The paper attempts to explain the association between Foreign Institutional Investor (FII) flows to Indian equity markets and option implied Volatility Index (VIX). Prior studies involving the relationship between FII flows and realized volatility provide contradictory findings and are largely inconclusive. Little empirical work is found to explain the relationship between FII flow and expected volatility as measured by the option implied VIX. We find evidence that India VIX does not have any influence on FII flows to Indian equity markets. Instead, there is evidence of significant reverse causality. The results indicate that the collective perception in the minds of investors about future volatility is fueled by FII flows.

The behavior of stock market volatility, its causes and effects have long been a subject of extensive theoretical and empirical research. Three factors are primarily responsible for such emphasis. First, volatility of returns has a paramount importance in asset pricing. Second, market crashes at various times renew the issue of effects of volatility shocks. Many market practitioners and researchers attribute the actions of informed participants like institutional investors and corporate insiders as the foremost cause for surge in stock market volatility. Thus, modeling and incorporating volatility forecasts become indispensable in asset valuation and implementation of investment strategies. Third, leaving out volatility in analyzing other market variables may lead to spurious references (Morgan and Morgan, 1987; Connolly, 1989; and Kryzanowski and Zhang, 1996).

The relationship between foreign institutional ownership and volatility is largely inconclusive. Contemporaneous nature of FII flows and stock market volatility, especially at times of economic crisis, prompts the popular press to attribute the former as an enhancer of the latter. The requirement of a clear understanding of stock market volatility in emerging economies stems from three aspects. First, a higher equity return volatility increases the cost of equity capital. Second, asset pricing and investment strategies need to factor in the relationship between priced-risk and return volatility. And third, higher volatility often increases the “option to wait” and therefore delays investments (Bekaert and Harvey, 1995). Also, empirical regularities in the behavior of volatility are extremely vital and decisive in the pricing of options under stochastic volatility option pricing models.

Applied Finance Journal, Foreign Institutional Investor (FII), FII Flow, Volatility Index (VIX), Volatility Expectations, Indian Equity Markets.