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Relationship
On the relationship between between oil
oil and equity markets: and equity
markets
evidence from South Asia
Md Hasib Noor 287
American International University-Bangladesh, Dhaka, Bangladesh, and
Received 6 April 2016
Anupam Dutta Revised 6 February 2017
Accepted 7 February 2017
Department of Accounting and Finance, University of Vaasa, Vaasa, Finland

Abstract
Purpose – The purpose of this paper is to investigate the volatility linkage between global oil market and
major South Asian equity markets.
Design/methodology/approach – In order to serve the purpose, the authors employ a recently developed
vector autoregressive-generalized autoregressive conditional heteroskedastic model to examine whether
shocks and volatility spill over from the oil market to various equity markets under consideration.
Findings – The findings of the empirical analysis suggest that all the markets studied do receive volatility from
the oil market. Not surprisingly, the authors do not find any significant evidence of volatility transmission
from the equity markets to the global oil market. Additionally, while computing the optimal portfolio weights and
hedge ratios, the authors document that inclusion of oil in the portfolio of stocks tends to reduce the risk of the
resultant portfolio.
Originality/value – Fully original.
Keywords South Asia, Hedge effectiveness, Oil market, VAR-GARCH model, Volatility transmission
Paper type Research paper

1. Introduction
This paper investigates whether the global oil market plays any significant role in the
equity markets of major South Asian countries. In particular, we aim to assess
the relationship between oil prices and stock market returns for India, Pakistan and
Sri Lanka. Empirical research in such field is crucial, since numerous studies argue that oil
price is one of the major indicators for an economy and hence changes in its volatility can
have substantial impacts on the stock market. For instance, Bernanke (1983) and Pindyck
(1991) report that large oil price movements tend to increase uncertainty about future prices
and thus cause delays in business investments. Ciner (2013) also claims that oil prices may
have important influences over the stock returns in two means. First, oil price shocks can
cause changes in expected cash flows by their effect on the overall economy. Second, oil
price shocks can affect the discount rate used to value equities by changing inflationary
expectations. Additionally, Vo (2011) argues that a growth in oil prices can impact the future
cash flows of a firm, either negatively or positively depending on whether the firm is
producing or consuming oil.
While numerous empirical studies (Kling, 1985; Chen et al., 1986; Sadorsky, 1999;
Papapetrou, 2001; Basher and Sadorsky, 2006; Killian and Park, 2009; Choi and Hammoudeh,
2010; Lee and Chiou, 2011 and others) have investigated the possible association between oil
price changes and stock returns, the literature on how the volatility spill overs from the oil
market to the equity markets is surprisingly limited. Ross (1989), however, reports that it is the
volatility of an asset, not its return, that is related to the rate of information flow to a market.
International Journal of Managerial
Vo (2009) also argues that volatility is an important variable for pricing derivatives, whose Finance
Vol. 13 No. 3, 2017
trading volume has quadrupled in recent years. He further adds that for making efficient pp. 287-303
© Emerald Publishing Limited
1743-9132
JEL Classification — G1 DOI 10.1108/IJMF-04-2016-0064
IJMF econometric inference about the mean of a variable under study, a correct specification of its
13,3 volatility is always needed. It is, therefore, essential for investors and policymakers to know
about the volatility transmission mechanism between oil and financial markets to better
understand the effect of oil price on specific equity markets.
South Asian market is considered one of the largest consumers of crude oil and petroleum-
related products. For instance, India is the fourth-largest net importer of crude oil and
288 petroleum products after the USA, China and Japan (US Energy Information Administration,
2014). In addition, India is currently importing more than 70 percent of its crude requirements
(Integrated Energy Policy (IEP) document published by Planning Commission in India) and
such dependence might go up to 90 percent due to limited supply and stagnation in domestic
production (Ghosh and Kanjilal, 2016). Likewise, Pakistan and Sri Lanka also import huge
amounts of crude oil and related products. Naranpanawa and Bandara (2012), for example,
report that Sri Lanka’s expenditure on petroleum imports has increased by about 39.3 percent
in 2010 (an increase in expenditure on oil imports from US$ 2.2 billion in 2009 to US$ 3
billion in 2010). In Pakistan, the oil import expenditures account for one-third of its total import
bill as well. Oil is an important commodity in this region, since all these countries mainly
produce agricultural products and different sectors such as industry, transport and agriculture
are highly dependent on crude oil. Thus, oil price shocks seem to have significant influences
over the economies considered. It is therefore important to study the dynamic link between
global oil prices and the stock returns of the selected emerging markets. Nevertheless,
investigating whether global oil market sends volatility to these emerging markets is non-
existent. Therefore, the objective of this study is to conceal this void.
At the empirical stage, we consider the application of a bivariate vector autoregressive –
generalized autoregressive conditional heteroskedastic (VAR-GARCH) model to examine how
the shocks and volatility are transferred from the oil market to different equity markets under
study. Employing this approach is beneficial, since it tends to capture the effect on current
volatility of both own innovation and lagged volatility shocks emanating from within a given
market and cross innovation and volatility transmission from interrelated markets. The data
we have considered in our analyses include daily observations spanning from January 1, 2000
to December 31, 2014. The findings of our analysis confirm that there do exist significant
volatility linkages between global oil prices and the stock returns of the selected markets. More
specifically, we document that all the considered stock markets are the recipients of volatility
