Global financial cycle and the predictability of oil market volatility: Evidence from a GARCH-MIDAS model

Abstract

This study examines the predictive power of the global financial cycle (GFCy) over oil market volatility using the GARCH-MIDAS framework. The GARCH-MIDAS model provides an appropriate setting to forecast high frequency oil market volatility using global predictors that are only available at low frequency. We show that the global financial cycle carries significant predictive information over both oil market volatility proxies, both in- and out-of-sample. The predictive relationship is found to be positive, more strongly during the pre-GFC period, suggesting that rising global asset prices coupled with improved cross-border capital flows and risk appetite are associated with rising volatility in the oil market. Further economic analysis suggests that the GARCH-MIDAS-GFCy model yields economic gains compared to the conventional GARCH-MIDAS-RV specification for a typical mean-variance investor, especially in the pre-GFC period, and the stance is found to be robust to risk aversion and leverage ratio. The economic gains observed from the GARCH-MIDAS-GFCy model, particularly during the pre-GFC period when world markets experienced a steady rise in global asset prices and cross-border capital flows, underline the potential role of risk appetite (or behavioural factors) in commodity market forecasts. Overall, our results suggest that global asset market conditions can provide significant forecasting gains for energy market models, with significant implications for both investors and policymakers.