Abstract

This study examines the causal relationship between the exchange rate and stock prices in Nigeria, using quarterly data from 1990-Q1 to 2009-Q4. The ADF and PP tests suggest that the series are random walk processes in their level form. Pair-wise Granger causality was tested within a multivariate co-integration and vector error correction model (VECM) framework. Three stock exchange indicators were used as proxies for stock prices to test the direction of causality between the variables, which gives three VAR models. The empirical findings suggest a long-run equilibrium relationship between the exchange rate and stock prices. They also show strong unidirectional causality running from stock prices to the exchange rate, whichever stock market indicator is used, and this supports the Stock Oriented Model (SOM). The estimated cointegrating vector shows that the exchange rate has a negative effect on Nigerian stock prices. The error correction term shows that the speed of adjustment is highest when stock market capitalization (SMC) is used as the proxy for stock prices, followed by the all-share index (ASI) and the value of shares traded (VST). The impulse response function (IRF) shows that shocks in the foreign exchange market and in the macroeconomic environment tend to worsen the Nigerian stock market. The ASI accounts for 84.7 per cent of the forecast error variance in the stock market, while the exchange rate (EXR) explains 12.3 per cent. This suggests that information within the stock market is the main driving force behind stock market variance.

CHAPTER ONE

INTRODUCTION

1.1 Background to the Study

The relationship between the foreign exchange rate and stock prices has attracted the attention of researchers and academics since the early 1990s. The last quarter of the twentieth century saw significant changes in the international financial system, including the emergence of new capital markets, the gradual removal of barriers to capital inflows and of foreign exchange restrictions, and the adoption of more flexible exchange rate arrangements in emerging and developing countries. These changes widened the range of investment opportunities, but they also increased the volatility of exchange rates and added a substantial element of risk to investment decisions and portfolio diversification. Studying the interaction between the foreign exchange market and the stock market has therefore become more complex and has attracted more research interest than before.

There is no theoretical consensus on whether a relationship between stock prices and exchange rates exists, or on the direction it takes. The two basic approaches to exchange rate determination, the flow oriented models (FOM) and the stock oriented models (SOM), disagree fundamentally. Flow oriented models assume that the exchange rate is determined largely by the current account or trade balance. They hold that changes in exchange rates affect international competitiveness and the trade balance, and thereby real variables such as real income and output. Stock prices, usually defined as the present value of the future cash flows of firms, should adjust to these economic prospects. The flow oriented models therefore imply a negative relationship between stock prices and exchange rates, with causation running from exchange rates to stock prices. The argument is that depreciation of the domestic currency makes local firms more competitive by making their exports cheaper in international markets. Higher exports raise incomes and so raise the stock prices of firms.

Stock oriented models, by contrast, emphasize the role of the capital account in determining exchange rates. A rise in domestic stock prices leads to appreciation of the domestic currency through a direct and an indirect channel. Through the direct channel, higher stock prices encourage investors to buy more domestic assets and to sell foreign assets at the same time to obtain the domestic currency they need for new purchases of domestic stocks. These shifts in the demand for and supply of currencies lead to appreciation of the domestic currency. The indirect channel works as follows. A rise in domestic asset prices increases wealth, which raises investors' demand for money, which in turn raises domestic interest rates. Higher interest rates attract foreign capital inflows and increase foreign demand for the domestic currency, which then appreciates. This approach therefore implies a positive relationship, with causality running from stock prices to the exchange rate.

Recent empirical work on Nigeria still reflects this disagreement. Gbadebo (2023), using the Toda-Yamamoto test and an asymmetric causality test, finds causality running from the exchange rate to stock prices with no feedback, and finds that positive exchange rate shocks can cause positive shocks in share prices but not the reverse. Adaramola, Abere and Ogiamien (2023) likewise report a long-run relationship and one-way causality from the exchange rate to stock price movement, whereas Kuhe, Torruam and Yaweh (2025), using monthly data for 2009 to 2024, find neither cointegration nor causality between the All Share Index and the exchange rate. Kuhe et al. (2025) also review earlier Nigerian studies and describe them as mixed and inconclusive.

Financial crises, which are marked by dramatic fluctuations in stock and foreign exchange markets, have been common in recent years, and this has led researchers and policy makers to investigate the link between the exchange rate and stock prices. A financial crisis can interfere with the ability of financial markets to channel funds to people with productive investment opportunities, and so can lead to a sharp contraction of economic activity. The term refers to a variety of situations in which financial institutions or assets suddenly lose a large part of their value, including stock market crashes, the bursting of financial bubbles, currency crises and sovereign defaults. The link between the stock and currency markets is widely believed to have helped to spread the Asian financial crisis of 1997. Recent studies indicate that the relationship itself shifts with market conditions. Kuhe et al. (2025) review evidence that the direction of causality between stock prices and exchange rates varies between crisis and tranquil periods, and that the 2007–2009 global financial crisis altered the nature of the relationship. Knowledge of the relationship between stock prices and the exchange rate will therefore help in predicting and mitigating the effects of financial crisis in Nigeria.

