The Effects of Oil Price Shocks on Stock Market Volatility: Evidence from European Data.

• Author: Degiannakis, Stavros

1. INTRODUCTION AND BRIEF REVIEW OF THE LITERATURE

   There is a consensus among academics and practitioners that oil and stock markets are often intertwined with the global economic activity. Ascertaining exact nature and sources of the linkage between oil and stock markets and the global economic activity has proved to be a promising area for researchers over the last few decades. The research interest mainly concentrates either on the impact of oil prices on stock market developments or the effects of oil prices on the economy. Adding to this literature, the main objective of the paper is to research into the effects of three oil price shocks (namely, supply side shocks, aggregate demand shocks and oil specific demand shocks) on stock market volatility, with particular reference in the European stock market.

   The seminal paper by Jones and Kaul (1996) was among the first to reveal a negative relationship between the oil prices and stock market returns. In addition, Sadorsky (1999) concludes that oil price changes are important determinants of stock market returns. In particular, he shows that stock markets respond negatively to a positive oil price change. Filis (2010), Chen (2009), Miller and Ratti (2009), Park and Ratti (2008), Driesprong et al. (2008) and Gjerde and Soettem (1999) second these findings by Sadorsky (1999) and Jones and Kaul (1996).

   The aforementioned negative relationship does not hold for stock markets operating in oil-exporting countries. Arouri and Rault (2012) show that for the oil-exporting countries, there is a positive relationship between oil price shocks and stock market returns. Other authors, though, do not find any relationship between oil price shocks and stock market returns (Jammazi and Aloui, 2010; Cong et al., 2008; Haung et al., 1996). Filis et al. (2011) provide an extensive review of the literature in the particular area.

   Studies particularly focused on the European stock markets reveal that positive oil price changes tend to negatively affect stock returns; nevertheless, the exact relationship depends on the sector. In particular, oil-related stock market sectors tend to appreciate in the event of a positive oil price change, whereas the reverse holds for oil-intensive sectors (see, for example, Scholtens and Yurtsever, 2012; Arouri, 2011; Arouri and Nguyen, 2010).

   Furthermore, a strand of the literature distinguishes the effects of oil price shocks on stock market activity according to their origin. Hamilton (2009a,b) and Kilian (2007a,b), in particular, suggest that different shocks in the oil market have different effects on stock markets. Kilian (2009) provides evidence that the response of aggregate stock returns differs depending on the cause of the oil price shock. Hamilton (2009a,b) disaggregates oil price shocks into two components, namely, the demand-side oil price shocks (which are caused by increased aggregate demand, e.g. due to the industrialization of China) and supply-side oil prices shocks (which are caused by alteration in the world oil production). In addition, Kilian (2009) identifies a third origin, the precautionary demand shocks or oil specific demand shocks. These are oil price shocks that are related with the uncertainty of the future availability of oil.

   Baumeister and Peersman (2012), Basher et al. (2012), Kilian and Lewis (2011), Filis et al. (2011), Lippi and Nobili (2012), Kilian and Park (2009), Apergis and Miller (2009), Lescaroux and Mignon (2008), Kilian (2008) and Barsky and Kilian (2004) also illustrate the importance of taking into consideration the origins of the oil price shock in this area of interest. For example, Hamilton (2009a,b) maintain that oil price shocks are mainly demand driven in the last decades and thus supply-side events do not exercise significant effects in oil prices. Lippi and Nobili (2012) proponent that supply-side oil price shocks have a negative effect in the economy, whereas the opposite is observed for the demand-side oil price shocks. In addition, Kilian and Park (2009) demonstrate that the supply-side oil price shocks do not have any effects on stock market returns, whereas stock markets tend to react negatively to oil specific demand shocks. On the other hand, they find that aggregate demand oil price shocks trigger a positive response from the stock markets. In the same line of reasoning, Filis et al. (2011) find evidence that the supply-side shocks do not seem to impact stock market returns, whereas the reverse holds for the demand-side shocks. Similarly, Basher et al. (2012) show that supply-side oil price shocks do not exercise an impact on the emerging stock market returns, whereas the aggregate demand oil price shocks seem to have a positive effect. Finally, they find evidence that the oil specific demand shocks put downward pressure on stock returns.

