Investigating Causal Relationships between Foreign Institutional Investment with respect to Stock Market Returns and Exchange Rate in India

The last two decades has seen India emerge as an important destination of investment in equity market by foreign institutional investors (FIIs). In the context of increasing significance of FIIs in the domestic financial markets, this paper aims at investigating the causal relationships between foreign institutional investment (FII) inflows and two important domestic financial market variables namely stock market returns and exchange rates using monthly data from April 1994 to December 2011. The Granger-causality test reveals that there is a unidirectional causality running from domestic stock market returns to FII inflows. This result suggests that FIIs coming to India are return chasers. We also find that there is a unidirectional causality running from exchange rate movements to FII inflows suggesting that instead of causing movements in exchange rates, the FII inflows are effect of the exchange rate movements.