International Research Journal of Finance and Economics ISSN 1450-2887 Issue 40 (2010) © EuroJournals Publishing, Inc.

2010 http://www.eurojournals.com/finance.htm

The Effects of Financial Deepening on Stock Market Returns and Volatility: Evidence from Nigeria
Nwezeaku, N.C Department of Financial Management,Federal University of Technology Owerri-Nigeria Okpara, G.C Department of Finance and Banking, Abia State University Uturu-Nigeria Abstract This paper investigates the effects of financial deepening on the stock market returns and volatility in Nigeria using the Generalized Autoregressive Conditional Hetroscedasticity (GARCH) model. Two different measures of financial deepening namely the ratio of money supply to Gross Domestic Product (FD1) and the ratio of Domestic Credits to GDP (FD2) were used, leading to the building of two GARCH models. Our results show that in both models, a high degree of financial deepening reduces significantly the level of risk (volatility) in the stock market and that conditional volatility of returns is fairly persistent. Employing a diagnostic test, we verified whether the GARCH model is mispecified and found that apart from recording improvement in the descriptive statistics, all the estimation pass the Ljung-Box Q12 and Q212 to check the autocorrelation and hetroscedasticity in the normalized residual of the model. The models were therefore found to be well specified and can be used for forecasting. The policy implication of the results is that the reduction or presence of low degree of volatility suggests that investors will demand for less risk premium in the stock market thereby creating lower cost of capital which is synonymous with increase in investment and hence economic development. The government should therefore gear its efforts towards deepening finance in the economy in order to achieve economic development and growth of the country.

Introduction
A common problem plaguing the growth of development economics is the “financial shallowness” which is usually an outcome of adoption of inappropriate financial policy. Financial market plays a vital role in the process of economic growth and development by facilitating savings and channeling funds from savers to investors. Financial intermediation of growth allows for financial deepening. Financial deepening can be viewed as an increase in the stock of financial assets (World Bank 1989:27). According to Shaw (1973:8), it involves specialization in financial functions and institutions, and organized domestic institution and markets gain relation to foreign markets and the curb (informal). He maintained that an increase in the real size of the monetary system will generate opportunities for the profitable operations of other institutions as well, from bill dealers to industrial banks and insurance companies. According to Nnanna and Dogo (1998), the concept of financial deepening is usually employed to explain a state of an atomized financial system, that is, a financial system which is largely free from financial repression. Oloyede (1998) maintained that financial deepening results from the adoption of

practices or patterns. the generalized ARCH (GARCH) model of Bollerslev (1986) and exponential GARCH (EGARCH) model of Nelson (1991) are the most common non linear time series models used in recent finance literature for studying volatility. The repression characterized various administrative controls over the system. ceilings were imposed on the growth of credit. etc. Moreover. credit rationing was practised as well as compulsory credit allocations to preferred sectors through credit guidelines. unanticipated information that alters expected returns on a stock. The GARCH model involves the joint estimation of a mean and conditional variance equations. yt=Xt γ + εt (1) where equation 1 is the conditional mean equation with Xt being the vector of exogeneous variables with an error term εt. 2007). In this study. on how to measure it. The GARCH (1. 1995) of the monetary and financial controls shows that interest rates were capped. and the summary and conclusion. 1998). to a lesser extent. ω . The effect of the repression has been “financial shallowness” (Ndekwu. Thus. While there is a general consensus on what constitutes stock market volatility and. Conversely shallow financial system is partly the consequence of distortions in the relative prices of finance. investors and economic forecasters to predict the path of an economy’s growth and the structure of volatility can imply that investors now need to hold more (or less) stocks in their portfolio to achieve diversification (Krainer. In particular. However.International Research Journal of Finance and Economics . The conditional variance is a function of three terms namely the mean. This paper therefore investigates the predictive power of financial deepening on stock market returns and volatility so as to add to the existing literature on the macroeconomic variables that lead to stock market volatility. it is called the conditional variance. the expected volatility of a security return plays an important role in option pricing theory. The Nigeria financial system has evidently been limited in its resources mobilization and hence financial deepening. Some economists see the causes of volatility in the arrival of new. largely from interest rate differentials. 2. there is far less agreement on the causes of changes in stock market volatility. Methodology The autoregressive conditional hetroscedasticity (ARCH) model of Engle (1982). some positive effects especially in the growth of financial institutions and financial instruments were recorded. shifts in investor tolerance of risk and increased uncertainty (Mala and Reddy. A critical review (Ndekwu. 2002:1).0. an interesting question in finance is what drives stock market volatility? The causes and degree of stock market volatility can help policy makers. de-regulation of interest rate in 1987 and deregulation of entry into the financial services industry.1) model in the standard form is specified as follows. investment decisions as characterized by asset pricing models strongly depend on the assessment of future returns and risk of various assets. namely relating real rates of return to real stock of finance. The next equation is the conditional variance equation stated as (2) σ2t = ω + ∝ ε2t-1 + βσ2t-1 2 • Since σ t is the one period ahead forecast variance based on past information.Issue 40 (2010) 68 appropriate real finance policy. following the structural adjustment programme in 1986 which led to de-control of foreign exchange market. 1991) on bank deposits structure and growth. we shall employ the GARCH model to estimate the impact of financial deepening on the conditional volatility. deregulation of interest rate had some salutary effect (Ndekwu. which in turn are driven by factors such as modifications in macroeconomic policies. Others claim that volatility is caused mainly by changes in trading volume. Thus. Thus. The rest of the paper is therefore divided into three sections. the methodology. foreign exchange controls were exercised. the estimation and interpretation of the model. changes in market volatility would merely reflect changes in the local or global economic environment. Ogwumike and Omole (1997) observed that on the capital market in Nigeria it had positive effect especially on the stock exchange.

