Impact of Oil Shocks on Real Exchange Rates in Indian Context

Under the guidance of :

Professor Aswini Kumar Mishra

Prepared by:

Vatsal Nadkarni 2020B3AA0493G

Ashray Kashyap 2020B3A70494G

Saahir Vaidya 2020B3A71142G

Mohammed Aman 2020B3A70607G

Jibran 2020B3A70367G
ACKNOWLEDGEMENTS
We express our thankfulness to Dr. Aswini Kumar Mishra for his guidance on various topics throughout
this project. Also to Kamesh Anand sir for his helpful tips on various analyses we can do. Also to Shreyas
Athreya for his helpful tips regarding the project.
Table of contents
ACKNOWLEDGEMENTS 2

ABSTRACT 4

Highlights: 5

Keywords: 5

INTRODUCTION 6

METHODOLOGY 8

ADF Test 10

DF-GLS Test 11

KPSS(Kwiatkowski-Phillips-Schmidt-Shin): 12

EMPIRICAL APPROACH 14

CONCLUSION 28

REFERENCES 29
ABSTRACT
In this study, real exchange rates of India are examined in relation to the effects of oil shocks during
Covid-19 using Markov-switching models. Because an oil shock can impact a system, this is a crucial
subject to research.Trade terms of a nation, which may impact its competitiveness. After shocks to the oil
demand, we find considerable exchange rate appreciation expectations in economies that export oil. We
discover scant evidence that oil supply shocks have an impact on exchange rates. Oman and UAE are
considered to be oil exporting countries. This paper uses other unit test roots to test the
stationarity.Exchange rates in both oil exporting and importing nations are impacted by shocks to the
global economy's demand.Nevertheless, there is no discernible trend in the appreciation and depreciation
of actual exchange rates. The findings support the idea that regime flipping is responsible for the effects of
oil shocks on real exchange rates.
Highlights:
1. With an emphasis on understanding the amount and direction of the effect in both the
short- and long-term, the goal of this study is to analyse the effects of oil shocks on
exchange rates in India during the time of COVID-19 using econometric methodologies.
2. Usage of Econometric tools like Markov chain model, Markov Switching model,Rolling
regression, Linear regression, HAC Test and various unit root tests like
ADF,DF-GLS,KPSS to test stationarity.

Keywords:
Markov-Switching model, oil shocks, Real exchange rates, VAR, SVAR, Demand shocks, Supply
shocks, Linear regression, Rolling regression, HAC Test, Random walk, Non-Linear regression,
CPI, Regime switching, ACF, PACF, ADF, DF-GLS, KPSS, CUSUM.
INTRODUCTION

One of the main forces influencing the world economy is the price of oil, and variations in that price can
have a big impact on currency rates. The direction and size of the effect of the relationship between oil
prices and currency rates are influenced by a wide range of variables, making it complex and nuanced.

Due to India's extensive reliance on oil imports to cover its energy demands, oil price shocks can have a
substantial impact on the country's economy. India is susceptible to changes in the price of crude oil
because it imports more than 80% of what it needs.

Rising oil prices raise India's import bill, causing an increase in the current account deficit, inflationary
pressures, and a reduction in the value of the Indian rupee. Reduced consumption, slower economic
growth, and larger budget deficits are some of the implications that might spread across the economy.
India has previously seen a series of oil price shocks, most notably the 1970s oil crisis, which had a
significant impact on the Indian economy. In recent years, India has been able to mitigate the
consequences of oil price shocks by pursuing a range of measures, including deregulating petrol prices,
increasing domestic oil output, and boosting the use of renewable energy sources.

The Covid-19 pandemic has seriously disrupted the world economy, causing exchange rate swings in a
number of nations. Changes in oil prices have been noted as a significant cause of exchange rate swings.
For policymakers, it is crucial to comprehend how oil shocks affect exchange rates since doing so can give
them insights into what drives exchange rate movements and help them make better economic policy
choices.

The research studied the relationship between oil prices and exchange rates using a variety of econometric
methodologies, according to Basher et al. (2012). These studies demonstrate a Granger-caused
relationship between the real price of oil and the real effective rate of exchange for the US dollar, with real
oil prices serving as the explanatory variable. However, according to other analyses, there was a structural
split or regime transition in 2002, and there is little correlation between oil prices and exchange rates,
particularly among oil-importing nations.

In his 2009 paper, Kilian presents a unique method for simulating how oil shocks affect the actual
exchange rate for a sample of oil-exporting and -importing nations. To illustrate the impacts of shocks to
the supply of oil, demand unique to the oil market, and demand shocks affecting the entire economy, the
authors use a Markov-switching model with discrete regimes. This model allows for nonlinearity in the
consequences of oil shocks. Estimates are more feasible thanks to the Markov-switching model's benefit
of time-varying causation between regimes and its use of data on fluctuating regime-switching
probabilities. A Markov-switching approach offers a more nuanced understanding of the dynamic
relationship between oil prices and currency rates, particularly in light of structural changes over time.
Economic theory suggests that a number of variables, such as restricted access to basic production inputs,
income transfers and aggregate demand effects, the real balance effect, the role of monetary policy,
inflation effects, and sector adjustment effects, could result in a negative correlation between oil prices and
economic activity. Empirical research have shown that oil price shocks have considerable effects on the
economy, with the detrimental consequences of oil price spikes being bigger than the advantageous
benefits of oil price reductions (Ghosh, 2011)
LITERATURE REVIEW

1. Basher et al., 2015.The impact of oil price shocks on exchange rates: A Markov switching
approach.
Studying the effect of oil prices and oil price shocks on exchange rates is crucial since it might impair a nation's
ability to compete. The majority of the literature estimates this impact using linear models, however a recent work
suggests using Markov-switching models to account for potential non-linearities. In order to provide a more
thorough understanding of how the oil market influences actual exchange rates, the article additionally adds
variables to account for shocks in oil supply and demand.
The analysis's conclusions point to the fact that using Markov-switching models with two regimes helps to confirm
the underlying non-linearities between real exchange rates and oil shocks for both oil exporting and importing
economies. Further proof that the estimated Markov-switching models accurately distinguished between the two
regimes comes from the regime classification measure. The Markov-switching model, as opposed to the linear
regression model, finds considerable appreciation pressures in oil exporting nations after oil demand shocks, making
the impact of oil shocks on exchange rates more important when employing the former.

