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Role Of FII in Indian Capital Market

Bachelor of Commerce Financial Markets Semester V


In Partial Fulfillment of the requirements

For the Award of Degree of Bachelor of Commerce Financial Markets

Submitted by

LAVINA JAIN Roll No.25


H.R. COLLEGE OF COMMERCE & ECONOMICS 123, D.W. Road, Churchgate, Mumbai 400 020.

College Name (With Address)

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This is to certify that Shri / Miss Lavina Jain of B.Com.-Financial Markets Semester V (2013 2014 ) has successfully completed the project on Role of FII in Indian Capital Market under the guidance of Ms.Poonam Jain.

Course Co-ordinator

Principal

Project Guide / Internal Examiner

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DECLARATION

I Lavina Jain the student of B.Com.- Financial Markets Semester V (2013 - 2014 ) hereby declare that I have completed the Project on Role of FII in Indian Capital Market

The information submitted is true and original to the best of my knowledge.

Signature of the Student Name of the Student Roll No.

ACKNOWLEDGEMENT

ROLE OF FINANCIAL INSTITUTION IN CAPITAL MARKET IN INDIA Sr. No. 1 Particulars Abstract Page No.

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Executive Summary Introduction Types of Institutional Investors History of FII Procedure for registration Regulation related to FII operation Indian Capital Market Influence of FII on Indian Capital Market Effects of FII on Indian Economy BSE SENSEX and FII Investment Correlation Institutional Investors registered in India Major Institutional Investors in India Investment trends of Institutional Investors Reasons for growth in FII Investment FII a cost benefit analysis Determinants of FII Comparison between FII and Mutual Fund Investment Role of Institutional Investors in Indian Capital Market Study of Major episodes of Volatility Statistical analysis Recommendation Conclusion Reference

ABSTRACT: An economy, apart from everything else, is a highly fluid transmission mechanism. Its beauty lies in how the smallest of changes have the most complex trickle-down effects. A paradigmatic example of how seemingly minor policy changes can jump start the economy can be illustrated by examining the effects of liberalization on capital market in India. The FIIs have been playing key role in the Indian capital market, since their entry in the early 1990s. Globalization had led to widespread liberalization and implementation of financial market reforms in many countries, mainly focusing on integrating the financial markets with the global markets. Indian Capital Market has also undergone metamorphic reforms in the past few years. Every segment of Indian Capital Market viz primary and secondary markets, derivatives, institutional investment and market intermediation has experienced impact of these changes which has significantly improved the transparency, efficiency and integration of Indian market with the global markets. This is one of the prime reasons why the foreign portfolio investments have been increasingly flowing into the Indian markets. 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 net investments have steadily grown. Thus, we can see that there has been a consistent rise in the FII inflows in to the country. While the concerns such as FII pulling back their investments and the kind of destabilizing effect on the capital market in India are all well-placed, comparatively less attention have been paid so far to analyzing the FII flows data and understanding their key features. A proper understanding of the nature and determinants of these flows, however, is essential for a meaningful debate about their effects as well as predicting their chances of their sudden reversals. Thus this project aims at studying the role of these Institutional investors and its impact on the capital markets in India. This also aims to find out the various factors and determinants for their investments and also cite out scenarios where in these investments when pulled back by these FII could really affect the capital markets in India.

EXECUTIVE SUMMARY: The objective of the project is to find the different role of institutional investors in the capital market in India and then to find the role of institutional investors in the major volatile episode in the capital market in India. Finally, to find the relationship between the Sensex variation with the variation of the investments made by the institutional investors. 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. 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 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. The methodology used to is regression analysis. The degree of association helps us to quantify the relationship between the variation in sensex due to the variation in the net investments made by the institutional investors. After completing the project I could recommend that Government should certainly encourage foreign institutional investment but should keep a check on the volatility factor. Long term funds should be given priority and encouraged some of the actions that could be taken to ensure stability are strengthening domestic institutional investors Operational flexibility to impart stability to the market Knowledge activities and research programs. To conclude with I would say that the foreign funds is certainly one of the most important cause of volatility in the Indian stock market and has had a considerable influence on it. Although it would not be fair enough to come to any conclusion as there are a lot of other factors beyond the scope of the study that effect returns and risks .it is not easy to predict the nature of the macroeconomic factors and their behavior but it has a great significance on any economy and its elements. Although generally a positive relation has been seen between the stock market returns and the FII inflows it is not easy to say which is the cause and which is the effect.

INTRODUCTION: Till 1980s Indian economy has remained quite closed towards the foreign investments but it was well realized by the government during 1990s that the foreign investment can play significant role to promote economic growth. It was the time when the wave of economic reforms also touched the capital market. The objective was all clear, i.e., to fasten the pulse of development in all economic activities. At the initial stages of reforms with regard to FIIs the credit can be given to the New Industrial Policy, 1991 framed by the government to focus on the importance of foreign direct investment in order to augment technological updating in a globalized world. In order to give further push to foreign investment, Government of India permitted the portfolio investment made by foreign institutional investors in India. The initial guidelines regarding the flow of capital by FIIs was suggested by Narsimhan Committee Report on financial system of India. Figure 1 given below has showed the trend of number of FIIs and Net Investment made by them during last decade. The information of the same has been obtained through the report published by SEBI. The capital market of India was gradually opened for foreign institutional investors. They were allowed to invest in all traded securities on the primary market and secondary markets including various financial products, viz., shares, debentures and warrants etc. India has always been an attractive destination for foreign investors as Indian economy has always been a good performer among other Asian countries. But whenever a crisis has been identified on Indian capital market or a financial crisis occurring at world level, it has always impacted the capital flows by portfolio investors. Therefore continuous evidences are obtained by researchers indicating the volatility shifts on the stock market due to the behavior of foreign institutional investors.

TYPES OF INSTITUTIONAL INVESTORS: A. DOMESTIC INSTITUTIONAL INVESTOR Domestic Institutional Investor is used to denote an investor - mostly of the form of an institution or entity, which invests money in the financial markets of its own country where the institution or entity was originally incorporated. In India, there are broadly four types of institutional investors.

DEVELOPMENTAL FINANCIAL INSTITUTIONS like Industrial Finance Corporation of India (IFCI), Industrial Credit and Investment Corporation of India (ICICI), Industrial Development Bank of India (IDBI), the State Financial Corporations, etc. The role played by these financial institutions (FIs) is to extend funds to the companies for both long terms financing and (more recently) working capital financing. The financial institutions extend both debt and equity financing to their nominee directors in the companies.

INSURANCE COMP ANIES like the Life Insurance Corporation (LIC), General Insurance Corporation (GIC), and their subsidiaries.

BANKS: Earlier banks used to finance only the working capital of the companies. But now they are also extending long-term finance to the companies.

