Empirical investigation of internal and external shocks on exchange rate volatility in Nigeria

Evidence from GARCH (1 1) forecasting technique

Bachelor Thesis , 2017 , 90 Pages , Grade: 2.1

Economics - Case Scenarios

The embracement of the International monetary funds’ (IMF) structural adjustment programme (SAP) in 1986 brought the Bretton-Woods system which marked a period of the largest experiment of the pegged exchange rate regimes in the post-World War II era to its knees. Ever since then, there has been a recoded high degree of volatility in the exchange rate of the naira vis-à-vis the US dollars.

In this regard, this study seeks to examine other sources of shocks to the exchange rate fluctuations in Nigeria relying on time series data covering the periods 1986-2015. To execute this effectively, the Generalized Autoregressive Conditional Heteroscedasticity (GARCH) model introduced by Tim Bollerslev (1986) was used to decompose these shocks into internal and external sources. Also, the time series properties of the data used were explored and the stationarity conditions of the chosen variables were examined by the help of ADF unit root test under three different test regression equations.

However, the GARCH (1 1) volatility forecasting result reveals that volatility shock is present and persistent and concludes that the fluctuations in the Real exchange rate of the naira is responsive to both domestic and international shocks. Consequently, this study recommends that policies be adopted to tame the degree of volatility in exchange rate because of the deleterious effect it could have on foreign transactions. Furthermore, to make the work more enticing and attractive to the readers, we sectionalized this study into Chapters; chapter one for introduction, chapter two for literature review, chapter three for Research methodology, chapter four for the presentation and analysis of empirical findings and chapter five.

TABLE OF CONTENTS

CHAPTER ONE. INTRODUCTION
1.1 BACKGROUND TO THE STUDY
1.2 STATEMENT OF THE PROBLEM
1.3 THE OBJECTIVES OF THE STUDY
1.4 RESEARCH QUESTIONS
1.5 RESEARCH HYPOTHESIS
1.6 DELIMITATION OF THE STUDY
1.7 SIGNIFICANCE OF THE STUDY

CHAPTER TWO. LITERATURE REVIEW
2.1 CONCEPTUAL FABRICS
2.2 THEORETICAL LITERATURE
2.2.1 THE THEORIES OF EXCHANGE RATE
2.3 EMPIRICAL REVIEW
2.3.1 FOREIGN STUDIES
2.3.2 DOMESTIC STUDIES
2.4 SUMMARY OF LITERATURE AND VALUE ADDED

CHAPTER THREE.RESEARCH METHODOLOGY
3.1 ANALYTICAL FRAMEWORK
3.1.1 GARCH (11) MODEL
3.2 MODEL SPECIFICATION
3.2.1 THE FUNCTIONAL FORM
3.2.2 THE MATHEMATICAL OR DETERMINISTIC MODEL SPECIFICATION
3.2.3 THE ECONOMETRIC OR STOCHASTIC MODEL SPECIFICATION
3.3 ESTIMATION TECHNIQUE
3.4 METHOD OF EVALUATION
3.4.1 ECONOMIC CRITERIA: A PRIORI EXPECTATIONS
3.4.2 STATISTICAL CRITERIA: FIRST ORDER TEST
3.4.3 THE ECONOMETRIC CRITERIA: THE SECOND ORDER TEST
3.5.1 STATIONARITY TEST OR TEST FOR THE PRESENCE OF UNIT ROOT
3.5.2 THE COINTEGRATION TEST
3.6 JUSTIFICATION FOR THE MODEL
3.7 SOURCES OF DATA
3.8 ECONOMETRIC SOFTWARE

CHAPTER FOUR. PRESENTATION AND ANALYSIS OF REGRESSION RESULTS
4.1 DESCRIPTIVE ANALYSIS:
4.1.1 TIME SERIES PLOT OF THE DATA AND THE TREND ANALYSIS
4.3 PRE-ESTIMATION TEST
4.4 THE GARCH (1 1) ESTIMATION RESULTS
4.7 THE INTERPRETATION OF THE REGRESSION RESULTS BASED ON THE THREE SELECTED CRITERIA
4.7.0: PARAMETER IDENTIFICATION
4.7.1 ECONOMIC CRITERIA
4.7.2 THE STATISTICAL CRITERIA (FIRST ORDER TEST
4.7.3 THE SECOND ORDER TESTS
4.8 EVALUATION OF WORKING HYPOTHESES AND ECONOMIC IMPLICATUONS OF THE FINDINGS

CHAPTER FIVE- SUMMARY, POLICY IMPLICATION, RECOMMENDATION AND CONCLUSIONS
5.1 THE SUMMARY OF THE STUDY
5.2 POLICY IMPLICATIONS OF THE STUDY
5.3 RECOMMENDATIONS OF THE STUDY
5.4 CONCLUSIONS
5.5 SUGGESSTED AREARS FOR FURTHER STUDIES

REFERENCES

APPENDICES

DEDICATION

Honestly, this research project is purposefully dedicated to God Almighty; the giver of wealth and wisdom and also to my indefatigable Sponsors, Mr. and Mrs. Leonard Ugwuja as well as my entire family members for their fervent prayers, love, support and wishes for me to become a graduate

ACKNOWLEDGEMENT

In the first place, my undiluted thankfulness goes to my heavenly father who made my academic journey a success

With profound gratitude and indebtedness, I acknowledge fully those authors and other researchers whose works and write-ups were cited, either paraphrased or quoted verbatim in the course of writing this project.

