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CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND TO THE STUDY

All economies paying serious attention to the issues of economic growth and

development have also been found paying such serious attention to the issues surrounding the

various components of national output (such as household consumption, investment by firms,

government expenditure, exports and imports). Investment appears to be the major

contributor to the national output. As such investment performance goes a long way in

defining the growth pace of any economy and consequently the rate and level of development

in such economies. However, investment is dependent on a number of factors, one of which

is exchange rate (which

is one of the most volatile variables in economic analysis).

Investment is the process of adding to capital (Arena et al, 2006 in Ogbanje et

al, 2010). Investment is seen as a major removal of the vicious circle of poverty in any

country with its ability to boost the production capacity and a key factor in economic growth.

Based on empirical studies, there is no doubt that a positive relationship exist between

investment rates and growth rates. Based on UNCTAD’s report (1999 in Prasanna, 2010),

countries that devote greater proportion of output and savings to investment may have a

sustainable rapid growth than countries with lesser investment. One key aspect of investment

to note is the one referred to as foreign direct investment. Foreign direct investment, which is

a major component of international capital flows refers to investment by multinational

companies with headquarters in developed countries. As a result of short ability of

developing countries to finance their domestic investment by domestic savings because their
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level of poverty, difficulty to contribute towards high investment emerged. This brought

about the embrace of foreign direct investment to bring relief by creating inflow of foreign

capital for high investment. The inflows of foreign direct investment have increased to a large

extent over the years in the world. This is because countries, especially developing countries,

embrace foreign direct investment as a crucial catalyst for economic development. Therefore,

countries begin to improve their business climate to attract and entice more foreign direct

investment and Nigeria is not an exception. In fact, acceleration of foreign direct investment

inflow to regions is the major objective for the establishment and launching of New

Partnership for Africa’s Development (NEPAD) (Adams, 2009 in Eregha, 2011). According

to World Bank (1996) in Saintuc (2011) “Foreign direct investment is seen as an investment

made to acquire a long and lasting management interest (normally 10% of voting stock) in a

business enterprise operating in a country other than that of the investors.” Therefore,

policymakers believe that foreign direct investment produces positive effects on host

countries by bridging the capital storage gap and complementing domestic investment. This

is why successive government in Nigeria has continued policies thought to encourage foreign

direct investment inflow to augment domestic savings and boost investment in the economy.

Foreign direct investment has been prominent mostly in the mining and quarrying, transport

and telecommunication, trading and agricultural areas of the economy.

Recent evidence points out that African region is largely marginalizing in the area of

financial globalization (Ogunleye, 2009) but their attraction of foreign direct investment

inflow is still considerably low compared to other developing economies like China.

Although foreign direct investment could be seen as an impetus to growth but can vary in

respect to the reigning exchange rate. According to (Omankhanlen, 2009) foreign exchange

rate has great effect on the inflow of FDI into the Nigerian economy. Therefore, some studies

like Egwaikhide et al (2005) and Ogunleye (2009) demonstrated the inflow of foreign direct
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investment to Africa as volatile. This has also presented domestic investment as being very

volatile.

This recent wave of private capital inflows could result in the realization of some of

the favorable side effects of foreign capital in these countries. One of these effects has been

referred to as ‘the real exchange rate problem’ i.e. the possibility that capital inflows give rise

to appreciation of the real exchange rate with adverse consequence for traded goods

production in the domestic economy. The need then arises to look into the effects of

exchange rate volatility on investment performance particularly in the Nigerian economy.

1.2 STATEMENT OF THE PROBLEM

The relationship that exists between exchange rate volatility and investment to

determine their effects on growth and development of countries has become one of the most

debated issues in the empirical literature. As a result of the importance of this issue, many

scholars’ attention has been attracted to the issue over the past half-century. Although

theoretical arguments conclude that the share of total investment located abroad may rise as

exchange rate volatility increases, this does not imply that exchange rate volatility depresses

domestic investment activity. In order to conclude that domestic aggregate investment

declines, one must show that the increase in domestic outflows is not offset by a rise in

foreign inflows. In the aggregate United States economy, exchange rate volatility has not had

a large contractionary effect on overall investment (Goldberg 1993).

The empirical evidence obtained from the extensive studies has been more of one-sided.

Many scholars concluded that foreign investment substitute domestic investment while very

few see foreign direct investment as a complement to domestic investment. They all acclaim

that the result vary from country to country (Apergis et al, 2006) especially in most

developing countries where domestic investment is seen as inferior to foreign ones.


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Therefore, there has not been a concrete consensus on this issue. Aminu et al (2013)

investigate the impact of exchange rate volatility on export in Nigeria. The study employes

three models, viz: Ordinary Least Square (OLS); Granger causality test; and ARCH and

GARCH techniques and also Augmented Dickey-Fuller technique was used in testing the

presence of unit root. The results of unit root suggested that all the variables in the model are

stationary at first difference, while causality test revealed that there is causation between

export and exchange rate in the country, but the causation flows from exchange rate to

export. Thus, exchange rate causes export. Furthermore, ARCH and GARCH results

suggested that the exchange rate is volatile nevertheless export is found to be non-volatile.

The study further showed that exchange rate is impacting positively on export, as shown by

the regression results. The elasticity results revealed that, the demand for Nigerian products

in the World market is fairly elastic. Bakare (2011) carried out an empirical analysis of the

consequences of the foreign exchange rate reforms on the performances of private domestic

investment in Nigeria. He employed the ordinary least square multiple regression analytical

method for the data analysis. Some statistical tools were employed to test the statistical

significance of the variables. The analysis started with the test of stationarity and co-

integration of Nigeria’s time series data. The empirical study found that the data were

stationary and co integrated. The multiple regression results showed a significant but negative

relationship between floating foreign exchange rate and private domestic investment in

Nigeria. These results were robust to a number of econometric specifications.