ASSET MANAGEMENT COMPANIES all the mutual funds including Unit Trust of India (UTI). The mutual funds collect funds from both individuals and corporate to invest in the financial assets of other companies. In India, the mutual funds participate largely in the equity capital of the companies. The mutual fund industry which is the major institutional investors in India started in 1963 with the formation of Unit Trust of India, at the initiative of the Government of India and Reserve Bank. The history of mutual funds in India can be broadly divided into four distinct phases First Phase: 1964-1987, Unit Trust of India (UTI) was established on 1963 by an Act of Parliament. Second Phase : 1987- 1993, Entry of Public Sector Funds .1987 marked the entry of non- UTI, public sector mutual funds set up by public sector banks and Life Insurance Corporation of India(LIC) and General Insurance Corporation of India (GIC). Third Phase: 1993-2003, Entry of Private Sector Funds in 1993. Kothari Pioneer (now merged with Franklin Templeton) was the first private sector mutual fund registered in July 1993.As at the end of January 2003;there were 33 mutual funds with total assets of Rs. 1, 21,805 crores. The Unit Trust of India with Rs.44, 541 crores of assets under management was way ahead of other mutual funds. Fourth Phase: 2003-2007, In Feb 2003 the Unit Trust of India Act 1963 UTI was bifurcated into two separate entities. The Specified Undertaking of Unit Trust of India, functioning under an administrator and under the rules framed by Government of India. The second is

the UTI Mutual Fund Ltd, sponsored by SBI, PNB, BOB and LIC. It is registered with SEBI and functions under the Mutual Fund Regulation, B.FOREIGN INSTITUTIONAL INVESTOR: The term Foreign Institutional Investor is defined by SEBI as under: "Means an institution established or incorporated outside India which proposes to make investment in India in securities. Provided that a domestic asset management company or domestic portfolio manager who manages funds raised or collected or brought from outside India for investment in India on behalf of a sub-account, shall be deemed to be a Foreign Institutional Investor." Foreign Investment refers to investments made by residents of a country in financial assets and production process of another country. Entities covered by the term FII include Overseas pension funds, mutual funds, investment trust, asset management company, nominee company, bank, institutional portfolio manager, university funds, endowments, foundations, charitable trusts, charitable societies etc.(fund having more than 20 investors with no single investor holding more than 10 per cent of the shares or units of the fund) (GOI (2005)). FIIs 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. The term is used most commonly in India to refer to outside companies investing in the financial markets of India. International institutional investors must register with Securities & Exchange Board of India (SEBI) to participate in the market. One of the major market regulations pertaining to FII involves placing limits on FII ownership in Indian companies. They actually evaluate the shares and deposits in a portfolio. WHY FIIS REQUIRED? FIIs contribute to the foreign exchange inflow as the funds from multilateral finance institutions and FDI (Foreign direct investment) are insufficient. Following are the some advantages of FIIs. It lowers cost of capital, access to cheap global credit. It supplements domestic savings and investments.

It leads to higher asset prices in the Indian market. And has also led to considerable amount of reforms in capital market and financial sector.

INVESTMENTS BY FIIS There are generally two ways to invest for FIIs. EQUITY INVESTMENT 100% investments could be in equity related instruments or up to 30% could be invested in debt instruments i.e.70 (Equity Instruments): 30 (Debt Instruments) 100% DEBT 100% investment has to be made in debt securities only EQUITY INVESTMENT ROUTE: In case of Equity route the FIIs can invest in the following instruments: A. Securities in the primary and secondary market including shares which are unlisted, listed or to be listed on a recognized stock exchange in India. B. Units of schemes floated by the Unit Trust of India and other domestic mutual funds, whether listed or not. C. Warrants

100% DEBT ROUTE: In case of Debt Route the FIIs can invest in the following instruments:

A. Debentures (Non Convertible Debentures, Partly Convertible Debentures etc.) B. Bonds C. Dated government securities D. Treasury Bills E. Other Debt Market Instruments It should be noted that foreign companies and individuals are not be eligible to invest through the 100% debt route.

HISTORY OF FII India opened its stock market to foreign investors in September 1992, and in 1993, received portfolio investment from foreigners in the form of foreign institutional investment in equities. This has become one of the main channels of FII in India for foreigners. Initially, there were terms and conditions which restricted many FIIs to invest in India. But in the course of time, in order to attract more investors, SEBI has simplified many terms such as: The ceiling for overall investment of FII was increased 24% of the paid up capital of Indian company. Allowed foreign individuals and hedge funds to directly register as FII. Investment in government securities was increased to US$5 billion. Simplified registration norms. PROCEDURE FOR REGISTRATION: The Procedure for registration of FII has been given by SEBI regulations. It states- no person shall buy, sell or otherwise deal in securities as a Foreign Institutional Investor unless he holds a certificate granted by the Board under these regulations. An application for grant of registration has to be made in Form A, the format of which is provided in the SEBI (FII) Regulations, 1995. THE ELIGIBILITY CRITERIA FOR APPLICANT SEEKING FII REGISTRATION IS AS FOLLOWS:

Good track record, professional competence and financial soundness. Regulated by appropriate foreign regulatory authority in the same capacity/category where registration is sought from SEBI. Permission under the provisions of the Foreign Exchange Management Act, 1999 (FEMA) from the RBI. Legally permitted to invest in securities outside country or its incorporation/establishment. The applicant must be a fit and proper person. Local custodian and designated bank to route its transactions. ELIGIBLE SECURITIES A FII can make investments only in the following types of securities: Securities in the primary and secondary markets including shares, debentures and warrants of unlisted, to- be-listed companies or companies listed on a recognized stock exchange. Units of schemes floated by domestic mutual funds including Unit Trust of India, whether listed on a recognized stock exchange or not, and units of scheme floated by a Collective Investment Scheme. Government Securities Derivatives traded on a recognized stock exchange like futures and options. FIIs can now invest in interest rate futures that were launched at the National Stock Exchange (NSE) on 31st August, 2009. Commercial paper. Security receipts REGULATION RELATING TO FII OPERATION Investment by FIIs is regulated under SEBI (FII) Regulations, 1995 and Regulation 5(2) of FEMA Notification No.20 dated May 3, 2000. SEBI acts as the nodal point in the entire process of FII registration. FIIs are required to apply to SEBI in a common application form in duplicate. A copy of the application form is sent by SEBI to RBI along with

their 'No Objection' so as to enable RBI to grant necessary permission under FEMA. RBI approval under FEMA enables a FII to buy/sell securities on stock exchanges and open foreign currency and Indian Rupee accounts with a designated bank branch. FIIs are required to allocate their investment between equity and debt instruments in the ratio of 70:30. However, it is also possible for an FII to declare itself a 100% debt FII in which case it can make its entire investment in debt instruments. All FIIs and their sub-accounts taken together cannot acquire more than 24% of the paid up capital of an Indian Company. Indian Companies can raise the above mentioned 24% ceiling to the Sectoral Cap / Statutory Ceiling as applicable by passing a resolution by its Board of Directors followed by passing a Special Resolution to that effect by its General Body. Further, in 2008 amendments were made to attract more foreign investors to register with SEBI, these amendments are: The definition of broad based fund under the regulations was substantially widened allowing several more sub accounts and FIIs to register with SEBI. Several new categories of registration viz. sovereign wealth funds, foreign individual, foreign corporate etc. were introduced, Registration once granted to foreign investors was made permanent without a need to apply for renewal from time to time thereby substantially reducing the administrative burden, Also the application fee for foreign investors applying for registration has recently been reduced by 50% for FIIs and sub accounts. Also, institutional investors including FIIs and their sub-accounts have been allowed to undertake short-selling, lending and borrowing of Indian securities from February 1, 2008.

