Fresh evidence on the oil-stock interactions under heterogeneous market conditions
Introduction
How does oil price fluctuations affect stock returns? One would assume that the question is settled long ago. But, in fact, it is not. While the economic literature provides competing theories regarding the sign of the impact (Fisher, 1930, Williams, 1938, Jones and Kaul, 1996, Kollias et al., 2013), the empirical observations post global financial crisis (GFC) 2008 have added several important dimensions to the oil-stock relationships. Either with standard models or modern incarnations, the findings suggest that stock returns respond to oil price fluctuations based on whether the oil shock is emanating from demand-side factors or supply-side factors (Kilian, 2009, Kilian and Park, 2009); whether the country is an oil importing or oil-exporting (Bjørnland, 2009, Bouri, 2015, Filis et al., 2011, Ramos and Veiga, 2013, Güntner, 2014, Silvapulle et al., 2017); types of firms and their sizes (Narayan and Sharma, 2011, Narayan and Narayan, 2014, Narayan and Sharma, 2014, Phan et al., 2015). Since the GFC, a growing body suggests that the effects of oil price on stock return and its volatility are not linear, rather depend on the existing market conditions (Aloui and Jammazi, 2009, Chen, 2010, Choi and Hammoudeh, 2010, Reboredo, 2010, Chang and Yu, 2013, Caporale et al., 2015, Zhu et al., 2016).
Given this background, our study is motivated by the recommendations made by Smyth and Narayan (2018) that there is a pressing need to combine diverse strands of oil-stock literature. Our first contribution is to fill this gap by marrying the literature on return-volatility interactions to the literature on nonlinearity in the relationships. Second, we contribute by examining the joint behavior of oil-stock markets by adopting a simultaneous modeling framework that is more appropriate than working with separate univariate models as the former allows us to capture ‘mean spillover’ and ‘mean-volatility’ interactions together and thus several hypotheses can be tested directly. However, our main contribution lies in improvising the benchmark model by adding nonlinear dimension to it.1 Third, we contribute by hypothesizing how return spillover and mean-volatility interactions vary under different heterogeneous market conditions, i.e. bear and bull markets.2 Further, stock returns are a financial variable and thus exhibit high and low volatility states, often due to the occurrence of exogenous events such as economic and financial crisis, war, pandemic, etc. Considering our sample span includes a few such events, therefore a regime switching model is best suited to identify and examine these switching dynamics occurred in the oil-stock relationships. The analysis will not only assist forecasters about oil-stock market interlinkages under heterogeneous market conditions but also benefit investors in designing appropriate hedging strategies and managing portfolios in face of any market failure. Our final contribution is implementing a threshold VAR asymmetric GARCH in mean (TVAR-AGARCH-M) model to verify the non-linear linkages, which has not yet been implemented in the literature and is superior to the benchmark VAR-GARCH-M models used recently in the literature. To the best of our knowledge, ours is the first to propose a nonlinear threshold model in VAR framework to study the asymmetric relationships between stock and oil markets.3
Our empirical approach is as follows. First, our paper verifies a set of hypotheses in heterogeneous market conditions. Specifically, we intend to examine how each of the three relationships viz.,(a) impact of oil price on stock return,(b) effect of oil price volatility on stock return, and(c) impact of stock return volatility on stock return, vary with ‘bull’ and ‘bear’ market conditions? Further, we shed some light on the volatility-spillover effect and how oil-stock market volatility is affected by its own past shocks? Second, we test these hypothesis using weekly time series data on three large net oil-importing countries of Asia, namely, India, Japan and Korea.4 Third, we rely on a two-stage method wherein a univariate Markov-switching heteroscedasticity (MSH) model on stock return has been adopted in the first stage to identify the high and low volatility (‘bear’ and ‘bull’, respectively) periods. Then, in the second stage, a TVAR-AGARCH-M model is implemented to identify the non-linear linkages. We confirm consistency of our results with robustness checks.
Our analysis unfolds that oil price volatility affects stock returns in highly volatile market conditions but not in low volatile market states. Further, we find evidence of strong asymmetry wherein lagged negative shocks strongly influences volatility in oil and stock markets. Specifically, we show that investors can hedge risky assets in one market with holding uncorrelated and less risky assets in their international portfolio, as in Batten et al. (2021). Finally, we show the appropriateness of TVAR-AGARCH-M model over the benchmark VAR-GARCH-M model, indicating robustness of our empirical findings.
The rest of the paper proceeds as follows. Methodology and results are discussed in Sections 2 Methodology, 3 Data and results, respectively. Section 4 gives concluding remarks.
Section snippets
Methodology
We first report the MSH model that distinguishes ‘bull’ and ‘bear’ market situations. Thereafter, we briefly mention the proposed TVAR-AGARCH-M model.
Data and results
We have considered three of the four largest net oil-importing countries of Asia, namely, India, Japan, and Korea. Our data is weekly time-series. The sample starts from January 2, 1995 for India and Japan whereas it starts from July 1, 1996 for Korea due to data availability. The sample ends on September 27, 2021 for all three countries. The aggregate stock indices are NIFTY50 for India, NIKKEI225 for Japan, and the KOSDAQ Composite Index for Korea. All financial data are collected from the
Conclusions
This paper is motivated by the unsettled debate on how oil price oscillations affect stock returns. The fact that unfavorable oil price fluctuations are risky for stock markets in large oil-importing countries, certain economic benefits can be derived from portfolio diversification and hedging these risks across international stock markets. We contribute to this ongoing debate by marrying diverse strands of literature on stock-oil integration, as documented in Smyth and Narayan (2018) but in
CRediT authorship contribution statement
Kushal Banik Chowdhury: Conceptualization, Methodology, Investigation, Formal analysis, Software, Validation, Writing – review & editing. Bhavesh Garg: Ideation, Literature review, Visualization, Writing – original draft, Writing – review & editing.
Acknowledgments
The authors are grateful to the Editor-in-Chief, Samuel Vigne, and an anonymous referee for providing valuable suggestions, which improved this paper significantly. The usual disclaimer applies.
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