ABSTRACT

The effect of inflation on the stock market has attracted many studies. Fisher theory postulates that the real rate of returns on common stocks do not depend on inflation, indicating that stocks should be independent of inflation. The studies have attempted to investigate how inflation affects the stock market and the studies have mainly used the aggregate stock market index. However, the use of aggregate indices may mislead on the actual performance of sector-specific indices. The empirical studies using the aggregate index across countries reveal mixed results. The negative and positive effect findings of inflation on stock market contradict the Fisher hypothesis which states that stocks should have a neutral relationship against inflation. In addition there was a difference in the effect of inflation on stock market volatility across the sectors of the stock market. This study investigated the effect of inflation on sector stock market volatility for Kenya Nairobi Securities Exchange. The sectors at the Nairobi Securities Exchange were agricultural, automobiles and accessories, the banking, commercial and services, construction and allied, energy and petroleum, insurance, investment, manufacturing and allied, telecommunication and technology sectors. Monthly secondary time series data, for the period 2006-2014, on inflation price earnings, and Nairobi Securities Exchange Index were used in the analysis. An empirical investigation on the effect of inflation on price earnings and Nairobi Securities Exchange Index was conducted. This study used Autoregressive Distributed Lag Model (ARDL) for sectors whose variables were stationary at levels. Johansen Cointegration Test was used for sectors whose variables were non- stationary. In the latter, Vector Error Correction Model (ECM) was used after confirmation of cointegration. In conclusion the results indicated that inflation affects the automobile and commercial sector price earnings ratio positively while in the short run the automobile sector, banking sector, commercial sector, construction sector, insurance sector, investment sector, manufacturing sector price earnings ratio are all positively correlated to inflation in the short run and in long run. Inflation was negatively correlated to energy sector and agricultural sector. The results indicated that inflation affects all sectors price earnings both in the long run and in the short run. Inflation affects the entire stock market positively