THE DYNAMICS OF EXCHANGE RATE EXPECTATIONS FORMATION: THE NIGERIAN PERSPECTIVE

Brnhard O. Ishioro, Ph. D. Dparmn of Economics Dla Sa Univrsiy, Abraka E-mail:bn_ishioro@yahoo.co.uk THE DYNAMICS OF EXCHANGE RATE EXPECTATIONS FORMATION: THE NIGERIAN PERSPECTIVE UDK / UDC: 336.748(669) JEL klasifikacija / JEL classificaion: E44, F31 Izvorni znansvni rad / Original scinific papr Primljno / Rcivd: 10. srpnja 2014. / July 10, 2014 Prihvaćno za isak / Accpd for publishing: 19. sudnog 2014. / Novmbr 19, 2014 Absrac This papr xamins h naur of xchang ra xpcaions formaion (whhr i is saic, forward or backward looking) and h major macroconomic drminans of xchang ra xpcaions formaion procss in Nigria. Basd on a robus rviw of boh mpirical and horical vidncs, h papr applid uni roo s, h Johansn coingraion and Error Corrcion Mchanism (ECM) in h validaion of h naur of xchang ra xpcaions formaion in Nigria. Th papr found ha in h conx of inflaionary xpcaions, xchang ra xpcaions formaion follows h srucuraliss inflaionary xpcaions. Th papr also found ha dpnding on h dfiniion of xchang ra adopd, ral incom is significan in xpcaions formaion and xpcaions formaion dos no follow h porfolio and chariss approachs. Prvious changs in xchang ra wr found o b significan in xpcaions formaion dpnding on h dfiniion of xchang adopd. Th papr rcommnds ha inflaionary xpcaions should b incorporad ino h policis of xchang ra xpcaions formaion survillanc. Ky words: Exchang Ra, Financial Asss, Raional Expcaions, Uni Roo 431

1. INTRODUCTION Exchang ra and xpcaions formaion hav bn cor and cnral issus in macroconomic analysis from h vry foundaion of h subjc (Moosa, 2000).Bu h formal analyical ramn of xpcaions formaion has only occurrd ovr h las 34 yars. During his priod i has, howvr, bn on of h mos imporan aras of advanc in rms of rsarch. Exchang ra according o Claassn (1997) dos no only rflc h rlaiv pric of domsic and forign goods, i also rflcs h rlaiv pric of domsic and forign financial asss. Th principal financial rol of xchang ra among ohrs is o quilibra h financial ass marks wihin an opn conomy wih inrnaional capial movmns. Whn inrnaional capial flows domina h forign mark, hy ac as h drminans of shor run movmns of xchang ra. Bu wihou capial flows, ha is, sric capial conrols, h xchang ra would cas o b a financial ass pric as a paralll xchang mark will mrg in which h xchang ra will divrg from h official on. As financial ass pric (quilibraing financial ass marks), h forign xchang ra has o b inrprd as implying ha a chang in h xchang ra is h major facor influncing h xpcd ra of rurn on financial asss (Claassn,1989; 1991). Ras of rurn ar h dominan incnivs for inrnaional financial capial flows whr h domsic and forign asss hav h sam mauriy and ar xposd o h sam risk, h rurn on h domsic ass mus hrfor qual h xpcd rurn on h forign asss (whr h asss ar prfc subsius wih rspc o hir rurns) or h link could b lss sric (i.. whr hy ar imprfc subsius). Th nd for h sudy of xchang ra xpcaions formaion primarily ariss bcaus conomic agns in dciding which cours of acion o follow ar consanly facd wih an uncrain nvironmn prvaln in mos dvlopd and dvloping counris financial scors and marks. This is dpndn on h sourc and naur of h uncrainy involvd in a paricular xchang ras dcision.uncrainy xiss whnvr individuals ar no complly awar of h ponial n consquncs of hir acions (Pasaran, 1981). Also, xchang ra xpcaions play a pivoal rol in almos all monary modls spcially for h opn conomy. Th brakhrough ha allowd a mor gnral approach o xchang ras xpcaions modling cam wih h ralizaion ha xpcaions could b rad as an unobsrvd componn. This mans ha xpcaions could b subsiud by hir drminans (xchang ras as financial asss and ohr domsic asss) onc an xplici rul of xpcaions formaion is assumd (s Nrlov 1958 and Cagan 1956).Bu a major disadvanag of his approach is h inabiliy o fficinly assss h xchang ras on h long run. Tha is h rason why on of h major focuss of his papr is o assss h dynamics of xchang ras xpcaions formaion using h macroconomic drminans of xchang ras in h shor-run. Bu for our purpos and wihin h dimnsion of 432

our inrs, h dynamics of xchang ras xpcaions formaion shall b xamind from h poin of viw of conomic horis such as: h monary, h porfolio including h fundamnaliss and h Chariss approachs o nabl us form a modifid mixd modl wih a wid spcrum of horical and mpirical suppor. Thrfor, his sudy is dircd a xploring how conomic agns form xchang ras xpcaions using domsic financial asss such as commrcial banks dposis and rasury bills. This is imporan for a numbr of rasons. No sudy has bn carrid ou in his aspc for h Nigrian conomy. Ths domsic financial asss ar h mos dmandd in h Nigrian conomy and as such would ac as crdibl rprsnaiv financial indicaors in h conx of a modifid mixd modl. Through his avnu, his sudy would conribu o h dba on h formulaion and implmnaion of a macro-financial modl. Furhrmor, h sudy hops o s h prfc subsiuabiliy hypohsis using macroconomic and financial fundamnals from h Nigrian conomy by applying boh h monary and porfolio prspcivs. Th conomic hory for drmining h forign xchang ra which assums prfc subsiuabiliy is known as h monary approach o xchang ras xpcaion formaion (Claassn, 1997). Thrfor, on of our aims (apar from h on sad abov) is o xamin h dynamics of forign xchang ras xpcaions formaion basically from h poin of viw of h monary and porfolio approachs. This papr is hrfor an amp a assssing h dynamics of forign xchang ra xpcaions formaion basd on h fundamnal financial and macroconomic variabls in h Nigrian conx. Following h inroducion, h rs of h papr is organizd as follows: A rviw of horical and mpirical liraur is givn in scion wo. Scion hr provids h mhodology and daa issus of h sudy whil h fourh scion prsns h rsuls of our simad quaions. Scion fiv concluds h papr and xamins h policy implicaions arising from h rsuls of h sudy. 2. THEORETICAL AND EMPIRICAL REVIEW 2.1. Thorical Rviw Following h macroconomic prspciv, hr ar wo major approachs wih wo supporiv viws o h hory of xchang ra xpcaions formaion. Th major approachs includ h monary and Porfolio approachs wih h fundamnaliss and chariss approachs as supporiv viws. Th major horical sudis wr mad by Frankl and Froo (1987a, 1987b, and 1987c); D Long al., (1990); Lux (1998); Barbris al., (1998) and mor rcnly Elln al., (2011).Ths sudis focusd on h Chariss and Fundamnaliss rol in xchang ra xpcaions formaion. Alhough hr may b ohr approachs and viws, h approachs mniond abov suffic for our purpos. 433

