ABSTARCT
The need to capture stock market and foreign exchange market nexus in Nigeria is underscored by the rapidly expanding financial markets integration due to trade and financial liberalization policies which seem to have enhanced the inflow of capital as well as accelerated investment/business interactions. Theoretically, the relationship between stock prices and exchange rate can be either positive or negative and can also run either way. This study therefore captures returns/mean and volatility spillovers between the stock and foreign exchange markets in Nigeria. The study empirically analyzes stock prices and exchange rate interactions with VAR and multivariate generalized autoregressive conditional heteroscedasticity (GARCH) models using monthly data from January 2000 to October 2014. The results of the E-G and Johansen cointegration test show that there is stable long-term equilibrium relationship between stock prices and exchange rate. The empirical evidence of the VAR-GARCH model shows a significant mean spillover running from stock market to exchange market but not a mean spillover from exchange market to stock market. Furthermore, the variance equation results show that there exist bi-directional volatility transmission effect between the two markets, indicating the past innovations in stock market have the great effect on future volatility in foreign exchange market, and vice versa. The results have important implications for international portfolio managers in the portfolio diversification decisions and risk hedging strategies.
CHAPTER ONE
Introduction
1.1 Background of the Study:
The relationship between stock prices and exchange rate has attracted much attention amongst financial expert, researchers and policy makers in Nigeria since the inception of the Structural Adjustment Programme (SAP) in 1986. The period witnessed significant changes in the Nigerian financial system, such as the emergence of new equity markets in terms of liberalization policy. This era saw the abolishment of trade barriers on capital flows and adoption of flexible exchange rate, which subsequently result to verities of investment opportunities. Hence, the broadened investment opportunities in turn promote frequent inflow and outflow of investment into the market. As a result, this has led to the increase in demand and supply for local currency and thus, the volatility in exchange rates that sometime affect the investment decisions and portfolio diversification of many investors.
However, the understanding of the influence of exchange rates on stock prices and their interactions in Nigeria cannot be over-emphasis. This is because of the significant role they play in stabilizing the macroeconomic environment, which in turn spur economic growth and development. Though, there has been thoughtful disagreement on the relationship between stock prices and exchange rate. It has been argued that the interplay of demand and supply of domestic currency partly determined stock price movement (Bahmani-Oskooee & Sohrabian, 1992). But this idea has been refuted by some scholars who believed that rise or fall in stock prices play a significant role in demand and supply of domestic currencies (Stavarek, 2005; Pan, Fok, & Lin, 2007). Thus, an appreciation of stock prices translates to the effectiveness of the market in terms of its performance. Therefore, an efficient market always attracts reasonable number of domestic and foreign investors. However, the inflows of foreign investors into the market due to its performance, causes increase in demand and supply of domestic currency. In like manner, the exchange rates appreciation due to increase in demand and supply of domestic currency is driven by the inflow of investment into the market as a result of rise in stock prices, while the depreciation in exchange rates reflects a decrease in inflow of investment due to a fall in stock prices cetris paribus (Granger, Huang, & Yang, 2000; Stavarek,
2005; Pan et al., 2007).
Obviously, it has been investigated that a well regulated and functioning stock market is crucial in
mobilizing capital for investment purposes and promotion of business activities. This in turn, facilitates company’s growth and the economy in general. Stock market as an integral part of financial market where securities of publicly held companies are issued and traded serves as a platform for diverting funds from surplus to deficit spending units which encourage productive investment. The stock market, as a vital component of free market economy, also provides companies with access to capital in exchange, giving the ownership of the company’s shares the opportunity to participate in the financial achievements of the shares they hold. This in turn, facilitates the decrease on over reliance on debt financing thereby increasing the overall efficiency and competitiveness of the companies (Murinde, 1996).
In Nigeria, the interactions of stock prices and exchange rates have brought so much doubt in the mind of many investors resulting to low share acquisition and fall in day to day business activities of the quoted companies. In addition to the strong hold of the influence of exchange rate fluctuations on stock price, other issues like insider trading, illegal private placement, earning pattern, cash flow streams, and market share holding alongside other macroeconomic factors like interest and inflation rates among others, have been proven to be responsible to the continuous drift in the stock prices in Nigeria (Siddiqui & Nabeel, 2013; and Manasseh, Asogwa, Agu & Aneke,
2014). This challenge has affected both the number of companies listed with the exchange, volume of shares traded and its contribution in terms of market capitalisation due to significant reduction in business activities in the market.
