Research Proposal

Changes in oil prices and their impact on Emerging Markets Returns
Instructor: Mr. Syed Kashif Saeed Group Members: Mehran Arshad (08-arid-1476) Muhammad Irfan (08-arid-1487) Adeel Ali (08-arid-1494) MBA 3rd Finance (Morning)

University Institute of Management Sciences PMAS-University of Arid Agriculture Rawalpindi

Introduction
The emerging markets refer to nation's social or business activity in the process of rapid growth and industrialization. Currently, there are approximately 28 emerging markets in the world, with the economies of China and India considered to be by far the two largest. Pakistani market is also considered under the emerging market segment of the global market. Emerging Markets heavily depend on oil imports for running their economic machinery as a result oil price shocks may have destabilizing effects on domestic financial markets. It implies that changes in oil prices will have an impact on the volatility of stock prices. In other words oil prices affects earnings of companies through which oil is a direct or indirect cost of operation. Oil prices did not fluctuate much before 1973. . After the Yom Kippur War started on October 6, 1973 the control of the crude oil price passed from the United States to OPEC and oil prices started to behave like prices of other commodities. Increase in oil prices will cause expected earnings to decline, and this brought about an immediate decrease in stock prices. If the stock market is inefficient, stock returns might be slowly affected. Oil being one of the most important macro economic factors will have strong linkages with financial markets in Pakistan. The purpose of this paper is to contribute to the literature on stock markets and energy prices by studying the impact of oil price changes on emerging stock market returns. This is an important and interesting topic to study because emerging economies are expected to consume an increasing share of the world's oil and become larger players in the global financial markets.

The prices of oil and the stock market works in opposite direction, with the increase in oil price leads to the decrease of the return in the stock market, likewise decrease in oil prices leads to the increase in the return of Stock market. Lastly increase in oil prices leads in the increase in the transportation cost as well as the heating costs for some elements, which in turns almost affect some of the manufacturing company. So, there is an impact of change in oil prices on the stock markets.

Literature Review:
Nooreen Mujahid, Roohi Ahmed and Khalid Mustafa (2005) have investigated relationship between the oil prices fluctuations and their impact on stock market. They have used daily data from March 1998-December 2005 for analysis purpose. The data was related to the Pakistani stock market only and nature of relationship between oil prices and stock market volatility estimated through this data. They have applied Ganger causality test among main variables and they have applied GARCH (1, 1) model. Pakistani economy heavily depends on oil imports and oil prices may shock and destabilized domestic financial markets. Their empirical results shown that there is no significant relationship between oil prices and stock market returns exist. They declared it as a result of more use of gas and increase liquidity in Pakistan. They haven’t found any significant relationship between the oil news and stock returns and no day of the week impact. They have found some relationship existence between the gas volume, price and stock market prices. Syed A. Basher and Perry Sadorsky (2006) have studied the impact of oil prices changes on the return of stock markets of emerging economies. They have used daily basis data of 21 stock markets emerging countries from December 1992-October 2005. Another important aspect of the study was that the data was valued in US Dollars and this was so to help the US and

international investors who have a Dollar trading account. They have not included countries like China and Russia because Stock markets of the countries have just started their proceedings at the time of research. They have estimated main equation by using Ordinary Least Square (OLS) model. This is an important topic to study because most of the emerging economies are expecting to increase the oil consumption in order to enlist themselves in larger players of the financial markets in the global economy. This fact can be realized with statistical evidence which tells that consumption of the emerging markets has increased by 37.2% in a period of 10 years from 1994-2004, which is the highest increase in oil consumption in the global oil consumption. They found that there is strong relationship between oil price changes and returns of the stock market of the emerging economies.

Robert D. Gay, Jr., Nova Southeastern University (March 2008) have investigated relationship between macroeconomic variables of the emerging economies and share prices. They have considered BRIC countries (i.e. Brazil, Russia, India and China) stock markets and implied the Box-Jenkins ARIMA model in order to check the relationship. They have used data of stock market index, exchange rate and oil prices of respective markets from March 1999 -June 2006. Their data was on monthly basis. Analysis of the macroeconomic variables effects revealed that there is no significant relationship between macroeconomic variables and share prices. The result wasn’t shocking for them because they knew that the some other international and domestic macroeconomic factors (like production, inflation, dividend yield, interest rates, trade balance, rate structure) might come in the play. Another interesting happening was that the relationship of the oil and stock prices which was hypothesized as negative by the researchers, showed inverse relation to the hypothesis. But this relation was inconsistent for all BRIC countries. This study has revealed that there is no significant

