Investing in energy: Can the crude oil market stabilize equity markets?

Abstract

Equity markets on the one hand and the crude oil market on the other do not operate in isolation. One way to assess the degree of interaction between markets is to measure return-to-volatility spillovers from one market to another. This approach leads to a network with markets as nodes and edge weights defined by spillovers. An interpretation of the network in terms of information flow provides a basis for the introduction of entropy concepts with the aim of assessing network stability, that is, the ability of the network to digest shocks. Considering a network of equity markets, the following question arises: Will the stability of a network of equity markets increase when the crude oil market is included as a further node? This question is obviously important for investors as well as for oil market regulators. We consider the example of Dow Jones (New York), FTSE (London), sx5e (euro area), SSEC (Shanghai), N225 (Tokyo), and WTI (West Texas Intermediate) crude oil, from 1997 through 2014.

Vector autoregressive models are fitted to series of daily price changes of stock indices and the crude oil price. Return-to-volatility spillovers are analyzed via forecast error variance decomposition (fevd). The resulting network structure is then characterized on the basis of entropy measures, which provide an assessment of network stability. Different network architectures --- with and without crude oil ---- are investigated.

It is found that crude oil has been able to increase equity market stability from about 2009 onwards. Investigating the role of the crude oil market as a news channel, we find that it can either mitigate news from other markets or act as a news source in itself, where the latter phenomenon predominates.

In certain circumstances, encouraging investors to consider investing in the crude oil market can have a stabilizing effect on markets. This may result in energy as well as equity markets being less vulnerable to shocks, and also in more stable investor portfolios.