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1.0         Introduction

1.1         Background of the Study

The relationship between foreign exchange rate and stock prices has attracted much attention of researchers and academics since the beginning of 1990s. The last quarter of last century has witnessed significant changes in the international financial system such as emergence of new capital markets, gradual abolishment of capital inflows barriers and foreign exchange restrictions, or adoption of more flexible exchange rate arrangements in emerging and developing countries. All mentioned features have broadened the variety of investment opportunities but, on the other hand, they have also increased volatility of exchange rates and added a substantial portion of risk to the overall investment decision and portfolio diversification process. Studying of interaction between foreign exchange and stock markets has become thereby more complex and has received more research interest than before.

There is theoretical consensus neither on the existence of relationship between stock prices and exchange rates nor on the direction of the relationship. Considering flow oriented models (FOM) and stock oriented models (SOM) as two basic approaches to the exchange rate determination, a cardinal disagreement can be found. Flow Oriented Models assume that the exchange rate is determined largely by a country’s current account or trade balance performance. These models posit that changes in exchange rates affect international competitiveness and trade balance, thereby influencing real economic variables such as real income and output (Dornbusch and Fisher, 1980). Stock prices, usually defined as a present value of future cash flows of firms, should adjust to the economic perspectives. Thus, flow oriented models represent a negative relationship between stock prices and exchanges rates with direction of causation running from exchange rates to stock prices. Causation can be explained as follows: domestic currency depreciation makes the local firms more competitive, making their exports cheaper in international market. Higher exports lead to higher incomes and increase in firms’ stock prices.

On the other hand, stock oriented models put much stress on the role of capital account in the exchange rates determination. A rise in domestic stock prices leads to the appreciation of domestic currency through direct and indirect channel. A rise in stock prices encourages investors to buy more domestic assets selling simultaneously foreign assets to


obtain domestic currency indispensable for buying new domestic stocks. Described shifts in demand and supply of currencies cause domestic currency appreciation. The indirect channel grounds in the following causality chain. An increase in domestic assets prices results in growth of wealth, which leads investors to increase their demand for money, which in turn raises domestic interest rates. Higher interest rates attract foreign capital inflow and initiate an increase in foreign demand for domestic currency and its subsequent appreciation (Branson, 1983; Frankel, 1983). Thus, this postulate a positive relationship with causality running from stock prices to exchange rate.

Financial crises characterized by dramatic fluctuations in stock and foreign exchange markets have been a common phenomenon in recent years. This realization directed researchers and policy makers to investigate the link between exchange rate and stock prices. Financial crisis can interfere with the ability of the financial markets to channel funds to people with productive investment opportunities, thereby leading to sharp contraction in economic activity (Frederic, 2004). Financial crisis refers to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. This includes stock market crashes, the bursting of other financial bubbles and currency crisis and sovereign defaults (Kindleberger and Aliber, 2005; Laeven and Valencia, 2008). As observed by Khalid and Kawai (2003); and Ito and Yuko (2004), the link between stock and currency markets helped propagate the Asian financial crisis in 1997. Thus knowledge of the relationship between stock prices and exchange rate will be helpful in predicting and mitigating the effects of financial crisis in Nigeria.

Most developed and developing countries have recognized the useful role stock markets play in promoting the efficiency of domestic financial system. According to Ilomolelian (2005); stock markets usefully compete with and complement the banking sector, thereby reducing the cost of borrowing. It is an economic institution, which promotes efficiency in capital formation and allocation and enables government and industry to raise long-term capital for financing new projects, and expanding and modernizing industrial/commercial concerns (Sanusi, 2004). If capital resources are not provided to these economic areas, especially industries where demand is growing and which are capable of increasing production and productivity, the rate of expansion of the economy often suffers.

The opportunities which stock markets offer investors for diversifying their portfolios also help lower the risk premium components in the cost of capital. Furthermore, more efficient


allocations of investors’ funds might also occur through stock price mechanism, as poor management of listed companies may have large effects on the price at which the market values a firm. In addition, listing on stock markets implies disclosure of information to investors; this encourages firms to improve their accounting standards and make management more transparent.

