An Econometric Investigation of Long and Short Run Relationship

among Global Crude Oil Price, Exchange Rate and Stock Price in India:
An ARDL-UECM Approach.
Shekhar Mishra

Assistant Professor (Finance)

Srusti Academy of Management

Abstract:

The present study aims to investigate the long and short run relationship between Global Crude
Oil Price, Exchange Rate Volatility and Stock Price in India using ARDL-UECM approach. The
study used monthly data from the period April 2000 to January 2015. The cointegration result
reveals that crude oil price tends to have long run relationship with exchange rate and stock price
and changes in the independent variables have significant impact on volatility of global crude oil
prices. The long run estimates of ARDL Process indicate that impact of exchange rate volatility
on crude oil is negative whereas the interaction between NSE Stock price and crude oil price is
positive. The Short Run Dynamic coefficients associated with long run relationships reveals that
the estimated error correction coefficient is negative which indicates that adjustment process
from short run deviation is quite slow. The analysis would enhance the understanding of
dynamic interaction between the global crude oil price, exchange rate and stock price. The
empirical outcome is of wider interest and has large implications for market integration, policy
makers and investors at large.

Keywords: Crude Oil Price, Exchange Rate, Stock Market, ARDL-UECM, Cointegration.

JEL Classification: E45; G11; G15

Introduction:

In literature, considerable research has been done to analyze the relationship between stock
returns across the international markets. The empirical outcomes of research revealed the
existence of significant cross-market interactions. The study of financial market integration
becomes more imperative owing to the contagious impact of Global Financial Turmoil which
engulfed majority of economies in the world. The empirical findings interest the investors in two
ways. Firstly if countries stock returns are positively related, then investors with information in
one market can predict the movement in the other. Secondly establishing the relationship
between stock prices and exchange rate may hold importance for multinational corporations.
Since the link between stock price and exchange rate may be used to predict the exchange rate
path, analysis of possible relationship between the same may hold importance for multinational
corporations. This is because the linkage between stock returns and exchange rate can have
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implications on the ability of multinational corporations to manage their exposure to foreign
contracts and exchange rate they face.

Existence of relationship between stock market performance and exchange rate behavior can be
well witnessed in an open economy. Traditional models show that fluctuations in exchange rate
affect the competitiveness affect the value of earnings as well as cost of funds, because many
companies borrow in foreign currencies to borrow their operations and hence its stock price
(Dornbusch and Fischer, 1980). On the other way round, vibrant stock market would attract
capital inflows from foreign investors, which increase the demand for its currency. In the
opposite case with the advent of fall in stock prices, foreign investors sell their stocks to avoid
further losses and convert their money into foreign currency to move out of the country and
consequently local currency depreciates. Thus movement in stock price and exchange rate may
affect each other.

Variations in Global Crude Oil Prices are also considered as one of the factors for understanding
stock price volatility. Crude oil as a worldwide required commodity plays a significant role in
development of energy economies. The fluctuations in crude oil prices have both direct and
indirect impact on economy of different countries and significantly on their prices. This has
made movements in oil price receive special attention in daily media. Liberalization and
integration of international markets have led to increased level of capital flows and international
events. This has made the global investors more vulnerable to emerging stock markets due its
relation with oil price fluctuation.

In the long term oil price effect transmits to macroeconomic indicators that influence liquidity of
stock markets and affect the long term equilibrium linkage between the integrated financial
markets. Impact of oil price shocks on stock returns can be ascertained through their effect on
expected earnings (Jones et. al., 2004). Stock Price in theory equals discounted expectation of
future cash flows (dividends) which in turn are affected by macroeconomic events that can be
possibly influenced by oil shocks. Oil price increase raises the production cost and thus
adversely affects the prospects of higher profits for firms traded in Indian Stock Markets.

On demand side, increase in oil price drives up the general level of prices, which translates into
lower real disposable income and consequently reduces demand. Impact of oil price can also be
felt on wage levels in form of secondary effects which along with general price levels result in
increased inflation. Central Bank usually controls this inflationary pressure through increase in
interest rates which make bond investments more attractive than stock markets which result in
lower stock prices. Oil exporting countries on the other hand benefit from higher export
revenues, which could be diminished by a decline in global oil demand.

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Figure 1: Time Series Movement of Monthly data of CNX Nifty, Global Crude Oil Price and
Exchange Rate Movements of INR/US$.

