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Oil Price Shocks and Stock Market Performance in Emerging Economies: Some Evidence using FAVAR Models

Naser, Hanan and Ahmed, Abdul Rashid (2016): Oil Price Shocks and Stock Market Performance in Emerging Economies: Some Evidence using FAVAR Models.

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Abstract

This paper examines the response of real stock prices to oil price shocks for four selected emerging economies over the period January 1991–March 2011. To overcome the problem of omitted information in small-scale vector autoregression (VAR) models, we utilize the factor augmented vector autoregressive (FAVAR) approach proposed by Bernanke et al. (2005). Accordingly, we follow Stock and Watson (2002b) and extract two factors which are significantly related with a large set of world-level and country-specific macroeconomic variables. We use the extracted factors as regressors in recursive VARs to assess the response of stock prices to oil price shocks. Our results suggest that the response of stock prices to oil price shocks is quite persistent and precise, but asymmetric across all the four economies. Specifically, we observe that stock prices in Brazil and India respond negatively to oil price shocks, whereas the response of stock prices to oil price shocks in China is positive. We also observe that stock prices in Russia initially respond positively, however, the response becomes negative after four months. The impulse-response results indicate that the impact of oil price shocks on stock prices is smaller for China than that of for remaining three countries. Overall, our results suggest that the use of FAVAR approach allows us to obtained more coherent evidence on the effects of oil price shocks on stock prices by obtaining relatively more precise responses and by increasing the understanding of such shocks from the theoretical point of view.

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