Sincerely, with exuberant heart of joy, I am also indebted to my supervisor; MR., DIVINE OBODOECHI for his proficiency, apt corrections, prayers and other of his words of encouragement that made this project work a very unique one. Uncle Divine, may the good Lord bless you.

In a very special way, I wish to acknowledge the uncountable roles my mother; MRS CAROLINE UGWUJA and my immediate elder brother; Solomon Ikenna Ugwuja as well as other members of my family through which God has made me what I am currently.

My profound gratitude also goes to my friends as well as other reserved names that significantly contributed to the success of this study. God bless you all

On the whole, I cannot afford to forget the researcher; my very humble self for the enormous trainings I underwent during the course of this research as well as my ability to learn Deo volente all that my lecturers have taught me and even outside that.

ABSTRACT

The embracement of the International monetary funds’ (IMF) structural adjustment programme (SAP) in 1986 brought the Bretton-Woods system which marked a period of the largest experiment of the pegged exchange rate regimes in the post-world war II era to its knees. Ever since then, there has been a recoded high degree of volatility in the exchange rate of the naira vis-à-vis the US dollars. In this regard, this study seeks to examine other sources of shocks to the exchange rate fluctuations in Nigeria relying on time series data covering the periods 1986-2015. To execute this effectively, the Generalized Autoregressive Conditional Heteroscedasticity (GARCH) model introduced by Tim Bollerslev (1986) was used to decompose these shocks into internal and external sources. Also, the time series properties of the data used were explored and the stationarity conditions of the chosen variables were examined by the help of ADF unit root test under three different test regression equations. However, the GARCH (1 1) volatility forecasting result reveals that volatility shock is present and persistent and concludes that the fluctuations in the Real exchange rate of the naira is responsive to both domestic and international shocks. Consequently, this study recommends that policies be adopted to tame the degree of volatility in exchange rate because of the deleterious effect it could have on foreign transactions. Furthermore, to make the work more enticing and attractive to the readers, we sectionalized this study into Chapters; chapter one for introduction, chapter two for literature review, chapter three for Research methodology, chapter four for the presentation and analysis of empirical findings and chapter five. For the Summary, Policy implications, conclusions and recommendations of the study.

CHAPTER ONE. INTRODUCTION

1.1 BACKGROUND TO THE STUDY

Exchange rate gyration is always perceived to be counter- productive to the goal of price stability. The country whose exchange rate volatility persists would be vulnerable to macroeconomic problems, such as, instability in domestic prices of fully imported goods and goods with high level of import content. When exchange rate volatility occurs in developed nations, it causes instability all over the world (Chege, 2009). The impact of global economy on emerging countries like Nigeria is driven significantly by swings in the currencies of the major economic powers like the United States. For example, when the US dollar was devalued in 1973, the value of the naira depreciated and the depreciation persisted due to the continuous devaluation of the Dollar.

The liberalization of capital flows in developing countries over the last three decades and the enormous increase in the scale and variety of cross-border financial transactions have clearly increased the magnitude of exchange rate variability in most countries with underdeveloped capital markets. Indeed, currency crises in emerging markets which have become more frequent in the last two decades, are especially notable cases of large exchange rate volatility (Carrera and Vuletin, 2003).

Alternatively, most developing nations of the world (especially Nigeria) have been plagued with high real exchange rate volatility which translates into high degree of uncertainty in the attainment of major macroeconomics and monetary policy objectives in the area of price stability and economic growth. Volatile exchange rates are connected with unpredictable movements in the relative prices in the economy. Hence, exchange rate stability is one of the main factors influencing foreign investments (Direct and portfolio), price stability and stable economic growth.

Exchange rate traditionally plays an important role in every country’s monetary policy because of its significant effect on the country’s international trade. Therefore, the central Bank of Nigeria on many episodes in the past had engaged in different exchange rate adjustment policies for the sole aim of achieving the macroeconomic objective of price stability, maintaining the balance of payment position and preserving the external value of the domestic currency. For instance, the exchange rate management policy in Nigeria has passed through four major stages namely: Fixed parity solely with the British pound sterling and the US dollars {1959-1985},but within this period, precisely in 1962,the CBN enacted the Exchange Control Act which vested the Federal Ministry of Finance with the authority to grant approvals for foreign exchange transactions while the CBN handled the private sector transactions through the commercial banks ,the adoption of the second-tier foreign exchange market {SFEM} 1986-1994, introduction of autonomous foreign exchange market {AFEM} 1995-1998, introduction of the inter-bank foreign exchange system {IFEM} and the Dutch auction system {DAS} 2000-2010. The table below exemplifies the various schemes of events in exchange rate management in Nigeria,

EXHIBITT 1.1: PERIODIC ADJUSTMENT IN EXCHANGE RATE MANAGEMENT SYSTEM IN NIGERIA

Abbildung in dieser Leseprobe nicht enthalten

Source: CBN Statistical Bulletin (2006) as cited in Oladapo and Oleyede (2014).

