Oil is the lifeblood of modern economies. As the countries speed up their pace of
modernization and urbanization, demand for oil rises significantly, indicating that
oil demand is highly correlated to economic growth, especially growth of industrial
sector. Therefore, understanding the relationship between changes in crude oil prices
and overall macroeconomic activity is of vital importance. Changes in world oil
prices affect macroeconomic costs in two ways: first, being an important input to
the production and consumer goods, a slowdown in economic activity takes place as
energy becomes more expensive. Second, rise in oil prices contributes directly to
the level of inflation, especially in energy-dependent economies, and its impact
over time is conditional on policy responses and supply-side management. On the
other hand, in modern and globalized economic scenario, stock markets are considered
to be the bellwether of macroeconomic activities.
There exist various transmission channels through which oil price fluctuations may
affect stock returns. On theoretical grounds, oil price changes affect stock market
returns or prices through their expected earnings (Jones et al., 2004). These expected
earnings or discounted cash flows reflect the economic conditions (e.g., inflation,
interest rate, production costs, income, economic growth, investors’ and consumers’
confidence) and the macroeconomic events that are likely to be influenced by oil
price changes or shocks (Park and Ratti, 2008). Accordingly, oil price changes may
have an impact on stock returns. Further, the impact of oil price fluctuations on
stock returns of oil importing and oil exporting countries is expected to be dissimilar,
as an increase in oil prices is considered good news in oil exporting countries
and bad news in oil importing countries; the reverse is expected when the oil price
decreases.
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