Responses of international stock markets to oil price surges: a regimeswitching

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1 Business School W O R K I N G P A P E R S E R I E S Working Paper Responses of inernaional sock markes o oil price surges: a regimeswiching perspecive Rania Jammazi Duc Khuong Nguyen hp:// IPAG Business School 184, Boulevard Sain-Germain 756 Paris France IPAG working papers are circulaed for discussion and commens only. They have no been peer-reviewed and may no be reproduced wihou permission of he auhors.

2 Responses of inernaional sock markes o oil price surges: a regimeswiching perspecive Rania Jammazi Inernaional finance group-tunisia & Universiy of Sousse, B.P. 37, Cié Erriadh, 423, Sousse, Tunisia jamrania2@yahoo.fr Duc Khuong Nguyen Deparmen of Finance and Informaion Sysems, ISC Paris School of Managemen, 22 Boulevard du For de Vaux, 7517 Paris, France dnguyen@iscparis.com Absrac We propose an enhanced regime-swiching model o invesigae he relaionships beween oil price surges and sock marke cycles in five oil-dependen counries over he period from January 1989 o December 27. Our model accouns for he join effecs of he WTI (Wes Texas Inermediae) and Bren oil markes and allows o simulaneously capure asymmery, volailiy persisence and regime shifs conained in he underlying financial daa. We find ha sock marke reurns srongly exhibi a regime-swiching behavior, bu hey reac differenly o he increases in he price of oil. More precisely, he condiional volailiy of sudied sock markes during he bear marke phases is found o be less affeced by oil price shocks han during he bull marke phases. Wheher he effecs of oil shocks are posiive and negaive depends grealy on he degree of reliance on impored oil, he share of he cos of oil in he naional income and he degree of improvemen in energy efficiency of a given counry. Finally, he relaively opposie effecs of he WTI and Bren oil markes sugges he poenial of subsiuion beween hem as well as he necessiy of a diversificaion sraegy of oil supply sources. Keywords: oil price shocks, sock marke cycles, regime-swiching model JEL classificaion: C58; F3; G15

3 1. Inroducion The analysis of crude oil price shocks on macroeconomic variables has received considerable aenion from academic researchers, invesors and policymakers following he 197s oil crisis. Using Granger causaliy ess, Hamilon (1983) shows ha rising oil prices are responsible for nine ou of en of he U.S. recessions since he Second World War, hus suggesing a negaive impac of oil price changes on U.S. oupu growh. A number of subsequen sudies, using various mehodologies and differen daases, reach similar conclusions and explain he oilgrowh relaionship by he oil price effecs on producion cos, inflaion expecaion, moneary policy, and invesor confidence (Mork, 1989; Bachmeier, 28; Cologni and Manera, 28). For example, Mork (1989) exends Hamilon (1983) s resuls by invesigaing he effecs of boh upward and downward oil price movemens on GDP growh. Mork finds ha oil price increases impeded economic growh bu oil price decreases did no appear o boos growh during he pos-second World War period, hus highlighing he asymmeric responses of growh o oil price increases and decreases. Some recen aemps such as Hamilon (23), Kilian (28), Zhang (28), Lardic and Mignon (28), and Cologni and Manera (29) confirm he asymmeric paern and also documen nonlinear links beween oil price shocks and growh (and oher macroeconomic variables). Anoher imporan finding of his lieraure is ha he oil price oupu relaionship is weakening in he Unied Saes and some oher oilimporing counries, especially during he recen decades and precisely afer he 1986 oil price collapse (Hamilon, 1996, 23; Blanchard and Gali, 27; Kilian, 28; Balke e al., 29). 1 The exen o which sock markes around he world are affeced by oil price movemens has only been invesigaed recenly. As oil price increases are found o negaively affec real oupu, he rise in he price of oil would expecedly cause he sock prices o decline owing o higher business operaing coss and lower corporae earnings. 2 This heoreical predicion is firsly confirmed by an imporan empirical sudy of Jones and Kaul (1996) who repor a significan negaive impac of crude oil shocks on sock marke reurns in wo ou of four major developed counries (Canada and he Unied Saes). Sadorsky (1999), Papaperou (21), and Ciner (21) provide evidence o suppor he Jones and Kaul (1996) s iniial findings. 1 Kilian (28) furher noes ha energy price shocks do no exer a significan impac on he U.S. economy, and ha oil shocks appear o be among many conribuing facors of he U.S. recession bu no a robus deerminan. See also Mory (1993) and Hondroyiannis e al. (21) for discussions on how oil prices can affec oher various macroeconomic variables including ineres raes, expor, impor, and governmen expendiure. 2 Cong e al. (28), Nandha and Faff (28), and Narayan and Sharma (211) examine he relaionship beween oil prices and firm reurns of differen counries, and find srong dependence beween hese wo variables. Arouri e al. (211) examine he volailiy ransmission beween oil and secor sock markes.

