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Submitted By: Dhruv Aghi Section-A, BBA LLB Roll no. 9


Symbiosis Law School, NOIDA Symbiosis International University, PUNE 26th March 2012

Under The Guidance of: Dr. Pushpa Negi


The project entitled IMPACT OF OIL PRICES ON THE STOCK MARKETsubmitted to the Symbiosis Law School, NOIDA for quantitative techniques as part of internal assessment is based on my original work carried out under the guidance of Dr. Pushpa Negi on 26/03/12. The research work has not been submitted elsewhere for award of any degree. The material borrowed from other sources and incorporated in the thesis has been duly acknowledged. I understand that I myself could be held responsible and accountable for plagiarism, if any, detected later on.

Signature of the candidate Date: 26/03/12

It is a great pleasure for us to put on records our appreciation and gratitude towards Dr. Pushpa Negi for his immense support and encouragement all through the preparation of this report and for his valuable support and suggestions for the improvement and editing of this project report. Last but not the least, we would like to thank the college staff, friends and others who directly or indirectly helped us in completing this project report.



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Stock market commentators like to draw parallels between the behavior of oil prices and stock prices on any given day. After all, who hasnt seen a headline like this: Oil Spike Pummels Stock Market? But evidence shows that a change in oil prices does not necessarily affect the stock market in any predictable and meaningful way. Before we explain why, lets look at the traditional wisdom, which holds that when oil prices rise, stocks fall, and vice versa. When oil prices rise, gasoline prices follow. Higher gas prices hurt consumers, who then have less money to spend on other goods and services. A decline in consumer spending causes businesses to see decreasing sales. At the same time, businesses are also hurt by higher oil prices because they use oil for gas and other goods as well, and must pay higher prices for it. As a result, high oil prices can create a drag on corporate earningsand businesses often end up passing those costs onto already-strapped consumers. Its a vicious cycle, and it seems obvious that it would cause stocks to decline. The opposite is true when oil prices fall. That seems reasonable enough. So why do we say the traditional wisdom isnt always true? Because higher oil prices dont always result in a drag on corporate earnings. There a number of reasons for this. For example, the U.S. economy is less dependent on oil than it used to be: Each dollar of U.S. gross domestic product produced today takes about half the oil it did 30 years ago. Additionally, much of the oil used by American businesses at any given time has been purchased under fixed-prices contracts that were negotiated when oil prices were much lower. So, we have two ways of looking at the same situation. The traditional wisdom holds that higher oil prices hurt stocks. But when we look a little deeper, we can see that isnt always the case. Thats quite a muddle, and it piqued the interest of economiststwo of whom set out to find out which is the case: Do higher oil prices hurt stocks, or dont they? These economists, based at the Federal Reserve Bank of Cleveland, looked at both oil prices and the S&P 500 Index, which is widely considered a broad indicator of stock market performance. The economists found, that over the past 10 years, oil prices and stock prices have mostly risen but there has been little correlation between them. That was the case even during periods of peak oil prices, when we might expect stocks to really suffer. The economists did find, however, that certain segments of the stock market were correlated with oil prices. For example, the Dow Jones Transportation Index rose when oil process rose, and fell when oil prices

fellpresumably because changes in oil prices have a significant effect on transportation companies. On the other hand, the Dow Jones Financials Index rose when oil prices fell, and fell when oil prices rosepresumably because the financial industry is not directly affected by oil prices. That information may offer investors some insight when it comes to buying and selling stocks during periods of high and low oil prices. When oil prices are high, you might want to sell (or short) airline stocks. When oil prices are low, you might want to buy energy stocks. Savvy stock pickers could potentially benefit in this way.

