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The Effects of Market Volatility on Corporate Survival in a Developing Capital Market

 

Mr Bala Suleiman Dalhat

Senior Lecturer,

Accounting and Finance Technology, Programme,

School of Management, Technology,

Abubakar Tafawa Balewa University,

Bauchi, Nigeria.

 

Abstract

 

Corporate survival depends to a great extent on the stability of some micro and macro economic variables. Fundamentally, the level of awareness of the investing populace counts a lot in resisting market volatility. Similarly, the rate of savings by individuals contributes immensely to the absorption of effects of price fluctuations. Nigeria’s capital market is not well developed to accommodate consistent price volatility. However, if the volatility of stock market prices is to be understood in terms of the efficient markets hypothesis, then there should be evidence that true investment value changes through time sufficiently to justify the price changes. Three indicators of change in true investment value of the aggregate stock market are considered: changes in dividends, in real interest rates, and in a direct measure of inter-temporal marginal rates of substitution. Although there are some ambiguities in interpreting the evidence, dividend changes appear to contribute very little toward justifying the observed historical volatility of stock prices. The other indicators contribute some, but still most of the volatility of stock market prices appears unexplained. Yet this determines the relevance of a company or otherwise in the market.

Bala Suleiman Dalhat and Aminu K. Kurfi Ph. D

 

Full Paper

Introduction

 

You often hear about stock market volatility, and how bad it is, but have you wondered how to compare volatility? Is it just something you know when you see it, or can it be quantified? Well, like most things, there are ways to quantify volatility so you can make the comparisons you want. First, we need to agree on definition of volatility. It's basically the variation from the average value over a measurement period. If a price varies a great deal from day to day, the volatility will be high, and conversely if the day to day variation is low, the value of volatility will be low as well. Another definition of volatility by Adeyi (2008) is, "Volatility" refers to the frequency of price turnarounds in a stock or the entire stock market, and the degree of these price reversals. It is a measure of uncertainty in the marketplace. Many industry professionals refer to volatility as a study of "fear" in the stock market. When investors become more skeptical of economic success or individual corporate growth, a stock or entire market can fluctuate with greater volatility than during times of relative normalcy. A stock that moves in a consistent direction without much deviation is said to have low volatility.

 

While it get pretty complicated in a hurry when you burrow into the statistics, and you factor in things like lognormal returns, and stationary processes, it can be approximated by saying that if the volatility is calculated by the standard deviation of the asset prices, then approximately two third of the time the price will be within one standard deviation of the average price over time. In most cases, one considers a high level of stock price volatility an indication of greater risk and, and therefore, this reduces value, all other factors being equal. In the case of call options on a stock, the opposite is true; there is a positive relationship between the volatility f the underlying stock and the value of the call option. This is because with greater volatility, there is greater potential for gain on the upside, and the downside protection of the option is also worth more (Reilly, 2002).

Risk is prevalent everywhere in life, but business risk can be managed and to some extent reduces volatility of products and share prices. Risk originate from a variety of sources including the physical environment of the business, the technology it employs for its operations, its people, organizational structure and strategy, and the political environment. How best to manage these risks is a major responsibility of managers. Effective risk management requires identification of the risks and developing strategies to mitigate them. The objective of risk management is to reduce the different risks related to any given activity to an acceptable level (Ayininuola;2007).

 

Investors generally conduct series of analyses to avoid risk. Where there are fluctuations in prices, investors became scared to invest so that they cannot fall victims of loss. This study intends to assess the effects of volatility on corporate survival in a growing capital market. An analysis of the prices of shares of companies that survived the period of global economic crises and those that crippled along the line will be conducted. Other companies that experience steady fluctuations in the last five years (2005-2009) in Nigeria will be conducted. A sample of fifteen (15) companies will be taken out of the population of 245 listed companies in the Nigerian Stock Exchange (NSE). A comparative study of the market prices of the stocks of the companies for the said period will be conducted. By implication, the study is going to rely mostly on secondary data.

