Professional Documents
Culture Documents
Relationship Between Stock Index Returns and Inflation
Relationship Between Stock Index Returns and Inflation
Submitted by
MEGHA.N.BAIS
Register number
04XQCM6054
entitled “An Empirical Analysis of Relationship between Stock Index Returns and
Inflation”” is the result of research work carried out by me, under the
guidance and supervision of Dr. Nagesh Malavalli, Principal, M. P. Birla
Institute of Management, Associate Bharatiya Vidya Bhavan, Bangalore.
I also declare that the dissertation has not been submitted to any
University/Institution for the award of any Degree/Diploma.
Place: Bangalore
Place: Bangalore
The completion of the research would have been impossible without the valuable
contributions of people from the academics, family and friends.
I hereby wish to express my sincere gratitude to all those who supported me
throughout the study.
A special thanks to my friend Lakshmi S.N. who made this report reality.
Last but certainly not the least, my family and friends who tolerated me and
cooperated when I was not so very best.
The study is conducted by considering inflation and various indices for various
periods. This is analyzed by using statistical tools like Augmented Dickey Fuller Unit
root Test, Grangers Co-integration test and Grangers causality test.
From the results it is clear that there is negative relationship between stock returns
and inflation, and suggests that investors cannot use common stock investments as a
hedge against rising prices or inflation. It is evident from the overall results that the
causality runs from inflation to stock returns and also in the reverse order.
CONTENTS
1 Introduction 1-13
- Background
- Theoretical Framework
2 Literature Review 14 -18
3 Research Methodology 19 – 31
- Problem Statement
- Objectives of the study
- Purpose of the study
- Hypothesis
- Sample Design
- statistical Methods
- Limitations of the study
4 Empirical Results 32 – 48
5 Conclusions 49 – 51
Bibliography 52 – 53
Annexure 54 - 67
LIST OF TABLES
The Efficient Markets Hypothesis (EMH) assumes that everyone has perfect
knowledge of all information available in the market. Therefore, the current price of an
individual stock (and the market as a whole) portrays all information available at time t.
accordingly, if real economic activity affects stock prices, then an efficient stock market
instantaneously digests and incorporates all available information about economic
variables. The rational behavior of market participants ensures that past and current
information is fully reflected in current stock prices. As such, investors are not able to
develop trading rules and, thus may not consistently earn higher than normal returns.
Therefore, it can be concluded that, in an information ally efficient market, past (current)
levels of economic activity are not useful in predicting current (future) stock prices.
If, however, lagged changes in some economic variables cause variations in stock
prices and past fluctuations in stock prices cause variations in the economic variable, then
bi-directional causality is implied between the two series. This behavior indicates stock
market inefficiency. In contrast, if changes in the economic variable neither influence nor
are influenced by stock price fluctuations, then the two series are independent of each
other and the market is information ally efficient.
The inflation rate is an important element in determining stock returns due to the
fact that during the times of high inflation, people recognize that the market is in a state
of economic difficulty. People are laid off work, which could cause production to
decrease. When people are laid off, they tend to buy only the essential items. Thus
production is cut even further. This eats into corporate profits, which in turn makes
dividends diminish. When dividends decrease, the expected return of stocks decrease,
causing stocks to depreciate in value.
It has only been in periods of accelerating inflation and tight monetary policy that
the market has really been poor. The depressing effect of accelerating inflation on the
stock market resulted from the perceived risk by investors that the monetary authorities
would tighten policy in order to control inflation, and that this would work by depressing
the economy and the real earnings of the corporate sector.
The overall level of the stock market will be affected by cyclical movements of
the economy. Prices will rise at times of easy money and low interest rates, which
provide a stimulus to economic growth. As interest rates and money tightens, so the
business environment will worsen, costs will rise, demand will fall, profits will be
squeezed from both sides, and stock prices will become depressed.
Theoretical Framework
The Indian Financial System
The Indian financial system consists of many institutions, instruments and
markets. Financial instruments range from the common coins, currency notes and
cheques, to the more exotic futures swaps of high finance.