186) 27. the size of currency outside the bank etc (Oloyede 1998). The two equations in each model will be jointly estimated.155) 0.0.Issue 40 (2010) news about volatility from the previous period measured as the lag of squared residual from the mean equation.42 (0.1) models are therefore stated as follows.71 (0.001) Model 1 Model 2 The models are the GARCH (1.629) -0. Joseph-Raji (2007). 3.168 (0.074 (0. ratio of domestic credit to GDP. The use of logarithmic price changes prevents nonstationarity of the level of stock prices from affecting stock returns volatility (Rashid and Ahmad 2008. There are several measures/indicators of financial deepening. we shall feature the ratio of money supply to GDP (FD1) and the ratio of domestic credit to GDP (FD2) as two measures of financial deepening. these include the ratio of money supply-to-GDP. autocorrelation and homoscedasticity condition of the market. In this study. .23 (0. The interpretation of the model follows the presentation of the estimated results in table 1 below. Table 1: λ1 28.091 (0. ε2t-1 and • last period’s forecast variance. Kuka.69 • International Research Journal of Finance and Economics . The logarithm of relative prices multiplied by 100 is used to calculate continuously compounded monthly stock returns.024) 0. Leon 2008. Papasyriopoulos and Molyneux (2000). (8) Rt = 100(InPt/Pt-1) Where Rt = stock market returns Pt = stock market price index for the period t Pt-1 = price index for the period t-1 Ln = the logarithm operator. ratio of non-bank savings to gross national savings. Model 1 Rt = λ1 + λ2Rt-1 + λ3FD1 + εt σ2t = ω + ∝ε2t-1 + βσ2t-1 + θFD1 Where Rt=stock market return Rt-1= the lagged value of return σ2t = conditional variance FD1= financial deepening measured as the ratio of money supply to GDP Model 2 Rt = λ1 + λ2Rt-1 + λ3FD2 + εt σ2t= ω + ∝ε2t-1 + βσ2t-1 + θFD2 Where FD2 = financial deepening measured as the ratio of domestic credit to GDP.687 (0. Our GARCH (1. Koulakiotis.000) 555.52 (0.036) λ2 0. The summary statistics of the market returns will be examined in order to determine the normality.000) -10.551) β 0.213 (0. σ2t-1 In the light of the above stated equations.003) ∝ -0.64 (0.831) -0.94 (0.154) θ -15. the degree of monetization.083 (0.694) ω 554.1) models with the t-statistics (in parentheses) at the 5% level of significant.147) λ3 -0. The skewness statistics and the kurtosis of the summary statistics will enable us to determine the normality condition while the Ljung-Box statistics Q and Q2 provide tests for the absence or presence of autocorrelation and hetroscedasticity respectively.13 (0. The computation is done as follows. Summary and Interpretation of the Estimated Models. Amoo. the size of non-bank institutions to the financial system. we shall state and analyze two different models involving two different measure of financial deepening.83 (0.

