Foreign Institutional Investment ICRA BULLETIN

Money
in the Indian Equity Market &
An Analysis of Daily Flows during January Finance
APRIL–SEPT. 2002
1999-May 2002
✝ ✝
PARAMITA MUKHERJEE , SUCHISMITA BOSE
✜
AND DIPANKOR COONDOO

Abstract
This paper explores the relationship of foreign institutional invest-
ment (FII) flows to the Indian equity market with its possible covariates based
on a daily data-set for the period January 1999 to May 2002. The set of
possible covariates considered comprises two types of variables. The first type This paper explores
includes variables reflecting daily market return and its volatility in domestic
and international equity markets as well as measures of co-movement of the relationship of
returns in these markets (viz., relevant betas). The second type of variables, on
the other hand, are essentially macroeconomic ones like exchange rate, short- foreign institutional
term interest rate and index of industrial production (IIP)—viz., variables that
are likely to affect foreign investors’ expectation about return in Indian equity investment (FII)
market.
It may be mentioned that our analysis has been primarily motivated
flows to the Indian
by the research done in this area by Chakrabarti (2001), results of which
equity market with
appeared in a recent issue of Money & Finance. Briefly, using a monthly data-
set Chakrabarti examined the nature and causes of FII net inflow into the its possible
Indian equity market during the period May 1993 to December 1999. He
obtained some interesting results: viz., (1) the FII net inflow is correlated with covariates based on
the return in Indian equity market and the former is more likely to be the
effect than the cause of the Indian equity market return; (2) so far as invest- a daily data set.
ment in Indian equity market is concerned, foreign investors do not seem to be
at an informational disadvantage compared to domestic investors; and (3) the
Asian crisis marked a regime shift in the sense that in the post-Asian crisis
period the return in the Indian equity market turned out to be the sole driver
of the FII inflow, whereas for the pre-Asian crisis period other covariates
reflecting return in other competing markets, urge for diversification etc., were
also found to be correlated with FII net inflow.

✝ Monetary Research Project, ICRA Ltd., Kolkata

✜
Economic Research Unit, Indian Statistical Institute, Kolkata 21
 ICRA BULLETIN Our endeavour has been to see if these results would carry through
when the phenomenon of FII flows was examined using a set of daily data on
Money the relevant variables. The data-set incorporates day to day variations and
& hence is better suited for examination of various interrelationships, including
Finance Granger causality for equity market operations that are typically short run
issues. Also, we tried to relate daily FII flows (distinguishing between three
APRIL–SEPT..2002
kinds of flows—viz., FII flows into the country or FII purchases, FII flows out
of the country or FII sales and the net FII inflows into the country or FII net).
We later modify the model specification to include a short past history of the
variables over different time frames, like a week or fortnight. We have also
made an attempt at relating FII flows to macroeconomic fundamentals for the
Indian economy.
Our results show that: (1) FII flows to and from the Indian market
tend to be caused by return in the domestic equity market and not the other
way round; (2) returns in the Indian equity market is indeed an important
(and perhaps the single most important) factor that influences FII flows into
Whereas the pre-
the country; (3) while FII sale and FII net inflow are significantly affected by
Mexican crisis the performance of the Indian equity market, FII purchase is not responsive to
this market performance; (4) FII investors do not seem to use Indian equity
period 1990-1994 market for the purpose of diversification of their investment; (5) return from
exchange rate variation and fundamentals of the Indian economy may have
saw most of the influence on FII decisions, but such influence does not seem to be strong, and;
finally, (6) daily FII flows are highly auto-correlated and this auto-correlation
emerging markets could not be accounted for by the all or some of the covariates considered in
our study.
performing much
I. Introduction
better compared to
The performance of the emerging equity markets1 vis-à-vis
the matured markets their matured counterparts in the developed world have shown repeated
reversals in recent times. Thus, whereas the pre-Mexican crisis period
in terms of both 1990-1994 saw most of the emerging markets performing much better
compared to the matured markets in terms of both return and associ-
return and ated risk, the pattern reversed during 1995-2001; a period which in
most part was affected by the Asian crisis and the associated contagion.
associated risk, the The recent past (i.e., the first quarter of 2002) has seen another reversal
of performance in which, the emerging markets (those of Asia and Latin
pattern reversed America, in particular) have shown a remarkable recovery, in terms of
both the level of return and risk while the matured markets have experi-
during 1995-2001. enced drop in return and rise in risk (IMF, June and September 2002).
The reasons behind these reversals may vary from one reversal
to another. However, one thing seems to be pretty clear—viz., such

1 This consists of capital markets in China, India, Indonesia, Korea,

Malaysia, Pakistan, The Philippines, Sri Lanka, Taiwan and China in Asia, Czech
Republic, Greece, Hungary, Poland Russia, Slovakia, Turkey, Egypt, Israel and

22 Jordan in Europe and the Middle East, Morocco, South Africa and Zimbabwe in
Africa and Brazil, Chile, Colombia, Mexico, Peru and Venezuela in Latin America.
reversals of market performances make foreign equity investment ICRA BULLETIN

extremely volatile—a phenomenon which is capable of destabilising the

domestic economy of the recipient country. It may therefore be essential
Money
to evolve appropriate built-in mechanisms in the economies of the &
countries receiving foreign equity investment such that destabilisation Finance
and damages can be minimised in case foreign investors suddenly with-
APRIL–SEPT. 2002
draw from the equity market. It is in this context that a careful exami-
nation of the nature of foreign institutional investment (FII) flow into an
economy is important, as it may help identify the strength of various
factors (including macroeconomic ones like level of production, interest
rate, etc.) that are likely to affect such flows and also the possible impact
Over the past ten
of such flows on the performance of the equity market concerned.
Over the past ten years or so India has gradually emerged as years or so India
an important destination of global investors’ investment in emerging
equity markets. Today India has a share of about 20 per cent2 in the has gradually
total global investment in all emerging equity markets together and the
outstanding FII investment3 in India stood at around Rs. 86,287 crore, emerged as an
as on end-March, 2002. FII investments as a percentage of market
capitalisation increased from 7.06 per cent in 1999-00, to 13.5 per cent important
in 2000-01 and further to 14.1 per cent in 2001-02. Given this growing
importance of FII for the Indian economy, it is apparent that the nature destination of global
and causation of such fund flows deserve careful examination. In a
recent issue of Money & Finance a comprehensive analysis by
investors’
Chakrabarti (2001) of the nature and causes of FII equity flows4 into
investment in
the Indian market appeared. In his analysis Chakrabarti mostly used
monthly data on FII net inflow as a proportion of the previous month’s emerging equity
market capitalisation, relevant stock market variables and other
financial market indicators (like the deposit rate, exchange rate, etc.) markets. Today India
and obtained the following main results: (a) though FII flows are highly
correlated with equity returns in India, they are more likely to be the has a share of about
effect than the cause of such returns; (b) so far as investment in the
Indian equity markets is concerned, global investors do not seem to be 20% in the total
at an informational disadvantage compared to local investors; and
(c) the Asian crisis marked a regime shift in the determinants of FII global investment in
flows to India, with the domestic equity returns becoming the sole
all emerging equity
driver of these flows in the post Asian crisis period. Our motivation is
essentially to take this analysis forward a few steps further. To be markets together.
specific, using daily data for the post Asian crisis period January
1999—May 2002, we have done a study similar to that of Chakrabarti

2 This is a close approximation, since part of the FII flow data contains a

small debt component.

3 Net FII, cumulative since 1990-91.
4 In case of India, the relative importance of the equity channel of FII

compared to debt, can be gauged from the fact that, for the financial year 2001-02,
the average monthly sales by FIIs was to the tune of Rs. 3771 crore and purchases
Rs. 3102 crore in the equity segment, while for debt sales and purchases were a
meagre Rs. 392 crore and Rs. 332 crore, respectively. 23
 ICRA BULLETIN in which we have tried to identify the relevant covariates of FII flow
into and out of the Indian equity market and also to determine the
Money nature of causality between the relevant variables. Since the use of
& daily data helps in determining the nature of causality with greater
Finance precision, our results of causality between FII flows and their major
covariates like domestic equity market return may prove to be useful
APRIL–SEPT..2002
from policy viewpoint. Next, going beyond Chakrabarti’s analysis, we
have carried out an in-depth statistical analysis to find out not only the
factors that affect net FII flow, but also those which affect FII sale and
purchase decisions.
The paper is organised as follows: In Section II we discuss
Since the use of
briefly about the importance of the and factors behind portfolio flows to
daily data helps in emerging markets, the nature of such flows during the past decade,
their suggested role in causing volatility and contagion in emerging
determining the markets. In the third section, we discuss how our analysis builds upon
Chakrabarti’s; we also describe our data-set and present the main
nature of causality results of our causality and regression analyses. The last section
concludes, relating our analysis to policy implications from empirical
with greater studies in various emerging markets, and the current policies being
followed in India with respect to foreign capital.
precision, our
II. International Portfolio Flows to Emerging Markets
results of causality As is well-known, international capital flows to emerging
markets is a somewhat recent phenomenon, which began at a reason-
between FII flows
able scale in the early 90s. On the theoretical side, the case for libe-
and their major ralisation of international capital flows is built around a few basic
tenets—viz., (a) free capital movements facilitate efficient allocation of
covariates like global savings, channelling resources to countries where they will be
most productive and thereby increasing growth and welfare globally;
domestic equity (b) access to foreign capital markets enable investors to achieve a
higher degree of portfolio diversification, thus allowing them to obtain
market return may higher returns at lower risk; (c) full convertibility for capital account
transactions complement the multilateral trading system which broad-
prove to be useful ens the channels through which countries obtain trade and investment
finance on much easier terms; and (d) liberalisation improves mac-
from policy
roeconomic performance as it subjects governments to greater market
viewpoint. discipline and penalises unsound monetary and fiscal policies. On the
practical side, on the other hand, the surge in international portfolio
investment over the past decade or so has been triggered by a number
of parallel developments. First, institutionalisation of savings in the
USA and the developed world since the 1980s placed a massive and
increasing volume of funds under the management of professional
portfolio managers,5 who for tactical reasons tend to prefer a widely