   Despite the fact that evidence proposes that the origin of the oil price shock triggers different responses from the stock markets, the majority of the literature does not consider them when examines its effects (see, inter alia, Arouri and Rault, 2012; Arouri and Nguyen, 2010; Bjornland, 2009; Chen, 2009; Park and Ratti, 2008).

   As aforementioned, the aim of this paper is to direct the attention of the research on the effects of the oil price shocks on stock market volatility. Studies in the early 80s and 90s (see, for example, Pindyck, 1991 and Bernanke, 1983, among others) reveal that increased energy prices generate uncertainty to firms, resulting in the delay of investment decisions. Furthermore, some authors opine that oil price innovations exercise an impact on aggregate uncertainty and they have significant negative effects on investments (see, inter alia, Ratti et al., 2011; Rahman and Serletis, 2011; Elder and Serletis, 2010). In addition, Bloom (2009) documents that stock market uncertainty increases after major shocks, such as the 2001 terrorist attack in U.S., OPEC oil supply disruptions, etc. Nevertheless, these studies have not considered the origins of the oil price shocks. We argue, though, that Bloom's choice of major shocks coincides with events that trigger certain oil price shocks, as these have been identified by Hamilton (2009a,b) and Kilian (2009, 2007a,b). For example, the 2001 terrorist attack in US triggered an oil specific demand shock, whereas OPEC oil supply disruptions cause supply-side oil price shocks. Thus, disentangling oil price shocks is of importance in understanding better stock market uncertainty.

   In addition, the literature has well established that the aforementioned firm's uncertainty and aggregate uncertainty can be represented by individual stock price volatility and stock market volatility, respectively (see, for example, Baum et al., 2010 and Bloom, 2009).

   Even though the characteristics of stock market volatility have been studied extensively in the past, (1) the literature remains silent on the effects of the different oil price shocks on stock market volatility. Rather, a plethora of research output centers its attention solely on spillover effects between the oil price volatility and stock market returns and volatility or the relationship between oil price volatility and firm investments. (2) This paper comes to fill this void.

   More specifically, the contribution of the paper is threefold. First, it contributes to the literature that studies the effects of three different oil price shocks--oil supply shock, aggregate demand shock and oil specific demand shock (3)--on the stock market. Unlike previous studies that examine the response of stock returns on oil price shocks, we investigate the response of stock market volatility, as a measure of uncertainty of stock market investments, using a Structural VAR model. Second, we provide evidence from both aggregate stock market indices and industrial sector indices, as according to Arouri et al. (2012, p.2) "the use of equity sector indices is, in our opinions, advantageous because market aggregation may mask the characteristics of various sectors". Third, in contrast to studies that mainly focus on the responses of stock market returns in individual countries in Europe or in the U.S. (Arouri, 2011; Arouri and Nguyen, 2010 and Scholtens and Yurtsever, 2012 are notable exceptions), emphasis of this research is placed on the pan-European stock market.

   In light of empirical evidence that underlines the relative importance of the demand-driven oil price shocks, we expect stock market volatility in Europe to be more sensitive to the aggregate demand shock and the oil specific demand shock than to the supply-side shock.

   Three volatility measures are utilized; conditional volatility, realized volatility and implied volatility. The conditional volatility, estimated from a predefined ARCH model, is the most widely applied method of quantifying volatility in financial time series. The realized volatility, introduced by Andersen and Bollerslev (1998), sums the high frequency squared log-returns to generate a lower frequency volatility measure. According to Ebens (1999), among others, the use of high frequency data for computing volatility at a lower frequency provides more accurate estimates of volatility. Implied volatility derives from the option pricing.

   The conditional volatility was chosen because it is the most generally applied measure of variance. The use of realized volatility measure is justified by the recent findings in financial literature that it provides more accurate estimates of volatility. On the other hand, the use of implied volatility is motivated by the fact that part of the literature illustrates that this type of volatility (a forward-looking measure) is more informational efficient compared to other volatility estimates, which represent the current-looking measures of volatility. (4)

   Thus, it is important to identify any differences in their responses to oil price shocks. Koopman et al. (2005) propose that both implied volatility...