A high rate of interest attracts more savings and discourages the flow of capital to the stock market and dearth of capital in the market may bid down returns. (0. The skewness for returns in all the models are positive.767) (0.84) are little above 3 unlike the kurtosis of the raw series (5.947 (0.90 (0.268) Model 2 -0.) is the LjungBox Q-statistics for the absence of autocorrelation and Q2(.05 (0. F stat Diagnostic Test Raw series -00.291) In the above diagnostic test (table 2).24 (0. The presence of low degree of volatility indicates that investors will not demand for much risk premium thereby creating lower cost of capital which boosts investment and encourages economic development.949) 2.) is the squared Ljung-Box Q-statistics for the absence of heteroskedasticity.705 3.63 (0. The distributions for all index returns seem to be non-normal.99 (0.728) (0.996) 11.28 5.816) 5.95 1.061 1. implying that a high degree of financial deepening reduces (volatility) risk in the stock market returns.53 0.497 (0. However.1) model of both variants of financial deepening. is the Jarque Berra test for normality.048 Obs* R-squared (0. The Q statistics for the absence of autocorrelation in the standard residuals for both . This could be so because liberalization of the banking system from interest rate ceilings and government intervention will have the effect of increasing the rate of interest.53) which is far greater then 3. The standard deviations and Kurtosis are lower.002) Model 1 -0. Table 2: Mean SD SK Kurt Q1 Q12 Q12 Q112 JB ARCH Test 0. implying that stock returns are more likely to be far above the mean value. the sum of ∝ and β. In other words. Their skewness diminishes greatly while their kurtosis (3.099 0. It can be seen from the results that the positive relationship between returns and standard deviation exists for all models.9 29.137 0.156 (0.05 (0. models 1 and 2 are improvements of the raw series.090 0. we report the descriptive statistics for the returns of the raw series and models 1 and 2.468 (0.64) for M/GDP and 0.836) 0. In both models (1 and 2).68 (0. ρ-values are in parentheses and J. financial deepening exerts a negative influence on the stock market returns.752) 6.826) Table 2 shows the summary statistics for the raw returns and the standardized residuals for the models. The diagnostics are presented as follows.10 (0.177 0.969) 2. The Jarque-Bera test statistics which are significant at 1% level in the raw series.711) (0. All returns in the models have fat tails and are therefore leptokurtic as seen in the kurtosis measures which are higher than 3.917) 0.B.752) (0.734) 2. the rate at which financial deepening exert negative influence on stock market returns is insignificant.84 0. It is also found that in both models.60 for DC/GDP) indicate that the conditional volatility of returns is not well persistent.634 (0.54 and 3.698) 0.Issue 40 (2010) 70 In the GARCH (1. the impact of shocks on the conditional variance lasts.803 3. However. but not quite for a long time.044 (0.008 1.115 (0.878) 0.481) 9.92 (0. We however. Q(.761) 5. financial deepening is a negative and significant determinant of conditional volatility.International Research Journal of Finance and Economics . have to subject these models to a diagnostic test in order to ascertain their reliability. indicating non normality are improved in the two models.54 0.125 0.693) 4.114 0.

The models were therefore found to be well specified and can be used for forecasting. Moreover. our GARCH model is well specified and can therefore be used for forecasting purposes. Employing a diagnostic test. Thus. Two different measures of financial deepening namely the ratio of money supply to Gross Domestic Product (M/GDP) and the ratio of Domestic Credits to GDP (Domcred/GDP) were used. Summary and Conclusion The paper investigates the effects of financial deepening on the stock market returns and volatility in Nigeria using the Generalized Autoregressive Conditional Hetroscedasticity (GARCH) model. While the expected volatility of a security return plays an important role in option pricing decision. The results of our investigation show that in both models. apart from recording improvement in the descriptive statistics.Issue 40 (2010) models are not statistically significant indicating that the mean equation is correctly specified. The causes and degree of stock market volatility can help policy makers. investors and economic forecasters to predict the path of an economy’s growth and the structure of volatility can imply that investors now need to hold more (or less) stocks in their portfolio to achieve diversification. we verified whether the GARCH models are mispecified and found that. a high degree of financial deepening reduces significantly the level of risk (volatility) in the stock market and that conditional volatility of returns is not quite persistent. The estimates of F-statistics and Obs* Rsquared statistics confirm that there is no evidence of remaining GARCH effect in our GARCH models. leading to the building of two GARCH models. investment decisions as characterized by asset pricing models strongly depend on the assessment of future returns and risk of various assets. The government should therefore gear its efforts towards deepening finance in the economy in order to achieve economic development and growth of the country .71 International Research Journal of Finance and Economics . The stock returns we used were a continuous compounded one derived from the logarithm of relative prices multiplied by 100. Also the insignificance of the Q2 statistics in both models shows that the variance equations are correctly specified and therefore has non-remaining ARCH effect. The policy implication of the results is that the reduction or presence of low degree of volatility suggests that investors will demand for less risk premium in the stock market thereby creating lower cost of capital which is synonymous with increase in investment and hence economic development. all the estimation pass the Ljung-Box Q12 and Q212 to check the autocorrelation and hetroscedasticity respectively in the normalized residual of the models.