As FDI is a capital investment, we may also consider studies examining the impact on

investment. Darby et al (1999) use a threshold model and find a negative long run

relationship between exchange rate volatility and investment in France, Germany, and the

US; and a negative short run relationship with investment in the UK and Italy. Bryne and

Davis (2003) find that a sustained 10% increase in the monthly volatility of the real effective
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exchange rate lowers the total volume of investment by 1.5%. According to Aizenman(1993)

It is shown that a fixed exchange rate regime is more conducive to FDI relative to a flexible

exchange rate, and this conclusion applies for both real and nominal shocks. The correlation

between investment and exchange rate volatility under a flexible exchange rate is shown to

depend on the nature of the shocks. If the dominant shocks are nominal, we will observe a

negative correlation, whereas if the dominant shocks are real, we will observe a positive

correlation between exchange rate volatility and the level of investment.

Also, Panel and cross-sectional data have been used in previous studies which likely

suffer stationarity, data comparability and heterogeneity problem (Atkinson et al, 2001) and

so this study will use pure time series to overcome this problem. This will help avoid

generalizing the results of region on Nigeria as previous study had done. Though works had

been done to determine the effect of foreign direct investment, domestic investment and

exchange rate but there is no recent work yet considering the frequent changes in exchange

rate with foreign direct investment and domestic investment on economic growth. Based on

this, the study intend to add to foreign direct investment- Domestic investment research by

empirically examining the issue in Nigeria unlike most previous studies that concluded based

on deduction from developing countries, Sub-Sahara and West Africa result point. This study

receives more relevance at a time like this when the Nigerian economy is faced with diverse

investment challenges and in turn growth and development problems. In order to put this

study in a better perspective, the following research questions shall be answered

The following basic questions will be answered by this research project:

1. What interaction exists between exchange rate volatility and investment performance

in the Nigerian economy?


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2. What are the effects of exchange rate volatility on investment performance in the

Nigerian economy?

3. What are the implications of the effects of exchange rate volatility on investment

performance in the Nigerian economy?

1.3 OBJECTIVES OF THE STUDY

The general objective of this research work is to critically examine the affects of

exchange rate volatility on investment performance in Nigerian economy.

To this end, the following specific objectives are obtained:

1. To examine the interaction that exists between exchange rate volatility and investment

performance in the Nigerian economy

2. To critically examine and analyse the effects of exchange rate volatility on investment

performance in the Nigerian economy

3. To critically assess the possible implications of the effects of exchange rate volatility

on investment performance in the Nigerian economy

1.4 STATEMENT OF HYPOTHESIS

The following hypothesis shall be tested in the course of the study:

Ho: There is no interaction between exchange rate volatility and investment performance in

the Nigerian economy

H1: There is interaction between exchange rate volatility and investment performance in the

Nigerian economy
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Ho: Exchange rate volatility has no significant effects on investment performance in the

Nigerian economy

H1: Exchange rate volatility has significant effects on investment performance in the Nigerian

economy

1.5 JUSTIFICATION OF THE STUDY

The particular interest in this study (and not some other studies) has been motivated

by the desire to fill the gaps created by this study in the literature. Moreso, there is a need to

present and increase the empirical knowledge and understanding of this study at this

particular period. More importantly, most economic decisions and policy prescriptions are

either directly or indirectly linked to investment performance which is affected by exchange

rate volatility. As such, this study is predicated on the need to enhance decision making in

this direction, especially at a time like this when the Nigerian economy is faced with different

investment challenges coupled with inevitable and critical volatility in exchange rate.

1.6 SCOPE OF THE STUDY

This study covers both theoretical and empirical issues surrounding exchange rate volatility

and investment performance. The analyses are specifically restricted to the Nigerian economy

from 1970-2012. The time frame for this study, 1970-2012, has been particularly chosen and

preferred to ensure the availability and accessibility of sufficient and reliable data, which will

aid the provision and presentation of results relevant for effective and efficient decision

making at this present time.

1.7 ORGANIZATION OF THE STUDY

This study is organized into five different chapters as highlighted below:


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Chapter one introduces the study and it contains the background to the study, statement of the

problem, research questions, objectives of the study, justification of the study, scope of the

study, and organization of the study.

Chapter two interrogates and review existing literature, focusing on both empirical and

theoretical literature.

Chapter three presents the research methodology.

Chapter four presents and analyzes the data.

Chapter five gives the summary, policy recommendation and conclusion; and this is followed

by the reference.

1.8 Definition of KeyTerms

1.8.1 Volatility: This is a technical term that is used to describe the erratic, unpredictable and

frequent changes in a variable. Volatility measures the speed rather than direction of changes

in a variable.

Exchange Rate: This can be defined as the rate at which a currency is traded in a foreign

exchange market. It measures the rate at which country’s currency is bought and sold. This

rate could be administratively determined or determined through the invisible hand of

demand and supply. Meanwhile, the most commonly adopted today is managed floating in

which the forces of demand and supply are allowed to determine the rate but under the

auspices of monetary authorities.

1.8.2 Investment: This can be defined as the increase in the capital stock of the economy. It

is deferment of present consumption to a later date in future.


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CHAPTER TWO

REVIEW OF LITERATURE

2.0 INTRODUCTION

The subject of exchange rate volatility and investment performance has received both

theoretical and empirical attentions from different researchers all over the world. As a way of

increasing the knowledge of this subject area, this aspect of this research work focuses on the

review of related literatures as well as relevant theories on investment. Consequently, the

synthesis provided would help in identifying and filing the gaps created by this issue in the

literature.

