Macroeconomics – Policies and Principles

Effect of Currency Fluctuation on FII Project Report

Group 9, Section-F Dishank Jain – 11FN-036 Rakhi Palsania -11FN-133 Shikhar Mishra -11DM-148 Vaqar Merchant -11IT-032 Vidhan Biyani -11DM-175

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Table of Contents

Scope and Purpose of the Study ............................................................................................................... 2

Currency Fluctuations ............................................................................................................................... 2

FDIs and FIIs .............................................................................................................................................. 2

Foreign Institutional Investors .................................................................................................................. 3

Currency Fluctuations and FII – Mutual Effects ........................................................................................ 4

Effect of FII on Indian Stock Market .......................................................................................................... 7

Conclusion ................................................................................................................................................. 7

References ................................................................................................................................................ 7

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Scope and Purpose of the Study

The scope of the study is very broad study of currency fluctuation and study of its effects is narrowed

down to FIIs only. The purpose of the study is to understand the currency fluctuation and its effect on

foreign institutional investors. Various articles from reputed newspapers and e-news sites on the

internet were followed for the understanding and the effect of currency fluctuation on FIIs was studied.

Currency Fluctuations

Currency fluctuation includes currency appreciation and depreciation. Any change in the value of a

country’s currency in the international market has far flung effects on its stock market, imports and

exports, net value, FDIs and FIIs. Currency value in India is very volatile and there are many factors which

participate in the improvisation or devaluation of money.

FDIs and FIIs

Both FDI and FII are related to investment in a foreign country. FDI or Foreign Direct Investment is an

investment that a parent company makes in a foreign country. On the contrary, FII or Foreign

Institutional Investor is an investment made by an investor in the markets of a foreign nation. In FII, the

companies only need to get registered in the stock exchange to make investments. But FDI is quite

different from it as they invest in a foreign nation.

The Foreign Institutional Investor is also known as hot money as the investors have the liberty to sell it

and take it back. But in Foreign Direct Investment, this is not possible. In simple words, FII can enter the

stock market easily and also withdraw from it easily. But FDI cannot enter and exit that easily. This

difference is what makes nations to choose FDI’s more than then FIIs.

FDI is more preferred to the FII as they are considered to be the most beneficial kind of foreign

investment for the whole economy. Foreign Direct Investment only targets a specific enterprise. It aims

to increase the enterprises capacity or productivity or change its management control. In an FDI, the

capital inflow is translated into additional production. The FII investment flows only into the secondary

market. It helps in increasing capital availability in general rather than enhancing the capital of a specific

enterprise.

The Foreign Direct Investment is considered to be more stable than Foreign Institutional Investor. FDI

not only brings in capital but also helps in good governance practices and better management skills and

even technology transfer. Though the Foreign Institutional Investor helps in promoting good governance

and improving accounting, it does not come out with any other benefits of the FDI.

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While the FDI flows into the primary market, the FII flows into secondary market. While FIIs are short-

term investments, the FDI’s are long term.

In short

1. FDI is an investment that a parent company makes in a foreign country. On the contrary, FII is an

investment made by an investor in the markets of a foreign nation.

2. FII can enter the stock market easily and also withdraw from it easily. But FDI cannot enter and exit

that easily.

3. Foreign Direct Investment targets a specific enterprise. The FII increases capital availability in general.

4. The Foreign Direct Investment is considered to be more stable than Foreign Institutional Investor.

Foreign Institutional Investors

FII means an entity established or incorporated outside India which proposes to make investment in

India. For this purpose, sub-accounts are to be maintained. Sub-account includes those foreign

corporations, foreign individuals, and institutions, funds or portfolios established or incorporated

outside India on whose behalf investments are proposed to be made in India by a FII.

Following entities / funds are eligible to get registered as FII:

Pension Funds

Mutual Funds

Insurance Companies

Investment Trusts

Banks

University Funds

Endowments

Foundations

Charitable Trusts / Charitable Societies

Further, following entities proposing to invest on behalf of broad based funds, are also eligible to be

registered as FIIs:

Asset Management Companies

Institutional Portfolio Managers

Trustees

Power of Attorney Holders

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Broad Based Fund means a fund established or incorporated outside India, which has at least twenty

investors with no single individual investor holding more than 10% shares or units of the fund.

Provided that if the fund has institutional investor(s) it shall not be necessary for the fund to

have twenty investors.

Provided further that if the fund has an institutional investor holding more than 10% of shares

or units in the fund, then the institutional investor must itself be broad based fund.

Parameters on which SEBI decides an FII applicant’s eligibility

Applicant’s track record, professional competence, financial soundness, experience, general

reputation of fairness and integrity. (The applicant should have been in existence for at least

one year).

Whether the applicant is registered with and regulated by an appropriate Foreign Regulatory

Authority in the same capacity in which the application is filed with SEBI.

Whether the applicant is a fit & proper person.

Currency Fluctuations and FII – Mutual Effects

Firstly, it is important to understand the effects of any sort of currency fluctuation on the Indian

economy, which affects its different industries and how that finally affects Foreign Investment.

