Investment Behavior of Foreign Institutional Investors and Implied Volatility Dynamics: An Empirical Study on the Indian Equity Derivatives Market

Abstract

The aim of this study is to examine the association between the capital flows of foreign institutional investors (FIIs) in the equity derivatives market in India and the implied volatility of options. Previous studies on FIIs and realized volatility in the equity market provide the basis for this study. Covering a period of ten years (2012–2021), this study established the importance of FII capital flows in explaining the implied volatility of options. The Granger causality test confirms the unidirectional flow of causality between FII and implied volatility (VIX) in the Indian stock market. The vector autoregression model developed in the study confirms the dynamic relationship between implied volatility and the investment behavior of foreign institutional investors (FIIs). The outcome of this study will help options traders to understand the mispricing of options because of FII’s buying pressure on implied volatility. The results will also help policymakers understand how institutional investors influence option pricing so that appropriate decisions can be made.