5 That is, the choice of pooled funds held by pension funds, life insurance

24 companies, mutual funds and investment trusts as repositories for the majority of
diversified portfolio spread out internationally. Second, there has been ICRA BULLETIN

a trend towards financial liberalisation both in developing countries

and countries in transition thus allowing global fund managers to reach
Money
the financial markets of these countries. 6 Third, developments in &
information technology have immensely lowered the cost of interna- Finance
tional trading in securities and made information dissemination on a
APRIL–SEPT. 2002
near real time basis possible. Fourth, a remarkable expansion of capital
markets in emerging economies has taken place due mostly to the
widespread privatisation of formerly State-owned enterprises. However,
the very elements that facilitated the inflow of foreign capital into
developing countries have also meant that foreign capital can now be
Performance
withdrawn from these countries far more quickly.
Analysis of performance of emerging equity markets during the reversals have
past decade has indicated that investment in these markets can provide
global investors with attractive absolute returns as well as some scope ushered in tactical
to diversify their portfolios. In fact, global investors reaped such
benefits in the first half of the 1990s, but the gains disappeared between investors such as a
1995 and 2001 with the reversal of performances of these markets
relative to their matured counterparts, as already mentioned (IMF, hedge fund.
2002). Such performance reversals have ushered in tactical investors
such as a hedge fund (which tries to achieve high absolute returns Understandably,
essentially by exploiting the high volatility of returns in these markets
through market timing). Understandably, such speculative and oppor-
such speculative
tunistic behaviour of these tactical investors has contributed to the
and opportunistic
volatility of FII inflows into emerging markets. Typically, global
investors allocate a small portion of their total assets to equities in behaviour of these
these markets to track a world or regional equity index 7 and also as a
means to diversify the portfolio held by them. Although this allocation tactical investors
is estimated to be a meagre 5 per cent of the total assets of global
investors, in absolute terms this investment has now crossed the US has contributed to
dollar 100 billion level (which is larger than the total market capitali-
sation of many individual emerging equity markets). More importantly, the volatility of FII
the share that individual emerging markets get of such investment is
often sizeable in relation to their total market capitalisation. inflows into
Performances of emerging equity markets vis-à-vis those of
emerging markets.
their matured counterparts in recent periods reveal the following

savings—increased the share of funds invested in securities and enhanced the role of
institutional investors compared to that of depository institutions. In the United
States, for example, the share of total financial sector assets held by institutional
investors rose from 32% in 1978 to 52% in 1993, while the share of depository
institutions fell from 57% to 34% over the same period (Federal Reserve System
[FRS], Flow of Funds).
6 Whose local capital markets were proving to be a bottleneck in the

growth process.
7 Like the S&P/IFC Composite index which is used as a benchmark for

measuring equity markets returns in emerging markets as a whole or IFC’s Asia or Latin
America indices which reflects the corresponding returns in specific regional markets. 25
 ICRA BULLETIN pattern: in the post-Mexican crisis period (to be more specific, during
1995-2001) the emerging equity markets, by and large, recorded much
Money smaller returns than those in the matured markets. Thus, whereas S&P
& 500 and NASDAQ recorded 14.77 and 13.62 per cent return, respec-
Finance tively, the corresponding figures for S&P/IFCI Composite, IFCI’s Asia,
EMEA (which covers emerging markets in Europe and the Middle East)
APRIL–SEPT..2002
and Latin America indices were –3.68, –9.81, 1.78 and 1.35, respec-
tively. Also, the risk associated with investment in the emerging equity
markets increased considerably during this period, whereas that for the
matured markets decreased. This was indicated by values of the Sharpe
ratio (which is the ratio of excess return of an asset over that of a risk
FII flows to the
free asset and the standard deviation of return of the asset concerned)
secondary equity recorded between –0.48 and –0.14 for the emerging markets as against
0.24 and 0.56 recorded for NASDAQ and S&P500, respectively. This
market do not have pattern, however, got reversed again during the first quarter of 2001-
2002, when the emerging markets (except those in Europe and the
any direct link with Middle East) recorded much higher return and lower risk compared to
those of S&P500 and NASDAQ.8
the level of real Let us next discuss briefly the possible effects of FII flow on the
recipient country’s economy. As such, FII flows to the secondary equity
investment in the market do not have any direct link with the level of real investment in
the economy. It is only by enhancing the efficiency and liquidity of
economy. It is only capital markets that such a flow can contribute to growth. Securities
markets in developing countries are typically both narrow and shallow.
by enhancing the
Therefore, FII participation may, a priori, induce considerable instabil-
efficiency and ity in these markets. The effect of such mobile capital flows can,
however, be quite complicated and therefore are highly controversial.
liquidity of capital In fact, country experiences differ considerably. Some studies found
clear evidence of benefits of such flow in the form of equity market
markets that such a development, capital market integration, lowering cost of capital, and
hence tend to question policy concerns regarding resource mobilisation,
flow can contribute market co-movements, contagion and volatility expressed by some
policy makers and academics to be largely unwarranted.9 The causes
to growth. of the instability and volatility of short-term portfolio capital flows to
emerging markets are often related to the way in which investment
funds are managed in order to confront uncertainty. It has been alleged

8 The underperformance of emerging market equities from a longer-term

perspective does not appear to be due to overvaluation, though price/earnings ratios

in emerging market equities have been high in some years. Some of the main factors
in this underperformance have been identified as the string of financial crises,
starting with Mexico in 1994, which has drastically pruned the US dollar returns on
emerging market equities as well as concerns about corporate transparency and
governance in the West and Japan and more so in the emerging markets.
9 See Errunza, 2001; for a very detailed review. Bekaert and Harvey, 1998,

2000, analyse pooled cross-section and time series data for US equity flows to about
20 emerging countries, including India. Kim and Singal, 2000, analyse 20 countries
26 from the IFC EM Database.
that international portfolio investors seek liquidity and use ‘quick exit’ ICRA BULLETIN

as a means of containing downside risk, thus making frequent marginal

adjustments to their portfolios. Further, shifts in the portfolio composi-
Money
tion of global investors are largely ascribed to changes in their percep- &
tions of country solvency rather than to variations in underlying asset Finance
value.10 A common conclusion from research, however, is that institu-
APRIL–SEPT. 2002
tions sometimes panic, disregard fundamentals and spread crisis even
to countries with strong fundamentals. The literature also notes that
individuals, too, can contribute to this destabilisation process by fleeing
from funds, particularly mutual funds and forcing fund managers to sell
when fundamentals do not warrant such sale.
We have looked for
Empirical results of the effect of FII activities on the volatility
of return are rather divided; some studies do not find that foreign covariates of FII
investors have any destabilising impacts on stock prices. 11 Evidences to
the contrary showing that foreign investors cause higher volatility in flows to India and
the market compared to domestic investors12 or that stocks in which
foreign investors mainly trade experience higher volatility compared to tried to ascertain
those in which they do not show much interest also exist. 13 These
studies also show that volatility caused by FII jumped significantly whether FII flows
around the crises period.
adjust in response
III. FII Flows to the Indian Equity Market
As already mentioned, the basic objective of our study is to
to changes in the
carry forward and supplement the empirical research on the FII flow to
condition of the
India reported in Chakrabarti (2001). To be specific, we have looked
for covariates of FII flows to India and tried to ascertain whether FII Indian equity market
flows adjust in response to changes in the condition of the Indian equity
market or such flows exert strong enough influence on this market so as or such flows exert
to affect significantly the return from variations in daily stock price
level. In what follows, we first explain our choice of the set of selected strong enough
variables and describe briefly the data set used and then present the
results that have been obtained. influence on this

FII Flows and Their Covariates—Choice of Variables market.

and Data
As is well-known, given the set of investment opportunities
available, a global investor would continuously adjust investment
portfolio round the clock using available market information and

10 See, for example FitzGerald,1999, in this context.

11 Chan, Kho and Stulz, (1999); Kim and Wei (1999) with Korean data;
Froot, O’ Connell, and Seasholes (2001) based on data from 44 countries.
12 For example, Jo, 2002, using data from the Korean stock markets, where

data is available for different categories of traders.