INDIAN CAPITAL MARKET: The Bombay Stock Exchange (BSE), which began formal trading in1875, is one of the oldest in Asia . Over the last decade, there has been a rapid change in the Indian securities market, both in primary as well as the secondary market. Advanced technology and online-based transactions have modernized the stock exchanges. In terms of the number of companies listed and total market capitalization, the Indian equity market is considered large relative to the countrys stage of economic development. Currently, there are 40 mutual funds, out of which 33 are in the private sector and 7 are in the public sector. Mutual funds were opened to the private sector in 1992. Earlier, in 1987, banks were allowed to enter this business, breaking the monopoly of the Unit Trust of India (UTI), which maintains a dominant position. Before 1992, many factors obstructed the expansion of equity trading. Fresh capital issues were controlled through the Capital Issues Control Act. Trading practices were not transparent, and there was a large amount of insider trading. Recognizing the importance of increasing invest or protection, several measures were enacted to improve the fairness of the capital market. The Securities and Exchange Board of India (SEBI) was established in 1988. There have been significant reforms in the regulation of the securities market since 1992 in conjunction with overall economic and financial reforms. In1992, the SEBI Act was enacted giving SEBI statutory status as a nap ex regulatory body. And a series of reforms was introduced to improve investor protection, automation of stock trading, integration of national markets, and efficiency of market operations. India has seen a tremendous change in the secondary market for equity. Among the processes that have already started and are soon to be fully implemented are electronic settlement trade and exchange-traded derivatives. Before 1995, markets in India used open outcry, a trading process in which traders shouted and hand signaled from within a pit. One major policy initiated by SEBI from1993involvedtheshiftofallexchangesto screen-based trading, motivated primarily by the need for greater transparency. The first exchange to be based on an open electronic limit order book was the National Stock Exchange (NSE), which started trading debt instruments in June 1994 and equity in November 1994. In March 1995, BSE shifted from open outcry to a limit order book market. Before 1994, Indias stock markets were dominated by BSE. In other parts of the

country, the financial industry did not have equal access to markets and was unable to participate informing prices compared with market participants in Mumbai (Bombay). As a result, the prices in markets outside Mumbai were often different from prices in Mumbai. These pricing errors limited order flow to these markets. Explicit nationwide connectivity and implicit movement toward one national market has changed this situation. NSE has established satellite communications which give all trading members of NSE equal access to the market. Similarly, BSE and the Delhi Stock Exchange are both expanding the number of trading terminals located all over the country. The arbitrages are eliminating pricing discrepancies between markets. The Indian capital market still faces many challenges if it is to promote more efficient allocation and mobilization of capital in the economy. First, market infrastructure has to be improved as it hinders the efficient flow of information and effective corporate governance. Second, the trading system has to be made more transparent. Third, India may need further integration of the national capital market through consolidation of stock exchanges. Fourth, the payment system has to be improved to better link the banking and securities industries. The capital market cannot thrive alone; it has to be integrated with the other segments of the financial system. The global trend is for the elimination of the traditional wall between banks and the securities market. Securities market development has to be supported by overall macroeconomic and financial sector environments. Further liberalization of interest rates, reduced fiscal deficits, fully market-based issuance of Government securities and a more competitive banking sector will help in the development of a sounder and a more efficient capital market in India.

INFLUENCE OF FII ON INDIAN MARKET Positive fundamentals combined with fast growing markets have made India an attractive destination for foreign institutional investors (FIIs). Portfolio investments brought in by FIIs have been the most dynamic source of capital to emerging markets in 1990s. At the same time there is unease over the volatility in foreign institutional investment flows and its impact on the stock market and the Indian economy. Apart from the impact they create on the market, their holdings will influence firm performance. For instance, when foreign institutional investors reduced their holdings in Dr. Reddys Lab by 7% to less than 18%, the company dropped from a high of around US$30 to the current level of below US$15. This 50% drop is apparently because of concerns about shrinking profit margins and financial performance. These instances made analysts to generally claim that foreign portfolio investment has a short term investment horizon. Growth is the only inclination for their investment. Some major impact of FII on stock market: They increased depth and breadth of the market. They played major role in expanding securities business. Their policy on focusing on fundamentals of share had caused efficient pricing of share. These impacts made the Indian stock market more attractive to FII & also domestic investors. The impact of FII is so high that whenever FII tend to withdraw the money from market, the domestic investors fearful and they also withdraw from market.

Now we analyze the net investment graph from 2000-01 to Nov 30,2011. From this, we can see that there is an increase in net investment till 200506 and there is a small decrease in investment in 2006-07 and then again, increase in 2007-08 and then again decrease in 2008-09. But there was a steep increase in the year 2009-10, 2010-11. This was the best period in the India Stock Market where stock prices were increased and the market was in good mood. Effects of FII on Indian Economy POSITIVE IMPACT: it has been emphasized upon the fact that the stock 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 the stock market reforms. The market reforms were initiated because of the presence of them and this in turn has led to increased flows. A.ENHANCED FLOWS OF EQUITY CAPITAL: FIIs are well known for a greater appetite for equity than debt in their asset structure. For example, pension funds in United Kingdom and United States had 68 per cent and 64 per cent, respectively, of their portfolios in equity in 1998. Not only it can help in supplementing the domestic savings for the purpose of development projects like building economic and social infrastructure but can also help in growth of rate of investment, it boosts the production, employment and income of the host country. B.MANAGING UNCERTAINTY AND CONTROLLING RISKS: FIIs promote financial innovation and development of hedging instruments. These because of their interest in hedging risks, are known to have contributed to the development of zero-coupon bonds and index futures. FIIs not only enhance competition in financial markets, but also improve the alignment of asset prices to fundamentals. FIIs in particular are known to have good information and low transaction costs. By aligning asset prices closer to fundamentals, they stabilize markets. In addition, a variety of FIIs with a variety of risk-return preferences also help in dampening volatility.