Financial Markets
Generally speaking, there is no specific place or location to indicate financial
markets. Wherever a financial transaction takes place, it is deemed to have taken place in
the financial market. Hence financial markets are pervasive in nature since financial
transactions are themselves very pervasive throughout the economic system.
i) Unorganized Markets
In these markets there a number of money lenders, indigenous bankers, traders
etc. who lend money to the public.
This definition includes some of the basic economics of inflation and would seem
to indicate that inflation is not defined as the increase in prices but as the increase in the
supply of money that causes the increase in prices i.e. inflation is a cause rather than an
effect.
On the other hand in this definition, inflation would appear to be the consequence
or result (rising prices) rather than the cause -- A persistent increase in the level of
consumer prices or a persistent decline in the purchasing power of money, caused by an
increase in available currency and credit beyond the proportion of available goods and
services.
It is the result of economic forces at work, rather than the conspiracy of merchants
and manufacturers, or the faulty functioning of the market mechanism, these can only be
short period.
Inflation represents an imbalance between the flow of incomes to people and the
spending power available with them on the one hand and the availability of goods and
services on the other.
Inflation can occur with unchanged availability of goods and a marked increase in
incomes in the hands of the people and desire to spend from past savings. There are also
situations were production remains sluggish and even declines while incomes in the
hands of the public rises on account of high levels of government and non government,
financed by borrowing from the banking system in a big way.
• Expenditure by government larger than its receipts from revenue and loans from the
public, which is known as deficit financing.
Where the deficit financing is of large dimensions, naturally the flow of
incomes is proceeding at a much faster pace than the capacity of the economy to
generate a corresponding larger supply of goods and services.
• Larger credit given by banks to the commercial sector not supported by productive
activities.
The RBI regulates the latter by imposing restrictions on credit in order to
bring about some equilibrium. The former can be controlled by government
imposing greater self discipline and keeping its expenditure within the limits of its
resources.
• Demand generated by unaccounted money.
• Delay in monsoon
• Increase in the purchasing power of the house holds.
• Liberal govt. policies on taxation, excise, customs etc.
• Expansion of currency.
Types of Inflation
Open inflation: when prices rise substantially and continuously, the phenomenon is
called open inflation.
Latent inflation: for a relatively short period there may be no increase in pieces but there
will be a substantial buildup of what is known as latent inflation. The
community is building up its liquid resources – cash, bank deposits
and short term investments.
Demand pull: it arises when prices are rising as a result of growing demand for goods
and services in relation to their supplies. Generally, it is caused by rising
current & capital expenditure on the part of the govt and the public.
Y0 is the level of real national income. An aggregate demand function D0
intersecting aggregate supply function S at point A. the price level remains at P0. an
upward shift in aggregate demand function will simply raise the price level. It can be seen
in the diagram that a rise in aggregate demand indicated by the aggregate demand
function D1 merely raises the price level to P1 without any impact on real national
income. This is a clear case of what is known as excess demand inflation.
Cost push inflation: it arises when there is a substantial increase in cost, on account of
wage & salary increase much in excess of productivity increases &
increase in the prices of important goods & services.
Fama and Schwert *1 (1977) in their study estimated the extent to which common
stocks are hedge against expected and unexpected components of inflation rate during
1953-71 periods. They found that the common stock returns are negatively related to the
expected components of the inflation and also to the unexpected components.
Their objectives was to find out the relationship between stock return and
expected inflation, whether stocks can be used as hedge against inflation and whether the
market is efficient in impounding available information about future inflation into stock
prices.
The data taken for their study was inflation rates from Jan.1953 to July 1971. The
common stocks taken are the continuously compounded stock of NYSE. They estimated
the relationship using the first twelve autocorrelation of the inflation rate and the nominal
returns for the monthly, quarterly and semiannual data. The returns to the NYSE are
approximately -5.5, with standard error of about 2.0, which implies that common stocks
are not a hedge against the expected inflation rates.
