Globalization and liberalization have brought dramatic changes in the financial sector of Indian economy. India has emerged as an important destination for global investment. Keeping this in view, the present study examines the dynamic relationship between stock market, market capitalization and net FII investment in India during the period from June 2002 to June 2005 by using Granger Causality Test and Vector Auto Regression Model. The results indicate that there is a unidirectional causal relationship between market capitalization and stock market, net FII investment with stock market. Again the VAR analysis shows that stock return and market capitalization have an impact over net FII investment in the expected direction over a short horizon.

Globalization and liberalization have brought dramatic changes in the financial sector of our economy. Since capital formation plays an important role in the development process, new products have emerged in the market. The advent of floating exchange rate, liberalization of capital account, development of 24-hour screen-based trading, increasing use of national currencies outside the country, and innovation of international financial products have led to the cross-country linkage of capital market. India has emerged as an important destination for global investment. This is reflected in the number of Foreign Institutional Investors (FIIs) registered with the Securities and Exchange Board of India (SEBI). The liberalization process of the Indian economy has been a contributing factor for the increase in financial flows. India in the last ten years has improved its macroeconomic performance with a shift towards more market discipline and increased capital movements. It is generally believed that FII investment broadens the base of portfolio diversification and causes a long-term increase in the stock prices by reducing the equilibrium rate of return.

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