The effect of inflation on stock returns and volatility at the Nairobi securities exchange
Abstract
The linkage between stock prices and inflation has been subjected to extensive research in the
past decades and has aroused the interests of academicians, researchers, practitioners and
policy makers globally. This study investigated the effect of inflation on stock market return
and volatility at the Nairobi Securities Exchange. Previous research findings have established
the existence of a negative relationship between stock prices and inflation. These findings
contradict the hypothesis by Fisher (1930) who argued that stock prices should be positively
related with expected inflation, providing a hedge against inflation. A correlational research
design was employed to establish whether inflation is associated with stock market return and
volatility. Specifically, it sought to answer the puzzle on the effect of inflation on the stock
return and volatility at the NSE. The project was conducted using monthly time series data on
NSE 20 share index and Consumer Price Index, for the period February 2004 to January
2014. The OLS estimation technique was employed to estimate a single equation relationship
with the stock return as the dependent variable and explanatory variable as inflation.
Regression results in this study indicate that inflation is not a significant explanatory variable
for the stock returns. The study reports a negative relationship between stock returns and
inflation contrary to Fishers (1930) hypothesis. This study applied the Generalized
Autoregressive Conditional Heteroskedasticity (GARCH) model to assess the impact of
inflation on stock market return and volatility. In addition, the impact of asymmetric shocks
was investigated using the EGARCH model developed by Sentana (1995). EGARCH model
results established that NSE stock market returns are asymmetric thus EGARCH was
preferred over standard GARCH which does not capture asymmetry. Results show weak but
significant support for the hypothesis that bad news exert more adverse effect on stock
market volatility than good news of the same magnitude. Furthermore, inflation rate and
change in inflation rate were found to have significant negative effect on stock market
volatility. However, it was verified that inflation rate itself has significantly higher power of
explaining stock exchange volatility than change in inflation whose magnitude is relatively
small as indicated by the low value of the EGARCH inflation coefficient. The findings of this
study can be helpful to the investors in better understanding the impact of inflation on market
risk which helps in selecting the appropriate investment strategy. Measures employed
towards restraining inflation in the country, therefore, would certainly reduce stock market
volatility and boost investor confidence.
Publisher
University of Nairobi