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test the validity of fisher effect in Malaysia by using conventional and islamic money market
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1.6 Problem Statement
Maintaining a low and stable inflation rate has become one of the challenges in the
macroeconomics management of most countries. Among others, Malaysia has a very
unique experience in terms of inflation. The economy has experienced both episodes of
high (1998 and 2008) and low (1985-1987) inflation regimes, and was able to maintain
low and stable inflation during the high economic growth period of (1988-1996). Below is
the graph of the inflation rate in Malaysia over the 40 years and it is divide by 2 sub
periods :
19721973
19741975
19761977
19781979
19801981
19821983
19841985
19861987
19881989
19901991
0
5
10
15
20
Inflation Rate in Malaysia (1972-1991) - 1st sub period
Inflation
19921993
19941995
19961997
19981999
20002001
20022003
20042005
20062007
20082009
20102011
0123456
Inflation Rate in Malaysia (1992-2011) - 2nd sub period
Inflation
High and volatile inflation is widely seen by economist to have a range of economic and
social costs hence the continued importance attached to the control of inflationary
pressure in an economy by both government and also the central bank. From the graph
above we can see that for the last 20 years inflation rate is extremely high in year 1998
and 2008. Due to the Asian crisis in 1998 and the substantial rise in the price of petrol
and diesel in 2008 was lead to the high inflation rate.
When inflation is volatile from year to year, it becomes difficult for individuals and
businesses to correctly predict the rate of inflation in the near future. Unanticipated
inflation occurs when economic agents (i.e people, businesses and government) make
errors in their inflation forecasts. Actual inflation may end up well below, or significantly
above expectations causing losses in real incomes and a redistribution of income and
wealth from one group in society to another.
It is a fact of life that people often confuse nominal and real values in their everyday lives
because the effects of inflation mislead them. For example, a worker might experience a
6 per cent rise in his money wages- giving the impression that he or she is better off in
real terms. However if inflation is also rising at 6 percent, in real terms there has been no
growth in income. Money illusion is most likely to occur when inflation is anticipated, so
that people’s expectations of inflation turn out to be some distance from the correct level.
When inflation fully anticipated there is much less risk of money illusion affecting both
individual employees and businesses.
Inflation and efficiency of the money market is determine at an equilibrium nominal price
Vt for money market instruments. In analyzing the efficiency for the treasury bill, banker
acceptance, negotiable certificate deposit and repurchase agreement, focus will be on
the question of how does the market correctly used available information about inflation
in setting the price Vt. Whether the price of Vt fully reflects available information on
inflation. If this so it means market is efficient thus we can use the variables to predict
future inflation.
Inflation level is vary over the period of time. As part of the financial planning process,
investors must decide on their most appropriate asset allocation, typically among stock,
bonds and treasury bill. Their appropriate asset allocation depends on factor such as the
overall goal, the investment horizon, risk tolerance etc. A young professional, for
example, might choose to invest her 401(k) portfolio as follows : 70 percent stocks, 20
percent bonds, and 10 percent treasury bill. The 10 percent allocation to treasury bills
could satisfy the need for liquidity and will reduce the overall risk of the portfolio.
However, any amount invested in treasury bill will earn lower returns over the long run
and will be subject to reinvestment risk. Our findings indicate that the returns on treasury
bill will barely compensate for inflation on a pre-tax basis. However, if a period of rising
inflation is anticipated, what should an investor do?
1.7 Research Questions and Objectives
The main interest of this study is to test the validity of Fisher Effect for the 4 of money
market instruments (treasury bill, banker acceptance, negotiable certificate document
and repurchase agreement). This is the joint test with the market efficiency. If the result
found the existing of Fisher Effect on the variables automatically ir shows that money
market is efficient and market is correctly use all available information to predict
expected inflation. This study also concern among 3 min asset classes of bonds, stocks
and treasury bill which are the best to compensate during different inflationary condition.
Specifically, the research questions begin as followings:
i. Does Malaysian Money Market is efficient to use all available information to
asses the distribution of expected inflation?
ii. Does among money market instruments (treasury bill, banker acceptance,
negotiable certificate deposit and repurchase agreement) exist the validity of
fisher effect?
iii. Does historical performance of treasury bills relative to bonds and stocks
compensate under different inflationary condition?
Thus the objective of the study is:
I. To investigate the existing of fisher effect for money market instrument namely
treasury bills, banker acceptances, negotiable certificates deposits and
repurchase agreements
II. To explore the efficiency of Malaysian Money Market in term of prices and yields
and to find out to what extend it is driven by the market forces.
III. To examine the historical performance of treasury bills relative to bonds and
stocks under different inflationary condition.
1.8 Theory of the study
1) Irving Fisher theory (1930) – Theory of interest rates
Irving hypothesized that the nominal interest rate should fully reflect all available
relevant information concerning the possible future values of the rate of inflation.
He stated that the nominal interest rate would approximately equal to the sum of
expected real return and expected rate of inflation. He suggested that real return
is determined by real factors and is independent of the inflation rate.