Review of Literature
1. Gogineni (2006) investigated the impact of daily oil price changes on the stock returns of a wide array of industries. In addition to the stock returns of industries that depend heavily on oil, stockreturns of some industries that use little oil also are sensitive to oil prices perhaps because their main customers are impacted by oil price changes. In addition, he presented robust estimates of industries cost-side and demand-side dependence on oil. These measures can serve as reliable benchmarks when classifying industries into oil-intensive and nonoil intensive groups, a distinction widely used in studies and media without any quantitative justification so far. Further, the sensitivity of industries returns to oil price changes depends on both the cost-side and demand-side dependence on oil and that the relative effects of these factors vary across industries. 2. Thornton and Welker (1999) in their study explored associations between U.S. firms' 10-K disclosures of market risk exposure, which were newly mandated by a 1997 SEC Release, and stock price sensitivity to underlying risk factors. Firms whose stock prices were more sensitive to oil and gas prices tended to have open year-end positions in commodity derivatives and disclose the value-at-risk or the sensitivity of their derivative contracts to commodity price changes. Firms whose stock prices were less sensitive to oil and gas prices tended not to have open year-end positions in commodity derivatives or, if they did, to give simple tabular disclosures of derivative contracts. On their SEC filing dates, firms that disclosed value-at-risk or sensitivity experienced more significant shifts than other firms did in stock-price sensitivity to oil and gas price changes. Firms disclosing that their material derivative contracts had zero net sensitivity to commodity price changes, given an assumed shift in commodity prices, experienced the most significant shifts instockprice sensitivity to those same price changes. Preliminary tests on an oilintensive sub-sample suggest a tentative economic interpretation of these results that is both intuitively appealing and consistent with the SEC's perceptions. Producers with naturally long oil exposure that disclosed the value-at-risk or sensitivity of their derivative contracts experienced a reduction in the sensitivity of their stock prices to oil price changes because such disclosures signaled to the market that they had implemented effective risk management strategies.

3. Sawyer and Nandha (2006) concluded that the important question in asset markets is whether oil prices are a global factor in asset returns. In this paper, we propose a hierarchical model of stock returns which assumes that markets are integrated conditional on a set of factors, including oil. The hierarchical model is a variant of the Jorion and Schwarz

model of market integration and permits significance testing of factors at three levels; global, country and sector. In an application to three countries across nine common sectors, we found the pattern of significance of oil was different than for six other commodities. While there is no evidence that oilis a global or country factor, there is evidence that oil is more significant at the sector level than other commodities. The average P-values for oil are less than for other commodities and, in Wald tests across sectors, oil behaves like a global market factor and a country market factor. The effect of oil is therefore both disaggregated and heterogeneous. There are two important implications of this study. First, in the aggregate, stock prices appear remarkably insensitive to oil prices, suggesting that the correlation between stock prices and oil prices is less certain than usually perceived. While an oil shock may cause a real economy recession, it does not necessarily cause an asset economy recession. A second implication relates to the testing of linear factor models. If factors affect asset prices in a hierarchy rather than linearly, tests of factor models must adjust for the hierarchical structure. 4. Davis and Diaz (2008) quantifed the time-varying effects of oil-price shocks on the U.S. economy, Federal Reserve policy, and global equity markets. While the first-round impact of oil-price shocks on U.S. economic growth has not changed materially over time, their formerlynegative second-round effects are notably absent over the past 25 years given oil's near-zero impact on long-term inflation expectations. Since oilprice shocks now represent a less-stagflationary policy tradeoff, they showed why the Federal Reserve should lower short-term interest rates in response to anoil-price shock under certain (but not all) macro scenarios. For domestic and international stocks, simple regressions reveal the anticipated inverse relationship, with a 10% increase in oilprices associated with a statistically significant 1.5% lower total return. However, the stock market's reaction varies dramatically depending on the source of the oil-price shock, with global stocks - in particular the industrial and materials sectors - responding quite favorably to oil-price increases attributed to global-demand shocks. A key implication is that oil-price increases do not uniformly lead to lower stock returns. Interestingly, our oil-price decomposition suggests that oil's recent surge cannot be explained by supply disruptions, global demand fundamentals, or the depreciation of the U.S. dollar. 5. Manera, Lanza, Grasso and Giovannini (2003) conclude that the identification of the forces that drive oil stock prices is extremely important given the size of the Oil&Gas industry and its links with the energy sector and the environment. In the next decade oil companies will have to deal with international policies to contrast climate change. This issue is likely to affect companies' shareholder values. In this paper we focus on the long-run financial determinants of the stock prices of six major oil companies (Bp, Chevron-Texaco, Eni, Exxon-Mobil, Royal Dutch


