Can Common Stocks Provide Hedge against Inflation? Evidence from SAARC Countries

The theory says that if stocks provide an effective hedge against inflation then the effect of expected inflation should be compensated in the form of nominal stock return. As Fisher Hypothesis (1930) concluded that nominal expected return on a security is a function of expected inflation rate as well as expected real interest rate. Bodie (1976) worked on Fisher Hypothesis and found that actual nominal return depends on expected and unexpected inflation rates and also it depends on expected and unexpected nominal returns. According to Geske and Roll (1983) a positive relationship exists between stock returns and inflation, based on the assumption that securities represent claims on real assets. When there is an increase in rate of inflation, it is expected that prices of real assets will also rise, thereby improving the value of securities representing a claim on such real assets. We found that various studies in this area reported against the hypothesis, showing a negative relationship between the two. However, certain other studies support the theory asserting that the relationship existing between stock returns and inflation is positive. While the negative relationship between inflation and stock return is against the theory, negative results have led to formation of hypothesis such as tax augmented hypothesis. The tax augmented hypothesis states that when we deduct tax from the stock returns, their relationship with inflation tends to get negative as the quantum and rate of taxes also rise along with inflation. This hypothesis also opines that initial researcher did not consider the tax impact when they were empirically testing the relationship between stock returns and inflation.