C. IMPROVING CAPITAL MARKETS: FIIs as professional bodies of asset managers and financial analysts enhance competition and efficiency of financial markets. By increasing the availability of riskier long term capital for projects, and increasing firms incentives to supply more information about them, the FIIs can help in the process of economic development. D. IMPROVED CORPORATE GOVERNANCE: Good corporate governance is essential to overcome the principal-agent problem between share-holders and management. Information asymmetries and incomplete contracts between share-holders and management are at the root of the agency costs. Bad corporate governance makes equity finance a costly option. With boards often captured by managers or passive, ensuring the rights of shareholders is a problem that needs to be addressed efficiently in any economy. Incentives for shareholders to monitor firms and enforce their legal rights are limited and individuals with small share-holdings often do not address the issue since others can free-ride on their endeavor. FIIs constitute professional bodies of asset managers and financial analysts, who, by contributing to better understanding of firms operations, improve corporate governance. Among the four models of corporate control takeover or market control via equity, leveraged control or market control via debt, direct control via equity, and direct control via debt or relationship banking-the third model, which is known as corporate governance movement, has institutional investors at its core. In this third model, board representation is supplemented by direct contacts by institutional investors. NEGATIVE IMPACT: If we see the market trends of past few recent years it is quite evident that Indian equity markets have become slaves of FIIs inflow and are dancing to their tune. And this dependence has to a great extent caused a lot of trouble for the Indian economy. Some of the factors are: A. POTENTIAL CAPITAL OUTFLOWS: Hot money refers to funds that are controlled by investors who actively seek short-term returns. These investors scan the market for short-term, high interest rate investment opportunities. Hot money can have economic and financial repercussions on countries and banks. When money is injected into a country, the exchange rate for the country gaining the money strengthens, while the exchange rate for the country losing the money weakens. If

money is withdrawn on short notice, the banking institution will experience a shortage of funds. B. INFLATION: Huge amounts of FII fund inflow into the country creates a lot of demand for rupee, and the RBI pumps the amount of Rupee in the market as a result of demand created. This situation leads to excess liquidity thereby leading to inflation where too much money chases too few goods. C. PROBLEM TO SMALL INVESTORS: The FIIs profit from investing in emerging financial stock markets. If the cap on FII is high then they can bring in huge amounts of funds in the countrys stock markets and thus have great influence on the way the stock markets behaves, going up or down. The FII buying pushes the stocks up and their selling shows the stock market the downward path. This creates problems for the small retail investor, whose fortunes get driven by the actions of the large FIIs. D. ADVERSE IMPACT ON EXPORTS: FII flows leading to appreciation of the currency may lead to the exports industry becoming uncompetitive due to the appreciation of the rupee. BSE SENSEX AND FII INVESTMENT CORRELATION Sensex is the commonly used name for the Bombay Stock Exchange Sensitive Index an index Composed of 30 of the largest and most actively traded stocks on the Bombay Stock Exchange (BSE). The term FII is used most commonly in India to refer to outside companies investing in the financial markets of India. FII investment is frequently referred to as hot money for the reason that it can leave the country at the same speed at which it comes in. In country like India; statutory agencies like SEBI have prescribed norms to register FIIs and also to regulate such investment flowing in through Fii .

Date 03-Sep-13 02-Sep-13

Gross Gross Purchase(Cr) Sale(Cr) 2,078.70 2,516.20 2,805.00 2,014.40

Net Cummulative Investment(Cr) Investment($Mn) -726.30 501.80 -108.59 76.19

FII Activity for the Year so far Gross Purchase (Cr) 77,858.80 78,888.30 66,766.60 Gross Sale (Cr) 55,799.80 54,449.10 57,642.70 Net Cummulative Investment Investment (Cr) ($Mn) 22,059.20 24,439.30 9,124.30 4,059.32 4,575.56 1,675.48

Month

January 2013 February 2013 March 2013

April 2013 May 2013 June 2013 July 2013 August 2013 September 2013

61,007.30 74,468.90 55,321.40 60,371.00 69,308.40 11,011.80

55,593.10 52,300.40 66,348.50 66,624.20 75,231.10 11,336.40

5,414.10 22,168.60

1,000.27 4,067.42

-11,026.90 -1,852.15 -6,253.30 -5,922.50 -324.60 -1,042.88 -902.51 -47.44

FII Activity for previous years Gross Purchase (Cr) Gross Sale (Cr) Net Cummulative Investment Investment (Cr) ($Mn)

Year

2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002

669,184.40 540,823.90 128,360.70 24,372.19 611,055.60 613,770.80 -2,714.20 -357.83

766,283.20 633,017.10 133,266.80 29,361.83 624,239.70 540,814.70 83,424.20 17,458.14

721,607.00 774,594.30 -52,987.40 -11,974.30 814,877.90 743,392.00 71,486.30 475,624.90 439,084.10 36,540.20 286,021.40 238,840.90 47,181.90 185,672.00 146,706.80 38,965.80 94,412.00 46,479.10 63,953.50 42,849.80 30,459.00 3,629.60 17,655.80 8,107.00 10,706.30 8,669.80 6,627.60 749.50

2001 2000

51,761.20 74,791.50

38,651.00 68,421.60

13,128.20 6,370.08

2,806.40 1,532.60

INSTITUTIONAL INVESTORS REGISTERED IN INDIA: MUTUAL FUNDS REGISTERED IN INDIA:

From the bar chart above it is clearly evident that the mutual fund industry is still at a nascent stage as compared to the FIIs. Since its inception in 1964 when the first mutual fund i.e. UTI had the monopoly for 25 years. It was thus in the year after 1989 that public sector banks and financial institution started their AMC .Finally in the third phase when private players entered the arena, it lead to a fierce battle to hold the top slot in the Indian mutual fund industry .The growing number of mutual fund companies corroborates the fact that Indian public are now looking for different avenues to invest their earnings and are confident on the working of capital market in India. This shows that SEBI has in a way restored the faith of these investors in spite of the different scams that rocked the capital market in India. FII REGISTERED IN INDIA: Lets look at some of the data to get an idea about the trend of FIIs in India, and also to see the future direction of their movement. India had 528 FIIs were registered with SEBI by end of 2001 and by end of Feb-2008 the number increased to1303. The trend in the number of registered FIIs has been consistently on the rise as can be seen from the table; showing the significant amount of confidence that Indian Capital market has developed in the last few years.

Not only has been the number increasing on a consistent basis, but the amount of inflow into Indian market has also seen a manifold increased. The gross purchase, sales and net investment figure on an annual basis gives a fair idea about the consistency of their investments in our country. As we can see in the investment trends table, except for 1998, the net investment by the FIIs in the Indian market has always been positive since liberalization which to a large extent tells about the consistency of their presence in Indian market. This is also evident from the fact that the number of FII registering in India is increasing in spite of the fact that SEBI has declined to issue any further PN notes and also asked them to get registered. This shows that India still remains the hot spot for the foreign investors in the coming years.

MAJOR INSTITUTIONAL INVESTORS IN INDIA The total number of Domestic institutional investors specially the mutual funds is 40 in number. Similarly insurance companies and other banks are very large in number. But out of these there are some heavy weights which solely by their investments are among the top 5 domestic institutional investors in India. Among the total FII registered i.e. 1303 by the end of Feb. 2008 the top 5 FII in terms of their investment in India are listed below.