However, in lieu with many industrial economies, greater flexibility of the exchange rate is much needed to allow the real exchange rate to converge easily with its equilibrium level and to contain the real shocks associated with the transition to market economy and the dwindling of oil production which is considered as the major source of external government revenues.

While the exchange rate volatility refers to a condition where a country’s real exchange rate deviates from an unobservable equilibrium, an exchange rate is said to be either overvalued or undervalued if it appreciates or depreciates more than its equilibrium (Aliyu, 2008). Unless, the equilibrium is explicitly specified, the concept of exchange rate volatility remains subjective.

In general, a prolonged and substantial exchange rate volatility can create severe macroeconomic disequilibria. The main intuition behind this is that an increase in exchange rate volatility leads to uncertainty which might negatively impact on trade flows.

As a corollary to the above, more far reaching studies on the shocks that cause volatility in exchange rate in Nigeria (naira) are encouraged because the problem of exchange rate volatility does not exist in isolation but it has tentacles which if left unchecked will result in undesirable multifactorial impacts. Hence, this research seeks to study the external and internal shocks on exchange rate volatility in Nigeria.

1.2 STATEMENT OF THE PROBLEM

Ever since the breakdown of the Bretton – Woods system in 1973, the exchange rates of many countries have been fluctuating considerably overtime, and many countries go to great lengths to manage their exchange rates. Probably the most prominent example is the European monetary Union where all the members abandoned their national currencies and adopted the Euro. A number of developing countries maintain other kinds of regimes of managed exchange rates, even when they face potent market pressures to let their exchange rates float. One of the main motives for these arrangements stems from the extreme volatility of exchange rate. Again, this is largely because the exchange rate is not only an important relative price of one currency in terms of others that connect the domestic and world markets for goods and assets but it also signals the competitiveness of a country’s exchange power with the rest of the world in the international market. Besides, it also serves as an anchor which supports sustainable macroeconomic balances in the long-run.

However, progressive volatility in the exchange rate could stem from the instability of economic fundamentals such as the inflation and interest rates as well as the balance of payments which have become more volatile by themselves. More recently, increase cross-border flows that have been facilitated by the trend towards liberalization of the capital account, the advancement in technology and currency speculation have also caused exchange rate to fluctuate (Hook and Boon 2000). This volatility introduces an element of uncertainty into doing business across borders. Arguably, this uncertainty hinders international trade and therefore, takes a toll in terms of economic welfare.

Strictly speaking, the exchange rate is subject to variations when it is not fixed, thus floating exchange rate tends to be more volatile. Volatility over any period interval tends to increase when supply, demand or both are likely to respond to large random shocks and when the elasticity of both supply and demand is low, volatility tends to be low (Obadaan: 2006).

Surprisingly, even though exchange rates are more volatile in flexible regime, yet, the International Monetary Fund (IMF) still advises the developing nations to allow their exchange rates float. This is largely because regime switching (the type of exchange rates regime) is not the sole factor that causes exchange rates to fluctuate but there are other coefficients responsible for the volatility in exchange rate. Again, to them (IMF) exchange rate flexibility allows for greater integration into the global capitalist economy.

Discerning from the above, we can now formally recognize the two major regimes through which countries could adopt to manage their exchange rate and they are; Fixed or pegged regime and flexible or floating regimes. But, there could also be an amalgam of the two regimes called managed float exchange rate regime or adjustable pegs.

Proponents of Fixed regimes often argued that floating exchange rate increases trade uncertainty and may in fact reduce trade volumes as it exposes businessmen to greater risks on account of fluctuations. Indeed, there is evidence that hard exchange rate pegs promote trade openness and economic integration {Rose: 2000, Frienkel and Rose: 2002}. Apart from gains from trade, Hanker and Schuler {1994} argued that hard exchange rate pegs could improve fiscal institutions thus propelling more sound budget management. Again, studies such as Calvo and Mendora {2000} and Calvo{2001} have pointed that the floating exchange rate regime may allow too much flexibility and discretion to policy makers and may not be able to provide relatively efficient nominal anchor. These notwithstanding, advocates of the flexible exchange rate exclaimed that external risks are rendered benign through adequate systematic hedge and hence having trade flows unaffected. Moreover, Tornell and Velasco {2000} purported that flexible exchange rate actually induces fiscal discipline by allowing the effects of unsound fiscal policies to immediately manifests through movements in exchange rates and price levels.

Nevertheless, the government of developing nations should try as much as possible to maintain stable exchange rate or reduce extreme volatility in their exchange rate while avoiding round tripping- a problem associated with forex rationing in order to prevent economic uncertainty in doing business.

Intuitively, it was based on the arguments in favor of floating exchange rate regime that Nigeria in 1986 adopted the IMF structural adjustment program {SAP} which was an outcome of Washington Consensus that preached for greater opening of the economy through foreign trade liberalization, flexible exchange rates, liberalization of capital account and fiscal discipline .This caused the exchange rate of the Naira to be more volatile from 1986 as against its relative stability in the 1970s. Fig 1.1 below shows the trend in exchange rate of the naira from 1970 to 2015.