2.1.1. Th Monary Approach According o Claassn (1997), h monary approach whn compard o h Porfolio approach is h firs and simpls prspciv of h financial approach o xchang ra xpcaions formaion. Th major assumpion of h monary approach is known as prfc subsiuabiliy of financial asss. This assumpion is somims calld h uncovrd inrs pariy which sas ha h xpcd ra of dprciaion of h local currncy mus qual h diffrnc bwn h domsic and forign ras of inrs, Jha (2003). Ohr assumpions of h monary approach includ: Porfolios adjus insananously o disquilibrium; and h absnc of any forign xchang conrols. Th prfc subsiuabiliy of domsic and forign financial asss simply mans ha h ras of rurn on boh ass cagoris ar qual; his concp of qualiy of ras of rurns is rfrrd o as inrs ra pariy in h liraur. A major issu rlaing o masurabiliy is ha, if h ras of rurns ar masurd according o h unis of h domsic currncy (such as h Nigrian Naira), h ra of rurn on shor rm domsic financial asss (such as h commrcial banks dposis) is dfind as h domsic rurns on hs asss. Bu h monary approach has bn aackd svrly on h grounds of boh prfc subsiuabiliy and h uncovrd inrs ra pariy bcaus wih prfc subsiuabiliy bwn domsic and forign financial asss, any rurn diffrnial bwn h wo yps of asss is immdialy liminad by xchang ra movmns. Any divrgnc in h xpcd ras of rurn givs ris o incipin capial flows. Th immdia racions of h currn xchang ra cancl h rurn diffrnial so ha h xpcd ras of rurn on domsic and forign financial asss ar qualizd (inrs ra pariy). Furhrmor, w argu in lin wih Jha (2003) ha vn if domsic and forign asss ar similar (which is crainly no h cas in Nigria and in mos dvloping counris) invsors may prciv diffrncs in risk causd by diffrncs in liquidiy, ax ramn, xchang risk, poliical risk and dfaul risk. Anohr imporan rason why invsors migh s domsic and forign financial asss as imprfc a any poin is ha, inrnaional businss cycls and naional policis (domsic monary policis) ar no prfcly synchronizd wih rspc o im, (Cumby and Obsfld, 1981; Loopsko, 1984). Nvrhlss, in lin wih Isard (1991); som dscripiv aspcs of h monary approach hav bn raind on pragmaic grounds. 2.1.2. Th Porfolio Approach Th Porfolio approach o xchang ra xpcaions formaion was primarily dsignd o ovrcom h inhrn dfcs associad wih h monary approach. Boh h Monary and Porfolio approachs ar summarizd blow in abl 1. 434

Tabl 1 Summary of h Monary and Porfolio Approachs o Exchang Ra Expcaion Formaion Major Characrisics of h Approach Monary Approach APPROACHES Porfolio Approach Mobiliy of Capial Capial mobiliy is assumd o b unrsricd Capial mobiliy is assumd o b ihr rsricd or unrsricd Subsiuabiliy of Financial Asss Assums prfc subsiuabiliy of forign and domsic financial asss which also mans risk nuraliy. Assums imprfc subsiuabiliy of domsic and forign financial asss connoing risk avrsion. Sourc: Adapd from Claassn (1997). From abl 1 abov, h porfolio approach assums ha domsic and forign financial asss ar imprfc subsius bcaus financial ass holdrs ar currncy risk or xchang ra risk avrs. Th principal hmaic assumpions of h Porfolio approach includ: hr is imprfc subsiuabiliy bwn domsic and forign financial asss; h invsor is risk avrs, and h uncovrd inrs ra pariy wih currncy risk prmium amongs ohrs. Th rducd form of xchang ra drminaion undr h assumpion of imprfc subsiuabiliy of domsic and forign financial asss according o h risk-prmium-augmnd uncovrd inrs ra pariy paradigm can b mahmaically sad as: I d I f EXR EXR EXR CcR (1) Whr I d is domsic inrs ra on financial asss. I f is forign inrs ra. EXR is h xpcd xchang ra EXR is h currn xchang ra. CcR is h currncy risk prmium. 435

Th adopion of quaion (1) abov dsrvs som xplanaions. As nod abov in scion 2.1.1 on monary approach o xchang ra xpcaion formaion, on of h major waknsss as ofn xplaind in h liraur is h uncovrd inrs ra pariy which invrsly mans ha if xchang ra risks ar covrd, h xpcd ras hav o b rplacd by h forward mark ra for forign xchang. Bu sinc h sysmaic failur of h ra as a rliabl drminan of h fuur spo ras also has implicaions for h uncovrd inrs ra pariy and uncovrd inrs ra canno b sd dircly; on of h ways of handling his sysmaic bias is o inroduc a currncy risk prmium variabl ( CcR ) as a ngaiv rm, (Claassn, 1997). From quaion (1), wih saic xchang ra xpcaions i can b dducd ha; EXR EXR 0, (2) EXR Th forign inrs ra is highr han h domsic inrs ra by h amoun of risk prmium. Howvr, quaion (1) is wrin as: EXR EXR (3) 1 I I CcR Whr d f EXR is h xchang ra prvaln a h bginning of priod. EXR is h xpcd xchang ra for h nd of priod. An implici assumpion in quaion (3) is ha i ook accoun of on priod (whr dno ihr on monh, hr monhs or on yar) and no of svral priods o nabl us form a link bwn h shor-run and h long-run priod. For h fuur priod +1, h xchang ra a h bginning of priod +1, ha is EXR 1, will b drmind by his quaion: EXR 1 EXR 1 1I I CcR d1 f1 1 Th diffrncs bwn quaion (3) and (4a) ar h priods of xchang ras xpcaions formaion ihr () a h currn priod or h (+1) for h fuur priod. For quaion (5) o saisfy our condiion for xpcaions formaion, EXR 1 mus b consisn wih h xpcd xchang ra EXR 1 such ha: (4a) 436