DOMESTIC INSTITUTIONAL INVESTORS

LIFE INSURANCE CORPORATION OF INDIA. Life Insurance in its modern form came to India from England in the year 1818. The first two decades of the twentieth century saw lot of growth in insurance business. From 44 companies with total business-in-force as Rs.22.44 crore, it rose to 176 companies with total business-in-force as

Rs.298 crore in 1938. During the mushrooming of insurance companies many financially unsound concerns were also floated which failed miserably. However, it was much later on the 19th of January, 1956, that life insurance in India was nationalized. About 154 Indian insurance companies, 16 non-Indian companies and 75 provident were operating in India at the time of nationalization. Nationalization was accomplished in two stages; initially the management of the companies was taken over by means of an Ordinance, and later, the ownership too by means of a comprehensive bill. The Parliament of India passed the Life Insurance Corporation Act on the 19th of June 1956, and the Life Insurance Corporation of India was created on 1st September, 1956, with the objective of spreading life insurance much more widely and in particular to the rural areas with a view to reach all insurable persons in the country, providing them adequate financial cover at a reasonable cost. LICs emergence as the biggest investor in the country should not surprise anyone. The state-owned company is 51 years old and enjoyed a state-sanctioned monopoly over the life insurance business till 2000. The firm has issued 220 million policies and earned total premium income of Rs39, 541 crore in 2006-07. It is allowed to invest 35% of its funds in equities. The largest chunk in LICs portfolio is the stake it owns in listed engineering giant Larsen and Toubro Ltd. The 15.7% stake in L&T is valued at more than Rs19, 642 crore. Other major investments include a 4.14% stake in Reliance Industries Ltd, the largest Indian company by market capitalization, 7.2 % in ICICI Bank Ltd, 13.4% in ITC Ltd and 4.2 % in Reliance Communications Ltd.

RELIANCE MUTUAL FUNDS:

Reliance Mutual Fund (RMF) is one of Indias leading Mutual Funds, with Average Assets Under Management (AAUM) of Rs. 90,938 Crores (AAUM for Mar 08 ) and an investor base of over 66.87 Lakhs.Reliance Mutual Fund, a part of the Reliance - Anil Dhirubhai Ambani Group, is one of the fastest growing mutual funds in the country. Reliance Capital Ltd. is one of Indias leading and fastest growing private sector financial services companies, and ranks among the top 3 private sector financial services and banking companies, in terms of net worth. Reliance Capital Ltd. has interests in asset management, life and general insurance, private equity and proprietary investments, stock broking and other financial services. ICICI PRUDENTIAL FUNDS: ICICI Prudential Asset Management Company enjoys the strong parentage of prudential plc, one of UK's largest players in the insurance & fund management sectors and ICICI Bank, a wellknown and trusted name in financial services in India. ICICI Prudential Asset Management Company, in a span of just over eight years, has forged a position of pre-eminence in the Indian Mutual Fund industry as one of the largest asset management companies in the country with assets under management of Rs. 37,906.24 crore (as of March 31, 2007). The Company manages a comprehensive range of schemes to meet the varying investment needs of its investors spread across 68 cities in the country. Upon its inception in May 1998 it manages 2 funds of Rs 160 Cr and has grown to manage 35 Funds worth Rs 62,008.95 Cr.

UTI MUTUAL FUNDS:

UTI Mutual Fund came into existence on 1st February 2003. Bank of Baroda (BOB), Punjab National Bank (PNB) and State Bank of India (SBI) and Life Insurance Corporation of India (LIC) are the sponsors of the UTI Mutual Fund. UTI Mutual Fund is managed by UTI Asset Management Company Private Limited (AMC). UTI AMC is a registered portfolio manager under the SEBI (Portfolio Managers) Regulations, 1993 for undertaking portfolio management services and also acts as the manager and marketer to offshore funds. UTI Mutual Fund has a nationwide network consisting 70 UTI Financial Centers (UFCs) and UTI International offices in London, Dubai and Bahrain. The fund has a track record of managing a variety of schemes catering to the needs of every class of citizenry.

HDFC MUTUAL FUND: HDFC (Housing Development Finance Corporation Limited) is one of the dominant players in the Indian mutual fund space. HDFC was incorporated in 1977 as the first specialized Mortgage Company in India. HDFC Mutual Funds are handled by HDFC Asset Management Company Limited. HDFC Asset Management Company was incorporated under the Companies Act, 1956, on December 10, 1999, and was approved to act as an Asset Management Company for the Mutual Fund by SEBI on July 3, 2000. The company also provides portfolio management / advisory services. FOREIGN INSTITUTIONAL INVESTORS:

DEUTSCHE GROUP:

DWS Investments part of Deutsche Asset Management, was founded in 1956 in Frankfurt/Main. With fund assets under management of euro 267 bn, the company is one of the Top 10 companies worldwide. In Europe, DWS is one of the leading mutual fund companies and currently manages euro 173 bn. In excess of more than euro 147 bn assets under management, DWS represents 22, 3% of the fund market in Germany, making it the unchallenged number one. The International nature of its business differentiates DWS significantly from its domestic and international competitors. DWS Investments activities span all the key European markets. In the USA, DWS is represented by DWS Scudder and manages assets of euro 86 bn. In spring 2006, it launched its first funds as well as the DWS brand in Singapore and India, continuing its successful expansion in the AsiaPacific region.

CITIGROUP: The formation of Citigroup in 1998 created a new model of financial services organization to serve its clients financial needs. As the company continues to grow and evolve, its increasingly evident that such a large, complex grouping of businesses can indeed succeed. With 275,000 employees working in more than 100 countries and territories, Citigroups globality and diversity contribute to its continued success. HSBC GLOBAL INVESTMENTS: HSBC Investments is one of the world's premier fund management organizations. It has established a strong reputation with institutional investors including corporations, governments, insurance companies and charities the world over for delivering consistently superior returns. In India we offer fund management services for institutional as well as retail investors. Our array of products includes Equity Funds Income /Debt Funds. MORGAN STANLEY &CO INTERNATIONAL LTD: Morgan Stanley is a global financial services firm and a market leader in securities, investment management and credit services. It has more than 600 offices in 27 countries and manages $421 billion in assets for institutional and individual clients around t h e world. Stanley Investment Management (MSIM), the asset management company of Morgan Stanley was established in 1975. Morgan Stanley entered Indian market in 1989 with the launch of India Magnum Fund. In 1994, Morgan Stanley launched Morgan Stanley Growth Fund (MSGF). It is one of the largest private sector schemes investing in equities. DSP MERRILL LYNCH : DSP Merrill Lynch Mutual Funds are managed by DSP Merrill Lynch Fund Managers. DSP Merrill Lynch Ltd. (DSPML) is a premier financial services provider and Merrill Lynch (ML) holds 90% stake in DSPML. DSPML was originally called DSP Financial Consultants Ltd. The firm traces its origins to D. S. Purbhoodas & Co., a securities and brokerage firm with over 140 years of experience in the Indian market. Merrill Lynch is one of the world's leading wealth management, capital markets and advisory

companies with offices in 37 countries and territories and total client assets of approximately $1.5 trillion.