Shell, Total-Fina-Elf) using multivariate cointegration techniques and vector error correction models. Weekly oil stock prices are analyzed together with the relevant stock market indexes, exchange rates, spot and future oil prices over the period January 1998 - April 2003. The empirical results confirm the statistical significance of the major financial variables in explaining the long-run dynamics of oil companies' stockvalues. 6. Fodor and Stowe (2010) studied that the BP Deepwater Horizon drilling rig exploded on April 20, 2010, leading to an unprecedented environmental and financial disaster. This paper details responses in the financial markets for BP securities, including stock, bonds, options, and credit default swaps. Following the disaster BP shares dropped more than 50 percent in value, with high volatility. BP share trading volume increased thirteen-fold, and option trading volume increased twenty-fold. The implied volatility of BP shares also jumped, ranging between two and four times its earlier levels. Interest rate spreads on BP bonds widened and the prices of credit default swaps exploded. Finally, on June 16, the company announced that cash dividends were suspended. We provide evidence from options markets that this dividend suspension was anticipated. From late June through September, there was a partial reversion to pre-explosion levels in all markets. We detail the degree of integration across markets, as wide swings in BPs outlook were simultaneously absorbed in the various markets. 7. Oseni (2009) parallel Brav & Heaton (2003) alleges market indeterminacy (a situation where it is impossible to determine whether an asset is efficiently or inefficiently priced) in the stock market. Kang (2008) argue that empirical tests of linear asset pricing models show presence of mispricing in asset pricing. Asset pricing is considered efficient if the asset price reflects all available market information to the extent no informed trader can outperform the market and/or the uninformed trader. This study examined the extent to which some information factors or market indices affect the stock price. A model defined by Al-Tamimi (2007) was used to regress the variables (stockprices, earnings per share, gross domestic product, lending interest rate and foreign exchange rate) after testing for multicollinarity among the independent variables. The multicollinarity test revealed very strong correlation between gross domestic product and crude oil price, gross domestic product and foreign exchange rate, lending interest rate and inflation rate. All the variables have positive correlation to stock prices with the exception of lending interest rate and foreign exchange rate. The outcomes of the study agree with earlier studies by Udegbunam and Eriki (2001); Ibrahim (2003) and Chaudhuri and Smiles (2004). This study has enriched the existing literature while it would help policy makers who are interested in deploying instruments of monetary policy and other economic indices for the growth of the capital market.


