On the time varying relationship between oil price and G7 equity index: a multivariate approach.

AuthorGuesmi, Khaled
  1. Introduction

    Previous studies were conducted within the last decade regarding asset classes, focusing on the commodity and financial market. Specifically, the recent financial crisis and synchronization in the financial market have drawn the concerns of the investors, academics and the finance practitioners. This study links with growing sectors of literature that depict the influence of oil price shocks on macroeconomic variables, specifically in advanced economics (Balaz and Londarev, 2006; Gronwald, 2008; and Cologni and Manera, 2009). From a theoretical perspective, the value of a share is reflected by the sum of future cash flows, which are discounted by a certain hurdle rate. The said discounted cash flows are vibrated by several economic factors, simultaneously, which can be influenced by the price of oil. Therefore, variation in stock prices can be explained--in a great extent--by the fluctuations in oil prices.

    Several previous studies have been conducted taking samples from two segments, namely, developing & developed countries and oil importing & exporting countries. Surprisingly enough, no conclusion could be drawn regarding the relationship of oil and stock. Within the context of European countries, Arouri and Nguyen (2010) examined the relationship between oil prices and 12 stock sectors (Automobile and Parts, Financials, Food and Beverages, Oil and Gas, HealthCare, Industrials, Basic Materials, Personal and Household Goods, Consumer Services, Technology, Telecommunications and Utilities), considering Stoxx600 in European countries. End of the day, they suggested that, depending on the activity sector, the reactions of stock returns to oil price changes differ in a great manner. Digging the four developed countries--Canada, UK, Japan and the USA--Jones and Kaul (1996) suggested that the price of oil plays an important role in the formation of returns of financial assets in the USA and Canada; whereas, for other countries, the influence of oil for the same was less obvious. Restoring to Autoregressive Conditional Jump Intensity Model, Chiou and Lee (2009) pointed out that, high fluctuations in oil prices (WTI-daily) have asymmetric unexpected effects on stock returns in the United States. Additionally, studies conducted by Malik and Ewing (2009) confirmed that, there is a significant spill over transmission mechanism of shocks, volatility between oil prices (WTI-weekly) equity and equity sector return. Likewise, taking the figures from the USA oil companies and using a VAR model, Huang et al. (1996) established a significant relationship between oil prices and stock returns of some oil companies; yet, they could not institute any significant relationship between these investigated markets. On the flip side, Sadorsky (1999) implemented a VAR model augmented with GARCH impacts using recent numbers and found that the USA equity market reacts significantly to fluctuations in oil prices. Filis et al. (2011) used the DCC-GARCH model and concluded that the conditional variances of oil (Brent) and stock prices do not differ for oil-importing and oil-exporting economies; and, demand-side shocks are stronger than the supply-side shocks.

    In a recent study, Kilian and Murphy (2014) developed a structural model of the global market for crude oil. They chalked out unexpected increases in international oil consumption, which is aligned with global business cycle. The speculative demand shifts played an important role during the earlier oil price shock episodes of 1979, 1986 and 1990. Going one step ahead, Sukcharoen et al. (2014) studied the relationship between the oil price and stock market index of various countries between 1982 and 2007, excluding the oil and gas stock companies from the stock indices to remove the obvious direct association. To model the general dependency between stock returns and oil price returns, copula method was used. The findings suggested a weak dependency between oil prices and stock indices for most cases; yet, interestingly enough, the introduction of Euro in 1999 altered the said relationship in a significant manner. Using the VAR-VECM, Cunado and De Gracia (2014) examined the impact of oil price shocks on stock returns, considering data of 12 oil importing European economies. Their study considered both world oil production and world oil prices to disentangle oil supply and oil demand shocks. We have pointed out that depending on the underlying causes of the oil price change, the response of the European real stock returns to an oil price shock may vary considerably. Caporale et al. (2014) studied the time-varying impact of oil price uncertainty on stock prices in China, considering weekly data on ten sectorial indices, over the period of January 1997--February 2014. Conclusion drawn from the estimation of a bivariate-GARCH-in-mean model highlights that oil price volatility has a positive effects on stock returns during periods characterized by demand-side shocks, in almost all sectors; the Consumer Services, Financials, Oil and Gas sectors happen to be the exceptional ones.

    The sleek side of this study is that, it is going to contribute to the growing literature on the relationship between the oil and stock market returns by detecting the transmission mechanisms of an oil price shock to the stock market returns, taking into account the samples from G7 countries (the USA, Japan, Germany, France, United Kingdom, Italy and Canada). On a more specific note, we have emphasized on the Corrected Dynamic Conditional Correlation Fractionally Integrated (c-DCC-FIAPARCH) (1) model to comprehend the relationship between WTI oil prices and stock market returns, using monthly data from February 1998 to February 2013.

    The FIAPARCH model permits us to analyse the long-run causal links between oil and stock markets, the...

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