Stock Market Response of Exchange Rate and Inflation Shocks in Nigeria: A Structural VAR Approach

Abstract

Motivated by the high inflation rates and fluctuating exchange rates as currently being experienced in Nigeria, this study investigates the stock market response of exchange rate and inflation shocks in Nigeria within the VAR methodology using the popular impulse response function, forecast error variance decomposition and Granger causality/exogeneity test. The data used consist of 258 monthly time series observations on inflation rates, end period Naira/dollar exchange rate and NSE All-share index from January 1996 to June 2017.  Stock market index and exchange rate data are converted into continuously compounded returns by taking the log difference. The results show that although, stock market responds negatively to exchange rate shock and positively to inflation shock, the effect of these shocks is insignificant. The main source of error variance in stock returns is own shock as both exchange rate and inflation shocks contribute less than 2% of the observed variation in stock returns up to the tenth period. There is no causal impact of both inflation and exchange rate on the Nigerian stock market. However, there is a long-run relationship between stock market returns, exchange rate returns and inflation. Thus, both inflation and exchange rate are not systematic risk factors that influence the stock market. Based on these findings, the study recommends that the monetary authorities should not allow the exchange rate and inflation to exceed the current level as this may have significant adverse effects on the stock market.