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Links Between Oil Prices And Macroeconomic Variables Finance Essay

CHAPTER 1

Throughout the history, Oil has played a critical role to shape countries development since effect of oil prices on a country’s economy has been and continuous to be keen interest from many people particularly economist. Given the importance of oil and the attention of oil prices receive in the financial press, a considerable economic literature has been devoted to study the impact of oil prices on macroeconomic variables such as inflation, growth rates and exchanged in one country ( e.g. Hamillton, 1983; Hooker, 1996; Eltony & Al-Wadi, 2001 and Keane & Prasad, 1996) Despite the documentation that oil price shocks have significant effects on the real economy.

In recent years, a large body of literature has focused on the links between oil prices and macroeconomic variables. It has confirmed that oil price fluctuations have significant effects on economic activity in many developed and emerging countries Cunado & Garcia, 2005; Balaz & Londarev, 2006; Gronwald, 2008; Cologni & Manera, 2008 and Kilian, 2008.

While a large body of empirical research has focus on the relationship between economic activity and oil price changes, few studies have been conducted on the relationship between financial markets and oil prices and those are mainly for few developed economies such as USA and UK, John & Kaul, 1992; John & Kaul, 1996; Huang, 1996; Gjerde & Saettem,1999.

Jones and Kaul (1992) examine the effect of oil prices on stock prices in the USA and finds that there are an effect of oil prices on aggregate real stock returns, including a lagged effect, in the period 1947 to 1991.

In a more recent study, Jones and Kaul (1996) test whether the reaction of international stock markets to oil prices can be justified by current and future changes in real cash flows and/or changes in expected returns. In contrast, the results for both the UK and Japan are not strong. In an important study, Huang et al. (1996) examine the link between daily oil future returns and daily US stock returns.

The evidence suggests that oil futures returns do lead some individual oil company stock returns but do not have much impact on general market indices. Gjerde and Saettem (1999) demonstrate that stock returns have a positive and delayed response to changes in industrial production and that the stock market responds rationally to oil price changes in the Norwegian market.

Since the bulk of what little work has been done has focused on stock markets in developed countries, very few studies have looked at the stock markets in emerging economies. Recent papers of oil prices effect on stock market distinguished between developed and emerging market response to the change in oil prices. Basher and Sadorsky (2006) stated that emerging economies are less able to reduce oil consumption and thus these countries are more energy intense and more exposed to oil price than more developed economies. Therefore oil price changes are likely to have a greater impact on profits and stock prices in emerging economies.

Maghyereh (2004) examines the relationship between oil prices and stock market return for 22 emerging economies for the period from 1998 to 2004 and concludes that the higher the country energy intensity consumption, the higher the response to oil prices. This result is been explained based on the efficient market hypothesis. Stock markets return in the emerging countries do not rationally signals changes in crude oil price.

There are also studied conducted in the Middle East country by Priftakis & Bhatti (2008) where examine the relationship or any linkages of oil price to the stock markets to the selected five oil producing countries in the Middle East. The paper use two methodologies to test for the presence of a co integrating relationship between two variables. Then the result from the co integration suggest that UEA stock market is co integrated in the short run model and co integration existed in the long run relationship for both the UEA and Saudi Arabia. Thus, a relationship may exist between oil price and the stock prices for these two countries. This study proves that maybe the effect of oil price is not the most important influence on the movement of the stock market indices in the five oil dependent countries.

There has been little studies done relating the relationship between oil price and the stock market index, yet still uncertain, in fact unproven, if oil price contributed to the movement in the stock markets in an important way, Priftakis and Bhatti ( 2008). Due to that, this study is focusing and elaborate more on the effect oil prices to stock market in the focusing countries such as Bahrain, Kuwait and Qatar where this dependent countries are mostly depend on the oil. This study would elaborate more on the whether if there are strongly linkages between oil price and stock market.

