Global Financial Crisis and Nigerian Stock Market Volatility

GLOBAL FINANCIAL CRISIS AND NIGERIAN STOCK MARKET VOLATILITY Abdul ADAMU Department of Business Administration, Nasarawa State University, Keffi – Nasarawa State. [email protected] com [email protected] com Tel. +2348029445391, +2348064851648. Paper presented at the National Conference on “Managing the challenges of Global Financial Crisis in Developing Economies” organised by the Faculty of Administration,

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Nasarawa State University, Keffi, Nasarawa State – Nigeria held between March 9 – 11, 2010. Abstract

The current global financial crisis is no longer news but a reality. Our policy makers in the country have been proven wrong based on their argument that the country was insulated. Some of the sectors that have felt the heat of the crisis are the banking sector and the stock market. In the stock market, investors lost trillions of naira due the downward fall in the prices of stock. Based on this, the study assesses the extent of the stock market volatility in the period preceding the crisis and the period of the crisis.

Using the All Share Index, the returns for various months were computed, descriptive statistics of the returns was calculated and the volatility of the market was estimated using the standard deviation. It was found that the stock market is highly volatile in the period of the financial crisis than the period preceding it. The recommendation is that the depth of instruments in the stock market should be varied in terms of fixed securities than equity instruments. Introduction The global economic crisis, which first emerged as a financial crisis in one country, has now fully installed itself with no bottom yet in sight.

The world economy is in a deep recession, and the danger of falling into a deflationary trap cannot be dismissed for many important countries (UNCTAD, 2009). The recent global economic crisis was a result of economic and political events in the United States. What started with amended federal policy and poor mortgage lending practices, resulted in a world-wide economic meltdown that spread like a virus (Beck, 2008). The US sub-prime mortgage market triggered the crisis as a result of credit crunch within this market.

Most countries around the world have approached this

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‘tsunami’ pragmatically with emergency funding support for relevant sectors, so as to mitigate the impact of the crisis on economies as well as avoiding the entire collapse of the international financial system (Ajakaiye & Fakiyesi, 2009). Despite these supports by various governments in the form bailout, it does not stop some countries to go into recession, because of large decline in their wealth, manifesting itself in falling productive capacity, growth, employment and welfare.

At first, the direct impact of the financial crisis on the African economies was limited as African countries has weak integration with the global economy and most commercial banks in the region refrained from investing in the troubled assets from the US and other part of the world (Adamu, 2008). This is why most commentators argue that Africa is so far insulated from the direct effects of the financial crisis at least in the short-run. But now, this is not the case as the rate of unemployment and liquidity squeeze is becoming unbearable.

In Nigeria, like other African developing countries, the initial response to the crisis was rather meek, as if our policy makers do not understand the gravity of the crisis. While the developed countries were busy trying to bailout their economy in order to mitigate the effects of the crisis, our leaders were hiding under the shadow of insulation. The most visible sector being hit by this crisis in the Nigerian economy is the capital market.

The Nigerian Stock Exchange, the flagship of Nigeria’s capital market has witnessed unprecedented turbulence since April, 2008. First, the downward slide of the stocks on the market dominated by the banking sector made experts restive and regulatory authorities jittery. While accusing fingers were being pointed at different directions as the cause of this volatility in the prices of stocks, the market began a free-fall never witnessed in the history of capital market operations in Nigeria.

Both local and foreign investors who had taken advantage of the optimal return on investments on the stock exchange began to scamper elsewhere in desperation. Some of the questions that are critical to this trend in the capital market are; what is the extent of the stock price volatility on the Nigerian Stock Exchange? What are the factors that impacted the stock price volatility? To what extent has this volatility in stock price affected investors?

What can the regulatory authority do to contain this problem? This paper will address the first question raised above. This part is the introduction and the rest of the paper is arranged as follows; section two discussed the concept of financial crisis, the Nigerian capital market and the crisis, then stock market volatility. In section three, we discuss data and methodology, then results and discussions in section four and finally, summary and conclusions in section five. The concept of financial crisis

The term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults (Kindleberger & Aliber, 2005, Laeven & Valencia, 2008).

Some economic theories that explained financial crises includes the World systems theory which explained the dangers and perils, which leading industrial nations will be facing (and are now facing) at the end of the long economic cycle, which began after the oil crisis of 1973. While Coordination games, a mathematical approach to modelling financial crises have emphasized that there is often positive feedback between market participants’ decisions (Krugman, 2008).