2.1 THEORETICAL LITERATURE REVIEW

2.1.1 Keynes’ Theory of Investment

Pentecost (2000, p.119) identifies two main components to the theory: (1) the role of

expectations; and (2) supply price of capital goods. He views the value of a piece of capital

equipment as the net present value of income that will be derived from the use of that

equipment, that is, income over and above its purchase cost. That is, value or demand price of

machine (V) is given by:

n m
Rt It
NPV   1  i 
t  m 1
t

t 0 1  i t
(1)

where n = the whole life of the piece of equipment

m = the whole investment period (that is the time it takes to set up the investment

equipment).

This may be one year or more.


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i = discount rate (normally, the rate of interest)

R = net receipts from use of machine in period/year t.

A net present value of zero indicates that the project is not profitable, while any positive NPV

shows that the project (or having the asset) is profitable.

The rate of discount which ensures that NPV is equal to zero, or that total net receipts

over the asset life equals the cost of the asset, is of great interest and it is called the internal

rate of return (IRR). It is what Keynes calls the marginal efficiency of capital (MEC) and is

actually the expected rate of return from a capital asset (Shapiro, 1974). IRR is the discount

rate that ensures that net receipts cover the initial cost.

2.1.2 The Accelerator theory of investment

The flexible accelerator model assumes the existence of an equilibrium, optimal, desired, or

long-run stock of capital required to produce a given output for a given technology, rate of

interest, and so forth (Gujarati (1988, p.519).


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2.1.3 Three core assumptions of neoclassical investment theory

2.1.3.1 The objective function of the enterprise

The separation of ownership and management in the modern corporation, a

phenomenon that Keynes saw as the root of many of the problems of modern capitalism,

created a principal agent problem that is difficult if not impossible to resolve. Neoclassical

financial theorists have made acrobatic theoretical efforts to defang the principal-agent

problem so that the Pareto efficiency properties of markets could escape unscarred from its

grasp.2 Unfortunately, the assumptions required to accomplish this task have no significant

foundation in empirical or institutional reality. Stiglitz has accurately characterized the

neoclassical principal-agent literature as “the triumph of ideology over theory and fact”

(1985, p. 134).

Neoclassical investment theory, on the other hand, fails even to acknowledge the

existence of the problem. Virtually all neoclassical models of the enterprise investment

decision begin with the unsupported assertion that the firm’s objective is pursuit of the

owners’ objectives: the firm maximizes market value. Three points about the value

maximization assumption are worthy of note. First, there is a great deal of empirical and

institutional evidence that this assumption is false and virtually no direct empirical evidence

that it is true. Second, if this highly questionable assumption is rejected, it is not at all clear

that a distinct neoclassical approach to the theory of the firm can be identified. In its absence,

neoclassical theorists have no generally agreed upon method for choosing an enterprise

objective function, for specifying the constraint set, or even for identifying the cost of

financial capital. Third, if firms are partly independent or semiautonomous from their owners

and can make investment decisions that run counter to shareholders’ perceived interests, there

is no wealth holder control of, or “sovereignty” over, the capital accumulation process and no
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mechanism to assure optimal coordination between the real and financial sectors of he

economy. Thus, when management is semiautonomous, the real sector becomes

semiautonomous as well, a result that is inconsistent with the neoclassical Vision.

2.1.3.2 Neoclassical risk or Keynesian uncertainty?

In the first footnote in his essay, Gordon notes that Post Keynesians have “correctly”

rejected the way in which neoclassical investment and financial theories represent agent

knowledge of the future. He does not, however, carry this critique into the body of the paper

and does not substitute an alternative Keynesian assumption about agent knowledge of the

future in his suggested Keynesian investment model. Yet, as Gordon knows, the choice

between neoclassical and Keynesian assumptions about knowledge of the future profoundly

affects the character of both investment and financial theory.

Neoclassical theory does indeed adopt the untenable assumption that agents can

assign numerical probabilities to all possible future economic states and, therefore, can

associate a probability distribution of expected returns with every possible choice available to

them. Stretching credulity still further, it adds the truly heroic assumption that agents are

absolutely certain that these probability distributions are knowledge - the truth, the whole

truth, and nothing but the truth about the future consequences of current agent choice. The

universal adoption of this logically and empirically repugnant assumption can only be

understood as “the triumph of ideology over theory and fact.”

2.1.3.3 Physical capital as a liquid asset: reversible investment

All neoclassical investment models that are demonstrably consistent with the

overarching neoclassical Vision of a well-coordinated and efficient system of markets assume

that long-lived capital assets have perfect or near perfect resale markets. Jorgenson’s model
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and Tobin’s q theory are the two most important examples. With perfect resale markets the

neoclassical investment decision is as riskless and reversible as the decision to hire a worker.

The liquidity of capital finds reflection in the neoclassical concept of a user cost or a “rental

price” for capital goods. Neoclassical firms are indifferent between owning and renting

their capital: in either case they are paying only for capital “services.” But renting capital

goods is not a very risky business. If expectations turn out to be disappointed by the

unfolding of events, the firm can always resell the goods or choose not to renew its rental

agreement at the end of the period. With liquid capital, the beyond-first-period future is not

particularly relevant, so neither is the degree of uncertainty. And when investment is

reversible, financial commitments are reversible as well. Capital goods can always be resold

to retire the debt that financed them and there is no “legacy of past [debt] contracts” to burden

the accumulation process (Minsky, 1982, p. 63).

