In the post-liberalization period, FII investments have become an important component of foreign capital inflows to India. Over the years, the number of FIIs as well as the magnitude of investment made by them have increased drastically. Against this backdrop, this paper tries to investigate the determinants of FII flows to India, and the causal relationship between FII investment inflow and the risk-returns in the Indian stock markets. The results indicate that the returns and volatility in the Indian markets emerge as the principal determinants of FII investment inflows. They also indicate that FIIs have not been looking at the Indian markets as a destination to diversify their portfolio risk. The authors find a preliminary evidence of absence of information disadvantage to FIIs in India.

Prior to 1990s, developing countries received capital flows, primarily in the form of official flows. Over the years the proportion of net long-term official flows, in the long-term capital flows to these countries, has fallen from about 50% in 1991 to 18% in 2001 (World Bank, 2002). This change has been brought about by the growing importance of private flows like Foreign Portfolio Investment (FPI) and Foreign Direct Investment (FDI). Before the Asian crisis of 1997, private capital inflows to emerging markets were almost evenly distributed between FPI and FDI. After the crisis, the scene has changed considerably. The FDI inflows have become a predominant component of the private capital inflows to the emerging markets (World Bank, 2002).

The widely-held perception about the two components of private capital inflows, viz., FDI and FPI, is that the former creates capacity in the form of physical and intellectual infrastructure, whereas, the latter operates through the capital market and could be purely speculative in nature. Associated with this perception is the presumption that direct investors consider long-term rewards on their investment and hence, these flows are stable and cold. From the perspective of international investors the rapidly growing emerging markets offer potentially higher rates of return and help in diversifying portfolio risk. This has been empirically confirmed by Divecha, et al., (1992) and Harvey (1995). It is argued that FPI flows increase the stock prices in the recipient markets, which in turn increases the Price-Earning (P/E) ratio of the concerned firms. Increase in P/E ratio tends to reduce the cost of capital and boosts the stock markets. This phenomenon has been witnessed in the case of Asian and Latin American countries (Calvo, 1996). The cost of equity capital is also cut down due to the sharing of risk by the foreign investors.

Applied Finance Journal, FII Investment, Indian stock markets, Foreign Portfolio Investment, FPI, Foreign Direct Investment, FDI, Asian Crisis, Net Present Value, NPV, FII Investments, Stock Markets, External
Commercial Borrowings, ECB, Securities and Exchange Board of India, SEBI, Indian Capital Market, International Capital Asset Pricing Model, ICAPM Approach, Reserve Bank of India, RBI.