Financial stress and exchange rate volatility in Nigeria: a predictability approach

Abstract This study investigates the predictability of financial stress (FS) for the volatility of the naira exchange rate amid recent instability, focusing on key foreign currencies like the USD, British pound, and Euro. To achieve the study’s objective, we formulate two distinct models. The first is a single-factor model based solely on FS to assess its independent predictability for exchange rate volatility in Nigeria. Given Nigeria’s status as a net oil exporter and oil’s influence on economic crises, the second model enhances the single-factor model by incorporating oil prices. Thus, we uncover the marginal effect of FS on exchange rate volatility in Nigeria after controlling for oil price. Findings reveal that FS predicts exchange rate volatility as well as heightens it against the USD and Euro. Also, including the oil price in the predictive model strengthens the single-factor model. This result is upheld when examining the marginal effect of accounting for oil price, confirming the robustness of our results. Finally, both in-sample and out-of-sample analyses emphasize the critical role of oil prices in enhancing exchange rate volatility forecasting in Nigeria.