Behavioural Finance Perspectives On FII Trading: Impacts On Liquidity And Market Stability

Nayeisha Puri, Army Institute of Law, Mohali

ABSTRACT

Foreign Institutional Investors (FIIs) have been pivotal in shaping the Indian capital markets, significantly influencing market dynamics and liquidity through their substantial capital inflows and outflows. While their investments enhance market depth and liquidity, they also introduce volatility due to their often-reactive trading strategies. Although extensive research has been conducted on the quantitative impacts of FIIs on market performance, the behavioural finance perspective—examining the psychological drivers behind their investment decisions—remains underexplored. FIIs, including hedge funds, insurance companies, pension funds, investment banks, and mutual funds, have played a crucial role in the development of the Indian capital markets since the economic liberalization of the 1990s. Their investment decisions are influenced by a combination of economic indicators, market conditions, and strategic objectives aimed at optimizing returns and managing risks.

This article delves into the behavioural aspects of FIIs, focusing on how cognitive biases, emotions, and social influences can lead to irrational investment behaviours that impact market liquidity. The study contrasts the current cautious approach of FIIs with the aggressive investment patterns of Domestic Institutional Investors (DIIs), who have increased their investments nearly threefold compared to the previous year. This surge in domestic investments has been a key factor in driving the stock market rally, supported by a broader trend of financialization of savings in India.

The findings highlight the growing influence of domestic investors, particularly DIIs and retail investors, who have consistently viewed market dips as buying opportunities, thereby stabilizing the market during periods of volatility. This behavioural resilience contrasts with the more reserved stance of FIIs, whose reduced investment levels reflect caution amid global uncertainties. The analysis underscores the need for a deeper understanding of FII behaviour for market regulators and participants, as their actions have substantial implications for market stability and the overall health of the financial system. While FIIs contribute positively to market growth and liquidity during stable periods, their behaviour during volatile times can exacerbate market fluctuations, posing challenges for market management and policy formulation. This article provides insights into the changing dynamics of market influence, emphasizing the critical role of behavioural finance in understanding the interplay between FII actions and market liquidity.