Three essays on the Fisher effect and asset returns

We attempt to resolve the puzzle that the nominal stock return is negatively correlated with expected inflation. To resolve the puzzle, we first determine periods when the expected real interest rate is empirically independent of expected inflation. For these specific time periods, we examine whether nominal stock returns move one-to-one with expected inflation. Using the CUSUM test, we find that the structural break in the relation between expected inflation and the expected real interest rate occurs in 1982Q4 and that the Fisher effect cannot be rejected after the CUSUM break in both the aggregate bond and stock markets.The insignificantly positive sensitivity of the aggregate nominal stock return to expected inflation over the period after the CUSUM break motivates us to investigate the potential real effect of expected inflation on the expected real stock return at the sector level, which operates through balance sheet items. Based on the Black and Scholes (1973) option pricing and Myers (1977) models, we hypothesize that an increase in the nominal interest rate due to an increase in the expected inflation rate may influence the value of growth opportunities and thus the disaggregate expected real stock return. For the most part, we find that the interaction between expected inflation and growth opportunities has a positive effect on the sectoral expected real stock return.We broaden the test of the Fisher hypothesis into international equity markets. We hypothesize that the potential invalidity of the international equity parity condition is partly due to exchange risk and market imperfections. We show that the covariances: between the expected exchange return, the expected domestic stock market return, and the expected foreign stock market return partially account for the failure of the parity condition. Specifically, we find that the estimated sensitivity of the expected exchange return to the expected stock market return differential for the G-7 countries vis-a-vis the U.S. is much less than unity. We also find that the risk premia provide only a partial explanation for the failure of the parity condition although the covariances are significantly different from zero for the G-7 countries except for the U.K.