2. Kilian, L., 2009. Not all oil price shocks are alike: disentangling demand and supply shocks in the
crude oil market.
The study "Not All Oil Price Shocks Are alike: Disentangling Supply and Demand Shocks in the Crude
Oil Market" looks at how different types of oil price shocks impact the economy. The authors argue that
demand and supply shocks must be differentiated from one another in order to comprehend the
macroeconomic impacts of oil price shocks.
The authors discover that supply-driven oil price shocks have a negative impact on the economy whereas
demand-driven oil price shocks have a favourable impact using a structural vector autoregression (SVAR)
model. In particular, they discover that supply-driven oil price shocks are connected to a decline in
economic activity while demand-driven shocks are connected to an increase.
Because they emphasise the necessity of taking the nature of oil price shocks into consideration when
forming policy responses, the authors contend that their findings have significant policy implications.
They contend that measures taken to lessen oil price volatility, such as boosting energy efficiency and
investing in alternative energy sources, might lessen the damaging effects on the economy of
supply-driven oil price shocks.

3. Amano, R., van Norden, S., 1998b. Exchange rates and oil prices. Rev. Int. Econ. 6, 683–694.
In the literature, there has been ongoing discussion about the connection between oil prices and exchange
rates. By demonstrating a strong correlation between the real domestic price of oil and the real effective
exchange rates for Germany, Japan, and the United States, this study adds to the conversation. Given the
significance of this subject, the authors contend that more investigation is required to build on their
findings.

4. Hamilton, J.D., 2003. What is an oil shock? J. Econ. 113, 363–398

In this study, the relationship between oil prices and GDP growth is investigated, with a focus on whether
or not the relationship is nonlinear and whether a nonlinear model is valid. The study concludes that a
nonlinear model, which accounts for the ambiguity around functional form, is a more accurate predictor
of GDP growth. According to the paper, endogenous factors that historically influenced variations in oil
prices were filtered out, which led in part to the nonlinear model's effectiveness.
The study indicates that it may not be appropriate to utilise oil prices as an exogenous instrument or
disturbance, and it advises using exogenous oil supply shock dummy variables or current and lag Qt
values in its instead.

5. The Macroeconomic Effects of Oil Price Shocks: Empirical Evidence for India Surender Kumar
TERI University, New Delhi, India
The relationship between oil prices and macroeconomic factors in the Indian economy between 1975 Q1
and 2004 Q3 is examined using Vector Auto-Regression (VAR) models. The scaled oil pricing model
surpasses other models in terms of statistical performance, according to the study, which examines the
effect of oil prices on the growth of industrial production using various specifications.
According to the study, there is evidence of a Granger causal relationship between macroeconomic
activity and oil prices, which suggests that oil price shocks can have a considerable influence on the
Indian economy.

6. Oil price fluctuations and U.S. dollar exchange rates Radhamés A. Lizardo a,1 , André V.
Mollick
The US dollar's value has been falling versus other significant currencies since 2001. This study explores
how changes in oil prices impact the value of the US dollar while accounting for variations in money
supply and output. With the exception of Norway, the majority of countries have a high correlation
between oil prices, the money supply, and output. The authors contend, in line with a prior study, that
changes in US dollar exchange rates can be predicted by changes in oil prices. According to the study, as
the real price of oil rises, the US dollar's value declines significantly in comparison to net oil exporters
like Canada, Mexico, and Russia, while it tends to appreciate against the currencies of oil importers like
Japan.

7. Oil Shocks in a Global Perspective: Are they Really that Bad? Tobias N. Rasmussen and Agustín
Roitman
Based on the experience of economic downturns in the 1970s and research on the effects of increasing oil
prices on the US economy, it is generally thought that oil shocks hurt countries that import oil. To fill a
gap in the literature on how oil prices affect developing economies, this study provides a worldwide
perspective on the macroeconomic consequences of oil prices. According to the study, oil prices are
unexpectedly closely linked to prosperous economic times worldwide, with the United States standing out
as being adversely impacted by rising oil prices. Although there is proof that there are adverse effects on
output, especially for OECD economies, the magnitude has typically been modest.

8. Engel, C., 1994. Can the Markov switching model forecast exchange rates? J. Int. Econ. 36,
151–165
The results of this study indicate that the Markov switching model fails to forecast exchange rates with
sufficient accuracy. The projections produced by this model typically do not have mean squared errors
that are lower than those of a random walk or the forward exchange rate. Weak evidence supports the
hypothesis that the segmented trends model outperforms its competitors at predicting the direction of
change in exchange rates, though. It's interesting to note that the Markov model performs better than
generalised random walk forecasts within the sample, but not outside the sample. The zero-drift random
walk has shown good performance in prior forecasting competitions, but models including an
error-correction term seem to perform better at longer horizons. Given that it can reliably detect runs in
either direction, the Markov model may perform better when there are significant swings in the exchange
rate.