2.2 REVIEW OF EMPIRICAL LITEARURE

The subject matter of the macroeconomic effects of exchange rate volatility on economic

aggregates such as income, investments, exports and other macroeconomic aggregates has

received attention from researchers across the globe. For instance, Bello and Salihu (2013)

investigated the impact of exchange rate volatility on export in Nigeria. They employed three

models, viz: Ordinary Least Square (OLS); Granger causality test; and ARCH and GARCH

techniques and also Augmented Dickey-Fuller technique was used in testing the presence of

unit root. The results of unit root suggested that all the variables in the model are stationary at

first difference, while causality test revealed that there is causation between export and

exchange rate in the country, but the causation flows from exchange rate to export. Thus,

exchange rate causes export. Furthermore, ARCH and GARCH results suggested that the

exchange rate is volatile nevertheless export is found to be non-volatile. The study further
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showed that exchange rate is impacting positively on export, as shown by the regression

results. The elasticity results revealed that, the demand for Nigerian products in the World

market is fairly elastic. Therefore, for export to improve and foreign exchange earnings

increase, the country should depreciate its currency, thereby reducing the price of its products

so as to increase demand, which is changing from import-led to export-led economy.

Consequently, in order to improve exports, efficient delivery services are needed, such as;

power supply, energy resources and infrastructure. Volatility in exchange rate is theoretically

counter- productive to attainment of other macroeconomic objectives. Related studies on the

effects of exchange rate volatility on trade include Fountas and Aristotelous (1999). He finds

a significant negative long run effect of exchange rate uncertainty on trade. Wei (1999) found

a negative and statistically significant effect for foreign exchange rate volatility on exports

taking account of futures and options instruments to hedge risk. Study by Baum et al (2004)

showed evidence of a positive relationship between exchange rate volatility and trade using a

poisson flexible lag structure, while Klaassen (2004) did not find evidence of any significant

effect of exchange rate volatility on trade for G7 economies. Caporale and Doroodian (1994)

used a generalized autoregressive conditional heteroskedasticity (GARCH) technique to

measure the volatility of exchange rate and discovered significant negative effect of volatility

on import trade. McKenzie and Brooks (1997) and McKenzie (1999) used ARCH modeling

and introduced an exchange rate volatility term into their export trade models for both

German-US and Australian trade flows respectively. Their results were statistically

significant but, showed positive impact of volatility on trade, while for McKenzie (1999), the

results were mixed. Furthermore, studies that employed panel estimation techniques,

according to Anderton and Skudelny (2001) emerge with better results. For example, Abrams

(1980), Thursby and Thursby (1987), Dell’Ariccia (1998), Pugh, et al (1999) and Rose

(1999), all found significant negative effect of the proxy for exchange rate uncertainty. In
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particular, while Dell’Ariccia (1998) found that the trade gains resulting from the elimination

of exchange rate volatility would have been 10 percent. Anderson and Skudelny (2005)

discovered that exchange rate volatility would decrease extra-euro area imports by around 10

percent.

Another strand of empirical studies apply gravity type trade model to assess the impact of

exchange rate volatility on bilateral trade. Pugh, et al (1999) use 16 OECD countries and

showed that volatility leads to a once and for all decrease in the level of trade by around 8

percent and Rose (2000) estimated a gravity trade model for 186 countries using a 5-year

moving average of the variance of the nominal exchange rate return and discovers that

exchange rate volatility has a significant negative impact on trade (estimates show that zero

exchange rate volatility would have resulted in a 13 percent increase in trade). It was this

seminal work (Rose (2000)) that started the debate that countries participating in a currency

union seemed to trade three times more than expected even when one controls for the impact

of exchange rate volatility. This discovery was christened the Rose effect. Rose and Engel

(2002) and Glick and Rose (2002) found empirical evidence in support of the Rose effect.

Furthermore, Aliyu (2007a) uses a gravitational model for Nigeria-India bilateral trade and

discovered that the exchange rate coefficient is theoretically consistent and statistically

significant in the import model for the Indian economy but not for the Nigerian economy.

Theoretically, it has been argued that returns on investments become largely unstable in an

economy with volatile exchange rate. Consequently, investment is seriously hampered in

such an economy which in turns great negative implications for overall growth of the

economy. This theoretical position has been empirically investigated in literature. Bakare

(2011) carried out an empirical analysis of the consequences of the foreign exchange rate

reforms on the performances of private domestic investment in Nigeria. He employed the

ordinary least square multiple regression analytical method for the data analysis. Some
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statistical tools were employed to test the statistical significance of the variables. The analysis

started with the test of stationarity and co-integration of Nigeria’s time series data. The

empirical study found that the data were stationary and co integrated. The multiple regression

results showed a significant but negative relationship between floating foreign exchange rate

and private domestic investment in Nigeria. These results were robust to a number of

econometric specifications. His findings and conclusion supports the need for the government

to dump the floating exchange regime and adopt purchasing power parity which has been

considered by researchers to be more appropriate in determining realistic exchange rate for

naira and contribute positively to macroeconomic performances in Nigeria.

Meanwhile, Asher (2012) examined the impact of exchange rate fluctuation on the Nigeria’s

economic growth with special emphasis on purchasing power of the average Nigeria and the

level of international trade transaction. Without exchange rate the exchange of goods and

services among trading partners will be faced with a lot of problems, which may virtually

narrow it down to trade by barter. This exchange also is used to determine the level of output

growth of the country. Hence, the rate at which exchange fluctuates calls for a lot of

attention. However, with already existing exchange rate policies, a constant exchange rate has

not been attained. The rate by which exchange rate fluctuates brings about uncertainty in the

trade transaction, and also the rate of naira has been unleashed and continues to depreciate.

