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1.

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 :

Inflation Rate in Malaysia (1972-1991) 1st sub period


20 15 10 5 0 Inflation

1990

Inflation Rate in Malaysia (1992-2011) 2nd sub period


6 5 4 3 2 1 0

1991

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

Inflation

2003

2004

2005

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2006

2007

2008

2009

2010

2011

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 peoples 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.

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