This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.
The effect of inflation on the returns to financial assets has been an important issue for many years. Due to the occurrence of high rates of inflation in Pakistan, this effect is now of considerable practical importance. Inflation is one of the most influential macroeconomic variables, which has negative impact on economic activities. It is important for an investor to be aware of the effects of inflation because if it gets out of hand, the plans may go down. In theory, stocks should be able to absorb the effects of inflation as revenue and earnings increase at the same velocity. Since multinational companies face global rivalry that may not have the same inflationary pressures but the companies that operate locally may have the different inflationary impacts. High increase in rates of inflation is dangerous for earnings of the firms and as consequence for stocks return. Decrease in stocks return eventually effects the decision of the investors. The inflationary destruction of purchasing power can convert an ultimate return which means that it does an investor nothing to earn on 10% when general prices also rise by 10%, as his net gain on purchasing power is zero. An investor invests in order to earn greater purchasing power to increase his standard of living, not to see nominal numbers grow.
There is another concept which is being discussed by the researchers and is very close to the concept of stock return and inflation relationship is the common stock as a hedge against inflation. It can be defined as "the effectiveness of common stocks as an inflation hedge means the extent to which stocks can be used to reduce the risk of real return of an investor which originates from uncertainty about the future level of general prices of consumption goods. It is worthwhile to indicate the relationship between this view of hedging against inflation. A security is an inflation hedge if it offers "protection" against inflation."
In 1930 I. Fisher proposed a hypothesis that real interest rate is independent to the rate of inflation but according to the later researchers got different results. They found that there is a negative relationship between stock return and rate of inflation and common stocks are poor hedge against inflation. This study also conducted research on the bases of prior empirical evidences and found contrary results as compare to fisher.
The rate of return consists of real return plus rate of inflation and an anticipated or unanticipated move in inflation has no impact on common stocks return.
Ho = Stocks return is independent to the rate of inflation
Outline of the Study
This paper is on Fisher Hypothesis, according to him the value of nominal return and inflation rate move together and as a consequence the value of real return remains stable in the long run.
According to the principle of neutrality the inflation rate is increased by the rate at which money grows but this change has no impact on real variable. The impact of money on interest rates can be understood with this principle. Interest rates are always considerable for macroeconomists to understand the economic conditions because the economy of coming future is related with the economy of present all the way through the savings and investments made in the present. To be aware of the Fisher Hypothesis accurately, it is crucial to realize the concepts of nominal rate and real rate. The nominal rate is the interest rate which we usually get to hear from the banks. The real rate is the interest rate which is found by correcting the value of nominal rate subsequently taking into account the impact of inflation. In other words to obtain real rate expected inflation rate is subtracted from the nominal rate.
Linter (1975) and Bodie (1976) found negative relation between actual equity returns and actual inflation. Fama and Schwert (1977) divided inflation into anticipated and unanticipated inflation and found that both are negatively related to stock returns. The empirical evidence of Jaffe and Mandelker (1976), Nelson (1976), and Oudet (1973) reveals that real stock returns are badly affected by both the anticipated and unanticipated inflation rate. This evidence is conflicting with the classical view of Irving Fisher. These empirical evidences have encouraged further theoretical research in relation between stock returns and the rate of inflation.
This researche's analysis is also based on the broader literature on stock return and inflation relationship. Research over the data of last decade has generated strong evidence that real return is not independent to the rate of inflation and there is negative relationship between stock return and rate of inflation.
Return that an investor is able to get on common stocks is called stock return. For the sake of analysis we calculate it as change in market capitalization divide by previous year market capitalization. Market capitalization is a product of number of shares floated in market and market prices of a share.
When price level of goods and services increased in an economy over a period of time this situation is called inflation. Under this situation, every unit of currency is able to buy smaller amount of goods and services; as a consequence inflation results as decline in the real value of money or we can say a loss of purchasing power. A stable condition of inflation not only provides a nurturing environment for the growth of economy, but also supports the poor and fixed income people who are suffering in the most vulnerable condition in the society.
CHAPTER 2: LITERATURE REVIEW
The following literature is based upon the previous studies which have examined the relationship between stock return and rate of inflation. Since inflation is an influential variable and it also explains the purchasing power of people so following some researches that had been done on the impact of inflation on stock return [Fama (1981), Firth (1979), Lintner (1975), Jaffe & Mandelker (1976), and Nelson (1976)] this paper will test the data of Pakistani market.