This has resulted to declines in standard of living of the population increase in costs of

production (this is because most of the raw materials needed by industries are usually

imported), which resulted in cost-push inflation. She made use of many tests, like the t-

statistics table, f-statistic table and the chi-square etc. She however concluded that real

exchange rate has a positive effect on the GDP.


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Exchange rate volatility undermines the degree of capital inflow into the economy. Foreign

investors are interested in the amount of profits they are able to repatriate back to their home

country, this is however greatly hindered by volatility of the economy where they are

investing. Jenkins and Thomas (2002) found that about 25 per cent of the total firms surveyed

identified exchange rate risk as an important determinant of FDI in the sub-region. The above

claim is supported by Mowatt and Zulu (1999).They identified exchange rate volatility as one

of the major barriers to FDI in Zimbabwe, Botswana and Mozambique Ogunleye (2008)

investigate the relationship between exchange rate volatility and FDI in SSA with particular

focus on Nigeria and South Africa. His investigation reveals that there is endogeneity

between exchange rate volatility and FDI inflows in both countries. He makes use of two-

stage least, and concluded that exchange rate volatility has deleterious effect on FDI inflows,

with FDI inflows aggravating exchange rate volatility in both countries. Exchange rate

volatility is driven largely by inflation, nominal and foreign reserves shocks in both countries.

Exchange rate and FDI policy coordination, with a view to minimizing the harmful effect of

exchange rate volatility and FDI on each other is, therefore, a challenge that fiscal and

monetary authorities must face. . However, these studies did not analyse the extent to which

exchange rate volatility constrains FDI in these countries. Meanwhile, Alaba (2003) attempts

to bridge the gap on the exchange rate volatility-FDI nexus for SSA countries. The study

aimed at determining the magnitude and direction of the effects of exchange rate movement

and its volatility on FDI flows to agriculture and manufacturing sectors in Nigeria.

Employing the GARCH measure of volatility, the error correction methodology was used for

the empirical investigation in testing the effects of both the official and parallel market

exchange rates on FDI flows to agriculture and manufacturing. While the results show that

the official market exchange rate movement significantly reduces FDI inflows to agriculture,

the same is, however, insignificant for the manufacturing FDI. For the volatility coefficients,
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official market exchange rate volatility was not found to be significant for FDI inflows.

Moreover, Adubi and Okunmadewa (1999) posited that Nigeria, a developing nation, is

expected to gain from export conversion price increase as a result of

currency devaluation. Findings by Obadan (1994) and Osuntogun, et al (1993) on the effect

of stable exchange on export performance showed that exchange rate affect a country’s

export performance. In addition, instability in an exchange rate with its attendant risk affect

exports earnings, performance and growth which turn out as positive to exporters when

devalued. Poor results from the floating exchange regimes of the 1970’s necessitated a

change in foreign exchange rate management. The structural adjustment program was

introduced in 1986 with the cardinal objective of restructuring the production base of the

economy with a positive bias for agricultural export production. This reform facilitated the

continued devaluation of the Nigerian naira with the expected increase in domestic prices of

agricultural export boasting domestic production.

Most investment decisions focus on a forecast of future events that is either explicit or

implicit. Generally asset pricing models postulate a positive relationship between a stock

portfolio’s expected returns and risk, which is often modelled by the variance of the asset

price. Dixit(1995) observed that most business manager are likely to be neutral towards

decision on risk and since investment decisions are rarely repeated, it is advisable for

business decisions to be made solely on the basis of expected return. Campa (1993), however,

puts forward a different argument

for the relationship between exchange rate level and FDI. In his model, the firm’s decision

whether or not to invest abroad depends on the expectations of future profitability. In such a

case, the higher the level of the exchange rate (measured in units of foreign currency per host

currency) and the more it is rising, the higher will be expectations of future profits from
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entering a foreign market. Therefore, Campa’s model predicts that an appreciation of the host

currency will increase FDI into the host country, ceteris paribus, which is contrary to the

prediction of Froot and Stein (1991). His empirical results analyzing the number of foreign

entrants entering the US provide evidence to support his model (Gorg and Wakelin 2001).

In another contribution, Blonigen (1997), using data on Japanese acquisitions in the US from

1975 to 1992, suggested that exchange rates can affect acquisition of FDI as this involves

purchasing firm specific assets in the foreign currency that can generate returns in another

currency. The argument that real dollar depreciations increase foreign acquisitions that is put

forth by Blonigen differs from the argument put forth by Froot and Stein (1991), although

they both have the same outcome. Froot and Stein show that exchange rate movements are

important because capital markets are imperfect. On the other hand, Blonigen shows that

exchange rate movements matter because while domestic and foreign firms may have the

same opportunities to purchase firm specific assets in the domestic market, foreign and

domestic firms do not

have the same opportunities to generate returns on these assets in foreign markets. Due to the

unequal level of access to markets, exchange rate movements may affect the relative level of

foreign firm acquisitions. Regarding the exchange rate, there is a statistically significant and

positive relationship with Japanese acquisition activity, which is in line with Blonigen’s

prediction. However, despite showing such a result, it remains unclear whether the

correlation between exchange rate movements and Japanese acquisition FDI is due to the

presence of firm specific assets (Blonigen’s claim) or due to the hypothesis put forth by Froot

and Stein (1991), which is an imperfect capital market. To test this question, Blonigen

separates acquisitions into those in the manufacturing industry and those in the non-

manufacturing industry. The reason for this is that firm-specific assets are said to be more

important in the manufacturing industry. Indeed, Blonigen finds that the co-efficient on the
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real exchange rate for non-manufacturing industries is statistically insignificant while the co-

efficient for the manufacturing industries is significant.