Most developed and developing countries recognize the useful role that stock markets play in promoting the efficiency of the domestic financial system. Stock markets usefully compete with and complement the banking sector, and so reduce the cost of borrowing. A stock market is an economic institution that promotes efficiency in capital formation and allocation, and it enables government and industry to raise long-term capital to finance new projects and to expand and modernize industrial and commercial concerns. If capital is not provided to these areas, especially to industries where demand is growing and which can raise production and productivity, the rate of expansion of the economy often suffers. The opportunities that stock markets give investors to diversify their portfolios also lower the risk premium in the cost of capital. More efficient allocation of investors' funds may also occur through the stock price mechanism, because poor management of listed companies may greatly affect the price at which the market values a firm. In addition, a stock market listing requires disclosure of information to investors, which encourages firms to improve their accounting standards and to make management more transparent.

At the time of the study, the Nigerian Stock Exchange was the second largest equity market in sub-Saharan Africa, after the South African exchange. About 266 companies were listed on it, and banks accounted for more than half of total market capitalization. The market had grown unprecedentedly in both the volume and the scale of its activities, stimulated by the banking sector consolidation, which reduced 89 weak banks to 25 stronger banks, each with a capital base of over five hundred billion naira in aggregate (about $4.3 billion). The spillover effect of the global crisis then set in, as investors in the market had been reaping large inflationary gains from excessive bank credit, which was fed by the recapitalization of the banks and by massive inflows of portfolio investment.

1.2 Statement of the Problem

The relationship between exchange rates and stock prices has preoccupied economists because both play important roles in the development of a country's economy. Despite the literature on the link between them, there is no consensus on the direction of causality. Two main viewpoints are in conflict. The Flow Oriented Model (FOM) holds that changes in exchange rates cause changes in stock prices, with a negative correlation. The Stock Oriented Model (SOM) holds that changes in stock prices affect exchange rates, with a positive correlation. There are also mixed viewpoints in the literature. Because there is no general agreement on any definite pattern of causal relationship between stock prices and exchange rates, further investigation of the causal relationship in Nigeria is imperative.

The recent global financial crisis was triggered by the United States mortgage crisis, the liberalization of global financial regulation and the boom and bust of the housing market. Its effect on weaker countries such as Nigeria makes an empirical study of this kind necessary. In Nigeria, the stock market lost about 70 per cent of its value between 2008 and 2009, which coincided with the global financial crisis that began in the United States in mid-2007 and spread to Nigeria in 2008. The Nigerian Stock Exchange All-Share Index (NSE-ASI) has seen large swings in recent years. The 1990s and early 2000s were an extraordinary period for the stock market index. The NSE-ASI rose by more than 900 per cent, from 513.8 in 1990 to 5,261.4 in 1999. It then rose from 8,110.0 in 2000 to an all-time high of 57,990.2 in 2007. The good times did not last, however, and the ASI fell sharply from 57,990.2 in 2007 to 31,450.78 in 2008 (CBN, 2008). Market indicators fell further in 2009. Turnover on the exchange closed 2009 at N685.72 billion, or 2.9 per cent of GDP, down by 71.2 per cent from the N2.4 trillion, or 10.4 per cent of GDP, recorded in 2008. Average daily activity fell from 775.65 million shares worth N9.95 billion in 2008 to 414.73 million shares worth N2.8 billion in 2009. The NSE-ASI dropped by 33.8 per cent, or 10,623.61 points, to close at 20,827.17 in 2009, after dropping by 45 per cent, or 26,539.44 points, to close at 31,450.7 in 2008. This performance reflects a significant reduction in stock prices in the period.

The naira meanwhile slid continuously in the foreign exchange market. In the official market, the exchange rate depreciated from N8.04 per US dollar in 1990 to N81.02 in 1995, and further to N129.22 in 2003 and N133.50 in 2004. It then appreciated slightly to N132.15 in 2005 and to N118.57 in 2008, before depreciating again to N148.91 in 2009.

Plotted together, these data show a continuous upward trend in the NSE-ASI from 1985 until it peaked in 2007, followed by a sharp drop in 2008 and 2009. The naira depreciated progressively between 1985 and 2004 and then oscillated from 2005 to 2009. Reading the exchange rate as the external value of the naira, the stock market indicator moved in the opposite direction to the exchange rate between 1990 and 2004, since the ASI rose as the naira depreciated. This period seemed to support the FOM. Between 2004 and 2008 the two moved in the same direction, which tended to support the SOM, and between 2008 and 2009 they again moved together, this time downward, which also favoured the SOM. The pattern shows no strong, definite relationship and does not reveal which variable leads. This raises the questions of what the relationship between the variables is and which one is the lead variable.

