Oil Price Volatility And Sectoral Returns Uncertainties: Evidence From A Threshold Based Approach For The Australian Equity Market

This paper examines the existence of a non-linear relationship between oil price volatility and equity market uncertainty. The study specifically analyses the pattern of effects of oil price volatility on the broader equity market as well as the sectoral equity returns volatility within Australian Economy. We use a logistic transition based autoregressive model (LSTR) developed by Terasvirta and Anderson (1992) and Terasvirta, (1994). We find that the hypothesis of linearity between oil price volatility and equity market uncertainty is rejected for six out of 10 sectors of the Australian economy. The retention of LSTR model suggests that the oil return volatility has high and low regimes that affect equity markets differently across the sectors. The transition functions suggest that switching of oil price volatility from low to high regime is abrupt for consumer discretion, financial and material sectors while such transition is smooth for consumer staple, energy, and industrial sectors. The results also show that some sectors are quicker in responding to heightened volatility. From the VAR framework, the impulse response functions show that a one period increase or a shock in oil price volatility raises volatility of equity in consumer discretion, consumer staple, finance, industry, telecom and consumer staple sectors. Of these, equity volatility in industries and financial sectors seem to exhibit a prolonged positive response following the oil price volatility shock. Also, equity volatility of industries seems to rise by much larger proportion compared to the equity volatility response of other sectors. These findings are helpful as a guide for sectoral rotation strategies. In view of the increased volatility of oil prices due to a negative impact of oil price shock and the resultant surge of uncertainty, Australian firms could formulate their short and long run investment plans based on volatility threshold level. Firms in consumer discretion, financial and industrial sector could consider postponement of investment if the volatility in oil price exceeds certain threshold. Also, firms in the consumer staple, energy and materials industry need to make prudent business decisions in situations where oil price volatility falls within the threshold range as identified by the LSTR2 models. Based on the findings, there is a need for public policy formulation to reduce the adverse impacts of increased oil price uncertainties on the Australian economy during periods of unforeseen random events including depressions and crises.