Summary of Gap

The empirical review above shows that most of the existing studies on the effects of

exchange rate volatility on macroeconomic aggregates have focused on variables like export,

output and foreign direct investment while its effects on domestic component of investments

has not received the sufficient attention. To this end, this study aims at bridging this

identified gap.
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CHAPTER THREE

RESEARCH METHODOLOGY

3.0 Introduction

This chapter describes the research design and methodology adopted to achieve the stated

objectives of the study. It presents the model specification, theoretical expectations, model

estimation techniques and sources of data.

3.1 Sources of Data

The study employs secondary source of data to analyse the effects of exchange rate volatility

on investment performance in the Nigerian economy. The major source of data used were

extracted from Central Bank of Nigeria (CBN) Statistical Bulletin (20011), while data on

volatility series is generated using GARCH.

3.2 Model specification

Given the theoretical framework explored in chapter two, the study will have a simple

econometric model. This model shall enable us to determine the quantitative inputs of effects

of exchange rate volatility on investment performance in the Nigerian economy. The

estimated model becomes for the study is derived thus:

𝑘 = 𝑓(𝑒𝑥𝑐ℎ𝑣, 𝑖𝑛𝑡, 𝑖𝑛𝑓)

Linearizing the model above, we have the estimated model for the study

𝑘 =∝ +𝛽𝑒𝑥𝑐ℎ𝑣 + 𝜃𝑖𝑛𝑡 + 𝜌 inf +µ

Where ∝ 𝜃, 𝛽, 𝜌 denotes the coefficient of the independent variables andµ indicates the

error term.

Exchv= exchange rate volatility series


22

Int= interest rate

Inf=inflation rate

3.3 A priori Expectation

3.3.1 Inflation

Theoretically, inflation rate could have positive or negative impact on investment

performance, depending on its level and some structural factors in such economy. For

example Fabayo and Ajilore (2006) argued that for Nigeria, inflation rate below 6% is good

for the economy, while at level above 6% inflation would have an undesirable effect on the

economy.

3.3.2 Interest rate

Interest rate is theoretically expected to vary inversely with investment. At higher level of

interest rate, investment level will be low and vice visa

3.3.3 Exchange rate volatility

High volatility of exchange rate is theoretically xpected to have negative impacts on

investment performance, and vice visa.

3.4 Model Estimation Techniques

In the process of analyzing our time series data, the data will be subject to Unit root test to

determine the stationarity of the variables used in the model, using Dickey Fuller test. This

implies that if we are dealing with time series data, we must make sure that the individual

time series are either stationary or that they are co integrated. If this is not the case, we may

be opened to the charge of engaging in spurious regression analysis.


23

Ordinary least square (OLS) shall be employed to determine the quantitative impact

of the macroeconomic effect of foreign aid on economic growth, using E-view statistical

packages.

3.5 Definition of Econometric terms

3.5.1 Co-efficient of determination;

The coefficient of determination 𝑅 2 (or sometimes 𝑟 2 ) is another measure of how well

the least squares equation

𝑦̂ = 𝑏0 + 𝑏1 x, performs as a predictor of y.

The coefficient of determination R2 is used in the context of statistical models whose main

purpose is the prediction of future outcomes on the basis of other related information. It is the

proportion of variability in a data set that is accounted for by the statistical model. It provides

a measure of how well future outcomes are likely to be predicted by the model.

There are several different definitions of R2 which are only sometimes equivalent. One

class of such cases includes that of linear regression. In this case, if an intercept is included

then R2 is simply the square of the sample correlation coefficient between the outcomes and

their predicted values, or in the case of simple linear regression, between the outcomes and

the values of the single regressor being used for prediction. In such cases, the coefficient of

determination ranges from 0 to 1. Important cases where the computational definition of R2

can yield negative values, depending on the definition used, arise where the predictions

which are being compared to the corresponding outcomes have not been derived from a

model-fitting procedure using those data, and where linear regression is conducted without

including an intercept. Additionally, negative values of R2 may occur when fitting non-linear

trends to data.
24

3.5.2 T-statistics;

The t- statistic is a measure of how extreme a statistical estimate is. We can compute

this statistic by subtracting the hypothesized value from the statistical estimate and then

dividing by the estimated standard error. In many cases, but not all situations, the

hypothesized value would be zero.

We have an indication that the hypothesized value is reasonable when the t-statistic is

close to zero. Alternately, we have an indication that the hypothesized value is not large

enough when the t-statistic is large positive. Finally, we can have an indication value is too

large that the hypothesized when the t-statistic is large negative. To formalize this approach,

we need to compare the t-statistic to a percentile from the t-distribution. The t-statistic is

sometimes also referred to as a t-test, t-ratio, or Wald statistic.

3.5.3 F-Statistics;

This measures the overall significance of the regression equation. The closer the value

is to zero, the higher the evidence against the null hypothesis and the more accurate the

estimates.

3.5.4 Autocorrelation;

The Durbin-Watson test is the simplest and commonly used model. We employ Durbin-

Watson statistics to test for serial correlation in stochastic error term. It is used to check

whether there is an important variable that is supposed to be included but was omitted in the

model. Also, the Durbin-Watson statistics is to detect the presence or absence of serial

correlation in the error term. It can only be concluded that the model is moderately

statistically efficient and effective in explaining the variation in the dependent variable if the

Durbin-Watson is close to two(2).


25

3.5.5 Akaile’s Information Criterion;

Akaile’s information criterion (AIC) is a more general criterion that can be applied to any

model that can be estimated by the method of maximum likelihood. It suggests maximizing;

−2 log 𝐿 2𝐾
+
𝑛 𝑛

where K, is the number of parameters in L. For the regression model, this criterion implies

minimizing (RSS exp (2k/n) J. AIC is commonly used, at least in nonlinear models and can

be computed using the standard regression programs.