Real Rate of Return = Nominal Rate – Expected Inflation
Nominal Rate = Real Rate of Return – Expected Inflation
2) Fama theory (1975) – Short-term interest rates as predictors of inflation
The model of market equilibrium in "Short-Term Interest Rates as Predictors of
Inflation" assumes that the expected real return is constant.
3) Asset Pricing Theory
A model that describes the relationship between risk and expected
return and that is used in the pricing of risky securities.
The general idea behind CAPM is that investors need to be compensated in two ways:
time value of money and risk. The time value of money is represented by the risk-free
(rf) rate in the formula and compensates the investors for placing money in any
investment over a period of time. The other half of the formula represents risk and
calculates the amount of compensation the investor needs for taking on additional risk.
This is calculated by taking a risk measure (beta) that compares the returns of the asset
to the market over a period of time and to the market premium (Rm-rf).
1.9 Significant of the study
The present study would extend the finance literature by making several important
contributions. The study would contribute to the body of knowledge of the Malaysia
money market by addressing some of the gaps in recent literature in particular, the lack
of extensive research in Malaysia money market, especially the effectiveness of money
market since with the many new money market instruments was introduced it contributes
to major development for economic growth. This study is going to use the Fisher Effect
theory as the a solid layer for the research to further confirm the accuracy of predictive
power of expected inflation thus automatically test for the market efficiency.
Firstly, there is not much extensive literature and empirical studies on the behavior of
Malaysian money market except some of respected researches, among which are
Annuar et al. (1989) with the study of Malaysian treasury bill as a predictor to inflation
and Wan Mansor and Norhayati (2000) that study regarding money market sensitivity on
stock returns. There are very minimal studies on the effectiveness of the Malaysian
money market and this gives motivation for this research to revisited studied done by
Annuar et al (1987) by adding other money market instrument in predicting inflation.
Secondly, this study are hoped to provide policy options and recommendation to both
government and central bank of Malaysia in developing suitable policy according to the
market characteristics a d gaining competitive advantages in these dynamic environment
and challenging global market. For instance, excess in money supply will cause for
inflation. Bank Negara Malaysia (BNM) is empowered on behalf of the government to
promote monetary stability and sound financial structure. One of the important roles of
BNM is to transmit its monetary policy. BNM seeks to maintain monetary stability
through ensuring that growth in bank credit and money supply are just adequate to
nurture growth in the economy, without causing inflationary pressure. Usually inflation is
always related with the money supply and many economists believe that inflation is
cause by high money supply in economy. When the inflation is relatively high the
government may use monetary tools to restrict money supply and credit creation in the
economy. The policy involves contractionary monetary policy, aiming at reducing money
supply. The monetary tool used by government such as Open Market Operation,
Statutory Reserve Requirement and Discount Rate.
Last but not least this study would beneficial to investor in deciding on their most
appropriate asset allocation, typically among stock, bonds and treasury bill depends on
different inflationary condition. This study also can help them to manage their investment
portfolio in order to minimize the risk and maximize the return. From the result of this
study, investors are able to properly allocate of their 3 main asset classes during inflation
is high, increasing and over the long-run.
Chapter 2
2.1 Review of literature
In an attempt to attain better insights into the subject matter, a through review of the
literature on the study of Fisher Effect is presented in this chapter. The review touched
on the various research works that have been afforded by different researchers in the
various parts of the world, with special focus on aspect of the Fisher Effect theory, as
expected real return is constant, nominal interest rates are explained one-for-one by
movements in the expected rate of inflation
2.2 Fundamental of Fisher Effect Theory and Market Efficiency (joint test)
Irving Fisher (1930) hypothesized that the nominal interest rate should fully reflect all
available relevant information concerning the possible future values of the rate of
inflation. He stated that the nominal interest rate would approximately equal to the sum
of the expected real return and expected rate of inflation. He suggested that the real
return is determined by real factors and is independent of the inflation rate. Earlier
studies suggest that there is a positive relationship between the nominal interest and the
level of commodity prices (well known in economics as the Gibson paradox) rather than
the relationship between the interest rate and the rate of change in prices as
hypothesized by Fisher. Most of these studies were summarized by Roll (1972).
Fama (1975) provide some empirical evidence as to the reliability of the Fisher
relationship or Fisher effect using U.SS data. His dual tests of market efficiency and the
hypothesis that the expected real return on the Treasury bill is constant confirms the
Fisher relationship. His results suggest that variation in nominal interest rates fully reflect
inflation expectation and that the nominal interest rates can be used as proxies for
expected inflation. Holvoet (1979) and Lenora (1980) also confirmed this effect using
Belgium and U.K data respectively. Roll (1970) showed that the prices in the treasury bill
market in the U.S. obey a fair game model which is an indication of market efficiency.
According to Clifton et al. (2005), the results from time-variant model indicate that the
constant coefficient test model and the use of the Treasury bill rate as proxy for
expected inflation are appropriate only for a period of low inflation. In all later periods,
however, invalidating use of the Treasury bill rate as a proxy for expected inflation.