from the oil market. As expected, we do not find any significant evidence of mean and volatility
spillover from the equity markets to the global oil market. The empirical analysis further
confirms that including oil in the portfolio of stocks seems to reduce the portfolio risk.
This study extends the prior literature in several aspects. First, to the best of our knowledge,
this is the initial study to inspect the volatility connection between global oil prices and stock
returns of major South Asian markets. Second, we aim to find optimal portfolio allocations on
the basis of oil and stock investments to examine whether oil market can be considered as an
effective hedge against the unfavorable movements in the price indices of the stock markets
studied. Third, whilst almost all the existing studies investigating the links between oil and
equity markets have been conducted on developed economies, we contribute to the emerging
market literature. Finally, the results of our investigation would assist the investors and traders
who are in quest of emerging market information and involved in making optimum portfolio
allocation decisions. Policymakers could also implement effective measures during periods of
uncertainty in order to reduce the oil price risk. Adopting such strategies will then help to
ensure a country’s economy from global oil price shocks.
The rest of the paper proceeds as follows. Section 2 reviews the relevant literature.
Section 3 involves the description of our data. Section 4 outlines the empirical methodology
used in this study. We then discuss the results of our assessment in Section 5. Section 6
concludes the paper.
2. Review of related literature Relationship
A strand of literature has investigated the associations between oil prices and stock market between oil
returns. Researchers, however, have reported mixed results. For example, Kling (1985) and equity
documents that changes in oil price and stock returns are negatively associated. Chen et al.
(1986), on the other hand, conclude that movements in oil price do not have any impact on markets
the stock returns. In addition to Kling (1985), Papapetrou (2001) also finds a negative
relation between oil price and equity returns. Moreover, few recent studies report that there 289
exist positive links between these two variables (see Basher and Sadorsky, 2006; Choi and
Hammoudeh, 2010).
Although the connection between oil prices and stock returns has been broadly assessed
by the earlier academics, only a limited number of empirical papers aim to examine how
volatility spill overs from oil markets to equity markets. For instance, Agren (2006) utilizes
an asymmetric form of the BEKK-GARCH(1,1) model to estimate the volatility spillover
from oil prices to stock markets in five major developed countries ( Japan, Norway, Sweden,
the UK and the USA). The findings of this research indicate strong evidence of volatility
transmission from oil to all stock markets considered, except for Sweden. Malik and
Hammoudeh (2007) also use the BEKK-GARCH(1,1) model to examine the volatility
and shock transmission mechanism among the US equity market, the global crude oil
market, and three Gulf equity markets including Bahrain, Kuwait and Saudi Arabia.
Their empirical findings confirm that Gulf equity markets do receive volatility from the
global oil market. They further report a significant volatility transmission from the stock
market to the oil market only in the case of Saudi Arabia. This latter finding implies that this
country plays a major role in the global oil market as the largest oil exporter.
While modeling volatility of stock and oil futures markets using a multivariate stochastic
volatility structure, Vo (2011) documents some major findings. First, the stock and oil
futures prices are inter-linked and their correlation follows a time-varying dynamic process
and tends to increase when the markets are more volatile. Second, conditioned on the past
information, the volatility in each market is very persistent. Third, there is inter-market
dependence in volatility. Innovations that hit either market can affect the volatility in the
other market. Besides, Ciner (2013) has attempted to examine the association between oil
price changes and stock returns by using recently developed frequency domain methods.
His work shows that there is a significant time variation in the linkage between oil and
equities. The author adds that oil price shocks with less than 12-month persistency have a
negative impact on stock returns, while shocks with persistency between 12 and 36 months
are associated with positive stock returns.
A more recent study by Lin et al. (2014) examines the dynamic volatility and volatility
transmission between oil and Ghanaian stock market returns in a multivariate setting using
the newly developed VAR-GARCH, VAR-AGARCH and DCC-GARCH frameworks.
For comparison purpose, the authors also take account of the Nigerian stock market in their
analysis. Their results suggest the existence of significant volatility spillover and
interdependence between oil and the two stock market returns. The study also reveals that
while spillover effects are stronger for Nigeria, the transmission of volatility is much more
apparent from oil to stock than from stock to oil in the case of Ghana. In addition, Bouri (2015a)
also makes an important contribution in the literature by investigating the return and volatility
linkages between oil prices and the Lebanese stock market by applying the VAR-GARCH
model to weekly data from January 30, 1998 to May 30, 2014. The study indicates weak
unidirectional return and volatility transmissions from oil prices to the Lebanese stock market.
The author further reports that the interrelationship between oil prices and Lebanese stocks
increases during the crisis and tends to reduce significantly in the post-crisis period.
Bouri (2015b), however, inspects the role of oil price volatility in predicting the
stock-market volatility of small oil-importing countries that have a substantial number of
IJMF investors from neighboring oil-exporting countries remains unexplored. In doing so, he
13,3 proposes a methodological extension of the recently developed causality-in-variance
procedure and considers the case of Lebanon and Jordan. For comparison purposes, the
author also considers stock markets of Morocco and Tunisia in his study. Empirical
analyses suggest the dynamic effects of the global financial crisis on the volatility spillovers