3.5.6 Standard Error of Estimate;

This is an indicator of the precision of the estimate. It is a measure of the dispersion of the

estimate from the true parameters. The larger the standard error of a parameter the less

reliable the parameter is and vice versa.

.
26

CHAPTER FOUR

ANALYSIS OF DATA AND DISCUSSION OF RESULTS

4.0 Introduction

This chapter is designed for the analysis of data and discussion of the findings for this study.

It also discusses the result obtained from the analysis and point out the reason(s) for each

result. Section 4.2 presents the Ordinary Least Square (OLS) results of the effect of exchange

rate volatility on investment performance in Nigeria, while section 4.3 contains the discussion

of major findings from the analysis using Eview package.

4.1 Results

The results are presented below


27

Table A1: Tabular Presentation of the Variables

YEAR INV EXCH INTR INF


1970 187.8 0.7143 4 13.8
1971 173.6 0.6579 4 16
1972 451.3 0.6579 4 3.2
1973 565.7 0.6579 4 5.4
1974 1223.5 0.6162 4 13.4
1975 3207.7 0.6267 3.5 33.9
1976 4041.3 0.6308 2.5 21.2
1977 5004.6 0.6514 3 15.4
1978 5200 0.6475 4 16.6
1979 4219.5 0.5605 4 11.8
1980 10163.4 0.5445 5 9.9
1981 18220.59 0.6369 5 20.9
1982 17145.82 0.6702 7 7.7
1983 13335.33 0.7486 7 23.2
1984 9149.76 0.8083 8.5 39.6
1985 8799.48 0.9996 8.5 5.5
1986 11351.46 3.3166 8.5 5.4
1987 15228.58 4.1916 11.5 10.2
1988 17562.21 5.353 11.5 38.3
1989 26825.51 7.65 17.5 40.9
1990 40121.31 9.0001 17.5 7.5
1991 45190.23 9.7545 15.5 13
1992 70809.16 19.6609 21.5 44.5
1993 96915.51 22.6309 26.9 57.2
1994 105575.5 21.8861 12.5 57
1995 141920.2 21.8861 12.5 72.8
1996 204047.6 21.8861 12.25 29.3
1997 242899.8 21.8861 12 8.5
1998 242256.3 21.886 12.95 10
1999 231661.7 92.5284 17 6.6
2000 331056.7 109.55 12 6.9
2001 372135.7 112.4864 12.95 18.9
2002 499681.5 126.4 18.88 12.9
2003 865876.5 135.4067 15.02 14
2004 863072.6 132.67 14.21 15
2005 804400.8 130.4 7 17.9
2006 1546526 128.27 8.8 8.2
2007 1936958 117.968 6.91 5.4
2008 2053006 130.75 7.03 16.1
2009 3050576 147.6 3.72 14.8
28

2010 4012919 148.67 3.5 14.7


2011 3908280 156.2 3.55 10.3
2012 3357398 155.7 3.5 10.7

SOURCES: Central BANK Statistical Bulletin (2012)

4.2 Graphical Trend of Investment Performance and Exchange Rate Volatility

Going by the table above, the investment performance in Nigeria has relatively been on the

increase, showing a positive trend. However, the particular trend in exchange rate volatility

cannot be adequately explained, as witnessed by rise and fall inherent in the figures.

To give a clear picture of the trends therefore, the following graphs are used
29

Figure 4.1: Trend of Investment Performance

inv
4500000
4000000
3500000
3000000
2500000
2000000 inv
1500000
1000000
500000
0
0 5 10 15 20 25 30 35 40 45 50
30

Figure 4.2: Trend of Exchange Rate Volatility

exch
180
160
140
120
100
80 exch
60
40
20
0
0 10 20 30 40 50
31

4.2.1 Unit Root Test.

It has often been argued that macroeconomic data is characterized by stochastic trend, and if

untreated, the statistical behavior of the estimators is influenced by such trend. The treatment

which involves differencing the data to determine the level of stationarity, is carried out in

this study using the ADF tests outlined in the previous section. The results are presented

below
32

Table 4.1: Unit Root Estimation using Augmented Dickey-Fuller (ADF) Test

Variables ADF t-statistic Probability At 5%

LOGINV I(0) 6.9339 0.0169 -2.9540

I(1) -0.4424 0.0000 -2.9571

EXCH I(0) 0.4639 0.3319 -2.9332

I(1) -5.2424 0.0000 -2.9350

INF I(0) -3.286 0.4310 -2.9332

I(1) -6.3529 0.0000 -2.9369

INTR I(0) -1.9469 0.6297 -2.9332

I(1) -7.709 0.0022 -2.9350

Source: Reseacher’s Computation


33

Where:

I(0) = Augmented Dickey-Fuller at level; and

I(1) = Augmented Dickey-Fuller at first difference

The results above shows that all the series are non-stationary at levels except inflation.

Taking the variables at their first difference, results show stationarity at 5% level of

significance. For consistency therefore, all the series are considered and taken at their first

difference.

4.2.2 Ordinary Least Squares Presentation

In an attempt to investigate the effect of exchange rate volatility on investment performance

in Nigeria, the Ordinary Least Squares econometrics technique is adopted. The results are

presented below:
34

Dependent Variable: LOG(INV)


Method: Least Squares
Date: 07/02/14 Time: 22:06
Sample: 1970 2012
Included observations: 43

Variable Coefficient Std. Error t-Statistic Prob.

