CAPITAL MARKET RESPONSE TO CRUDE OIL PRICE FLUCTUATIONS AND FOREIGN EXCHANGE RATE IN NIGERIA (1985:1-2017:8)

CAPITAL MARKET RESPONSE TO CRUDE OIL PRICE FLUCTUATIONS AND FOREIGN EXCHANGE RATE IN NIGERIA (1985:1-2017:8)

ABSTRACT: This study investigates the response of capital market activities to crude oil price fluctuations and foreign exchange rate movements in Nigeria. Using All Share Index (ASI) as proxy for Capital Market activities, Dollar Price of Oil (DPO) as proxy for Crude Oil Price and Foreign Exchange Rate (FXR) as working variables, the study employed Unit Root Test, Johansen Cointegration test, Granger Causality test, Error Correction Mechanism and the GARCH model on monthly time series Nigerian data for the period 1985-2017. The results revealed that all variables are stationary at first difference. The dollar prices of oil and foreign exchange rate exhibit long-run influence on all-share indexes. Bidirectional causality runs between the dollar price of oil and all share index while causality flows from foreign exchange rate to all share index. An increase in the volatility of the dollar price of oil reduces variations in all share index while volatility in foreign exchange rate exhibits a weak positive influence on the volatility of all share index. Based on this study, conclusions were made that oil price fluctuations have a negative but significant causal influence with all share index while the foreign exchange rate has a positive but insignificant causal influence on all share index in Nigeria. We, therefore, recommend that there should be an effective forecast analysis of the movement in the foreign exchange rate and the dollar price of oil to reduce the effects of shocks on the activities of the Capital Market in Nigeria.

CHAPTER ONE

INTRODUCTION

 Background of the Study

The Nigerian economy has been dominated by crude oil revenue since the early 1970s. The country is now rated as the world seventh-largest producer of oil. Generally, oil revenue has continued to account for about 40 percent of the gross domestic product. For instance, oil revenues gave an account for an average of 27.75 percent of total export between 2000 and 2005 and also provided an average of 38.16 percent of the gross domestic product over the same period. The oil has effectively dominated the nation’s economic activities and the national budget is built annually around oil production and revenue. It, therefore, implies that the general performance of the government budget, aggregate economy, and its subsectors will become much more sensitive to the vagaries of the oil production activities and market performance (Asaolu and Ilo 2012).

The federally collected revenue stood at N5, 695.1billon in 2006, 7.5 percent over the 2005 performance. The revenue performance, which was 32.7 percent of GDP, was largely attributed to huge receipts from the oil sector as the prices of crude oil exceeded the budget benchmark price (CBN, 2006). This expectedly will boost the purchasing power of the economy, promote industrial growth and investment. Consequently, it is expected that this will boost the earnings of corporate firms, dividend payments to investors, while simultaneously increasing stock prices.

Oil price volatility has captured the interest of researchers as an important determinant affecting the macroeconomic activities and ultimately the stock market indices in different ways and different parts of the world especially since the experience of the first oil crisis in 1973. According to Hamilton (1983), seven of the eight postwar recessions in the United States have been preceded by a dramatic rise in the price of crude. The mainstream empirical estimates suggested the doubling of oil price increases between 2003 and 2005 cumulatively lowered the global output at least by 1.5% or about 750 billion dollars till 2005 (Ragoff, 2006). Such conclusions and estimations have provided the base for the researchers to consider oil as an important determinant while evaluating the economic activities in any country.

The need for this work stemmed from studies of the Nigerian oil and gas sector, particularly from observing the extent of changes in international fuel prices over time. This raised the question “Will investment in the stock exchange yield equivalent returns as direct investment in oil and gas?” The research is set out to identify the existence of relationships linking stock prices, oil prices and exchange rate, the extent of this bond and if these relationships can be exploited by proxy investments i.e. if equivalent benefits will accrue to investors by investing in one of the variables instead of another.

Thus the impact (positive or negative) which oil price volatility could have on any economy, depends on what part of the segment such economy falls into and of course the nature of such price change (rise or fall). However, the Nigerian economy uniquely qualifies as both an oil-exporting and importing economy, because she exports crude oil, but imports refined petroleum products. Making a conclusive and authoritative statement on the impact of oil price volatility on the Nigerian economy is therefore difficult (Rentschler, 2013).

Oil is the livewire of any country because of its diverse use. The importance of oil on economic activities can be felt when there is fluctuation in the prices of oil. As economic activities increases as a result of economic growth, the demand for oil increases. The prospects of future oil supply are highly uncertain considering persistent political fluctuation in exporting countries and the uncertainty regarding the discovery of new reserves. As an outcome of such uncertainties, oil prices could experience further drastic fluctuations in the future (Rentschler, 2013).