13 Bae and Chan, 2001, analyse data from the Standard & Poor’s (formerly

the IFC) Emerging Markets Database (EMDB), which covers more than 2000 stocks
from 45 emerging markets. 27
 ICRA BULLETIN thereby tracking returns in all possible markets. So far as the trading
behaviour of these investors is concerned, studies examining such
Money behaviour suggest broadly two types of trading behaviour (see Box 1
& for a brief description of these trading types). Further, for a given unit
Finance time interval (may be a time span of a few minutes, a day, a week or a
month), the investor’s actions may be aggregated and summarised into
APRIL–SEPT..2002
two basic measures—viz., sale and purchase—and a corresponding
overall measure of net sale or net purchase, as the case may be.
Following this logic, we have chosen to examine the nature of FII flow
to India in terms of three variables—viz., FII sale (henceforth denoted
by FIIS), FII purchase (henceforth denoted by FIIP) and net FII invest-
We have chosen to
ment (henceforth denoted by FIIN). It may be noted that in his analysis
use daily data, since Chakrabarti used monthly data on net FII flow as a proportion of the
size of market capitalisation (henceforth denoted by MCAP) of the
we felt that a set of previous month as the variable to be explained instead of the net FII
flow.14 As regards the data frequency, we have chosen to use daily data,
daily data should be since we felt that a set of daily data should be more appropriate for
examining the nature of causality, so far as the relationship between FII
more appropriate for flows and their major covariates are concerned. For the sake of com-
parison with Chakrabarti’s results, we have also considered FIIN as a
examining the proportion of MCAP (henceforth denoted by RATIO_FIIN). Similarly
defined ratio variables for FIIP (henceforth denoted by RATIO_FIIP)
nature of causality, and FIIS (henceforth denoted by RATIO_FIIS) have also been consi-
dered. However, since daily data on MCAP are unavailable, we have
so far as the
had to calculate a time series of daily MCAP using a method of appro-
relationship ximation.
As regards the choice of covariates of the FII variables, to the
between FII flows extent possible we have tried to incorporate into the analysis a set of
variables that appear, a priori, to be the primary determinants of
and their major global investors’ demand/supply for/of stocks in the Indian market. To
be precise, we have considered two different sets of variables—one
covariates are relating to the Indian and other equity markets which tend to compete
for global investors’ investment and the other relating to the Indian
concerned. economy which may be relevant for investors’ expectation formation
about the Indian market. The first set of variables include daily return
in Rupee terms in the Indian market and corresponding returns in US

14 In this context, the following point may be noted: As FII transactions

take place on a day to day basis (or for that matter, even over shorter time inter-
vals), use of monthly aggregates may blur the picture considerably. Further, since the
ratio of net FII flow to the total size of market capitalisation (henceforth denoted as
Mcap) is rather small for India (and the monthly variation in this ratio is even
smaller), any analysis using this ratio as the explained variable may fail to capture
the true relationship between FII flow and its various covariates identified as
important explanatory factors for this flow in the literature as well as in
28 Chakrabarti’s own analysis.
 ICRA BULLETIN
BOX 1
Money
Studies examining foreign institutional investors’ behaviour suggest broadly two
types of trading behaviour—viz., momentum (M) or positive-feedback trading(PT) &
and herding(H) strategies1, which may or may not be within the bounds of rational Finance
behaviour2. Briefly, strategy M is the tendency of an investor to buy and sell stocks
based on their observed return records—i.e., to buy recent winners and sell recent APRIL–SEPT. 2002

losers3. There are strong evidences of contemporaneous momentum trading by

funds, induced both by the managers and investors when trading is done on the
basis of contemporaneous return information4. Such momentum trading is espe-
cially found to be strong during periods of financial crisis. Momentum trading at a
lag5 is observed during non-crisis periods. Typically, such trading decisions are
mostly taken at the managerial level. Understandably, the M or PT strategy may Briefly, strategy M is
exacerbate price movements and thus accentuate volatility. It is also found that funds
often go in for contagion trading—i.e., they systematically sell assets from one the tendency of an
country when asset prices fall in another, however, such contagion trading is prima-
rily to meet redemption by individual investors, and is not a management strategy6. investor to buy and
The H strategy refers to a situation in which all investors act/react in a similar manner.
Herding is intentional, if investors are influenced into reversing a planned investment sell stocks based on
decision after observing others, and this in turn, increases volatility in the market.
their observed
1 See for example, Froot et al (2001); Kim and Wei (1999).
2 Bikhchandani and Sharma, 2001, provides an overview of the recent theoreti-
return records. The
cal and empirical research on herd behaviour in financial markets.
3 This form of herd behaviour is not rational under the efficient-markets hy- H strategy refers to a
pothesis since market prices are assumed to reflect all available information.
4 Such studies take into account returns for the same day, month or quarter. situation in which
5 That is, trading is based on return information pertaining to the previous day,

month or quarter. all investors act/

6 As found by Kaminsky et al , 2002, using data from 13 US mutual funds;

which are dedicated Latin America funds. react in a similar

manner.
Dollar terms in competing markets, measures of volatility of these
returns (taken as proxy of the corresponding risks), daily return implied
by day to day variations in the Rupee-Dollar exchange rate. More
specifically, this set consists of the following variables:
1. Daily return in the Indian market calculated on the basis of
day to day variations in the value of BSE Sensex (henceforth
denoted by BSE_RET);15
2. Volatility of daily return in the Indian market calculated as the
standard deviation of previous 7/ 15/ 30 days’ daily returns
based on the BSE Sensex (henceforth denoted by BSE_RETVOL);
3. Daily return in the international equity market based on the

15 BSE Sensex is compiled using a set of 30 major shares and reports from

stock markets suggest that FIIs mostly restrict their trading to the shares covered in
the BSE Sensex. 29
 ICRA BULLETIN day to day variations in the value of the MSCI World Index
(henceforth denoted by MSCI_RET);16
Money 4. Daily return in the US equity market based on the day to day
& variations in the S&P500 (henceforth denoted by S&P_RET);
Finance 5. Volatility of daily return in the international equity market
calculated as the standard deviation of previous 7/ 15/ 30 days’
APRIL–SEPT..2002
daily returns based on MSCI World index (henceforth denoted
by MSCIRET_VOL);
6. Volatility of daily return in the US equity market calculated as
the standard deviation of previous 7/ 15/ 30 days’ daily returns
based on the S&P500 index (henceforth denoted by
S&PRET_VOL);
7. Extent of co-movement of daily returns in Indian and Interna-
tional equity markets as measured by the beta of returns from
BSE Sensex and MSCI World Index (henceforth denoted by
BETA_MSCI);
The second set,
8. Extent of co-movement of daily returns in Indian and the US
includes two equity markets as measured by the beta of returns from BSE
Sensex and S&P500 Index (henceforth denoted by
macroeconomic BETA_MSCI); and finally
9. Daily return from day to day variations in the Rupee—USD
variables—viz., the exchange rate (henceforth denoted by EXCH).

index of industrial The second set, on the other hand, includes two macroeconomic
variables—viz., the index of industrial production (henceforth denoted
production and the by IIP) taken as a proxy for short run real income changes and the call
money rate (henceforth denoted by CMR) taken as a proxy for short-
call money rate. term interest rate. These two variables, taken to reflect the short run
variations in the fundamentals of the Indian economy, have been used
together with the equity market-related variables to see whether or not
global investors take into account their expectations about the state of
the Indian economy. The sample period of the daily data set is January
1999—May 2002, which wholly relates to the post- Asian crisis period.
For a fuller description of these variables and the sources of data on
them, see Box 2. See also Appendix 1 some general information on FII
investment activities as well as the Indian stock market and related
charts and Appendix 2 for a description of the method used to build up
the time series of daily MCAP.

The Results
In the present analysis we have mostly used appropriate linear
regression techniques to testify various hypotheses concerning FII flows
to the Indian equity market. For the hypotheses relating to the direction

16 This index, also used by Chakrabarti, is known to be closely tracked by

30 FIIs operating in India.

 ICRA BULLETIN
BOX 2
The data series and Sources: Stock Market Series Money
Domestic &
FIIP DailyFII Purchses or inflows into the Indian equity markets, Finance
Source: website of SEBI; www.sebi.gov.in
FIIS DailyFII Sales or outflows from the Indian equity markets, APRIL–SEPT. 2002

Source: website of SEBI; www.sebi.gov.in

FIIN Daily Net FII inflows into the Indian equity markets; the difference
between FIIP and FIIS, Source :website of SEBI; www.sebi.gov.in
BSE Sensex The 30 share BSE stock price index; daily closing values, Source:
website of the Mumbai Stock Exchange; www.bseindia.com
Mcap: Daily market capitalisation on the BSE, Source: BSE website and
our estimation as per Appendix1.

International
S&P 500 The daily series for the S&P500 stock price index; Source: website
of Standard and Poors
MSCI WI The daily series for the MSCI World Index, a weighted stock
price index for all countries1; Source: website of Morgan Stanley
Capital International Inc; www.msci.com

Others
Exch Daily exchange rate of the Indian rupee vis a vis the US dollar
CMR Daily Call money rate; Source RBI website; www.rbi.org.in
IIP Index of Industrial production reported weekly; Source: RBI
Handbook of Statistics on Indian Economy, 2001 and CMIE
Monthly Review of the Indian Economy

Estimated series
Ratio_FIIN Ratio of FIIN to previous day’s Mcap2
Ratio_FIIP Ratio of FIIP to previous day’s Mcap
Ratio_FIIS Ratio of FIIS to previous day’s Mcap
FIIN_MAk(t-1) k-day moving average value of FIIN calculated using FIIN(t-k) to
FIIN(t-1), k=7,15,30.
FIIP_MAk(t-1) k-day moving average value of FIIP calculated using FIIP(t-k) to
FIIP(t-1), k=7,15,30.
FIIS_MAk(t-1) k-day moving average value of FIIS calculated using FIIS(t-k) to
FIIS(t-1), k=7,15,30.
BSE_Ret Daily returns on the BSE Sensex, calculated as the excess of the
logarithm of the index value on a date over the logarithm of the
index value on the previous day.
BSERET_MAk(t-2) k-day moving average value of return on BSE calculated using
BSE_Rte(t-k) to BSE_RET(t-2), k=7,15,30.
BSE_RetVol k(t-2) k-day moving average volatility of, returns on BSE Sensex or the
standard deviation of BSE_Ret(t-k) to BSE_Ret(t-2), k=7,15,30.