Thus, they concluded that common stock returns are negatively related to the
expected inflation rate during the period 1953-71, it cannot be used as hedge against
inflation. Possibility for negative relationship between common stock returns & the
expected inflation rate could be that the market might be inefficient in impounding
available information about future inflation into stock prices.
The main objective of their study was to find out the long term relationship
between stock returns and inflation. The data for the study is two centuries, 1802-1990
stock returns, short term & long term bonds, & inflation in both United States & United
Kingdom. The ex ante long term inflation has been arrived at by using an instrumental
variables approach. The instruments used are past inflation rates & short and long term
interest rates that have theoretical support as measures of ex ante inflation. Using ex post
inflation as proxy for ex ante inflation rates.
Jacob and Richardson took the help of regression to estimation the relationship.
For ex post relation, they regressed one year stock returns on one year inflation & five
year stock returns on five year inflation:
R t+1 = α 1+ β1 π t+1 +έt
Hypothesis β5 = β1 versus the alternative β5 > β1. The results showed that the
regression coefficient of five year stock returns on the contemporaneous five year
inflation rate is significantly positive, β5 = 0.52, with a standard error of 0.17. Therefore,
nominal stock returns & inflation tend to move together over the sample, thus supporting
the view that stocks provide some compensation for movements in inflation. On the other
hand, they found that the estimate of β1 = 0.07 close to zero, indicating that the stocks
seems to compensate for inflation in the long run.
*2 indicate reference article no.2 Jacob Boudoukh and Matthew Richardson- see bibliography.
For the ex ante relation various instruments have been used by them. The
instrumental variable estimation is generated from the following system of equations:
[ ]
E (Σ R t+I – α j – β j Σ π t+I) Zjt = 0
Where, Rt denotes stock returns, πt denoted inflation rates & Zjt is a set of
instruments associated with particular horizon j.The first set of instruments includes the
one year interest rate & the long tern interest rates. To capture the movements in one year
& five year expected inflation, respectively. The second set of instruments includes the
past one year & five year inflation rates. The results support a positive relation between
stock returns & ex ante inflation. Thus Jacob and Richardson provide strong support for a
positive relation between nominal stock returns & inflation at long horizon.
The data taken are monthly compounded inflation rates for individual countries
from January 1947 to December 1979. Stock market returns are obtained from IFS & CIP
indices of about 26 countries. He estimated the first four autocorrelation for inflation
rates & stock market returns for both IFS & CIP. Monthly inflation rates in almost all
countries have positive autocorrelations. IFS stock returns also have positive
autocorrelation.
In order to investigate the relation between nominal stock returns & inflation, the
regression model is estimated by using three different estimates of the expected inflation
rates, contemporaneous inflation rates as proxies for expected inflation, decomposition of
inflation into expected & unexpected components by ARIMA models and short term
interest rates are used as predictors of inflation.
Bharat kolluri *4 (2005) has made an attempt to identify the casual influence of
inflation on stock returns and a reverse causality from stock return to inflation. The
results indicate bidirectional causality between these two variables.Many of the previous
studies focused on the interpretation of the puzzling negative relationship ignoring the
basic issue of causality. This study corrects this deficiency by examining the basic issue
of causality between stock returns and inflation.
The main objectives of the study was to find out the relationship between stock
returns and inflation using Grangers Co-integration test, the direction of causality
between stock returns and inflation and to find out whether common stock are hedge
against inflation or that they compensate investors for rising prices.
The data used are the continuously compounded monthly returns covering the
period from 1960:1 to 2004:12, of the US. The data on nominal stock returns (RE),
inflation (INF), and Real Treasury bill rate (RTB) are obtained from Ibbotson Associates
(2004). the common stock return measure is based on the Standard and Poor’s (S&P)
composite index. Methodology used is the unit root test called Augmented Dickey Fuller
test. This test is done to find out the stationarity of the time series data. The second used
here is the Grangers co integartion test. To examine if the nominal stock returns and
expected inflation are co-integrated, that is, if they move together for a long period of
time. This is done regressing the two variables on each other.Residuals generated from
such a regression should be stationary. The third test used is the Grangers Causality test.