1.2 Background of Market

1.2.1 Background Qatar Exchange Market

The Qatar Exchange (formerly known as Doha Securities Market) is the principal stock market of Qatar. The market was founded in 1997 and it is located in the capital city of Doha. Its name is abbreviated to DSM. NYSE Euronext owns 20% of DSM. The market currently has 44 listed companies. Then in June 2009, the market was changed into a shareholding company named the Qatar Exchange. Qatar Exchange (QE) was created on June 19, 2009 and is the successor of Doha Securities Market.

The market established in accordance with Decree Law (14) for the year 1995 and commenced operations in May 26, 1997.  At the time of inception, seventeen companies were listed on the market with a QR 6 billion in total market capitalization and five brokerage firms were licensed in order to conduct brokerage business. Before market inception, share trading was performed by a number of unlicensed brokerage firms.

The market has entered into a new phase at the time when Law # 33 for the Year 2005 was issued.  The new phase resulted in transforming Doha Securities Market (DSM) into a shareholding company-named Qatar Exchange (QE).

1.2.2 Background Kuwait Exchange Market

The Kuwait Stock Exchange (KSE) is the national stock market of The State of Kuwait. Although several share holding companies (such as NBK in 1952) existed in Kuwait prior to the creation of the KSE, it was not until October 1962 that a law was passed to organize the country's stock market.

The Kuwait Stock Exchange enjoys an independent judicial personality with the right of litigation in a mode facilitating the performance of its functions for the purpose of realizing the objectives of its organization in the best manner within the scope of regulations and laws governing the Stock Exchange operations.

The Stock Exchange within its activity act to direct and rationalize dealing in stocks and securities, within the scope of its powers in order to develop and stabilize dealing in securities in a manner securing safe, easy and accurate transactions so as to avoid any confusion in dealings.

1.2.3 Background Bahrain Market

The Bahrain Stock Exchange (BSE), was established in 1987 by Amiri Decree No.(4) and officially commenced operations on June 17, 1989 with twenty-nine listed companies. Currently, there are 50 companies listed on the exchange.

The BSE operates as an autonomous institution supervised by an independent Board of Directors, chaired by the Governor of the Central Bank of Bahrain.

The BSE has pre-market sessions from 09:15am to 09:30am and normal trading sessions from 09:30am to 12:30pm on all days of the week except Saturdays, Fridays and holidays declared by the Exchange in advance. There are three indices that track the BSE, The Bahrain All Share Index, The Dow Jones Bahrain Index and the Estirad Index.The emergence of the capital markets sector in the Kingdom of Bahrain dates back to 1921 following the establishment of the first branch of a commercial bank (Standard Chartered Bank).

In 1957, the first Bahraini Public Shareholding Company was established. Since then, more local public shareholding companies began to operate, reaching their peak in the beginning of the 1980’s.

The Exchange officially commenced operations in June 1989. The establishment of the Exchange enhanced the investment environment in Bahrain’s capital market sector, increasing the number and type of investment instruments registered at the BSE.

1.3 Problem Statement

Most of the studies more considering on the effect of the oil prices in the macroeconomic factor such as Recent stock prices relationships between Japanese and US stock market by Kurihara (2006) where examine empirical analysis of the relationship between recent Japanese stock prices and macroeconomic variables under the quantitative easing policy in Japan.

Then the other study also indicate similar research by Coleman(2008) where explaining how macroeconomic indicators effect the performance stock market using Ghana Stock Exchange as a case study. There are little study been done relating the relationship between oil price and the stock market index, yet it is still uncertain and unproven whether oil prices contribute in important way to the stock market, Priftakis and Bhatti,(2008) where the results rejects convincingly that there is no linkage between the prices of oil and stocks market prices in five oil dependent countries namely Kuwait, Oman, United Arab Emirates(UAE), Qatar and Saudi Arabia.

Thus, this study are been carried out to identified is there any relationship between oil prices changes to stock market in the Middle East countries namely Bahrain, Kuwait, and Qatar.