Fig:1. 1 The trend in the movement of Nigeria’s exchange rate {1970 Abbildung in dieser Leseprobe nicht enthalten Source’ Author’s Own Work, 2017.

Expectedly, from the fig above, we could directly deduce that exchange rate of the Naira was relatively stable from 1970 to 1985 because the exchange rate of the Naira was still under the fixed parity with the British pound sterling and the US dollars. But, however, it started fluctuating considerably from 1986 which marked the beginning of SAP period in Nigeria. Again, a vivid look at the graph reveals the presence of a drift in the fluctuations of Nigeria’s exchange rate as from the 10th month of 1999 {see fig 1.2 for more clarification}. This poison jump process as seen above was due to a change of exchange rate management policy of the CBN from “autonomous foreign exchange market, AFEM” introduced in 1995 to the adoption of the “interbank foreign exchange market, IFEM” on the 25th of October 1999 designed as a two-way quote system intended to diversify the supply of foreign exchange in the economy by allowing for the Bureau de change to source for their forex requirement from the IFEM with the aim of assisting the naira to achieve a realistic exchange rate. But, owing to the supply-side rigidities, heavy debt service burden, speculative demand driven by uncertainties as well as expectations of future depreciation of naira, the excess liquidity in the system induced by the transfer of government accounts from CBN to banks, and huge prodigal budgetary spending in 1999 on unproductive ventures, the operation of the IFEM was a colossal failure. Conversely, the introduction of Dutch Auction System {DAS} in July 2002 in which both the CBN and authorized foreign exchange dealers participated in the forex market to buy and sell foreign exchange where the CBN was expected to determine the amount of forex it would be willing to sell at the price buyers are willing to buy caused the drift to be outlived and hence assisted in enhancing the relative stability of the naira in comparison with the US dollars from the 2nd quarter of 2002 until the emergence of irrational market exuberance [also see fig 1.2 below}

Notwithstanding, the poison jump or a drift was also felt in the beginning of the last quarter of 2015 due to the imposition of forex rationing in September 2015 which was as a result of huge volume of capital flight experienced within the period. This rationing of the forex sparked off the activities of the local arbitrageurs which precipitated the problem of round tripping.

Fig,1.2: A Panoramic view of exchange rate movement using monthly series Abbildung in dieser Leseprobe nicht enthalten

Source’ Author’s Own Work, 2017.

Apparently, a critical view of the two graphs above would show that under a floating exchange rate regime, any policy alteration would immediately manifest through a drift process in the fluctuations of the exchange rate.

In general, this study seeks to explore other shocks (internal and external shocks) on exchange rate volatility in Nigeria other than regime shifting or policy change.

1.3 THE OBJECTIVES OF THE STUDY

It is not less imperative to state the broad objective of this research having pinpointed the various sources and determinants of exchange rates variations and some of the economic impacts of exchange rate volatility in Nigeria.

The primary objective of this study is to investigate both the internal and external shocks on exchange rate volatility in Nigeria. The specific objective that follows suite is to examine the relative weights or impacts of these shocks on the volatility in Nigeria’s exchange rate. And finally, to recommend policies aimed at reducing the degree of volatility in Nigeria exchange rate.

1.4 RESEARCH QUESTIONS

The questions this research work intends to unzip stem directly from our research objectives. The questions are structured as thus:

1. What are the internal and external shocks/factors that cause volatility in Nigeria exchange rates?
2. Which of these shocks has more bearings to the Nigeria exchange rate volatility?

1.5 RESEARCH HYPOTHESIS.

Based on the statement of the problem and the purpose of study, the following hypothesis was thus formulated;

Ho: Internal shocks are more statistically significant in explaining the volatility in Nigeria exchange rates.
Ho: External shocks are rather more statistically significant in explaining the volatility in Nigeria exchange rate.

1.6 DELIMITATION OF THE STUDY

There was a great transition from fixed exchange rate regime to floating exchange rate regime in Nigeria since the embracement of the international Monetary Fund (IMF) Structural Adjustment Programme in 1986. Ever since then, the exchange rate of Nigerian naira in comparison with the US dollar has been volatile all through different time frame. On account of this, we examine the shocks on exchange rate volatility in Nigeria relying on time series data spanning the period 1986-2015. The variables that will be used in the empirical analysis include, real official exchange rate, money supply, economic growth, capital flight and economic openness (proxied by trade openness). We adopted the time horizon which began from 1986 because it marked the beginning of SAP period in Nigeria.

In general, the variables and the time frame selected for this study are as a result of data availability.

1.7 SIGNIFICANCE OF THE STUDY

It is well-established in the literature that getting the exchange rate right or maintaining relative stability is important for both internal and external balance and consequently growth in the economy.

Empirically, it is not uncommon that exchange rate volatility provokes high costs of commodities for the domestic economy. On account of fluctuations, exchange rate volatility increases trade uncertainty and may, in fact, reduce trade volumes as it exposes importers to greater risks. Nonetheless, exchange rate fluctuations can be internalized by effectively hedging against exchange rate risk through the use of forward exchange rate as a sign of future spot rate.