Sauter and Awerbuch (2003) posit that a rise in oil prices leads to a decrease in economic activities. Basher and Sadorsky (2006) speculated that future oil demand is difficult to predict but is generally highly correlated with the growth in industrial production and the foreign exchange rate. And countries with rapid economic growth are the ones most likely to dramatically increase their demand for oil.

Omorokunwa and Oviasogie (2013) conceived that the stock markets of the developed economy are generally assumed to be more liquid and efficient compared to their counterparts in emerging economies like Nigeria.

Financial literature is filled with theoretical and empirical evidence of the relationship between oil price and stock market volatility in developed economies. However, in developing countries like Nigeria, there is a scarcity of empirical evidence on the effect of oil price volatility on stock price volatility. Thus the study seeks to close this gap by raising the following question: What are the relationship between oil price volatility, stock price volatility and the foreign exchange rate in Nigeria?

An unresolved research issue in the stock market is the role played by oil prices and the foreign exchange rate. If you ask a layman about the relationship between the price of oil and the stock market or the relationship between the stock market and foreign exchange rate, the expected answer would be: “the relationship is negative”. This kind of view is also shared by the financial press. But in reality, the relationship is much more complicated than this simple answer. It depends on the circumstances and the prevailing state of the macroeconomy (Hammoudeh, 2009). While most prior research on the relationship between oil prices and stock market could not find strong and convincing evidence to support the proposition that oil prices drive the stock market returns (Pescatori and Mowry, 2008., Fisher 2005., Agusman and Deriantino, 2008., Weiner,2005 and Apergis and Miller, 2009), yet several studies have found evidence to the contrary. Some of the studies that shows that a relationship exists between oil prices and the stock market include those of Sadorsky (2008), Aloui and Jamazi (2009), El-Sharif, Brown, Burton, Nixon, and Russell (2005), Hammoudeh (2009), Gogineni (2007) and Rault and Aruori (2009). It is against this backdrop that this study was carried out to find out whether oil price volatility and foreign exchange rate affects stock market performance in Nigeria.

Statement of the Problem

Crude oil as a key source of energy in Nigeria and the world, as well as oil, is an important part of the economy of Nigeria, plays a strong role in influencing the economic and political fate of the country. Crude oil has generated great wealth for Nigeria, but its effect on the growth of the Nigerian economy concerning returns and productivity is still questionable (Odularu 2007).

Sharp increases in the international oil prices, foreign exchange rate and the violent fluctuations of the capital market are generally regarded as factors discouraging economic growth (Jin, 2008).

According to the economist Stephen Ross who postulated in his theory (arbitrage pricing theory), there are some macroeconomic variables responsible for the distortion in price movement in the capital market but failed to mention anyone.

The price of oil is a macro-economic factor because of the nature of the Nigerian economy which is a mono-product economy that depends heavily on the oil and gas sector; therefore, if anything happens to the crude oil price in the oil market and the foreign exchange rate, it will certainly affect the capital market as well as stock price. Thus, the basic question is will this effect be positive or negative?

However, despite this, the major relationship between the price of oil, foreign exchange rate, and the stock market has not been explicitly explored or determined. So there is still a lot of controversy as to the exact nature of the relationship between crude oil price, foreign exchange rate and the capital market; not just in Nigeria, but globally. It is on this note this research finds out the capital market response to crude oil price fluctuations and foreign exchange rates in the Nigerian economy, as well as suggests methods of minimizing the adverse effects it can produce on the capital market and the economy as a whole.

Aim and Objectives of the Study

This research aims to determine the nature and extent of the relationship between fluctuations in the dollar price of oil, foreign exchange rate and all share index in Nigeria.

This study intends to achieve the following specific objectives:

1. To examine if there exists a significant long-run relationship between oil price fluctuations, foreign exchange rate and all share index in Nigeria.
2. To investigate if there exists a significant causal relationship between oil price fluctuations and all share index in Nigeria.
3. To investigate if there exists a significant causal relationship between foreign exchange rate and all share index in Nigeria.
4. To investigate the transmission of volatility between crude oil price fluctuation and all share index in Nigeria.
5. To examine the transmission of volatility between the foreign exchange rate and all share index.
6. To examine the significant impact of oil price fluctuations and foreign exchange on all share index in Nigeria.

