Oil Prices and Stock Market in Emerging Markets Finance Essay

Investors and business analysts usually think oil prices influence stock market performances, yet few studies have shown the impact of oil price volatility on stock markets in emerging markets. To study the relationship between oil price volatility and stock market performance in the emerging markets is rather essential in that the financial markets in those countries are developing quickly and getting more integrated into global financial markets. This paper examines monthly data of oil prices and stock market indices, and conducts tests on covariance and correlation on the two variables. Based on statistical inference, qualitative and quantitative analyses are derived on the extent to which the oil prices affect stock markets and how sensitive the stock markets are to oil price volatility.

Introduction

It is important to understand the relationship between energy markets and financial markets as it provides a good indicator of macro economy and the well-being of financial markets. Energy prices such as oil price, coal price, and propane price affect other commodity prices, which influence transportation costs, heating costs, and ultimately the stock market performance in general. In other words, to what extend does the oil price volatility affect the stock market is of great importance. Though conventionally, people associate higher oil prices with poor stock market performance or even economic crisis, it is necessary to employ empirical evidence to demonstrate such relationship. Given that the stock market capitalization in the emerging countries has grown ten-fold and the market share in capitalization has grown two-fold in the last decade (Chittedi, 2009), this paper proposes a study to examine the oil price volatility and stock market performance in the BRIC countries, namely, Brazil, Russia, India, and China. For emerging markets, such as Brazil, India, Russia, and China, it is rather important to emphasize the role of energy, especially oil in developing their economies. In other words, it is meaningful to examine the financial markets in developing countries that depend heavily on oil. In developing countries, higher oil price could jack up commodity prices which might cause inflation and unemployment (IMF, 2010). Specifically, this project includes collecting data on oil prices and indices for stock market performance in the emerging markets, and derives the covariance coefficients and correlation coefficients of oil prices and stock market indices. Based on statistical results, it is straightforward to conclude which markets are the most sensitive to oil price changes and to what extend does oil price affect the stock market. Furthermore, this projects looks into which industries/sectors in those economies are most susceptible to oil price volatility; in other words, the project sheds light on portfolio diversification for risk-averse investors who are interested in emerging markets.

Literature Review

Traditionally, most businesses think higher oil price increase leads to higher commodity prices which in turn drive stock markets indices such as S&P 500 index down. Nevertheless, not all stocks are affected equally; consumer discretionary stocks tend to perform better than the average whereas energy stocks usually perform poorly (Alpha, 2008). Some studies look at the relationship between stock market indices and various macroeconomic variables, such as inflation rate, exchange rate, and employment rate (Muradoglu et al, 2000). Using indices for international stock markets and world oil prices, Agren (2006) discovered a covariance between oil price volatility and average stock market returns in four developed countries. In emerging markets, Gay(2008) has shown that there was significant impact of oil prices and exchange rates on stock market returns in 13 countries. Spivak (2010) has discovered that the correlation coefficient between the oil prices and the MSCI World Stock index is about 0.87, which translates into a moderately strong impact of oil price volatility. In addition, evidence from 1997 Asian financial crisis indicates that oil price volatility played a big role in causing the market failure or even political stability (Nandha & Hammoudeh, 2007). In the last decade, the BRIC countries experienced great transformation in stock markets, mostly taking market liberalization measures to streamline the transaction process and join with developed markets (Chittedi, 2009). In other words, significant structural changes are taking place or have taken place in the financial markets of those countries.

Methodology

While some studies use regression analysis on stock market indices and oil prices, this project employs covariance and correlation tests across the years in order to investigate the relationship between the two variables. The analysis strives to answer research questions such as to what extent is the stock market affected by the energy prices in the BRIC countries. Among the BRIC countries, which countries exhibit the greatest influence by oil prices? Given the oil prices is globally intertwined, knowing this relationships can provide some insight into understanding the oil price and economy in a global context. To answer those questions, the study examines monthly stock market indices in the BRIC countries and oil price indicators in those countries. Those data is available on Organization for Economic Cooperation and Development website. The time frame is between June 1998 and June 2008. Covariance and correlation both show whether variables are positively or negatively related, though correlation provides the extent to which the variables move together. Covariance indicates how two variables are related. Covariance determines the extent to which two variables move together and the magnitude of those movements (Grossman & Livingstone, 2009).

Analysis and Conclusion

By graphing some selected data in scatterplot in SPSS, it is straightforward to see the directions of movement of the two variables in the BRIC countries. Based on this relationship, conclusion can be made with regard to which country is most sensitive to oil price volatility. Furthermore, one can infer from this evidence some policy implications in those countries. For example, questions such as does the local financial market fully integrated with international market or how the government should do in term of opening up and restructuring local financial markets. Statistical results from covariance tests illustrate how much the oil price and stock market performance change together. The linear dependence between two variables implies the direction of the movements and the degree of the movements. For example, a negative covariance between oil price and stock market index suggest that the oil price moves in the opposite direction of stock market index. Depending on the numerical value of the covariance, it is possible to compare the intensity of those relationships. A zero covariance shows there is no linear relationship between oil price and stock market. Correlation test results specify whether and how strong the two variables are related (Grossman & Livingstone, 2009). A correlation coefficient between -1 and 1 will be generated. The square of the correlation coefficient shows the fraction of the variation in oil price indices that is correlated to stock market indices. For instance, a correlation coefficient of +0.3 means that the oil price and stock markets move in the same direction, and 9% of the variations are related. On contrary, a correlation coefficient of -0.75 implies higher oil price is correlated with lower stock market performance, and 59.25% of the variations are related.

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