This is done to find out the direction of causality.
Basabi Bhattacharya & Jaydeep Mukherjee*5 (2005) investigates the nature of the
causal relationship between stock prices and inflation in India. And it has been found that
there exists two way causation between stock prices and rate of inflation.
The purpose of the study was to analyze the relationship between stock prices and
inflation with implications on efficiency of stock markets and to determine whether stock
returns are a leading indicator for future real economic activity.
The data for the study is the monthly stock prices of BSE. Methodology used is
the Unit root test such as ADF to determine the stationarity of the data, Grangers co-
integration test to determine the co-integration between stock returns and inflation and
Toda and Yamamoto version Grangers non causality test to test lead and lag variable.
And for the selection of the Hsiao’s optimum lag length was used which has given
optimum lag length to be 2.
The study concluded that there is a bidirectional causality between stock price and
the rate of inflation, thus implying that the market informational efficiency hypothesis
can be rejected for BSE sensitive index.
Problem statement
There are various studies, which have been done to examine the relationship
between inflation and stock returns by taking various statistical models and various
indices. This study explores the evidence of relationship between inflation rates and stock
returns and also lead lag relationship between the two. And to find out whether the
market is efficient in impounding available information about future inflation into stock
prices.
Likewise one would expect a positive relationship between stock returns and the
rate of inflation. But numerous studies have showed that common stock returns are
negatively correlated with inflation, the value of stocks decreases as inflation rises.
Hypothesis 1
H0: There is no significant relation between stock returns and inflation rates
H1: There is significant relation between stock returns and inflation rates
Hypothesis 2
H0: There is no significant lead and lag relationship between stock returns and
Inflation
H1: There is significant lead and lag relationship between stock returns and Inflation
Study Design
a) Study Type: The study type is analytical, quantitative and historical.
Analytical because facts and existing information is used for the analysis,
Quantitative as relationship is examined by expressing variables in
measurable terms
Historical as the historical information is used for analysis and
interpretation.
b) Study population: population is the indices of national stock exchange & 30 stocks of
Bombay stock exchange and wholesale price index.
e) Sampling technique: Deliberate sampling is used because only particular units are
selected from the sampling frame. Such a selection is undertaken
as these units represent the population in a better way and reflect
better relationship with the other variable.
f) Period of the study: the period is different for different indices. CNX nifty is taken for
ten years from April, 1995 to March, 2005, Bank Index for five
years from January, 2000 to March, 2005 and BSE Sensex from
July, 1996 to March, 2005.
Data Source: Historical share prices of the NSE sample are taken from
www.nseindia.com and BSE from www.financeyahoo.com and wholesale
price index are taken from www.rbi.org.in
Software packages: various softwares packages like SSPS, Eview and Spreedsheet have
been used to run the statistical models. SSPS and spreadsheet is used
for regression and Eview for calculating ADF Test, Grangers Co-
integration Test and Grangers causality Test.
Statistical Models
• Augmented Dicky Fuller test to test the stationary of the series.
• Granger’s cointegration approach to test for co integration between the series.
• Granger’s Causality test
Samples
CNX Bank Index is an index comprised of the most liquid and large capitalized
Indian Banking stocks. It provides investors and market intermediaries with a benchmark
that captures the capital market performance of Indian Banks. The index will have 12
stocks from the banking sector which trade on the National Stock Exchange.
BSE Sensex
Of the 23 stock exchanges in the India, Mumbai's (earlier known as Bombay),
Bombay Stock Exchange is the largest, with over 6,000 stocks listed. The BSE accounts
for over two thirds of the total trading volume in the country. Established in 1875, the
exchange is also the oldest in Asia. Among the twenty-two Stock Exchanges recognized
by the Government of India under the Securities Contracts (Regulation) Act, 1956, it was
the first one to be recognized.
• The results may not give accurate picture as there could be many other macro
factors other than inflation which affects the stock returns at the same period.
• The study is limited to only three indices.
