Foreign Institutional Investment and Stock Market Volatility in India: An Empirical Analysis

Abstract

The two major capital market reforms of (i) entry of Foreign Institutional Investors (FIIs) in Indian stock market (ii) permission to Indian companies for raising capital from foreign stock exchanges by means of American Depository Receipts (ADRs) / Global Depository Receipts (GDRs). Further introduction of two-way fungibility in these instruments of ADRs / GDRs leads to reduction of the sovereignty of Indian stock market. As such, Indian stock market now, is not only sensitive to national events but also more sensitive to international events. Due to the speculative motive of FIIs investment, investment by FIIs is subject to frequent reversals. Volatility is a measure of how far the current price of an asset deviates from its average past prices. Investors demand higher risk premium as a compensation for increased risk due to volatility. A higher risk premium implies higher cost of capital and thus lowers investment. The prevailing inefficiency in emerging securities markets including India further magnifies the problem of volatility.  In this paper, an effort is made to predict stock return volatility and contribution of FIIs investment to that volatility using high frequency data (daily data).