between oil and the stock markets of oil-importing countries and provide more insights into
290 the seemingly contradictory effects of being oil-importers while having investors from
oil-exporting countries. The author also finds that the volatility spillover is much more
apparent from the world oil market to the stock market of Jordan than the other way around,
whereas oil volatility is not a good predictor of Lebanese stock market volatility.
Additionally, a small number studies use sector indices to estimate the volatility spillover
effect between oil and stock prices. For instance, Malik and Ewing (2009) employ bivariate
BEKK-GARCH (1,1) models to examine the volatility transmission between oil prices and
five US sector indices. The sectors considered in their study include financials, industrials,
consumer services, health care and technology. The authors document that there exists
significant transmission of shocks and volatility between oil prices and different equity
market sectors. Besides, Soytas and Oran (2011) assess the inter-temporal links between
global oil prices, ISE 100 and ISE electricity index returns unadjusted and adjusted for
market effects. The study examines the causality using the Cheung-Ng approach and
reports that world oil prices Granger cause electricity index and adjusted electricity index
returns in variance, but not the aggregate market index returns.
More recently, Sadorsky (2012) uses multivariate GARCH models to analyze the
volatility spillovers between oil prices and the stock prices of clean energy companies and
technology companies. To serve his purpose, the author adopts four different multivariate
GARCH approaches, namely, BEKK, diagonal, constant conditional correlation and
dynamic conditional correlation models. The findings confirm that the stock prices of clean
energy companies correlate more highly with technology stock prices than with oil prices.
Other notable articles that investigate the possible oil-stock relationship at sector levels
include Arouri et al. (2011, 2012) and Degiannakis et al. (2013). Arouri et al. (2011), for
instance, employ a generalized VAR-GARCH method to examine the extent of volatility
transmission between oil and stock markets in Europe and the USA at the sector-level.
The findings of their research confirm the existence of significant volatility spillover
between oil and sector stock returns. The authors also add that the spillover is usually
unidirectional from oil markets to stock markets in Europe, but bidirectional in the USA.
Degiannakis et al. (2013) investigate the time-varying correlation between oil prices returns
and European industrial sector indices returns, considering the origin of the oil price shock.
The authors apply a time-varying multivariate heteroskedastic framework to assess the
above hypothesis using the data from ten European sectors. The contemporaneous
correlations suggest that the relationship between sector indices and oil prices change over
time and they are industry specific. The authors then find that the supply-side oil price
shocks result in low to moderate positive correlation levels, the precautionary demand oil
price shocks lead to almost zero correlation levels, while the aggregate demand oil price
shocks generate significant changes in the correlation levels (either positive or negative).
The authors also suggest that both the origin of the oil price shock and the type of industry
are important determinants of the correlation level between industrial sectors’ returns and
oil prices. The study further shows that during the financial crisis of 2008 some sectors were
providing diversification opportunities to investors dealing with the crude oil market.
While Agren (2006), Malik and Ewing (2009), Arouri et al. (2011, 2012) and similar other
studies mostly focus on the developed or frontier markets, we aim to extend the scarce
literature on the association between global oil and emerging stock markets by assessing the
extent of volatility transmission, portfolio designs and hedging effectiveness (HE) in oil and
major emerging economies in South Asia. This can be considered as an important Relationship
contribution, because Basher and Sadorsky (2006) argue that oil price shocks are more severe between oil
in emerging economies than developed markets as the formers appear to be more energy and equity
sensitive. Besides, at the end of 2015, emerging economies account for 58.1 percent of global
energy consumption and most importantly, oil still remains the world’s leading fuel, markets
accounting for 32.9 percent of the overall energy consumption[1]. Thus the impacts of oil price
shocks on emerging market equity returns merit further assessment, since such shocks can 291
transmit into equity markets leading to immediate instabilities in financial markets and
distant disruptions of economic activities (Bouri, 2015b). Besides, as we have discussed earlier,
the oil consumption in the South Asian economies considered in our study has significantly
increased over the last decade. Since oil is one of the most important production factors,
increased oil prices often lead to higher production costs in these large oil-importing countries.
Additionally, the South Asian economy is largely moved by its agricultural sector and the
costs of agricultural products are significantly related to the transport sector which utilizes
the highest amount of crude oil and petroleum-related products in this region. In addition, the
metal industries of the countries under study are also highly oil-intensive. Since metals are
widely used in various fields of national economy, oil price volatility is likely to bring
uncertainty to the overall economic growth through its impact on metal markets. In this
background, investigating the extent to which oil price volatility shocks are transmitted to the
selected stock markets and vice versa is essential to develop the basic understanding of
volatility spillovers between oil prices and stock markets in oil-importing countries and
provides valuable insights regarding information flows across markets (Bouri, 2015b).
Nevertheless, regarding the context of large oil-importing countries in the South Asian region,
the relationship between oil and stock markets has been surprisingly understudied. In order to
conceal this void in the current literature, the present paper inspects both return and volatility
linkages between global oil prices and the major South Asian equity markets, which remains
an unexplored research area.