Jaffe & Mandelker (1976) tested the vital hypothesis that 'the real rate of return is independent to the expected rate of inflation' this hypothesis is called the 'Fisher effect'. The analysis showed a negative relationship between the stock returns and rates of inflation, it was also found that there was a positive relationship between these two variables over a much longer period of time. The implication of this empirical study was hidden until the effects of anticipated and unanticipated rates of inflation were separated. However, the relationship between the anticipated rate of inflation and the returns to risky assets has been examined in less depth. Jaffe and Mandelker (1976) reveal that the returns on stocks appear to be significantly negatively related to the anticipated rate of inflation, a finding inconsistent with the Fisher effect and possibly suggestive of market inefficiency.
Nelson (1976) tested the hypothesis that expected rates of return is made up of a "real" return and the expected rate of inflation and the real return does not move systematically with the rate of inflation. The results obtained didn't agree with the Fisher hypothesis but to some extent suggests that Nelson (1976) a negative relation between returns and both anticipated rates of inflation and unanticipated changes in the rate of inflation has prevailed over the post-war period. This was also found that rate of return on common stocks were negatively correlated with the rate of inflation over short periods of time. A common stock can be considered as a claim to present and future money, and to present and future goods. A claim to future money is negative if a company is a net debtor. Let's assume that if the expected rate of inflation changes, there will be no change in the present value of future goods or of present goods and money on the spot when the forecast changes. It's just the value of future money which was changed.' To the level that a common stock represents claims to future money, its value ought to change when the forecasted rate of inflation changes.
Sharpe (2000) proposed the hypotheses that expected inflation has no effect on required real returns, expected inflation should have no effect on the price-earnings ratio, once we control for expected real earnings growth. An increase in inflation depresses equity valuations since higher inflation is linked with lower real earnings growth outlook.
Bodie (1976) also reveal that the real return on equity is negatively related to both anticipated and unanticipated inflation, at least in the short run. It was felt by the Fisher that the real and monetary sector of the economy is basically independent. Thus, he proposed the hypotheses that the anticipated real return is determined by real factors, for example the productivity of capital, time preferences of investor, and tastes for risk, and that the anticipated real return and the anticipated inflation rate are unrelated. This assumption allows to analyze asset return and inflation relationships. Non-inflationary factors can cause variation in nominal returns that can be large or small comparative to the variation in nominal returns linked with the anticipated and unanticipated inflation rate. According to Fama (1981) Common stocks return are negatively related to the expected and unexpected inflation rate. Some of the variation in stocks return is due to their negative measured relationships with anticipated and unanticipated inflation rate. The negative relation of stock returns with anticipated inflation rates doesn't account for a large segment of the variation in stock returns, and it doesn't give the impression to imply profitable trading rules.
According to the proposition that stocks provide a hedge against inflation implies that real value of stocks remain unchanged when the stock prices rise at a sufficient rate. There is some consent on how the inflation affects nominal or real earnings of an organization some authors say earnings grow in real terms because of the inflation. Oudet (1973) argue that there is a negative effect of inflation on stock returns during the period of inflation. Let's take an example that stock prices increases at the beginning of the inflationary period so the investors finally will expect that prices will be return to a lower level. At this point if the investors require a higher return on their money invested to reimburse for inflation, investors will bid down the prices of stock even further. Oudet (1973) said that stock prices catch up with rates of inflation in the long run, the reduced form was reestimated including twenty lags of the inflation rate. The whole effect of inflation on stock returns is negative.
Gultekin (1983) studied behavior of stock return in the periods of high inflation in twenty six countries and found contrary results to the Fisher Hypothesis, which tells that real rates of return on stocks and anticipated inflation rates are independent and the nominal stock returns have variation in one-to-one associated with anticipated inflation. There is an unchanged lack of positive relation between the both stock returns and inflation in most of the studied countries of the countries. It is found that low value of stocks during the periods of high inflation is a result of the failure of investors to adjust organizations' profits for the inflation premium component of interest expense (that, they argue, shows a return of capital instead of an expense), and from the capitalization of organizations' profits at the nominal rate (instead of the notionally corrected real rate) of interest. The tax laws also make the stock prices sensitive to alter in the anticipated rate of inflation in the non-financial organizations. The management of the money supply by the government in order to get control over the output of the economy also provides inflation a direct impact on the stock pricing system. So the inflation is more than a monetary phenomenon in this framework.
