Abstract
his study examines (i) the dynamic shocks and volatility interactions between each of the eleven U.S. economic sectors and the oil market; (ii) riskminimizing optimal capital allocations between each sector and oil; and (iii) the hedging effectiveness resulting from the inclusion of oil in each sector portfolio. Using weekly data spanning the period June 1994 through February 2016, we document the following regularities: (i) the conditional correlation between each sector and the oil market is time-varying and slowly decaying; (ii) there is either volatility or shock transmission from oil to each sector but not the reverse; and (iii) investors can minimize and hedge risk by allocating a portion of their wealth to oil commodities and forming a portfolio consisting of sector stocks and oil commodities. however, they will need to overweight their investment in sector stocks. Our findings indicate that oil commodities offer diversification potential to U.S. investors holding sector portfolios such as sector ETFs and mutual funds. Further, the risk parity portfolio weights significantly differ from the capital allocation weights.
Highlights
The increase in integration and volatility of financial markets has made equity and oil prices increasingly sensitive to innovations such as deregulation, political instability, political-economic events, financial crashes, and investors' psychological expectations (Yu et al 2008)
Using the Tse (2000) test, we examine whether the correlation between oil price changes and sector returns is constant, with the null hypothesis being that there is Constant Conditional Correlation (CCC)
This study investigates volatility and shock interactions between each U.S sector equity index and the oil market using the newly developed EDCCGARCH model
Summary
The increase in integration and volatility of financial markets has made equity and oil prices increasingly sensitive to innovations such as deregulation, political instability, political-economic events, financial crashes, and investors' psychological expectations (Yu et al 2008). The financialization of oil commodities through the creation of oil futures, options, and swap agreements has attracted global investors who are increasingly interested in holding oil-based financial instruments as investments, contrary to oil’s traditional role of hedging risk and supporting “real” economic activity (Vivian and Wohar, 2012). This development has increased liquidity as well as volatility in the oil market. There are volatility and shock interactions between the oil and equity markets
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