9. Dumas, B., 1992. Dynamic equilibrium and the real exchange rate in a spatially separated
world. Rev. Financ. Stud. 5, 153–180.
According to the literature, when quantity adjustment is slow, departures from the Law of One Price
display an AR (1) process rather than a martingale process and stay within two boundary values.
Furthermore, when the deviation is at zero and when it is at its maximum value at the boundaries, the
conditional volatility of the deviation is greatest and zero, respectively. Additionally, the AR (1) process
exhibits heteroskedasticity and nonlinearity. The physical imbalance is caused by a centrifugal or
divergent process inside the cone, where it spends a lot of time close to the edges and is very persistent.
The risk premium is equal to the forward premium times the derivative of the real exchange rate with
regard to capital imbalance, and the model is able to rationalise the direction of deviations from
uncovered interest rate parity.

10. The empirical relationship between energy futures prices and exchange rates Perry Sadorsky
The major conclusions of the study show that a trade-weighted index of exchange rates and futures prices
for crude oil, heating oil and unleaded petrol are co-integrated. This suggests that there is Granger
causation and a long-run equilibrium relationship between some of these variables. For initial differences
resulting from co-integration, modelling must be done using a VECM rather than a VAR. Exchange rate
changes occur before changes in the price of heating oil futures both in the long- and short-terms, and
they also occur before changes in the price of crude oil futures in the short-term. According to the
research, in the long-run equilibrium, a 1% increase in exchange rates lowers the price of crude oil futures
by 0.373%.

11. The role of oil price shocks on exchange rates for the selected Asian countries: Asymmetric
evidence from nonlinear ARDL and generalized IRFs approaches
The analysis of the relationship between oil price shocks and real exchange rates in a few Asian
economies, taking into account the significance of oil price asymmetry, is the primary contribution of the
research. The nonlinear autoregressive distributed lag (NARDL) and generalised impulse response
functions (GIRFs) are the two methods the authors employ. The NARDL technique demonstrates that,
both in the short and long runs, oil prices have an asymmetric impact on the currencies of a few Asian
economies, including Bangladesh, China, India, Korea, the Philippines, and Thailand. The GIRFs
approach further demonstrates that the currencies of the chosen Asian countries are more sensitive to
positive oil price shocks than to negative ones.

12. Clarida, R.H., Gali, J., 1994. Sources of real exchange rate fluctuations: how important are
nominal shocks?
The relative significance of various forms of shocks in explaining changes in the real exchange rate is
examined in the work by Clarida and Gali. While prior research has concentrated on the role of real
shocks in causing real exchange rate movements, the authors contend that nominal shocks, such as
adjustments to monetary policy or changes in inflation expectations, may also be significant. The authors
discover that nominal shocks, especially in the short term, account for a sizable share of real exchange
rate changes using a structural vector autoregression (VAR) model.

13. Cashin, P., Cespedes, L.F., Sahay, R., 2004. Commodity currencies and the real exchange rate.
The relationship between commodity prices and the actual exchange rate of nations that export
commodities is examined in the study by Cashin, Cespedes, and Sahay. The authors contend that because
nations that export commodities may see changes in their terms of trade and income levels, fluctuations in
commodity prices can have a considerable impact on the actual exchange rate.
The authors show convincing evidence of a favourable association between commodity prices and the real
exchange rate of commodity-exporting countries using a panel dataset of 63 countries for the years
1960–2001.
As they highlight the potential risks and opportunities related to commodity price fluctuations, the authors
contend that their findings have significant policy implications.

14. Cashin, P., Mohaddes, K., Raissi, M., Raissi, M., 2014. The differential effects of oil demand and
supply shocks on the global economy.
The world economy is examined in the article by Cashin, Mohaddes, Raissi, and Raissi for how oil
demand and supply shocks differ. While earlier studies concentrated on the effects of oil supply shocks,
the authors contend that shifts in oil demand can also have significant macroeconomic repercussions.
The authors discover that both oil supply and demand shocks have large effects on the global economy,
but the consequences vary among regions and nations when using a global vector autoregression (GVAR)
model. They specifically discover that oil supply shocks have a greater impact on oil-exporting countries
than oil demand shocks do on oil-importing ones.
The authors contend that their findings have significant policy ramifications because they show how
crucial it is for decision-makers to take into account the varied consequences of supply and demand
shocks to the oil market when developing policy.

15. Kilian, L., Park, C., 2007. The impact of oil price shocks on the U.S. stock market.
The effect of oil price shocks on the US stock market is examined in the paper by Kilian and Park.
According to the authors, changes in investor mood and repercussions on the real economy allow oil price
shocks to significantly affect the economy.
The authors discover that oil price shocks have a considerable negative influence on the US stock market
using a structural vector autoregression (SVAR) model, with the impact being greater for oil supply
shocks than oil demand shocks. Additionally, they discover that oil-intensive industries like
manufacturing and transportation have a stronger impact.
The authors suggest that their findings have important implications for policymakers and investors, as
they highlight the need to consider the impact of oil price shocks in their decision-making processes.

16. Bénassy-Quéré, A., Mignon, V., Penot, A., 2007. China and the relationship between the oil price
and the dollar. Energy Policy 35, 5795–5805
The study looks at the correlation between the real price of dollar and the real price of oil from 1974 to
2004. According to the data, there is a direct causal relationship between a rise in oil prices of 10% and a
long-term dollar appreciation of 4.3%.

According to the analysis, there is proof of a long-term relationship between the two series in real terms,
and the dollar is causally linked to oil. The dollar real effective exchange rate is only slowly moving
towards the long-term target, according to the calculation of a VECM. However, the empirical findings
are unable to account for the evolutions seen between 2002 and 2004, when oil prices increased while the
value of the dollar declined.