1.4 Objective Of The Study

The purpose of this study is to investigate the effect of oil price to the stock market return of emerging market in the Middles East countries where specifically are:

I. To investigate the effect of oil price to the stock market in Bahrain

II. To identify the effect of oil price to the stock market in Kuwait

III. To analyze the effect of oil price to the stock market in Qatar

1.5 Research Question

Thus, in order to answer the question:

I. Is there any effect of oil price fluctuation to stock market in Bahrain?

II. What is the effect of oil price change to stock market in Kuwait?

III. Is there any effect of oil price to stock market in Qatar?

1.6 Scope Of The Study

This study focuses only on the affect of the oil price to the stock market in the Middle East countries. These studies focused only 3 countries namely Bahrain stock market, Kuwait stock market, and Qatar stock market. The weekly price returns from year 2006 to 2010 is been reached for this study.

1.7 Limitation of Study

The biggest obstacle in conducting this research is the time that has been given to finish it. The time that has been given is about 4 month ; it is hard to make a very precise outcome about the topic in that period of time. With the time obstacle it will be more complicated to do this research when during this time researcher also has to do the internship program. This has made the really time that have to conduct this research less than 4 month.

Although the ways to do research have done by student in their study in research methodology and report writing, they still have difficulties in doing the research; therefore the role of advisor is important during this time. Unfortunately because of the internship program, it become hard to get an advice from lecturer because researcher is far away from the advisor and correction only can made when we have appointment with advisor. This has make the researcher are not fully understand what is wrong in their research.

Besides that, all the data is based on secondary data that have been publish, therefore all the method will use is base on these data.

1.8 Significant Of Study

Oil price is an important variable, which acts as a conduit through which the real exchange rates and domestic stock prices are linked, thus the study about it is been useful to policy makers, government agencies, all market participant such portfolio manager, investor and lastly finance literature that concern on the fluctuation of oil price to stock market.

Policy makers could manage the economy and further help develop stock markets more efficiently by managing macroeconomic variables that impact on the stock markets effect on the changes of prices levels on their own economies and stock markets. Besides that, government policy makers may play a role in influencing real exchange rates and stock prices through the use of oil prices, as the countries in this sample are among the biggest oil producers in the world.

Furthermore, empirical finding prove extremely useful to investors who need to understand the exact effect of international oil price changes on certain stocks across industries as well as for managers of certain firms who need a more thorough evaluation about the efficiency of hedging policies affected by oil price changes. The used of information on macroeconomic can help market traders and money market analysts manage better on their portfolio.

Lastly, these information could be useful to the finance literature since the findings could be apply in order to predict the effect of oil prices to stock market especially in Bahrain, Kuwait and Qatar.

1.9 Research Structure

This research is organized into five main chapters. Chapter One contain the introduction of this study; it explain the background of the study, problem statement, listing of the objective of study and research question, discuss about the scope of the study, significant of study, limitation of this study and also the research structure. In Chapter Two, present review of literature on the evolution of previous research and theories related to it. Chapter Three presents the research methodology employed. This includes the development and procedures of this research. Following that, Chapter Four present the result, and data analysis of the study. Finally, Chapter Five will be covered the discussion on the findings and concludes with the recommendation for the future research.

CHAPTER 2

LITERATURE REVIEW

2.1 Introduction

This chapter will be summarize the previous research that relate to this study about relationship between oil price and market return where had has been investigated by a number of researchers. This part will be divided by three main points which are studied in developed country, developing country and also across other region as well.

2.2 Research effect oil price to stock market in developed countries.

Nicholas and Stephen (2009) investigates how explicit shocks that characterize the endogenous character of oil price changes affect stock market return in Australia, Canada, France, Germany, Italy, UK and US. These countries uses the vector error correction (VEC) or vector autoregressive model as appropriate by collecting monthly data on goods prices(P). The results show that different oil market structures shock market returns. The International stock market returns do not respond in a large way to oil market shocks since the significant effect that exist proves small in magnitude.

