VOLATILITY SPILLOVER BETWEEN FOREIGN EXCHANGE AND STOCK MARKETS IN NIGERIA

VOLATILITY SPILLOVER BETWEEN FOREIGN EXCHANGE AND STOCK MARKETS IN NIGERIA

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ABSTRACT

Financial market volatility and contagion has been a major concern for policy makers and market participants around the world due to risk and vulnerabilities emanating from exchange rate shocks. Thus, an understanding of the extent of interconnectedness between stock and foreign exchange market is crucial for macroeconomic stability. Therefore, this study “Volatility Spillover between Foreign Exchange and Stock Markets in Nigeria” investigated the magnitude of foreign exchange and stock market integration in Nigeria using weekly time series data from 2000 to 2017 in order to ascertain the extent of volatility in the stock and foreign exchange markets as well as to assess the extent of volatility spillover across the markets. Predicated on a modified version of the portfolio balance approach, the adapted model was estimated using Exponential GARCH, and the VAR-based Forecast Error Variance Decomposition (FEVD) proposed by Diebold and Yilmaz (2012) to establish the extent of foreign exchange and stock market interdependence. The findings reveal that a negative but statistically significant relationship exists between the foreign exchange and stock markets where a percentage change in All Share Index exerts negative (0.1%) impact on exchange rate while a percentage change in exchange rate leads to a 0.6% decline of the All Share Index. This suggests that volatility in the latter is more pronounced. Furthermore, it was observed that volatility spills over from the foreign exchange market to the stock market and this was particularly striking during turbulent periods such as the 2008 global financial crisis and the devaluation of the Naira in the 4th quarter of 2014. This resulted in a spillover index of 2.1% from the foreign exchange to stock market and 0.2% from the stock market to foreign exchange market. The study concludes that exchange rate stability is paramount for a stable asset market in Nigeria, and recommends that monetary authorities should give more priority towards achieving foreign exchange stability.

CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

The level of financial market integration has been on the increase as a result of financial reforms

and liberalization of capital accounts in countries around the world. In addition, the advancement

in technology has also allowed information to be transmitted freely across global financial

markets than ever before. These developments have reduced the isolation of domestic markets

and increased their vulnerability to news and shocks thereby causing volatility and possible

spillover across asset markets. Most developed and developing economies of the world have

experienced high exchange rate volatility, which translates to high degree of uncertainty and

obstructs the attainment of government‟s macro-economic objectives. Volatile exchange rates

and stock market prices influence foreign investments. This is because investors are interested in

returns as well as the uncertainty of such returns. An excessively volatile stock market weakens

consumer confidence and reduces investment spe


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