Since exchange rate volatility induces fiscal discipline, that is, by showing the effects of unsound fiscal policies through movements in exchange rates, the importance of this study to the government cannot be overemphasized.

Again, it is no gainsay that the effectiveness of any country’s international trade policies depends on the magnitude of income and price elasticity of its imports and exports as well as the impact of its exchange rate and volatility of exchange rate on import and export demand. If this is the case, this empirical work on the exchange rate volatility is of immense importance to policy makers for the formulation of trade policies. Inasmuch as this research paper focuses on exchange rate volatility in Nigeria which introduces uncertainty into doing business, this empirical work therefore has a great relevance to the businessmen (importer and exporters and even other domestic sellers) in the country.

In general, the present empirical study is an addition to the existing literature in the developing nations generally and particularly to the Nigeria’s literature. Consequently, our study would be helpful to students, scholars and other researchers as it encourages further researches on the said topic,

CHAPTER TWO. LITERATURE REVIEW

2.1 CONCEPTUAL FABRICS

Keywords: Shocks, Exchange Rate, Volatility and Exchange Rate Volatility.

Denotatively, a shock is a sudden, heavy impact. It is a sudden, upsetting or surprising event, disturbance or experience. Hence, all the factors, both internal or external and favourable or unfavourable that cause a sudden disturbance on some phenomena either positively or pejoratively are referred to as shocks. In this study, external shocks are all exogenous factors that affect a phenomenon. They are made up of disruptions and catastrophe that may be unexpected or expected outside the economy while all the factors causing disturbances on something from within a particular scene are called internal shocks.

Exchange rate is the rate at which one country’s currency exchanges or is sold for another in a forex market. It is the price of a country’s currency expressed in terms of one unit of another country’s currency. In this effect, two forms of exchange rate can be gleaned namely, nominal and real exchange rate. The former is the home- country currency price of a foreign currency. It measures the relative price of two countries’ currencies in a given moment in the foreign exchange market. While the latter is seen as the rate at which two countries’ goods trade against each other (Reinert, 2012, Krugman, Obstfeld, 2007).

Volatility is used to describe the oscillation movements of asset prices. That is, the up and down movement and the degree of changes in the values of securities. In financial econometrics, volatility is the relative rate at which say the price of a security moves up and down and it is derived by calculating the annualized standard deviation of daily changes in price. If the price of a stock moves up and down rapidly over short time period, it has high volatility and low volatility if otherwise. However, a scenario where there is a slow and steady rise of market prices is technically regarded as “Tortoise Rally”.

In general, when exchange rate swings, fluctuates or oscillates like a simple pendulum due to influences or pressures exerted on it by either external factors/shocks [such as, Trade openness, capital flows, oil prices etc.] or internal factors [namely, output growth, money supply, domestic interest rate, government deficit, consumer price and political risks etc.] a situation called exchange rate volatility ensues. Thus, what comes to mind whenever we talk about volatility is usually the movement of a simple pendulum suspended on a spring as shown below;

Abbildung in dieser Leseprobe nicht enthalten

SOURCE; Authors abstraction

Fig.2 1: A skeletal view of Exchange Rate Volatility,

P.E = Potential Energy of the Exchange rate while K.E = the Kinetic Energy.

Where P.E = maximum, Exchange rate is in a state of rest. The Exchange rate swings from one end to another where its P.E is Maximum through the center at which it now has a maximum Kinetic energy that sustains its fluctuations. But the moment exchange rate starts fluctuating due to shocks or regime shift, its P.E disappears and approaches O while its K.E [Kinetic Energy which is energy at motion] reaches maximum. Hence, high volatility occurs at K.E = maximum.

FIG.2 2: FACTORS AFFECTING EXCHANGE RATE GYRATIONS

Abbildung in dieser Leseprobe nicht enthalten

SOURCE: Authors conceptualizations

On the whole, the unexpected movement in Exchange rate is termed Exchange rate volatility [Ozturk, 2006]. It is associated with currency depreciation or appreciation and may have no trend to it [Martson et al, 1988]. Exchange rates are extremely volatile in the short term because they are very responsive to monetary policy, Central Bank intervention policies, and changes in expectations, and are also influenced by relative commodity prices in the long-run (Samuelson and Nordhaus, 2001).

2.2 THEORETICAL LITERATURE

2.2.1 THE THEORIES OF EXCHANGE RATE

The theories of Exchange rate began to flourish in the beginning of 1960s. However, despite their large number and considerable diversity, most of them considered only some selected issues and there are few works carried out in conducting a comprehensive analysis of the factors influencing the exchange rate levels.

The most known theoretical explanation of long- term stability and consistency of bilateral exchange rate is purchasing power parity (PPP) hypothesis. Many monetary models á L á Dornbusch (1986) hinge on the validity of long – run PPP theory while many other macroeconomic models often use PPP to link domestic and foreign development especially in developing countries like Nigeria.