3. Data
The stock market data consist of the Morgan Stanley Capital International (MSCI) country
index observations for India, Pakistan and Sri Lanka. The use of MSCI index is
advantageous, since it measures the stock prices in US dollars. In order to retain a large data
set, we use daily records. The sample period starts in January 1, 2001 and ends in
December 31, 2014, yielding a total of 3,653 observations. In addition, we use daily data for
the same time period for Brent crude oil prices. We have chosen this type of oil as it presents
60 percent of the world oil daily consumption (Maghyereh, 2004). All the information is
extracted from the DATASTREAM website.

3.1 Descriptive statistics

Table I reports the descriptive statistics for each of the return series considered in the present
study. Surprisingly, the average returns for all the indices are positive. The oil market shows

Market Mean SD Skewness Kurtosis Jarque-Bera test

Oil 0.00025 0.0220 −0.169 8.97 5,450.25 (00)***

India 0.00040 0.0171 −0.075 11.61 11,287.20 (00)***
Pakistan 0.00030 0.0162 −0.332 7.03 2,542.42 (00)***
Sri Lanka 0.00055 0.0157 1.573 45.08 271,007.10 (00)***
Notes: This table reports the main descriptive statistics for various return indices studied. The values in Table I.
parentheses denote the p-values. ***Significant at 1 percent level Descriptive statistics
IJMF higher volatility than the equity markets, while amongst the stock indices, Indian market is
13,3 more volatile than the rest. Additionally, most of the indices exhibit negative skewness
implying that large negative stock returns are more common than large positive returns in
these markets. We report positively skewed returns only for Sri Lankan equity market.
In terms of kurtosis, each of the indices is leptokurtic which is a usual case in high frequency
financial time series data. Figures 1-4, where we plot the returns of the indices, also indicate the
292 presence of volatility clustering and hence the GARCH process, proposed by Engle (1982) and
Bollerslev (1986), is a preferred option for modeling the return series. Moreover, the Jarque-Bera
test rejects the null hypothesis that the return series follows a normal distribution.

4. Methodology
GARCH-type models have been widely used in order to detect the volatility transmission
linkages among different return indices. Popular multivariate GARCH specifications include
BEKK, CCC and DCC models. Studies that adopt these specifications to assess the volatility
spillover effects between oil and equity markets consist of Malik and Hammoudeh (2007),
Malik and Ewing (2009) and Kang et al. (2009) and several others. However, these models

OIL
0.20

0.15

0.10

0.05

0.00

–0.05

–0.10

Figure 1. –0.15
Daily returns for
oil market –0.20
01 02 03 04 05 06 07 08 09 10 11 12 13 14

INDIA
0.20

0.15

0.10

0.05

0.00

–0.05

Figure 2. –0.10
Daily stock returns
for India –0.15
01 02 03 04 05 06 07 08 09 10 11 12 13 14
 0.12
PAKISTAN Relationship
between oil
0.08
and equity
0.04
markets
0.00
293
–0.04

–0.08

–0.12 Figure 3.
Daily stock returns
–0.16 for Pakistan
01 02 03 04 05 06 07 08 09 10 11 12 13 14

SRI LANKA
0.3

0.2

0.1

0.0

–0.1
Figure 4.
Daily stock returns
–0.2 for Sri Lanka
01 02 03 04 05 06 07 08 09 10 11 12 13 14

often experience convergence problems and also involve computational complications

(Arouri et al., 2012; Bouri, 2015a). With a view to avoiding all these aforementioned
complexities, we consider employing the recently developed VAR-GARCH model proposed
by Ling and McAleer (2003). This specification contains fewer parameters compared to
other models such as BEKK and overcomes the convergence problem. Chang et al. (2011),
Arouri et al. (2011) and Bouri (2015a) have also chosen this model to estimate the volatility
transmission relationship between oil and stock markets.
Now, using Akaike information criterion and Schwartz information criterion, we have
selected the optimal number of lags and on the basis of these results, we employ the
following bivariate VAR(1)-GARCH (1,1) model defined as follows:

Rt ¼ C þyRt1 þet

1=2
et ¼ Dt Zt (1)
Within this framework, Rt denotes a 2 × 1 vector of daily returns on oil and stock market
indices at time t, C refers to a 2 × 1 vector of constants, θ is a 2 × 2 matrix of parameters
measuring the impacts of own lagged and cross mean transmissions between two markets, εt is
IJMF the residual of the mean equation for the oil and stock returns at time t, ηt indicates
pffiffiffiffi p a 2 ×1
1=2 ffiffiffiffiffi
13,3 vector of independently and identically distributed innovations and Dt ¼ diag hst ; hot ,
where, hst and hot representing the conditional variances of stock and oil returns, respectively,
are defined as follows:

hst ¼ c2s þb211 hst1 þb221 hot1 þa211 e2s;t1 þa221 e2o;t1 (2)
294

hot ¼ c2o þb212 hst1 þb222 hot1 þa212 e2s;t1 þa222 e2o;t1 (3)

Equations (2) and (3) permit us to estimate how shocks and volatility spill over across time
as well as across the return indices. Moreover, the conditional covariance between oil and
stock returns is estimated as follows:
qffiffiffiffi qffiffiffiffiffi
hso
t ¼ rt hst U hot (4)

where ρt denotes the conditional correlation between oil and stock returns at time t.
Now, for the purpose of capturing the non-normality associated with oil and stock prices,
we apply the quasi-maximum likelihood estimation technique to obtain the estimates of the
parameters of our VAR(1)-GARCH (1,1) model. These findings are then used to compute
the optimal weights and hedge ratios.

5. Empirical results
This section reports the findings of our empirical analyses. We first execute the Augmented
Dickey and Fuller (1979, 1981) and Phillips and Perrron (1988) tests to check the stationarity
conditions for each of the return indices considered in this study. We then document the
results of the VAR-GARCH models to investigate the volatility transmission relationship
between oil and each of the stock markets considered. The final subsection discusses the
results of optimum portfolio weights and hedge effectiveness.