INVESTMENT TRENDS OF INSTITUTIONAL INVESTORS: INVESTMENT TRENDS OF INDIAN MUTUAL FUND INDUSTRY: The Assets under Management of UTI was Rs.4563 Cr by the end of 1987. Let me concentrate about the performance of mutual funds in India through figures. From Rs.04563 Cr. the Assets under Management rose to Rs. 32977 Cr in March 1993. The net asset value (NAV) of mutual funds in India declined when stock prices started falling in the year 1992. Those days, the market regulations did not allow portfolio shifts into alternative investments. There was rather no choice apart from holding the cash or to further continue investing in shares. A lone UTI with just one scheme in 1964 now competes with as many as 400 odd products and 34 players in the market. In spite of the stiff competition and losing market share, Last six years have been the most turbulent as well as exiting ones for the industry. New players have come in, while others have decided to close shop by either selling off or merging with others. Product innovation is now pass with the game shifting to performance delivery in fund management as well as service. The industry is also having a profound impact on financial markets. While UTI has always been a dominant player on the bourses as well as the debt markets, the new generations of private funds, which have gained substantial mass, are now flexing their muscles. Fund managers, by their selection criteria for stocks have forced corporate governance on the industry. Rewarding honest and transparent management with higher valuations has created a system of risk- reward created where the corporate sector is more transparent then before. Funds collection has been increasing in last 5 years which can be attributed to the fact of sound economic growth and the confidence of the retail investors on the capital market of India.

FOREIGN INSTITUTIONAL INVESTMENT (FII) is one of the main channels of foreign investment in India. Foreign institutional investors (FIIs) were permitted to invest in Indian securities market in 1993. Since then, their investments into Indian equity market have grown by leaps and bounds. In fact, FIIs, as a class of institutional investors, have assumed a major role in mature and emerging market economies, in recent years. The FII in the Indian equity markets has risen steadily since 2003-04. The gross purchases of debt and equity together by FIIs increased by 50.0 per cent to Rs. 5,20,508 crore in 2006-07 from Rs. 3,46,978 crore in 2005-06

INVESTMENTS BY FOREIGN INSTITUTIONAL INVESTORS The gross sales by FIIs also rose by 60.3 per cent to Rs. 4, 89,667 crore from Rs. 3, 05,512 crore during the same period. However, the net investment by FIIs in 2006-07 declined by 25.6 per cent to Rs. 30,840 crore in 2006-07 from Rs. 41,467 crore in 2005- 06 mainly due to large net outflows from the equity segment. But the cumulative net investment by FIIs in Indian stock market (since 1993) crossed USD 50 billion at the end of March 2007. As on March 31, 2007, the cumulative net investment by FIIs was USD 52 billion. The cumulative net investment by FIIs at acquisition cost, which was USD 15.8 billion at the end of March 2003, had risen to USD 45.3 billion at the end of March 2006. The FII in equity, which was high in the previous years, declined in 2006-07. During 2006-07, FIIs reduced their investment, in both equities as well as debt securities. The net FII investment in equity during 2006-07 was Rs. 25,236 crore, at its lowest in past three years. This was mainly due to large net sales in some months of 2006-07.

INVESTMENT TRENDS BY FII As far as the investment trends of FII are considered we can see that the trend and the actual investment go hand in hand except in 98-99 and 20032004.The net investment flows by FIIs were negative during 1998-99 primarily because of the uncertainty that prevailed after India tested a series of nuclear bombs in May 1998 and the imposition of economic sanctions by the US, Japan and other industrialized countries but the FIIs portfolio flows quickly recovered and have become a positive net investment from the subsequent years onwards.

REASONS FOR GROWTH IN FII INVESTMENTS Global liquidity is, of course, the primary cause of the recent surge in Asian markets including India. Also low interest rate regime has led foreign investors to look for fresh avenues to invest. This has resulted in most emerging markets seeing heavy inflows. FIIs see India as a good destination to invest in and make money. They are happy with the Indian government's commitment to economic reforms. They are also looking closely at sectors (and companies within these sectors) which they think have potential. Infact, the growing competitiveness of Indian companies is an enticing factor.

Long-Term Capital Gains Tax: which is the tax an investor pays when he sells his shares after more than a year -- has been abolished; thus one can sell his shares without having to pay the government any kind of tax. Rupee Appreciation: The dollar has been falling in value vis--vis other currencies. As a result, FIIs dont find the thought of investing in the US market all that attractive. They know they will make more money if they invest elsewhere. Economic Growth: As mentioned earlier we witnessed a GDP growth rate of about 8.5% last year. Our industries like Telecom, Banking etc are doing relatively well. All these make our country very attractive to invest in.

The sheer size of India and the relative stability the country offers are other obvious plus points. Whatever the case may be, a perception is gaining momentum that foreign investors are here to stay at least in the short-term. FOREIGN INSTITUTIONAL INVESTMENT: A COST BENEFIT ANALYSIS The role of foreign investment over the years cant be ignored . It certainly has had an impact on the Indian stock market with a lot of benefits but along with these benefits there are a few costs attached with it. Therefore it is useful to summarize the benefits and costs for India of having foreign inflows. 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. 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 exportoriented, 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. 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.

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 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 vise 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.

COMPARISON BETWEEN FIIs AND MUTUAL FUNDS INVESTMENTS The comparison between the FII purchases and net investment with Mutual funds for the period reveals some interesting information. The amount of mutual fund investment in our country is very meager as compared to that of FIIs. It means that Indian public is still not putting its bet on mutual funds and. FIIs are much more aggressive in nature than mutual funds, which seem to have been very constant in their approach to the Indian equity market. Since May04, when the stock market crashed by 800 points in a day, the market has recovered smartly and the FIIs have been able to cash on to the gains by buying Value stocks during the lean periods, or buying on the dips. While the mutual funds have seems to taken a different route altogether and have been net sellers for most of the period since May04. But after the year 2004 mutual Fund investment have also a tremendous increase. There activity is the proof of the condition that has prevailed in the capital market recently that has created a lot of faith among the retail investors also. Also in the year 2007 has so far been the best year for mutual fund industry as it has shown a tremendous growth in terms of net investment. This corroborates the fact that now Indian public has started recognizing mutual fund as tool for investing in the capital market in India.

