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IMPACT OF EXCHANGE RATE VOLATILITY AND NAIRA DEPRECIATIONON FOREIGN EXCHANGE RISK MANAGEMENT IN NIGERIAN BANKS

CHAPTER ONE
INTRODUCTION
1.1 Background to the Study
The Nigerian economy, heavily reliant on oil exports, has long been susceptible to external shocks that manifest in exchange rate volatility and currency depreciation. Exchange rate volatility denotes the unpredictable fluctuations in the value of the naira against major foreign currencies, often measured through models like Generalized Autoregressive Conditional Heteroskedasticity (GARCH), while naira depreciation refers to a persistent decline in its value, leading to increased costs for imports and foreign-denominated debts (Adenekan et al., 2019). These phenomena have intensified since the 2016 recession and subsequent policy reforms, exacerbating foreign exchange (FX) risks for banks, which include transaction, translation, and economic exposures (Olayungbo, 2021).

Scholarly research highlights that volatility arises from factors such as oil price swings, foreign reserve depletion, and speculative activities, directly impacting banks’ risk management practices (Yinusa & Akinlo, 2008). For instance, banks in Nigeria hold significant foreign currency assets and liabilities, making them vulnerable to balance sheet revaluations during depreciation episodes, which can erode profitability and capital adequacy (Obi & Okafor, 2025). Empirical studies using GARCH models demonstrate that high volatility increases the risk premium on naira-denominated assets, prompting banks to adopt hedging instruments like forwards and swaps, though their effectiveness is limited by market illiquidity (Adenekan et al., 2019; Olayungbo, 2021).

Naira depreciation, often policy-induced through devaluations, amplifies these risks by inflating the local currency value of foreign liabilities, leading to higher provisioning and reduced lending capacity (Aliyu, 2010). Researchers note asymmetric effects, where depreciation shocks have more pronounced negative impacts on bank performance than appreciations, due to Nigeria’s import-dependent economy (Mesagan et al., 2021). For example, during periods of sharp depreciation, banks experience heightened credit risks from borrowers exposed to foreign currency loans, necessitating robust risk management frameworks (Obi & Okafor, 2025).

Despite these challenges, some studies suggest potential benefits, such as improved export competitiveness for non-oil sectors indirectly supporting bank lending, though evidence in Nigeria remains mixed (Chude & Chude, 2023). Volatility modeling reveals persistent clustering, where large fluctuations follow each other, complicating predictive risk management (Olayungbo, 2021). This study delves into how exchange rate volatility and naira depreciation influence FX risk management in Nigerian banks, drawing on theoretical frameworks like the International Fisher Effect and empirical evidence from emerging markets.

1.2 Statement of the Problem
Persistent exchange rate volatility and naira depreciation pose systemic threats to Nigerian banks’ stability, as they amplify FX exposures and undermine traditional risk mitigation strategies (Yinusa & Akinlo, 2008). Depreciation increases the naira equivalent of foreign debts, leading to liquidity strains and higher non-performing loans, particularly in sectors reliant on imports (Aliyu, 2010). Volatility, characterized by unpredictable swings, heightens uncertainty, discouraging foreign investments and forcing banks to maintain costly buffers (Mesagan et al., 2021).

Empirical analyses indicate that while banks employ hedging and diversification, these are often ineffective amid regulatory constraints and market inefficiencies, resulting in elevated operational costs and reduced profitability (Obi & Okafor, 2025). For instance, GARCH-based studies show that volatility shocks persist longer in Nigeria due to weak institutional frameworks, exacerbating risk management failures (Adenekan et al., 2019). Prior research predominantly examines macroeconomic impacts, with limited focus on bank-specific FX risk dynamics, creating a gap in understanding adaptive strategies (Chude & Chude, 2023; Olayungbo, 2021).

This oversight is critical, as unmanaged risks can cascade into broader financial instability, as evidenced by past banking crises linked to currency mismatches (Yinusa & Akinlo, 2008). The study addresses this by exploring the direct and indirect effects on risk management practices, aiming to inform evidence-based interventions.

1.3 Objectives of the Study

The main objective examines the impact of exchange rate volatility and naira depreciation on foreign exchange risk management in Nigerian banks.

The specific objectives are:

1. Identify effects of exchange rate volatility on FX risk exposure and management strategies in Nigerian banks.
2. Assess consequences of naira depreciation on bank balance sheets, profitability, and risk mitigation practices.
3. Propose policy and practical recommendations to strengthen foreign exchange risk management in Nigerian banks amid ongoing volatility and depreciation.

1.4 Research Questions

1. How does exchange rate volatility affect foreign exchange risk exposure and management in Nigerian banks?
2. What are the implications of naira depreciation for bank financial performance and FX risk strategies?
3. What policy measures and practical strategies can be recommended to improve foreign exchange risk management in Nigerian banks under conditions of volatility and depreciation?

1.5 Significance of the Study

This research contributes to scholarly discourse on emerging market finance by elucidating FX risk dynamics in Nigeria, aiding academics in refining volatility models. For practitioners, it offers insights into adaptive hedging, enhancing bank resilience. Policymakers benefit from evidence on policy transmission, supporting stable exchange regimes (Yinusa & Akinlo, 2008).

1.6 Scope of the Study
The study encompasses major Nigerian banks from 2010 to 2025, focusing on post-recession volatility. It utilizes secondary data and econometric models like GARCH for analysis.

1.7 Limitations of the Study
Constraints include data inconsistencies from volatile markets and model assumptions in volatility estimation. These are addressed via robustness checks and multiple data sources.

References

Adenekan, A. T., Sanni, G. K., & Itodo, A. I. (2019). Investigating the impact of exchange rate volatility on naira exchange rate in Nigeria. Economic and Financial Review, 57(3), 1-16.

Aliyu, S. U. R. (2010). Impact of exchange rate depreciation on the balance of payments: Empirical evidence from Nigeria. African Journal of Economic and Sustainable Development, 2(1), 1-15.

Chude, N. P., & Chude, D. I. (2023). The impact of exchange rate policy on non-oil exports in Nigeria: An ARDL approach. International Journal of Economics and Finance Studies, 15(1), 45-62.

Mesagan, E. P., Alimi, O. Y., & Yusuf, I. A. (2021). Exchange rate fluctuations and sectoral exports in Nigeria: A VECM analysis. Journal of African Business, 22(3), 345-362.

Obi, K. O., & Okafor, C. (2025). Impact of exchange rate on the profitability of commercial banks in Nigeria. International Journal of Economics, Finance and Management, 10(3), 114-127.

Olayungbo, D. O. (2021). Exchange rate volatility, stock price fluctuations and the lending behaviour of banks in Nigeria. Journal of Economics and International Finance, 13(2), 78-89.

Yinusa, D. O., & Akinlo, A. E. (2008). Exchange rate volatility and the extent of currency substitution in Nigeria. Indian Economic Review, 43(2), 161-181.