Cause and effect between FII trading behaviour and stock market returns

Abstract

PurposeThe purpose of this paper is to examine the direction of causality between foreign institutional investment (FII) trading volume and stock market returns in the Indian context. There is evidence of uni‐directional causalities from stock returns to FII flows across various sample periods. The paper attempts to establish whether net FII trading volume causes variations in stock market returns or vice versa.Design/methodology/approachUsing daily data on three different measures of FII trading volume as proxy for FII trading behaviour and S&P CNX Nifty returns, Granger‐causality approach is applied to investigate the bi‐directional causality between net FII trades and returns.FindingsBi‐directional causality between net FII investment and Indian stock market return is observed. In general, the FIIs seem to be chasing the Indian stock market returns. It is found that FII trading behaviour resulting in heavy trading volumes may cause variations in stock market returns only in the very short‐term, but afterwards, it is the stock market returns which cause changes in FII trading behaviour.Research limitations/implicationsSince foreign equity investors monitor the movement of stock prices, and furthermore, the role of FIIs' exerting impact on Indian stock markets tends to be growing, the authorities will have to develop an environment where FIIs would maintain their positions with confidence, thereby making the markets, as well as investments, more stable. This research considered only stock market returns to test its relationship with three measures of FII trading volume; more macroeconomic as well as microeconomic variables may further be considered for the purpose.Originality/valueThe paper contributes some empirical evidence using three different measures of FII trading volume as proxy of FII trading behaviour, and its bi‐directional relationship with Indian stock market returns.