NISER. R. Ibadan. M. (1995) “Monetary Policy and the Liberalization of the Financial Sector” in Iwayemi.C. T. The Financial System’s Role in Resource Mobilization and Investment An Analysis of Financial Deepening in the Nigeria Financial Sector in the Dynamics of Managing the Nigerian Financial System in the 21st Century CBN. S. 45. (2006) Analytical Framework and Empirical Analysis of Transaction Costs and Efficiency of the Nigerian Capital Market. Journal of Economterics. (2002) “Stock Market Volatility” FRBSF Economic Letter. Sept. Rajni and Reddy Mahendra (2007). Journal of Finance and Economics. Vol. Mala. Leon. Rashid. Journal of Finance and Economics. Ndewku. Nnanna. Paper for 3rd Bankers’ Conference of the Chartered Institute of Bankers of Nigeria. Generalized Autoregressive Conditional Heteroskedasticity.G. Asymmetric Relationship Between Stock Price Returns and Volatility: Evidence from Nigerian Stock Market. Ibadan. (1982).T. and Omole. The Financial System’s Role in Resource Mobilization and Investment An Analysis of Financial Deepening in the Nigeria Financial Sector in the Dynamics of Managing the Nigerian Financial System in the 21st Century CBN. Measuring Stock Market Volatility in an Emerging Economy. Okpara. Journal of Econometrics. ‘ARCH models as Diffusions Approximations’. (2008). Inflation. Western Banking. 200232.3 Oloyede Adebisi (1998). “More Evidence on the Relationship between Stock Price Returns and Volatility”. (1991). 50(3):987-1008. World Development Report. Ndewku. Nelson. J.4. (1991) Interest Rates. (2008).pp1-4.F. Koulakiotis. 31(1):307-327. (1995) “Turnaround Management Strategies for Nigerian Banks. Issues on Development. CBN: Research and Statistics Department. G. Ogwunmike. 7-38. Econometrica. Guest Speaker. International Research Journal of Finance and Economics Issue 8. 56. Krainer. Konan N. [17] [18] [19] . A. and Molyneux P. 347-370. NISER Monogragh Series No. (2006).A. (1997) Mobilizing Domestic Resource for Economic Development in Nigeria: The Role of the Capital Market. ‘Conditional Heteroskedastcity in Asset Returns: A New Approach’. World Bank (1989). Nonlinear Methods.B. & Dogo. Research Paper.O. Ndekwu. Structural Reform. E.. Akin (ed) Macroeconomic Policy Issues in an Open Developing Economy: A Case Study of Nigeria Ibadan: NCEMA. (1990). Papasyriopoulos.Issue 40 (2010) 72 References [1] [2] [3] [4] [5] [6] [7] [8] [9] [10] [11] [12] [13] [14] [15] [16] Bollerslve. AERC. and Joseph-Raji G. D. Bank Deposits and Growth of the Nigerian Economy..C. Issue 20.K. A. F. Ndekwu. Shaw. Predicting Stock Returns Volatility: An Evaluation of Linear vs. Kukah.A. Econometrics. Nelson. E. “An Empirical Study of the Relation between Stock Market Returns and Volatility in the BRVM”. (1973). and Ahmad S. Amoo B. J. International Research Journal of Finance and Economics. Financial Deepening in Economic Development.Y. A Multi-Disciplinary International Journal on Sustainable Development. 45.1 No. New York: Oxford University Press. D. Engle. N. p. (1999). International Research Journal of Finance and Economics. Monetary Policy and Financial Deepening: The Nigeria Experience: Mimeo. (1986).S. D.International Research Journal of Finance and Economics . Autoregressive Conditional Heteroscadasticity with Estimates of the variance of the U. (1998). (2008). Issue 14.

6 41.7 18.3 15.73 International Research Journal of Finance and Economics .4 1993 39.3 13.5 65.6 15.5 2006 37 1 Sources: Personal Computations From 1.5 7.3 22.1 8.6 41.2 41.1 35.6 28.7 21.9 37.3 1991 52.8 12.8 21.4 19.6 39.4 1985 27.3 130.4 19.9 23.2 56.2 54 2002 10.8 29.2 -11.9 1999 -7.8 1988 22.2 Cred/GDP(FD2) 52.8 17.5 30.2 22.2 13.4 16.6 14.1 Year Rmt RMTt-1 1984 20.4 53.2 15 15.2 12.7 2004 18.2 10. Statistical Bulletin of the Central Bank of Nigeria.1 18.8 10.8 27.1 19.2 44.3 24.4 1986 28.7 35.4 1987 16.4 20.1 11 9.9 45.8 4.8 18.2 2001 35.6 1995 130.3 27.2 17.2 2003 65.1 18.5 52.4 1990 58 39. Annual Reports of the Nigerian Stock Exchange 2.9 -7.5 1994 45.3 7.6 1996 37.6 1889 39.3 15.6 28.2 19. .3 1998 -11.9 1997 -7.7 15.13 17.9 2000 54 -7.4 58 1992 41.8 2005 1 18.Issue 40 (2010) Appendix Table 3: Returns and Financial Deepening Data M/GDP(FD1) 36.