Oil prices can also act as a channel through which the real exchange affects the stock. Oil price
can also act as an explanatory variable to reflect the impact of exchange rate on stock prices. The
impact of fluctuating oil price on stock market and exchange rate differ from country to country
depending on whether the country is an oil exporter or oil importer. For oil exporting countries,
rise in global oil price improves trade balance, leading to higher current account surplus, and
improves net foreign asset position. For such countries, rise in global crude oil price also raises
the private disposable income, which raises the domestic demand. This in turn raises the
corporate profitability and stock prices, thereby causing their exchange rate to appreciate. For oil
importing countries increase in global crude oil prices creates trade imbalance and plays a bigger
role in creating Current Account Deficit. For such countries, trade deficit are offset by weaker
growth and over time real exchange rate depreciates and stock prices decrease. (Abdelaziz. et.al.
2008).

Literature Review:

The relationship between oil price, exchange rate and stock price has drawn the attention of
many researchers and practitioners. Substantial number of researches has been made which
explore the interaction among the given variables. Some literature demonstrates the relationship
between crude oil price and stock, while some explore the relationship between exchange rate
and stock price. Very few literatures are available which discuss about the combined interaction
among the given variables.
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Michael Gavin (1989) analyzed the model of the small, open economy in which the stock market
rather than bond market determines the aggregate demand. The author found that the asset price
and output dynamics can differ in many ways beside conventional Mundell Fleming Model.
Through his study, the author postulated that the interaction of output, profitability, stock prices
and aggregate demand tends to dampen the exchange rate implications of shifts in monetary
policy. The author found that if the stock market effects are large enough and if money is not too
neutral it is theoretically possible for an expansionary monetary policy to lead to real exchange
rate appreciation, rather than depreciation.

Hamao et.al. (1990) employed Autoregressive Conditional Heteroskedastic (ARCH) famiy of

statistical models to explore and analyze the pricing relationships between daily opening and
closing stock prices of major stock indices of Tokyo, London and New York stock markets. The
authors found the evidence of price volatility spillovers from New York to Tokyo, London to
Tokyo and New York to London. The authors witnessed no price volatility spillover effects in
other directions for pre October 1987 period.

Charles M. Jones and Gautam Kaul (1996) tested whether the reaction of international stock
markets to oil shocks can be justified by the current and future changes in real cash flows and/ or
changes in expected returns. The authors postulated that in the post war period, the reaction of
United States and Canadian stock prices to oil shocks can be completely accounted for by the
impact of these shocks on real cash flows alone. In contrast, in United Kingdom and Japan,
innovations in oil prices appear to cause larger changes in stock prices than can be justified by
subsequent changes in real cash flows or by changing expected returns.

Roger. D. Huang, Ronald.W. Masulis and Hans R. Stoll (1996) analysed the information
transmission mechanism linking oil futures with stock prices, where the authors examined the
lead lag cross-correlations of returns in one market with other. The authors used Vector Auto
Regression (VAR) Model to investigate the dynamic interactions between New York Mercantile
Exchange (NYMEX) and U.S. stock prices to examine the effects of energy shocks on financial
markets. They also examined the extent to which the markets are contemporaneously correlated
with particular attention paid to the association of oil price indices with S&P 500 Index; 12
major industry stock price indices and 3 individual oil company stock prices. The estimates of
their model for various time series of returns found that Petroleum Industry Stock Index and oil
company stocks were the only series where null hypothesis that oil futures do not lead Treasury
Bill Rates and Stock Returns can be rejected. Hypothesis that oil futures lag other two series was
also liable to be rejected.

Yin-Wong Cheung and Lilian K. Ng (1998) used Johanssen Cointegration technique to find
empirical evidence of long run co-movements between sample of five national stock market
indices and measure of aggregate real activity including real oil price, real consumption, real
money and real output. The authors found that real returns on these indices are typically related

Page | 4
to transitory deviations from the long run relationship and to changes in macroeconomic
variables.

W.J.C.Granger et.al. (1998) applied Unit Root and Cointegration models to determine the
appropriate Granger Causality Relations between stock prices and exchange rates airing Asian
Crisis. The authors found positive correlations between exchange rates and stock prices from
data of Japan and Thailand, whereas the data of Taiwan indicated negative correlations between
the variables.

Bruce.J.Morley and Eric.J.Pentecost (1998) employed Error Correction Model (ECM) to

examine the dynamic, behavioural, relationship between the excess returns of foreign exchange
and the variables that measure the stock market risk factor for G-7 countries. The test results for
major currencies supported the the hypothesis that the excess foreign exchange returns are
related to relative risks of equity markets. The researchers also found the evidence of non-
monotonic adjustments in some equations with respect to U.S Dollar which suggest short run
exchange rate movements.

