The impact of inflation on stock market liquidity: the case of Nairobi securities exchange

Abstract

The relationship between inflation and stock market performance has intrigued researchers who have attempted to explain how a nominal variable such as inflation should determine a real variable (asset prices). Recent research findings have established the existence of a negative relationship between stock market performance and inflation. These findings contradict the hypothesis by Fisher (1930) who argued that stock returns should be positively related with expected inflation, providing a hedge against rising prices. This study investigated the relationship between inflation and liquidity of the Nairobi Securities Exchange. Liquidity of the stock market is vital if the market is to play a significant role in the development by facilitating mobilization of long-term capital. This therefore shows the immense potential that the Nairobi Securities Exchange may have towards fostering the country’s economy should the Kenyan government promote a saving culture and consequently improve investments income of the populace through appropriate policies. The study’s objective was to determine the impact of inflation on the liquidity of Nairobi Securities Exchange thus assess the validity of the Fisherian hypothesis using turnover rates at the Nairobi Securities Exchange and to draw policy conclusions and recommendations based on empirical findings. The study was conducted using annual data on selected stocks from a sample of twenty companies listed at the Nairobi Securities Exchange, for the period 2002-2011. Descriptive statistics and simple regression analyses were employed to estimate a single equation with stock market liquidity as the dependent variable and explanatory variables as inflation.interest rates and GDP growth. The study reports a negative relationship between stock market liquidity and inflation contrary to Fisher’s hypothesis. The findings of this study shed light on the price discovery process at the Nairobi Securities Exchange indicating that investors fail to factor in the effect of inflation on stocks at the securities exchange. The study recommends increased investor education to remedy this anomaly.