A comprehensive empirical analysis of the predictive impact of the price of crude oil on aggregate equity return volatility

Given the impact of changes in the price of crude oil on expected cash flows, rate of interest and inflation as well as investors’ increasingly utilization of crude oil as a financial asset, it is reasonable to suspect that we could substantially improve the accuracy of equity return volatility forecasts by conditioning on the price of crude oil. To evaluate this hypothesis, we carry out an out-of-sample forecasting study for monthly aggregate equity return realized volatility using an autoregressive benchmark and alternative specifications that employ the price of crude oil. Our approach also takes into account the possibility that relative predictive performance changes over the out-of-sample. Several interesting findings are unraveled: First, there is evidence of threshold nonlinearity in forecasting. Second, this statistical evidence also results in economic gains. Third, the evidence of predictability is strong at long forecast horizons while somewhat weak one-month ahead. Fourth, the predictive power associated with certain nonlinear crude oil price measures concentrates from the onset of the Great Recession and onwards.