Following the continuous drift in the stock prices orchestrated by the aforementioned, the market has been sluggish in its performance compared to other emerging markets like Johannesburg and Egypt stock markets due to loss of investor’s confidence, macroeconomic instability and fear of losing investible funds. The lack of confidence erupted by share prices fluctuations perpetuated by exchange rates fluctuations and high level of corruption prevalent in the market has been argued to be responsible for the inconsistent record shown by performance indicators such as market capitalization as % of GDP and number of listed companies among others (Manasseh et al., 2014). Evidence has shown that between 2000 and 2006, Nigeria stock market on average, accounted for about 14.47% market capitalization while Johannesburg and Egypt stock market accounted for
186.9% and 48.67% respectively. In the same vein, in 2007, the market capitalisation recorded
105.65 billion US dollar. The amazing record was celebrated as the best in the history of the Nigerian stock market but has no ground compared to Johannesburg and Egypt stock market that maintained an amazing record of about 836.34 and 139.69 billion US dollar respectively. In
addition, from 2008 to 2012, the market on average accounted for only 15.86% market capitalisation as % of GDP while Johannesburg and Egypt account for 178.3% and 36.14% respectively (World Bank Development Indicator (WDI)).
Considering the performance of the market which has not been quite impressing compared to other emerging market as discussed, the market authorities have been in their effort to restore sanity in the market. In addition, due to the role of viable financial system and efficient stock market in particular, attention has been directed to the policy reforms that have the temerity of restoring the abated investor’s confidence through the introduction of some best practices. Hence, to engender public confidence in the banking system seen as the bedrock of the market and enhance customer protection, the CBN established the Consumer and Financial Protection Division to provide a platform through which consumers can seek redress (Sanusi cited in Manasseh et al., 2014). In like manner, in 2000, the Independent Corrupt Practices and other related Crime Commission (ICPC) was established to investigate reports on corruption and in appropriate cases prosecutes offenders, while in 2003 among others, the Economic and Financial Crimes Commission (EFCC) was established as a law enforcement agency to investigate financial crimes and money laundry so as to reduce the height of corruption in the market (Manasseh et al., 2014).
In the effort to stabilise exchange rate environment in Nigeria, successive governments have undertaken several policy reforms interventions evolving from fixed regime in the 1960s to a pegged arrangement between the 1970s and the mid-1980s. However, following the Structural Adjustment Programme (SAP) reform introduced in 1986, various types of floating exchange rate regime such as free and managed float have been adopted to address the issue of exchange rate fluctuations and its ugly influence on firm’s values and stock prices in Nigeria (Sanusi, 2004). Given the central role of exchange rate in the economy generally, and its importance to international trade and investments in particular, Autonomous Foreign Exchange Market (AFEM) and Inter-Bank Foreign Exchange Market (IFEM) was introduced in 1995 and 1999 respectively to ensure equilibrium exchange rate. IFEM which was replaced by Dutch Auction System (DAS) in 2002 was designed as a two-way quote system, and charged with the responsibility to diversify the supply of foreign exchange in the economy by encouraging the funding of the inter-bank operations from privately-earned foreign exchange with the aim of assisting the naira to achieve a realistic exchange rate (Sanusi, 2004). Hence, considering the effort to stabilise the exchange rate environment and reforms in the stock markets, there is the need for proper understanding of the relationship between exchange rate and stock price of the quoted companies in Nigeria, amidst its relevance in attracting portfolio investment and the need to minimize the distortion it may cause the economy in general.
1.2 Statement of the Problem:
In 2008, the global financial crisis that was characterized by unexpected fall in the prices of equities and astonishing fluctuations in exchange rates has brought to fore the importance of stable exchange rate, and the need for proper understanding of the link between exchange rate and stock prices. Many researchers have increasingly diverted their quest to unravel the stock prices-exchange rate nexus as world economies become more integrated. This is particularly important for the far less researched developing countries like Nigeria, which equally felt the impact of an overwhelming world-wide economic tremor (Mutiu, Oluwatosin & Olusegun, 2009).