On the other hand, other studies have provided contrary empirical evidence regarding
the Fisher hypothesis. Nelson and Schwert (1977) and Roll (1972) show that there is no
statistically reliable relationship between interest rates observed in the market at any
point in time and the rate of inflation subsequently observed. A similar conclusion was
arrived at by Mansor (1981) using the Malaysia data. The similar result from Annuar et
al. (1987) the study found that, using 3 months treasury bills discount rates to
approximate monthly nominal return, the Malaysian 91-days treasury bill market was not
efficient. They found that there is no basis to use short term interest rate as proxy for
expected inflation. Such results suggest an efficient market, in a sense that, relevant
available information is not fully utilized in setting interest rates.
Many believe that in the short run, especially during the time of fluctuations, Fisher effect
may not hold fully, it is likely to prevail in the long run. Amongst many, Atkins (1989)
found evidence for a long-run relationship between inflation and nominal interest rate in
the USA and Australia. MacDonald and Murphy (1989) found no evidence of a stable
long-run relationship between the two variables for USA, Belgium, Canada and UK,
unless they split the data according to the exchange rate regime that validated the
existence of Fisher effect only for Canada and USA Dutt and Ghosh (1995) found no
evidence of long-run relation between the two even after splitting the sample according
to the exchange rate regime for Canada. Crowder and Hoffman (1996) and Crowder
(1997) using US data and Canadian data successively found strong evidence of Fisher
effect for a sample that spans both fixed and flexible exchange rate regimes. Koustas
and Serletis (1999) using postwar data found the absence of Fisher effect for range of
industrial countries. Atkins and Coe found the presence of Fisher effect in the USA and
Canada. Hassan (1999) found partial Fisher effect in Pakistan.
According to Shabbir Ahmad (2010), this study is an attempt to test the
validity of Fisher effect using bound testing econometric methodology
given by Pesaran et al. (2001) for four developing and two oil-producing
countries. This technique of finding the long-run relationship between the
two or more variables has several advantages over other existing
methodologies. Estimation results on the basis of lending rate show that the
presence of Fisher effect in Bangladesh is difficult to verify. For Sri Lanka,
using T-bill and money market rate, the Fisher effect is found while
estimation results based on deposit rate show the absence of this effect.
The estimation results for India show that except the bank rate, the
presence of Fisher effect is strongly supported. For Pakistan, Kuwait
and Saudi Arabia, the presence of Fisher effect is found using a variety of
the interest rates. However, a one-to-one relation between the inflation rate
and the interest rate, i.e. strict form of Fisher effect for most of the countries
involved, is not found.
2.3 Stocks, Bonds and Treasury Bill to Compensate Inflation
According to the theory of interest rates attributed to Irving Fisher (1930), nominal
risk-free interest rates should be equal to the expected inflation rate plus a real rate
of return. If this is the case and real returns are somewhat constant. Treasury
bill rates will move closely with inflation rates and constitute, to a certain degree, an
inflation hedge. The Fisher hypothesis has been extensively studied in the economics
and finance literature. The studies look at both cross-country data and time series
data for individual countries. While the results vary across countries, time, and the
measure of inflation expectations used, there is in general, strong support for an
empirical relationship between nominal interest rates and expected inflation. Most
studies report a stronger correlation over long periods than over short periods,
suggesting
a lag exists in adjustments of nominal interest rates to infiation expectations. For a
sample of this literature see Berument and Jelassi (2002), Cooray (2003), Crowder and
Hoffman (1996), and Fahmy and Kandil (2002).
Inflation expectations should have a similar effect on long-term bond nominal
interest rates. As inflation expectations increase, bond yields to maturity must
increase to compensate investors. However, given their constant coupon payments
and par values, bigher bond yields can only be achieved by a downward
adjustment of current bond prices. This drop in the price results in lower realized
rates of return over the short run. Empirical studies do support this negative relationship
between increases in inflation and lower bond returns. See, for example,
Smirlock (1986). Thus, long-term bonds could be poor performers over short periods
when inflation increases. The relationship between inflation and
stock returns is more complicated. Some economists argue that companies, for the
most part, will be able to pass cost increases to the consumer and ensure that
profits are preserved during inflationary times. If this is the case, stock prices would not
suffer with increases in inflation. However, as is true in the case of bonds, when inflation
increases, the expected nominal returns on stocks should increase, and for this to
happen, current stock prices need to adjust down. Most studies document a negative
correlation between inflation increases and stock returns over short periods. Thus, at
least for the short run, stocks could be poor performers during inflationary periods. For a
sample of this literature, see Cambell and Vuolteenaho (2004), DeFina (1991), Gultekin
(1983), and Sharpe (2002).
According to Caroline et al. (2011) the study revealed that there is long run relationship
between expected and unexpected inflation with stock returns but there is no short run
relationship between these variables for Malaysia and US but it exists for China.
The current study extends this literature by examining the performance under different
inflationary conditions of these three main asset classes simultaneously. The emphasis
is on the relative performance. Also, we concentrate on one-year returns and emphasize
the short term. Our focus is on the practical implications for the investor, rather than
testing particular theories, such as the Fisher hypothesis.