4 However, he above-menioned negaive relaionship does no always hold when more recen daases are considered. Using daa from sock markes of six OECD counries over he period , Miller and Rai (29) provide evidence of a robus negaive long-run link beween oil price increases and sock marke reurns, bu his link disappears afer Sepember Bubbles in asse markes and/or crude oil markes may, according o he auhors, be responsible for his insable relaionship. Jammazi and Aloui (21) find similar resuls for hree developed markes (France, Japan, and Unied Kingdom) while making use of wavele and MS-VAR model (Markov-swiching Vecor Auoregressions). The negaive relaionship also appears o be more pronounced during he pre-1999 period. Moreover, while some recen sudies find convincing evidence of posiive impac of crude oil changes on sock marke reurns (El Sharif e al., 25; Narayan and Narayan, 21; Ono, 211), he ohers documen weak evidence ha crude oil prices affec sock marke reurns in eiher a posiive or negaive way (Huang e al., 1996; Maghyereh, 24; Cong e al., 28; Apergis and Miller, 29; Al Janabi e al., 21). 3 These mixed resuls can be explained by he heerogeneous degree of oil dependence ha exiss among sample markes. For insance, Park and Rai (28) demonsrae ha sock marke responses o an oil shock depend on wheher he considered counry is a ne imporer or a ne exporer of oil. The sign of sock marke reacion may also differ grealy depending on he origin of oil price increases, i.e., he aggregae demand/precauionary demand shock or supply shock (Kilian and Park, 29). Aloui e al. (212) show ha marke s oil-dependence profile maer for he reacion of sock reurn and ha he oil risk is prevailing for markes exhibiing posiive correlaion wih oil reurns. Anoher imporan concern of he relaed lieraure is he poenial of asymmeries and nonlineariies ha may characerize he oil-sock marke relaionship. No only sock markes reac differenly o oil price increases and decreases, bu oil shocks can cause differen effecs on sock reurns depending on wheher sock markes are on bearish and bullish saes. More imporanly, he accurae modeling of he links beween oil and sock markes should no underscore he regime-swiching behavior of reurn series. As o sock reurns, Turner e al. (1989) and Chu e al. (1996) apply Markov-swiching auoregressive models (MS-AR) and find srong evidence of regime-swiching behavior. Based on a parsimonious regime swiching model, and Maheu and McCurdy (2) also documen he exisence of a high-reurn sa- 3 Several sudies address he relaionship beween oil prices and sock reurns a he secor level (Boyer and Filion, 27; El-Sharif e al., 25; Nandha and Faff, 28; Nandha and Brooks, 29; Arouri and Nguyen, 21). Overall, hey show ha he reacion of secor reurns o changes in oil prices differs sensiively across secors and ha he presence of he oil asses in a porfolio of secor socks permis o improve he porfolio s risk-reurn characerisics.

5 ble sae (bull marke) and low-reurn volaile sae (bear marke) for monhly U.S. sock marke reurns. Regime shifs have also been found in he dynamics of condiional volailiy of sock reurns (Cai, 1994; Hamilon and Susmel, 1994; Diamanis, 28; Chang, 29). Concerning he oil markes, several sudies have concluded ha regime swiches and asymmeric volailiy play a decisive role in forecasing reurns, volailiy and ail disribuions of crude oil reurns (Fong and See, 22; Vo, 29; Chang, 212). Taken ogeher, hese findings sugges he relevance and usefulness of regime-swiching models in exploring he dynamic ineracions beween oil prices and sock marke reurns. In his aricle we also address he issue of oil-sock marke ineracions by exending he exising lieraure in several ways. We firs invesigae he reacion of inernaional sock markes in five developed counries (Canada, Germany, Japan, Unied Kingdom and Unied Saes) o oil price increases using a wo-regime MS-EGARCH model, inroduced by Henry (29). Recen empirical sudies have confirmed ha his model allows for a beer descripion of he underlying daa of sock and commodiy reurns given is abiliy o simulaneously capure asymmery, persisence as well as regime shifs (Chkili e al., 212; Chang, 212). For example, Chang (212) uses MS-EGARCH model wih Suden- disribued error erms o invesigae wheher informaion regarding regime-swiching propery can affec he behavior of crude oil fuures reurns. He finds ha he model generaes accurae forecass and provides grea flexibiliy in fiing he basic disribuion of he daa. Second, we focus on esing he predicive power of boh WTI and Bren oil prices for sock marke reurns. The simulaneous consideraion of he effecs from he wo crude oil benchmarks is of paricular ineres in he sense ha i guaranees a more realisic represenaion of he global oil marke. 4 Finally, while mos of he exising sudies end o disinguish beween posiive and negaive variaions of oil prices (e.g., Basher and Sadorsky, 26; Sadorsky, 28; Nandha and Faff, 28), we employ a more refined nonlinear oil price measure proposed by Hamilon (1996), namely he ne oil price increase (NOPI). Here our moivaions regarding he use of NOPI are wofold. On he one hand, here is lack of consensus on he effec of he oil price variaions (hikes and falls) on he sock markes, and hus a new research in his direcion is no necessary. On he oher hand, besides he asymmeric reacion of inernaional sock marke reurns o oil price in- 4 Hammoudeh e al. (28), among ohers, examine he asymmeric adjusmen process beween four crude oil benchmark prices (WTI, Bren, Dubai, and Maya). Their resuls indicae ha he WTI and Bren markes are much more liquid and have sronger leadership saure han he Dubai and Maya benchmarks. More ineresingly, hese benchmark prices adjus o a common equilibrium in he long run, regardless of heir properies and physical locaions.

