FOREIGN EXCHANGE-RISK PRICING IN THE NIGERIAN STOCK MARKET
Date
2012-07-22
Authors
AFOLABI, EMMANUEL OLOWOOKERE
Journal Title
Journal ISSN
Volume Title
Publisher
University Of Ibadan
Abstract
Foreign Portfolio Investment (FPI) is a major source of liquidity to domestic firms.
However, foreign exchange-risk makes returns to foreign investors uncertain thereby
discouraging FPI. This uncertainty is more pronounced in developing economies
where exchange rates play key roles and markets for hedging are underdeveloped.
While studies from different economies have shown that firms hedge foreign
exchange-risk or pay a premium to investors who bear it, previous studies on Nigeria
have paid little attention to this important source of risk. A manifestation of this risk
was the exchange rate depreciation from N117.97 per US dollars in 2007 to N132 in
2008 coinciding with an outflow of N633.96 billion from the Nigerian Stock Exchange
(NSE). Therefore, this study analysed the foreign exchange-risk exposure and the
premium (price) paid to risk-averse investors bearing this risk.
The Adler and Dumas international capital asset pricing model was modified to
incorporate the liquidity state of the NSE and this provided the framework for
estimating the Fama and MacBeth two-pass regressions. Employing NSE data on 200
Nigerian firms from January 2000 to December 2009, the first-pass time-series
regressions were used to estimate the risk exposure, while the second-pass pooled
cross-sectional time-series regressions, with corrected standard errors, were used to
estimate the risk prices. The pooled regressions solved the error-in-variable problem
and the loss of the first five years typical of the Fama and MacBeth method.
Deviations from Purchasing Power Parity (PPP) were also computed and used to
complement changes in the bilateral rates and Real Effective Exchange Rate (REER)
that were the conventional measures of foreign exchange-risk. Moreover, empirical
analyses were broken down by firm-size, sector and episodes of exchange rate
changes.
More than 80.0% of Nigerian firms were exposed to bilateral exchange rate risk; over
60.0% to PPP-deviation risk and about 12.0% to REER risk. Foreign exchange-risk
exposure was mostly negative; implying that Nigerian firms were net importers. Thus,
because firms were unable to hedge their exposure to foreign exchange risk, their
average monthly values reduced by 1.67% as a result of exchange rate depreciation.
Foreign exchange-risk exposure was higher generally in larger firms and particularly
in financial firms and there was the tendency for more firms to be exposed during
episodes of naira depreciation. Further, foreign exchange-risk was priced
(undiversifiable) on the NSE as risk-averse investors demanded a monthly premium of
1.65% on the bilateral rate risk, 0.99% on the PPP-deviation risk and 0.23% on the
REER risk. Exposure to the bilateral exchange rate risk, the PPP-deviation risk and
REER risk therefore raised the annual cost of capital of Nigerian firms by 19.80%,
11.88% and 2.76% respectively.
The widespread foreign exchange-risk exposure commanded a risk premium on the
Nigerian stock market. Therefore, the regulatory authorities should recognise that
firms‘ costs of capital tend to rise as Nigeria‘s exchange rate system becomes more
market-determined and should design appropriate instruments for hedging. Nigerian
firms also need to actively manage their exposure to foreign exchange-risk.
Description
Keywords
Asset pricing, , Cost of capital, , Foreign exchange-risk exposure, , Liquidity, , Pooled regressions