Research Questions

Because of the objectives, the following research questions are addressed:

1. What is the extent of the long-run relationship between oil price fluctuations, foreign exchange rate and all share index in Nigeria?
2. What is the nature of causality relationship between oil price fluctuations and all share index in Nigeria?
3. What is the extent of the causality relationship between foreign exchange rate and all share index in Nigeria?
4. What is the nature of the transmission of volatility between oil price fluctuation and all share index in Nigeria?
5. What is the magnitude of transmission of volatility between the foreign exchange rate and all share index in Nigeria?
6. What is the significant impact of oil price fluctuations and foreign exchange rate on all share index in Nigeria?

 Research Hypotheses

The study proposes the following hypotheses which are cast in the null form:

H₀₁: There is no significant long-run relationship between oil price fluctuations, foreign exchange rate and all share index in Nigeria.

H₀₂: There is no significant causal relationship between oil price fluctuations and all share index in Nigeria.

H₀₃: There is no significant causal relationship between foreign exchange rate and all share index in Nigeria.

H₀₄: There is no transmission of volatility from oil price fluctuations and all share index in Nigeria.

H₀₅: There is no transmission of volatility from the foreign exchange rate and all share index in Nigeria.

H₀₆: There is no significant impact of oil price fluctuations and foreign exchange rate on all share index in Nigeria.

Significance of the Study

This study will be relevant and essential since it is meant to provide insight and the direction on capital market response to crude oil price fluctuations and foreign exchange rate in Nigeria. A study of this kind is expected to provide useful information to both the government and most policymakers in Nigeria.

Besides, the research findings and recommendations of this work will serve as a reference source and a point of departure for further research.

The Government: Since the study takes into account the influence of macroeconomic variables on variation in oil prices, by using the outcome government can frame out suitable policies on a long term basis that will help in nurturing a healthy economy and resultant capital market.

Policy Makers/Corporate Governance: As every company management tries to maximize the wealth of its shareholders, a clear idea about the return generating variables and their influence will help the management to frame various policies to maximize the wealth of the shareholders.

Researchers: The result of this empirical research will help other researchers to understand whether the movement of oil prices and foreign exchange rate in Nigeria is subject to change in the capital market.

Investors and Financial Analyst: A study focusing on crude oil price fluctuation, foreign exchange rate and how the capital market responds to it either positively or negatively, the outcome will be a tool for investment analysts in the hands of investors, portfolio managers and mutual funds who are mostly concerned with changing share prices.

The Scope of the Study

1. Content Scope: This study spans the period of 1985-2017, making use of high-frequency monthly data of all share index, crude oil price and foreign exchange rate obtained from the CBN statistical bulletin and the NSE statistical bulletin, with focus on detailed analysis. The theoretical underpinning of this study includes Stock Valuation Theory, Arbitrage Pricing Theory, Efficient Market Hypothesis Theory, and Capital Asset Pricing Theory.
2. Geographical Scope: This study evaluates two fundamental macroeconomic variables which are crude oil price and foreign exchange rate within the boundaries of the Nigerian Capital Market.

Limitations of the Study

The following are the limitations of this study:

• The use of proxies for capital markets and crude oil prices, which may not capture the actual concept studied.
• The data used were secondary, and their validity and reliability may not be within the powers of the author.
• The use of historical data may not be a good predictor of future actual prices.

 Definition of Terms

Capital Market: A financial market in which long-term debt (over a year) or equity-backed securities are bought or sold. Capital market channel the wealth of savers to those who can put it to long-term productive use, such as companies or governments making long term investments.

Response: A reaction to an event, occurrence, situation, or a change to its environment, aimed at its containment or control. It is any behavior that results from a stimulus.

Crude Oil Price: This is used to measure the spot price of several barrels of oil. The prices of crude oil from which various petroleum products like gasoline are derived are dependent on several factors that affect the demand and supply of crude oil.

Fluctuation: This is a situation in which prices, levels or interest rates go up and down. It is an irregular rising and falling in number or amount, a variation.

Foreign Exchange Rate: This is the conversion rate of one currency into another currency. This rate depends on the local demand for foreign currencies and their local supply, country’s trade balance, the strength of its economy, and other such factors.

Organization of the Study

This study is divided into five chapters. Chapter one which is the present chapter, gives a general overview of the study, introduction, statement of the problem, the objective of the study, research questions, research hypotheses, significance of the study, the scope of the study, limitations of the study.

Chapter two reviews papers related to this topic. It includes conceptual framework, theoretical issues, empirical issues and the gap in literature relating to this topic.

The third chapter focuses on the research methodology it includes, including research design, the population of the study, sampling procedure and sample size, method of data collection, operational measures of variables, model specification and statistical technique in finding statistical relationship amongst the variables.

Chapter four involves the presentation of data, data analysis, hypotheses testing and discussion of results obtained in chapter three. Lastly, chapter five summarizes the major findings in this research study, concludes, recommends and gives policy implications of the findings.