The interactions between exchange rates (Naira per USD) and stock prices measured with All Share Index (ASI) has been an issue of discuss. The persistent fluctuations of stock prices (i.e. ASI) and instability of exchange rates have been a source of doubt in the investment decision of many portfolio managers. This has affected the investor’s confidence and general performance of the economy through a drastic fall in the inflow of portfolio investment. Consequently, in 2010, the market experienced a sharp fall in portfolio investments inflow from 87.1 percent to 65.5 percent, which amounted to about $3.9 billion. Also in 2011, foreign direct investment inflow as a share of GDP into the market that got to its peak in 2009 with a record of 89.9% drastically fell to 19.7% due to the abated confidence, instigated by exchange rate volatility and stock prices fluctuation. As a result, many investible ideas of portfolio managers to buy and sell securities in the market were thrown to abyss. And this has caused an increased repatriation of foreign portfolio investments in both the capital and money markets due to the sense of insecurity and fear of losing their investible fund (Zubair, 2013; and Asogwa & Manasseh, 2014).
Furthermore, the instability of the local currency (Naira) rooted in exchange rate volatility also dared the performance indicators through its ugly influence on stock prices. However, the unstable exchange rate environment and a continuous depreciation of Naira relative to dollar have thrown the investors into skeptic mood, leaving the stock market in a state of chaos which resulted to a withdrawal/loss of N2.8 trillion worth of investment from the market. Within a period of just six months, market capitalisation crash from N12.5 trillion as at February to N9.7 trillion as at August
2008. This was not a very simple arithmetic for an emerging market economy like Nigeria, especially given the fact that many of the investors in the market were yet to understand the full mode of operation of the stock market (Agu, Manasseh & Aneke, 2012).
Subsequently, high rate of exchange rate and the persistent depreciation of Naira have not fared well in Nigeria because of its influence on stock prices fluctuations. This has limit the access of quoted firms including the banks to operating capital, reducing the volume and values of stock traded in the market. However, the interactions of stock prices and exchange rate in Nigeria have really called for concern in the mind of every meaning Nigerian and policy makers. As shown in figure 1.1 below, persistent increase in exchange rate has been a strong challenge facing the stock prices, cetris paribus. As the exchange rate (ER) keeps increasing, stock price (SP) measured with All Share Index (ASI) decreases.
Figure 1.1 NSE Monthly All Share Index and Exchange rate in Nigeria 2000 to 2012:
2000m1 2002m1 2004m1 2006m1 2008m1 2010m1 2012m1 time
SPÂ Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â ER
Source: Author’s Computation.(Data sourced from CBN statistical bulletin 2012)
For example, a glance at figure 1.1 shows that between 2000 to first month of 2006, the ugly influence of high exchange rate volatility depreciated the values of stock of all the quoted companies but in the middle of 2006, the all share price index (SP) slightly increase from 5752.9 points in 2000 to 23679.44 even in the presence of high exchange rate and depreciation of naira. However, due to the intervention of the authority, by the replacement of inter Bank Foreign Exchange Market (IFEM) with Dutch Auction System (DAS) in 2002 that was viewed to be more effective than weakened IFEM and Autonomous Foreign Exchange Market (AFEM)) that have failed in stabilizing the exchange rate environment over the years, the market regain it momentum, leading to an amazing record of 54189.9 points in the first month of 2008 which finally crashed toward the end of first quarter of the same year. Hence, from 2009 till present, the market has been struggling to survive as evidenced in the figure above. In like manner, over the same period, exchange rate appreciated to N101.7 per USD in 2000, then depreciated to N131.2 per USD in
2006. After which, it appreciated gradually, reaching a trough of N118.55 per USD at the same period the stock price (SP) surged to its peak (54189.9 points). Thus, from the beginning of 2009 till date, there has been continues depreciation of exchange rate in the market exposing the stock market to risk (NSE, 2014, World Bank Development Indicator (WDI)).
Even though serious concern have been shown by all the regulators, beginning from the introduction of Investment Security Acts by the Securities and Exchange Commission; the replacement of IFEM with the Dutch Auction System (DAS) by Central Bank of Nigeria; the establishment of the Asset Management Corporation of Nigeria (AMCON) by the Ministry of Finance; among others, the introduction of Economic and Financial Crimes Commission (EFCC) as a law enforcement agency to investigate financial crimes and money laundering to stabilize the exchange rate environment and restore investors’ confidence in the market. Yet these concerns have not translated into effective policy intervention in the market (Agu et al., 2012). The effectiveness of policy intervention has been circumscribed by limited understanding of the relationship between stock prices and exchange rate interaction in Nigeria. Therefore, it is pertinent to investigate the relationship between stock prices and exchange rate volatility in the Nigeria so as to add to the already existing knowledge and to broaden the understanding of their relationship. Thus, the following research questions are formulated to guide the study.