 

Related Literature

Those who are new to stock market investing might be primarily concerned with the price of stock over a period of time. After all, it is the price that ultimately generates profits. But many factors affect how stock prices move. The concept of volatility plays an important role in market analysis. Those who are constantly aware of volatility have an advantage in predicting stock prices. It is an important component of the financial system that can lead to better investing decisions.

 

Definition

 

"Volatility" refers to the frequency of price turnarounds in a stock or the entire stock market, and the degree of these price reversals. It is a measure of uncertainty in the marketplace. Many industry professionals refer to volatility as a study of "fear" in the stock market. When investors become more skeptical of economic success or individual corporate growth, a stock or entire market can fluctuate with greater volatility than during times of relative normalcy. A stock that moves in a consistent direction without much deviation is said to have low volatility (Highland; 2010).

 

Causes

 

The tight interrelationships between different areas of the financial system are often displayed in the behavior of the stock market. The Great Bear Market of 2008 was a textbook example of how problems in the real estate and loan industries can have dramatic consequences on stocks in entirely unrelated sectors. Whenever a general crisis threatens an entire economy, volatility in the stock market is sure to increase. Even in stable times, threats against a particular sector, such as pharmaceutical stocks, can become more volatile because of changes in regulatory practices, such as policies by the National Agency for Food and Drug Administration and Control (NAFDAC).

 

In addition, every three months the stock market enters an "earnings season" in which the overall economic climate is quantified by corporate earnings reports. This, too, can lead to increased volatility.

 

Measurements

 

The volatility of the stock market is closely watched and quantified in several ways. One of the most prominent measures of volatility is the Chicago Board Options Exchange Volatility Index, commonly called VIX. Many refer to the VIX as the "fear gauge," as it is a direct measure of how investors see the stock market outlook over a short period into the future. When the VIX rises, volatility increases. This is usually accompanied by larger swings in stock prices and ultimately a decline in the stock market. Individual stocks can be compared against market volatility by studying their "beta" values. These are calculated by comparing a stock's price action with the overall action of a major index.

 

Profiting from Volatility

 

When the stock market becomes more volatile, it can be dangerous to buy into stocks. However, there are other ways to profit from the increased volatility. There are exchange traded funds, or ETFs, that correspond to all kinds of stock market behavior. These are traded like regular shares of stock, but they do not actually represent any corporation. Instead, they offer returns that correspond to their particular measurement. Some funds, increase in share price when the stock market decreases from increased volatility. Those who trade stock options often benefit from increased volatility as well. Most stock options increase in price even if their underlying stock remains unchanged, so long as volatility in the market rises.

Periodic fluctuation in the rate of economic activity, as measured by levels of employment, prices, and production signifies volatility. Economists have long debated why periods of prosperity are eventually followed by economic crises (stock-market crashes, bankruptcies and unemployment). Some have identified recurring 8-to-10-year cycles in market economies; longer cycles have also been proposed, notably by Nikolay and Kondratev (2010). Apart from random shocks to the economy, such as wars and technological changes, the main influences on the level of economic activity are investment and consumption. An increase in investment, as when a factory is built, leads to consumption because the workers employed to build the factory have wages to spend. Conversely, increases in consumer demand cause new factories to be built to satisfy the demand. Eventually the economy reaches its full capacity, and, with little free capital and no new demand, the process reverses itself and contraction ensues. Natural fluctuations in agricultural markets, psychological factors such as a bandwagon mentality, and changes in the money supply have all been proposed as explanations for initial changes in investment and consumption. Many governments used monetary policy to moderate the business cycle, aiming to prevent the extremes of inflation and depression by stimulating the national economy in slack times and restraining it during expansions.

The recurring and fluctuating levels of economic activity that an economy experiences over a long period of time scares investors due to fear of prolonged risk of loss. This is more common in developing economies. The five stages of the business cycle are growth (expansion), peak, recession (contraction), trough and recovery. At one time, business cycles were thought to be extremely regular, with predictable durations. But today business cycles are widely known to be irregular - varying in frequency, magnitude and duration due to business dynamics.