EXR = EXR 1 (4b) If EXR is subsiud ino quaion (4a), w obain: EXR EXR 1 1Id I f CcR 11Id I f CcR 1 1 1 1 1 (5) obain: For h n xpcaions formaion, w can ransform quaion (5) o EXR EXR 1Id I 1 1 1 1... 1 f CcR Id I f CcR Id I n f CcR n n Equaion (6) has bn xndd o conain an rraic numbr of priods whr h las and longs priods ar rprsnd by n for all cagoris of variabls of inrs whos bhavioral parn could b whimsical. This mans h prsn xchang ra conains all informaion abou h probabl fuur valus of Id, I f, CcR and h long-run xchang ra EXR n which is h anchor of h currn xchang ra. Furhrmor, Claassn (1997) argud ha facors ha can influnc h xpcd fuur xchang ra EXR n can also influnc h currn xchang ra ( EXR ). Th currn xchang ra dpnds on boh nx yar s xpcd domsic and forign inrs ras and on h xpcd xchang ra n yars from now. n (6) 2.1.3. Th Fundamnaliss Expcaions Formaion Modls Boh h monary and porfolio approachs considrd abov ar of h fundamnalis s yp. Th fundamnaliss look a h macroconomic framwork of xchang ras xpcaions formaion basd on inrs ra diffrnials, c. Basd on h fundamnaliss viw, i is concivabl and vn probabl, ha invsors, givn shor horizons, nd o forcas by xrapolaing from currn rnds (Mzlr, 1941; Goodwin 1947 and mor rcnly Mary, 2004) whil ovr longr horizons, hy prdic a rurn o fundamnal variabls (such as rlaiv prics). This yp of xchang ras xpcaions formaion can b wrin as: EXR EXR a EXR1 EXR (7) Whr EXR 1 is h long run xchang ra. Th cofficin a (whr a 1) indicas h im profil of xpcaions. 437

2.1.4. Th Chariss Expcaions Formaion Modl Th Chariss nd o forcas by xrapolaing currn rnds if hy hav bandwagon xpcaions (rnd following xpcaions mchanism). Th mos ssnial lmns of h Chariss modl ar h prfc subsiuabiliy and uncovrd inrs ra pariy (Mary, 2004; Frankl and Froo, 1987, 1989); h ohr lmn is h procss of xchang ra xpcaion formaion ha rjcs raional xpcaions in favor of xrapolaiv, adapiv (larning from forcas rrors) and rgrssiv xpcaions. Howvr, h Chariss look a h pas bhaviors of xchang ras and xrapola h pas rnd ino h fuur. This simply implis ha xpcaions ar formd on h basis of pas voluion of xchang ra wih is prvious valu summing up h xpcd informaion. This is xprssd as: EXR EXR b EXR1 EXR 1 OR (8a) EXR EXR b EXR1 EXR 1 (8b) Whr EXR is h logarihm of h xchang ra ha is xpcd a h currn priod. EXR is h logarihm of h nominal xchang ra obsrvd a im. EXR 1 is h xchang ra of h prvious priod. Many ohr prvious priods may b akn ino accoun ( EXR 2,..., EXR n ). Thr cass mrg from quaion (8a) and (8b) basd on h valu and naur of b.firs, if b 0, i implis ha h xpcd xchang ra is a disribud lag of h obsrvd nominal xchang ra ( EXR ).An ass holdr ha adops h disribud xpcaions usually xpcs xchang ra incras o b followd by fuur dcras. Scond, if b 0, h financial asss holdr xpcs an xchang ra incras o b linkd o a fuur incras. This follows h bandwagon xpcaions. Third, if b=0, h financial ass holdr xpcs xchang ra o b saic a h currn priod. This follows h saic xpcaions paradigm. Bénassy-Quéré al., (1999) argud ha h rgrssiv modl (manrvring xpcaion mchanism) could b classifid as h Chariss modl. From quaions (7) and (8a, 8b) w could sablish a wighd avrag of xpcaions formaion as suggsd by Camn and Gnbrg (1990), and adapd by Claassn (1997) as: 1 1 1 1 1 EXR EXR a EXR EXR EXR b EXR EXR EXR a EXR EXR b EXR EXR 1 1 (9) 438

If is high, xpcaions ar mainly formd on h basis of fundamnals. In which cas, boh h xpcd and h acual xchang would mainly rflc is fundamnals. Bu if quals on, i rflcs h framwork of raional xpcaions. All h modls of xchang ras ha work wih raional xpcaions ar of h fundamnaliss yp. 2.2. Empirical Rviw Thr ar wo major prspcivs o h mpirical sudy and analysis of xchang ra xpcaions formaion: h microconomic and macroconomic prspcivs. Th microconomic prspciv is mainly concrnd wih h bhavior of individual invsor, spculaor and ohr mark acors. This prspciv is ssnially drmind by h analysis of h prsumd bhavior of h financial asss holdr using survys and laboraory xprimnal invsigaions. Sudis ha adop h microconomic prspciv ar ofn concrnd wih issus rlaing o irraional bhavior of h conomic agns, mark hrogniy, cagoris of acors and radrs (rnd followrs, modl followrs and porfolio managrs) and h ruls guiding h bhavior and acions of h mark paricipans. For insanc, Bénassy-Quéré al., (1999) sudid h naur of xchang ra xpcaions formaion of 40 lading forign xchang forcasrs/dalrs. Th xrapolaiv, adapiv, rgrssiv and mixd modls wr usd as h xpcaional srucurs for h drminaion of h procss of xpcaion formaion. Survy daa sourcd from h Consnsus Forcass of London for 3 and 12 monhs xpcaions of h US Dollar bilaral ras of h Dusch Mark (Grmany), Yn (Japans) and Pound Srling (England) for h priod January 1990 o Dcmbr 1994 wr applid for h simaion of hir modls. Panl simaion chniqu (fixd and random ffcs) was adopd. Th sudy found among ohrs ha: xchang ra xpcaions wr found o b sabl a h 3 and 12 monhs horizon. Th sudy also found ha h bhavior of conomic agns in h forign xchang mark is hrognous; and ha agns rly mor on public forcass in mos cass for xpcaion formaion. A major criicism of his sudy is ha h im span is oo shor o mak maningful policy rcommndaions. Macroconomic aggrgas wr xcludd from h sudy. This is a prilous and lamnabl omission as xchang ra xpcaions ar no only formd basd on prvious changs in xchang ra and non-macroconomic variabls. Ohr sudis ha usd survy daa includ: Takagi (1991), Dominguz (1986), Frankl and Froo (1987a,1987b), Bank of Japan (1989), Froo and Frankl (1990), Io (1990), MacDonald and Torranc (1988), Cavalgia al., (1993), Chinn and Frankl (1994), Pra and Ucum (1996), Kim (1997), MacDonald and Marsh (1996), Ellio and Io (1999), Bénassy-Quéré, Larriban and MacDonald (2003), 439

