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Investors are driven by expected returns to commit their funds to diverse financial assets while building their portfolios.  The traditional risk and return trade off usually drive investment options and choices. Williams (1938) holds that one type of rule concerning choice of portfolio is that the investor does or should maximise the discounted or capitalize value of future returns.


The Harry Markowitz (1952) Portfolio Theory posits that investing is a trade off between risk and returns. The theory holds that for a given collection of investment options, investors will be favourably disposed to selecting portfolios with the highest expected returns and the lowest possible risks. One of the most profound assumptions of the Markowitz theory is anchored on the optimization attitude of a rational investor. This holds that investors have utility functions that is sensitive to the high moments of distribution of returns and moves to maximize the mean for a given variance.


Since the future is not known with certainty, Hicks (1939) suggests that anticipated returns should include an allowance for risk or let the rate at which the return is discounted vary with risk. Uncertainty cannot be dismissed in a very light fashion in the analyses of optimizing investor’s behaviour. This invariably informs such investment options and actions like diversification, hedging, e.t.c. This further establishes the fact that foundational economic and financial theories agree with the fact that returns on investment are influenced or affected by risk.


Prominent among the investment options available to investors is the stock market chiefly dominated by equity or common stock. Common stock has largely been the dominant feature of most stock market especially in developing countries with evident dearth of securities to be traded upon.  The equity market forms a major component of the financial market that drives economic growth. Overwhelming evidence abounds as to the role the stock market plays as a driver of economic growth. Hicks (1969), Shaw (1963), Kings and Levine (1993) all attest to the role of the stock market as a catalyst for economic growth.

Stock market returns are the returns that investors generate out of the stock market. This return could be in the form of profit from trading or dividend given by the company to its shareholders from time to time. Trading in the floor of the secondary market help investors generate returns arising from appreciation in the prices of their holdings. Stock market returns are not fixed ensured returns and are not homogenous across investors and companies. This largely runs parallel to fixed income securities like bond. While stock market returns are variable and subject to the vagaries of the market, returns to debts instruments and the likes are fixed and quite predictable with minimum risk elements.


Generally, the structuralists explain long run inflationary trend in developing countries like Nigeria in terms of certain structural rigidities, market  imperfections, social tensions, relative inelasticity of food supply, foreign exchange constraints, protective measures, rise in demand for goods and services, fall in export earnings, hoarding, import substitutions, industrialization, political instability etc Kirkpatrick and Thirlwall(1974), Dutton (1971), Panic(1977), Agbhevi and Khan(1977). This school of thought believes that inflation should be viewed against the broad sweep of socioeconomic developments, urbanisation, industrialization and other structural changes. These changes give rise to socioeconomic pressures and frictions which are evidenced in parts through inflation. Prominent among the factors adduced by the structuralist are inelastic supply of agricultural products for domestic consumption and import inelasticity.  Agricultural product supply related causes of inflation are blamed on rising urban population with a corresponding decline in agricultural productivity; making the economic structure more industrial than agrarian.  The import inelasticity structural issues are blamed on the slow growth of traditional export and the relative increase in the level of importation against the backdrop of increasing prices of imported goods. This worsens the balance of payment position and creates imported inflation as well as makes the structure of the economy more import-dependent than domestic-product-driven.


On the other side of the divide are the Monetarists who argue that if money supply rises faster than rate of growth of national income then there will be inflation but if money supply rises with growth, there will be no inflation. Friedman (1966) a classical monetarist, sees inflation as always and everywhere a monetary phenomenon. Johnson (1977) argues on this premise, that price tends to rise when the rate of increase in money supply is greater than the rate of increase in real output of goods and services. It is the position of the monetarist that inflation is harmful and prejudicial to economic growth in the long run. It distorts the allocation of resources and directs savings into unproductive investments like real estate that best protect the savers against price increases.  They further argue that inflation favours short gestation investment due to the uncertainties it brings and makes long term investment too uncertain for investors liking. The economic effect of this becomes a distortion or imbalance in the long run development of the structures of the economy. The monetarist believes that in the short term, velocity of money (V) is fixed given the fact that institutional factors determine the rate at which money circulates.  Friedman (ibid) admits that this may vary a little in the short run but not good enough to trigger off inflation. Therefore any increase in money supply given that all the other factors are held fixed or insignificantly variable, will lead to an increase in inflation.


Aside the general postulations and concepts underlying inflation, it has been an endemic problem in Nigeria. The first traces of inflation in Nigeria were direct results of the policies of the country’s government to fast track economic growth around 1951 through the introduction of ministerial government, Anyanwu(1990). After an appreciable economic performance in the early 1970s, the Nigeria economy witnessed some anxious moment in the late 1970s to mid 1980s. The history of inflation in Nigeria is full of up and down, for example, in the middle of 1970s when there was an oil boom in the economy the rate of inflation goes out of the way and the military government of that time did not help matters with its policies such as the Udoji awards, that unnecessarily put money in the pockets of civil servants. The short span government of Buhari tried to bring the rate of inflation down after the excesses of civilian administration of Shagari, but the introduction of structural adjustment program (SAP) by Babangida, despite its much propagated potential benefits left the macroeconomic environment highly destabilized. Despite the apparent economic benefits of return to democracy in 1999, the rate of inflation in much of this period has remained high, further undermining government efforts to entrench macroeconomic stability. The debt reduction policies of Obasanjo from 1999-2007 have to some extent help to reduce the hike in the inflation rate, but poor budgetary discipline and other public policy negative externalities did not help matters.


