An Empirical Study of the Relationship Between Foreign Portfolio Investment and Stock Market Volatility in Emerging Markets

Posted: Sep 02, 1980

• Harper Torres
• Henry Smith
• Isabella Green

Abstract

This research presents a novel methodological framework for analyzing the complex relationship between foreign portfolio investment (FPI) and stock market volatility in emerging markets. Departing from conventional linear regression approaches, we introduce a multi-scale decomposition technique combined with regime-switching models to capture the time-varying and scale-dependent nature of this relationship. Our study examines data from 15 emerging markets over the period 2000-2023, employing wavelet analysis to decompose volatility and FPI flows across different investment horizons. The findings reveal previously undocumented asymmetries in how FPI impacts market stability, with short-term speculative flows exhibiting destabilizing effects while long-term strategic investments demonstrate stabilizing properties. Furthermore, we identify critical threshold levels beyond which FPI inflows transition from stabilizing to destabilizing, providing policymakers with actionable insights for capital flow management. The methodological innovation lies in our ability to simultaneously analyze frequency-domain characteristics and regime-dependent behaviors, offering a more nuanced understanding than previous studies that treated FPI as a homogeneous phenomenon. Our results challenge the conventional wisdom that FPI uniformly increases market volatility and instead demonstrate that the relationship is highly conditional on both the composition of flows and the institutional characteristics of host markets.