relationship between oil prices, exchange rate and share prices, so other domestic and macroeconomic factors should also be consider. Chien-Ming Huang and Yen-Hsien Lee: The crude oil price increases, affect productive cost structures and drive firm to raise sale price, and the rising pressure in cost also reduce firm profitability and consumption. The purposes of this research are to examine the relationship between oil prices and REIT returns and to investigate whether oil price increases contribute to positive REIT returns. This study re-examines the relationship between REIT returns and other markets as bond and stock market. ARJI model is used and, the analytical results reveal that REIT returns rise in response to increase in expected oil price and provide a good partial hedge. Also that REIT returns decreases while deflation period and more sensitive in the long term. Results show the positive and significant effects of expected oil price growth on REIT returns. The relationship between oil and REIT markets depends on the anticipated mentality of market investors and behaviors of oil price profoundly impact the price movements of REITs and present the positive effects. Mehmet Eryiğit: Oil is the lifeblood of modern economics. The forecasting of oil demand in future is not easy but it can be said that the demand for oil and the industrial development are highly correlated. China and India (these countries are called emerging economies which are growing very fast) are expected to demand and consume the most of the world’s oil. In this paper, the extended market model oil price in dollars was used to determine the effects of the oil price in dollars changes on market indexes in Istanbul Stock Exchange (ISE) for the period of 2000.01.04.In results the price changes of oil or energy affect emerging markets more than developed markets. It is found that oil price changes have a significant positive effect on Wood, Paper &Printing, Insurance and Electricity sub-sector indices. All the sectors have positive effects while changes in the oil prices and uncertainty. Oil price volatility increases risk and uncertainty which negatively affect the stock

prices and reduces wealth and investment. For this purpose model of Faft & Brails ford’s (1999) was used. Shawkat Hammoudeh and Salim Al-Gudhea: This paper examines the shortrun relationships between oil prices and GCC stock markets. GCC are the major emerging markets, oil prices have a great effect upon the stock markets of these countries. Over few years oil prices have changed with sequences of very large increases and decreases. Recently many researches have conduct to determine the relationship of oil prices and stock markets in European, Asia and Latin America emerging markets. However, less attention has been paid to smaller emerging markets, especially in the Gulf Cooperating Council (GCC) countries where share dealing is a relatively recent phenomenon. As far as we know, only three recent papers have attempted to investigate the relationships between oil and stock markets in GCC countries. There is a bidirectional relationship between Saudi stock returns and oil price changes. The findings also suggest that the other GCC markets are not directly linked to oil prices and are less dependent on oil exports and are more influenced by domestic factors. . Uses VAR analysis to study the effect of oil price changes on GCC stock markets and shows that only the Saudi and Omani markets have predictive power of oil price increase. Our results show that there are significant links between the two variables in Qatar, Oman, and UAE. Thus, stock markets in these countries react positively to oil price increases. For Bahrain, Kuwait, and Saudi Arabia we found that oil price changes do not affect stock market returns. Robert W. Faff and Timothy J. Brailsford: The purpose of this paper is to investigate the sensitivity of Australian industry equity returns to oil price factor over period 1983-1996. In this impact of oil price changes is seen in different countries like Canada, Us, Japan UK and etc. For this different methodologies were used e.g. Chen et al used multifactor asset pricing model using innovations in a set of macroeconomic variables. Other models were also used like

arbitrage pricing theory (APT) and capital asset pricing model (CAPM) to see variation in equity returns. The results confirmed that positive sensitivity was seen in oil and gas, and diversified resources industries and negative sensitivity was also seen in paper, packaging, and transportation industries. The results also showed that industries were not homogeneous and different factors can affect industry returns in different ways. C. EMRE ALPER: The purpose of this paper is to give answer the question ‘could the liquidity crisis have been avoided? Without resorting the lack of unfavorable external condition during 2000, such as increase in oil prices as well as the unfavorable change in the US$/Euro parity. Almost 12 months after the launching of the three-year stabilization program backed by the International Monetary Fund (IMF), Turkey experienced an acute liquidity crisis that threatened the viability of this disinflation and the fiscal adjustment program. Turkey liquidity crisis was seen by different ways and it’s causes were known. Special attention will be devoted on monetary policy, exchange rate and important development that led to crisis. The disinflation program was used for liquidity crisis reasons. The paper reviewed the main development in Turkey in eleven month of stabilization program. It was seen that three important factors could cause the liquidity crisis Geert Bekaert and Campbell R. Harvey: We find that most of emerging markets exhibit time varying integration. Some appear more integrated, other markets appear segmented even foreigners have free access to their capital markets. The reward of risk is common in all integrated countries while in segmented market the reward of risk is not same because sources of risk are different. We want to see whether more countries are integrated into world capital markets or not and what they have done for it. For it asset pricing theory is used, mild segmentation model is used for segmentation