5.1 Unit root tests

Table II displays the results of the unit root tests. Both Augmented Dickey and Fuller (ADF)
as well as Phillips and Perrron (PP) tests confirm that the null hypothesis of no unit root
holds suggesting that all the price indices appear to be non-stationary. However, the first
differenced series are stationary. We hence report that all the individual return indices tend
to have unit roots. These results are important, since the stationarity condition will permit
us to adopt the autoregressive process for modeling the returns.

ADF tests PP tests

Sector Level 1st difference Level 1st difference

Oil −1.61 (0.47) −62.65 (0.00)*** −1.63 (0.46) −62.62 (0.00)***

India −1.31 (0.62) −55.98 (0.00)*** −1.23 (0.66) −55.94 (0.00)***
Pakistan −1.54 (0.51) −54.30 (0.00)*** −1.55 (0.50) −55.39 (0.00)***
Table II. Sri Lanka −0.96 (0.76) −50.12 (0.00)*** −1.06 (0.73) −50.44 (0.00)***
Results of unit Notes: This table shows the results for the ADF and PP tests. The values in parentheses denote the p-values.
root tests ***Significant at 1 percent level
5.2 Estimation of the VAR(1)-GARCH(1,1) model Relationship
The estimated results of our bivariate VAR(1)-GARCH(1,1) model have been reported in between oil
Tables III-V. These findings will allow us to investigate the association between first and and equity
second order moments of global oil market and different South Asian equity markets.
In Tables III-V, hot1 measures the conditional variance of the oil market at time t-1 and hst1 markets
indicates the conditional variance of a particular equity market at time t-1. The squared
error terms e2s;t1 and e2o;t1 measure the effects of unexpected news or shocks in stock and 295
oil markets, respectively.
Table III displays the results of our first model which contains the oil and Indian equity
markets. These findings reveal that for both markets past returns can be used to predict the
current returns. This outcome signals the short-term predictability in each market. Moreover,
we report that lagged oil returns have negative and significant impact on Indian equities.

Independent Variable Stock Oil

Panel A: mean equation

rst1 0.1062 (0.00)*** −0.0275 (0.10)
rot1 −0.0284 (0.01)** 0.0857 (0.00)***
Panel B: variance equation
e2s;t1 0.1121 (0.00)*** 0.0016 (0.41)
e2o;t1 0.0084 (0.00)*** 0.0659 (0.00)***
hst1 0.7396 (0.00)*** 0.0039 (0.11)
hot1 0.0356 (0.00)*** 0.7921 (0.00)***
Notes: This table reports the findings of VAR(1)-GARCH(1,1) model for Indian equity market. Panel A
contains the results of the mean equation, while Panel B shows the same for variance equation. r st1 refers to
the return on Indian stock market at time t−1 and r ot1 denotes the same for oil market hot1 measures the
conditional variance of the oil market at time t−1 and hst1 indicates the conditional variance of Indian Table III.
equity market at time t−1. The squared error terms e2s;t1 and e2o;t1 measure the effects of unexpected Results of the VAR(1)-
news or shocks in stock and oil markets, respectively. The values in parentheses denote the p-values. GARCH(1,1) model for
**,***Significant at 5 and 1 percent levels, respectively Indian market

Independent variable Stock Oil

Panel A: mean equation

rst1 0.0675 (0.00)*** 0.0087 (0.67)
rot1 0.0326 (0.00)*** −0.0157 (0.35)
Panel B: variance equation
e2s;t1 0.1392 (0.00)*** 0.0018 (0.12)
e2o;t1 0.0054 (0.00)*** 0.0297 (0.00)***
hst1 0.8159 (0.00)*** 0.0001 (0.43)
hot1 0.0005 (0.00)*** 0.9604 (0.00)***
Notes: This table reports the findings of VAR(1)-GARCH(1,1) model for Pakistani equity market. Panel A
contains the results of the mean equation, while Panel B shows the same for variance equation. r st1 refers to
the return on Pakistani stock market at time t−1 and r ot1 denotes the same for oil market hot1 measures the
conditional variance of the oil market at time t−1 and hst1 indicates the conditional variance of Pakistani Table IV.
equity market at time t−1. The squared error terms e2s;t1 and e2o;t1 measure the effects of unexpected news or Results of the VAR(1)-
shocks in stock and oil markets, respectively. The values in parentheses denote the p-values. ***Significant GARCH(1,1) model for
at 1 percent level Pakistani market
IJMF Independent variable Stock Oil
13,3
Panel A: mean equation
r st1 0.2001 (0.00)*** −0.0181 (0.44)
r ot1 0.0094 (0.00)*** −0.0401 (0.04)**
Panel B: variance equation
296 e2s;t1 0.0731 (0.00)*** 0.0047 (0.18)
e2o;t1 0.0059 (0.00)*** 0.1112 (0.00)***
hst1 0.9210 (0.00)*** 0.0007 (0.31)
hot1 0.0102 (0.03)** 0.8215 (0.00)***
Notes: This table reports the findings of VAR(1)-GARCH(1,1) model for Sri Lankan equity market. Panel A
contains the results of the mean equation, while Panel B shows the same for variance equation. r st1 refers to
the return on Sri Lankan stock market at time t−1 and r ot1 denotes the same for oil market hot1 measures the
Table V. conditional variance of the oil market at time t−1 and hst1 indicates the conditional variance of Sri Lankan
Results of the VAR(1)- equity market at time t−1. The squared error terms e2s;t1 and e2o;t1 measure the effects of unexpected news or
GARCH(1,1) model for shocks in stock and oil markets, respectively. The values in parentheses denote the p-values.
Sri Lankan market **,***Significant at 5 and 1 percent levels, respectively

