In Search of Money Illusion in CEE Stock Markets: The CAPM Approach
SSE Riga Student Research Papers 2009
75 Pages Posted: 28 Nov 2009 Last revised: 6 Oct 2019
Date Written: November 6, 2009
We investigate whether the hypothesis of money illusion can explain the negative or non-existent stock returns and inflation co-movement, and lead to deviations from the CAPM-implied risk-return relation in ten Central Eastern European (CEE) markets. We employ the Cohen, Polk and Vuolteenaho (2005) methodology which allows us to test the hypothesis by utilizing the cross-sectional implications of the Modigliani and Cohn (1979) proposition, and thus avoids the need to discriminate between competing rational explanations. The hypothesis of no money illusion cannot be rejected in any of the researched CEE equity markets. Conversely, we find no significant inflationary effect on the Security Market Line (SML) in eight markets, indicating that the stock return and inflation relationship requires alternative explanations. In Lithuania and Poland inflation positively affects the SML, making safe (risky) stocks relatively underpriced (overpriced) in comparison to the market.
Keywords: behavioural finance, investor irrationalities, money illusion, inflation, stock market, Capital Asset Pricing Model (CAPM), Security Market Line (SML), Central Eastern Europe (CEE)
JEL Classification: G12, G14, N24
Suggested Citation: Suggested Citation
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