and integration, other models are also used to see integration. The econometric model is used that shows degree of integration to change through time. Research has made three assumptions, all markets are perfectly integrated, individual markets are perfectly segmented, and local markets are partially integrated with the degree of integration being constant. Gerben Driesprong Ben Jacobsen Benjamin Maat (2005): We report evidence that changes in oil prices predict stock market returns worldwide. This paper investigates whether changes in oil prices predict stock returns. We consider the data of 48 countries, by using the regression model we find that the stock returns tend to be lower after oil price increases and higher if the oil price falls in the previous month. This predictability is not only statistically significant but also economically significant in many countries and the world market index. The main contribution of our paper is that we are the first to document this strong predictability of stock returns using oil price changes. From a market efficiency perspective our findings are important because they add a new variable to the list of economic variables that seem to have forecasting power. We find that this predictability is especially strong in the developed markets in our sample of countries and the world market index. While we offer no conclusive evidence, a possible explanation for our findings is that investors react in different point in time to changes in the oil price or have difficulty in assessing the impact of these changes on the value of stocks not related to the oil sector. In that case the gradual information diffusion hypothesis recently proposed by Hong and Stein (1999) might apply to oil prices. Our finding that the effect is less pronounced in oil related sectors gives support for this hypothesis.

Sandrine Lardic & Valérie Mignon: The aim of this paper is to study the longterm relationship between oil prices and economic activity. These studies generally put forward an inverse relationship between the two variables; by using the asymmetric co-integration framework we find that rising oil prices appear to retard aggregate economic activity by more than falling oil prices stimulate it. In order to account for these characteristics, we propose to use the asymmetric co integration framework, Oil prices may have an impact on economic activity through various transmission channels. First, there is the classic supply-side effect according to which rising oil prices are indicative of the reduced availability of a basic input to production, leading to a reduction of potential output (see, among others, consequently, there is a rise in cost production, and the growth of output and productivity are slowed. Second, an increase of oil prices deteriorates terms of trade for oil-importing countries). Thus, there is a wealth transfer from oil-importing countries to oil-exporting ones, leading to a fall of the purchasing power of firms and households in oil-importing countries. Third, according to the real balance effect, an increase in oil prices would lead to increase money demand. Due to the failure of monetary authorities to meet growing money demand with increased supply, there is a rise of interest rates and a retard in economic growth (for a detailed discussion on the impact of monetary policy. Fourth, a rise in oil prices generates inflation. The latter can be accompanied by indirect effects, called second round effects, given rise to price–wages loops. Fifth, an oil price increase may have a negative effect on consumption, investment and stock prices.

Methodology
We will check our results by the following regression model

Yi=β+β₂Xi+µi
In the above given model, Yi is return of the stock market and Xi is the fluctuations in the oil prices. µi is error term and encompasses all other variables which may affect the stock market returns. For evaluating our regression model we have defined methodology which comprises of estimation of market return and estimation of fluctuations in the oil prices over a certain period of time. We will calculate the market return by using the data of index prices of the stocks of the emerging markets. Its mathematical presentation is given below

Ri =I/Iο-1
The fluctuations in the oil prices will be estimated by using simple Price Index and its mathematical presentation will be some how like this:

PI= (P-Pο)/Pο*100
We will estimate the values of our variables by using the above mentioned equations and then insert them in the regression model and then we will check correlation between the two variables. Finally we check validity of our model by testing of Hypothesis.

T=β₂ (e) - β₂/s.d (β₂)

References
“Does Oil Price Transmit to Emerging Stock Returns: A case study of Pakistan Economy” by Nooreen Mujahid, Roohi Ahmed and Khalid Mustafa (2005). 2. “Effect of Macroeconomic Variables on Stock Market Returns for Four Emerging Economies: Brazil, Russia, India, and China” by ‘ Robert D. Gay, Jr., Nova Southeastern University’ 3. Effects of Oil Price Changes on the Sector Indices of Istanbul Stock Exchange by Mehmet Eryiğit (Euro Journals Publishing, Inc. 2009 http://www.eurojournals.com/finance.htm) 4. Pricing Risk, Oil and Financial Factors in Saudi Sector Index Returns by ’ Shawkat Hammoudeh and Salim Al-Gudhea’ 1. 5. “Oil price risk and emerging stock markets” by ‘Syed A. Basher and Perry Sadorsky’ (2006). 6. Oil price risk and the Australian stock market By Robert W. Faffa,*, Timothy J. Brails ford 7. On the short-term influence of oil price changes on stock markets in GCC countries: linear and nonlinear analyses By Mohamed El Hedi AROURI and Julian FOUQUAU 8. Oil prices and economic activity: An asymmetric co integration approach By Sandrine 9. Striking Oil: Another Puzzle? By Gerben Driesprong, Ben Jacobsen and Benjamin Maat 10. The Relationship between Oil Price Growth and REIT Returns by ChienMing Huang & Yen-Hsien Lee © Euro Journals Publishing, Inc. 2009 11. The Turkish Liquidity Crisis of 2000: What Went Wrong By C. EMRE ALPER 12. Time-varying World Market Integration By Geert Bekaert and campbell R. Harvey 13. Lardic & Valérie Mignon 14. www.wikipedia.org 15. www.google.com.pk

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