Chung and Wong (2000), Evans and Lyons (2004), Drgr and Sadmann (2006). Mos of hs sudis found suppor for h xrapolaiv and rgrssiv xpcaions formaion. Ths sudis concludd ha forcasing a horizon longr han hr monhs confirm vidnc for h prsnc of sabilizing xpcaions. On h ohr hand, h macroconomic prspciv primarily applis h mony dmand funcion in sudying h impac of macroconomic and financial aggrgas on xchang ra xpcaions formaion. Financial mark horis ar usd in h analysis of h bhavior of h conomic agn. Rsuls obaind by hs sudis lnd suppor o xrapolaiv, rgrssiv, raional and adapiv xpcaions, and rvals ha xpcaions rgrssiv undr hyprinflaion. Mos of hs sudis wr spcifically conducd on ihr h assumpion of covrd inrs ras pariy lik Claassn and Wyplosz (1985), Frnkl and Lvich (1975), (1977), Frnkl (1976), Clinon (1988), Taylor (1987), Fama (1984) or uncovrd inrs ra pariy lik Driskill (1981), Smih and Wickns (1990), Mussa (1984) and Taylor (1995). Ths sudis focusd on h invsigaion of h monary, porfolio, h fundamnaliss and Chariss hypohss. 3. DATA AND ESTIMATION ISSUES 3.1. Sourc and Dscripion of Daa This sudy usd im sris daa on h variabls obaind from h Cnral Bank of Nigria (CBN) Saisical Bullin from 1970 o 2012. Th sris includ xchang ra (EXR) dfind as h official ra of h US Dollar o Naira (usually xprssd as unis of forign currncy pr uni of domsic currncy) whil EXR 1 is h on priod laggd valu of h currn xchang ra. Also, w dfind xchang ra in rms of h Naira cross xchang ra for h US Dollar ( EXRD ) and Pounds Srling ( EXRP ). Th ra of rurns on h dmand dposis (rordmd) is dfind as hr (3) monhs dposis ra. This is usd as a rprsnaiv variabl for shor im horizon and shor rm domsic financial ass. Th ra of rurns on savings dposis (rorsvd) is dfind as six (6) monhs dposis ra and, Th ra of rurns on im dposis ( rortmd 1 and rortmd 2 ) ar dfind as wlv (12) monhs and ovr wlv (12) monhs ras of rurn on im dposis. Th im dposi is cagorisd ino wo o 440

rprsn long and longr im horizons. Ths dposis cagoris ar masurd as h domsic dposis ras (inrs ras) on hm. Th ra of rurns on h dposis indica h rlaiv yilds on financial insrumns dnominad in h naira (masurd in own currncy rms). Th ra of rurn on rasury bills (rortrb) is dfind as h Trasury bill ra. Th dposis of commrcial banks and rasury bills wr usd as proxis for domsic financial asss. Also, hy srv as h financial indicaors in h xchang ra modl. Th incom of h invsor and financial asss holdr ( GDP ) is dfind as Gross Domsic Produc (GDP) pr capia dflad by inflaion. Th ra of inflaion (INFL) was also includd as a macroconomic fundamnal ha is ssnial in h xchang ra xpcaions formaion procss. Th dfiniions and inclusion of incom and inflaion wr adopd in consonanc wih h pragmaic pracic of Drgr and Sadmann (2006) and Mussa (1982) ha rfrrd o inflaion and h incom of h invsor or financial asss holdr as major macroconomic fundamnals in xchang ra xpcaions formaion. Thy argud ha h currn xchang ra is a funcion of h pah akn by hs macroconomic fundamnals. 3.2. Modl Spcificaion In h spcificaion of h xchang ras xpcaions formaion modl, w ook cognizanc of h horical posiions of Muh (1961), Sargn (1973), Lidrman (1982) and mor rcnly Nyong (2001), ha is, xchang ra xpcaions ar condiiond on all h availabl informaion in h conx of h raional xpcaions. From quaion (4) h rducd form of quaions (3), (5), (6) and (7); a sylizd spcificaion of h drminans of xchang ra xpcaions formaion is formulad assuming ha: EXR EXR. So ha h funcional form is sad as: EXR a EXR INFL GDP rorsvd rordmd rortmd1 rortmd2 rortrb 1,,,,,,, whr rprsns vcor of h cofficins of h rgrssors. INFL rprsns ra of inflaion a im. GDP rprsns a proxy for incom of h invsor a im. (10) rorsvd rprsns on o six(6) monhs ra of rurn on savings dposi a im. 441

rordmd rprsns hr (1-3) monhs ra of rurn on dmand dposis a im. rortmd 1 rprsns wlv (12) monhs ra of rurn on im dposis a im. rortmd 2 rprsns abov wlv (12) monhs ra of rurn on im dposis a im. rortrb rprsns ra of rurn on rasury bills a im. EXR = Exchang ra a im ( 1 ) i.. prvious on yar 1 priod. Thr dfiniions of xchang ras wr usd in his sudy: h Naira cross xchang ra on h US Dollars; h Naira cross xchang ra on h Briish Pounds Srling, and h official xchang ra. Th drminans of xchang ra wr summarily prsnd by Salmi (1984), Oaikhnan and Edo (2000), and Obadan (2007, 2012). Ths sudis nod ha xchang ra xpcaions formaion rac as any ohr pric of financial asss o is dmand and supply whil ovr h long-run, is valu may b dominad by fundamnal conomic facors. From h subsiuabiliy (of forign and domsic financial asss) claus of boh h porfolio and h monary approachs, h drminans of h dmand for domsic financial asss vis-a-vis h forign asss can b incorporad ino h shor-run approach as drminans sinc h shor-run aks ino cognizanc on monh, hr monhs, or on yar as applid by Bénassy- Quéré al., (1999) and, Drgr and Sadmann (2006). Th drminans ar xprssd in an conomric modl (a modifid mixd modl) as: (11a) (11b) (11c) Th xpcd signs of h cofficins for quaion (11a) ar: aa0, aaaaa, a 0 1, 3 2, 4, 5, 6, 7 8 Th xpcd signs of h cofficins for quaion (11b) 0,, 0 ar: 1, 3 2, 4, 5, 6, 7 8 442

Th xpcd signs of h cofficins for quaion (11c) ar: bbbb b bb0, b, 0 1, 3 2, 4, 5, 6, 7 8 Th cofficin for h prvious priod(on yar) xchang ra EXR ) is xpcd o b posiiv connoing h fac ha currn ( 1 xpcaions ar formd basd on h naur of h prvious priod xchang ra. Also, h sign of h cofficin of Incom is posiiv rflcing h ransacionary mony incom which is xpcd o incras h currn dmand for xchang ra as i incrass (akin o Nyong, 2001; and Lidrman, 1981). Th ngaiv signs of h cofficins of h ras of rurns of banks dmand, savings, im dposis and Trasury bill ra ar anchord on h hypohsis of financial asss subsiuabiliy basd on h Porfolio hory (Claassn, 1997 and Nnanna, 2002). Th Nigrian conomy is an opn conomy, hrfor, i is xpcd ha h porfolio of h invsor b mad of boh domsic and forign financial asss. As h rurns on h domsic asss bcom mor araciv, forign financial asss in h porfolio of h invsor rducs as posid by h asss subsiuabiliy hypohsis. Hnc, ngaiv signs ar aachd o h cofficins of hs domsic asss. Th cofficin of h ra of inflaion is ngaiv basd on h srucuraliss prspciv ha h scarciy of forign xchang is synonymous wih high inflaionary ra, ha is, inflaion rsuls from h prsnc of srucural rigidiis of xchang ra lading o xchang ra dprciaion (Nyong, 2001; Oaikhnan and Edo, 2000). A singl modl was spcifid for all cagoris of financial asss holdrs basd on h assumpion of h coxisnc of diffrn yps of financial asss holdrs as suggsd by Bénassy-Quéré al. (1999). Equaion (11a, 11b and 11c) can b spcifid in four dgnra and spcific forms: EXR b b * EXR b * INFL (12) 0 1 j 2 j Equaion (12) is spcifid o s h impac of inflaionary xpcaions on xchang ra xpcaions formaion. EXR c c * EXR c * GDP c * rortrb c * INFL (13a) 0 1 1 2 1 3 1 4 1 EXR d d * EXR d * GDP d * rortmd1 d * rortrb d * INFL (13b) 0 1 1 2 1 3 1 4 1 5 1 EXR * EXR * GDP * rortmd2 * rortrb * INFL (13c) 0 1 1 2 1 3 1 4 1 5 1 EXR * EXR * GDP * rordmd * rortrb * INFL (13d) 0 1 1 2 1 3 1 4 1 5 1 443