Positive feedback implies that there may be dramatic changes in asset values in response to small changes in economic fundamentals, Minsky’s theorised that financial fragility is a typical feature of any capitalist economy and financial fragility levels move together with the business cycle, but the Herding and Learning models explained that asset purchases by a few agents encourage others to buy too, not because the true value of the asset increases when many buy (which is called “strategic omplementarity”), but because investors come to believe the true asset value is high when they observe others buying (Avery & Zemsky, 1998, Chari and Kehoe, 2004, Cipriani & Guarino, 2008). The Nigerian Capital Market and the Crisis The All Share Index and the market capitalisation of the 233 listed equities capture activities and performance on the Nigerian Stock Exchange (NSE). Before the crisis, there has been a consistent growth in these performance indicators over the year (see fig. 1).

For instance, the All Share Index according to data from www. cashcraft. com grow from a value of 12,137 in 2002 to 66,371. 2 points on March 5, 2008, with a market capitalisation of about N12. 640 trillion, after which values fell to 20,827. 17 points on December 31, 2009, with a market capitalisation of 4. 989 trillion because of the meltdown. This shows that by the end of the year 2009, the All Share Index had lost a total share of about 69%, while market capitalisation had lost 61% of its value.

There are concerns regarding how rapidly the global financial crisis affected the Nigerian Capital Market, especially given that there is virtually no cross-ownership of banks (investment or otherwise) between Nigeria and foreign countries, and there is hardly any domestic mortgage market for there to be a sub-prime problem as found particularly in the UK and the USA (Aluko, 2008; Ajakaiye & Fakiyesi, 2009). The decline of indicators of activities on the NSE before the escalation of the crisis on the global scene in July 2008 became a source of concern for many.

It is difficult to attribute this decline to any particular factor, but those factors that may have direct or indirect impact are as follows; i. Foreign portfolio investments withdrawals and reduced foreign direct investment affect investor confidence in Nigeria (Adamu, 2008; Aluko, 2008; and Ajakaiye & Fakiyesi, 2009). This is the case because most foreigners withhold their investments in order to service their financial problems at home.

This exposed the country to FDI uncertainties and vagaries, particularly in an era where public-private partnership (PPP) of huge investment plans such as oil and gas – LNG projects, power plants, railways, housing and roads are being encouraged. ii. Another factor which according to Ajakaiye & Fakiyesi (2009) that had serious impact on the stock market is what they called the ‘intensifiers’. These include policy interpretations by the market, which may have been induced by the slow government initial stand on the economy. This also includes interpretation of announcements, proclamations and rumours by the market.

Examples include the proposed recapitalisation plan of the stock market players (stock broking firms), as well as rumours on the termination of margin lending by banks. iii. The phenomenon of marginal lending in Nigeria, whereby investors borrow money from banks to invest in other financial instruments like IPOs of banks with the hope of making quick returns. This may also be termed Nigeria’s own version of the ‘sub-prime problem’, as it resulted in an exploding domestic stock market and stock prices and astounding returns to both the speculators and providers of the margin funds.

This make the banks to feel the heat of the crisis as most margin loans become difficult to repay due to the downward trend in the market. iv. With the currency overdependence on oil revenue, the downward trend in the price of crude oil and prospects for economic recession in the developed world and Europe which are the markets for the oil, also contributed for the fall in the stock market. Because it look as if Nigeria’s capital market bear cycle actually began with the decline of oil prices in July, and accelerated with its further decline in September and October (Aluko, 2008; Ajakaiye & Fakaiye, 2009).

Stock Market Volatility Stock volatility refers to the potential for a given stock to experience a drastic decrease or increase in value within a predetermined period of time. Investors evaluate the volatility of stock before making a decision to purchase a new stock offering, buy additional shares of a stock already in the portfolio, or sell stock currently in the possession of the investor. In recent months, it has not been unusual to see the value of major stock indexes, such as the S 500, NIKKEI, DOW JONES, KOSPI, FTSE, and our own NSE-ASI change by as much as 3% in a single day.