17. Kilian, L., 2009. Not all oil price shocks are alike: disentangling demand and supply shocks in the
crude oil market.
The study "Not all oil price shocks are alike: disentangling demand and supply shocks in the crude oil
market" examines how various forms of oil price shocks affect the economy. In order to understand the
macroeconomic effects of oil price shocks, the authors contend that demand and supply shocks must be
distinguished from one another.
The authors discover that supply-driven oil price shocks have a negative impact on the economy whereas
demand-driven oil price shocks have a favourable impact using a structural vector autoregression (SVAR)
model. Because they emphasise the necessity of taking the nature of oil price shocks into consideration
when forming policy responses, the authors contend that their findings have significant policy
implications. They contend that measures taken to lessen oil price volatility, such as boosting energy
efficiency and investing in alternative energy sources, might lessen the damaging effects on the economy
of supply-driven oil price shocks.

18. Charnavoki, V., Dolado, J.J., 2014. The effects of global shocks on small commodity- exporting
economies: lessons from Canada. Am. Econ. J.:Macroecon. 6, 207–237
For a much smaller economy, this study examines the three types of oil price shocks (Kilian, 2009).
Because Canada is a significant exporter of basic commodities as well, the choice of economy is
important to us. The same might be said for India's agrarian economy, which exports a number of
common goods to other countries. This study also covers a number of predictions resulting from oil price
shocks, including the Dutch Disease impact, spending effect, commodity currency effect, spending effect,
and external balance effect. By including the appropriate variables in our model, we will attempt to
account for both the first and the last effects in our study. The cause of shock is crucial to understanding
the Dutch Disease effect, as this paper mentions.

19. Pass-through Effects of Oil Prices on LATAM Emerging Stocks before and during COVID-19: An
Evidence from a Wavelet -VAR Analysis, Gaytan, Rafuddin, et al. (2023)
This study used a VAR model to analyse how fluctuations in oil prices affected the stock markets of
LATAM (Latin American nations). The study's findings suggest that temporal frequency should be used to
determine how oil prices are passed down to stock market profits. Investors may feel more confident in
reducing risk in their portfolios as a result of this. The COVID pandemic, a recent significant shock to all
economies around the world, is also a focus of this paper's attention.
 20. Jain, Anshul; Ghosh, Sajal (2013). Dynamics of global oil prices, exchange rate and precious
metal prices in India. Resources Policy, 38(1), 88–93.
The linkages between these three variables and their effects on the Indian economy are examined by Jain
and Ghosh (2013). Granger causality tests are used to determine the cause of changes in oil, gold, and
currency rates as well as the amount of lag utilizing auto regressive distributed lag models.

The Indian economy is shown to be significantly impacted by oil prices, with higher oil prices resulting in
higher inflation and slower economic growth. The Indian economy is significantly impacted by exchange
rates as well, with greater exchange rate volatility resulting in less commerce. Finally, they discover that
there is little correlation between precious metals prices and the Indian economy and that there is little
effect on inflation or economic growth.

21. Examining crude oil price – Exchange rate nexus for India during the period of extreme oil price
volatility ,Sajal Ghosh, 2011, Management Development Institute (MDI), Gurgaon, India
The study uses daily data from July 2, 2007, to November 28, 2008, to examine the relationship between
crude oil prices and exchange rates in India. The effect of oil price shocks on the nominal exchange rate is
examined by the authors using the Generalised Autoregressive Conditional Heteroskedasticity (GARCH)
and Exponential GARCH (EGARCH) models. The study's conclusions show that a rise in oil prices
causes the value of the Indian rupee to decline relative to the US dollar.

22. Analysis of The Oil, Price and Currency factor of Economic Growth in Azerbaijan, Humbatova et
al., 2019, Azerbaijan State University of Economics (UNEC)
This paper uses macroeconomic variables such as GDP, CPI, GNI and establishes them as main factors
towards oil production. This study has been done with respect to the Azerbaijan economy. From this point
of view, Azerbaijan exports to the world market a hydrocarbon (oil and oil products), its richest natural
resource. Naturally, its economy depends on market positions, market supply and world market prices for
these products.

23. Oil Price Shocks to Foreign Assets and Liabilities in Saudi Arabia under egged Exchange Rate,
Samargandi, Sohag (2022)
This research helps us comprehend the effects of oil price shocks on a pegged exchange rate economy like
Saudi Arabia even if India does not have a fixed exchange rate. The TVP-VAR data show that the Saudi
economy experienced negative net foreign assets during the COVID-19 pandemic, mostly due to a
substantial plague of rising global oil prices. The pegged currency rate made it possible to adopt
straightforward macroeconomic policies and lower transaction costs. The requirement for building up
significant quantities of foreign reserves was the only drawback.

24. The Impact of Oil Price and Oil Volatility Index (OVX) on the Exchange Rate in Sub-Saharan
Africa: Evidence from Oil Importing/Exporting Countries, Korley, Giouvris (2022)
Oil prices and the OVX (Oil Volatility Index) are key predictors of economic activity, according to theory.
This study investigates the hypothesis that a rising (falling) OVX leads to a depreciating (appreciating)
local currency. They have implemented a control for the COVID-19 epidemic and the 2008 financial
crisis. This study discovered that, for all nations, the exchange rate responds to changes in the price of oil
and the OVX mostly at lower quantiles (bearish markets), demonstrating the sensitivity of investors. Oil
price uncertainty was measured using OVX, which can also be employed in our model.

METHODOLOGY

The model uses data from the World Bank, and calculations and estimations of models were done using R
code. Various variables were estimated using this data (such as real exchange rate, real oil prices etc.) The
data used corresponds mainly with reference to the oil-consuming country of India with focus also on two
oil-producing countries, Oman and UAE. The data was collected for the period 2010-2021, and checks the
oil shocks during COVID-19.

The frequency of the data was monthly, and the various variables that were explicitly collected from the
World bank were CPI, Exchange rates and Oil prices.