Statistical Models
In this study, a co-integration approach using the Engle-Granger methodology is
applied to capture both the long run and the short run dynamics of stock returns and
inflation rates. Before doing co-integration analysis, it is necessary to test whether the
time series are stationary at levels by running Augmented Dickey fuller (ADF) test on the
series. Because most time series are non stationary in levels, and the original data need to
be transformed to obtain stationary series. And then the granger causality test is done to
test the causal relationship between stock returns and inflation.
Stationarity
According to Engle and Granger, a time series is said to be stationary if
displacement over time does not alter the characteristics of a series in a sense that
probability distribution remains constant over time. In other words, the mean, variance
and co-variance of the series should be constant over time. A nonstatioanry time series
will have a time varying mean or a time varying variance or both or are
autocorrelated.The degree of co-integration is closely related with stationary.
It is evident from the time-series literature that the standard estimation and
statistical test procedures are highly inappropriate, and even invalid, when the variables
involved are nonstationary.
The empirical works based on time series data assumes that the underlying time
series is stationary. In regressing a time series variable on another time series variables,
one often obtains a very high R2 (residuals) even though there is no meaningful
relationship between the two variables. This situation exemplifies the problem of
spurious or nonsense regression, which arises when data is non stationary.
Testing Stationarity
In general, the procedure start with whether the variables Y in its level form is
stationary. If the hypothesis is rejected, then the series is transformed into first difference
of the variable and tested for stationarity. If first difference series is stationary, this
implies that Y is I(1).
H0: Series has Unit root : Non Stationary
H1: Series does not have Unit root : Stationary
Where c and ρ are parameters and is to be white noise. If -1 < ρ < 1, then Y is
stationary series . While ρ if = 1, y is non stationary series. Therefore, why not simply
regress Yt on its lagged value yt-1 and find out if the estimated ρ is statistically equal to 1
? If it is, then Yt is nonstationary this is the general idea behind the unit root test of
stationarity. The test is carried out by estimating an equation with Yt-1 subtracted from
both sides of the equation.
Δyt = C + γt-1 + εt
Where δ = (ρ-1), and the null and alternative hypotheses are
Dickey and fuller simulated the critical values for selected sample sizes. More
recently, Mackinnon (19991) has implemented a much larger set of simulations than
those tabulated by Dickey and Fuller.
The unit root test is based on the following three regression forms:
1. Without intercept and trend (random walk) ΔYt = δYt-1 + εt
2. with intercept (random walk with drift) ΔYt = α + δYt-1 +εt
3. with intercept and trend (with drift around a stochactic trend) ΔYt = α βT + δYt-1 +εt
Where, α is the intercept/constant, T is trend, β is the slope i.e level of
dependency and integration, δ is drift parameter i.e. Change from Yt to Yt-1 and εt is the
error term.
In general, the procedure start with whether the variables X and Y in its level
form under none, intercept and trend and intercept is stationary. If the hypothesis is
rejected, then the series is transformed into first difference of the variable and tested for
stationarity. If first difference series is stationary, this implies that X and Y are I(1).
In general, if Yt and Xt are both integrated of order I (d), then any linear
combination of the two series will also be I (d)... That is, the residuals obtained on
regressing Yt on Xt are I (d).
If two or more series are co integrated then even though the series themselves
may be non stationary, they will move closely together over time and their difference will
be stationary. Their long run relationship is the equilibrium to which the system
converges overtime and the disturbance term Et can be construed as the disequilibrium
error or the distance that the system is away from equilibrium at time t.
The Engle granger test is a two step process:
• First estimating an ordinary least square (OLS) regression on the data. A
regression of one integrated variable on the other integrated variables (x on y and
y on x).
Yt = a + bx t + e t
X & y will be co-integrated if and only if e is stationary.
• Then test the residuals from regression for stationarity using a unit root test such
as ADF.
Although regression analysis deals with the dependence of one variable on other
variables, it does not necessarily imply causation. In other words, the existence of a
relationship between variables does not prove causality or direction of influence. More
generally, since the future cannot predict the past, if variable X causes variable Y, then
changes in X should precede changes in Y.