Perry Sadorsky (1999) examined the role of oil prices and oil price volatility on real stock returns
by employing Vector Auto Regression Model and found that both the independent variables play
a significant role in affecting the real stock returns. The author found that after 1986, oil price
movements explain a larger fraction of the forecast error variance in real stock returns as
compared to interest rates and their volatility shocks also have asymmetric effect on economy.

O. Felix Ayadi, Amitava Chatterjee and C.Pat Obi (2000) investigated the impact of energy
sector on the functioning of Nigerian Economy, including the financial markets under the Vector
Auto Regression (VAR) Framework. Their results revealed the significant influence of energy
sector on Nigerian Economy by acting as a prime mover.

Mansor.H.Ibrahim (2000) used Bivariate as well as Multivariate Cointegration and Granger

Causality Test to analyze the interactions between stock prices and exchange rates in Malaysia.
The author found that although there was no relationship between the exchange rate measures
and stock prices in bivariate models, there was evidence of cointegration when the models were
extended to include M2 money supply and reserves.

Eisa.A.Aleisa and Sel. Dibooglu (2002) investigated the sources of real exchange rate
movements in Saudi Arabia by decomposing real exchange rate movements into those
attributable to real and nominal shocks. Using Structural VAR model and assuming long run
neutrality of nominal shocks, the authors found that real shocks play a significant role in
explaining real exchange rate movements in Saudi Arabia. The authors found that oil production
shocks instead of real oil price shocks were responsible for real exchange rate movements.

Abdulnasser Hatemi.J and Manuchehr Irandoust (2002) used Granger Non-Causality testing
procedure developed by Toda and Yamamoto (1995) to study the inter relationship between
exchange rates and stock markets in Sweden. The authors employed Vector Auto Regression
(VAR) Model to examine the relation the causal relationship between the variables between the
Page | 5
variables and found that Granger Causality is unidirectional running from stock prices to
effective exchange rates. The results also revealed that an increase in Swedish stock prices is also
associated with an appreciation of the Swedish Krona.

Alok Kumar Mishra (2004) used Granger Causality Test and Vector Auto Regression Technique
on monthly stock return, exchange rate, interest rate and demand for money for the period
1992:4 to 2002:3 to examine whether the stock market and foreign exchange markets are related
to each other. The author found that there exists a unidirectional causality between the exchange
rate and interest rate and between the exchange rate return and demand for money. The author
found no evidence of Granger Causality between the exchange rate return and stock return.
Through Vector Auto Regression Modelling, the study confirmed that though sock return,
exchange rate return, the demand for money and interest rate are related to each other but any
consistent relationship doesn’t exist between them.

Abdulnasser Hatemi-J and Eduardo Roca (2005) used bootstrap causality tests with leveraged
adjustments to investigate the link between exchange rates and stock prices in
Malaysia,Indonesia,Phillipines and Thailand for the periods immediately before and during the
1997 Asian Crisis.. The authors in their study found significant relationship among the variables
during the non-crisis period and the relationship was not significant during non crisis period.

Syed.a.Basher and Peter Sadorsky (2006) investigated the relationship between oil price risk and
emerging stock market returns using International Multi Factor model. The International Multi
Factor Model allows for both conditional and unconditional risk factors to investigate the same.
The authors found a strong evidence of impact of oil price risk on stock market returns and also
presented other risk factors like market risk, total risk, Skewness and Kurtosis.

Quere et.al. (2007) studied the causality and cointegration between the real price of oil and real
price of the dollar over the 1974-2004 periods. The results suggested that a 10% rise in oil price
coincides with a 4.3% appreciation of the Dollar in the long run. The authors also found that
causality runs from oil to the dollar.

Chen et.al. (2007) investigated the long run relationship between real oil prices and real
exchange rates by using monthly panel of G-7 Countries from 1972:1 to 2005:10. The authors
examined whether exchange rate are cointegrated with real oil prices. The authors found that real
oil prices may have been the dominant source of real exchange rate movements and there exist a
link between real oil prices and real exchange rates. Estimates of Panel Predictive Regression
conducted by them showed that real oil prices have significant forecasting power.

Mohan Nandha and Shawkat Hammoudeh (2007) examined the relationship between beta risk
and realized stock index return in the presence of oil and exchange rate sensitivities for 15
countries in the Asia Pacific region using the international factor model. The authors found that
in terms of oil sensitivity, only Phillipines and South Korea are oil sensitive to changes in the oil
price in short run, when the price is expressed in local currency only, as no country shows
sensitivity to oil price measured in U.S. Dollars regardless whether the oil market is up or down.
The authors also found that nine countries were affected by changes in the exchange rate. In
Page | 6
terms of relative factor sensitivity distribution, the authors concluded that stock markets were
more conditionally sensitive to local currency oil price changes than to beta risk wherever the
relationships were significant.