This result is consistent with the existing literature, though Tarak et al. (2014) document the
reverse case for Indian market. Our results further suggest that the stock market in India does
receive volatility from the global oil market. This finding is expected, since India is one of
largest consumers of crude oil and thus oil price shocks are likely to affect the Indian equity
market and hence the real economic activity. Ghosh and Kanjilal (2016) also document that an
increase in crude oil price leads to an increase in subsidy burden of the Indian government as
the cost of imported items goes up and this in turn fuels inflation which discourages investment
in the stock market. Not surprisingly, there is no evidence of volatility transmission from the
corresponding stock market to the global oil market. Additionally, the equity market in Indian
tends to have a direct shock effect from oil returns. Furthermore, both the stock as well as oil
markets are affected by their own-lagged news and own past volatility.
The outcomes of the second model involving the oil and Pakistani stock markets are
presented in Table IV. Inspecting these findings indicates that current stock returns
are significantly affected by the past equity returns, while this is not the case for oil market.
In addition, the past oil returns have significant and positive impacts on the current stock
returns. This finding contradicts with most of the earlier studies, though Bouri (2015a) and
Mohanty et al. (2011) report similar findings for Lebanese and GCC markets, respectively. One
interesting finding is that current oil returns cannot be predicted using the past returns in oil
market. Now, the estimates of the variance equation confirm that past volatility in oil market
markedly influence the current volatility of the stock market in Pakistan. This volatility
linkage is also expected, since oil is one of the most utilized materials in Pakistan and
consequently, significant variations in global oil price seem to substantially affect its national
economy. For instance, agricultural and industrial sectors in Pakistan are mainly dependent
on crude oil and thus higher oil prices are expected to shrink the output through higher
production costs. Accordingly, the stock market performance of the firms operating in those
sectors is affected severely. As anticipated, the crude oil market is not affected by the past
news and shocks of the equity market under consideration. The significant coefficient on
e2o;t1 suggests that equity market returns are directly affected by the news stemming from
the oil market. Moreover, the results also reveal that both oil and Pakistani equity markets are
greatly influenced by their own-lagged news as well as own past volatility.
Table V reports the results of our third and final model which includes the oil and
Sri Lankan stock markets. Our results document that past returns are useful for the prediction
of current returns in each market. In addition, the lagged oil returns show significant and
positive effects on the current returns on Sri Lankan equity market. The numbers shown in Relationship
Table V further confirm our hypothesis that volatility significantly transmits from the oil between oil
market to the corresponding stock market. This outcome is not surprising as Sri Lanka imports and equity
100 percent of the crude oil needed in this country and hence a rise in oil price leads to a
significant increase in domestic prices in an oil importing developing country like Sri Lanka. markets
Naranpanawa and Bandara (2012) also argue that Sri Lanka has been one of the hardest hit
oil-importing countries in the world. The authors also add that a sharp increase in oil prices will 297
impact Sri Lankan post-war economic recovery and would increase poverty in the war affected
North and Eastern regions in the island. Like the other models, we do not find any sign of
volatility spillover from the equity market to the global crude oil market. The significant
coefficient on e2o;t1 indicates that equity market returns are directly affected by the news
deriving from the oil market. Furthermore, the findings specify that the conditional volatility of
both oil and equity markets are affected by their own-lagged news and own past volatility.
In summary, the findings of our empirical analysis show significant volatility
transmission from the oil market to various equity markets under investigation.
Thus, oil price changes seem to move the stock markets and hence the overall economy of
these countries. However, one should note that compared to the effects of own-lagged
shocks and volatilities, the amount of cross-market shocks and volatilities is found to be
much smaller. These results suggest that the impacts of own past news as well as
volatility are more vital in forecasting current volatility in the oil and equity markets.

5.3 Optimal portfolio weights and hedge ratios

Using the estimates of our bivariate VAR(1)-GARCH(1,1) model, we now discuss how oil
price risk can be hedged effectively. Suppose, an investor is holding a set of stocks in one of
the markets under study and he would like to hedge his exposure against the adverse
movements in oil price. Following Kroner and Ng (1998), the optimal portfolio weight can be
constructed as follows:
hst hso
t ¼
oso t
(5)
ht 2hso
o s
t þht

and:
8
> t o0
0; if oso
<
oso ¼ t ;
oso if 0p oso
t p1
t
>
: 1; if ot 41
so

where osot indicates the weight of oil in a one-dollar portfolio consisting of crude oil and
stock at time t, hst and hot are the conditional covariances of stock and oil markets,
respectively, and hso
t refers to the covariance term between stock and oil returns
 at time t.
The weight for the stock index for a particular market is given by 1oso t .
In addition, our results are also helpful for computing optimal hedge ratios for the
portfolio considered. Kroner and Sultan (1993) show that in order to minimize the risk of a
portfolio, an investor should short βt dollar in the stock market which is one dollar long in
the oil market, where βt is given by:
hso
bso
t ¼
t
(6)
hst
so
Table VI displays the values of optimum portfolio weights oso
t and hedge ratios bt . Our results
indicate that the optimal weights vary from 35 percent for Pakistani market to 46 percent for
IJMF Indian market. These findings reveal that for a $1 portfolio, on average 35 cents should be
13,3 invested in the oil market and the remaining 65 cents should be invested in the Pakistani stocks.
For the Indian market, these weights are 46and 54 percent, respectively. Thus the overall
outcomes suggest that investors holding assets in South Asia should invest more in stocks than
in oil with a view to minimizing the portfolio risk without impacting the expected return.
The values of the hedge ratios, on the other hand, tend to be low for all the portfolios.
298 These results indicate that hedging is highly effective in the markets considered in our
research. For example, the estimated risk minimizing hedge ratio for our VAR(1)-GARCH
(1,1) model is 0.10 between oil and Sri Lankan equity markets. This finding reveals that
while holding a long position for $1 in the oil market, investors should short 10 cents of the
Sri Lankan stock index.
Following Ku et al. (2007), we also obtain the HE across the considered portfolios.
This can be determined by examining the realized hedging errors given as follows:
V ar unhedged V ar hedged
HE ¼ (7)
V ar unhedged

