STOCK RETURNS-INFLATION RELATION IN INDIA, 1980-2004

This study contributes to the stock returns-inflation relation literature in developing countries by revisiting the issue with reference to an emerging economy, namely India. More specifically, it tests whether the Indian stock market provides an effective hedge against inflation using monthly data on real stock return, inflation and real activity from April 1980 to March 2004 and a two-step estimation procedure. Results of the study indicate that (i) the Indian stock market reflects future real activity; (ii) the negative stock returns-inflation relation emerges from the unexpected component of the inflation and (iii) this negative relation vanishes when we control for the inflation-real activity relation, thereby providing a strong support for Fama’s proxy effect hypothesis. The split period analyses provided support for accepting Fama’s hypothesis only in pre-reform period. In the post reform period, stock market serves as a hedge against inflation.