Equaion (13a) is spcifid o ascrain h impac of incom of h invsor and rasury bills on xchang ra xpcaions formaion. Equaion (13b), (13c) and (13d) wr spcifid basd on h financial asss subsiuabiliy hypohsis. Modls wr spcifid for only wo cagoris of dposis (wih im dposi having wo varians) bcaus of h naur of rurns. Dmand dposis incur a cos for h financial ass holdr whil im dposis or saving dposis yilds a posiiv rurn (incom) for h financial ass holdr. In quaion (11a, 11b and 11c), (12), (13a, 13b, 13c and 13d); h signs of h cofficins of h rgrssors and hir impacs ar xpcd o b in lin wih sandard horis of xchang ra drminaion (Drgr and Sadmann, 2006). 3.3. Esimaion Tchniqus 3.3.1. Saionariy and Uni Roo Tss Srious problms ar ofn ncounrd in conomric analysis if h im sris ar non-saionary. A sudy lik Phillips (1986) has shown ha h saisical propris of rgrssion analysis ha applis nonsaionary im sris ar unrliabl and a bs dubious (Charmza and Dadman, 1993). Furhrmor, saionariy (uni roo) ss will hlp us avoid h implici dangr ofn manaing from inrpring rgrssion oucoms for im sris variabls ha ar drminisically rndd(almos always divrging in im). W applid h Augmnd Dicky Fullr (ADF) uni roo s. W sd for h saionariy of our sris wih a viw o ascraining hir ordr of ingraion (whhr h ras of rurns on h dposis cagoris ar prsisn or no as rpord by Prron (1988) and, Sock and Wason (1988)). Ths sudis rpord h prsnc of uni roo a lvls showing ha h ra of rurns wr prsisn. Issus rlaing o saionariy and drminaion of h ordr of ingraion ar xhausivly rad in (Omoor 2007, 2008a, 2008b, 2008c and 2009; Banrj al., 1986 and 1992; Domowiz and Elbadawi, 1987; Engl and Grangr (1987); Hndry (1989); Johansn and Juslius (1990); Hndry and Ericsson (1991); Grangr and Nwbold (1974, 1986); Said and Dicky (1984); Podvinsky (1990) and Blangiwicz and Charmza (1990) amongs ohrs. 3.3.2. Coingraion/Long-Run Rlaionship Th Johansn coingraion s was applid in h drminaion of h long-run quilibrium rlaionship among h variabls of inrs. According o Engl and Grangr (1987) and, Charmza and Dadman (1993) wo im sris variabls X and Y ar coingrad of ordr d or b 444

givn ha db 0. This is spcifid as: X, Y ~CI(d,b). This is subjc o h condiion ha boh sris mus b ncssarily ingrad of ordr d (h sam ordr; and hr xiss a linar combinaion of h wo variabls such ha 1. X 2. Y is ingrad of ordr d b. If hr is a long- run rlaionship bwn wo (or mor) of h sris ha ar I( d ); any dviaion from h long-run pah bcoms I (0) implying ha h sris ar coingrad. 3.3.3. Error Corrcion Mchanism (ECM)/Shor-Run Rlaionship Th shor-run analysis basd on h Error Corrcion Mchanism (ECM) is adopd in his sudy. Th ECM was adopd in his sudy for h following rasons. Whlan (2013) argud ha modls usd o analyzd raional xpcaions mus mov from h srucural form o h rduc form. Raional xpcaions modls ar usually formulad by assuming ha h driving variabls ar gnrad by backward looking im sris modls such as ECM. Th ECM usually prmis h modlling of h shor-run adjusmns ha lad o a long-run quilibrium, ha is, i incorporas boh changs in shor-run adjusmn and long-run quilibrium. Furhrmor, h ECM whn adopd in h simaion of xchang ra xpcaion formaion prmis h ingraion of shor-rm flucuaions around h long-run quilibrium. In ordr for h modl o incorpora h ECM, Charmza and Dadman (1993) posid ha h wo (or mor) sris in h long-run rlaionship mus b ingrad of h sam ordr and h rror rm mus ncssarily b I (0). This is why Engl and Grangr (1987) argud ha any coingrad sris hav an rror corrcion rprsnaion implying ha coingraion is a ncssary condiion for rror corrcion o hold (s Engl and Grangr 1991). A corollary o ha argumn is ha, if all h sris ar I(0) and h rror rm I(0) hn coingraion analysis is no ncssary. 4. ANALYSES OF RESULTS 4.1. Rsuls of Uni Roo Ts Th rsuls of h Augmnd Dicky Fullr ss ar prsnd in abl 2 blow. Eigh sris mployd in his sudy ar shown using hir rprsnaiv symbols. 445

Uni Roo Tss Rsuls Variabl LEVEL FIRST DIFFERENCE Inrcp Inrcp/Trnd Non Tabl 2 ORDER OF INTEGRATION EXR -1.1697-1.8273-0.7519-4.0884* I(1) EXRD 0.1221-2.3319 1.6213-5.5641* I(1) EXRP -0.2123-2.5011 1.0954-6.0251* I(1) INFL -2.7914-3.5222-1.7079-5.3706* I(1) GDP -0.01188-1.9055 1.3758-1.6104*** I(1) rordmd -2.8611-2.8609-0.3005-2.5124** I(1) rorsvd -2.2620-2.5664 0.7654-4.9450* I(1) rortmd1-2.3892-3.4211-0.3952-6.2582* I(1) rortmd2-2.4159-2.6730-0.7907-7.0416* I(1) rortrb -2.4381-2.6434-0.8311-6.7516* I(1) Sourc: Auhor s compuaion No: * and ** conno 1 prcn and 5 prcn lvl of significanc rspcivly. All h variabls wr saionary a firs diffrnc (ingrad of ordr on). Thrfor, i is obvious from Tabl 2 abov ha h null hypohss of no uni roos for all h im sris ar rjcd a hir firs diffrncs sinc h ADF s saisic valus ar lss han h criical valus a h diffrn lvls of significancs. 4.2. Coingraion Rsul 4.2.1. Coingraion Rsul for All Sris Th coingraion rsuls ar prsnd in wo cagoris. Th firs cagory covrs h sris in h sudy. Th firs cagory is also rpord in wo forms (s abls 3a and 3b): Trac saisic and Maximum Eign valu ss. Th scond cagory focusd on xchang ras and h ra of inflaion (s abl 3c blow) Tabl 3a Rsuls of h Johansn Coingraion Analysis (Trac Saisic) Hypohsizd No. Eign Valu Trac Saisic 0.05 Probabiliy of CE(s) Criical Valu Non ** 0.8975 254.03 159.53 0.0000 A Mos 1 ** 0.8652 183.42 125.62 0.0000 A Mos 2 ** 0.7639 121.29 95.75 0.0003 A Mos 3 ** 0.6536 76.54 69.82 0.0132 A Mos 4 0.4636 43.68 47.36 0.1169 A Mos 5 0.3650 24.37 29.79 0.1853 A Mos 6 0.2821 10.29 15.47 0.2591 A Mos 7 0.00041 0.0137 3.84 0.9067 Sourc: Auhor s Compuaion No: *(**) dnos rjcion of h hypohsis a 5 prcn (1 prcn) significanc lvl. Trac saisic s indicas four (4) coingraing quaions a 5 prcn significanc lvl. 446

