India’s emergence as an economic force is a recent development. Foreign investment is one of the primary factors for its augmented growth. A look at stock indices since 2006 shows that the market appreciates when foreign institutional investments (FIIs) are highest, and bottoms out when FIIs are missing in action. For instance, during 2008, the market fell by almost 50 percent due to the global financial meltdown, eroding the gains of 2007. FIIs have dominated Indian equities ever since the markets were opened up in 1993. Positive fundamentals accompanied by fast growing markets have made India an alluring destination for FIIs in Asia. FIIs have affected the economy positively in terms of capital market reforms, increased liquidity and depth. At the same time it needs to be seriously considered that FIIs give leverage to the market causing it to lose control, and this puts the small investors at potential disadvantage. Also huge flow of FII funds into the country creates a lot of demand for the rupee, which results in increased inflation and causes appreciation of the domestic currency. This further creates exports-related problems and makes them less lucrative. These complications create a need to understand the dynamics of FIIs.
This research paper empirically investigates the dynamic interactions of FIIs with the stock market (Nifty) returns and its volatility. The study uses the daily data for FIIs and Nifty from January, 2004 to September, 2012. The results support the feedback trading behaviour of FIIs. They are return chasers as they follow changes in Nifty returns. Further, FIIs affect the volatility of Nifty returns and this has destabilising effects causing upheaval in the Indian capital market.
