Financial and Oil Market’s Co-Movements by a Regime-Switching Copula

Abstract

Over the years, oil prices and financial stock markets have always had a complex relationship. This paper analyzes the interactions and co-movements between the oil market (WTI crude oil) and two major stock markets in Europe and the US (the Euro Stoxx 50 and the SP500) for the period from 1990 to 2023. For that, I use both the time-varying and the Markov copula models. The latter one represents an extension of the former one, where the constant term of the dynamic dependence parameter is driven by a hidden two-state first-order Markov chain. It is also called the dynamic regime-switching (RS) copula model. To estimate the model, I use the inference function for margins (IFM) method together with Kim’s filter for the Markov switching process. The marginals of the returns are modeled by the GARCH and GAS models. Empirical results show that the RS copula model seems adequate to measure and evaluate the time-varying and non-linear dependence structure. Two persistent regimes of high and low dependency have been detected. There was a jump in the co-movements of both pairs during high regimes associated with instability and crises. In addition, the extreme dependence between crude oil and US/European stock markets is time-varying but also asymmetric, as indicated by the SJC copula. The correlation in the lower tail is higher than that in the upper. Hence, oil and stock returns are more closely joined and tend to co-move more closely together in bullish periods than in bearish periods. Finally, the dependence between WTI crude oil and the SP500 stock index seems to be more affected by exogenous shocks and instability than the oil and European stock markets.