1.3 Research Questions:
The following research questions will be addressed in this study:
1. What is the long run relationship between stock prices and exchange rate?
2. What is the direction of mean spill-over between stock prices and exchange rate?
3. What is the direction of transmission of volatility between stock prices and exchange rate?
1.4 Objectives of the Study:
The broad objective of this study is to examine stock prices and exchange rate interactions in
Nigeria. The specific objectives of the study are:
1. To examine the long run relationship between stock prices and exchange rate.
2. To ascertain the direction of mean spill-over between stock prices and exchange rate.
3. To examine the direction of transmission of volatility between stock prices and exchange rate.
1.5 Research Hypotheses:
The null hypotheses of the study are as follows;
H01: there is no significant long run relationship between stock prices and exchange rate. H02: there is no mean spill-over between stock prices and exchange rate.
H03: there is no transmission of volatility between stock prices and exchange rate.
1.6 Significance of the Study:
The current pattern of concomitant advancement of foreign equity investment flows and exchange rate movement does pose concern for the policy makers, market analyst and researchers. These may have multifaceted ramifications in terms of economic and financial stability of the economy in which exchange rate does have a role to play. However, the results of this study will have implications for both the participants of the stock and foreign exchange Markets in Nigeria. For instance, If causal relationships are detected from stock prices to exchange rates, the participants in the foreign exchange market can devise rules to predict the movements of exchange rates. On the other hand, if causal relationships are found from exchange rates to stock prices, participants of the stock market can devise rules to predict the movements of stock prices. Predictability of exchange rates or stock prices may lead to profitable trading strategies. Furthermore, the predictability of exchange rates or stock prices violates the applicability of the efficient markets hypothesis in its semi-strong form.
Moreso, the outcome of this study will have policy implication for the government. Sometimes policy-makers advocate less expensive currency in order to boost the export sector. They should be aware whether such a policy might depress the stock market. Therefore, economic, financial policymakers and regulators needs to know the relationship between asset prices, such as those between exchange rates and stock prices, if they are to formulate the appropriate policies. In addition, the understanding of the stock prices-exchange rate relationship may prove helpful to foresee a crisis. Khalid and Kawai (2003) as well as Ito and Yuko (2004) among others, claim that the link between the stock and currency markets helped propagate the Asian Financial Crisis in 1997. It is believed that the sharp depreciation of the Thai baht triggered depreciation of other currencies in the region, which led to the collapse of the stock markets as well. Awareness about such a relationship between
the two markets would trigger preventive action before the spread of a crisis.
Lastly, this study will add to the existing literatures on the interrelationship between the stock market and foreign exchange market.
1.7 Scope of the Study:
The study focuses on stock prices and exchange rate interactions in Nigeria, using monthly data of stock prices, captured by All Share Price Index (ASI) and nominal Naira-Dollar exchange rates. The choice of the All-Share Price Index as a proxy is based on two major considerations. Firstly, it is a ratio and is therefore already in standard measurement that needs no further conversion. Secondly, more than any other variables, it has the capacity of capturing trends in all stock prices simultaneously. Given that each price movement that reflects in the ASI is in ratio of the original price, the ASI equally gives a weighted average of the prices and of other economic activities relating to trading in the market. The study will span from January, 2000 to October, 2014. The sample choice is informed by the fact that Nigeria during this period practiced dirty floating exchange system and persistent volatility in exchange rate was evidenced within the period and it also correspond with the period after the liberalization of the Nigerian Stock Market. The monthly data of stock price index are collected from the Nigeria Stock Exchange databank at www.nse.com.ng, while the Monthly data of exchange are (Naira/US$) are gathered from the Central Bank of Nigeria (CBN) 2013 statistical bulletin and CBN databank at www.cbnbank.org.
The variables in levels are denoted by SPt and ERt, respectively for log stock prices and log exchange rate, while their first differences (RSPt and RERt) are continuously compounded returns; the data are in percentage and are multiplied by 100. The study uses the first difference of the natural logarithm of stock prices and the first difference of the natural logarithm of exchange rate. It is important to note that the first difference of the natural logarithm of stock prices represents the stock returns series and that the first difference of the natural logarithm of exchange rate represents the change in exchange rates. Therefore, the rates of change of data series are calculated as:
, = × ( , ), where , is the price level of market ( = 1 for stock prices and = 2
,
for exchange rate) at time t.
This material content is developed to serve as a GUIDE for students to conduct academic research
ANALYSIS OF STOCK PRICES AND EXCHANGE RATE INTERACTIONS IN NIGERIA
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