FII Flows and Stock Market Volatility : Exploring Causal Link

In the age of transnational capitalism, significant amounts of capital are flowing from developed world to emerging economies like India. An important feature of the development of stock market in India has been the growing participation of Foreign Institutional Investors (FIIs) in the last 15 years. In India, major portion of FIIs has gone into equities since its inception in 1990's. Given the huge volume of these flows, especially after 2003, its impact on domestic financial market is worthy of a rigorous empirical analysis. The existing literature suggests that the short-term nature of FII has a possibility of bidirectional causality running between it and stock returns. As the Indian equity market is growing, the trend and future prospects in FIIs has become a topic of great concern. The paper is intended at exploring the causal relationship between FIIs inflows and volatility in indices of NSE by adopting Granger Causality test in a bivariate VAR framework. The objective of the paper was to explore answer to the research question whether movements in FIIs inflows have an effect on stock market returns or movements in stock market returns have an effect on direction of FIIs inflows in India in particularly at National Stock Exchange, one of the fastest emerging stock markets with high volatility. The analysis covered daily data series on FIIs inflows and S&P CNX NIFTY for seven financial years from April 2003 to March 2010. To investigate whether the data is stationary or not, the researchers used Augmented Dickey Fuller test and Phillips Perron test