Sana Zaouali (2007) conducted the quantitative analysis on the potential impact of the rise in oil
prices on the Chinese economy. The author employed Computable General Equilibrium (CGE)
Model its macroeconomic and sectoral effects. The analysis revealed that the rise of international
oil prices caused an economic cost to the Chinese economy and decrease in its welfare. The
authors revealed that rise in oil price has caused GDP to drop by 0.5% with US $10 increase in
international oil price and drop by 0.9% with US$25 increase in international oil prices.

Cong et.al. (2008) investigated the interactive relationships between oil price shocks and Chinese
Stock Markets using Multivariate Vector Auto Regression. The authors found that Oil Price
Shocks do not show statistically significant impact on the real stock returns of most Chinese
stock indices except for manufacturing index and some oil companies. The authors revealed that
increase of speculation in mining index and petrochemical index and consequent rise in their
stock returns could be attributed increase in oil price volatility.

Mohammed Abdelaziz, Georgios Chortareas and Andrea Cipollini (2008) tried to analyse the
linkage between stock prices, oil price and exchange rate in four Middle East emerging markets
of Kuwait, Egypt, Oman and Saudi Arabia. In their sample the authors did not find any evidence
of cointegration between stock prices and real exchange rates or of the cointegration among
stock prices, real exchange rates and other exogeneous variables such as the US Stock Price or
the oil price. To look for the possibility of presence of regime shifts attributing to these findings,
the authors further divided the sample into two sub periods based on real oil price shock in
March 1999. The Johansen Trace Statistics revealed the evidence of cointegration only for
second sub sample , among stock prices, real exchange rates and oil prices in Egypt, Oman and
Saudi Arabia and between stock prices in Kuwait. The authors utilized the full sample and
included deterministic dummies in the VECM to attempt to capture the regime shifts. The FIML
estimation results corroborated the findings from splitting the sample, which indicated that the
oil prices have long run positive effect on stock market of each country.

Irene Henriques and Peter Sadorsky (2008) applied Vector Auto Regression Model to investigate
the empirical relationship between alternative energy stock prices, technology stock prices, oil
prices and interest rates. Through their study the authors revealed that technology stock prices
and oil prices each individually Granger cause the stock prices of alternative energy companies.
The simulation results conducted by them showed that shock to technology stock prices has a
larger impact on alternative energy stock prices than does a shock to oil prices.

Parvar et.al. (2008). tested the validity of Dutch Diseases Hypothesis by examining the
relationship between the real oil prices and real exchange rate in sample of fourteen oil exporting
countries using ARDL Bounds test of cointegration. The authors found the existence of a stable
relationship between real exchange rates and real oil prices in all the countries considered in the
sample suggesting a strong support for Dutch Diseases Hypothesis.

Page | 7
Ortuk et.al. (2008) used Johanssen Cointegration test and Granger Causality test to investigate
the link between international oil prices and the exchange rate in the case of small industrial
economy of Turkey and analyse the relationship between the time series variables. In their study
the authors found that international oil prices Granger Cause the USD/YTL exchange rate.

Gerben Driesprong, Ben Jacobsen and Benjamin Mat (2008) demonstrated the impact of rising
oil prices which significantly lowers future stock returns of developed economies. Through their
study authors showed that investors react at different times and undermine the direct economic
effect of oil price changes on the economy.

Lutz Kilian and Cheolbeom Park (2009) utilized VAR Framework to anlayse the impact of oil
price shocks on the U.S. Stock Market and found that reaction of U.S. real stock returns to an oil
shock differs greatly depending on whether the change in oil price is driven by demand or supply
shocks in the oil market. The authors revealed that demand and supply shocks driving the global
crude oil market jointly account for 22% of the long run variation in the U.S. real stock returns.

