Relationship between Stocks Return and Rate of Inflation - Free Essay Example

Sample details Pages: 16 Words: 4750 Downloads: 8 Date added: 2017/06/26 Category Finance Essay Type Argumentative essay Did you like this example? 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. Don’t waste time! Our writers will create an original "Relationship between Stocks Return and Rate of Inflation" essay for you Create order 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 c oncept 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 e vidences and found contrary results as compare to fisher. Problem Statement 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. Hypotheses 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 economy because they relate the future economy with the present economy through the savings and investments made in the present. To understand the Fisher Hypothesis properly, it is essential to understand 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 corrected interest rate value of nominal rate after considering the impact of inflation. In other words the real rate is obtained by subt racting the expected inflation rate 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 researches 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 relationsh ip between stock return and rate of inflation. Definitions Stock Return 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. Inflation Rate An increase in prices of goods and services in an economy over a period of time is called inflation. When the price level increases, each unit of currency buys fewer 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. H owever, 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 consist of a real return plus the expected rate of inflation and the real return does not move systematically with the rate of inflation. The results obtained didnt 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 comm on 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. Lets 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. Its 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 anti cipated 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 doesnt account for a large segment of the variation in stock returns, and it doesnt 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. Lets 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) s aid 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 cap italization 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 direct ion 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 Fishers 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 relat ionship 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 doesnt show that this effect occ urs 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. Fishers 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 t hat 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 Famas 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 betw een inflation and real activity that come from the monetary sector to provoke fake negative relationship between stock returns and inflation. Marshall (1992) has studied the CO-MOVEMENTS OF REAL asset returns, inflation, and money growth extensively. He found significantly negative correlation between real equity returns and inflation. This reality is not particularly unexpected; many studies come to a conclusion that the correlations between ex ante real asset returns and anticipated inflation are also negative. Contrary to these patterns, the correlation between money growth and real equity returns is found weakly positive, whereas the correlation between money growth and the real bond return is found zero. CHAPTER 3: RESEARCH METHODS 3.1 Method of Data Collection In collection of data there are two sources available i.e. primary data source and secondary data source. In this research secondary data has been used. In analysis for this paper Secondary data is gathered from journal articles, research papers and electronic media. Data for monthly inflation rate is collected from Economic Survey of Pakistan which is fairly represented by the Consumer Price Index (CPI). Data of market capitalization of cement sector of Pakistan was needed for the calculation of stock return. This data is collected from the website of Business Recorder. Firth (1979) worked on the data of rates of inflation for the period 1955-1976. The percentage monthly stock market returns were obtained from the London Business School share price databank. Monthly Index of Retail Prices (I.R.P.) measured the inflation rate and to check the results the Wholesale Price Index was also used. Nelson (1976) also worked on the monthly stock returns consist of the Scholes Index of value-weighted returns for the period January 1953 to December 1972 and the stock returns of the Standard and Poors 500 Index for January 1973 to June 1974. Jaffe Mandelker (1976) employed the Lawrence Fisher Index to measure the return on the market. LFI is an equally-weighted portfolio of all securities listed on the New York Stock Exchange. Consumer Price Index (CPI) was used as the measure of the price level and to check, some of the results were duplicated with the Wholesale Price Index (WPI). The bulk of the study employed monthly data from January 1953 to December 1971. The stock return on the market for this latter sample was taken from the Cowles Series Data and the Standard and Poors Index. 3.2 Sample Size Monthly data from January 1999 to December 2008 has been used in this study. The sample size is 120 observations (N=120). 3.3 Research Model Developed The data was put into SPSS (statistical package for social sciences) and analyzed by using General Liner Model to find out the relationship between stock return and rate of inflation. Here dummy variable is required due to the jumping data which means that at some places stocks return was showing abnormal behavior. In this analysis 1 is assigned to the data which is showing abnormal behavior and 0 is assigned to the data which is showing normal behavior. R = ÃÆ'Ã… ½Ãƒâ€šÃ‚ ± + ÃÆ'Ã… ½Ãƒâ€šÃ‚ ²1I + ÃÆ'Ã… ½Ãƒâ€šÃ‚ ²2[Dummy] + e Where R = Stock return I = Rate of inflation B= Beta Dummy= Variable used to get better results e= Error term 3.4 Statistical Technique To analyze the relationship between stock return and rate of inflation Multiple Linear Regression has been used. This technique is used to assess the relationship between one dependent variable and several independent variables. It measures that how strongly each independent variable predicts the dependent variable. We also use correlation technique to find out what sort of relationship exists between stock return and rate of inflation whether it is positive or negative. Jaffe Mandelker (1976), Nelson (1976), Fama (1981), Linter (1975) and Firth (1979) used regression model to study the relationship between stock return and rate of inflation. In statistics, regression analysis has ability for modeling and analyzing several variables, when the focus of the study is on the relationship between a dependent variable and one or more independent variables. More specifically, regression analysis helps to understand how the typical value of the dependent variable changes when any one o f the independent variables shows any variation. CHAPTER 4: RESULTS 4.1 Findings and Interpretations of the Results Descriptive Statistics Mean Std. Deviation N Stock Return 3.1173 14.51389 120 Inflation Rate 7.0845 5.19841 120 Dummy .0417 .20066 120 Total number of observations is 120. Dummy