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.