Furthermore, albeit the PPP hypothesis may not be regarded as an explicit exchange rate theory, it may still serve to provide fundamental determinant that can be used to calculate the long- run exchange rates and assess the appropriate level of exchange rates when a long run relationship exists. The modern explanation of the long term exchange rates determination is based upon the theory of purchasing power parity (PPP) between different currencies that derive its essential validity from the law of one/single price. According to the purchasing power parity (PPP) theory, in the long- run, identical products and services in different countries should cost the same. This is based on the principle that exchange rate will adjust to eliminate the arbitrage opportunity of buying cheaper goods or services in one country and selling it at increased prices in another (Boykorayev, 2008). The theory only holds for tradable goods and ignores several real world factors such as tariffs and transaction costs. The other assumption is the existence of competitive markets for the goods and services in all countries.

The relative version of the PPP doctrine avoids some of the weaknesses characteristics of its absolute version and continues to serve as the foundation for the theory of evolution of exchange rates over time.

The short term behavior of exchange rate can be explained by the uncovered interest parity (UIP) condition (Montiel, 2012). The characteristics/features of this approach is regarding currencies basically as assets.

The fundamental importance of the long-term rate of exchange as elucidated by the PPP doctrine with all the attendant qualifications resides within this context in anchoring the current exchange rate in expectations for the future after accounting for the difference in the foreign and domestic interest rates. However, long –run general equilibrium implies that both the PPP conditions and the UIP conditions hold concurrently (Ludkowski, 2007).

In general, the various forms of exchange rate theories can be discussed under the following sub- headings namely;

- The asset approach
- Sterilization
- Exchange rates and the trade balance
- Overshooting exchange rates
- Currency substitution
- The role of news
- Foreign exchange market microstructure

We shall take a cursory discussion of some of these above mentioned theories and/or approaches of exchange rates.

Prior to the monetary approach emphasis of the 1970s it was not uncommon to emphasize international trade flows as primary determinants of exchange rate. This was largely due to the fact that governments maintained tight restrictions on international flows of financial capital. The role of exchange rate changes in eliminating international trade imbalances suggests that we should expect countries with current trade surpluses to have an appreciating currency, whereas countries with trade deficits should have depreciating currencies. Such exchange rate changes would lead to changes in international relative prices that would work to eliminate the trade imbalance.

However, in recent years it has become unequivocal that the world does not work in the simple way described above. For instance, with financial liberalization we have seen that the volume of international trade in financial assets now dwarfs trade in goods and services. Moreover, we have witnessed some instances where countries with trade surpluses have depreciating currencies, whereas countries with trade deficits have appreciating currencies. Economists have responded to such real- world events by devising several alternative views of exchange rate determination. These theories place a much greater emphasis on the role of exchange rate as one of many prices in the worldwide market for financial assets. We shall within this sub section see some of the recent advances in exchange rate theory.

i. THE ASSET APPROACH

Modern exchange rate models emphasize financial- asset markets rather than the traditional view of exchange rate adjusting to equilibrate international trade in goods. The exchange rate is viewed as adjusting to equilibrate international trade in financial assets, because goods prices adjust slowly relative to financial assets prices and financial assets are traded continuously each business day. The shift in emphasis from goods market to assets market has important implication. Exchange rates will change every day or even every minute as supplies of and demands for financial assets of different nations change.

An important consequence of the asset approach is that exchange rates should be much more volatile or variable than goods prices.

Exchange rate models emphasizing financial asset markets typically assume “prefect capital mobility”. Put differently, capital flows freely between nations as there are no significant transaction costs or capital controls to serve as barriers to investment in such a world - covered interest arbitrage will ensure covered interest rate parity. Algebraically,

Abbildung in dieser Leseprobe nicht enthalten

Where “i” is the domestic interest rate and “if,” is the foreign interest rate. Since this relationship will hold continuously, spot and forward exchange rate as well as interest rates adjust instantaneously to changing financial- market conditions.

Within the family of asset approach models, there are two basic groups viz: the monetary approach and the portfolio balance approach. In the monetary approach, the exchange rate for any two currencies is determined by relative money demand and money supply between the two countries. Relative supplies of domestic and foreign bonds are inconsequential.

The portfolio balance approach allows relative bond supplies and demands as well as relative money market conditions to determine the exchange rates.

ii. STERILIZATION

In recent years, an important topic of debate has emerged from the literature on the monetary approach regarding the ability of Central banks to sterilize reserve flows. Sterilization refers to Central banks offsetting international reserve flows to follow an independent monetary policy. Under the monetary approach to the balance of payment (with fixed exchange rates), if a country had an excess supply of money that country would tend to lose international reserves or run a deficit until money supply equals money demand. If, for some reason, the Central bank desires this higher money supply and reacts to the deficit by further increasing the money supply, then the deficit will increase and persist as long as the Central bank tries to maintain a money supply in excess of money demand. For an excess demand for money, the process is reversed, the excess demand results in reserve inflows to equate money supply to money demand, if the central bank tries to decrease the money supply so that the excess demand still exists, its efforts would be thwarted by further reserve inflows persisting as long as the Central bank tries to maintain the policy of a money supply less than money demand. The discussion so far, relates to the standard monetary approach theory with no sterilization.