8. Cifarelli , Paladino (2008) assessed empirically whether speculation affects oil price dynamics. The growing presence of financial operators in the oil markets has led to the diffusion of trading techniques based on extrapolative expectations. Strategies of this kind foster feedback trading that may cause large departures of prices from their fundamental values. We investigate this hypothesis using a modified CAPM that follows Shiller (1984) and Sentana and Wadhwani (1992). At first, a univariate GARCH(1,1)-M is estimated assuming that the risk premium is a function of the conditional oil price volatility. The single factor model, however, is outperformed by the multifactor ICAPM (Merton, 1973) which takes into account a larger investment opportunity set. The analysis is then carried out using a trivariate CCC GARCH-M model with complex nonlinear conditional mean equations where oil price dynamics are associated with both stock market and exchange rate behavior. We find strong evidence that oil price shifts are negatively related to stock price and exchange rate changes and that a complex web of time varying first and second order conditional moment interactions affect both the CAPM and feedback trading components of the model. Despite the difficulties, we identify a significant role of speculation in the oil market which is consistent with the observed large daily upward and downward shifts in prices. A clear evidence that it is not a fundamentals-driven market. Thus, from a policy point of view - given the impact of volatile oil prices on global inflation and growth - actions that monitor more effectively speculative activities on commodity markets are to be welcomed. 9. Tansuchat, Chang and McAleer (2010) investigated the conditional correlations and volatility spillovers between crude oil returns and stock index returns. Daily returns from 2 January 1998 to 4 November 2009 of the crude oil spot, forward and futures prices from the WTI and Brent markets, and the FTSE100, NYSE, Dow Jones and S&P500 index returns, are analysed using the CCC model of Bollerslev (1990), VARMA-GARCH model of Ling and McAleer (2003), VARMA-AGARCH model of McAleer, Hoti and Chan (2008), and DCC model of Engle (2002). Based on the CCC model, the estimates of conditional correlations for returns across markets are very low, and some are not statistically significant, which means the conditional shocks are correlated only in the samemarket and not across markets. However, the DCC estimates of the conditional correlations are always significant. This result makes it clear that the assumption of constant conditional correlations is not supported empirically. Surprisingly, the empirical results from the VARMA-GARCH and VARMA-AGARCH models provide little evidence of volatility spillovers between the crude oil and financial markets. The evidence of asymmetric effects of negative and positive shocks of equal magnitude on the


conditional variances suggests that VARMA-AGARCH is superior to VARMA-GARCH and CCC. 10. Alpanda and Alva (2008) concluded that the market value of U.S. corporations was nearly halved following the oil crisis of October 1973. Real energy prices more than doubled by the end of the decade, increasing energy costs and spurring innovation in energy-saving technologies by corporations. This paper uses a neo-classical growth model to quantify the impact of the increase in energy prices on the marketvalue of U.S. corporations. In the model, corporations adopt energy-saving technologies as a response to the energy price shock and the price of installed capital falls due to investment irreversibility. The model calibrated to match the subsequent decline in energy consumption in the U.S. generates a 24% decline in market valuation - accounting for nearly half of what is observed in the data. 11. Khan (2010) investigated the short-run and long-run relationship between the crude oil prices and the stock market of BRIC countries by using Structural Vector Error Correction technique. By imposing short-run and long-run restrictions, the results indicate that the real stock returns of Russia, India and China follows Efficient Market Hypothesis (EMH) in response to crude oil shock. Brazils real stock returns do not follow EMH due to its transformed status as crude oil exporter. The industrial production of BRIC countries behaves almost in a similar fashion. The output increase in short-run and decrease over short to long-run period. This behavior is attributed to short-run commercial oil future contracts with physical delivery. This reduces the impact of initial oil shock to the output. The short-term interest rate behavior varies to some extent among BRIC countries. In case of Brazil and Russia which can be categorized as net crude oil exporters, the interest rates increase over short-run and then decline from short to long-run (negative change). On the contrary, the Indian and Chinese interest rates increase over shortrun and decline over long-run (positive change). The increase in interest rates is attributed to contain the inflationary pressure while the decline in interest rates is associated with increase in the output. 12. Yang, Fok and Chang (2007) examined the valuation effects of corporate name changes involved oil related terms during recent oil price surges. Using data from the U.S. and Canadian stock markets, we show that there is a tendency for companies in both markets to add oil or petroleum to their corporate names when oil prices are high. Results show that U.S. investors react more positively for firms that add oil-related terms to their names. Name changes trigger short-term positive and longterm negative returns in the Canadian market. Our results add supports of the literature that investors are potentially influenced by corporate name changes associated with market wide sentiments.