W sablishd basd on h rsul of h Johansn coingraion s ha hr ar four coingraing quaions for xchang ra, dmand dposis, saving dposis, im dposis, rasury bills ra, incom and ra of inflaion. Th xisnc of coingraing quaions mans ha hr is long-run rlaionship among h variabls in h modl. Furhrmor, h xisnc of a long-run quilibrium rlaionship simply mans ha if any of h variabls usd in h modl dvia from is long-run man valu as a rsul of a disurbanc, i will rurn o h common long-run quilibrium as soon as h disurbanc wakns and is ovr. Tabl 3b Rsuls of h Johansn Coingraion Analysis (Maximum Eign Saisic) Hypohsizd Eign Valu Max-Eign 0.05 Probabiliy No. of CE(s) Saisic Criical Valu Non ** 0.8975 70.60 52..36 0.0003 A Mos 1 ** 0.8652 62.13 46.23 0.0005 A Mos 2 ** 0.7639 44.76 40.08 0.0138 A Mos 3** 0.6536 33.88 30.86 0.0257 A Mos 4 0.4636 19.31 27.53 0.3911 A Mos 5 0.3650 14.079 21.13 0.3586 A Mos 6 0.2821 10.28 14.26 0.1945 A Mos 7 0.00041 0.0137 3.84 0.9067 Sourc: Auhor s Compuaion No: *(**) dnos rjcion of h hypohsis a 5 prcn (1 prcn) significanc lvl. Maximum Eign saisic s indicas four (4) coingraing quaions a 5 prcn significanc lvl Th maximum Eign Saisic confirms h xisnc of four (4) coingraing quaions or vcors a h 1 prcn lvl of significanc. 4.2.1. Coingraion Rsul for Exchang Ras and Inflaion Th coingraion s xamind h long run rlaionship bwn xchang ra and ra of inflaion. Tabl 3c prsns h rsuls of h liklihood raio ss for h numbr of coingraing vcors. Tabl 3c Rsuls of h Johansn Coingraion Analysis (Trac Saisic) Hypohsizd Eign Valu Trac Saisic 0.05 Probabiliy No. of CE(s) Criical Valu Non * 0.493 27.56 25.87 0.0200 A Mos 1 0.202 6.82 12.52 0.371 Maximum Eign Saisic Hypohsizd Eign Valu Maximum 0.05 Probabiliy No. of CE(s) Eign Saisic Criical Valu Non * 0.493 20.70 19.39 0.0200 A Mos 1 0.202 6.82 12.52 0.371 Sourc: Auhor s Compuaion No: *(**) dnos rjcion of h hypohsis a 5 prcn (1 prcn) significanc lvl. Trac saisic and Maximum Eign ss indica on (1) coingraing quaion a 5 prcn significanc lvl 447

Boh h rac saisic and maximum Eign saisic confirm h xisnc of 1 coingraing vcor or quaion. This implis h xisnc of a long-run rlaionship bwn xchang ra xpcaions and ra of inflaion. 4.3. Error Corrcion Mchanism Rsul Having sablishd h xisnc of a long-run rlaionship among h variabl, w sd h rsiduals for saionariy o ascrain h applicabiliy of ECM or ohrwis. Th rsuls of h rsiduals s for saionariy ar shown blow in abl 4. 4.3.1. Augmnd Dicky Fullr Uni Roo Ts on Rsiduals Augmnd Uni Roo Tss of Rsiduals Rsidual ADF Saisic Dcision Opimal Lag Lngh ECM 1-3.2604 Saionary a lvls 2 wih no consan ECM 2-4.5754 Saionary a lvls 2 wih no consan ECM 3-2.9855 Saionary a lvls 2 wih no consan ECM 4-2.4350 Saionary a lvls 2 wih no consan Sourc: Auhor s Compuaion Tabl 4 No: ECM 1 rprsns h rsidual obaind from h long-run xchang ra/inflaionary xpcaions modl. ECM 2 rprsns h rsidual obaind from h long-run xchang ra/incom modl. ECM 3 and ECM 4 rprsn h rsidual obaind from h long-run xchang ra/domsic financial asss modl. Th rsuls of h ADF uni roo s of rsiduals of h long-run modls (3a), (b), (c) and (d) ar rpord in abl abov. Th opimal lag lnghs usd ar also rpord. Rcall ha if h rsiduals obaind from h long-run vrsion of quaion (12), (13a, b, c and d) ar non-saionary; hn h simad long-run rlaionship connos a spurious rgrssion. Bu if h rsiduals ar saionary, hn h simad long-run rlaionship implis a coingraing rlaionship. To s h saionariy of h rsiduals, w adopd ADF s whr h criical valus abulad by Mackinnon (1996) ar compard wih h ADF saisic. Th simad ADF saisics wr lss han h Mackinnon criical valu (-1.95) a h 5% significanc lvl. Th rsuls of h ADF uni roo s show ha h rsiduals wr saionary a lvl which implis ha w rjc h null hypohsis of uni roo in h rsidual rrors; implying also ha h variabls ar coingrad. Hnc, w procd o h ECM simaion. 448