6 creases and decreases, pas sudies agree, a leas o some exen, ha he effecs of oil price increases are more imporan han hose associaed wih oil price decreases (Bjørnland, 29). The remainder of his aricle is organized as follows. Secion 2 describes he daa and inroduces he Markov-swiching EGARCH framework used in his sudy. Secion 3 presens and discusses he esimaion resuls. Secion 4 provides some concluding remarks. 2. Daa and economeric mehod 2.1 Daa and variables specificaion The daa consis of monhly reurns on sock marke indices of five major indusrial counries, namely DJIA (Unied Saes), DAX3 (Germany), FTSE1 (Unied Kingdom), TSX (Canada), and NIKKEI225 (Japan). For crude oil, we use he monhly reurns on wo inernaional price benchmarks: he Wes Texas Inermediae (WTI) and he Europe Bren. Our sudy period runs from January 1989 hrough December 27 and covers monhs of hisorically high and volaile oil prices. I is worh noing ha oil price movemens over his period were driven no only by supply disrupions as in 199 bu also by a variey of facors including, among ohers, marke speculaions and he coninued upward rend in oil demand especially from developing counries since 1999, which are ypically associaed wih slowdowns in oil supply growh (Jammazi, 212). Crude oil prices are exraced from he Energy Informaion Adminisraion (US Deparmen of Energy), and sock marke prices are obained from Daasream Inernaional. We compue he sock and oil reurns by aking he difference in he logarihm of wo successive prices. In he lieraure, several proxies for oil price shocks have been developed o model he nonlineariy and asymmery of oil price effecs on sock marke reurns. They include, among ohers, he growh rae of oil prices, he increases in oil prices, he decreases in oil prices, he ne oil price measure, he scaled oil prices (Lee e al., 1995; Hamilon, 1996). Following he suggesions of recen research ha oil price increases have srong and negaive consequences for economic, financial and indusrial aciviies (e.g., Hamilon, 1983; Bjørnland, 29; Sari e al., 21), we resric our choice of oil measure o he ne oil price increase (NOPI), inroduced by Hamilon (1996). This measure is consruced as he difference beween he curren monhly price and is highes value over he previous year if i is posiive, and zero oherwise as follows

7 oil max( oil 1,..., oil 12, if oil -1,..., oil 12) NOPI (1), oherwise Several works have used he NOPI o analyze he relaionship beween oil price shocks and sock reurns (Park and Rai, 28; Cong e al., 28). For example, Cong e al. (28) find ha some imporan oil price shocks depress Chinese oil company sock prices. Hamilon (1996) noes ha mos increases in oil price since 1986 have been immediaely followed by even larger decreases. So, i is more appropriae o compare he curren price of oil wih is posiion over he previous year raher han during he previous monh alone. 2.2 Markov-swiching EGARCH model Le s firsly consider a sandard EGARCH (1,1) process inroduced by Nelson (1991) as given in Eq. (2) ln( h ) 1 1 2/ ln h 1 (2) h 1 h 1 where h denoes he condiional variance and is sricly posiive. is he error erm from he condiional mean process. The EGARCH model is advanageous in ha i does no require he imposiion of non-negaiviy consrains as in he sandard GARCH model. I furher incorporaes he asymmeric reacion of condiional volailiy o news (shocks) affecing he sysem. Lamoureux and Lasrappes (199) argue ha he high degree of persisence found in he condiional volailiy of he sandard GARCH model may be spurious in he presence of negleced srucural breaks. Hamilon and Susmel (1994) also share his viewpoin and consruc a regime swiching model by modifying he condiional variance equaion o make i dependen on he sae of he economy. Henry (29) exends he exising Markov-swiching (MS) models o accommodae imporan sylized facs of financial reurns such as volailiy persisence, asymmery and regime shifs. Given is modeling advanages and economic relevance, we make use of Henry (29) s MS-EGARCH model o examine he oil-sock marke relaionships. Formally, le r denoe he logarihmic reurn on sock marke index of a given counry and is ime-variaions can be modeled by a univariae MS-EGARCH(1,1) model as follows