Granger causality is a technique for determining whether one time series is useful
in forecasting another. Ordinarily, regressions reflect "mere" correlations, but Clive
Granger causality test shows about the causality between two series.
Hypothesis:
H0 = ADF > critical values -- not reject hull hypothesis i.e., unit root exists.
H1 = ADF < critical values – reject null hypothesis i.e. unit root does not exist.
However, the series at 1st difference level is stationary as ADF is greater than
critical value the 1st difference level is nothing but the log natural returns of the raw
prices. Log natural returns are to make series mean and variance constant. Thus WPI
series is stationary at I (1) and null hypothesis is rejected at 1%, 5% and 10% level of
significance.
Graph no. 1
200
150
WPI prices
100
50
0
1 11 21 31 41 51 61 71 81 91 101 111
No.of observation
Interpretation
The stationarity of a series can also be presented graphically. The graph above
indicates the rough idea on whether a time series is stationary or not. The series seems as
a non stationary data since it is increaseing upward as time changes.
S & P CNX Nifty:
The CNX Nifty prices are taken from April, 1995 to March, 2005. The data taken
are raw closing prices. The unit root result is as under:
Hypothesis:
H0 = ADF > critical values -- not reject hull hypothesis i.e., unit root exists.
H1 = ADF < critical values – reject null hypothesis i.e. unit root does not exist.
Graph no 2
2500
2000
Nifty prices
1500
1000
500
0
1 12 23 34 45 56 67 78 89 100 111
No of observation
Interpretation
The graph above speaks about the stationarity of the eries. It indicates whether a
time series is stationary or not. Nifty movements from April, 1995 to March, 2005
showing upward trend. Thus the series seems as a non stationary data since it is
increaseing upward as time changes.
Bank Index:
The Bank index is for the period January 2000 to march, 2005. The Data taken are
raw closing prices. The unit root result is as under:
Hypothesis:
H0 = ADF > critical values -- not reject hull hypothesis i.e., unit root exists.
H1 = ADF < critical values – reject null hypothesis i.e. unit root does not exist.
Graph No 3
4000
bank Index prices
3000
2000
1000
0
1 6 11 16 21 26 31 36 41 46 51 56 61
No of observations
Interpretation
The bank index movements are moving upward as time changes, indicating the
non stationarity nature of the series. Thus it can be concluded from the graph that the
bank index time series are non stationary.
BSE Sensex:
The BSE sensex is taken from January 1996 to March, 2005. The data taken for
ADF are the raw closing prices. The unit root result is as under:
Hypothesis:
H0 = ADF > critical values -- not reject hull hypothesis i.e., unit root exists.
H1 = ADF < critical values – reject null hypothesis i.e. unit root does not exist.
Graph No.4
7000.00
6000.00
5000.00
4000.00
3000.00
2000.00
1000.00
0.00
1 12 23 34 45 56 67 78 89 100
No of observations
Interpretation
The above graph of BSE Sensex is moving upward from January 1996 to march,
2005, indicating the non stationarity of the series.
Grangers Co integration Test:
Co integration between CNX Nifty and Whole sale price index
• An ordinary least square (OLS) regression is done on the data. First x is regressed
on y then y on x.
X on Y -- Dependent variable(X) is CNX Nifty and Independent variable(Y) is WPI.
Y on X -- Dependent variable(X) is WPI and Independent variable(Y) is CNX Nifty.
• An ordinary least square (OLS) regression is done on the data. First x is regressed on
y then y on x.
X on Y -- Dependent variable(X) is Bank Index and Independent variable(Y) is WPI.
Y on X -- Dependent variable(X) is WPI and Independent variable(Y) is bank Index.
• An ordinary least square (OLS) regression is done on the data. First x is regressed on
y then y on x.
X on Y -- Dependent variable(X) is BSE Sensex and Independent variable(Y) is WPI.
Y on X -- Dependent variable(X) is WPI and Independent variable(Y) is BSE Sensex.
