STOCK MARKET SIGNALS OF CHANGES IN EXPECTED INFLATION

This paper examines the relationship between stock returns and several measures of expected inflation. The proxies include the inflation forecasts extracted from U.S. Treasury bill yields, the mean forecast of surveys conducted by the Institute for Social Research, and the predictions from a rolling time-series model. Unlike recent studies, there does not appear to be a significant negative relationship between stock returns and expected inflation at the beginning of the period. The results are consistent with the hypothesis that stock returns signal changes in expected inflation.     

CONDITIONAL HETEROSCEDASTICITY IN THE MARKET MODEL AND EFFICIENT ESTIMATES OF BETAS

Previous studies have investigated only unconditional heteroscedasticity in the market model. This paper tests for both conditional and unconditional heteroscedasticities as well as normality. Using the monthly stock rate of return data secured from the Center for Research in Security Prices (CRSP) tape for 1976 through 1983, this paper shows that conditional heteroscedasticity is more widespread than unconditional heteroscedasticity, suggesting the necessity of model refinements that take conditional heteroscedasticity into account. This paper provides an alternative estimation of betas of individual securities and portfolios based on the autoregressive conditional heteroscedastic (ARCH) model introduced by Engle. The efficiency of the market model coefficients is markedly improved across all firms in the sample through the ARCH technique.     

THE EXISTENCE OF HETEROSCEDASTICITY AND ITS EFFECT ON ESTIMATES OF THE MARKET MODEL PARAMETERS

A number of recent studies have found significant evidence of heteroscedasticity in the market model. These studies have only documented the existence of heteroscedasticity and have not determined the actual impact of this econometric aberration in the estimation process. This study develops a more general specification to determine the effects of heteroscedasticity on the market model parameters. The consequences of this econometric problem in relation to efficiency-bias, temporal stability of betas, and estimates of systematic risk are revealed in the estimation of a maximum likelihood specification.     

PERSONAL TAXES,INFLATION AND MARKET VALUATION

In an inflation-non-indexed progressive tax system, inflation results in a “bracket-creep” effect that reduces the demand for corporate debt while the tax-deductibility of nominal interest makes the use of debt financing cheaper. The interactive effect of inflation and differential dividend and capital gains taxes on the value of a levered firm is analyzed in this paper. Under a non-indexed progressive tax system, inflation decreases the value of the unlevered firm but the effect of inflation on the firm's debt-to-asset ratio is theoretically indeterminate. The gain from leverage is also derived and compared with other valuation models.     

COMMON STOCK RETURNS,EXPECTED INFLATION,AND THE RATIONAL EXPECTATIONS HYPOTHESIS

This paper provides empirical evidence that expected inflation has a cross-sectional impact on common stock returns. The study differs from others in that (a) the relation between stock returns and expected inflation is investigated in a two-factor asset pricing model, where the factors are the return on an equally weighted stock portfolio and the expected rate of inflation; (b) the estimation of the expected rate of inflation is based on the rational expectations hypothesis of Muth; and (c) a non-linear seemingly unrelated regression technique is employed to determine consistent and asymptotically efficient estimates. The joint hypothesis of the two-factor asset pricing model and rational expectations is not rejected in this study. It is found that the return on common stocks is significantly affected by expected inflation. Also stocks whose returns are positively correlated with expected inflation have lower expected returns.     

STOCK MARKET REACTION TO GOOD AND BAD INFLATION NEWS

This article shows that differentiating between good and bad inflation news is important to understanding how inflation affects stock market returns. Summing positive and negative inflation shocks as in previous studies tends to wash out or mute the effects of inflation news on stock returns. More specifically, we find that, depending on the economic state, positive and negative inflation shocks can produce a variety of stock market reactions. We conclude that the effect of inflation on stock returns is conditional on whether investors perceive inflation shocks as good or bad news in different economic states.     

AUTOCORRELATION IN MARKET MODEL RESIDUALS

Autocorrelation in market model residuals affects the estimate of market risk measured by beta. Correction for autocorrelation can substantially change the estimate of beta for some common stocks. In view of the importance of beta estimates in financial research and investment practice, an examination is undertaken in this paper of the prevalence of autocorrelation and two of its causes. The evidence indicates that negative autocorrelation affects estimates of beta for a large number of stocks. In addition, negative autocorrelation is most prevalent among thinly traded and low-priced stocks.     

ESTIMATING THE MARKET MODEL ROBUSTLY

There is now considerable evidence in the literature that the ordinary least squares assumptions fail to hold when estimating the market model parameters. This paper describes a robust estimation procedure which provides automatic protection against departures from normality. The market model parameters are then estimated for a sample of securities using both the least squares method and the robust procedure. Analysis shows that the results under the two procedures may differ considerably.