4.3.2. ECM Rsul for Exchang Ra and Inflaionary Expcaion Modl Th rsul of h ECM using xchang ra dfind as h official xchang ra of h US Dollar o Naira is prsnd in h abl shown blow. Exchang ra was usd as h dpndn variabl whil h indpndn variabls includ h diffrncd valu of incom, ra of inflaion, h diffrncd valu of xchang ra wih rror corrcion paramr. Tabl 5 Rsul of Error Corrcion Mchanism (ECM) for Exchang Ra and Inflaionary Expcaion Modl Tabl Variabl Cofficin Sandard Errors -sa Prob. C 91.880 10.302 8.918 0.000 DEXR (-1) 46.841 0.195-1.733 0.019 DEXR (-2) 24.612 0.189-1.310 0.201 DINFL (-1) -1.273 0.384-3.316 0.002 ECM (-1) -0.420 0.685 1.490 0.241 Sourc: Auhor s Compuaion R 2 = 0.63 Adjusd R 2 = 0.59 DW = 1.827 Prob. (F-saisic) = 0.0000 Th signs of h cofficins of h rgrssors saisfy our a priori / horical xpcaions. Th ngaiv sign of h cofficin of inflaion connos ha basd on h immdia pas priod prformanc of inflaion, financial asss holdrs form ngaiv xpcaions abou h currn prformanc of xchang ras. Th valu of h R squar mans ha abou 63 prcn of h variaion in h rgrssand is xplaind by h variaions in h rgrssors. Th shor-run analysis basd on h ECM shows ha in Nigria wihin h priod undr considraion, xchang ra of h prvious priod ha is, h laggd valu of xchang ra (EXR(-1)) for h immdia pas priod is saisically significan in xplaining xchang ra xpcaions formaion. In consonanc wih Bénassy-Quéré al., (1999), his implis ha invsors/ financial asss holdrs us prvious priod xchang ra chang as a vriabl insrumn for prdicing currn/subsqun priod changs in xchang ra. This mans ha h magniud of a prvious forcas rror is offs in h currn/nx priod by a saisically significan proporion. This is a validaion of h forward looking hypohsis. Th rsuls also show ha inflaionary xpcaions of h immdia pas priod (on priod) is saisically significan in xplaining xchang ra xpcaions formaion. Th cofficin of h rror corrcion rm in h xchang ra/inflaionary xpcaions quaion is ngaiv, bu saisically insignifican. This mans ha h rror corrcion rm dos no conribu o h xplanaion of h changs in xchang ras xpcaion formaion. Furhrmor, sinc h rror rm is 449

saisically insignifican, i suggss h xisnc of unidircional causaliy running from h laggd valu of ral inflaion o xchang ras. In h conx of inflaionary xpcaion, abou 0.42 of h discrpancy in h quilibrium valu in h prvious priod is liminad in h currn priod. Wihin h framwork of inflaionary xpcaion, xchang ra xpcaions formaion adjuss a a rlaivly high spd. 4.3.3. Error Corrcion Mchanism: Rsul for Exchang Ra and Ral Incom Modl Tabl 6 Rsuls of Error Corrcion Mchanism: Exchang Ra and Ral Incom Tabl Cofficin Sandard Error - Probabiliy. Variabl saisic C 55.831 9.860 5.664 0.0000 DEXP (-1) 0.119 0.491 0.243 0.0025 DLGDPC (-1) 0.620 4.246 2.045 0.0011 DINFL (-1) -0.265 1.185-2.362 0.233 ECM (-1) -0.514 0.496 1.477 0.163 Sourc: Auhor s Compuaion R 2 = 0.54 Adjusd R 2 = 0.49 DW = 2.010 Th hypohsis ha incom is fundamnal o h dmand for xchang ras and financial asss subsiuabiliy hypohsis undr h raional xpcaions modl is validad in all h modls in his sudy bcaus h cofficin of h incom variabl was saisically significan and had h righ sign in h shor-run. This mans ha incom is fundamnal o xchang ra xpcaions formaion in Nigria. 4.3.4. Rsuls of Error Corrcion Mchanism: Exchang Ra and Ra of Rurns on Dmand Dposi Th rsuls of h ECM using xchang ra dfind as Naira cross xchang ra on US Dollars ar prsnd in h abl shown blow. Exchang ra was usd as h rgrssand whil h rgrssors includ h diffrncd valu of dmand dposis (hr monhs) bank ra on dposis), incom, ra of inflaion, h diffrncd valu of xchang ra wih rror corrcion paramr. This rprsns a shor-im horizon. 450

Tabl 7 Rsuls of Error Corrcion Mchanism (ECM): Exchang Ra and Domsic Financial Asss (Dmand Dposis) Variabl Cofficin Sandard Errors -saisic Probabiliy C 142.018 23.043 0.1660 0.0000 DEXRD(-1) 0.456 0.403 1.1298 0.2688 DLGDPC(-1) 0.00077 0.0003 2.510 0.0268 DrorDMD(-1) -7.0009 1.757-3.990 0.0005 DINFL (-1) -0.308 0.424 2.172 0.0047 ECM (-1) -0.224 0.438 0.0384 0.6910 Sourc: Auhor s Compuaion R 2 = 0.49 Adjusd R 2 = 0.39 DW = 1.868 Prob.(F-Saisic) = 0.0024 Th rsuls of h xchang ra xpcaion formaion basd on h hypohsis of financial asss prfc subsiuabiliy ar shown in abl 7 abov. Th domsic financial asss (dmand dposis) usd in his sudy was saisically significan. This shows ha h hypohsis of prfc subsiuabiliy of financial asss bwn domsic and forign asss ihr xplain or suppor xchang ras xpcaion formaion in Nigria during h priod undr considraion. Convrsly, h rsuls sm o invalida h financial asss imprfc subsiuabiliy hypohsis of h porfolio approach. 4.3.5. Rsuls of Error Corrcion Mchanism: Exchang Ra and On Yar Tim Dposi Ra Th rsuls of h ECM using xchang ra dfind as Naira cross xchang ra on US Dollars ar prsnd in h abl shown blow. Exchang ra was usd as h dpndn variabl whil h indpndn variabls includ h diffrncd valu of im dposis (on yar (wlv monhs) bank ra on dposi), incom, ra of inflaion, h diffrncd valu of xchang ra wih rror corrcion paramr. Tabl 8 Rsuls ECM Exchang Ra and Domsic Financial Asss (Twlv Monhs Tim Dposis Ra) Variabl Cofficin Sandard saisic Probabiliy. Errors C 140.590 19.364 7.253 0.0000 DEXRD(-1) 0.475 0.375 1.267 0.0030 DLGDPC(-1) 0.000695 0.00027 2.490 0.0195 DrorTMD1(-1) -6.697 1.417-4.728 0.0001 DINFL (-1) -0.305 0.391 0.780 0.0368 ECM (-1) -0.160 0.413-0.376 0.710 Sourc: Auhor s Compuaion 451