ROLE OF INSTITUTIONAL INVESTORS IN CAPITAL MARKET IN INDIA: As the Indian capital market opened its gates for the foreign institutional investors. With time there has been an increasing trends of their participating in the capital market. With there increasing participation there has been a lot of effect on many parameters of the Indian capital market. The major effect of the increasing participation of the institutional investors has been observed in the following areas. Liquidity: Market liquidity is a business, economics or investment term that refers to an asset's ability to be easily converted through an act of buying or selling without causing a significant movement in the price and with minimum loss of value. An act of exchange of a less liquid asset with a more liquid asset is called liquidation. Liquidity also refers both to that quality of a business which enables it to meet its payment obligations, in terms of possessing sufficient liquid assets; and to such assets themselves. A liquid asset has some or more of the following features. It can be sold (1) rapidly, (2) with minimal loss of value, (3) anytime within market hours. The essential characteristic of a liquid market is that there are ready and willing buyers and sellers at all times. An elegant definition of liquidity is also the probability that the next trade is executed at a price equal to the last one. A market may be considered deeply liquid if there are ready and willing buyers and sellers in large quantities. This is related to a market depth, where sometimes orders cannot strongly influence prices. The liquidity of a product can be measured as how often it is bought and sold; this is known as volume. Often investments in liquid markets such as the stock exchange or futures markets are considered to be more liquid than investments such as real estate, based on their ability to be converted quickly. Some assets with liquid secondary markets may be more advantageous to own, are willing to pay a higher price for the asset than for comparable assets without a liquid secondary market. 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 has a cost attached to it and also in 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: Generally people transact for three reasons hedging speculating and arbitraging Hedgers are those to intend to hedge their risk. Speculation may be defined as the purchase or sale of a good with a view to resale or repurchase at a later date, where the motive behind such action is the expectation of changes in the prices. Speculation is one of the most watched activity in any capital market its importance varies in different countries in countries like in US it forms an integral part of the market whereas in developing countries like India its taken as a threat. It is often believe that speculators even out the price fluctuation by due to change in demand and supply condition but the concerns about the adverse effects of speculation come from two sources. First, the possibility that speculation, instead of evening out price fluctuations, may end up exacerbating such fluctuations. Second, is the problem of speculation destabilizing rather than stabilizing prices and hence affecting resource allocation. Through speculation, future expected price not only depends on, but also has an impact on the spot price. The market for shares is subject to much larger fluctuations than the market for bonds or even commodities. Shares represent a share in the expected future profits of a company. When fortunes of companies both in the short run as well as in the medium to long run fluctuate, so do share prices. Uncertainty regarding the future leads to heavy discounting of future profits, and to focus on short-period expectations about capital value rather than long-period prospects of the company. 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.

Volatility: Volatility most frequently refers to the standard deviation of the change in value of a financial instrument with a specific time horizon. It is often used to quantify the risk of the instrument over that time period. Volatility is typically expressed in annualized terms, and it may either be an absolute number ($5) or a fraction of the mean (5%). Volatility is often viewed as a negative in that it represents uncertainty and risk. However, volatility can be good in that if one shorts on the peaks, and buys on the lows one can make money, with greater money coming with greater volatility. The possibility for money to be made via volatile markets is how short term market players like day traders hope to make money, and is in contrast to the long term investment view of buy and hold. In today's markets, it is also possible to trade volatility directly, through the use of derivative securities such as options and variance swaps. 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 Indias 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 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--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.

A STUDY OF MAJOR EPISODES OF VOLATILITY Asian Major Episodes of Volatility Excess volatility induced by the foreign investment is often taken as an argument against liberalization with such incidences happening in the past. Let us now try to find out whether the foreign investors in particular destabilize the capital market beyond a level. The two most common examples of such destabilization caused by the portfolio investment particularly the hedge funds are the Asian crisis of 1997 and the ERM crisis of 1992. I. ERM crisis The high-profile ERM crisis of 1992 came with speculators betting that the member countries of the European Monetary System (EMS) were converging to the European Monetary Union (EMU), and high-inflation countries would have to realign their exchange rates, but the extent of depreciation would be less than the interest rate differential between the high-inflation and low-inflation countries. The expectation regarding the extent of exchange rate adjustment led to carry trade borrowing from the low interest ERM countries and lending to the high interest countries, or in the forward currency market, taking a long position in the higher yielding currency and shorting the lower-yielding currency. In spite of the material impact of hedge fund activities in the ERM crisis, the role of the hedge funds in the crisis was limited. The practice of extending lines of credit to offshore entities on a non-recourse basis against collateral was not widely accepted by most banks, and foreign exchange trading was primarily an inter-bank activity. East Asian crisis After ten years (198697) of pegging of the Thai baht to the U.S. dollar, on July 2, 1997, the peg had to be abandoned, and this created pressure on other Asian currencies, and eventually brought down the Malaysian ringgit, the Indonesian rupiah, the Philippine peso, and the Korean won. By end-1997, these currencies had lost between 44 and 56 percent of their value against the U.S. dollar, bankrupting many Asian corporations and banks that had borrowed in foreign currencies, and leading to a significant contraction of the economies. This episode is known as the East Asian crisis or Asian crisis.Foreign investors were often blamed for the dramatic difficulties of the East Asian countries at the times of the 1997 crisis. It was believed that the developing countries were more vulnerable to vacillations in international flows than ever before A variety of

reasons are adduced to explain why foreign investors can have a destabilizing effect on capital markets in emerging economies. Foremost among them are the pursuit of a positive feedback strategy that is buying when prices are rising and selling when prices are falling, thereby exacerbating both the upswings and downswings. Positive feedback leads to bubbles when prices depart from fundamentals and to crashes when bubbles burst. It is also believed that the Asian financial crisis was the result of a panic created in the market Prime Minister Mahathir Mohammed of Malaysia accused hedge funds of being the modern equivalent of highwaymen in breaking the Asian currencies. Aggressive flow of the carry trade down the credit spectrum in Asia during the 1990s from sovereign credit, to top -tier domestic commercial banks, to lower-tier commercial banks and finance companies, and finally to firms. The excessive build-up of foreign debt, they attribute to the confidence of domestic companies and banks in the fixed official exchange rate. 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. During the stock market scam which shook the capital market in India the FII were also one of the major factors which exacerbate the fall in the sensex. During the Black Monday episode the FII were also on a heavy selling spree which ultimately lead to some major fall in the sensex value. 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. 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, Indias 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 clearing and settlement systems and risk management mechanisms. Product diversification and introduction derivatives. Strengthening of the rupee dollar exchange rate and low interest rates in the US. Post 2004 Major Volatile Episodes: As from the above graph it is clear that in 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 panick among the investors and further exacerbating the fall. But in the case of mutual fund investment went up during the time shows that the the domestic institutional investors cash on the fall of sensex because of the strong fundamentals of the Indian capital market. By looking at the above graph 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 there 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 graph that this time around the FII were the main cause of the crash of the sensex on 18th October. But also there comes an interesting fact that there was also a heavy selling on 22nd October but this time the FII 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 73 Billion)sharwes by FIIs 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 countrys Finance Minister, issued an evening press release denying the latter. STATISTICAL ANALYSIS For the purpose of statistical analysis I have considered 7 yrs data of FII Net Investments, Mutual Funds Net Invesments ,NSE S&P CNX Nifty and BSE Sensex Indices. Statistical Analysis is carried out to find the degree of association between the Net investments by the institutional investors with the capital market i.e (Sensex & Nifty indices). Since 7 years data is a very comprehensive data and the internal and the extraneous factors have been changing over the time which does have impact on the Indian capital market. So in order to have appropriate data I calculated the volatility of BSE Sensex for each year and then divided them into 3 periods i.e 2001-2003,2004-2005,2006-Feb 2008. Then I have applied

regression analysis to find out the degree of association among the FII Net Investments ,the Sensex and Mutual Fund Investments , the Sensex . Similarly the degree of association is been calculated for Nifty index with FII and Mutual funds net investments.