1This index includes India.

2A possible econometric rationale for taking the ratio variables could be to
eliminate heteroscedasticity; however, it is found that even if we take the ratio to MCap,
heteroscedasticity is not eliminated for FIIN and FIIS series.
31
 ICRA BULLETIN
S&P_Ret Daily returns on the S&P500, calculated as the excess of the
Money logarithm of the index value on a date over the logarithm of the

& index value on the previous day.

S&PRet_MAk(t-2) k-day moving average value of returns on S&P500 calculated
Finance using S&P_Ret(t-k) to S&P_Ret(t-2), k=7,15,30.
S&P_RetVol k(t-2) k-day moving average volatility of, returns on S&P500 or the
APRIL–SEPT..2002 standard deviation of S&P_Ret(t-k) to S&P_Ret(t-2), k=7,15,30.
MSCI_Ret Returns on the MSCIWI, calculated as the excess of the loga-
rithm of the index value on a date over the logarithm of the index
value on the previous day.
MSCIRet_MAk(t-2) k-day moving average value of returns on MSCIWI calculated
using MSCI_Ret(t-k) to MSCI_Ret(t-2), k=7,15,30
MSCIRetVol k(t-2) k-day moving average volatility of, returns on MSCIWI or the
standard deviation of MSCI_Ret(t-k) to MSCI_Ret(t-2),
k=7,15,30.
BETA_S&Pkk(t-2) betas of BSE wrt S&P500 based on previous kk day’s data start-
ing from (t-2), kk=15,30
When it comes to BETA_MSCIkk(t-2) betas of BSE wrt MSCI based on previous kk day’s data starting
from (t-2), kk=15,30
the case of foreign
Exch_Ret Daily returns on the Rupee’s exchange rate, calculated as the
excess of the logarithm of Exch on a date over the logarithm of
investment in a thin
Exch on the previous day.
equity market like
Notes : (a) The problem of non-synchronised trading in the different markets have been
that of India, there is overcome by removing such dates.
(b) The routine tests of normality and unit root for stationarity for all series have
been conducted and the regressions framed accordingly.
a prevalent feeling

that FII activities of causation between FII flows and some of their covariates, we have
used the technique of pair-wise Granger Causality test. The results are
exert a strong
presented below.
demonstration effect
A. Direction of Causation between FII flows and Return in the
and thus drive the Indian Stock Market
For any type of investor, domestic or foreign, market return
domestic stock is generally the prime driver of equity investments. However, when
it comes to the case of foreign investment in a thin equity market like
market. that of India, there is a prevalent feeling that FII activities exert
a strong demonstration effect and thus drive the domestic stock
market.
In other words, some believe that the day to day FII trading in
Indian market, rather than being influenced by the market return,
induces the daily market return to be what it is. As a starting point we
examine the nature of pair-wise causality between daily measures of FII
investment and corresponding BSE_RET separately for the three FII
variables (viz., FIIP, FIIS and FIIN). The results are given in Table 1. It
may be mentioned here that Chakrabarti (2001) also examined the
32 nature of causality between FIIN and BSE_RET mostly on the basis of
monthly data on these variables.17 However, given the facts that ICRA BULLETIN

Granger causality test is designed essentially to detect statistically

significant short run lead-lag relationship present in a data-set on a pair
Money
of variables and that equity market responses are typically extremely &
quick and of very short run nature, examination of causality based on a Finance
monthly data set may fail to capture the exact nature of causality.
APRIL–SEPT. 2002
The results in Table 1 clearly suggest that causation runs from

TABLE 1
Pairwise Granger Causality Tests between BSE Return and FII

Value of F-statistics at different lags

Lags —> 2 3 4 5 6 7
PANEL 1
BSE Return does not
Granger Cause FIIN 25.98* 17.33* 15.95* 13.53* 11.72* 10.21*
FIIN does not Granger
That equity market
Cause BSE Return 1.90 1.41 2.87 2.02 1.45 1.42
responses are
PANEL 2
BSE Return does not
Granger Cause FIIP 4.32+ 4.42* 5.67* 5.75* 4.70* 4.18*
typically extremely
FIIP does not Granger
Cause BSE Return 1.44 0.94 4.39* 3.33 3.19* 2.99* quick and of very
PANEL 3
short run nature,
BSE Return does not
Granger Cause FIIS 8.69* 6.18* 5.55* 4.84* 4.34* 3.69*
FIIS does not Granger
examination of
Cause BSE Return 7.37* 4.94* 3.62 2.99 3.03 2.69
causality based on a
PANEL 4
BSE_RET does not Granger
Cause RATIOFIIN 28.91* 19.09* 17.27* 14.11* 12.17* 10.49*
monthly data set
RATIOFIIN does not
Granger Cause BSE_RET 2.89 2.24 3.41 2.41 1.84 1.71 may fail to capture
PANEL 5
the exact nature of
BSE Return does not Granger
Cause RATIOFIIP 3.04+ 2.80+ 4.25* 3.97* 3.35* 2.83*
RATIOFIIP does not Granger
causality.
Cause BSE Return 0.96 0.60 4.02* 3.07 2.96 2.67
PANEL 6
BSE Return does not
Granger Cause RATIOFIIS 18.16* 11.37* 8.50* 6.86* 5.76* 4.88*
RATIOFIIS does not
Granger Cause BSE Return 6.22* 4.20 2.98 2.74 2.80 2.31
*’ Denotes rejection at 1% level of significance
+’ Denotes rejection at 5% level of significance

17 He has done the causality test taking the daily data for a limited period

of one year (1999, in the post-Asian crisis period), most of his analysis of causality
for the pre-crisis period was based on monthly data (1993 to 1999). 33
 ICRA BULLETIN BSE_RET to FIIN and not the other way. This is true for FIIS and FIIP
and their ratios also, barring a few cases where no definite conclusion
Money can be drawn. For these variables, causality, if found statistically
& significant, is unidirectional running from BSE_RET to FII flows. 18 This
Finance lends further credence to the supposition that FII flows to India are
mostly in response to contemporaneous returns in the Indian stock
APRIL–SEPT..2002
markets (in the post Asian crisis period) rather than FII inflows and
outflows being the cause of returns in the national markets.

B. Effect of BSE Returns

Having identified the nature of causality, we next examine
As day to day
whether or not contemporaneous BSE_RET significantly affect daily FII
variation in the FII inflows/outflows. Regression of the FIIN, FIIP, FIIS on BSE_RET yielded
results quite contrary to expectations as the coefficient of BSE_RET
flow variables as turned out to be statistically non-significant in all of these regressions
(Table 2.1). However, when RATIOFIIN was taken as the dependent
well as the market variable, the estimated positive coefficient of BSE_RET turned out to be
significant at 5 per cent level—a result, which was also obtained by
return is likely to Chakrabarti. However, BSE_RET again was found to be non-significant
determinant for RATIOFIIP and RATIOFIIS. Since the RATIOFIIP and
contain relatively RATIOFIIS which are the components of RATIO_FIIN are not affected
by contemporaneous value of BSE_RET, it becomes somewhat difficult
large random to reconcile the observed dependence of RATIO_FIIN on the current
level BSE_RET.
components, one
As day to day variation in the FII flow variables as well as the
would not expect market return is likely to contain relatively large random components,
one would not expect high correlation between FII flow and market
high correlation return (which indeed was the case in our exercise). We therefore tried
next to explore whether the FII flow variables would show up any
between FII flow and stronger dependence on market return if daily variations were filtered
through moving average smoothing. The results obtained by regressing
market return. 7-day moving average values of FIIN, FIIP, FIIS and RATIO_FIIN on
the corresponding 7-day moving average values of BSE_RET suggest
that while FII sale and FII net inflow are significantly affected by
market return (the former being affected positively and the latter
negatively, as to be expected), FII purchase is not responsive to
variations in market return (Tab 2.2). In other words, a drop/rise in
average return over the previous 7 days would induce a FI investor to

18 Studies examining the pattern of aggregate international portfolio flows

found evidences of contemporaneous positive correlation between inflows and

returns and lagged returns (Bohn and Tesar, 1996, Brennan and Cao, 1997 and
Froot, O’ Connell, and Seasholes, 2001). The last mentioned study also found
sensitivity of local stock prices to foreign inflows to be positive and large and also
that inflows had positive forecasting power for future emerging-market returns.
Other studies on the Indian equity market have also found evidence of the relation-
ship between net FII and returns on equity (Batra, 1999). On the other hand, Bhatia
(2000) has shown that daily net FII inflows are a significant determinant of the
34 daily returns on the BSE.
raise/reduce sale promptly, but it might fail to induce a change in the ICRA BULLETIN

level of her purchase—a result which is suggestive of some kind of

asymmetry of behaviour so far as FII trading in Indian market is
Money
concerned. &
Finance
C. Other Factors Influencing FII Flows
APRIL–SEPT. 2002
To identify other significant non-domestic return determinants
of different FII flows, we considered a set of other possible determi-
nants, domestic as well as international. As already mentioned, this set
comprised MSCI_RET, S&P_RET, BSE_RETVOL, BETA_MSCI,
A drop/rise in
TABLE 2.1
Regression of FII on BSE Return average return over
Regressands ——>
the previous 7 days
Regressors FIIN Ratio- FIIP Ratio- FIIS Ratio-
FIIN FIIP FIIP
would induce a FI
Constant 34.09* 0.001* 219.3* 0.007* 185.25* 0.006*
(0.0) (0.0) (0.0) (0.0) (0.0) (0.0) investor to raise/
BSE Return 447.02 0.01* 0.06 0.01 -447.03 -0.01
(0.05) (0.04) (0.99) (0.42) (0.057) (0.21)
reduce sale
R-squared 0.0049 0.0053 0.0000 0.0009 0.0055 0.0022
Adjusted R-squared 0.0037 0.0041 -0.0012 -0.0003 0.0043 0.0010 promptly, but it
S.E. of regression 119.81 0.0036 141.81 0.004 113.15 0.003
Durbin-Watson stat 1.61 1.58 1.11 1.39 0.95 1.18 might fail to induce
Note: 1. ‘*’ denotes significant at 5%
2. Figures in parenthesis are p-values of the regression coefficients a change in the level
3. Regressions are formulated keeping in view the stationarity of
variables of her purchase.

