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

See all articles by Ernesta Orlovaitė

Ernesta Orlovaitė

University of Manchester, Global Development Institute, Students

Aurimas Racas

Stockholm School of Economics, Riga

Date Written: November 6, 2009

Abstract

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

Orlovaitė, Ernesta and Racas, Aurimas, In Search of Money Illusion in CEE Stock Markets: The CAPM Approach (November 6, 2009). SSE Riga Student Research Papers 2009, Available at SSRN: https://ssrn.com/abstract=1515042 or http://dx.doi.org/10.2139/ssrn.1515042

Ernesta Orlovaitė (Contact Author)

University of Manchester, Global Development Institute, Students ( email )

Oxford Road
Manchester, M13 9PL
United Kingdom

Aurimas Racas

Stockholm School of Economics, Riga ( email )

Strelnieku iela 4a
Riga, LV 1010
Latvia

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