Likka Korhonen and Tuuli Juurikkala (2009) assessed the determinants of equilibrium real
exchange rate in sample of oil dependent OPEC countries from 1975 to 2005. Utilizing pooled
mean group and mean group estimators. The authors found that price of oil have a significant
effect on real exchange rates in sample of oil producing countries. The authors revealed that
higher oil price lead to appreciation of real exchange rate and the elasticity of the real exchange
rate with respect to oil price is typically between 0.4 and 0.5

J. Issac Miller and Ronald A. Ratti (2009) analyzed the long-run relationship between the world
price of crude oil and international stock markets over the period of 1971:1-2008:3 using a
cointegrated Vector Error Correction Model (VECM) with additional regressors. The authors
allowed for endogeneously identified breaks in the cointegrating and error correction matrices
and found evidence for breaks after 1980:5, 1988:1 and 1999:9. The authors found the existence
of long run relationship between the series for six OECD countries for 1971:1-1980:5 and 1988:2
- 1999:9, indicating that stock markets respond negatively to increase in oil price in the long run.
During 1980:6-1988:1, the authors found relationships that are not statistically significantly
different from either zero or from the relationships of the previous period. The expected negative
long run relationship appeared to disintegrate after 1999:9.

Basher et.al. (2010) proposed and estimated Structural Vector Auto Regression to investigate the
dynamic relationship between oil price, exchange rate and stock price. The authors calculated the
Impulse Responses in two ways viz. Standard and Projection based methods. Through their
study, the authors revealed that positive shocks to oil prices tend to depress emerging market
stock prices and US Dollar exchange rates in the short run.

C. Toraman et.al. (2011) investigated the effects of Oil Price changes on Istanbul Stock
Exchange (ISE) 100 Composite Index, Service Index, Industrial Index AND Technology Index
of ISE. The authors used Co integration Test and Vector Error Correction Model (VECM) to test
the δong run relationship and short run relationship. The results of authors’ study revealed that
32.71 % of forecasting error variance of industrial index and 16.40% of ISE 100 Index is
Page | 8
explained by crude oil prices. About other indices 12.60 % of the forecasting error variance of
services index, 11.82% of forecasting error variance of financial index and 5.38% of technology
index are explained by crude oil prices.

M.A. Abedeyi .et. al. (2012) estimated the effect of oil price shocks and exchange rates on the
real stock returns in Nigeria over the period of 1985:1-2008:4 using a multivariate VAR
Analysis. The authors, empirical results showed an immediate and negative real stock returns to
oil price shock in Nigeria. The Granger Causality Test applied by the authors indicated that
causation run from oil price shocks to stock returns, implying that variation in stock market is
explained by the oil price volatility. However in case of exchange rate causation run was from
stock returns to real exchange rate indicating the need of focus on domestic economic policies to
stabilize the stock markets.

A.A.A.Rostamy et. al. (2013) in their study examined the impact of market return, oil price,
exchange rate and interest rate changes on the stock returns of 36 industry sectors of Teheran
Stock Exchange. The authors employed Multivariate Regression Model to analyze the
relationship among the variables and used Auto Regressive Distributed Lag (ARDL) to test the
model. Their findings indicated the significant impact of market return, oil price, exchange rate
and interest rate on some industries’ returns while some had contrary results.

From the literature available one can construe that changes in oil prices and fluctuations in
exchange rate are instrumental in predicting stock market returns and have impact on domestic
macroeconomic conditions, albeit with varying results depending on different economies and
their exposure to the international market. The empirical outcomes as observed from the given
literature are sensitive to the type of economy, methodology employed and time period under
study. From the given context, it becomes difficult to generalize the empirical results as each
market is unique in terms of its own rules, regulations and type of investor’s mindset. Further the
studies have been more or less confined to either developed or emerging market economies.
There has been a dearth of study on the given context, taking into account the developing
economies like India. The present paper attempts to analyze the combined interaction among
global crude oil price, exchange rate volatility and stock price in Indian economic scenario.

Research Methodology

Econometricians and authors have proposed many methods to test for long run equilibrium
relationship among time series variables. Methods like Engle and Granger (1987) test, Fully
Modified OLS Procedure of Phillips and Hansen (1990), Maximum Likelihood based Johnssen
and Johanssen- Juleius Test (1990) were used extensively to look for long run equilibrium
relationship among the variables. However these methods require variables to be integrated of
order one i.e. I (1) and they suffer from low power. In addition these methods are not appropriate
for small samples. Due to these problems, Auto Regressive Distributed Lag (ARDL) Approach
to Cointegration was developed to study long run equilibrium relationship among the variables
and this model deals with single cointegration. ARDL Model was originally introduced by
Pesaran and Shin (1999) and was further extended by Pesaran et.al. (2001). The ARDL approach

Page | 9
is based on Unrestricted Error Correction Model (UECM) and has the advantage of not requiring
all variables to be I (1) as compared to Johanssen Framework. The approach is still applicable if
we have I (0) and I (1) variables in our data set. The ARDL Bounds test method of cointegration
has certain econometric advantages over other types of Cointegration techniques. First the model
can be applied to small size (Pesaran. et.al. 2001) and therefore, conducting Bounds Test will be
appropriate for present study. Secondly, this approach estimates the short run and long run
components of model. The ARDL model simultaneously removes problem associated with
omitted variable and autocorrelation. Thirdly, this model can be applied regardless of the
stationary properties of the variables in the sample. Fourthly, ARDL model can accommodate
greater number of variables in comparison to other Vector Auto Regressive (VAR) models.
Finally, once the orders of the lags in the ARDL model have been appropriately selected, we can
estimate the cointegration relationship using a simple Ordinary Least Squares (OLS) method.