India has a managed floating exchange rate system. This implies that the exchange rates are decided by

international trade of currency but the government does intervene when it deems necessary. It

intervenes by controlling the money supply in the economy and as per the demands of the situation.

An example:

Say the Rupee is currently trading at 50 Rs. = $1

Two scenarios are now possible:

Scenario 1:

40 Rs. = $1

This essentially implies that the Rupee has now appreciated, or that the Rupee had become stronger.

This also implies that Indian goods have gotten more expensive and will lead to an increase in imports.

Scenario 2:

50 Rs. = $1

This implies that the Rupee has now become weaker or depreciated and also implies that Indian goods

have now become cheaper as compared to foreign goods resulting in an increase in exports.

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These effects may be result of:

Interest rates: Increasing interest rates mean higher returns on investments in the home country which

result in higher investments, this in turn results in a greater demand for the Rupee which eventually

causes it to appreciate. The direct affects of this appreciation on the FII’s can be explained with the help

of the following example:

An FII invests at an exchange rate of $1 = Rs. 50 and invests an amount of Rs. 10 lakhs which is

equivalent to $20000. Now, say, after a year the Rupee appreciates to $1 = Rs. 40. Excluding the returns

on the investment it can now be seen that it can be seen that the investment is now worth

$25000(100000/40). Thus, the appreciation of the Rupee is a positive sign and encourages Foreign

Institutional Investment.

The impact of Rupee fluctuation on the industry

Considering the previous example, the appreciation of the Rupee has now led to making imports

cheaper which spells good news for companies who rely on imports.

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Rupee movement has a very high correlation with stock price movement in India. This is explained by

the fact that foreign institutional investors (FIIs) are the largest group of investors in the Indian stock

market and their buying and selling has a big influence on domestic stock prices. FIIs tend to track rupee

movement closely as the returns they make on their Indian holdings can be affected significantly by

currency movements.

For example, if the Nifty returned 0.51 per cent in one month, the domestic investors would

have broken even on their Nifty investment. FIIs investing in Nifty would, on the other hand,

have lost 6 per cent in the same period largely due to currency movement if they were from the

US.

FIIs from other countries too would have made losses but to a lower extent as the rupee has been

depreciating against most major currencies, including the yen, euro, pound and Australian dollar over

the past month. It is, therefore, not surprising those FIIs would track rupee closely and their outflows

would accelerate in a scenario of rapid currency depreciation.

The stance of FIIs has an equally strong impact on the movement on the Indian currency. On days when

Indian stocks witness a sell-off, the rupee too depreciates on fears that FIIs could be moving out of

Indian stocks. The situation is the reverse on days when Indian stocks rally. The fact that our current

account deficit is financed mainly through foreign portfolio flows and India's forex reserves of $316

billion is largely built through FII inflows, could explain the influence that these flows have on the

rupee's direction.

The following table shows year-wise FII investments in India in

Year FII (INR Cr.)

1997 8574.5

1998 5957.2

1999 -1584

2000 10122.1

2001 9933.4

2002 8762.6

2003 45764.7

2004 45881.3

2005 41466.7

2006 30840.4

2007 66179.1

2008 -45811

2009 142658.3

2010 146438.1

2011 8503.7

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Effect of change in FII on Indian Stock Market

1) Impact of FIIs on Sensex: The relationship between these two variables is more in the period

when there is bearish trend. The correlation is although very subtle and hence the relationship is

not very significantly effective on each other.

2) Impact of FIIs on Nifty: Nifty shows a strong decline with withdrawal of FIIs.

3) Impact of FIIs on Industrial Sectorial Indices: In different Industrial sectorial indices of BSE (BSE

Auto, BSE Banking, BSE CD, BSE FMCG, BSE Realty) the correlation is always less. FII doesn’t have

much impact on the sectorial indices. The withdrawal by FIIs is resulting in a fall in the indices

and so FIIs are playing a good role in the industrial sectorial indices.

4) FIIs have less impact on other stock indices and other unexplained variables are also influencing

the Indices.

5) In bearish trend the volatility in Indian Stock indices due to FIIs is more than in bullish trend. No

doubt FII inflow is more in bearish times. The domestic investors also play an important role. FIIs

influence market more when domestic investors are not in the market.

Conclusion

The above graph shows an almost linear pattern. It can be attributed to the fact that the correlation

coefficient among the selected companies in the portfolio is quite high. According to the Table 5, all the

pair of companies has this value above 0. This means that this portfolio does not provide hedging i.e.

reduces the risk in the portfolio. As one stock increase, the others would also increase and vice-versa.

Hence, it is not advisable for any investor to participate in such a portfolio of investment which does

provide any protection on risk.

References

1. http://www.sebi.gov.in/sebiweb/investment/statistics.jsp?s=fii#

2. http://stockshastra.moneyworks4me.com/learn/exchange-rate-fluctuation-rupee-appreciation-

impact-on-stock-markets/

3. http://www.mydigitalfc.com/stock-market/currency-fluctuations-will-not-trigger-fii-exit-only-

hot-money-may-flow-out-640

4. http://www.business-standard.com/india/news/fii-inflows-steady-despite-se-asian-crisis-

sebi/63647/

5. http://www.indistock.com/currency-derivatives/default.asp