Sardosky (1999) investigate the dynamic interaction between oil price also finds that oil price and other economic variables including stocks returns using US data and he finds that oil price change and oil price volatility have a significant negative impact on real stock return. The study also finds industrial production and interest rate responses positively to real stock return shocks.

Ramon and Gabriel (2005) tried to study which variables reacts more rapidly to changes in oil price either industrial production or stock return by developing a Markov switching model. The finding shows that an increase in oil price has a negative effect on industrial production and on stock market.

Stock market reacts more rapidly than industrial production to raise in oil price, but in the long period, the effect on industrial production will be higher than on stock return.

Jones and Kaul (1992) examine the effect of oil prices on stock prices in the USA. They find an effect of oil prices on aggregate real stock returns, including a lagged effect, in the period 1947 to 1991. In a more recent study, Jones and Kaul (1996) test whether the reaction of international stock markets to oil prices can be justified by current and future changes in real cash flows and/or changes in expected returns. They find that in the postwar period, the reaction of US and Canadian stock prices to oil shocks can be completely accounted for by the impact of these shocks on real cash flows.

Park and Ratti (2008) examine Oil price shocks and stock markets in the U.S. A multivariate VAR analysis is conducted with linear and non-linear specification of oil price shocks. Oil price shocks have a statistically significant impact on real stock returns contemporaneously and/or within the following month in the U.S. over 1986 to 2005.

Recent contributions finding significant effects of oil price shocks on macroeconomic activity for most countries in their samples include Cologni, Manera & Kilian, 2008 on the G-7; Rodriguez & Sanchez, 2005 for G-7 and Cunado & Garcia, 2005 for Asian countries. Jones and Kaul (1996) find that oil price increases in the post war period had a significantly detrimental effect on aggregate stock returns.

Sadorsky (1999) reports that oil price increases have significantly negative impacts on U.S. stocks and that the magnitude of the effect may have increased since the mid

1980s. Ciner (2001) concludes that a statistically significant relationship exists between real stock returns and oil price futures, but that the connection is non-linear.

In contrast, Huang et al. (1996) do not find a significant connection between daily price of oil futures and general U.S. stock returns.

Burbridge and Harrison (1984) examined the impact of oil price shocks on some macroeconomic variables in the USA and Canada. Using VAR models they show that the 1973-1974 oil embargo explains a substantial part of the behavior of industrial production on each of the countries examined. However, for the oil price changes in 1979-1980 they find little evidence that the changes in oil prices had effect on industrial production.

Nicholas and Stephen (2009) investigate how explicit shocks that characterize the endogenous character of oil price changes affect stock market return in France, Germany, and Italy. These countries uses the vector error correction (VEC) or vector autoregressive model as appropriate by collecting monthly data on goods prices(P). The results show that different oil market structures shock market returns. The International stock market returns do not respond in a large way to oil market shocks since the significant affect that exist proves small in magnitude.

Park and Ratti (2008) examine Oil price shocks and stock markets in the 13 Europe countries where a multivariate VAR analysis is conducted with linear and non-linear specification of oil price shocks. Oil price shocks have a statistically significant impact on real stock returns contemporaneously and/or within the following month in the these 13 Europe over 1986 to 2005.

In the other hand, Papapetrou (2001) analyst Oil price shocks, stock market, economic activity and employment in Greece by using a multivariate vector-autoregression (VAR) approach, this paper attempts to shed light into the dynamic relationship among oil prices, real stock prices, interest rates, real economic activity and employment for Greece. The empirical evidence suggests that oil price changes affect real economic activity and employment. Oil prices are important in explaining stock price movements. Stock returns do not lead to changes in real activity and employment. The results suggest that a positive oil price shock depresses real stock returns.

Recent contributions finding significant effects of oil price shocks on macroeconomic activity for most countries in their samples (Cologni,2008; Manera, 2008; and Kilian, 2008) on the G-7.While Jimenez-Rodriguez and Sanchez (2005) for G-7 and Norway.

