Oil Prices Implied Volatility or Direction: Which Matters More to Financial Markets?

Abstract

We examine the impact of oil price uncertainty on U.S. stock returns by industry using the United States Oil Fund options implied volatility OVX index and a GJR-GARCH model. To do so, we test the effect of the implied volatility of oil on a wide array of domestic industries’ returns using daily data from 2007 to 2016, controlling for a variety of variables such as aggregate market returns, market volatility, exchange rates, interest rates, and inflation expectation. Our main finding is that the implied volatility of oil prices has a consistent and statistically significant negative impact on eight out of ten industries. Oil prices, on the other hand, yield mixed results with only three industries showing a positive and significant effect, and two industries exhibiting a negative and significant effect. These findings are an indication that the volatility of oil has now surpassed oil prices themselves in terms of their influence on financial markets. Furthermore, we show that both oil prices and their volatility have a positive and significant effect on corporate bonds credit spreads. Overall, our results indicate that oil price uncertainty increases the risk of future cash flows for goods and services, resulting in negative stock market returns and higher corporate bond credit spreads.