Unfortunately for many investors, the general direction of those changes has been downward. To many, this volatility is driven by the recent global financial crisis. Stock market volatility tends to be persistent; that is, periods of high volatility as well as low volatility tend to last for months. In particular, periods of high volatility tend to occur when stock prices are falling and during recessions. Stock market volatility also is positively related to volatility in economic variables, such as inflation, industrial production, and debt levels in the corporate sector (Schwert, 1989).

The persistence in volatility is not surprising: stock market volatility should depend on the overall health of the economy, and real economic variables themselves tend to display persistence. The persistence of stock market return volatility has two interesting implications. First, volatility is a proxy for investment risk. Persistence in volatility implies that the risk and return trade-off changes in a predictable way over the business cycle. Second, the persistence in volatility can be used to predict future economic variables.

For example, Campbell, Lettau, Malkiel, and Xu (2001) show that stock market volatility helps to predict GDP growth. Volatility may impair the smooth functioning of the financial system and adversely affect economic performance (Mala & Reddy, 2007). Similarly, stock market volatility also has a number of negative implications. One of the ways in which it affects the economy is through its effect on consumer spending (Campbell, 1996; Starr-McCluer, 1998; Ludvigson & Steindel, 1999; and Poterba, 2000).

The impact of stock market volatility on consumer spending is related via the wealth effect. Increased wealth will drive up consumer spending. However, a fall in stock market will weaken consumer confidence and thus drive down consumer spending. Stock market volatility may also affect business investment (Zuliu, 1995) and economic growth directly (Levine & Zervos, 1996; and Arestis, Demetriades, & Luintel, 2001). A rise in stock market volatility can be interpreted as a rise in risk of equity investment and thus a shift of funds to less risky assets.

This move could lead to a rise in cost of funds to firms and thus new firms might bear this effect as investors will turn to purchase of stock in larger, well known firms. While there is a general consensus on what constitutes stock market volatility and, to a lesser extent, on how to measure it, there is far less agreement on the causes of changes in stock market volatility. Some economists see the causes of volatility in the arrival of new, unanticipated information that alters expected returns on a stock (Engle, 1982).

Thus, changes in market volatility would merely reflect changes in the local or global economic environment. Others claim that volatility is caused mainly by changes in trading volume, practices or patterns, which in turn are driven by factors such as modifications in macroeconomic policies, shifts in investor tolerance of risk and increased uncertainty. The degree of stock market volatility can help forecasters predict the path of an economy’s growth and the structure of volatility can imply that “investors now need to hold more stocks in their portfolio to achieve diversification”(Krainer, 2002).

Data and Methodology This research relies on the daily All Share Index (ASI) of the Nigerian Stock Exchange as reported by the exchange and on Cashcraft database. There are 233 listed companies on the Nigerian Stock Exchange and the ASI is the major index that captures the performance of all the shares of the listed companies. Using the ASI, the monthly returns (%) were calculated using the formula below; Where Vf is the ASI at the end of the month, and Vi is the ASI at the beginning of the month. These returns were calculated for all the 48 months used in this study.

We measure volatility using the standard deviation and/or variance. This is done by dividing the period under study into two. The first period comprises of 24 months observation for 2006 and 2007, the period prior to the crisis and the second 24 observations were for 2008 and 2009, the period of the crisis. In examining volatility changes over time, we compare the variances or standard deviations of the different periods and determine if they are statistically significantly different from each other. To estimate volatility, the expected returns or mean for these periods returns were computed using the equation;

This implies that is the average of the return values. Using this value for and the variance estimate results in a formula for the volatility is given as; . It follows that the estimation of the volatility constant given by Wilmott, Howison and Dewynne (1995) is: Lastly, the expected returns and the standard deviations will be used in testing the hypothesis whether there is a significant difference between the means of the two observation using t – statistic for testing difference of two means. Results and Discussions Table 1 shows the descriptive statistics of the monthly returns for the two periods.