Burbridge and Harrison (1984) examined the impact of oil price shocks on some macroeconomic variables in the UK and Germany. Using VAR models they show that the 1973-1974 oil embargo explains a substantial part of the behavior of industrial production on each of the countries examined. However, for the oil price changes in 1979-1980 they find little evidence that the changes in oil prices had effect on industrial production.

Aloui and Jammazi (2009) tried to examine the relationship between crude oil shocks and stock market returns of UK and France. The sample period covers in monthly frequency, January 1989 to December 2007 by using the MS-EGARCH and NOPI models. Their findings show oil price increases are statistically correlated to real equity returns. Real stock returns display significant evidence of regime switching.A multi-factor model was employed to investigate the relationship between oil pricing risk and the equity returns earned by UK-listed oil and gas firms, Sharif, Brown, Burton, Nixon and Russell (2005). The results indicate that oil and gas stock returns are impacted by several risks factors, namely: changes in crude oil prices, the stock market as a whole and the exchange rate. A rise in oil prices or equity market as a whole tends to increase the return on the UK oil and gas equity index while an increase in the US $ exchange rate typically decreases the return.

2.3 Research effect oil price to stock market in developing countries

ElAnashasy (2006) examined the effects of oil price stocks on Venezuela’s economic performance over 1950 to 2001. They investigated the relationship between oil prices, governmental revenues, government consumption spending, GDP and investment by employing a general to specific modeling (VAR and VECM). They found two long run relations consistent with economic growth and fiscal balance. Furthermore, they found that this relationship is important not only for the long run performance but also for the short run fluctuations.

Its shows that many researchers were focus on the developed countries. Since there are many activity that are connected with the oil price in developed country compare to developing country. So the investigation on the oil prices to stock market in emerging country still in a smaller amount therefore a study about this topic is important in order to get a better understanding about oil price toward developing country.

Jin (2008) discovered that the oil price increases exerts a positive impact on economic growth of Russia by using the real GDP of Russia, the real effective exchange rate and the international price of crude oil.

This paper was examined the impact of oil price shock and exchange rate volatility on economic growth. Specifically, a 10% permanent increase in international oil prices is associated with a 5.16% growth in Russian GDP.

Raguindin and Reyes (2005) examined the effects of oil price shocks on the Philippine economy over the period of 1981 to 2003. Their impulse response functions for the symmetric transformation of oil prices showed that an oil price shocks leads to a prolonged reduction in the real GDP of the Philippines. Conversely, in their asymmetric VAR model, oil price decreases play a greater role in each variable’s fluctuations than oil price increases.

Besides that, Nandha (2007), was examine the relationship between beta risk and realized stock index return in the presence of oil and exchange rate sensitivities for 15 countries in the Asia Pacific region which is including Australia, China, Hong Kong, India, Indonesia, Japan, Malaysia, New Zealand, Pakistan, Philippines, Singapore, South Korea, Sri Lanka, Taiwan and Thailand . By using sample period for all the financial and oil variables is weekly and covers the period 05/04/1994 until 30/06/2004, the results of Mohan N.’s paper shows that only the Philippines and South Korea are oil sensitive to changes in the oil price in the short run,

when the price is expressed in local currency only. His also mentioned that basically no country shows sensitivity to oil prices measured in US dollar regardless whether the oil market is up or down.

Raguindin and Reyes (2005) examined the effects of oil price shocks on the Philippine economy over the period of 1981 to 2003. Their impulse response functions for the symmetric transformation of oil prices showed that an oil price shocks leads to a prolonged reduction in the real GDP of the Philippines. Conversely, in their asymmetric VAR model, oil price decreases play a greater role in each variable’s fluctuations than oil price increases.

Several researchers used the data to apply different multiple regression models. The main difference therefore for this study is that Panos and Bhatti (2008) uses new methodologies which is unobserved-components model for measuring the linkage between of oil price and stock markets of the selected five countries such as Kuwait, Oman, United Arab Emirates (UAE), Qatar and Saudi Arabia. The results rejects convincingly that there is no linkage between the prices of oil and the stock market prices in these oil based economies.