8 r i wih / I ln( hi ) i i h i, S(, hi ) 2/ i ln( hi, 1 ) i 1 h i, 1 (3) where I 1 refers o he informaion se conaining all informaion available up o ime ( 1) and he error erm which follows a Suden- disribuion as in Bollerslev (1987). i is he sae-dependen condiional mean of he reurn generaing process. The asymmeric reacion of condiional volailiy o good and bad news is capured by he coefficien δ. If he esimae of δ is ypically negaive in sign, a negaive shock o unexpeced reurns ( ) will generae more impacs on volailiy han a posiive shock of he same magniude. The model in Eq. (3) allows for he exisence of wo saes i indexed by an unobservable discree variable (s ) for all whose values depend on he sae of he marke. In pracice, s akes he value of when he marke is characerized by low expeced reurn and high variance (bear marke regime) and he value of 1 when i is characerized by high expeced reurn and low variance (bull marke regime). Following Hamilon (1989), we assume ha he ransiion beween he saes follows he firs-order wo-sae Markov process as follows where p s p( s p( s / s / s 1/ s p( s 1/ s ) 1 p ) 1 p 1) p ii p 11 p( s i / s 1 i) p, for i, 1, is he probabiliy ha he considered sock marke swiches from one sae a ime ( 1) o anoher sae a ime, wih he following condiion being held: p p 1. The expeced duraion of he regime i is given by E D) 1 (1 p ). i 1 i 2 ( i Similar o Henry (29), he ransiion probabiliies are assumed o be consan over ime according o a logisic funcion such as p e and e( ) 1 e( ) p 11 (5) 1 e( ) Based on he above-described framework, we are now able o examine he oil price shocks on he regime-swiching behavior of sock marke reurns by inroducing he NOPI ino he variance equaion. Our exended condiional MS-EGARCH(1,1) model for sock reurns ake he following form (4)

9 r i wih / I 1 ln( hi ) i i h i, 1 1 S(, h ) i 2 / i ln( hi, 1 ) i 1 h i, 1 NOPI Wi 1 NOPI Bi 1 (6) where λ is a coefficien associaed o he lagged oil variable. As a byproduc of he esimaion sep, we obain he smoohed probabiliies of being in he sae i for i 1,..., P /,..., ) (7) ( S i T 1 The smoohed probabiliies are derived by using informaion from he enire sample and are of grea ineres in deermining if and when regime shifs have occurred. k 3. Resuls and discussion 3.1 Regime-swiching behavior of sock marke reurns We begin our empirical analysis wih esimaing he baseline MS-EGARCH model wihou he NOPI variable for he six sock markes under consideraion. This model is subjec o regime shifs in boh mean and variance srucures. We repor he esimaion resuls in Table 1. The regime and regime 1 correspond o he bear and bull marke phases respecively. Table 1 Esimaion resuls of he MS-EGARCH(1,1) model wihou he oil price effecs DJIA DAX3 NIKKEI225 TSX FTSE *** *** *** (.351) (-5.823) (-2.88) (-8.341) (-.739) *** *** ** ***.542 ** (2.999) (3.9) (2.85) (14.67) (1.739) * *** *** (3.315) (.694) (4.239) (15.743) (.667) ** *** *** (1.941) (.21) (2.326) (2.7332) (1.77) * *** ***.4965 (1.152) (4.594) (.416) (16.298) (.529) (.411) *** (4.241) (-.775) *** (2.564) *** (6.869) *** *** (.87) (3.738) (.977) (119.86) (.483) (.361).6581 * (1.641) *** (-3.383) *** (82.413) *** (7.175) (-.734) *** (-16.86) (.668) * (-1.528) (-.359) (.382) (-.36) (-.44) *** (9.92) (-.958) *** *** *** *** (4.357) *** (3.952) (2.964) *** (-4.772) (2.151) * (-1.395) (-4.724).8315 ** (2.69) (.194) * (1.445)