TABLE 2.2
Regression of FII_MA on BSE Return_MA

Regressands ——>

Regressors FIIN_MA RatioFIIN_MA FIIP_MA FIIS_MA

Constant 34.76* 0.001* 220.17* 185.4054*
(0.0) (0.0) (0.0) (0.0)
Moving Average of
BSE Return 2603.83* 0.089* -641.60 -3246.149*
(0.0004) (0.0001) (0.55) (0.0003)
R-squared 0.09 0.11 0.00 0.08
Adjusted R-squared 0.087 0.112 0.001 0.080
S.E. of regression 62.25 0.0019 101.14 81.39
Durbin-Watson stat 0.163 0.171 0.053 0.066

Note: 1. ‘*’ denotes significant at 5%

2. Figures in parenthesis are p-values of the regression coefficients
3. Regressions are formulated keeping in voew the stationarity of
variables
35
ICRA BULLETIN BETA_S&P, EXCH (all these variables were considered by Chakrabarti
(2001) for explaining FIIN) and, in addition, MSCI_RETVOL,
Money S&P_RETVOL, IIP and CMR.19 Multiple regression analysis was done
& separately for each of the FII variables—viz., FIIN, FIIP, FIIS, their
Finance ratio versions RATIOFIIN, RATIOFIIP, RATIOFIIS and also their
moving average versions FIIN_MA, FIIP_MA, FIIS_MA20—using
APRIL–SEPT..2002

TABLE 3A
Stage 1 Regression results of FII on all relevant variables

REGRESSION A: Stage 1

Regression Coefficients FIIN Ratio FIIN_MA FIIP Ratio FIIP_MA FIIS Ratio FIIS_MA
FIIN 15(t-1) FIIP 15(t-1) FIIS 15(t-1)

Constant -29.06 -0.001 -9.84 137.05 0.01 136.47 166.10 0.01 146.30
(0.14) (0.12) (0.58) (0.0) (0.0) (0.0) (0.0) (0.0) (0.0)
Lagged BSE Return 1285.21 0.04 -15.80 408.05 0.01 -437.76 -877.39 -0.03 -422.01
(0.0) (0.0) (0.87) (0.18) (0.18) (0.016) (0.0005) (0.0) (0.0095)
BSE Return 15-day
MA(t-2) 776.92 0.02 3426.23 1455.58 -0.01 433.96 677.97 -0.03 -2993.03
(0.52) (0.59) (0.0004) (0.44) (0.78) (0.79) (0.71) (0.41) (0.05)
BSE Return 15-day
Volatility(t-2) 587.96 0.02 2134.64 3164.84 0.03 4783.72 2577.51 0.01 2649.34
(0.49) (0.48) (0.004) (0.03) (0.35) (0.0003) (0.04) (0.67) (0.0099)
Lagged MSCI Return 393.554 -0.002 -260.48 -1237.87 -0.05 -922.41 -1630.71 -0.05 -662.13
(0.73) (0.96) (0.53) (0.33) (0.14) (0.28) (0.15) (0.07) (0.299)
MSCI Return 15-day
MA(t-2) -16601.52 -0.46 -2105.64 -16763.99 -0.65 -10479.46 -160.46 -0.19 -8372.86
(0.017) (0.03) (0.66) (0.19) (0.018) (0.35) (0.99) (0.39) (0.36)
MSCI Return 15-day
Volatility(t-2) -7446.42 -0.18 -592.82 -7372.09 -0.01 -2060.30 72.42 0.17 -1470.89
(0.07) (0.14) (0.86) (0.297) (0.94) (0.73) (0.989) (0.15) (0.76)
Lagged S&P Return -150.21 0.01 45.69 621.42 0.03 403.22 771.12 0.02 357.56
(0.85) (0.69) (0.86) (0.51) (0.18) (0.51) (0.33) (0.19) (0.46)
S&P Return 15-day
MA(t-2) 17196.60 0.48 2571.63 16217.83 0.60 10508.50 -981.58 0.11 7935.17
(0.009) (0.0096) (0.57) (0.19) (0.02) (0.35) (0.92) (0.57) (0.38)
S&P Return 15-day
Volatility(t-2) 9631.50 0.27 970.09 7840.28 0.11 1623.88 -1790.15 -0.16 656.41
(0.008) (0.02) (0.72) (0.20) (0.49) (0.75) (0.68) (0.12) (0.87)
Beta_MSCI 15-day (t-2) 7.53 0.00 2.06 -5.45 0.0001 -15.80 -12.98 0.00 -17.86
(0.697) (0.66) (0.87) (0.87) (0.94) (0.58) (0.68) (0.76) (0.44)
Beta (S&P) 15-day (t-2) 11.03 0.00 14.88 15.42 0.001 48.63 4.39 0.0003 33.74
(0.69) (0.78) (0.47) (0.70) (0.61) (0.13) (0.91) (0.77) (0.23)

R-squared 0.09 0.10 0.15 0.05 0.05 0.18 0.05 0.07 0.18
Adjusted R-squared 0.08 0.08 0.14 0.04 0.03 0.17 0.04 0.06 0.17
S.E. of regression 115.99 0.003 49.25 138.57 0.00 84.32 110.59 0.003 70.36
Durbin-Watson stat 1.73 1.70 0.06 1.19 1.48 0.05 0.99 1.24 0.04

Note: Figures in parenthesis are the p-values of coefficients

19 So far as the volatility variables are concerned, for each of them we

considered two different versions—measured as the standard deviation of the values

observed over the previous 7 and 15 days, respectively.
20 Three different sets of moving averaged variables were compiled using

moving average period of 7, 15 and 30 days, respectively. This was done essentially

36 to see whether or not the regression results would be sensitive to the choice of the
period of moving average.
BSE_RET along with the set of non-domestic return determinants listed ICRA BULLETIN

above. This analysis was done in several stages.21 Here let us first
summarise the qualitative results obtained on the nature of relationship
Money
of different types of FII flows with the variables that we identified to be &
possible covariates of these flows. (We present here only some repre- Finance
sentative results in Tables 3A and 3B.)
APRIL–SEPT. 2002

TABLE 3B
Stage 2 Regression Results of FII on all relevant variables

REGRESSION A: Stage 2
Regression Co-efficients FIIN Ratio FIIN_MA FIIP Ratio FIIP_MA FIIS Ratio FIIS_MA
FIIN 15(t-1) FIIP 15(t-1) FIIS 15(t-1)
Constant -17.21 -0.001 -0.28 69.84 0.005 2.40 57.25 0.003 1.15
(0.27) (0.19) (0.79) (0.0) (0.0) (0.07) (0.0) (0.0) (0.23)
Lagged BSE Return 1252.26 0.04 -9.43 -694.50 -0.03 -14.78
(0.0) (0.0) (0.65) (0.0007) (0.0) (0.37)
BSE Return 15-day MA(t-2) 159.07 187.86
(0.13) (0.003)
BSE Return 15-day Volatility(t-2) 74.92 1132.59 -31.30 324.36 21.04
(0.25) (0.04) (0.67) (0.48) (0.67)
Lagged MSCI Return -0.01
(0.18)
MSCI Return 15-day MA(t-2) -14793.27 -0.37 -0.50
(0.02) (0.04) (0.01)
MSCI Return 15-day Volatility(t-2) -5046.68
(0.13)
S&P Return 15-day MA(t-2) 14899.95 0.39 0.43
(0.01) (0.02) (0.03)
S&P Return 15-day Volatility(t-2) 7411.93 0.12
(0.01) (0.002)
Other Regressors Lag1 Lag1 Lag1 Lag1 Lag1 Lag1 Lag1 Lag1 Lag1
FIIN Ratio FIIN_ FIIP Ratio FIIP_ FIIS Ratio FIIS_
FIIN MA15 FIIP MA15 FIIS MA15
(Lagged Variables) 0.17 0.19 1.18 0.296 0.29 1.23 0.36 0.32 1.27
Lag2 Lag2 Lag2 Lag2 Lag2 Lag2
FIIN_ FIIP FIIP_ FIIS Ratio FIIS_
MA15 MA15 FIIS MA15
-0.21 0.302 -0.24 0.31 0.22 -0.10
Lag3
FIIS_
MA15
-0.18
R-squared 0.11 0.12 0.96 0.27 0.10 0.99 0.37 0.26 0.99
Adjusted R-squared 0.11 0.11 0.96 0.27 0.10 0.99 0.37 0.25 0.99
S.E. of regression 114.26 0.00 10.56 120.77 0.004 10.30 89.83 0.003 7.80
Durbin-Watson stat 2.10 2.12 2.04 2.11 2.13 2.11 2.08 2.06 2.05
Note: 1. Figures in brackets are the p-values of coefficients
2. P-values for all the lagged dependent variables are less than or equal to zero.
3. Since the package we used doesn’t provide Durbin h-stats, we report the DW here.