In view of the above mentioned advantages, ARDL-UECM model used in the present study has
the following form:
�

∆ ln � = + ∑� ∆ln � t−i + ∑� ∆ln �� t−i + ∑� ∆ln �� ��� t−i

�= �= �=
+ β ln NSE t−i + β ln Oil t−i + β ln Ex Rate t−i + t

Equation (1)
�

∆ ln �� = + ∑� ∆ln � t−i + ∑� ∆ln �� t−i + ∑� ∆ln �� ��� t−i

�= �= �=
+ β ln NSE t−i + β ln Oil t−i + β ln Ex Rate t−i + t

Equation (2)
�

∆ ln �� ��� = + ∑� ∆ln � t−i + ∑� ∆ln �� t−i + ∑� ∆ln �� ��� t−i

�= �= �=
+ β ln NSE t−i + β ln Oil t−i + β ln Ex Rate t−i + t

Equation (3)

∆ denotes the first difference operator and β0 is the intercept. β1 to β3 on the right hand side
corresponds to long run relationship and 1 to 3 represent short run dynamics of the model. t
represents white noise error term or residuals.

The first step in ARDL Bounds Testing approach is to estimate Equation (1) to Equation (3)
using OLS Method in order to test for existence of Long Run Relationship among the variables
by conducting an F-Test for the joint significance of the coefficients of the lagged level
variables, i.e. H0 μ β1 = β2= β3= 0 against the alternate H1 μ β1 ≠ β2≠ β3≠ 0 which normalizes
dependent variable by F(Dependent Variable/Independent Variables). Set of two critical value
bounds for F-Test statistics are given by Pesaran et.al. (2001) for the cointegration test. The

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lower critical value Bound assumes all variables are I (0) which means that there is no
cointegration relationship between the examined variables and the upper bound assumes that all
the variables are I (1) signifying cointegration among the variables. If computed F statistics falls
below the lower bound critical value, the null hypothesis of no cointegration cannot be rejected.
On the contrary if computed F Statistics lies above the upper bound critical value, the null
hypothesis is rejected implying the presence of long run cointegration relationship among the
variables in the model. If calculated value falls within the bound, then inference is inconclusive.

In the second step once cointegration is established, the conditional ARDL long run model can
be established as follows:
�

ln � = + ∑� ln � t−i + ∑� ln �� t−i + ∑� ln �� ��� t−i + t

�= �= �=

Equation (4)
�

ln �� = + ∑� ln � t−i + ∑� ln �� t−i + ∑� ln �� ��� t−i + t

�= �= �=

Equation (5)
�

ln �� ��� = + ∑� ln � t−i + ∑� ln �� t−i + ∑� ln �� ��� t−i + t

�= �= �=

Equation (6)

This involves selecting the orders of ARDL (p,q) model using Akaike Information Criterion
(AIC). In third and final step, Short Run Dynamic Parameters are obtained by estimating Error
Correction Model associated with long run estimates. Thus error correction version of ARDL-
UECM model can be specified as follows.
�

∆ ln � = + ∑ ∆ln � t−i + ∑ ∆ln �� t−i + ∑ ∆ln �� ��� t−i

�= �= �=
+ ECt− + t

Equation (7)
�

∆ ln �� = +∑ ∆ln �� t−i + ∑ ∆ln � t−i + ∑ ∆ln �� ��� t−i

�= �= �=
+ ECt− + t

Equation (8)

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 �

∆ ln �� ��� = + ∑ ∆ln �� ��� t−i +∑ ∆ln �� t−i + ∑ ∆ln � t−i

�= �= �=
+ ECt− + t

Equation (9)

Where is the speed of adjustment parameter and EC is the residuals obtained from estimated
cointegration models of Equation (1) to Equation (3).

The present study uses monthly data on closing prices of S & P CNX Nifty of National Stock
Exchange (NSE), Oil Price data from Petroleum Planning and Analysis Cell, Ministry of
Petroleum, Government of India and Exchange Rate from official website of Reserve Bank of
India. The data used in the study covers time span from Year 2000 to Year 2015.