where Varunhedged indicates the variance of the returns on the portfolio of stocks and
Varhedged denotes the variance of returns of the oil-stock portfolios. A higher HE of a given
portfolio indicates the greater portfolio risk reduction which implies that the underlying
investment strategy is deemed as a better hedging strategy (Arouri et al., 2011). Table VII
displays the unhedged portfolio variance, hedged portfolio variance and HE ratios
computed using Equation (7). The findings suggest that hedging strategies comprising oil
and stock assets seem to reduce the portfolio risk considerably. We further document that
the reduction in variance due to the inclusion of oil in an optimal portfolio ranges from
29.16 percent for Sri Lankan equity market to 65.11 percent for Indian stock market.

5.4 Robustness checking

Up to now, all the data used in our empirical investigation are expressed in US dollars.
One could, however, expect that the volatility spillover from oil to the underlying equity
markets might be due to this dollar effect. We, therefore, repeat our analysis using the local

Portfolio oso
t bso
t

India/Oil 0.46 0.13

Pakistan/Oil 0.35 0.05
Table VI. Sri Lanka/Oil 0.36 0.10
Portfolio optimum Notes: This table shows the average optimal weights along with hedge ratios for an oil-stock market
weights and portfolio. The Brent crude oil index is used to present the oil asset, while MSCI indices are employed to
hedge ratios represent the major South Asian equity markets

India Pakistan Sri Lanka

Variance (unhedged) 2.95 2.65 2.47

Variance (hedged) 1.03 1.70 1.73
HE (%) 65.11 35.23 29.16
Notes: This table presents the hedging effectiveness across different oil-stock portfolios. Varunhedged
Table VII. indicates the variance of the returns on the portfolio of stocks and Varhedged denotes the variance of returns of
Hedging effectiveness the oil-stock portfolios. HE implies the hedging effectiveness
currency stock indices in order to assess the robustness of our earlier findings. These indices Relationship
comprise BSE-30 (Indian market), KSE-100 (Pakistan market) and CSE all share price index between oil
(ASPI) (Sri Lankan market) which have been widely used in existing literature. The sample and equity
period remains the same. It is also noteworthy that the stock markets, considered in this study,
have overlapping trading hours with the Brent oil market which could introduce possible markets
biases. Several researchers (Lin et al., 2014; Arouri et al., 2012) argue that using weekly data
instead of daily observations could avoid potential biases that may arise from considering 299
daily data (e.g. the bid-ask effect and non-synchronous trading days). Following these
previous studies, we replicate our analysis using Brent weekly prices. Besides, we also use the
Malaysian Tapis crude as a proxy for the South Asian oil market. Lu et al. (2014), for example,
mention that Tapis is often used as a benchmark for Asia-Pacific oil market.
Table VIII reports the findings which are obtained by using these new oil and stock price
series. Panel A contains the outcomes for Tapis crude, while Panel B shows the same for the
Brent crude. These results mostly conform to those reported in Tables III-V. The only major
exception we document is that we now find a bidirectional volatility linkage between Indian
equity and Brent weekly oil markets. Although we initially evidence that volatility runs only
from global oil to Indian equity market, this exception could be attributed to the fact that India
is currently the third largest consumer of crude oil and petroleum products after the USA and
China. This high consumption of petroleum products in this important economy might cause
the global oil market to move. Nonetheless, the corresponding coefficient is found to be weakly
significant ( p-value ¼ 0.09) and its magnitude is also extremely small which can be negligible
in research practice. To sum up, our overall findings are quite robust in that we document
nearly similar results irrespective of the types of data used in the analysis.

6. Conclusion
This is the initial study to examine the extent of volatility transmission, portfolio designs, and
HE in oil and equity markets in South Asia. In particular, we make an attempt to inspect the

Independent
variable BSE-30 Oil KSE-100 Oil CSE-ASPI Oil

Panel A: Tapis daily

rst1 0.0593 (0.00)*** −0.0063 (0.53) 0.0732 (0.00)*** 0.0016 (0.94) 0.2041 (0.00)*** 0.0140 (0.60)
rot1 −0.0470 (0.00)*** 0.1053 (0.00)*** 0.0114 (0.17) 0.0169 (0.03)** 0.0047 (0.47) −0.0352 (0.07)*
e2s;t1 0.3107 (0.00)*** 0.0166 (0.10) 0.3920 (0.00)*** 0.0095 (0.70) 0.4297 (0.00)*** 0.0074 (0.49)
e2o;t1 0.0315 (0.04)** 0.1823 (0.00)*** 0.0205 (0.02)** 0.1781 (0.00)*** 0.0611 (0.09)* 0.4334 (0.00)***
hst1 0.9410 (0.00)*** 0.0024 (0.36) 0.8981 (0.00)*** 0.0097 (0.45) 0.8888 (0.00)*** 0.0069 (0.12)
hot1 0.0177 (0.00)*** 0.9814 (0.00)*** 0.0068 (0.02)** 0.9827 (0.00)*** 0.1050 (0.00)*** 0.3633 (0.00)***

