Impact of the Volatility of Macroeconomic Variables on the Volatility of Stock Market Returns: Nigeria’s Experience

Introduction

In last three decades many studies have examined associations between macroeconomic variables and stock returns. These studies include; Fama (1981, 1990), Geske and Roll (1983), and Chen, Roll, and Ross (1986). However, most of these studies focused on developed markets by using the Autoregressive Conditional Heteroscedasticity (ARCH) model and the Generalized ARCH (GARCH) model. For instance, Schwert (1989) and, Flannery and Protopapadakis (2002) tested the effect of domestic macroeconomic variables on stock volatility for the United States. They found weak evidence that such factors could predict stock market returns which are inherently volatile. With these studies, it becomes obvious that a clear understanding of stock market determinants is very important for investors, regulators, policy makers and, academic researchers.

With regard to the Nigerian economy, the few empirical evidences that exist produce mixed results. Maku and Atanda (2009), Adaramola(2011), Arodoye(2012) and, Osamwonyi and Evbayiro-Osagie(2012) in their respective studies observed that the Nigerian Stock returns are more responsive to changes in macroeconomic variables . Also, Soyode (1993) and, Olowe (2007) show that a cointegrating relationship exists between macroeconomic variables and Nigerian stock prices. However, Asaolu and Ogunmuyiwa (2011) and, Izedonmi and Abdullahi(2011) reveal that a weak relationship exists between Stock price and macroeconomic variables in Nigeria. It is worthy of note, that all previous studies in Nigeria do not take cognizance of the time varying of financial data.. In view of this, the question still remains. Do macroeconomic indicators exert shock on stock returns? It is in an attempt to answer this question that the study aims at using GARCH-X Model as proposed by Lee(1994) to examine the relationship between the macroeconomic variable volatility and the volatility of Nigeria stock market returns. This differs in methodology in terms of other studies carried out in Nigeria. The reason for this methodological change is to take care of volatility clustering, leptokurtosis, and the assumption of homoscedasticity that characterize financial time series, such as stock market returns. This is designed to account for a time-varying variance that usually is associated with high frequency financial and economic data. Therefore, ordinary least square models are not adequate to analyze data that exhibit variances that change through time (Rachev et al., 2007) as done by previous studies in Nigeria.

This paper extends the previous research by investigating the reaction of stock returns volatility to short run deviation of the long run equilibrium of cointegrated series(i.e. short-run deviations between stock returns and a set of macroeconomic variables) within the framework of a Generalized Autoregressive Conditional Heteroscedasticity (GARCH) model. Specifically, the paper seeks to investigate the contemporaneous effects of changes in the volatility of the short run deviation on the long run equilibrium of cointegrated macroeconomic variables on volatility of stock market returns in Nigeria. That is, to examine whether macroeconomic factors collectively contribute to the dynamics of the Nigeria’s stock market. This study is inspired by the works of Shiller (1981) and, Hansen and Jagannathan (1991), which revealed that the volatility of real activity should be related to stock market volatility.