An Analysis into Interrelationship between Foreign Institutional Investments, Stock Market Returns and Exchange Rate Movement

Indian Capital markets have seen a surge of Capital inflow post 1992 after Securities Exchange Board of India was incorporated. One of the major economic reforms in the capital market was to allow Foreign Portfolio Investments to invest in Indian Companies.This paper attempts to understand the inter-relationship between FII and select macro-economic variables which include Stock Market Returns and Exchange rate Movement. BSE-Sensex is chosen to compute the stock market returns and INR-UDR spot rate is assumed for calculating the exchange rate movement. The period of study is chosen from 1st January 2004 to 31st December 2015 which includes a total period of 11 years. The study was done using the Correlation Test, Johansen’s Co-integration Test and the Vector Auto Regression Model (VAR). FII, Return on SENSEX and Return on exchange rate seem to be very strong as reflected in the correlation test. However between Sensex movement and exchange rate movement it was found that Sensex has a very strong positive correlation with the movement of FII. The co-integration test indicated a long run movement between the three variables. VAR model proved that return on FII is influenced by time lag 1 and 2 of returns on FII and is also influenced by time lag 1 of Sensex. Return on SENSEX is influenced by time lag 1 and 2 of returns on Sensex and time lag 1 of return on FII. INR-US$ exchange rate is influenced by only time lag 1 and 2 of INR-US$ exchange rate itself.