 

Investopedia Says

 

A business cycle is a sequence of economic activity in a nation's economy that is typically characterized by four phases—recession, recovery, growth, and decline—that repeat themselves over time. Economists note, however, that complete business cycles vary in length. The duration of business cycles can be anywhere from about two to twelve years, with most cycles averaging about six years in length. In addition, some business analysts have appropriated the business cycle model and terminology to study and explain fluctuations in business inventory and other individual elements of corporate operations. But the term "business cycle" is still primarily associated with larger (regional, national, or industry wide) business trends.

 

Stages of a Business Cycle

 

RECESSION: A recession—also sometimes referred to as a trough—is a period of reduced economic activity in which levels of buying, selling, production, and employment typically diminish. This is the most unwelcome stage of the business cycle for business owners and consumers alike. A particularly severe recession is known as a depression.

RECOVERY: Also known as an upturn, the recovery stage of the business cycle is the point at which the economy "troughs" out and starts working its way up to better financial footing.

GROWTH: Economic growth is in essence a period of sustained expansion. Hallmarks of this part of the business cycle include increased consumer confidence, which translates into higher levels of business activity. Because the economy tends to operate at or near full capacity during periods of prosperity, growth periods are also generally accompanied by inflationary pressures.

DECLINE: Also referred to as a contraction or downturn, a decline basically marks the end of the period of growth in the business cycle. Declines are characterized by decreased levels of consumer purchases (especially of durable goods) and, subsequently, reduced production by businesses.

 

Factors That Shape Business Cycles

 

For centuries, economists regarded economic downturns as "diseases" that had to be treated; it followed, then, that economies characterized by growth and affluence were regarded as "healthy" economies. However, many economists had begun to recognize that economies were cyclical by their very nature, Today, economists, corporate executives, and business owners cite several factors as particularly important in shaping the complexion of business environments (Soludo; 2004).

 

Volatility of Investment Spending

 

Variations in investment spending are one of the important factors in business cycles. Investment spending is considered the most volatile component of the aggregate or total demand (it varies much more from year to year than the largest component of the aggregate demand, the consumption spending). Increases in investment spur a subsequent increase in aggregate demand, leading to economic expansion. There are several reasons for the volatility that can often be seen in investment spending. One generic reason is the pace at which investment accelerates in response to upward trends in sales. This linkage, which is called the acceleration principle by economists, can be briefly explained as follows. Suppose a firm is operating at full capacity. When sales of its goods increase, output will have to be increased by increasing plant capacity through further investment. As a result, changes in sales result in magnified percentage changes in investment expenditures. This accelerates the pace of economic expansion, which generates greater income in the economy, leading to further increases in sales. Thus, once the expansion starts, the pace of investment spending accelerates. In more concrete terms, the response of the investment spending is related to the rate at which sales are increasing. In general, if an increase in sales is expanding, investment-spending rises, and if an increase in sales has peaked and is beginning to slow, investment-spending falls. Thus, the pace of investment spending is influenced by changes in the rate of sales (Ibe; 2008).

 

Politically Generated Business Cycles

 

Many economists have hypothesized that business cycles are the result of the politically motivated use of macroeconomic policies (monetary and fiscal policies) that are designed to serve the interest of politicians running for re-election. The theory of political business cycles is predicated on the belief that elected officials (the president, members of congress, governors, etc.) have a tendency to engineer expansionary macroeconomic policies in order to aid their re-election efforts ( Ibe; 2008).

 

Monetary Policies

 

Variations in the nation's monetary policies, independent of changes induced by political pressures, are an important influence in business cycles as well. Use of fiscal policy—increased government spending and/or tax cuts—is the most common way of boosting aggregate demand, causing an economic expansion especially in a developing economy. Moreover, the decisions of the Federal Reserve, which controls interest rates, can have a dramatic impact on consumer and investor confidence as well.