Hammoudeh and Eleisa (2004) study the relationship between oil prices and stock prices for five members (Bahrain, Kuwait, Oman, Saudi Arabia, and the United Arab Emirates) of the Gulf Cooperation Council (GCC). Using daily data they find that only the Saudi Arabia stock market has a bi-directional relationship between oil prices and stock prices.

On the other hand, other study proves inverse conclusion. Fayoumi (2009) examines the relationship between changes in oil prices and stock market return in three oil importing countries namely Turkey, Tunisia and Jordan. These countries are different from the other Middle East countries especially Gulf Cooperation Council (GCC) since they are oil net importers thus oil price change are likely to have greater impact on profit and stock prices. Monthly data from December 1997 to March 2008 together with co-integrated system in a Vector Error Correction Model (VECM) been carried out. Based on the result, not supported that oil prices lead to changes in stock market return. The study evidencing macroeconomic variables are more strongly affected the stock return compared with oil price.

Maghyereh and Ahmad ( 2007 ) whose examine the linkages between oil prices and stock market in the Middle East countries specifically in GCC countries which are Oman, Bahrain, Kuwait and Saudi Arabia. This study employs newly developed techniques of rank tests of nonlinear analysis. Since the data were selected on these four GCC market, all were collected piece by piece directly from individual exchange and encompass the period 1 January to 31 December 2003. The results show that no relationship between oil prices and the GCC stock market returns, which is against the important of the oil prices on the economy of these countries. This argues that the conclusion is due to the fact that they focus solely on linear dependences but empirical analysis supports that oil price impacts the stock price indices in GCC countries is in a nonlinear fashion. Thus, the statistical analysis in this paper obviously supports a nonlinear modelling of the relationship between oil and the economy, which is consistent with some authors, such as Mork (1989), Mork et al. (1994), and Hamilton (1996, 2000).

Adjasi ( 2009) has been examine Macroeconomic uncertainty and conditional stock- price volatility in frontier African markets evidence from Ghana. This emerging market in Africa. There is negative and significant volatility from gold prices, oil prices and money supply to the stock price. High uncertainty in these variable reduce volatility on the stock market.

2.4 Study Across Region

On the issue of the effect of oil price shocks on stocks market returns (John & Kaul,1996; Sadorsky, 1999; and ciner, 2001) report a significant negative connection, while (Chen,1986; and Huang et al, 1996) do not.

A negative association between oil price shocks and stock market returns has been reported in several recent papers. Nandha and Faff ( 2008) find oil prices rises have a detrimental effect on stocks in all sectors except mining and oil and gas industries.

O’ Neill ( 2008) find that oil prices increases lead to reduced stock return in United States , United Kingdom and France, and Park and Ratti (2008) report that oil price shocks have a statistically significant negative impact on real stock return in the US and 12 European oil importing countries. In new strands in the literature , Killian and Park ( 2007) report that only oil price increase driven by precautionary demand for oil over concern about future oil supplies negatively affect stock prices.

Hong ( 2002) also identify a negative association between oil price return and stock market return. Pollet(2002) and Driesprong (2003) find that oil price changes predict stock market returns on a global basis while Hammoudeh and Eleisa (2004) also discovered the importance of the oil factor for stock price in certain oil exporting economies. El syarif (2005) through a sector based analysis investigate the relationship between oil prices and stock return listed in the London Stock Exchange. The empirical findings display that a significant positive association between oil prices and oil related stock returns is present.

2.5 Conclusion

From the above past literature, it can be concluded that most of the studies show that Oil Price was not significantly affect the stock market return. Oil Price shocks statistically significant impact on real stock returns on developed countries compared developing countries. Thus, there are little evidence of asymmetric effect for the oil developing countries especially importing European countries.

This shows that Oil Price only effect the exporter countries which from developed countries compared emerging countries since there are small in portion. Besides that, the study evidencing macroeconomic variables such as inflation, interest rate and exchange rates are more strongly affected the stock market return compared with Oil Price .

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