The paper by Basher et al. uses the following matrix regression model for various approximations:

A0yt = A(L)yt−1+ εt
yt = A0-1A(L)yt−1+A0-1 εt
et = A0-1 εt
et is the matrix for errors in VAR.

This is an autoregression model of the Lth order and the variable A0 is the shock matrix. yt is the matrix
which contains (1) global-oil-production, (2) global economic activity measure and (3) the real oil-price
in USD. This paper also uses a similar model with the same shock matrices.

The Markov switching approach used in the paper by Basher et. al (2016) was used to model the oil-price
shocks in India. For the exchange rate of the Indian rupee the following linear regression equation was
used:

Δfxt = β0 + β1εst + β2εdt + β3εpt + β4Δfxt−1 + ut

εst → Oil supply shock for the period t

εdt → Total demand shock for the period t
εpt → Oil demand shock for the period t
Δfxt → Change in exchange rate for the period t

Δfxt = β0,st + β1,stεst + β2,stεdt + β3,stεpt + β4,stΔfxt−1 + ut

MSM takes into consideration the likelihood that state (st) dependence may affect how oil shocks affect
exchange rates. The state at time period t, and not any other state, determines the likelihood of a transition
from state l at time period t to state m at time period t + 1 (Basher, 2016). The assumption is that the
process that generates stochastic regime follows an ergodic, homogeneous, first-order Markov chain with
a finite number of regimes (M) and constant transition probabilities.

plm = Pr(st+1 = mst+1 = l), plm >= 0, Summ,M(Plm) = 1

The models assume normal distribution and student-t distribution about the error term.

Here we assume that the shocks are all predetermined. Also, the lags for the shock explanatory variables
are not included in the equation since Markets for currency rates are quite effective and they absorb the
new changes quickly. One dependent variable lag is included as it provides better fit according to
Kilian(2009).

This paper assumes a similar model, but with focus on the research gaps that were mentioned before. It
looks at India specifically, which is an oil importing country, the shocks are most recent which is due to
low demand shock(caused by low frequency of driving due to lockdowns) to the oil industry during
COVID-19.

The consequences of the three oil shocks are studied, and the nonlinearity we take into account in the
factors impacting the exchange rate is considered in the form of several regimes, where the parameters are
constant for a regime and varied between regimes. The Markov model truly does a great job of handling
this. The structural split in oil prices is shown by the regime transitions. Instead of linear models with
constant parameters and no regime of structural nature shows changes, the Markov Switching technique
enables time varying causation across regimes (Basher, 2016).

Instead of having to estimate a linear model for each regime entirely separately, the Markov-switching
model offers the advantage of leveraging information about the changing probability of switching to a
particular regime throughout the estimation process. Estimation with linear models is typically not
feasible when a sample has many breaks because the subsamples are too small. In other words, with a
Markov regime technique, more data are employed for estimation.

To assess the precision of the Markov switching models, Ang and Bekaert (2002) developed the regime
classification measure (RCM). The formula used to calculate this statistic is as follows:
RCM(S) = 100 * S / (T * ∏(p~j, t=1 to T) Sj,t)
where:
● RCM(S) is the Relative Change Measure
● S is the initial value of the asset
● T is the total number of time periods in the series
● ∏ represents the product operator
● p~j,t is the value of the asset at time t in the jth period (where j=1 to p)
 ● Sj,t is the value of the asset at time t in the jth period
The RCM measures the relative change in the product of the asset's value over time, taking into account
the values of the asset in each time period and the number of periods in the series. It is calculated by
dividing the initial value of the asset by the product of the values of the asset in each time period raised to
the power of 1/T (where T is the total number of time periods). The resulting value is expressed as a
percentage, multiplied by 100 in the equation above. The RCM can be used to compare the performance
of different assets or to track the performance of a single asset over time.

To check whether a time series dataset has a unit root or not, statistical procedures known as unit root tests
are done. Non-stationary time series data have a unit root, which suggests that the data has a trend and
that its statistical features change over time.

To determine if a time series is stationary or not, a unit root test can be done. The mean and variance of
stationary data remain constant across time, among other statistical features. On the other hand,
non-stationary data have statistical characteristics that change over time and could show trends, cycles, or
seasonality.

DF-GLS Test

The DF-GLS test is a modified version of the Dickey-Fuller test for unit root testing, which takes into
account the possibility of autocorrelation and heteroskedasticity in the time series data. The test is
performed by regressing the first-differenced dependent variable (y) on its own lagged values, and a
constant term, as follows:

Δy(t) = γy(t-1) + β0 + ε(t)

where:
➔ Δy(t) is the first-differenced value of the dependent variable at time t
➔ y(t-1) is the lagged value of the dependent variable at time t-1
➔ β0 is a constant term
➔ γ is the coefficient on the lagged dependent variable
➔ ε(t) is the error term at time t

The DF-GLS test involves estimating the γ coefficient using a Generalized Least Squares (GLS) approach,
which takes into account the possibility of autocorrelation and heteroskedasticity in the error term. The
GLS estimator is given by:
γ(GLS) = [(1-α)Σu(t-1)u(t)] / [(Σu(t-1)^2)^0.5(Σu(t)^2)^0.5]
where:
➔ u(t) is the residual from the first-differenced regression above
 ➔ α is a coefficient that depends on the number of lagged values included in the regression, the
sample size, and the assumed autocorrelation structure of the errors. This coefficient is typically
estimated using Monte Carlo simulation methods.
The test statistic for the DF-GLS test is then calculated as:
DF-GLS = - (T-1)^(1/2) γ(GLS)
where T is the sample size.

The critical values for the test statistic can be obtained from tables or software, and depend on the
significance level and the number of lagged values included in the regression.
If the calculated test statistic is less than the critical value, then the null hypothesis of a unit root (i.e.,
non-stationarity) in the time series data can be rejected, indicating that the data is stationary. If the
calculated test statistic is greater than the critical value, then the null hypothesis cannot be rejected,
indicating that the data is non-stationary.