If sterilization is possible, then the monetary authorities may, in fact be able to determine the money supply in the short run without having reserve flows offset the monetary authorities’ goals. The use of the word sterilization is due to the fact that the Central bank must be able to neutralize or sterilize any reserve flows induced by monetary policy if the policy is to achieve the Central banks’ money supply goals, for instance, if the Central bank is following some money supply growth path and then money demand increases leading to reserve inflows, the Central bank must be able to sterilize these reserve inflows to keep the money supply from rising to what it considers undesirable levels. This is done by decreasing domestic credit by an amount equal to the growth of international reserves, thus keeping base money and the money supply constant.

So far, we have discussed sterilization in the context of floating exchange rates. In turns, let’s examine how a sterilization process might occur in a fixed exchange rate system. Suppose the English pound sterling is appreciating against the dollar and the Bank of England decides to intervene in the foreign exchange market to increase the value of the dollar and stop the pound sterling from appreciating. The Bank of England increases domestic credit in order to purchase US dollar denominated bonds. The increased demand for dollar bonds would mean an increase in the demand for dollars in the forex market. This results in the higher foreign exchange value. Now, suppose the Bank of England has a target level of the English/England money supply that requires the increase in domestic credit to be offset, the Bank of England will sell pound denominated bonds in England to reduce the domestic money supply. The domestic English money supply was originally increased by the increase in domestic credit used to buy dollar bonds. The money supply ultimately returns to its initial level as the Bank of England uses a domestic Open Market Operation (former term for Central Bank purchases and sales of domestic bonds) to influence domestic credit.

In this scenario, the Bank of England uses sterilized intervention to achieve its goal of slowing the appreciation of English pound with no effect on the England money supply.

Sterilized intervention is ultimately an exchange of domestic bonds for foreign bonds.

We may as well question how sterilized intervention could cause a change in the exchange rate if the money supplies are unchanged. It is difficult to explain in terms of a monetary approach model but not in terms of a portfolio balance approach. When the Bank of England buys dollar assets, the supply of dollar asset relative to pound assets available to private market participant is reduced. This should cause the pound to depreciate, an effect that is reinforced by Open-market sale of pound securities by the Bank of England.

Even in a monetary approach setting, it is possible for sterilized intervention with unchanged money supplies to have an effect on the spot exchange rate if money demand changes. The intervention activity could alter the private market view of what to expect in the future. If the intervention changes expectations in a manner that changes the money demand (for e.g. money demand in England falls because the intervention leads people to suspect higher inflation) then the spot rate could change.

iii. EXCHANGE RATE AND TRADE BALANCE

Though we discussed the recent shift in emphasis away from exchange rate models that rely on international trade in goods to exchange rate models based on financial assets, yet, there are still useful roles for trade flows in asset-approach models, since trade flows have implications for financial asset flows.

If balance of trade deficits is financed by depleting domestic stocks of foreign currency, and trade surpluses are associated with increases in domestic holdings of foreign money, we can view the role for the trade account. If the exchange rates adjust so that the stocks of domestic and foreign money are willingly held, then the country with a trade surplus would be accumulating foreign currency. As holdings of foreign money increase relative to domestic money, the relative value of foreign money will fall, or the foreign currency will depreciate. Even though realized trade flows and the attendant changes in currency holdings will determine the current spot exchange rate, the expected future change in the spot rate will be affected by expectations regarding the future balance of trade and its implied currency holdings. An important aspect of this analysis is that changes in the future expected value of a currency can have an immediate impact on current spot rates. The point here is that events that are anticipated to occur in the future have effects on prices today.

We noted that current spot exchange rates are affected by changes in expectations concerning future trade flows. As is often the case in economic phenomena, the short-run effect of some new event determining the balance of trade can differ from the long run result.

The inclusion of the balance of trade as a determinant of exchange rates allows us to reconcile the modern theory of exchange rate determination with accounts in the popular press, which often emphasize the trade account in the explanation of exchange rate behavior. As previously shown, it is possible to make sense of balance of trade flows in a model when the exchange rate is determined by desired and actual financial-asset flows, so that the role of trade flows in exchange rate determination may be consistent with the modern asset approach to the exchange rate.

iv OVERSHOOTING EXCHANGE RATE

We know that purchasing power parity (PPP) does not hold well under flexible exchange rates. Exchange rates exhibit much more volatile behavior than prices do. We might expect that in the short run-following some disturbance to equilibrium, prices will adjust slowly to the new equilibrium levels whereas exchange rates and interest rate will adjust quickly. These different speeds of adjustment to equilibrium allow for some interesting behaviour regarding exchange rates and prices.

