Stock market plays a very crucial role in assessing economic conditions of any country through improved stock returns usually signified by higher profit to firms. This consequently engenders economic growth and vice versa. Basically stock exchange market serves as a channel through which surplus funds are moved from Lender-Savers to Borrower-Spenders who have shortages of funds (Mishkin 2000). Based on this premise, volatility in stock prices can significantly affect the performance of the financial sector as well as the entire economy.
However understanding the origins of stock market volatility has long been a topic of considerable interest to policy makers and financial analysts. Policy makers are interested in the main determinants of volatility and its spillover effects on real activities. Financial analysts on other hand are interested in the direct effects time-varying volatility exerts on the pricing and hedging of more exotic derivatives. In both cases, forecasting stock market volatility constitutes a formidable challenge but also a fundamental instrument to manage the risks faced by these institutions (Corradi, Distaso and Mele 2009).
The financial position of an economy that is mainly determined by the capital market is susceptible to its foreign exchange volatility. Hence, this makes foreign exchange market developments to have cost implications for all the economic agents. Benita and Lauterbach (2004) upheld that exchange rate volatility have real economic costs that affect price stability, firm profitability and the general economic stability. Exchange rate volatility has implications for the financial system of a country especially the stock market. However a survey of the available literature revealed divergent views of researchers on the issue of whether foreign exchange rate variability influences stock market volatility or not (Chen et al. 2004; Carruth et al., 2000; Kanas 2000 and Serven, 2003).
Three events – Asian currency crises, the advent of floating exchange rate in the early 1970s and financial market reforms in the early 1990s have prompted financial analysts into determining the link between these two markets (Mishra, 2004). Also, the internationalization of capital markets has resulted in inflow of vast sums of funds between countries and in the cross listing of equities. This has therefore made investors and firms more interested in the volatility of exchange rate and its effects on stock market. Floating exchange rate appreciation reduces the competitiveness of export markets; and has a negative effect on the domestic stock market (Yucel and Kurt, 2003). But, for import dependent economy like Nigeria, it may have positive effects on the stock market by lowering input costs. Serven (2003) used the US industry-level investment to show that exchange rate uncertainty significantly has negative long-run effects on investment.
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Exchange Rate Volatility and the Stock Market: The Nigerian Experience