21
First, we have checked for stationarity of all the variables concerned.
Then, we have specified the regressions keeping in view to the order of integration of
the variables concerned. In all cases the regressions have been done in two stages,
detecting residual auto-correlation at the first stage, we have run the regressions
again. In stage 2, we included only the significant variables at stage 1 and the
lagged dependent variable as the regressors. 37
 ICRA BULLETIN C1. FII Flows and BSE Return
As regards the relation between daily FII net inflow and BSE
Money return, a definite positive association with the previous day’s return was
& observed in all the regressions estimated. Similarly, for daily FII sale
Finance the association with the previous day’s return was always found to be
negative and significant. However, no definite association between
APRIL–SEPT..2002
daily FII purchase and previous day’s market return was noticed. One
might surmise that daily FII activities might be based, not just on
previous day’s return information, but on the history of return over the
previous few days. Thus, for example, daily FII sale may be thought to
depend, not just on previous day’s return but also on the average and
the standard deviation of returns observed during the previous 7 or 15
days (the standard deviation being taken as a measure of volatility of
returns). Ceteris paribus, FII sale/purchase should be positively/nega-
tively related to average return and negatively/positively related to
volatility. We, however, failed to observe any definite association with
One might surmise
average return or return volatility of any of the daily FII flow variable.
that daily FII Very similar results were obtained when the FII variables were used in
ratio form. But use of moving average variables—i.e., FIIN_MA,
activities might be FIIP_MA and FIIS_MA—showed definite positive association of FII net
inflow, FII purchase and FII sale with return and volatility, but not with
based, not just on average return. While a positive association of return volatility with FII
sale seems intuitively justifiable, its negative association with the other
previous day’s two FII flows appears somewhat unrealistic.

return information, C2. FII Flows and Return and Volatility in Competing markets
As already mentioned, in our regression strategy, we included
but on the history of
the return and volatility variables relating to the S&P500 index and
return over the MSCI index (viz., MSCI_RET, S&P_RET, MSCI_RETVOL and
S&P_RETVOL) in the set of possible regressors, as indicators of return
previous few days. and risk involved in investing in the US and the World equity markets,
other than the Indian one (see Box 3 in this context). The hypothesis of
portfolio return maximisation suggests reallocation of investment in
favour of markets in which risk is minimised (as measured by Sharpe
ratio—i.e., excess return per unit of volatility) and this in turn means,
ceteris paribus, a positive/negative partial association with competing
market returns/volatility of FII net inflow and FII purchase and a nega-
tive/positive association with FII sale. In our exercise, we did get result
supporting the hypothesis of return maximisation only in some cases,
not unequivocally. This is in conformity with the result that Chakrabarti
(2001) obtained for the post-Asian crisis sub-period using monthly data.
We also found in most of the cases that S&P variables and
MSCI variables are simultaneously significant. We checked the correla-
tion between these variables which, turned out to be quite high
(Table 4) implying thereby the possibility of multicollinearity, given the
extent of integration of the world and US markets. We therefore ran
38 separate regressions for S&P variables and MSCI variables. The results
 ICRA BULLETIN
BOX 3
Money
We have also tried to see to what extent the performance of matured equity markets
affect that of the Indian equity market and therefore we examined the possible inter- &
dependence of BSE and S&P returns. To see whether or not S&P return exerts a Finance
significant causal effect on the BSE return we carry out a Granger causality test for the
APRIL–SEPT. 2002
same the results are as below.

Granger Causality Tests between S&P and BSE Returns

Value of F-statistics at different lags

SP500_RET does
not Granger Cause
BSE_RET 7.79* + 6.5* + 5.04* + 4.32* + 3.76* + 3.30* +
*’ Denotes rejection at 1% level of significance
+’ Denotes rejection at 5% level of significance

There is clear evidence of S&P return causing BSE return unilaterally. This was to be
expected and perhaps suggestive of the fact that a fluctuation in the US (matured)
equity market would get transmitted to the Indian market.

(Table 5) showed that while only the MSCI return volatility but not the
average return itself was significant, in more than one cases both S&P
return and its volatility were significant. See, however, Table 3A which
suggests that whereas FII net inflow is affected by return and volatility
of both MSCI and S&P, the corresponding purchase and sale flows are
mostly not affected by these.

TABLE 4
Correlation

Set of Regressors in Table 3A and 3B

BSE_R1 BSE_RE BSER BETA BETA MSCI MSCI_ MSCI SP_RE SP_RE SPRET
ETLAG TVOL15 ET_MA _MSCI _SP 15 _RET RETVOL RET_ TLAG1 TVOL _MA
(t-2) 15(t-2) 15(t-2) (t-2) LAG1 15(t-2) MA 15(t-2) 15(t-2)
15(t-2)

BSE_RETLAG1 1.00 -0.03 0.01 0.01 -0.02 0.14 -0.02 0.13 0.07 0.01 0.14
BSE_RETVOL15(t-2) 1.00 -0.32 -0.06 0.06 0.05 0.50 -0.05 0.05 0.50 -0.02
BSERET_MA15(t-2) 1.00 -0.05 -0.16 -0.03 -0.31 0.42 -0.03 -0.30 0.36
BETA_MSCI15(t-2) 1.00 0.86 -0.02 0.07 -0.15 -0.02 -0.06 -0.16
BETA_SP15(t-2) 1.00 -0.02 0.11 -0.24 -0.01 -0.01 -0.23
MSCI_RETLAG1 1.00 0.09 0.04 0.89 0.11 0.05
MSCI_RETVOL15(t-2) 1.00 -0.12 0.08 0.88 -0.10
MSCIRET_MA15(t-2) 1.00 0.01 -0.08 0.95
SP_RETLAG1 1.00 0.10 -0.01
SP_RETVOL15(t-2) 1.00 -0.07
SPRET_MA15(t-2) 1.00

39
ICRA BULLETIN C3. FII Flows and Betas of the Indian Equity Market
Following the logic of hedging and diversification of portfolio,
Money one would expect a significant negative (positive) partial association of
& the betas for Indian market with respect to S&P500 and MSCI indices
Finance (i.e., BETA_S&P and BETA_MSCI) with FII net inflow and sale (FII
purchase), in case the hypothesis that FII flow to India essentially serve
APRIL–SEPT..2002
as a means of diversification is true. Our results failed to find support
for this hypothesis as in most cases these variables turned out to be
statistically non-significant.22

TABLE 5
Regression of FII on MSCI and S&P separetely

STAGE 2 Results STAGE 2 Results

REGRESSION B1: on MSCI variables REGRESSION B2: on S&P variables

Coefficients RatioFIIN Coefficients FIIN RatioFIIN

Constant -0.0001 Constant -19.80 -0.001
(0.77) (0.21) (0.17)
Lagged BSE Return 0.04 Lagged BSE Return 1265.56 0.04
(0.0) (0.0) (0.0)
MSCI Return Fortnightly Volatility(t-2) 0.11 S&P Return Fortnightly MA(t-2) 2283.31 0.07
(0.02) (0.11) (0.14)
Lag1RatioFIIN 0.21 S&P Return Fortnightly Volatility(t-2) 3944.58 0.13
(0.002) (0.001)
R-squared 0.105 Lag1FIIN 0.18
Adjusted R-squared 0.101 Lag1RatioFIIN 0.00
S.E. of regression 0.003
Durbin-Watson stat 2.13 R-squared 0.102 0.109
Adjusted R-squared 0.097 0.104
S.E. of regression 114.877 0.003
Durbin-Watson stat 2.10 2.07

Note: 1. Figures in brackets are the p-values of coefficients

2. P-values for all the lagged dependent variables are less than or equal to zero.
3. Second stage regressions for FIIN in B1 and RatioFIIP in B1 and B2 have not been done since neither of the
MSCI/S&P variables were significant at the first stage.
4. Since the package we used doesn’t provide Durbin h-stats, we report the DW here.

C4. FII Flows and Return on Exchange Rate

We selected the return from day to day variations in Rupee-
USD exchange rate as a possible covariate on the presumption that this
being an opportunity cost, foreign investors might take into account
this for investment flows to the Indian equity market. However, its
effect mostly turned out to be statistically non-significant.

C5. FII Flows and Macroeconomic Variables

In order to verify whether or not foreign investors track the
state of Indian economy for making investment here, we considered IIP

22
Initially both the beta variables were included together in the regression
equations on the presumption that they would be independent, as the concerned
markets were very different. However, the sample correlation of these variables was
found to be very high, implying thereby a high degree of integration of the markets.
We next tried to see the effects of these variables on FII flows separately. Even in
40 that case the effects of these variables were found statistically non-significant.
and CMR as indicators of the real economic activity in India and tried ICRA BULLETIN

these as possible determinants of the FII flows. This exercise, however,

was done on a very limited scale and only the possible effects of these
Money
variables on FII net flow was examined (Table 6A and 6B). Some &
Finance
TABLE 6A APRIL–SEPT. 2002
Regression of FII on real sector variables

REGRESSION A
Stage 1
Coefficients FIIN_MA FIIP_MA FIIS_MA
15(t-2) 15(t-2) 15(t-2)
Constant -237.05 -558.58 -321.47
(0.01) (0.0) (0.0)
Lagged BSE Return -32.25 -503.87 -471.69
(0.78) (0.02) (0.00)
BSE Return Weekly MA(t-2) 1172.53 -2078.30 -3251.30 Some evidence of
(0.07) (0.04) (0.0)
IIP 1.60 4.20 2.60 positive association
(0.0) (0.0) (0.0)
CMR 1.52 12.00 10.48 of both IIP and CMR
(0.42) (0.0) (0.0)

