Equity Risk Premium, Macro-Economic Variables and Co-Integration: Evidence from Nigeria

Abstract

The paper examines the long-run causal relationship between equity risk premium and a set of macroeconomic variables namely GDP growth rate, inflation, interest rate and financial deepening for a period of 25 years, ranging from 1985 to 2010.  We particularly adopt the J-J co-integration approach and the results obtained reveal that there is a long-run relationship between equity risk premium and the specified macroeconomic variables. The Ganger causality test shows a unidirectional causality running from inflation to equity risk premium and also from interest rate to financial deepening. However, no causality relationship was detected between the pairs of GDP growth rate and equity risk premium; interest rate and equity risk premium as well as between financial deepening and equity premium. The Forecast Error Variance Decomposition (FEVD) shows that although macroeconomic variables are sources of volatility to the equity market in Nigeria, own shocks emanating from the equity market constitute the dominant source of volatility. It is therefore recommended that investors in the Nigerian capital market as well as policy makers should be mindful of these observations in formulating investment decisions.