Impact of foreign and domestic investment in stock market volatility: Empirical evidence from India

Abstract

Volatility is one of the most important factors of investment decisions. Unexpected information forces the investor to trade abnormally in the market which in turn affects the volatility of the market. But this kind of trading behavior has a different impact on the different market segments. This study investigates the effect of unexpected DII and FPI flows on the volatility of large-cap, mid-cap and, small-cap stocks in Indian markets. Using ARMA (1, 1) and TGARCH (1, 1) model, we estimate the impact of unexpected FPI and DII flows on volatility. The main result of the study shows that unexpected flow of FPIs has a positive impact on market volatility but this impact is reduced by unexpected flow of DIIs. Further, results show that unexpected selling of FPIs increase volatility more than unexpected purchase. Impact of unexpected flow of DIIs flow is more dominating in small-cap stocks. Results from this study are useful for policymakers and regulator.

Keywords:

• volatility
• FPI
• DII
• GARCH

Jel classifications:

• C580
• G170
• G230
• G280

PUBLIC INTEREST STATEMENT

There are two broad sources of investments in Indian stock market: Foreign Portfolio Investments (FPIs) and Domestic Institutional Investments (DIIs). DIIs, unlike FPIs, are considered a stable source of capital because they are domestic in nature. Unexpected information forces abnormal trade, but this abnormality is non-uniform in different market segments. This study investigates the effect of unexpected DIIs and FPIs flows on the volatility (fluctuation) of large-cap, mid-cap and, small-cap stocks in Indian markets. Results show that unexpected flow of FPIs has a positive impact on volatility but this impact is reduced by unexpected flow of DIIs in large cap and midcap stocks. In small-cap stocks, unexpected flow of DIIs increases volatility.

This study recommends that government should maintain a balance between FPIs and DIIs. This study is the first attempt to explore the relationship between market volatility of three different segments and investment flows of both DIIs and FPIs.

Notes

1. Henry (2000) reported that stock market liberalizations increase private investment booms in developing countries, which leads to an increase in profitability and reduce the cost of capital in these countries. Foreign portfolio investment increased from USD 1638 Million in 1993–1994 to USD 251,545 Million in December 2017 whereas mutual fund investment increased from INR 62,076 Cr in 1993–1994 to INR 15,395,928 Cr in December 2017. Security and exchange board of India (SEBI): Handbook of statistics.

2. Based on this research the following hypotheses are very pronounced—the base-broadening hypothesis, the price-pressure hypothesis and the positive feedback hypothesis (Apte & Badrinath, 2003; Clerk & Berko, 1997). The base-broadening hypothesis suggests that the expansion of investor-base leads to the increased level of diversification which reduces the systematic risk, required risk premium cost of capital and, increase expected return (Errunza & Losq, 1985, 1989; Merton, 1987). The entry of foreign portfolio investors in emerging markets also reduces the perceived liquidity risk in the market (Allen & Gale, 1991; Hargis, 1995; Pagano, 1989). Thus base-broadening hypothesis suggests a long-term cointegrating relationship between the flow of foreign portfolio investment and aggregate level of stock-prices with causality running from investment flow to stock prices. Warther (1995) in his price-pressure hypothesis suggests that temporary illiquidity increase in the share price and predicts that this change in share price is subsequently reversed. According to positive feedback trading investors take information signals from the recent past price patterns and form their extrapolative expectation about the future prices therefore, the investment-flow lags behind the returns (Brennan & Cao, 1997). Warther (1995), Edelen and Warner (2001), and Watson and Wickramanayake (2012) study and find a positive relationship between aggregate fund flows and market returns.

3. Nifty 50 is the index of large-cap firms so Nifty 50 is used as synonymous of Nifty largecap50.

4. To tackle the high variability, we took natural logarithm of the entire variable. Hence the study uses natural logarithm of all variable for modelling.

5. The lags have been selected after evaluating other lags as it pronounced by Box Jenson methodology.

6. The LB statistic for residuals of the model for cumulative autocorrelations up to lag 10 is small but significant at 5 percent. However, the LB statistic for squared residuals is not significant which shows that the TGARCH (1, 1) is sufficient to capture the ARCH effect in the return series.

7. Purchase ratio is defined as the gross purchase by FPIs divided by gross purchase By DIIs.

8. Sales ratio is defined as the gross sales by FPIs divided by gross sales By DIIs.

9. Full equation model used for the study is described in appendix.

Additional information

Funding

The authors received no direct funding for this research.

Notes on contributors

Bhaskar Chhimwal

Bhaskar Chhimwal is a young scholar in Shailesh j. Mehta school of Management (SJMSOM), Indian Institute of Management Bombay (IIT Bombay), India. His research interest is financial economics, Investment strategies and portfolio management.

Varadraj Bapat

Varadraj Bapat is Associate Professor in Accounting and Finance in Shailesh j. Mehta school of Management (SJMSOM), Indian Institute of Management Bombay (IIT Bombay), India. He has obtained professional qualifications in Chartered Accountancy (with All India Rank), Cost Accountancy, and Information System Audit before obtaining PhD from IIT, Bombay. He has a consulting and teaching experience over 25 years. He has authored many research papers in national and international index journals and has authored many books published by reputed publishers. His areas of research include financial accounting, Managerial accounting, Financial Inclusion, Corporate Governance, Family Business analysis, Portfolio Management, Indian business and economic Model. He is member of Board of Governors for IIT Guwahati and NIT Manipur.