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Inflation, inflation risk, and stock returns

  • John Ammer
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    This paper investigates the empirical relation between inflation and stock returns in ten industrialized countries, with a focus on the implications for links between inflation and the macroeconomy. The stock return decomposition of Campbell and Shiller (1988) is used to determine the extent to which the negative contemporaneous stock return associated with a positive inflation surprise is due to (a) lower future real dividends and (b) higher future required real equity returns. The empirical results suggest that generally higher inflation is associated with both lower real dividends and lower required real equity returns in the future. The evidences favors corporate tax-related theories (e.g. Feldstein (1980))--in which distortions in the tax system cause an increase in inflation to raise the firm's effective cost of capital relative to the return earned by investors in the firm--relative to the "risk premium story" that has been credited to Tobin (1958). However, for the United States and the United Kingdom, estimates of the arbitrage pricing theory (APT) model with a conditionally heteroscedastic inflation risk factor suggest that inflation may have increased the average real cost of equity capital by as much as fifty basis points.

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    File URL: http://www.federalreserve.gov/pubs/ifdp/1994/464/default.htm
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    File URL: http://www.federalreserve.gov/pubs/ifdp/1994/464/ifdp464.pdf
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    Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 464.

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    Date of creation: 1994
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    Handle: RePEc:fip:fedgif:464
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    1. Najand, Mohammad, 1991. "A Test of the Risk Premium Hypothesis," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 14(3), pages 207-16, Fall.
    2. Fama, Eugene F. & Schwert, G. William, 1977. "Asset returns and inflation," Journal of Financial Economics, Elsevier, vol. 5(2), pages 115-146, November.
    3. John Y. Campbell & John Ammer, 1991. "What Moves the Stock and Bond Markets? A Variance Decomposition for Long-Term Asset Returns," NBER Working Papers 3760, National Bureau of Economic Research, Inc.
    4. Campbell, John Y, 1991. "A Variance Decomposition for Stock Returns," Economic Journal, Royal Economic Society, vol. 101(405), pages 157-79, March.
    5. Martin Evans & Paul Wachtel, 1993. "Inflation regimes and the sources of inflation uncertainty," Proceedings, Federal Reserve Bank of Cleveland, pages 475-520.
    6. Connor, Gregory & Korajczyk, Robert A., 1988. "Risk and return in an equilibrium APT : Application of a new test methodology," Journal of Financial Economics, Elsevier, vol. 21(2), pages 255-289, September.
    7. Shanken, Jay, 1992. "On the Estimation of Beta-Pricing Models," Review of Financial Studies, Society for Financial Studies, vol. 5(1), pages 1-33.
    8. Mark J. Buono, 1989. "The Relationship Between The Variability Of Inflation And Stock Returns: An Empirical Investigation," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 12(4), pages 329-339, December.
    9. David P. Ely & Kenneth J. Robinson, 1989. "The stock market and inflation: a synthesis of the theory and evidence," Economic and Financial Policy Review, Federal Reserve Bank of Dallas, issue Mar, pages 17-29.
    10. Douglas K. Pearce & V. Vance Roley, 1987. "Firm Characteristics, Unanticipated Inflation, and Stock Returns," NBER Working Papers 2366, National Bureau of Economic Research, Inc.
    11. Geske, Robert & Roll, Richard, 1983. " The Fiscal and Monetary Linkage between Stock Returns and Inflation," Journal of Finance, American Finance Association, vol. 38(1), pages 1-33, March.
    12. McDevitt, Catherine L., 1989. "The role of the nominal tax system in the common stock returns/expected inflation relationship," Journal of Monetary Economics, Elsevier, vol. 24(1), pages 93-107, July.
    13. Gultekin, N Bulent, 1983. " Stock Market Returns and Inflation: Evidence from Other Countries," Journal of Finance, American Finance Association, vol. 38(1), pages 49-65, March.
    14. Campbell, J.Y. & Perron, P., 1991. "Pitfalls and Opportunities: What Macroeconomics should know about unit roots," Papers 360, Princeton, Department of Economics - Econometric Research Program.
    15. John Ammer, 1993. "Macroeconomic risk and asset pricing: estimating the apt with observable factors," International Finance Discussion Papers 448, Board of Governors of the Federal Reserve System (U.S.).
    16. Mohammad Najand, 1991. "A Test Of The Risk Premium Hypothesis," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 14(3), pages 207-216, 09.
    17. Martin Feldstein, 1978. "Inflation and the Stock Market," NBER Working Papers 0276, National Bureau of Economic Research, Inc.
    18. Huberman, Gur & Schwert, G William, 1985. "Information Aggregation, Inflation, and the Pricing of Indexed Bonds," Journal of Political Economy, University of Chicago Press, vol. 93(1), pages 92-114, February.
    19. Rose, Andrew Kenan, 1988. " Is the Real Interest Rate Stable?," Journal of Finance, American Finance Association, vol. 43(5), pages 1095-1112, December.
    20. Ross, Stephen A., 1976. "The arbitrage theory of capital asset pricing," Journal of Economic Theory, Elsevier, vol. 13(3), pages 341-360, December.
    21. Kaul, Gautam, 1987. "Stock returns and inflation : The role of the monetary sector," Journal of Financial Economics, Elsevier, vol. 18(2), pages 253-276, June.
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