The Nigerian Stock Exchange, outstripped only by South Africa Stock Exchange, is the second largest equity market in sub-Saharan Africa. Roughly 266 companies are listed on the Exchange, with banks accounting for more than half of total market capitalization (Muhlberger, 2010). The market witnessed an unprecedented growth in both the volume and scale of its activities, which was stimulated by the concluded banking sector consolidation. A process which saw the collapse/merger of eighty nine (89) weak banks into twenty five (25) strong banks with a capital base of over five hundred billion naira (about $4.3 billion). The spillover effect of the global crisis set in as investors in the market began reaping huge inflationary income from excessive banks credits nurtured by capitalization of the banks and massive inflows of portfolio investments (Aliyu, 2009)

1.2        Statement of the Problem

The relationship between exchange rates and stock prices has preoccupied the minds of economists since they play important roles in influencing the development of a country’s economy (Aydemik and Demirhare, 2009). Despite the existence of literature on the link between exchange rate and stock prices, there is no consensus on the direction of causality (Tabak, (2006); Granger et al, (2000)). There exist two main diverging viewpoints namely: the Flow Oriented Model (FOM) by Dounbusch and Fisher (1980) which posits that changes in exchange rates causes change in stock prices with a negative correlation and the Stock Oriented Model (SOM) by Branson and Frankel (1983) which opines that changes in stock prices affect exchange rates with a positive correlation. Also, there exist mixed viewpoints in literature (see Aggarwal, 1981; Sonnen and Hennigar, 1988).

Since there is no general consensus on any definite pattern of causal relationship between stock prices and exchanges rates, further investigation on the causal relationship between exchange rate and stock prices in Nigeria becomes imperative.

The recent global financial crisis, which was precipitated by the United States Mortgage crises, liberalization of global financial regulations and boom and burst in the housing market and its effect on other weaker countries like Nigeria necessitates the need for


an empirical study of this nature. Evidence in Nigeria shows that between 2008 and 2009 the stock market collapsed by 70% point (Sanusi, 2010). This coincides with the period of global financial crisis which began in middle 2007 in United States and spread into Nigeria in 2008.

Nigerian Stock Exchange Market All-Share Index (NSE-ASI) witnessed huge swings in recent years. The 1990s and early 2000 were an extraordinary decades for stock market index. The NSE-ASI increased more than 900 percent point from 513.8 in 1990 to 5261.4 in 1999. By late 2000, NSE-ASI had reached all high of 57,990.2 as it frog-leaped from 8,110.0 in 2000 to 57,990.2 in 2007. Unfortunately, the good time did not last as ASI nosedived sharply from 57,990.2 in 2007 to 31,450.78 in 2008 (CBN, 2008). The market indicators further recorded downward movements in 2009. Turnover on the exchange closed the year 2009 at N685.72 billion or 2.9% of GDP down by 71.2% from the N2.4 trillion representing 10.4% of GDP recorded in 2008. Average daily activity dropped from 775.65 million shares worth N9.95 billion in 2008 to 414.73 million shares valued at N2.8 billion in 2009. The Nigerian Stock Exchange All-Share Index (NSE-ASI) dropped by 33.8% or 10623.61 points to close at 20827.17 in 2009. The NSE-ASI had in 2008 dropped by 45% or 26539.44 points to close at 31450.7 (Okereke-Onyiuke, 2009). The performance of the index reflects a significant reduction in stock prices during this period.

The naira exchange rate witnessed a continuous slide in the foreign exchange markets. In the official market, the exchange rate depreciated from N8.04 per US dollar in 1990 to N81.02 per dollar in 1995 and further to N129.22, N133.50 in 2003 and 2004 respectively and thereafter appreciated slightly from N133.50 in 2004 to N132.15 in 2005 and to all high of N118.57 in 2008. It further depreciated from N118.57 in 2008 to N148.91 in 2009.


Figure 1: Line Graph: Exchange Rate (EXR) Vs All Share Index (ASI)

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