Introduction
It is quite logical for a person to assume that when oil prices increase, the stock market will drop because of the negative correlation of the two variables. It makes sense that when oil prices increase, fuel will be expensive and therefore the cost of transportation, production, and expenses on heating will be costly. These effects will be transferred to the corporate earning making them low. The increase in fuel prices can as well cause concerns of inflation and therefore restrict clients’ optional purchases (Henriques and Sadorsky 452). On the other hand, the costly crude oil can be associated with a booming economy as higher prices could be an indication of strong business performance and an increase in fuel demand.
Purpose of Study
To allow researchers to speak in one voice and offer widely acceptable and conclusive results of the connection between oil prices and stock markets, this paper will correct the limitations in past studies (Sadorsky 452). This is a fresh look at the question of whether oil prices are negatively correlated with the stock market prices (Park and Ratti 2592) to enable business managers to understand stock markets price dynamics about oil price (Huang et al 4).
Literature Search
Literature offers a contradictory conclusion on the effect that oil prices have on stock markets. Even though the changes in the prices of fuel are mostly considered an important variable incomprehension of the fluctuations in stock prices, researchers and scholars have failed to agree on the type of association that exists, whether it’s a positive correlation or a negative correlation (Kilian 17). From the study by Kilian, she cites several pieces of literature with mixed findings. For instance, Kilian studies show that crude oil price increases caused a decline in the stock market (Kilian 17). Chen, Roll, and Ross, on the other hand, found that oil price changes did not have any significant impact on the prices of assets, Jones and Kaul on the other hand show that there was a negative correlation between the stock returns and oil prices.
Methodology
As mentioned earlier, this is a fresh look at a question that has extensively been researched. However, certain limitations have probably resulted in the contradicting result of the previous results. It’s these limitations that this methodology will correct and then derive a proper design of studying the relationship between oil prices and stock market prices (Kilian 17). The first limitation has been to hold other factors constant while varying the oil price. Second, researchers assumed that even when they controlled reverse causality, the current model shows that the impact of exogenous factors like an increased oil price was the same, despite the type of underlying shock in the oil market responsible for causing the increase of the oil price (Kilian 17).
This research shall address the limitations by employing a structural VAR MODEL which measures the way the US stock market variable relates with the demand and supply shock on the international oil market.
Empirical Analysis
There are several questions that this study will seek to answer. This search will offer a direct answer to why the stock market of the previous years has been surprisingly resilient to higher pieces of oil. Whether or not there exist a stable negative relationship between oil prices and the stock market and then how important was the connection (Pescatori and Mowry para. 4). This will help to understand why current empirical results where the reduced-form regression offered mixed results.
References
Henriques, Irene and Sadorsky, Perry. Oil Prices And The Stock Prices Of Alternative Energy Companies. Enery Economics 21.5(2008): 449-469
Huang, Roger, Masulis, Ronald and Stoll, Hans. Energy Shocks and Financial Markets. Journal of Futures Markets, 16.1(1996): 1-27
Kilian, Lutz. The Impact Of Oil Price Shocks On The U.S. Stock Market. International Economic Review, 50(2009):1-40
Park, Jungwook and Ratti, Ronald. Oil Price Shocks And Stock Markets In The U.S. And 13 European Countries. Enery Economics, 21.5(2008): 2587-2608
Pescatori, Andrea and Mowry, Beth. Do Oil Prices Directly Affect The Stock Market? Economic Trends. 2008. Web.
Sadorsky, Perry. Oil Price Shocks and Stock Market Activity. Enery Economics, 21.5 (2009): 449-469