 

Fluctuations in Exports and Imports

 

The difference between exports and imports is the net foreign demand for goods and services. This is also called net exports. Because net exports are a component of the aggregate demand in the economy, variations in exports and imports can lead to business fluctuations as well. There are many reasons for variations in exports and imports over time. Growth in the gross domestic product (GDP) of an economy is the most important determinant of its demand for imported goods—as people's incomes grow their appetite for additional goods and services, including goods produced abroad, increases. The opposite holds when foreign economies are growing. Growth in incomes in foreign countries also leads to an increased demand for imported goods by the residents of these countries. This, in turn causes exports to grow in Europe and the U.S. Currency exchange rates can also have a dramatic impact on international trade and hence, domestic business cycles as well.

 

Effects of Volatility

 

FAS 123 (R) states that an entity's estimate of expected volatility should be reasonable and supportable. Factors to consider in estimating expected volatility includes:

a.         Volatility of the share price, including changes in that volatility and possible mean reversion of that volatility, over the most recent period that is generally commensurate with (1) the contractual term of the option if a lattice model is being used to estimate fair value or (2) the expected term of the option if a closed-form model is being used. For example, in computing historical volatility, an entity might disregard an identifiable period of time in which its share price was extraordinarily volatile because of a failed takeover bid if a similar event is not expected to recur during the expected or contractual term. If an entity's share price was extremely volatile for an identifiable period of time, for instance, due to a general market decline, that entity might place less weight on its volatility during that period of time because of possible mean reversion.

b.         The implied volatility of the share price determined from the market prices of traded options or other traded financial instruments such as outstanding convertible debt, if any.

c.         For public companies, the length of time an entity's shares have been publicly traded. If that period is shorter than the expected or contractual term of the option, the term structure of volatility for the longest period for which trading activity is available should be more relevant. A newly public entity also might consider the expected volatility of similar entities. A nonpublic entity might base its expected volatility on the expected volatilities of entities that are similar except for having publicly traded securities.

d.         Appropriate and regular intervals for price observations. If an entity considers historical volatility in estimating expected volatility, it should use intervals that are appropriate based on the facts and circumstances and that provide the basis for a reasonable fair value estimate. For example, a publicly traded entity would likely use daily price observations, while a nonpublic entity with shares that occasionally change hands at negotiated prices might use monthly price observations.

e.         Corporate and capital structure. An entity's corporate structure may affect expected volatility (paragraph A21). An entity's capital structure also may affect expected volatility; for example, highly leveraged entities tend to have higher volatilities.

 

ASX (2010) states that, to the pure chartist this indicator can be employed as an initial filter, which can be applied over a selection of markets, to arrive at the most suitable individual market that will fit a particular style or method.

 

The section highlighted to us the concept of volatility and its relative effects on the success or otherwise of companies. Volatility is a measure of how wild or quiet the market is relative to its history. It can be more accurately defined as the standard deviation of a series of price changes measured at regular intervals.

Volatility is generally measured using price changes expressed in logarithmic form, but can also be assessed using percentage changes in price. Price percentage changes would appear to reflect a more accurate picture of the market, despite the assumption that prices change at fixed intervals, which isn't necessarily how it is. On the other hand, logarithmic price changes assume prices are changing continuously, but that doesn't necessarily depict the market as it really is either.

 

A different approach at calculating historical volatility is to use the range between the high and the low and measure how it changes, rather than using standard deviation.

 

Methodology

 

The study adopts the use of secondary source of data where published financial statements of the selected companies serve as the major source. The indices to be used by this study to measure the volatility of the companies are share price, earnings and dividend. A simple analysis of deviations from the previous period’s outcome will give an insight of the effect on the company. The population is the entire listed companies in Nigerian Stock Exchange (NSE), but the sample is just fifteen companies selected based on geographical locations across the country.