A growing body of work on the relationship between the variables exists for developed countries and for Asian countries, where it was motivated by the Asian financial crisis, but few attempts have been made in developing countries such as Nigeria. Recent Nigerian studies have used a range of methods, including Toda-Yamamoto and asymmetric causality tests (Gbadebo, 2023), ARDL bounds tests with inflation, interest rate and GDP added to the exchange rate and the stock index (Adaramola et al., 2023), and cointegrated VAR models with money supply (Kuhe et al., 2025), but they reach different conclusions. One major problem of the standard Granger causality test is that its outcome is sensitive to the number of lags in the model, and it has been suggested that a VAR model should be used to allow the lag length to be chosen. Using the NSE-ASI alone as a proxy for stock prices may also fail to represent stock prices in Nigeria adequately.

This study departs from existing Nigerian studies in four main respects. First, two relevant variables, inflation rate and interest rate, are included to sharpen the cointegration and causality inferences, since it is well known that causality and cointegration inferences are strongly influenced by the omission of relevant causal variables. Second, the direction of causality between exchange rates and stock prices is tested in a multivariate framework using the VECM. Third, alternative stock market indices, namely the All Share Index (ASI), Stock Market Capitalization (SMC) and Value of Shares Traded (VST), are used as proxies for stock prices. Fourth, the Impulse Response Function (IRF) and the Forecast Error Variance Decomposition (FEVD) are used to trace the effect of shocks to the innovations in current and future values and to test the transmission of periodic shocks respectively.

Against this background, it is relevant to investigate whether there is any relationship between the exchange rate and stock prices in the Nigerian economy, using high-frequency data to test for causality in a multivariate framework. The study therefore seeks to answer the following research questions:

i. What is the relationship between the exchange rate and stock prices in Nigeria?

ii. What is the direction of causality between the exchange rate and stock prices in Nigeria?

iii. What is the extent of transmission of periodic shocks between the exchange rate and stock prices in Nigeria?

iv. What is the extent of forecast error variance between the exchange rate and stock prices in Nigeria?

1.3 Objectives of the Study

The broad objective of the study is to investigate the causal relationship between the exchange rate and stock prices in Nigeria. Specifically, the study intends to:

i. Determine the relationship between the naira exchange rate and stock prices.

ii. Determine the direction of causality between the exchange rate and stock prices.

iii. Examine the transmission of periodic shocks between the exchange rate and stock prices.

iv. Examine the forecast error variance between the exchange rate and stock prices.

1.4 Research Hypotheses

The hypotheses are stated as follows:

1. Stock prices have no significant relationship with exchange rates.

2. There is no direction of causality between stock prices and exchange rates.

3. There is no transmission of periodic shocks between the exchange rate and stock prices.

4. There is no forecast error variance between stock prices and the exchange rate.

1.5 Significance of the Study

Whether exchange rate fluctuations affect stock prices in Nigeria is more than a matter of intellectual curiosity. It is a crucial policy issue for policy makers and investors, because information from one market can be used to predict the behaviour of the other. If the stock and foreign exchange markets are related and causality runs from the stock market to the foreign exchange market, the authorities can focus on domestic economic policies to stabilize the stock market. If, on the other hand, causality runs from the foreign exchange market to the stock market, a crisis in the stock market can be prevented by controlling exchange rates. Kuhe et al. (2025) draw a related conclusion from their own results, namely that policy makers should not rely on exchange rate management alone to influence the stock market.

The study will also help policy makers in decisions on monetary and fiscal policy. A booming stock market has a positive effect on aggregate demand, and if the effect is large enough, expansionary or contractionary monetary policies that target the interest rate and exchange rate may be neutralized. Policy makers sometimes advocate devaluation to boost the export sector, and they should know whether such a policy might depress the stock market. The study will also benefit investors in managing their exposure to contracts and exchange rate risk, and so help to stabilize their earnings.

1.6 Scope of the Study

To examine the relationship between the exchange rate and stock prices in Nigeria, quarterly time series data are used. The study covers the period 1990-Q1 to 2009-Q4. The scope was chosen because of the availability of data, and because the period covers both the pre-crisis and the crisis periods.

References

Adaramola, A. O., Abere, M. A., & Ogiamien, O. F. (2023). Effect of exchange rate on stock price movement in Nigeria. Financial Markets, Institutions and Risks, 7(2).

Gbadebo, A. D. (2023). Causality evidence of exchange rate–stock price relation in Nigeria: Symmetric and asymmetric approach. Acta Universitatis Danubius. Œconomica, 19(4), 193–209.

Kuhe, D. A., Torruam, J. T., & Yaweh, B. I. (2025). Stock market prices and foreign exchange rate interactions in Nigeria: Evidence from cointegrated VAR model. FUDMA Journal of Sciences, 9(7), 304–314. https://doi.org/10.33003/fjs-2025-0907-3804