To calculate the volatility of the BSE Index and to find out the degree of association ,the formula and the methodology is given below. 1. Volatility Volatility is a measure of the range of an asset price about its mean level over a fixed amount of time. It follows that volatility is linked to the variance of an asset price. If a stock is labeled as volatile then the price will varies greatly over time. Conversely, a less volatile stock will have a price that will deviate relatively little over time. Since volatility is associated with risk, the more volatile that a stock is, the more risky it is. Consequently, the more risky a stock is, the harder it is to say with any certainty what the future price of the stock will be. Computing the Volatility The estimation of volatility comes from a mathematical model of stock prices. The mathematical model we will use is based on three assumptions about stock prices and their movements. The first assumption that we will be using is that volatility is constant. The next assumption is that stock prices cannot be negative; once a stock price reaches $0 it cannot go any lower. The third assumption is that the price of a stock is a normal random variable. Thus volatility is calculated as standard deviation as it is the standard measurement device used worldwide to calculate the volatility. Standard deviation is a statistical term that provides a good indication of volatility. It measures how widely values (closing prices for instance) are dispersed from the average. Dispersion is difference between the actual value (closing price) and the average value (mean closing price). The larger the difference between the closing prices and the average price, the higher the standard deviation will

be and the higher the volatility. The closer the closing prices are to the average price, the lower the standard deviation and the lower the volatility.

2. Regression Analysis: Regression Analysis is another statistical tool for measuring the association between two variables. It is a technique used to predict the nature and closeness of relationships between two or more variables. This analysis helps the researchers to evaluate the causal effect of one variable on another variable. It is used to predict the variability in the dependent variable based on the information of one or more independent variable. Regression analysis that involves two variable is termed as bivariate linear regression analysis. It is expressed as following equation. Y=a+b*X Where Y is the dependent variable (Sensex and Nifty Indices ) X is the independent variable (FII Investments and Mutual Funds Investments). a & b are two constants which are known as regression coefficients. b is the slope coefficient i.e the value of b is the change in value of Y with corresponding change in one unit of X. The constant b can be calculated using following formula: b = n(XY)- XY n(X)2 (-X)2 a represents Y intercepts when X=0. a =Y-bX where Y=the mean of values of dependent variable. X=the mean of values of independent variable. We now develop the estimated regression equation = a+bX represents the estimated value of dependent variable for a given value of X. Strength of Association - R2

The above developed estimated regression equation can only explain the nature of relationshipbetween two variables.However, if the researcher wants to know how strong or weak the relationship is i.e to what degree that the variation in Y can be explained by X.the coefficient of determination denoted by R2 is used. R2 which is measured in percentage will explain how much of the total variation in Y is explained by X variable. R2 = explained Variance / Total Variance Total Variance=Explained Variance Unexplained Variance R2 = (Total Variance- Unexplained Variance) / Total Variance. Unexplained Variance = (Yi- )2 Total variance= (Yi- Y)2 Tables below give the results of the regression analysis done on the data above mentioned. The above table which shows the result of the regression analysis done with ssensex as the dependent variable and FII as the independent variable. Volatility is calculated for sensex and the table shows that the sensex volatility has been increasing over the years. The value of R2 implies that the in the year 2001 2003 , the total variation of sensex nearly 27% is explained by the variation of FII investments. Over the years it has been following a decreasing trend which is good for the Indian capital market as this shows that FII is not the only criteria on which the volatility of sensex is dependent. The above table shows the analysis ran between the sensex and the mutual funds in india.As we know mutual funds in india are at a nascent stage . the result of R2 tells us that the dependency of sensex variation on the mutual fund investment has been increasing over the years. The Above graph shows us the volatility of Nifty over the period of seven years and the results tell us that the volatility has been increased over the years. The Value of R 2 also tells us that the total variation of nifty index, nearly 26% is explained by the variation in FII net investment in the year 2001-2003 and has been decreasing over the years.

Interpretation of the Analysis. Now looking at the result table above it is clearly visible that volatility has increased tremendously during the years.Volatility has increased six times in the case of Sensex and for nifty it has increased nine times as compared to what it was there in the years 20012003. Also the value of the constant a in the regression equation is following an increasing trend which tells the effect on the dependent variable when the independent variable is zero. Similarly the constant bwhich tells the magnitudinal change with one unit change in the independent variable is also following a decreasing trend in the case of FII investments but in the case of mutual funds it is showing an increasing trend which tells us that domestic institutional investors are also restoring faith in the market and subsequently they have increased there participation in the capital market. The degree of association i.e R square tells us an important fact that slowly and steadily the degree of association of FII investments with the Sensex is decreasing .It tells us the fact that in the year 2001-2003 around 27% of the total variance shown by sensex could be explained by FII investments in both the leading stock exchanges in india.Also in the subsequent years the value or R square is decreasing in case of FII investments leading to the fact that the volatility effect of FII on the capital market is on the decreasing trend,which is beneficial for the Indian stock market.Also the increasing value of R square in case of mutual funds is also a positive sign for the Indian stock market as it tells us that the domestic investors over the years has shown increased participation and helped the market to stablise inspite of such high volatility .

Recommendations After analyzing the nature and behavior of the foreign institutional investment in the past and its influence on the Indian stock market it would be safe enough to say that foreign funds are one of the most volatile instruments floating in the market and needs to be handled cautiously. Government should certainly encourage foreign institutional investment but should keep a check on the volatility factor. Long term funds should be given priority and encouraged some of the actions that could be taken to ensure stability are strengthening domestic institutional investors The participation of domestic pension funds in the equity market would augment the diversity of views on the market and hence the domestic pension funds must be encouraged . Broad basing of eligible entities In order to address the market integrity concerns arising out of allowing some entities, which do not have reputational risk or are unregulated, there is merit in prohibiting such entities from getting registered. Operational flexibility to impart stability to the market The stability of foreign investment in India will be enhanced if FIIs are able to switch between equity and debt investments in India, depending on their view about future equity returns. SEBI can make such policies. Knowledge activities and research programs There must be a lot of research programs and studies conducted by the economic affairs regulators in India.

Conclusion After analyzing the nature of FII in the past it would be safe enough to say that the foreign funds is certainly one of the most important cause of volatility in the Indian stock market and has had a considerable influence on it. Although it would not be fair enough to come to any conclusion as there are a lot of other factors beyond the scope of the study that effect returns and risks .it is not easy to predict the nature of the macroeconomic factors and their behavior but it has a great significance on any economy and its elements. Although generally a positive relation has been seen between the stock market returns and the FII inflows it is not easy to say which is the cause n which is the effect and strange behavior has also been noticed in the past. Foreign investment certainly are influencing the Indian stock market but the extent of this influence cannot be determined or rather the extent of Indias dependence on the FIIs is a subjective issue as on no clear grounds can we see a permanent relationship between the stock market returns and the Foreign inflows. But to generalize they have shown a positive relation most of the time apart from a few occasions where the behavior of their relation was difficult to explain.