The predictive effect of risk aversion on oil returns under different market conditions

Abstract

This paper uses a new risk aversion index to investigate the predictive effect of risk aversion on oil returns under different market conditions. Moreover, we assess whether the US partisan conflict shapes the prediction of risk aversion for oil returns. Based on the quantile regressions of oil returns on lagged risk aversion changes, we find that risk aversion negatively predicts oil returns after oil financialization, and such a predictive effect is stronger under bearish market conditions. Also, we find that the negative predictive effect of risk aversion is weaker with increasing lags in bearish stages, but this negative effect does not last in bullish stages and even becomes positive at a longer lag. Finally, we find that the US partisan conflict mitigates the negative predictive effect of risk aversion on oil returns in the post-financialization period, and this mitigation is stronger in upward market conditions. Our findings provide novel insight into the determinants of oil prices from the perspective of investors' risk appetite.