The effect of cross-border portfolio flows and psychology of investors on stock returns: A case of Thailand

There are two main objectives in this study. The first objective is to investigate bi-variate causal relationships between foreign portfolio flows and stock returns in the Thai stock market by using the Granger-causality test. The series data was divided into two sub-periods; before and during the Asian financial crisis. The results indicate that there is a uni-directional relationship from stock returns to foreign portfolio flows before and during the Asian financial crisis. It supported the hypothesis that stock returns today stimulate future foreign portfolio flows. Though the general belief is that foreign portfolio flows drive up stock returns, the empirical results showed no causality relationship from foreign portfolio flows to stock returns before and during the Asian financial crisis.; The second objective of this study is to apply financial behavior theories based on positive feedback trading strategies and crowd behaviors in order to examine investor behaviors. Additionally, the author further examines trading interdependencies among foreign and domestic investors, and the effect of their trading on the behaviors of the Thai stock market. Before the Asian financial crisis, the results from Vector Autoregression (VAR) Model and Impulse Response function showed that all market participants pursued positive feedback strategies. Foreign investors led other investors by pushing the price away from fundamental value, then domestic institutional investors and domestic individual investors followed foreign investors and pushed the price even further from the fundamental value. These trading patterns among market participants potentially caused the market misbehave. During the Asian financial crisis, foreign and domestic institutional investors still pursued positive feedback strategies, but domestic individual investors did not. Domestic individual investors changed their trading strategies from following the crowd to trading against foreign and domestic institutional investors.; The findings from this study have several policy implications. First, capital policy is not needed in the Thai stock market because there is no evidence that foreign portfolio flows influence the stock prices. Second, with the presence of positive feedback traders and crowd behaviors affecting the stability of the market, Thai regulators may consider implementing policies to control short-term investors in the market.