The Effect of Inflation on Financial Assets

Topics: Inflation, Stock, Stock market Pages: 18 (5454 words) Published: June 20, 2011
CHAPTER 1: INTRODUCTION

1.1 Overview

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 these views 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. It was 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.

1.2 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.

1.3 Hypotheses
Ho = Stocks return is independent to the rate of inflation

1.4 Outline of the Study
This thesis 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 usually gets 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...

References: • Bodie, Z. (1976) "Common Stocks as a Hedge against Inflation." Journal of Finance, Vol. 31. No.2. pp. 459-470.
• Day, T. E. (1984) “Real Stock Returns and Inflation.” Journal of Finance, Vol. 39. No. 2. pp. 493-502.
• Fama, E. F. & Schwert, G. W. (1977) “Asset Returns and Inflation.” Journal of Financial Economics, No. 5. pp. 115-146.
• Fama, E. F. (1981) “Stock Return, Real Activity, Inflation, and Money.” The American Economic Review, Vol. 71. No. 4. pp. 545-565.
• Firth, M. (1979) “Relationship between Stock Markets Return and Rates of Inflation.” Journal of Finance, Vol. 34. No. 3. pp. 743-749.
• Gultekin, N. B. (1983) “Stock Market Returns and Inflation: Evidence from Other Countries.” Journal of Finance, Vol. 38. No. 1. pp. 49-65.
• Jaffe, F. J. & Mandelker, G. (1976) "The 'Fisher Effect ' for Risky Assets: An Empirical Investigation." Journal of Finance, Vol. 31. No. 2. pp. 447-458.
• Lintner, J. (1975) “Inflation and Security Returns.” Journal of Finance, Vol. 30. No. 2. pp. 259-280.
• Luintel, K. B. & Paudyal, K. (2006) “Are Common Stocks A Hedge against Inflation?” Journal of Financial Research, Vol. 29. No. 1. pp. 1-19
• Marshall, D
• Nelson, C. R. (1976) "Inflation and Rates of Return on Common Stocks." Journal of Finance, Vol. 31. No. 2. pp. 471-483.
• Oudet, B. A. (1973) "The Variation of the Return on Stocks in Periods of Inflation." Journal of Financial and Quantitative Analysis, Vol. 8. No. 2. pp. 247-258.
• Schwert, G. W. (1981) “The Adjustment of Stock Prices to Information about Inflation.” Journal of Finance, Vol. 36. No. 1. pp. 15-29.
• Sharpe, S. A. (2000) “Reexamining Stock Valuation and Inflation: The Implications of Analysts’ Earnings Forecasts. “Division of Research and Statistics, Federal Reserve Board, Washington, D.C. 20551. Vol. 84. No. 4. pp. 632-648
• Van Horne, J
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