This study investigated the effect of foreign institutional investment (FII) on the returns of Indian stock market using monthly data collected over the period from January 1993 to May 2012. By applying augmented Dickey-Fuller unit root test, Johansen cointegration test, Granger causality test and vector error correction model (VECM), this study found that FII and Sensex are level and first difference stationary series, respectively. It also found positive long-run equilibrium relationship between stock market index and FII. The study also revealed bidirectional causality between stock market index and FII. This study formulated VECM, which can be used for the estimation purpose. The major implication that this study derived is that foreign investments play a beneficial role in the development of the Indian economy and, therefore, the Indian government should try to maximise net foreign investment. The results obtained in this study were based on the monthly data of Sensex and FII; therefore, one needs to be cautious before generalising the results. For future research, one may consider other Indian stock market indices, sector indices and individual companies. Even more robust analysis can be done by reducing the frequency of data, which will help in validating the result of this study.
Foreign institutional investment, Indian stock market return, Cointegration test, Granger causality test, Vector error correction model