Empirical Results and Discussions:

Unit Root Tests:

In Time Series Analysis, before running the Causality Test, the preliminary and most important
step is to test the stationarity of variables, in order to avoid spurious results. The use of non
stationary variables in the time series analysis leads to misleading inference (Libanio, 2005).

Table 1 : Results of Augmented Dickey Fuller (ADF) Test

Intercept Intercept and Trend
Variables Level First Difference Level First Difference
Crude Oil -1.544196 -6.70503 -0.555472 -6.77591
NSE (Closing Prices) -0.50142 -5.70173 -2.27015 -5.69959
Ex. Rate -0.386242 -4.38733 -1.26725 -4.50665

In this paper Augmented Dickey Fuller (ADF) Test is employed to look for the Unit Root in each
variable and thereby determine the order of integration. The results of the Unit Root Test are
presented in Table 1. The result of ADF test with intercept as well as with intercept and trend
reveals that variables at level are non stationary but at first difference the given variables possess
stationary properties. The ADF Test results confirm that variables are integrated of order 1 i.e. I
(1) and thus ARDL approach can be employed.

Bounds F Test for Cointegration:

Table 2 presents the result of ARDL Bounds F- Test for cointegration relationship based on
Equation (1) to Equation (3). The approximate lag length for Conditional ARDL-UECM was
selected on the basis of Akaike Information Criterion.

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 Table 2 : Results of ARDL Bounds Testing Approach
Dependent Independent Model Specification F-Statistics Inference
Variable Variables
NSE Crude Oil, Ex. FNSE (NSE/Crude Oil, Ex. 0.923074 No.
Rate Rate) Cointegration
Crude Oil NSE , Ex. Rate FCrude Oil(Crude Oil/NSE, Ex. 9.137617**
Rate) Cointegration
Ex. Rate NSE , Crude FEx. Rate (Ex. Rate/NSE,Crude 1.470825 No.
Oil Oil) Cointegration
Note: ** indicates computed F- Statistics fall upper bound critical value. Asymptotic critical
bound values are obtained from Pesaran et.al. The Critical Bound Values at 5 % significance level
are 3.23 - 4.35

The results reveal that computed F- Statistics at 9.13 is greater than upper bound value of 4.35 at
5% significance level. Thus null hypothesis of no cointegration is rejected and Crude Oil tends to
have long run relationship with Exchange Rate and NSE Stock price. Besides the result confirm
the absence of level relationship (long run relationship) when NSE Stock price as dependent
variable is regressed on Crude Oil and Exchange Rate. Similarly when Exchange Rate is the
dependent variable, the calculated F Statistic is found to be lower than lower critical value at 5%
significance level.

Thus among Equation (1) to Equation (3), for Equation (2) null hypothesis of non cointegration
is rejected, indicating there is stable long run relationships among the variables and implies that
that the considered variables are cointegrated among them i.e. the series cannot move far from
each other or they cannot move independently of each other. Besides the cointegration among
variable implies that there is some adjustment process in short run, preventing the errors in the
long run relationship from becoming larger and larger.

Long – run Estimates of ARDL Process:

After examining the possible existence of cointegration relationship among the given variables in
equation (1) to equation (3), equation (2) in which cointegration is established, is estimated for
the long run coefficients of the selected ARDL (1, 1, 1) model based on Akaike Information
Criterion. The results are presented in Table 3

Table 3: Estimated Long-Run Coefficients using the ARDL (1,1,1) Approach

Dependent Variable: Ln(Crude Oil)
Regressor Coefficient t-statistic Prob.Value
Constant 0.585799 2.605 0.0100 ***
Ln (NSE) 0.0805945 0.8128 0.4175
LN (NSE)t-1 −0.0163382 −0.1586 0.8741
LN (Ex. Rate) −0.346986 −1.208 0.2288
LN (Ex Rate)t-1 0.142702 0.4909 0.6241
*** indicate significance at one percent significance level. Optimal lag length is determined by
the Akaike Information Criterion.
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The results indicate that impact of exchange rate volatility on crude oil is negative , whereas the
relation between NSE Stock Price and Crude Oil is positive.

Short-run Dynamics of ARDL Process:

The results of short run dynamic coefficients associated with the long-run relationships derived
from equation (8) are presented in Table-4. Here also the optimal lag length for Error Correction
Representation is also determined by Akaike Information Criterion.