13. Driesprong, Jacobsen and Maat (2007) studied that changes in oil prices predict stock market returns worldwide. In our thirty year sample of monthly returns for developed stock markets, we find statistically significant predictability for twelve out of eighteen countries as well as for the world market index. Results are similar for our shorter time series of emerging markets. We find no evidence that our results can be explained by time varying risk premia. Even though oil price shocks increase risk, investors seem to underreact to information in the price of oil: a rise in oil prices does not lead to higherstock market returns, but drastically lowers returns. For instance, an oil price shock of one standard deviation (around 10 percent) predictably lowers world market returns by one percent.Oil price changes also significantly predict negative excess returns. Our findings are consistent with the hypothesis of a delayed reaction by investors to oil price changes. In line with this hypothesis the relation between monthly stock returns and lagged monthly oil price changes becomes substantially stronger once we introduce lags of several trading days between monthly stock returns and lagged monthly oil price changes. 14. Hayo and Kutan (2009) analyzed the impact of news, oil prices, and international financial market developments on daily returns on Russian bond and stock markets. First, there is some persistence in both bond and stock market returns. Second, we find that U.S. stock market returns Granger-cause Russian financial markets. Third, growth in oil prices has a positive effect on Russianstock market returns. Fourth, there is a significant economic and statistical influence of a specific type of news on the Russian bond market: Positive (negative) news related to the energy sector raise (lower) daily returns by one percentage point. News from the war in Chechnya, on the other hand, do not appear to have a significant influence on financial markets. 15. Rault and Arouri (2009) investigated that in the empirical literature, only few studies have focused on the relationship between oil prices and stock markets in net oil-importing countries. In net oil-exporting countries this relationship has not been widely researched. This paper implements the panel-data approach of Knya (2006), which is based on SUR systems and Wald tests with countryspecific bootstrap critical values to study the sensitivity of stock markets to oil prices in GCC (Gulf Corporation Council) countries. Using two different (weekly and monthly) datasets covering respectively the periods from 7 June 2005 to 21 October 2008, and from January 1996 to December 2007, we show strong statistical evidence that the causal relationship is consistently bi-directional for Saudi Arabia. Stock market price changes in the other GCC member countries do not Granger cause oil price changes, whereas oil price shocks Granger


cause stock price changes. Therefore, investors in GCC stock markets should look at the changes in oil prices, whereas investors in oil markets should look at changes in the Saudi stock market.


Market commentators and journalists like to draw direct lines between the behavior of crude oil prices and market behavior on a given day, with such headlines as Oil Spike Pummels Stock Market (Wall Street Journal) or U.S. Stocks Rally as Oil Prices Fall(Financial Times). But does a change in oil prices affect the overall stock market in any predictable, meaningful way? Might a hike in crude foretell a weak day on the Street? It seems logical to assume that oil prices and stock market performance might be negatively correlated. More expensive fuel translates into higher transportation, production, and heating costs, which can put a drag on corporate earnings. Rising fuel prices can also stir up concerns about inflation and curtail consumers discretionary spending. But it is also possible to associate expensive crude with a booming economy. Higher prices could reflect stronger business performance and increased demand for fuel. Which is it? A look at oil prices and the S&P 500 index suggests neither. Both oil prices and the S&P 500 index have mostly climbed over the past 10 years, but they have frequently moved in opposite directions. Sometimes they rise and fall together, but the relationship between oil and stocks does not appear to be very strong. The following scatter plot relates the weekly behavior of crude prices with S&P 500 performance since the beginning of 1998. If a clear negative relationship between oil prices and the S&P 500 index existed, we would expect to see the points aligned along somewhat of a downward-sloping line, indicating poorer stock performance when oil prices pick up. No such relationship is evident, at least not in the time period sampled. Furthermore, the correlation between weekly averages of the spot oil price and the S&P 500 index is a weak and statistically insignificant 0.021 for the past 10 years (with a confidence level of 95 percent). It is possible that a stronger correlation might exist for data at different frequencies (daily, weekly, monthly) or with different stock indexes. The S&P 500 index is widely used as a broad market indicator because it contains the stocks of 500 leading U.S. companies that trade on the two largest U.S. stock markets, the New York Stock Exchange and the Nasdaq. We can expand the industries covered by including other indexes: S&P Financial, S&P Industrial, Dow Jones Industrial, Dow Jones Transportation, the Nasdaq Composite, and the NYSE Composite, and we can look at data at all three frequencies to see if either of these factors affect the correlation. It is also possible that the relationship between oil and the stock market changes over time, say when oil prices are at a trough versus when they are at a peak. To investigate this possibility, we designate the 18-month period surrounding December 1998 as an oil price trough (from March 1998 to September 1999) and the most recent 18-month period


