equity market of Rs.88 lakh crore contained Rs.5 lakh crore of gross turnover by FIIs. This suggests that as yet, FIIs are a small part of the Indian equity market. Transactions by FIIs of Rs.5 lakh crore in a year might have been large in 1993, but the success of a radical new market design in the Indian equity market have led to enormous growth of liquidity and market efficiency on the equity market. Through this, India’s ability to absorb substantial transactions on the equity market appears to be in place. The net FII inflows into India have been less volatile compared to other emerging markets this stability could be attributed to several factors: Strong economic fundamentals and attractive valuation of companies. Improved regulatory standards, high quality of disclosure and corporate governance requirement, accounting standards, shortening of settlement cycles, efficiency of Tolani Institute of Management Studies

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clearing and settlement systems and risk management mechanisms. Product diversification and introduction of derivatives. Strengthening of the rupee dollar exchange rate and low interest rates in the US. Post 2004 Major Volatile Episodes: As from the month of Jan 2008 the BSE Sensex was already moving down due to the weak global cues and US recession and similarly the FII investment fell drastically during that period running panic among the investors and further exacerbating the fall. But in the case of mutual fund investment went up during the time shows that the domestic institutional investors cash on the fall of Sensex because of the strong fundamentals of the Indian capital market. We can very well say that this time around the fall of BSE Sensex was majorly due to the FII which went on a selling spree which lead to the fall of the market during this Crash.FII acted in this fashion because of the weak global cues i.e. at that point of time other emerging markets were also down. The fall of 769 points by Sensex on Dec 17, 2007 was attributed to the fact mainly due to the subprime losses and also was exacerbated due to the withdrawal of investments by the FII. As the subprime losses mainly hit the US economy and the majority of FII participating in the Indian capital market are from US .To cover their losses in US they started selling in India which lead to the fall of Sensex on that particular day and subsequent days. During the month of October 2007 Indian govt. took some strict measure to control the usage of the Participatory notes. The restrictions proposed by SEBI in regulating participatory notes in a sudden announcement wrought havoc in the operations of the share market causing a fall of over 1,700 points in the Sensex on Wednesday. SEBI should have used some pragmatic caution by avoiding the announcement and introducing regulatory steps in a phased manner. The share market is extremely vulnerable to the sentiments created by the utterances of those in regulatory authority. This lead the FII to withdraw from the Indian market as they were not sure of how the measure taken by the govt. will be implemented .This is clearly viable from the above that this time Tolani Institute of Management Studies

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around the FII were the main cause of the crash of the Sensex on 18 Oct. But also there comes an th

interesting fact that there was also a heavy selling on 22 October but this time the FII nd

Withdrawal effect was offset by the Huge investment made by domestic institutional investor specially LIC, which saved the market from a heavy meltdown. The reasons being given for the crash are the sale of Rs 7300 crore (Rs 73Billion) shares by FII’s in the past 1 week, an expected increase in interest rates by the US Feds, a crash in the international commodity prices, and the straw which broke its back seems to be a government circular which was interpreted that FIIs should be taxed. P Chidambaram, the country’s Finance Minister, issued an evening press release denying the latter.

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Objectives of project

•

To study the impact of FII on Indian stock market.

•

To understand the concept of BSE sensitive index.

•

To understand the concept of FIIs.

•

To understand the relationship between the Sensex and FII.

•

To know the sector which get affected more by activities of FIIs.

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Methodology Data Collection Method: Here, information plays an important role to make research successful. Basically there are two types of sources to collect data namely they are as under.

•

Primary data

•

Secondary data

For this project only secondary data was used.

Secondary data: For the secondary data various literatures, books, journals, magazines, web links are used. As there are not possibilities of collecting data personally so no questionnaire is made. SAMPLING DESIGN: • Universe In this study the universe is finite and will take into the consideration related news and events that have happened in last few year. • Sampling Unit: As this study revolves around the foreign institutional investment and Indian stock market. For the sampling unit is confined to only the Indian stock market.

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Techniques of analysis Regression analysis and Correlation analysis: Regression Analysis: We can analyze how a single dependent variable is affected by the values of one or more independent variables — for example, how an athlete's performance is affected by such factors as age, height, and weight.

Correlation: This analysis tool and its formulas measure the relationship between two data sets that are scaled to be independent of the unit of measurement. We can use the Correlation tool to determine whether two ranges of data move together — that is, whether large values of one set are associated with large values of the other (positive correlation), whether small values of one set are associated with large values of the other (negative correlation), or whether values in both sets are unrelated (correlation near zero).

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TO FIND THE RELATIONSHIP BETWEEN THE FIIS EQUITY INVESTMENT PATTERN AND INDIAN STOCK INDICES. The sample data consists of 24 observations for FII, Sensex and S&P CNX Nifty starting from January 2001 to February 2011. Average index of all the indices and daily net investments made by FII is taken into consideration in the study. FII was taken as independent variable. Stock indices were taken as dependent variable. The data was taken from various financial sites. The relationship between the FII’s equity investment pattern and Indian stock indices is studied for the 10 year with the help of correlation and regression analysis. The results and the analysis are shown below:

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Correlation CORRELATION WITH FII

Indices Auto Bankx IT FMCG Oil and Gas

SENSEX 0.352

NIFTY 0.35

Correlation with FII 0.32 0.33 0.16 0.17 0.27

From the above table we can say that FII has a positive impact on the indices which means that if FIIs come in India then they will affect Indian Capital market. FIIs have same co-relation with Sensex as well as Nifty. FII ‘s impact on sectorial indices is also positive which shows that bank sector is most affected sector amongst which we have analyzed and IT sector is the least affected sector but they are affected positively.

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Hypothesis test

Null Hypothesis (H0): Sensex does not rises with the increase in FIIs investment Hypothesis (Ha): Sensex rises with the increase in FIIs investment.

Correlations FII INVESTMENT CHANGE IN SENSEX FII INVESTMENT

Pearson Correlation

.352**

1

Sig. (2-tailed)

.000

N CHANGE IN SENSEX

Pearson Correlation

2722

2721

.352**

1

Sig. (2-tailed)

.000

N

2721

2722

**. Correlation is significant at the 0.01 level (2-tailed).

Regression Model Std. Error of the Model 1

R

R Square .352a

Adjusted R Square

.124

.124

Estimate 175.463

a. Predictors: (Constant), FII INVESTMENT

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The data includes 2722 observations of daily basis of Sensex and FIIs in year from 2000 to 2011. The correlation and regression is calculated. Here the correlation 0.35 which shows that both have positive relation if FII increase then Sensex will also increase. But if we compare the significance with the degree of freedom then null hypothesis is accepted because (0.00