Interpretation
The calculated F values from lag 2 to 24 are greater than the F statistics, which
rejects the null hypothesis. And the P value is also close to zero. Thus there is
bidirectional causality at every lag between CNX Nifty and WPI.
Interpretation
As the P value is close to zero and the calculated F values from lag 2 to 12 are
greater than the F statistics, the null hypothesis is rejected. Thus there is bidirectional
causality between bank indexes to WPI.
Interpretation
The calculated F values from lag 2 to 24 are greater than the F statistics, which
rejects the null hypothesis. The P values are also close to zero. Thus there is bidirectional
causality between bank indexes to WPI.
As the index is nothing but weighted average of the share prices of various
companies from different sectors, the sensex has been considered to see the impact of
inflation on it. Sensex, Nifty and Bank index are considered to see where they move in
the same direction or not.
After analyzing the data using the various Grangers test, it has been found that
there is no positive relationship between stock returns and inflation. The results of the
three indices are:
• CNX Nifty:
The nifty is considered for a period of 10 years. The series is stationary at I(1), but
it is negatively related to inflation as the coefficients statistically significant with negative
sign (-3.027) & (-0.01742) And there exists a bidirectional causal relationship between
nifty and inflation.
• Bank Index:
The bank index is considered for 5 years. The series is stationary at I(1). And its
coefficient is also statistically significant with a negative sign (-3.643) & (-0.01515).
Thus showing the negative relation between the two. Its causal relationship is in both
directions.
• BSE Sensex:
The results of BSE are also same as nifty and bank. Study is done for a period of 9
years. It is stationary at I (1) and its coefficients are (-3.146) & (-0.01692) showing the
negative relation. And the causality runs from the both direction.
Thus, the relationship between stock returns and inflation does not change with
indices.
It is evident from the overall results that the causality runs from inflation to stock
returns and also in the reverse order with a negative sign in both directions. The
coefficients are statistically significant with a negative sign.
The negative relationship can be interpreted several ways: for example the
unexpected inflation is generally considered to be positively correlated with inflation
uncertainty and high level of inflation uncertainty discourages investments in risky assets
and results in reduced nominal returns. Another interpreted is that the negative relation is
due to the fact that changes in expected inflation are most likely to be positively
correlated with unexpected inflation.
It can be concluded that the stocks are a perverse inflation hedge. This does not
mean that equities are hazardous to investors’ health. Stocks are priced today to yield
very lucrative returns. The prospective returns have to be good; however, to compensate
stockholders for the risk they bear because equities are a perverse inflation hedge. When
the rate of inflation unexpected increases, real stock prices will fall. Conversely, when the
rate of inflation unexpectedly drops, real stock prices will raise.
So if one does not mind bearing some risk especially the risk that the inflation rate
may be higher than stocks are a good investment. If one seeks an inflation hedge, stocks
are generally poor investments. My conclusion rests on the observation that rising
inflation rates tend to depress corporate earnings and thereby stock prices, which has
been proved by the Grangers co integration test.
Thus, if one wants to cover the stock price risks, he can go for derivative market.
If an investor is having underlying asset and wants to protect himself from unexpected
inflation movements, he can enter the future market by entering into long and short
contracts based on future predictions.
Bibliography
TEXT BOOKS:
• Basic Econometrics
- Damodar N.Gujarati, (fourth edition)
• Macroeconomics
- Mishra and Puri
• Multinational Financial Management
- Alan C. Shapiro ( seventh edition)
REFERENCE BOOKS
• Inflation in India – Indian Institute of Management, Bangalore
• Market Models -- Indian Institute of Management, Bangalore.
WEB SITES:
• www.nseindia.com
• www.financeyahoo.com
• www.inflationdata.com
• www.google.com
• www.investorpedia.com
• www.bseindia.com
• www.rbi.org.in
ARTICLES:
• Stock market and macro economic behaviour in India
-- Sangeeta Chakravarty, Institute of Economic growth, University
Enclave, Delhi.
• An overview of the impact of inflation on the stock market
-- Richard T.Coghlam and J.Anthony Boekh.