consists of two categories in which 115 are showing normal behavior and 5 are showing abnormal behavior. Abnormal behavior means different behavior of stocks return due to some fundamental factors. Correlations Stock Return Inflation Rate Stock Return Pearson Correlation 1 -.228* Sig. (2-tailed) .012 N 120 120 Inflation Rate Pearson Correlation -.228* 1 Sig. (2-tailed) .012 N 120 120 *. Correlation is significant at the 0.05 level (2-tailed). Here we examine the relationship between stocks return and rate of inflation. This table shows that there is a significant negative relationship between the two variables (r = -0.228, P 0.000). ANOVAb Model Sum of Squares df Mean Square F Sig. 1 Regression 1298.754 1 1298.754 6.448 .012a Residual 23768.954 118 201.432 Total 25067.708 119 It can be viewed that the value for regression sum of square is smaller than the value for the residual sum of square and as the value of the regression is smaller than the residual, showed that the independent variables cannot accounted for most of the variation in the dependent variable. The F ratio in the Analysis of Variance 6.448 and significant p value is 0.012. This provides evidence of existence of a linear relationship between the dependent variable (stocks return) and the independent variables (inflation). Coefficientsa Model Unstandardized Coefficients Standardized Coefficients t Sig. B Std. Error Beta 1 (Constant) 6.153 1.835 3.354 .001 Inflation Rate -.661 .208 -.237 -3.182 .002 Dummy 39.604 5.386 .548 7.354 .000 a. Dependent Variable: Stock Return Equation Stocks Return = 6.153 0.661 (Inflation) 39.604 (0 , 1) + e Model Summaryb Model R R Square Adjusted R Square Std. Error of the Estimate Durbin-Watson 1 .593a .352 .340 11.78716 2.124 a. Predictors: (Constant), Dummy, Inflation Rate b. Dependent Variable: Stock Return It can be seen that the value of R obtained for the data results is 0.593, which is a high and near to +1. This shows a strong relationship between the dependant and independent variables. R Square (coefficient of determination) is the proportion of variation in the dependent variable explained by the regression model. Larger values of R square indicate the model fits the data well and it can be obtained by squaring the value of R. Since the R squared value for our data set is 0.352which is low value. Furthermore it can be obtained that 35.2 % of the total variation is explained by the independent variables. Reason behind the low value of adjusted R square is that there are many other factors that affect the stocks return but since our focus is on inflation so this low value is acceptable for us. According to the Jaffe Mandelker (1976) there is a significant negative relationship between stock return and rate of inflation, although the coefficient of determination is found low. It recommends that the stock market is not a good hedge against inflation. According to this condition the investors whose real wealth is decreased by high inflation can expect that this effect can be compounded because of a lower return on the stock market. This point is also considerable that one should distinguish between anticipated and unanticipated inflation in order to correctly measure the relationship. Fama (1981) rejected the hypothesis that common stocks are good hedge against anticipated monthly inflation rate because it is found that there is negative relationship between stock return and rate of inflation. 4.2 Hypotheses Assessment Summary Hypothesis: Ho = Stocks return is independent to the rate of inflation Hypothesis is rejected because all the values are significant. Correlation: Ho = stocks return and inflation are not correlated (r = -0.228, P 0.000) Regression: Value of R square and adjusted R square R square = 0.352 and adjusted R square = 0.34 In this paper it is hypothesized that stocks return is independent to the rate of inflation. The results reject the hypothesis and shows that there is a significant negative relationship between stocks return and rate of inflation. The low value of R square shows that there are many other factors that affect stock return. Jaffe Mandelker (1976), Nelson (1976), and Linter (1975) also found negative relationship between stocks return and rate of inflation. They revealed that stocks return are badly affected by inflation. These findings are inconsistent with the Fisher effect. CHAPTER 5: DISCUSSIONS, CONCLUSION, IMPLICATIONS AND FUTURE RESEARCH 5.1 Conclusion After analyzing the researches done in U.S. and U.K. we test the relationship between stocks return and rate of inflation in the Pakistani market. Due to the high rates of inflation in Pakistan, this relationship is now of considerable practical importance. Inflation has negative impact on economic activities so every investor should be careful about it. In this paper we test ten years data of stocks return and rate of inflation through multiple regression and found a negative relationship between stock return and rate of inflation. The empirical evidence of Bodie (1976), Fama and Schwert (1977), Jaffe and Mandelker (1976), Nelson (1976), and Linter (1975) suggests that real stock returns are badly affected by both the anticipated and unanticipated components of inflation rate. This evidence is different from the classical view of Irving Fisher. The low value of adjusted R square shows that there are many other factors that affect the stocks return but since our researchs focus was on inflation rate therefore we avoid considering other variables. 5.2 Discussion Every investor wants to make a secure investment and for this purpose a term Hedge is used. Hedge means to reduce the risk of an investment. The effectiveness of common stocks as an inflation hedge means the extent to which they can be used to reduce the risk of an investors real return. For common stocks to qualify as an inflation hedge they must be free of downside risk stemming from all sources, not just from inflation. Another definition of the term inflation hedge as applied to common stocks can be expressed as follows: a security is an inflation hedge if its real return is independent of the rate of inflation. This is the definition employed by, Fama (1981), and Oudet (1973). Unanticipated increase in inflation rate and less than expected demand might create severe crises for the cement sector. Main component of the cost is fuel. Pakistans cement sector is facing problem of high prices of oil and coal which directly increase the cost of production. Inflation affects people s purchasing power which in turn decreases construction and other activities. Although cement sector of Pakistan is surviving through its exports but in Pakistan construction activities are slow. This situation compels the players of the sector to decrease their retail prices. Due to the mentioned problems profit of the sector has decreased which in turn will affect the stock return. 5.3 Implication and Recommendation The beneficiaries of this research are students who further study on the relationship between stock returns and rate of inflation in Cement Sector of Pakistan. Because there are many other variables which affect the common stocks return. As this research is based on 10 years monthly data of only one sector so the significance of this research still would not as contented as it would be. Whereas this research provides much deeper understanding of relationship between stocks return and rate of inflation in Cement capital Sector of Pakistan that how real return is affected by the changes in inflation. 5.4 Future Research