For the period 2006 – 2007, the average return was 3. 42% with a standard deviation of 5. 37%. This is showing that during this period, stock market returns was less volatile because a less volatile stock will have a price/return that will deviate relatively from the mean little over time. This is the period when investors have consistent positive returns on their investment and there are willing to invest because stock returns are less volatile and their exposure to risk is less. Table 1. Descriptive Statistics RETURNS %2006-072008-09 Mean3. 4233 -4. 3658 Standard Error1. 09552. 5003 Median3. 550-4. 8400 ModeN/AN/A Standard Deviation5. 367012. 2489 Sample Variance28. 8050150. 0365 Kurtosis0. 67236. 3865 Skewness0. 39191. 4372 Range24. 6669. 15 Minimum-7. 44-30. 95 Maximum17. 2238. 2 Sum82. 16-104. 78 Count2424 Source; excel output On the other hand, during the period 2008 – 2009, there was a negative average return of –4. 37% with a standard deviation of 12. 25% showing high volatility in returns. This is as a result of the accelerated downward fall of the stock prices on the Nigerian Stock Exchange as a result of loss of investors’ confidence due to the global financial crisis.

This period is characterised by negative returns which results to high volatility, and as we can see, the more volatile that a stock is, the harder it is to isolate where it could be on a future date. Since volatility is associated with risk, the more volatile that a stock is, the more risky it is. Consequently, the more risky a stock is, the harder it is to say with any certainty what the future price of the stock will be. When people invest, they would like to have no risk. The least amount of risk that is involved, the better the investment is.

Since almost every investment has some risk, investors have looked for ways to minimize risk, so their best reaction was to avoid the stock market and this affected the market. The other descriptive statistics showed that both distributions are positive or right – skewed, meaning that most of the returns are in the lower portion of the distribution and there are some returns that has extremely large values and this pull the mean return upward to be greater than the median, specifically for the second period. Both has a positive kurtosis value of 0. 6723 and 6. 865 indicates a distribution with a sharper peak than a bell – shaped curves. The result of the test for the hypothesis to determine whether there is a significant difference between the means of the two observations is presented in table 2 below. The hypothesis is; Ho: µ1 = µ2 i. e. there is no difference in the means of the two observations H1: µ1 ? µ2 i. e. there is difference in the means of the two observations. From the result of the t- test, the null hypothesis is rejected at 5% level of significance. This is because t = 2. 85 ; t = 2. 01. the p – value computed is 0. 064 and it indicates that if the means are equal, the probability of observing a difference this large in the sample means is only 0. 0064. Based on this, there is sufficient evidence to conclude that the mean returns are different for the two periods, and that returns are lower in the period of the crisis than the period before it. This confirms the reason why there is higher volatility in this period than the other period. Table 2. t – Test for differences in Two means (assumes equal population variances) Data Hypothesized Difference0 Level of Significance0. 05 Population 1 Sample Sample Size24 Sample Mean3. 233 Sample Standard Deviation5. 367 Population 2 Sample Sample Size24 Sample Mean-4. 3658 Sample Standard Deviation12. 2489 Intermediate Calculations Population 1 Sample Degrees of Freedom23 Population 2 Sample Degrees of Freedom23 Total Degrees of Freedom46 Pooled Variance89. 42012 Difference in Sample Means7. 7891 t Test Statistic2. 853384 Two-Tail Test Lower Critical Value-2. 012896 Upper Critical Value2. 012896 p-Value0. 006463 Reject the null hypothesis Source; Excel output Conclusion and recommendations The paper studied the extent of the stock market volatility in the period of 2006 – 2009.

The period is divided into 24 months each to study the volatility of market returns between 2006 – 2007, and between 2008 – 2009. On the basis of the results it was found that the period 2006 – 2007 is less volatile than the period of 2008 – 2009; and this is due to the global financial that have affected investors’ confidence. Since volatility is associated with risk, the more volatile that a stock is, the more risky it is. Consequently, the more risky a stock is, the harder it is to say with any certainty what the future price of the stock will be. When people invest, they would like to have no risk.

The least amount of risk that is involved, the better the investment is. Since almost every investment has some risk, investors have looked for ways to minimize risk, so their best reaction was to avoid the stock market and this affected the market. The recommendation is that the stock market instruments need to be diversified away form equity instruments to more of fixed security instruments. References Adamu, A. (2008). The Effects of global financial crisis on Nigerian Economy. International Journal of Investment and Finance Vol. 1. #1&2. Ajakaiye, O. & Fakiyesi, T. (2009). Global financial crisis Discussion paper 8: Nigeria.