The literature on real returns and inflation often shows the differences between anticipated and unanticipated inflation. According to Day (1984) It has been observed empirically, the current rate of inflation and the ex post real returns on securities are negatively related. The implications of this explanation are constant with the hypothesis tested empirically by Fama, which tells that the negative relation of real stock returns and unanticipated inflation is the result of a "proxy effect" for the more essential determinants of real stock values. The analysis tells a functional form for the relationship between real stock returns and these essential economic variables. This form is of specific interest because it explains ex post real returns in terms of economic variables that are observable.
The expected inflation rate is defined as the expected annual rate of change. Horne and Glassmir (1972) says that If the prices, wages, and other costs change exactly in keeping with the unanticipated change in inflation, share value is unaffected by the operating earnings term. It means any alteration in the value of an unanticipated change in inflation would be explained by the firm is a net debtor or net creditor and by the tax impact of anticipated depreciation charges. Since these factors has importance than leads or lags in prices as compare to wages and other costs, their mutual effects on value would be only moderate. In many cases, the lead or lag explains the direction of the alteration in stocks value that accompanies an unexpected alteration in inflation. So whether or not wages and other costs lag prices in during the periods of inflation has a profound impact on the performance of stock price.
Luintel and Paudyal (2006) say that common stocks are expected to hedge against inflation therefore, in an efficient market, return on common stocks ought to keep pace with the inflation rate. According to Luintel and Paudyal (2006) there is a relationship between stock and goods price indexes in both aggregate and disaggregate (industry) data. Commodity price elasticity is also above the unity in overall market index. These facts of above unity elasticity are constant with the Fisher's tax-augmented version; that is, the stocks return should exceed the inflation rate to compensate for the loss in the real wealth of the investors who pay taxes. Therefore common stocks are expected to hedge against inflation.
An important reason to expect a relationship between stock returns and unanticipated inflation is that unanticipated inflation brings new information regarding the future levels of anticipated inflation. Fama (1981) says that fluctuation in the structure of interest rates shows to be subjective by inflationary expectations. For the future if expectations of inflation are higher, current nominal interest rates are expected to increase so that expected real interest rates might not be affected by the level of anticipated inflation. An unanticipated rise in anticipated inflation has a big impact on value the longer the time to maturity of the debt, and it results in the transfer of wealth from bond-holders to stockholders. Same effects occur for the value of other long-term fixed price contracts. Precisely, when it seems that stock returns are significantly negatively affected in the 15 trading days adjoining the announcement of unanticipated inflation of the Consumer Price Index (CPI), it doesn't show that this effect occurs initially on or before the date of announcement. Schwert (1981) says that this situation might indicate that there is both leakage of information before the formal announcement, and an inefficient, slow response by the stock market following the announcement.
Fisher's great work has been a major landmark in the field of economic research because first time in the history he worked on the fundamental relations between prices, returns, borrowing and lending, and "real" investment decisions when many researchers simultaneously pursued their own self interest in purely competitive markets. Following to the Fisher, Linter (1975) proposed a hypotheses that during the period in which inflation rates are increased, even a continuance of higher constant steady-state rates of inflation will leave the anticipated real rates of return on common stocks just as high as it was before the inflationary period and anticipated nominal rates of returns will also be higher. In the results he found that nominal and the real rates of return on common stocks are negatively and very significantly related to inflation rates.
There are many evidences that stock returns and inflation are negatively related. Bodie (1976), Jaffe and Mandelker (1976), Nelson (1976), and Fama's article with Schwert (1977) reported negative relations between stock returns and both the anticipated and unanticipated components of inflation. Fama (1981) proposed hypothesis that the negative relationship between stock returns and inflation are surrogating for positive relations between stock returns and real variables that are more fundamental determinants of equity values. The negative relationship between stock returns and inflation are influenced by negative relationship between inflation and real activity which is defined by a combination of theory of money demand and the quantity theory of money. Sine it is predicted by the surrogated effect hypothesis of Fama (1981), the more inconsistent of the stock return and inflation relations dissipate when both real variables and measures of anticipated and unanticipated inflation are used to define stock returns. In a nut shell, the story proposed is a union of intellectual prospective for the real and monetary sectors. The model of the monetary sector represents that in pricing of goods and services, markets of goods do rational assessments of the present nominal monetary supply and real activity of future. The theory of the monetary sector is a combination of theory of money demand with an examination of the characteristics of the money supply process then it intimates negative relationship between inflation and future rates of growth of real activity. The theory of the real sector intimates that there is a positive relation between stock returns and anticipated growth rates of real activity. The positive relationship between stock returns and real activity that comes from the real sector incorporate with the negative relationship between inflation and real activity that come from the monetary sector to provoke fake negative relationship between stock returns and inflation.