 

Analysis of Data

 

S/N	NAME OF THE COMPANY	2009	2008	2007	2006	2005	REMARK
1.	UNILEVER NIGERIA PLC	N	N	N	N	N
	Price	16	28	20	25	18	Fluctuations occur
	Earnings	10	5	-	-	-	“
	Dividend	7	3	-	-	-	“
2.	FLOUR MILLS NIG. PLC
	Price	21	22	35	15	12	“
	Earnings	1.12	2.59	2.78	1.45	2.86	“
	Dividend	-	0.5	1.00	1.20	0.85	“
3.	CADBURY NIGERIA PLC
	Price	8.65	4.85	12.5	21.5	28.0	“
	Earning	(2.44	(6.6)	(4.28	2.70	2.81	“
	Dividend	16	13	-	-	-	“
4.	ASHAKA CEMENT PLC
	Price	13.5	10.9	8.51	4.78	1.54	“
	Earning	3	3	3	0.5	0	“
	Dividend						“
5.	BCC/DANGOTE CEMENT
	Price	42.9	15.4	14.5	10.7	11.2	“
	Earning	6	11	14	12	10	“
	Dividend	0	0	0	2,4	3.5	“
6.	NESTLE NIGERIA PLC
	Price	212	233	220	282	280	“
	Earning	12.6	14.3	9.62	15.7	19.3	“
	Dividend	12.5	9.5	2.5	16.0	18.5	“
7.	FIRST ALUMINIUM PLC
	Price	6.5	11.4	4.6	11.3	14.6	“
	Earning	1.2	1.8	1.00	3.2	6.10	“
	Dividend	0.60	0.60	0.75	0.80	0.85	“
8.	NORTHERN FLOUR MILLS
	Price	4.0	5.20	3.5	6.2	7.4	“
	Earning	0.86	1.10	0.52	1.8	1.86	“
	Dividend	-	-	0.50	0.80	1.00	“
9.	DIAMOND BANK PLC
	Price	12.0	10.5	6.75	14.8	21.5	“
	Earning	3.2	4.8	2.8	4.5	5.4	“
	Dividend	-	0.50	0.80	1.5	1.5	“
10.	NATIONAL SALT PLC
	Price	2.50	1.80	1.75	3.50	3.85	“
	Earning	1.00	1.00	0.85	1.80	2.10	“
	Dividend	0.20	0.40	0.30	0.75	1.00	“
11.	VITAFOAM NIG. PLC
	Price	3.31	5.98	3.51	7.00	7.31	“
	Earning	0.51	0.92	0.66	1.86	1.96	“
	Dividend	0.12	0.15	0.10	0.27	0.50	“
12.	UNION BANK PLC
	Price	12.0	10.8	10.5	22.0	20.0	“
	Earning	2.0	1.88	2.62	2.31	2.10	“
	Dividend	0.75	1.25	1.35	1.40	1.4	“
13.	WEMA BANK PLC
	Price	4.70	4.40	3.90	3.85	3.80	“
	Earning	1.20	1.22	1.05	1.70	1.68	“
	Dividend	0.50	0.80	1.10	1.15	1.10	“
14.	ABC MOTORS PLC
	Price	2.50	3.60	3.85	6.50	6.48	“
	Earning	1.22	1.05	0.95	1.65	1.72	“
	Dividend	-	0.40	-	0.75	0.60	“
15.	P. S. MANDRIDES
	Price	4.50	4.90	3.95	6.25	6.50	“
	Earning	0.90	0.92	0.86	1.02	1.10	“
	Dividend	0.20	0.20	0.25	0.40	0.55	“

SOURCE: NSE FACTBOOK 2010

 