R-squared 0.10 0.22 0.22 with FIIN was

Adjusted R-squared 0.09 0.21 0.22
S.E. of regression 50.42 82.16 68.20 obtained.
Durbin-Watson stat 0.05 0.08 0.09
Stage 2
Coefficients FIIN_MA FIIP_MA FIIS_MA
15(t-2) 15(t-2) 15(t-2)
Constant -3.62 -4.68 -6.94
(0.68) (0.6) (0.26)
Lagged BSE Return 13.81 -9.24 -24.21
(0.54) (0.66) 90.16)
BSE Return Weekly MA(t-2) 218.53 243.87 31.92
(0.0) (0.0) (0.37)
IIP 0.03 0.04 0.05
(0.54) (0.51) (0.16)
CMR -0.01 0.04 0.14
(0.96) (0.8) (0.53)
Other Regressors LAG1FII LAG1FII LAG1FII
N_15MA P_15MA S_15MA
(Lagged Variables) 1.16 1.20 1.36
LAG2FII LAG2FII LAG2FII
N_15MA P_15MA S_15MA
-0.19 -0.21 -0.37
R-squared 0.96 0.99 0.99
Adjusted R-squared 0.96 0.99 0.99
S.E. of regression 10.47 10.15 7.99
Durbin-Watson stat 2.03 2.08 2.16
Note: 1. Figures in brackets are the p-values of coefficients
41
 ICRA BULLETIN
TABLE 6B
Money Regression of FII on real sector variables

& REGRESSION B
Stage 1
Finance Coefficients FIIN_MA FIIP_MA FIIS_MA
APRIL–SEPT..2002 15(t-2) 15(t-2) 15(t-2)
Constant -263.9 -711.3 -447.3
(0.01) (0.0) (0.0)
Lagged BSE Return -20.2 -461.2 -441.1
(0.87) (0.03) (0.005)
BSE Return Weekly MA(t-2) 1199.1 -1964.1 -3163.6
(0.07) (0.07) (0.0)
IIP Weekly MA(t-2) 1.7 4.8 3.1
(0.0) (0.0) (0.0)
Lagged CMR -0.1 4.9 5.0
(0.95) (0.15) (0.06)
CMR Weekly MA(t-2) 3.5 14.5 11.0
Such regression (0.34) (0.01) (0.007)
R-squared 0.10 0.26 0.26
results would have Adjusted R-squared 0.09 0.25 0.26
S.E. of regression 50.45 80.11 66.58
economic Durbin-Watson stat 0.05 0.04 0.05

Stage 2
explanation in terms
Coefficients FIIN_MA FIIP_MA FIIS_MA
15(t-2) 15(t-2) 15(t-2)
some kind of
Constant -4.13 -3.22 -6.30
(0.57) (0.75) (0.38)
dynamic adjustment Lagged BSE Return -9.82 -24.71
(0.64) (0.16)
mechanism being BSE Return Weekly MA(t-2) 219.08 238.76 27.57
(0.0) (0.0) (0.43)
involved in the IIP Weekly MA(t-2) 0.03 0.02 0.04
(0.48) (0.76) (0.37)
Lagged CMR 0.02
determination of (0.95)
CMR Weekly MA(t-2) 0.24 0.32
current daily value a (0.41) (0.22)
Other Regressors LAG1FII LAG1FII LAG1FII
given FII flow. N_15MA P_15MA S_15MA
(Lagged Variables) 1.16 1.20 1.36
LAG2FII LAG2FII LAG2FII
N_15MA P_15MA S_15MA
-0.19 -0.21 -0.37
R-squared 0.96 0.99 0.99
Adjusted R-squared 0.96 0.99 0.99
S.E. of regression 10.46 10.15 7.99
Durbin-Watson stat 2.02 2.08 2.15
Note: 1. Figures in brackets are the p-values of coefficients
2. P-values for all the lagged dependent variables are less than or equal to
zero.
3. Since the package we used doesn’t provide Durbin h-stats, we report the
42 DW here.
evidence of positive association of both IIP and CMR with FIIN was ICRA BULLETIN

obtained. However, as we shall discuss next, the regression results were

far from satisfactory as there was strong indications of highly auto-
Money
correlated regression disturbance term of the specified regression &
equations.23 Finance
APRIL–SEPT. 2002
C6. Auto-correlation of FII Flows
Preliminary statistical analysis of the original series of daily FII
flows indicated that these were stationary in nature (i.e., contained no
significant time trend but were auto-correlated). This auto-correlation
got reflected in all the regression equations estimated to find out
While the
statistically significant covariates of the various measures of FII flows.
This means none of the covariates—be it related to equity market dependence of net
performances or to the performance of the Indian economy—could
explain singly or jointly the observed auto-correlation of the FII flows. FII flows on daily
Use of lagged value of the concerned FII flow variable as a regressor,
however, removed the auto-correlation altogether. But inclusion of the return in the
lagged value of FII flow variable in most of the cases caused the
erstwhile significant determinant to turn non-significant. As a result, the domestic equity
only statistically satisfactory regression results turned out to be the ones
having market return (i.e., one or the other variant of BSE_RET) and market is suggestive
lagged value of the concerned FII flow. Such regression results would
have economic explanation in terms some kind of dynamic adjustment
of foreign investors’
mechanism being involved in the determination of current daily value a
return-chasing
given FII flow. In other words, these results may be taken to mean that
for individual FII flow there is a desired level determined solely by behaviour, their
BSE_RET or some variant of it and the actual value constantly tries to
reach this desired level. decisions seem to

IV. Concluding Observations get affected also by

Our results suggest that though FII flows to and from India are
significantly affected by return in the domestic equity market,24 the the recent history of
latter is not significantly influenced by variation in these flows. It is
also found that apart from the return in the domestic market there are market return and its
other covariates of such flows. While the dependence of net FII flows on
volatility in
daily return in the domestic equity market—at a day’s lag, to be more
specific—is suggestive of foreign investors’ return-chasing behaviour, international and
their decisions seem to get affected also by the recent history of market
return and its volatility in international and domestic stock markets as domestic stock
well. We also found that the sets of factors affecting FII sale and
purchase were not the same. It appeared that some factors would affect markets as well.
purchase or sale decision of foreign investors, but not the corresponding

23 But one cannot possibly avoid this auto-correlation, specially when the

moving average of the concerned variables are used in regression.

24 In the sense of Granger causality.
43
 ICRA BULLETIN net FII flow. For example, while FII purchase from and sale to the
Indian market appeared to be sensitive to the volatility of domestic
Money market return (with both purchase and sale responding positively to
& volatility change in the recent past), the corresponding net inflow
Finance appeared to be positively related to the volatility of return in the
foreign market.
APRIL–SEPT..2002
This might be due to the simultaneous portfolio adjustment in
several markets together done by foreign investors. We however failed
to find evidence of any portfolio diversification benefit reaped by FIIs
by investing in the Indian market (as suggested by lack of statistical
significance of the effect of betas of the BSE Sensex with respect to the
The scope of using
MSCI world and S&P 500 indices on various FII flows). Day to day
the Indian equity variations in the exchange rate also turned out to be unimportant so far
as FII transactions were concerned (in fact, though the effect of ex-
market for the change rate return on the net FII inflow was sometimes found to be
significant, its effect on FII purchase or sale was never significant).
purpose of portfolio Juxtaposing results of our study with those obtained by
Chakrabarti for the comparable post-Asian crisis period, one may
diversification arose notice quite a few agreements. For example, both the studies tend to
show the predominance of the Indian equity market return as the prime
due to the non- mover of the FII net inflow into India. This may be a matter of concern
as this suggests that the rate of FII inflow into the country would be
synchronised governed mostly by the performance of the domestic equity market and/
or foreign investors’ expectation about this performance and hence
movement of the
variation in the country’s foreign exchange reserve would, to some
Indian equity market extent, be outside the monetary authority’s control. Given the fact that
FII flows can be extremely volatile, a drop of return in the India equity
vis-à-vis the other market may result in sudden massive withdrawals of FII which may
result in quite disturbing consequences on the country’s economy, unless
equity markets of an appropriate stabilisation mechanism is built into the domestic
economic system.
the world. Further cause for concern relates to the finding that unlike in
the pre-Asian crisis period, as found by Chakrabarti, foreign investors
no longer use equity investment in India as a means of diversification
of their portfolio. In fact, the scope of using the Indian equity market
for the purpose of portfolio diversification arose due to the non-synchro-
nised movement of the Indian equity market vis-à-vis the other equity
markets of the world. Recent evidences suggest a stronger co-movement
of market returns and it is possibly for that reason foreign investors no
longer are able to use the Indian equity market for portfolio diversifica-
tion. The point of concern, however, lies elsewhere—viz., a stronger
integration of the Indian market with the equity market elsewhere
exposes the country to the danger of contagion of global financial crises
in future.
Findings of several studies on FII flows to emerging equity
markets over the world have shown the importance of financial market
44 infrastructure such as the market size, market liquidity, trading costs,
information dissemination, and legal mechanisms relating to property ICRA BULLETIN

rights etc., for attracting foreign portfolio investments into those

countries.25 In some studies variables relating to investment barriers,
Money
dividend yield, liquidity, firm size and profitability26 etc., have also &
been found to be significant determinants of FII inflow. These apart, the Finance
need for harmonisation of corporate governance, accounting, listing
APRIL–SEPT. 2002
and other rules with those followed in international financial centres as
well as strengthening of securities markets’ enforcement have also been
stressed for improving competitiveness in attracting foreign portfolio
investment inflow.27
Policy implications of the findings just mentioned above are
The prime focus
that a move towards a more liberalised regime in the emerging market
economies should be accompanied by further improvements in the should be on
regulatory system of the financial sector.28 Our results additionally
suggest that in the case of India (and other countries having thin and regaining investors’
shallow equity markets) the prime focus should be on regaining inves-
tors’ confidence in the equity market so as to strengthen the domestic confidence in the
investor base of the market.29 Once this is achieved, a built-in cushion
against possible destabilising effects of sudden reversal of foreign equity market so as
inflows might develop. Only then would it be possible to reap fully the
benefits of capital market integration. to strengthen the

domestic investor

base of the market.