R 2 = 0.56 Adjusd. R 2 = 0.47 DW = 1.951 Prob. (F-Saisic) = 0.00044 Th rsuls shown in abl 8 abov indica ha using h 12 monhs im dposi ra as a proxy for domsic financial ass, h prfc subsiuabiliy of financial asss is suppord in h Nigrian conx Alhough h ECM rsuls show ha h spd of adjusmn of h modl is abou 16 prcn, h cofficin of h rror corrcion rm is no saisically significan. In raliy, h rsuls can b xplaind in h conx of ihr h porfolio or monary approach bcaus if h financial asss holdrs ar risk avrs, hy won considr h rurns on forign financial asss as subsiuabl wih h risklss rurns on domsic financial asss. In which cas, h financial asss holdr will almos always rquir a highr yild on forign financial asss as subsiu for hir risk avrsion. Alrnaivly, h invsors will hdg agains h currncy risk in h forward xchang mark. 4.3.6. Rsuls of Error Corrcion Mchanism: Exchang Ra and Ovr On Yar Tim Dposi Ra Th rsuls of h ECM using xchang ra dfind as Naira cross xchang ra on h Briish Pounds Srling ar prsnd in h abl shown blow. Exchang ra was usd as h dpndn variabl whil h indpndn variabls includ im dposis (dfind as ovr on yar bank ra on dposi), incom, ra of inflaion, h diffrncd valu of xchang ra wih rror corrcion paramr. A singl domsic financial ass vrsion of quaion (3c) was usd. Tabl 9 Rsuls of ECM: Exchang Ra and Domsic Financial Asss (Ovr On Yar Tim Dposi Ra) Variabl Cofficin Sandard - saisic Probabiliy. Errors C 130.956 14.324 9.130 0.0000 DEXRP(-1) 0.373 0.330 1.129 0.2600 DLGDPC(-1) 0.006 0.00025 2.665 0.0130 DrorTMD2(-1) -6.109 1.036-5.892 0.0000 DINFL (-1) -0.166 0.339 3.489 0.0041 ECM (-1) -0.110 0.346 0.319 0.752 Sourc: Auhor s Compuaion R 2 = 0.64 Adj. R 2 = 0.58 DW = 1.909 Th Error Corrcion Mchanism (ECM) rsul shown in abl 9 abov dnod ha h cofficins of h rgrssors had h xpcd signs. Th dpndn variabl usd for h abov ECM modl is h Naira cross xchang ra o h Pounds Srling. Th domsic financial ass rfrrd o in h modl in h im dposi dfind as banks dposi ra of ovr on yar a proxy for longr im horizon. Th ngaiv sign of h cofficin of im dposi 452

connos ha as xpcaions of incras in h ra of rurns of h financial ass highn coupld wih h vidnc of prvious incras in h ra of rurns; h dmand for Pounds srling will dcras. This mans ha ovr h longr priod horizon, im dposi is a ky drminan of xchang ra xpcaions formaion in Nigria. Th R squar suggss ha abou 64 prcn of h variaion in h dpndn variabl was accound for by h variaion in h indpndn variabls. From h rsuls shown abov, h rror corrcion rm is ngaiv bu saisically insignifican. I has a valu of -0.110. This valu connos h ra of convrgnc o h quilibrium sa pr yar. Explicily, h spd of adjusmn of any disquilibrium in his modl owards a long-run quilibrium is abou 11 prcn of h disquilibrium of h prvious priod is corrcd in h currn priod. 4.3.7. Rsuls of Error Corrcion Mchanism (ECM): Exchang Ra and Trasury Bills Th rsuls of h ECM using xchang ra dfind as Naira cross xchang ra on Pounds Srling ar prsnd in h abl shown blow. Exchang ra was usd as h dpndn variabl whil h indpndn variabls includ rasury bills, incom, ra of inflaion, h diffrncd valu of xchang ra wih rror corrcion paramr. Tabl 10 Rsuls of Error Corrcion Mchanism (ECM): Exchang Ra and Domsic Financial Asss (Trasury Bills) Variabl Cofficin Sandard -saisic Probabiliy Error C 121.709 14.638 8.315 0.0000 DEXRP(-1) 0.618 0.366 1.690 0.1030 DLGDPC(-1) 0.00051 0.000026 1.936 0.0640 DrorTRB(-1) -5.686 1.1063-5.140 0.0000 DINFL (-1) -0.055 0.362 0.153 0.2430 ECM (-1) -0.492 0.358 1.374 0.1813 Sourc: Auhor s Compuaion R 2 = 0.59 Adjusd R 2 = 0.51 DW = 1.868 Prob.(F-Saisic) = 0.00016 Th xchang ra of Naira on Pounds Srling is usd as rgrssand and Trasury bill ra is usd as a proxy for domsic financial ass in ECM rsuls ar prsnd abov. Th prfc subsiuabiliy hypohsis of financial is validad by our rsuls. All h variabls had h righ and xpcd signs and ar saisically significan xcp h on-priod diffrncd valus of xchang ra and inflaion. Th ngaiv sign of h cofficin of h rasury bill ra implis ha an incras in h own ra of rasury bills lads o an incras in is dmand wih a dcras in h dmand for alrnaiv financial asss including h Naira on Pounds Srling 453

xchang ras. This furhr implis ha h financial asss holdr considrs hs asss as prfc subsius. Hnc if h ra of rurns on rasury bills is abov h ra of rurns on h forign ass i will apprcia rlaiv o is quilibrium valu whil h ohr dprcia in valu. Th rror corrcion rm connos h fac ha abou 49.2 prcn of h disquilibrium in h prvious priod is corrcd in h currn priod. 5. CONCLUSION AND POLICY RECOMMENDATIONS OF OUR FINDINGS This papr usd im sris daa of slcd macroconomic and financial fundamnals (as inflaion, rasury bill ra, dmand dposis, saving dposis and im dposis, and ral GDP pr capia) o invsiga how xchang ra xpcaions formd in Nigria. Th papr adopd a modifid mixd modl basd on h Porfolio, Chariss and Fundamnaliss approachs. Exchang ra xpcaion is linkd o inflaionary xpcaions in Nigria dpnding on h xchang ra dfiniion ha is adopd. Hnc, inflaionary xpcaions ar adjudgd o b quinssnial o xchang ra xpcaions formaion in Nigria in h shor-run. In h long-run, i was found ha a long-run quilibrium rlaionship xis bwn xchang ras and ra of inflaion. Thus, xchang ra xpcaions can b sabilizd and conrolld hrough inflaionary xpcaions monioring and rgulaion. Thr is nd o curail inflaion in ordr o rsor sabiliy o xchang ra xpcaions formaion in Nigria. Also, h sudy found ha h ovr on yar ra of rurns on im dposi is a drminan of xchang ras xpcaions formaion in Nigria. Th policy implicaion of his finding is ha, xchang ra xpcaions formaion should b conrolld in allianc wih h monary dsignd and implmnd o rgula commrcial banks dposis. Furhrmor, banks dposis should b usd as pon insrumn for h conrol of xchang ras in Nigria. This furhr suggss ha bank dposis spcially im dposi ar snsiiv monary policy wapon for h rgulaion of boh h xrnal and domsic conomis. Th hypohsis of xchang ras xpcaion formaion basd on h monary approach s prfc subsiuabiliy of financial asss in h Nigrian conx is no validad by our rsuls. This mans ha xchang ra xpcaions formaion in Nigria follows financial asss imprfc subsiuabiliy of h porfolio modl. GDP pr capia (incom) is saisically significan in h xplanaion of xchang ra xpcaion formaion in his sudy during h priod undr considraion. This papr found suppor for h rgrssiv modls of xchang ra xpcaions formaion hrby xnding h rsuls obaind by h backward looking modls. 454

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