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Extracting Inflation from Stock Returns to Test Purchasing Power Parity

  • Chowdhry, Bhagwan

    (U of California, Los Angeles)

  • Roll, Richard
  • Xia, Yihong

    (University of Pennsylvania)

We provide a novel method for extracting estimates of realized pure price inflation from stock returns. The key is recognizing that pure price inflation should affect nominal returns of all traded assets by exactly the same amount. The popular Fama-French three-factor model is employed to purge stock returns of real economic factors. We uncover evidence that purchasing power parity holds quite well using the extracted inflation measures.

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Paper provided by University of Pennsylvania, Wharton School, Weiss Center in its series Working Papers with number 03-1.

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Date of creation: Jun 2003
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Handle: RePEc:ecl:upafin:03-1
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  1. Fama, Eugene F & French, Kenneth R, 1995. " Size and Book-to-Market Factors in Earnings and Returns," Journal of Finance, American Finance Association, vol. 50(1), pages 131-55, March.
  2. Karolyi, G. Andrew & Stulz, Rene M., 2003. "Are financial assets priced locally or globally?," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 16, pages 975-1020 Elsevier.
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  6. Kenneth Rogoff, 1996. "The Purchasing Power Parity Puzzle," Journal of Economic Literature, American Economic Association, vol. 34(2), pages 647-668, June.
  7. Dixit, A., 1988. "Entry And Exit Decisions Under Uncertainty," Papers 91, Princeton, Department of Economics - Financial Research Center.
  8. Fama, Eugene F & MacBeth, James D, 1973. "Risk, Return, and Equilibrium: Empirical Tests," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 607-36, May-June.
  9. James H. Stock & Mark W.Watson, 2003. "Forecasting Output and Inflation: The Role of Asset Prices," Journal of Economic Literature, American Economic Association, vol. 41(3), pages 788-829, September.
  10. Shanken, Jay, 1992. "On the Estimation of Beta-Pricing Models," Review of Financial Studies, Society for Financial Studies, vol. 5(1), pages 1-33.
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  12. Carhart, Mark M, 1997. " On Persistence in Mutual Fund Performance," Journal of Finance, American Finance Association, vol. 52(1), pages 57-82, March.
  13. David G. Barr & John Y. Campbell, 1996. "Inflation, Real Interest Rates, and the Bond Market: A Study of UK Nominal and Index-Linked Government Bond Prices," NBER Working Papers 5821, National Bureau of Economic Research, Inc.
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  15. Hali J. Edison & B. Dianne Pauls, 1991. "Re-assessment of the relationship between real exchange rates and real interest rates: 1974-1990," International Finance Discussion Papers 408, Board of Governors of the Federal Reserve System (U.S.).
  16. Paul Krugman, 1986. "Pricing to Market when the Exchange Rate Changes," NBER Working Papers 1926, National Bureau of Economic Research, Inc.
  17. Dixit, Avinash K, 1989. "Hysteresis, Import Penetration, and Exchange Rate Pass-Through," The Quarterly Journal of Economics, MIT Press, vol. 104(2), pages 205-28, May.
  18. Boudoukh, Jacob & Richardson, Matthew & Whitelaw, Robert F, 1994. " Industry Returns and the Fisher Effect," Journal of Finance, American Finance Association, vol. 49(5), pages 1595-1615, December.
  19. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
  20. Kenneth Rogoff, 2002. "Dornbusch's Overshooting Model After Twenty-Five Years," IMF Working Papers 02/39, International Monetary Fund.
  21. Pagan, Adrian, 1984. "Econometric Issues in the Analysis of Regressions with Generated Regressors," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 25(1), pages 221-47, February.
  22. Delgado, Francisco A., 1991. "Hysteresis, menu costs, and pricing with random exchange rates," Journal of Monetary Economics, Elsevier, vol. 28(3), pages 461-484, December.
  23. Mussa, Michael, 1982. "A Model of Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 90(1), pages 74-104, February.
  24. Adler, Michael & Lehmann, Bruce, 1983. " Deviations from Purchasing Power Parity in the Long Run," Journal of Finance, American Finance Association, vol. 38(5), pages 1471-87, December.
  25. Mankiw, N Gregory, 1985. "Small Menu Costs and Large Business Cycles: A Macroeconomic Model," The Quarterly Journal of Economics, MIT Press, vol. 100(2), pages 529-38, May.
  26. John M. Griffin, 2002. "Are the Fama and French Factors Global or Country Specific?," Review of Financial Studies, Society for Financial Studies, vol. 15(3), pages 783-803.
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