In summary, the DF-GLS test is a statistical method used to test for the presence of a unit root in time
series data, taking into account the possibility of autocorrelation and heteroskedasticity in the errors. The
test involves regressing the first-differenced dependent variable on lagged values and a constant term,
estimating the γ coefficient using a GLS approach, and calculating a test statistic to determine whether the
data is stationary or non-stationary.

KPSS(Kwiatkowski-Phillips-Schmidt-Shin):

The KPSS test is another statistical method used to test for stationarity in time series data. Unlike the
DF-GLS test, which tests for the presence of a unit root (i.e., non-stationarity), the KPSS test tests for the
presence of a trend in the data.

The test is performed by regressing the dependent variable (y) on a constant term and a linear trend, as
follows:

y(t) = β0 + β1t + ε(t)

where:

● y(t) is the value of the dependent variable at time t

● β0 and β1 are the intercept and slope coefficients, respectively
● t is a time trend variable
● ε(t) is the error term at time t

The KPSS test statistic is then calculated as the sum of squared residuals from this regression, normalized
by the sample size and variance of the error term:
KPSS = T-2 Σ(ε(t)2) / σ2

where:

● T is the sample size

● ε(t) is the error term at time t
● σ^2 is the estimated variance of the error term

The critical values for the test statistic can be obtained from tables or software, and depend on the
significance level and the null hypothesis being tested (i.e., whether the data is stationary or
non-stationary).

If the calculated test statistic is greater than the critical value, then the null hypothesis of stationarity can
be rejected, indicating that the data is non-stationary with a trend. If the calculated test statistic is less than
the critical value, then the null hypothesis cannot be rejected, indicating that the data is stationary.

In summary, the KPSS test is a statistical method used to test for stationarity in time series data,
specifically testing for the presence of a trend in the data. The test involves regressing the dependent
variable on a constant term and a linear trend, calculating a test statistic based on the sum of squared
residuals, and comparing the calculated test statistic to critical values to determine whether the data is
stationary or non-stationary with a trend.
EMPIRICAL APPLICATION

Data from 2010/1/1 to 2022/1/1 is used for calculating the effect of oil price shocks on the exchange rates
in the COVID regime. There are 2 exporters of oil - Dubai,Oman and the importer is India.
The data is used along with the consumer price index of the respective countries to remove the effects of
inflation for the period and then adjusted with the trading weighted exchange rate for India with a base at
2010 (set to 100) due to oil trading. We took fixed exchange rate countries as a control for our experiment
to check if regimes still exist here. Some variations will still exist in the real exchange rates of these
countries because they are inflation adjusted.

The Markov-switching model captures these possible aspects of the process that results in the adjustment
of the exchange rate to oil shocks, which may be nonlinear or asymmetric. When it appears that
exogenous events are primarily responsible for the adjustment, the Markov-switching approach has been
shown to be helpful. Our sample period includes COVID-19 as a shock to the oil prices due to the low
demand for oil due to lockdowns in a lot of regions.

We used Kilian's (2009) modelling approach without considering how it might affect the oil market or
macroeconomic factors.

The real foreign exchange rate of India was tested for stationarity using DF-GLS, ADF and KPSS test
demonstrate that it is stationary

The relationship between changes in the oil market and macroeconomic events. In other words, the
Markov regime's generation process is exogenous. In the past, there have been positive and negative
values in the relationship between oil prices and exchange rates.

The SVAR model was used to determine the shocks of oil prices on oil demand , supply and aggregate
demand with the assumption that there is no possibility of fixing these effects.

In time series analysis, the relationship between two variables—typically a dependent variable and one or
more independent variables—over a rolling or moving time window is determined using rolling
regression. Another name for it is regression with a sliding or moving window.

In a rolling regression, the coefficients and intercept of the regression are estimated at each point in time
using a fixed-size window of observations. The window advances by one observation as fresh
observations become available, and the regression parameters are re-estimated using the current window
of data.
This method enables the monitoring of prospective relationship modifications as well as the evaluation of
the relationship between the variables throughout time. It enables for the detection of changes in the
relationship as new data is introduced, which is especially helpful when the relationship between the
variables is not stationary over time.

Fig 3.1: Rolling of regression of oil shocks

Rolling regression is used to determine the relation between the oil shock parameters and the first
difference of the real exchange rate of India - US whose OLS - based CUSUM test whose high p value
proved that the slope coefficients are stable but recursive CUSUM test showed a low p value. A similar
analysis was done using trade weighted exchange rate which showed a p-value of > 0.9 aside from
oil-price shock.

The Markov switching model is responsible for separating the data into 2 regimes to observe the effects of
COVID-19 pandemic on the oil prices. The effects of this shock being exogenous and asymmetric with
the previous regime are captured by the model. Due to the presence of an exogenous event we can assume
that the effects - the shocks of oil price and oil demand and oil supply are independent of each other. The
market is assumed to adjust rapidly to oil price shocks therefore no lags are used for the oil demand,
shock and price.
 The Markov model indicates that Oman and India show a change in the 2nd regime - after the oil shock
but the United Arab Emirates does not show the same.

Fig 3.2: Residuals of oil shocks

The impacts of oil shocks on real exchange rates are estimated through a succession of linear regression
models, each of which is assessed.

Regression analysis is performed on the country's real exchange rate (FX_COUNTRY_NAME) monthly
return using oil shocks and a one-period lag.

The results that follow can be seen as baseline findings showing the connection between real exchange
rates and oil shocks in the absence of any switching effects.

