Risk appetite and oil prices

Abstract

We demonstrate that oil prices and their volatility are no longer determined solely by real economic shocks to supply of and demand for oil, but are also driven by shocks originating in the economic uncertainty and risk appetite of investors that prevail in the equity market. The contribution of the latter factor has become particularly remarkable since the mid-2000s. To establish these results, we dismantle the squared VIX index, determined in the S&P 500 options market, into the conditional variance in stock returns (to proxy for economic uncertainty) and the equity variance risk premium (to proxy for risk appetite). Using threshold-GARCH, structural vector auto regression and causality models, we provide evidence about the link between risk appetite, oil price returns and volatility. Furthermore, investors' appetite for risk drives changes in the OVX, which measures perceptions about future oil volatility, but not vice versa. Our results provide a better understanding of the relationship between oil, the VIX and its two proposed components. In particular, we show that changes in the risk appetite of investors are an important determinant not only for the price of equities but also for that of the most important energy resource – oil.