Table 4: Error Correction Representation for the selected ARDL (1,1,1) Model.
Dependent Variable: ∆ln Crude Oil
Regressor Coefficient T-Statistic Probability. Value
Constant −0.00208205 −0.3447 0.7308
∆ln Crude Oilt-1 0.491741 3.551 0.0005 ***
∆ln NSEt-1 0.326629 3.539 0.0005 ***
∆ln Ex.Ratet-1 −0.239542 −0.8980 0.3705
ECMt-1 −0.256131 −1.624 0.1061
R2 = 0.217884 AIC = −392.7266
F(4, 170) = 11.83975 SIC = −376.9027
D-W Statistic = 1.899006
Results of Diagnostics Test
Diagnostic Test Test Statistic P-Value
Ramsay’s RESET Test for Specification 2.183316 0.116
(Squares and Cubes)
Ramsay’s RESET test for specification 4.168603 0.0427
(squares only)
Ramsay’s RESET test for specification (Cubes 3.398659 0.067
only)
White’s Heteroskedasticity Test 18.103028 0.202129
Normality Test 22.379 0.00001
Breusch-Godfrey Test 2.134488 0.0246

The results of the short run dynamic coefficients associated with long-run relationships obtained
from equation 8 reveals that the estimated error correction coefficient is negative. The negative
value indicates that adjustment process from short run deviation is quite slow. More precisely,
the negative value indicates that 26% of disequilibrium in crude oil prices from the previous
period will be converges back to long run equilibrium in the current period.

The regression for the given ARDL Model equation is well specified as tested by the Ramsey
RESET Test. The equation also passes the diagnostic tests Durbin Watson Test and Breusch
Godfrey Test for serial correlation, White Heteroscedasticity Test for possible heteroskedasticity
and Normality Test.

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Stability of the ARDL Process

Finally the stability of the long run coefficients together with short run dynamics is examined by
applying the CUSUM (Cumulative Sum of Recursive Residuals) and CUSUMQ (Cumulative
Sum of Squares of Recursive Residuals) plots (Brown et.al. 1975). If the plots of the CUSUM
and CUSUMQ statistics stay within the critical bounds of five percent significance level, the null
hypothesis of all coefficients in the given regression are stable and cannot be rejected. Figure 3
and Figure 4 plot the results for CUSUM and CUSUMQ test. The CUSUM and CUSUMQ
statistics are well within the 5 % significance level critical bounds, indicating that short run and
long run coefficients in the ARDL-Error Correction model are stable.

Plot of CUSUM and CUSUMQ (Stability Test)

Figure 3: Plot of Cumulative Sum of Recursive Residuals.

The straight lines represent the critical bounds at 5% significance level

Figure 4: Plot of Cumulative Sum of Squares of Recursive Residuals.

The straight lines represent the critical bounds at 5% significance level

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Conclusion:

Owing to the dynamic relationship between aggregate stock prices, exchange rates and crude oil
prices, the study contributes to existing literature by studying the liaison of the three variables
taken together, in reference to an emerging economy like India. The implications are crucial in
context of emerging contribution of India to global economy and investment avenues it offers for
multinationals, global institutions and investors. The paper aims to examine the dynamism of the
relationship among the given variables by studying the long run and short run relationship among
the given variables.

The relationship among the given variables is examined through a robust empirical framework
by adopting highly acclaimed ARDL-UECM approach. The empirical findings suggest the
existence of long term relationship among the given variables. It is found that stock market as an
independent variable has positive impact and foreign exchange rate as an independent variable
has negative impact on crude oil price as dependent variable. In Indian economic scenario, stock
market leads the oil market.

Although the empirical outcome is contrary to general perception that oil market causes stock
market, yet the study can pose to be significant in context of global oil market and global
economic activity. Oil consumption in most of the developed economies is flat or in decline and
as a result emerging market economic growth (as proxy by their stock prices) is likely to be an
important source of demand side pricing pressure in the oil market (Tripathi et.al. 2012).India
being one of the largest importer of oil in the word, the Indian stock price reflecting the
economic activity of India exert influence on the crude oil price. Further we also observe the
impact of Foreign Exchange Rate in India on crude oil prices. We do not observe any causal
relationship among stock prices and exchange rate.

The empirical outcome is of wider interest and has large implication for market integration,
policy makers and investors at large. Since these markets are integrated, from the investment
point of view, risk reduction cannot be achieved in the long run by holding assets from these
markets in the same portfolio. However in the short run, the investors can reap the benefits of
diversification by investing in combination of either oil and foreign exchange market, or in
stocks and foreign exchange market. By comparing all the three markets, it can be inferred that
stock market rules the roost and its movement indicates the economic activity which in turn
determines the other market indicators.

Page | 16
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