• How Inflation Swindles the equity investors
-- Warren E.Buffett
• Stocks are not an Inflation hedge
-- Richard W.Kopcke
• The Mythes of common stocks and Inflation
-- Steven C.Leuthold
• Inflation and the stock market
-- Franco Modigliani and Richard A.Cohn
REFERENCES:
1. Fama and Schwartz (1977), “Asset Returns and Inflation”, Journal of Financial
economics, Vol.5, November, pp. 115-46.
2. Jacob Boudoukh and Matthew Richardson (1993), “Stock returns and Inflation:
A long horizon Perspective”, American Economic review, Vol.83, pp. 1346-
1355.
3. Gultekin, N B (1983), “Stock market Returns and Inflation: evidence from other
countries”, The Journal of Finance, Vol. 38, No.1 (March), pp. 49-65.
4. Bharat Kolluri (2005), “Stock Market returns and Inflation: An Analysis of the
Direction of Causality”. The ICFAI University Press.
Reference No4 -- ADF Unit Root Test on WPI [1st difference level]
Reference No. 8 -- ADF Unit Root Test on Nifty [1st difference level]
Reference No. 12 -- ADF Unit Root Test on Bank Index [1st difference level]
Reference No. 14-- ADF Unit Root Test on BSE Sensex [intercept]
Reference No. 16-- ADF Unit Root Test on BSE Sensex [1st difference level]
Coefficients
Unstandardized Standardized t Sig.
Coefficients Coefficients
Model B Std. Error Beta
1 (Constant) 4.048 1.186 3.414 .001
WPI -3.027 1.181 -.230 -2.563 .012
Dependent Variable: NIFTY
Coefficients
Unstandardize Standardized t Sig.
d Coefficients Coefficients
Model B Std. Error Beta
1 (Constant) 1.022 .007 148.650 .000
NIFTY -1.742E-02 .007 -.230 -2.563 .012
Dependent Variable: WPI
Coefficients
Unstandardized Standardized t Sig.
Coefficients Coefficients
Model B Std. Beta
Error
1 (Constant) 4.679 1.938 2.414 .019
WPI -3.643 1.930 -.235 - .064
1.888
Dependent Variable: BANK
Coefficients
Unstandardized Standardized t Sig.
Coefficients Coefficients
Model B Std. Beta
Error
1 (Constant) 1.020 .008 124.13 .000
9
BANK -1.515E-02 .008 -.235 -1.888 .064
Dependent Variable: WPI
Reference no.21 Residual based Co-integration Test on X on Y
[BANK & WPI]
Coefficients
Unstandardized Standardized t Sig.
Coefficients Coefficients
Model B Std. Beta
Error
1 (Constant) 4.166 1.312 3.174 .002
WPI -3.146 1.307 -.231 -2.407 .018
Dependent Variable: BSE
Coefficients
Unstandardized Standardized t Sig.
Coefficients Coefficients
Model B Std. Beta
Error
1 (Constant) 1.021 .007 143.720 .000
BSE -1.692E-02 .007 -.231 -2.407 .018
Dependent Variable: WPI
F critical values:
Level of No. of observations for different lags
significance 117 115 113 107 95
(lag 2) (lag 4) (lag 6) (lag 12) (lag 24)
1% 1.23 1.21 1.19 1.12 1.74
5% 1.32 1.29 1.27 1.20 1.07
10% 1.50 1.47 1.44 1.36 1.21
F critical values
Level of No. of observations for different lags
significance 60 58 56 50 (lag 24)
(lag 2) (lag 4) (lag 6) (lag 12)
1% 1.40 1.35 1.31 1.17 --
5% 1.53 1.48 1.43 1.28 --
10% 1.84 1.78 1.72 1.53 --
F critical values
Level of No. of observations for different lags
significance 103 101 99 93 81
(lag 2) (lag 4) (lag 6) (lag 12) (lag 24)
1% 1.06 1.04 1.04 0.98 0.85
5% 1.15 1.13 1.11 0.05 0.91
10% 1.31 0.94 1.26 1.19 1.03