Oversea Development Institute, London. Aluko, M. (2008). The global financial meltdown: Impact on Nigeria’s capital market and foreign reserves. retrieved from www. google. com on 14 January, 2010. Arestis, P. , Demetriades, P. O. & Luintel, K. B. (2001). Financial development and economic growth: The role of stock markets. Journal of Money, Credit and Banking, 33(2):16-41. Avery, C. , & Zemsky, P. (1998). Multidimensional uncertainty and herd behavior in financial markets. American Economic Review 88, pp. 724-748. Campbell, J. (1996). Consumption and the stock market: Interpreting international experience.

NBER Working Paper, 5610. Campbell, J. , Lettau, M. , Malkiel, B. , & Xu, Y. (2001). Have individual stocks become more volatile? An empirical exploration of idiosyncratic risk. Journal of Finance 56, pp. 1–43. Chari, V. , & Kehoe, P. (2004). Financial crises as herds: overturning the critiques. Journal of Economic Theory 119, pp. 128-150. Cipriani, M. , & Guarino, A. (2008). Herd behavior and contagion in financial markets. The B. E. Journal of Theoretical Economics 8(1) (Contributions), Article 24, pp. 1-54. Engle, R. F. (1982). Autoregressive conditional heteroscadasticity with estimates of the variance of the U. K. inflation.

Econometrica, 50(3):987-1008. Kinder, C. (2002). Estimating Stock Volatility. retrievd from www. google. com on 19 January, 2010. Kindleberger, C. P. , & Aliber, R. (2005). Manias, Panics, and Crashes: A History of Financial Crises (5th ed). Wiley, ISBN 0471467146. Krainer, J. (2002). Stock market volatility. FRBSF Economic Letter, Western Banking, 2002-32, pp1-4. Krugman, P. (2008, October, 27). The widening gyre. New York Times. Laeven, L. , & Valencia, F. (2008). Systemic banking crises: A new database. International Monetary Fund Working Paper 08/224. Levine, R & S. Zervos (1996). Stock market development and long-run growth.

World Bank Economic Review, 10(1):323-339. Ludvigson, S & C. Steindel (1999). How important is the stock market effect on consumption. Federal Reserve Bank of New York Economic Policy Review, 5(1):29-51. Mala, R, & Reddy, M. (2007). Measuring stock market volatility in an emerging economy. International Research Journal of Finance and Economics Issue 8 126-133. Poterba, J. M. (2000). Stock market wealth and consumption”, Journal of Economic Perspectives, 14(2):99-118. Schwert, W. (1989). Why does stock market volatility change over time? Journal of Finance 44, pp. 1,115–1,153. Starr-McCluer, M. (1998).

Stock market wealth and consumer spending. Board of Governors of the Federal Reserve System, Finance and Economics Discussion Paper Series, 8/20. UNCTAD (2009). Global economic meltdown. Geneva: United Nation Conference on Trade and development Wilmott, P. , Howison, S. , & Dewynne, J. (1995). The Mathematics of Financial Derivatives. New York: Cambridge University Press. Zuliu, H (1995). Stock market volatility and corporate investment”, IMF Working Paper, 95/102. www. cashcraft. com Appendices 1. Monthly returns computed using the NSE-ASI MONTHS/ YEARSRETURNS %MONTHS/ YEARSRETURNS % Jan-06-1. 69Jan-08-0. 02 Feb-060. 30Feb-08-11. 1 Mar-06-2. 00Mar-08-4. 01 Apr-06-0. 75Apr-08-5. 67 May-065. 45May-08-0. 33 Jun-065. 66Jun-080. 00 Jul-066. 75Jul-08-6. 90 Aug-0617. 22Aug-08-9. 22 Sep-060. 67Sep-08-6. 07 Oct-060. 35Oct-08-20. 96 Nov-06-3. 84Nov-08-9. 08 Dec-064. 92Dec-08-2. 37 Jan-078. 93Jan-09-30. 95 Feb-0710. 62Feb-097. 17 Mar-074. 87Mar-09-12. 60 Apr-078. 44Apr-098. 15 May-075. 95May-0938. 20 Jun-072. 44Jun-09-12. 63 Jul-070. 94Jul-09-7. 09 Aug-07-7. 44Aug-09-10. 42 Sep-07-0. 12Sep-09-2. 2 Oct-07-0. 16Oct-09-3. 08 Nov-077. 82Nov-09-3. 64 Dec-076. 83Dec-090. 05 Figure 1. Stock market performance, 2002-2009 Source: Extracted from Ajakaiye and Fakiyesi (2009)

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