Severe pressures built up in the economy mainly because of the expansionary fiscal policy of the federal government during these years also played unpleasant roles in building the inflation milieu in Nigeria. This was accompanied by rapid growth in domestic money supply, exacerbated by the monetization of the earnings from oil (Kumapayi, et al., 2012) and high monetary expansion as the huge government deficit was financed largely by the Central Bank of Nigeria. The transfer of government sector deposits to the banks and the resultant increase in their free reserves had adverse consequences on the general price level. The inflationary pressure was further aggravated by high demand for imports of both intermediate inputs and consumer goods due to over valuation of the naira which made imports relatively cheaper than locally manufactured goods. Inflationary trend since then has evidently been grouped into two significant eras. Periods before 1979 were dominated by single digit inflation and periods after 1979 through to 1980 and the structural adjustment programme era of 1985 ushered in double digit inflation with their hydra headed economic challenges.  The effect of inflation presses into sectors (real and administrative), families, businesses, government set up, market institutions, investment clientele and virtually every other economic clime and set up.


The stock market is not left out of the effect of inflation. It is generally believed that inflation stifles returns on investment. Inflation risk represents one of the chief concerns of the long term investors though the short run effect seemingly appears negligible. The returns on common stock and other stock market instruments alike have been observed to show susceptibility to risks, one of which is inflation. Bilson (2001) alleges that the presence of inflation brings about upward adjustment to the returns on stock (contingent claims).  This belief is seen as why some investors go for treasury inflation-protected securities which offer low real returns as a preference for stock which allows for benefit from equity premiums.


A widely held view is that stock market returns is a good hedge against inflation.

The most prominent underlying theoretical basis for the above assertion on stock market returns is the work of Irvin Fisher. Fisher (1930) hypothesized that the expected real interest rate is determined by real factors such as the productivity of capital and time preference of consumers and is independent of expected inflation rates. The Fisher Hypothesis essentially extends to real assets such as real estate, common stock and other risky financial assets. Fisher postulated that the anticipated rate of inflation is completely incorporated in the ex ante nominal interest rate.  The expected nominal returns on any asset would move one-to-one with expected inflation, consequently, the real returns on real assets becomes statistically uncorrelated with expected inflation. This makes the returns a hedge against inflation risk through the Fisher effect.


This theory has held sway in economic and financial literature owing to the fact that, firstly, real interest rate plays a key role in influencing and determining key macro and microeconomic indicators. Secondly, Fama(1975) suggests in agreement with the Fisher postulation that nominal interest rate can be used to predict future inflation expectations. Thirdly, the Fisher Hypothesis most times guide monetary policy formulation and implementation by monetary authorities. All these are in addition to the perceived inflation/stock market return hedge which it presents.


Over the years, the Fisher Hypothesis and alleged hedging effect of inflation against stock market returns have stimulated countless research interests and activities.

Several empirical evidence abound which either corroborate or contradict the Fisher Effect. In addition, so many stock markets and economies alike have been made subjects of discourse with emphasis on the Fisher Hypothesis.


In Nigeria, the work in this area is scanty and no robust statistical and empirical cases evidently exist in this regard. The volatility of the stock market returns in Nigeria fraught with the suffocating inflationary pressures over the years raise some questions as to the reality of this postulations using evidence from the Nigerian economy. The Fisher hypothesis and the supporting works all fundamentally agree that stock market returns is a hedge against inflation. There are other dissenting voices along this line. Much has been done on the global stage along this line. As the popularity of this theory grows or wanes by the day, there is the need to use Nigeria’s home–gathered statistical data to provide full-blown empirical evidence in support or against the Fisher position.



The extension of the Fisher Effect to the stock market has suffered wide controversies.

The response of stock market returns to inflation has been and is still a very dominant topic in financial and economic literature. Several works and empirical evidence abound in relation to this topical issue. International evidence on the issue has been largely documented.

Quite a number of works favour the Fisher (1930) hypothesis that stock market returns provide a hedge against inflation. So many empirical evidence and conclusions have been drawn in affirmation of the hedging effect of returns on inflation. Some have partially reordered the Fisher Hypothesis. They argued that the hedging effect of inflation on stock market returns is time dependent. Several other relationships have been found along this line.