At times, it appears that spot exchange rates move too much given some economic disturbances. Also we have observed instances when country ‘‘A’’ has a higher inflation rate than country ‘‘B’’ yet A’s currency appreciates relative to B’s. Such anomalies can be explained in the context of an “overshooting exchange rate models”. As a result of overshooting exchange rate we observe a period where country A has rising prices relative to say prices of country B yet A’s currency appreciates relative to B’s currency. We might explain this period as one in which fixed prices increase lowering real money balances and raising interest rates. Country A experiences capital inflows in response to the higher interest rates so that A’s currency appreciates steadily at the same rate as the interest rate increase to maintain interest rate parity.

v. CURRENCY SUBSTITUTION

Economists have long argued that one of the advantages of flexible exchange rates is that countries become independent in terms of their ability to formulate domestic monetary policy. This is obviously not true when exchange rates are fixed (see Mundell fleming Model for detailed explanation). Also, in the popular concept of unholy trinity, if country ‘A’ must maintain a fixed exchange rate with country ‘B’, then ‘A’ must follow a monetary policy similar to that of ‘B’. Should ‘A’ follow an inflationary monetary policy where prices are rising say 30 percent per year, whereas ‘B’ follows a policy aimed at price stability, then a fixed rate of exchange between the currencies of ‘A’ and ‘B’ will prove very difficult if not abortive to maintain, But, with flexible exchange rates, ‘A’ and ‘B’ can each choose any monetary policy they like and the exchange rate will simply change overtime to adjust for other inflation differentials.

The independence of domestic monetary policy under flexible exchange rates may be reduced if there is an international demand for currencies. Suppose country ‘B’ residents desire to hold currency A for future transactions or as a part of investment portfolio, the money demand shifts from B to A currency and the exchange rate will shift as well. In a region with substitutable currencies, shifts in money demand between currencies will add an additional element of exchange rate variability.

With fixed exchange rates, Central banks make currencies perfect substitutes on the supply side. They alter the supplies of currency to maintain the exchange rate peg. The issue of currency substitution deals with the substitutability among currencies on the demand side of the market. Perfectly, substitutable currencies indicated that demanders are indifferent between the use of one currency and another.

vi. THE ROLE OF NEWS

Considering the theories of exchange rate determination discussed so far, we might believe that with all this knowledge, experts should be quite adept at forecasting future exchange rates. In fact, forecasting future spot exchange rates is difficult. Although researchers have shown the theories we have covered to be relevant in terms of explaining systematic patterns of exchange rate behavior. The usefulness of these theories for predicting futures exchange rates is limited by the propensity for the unexpected to occur. The real world is featured by unpredictable shocks or surprise. When some unexpected event takes place, we refer to this as news. Since interest rates, prices and income are often affected by news, it follows that exchange rates too will be affected by news. By definition, the exchange rate changes linked to news would be unexpected. We find great difficulty in predicting future spot rates because we know that exchange rates will be in part, determined by events that cannot be foreseen.

The news also has implications for Purchasing Power Parity (PPP). Because exchange rates are financial asset prices that respond quickly to new information, news will have an immediate impact on exchange rates. Prices of goods and services, however, will not be affected by news in such a quick manner. The very obvious reason is that goods and services are often contracted for in advance, so that prices are inflexible for the duration of the contract.

It is important to realize that the variability of the exchange rates is as a result of new development. In recent years, research has shown that news regarding unemployment rates has the biggest effect on exchange rates. ‘‘Volatile exchange rates simply reflects turbulent times’’.

viii. FOREIGN EXCHANGE MARKET MICROSTRUCTURE

The determinants of exchange rate as reviewed earlier identify the fundamentals that should cause changes in exchange rates. As news related to money supplies, trade balances, or fiscal policies is received by the market, exchange rates will change to reflect this news. We might construe this description as being macro, as such news affects the entire economy and other prices change along with exchange rates. However, there is also a micro level, at which exchange rates are determined by interactions among traders. Beyond the macro news or public information shared by all, there also exist private information from which some traders know more than others about the current state of the market (a concept known as asymmetric information). Understanding “the market micro structure” allows us to explain the evolution of the foreign exchange market in an intra-daily sense in which foreign exchange traders adjust their bid and ask quotes throughout the business day in the absence of any macro news.

A foreign exchange trader may be motivated to alter his or her exchange quotes in response to changes in their position with respect to orders to buy and sell a currency. For instance, assuming Nonso is a foreign exchange trader at Zenith bank who specializes in the Naira/Dollar market. The bank management controls risks associated with foreign currency trading by limiting the extent to which traders can take a position that would expose the bank to potential loss from unexpected changes in exchange rates. If Nonso has agreed to buy more dollars than he has agreed to sell, he has a long position in the dollar and will profit from dollar appreciation and lose from dollar depreciation. Conversely, if Nonso has agreed to sell more dollars than he has agreed to buy, he has short position in the dollar and will profit from dollar depreciation and lose from dollar appreciation. Thus, Nonso’s position at any point in time may be called his inventory. Traders, however, adjust their quotes in response to inventory changes. At the end of each day most traders balance their position and are said to go home ‘flat’. This means that their orders to buy a currency are just equal to their orders to sell.

[...]

• College: University of Nigeria
• Course: ECONOMICS
• Grade: 2.1
• Author: Ugwuja Chinonso Oliver (Author)
• Publication Year: 2017
• Pages: 90
• Catalog Number: V457704
• ISBN (eBook): 9783668911369
• ISBN (Book): 9783668911376
• Language: English
• Tags: empirical, nigeria, evidence, garch, EXCHANGE RATE, VOLATILITY, GARCH MODELS AND EMPIRICAL ANALYSIS