Oil price shocks and cost of capital: Does market liquidity play a role?

This paper provides novel perspective to the oil-stock market nexus by examining the role of stock market liquidity in the propagation of oil price shocks to the cost of capital (CoC) estimates from a set of 34 global economies. Utilizing implied cost of capital estimates that are extracted from a dividend discount model and disaggregated oil price shock series including oil supply, consumption demand, inventory demand and economic activity shocks, we show that oil price shocks have quite heterogeneous effects on equity financing costs across the world economies, depending on the nature of the shock and the time horizon. Our findings show that oil supply shocks have a consistent positive effect on CoC, particularly for emerging economies and net oil importers, suggesting that supply driven oil price uncertainty significantly raises firm level financing costs regardless of the level of market liquidity. Interestingly however, market liquidity takes on a significant role when interacted with oil consumption demand shocks, suggesting that the effect of oil demand shocks on firms' financing costs is transmitted via the liquidity channel. Considering that liquidity dry-ups can severely impact firm financing costs, our findings provide important insights to policy makers as demand driven oil market shocks present a double challenge via its effects on market liquidity dynamics, which in turn, can enhance the negative impact of these shocks on firm financing costs and corporate investment activity. Overall, the findings highlight the role of market liquidity in the propagation of oil price shocks to firm financing costs with significant implications for corporate managers and policy makers.