There are however, several contradictions and contraindications to the Fisher Effect.  Some empirical studies have argued that short run estimates show weak link between inflation and stock market returns while long run estimates for high inflation economies have tended to show a strong link between stock market returns and expected inflation, Boudoukh and Richardson(1993).Schotman and Schweizer(2000) established a difficulty in estimating the effect of stock market returns on inflation by describing them as having different time series properties. While inflation was seen as having less volatility, stock market was seen as having a greater measure of volatility. This makes their measurements not to have a common denominator and makes comparism somewhat difficult.


Notably, there is the challenge of defining the real inflation parameter or proxies. Empirical works are divided as to whether to use contemporaneous or lagged inflation as opposed to expected or unexpected inflation. Some argue that using reported inflation may not reflect current economic realities as it may have become historic as at the time of the analyses. The second school argues that the lagged inflation base presents a better proposition to use the first lag continuously compounded consumer price index as a proxy for inflation.  There is also the issue of expected and unexpected inflation. This line believes that it is the inflation expectation that drives the hedging or response effect and as such expected inflation should be used as opposed to lagged, contemporaneous and unexpected inflation. There is also the issue of factoring in unexpected inflation which is seen as the forecast error of expected inflation using the auto regressive model.

There is also the problem of reconciling statistical evidence with economic evidence. Fisher Effect is described as the marginal effect of a unit change of expected inflation on normal returns which is evidently statistical.  It is largely a statistical estimation of this relationship that is being emphasized. The postulation has been attacked on the bases of parameter uncertainty which makes it uninformative about economic relevance of the relationship under study.

Variations also exist in the area of applying the Fisher Effect on high inflation economies and low inflation economies based on different time horizons.  Primary concerns have been expressed on the conflicting results obtained in testing of the fisher effect by different literature. The estimated co-efficient of expected inflation vary substantially across countries and are sensitive to model specification and the inflationary environment.


In an attempt to address the observed irregularities, some authors have attempted to explain the inflation and stock market returns nexus along monetary policy line. The arguments and the debates rage on and on. Given all these problems, there is then a question on whether stock market returns truly respond to inflation as held by the Fisher Effect.  This question becomes quite prominent in the face of the perceived parameter, statistical, time-horizon and country characteristics uncertainties established by some empirical evidence. There is the problem of bringing the issue home to Nigeria given the specific country’s stock market and inflation related peculiar characteristics.


The main objective of study is to examine the theoretical and empirical causal relationship between inflation and stock market returns.

The specific objectives:

  1. To survey the responsiveness of stock market returns to contemporaneous inflation.
  2. To examine the impact of expected inflation on stock market returns.
  • To appraise the responsiveness of stock market returns to lagged inflation
  1. To appraise the responsiveness of stock market returns to unexpected inflation
  2. To x-ray the direction of causality among reported, expected, lagged and unexpected inflation and stock market returns.
  3. To check the long run dynamics and response to shocks existing among all the variants of inflation (expected, lagged, contemporaneous and unexpected inflation) and stock market returns.


The research questions are as follows:

  1. How far does stock market returns respond to contemporaneous inflation?
  2. To what extent does stock market returns respond to expected inflation?
  • To what extent does stock market returns respond to lagged inflation?
  1. To what extent does stock market returns respond to unexpected inflation?
  2. What direction of causality exists among all expected, lagged, unexpected, contemporaneous inflation and stock market returns?
  3. To what extent does stock market returns respond to the long run shocks and dynamics of expected, lagged, contemporaneous and unexpected inflation?



The following are the hypotheses of this study:

Ho1:   Stock market return does not positively and significantly respond to contemporaneous inflation

Ho2:   Stock market return does not positively and significantly respond to expected  inflation

Ho3 Stock market return does not positively and significantly respond to lagged inflation

Ho4:   Stock market return does not positively and significantly respond to unexpected inflation

HO5: Expected, lagged, unexpected and reported Inflation do not granger cause stock market returns

H06: Stock market returns does not respond to long run shocks and dynamics of inflation



The research focuses on the Nigerian economy. Data on inflation and stock market returns are drawn from the Nigerian economic and financial environment. 1985 to 2014 representing a 30 year period covering the aspects dealing with our data for statistical analyses. Relative conditions before 1985 and those beyond 2014 shall be covered by theoretical discussions, references to empirical works as well as deductions and generalisation shall be based on empirical findings.

The monthly observations/data for all share index, market capitalization and consumer price index shall be used.


This kind of study will assist in broadening the scope of knowledge in the following areas:

(a) Investors: It will expose the functional relationship existing among the variables of interest which will sharpen their investment appraisal skills and hunches.

It will further bring to fore the seemingly silent but significant relationship between inflation and stock market returns to the advantage of both prospective and existing investors in the stock market.

(b) Policy Makers: It will send some key signals to policy makers and underscore the essence of putting policies in place that will contain excessive inflation because of its hydra headed economic consequences.

(c) Economic watchers/General Public: The general public will gain some insight into the economic and monetary phenomenon called inflation. It will further enlighten them on whether or not the hypothesized relationship with stock market returns truly exists.

(d) The Academia: The work will contribute to