Extracting Inflation from Stock Returns to Test Purchasing Power Parity

48 Pages Posted: 31 Jul 2003

See all articles by Yihong Xia

Yihong Xia

University of California, Los Angeles (Deceased)

Bhagwan Chowdhry

UCLA Anderson; Indian School of Business

Richard Roll

California Institute of Technology

Date Written: July 2004

Abstract

Relative purchasing power parity (PPP) holds for pure price inflations, which affect prices of all goods and services by the same proportion, while leaving relative prices unchanged. Pure price inflations also affect nominal returns of all traded financial assets by exactly the same amount. Recognizing that relative PPP may not hold for the official inflation data constructed from commodity price indices because of relative price changes and other frictions that cause prices to be \sticky, we provide a novel method for extracting a proxy for realized pure price inflation from stock returns. We find strong support for relative PPP in the short run using the extracted inflation measures.

Keywords: purchasing power parity, foreign exchange rate volatility

JEL Classification: F3, G0

Suggested Citation

Xia, Yihong and Chowdhry, Bhagwan and Roll, Richard W., Extracting Inflation from Stock Returns to Test Purchasing Power Parity (July 2004). Available at SSRN: https://ssrn.com/abstract=417920 or http://dx.doi.org/10.2139/ssrn.417920

Yihong Xia

University of California, Los Angeles (Deceased)

N/A

Bhagwan Chowdhry (Contact Author)

UCLA Anderson ( email )

Los Angeles, CA 90095-1481
United States
310-825-5883 (Phone)
310-206-5455 (Fax)

HOME PAGE: http://bit.ly/bhagwanUCLA

Indian School of Business ( email )

Hyderabad, Gachibowli 500 032
India

HOME PAGE: http://bit.ly/bhagwanUCLA

Richard W. Roll

California Institute of Technology ( email )

1200 East California Blvd
Mail Code: 228-77
Pasadena, CA 91125
United States
626-395-3890 (Phone)
310-836-3532 (Fax)

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