C 7.469840 0.475507 15.70922 0.0000


GARCH01 0.000140 1.30E-05 10.75776 0.0000
INF 0.013225 0.015022 0.880317 0.3841
INTR 0.172720 0.039706 4.349960 0.0001

R-squared 0.772653 Mean dependent var 10.86405


Adjusted R-squared 0.755165 S.D. dependent var 2.791402
S.E. of regression 1.381209 Akaike info criterion 3.572203
Sum squared resid 74.40176 Schwarz criterion 3.736036
Log likelihood -72.80237 Hannan-Quinn criter. 3.632619
F-statistic 44.18133 Durbin-Watson stat 0.350308
Prob(F-statistic) 0.000000

Source: Researcher’s Computation

From the above table, it can be seen that there is a problem of autocorrelation, as the Durbin-

Watson (DW) statistic is far from two (the value is 0.35). The R-squared and adjusted R-

squared are also not statistically standard. Given this, the dependent variable is lagged by one

in order to correct for the problem. The results are presented in the table below
35

Dependent Variable: LOG(INV)


Method: Least Squares
Date: 07/02/14 Time: 22:11
Sample (adjusted): 1971 2012
Included observations: 42 after adjustments

Variable Coefficient Std. Error t-Statistic Prob.

C 0.912920 0.287631 3.173925 0.0030


LOG(INV(-1)) 0.913078 0.035754 25.53764 0.0000
GARCH01 1.00E-05 5.72E-06 1.750443 0.0883
INF 0.000690 0.003351 0.205979 0.8379
INTR 0.013779 0.010542 1.307001 0.1993

R-squared 0.988319 Mean dependent var 10.99807


Adjusted R-squared 0.987056 S.D. dependent var 2.681575
S.E. of regression 0.305091 Akaike info criterion 0.574933
Sum squared resid 3.443988 Schwarz criterion 0.781798
Log likelihood -7.073586 Hannan-Quinn criter. 0.650757
F-statistic 782.6018 Durbin-Watson stat 1.699147
Prob(F-statistic) 0.000000

Source: Researcher’s Computation


36

Lagging the dependent variable by one clearly shows an improvement in the results

previously obtained. The R-squared and adjusted R-squared improved from 0.772653 and

0.755165 to 0.988319 and 0.987056 respectively. The Durbin Watson result also improved

from 0.350308 to 1.699147.

With respect to the major diagnostic statistics, the coefficient of determination, R-squared of

0.988319 indicates that more 95% of total variation in investment performance is explained

by all the explanatory variables included in the model. The high coefficient of determination

implies that the model has a very good fit. Apart from the coefficient of determination, the

Durbin-Watson statistic is approximately equals to 2, which indicates that the estimated

regression model is free from the problem of autocorrelation. One of the assumptions of the

Ordinary Least Square technique is that the error term is independent of the error term in

another period. The Durbin-Watson of approximately 2.0 therefore implies that this

assumption is fulfilled in the model.

4.3 Discussion of Major Findings

From the OLS results obtained and as regards the impact of exchange rate volatility on

investment performance in Nigeria, it is evident that a positive relationship exists between

exchange rate volatility and investment performance. The result of the estimated model

indicates that a 1 unit increase in exchange rate volatility leads to a 1 unit increase in

investment performance. However, this relationship is not statistically significant at 5% level.

This result differs from the findings of Aristotelous (1999) and Wei (1999). The result

however is consistent with the findings of McKenzie and Brooks (1997) and McKenzie

(1999).

Also, the OLS results show a positive statistically insignificant relationship between interest

rate and investment performance. The results reveal further that there is also a positive
37

relationship between inflation and investment performance. This however is not statistically

significant at 5%.
38

CHAPTER FIVE

SUMMARY, RECOMMENDATIONS AND CONCLUSIONS

5.0 INTRODUCTION

This research work employs both theoretical and statistical techniques to examine the impact

of exchange rate volatility on investment performance in Nigeria, using a simple observation

from 1970-2012. This chapter focuses on the summary account of the whole research work,

suggests policy recommendations, and the conclusion of the study.

5.1 SUMMARY

The main objective of this research work is to examine the impact of exchange rate volatility

on investment performance Nigeria. The first step in the empirical analysis involves testing

the time series characteristics of the data using Augmented Dickey-Fuller (ADF) test and

proceeds to the estimation of Ordinary Least Squares (OLS) method.

The findings of the study reveal that there is a positive and statistically significant

relationship between exchange rate volatility and investment performance in Nigeria. The

results also confirm a positive relationship between interest rate and investment performance;

and also a positive relationship between inflation and exchange rate performance though not

statistically significant.

5.2 POLICY RECOMMENDATIONS

The estimated results show that exchange rate volatility is positively related to economic

growth in Nigeria. Given this finding, the following policy recommendations are made:
39

1. Policy makers in Nigeria should pay special attention to the specific exchange rate

regime and structure in Nigeria. This would mean reassessing the pros and cons of the

basic exchange rate regimes i.e. the floating and fixed exchange rate regimes.

2. In order to achieve sustainable growth and development through increased investment

in Nigeria, policy makers should ensure adequate management of exchange rate,

taking cognizance of its impacts on imports and exports.

5.3 CONCLUSION

In conclusion, this research work has examined the impacts of exchange rate volatility on

investment performance in Nigeria between 1970-2012. The study employed the Ordinary

Least Square (OLS) methods of regression analysis. The results reveal that there is a positive

statistically significant relationship between exchange rate volatility and investment

performance in Nigeria.

Based on the estimated results, this study recommends among other things that policy makers

in Nigeria should ensure adequate exchange rate management, with its impacts on trade.
40

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