Table 1: Statistics of oil-shocks

n mean sd median trimmed mad min max range skew kurtosis se

SupplyShock 119 0 0.62 0.00 -0.02 0.65 -1.30 1.75 3.00 0.31 -0.07 0.06

DemandShock 119 0 0.62 0.01 0.02 0.63 -2.01 1.27 3.29 -0.35 0.10 0.06
OilPriceShock 119 0 0.62 0.02 0.04 0.60 -2.47 4.14 -0.84 -0.84 1.84 0.06

Real returns (per month) were calculated for each country using the formula rt = 100 ln(PT_country /
PT1_coutnry); here PT is considered as real exchange rate. Rate over time t. Table displays summary data
on the shocks and real exchange rate returns. Each of the three shock variables has a mean value of zero
(to 3 decimal places), and each shock has a standard deviation that is very near to 1. Similar variability
(difference between the max value and least value) can be seen in each shock.Returns from average
exchange rates are negligible in comparison to their respective standard mistakes.

Table 2: Unit Root tests on oil shocks and real exchange rates
df-gls(c) df-gls(t) kpss(mu) kpss(tau)
supply -2.5765 -2.9988 0.0633 0.0519
demand -2.4618 -3.1192 0.0405 0.0355
oil -1.5053 -2.1535 0.0475 0.0478
oman -0.1402 -2.4578 0.7319 0.0736
dubai -0.5572 -1.7556 0.5437 0.2396
india -1.5436 -2.9372 0.0293 0.029

DFGLS test for India shows that it is insignificant, stationary with constant and trend at 5% significance
level in DF-GLS Test. KPSS is stationary output

The DF-GLS test for Dubai is insignificant so stationary . KPSS(mu) is significant at 5% . KPSS (tau) is
significant at even 1% so non-stationary

The DF-GLS test for Oman is insignificant so stationary . KPSS( mu) is significant at 5% is non stationary

DF-GLS demand is insignificant so stationary . KPSS is also insignificant so stationary

DF-GLS oil is stationary constant and trend KPSS is stationary for constant and trend.

The above table gives the result of the unit root test on the monthly exchange rates and data of oil shocks
Supply stands for a shock to the world's oil supply, Demand for a shock to the world's economic activity,
and Oil for a shock to the world's oil prices.
 Fig 3.3 Nominal & Real exchange rate of Indian rupee with US dollar

The above figure shows the variation of nominal and real exchange rates of India in the time duration
2010 to 2021.
 Fig 3.4 Empirical fluctuation process - OLS base Cumulative sum

A statistical method for spotting changes in the mean value of a time series is the OLS-based cumulative
sum (CUSUM) test. Since it is a sequential test, it can be used with data that is gradually made available.

The Ordinary Least Squares (OLS)-based CUSUM test is based on OLS regression, a method for
estimating the parameters of a linear regression model. A cumulative sum of the OLS regression residuals
is computed and shown against time in this test. The cumulative total will diverge from its predicted
value, signaling a change point in the time series, if the mean value of the time series changes.

There are two primary steps to the test. The first step is to estimate the linear regression model's
parameters using OLS. The cumulative sum of the residuals is computed and plotted against time in the
second step. As soon as the cumulative sum surpasses a specific threshold, a change point is recognised.
 Fig 3.5 Fit and residuals of difference in production of oil

To determine if a moving average (MA) process is present in a time series, you would typically examine
the autocorrelation function (ACF) plot. A significant correlation at the first lag (lag 1) with subsequent
lags decaying to zero or near-zero would suggest the presence of an MA process. The partial
autocorrelation function (PACF) plot can also be examined to help distinguish between AR and MA
processes. Change in production of oil; the ACF and PACF residuals show that the lags are white noise to
each other. Thus, the autocorrelations are white noise and not associated with each other in their lags.
 Fig 3.6 Real Oil prices over time

The above figure shows the variation in real oil prices. There is a sudden drop in real price in the year
2014, which was caused due to increased expectations.
 Fig 3.7: Difference in real oil price which represents the Indian Basket composition of Oman & Dubai
sour and sweet grade.

We can see that DemandShock and SupplyShock are positively correlated, so an increase in supply is
leading to a decrease in oil prices.
 Fig 3.8 Recursive cumulative sum test result

As each new data point becomes available, the recursive CUSUM test calculates the cumulative total of
the deviations from the mean. Then, a threshold value is used to gauge whether a change in the mean has
happened by comparing this cumulative total to it.
From the 2 CUSUM tests above we can deduce that there is instability of oil shock effects on real foreign
exchange of India because of high p-values in the linear model. Hence we should shift to a Markov
Switching model to better capture the non linear relationship.
 Table 3: Impact of oil shocks on real exchange rates - linear model

intercept supply demand oil delta(fx,-1) R squared

Oman 9.92E-02 -5.36E-03 -8.15E-05 4.04E-02 1.88E-01 0.04336
0.00857 0.92506 0.99888 0.48392 0.05403
Dubai 0.084558 0.031544 0.005755 0.32562 0.038315 0.09509
0.16996 0.75113 0.95308 0.00132 0.68143
India 0.03382 -0.04316 0.08148 -0.09215 0.09333 0.01182
0.83 0.865 0.747 0.717 0.319

The R square values for these regressions are very low. There is low to medium degree of continuance in
the real exchange rates due to the one period lag of exchange rate for each country. This appears to be
consistent with the findings in Atems et al(2015), and Sadorsky et al (2016). The low significance of the
coefficients implies that there is a non-linear relationship between these variables.