10 p.9863 [51.6m] [21.6m].8949 [9.44m] [5.51m] [1.57m] p [134m] [14m] [7.56m] [3.3m] [9.68m] Log-Likelihood Q(12) Q 2 (12) LR Noes: This able repors he esimaion resuls of he MS-EGARCH(1,1) model wih a consan parameer (), and ARCH (), GARCH (β) and asymmeric () erms. and are he parameers of he logisic funcion for deermining he values of he ransiion probabiliies. The -saisics of he esimaes are repored beween parenheses. Q(12) and Q 2 (12) refer o he empirical saisics of he Ljung-Box es for auocorrelaion applied o he residual and squared residuals a lag 12. Numbers in brackes represen he expeced duraions (expressed in monhs) of saying in regimes and 1. A he firs sigh, Table 1 shows ha all he sock marke reurns are characerized by negaive reurns during he bear marke sae, excep for he DJIA. However, he saedependence reurns are no significan for he US and UK sock markes. The lowes monhly reurn is found in Germany (-1.25%), preceded by Japan (-.91%) and Canada (-.25%). The bull marke regime is inversely characerized by high and significan reurns in all cases. I is also easy o observe he high persisence of he wo regimes in view of he ransiion probabiliies, p and p 11 (i.e., he probabiliy of saying in he same regime) ha exceed 7%, excep for he Unied Kingdom where p is abou.36. The expeced duraions of saying in he bull regime appear o be much longer han he bear regime for he Unied Saes, Germany and he Unied Kingdom (134, 14 and 9.7 monhs agains 51.6, 21.6 and 1.6 monhs), while for Japan and Canada he bear regime is found o be longer-lasing wih expeced duraions of 9.44 and 5.51 monhs respecively. The quick, decisive and effecive acions aken by economic auhoriies afer an unexpeced shudown or crash may explain he persisence of he bull regime in Germany, he Unied Kingdom and he Unied Saes DJIA3 Reurn Condiional Variance (A) Unied Saes of America Sm-Prob-Regime Sm-Prob-Regime 1

11 DJIA3 Reurn Condiional Variance Sm-Prob-Regime Sm-Prob-Regime 1 (B) Germany FTSE1 Reurn Condiional Variance Sm-Prob-Regime 1 Sm-Prob-Regime (C) Unied Kingdom NIKKEI225 Reurn Condiional Variance (D) Japan Sm-Prob-Regime Sm-Prob-Regime TSX Reurn Condiional Variance Sm-Prob-Regime Sm-Prob-Regime 1 (E) Canada

12 WTI crude oil price BRENT crude oil price NOPI-WTI NOPI-BRENT (F) Crude oil in dollars per barrel Figure 1 Dynamics of monh reurns, condiional variances and smoohed probabiliies The lef verical panel (A-E) shows he monhly sock marke reurns ogeher wih he condiional variances obained from he MS-EGARCH model wihou oil shocks. The righ verical panel (A-E) displays he smoohed probabiliies of regime (low-mean and high-volailiy regime) and of regime 1 (high-mean and low-volailiy regime) a ime. The panel (F) shows he monhly WTI and Bren crude oil prices as well as heir associaed NOPI measures. The shaded verical bars indicae he growh cycle recessions as daed by he Economic Cycle Research Insiue. The sample period runs from January 1989 o December 27 wih a oal of 228 monhly observaions. The panels (A-E) of Figure 1 show he smoohed probabiliies ha sock marke reurns say eiher in bear regime or in bull regime. We clearly find evidence of dynamic ransiion beween he high and low volailiy regimes. In paricular, periods of high volailiy in hree ou of he five counries examined (Canada, Japan and he Unied Kingdom) show a relaively srong coincidence wih he counry-specific growh rae cycle chronologies provided by he Economic Cycle Research Insiue (ECRI) over he period (i.e., shaded areas in he associaed graphs). 5 The coincidence beween he high-volailiy regime and economic recessions seems o be very frequen for Canada and Japan. The high-volailiy regime in he UK sock marke is almos relaed o he recession periods around he end of 198s, he Asian financial crisis, and he 2-22 do-com bubble. Ineresingly, he esimaed smoohed probabiliies for U.K. are comparaively he closes. The condiional variance of his marke reaches is maximum peak value ogeher wih he lowes reurn value during 25. This dramaic fall in he FTSE 1 reurns (8.92%) seems o be affeced by energy crisis and he U.K. pension crisis in Overall, he UK sock marke shows small increases in volailiy bu srong falls in reurns. This could be jusified by he plos of he smoohed probabiliies where several periods of low mean-high variance saes are clearly 5 ECRI has esablished growh rae cycle chronologies for more han 2 counries and hey are especially relevan o cyclical flucuaions in securiies markes. See ECRI s websie for more deails regarding he consrucion mehods of peak and rough daes for he growh cycles. 6 The UK banking losses may be responsible for he urmoil in he sock marke, forcing caasrophic losses in pension funds. According o he Associaion for Paymen Clearing Services (APACS), many UK banks were experienced significan losses due o rising levels of fraud. Indeed, fraud losses almos doubled from 12.2 million o 23.2 million beween 24 and 25).

