Modeling returns and volatility transmission between oil price and US–Nigeria exchange rate

Abstract

This paper models returns and volatility transmission between oil price (OP) and US–Nigeria exchange rate (EXR). Consequently, it provides five main innovations: (i) it analyzes OP and EXR using the recently developed test by Narayan and Popp (2010) (NP) which allows for two structural breaks in the data series (ii) it employs the Narayan and Liu (2011) (NL) GARCH unit root test to evaluate robustness of NP test (iii) it considers the newly developed VAR-GARCH model to capture the spillover effects in the returns and volatility of OP and EXR; (iv) it modifies the VAR-GARCH model to account for structural breaks obtained from the NP procedure and (v) using the results obtained from the VAR-GARCH model, it examines the optimal weights of holding oil and foreign exchange (FX) assets and also computes the hedging ratios in the presence of oil risk. Based on the NP and NL tests, it finds robust structural breaks that coincide with the period of global financial crisis as well as period of FX crisis in Nigeria. Also, it establishes a bidirectional returns and spillover transmission between oil and FX markets. Finally, its findings reveal evidence of hedging effectiveness involving oil and FX markets in Nigeria and thus, the inclusion of oil into a diversified portfolio of FX will improve its risk-adjusted return performance.