From the responses in the above table, it is vividly clear that the prices of shares of the various companies under review have suffered during the economic crisis which had constantly manifested either a decline in earnings or fall in prices over time. The variables used have not been stable and steady throughout the period of the study. For instance, some companies have suspended the payment of dividend due to low earnings following the global economic crisis (Flour Mills, Diamond Bank and Northern Nigeria Flour Mills). An unstructured interview was conducted on some individual investors selected randomly to express what they feel is the basic factor hindering full capacity patronage to the stock exchange. The obvious reason proffered by all the respondents was that the prices of shares cannot be predicted with accuracy, and risk cannot be easily quantified especially where alternative investment outlets are available. Again, some respondents testified that availability of alternative investment avenues which gives more confidence on the side of the investors coupled with high risk and uncertainty are the basic factors that scares investors. This eventually inhibits corporate growth and survival. To this effect, companies in the recent years have suffered low turnover, price decline, low earnings and in some instance inability to pay dividend.

 

Findings

 

The study found that volatility affects the chances of companies to enjoy the patronage of investors. In Nigeria, the level of awareness of investors is very low compared with advanced economies. The low level of basic infra structure makes production and service delivery very expensive which subjects competition very harsh to the existing companies. Importation has made the local companies to lose patronage despite series of campaign by the government upon the citizens to be patriotic. The period of global economic crisis has affected almost every economy in the world but developing economies such as Nigeria which is highly dependent have suffered much more than others. The inability of companies to maintain the payment of dividends and effective growth in dividend is a deviation from the norms expected by investors to enjoy. This is an index that non expert use to  measure the performance of companies before deciding whether to invest or remain as investors or to divest. Whenever shareholders divest, the prospect of the company declines and the chances of growth and survival becomes bleak.

 

Conclusion

 

Volatility of share prices indicates instability of prices which is caused by many factors both quantitative and qualitative. To a risk averse and rational individual, investment becomes a bit difficult, since the person will be scared with the trend in which the prices changes overtime. Whenever investors are scared, the level of investment becomes very low and the companies suffer low capital volume. Hence, economy of scale cannot be easily achieved. This leads to low turnover, low profitability, low earning, low dividend and eventually loss of investor and/or shareholder confidence. Nigeria’s companies suffer series of predicaments ranging from lack of infra structure to lack of proper management. The global economic crisis had affected well developed economies especially the capital market operations. Nigeria being a growing economy coupled with the menace of illiteracy and corruption have a bitter experience of the situation. Many listed companies could not pay dividends in the last five years. Inadequate growth potentials have stunted corporate survival leading to closure of many companies and subsequent divestment into the other sectors of the economy.

 

The study recommends improved infrastructure and a sensitization to make citizens and other investors aware of the relevance of the stock exchange so that adequate capital would be provided to maintain steady growth and development of companies and the economy at large. Fiscal measures should be taken to give tax concessions to companies that are not performing as a result of the difficulties they found themselves in due the economic recession.

 

References

 

Adeyi, J. A. (2008) Profiting with Stocks, GO-GO Publishers, Jos, Nigeria

ASX (2010) Charting Library, Historical price volatility, Australian Securities Exchange.

Ayininuola, S. I. (2007) Enterprise Risk Management Framework and Implementation Challenges, Union Digest, Vol. 11 No. 3 & 4

Britannica Concise Encyclopedia. Britannica Concise Encyclopedia. © 1994-2010 Encyclopædia Britannica, Inc. 

Highland, J. (2010) Stock Volatility Information,http//:www. e How.com.answers.

Ibe, A. C. (2008) The Global Financial Crisis: Lessons for Nigeria, Union Digest: An Economic and Business Publication of Union Bank of Nigeria Plc. Vol. 14 No 4

Nicholay, C. and Kondradev, E (2007) Coping with Long-Term Volatility, The Journal of Finance and Banking, Vol. 6 No 12

Nigerian Stock Exchange (NSE) FACTBOOK 2010

Nigerian Stock Exchange Journal (2010)

Reilly, F. K. and Heed, E. (2005) Investments, CBS- College Publishing, New York, USA.

Soludo, C. C. (2004) Coping with Volatility of Share Prices: Nigeria’s Experience: Workshop organized for Bank Executives (Pre-Consolidation) at the Central bank of Nigeria, Abuja