13 deeced. The bear regime is frequen, bu shor-lived (abou 1 monh) as compared o he duraion of economic recession phases idenified by he ECRI, which appears o be much fewer and longer-lasing. The longes period of bear marke in he Unied Kingdom ook place during he 2-22 do-com bubble. The paerns of ransiion probabiliies in he US and German sock markes are much differen from he ohers. They experienced a single and significan bearish phase over a long period of ime (from March 21 o April 24 for Germany and from January 1998 o Ocober 23 for he Unied Saes). The adven of he bear regime in hese counries is likely o coincide wih he Asian financial crisis, he sock marke bubble of 1999/2 as well as he erroris aack of 21. Aferwards, hese markes ener ino he bull regime. Overall, he findings from he baseline model wihou he oil price effecs seem o be consisen wih previous research. For insance, Qiao (28) and Jammazi and Aloui (21) find ha he sock markes in Canada, Japan and he Unied Saes, among ohers, were very volaile following he collapse of he do-com bubble in 1999, and ha hey hen swiched gradually o a lower volailiy regime. 3.2 The impac of oil price shocks on sock marke cycles Miller and Rai (29) sugges ha he presence of several sock marke and/or oil price bubbles may be responsible for he apparen weakening of he negaive long-run relaionship beween real oil prices and real sock prices since he urn of he cenury. Thus, a MS-EGARCH model accouning direcly for crude oil shocks is more suiable for gauging he dynamic behavior of sock marke reurns. Here we esimae a MS-EGARCH(1,1) model where he wo NOPI measures consruced from he WTI and Bren oil prices are simulaneously inroduced as exogenous variables. Our informaion crieria (AIC and BIC) selec one lag for boh NOPI variables. We mainain he same regime-dependen model as in he previous secion and allow he coefficiens associaed wih NOPI variables o swich beween he wo saes. The esimaion resuls are repored in Table 2. Compared o hose in Table 1, we firs observe an increase in he log-likelihood raios for all cases, excep for he TSX (abou 7.5 poins for NIKKEI225, 3 poins for DJIA and DAX3, and 2.5 poins for FTSE1). The exended MS-EGARCH models hus perform beer han he baseline models wihou oil price shocks. The Box-Pierce saisics indicae no serial correlaion eiher in he esimaed residuals (Q) or he esimaed squared residuals (Q 2 ), suggesing he suiabiliy of he fied models.

14 A look a he esimaed coefficiens shows evidence of wo disinc regimes for each of he sock markes under consideraion. When he effecs of oil shocks are accouned for, he expeced duraions of bear and bull marke periods decline sharply in he Unied Saes (2 and 14 imes lower han hose of he baseline model in Table 1) and Germany (8 and 3 imes lower han hose of he baseline model in Table 1). For he UK sock marke, he expeced duraion of bear marke remains he same, bu ha of he bull marke declines. In Japan and Canada, he expeced duraion of boh bear and bull markes increased. These findings sugges ha he sock markes in he Unied Saes, Germany and o some exen he Unied Kingdom may ake a shorer ime o recover from a bear period caused by an oil price shock. The effeciveness of moneary policies may be behind his abiliy o reac o negaive shocks. Kollias e al. (211) also find ha he oil-sock relaionships for Unied Saes and Unied Kingdom seem o be neural during he erroris incidens during he period and explain his resul by he superior efficiency of he UK and US sock markes in absorbing he impac of poliical evens. Wih regard o he coincidence beween economic recession phases (or cyclical flucuaions in sock markes) and NOPI shocks, Figure 1 shows ha he oil crises caused by he firs Gulf war, Eas Asian currency crisis as well as by a se of geopoliical evens coupled wih naural disasers (e.g., hurricane Karina, he Norh Korean missile es, conflic beween Israel and Lebanon, worries over Iranian nuclear powers) seem o be associaed wih he , 1996 and sock marke crashes for Japan and Canada. On he oher hand, oil shocks caused evenually by he 2-21 US energy crisis owing o manipulaion by elecriciy producers including Enron and Relian Energy appear o coincide wih he US, UK and Canadian bear markes during Aside from hese evens, bear markes occurred during he oil price surge associaed wih he 23 invasion of Iraq are also delineaed in he case of he US, Germany and Japan. The remaining periods of oil crisis may affec he sock marke reurns bu no srong enough o derail heir robus recovery (Hamilon, 24). Table 2 Esimaion resuls of he exended MS-EGARCH(1,1) model wih oil price effecs DJIA Dax3 NIKKEI225 TSX FTSE *** *** *** ***.1415 (-43.3) (-7.57) (-2.735) (-6.461) (.516) *** ***.829 *** ***.547 *** (5.146) (5.98) (3.377) (1.22) (2.277) *** * 2.34 *** *** (2,162) (1,58) (6.158) (1.541) (1,56) ***.8764 ** (.2986) (,743) (5.599) (2.447) (,614) * *** *** *