25 Applying a panel data approach on bilateral gross cross-border equity

flows between 14 countries, during1989-96 find that asset flows depend on market
size in both source and destination country as well as trading costs, in which both
information and the transaction technology play a role. Portes and Rey, 2000.
Garibaldi et al (2002) analysing capital flows to 25 European transition economies
showed that FPI was volatile and concentrated in a handful of countries (notably
Russia). Regressions showed that the presence of a financial market infrastructure
and property rights indicator were the only significant explanatory variables for FPI.
Claessens et al (2002) analysing data from 77 countries, find that factors such as
shareholder protection and the quality of local legal systems which make it and
easier for investors to buy shares and firms to list in public markets play a prime role
in determining the degree of integration with international capital markets.
26 Liljeblom and Löflund (2000), using company specific data on degree of

foreign ownership, in the Finnish market, which recently abolished capital controls.
27 Classens et al (2002).
28 The present stance on capital controls of Indian policy makers is in

place; policy makers in India have justifiably treated capital account liberalisation
as a process and not an event and reiterated that capital account liberalisation and
reform of the financial system should move in tandem (Rangarajan and Prasad,
1999; Rangarajan, 2000; Jalan, 2002).
29 To take care of malpractice which discourage stock market participation

by a majority of savers in our country (see NSE, 2001, in this context). A survey by
SEBI and NCAER showed that alleged malpractice like insider trading and low
confidence in brokers/sub-brokers, company management/auditors were the main
causes behind lack of domestic savers’ confidence in the equity markets. Further
regulatory authorities would need to look into alleged restrictive practices by FIIs
like price rigging as suggested by Samal (1997). 45
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Portfolio Flows of International Investors” Journal of Financial Econo-
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Garibaldi, Pietro, Nada Mora, Ratna Sahay and Jeromin Zettlemeyer (2002),
“What Moves Capital to Transition Economies”, IMF Working Paper No.
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International Monetary Fund, (2002), Global Financial Stability Report, World
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47
 ICRA BULLETIN Appendix 1: Some Information Relating to FII Operations
in India
Money • FIIs in India include Asset Management Companies, Pension
& Funds, Mutual Funds, Investment Trusts as Nominee Compa-
Finance nies, Incorporated/Institutional Portfolio Managers or their
Power of Attorney holders, University Funds, Endowment
APRIL–SEPT..2002
Foundations, Charitable Trusts and Charitable Societies.
• SEBI acts as the nodal point in the entire process of FII registra-
tion. RBI approval under FEMA enables an FII to buy/sell
securities on Stock Exchanges and open foreign currency and
Indian Rupee accounts with a designated bank branch. Invest-
The presence of ment by FIIs in India is regulated under SEBI (FII) Regulations ,
1995 and Regulation 5(2) of FEMA.
Sectoral Cap/ • FIIs are required to allocate their investment between equity and
debt instruments in the ratio of 70:30. (However, it is also possi-
Statutory Ceiling ble for an FII to declare itself a 100 per cent debt FII in which
case it can make its entire investment in debt instruments).
means that foreign
• FIIs can buy/sell securities on Stock Exchanges. They can also
investment from all invest in listed and unlisted securities outside Stock Exchanges,
where the price has been approved by RBI.
sources cannot • No individual FII/sub-account can acquire more than 10 per
cent of the paid-up capital of an Indian company. All FIIs and
exceed a specified their sub-accounts taken together cannot acquire more than 24
per cent of the paid-up capital of an Indian Company. Indian
level. A Company to Companies can raise the above-mentioned 24 per cent ceiling
to the Sectoral Cap/Statutory Ceiling as applicable by passing
which no sectoral a resolution by its Board of Directors followed by passing a
Special Resolution to that effect by its General Body. The
cap/statutory ceiling presence of Sectoral Cap/Statutory Ceiling means that foreign
investment from all sources cannot exceed a specified level. A
is applicable can Company to which no sectoral cap/statutory ceiling is applica-
ble can raise the limit of permissible FII investment to 100 per
raise the limit of cent of the paid-up capital. A Company to which a 49 per cent
Sectoral Cap is applicable can raise the limit of permissible FII
permissible FII investment to 49 per cent and if there is an existing foreign
direct investment of 15 per cent, possible FII investment can
investment to 100%
only be up to 34 per cent.
• No permission from RBI is needed so long as the FIIs purchase
of the paid-up
and sell on recognised stock exchange. However, all non-stock
capital. exchange sales/purchases require RBI permission.
• FIIs can avail of the Forward Cover Facility from the Autho-
rised Dealer subject to certain conditions.
• High Net Worth Individuals /foreign corporates can invest
through SEBI Registered FIIs subject to a sub-limit of 5 per cent
each, within the aggregated limit of 24 per cent.
• FIIs can trade in Exchange Traded Derivative Contracts.

48 Source: RBI and SEBI websites.

 Trends in BSE and FII Operations in India ICRA BULLETIN

During Our Sample Period

Money
CHART A1 &
Returns on BSE and Net FII
Finance
Cumulative FIIN Cumulative Returns on BSE APRIL–SEPT. 2002
35000 0.8
30000 0.7
Cumulative FIIN (Rs.Cr)

Cumulative BSE Returns

0.6
25000 0.5
20000 0.4
0.3
15000
0.2
10000 0.1
5000 0
-0.1
0 -0.2

31-May-02
1-Jan-99

29-Mar-00

16-Mar-01

4-Mar-02
28-Sep-99

21-Sep-00

7-Sep-01
29-Dec-99

18-Dec-00
5-Jul-99

27-Jun-00

13-Jun-01

6-Dec-01
6-Apr-99

-5000 -0.3

CHART A2.1
Net FII and the Sensex, for 3 sub periods of the sample.

500 FIIN Sensex (Close) 6000

400
5500
300
5000
200
Sensex
FII net

100 4500
0
4000
-100
-200 3500

-300 3000
14-May-99
1-Jan-99

21-Mar-00
5-Mar-99

18-Jan-00
16-Nov-99
9-Sep-99

16-Dec-99
14-Jun-99

11-Aug-99
13-Jul-99

20-Apr-00
9-Apr-99

17-Feb-00
3-Feb-99

12-Oct-99

49
50

ICRA BULLETIN
Money
APRIL–SEPT..2002

&
Finance
FII net FII net

-150
-100

1000
1200
-600
-400
-200
100
150
200
250
300
350
-50

200
400
600
800
50
0

0
2-May-01 2-May-00
28-May-01 25-May-00
21-Jun-01 19-Jun-00
17-Jul-01

FIIN

FIIN
12-Jul-00
10-Aug-01 4-Aug-00
7-Sep-01 30-Aug-00
4-Oct-01

CHART A2.3

CHART A2.2
25-Sep-00
31-Oct-01
19-Oct-00
27-Nov-01
14-Nov-00
26-Dec-01

Sensex (Close)

Sensex (Close)
7-Dec-00
21-Jan-02
2-Jan-01
14-Feb-02
25-Jan-01
12-Mar-02
20-Feb-01
10-Apr-02
19-Mar-01
7-May-02
12-Apr-01
31-May-02
2400
2600
2800
3000
3200
3400
3600
3800
4000

3000
3200
3400
3600
3800
4000
4200
4400
4600
4800
5000
Sensex Sensex
 APPENDIX 2: Approximation of Daily Market Capitalisation ICRA BULLETIN

Notation:
qijt : No. of outstanding shares of the i-th company on the j-th Money
day of month t &
pijt : Price of a share of the i-th company on the j-th day of Finance
month t
APRIL–SEPT. 2002
mcijt = pijt q ijt : market capitalisation of the i-th company’s
shares on the j-th day of month t
MC jt = ∑ mcijt : aggregate market capitalisation on the j-th
i
day of month t
We want to find approximate value of MC jt .
We have
∑p ijt qijt ∑p i0 q ijt ∑p i0 q ijt
MC jt = ∑ p ijt qijt = i i
∑p q i 0 = Π Pjt i
∑p qi 0 (1)
∑p ∑p ∑p
i0 i0
i i0 qijt i0 qi 0 i i0 qi 0 i
i i i

where Π Pjt is the Paasche share price index for the j-th day of
month t with respect to some base date 0,

∑p i0 qijt
i
= Q jt is an index of volume of outstanding shares
∑pi
i0 qi 0

for the j-th day of month t with respect to the base date,

∑p i0 qio is the aggregate market capitalisation on the base

date. i

We assume Q jt = Qt i.e., index of volume of outstanding

shares is same for all days of a month.
Then (1) yields: MC jt = Π Pjt Qt MC 0 , where MC 0 = ∑ p i 0 q i 0
i
We have data on MCt: aggregate market capitalization for
month t.
Π t : the available stock price index for month t, we may
approximate QtMC0 by (MCt/ P t ). Substituting the Paasche daily stock
price index Π jt by the corresponding available daily stock price
P

index, say, P jt give us the following approximate formula for daily

market capitalisation
 MC t 
MC jt = Π jt  
 Πt 

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