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It is important to pin point that even when foreigners are noisy and irrational, their activity does not necessarily have a destabilizing impact. Domestic investors may be powerful enough and the market as a whole concisely liquid to accommodate selling or buying pressures from noisy foreigners. As long as domestic investors are not subject to the same imperfections that give mount to noisy trading strategies, foreigners should have no impact on volatility. Nevertheless, they find no permanent effects of net foreign order imbalances on prices and volatility. Domestic investors very quickly accommodate large sales or purchases by foreign Investors.
One is that the relationship between volume and volatility is motivated by changes in fundamentals. If investors interpret information differently, new information will cause both price changes and trading. This gives rise to a contemporaneous connection between volatility and trading. Trading is the procedure through which private information is incorporated into prices. In this kind of case the causality runs from volatility to volume and markets are efficient.
The other option is that trading itself generates volatility in prices. Foreign trading is part and parcel of the total trading volume. Given that there is the positive relationship between total volume and volatility; anyone would expect that foreign trading is also associated with volatility. This relationship can denote two things. First and foremost is that it can reflect the heterogeneity within the group of foreign investors. This heterogeneity causes the information flow to about fundamentals to be associated with trading. Second thing is that it can mean that foreigners pursue noisy trading strategies and that their activity is not arbitraged away by domestic investors.
If the degree of heterogeneity among groups of foreign and domestic investors is the same then the two groups should exhibit proportional amounts of trading based on heterogeneity and fundamentals. Therefore, controlling for total trading volume, foreign trading should have no impact on volatility if foreign investors are as noisy as domestic. Nonetheless, if foreign investors are especially noisy and irrational, then even controlling for total trading volume their activity may have an impact on volatility. The relationship between trading volume and volatility is of some significance.
As on recent days total Investment of FII in India is apprx 1.5 lacs Crore and opposite to that Mutual funds investment is nearly 1.2 lacs crore, and in last three years gratitude to rally on Indices Mutual funds market has increased by whooping 30-40% and so as FII inflow. Except, only critical issue is if FII press selling button to book profit and to pump out their money in that event will household investors along with Mutual funds will save the grace for Indian Equity markets? This is the matter of question which is roaming in everyone's mind after Sensex and Nifty has corrected by whopping 12-13% in October itself, where net data shows FII were the sellers to the tune of Rs.2500 crore and opposite to that Mutual funds where buyers by Rs.1500 crore.
In this situation how Mutual funds role will be in coming months and time when market has become extremely hot-blooded is very interesting to investigate especially after SEBI has given permission to Mutual funds to trade in Derivatives markets and how Mutual funds will save Indian Indices to not behave in the mode as per FII Inflow and Outflow. These are all the possible questions can be answered after studding Behavior of Mutual funds in days to come.