15 (1.597) (2.234) (.24) (9.398) (1.63) *** *** -.82 *** *** (2.43) (11.262) (-3.14) (-2.692) (.528) *** *** *** (-3.61) (1.143) (1.68) (86.268) (3.77) ***.8641 *** *** *** (33.254) (1.292) (-7.719) (-5.315) (-.573) *** ( ) (.467) (.469) (-.14) (-.46) ** (1.76) (-.551) (-.674) (-.43) (-.69) *** * W, (.7) (3.2) (-1.) (-.6) (-1.387) *.1281 * *** ***.5929 ** W,1 (1.5) (1.3) (-2.7) (-4.2) (2.84) * *** * B, (-1.4) (-2.1) (.6) (.7) (1.323) ** ** *** *** *** B,1 (-1.7) (-1.8) (2.3) (4.3) (-2.424) *** *** (,612) (-,653) (-3.115) (-3,164) (-,87) *** *** *** *.3217 (-2.829) (5.98) (2.675) (1.595) (,287) p.6524 [2.5m] [2.6m] [14.6m] [8.1m] [1.8m] p [9.7m].9781 [45.5m] [17.5m].7926 [4.8m].4264 [1.7m] Log-Likelihood Q(12) Q 2 (12) Noes: This able repors he esimaion resuls of he MS-EGARCH(1,1) model wih a consan parameer (), and ARCH (), GARCH (β) and asymmeric () erms. W and B are he parameers associaed wih he effecs of he WTI and Bren oil prices respecively. and are he parameers of he logisic funcion for deermining he values of he ransiion probabiliies. The -saisics of he esimaes are repored beween parenheses. Q(12) and Q 2 (12) refer o he empirical saisics of he Ljung-Box es for auocorrelaion applied o he residual and squared residuals a lag 12. Numbers in brackes represen he expeced duraions (expressed in monhs) of saying in regimes and 1. The direc effecs of NOPI variables on he regime-swiching behavior of he condiional volailiy, represened by he coefficiens, differ across markes in erms of boh sign and magniude. The WTI NOPI variable has significan effec on all sock markes during he bull regime, bu only wo markes (Germany and he Unied Kingdom) during he bear regime. The impac from he Bren NOPI is significan for all sock markes during he bull regime and for hree markes during he bear regime (Germany, he Unied Saes, and he Unied Kingdom). While he Bren NOPI ends o significanly reduce he volailiy of sock markes in he Unied Saes and Germany for boh regimes, he WTI NOPI raises i. For Canada and Japan, he effecs of he NOPI associaed wih he Bren and WTI markes are respecively posiive and negaive. The NOPI effecs are compleely opposie for he Unied Kingdom wih respec o he wo oil markes and he regimes followed by sock marke reurns.

16 I is obvious from our findings ha alhough he level of sensiiviy o oil price changes may vary across markes and regimes, rising oil prices have cerain cos implicaions ha in urn affec share prices. In our sudy, since sample counries are ne imporers of oil excep for Canada, higher oil prices would drive up heir producion coss and paricularly he cos of energy-inensive secors such as ranspor and chemicals producs (Kilian and Park, 29). For insance, he ranspor secor consumes more han 7% of he US oal consumpion of crude oil. Hamilon (29) provides evidence ha he US recession of is coupled wih a collapse in auomobile purchases, a slowdown in overall consumer spending and a sharp drop in consumer senimen, which is exacly consisen wih wha happened following oher hisorical oil shocks. Furhermore, Figure 1 reveals ha he recession phases deeced during 2-23 and 23 respecively for he US and German markes sick perfecly o he periods of airline indusry sruggle wih bankrupcy and persisenly high cos of fuel driven usually by rising oil prices. Gong (27) repors ha 1 major US airline companies were forced o declared bankrupcy since he year of 2 because of he soaring prices of crude oil. Some of hem have recovered afer filing a plan of reorganizaion according o Chaper 11 in he US Bankrupcy Code. On he oher hand, here are, during he period 2-25, 5 European airline bankrupcies including wo German companies (Berlin Je and Aero Lloyd). Wha we can ell from hese findings is ha sock markes are less affeced by he increases in he price of oil during he bear marke phases. This regime-asymmeric reacion o oil price increases can be explained by he reduced dependence of indusrial producion and various economic secors on crude oil in imes of economic recessions. In addiion, wheher he effecs of oil shocks on sock marke volailiy are posiive and negaive should depends on he degree of reliance on impored oil, he share of he cos of oil in he income and he degree of improvemen in energy efficiency of a given counry. Our resuls finally sugges he poenial of subsiuion beween he wo oil markes as we find heir opposie effecs on he volailiy of our sample markes. Here i is worh noing ha he resor o he diversificaion of foreign oil supply sources can lead o improve he resilience of sock markes depending on heir acual regime. The above-menioned diversificaion sraegy will no only secure a sable access o energy resources and guaraneeing price sabiliy (Vivoda, 29), bu also permi o avoid rising oil price risk and poliical insabiliy risk. The firs risk is ofen due o increased axes and royalies from oil producion as well as o poliical inenion for aking advanage of privae oil holdings naionalizaion like he Venezuela s 27 naionalizaion of Exxon s oil as-