beginning February 2007 as a price peak, and compare the correlations. As it turns out, correlations between oil prices and all of these stock indexes at the daily, weekly, and monthly levels for the two time periods also reveal very few relationships of statistical significance.


REFERENCES 1. Gogineni, Sridhar, Oil and the Stock Market: An Industry Level Analysis (February 19, 2010). The Financial Review, Forthcoming . Available at SSRN: 2. Thornton, Daniel B. and Welker, Michael, Impact of Market Risk Disclosures on Stock Price Sensitivity to Oil and Gas Prices (April 1999). Available at SSRN: or 3. Sawyer, Kim R. and Nandha, Mohan, How Oil Moves Stock Prices (June 20, 2006). Available at SSRN: or 4. Davis, Joseph H. and Aliaga-Diaz, Roger A, Oil, the Economy, and the Stock Market (April 2008). Available at SSRN: 5. Manera, Matteo, Lanza, Alessandro, Grasso, Margherita and Giovannini, Massimo, Long-run Models of Oil Stock Prices (October 2003). FEEM Working Paper No. 96.2003. Available at SSRN: or 6. Driesprong, Gerben, Jacobsen, Ben and Maat, Benjamin, Striking Oil: Another Puzzle (July 2003, 11). ERIM Report Series Reference No. ERS2003-082-F&A. Available at SSRN: 7. Fodor, Andy and Stowe, John D., The BP Oil Disaster: Stock and Option Market Reactions (December 20, 2010). Available at SSRN: or 8. Manera, Matteo, Lanza, Alessandro, Grasso, Margherita and Giovannini, Massimo, Conditional Correlations in the Returns on Oil Companies Stock Prices and Their Determinants (April 2004). FEEM Working Paper No. 71.04. Available at SSRN: or 9. Oseni, Jimoh Ezekiel, Determinants of Equity Prices in the Stock Markets (January 14, 2009). Available at SSRN: or


10. Simpson, John L., Evans, John P. and Husain, Tasneem, The Importance of the Relationship between OPEC Oil Prices and Gulf Cooperating Economy Banking Stock Returns (September 2004). University of Wollongong in Dubai Working Paper No. 21/2004. Available at SSRN: or 11. Cifarelli, Giulio and Paladino, Giovanna, Oil Price Dynamics and Speculation: A Multivariate Financial Approach (November 4, 2008). Available at SSRN: or 12. Tansuchat, Roengchai, Chang, Chia-Lin and McAleer, Michael, Conditional Correlations and Volatility Spillovers between Crude Oil and Stock Index Returns (January 10, 2010). Available at SSRN: or 13. Goriaev , Alexei and Zabotkin, Alexei, Risks of Investing in the Russian Stock Market: Lessons of the First Decade. Emerging Markets Review, Forthcoming. Available at SSRN: 14. Sariannidis, Nikolaos, Litinas, Nicolaos , Konteos , George and Giannarakis, Grigoris, A GARCH Examination of Macroeconomic Effects on U.S. Stock Market: A Distinguish between the Total Market Index and the Sustainability Index (February 10, 2009). Available at SSRN: or 15. Khan, Salman, Crude Oil Price Shocks to Emerging Markets: Evaluating the BRICs Case (April 30, 2010). Available at SSRN: or