REDUCING EXCHANGE RATE VOLATILITY VIA FOREIGN EXCHANGE RESERVES IN NIGERIA (1986–2025)

This study investigates the role of foreign exchange reserves in reducing exchange rate volatility in Nigeria over the period 1986 to 2025. Set against a backdrop of chronic exchange rate instability, multiple currency regimes, and mounting reserve depletion episodes, the research asks a fundamental question: do larger foreign exchange reserves systematically reduce the conditional variance of the naira–dollar exchange rate? Using a GARCH(1,1) framework to generate exchange rate volatility as the dependent variable, and employing Ordinary Least Squares (OLS), Fully Modified OLS (FMOLS), Dynamic OLS (DOLS), and Autoregressive Distributed Lag (ARDL) bounds testing approaches, the paper finds strong and consistent evidence that foreign exchange reserves exert a statistically significant negative effect on exchange rate volatility. The estimated coefficient on reserves ranges from −0.342 to −0.401 across specifications, suggesting that a 10 percent increase in reserves is associated with a 3.4 to 4.0 percent reduction in exchange rate volatility, all else constant. Among the eight control variables — global GDP growth, commodity prices (oil), domestic GDP growth, inflation, capital flows, investor sentiment (VIX), election cycles, and policy uncertainty — inflation, adverse investor sentiment, election-year dummies, and policy uncertainty are associated with higher volatility, while commodity prices and capital flows dampen it. These findings survive a battery of post-estimation diagnostics, including serial correlation, heteroskedasticity, normality, structural stability, and functional form tests. The study contributes to an underdeveloped strand of literature on the macroeconomic effectiveness of reserve management in commodity-dependent African economies, and draws important policy lessons for the Central Bank of Nigeria and peer institutions.