17 ses (Sanislaw, 28). The risk of poliical insabiliy in major oil-exporing counries is high and causes prolonged and massive oil supply disrupions. Examples include he Venezuelan srike of 22, he 23 s civil unres in Nigeria, he US miliary inervenion in Iraq in 23 and he oil pipeline saboage by Sudanese rebels in 24. Anoher reason is ha possible serious disrupions o oil refinery operaions may occur in he adven of unexpeced naural disasers or fire accidens (e.g., he hurricane Karina ha heavily hi he Gulf of Mexico in 25). They hus give incenives o an appropriae geographical diversificaion of oil supply sources among he world s mos imporan oil producion areas (Alaska s Norh Slope, he Gulf of Mexico and he Norh Sea of Europe). The diversificaion is more han necessary as he producion of oil in hese areas is expeced o decline rapidly and he coss of oil exracion are becoming prohibiive (Vivoda, 211). I should be noed ha developed counries including he Unied Saes are seeking oher safe zones wih lower coss and focus on a diversificaion sraegy of crude oil impor sources in order o ensure long-erm energy securiy (Jammazi, 212). 4. Concluding remarks To he exen ha global invesors increasingly use porfolio diversificaion as a sraegy o minimize cerain ypes of risk, he analysis of he relaionships beween oil prices and sock marke reurns is of paramoun imporance and relevance for invesor s opimal asse allocaion decisions. In his paper, we invesigae he role of crude oil price increases in explaining he behavior of sock reurns in five developed counries using a Markov-swiching EGARCH model where he simulaneous effecs of he NOPI variables associaed wih boh he WTI and Bren markes are considered. This model capures some of he mos imporan sylized facs of sock and oil reurn series such as persisence, asymmery and srucural change. No only he sock markes are allowed o swich discreely beween wo disinc regimes (highand low-volailiy regimes), bu also i is possible o assess he regime dependence in he oil price impacs, volailiy persisence and asymmeric responses of he sock markes o shocks. Our resuls from he baseline model wihou oil price effecs indicae ha sock reurns in all he considered markes exhibi a regime-swiching behavior. The high-volailiy regime is dominan in Canada and Japan, whereas he low-volailiy regime appears is frequenly observed for Germany, he Unied Saes and he Unied Kingdom. We furher find ha he highvolailiy regime is associaed wih he economic recession periods for Canada, Japan and, o some exen, he Unied Kingdom. The effecs of inernaional marke crashes or crises were

18 shorer-lived for he Unied Kingdom (1 monh), whereas he US and German sock markes experienced a single crash over a long period of ime (3 o 6 years). The laer occurred a he ime of he economic slowdown and recessions. The exended MS-EGARCH model ha accouns for he join effecs of he wo NOPI measures provides several insighful resuls. Similar o he baseline model, we find ha he condiional volailiy of he sudied sock markes is regime-dependen, bu is responses o oil price shocks are no he same. In general, sock marke volailiy is found o be less dependen on he increases in he price of oil during he bear marke phases and he sign of oil price effecs depends on he degree of reliance on impored oil, he share of he cos of oil in he income and he degree of improvemen in energy efficiency of a given counry. The relaively opposie effecs of he WTI and Bren oil markes sugges a poenial of subsiuion beween hem as well as he necessiy of a diversificaion sraegy of oil supply sources. Oher facors ha poenially affec he sensiiviy of sock markes o rising oil price include he weigh of energy-based secors in he overall marke index, he dependence on impored crude oil from unsable counries, he sraegic soluions adoped o evenually proec he margin profi of a given indusry, and he level of encouragemen and suppor given o oil-relaed indusries o develop and use alernaive and susainable energy sources. Our framework can be exended o invesigae wheher a rise in he price of crude oil leads o increase he probabiliy of being in he bear marke period by leing he ransiion probabiliies be a funcion of NOPI measures. References Basher, S., Sadorsky, P., 26. Oil price risk and emerging sock markes. Global Finance Journal 17, Al Janabi, M.A.M., Haemi, J.A., Irandous, M., 21. An empirical invesigaion of he informaional efficiency of he GCC equiy markes: evidence from boosrap simulaion. Inernaional Review of Financial Analysis 19, Aloui, C., Nguyen, D.K., Njeh, H., 212. Assessing he impacs of oil price flucuaions on sock reurns in emerging markes. Economic Modelling 29, Apergis, N., Miller, S.M., 29. Do srucural oil-marke shocks affec sock prices? Energy Economics 31, Arouri, M., Jouini, J., Nguyen, D.K., 211. Volailiy spillovers beween oil prices and sock secor reurns: implicaions for porfolio managemen. Journal of Inernaional Money and Finance 3, Arouri, M., Nguyen, D.K., 21. Oil prices, sock markes and porfolio invesmen: evidence from secor analysis in Europe over he las decade. Energy Policy 38, Bachmeier, L., 28. Moneary policy and he ransmission of oil shocks. Journal of Macroeconomics 3, Balke, N., Brown, S., Yucel, M., 29. Oil price shocks and U.S economic aciviy: An inernaional perspecive. Energy Journal 23,

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