Table 4: Impact of oil shocks on real exchange rates - markov switching model

State Intercept Supply Demand Oil delta(FX,-1) Sigma LL

Oman S1 0.77780304 -0.83783595 0.104447438 0.1480971 -0.007046545 0.1543622 -38.98243
t-stat 8.85218648 -4.09381938 0.528133178 1.2356605 -0.072576058 4.577987
S2 0.06042767 -0.02755375 -0.008037363 0.0491095 0.084771653 0.3537751
t-stat 1.66935914 -0.5107384 -0.145783028 0.8920128 0.745568433 14.5263894
Dubai S1 -0.6251959 0.01974931 -0.53446241 0.820014 1.30361355 1.128051 -42.07357
t-stat -1.5605758 0.03509398 -1.01753075 2.68116833 1.24544024 6.0046394
S2 0.1702138 -0.03784811 -0.01051843 -0.03070022 0.01394478 0.1846982
t-stat 8.0101887 -1.11626591 -0.32078601 -0.75022175 0.47275547 9.3676576
India S1 0.93175189 1.8298856 -0.32706885 -3.9458951 -0.0009483586 1.818386 -218.62806
t-stat 1.82516517 2.0703975 -0.63950526 -3.4968057 -0.0052579742 6.15558
S2 -0.0104665 -0.181781 0.09925697 0.2257749 0.1458306069 1.442565
t-stat -0.06991763 -0.7814806 0.38864469 0.9593476 1.378739855 13.783133

Sigma in Table 4 is standard deviation of the regimes, namely S1 and S2. Supply shocks have a negative
effect on Oman's currency and coefficient is statistically significant, in the S1 regime. The same however
is not significant in the S2 regime. For Dubai, the oil price shocks are significant in the S1 regime and
have a positive effect on its currency (exporting country). For India, there is a significant appreciative
effect due to Supply shocks and a significant depreciative regime due to Oil price shocks in the S1 regime.
The autocorrelation function and partial autocorrelation function of the residuals can help to check for lag
in autocorrelation in the data. The time series is non random because a lot of autocorrelations are
significant non-zero(below the dotted line). High degree of correlation at lag 2 of the PACF plot. The
PACF plot tails off after lag 2 so it could be modeled as an MA(4) process.

Fig 3.9 Residuals of nominal exchange rate of India

Similarly, PACF lags off after lag 2 in Fig 3.9. ACF plots significantly cut off after lag 4. Hence this could
be modeled as a MA(4) process.

Fig 3.10: (in blue) Smooth probability of high volatility state

 Fig 3.11:
(in red) Real foreign exchange rate of countries with time

Table 5: Transition probabilities and expected durations

P11 P12 P21 P22 DU1 DU2 RCM

Oman 0.90726049 0.000001 0.09273951 0.999999 1.08E+01 1.00E+06 4.528613
Dubai 0.3124593 0.1476469 0.6875407 0.8523531 1.454459 6.772915 44.69731
India 0.999999 0.01027327 0.000001 0.98972673 1.00E+06 9.73E+01 0.225248

The Markov Switching Model model works well for Oman and India as specified by the low RCM value.
The RCM statistic was introduced in Ang and Bekaert (2002). RCM. Therefore, it is crucial if the RCM
value of the model tends to zero and smooth probability tends to one, respectively, to ensure noticeably
different regimes. RCM for Dubai signifies the lowest classification among all the countries.
Sigma in Table 4 refers to the standard deviation of each regime, namely S1 and S2. It shows the amount
of volatility, given by the standard deviation of every regime. The state which has the highest estimated
coefficient biomes the high volatility sate.
For Oman, S2 is the high volatility regime. For Dubai, S1 is the high volatility regime because its
coefficient is larger than that of the S2 regime. Similarly, for India, S1 is the high volatility regime and S2
is the low volatility regime. All sigmas are statistically significant. Smaller RCM implies clearer shifting
patterns between regimes (Basher et al 2016).
P11, P12, P21 and P22 are transition probabilities which signify how likely are regimes to change from 1
regime to another. The likelihood of transitioning from state l at time period t to state m at time period t +
1 is determined only by the state at time period t. P11 and P22 are constant regime probabilities- high
values here indicate a persistent regime. Here Oman and India have very high constant regime
probabilities. This means they are less likely to switch to the other regime.
DU1 and DU2 signify the expected duration a country is expected to stay in a regime. P11 and P22 for
Oman and India are high- this fact is further taken forward by the large DU1 and DU2 values for both
countries.
CONCLUSION

The residuals' significant and partial autocorrelation functions indicate that the data of foreign exchange of
India is MA. By calculating the cumulative total of deviations from the mean and comparing it to a
threshold value, the recursive CUSUM test can identify changes in the mean of a time series. The
CUSUM tests for stability measurement in the linear shows instability of oil shock effects on real foreign
exchange rate of India because of high p-values. All of the countries' regressions for the given variables
have very low R squared values in the linear model- this means that a non-linear relationship exists
between the parameters.
Volatility of regimes can be identified using sigma and RCM statistics. Transition probabilities and
Expected regime durations provide further insight into the same. The higher volatility regime can be
identified by which sigma coefficient is higher
Impact of oil shocks on real exchange rates were found via Markov Switching models, which has the
advantage of catching potential nonlinear exchange rate effects of oil shocks that linear models would
miss. The present analysis using the Markov Switching Model yields a number of significant discoveries.
The use of Markov-switching regime models first supports the underlying nonlinearities between oil
shocks (demand and supply) and the actual exchange rate by having two regimes that import oil here in
the context of India during Covid-19 era. With respect to India, the S1 regime contains significant
appreciative pressures through Supply shocks and significant depreciative measures through Oil Price
Shocks (as expected from an oil importing country).

Many variables that impact exchange rates in reality are there but this analysis has assumed a large part of
them to be ceteris paribus, such as the effects of monetary and fiscal policies across nations, a nation’s
openness to trade and financially interact with various nations, nonlinear models that could be present
(like stickiness of wages downward), and their exchange rate models (fixed or floating), which can be
found in the product and labor markets are just a few of the variables that have an impact on exchange
rates in practise.
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