Panel B: Brent weekly

rst1 −0.0852 (0.03)** 0.0153 (0.48) 0.0692 (0.08)* 0.0622 (0.11) 0.2392 (0.00)*** 0.0783 (0.10)
rot1 −0.0089 (0.77) 0.2395 (0.00)*** 0.0388 (0.08)* 0.2317 (0.00)*** −0.0538 (0.06)* 0.2516 (0.00)***
e2s;t1 0.2472 (0.00)*** 0.0475 (0.20) 0.5413 (0.00)*** 0.0632 (0.27) 0.4568 (0.00)*** 0.0617 (0.29)
e2o;t1 0.1254 (0.00)*** 0.2519 (0.00)*** 0.0791 (0.02)** 0.2073 (0.00)*** 0.1088 (0.00)*** 0.1842 (0.00)***
hst1 0.9550 (0.00)*** 0.0008 (0.09)* 0.7065 (0.00)*** 0.0146 (0.55) 0.8726 (00)*** 0.0195 (0.15)
hot1 0.0769 (0.00)*** 0.9540 (0.00)*** 0.0915 (0.02)** 0.9728 (0.00)*** 0.0380 (0.03)** 0.9778 (0.00)***
Notes: The results of this table check the robustness of our initial findings. Panel A contains the results for the Tapis daily
crude oil prices and Panel B documents the same for the Brent weekly crude oil prices. r st1 refers to the return on stock
market at time t−1 and rot1 denotes the same for oil market. hot1 measures the conditional variance of the oil market at time
t−1 and hst1 indicates the conditional variance for equity market at time t−1. The squared error terms e2s;t1 and e2o;t1
measure the effects of unexpected news or shocks in stock and oil markets, respectively. The values in parentheses denote Table VIII.
the p-values. *,**,***Significant at 10, 5 and 1 percent levels, respectively Robustness checking
IJMF link between oil prices and stock market returns for India, Pakistan and Sri Lanka. In our
13,3 empirical investigation, we employ a bivariate VAR-GARCH methodology to investigate
whether the returns and volatility spill over from the oil market to different stock markets
under study. Our sample period ranges from January 1, 2000 to December 31, 2014.
The findings of our research suggest that there exists significant linkage between the first
and second order moments of the selected equity and global oil markets. Interestingly, all the
300 markets studied are the recipients of volatility from the oil market. This finding is not startling,
since the South Asian countries are major consumers of crude oil and petroleum-related
products. Firms trading in transport, agriculture and industrial sectors largely depend on crude
oil and thus oil price variations have significant impacts on the overall economy of this region.
As expected, we do not find any evidence of volatility transmission from the equity markets to
the global oil market. This is also an obvious case, since all these countries are oil importing,
not oil exporting. Using our results obtained from the VAR(1)-GARCH(1,1) model, we also
compute the optimal portfolio weights and hedge ratios. The results, in general, reveal that
including oil in the portfolio of stocks is likely to reduce the portfolio risk. The results further
show that while comparing the three major South Asian countries, hedging is more effective in
the Indian stock market. Consistent with the findings of earlier research, we also conclude that
oil should be considered as an integral part of a diversified portfolio of stocks in order to
improve the risk-adjusted performance of the resulting portfolio.
The outcomes of this paper are useful for understanding the possible interaction between
the South Asian economy and the global oil market. In addition, since volatility and shock
transmission among different markets has practical implications for investors and financial
market participants seeking to make optimal portfolio allocation decisions, the results of this
study will assist them to further their knowledge for taking proper investment decisions.
Besides, our investigation will also provide insights into means of building precise
asset-pricing models and predicting stock market trends.
Moreover, the findings of our empirical research could also help the regulators and
policymakers to develop effective and appropriate strategies to minimize the oil market
dependency. One possible policy could be the improvement of the strategic oil reserves system
of the countries under study to stable their oil price, as the oil reserve is essential for those
nations which are highly dependent on imported oil. Previous studies such as Wang and Zhang
(2014) and Zhang and Tu (2016) also argue that the oil reserve system reduces the impacts of oil
supply shocks by stabilizing prices and eliminating the risk of oil supply by changing the
oil inventory during turbulent periods. Additionally, Maghyereh and Awartani (2015) suggest
that oil-importing countries could benefit from building their strategic petroleum reserves and
thus protect their economies against the risk of disruptions in global oil supplies. Furthermore,
the industrial sectors in the selected South Asian countries could make use of other energies, for
example, biofuels and solar energy, in order to limit the effect of oil market uncertainty.
Such renewable and environmental friendly energies should be exploited so as to diversify the
energy structure and moderate the dependence on foreign oil (Wang and Zhang, 2014).

Note
1. The information is available at: www.bp.com

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Liu, M.-L., Ji, Q. and Fan, Y. (2013), “How does oil market uncertainty interact with other markets:
an empirical analysis of implied volatility index?”, Energy, Vol. 55, pp. 860-868. and equity
markets
Corresponding author
Anupam Dutta can be contacted at: adutta@uwasa.fi 303

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