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This is my understanding:

Fisher effect posits that expected nominal returns on any asset would move one-for-one with expected inflation. That is, when expected inflation increase, the nominal return on stock would also increase, is this correct? Besides, based on the theory, inflation would also cause nominal interest rate (the rate which dividend is discounted to the present to obtain stock price -Present Value Model) to increase, which would decrease stock price.

My problem: The two conclusion above contradicts and I'm confused. Can anyone point the mistake of my thoughts? or PVM and fisher effect cannot be viewed together?

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  • $\begingroup$ Can anyone help? I'm really confused.. : ( $\endgroup$ – Josephine PM Dec 21 '17 at 9:26
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It’s simpler if you start with a bond. If the yield increases (expected return), the price goes down. Future returns are higher, but if you were holding it before the price change, you get a capital loss. Your return to maturity will still be the previous (lower) yield; the capital loss acts as a drag on the future expected returns.

If we assume that the only thing that changes in the stock valuation, an increased discount rate causes a fall in price, with a higher expected return later.

However, the situation for equities is more complicated. The fair value is the discounted value of future cash flows. If expected inflation is higher, why are not the cash flows also higher? Therefore, you need to model the relationship between cash flows and inflation.

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There is no contradiction between PVM and Fischer effect.

Perhaps you are misinterpreting what "expected nominal return" means.

Expected nominal return is the return an investor expects from his investment.

The theory does not imply that incresead inflation will automatically increase company profits by the same amount. Instead the value of the stock is reduced, just as the NPV calculation implies.

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